[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. 1.170 to 1.300)
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 (Continued) 3
Finding Aids:
Table of CFR Titles and Chapters........................ 1119
Alphabetical List of Agencies Appearing in the CFR...... 1139
Table of OMB Control Numbers............................ 1149
List of CFR Sections Affected........................... 1167
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Cite this Code: CFR
To cite the regulations in
this volume use title,
part and section number.
Thus, 26 CFR 1.170-0
refers to title 26, part
1, section 170-0.
----------------------------
[[Page v]]
EXPLANATION
The Code of Federal Regulations is a codification of the general and
permanent rules published in the Federal Register by the Executive
departments and agencies of the Federal Government. The Code is divided
into 50 titles which represent broad areas subject to Federal
regulation. Each title is divided into chapters which usually bear the
name of the issuing agency. Each chapter is further subdivided into
parts covering specific regulatory areas.
Each volume of the Code is revised at least once each calendar year
and issued on a quarterly basis approximately as follows:
Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1
The appropriate revision date is printed on the cover of each
volume.
LEGAL STATUS
The contents of the Federal Register are required to be judicially
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie
evidence of the text of the original documents (44 U.S.C. 1510).
HOW TO USE THE CODE OF FEDERAL REGULATIONS
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To determine whether a Code volume has been amended since its
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Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative
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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
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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
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PAST PROVISIONS OF THE CODE
Provisions of the Code that are no longer in force and effect as of
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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
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not dropped in error.
INCORPORATION BY REFERENCE
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This material, like any other properly issued regulation, has the force
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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
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(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
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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
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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.
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the revision dates of the 50 CFR titles.
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INQUIRIES
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The eCFR is a regularly updated, unofficial editorial compilation of
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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, Michele Bugenhagen 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. 1.170 to 1.300)
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Part
chapter i--Internal Revenue Service, Department of the
Treasury (Continued)...................................... 1
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CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
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SUBCHAPTER A--INCOME TAX (CONTINUED)
Part Page
1 Income taxes (Continued).................... 5
Supplementary Publications: Internal Revenue Service Looseleaf
Regulations System.
Additional supplementary publications are issued covering Alcohol and
Tobacco Tax Regulations, and Regulations Under Tax Conventions.
[[Page 5]]
SUBCHAPTER A_INCOME TAX (CONTINUED)
PART 1_INCOME TAXES (CONTINUED)--Table of Contents
Normal Taxes and Surtaxes (Continued)
COMPUTATION OF TAXABLE INCOME (CONTINUED)
Itemized Deductions for Individuals and Corporations (Continued)
Sec.
1.170-3 Contributions or gifts by corporations (before amendment by Tax
Reform Act of 1969).
1.170A-1 Charitable, etc., contributions and gifts; allowance of
deduction.
1.170A-2 Amounts paid to maintain certain students as members of the
taxpayer's household.
1.170A-3 Reduction of charitable contribution for interest on certain
indebtedness.
1.170A-4 Reduction in amount of charitable contributions of certain
appreciated property.
1.170A-4A Special rule for the deduction of certain charitable
contributions of inventory and other property.
1.170A-5 Future interests in tangible personal property.
1.170A-6 Charitable contributions in trust.
1.170A-7 Contributions not in trust of partial interests in property.
1.170A-8 Limitations on charitable deductions by individuals.
1.170A-9 Definition of section 170(b)(1)(A) organization.
1.170A-10 Charitable contributions carryovers of individuals.
1.170A-11 Limitation on, and carryover of, contributions by
corporations.
1.170A-12 Valuation of a remainder interest in real property for
contributions made after July 31, 1969.
1.170A-13 Recordkeeping and return requirements for deductions for
charitable contributions.
1.170A-14 Qualified conservation contributions.
1.170A-15 Substantiation requirements for charitable contribution of a
cash, check, or other monetary gift.
1.170A-16 Substantiation and reporting requirements for noncash
charitable contributions.
1.170A-17 Qualified appraisal and qualified appraiser.
1.170A-18 Contributions of clothing and household items.
1.171-1 Bond premium.
1.171-2 Amortization of bond premium.
1.171-3 Special rules for certain bonds.
1.171-4 Election to amortize bond premium on taxable bonds.
1.171-5 Effective date and transition rules.
1.172-1 Net operating loss deduction.
1.172-2 Net operating loss in case of a corporation.
1.172-3 Net operating loss in case of a taxpayer other than a
corporation.
1.172-4 Net operating loss carrybacks and net operating loss carryovers.
1.172-5 Taxable income which is subtracted from net operating loss to
determine carryback or carryover.
1.172-6 Illustration of net operating loss carrybacks and carryovers.
1.172-7 Joint return by husband and wife.
1.172-8 Net operating loss carryovers for regulated transportation
corporations.
1.172-9 Election with respect to portion of net operating loss
attributable to foreign expropriation loss.
1.172-10 Net operating losses of real estate investment trusts.
1.172-13 Product liability losses.
1.173-1 Circulation expenditures.
1.174-1 Research and experimental expenditures; in general.
1.174-2 Definition of research and experimental expenditures.
1.174-3 Treatment as expenses.
1.174-4 Treatment as deferred expenses.
1.175-1 Soil and water conservation expenditures; in general.
1.175-2 Definition of soil and water conservation expenditures.
1.175-3 Definition of ``the business of farming.''
1.175-4 Definition of ``land used in farming.''
1.175-5 Percentage limitation and carryover.
1.175-6 Adoption or change of method.
1.175-7 Allocation of expenditures in certain circumstances.
1.178-1 Depreciation or amortization of improvements on leased property
and cost of acquiring a lease.
1.179-0 Table of contents for section 179 expensing rules.
1.179-1 Election to expense certain depreciable assets.
1.179-2 Limitations on amount subject to section 179 election.
1.179-3 Carryover of disallowed deduction.
1.179-4 Definitions.
1.179-5 Time and manner of making election.
1.179-5T Time and manner of making election (temporary).
1.179-6 Effective/applicability dates.
1.179A-1 [Reserved]
1.179B-1T Deduction for capital costs incurred in complying with
Environmental
[[Page 6]]
Protection Agency sulfur regulations (temporary).
1.179C-1 Election to expense certain refineries.
1.180-1 Expenditures by farmers for fertilizer, etc.
1.180-2 Time and manner of making election and revocation.
1.181-0 Table of contents.
1.181-1 Deduction for qualified film and television production costs.
1.181-2 Election to deduct production costs.
1.181-3 Qualified film or television production.
1.181-4 Special rules.
1.181-5 Examples.
1.181-6 Effective/applicability date.
1.182-1 Expenditures by farmers for clearing land; in general.
1.182-2 Definition of ``the business of farming.''
1.182-3 Definition, exceptions, etc., relating to deductible
expenditures.
1.182-4 Definition of ``land suitable for use in farming'', etc.
1.182-5 Limitation.
1.182-6 Election to deduct land clearing expenditures.
1.183-1 Activities not engaged in for profit.
1.183-2 Activity not engaged in for profit defined.
1.183-3 Election to postpone determination with respect to the
presumption described in section 183(d). [Reserved]
1.183-4 Taxable years affected.
1.186-1 Recoveries of damages for antitrust violations, etc.
1.187-1 Amortization of certain coal mine safety equipment.
1.187-2 Definitions.
1.188-1 Amortization of certain expenditures for qualified on-the-job
training and child care facilities.
1.190-1 Expenditures to remove architectural and transportation barriers
to the handicapped and elderly.
1.190-2 Definitions.
1.190-3 Election to deduct architectural and transportation barrier
removal expenses.
1.193-1 Deduction for tertiary injectant expenses.
1.194-1 Amortization of reforestation expenditures.
1.194-2 Amount of deduction allowable.
1.194-3 Definitions.
1.194-4 Time and manner of making election.
1.195-1 Election to amortize start-up expenditures.
1.195-2 Technical termination of a partnership.
1.197-0 Table of contents.
1.197-1T Certain elections for intangible property (temporary).
1.197-2 Amortization of goodwill and certain other intangibles.
1.199A-0 Table of contents.
1.199A-1 Operational rules.
1.199A-2 Determination of W-2 wages and unadjusted basis immediately
after acquisition of qualified property.
1.199A-3 Qualified business income, qualified REIT dividends, and
qualified PTP income.
1.199A-4 Aggregation.
1.199A-5 Specified service trades or businesses and the trade or
business of performing services as an employee.
1.199A-6 Relevant passthrough entities (RPEs), publicly traded
partnerships (PTPs), trusts, and estates.
1.199A-7 Section 199A(a) Rules for Cooperatives and their patrons.
1.199A-8 Deduction for income attributable to domestic production
activities of specified agricultural or horticultural
cooperatives.
1.199A-9 Domestic production gross receipts.
1.199A-10 Allocation of cost of goods sold (COGS) and other deductions
to domestic production gross receipts (DPGR), and other rules.
1.199A-11 Wage limitation for the section 199A(g) deduction.
1.199A-12 Expanded affiliated groups.
Additional Itemized Deductions for Individuals
1.211-1 Allowance of deductions.
1.212-1 Nontrade or nonbusiness expenses.
1.213-1 Medical, dental, etc., expenses.
1.215-1 Periodic alimony, etc., payments.
1.215-1T Alimony, etc., payments (temporary).
1.216-1 Amounts representing taxes and interest paid to cooperative
housing corporation.
1.216-2 Treatment as property subject to depreciation.
1.217-1 Deduction for moving expenses paid or incurred in taxable years
beginning before January 1, 1970.
1.217-2 Deduction for moving expenses paid or incurred in taxable years
beginning after December 31, 1969.
1.219-1 Deduction for retirement savings.
1.219-2 Definition of active participant.
1.221-1 Deduction for interest paid on qualified education loans after
December 31, 2001.
1.221-2 Deduction for interest due and paid on qualified education loans
before January 1, 2002.
Special Deductions for Corporations
1.241-1 Allowance of special deductions.
1.242-1 Deduction for partially tax-exempt interest.
1.243-1 Deduction for dividends received by corporations.
1.243-2 Special rules for certain distributions.
[[Page 7]]
1.243-3 Certain dividends from foreign corporations.
1.243-4 Qualifying dividends.
1.243-5 Effect of election.
1.245-1 Dividends received from certain foreign corporations.
1.245A-1--1.245A-4 [Reserved]
1.245A-5 Limitation of section 245A deduction and section 954(c)(6)
exception.
1.245A-6 Coordination of extraordinary disposition and disqualified
basis rules.
1.245A-7 Coordination rules for simple cases.
1.245A-8 Coordination rules for complex cases.
1.245A-9 Other rules and definitions.
1.245A-10 Examples.
1.245A-11 Applicability dates.
1.245A(d)-1 Disallowance of foreign tax credit or deduction.
1.245A(e)-1 Special rules for hybrid dividends.
1.246-1 Deductions not allowed for dividends from certain corporations.
1.246-2 Limitation on aggregate amount of deductions.
1.246-3 Exclusion of certain dividends.
1.246-4 Dividends from a DISC or former DISC.
1.246-5 Reduction of holding periods in certain situations.
1.247-1 Deduction for dividends paid on preferred stock of public
utilities.
1.248-1 Election to amortize organizational expenditures.
1.249-1 Limitation on deduction of bond premium on repurchase.
1.250-0 Table of contents.
1.250-1 Introduction.
1.250(a)-1 Deduction for foreign-derived intangible income (FDII) and
global intangible low-taxed income (GILTI).
1.250(b)-1 Computation of foreign-derived intangible income (FDII).
1.250(b)-2 Qualified business asset investment (QBAI).
1.250(b)-3 Foreign-derived deduction eligible income (FDDEI)
transactions.
1.250(b)-4 Foreign-derived deduction eligible income (FDDEI) sales.
1.250(b)-5 Foreign-derived deduction eligible income (FDDEI) services.
1.250(b)-6 Related party transactions.
Items Not Deductible
1.261-1 General rule for disallowance of deductions.
1.262-1 Personal, living, and family expenses.
1.263(a)-0 Outline of regulations under section 263(a).
1.263(a)-1 Capital expenditures; in general.
1.263(a)-2 Amounts paid to acquire or produce tangible property.
1.263(a)-3 Amounts paid to improve tangible property.
1.263(a)-4 Amounts paid to acquire or create intangibles.
1.263(a)-5 Amounts paid or incurred to facilitate an acquisition of a
trade or business, a change in the capital structure of a
business entity, and certain other transactions.
1.263(a)-6 Election to deduct or capitalize certain expenditures.
1.263(b)-1 Expenditures for advertising or promotion of good will.
1.263(c)-1 Intangible drilling and development costs in the case of oil
and gas wells.
1.263(e)-1 Expenditures in connection with certain railroad rolling
stock.
1.263(f)-1 Reasonable repair allowance.
1.263A-0 Outline of regulations under section 263A.
1.263A-1 Uniform capitalization of costs.
1.263A-2 Rules relating to property produced by the taxpayer.
1.263A-3 Rules relating to property acquired for resale.
1.263A-4 Rules for property produced in a farming business.
1.263A-5 Exception for qualified creative expenses incurred by certain
free-lance authors, photographers, and artists. [Reserved]
1.263A-6 Rules for foreign persons. [Reserved]
1.263A-7 Changing a method of accounting under section 263A.
1.263A-8 Requirement to capitalize interest.
1.263A-9 The avoided cost method.
1.263A-10 Unit of property.
1.263A-11 Accumulated production expenditures.
1.263A-12 Production period.
1.263A-13 Oil and gas activities.
1.263A-14 Rules for related persons.
1.263A-15 Effective dates, transitional rules, and anti-abuse rule.
1.264-1 Premiums on life insurance taken out in a trade or business.
1.264-2 Single premium life insurance, endowment, or annuity contracts.
1.264-3 Effective date; taxable years ending after March 1, 1954,
subject to the Internal Revenue Code of 1939.
1.264-4 Other life insurance, endowment, or annuity contracts.
1.265-1 Expenses relating to tax-exempt income.
1.265-2 Interest relating to tax-exempt income.
1.265-3 Nondeductibility of interest relating to exempt-interest
dividends.
1.266-1 Taxes and carrying charges chargeable to capital account and
treated as capital items.
1.267A-1 Disallowance of certain interest and royalty deductions.
1.267A-2 Hybrid and branch arrangements.
1.267A-3 Income inclusions and amounts not treated as disqualified
hybrid amounts.
[[Page 8]]
1.267A-4 Disqualified imported mismatch amounts.
1.267A-5 Definitions and special rules.
1.267A-6 Examples.
1.267A-7 Applicability dates.
1.267(a)-1 Deductions disallowed.
1.267(a)-2T Temporary regulations; questions and answers arising under
the Tax Reform Act of 1984 (temporary).
1.267(a)-3 Deduction of amounts owed to related foreign persons.
1.267(b)-1 Relationships.
1.267(c)-1 Constructive ownership of stock.
1.267(d)-1 Amount of gain where loss previously disallowed.
1.267(d)-2 Effective/applicability dates.
1.267(f)-1 Controlled groups.
1.268-1 Items attributable to an unharvested crop sold with the land.
1.269-1 Meaning and use of terms.
1.269-2 Purpose and scope of section 269.
1.269-3 Instances in which section 269(a) disallows a deduction, credit,
or other allowance.
1.269-4 Power of district director to allocate deduction, credit, or
allowance in part.
1.269-5 Time of acquisition of control.
1.269-6 Relationship of section 269 to section 382 before the Tax Reform
Act of 1986.
1.269-7 Relationship of section 269 to sections 382 and 383 after the
Tax Reform Act of 1986.
1.269B-1 Stapled foreign corporations.
1.270-1 Limitation on deductions allowable to individuals in certain
cases.
1.271-1 Debts owed by political parties.
1.272-1 Expenditures relating to disposal of coal or domestic iron ore.
1.273-1 Life or terminable interests.
1.274-1 Disallowance of certain entertainment, gift and travel expenses.
1.274-2 Disallowance of deductions for certain expenses for
entertainment, amusement, recreation, or travel.
1.274-3 Disallowance of deduction for gifts.
1.274-4 Disallowance of certain foreign travel expenses.
1.274-5 Substantiation requirements.
1.274-5T Substantiation requirements (temporary).
1.274-6 Expenditures deductible without regard to trade or business or
other income producing activity.
1.274-6T Substantiation with respect to certain types of listed property
for taxable years beginning after 1985 (temporary).
1.274-7 Treatment of certain expenditures with respect to entertainment-
type facilities.
1.274-8 Effective/applicability date.
1.274-9 Entertainment provided to specified individuals.
1.274-10 Special rules for aircraft used for entertainment.
1.274-11 Disallowance of deductions for certain entertainment,
amusement, or recreation expenditures paid or incurred after
December 31, 2017.
1.274-12 Limitation on deductions for certain food or beverage expenses
paid or incurred after December 31, 2017.
1.274-13 Disallowance of deductions for certain qualified transportation
fringe expenditures.
1.274-14 Disallowance of deductions for certain transportation and
commuting benefit expenditures.
1.275-1 Deduction denied in case of certain taxes.
1.276-1 Disallowance of deductions for certain indirect contributions to
political parties.
1.278-1 Capital expenditures incurred in planting and developing citrus
and almond groves.
1.279-1 General rule; purpose.
1.279-2 Amount of disallowance of interest on corporate acquisition
indebtedness.
1.279-3 Corporate acquisition indebtedness.
1.279-4 Special rules.
1.279-5 Rules for application of section 279(b).
1.279-6 Application of section 279 to certain affiliated groups.
1.279-7 Effect on other provisions.
1.280B-1 Demolition of structures.
1.280C-1 Disallowance of certain deductions for wage or salary expenses.
1.280C-3 Disallowance of certain deductions for qualified clinical
testing expenses when section 28 credit is allowable.
1.280C-4 Credit for increasing research activities.
1.280F-1T Limitations on investment tax credit and recovery deductions
under section 168 for passenger automobiles and certain other
listed property; overview of regulations (temporary).
1.280F-2T Limitations on recovery deductions and the investment tax
credit for certain passenger automobiles (temporary).
1.280F-3T Limitations on recovery deductions and the investment tax
credit when the business use percentage of listed property is
not greater than 50 percent (temporary).
1.280F-4T Special rules for listed property (temporary).
1.280F-5T Leased property (temporary).
1.280F-6 Special rules and definitions.
1.280F-7 Property leased after December 31, 1986.
1.280G-1 Golden parachute payments.
1.280H-0T Table of contents (temporary).
1.280H-1T Limitation on certain amounts paid to employee-owners by
personal service corporations electing alternative taxable
years (temporary).
Taxable Years Beginning Prior to January 1, 1986
1.274-5A Substantiation requirements.
[[Page 9]]
Terminal Railroad Corporations and Their Shareholders
1.281-1 In general.
1.281-2 Effect of section 281 upon the computation of taxable income.
1.281-3 Definitions.
1.281-4 Taxable years affected.
1.282-1.300 [Reserved]
Authority: 26 U.S.C. 7805.
Section 1.170A-1 also issued under 26 U.S.C. 170(a).
Section 1.170A-6 also issued under 26 U.S.C. 170(f)(4); 26 U.S.C.
642(c)(5).
Section 1.170A-12 also issued under 26 U.S.C. 170(f)(4).
Section 1.170A-13 also issued under 26 U.S.C. 170(f)(8).
Section 1.170A-15 also issued under 26 U.S.C. 170(a)(1).
Section 1.170A-16 also issued under 26 U.S.C. 170(a)(1) and
170(f)(11).
Section 1.170A-17 also issued under 26 U.S.C. 170(a)(1) and
170(f)(11).
Section 1.170A-18 also issued under 26 U.S.C. 170(a)(1).
Section 1.171-2 also issued under 26 U.S.C. 171(e).
Section 1.171-3 also issued under 26 U.S.C. 171(e).
Section 1.171-4 also issued under 26 U.S.C. 171(c).
Section 1.179-1 also issued under 26 U.S.C. 179(d)(6) and (10).
Section 1.179-4 also issued under 26 U.S.C. 179(c).
Section 1.179-6 also issued under 26 U.S.C. 179(c).
Section 1.197-2 also issued under 26 U.S.C. 197.
Section 1.199A-1 also issued under 26 U.S.C. 199A(f)(4).
Section 1.199A-2 also issued under 26 U.S.C. 199A(b)(5), (f)(1)(A),
(f)(4), and (h).
Section 1.199A-3 also issued under 26 U.S.C. 199A(c)(4)(C) and
(f)(4).
Section 1.199A-4 also issued under 26 U.S.C. 199A(f)(4).
Section 1.199A-5 also issued under 26 U.S.C. 199A(f)(4).
Section 1.199A-6 also issued under 26 U.S.C. 199A(f)(1)(B) and
(f)(4).
Section 1.199A-7 also issued under 26 U.S.C. 199A(f)(4) and (g)(6).
Section 1.199A-8 also issued under 26 U.S.C. 199A(g)(6).
Section 1.199A-9 also issued under 26 U.S.C. 199A(g)(6).
Section 1.199A-10 also issued under 26 U.S.C. 199A(g)(6).
Section 1.199A-11 also issued under 26 U.S.C. 199A(g)(6).
Section 1.199A-12 also issued under 26 U.S.C. 199A(g)(6).
Section 1.216-2 also issued under 26 U.S.C. 216(d).
Section 1.221-2 also issued under 26 U.S.C. 221(d).
Section 1.245A-5 also issued under 26 U.S.C. 245A(g), 951A(a),
954(c)(6)(A), and 965(o).
Sections 1.245A-6 through 1.245A-11 also issued under 26 U.S.C.
245A(g), 882(c)(1)(A), 951A, 954(b)(5), 954(c)(6), and 965(o).
Section 1.245A(d)-1 also issued under 26 U.S.C. 245A(g).
Section 1.245A(e)-1 also issued under 26 U.S.C. 245A(g).
Section 1.250-0 also issued under 26 U.S.C. 250(c).
Section 1.250-1 also issued under 26 U.S.C. 250(c).
Section 1.250(a)-1 also issued under 26 U.S.C. 250(c) and 6001.
Section 1.250(b)-1 also issued under 26 U.S.C. 250(c) and 6001.
Section 1.250(b)-2 also issued under 26 U.S.C. 250(c).
Section 1.250(b)-3 also issued under 26 U.S.C. 250(c).
Section 1.250(b)-4 also issued under 26 U.S.C. 250(c).
Section 1.250(b)-5 also issued under 26 U.S.C. 250(c).
Section 1.250(b)-6 also issued under 26 U.S.C. 250(c).
Section 1.263A-1 also issued under 26 U.S.C. 263A(j).
Section 1.263A-2 also issued under 26 U.S.C. 263A(j).
Section 1.263A-3 also issued under 26 U.S.C. 263A(j).
Section 1.263A-4 also issued under 26 U.S.C. 263A.
Section 1.263A-4T also issued under 26 U.S.C. 263A.
Section 1.263A-5 also issued under 26 U.S.C. 263A.
Section 1.263A-6 also issued under 26 U.S.C. 263A.
Section 1.263A-7 also issued under 26 U.S.C. 263A(j).
Section 1.263A-7T also issued under 26 U.S.C. 263A.
Sections 1.263A-8 through 1.263A-15 also issued under 26 U.S.C.
263A(j).
Sections 1.267A-1 through 1.267A-7 also issued under 26 U.S.C.
267A(e).
Section 1.267(a)-3 also issued under 26 U.S.C. 267(a)(3)(A) and
(a)(3)(B)(ii).
Section 1.267(f)-1 also issued under 26 U.S.C. 267 and 1502.
Section 1.269-3(d) also issued under 26 U.S.C. 382(m).
Section 1.274-2 also issued under 26 U.S.C. 274(o).
Section 1.274-5 also issued under 26 U.S.C. 274(d).
Section 1.274-5T also issued under 26 U.S.C. 274(d).
Section 1.274-9 also issued under 26 U.S.C. 274(o).
Section 1.274-10 also issued under 26 U.S.C. 274(o).
[[Page 10]]
Section 1.274-11 also issued under 26 U.S.C. 274.
Section 1.274-12 also issued under 26 U.S.C. 274.
Section 1.274-13 also issued under 26 U.S.C. 274.
Section 1.274-14 also issued under 26 U.S.C. 274.
Section 1.274(d)-1 also issued under 26 U.S.C. 274(d).
Section 1.274(d)-1T also issued under 26 U.S.C. 274(d).
Section 1.280C-4 also issued under 26 U.S.C. 280C(c)(4).
Section 1.280F-1T also issued under 26 U.S.C. 280F.
Section 1.280F-6 also issued under 26 U.S.C. 280F.
Section 1.280F-7 also issued under 26 U.S.C. 280F(c).
Section 1.280G-1 also issued under 26 U.S.C. 280G(b) and (e).
Source: T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31,
1960, T.D. 9381, 73 FR 8604, Feb. 15, 2008, unless otherwise noted.
COMPUTATION OF TAXABLE INCOME (CONTINUED)
Itemized Deductions for Individuals and Corporations (Continued)
Sec. 1.170-3 Contributions or gifts by corporations (before amendment
by Tax Reform Act of 1969).
(a) In general. The deduction by a corporation in any taxable year
for charitable contributions, as defined in section 170(c), is limited
to 5 percent of its taxable income for the year computed without regard
to:
(1) The deduction for charitable contributions,
(2) The special deductions for corporations allowed under part VIII
(except section 248), subchapter B, chapter 1 of the Code,
(3) Any net operating loss carryback to the taxable year under
section 172,
(4) The special deduction for Western Hemisphere trade corporations
under section 922, and
(5) Any capital loss carryback to the taxable year under section
1212(a)(1).
A contribution by a corporation to a trust, chest, fund, or foundation
organized and operated exclusively for religious, charitable,
scientific, literary, or educational purposes or for the prevention of
cruelty to children or animals is deductible only if the contribution is
to be used in the United States or its possessions for those purposes.
See section 170(c)(2). For the purposes of section 170, amounts excluded
from the gross income of a corporation under section 114 (relating to
sports programs conducted for the American National Red Cross) are not
to be considered contributions or gifts. For reduction or disallowance
of certain charitable, etc., deductions, see paragraphs (c)(2), (e), and
(f) of Sec. 1.170-1.
(b) Election by corporations on an accrual method. A corporation
reporting its taxable income on an accrual method may elect to have a
charitable contribution (as defined in section 170 (c)) considered as
paid during the taxable year, if payment is actually made on or before
the fifteenth day of the third month following the close of the year and
if, during the year, the board of directors authorized the contribution.
The election must be made at the time the return for the taxable year is
filed, by reporting the contribution on the return. There shall be
attached to the return when filed a written declaration that the
resolution authorizing the contribution was adopted by the board of
directors during the taxable year, and the declaration shall be verified
by a statement signed by an officer authorized to sign the return that
it is made under the penalties of perjury. There shall also be attached
to the return when filed a copy of the resolution of the board of
directors authorizing the contribution.
(c) Charitable contributions carryover of corporations--(1)
Contributions made in taxable years beginning before January 1, 1962.
Subject to the rules set forth in subparagraph (3) of this paragraph,
any contributions made by a corporation in a taxable year (hereinafter
in this paragraph referred to as the contribution year) subject to the
Code beginning before January 1, 1962, in excess of the amount
deductible in such contribution year under the 5-percent limitation of
section 170(b)(2) are deductible in each of the two succeeding taxable
years in order of time, but only to the extent of the lesser of the
following amounts:
(i) The excess of the maximum amount deductible for the succeeding
year under the 5-percent limitation of
[[Page 11]]
section 170(b)(2) over the contributions made in that year; and
(ii) In the case of the first taxable year succeeding the
contribution year, the amount of the excess contributions; and, in the
case of the second taxable year succeeding the contribution year, the
portion of the excess contributions not deductible in the first
succeeding taxable year.
The application of the rules in this subparagraph may be illustrated by
the following example:
Example. A corporation which reports its income on the calendar year
basis makes a charitable contribution of $10,000 in June 1961,
anticipating taxable income for 1961 of $200,000. Its actual taxable
income (without regard to any deduction for charitable contributions)
for 1961 is only $50,000 and the charitable deduction for that year is
limited to $2,500 (5 percent of $50,000). The excess charitable
contribution not deductible in 1961 ($7,500) represents a carryover
potentially available as a deduction in the two succeeding taxable
years. The corporation has taxable income (without regard to any
deduction for charitable contributions) of $150,000 in 1962 and makes a
charitable contribution of $2,500 in that year. For 1962, the
corporation may deduct as a charitable contribution the amount of $7,500
(5 percent of $150,000). This amount consists first of the $2,500
contribution made in 1962, and $5,000 of the $7,500 carried over from
1961. The remaining $2,500 carried over from 1961 and not allowable as a
deduction in 1962 because of the 5-percent limitation may be carried
over to 1963. The corporation has taxable income (without regard to any
deduction for charitable contributions) of $100,000 in 1963 and makes a
charitable contribution of $3,000. For 1963, the corporation may deduct
under section 170 the amount of $5,000 (5 percent of $100,000). This
amount consists first of the $3,000 contributed in 1963, and $2,000 of
the $2,500 carried over from 1961 to 1963. The remaining $500 of the
carryover from 1961 is not allowable as a deduction in any year because
of the 2-year limitation with respect to excess contributions made in
taxable years beginning before January 1, 1962.
(2) Contributions made in taxable years beginning after December 31,
1961. Subject to the rules set forth in subparagraph (3) of this
paragraph, any contributions made by a corporation in a taxable year
(hereinafter in this paragraph referred to as the contribution year)
beginning after December 31, 1961, in excess of the amount deductible in
such contribution year under the 5-percent limitation of section
170(b)(2) are deductible in each of the five succeeding taxable years in
order of time, but only to the extent of the lesser of the following
amounts:
(i) The excess of the maximum amount deductible for such succeeding
taxable year under the 5-percent limitation of section 170(b)(2) over
the sum of the contributions made in that year plus the aggregate of the
excess contributions which were made in taxable years before the
contribution year and which are deductible under this paragraph in such
succeeding taxable year; or
(ii) In the case of the first taxable year succeeding the
contribution year, the amount of the excess contributions, and in the
case of the second, third, fourth, or fifth taxable years succeeding the
contribution year, the portion of the excess contributions not
deductible under this subparagraph for any taxable year intervening
between the contribution year and such succeeding taxable year.
The application of the rules of this subparagraph may be illustrated by
the following example:
Example. A corporation which reports its income on the calendar year
basis makes a charitable contribution of $20,000 in June 1964,
anticipating taxable income for 1964 of $400,000. Its actual taxable
income (without regard to any deduction for charitable contributions)
for 1964 is only $100,000 and the charitable deduction for that year is
limited to $5,000 (5 percent of $100,000). The excess charitable
contribution not deductible in 1964 ($15,000) represents a carryover
potentially available as a deduction in the five succeeding taxable
years. The corporation has taxable income (without regard to any
deduction for charitable contributions) of $150,000 in 1965 and makes a
charitable contribution of $5,000 in that year. For 1965 the corporation
may deduct as a charitable contribution the amount of $7,500 (5 percent
of $150,000). This amount consists first of the $5,000 contribution made
in 1965, and $2,500 carried over from 1964. The remaining $12,500
carried over from 1964 and not allowable as a deduction for 1965 because
of the 5-percent limitation may be carried over to 1966. The corporation
has taxable income (without regard to any deduction for charitable
contributions) of $200,000 in 1966 and makes a charitable contribution
of $5,000. For 1966, the corporation may deduct the amount of $10,000 (5
percent of $200,000). This amount consists first of the $5,000
contributed in 1966,
[[Page 12]]
and $5,000 of the $12,500 carried over from 1964 to 1966. The remaining
$7,500 of the carryover from 1964 is available for purposes of computing
the charitable contributions carryover from 1964 to 1967, 1968, and
1969.
(3) Reduction of excess contributions. A corporation having a net
operating loss carryover (or carryovers) must apply the special rule of
section 170(b)(3) and this subparagraph before computing under
subparagraph (1) or (2) of this paragraph the charitable contributions
carryover for any taxable year subject to the Internal Revenue Code of
1954. In determining the amount of charitable contributions that may be
deducted in accordance with the rules set forth in subparagraph (1) or
(2) of this paragraph in taxable years succeeding the contribution year,
the excess of contributions made by a corporation in the contribution
year over the amount deductible in such year must be reduced by the
amount by which such excess reduces taxable income (for purposes of
determining the net operating loss carryover under the second sentence
of section 172(b)(2) and increases a net operating loss carryover to a
succeeding taxable year. Thus, if the excess of the contributions made
in a taxable year over the amount deductible in the taxable year is
utilized to reduce taxable income (under the provisions of section
172(b)(2)) for such year, thereby serving to increase the amount of the
net operating loss carryover to a succeeding year or years, no
charitable contributions carryover will be allowed. If only a portion of
the excess charitable contributions is so used, the charitable
contributions carryover. will be reduced only to that extent. The
application of the rules of this subparagraph may be illustrated by the
following example:
Example. A corporation which reports its income on the calendar year
basis makes a charitable contribution of $10,000 during the taxable year
1960. Its taxable income for 1960 is $80,000 (computed without regard to
any net operating loss deduction and computed in accordance with section
170(b)(2) without regard to any deduction for charitable contributions).
The corporation has a net operating loss carryover from 1959 of $80,000.
In the absence of the net operating loss deduction the corporation would
have been allowed a deduction for charitable contributions of $4,000 (5
percent of $80,000). After the application of the net operating loss
deduction the corporation is allowed no deduction for charitable
contributions, and there is a tentative charitable contribution
carryover of $10,000. For purposes of determining the net operating loss
carryover to 1961 the corporation computes its taxable income for its
prior taxable year 1960 under section 172(b)(2) by deducting the $4,000
charitable contribution. Thus, after the $80,000 net operating loss
carryover is applied against the $76,000 of taxable income for 1960
(computed in accordance with section 172(b)(2)), there remains a $4,000
net operating loss carryover to 1961. Since the application of the net
operating loss carryover of $80,000 from 1959 reduces the taxable income
for 1960 to zero, no part of the $10,000 of charitable contributions in
that year is deductible under section 170(b)(2). However, in determining
the amount of the allowable charitable contributions carryover to the
taxable years 1961 and 1962, the $10,000 must be reduced by the portion
thereof ($4,000) which was used to reduce taxable income for 1960 (as
computed for purposes of the second sentence of section 172(b)(2)) and
which thereby served to increase the net operating loss carryover to
1961 from zero to $4,000.
(4) Year contribution is made. For purposes of this paragraph,
contributions made by a corporation in a contribution year include
contributions which, in accordance with the provisions of section
170(a)(2) and paragraph (b) of this section, are considered as paid
during such contribution year.
(5) Effect of net operating loss carryback to contribution year. The
amount of the excess contribution for a contribution year (computed as
provided in this paragraph) shall not be increased because a net
operating loss carryback is available as a deduction in the contribution
year. In addition, in determining (under the provisions of section
172(b)(2)) the amount of the net operating loss for any year subsequent
to the contribution year which is a carryback or carryover to taxable
years succeeding the contribution year, the amount of contributions
shall be limited to the maximum amount deductible under the 5-percent
limitation of section 170(b)(2) (computed without regard to any net
operating loss carryback or any of the modifications referred to in
section 172(d)) for the contribution year.
(6) Effect of net operating loss carryback to taxable years
succeeding the contribution year. The amount of the
[[Page 13]]
charitable contribution from a preceding taxable year which is
deductible (as provided in this paragraph) in a current taxable year
(hereinafter referred to in this subparagraph as the ``deduction year'')
shall not be reduced because a net operating loss carryback is available
as a deduction in the deduction year. In addition, in determining (under
the provisions of section 172(b)(2)) the amount of the net operating
loss for any year subsequent to the deduction year which is a carryback
or a carryover to taxable years succeeding the deduction year, the
amount of contributions shall be limited to the maximum amount
deductible under the 5-percent limitation of section 170(b)(2) (computed
without regard to any net operating loss carryback or any of the
modifications referred to in section 172(d)) for the deduction year.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6605, 27 FR
8096, Aug. 15, 1962; T.D. 6900, 31 FR 14640, Nov. 17, 1966; T.D. 7207,
37 FR 20768, Oct. 4, 1972]
Sec. 1.170A-1 Charitable, etc., contributions and gifts; allowance
of deduction.
(a) Allowance of deduction. Any charitable contribution, as defined
in section 170(c), actually paid during the taxable year is allowable as
a deduction in computing taxable income irrespective of the method of
accounting employed or of the date on which the contribution is pledged.
However, charitable contributions by corporations may under certain
circumstances be deductible even though not paid during the taxable year
as provided in section 170(a)(2) and Sec. 1.170A-11. For rules relating
to record keeping and return requirements in support of deductions for
charitable contributions (whether by an itemizing or nonitemizing
taxpayer), see Sec. Sec. 1.170A-13 (generally applicable to
contributions on or before July 30, 2018), 1.170A-14, 1.170A-15, 1.170A-
16, 1.170A-17, and 1.170A-18. The deduction is subject to the
limitations of section 170(b) and Sec. 1.170A-8 or Sec. 1.170A-11.
Subject to the provisions of section 170(d) and Sec. Sec. 1.170A-10 and
1.170A-11, certain excess charitable contributions made by individuals
and corporations shall be treated as paid in certain succeeding taxable
years. For provisions relating to direct charitable deductions under
section 63 by nonitemizers, see section 63 (b)(1)(C) and (i) and section
170(i). For rules relating to the detemination of, and the deduction
for, amounts paid to maintain certain students as members of the
taxpayer's household and treated under section 170(g) as paid for the
use of an organization described in section 170(c) (2), (3), or (4), see
Sec. 1.170A-2. For the reduction of any charitable contributions for
interest on certain indebtedness, see section 170(f)(5) and Sec.
1.170A-3. For a special rule relating to the computation of the amount
of the deduction with respect to a charitable contribution of certain
ordinary income or capital gain property, see section 170(e) and
Sec. Sec. 1.170A-4 and 1.170A-4A. For rules for postponing the time for
deduction of a charitable contribution of a future interest in tangible
personal property, see section 170(a)(3) and Sec. 1.170A-5. For rules
with respect to transfers in trust and of partial interests in property,
see section 170(e), section 170(f) (2) and (3), Sec. Sec. 1.170A-4,
1.170A-6, and 1.170A-7. For definition of the term section 170(b)(1)(A)
organization, see Sec. 1.170A-9. For valuation of a remainder interest
in real property, see section 170(f)(4) and the regulations thereunder.
The deduction for charitable contributions is subject to verification by
the district director.
(b) Time of making contribution. Ordinarily, a contribution is made
at the time delivery is effected. The unconditional delivery or mailing
of a check which subsequently clears in due course will constitute an
effective contribution on the date of delivery or mailing. If a taxpayer
unconditionally delivers or mails a properly endorsed stock certificate
to a charitable donee or the donee's agent, the gift is completed on the
date of delivery or, if such certificate is received in the ordinary
course of the mails, on the date of mailing. If the donor delivers the
stock certificate to his bank or broker as the donor's agent, or to the
issuing corporation or its agent, for transfer into the name of the
donee, the gift is completed on the date the stock is transferred on the
books of the corporation.
[[Page 14]]
For rules relating to the date of payment of a contribution consisting
of a future interest in tangible personal property, see section
170(a)(3) and Sec. 1.170A-5.
(c) Value of a contribution in property. (1) If a charitable
contribution is made in property other than money, the amount of the
contribution is the fair market value of the property at the time of the
contribution reduced as provided in section 170(e)(1) and paragraph (a)
of Sec. 1.170A-4, or section 170(e)(3) and paragraph (c) of Sec.
1.170A-4A.
(2) The fair market value is the price at which the property would
change hands between a willing buyer and a willing seller, neither being
under any compulsion to buy or sell and both having reasonable knowledge
of relevant facts. If the contribution is made in property of a type
which the taxpayer sells in the course of his business, the fair market
value is the price which the taxpayer would have received if he had sold
the contributed property in the usual market in which he customarily
sells, at the time and place of the contribution and, in the case of a
contribution of goods in quantity, in the quantity contributed. The
usual market of a manufacturer or other producer consists of the
wholesalers or other distributors to or through whom he customarily
sells, but if he sells only at retail the usual market consists of his
retail customers.
(3) If a donor makes a charitable contribution of property, such as
stock in trade, at a time when he could not reasonably have been
expected to realize its usual selling price, the value of the gift is
not the usual selling price but is the amount for which the quantity of
property contributed would have been sold by the donor at the time of
the contribution.
(4) Any costs and expenses pertaining to the contributed property
which were incurred in taxable years preceding the year of contribution
and are properly reflected in the opening inventory for the year of
contribution must be removed from inventory and are not a part of the
cost of goods sold for purposes of determining gross income for the year
of contribution. Any costs and expenses pertaining to the contributed
property which are incurred in the year of contribution and would, under
the method of accounting used, be properly reflected in the cost of
goods sold for such year are to be treated as part of the costs of goods
sold for such year. If costs and expenses incurred in producing or
acquiring the contributed property are, under the method of accounting
used, properly deducted under section 162 or other section of the Code,
such costs and expenses will be allowed as deductions for the taxable
year in which they are paid or incurred whether or not such year is the
year of the contribution. Any such costs and expenses which are treated
as part of the cost of goods sold for the year of contribution, and any
such costs and expenses which are properly deducted under section 162 or
other section of the Code, are not to be treated under any section of
the Code as resulting in any basis for the contributed property. Thus,
for example, the contributed property has no basis for purposes of
determining under section 170(e)(1)(A) and paragraph (a) of Sec.
1.170A-4 the amount of gain which would have been recognized if such
property had been sold by the donor at its fair market value at the time
of its contribution. The amount of any charitable contribution for the
taxable year is not to be reduced by the amount of any costs or expenses
pertaining to the contributed property which was properly deducted under
section 162 or other section of the Code for any taxable year preceding
the year of the contribution. This subparagraph applies only to property
which was held by the taxpayer for sale in the course of a trade or
business. The application of this subparagraph may be illustrated by the
following examples:
Example 1. In 1970, A, an individual using the calendar year as the
taxable year and the accrual method of accounting, contributed to a
church property from inventory having a fair market value of $600. The
closing inventory at the end of 1969 properly included $400 of costs
attributable to the acquisition of such property, and in 1969 A properly
deducted under section 162 $50 of administrative and other expenses
attributable to such property. Under section 170(e)(1)(A) and paragraph
(a) of Sec. 1.170A-4, the amount of the charitable contribution allowed
for 1970 is
[[Page 15]]
$400 ($600-[$600-$400]). Pursuant to this subparagraph, the cost of
goods sold to be used in determining gross income for 1970 may not
include the $400 which was included in opening inventory for that year.
Example 2. The facts are the same as in Example 1 except that the
contributed property was acquired in 1970 at a cost of $400. The $400
cost of the property is included in determining the cost of goods sold
for 1970, and $50 is allowed as a deduction for that year under section
162. A is not allowed any deduction under section 170 for the
contributed property, since under section 170(e)(1)(A) and paragraph (a)
of Sec. 1.170A-4 the amount of the charitable contribution is reduced
to zero ($600-[$600-$0]).
Example 3. In 1970, B, an individual using the calendar year as the
taxable year and the accrual method of accounting, contributed to a
church property from inventory having a fair market value of $600. Under
Sec. 1.471-3(c), the closing inventory at the end of 1969 properly
included $450 costs attributable to the production of such property,
including $50 of administrative and other indirect expenses which, under
his method of accounting, was properly added to inventory rather than
deducted as a business expense. Under section 170(e)(1)(A) and paragraph
(a) of Sec. 1.170A-4, the amount of the charitable contribution allowed
for 1970 is $450 ($600-[$600-$450]). Pursuant to this subparagraph, the
cost of goods sold to be used in determining gross income for 1970 may
not include the $450 which was included in opening inventory for that
year.
Example 4. The facts are the same as in Example 3 except that the
contributed property was produced in 1970 at a cost of $450, including
$50 of administrative and other indirect expenses. The $450 cost of the
property is included in determining the cost of goods sold for 1970. B
is not allowed any deduction under section 170 for the contributed
property, since under section 170(e)(1)(A) and paragraph (a) of Sec.
1.170A-4 the amount of the charitable contribution is reduced to zero
($600-[$600-$0]).
Example 5. In 1970, C, a farmer using the cash method of accounting
and the calendar year as the taxable year, contributed to a church a
quantity of grain which he had raised having a fair market value of
$600. In 1969, C paid expenses of $450 in raising the property which he
properly deducted for such year under section 162. Under section
170(e)(1)(A) and paragraph (a) of Sec. 1.170A-4, the amount of the
charitable contribution in 1970 is reduced to zero ($600-[$600-$0]).
Accordingly, C is not allowed any deduction under section 170 for the
contributed property.
Example 6. The facts are the same as in Example 5 except that the
$450 expenses incurred in raising the contributed property were paid in
1970. The result is the same as in Example 5, except the amount of $450
is deductible under section 162 for 1970.
(5) For payments or transfers to an entity described in section
170(c) by a taxpayer carrying on a trade or business, see Sec. 1.162-
15(a).
(d) Purchase of an annuity. (1) In the case of an annuity or portion
thereof purchased from an organization described in section 170(c),
there shall be allowed as a deduction the excess of the amount paid over
the value at the time of purchase of the annuity or portion purchased.
(2) The value of the annuity or portion is the value of the annuity
determined in accordance with paragraph (e)(1)(iii) (b)(2) of Sec.
1.101-2.
(3) For determining gain on any such transaction constituting a
bargain sale, see section 1011(b) and Sec. 1.1011-2.
(e) Transfers subject to a condition or power. If as of the date of
a gift a transfer for charitable purposes is dependent upon the
performance of some act or the happening of a precedent event in order
that it might become effective, no deduction is allowable unless the
possibility that the charitable transfer will not become effective is so
remote as to be negligible. If an interest in property passes to, or is
vested in, charity on the date of the gift and the interest would be
defeated by the subsequent performance of some act or the happening of
some event, the possibility of occurrence of which appears on the date
of the gift to be so remote as to be negligible, the deduction is
allowable. For example, A transfers land to a city government for as
long as the land is used by the city for a public park. If on the date
of the gift the city does plan to use the land for a park and the
possibility that the city will not use the land for a public park is so
remote as to be negligible, A is entitled to a deduction under section
170 for his charitable contribution.
(f) Special rules applicable to certain contributions. (1) See
section 14 of the Wild and Scenic Rivers Act (Pub. L. 90-542, 82 Stat.
918) for provisions relating to the claim and allowance of the value of
certain easements as a charitable contribution under section 170.
(2) For treatment of gifts accepted by the Secretary of State or the
Secretary
[[Page 16]]
of Commerce, for the purpose of organizing and holding an international
conference to negotiate a Patent Corporation Treaty, as gifts to or for
the use of the United States, see section 3 of joint resolution of
December 24, 1969 (Pub. L. 91-160, 83 Stat. 443).
(3) For treatment of gifts accepted by the Secretary of the
Department of Housing and Urban Development, for the purpose of aiding
or facilitating the work of the Department, as gifts to or for the use
of the United States, see section 7(k) of the Department of Housing and
Urban Development Act (42 U.S.C. 3535), as added by section 905 of Pub.
L. 91-609 (84 Stat. 1809).
(g) Contributions of services. No deduction is allowable under
section 170 for a contribution of services. However, unreimbursed
expenditures made incident to the rendition of services to an
organization contributions to which are deductible may constitute a
deductible contribution. For example, the cost of a uniform without
general utility which is required to be worn in performing donated
services is deductible. Similarly, out-of-pocket transportation expenses
necessarily incurred in performing donated services are deductible.
Reasonable expenditures for meals and lodging necessarily incurred while
away from home in the course of performing donated services also are
deductible. For the purposes of this paragraph, the phrase while away
from home has the same meaning as that phrase is used for purposes of
section 162 and the regulations thereunder.
(h) Payment in exchange for consideration--(1) Burden on taxpayer to
show that all or part of payment is a charitable contribution or gift.
No part of a payment that a taxpayer makes to or for the use of an
organization described in section 170(c) that is in consideration for
(as defined in paragraph (h)(4)(i) of this section goods or services (as
defined in paragraph (h)(4)(ii) of this section is a contribution or
gift within the meaning of section 170(c) unless the taxpayer--
(i) Intends to make a payment in an amount that exceeds the fair
market value of the goods or services; and
(ii) Makes a payment in an amount that exceeds the fair market value
of the goods or services.
(2) Limitation on amount deductible--(i) In general. The charitable
contribution deduction under section 170(a) for a payment a taxpayer
makes partly in consideration for goods or services may not exceed the
excess of--
(A) The amount of any cash paid and the fair market value of any
property (other than cash) transferred by the taxpayer to an
organization described in section 170(c); over
(B) The fair market value of the goods or services received or
expected to be received in return.
(ii) Special rules. For special limits on the deduction for
charitable contributions of ordinary income and capital gain property,
see section 170(e) and Sec. Sec. 1.170A-4 and 1.170A-4A.
(3) Payments resulting in state or local tax benefits--(i) State or
local tax credits. Except as provided in paragraph (h)(3)(vi) of this
section, if a taxpayer makes a payment or transfers property to or for
the use of an entity described in section 170(c), the amount of the
taxpayer's charitable contribution deduction under section 170(a) is
reduced by the amount of any state or local tax credit that the taxpayer
receives or expects to receive in consideration for the taxpayer's
payment or transfer.
(ii) State or local tax deductions--(A) In general. If a taxpayer
makes a payment or transfers property to or for the use of an entity
described in section 170(c), and the taxpayer receives or expects to
receive state or local tax deductions that do not exceed the amount of
the taxpayer's payment or the fair market value of the property
transferred by the taxpayer to the entity, the taxpayer is not required
to reduce its charitable contribution deduction under section 170(a) on
account of the state or local tax deductions.
(B) Excess state or local tax deductions. If the taxpayer receives
or expects to receive a state or local tax deduction that exceeds the
amount of the taxpayer's payment or the fair market value of the
property transferred, the taxpayer's charitable contribution deduction
under section 170(a) is reduced.
(iii) In consideration for. For purposes of paragraph (h) of this
section, the term in consideration for has the meaning set forth in
paragraph (h)(4)(i) of this section.
[[Page 17]]
(iv) Amount of reduction. For purposes of paragraph (h)(3)(i) of
this section, the amount of any state or local tax credit is the maximum
credit allowable that corresponds to the amount of the taxpayer's
payment or transfer to the entity described in section 170(c).
(v) State or local tax. For purposes of paragraph (h)(3) of this
section, the term state or local tax means a tax imposed by a State, a
possession of the United States, or by a political subdivision of any of
the foregoing, or by the District of Columbia.
(vi) Exception. Paragraph (h)(3)(i) of this section shall not apply
to any payment or transfer of property if the total amount of the state
and local tax credits received or expected to be received by the
taxpayer is 15 percent or less of the taxpayer's payment, or 15 percent
or less of the fair market value of the property transferred by the
taxpayer.
(vii) Examples. The following examples illustrate the provisions of
this paragraph (h)(3). The examples in paragraph (h)(6) of this section
are not illustrative for purposes of this paragraph (h)(3).
(A) Example 1. A, an individual, makes a payment of $1,000 to X, an
entity described in section 170(c). In exchange for the payment, A
receives or expects to receive a state tax credit of 70 percent of the
amount of A's payment to X. Under paragraph (h)(3)(i) of this section,
A's charitable contribution deduction is reduced by $700 (0.70 x
$1,000). This reduction occurs regardless of whether A is able to claim
the state tax credit in that year. Thus, A's charitable contribution
deduction for the $1,000 payment to X may not exceed $300.
(B)Example 2. B, an individual, transfers a painting to Y, an entity
described in section 170(c). At the time of the transfer, the painting
has a fair market value of $100,000. In exchange for the painting, B
receives or expects to receive a state tax credit equal to 10 percent of
the fair market value of the painting. Under paragraph (h)(3)(vi) of
this section, B is not required to apply the general rule of paragraph
(h)(3)(i) of this section because the amount of the tax credit received
or expected to be received by B does not exceed 15 percent of the fair
market value of the property transferred to Y. Accordingly, the amount
of B's charitable contribution deduction for the transfer of the
painting is not reduced under paragraph (h)(3)(i) of this section.
(C) Example 3. C, an individual, makes a payment of $1,000 to Z, an
entity described in section 170(c). In exchange for the payment, under
state M law, C is entitled to receive a state tax deduction equal to the
amount paid by C to Z. Under paragraph (h)(3)(ii)(A) of this section,
C's charitable contribution deduction under section 170(a) is not
required to be reduced on account of C's state tax deduction for C's
payment to Z.
(viii) Safe harbor for payments by C corporations and specified
passthrough entities. For payments by a C corporation or by a specified
passthrough entity to an entity described in section 170(c), where the C
corporation or specified passthrough entity receives or expects to
receive a State or local tax credit that reduces the charitable
contribution deduction for such payments under paragraph (h)(3) of this
section, see Sec. 1.162-15(a)(3) (providing safe harbors under section
162(a) to the extent of that reduction).
(ix) Safe harbor for individuals. Under certain circumstances, an
individual who itemizes deductions and makes a payment to an entity
described in section 170(c) in consideration for a State or local tax
credit may treat the portion of such payment for which a charitable
contribution deduction is disallowed under paragraph (h)(3) of this
section as a payment of State or local taxes under section 164. See
Sec. 1.164-3(j), providing a safe harbor for certain payments by
individuals in exchange for State or local tax credits.
(x) Effective/applicability date. This paragraph (h)(3) applies to
amounts paid or property transferred by a taxpayer after August 27,
2018.
(4) Definitions. For purposes of this paragraph (h), the following
definitions apply:
(i) In consideration for. A taxpayer receives goods or services in
consideration for a taxpayer's payment or transfer to an entity
described in section 170(c) if, at the time the taxpayer makes the
payment to such entity, the
[[Page 18]]
taxpayer receives or expects to receive goods or services from that
entity or any other party in return.
(ii) Goods or services. Goods or services means cash, property,
services, benefits, and privileges.
(iii) Applicability date. The definitions provided in this paragraph
(h)(4) are applicable to amounts paid or property transferred on or
after December 17, 2019.
(5) Certain goods or services disregarded. For purposes of section
170(a) and paragraphs (h)(1) and (h)(2) of this section, goods or
services described in Sec. 1.170A-13(f)(8)(i) or Sec. 1.170A-
13(f)(9)(i) are disregarded.
(6) Donee estimates of the value of goods or services may be treated
as fair market value--(i) In general. For purposes of section 170(a), a
taxpayer may rely on either a contemporaneous written acknowledgment
provided under section 170(f)(8) and Sec. 1.170A-13(f) or a written
disclosure statement provided under section 6115 for the fair market
value of any goods or services provided to the taxpayer by the donee
organization.
(ii) Exception. A taxpayer may not treat an estimate of the value of
goods or services as their fair market value if the taxpayer knows, or
has reason to know, that such treatment is unreasonable. For example, if
a taxpayer knows, or has reason to know, that there is an error in an
estimate provided by an organization described in section 170(c)
pertaining to goods or services that have a readily ascertainable value,
it is unreasonable for the taxpayer to treat the estimate as the fair
market value of the goods or services. Similarly, if a taxpayer is a
dealer in the type of goods or services provided in consideration for
the taxpayer's payment and knows, or has reason to know, that the
estimate is in error, it is unreasonable for the taxpayer to treat the
estimate as the fair market value of the goods or services.
(7) Examples. The following examples illustrate the rules of this
paragraph (h).
Example 1. Certain goods or services disregarded. Taxpayer makes a
$50 payment to Charity B, an organization described in section 170(c),
in exchange for a family membership. The family membership entitles
Taxpayer and members of Taxpayer's family to certain benefits. These
benefits include free admission to weekly poetry readings, discounts on
merchandise sold by B in its gift shop or by mail order, and invitations
to special events for members only, such as lectures or informal
receptions. When B first offers its membership package for the year, B
reasonably projects that each special event for members will have a cost
to B, excluding any allocable overhead, of $5 or less per person
attending the event. Because the family membership benefits are
disregarded pursuant to Sec. 1.170A-13(f)(8)(i), Taxpayer may treat the
$50 payment as a contribution or gift within the meaning of section
170(c), regardless of Taxpayer's intent and whether or not the payment
exceeds the fair market value of the goods or services. Furthermore, any
charitable contribution deduction available to Taxpayer may be
calculated without regard to the membership benefits.
Example 2. Treatment of good faith estimate at auction as the fair
market value. Taxpayer attends an auction held by Charity C, an
organization described in section 170(c). Prior to the auction, C
publishes a catalog that meets the requirements for a written disclosure
statement under section 6115(a) (including C's good faith estimate of
the value of items that will be available for bidding). A representative
of C gives a copy of the catalog to each individual (including Taxpayer)
who attends the auction. Taxpayer notes that in the catalog C's estimate
of the value of a vase is $100. Taxpayer has no reason to doubt the
accuracy of this estimate. Taxpayer successfully bids and pays $500 for
the vase. Because Taxpayer knew, prior to making her payment, that the
estimate in the catalog was less than the amount of her payment,
Taxpayer satisfies the requirement of paragraph (h)(1)(i) of this
section. Because Taxpayer makes a payment in an amount that exceeds that
estimate, Taxpayer satisfies the requirements of paragraph (h)(1)(ii) of
this section. Taxpayer may treat C's estimate of the value of the vase
as its fair market value in determining the amount of her charitable
contribution deduction.
Example 3. Good faith estimate not in error. Taxpayer makes a $200
payment to Charity D, an organization described in section 170(c). In
return for Taxpayer's payment, D gives Taxpayer a book that Taxpayer
could buy at retail prices typically ranging from $18 to $25. D provides
Taxpayer with a good faith estimate, in a written disclosure statement
under section 6115(a), of $20 for the value of the book. Because the
estimate is within the range of typical retail prices for the book, the
estimate contained in the written disclosure statement is not in error.
Although Taxpayer knows that the book is sold for as much as $25,
Taxpayer may treat the estimate of $20 as the fair market value of
[[Page 19]]
the book in determining the amount of his charitable contribution
deduction.
(i) [Reserved]
(j) Exceptions and other rules. (1) The provisions of section 170 do
not apply to contributions by an estate; nor do they apply to a trust
unless the trust is a private foundation which, pursuant to section
642(c)(6) and Sec. 1.642(c)-4, is allowed a deduction under section 170
subject to the provisions applicable to individuals.
(2) No deduction shall be allowed under section 170 for a charitable
contribution to or for the use of an organization or trust described in
section 508(d) or 4948(c)(4), subject to the conditions specified in
such sections and the regulations thereunder.
(3) For disallowance of deductions for contributions to or for the
use of communist controlled organizations, see section 11(a) of the
Internal Security Act of 1950, as amended (50 U.S.C. 790).
(4) For denial of deductions for charitable contributions as trade
or business expenses and rules with respect to treatment of payments to
organizations other than those described in section 170(c), see section
162 and the regulations thereunder.
(5) No deduction shall be allowed under section 170 for amounts paid
to an organization:
(i) Which is disqualified for tax exemption under section 501(c)(3)
by reason of attempting to influence legislation, or
(ii) Which participates in, or intervenes in (including the
publishing or distribution of statements), any political campaign on
behalf of or in opposition to any candidate for public office.
For purposes of determining whether an organization is attempting to
influence legislation or is engaging in political activities, see
sections 501(c)(3), 501(h), 4911 and the regulations thereunder.
(6) No deduction shall be allowed under section 170 for expenditures
for lobbying purposes, the promotion or defeat of legislation, etc. See
also the regulations under sections 162 and 4945.
(7) No deduction for charitable contributions is allowed in
computing the taxable income of a common trust fund or of a partnership.
See sections 584(d)(3) and 703(a)(2)(D). However, a partner's
distributive share of charitable contributions actually paid by a
partnership during its taxable year may be allowed as a deduction in the
partner's separate return for his taxable year with or within which the
taxable year of the partnership ends, to the extent that the aggregate
of his share of the partnership contributions and his own contributions
does not exceed the limitations in section 170(b).
(8) For charitable contributions paid by a nonresident alien
individual or a foreign corporation, see Sec. 1.170A-4(b)(5) and
sections 873, 876, 877, and 882(c), and the regulations thereunder.
(9) Charitable contributions paid by bona fide residents of a
section 931 possession as defined in Sec. 1.931-1(c)(1) or Puerto Rico
are deductible only to the extent allocable to income that is not
excluded under section 931 or 933. For the rules for allocating
deductions for charitable contributions, see the regulations under
section 861.
(10) For carryover of excess charitable contributions in certain
corporate acquisitions, see section 381(c)(19) and the regulations
thereunder.
(11) No deduction shall be allowed under section 170 for out-of-
pocket expenditures on behalf of an eligible organization (within the
meaning of Sec. 1.501(h)-2(b)(1)) if the expenditure is made in
connection with influencing legislation (within the meaning of section
501(c)(3) or Sec. 56.4911-2), or in connection with the payment of the
organization's tax liability under section 4911. For the treatment of
similar expenditures on behalf of other organizations see paragraph
(h)(6) of this section.
(k) Effective/applicability date. In general this section applies to
contributions made in taxable years beginning after December 31, 1969.
Paragraph (j)(11) of this section, however, applies only to out-of-
pocket expenditures made in taxable years beginning after December 31,
1976. In addition, paragraph (h) of this section applies only to
payments made on or after December 16, 1996. However, taxpayers may rely
on the rules of paragraph (h) of this section for payments made on or
after January 1, 1994. Paragraph (j)(9) of this section is applicable
for taxable years
[[Page 20]]
ending after April 9, 2008. The third sentence of paragraph (a) applies
as provided in the sections referenced in that sentence.
(68A Stat. 58, 26 U.S.C. 170(a)(1); 68A Stat. 917, 26 U.S.C. 7805)
[T.D. 7207, 37 FR 20771, Oct. 4, 1972, as amended by T.D. 7340, 40 FR
1238, Jan. 7, 1975; T.D. 7807, 47 FR 4510, Feb. 1, 1982; T.D. 8002, 49
FR 50666, Dec. 31, 1984; T.D. 8308, 55 FR 35587, Aug. 31, 1990; T.D.
8690, 61 FR 65951, Dec. 16, 1996; T.D. 9194, 70 FR 18928, Apr. 11, 2005;
T.D. 9391, 73 FR 19358, Apr. 9, 2008; T.D. 9836, 83 FR 36421, July 30,
2018; 83 FR 45827, Sept. 11, 2018; T.D. 9864, 84 FR 27530, June 13,
2019; T.D, 9907, 85 FR 48474, Aug. 11, 2020]
Sec. 1.170A-2 Amounts paid to maintain certain students as members
of the taxpayer's household.
(a) In general. (1) The term charitable contributions includes
amounts paid by the taxpayer during the taxable year to maintain certain
students as members of his household which, under the provisions of
section 170(h) and this section, are treated as amounts paid for the use
of an organization described in section 170(c) (2), (3), or (4), and
such amounts, to the extent they do not exceed the limitations under
section 170(h)(2) and paragraph (b) of this section, are contributions
deductible under section 170. In order for such amounts to be so
treated, the student must be an individual who is neither a dependent
(as defined in section 152) of the taxpayer nor related to the taxpayer
in a manner described in any of the paragraphs (1) through (8) of
section 152(a), and such individual must be a member of the taxpayer's
household pursuant to a written agreement between the taxpayer and an
organization described in section 170(c) (2), (3), or (4) to implement a
program of the organization to provide educational opportunities for
pupils or students placed in private homes by such organization.
Furthermore, such amounts must be paid to maintain such individual
during the period in the taxable year he is a member of the taxpayer's
household and is a full-time pupil or student in the 12th or any lower
grade at an educational institution, as defined in section 151(e)(4) and
Sec. 1.151-3, located in the United States. Amounts paid outside of
such period, but within the taxable year, for expenses necessary for the
maintenance of the student during the period will qualify for the
charitable contributions deduction if the other limitation requirements
of the section are met.
(2) For purposes of subparagraph (1) of this paragraph, amounts
treated as charitable contributions include only those amounts actually
paid by the taxpayer during the taxable year which are directly
attributable to the maintenance of the student while he is a member of
the taxpayer's household and is attending an educational institution on
a full-time basis. This would include amounts paid to insure the well-
being of the individual and to carry out the purpose for which the
individual was placed in the taxpayer's home. For example, a deduction
under section 170 would be allowed for amounts paid for books, tuition,
food, clothing, transportation, medical and dental care, and recreation
for the individual. Amounts treated as charitable contributions under
this section do not include amounts which the taxpayer would have
expended had the student not been in the household. They would not
include, for example, amounts paid in connection with the taxpayer's
home for taxes, insurance, interest on a mortgage, repairs, etc.
Moreover, such amounts do not include any depreciation sustained by the
taxpayer in maintaining such student or students in his household, nor
do they include the value of any services rendered on behalf of such
student or students by the taxpayer or any member of the taxpayer's
household.
(3) For purposes of section 170(h) and this section, an individual
will be considered to be a full-time pupil or student at an educational
institution only if he is enrolled for a course of study prescribed for
a full-time student at such institution and is attending classes on a
full-time basis. Nevertheless, such individual may be absent from school
due to special circumstances and still be considered to be in full-time
attendance. Periods during the regular school term when the school is
closed for holidays, such as Christmas and Easter, and for periods
between semesters are treated as periods during which the pupil or
student is in full-time attendance at the school. Also,
[[Page 21]]
absences during the regular school term due to illness of such
individual shall not prevent him from being considered as a full-time
pupil or student. Similarly, absences from the taxpayer's household due
to special circumstances will not disqualify the student as a member of
the household. Summer vacations between regular school terms are not
considered periods of school attendance.
(4) When claiming a deduction for amounts described in section
170(h) and this section, the taxpayer must submit with his return a copy
of his agreement with the organization sponsoring the individual placed
in the taxpayer's household, together with a summary of the various
items for which amounts were paid to maintain such individual, and a
statement as to the date the individual became a member of the household
and the period of his full-time attendance at school and the name and
location of such school. Substantiation of amounts claimed must be
supported by adequate records of the amounts actually paid. Due to the
nature of certain items, such as food, a record of amount spent for all
members of the household, with an equal portion thereof allocated to
each member, will be acceptable.
(b) Limitations. Section 170(h) and this section shall apply to
amounts paid during the taxable year only to the extent that the amounts
paid in maintaining each pupil or student do not exceed $50 multiplied
by the number of full calendar months in the taxable year that the pupil
or student is maintained in accordance with the provisions of this
section. For purposes of such limitation if 15 or more days of a
calendar month fall within the period to which the maintenance of such
pupil or student relates, such month is considered as a full calendar
month. To the extent that such amounts qualify as charitable
contributions under section 170(c), the aggregate of such amounts plus
other contributions made during the taxable year for the use of an
organization described in section 170(c) is deductible under section 170
subject to the limitation provided in section 170(b)(1)(B) and paragraph
(c) of Sec. 1.170A-8.
(c) Compensation or reimbursement. Amounts paid during the taxable
year to maintain a pupil or student as a member of the taxpayer's
household as provided in paragraph (a) of this section, shall not be
taken into account under section 170(h) and this section, if the
taxpayer receives any money or other property as compensation or
reimbursement for any portion of such amounts. The taxpayer will not be
denied the benefits of section 170(h) if he prepays an extraordinary or
nonrecurring expense such as a hospital bill or vacation trip, at the
request of the individual's parents or the sponsoring organization and
is reimbursed for such prepayment. The value of services performed by
the pupil or student in attending to ordinary chores of the household
will generally not be considered to constitute compensation or
reimbursement. However, if the pupil or student is taken into the
taxpayer's household to replace a former employee of the taxpayer or
gratuitously to perform substantial services for the taxpayer, the facts
and circumstances may warrant a conclusion that the taxpayer received
reimbursement for maintaining the pupil or student.
(d) No other amount allowed as deduction. Except to the extent that
amounts described in section 170(h) and this section are treated as
charitable contributions under section 170(c) and, therefore, deductible
under section 170(a), no deduction is allowed for any amount paid to
maintain an individual, as a member of the taxpayer's household, in
accordance with the provisions of section 170(h) and this section.
(e) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. The X organization is an organization described in
section 170(c)(2) and is engaged in a program under which a number of
European children are placed in the homes of U.S. residents in order to
further the children's high school education. In accordance with
paragraph (a) of this section, the taxpayer, A, who reports his income
on the calendar year basis, agreed with X to take two of the children,
and they were placed in the taxpayer's home on January 2, 1970, where
they remained until January 21, 1971, during which time they were fully
maintained by the taxpayer. The children enrolled at the local high
school for the full course of study
[[Page 22]]
prescribed for 10th grade students and attended the school on a full-
time basis for the spring semester starting January 18, 1970, and ending
June 3, 1970, and for the fall semester starting September 1, 1970, and
ending January 13, 1971. The total cost of food paid by A in 1970 for
himself, his wife, and the two children amounted to $1,920, or $40 per
month for each member of the household. Since the children were actually
full-time students for only 8\1/2\ months during 1970, the amount paid
for food for each child during that period amounted to $340. Other
amounts paid during the 8 1/2-month period for each child for laundry,
lights, water, recreation, and school supplies amounted to $160. Thus,
the amounts treated under section 170(h) and this section as paid for
the use of X would, with respect to each child, total $500 ($340 +
$160), or a total for both children of $1,000, subject to the
limitations of paragraph (b) of this section. Since, for purposes of
such limitations, the children were full-time students for only 8 full
calendar months during 1970 (less than 15 days in January 1970), the
taxpayer may treat only $800 as a charitable contribution made in 1970,
that is, $50 multiplied by the 8 full calendar months, or $400 paid for
the maintenance of each child. Neither the excess payments nor amounts
paid to maintain the children during the period before school opened and
for the period in summer between regular school terms is taken into
account by reason of section 170(h). Also, because the children were
full-time students for less than 15 days in January 1971 (although
maintained in the taxpayer's household for 21 days), amounts paid to
maintain the children during 1971 would not qualify as a charitable
contribution.
Example 2. A religious organization described in section 170(c)(2)
has a program for providing educational opportunities for children it
places in private homes. In order to implement the program, the
taxpayer, H, who resides with his wife, son, and daughter of high school
age in a town in the United States, signs an agreement with the
organization to maintain a girl sponsored by the organization as a
member of his household while the child attends the local high school
for the regular 1970-71 school year. The child is a full-time student at
the school during the school year starting September 6, 1970, and ending
June 6, 1971, and is a member of the taxpayer's household during that
period. Although the taxpayer pays $200 during the school period falling
in 1970, and $240 during the school period falling in 1971, to maintain
the child, he cannot claim either amount as a charitable contribution
because the child's parents, from time to time during the school year,
send butter, eggs, meat, and vegetables to H to help defray the expenses
of maintaining the child. This is considered property received as
reimbursement under paragraph (c) of this section. Had her parents not
contributed the food, the fact that the child, in addition to the normal
chores she shared with the taxpayer's daughter, such as cleaning their
own rooms and helping with the shopping and cooking, was responsible for
the family laundry and for the heavy cleaning of the entire house while
the taxpayer's daughter had no comparable responsibilities would also
preclude a claim for a charitable contributions deduction. These
substantial gratuitous services are considered property received as
reimbursement under paragraph (c) of this section.
Example 3. A taxpayer resides with his wife in a city in the eastern
United States. He agrees, in writing, with a fraternal society described
in section 170(c)(4) to accept a child selected by the society for
maintenance by him as a member of his household during 1971 in order
that the child may attend the local grammar school as a part of the
society's program to provide elementary education for certain children
selected by it. The taxpayer maintains the child, who has as his
principal place of abode the home of the taxpayer, and is a member of
the taxpayer's household, during the entire year 1971. The child is a
full-time student at the local grammar school for 9 full calendar months
during the year. Under the agreement, the society pays the taxpayer $30
per month to help maintain the child. Since the $30 per month is
considered as compensation or reimbursement to the taxpayer for some
portion of the maintenance paid on behalf of the child, no amounts paid
with respect to such maintenance can be treated as amounts paid in
accordance with section 170(h). In the absence of the $30 per month
payments, if the child qualifies as a dependent of the taxpayer under
section 152(a)(9), that fact would also prevent the maintenance payments
from being treated as charitable contributions paid for the use of the
fraternal society.
(f) Effective date. This section applies only to contributions paid
in taxable years beginning after December 31, 1969.
[T.D. 7207, 37 FR 20774, Oct. 4, 1972]
Sec. 1.170A-3 Reduction of charitable contribution for interest
on certain indebtedness.
(a) In general. Section 170(f)(5) requires that the amount of a
charitable contribution be reduced for certain interest to the extent
necessary to avoid the deduction of the same amount both as an interest
deduction under section 163 and as a deduction for charitable
[[Page 23]]
contributions under section 170. The reduction is to be determined in
accordance with paragraphs (b) and (c) of this section.
(b) Interest attributable to postcontribution period. In determining
the amount to be taken into account as a charitable contribution for
purposes of section 170, the amount determined without regard to section
170(f)(5) or this section shall be reduced by the amount of interest
which has been paid, or is to be paid, by the taxpayer, which is
attributable to any liability connected with the contribution, and which
is attributable to any period of time after the making of the
contribution. The deduction otherwise allowable for charitable
contributions under section 170 is required to be reduced pursuant to
section 170(f)(5) and this section only if, in connection with a
charitable contribution, a liability is assumed by the recipient of the
contribution or by any other person or if the charitable contribution is
of property which is subject to a liability. Thus, if a charitable
contribution is made in property and the transfer is conditioned upon
the assumption of a liability by the donee or by some other person, the
contribution must be reduced by the amount of any interest which has
been paid, or will be paid, by the taxpayer, which is attributable to
the liability, and which is attributable to any period after the making
of the contribution. The adjustment referred to in this paragraph must
also be made where the contributed property is subject to a liability
and the value of the property reflects the payment by the donor of
interest with respect to a period of time after the making of the
contribution.
(c) Interest attributable to precontribution period. If, in
connection with the charitable contribution of a bond, a liability is
assumed by the recipient or by any other person, or if the bond is
subject to a liability, then, in determining the amount to be taken into
account as a charitable contribution under section 170, the amount
determined without regard to section 170(f)(5) and this section shall,
without regard to whether any reduction may be required by paragraph (b)
of this section, also be reduced for interest which has been paid, or is
to be paid, by the taxpayer on indebtedness incurred or continued to
purchase or carry such bond, and which is attributable to any period
before the making of the contribution. However, the reduction referred
to in this paragraph shall be made only to the extent that such
reduction does not exceed the interest (including bond discount and
other interest equivalent) receivable on the bond, and attributable to
any period before the making of the contribution which is not, by reason
of the taxpayer's method of accounting, includible in the taxpayer's
gross income for any taxable year. For purposes of section 170(f)(5) and
this section the term bond means any bond, debenture, note, or
certificate or other evidence of indebtedness.
(d) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. On January 1, 1970, A, a cash basis taxpayer using the
calendar year as the taxable year, contributed to a charitable
organization real estate having a fair market value and adjusted basis
of $10,000. In connection with the contribution the charitable
organization assumed an indebtedness of $8,000 which A had incurred. On
December 31, 1969, A prepaid one year's interest on that indebtedness
for 1970, amounting to $960, and took an interest deduction of $960 for
such amount. The amount of the gift, determined without regard to this
section, is $2,960 ($10,000 less $8,000, the outstanding indebtedness,
plus $960, the amount of prepaid interest). In determining the amount of
the deduction for the charitable contribution, the value of the gift
($2,960) must be reduced by $960 to eliminate from the computation of
such deduction that portion thereof for which A has been allowed an
interest deduction.
Example 2. (a) On January 1, 1970, B, an individual using the cash
receipts and disbursements method of accounting, purchased for $9,950 a
5\1/2\ percent $10,000, 20-year M Corporation bond, the interest on
which was payable semiannually on June 30 and December 31. The M
Corporation had issued the bond on January 1, 1960, at a discount of
$720 from the principal amount. On December 1, 1970, B donated the bond
to a charitable organization, and, in connection with the contribution,
the charitable organization assumed an indebtedness of $7,000 which B
had incurred to purchase and carry the bond.
(b) During the calendar year 1970 B paid accrued interest of $330 on
the indebtedness for the period from January 1, 1970, to December
[[Page 24]]
1, 1970, and has taken an interest deduction of $330 for such amount. No
portion of the bond discount of $36 a year ($720 divided by 20 years)
has been included in B's income, and of the $550 of annual interest
receivable on the bond, he included in income only the June 30, 1970,
payment of $275.
(c) The market value of the bond on December 1, 1970, was $9,902.
Such value includes $229 of interest receivable which had accrued from
July 1 to December 1, 1970.
(d) The amount of the charitable contribution determined without
regard to this section is $2,902 ($9,902, the value of the property on
the date of gift, less $7,000, the amount of the liability assumed by
the charitable organization). In determining the amount of the allowable
deduction for charitable contributions, the value of the gift ($2,902)
must be reduced to eliminate from the deduction that portion thereof for
which B has been allowed an interest deduction. Although the amount of
such interest deduction was $330, the reduction required by this section
is limited to $262, since the reduction is not in excess of the amount
of interest income on the bond ($229 of accrued interest plus $33, the
amount of bond discount attributable to the 11-month period B held the
bond).
(e) Effective date. This section applies only to contributions paid
in taxable years beginning after December 31, 1969.
[T.D. 7207, 37 FR 20775, Oct. 4, 1972]
Sec. 1.170A-4 Reduction in amount of charitable contributions of
certain appreciated property.
(a) Amount of reduction. Section 170(e)(1) requires that the amount
of the charitable contribution which would be taken into account under
section 170(a) without regard to section 170(e) shall be reduced before
applying the percentage limitations under section 170(b):
(1) In the case of a contribution by an individual or by a
corporation of ordinary income property, as defined in paragraph (b)(1)
of this section, by the amount of gain (hereinafter in this section
referred to as ordinary income) which would have been recognized as gain
which is not long-term capital gain if the property had been sold by the
donor at its fair market value at the time of its contribution to the
charitable organization,
(2) In the case of a contribution by an individual of section 170(e)
capital gain property, as defined in paragraph (b)(2) of this section,
by 50 percent of the amount of gain (hereinafter in this section
referred to as long-term capital gain) which would have been recognized
as long-term capital gain if the property had been sold by the donor at
its fair market value at the time of its contribution to the charitable
organization, and
(3) In the case of a contribution by a corporation of section 170(e)
capital gain property, as defined in paragraph (b)(2) of this section,
by 62\1/2\ percent of the amount of gain (hereinafter in this section
referred to as long-term capital gain) which would have been recognized
as long-term capital gain if the property had been sold by the donor at
its fair market value at the time of its contribution to the charitable
organization.
Section 170(e)(1) and this paragraph do not apply to reduce the amount
of the charitable contribution where, by reason of the transfer of the
contributed property, ordinary income or capital gain is recognized by
the donor in the same taxable year in which the contribution is made.
Thus, where income or gain is recognized under section 453(d) upon the
transfer of an installment obligation to a charitable organization, or
under section 454(b) upon the transfer of an obligation issued at a
discount to such an organization, or upon the assignment of income to
such an organization, section 170(e)(1) and this paragraph do not apply
if recognition of the income or gain occurs in the same taxable year in
which the contribution is made. Section 170(e)(1) and this paragraph
apply to a charitable contribution of an interest in ordinary income
property or section 170(e) capital gain property which is described in
paragraph (b) of Sec. 1.170A-6, or paragraph (b) of Sec. 1.170A-7. For
purposes of applying section 170(e)(1) and this paragraph it is
immaterial whether the charitable contribution is made ``to'' the
charitable organization or whether it is made ``for the use of'' the
charitable organization. See Sec. 1.170A-8(a)(2).
(b) Definitions and other rules. For purposes of this section:
(1) Ordinary income property. The term ordinary income property
means property any portion of the gain on which would not have been long
term capital gain if the property had been
[[Page 25]]
sold by the donor at its fair market value at the time of its
contribution to the charitable organization. Such term includes, for
example, property held by the donor primarily for sale to customers in
the ordinary course of his trade or business, a work of art created by
the donor, a manuscript prepared by the donor, letters and memorandums
prepared by or for the donor, a capital asset held by the donor for not
more than 1 year (6 months for taxable years beginning before 1977; 9
months for taxable years beginning in 1977), and stock described in
section 306(a), 341(a), or 1248(a) to the extent that, after applying
such section, gain on its disposition would not have been long-term
capital gain. The term does not include an income interest in respect of
which a deduction is allowed under section 170(f)(2)(B) and paragraph
(c) of Sec. 1.170A-6.
(2) Section 170(e) capital gain property. The term section 170(e)
capital gain property means property any portion of the gain on which
would have been treated as long-term capital gain if the property had
been sold by the donor at its fair market value at the time of its
contribution to the charitable organization and which:
(i) Is contributed to or for the use of a private foundation, as
defined in section 509(a) and the regulations thereunder, other than a
private foundation described in section 170(b)(1)(E),
(ii) Constitutes tangible personal property contributed to or for
the use of a charitable organization, other than a private foundation to
which subdivision (i) of this subparagraph applies, which is put to an
unrelated use by the charitable organization within the meaning of
subparagraph (3) of this paragraph, or
(iii) Constitutes property not described in subdivision (i) or (ii)
of this subparagraph which is 30-percent capital gain property to which
an election under paragraph (d)(2) of Sec. 1.170A-8 applies.
For purposes of this subparagraph a fixture which is intended to be
severed from real property shall be treated as tangible personal
property.
(3) Unrelated use--(i) In general. The term unrelated use means a
use which is unrelated to the purpose or function constituting the basis
of the charitable organization's exemption under section 501 or, in the
case of a contribution of property to a governmental unit, the use of
such property by such unit for other than exclusively public purposes.
For example, if a painting contributed to an educational institution is
used by that organization for educational purposes by being placed in
its library for display and study by art students, the use is not an
unrelated use; but if the painting is sold and the proceeds used by the
organization for educational purposes, the use of the property is an
unrelated use. If furnishings contributed to a charitable organization
are used by it in its offices and buildings in the course of carrying
out its functions, the use of the property is not an unrelated use. If a
set or collection of items of tangible personal property is contributed
to a charitable organization or governmental unit, the use of the set or
collection is not an unrelated use if the donee sells or otherwise
disposes of only an insubstantial portion of the set or collection. The
use by a trust of tangible personal property contributed to it for the
benefit of a charitable organization is an unrelated use if the use by
the trust is one which would have been unrelated if made by the
charitable organization.
(ii) Proof of use. For purposes of applying subparagraph (2)(ii) of
this paragraph, a taxpayer who makes a charitable contribution of
tangible personal property to or for the use of a charitable
organization or governmental unit may treat such property as not being
put to an unrelated use by the donee if:
(a) He establishes that the property is not in fact put to an
unrelated use by the donee, or
(b) At the time of the contribution or at the time the contribution
is treated as made, it is reasonable to anticipate that the property
will not be put to an unrelated use by the donee. In the case of a
contribution of tangible personal property to or for the use of a
museum, if the object donated is of a general type normally retained by
such museum or other museums for museum purposes, it will be reasonable
for the donor to anticipate, unless he has actual knowledge to the
contrary, that
[[Page 26]]
the object will not be put to an unrelated use by the donee, whether or
not the object is later sold or exchanged by the donee.
(4) Property used in trade or business. For purposes of applying
subparagraphs (1) and (2) of this paragraph, property which is used in
the trade or business, as defined in section 1231(b), shall be treated
as a capital asset, except that any gain in respect of such property
which would have been recognized if the property had been sold by the
donor at its fair market value at the time of its contribution to the
charitable organization shall be treated as ordinary income to the
extent that such gain would have constituted ordinary income by reason
of the application of section 617 (d)(1), 1245(a), 1250(a), 1251(c),
1252(a), or 1254(a).
(5) Nonresident alien individuals and foreign corporations. The
reduction in the case of a nonresident alien individual or a foreign
corporation shall be determined by taking into account the gain which
would have been recognized and subject to tax under chapter 1 of the
Code if the property had been sold or disposed of within the United
States by the donor at its fair market value at the time of its
contribution to the charitable organization. However, the amount of such
gain which would have been subject to tax under section 871(a) or 881
(relating to gain not effectively connected with the conduct of a trade
or business within the United States) if there had been a sale or other
disposition within the United States shall be treated as long-term
capital gain. Thus, a charitable contribution by a nonresident alien
individual or a foreign corporation of property the sale or other
disposition of which within the United States would have resulted in
gain subject to tax under section 871(a) or 881 will be reduced only as
provided in section 170(e)(1)(B) and paragraph (a) (2) or (3) of this
section, but only if the property contributed is described in
subdivision (i), (ii), or (iii) of subparagraph (2) of this paragraph. A
charitable contribution by a nonresident alien individual or a foreign
corporation of property the sale or other disposition of which within
the United States would have resulted in gain subject to tax under
section 871(a) or 881 will in no case be reduced under section
170(e)(1)(A) and paragraph (a)(1) of this section.
(c) Allocation of basis and gain--(1) In general. Except as provided
in subparagraph (2) of this paragraph:
(i) If a taxpayer makes a charitable contribution of less than his
entire interest in appreciated property, whether or not the transfer is
made in trust, as, for example, in the case of a transfer of appreciated
property to a pooled income fund described in section 642(c)(5) and
Sec. 1.642(c)-5, and is allowed a deduction under section 170 for a
portion of the fair market value of such property, then for purposes of
applying the reduction rules of section 170(e)(1) and this section to
the contributed portion of the property the taxpayer's adjusted basis in
such property at the time of the contribution shall be allocated under
section 170(e)(2) between the contributed portion of the property and
the noncontributed portion.
(ii) The adjusted basis of the contributed portion of the property
shall be that portion of the adjusted basis of the entire property which
bears the same ratio to the total adjusted basis as the fair market
value of the contributed portion of the property bears to the fair
market value of the entire property.
(iii) The ordinary income and the long-term capital gain which shall
be taken into account in applying section 170(e)(1) and paragraph (a) of
this section to the contributed portion of the property shall be the
amount of gain which would have been recognized as ordinary income and
long-term capital gain if such contributed portion had been sold by the
donor at its fair market value at the time of its contribution to the
charitable organization.
(2) Bargain sale. (i) Section 1011(b) and Sec. 1.1011-2 apply to
bargain sales of property to charitable organizations. For purposes of
applying the reduction rules of section 170(e)(1) and this section to
the contributed portion of the property in the case of a bargain sale,
there shall be allocated under section 1011(b) to the contributed
portion of the property that portion of the adjusted basis of the entire
property that bears the same ratio to the total adjusted basis as the
fair market value of
[[Page 27]]
the contributed portion of the property bears to the fair market value
of the entire property. For purposes of applying section 170(e)(1) and
paragraph (a) of this section to the contributed portion of the property
in such a case, there shall be allocated to the contributed portion the
amount of gain that is not recognized on the bargain sale but that would
have been recognized if such contributed portion had been sold by the
donor at its fair market value at the time of its contribution to the
charitable organization.
(ii) The term bargain sale, as used in this subparagraph, means a
transfer of property which is in part a sale or exchange of the property
and in part a charitable contribution, as defined in section 170(c), of
the property.
(3) Ratio of ordinary income and capital gain. For purposes of
applying subparagraphs (1)(iii) and (2)(i) of this paragraph, the amount
of ordinary income (or long-term capital gain) which would have been
recognized if the contributed portion of the property had been sold by
the donor at its fair market value at the time of its contribution shall
be that amount which bears the same ratio to the ordinary income (or
long-term capital gain) which would have been recognized if the entire
property had been sold by the donor at its fair market value at the time
of its contribution as (i) the fair market value of the contributed
portion at such time bears to (ii) the fair market value of the entire
property at such time. In the case of a bargain sale, the fair market
value of the contributed portion for purposes of subdivision (i) is the
amount determined by subtracting from the fair market value of the
entire property the amount realized on the sale.
(4) Donee's basis of property acquired. The adjusted basis of the
contributed portion of the property, as determined under subparagraph
(1) or (2) of this paragraph, shall be used by the donee in applying to
the contributed portion such provisions as section 514(a)(1), relating
to adjusted basis of debt-financed property; section 1015(a), relating
to basis of property acquired by gift; section 4940(c)(4), relating to
capital gains and losses in determination of net investment income; and
section 4942(f)(2)(B), relating to net short-term capital gain in
determination of tax on failure to distribute income. The fair market
value of the contributed portion of the property at the time of the
contribution shall not be used by the donee as the basis of such
contributed portion.
(d) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. (a) On July 1, 1970, C, an individual, makes the
following charitable contributions, all of which are made to a church
except in the case of the stock (as indicated):
------------------------------------------------------------------------
Fair
Property market Adjusted Recognized
value basis gain sold
------------------------------------------------------------------------
Ordinary income property................ $50,000 $35,000 $15,000
Property which, if sold, would produce
long-term capital gain:
(1) Stock held more than 6 months
contributed to--.....................
(i) A church........................ 25,000 21,000 4,000
(ii) A private foundation not 15,000 10,000 5,000
described in section 170(b)(1)(E)..
(2) Tangible personal property held 12,000 6,000 6,000
more than 6 months (put to unrelated
use by church).......................
-------------------------------
Total.................................. 102,000 72,000 30,000
------------------------------------------------------------------------
(b) After making the reductions required by paragraph (a) of this
section, the amount of charitable contributions allowed (before
application of section 170(b) limitations) is as follows:
------------------------------------------------------------------------
Fair
Property market Reduction Contribution
value allowed
------------------------------------------------------------------------
Ordinary income property............. $50,000 $15,000 $35,000
Property which, if sold, would
produce long-term capital gain:
(1) Stock contributed to:..........
(i) The church................... 25,000 ......... 25,000
(ii) The private foundation...... 15,000 2,500 12,500
(2) Tangible personal property..... 12,000 3,000 9,000
----------------------------------
Total............................... 102,000 20,500 81,500
------------------------------------------------------------------------
(c) If C were a corporation, rather than an individual, the amount
of charitable contributions allowed (before application of section
170(b) limitation) would be as follows:
[[Page 28]]
------------------------------------------------------------------------
Fair
Property market Reduction Contribution
value allowed
------------------------------------------------------------------------
Ordinary income property............. $50,000 $15,000 $35,000
Property which, if sold, would
produce long-term capital gain:
(1) Stock contributed to:..........
(i) The church................... 25,000 ......... 25,000
(ii) The private foundation...... 15,000 3,125 11,875
(2) Tangible personal property..... 12,000 3,750 8,250
----------------------------------
Total............................ 102,000 21,875 80,125
------------------------------------------------------------------------
Example 2. On March 1, 1970, D, an individual, contributes to a
church intangible property to which section 1245 applies which has a
fair market value of $60,000 and an adjusted basis of $10,000. At the
time of the contribution D has used the property in his business for
more than 6 months. If the property had been sold by D at its fair
market value at the time of its contribution, it is assumed that under
section 1245 $20,000 of the gain of $50,000 would have been treated as
ordinary income and $30,000 would have been long-term capital gain.
Under paragraph (a)(1) of this section, D's contribution of $60,000 is
reduced by $20,000.
Example 3. The facts are the same as in Example 2 except that the
property is contributed to a private foundation not described in section
170(b)(1)(E). Under paragraph (a) (1) and (2) of this section, D's
contribution is reduced by $35,000 (100 percent of the ordinary income
of $20,000 and 50 percent of the long-term capital gain of $30,000).
Example 4. (a) In 1971, E, an individual calendar-year taxpayer,
contributes to a church stock held for more than 6 months which has a
fair market value of $90,000 and an adjusted basis of $10,000. In 1972,
E also contributes to a church stock held for more than 6 months which
has a fair market value of $20,000 and an adjusted basis of $10,000. E's
contribution base for 1971 is $200,000; and for 1972, is $150,000. E
makes no other charitable contributions for these 2 taxable years.
(b) For 1971 the amount of the contribution which may be taken into
account under section 170(a) is limited by section 170(b)(1)(D)(i) to
$60,000 ($200,000 x 30%), and A is allowed a deduction for $60,000.
Under section 170(b)(1)(D)(ii), E has a $30,000 carryover to 1972 of 30-
percent capital gain property, as defined in paragraph (d)(3) of Sec.
1.170A-8. For 1972 the amount of the charitable contributions deduction
is $45,000 (total contributions of $50,000 [$30,000 + $20,000] but not
to exceed 30% of $150,000).
(c) Assuming, however, that in 1972 E elects under section
170(b)(1)(D)(iii) and paragraph (d)(2) of Sec. 1.170A-8 to have section
170(e)(1)(B) apply to his contributions and carryovers of 30-percent
capital gain property, he must apply section 170(d)(1) as if section
170(e)(1)(B) had applied to the contribution for 1971. If section 170
(e)(1)(B) had applied in 1971 to his contributions of 30-percent capital
gain property, E's contribution would have been reduced from $90,000 to
$50,000, the reduction of $40,000 being 50 percent of the gain of
$80,000 ($90,000-$10,000) which would have been recognized as long-term
capital gain if the property had been sold by E at its fair market value
at the time of its contribution to the church. Accordingly, by taking
the election into account, E has no carryover of 30-percent capital gain
property to 1972 since the charitable contributions deduction of $60,000
allowed for 1971 in respect of that property exceeds the reduced
contribution of $50,000 for 1971 which may be taken into account by
reason of the election. The charitable contributions deduction of
$60,000 allowed for 1971 is not reduced by reason of the election.
(d) Since by reason of the election E is allowed under paragraph
(a)(2) of this section a charitable contributions deduction for 1972 of
$15,000 ($20,000-[($20,000- $10,000) x 50%]) and since the $30,000
carryover from 1971 is eliminated, it would not be to E's advantage to
make the election under section 170(b)(1)(D)(iii) in 1972.
Example 5. In 1970, F, an individual calendar-year taxpayer, sells
to a church for $4,000 ordinary income property with a fair market value
of $10,000 and an adjusted basis of $4,000. F's contribution base for
1970 is $20,000, and F makes no other charitable contributions in 1970.
Thus, F makes a charitable contribution to the church of $6,000
($10,000-$4,000 amount realized), which is 60% of the value of the
property. The amount realized on the bargain sale is 40% ($4,000/
$10,000) of the value of the property. In applying section 1011(b) to
the bargain sale, adjusted basis in the amount of $1,600 ($4,000
adjusted basis x 40%) is allocated under Sec. 1.1011-2(b) to the
noncontributed portion of the property, and F recognizes $2,400 ($4,000
amount realized less $1,600 adjusted basis) of ordinary income. Under
paragraphs (a)(1) and (c)(2)(i) of this section, F's contribution of
$6,000 is reduced by $3,600 ($6,000 - [$4,000 adjusted basis x 60%])
(i.e., the amount of ordinary income that would have been recognized on
the contributed portion had the property been sold). The reduced
contribution of $2,400 consists of the portion ($4,000 x 60%) of the
adjusted basis not allocated to the noncontributed portion of the
property. That is, the reduced contribution consists of the portion of
the adjusted basis allocated to the contributed portion. Under sections
1012 and 1015(a) the basis of the property to the church is $6,400
($4,000 + $2,400).
Example 6. In 1970, G, an individual calendar-year taxpayer, sells
to a church for $6,000 ordinary income property with a fair market value
of $10,000 and an adjusted basis of $4,000. G's contribution base for
1970 is
[[Page 29]]
$20,000, and G makes no other charitable contributions in 1970. Thus, G
makes a charitable contribution to the church of $4,000 ($10,000 -
$6,000 amount realized), which is 40% of the value of the property. The
amount realized on the bargain sale is 60% ($6,000 / $10,000) of the
value of the property. In applying section 1011(b) to the bargain sale,
adjusted basis in the amount of $2,400 ($4,000 adjusted basis x 60%) is
allocated under Sec. 1.1011-2(b) to the noncontributed portion of the
property, and G recognizes $3,600 ($6,000 amount realized less $2,400
adjusted basis) of ordinary income. Under paragraphs (a)(1) and
(c)(2)(i) of this section, G's contribution of $4,000 is reduced by
$2,400 ($4,000 - [$4,000 adjusted basis x 40%]) (i.e., the amount of
ordinary income that would have been recognized on the contributed
portion had the property been sold). The reduced contribution of $1,600
consist of the portion ($4,000 x 40%) of the adjusted basis not
allocated to the noncontributed portion of the property. That is, the
reduced contribution consists of the portion of the adjusted basis
allocated to the contributed portion. Under sections 1012 and 1015(a)
the basis of the property to the church is $7,600 ($6,000 + $1,600).
Example 7. In 1970, H, an individual calendar-year taxpayer, sells
to a church for $2,000 stock held for not more than 6 months which has
an adjusted basis of $4,000 and a fair market value of $10,000. H's
contribution base for 1970 is $20,000, and H makes no other charitable
contributions in 1970. Thus, H makes a charitable contribution to the
church of $8,000 ($10,000 - $2,000 amount realized), which is 80% of the
value of the property. The amount realized on the bargain sale is 20%
($2,000 / $10,000) of the value of the property. In applying section
1011(b) to the bargain sale, adjusted basis in the amount of $800
($4,000 adjusted basis x 20%) is allocated under Sec. 1.1011-2(b) to
the noncontributed portion of the property, and H recognizes $1,200
($2,000 amount realized less $800 adjusted basis) of ordinary income.
Under paragraphs (a)(1) and (c)(2)(i) of this section, H's contribution
of $8,000 is reduced by $4,800 ($8,000 - [$4,000 adjusted basis x 80%])
(i.e., the amount of ordinary income that would have been recognized on
the contributed portion had the property been sold). The reduced
contribution of $3,200 consists of the portion ($4,000 x 80%) of the
adjusted basis not allocated to the noncontributed portion of the
property. That is, the reduced contribution consists of the portion of
the adjusted basis allocated to the contributed portion. Under sections
1012 and 1015(a) the basis of the property to the church is $5,200
($2,000 + $3,200).
Example 8. In 1970, F, an individual calendar-year taxpayer, sells
for $4,000 to a private foundation not described in section 170(b)(1)(E)
property to which section 1245 applies which has a fair market value of
$10,000 and an adjusted basis of $4,000. F's contribution base for 1970
is $20,000, and F makes no other charitable contributions in 1970. At
the time of the bargain sale, F has used the property in his business
for more than 6 months. Thus F makes a charitable contribution of $6,000
($10,000 - $4,000 amount realized), which is 60% of the value of the
property. The amount realized on the bargain sale is 40% ($4,000/
$10,000) of the value of the property. If the property had been sold by
F at its fair market value at the time of its contribution, it is
assumed that under section 1245 $4,000 of the gain of $6,000 ($10,000-
$4,000 adjusted basis) would have been treated as ordinary income and
$2,000 would have been long-term capital gain. In applying section
1011(b) to the bargain sale, adjusted basis in the amount of $1,600
($4,000 adjusted basis x 40%) is allocated under Sec. 1.1011-2(b) to
the noncontributed portion of the property, and F's recognized gain of
$2,400 ($4,000 amount realized less $1,600 adjusted basis) consists of
$1,600 ($4,000 x 40%) of ordinary income and $800 ($2,000 x 40%) of
long-term capital gain. Under paragraphs (a) and (c)(2)(i) of this
section, F's contribution of $6,000 is reduced by $3,000 (the sum of
$2,400 ($4,000 x 60%) of ordinary income and $600 ([$2,000 x 60%] x 50%)
of long-term capital gain) (i.e., the amount of gain that would have
been recognized on the contributed portion had the property been sold).
The reduced contribution of $3,000 consists of $2,400 ($4,000 x 60%) of
adjusted basis and $600 ([$2,000 x 60%] x 50%) of long-term capital gain
not used as a reduction under paragraph (a)(2) of this section. Under
sections 1012 and 1015(a) the basis of the property to the private
foundation is $6,400 ($4,000 + $2,400).
Example 9. On January 1, 1970, A, an individual, transfers to a
charitable remainder annuity trust described in section 664 (d)(1) stock
which he has held for more than 6 months and which has a fair market
value of $250,000 and an adjusted basis of $50,000, an irrevocable
remainder interest in the property being contributed to a private
foundation not described in section 170(b)(1)(E). The trusts provides
that an annuity of $12,500 a year is payable to A at the end of each
year for 20 years. By reference to Sec. 20.2031-7A(c) of this chapter
(Estate Tax Regulations) the figure in column (2) opposite 20 years is
11.4699. Therefore, under Sec. 1.664-2 the fair market value of the
gift of the remainder interest to charity is $106,626.25 ($250,000 -
[$12,500 x 11.4699]). Under paragraph (c)(1)(ii) of this section, the
adjusted basis allocated to the contributed portion of the property is
$21,325.25 ($50,000 x $106,626.25/$250,000). Under paragraphs (a)(2) and
(c)(1) of this section, A's contribution is reduced by $42,650.50 (50
percent x [$106,626.25-$21,325.25]) to $63,975.75 ($106,626.25-
$42,650.50). If, however, the irrevocable remainder interest in the
property had been contributed to a section 170(b)(1)(A)
[[Page 30]]
organization, A's contribution of $106,626.25 would not be reduced under
paragraph (a) of this section.
Example 10. (a) On July 1, 1970, B, a calendar-year individual
taxpayer, sells to a church for $75,000 intangible property to which
section 1245 applies which has a fair market value of $250,000 and an
adjusted basis of $75,000. Thus, B makes a charitable contribution to
the church of $175,000 ($250,000-$75,000 amount realized), which is 70%
($175,000/$250,000) of the value of the property, the amount realized on
the bargain sale is 30% ($75,000/$250,000) of the value of the property.
At the time of the bargain sale, B has used the property in his business
for more than 6 months. B's contribution base for 1970 is $500,000, and
B makes no other charitable contributions in 1970. If the property had
been sold by B at its fair market value at the time of its contribution,
it is assumed that under section 1245 $105,000 of the gain of $175,000
($250,000-$75,000 adjusted basis) would have been treated as ordinary
income and $70,000 would have been long-term capital gain. In applying
section 1011(b) to the bargain sale, adjusted basis in the amount of
$22,500 ($75,000 adjusted basis x 30%) is allocated under Sec. 1.1011-
2(b) to the noncontributed portion of the property and B's recognized
gain of $52,500 ($75,000 amount realized less $22,500 adjusted basis)
consists of $31,500 ($105,000 x 30%) of ordinary income and $21,000
($70,000 x 30%) of long term capital gain.
(b) Under paragraphs (a)(1) and (c)(2)(i) of this section B's
contribution of $175,000 is reduced by $73,500 ($105,000 x 70%) (i.e.,
the amount of ordinary income that would have been recognized on the
contributed portion had the property been sold). The reduced
contribution of $101,500 consists of $52,500 [$75,000 x 70%] of adjusted
basis allocated to the contributed portion of the property and $49,000
[$70,000 x 70%] of long-term capital gain allocated to the contributed
portion. Under sections 1012 and 1015(a) the basis of the property to
the church is $127,500 ($75,000 + $52,500).
(e) Effective date. This section applies only to contributions paid
after December 31, 1969, except that, in the case of a charitable
contribution of a letter, memorandum, or property similar to a letter or
memorandum, it applies to contributions paid after July 25, 1969.
[T.D. 7207, 37 FR 20776, Oct. 4, 1972; 37 FR 22982, Oct. 27, 1972, as
amended by T.D. 7728, 45 FR 72650, Nov. 3, 1980; T.D. 7807, 47 FR 4510,
Feb. 1, 1982; T.D. 8176, 53 FR 5569, Feb. 25, 1988; T.D. 8540, 59 FR
30102, June 10, 1994]
Sec. 1.170A-4A Special rule for the deduction of certain charitable
contributions of inventory and other property.
(a) Introduction. Section 170(e)(3) provides a special rule for the
deduction of certain qualified contributions of inventory and certain
other property. To be treated as a ``qualified contribution'', a
contribution must meet the restrictions and requirements of section
170(e)(3)(A) and paragraph (b) of this section. Paragraph (b)(1) of this
section describes the corporations whose contributions may be subject to
this section, the exempt organizations to which these contributions may
be made, and the kinds of property which may be contributed. Under
paragraph (b)(2) of this section, the use of the property must be
related to the purpose or function constituting the ground for the
exemption of the organization to which the contribution is made. Also,
the property must be used for the care of the ill, needy, or infants.
Under paragraph (b)(3) of this section, the recipient organization may
not, except as there provided, require or receive in exchange money,
property, or services for the transfer or use of property contributed
under section 170(e)(3). Under paragraph (b)(4) of this section, the
recipient organization must provide the contributing taxpayer with a
written statement representing that the organization intends to comply
with the restrictions set forth in paragraph (b) (2) and (3) of this
section on the use and transfer of the property. Under paragraph (b)(5)
of this section, the contributed property must conform to any applicable
provisions of the Federal Food, Drug, and Cosmetic Act (as amended), and
the regulations thereunder, at the date of contribution and for the
immediately preceding 180 days. Paragraph (c) of this section provides
the rules for determining the amount of reduction of the charitable
contribution under section 170(e)(3). In general, the amount of the
reduction is equal to one-half of the amount of gain (other than gain
described in paragraph (d) of this section) which would not have been
long-term capital gain if the property had been sold by the donor-
taxpayer at fair market value at the
[[Page 31]]
date of contribution. If, after this reduction, the amount of the
deduction would be more than twice the basis of the contributed
property, the amount of the deduction is accordingly further reduced
under paragraph (c)(1) of this section. The basis of contributed
property which is inventory is determined under paragraph (c)(2) of this
section, and the donor's cost of goods sold for the year of contribution
must be adjusted under paragraph (c)(3) of this section. Under paragraph
(d) of this section, a deduction is not allowed for any amount which, if
the property had been sold by the donor-taxpayer, would have been gain
to which the recapture provisions of section 617, 1245, 1250, 1251, or
1252 would have applied. For purposes of section 170(e)(3) the rules of
Sec. 1.170A-4 apply where not inconsistent with the rules of this
section.
(b) Qualified contributions--(1) In general. A contribution of
property qualifies under section 170(e)(3) of this section only if it is
a charitable contribution:
(i) By a corporation, other than a corporation which is an electing
small business corporation within the meaning of section 1371(b);
(ii) To an organization described in section 501(c)(3) and exempt
under section 501(a), other than a private foundation, as defined in
section 509(a), which is not an operating foundation, as defined in
section 4942(j)(e);
(iii) Of property described in section 1221 (1) or (2);
(iv) Which contribution meets the restrictions and requirements of
paragraph (b) (2) through (5) of this section.
(2) Restrictions on use of contributed property. In order for the
contribution to qualify under this section, the contributed property is
subject to the following restrictions in use. If the transferred
property is used or transferred by the donee organization (or by any
subsequent transferee that furnished to the donee organization the
written statement described in paragraph (b)(4)(ii) of this section) in
a manner inconsistent with the requirements of subdivision (i) or (ii)
of this paragraph (b)(2) or the requirements of paragraph (b)(3) of this
section, the donor's deduction is reduced to the amount allowable under
section 170 of the regulations thereunder, determined without regard to
section 170(e)(3) of this section. If, however, the donor establishes
that, at the time of the contribution, the donor reasonably anticipated
that the property would be used in a manner consistent with those
requirements, then the donor's deduction is not reduced.
(i) Requirement of use for exempt purpose. The use of the property
must be related to the purpose or function constituting the ground for
exemption under section 501(c)(3) of the organization to which the
contribution is made. The property may not be used in connection with
any activity which gives rise to unrelated trade or business income, as
defined in sections 512 and 513 and the regulations thereunder.
(ii) Requirement of use for care of the ill, needy, or infants--(A)
In general. The property must be used for the care of the ill, needy, or
infants, as defined in this subdivision (ii). The property itself must
ultimately either be transferred to (or for the use of) the ill, needy,
or infants for their care or be retained for their care. No other person
may use the contributed property except as incidental to primary use in
the care of the ill, needy, or infants. The organization may satisfy the
requirement of this subdivision by transferring the property to a
relative, custodian, parent or guardian of the ill or needy individual
or infant, or to any other individual if it makes a reasonable effort to
ascertain that the property will ultimately be used primarily for the
care of the ill or needy individual, or infant, and not for the primary
benefit of any other person. The recipient organization may transfer the
property to another exempt organization within the jurisdiction of the
United States which meets the description contained in paragraph
(b)(1)(ii) of this section, or to an organization not within the
jurisdiction of the United States that, but for the fact that it is not
within the jurisdiction of the United States, would be described in
paragraph (b)(1)(ii) of this section. If an organization transfers the
property to another organization, the transferring organization must
obtain a written statement from the transferee organization as set forth
in paragraph (b)(4) of this section. If
[[Page 32]]
the property is ultimately transferred to, or used for the benefit of,
ill or needy persons, or infants, not within the jurisdiction of the
United States, the organization which so transfers the property outside
the jurisdiction of the United States must necessarily be a corporation.
See section 170(c)(2) and Sec. 1.170A-11(a). For purposes of this
subdivision, if the donee-organization charges for its transfer of
contributed property (other than a fee allowed by paragraph (b)(3)(ii)
of this section), the requirement of this subdivision is not met. See
paragraph (b)(3) of this section.
(B) Definition of the ill. An ill person is a person who requires
medical care within the meaning of Sec. 1.213-1(e). Examples of ill
persons include a person suffering from physical injury, a person with a
significant impairment of a bodily organ, a person with an existing
handicap, whether from birth or later injury, a person suffering from
malnutrition, a person with a disease, sickness, or infection which
significantly impairs physical health, a person partially or totally
incapable of self-care (including incapacity due to old age). A person
suffering from mental illness is included if the person is hospitalized
or institutionalized for the mental disorder, or, although the person is
nonhospitalized or noninstitutionalized, if the person's mental illness
constitutes a significant health impairment.
(C) Definition of care of the ill. Care of the ill means alleviation
or cure of an existing illness and includes care of the physical,
mental, or emotional needs of the ill.
(D) Definition of the needy. A needy person is a person who lacks
the necessities of life, involving physical, mental, or emotional well-
being, as a result of poverty or temporary distress. Examples of needy
persons include a person who is financially impoverished as a result of
low income and lack of financial resources, a person who temporarily
lacks food or shelter (and the means to provide for it), a person who is
the victim of a natural disaster (such as fire or flood), a person who
is the victim of a civil disaster (such as a civil disturbance), a
person who is temporarily not self-sufficient as a result of a sudden
and severe personal or family crisis (such as a person who is the victim
of a crime of violence or who has been physically abused), a person who
is a refugee or immigrant and who is experiencing language, cultural, or
financial difficulties, a minor child who is not self-sufficient and who
is not cared for by a parent or guardian, and a person who is not self-
sufficient as a result of previous institutionalization (such as a
former prisoner or a former patient in a mental institution).
(E) Definition of care of the needy. Care of the needy means
alleviation or satisfaction of an existing need. Since a person may be
needy in some respects and not needy in other respects, care of the
needy must relate to the particular need which causes the person to be
needy. For example, a person whose temporary need arises from a natural
disaster may need temporary shelter and food but not recreational
facilities.
(F) Definition of infant. An infant is a minor child (as determined
under the laws of the jurisdiction in which the child resides).
(G) Definition of care of an infant. Care of an infant means
performance of parental functions and provision for the physical,
mental, and emotional needs of the infant.
(3) Restrictions on Transfer of contributed property--(i) In
general. Except as otherwise provided in subdivision (ii) of this
paragraph (b)(3), a contribution will not qualify under this section, if
the donee-organization or any transferee of the donee-organization
requires or receives any money, property, or services for the transfer
or use of property contributed under section 170(e)(3). For example, if
an organization provides temporary shelter for a fee, and also provides
free meals to ill or needy individuals, or infants using food
contributed under this section the contribution of food is subject to
this section (if the other requirements of this section are met).
However, the fee charged by the organization for the shelter may not be
increased merely because meals are served to the ill or needy
individuals or infants.
(ii) Exception. A contribution may qualify under this section if the
donee-organization charges a fee to another
[[Page 33]]
organization in connection with its transfer of the donated property,
if:
(A) The fee is small or nominal in relation to the value of the
transferred property and is not determined by this value; and
(B) The fee is designed to reimburse the donee-organization for its
administrative, warehousing, or other similar costs.
For example, if a charitable organization (such as a food bank) accepts
surplus food to distribute to other charities which give the food to
needy persons, a small fee may be charged to cover administrative,
warehousing, and other similar costs. This fee may be charged on the
basis of the total number of pounds of food distributed to the
transferee charity but not on the basis of the value of the food
distributed. The provisions of this subdivision (ii) do not apply to a
transfer of donated property directly from an organization to ill or
needy individuals, or infants.
(4) Requirement of a written statement--(i) Furnished to taxpayer.
In the case of any contribution made on or after March 3, 1982, the
donee-organization must furnish to the taxpayer a written statement
which:
(A) Describes the contributed property, stating the date of its
receipt;
(B) Represents that the property will be used in compliance with
section 170(e)(3) and paragraphs (b) (2) and (3) of this section;
(C) Represents that the donee-organization meets the requirements of
paragraph (b)(1)(ii) of this section; and
(D) Represents that adequate books and records will be maintained,
and made available to the Internal Revenue Service upon request.
The written statement must be furnished within a reasonable period after
the contribution, but not later than the date (including extensions) by
which the donor is required to file a United States corporate income tax
return for the year in which the contribution was made. The books and
records described in (D) of this subdivision (i) need not trace the
receipt and disposition of specific items of donated property if they
disclose compliance with the requirements by reference to aggregate
quantities of donated property. The books and records are adequate if
they reflect total amounts received and distributed (or used), and
outline the procedure used for determining that the ultimate recipient
of the property is an ill or needy individual, or infant. However, the
books and records need not reflect the names of the ultimate individual
recipients or the property distributed to (or used by) each one.
(ii) Furnished to transferring organization. If an organization that
received a contribution under this section transfers the contributed
property to another organization on or after March 3, 1982, the
transferee organization must furnish to the transferring organization a
written statement which contains the information required in paragraph
(b)(4)(i) (A), (B) and (D) of this section. The statement must also
represent that the transferee organization meets the requirements of
paragraph (b)(1)(ii) of this section (or, in the case of a transferee
organization which is a foreign organization not within the jurisdiction
of the United States, that, but for such fact, the organization would
meet the requirements of paragraph (b)(1)(ii) of this section). The
written statement must be furnished within a reasonable period after the
transfer.
(5) Requirement of compliance with the Federal Food, Drug, and
Cosmetic Act--(i) In general. With respect to property contributed under
this section which is subject to the Federal Food, Drug, and Cosmetic
Act (as amended), and regulations thereunder, the contributed property
must comply with the applicable provisions of that Act and regulations
thereunder at the date of the contribution and for the immediately
preceding 180 days. In the case of specific items of contributed
property not in existence for the entire period of 180 days immediately
preceding the date of contribution, the requirement of this paragraph
(b)(5) is considered met if the contributed property complied with that
Act and the regulations thereunder during the period of its existence
and at the date of contribution and if, for the 180 day period prior to
contribution other property (if any) held by the taxpayer at any time
during that period, which property was fungible with the contributed
property, complied with that Act
[[Page 34]]
and the regulations thereunder during the period held by the taxpayer.
(ii) Example. The rule of this paragraph (b)(5) may be illustrated
by the following example.
Example. Corporation X a grocery store, contributes 12 crates of
navel oranges. The oranges were picked and placed in the grocery store's
stock two weeks prior to the date of contribution. The contribution
satisfies the requirements of this paragraph (b)(5) if X complied with
the Act and regulations thereunder for 180 days prior to the date of
contribution with respect to all navel oranges in stock during that
period.
(c) Amount of reduction--(1) In general. Section 170(e)(3)(B)
requires that the amount of the charitable contribution subject to this
section which would be taken into account under section 170(a), without
regard to section 170(e), must be reduced before applying the percentage
limitations under section 170(b). The amount of the first reduction is
equal to one-half of the amount of gain which would not have been long-
term capital gain if the property had been sold by the donor-taxpayer at
its fair market value on the date of its contribution, excluding,
however, any amount described in paragraph (d) of this section. If the
amount of the charitable contribution which remains after this reduction
exceeds twice the basis of the contributed property, then the amount of
the charitable contribution is reduced a second time to an amount which
is equal to twice the amount of the basis of the property.
(2) Basis of contributed property which is inventory. For the
purposes of this section, notwithstanding the rules of Sec. 1.170A-
1(c)(4), the basis of contributed property which is inventory must be
determined under the donor's method of accounting for inventory for
purposes of United States income tax. The donor must use as the basis of
the contributed item the inventoriable carrying cost assigned to any
similar item not included in closing inventory. For example, under the
LIFO dollar value method of accounting for inventory, where there has
been an invasion of a prior year's layer, the donor may choose to treat
the item contributed as having a basis of the unit's cost with reference
to the layer(s) of prior year(s) cost or with reference to the current
year cost.
(3) Adjustment to cost of goods sold. Notwithstanding the rules of
Sec. 1.170A-1(c)(4), the donor of the property which is inventory
contributed under this section must make a corresponding adjustment to
cost of goods sold by decreasing the cost of goods sold by the lesser of
the fair market value of the contributed item or the amount of basis
determined under paragraph (c)(2) of this section.
(4) Examples. The rules of this paragraph (c) may be illustrated by
the following examples:
Example 1. During 1978 corporation X, a calendar year taxpayer,
makes a qualified contribution of women's coats which were section
1221(1) property. The fair market value of the property at the date of
contribution is $1,000, and the basis of the property is $200. The
amount of the charitable contribution which would be taken into account
under section 170(a) is the fair market value ($1,000). The amount of
gain which would not have been long-term capital gain if the property
had been sold is $800 ($1,000-$200). The amount of the contribution is
reduced by one-half the amount which would not have been capital gain if
the property had been sold ($800/2=-$400).
After this reduction, the amount of the contribution which may be
taken into account is $600 ($1,000-$400). A second reduction is made in
the amount of the charitable contribution because this amount (as first
reduced to $600) is more than $400 which is an amount equal to twice the
basis of the property. The amount of the further reduction is $200
[$600-(2 x $200)], and the amount of the contribution as finally reduced
is $400 [$1,00-($400 + $200)]. X would also have to decrease its cost of
goods sold for the year of contribution by $200.
Example 2. Assume the same facts as set forth in Example 1 except
that the basis of the property is $600. The amount of the first
reduction is $200 (($1,000-$600)/2).
As reduced, the amount of the contribution which may be taken into
account is $800 ($1,000-$200). There is no second reduction because $800
is less than $1,200 which is twice the basis of the property. However, X
would have to decrease its cost of goods sold for the year of
contribution by $600.
(d) Recapture excluded. A deduction is not allowed under section
170(e)(3) or this section for any amount which, if the property had been
sold by the donor-taxpayer on the date of its contribution for an amount
equal to its fair market value, would have been
[[Page 35]]
treated as ordinary income under section 617, 1245, 1250, 1251, or 1252.
Thus, before making either reduction required by section 170(e)(3)(B)
and paragraph (c) of this section, the fair market value of the
contributed property must be reduced by the amount of gain that would
have been recognized (if the property had been sold) as ordinary income
under section 617, 1245, 1250, 1251, or 1252.
(e) Effective date. This section applies to qualified contributions
made after October 4, 1976.
[T.D. 7807, 47 FR 4510, Feb. 1, 1982, as amended by T.D. 7962, 49 FR
27317, July 3, 1984]
Sec. 1.170A-5 Future interests in tangible personal property.
(a) In general. (1) A contribution consisting of a transfer of a
future interest in tangible personal property shall be treated as made
only when all intervening interests in, and rights to the actual
possession or enjoyment of, the property:
(i) Have expired, or
(ii) Are held by persons other than the taxpayer or those standing
in a relationship to the taxpayer described in section 267(b) and the
regulations thereunder, relating to losses, expenses, and interest with
respect to transactions between related taxpayers.
(2) Section 170(a)(3) and this section have no application in
respect of a transfer of an undivided present interest in property. For
example, a contribution of an undivided one-quarter interest in a
painting with respect to which the donee is entitled to possession
during 3 months of each year shall be treated as made upon the receipt
by the donee of a formally executed and acknowledged deed of gift.
However, the period of initial possession by the donee may not be
deferred in time for more than 1 year.
(3) Section 170(a)(3) and this section have no application in
respect of a transfer of a future interest in intangible personal
property or in real property. However, a fixture which is intended to be
severed from real property shall be treated as tangible personal
property. For example, a contribution of a future interest in a
chandelier which is attached to a building is considered a contribution
which consists of a future interest in tangible personal property if the
transferor intends that it be detached from the building at or prior to
the time when the charitable organization's right to possession or
enjoyment of the chandelier is to commence.
(4) For purposes of section 170(a)(3) and this section, the term
future interest has generally the same meaning as it has when used in
section 2503 and Sec. 25.2503-3 of this chapter (Gift Tax Regulations);
it includes reversions, remainders, and other interests or estates,
whether vested or contingent, and whether or not supported by a
particular interest or estate, which are limited to commence in use,
possession, or enjoyment at some future date or time. The term future
interest includes situations in which a donor purports to give tangible
personal property to a charitable organization, but has an
understanding, arrangement, agreement, etc., whether written or oral,
with the charitable organization which has the effect of reserving to,
or retaining in, such donor a right to the use, possession, or enjoyment
of the property.
(5) In the case of a charitable contribution of a future interest to
which section 170(a)(3) and this section apply the other provisions of
section 170 and the regulations thereunder are inapplicable to the
contribution until such time as the contribution is treated as made
under section 170(a)(3).
(b) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. On December 31, 1970, A, an individual who reports his
income on the calendar year basis, conveys by deed of gift to a museum
title to a painting, but reserves to himself the right to the use,
possession, and enjoyment of the painting during his lifetime. It is
assumed that there was no intention to avoid the application of section
170(f)(3)(A) by the conveyance. At the time of the gift the value of the
painting is $90,000. Since the contribution consists of a future
interest in tangible personal property in which the donor has retained
an intervening interest, no contribution is considered to have been made
in 1970.
Example 2. Assume the same facts as in Example 1 except that on
December 31, 1971, A relinquishes all of his right to the use,
possession, and enjoyment of the painting and
[[Page 36]]
delivers the painting to the museum. Assuming that the value of the
painting has increased to $95,000, A is treated as having made a
charitable contribution of $95,000 in 1971 for which a deduction is
allowable without regard to section 170(f)(3)(A).
Example 3. Assume the same facts as in Example 1 except A dies
without relinquishing his right to the use, possession, and enjoyment of
the painting. Since A did not relinquish his right to the use,
possession, and enjoyment of the property during his life, A is treated
as not having made a charitable contribution of the painting for income
tax purposes.
Example 4. Assume the same facts as in Example 1 except A, on
December 31, 1971, transfers his interest in the painting to his son, B,
who reports his income on the calendar year basis. Since the
relationship between A and B is one described in section 267(b), no
contribution of the remainder interest in the painting is considered to
have been made in 1971.
Example 5. Assume the same facts as in Example 4. Also assume that
on December 31, 1972, B conveys to the museum the interest measured by
A's life. B has made a charitable contribution of the present interest
in the painting conveyed to the museum. In addition, since all
intervening interests in, and rights to the actual possession or
enjoyment of the property, have expired, a charitable contribution of
the remainder interest is treated as having been made by A in 1972 for
which a deduction is allowable without regard to section 170(f)(3)(A).
Such remainder interest is valued according to Sec. 20.2031-7A(c) of
this chapter (estate tax regulations), determined by subtracting the
value of B's interest measured by A's life expectancy in 1972, and B
receives a deduction in 1972 for the life interest measured by A's life
expectancy and valued according to Table A(1) in such section.
Example 6. On December 31, 1970, C, an individual who reports his
income on the calendar year basis, transfers a valuable painting to a
pooled income fund described in section 642(c)(5), which is maintained
by a university. C retains for himself for life an income interest in
the painting, the remainder interest in the painting being contributed
to the university. Since the contribution consists of a future interest
in tangible personal property in which the donor has retained an
intervening interest, no charitable contribution is considered to have
been made in 1970.
Example 7. On January 15, 1972, D, an individual who reports his
income on the calendar year basis, transfers a capital asset held for
more than 6 months consisting of a valuable painting to a pooled income
fund described in section 642(c)(5), which is maintained by a
university, and creates an income interest in such painting for E for
life. E is an individual not standing in a relationship to D described
in section 267(b). The remainder interest in the property is contributed
by D to the university. The trustee of the pooled income fund puts the
painting to an unrelated use within the meaning of paragraph (b)(3) of
Sec. 1.170A-4. Accordingly, D is allowed a deduction under section 170
in 1972 for the present value of the remainder interest in the painting,
after reducing such amount under section 170 (e)(1)(B)(i) and paragraph
(a)(2) of Sec. 1.170A-4. This reduction in the amount of the
contribution is required since under paragraph (b)(3) of that section
the use by the pooled income fund of the painting is a use which would
have been an unrelated use if it had been made by the university.
(c) Effective date. This section applies only to contributions paid
in taxable years beginning after December 31, 1969.
[T.D. 7207, 37 FR 20779, Oct. 4, 1972, as amended by T.D. 8540, 59 FR
30102, June 10, 1994]
Sec. 1.170A-6 Charitable contributions in trust.
(a) In general. (1) No deduction is allowed under section 170 for
the fair market value of a charitable contribution of any interest in
property which is less than the donor's entire interest in the property
and which is transferred in trust unless the transfer meets the
requirements of paragraph (b) or (c) of this section. If the donor's
entire interest in the property is transferred in trust and is
contributed to a charitable organization described in section 170(c), a
deduction is allowed under section 170. Thus, if on July 1, 1972,
property is transferred in trust with the requirement that the income of
the trust be paid for a term of 20 years to a church and thereafter the
remainder be paid to an educational organization described in section
170(b)(1)(A), a deduction is allowed for the value of such property. See
section 170(f)(2) and (3)(B), and paragraph (b)(1) of Sec. 1.170A-7.
(2) A deduction is allowed without regard to this section for a
contribution of a partial interest in property if such interest is the
taxpayer's entire interest in the property, such as an income interest
or a remainder interest. If, however, the property in which such partial
interest exists was divided in order to create such interest and thus
avoid section 170(f)(2), the deduction
[[Page 37]]
will not be allowed. Thus, for example, assume that a taxpayer desires
to contribute to a charitable organization the reversionary interest in
certain stocks and bonds which he owns. If the taxpayer transfers such
property in trust with the requirement that the income of the trust be
paid to his son for life and that the reversionary interest be paid to
himself and immediately after creating the trust contributes the
reversionary interest to a charitable organization, no deduction will be
allowed under section 170 for the contribution of the taxpayer's entire
interest consisting of the reversionary interest in the trust.
(b) Charitable contribution of a remainder interest in trust--(1) In
general. No deduction is allowed under section 170 for the fair market
value of a charitable contribution of a remainder interest in property
which is less than the donor's entire interest in the property and which
the donor transfers in trust unless the trust is:
(i) A pooled income fund described in section 642(c)(5) and Sec.
1.642(c)-5,
(ii) A charitable remainder annuity trust described in section
664(d)(1) and Sec. 1.664-2, or
(iii) A charitable remainder unitrust described in section 664(d)(2)
and Sec. 1.664-3.
(2) Value of a remainder interest. The fair market value of a
remainder interest in a pooled income fund shall be computed under Sec.
1.642(c)-6. The fair market value of a remainder interest in a
charitable remainder annuity trust shall be computed under Sec. 1.664-
2. The fair market value of a remainder interest in a charitable
remainder unitrust shall be computed under Sec. 1.664-4. However, in
some cases a reduction in the amount of a charitable contribution of the
remainder interest may be required. See section 170(e) and Sec. 1.170A-
4.
(c) Charitable contribution of an income interest in trust--(1) In
general. No deduction is allowed under section 170 for the fair market
value of a charitable contribution of an income interest in property
which is less than the donor's entire interest in the property and which
the donor transfers in trust unless the income interest is either a
guaranteed annuity interest or a unitrust interest, as defined in
paragraph (c)(2) of this section, and the grantor is treated as the
owner of such interest for purposes of applying section 671, relating to
grantors and others treated as substantial owners. See section
4947(a)(2) for the application to such income interests in trust of the
provisions relating to private foundations and section 508(e) for rules
relating to provisions required in the governing instruments.
(2) Definitions. For purposes of this paragraph:
(i) Guaranteed annuity interest. (A) An income interest is a
``guaranteed annuity interest'' only if it is an irrevocable right
pursuant to the governing instrument of the trust to receive a
guaranteed annuity. A guaranteed annuity is an arrangement under which a
determinable amount is paid periodically, but not less often than
annually, for a specified term of years or for the life or lives of
certain individuals, each of whom must be living at the date of transfer
and can be ascertained at such date. Only one or more of the following
individuals may be used as measuring lives: the donor, the donor's
spouse, and an individual who, with respect to all remainder
beneficiaries (other than charitable organizations described in section
170, 2055, or 2522), is either a lineal ancestor or the spouse of a
lineal ancestor of those beneficiaries. A trust will satisfy the
requirement that all noncharitable remainder beneficiaries are lineal
descendants of the individual who is the measuring life, or that
individual's spouse, if there is less than a 15% probability that
individuals who are not lineal descendants will receive any trust
corpus. This probability must be computed, based on the current
applicable Life Table contained in Sec. 20.2031-7, at the time property
is transferred to the trust taking into account the interests of all
primary and contingent remainder beneficiaries who are living at that
time. An interest payable for a specified term of years can qualify as a
guaranteed annuity interest even if the governing instrument contains a
savings clause intended to ensure compliance with a rule against
perpetuities. The savings clause must utilize a period for vesting
[[Page 38]]
of 21 years after the deaths of measuring lives who are selected to
maximize, rather than limit, the term of the trust. The rule in this
paragraph that a charitable interest may be payable for the life or
lives of only certain specified individuals does not apply in the case
of a charitable guaranteed annuity interest payable under a charitable
remainder trust described in section 664. An amount is determinable if
the exact amount which must be paid under the conditions specified in
the governing instrument of the trust can be ascertained as of the date
of transfer. For example, the amount to be paid may be a stated sum for
a term of years, or for the life of the donor, at the expiration of
which it may be changed by a specified amount, but it may not be
redetermined by reference to a fluctuating index such as the cost of
living index. In further illustration, the amount to be paid may be
expressed in terms of a fraction or percentage of the cost of living
index on the date of transfer.
(B) An income interest is a guaranteed annuity interest only if it
is a guaranteed annuity interest in every respect. For example, if the
income interest is the right to receive from a trust each year a payment
equal to the lesser of a sum certain or a fixed percentage of the net
fair market value of the trust assets, determined annually, such
interest is not a guaranteed annuity interest.
(C) Where a charitable interest is in the form of a guaranteed
annuity interest, the governing instrument of the trust may provide that
income of the trust which is in excess of the amount required to pay the
guaranteed annuity interest shall be paid to or for the use of a
charitable organization. Nevertheless, the amount of the deduction under
section 170(f)(2)(B) shall be limited to the fair market value of the
guaranteed annuity interest as determined under paragraph (c)(3) of this
section. For a rule relating to treatment by the grantor of any
contribution made by the trust in excess of the amount required to pay
the guaranteed annuity interest, see paragraph (d)(2)(ii) of this
section.
(D) If the present value on the date of transfer of all the income
interests for a charitable purpose exceeds 60 percent of the aggregate
fair market value of all amounts in the trust (after the payment of
liabilities), the income interest will not be considered a guaranteed
annuity interest unless the governing instrument of the trust prohibits
both the acquisition and the retention of assets which would give rise
to a tax under section 4944 if the trustee had acquired such assets. The
requirement in this subdivision (D) for a prohibition in the governing
instrument against the retention of assets which would give rise to a
tax under section 4944 if the trustee had acquired the assets shall not
apply to a transfer in trust made on or before May 21, 1972.
(E) Where a charitable interest in the form of a guaranteed annuity
interest is transferred after May 21, 1972, the charitable interest
generally is not a guaranteed annuity interest if any amount may be paid
by the trust for a private purpose before the expiration of all the
charitable annuity interests. There are two exceptions to this general
rule. First, the charitable interest is a guaranteed annuity interest if
the amount payable for a private purpose is in the form of a guaranteed
annuity interest and the trust's governing instrument does not provide
for any preference or priority in the payment of the private annuity as
opposed to the charitable annuity. Second, the charitable interest is a
guaranteed annuity interest if under the trust's governing instrument
the amount that may be paid for a private purpose is payable only from a
group of assets that are devoted exclusively to private purposes and to
which section 4947(a)(2) is inapplicable by reason of section
4947(a)(2)(B). For purposes of this paragraph (c)(2)(i)(E), an amount is
not paid for a private purpose if it is paid for an adequate and full
consideration in money or money's worth. See Sec. 53.4947-1(c) of this
chapter for rules relating to the inapplicability of section 4947(a)(2)
to segregated amounts in a split-interest trust.
(F) For rules relating to certain governing instrument requirements
and to the imposition of certain excise taxes where the guaranteed
annuity interest is in trust and for rules governing payment of private
income interests by a
[[Page 39]]
split-interest trust, see section 4947(a)(2) and (b)(3)(A), and the
regulations thereunder.
(ii) Unitrust interest. (A) An income interest is a ``unitrust
interest'' only if it is an irrevocable right pursuant to the governing
instrument of the trust to receive payment, not less often than annually
of a fixed percentage of the net fair market value of the trust assets,
determined annually. In computing the net fair market value of the trust
assets, all assets and liabilities shall be taken into account without
regard to whether particular items are taken into account in determining
the income of the trust. The net fair market value of the trust assets
may be determined on any one date during the year or by taking the
average of valuations made on more than one date during the year,
provided that the same valuation date or dates and valuation methods are
used each year. Where the governing instrument of the trust does not
specify the valuation date or dates, the trustee shall select such date
or dates and shall indicate his selection on the first return on Form
1041 which the trust is required to file. Payments under a unitrust
interest may be paid for a specified term of years or for the life or
lives of certain individuals, each of whom must be living at the date of
transfer and can be ascertained at such date. Only one or more of the
following individuals may be used as measuring lives: the donor, the
donor's spouse, and an individual who, with respect to all remainder
beneficiaries (other than charitable organizations described in section
170, 2055, or 2522), is either a lineal ancestor or the spouse of a
lineal ancestor of those beneficiaries. A trust will satisfy the
requirement that all noncharitable remainder beneficiaries are lineal
descendants of the individual who is the measuring life, or that
individual's spouse, if there is less than a 15% probability that
individuals who are not lineal descendants will receive any trust
corpus. This probability must be computed, based on the current
applicable Life Table contained in Sec. 20.2031-7, at the time property
is transferred to the trust taking into account the interests of all
primary and contingent remainder beneficiaries who are living at that
time. An interest payable for a specified term of years can qualify as a
unitrust interest even if the governing instrument contains a savings
clause intended to ensure compliance with a rule against perpetuities.
The savings clause must utilize a period for vesting of 21 years after
the deaths of measuring lives who are selected to maximize, rather than
limit, the term of the trust. The rule in this paragraph that a
charitable interest may be payable for the life or lives of only certain
specified individuals does not apply in the case of a charitable
unitrust interest payable under a charitable remainder trust described
in section 664.
(B) An income interest is a unitrust interest only if it is a
unitrust interest in every respect. For example, if the income interest
is the right to receive from a trust each year a payment equal to the
lesser of a sum certain or a fixed percentage of the net fair market
value of the trust assets, determined annually, such interest is not a
unitrust interest.
(C) Where a charitable interest is in the form of a unitrust
interest, the governing instrument of the trust may provide that income
of the trust which is in excess of the amount required to pay the
unitrust interest shall be paid to or for the use of a charitable
organization. Nevertheless, the amount of the deduction under section
170(f)(2)(B) shall be limited to the fair market value of the unitrust
interest as determined under paragraph (c)(3) of this section. For a
rule relating to treatment by the grantor of any contribution made by
the trust in excess of the amount required to pay the unitrust interest,
see paragraph (d)(2)(ii) of this section.
(D) Where a charitable interest is in the form of a unitrust
interest, the charitable interest generally is not a unitrust interest
if any amount may be paid by the trust for a private purpose before the
expiration of all the charitable unitrust interests. There are two
exceptions to this general rule. First, the charitable interest is a
unitrust interest if the amount payable for a private purpose is in the
form of a unitrust interest and the trust's governing instrument does
not provide for
[[Page 40]]
any preference or priority in the payment of the private unitrust
interest as opposed to the charitable unitrust interest. Second, the
charitable interest is a unitrust interest if under the trust's
governing instrument the amount that may be paid for a private purpose
is payable only from a group of assets that are devoted exclusively to
private purposes and to which section 4947(a)(2) is inapplicable by
reason of section 4947(a)(2)(B). For purposes of this paragraph
(c)(2)(ii)(D), an amount is not paid for a private purpose if it is paid
for an adequate and full consideration in money or money's worth. See
Sec. 53.4947-1(c) of this chapter for rules relating to the
inapplicability of section 4947(a)(2) to segregated amounts in a split-
interest trust.
(E) For rules relating to certain governing instrument requirements
and to the imposition of certain excise taxes where the unitrust
interest is in trust and for rules governing payment of private income
interests by a split-interest trust, see section 4947(a)(2) and
(b)(3)(A), and the regulations thereunder.
(3) Valuation of income interest. (i) The deduction allowed by
section 170(f)(2)(B) for a charitable contribution of a guaranteed
annuity interest is limited to the fair market value of such interest on
the date of contribution, as computed under Sec. 20.2031-7 or, for
certain prior periods, 20.2031-7A of this chapter (Estate Tax
Regulations).
(ii) The deduction allowed under section 170(f)(2)(B) for a
charitable contribution of a unitrust interest is limited to the fair
market value of the unitrust interest on the date of contribution. The
fair market value of the unitrust interest shall be determined by
subtracting the present value of all interests in the transferred
property other than the unitrust interest from the fair market value of
the transferred property.
(iii) If by reason of all the conditions and circumstances
surrounding a transfer of an income interest in property in trust it
appears that the charity may not receive the beneficial enjoyment of the
interest, a deduction will be allowed under paragraph (c)(1) of this
section only for the minimum amount it is evident the charity will
receive. The application of this subdivision may be illustrated by the
following examples:
Example 1. In 1972, B transfers $20,000 in trust with the
requirement that M Church be paid a guaranteed annuity interest (as
defined in subparagraph (2)(i) of this paragraph) of $4,000, payable
annually at the end of each year for 9 years, and that the residue
revert to himself. Since the fair market value of an annuity of $4,000 a
year for a period of 9 years, as determined under Sec. 20.2031-7A(c) of
this chapter, is $27,206.80 ($4,000 x 6.8017), it appears that M will
not receive the beneficial enjoyment of the income interest.
Accordingly, even though B is treated as the owner of the trust under
section 673, he is allowed a deduction under subparagraph (1) of this
paragraph for only $20,000, which is the minimum amount it is evident M
will receive.
Example 2. In 1975, C transfers $40,000 in trust with the
requirement that D, an individual, and X Charity be paid simultaneously
guaranteed annuity interests (as defined in subparagraph (2)(i) of this
paragraph) of $5,000 a year each, payable annually at the end of each
year, for a period of 5 years and that the remainder be paid to C's
children. The fair market value of two annuities of $5,000 each a year
for a period of 5 years is $42,124 ([$5,000 x 4.2124] x 2), as
determined under Sec. 20.2031-7A(c) of this chapter. The trust
instrument provides that in the event the trust fund is insufficient to
pay both annuities in a given year, the trust fund will be evenly
divided between the charitable and private annuitants. The deduction
under subparagraph (1) of this paragraph with respect to the charitable
annuity will be limited to $20,000, which is the minimum amount it is
evident X will receive.
Example 3. In 1975, D transfers $65,000 in trust with the
requirement that a guaranteed annuity interest (as defined in
subparagraph (2)(i) of this paragraph) of $5,000 a year, payable
annually at the end of each year, be paid to Y Charity for a period of
10 years and that a guaranteed annuity interest (as defined in
subparagraph (2)(i) of this paragraph) of $5,000 a year, payable
annually at the end of each year, be paid to W, his wife, aged 62, for
10 years or until her prior death. The annuities are to be paid
simultaneously, and the remainder is to be paid to D's children. The
fair market value of the private annuity is $33,877 ($5,000 x 6.7754),
as determined pursuant to Sec. 20.2031-7A(c) of this chapter and by the
use of factors involving one life and a term of years as published in
Publication 723A (12-70). The fair market value of the charitable
annuity is $36,800.50 ($5,000 x 7.3601), as determined under Sec.
20.2031-7A(c) of this chapter. It is not evident from the governing
instrument of the trust or
[[Page 41]]
from local law that the trustee would be required to apportion the trust
fund between the wife and charity in the event the fund were
insufficient to pay both annuities in a given year. Accordingly, the
deduction under subparagraph (1) of this paragraph with respect to the
charitable annuity will be limited to $31,123 ($65,000 less $33,877 [the
value of the private annuity]), which is the minimum amount it is
evident Y will receive.
(iv) See paragraph (b)(1) of Sec. 1.170A-4 for rule that the term
ordinary income property for purposes of section 170(e) does not include
an income interest in respect of which a deduction is allowed under
section 170(f)(2)(B) and this paragraph.
(4) Recapture upon termination of treatment as owner. If for any
reason the donor of an income interest in property ceases at any time
before the termination of such interest to be treated as the owner of
such interest for purposes of applying section 671, as for example,
where he dies before the termination of such interest, he shall for
purposes of this chapter be considered as having received, on the date
he ceases to be so treated, an amount of income equal to (i) the amount
of any deduction he was allowed under section 170 for the contribution
of such interest reduced by (ii) the discounted value of all amounts
which were required to be, and actually were, paid with respect to such
interest under the terms of trust to the charitable organization before
the time at which he ceases to be treated as the owner of the interest.
The discounted value of the amounts described in subdivision (ii) of
this subparagraph shall be computed by treating each such amount as a
contribution of a remainder interest after a term of years and valuing
such amount as of the date of contribution of the income interest by the
donor, such value to be determined under Sec. 20.2031-7 of this chapter
consistently with the manner in which the fair market value of the
income interest was determined pursuant to subparagraph (3)(i) of this
paragraph. The application of this subparagraph will not be construed to
disallow a deduction to the trust for amounts paid by the trust to the
charitable organization after the time at which the donor ceased to be
treated as the owner of the trust.
(5) Illustrations. The application of this paragraph may be
illustrated by the following examples:
Example 1. On January 1, 1971, A contributes to a church in trust a
9-year irrevocable income interest in property. Both A and the trust
report income on a calendar year basis. The fair market value of the
property placed in trust is $10,000. The trust instrument provides that
the church will receive an annuity of $500, payable annually at the end
of each year for 9 years. The income interest is a guaranteed annuity
interest as defined in subparagraph (2)(i) of this paragraph; upon
termination of such interest the residue of the trust is to revert to A.
By reference to Sec. 20.2031-7A(c) of this chapter, it is found that
the figure in column (2) opposite 9 years is 6.8017. The present value
of the annuity is therefore $3,400.85 ($500 x 6.8017). The present value
of the income interest and A's charitable contribution for 1971 is
$3,400.85.
Example 2. (a) On January 1, B contributes to a church in trust a 9-
year irrevocable income interest in property. Both B and the trust
report income on a calendar year basis. The fair market value of the
property placed in trust is $10,000. The trust instrument provides that
the trust will pay to the church at the end of each year for 9 years 5
percent of the fair market value of all property in the trust at the
beginning of the year. The income interest is a unitrust interest as
defined in subparagraph (2)(ii) of this paragraph; upon termination of
such interest the residue of the trust is to revert to B.
(b) The section 7520 rate at the time of the transfer was 6.0
percent. By reference to Table F(6.0) in Sec. 1.664-4(e)(6), the
adjusted payout rate is 4.717% (5% x 0.943396). The present value of the
reversion is $6,473.75, computed by reference to Table D in Sec. 1.664-
4(e)(6), as follows:
Factor at 4.6 percent for 9 years............................ 0.654539
Factor at 4.8 percent for 9 years............................ .642292
----------
Difference................................................. .012247
Interpolation adjustment:
4.717% - 4.6% / 0.2% = x / 0.012247
x = 0.007164
Factor at 4.6 percent for 9 years............................ .654539
Less: Interpolation adjustment............................... .007164
----------
Interpolated factor........................................ .647375
Present value of reversion ($10,000 x 0.647375).............. $6,473.75
(c) The present value of the income interest and B's charitable
contribution is $3,526.25 ($10,000-$6,473.75).
Example 3. (a) On January 1, 1971, C contributes to a church in
trust a 9-year irrevocable income interest in property. Both C and the
trust report income on a calendar year basis. The fair market value of
the property placed in trust is $10,000. The trust
[[Page 42]]
instrument provides that the church will receive an annuity of $500,
payable annually at the end of each year for 9 years. The income
interest is a guaranteed annuity interest as defined in subparagraph
(2)(i) of this paragraph; upon termination of such interest the residue
of the trust is to revert to C. C's charitable contribution for 1971 is
$3,400.85, determined as provided in Example 1. The trust earns income
of $600 in 1971, $400 in 1972, and $500 in 1973, all of which is taxable
to C under section 671. The church is paid $500 at the end of 1971,
1972, and 1973, respectively. On December 31, 1973, C dies and ceases to
be treated as the owner of the income interest under section 673.
(b) Pursuant to subparagraph (4) of this paragraph, the discounted
value as of January 1, 1971, of the amounts paid to the church by the
trust is $1,336.51, determined by reference to column (4) of Sec.
20.2031-7A(c) of this chapter, as follows:
----------------------------------------------------------------------------------------------------------------
Annuity Years from
----------------------------------------------------------------- Jan. 1, Discount
Amount 1971, to Discount value as
Payment date paid payment factor of Jan. 1,
date 1971
----------------------------------------------------------------------------------------------------------------
Dec. 31, 1971................................................... $500 1 0.943396 $471.70
Dec. 31, 1972................................................... 500 2 .889996 445.00
Dec. 31, 1973................................................... 500 3 .839619 419.81
-----------------------------------------------
Total discounted value...................................... .......... .......... .......... 1,336.51
----------------------------------------------------------------------------------------------------------------
(c) Pursuant to subparagraph (4) of this paragraph, there must be
included in C's gross income for 1973 the amount of $2,064.34 ($3,400.85
less $1,336.51).
(d) For deduction by the trust for amounts paid to the church after
December 31, 1973, see section 642(c)(1) and the regulations thereunder.
(d) Denial of deduction for certain contributions by a trust. (1) If
by reason of section 170(f)(2)(B) and paragraph (c) of this section a
charitable contributions deduction is allowed under section 170 for the
fair market value of an income interest transferred in trust, neither
the grantor of the income interest, the trust, nor any other person
shall be allowed a deduction under section 170 or any other section for
the amount of any charitable contribution made by the trust with respect
to, or in fulfillment of, such income interest.
(2) Section 170(f)(2)(C) and subparagraph (1) of this paragraph
shall not be construed, however, to:
(i) Disallow a deduction to the trust, pursuant to section 642(c)(1)
and the regulations thereunder, for amounts paid by the trust after the
grantor ceases to be treated as the owner of the income interest for
purposes of applying section 671 and which are not taken into account in
determining the amount of recapture under paragraph (c)(4) of this
section, or
(ii) Disallow a deduction to the grantor under section 671 and Sec.
1.671-2(c) for a charitable contribution made by the trust in excess of
the contribution required to be made by the trust under the terms of the
trust instrument with respect to, or in fulfillment of, the income
interest.
(3) Although a deduction for the fair market value of an income
interest in property which is less than the donor's entire interest in
the property and which the donor transfers in trust is disallowed under
section 170 because such interest is not a guaranteed annuity interest,
or a unitrust interest, as defined in paragraph (c)(2) of this section,
the donor may be entitled to a deduction under section 671 and Sec.
1.671-2(c) for any charitable contributions made by the trust if he is
treated as the owner of such interest for purposes of applying section
671.
(e) Effective date. This section applies only to transfers in trust
made after July 31, 1969. In addition, the rule in paragraphs
(c)(2)(i)(A) and (ii)(A) of this section that guaranteed annuity
interests and unitrust interests, respectively, may be payable for a
specified term of years or for the life or lives of only certain
individuals applies to transfers made on or after April 4, 2000. If a
transfer is made to a trust on or after April 4, 2000 that uses an
individual other than one permitted in paragraphs (c)(2)(i)(A) and
(ii)(A) of this section, the trust may be reformed to satisfy this rule.
As an alternative to reformation, rescission may be
[[Page 43]]
available for a transfer made on or before March 6, 2001. See Sec.
25.2522(c)-3(e) of this chapter for the requirements concerning
reformation or possible rescission of these interests.
[T.D. 7207, 37 FR 20780, Oct. 5, 1972; 37 FR 22982, Oct. 27, 1972, as
amended by T.D. 7340, 40 FR 1238, Jan. 7, 1975; T.D. 7955, 49 FR 19975,
May 11, 1984; T.D. 8540, 59 FR 30102, June 10, 1994; T.D. 8819, 64 FR
23189, 23228, Apr. 30, 1999; 64 FR 33196, June 22, 1999; T.D. 8923, 66
FR 1041, Jan. 5, 2001; T.D. 9068, 68 FR 40131, July 7, 2003]
Sec. 1.170A-7 Contributions not in trust of partial interests in property.
(a) In general. (1) In the case of a charitable contribution, not
made by a transfer in trust, of any interest in property which consists
of less than the donor's entire interest in such property, no deduction
is allowed under section 170 for the value of such interest unless the
interest is an interest described in paragraph (b) of this section. See
section 170(f)(3)(A). For purposes of this section, a contribution of
the right to use property which the donor owns, for example, a rent-free
lease, shall be treated as a contribution of less than the taxpayer's
entire interest in such property.
(2)(i) A deduction is allowed without regard to this section for a
contribution of a partial interest in property if such interest is the
taxpayer's entire interest in the property, such as an income interest
or a remainder interest. Thus, if securities are given to A for life,
with the remainder over to B, and B makes a charitable contribution of
his remainder interest to an organization described in section 170(c), a
deduction is allowed under section 170 for the present value of B's
remainder interest in the securities. If, however, the property in which
such partial interest exists was divided in order to create such
interest and thus avoid section 170(f)(3)(A), the deduction will not be
allowed. Thus, for example, assume that a taxpayer desires to contribute
to a charitable organization an income interest in property held by him,
which is not of a type described in paragraph (b)(2) of this section. If
the taxpayer transfers the remainder interest in such property to his
son and immediately thereafter contributes the income interest to a
charitable organization, no deduction shall be allowed under section 170
for the contribution of the taxpayer's entire interest consisting of the
retained income interest. In further illustration, assume that a
taxpayer desires to contribute to a charitable organization the
reversionary interest in certain stocks and bonds held by him, which is
not of a type described in paragraph (b)(2) of this section. If the
taxpayer grants a life estate in such property to his son and
immediately thereafter contributes the reversionary interest to a
charitable organization, no deduction will be allowed under section 170
for the contribution of the taxpayer's entire interest consisting of the
reversionary interest.
(ii) A deduction is allowed without regard to this section for a
contribution of a partial interest in property if such contribution
constitutes part of a charitable contribution not in trust in which all
interests of the taxpayer in the property are given to a charitable
organization described in section 170(c). Thus, if on March 1, 1971, an
income interest in property is given not in trust to a church and the
remainder interest in the property is given not in trust to an
educational organization described in section 170(b)(1)(A), a deduction
is allowed for the value of such property.
(3) A deduction shall not be disallowed under section 170(f)(3)(A)
and this section merely because the interest which passes to, or is
vested in, the charity may be defeated by the performance of some act or
the happening of some event, if on the date of the gift it appears that
the possibility that such act or event will occur is so remote as to be
negligible. See paragraph (e) of Sec. 1.170A-1.
(b) Contributions of certain partial interests in property for which
a deduction is allowed. A deduction is allowed under section 170 for a
contribution not in trust of a partial interest which is less than the
donor's entire interest in property and which qualifies under one of the
following subparagraphs:
(1) Undivided portion of donor's entire interest. (i) A deduction is
allowed under section 170 for the value of a charitable contribution not
in trust of an undivided portion of a donor's entire
[[Page 44]]
interest in property. An undivided portion of a donor's entire interest
in property must consist of a fraction or percentage of each and every
substantial interest or right owned by the donor in such property and
must extend over the entire term of the donor's interest in such
property and in other property into which such property is converted.
For example, assuming that in 1967 B has been given a life estate in an
office building for the life of A and that B has no other interest in
the office building, B will be allowed a deduction under section 170 for
his contribution in 1972 to charity of a one-half interest in such life
estate in a transfer which is not made in trust. Such contribution by B
will be considered a contribution of an undivided portion of the donor's
entire interest in property. In further illustration, assuming that in
1968 C has been given the remainder interest in a trust created under
the will of his father and C has no other interest in the trust, C will
be allowed a deduction under section 170 for his contribution in 1972 to
charity of a 20-percent interest in such remainder interest in a
transfer which is not made in trust. Such contribution by C will be
considered a contribution of an undivided portion of the donor's entire
interest in property. If a taxpayer owns 100 acres of land and makes a
contribution of 50 acres to a charitable organization, the charitable
contribution is allowed as a deduction under section 170. A deduction is
allowed under section 170 for a contribution of property to a charitable
organization whereby such organization is given the right, as a tenant
in common with the donor, to possession, dominion, and control of the
property for a portion of each year appropriate to its interest in such
property. However, for purposes of this subparagraph a charitable
contribution in perpetuity of an interest in property not in trust where
the donor transfers some specific rights and retains other substantial
rights will not be considered a contribution of an undivided portion of
the donor's entire interest in property to which section 170(f)(3)(A)
does not apply. Thus, for example, a deduction is not allowable for the
value of an immediate and perpetual gift not in trust of an interest in
original historic motion picture films to a charitable organization
where the donor retains the exclusive right to make reproductions of
such films and to exploit such reproductions commercially.
(ii) With respect to contributions made on or before December 17,
1980, for purposes of this subparagraph a charitable contribution of an
open space easement in gross in perpetuity shall be considered a
contribution of an undivided portion of the donor's entire interest in
property to which section 170(f)(3)(A) does not apply. For this purpose
an easement in gross is a mere personal interest in, or right to use,
the land of another; it is not supported by a dominant estate but is
attached to, and vested in, the person to whom it is granted. Thus, for
example, a deduction is allowed under section 170 for the value of a
restrictive easement gratuitously conveyed to the United States in
perpetuity whereby the donor agrees to certain restrictions on the use
of his property, such as, restrictions on the type and height of
buildings that may be erected, the removal of trees, the erection of
utility lines, the dumping of trash, and the use of signs. For the
deductibility of a qualified conservation contribution, see Sec.
1.170A-14.
(2) Partial interests in property which would be deductible in
trust. A deduction is allowed under section 170 for the value of a
charitable contribution not in trust of a partial interest in property
which is less than the donor's entire interest in the property and which
would be deductible under section 170(f)(2) and Sec. 1.170A-6 if such
interest had been transferred in trust.
(3) Contribution of a remainder interest in a personal residence. A
deduction is allowed under section 170 for the value of a charitable
contribution not in trust of an irrevocable remainder interest in a
personal residence which is not the donor's entire interest in such
property. Thus, for example, if a taxpayer contributes not in trust to
an organization described in section 170(c) a remainder interest in a
personal residence and retains an estate in such property for life or
for a term of years, a deduction is allowed under section
[[Page 45]]
170 for the value of such remainder interest not transferred in trust.
For purposes of section 170(f)(3)(B)(i) and this subparagraph, the term
personal residence means any property used by the taxpayer as his
personal residence even though it is not used as his principal
residence. For example, the taxpayer's vacation home may be a personal
residence for purposes of this subparagraph. The term personal residence
also includes stock owned by a taxpayer as a tenant-stockholder in a
cooperative housing corporation (as those terms are defined in section
216(b) (1) and (2)) if the dwelling which the taxpayer is entitled to
occupy as such stockholder is used by him as his personal residence.
(4) Contribution of a remainder interest in a farm. A deduction is
allowed under section 170 for the value of a charitable contribution not
in trust of an irrevocable remainder interest in a farm which is not the
donor's entire interest in such property. Thus, for example, if a
taxpayer contributes not in trust to an organization described in
section 170(c) a remainder interest in a farm and retains an estate in
such farm for life or for a term of years, a deduction is allowed under
section 170 for the value of such remainder interest not transferred in
trust. For purposes of section 170(f)(3)(B)(i) and this subparagraph,
the term farm means any land used by the taxpayer or his tenant for the
production of crops, fruits, or other agricultural products or for the
sustenance of livestock. The term livestock includes cattle, hogs,
horses, mules, donkeys, sheep, goats, captive fur-bearing animals,
chickens, turkeys, pigeons, and other poultry. A farm includes the
improvements thereon.
(5) Qualified conservation contribution. A deduction is allowed
under section 170 for the value of a qualified conservation
contribution. For the definition of a qualified conservation
contribution, see Sec. 1.170A-14.
(c) Valuation of a partial interest in property. Except as provided
in Sec. 1.170A-14, the amount of the deduction under section 170 in the
case of a charitable contribution of a partial interest in property to
which paragraph (b) of this section applies is the fair market value of
the partial interest at the time of the contribution. See Sec. 1.170A-
1(c). The fair market value of such partial interest must be determined
in accordance with Sec. 20.2031-7, of this chapter (Estate Tax
Regulations), except that, in the case of a charitable contribution of a
remainder interest in real property which is not transferred in trust,
the fair market value of such interest must be determined in accordance
with section 170(f)(4) and Sec. 1.170A-12. In the case of a charitable
contribution of a remainder interest in the form of a remainder interest
in a pooled income fund, a charitable remainder annuity trust, or a
charitable remainder unitrust, the fair market value of the remainder
interest must be determined as provided in paragraph (b)(2) of Sec.
1.170A-6. However, in some cases a reduction in the amount of a
charitable contribution of the remainder interest may be required. See
section 170(e) and paragraph (a) of Sec. 1.170A-4.
(d) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. A, an individual owning a 10-story office building,
donates the rent-free use of the top floor of the building for the year
1971 to a charitable organization. Since A's contribution consists of a
partial interest to which section 170(f)(3)(A) applies, he is not
entitled to a charitable contributions deduction for the contribution of
such partial interest.
Example 2. In 1971, B contributes to a charitable organization an
undivided one-half interest in 100 acres of land, whereby as tenants in
common they share in the economic benefits from the property. The
present value of the contributed property is $50,000. Since B's
contribution consists of an undivided portion of his entire interest in
the property to which section 170(f)(3)(B) applies, he is allowed a
deduction in 1971 for his charitable contribution of $50,000.
Example 3. In 1971, D loans $10,000 in cash to a charitable
organization and does not require the organization to pay any interest
for the use of the money. Since D's contribution consists of a partial
interest to which section 170(f)(3)(A) applies, he is not entitled to a
charitable contributions deduction for the contribution of such partial
interest.
(e) Effective date. This section applies only to contributions made
after July 31, 1969. The deduction allowable under Sec. 1.170A-
7(b)(1)(ii) shall be available
[[Page 46]]
only for contributions made on or before December 17, 1980. Except as
otherwise provided in Sec. 1.170A-14(g)(4)(ii), the deduction allowable
under Sec. 1.170A-7(b)(5) shall be available for contributions made on
or after December 18, 1980.
(83 Stat. 544, 26 U.S.C. 170(f)(4); 83 Stat. 560, 26 U.S.C. 642(c)(5);
68A Stat. 917, 26 U.S.C. 7805)
[T.D. 7207, 37 FR 20782, Oct. 4, 1972; 37 FR 22982, Oct. 27, 1972, as
amended by T.D. 7955, 49 FR 19975, May 11, 1984; T.D. 8069, 51 FR 1498,
Jan. 14, 1986; T.D. 8540, 59 FR 30102, June 10, 1994]
Sec. 1.170A-8 Limitations on charitable deductions by individuals.
(a) Percentage limitations--(1) In general. An individual's
charitable contributions deduction is subject to 20-, 30-, and 50-
percent limitations unless the individual qualifies for the unlimited
charitable contributions deduction under section 170(b)(1)(C). For a
discussion of these limitations and examples of their application, see
paragraphs (b) through (f) of this section. If a husband and wife make a
joint return, the deduction for contributions is the aggregate of the
contributions made by the spouses, and the limitations in section 170(b)
and this section are based on the aggregate contribution base of the
spouses. A charitable contribution by an individual to or for the use of
an organization described in section 170(c) may be deductible even
though all, or some portion, of the funds of the organization may be
used in foreign countries for charitable or educational purposes.
(2) ``To'' or ``for the use of'' defined. For purposes of section
170, a contribution of an income interest in property, whether or not
such contributed interest is transferred in trust, for which a deduction
is allowed under section 170(f)(2)(B) or (3)(A) shall be considered as
made ``for the use of'' rather than ``to'' the charitable organization.
A contribution of a remainder interest in property, whether or not such
contributed interest is transferred in trust, for which a deduction is
allowed under section 170(f)(2)(A) or (3)(A), shall be considered as
made ``to'' the charitable organization except that, if such interest is
transferred in trust and, pursuant to the terms of the trust instrument,
the interest contributed is, upon termination of the predecessor estate,
to be held in trust for the benefit of such organization, the
contribution shall be considered as made ``for the use of'' such
organization. Thus, for example, assume that A transfers property to a
charitable remainder annuity trust described in section 664(d)(1) which
is required to pay to B for life an annuity equal to 5 percent of the
initial fair market value of the property transferred in trust. The
trust instrument provides that after B's death the remainder interest in
the trust is to be transferred to M Church or, in the event M Church is
not an organization described in section 170(c) when the amount is to be
irrevocably transferred to such church, to an organization which is
described in section 170(c) at that time. The contribution by A of the
remainder interest shall be considered as made ``to'' M Church. However,
if in the trust instrument A had directed that after B's death the
remainder interest is to be held in trust for the benefit of M Church,
the contribution shall be considered as made ``for the use of'' M
Church. This subparagraph does not apply to the contribution of a
partial interest in property, or of an undivided portion of such partial
interest, if such partial interest is the donor's entire interest in the
property and such entire interest was not created to avoid section
170(f)(2) or (3)(A). See paragraph (a)(2) of Sec. 1.170A-6 and
paragraphs (a)(2)(i) and (b)(1) of Sec. 1.170A-7.
(b) 50-percent limitation. An individual may deduct charitable
contributions made during a taxable year to any one or more section
170(b)(1)(A) organizations, as defined in Sec. 1.170A-9, to the extent
that such contributions in the aggregate do not exceed 50 percent of his
contribution base, as defined in section 170(b)(1)(F) and paragraph (e)
of this section, for the taxable year. However, see paragraph (d) of
this section for a limitation on the amount of charitable contributions
of 30-percent capital gain property. To qualify for the 50-percent
limitation the contributions must be made ``to,'' and not merely ``for
the use of,'' one of the specified organizations. A contribution to an
organization referred to in section 170(c)(2), other than a section
170(b)(1)(A) organization, will
[[Page 47]]
not qualify for the 50-percent limitation even though such organization
makes the contribution available to an organization which is a section
170 (b)(1)(A) organization. For provisions relating to the carryover of
contributions in excess of 50-percent of an individual's contribution
base see section 170(d)(1) and paragraph (b) of Sec. 1.170A-10.
(c) 20-percent limitation. (1) An individual may deduct charitable
contributions made during a taxable year:
(i) To any one or more charitable organizations described in section
170(c) other than section 170(b)(1)(A) organizations, as defined in
Sec. 1.170A-9, and,
(ii) For the use of any charitable organization described in section
170(c), to the extent that such contributions in the aggregate do not
exceed the lesser of the limitations under subparagraph (2) of this
paragraph.
(2) For purposes of subparagraph (1) of this paragraph the
limitations are:
(i) 20 percent of the individual's contribution base, as defined in
paragraph (e) of this section, for the taxable year, or
(ii) The excess of 50 percent of the individual's contribution base,
as so defined, for the taxable year over the total amount of the
charitable contributions allowed under section 170(b)(1)(A) and
paragraph (b) of this section, determined by first reducing the amount
of such contributions under section 170(e)(1) and paragraph (a) of Sec.
1.170A-4 but without applying the 30-percent limitation under section
170(b)(1)(D)(i) and paragraph (d)(1) of this section.
However, see paragraph (d) of this section for a limitation on the
amount of charitable contributions of 30-percent capital gain property.
If an election under section 170(b)(1)(D)(iii) and paragraph (d)(2) of
this section applies to any contributions of 30-percent capital gain
property made during the taxable year or carried over to the taxable
year, the amount allowed for the taxable year under paragraph (b) of
this section with respect to such contributions for purposes of applying
subdivision (ii) of this subparagraph shall be the reduced amount of
such contributions determined by applying paragraph (d)(2) of this
section.
(d) 30-percent limitation--(1) In general. An individual may deduct
charitable contributions of 30-percent capital gain property, as defined
in subparagraph (3) of this paragraph, made during a taxable year to or
for the use of any charitable organization described in section 170(c)
to the extent that such contributions in the aggregate do not exceed 30-
percent of his contribution base, as defined in paragraph (e) of this
section, subject, however, to the 50- and 20-percent limitations
prescribed by paragraphs (b) and (c) of this section. For purposes of
applying the 50-percent and 20-percent limitations described in
paragraphs (b) and (c) of this section, charitable contributions of 30-
percent capital gain property paid during the taxable year, and limited
as provided by this subparagraph, shall be taken into account after all
other charitable contributions paid during the taxable year. For
provisions relating to the carryover of certain contributions of 30-
percent capital gain property in excess of 30-percent of an individual's
contribution base, see section 170(b)(1)(D)(ii) and paragraph (c) of
Sec. 1.170A-10.
(2) Election by an individual to have section 170(e)(1)(B) apply to
contributions--(i) In general. (A) An individual may elect under section
170(b)(1)(D)(iii) for any taxable year to have the reduction rule of
section 170(e)(1)(B) and paragraph (a) of Sec. 1.170A-4 apply to all
his charitable contributions of 30-percent capital gain property made
during such taxable year or carried over to such taxable year from a
taxable year beginning after December 31, 1969. If such election is made
such contributions shall be treated as contributions of section 170(e)
capital gain property in accordance with paragraph (b)(2)(iii) of Sec.
1.170A-4. The election may be made with respect to contributions of 30-
percent capital gain property carried over to the taxable year even
though the individual has not made any contribution of 30-percent
capital gain property in such year. If such an election is made, section
170(b)(1)(D) (i) and (ii) and subparagraph (1) of this paragraph shall
not apply to such contributions made during such year. However, such
contributions must be reduced as required
[[Page 48]]
under section 170(e)(1)(B) and paragraph (a) of Sec. 1.170A-4.
(B) If there are carryovers to such taxable year of charitable
contributions of 30-percent capital gain property made in preceding
taxable years beginning after December 31, 1969, the amount of such
contributions in each such preceding year shall be reduced as if section
170(e)(1)(B) had applied to them in the preceding year and shall be
carried over to the taxable year and succeeding taxable years under
section 170(d)(1) and paragraph (b) of Sec. 1.170A-10 as contributions
of property other than 30-percent capital gain property. For purposes of
applying the immediately preceding sentence, the percentage limitations
under section 170(b) for the preceding taxable year and for any taxable
years intervening between such year and the year of the election shall
not be redetermined and the amount of any deduction allowed for such
years under section 170 in respect of the charitable contributions of
30-percent capital gain property in the preceding taxable year shall not
be redetermined. However, the amount of the deduction so allowed under
section 170 in the preceding taxable year must be subtracted from the
reduced amount of the charitable contributions made in such year in
order to determine the excess amount which is carried over from such
year under section 170(d)(1). If the amount of the deduction so allowed
in the preceding taxable year equals or exceeds the reduced amount of
the charitable contributions, there shall be no carryover from such year
to the year of the election.
(C) An election under this subparagraph may be made for each taxable
year in which charitable contributions of 30-percent capital gain
property are made or to which they are carried over under section
170(b)(1)(D)(ii). If there are also carryovers under section 170(d)(1)
to the year of the election by reason of an election made under this
subparagraph for a previous taxable year, such carryovers under section
170(d)(1) shall not be redetermined by reason of the subsequent
election.
(ii) Husband and wife making joint return. If a husband and wife
make a joint return of income for a contribution year and one of the
spouses elects under this subparagraph in a later year when he files a
separate return, or if a spouse dies after a contribution year for which
a joint return is made, any excess contribution of 30-percent capital
gain property which is carried over to the election year from the
contribution year shall be allocated between the husband and wife as
provided in paragraph (d)(4) (i) and (iii) of Sec. 1.170A-10. If a
husband and wife file separate returns in a contribution year, any
election under this subparagraph in a later year when a joint return is
filed shall be applicable to any excess contributions of 30-percent
capital gain property of either taxpayer carried over from the
contribution year to the election year. The immediately preceding
sentence shall also apply where two single individuals are subsequently
married and file a joint return. A remarried individual who filed a
joint return with his former spouse for a contribution year and
thereafter files a joint return with his present spouse shall treat the
carryover to the election year as provided in paragraph (d)(4)(ii) of
Sec. 1.170A-10.
(iii) Manner of making election. The election under subdivision (i)
of this subparagraph shall be made by attaching to the income tax return
for the election year a statement indicating that the election under
section 170(b)(1)(D)(iii) and this subparagraph is being made. If there
is a carryover to the taxable year of any charitable contributions of
30-percent capital gain property from a previous taxable year or years,
the statement shall show a recomputation, in accordance with this
subparagraph and Sec. 1.170A-4, of such carryover, setting forth
sufficient information with respect to the previous taxable year or any
intervening year to show the basis of the recomputation. The statement
shall indicate the district director, or the director of the internal
revenue service center, with whom the return for the previous taxable
year or years was filed, the name or names in which such return or
returns were filed, and whether each such return was a joint or separate
return.
(3) 30-percent capital gain property defined. If there is a
charitable contribution of a capital asset which, if it were sold by the
donor at its fair market
[[Page 49]]
value at the time of its contribution, would result in the recognition
of gain all, or any portion, of which would be long-term capital gain
and if the amount of such contribution is not required to be reduced
under section 170(e)(1)(B) and Sec. 1.170A-4(a)(2), such capital asset
shall be treated as ``30-percent capital gain property'' for purposes of
section 170 and the regulations thereunder. For such purposes any
property which is property used in the trade or business, as defined in
section 1231(b), shall be treated as a capital asset. However, see
paragraph (b)(4) of Sec. 1.170A-4. For the treatment of such property
as section 170(e) capital gain property, see paragraph (b)(2)(iii) of
Sec. 1.170A-4.
(e) Contribution base defined. For purposes of section 170 the term
contribution base means adjusted gross income under section 62, computed
without regard to any net operating loss carryback to the taxable year
under section 172. See section 170(b)(1)(F).
(f) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. B, an individual, reports his income on the calendar-year
basis and for 1970 has a contribution base of $100,000. During 1970 he
makes charitable contributions of $70,000 in cash, of which $40,000 is
given to section 170(b)(1)(A) organizations and $30,000 is given to
other organizations described in section 170(c). Accordingly, B is
allowed a charitable contributions deduction of $50,000 (50% of
$100,000), which consists of the $40,000 contributed to section
170(b)(1)(A) organizations and $10,000 of the $30,000 contributed to the
other organizations. Under paragraph (c) of this section, only $10,000
of the $30,000 contributed to the other organizations is allowed as a
deduction since such contribution of $30,000 is allowed to the extent of
the lesser of $20,000 (20% of $100,000) or $10,000 ([50% of $100,000]-
$40,000 (contributions allowed under section 170(b)(1)(A) and paragraph
(b) of this section)). Under section 170 (b)(1)(D)(ii) and (d)(1) and
Sec. 1.170A-10, B is not allowed a carryover to 1971 or to any other
taxable year for any of the $20,000 ($30,000-$10,000) not deductible
under section 170(b)(1)(B) and paragraph (c) of this section.
Example 2. C, an individual, reports his income on the calendar-year
basis and for 1970 has a contribution base of $100,000. During 1970 he
makes charitable contributions of $40,000 in 30-percent capital gain
property to section 170(b)(1)(A) organizations and of $30,000 in cash to
other organizations described in section 170(c). The 20-percent
limitation in section 170(b)(1)(B) and paragraph (c) of this section is
applied before the 30-percent limitation in section 170(b)(1)(D)(i) and
paragraph (d) of this section; accordingly section 170(b)(1)(B)(ii)
limits the deduction for the $30,000 cash contribution to $10,000 ([50%
of $100,000]- $40,000). The amount of the contribution of 30-percent
capital gain property is limited by section 170(b)(1)(D)(i) and
paragraph (d) of this section to $30,000 (30% of $100,000). Accordingly,
C's charitable contributions deduction for 1970 is limited to $40,000
($10,000 + $30,000). Under section 170 (b)(1)(D)(ii) and paragraph (c)
of Sec. 1.170A-10, C is allowed a carryover to 1971 of $10,000
($40,000-$30,000) in respect of his contributions of 30-percent capital
gain property. C is not allowed a carryover to 1971 or to any other
taxable year for any of the $20,000 cash ($30,000-$10,000) not
deductible under section 170(b)(1)(B) and paragraph (c) of this section.
Example 3. (a) D, an individual, reports his income on the calendar-
year basis and for 1970 has a contribution base of $100,000. During 1970
he makes charitable contributions of $70,000 in cash, of which $40,000
is given to section 170(b)(1)(A) organizations and $30,000 is given to
other organizations described in section 170(c). During 1971 D makes
charitable contributions to a section 170(b)(1)(A) organization of
$12,000, consisting of cash of $1,000 and $11,000 in 30-percent capital
gain property. His contribution base for 1971 is $10,000.
(b) For 1970, D is allowed a charitable contributions deduction of
$50,000 (50% of $100,000), which consists of the $40,000 contributed to
section 170(b)(1)(A) organizations and $10,000 of the $30,000
contributed to the other organizations. Under paragraph (c) of this
section, only $10,000 of the $30,000 contributed to the other
organizations is allowed as a deduction since such contribution of
$30,000 is allowed to the extent of the lesser of $20,000 (20% of
$100,000) or $10,000 ([50% of $100,000]-$40,000 (contributions allowed
under section 170(b)(1)(A) and paragraph (b) of this section)). D is not
allowed a carryover to 1971 or to any other taxable year for any of the
$20,000 ($30,000-$10,000) not deductible under section 170(b)(1)(B) and
paragraph (c) of this section.
(c) For 1971, D is allowed a charitable contributions deduction of
$4,000, consisting of $1,000 cash and $3,000 of the 30-percent capital
gain property (30% of $10,000). Under section 170(b)(1)(D)(ii) and
paragraph (c) of Sec. 1.170A-10, D is allowed a carryover to 1972 of
$8,000 ($11,000-$3,000) in respect of his contribution of 30-percent
capital gain property in 1971.
Example 4. (a) E, an individual, reports his income on the calendar-
year basis and for 1970 has a contribution base of $100,000. During 1970
he makes charitable contributions of $70,000 in cash, of which $40,000
is given to
[[Page 50]]
section 170(b)(1)(A) organizations and $30,000 is given to other
organizations described in section 170(c). During 1971 E makes
charitable contributions to a section 170(b)(1)(A) organization of
$14,000 consisting of cash of $3,000 and $11,000 in 30-percent capital
gain property. His contribution base for 1971 is $10,000.
(b) For 1970, E is allowed a charitable contributions deduction of
$50,000 (50% of $100,000), which consists of the $40,000 contributed to
section 170(b)(1)(A) organizations and $10,000 of the $30,000
contributed to the other organizations. Under paragraph (c) of this
section, only $10,000 of the $30,000 contributed to the other
organizations is allowed as a deduction since such contribution of
$30,000 is allowed to the extent of the lesser of $20,000 (20% of
$100,000) or ($10,000 ([50% of $100,000]-$40,000 (contributions allowed
under section 170(b)(1)(A) and paragraph (b) of this section)). E is not
allowed a carryover to 1971 or to any other taxable year for any of the
$20,000 ($30,000-$10,000) not deductible under section 170(b)(1)(B) and
paragraph (c) of this section.
(c) For 1971, E is allowed a charitable contributions deduction of
$5,000 (50% of $10,000), consisting of $3,000 cash and $2,000 of the
$3,000 (30% of $10,000) 30-percent capital gain property which is taken
into account. This result is reached because, as provided in section
170(b)(1)(D)(i) and paragraph (d)(1) of this section, cash contributions
are taken into account before charitable contributions of 30-percent
capital gain property. Under section 170(b)(1)(D)(ii) and (d)(1) and
paragraphs (b) and (c) of Sec. 1.170A-10, E is allowed a carryover of
$9,000 ([$11,000-$3,000] plus [$6,000 -$5,000]) to 1972 in respect of
his contribution of 30-percent capital gain property in 1971.
Example 5. In 1970, C, a calendar-year individual taxpayer,
contributes to section 170(b)(1)(A) organizations the amount of $8,000,
consisting of $3,000 in cash and $5,000 in 30-percent capital gain
property. In 1970, C also makes charitable contributions of $8,500 in 30
percent capital gain property to other organizations described in
section 170(c). C's contribution base for 1970 is $20,000. The 20-
percent limitation in section 170(b)(1)(B) and paragraph (c) of this
section is applied before the 30-percent limitation in section
170(b)(1)(D)(i) and paragraph (d) of this section; accordingly, section
170(b)(1)(B)(ii) limits the deduction for the $8,500 of contributions to
the other organizations described in section 170(c) to $2,000 ([50% of
$20,000]-[$3,000 + $5,000]). However, the total amount of contributions
of 30-percent capital gain property which is allowed as a deduction for
1970 is limited by section 170(b)(1)(D)(i) and paragraph (d) of this
section to $6,000 (30% of $20,000), consisting of the $5,000
contribution to the section 170(b)(1)(A) organizations and $1,000 of the
contributions to the other organizations described in section 170(c).
Accordingly C is allowed a charitable contributions deduction for 1970
of $9,000, which consists of $3,000 cash and $6,000 of the $13,500 of
30-percent capital gain property. C is not allowed to carryover to 1971
or any other year the remaining $7,500 because his contributions of 30-
percent capital gain property for 1970 to section 170(b)(1)(A)
organizations amount only to $5,000 and do not exceed $6,000 (30% of
$20,000). Thus, the requirement of section 170(b)(1)(D)(ii) is not
satisfied.
Example 6. During 1971, D, a calendar-year individual taxpayer,
makes a charitable contribution to a church of $8,000, consisting of
$5,000 in cash and $3,000 in 30-percent capital gain property. For such
year, D's contribution base is $10,000. Accordingly, D is allowed a
charitable contributions deduction for 1971 of $5,000 (50% of $10,000)
of cash. Under section 170(d)(1) and paragraph (b) of Sec. 1.170A-10, D
is allowed a carryover to 1972 of his $3,000 contribution of 30-percent
capital gain property, even though such amount does not exceed 30
percent of his contribution base for 1971.
Example 7. In 1970, E, a calendar-year individual taxpayer, makes a
charitable contribution to a section 170(b)(1)(A) organization in the
amount of $10,000, consisting of $8,000 in 30-percent capital gain
property and of $2,000 (after reduction under section 170(e)) in other
property. E's contribution base of 1970 is $20,000. Accordingly, E is
allowed a charitable contributions deduction for 1970 of $8,000,
consisting of the $2,000 of property the amount of which was reduced
under section 170(e) and $6,000 (30% of $20,000) of the 30-percent
capital gain property. Under section 170(b)(1)(D)(ii) and paragraph (c)
of Sec. 1.170A-10, E is allowed to carryover to 1971 $2,000 ($8,000-
$6,000) of his contribution of 30-percent capital gain property.
Example 8. (a) In 1972, F, calendar-year individual taxpayer, makes
a charitable contribution to a church of $4,000, consisting of $1,000 in
cash and $3,000 in 30-percent capital gain property. In addition, F
makes a charitable contribution in 1972 of $2,000 in cash to an
organization described in section 170(c)(4). F also has a carryover from
1971 under section 170(d)(1) of $5,000 (none of which consists of
contributions of 30-percent capital gain property) and a carryover from
1971 under section 170(b)(1)(D)(ii) of $6,000 of contributions of 30-
percent capital gain property. F's contribution base for 1972 is
$11,000.
Accordingly, F is allowed a charitable contributions deduction for
1972 of $5,500 (50% of $11,000), which consists of $1,000 cash
contributed in 1972 to the church, $3,000 of 30-percent capital gain
property contributed in 1972 to the church, and $1,500 (carryover of
$5,000 but not to exceed [$5,500-($1,000 + $3,000)]) of the carryover
from 1971 under section 170(d)(1).
[[Page 51]]
(b) No deduction is allowed for 1972 for the contribution in that
year of $2,000 cash to the section 170(c)(4) organization since section
170(b)(1)(B)(ii) and paragraph (c) of this section limit the deduction
for such contribution to $0([50% of $11,000]-[$1,000 + $1,500 +
$3,000]). Moreover, F is not allowed a carryover to 1973 or to any other
year for any of such $2,000 cash contributed to the section 170(c)(4)
organization.
(c) Under section 170(d)(1) and paragraph (b) of Sec. 1.170A-10, F
is allowed a carryover to 1973 from 1971 of $3,500 ($5,000-$1,500) of
contributions of other than 30-percent capital gain property. Under
section 170(b)(1)(D)(ii) and paragraph (c) of Sec. 1.170A-10, F is
allowed a carryover to 1973 from 1971 of $6,000 ($6,000-$0 of such
carryover treated as paid in 1972) of contributions of 30-percent
capital gain property. The portion of such $6,000 carryover from 1971
which is treated as paid in 1972 is $0 ([50% of $11,000]-[$4,000
contributions to the church in 1972 plus $1,500 of section 170(d)(1)
carryover treated as paid in 1972]).
Example 9. (a) In 1970, A, a calendar-year individual taxpayer,
makes a charitable contribution to a church of 30-percent capital gain
property having a fair market value of $60,000 and an adjusted basis of
$10,000. A's contribution base for 1970 is $50,000, and he makes no
other charitable contributions in that year. A does not elect for 1970
under paragraph (d)(2) of this section to have section 170(e)(1)(B)
apply to such contribution. Accordingly, under section 170(b)(1)(D)(i)
and paragraph (d) of this section, A is allowed a charitable
contributions deduction for 1970 of $15,000 (30% of $50,000). Under
section 170(b)(1)(D)(ii) and paragraph (c) of Sec. 1.170A-10, A is
allowed a carryover to 1971 of $45,000 ($60,000-$15,000) for his
contribution of 30-percent capital gain property.
(b) In 1971, A makes a charitable contribution to a church of 30-
percent capital gain property having a fair market value of $11,000 and
an adjusted basis of $10,000. A's contribution base for 1971 is $60,000,
and he makes no other charitable contributions in that year. A elects
for 1971 under paragraph (d)(2) of this section to have section
170(e)(1)(B) and Sec. 1.170A-4 apply to his contribution of $11,000 in
that year and to his carryover of $45,000 from 1970. Accordingly, he is
required to recompute his carryover from 1970 as if section 170(e)(1)(B)
had applied to his contribution of 30-percent capital gain property in
that year.
(c) If section 170(e)(1)(B) had applied in 1970 to his contribution
of 30-percent capital gain property, A's contribution would have been
reduced from $60,000 to $35,000, the reduction of $25,000 being 50
percent of the gain of $50,000 ($60,000-$10,000) which would have been
recognized as long-term capital gain if the property had been sold by A
at its fair market value at the time of the contribution in 1970.
Accordingly, by taking the election under paragraph (d)(2) of this
section into account, A has a recomputed carryover to 1971 of $20,000
($35,000- $15,000) of his contribution of 30-percent capital gain
property in 1970. However, A's charitable contributions deduction of
$15,000 allowed for 1970 is not recomputed by reason of the election.
(d) Pursuant to the election for 1971, the contribution of 30-
percent capital gain property for 1971 is reduced from $11,000 to
$10,500, the reduction of $500 being 50 percent of the gain of $1,000
($11,000-$10,000) which would have been recognized as long-term capital
gain if the property had been sold by A at its fair market value at the
time of its contribution in 1971.
(e) Accordingly, A is allowed a charitable contributions deduction
for 1971 of $30,000 (total contributions of $30,500 [$20,000 + $10,500]
but not to exceed 50% of $60,000).
(f) Under section 170(d)(1) and paragraph (b) of Sec. 1.170A-10, A
is allowed a carryover of $500 ($30,500-$30,000) to 1972 and the 3
succeeding taxable years. The $500 carryover, which by reason of the
election is no longer treated as a contribution of 30-percent capital
gain property, is treated as carried over under paragraph (b) of Sec.
1.170A-10 from 1970 since in 1971 current year contributions are
deducted before contributions which are carried over from preceding
taxable years.
Example 10. The facts are the same as in Example 9 except that A
also makes a charitable contribution in 1971 of $2,000 cash to a private
foundation not described in section 170(b)(1)(E) and that A's
contribution base for that year is $62,000, instead of $60,000.
Accordingly, A is allowed a charitable contributions deduction for 1971
of $31,000, determined in the following manner Under section
170(b)(1)(A) and paragraph (b) of this section, A is allowed a
charitable contributions deduction for 1971 of $30,500, consisting of
$10,500 of property contributed to the church in 1971 and of $20,000
(carryover of $20,000 but not to exceed [($62,000 x 50%)-$10,500]) of
contributions of property carried over to 1971 under section 170(d)(1)
and paragraph (b) of Sec. 1.170A-10. Under section 170(b)(1)(B) and
paragraph (c) of this section, A is allowed a charitable contributions
deduction for 1971 of $500 ([50% of $62,000]-[$10,500 + $20,000]) of
cash contributed to the private foundation in that year. A is not
allowed a carryover to 1972 or to any other taxable year for any of the
$1,500 ($2,000-$500) cash not deductible in 1971 under section
170(b)(1)(B) and paragraph (c) of this section.
Example 11. The facts are the same as in Example 9 except that A's
contribution base for 1970 is $120,000. Thus, before making the election
under paragraph (d)(2) of this section for 1971, A is allowed a
charitable contributions deduction for 1970 of $36,000 (30% of $120,000)
and is allowed a carryover to 1971 of $24,000 ($60,000-$36,000). By
making the
[[Page 52]]
election for 1971, A is required to recompute the carryover from 1970,
which is reduced from $24,000 to zero, since the charitable
contributions deduction of $36,000 allowed for 1970 exceeds the reduced
$35,000 contribution for 1970 which iay be taken into account by reason
of the election for 1971. Accordingly, A is allowed a deduction for 1971
of $10,500 and is allowed no carryover to 1972, since the reduced
contribution for 1971 ($10,500) does not exceed the limitation of
$30,000 (50% of $60,000) for 1971 which applies under section 170(d)(1)
and paragraph (b) of Sec. 1.170A-10. A's charitable contributions
deduction of $36,000 allowed for 1970 is not recomputed by reason of the
election. Thus, it is not to A's advantage to make the election under
paragraph (d)(2) of this section.
Example 12. (a) B, an individual, reports his income on the
calendar-year basis and for 1970 has a contribution base of $100,000.
During 1970 he makes charitable contributions of $70,000, consisting of
$50,000 in 30-percent capital gain property contributed to a church and
$20,000 in cash contributed to a private foundation not described in
section 170(b)(1)(E). For 1971, B's contribution base is $40,000, and in
that year he makes a charitable contribution of $5,000 in cash to such
private foundation. During the years involved B makes no other
charitable contributions.
(b) The amount of the contribution of 30-percent capital gain
property which may be taken into account for 1970 is limited by section
170(b)(1)(D)(i) and paragraph (d) of this section to $30,000 (30% of
$100,000). Accordingly, under section 170(b)(1)(A) and paragraph (b) of
this section B is allowed a deduction for 1970 of $30,000 of 30-percent
capital gain property (contribution of $30,000 but not to exceed $50,000
[50% of $100,000]). No deduction is allowed for 1970 for the
contribution in that year of $20,000 of cash to the private foundation
since section 170(b)(1)(B)(ii) and paragraph (c) of this section limit
the deduction for such contribution to $0 ([50% of $100,000]- $50,000,
the amount of the contribution of 30-percent capital gain property).
(c) Under section 170(b)(1)(D)(ii) and paragraph (c) of Sec.
1.170A-10, B is allowed a carryover to 1971 of $20,000 ($50,000-[30% of
$100,000]) of his contribution in 1970 of 30-percent capital gain
property. B is not allowed a carryover to 1971 or to any other taxable
year for any of the $20,000 cash contribution in 1970 which is not
deductible under section 170(b)(1)(B) and paragraph (c) of this section.
(d) The amount of the contribution of 30-percent capital gain
property which may be taken into account for 1971 is limited by section
170(b)(1)(D)(i) and paragraph (d) of this section to $12,000 (30% of
$40,000).
Accordingly, under section 170(b)(1)(A) and paragraph (b) of this
section B is allowed a deduction for 1971 of $12,000 of 30-percent
capital gain property (contribution of $12,000 but not to exceed $20,000
[50% of $40,000]). No deduction is allowed for 1971 for the contribution
in that year of $5,000 of cash to the private foundation, since section
170(b)(1)(B)(ii) and paragraph (c) of this section limit the deduction
for such contribution to $0 ([50% of $40,000] -$20,000 carryover of 30-
percent capital gain property from 1970).
(e) Under section 170(b)(1)(D)(ii) and paragraph (c) of Sec.
1.170A-10, B is allowed a carryover to 1972 of $8,000 ($20,000-[30% of
$40,000]) of his contribution in 1970 of 30-percent capital gain
property. B is not allowed a carryover to 1972 or to any other taxable
year for any of the $5,000 cash contribution for 1971 which is not
deductible under section 170(b)(1)(B) and paragraph (c) of this section.
Example 13. D, an individual, reports his income on the calendar-
year basis and for 1970 has a contribution base of $100,000. On March 1,
1970, he contributes to a church intangible property to which section
1245 applies which has a fair market value of $60,000 and an adjusted
basis of $10,000. At the time of the contribution D has used the
property in his business for more than 6 months. If the property had
been sold by D at its fair market value at the time of its contribution,
it is assumed that under section 1245 $20,000 of the gain of $50,000
would have been treated as ordinary income and $30,000 would have been
long-term capital gain. Since the property contributed is ordinary
income property within the meaning of paragraph (b)(1) of Sec. 1.170A-
4, D's contribution of $60,000 is reduced under paragraph (a)(1) of such
section to $40,000 ($60,000-$20,000 ordinary income). However, since the
property contributed is also 30-percent capital gain property within the
meaning of paragraph (d)(3) of this section, D's deduction for 1970 is
limited by section 170(b)(1)(D)(i) and paragraph (d) of this section to
$30,000 (30% of $100,000). Under section 170(b)(1)(D)(ii) and paragraph
(c) of Sec. 1.170A-10, D is allowed to carry over to 1971 $10,000
($40,000-$30,000) of his contribution of 30-percent capital gain
property.
Example 14. C, an individual, reports his income on the calendar-
year basis and for 1970 has a contribution base of $50,000. During 1970
he makes charitable contributions to a church of $57,000, consisting of
$2,000 cash and of 30-percent capital gain property with a fair market
value of $55,000 and an adjusted basis of $15,000. In addition, C
contributes $3,000 cash in 1970 to a private foundation not described in
section 170(b)(1)(E). For 1970, C elects under paragraph (d)(2) of this
section to have section 170(e)(1)(B) and Sec. 1.170A-4(a) apply to his
contribution of property to the church. Accordingly, for 1970 C's
contribution of property to the church is reduced from $55,000 to
$35,000, the reduction of $20,000 being 50 percent of the gain of
$40,000
[[Page 53]]
($55,000 -$15,000) which would have been recognized as long-term capital
gain if the property had been sold by C at its fair market value at the
time of its contribution to the church. Under section 170(b)(1)(A) and
paragraph (b) of this section, C is allowed a charitable contributions
deduction for 1970 of $25,000 ([$2,000 + $35,000] but not to exceed
[$50,000 x 50%]). Under section 170(d)(1) and paragraph (b) of Sec.
1.170A-10, C is allowed a carryover from 1970 to 1971 of $12,000
($37,000-$25,000). No deduction is allowed for 1970 for the contribution
in that year of $3,000 cash to the private foundation since section
170(b)(1)(B) and paragraph (c) of this section limit the deduction for
such contribution to the smaller of $10,000 ($50,000 x 20%) or $0
([$50,000 x 50%]-$25,000). C is not allowed a carryover from 1970 for
any of the $3,000 cash contribution in that year which is not deductible
under section 170(b)(1)(B) and paragraph (c) of this section.
Example 15. (a) D, an individual, reports his income on the
calendar-year basis and for 1970 has a contribution base of $100,000.
During 1970 he makes a charitable contribution to a church of 30-percent
capital gain property with a fair market value of $40,000 and an
adjusted basis of $21,000. In addition, he contributes $23,000 cash in
1970 to a private foundation not described in section 170(b)(1)(E). For
1970, D elects under paragraph (d)(2) of this section to have section
170(e)(1)(B) and Sec. 1.170A-4(a) apply to his contribution of property
to the church. Accordingly, for 1970 D's contribution of property to the
church is reduced from $40,000 to $30,500, the reduction of $9,500 being
50 percent of the gain of $19,000 ($40,000-$21,000) which would have
been recognized as long-term capital gain if the property had been sold
by D at its fair market value at the time of its contribution to the
church. Under section 170(b)(1)(A) and paragraph (b) of this section, D
is allowed a charitable contributions deduction for 1970 of $30,500 for
the property contributed to the church. In addition, under section
170(b)(1)(B) and paragraph (c) of this section D is allowed a deduction
of $19,500 for the cash contributed to the private foundation, since
such contribution of $23,000 is allowed to the extent of the lesser of
$20,000 (20% of $100,000) or $19,500 ([$100,000 x 50%]-$30,500). D is
not allowed a carryover to 1971 or to any other taxable year for any of
the $3,500 ($23,000-$19,500) of cash not deductible under section
170(b)(1)(B) and paragraph (c) of this section.
(b) If D had not made the election under paragraph (d)(2) of this
section for 1970, his deduction for 1970 under section 170(a) for the
$40,000 contribution of property to the church would have been limited
by section 170(b)(1)(D)(i) and paragraph (d) of this section to $30,000
(30% of $100,000), and under section 170(b)(1)(D)(ii) and paragraph (c)
of Sec. 1.170A-10 he would have been allowed a carryover to 1971 of
$10,000 ($40,000-$30,000) for his contribution of such property. In
addition, he would have been allowed under section 170(b)(1)(B)(ii) and
paragraph (c) of this section for 1970 a charitable contributions
deduction of $10,000 ([$100,000 x 50%]-$40,000) for the cash contributed
to the private foundation. In such case, D would not have been allowed a
carryover to 1971 or to any other taxable year for any of the $13,000
($23,000-$10,000) of cash not deductible under section 170(b)(1)(B) and
paragraph (c) of this section.
(g) Effective date. This section applies only to contributions paid
in taxable years beginning after December 31, 1969.
[T.D. 7207, 37 FR 20783, Oct. 4, 1972; 37 FR 22982, Oct. 27, 1972]
Sec. 1.170A-9 Definition of section 170(b)(1)(A) organization.
(a) The term section 170(b)(1)(A) organization as used in the
regulations under section 170 means any organization described in
paragraphs (b) through (j) of this section, effective with respect to
taxable years beginning after December 31, 1969, except as otherwise
provided. Section 1.170-2(b) shall continue to be applicable with
respect to taxable years beginning prior to January 1, 1970. The term
one or more organizations described in section 170(b)(1)(A) (other than
clauses (vii) and (viii)) as used in sections 507 and 509 of the
Internal Revenue Code (Code) and the regulations means one or more
organizations described in paragraphs (b) through (f) of this section,
except as modified by the regulations under part II of subchapter F of
chapter 1 or under chapter 42.
(b) Church or a convention or association of churches. An
organization is described in section 170(b)(1)(A)(i) if it is a church
or a convention or association of churches.
(c) Educational organization and organizations for the benefit of
certain State and municipal colleges and universities--(1) Educational
organization. An educational organization is described in section
170(b)(1)(A)(ii) if its primary function is the presentation of formal
instruction and it normally maintains a regular faculty and curriculum
and normally has a regularly enrolled body of pupils or students in
attendance at
[[Page 54]]
the place where its educational activities are regularly carried on. The
term includes institutions such as primary, secondary, preparatory, or
high schools, and colleges and universities. It includes Federal, State,
and other public-supported schools which otherwise come within the
definition. It does not include organizations engaged in both
educational and noneducational activities unless the latter are merely
incidental to the educational activities. A recognized university which
incidentally operates a museum or sponsors concerts is an educational
organization within the meaning of section 170(b)(1)(A)(ii). However,
the operation of a school by a museum does not necessarily qualify the
museum as an educational organization within the meaning of this
subparagraph.
(2) Organizations for the benefit of certain State and municipal
colleges and universities. (i) An organization is described in section
170(b)(1)(A)(iv) if it meets the support requirements of subdivision
(ii) of this subparagraph and is organized and operated exclusively to
receive, hold, invest, and administer property and to make expenditures
to or for the benefit of a college or university which is an
organization described in subdivision (iii) of this subparagraph. The
phrase ``expenditures to or for the benefit of a college or university''
includes expenditures made for any one or more of the normal functions
of colleges and universities such as the acquisition and maintenance of
real property comprising part of the campus area; the erection of, or
participation in the erection of, college or university buildings; the
acquisition and maintenance of equipment and furnishings used for, or in
conjunction with, normal functions of colleges and universities; or
expenditures for scholarships, libraries and student loans.
(ii) To qualify under section 170(b)(1)(A)(iv), the organization
receiving the contribution must normally receive a substantial part of
its support from the United States or any State or political subdivision
thereof or from direct or indirect contributions from the general
public, or from a combination of two or more of such sources. For such
purposes, the term ``support'' does not include income received in the
exercise or performance by the organization of its charitable,
educational, or other purpose or function constituting the basis for its
exemption under section 501(a). An example of an indirect contribution
from the public is the receipt by the organization of its share of the
proceeds of an annual collection campaign of a community chest,
community fund, or united fund. In determining the amount of support
received by such organization with respect to a contribution of property
which is subject to reduction under section 170(e), the fair market
value of the property shall be taken into account.
(iii) The college or university (including a land grant college or
university) to be benefited must be an educational organization referred
to in section 170(b)(1)(A)(ii) and subparagraph (1) of this paragraph
which is an agency or instrumentality of a State or political
subdivision thereof, or which is owned or operated by a State or
political subdivision thereof or by an agency or instrumentality of one
or more States or political subdivisions.
(d) Hospitals and medical research organizations--(1) Hospitals. An
organization (other than one described in paragraph (d)(2) of this
section) is described in section 170(b)(1)(A)(iii) if--
(i) It is a hospital; and
(ii) Its principal purpose or function is the providing of medical
or hospital care or medical education or medical research.
(A) The term hospital includes--
(1) Federal hospitals; and
(2) State, county, and municipal hospitals which are
instrumentalities of governmental units referred to in section 170(c)(1)
and otherwise come within the definition. A rehabilitation institution,
outpatient clinic, or community mental health or drug treatment center
may qualify as a ``hospital'' within the meaning of paragraph (d)(1)(i)
of this section if its principal purpose or function is the providing of
hospital or medical care. For purposes of this paragraph (d)(1)(ii), the
term medical care shall include the treatment of any physical or mental
disability or condition, whether on an inpatient or outpatient basis,
provided the cost of such treatment is deductible under section 213 by
the person
[[Page 55]]
treated. An organization, all the accommodations of which qualify as
being part of a ``skilled nursing facility'' within the meaning of 42
U.S.C. 1395x(j), may qualify as a ``hospital'' within the meaning of
paragraph (d)(1)(i) of this section if its principal purpose or function
is the providing of hospital or medical care. For taxable years ending
after June 28, 1968, the term hospital also includes cooperative
hospital service organizations which meet the requirements of section
501(e) and Sec. 1.501(e)-1.
(B) The term hospital does not, however, include convalescent homes
or homes for children or the aged, nor does the term include
institutions whose principal purpose or function is to train handicapped
individuals to pursue some vocation. An organization whose principal
purpose or function is the providing of medical education or medical
research will not be considered a ``hospital'' within the meaning of
paragraph (d)(1)(i) of this section, unless it is also actively engaged
in providing medical or hospital care to patients on its premises or in
its facilities, on an inpatient or outpatient basis, as an integral part
of its medical education or medical research functions. See, however,
paragraph (d)(2) of this section with respect to certain medical
research organizations.
(2) Certain medical research organizations--(i) Introduction. A
medical research organization is described in section 170(b)(1)(A)(iii)
if the principal purpose or functions of such organization are medical
research and if it is directly engaged in the continuous active conduct
of medical research in conjunction with a hospital. In addition, for
purposes of the 50 percent limitation of section 170(b)(1)(A) with
respect to a contribution, during the calendar year in which the
contribution is made such organization must be committed to spend such
contribution for such research before January 1 of the fifth calendar
year which begins after the date such contribution is made. An
organization need not receive contributions deductible under section 170
to qualify as a medical research organization and such organization need
not be committed to spend amounts to which the limitation of section
170(b)(1)(A) does not apply within the 5-year period referred to in this
paragraph (d)(2)(i). However, the requirement of continuous active
conduct of medical research indicates that the type of organization
contemplated in this paragraph (d)(2) is one which is primarily engaged
directly in the continuous active conduct of medical research, as
compared to an inactive medical research organization or an organization
primarily engaged in funding the programs of other medical research
organizations. As in the case of a hospital, since an organization is
ordinarily not described in section 170(b)(1)(A)(iii) as a hospital
unless it functions primarily as a hospital, similarly a medical
research organization is not so described unless it is primarily engaged
directly in the continuous active conduct of medical research in
conjunction with a hospital. Accordingly, the rules of this paragraph
(d)(2) shall only apply with respect to such medical research
organizations.
(ii) General rule. An organization (other than a hospital described
in paragraph (d)(1) of this section) is described in section
170(b)(1)(A)(iii) only if within the meaning of this paragraph (d)(2):
(A) The principal purpose or functions of such organization are to
engage primarily in the conduct of medical research; and
(B) It is primarily engaged directly in the continuous active
conduct of medical research in conjunction with a hospital which is--
(1) Described in section 501(c)(3);
(2) A Federal hospital; or
(3) An instrumentality of a governmental unit referred to in section
170(c)(1).
(C) In order for a contribution to such organization to qualify for
purposes of the 50 percent limitation of section 170(b)(1)(A), during
the calendar year in which such contribution is made or treated as made,
such organization must be committed (within the meaning of paragraph
(d)(2)(viii) of this section) to spend such contribution for such active
conduct of medical research before January 1 of the fifth calendar year
beginning after the date such contribution is made. For the
[[Page 56]]
meaning of the term ``medical research'' see paragraph (d)(2)(iii) of
this section. For the meaning of the term ``principal purpose or
functions'' see paragraph (d)(2)(iv) of this section. For the meaning of
the term ``primarily engaged directly in the continuous active conduct
of medical research'' see paragraph (d)(2)(v) of this section. For the
meaning of the term ``medical research in conjunction with a hospital''
see paragraph (d)(2)(vii) of this section.
(iii) Definition of medical research. Medical research means the
conduct of investigations, experiments, and studies to discover,
develop, or verify knowledge relating to the causes, diagnosis,
treatment, prevention, or control of physical or mental diseases and
impairments of man. To qualify as a medical research organization, the
organization must have or must have continuously available for its
regular use the appropriate equipment and professional personnel
necessary to carry out its principal function. Medical research
encompasses the associated disciplines spanning the biological, social
and behavioral sciences. Such disciplines include chemistry
(biochemistry, physical chemistry, bioorganic chemistry, etc.),
behavioral sciences (psychiatry, physiological psychology,
neurophysiology, neurology, neurobiology, and social psychology, etc.),
biomedical engineering (applied biophysics, medical physics, and medical
electronics, for example, developing pacemakers and other medically
related electrical equipment), virology, immunology, biophysics, cell
biology, molecular biology, pharmacology, toxicology, genetics,
pathology, physiology, microbiology, parasitology, endocrinology,
bacteriology, and epidemiology.
(iv) Principal purpose or functions. An organization must be
organized for the principal purpose of engaging primarily in the conduct
of medical research in order to be an organization meeting the
requirements of this paragraph (d)(2). An organization will normally be
considered to be so organized if it is expressly organized for the
purpose of conducting medical research and is actually engaged primarily
in the conduct of medical research. Other facts and circumstances,
however, may indicate that an organization does not meet the principal
purpose requirement of this paragraph (d)(2)(iv) even where its
governing instrument so expressly provides. An organization that
otherwise meets all of the requirements of this paragraph (d)(2)
(including this paragraph (d)(2)(iv)) to qualify as a medical research
organization will not fail to so qualify solely because its governing
instrument does not specifically state that its principal purpose is to
conduct medical research.
(v) Primarily engaged directly in the continuous active conduct of
medical research--(A) In order for an organization to be primarily
engaged directly in the continuous active conduct of medical research,
the organization must either devote a substantial part of its assets to,
or expend a significant percentage of its endowment for, such purposes,
or both. Whether an organization devotes a substantial part of its
assets to, or makes significant expenditures for, such continuous active
conduct depends upon the facts and circumstances existing in each
specific case. An organization will be treated as devoting a substantial
part of its assets to, or expending a significant percentage of its
endowment for, such purposes if it meets the appropriate test contained
in paragraph (d)(2)(v)(B) of this section. If an organization fails to
satisfy both of such tests, in evaluating the facts and circumstances,
the factor given most weight is the margin by which the organization
failed to meet such tests. Some of the other facts and circumstances to
be considered in making such a determination are--
(1) If the organization fails to satisfy the tests because it failed
to properly value its assets or endowment, then upon determination of
the improper valuation it devotes additional assets to, or makes
additional expenditures for, such purposes, so that it satisfies such
tests on an aggregate basis for the prior year in addition to such tests
for the current year;
(2) The organization acquires new assets or has a significant
increase in the value of its securities after it had developed a budget
in a prior year based on the assets then owned and the then current
values;
[[Page 57]]
(3) The organization fails to make expenditures in any given year
because of the interrelated aspects of its budget and long-term planning
requirements, for example, where an organization prematurely terminates
an unsuccessful program and because of long-term planning requirements
it will not be able to establish a fully operational replacement program
immediately; and
(4) The organization has as its objective to spend less than a
significant percentage in a particular year but make up the difference
in the subsequent few years, or to budget a greater percentage in an
earlier year and a lower percentage in a later year.
(B) For purposes of this section, an organization which devotes more
than one half of its assets to the continuous active conduct of medical
research will be considered to be devoting a substantial part of its
assets to such conduct within the meaning of paragraph (d)(2)(v)(A) of
this section. An organization which expends funds equaling 3.5 percent
or more of the fair market value of its endowment for the continuous
active conduct of medical research will be considered to have expended a
significant percentage of its endowment for such purposes within the
meaning of paragraph (d)(2)(v)(A) of this section.
(C) Engaging directly in the continuous active conduct of medical
research does not include the disbursing of funds to other organizations
for the conduct of research by them or the extending of grants or
scholarships to others. Therefore, if an organization's primary purpose
is to disburse funds to other organizations for the conduct of research
by them or to extend grants or scholarships to others, it is not
primarily engaged directly in the continuous active conduct of medical
research.
(vi) Special rules. The following rules shall apply in determining
whether a substantial part of an organization's assets are devoted to,
or its endowment is expended for, the continuous active conduct of
medical research activities:
(A) An organization may satisfy the tests of paragraph (d)(2)(v)(B)
of this section by meeting such tests either for a computation period
consisting of the immediately preceding taxable year, or for the
computation period consisting of the immediately preceding four taxable
years. In addition, for taxable years beginning in 1970, 1971, 1972,
1973, and 1974, if an organization meets such tests for the computation
period consisting of the first four taxable years beginning after
December 31, 1969, an organization will be treated as meeting such
tests, not only for the taxable year beginning in 1974, but also for the
preceding four taxable years. Thus, for example, if a calendar year
organization failed to satisfy such tests for a computation period
consisting of 1969, 1970, 1971, and 1972, but on the basis of a
computation period consisting of the years 1970 through 1973, it
expended funds equaling 3.5 percent or more of the fair market value of
its endowment for the continuous active conduct of medical research,
such organization will be considered to have expended a significant
percentage of its endowment for such purposes for the taxable years 1970
through 1974. In applying such tests for a four-year computation period,
although the organization's expenditures for the entire four-year period
shall be aggregated, the fair market value of its endowment for each
year shall be summed, even though, in the case of an asset held
throughout the four-year period, the fair market value of such an asset
will be counted four times. Similarly, the fair market value of an
organization's assets for each year of a four-year computation period
shall be summed.
(B) Any property substantially all the use of which is
``substantially related'' (within the meaning of section 514(b)(1)(A))
to the exercise or performance of the organization's medical research
activities will not be treated as part of its endowment.
(C) The valuation of assets must be made with commonly accepted
methods of valuation. A method of valuation made in accordance with the
principles stated in the regulations under section 2031 constitutes an
acceptable method of valuation. Assets may be valued as of any day in
the organization's taxable year to which such valuation applies,
provided the organization follows a consistent practice of valuing such
asset as of such date in all
[[Page 58]]
taxable years. For purposes of paragraph (d)(2)(v) of this section, an
asset held by the organization for part of a taxable year shall be taken
into account by multiplying the fair market value of such asset by a
fraction, the numerator of which is the number of days in such taxable
year that the organization held such asset and the denominator of which
is the number of days in such taxable year.
(vii) Medical research in conjunction with a hospital. The
organization need not be formally affiliated with a hospital to be
considered primarily engaged directly in the continuous active conduct
of medical research in conjunction with a hospital, but in any event
there must be a joint effort on the part of the research organization
and the hospital pursuant to an understanding that the two organizations
will maintain continuing close cooperation in the active conduct of
medical research. For example, the necessary joint effort will normally
be found to exist if the activities of the medical research organization
are carried on in space located within or adjacent to a hospital, the
organization is permitted to utilize the facilities (including
equipment, case studies, etc.) of the hospital on a continuing basis
directly in the active conduct of medical research, and there is
substantial evidence of the close cooperation of the members of the
staff of the research organization and members of the staff of the
particular hospital or hospitals. The active participation in medical
research by members of the staff of the particular hospital or hospitals
will be considered to be evidence of such close cooperation. Because
medical research may involve substantial investigation, experimentation
and study not immediately connected with hospital or medical care, the
requisite joint effort will also normally be found to exist if there is
an established relationship between the research organization and the
hospital which provides that the cooperation of appropriate personnel
and the use of facilities of the particular hospital or hospitals will
be required whenever it would aid such research.
(viii) Commitment to spend contributions. The organization's
commitment that the contribution will be spent within the prescribed
time only for the prescribed purposes must be legally enforceable. A
promise in writing to the donor in consideration of his making a
contribution that such contribution will be so spent within the
prescribed time will constitute a commitment. The expenditure of
contributions received for plant, facilities, or equipment, used solely
for medical research purposes (within the meaning of paragraph
(d)(2)(ii) of this section), shall ordinarily be considered to be an
expenditure for medical research. If a contribution is made in other
than money, it shall be considered spent for medical research if the
funds from the proceeds of a disposition thereof are spent by the
organization within the five-year period for medical research; or, if
such property is of such a kind that it is used on a continuing basis
directly in connection with such research, it shall be considered spent
for medical research in the year in which it is first so used. A medical
research organization will be presumed to have made the commitment
required under this paragraph (d)(2)(viii) with respect to any
contribution if its governing instrument or by-laws require that every
contribution be spent for medical research before January 1 of the fifth
year which begins after the date such contribution is made.
(ix) Organizational period for new organizations. A newly created
organization, for its ``organizational'' period, shall be considered to
be primarily engaged directly in the continuous active conduct of
medical research in conjunction with a hospital within the meaning of
paragraphs (d)(2)(v) and (d)(2)(vii) of this section if during such
period the organization establishes to the satisfaction of the
Commissioner that it reasonably can be expected to be so engaged by the
end of such period. The information to be submitted shall include
detailed plans showing the proposed initial medical research program,
architectural drawings for the erection of buildings and facilities to
be used for medical research in accordance with such plans, plans to
assemble a professional staff and detailed projections showing the
timetable for the expected accomplishment of the
[[Page 59]]
foregoing. The ``organizational'' period shall be that period which is
appropriate to implement the proposed plans, giving effect to the
proposed amounts involved and the magnitude and complexity of the
projected medical research program, but in no event in excess of three
years following organization.
(x) Examples. The application of this paragraph (d)(2) may be
illustrated by the following examples:
Example 1. N, an organization referred to in section 170(c)(2), was
created to promote human knowledge within the field of medical research
and medical education. All of N's assets were contributed to it by A and
consist of a diversified portfolio of stocks and bonds. N's endowment
earns 3.5 percent annually, which N expends in the conduct of various
medical research programs in conjunction with Y hospital. N is located
adjacent to Y hospital, makes substantial use of Y's facilities, and
there is close cooperation between the staffs of N and Y. N is directly
engaged in the continuous active conduct of medical research in
conjunction with a hospital, meets the principal purpose test described
in paragraph (d)(2)(iv) of this section, and is therefore an
organization described in section 170(b)(1)(A)(iii).
Example 2. O, an organization referred to in section 170(c)(2), was
created to promote human knowledge within the field of medical research
and medical education. All of O's assets consist of a diversified
portfolio of stocks and bonds. O's endowment earns 3.5 percent annually,
which O expends in the conduct of various medical research programs in
conjunction with certain hospitals. However, in 1974, O receives a
substantial bequest of additional stocks and bonds. O's budget for 1974
does not take into account the bequest and as a result O expends only
3.1 percent of its endowment in 1974. However, O establishes that it
will expend at least 3.5 percent of its endowment for the active conduct
of medical research for taxable years 1975 through 1978. O is therefore
directly engaged in the continuous active conduct of medical research in
conjunction with a hospital for taxable year 1975. Since O also meets
the principal purpose test described in paragraph (d)(2)(iv) of this
section, it is therefore an organization described in section
170(b)(1)(A)(iii) for taxable year 1975.
Example 3. M, an organization referred to in section 170(c)(2), was
created to promote human knowledge within the field of medical research
and medical education. M's activities consist of the conduct of medical
research programs in conjunction with various hospitals. Under such
programs, researchers employed by M engage in research at laboratories
set aside for M within the various hospitals. Substantially all of M's
assets consist of 100 percent of the stock of X corporation, which has a
fair market value of approximately 100 million dollars. X pays M
approximately 3.3 million dollars in dividends annually, which M expends
in the conduct of its medical research programs. Since M expends only
3.3 percent of its endowment, which does not constitute a significant
percentage, in the active conduct of medical research, M is not an
organization described in section 170(b)(1)(A)(iii) because M is not
engaged in the continuous active conduct of medical research.
(xi) Special rule for organizations with existing ruling. This
paragraph (d)(2)(xi) shall apply to an organization that prior to
January 1, 1970, had received a ruling or determination letter which has
not been expressly revoked holding the organization to be a medical
research organization described in section 170(b)(1)(A)(iii) and with
respect to which the facts and circumstances on which the ruling was
based have not substantially changed. An organization to which this
paragraph (d)(2)(xi) applies shall be treated as an organization
described in section 170(b)(1)(A)(iii) for a period not ending prior to
90 days after February 13, 1976 (or where appropriate, for taxable years
beginning before such 90th day). In addition, with respect to a grantor
or contributor under sections 170, 507, 545(b)(2), 556(b)(2), 642(c),
4942, 4945, 2055, 2106(a)(2), and 2522, the status of an organization to
which this paragraph (d)(2)(xi) applies will not be affected until
notice of change of status under section 170(b)(1)(A)(iii) is made to
the public (such as by publication in the Internal Revenue Bulletin).
The preceding sentence shall not apply if the grantor or contributor had
previously acquired knowledge that the Internal Revenue Service had
given notice to such organization that it would be deleted from
classification as a section 170(b)(1)(A)(iii) organization.
(e) Governmental unit. A governmental unit is described in section
170(b)(1)(A)(v) if it is referred to in section 170(c)(1).
(f) Definition of section 170(b)(1)(A)(vi) organization--(1) In
general. An organization is described in section 170(b)(1)(A)(vi) if
it--
[[Page 60]]
(i) Is referred to in section 170(c)(2) (other than an organization
specifically described in paragraphs (b) through (e) of this section);
and
(ii) Normally receives a substantial part of its support from a
governmental unit referred to in section 170(c)(1) or from direct or
indirect contributions from the general public (``publicly supported'').
For purposes of this paragraph (f), an organization is publicly
supported if it meets the requirements of either paragraph (f)(2) of
this section (33\1/3\ percent support test) or paragraph (f)(3) of this
section (facts and circumstances test). Paragraph (f)(4) of this section
defines ``normally'' for purposes of the 33\1/3\ percent support test
and the facts and circumstances test, and for new organizations in the
first five years of the organization's existence as a section 501(c)(3)
organization. Paragraph (f)(5) of this section provides for
determinations of foundation classification and rules for reliance by
donors and contributors. Paragraphs (f)(6), (f)(7), and (f)(8) of this
section list the items that are included and excluded from the term
support. Paragraph (f)(9) of this section provides examples of the
application of this paragraph. Types of organizations that, subject to
the provisions of this paragraph (f), generally qualify under section
170(b)(1)(A)(vi) as ``publicly supported'' are publicly or
governmentally supported museums of history, art, or science, libraries,
community centers to promote the arts, organizations providing
facilities for the support of an opera, symphony orchestra, ballet, or
repertory drama or for some other direct service to the general public.
(2) Determination whether an organization is ``publicly supported'';
33\1/3\ percent support test. An organization is publicly supported if
the total amount of support (see paragraphs (f)(6), (f)(7), and (f)(8)
of this section) that the organization normally (see paragraph (f)(4)(i)
of this section) receives from governmental units referred to in section
170(c)(1), from contributions made directly or indirectly by the general
public, or from a combination of these sources, equals at least 33\1/3\
percent of the total support normally received by the organization. See
paragraph (f)(9), Example 1 of this section.
(3) Determination whether an organization is ``publicly supported'';
facts and circumstances test. Even if an organization fails to meet the
33\1/3\ percent support test described in paragraph (f)(2) of this
section, it is publicly supported if it normally (see paragraph
(f)(4)(i) of this section) receives a substantial part of its support
from governmental units, from contributions made directly or indirectly
by the general public, or from a combination of these sources, and meets
the other requirements of this paragraph (f)(3). In order to satisfy the
facts and circumstances test, an organization must meet the requirements
of paragraphs (f)(3)(i) and (f)(3)(ii) of this section. In addition, the
organization must be in the nature of an organization that is publicly
supported, taking into account all pertinent facts and circumstances,
including the factors listed in paragraphs (f)(3)(iii)(A) through
(f)(3)(iii)(E) of this section.
(i) Ten-percent support limitation. The percentage of support (see
paragraphs (f)(6), (f)(7) and (f)(8) of this section) normally received
by an organization from governmental units, from contributions made
directly or indirectly by the general public, or from a combination of
these sources, must be substantial. For purposes of this paragraph
(f)(3), an organization will not be treated as normally receiving a
substantial amount of governmental or public support unless the total
amount of governmental and public support normally received equals at
least 10 percent of the total support normally received by such
organization.
(ii) Attraction of public support. An organization must be so
organized and operated as to attract new and additional public or
governmental support on a continuous basis. An organization will be
considered to meet this requirement if it maintains a continuous and
bona fide program for solicitation of funds from the general public,
community, or membership group involved, or if it carries on activities
designed to attract support from governmental units or other
organizations described in section 170(b)(1)(A)(i) through
(b)(1)(A)(vi). In determining whether an organization maintains a
continuous and bona fide program for solicitation of funds from the
general public or
[[Page 61]]
community, consideration will be given to whether the scope of its
fundraising activities is reasonable in light of its charitable
activities. Consideration will also be given to the fact that an
organization, in its early years of existence, may limit the scope of
its solicitation to persons deemed most likely to provide seed money in
an amount sufficient to enable it to commence its charitable activities
and expand its solicitation program.
(iii) In addition to the requirements set forth in paragraphs
(f)(3)(i) and (f)(3)(ii) of this section that must be satisfied, all
pertinent facts and circumstances, including the following factors, will
be taken into consideration in determining whether an organization is
``publicly supported'' within the meaning of paragraph (f)(1) of this
section. However, an organization is not generally required to satisfy
all of the factors in paragraphs (f)(3)(iii)(A) through (f)(3)(iii)(E)
of this section. The factors relevant to each case and the weight
accorded to any one of them may differ depending upon the nature and
purpose of the organization and the length of time it has been in
existence.
(A) Percentage of financial support. The percentage of support
received by an organization from public or governmental sources will be
taken into consideration in determining whether an organization is
``publicly supported.'' The higher the percentage of support above the
10 percent requirement of paragraph (f)(3)(i) of this section from
public or governmental sources, the lesser will be the burden of
establishing the publicly supported nature of the organization through
other factors, including those described in this paragraph (f)(3), while
the lower the percentage, the greater will be the burden. If the
percentage of the organization's support from public or governmental
sources is low because it receives a high percentage of its total
support from investment income on its endowment funds, such fact will be
treated as evidence of an organization being ``publicly supported'' if
such endowment funds were originally contributed by a governmental unit
or by the general public. However, if such endowment funds were
originally contributed by a few individuals or members of their
families, such fact will increase the burden on the organization of
establishing that it is ``publicly supported'' taking into account all
pertinent facts and circumstances, including the other factors described
in paragraph (f)(3)(iii) of this section.
(B) Sources of support. The fact that an organization meets the
requirement of paragraph (f)(3)(i) of this section through support from
governmental units or directly or indirectly from a representative
number of persons, rather than receiving almost all of its support from
the members of a single family, will be considered evidence of an
organization being ``publicly supported.'' In determining what is a
``representative number of persons,'' consideration will be given to the
type of organization involved, the length of time it has been in
existence, and whether it limits its activities to a particular
community or region or to a special field which can be expected to
appeal to a limited number of persons.
(C) Representative governing body. The fact that an organization has
a governing body which represents the broad interests of the public,
rather than the personal or private interests of a limited number of
donors (or persons standing in a relationship to such donors which is
described in section 4946(a)(1)(C) through (a)(1)(G)), will be
considered evidence of an organization being ``publicly supported.'' An
organization will be treated as having a representative governing body
if it has a governing body (whether designated in the organization's
governing instrument or bylaws as a Board of Directors, Board of
Trustees, or similar governing body) which is comprised of public
officials acting in their capacities as such; of individuals selected by
public officials acting in their capacities as such; of persons having
special knowledge or expertise in the particular field or discipline in
which the organization is operating; of community leaders, such as
elected or appointed officials, clergymen, educators, civic leaders, or
other such persons representing a broad cross-section of the views and
interests of the community; or, in the case of a
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membership organization, of individuals elected pursuant to the
organization's governing instrument or bylaws by a broadly based
membership.
(D) Availability of public facilities or services; public
participation in programs or policies. (1) The fact that an organization
generally provides facilities or services directly for the benefit of
the general public on a continuing basis (such as a museum or library
which holds open its building or facilities to the public, a symphony
orchestra which gives public performances, a conservation organization
which provides educational services to the public through the
distribution of educational materials, or an old age home which provides
domiciliary or nursing services for members of the general public) will
be considered evidence that such organization is ``publicly supported.''
(2) The fact that an organization is an educational or research
institution which regularly publishes scholarly studies that are widely
used by colleges and universities or by members of the general public
will also be considered evidence that such organization is ``publicly
supported.''
(3) The following factors will also be considered evidence that an
organization is ``publicly supported'':
(i) The participation in, or sponsorship of, the programs of the
organization by members of the public having special knowledge or
expertise, public officials, or civic or community leaders.
(ii) The maintenance of a definitive program by an organization to
accomplish its charitable work in the community, such as combating
community deterioration in an economically depressed area that has
suffered a major loss of population and jobs.
(iii) The receipt of a significant part of its funds from a public
charity or governmental agency to which it is in some way held
accountable as a condition of the grant, contract, or contribution.
(E) Additional factors pertinent to membership organizations. The
following are additional factors to be considered in determining whether
a membership organization is ``publicly supported'':
(1) Whether the solicitation for dues-paying members is designed to
enroll a substantial number of persons in the community or area, or in a
particular profession or field of special interest (taking into account
the size of the area and the nature of the organization's activities).
(2) Whether membership dues for individual (rather than
institutional) members have been fixed at rates designed to make
membership available to a broad cross section of the interested public,
rather than to restrict membership to a limited number of persons.
(3) Whether the activities of the organization will be likely to
appeal to persons having some broad common interest or purpose, such as
educational activities in the case of alumni associations, musical
activities in the case of symphony societies, or civic affairs in the
case of parent-teacher associations. See Example 2 through Example 5
contained in paragraph (f)(9) of this section for illustrations of this
paragraph (f)(3).
(4) Definition of normally; general rule--(i) Normally; 33\1/3\
percent support test. An organization ``normally'' receives the
requisite amount of public support and meets the 33\1/3\ percent support
test for a taxable year and the taxable year immediately succeeding that
year, if, for the taxable year being tested and the four taxable years
immediately preceding that taxable year, the organization meets the
33\1/3\ percent support test on an aggregate basis.
(ii) Normally; facts and circumstances test. An organization
``normally'' receives the requisite amount of public support and meets
the facts and circumstances test of paragraph (f)(3) for a taxable year
and the taxable year immediately succeeding that year, if, for the
taxable year being tested and the four taxable years immediately
preceding that taxable year, the organization meets the facts and
circumstances test on an aggregate basis. In the case of paragraphs
(f)(3)(iii)(A) and (f)(3)(iii)(B) of this section, facts pertinent to
years preceding the five-year period may also be taken into
consideration. The combination of factors set forth in paragraphs
(f)(3)(iii)(A) through (f)(3)(iii)(E) of this section that an
organization normally must meet does not have to be the same for
[[Page 63]]
each five-year period so long as there exists a sufficient combination
of factors to show compliance with the facts and circumstances test.
(iii) Special rule. The fact that an organization has normally met
the requirements of the 33\1/3\ percent support test for a current
taxable year, but is unable normally to meet such requirements for a
succeeding taxable year, will not in itself prevent such organization
from meeting the facts and circumstances test for such succeeding
taxable year.
(iv) Example. The application of paragraphs (f)(4)(i), (f)(4)(ii),
and (f)(4)(iii) of this section may be illustrated by the following
example:
Example. (i) X is recognized as an organization described in section
501(c)(3). On the basis of support received during taxable years 2008,
2009, 2010, 2011, and 2012, in the aggregate, X receives at least 33\1/
3\ percent of its support from governmental units referred to in section
170(c)(1), from contributions made directly or indirectly by the general
public, or from a combination of these sources. Consequently, X meets
the 33\1/3\ percent support test for taxable year 2012 (the current
taxable year). X also meets the 33\1/3\ support test for 2013, as the
immediately succeeding taxable year.
(ii) In taxable years 2009, 2010, 2011, 2012, and 2013, in the
aggregate, X does not receive at least 33\1/3\ percent of its support
from governmental units referred to in section 170(c)(1), from
contributions made directly or indirectly by the general public, or from
a combination of these sources. However, X still meets the 33\1/3\
percent support test for taxable year 2013 based on the aggregate
support received for taxable years 2008 through 2012.
(iii) In taxable years 2010, 2011, 2012, 2013, and 2014, in the
aggregate, X does not receive at least 33\1/3\ percent of its support
from governmental units referred to in section 170(c)(1), from
contributions made directly or indirectly by the general public, or from
a combination of these sources. X does not meet the 33\1/3\ percent
support test for taxable year 2014.
(iv) X meets the facts and circumstances test for taxable year 2013
and for taxable year 2014 (the immediately succeeding taxable year)
based on the aggregate support X receives, X's fundraising program, and
consideration of other factors, including those listed in paragraphs
(f)(3)(iii)(A) through (f)(3)(iii)(E) of this section, during taxable
years 2009, 2010, 2011, 2012, and 2013. Therefore, even though X does
not meet the 33\1/3\ percent support test for taxable year 2014, X is
still an organization described in section 170(b)(1)(A)(vi) for that
year.
(v) Normally; first five years of an organization's existence. (A)
An organization ``normally'' receives the requisite amount of public
support and meets the 33\1/3\ percent public support test or the facts
and circumstances test during its first five taxable years as a section
501(c)(3) organization if the organization can reasonably be expected to
meet the requirements of the 33\1/3\ percent support test or the facts
and circumstances test during that period. With respect to such
organization's sixth taxable year, the general definition of normally
set forth in paragraphs (f)(4)(i), (f)(4)(ii), and (f)(4)(iii) of this
section apply. Alternatively, the organization shall be treated as
``normally'' meeting the 33\1/3\ percent support test or the facts and
circumstances test for its sixth taxable year (but not its seventh
taxable year) if it meets the 33\1/3\ percent support test or the facts
and circumstances test under the definition of normally set forth in
paragraphs (f)(4)(i), (f)(4)(ii), and (f)(4)(iii) of this section for
its fifth taxable year (based on support received in its first through
fifth taxable years).
(B) Basic consideration. In determining whether an organization can
reasonably be expected (within the meaning of paragraph (f)(4)(v)(A) of
this section) to meet the requirements of the 33\1/3\ percent support
test or the facts and circumstances test during its first five taxable
years, the basic consideration is whether its organizational structure,
current or proposed programs or activities, and actual or intended
method of operation are such as can reasonably be expected to attract
the type of broadly based support from the general public, public
charities, and governmental units that is necessary to meet such tests.
The factors that are relevant to this determination, and the weight
accorded to each of them, may differ from case to case, depending on the
nature and functions of the organization. The information to be
considered for this purpose shall consist of all pertinent facts and
circumstances, including the factors set forth in paragraph (f)(3) of
this section.
[[Page 64]]
(vi) Example. The application of paragraph (f)(4)(v) of this section
may be illustrated by the following example:
Example. (i) Organization Y was formed in January 2008, and uses a
taxable year ending December 31. After September 9, 2008, and before
December 31, 2008, Organization Y filed Form 1023 requesting recognition
of exemption as an organization described in section 501(c)(3) and in
sections 170(b)(1)(A)(vi) and 509(a)(1). In its application,
Organization Y established that it can reasonably be expected to operate
as a publicly supported organization under paragraph (f)(2) or (f)(3)
and paragraph (f)(4)(v) of this section. Subsequently, Organization Y
received a ruling or determination letter that it is an organization
described in section 501(c)(3) and sections 170(b)(1)(A)(vi) and
509(a)(1) effective as of the date of its formation.
(ii) Organization Y is described in sections 170(b)(1)(A)(vi) and
509(a)(1) for its first five taxable years (the taxable years ending
December 31, 2008, through December 31, 2012).
(iii) Organization Y can qualify as a publicly supported
organization for the taxable year ending December 31, 2013, if
Organization Y can meet the requirements of either paragraph (f)(2) or
paragraph (f)(3) of this section or Sec. 1.509(a)-3(a) and Sec.
1.509(a)-(3)(b) for the taxable years ending December 31, 2009, through
December 31, 2013, or for the taxable years ending December 31, 2008,
through December 31, 2012.
(vii) Organizations reclassified as private foundations. (A) New
publicly supported organizations. If a new publicly supported
organization described under section 170(b)(1)(A)(vi) cannot meet the
requirements of the 33\1/3\ percent test of paragraph (f)(2) or the
facts and circumstances test of paragraph (f)(3) for its sixth taxable
year under the general definition of normally set forth in paragraphs
(f)(4)(i), (f)(4)(ii), and (f)(4)(iii) of this section or under the
alternate rule set forth in paragraph (f)(4)(v) of this section
(effectively failing to meet a public support test for both its fifth
and sixth taxable years), it will be treated as a private foundation as
of the first day of its sixth taxable year only for purposes of sections
507, 4940, and 6033. Such an organization must file a Form 990-PF,
``Return of Private Foundation or Section 4947(a)(1) Nonexempt
Charitable Trust Treated as a Private Foundation,'' and will be liable
for the net investment tax imposed by section 4940 and, if applicable,
the private foundation termination tax imposed by section 507(c), for
its sixth taxable year. For succeeding taxable years, the organization
will be treated as a private foundation for all purposes.
(B) Other publicly supported organizations. A publicly supported
organization described in section 170(b)(1)(A)(vi) (other than a new
publicly supported organization described in paragraph (f)(4)(vii)(A) of
this section) that has failed to meet both the 33\1/3\ percent support
test and the facts and circumstances test for any two consecutive
taxable years will be treated as a private foundation as of the first
day of the second consecutive taxable year only for purposes of sections
507, 4940, and 6033. Such an organization must file a Form 990-PF,
``Return of Private Foundation or Section 4947(a)(1) Nonexempt
Charitable Trust Treated as a Private Foundation,'' and will be liable
for the net investment tax imposed by section 4940 and, if applicable,
the private foundation termination tax imposed by section 507(c), for
the second consecutive failed taxable year. For succeeding taxable
years, the organization will be treated as a private foundation for all
purposes.
(5) Determinations of foundation classification and reliance. (i) A
ruling or determination letter that an organization is described in
section 170(b)(1)(A)(vi) may be issued to an organization. Such
determination may be made in conjunction with the recognition of the
organization's tax-exempt status or at such other time as the
organization believes it is described in section 170(b)(1)(A)(vi). The
ruling or determination letter that the organization is described in
section 170(b)(1)(A)(vi) may be revoked if, upon examination, the
organization has not met the requirements of paragraph (f) of this
section. The ruling or determination letter that the organization is
described in section 170(b)(1)(A)(vi) also may be revoked if the
organization's application for a ruling or determination contained one
or more material misstatements or omissions of fact or if such
application was part of a scheme or plan to avoid or evade any provision
of the Internal Revenue Code. The revocation of the determination that
an organization is described in
[[Page 65]]
section 170(b)(1)(A)(vi) does not preclude revocation of the
determination that the organization is described in section 501(c)(3).
(ii) Status of grantors or contributors. For purposes of sections
170, 507, 545(b)(2), 642(c), 4942, 4945, 4966, 2055, 2106(a)(2), and
2522, grantors or contributors may rely upon a determination letter or
ruling that an organization is described in section 170(b)(1)(A)(vi)
until the IRS publishes notice of a change of status (for example, in
the Internal Revenue Bulletin or Publication 78, ``Cumulative List of
Organizations described in Section 170(c) of the Internal Revenue Code
of 1986,'' which can be searched at http://www.irs.gov.) For this
purpose, grantors or contributors also may rely on an advance ruling
that expires on or after June 9, 2008. However, a grantor or contributor
may not rely on such an advance ruling or any determination letter or
ruling if the grantor or contributor was responsible for, or aware of,
the act or failure to act that resulted in the organization's loss of
classification under section 170(b)(1)(A)(vi) or acquired knowledge that
the IRS had given notice to such organization that it would be deleted
from such classification.
(iii) Reliance by grantors or contributors. A grantor or
contributor, other than one of the organization's founders, creators, or
foundation managers (within the meaning of section 4946(b)), will not be
considered to be responsible for, or aware of, the act or failure to act
that resulted in the loss of the organization's ``publicly supported''
classification under section 170(b)(1)(A)(vi), if such grantor or
contributor has made such grant or contribution in reliance upon a
written statement by the grantee organization that such grant or
contribution will not result in the loss of such organization's
classification as a publicly supported organization as described in
section 170(b)(1)(A)(vi). Such statement must be signed by a responsible
officer of the grantee organization and must set forth sufficient
information, including a summary of the pertinent financial data for the
five taxable years immediately preceding the current taxable year, to
assure a reasonably prudent person that his grant or contribution will
not result in the loss of the grantee organization's classification as a
publicly supported organization as described in section
170(b)(1)(A)(vi). If a reasonable doubt exists as to the effect of such
grant or contribution, or if the grantor or contributor is one of the
organization's founders, creators, or foundation managers, the procedure
set forth in paragraph (f)(6)(iv) of this section for requesting a
determination from the IRS may be followed by the grantee organization
for the protection of the grantor or contributor.
(6) Definition of support; meaning of general public--(i) In
general. In determining whether the 33\1/2\ percent support test or the
10 percent support limitation described in paragraph (f)(3)(i) of this
section is met, contributions by an individual, trust, or corporation
shall be taken into account as support from direct or indirect
contributions from the general public only to the extent that the total
amount of the contributions by any such individual, trust, or
corporation during the period described in paragraph (f)(4)(i) or
paragraph (f)(4)(ii) of this section does not exceed two percent of the
organization's total support for such period, except as provided in
paragraph (f)(6)(ii) of this section. Therefore, for example, any
contribution by one individual will be included in full in the
denominator of the fraction determining the 33\1/2\ percent support or
the 10 percent support limitation, but will be includible in the
numerator of such fraction only to the extent that such amount does not
exceed two percent of the denominator. In applying the two percent
limitation, all contributions made by a donor and by any person or
persons standing in a relationship to the donor that is described in
section 4946(a)(1)(C) through (a)(1)(G) and the related regulations
shall be treated as made by one person. The two percent limitation shall
not apply to support received from governmental units referred to in
section 170(c)(1) or to contributions from organizations described in
section 170(b)(1)(A)(vi), except as provided in paragraph (f)(6)(v) of
this section. For purposes of paragraphs (f)(2), (f)(3)(i), and
(f)(7)(iii)(A)(2) of this section, the
[[Page 66]]
term indirect contributions from the general public includes
contributions received by the organization from organizations (such as
section 170(b)(1)(A)(vi) organizations) that normally receive a
substantial part of their support from direct contributions from the
general public, except as provided in paragraph (f)(6)(v) of this
section. See the examples in paragraph (f)(9) of this section for the
application of this paragraph (f)(6)(i). For purposes of this paragraph
(f), the term contributions includes qualified sponsorship payments (as
defined in Sec. 1.513-4) in the form of money or property (but not
services).
(ii) Exclusion of unusual grants. (A) For purposes of applying the
two percent limitation described in paragraph (f)(6)(i) of this section
to determine whether the 33\1/3\ percent support test or the 10 percent
support limitation in paragraph (f)(3)(i) of this section is satisfied,
one or more contributions may be excluded from both the numerator and
the denominator of the applicable support fraction if such contributions
meet the requirements of paragraph (f)(6)(iii) of this section. The
exclusion provided by this paragraph (f)(6)(ii) is generally intended to
apply to substantial contributions or bequests from disinterested
parties, which contributions or bequests--
(1) Are attracted by reason of the publicly supported nature of the
organization;
(2) Are unusual or unexpected with respect to the amount thereof;
and
(3) Would, by reason of their size, adversely affect the status of
the organization as normally being publicly supported for the applicable
period described in paragraph (f)(4) of this section.
(B) In the case of a grant (as defined in Sec. 1.509(a)-3(g)) that
meets the requirements of this paragraph (f)(6)(ii), if the terms of the
granting instrument require that the funds be paid to the recipient
organization over a period of years, the grant amounts received by the
organization may be excluded for such year or years in which they would
otherwise be includible in computing support under the method of
accounting on the basis of which the organization regularly computes its
income in keeping its books under section 446. However, no item of gross
investment income may be excluded under this paragraph (f)(6). The
provisions of this paragraph (f)(6) shall apply to exclude unusual
grants made during any of the applicable periods described in paragraph
(f)(4) or paragraph (f)(6) of this section. See paragraph (f)(6)(iv) of
this section as to reliance by a grantee organization upon an unusual
grant ruling under this paragraph (f)(6).
(iii) Determining factors. In determining whether a particular
contribution may be excluded under paragraph (f)(6)(ii) of this section,
all pertinent facts and circumstances will be taken into consideration.
No single factor will necessarily be determinative. For some of the
factors similar to the factors to be considered, see Sec. 1.509(a)-
3(c)(4).
(iv) Grantors and contributors. Prior to the making of any grant or
contribution that will allegedly meet the requirements for exclusion
under paragraph (f)(6)(ii) of this section, a potential grantee
organization may request a determination whether such grant or
contribution may be so excluded. Requests for such determination may be
filed by the grantee organization in the time and manner specified by
revenue procedure or other guidance published in the Internal Revenue
Bulletin. The issuance of such determination will be at the sole
discretion of the Commissioner. The organization must submit all
information necessary to make a determination on the factors referred to
in paragraph (f)(6)(iii) of this section. If a favorable determination
is issued, such determination may be relied upon by the grantor or
contributor of the particular contribution in question for purposes of
sections 170, 507, 545(b)(2), 642(c), 4942, 4945, 4966, 2055,
2106(a)(2), and 2522 and by the grantee organization for purposes of
paragraph (f)(6)(ii) of this section.
(v) Grants from public charities. Pursuant to paragraph (f)(6)(i) of
this section, contributions received from a governmental unit or from a
section 170(b)(1)(A)(vi) organization are not subject to the two percent
limitation described in paragraph (f)(6)(i) of this section unless such
contributions represent amounts which have been expressly or impliedly
earmarked by a
[[Page 67]]
donor to such governmental unit or section 170(b)(1)(A)(vi) organization
as being for, or for the benefit of, the particular organization
claiming section 170(b)(1)(A)(vi) status. See Sec. 1.509(a)-3(j)(3) for
examples illustrating the rules of this paragraph (f)(6)(v).
(7) Definition of support; special rules and meaning of terms--(i)
Definition of support. For purposes of this paragraph (f), the term
``support'' shall be as defined in section 509(d) (without regard to
section 509(d)(2)). The term ``support'' does not include--
(A) Any amounts received from the exercise or performance by an
organization of its charitable, educational, or other purpose or
function constituting the basis for its exemption under section 501(a).
In general, such amounts include amounts received from any activity the
conduct of which is substantially related to the furtherance of such
purpose or function (other than through the production of income); or
(B) Contributions of services for which a deduction is not
allowable.
(ii) For purposes of the 33\1/3\ percent support test and the 10
percent support limitation in paragraph (f)(3)(i) of this section, all
amounts received that are described in paragraph (f)(7)(i)(A) or
paragraph (f)(7)(i)(B) of this section are to be excluded from both the
numerator and the denominator of the fractions determining compliance
with such tests, except as provided in paragraph (f)(7)(iii) of this
section.
(iii) Organizations dependent primarily on gross receipts from
related activities. (A) Notwithstanding the provisions of paragraph
(f)(7)(i) of this section, an organization will not be treated as
satisfying the 33\1/3\ percent support test or the 10 percent support
limitation in paragraph (f)(3)(i) of this section if it receives--
(1) Almost all of its support (as defined in section 509(d)) from
gross receipts from related activities; and
(2) An insignificant amount of its support from governmental units
(without regard to amounts referred to in paragraph (f)(7)(i)(A) of this
section) and contributions made directly or indirectly by the general
public.
(B) Example. The application of this paragraph (f)(7)(iii) may be
illustrated by the following example:
Example. Z, an organization described in section 501(c)(3), is
controlled by A, its president. Z received $500,000 during the period
consisting of the current taxable year and the four immediately
preceding taxable years under a contract with the Department of
Transportation, pursuant to which Z has engaged in research to improve a
particular vehicle used primarily by the Federal government. During this
same period, the only other support received by Z consisted of $5,000 in
small contributions primarily from Z's employees and business
associates. The $500,000 amount constitutes support under sections
509(d)(2) and 509(a)(2)(A). Under these circumstances, Z meets the
conditions of paragraphs (f)(7)(iii)(A)(1) and (f)(7)(iii)(A)(2) of this
section and will not be treated as meeting the requirements of either
the 33\1/3\ percent support test or the facts and circumstances test. As
to the rules applicable to organizations that fail to qualify under
section 170(b)(1)(A)(vi) because of the provisions of this paragraph
(f)(7)(iii), see section 509(a)(2) and the related regulations. For the
distinction between gross receipts (as referred to in section 509(d)(2))
and gross investment income (as referred to in section 509(d)(4)), see
Sec. 1.509(a)-3(m).
(iv) Membership fees. For purposes of this paragraph (f)(7), the
term support shall include ``membership fees'' within the meaning of
Sec. 1.509(a)-3(h) (that is, if the basic purpose for making a payment
is to provide support for the organization rather than to purchase
admissions, merchandise, services, or the use of facilities).
(v) Unrelated business activities. The term net income from
unrelated business activities in section 509(d)(3) includes (but is not
limited to) an organization's unrelated business taxable income (UBTI)
within the meaning of section 512. However, when calculating UBTI for
purposes of determining support (within the meaning of this paragraph
(f)(7)), section 512(a)(6) does not apply. Accordingly, in the case of
an organization that derives gross income from the regular conduct of
two or more unrelated business activities, support includes the
aggregate of gross income from all such unrelated business activities
less the aggregate of the deductions allowed with respect to all such
unrelated business activities. Nonetheless, when determining support,
such organization can use either its UBTI calculated under section
512(a)(6) or its UBTI calculated in the aggregate.
[[Page 68]]
(8) Support from a governmental unit. (i) For purposes of the 33\1/
3\ percent support test and the 10 percent support limitation described
in paragraph (f)(3)(i) of this section, the term support from a
governmental unit includes any amounts received from a governmental
unit, including donations or contributions and amounts received in
connection with a contract entered into with a governmental unit for the
performance of services or in connection with a government research
grant. However, such amounts will not constitute support from a
governmental unit for such purposes if they constitute amounts received
from the exercise or performance of the organization's exempt functions
as provided in paragraph (f)(7)(i)(A) of this section.
(ii) For purposes of paragraph (f)(8)(i) of this section, any amount
paid by a governmental unit to an organization is not to be treated as
received from the exercise or performance of its charitable,
educational, or other purpose or function constituting the basis for its
exemption under section 501(a) (within the meaning of paragraph
(f)(7)(i)(A) of this section) if the purpose of the payment is primarily
to enable the organization to provide a service to, or maintain a
facility for, the direct benefit of the public (regardless of whether
part of the expense of providing such service or facility is paid for by
the public), rather than to serve the direct and immediate needs of the
payor. For example--
(A) Amounts paid for the maintenance of library facilities which are
open to the public;
(B) Amounts paid under government programs to nursing homes or homes
for the aged in order to provide health care or domiciliary services to
residents of such facilities; and
(C) Amounts paid to child placement or child guidance organizations
under government programs for services rendered to children in the
community, are considered payments the purpose of which is primarily to
enable the recipient organization to provide a service or maintain a
facility for the direct benefit of the public, rather than to serve the
direct and immediate needs of the payor. Furthermore, any amount
received from a governmental unit under circumstances such that the
amount would be treated as a ``grant'' within the meaning of Sec.
1.509(a)-3(g) will generally constitute ``support from a governmental
unit'' described in this paragraph (f)(8), rather than an amount
described in paragraph (f)(7)(i)(A) of this section.
(9) Examples. The application of paragraphs (f)(1) through (f)(8) of
this section may be illustrated by the following examples:
Example 1. (i) M is recognized as an organization described in
section 501(c)(3). For the years 2008 through 2012 (the applicable
period with respect to the taxable year 2012 under paragraph (f)(4) of
this section), M received support (as defined in paragraphs (f)(6)
through (8) of this section) of $600,000 from the following sources:
Investment income............................................ $300,000
City R (a governmental unit described in section 170(c)(1)).. 40,000
United Fund (an organization described in section 40,000
170(b)(1)(A)(vi))...........................................
Contributions (including six contributions in excess of the 220,000
two-percent limit, totaling $170,000).......................
----------
Total support............................................ 600,000
(ii) With respect to the taxable year 2012, M's public support is
computed as follows:
Support from a governmental unit described in section $40,000
170(c)(1)...................................................
Indirect contributions from the general public (United Fund). 40,000
Contributions by various donors that were not in excess of 50,000
$12,000, or two percent of total support....................
[[Page 69]]
Six contributions that were each in excess of $12,000, or two 72,000
percent of total support, up to the two-percent limitation,
6 x $12,000.................................................
----------
Total support............................................ 202,000
(iii) M's support from governmental units referred to in section
170(c)(1) and from direct and indirect contributions from the general
public (as defined in paragraph (f)(6) of this section) with respect to
the taxable year 2012 normally exceeds 33\1/3\ percent of M's total
support ($202,000/$600,000 = 33.67 percent) for the applicable period
(2008 through 2012). M meets the 33\1/3\ percent support test with
respect to 2012 and is therefore publicly supported for the taxable
years 2012 and 2013.
Example 2. (i) N is recognized as an organization described in
section 501(c)(3). It was created to maintain public gardens containing
botanical specimens and displaying statuary and other art objects. The
facilities, works of art, and a large endowment were all contributed by
a single contributor. The members of the governing body of the
organization are unrelated to its creator. The gardens are open to the
public without charge and attract a substantial number of visitors each
year. For the current taxable year and the four taxable years
immediately preceding the current taxable year, 95 percent of the
organization's total support was received from investment income from
its original endowment. N also maintains a membership society that is
supported by members of the general public who wish to contribute to the
upkeep of the gardens by paying a small annual membership fee. Over the
five-year period in question, these fees from the general public
constituted the remaining five percent of the organization's total
support for such period.
(ii) Under these circumstances, N does not meet the 33\1/3\ percent
support test for its current taxable year. Furthermore, because only
five percent of its total support is, with respect to the current
taxable year, normally received from the general public, N does not
satisfy the 10 percent support limitation described in paragraph
(f)(3)(i) of this section and therefore does not qualify as publicly
supported under the facts and circumstances test. Because N has failed
to satisfy the 10 percent support limitation under paragraph (f)(3)(i)
of this section, none of the other requirements or factors set forth in
paragraphs (f)(3)(iii)(A) through (f)(3)(iii)(E) of this section can be
considered in determining whether N qualifies as a publicly supported
organization. For its current taxable year, therefore, N is not an
organization described in section 170(b)(1)(A)(vi).
Example 3. (i) O, an art museum, is recognized as an organization
described in section 501(c)(3). In 1930, O was founded in S City by the
members of a single family to collect, preserve, interpret, and display
to the public important works of art. O is governed by a Board of
Trustees that originally consisted almost entirely of members of the
founding family. However, since 1945, members of the founding family or
persons standing in a relationship to the members of such family
described in section 4946(a)(1)(C) through (G) have annually constituted
less than one-fifth of the Board of Trustees. The remaining board
members are citizens of S City from a variety of professions and
occupations who represent the interests and views of the people of S
City in the activities carried on by the organization rather than the
personal or private interests of the founding family. O solicits
contributions from the general public and, for the current taxable year
and each of the four taxable years immediately preceding the current
taxable year, O has received total contributions (in small sums of less
than $100, none of which exceeds two percent of O's total support for
such period) in excess of $10,000. These contributions from the general
public (as defined in paragraph (f)(6) of this section) represent 25
percent of the organization's total support for such five-year period.
For this same period, investment income from several large endowment
funds has constituted 75 percent of O's total support. O expends
substantially all of its annual income for its exempt purposes and thus
depends upon the funds it annually solicits from the public as well as
its investment income in order to carry out its activities on a normal
and continuing basis and to acquire new works of art. O has, for the
entire period of its existence, been open to the public and more than
300,000 people (from S City and elsewhere) have visited the museum in
each of the current taxable year and the four immediately preceding
taxable years.
(ii) Under these circumstances, O does not meet the 33\1/3\ percent
support test for its current year because it has received only 25
percent of its total support for the applicable five-year period from
the general public. However, under the facts set forth above, O meets
the 10 percent support limitation under paragraph (f)(3)(i) of this
section, as well as the requirements of paragraph (f)(3)(ii) of this
section. Under all of the facts set forth in this example, O is
considered as meeting the requirements of the facts and circumstances
test on the basis of satisfying
[[Page 70]]
paragraphs (f)(3)(i) and (f)(3)(ii) of this section and the factors set
forth in paragraphs (f)(3)(iii)(A) through (f)(3)(iii)(D) of this
section. O is therefore publicly supported for its current taxable year
and the immediately succeeding taxable year.
Example 4. (i) In 1960, the P Philharmonic Orchestra was organized
in T City through the combined efforts of a local music society and a
local women's club to present to the public a wide variety of musical
programs intended to foster music appreciation in the community. P is
recognized as an organization described in section 501(c)(3). The
orchestra is composed of professional musicians who are paid by the
association. Twelve performances open to the public are scheduled each
year. A small admission fee is charged for each of these performances.
In addition, several performances are staged annually without charge.
During the current taxable year and the four taxable years immediately
preceding the current taxable year, P has received separate
contributions of $200,000 each from A and B (not members of a single
family) and support of $120,000 from the T Community Chest, a public
federated fundraising organization operating in T City. P depends on
these funds in order to carry out its activities and will continue to
depend on contributions of this type to be made in the future. P has
also begun a fundraising campaign in an attempt to expand its activities
for the coming years. P is governed by a Board of Directors comprised of
five individuals. A faculty member of a local college, the president of
a local music society, the head of a local banking institution, a
prominent doctor, and a member of the governing body of the local
chamber of commerce currently serve on P's Board and represent the
interests and views of the community in the activities carried on by P.
(ii) With respect to P's current taxable year, P's sources of
support are computed on the basis of the current taxable year and the
four taxable years immediately preceding the current taxable year, as
follows:
Contributions................................................ $520,000
Receipts from performances................................... 100,000
----------
Total support............................................ 620,000
Less:
Receipts from performances (excluded under paragraph 100,000
(f)(7)(i)(A) of this section)...............................
----------
Total support for purposes of paragraphs (f)(2) and 520,000
(f)(3)(i) of this section...............................
(iii) For purposes of paragraphs (f)(2) and (f)(3)(i) of this
section, P's public support is computed as follows:
T Community Chest (indirect support from the general public). 120,000
Two contributions from A & B (each in excess of $10,400 - 2 20,800
percent of total support) 2 x $10,400.......................
----------
Total.................................................... 140,800
(iv) Under these circumstances, P does not meet the 33\1/3\ percent
support test for its current year because it has received only 27
percent of its total support ($140,800/$520,000) for the applicable
five-year period from the general public. However, under the facts set
forth above, P meets the 10 percent support limitation under paragraph
(f)(3)(i) of this section, as well as the requirements of paragraph
(f)(3)(ii) of this section. Under all of the facts set forth in this
example, P is considered as meeting the requirements of the facts and
circumstances test on the basis of satisfying paragraphs (f)(3)(i) and
(f)(3)(ii) of this section and the factors set forth in paragraphs
(f)(3)(iii)(A) through (f)(3)(iii)(D) of this section. P is therefore
publicly supported for its current taxable year and the immediately
succeeding taxable year.
Example 5. (i) Q is recognized as an organization described in
section 501(c)(3). It is a philanthropic organization founded in 1965 by
C for the purpose of making annual contributions to worthy charities. C
created Q as a charitable trust by the transfer of appreciated
securities worth $500,000 to Q. Pursuant to the trust agreement, C and
two other members of his family are the sole trustees of Q and are
vested with the right to appoint successor trustees. In each of the
current taxable year and the four taxable years immediately preceding
the current
[[Page 71]]
taxable year, Q received $12,000 in investment income from its original
endowment. Each year Q makes a solicitation for funds by operating a
charity ball at C's residence. Guests are invited and requested to make
contributions of $100 per couple. During the five-year period at issue,
$15,000 was received from the proceeds of these events. C and his family
have also made contributions to Q of $25,000 over the five-year period
at issue. Q makes disbursements each year of substantially all of its
net income to the public charities chosen by the trustees.
(ii) Q's sources of support for the current taxable year and the
four taxable years immediately preceding the current taxable year as
follows:
Investment income............................................ $60,000
Contributions................................................ 40,000
----------
Total support............................................ 100,000
(iii) For purposes of paragraphs (f)(2) and (f)(3)(i) of this
section, Q's public support is computed as follows:
Contributions from the general public........................ $ 15,000
C's contribution (in excess of $ 2,000 - 2 percent of total 2,000
support) 1 x $2,000.........................................
----------
Total.................................................... 17,000
(iv) Under these circumstances, Q does not meet the 33\1/3\ percent
support test for its current year because it has received only 17
percent of its total support ($17,000/$100,000) for the applicable five-
year period from the general public. Thus, Q's classification as a
``publicly supported'' organization depends on whether it meets the
requirements of the facts and circumstances test. Even though it
satisfies the 10 percent support limitation under paragraph (f)(3)(i) of
this section, its method of solicitation makes it questionable whether Q
satisfies the requirements of paragraph (f)(3)(ii) of this section.
Because of its method of operating, Q also has a greater burden of
establishing its publicly supported nature under paragraph
(f)(3)(iii)(A) of this section. Based upon the foregoing facts and
circumstances, including Q's failure to receive favorable consideration
under the factors set forth in paragraphs (f)(3)(iii)(B),
(f)(3)(iii)(C), and (f)(3)(iii)(D) of this section, Q does not satisfy
the facts and circumstances test.
(10) Community trust; introduction. Community trusts have often been
established to attract large contributions of a capital or endowment
nature for the benefit of a particular community or area, and often such
contributions have come initially from a small number of donors. While
the community trust generally has a governing body comprised of
representatives of the particular community or area, its contributions
are often received and maintained in the form of separate trusts or
funds, which are subject to varying degrees of control by the governing
body. To qualify as a ``publicly supported'' organization, a community
trust must meet the 33\1/3\ percent support test, or, if it cannot meet
that test, be organized and operated so as to attract new and additional
public or governmental support on a continuous basis sufficient to meet
the facts and circumstances test. Such facts and circumstances test
includes a requirement of attraction of public support in paragraph
(f)(3)(ii) of this section which, as applied to community trusts,
generally will be satisfied if they seek gifts and bequests from a wide
range of potential donors in the community or area served, through banks
or trust companies, through attorneys or other professional persons, or
in other appropriate ways that call attention to the community trust as
a potential recipient of gifts and bequests made for the benefit of the
community or area served. A community trust is not required to engage in
periodic, community-wide, fundraising campaigns directed toward
attracting a large number of small contributions in a manner similar to
campaigns conducted by a
[[Page 72]]
community chest or united fund. Paragraph (f)(11) of this section
provides rules for determining the extent to which separate trusts or
funds may be treated as component parts of a community trust, fund, or
foundation (herein collectively referred to as a ``community trust,''
and sometimes referred to as an ``organization'') for purposes of
meeting the requirements of this paragraph for classification as a
publicly supported organization. Paragraph (f)(12) of this section
contains rules for trusts or funds that are prevented from qualifying as
component parts of a community trust by paragraph (f)(11) of this
section.
(11) Community trusts; requirements for treatment as a single
entity--(i) General rule. For purposes of sections 170, 501, 507, 508,
509, and Chapter 42, any organization that meets the requirements
contained in paragraphs (f)(11)(iii) through (f)(11)(vi) of this section
will be treated as a single entity, rather than as an aggregation of
separate funds, and except as otherwise provided, all funds associated
with such organization (whether a trust, not-for-profit corporation,
unincorporated association, or a combination thereof) which meet the
requirements of paragraph (f)(11)(ii) of this section will be treated as
component parts of such organization.
(ii) Component part of a community trust. In order to be treated as
a component part of a community trust referred to in this paragraph
(f)(11) (rather than as a separate trust or not-for-profit corporation
or association), a trust or fund:
(A) Must be created by a gift, bequest, legacy, devise, or other
transfer to a community trust which is treated as a single entity under
this paragraph (f)(11); and
(B) May not be directly or indirectly subjected by the transferor to
any material restriction or condition (within the meaning of Sec.
1.507-2(a)(7)) with respect to the transferred assets. For purposes of
this paragraph (f)(11)(ii)(B), if the transferor is not a private
foundation, the provisions of Sec. 1.507-2(a)(7) shall be applied to
the trust or fund as if the transferor were a private foundation
established and funded by the person establishing the trust or fund and
such foundation transferred all its assets to the trust or fund. Any
transfer made to a fund or trust which is treated as a component part of
a community trust under this paragraph (f)(11)(ii) will be treated as a
transfer made ``to'' a ``publicly supported'' community trust for
purposes of sections 170(b)(1)(A) and 507(b)(1)(A) if such community
trust meets the requirements of section 170(b)(1)(A)(vi) as a ``publicly
supported'' organization at the time of the transfer, except as provided
in paragraph (f)(5)(ii) of this section or Sec. Sec. 1.508-1(b)(4) and
1.508-1(b)(6) (relating, generally, to reliance by grantors and
contributors). See also paragraphs (f)(12)(ii) and (f)(12)(iii) of this
section for special provisions relating to split-interest trusts and
certain private foundations described in section 170(b)(1)(F)(iii).
(iii) Name. The organization must be commonly known as a community
trust, fund, foundation, or other similar name conveying the concept of
a capital or endowment fund to support charitable activities (within the
meaning of section 170(c)(1) or section 170(c)(2)(B)) in the community
or area it serves.
(iv) Common instrument. All funds of the organization must be
subject to a common governing instrument or a master trust or agency
agreement (herein referred to as the ``governing instrument''), which
may be embodied in a single document or several documents containing
common language. Language in an instrument of transfer to the community
trust making a fund subject to the community trust's governing
instrument or master trust or agency agreement will satisfy the
requirements of this paragraph (f)(11)(iv). In addition, if a community
trust adopts a new governing instrument (or creates a corporation) to
put into effect new provisions (applying to future transfers to the
community trust), the adoption of such new governing instrument (or
creation of a corporation with a governing instrument) which contains
common language with the existing governing instrument shall not
preclude the community trust from meeting the requirements of this
paragraph (f)(11)(iv).
[[Page 73]]
(v) Common governing body. (A) The organization must have a common
governing body or distribution committee (herein referred to as the
``governing body'') which either directs or, in the case of a fund
designated for specified beneficiaries, monitors the distribution of all
of the funds exclusively for charitable purposes (within the meaning of
section 170(c)(1) or section 170(c)(2)(B)). For purposes of this
paragraph (f)(11)(v), a fund is designated for specified beneficiaries
only if no person is left with the discretion to direct the distribution
of the fund.
(B) Powers of modification and removal. The fact that the exercise
of any power described in this paragraph (f)(11)(v)(B) is reviewable by
an appropriate State authority will not preclude the community trust
from meeting the requirements of this paragraph (f)(11)(v)(B). Except as
provided in paragraph (f)(11)(v)(C) of this section, the governing body
must have the power in the governing instrument, the instrument of
transfer, the resolutions or by-laws of the governing body, a written
agreement, or otherwise--
(1) To modify any restriction or condition on the distribution of
funds for any specified charitable purposes or to specified
organizations if in the sole judgment of the governing body (without the
necessity of the approval of any participating trustee, custodian, or
agent), such restriction or condition becomes, in effect, unnecessary,
incapable of fulfillment, or inconsistent with the charitable needs of
the community or area served;
(2) To replace any participating trustee, custodian, or agent for
breach of fiduciary duty under State law; and
(3) To replace any participating trustee, custodian, or agent for
failure to produce a reasonable (as determined by the governing body)
return of net income (within the meaning of paragraph (f)(11)(v)(F) of
this section) over a reasonable period of time (as determined by the
governing body).
(C) Transitional rule--(1) Notwithstanding paragraph (f)(11)(v)(B)
of this section, if a community trust meets the requirements of
paragraph (f)(11)(v)(C)(3) of this section, then in the case of any
instrument of transfer which is executed before July 19, 1977, and is
not revoked or amended thereafter (with respect to any dispositive
provision affecting the transfer to the community trust), and in the
case of any instrument of transfer which is irrevocable on January 19,
1982, the governing body must have the power to cause proceedings to be
instituted (by request to the appropriate State authority)--
(i) To modify any restriction or condition on the distribution of
funds for any specified charitable purposes or to specified
organizations if in the judgment of the governing body such restriction
or condition becomes, in effect, unnecessary, incapable of fulfillment,
or inconsistent with the charitable needs of the community or area
served; and
(ii) To remove any participating trustee, custodian, or agent for
breach of fiduciary duty under State law.
(2) The necessity for the governing body to obtain the approval of a
participating trustee to exercise the powers described in paragraph
(f)(11)(v)(C)(1) of this section shall be treated as not preventing the
governing body from having such power, unless (and until) such approval
has been (or is) requested by the governing body and has been (or is)
denied.
(3) Paragraph (f)(11)(v)(C)(1) of this section shall not apply
unless the community trust meets the requirements of paragraph
(f)(11)(v)(B) of this section, with respect to funds other than those
under instruments of transfer described in the first sentence of such
paragraph (f)(11)(v)(C)(1) of this section, by January 19, 1978, or such
later date as the Commissioner may provide for such community trust, and
unless the community trust does not, once it so complies, thereafter
solicit for funds that will not qualify under the requirements of
paragraph (f)(11)(v)(B) of this section.
(D) Inconsistent State law--(1) For purposes of paragraphs
(f)(11)(v)(B)(1), (f)(11)(v)(B)(2), (f)(11)(v)(B)(3),
(f)(11)(v)(C)(1)(i), (f)(11)(v)(C)(1)(ii), and (f)(11)(v)(E) of this
section, if a power described in such a provision is inconsistent with
State law even if such power were expressly granted to the governing
body by the governing instrument and were accepted without
[[Page 74]]
limitation under an instrument of transfer, then the community trust
will be treated as meeting the requirements of such a provision if it
meets such requirements to the fullest extent possible consistent with
State law (if such power is or had been so expressly granted).
(2) For example, if, under the conditions of paragraph
(f)(11)(v)(D)(1) of this section, the power to modify is inconsistent
with State law, but the power to institute proceedings to modify, if so
expressly granted, would be consistent with State law, the community
trust will be treated as meeting such requirements to the fullest extent
possible if the governing body has the power (in the governing
instrument or otherwise) to institute proceedings to modify a condition
or restriction. On the other hand, if in such a case the community trust
has only the power to cause proceedings to be instituted to modify a
condition or restriction, it will not be treated as meeting such
requirements to the fullest extent possible.
(3) In addition, if, for example, under the conditions of paragraph
(f)(11)(v)(D)(1) of this section, the power to modify and the power to
institute proceedings to modify a condition or restriction is
inconsistent with State law, but the power to cause such proceedings to
be instituted would be consistent with State law, if it were expressly
granted in the governing instrument and if the approval of the State
Attorney General were obtained, then the community trust will be treated
as meeting such requirements to the fullest extent possible if it has
the power (in the governing instrument or otherwise) to cause such
proceedings to be instituted, even if such proceedings can be instituted
only with the approval of the State Attorney General.
(E) Exercise of powers. The governing body shall (by resolution or
otherwise) commit itself to exercise the powers described in paragraphs
(f)(11)(v)(B), (f)(11)(v)(C), and (f)(11)(v)(D) of this section in the
best interests of the community trust. The governing body will be
considered not to be so committed where it has grounds to exercise such
a power and fails to exercise it by taking appropriate action. Such
appropriate action may include, for example, consulting with the
appropriate State authority prior to taking action to replace a
participating trustee.
(F) Reasonable return. In addition to the requirements of paragraphs
(f)(11)(v)(B), (f)(11)(v)(C), (f)(11)(v)(D), or (f)(11)(v)(E) of this
section, the governing body shall (by resolution or otherwise) commit
itself to obtain information and take other appropriate steps with the
view to seeing that each participating trustee, custodian, or agent,
with respect to each restricted trust or fund that is, and with respect
to the aggregate of the unrestricted trusts or funds that are, a
component part of the community trust, administers such trust or fund in
accordance with the terms of its governing instrument and accepted
standards of fiduciary conduct to produce a reasonable return of net
income (or appreciation where not inconsistent with the community
trust's need for current income), with due regard to safety of
principal, in furtherance of the exempt purposes of the community trust
(except for assets held for the active conduct of the community trust's
exempt activities). In the case of a low return of net income (and,
where appropriate, appreciation), the IRS will examine carefully whether
the governing body has, in fact, committed itself to take the
appropriate steps. For purposes of this paragraph (f)(11)(v)(F), any
income that has been designated by the donor of the gift or bequest to
which such income is attributable as being available only for the use or
benefit of a broad charitable purpose, such as the encouragement of
higher education or the promotion of better health care in the
community, will be treated as unrestricted. However, any income that has
been designated for the use or benefit of a named charitable
organization or agency or for the use or benefit of a particular class
of charitable organizations or agencies, the members of which are
readily ascertainable and are less than five in number, will be treated
as restricted.
(vi) Common reports. The organization must prepare periodic
financial reports treating all of the funds which are held
[[Page 75]]
by the community trust, either directly or in component parts, as funds
of the organization.
(12) Community trusts; treatment of trusts and not-for-profit
corporations and associations not included as components. (i) For
purposes of sections 170, 501, 507, 508, 509, and Chapter 42, any trust
or not-for-profit corporation or association that is alleged to be a
component part of a community trust, but that fails to meet the
requirements of paragraph (f)(11)(ii) of this section, shall not be
treated as a component part of a community trust and, if a trust, shall
be treated as a separate trust and be subject to the provisions of
section 501, section 4947(a)(1), or section 4947(a)(2), as the case may
be. If such organization is a not-for-profit corporation or association,
it will be treated as a separate entity, and, if it is described in
section 501(c)(3), it will be treated as a private foundation unless it
is described in section 509(a)(1), section 509(a)(2), section 509(a)(3),
or section 509(a)(4). In the case of a fund that is ultimately treated
as not being a component part of a community trust pursuant to this
paragraph (f)(12), if the Forms 990 filed annually by the community
trust included financial information with respect to such fund and
treated such fund in the same manner as other component parts thereof,
such returns filed by the community trust prior to the taxable year in
which the Commissioner notifies such fund that it will not be treated as
a component part will be treated as its separate return for purpose of
Subchapter A of Chapter 61 of Subtitle F, and the first such return
filed by the community trust will be treated as the notification
required of the separate entity for purposes of section 508(a).
(ii) If a transfer is made in trust to a community trust to make
income or other payments for a period of a life or lives in being or a
term of years to any individual or for any noncharitable purpose,
followed by payments to or for the use of the community trust (such as
in the case of a charitable remainder annuity trust or a charitable
remainder unitrust described in section 664 or a pooled income fund
described in section 642(c)(5)), such trust will be treated as a
component part of the community trust upon the termination of all
intervening noncharitable interests and rights to the actual possession
or enjoyment of the property if such trust satisfies the requirements of
paragraph (f)(11) of this section at such time. Until such time, the
trust will be treated as a separate trust. If a transfer is made in
trust to a community trust to make income or other payments to or for
the use of the community trust, followed by payments to any individual
or for any noncharitable purpose, such trust will be treated as a
separate trust rather than as a component part of the community trust.
See section 4947(a)(2) and the related regulations for the treatment of
such split-interest trusts. The provisions of this paragraph (f)(12)(ii)
provide rules only for determining when a charitable remainder trust or
pooled income fund may be treated as a component part of a community
trust and are not intended to preclude a community trust from
maintaining a charitable remainder trust or pooled income fund. For
purposes of grantors and contributors, a pooled income fund of a
publicly supported community trust shall be treated no differently than
a pooled income fund of any other publicly supported organization.
(iii) An organization described in section 170(b)(1)(F)(iii) will
not ordinarily satisfy the requirements of paragraph (f)(11)(ii) of this
section because of the unqualified right of the donor to designate the
recipients of the income and principal of the trust. Such organization
will therefore ordinarily be treated as other than a component part of a
community trust under paragraph (f)(12)(i) of this section. However, see
section 170(b)(1)(F)(iii) and the related regulations with respect to
the treatment of contributions to such organizations.
(13) Method of accounting. For purposes of section 170(b)(1)(A)(vi),
an organization's support will be determined under the method of
accounting on the basis of which the organization regularly computes its
income in keeping its books under section 446. For example, if a grantor
makes a grant to an organization payable over a term of years, such
grant will be includible in
[[Page 76]]
the support fraction of the grantee organization under the method of
accounting on the basis of which the grantee organization regularly
computes its income in keeping its books under section 446.
(14) Transition rules. (i) An organization that received an advance
ruling, that expires on or after June 9, 2008, that it will be treated
as an organization described in sections 170(b)(1)(A)(vi) and 509(a)(1)
will be treated as meeting the requirements of paragraph (f)(2) or
paragraph (f)(3) of this section for the first five taxable years of its
existence as a section 501(c)(3) organization unless the IRS issued to
the organization a proposed determination prior to September 9, 2008,
that the organization is not described in sections 170(b)(1)(A)(vi) and
509(a)(1) or in section 509(a)(2).
(ii) Paragraph (f)(4)(v) of this section shall not apply with
respect to an organization that received an advance ruling that expired
prior to June 9, 2008, and that did not timely file with the Internal
Revenue Service the required information to establish that it is an
organization described in sections 170(b)(1)(A)(vi) and 509(a)(1) or in
section 509(a)(2).
(iii) An organization that fails to meet a public support test for
its first taxable year beginning on or after January 1, 2008, under the
regulations in this section may use the prior tests set forth in Sec.
1.170A-9(e)(2) or Sec. 1.170A-9(e)(3), or in Sec. Sec. 1.509(a)-
3(a)(2) and 1.509(a)-3(a)(3), as in effect before September 9, 2008 (as
contained in 26 CFR part 1 revised April 1, 2008), to determine whether
the organization was publicly supported for its 2008 taxable year based
on its satisfaction of a public support test for taxable year 2007,
computed over the period 2003 through 2006.
(iv) Examples. The application of this paragraph (f)(14) may be
illustrated by the following examples:
Example 1. (i) Organization X was formed in January 2004 and uses a
taxable year ending June 30. Organization X received an advance ruling
letter that it is recognized as an organization described in section
501(c)(3) effective as of the date of its formation and that it is
treated as a publicly supported organization under sections
170(b)(1)(A)(vi) and 509(a)(1) during the five-year advance ruling
period that will end on June 30, 2008. This date is on or after June 9,
2008.
(ii) Under the transition rule, Organization X is a publicly
supported organization described in sections 170(b)(1)(A)(vi) and
509(a)(1) for the taxable years ending June 30, 2004, through June 30,
2008. Organization X does not need to establish within 90 days after
June 30, 2008, that it met a public support test under Sec. 1.170A-9(e)
or Sec. 1.509(a)-3, as in effect prior to September 9, 2008, (as
contained in 26 CFR part 1 revised April 1, 2008), for its advance
ruling period.
(iii) Organization X can qualify as a publicly supported
organization for the taxable year ending June 30, 2009, if Organization
X can meet the requirements of paragraph (f)(2) or (f)(3) of this
section or Sec. Sec. 1.509(a)-3(a)(2) and 1.509(a)-3(a)(3) for the
taxable years ending June 30, 2005, through June 30, 2009, or for the
taxable years ending June 30, 2004, through June 30, 2008. In addition,
for its taxable year ending June 30, 2009, Organization X may qualify as
a publicly supported organization by availing itself of the transition
rule contained in paragraph (f)(14)(iii) of this section, which looks to
support received by X in the taxable years ending June 30, 2004, through
June 30, 2007.
Example 2. (i) Organization Y was formed in January 2000, and uses a
taxable year ending December 31. Organization Y received a final
determination that it was recognized as tax-exempt under section
501(c)(3) and as a publicly supported organization prior to September 9,
2008.
(ii) For taxable year 2008, Organization Y will qualify as publicly
supported if it meets the requirements under either paragraph (f)(2) or
(f)(3) of this section or Sec. Sec. 1.509(a)-3(a)(2) or 1.509(a)-
3(a)(3) for the five-year period January 1, 2004, through December 31,
2008. Organization Y will also qualify as publicly supported for taxable
year 2008 if it meets the requirements under Sec. 1.170A-9(e)(2) or
Sec. 1.170A-9(e)(3), or under Sec. Sec. 1.509(a)-3(a)(2) and 1.509(a)-
3(a)(3), as in effect prior to September 9, 2008, (as contained in 26
CFR part 1 revised April 1, 2008) for taxable year 2007, using the four-
year period from January 1, 2003, through December 31, 2006.
(g) Private operating foundation. An organization is described in
section 170(b)(1) (A)(vii) and (E)(i) if it is a private ``operating
foundation'' as defined in section 4942(j)(3) and the regulations
thereunder.
(h) Private nonoperating foundation distributing amount equal to all
contributions received--(1) In general. (i) An organization is described
in section 170(b)(1) (A)(vii) and (E)(ii) if it is a private foundation
which, not later than the 15th day of the third month after the close of
its taxable year in which
[[Page 77]]
any contributions are received, distributes an amount equal in value to
100 percent of all contributions received in such year. Such
distributions must be qualifying distributions (as defined in section
4942(g) without regard to paragraph (3) thereof) which are treated,
after the application of section 4942(g)(3), as distributions out of
corpus in accordance with section 4942(h). Qualifying distributions, as
defined in section 4942(g) without regard to paragraph (3) thereof,
cannot be made to (i) an organization controlled directly or indirectly
by the foundation or by one or more disqualified persons (as defined in
section 4946) with respect to the foundation or (ii) a private
foundation which is not an operating foundation (as defined in section
4942(j)(3)). The phrase ``after the application of section 4942(g)(3)''
means that every contribution described in section 4942(g)(3) received
by a private foundation described in this subparagraph in a particular
taxable year must be distributed (within the meaning of section
4942(g)(3)(A)) by such foundation not later than the 15th day of the
third month after the close of such taxable year in order for any other
distribution by such foundation to be counted toward the 100-percent
requirement described in this subparagraph.
(ii) In order for an organization to meet the distribution
requirements of subdivision (i) of this subparagraph, it must, not later
than the 15th day of the third month after the close of its taxable year
in which any contributions are received, distribute (within the meaning
of subdivision (i) of this subparagraph) an amount equal in value to 100
percent of all contributions received in such year and have no remaining
undistributed income for such year.
(iii) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. X is a private foundation on a calendar year basis. As of
January 1, 1971, X had no undistributed income for 1970. X's
distributable amount for 1971 was $600,000. In July 1971, A, an
individual, contributed $500,000 (fair market value determined at the
time of the contribution) of appreciated property to X (which, if sold,
would give rise to long-term capital gain). X did not receive any other
contribution in either 1970 or 1971. During 1971, X made qualifying
distributions of $700,000 which were treated as made out of the
undistributed income for 1971 and $100,000 out of corpus. X will meet
the requirements of section 170(b)(1)(E)(ii) for 1971 if it makes
additional qualifying distributions of $400,000 out of corpus by March
15, 1972.
Example 2. Assume the facts as stated in Example 1, except that as
of January 1, 1971, X had $100,000 of undistributed income for 1970.
Under these circumstances, the $700,000 distributed by X in 1971 would
be treated as made out of the undistributed income for 1970 and 1971. X
would therefore have to make additional qualifying distributions of
$500,000 out of corpus between January 1, 1972, and March 15, 1972, in
order to meet the requirements of section 170(b)(1)(E)(ii) for 1971.
(2) Special rules. In applying subparagraph (1) of this paragraph:
(i) For purposes of section 170(b)(1)(A)(vii), an organization
described in section 170(b)(1)(E)(ii) must distribute all contributions
received in any year, whether of cash or property. However, solely for
purposes of section 170(e)(1)(B)(ii), an organization described in
section 170(b)(1)(E)(ii) is required to distribute all contributions of
property only received in any year. Contributions for purposes of this
paragraph do not include bequests, legacies, devises, or transfers
within the meaning of section 2055 or 2106(a)(2) with respect to which a
deduction was not allowed under section 170.
(ii) Any distributions made by a private foundation pursuant to
subparagraph (1) of this paragraph with respect to a particular taxable
year shall be treated as made first out of contributions of property and
then out of contributions of cash received by such foundation in such
year.
(iii) A private foundation is not required to trace specific
contributions of property, or amounts into which such contributions are
converted, to specific distributions.
(iv) For purposes of satisfying the requirements of section
170(b)(1)(D)(ii), except as provided to the contrary in this subdivision
(iv), the fair market value of contributed property, determined on the
date of contribution, is required to be used for purposes of determining
whether an amount equal in value to 100 percent of the contribution
received has been distributed. However,
[[Page 78]]
reasonable selling expenses, if any, incurred by the foundation in the
sale of the contributed property may be deducted from the fair market
value of the contributed property on the date of contribution, and
distribution of the balance of the fair market value will satisfy the
100 percent distribution requirement. If a private foundation receives a
contribution of property and, within 30 days thereafter, either sells
the property or makes an in kind distribution of the property to a
public charity, then at the choice of the private foundation the gross
amount received on the sale (less reasonable selling expenses incurred)
or the fair market value of the contributed property at the date of its
distribution to the public charity, and not the fair market value of the
contributed property on the sale of contribution (less reasonable
selling expenses, if any), is considered to be the amount of the fair
market value of the contributed property for purposes of the
requirements of section 170(b)(1)(D)(ii).
(v) A private foundation may satisfy the requirements of
subparagraph (1) of this paragraph for a particular taxable year by
electing (pursuant to section 4942(h)(2) and the regulations thereunder)
to treat a portion or all of one or more distributions, made not later
than the 15th day of the third month after the close of such year, as
made out of corpus.
(3) Transitional rules--(i) Taxable years beginning before January
1, 1970, and ending after December 31, 1969. In order for an
organization to meet the distribution requirements of subparagraph
(1)(i) of this paragraph for a taxable year which begins before January
1, 1970, and ends after December 31, 1969, it must, not later than the
15th day of the third month after the close of such taxable year,
distribute (within the meaning of subparagraph (1)(i) of this paragraph)
an amount equal in value to 100 percent of all contributions (other than
contributions described in section 4942(g)(3)) which were received
between January 1, 1970, and the last day of such taxable year. Because
the organization is not subject to the provisions of section 4942 for
such year, the organization need not satisfy subparagraph (1)(ii) of
this paragraph or the phrase ``after the application of section
4942(g)(3)'' for such year.
(ii) Extension of period. For purposes of section 170(b)(1)(A)(vii)
and 170(e)(1)(B)(ii), in the case of a taxable year ending in either
1970, 1971 or 1972, the period referred to in section 170(b)(1)(E)(ii)
for making distributions shall not expire before April 2, 1973.
(4) Adequate records required. A taxpayer claiming a deduction under
section 170 for a charitable contribution to a foundation described in
subparagraph (1) of this paragraph must obtain adequate records or other
sufficient evidence from such foundation showing that the foundation
made the required qualifying distributions within the time prescribed.
Such records or other evidence must be attached to the taxpayer's return
for the taxable year for which the charitable contribution deduction is
claimed. If necessary, an amended income tax return or claim for refund
may be filed in accordance with Sec. 301.6402-2 and Sec. 301.6402-3 of
this chapter (procedure and administration regulations).
(i) Private foundation maintaining a common fund--(1) Designation by
substantial contributors. An organization is described in section
170(b)(1) (A)(vii) and (E)(iii) if it is a private foundation all of the
contributions to which are pooled in a common fund and which would be
described in section 509(a)(3) but for the right of any donor who is a
substantial contributor or his spouse to designate annually the
recipients, from among public charities, of the income attributable to
the donor's contribution to the fund and to direct (by deed or by will)
the payment, to public charities, of the corpus in the common fund
attributable to the donor's contribution. For purposes of this
paragraph, the private foundation is to be treated as meeting the
requirements of section 509(a)(3) (A) and (B) even though donors to the
foundation, or their spouses, retain the right to, and in fact do,
designate public charities to receive income or corpus from the fund.
(2) Distribution requirements. To qualify under subparagraph (1) of
this paragraph, the private foundation described therein must be
required by its governing instrument to distribute, and it
[[Page 79]]
must in fact distribute (including administrative expenses):
(i) All of the adjusted net income (as defined in section 4942(f))
of the common fund to one or more public charities not later than the
15th day of the third month after the close of the taxable year in which
such income is realized by the fund, and
(ii) All the corpus attributable to any donor's contribution to the
fund to one or more public charities not later than 1 year after the
donor's death or after the death of the donor's surviving spouse if such
surviving spouse has the right to designate the recipients of such
corpus.
(3) Failure to designate. A private foundation will not fail to
qualify under this paragraph merely because a substantial contributor or
his spouse fails to exercise his right to designate the recipients of
income or corpus of the fund, provided that the income and corpus
attributable to his contribution are distributed as required by
subparagraph (2) of this paragraph.
(4) Definitions. For purposes of this paragraph:
(i) The term substantial contributor is as defined in section
507(d)(2) and the regulations thereunder.
(ii) The term public charity means an organization described in
section 170(b)(1)(A) (i) through (vi). If an organization is described
in section 170(b)(1)(A) (i) through (vi), and is also described in
section 170(b)(1)(A)(viii), it shall be treated as a public charity for
purposes of this paragraph.
(iii) The term income attributable to means the income earned by the
fund which is properly allocable to the contributed amount by any
reasonable and consistently applied method. See, for example, Sec.
1.642(c)-5(c).
(iv) The term corpus attributable to means the portion of the corpus
of the fund attributable to the contributed amount. Such portion may be
determined by any reasonable and consistently applied method.
(v) The term donor means any individual who makes a contribution
(whether of cash or property) to the private foundation, whether or not
such individual is a substantial contributor.
(j) Section 509(a) (2) or (3) organization. An organization is
described in section 170(b)(1)(A)(viii) if it is described in section
509(a) (2) or (3) and the regulations thereunder.
(k) Effective/applicability date--(1) In general. These regulations
shall apply to taxable years beginning after December 31, 1969.
(2) Applicability date. The regulations in paragraph (f) of this
section shall apply to taxable years beginning on or after January 1,
2008. For tax years beginning after December 31, 1969, and beginning
before January 1, 2008, see Sec. 1.170A-9(e) (as contained in 26 CFR
part 1 revised April 1, 2008).
(3) Applicability date. Paragraph (f)(7)(v) of this section applies
to taxable years beginning on or after December 2, 2020. Taxpayers may
choose to apply this section to taxable years beginning on or after
January 1, 2018, and before December 2, 2020.
[T.D. 7242, 38 FR 12, Jan. 3, 1973; 38 FR 3598, Feb. 8, 1973, as amended
by T.D. 7406, 41 FR 7096, Feb. 17, 1976; T.D. 7440, 41 FR 50650, Nov.
17, 1976; T.D. 7456, 42 FR 4436, Jan. 25, 1977; T.D. 7679, 45 FR 13452,
Feb. 29, 1980; T.D. 8100, 51 FR 31614, Sept. 4, 1986; T.D. 8991, 67 FR
20437, Apr. 25, 2002; T.D. 9423, 73 FR 52533, Sept. 9, 2008; T.D. 9549,
76 FR 55750, Sept. 8, 2011; T.D. 9933, 85 FR 77978, Dec. 2, 2020]
Sec. 1.170A-10 Charitable contributions carryovers of individuals.
(a) In general. (1) Section 170(d)(1), relating to carryover of
charitable contributions in excess of 50 percent of contribution base,
and section 170(b)(1)(D)(ii), relating to carryover of charitable
contributions in excess of 30 percent of contribution base, provide for
excess charitable contributions carryovers by individuals of charitable
contributions to section 170(b)(1)(A) organizations described in Sec.
1.170A-9. These carryovers shall be determined as provided in paragraphs
(b) and (c) of this section. No excess charitable contributions
carryover shall be allowed with respect to contributions ``for the use
of,'' rather than ``to,'' section 170(b)(1)(A) organizations or with
respect to contributions ``to'' or ``for the use of'' organizations
which are not section 170(b)(1)(A) organizations. See Sec. 1.170A-
8(a)(2) for definitions of ``to'' or ``for the use of'' a charitable
organization.
[[Page 80]]
(2) The carryover provisions apply with respect to contributions
made during a taxable year in excess of the applicable percentage
limitation even though the taxpayer elects under section 144 to take the
standard deduction in that year instead of itemizing the deduction
allowable in computing taxable income for that year.
(3) For provisions requiring a reduction of the excess charitable
contribution computed under paragraph (b)(1) or (c)(1) of this section
when there is a net operating loss carryover to the taxable year, see
paragraph (d)(1) of this section.
(4) The provisions of section 170 (b)(1)(D)(ii) and (d)(1) and this
section do not apply to contributions by an estate; nor do they apply to
a trust unless the trust is a private foundation which, pursuant to
Sec. 1.642(c)-4, is allowed a deduction under section 170 subject to
the provisions applicable to individuals.
(b) 50-percent charitable contributions carryover of individuals--
(1) Computation of excess of charitable contributions made in a
contribution year. Under section 170(d)(1), subject to certain
conditions and limitations, the excess of:
(i) The amount of the charitable contributions made by an individual
in a taxable year (hereinafter) in this paragraph referred to as the
``contribution year'') to section 170(b)(1)(A) organizations described
in Sec. 1.170A-9, over
(ii) 50 percent of his contribution base, as defined in section
170(b)(1)(F), for such contribution year, shall be treated as a
charitable contribution paid by him to a section 170(b)(1)(A)
organization in each of the 5 taxable years immediately succeeding the
contribution year in order of time. However, such excess to the extent
it consists of contributions of 30-percent capital gain property, as
defined in Sec. 1.170A-8(d)(3), shall be subject to the rules of
section 170(b)(1)(D)(ii) and paragraph (c) of this section in the years
to which it is carried over. A charitable contribution made in a taxable
year beginning before January 1, 1970, to a section 170(b)(1)(A)
organization and carried over to a taxable year beginning after December
31, 1969, under section 170(b)(5) (before its amendment by the Tax
Reform Act of 1969) shall be treated in such taxable year beginning
after December 31, 1969, as a charitable contribution of cash subject to
the limitations of this paragraph, whether or not such carryover
consists of contributions of 30-percent capital gain property or of
ordinary income property described in Sec. 1.170A-4(b)(1). For purposes
of applying this paragraph and paragraph (c) of this section, such a
carryover from a taxable year beginning before January 1, 1970, which is
so treated as paid to a section 170(b)(1)(A) organization in a taxable
year beginning after December 31, 1969, shall be treated as paid to such
an organization under section 170(d)(1) and this section. The provisions
of this subparagraph may be illustrated by the following examples:
Example 1. Assume that H and W (husband and wife) have a
contribution base for 1970 of $50,000 and for 1971 of $40,000 and file a
joint return for each year. Assume further that in 1970 they make a
charitable contribution in cash of $26,500 to a church and $1,000 to X
(not a section 170(b)(1)(A) organization) and in 1971 they make a
charitable contribution in cash of $19,000 to a church and $600 to X.
They may claim a charitable contributions deduction of $25,000 in 1970,
and the excess of $26,500 (contribution to the church) over $25,000 (50
percent of contribution base), or $1,500, constitutes a charitable
contributions carryover which shall be treated as a charitable
contribution paid by them to a section 170(b)(1)(A) organization in each
of the 5 succeeding taxable years in order of time. No carryover is
allowed with respect to the $1,000 contribution made to X in 1970. Since
50 percent of their contribution base for 1971 ($20,000) exceeds the
charitable contributions of $19,000 made by them in 1971 to section
170(b)(1)(A) organizations (computed without regard to section 170
(b)(1)(D)(ii) and (d)(1) and this section), the portion of the 1970
carryover equal to such excess of $1,000 ($20,000 minus $19,000) is
treated, pursuant to the provisions of subparagraph (2) of this
paragraph, as paid to a section 170(b)(1)(A) organization in 1971; the
remaining $500 constitutes an unused charitable contributions carryover.
No deduction for 1971, and no carryover, are allowed with respect to the
$600 contribution made to X in 1971.
Example 2. Assume the same facts as in Example 1 except that H and W
have a contribution base for 1971 of $42,000. Since 50 percent of their
contribution base for 1971 ($21,000) exceeds by $2,000 the charitable
contribution of $19,000 made by them in 1971 to the section 170(b)(1)(A)
organization (computed without regard to section 170 (b)(1)(D)(ii) and
(d)(1) and this section), the full amount of the 1970
[[Page 81]]
carryover of $1,500 is treated, pursuant to the provisions of
subparagraph (2) of this paragraph, as paid to a section 170(b)(1)(A)
organization in 1971. They may also claim a charitable contribution of
$500 ($21,000 -$20,500[$19,000 + $1,500]) with respect to the gift to X
in 1971. No carryover is allowed with respect to the $100 ($600-$500) of
the contribution to X which is not deductible in 1971.
(2) Determination of amount treated as paid in taxable years
succeeding contribution year. In applying the provisions of subparagraph
(1) of this paragraph, the amount of the excess computed in accordance
with the provisions of such subparagraph and paragraph (d)(1) of this
section which is to be treated as paid in any one of the 5 taxable years
immediately succeeding the contribution year to a section 170(b)(1)(A)
organization shall not exceed the lesser of the amounts computed under
subdivisions (i) to (iii), inclusive, of this subparagraph:
(i) The amount by which 50 percent of the taxpayer's contribution
base for such succeeding taxable year exceeds the sum of:
(a) The charitable contributions actually made (computed without
regard to the provisions of section 170 (b)(1)(D)(ii) and (d)(1) and
this section) by the taxpayer in such succeeding taxable year to section
170(b)(1)(A) organizations, and
(b) The charitable contributions, other than contributions of 30-
percent capital gain property, made to section 170(b)(1)(A)
organizations in taxable years preceding the contribution year which,
pursuant to the provisions of section 170(d)(1) and this section, are
treated as having been paid to a section 170(b)(1)(A) organization in
such succeeding year.
(ii) In the case of the first taxable year succeeding the
contribution year, the amount of the excess charitable contribution in
the contribution year, computed under subparagraph (1) of this paragraph
and paragraph (d)(1) of this section.
(iii) In the case of the second, third, fourth, and fifth taxable
years succeeding the contribution year, the portion of the excess
charitable contribution in the contribution year, computed under
subparagraph (1) of this paragraph and paragraph (d)(1) of this section,
which has not been treated as paid to a section 170(b)(1)(A)
organization in a year intervening between the contribution year and
such succeeding taxable year.
For purposes of applying subdivision (i)(a) of this subparagraph, the
amount of charitable contributions of 30-percent capital gain property
actually made in a taxable year succeeding the contribution year shall
be determined by first applying the 30-percent limitation of section
170(b)(1)(D)(i) and paragraph (d) of Sec. 1.170A-8. If a taxpayer, in
any one of the 4 taxable years succeeding a contribution year, elects
under section 144 to take the standard deduction instead of itemizing
the deductions allowable in computing taxable income, there shall be
treated as paid (but not allowable as a deduction) in such standard
deduction year the lesser of the amounts determined under subdivisions
(i) to (iii), inclusive, of this subparagraph. The provisions of this
subparagraph may be illustrated by the following examples:
Example 1. Assume that B has a contribution base for 1970 of $20,000
and for 1971 of $30,000. Assume further that in 1970 B contributed
$12,000 in cash to a church and in 1971 he contributed $13,500 in cash
to the church. B may claim a charitable contributions deduction of
$10,000 in 1970, and the excess of $12,000 (contribution to the church)
over $10,000 (50 percent of B's contribution base), or $2,000,
constitutes a charitable contributions carryover which shall be treated
as a charitable contribution paid by B to a section 170(b)(1)(A)
organization in the 5 taxable years succeeding 1970 in order of time. B
may claim a charitable contributions deduction of $15,000 in 1971. Such
$15,000 consists of the $13,500 contribution to the church in 1971 and
$1,500 carried over from 1970 and treated as a charitable contribution
paid to a section 170(b)(1)(A) organization in 1971. The $1,500
contribution treated as paid in 1971 is computed as follows:
1970 excess contributions.................................... $2,000
==========
50 percent of B's contribution base for 1971................. 15,000
Less:
Contributions actually made in 1971 to section $13,500
170(b)(1)(A) organizations.....................
Contributions made to section 170(b)(1)(A) 0 13,500
organizations in taxable years prior to 1970
treated as having been paid in 1971............
---------------------
Balance..................................... ......... 1,500
==========
[[Page 82]]
Amount of 1970 excess treated as paid in 1971--the lesser of 1,500
$2,000 (1970 excess contributions) or $1,500 (excess of 50
percent of contribution base for 1971 ($15,000) over the sum
of the section 170(b)(1)(A) contributions actually made in
1971 ($13,500) and the section 170(b)(1)(A) contributions
made in years prior to 1970 treated as having been paid in
1971 ($0))..................................................
==========
If the excess contributions made by B in 1970 had been $1,000 instead of
$2,000, then, for purposes of this example, the amount of the 1970
excess treated as paid in 1971 would be $1,000 rather than $1,500.
Example 2. Assume the same facts as in Example 1, and, in addition,
that B has a contribution base for 1972 of $10,000 and for 1973 of
$20,000. Assume further with respect to 1972 that B elects under section
144 to take the standard deduction in computing taxable income and that
his actual contributions to section 170(b)(1)(A) organizations in that
year are $300 in cash. Assume further with respect to 1973 that R
itemizes his deductions, which include a $5,000 cash contribution to a
church. B's deductions for 1972 are not increased by reason of the $500
available as a charitable contributions carryover from 1970 (excess
contributions made in 1970 ($2,000) less the amount of such excess
treated as paid in 1971 ($1,500)), since B elected to take the standard
deduction in 1972. However, for purposes of determining the amount of
the excess charitable contributions made in 1970 which is available as a
carryover to 1973, B is required to treat such $500 as a charitable
contribution paid in 1972--the lesser of $500 or $4,700 (50 percent of
contribution base ($5,000) over contributions actually made in 1972 to
section 170(b)(1)(A) organizations ($300)). Therefore, even though the
$5,000 contribution made by B in 1973 to a church does not amount to 50
percent of B's contribution base for 1973 (50 percent of $20,000), B may
claim a charitable contributions deduction of only the $5,000 actually
paid in 1973 since the entire excess charitable contribution made in
1970 ($2,000) has been treated as paid in 1971 ($1,500) and 1972 ($500).
Example 3. Assume the following factual situation for C who itemizes
his deductions in computing taxable income for each of the years set
forth in the example:
----------------------------------------------------------------------------------------------------------------
1970 1971 1972 1973 1974
----------------------------------------------------------------------------------------------------------------
Contribution base............................................. $10,000 $7,000 $15,000 $10,000 $9,000
=================================================
Contributions of cash to section 170(b)(1)(A) organizations 6,000 4,400 8,000 3,000 1,500
(no other contributions).....................................
Allowable charitable contributions deductions computed without 5,000 3,500 7,500 3,000 1,500
regard to carryover of contributions.........................
-------------------------------------------------
Excess contributions for taxable year to be treated as paid in 1,000 900 500 0 0
5 succeeding taxable years...................................
----------------------------------------------------------------------------------------------------------------
Since C's contributions in 1973 and 1974 to section 170(b)(1)(A)
organizations are less than 50 percent of his contribution base for such
years, the excess contributions for 1970, 1971, and 1972 are treated as
having been paid to section 170(b)(1)(A) organizations in 1973 and 1974
as follows:
1973
------------------------------------------------------------------------
Less:
Amount
treated Available
Contribution year Total as paid charitable
excess in year contributions
prior to carryovers
1973
------------------------------------------------------------------------
1970............................... $1,000 0 $1,000
1971............................... 900 0 900
1972............................... 500 0 500
------------------------------------
Total............................ ......... ......... 2,400
50 percent of B's contribution base for 1973............. $5,000
Less: Charitable contributions made in 1973 to section 3,000
170(b)(1)(A) organizations..............................
--------------
2,000
==============
Amount of excess contributions treated as paid in 1973-- 2,000
lesser of $2,400 (available carryovers to 1973) or
$2,000 (excess of 50 percent of contribution base
($5,000) over contributions actually made in 1973 to
section 170(b)(1)(A) organizations ($3,000))............
==============
------------------------------------------------------------------------
1974
------------------------------------------------------------------------
Less:
Amount
treated Available
Contribution year Total as paid charitable
excess in year contributions
prior to carryovers
1974
------------------------------------------------------------------------
1970............................... $1,000 $1,000
1971............................... 900 900
1972............................... 500 100 $40
[[Page 83]]
1973............................... 0 0
------------------------------------
Total............................ ......... ......... 400
50 percent of B's contribution base for 1974............. $4,500
Less: Charitable contributions made in 1974 to section 1,500
170(b)(1)(A) organizations..............................
--------------
3,000
==============
Amount of excess contributions treated as paid in 1974-- 400
the lesser of $400 (available carryovers to 1974) or
$3,000 (excess of 50 percent of contribution base
($4,500) over contributions actually made in 1974 to
section 170(b)(1)(A) organizations ($1,500))............
==============
------------------------------------------------------------------------
(c) 30-percent charitable contributions carryover of individuals--
(1) Computation of excess of charitable contributions made in a
contribution year. Under section 170(b)(1)(D)(ii), subject to certain
conditions and limitations, the excess of:
(i) The amount of the charitable contributions of 30-percent capital
gain property, as defined in Sec. 1.170A-8(d)(3), made by an individual
in a taxable year (hereinafter in this paragraph referred to as the
``contribution year'') to section 170(b)(1)(A) organizations described
in Sec. 1.170A-9, over
(ii) 30 percent of his contribution base for such contribution year,
shall, subject to section 170(b)(1)(A) and paragraph (b) of Sec.
1.170A-8, be treated as a charitable contribution of 30-percent capital
gain property paid by him to a section 170(b)(1)(A) organization in each
of the 5 taxable years immediately succeeding the contribution year in
order of time. In addition, any charitable contribution of 30-percent
capital gain property which is carried over to such years under section
170(d)(1) and paragraph (b) of this section shall also be treated as
though it were a carryover of 30-percent capital gain property under
section 170(b)(1)(D)(ii) and this paragraph. The provisions of this
subparagraph may be illustrated by the following examples:
Example 1. Assume that H and W (husband and wife) have a
contribution base for 1970 of $50,000 and for 1971 of $40,000 and file a
joint return for each year. Assume further that in 1970 they contribute
$20,000 cash and $13,000 of 30-percent capital gain property to a
church, and that in 1971 they contribute $5,000 cash and $10,000 of 30-
percent capital gain property to a church. They may claim a charitable
contributions deduction of $25,000 in 1970 and the excess of $33,000
(contributed to the church) over $25,000 (50 percent of contribution
base), or $8,000, constitutes a charitable contributions carryover which
shall be treated as a charitable contribution of 30-percent capital gain
property paid by them to a section 170(b)(1)(A) organization in each of
the 5 succeeding taxable years in order of time. Since 30 percent of
their contribution base for 1971 ($12,000) exceeds the charitable
contributions of 30-percent capital gain property ($10,000) made by them
in 1971 to section 170(b)(1)(A) organizations (computed without regard
to section 170 (b)(1)(D)(ii) and (d)(1) and this section), the portion
of the 1970 carryover equal to such excess of $2,000 ($12,000--$10,000)
is treated, pursuant to the provisions of subparagraph (2) of this
paragraph, as paid to a section 170(b)(1)(A) organization in 1971; the
remaining $6,000 constitutes an unused charitable contributions
carryover in respect of 30-percent capital gain property from 1970.
Example 2. Assume the same facts as in Example 1 except the $33,000
of charitable contributions in 1970 are all 30-percent capital gain
property. Since their charitable contributions in 1970 exceed 30 percent
of their contribution base ($15,000) by $18,000 ($33,000--$15,000), they
may claim a charitable contributions deduction of $15,000 in 1970, and
the excess of $33,000 over $15,000, or $18,000, constitutes a charitable
contributions carryover which shall be treated as a charitable
contribution of 30-percent capital gain property paid by them to a
section 170(b)(1)(A) organization in each of the 5 succeeding taxable
years in order of time. Since they are allowed to treat only $2,000 of
their 1970 contribution as paid in 1971, they have a remaining unused
charitable contributions carryover of $16,000 in respect of 30-percent
capital gain property from 1970.
(2) Determination of amount treated as paid in taxable years
succeeding contribution year. In applying the provisions of subparagraph
(1) of this paragraph, the amount of the excess computed in accordance
with the provisions of such subparagraph and paragraph (d)(1) of this
section which is to be treated as paid in any one of the 5 taxable years
immediately succeeding the contribution year to a section 170(b)(1)(A)
organization shall not exceed the least of the amounts computed under
subdivisions (i) to (iv), inclusive, of this subparagraph:
(i) The amount by which 30 percent of the taxpayer's contribution
base for
[[Page 84]]
such succeeding taxable year exceeds the sum of:
(a) The charitable contributions of 30-percent capital gain property
actually made (computed without regard to the provisions of section 170
(b)(1)(D)(ii) and (d)(1) and this section) by the taxpayer in such
succeeding taxable year to section 170(b)(1)(A) organizations, and
(b) The charitable contributions of 30-percent capital gain property
made to section 170(b)(1)(A) organizations in taxable years preceding
the contribution year, which, pursuant to the provisions of section 170
(b)(1)(D)(ii) and (d)(1) and this section, are treated as having been
paid to a section 170(b)(1)(A) organization in such succeeding year.
(ii) The amount by which 50 percent of the taxpayer's contribution
base for such succeeding taxable year exceeds the sum of:
(a) The charitable contributions actually made (computed without
regard to the provisions of section 170 (b)(1)(D)(ii) and (d)(1) and
this section) by the taxpayer in such succeeding taxable year to section
170(b)(1)(A) organizations,
(b) The charitable contributions of 30-percent capital gain property
made to section 170(b)(1)(A) organizations in taxable years preceding
the contribution year which, pursuant to the provisions of section 170
(b)(1)(D)(ii) and (d)(1) and this section, are treated as having been
paid to a section 170(b)(1)(A) organization in such succeeding year, and
(c) The charitable contributions, other than contributions of 30-
percent capital gain property, made to section 170(b)(1)(A)
organizations which, pursuant to the provisions of section 170(d)(1) and
paragraph (b) of this section, are treated as having been paid to a
section 170(b)(1)(A) organization in such succeeding year.
(iii) In the case of the first taxable year succeeding the
contribution year, the amount of the excess charitable contribution of
30-percent capital gain property in the contribution year, computed
under subparagraph (1) of this paragraph and paragraph (d)(1) of this
section.
(iv) In the case of the second, third, fourth, and fifth succeeding
taxable years succeeding the contribution year, the portion of the
excess charitable contribution of 30-percent capital gain property in
the contribution year (computed under subparagraph (1) of this paragraph
and paragraph (d)(1) of this section) which has not been treated as paid
to a section 170(b)(1)(A) organization in a year intervening between the
contribution year and such succeeding taxable year.
For purposes of applying subdivisions (i) and (ii) of this subparagraph,
the amount of charitable contributions of 30-percent capital gain
property actually made in a taxable year succeeding the contribution
year shall be determined by first applying the 30-percent limitation of
section 170(b)(1)(D)(i) and paragraph (d) of Sec. 1.170A-8. If a
taxpayer, in any one of the four taxable years succeeding a contribution
year, elects under section 144 to take the standard deduction instead of
itemizing the deductions allowable in computing taxable income, there
shall be treated as paid (but not allowable as a deduction) in the
standard deduction year the least of the amounts determined under
subdivisions (i) to (iv), inclusive, of this subparagraph. The
provisions of this subparagraph may be illustrated by the following
example:
Example. Assume the following factual situation for C who itemizes
his deductions in computing taxable income for each of the years set
forth in the example:
----------------------------------------------------------------------------------------------------------------
1970 1971 1972 1973 1974
----------------------------------------------------------------------------------------------------------------
Contribution base................................... $10,000 $15,000 $20,000 $15,000 $33,000
-----------------------------------------------------------
Contributions of cash to section 170(b)(1)(A) 2,000 8,500 0 14,000 700
organizations......................................
-----------------------------------------------------------
Contributions of 30-percent capital gain property to 5,000 0 7,800 0 6,400
section 170(b)(1)(A) organizations.................
-----------------------------------------------------------
[[Page 85]]
Allowable charitable contributions deductions
(computed without regard to carryover of
contributions) subject to limitations of:
50 percent........................................ 2,000 7,500 0 7,500 700
30 percent........................................ 3,000 0 6,000 0 6,400
-----------------------------------------------------------
Total........................................... 5,000 7,500 6,000 7,500 7,100
----------------------------------------------------------------------------------------------------------------
Excess of contributions for taxable year to be
treated as paid in 5 succeeding taxable years:
Carryover of contributions of property other than 0 1,000 0 6,500
30-percent capital gain property.................
Carryover of contributions of 30-percent capital 2,000 0 1,800 0
gain property....................................
----------------------------------------------------------------------------------------------------------------
C's excess contributions for 1970, 1971, 1972, and 1973 which are treated as having been paid to section
170(b)(1)(A) organizations in 1972, 1973, and 1974 are indicated below. The portion of the excess charitable
contribution for 1972 of 30-percent capital gain property which is not treated as paid in 1974 ($1,800-$900)
is available as a carryover to 1975.
1971
----------------------------------------------------------------------------------------------------------------
Total excess Less: Available charitable
------------------------ Amount contributions
treated as carryovers
Contribution paid in -----------------------
50% 30% years
prior to 50% 30%
1971
----------------------------------------------------------------------------------------------------------------
1970................................................ 0 $2,000 0 0 $2,000
=======================
50 percent of C's contribution base for 1971............................................ $7,500
30 percent of C's contribution base for 1971............................................ .......... 4,500
Less: Charitable contributions actually made in 1971 to section 170(b)(1)(A) 7,500 0
organizations ($8,500, but not to exceed 50% of contribution base).....................
-----------------------
Excess.............................................................................. 0 4,500
=======================
The amount of excess contributions for 1970 of 30-percent capital gain property which is
treated as paid in 1971 is the least of:
(i) Available carryover from 1970 to 1971 of contributions of 30-percent capital gain 2,000
property.............................................................................
(ii) Excess of 50 percent of contribution base for 1971 ($7,500) over sum of 0
contributions actually made in 1971 to section 170(b)(1)(A) organizations ($7,500)...
(iii) Excess of 30 percent of contribution base for 1971 ($4,500) over contributions 4,500 ..........
of 30 percent capital gain property actually made in 1971 to section 170(b)(1)(A)
organizations ($0)...................................................................
-----------------------
Amount treated as paid.............................................................. .......... 0
----------------------------------------------------------------------------------------------------------------
1972
----------------------------------------------------------------------------------------------------------------
Total excess Less: Available charitable
------------------------ Amount contributions
treated as carryovers
Contribution year paid in -----------------------
50% 30% years
prior to 50% 30%
1972
----------------------------------------------------------------------------------------------------------------
1970................................................ 0 $2,000 0 0 $2,000
1971................................................ $1,000 0 0 $1,000 0
-----------------------
1,000 2,000
=======================
50 percent of C's contribution base for 1972............................................ 10,000 ..........
30 percent of C's contribution base for 1972............................................ .......... 6,000
Less: Charitable contributions actually made in 1972 to section 170(b)(1)(A) 0 6,000
organizations ($7,800, but not to exceed 30% of contribution base).....................
=======================
Excess.............................................................................. 10,000 0
=======================
(1) The amount of excess contributions for 1971 of property other than 30-percent
capital gain property which is treated as paid in 1972 is the lesser of:
(i) Available carryover from 1971 to 1972 of contributions of property other than 30- 1,000 ..........
percent capital gain property........................................................
(ii) Excess of 50 percent of contribution base for 1972 ($10,000) over contributions 4,000 ..........
actually made in 1972 to section 170(b)(1)(A) organizations ($6,000).................
-----------------------
Amount treated as paid.............................................................. .......... 1,000
=======================
[[Page 86]]
(2) The amount of excess contributions for 1970 of 30-percent capital gain property
which is treated as paid in 1972 is the least of:
(i) Available carryover from 1970 to 1972 of contributions of 30-percent capital gain 2,000 ..........
property.............................................................................
(ii) Excess of 50 percent of contribution base for 1972 ($10,000) over sum of 3,000 ..........
contributions actually made in 1972 to section 170(b)(1)(A) organizations ($6,000)
and excess contributions for 1971 treated under item (1) above as paid in 1972
($1,000).............................................................................
(iii) Excess of 30 percent of contribution base for 1972 ($6,000) over contributions 0 ..........
of 30-percent capital gain property actually made in 1972 to section 170(b)(1)(A)
organizations ($6,000)...............................................................
-----------------------
Amount treated as paid.............................................................. .......... 0
----------------------------------------------------------------------------------------------------------------
1973
----------------------------------------------------------------------------------------------------------------
Total excess Less: Available charitable
------------------------ Amount contributions
treated as carryovers
Contribution year paid in -----------------------
50% 30% years
prior to 50% 30%
1973
----------------------------------------------------------------------------------------------------------------
1970................................................ 0 $2,000 0 0 $2,000
1971................................................ $1,000 0 $1,000 0 0
1972................................................ 0 1,800 0 0 1,800
-----------------------
0 3,800
=======================
50 percent of C's contribution base for 1973............................................ $7,500
30 percent of C's contribution base for 1973............................................ .......... 4,500
Less: Charitable contributions actually made in 1973 to section 170(b)(1)(A) 7,500 0
organizations ($14,000, but not to exceed 50% of contribution base)....................
-----------------------
Excess.............................................................................. 0 4,500
=======================
(1) The amount of excess contributions for 1970 of 30-percent capital gain property
which is treated as paid in 1973 is the least of:
(i) Available carryover from 1970 to 1973 of contributions of 30-percent capital gain 2,000 ..........
property.............................................................................
(ii) Excess of 50 percent of contribution base for 1973 ($7,500) over contributions 0 ..........
actually made in 1973 to section 170(b)(1)(A) organizations ($7,500).................
(iii) Excess of 30 percent of contribution base for 1973 ($4,500) over contributions 4,500 ..........
of 30-percent capital gain property actually made in 1973 to section 170(b)(1)(A)
organizations ($0)...................................................................
-----------------------
Amount treated as paid.............................................................. 0
=======================
(2) The amount of excess contributions for 1972 of 30-percent capital gain property
which is treated as paid in 1973 is the least of:
(i) Available carryover from 1972 to 1973 of contributions of 30-percent capital gain 1,800 ..........
property.............................................................................
(ii) Excess of 50 percent of contribution base for 1973 ($7,500) over contributions 0 ..........
actually made in 1973 to section 170(b)(1)(A) organizations ($7,500).................
(iii) Excess of 30 percent of contribution base for 1973 ($4,500) over sum of 4,500 ..........
contributions of 30-percent capital gain property actually made in 1973 to section
170(b)(1)(A) organizations ($0) and excess contributions for 1970 treated under item
(1) above as paid in 1973 ($0).......................................................
-----------------------
Amount treated as paid.............................................................. 0 ..........
----------------------------------------------------------------------------------------------------------------
1974
----------------------------------------------------------------------------------------------------------------
Total excess Less: Available charitable
------------------------ Amount contributions
treated as carryovers
Contribution year paid in -----------------------
50% 30% years
prior to 50% 30%
1974
----------------------------------------------------------------------------------------------------------------
1970................................................ 0 $2,000 0 0 $2,000
1971................................................ $1,000 0 $1,000 0 0
1972................................................ 0 1,800 0 0 1,800
1973................................................ 6,500 0 0 $6,500 0
-----------------------
[[Page 87]]
6,500 3,800
=======================
50 percent of C's contribution base for 1974............................................ 16,500 ..........
30 percent of C's contribution base for 1974............................................ .......... 9,900
Less: Charitable contributions actually made in 1974 to section 170(b)(1)(A) 700 6,400
organizations..........................................................................
-----------------------
Excess.............................................................................. 15,800 3,500
=======================
(1) The amount of excess contributions for 1973 of property other than 30-percent
capital gain property which is treated as paid in 1974 is the lesser of:
(i) Available carryover from 1973 to 1974 of contributions of property other than 30- 6,500 ..........
percent capital gain property........................................................
(ii) Excess of 50 percent of contribution base for 1974 ($16,500) over contributions 9,400 ..........
actually made in 1974 to section 170(b)(1)(A) organizations ($7,100).................
-----------------------
Amount treated as paid.............................................................. .......... 6,500
=======================
(2) The amount of excess contributions for 1970 of 30-percent capital gain property
which is treated as paid in 1974 is the least of:
(i) Available carryover from 1970 to 1974 of contributions of 30-percent capital gain $2,000
property.............................................................................
(ii) Excess of 50 percent of contribution base for 1974 ($16,500) over sum of 2,900
contributions actually made in 1974 to section 170(b)(1)(A) organizations ($7,100)
and excess contributions for 1973 of property other than 30-percent capital gain
property treated under item (1) above as paid in 1974 ($6,500).......................
(iii) Excess of 30 percent of contribution base for 1974 ($9,900) over contributions 3,500 ..........
of 30-percent capital gain property actually made in 1974 to section 170(b)(1)(A)
organizations ($6,400)...............................................................
-----------------------
Amount treated as paid.............................................................. .......... $2,000
=======================
(3) The amount of excess contributions for 1972 of 30-percent capital gain property
which is treated as paid in 1974 is the least of:
(i) Available carryover from 1972 to 1974 of contributions of 30-percent capital gain 1,800
property.............................................................................
(ii) Excess of 50 percent of contribution base for 1974 ($16,500) over sum of 900
contributions actually made in 1974 to section 170(b)(1)(A) organizations ($7,100)
and excess contributions for 1973 and 1970 treated under items (1) and (2) above as
paid in 1974 ($8,500)................................................................
(iii) Excess of 30 percent of contribution base for 1974 ($9,900) over sum of 1,500 ..........
contributions of 30-percent capital gain property actually made in 1974 to section
170(b)(1)(A) organizations ($6,400) and excess contributions for 1970 of 30-percent
capital gain property treated under item (2) above as paid in 1974 ($2,000)..........
-----------------------
Amount treated as paid.............................................................. .......... 900
----------------------------------------------------------------------------------------------------------------
(d) Adjustments--(1) Effect of net operating loss carryovers on
carryover of excess contributions. An individual having a net operating
loss carryover from a prior taxable year which is available as a
deduction in a contribution year must apply the special rule of section
170(d)(1)(B) and this subparagraph in computing the excess described in
paragraph (b)(1) or (c)(1) of this section for such contribution year.
In determining the amount of excess charitable contributions that shall
be treated as paid in each of the 5 taxable years succeeding the
contribution year, the excess charitable contributions described in
paragraph (b)(1) or (c)(1) of this section must be reduced by the amount
by which such excess reduces taxable income (for purposes of determining
the portion of a net operating loss which shall be carried to taxable
years succeeding the contribution year under the second sentence of
section 172(b)(2)) and increases the net operating loss which is carried
to a succeeding taxable year. In reducing taxable income under the
second sentence of section 172(b)(2), an individual who has made
charitable contributions in the contribution year to both section
170(b)(1)(A) organizations, as defined in Sec. 1.170A-9, and to
organizations which are not section 170(b)(1)(A) organizations must
first deduct contributions
[[Page 88]]
made to the section 170(b)(1)(A) organizations from his adjusted gross
income computed without regard to his net operating loss deduction
before any of the contributions made to organizations which are not
section 170(b)(1)(A) organizations may be deducted from such adjusted
gross income. Thus, if the excess of the contributions made in the
contribution year to section 170(b)(1)(A) organizations over the amount
deductible in such contribution year is utilized to reduce taxable
income (under the provisions of section 172(b)(2)) for such year,
thereby serving to increase the amount of the net operating loss
carryover to a succeeding year or years, no part of the excess
charitable contributions made in such contribution year shall be treated
as paid in any of the 5 immediately succeeding taxable years. If only a
portion of the excess charitable contributions is so used, the excess
charitable contributions shall be reduced only to that extent. The
provisions of this subparagraph may be illustrated by the following
examples:
Example 1. B, an individual, reports his income on the calendar year
basis and for the year 1970 has adjusted gross income (computed without
regard to any net operating loss deduction) of $50,000. During 1970 he
made charitable contributions of cash in the amount of $30,000 all of
which were to section 170(b)(1)(A) organizations. B has a net operating
loss carryover from 1969 of $50,000. In the absence of the net operating
loss deduction B would have been allowed a deduction for charitable
contributions of $25,000. After the application of the net operating
loss deduction, B is allowed no deduction for charitable contributions,
and there is (before applying the special rule of section 170(d)(1)(B)
and this subparagraph) a tentative excess charitable contribution of
$30,000. For purposes of determining the net operating loss which
remains to be carried over to 1971, B computes his taxable income for
1970 under section 172(b)(2) by deducting the $25,000 charitable
contribution. After the $50,000 net operating loss carryover is applied
against the $25,000 of taxable income for 1970 (computed in accordance
with section 172(b)(2), assuming no deductions other than the charitable
contributions deduction are applicable in making such computation),
there remains a $25,000 net operating loss carryover to 1971. Since the
application of the net operating loss carryover of $50,000 from 1969
reduces the 1970 adjusted gross income (for purposes of determining 1970
tax liability) to zero, no part of the $25,000 of charitable
contributions in that year is deductible under section 170(b)(1).
However, in determining the amount of the excess charitable
contributions which shall be treated as paid in taxable years 1971,
1972, 1973, 1974, and 1975, the $30,000 must be reduced to $5,000 by the
portion of the excess charitable contributions ($25,000) which was used
to reduce taxable income for 1970 (as computed for purposes of the
second sentence of section 172(b)(2)) and which thereby served to
increase the net operating loss carryover to 1971 from zero to $25,000.
Example 2. Assume the same facts as in Example 1, except that B's
total charitable contributions of $30,000 in cash made during 1970
consisted of $25,000 to section 170(b)(1)(A) organizations and $5,000 to
organizations other than section 170(b)(1)(A) organizations. Under these
facts there is a tentative excess charitable contribution of $25,000,
rather than $30,000 as in Example 1. For purposes of determining the net
operating loss which remains to be carried over to 1971, B computes his
taxable income for 1970 under section 172(b)(2) by deducting the $25,000
of charitable contributions made to section 170(b)(1)(A) organizations.
Since the excess charitable contribution of $25,000 determined in
accordance with paragraph (b)(1) of this section was used to reduce
taxable income for 1970 (as computed for purposes of the second sentence
of section 172(b)(2)) and thereby served to increase the net operating
loss carryover to 1971 from zero to $25,000, no part of such excess
charitable contributions made in the contribution year shall be treated
as paid in any of the five immediately succeeding taxable years. No
carryover is allowed with respect to the $5,000 of charitable
contributions made in 1970 to organizations other than section
170(b)(1)(A) organizations.
Example 3. Assume the same facts as in Example 1, except that B's
total contributions of $30,000 made during 1970 were of 30-percent
capital gain property. Under these facts there is a tentative excess
charitable contribution of $30,000. For purposes of determining the net
operating loss which remains to be carried over to 1971, B computes his
taxable income for 1970 under section 172(b)(2)(B) by deducting the
$15,000 (30% of $50,000) contribution of 30-percent capital gain
property which would have been deductible in 1970 absent the net
operating loss deduction. Since $15,000 of the excess charitable
contribution of $30,000 determined in accordance with paragraph (c)(1)
of this section was used to reduce taxable income for 1970 (as computed
for purposes of the second sentence of section 172(b)(2)) and thereby
served to increase the net operating loss carryover to 1971 from zero to
$15,000, only $15,000 ($30,000--$15,000) of such excess shall be treated
as paid in taxable years 1971, 1972, 1973, 1974, and 1975.
[[Page 89]]
(2) Effect of net operating loss carryback to contribution year. The
amount of the excess contribution for a contribution year computed as
provided in paragraph (b)(1) or (c)(1) of this section and subparagraph
(1) of this paragraph shall not be increased because a net operating
loss carryback is available as a deduction in the contribution year.
Thus, for example, assuming that in 1970 there is an excess contribution
of $50,000 (determined as provided in paragraph (b)(1) of this section)
which is to be carried to the 5 succeeding taxable years and that in
1973 the taxpayer has a net operating loss which may be carried back to
1970, the excess contribution of $50,000 for 1970 is not increased by
reason of the fact that the adjusted gross income for 1970 (on which
such excess contribution was based) is subsequently decreased by the
carryback of the net operating loss from 1973. In addition, in
determining under the provisions of section 172(b)(2) the amount of the
net operating loss for any year subsequent to the contribution year
which is a carryback or carryover to taxable years succeeding the
contribution year, the amount of contributions made to section
170(b)(1)(A) organizations shall be limited to the amount of such
contributions which did not exceed 50 percent or, in the case of 30-
percent capital gain property, 30 percent of the donor's contribution
base, computed without regard to any of the modifications referred to in
section 172(d), for the contribution year. Thus, for example, assume
that the taxpayer has a net operating loss in 1973 which is carried back
to 1970 and in turn to 1971 and that he has made charitable
contributions in 1970 to section 170(b)(1)(A) organizations. In
determining the maximum amount of such charitable contributions which
may be deducted in 1970 for purposes of determining the taxable income
for 1970 which is deducted under section 172(b)(2) from the 1973 loss in
order to ascertain the amount of such loss which is carried back to
1971, the 50-percent limitation of section 170(b)(1)(A) is based upon
the adjusted gross income for 1970 computed without taking into account
the net operating loss carryback from 1973 and without making any of the
modifications specified in section 172(d).
(3) Effect of net operating loss carryback to taxable years
succeeding the contribution year. The amount of the charitable
contribution from a preceding taxable year which is treated as paid, as
provided in paragraph (b)(2) or (c)(2) of this section, in a current
taxable year (hereinafter referred to in this subparagraph as the
``deduction year'') shall not be reduced because a net operating loss
carryback is available as a deduction in the deduction year. In
addition, in determining under the provisions of section 172(b)(2) the
amount of the net operating loss for any taxable year subsequent to the
deduction year which is a carryback or carryover to taxable years
succeeding the deduction year, the amount of contributions made to
section 170(b)(1)(A) organizations in the deduction year shall be
limited to the amount of such contributions, which were actually made in
such year and those which were treated as paid in such year, which did
not exceed 50 percent or, in the case of 30-percent capital gain
property, 30 percent of the donor's contribution base, computed without
regard to any of the modifications referred to in section 172(d), for
the deduction year.
(4) Husband and wife filing joint returns--(i) Change from joint
return to separate returns. If a husband and wife:
(a) Make a joint return for a contribution year and compute an
excess charitable contribution for such year in accordance with the
provisions of paragraph (b)(1) or (c)(1) of this section and
subparagraph (1) of this paragraph, and
(b) Make separate returns for one or more of the 5 taxable years
immediately succeeding such contribution year, any excess charitable
contribution for the contribution year which is unused at the beginning
of the first such taxable year for which separate returns are filed
shall be allocated between the husband and wife. For purposes of the
allocation, a computation shall be made of the amount of any excess
charitable contribution which each spouse would have computed in
accordance with paragraph (b)(1) or (c)(1) of this section and
subparagraph
[[Page 90]]
(1) of this paragraph if separate returns (rather than a joint return)
had been filed for the contribution year. The portion of the total
unused excess charitable contribution for the contribution year
allocated to each spouse shall be an amount which bears the same ratio
to such unused excess charitable contribution as such spouse's excess
contribution, based on the separate return computation, bears to the
total excess contributions of both spouses, based on the separate return
computation. To the extent that a portion of the amount allocated to
either spouse in accordance with the foregoing provisions of this
subdivision is not treated in accordance with the provisions of
paragraph (b)(2) or (c)(2) of this section as a charitable contribution
paid to a section 170(b)(1)(A) organization in the taxable year in which
a separate return or separate returns are filed, each spouse shall for
purposes of paragraph (b)(2) or (c)(2) of this section treat his
respective unused portion as the available charitable contributions
carryover to the next succeeding taxable year in which the joint excess
charitable contribution may be treated as paid in accordance with
paragraph (b)(1) or (c)(1) of this section. If such husband and wife
make a joint return in one of the 5 taxable years immediately succeeding
the contribution year with respect to which a joint excess charitable
contribution is computed and following such first taxable year for which
such husband and wife filed a separate return, the amounts allocated to
each spouse in accordance with this subdivision for such first year
reduced by the portion of such amounts treated as paid to a section
170(b)(1)(A) organization in such first year and in any taxable year
intervening between such first year and the succeeding taxable year in
which the joint return is filed shall be aggregated for purposes of
determining the amount of the available charitable contributions
carryover to such succeeding taxable year. The provisions of this
subdivision may be illustrated by the following example:
Example. (a) H and W file joint returns for 1970, 1971, and 1972,
and in 1973 they file separate returns. In each such year H and W
itemize their deductions in computing taxable income. Assume the
following factual situation with respect to H and W for 1970:
1970
------------------------------------------------------------------------
Joint
H W return
------------------------------------------------------------------------
Contribution base......................... $50,000 $40,000 $90,000
=============================
Contributions of cash to section 37,000 28,000 65,000
170(b)(1)(A) organizations (no other
contributions)...........................
Allowable charitable contributions 25,000 20,000 45,000
deductions...............................
-----------------------------
Excess contributions for taxable year to 12,000 8,000 20,000
be treated as paid in 5 succeeding
taxable years............................
------------------------------------------------------------------------
(b) The joint excess charitable contribution of $20,000 is to be
treated as having been paid to a section 170(b)(1)(A) organization in
the 5 succeeding taxable years. Assume that in 1971 the portion of such
excess treated as paid by H and W is $3,000, and that in 1972 the
portion of such excess treated as paid is $7,000. Thus, the unused
portion of the excess charitable contribution made in the contribution
year is $10,000 ($20,000 less $3,000 [amount treated as paid in 1971]
and $7,000 [amount treated as paid in 1972]). Since H and W file
separate returns in 1973, $6,000 of such $10,000 is allocable to H, and
$4,000 is allocable to W. Such allocation is computed as follows:
$12,000 (excess charitable contributions made by H (based on separate
return computation) in 1970)/$20,000 (total excess charitable
contributions made by H and W (based on separate return
computation) in 1970) x $10,000 = $6,000
$8,000 (excess charitable contributions made by W (based on separate
return computation) in 1970)/$20,000 (total excess charitable
contributions made by H and W (based on separate return
computation) in 1970) x $10,000 = $4,000
(c) In 1973 H has a contribution base of $70,000, and he contributes
$14,000 in cash to a section 170(b)(1)(A) organization. In 1973 W has a
contribution base of $50,000, and she contributes $10,000 in cash to a
section 170(b)(1)(A) organization. Accordingly, H may claim a charitable
contributions deduction of $20,000 in 1973, and W may claim a charitable
contributions deduction of $14,000 in 1973. H's $20,000 deduction
consists of the $14,000 contribution made to the section 170(b)(1)(A)
organization in 1973 and the $6,000 carried over from 1970 and treated
as a charitable contribution paid by him to a section 170(b)(1)(A)
organization in 1973. W's $14,000 deduction consists of the $10,000
contribution made to a section 170(b)(1)(A) organization in 1973 and the
$4,000 carried over
[[Page 91]]
from 1970 and treated as a charitable contribution paid by her to a
section 170(b)(1)(A) organization in 1973.
(d) The $6,000 contribution treated as paid in 1973 by H, and the
$4,000 contribution treated as paid in 1973 by W, are computed as
follows:
------------------------------------------------------------------------
H W
------------------------------------------------------------------------
Available charitable contribution carryover (see $6,000 $4,000
computations in (b))...............................
===================
50 percent of contribution base..................... 35,000 25,000
Contributions of cash made in 1973 to section 14,000 10,000
170(b)(1)(A) organizations (no other contributions)
-------------------
21,000 15,000
Amount of excess contributions treated as paid in $6,000 ........
1973: The lesser of $6,000 (available carryover of
H to 1973) or $21,000 (excess of 50 percent of
contribution base ($35,000) over contributions
actually made in 1973 to section 170(b)(1)(A)
organizations ($14,000))...........................
==========
The lesser of $4,000 (available carryover of W to ........ $4,000
1973) or $15,000 (excess of 50 percent of
contribution base ($25,000) over contributions
actually made in 1973 to section 170(b)(1)(A)
organizations ($10,000)).........................
------------------------------------------------------------------------
(e) It is assumed that H and W made no contributions of 30-percent
capital gain property during these years. If they had made such
contributions, there would have been similar adjustments based on 30
percent of the contribution base.
(ii) Change from separate returns to joint return. If in the case of
a husband and wife:
(a) Either or both of the spouses make a separate return for a
contribution year and compute an excess charitable contribution for such
year in accordance with the provisions of paragraph (b)(1) or (c)(1) of
this section and subparagraph (1) of this paragraph, and
(b) Such husband and wife make a joint return for one or more of the
taxable years succeeding such contribution year, the excess charitable
contribution of the husband and wife for the contribution year which is
unused at the beginning of the first taxable year for which a joint
return is filed shall be aggregated for purposes of determining the
portion of such unused charitable contribution which shall be treated in
accordance with paragraph (b)(2) or (c)(2) of this section as a
charitable contribution paid to a section 170(b)(1)(A) organization. The
provisions of this subdivision also apply in the case of two single
individuals who are subsequently married and file a joint return. A
remarried taxpayer who filed a joint return with a former spouse in a
contribution year with respect to which an excess charitable
contribution was computed and who in any one of the 5 taxable years
succeeding such contribution year files a joint return with his or her
present spouse shall treat the unused portion of such excess charitable
contribution allocated to him or her in accordance with subdivision (i)
of this subparagraph in the same manner as the unused portion of an
excess charitable contribution computed in a contribution year in which
he filed a separate return, for purposes of determining the amount which
in accordance with paragraph (b)(2) or (c)(2) of this section shall be
treated as paid to an organization specified in section 170(b)(1)(A) in
such succeeding year.
(iii) Unused excess charitable contribution of deceased spouse. In
case of the death of one spouse, any unused portion of an excess
charitable contribution which is allocable in accordance with
subdivision (i) of this subparagraph to such spouse shall not be treated
as paid in the taxable year in which such death occurs or in any
subsequent taxable year except on a separate return made for the
deceased spouse by a fiduciary for the taxable year which ends with the
date of death or on a joint return for the taxable year in which such
death occurs. The application of this subdivision may be illustrated by
the following example:
Example. Assume the same facts as in the example in subdivision (i)
of this subparagraph except that H dies in 1972 and W files a separate
return for 1973. W made a joint return for herself and H for 1972. In
the example, the unused excess charitable contribution as of January 1,
1973, was $10,000, $6,000 of which was allocable to H and $4,000 to W.
No portion of the $6,000 allocable to H may be treated as paid by W or
any other person in 1973 or any subsequent year.
(e) Information required in support of a deduction of an amount
carried over and treated as paid. If, in a taxable year, a deduction is
claimed in respect of an excess charitable contribution which, in
accordance with the provisions of
[[Page 92]]
paragraph (b)(2) or (c)(2) of this section, is treated (in whole or in
part) as paid in such taxable year, the taxpayer shall attach to his
return a statement showing:
(1) The contribution year (or years) in which the excess charitable
contributions were made,
(2) The excess charitable contributions made in each contribution
year, and the amount of such excess charitable contributions consisting
of 30-percent capital gain property,
(3) The portion of such excess, or of each such excess, treated as
paid in accordance with paragraph (b)(2) or (c)(2) of this section in
any taxable year intervening between the contribution year and the
taxable year for which the return is made, and the portion of such
excess which consists of 30-percent capital gain property.
(4) Whether or not an election under section 170(b)(1)(D)(iii) has
been made which affects any of such excess contributions of 30-percent
capital gain property, and
(5) Such other information as the return or the instructions
relating thereto may require.
(f) Effective date. This section applies only to contributions paid
in taxable years beginning after December 31, 1969. For purposes of
applying section 170(d)(1) with respect to contributions paid in a
taxable year beginning before January 1, 1970, subsection (b)(1)(D),
subsection (e), and paragraphs (1), (2), (3), and (4) of subsection (f)
of section 170 shall not apply. See section 201(g)(1)(D) of the Tax
Reform Act of 1969 (83 Stat. 564).
[T.D. 7207, 37 FR 20787, Oct. 4, 1972; 37 FR 22982, Oct. 27, 1972, as
amended by T.D. 7340, 40 FR 1240, Jan. 7, 1975]
Sec. 1.170A-11 Limitation on, and carryover of, contributions by corporations.
(a) In general. The deduction by a corporation in any taxable year
for charitable contributions, as defined in section 170(c), is limited
to 5 percent of its taxable income for the year, computed without regard
to:
(1) The deduction under section 170 for charitable contributions,
(2) The special deductions for corporations allowed under Part VIII
(except section 248), Subchapter B, Chapter 1 of the Code,
(3) Any net operating loss carryback to the taxable year under
section 172, and
(4) Any capital loss carryback to the taxable year under section
1212(a)(1).
A charitable contribution by a corporation to a trust, chest, fund, or
foundation described in section 170(c)(2) is deductible under section
170 only if the contribution is to be used in the United States or its
possessions exclusively for religious, charitable, scientific, literary,
or educational purposes or for the prevention of cruelty to children or
animals. For the purposes of section 170, amounts excluded from the
gross income of a corporation under section 114, relating to sports
programs conducted for the American National Red Cross, are not to be
considered contributions or gifts.
(b) Election by corporations on an accrual method. (1) A corporation
reporting its taxable income on an accrual method may elect to have a
charitable contribution treated as paid during the taxable year, if
payment is actually made on or before the 15th day of the third month
following the close of such year and if, during such year, its board of
directors authorizes the charitable contribution. If by reason of such
an election a charitable contribution (other than a contribution of a
letter, memorandum, or property similar to a letter or memorandum) paid
in a taxable year beginning after December 31, 1969, is treated as paid
during a taxable year beginning before January 1, 1970, the provisions
of Sec. 1.170A-4 shall not be applied to reduce the amount of such
contribution. However, see section 170(e) before its amendment by the
Tax Reform Act of 1969.
(2) The election must be made at the time the return for the taxable
year is filed, by reporting the contribution on the return. There shall
be attached to the return when filed a written declaration stating that
the resolution authorizing the contribution was adopted by the board of
directors during the taxable year. For taxable years beginning before
January 1, 2003, the declaration shall be verified by a statement signed
by an officer authorized to sign the return that it is made under
[[Page 93]]
penalties of perjury, and there shall also be attached to the return
when filed a copy of the resolution of the board of directors
authorizing the contribution. For taxable years beginning after December
31, 2002, the declaration must also include the date of the resolution,
the declaration shall be verified by signing the return, and a copy of
the resolution of the board of directors authorizing the contribution is
a record that the taxpayer must retain and keep available for inspection
in the manner required by Sec. 1.6001-1(e).
(c) Charitable contributions carryover of corporations--(1) In
general. Subject to the reduction provided in subparagraph (2) of this
paragraph, any charitable contributions made by a corporation in a
taxable year (hereinafter in this paragraph referred to as the
``contribution year'') in excess of the amount deductible in such
contribution year under the 5-percent limitation of section 170(b)(2)
are deductible in each of the five succeeding taxable years in order of
time, but only to the extent of the lesser of the following amounts:
(i) The excess of the maximum amount deductible for such succeeding
taxable year under the 5-percent limitation of section 170(b)(2) over
the sum of the charitable contributions made in that year plus the
aggregate of the excess contributions which were made in taxable years
before the contribution year and which are deductible under this
paragraph in such succeeding taxable year; or
(ii) In the case of the first taxable year succeeding the
contribution year, the amount of the excess charitable contributions,
and in the case of the second, third, fourth, and fifth taxable years
succeeding the contribution year, the portion of the excess charitable
contributions not deductible under this subparagraph for any taxable
year intervening between the contribution year and such succeeding
taxable year.
This paragraph applies to excess charitable contributions by a
corporation, whether or not such contributions are made to, or for the
use of, the donee organization and whether or not such organization is a
section 170(b)(1)(A) organization, as defined in Sec. 1.170A-9. For
purposes of applying this paragraph, a charitable contribution made in a
taxable year beginning before January 1, 1970, which is carried over to
taxable year beginning after December 31, 1969, under section 170(b)(2)
(before its amendment by the Tax Reform Act of 1969) and is deductible
in such taxable year beginning after December 31, 1969, shall be treated
as deductible under section 170(d)(1) and this paragraph. The
application of this subparagraph may be illustrated by the following
example:
Example. A corporation which reports its income on the calendar year
basis makes a charitable contribution of $20,000 in 1970. Its taxable
income (determined without regard to any deduction for charitable
contributions) for 1970 is $100,000. Accordingly, the charitable
contributions deduction for that year is limited to $5,000 (5 percent of
$100,000). The excess charitable contribution not deductible in 1970
($15,000) is a carryover to 1971. The corporation has taxable income
(determined without regard to any deduction for charitable
contributions) of $150,000 in 1971 and makes a charitable contribution
of $5,000 in that year. For 1971 the corporation may deduct as a
charitable contribution the amount of $7,500 (5 percent of $150,000).
This amount consists of the $5,000 contribution made in 1971 and of the
$2,500 carried over from 1970. The remaining $12,500 carried over from
1970 and not allowable as a deduction for 1971 because of the 5-percent
limitation may be carried over to 1972. The corporation has taxable
income (determined without regard to any deduction for charitable
contributions) of $200,000 in 1972 and makes a charitable contribution
of $5,000 in that year. For 1972 the corporation may deduct the amount
of $10,000 (5 percent of $200,000). This amount consists of the $5,000
contributed in 1972, and $5,000 of the $12,500 carried over from 1970 to
1972. The remaining $7,500 of the carryover from 1970 is available for
purposes of computing the charitable contributions carryover from 1970
to 1973, 1974, and 1975.
(2) Effect of net operating loss carryovers on carryover of excess
contributions. A corporation having a net operating loss carryover from
any taxable year must apply the special rule of section 170(d)(2)(B) and
this subparagraph before computing under subparagraph (1) of this
paragraph the excess charitable contributions carryover from any taxable
year. In determining the amount of excess charitable contributions that
may be deducted in accordance with subparagraph (1) of this paragraph in
taxable years succeeding
[[Page 94]]
the contribution year, the excess of the charitable contributions made
by a corporation in the contributions year over the amount deductible in
such year must be reduced by the amount by which such excess reduces
taxable income for purposes of determining the net operating loss
carryover under the second sentence of section 172(b)(2)) and increases
a net operating loss carryover to a succeeding taxable year. Thus, if
the excess of the contributions made in a taxable year over the amount
deductible in the taxable year is utilized to reduce taxable income
(under the provisions of section 172(b)(2)) for such year, thereby
serving to increase the amount of the net operating loss carryover to a
succeeding taxable year or years, no charitable contributions carryover
will be allowed. If only a portion of the excess charitable
contributions is so used, the charitable contributions carryover will be
reduced only to that extent. The application of this subparagraph may be
illustrated by the following example:
Example. A corporation, which reports its income on the calendar
year basis, makes a charitable contribution of $10,000 during 1971. Its
taxable income for 1971 is $80,000 (computed without regard to any net
operating loss deduction and computed in accordance with section
170(b)(2) without regard to any deduction for charitable contributions).
The corporation has a net operating loss carryover from 1970 of $80,000.
In the absence of the net operating loss deduction the corporation would
have been allowed a deduction for charitable contributions of $4,000 (5
percent of $80,000). After the application of the net operating loss
deduction the corporation is allowed no deduction for charitable
contributions, and there is a tentative charitable contribution
carryover from 1971 of $10,000. For purposes of determining the net
operating loss carryover to 1972 the corporation computes its taxable
income for 1971 under section 172(b)(2) by deducting the $4,000
charitable contribution. Thus, after the $80,000 net operating loss
carryover is applied against the $76,000 of taxable income for 1971
(computed in accordance with section 172(b)(2)), there remains a $4,000
net operating loss carryover to 1972. Since the application of the net
operating loss carryover of $80,000 from 1970 reduces the taxable income
for 1971 to zero, no part of the $10,000 of charitable contributions in
that year is deductible under section 170(b)(2). However, in determining
the amount of the allowable charitable contributions carryover from 1971
to 1972, 1973, 1974, 1975, and 1976, the $10,000 must be reduced by the
portion thereof ($4,000) which was used to reduce taxable income for
1971 (as computed for purposes of the second sentence of section
172(b)(2)) and which thereby served to increase the net operating loss
carryover from 1970 to 1972 from zero to $4,000.
(3) Effect of net operating loss carryback to contribution year. The
amount of the excess contribution for a contribution year computed as
provided in subparagraph (1) of this paragraph shall not be increased
because a net operating loss carryback is available as a deduction in
the contribution year. In addition, in determining under the provisions
of section 172(b)(2) the amount of the net operating loss for any year
subsequent to the contribution year which is a carryback or carryover to
taxable years succeeding the contribution year, the amount of any
charitable contributions shall be limited to the amount of such
contributions which did not exceed 5 percent of the donor's taxable
income, computed as provided in paragraph (a) of this section and
without regard to any of the modifications referred to in section
172(d), for the contribution year. For illustrations see paragraph
(d)(2) of Sec. 1.170A-10.
(4) Effect of net operating loss carryback to taxable year
succeeding the contribution year. The amount of the charitable
contribution from a preceding taxable year which is deductible (as
provided in this paragraph) in a current taxable year (hereinafter
referred to in this subparagraph as the ``deduction year'') shall not be
reduced because a net operating loss carryback is available as a
deduction in the deduction year. In addition, in determining under the
provisions of section 172(b)(2) the amount of the net operating loss for
any taxable year subsequent to the deduction year which is a carryback
or a carryover to taxable years succeeding the deduction year, the
amount of contributions made in the deduction year shall be limited to
the amount of such contributions, which were actually made in such year
and those which were deductible in such year under section 170(d)(2),
which did not exceed 5 percent of the donor's taxable income, computed
as provided in paragraph (a) of this section and
[[Page 95]]
without regard to any of the modifications referred to in section
172(d), for the deduction year.
(5) Year contribution is made. For purposes of this paragraph,
contributions made by a corporation in a contribution year include
contributions which, in accordance with the provisions of section
170(a)(2) and paragraph (b) of this section, are considered as paid
during such contribution year.
(d) Effective date. This section applies only to contributions paid
in taxable years beginning after December 31, 1969. For purposes of
applying section 170(d)(2) with respect to contributions paid, or
treated under section 170(a)(2) as paid, in a taxable year beginning
before January 1, 1970, subsection (e), and paragraphs (1), (2), (3),
and (4) of subsection (f) of section 170 shall not apply. See section
201(g)(1)(D) of the Tax Reform Act of 1969 (83 Stat. 564).
[T.D. 7207, 37 FR 20793, Oct. 4, 1972, as amended by T.D. 7807, 47 FR
4512, Feb. 1, 1982; T.D. 9100, 68 FR 70704, Dec. 19, 2003; T.D. 9300, 71
FR 71041, Dec. 8, 2006]
Sec. 1.170A-12 Valuation of a remainder interest in real property
for contributions made after July 31, 1969.
(a) In general. (1) Section 170(f)(4) provides that, in determining
the value of a remainder interest in real property for purposes of
section 170, depreciation and depletion of such property shall be taken
into account. Depreciation shall be computed by the straight line method
and depletion shall be computed by the cost depletion method. Section
170(f)(4) and this section apply only in the case of a contribution, not
made in trust, of a remainder interest in real property made after July
31, 1969, for which a deduction is otherwise allowable under section
170.
(2) In the case of the contribution of a remainder interest in real
property consisting of a combination of both depreciable and
nondepreciable property, or of both depletable and nondepletable
property, and allocation of the fair market value of the property at the
time of the contribution shall be made between the depreciable and
nondepreciable property, or the depletable and nondepletable property,
and depreciation or depletion shall be taken into account only with
respect to the depreciable or depletable property. The expected value at
the end of its ``estimated useful life'' (as defined in paragraph (d) of
this section) of that part of the remainder interest consisting of
depreciable property shall be considered to be nondepreciable property
for purposes of the required allocation. In the case of the contribution
of a remainder interest in stock in a cooperative housing corporation
(as defined in section 216(b)(1)), an allocation of the fair market
value of the stock at the time of the contribution shall be made to
reflect the respective values of the depreciable and nondepreciable
property underlying such stock, and depreciation on the depreciable part
shall be taken into account for purposes of valuing the remainder
interest in such stock.
(3) If the remainder interest that has been contributed follows only
one life, the value of the remainder interest shall be computed under
the rules contained in paragraph (b) of this section. If the remainder
interest that has been contributed follows a term for years, the value
of the remainder interest shall be computed under the rules contained in
paragraph (c) of this section. If the remainder interest that has been
contributed is dependent upon the continuation or the termination of
more than one life or upon a term certain concurrent with one or more
lives, the provisions of paragraph (e) of this section shall apply. In
every case where it is provided in this section that the rules contained
in Sec. 25.2512-5 (or, for certain prior periods, Sec. 25.2512-5A) of
this chapter (Gift Tax Regulations) apply, such rules shall apply
notwithstanding the general effective date for such rules contained in
paragraph (a) of such section. Except as provided in Sec. 1.7520-3(b)
of this chapter, for transfers of remainder interests after April 30,
1989, the present value of the remainder interest is determined under
Sec. 25.2512-5 of this chapter by use of the interest rate component on
the date the interest is transferred unless an election is made under
section 7520 and Sec. 1.7520-2 of this chapter to compute the present
value of the interest transferred by use of the interest rate component
for either of the 2 months preceding the month in which the interest
[[Page 96]]
is transferred. In some cases, a reduction in the amount of a charitable
contribution of a remainder interest, after the computation of its value
under section 170(f)(4) and this section, may be required. See section
170(e) and Sec. 1.170A-4.
(b) Valuation of a remainder interest following only one life--(1)
General rule. The value of a remainder interest in real property
following only one life is determined under the rules provided in Sec.
20.2031-7 (or for certain prior periods, Sec. 20.2031-7A) of this
chapter (Estate Tax Regulations), using the interest rate and life
contingencies prescribed for the date of the gift. See, however, Sec.
1.7520-3(b) (relating to exceptions to the use of prescribed tables
under certain circumstances). However, if any part of the real property
is subject to exhaustion, wear and tear, or obsolescence, the special
factor determined under paragraph (b)(2) of this section shall be used
in valuing the remainder interest in that part. Further, if any part of
the property is subject to depletion of its natural resources, such
depletion is taken into account in determining the value of the
remainder interest.
(2) Computation of depreciation factor. If the valuation of the
remainder interest in depreciable property is dependent upon the
continuation of one life, a special factor must be used. The factor
determined under this paragraph (b)(2) is carried to the fifth decimal
place. The special factor is to be computed on the basis of the interest
rate and life contingencies prescribed in Sec. 20.2031-7 of this
chapter (or for periods before May 1, 2009, Sec. 20.2031-7A) and on the
assumption that the property depreciates on a straight-line basis over
its estimated useful life. For transfers for which the valuation date is
on or after May 1, 2009, special factors for determining the present
value of a remainder interest following one life and an example
describing the computation are contained in Internal Revenue Service
Publication 1459, ``Actuarial Valuations Version 3C'' (2009). This
publication is available, at no charge, electronically via the IRS
Internet site at http://www.irs.gov. For transfers for which the
valuation date is after April 30, 1999, and before May 1, 2009, special
factors for determining the present value of a remainder interest
following one life and an example describing the computation are
contained in Internal Revenue Service Publication 1459, ``Actuarial
Values, Book Gimel,'' (7-99). For transfers for which the valuation date
is after April 30, 1989, and before May 1, 1999, special factors for
determining the present value of a remainder interest following one life
and an example describing the computation are contained in Internal
Revenue Service Publication 1459, ``Actuarial Values, Gamma Volume,''
(8-89). These publications are no longer available for purchase from the
Superintendent of Documents, United States Government Printing Office.
However, they may be obtained by requesting a copy from: CC:PA:LPD:PR
(IRS Publication 1459), room 5205, Internal Revenue Service, P.O.Box
7604, Ben Franklin Station, Washington, DC 20044. See, however, Sec.
1.7520-3(b) (relating to exceptions to the use of prescribed tables
under certain circumstances). Otherwise, in the case of the valuation of
a remainder interest following one life, the special factor may be
obtained through use of the following formula:
[GRAPHIC] [TIFF OMITTED] TR10AU11.000
Where:
n = the estimated number of years of useful life,
i = the applicable interest rate under section 7520 of the Internal
Revenue Code,
[[Page 97]]
v = 1 divided by the sum of 1 plus the applicable interest rate under
section 7520 of the Internal Revenue Code,
x = the age of the life tenant, and
lx = number of persons living at age x as set forth in Table 2000CM of
Sec. 20.2031-7 of this chapter (or, for periods before May 1,
2009, the tables set forth under Sec. 20.2031-7A).
(3) The following example illustrates the provisions of this
paragraph (b):
Example. A, who is 62, donates to Y University a remainder interest
in a personal residence, consisting of a house and land, subject to a
reserved life estate in A. At the time of the gift, the land has a value
of $30,000 and the house has a value of $100,000 with an estimated
useful life of 45 years, at the end of which period the value of the
house is expected to be $20,000. The portion of the property considered
to be depreciable is $80,000 (the value of the house ($100,000) less its
expected value at the end of 45 years ($20,000)). The portion of the
property considered to be nondepreciable is $50,000 (the value of the
land at the time of the gift ($30,000) plus the expected value of the
house at the end of 45 years ($20,000)). At the time of the gift, the
interest rate prescribed under section 7520 is 8.4 percent. Based on an
interest rate of 8.4 percent, the remainder factor for $1.00 prescribed
in Sec. 20.2031-7(d) for a person age 62 is 0.26534. The value of the
nondepreciable remainder interest is $13,267.00 (0.26534 times $50,000).
The value of the depreciable remainder interest is $15,053.60 (0.18817,
computed under the formula described in paragraph (b)(2) of this
section, times $80,000). Therefore, the value of the remainder interest
is $28,320.60.
(c) Valuation of a remainder interest following a term for years.
The value of a remainder interest in real property following a term for
years shall be determined under the rules provided in Sec. 25.2512-5
(or, for certain prior periods, Sec. 25.2512-5A) of this chapter (Gift
Tax Regulations) using Table B provided in Sec. 20.2031-7(d)(6) of this
chapter. However, if any part of the real property is subject to
exhaustion, wear and tear, or obsolescence, in valuing the remainder
interest in that part the value of such part is adjusted by subtracting
from the value of such part the amount determined by multiplying such
value by a fraction, the numerator of which is the number of years in
the term or, if less, the estimated useful life of the property, and the
denominator of which is the estimated useful life of the property. The
resultant figure is the value of the property to be used in Sec.
25.2512-5 (or, for certain prior periods, Sec. 25.2512-5A) of this
chapter (Gift Tax Regulations). Further, if any part of the property is
subject to depletion of its natural resources, such depletion shall be
taken into account in determining the value of the remainder interest.
The provisions of this paragraph as it relates to depreciation are
illustrated by the following example:
Example. In 1972, B donates to Z University a remainder interest in
his personal residence, consisting of a house and land, subject to a 20
year term interest provided for his sister. At such time the house has a
value of $60,000, and an expected useful life of 45 years, at the end of
which time it is expected to have a value of $10,000, and the land has a
value of $8,000. The value of the portion of the property considered to
be depreciable is $50,000 (the value of the house ($60,000) less its
expected value at the end of 45 years ($10,000)), and this is multiplied
by the fraction 20/45. The product, $22,222.22, is subtracted from
$68,000, the value of the entire property, and the balance, $45,777.78,
is multiplied by the factor .311805 (see Sec. 25.2512-5A(c)). The
result, $14,273.74, is the value of the remainder interest in the
property.
(d) Definition of estimated useful life. For the purposes of this
section, the determination of the estimated useful life of depreciable
property shall take account of the expected use of such property during
the period of the life estate or term for years. The term ``estimated
useful life'' means the estimated period (beginning with the date of the
contribution) over which such property may reasonably be expected to be
useful for such expected use. This period shall be determined by
reference to the experience based on any prior use of the property for
such purposes if such prior experience is adequate. If such prior
experience is inadequate or if the property has not been previously used
for such purposes, the estimated useful life shall be determined by
reference to the general experience of persons normally holding similar
property for such expected use, taking into account present conditions
and probable future developments. The estimated useful life of such
depreciable property is not limited to the period of the life estate or
term for years preceding the remainder interest. In determining the
expected use and the estimated useful
[[Page 98]]
life of the property, consideration is to be given to the provisions of
the governing instrument creating the life estate or term for years or
applicable local law, if any, relating to use, preservation, and
maintenance of the property during the life estate or term for years. In
arriving at the estimated useful life of the property, estimates, if
available, of engineers or other persons skilled in estimating the
useful life of similar property may be taken into account. At the option
of the taxpayer, the estimated useful life of property contributed after
December 31, 1970, for purposes of this section, shall be an asset
depreciation period selected by the taxpayer that is within the
permissible asset depreciation range for the relevant asset guideline
class established pursuant to Sec. 1.167(a)-11(b) (4)(ii). For purposes
of the preceding sentence, such period, range, and class shall be those
which are in effect at the time that the contribution of the remainder
interest was made. At the option of the taxpayer, in the case of
property contributed before January 1, 1971, the estimated useful life,
for purposes of this section, shall be the guideline life provided in
Revenue Procedure 62-21 for the relevant asset guideline class.
(e) Valuation of a remainder interest following more than one life
or a term certain concurrent with one or more lives. (1)(i) If the
valuation of the remainder interest in the real property is dependent
upon the continuation or the termination of more than one life or upon a
term certain concurrent with one or more lives, a special factor must be
used.
(ii) The special factor is to be computed on the basis of--
(A) Interest at the rate prescribed under Sec. 25.2512-5 (or, for
certain prior periods, Sec. 25.2512-5A) of this chapter, compounded
annually;
(B) Life contingencies determined from the values that are set forth
in the mortality table in Sec. 20.2031-7 (or, for certain prior
periods, Sec. 20.2031-7A) of this chapter; and
(C) If depreciation is involved, the assumption that the property
depreciates on a straight-line basis over its estimated useful life.
(iii) If any part of the property is subject to depletion of its
natural resources, such depletion must be taken into account in
determining the value of the remainder interest.
(2) In the case of the valuation of a remainder interest following
two lives, the special factor may be obtained through use of the
following formula:
[GRAPHIC] [TIFF OMITTED] TR10JN94.001
Where:
n = the estimated number of years of useful life,
i = the applicable interest rate under section 7520 of the Internal
Revenue Code,
v = 1 divided by the sum of 1 plus the applicable interest rate under
section 7520 of the Internal Revenue Code,
x and y = the ages of the life tenants, and
lx and ly = the number of persons living at ages x and y as set forth in
Table 2000CM in Sec. 20.2031-7 (or, for prior periods, in
Sec. 20.2031-7A) of this chapter.
(3) Notwithstanding that the taxpayer may be able to compute the
special factor in certain cases under paragraph (2), if a special factor
is required in the case of an actual contribution, the Commissioner will
furnish the factor to the donor upon request. The request must be
accompanied by a statement of the sex and date of birth of each person
the duration of whose life may affect the value of the remainder
interest, copies of the relevant instruments, and, if depreciation is
involved, a statement of the estimated useful life of the depreciable
property. However, since remainder interests in that part of any
property which is depletable cannot be valued on a purely actuarial
[[Page 99]]
basis, special factors will not be furnished with respect to such part.
Requests should be forwarded to the Commissioner of Internal Revenue,
Attention: OP:E:EP:A:1, Washington, DC 20224.
(f) Effective/applicability date. This section applies to
contributions made after July 31, 1969, except that paragraphs (b)(2)
and (b)(3) apply to all contributions made on or after May 1, 2009.
[T.D. 7370, 40 FR 34337, Aug. 15, 1975, as amended by T.D. 7955, 49 FR
19975, May 11, 1984; T.D. 8540, 59 FR 30102, 30104, June 10, 1994; T.D.
8819, 64 FR 23228, Apr. 30, 1999; T.D. 8886, 65 FR 36909, 36943, June
12, 2000; T.D. 9448, 74 FR 21439, 21518, May 7, 2009; 74 FR 27079, June
8, 2009; T.D. 9540, 76 FR 49571, 49612, Aug. 10, 2011]
Sec. 1.170A-13 Recordkeeping and return requirements for deductions
for charitable contributions.
(a) Charitable contributions of money made in taxable years
beginning after December 31, 1982--(1) In general. If a taxpayer makes a
charitable contribution of money in a taxable year beginning after
December 31, 1982, the taxpayer shall maintain for each contribution one
of the following:
(i) A cancelled check.
(ii) A receipt from the donee charitable organization showing the
name of the donee, the date of the contribution, and the amount of the
contribution. A letter or other communication from the donee charitable
organization acknowledging receipt of a contribution and showing the
date and amount of the contribution constitutes a receipt for purposes
of this paragraph (a).
(iii) In the absence of a canceled check or receipt from the donee
charitable organization, other reliable written records showing the name
of the donee, the date of the contribution, and the amount of the
contribution.
(2) Special rules--(i) Reliability of records. The reliability of
the written records described in paragraph (a)(1)(iii) of this section
is to be determined on the basis of all of the facts and circumstances
of a particular case. In all events, however, the burden shall be on the
taxpayer to establish reliability. Factors indicating that the written
records are reliable include, but are not limited to:
(A) The contemporaneous nature of the writing evidencing the
contribution.
(B) The regularity of the taxpayer's recordkeeping procedures. For
example, a contemporaneous diary entry stating the amount and date of
the donation and the name of the donee charitable organization made by a
taxpayer who regularly makes such diary entries would generally be
considered reliable.
(C) In the case of a contribution of a small amount, the existence
of any written or other evidence from the donee charitable organization
evidencing receipt of a donation that would not otherwise constitute a
receipt under paragraph (a)(1)(ii) of this section (including an emblem,
button, or other token traditionally associated with a charitable
organization and regularly given by the organization to persons making
cash donations).
(ii) Information stated in income tax return. The information
required by paragraph (a)(1)(iii) of this section shall be stated in the
taxpayer's income tax return if required by the return form or its
instructions.
(3) Taxpayer option to apply paragraph (d)(1) to pre-1985
contribution. See paragraph (d)(1) of this section with regard to
contributions of money made on or before December 31, 1984.
(b) Charitable contributions of property other than money made in
taxable years beginning after December 31, 1982--(1) In general. Except
in the case of certain charitable contributions of property made after
December 31, 1984, to which paragraph (c) of this section applies, any
taxpayer who makes a charitable contribution of property other than
money in a taxable year beginning after December 31, 1982, shall
maintain for each contribution a receipt from the donee showing the
following information:
(i) The name of the donee.
(ii) The date and location of the contribution.
(iii) A description of the property in detail reasonably sufficient
under the circumstances. Although the fair market value of the property
is one of the circumstances to be taken into account in determining the
amount of detail to be included on the receipt, such value need not be
stated on the receipt.
[[Page 100]]
A letter or other written communication from the donee acknowledging
receipt of the contribution, showing the date of the contribution, and
containing the required description of the property contributed
constitutes a receipt for purposes of this paragraph. A receipt is not
required if the contribution is made in circumstances where it is
impractical to obtain a receipt (e.g., by depositing property at a
charity's unattended drop site). In such cases, however, the taxpayer
shall maintain reliable written records with respect to each item of
donated property that include the information required by paragraph
(b)(2)(ii) of this section.
(2) Special rules--(i) Reliability of records. The rules described
in paragraph (a)(2)(i) of this section also apply to this paragraph (b)
for determining the reliability of the written records described in
paragraph (b)(1) of this section
(ii) Content of records. The written records described in paragraph
(b)(1) of this section shall include the following information and such
information shall be stated in the taxpayers income tax return if
required by the return form or its instructions:
(A) The name and address of the donee organization to which the
contribution was made.
(B) The date and location of the contribution.
(C) A description of the property in detail reasonable under the
circumstances (including the value of the property), and, in the case of
securities, the name of the issuer, the type of security, and whether or
not such security is regularly traded on a stock exchange or in an over-
the-counter market.
(D) The fair market value of the property at the time the
contribution was made, the method utilized in determining the fair
market value, and, if the valuation was determined by appraisal, a copy
of the signed report of the appraiser.
(E) In the case of property to which section 170(e) applies, the
cost or other basis, adjusted as provided by section 1016, the reduction
by reason of section 170(e)(1) in the amount of the charitable
contribution otherwise taken into account, and the manner in which such
reduction was determined. A taxpayer who elects under paragraph (d)(2)
of Sec. 1.170A-8 to apply section 170(e)(1) to contributions and
carryovers of 30 percent capital gain property shall maintain a written
record indicating the years for which the election was made and showing
the contributions in the current year and carryovers from preceding
years to which it applies. For the definition of the term ``30-percent
capital gain property,'' see paragraph (d)(3) of Sec. 1.170A-8.
(F) If less than the entire interest in the property is contributed
during the taxable year, the total amount claimed as a deduction for the
taxable year due to the contribution of the property, and the amount
claimed as a deduction in any prior year or years for contributions of
other interests in such property, the name and address of each
organization to which any such contribution was made, the place where
any such property which is tangible property is located or kept, and the
name of any person, other than the organization to which the property
giving rise to the deduction was contributed, having actual possession
of the property.
(G) The terms of any agreement or understanding entered into by or
on behalf of the taxpayer which relates to the use, sale, or other
disposition of the property contributed, including for example, the
terms of any agreement or understanding which:
(1) Restricts temporarily or permanently the donee's right to use or
dispose of the donated property,
(2) Reserves to, or confers upon, anyone (other than the donee
organization or an organization participating with the donee
organization in cooperative fundraising) any right to the income from
the donated property or to the possession of the property, including the
right to vote donated securities, to acquire the property by purchase or
otherwise, or to designate the person having such income, possession, or
right to acquire, or
(3) Earmarks donated property for a particular use.
(3) Deductions in excess of $500 claimed for a charitable
contribution of property other than money--(i) In general. In addition
to the information required
[[Page 101]]
under paragraph (b)(2)(ii) of this section, if a taxpayer makes a
charitable contribution of property other than money in a taxable year
beginning after December 31, 1982, and claims a deduction in excess of
$500 in respect of the contribution of such item, the taxpayer shall
maintain written records that include the following information with
respect to such item of donated property, and shall state such
information in his or her income tax return if required by the return
form or its instructions:
(A) The manner of acquisition, as for example by purchase, gift
bequest, inheritance, or exchange, and the approximate date of
acquisition of the property by the taxpayer or, if the property was
created, produced, or manufactured by or for the taxpayer, the
approximate date the property was substantially completed.
(B) The cost or other basis, adjusted as provided by section 1016,
of property, other than publicly traded securities, held by the taxpayer
for a period of less than 12 months (6 months for property contributed
in taxable years beginning after December 31, 1982, and on or before
June 6, 1988, immediately preceding the date on which the contribution
was made and, when the information is available, of property, other than
publicly traded securities, held for a period of 12 months or more (6
months or more for property contributed in taxable years beginning after
December 31, 1982, and on or before June 6, 1988, preceding the date on
which the contribution was made.
(ii) Information on acquisition date or cost basis not available. If
the return form or its instructions require the taxpayer to provide
information on either the acquisition date of the property or the cost
basis as described in paragraph (b)(3)(i) (A) and (B), respectively, of
this section, and the taxpayer has reasonable cause for not being able
to provide such information, the taxpayer shall attach an explanatory
statement to the return. If a taxpayer has reasonable cause for not
being able to provide such information, the taxpayer shall not be
disallowed a charitable contribution deduction under section 170 for
failure to comply with paragraph (b)(3)(i) (A) and (B) of the section.
(4) Taxpayer option to apply paragraph (d) (1) and (2) to pre-1985
contributions. See paragraph (d) (1) and (2) of this section with regard
to contributions of property made on or before December 31, 1984.
(c) Deductions in excess of $5,000 for certain charitable
contributions of property made after December 31, 1984--(1) General
Rule--(i) In general. This paragraph applies to any charitable
contribution made after December 31, 1984, by an individual, closely
held corporation, personal service corporation, partnership, or S
corporation of an item of property (other than money and publicly traded
securities to which Sec. 1.170A-13(c)(7)(xi)(B) does not apply if the
amount claimed or reported as a deduction under section 170 with respect
to such item exceeds $5,000. This paragraph also applies to charitable
contributions by C corporations (as defined in section 1361(a)(2) of the
Code) to the extent described in paragraph (c)(2)(ii) of this section.
No deduction under section 170 shall be allowed with respect to a
charitable contribution to which this paragraph applies unless the
substantiation requirements described in paragraph (c)(2) of this
section are met. For purposes of this paragraph (c), the amount claimed
or reported as a deduction for an item of property is the aggregate
amount claimed or reported as a deduction for a charitable contribution
under section 170 for such items of property and all similar items of
property (as defined in paragraph (c)(7)(iii) of this section) by the
same donor for the same taxable year (whether or not donated to the same
donee).
(ii) Special rule for property to which section 170(e) (3) or (4)
applies. For purposes of this paragraph (c), in computing the amount
claimed or reported as a deduction for donated property to which section
170(e) (3) or (4) applies (pertaining to certain contributions of
inventory and scientific equipment) there shall be taken into account
only the amount claimed or reported as a deduction in excess of the
amount which would have been taken into account for tax purposes by the
donor as costs of goods sold if the donor had sold
[[Page 102]]
the contributed property to the donee. For example, assume that a donor
makes a contribution from inventory of clothing for the care of the
needy to which section 170(e)(3) applies. The cost of the property to
the donor was $5,000, and, pursuant to section 170(e)(3)(B), the donor
claims a charitable contribution deduction of $8,000 with respect to the
property. Therefore, $3,000 ($8,000-$5,000) is the amount taken into
account for purposes of determining whether the $5,000 threshold of this
paragraph (c)(1) is met.
(2) Substantiation requirements--(i) In general. Except as provided
in paragraph (c)(2)(ii) of this section, a donor who claims or reports a
deduction with respect to a charitable contribution to which this
paragraph (c) applies must comply with the following three requirements:
(A) Obtain a qualified appraisal (as defined in paragraph (c) (3) of
this section) for such property contributed. If the contributed property
is a partial interest, the appraisal shall be of the partial interest.
(B) Attach a fully completed appraisal summary (as defined in
paragraph (c) (4) of this section) to the tax return (or, in the case of
a donor that is a partnership or S corporation, the information return)
on which the deduction for the contribution is first claimed (or
reported) by the donor.
(C) Maintain records containing the information required by
paragraph (b) (2) (ii) of this section.
(ii) Special rules for certain nonpublicly traded stock, certain
publicly traded securities, and contributions by certain C corporations.
(A) In cases described in paragraph (c)(2)(ii)(B) of this section, a
qualified appraisal is not required, and only a partially completed
appraisal summary form (as described in paragraph (c)(4)(iv)(A) of this
section) is required to be attached to the tax or information return
specified in paragraph (c)(2)(i)(B) of this section. However, in all
cases donors must maintain records containing the information required
by paragraph (b)(2)(ii) of this section.
(B) This paragraph (c)(2)(ii) applies in each of the following
cases:
(1) The contribution of nonpublicly traded stock, if the amount
claimed or reported as a deduction for the charitable contribution of
such stock is greater than $5,000 but does not exceed $10,000;
(2) The contribution of a security to which paragraph (c)(7)(xi)(B)
of this section applies; and
(3) The contribution of an item of property or of similar items of
property described in paragraph (c)(1) of this section made after June
6, 1988, by a C corporation (as defined in section 1361(a)(2) of the
Code), other than a closely held corporation or a personal service
corporation.
(3) Qualified appraisal--(i) In general. For purposes of this
paragraph (c), the term ``qualified appraisal'' means an appraisal
document that--
(A) Relates to an appraisal that is made not earlier than 60 days
prior to the date of contribution of the appraised property nor later
than the date specified in paragraph (c)(3)(iv)(B) of this section;
(B) Is prepared, signed, and dated by a qualified appraiser (within
the meaning of paragraph (c)(5) of this section);
(C) Includes the information required by paragraph (c)(3)(ii) of
this section; and
(D) Does not involve an appraisal fee prohibited by paragraph (c)(6)
of this section.
(ii) Information included in qualified appraisal. A qualified
appraisal shall include the following information:
(A) A description of the property in sufficient detail for a person
who is not generally familiar with the type of property to ascertain
that the property that was appraised is the property that was (or will
be) contributed;
(B) In the case of tangible property, the physical condition of the
property;
(C) The date (or expected date) of contribution to the donee;
(D) The terms of any agreement or understanding entered into (or
expected to be entered into) by or on behalf of the donor or donee that
relates to the use, sale, or other disposition of the property
contributed, including, for example, the terms of any agreement or
understanding that--
(1) Restricts temporarily or permanently a donee's right to use or
dispose of the donated property,
[[Page 103]]
(2) Reserves to, or confers upon, anyone (other than a donee
organization or an organization participating with a donee organization
in cooperative fundraising) any right to the income from the contributed
property or to the possession of the property, including the right to
vote donated securities, to acquire the property by purchase or
otherwise, or to designate the person having such income, possession, or
right to acquire, or
(3) Earmarks donated property for a particular use;
(E) The name, address, and (if a taxpayer identification number is
otherwise required by section 6109 and the regulations thereunder) the
identifying number of the qualified appraiser; and, if the qualified
appraiser is acting in his or her capacity as a partner in a
partnership, an employee of any person (whether an individual,
corporation, or partnerships), or an independent contractor engaged by a
person other than the donor, the name, address, and taxpayer
identification number (if a number is otherwise required by section 6109
and the regulations thereunder) of the partnership or the person who
employs or engages the qualified appraiser;
(F) The qualifications of the qualified appraiser who signs the
appraisal, including the appraiser's background, experience, education,
and membership, if any, in professional appraisal associations;
(G) A statement that the appraisal was prepared for income tax
purposes;
(H) The date (or dates) on which the property was appraised;
(I) The appraised fair market value (within the meaning of Sec.
1.170A-1 (c)(2)) of the property on the date (or expected date) of
contribution;
(J) The method of valuation used to determine the fair market value,
such as the income approach, the market-data approach, and the
replacement-cost-less-depreciation approach; and
(K) The specific basis for the valuation, such as specific
comparable sales transactions or statistical sampling, including a
justification for using sampling and an explanation of the sampling
procedure employed.
(iii) Effect of signature of the qualified appraiser. Any appraiser
who falsely or fraudulently overstates the value of the contributed
property referred to in a qualified appraisal or appraisal summary (as
defined in paragraphs (c) (3) and (4), respectively, of this section)
that the appraiser has signed may be subject to a civil penalty under
section 6701 for aiding and abetting an understatement of tax liability
and, moreover, may have appraisals disregarded pursuant to 31 U.S.C.
330(c).
(iv) Special rules--(A) Number of qualified appraisals. For purposes
of paragraph (c)(2)(i)(A) of this section, a separate qualified
appraisal is required for each item of property that is not included in
a group of similar items of property. See paragraph (c)(7)(iii) of this
section for the definition of similar items of property. Only one
qualified appraisal is required for a group of similar items of property
contributed in the same taxable year of the donor, although a donor may
obtain separate qualified appraisals for each item of property. A
qualified appraisal prepared with respect to a group of similar items of
property shall provide all the information required by paragraph
(c)(3)(ii) of this section for each item of similar property, except
that the appraiser may select any items whose aggregate value is
appraised at $100 or less and provide a group description of such items.
(B) Time of receipt of qualified appraisal. The qualified appraisal
must be received by the donor before the due date (including extensions)
of the return on which a deduction is first claimed (or reported in the
case of a donor that is a partnership or S corporation) under section
170 with respect to the donated property, or, in the case of a deduction
first claimed (or reported) on an amended return, the date on which the
return is filed.
(C) Retention of qualified appraisal. The donor must retain the
qualified appraisal in the donor's records for so long as it may be
relevant in the administration of any internal revenue law.
(D) Appraisal disregarded pursuant to 31 U.S.C. 330(c). If an
appraisal is disregarded pursuant to 31 U.S.C. 330(c) it shall have no
probative effect as to the value of the appraised property. Such
[[Page 104]]
appraisal will, however, otherwise constitute a ``qualified appraisal''
for purposes of this paragraph (c) if the appraisal summary includes the
declaration described in paragraph (c)(4)(ii)(L)(2) and the taxpayer had
no knowledge that such declaration was false as of the time described in
paragraph (c)(4)(i)(B) of this section.
(4) Appraisal summary--(i) In general. For purposes of this
paragraph (c), except as provided in paragraph (c)(4)(iv)(A) of this
section, the term appraisal summary means a summary of a qualified
appraisal that--
(A) Is made on the form prescribed by the Internal Revenue Service;
(B) Is signed and dated (as described in paragraph (c)(4)(iii) of
this section) by the donee (or presented to the donee for signature in
cases described in paragraph (c)(4)(iv)(C)(2) of this section);
(C) Is signed and dated by the qualified appraiser (within the
meaning of paragraph (c)(5) of this section) who prepared the qualified
appraisal (within the meaning of paragraph (c)(3) of this section); and
(D) Includes the information required by paragraph (c)(4)(ii) of
this section.
(ii) Information included in an appraisal summary. An appraisal
summary shall include the following information:
(A) The name and taxpayer identification number of the donor (social
security number if the donor is an individual or employer identification
number if the donor is a partnership or corporation);
(B) A description of the property in sufficient detail for a person
who is not generally familiar with the type of property to ascertain
that the property that was appraised is the property that was
contributed;
(C) In the case of tangible property, a brief summary of the overall
physical condition of the property at the time of the contribution;
(D) The manner of acquisition (e.g., purchase, exchange, gift, or
bequest) and the date of acquisition of the property by the donor, or,
if the property was created, produced, or manufactured by or for the
donor, a statment to that effect and the approximate date the property
was substantially completed;
(E) The cost or other basis of the property adjusted as provided by
section 1016;
(F) The name, address, and taxpayer identification number of the
donee;
(G) The date the donee received the property;
(H) For charitable contributions made after June 6, 1988, a
statement explaining whether or not the charitable contribution was made
by means of a bargain sale and the amount of any consideration received
from the donee for the contribution;
(I) The name, address, and (if a taxpayer identification number is
otherwise required by section 6109 and the regulations thereunder) the
identifying number of the qualified appraiser who signs the appraisal
summary and of other persons as required by paragraph (c)(3)(ii)(E) of
this section;
(J) The appraised fair market value of the property on the date of
contribution;
(K) The declaration by the appraiser described in paragraph
(c)(5)(i) of this section;
(L) A declaration by the appraiser stating that--
(1) The fee charged for the appraisal is not of a type prohibited by
paragraph (c)(6) of this section; and
(2) Appraisals prepared by the appraiser are not being disregarded
pursuant to 31 U.S.C. 330(c) on the date the appraisal summary is signed
by the appraiser; and
(M) Such other information as may be specified by the form.
(iii) Signature of the original donee. The person who signs the
appraisal summary for the donee shall be an official authorized to sign
the tax or information returns of the donee, or a person specifically
authorized to sign appraisal summaries by an official authorized to sign
the tax or information returns of such done. In the case of a donee that
is a governmental unit, the person who signs the appraisal summary for
such donee shall be the official authorized by such donee to sign
appraisal summaries. The signature of the donee on the appraisal summary
does not represent concurrence in the appraised value of the contributed
[[Page 105]]
property. Rather, it represents acknowledgment of receipt of the
property described in the appraisal summary on the date specified in the
appraisal summary and that the donee understands the information
reporting requirements imposed by section 6050L and Sec. 1.6050L-1. In
general, Sec. 1.6050L-1 requires the donee to file an information
return with the Internal Revenue Service in the event the donee sells,
exchanges, consumes, or otherwise disposes of the property (or any
portion thereof) described in the appraisal summary within 2 years after
the date of the donor's contribution of such property.
(iv) Special rules--(A) Content of appraisal summary required in
certain cases. With respect to contributions of nonpublicly traded stock
described in paragraph (c)(2)(ii)(B)(1) of this section, contributions
of securities described in paragraph (c)(7)(xi)(B) of this section, and
contributions by C corporations described in paragraph (c)(2)(ii)(B)(3)
of this section, the term appraisal summary means a document that--
(1) Complies with the requirements of paragraph (c)(4)(i) (A) and
(B) of this section,
(2) Includes the information required by paragraph (c)(4)(ii) (A)
through (H) of this section,
(3) Includes the amount claimed or reported as a charitable
contribution deduction, and
(4) In the case of securities described in paragraph (c)(7)(xi)(B)
of this section, also includes the pertinent average trading price (as
described in paragraph (c)(7)(xi)(B)(2)(iii) of this section).
(B) Number of appraisal summaries. A separate appraisal summary for
each item of property described in paragraph (c)(1) of this section must
be attached to the donor's return. If, during the donor's taxable year,
the donor contributes similar items of property described in paragraph
(c)(1) of this section to more than one donee, the donor shall attach to
the donor's return a separate appraisal summary for each donee. See
paragraph (c)(7)(iii) of this section for the definition of similar
items of property. If, however, during the donor's taxable year, a donor
contributes similar items of property described in paragraph (c)(1) of
this section to the same donee, the donor may attach to the donor's
return a single appraisal summary with respect to all similar items of
property contributed to the same donee. Such an appraisal summary shall
provide all the information required by paragraph (c)(4)(ii) of this
section for each item of property, except that the appraiser may select
any items whose aggregate value is appraised at $100 or less and provide
a group description for such items.
(C) Manner of acquisition, cost basis and donee's signature. (1) If
a taxpayer has reasonable cause for being unable to provide the
information required by paragraph (c)(4)(ii) (D) and (E) of this section
(relating to the manner of acquisition and basis of the contributed
property), an appropriate explanation should be attached to the
appraisal summary. The taxpayer's deduction will not be disallowed
simply because of the inability (for reasonable cause) to provide these
items of information.
(2) In rare and unusual circumstances in which it is impossible for
the taxpayer to obtain the signature of the donee on the appraisal
summary as required by paragraph (c)(4)(i)(B) of this section, the
taxpayer's deduction will not be disallowed for that reason provided
that the taxpayer attaches a statement to the appraisal summary
explaining, in detail, why it was not possible to obtain the donee's
signature. For example, if the donee ceases to exist as an entity
subsequent to the date of the contribution and prior to the date when
the appraisal summary must be signed, and the donor acted reasonably in
not obtaining the donee's signature at the time of the contribution,
relief under this paragraph (c)(4)(iv)(C)(2) would generally be
appropriate.
(D) Information excluded from certain appraisal summaries. The
information required by paragraph (c)(4)(i)(C), paragraph (c)(4)(ii)
(D), (E), (H) through (M), and paragraph (c)(4)(iv)(A)(3), and the
average trading price referred to in paragraph (c)(4)(iv)(A)(4) of this
section do not have to be included on the appraisal summary at the time
it is
[[Page 106]]
signed by the donee or a copy is provided to the donee pursuant to
paragraph (c)(4)(iv)(E) of this section.
(E) Statement to be furnished by donors to donees. Every donor who
presents an appraisal summary to a donee for signature after June 6,
1988, in order to comply with paragraph (c)(4)(i)(B) of this section
shall furnish a copy of the appraisal summary to such donee.
(F) Appraisal summary required to be provided to partners and S
corporation shareholders. If the donor is a partnership or S
corporation, the donor shall provide a copy of the appraisal summary to
every partner or shareholder, respectively, who receives an allocation
of a charitable contribution deduction under section 170 with respect to
the property described in the appraisal summary.
(G) Partners and S corporation shareholders. A partner of a
partnership or shareholder of an S corporation who receives an
allocation of a deduction under section 170 for a charitable
contribution of property to which this paragraph (c) applies must attach
a copy of the partnership's or S corporation's appraisal summary to the
tax return on which the deduction for the contribution is first claimed.
If such appraisal summary is not attached, the partner's or
shareholder's deduction shall not be allowed except as provided for in
paragraph (c)(4)(iv)(H) of this section.
(H) Failure to attach appraisal summary. In the event that a donor
fails to attach to the donor's return an appraisal summary as required
by paragraph (c)(2)(i)(B) of this section, the Internal Revenue Service
may request that the donor submit the appraisal summary within 90 days
of the request. If such a request is made and the donor complies with
the request within the 90-day period, the deduction under section 170
shall not be disallowed for failure to attach the appraisal summary,
provided that the donor's failure to attach the appraisal summary was a
good faith omission and the requirements of paragraph (c) (3) and (4) of
this section are met (including the completion of the qualified
appraisal prior to the date specified in paragraph (c)(3)(iv)(B) of this
section).
(5) Qualified appraiser--(i) In general. The term qualified
appraiser means an individual (other than a person described in
paragraph (c)(5)(iv) of this section) who includes on the appraisal
summary (described in paragraph (c)(4) of this section), a declaration
that--
(A) The individual either holds himself or herself out to the public
as an appraiser or performs appraisals on a regular basis;
(B) Because of the appraiser's qualifications as described in the
appraisal (pursuant to paragraph (c)(3)(ii)(F) of this section), the
appraiser is qualified to make appraisals of the type of property being
valued;
(C) The appraiser is not one of the persons described in paragraph
(c)(5)(iv) of this section; and
(D) The appraiser understands that an intentionally false or
fraudulent overstatement of the value of the property described in the
qualified appraisal or appraisal summary may subject the appraiser to a
civil penalty under section 6701 for aiding and abetting an
understatement of tax liability, and, moreover, the appraiser may have
appraisals disregarded pursuant to 31 U.S.C. 330(c) (see paragraph
(c)(3)(iii) of this section).
(ii) Exception. An individual is not a qualified appraiser with
respect to a particular donation, even if the declaration specified in
paragraph (c)(5)(i) of this section is provided in the appraisal
summary, if the donor had knowledge of facts that would cause a
reasonable person to expect the appraiser falsely to overstate the value
of the donated property (e.g., the donor and the appraiser make an
agreement concerning the amount at which the property will be valued and
the donor knows that such amount exceeds the fair market value of the
property).
(iii) Numbers of appraisers. More than one appraiser may appraise
the donated property. If more than one appraiser appraises the property,
the donor does not have to use each appraiser's appraisal for purposes
of substantiating the charitable contribution deduction pursuant to this
paragraph (c). If the donor uses the appraisal of more than one
appraiser, or if two or more appraisers contribute to a single
appraisal, each appraiser shall comply
[[Page 107]]
with the requirements of this paragraph (c), including signing the
qualified appraisal and appraisal summary as required by paragraphs
(c)(3)(i)(B) and (c)(4)(i)(C) of this section, respectively.
(iv) Qualified appraiser exclusions. The following persons cannot be
qualified appraisers with respect to particular property:
(A) The donor or the taxpayer who claims or reports a deductions
under section 170 for the contribution of the property that is being
appraised.
(B) A party to the transaction in which the donor acquired the
property being appraised (i.e., the person who sold, exchanged, or gave
the property to the donor, or any person who acted as an agent for the
transferor or for the donor with respect to such sale, exchange, or
gift), unless the property is donated within 2 months of the date of
acquisition and its appraised value does not exceed its acquisition
price.
(C) The donee of the property.
(D) Any person employed by any of the foregoing persons (e.g., if
the donor acquired a painting from an art dealer, neither the art dealer
nor persons employed by the dealer can be qualified appraisers with
respect to that painting).
(E) Any person related to any of the foregoing persons under section
267(b), or, with respect to appraisals made after June 6, 1988, married
to a person who is in a relationship described in section 267(b) with
any of the foregoing persons.
(F) An appraiser who is regularly used by any person described in
paragraph (c)(5)(iv) (A), (B), or (C) of this section and who does not
perform a majority of his or her appraisals made during his or her
taxable year for other persons.
(6) Appraisal fees--(i) In general. Except as otherwise provided in
paragraph (c)(6)(ii) of this section, no part of the fee arrangement for
a qualified appraisal can be based, in effect, on a percentage (or set
of percentages) of the appraised value of the property. If a fee
arrangement for an appraisal is based in whole or in part on the amount
of the appraised value of the property, if any, that is allowed as a
deduction under section 170, after Internal Revenue Service examination
or otherwise, it shall be treated as a fee based on a percentage of the
appraised value of the property. For example, an appraiser's fee that is
subject to reduction by the same percentage as the appraised value may
be reduced by the Internal Revenue Service would be treated as a fee
that violates this paragraph (c)(6).
(ii) Exception. Paragraph (c)(6)(i) of this section does not apply
to a fee paid to a generally recognized association that regulates
appraisers provided all of the following requirements are met:
(A) The association is not organized for profit and no part of the
net earnings of the association inures to the benefit of any private
shareholder or individual (these terms have the same meaning as in
section 501(c)),
(B) The appraiser does not receive any compensation from the
association or any other persons for making the appraisal, and
(C) The fee arrangement is not based in whole or in part on the
amount of the appraised value of the donated property, if any, that is
allowed as a deduction under section 170 after Internal Revenue Service
examination or otherwise.
(7) Meaning of terms. For purposes of this paragraph (c)--
(i) Closely held corporation. The term closely held corporation
means any corporation (other than an S corporation) with respect to
which the stock ownership requirement of paragraph (2) of section 542(a)
of the Code is met.
(ii) Personal service corporation. The term personal service
corporation means any corporation (other than an S corporation) which is
a service organization (within the meaning of section 414(m)(3) of the
Code).
(iii) Similar items of property. The phrase similar items of
property means property of the same generic category or type, such as
stamp collections (including philatelic supplies and books on stamp
collecting), coin collections (including numismatic supplies and books
on coin collecting), lithographs, paintings, photographs, books,
nonpublicly traded stock, nonpublicly traded securities other than
nonpublicly trade stock, land, buildings, clothing, jewelry, funiture,
electronic equipment,
[[Page 108]]
household appliances, toys, everyday kitchenware, china, crystal, or
silver. For example, if a donor claims on her return for the year
deductions of $2,000 for books given by her to College A, $2,500 for
books given by her to College B, and $900 for books given by her to
College C, the $5,000 threshold of paragraph (c)(1) of this section is
exceeded. Therefore, the donor must obtain a qualified appraisal for the
books and attach to her return three appraisal summaries for the books
donated to A, B, and C. For rules regarding the number of qualified
appraisals and appraisal summaries required when similar items of
property are contributed, see paragraphs (c)(3)(iv)(A) and
(c)(4)(iv)(B), respectively, of this section.
(iv) Donor. The term donor means a person or entity (other than an
organization described in section 170(c) to which the donated property
was previously contributed) that makes a charitable contribution of
property.
(v) Donee. The term donee means--
(A) Except as provided in paragraph (c)(7)(v) (B) and (C) of this
section, an organization described in section 170(c) to which property
is contributed,
(B) Except as provided in paragraph (c)(7)(v)(C) of this section, in
the case of a charitable contribution of property placed in trust for
the benefit of an organization described in section 170(c), the trust,
or
(C) In the case of a charitable contribution of property placed in
trust for the benefit of an organization described in section 170(c)
made on or before June 6, 1988, the beneficiary that is an organization
described in section 170(c), or if the trust has assumed the duties of a
donee by signing the appraisal summary pursuant to paragraph
(c)(4)(i)(B) of this section, the trust.
In general, the term, refers only to the original donee. However, with
respect to paragraph (c)(3)(ii)(D), the last sentence of paragraph
(c)(4)(iii), and paragraph (c)(5)(iv)(C) of this section, the term donee
means the original donee and all successor donees in cases where the
original donee transfers the contributed property to a successor donee
after July 5, 1988.
(vi) Original donee. The term original donee means the donee to or
for which property is initially donated by a donor.
(vii) Successor donee. The term successor donee means any donee of
property other than its original donee (i.e., a transferee of property
for less than fair market value from an original donee or another
successor donee).
(viii) Fair market value. For the meaning of the term fair market
value, see section 1.170A-1(c)(2).
(ix) Nonpublicly traded securities. The term nonpublicly traded
securities means securities (within the meaning of section 165(g)(2) of
the Code) which are not publicly traded securities as defined in
paragraph (c)(7)(xi) of this section.
(x) Nonpublicly traded stock. The term nonpublicly traded stock
means any stock of a corporation (evidence by a stock certificate) which
is not a publicly traded security. The term stock does not include a
debenture or any other evidence of indebtedness.
(xi) Publicly traded securities--(A) In general. Except as provided
in paragraph (c)(7)(xi)(C) of this section, the term publicly traded
securities means securities (within the meaning of section 165(g)(2) of
the Code) for which (as of the date of the contribution) market
quotations are readily available on an established securities market.
For purposes of this section, market quotations are readily available on
an established securities market with respect to a security if:
(1) The security is listed on the New York Stock Exchange, the
American Stock Exchange, or any city or regional exchange in which
quotations are published on a daily basis, including foreign securities
listed on a recognized foreign, national, or regional exchange in which
quotations are published on a daily basis;
(2) The security is regularly traded in the national or regional
over-the-counter market, for which published quotations are available;
or
(3) The security is a share of an open-end investment company
(commonly known as a mutual fund) registered under the Investment
Company Act of 1940, as amended (15 U.S.C. 80a-1 to 80b-2), for which
quotations are published
[[Page 109]]
on a daily basis in a newspaper of general circulation throughout the
United States.
(If the market value of an issue of a security is reflected only on an
interdealer quotation system, the issue shall not be considered to be
publicly traded unless the special rule described in paragraph
(c)(7)(xi)(B) of this section is satisfied.)
(B) Special rule--(1) In General. An issue of a security that does
not satisfy the requirements of paragraph (c)(7)(xi)(A) (1), (2), or (3)
of this section shall nonetheless be considered to have market
quotations readily available on an established securities market for
purposes of paragraph (c)(7)(xi)(A) of this section if all of the
following five requirements are met:
(i) The issue is regularly traded during the computational period
(as defined in paragraph (c)(7)(xi)(B)(2)(iv) of this section) in a
market that is reflected by the existence of an interdealer quotation
system for the issue,
(ii) The issuer or an agent of the issuer computes the average
trading price (as defined in paragraph (c)(7)(xi)(B)(2)(iii) of this
section) for the issue for the computational period,
(iii) The average trading price and total volume of the issue during
the computational period are published in a newspaper of general
circulation throughout the United States not later than the last day of
the month following the end of the calendar quarter in which the
computational period ends,
(iv) The issuer or its agent keeps books and records that list for
each transaction during the computational period involving each issue
covered by this procedure the date of the settlement of the transaction,
the name and address of the broker or dealer making the market in which
the transaction occurred, and the trading price and volume, and
(v) The issuer or its agent permits the Internal Revenue Service to
review the books and records described in paragraph (c)(7)(xi)(B)(1)(iv)
of this section with respect to transactions during the computational
period upon giving reasonable notice to the issuer or agent.
(2) Definitions. For purposes of this paragraph (c)(7)(xi)(B)--
(i) Issue of a security. The term issue of a security means a class
of debt securities with the same obligor and identical terms except as
to their relative denominations (amounts) or a class of stock having
identical rights.
(ii) Interdealer quotation system. The term interdealer quotation
system means any system of general circulation to brokers and dealers
that regularly disseminates quotations of obligations by two or more
identified brokers or dealers, who are not related to either the issuer
of the security or to the issuer's agent, who compute the average
trading price of the security. A quotation sheet prepared and
distributed by a broker or dealer in the regular course of its business
and containing only quotations of such broker or dealer is not an
interdealer quotation system.
(iii) Average trading price. The term average trading price means
the mean price of all transactions (weighted by volume), other than
original issue or redemption transactions, conducted through a United
States office of a broker or dealer who maintains a market in the issue
of the security during the computational period. For this purpose, bid
and asked quotations are not taken into account.
(iv) Computational period. For calendar quarters beginning on or
after June 6, 1988, the term computational period means weekly during
October through December (beginning with the first Monday in October and
ending with the first Sunday following the last Monday in December) and
monthly during January through September (beginning January 1). For
calendar quarters beginning before June 6, 1988, the term computational
period means weekly during October through December and monthly during
January through September.
(C) Exception. Securities described in paragraph (c)(7)(xi) (A) or
(B) of this section shall not be considered publicly traded securities
if--
(1) The securities are subject to any restrictions that materially
affect the value of the securities to the donor or prevent the
securities from being freely traded, or
[[Page 110]]
(2) If the amount claimed or reported as a deduction with respect to
the contribution of the securities is different than the amount listed
in the market quotations that are readily available on an established
securities market pursuant to paragraph (c)(7)(xi) (A) or (B) of this
section.
(D) Market quotations and fair market value. The fair market value
of a publicly traded security, as defined in this paragraph (c)(7)(xi),
is not necessarily equal to its market quotation, its average trading
price (as defined in paragraph (c)(7)(xi)(B)(2)(iii) of this section),
or its face value, if any. See section 1.170A-1(c)(2) for the definition
of fair market value.
(d) Charitable contributions; information required in support of
deductions for taxable years beginning before January 1, 1983--(1) In
general. This paragraph (d)(1) shall apply to deductions for charitable
contributions made in taxable years beginning before January 1, 1983. At
the option of the taxpayer the requirements of this paragraph (d)(1)
shall also apply to all charitable contributions made on or before
December 31, 1984 (in lieu of the requirements of paragraphs (a) and (b)
of this section). In connection with claims for deductions for
charitable contributions, taxpayers shall state in their income tax
returns the name of each organization to which a contribution was made
and the amount and date of the actual payment of each contribution. If a
contribution is made in property other than money, the taxpayer shall
state the kind of property contributed, for example, used clothing,
paintings, or securities, the method utilized in determining the fair
market value of the property at the time the contribution was made, and
whether or not the amount of the contribution was reduced under section
170(e). If a taxpayer makes more than one cash contribution to an
organization during the taxable year, then in lieu of listing each cash
contribution and the date of payment the taxpayer may state the total
cash payments made to such organization during the taxable year. A
taxpayer who elects under paragraph (d)(2) of Sec. 1.170A-8 to apply
section 170(e)(1) to his contributions and carryovers of 30-percent
capital gain property must file a statement with his return indicating
that he has made the election and showing the contributions in the
current year and carryovers from preceding years to which it applies.
For the definition of the term 30-percent capital gain property, see
paragraph (d)(3) of Sec. 1.170A-8.
(2) Contribution by individual of property other than money. This
paragraph (d)(2) shall apply to deductions for charitable contributions
made in taxable years beginning before January 1, 1983. At the option of
the taxpayer, the requirements of this paragraph (d)(2) shall also apply
to contributions of property made on or before December 31, 1984 (in
lieu of the requirements of paragraph (b) of this section). If an
individual taxpayer makes a charitable contribution of an item of
property other than money and claims a deduction in excess of $200 in
respect of his contribution of such item, he shall attach to his income
tax return the following information with respect to such item:
(i) The name and address of the organization to which the
contribution was made.
(ii) The date of the actual contribution.
(iii) A description of the property in sufficient detail to identify
the particular property contributed, including in the case of tangible
property the physical condition of the property at the time of
contribution, and, in the case of securities, the name of the issuer,
the type of security, and whether or not such security is regularly
traded on a stock exchange or in an over-the-counter market.
(iv) The manner of acquisition, as, for example, by purchase, gift,
bequest, inheritance, or exchange, and the approximate date of
acquisition of the property by the taxpayer or, if the property was
created, produced, or manufactured by or for the taxpayer, the
approximate date the property was substantially completed.
(v) The fair market value of the property at the time the
contribution was made, the method utilized in determining the fair
market value, and, if the valuation was determined by appraisal, a copy
of the signed report of the appraiser.
[[Page 111]]
(vi) The cost or other basis, adjusted as provided by section 1016,
of property, other than securities, held by the taxpayer for a period of
less than 5 years immediately preceding the date on which the
contribution was made and, when the information is available, of
property, other than securities, held for a period of 5 years or more
preceding the date on which the contribution was made.
(vii) In the case of property to which section 170(e) applies, the
cost or other basis, adjusted as provided by section 1016, the reduction
by reason of section 170(e)(1) in the amount of the charitable
contribution otherwise taken into account, and the manner in which such
reduction was determined.
(viii) The terms of any agreement or understanding entered into by
or on behalf of the taxpayer which relates to the use, sale, or
disposition of the property contributed, as, for example, the terms of
any agreement or understanding which:
(A) Restricts temporarily or permanently the donee's right to
dispose of the donated property,
(B) Reserves to, or confers upon, anyone other than the donee
organization or other than an organization participating with such
organization in cooperative fundraising, any right to the income from
such property, to the possession of the property, including the right to
vote securities, to acquire such property by purchase or otherwise, or
to designate the person to have such income, possession, or right to
acquire, or
(C) Earmarks contributed property for a particular charitable use,
such as the use of donated furniture in the reading room of the donee
organization's library.
(ix) The total amount claimed as a deduction for the taxable year
due to the contribution of the property and, if less than the entire
interest in the property is contributed during the taxable year, the
amount claimed as a deduction in any prior year or years for
contributions of other interests in such property, the name and address
of each organization to which any such contribution was made, the place
where any such property which is tangible property is located or kept,
and the name of any person, other than the organization to which the
property giving rise to the deduction was contributed, having actual
possession of the property.
(3) Statement from donee organization. Any deduction for a
charitable contribution must be substantiated, when required by the
district director, by a statement from the organization to which the
contribution was made indicating whether the organization is a domestic
organization, the name and address of the contributor, the amount of the
contribution, the date of actual receipt of the contribution, and such
other information as the district director may deem necessary. If the
contribution includes an item of property, other than money or
securities which are regularly traded on a stock exchange or in an over-
the-counter market, which the donee deems to have a fair market value in
excess of $500 ($200 in the case of a charitable contribution made in a
taxable year beginning before January 1, 1983) at the time of receipt,
such statement shall also indicate for each such item its location if it
is retained by the organization, the amount received by the organization
on any sale of the property and the date of sale or, in case of any
other disposition of the property, the method of disposition. In the
case of any contribution of tangible personal property, the statement
shall indicate the use of the property by the organization and whether
or not it is used for a purpose or function constituting the basis for
the donee organization's exemption from income tax under section 501 or,
in the case of a governmental unit, whether or not it is used for
exclusively public purposes.
(e) [Reserved]
(f) Substantiation of charitable contributions of $250 or more--(1)
In general. No deduction is allowed under section 170(a) for all or part
of any contribution of $250 or more unless the taxpayer substantiates
the contribution with a contemporaneous written acknowledgment from the
donee organization. A taxpayer who makes more than one contribution of
$250 or more to a donee organization in a taxable
[[Page 112]]
year may substantiate the contributions with one or more contemporaneous
written acknowledgments. Section 170(f)(8) does not apply to a payment
of $250 or more if the amount contributed (as determined under Sec.
1.170A-1(h)) is less than $250. Separate contributions of less than $250
are not subject to the requirements of section 170(f)(8), regardless of
whether the sum of the contributions made by a taxpayer to a donee
organization during a taxable year equals $250 or more.
(2) Written acknowledgment. Except as otherwise provided in
paragraphs (f)(8) through (f)(11) and (f)(13) of this section, a written
acknowledgment from a donee organization must provide the following
information--
(i) The amount of any cash the taxpayer paid and a description (but
not necessarily the value) of any property other than cash the taxpayer
transferred to the donee organization;
(ii) A statement of whether or not the donee organization provides
any goods or services in consideration, in whole or in part, for any of
the cash or other property transferred to the donee organization;
(iii) If the donee organization provides any goods or services other
than intangible religious benefits (as described in section 170(f)(8)),
a description and good faith estimate of the value of those goods or
services; and
(iv) If the donee organization provides any intangible religious
benefits, a statement to that effect.
(3) Contemporaneous. A written acknowledgment is contemporaneous if
it is obtained by the taxpayer on or before the earlier of--
(i) The date the taxpayer files the original return for the taxable
year in which the contribution was made; or
(ii) The due date (including extensions) for filing the taxpayer's
original return for that year.
(4) Donee organization. For purposes of this paragraph (f), a donee
organization is an organization described in section 170(c).
(5) Goods or services. Goods or services means cash, property,
services, benefits, and privileges.
(6) In consideration for. A donee organization provides goods or
services in consideration for a taxpayer's payment if, at the time the
taxpayer makes the payment to the donee organization, the taxpayer
receives or expects to receive goods or services in exchange for that
payment. Goods or services a donee organization provides in
consideration for a payment by a taxpayer include goods or services
provided in a year other than the year in which the taxpayer makes the
payment to the donee organization.
(7) Good faith estimate. For purposes of this section, good faith
estimate means a donee organization's estimate of the fair market value
of any goods or services, without regard to the manner in which the
organization in fact made that estimate. See Sec. 1.170A-1(h)(6) for
rules regarding when a taxpayer may treat a donee organization's
estimate of the value of goods or services as the fair market value.
(8) Certain goods or services disregarded--(i) In general. For
purposes of section 170(f)(8), the following goods or services are
disregarded--
(A) Goods or services that have insubstantial value under the
guidelines provided in Revenue Procedures 90-12, 1990-1 C.B. 471, 92-49,
1992-1 C.B. 987, and any successor documents. (See Sec.
601.601(d)(2)(ii) of the Statement of Procedural Rules, 26 CFR part
601.); and
(B) Annual membership benefits offered to a taxpayer in exchange for
a payment of $75 or less per year that consist of--
(1) Any rights or privileges, other than those described in section
170(l), that the taxpayer can exercise frequently during the membership
period. Examples of such rights and privileges may include, but are not
limited to, free or discounted admission to the organization's
facilities or events, free or discounted parking, preferred access to
goods or services, and discounts on the purchase of goods or services;
and
(2) Admission to events during the membership period that are open
only to members of a donee organization and for which the donee
organization reasonably projects that the cost per person (excluding any
allocable overhead) attending each such event is within the limits
established for ``low cost articles'' under section 513(h)(2).
[[Page 113]]
The projected cost to the donee organization is determined at the time
the organization first offers its membership package for the year (using
section 3.07 of Revenue Procedure 90-12, or any successor documents, to
determine the cost of any items or services that are donated).
(ii) Examples. The following examples illustrate the rules of this
paragraph (f)(8).
Example 1. Membership benefits disregarded. Performing Arts Center E
is an organization described in section 170(c). In return for a payment
of $75, E offers a package of basic membership benefits that includes
the right to purchase tickets to performances one week before they go on
sale to the general public, free parking in E's garage during evening
and weekend performances, and a 10% discount on merchandise sold in E's
gift shop. In return for a payment of $150, E offers a package of
preferred membership benefits that includes all of the benefits in the
$75 package as well as a poster that is sold in E's gift shop for $20.
The basic membership and the preferred membership are each valid for
twelve months, and there are approximately 50 performances of various
productions at E during a twelve-month period. E's gift shop is open for
several hours each week and at performance times. F, a patron of the
arts, is solicited by E to make a contribution. E offers F the preferred
membership benefits in return for a payment of $150 or more. F makes a
payment of $300 to E. F can satisfy the substantiation requirement of
section 170(f)(8) by obtaining a contemporaneous written acknowledgment
from E that includes a description of the poster and a good faith
estimate of its fair market value ($20) and disregards the remaining
membership benefits.
Example 2. Contemporaneous written acknowledgment need not mention
rights or privileges that can be disregarded. The facts are the same as
in Example 1, except that F made a payment of $300 and received only a
basic membership. F can satisfy the section 170(f)(8) substantiation
requirement with a contemporaneous written acknowledgment stating that
no goods or services were provided.
Example 3. Rights or privileges that cannot be exercised frequently.
Community Theater Group G is an organization described in section
170(c). Every summer, G performs four different plays. Each play is
performed two times. In return for a membership fee of $60, G offers its
members free admission to any of its performances. Non-members may
purchase tickets on a performance by performance basis for $15 a ticket.
H, an individual who is a sponsor of the theater, is solicited by G to
make a contribution. G tells H that the membership benefit will be
provided in return for any payment of $60 or more. H chooses to make a
payment of $350 to G and receives in return the membership benefit. G's
membership benefit of free admission is not described in paragraph
(f)(8)(i)(B) of this section because it is not a privilege that can be
exercised frequently (due to the limited number of performances offered
by G). Therefore, to meet the requirements of section 170(f)(8), a
contemporaneous written acknowledgment of H's $350 payment must include
a description of the free admission benefit and a good faith estimate of
its value.
Example 4. Multiple memberships. In December of each year, K, an
individual, gives each of her six grandchildren a junior membership in
Dinosaur Museum, an organization described in section 170(c). Each
junior membership costs $50, and K makes a single payment of $300 for
all six memberships. A junior member is entitled to free admission to
the museum and to weekly films, slide shows, and lectures about
dinosaurs. In addition, each junior member receives a bi-monthly, non-
commercial quality newsletter with information about dinosaurs and
upcoming events. K's contemporaneous written acknowledgment from
Dinosaur Museum may state that no goods or services were provided in
exchange for K's payment.
(9) Goods or services provided to employees or partners of donors--
(i) Certain goods or services disregarded. For purposes of section
170(f)(8), goods or services provided by a donee organization to
employees of a donor, or to partners of a partnership that is a donor,
in return for a payment to the organization may be disregarded to the
extent that the goods or services provided to each employee or partner
are the same as those described in paragraph (f)(8)(i) of this section.
(ii) No good faith estimate required for other goods or services. If
a taxpayer makes a contribution of $250 or more to a donee organization
and, in return, the donee organization offers the taxpayer's employees
or partners goods or services other than those described in paragraph
(f)(9)(i) of this section, the contemporaneous written acknowledgment of
the taxpayer's contribution is not required to include a good faith
estimate of the value of such goods or services but must include a
description of those goods or services.
(iii) Example. The following example illustrates the rules of this
paragraph (f)(9).
[[Page 114]]
Example. Museum J is an organization described in section 170(c).
For a payment of $40, J offers a package of basic membership benefits
that includes free admission and a 10% discount on merchandise sold in
J's gift shop. J's other membership categories are for supporters who
contribute $100 or more. Corporation K makes a payment of $50,000 to J
and, in return, J offers K's employees free admission for one year, a
tee-shirt with J's logo that costs J $4.50, and a gift shop discount of
25% for one year. The free admission for K's employees is the same as
the benefit made available to holders of the $40 membership and is
otherwise described in paragraph (f)(8)(i)(B) of this section. The tee-
shirt given to each of K's employees is described in paragraph
(f)(8)(i)(A) of this section. Therefore, the contemporaneous written
acknowledgment of K's payment is not required to include a description
or good faith estimate of the value of the free admission or the tee-
shirts. However, because the gift shop discount offered to K's employees
is different than that offered to those who purchase the $40 membership,
the discount is not described in paragraph (f)(8)(i) of this section.
Therefore, the contemporaneous written acknowledgment of K's payment is
required to include a description of the 25% discount offered to K's
employees.
(10) Substantiation of out-of-pocket expenses. A taxpayer who incurs
unreimbursed expenditures incident to the rendition of services, within
the meaning of Sec. 1.170A-1(g), is treated as having obtained a
contemporaneous written acknowledgment of those expenditures if the
taxpayer--
(i) Has adequate records under paragraph (a) of this section to
substantiate the amount of the expenditures; and
(ii) Obtains by the date prescribed in paragraph (f)(3) of this
section a statement prepared by the donee organization containing--
(A) A description of the services provided by the taxpayer;
(B) A statement of whether or not the donee organization provides
any goods or services in consideration, in whole or in part, for the
unreimbursed expenditures; and
(C) The information required by paragraphs (f)(2) (iii) and (iv) of
this section.
(11) Contributions made by payroll deduction--(i) Form of
substantiation. A contribution made by means of withholding from a
taxpayer's wages and payment by the taxpayer's employer to a donee
organization may be substantiated, for purposes of section 170(f)(8), by
both--
(A) A pay stub, Form W-2, or other document furnished by the
employer that sets forth the amount withheld by the employer for the
purpose of payment to a donee organization; and
(B) A pledge card or other document prepared by or at the direction
of the donee organization that includes a statement to the effect that
the organization does not provide goods or services in whole or partial
consideration for any contributions made to the organization by payroll
deduction.
(ii) Application of $250 threshold. For the purpose of applying the
$250 threshold provided in section 170(f)(8)(A) to contributions made by
the means described in paragraph (f)(11)(i) of this section, the amount
withheld from each payment of wages to a taxpayer is treated as a
separate contribution.
(12) Distributing organizations as donees. An organization described
in section 170(c), or an organization described in 5 CFR 950.105 (a
Principal Combined Fund Organization for purposes of the Combined
Federal Campaign) and acting in that capacity, that receives a payment
made as a contribution is treated as a donee organization solely for
purposes of section 170(f)(8), even if the organization (pursuant to the
donor's instructions or otherwise) distributes the amount received to
one or more organizations described in section 170(c). This paragraph
(f)(12) does not apply, however, to a case in which the distributee
organization provides goods or services as part of a transaction
structured with a view to avoid taking the goods or services into
account in determining the amount of the deduction to which the donor is
entitled under section 170.
(13) Transfers to certain trusts. Section 170(f)(8) does not apply
to a transfer of property to a trust described in section 170(f)(2)(B),
a charitable remainder annuity trust (as defined in section 664(d)(1)),
or a charitable remainder unitrust (as defined in section 664(d)(2) or
(d)(3) or Sec. 1.664(3)(a)(1)(i)(b)). Section 170(f)(8) does apply,
however, to a transfer to a pooled income fund (as defined in section
642(c)(5)); for such a transfer, the contemporaneous written
[[Page 115]]
acknowledgment must state that the contribution was transferred to the
donee organization's pooled income fund and indicate whether any goods
or services (in addition to an income interest in the fund) were
provided in exchange for the transfer. The contemporaneous written
acknowledgment is not required to include a good faith estimate of the
income interest.
(14) Substantiation of payments to a college or university for the
right to purchase tickets to athletic events. For purposes of paragraph
(f)(2)(iii) of this section, the right to purchase tickets for seating
at an athletic event in exchange for a payment described in section
170(l) is treated as having a value equal to twenty percent of such
payment. For example, when a taxpayer makes a payment of $312.50 for the
right to purchase tickets for seating at an athletic event, the right to
purchase tickets is treated as having a value of $62.50. The remaining
$250 is treated as a charitable contribution, which the taxpayer must
substantiate in accordance with the requirements of this section.
(15) Substantiation of charitable contributions made by a
partnership or an S corporation. If a partnership or an S corporation
makes a charitable contribution of $250 or more, the partnership or S
corporation will be treated as the taxpayer for purposes of section
170(f)(8). Therefore, the partnership or S corporation must substantiate
the contribution with a contemporaneous written acknowledgment from the
donee organization before reporting the contribution on its income tax
return for the year in which the contribution was made and must maintain
the contemporaneous written acknowledgment in its records. A partner of
a partnership or a shareholder of an S corporation is not required to
obtain any additional substantiation for his or her share of the
partnership's or S corporation's charitable contribution.
(16) Purchase of an annuity. If a taxpayer purchases an annuity from
a charitable organization and claims a charitable contribution deduction
of $250 or more for the excess of the amount paid over the value of the
annuity, the contemporaneous written acknowledgment must state whether
any goods or services in addition to the annuity were provided to the
taxpayer. The contemporaneous written acknowledgment is not required to
include a good faith estimate of the value of the annuity. See Sec.
1.170A-1(d)(2) for guidance in determining the value of the annuity.
(17) Substantiation of matched payments--(i) In general. For
purposes of section 170, if a taxpayer's payment to a donee organization
is matched, in whole or in part, by another payor, and the taxpayer
receives goods or services in consideration for its payment and some or
all of the matching payment, those goods or services will be treated as
provided in consideration for the taxpayer's payment and not in
consideration for the matching payment.
(ii) Example. The following example illustrates the rules of this
paragraph (f)(17).
Example. Taxpayer makes a $400 payment to Charity L, a donee
organization. Pursuant to a matching payment plan, Taxpayer's employer
matches Taxpayer's $400 payment with an additional payment of $400. In
consideration for the combined payments of $800, L gives Taxpayer an
item that it estimates has a fair market value of $100. L does not give
the employer any goods or services in consideration for its
contribution. The contemporaneous written acknowledgment provided to the
employer must include a statement that no goods or services were
provided in consideration for the employer's $400 payment. The
contemporaneous written acknowledgment provided to Taxpayer must include
a statement of the amount of Taxpayer's payment, a description of the
item received by Taxpayer, and a statement that L's good faith estimate
of the value of the item received by Taxpayer is $100.
(18) Effective date. This paragraph (f) applies to contributions
made on or after December 16, 1996. However, taxpayers may rely on the
rules of this paragraph (f) for contributions made on or after January
1, 1994.
[T.D. 8002, 49 FR 50664, 50666, Dec. 31, 1984, as amended by T.D. 8003,
49 FR 50659, Dec. 31, 1984; T.D. 8199, 53 FR 16080, May 5, 1988; 53 FR
18372, May 23, 1988; T.D. 8623, 60 FR 53128, Oct. 12, 1995; T.D. 8690,
61 FR 65952, Dec. 16, 1996; T.D. 9864, 84 FR 27530, June 13, 2019; T.D.
9907, 85 FR 48474, Aug. 11, 2020]
[[Page 116]]
Sec. 1.170A-14 Qualified conservation contributions.
(a) Qualified conservation contributions. A deduction under section
170 is generally not allowed for a charitable contribution of any
interest in property that consists of less than the donor's entire
interest in the property other than certain transfers in trust (see
Sec. 1.170A-6 relating to charitable contributions in trust and Sec.
1.170A-7 relating to contributions not in trust of partial interests in
property). However, a deduction may be allowed under section
170(f)(3)(B)(iii) for the value of a qualified conservation contribution
if the requirements of this section are met. A qualified conservation
contribution is the contribution of a qualified real property interest
to a qualified organization exclusively for conservation purposes. To be
eligible for a deduction under this section, the conservation purpose
must be protected in perpetuity.
(b) Qualified real property interest--(1) Entire interest of donor
other than qualified mineral interest. (i) The entire interest of the
donor other than a qualified mineral interest is a qualified real
property interest. A qualified mineral interest is the donor's interest
in subsurface oil, gas, or other minerals and the right of access to
such minerals.
(ii) A real property interest shall not be treated as an entire
interest other than a qualified mineral interest by reason of section
170(h)(2)(A) and this paragraph (b)(1) if the property in which the
donor's interest exists was divided prior to the contribution in order
to enable the donor to retain control of more than a qualified mineral
interest or to reduce the real property interest donated. See Treasury
regulations Sec. 1.170A-7(a)(2)(i). An entire interest in real property
may consist of an undivided interest in the property. But see section
170(h)(5)(A) and the regulations thereunder (relating to the requirement
that the conservation purpose which is the subject of the donation must
be protected in perpetuity). Minor interests, such as rights-of-way,
that will not interfere with the conservation purposes of the donation,
may be transferred prior to the conservation contribution without
affecting the treatment of a property interest as a qualified real
property interest under this paragraph (b)(1).
(2) Perpetual conservation restriction. A ``perpetual conservation
restriction'' is a qualified real property interest. A ``perpetual
conservation restriction'' is a restriction granted in perpetuity on the
use which may be made of real property--including, an easement or other
interest in real property that under state law has attributes similar to
an easement (e.g., a restrictive covenant or equitable servitude). For
purposes of this section, the terms easement, conservation restriction,
and perpetual conservation restriction have the same meaning. The
definition of perpetual conservation restriction under this paragraph
(b)(2) is not intended to preclude the deductibility of a donation of
affirmative rights to use a land or water area under Sec. 1.170A-
13(d)(2). Any rights reserved by the donor in the donation of a
perpetual conservation restriction must conform to the requirements of
this section. See e.g., paragraph (d)(4)(ii), (d)(5)(i), (e)(3), and
(g)(4) of this section.
(c) Qualified organization--(1) Eligible donee. To be considered an
eligible donee under this section, an organization must be a qualified
organization, have a commitment to protect the conservation purposes of
the donation, and have the resources to enforce the restrictions. A
conservation group organized or operated primarily or substantially for
one of the conservation purposes specified in section 170(h)(4)(A) will
be considered to have the commitment required by the preceding sentence.
A qualified organization need not set aside funds to enforce the
restrictions that are the subject of the contribution. For purposes of
this section, the term qualified organization means:
(i) A governmental unit described in section 170(b)(1)(A)(v);
(ii) An organization described in section 170(b)(1)(A)(vi);
(iii) A charitable organization described in section 501(c)(3) that
meets the public support test of section 509(a)(2);
(iv) A charitable organization described in section 501(c)(3) that
meets the requirements of section 509(a)(3) and is controlled by an
organization
[[Page 117]]
described in paragraphs (c)(1) (i), (ii), or (iii) of this section.
(2) Transfers by donee. A deduction shall be allowed for a
contribution under this section only if in the instrument of conveyance
the donor prohibits the donee from subsequently transferring the
easement (or, in the case of a remainder interest or the reservation of
a qualified mineral interest, the property), whether or not for
consideration, unless the donee organization, as a condition of the
subsequent transfer, requires that the conservation purposes which the
contribution was originally intended to advance continue to be carried
out. Moreover, subsequent transfers must be restricted to organizations
qualifying, at the time of the subsequent transfer, as an eligible donee
under paragraph (c)(1) of this section. When a later unexpected change
in the conditions surrounding the property that is the subject of a
donation under paragraph (b)(1), (2), or (3) of this section makes
impossible or impractical the continued use of the property for
conservation purposes, the requirement of this paragraph will be met if
the property is sold or exchanged and any proceeds are used by the donee
organization in a manner consistent with the conservation purposes of
the original contribution. In the case of a donation under paragraph
(b)(3) of this section to which the preceding sentence applies, see also
paragraph (g)(5)(ii) of this section.
(d) Conservation purposes--(1) In general. For purposes of section
170(h) and this section, the term conservation purposes means--
(i) The preservation of land areas for outdoor recreation by, or the
education of, the general public, within the meaning of paragraph (d)(2)
of this section,
(ii) The protection of a relatively natural habitat of fish,
wildlife, or plants, or similar ecosystem, within the meaning of
paragraph (d)(3) of this section,
(iii) The preservation of certain open space (including farmland and
forest land) within the meaning of paragraph (d)(4) of this section, or
(iv) The preservation of a historically important land area or a
certified historic structure, within the meaning of paragraph (d)(5) of
this section.
(2) Recreation or education--(i) In general. The donation of a
qualified real property interest to preserve land areas for the outdoor
recreation of the general public or for the education of the general
public will meet the conservation purposes test of this section. Thus,
conservation purposes would include, for example, the preservation of a
water area for the use of the public for boating or fishing, or a nature
or hiking trail for the use of the public.
(ii) Access. The preservation of land areas for recreation or
education will not meet the test of this section unless the recreation
or education is for the substantial and regular use of the general
public.
(3) Protection of environmental system--(i) In general. The donation
of a qualified real property interest to protect a significant
relatively natural habitat in which a fish, wildlife, or plant
community, or similar ecosystem normally lives will meet the
conservation purposes test of this section. The fact that the habitat or
environment has been altered to some extent by human activity will not
result in a deduction being denied under this section if the fish,
wildlife, or plants continue to exist there in a relatively natural
state. For example, the preservation of a lake formed by a man-made dam
or a salt pond formed by a man-made dike would meet the conservation
purposes test if the lake or pond were a nature feeding area for a
wildlife community that included rare, endangered, or threatened native
species.
(ii) Significant habitat or ecosystem. Significant habitats and
ecosystems include, but are not limited to, habitats for rare,
endangered, or threatened species of animal, fish, or plants; natural
areas that represent high quality examples of a terrestrial community or
aquatic community, such as islands that are undeveloped or not intensely
developed where the coastal ecosystem is relatively intact; and natural
areas which are included in, or which contribute to, the ecological
viability of a local, state, or national park, nature preserve, wildlife
refuge, wilderness area, or other similar conservation area.
(iii) Access. Limitations on public access to property that is the
subject of a
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donation under this paragraph (d)(3) shall not render the donation
nondeductible. For example, a restriction on all public access to the
habitat of a threatened native animal species protected by a donation
under this paragraph (d)(3) would not cause the donation to be
nondeductible.
(4) Preservation of open space--(i) In general. The donation of a
qualified real property interest to preserve open space (including
farmland and forest land) will meet the conservation purposes test of
this section if such preservation is--
(A) Pursuant to a clearly delineated Federal, state, or local
governmental conservation policy and will yield a significant public
benefit, or
(B) For the scenic enjoyment of the general public and will yield a
significant public benefit.
An open space easement donated on or after December 18, 1980, must meet
the requirements of section 170(h) in order to be deductible.
(ii) Scenic enjoyment--(A) Factors. A contribution made for the
preservation of open space may be for the scenic enjoyment of the
general public. Preservation of land may be for the scenic enjoyment of
the general public if development of the property would impair the
scenic character of the local rural or urban landscape or would
interfere with a scenic panorama that can be enjoyed from a park, nature
preserve, road, waterbody, trail, or historic structure or land area,
and such area or transportation way is open to, or utilized by, the
public. ``Scenic enjoyment'' will be evaluated by considering all
pertinent facts and circumstances germane to the contribution. Regional
variations in topography, geology, biology, and cultural and economic
conditions require flexibility in the application of this test, but do
not lessen the burden on the taxpayer to demonstrate the scenic
characteristics of a donation under this paragraph. The application of a
particular objective factor to help define a view as scenic in one
setting may in fact be entirely inappropriate in another setting. Among
the factors to be considered are:
(1) The compatibility of the land use with other land in the
vicinity;
(2) The degree of contrast and variety provided by the visual scene;
(3) The openness of the land (which would be a more significant
factor in an urban or densely populated setting or in a heavily wooded
area);
(4) Relief from urban closeness;
(5) The harmonious variety of shapes and textures;
(6) The degree to which the land use maintains the scale and
character of the urban landscape to preserve open space, visual
enjoyment, and sunlight for the surrounding area;
(7) The consistency of the proposed scenic view with a methodical
state scenic identification program, such as a state landscape
inventory; and
(8) The consistency of the proposed scenic view with a regional or
local landscape inventory made pursuant to a sufficiently rigorous
review process, especially if the donation is endorsed by an appropriate
state or local governmental agency.
(B) Access. To satisfy the requirement of scenic enjoyment by the
general public, visual (rather than physical) access to or across the
property by the general public is sufficient. Under the terms of an open
space easement on scenic property, the entire property need not be
visible to the public for a donation to qualify under this section,
although the public benefit from the donation may be insufficient to
qualify for a deduction if only a small portion of the property is
visible to the public.
(iii) Governmental conservation policy--(A) In general. The
requirement that the preservation of open space be pursuant to a clearly
delineated Federal, state, or local governmental policy is intended to
protect the types of property identified by representatives of the
general public as worthy of preservation or conservation. A general
declaration of conservation goals by a single official or legislative
body is not sufficient. However, a governmental conservation policy need
not be a certification program that identifies particular lots or small
parcels of individually owned property. This requirement will be met by
donations that further a specific, identified conservation project, such
as the preservation of land within a state or local landmark district
that is locally recognized
[[Page 119]]
as being significant to that district; the preservation of a wild or
scenic river, the preservation of farmland pursuant to a state program
for flood prevention and control; or the protection of the scenic,
ecological, or historic character of land that is contiguous to, or an
integral part of, the surroundings of existing recreation or
conservation sites. For example, the donation of a perpetual
conservation restriction to a qualified organization pursuant to a
formal resolution or certification by a local governmental agency
established under state law specifically identifying the subject
property as worthy of protection for conservation purposes will meet the
requirement of this paragraph. A program need not be funded to satisfy
this requirement, but the program must involve a significant commitment
by the government with respect to the conservation project. For example,
a governmental program according preferential tax assessment or
preferential zoning for certain property deemed worthy of protection for
conservation purposes would constitute a significant commitment by the
government.
(B) Effect of acceptance by governmental agency. Acceptance of an
easement by an agency of the Federal Government or by an agency of a
state or local government (or by a commission, authority, or similar
body duly constituted by the state or local government and acting on
behalf of the state or local government) tends to establish the
requisite clearly delineated governmental policy, although such
acceptance, without more, is not sufficient. The more rigorous the
review process by the governmental agency, the more the acceptance of
the easement tends to establish the requisite clearly delineated
governmental policy. For example, in a state where the legislature has
established an Environmental Trust to accept gifts to the state which
meet certain conservation purposes and to submit the gifts to a review
that requires the approval of the state's highest officials, acceptance
of a gift by the Trust tends to establish the requisite clearly
delineated governmental policy. However, if the Trust merely accepts
such gifts without a review process, the requisite clearly delineated
governmental policy is not established.
(C) Access. A limitation on public access to property subject to a
donation under this paragraph (d)(4)(iii) shall not render the deduction
nondeductible unless the conservation purpose of the donation would be
undermined or frustrated without public access. For example, a donation
pursuant to a governmental policy to protect the scenic character of
land near a river requires visual access to the same extent as would a
donation under paragraph (d)(4)(ii) of this section.
(iv) Significant public benefit--(A) Factors. All contributions made
for the preservation of open space must yield a significant public
benefit. Public benefit will be evaluated by considering all pertinent
facts and circumstances germane to the contribution. Factors germane to
the evaluation of public benefit from one contribution may be irrelevant
in determining public benefit from another contribution. No single
factor will necessarily be determinative. Among the factors to be
considered are:
(1) The uniqueness of the property to the area;
(2) The intensity of land development in the vicinity of the
property (both existing development and foreseeable trends of
development);
(3) The consistency of the proposed open space use with public
programs (whether Federal, state or local) for conservation in the
region, including programs for outdoor recreation, irrigation or water
supply protection, water quality maintenance or enhancement, flood
prevention and control, erosion control, shoreline protection, and
protection of land areas included in, or related to, a government
approved master plan or land management area;
(4) The consistency of the proposed open space use with existing
private conservation programs in the area, as evidenced by other land,
protected by easement or fee ownership by organizations referred to in
Sec. 1.170A-14(c)(1), in close proximity to the property;
(5) The likelihood that development of the property would lead to or
contribute to degradation of the scenic,
[[Page 120]]
natural, or historic character of the area;
(6) The opportunity for the general public to use the property or to
appreciate its scenic values;
(7) The importance of the property in preserving a local or regional
landscape or resource that attracts tourism or commerce to the area;
(8) The likelihood that the donee will acquire equally desirable and
valuable substitute property or property rights;
(9) The cost to the donee of enforcing the terms of the conservation
restriction;
(10) The population density in the area of the property; and
(11) The consistency of the proposed open space use with a
legislatively mandated program identifying particular parcels of land
for future protection.
(B) Illustrations. The preservation of an ordinary tract of land
would not in and of itself yield a significant public benefit, but the
preservation of ordinary land areas in conjunction with other factors
that demonstrate significant public benefit or the preservation of a
unique land area for public employment would yield a significant public
benefit. For example, the preservation of a vacant downtown lot would
not by itself yield a significant public benefit, but the preservation
of the downtown lot as a public garden would, absent countervailing
factors, yield a significant public benefit. The following are other
examples of contributions which would, absent countervailing factors,
yield a significant public benefit: The preservation of farmland
pursuant to a state program for flood prevention and control; the
preservation of a unique natural land formation for the enjoyment of the
general public; the preservation of woodland along a public highway
pursuant to a government program to preserve the appearance of the area
so as to maintain the scenic view from the highway; and the preservation
of a stretch of undeveloped property located between a public highway
and the ocean in order to maintain the scenic ocean view from the
highway.
(v) Limitation. A deduction will not be allowed for the preservation
of open space under section 170(h)(4)(A)(iii), if the terms of the
easement permit a degree of intrusion or future development that would
interfere with the essential scenic quality of the land or with the
governmental conservation policy that is being furthered by the
donation. See Sec. 1.170A-14(e)(2) for rules relating to inconsistent
use.
(vi) Relationship of requirements--(A) Clearly delineated
governmental policy and significant public benefit. Although the
requirements of ``clearly delineated governmental policy'' and
``significant public benefit'' must be met independently, for purposes
of this section the two requirements may also be related. The more
specific the governmental policy with respect to the particular site to
be protected, the more likely the governmental decision, by itself, will
tend to establish the significant public benefit associated with the
donation. For example, while a statute in State X permitting
preferential assessment for farmland is, by definition, governmental
policy, it is distinguishable from a state statute, accompanied by
appropriations, naming the X River as a valuable resource and
articulating the legislative policy that the X River and the relatively
natural quality of its surrounding be protected. On these facts, an open
space easement on farmland in State X would have to demonstrate
additional factors to establish ``significant public benefit.'' The
specificity of the legislative mandate to protect the X River, however,
would by itself tend to establish the significant public benefit
associated with an open space easement on land fronting the X River.
(B) Scenic enjoyment and significant public benefit. With respect to
the relationship between the requirements of ``scenic enjoyment'' and
``significant public benefit,'' since the degrees of scenic enjoyment
offered by a variety of open space easements are subjective and not as
easily delineated as are increasingly specific levels of governmental
policy, the significant public benefit of preserving a scenic view must
be independently established in all cases.
[[Page 121]]
(C) Donations may satisfy more than one test. In some cases, open
space easements may be both for scenic enjoyment and pursuant to a
clearly delineated governmental policy. For example, the preservation of
a particular scenic view identified as part of a scenic landscape
inventory by a rigorous governmental review process will meet the tests
of both paragraphs (d)(4)(i)(A) and (d)(4)(i)(B) of this section.
(5) Historic preservation--(i) In general. The donation of a
qualified real property interest to preserve an historically important
land area or a certified historic structure will meet the conservation
purposes test of this section. When restrictions to preserve a building
or land area within a registered historic district permit future
development on the site, a deduction will be allowed under this section
only if the terms of the restrictions require that such development
conform with appropriate local, state, or Federal standards for
construction or rehabilitation within the district. See also, Sec.
1.170A-14(h)(3)(ii).
(ii) Historically important land area. The term historically
important land area includes:
(A) An independently significant land area including any related
historic resources (for example, an archaeological site or a Civil War
battlefield with related monuments, bridges, cannons, or houses) that
meets the National Register Criteria for Evaluation in 36 CFR 60.4 (Pub.
L. 89-665, 80 Stat. 915);
(B) Any land area within a registered historic district including
any buildings on the land area that can reasonably be considered as
contributing to the significance of the district; and
(C) Any land area (including related historic resources) adjacent to
a property listed individually in the National Register of Historic
Places (but not within a registered historic district) in a case where
the physical or environmental features of the land area contribute to
the historic or cultural integrity of the property.
(iii) Certified historic structure. The term certified historic
structure, for purposes of this section, means any building, structure
or land area which is--
(A) Listed in the National Register, or
(B) Located in a registered historic district (as defined in section
48(g)(3)(B)) and is certified by the Secretary of the Interior (pursuant
to 36 CFR 67.4) to the Secretary of the Treasury as being of historic
significance to the district.
A structure for purposes of this section means any structure, whether or
not it is depreciable. Accordingly easements on private residences may
qualify under this section. In addition, a structure would be considered
to be a certified historic structure if it were certified either at the
time the transfer was made or at the due date (including extensions) for
filing the donor's return for the taxable year in which the contribution
was made.
(iv) Access. (A) In order for a conservation contribution described
in section 170(h)(4)(A)(iv) and this paragraph (d)(5) to be deductible,
some visual public access to the donated property is required. In the
case of an historically important land area, the entire property need
not be visible to the public for a donation to qualify under this
section. However, the public benefit from the donation may be
insufficient to qualify for a deduction if only a small portion of the
property is so visible. Where the historic land area or certified
historic structure which is the subject of the donation is not visible
from a public way (e.g., the structure is hidden from view by a wall or
shrubbery, the structure is too far from the public way, or interior
characteristics and features of the structure are the subject of the
easement), the terms of the easement must be such that the general
public is given the opportunity on a regular basis to view the
characteristics and features of the property which are preserved by the
easement to the extent consistent with the nature and condition of the
property.
(B) Factors to be considered in determining the type and amount of
public access required under paragraph (d)(5)(iv)(A) of this section
include the historical significance of the donated property, the nature
of the features that are the subject of the easement, the remoteness or
accessibility of the site of the donated property, the possibility of
physical hazards to the public visiting the property (for example, an
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unoccupied structure in a dilapidated condition), the extent to which
public access would be an unreasonable intrusion on any privacy
interests of individuals living on the property, the degree to which
public access would impair the preservation interests which are the
subject of the donation, and the availability of opportunities for the
public to view the property by means other than visits to the site.
(C) The amount of access afforded the public by the donation of an
easement shall be determined with reference to the amount of access
permitted by the terms of the easement which are established by the
donor, rather than the amount of access actually provided by the donee
organization. However, if the donor is aware of any facts indicating
that the amount of access that the donee organization will provide is
significantly less than the amount of access permitted under the terms
of the easement, then the amount of access afforded the public shall be
determined with reference to this lesser amount.
(v) Examples. The provisions of paragraph (d)(5)(iv) of this section
may be illustrated by the following examples:
Example 1. A and his family live in a house in a certified historic
district in the State of X. The entire house, including its interior,
has architectural features representing classic Victorian period
architecture. A donates an exterior and interior easement on the
property to a qualified organization but continues to live in the house
with his family. A's house is surrounded by a high stone wall which
obscures the public's view of it from the street. Pursuant to the terms
of the easement, the house may be opened to the public from 10:00 a.m.
to 4:00 p.m. on one Sunday in May and one Sunday in November each year
for house and garden tours. These tours are to be under the supervision
of the donee and open to members of the general public upon payment of a
small fee. In addition, under the terms of the easement, the donee
organization is given the right to photograph the interior and exterior
of the house and distribute such photographs to magazines, newsletters,
or other publicly available publications. The terms of the easement also
permit persons affiliated with educational organizations, professional
architectural associations, and historical societies to make an
appointment through the donee organization to study the property. The
donor is not aware of any facts indicating that the public access to be
provided by the donee organization will be significantly less than that
permitted by the terms of the easement. The 2 opportunities for public
visits per year, when combined with the ability of the general public to
view the architectural characteristics and features that are the subject
of the easement through photographs, the opportunity for scholarly study
of the property, and the fact that the house is used as an occupied
residence, will enable the donation to satisfy the requirement of public
access.
Example 2. B owns an unoccupied farmhouse built in the 1840's and
located on a property that is adjacent to a Civil War battlefield.
During the Civil War the farmhouse was used as quarters for Union
troops. The battlefield is visited year round by the general public. The
condition of the farmhouse is such that the safety of visitors will not
be jeopardized and opening it to the public will not result in
significant deterioration. The farmhouse is not visible from the
battlefield or any public way. It is accessible only by way of a private
road owned by B. B donates a conservation easement on the farmhouse to a
qualified organization. The terms of the easement provide that the donee
organization may open the property (via B's road) to the general public
on four weekends each year from 8:30 a.m. to 4:00 p.m. The donation does
not meet the public access requirement because the farmhouse is safe,
unoccupied, and easily accessible to the general public who have come to
the site to visit Civil War historic land areas (and related resources),
but will only be open to the public on four weekends each year. However,
the donation would meet the public access requirement if the terms of
the easement permitted the donee organization to open the property to
the public every other weekend during the year and the donor is not
aware of any facts indicating that the donee organization will provide
significantly less access than that permitted.
(e) Exclusively for conservation purposes--(1) In general. To meet
the requirements of this section, a donation must be exclusively for
conservation purposes. See paragraphs (c)(1) and (g)(1) through
(g)(6)(ii) of this section. A deduction will not be denied under this
section when incidental benefit inures to the donor merely as a result
of conservation restrictions limiting the uses to which the donor's
property may be put.
(2) Inconsistent use. Except as provided in paragraph (e)(4) of this
section, a deduction will not be allowed if the contribution would
accomplish one of the enumerated conservation purposes but would permit
destruction of other significant conservation interests. For example,
the preservation of
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farmland pursuant to a State program for flood prevention and control
would not qualify under paragraph (d)(4) of this section if under the
terms of the contribution a significant naturally occurring ecosystem
could be injured or destroyed by the use of pesticides in the operation
of the farm. However, this requirement is not intended to prohibit uses
of the property, such as selective timber harvesting or selective
farming if, under the circumstances, those uses do not impair
significant conservation interests.
(3) Inconsistent use permitted. A use that is destructive of
conservation interests will be permitted only if such use is necessary
for the protection of the conservation interests that are the subject of
the contribution. For example, a deduction for the donation of an
easement to preserve an archaeological site that is listed on the
National Register of Historic Places will not be disallowed if site
excavation consistent with sound archaeological practices may impair a
scenic view of which the land is a part. A donor may continue a pre-
existing use of the property that does not conflict with the
conservation purposes of the gift.
(f) Examples. The provisions of this section relating to
conservation purposes may be illustrated by the following examples.
Example 1. State S contains many large tract forests that are
desirable recreation and scenic areas for the general public. The
forests' scenic values attract millions of people to the State. However,
due to the increasing intensity of land development in State S, the
continued existence of forestland parcels greater than 45 acres is
threatened. J grants a perpetual easement on a 100-acre parcel of
forestland that is part of one of the State's scenic areas to a
qualifying organization. The easement imposes restrictions on the use of
the parcel for the purpose of maintaining its scenic values. The
restrictions include a requirement that the parcel be maintained forever
as open space devoted exclusively to conservation purposes and wildlife
protection, and that there be no commercial, industrial, residential, or
other development use of such parcel. The law of State S recognizes a
limited public right to enter private land, particularly for
recreational pursuits, unless such land is posted or the landowner
objects. The easement specifically restricts the landowner from posting
the parcel, or from objecting, thereby maintaining public access to the
parcel according to the custom of the State. J's parcel provides the
opportunity for the public to enjoy the use of the property and
appreciate its scenic values. Accordingly, J's donation qualifies for a
deduction under this section.
Example 2. A qualified conservation organization owns Greenacre in
fee as a nature preserve. Greenacre contains a high quality example of a
tall grass prairie ecosystem. Farmacre, an operating farm, adjoins
Greenacre and is a compatible buffer to the nature preserve. Conversion
of Farmacre to a more intense use, such as a housing development, would
adversely affect the continued use of Greenacre as a nature preserve
because of human traffic generated by the development. The owner of
Farmacre donates an easement preventing any future development on
Farmacre to the qualified conservation organization for conservation
purposes. Normal agricultural uses will be allowed on Farmacre.
Accordingly, the donation qualifies for a deduction under this section.
Example 3. H owns Greenacre, a 900-acre parcel of woodland, rolling
pasture, and orchards on the crest of a mountain. All of Greenacre is
clearly visible from a nearby national park. Because of the strict
enforcement of an applicable zoning plan, the highest and best use of
Greenacre is as a subdivision of 40-acre tracts. H wishes to donate a
scenic easement on Greenacre to a qualifying conservation organization,
but H would like to reserve the right to subdivide Greenacre into 90-
acre parcels with no more than one single-family home allowable on each
parcel. Random building on the property, even as little as one home for
each 90 acres, would destroy the scenic character of the view.
Accordingly, no deduction would be allowable under this section.
Example 4. Assume the same facts as in example (3), except that not
all of Greenacre is visible from the park and the deed of easement
allows for limited cluster development of no more than five nine-acre
clusters (with four houses on each cluster) located in areas generally
not visible from the national park and subject to site and building plan
approval by the donee organization in order to preserve the scenic view
from the park. The donor and the donee have already identified sites
where limited cluster development would not be visible from the park or
would not impair the view. Owners of homes in the clusters will not have
any rights with respect to the surrounding Greenacre property that are
not also available to the general public. Accordingly, the donation
qualifies for a deduction under this section.
Example 5. In order to protect State S's declining open space that
is suited for agricultural use from increasing development pressure that
has led to a marked decline in such open space, the Legislature of State
S passed a statute authorizing the purchase of ``agricultural land
development rights'' on open
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acreage. Agricultural land development rights allow the State to place
agricultural preservation restrictions on land designated as worthy of
protection in order to preserve open space and farm resources.
Agricultural preservation restrictions prohibit or limit construction or
placement of buildings except those used for agricultural purposes or
dwellings used for family living by the farmer and his family and
employees; removal of mineral substances in any manner that adversely
affects the land's agricultural potential; or other uses detrimental to
retention of the land for agricultural use. Money has been appropriated
for this program and some landowners have in fact sold their
``agricultural land development rights'' to State S. K owns and operates
a small dairy farm in State S located in an area designated by the
Legislature as worthy of protection. K desires to preserve his farm for
agricultural purposes in perpetuity. Rather than selling the development
rights to State S, K grants to a qualified organization an agricultural
preservation restriction on his property in the form of a conservation
easement. K reserves to himself, his heirs and assigns the right to
manage the farm consistent with sound agricultural and management
practices. The preservation of K's land is pursuant to a clearly
delineated governmental policy of preserving open space available for
agricultural use, and will yield a significant public benefit by
preserving open space against increasing development pressures.
(g) Enforceable in perpetuity--(1) In general. In the case of any
donation under this section, any interest in the property retained by
the donor (and the donor's successors in interest) must be subject to
legally enforceable restrictions (for example, by recordation in the
land records of the jurisdiction in which the property is located) that
will prevent uses of the retained interest inconsistent with the
conservation purposes of the donation. In the case of a contribution of
a remainder interest, the contribution will not qualify if the tenants,
whether they are tenants for life or a term of years, can use the
property in a manner that diminishes the conservation values which are
intended to be protected by the contribution.
(2) Protection of a conservation purpose in case of donation of
property subject to a mortgage. In the case of conservation
contributions made after February 13, 1986, no deducion will be
permitted under this section for an interest in property which is
subject to a mortgage unless the mortgagee subordinates its rights in
the property to the right of the qualified organization to enforce the
conservation purposes of the gift in perpetuity. For conservation
contributions made prior to February 14, 1986, the requirement of
section 170 (h)(5)(A) is satisfied in the case of mortgaged property
(with respect to which the mortgagee has not subordinated its rights)
only if the donor can demonstrate that the conservation purpose is
protected in perpetuity without subordination of the mortgagee's rights.
(3) Remote future event. A deduction shall not be disallowed under
section 170(f)(3)(B)(iii) and this section merely because the interest
which passes to, or is vested in, the donee organization may be defeated
by the performance of some act or the happening of some event, if on the
date of the gift it appears that the possibility that such act or event
will occur is so remote as to be negligible. See paragraph (e) of Sec.
1.170A-1. For example, a state's statutory requirement that use
restrictions must be rerecorded every 30 years to remain enforceable
shall not, by itself, render an easement nonperpetual.
(4) Retention of qualified mineral interest--(i) In general. Except
as otherwise provided in paragraph (g)(4)(ii) of this section, the
requirements of this section are not met and no deduction shall be
allowed in the case of a contribution of any interest when there is a
retention by any person of a qualified mineral interest (as defined in
paragraph (b)(1)(i) of this section) if at any time there may be
extractions or removal of minerals by any surface mining method.
Moreover, in the case of a qualified mineral interest gift, the
requirement that the conservation purposes be protected in perpetuity is
not satisfied if any method of mining that is inconsistent with the
particular conservation purposes of a contribution is permitted at any
time. See also Sec. 1.170A-14(e)(2). However, a deduction under this
section will not be denied in the case of certain methods of mining that
may have limited, localized impact on the real property but that are not
irremediably destructive of significant conservation interests. For
example, a deduction will not be denied in a case
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where production facilities are concealed or compatible with existing
topography and landscape and when surface alteration is to be restored
to its original state.
(ii) Exception for qualified conservation contributions after July
1984. (A) A contribution made after July 18, 1984, of a qualified real
property interest described in section 170(h)(2)(A) shall not be
disqualified under the first sentence of paragraph (g)(4)(i) of this
section if the following requirements are satisfied.
(1) The ownership of the surface estate and mineral interest were
separated before June 13, 1976, and remain so separated up to and
including the time of the contribution.
(2) The present owner of the mineral interest is not a person whose
relationship to the owner of the surface estate is described at the time
of the contribution in section 267(b) or section 707(b), and
(3) The probability of extraction or removal of minerals by any
surface mining method is so remote as to be negligible.
Whether the probability of extraction or removal of minerals by surface
mining is so remote as to be negligible is a question of fact and is to
be made on a case by case basis. Relevant factors to be considered in
determining if the probability of extraction or removal of minerals by
surface mining is so remote as to be negligible include: Geological,
geophysical or economic data showing the absence of mineral reserves on
the property, or the lack of commercial feasibility at the time of the
contribution of surface mining the mineral interest.
(B) If the ownership of the surface estate and mineral interest
first became separated after June 12, 1976, no deduction is permitted
for a contribution under this section unless surface mining on the
property is completely prohibited.
(iii) Examples. The provisions of paragraph (g)(4)(i) and (ii) of
this section may be illustrated by the following examples:
Example 1. K owns 5,000 acres of bottomland hardwood property along
a major watershed system in the southern part of the United States.
Agencies within the Department of the Interior have determined that
southern bottomland hardwoods are a rapidly diminishing resource and a
critical ecosystem in the south because of the intense pressure to cut
the trees and convert the land to agricultural use. These agencies have
further determined (and have indicated in correspondence with K) that
bottomland hardwoods provide a superb habitat for numerous species and
play an important role in controlling floods and purifying rivers. K
donates to a qualified organization his entire interest in this property
other than his interest in the gas and oil deposits that have been
identified under K's property. K covenants and can ensure that, although
drilling for gas and oil on the property may have some temporary
localized impact on the real property, the drilling will not interfere
with the overall conservation purpose of the gift, which is to protect
the unique bottomland hardwood ecosystem. Accordingly, the donation
qualifies for a deduction under this section.
Example 2. Assume the same facts as in Example 1, except that in
1979, K sells the mineral interest to A, an unrelated person, in an
arm's-length transaction, subject to a recorded prohibition on the
removal of any minerals by any surface mining method and a recorded
prohibition against any mining technique that will harm the bottomland
hardwood ecosystem. After the sale to A, K donates a qualified real
property interest to a qualified organization to protect the bottomland
hardwood ecosystem. Since at the time of the transfer, surface mining
and any mining technique that will harm the bottomland hardwood
ecosystem are completely prohibited, the donation qualifies for a
deduction under this section.
(5) Protection of conservation purpose where taxpayer reserves
certain rights--(i) Documentation. In the case of a donation made after
February 13, 1986, of any qualified real property interest when the
donor reserves rights the exercise of which may impair the conservation
interests associated with the property, for a deduction to be allowable
under this section the donor must make available to the donee, prior to
the time the donation is made, documentation sufficient to establish the
condition of the property at the time of the gift. Such documentation is
designed to protect the conservation interests associated with the
property, which although protected in perpetuity by the easement, could
be adversely affected by the exercise of the reserved rights. Such
documentation may include:
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(A) The appropriate survey maps from the United States Geological
Survey, showing the property line and other contiguous or nearby
protected areas;
(B) A map of the area drawn to scale showing all existing man-made
improvements or incursions (such as roads, buildings, fences, or gravel
pits), vegetation and identification of flora and fauna (including, for
example, rare species locations, animal breeding and roosting areas, and
migration routes), land use history (including present uses and recent
past disturbances), and distinct natural features (such as large trees
and aquatic areas);
(C) An aerial photograph of the property at an appropriate scale
taken as close as possible to the date the donation is made; and
(D) On-site photographs taken at appropriate locations on the
property. If the terms of the donation contain restrictions with regard
to a particular natural resource to be protected, such as water quality
or air quality, the condition of the resource at or near the time of the
gift must be established. The documentation, including the maps and
photographs, must be accompanied by a statement signed by the donor and
a representative of the donee clearly referencing the documentation and
in substance saying ``This natural resources inventory is an accurate
representation of [the protected property] at the time of the
transfer.''.
(ii) Donee's right to inspection and legal remedies. In the case of
any donation referred to in paragraph (g)(5)(i) of this section, the
donor must agree to notify the donee, in writing, before exercising any
reserved right, e.g. the right to extract certain minerals which may
have an adverse impact on the conservation interests associated with the
qualified real property interest. The terms of the donation must provide
a right of the donee to enter the property at reasonable times for the
purpose of inspecting the property to determine if there is compliance
with the terms of the donation. Additionally, the terms of the donation
must provide a right of the donee to enforce the conservation
restrictions by appropriate legal proceedings, including but not limited
to, the right to require the restoration of the property to its
condition at the time of the donation.
(6) Extinguishment. (i) In general. If a subsequent unexpected
change in the conditions surrounding the property that is the subject of
a donation under this paragraph can make impossible or impractical the
continued use of the property for conservation purposes, the
conservation purpose can nonetheless be treated as protected in
perpetuity if the restrictions are extinguished by judicial proceeding
and all of the donee's proceeds (determined under paragraph (g)(6)(ii)
of this section) from a subsequent sale or exchange of the property are
used by the donee organization in a manner consistent with the
conservation purposes of the original contribution.
(ii) Proceeds. In case of a donation made after February 13, 1986,
for a deduction to be allowed under this section, at the time of the
gift the donor must agree that the donation of the perpetual
conservation restriction gives rise to a property right, immediately
vested in the donee organization, with a fair market value that is at
least equal to the proportionate value that the perpetual conservation
restriction at the time of the gift, bears to the value of the property
as a whole at that time. See Sec. 1.170A-14(h)(3)(iii) relating to the
allocation of basis. For purposes of this paragraph (g)(6)(ii), that
proportionate value of the donee's property rights shall remain
constant. Accordingly, when a change in conditions give rise to the
extinguishment of a perpetual conservation restriction under paragraph
(g)(6)(i) of this section, the donee organization, on a subsequent sale,
exchange, or involuntary conversion of the subject property, must be
entitled to a portion of the proceeds at least equal to that
proportionate value of the perpetual conservation restriction, unless
state law provides that the donor is entitled to the full proceeds from
the conversion without regard to the terms of the prior perpetual
conservation restriction.
(h) Valuation--(1) Entire interest of donor other than qualified
mineral interest. The value of the contribution under section 170 in the
case of a contribution
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of a taxpayer's entire interest in property other than a qualified
mineral interest is the fair market value of the surface rights in the
property contributed. The value of the contribution shall be computed
without regard to the mineral rights. See paragraph (h)(4), example (1),
of this section.
(2) Remainder interest in real property. In the case of a
contribution of any remainder interest in real property, section
170(f)(4) provides that in determining the value of such interest for
purposes of section 170, depreciation and depletion of such property
shall be taken into account. See Sec. 1.170A-12. In the case of the
contribution of a remainder interest for conservation purposes, the
current fair market value of the property (against which the limitations
of Sec. 1.170A-12 are applied) must take into account any pre-existing
or contemporaneously recorded rights limiting, for conservation
purposes, the use to which the subject property may be put.
(3) Perpetual conservation restriction--(i) In general. The value of
the contribution under section 170 in the case of a charitable
contribution of a perpetual conservation restriction is the fair market
value of the perpetual conservation restriction at the time of the
contribution. See Sec. 1.170A-7(c). If there is a substantial record of
sales of easements comparable to the donated easement (such as purchases
pursuant to a governmental program), the fair market value of the
donated easement is based on the sales prices of such comparable
easements. If no substantial record of market-place sales is available
to use as a meaningful or valid comparison, as a general rule (but not
necessarily in all cases) the fair market value of a perpetual
conservation restriction is equal to the difference between the fair
market value of the property it encumbers before the granting of the
restriction and the fair market value of the encumbered property after
the granting of the restriction. The amount of the deduction in the case
of a charitable contribution of a perpetual conservation restriction
covering a portion of the contiguous property owned by a donor and the
donor's family (as defined in section 267(c)(4)) is the difference
between the fair market value of the entire contiguous parcel of
property before and after the granting of the restriction. If the
granting of a perpetual conservation restriction after January 14, 1986,
has the effect of increasing the value of any other property owned by
the donor or a related person, the amount of the deduction for the
conservation contribution shall be reduced by the amount of the increase
in the value of the other property, whether or not such property is
contiguous. If, as a result of the donation of a perpetual conservation
restriction, the donor or a related person receives, or can reasonably
expect to receive, financial or economic benefits that are greater than
those that will inure to the general public from the transfer, no
deduction is allowable under this section. However, if the donor or a
related person receives, or can reasonably expect to receive, a
financial or economic benefit that is substantial, but it is clearly
shown that the benefit is less than the amount of the transfer, then a
deduction under this section is allowable for the excess of the amount
transferred over the amount of the financial or economic benefit
received or reasonably expected to be received by the donor or the
related person. For purposes of this paragraph (h)(3)(i), related person
shall have the same meaning as in either section 267(b) or section
707(b). (See Example 10 of paragraph (h)(4) of this section.)
(ii) Fair market value of property before and after restriction. If
before and after valuation is used, the fair market value of the
property before contribution of the conservation restriction must take
into account not only the current use of the property but also an
objective assessment of how immediate or remote the likelihood is that
the property, absent the restriction, would in fact be developed, as
well as any effect from zoning, conservation, or historic preservation
laws that already restrict the property's potential highest and best
use. Further, there may be instances where the grant of a conservation
restriction may have no material effect on the value of the property or
may in fact serve to enhance, rather than reduce, the value of property.
In such instances no deduction would be
[[Page 128]]
allowable. In the case of a conservation restriction that allows for any
development, however limited, on the property to be protected, the fair
maket value of the property after contribution of the restriction must
take into account the effect of the development. In the case of a
conservation easement such as an easement on a certified historic
structure, the fair market value of the property after contribution of
the restriction must take into account the amount of access permitted by
the terms of the easement. Additionally, if before and after valuation
is used, an appraisal of the property after contribution of the
restriction must take into account the effect of restrictions that will
result in a reduction of the potential fair market value represented by
highest and best use but will, nevertheless, permit uses of the property
that will increase its fair market value above that represented by the
property's current use. The value of a perpetual conservation
restriction shall not be reduced by reason of the existence of
restrictions on transfer designed solely to ensure that the conservation
restriction will be dedicated to conservation purposes. See Sec.
1.170A-14 (c)(3).
(iii) Allocation of basis. In the case of the donation of a
qualified real property interest for conservation purposes, the basis of
the property retained by the donor must be adjusted by the elimination
of that part of the total basis of the property that is properly
allocable to the qualified real property interest granted. The amount of
the basis that is allocable to the qualified real property interest
shall bear the same ratio to the total basis of the property as the fair
market value of the qualified real property interest bears to the fair
market value of the property before the granting of the qualified real
property interest. When a taxpayer donates to a qualifying conservation
organization an easement on a structure with respect to which deductions
are taken for depreciation, the reduction required by this paragraph
(h)(3)(ii) in the basis of the property retained by the taxpayer must be
allocated between the structure and the underlying land.
(4) Examples. The provisions of this section may be illustrated by
the following examples. In examples illustrating the value or
deductibility of donations, the applicable restrictions and limitations
of Sec. 1.170A-4, with respect to reduction in amount of charitable
contributions of certain appreciated property, and Sec. 1.170A-8, with
respect to limitations on charitable deductions by individuals. must
also be taken into account.
Example 1. A owns Goldacre, a property adjacent to a state park. A
wants to donate Goldacre to the state to be used as part of the park,
but A wants to reserve a qualified mineral interest in the property, to
exploit currently and to devise at death. The fair market value of the
surface rights in Goldacre is $200,000 and the fair market value of the
mineral rights in $100.000. In order to ensure that the quality of the
park will not be degraded, restrictions must be imposed on the right to
extract the minerals that reduce the fair market value of the mineral
rights to $80,000. Under this section, the value of the contribution is
$200,000 (the value of the surface rights).
Example 2. In 1984 B, who is 62, donates a remainder interest in
Greenacre to a qualifying organization for conservation purposes.
Greenacre is a tract of 200 acres of undeveloped woodland that is valued
at $200,000 at its highest and best use. Under Sec. 1.170A-12(b), the
value of a remainder interest in real property following one life is
determined under Sec. 25.2512-5 of this chapter (Gift Tax Regulations).
(See Sec. 25.2512-5A of this chapter with respect to the valuation of
annuities, interests for life or term of years, and remainder or
reversionary interests transferred before May 1, 2009.) Accordingly, the
value of the remainder interest, and thus the amount eligible for an
income tax deduction under section 170(f), is $55,996 ($200,000 x
.27998).
Example 3. Assume the same facts as in Example 2, except that
Greenacre is B's 200-acre estate with a home built during the colonial
period. Some of the acreage around the home is cleared; the balance of
Greenacre, except for access roads, is wooded and undeveloped. See
section 170(f)(3)(B)(i). However, B would like Greenacre to be
maintained in its current state after his death, so he donates a
remainder interest in Greenacre to a qualifying organization for
conservation purposes pursunt to section 170 (f)(3)(B)(iii) and
(h)(2)(B). At the time of the gift the land has a value of $200,000 and
the house has a value of $100,000. The value of the remainder interest,
and thus the amount eligible for an income tax deduction under section
170(f), is computed pursuant to Sec. 1.170A-12. See Sec. 1.170A-
12(b)(3).
[[Page 129]]
Example 4. Assume the same facts as in Example 2, except that at age
62 instead of donating a remainder interest B donates an easement in
Greenacre to a qualifying organization for conservation purposes. The
fair market value of Greenacre after the donation is reduced to
$110,000. Accordingly, the value of the easement, and thus the amount
eligible for a deduction under section 170(f), is $90,000 ($200,000 less
$110,000).
Example 5. Assume the same facts as in Example 4, and assume that
three years later, at age 65, B decides to donate a remainder interest
in Greenacre to a qualifying organization for conservation purposes.
Increasing real estate values in the area have raised the fair market
value of Greenacre (subject to the easement) to $130,000. Accordingly,
the value of the remainder interest, and thus the amount eligible for a
deduction under section 170(f), is $41,639 ($130,000 x .32030).
Example 6. Assume the same facts as in Example 2, except that at the
time of the donation of a remainder interest in Greenacre, B also
donates an easement to a different qualifying organization for
conservation purposes. Based on all the facts and circumstances, the
value of the easement is determined to be $100,000. Therefore, the value
of the property after the easement is $100,000 and the value of the
remainder interest, and thus the amount eligible for deduction under
section 170(f), is $27,998 ($100,000 x .27998).
Example 7. C owns Greenacre, a 200-acre estate containing a house
built during the colonial period. At its highest and best use, for home
development, the fair market value of Greenacre is $300,000. C donates
an easement (to maintain the house and Green acre in their current
state) to a qualifying organization for conservation purposes. The fair
market value of Greenacre after the donation is reduced to $125,000.
Accordingly, the value of the easement and the amount eligible for a
deduction under section 170(f) is $175.000 ($300,000 less $125,000).
Example 8. Assume the same facts as in Example 7 and assume that
three years later, C decides to donate a remainder interest in Greenacre
to a qualifying organization for conservation purposes. Increasing real
estate values in the area have raised the fair market value of Greenacre
to $180.000. Assume that because of the perpetual easement prohibiting
any development of the land, the value of the house is $120,000 and the
value of the land is $60,000. The value of the remainder interest, and
thus the amount eligible for an income tax deduction under section
170(f), is computed pursuant to Sec. 1.170A-12. See Sec. 1.170A-
12(b)(3).
Example 9. D owns property with a basis of $20,000 and a fair market
value of $80,000. D donates to a qualifying organization an easement for
conservation purposes that is determined under this section to have a
fair market value of $60,000. The amount of basis allocable to the
easement is $15,000 ($60,000/$80,000 = $15,000/$20,000). Accordingly,
the basis of the property is reduced to $5,000 ($20,000 minus $15,000).
Example 10. E owns 10 one-acre lots that are currently woods and
parkland. The fair market value of each of E's lots is $15,000 and the
basis of each lot is $3,000. E grants to the county a perpetual easement
for conservation purposes to use and maintain eight of the acres as a
public park and to restrict any future development on those eight acres.
As a result of the restrictions, the value of the eight acres is reduced
to $1,000 an acre. However, by perpetually restricting development on
this portion of the land, E has ensured that the two remaining acres
will always be bordered by parkland, thus increasing their fair market
value to $22,500 each. If the eight acres represented all of E's land,
the fair market value of the easement would be $112,000, an amount equal
to the fair market value of the land before the granting of the easement
(8 x $15,000 = $120,000) minus the fair market value of the encumbered
land after the granting of the easement (8 x $1,000 = $8,000). However,
because the easement only covered a portion of the taxpayer's contiguous
land, the amount of the deduction under section 170 is reduced to
$97,000 ($150,000-$53,000), that is, the difference between the fair
market value of the entire tract of land before ($150,000) and after ((8
x $1,000) + (2 x $22,500)) the granting of the easement.
Example 11. Assume the same facts as in example (10). Since the
easement covers a portion of E's land, only the basis of that portion is
adjusted. Therefore, the amount of basis allocable to the easement is
$22,400 ((8 x $3,000) x ($112,000/$120,000)). Accordingly, the basis of
the eight acres encumbered by the easement is reduced to $1,600
($24,000-$22,400), or $200 for each acre. The basis of the two remaining
acres is not affected by the donation.
Example 12. F owns and uses as professional offices a two-story
building that lies within a registered historic district. F's building
is an outstanding example of period architecture with a fair market
value of $125,000. Restricted to its current use, which is the highest
and best use of the property without making changes to the facade, the
building and lot would have a fair market value of $100,000, of which
$80,000 would be allocable to the building and $20,000 woud be allocable
to the lot. F's basis in the property is $50,000, of which $40,000 is
allocable to the building and $10,000 is allocable to the lot. F's
neighborhood is a mix of residential and commercial uses, and it is
possible that F (or another owner) could enlarge the building for more
extensive commercial use, which is its highest and best use. However,
this would require changes to the facade. F would like to
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donate to a qualifying preservation organization an easement restricting
any changes to the facade and promising to maintain the facade in
perpetuity. The donation would qualify for a deduction under this
section. The fair market value of the easement is $25,000 (the fair
market value of the property before the easement, $125,000, minus the
fair market value of the property after the easement, $100,000).
Pursuant to Sec. 1.170A-14(h)(3)(iii), the basis allocable to the
easement is $10,000 and the basis of the underlying property (building
and lot) is reduced to $40,000.
(i) Substantiation requirement. If a taxpayer makes a qualified
conservation contribution and claims a deduction, the taxpayer must
maintain written records of the fair market value of the underlying
property before and after the donation and the conservation purpose
furthered by the donation, and such information shall be stated in the
taxpayer's income tax return if required by the return or its
instructions. See also Sec. 1.170A-13(c) (relating to substantiation
requirements for deductions in excess of $5,000 for charitable
contributions made on or before July 30, 2018); Sec. 1.170A-16(d)
(relating to substantiation of charitable contributions of more than
$5,000 made after July 30, 2018); Sec. 1.170A-17 (relating to the
definitions of qualified appraisal and qualified appraiser for
substantiation of contributions made on or after January 1, 2019); and
section 6662 (relating to the imposition of an accuracy-related penalty
on underpayments). Taxpayers may rely on the rules in Sec. 1.170A-16(d)
for contributions made after June 3, 2004, or appraisals prepared for
returns or submissions filed after August 17, 2006. Taxpayers may rely
on the rules in Sec. 1.170A-17 for appraisals prepared for returns or
submissions filed after August 17, 2006.
(j) Effective/applicability dates. Except as otherwise provided in
Sec. 1.170A-14(g)(4)(ii) and Sec. 1.170A-14(i), this section applies
only to contributions made on or after December 18, 1980.
[T.D. 8069, 51 FR 1499, Jan. 14, 1986; 51 FR 5322, Feb. 13, 1986; 51 FR
6219, Feb. 21, 1986, as amended by T.D. 8199, 53 FR 16085, May 5, 1988;
T.D. 8540, 59 FR 30105, June 10, 1994; T.D. 8819, 64 FR 23228, Apr. 30,
1999; T.D. 9448, 74 FR 21518, May 7, 2009; T.D. 9836, 83 FR 36422, July
30, 2018]
Sec. 1.170A-15 Substantiation requirements for charitable contribution
of a cash, check, or other monetary gift.
(a) In general--(1) Bank record or written communication required.
No deduction is allowed under sections 170(a) and 170(f)(17) for a
charitable contribution in the form of a cash, check, or other monetary
gift, as described in paragraph (b)(1) of this section, unless the donor
substantiates the deduction with a bank record, as described in
paragraph (b)(2) of this section, or a written communication, as
described in paragraph (b)(3) of this section, from the donee showing
the name of the donee, the date of the contribution, and the amount of
the contribution.
(2) Additional substantiation required for contributions of $250 or
more. No deduction is allowed under section 170(a) for any contribution
of $250 or more unless the donor substantiates the contribution with a
contemporaneous written acknowledgment, as described in section
170(f)(8) and Sec. 1.170A-13(f), from the donee.
(3) Single document may be used. The requirements of paragraphs
(a)(1) and (2) of this section may be met by a single document that
contains all the information required by paragraphs (a)(1) and (2) of
this section, if the document is obtained by the donor no later than the
date prescribed by paragraph (c) of this section.
(b) Terms--(1) Monetary gift includes a transfer of a gift card
redeemable for cash, and a payment made by credit card, electronic fund
transfer (as described in section 5061(e)(2)), an online payment
service, or payroll deduction.
(2) Bank record includes a statement from a financial institution,
an electronic fund transfer receipt, a canceled check, a scanned image
of both sides of a canceled check obtained from a bank website, or a
credit card statement.
(3) Written communication includes email.
(c) Deadline for receipt of substantiation. The substantiation
described in paragraph (a) of this section must be received by the donor
on or before the earlier of--
(1) The date the donor files the original return for the taxable
year in which the contribution was made; or
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(2) The due date, including any extension, for filing the donor's
original return for that year.
(d) Special rules--(1) Contributions made by payroll deduction. In
the case of a charitable contribution made by payroll deduction, a donor
is treated as meeting the requirements of section 170(f)(17) and
paragraph (a) of this section if, no later than the date described in
paragraph (c) of this section, the donor obtains--
(i) A pay stub, Form W-2, ``Wage and Tax Statement,'' or other
employer-furnished document that sets forth the amount withheld during
the taxable year for payment to a donee; and
(ii) A pledge card or other document prepared by or at the direction
of the donee that shows the name of the donee.
(2) Distributing organizations as donees. The following
organizations are treated as donees for purposes of section 170(f)(17)
and paragraph (a) of this section, even if the organization (pursuant to
the donor's instructions or otherwise) distributes the amount received
to one or more organizations described in section 170(c):
(i) An organization described in section 170(c).
(ii) An organization described in 5 CFR 950.105 (a Principal
Combined Fund Organization (PCFO) for purposes of the Combined Federal
Campaign (CFC)) and acting in that capacity. For purposes of the
requirement for a written communication under section 170(f)(17), if the
donee is a PCFO, the name of the local CFC campaign may be treated as
the name of the donee organization.
(e) Substantiation of out-of-pocket expenses. Paragraph (a)(1) of
this section does not apply to a donor who incurs unreimbursed expenses
of less than $250 incident to the rendition of services, within the
meaning of Sec. 1.170A-1(g). For substantiation of unreimbursed out-of-
pocket expenses of $250 or more, see Sec. 1.170A-13(f)(10).
(f) Charitable contributions made by partnership or S corporation.
If a partnership or an S corporation makes a charitable contribution,
the partnership or S corporation is treated as the donor for purposes of
section 170(f)(17) and paragraph (a) of this section.
(g) Transfers to certain trusts. The requirements of section
170(f)(17) and paragraphs (a)(1) and (3) of this section do not apply to
a transfer of a cash, check, or other monetary gift to a trust described
in section 170(f)(2)(B); a charitable remainder annuity trust, as
described in section 664(d)(1) and the corresponding regulations; or a
charitable remainder unitrust, as described in section 664(d)(2) or
(d)(3) and the corresponding regulations. The requirements of section
170(f)(17) and paragraphs (a)(1) and (2) of this section do apply,
however, to a transfer to a pooled income fund, as defined in section
642(c)(5).
(h) Effective/applicability date. This section applies to
contributions made after July 30, 2018. Taxpayers may rely on the rules
of this section for contributions made in taxable years beginning after
August 17, 2006.
[T.D. 9836, 83 FR 36422, July 30, 2018]
Sec. 1.170A-16 Substantiation and reporting requirements for noncash
charitable contributions.
(a) Substantiation of charitable contributions of less than $250--
(1) Individuals, partnerships, and certain corporations required to
obtain receipt. Except as provided in paragraph (a)(2) of this section,
no deduction is allowed under section 170(a) for a noncash charitable
contribution of less than $250 by an individual, partnership, S
corporation, or C corporation that is a personal service corporation or
closely held corporation unless the donor maintains for each
contribution a receipt from the donee showing the following information:
(i) The name and address of the donee;
(ii) The date of the contribution;
(iii) A description of the property in sufficient detail under the
circumstances (taking into account the value of the property) for a
person who is not generally familiar with the type of property to
ascertain that the described property is the contributed property; and
(iv) In the case of securities, the name of the issuer, the type of
security, and whether the securities are publicly traded securities
within the meaning of Sec. 1.170A-13(c)(7)(xi).
[[Page 132]]
(2) Substitution of reliable written records--(i) In general. If it
is impracticable to obtain a receipt (for example, where a donor
deposits property at a donee's unattended drop site), the donor may
satisfy the recordkeeping rules of this paragraph (a) by maintaining
reliable written records, as described in paragraphs (a)(2)(ii) and
(iii) of this section, for the contributed property.
(ii) Reliable written records. The reliability of written records is
to be determined on the basis of all of the facts and circumstances of a
particular case, including the proximity in time of the written record
to the contribution.
(iii) Contents of reliable written records. Reliable written records
must include--
(A) The information required by paragraph (a)(1) of this section;
(B) The fair market value of the property on the date the
contribution was made;
(C) The method used in determining the fair market value; and
(D) In the case of a contribution of clothing or a household item as
defined in Sec. 1.170A-18(c), the condition of the item.
(3) Additional substantiation rules may apply. For additional
substantiation rules, see paragraph (f) of this section.
(b) Substantiation of charitable contributions of $250 or more but
not more than $500. No deduction is allowed under section 170(a) for a
noncash charitable contribution of $250 or more but not more than $500
unless the donor substantiates the contribution with a contemporaneous
written acknowledgment, as described in section 170(f)(8) and Sec.
1.170A-13(f).
(c) Substantiation of charitable contributions of more than $500 but
not more than $5,000--(1) In general. No deduction is allowed under
section 170(a) for a noncash charitable contribution of more than $500
but not more than $5,000 unless the donor substantiates the contribution
with a contemporaneous written acknowledgment, as described in section
170(f)(8) and Sec. 1.170A-13(f), and meets the applicable requirements
of this section.
(2) Individuals, partnerships, and certain corporations also
required to file Form 8283 (Section A). No deduction is allowed under
section 170(a) for a noncash charitable contribution of more than $500
but not more than $5,000 by an individual, partnership, S corporation,
or C corporation that is a personal service corporation or closely held
corporation unless the donor completes Form 8283 (Section A), ``Noncash
Charitable Contributions,'' as provided in paragraph (c)(3) of this
section, or a successor form, and files it with the return on which the
deduction is claimed.
(3) Completion of Form 8283 (Section A). A completed Form 8283
(Section A) includes--
(i) The donor's name and taxpayer identification number (for
example, a social security number or employer identification number);
(ii) The name and address of the donee;
(iii) The date of the contribution;
(iv) The following information about the contributed property:
(A) A description of the property in sufficient detail under the
circumstances, taking into account the value of the property, for a
person who is not generally familiar with the type of property to
ascertain that the described property is the contributed property;
(B) In the case of real or tangible personal property, the condition
of the property;
(C) In the case of securities, the name of the issuer, the type of
security, and whether the securities are publicly traded securities
within the meaning of Sec. 1.170A-13(c)(7)(xi);
(D) The fair market value of the property on the date the
contribution was made and the method used in determining the fair market
value;
(E) The manner of acquisition (for example, by purchase, gift,
bequest, inheritance, or exchange), and the approximate date of
acquisition of the property by the donor (except that in the case of a
contribution of publicly traded securities as defined in Sec. 1.170A-
13(c)(7)(xi), a representation that the donor held the securities for
more than one year is sufficient) or, if the property was created,
produced, or manufactured by or for the donor, the approximate date the
property was substantially completed;
[[Page 133]]
(F) The cost or other basis, adjusted as provided by section 1016,
of the property (except that the cost or basis is not required for
contributions of publicly traded securities (as defined in Sec. 1.170A-
13(c)(7)(xi)) that would have resulted in long-term capital gain if sold
on the contribution date, unless the donor has elected to limit the
deduction to basis under section 170(b)(1)(C)(iii));
(G) In the case of tangible personal property, whether the donee has
certified it for a use related to the purpose or function constituting
the donee's basis for exemption under section 501, or in the case of a
governmental unit, an exclusively public purpose; and
(v) Any other information required by Form 8283 (Section A) or the
instructions to Form 8283 (Section A).
(4) Additional requirement for certain vehicle contributions. In the
case of a contribution of a qualified vehicle described in section
170(f)(12)(E) for which an acknowledgment by the donee organization is
required under section 170(f)(12)(D), the donor must attach a copy of
the acknowledgment to the Form 8283 (Section A) for the return on which
the deduction is claimed.
(5) Additional substantiation rules may apply. For additional
substantiation rules, see paragraph (f) of this section.
(d) Substantiation of charitable contributions of more than $5,000--
(1) In general. Except as provided in paragraph (d)(2) of this section,
no deduction is allowed under section 170(a) for a noncash charitable
contribution of more than $5,000 unless the donor--
(i) Substantiates the contribution with a contemporaneous written
acknowledgment, as described in section 170(f)(8) and Sec. 1.170A-
13(f);
(ii) Obtains a qualified appraisal, as defined in Sec. 1.170A-
17(a)(1), prepared by a qualified appraiser, as defined in Sec. 1.170A-
17(b)(1); and
(iii) Completes Form 8283 (Section B), as provided in paragraph
(d)(3) of this section, or a successor form, and files it with the
return on which the deduction is claimed.
(2) Exception for certain noncash contributions. A qualified
appraisal is not required, and a completed Form 8283 (Section A)
containing the information required in paragraph (c)(3) of this section
meets the requirements of paragraph (d)(1)(iii) of this section for
contributions of--
(i) Publicly traded securities as defined in Sec. 1.170A-
13(c)(7)(xi);
(ii) Property described in section 170(e)(1)(B)(iii) (certain
intellectual property);
(iii) A qualified vehicle described in section 170(f)(12)(A)(ii) for
which an acknowledgment under section 170(f)(12)(B)(iii) is provided;
and
(iv) Property described in section 1221(a)(1) (inventory and
property held by the donor primarily for sale to customers in the
ordinary course of the donor's trade or business).
(3) Completed Form 8283 (Section B). A completed Form 8283 (Section
B) includes--
(i) The donor's name and taxpayer identification number (for
example, a social security number or employer identification number);
(ii) The donee's name, address, taxpayer identification number,
signature, the date signed by the donee, and the date the donee received
the property;
(iii) The appraiser's name, address, taxpayer identification number,
appraiser declaration, as described in paragraph (d)(4) of this section,
signature, and the date signed by the appraiser;
(iv) The following information about the contributed property:
(A) The fair market value on the valuation effective date, as
defined in Sec. 1.170A-17(a)(5)(i).
(B) A description in sufficient detail under the circumstances,
taking into account the value of the property, for a person who is not
generally familiar with the type of property to ascertain that the
described property is the contributed property.
(C) In the case of real property or tangible personal property, the
condition of the property;
(v) The manner of acquisition (for example, by purchase, gift,
bequest, inheritance, or exchange), and the approximate date of
acquisition of the property by the donor, or, if the property was
created, produced, or manufactured by or for the donor, the approximate
date the property was substantially completed;
[[Page 134]]
(vi) The cost or other basis of the property, adjusted as provided
by section 1016;
(vii) A statement explaining whether the charitable contribution was
made by means of a bargain sale and, if so, the amount of any
consideration received for the contribution; and
(viii) Any other information required by Form 8283 (Section B) or
the instructions to Form 8283 (Section B).
(4) Appraiser declaration. The appraiser declaration referred to in
paragraph (d)(3)(iii) of this section must include the following
statement: ``I understand that my appraisal will be used in connection
with a return or claim for refund. I also understand that, if there is a
substantial or gross valuation misstatement of the value of the property
claimed on the return or claim for refund that is based on my appraisal,
I may be subject to a penalty under section 6695A of the Internal
Revenue Code, as well as other applicable penalties. I affirm that I
have not been at any time in the three-year period ending on the date of
the appraisal barred from presenting evidence or testimony before the
Department of the Treasury or the Internal Revenue Service pursuant to
31 U.S.C. 330(c).''
(5) Donee signature--(i) Person authorized to sign. The person who
signs Form 8283 (Section B) for the donee must be either an official
authorized to sign the tax or information returns of the donee, or a
person specifically authorized to sign Forms 8283 (Section B) by that
official. In the case of a donee that is a governmental unit, the person
who signs Form 8283 (Section B) for the donee must be an official of the
governmental unit.
(ii) Effect of donee signature. The signature of the donee on Form
8283 (Section B) does not represent concurrence in the appraised value
of the contributed property. Rather, it represents acknowledgment of
receipt of the property described in Form 8283 (Section B) on the date
specified in Form 8283 (Section B) and that the donee understands the
information reporting requirements imposed by section 6050L and Sec.
1.6050L-1.
(iii) Certain information not required on Form 8283 (Section B)
before donee signs. Before Form 8283 (Section B) is signed by the donee,
Form 8283 (Section B) must be completed (as described in paragraph
(d)(3) of this section), except that it is not required to contain the
following:
(A) The appraiser declaration or information about the qualified
appraiser.
(B) The manner or date of acquisition.
(C) The cost or other basis of the property.
(D) The appraised fair market value of the contributed property.
(E) The amount claimed as a charitable contribution.
(6) Additional substantiation rules may apply. For additional
substantiation rules, see paragraph (f) of this section.
(7) More than one appraiser. More than one appraiser may appraise
the donated property. If more than one appraiser appraises the property,
the donor does not have to use each appraiser's appraisal for purposes
of substantiating the charitable contribution deduction under this
paragraph (d). If the donor uses the appraisal of more than one
appraiser, or if two or more appraisers contribute to a single
appraisal, each appraiser shall comply with the requirements of this
paragraph (d) and the requirements in Sec. 1.170A-17, including signing
the qualified appraisal and appraisal summary.
(e) Substantiation of noncash charitable contributions of more than
$500,000--(1) In general. Except as provided in paragraph (e)(2) of this
section, no deduction is allowed under section 170(a) for a noncash
charitable contribution of more than $500,000 unless the donor--
(i) Substantiates the contribution with a contemporaneous written
acknowledgment, as described in section 170(f)(8) and Sec. 1.170A-
13(f);
(ii) Obtains a qualified appraisal, as defined in Sec. 1.170A-
17(a)(1), prepared by a qualified appraiser, as defined in Sec. 1.170A-
17(b)(1);
(iii) Completes, as described in paragraph (d)(3) of this section,
Form 8283 (Section B) and files it with the return on which the
deduction is claimed; and
(iv) Attaches the qualified appraisal of the property to the return
on which the deduction is claimed.
[[Page 135]]
(2) Exception for certain noncash contributions. For contributions
of property described in paragraph (d)(2) of this section, a qualified
appraisal is not required, and a completed Form 8283 (Section A),
containing the information required in paragraph (c)(3) of this section,
meets the requirements of paragraph (e)(1)(iii) of this section.
(3) Additional substantiation rules may apply. For additional
substantiation rules, see paragraph (f) of this section.
(f) Additional substantiation rules--(1) Form 8283 (Section B)
furnished by donor to donee. A donor who presents a Form 8283 (Section
B) to a donee for signature must furnish to the donee a copy of the Form
8283 (Section B).
(2) Number of Forms 8283 (Section A or Section B)--(i) In general.
For each item of contributed property for which a Form 8283 (Section A
or Section B) is required under paragraphs (c), (d), or (e) of this
section, a donor must attach a separate Form 8283 (Section A or Section
B) to the return on which the deduction for the item is claimed.
(ii) Exception for similar items. The donor may attach a single Form
8283 (Section A or Section B) for all similar items of property, as
defined in Sec. 1.170A-13(c)(7)(iii), contributed to the same donee
during the donor's taxable year, if the donor includes on Form 8283
(Section A or Section B) the information required by paragraph (c)(3) or
(d)(3) of this section for each item of property.
(3) Substantiation requirements for carryovers of noncash
contribution deductions. The rules in paragraphs (c), (d), and (e) of
this section (regarding substantiation that must be submitted with a
return) also apply to the return for any carryover year under section
170(d).
(4) Partners and S corporation shareholders--(i) Form 8283 (Section
A or Section B) must be provided to partners and S corporation
shareholders. If the donor is a partnership or S corporation, the donor
must provide a copy of the completed Form 8283 (Section A or Section B)
to every partner or shareholder who receives an allocation of a
charitable contribution deduction under section 170 for the property
described in Form 8283 (Section A or Section B). Similarly, a recipient
partner or shareholder that is a partnership or S corporation must
provide a copy of the completed Form 8283 (Section A or Section B) to
each of its partners or shareholders who receives an allocation of a
charitable contribution deduction under section 170 for the property
described in Form 8283 (Section A or Section B).
(ii) Partners and S corporation shareholders must attach Form 8283
(Section A or Section B) to return. A partner of a partnership or
shareholder of an S corporation who receives an allocation of a
charitable contribution deduction under section 170 for property to
which paragraph (c), (d), or (e) of this section applies must attach a
copy of the partnership's or S corporation's completed Form 8283
(Section A or Section B) to the return on which the deduction is
claimed.
(5) Determination of deduction amount for purposes of substantiation
rules--(i) In general. In determining whether the amount of a donor's
deduction exceeds the amounts set forth in section 170(f)(11)(B)
(noncash contributions exceeding $500), 170(f)(11)(C) (noncash
contributions exceeding $5,000), or 170(f)(11)(D) (noncash contributions
exceeding $500,000), the rules of paragraphs (f)(5)(ii) and (iii) of
this section apply.
(ii) Similar items of property must be aggregated. Under section
170(f)(11)(F), the donor must aggregate the amount claimed as a
deduction for all similar items of property, as defined in Sec. 1.170A-
13(c)(7)(iii), contributed during the taxable year. For rules regarding
the number of qualified appraisals and Forms 8283 (Section A or Section
B) required if similar items of property are contributed, see Sec.
1.170A-13(c)(3)(iv)(A) and (4)(iv)(B).
(iii) For contributions of certain inventory and scientific
property, excess of amount claimed over cost of goods sold taken into
account--(A) In general. In determining the amount of a donor's
contribution of property to which section 170(e)(3) (relating to
contributions of inventory and other property) or (e)(4) (relating to
contributions of scientific property used for research) applies, the
donor must take into account only the excess of the amount claimed as a
deduction over the amount that
[[Page 136]]
would have been treated as the cost of goods sold if the donor had sold
the contributed property to the donee.
(B) Example. The following example illustrates the rule of this
paragraph (f)(5)(iii):
Example. X Corporation makes a contribution of inventory described
in section 1221(a)(2). The contribution, described in section 170(e)(3),
is for the care of the needy. The cost of the property to X Corporation
is $5,000 and the fair market value of the property at the time of the
contribution is $11,000. Pursuant to section 170(e)(3)(B), X Corporation
claims a charitable contribution deduction of $8,000 ($5,000 + \1/2\ x
($11,000 - 5,000) = $8,000). The amount taken into account for purposes
of determining the $5,000 threshold of paragraph (d) of this section is
$3,000 ($8,000-$5,000).
(g) Effective/applicability date. This section applies to
contributions made after July 30, 2018. Taxpayers may rely on the rules
of this section for contributions made after June 3, 2004, or appraisals
prepared for returns or submissions filed after August 17, 2006.
[T.D.9836, 83 FR 36423, July 30, 2018]
Sec. 1.170A-17 Qualified appraisal and qualified appraiser.
(a) Qualified appraisal--(1) Definition. For purposes of section
170(f)(11) and Sec. 1.170A-16(d)(1)(ii) and (e)(1)(ii), the term
qualified appraisal means an appraisal document that is prepared by a
qualified appraiser (as defined in paragraph (b)(1) of this section) in
accordance with generally accepted appraisal standards (as defined in
paragraph (a)(2) of this section) and otherwise complies with the
requirements of this paragraph (a).
(2) Generally accepted appraisal standards defined. For purposes of
paragraph (a)(1) of this section, generally accepted appraisal standards
means the substance and principles of the Uniform Standards of
Professional Appraisal Practice, as developed by the Appraisal Standards
Board of the Appraisal Foundation.
(3) Contents of qualified appraisal. A qualified appraisal must
include--
(i) The following information about the contributed property:
(A) A description in sufficient detail under the circumstances,
taking into account the value of the property, for a person who is not
generally familiar with the type of property to ascertain that the
appraised property is the contributed property.
(B) In the case of real property or tangible personal property, the
condition of the property.
(C) The valuation effective date, as defined in paragraph (a)(5)(i)
of this section.
(D) The fair market value, within the meaning of Sec. 1.170A-
1(c)(2), of the contributed property on the valuation effective date;
(ii) The terms of any agreement or understanding by or on behalf of
the donor and donee that relates to the use, sale, or other disposition
of the contributed property, including, for example, the terms of any
agreement or understanding that--
(A) Restricts temporarily or permanently a donee's right to use or
dispose of the contributed property;
(B) Reserves to, or confers upon, anyone, other than a donee or an
organization participating with a donee in cooperative fundraising, any
right to the income from the contributed property or to the possession
of the property, including the right to vote contributed securities, to
acquire the property by purchase or otherwise, or to designate the
person having income, possession, or right to acquire; or
(C) Earmarks contributed property for a particular use;
(iii) The date, or expected date, of the contribution to the donee;
(iv) The following information about the appraiser:
(A) Name, address, and taxpayer identification number.
(B) Qualifications to value the type of property being valued,
including the appraiser's education and experience.
(C) If the appraiser is acting in his or her capacity as a partner
in a partnership, an employee of any person, whether an individual,
corporation, or partnership, or an independent contractor engaged by a
person other than the donor, the name, address, and taxpayer
identification number of the partnership or the person who employs or
engages the qualified appraiser;
(v) The signature of the appraiser and the date signed by the
appraiser (appraisal report date);
[[Page 137]]
(vi) The following declaration by the appraiser: ``I understand that
my appraisal will be used in connection with a return or claim for
refund. I also understand that, if there is a substantial or gross
valuation misstatement of the value of the property claimed on the
return or claim for refund that is based on my appraisal, I may be
subject to a penalty under section 6695A of the Internal Revenue Code,
as well as other applicable penalties. I affirm that I have not been at
any time in the three-year period ending on the date of the appraisal
barred from presenting evidence or testimony before the Department of
the Treasury or the Internal Revenue Service pursuant to 31 U.S.C.
330(c)'';
(vii) A statement that the appraisal was prepared for income tax
purposes;
(viii) The method of valuation used to determine the fair market
value, such as the income approach, the market-data approach, or the
replacement-cost-less-depreciation approach; and
(ix) The specific basis for the valuation, such as specific
comparable sales transactions or statistical sampling, including a
justification for using sampling and an explanation of the sampling
procedure employed.
(4) Timely appraisal report. A qualified appraisal must be signed
and dated by the qualified appraiser no earlier than 60 days before the
date of the contribution and no later than--
(i) The due date, including extensions, of the return on which the
deduction for the contribution is first claimed;
(ii) In the case of a donor that is a partnership or S corporation,
the due date, including extensions, of the return on which the deduction
for the contribution is first reported; or
(iii) In the case of a deduction first claimed on an amended return,
the date on which the amended return is filed.
(5) Valuation effective date--(i) Definition. The valuation
effective date is the date to which the value opinion applies.
(ii) Timely valuation effective date. For an appraisal report dated
before the date of the contribution, as described in Sec. 1.170A-1(b),
the valuation effective date must be no earlier than 60 days before the
date of the contribution and no later than the date of the contribution.
For an appraisal report dated on or after the date of the contribution,
the valuation effective date must be the date of the contribution.
(6) Exclusion for donor knowledge of falsity. An appraisal is not a
qualified appraisal for a particular contribution, even if the
requirements of this paragraph (a) are met, if the donor either failed
to disclose or misrepresented facts, and a reasonable person would
expect that this failure or misrepresentation would cause the appraiser
to misstate the value of the contributed property.
(7) Number of appraisals required. A donor must obtain a separate
qualified appraisal for each item of property for which an appraisal is
required under section 170(f)(11)(C) and (D) and paragraph (d) or (e) of
Sec. 1.170A-16 and that is not included in a group of similar items of
property, as defined in Sec. 1.170A-13(c)(7)(iii). For rules regarding
the number of appraisals required if similar items of property are
contributed, see section 170(f)(11)(F) and Sec. 1.170A-13(c)(3)(iv)(A).
(8) Time of receipt of qualified appraisal. The qualified appraisal
must be received by the donor before the due date, including extensions,
of the return on which a deduction is first claimed, or reported in the
case of a donor that is a partnership or S corporation, under section
170 with respect to the donated property, or, in the case of a deduction
first claimed, or reported, on an amended return, the date on which the
return is filed.
(9) Prohibited appraisal fees. The fee for a qualified appraisal
cannot be based to any extent on the appraised value of the property.
For example, a fee for an appraisal will be treated as based on the
appraised value of the property if any part of the fee depends on the
amount of the appraised value that is allowed by the Internal Revenue
Service after an examination.
(10) Retention of qualified appraisal. The donor must retain the
qualified appraisal for so long as it may be relevant in the
administration of any internal revenue law.
(11) Effect of appraisal disregarded pursuant to 31 U.S.C. 330(c).
If an appraiser
[[Page 138]]
has been prohibited from practicing before the Internal Revenue Service
by the Secretary under 31 U.S.C. 330(c) at any time during the three-
year period ending on the date the appraisal is signed by the appraiser,
any appraisal prepared by the appraiser will be disregarded as to value,
but could constitute a qualified appraisal if the requirements of this
section are otherwise satisfied, and the donor had no knowledge that the
signature, date, or declaration was false when the appraisal and Form
8283 (Section B) were signed by the appraiser.
(12) Partial interest. If the contributed property is a partial
interest, the appraisal must be of the partial interest.
(b) Qualified appraiser--(1) Definition. For purposes of section
170(f)(11) and Sec. 1.170A-16(d)(1)(ii) and (e)(1)(ii), the term
qualified appraiser means an individual with verifiable education and
experience in valuing the type of property for which the appraisal is
performed, as described in paragraphs (b)(2) through (4) of this
section.
(2) Education and experience in valuing the type of property--(i) In
general. An individual is treated as having education and experience in
valuing the type of property within the meaning of paragraph (b)(1) of
this section if, as of the date the individual signs the appraisal, the
individual has--
(A) Successfully completed (for example, received a passing grade on
a final examination) professional or college-level coursework, as
described in paragraph (b)(2)(ii) of this section, in valuing the type
of property, as described in paragraph (b)(3) of this section, and has
two or more years of experience in valuing the type of property, as
described in paragraph (b)(3) of this section; or
(B) Earned a recognized appraiser designation, as described in
paragraph (b)(2)(iii) of this section, for the type of property, as
described in paragraph (b)(3) of this section.
(ii) Coursework must be obtained from an educational organization,
generally recognized professional trade or appraiser organization, or
employer educational program. For purposes of paragraph (b)(2)(i)(A) of
this section, the coursework must be obtained from--
(A) A professional or college-level educational organization
described in section 170(b)(1)(A)(ii);
(B) A generally recognized professional trade or appraiser
organization that regularly offers educational programs in valuing the
type of property; or
(C) An employer as part of an employee apprenticeship or educational
program substantially similar to the educational programs described in
paragraphs (b)(2)(ii)(A) and (B) of this section.
(iii) Recognized appraiser designation defined. A recognized
appraiser designation means a designation awarded by a generally
recognized professional appraiser organization on the basis of
demonstrated competency.
(3) Type of property defined--(i) In general. The type of property
means the category of property customary in the appraisal field for an
appraiser to value.
(ii) Examples. The following examples illustrate the rule of
paragraphs (b)(2)(i) and (b)(3)(i) of this section:
Example (1). Coursework in valuing type of property. There are very
few professional-level courses offered in widget appraising, and it is
customary in the appraisal field for personal property appraisers to
appraise widgets. Appraiser A has successfully completed professional-
level coursework in valuing personal property generally but has
completed no coursework in valuing widgets. The coursework completed by
Appraiser A is for the type of property under paragraphs (b)(2)(i) and
(b)(3)(i) of this section.
Example (2). Experience in valuing type of property. It is customary
for professional antique appraisers to appraise antique widgets.
Appraiser B has 2 years of experience in valuing antiques generally and
is asked to appraise an antique widget. Appraiser B has obtained
experience in valuing the type of property under paragraphs (b)(2)(i)
and (b)(3)(i) of this section.
Example (3). No experience in valuing type of property. It is not
customary for professional antique appraisers to appraise new widgets.
Appraiser C has experience in appraising antiques generally but no
experience in appraising new widgets. Appraiser C is asked to appraise a
new widget. Appraiser C does not have experience in valuing the type of
property under paragraphs (b)(2)(i) and (b)(3)(i) of this section.
(4) Verifiable. For purposes of paragraph (b)(1) of this section,
education and experience in valuing the type of
[[Page 139]]
property are verifiable if the appraiser specifies in the appraisal the
appraiser's education and experience in valuing the type of property, as
described in paragraphs (b)(2) and (3) of this section, and the
appraiser makes a declaration in the appraisal that, because of the
appraiser's education and experience, the appraiser is qualified to make
appraisals of the type of property being valued.
(5) Individuals who are not qualified appraisers. The following
individuals are not qualified appraisers for the appraised property:
(i) An individual who receives a fee prohibited by paragraph (a)(9)
of this section for the appraisal of the appraised property.
(ii) The donor of the property.
(iii) A party to the transaction in which the donor acquired the
property (for example, the individual who sold, exchanged, or gave the
property to the donor, or any individual who acted as an agent for the
transferor or for the donor for the sale, exchange, or gift), unless the
property is contributed within 2 months of the date of acquisition and
its appraised value does not exceed its acquisition price.
(iv) The donee of the property.
(v) Any individual who is either--
(A) Related, within the meaning of section 267(b), to, or an
employee of, an individual described in paragraph (b)(5)(ii), (iii), or
(iv) of this section;
(B) Married to an individual described in paragraph (b)(5)(v)(A) of
this section; or
(C) An independent contractor who is regularly used as an appraiser
by any of the individuals described in paragraph (b)(5)(ii), (iii), or
(iv) of this section, and who does not perform a majority of his or her
appraisals for others during the taxable year.
(vi) An individual who is prohibited from practicing before the
Internal Revenue Service by the Secretary under 31 U.S.C. 330(c) at any
time during the three-year period ending on the date the appraisal is
signed by the individual.
(c) Effective/applicability date. This section applies to
contributions made on or after January 1, 2019. Taxpayers may rely on
the rules of this section for appraisals prepared for returns or
submissions filed after August 17, 2006.
[T.D. 9836, 83 FR 36425, July 30, 2018]
Sec. 1.170A-18 Contributions of clothing and household items.
(a) In general. Except as provided in paragraph (b) of this section,
no deduction is allowed under section 170(a) for a contribution of
clothing or a household item (as described in paragraph (c) of this
section) unless--
(1) The item is in good used condition or better at the time of the
contribution; and
(2) The donor meets the substantiation requirements of Sec. 1.170A-
16.
(b) Certain contributions of clothing or household items with
claimed value of more than $500. The rule described in paragraph (a)(1)
of this section does not apply to a contribution of a single item of
clothing or a household item for which a deduction of more than $500 is
claimed, if the donor submits with the return on which the deduction is
claimed a qualified appraisal, as defined in Sec. 1.170A-17(a)(1), of
the property prepared by a qualified appraiser, as defined in Sec.
1.170A-17(b)(1), and a completed Form 8283 (Section B), ``Noncash
Charitable Contributions,'' as described in Sec. 1.170A-16(d)(3).
(c) Definition of household items. For purposes of section
170(f)(16) and this section, the term household items includes
furniture, furnishings, electronics, appliances, linens, and other
similar items. Food, paintings, antiques, and other objects of art,
jewelry, gems, and collections are not household items.
(d) Effective/applicability date. This section applies to
contributions made after July 30, 2018. Taxpayers may rely on the rules
of this section for contributions made after August 17, 2006.
[T.D. 9836, 83 FR 36427, July 30, 2018]
Sec. 1.171-1 Bond premium.
(a) Overview--(1) In general. This section and Sec. Sec. 1.171-2
through 1.171-5 provide rules for the determination and amortization of
bond premium by a holder. In general, a holder amortizes bond premium by
offsetting the interest allocable to an accrual period with the premium
allocable to that period.
[[Page 140]]
Bond premium is allocable to an accrual period based on a constant
yield. The use of a constant yield to amortize bond premium is intended
to generally conform the treatment of bond premium to the treatment of
original issue discount under sections 1271 through 1275. Unless
otherwise provided, the terms used in this section and Sec. Sec. 1.171-
2 through 1.171-5 have the same meaning as those terms in sections 1271
through 1275 and the corresponding regulations. Moreover, unless
otherwise provided, the provisions of this section and Sec. Sec. 1.171-
2 through 1.171-5 apply in a manner consistent with those of sections
1271 through 1275 and the corresponding regulations. In addition, the
anti-abuse rule in Sec. 1.1275-2(g) applies for purposes of this
section and Sec. Sec. 1.171-2 through 1.171-5.
(2) Cross-references. For rules dealing with the adjustments to a
holder's basis to reflect the amortization of bond premium, see Sec.
1.1016-5(b). For rules dealing with the treatment of bond issuance
premium by an issuer, see Sec. 1.163-13.
(b) Scope--(1) In general. Except as provided in paragraph (b)(2) of
this section and Sec. 1.171-5, this section and Sec. Sec. 1.171-2
through 1.171-4 apply to any bond that, upon its acquisition by the
holder, is held with bond premium. For purposes of this section and
Sec. Sec. 1.171-2 through 1.171-5, the term bond has the same meaning
as the term debt instrument in Sec. 1.1275-1(d).
(2) Exceptions. This section and Sec. Sec. 1.171-2 through 1.171-5
do not apply to--
(i) A bond described in section 1272(a)(6)(C) (regular interests in
a REMIC, qualified mortgages held by a REMIC, and certain other debt
instruments, or pools of debt instruments, with payments subject to
acceleration);
(ii) A bond to which Sec. 1.1275-4 applies (relating to certain
debt instruments that provide for contingent payments);
(iii) A bond held by a holder that has made a Sec. 1.1272-3
election with respect to the bond;
(iv) A bond that is stock in trade of the holder, a bond of a kind
that would properly be included in the inventory of the holder if on
hand at the close of the taxable year, or a bond held primarily for sale
to customers in the ordinary course of the holder's trade or business;
or
(v) A bond issued before September 28, 1985, unless the bond bears
interest and was issued by a corporation or by a government or political
subdivision thereof.
(c) General rule--(1) Tax-exempt obligations. A holder must amortize
bond premium on a bond that is a tax-exempt obligation. See Sec. 1.171-
2(c) Example 4.
(2) Taxable bonds. A holder may elect to amortize bond premium on a
taxable bond. Except as provided in paragraph (c)(3) of this section, a
taxable bond is any bond other than a tax-exempt obligation. See Sec.
1.171-4 for rules relating to the election to amortize bond premium on a
taxable bond.
(3) Bonds the interest on which is partially excludable. For
purposes of this section and Sec. Sec. 1.171-2 through 1.171-5, a bond
the interest on which is partially excludable from gross income is
treated as two instruments, a tax-exempt obligation and a taxable bond.
The holder's basis in the bond and each payment on the bond are
allocated between the two instruments based on a reasonable method.
(d) Determination of bond premium--(1) In general. A holder acquires
a bond at a premium if the holder's basis in the bond immediately after
its acquisition by the holder exceeds the sum of all amounts payable on
the bond after the acquisition date (other than payments of qualified
stated interest). This excess is bond premium, which is amortizable
under Sec. 1.171-2.
(2) Additional rules for amounts payable on certain bonds.
Additional rules apply to determine the amounts payable on a variable
rate debt instrument, an inflation-indexed debt instrument, a bond that
provides for certain alternative payment schedules, and a bond that
provides for remote or incidental contingencies. See Sec. 1.171-3.
(e) Basis. A holder determines its basis in a bond under this
paragraph (e). This determination of basis applies only for purposes of
this section and Sec. Sec. 1.171-2 through 1.171-5. Because of the
application of this paragraph (e), the holder's basis in the bond for
purposes of these sections may differ from the holder's basis for
determining gain or
[[Page 141]]
loss on the sale or exchange of the bond.
(1) Determination of basis--(i) In general. In general, the holder's
basis in the bond is the holder's basis for determining loss on the sale
or exchange of the bond.
(ii) Bonds acquired in certain exchanges. If the holder acquired the
bond in exchange for other property (other than in a reorganization
defined in section 368) and the holder's basis in the bond is determined
in whole or in part by reference to the holder's basis in the other
property, the holder's basis in the bond may not exceed its fair market
value immediately after the exchange. See paragraph (f) Example 1 of
this section. If the bond is acquired in a reorganization, see section
171(b)(4)(B).
(iii) Convertible bonds--(A) General rule. If the bond is a
convertible bond, the holder's basis in the bond is reduced by an amount
equal to the value of the conversion option. The value of the conversion
option may be determined under any reasonable method. For example, the
holder may determine the value of the conversion option by comparing the
market price of the convertible bond to the market prices of similar
bonds that do not have conversion options. See paragraph (f) Example 2
of this section.
(B) Convertible bonds acquired in certain exchanges. If the bond is
a convertible bond acquired in a transaction described in paragraph
(e)(1)(ii) of this section, the holder's basis in the bond may not
exceed its fair market value immediately after the exchange reduced by
the value of the conversion option.
(C) Definition of convertible bond. A convertible bond is a bond
that provides the holder with an option to convert the bond into stock
of the issuer, stock or debt of a related party (within the meaning of
section 267(b) or 707(b)(1)), or into cash or other property in an
amount equal to the approximate value of such stock or debt. For bonds
issued on or after February 5, 2013, the term stock in the preceding
sentence means an equity interest in any entity that is classified, for
Federal tax purposes, as either a partnership or a corporation.
(2) Basis in bonds held by certain transferees. Notwithstanding
paragraph (e)(1) of this section, if the bond is transferred basis
property (as defined in section 7701(a)(43)) and the transferor had
acquired the bond at a premium, the holder's basis in the bond is--
(i) The holder's basis for determining loss on the sale or exchange
of the bond; reduced by
(ii) Any amounts that the transferor could not have amortized under
this paragraph (e) or under Sec. 1.171-4(c), except to the extent that
the holder's basis already reflects a reduction attributable to such
nonamortizable amounts.
(f) Examples. The following examples illustrate the rules of this
section:
Example 1. Bond received in liquidation of a partnership interest.
(i) Facts. PR is a partner in partnership PRS. PRS does not have any
unrealized receivables or inventory items as defined in section 751. On
January 1, 1998, PRS distributes to PR a taxable bond, issued by an
unrelated corporation, in liquidation of PR's partnership interest. At
that time, the fair market value of PR's partnership interest is $40,000
and the basis is $100,000. The fair market value of the bond is $40,000.
(ii) Determination of basis. Under section 732(b), PR's basis in the
bond is equal to PR's basis in the partnership interest. Therefore, PR's
basis for determining loss on the sale or exchange of the bond is
$100,000. However, because the distribution is treated as an exchange
for purposes of section 171(b)(4), PR's basis in the bond is $40,000 for
purposes of this section and Sec. Sec. 1.171-2 through 1.171-5. See
paragraph (e)(1)(ii) of this section.
Example 2. Convertible bond. (i) Facts. On January 1, A purchases
for $1,100 B corporation's bond maturing in three years from the
purchase date, with a stated principal amount of $1,000, payable at
maturity. The bond provides for unconditional payments of interest of
$30 on January 1 and July 1 of each year. In addition, the bond is
convertible into 15 shares of B corporation stock at the option of the
holder. On the purchase date, B corporation's nonconvertible, publicly-
traded, three-year debt of comparable credit quality trades at a price
that reflects a yield of 6.75 percent, compounded semiannually.
(ii) Determination of basis. A's basis for determining loss on the
sale or exchange of the bond is $1,100. As of the purchase date,
discounting the remaining payments on the bond at the yield at which B's
similar nonconvertible bonds trade (6.75 percent, compounded
semiannually) results in a present
[[Page 142]]
value of $980. Thus, the value of the conversion option is $120. Under
paragraph (e)(1)(iii)(A) of this section, A's basis is $980 ($1,100-
$120) for purposes of this section and Sec. Sec. 1.171-2 through 1.171-
5. The sum of all amounts payable on the bond other than qualified
stated interest is $1,000. Because A's basis (as determined under
paragraph (e)(1)(iii)(A) of this section) does not exceed $1,000, A does
not acquire the bond at a premium.
(iii) Applicability date. Notwithstanding Sec. 1.171-5(a)(1), this
Example 2 applies to bonds acquired on or after July 6, 2011.
[T.D. 8746, 62 FR 68177, Dec. 31, 1997, as amended by T.D. 9533, 76 FR
39280, July 6, 2011; T.D. 9612, 78 FR 8005, Feb. 5, 2013; T.D. 9637, 78
FR 54759, Sept. 6, 2013]
Sec. 1.171-2 Amortization of bond premium.
(a) Offsetting qualified stated interest with premium--(1) In
general. A holder amortizes bond premium by offsetting the qualified
stated interest allocable to an accrual period with the bond premium
allocable to the accrual period. This offset occurs when the holder
takes the qualified stated interest into account under the holder's
regular method of accounting.
(2) Qualified stated interest allocable to an accrual period. See
Sec. 1.446-2(b) to determine the accrual period to which qualified
stated interest is allocable and to determine the accrual of qualified
stated interest within an accrual period.
(3) Bond premium allocable to an accrual period. The bond premium
allocable to an accrual period is determined under this paragraph
(a)(3). Within an accrual period, the bond premium allocable to the
period accrues ratably.
(i) Step one: Determine the holder's yield. The holder's yield is
the discount rate that, when used in computing the present value of all
remaining payments to be made on the bond (including payments of
qualified stated interest), produces an amount equal to the holder's
basis in the bond as determined under Sec. 1.171-1(e). For this
purpose, the remaining payments include only payments to be made after
the date the holder acquires the bond. The yield is calculated as of the
date the holder acquires the bond, must be constant over the term of the
bond, and must be calculated to at least two decimal places when
expressed as a percentage.
(ii) Step two: Determine the accrual periods. A holder determines
the accrual periods for the bond under the rules of Sec. 1.1272-
1(b)(1)(ii).
(iii) Step three: Determine the bond premium allocable to the
accrual period. The bond premium allocable to an accrual period is the
excess of the qualified stated interest allocable to the accrual period
over the product of the holder's adjusted acquisition price (as defined
in paragraph (b) of this section) at the beginning of the accrual period
and the holder's yield. In performing this calculation, the yield must
be stated appropriately taking into account the length of the particular
accrual period. Principles similar to those in Sec. 1.1272-1(b)(4)
apply in determining the bond premium allocable to an accrual period.
(4) Bond premium in excess of qualified stated interest--(i) Taxable
bonds--(A) Bond premium deduction. In the case of a taxable bond, if the
bond premium allocable to an accrual period exceeds the qualified stated
interest allocable to the accrual period, the excess is treated by the
holder as a bond premium deduction under section 171(a)(1) for the
accrual period. However, the amount treated as a bond premium deduction
is limited to the amount by which the holder's total interest inclusions
on the bond in prior accrual periods exceed the total amount treated by
the holder as a bond premium deduction on the bond in prior accrual
periods. A deduction determined under this paragraph (a)(4)(i)(A) is not
subject to section 67 (the 2-percent floor on miscellaneous itemized
deductions). See Example 1 of Sec. 1.171-3(e).
(B) Carryforward. If the bond premium allocable to an accrual period
exceeds the sum of the qualified stated interest allocable to the
accrual period and the amount treated as a deduction for the accrual
period under paragraph (a)(4)(i)(A) of this section, the excess is
carried forward to the next accrual period and is treated as bond
premium allocable to that period.
(C) Carryforward in holder's final accrual period--(1) Bond premium
deduction. If there is a bond premium
[[Page 143]]
carryforward determined under paragraph (a)(4)(i)(B) of this section as
of the end of the holder's accrual period in which the bond is sold,
retired, or otherwise disposed of, the holder treats the amount of the
carryforward as a bond premium deduction under section 171(a)(1) for the
holder's taxable year in which the sale, retirement, or other
disposition occurs. For purposes of Sec. 1.1016-5(b), the holder's
basis in the bond is reduced by the amount of bond premium allowed as a
deduction under this paragraph (a)(4)(i)(C)(1).
(2) Effective/applicability date. Notwithstanding Sec. 1.171-
5(a)(1), paragraph (a)(4)(i)(C)(1) of this section applies to a bond
acquired on or after January 4, 2013. A taxpayer, however, may rely on
paragraph (a)(4)(i)(C)(1) of this section for a bond acquired before
that date.
(ii) Tax-exempt obligations. In the case of a tax-exempt obligation,
if the bond premium allocable to an accrual period exceeds the qualified
stated interest allocable to the accrual period, the excess is a
nondeductible loss. If a regulated investment company (RIC) within the
meaning of section 851 has excess bond premium for an accrual period
that would be a nondeductible loss under the prior sentence, the RIC
must use this excess bond premium to reduce its tax-exempt interest
income on other tax-exempt obligations held during the accrual period.
(5) Additional rules for certain bonds. Additional rules apply to
determine the amortization of bond premium on a variable rate debt
instrument, an inflation-indexed debt instrument, a bond that provides
for certain alternative payment schedules, and a bond that provides for
remote or incidental contingencies. See Sec. 1.171-3.
(b) Adjusted acquisition price. The adjusted acquisition price of a
bond at the beginning of the first accrual period is the holder's basis
as determined under Sec. 1.171-1(e). Thereafter, the adjusted
acquisition price is the holder's basis in the bond decreased by--
(1) The amount of bond premium previously allocable under paragraph
(a)(3) of this section; and
(2) The amount of any payment previously made on the bond other than
a payment of qualified stated interest.
(c) Examples. The following examples illustrate the rules of this
section. Each example assumes the holder uses the calendar year as its
taxable year and has elected to amortize bond premium, effective for all
relevant taxable years. In addition, each example assumes a 30-day month
and 360-day year. Although, for purposes of simplicity, the yield as
stated is rounded to two decimal places, the computations do not reflect
this rounding convention. The examples are as follows:
Example 1. Taxable bond. (i) Facts. On February 1, 1999, A purchases
for $110,000 a taxable bond maturing on February 1, 2006, with a stated
principal amount of $100,000, payable at maturity. The bond provides for
unconditional payments of interest of $10,000, payable on February 1 of
each year. A uses the cash receipts and disbursements method of
accounting, and A decides to use annual accrual periods ending on
February 1 of each year.
(ii) Amount of bond premium. The interest payments on the bond are
qualified stated interest. Therefore, the sum of all amounts payable on
the bond (other than the interest payments) is $100,000. Under Sec.
1.171-1, the amount of bond premium is $10,000 ($110,000-$100,000).
(iii) Bond premium allocable to the first accrual period. Based on
the remaining payment schedule of the bond and A's basis in the bond,
A's yield is 8.07 percent, compounded annually. The bond premium
allocable to the accrual period ending on February 1, 2000, is the
excess of the qualified stated interest allocable to the period
($10,000) over the product of the adjusted acquisition price at the
beginning of the period ($110,000) and A's yield (8.07 percent,
compounded annually). Therefore, the bond premium allocable to the
accrual period is $1,118.17 ($10,000-$8,881.83).
(iv) Premium used to offset interest. Although A receives an
interest payment of $10,000 on February 1, 2000, A only includes in
income $8,881.83, the qualified stated interest allocable to the period
($10,000) offset with bond premium allocable to the period ($1,118.17).
Under Sec. 1.1016-5(b), A's basis in the bond is reduced by $1,118.17
on February 1, 2000.
Example 2. Alternative accrual periods. (i) Facts. The facts are the
same as in Example 1 of this paragraph (c) except that A decides to use
semiannual accrual periods ending on February 1 and August 1 of each
year.
(ii) Bond premium allocable to the first accrual period. Based on
the remaining payment schedule of the bond and A's basis in the bond,
A's yield is 7.92 percent, compounded semiannually. The bond premium
allocable to the accrual period ending on August 1, 1999, is the excess
of the qualified
[[Page 144]]
stated interest allocable to the period ($5,000) over the product of the
adjusted acquisition price at the beginning of the period ($110,000) and
A's yield, stated appropriately taking into account the length of the
accrual period (7.92 percent/2). Therefore, the bond premium allocable
to the accrual period is $645.29 ($5,000-$4,354.71). Although the
accrual period ends on August 1, 1999, the qualified stated interest of
$5,000 is not taken into income until February 1, 2000, the date it is
received. Likewise, the bond premium of $645.29 is not taken into
account until February 1, 2000. The adjusted acquisition price of the
bond on August 1, 1999, is $109,354.71 (the adjusted acquisition price
at the beginning of the period ($110,000) less the bond premium
allocable to the period ($645.29)).
(iii) Bond premium allocable to the second accrual period. Because
the interval between payments of qualified stated interest contains more
than one accrual period, the adjusted acquisition price at the beginning
of the second accrual period must be adjusted for the accrued but unpaid
qualified stated interest. See paragraph (a)(3)(iii) of this section and
Sec. 1.1272-1(b)(4)(i)(B). Therefore, the adjusted acquisition price on
August 1, 1999, is $114,354.71 ($109,354.71 + $5,000). The bond premium
allocable to the accrual period ending on February 1, 2000, is the
excess of the qualified stated interest allocable to the period ($5,000)
over the product of the adjusted acquisition price at the beginning of
the period ($114,354.71) and A's yield, stated appropriately taking into
account the length of the accrual period (7.92 percent/2). Therefore,
the bond premium allocable to the accrual period is $472.88 ($5,000-
$4,527.12).
(iv) Premium used to offset interest. Although A receives an
interest payment of $10,000 on February 1, 2000, A only includes in
income $8,881.83, the qualified stated interest of $10,000 ($5,000
allocable to the accrual period ending on August 1, 1999, and $5,000
allocable to the accrual period ending on February 1, 2000) offset with
bond premium of $1,118.17 ($645.29 allocable to the accrual period
ending on August 1, 1999, and $472.88 allocable to the accrual period
ending on February 1, 2000). As indicated in Example 1 of this paragraph
(c), this same amount would be taken into income at the same time had A
used annual accrual periods.
Example 3. Holder uses accrual method of accounting. (i) Facts. The
facts are the same as in Example 1 of this paragraph (c) except that A
uses an accrual method of accounting. Thus, for the accrual period
ending on February 1, 2000, the qualified stated interest allocable to
the period is $10,000, and the bond premium allocable to the period is
$1,118.17. Because the accrual period extends beyond the end of A's
taxable year, A must allocate these amounts between the two taxable
years.
(ii) Amounts allocable to the first taxable year. The qualified
stated interest allocable to the first taxable year is $9,166.67
($10,000 x \11/12\). The bond premium allocable to the first taxable
year is $1,024.99 ($1,118.17 x \11/12\).
(iii) Premium used to offset interest. For 1999, A includes in
income $8,141.68, the qualified stated interest allocable to the period
($9,166.67) offset with bond premium allocable to the period
($1,024.99). Under Sec. 1.1016-5(b), A's basis in the bond is reduced
by $1,024.99 in 1999.
(iv) Amounts allocable to the next taxable year. The remaining
amounts of qualified stated interest and bond premium allocable to the
accrual period ending on February 1, 2000, are taken into account for
the taxable year ending on December 31, 2000.
Example 4. Tax-exempt obligation. (i) Facts. On January 15, 1999, C
purchases for $120,000 a tax-exempt obligation maturing on January 15,
2006, with a stated principal amount of $100,000, payable at maturity.
The obligation provides for unconditional payments of interest of
$9,000, payable on January 15 of each year. C uses the cash receipts and
disbursements method of accounting, and C decides to use annual accrual
periods ending on January 15 of each year.
(ii) Amount of bond premium. The interest payments on the obligation
are qualified stated interest. Therefore, the sum of all amounts payable
on the obligation (other than the interest payments) is $100,000. Under
Sec. 1.171-1, the amount of bond premium is $20,000 ($120,000--
$100,000).
(iii) Bond premium allocable to the first accrual period. Based on
the remaining payment schedule of the obligation and C's basis in the
obligation, C's yield is 5.48 percent, compounded annually. The bond
premium allocable to the accrual period ending on January 15, 2000, is
the excess of the qualified stated interest allocable to the period
($9,000) over the product of the adjusted acquisition price at the
beginning of the period ($120,000) and C's yield (5.48 percent,
compounded annually). Therefore, the bond premium allocable to the
accrual period is $2,420.55 ($9,000-$6,579.45).
(iv) Premium used to offset interest. Although C receives an
interest payment of $9,000 on January 15, 2000, C only receives tax-
exempt interest income of $6,579.45, the qualified stated interest
allocable to the period ($9,000) offset with bond premium allocable to
the period ($2,420.55). Under Sec. 1.1016-5(b), C's basis in the
obligation is reduced by $2,420.55 on January 15, 2000.
[T.D. 8746, 62 FR 68178, Dec. 31, 1997, as amended by T.D. 9653, 79 FR
2590, Jan. 15, 2014]
[[Page 145]]
Sec. 1.171-3 Special rules for certain bonds.
(a) Variable rate debt instruments. A holder determines bond premium
on a variable rate debt instrument by reference to the stated redemption
price at maturity of the equivalent fixed rate debt instrument
constructed for the variable rate debt instrument. The holder also
allocates any bond premium among the accrual periods by reference to the
equivalent fixed rate debt instrument. The holder constructs the
equivalent fixed rate debt instrument, as of the date the holder
acquires the variable rate debt instrument, by using the principles of
Sec. 1.1275-5(e). See paragraph (e) Example 1 of this section.
(b) Inflation-indexed debt instruments. A holder determines bond
premium on an inflation-indexed debt instrument by assuming that there
will be no inflation or deflation over the remaining term of the
instrument. The holder also allocates any bond premium among the accrual
periods by assuming that there will be no inflation or deflation over
the remaining term of the instrument. The bond premium allocable to an
accrual period offsets qualified stated interest allocable to the
period. Notwithstanding Sec. 1.171-2(a)(4), if the bond premium
allocable to an accrual period exceeds the qualified stated interest
allocable to the period, the excess is treated as a deflation adjustment
under Sec. 1.1275-7(f)(1)(i). However, the rules in Sec. 1.171-
2(a)(4)(i)(C) apply to any remaining deflation adjustment attributable
to bond premium as of the end of the holder's accrual period in which
the bond is sold, retired, or otherwise disposed of. See Sec. 1.1275-7
for other rules relating to inflation-indexed debt instruments.
(c) Yield and remaining payment schedule of certain bonds subject to
contingencies--(1) Applicability. This paragraph (c) provides rules that
apply in determining the yield and remaining payment schedule of certain
bonds that provide for an alternative payment schedule (or schedules)
applicable upon the occurrence of a contingency (or contingencies). This
paragraph (c) applies, however, only if the timing and amounts of the
payments that comprise each payment schedule are known as of the date
the holder acquires the bond (the acquisition date) and the bond is
subject to paragraph (c)(2), (3), or (4) of this section. A bond does
not provide for an alternative payment schedule merely because there is
a possibility of impairment of a payment (or payments) by insolvency,
default, or similar circumstances. See Sec. 1.1275-4 for the treatment
of a bond that provides for a contingency that is not described in this
paragraph (c).
(2) Remaining payment schedule that is significantly more likely
than not to occur. If, based on all the facts and circumstances as of
the acquisition date, a single remaining payment schedule for a bond is
significantly more likely than not to occur, this remaining payment
schedule is used to determine and amortize bond premium under Sec. Sec.
1.171-1 and 1.171-2.
(3) Mandatory sinking fund provision. Notwithstanding paragraph
(c)(2) of this section, if a bond is subject to a mandatory sinking fund
provision described in Sec. 1.1272-1(c)(3), the provision is ignored
for purposes of determining and amortizing bond premium under Sec. Sec.
1.171-1 and 1.171-2.
(4) Treatment of certain options--(i) Applicability. Notwithstanding
paragraphs (c)(2) and (3) of this section, the rules of this paragraph
(c)(4) determine the remaining payment schedule of a bond that provides
the holder or issuer with an unconditional option or options,
exercisable on one or more dates during the remaining term of the bond,
to alter the bond's remaining payment schedule.
(ii) Operating rules. A holder determines the remaining payment
schedule of a bond by assuming that each option will (or will not) be
exercised under the following rules:
(A) Issuer options. In general, the issuer is deemed to exercise or
not exercise an option or combination of options in the manner that
minimizes the holder's yield on the obligation. However, the issuer of a
taxable bond is deemed to exercise or not exercise a call option or
combination of call options in the manner that maximizes the holder's
yield on the bond.
(B) Holder options. A holder is deemed to exercise or not exercise
an option or combination of options in the manner
[[Page 146]]
that maximizes the holder's yield on the bond.
(C) Multiple options. If both the issuer and the holder have
options, the rules of paragraphs (c)(4)(ii)(A) and (B) of this section
are applied to the options in the order that they may be exercised.
Thus, the deemed exercise of one option may eliminate other options that
are later in time.
(5) Subsequent adjustments--(i) In general. Except as provided in
paragraph (c)(5)(ii) of this section, if a contingency described in this
paragraph (c) (including the exercise of an option described in
paragraph (c)(4) of this section) actually occurs or does not occur,
contrary to the assumption made pursuant to paragraph (c) of this
section (a change in circumstances), then solely for purposes of section
171, the bond is treated as retired and reacquired by the holder on the
date of the change in circumstances for an amount equal to the adjusted
acquisition price of the bond as of that date. If, however, the change
in circumstances results in a substantially contemporaneous pro-rata
prepayment as defined in Sec. 1.1275-2(f)(2), the pro-rata prepayment
is treated as a payment in retirement of a portion of the bond. See
paragraph (e) Example 2 of this section.
(ii) Bond premium deduction on the issuer's call of a taxable bond.
If a change in circumstances results from an issuer's call of a taxable
bond or a partial call that is a pro-rata prepayment, the holder may
deduct as bond premium an amount equal to the excess, if any, of the
holder's adjusted acquisition price of the bond over the greater of--
(A) The amount received on redemption; and
(B) The amounts that would have been payable under the bond (other
than payments of qualified stated interest) if no change in
circumstances had occurred.
(d) Remote and incidental contingencies. For purposes of determining
and amortizing bond premium, if a bond provides for a contingency that
is remote or incidental (within the meaning of Sec. 1.1275-2(h)), the
holder takes the contingency into account under the rules for remote and
incidental contingencies in Sec. 1.1275-2(h).
(e) Examples. The following examples illustrate the rules of this
section. Each example assumes the holder uses the calendar year as its
taxable year and has elected to amortize bond premium, effective for all
relevant taxable years. In addition, each example assumes a 30-day month
and 360-day year. Although, for purposes of simplicity, the yield as
stated is rounded to two decimal places, the computations do not reflect
this rounding convention. The examples are as follows:
Example 1. Variable rate debt instrument. (i) Facts. On March 1,
1999, E purchases for $110,000 a taxable bond maturing on March 1, 2007,
with a stated principal amount of $100,000, payable at maturity. The
bond provides for unconditional payments of interest on March 1 of each
year based on the percentage appreciation of a nationally-known
commodity index. On March 1, 1999, it is reasonably expected that the
bond will yield 12 percent, compounded annually. E uses the cash
receipts and disbursements method of accounting, and E decides to use
annual accrual periods ending on March 1 of each year. Assume that the
bond is a variable rate debt instrument under Sec. 1.1275-5.
(ii) Amount of bond premium. Because the bond is a variable rate
debt instrument, E determines and amortizes its bond premium by
reference to the equivalent fixed rate debt instrument constructed for
the bond as of March 1, 1999. Because the bond provides for interest at
a single objective rate that is reasonably expected to yield 12 percent,
compounded annually, the equivalent fixed rate debt instrument for the
bond is an eight-year bond with a principal amount of $100,000, payable
at maturity. It provides for annual payments of interest of $12,000. E's
basis in the equivalent fixed rate debt instrument is $110,000. The sum
of all amounts payable on the equivalent fixed rate debt instrument
(other than payments of qualified stated interest) is $100,000. Under
Sec. 1.171-1, the amount of bond premium is $10,000 ($110,000 -
$100,000).
(iii) Bond premium allocable to each accrual period. E allocates
bond premium to the remaining accrual periods by reference to the
payment schedule on the equivalent fixed rate debt instrument. Based on
the payment schedule of the equivalent fixed rate debt instrument and
E's basis in the bond, E's yield is 10.12 percent, compounded annually.
The bond premium allocable to the accrual period ending on March 1,
2000, is the excess of the qualified stated interest allocable to the
period for the equivalent fixed rate debt instrument ($12,000) over the
product of the adjusted acquisition price at the beginning of
[[Page 147]]
the period ($110,000) and E's yield (10.12 percent, compounded
annually). Therefore, the bond premium allocable to the accrual period
is $870.71 ($12,000-$11,129.29). The bond premium allocable to all the
accrual periods is listed in the following schedule:
------------------------------------------------------------------------
Adjusted
acquisition Premium
Accrual period ending price at allocable
beginning of to accrual
accrual period period
------------------------------------------------------------------------
3/1/00..................................... $110,000.00 $870.71
3/1/01..................................... 109,129.29 958.81
3/1/02..................................... 108,170.48 1,055.82
3/1/03..................................... 107,114.66 1,162.64
3/1/04..................................... 105,952.02 1,280.27
3/1/05..................................... 104,671.75 1,409.80
3/1/06..................................... 103,261.95 1,552.44
3/1/07..................................... 101,709.51 1,709.51
----------------------------
.............. 10,000.00
------------------------------------------------------------------------
(iv) Qualified stated interest for each accrual period. Assume the
bond actually pays the following amounts of qualified stated interest:
------------------------------------------------------------------------
Qualified
Accrual period ending stated
interest
------------------------------------------------------------------------
3/1/00..................................................... $2,000.00
3/1/01..................................................... 0.00
3/1/02..................................................... 0.00
3/1/03..................................................... 10,000.00
3/1/04..................................................... 8,000.00
3/1/05..................................................... 12,000.00
3/1/06..................................................... 15,000.00
3/1/07..................................................... 8,500.00
------------------------------------------------------------------------
(v) Premium used to offset interest. E's interest income for each
accrual period is determined by offsetting the qualified stated interest
allocable to the period with the bond premium allocable to the period.
For the accrual period ending on March 1, 2000, E includes in income
$1,129.29, the qualified stated interest allocable to the period
($2,000) offset with the bond premium allocable to the period ($870.71).
For the accrual period ending on March 1, 2001, the bond premium
allocable to the accrual period ($958.81) exceeds the qualified stated
interest allocable to the period ($0) and, therefore, E does not have
interest income for this accrual period. However, under Sec. 1.171-
2(a)(4)(i)(A), E may deduct as bond premium $958.81, the excess of the
bond premium allocable to the accrual period ($958.81) over the
qualified stated interest allocable to the accrual period ($0). For the
accrual period ending on March 1, 2002, the bond premium allocable to
the accrual period ($1,055.82) exceeds the qualified stated interest
allocable to the accrual period ($0) and, therefore, E does not have
interest income for the accrual period. Under Sec. 1.171-2(a)(4)(i)(A),
E's deduction for bond premium for the accrual period is limited to
$170.48, the excess of E's total interest inclusions on the bond in
prior accrual periods ($1,129.29) over the total amount treated by E as
a bond premium deduction in prior accrual periods ($958.81). Under Sec.
1.171-2(a)(4)(i)(B), E must carry forward the remaining $885.34 of bond
premium allocable to the period ending March 1, 2002, and treat it as
bond premium allocable to the period ending March 1, 2003. The amount E
includes in income for each accrual period is shown in the following
schedule:
----------------------------------------------------------------------------------------------------------------
Premium
Qualified allocable Interest Premium Premium
Accrual period ending stated to accrual income deduction carryforward
interest period
----------------------------------------------------------------------------------------------------------------
3/1/00........................................ $2,000.00 $870.71 $1,129.29 ........... ............
3/1/01........................................ 0.00 958.81 0.00 $958.81 ............
3/1/02........................................ 0.00 1,055.82 0.00 170.48 $885.34
3/1/03........................................ 10,000.00 1,162.64 7,951.93 ........... ............
3/1/04........................................ 8,000.00 1,280.27 6,719.73 ........... ............
3/1/05........................................ 12,000.00 1,409.80 10,590.20 ........... ............
3/1/06........................................ 15,000.00 1,552.44 13,447.56 ........... ............
3/1/07........................................ 8,500.00 1,709.51 6,790.49
-------------
........... 10,000.00 ........... ........... ............
----------------------------------------------------------------------------------------------------------------
Example 2. Partial call that results in a pro-rata prepayment. (i)
Facts. On April 1, 1999, M purchases for $110,000 N's taxable bond
maturing on April 1, 2006, with a stated principal amount of $100,000,
payable at maturity. The bond provides for unconditional payments of
interest of $10,000, payable on April 1 of each year. N has the option
to call all or part of the bond on April 1, 2001, at a 5 percent premium
over the principal amount. M uses the cash receipts and disbursements
method of accounting.
(ii) Determination of yield and the remaining payment schedule. M's
yield determined without regard to the call option is 8.07 percent,
compounded annually. M's yield determined by assuming N exercises its
call option is 6.89 percent, compounded annually. Under paragraph
(c)(4)(ii)(A) of this section, it is assumed N will not exercise the
call option because exercising the option would minimize M's yield.
Thus, for purposes of determining and amortizing bond premium, the bond
is
[[Page 148]]
assumed to be a seven-year bond with a single principal payment at
maturity of $100,000.
(iii) Amount of bond premium. The interest payments on the bond are
qualified stated interest. Therefore, the sum of all amounts payable on
the bond (other than the interest payments) is $100,000. Under Sec.
1.171-1, the amount of bond premium is $10,000 ($110,000-$100,000).
(iv) Bond premium allocable to the first two accrual periods. For
the accrual period ending on April 1, 2000, M includes in income
$8,881.83, the qualified stated interest allocable to the period
($10,000) offset with bond premium allocable to the period ($1,118.17).
The adjusted acquisition price on April 1, 2000, is $108,881.83
($110,000-$1,118.17). For the accrual period ending on April 1, 2001, M
includes in income $8,791.54, the qualified stated interest allocable to
the period ($10,000) offset with bond premium allocable to the period
($1,208.46). The adjusted acquisition price on April 1, 2001, is
$107,673.37 ($108,881.83-$1,208.46).
(v) Partial call. Assume N calls one-half of M's bond for $52,500 on
April 1, 2001. Because it was assumed the call would not be exercised,
the call is a change in circumstances. However, the partial call is also
a pro-rata prepayment within the meaning of Sec. 1.1275-2(f)(2). As a
result, the call is treated as a retirement of one-half of the bond.
Under paragraph (c)(5)(ii) of this section, M may deduct $1,336.68, the
excess of its adjusted acquisition price in the retired portion of the
bond ($107,673.37/2, or $53,836.68) over the amount received on
redemption ($52,500). M's adjusted basis in the portion of the bond that
remains outstanding is $53,836.68 ($107,673.37-$53,836.68).
[T.D. 8746, 62 FR 68180, Dec. 31, 1997, as amended by T.D. 8838, 64 FR
48547, Sept. 7, 1999; T.D. 9609, 78 FR 668, Jan. 4, 2013; T.D. 9653, 79
FR 2591, Jan. 15, 2014]
Sec. 1.171-4 Election to amortize bond premium on taxable bonds.
(a) Time and manner of making the election--(1) In general. A holder
makes the election to amortize bond premium by offsetting interest
income with bond premium in the holder's timely filed federal income tax
return for the first taxable year to which the holder desires the
election to apply. The holder should attach to the return a statement
that the holder is making the election under this section.
(2) Coordination with OID election. If a holder makes an election
under Sec. 1.1272-3 for a bond with bond premium, the holder is deemed
to have made the election under this section.
(b) Scope of election. The election under this section applies to
all taxable bonds held during or after the taxable year for which the
election is made.
(c) Election to amortize made in a subsequent taxable year--(1) In
general. If a holder elects to amortize bond premium and holds a taxable
bond acquired before the taxable year for which the election is made,
the holder may not amortize amounts that would have been amortized in
prior taxable years had an election been in effect for those prior
years.
(2) Example. The following example illustrates the rule of this
paragraph (c):
Example. (i) Facts. On May 1, 1999, C purchases for $130,000 a
taxable bond maturing on May 1, 2006, with a stated principal amount of
$100,000, payable at maturity. The bond provides for unconditional
payments of interest of $15,000, payable on May 1 of each year. C uses
the cash receipts and disbursements method of accounting and the
calendar year as its taxable year. C has not previously elected to
amortize bond premium, but does so for 2002.
(ii) Amount to amortize. C's basis for determining loss on the sale
or exchange of the bond is $130,000. Thus, under Sec. 1.171-1, the
amount of bond premium is $30,000. Under Sec. 1.171-2, if a bond
premium election were in effect for the prior taxable years, C would
have amortized $3,257.44 of bond premium on May 1, 2000, and $3,551.68
of bond premium on May 1, 2001, based on annual accrual periods ending
on May 1. Thus, for 2002 and future years to which the election applies,
C may amortize only $23,190.88 ($30,000-$3,257.44-$3,551.68).
(d) Revocation of election. The election under this section may not
be revoked unless approved by the Commissioner. Because a revocation of
the election is a change in accounting method, a taxpayer must follow
the rules under Sec. 1.446-1(e)(3)(i) to request the Commissioner's
consent to revoke the election. A revocation of the election applies to
all taxable bonds held during or after the taxable year for which the
revocation is effective. The holder may not amortize any remaining bond
premium on bonds held at the beginning of the taxable year for which the
revocation is effective. Therefore, no adjustment under section 481 is
allowed upon the revocation of the election because no
[[Page 149]]
items of income or deduction are omitted or duplicated.
[T.D. 8746, 62 FR 68182, Dec. 31, 1997]
Sec. 1.171-5 Effective date and transition rules.
(a) Effective date--(1) In general. Sections 1.171-1 through 1.171-4
apply to bonds acquired on or after March 2, 1998. However, if a holder
makes the election under Sec. 1.171-4 for the taxable year containing
March 2, 1998, or any subsequent taxable year, Sec. Sec. 1.171-1
through 1.171-4 apply to bonds held on or after the first day of the
taxable year in which the election is made.
(2) Transition rule for use of constant yield. Notwithstanding
paragraph (a)(1) of this section, Sec. 1.171-2(a)(3) (providing that
the bond premium allocable to an accrual period is determined with
reference to a constant yield) does not apply to a bond issued before
September 28, 1985.
(b) Coordination with existing election. A holder is deemed to have
made the election under Sec. 1.171-4 for the taxable year containing
March 2, 1998, if the holder elected to amortize bond premium under
section 171 and that election is effective on March 2, 1998. If the
holder is deemed to have made the election under Sec. 1.171-4 for the
taxable year containing March 2, 1998, Sec. Sec. 1.171-1 through 1.171-
4 apply to bonds acquired on or after the first day of that taxable
year. See Sec. 1.171-4(d) for rules relating to a revocation of an
election under section 171.
(c) Accounting method changes--(1) Consent to change. A holder
required to change its method of accounting for bond premium to comply
with Sec. Sec. 1.171-1 through 1.171-3 must secure the consent of the
Commissioner in accordance with the requirements of Sec. 1.446-1(e).
Paragraph (c)(2) of this section provides the Commissioner's automatic
consent for certain changes. A holder making the election under Sec.
1.171-4 does not need the Commissioner's consent to make the election.
(2) Automatic consent. The Commissioner grants consent for a holder
to change its method of accounting for bond premium with respect to
taxable bonds to which Sec. Sec. 1.171-1 through 1.171-3 apply. Because
this change is made on a cut-off basis, no items of income or deduction
are omitted or duplicated and, therefore, no adjustment under section
481 is allowed. The consent granted by this paragraph (c)(2) applies
provided--
(i) The holder elected to amortize bond premium under section 171
for a taxable year prior to the taxable year containing March 2, 1998,
and that election has not been revoked;
(ii) The change is made for the first taxable year for which the
holder must account for a bond under Sec. Sec. 1.171-1 through 1.171-3;
and
(iii) The holder attaches to its return for the taxable year
containing the change a statement that it has changed its method of
accounting under this section.
[T.D. 8746, 62 FR 68182, Dec. 31, 1997]
Sec. 1.172-1 Net operating loss deduction.
(a) Allowance of deduction. Section 172(a) allows as a deduction in
computing taxable income for any taxable year subject to the Code the
aggregate of the net operating loss carryovers and net operating loss
carrybacks to such taxable year. This deduction is referred to as the
net operating loss deduction. The net operating loss is the basis for
the computation of the net operating loss carryovers and net operating
loss carrybacks and ultimately for the net operating loss deduction
itself. The net operating loss deduction shall not be disallowed for any
taxable year merely because the taxpayer has no income from a trade or
business for the taxable year.
(b) Steps in computation of net operating loss deduction. The three
steps to be taken in the ascertainment of the net operating loss
deduction for any taxable year subject to the Code are as follows:
(1) Compute the net operating loss for any preceding or succeeding
taxable year from which a net operating loss may be carried over or
carried back to such taxable year.
(2) Compute the net operating loss carryovers to such taxable year
from such preceding taxable years and the net operating loss carrybacks
to such taxable year from such succeeding taxable years.
(3) Add such net operating loss carryovers and carrybacks in order
to
[[Page 150]]
determine the net operating loss deduction for such taxable year.
(c) Statement with tax return. Every taxpayer claiming a net
operating loss deduction for any taxable year shall file with his return
for such year a concise statement setting forth the amount of the net
operating loss deduction claimed and all material and pertinent facts
relative thereto, including a detailed schedule showing the computation
of the net operating loss deduction.
(d) Ascertainment of deduction dependent upon net operating loss
carryback. If the taxpayer is entitled in computing his net operating
loss deduction to a carryback which he is not able to ascertain at the
time his return is due, he shall compute the net operating loss
deduction on his return without regard to such net operating loss
carryback. When the taxpayer ascertains the net operating loss
carryback, he may within the applicable period of limitations file a
claim for credit or refund of the overpayment, if any, resulting from
the failure to compute the net operating loss deduction for the taxable
year with the inclusion of such carryback; or he may file an application
under the provisions of section 6411 for a tentative carryback
adjustment.
(e) Law applicable to computations. (1) In determining the amount of
any net operating loss carryback or carryover to any taxable year, the
necessary computations involving any other taxable year shall be made
under the law applicable to such other taxable year.
(2) The net operating loss for any taxable year shall be determined
under the law applicable to that year without regard to the year to
which it is to be carried and in which, in effect, it is to be deducted
as part of the net operating loss deduction.
(3) The amount of the net operating loss deduction which shall be
allowed for any taxable year shall be determined under the law
applicable to that year.
(f) Electing small business corporations. In determining the amount
of the net operating loss deduction of any corporation, there shall be
disregarded the net operating loss of such corporation for any taxable
year for which such corporation was an electing small business
corporation under subchapter S (section 1371 and following), chapter 1
of the Code. In applying section 172(b)(1) and (2) to a net operating
loss sustained in a taxable year in which the corporation was not an
electing small business corporation, a taxable year in which the
corporation was an electing small business corporation is counted as a
taxable year to which such net operating loss is carried back or over.
However, the taxable income for such year as determined under section
172(b)(2) is treated as if it were zero for purposes of computing the
balance of the loss available to the corporation as a carryback or
carryover to other taxable years in which the corporation is not an
electing small business corporation. See section 1374 and the
regulations thereunder for allowance of a deduction to shareholders for
a net operating loss sustained by an electing small business
corporation.
(g) Husband and wife. The net operating loss deduction of a husband
and wife shall be determined in accordance with this section, but
subject also to the provisions of Sec. 1.172-7.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 8107, 51 FR
43345, Dec. 2, 1986]
Sec. 1.172-2 Net operating loss in case of a corporation.
(a) Modification of deductions. A net operating loss is sustained by
a corporation in any taxable year if and to the extent that, for such
year, there is an excess of deductions allowed by chapter 1 of the Code
over gross income computed thereunder. In determining the excess of
deductions over gross income for such purpose--
(1) Items not deductible. No deduction shall be allowed under--
(i) Section 172 for the net operating loss deduction, and
(ii) Section 922 in respect of Western Hemisphere trade
corporations;
(2) Dividends received. The 85-percent limitation provided by
section 246(b) shall not apply to the deductions otherwise allowed
under--
(i) Section 243(a) in respect of dividends received from domestic
corporations.
[[Page 151]]
(ii) Section 244 in respect of dividends received on preferred stock
of public utilities, and
(iii) Section 245 in respect of dividends received from foreign
corporations; and
(3) Dividends paid. The deduction granted by section 247 in respect
of dividends paid on the preferred stock of public utilities shall be
computed without regard to subsection (a)(1)(B) of Section 247.
(b) Example. The following example illustrates the application of
paragraph (a):
Example. For the calendar year 1981, the X corporation has a gross
income of $400,000 and total deductions allowed by chapter 1 of the Code
of $375,000 exclusive of any net operating loss deduction and exclusive
of any deduction for dividends received or paid. Corporation X in 1981
received $100,000 of dividends entitled to the benefits of section
243(a). These dividends are included in Corporation X's $400,000 gross
income. Corporation X has no other deductions to which section 172(d)
applies. On the basis of these facts, Corporation X has a net operating
loss for the year 1981 of $60,000, computed as follows:
Deductions for 1981.......................................... $375,000
Plus: Deduction for dividends received, computed without 85,000
regard to the limitation provided in section 246(b) (85% of
$100,000)...................................................
----------
Total.................................................. 460,000
Less: Gross income for 1981 (including $100,000 dividends)... 400,000
----------
Net operating loss for 1981............................ 60,000
(c) Qualified real estate investment trusts. For taxable years
ending after October 4, 1976, the net operating loss of a qualified real
estate investment trust (as defined in Sec. 1.172-10(b)) is computed by
taking into account the adjustments described in section 857(b)(2)
(other than the deduction for dividends paid, as defined in section
561), as well as the modifications required by paragraph (a)(1) of this
section. Thus, for example, the special deductions for dividends
received, etc., provided in part VIII of subchapter B (other than
section 248), as well as the net operating loss deduction under section
172, are not allowed in computing the net operating loss of a qualified
real estate investment trust.
[T.D. 8107, 51 FR 43345, Dec. 2, 1986]
Sec. 1.172-3 Net operating loss in case of a taxpayer other than
a corporation.
(a) Modification of deductions. A net operating loss is sustained by
a taxpayer other than a corporation in any taxable year if and to the
extent that, for such year there is an excess of deductions allowed by
chapter 1 of the Internal Revenue Code over gross income computed
thereunder. In determining the excess of deductions over gross income
for such purpose:
(1) Items not deductible. No deduction shall be allowed under:
(i) Section 151 for the personal exemptions or under any other
section which grants a deduction in lieu of the deductions allowed by
section 151,
(ii) Section 172 for the net operating loss deduction, and
(iii) Section 1202 in respect of the net long-term capital gain.
(2) Capital losses. (i) The amount deductible on account of business
capital losses shall not exceed the sum of the amount includible on
account of business capital gains and that portion of nonbusiness
capital gains which is computed in accordance with paragraph (c) of this
section.
(ii) The amount deductible on account of nonbusiness capital losses
shall not exceed the amount includible on account of nonbusiness capital
gains.
(3) Nonbusiness deductions--(i) Ordinary deductions. Ordinary
nonbusiness deductions shall be taken into account without regard to the
amount of business deductions and shall be allowed in full to the
extent, but not in excess, of that amount which is the sum of the
ordinary nonbusiness gross income and the excess of nonbusiness capital
gains over nonbusiness capital losses. See paragraph (c) of this
section. For purposes of section 172, nonbusiness deductions and income
are those deductions and that income which are not attributable to, or
derived from, a taxpayer's trade or business. Wages and salary
constitute income attributable to the taxpayer's trade or business for
such purposes.
(ii) Sale of business property. Any gain or loss on the sale or
other disposition of property which is used in the taxpayer's trade or
business and which is
[[Page 152]]
of a character that is subject to the allowance for depreciation
provided in section 167, or of real property used in the taxpayer's
trade or business, shall be considered, for purposes of section
172(d)(4), as attributable to, or derived from, the taxpayer's trade or
business. Such gains and losses are to be taken into account fully in
computing a net operating loss without regard to the limitation on
nonbusiness deductions. Thus, a farmer who sells at a loss land used in
the business of farming may, in computing a net operating loss, include
in full the deduction otherwise allowable with respect to such loss,
without regard to the amount of his nonbusiness income and without
regard to whether he is engaged in the trade or business of selling
farms. Similarly, an individual who sells at a loss machinery which is
used in his trade or business and which is of a character that is
subject to the allowance for depreciation may, in computing the net
operating loss, include in full the deduction otherwise allowable with
respect to such loss.
(iii) Casualty losses. Any deduction allowable under section
165(c)(3) for losses of property not connected with a trade or business
shall not be considered, for purposes of section 172(d)(4), to be a
nonbusiness deduction but shall be treated as a deduction attributable
to the taxpayer's trade or business.
(iv) Self-employed retirement plans. Any deduction allowed under
section 404, relating to contributions of an employer to an employees'
trust or annuity plan, or under section 405(c), relating to
contributions to a bond purchase plan, to the extent attributable to
contributions made on behalf of an individual while he is an employee
within the meaning of section 401(c)(1), shall not be treated, for
purposes of section 172(d)(4), as attributable to, or derived from, the
taxpayer's trade or business, but shall be treated as a nonbusiness
deduction.
(v) Limitation. The provisions of this subparagraph shall not be
construed to permit the deduction of items disallowed by subparagraph
(1) of this paragraph.
(b) Treatment of capital loss carryovers. Because of the distinction
between business and nonbusiness capital gains and losses, a taxpayer
who has a capital loss carryover from a preceding taxable year,
includible by virtue of section 1212 among the capital losses for the
taxable year in issue, is required to determine how much of such capital
loss carryover is a business capital loss and how much is a nonbusiness
capital loss. In order to make this determination, the taxpayer shall
first ascertain what proportion of the net capital loss for such
preceding taxable year was attributable to an excess of business capital
losses over business capital gains for such year, and what proportion
was attributable to an excess of nonbusiness capital losses over
nonbusiness capital gains. The same proportion of the capital loss
carryover from such preceding taxable year shall be treated as a
business capital loss and a nonbusiness capital loss, respectively. In
order to determine the composition (business--nonbusiness) of a net
capital loss for a taxable year, for purposes of this paragraph, if such
net capital loss is computed under paragraph (b) of Sec. 1.1212-1 and
takes into account a capital loss carryover from a preceding taxable
year, the composition (business--nonbusiness) of the net capital loss
for such preceding taxable year must also be determined. For purposes of
this paragraph, the term capital loss carryover means the sum of the
short-term and long-term capital loss carryovers from such year. This
paragraph may be illustrated by the following examples:
Example 1. (i) A, an individual, has $5,000 ordinary taxable income
(computed without regard to the deductions for personal exemptions) for
the calendar year 1954 and also has the following capital gains and
losses for such year: Business capital gains of $2,000; business capital
losses of $3,200; nonbusiness capital gains of $1,000; and nonbusiness
capital losses of $1,200.
(ii) A's net capital loss for the taxable year 1954 is $400,
computed as follows:
Capital losses............................................... $4,400
Capital gains................................................ 3,000
----------
Excess of capital losses over capital gains.................. 1,400
Less: $1,000 of such ordinary taxable income................. 1,000
----------
Net capital loss for 1954................................ 400
(iii) A's capital losses for 1954 exceeded his capital gains for
such year by $1,400. Since A's business capital losses for 1954 exceeded
his business capital gains for such year by
[[Page 153]]
$1,200, 6/7ths ($1,200/$1,400) of A's net capital loss for 1954 is
attributable to an excess of his business capital losses over his
business capital gains for such year. Similarly, 1/7th of the net
capital loss is attributable to the excess of nonbusiness capital losses
over nonbusiness capital gains. Since the capital loss carryover for
1954 to 1955 is $400, 6/7ths of $400, or $342.86, shall be treated as a
business capital loss in 1955; and 1/7th of $400, or $57.14, as a
nonbusiness capital loss.
Example 2. (i) A, an individual who is computing a net operating
loss for the calendar year 1966, has a capital loss carryover from 1965
of $8,000. In order to apply the provisions of this paragraph, A must
determine what portion of the $8,000 carryover is attributable to the
excess of business capital losses over business capital gains and what
portion thereof is attributable to the excess of nonbusiness capital
losses over nonbusiness capital gains. For 1965, A had $10,000 ordinary
taxable income (computed without regard to the deductions for personal
exemptions), and a short-term capital loss carryover of $6,000 from
1964. In order to determine the composition (business--nonbusiness) of
the $8,000 carryover from 1965, A first determines that of the $6,000
carryover from 1964, $5,000 is a business capital loss and $1,000 is a
nonbusiness capital loss. This must be done since, under paragraph (b)
of Sec. 1.1212-1, the net capital loss for 1965 is computed by taking
into account the capital loss carryover from 1964. A's capital gains and
losses for 1965 are as follows:
------------------------------------------------------------------------
Carried over
1965 from 1964
------------------------------------------------------------------------
Business capital gains........................ $2,000 0
Business capital losses....................... 3,000 $5,000
Nonbusiness capital gains..................... 4,000 0
Nonbusiness capital losses.................... 6,000 1,000
------------------------------------------------------------------------
(ii) A's net capital loss for the taxable year 1965 is $8,000,
computed as follows:
Capital losses (including carryovers)........................ $15,000
Capital gains................................................ 6,000
----------
Excess of capital losses over capital gains.................. 9,000
Less: $1,000 of such ordinary taxable income................. 1,000
----------
Net capital loss for 1965................................ 8,000
(iii) A's capital losses, including carryovers, for 1965 exceeded
his capital gains for such year by $9,000. Since A's business capital
losses for 1965 exceeded his business capital gains for such year by
$6,000, 2/3rds ($6,000/$9,000) of A's net capital loss for 1965 is
attributable to an excess of his business capital losses over his
business capital gains for such year. Similarly, 1/3rd of the net
capital loss is attributable to the excess of nonbusiness capital losses
over nonbusiness capital gains. Since the total capital loss carryover
from 1965 to 1966 is $8,000, 2/3rds of $8,000, or $5,333.33, shall be
treated as a business capital loss in 1966; and 1/3rd of $8,000, or
$2,666.67, as a nonbusiness capital loss.
(c) Determination of portion of nonbusiness capital gains available
for the deduction of business capital losses. In the computation of a
net operating loss a taxpayer other than a corporation must use his
nonbusiness capital gains for the deduction of his nonbusiness capital
losses. Any amount not necessary for this purpose shall then be used for
the deduction of any excess of ordinary nonbusiness deductions over
ordinary nonbusiness gross income. The remainder, computed by applying
the excess ordinary nonbusiness deductions against the excess
nonbusiness capital gains, shall be treated as nonbusiness capital gains
and used for the purpose of determining the deductibility of business
capital losses under paragraph (a)(2)(i) of this section. This principle
may be illustrated by the following example:
Example. (1) A, an individual, has a total nonbusiness gross income
of $20,500, computed as follows:
Ordinary gross income........................................ $7,500
Capital gains................................................ 13,000
------------
Total gross income....................................... 20,500
(2) A also has total nonbusiness deductions of $16,000, computed as
follows:
Ordinary deductions.......................................... $9,000
Capital loss................................................. 7,000
----------
Total deductions......................................... 16,000
(3) The portion of nonbusiness capital gains to be used for the
purpose of determining the deductibility of business capital losses is
$4,500, computed as follows:
Nonbusiness capital gains.................................... $13,000
Less: Nonbusiness capital loss............................... 7,000
------------
Excess to be taken into account for purposes of paragraph 6,000
(a)(3)(i) of this section...................................
Ordinary nonbusiness deductions................... $9,000
Less: Ordinary nonbusiness gross income........... 7,500
-------- 1,500
----------
Portion of nonbusiness capital gains to be used for purposes 4,500
of paragraph (a)(2)(i) of this section......................
(d) Joint net operating loss of husband and wife. In the case of a
husband and wife, the joint net operating loss for any taxable year for
which a joint return is filed is to be computed on the
[[Page 154]]
basis of the combined income and deductions of both spouses, and the
modifications prescribed in paragraph (a) of this section are to be
computed as if the combined income and deductions of both spouses were
the income and deductions of one individual.
(e) Illustration of computation of net operating loss of a taxpayer
other than a corporation--(1) Facts. For the calendar year 1954 A, an
individual, has gross income of $483,000 and allowable deductions of
$540,000. The latter amount does not include the net operating loss
deduction or any deduction on account of the sale or exchange of capital
assets. Included in gross income are business capital gains of $50,000
and ordinary nonbusiness income of $10,000. Included among the
deductions are ordinary nonbusiness deductions of $12,000 and a
deduction of $600 for his personal exemption. A has a business capital
loss of $60,000 in 1954. A has no other items of income or deductions to
which section 172(d) applies.
(2) Computation. On the basis of these facts, A has a net operating
loss for 1954 of $104,400, computed as follows:
Deductions for 1954 (as specified in first sentence of $540,000
subparagraph (1))...........................................
Plus: Amount of business capital loss ($60,000) to extent 50,000
such amount does not exceed business capital gains ($50,000)
------------
Total.................................................... 590,000
Less: Excess of ordinary nonbusiness deductions $2,000
over ordinary nonbusiness gross income ($12,000
minus $10,000)...................................
Deduction for personal exemption.................. 600
-------- $2,600
----------
Deductions for 1954 adjusted as required by section 172(d)... 587,400
Gross income for 1954............................. 483,000
------------
Net operating loss for 1954................... 104,400
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6828, 30 FR
7805, June 17, 1965; T.D. 6862, 30 FR 14427, Nov. 18, 1965; T.D. 8107,
51 FR 43345, Dec. 2, 1986]
Sec. 1.172-4 Net operating loss carrybacks and net operating loss carryovers.
(a) General provisions--(1) Years to which loss may be carried--(i)
In general. In order to compute the net operating loss deduction the
taxpayer must first determine the part of any net operating losses for
any preceding or succeeding taxable years which are carrybacks or
carryovers to the taxable year in issue.
(ii) General rule for carrybacks and carryovers. Except as provided
in section 172 (b)(1)(C), (D), (E), (F), (G), (H), (I), and (J),
paragraphs (a)(1)(iii), (iv), (v), and (vi) of this section, and Sec.
1.172-10(a), a net operating loss shall be carried back to the 3
preceding taxable years and carried over to the 15 succeeding taxable
years (5 succeeding taxable years for a loss sustained in a taxable year
ending before January 1, 1976).
(iii) Loss of a regulated transportation corporation. Except as
provided in subdivision (iv) of this subparagraph and Sec. 1.172-10(a),
a net operating loss sustained by a taxpayer which is a regulated
transportation corporation (as defined in section 172(g)(1)) in a
taxable year ending before January 1, 1976, shall, subject to the
provisions of section 172(g) and Sec. 1.172-8, be carried back to the
taxable years specified in paragraph (a)(1)(ii) of this section and
shall be carried over to the 7 succeeding taxable years.
(iv) Loss attributable to foreign expropriation. If the provisions
of section 172(b)(3)(A) and Sec. 1.172-9 are satisfied, the portion of
a net operating loss attributable to a foreign expropriation loss (as
defined in section 172(h)) shall not be a net operating loss carryback
to any taxable year preceding the taxable year of such loss and shall be
a net operating loss carryover to each of the 10 taxable years following
the taxable year of such loss.
(v) Loss of a financial institution. A net operating loss sustained
in a taxable year beginning after December 31, 1975, by a taxpayer to
which section 585, 586, or 593 applies shall be carried back (except as
provided in Sec. 1.172-10(a)) to the 10 preceding taxable years and
shall be carried over to the 5 succeeding taxable years.
(vi) Loss of a Bank for Cooperatives. A net operating loss sustained
by a taxpayer which is a Bank for Cooperatives (organized and chartered
pursuant to section 2 of the Farm Credit Act of 1933 (12 U.S.C. 1134))
shall be carried back (except as provided in Sec. 1.172-10(a)) to the
10 preceding taxable years and shall be carried over to the 5 succeeding
taxable years.
[[Page 155]]
(2) Periods of less than 12 months. A fractional part of a year
which is a taxable year under sections 441(b) and 7701(a)(23) is a
preceding or a succeeding taxable year for the purpose of determining
under section 172 the first, second, etc., preceding or succeeding
taxable year.
(3) Amount of loss to be carried. The amount which is carried back
or carried over to any taxable year is the net operating loss to the
extent it was not absorbed in the computation of the taxable (or net)
income for other taxable years, preceding such taxable year, to which it
may be carried back or carried over. For the purpose of determining the
taxable (or net) income for any such preceding taxable year, the various
net operating loss carryovers and carrybacks to such taxable year are
considered to be applied in reduction of the taxable (or net) income in
the order of the taxable years from which such losses are carried over
or carried back, beginning with the loss for the earliest taxable year.
(4) Husband and wife. The net operating loss carryovers and
carrybacks of a husband and wife shall be determined in accordance with
this section, but subject also to the provisions of Sec. 1.172-7.
(5) Corporate acquisitions. For the computation of the net operating
loss carryovers in the case of certain acquisitions of the assets of a
corporation by another corporation, see section 381 and the regulations
thereunder.
(6) Special limitations. For special limitations on the net
operating loss carryovers in certain cases of change in both the
ownership and the trade or business of a corporation and in certain
cases of corporate reorganization lacking specified continuity of
ownership, see section 382 and the regulations thereunder.
(7) Electing small business corporations. For special rule
applicable to corporations which were electing small business
corporations under Subchapter S (section 1361 and following), chapter 1
of the Code, during one or more of the taxable years described in
section 172 (b)(1), see paragraph (f) of Sec. 1.172-1.
(b) Portion of net operating loss which is a carryback or a
carryover to the taxable year in issue. (1) A net operating loss shall
first be carried to the earliest of the several taxable years for which
such loss is allowable as a carryback or a carryover, and shall then be
carried to the next earliest of such several taxable years, etc. Except
as provided in Sec. 1.172-9, the entire net operating loss shall be
carried back to such earliest year.
(2) The portion of the loss which shall be carried to any of such
several taxable years subsequent to the earliest taxable year is the
excess of such net operating loss over the sum of the taxable incomes
(computed as provided in Sec. 1.172-5) for all of such several taxable
years preceding such subsequent taxable year.
(3) If a portion of the net operating loss for a taxable year is
attributable to a foreign expropriation loss (as defined in section
172(h)) and if an election under paragraph (c) of Sec. 1.172-9 is made
with respect to such portion of the net operating loss, then see Sec.
1.172-9 for the separate treatment of such portion of the net operating
loss.
(c) Illustration. The principles of this section are illustrated in
Sec. 1.172-6.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 8107, 51 FR
43345, Dec. 2, 1986]
Sec. 1.172-5 Taxable income which is subtracted from net operating
loss to determine carryback or carryover.
(a) Taxable year subject to the Internal Revenue Code of 1954. The
taxable income for any taxable year subject to the Internal Revenue Code
of 1954 which is subtracted from the net operating loss for any other
taxable year to determine the portion of such net operating loss which
is a carryback or a carryover to a particular taxable year is computed
with the modifications prescribed in this paragraph. These modifications
shall be made independently of, and without reference to, the
modifications required by Sec. Sec. 1.172-2(a) and 1.172-3(a) for
purposes of computing the net operating loss itself.
(1) Modifications applicable to unincorporated taxpayers only. In
the case of a taxpayer other than a corporation, in computing taxable
income and adjusted gross income:
[[Page 156]]
(i) No deduction shall be allowed under section 151 for the personal
exemptions (or under any other section which grants a deduction in lieu
of the deductions allowed by section 151) and under section 1202 in
respect of the net long-term capital gain.
(ii) The amount deductible on account of losses from sales or
exchanges of capital assets shall not exceed the amount includible on
account of gains from sales or exchanges of capital assets.
(2) Modifications applicable to all taxpayers. In the case either of
a corporation or of a taxpayer other than a corporation:
(i) Net operating loss deduction. The net operating loss deduction
for such taxable year shall be computed by taking into account only such
net operating losses otherwise allowable as carrybacks or carryovers to
such taxable year as were sustained in taxable years preceding the
taxable year in which the taxpayer sustained the net operating loss from
which the taxable income is to be deducted. Thus, for such purposes, the
net operating loss for the loss year or any taxable year thereafter
shall not be taken into account.
Example. The taxpayer's income tax returns are made on the basis of
the calendar year. In computing the net operating loss deduction for
1954, the taxpayer has a carryover from 1952 of $9,000, a carryover from
1953 of $6,000, a carryback from 1955 of $18,000, and a carryback from
1956 of $10,000, or an aggregate of $43,000 in carryovers and
carrybacks. Thus, the net operating loss deduction for 1954, for
purposes of determining the tax liability for 1954, is $43,000. However,
in computing the taxable income for 1954 which is subtracted from the
net operating loss for 1955 for the purpose of determining the portion
of such loss which may be carried over to subsequent taxable years, the
net operating loss deduction for 1954 is $15,000, that is, the aggregate
of the $9,000 carryover from 1952 and the $6,000 carryover from 1953. In
computing the net operating loss deduction for such purpose, the $18,000
carryback from 1955 and the $10,000 carryback from 1956 are disregarded.
In computing the taxable income for 1954, however, which is subtracted
from the net operating loss for 1956 for the purpose of determining the
portion of such loss which may be carried over to subsequent taxable
years, the net operating loss deduction for 1954 is $33,000, that is,
the aggregate of the $9,000 carryover from 1952, the $6,000 carryover
from 1953, and the $18,000 carryback from 1955. In computing the net
operating loss deduction for such purpose, the $10,000 carryback from
1956 is disregarded.
(ii) Recomputation of percentage limitations. Unless otherwise
specifically provided in this subchapter, any deduction which is limited
in amount to a percentage of the taxpayer's taxable income or adjusted
gross income shall be recomputed upon the basis of the taxable income or
adjusted gross income, as the case may be, determined with the
modifications prescribed in this paragraph. Thus, in the case of an
individual the deduction for medical expenses would be recomputed after
making all the modifications prescribed in this paragraph, whereas the
deduction for charitable contributions would be determined without
regard to any net operating loss carryback but with regard to any other
modifications so prescribed. See, however, the regulations under
paragraph (g) of Sec. 1.170-2 (relating to charitable contributions
carryover of individuals) and paragraph (c) of Sec. 1.170-3 (relating
to charitable contributions carryover of corporations) for special rules
regarding charitable contributions in excess of the percentage
limitations which may be treated as paid in succeeding taxable years.
Example 1. For the calendar year 1954 the taxpayer, an individual,
files a return showing taxable income of $4,800, computed as follows:
Salary....................................................... $5,000
Net long-term capital gain................................... 4,000
----------
Total gross income....................................... 9,000
Less: Deduction allowed by section 1202 in respect of net 2,000
long-term capital gain......................................
----------
Adjusted gross income...................................... 7,000
Less:
Deduction for personal exemption................ $600
Deduction for medical expense ($410 actually 200
paid but allowable only to extent in excess of
3 percent of adjusted gross income)............
Deduction for charitable contributions ($2,000 $1,400
actually paid but allowable only to extent not
in excess of 20 percent of adjusted gross
income)........................................
-----------
......... $2,200
----------
Taxable income........................................... 4,800
[[Page 157]]
In 1955 the taxpayer undertakes the operation of a trade or business and
sustains therein a net operating loss of $3,000. Under section
172(b)(2), it is determined that the entire $3,000 is a carryback to
1954. In 1956 he sustains a net operating loss of $10,000 in the
operation of the business. In determining the amount of the carryover of
the 1956 loss to 1957, the taxable income for 1954 as computed under
this paragraph is $3,970, determined as follows:
Salary....................................................... $5,000
Net long-term capital gain................................... 4,000
----------
Total gross income....................................... 9,000
Less: Deduction for carryback of 1955 net operating loss..... 3,000
----------
Adjusted gross income.................................... 6,000
Less:
Deduction for medical expense ($410 actually $230 .........
paid but allowable only to extent in excess of
3 percent of adjusted gross income as modified
under this paragraph)..........................
Deduction for charitable contributions ($2,000 1,800 .........
actually paid but allowable only to extent not
in excess of 20 percent of adjusted gross
income determined with all the modifications
prescribed in this paragraph other than the net
operating loss carryback)......................
-----------
......... 2,030
----------
Taxable income........................................... 3,970
Example 2. For the calendar year 1959 the taxpayer, an individual,
files a return showing taxable income of $5,700, computed as follows:
Salary....................................................... $5,000
Net long-term capital gain................................... 4,000
----------
Total gross income....................................... 9,000
Less: Deduction allowed by section 1202 in respect of net 2,000
long-term capital gain......................................
----------
Adjusted gross income...................................... 7,000
Less:
Deduction for personal exemption................ $600 .........
Standard deduction allowed by section 141....... $700 .........
-----------
......... $1,300
----------
Taxable income................................ ......... 5,700
In 1960 the taxpayer undertakes the operation of a trade or business and
sustains therein a net operating loss of $4,700. In 1961 he sustains a
net operating loss of $10,000 in the operation of the business. Under
section 172(b)(2), it is determined that the entire amount of each loss,
$4,700 and $10,000, is a carryback to 1959. In determining the amount of
the carryover of the 1961 loss to 1962, the taxable income for 1959 as
computed under this paragraph is $3,870, determined as follows:
Salary....................................................... $5,000
Net long-term capital gain................................... 4,000
----------
Total gross income....................................... 9,000
Less: Deduction for carryback of 1960 net operating loss..... 4,700
----------
Adjusted gross income.................................... 4,300
Less: Standard deduction..................................... 430
----------
Taxable income........................................... 3,870
(iii) Minimum limitation. The taxable income, as modified under this
paragraph, shall in no case be considered less than zero.
(3) Electing small business corporations. For special rule
applicable to corporations which were electing small business
corporations under Subchapter S (section 1361 and following), Chapter 1
of the Code, during one or more of the taxable years described in
section 172(b)(1), see paragraph (f) of Sec. 1.172-1.
(4) Qualified real estate investment trust. Where a net operating
loss is carried over to a qualified taxable year (as defined in Sec.
1.172-10(b)) ending after October 4, 1976, the real estate investment
trust taxable income (as defined in section 857(b)(2)) shall be used as
the ``taxable income'' for that taxable year to determine, under section
172(b)(2), the balance of the net operating loss available as a
carryover to a subsequent taxable year. The real estate investment trust
taxable income, however, is computed by applying the rules applicable to
corporations in paragraph (a)(2) of this section. Thus, in computing
real estate investment trust taxable income for purposes of section
172(b)(2), the net operating loss deduction for the taxable year shall
be computed in accordance with paragraph (a)(2)(i) of this section. The
principles of this subparagraph may be illustrated by the following
examples:
Example 1. Corporation X, a calendar year taxpayer, is formed on
January 1, 1977. X incurs a net operating loss of $100,000 for its
taxable year 1977, which under section 172(b)(2), is a carryover to
1978. For 1978 X is a qualified real estate investment trust (as defined
in Sec. 1.172-10(b)) and has real estate investment trust taxable
income (determined without regard to the deduction for dividends paid or
the net operating loss deduction) of $150,000, all of which consists of
ordinary income. X pays dividends in 1978 totaling $120,000 that qualify
for the deduction for
[[Page 158]]
dividends paid under section 857(b)(2)(B). The portion of the 1977 net
operating loss available as a carryover to 1979 and subsequent years is
$70,000 (i.e., the excess of the amount of the net operating loss
($100,000) over the amount of the real estate investment trust taxable
income for 1978 ($30,000), determined by taking into account the
deduction for dividends paid allowable under section 857(b)(2)(B) and
without taking into account the net operating loss of 1977).
Example 2. (i) Assume the same facts as in Example 1, except that
the $150,000 of real estate investment trust taxable income (determined
without the net operating loss deduction or the dividends paid
deduction) consists of $80,000 of ordinary income and $70,000 of net
capital gain. The amount of capital gain dividends which may be paid for
1978 is limited to $50,000, that is, the amount of the real estate
investment trust taxable income for 1978, determined by taking into
account the net operating loss deduction for the taxable year, but not
the deduction for dividends paid ($150,000 minus $100,000). See Sec.
1.857-6(e)(1)(ii).
(ii) X designated $50,000 of the $120,000 of dividends paid as
capital gains dividends (as defined in section 857(b)(3)(C) and Sec.
1.857-6(e)). Thus, $70,000 is an ordinary dividend. Since both ordinary
dividends and capital gains dividends are taken into account in
computing the deduction for dividends paid under section 857(b)(2)(B),
the result will be the same as in Example 1; that is, the portion of the
1977 net operating loss available as a carryover to 1979 and subsequent
years is $70,000.
(b) [Reserved]
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6862, 30 FR
14428, Nov. 18, 1965; T.D. 6900, 31 FR 14641, Nov. 17, 1966; T.D. 7767,
46 FR 11263, Feb. 6, 1981; T.D. 8107, 51 FR 43346, Dec. 2, 1986]
Sec. 1.172-6 Illustration of net operating loss carrybacks and carryovers.
The application of Sec. 1.172-4 may be illustrated by the following
example:
(a) Facts. The books of the taxpayer, whose return is made on the
basis of the calendar year, reveal the following facts:
------------------------------------------------------------------------
Net
Taxable year Taxable operating
income loss
------------------------------------------------------------------------
1954.............................................. $15,000
1955.............................................. 30,000
1956.............................................. ......... ($75,000)
1957.............................................. 20,000
1958.............................................. ......... (150,000)
1959.............................................. 30,000
1960.............................................. 35,000
1961.............................................. 75,000
1962.............................................. 17,000
1963.............................................. 53,000
------------------------------------------------------------------------
The taxable income thus shown is computed without any net operating loss
deduction. The assumption is also made that none of the other
modifications prescribed in Sec. 1.172-5 apply. There are no net
operating losses for 1950, 1951, 1952, 1953, 1964, 1965, or 1966.
(b) Loss sustained in 1956. The portions of the $75,000 net
operating loss for 1956 which shall be used as carrybacks to 1954 and
1955 and as carryovers to 1957, 1958, 1959, 1960, and 1961 are computed
as follows:
(1) Carryback to 1954. The carryback to this year is $75,000, that
is, the amount of the net operating loss.
(2) Carryback to 1955. The carryback to this year is $60,000,
computed as follows:
Net operating loss........................................... $75,000
Less:
Taxable income for 1954 (computed without the deduction of 15,000
the carryback from 1956)..................................
----------
Carryback................................................ 60,000
(3) Carryover to 1957. The carryover to this year is $30,000,
computed as follows:
Net operating loss................................ ......... $75,000
Less:
Taxable income for 1954 (computed without the $15,000 .........
deduction of the carryback from 1956)..........
Taxable income for 1955 (computed without the 30,000 .........
deduction of the carryback from 1956 or the
carryback from 1958)...........................
-----------
......... 45,000
----------
Carryover..................................... ......... 30,000
(4) Carryover to 1958. The carryover to this year is $10,000,
computed as follows:
Net operating loss................................ ......... $75,000
Less:
Taxable income for 1954 (computed without the $15,000 .........
deduction of the carryback from 1956)..........
Taxable income for 1955 (computed without the 30,000 .........
deduction of the carryback from 1956 or the
carryback from 1958)...........................
Taxable income for 1957 (computed without the 20,000 .........
deduction of the carryover from 1956 or the
carryback from 1958)...........................
-----------
......... 65,000
----------
Carryover..................................... ......... 10,000
[[Page 159]]
(5) Carryover to 1959. The carryover to this year is $10,000,
computed as follows:
Net operating loss................................ ......... $75,000
Less:
Taxable income for 1954 (computed without the $15,000
deduction of the carryback from 1956)..........
Taxable income for 1955 (computed without the 30,000
deduction of the carryback from 1956 or the
carryback from 1958)...........................
Taxable income for 1957 (computed without the 20,000
deduction of the carryover from 1956 or the
carryback from 1958)...........................
Taxable income for 1958 (a year in which a net 0
operating loss was sustained)..................
-------- 65,000
----------
Carryover..................................... ......... 10,000
(6) Carryover to 1960. The carryover to this year is $0, computed as
follows:
Net operating loss................................ ......... $75,000
Less:
Taxable income for 1954 (computed without the $15,000
deduction of the carryback from 1956)..........
Taxable income for 1955 (computed without the 30,000
deduction of the carryback from 1956 or the
carryback from 1958)...........................
Taxable income for 1957 (computed without the 20,000
deduction of the carryover from 1956 or the
carryback from 1958)...........................
Taxable income for 1958 (a year in which a net 0
operating loss was sustained)..................
Taxable income for 1959 (computed without the 30,000
deduction of the carryover from 1956 or the
carryover from 1958)...........................
-------- 95,000
----------
Carryover..................................... ......... 0
(7) Carryover to 1961. The carryover to this year is $0, computed as
follows:
Net operating loss................................ ......... $75,000
Less:
Taxable income for 1954 (computed without the $15,000
deduction of the carryback from 1956)..........
Taxable income for 1955 (computed without the 30,000
deduction of the carryback from 1956 or the
carryback from 1958)...........................
Taxable income for 1957 (computed without the 20,000
deduction of the carryover from 1956 or the
carryback from 1958)...........................
Taxable income for 1958 (a year in which a net 0
operating loss was sustained)..................
Taxable income for 1959 (computed without the 30,000
deduction of the carryover from 1956 or the
carryover from 1958)...........................
Taxable income for 1960 (computed without the 35,000
deduction of the carryover from 1956 or the
carryover from 1958)...........................
-------- 130,000
----------
Carryover..................................... ......... 0
(c) Loss sustained in 1958. The portions of the $150,000 net
operating loss for 1958 which shall be used as carrybacks to 1955, 1956,
and 1957 and as carryovers to 1959, 1960, 1961, 1962, and 1963 are
computed as follows:
(1) Carryback to 1955. The carryback to this year is $150,000, that
is, the amount of the net operating loss.
(2) Carryback to 1956. The carryback to this year is $150,000,
computed as follows:
Net operating loss........................................... $150,000
Less:
Taxable income for 1955 (the $30,000 taxable income for 0
such year reduced by the carryback to such year of $60,000
from 1956, the carryback from 1958 to 1955 not being taken
into account).............................................
----------
Carryback................................................ 150,000
(3) Carryback to 1957. The carryback to this year is $150,000,
computed as follows:
Net operating loss................................ ......... $150,000
Less:
Taxable income for 1955 (the $30,000 taxable 0
income for such year reduced by the carryback
to such year of $60,000 from 1956, the
carryback from 1958 to 1955 not being taken
into account)..................................
Taxable income for 1956 (a year in which a net 0
operating loss was sustained)..................
-------- 0
----------
Carryback..................................... ......... 150,000
(4) Carryover to 1959. The carryover to this year is $150,000,
computed as follows:
Net operating loss................................ ......... $150,000
Less:
Taxable income for 1955 (the $30,000 taxable 0
income for such year reduced by the carryback
to such year of $60,000 from 1956, the
carryback from 1958 to 1955 not being taken
into account)..................................
Taxable income for 1956 (a year in which a net 0
operating loss was sustained)..................
Taxable income for 1957 (the $20,000 taxable 0
income for such year reduced by the carryover
to such year of $30,000 from 1956, the
carryback from 1958 to 1957 not being taken
into account)..................................
[[Page 160]]
-------- 0
----------
Carryover..................................... ......... 150,000
(5) Carryover to 1960. The carryover to this year is $130,000,
computed as follows:
Net operating loss................................ ......... $150,000
Less:
Taxable income for 1955 (the $30,000 taxable 0
income for such year reduced by the carryback
to such year of $60,000 from 1956, the
carryback from 1958 to 1955 not being taken
into account)..................................
Taxable income for 1956 (a year in which a net 0
operating loss was sustained)..................
Taxable income for 1957 (the $20,000 taxable 0
income for such year reduced by the carryover
to such year of $30,000 from 1956, the
carryback from 1958 to 1957 not being taken
into account)..................................
Taxable income for 1959 (the $30,000 taxable $20,000
income for such year reduced by the carryover
to such year of $10,000 from 1956, the
carryover from 1958 to 1959 not being taken
into account)..................................
-------- 20,000
----------
Carryover..................................... ......... 130,000
(6) Carryover to 1961. The carryover to this year is $95,000,
computed as follows:
Net operating loss................................ ......... $150,000
Less:
Taxable income for 1955 (the $30,000 taxable 0
income for such year reduced by the carryback
to such year of $60,000 from 1956, the
carryback from 1958 to 1955 not being taken
into account)..................................
Taxable income for 1956 (a year in which a net 0
operating loss was sustained)..................
Taxable income for 1957 (the $20,000 taxable 0
income for such year reduced by the carryover
to such year of $30,000 from 1956, the
carryback from 1958 to 1957 not being taken
into account)..................................
Taxable income for 1959 (the $30,000 taxable $20,000
income for such year reduced by the carryover
to such year of $10,000 from 1956, the
carryover from 1958 to 1959 not being taken
into account)..................................
Taxable income for 1960 (the $35,000 taxable 35,000
income for such year reduced by the carryover
to such year of $0 from 1956, the carryover
from 1958 to 1960 not being taken into account)
-------- 55,000
----------
Carryover..................................... ......... 95,000
(7) Carryover to 1962. The carryover to this year is $20,000,
computed as follows:
Net operating loss................................ ......... $150,000
Less:
Taxable income for 1955 (the $30,000 taxable 0
income for such year reduced by the carryback
to such year of $60,000 from 1956, the
carryback from 1958 to 1955 not being taken
into account)..................................
Taxable income for 1956 (a year in which a net 0
operating loss was sustained)..................
Taxable income for 1957 (the $20,000 taxable 0
income for such year reduced by the carryover
to such year of $30,000 from 1956, the
carryback from 1958 to 1957 not being taken
into account)..................................
Taxable income for 1959 (the $30,000 taxable $20,000
income for such year reduced by the carryover
to such year of $10,000 from 1956, the
carryover from 1958 to 1959 not being taken
into account)..................................
Taxable income for 1960 (the $35,000 taxable 35,000
income for such year reduced by the carryover
to such year of $0 from 1956, the carryover
from 1958 to 1960 not being taken into account)
Taxable income for 1961 (the $75,000 taxable 75,000
income for such year reduced by the carryover
to such year of $0 from 1956, the carryover
from 1958 to 1961 not being taken into account)
-------- 130,000
----------
Carryover..................................... ......... 20,000
(8) Carryover to 1963. The carryover to this year is $3,000,
computed as follows:
Net operating loss................................ ......... $150,000
Less:
Taxable income for 1955 (the $30,000 taxable 0
income for such year reduced by the carryback
to such year of $60,000 from 1956, the
carryback from 1958 to 1955 not being taken
into account)..................................
Taxable income for 1956 (a year in which a net 0
operating loss was sustained)..................
Taxable income for 1957 (the $20,000 taxable 0
income for such year reduced by the carryover
to such year of $30,000 from 1956, the
carryback from 1958 to 1957 not being taken
into account)..................................
[[Page 161]]
Taxable income for 1959 (the $30,000 taxable $20,000
income for such year reduced by the carryover
to such year of $10,000 from 1956, the
carryover from 1958 to 1959 not being taken
into account)..................................
Taxable income for 1960 (the $35,000 taxable 35,000
income for such year reduced by the carryover
to such year of $0 from 1956, the carryover
from 1958 to 1960 not being taken into account)
Taxable income for 1961 (the $75,000 taxable 75,000 .........
income for such year reduced by the carryover
to such year of $0 from 1956, the carryover
from 1958 to 1961 not being taken into account)
Taxable income for 1962 (computed without the 17,000
deduction of the carryover from 1958)..........
-------- 147,000
----------
Carryover..................................... ......... 3,000
(d) Determination of net operating loss deduction for each year. The
carryovers and carrybacks computed under paragraphs (b) and (c) of this
section are used as a basis for the computation of the net operating
loss deduction in the following manner:
----------------------------------------------------------------------------------------------------------------
Carryover Carryback Net
---------------------------------------- operating
Taxable year From From From From loss
1956 1958 1956 1958 deduction
----------------------------------------------------------------------------------------------------------------
1954......................................................... $0 $0 $75,000 $0 $75,000
1955......................................................... 0 0 60,000 150,000 210,000
1957......................................................... 30,000 0 0 150,000 180,000
1959......................................................... 10,000 150,000 0 0 160,000
1960......................................................... 0 130,000 0 0 130,000
1961......................................................... 0 95,000 0 0 95,000
1962......................................................... 0 20,000 0 0 20,000
1963......................................................... 0 3,000 0 0 3,000
----------------------------------------------------------------------------------------------------------------
Sec. 1.172-7 Joint return by husband and wife.
(a) In general. This section prescribes additional rules for
computing the net operating loss carrybacks and carryovers of a husband
and wife making a joint return for one or more of the taxable years
involved in the computation of the net operating loss deduction.
(b) From separate to joint return. If a husband and wife, making a
joint return for any taxable year, did not make a joint return for any
of the taxable years involved in the computation of a net operating loss
carryover or a net operating loss carryback to the taxable year for
which the joint return is made, such separate net operating loss
carryover or separate net operating loss carryback is a joint net
operating loss carryover or joint net operating loss carryback to such
taxable year.
(c) Continuous use of joint return. If a husband and wife making a
joint return for a taxable year made a joint return for each of the
taxable years involved in the computation of a net operating loss
carryover or net operating loss carryback to such taxable year, the
joint net operating loss carryover or joint net operating loss carryback
to such taxable year is computed in the same manner as the net operating
loss carryover or net operating loss carryback of an individual under
Sec. 1.172-4 but upon the basis of the joint net operating losses and
the combined taxable income of both spouses.
(d) From joint to separate return. If a husband and wife making
separate returns for a taxable year made a joint return for any, or all,
of the taxable years involved in the computation of a net operating loss
carryover or net operating loss carryback to such taxable year, the
separate net operating loss carryover or separate net operating loss
carryback of each spouse to the taxable year is computed in the manner
set forth in Sec. 1.172-4 but with the following modifications:
(1) Net operating loss. The net operating loss of each spouse for a
taxable year for which a joint return was made shall be deemed to be
that portion of the joint net operating loss (computed in accordance
with paragraph (d) of
[[Page 162]]
Sec. 1.172-3) which is attributable to the gross income and deductions
of such spouse, gross income and deductions being taken into account to
the same extent that they are taken into account in computing the joint
net operating loss.
(2) Taxable income to be subtracted--(i) Net operating loss of other
spouse. The taxable income of a particular spouse for any taxable year
which is subtracted from the net operating loss of such spouse for
another taxable year in order to determine the amount of such loss which
may be carried back or carried over to still another taxable year is
deemed to be, in a case in which such taxable income was reported in a
joint return, the sum of the following:
(a) That portion of the combined taxable income of both spouses for
such year for which the joint return was made which is attributable to
the gross income and deductions of the particular spouse, gross income
and deductions being taken into account to the same extent that they are
taken into account in computing such combined taxable income, and
(b) That portion of such combined taxable income which is
attributable to the other spouse; but, if such other spouse sustained a
net operating loss in a taxable year beginning on the same date as the
taxable year in which the particular spouse sustained the net operating
loss from which the taxable income is subtracted, then such portion
shall first be reduced by such net operating loss of such other spouse.
(ii) Modifications. For purposes of this subparagraph, the combined
taxable income shall be computed as though the combined income and
deductions of both spouses were those of one individual. The provisions
of Sec. 1.172-5 shall apply in computing the combined taxable income
for such purposes except that the net operating loss deduction shall be
determined without taking into account any separate net operating loss
of either spouse, or any joint net operating loss of both spouses, which
was sustained in a taxable year beginning on or after the date of the
beginning of the taxable year in which the particular spouse sustained
the net operating loss from which the taxable income is subtracted.
(e) Recurrent use of joint return. If a husband and wife making a
joint return for any taxable year made a joint return for one or more,
but not all, of the taxable years involved in the computation of a net
operating loss carryover or net operating loss carryback to such taxable
year, such net operating loss carryover or net operating loss carryback
to the taxable year is computed in the manner set forth in paragraph (d)
of this section. Such net operating loss carryover or net operating loss
carryback is considered a joint net operating loss carryover or joint
net operating loss carryback to such taxable year.
(f) Joint carryovers and carrybacks. The joint net operating loss
carryovers and the joint net operating loss carrybacks to any taxable
year for which a joint return is made are all the net operating loss
carryovers and net operating loss carrybacks of both spouses to such
taxable year. For example, a husband and wife file a joint return for
the calendar year 1956, having a joint taxable income for such year. The
wife filed a separate return for the calendar years 1954 and 1955, in
which years she sustained net operating losses. The husband filed
separate returns for his fiscal year ending June 30, 1955, and, having
received permission to change his accounting period to a calendar year
basis, for the 6-month period ending December 31, 1955. The husband
sustained net operating losses in both such taxable years. Since the
husband and wife did not file a joint return for any taxable year
involved in the computation of the net operating loss carryovers to 1956
from 1954 and 1955, the joint net operating loss carryovers to 1956 are
the separate net operating loss carryovers of the wife from the calendar
years 1954 and 1955 and the separate net operating loss carryovers of
the husband from the fiscal year ending June 30, 1955, and from the
short taxable year ending December 31, 1955. If the husband and wife
also file joint returns for the calendar years 1957, 1958, and 1959,
having joint taxable income in 1957 and 1958 and a joint net operating
loss in 1959, the joint net operating loss carrybacks to
[[Page 163]]
1956, 1957, and 1958 from 1959 are computed on the basis of the joint
net operating loss for 1959, since separate returns were not made for
any taxable year involved in the computation of such carrybacks.
(g) Illustration of principles. In the following examples, which
illustrate the application of this section, it is assumed that there are
no items of adjustment under section 172(b)(2)(A) and that the taxable
income or loss in each case is the taxable income or loss determined
without any net operating loss deduction. The taxpayers in each example,
H, a husband, and W, his wife, report their income on the calendar-year
basis.
Example 1. H and W filed joint returns for 1954 and 1955. They
sustained a joint net operating loss of $1,000 for 1954 and a joint net
operating loss of $2,000 for 1955. For 1954 the deductions of H exceeded
his gross income by $700, and the deductions of W exceeded her gross
income by $300, the total of such amounts being $1,000. Therefore, $700
of the $1,000 joint net operating loss for 1954 is considered the net
operating loss of H for 1954, and $300 of such joint net operating loss
is considered the net operating loss of W for 1954. For 1955 the gross
income of H exceeded his deductions, so that his separate taxable income
would be $1,500, and the deductions of W exceeded her gross income by
$3,500. Therefore, all of the $2,000 joint net operating loss for 1955
is considered the separate net operating loss of W for 1955.
Example 2. (i) H and W filed joint returns for 1954 and 1956, and
separate returns for 1955 and 1957. For the years 1954, 1955, 1956, and
1957 they had taxable incomes and net operating losses as follows,
losses being indicated in parentheses:
------------------------------------------------------------------------
1954 1955 1956 1957
------------------------------------------------------------------------
H............................... ($5,000) ($2,500) $6,500 ($4,000)
W............................... (3,000) 2,000 3,000 (1,500)
---------------------------------------
Total......................... (8,000) ........ 9,500 ........
------------------------------------------------------------------------
(ii) The net operating loss carryover of H from 1957 to 1958 is
$4,000, that is, his $4,000 net operating loss for 1957 which is not
reduced by any part of the taxable income for 1956, since none of such
taxable income is attributable to H and the portion attributable to W is
entirely offset by her separate net operating loss for her taxable year
1957, which taxable year begins on the same date as H's taxable year
1957. H's $4,000 net operating loss for 1957 likewise is not reduced by
reference to 1955 since H sustained a loss in 1955. The $0 taxable
income for 1956 which reduces H's net operating loss for 1957 is
computed as follows:
(iii) The combined taxable income of $9,500 for 1956 is reduced to
$1,000 by the net operating loss deduction for such year of $8,500. This
net operating loss deduction is computed without taking into account any
net operating loss of either H or W sustained in a taxable year
beginning on or after January 1, 1957, the date of the beginning of the
taxable year in which H sustained the net operating loss from which the
taxable income is subtracted. This $8,500 is composed of H's carryovers
of $5,000 from 1954 and $2,500 from 1955, and of W's carryover of $1,000
from 1954 (the excess of W's $3,000 loss for 1954 over her $2,000 income
for 1955). None of the $1,000 combined taxable income for 1956 (computed
with the net operating loss deduction described above) is attributable
to H since it is caused by W's income (computed after deducting her
separate carryover) offsetting H's loss (computed by deducting from his
income his separate carryovers). No part of the $1,000 combined taxable
income for 1956 which is attributable to W is used to reduce H's net
operating loss for 1957 since such taxable income attributable to W must
first be reduced by W's $1,500 net operating loss for 1957, her taxable
year beginning on the same date as the taxable year of H in which he
sustained the net operating loss from which the taxable income is
subtracted.
(iv) The net operating loss carryover of W from 1957 to 1958 is
$500, her $1,500 loss reduced by the sum of her $0 taxable income for
1955 (computed by taking into account her $3,000 carryover from 1954)
and her $1,000 taxable income for 1956, that is, the portion of the
combined taxable income for 1956 which is attributable to her.
Example 3. (i) Assume the same facts as in Example 2 except that for
1957 the net operating loss of W is $200 instead of $1,500.
(ii) The net operating loss carryover of H from 1957 to 1958 is
$3,200, that is, his $4,000 net operating loss for 1957 reduced by the
sum of his $0 taxable income for 1955 (a year in which he sustained a
loss) and his $800 taxable income for 1956. Such $800 is computed as
follows:
(iii) The combined taxable income for 1956, computed with the net
operating loss deduction in the manner described in Example 2, remains
$1,000, no part of which is attributable to H. To the $0 taxable income
attributable to H for 1956 there is added $800, the excess of the $1,000
taxable income for such year attributable to W over her $200 net
operating loss sustained in 1957, a taxable year beginning on the same
date as the taxable year of H in which he sustained the $4,000 net
operating loss from which the taxable income is subtracted.
(iv) W has no net operating loss carryover from 1957 to 1958 since
her net operating loss
[[Page 164]]
of $200 for 1957 does not exceed the $1,000 taxable income for 1956
attributable to her.
Example 4. (i) Assume the same facts as in Example 2, except that W
changes her accounting period in 1957 to a fiscal year ending on January
31, and has neither income nor losses for the taxable year January 1,
1957, to January 31, 1957, or for the fiscal year February 1, 1957, to
January 31, 1958, but has a net operating loss of $200 for the fiscal
year February 1, 1958, to January 31, 1959.
(ii) The net operating loss carryover of H from 1957 to 1958 is
$3,000, that is, his net operating loss of $4,000 for 1957 reduced by
the sum of his $0 taxable income for 1955 (a year in which he sustained
a loss) and his $1,000 taxable income for 1956. Such $1,000 is computed
as follows:
(iii) The combined taxable income for 1956, computed with the net
operating loss deduction in the manner described in Example 2, remains
$1,000, no part of which is attributable to H. To the $0 taxable income
attributable to H for 1956 there is added the $1,000 taxable income
attributable to W for such year. The taxable income attributable to W is
not reduced by any amount since she does not have a net operating loss
for her taxable year beginning on January 1, 1957, the date of the
beginning of the taxable year of H in which he sustained the $4,000 net
operating loss from which his taxable income is subtracted.
(iv) The net operating loss carryover of W from the fiscal year
beginning February 1, 1958, to her next fiscal year is $200, that is,
her net operating loss of $200 for the fiscal year beginning February 1,
1958, reduced by the sum of her $0 taxable income for 1956, her $0
taxable income for the taxable year January 1, 1957, to January 31, 1957
(a year in which she had neither income nor loss), and her $0 taxable
income for the fiscal year February 1, 1957, to January 31, 1958 (also a
year in which she had neither income nor loss). The $0 taxable income
for 1956 is computed as follows:
(v) The combined taxable income of $9,500 for 1956 is reduced to $0
amount by the net operating loss deduction for such year of $12,500.
This net operating loss deduction is computed by taking into account the
net operating loss of H for 1957 since it was sustained in a taxable
year beginning before February 1, 1958, the date of the beginning of the
taxable year of W in which she sustained the $200 net operating loss
from which her taxable income is subtracted. This $12,500 is composed of
H's carryovers of $5,000 from 1954 and $2,500 from 1955 and of his
carryback of $4,000 from 1957, plus W's carryover of $1,000 from 1954
(the excess of W's $3,000 loss for 1954 over her $2,000 income for
1955). Since there is no combined taxable income for 1956, there is no
taxable income attributable to W for such year.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 8107, 51 FR
43346, Dec. 2, 1986]
Sec. 1.172-8 Net operating loss carryovers for regulated
transportation corporations.
(a) In general. A net operating loss sustained in a taxable year
ending before January 1, 1976, shall be a carryover to the 7 succeeding
taxable years if the taxpayer is a regulated transportation corporation
(as defined in paragraph (b) of this section) for the loss year and for
the 6th and 7th succeeding taxable years. If, however, the taxpayer is a
regulated transportation corporation for the loss year and for the 6th
succeeding taxable year, but not for the 7th succeeding taxable year,
then the loss shall be a carryover to the 6 succeeding taxable years. If
the taxpayer is not a regulated transportation corporation for the 6th
succeeding taxable year then this section shall not apply. A net
operating loss sustained in a taxable year ending after December 31,
1975, shall be a carryover to the 15 succeeding taxable years.
(b) Regulated transportation corporations. A corporation is a
regulated transportation corporation for a taxable year if it is
included within one or more of the following categories:
(1) Eighty percent or more of the corporation's gross income
(computed without regard to dividends and capital gains and losses) for
such taxable year is income from transportation sources described in
paragraph (c) of this section.
(2) The corporation is a railroad corporation, subject to Part I of
the Interstate Commerce Act, which is either a lessor railroad
corporation described in section 7701(a)(33)(G) or a common parent
railroad corporation described in section 7701(a)(33)(H).
(3) The corporation is a member of a regulated transportation system
for the taxable year. For purposes of this section, a member of a
regulated transportation system for a taxable year means a member of an
affiliated group of corporations making a consolidated return for such
year, if 80 percent or
[[Page 165]]
more of the sum of the gross incomes of the members of the affiliated
group for such year (computed without regard to dividends, capital gains
and losses, or eliminations for intercompany transactions) is derived
from transportation sources described in paragraph (c) of this section.
For purposes of this subparagraph, income derived by a corporation
described in subparagraph (2) of this paragraph from leases described in
section 7701(a)(33)(G) shall be considered as income from transportation
sources described in paragraph (c) of this section.
(c) Transportation sources. For purposes of this section, income
from ``transportation sources'' means income received directly in
consideration for transportation services, and income from the
furnishing or sale of essential facilities, products, and other services
which are directly necessary and incidental to the furnishing of
transportation services. For purposes of the preceding sentence, the
term transportation services means:
(1) Transportation by railroad as a common carrier subject to the
jurisdiction of the Interstate Commerce Commission;
(2)(i) Transportation, which is not included in subparagraph (1) of
this paragraph:
(a) On an intrastate, suburban, municipal, or interurban electric
railroad,
(b) On an intrastate, municipal, or suburban trackless trolley
system,
(c) On a municipal or suburban bus system, or
(d) By motor vehicle not otherwise included in this subparagraph, if
the rates for the furnishing or sale of such transportation are
established or approved by a regulatory body described in section
7701(a)(33)(A);
(ii) In the case of a corporation which establishes to the
satisfaction of the district director that:
(a) Its revenue from regulated rates from transportation services
described in subdivision (i) of this subparagraph and its revenue
derived from unregulated rates are derived from its operation of a
single interconnected and coordinated system or from the operation of
more than one such system, and
(b) The unregulated rates have been and are substantially as
favorable to users and consumers as are the regulated rates,
transportation, which is not included in subparagraph (1) of this
paragraph, from which such revenue from unregulated rates is derived.
(3) Transportation by air as a common carrier subject to the
jurisdiction of the Civil Aeronautics Board; and
(4) Transportation by water by common carrier subject to the
jurisdiction of either the Interstate Commerce Commission under Part III
of the Interstate Commerce Act (54 Stat. 929), or the Federal Maritime
Board under the Intercoastal Shipping Act, 1933 (52 Stat. 965).
(d) Corporate acquisitions. This section shall apply to a carryover
of a net operating loss sustained by a regulated transportation
corporation (as defined in paragraph (b) of this section) to which an
acquiring corporation succeeds under section 381(a) only if the
acquiring corporation is a regulated transportation corporation (as
defined in paragraph (b) of this section):
(1) For the sixth succeeding taxable year in the case of a carryover
to the sixth succeeding taxable year, and
(2) For the sixth and seventh succeeding taxable years in the case
of a carryover to the seventh succeeding taxable year.
[T.D. 6862, 30 FR 14430, Nov. 18, 1965, as amended by T.D. 8107, 51 FR
43346, Dec. 2, 1986]
Sec. 1.172-9 Election with respect to portion of net operating loss
attributable to foreign expropriation loss.
(a) In general. If a taxpayer has a net operating loss for a taxable
year ending after December 31, 1958, and if the foreign expropriation
loss for such year (as defined in paragraph (b)(1) of this section)
equals or exceeds 50 percent of the net operating loss for such year,
then the taxpayer may elect (at the time and in the manner provided in
paragraph (c) (1) or (2) of this section, whichever is applicable) to
have the provisions of this section apply. If the taxpayer so elects,
the portion of the net operating loss for such taxable year attributable
(under paragraph (b)(2) of this section) to such foreign expropriation
loss shall not be a net operating loss carryback to any taxable year
preceding the taxable year of such loss
[[Page 166]]
and shall be a net operating loss carryover to each of the ten taxable
years following the taxable year of such loss. In such case, the
portion, if any, of the net operating loss not attributable to a foreign
expropriation loss shall be carried back or carried over as provided in
paragraph (a)(1)(ii) of Sec. 1.172-4.
(b) Determination of ``foreign expropriation loss''--(1) Definition
of ``foreign expropriation loss''. The term foreign expropriation loss
means, for any taxable year, the sum of the losses allowable as
deductions under section 165 (other than losses from, or which under
section 165(g) or 1231(a) are treated or considered as losses from,
sales or exchanges of capital assets and other than losses described in
section 165(i)(1)) sustained by reason of the expropriation,
intervention, seizure, or similar taking of property by the government
or any foreign country, any political subdivision thereof, or any agency
or instrumentality of the foregoing. For purposes of the preceding
sentence, a debt which becomes worthless in whole or in part, shall, to
the extent of any deduction allowed under section 166(a), be treated as
a loss allowable as a deduction under section 165.
(2) Portion of the net operating loss attributable to a foreign
expropriation loss. (i) Except as provided in subdivision (ii) of this
subparagraph, the portion of the net operating loss for any taxable year
attributable to a foreign expropriation loss is the amount of the
foreign expropriation loss for such taxable year (determined under
subparagraph (1) of this paragraph).
(ii) The portion of the net operating loss for a taxable year
attributable to a foreign expropriation loss shall not exceed the amount
of the net operating loss, computed under section 172(c), for such year.
(3) Examples. The application of this paragraph may be illustrated
by the following examples:
Example 1. M Corporation, a domestic calendar year corporation
manufacturing cigars in the United States, owns, in country X, a tobacco
plantation having an adjusted basis of $400,000 and farm equipment
having an adjusted basis of $300,000. On January 15, 1961, country X
expropriates the plantation and equipment without any allowance for
compensation. For the taxable year 1961, M Corporation sustains a loss
from the operation of its business (not including losses from the
seizure of its plantation and equipment in country X) of $200,000, which
loss would not have been sustained in the absence of the seizure.
Accordingly, M has a net operating loss of $900,000 (the sum of
$400,000, $300,000, and $200,000). For purposes of section 172(k)(1), M
Corporation has a foreign expropriation loss for 1961 of $700,000 (the
sum of $400,000 and $300,000, the losses directly sustained by reason of
the seizure of its property by country X). Since the foreign
expropriation loss for 1961, $700,000, equals or exceeds 50 percent of
the net operating loss for such year, or $450,000 (i.e., 50 percent of
$900,000), M Corporation may make the election under paragraph (c)(2) of
this section with respect to $700,000, the portion of the net operating
loss attributable to the foreign expropriation loss.
Example 2. Assume the same facts as in Example 1 except that for
1961, M Corporation has operating profits of $300,000 (not including
losses from the seizure of its plantation and equipment in country X) so
that its net operating loss (as defined in section 172(c)) is only
$400,000. Under the provisions of section 172(k)(2) and paragraph (b)(2)
of this section, the portion of the net operating loss for 1961
attributable to a foreign expropriation loss is limited to $400,000, the
amount of the net operating loss.
(c) Time and manner of making election--(1) Taxable years ending
after December 31, 1963. In the case of a taxpayer who has a foreign
expropriation loss for a taxable year ending after December 31, 1963,
the election referred to in paragraph (a) of this section shall be made
by attaching to the taxpayer's income tax return (filed within the time
prescribed by law, including extensions of time) for the taxable year of
such foreign expropriation loss a statement containing the information
required by subparagraph (3) of this paragraph. Such election shall be
irrevocable after the due date (including extensions of time) of such
return.
(2) Information required. The statement referred to in subparagraph
(1) of this paragraph shall contain the following information:
(i) The name, address, and taxpayer account number of the taxpayer;
(ii) A statement that the taxpayer elects under section
172(b)(3)(A)(ii) or (iii), whichever is applicable, to have section
172(b)(1)(D) of the Code apply;
(iii) The amount of the net operating loss for the taxable year; and
[[Page 167]]
(iv) The amount of the foreign expropriation loss for the taxable
year, including a schedule showing the computation of such foreign
expropriation loss.
(d) Amount of foreign expropriation loss which is a carryover to the
taxable year in issue--(1) General. If a portion of a net operating loss
for the taxable year is attributable to a foreign expropriation loss and
if an election under paragraph (a) of this section has been made with
respect to such portion of the net operating loss, then such portion
shall be considered to be a separate net operating loss for such year,
and, for the purpose of determining the amount of such separate loss
which may be carried over to other taxable years, such portion shall be
applied after the other portion (if any) of such net operating loss.
Such separate loss shall be carried to the earliest of the several
taxable years to which such separate loss is allowable as a carryover
under the provisions of paragraph (a)(1)(iv) of Sec. 1.172-4, and the
amount of such separate loss which shall be carried over to any taxable
year subsequent to such earliest year is an amount (not exceeding such
separate loss) equal to the excess of:
(i) The sum of (a) such separate loss and (b) the other portion (if
any) of the net operating loss (i.e., that portion not attributable to a
foreign expropriation loss) to the extent such other portion is a
carryover to such earliest taxable year, over
(ii) The sum of the aggregate of the taxable incomes (computed as
provided in Sec. 1.172-5) for all of such several taxable years
preceding such subsequent taxable year.
(2) Cross reference. The portion of a net operating loss which is
not attributable to a foreign expropriation loss shall be carried back
or carried over, in accordance with the rules provided in paragraph
(b)(1) of Sec. 1.172-4, as if such portion were the only net operating
loss for such year.
(3) Examples. The application of this paragraph may be illustrated
by the following examples:
Example 1. Corporation A, organized in 1960 and whose return is made
on the basis of the calendar year, incurs for 1960 a net operating loss
of $10,000, of which $7,500 is attributable to a foreign expropriation
loss. With respect to such $7,500, A makes the election described in
paragraph (a) of this section. In each of the years 1961, 1962, 1963,
1964, and 1965, A has taxable income in the amount of $600 (computed
without any net operating loss deduction). The assumption is made that
none of the other modifications prescribed in Sec. 1.172-5 apply. The
portion of the net operating loss attributable to the foreign
expropriation loss which is a carryover to the year 1966 is $7,000,
which is the sum of $7,500 (the portion of the net operating loss
attributable to the foreign expropriation loss) and $2,500 (the other
portion of the net operating loss available as a carryover to 1961),
minus $3,000 (the aggregate of the taxable incomes for taxable years
1961 through 1965).
Example 2. Assume the same facts as in Example 1 except that taxable
income for each of the years 1961 through 1965 is $400 (computed without
any net operating loss deduction). The carryover to the year 1966 is
$7,500, that is, the sum of $7,500 (the portion of the net operating
loss attributable to the foreign expropriation loss) and $2,500 (the
other portion of the net operating loss available as a carryover to
1961), minus $2,000 (the aggregate of the taxable incomes for taxable
years 1961 through 1965), but limited to $7,500 (the portion of the net
operating loss attributable to the foreign expropriation loss).
(e) Taxable income which is subtracted from net operating loss to
determine carryback or carryover. In computing taxable income for a
taxable year (hereinafter called a ``prior taxable year'') for the
purpose of determining the portion of a net operating loss for another
taxable year which shall be carried to each of the several taxable years
subsequent to the earliest taxable year to which such loss may be
carried, the net operating loss deduction for any such prior taxable
year shall be determined without regard to that portion, if any, of a
net operating loss for a taxable year attributable to a foreign
expropriation loss, if such portion may not, under the provisions of
section 172(b)(1)(D) and paragraph (a)(1)(iv) of Sec. 1.172-4, be
carried back to such prior taxable year. Thus, if the taxpayer has a
foreign expropriation loss for 1962 and elects the 10-year carryover
with respect to the portion of his net operating loss for 1962
attributable to the foreign expropriation loss, then in computing
taxable income for the year 1960 for the purpose of determining the
portion of a net operating loss for 1963 which is carried to
[[Page 168]]
years subsequent to 1960, the net operating loss deduction for 1960 is
determined without regard to the portion of the net operating loss for
1962 attributable to the foreign expropriation loss, since under the
provisions of section 172(b)(1)(D) and paragraph (a)(1)(iv) of Sec.
1.172-4 such portion of the net operating loss for 1962 may not be
carried back to 1960.
[T.D. 6862, 30 FR 14431, Nov. 18, 1965, as amended by T.D. 8107, 51 FR
43346, Dec. 2, 1986]
Sec. 1.172-10 Net operating losses of real estate investment trusts.
(a) Taxable years to which a loss may be carried. (1) A net
operating loss sustained by a qualified real estate investment trust (as
defined in paragraph (b)(1) of this section) in a qualified taxable year
(as defined in paragraph (b)(2) of this section) ending after October 4,
1976, shall not be carried back to a preceding taxable year.
(2) A net operating loss sustained by a qualified real estate
investment trust in a qualified taxable year ending before October 5,
1976, shall be carried back to the 3 preceding taxable years. However,
see Sec. 1.857-2(a)(5), which does not allow the net operating loss
deduction in computing real estate investment trust taxable income for
taxable years ending before October 5, 1976.
(3) A net operating loss sustained by a qualified real estate
investment trust in a qualified taxable year ending after December 31,
1972, shall be carried over to the 15 succeeding taxable years. However,
see Sec. 1.857-2(a)(5).
(4) A net operating loss sustained by a qualified real estate
investment trust in a qualified taxable year ending before January 1,
1973, shall be carried over to 8 succeeding taxable years. However, see
Sec. 1.857-2(a)(5).
(5) A net operating loss sustained in a taxable year for which the
taxpayer is not a qualified real estate investment trust generally may
be carried back to the 3 preceding taxable years; however, a net
operating loss sustained in a taxable year ending after December 31,
1975, shall not be carried back to any qualified taxable year. However,
see Sec. 1.857-2(a)(5), with respect to a net operating loss sustained
in a taxable year ending before January 1, 1976.
(6) A net operating loss sustained in a taxable year ending after
December 31, 1975, for which the taxpayer is not a qualified real estate
investment trust generally may be carried over to the 15 succeeding
taxable years.
(7)(i) A net operating loss sustained in a taxable year ending
before January 1, 1986, for which the taxpayer is not a qualified real
estate investment trust generally may be a net operating loss carryover
to each of the 5 succeeding taxable years. However, where the loss was a
net operating loss carryback to one or more qualified taxable years, the
net operating loss, in accordance with paragraph (a)(7)(ii) of this
section shall be--
(A) Carried over to the 15 succeeding taxable years if the loss
could be a net operating loss carryover to a taxable year ending in
1981, or
(B) Carried over to the 5, 6, 7, or 8 succeeding taxable years if
paragraph (a)(7)(i)(A) of this section does not apply.
(ii) For purposes of determining whether a net operating loss could
be a carryover to a taxable year ending in 1981 under paragraph
(a)(7)(i)(A) of this section or, where paragraph (a)(7)(i)(A) of this
section does not apply, to determine the actual carryover period under
paragraph (a)(7)(i)(B) of this section, the net operating loss shall
have a carryover period of 5 years, and such period shall be increased
(to a number not greater than 8) by the number of qualified taxable
years to which such loss was a net operating loss carryback; however,
where the taxpayer acted so as to cause itself to cease to be a
qualified real estate investment trust and the principal purpose for
such action was to secure the benefit of the allowance of a net
operating loss carryover under section 172(b)(1)(B), the net operating
loss carryover period shall be limited to 5 years. However, see Sec.
1.857-2(a)(5).
(8) A qualified taxable year is a taxable year preceding or
following the taxable year of the net operating loss, for purposes of
section 172(b)(1), even though the loss may not be carried to, or
allowed as a deduction in, such qualified taxable year. Thus, a
qualified taxable year ending before October 5, 1976 (for which no net
operating loss
[[Page 169]]
deduction is allowable) is nevertheless a preceding or following taxable
year for purposes of section 172(b)(1). Moreover, a qualified taxable
year ending after October 4, 1976 (to which a net operating loss cannot
be carried back because of section 172(b)(1)(E)) is nevertheless a
preceding taxable year for purposes of section 172(b)(1). For purposes
of determining, under section 172(b)(2), the balance of the loss
available as a carryback or carryover to other taxable years, however,
the net operating loss is not reduced on account of such qualified
taxable year being a preceding or following taxable year.
(b) Definitions. For purposes of this section and Sec. Sec. 1.172-2
and 1.172-5:
(1) The term qualified real estate investment trust means, with
respect to any taxable year, a real estate investment trust within the
meaning of part II of subchapter M which is taxable for such year under
that part as a real estate investment trust, and
(2) The term qualified taxable year means a taxable year for which
the taxpayer is a qualified real estate investment trust.
(c) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. (i) Facts. X was a qualified real estate investment trust
for the taxable years ending on December 31, 1972, and December 31,
1973. X was not a qualified real estate investment trust for the taxable
years ending on December 31, 1971, and December 31, 1974. X sustained a
net operating loss for the taxable year ending on December 31, 1974.
(ii) Applicable carryback and carryover periods. The net operating
loss must be carried back to the 3 preceding taxable years. Under Sec.
1.857-2 (a)(5) the net operating loss deduction shall not be allowed in
computing real estate investment trust taxable income for the years
ending December 31, 1972, and December 31, 1973. Where a net operating
loss is sustained in a taxable year ending before January 1, 1976, for
which the taxpayer is not a qualified real estate investment trust and
the loss is a net operating loss carryback to one or more qualified
taxable years, the carryover period is determined under Sec. 1.172-10
(a)(7); the carryover period is determined by first applying the rule
provided in paragraph (a)(7)(ii) of this section to obtain the carryover
period for purposes of determining whether the net operating loss could
have been a net operating loss carryover to a taxable year ending in
1981. Under these facts, paragraph (a)(7)(ii) of this section provides
for a 7-year carryover period (5 years increased by the 2 qualified
taxable years to which the loss was a net operating loss carryback);
therefore, since the carryover period provided for by paragraph
(a)(7)(ii) of this section would allow the net operating loss to be a
net operating loss carryover to a taxable year ending in 1981, under
paragraph (a)(7)(ii)(A) of this section the applicable carryover period
is 15 years (provided that X did not act so as to cause itself to cease
to qualify as a real estate investment trust for the principal purpose
of securing the benefit of a net operating loss carryover under section
172 (b)(1)(B)).
Example 2. (i) Facts. The facts are the same as in example (1)
except that the taxable year ending December 31, 1973, was not a
qualified taxable year for X.
(ii) Applicable carryback and carryover periods. The net operating
loss must be carried back to the 3 preceding taxable years. Section
1.857-2 (a)(5) provides that the net operating loss deduction shall not
be allowed in computing real estate investment trust taxable income for
the year ending December 31, 1972. Under these facts the carryover
period is determined under Sec. 1.172-10 (a)(7). Paragraph (a)(7)(ii)
of this section provides for a 6 year carryover period (5 years
increased by the 1 qualified taxable year to which the loss was a net
operating loss carryback); therefore, since a 6 year carryover period
would not allow the net operating loss to be a net operating loss
carryover to a taxable year ending in 1981, paragraph (a)(7)(i)(A) of
this section does not apply. Where the rule stated in paragraph
(a)(7)(i)(A) of this section does not apply, paragraph (a)(7)(i)(B) of
this section provides that the applicable carryover period is the
carryover period determined under paragraph (a)(7)(ii) of this section,
which, in this case, is 6 years (provided that the principal purpose for
X acting so as to cause itself to cease to qualify as a real estate
investment trust was not to secure the benefit of the allowance of a net
operating loss carryover under section 172 (b)(1)(B)).
(d) Cross references. See Sec. Sec. 1.172-2(c) and 1.172-5(a)(5)
for the computation of the net operating loss of a qualified real estate
investment trust for a taxable year ending after October 4, 1976, and
the amount of a net operating loss which is absorbed when carried over
to a qualified taxable year ending after October 4, 1976. See Sec.
1.857-2(a)(5), which provides that for a taxable year ending before
October 5, 1976, the net operating loss deduction is not allowed in
computing the real estate investment
[[Page 170]]
trust taxable income of a qualified real estate investment trust.
[T.D. 7767, 46 FR 11263, Feb. 6, 1981, as amended by T.D. 8107, 51 FR
43346, Dec. 2, 1986]
Sec. 1.172-13 Product liability losses.
(a) Entitlement to 10-year carryback--(1) In general. Unless an
election is made pursuant to paragraph (c) of this section, in the case
of a taxpayer which has a product liability loss (as defined in section
172(j) and paragraph (b)(1) of this section) for a taxable year
beginning after September 30, 1979 (hereinafter ``loss year''), the
product liability loss shall be a net operating loss carryback to each
of the 10 taxable years preceding the loss year.
(2) Years to which loss may be carried. A product liability loss
shall first be carried to the earliest of the taxable years to which
such loss is allowable as a carryback and shall then be carried to the
next earliest of such taxable years, etc.
(3) Example. The application of this paragraph may be illustrated as
follows:
Example. Taxpayer A incurs a net operating loss for taxable year
1980 of $80,000, of which $60,000 is a product liability loss. A's
taxable income for each of the 10 years immediately preceding taxable
year 1980 was $5,000. The product liability loss of $60,000 is first
carried back to the 10th through the 4th preceding taxable years ($5,000
per year), thus offsetting $35,000 of the loss. The remaining $25,000 of
product liability loss is added to the remaining portion of the total
net operating loss for taxable year 1980 which was not a product
liability loss ($20,000), and the total is then carried back to the 3rd
through 1st years preceding taxable year 1980, which offsets $15,000 of
this loss. The remaining loss ($30,000) is carried forward pursuant to
section 172(b)(1) and the regulations thereunder without regard to
whether all or any portion thereof originated as a product liability
loss.
(b) Definitions--(1) Product liability loss. The term product
liability loss means, for any taxable year, the lesser of--
(i) The net operating loss for the current taxable year (not
including the portion of such net operating loss attributable to foreign
expropriation losses, as defined in Sec. 1.172-11), or
(ii) The total of the amounts allowable as deductions under sections
162 and 165 directly attributable to--
(A) Product liability (as defined in paragraph (b)(2) of this
section), and
(B) Expenses (including settlement payments) incurred in connection
with the investigation or settlement of or opposition to claims against
the taxpayer on account of alleged product liability.
Indirect corporate expense, or overhead, is not to be allocated to
product liability claims so as to become a product liability loss.
(2) Product liability. (i) The term product liability means the
liability of a taxpayer for damages resulting from physical injury or
emotional harm to individuals, or damage to or loss of the use of
property, on account of any defect in any product which is manufactured,
leased, or sold by the taxpayer. The preceding sentence applies only to
the extent that the injury, harm, or damage occurs after the taxpayer
has completed or terminated operations with respect to the product,
including, but not limited to the manufacture, installation, delivery,
or testing of the product, and has relinquished possession of such
product.
(ii) The term product liability does not include liabilities arising
under warranty theories relating to repair or replacement of the
property that are essentially contract liabilities. For example, the
costs incurred by a taxpayer in repairing or replacing defective
products under the terms of a warranty, express or implied, are not
product liability losses. On the other hand, the taxpayer's liability
for damage done to other property or for harm done to persons that is
attributable to a defective product may be product liability losses
regardless of whether the claim sounds in tort or contract. Further,
liability incurred as a result of services performed by a taxpayer is
not product liability. For purposes of the preceding sentence, where
both a product and services are integral parts of a transaction, product
liability does not arise until all operations with respect to the
product are completed and the taxpayer has relinquished possession of
it. On the other hand, any liability
[[Page 171]]
that arises after completion of the initial delivery, installation,
servicing, testing, etc., is considered ``product liability'' even if
such liability arises during the subsequent servicing of the product
pursuant to a service agreement or otherwise.
(iii) Liability for injury, harm, or damage due to a defective
product as described in this subparagraph shall be ``product liability''
notwithstanding that the liability is not considered product liability
under the law of the State in which such liability arose.
(iv) Amounts paid for insurance against product liability risks are
not paid on account of product liability.
(v) Notwithstanding subparagraph (iv), an amount is paid on account
of product liability (even if such amount is paid to an insurance
company) if the amount satisifies the provisions of paragraph (b)(2) (i)
through (iii) of this section and the amount--
(A) Is paid on account of specific claims against the taxpayer (or
on account of expenses incurred in connection with the investigation or
settlement of or opposition to such claims), subsequent to the events
giving rise to the claims and pursuant to a contract entered into before
those events,
(B) Is not refundable, and
(C) Is not applicable to other claims, other expenses or to
subsequent coverage.
(3) Examples. Paragraph (b)(2) of this section is illustrated by the
following examples:
Example 1. X, a manufacturer of heating equipment, sells a boiler to
A, a homeowner. Subsequent to the sale and installation of the boiler,
the boiler explodes due to a defect causing physical injury to A. A sues
X for damages for the injuries sustained in the explosion and is awarded
$250,000, which X pays. The payment was made on account of product
liability.
Example 2. Assume the same facts as in Example 1 and that A also
sues under the contract with X to recover for the cost of the boiler and
recovers $1,000, the boiler's replacement cost. The $1,000 payment is
not a payment on account of product liability. Similarly, if X agrees to
repair the destroyed boiler, any amount expended by X for such repair is
not payment made on account of product liability.
Example 3. Y, a professional medical association, is sued by B, a
patient, in an action based on the malpractice of one of its doctors. B
recovers $25,000. Because the suit was based on the services of B, the
payment is not made on account of product liability.
Example 4. R, a retailer of communications equipment, sells a
telecommunication device to C. R also contracts with C to service the
equipment for 3 years. While R is installing the equipment, the unit
catches on fire due to faulty wiring within the unit and destroys C's
office. Because R had not relinquished possession of this equipment when
the fire started, any amount paid to C by R for the damage to C's
property on account of the defective product is not payment on account
of product liability.
Example 5. Assume the same facts as in Example 4 except that the
fire and resulting property damages occurred after R had installed the
equipment and relinquished possession of it. Any amount paid for the
property damages sustained on account of the defective product is
payment on account of product liability.
Example 6. Assume the same facts as in Example 4 except that the
equipment catches on fire during the subsequent servicing of the unit.
Because C is in possession of the unit during the servicing, any amount
paid for the property damage sustained on account of the defective
product would be payment on account of product liability.
Example 7. X, a manufacturer of computers, sells a computer to A. X
also has its employees periodically service the computer for A from time
to time after it is placed in service. After the initial delivery,
installation, servicing, and testing of the computer is completed, the
computer catches on fire while X's employee is servicing the equipment.
This fire causes property damage to A's office and physical injury to A.
Any amount paid for the property or physical damage sustained on account
of the defective product is payment on account of product liability.
(c) Election--(1) In general. The 10-year carryback provision of
this section applies, except as provided in this paragraph, to any
taxpayer who, for a taxable year beginning after September 30, 1979,
incurs a product liability loss. Any taxpayer entitled to a 10-year
carryback under paragraph (a) of this section in any loss year may elect
(at the time and in the manner provided in paragraph (c)(2) of this
section) to have the carryback period with respect to the product
liability loss determined without regard to the carryback rules provided
by paragraph (a) of this section. If the taxpayer so elects, the product
liability loss shall not be carried back to the 10th through the 4th
taxable years preceding the loss
[[Page 172]]
year. In such case, the product liability loss shall be carried back or
carried over as provided by section 172(b) (except subparagraph (1)(I)
thereof) and the regulations thereunder.
(2) Time and manner of making election. An election by any taxpayer
entitled to the 10-year carryback for the product liability loss to have
the carryback with respect to such loss determined without regard to the
10-year carryback provision of paragraph (a) of this section must be
made by attaching to the taxpayer's tax return (filed within the time
prescribed by law, including extensions of time) for the taxable year in
which such product liability loss is sustained, a statement containing
the information required by paragraph (c)(3) of this section. Such
election, once made for any taxable year, shall be irrevocable after the
due date (including extensions of time) of the taxpayer's tax return for
that taxable year.
(3) Information required. In the case of a statement filed after
April 25, 1983, the statement referred to in paragraph (c)(2) of this
section shall contain the following information:
(i) The name, address, and taxpayer identifying number of the
taxpayer; and
(ii) A statement that the taxpayer elects under section 172(j)(3)
not to have section 172(b)(1)(I) apply.
(4) Relationship with section 172(b)(3)(C) election. If a taxpayer
sustains during the taxable year both a net operating loss not
attributable to product liability and a product liability loss (as
defined in section 172(j)(1) and paragraph (b)(1) of this section), an
election pursuant to section 172(b)(3)(C) (relating to election to
relinquish the entire carryback period) does not preclude the product
liability loss from being carried back 10 years under section
172(b)(1)(I) and paragraph (a)(1) of this section.
[T.D. 8096, 51 FR 30482, Aug. 27, 1986]
Sec. 1.173-1 Circulation expenditures.
(a) Allowance of deduction. Section 173 provides for the deduction
from gross income of all expenditures to establish, maintain, or
increase the circulation of a newspaper, magazine, or other periodical,
subject to the following limitations:
(1) No deduction shall be allowed for expenditures for the purchase
of land or depreciable property or for the acquisition of circulation
through the purchase of any part of the business of another publisher of
a newspaper, magazine, or other periodical;
(2) The deduction shall be allowed only to the publisher making the
circulation expenditures; and
(3) The deduction shall be allowed only for the taxable year in
which such expenditures are paid or incurred.
Subject to the provisions of paragraph (c) of this section, the
deduction permitted under section 173 and this paragraph shall be
allowed without regard to the method of accounting used by the taxpayer
and notwithstanding the provisions of section 263 and the regulations
thereunder, relating to capital expenditures.
(b) Deferred expenditures. Notwithstanding the provisions of
paragraph (a)(3) of this section, expenditures paid or incurred in a
taxable year subject to the Internal Revenue Code of 1939 which are
deferrable pursuant to I.T. 3369 (C.B. 1940-1, 46), as modified by Rev.
Rul. 57-87 (C.B. 1957-1, 507) may be deducted in the taxable year
subject to the Internal Revenue Code of 1954 to which so deferred.
(c) Election to capitalize. (1) A taxpayer entitled to the deduction
for circulation expenditures provided in section 173 and paragraph (a)
of this section may, in lieu of taking such deduction, elect to
capitalize the portion of such circulation expenditures which is
properly chargeable to capital account. As a general rule, expenditures
normally made from year to year in an effort to maintain circulation are
not properly chargeable to capital account; conversely, expenditures
made in an effort to establish or to increase circulation are properly
chargeable to capital account. For example, if a newspaper normally
employs five persons to obtain renewals of subscriptions by telephone,
the expenditures in connection therewith would not be properly
chargeable to capital account. However, if such newspaper, in a special
effort to increase its circulation, hires
[[Page 173]]
for a limited period 20 additional employees to obtain new subscriptions
by means of telephone calls to the general public, the expenditures in
connection therewith would be properly chargeable to capital account. If
an election is made by a taxpayer to treat any portion of his
circulation expenditures as chargeable to capital account, the election
must apply to all such expenditures which are properly so chargeable. In
such case, no deduction shall be allowed under section 173 for any such
expenditures. In particular cases, the extent to which any deductions
attributable to the amortization of capital expenditures are allowed may
be determined under sections 162, 263, and 461.
(2) A taxpayer may make the election referred to in subparagraph (1)
of this paragraph by attaching a statement to his return for the first
taxable year to which the election is applicable. Once an election is
made, the taxpayer must continue in subsequent taxable years to charge
to capital account all circulation expenditures properly so chargeable,
unless the Commissioner, on application made to him in writing by the
taxpayer, permits a revocation of such election for any subsequent
taxable year or years. Permission to revoke such election may be granted
subject to such conditions as the Commissioner deems necessary.
(3) Elections filed under section 23(bb) of the Internal Revenue
Code of 1939 shall be given the same effect as if they were filed under
section 173. (See section 7807(b)(2).)
Sec. 1.174-1 Research and experimental expenditures; in general.
Section 174 provides two methods for treating research or
experimental expenditures paid or incurred by the taxpayer in connection
with his trade or business. These expenditures may be treated as
expenses not chargeable to capital account and deducted in the year in
which they are paid or incurred (see Sec. 1.174-3), or they may be
deferred and amortized (see Sec. 1.174-4). Research or experimental
expenditures which are neither treated as expenses nor deferred and
amortized under section 174 must be charged to capital account. The
expenditures to which section 174 applies may relate either to a general
research program or to a particular project. See Sec. 1.174-2 for the
definition of research and experimental expenditures. The term paid or
incurred, as used in section 174 and in Sec. Sec. 1.174-1 to 1.174-4,
inclusive, is to be construed according to the method of accounting used
by the taxpayer in computing taxable income. See section 7701(a)(25).
Sec. 1.174-2 Definition of research and experimental expenditures.
(a) In general. (1) Research or experimental expenditures defined.
The term research or experimental expenditures, as used in section 174,
means expenditures incurred in connection with the taxpayer's trade or
business which represent research and development costs in the
experimental or laboratory sense. The term generally includes all such
costs incident to the development or improvement of a product. The term
includes the costs of obtaining a patent, such as attorneys' fees
expended in making and perfecting a patent application. Expenditures
represent research and development costs in the experimental or
laboratory sense if they are for activities intended to discover
information that would eliminate uncertainty concerning the development
or improvement of a product. Uncertainty exists if the information
available to the taxpayer does not establish the capability or method
for developing or improving the product or the appropriate design of the
product. Whether expenditures qualify as research or experimental
expenditures depends on the nature of the activity to which the
expenditures relate, not the nature of the product or improvement being
developed or the level of technological advancement the product or
improvement represents. The ultimate success, failure, sale, or use of
the product is not relevant to a determination of eligibility under
section 174. Costs may be eligible under section 174 if paid or incurred
after production begins but before uncertainty concerning the
development or improvement of the product is eliminated.
(2) Production costs. Except as provided in paragraph (a)(5) of this
section (the rule concerning the application of
[[Page 174]]
section 174 to components of a product), costs paid or incurred in the
production of a product after the elimination of uncertainty concerning
the development or improvement of the product are not eligible under
section 174.
(3) Product defined. For purposes of this section, the term product
includes any pilot model, process, formula, invention, technique,
patent, or similar property, and includes products to be used by the
taxpayer in its trade or business as well as products to be held for
sale, lease, or license.
(4) Pilot model defined. For purposes of this section, the term
pilot model means any representation or model of a product that is
produced to evaluate and resolve uncertainty concerning the product
during the development or improvement of the product. The term includes
a fully-functional representation or model of the product or, to the
extent paragraph (a)(5) of this section applies, a component of the
product.
(5) Application of section 174 to components of a product. If the
requirements of paragraph (a)(1) of this section are not met at the
level of a product (as defined in paragraph (a)(3) of this section),
then whether expenditures represent research and development costs is
determined at the level of the component or subcomponent of the product.
The presence of uncertainty concerning the development or improvement of
certain components of a product does not necessarily indicate the
presence of uncertainty concerning the development or improvement of
other components of the product or the product as a whole. The rule in
this paragraph (a)(5) is not itself applied as a reason to exclude
research or experimental expenditures from section 174 eligibility.
(6) Research or experimental expenditures--exclusions. The term
research or experimental expenditures does not include expenditures
for--
(i) The ordinary testing or inspection of materials or products for
quality control (quality control testing);
(ii) Efficiency surveys;
(iii) Management studies;
(iv) Consumer surveys;
(v) Advertising or promotions;
(vi) The acquisition of another's patent, model, production or
process; or
(vii) Research in connection with literary, historical, or similar
projects.
(7) Quality control testing. For purposes of paragraph (a)(6)(i) of
this section, testing or inspection to determine whether particular
units of materials or products conform to specified parameters is
quality control testing. However, quality control testing does not
include testing to determine if the design of the product is
appropriate.
(8) Expenditures for literary, historical, or similar research--
cross reference. See section 263A and the regulations thereunder for
cost capitalization rules which apply to expenditures paid or incurred
for research in connection with literary, historical, or similar
projects involving the production of property, including the production
of films, sound recordings, video tapes, books, or similar properties.
(9) Research or experimental expenditures limited to reasonable
amounts. Section 174 applies to a research or experimental expenditure
only to the extent that the amount of the expenditure is reasonable
under the circumstances. In general, the amount of an expenditure for
research or experimental activities is reasonable if the amount would
ordinarily be paid for like activities by like enterprises under like
circumstances. Amounts supposedly paid for research that are not
reasonable under the circumstances may be characterized as disguised
dividends, gifts, loans, or similar payments. The reasonableness
requirement of this paragraph (a)(9) does not apply to the
reasonableness of the type or nature of the activities themselves.
(10) Amounts paid to others for research or experimentation. The
provisions of this section apply not only to costs paid or incurred by
the taxpayer for research or experimentation undertaken directly by him
but also to expenditures paid or incurred for research or
experimentation carried on in his behalf by another person or
organization (such as a research institute, foundation, engineering
company, or similar contractor). However, any expenditures for research
or experimentation carried on in the taxpayer's behalf by another person
are not expenditures to which
[[Page 175]]
section 174 relates, to the extent that they represent expenditures for
the acquisition or improvement of land or depreciable property, used in
connection with the research or experimentation, to which the taxpayer
acquires rights of ownership.
(11) Examples. The following examples illustrate the application of
this paragraph (a).
Example 1. Amounts paid to others for research or experimentation
allowed as a deduction. A engages B to undertake research and
experimental work in order to create a particular product. B will be
paid annually a fixed sum plus an amount equivalent to his actual
expenditures. In 1957, A pays to B in respect of the project the sum of
$150,000 of which $25,000 represents an addition to B's laboratory and
the balance represents charges for research and experimentation on the
project. It is agreed between the parties that A will absorb the entire
cost of this addition to B's laboratory which will be retained by B. A
may treat the entire $150,000 as expenditures under section 174.
Example 2. Amounts paid to others not allowable as a deduction. S
Corporation, a manufacturer of explosives, contracts with the T research
organization to attempt through research and experimentation the
creation of a new process for making certain explosives. Because of the
danger involved in such an undertaking, T is compelled to acquire an
isolated tract of land on which to conduct the research and
experimentation. It is agreed that upon completion of the project T will
transfer this tract, including any improvements thereon, to S. Section
174 does not apply to the amount paid to T representing the costs of the
tract of land and improvements.
Example 3. Pilot model. U is engaged in the manufacture and sale of
custom machines. U contracts to design and produce a machine to meet a
customer's specifications. Because U has never designed a machine with
these specifications, U is uncertain regarding the appropriate design of
the machine, and particularly whether features desired by the customer
can be designed and integrated into a functional machine. U incurs a
total of $31,000 on the project. Of the $31,000, U incurs $10,000 of
costs on materials and labor to produce a model that is used to evaluate
and resolve the uncertainty concerning the appropriate design. U also
incurs $1,000 of costs using the model to test whether certain features
can be integrated into the design of the machine. This $11,000 of costs
represents research and development costs in the experimental or
laboratory sense. After uncertainty is eliminated, U incurs $20,000 to
produce the machine for sale to the customer based on the appropriate
design. The model produced and used to evaluate and resolve uncertainty
is a pilot model within the meaning of paragraph (a)(4) of this section.
Therefore, the $10,000 incurred to produce the model and the $1,000
incurred on design testing activities qualifies as research or
experimental expenditures under section 174. However, section 174 does
not apply to the $20,000 that U incurred to produce the machine for sale
to the customer based on the appropriate design. See paragraph (a)(2) of
this section (relating to production costs).
Example 4. Product component redesign. Assume the same facts as
Example 3, except that during a quality control test of the machine, a
component of the machine fails to function due to the component's
inappropriate design. U incurs an additional $8,000 (including design
retesting) to reconfigure the component's design. The $8,000 of costs
represents research and development costs in the experimental or
laboratory sense. After the elimination of uncertainty regarding the
appropriate design of the component, U incurs an additional $2,000 on
its production. The reconfigured component produced and used to evaluate
and resolve uncertainty with respect to the component is a pilot model
within the meaning of paragraph (a)(4) of this section. Therefore, in
addition to the $11,000 of research and experimental expenditures
previously incurred, the $8,000 incurred on design activities to
establish the appropriate design of the component qualifies as research
or experimental expenditures under section 174. However, section 174
does not apply to the additional $2,000 that U incurred for the
production after the elimination of uncertainty of the re-designed
component based on the appropriate design or to the $20,000 previously
incurred to produce the machine. See paragraph (a)(2) of this section
(relating to production costs).
Example 5. Multiple pilot models. V is a manufacturer that designs a
new product. V incurs $5,000 to produce a number of models of the
product that are to be used in testing the appropriate design before the
product is mass-produced for sale. The $5,000 of costs represents
research and development costs in the experimental or laboratory sense.
Multiple models are necessary to test the design in a variety of
different environments (exposure to extreme heat, exposure to extreme
cold, submersion, and vibration). In some cases, V uses more than one
model to test in a particular environment. Upon completion of several
years of testing, V enters into a contract to sell one of the models to
a customer and uses another model in its trade or business. The
remaining models were rendered inoperable as a result of the testing
process. Because V produced the models to resolve uncertainty regarding
the appropriate design of the product, the models are pilot models under
paragraph (a)(4) of this section. Therefore, the $5,000 that V incurred
[[Page 176]]
in producing the models qualifies as research or experimental
expenditures under section 174. See also paragraph (a)(1) of this
section (ultimate use is not relevant).
Example 6. Development of a new component; pilot model. W wants to
improve a machine for use in its trade or business and incurs $20,000 to
develop a new component for the machine. The $20,000 is incurred for
engineering labor and materials to produce a model of the new component
that is used to eliminate uncertainty regarding the development of the
new component for the machine. The $20,000 of costs represents research
and experimental costs in the experimental or laboratory sense. After W
completes its research and experimentation on the new component, W
incurs $10,000 for materials and labor to produce the component and
incorporate it into the machine. The model produced and used to evaluate
and resolve uncertainty with respect to the new component is a pilot
model within the meaning of paragraph (a)(4) of this section. Therefore,
the $20,000 incurred to produce the model and eliminate uncertainty
regarding the development of the new component qualifies as research or
experimental expenditures under section 174. However, section 174 does
not apply to the $10,000 of production costs of the component because
those costs were not incurred for research or experimentation. See
paragraph (a)(2) of this section (relating to production costs).
Example 7. Disposition of a pilot model. X is a manufacturer of
aircraft. X is researching and developing a new, experimental aircraft
that can take off and land vertically. To evaluate and resolve
uncertainty during the development or improvement of the product and
test the appropriate design of the experimental aircraft, X produces a
working aircraft at a cost of $5,000,000. The $5,000,000 of costs
represents research and development costs in the experimental or
laboratory sense. In a later year, X sells the aircraft. Because X
produced the aircraft to resolve uncertainty regarding the appropriate
design of the product during the development of the experimental
aircraft, the aircraft is a pilot model under paragraph (a)(4) of this
section. Therefore, the $5,000,000 of costs that X incurred in producing
the aircraft qualifies as research or experimental expenditures under
section 174. Further, it would not matter if X sold the pilot model or
incorporated it in its own business as a demonstration model. See
paragraph (a)(1) of this section (ultimate use is not relevant).
Example 8. Development of new component; pilot model. Y is a
manufacturer of aircraft engines. Y is researching and developing a new
type of compressor blade, a component of an aircraft engine, to improve
the performance of an existing aircraft engine design that Y already
manufactures and sells. To test the appropriate design of the new
compressor blade and evaluate the impact of fatigue on the compressor
blade design, Y produces and installs the compressor blade on an
aircraft engine held by Y in its inventory. The costs of producing and
installing the compressor blade component that Y incurred represent
research and development costs in the experimental or laboratory sense.
Because Y produced the compressor blade component to resolve uncertainty
regarding the appropriate design of the component, the component is a
pilot model under paragraph (a)(4) of this section. Therefore, the costs
that Y incurred to produce and install the component qualify as research
or experimental expenditures under section 174. See paragraph (a)(5) of
this section (regarding the application of section 174 to components of
a product). However, section 174 does not apply to Y's costs of
producing the aircraft engine on which the component was installed. See
paragraph (a)(2) of this section (relating to production costs).
Example 9. Variant product. T is a fuselage manufacturer for
commercial and military aircraft. T is modifying one of its existing
fuselage products, Class 20XX-1, to enable it to carry a larger
passenger and cargo load. T modifies the Class 20XX-1 design by
extending its length by 40 feet. T incurs $1,000,000 to develop and
evaluate different designs to resolve uncertainty with respect to the
appropriate design of the new fuselage class, Class 20XX-2. The
$1,000,000 of costs represents research and development costs in the
experimental or laboratory sense. Although Class 20XX-2, is a variant of
Class 20XX-1, Class 20XX-2 is a new product because the information
available to T as a result of T's development of Class 20XX-1 does not
resolve uncertainty with respect to T's development of Class 20XX-2.
Therefore, the $1,000,000 of costs that T incurred to develop and
evaluate the Class 20XX-2 qualifies as research or experimental
expenditures under section 174. Paragraph (a)(5) of this section does
not apply, as the requirements of paragraph (a)(1) of this section are
met with respect to the entire product.
Example 10. New process development. Z is a wine producer. Z is
researching and developing a new wine production process that involves
the use of a different method of crushing the wine grapes. In order to
test the effectiveness of the new method of crushing wine grapes, Z
incurs $2,000 in labor and materials to conduct the test on this part of
the new manufacturing process. The $2,000 of costs represents research
and development costs in the experimental or laboratory sense.
Therefore, the $2,000 incurred qualifies as research or experimental
expenditures under section 174 because it is a cost incident to the
development or improvement of a component of a process.
[[Page 177]]
(b) Certain expenditures with respect to land and other property.
(1)Land and other property. Expenditures by the taxpayer for the
acquisition or improvement of land, or for the acquisition or
improvement of property which is subject to an allowance for
depreciation under section 167 or depletion under section 611, are not
deductible under section 174, irrespective of the fact that the property
or improvements may be used by the taxpayer in connection with research
or experimentation. However, allow- ances for depreciation or depletion
of property are considered as research or experimental expenditures, for
purposes of section 174, to the extent that the property to which the
allowances relate is used in connection with research or
experimentation. If any part of the cost of acquisition or improvement
of depreciable property is attributable to research or experimentation
(whether made by the taxpayer or another), see subparagraphs (2), (3),
and (4) of this paragraph.
(2) Expenditure resulting in depreciable property. Expenditures for
research or experimentation which result, as an end product of the
research or experimentation, in depreciable property to be used in the
taxpayer's trade or business may, subject to the limitations of
subparagraph (4) of this paragraph, be allowable as a current expense
deduction under section 174(a). Such expenditures cannot be amortized
under section 174(b) except to the extent provided in paragraph (a)(4)
of Sec. 1.174-4.
(3) Amounts paid to others for research or experimentation resulting
in depreciable property. If expenditures for research or experimentation
are incurred in connection with the construction or manufacture of
depreciable property by another, they are deductible under section
174(a) only if made upon the taxpayer's order and at his risk. No
deduction will be allowed (i) if the taxpayer purchases another's
product under a performance guarantee (whether express, implied, or
imposed by local law) unless the guarantee is limited, to engineering
specifications or otherwise, in such a way that economic utility is not
taken into account; or (ii) for any part of the purchase price of a
product in regular production. For example, if a taxpayer orders a
specially-built automatic milling machine under a guarantee that the
machine will be capable of producing a given number of units per hour,
no portion of the expenditure is deductible since none of it is made at
the taxpayer's risk. Similarly, no deductible expense is incurred if a
taxpayer enters into a contract for the construction of a new type of
chemical processing plant under a turn-key contract guaranteeing a given
annual production and a given consumption of raw material and fuel per
unit. On the other hand, if the contract contained no guarantee of
quality of production and of quantity of units in relation to
consumption of raw material and fuel, and if real doubt existed as to
the capabilities of the process, expenses for research or
experimentation under the contract are at the taxpayer's risk and are
deductible under section 174(a). However, see subparagraph (4) of this
paragraph.
(4) Deductions limited to amounts expended for research or
experimentation. The deductions referred to in paragraphs (b)(2) and (3)
of this section for expenditures in connection with the acquisition or
production of depreciable property to be used in the taxpayer's trade or
business are limited to amounts expended for research or experimentation
within the meaning of section 174 and paragraph (a) of this section.
(5) Examples. The following examples illustrate the application of
paragraph (b) of this section.
Example 1. Amounts paid to others for research or experimentation
resulting in depreciable property. X is a tool manufacturer. X has
developed a new tool design, and orders a specially-built machine from Y
to produce X's new tool. The machine is built upon X's order and at X's
risk, and Y does not provide a guarantee of economic utility. There is
uncertainty regarding the appropriate design of the machine. Under X's
contract with Y, X pays $15,000 for Y's engineering and design labor,
$5,000 for materials and supplies used to develop the appropriate design
of the machine, and $10,000 for Y's machine production materials and
labor. The $15,000 of engineering and design labor costs and the $5,000
of materials and supplies costs represent research and development costs
in the experimental or laboratory sense. Therefore, the $15,000 X pays Y
for Y's engineering and design labor and the $5,000 for materials and
[[Page 178]]
supplies used to develop the appropriate design of the machine are for
research or experimentation under section 174. However, section 174 does
not apply to the $10,000 of production costs of the machine because
those costs were not incurred for research or experimentation. See
paragraph (a)(2) of this section (relating to production costs) and
paragraph (b)(4) of this section (limiting deduction to amounts expended
for research or experimentation).
Example 2. Expenditures with respect to other property. Z is an
aircraft manufacturer. Z incurs $5,000,000 to construct a new test bed
that will be used in the development and improvement of Z's aircraft. No
portion of Z's $5,000,000 of costs to construct the new test bed
represent research and development costs in the experimental or
laboratory sense to develop or improve the test bed. Because no portion
of the costs to construct the new test bed were incurred for research or
experimentation, the $5,000,000 will be considered an amount paid or
incurred in the production of depreciable property to be used in the
taxpayer's trade or business that are not allowable under section 174.
However, the allowances for depreciation of the test bed are considered
research and experimental expenditures of other products, for purposes
of section 174, to the extent the test bed is used in connection with
research or experimentation of other products. See paragraph (b)(1) of
this section (depreciation allowances may be considered research or
experimental expenditures).
Example 3. Expenditure resulting in depreciable property. Assume the
same facts as Example 2, except that $50,000 of the costs of the test
bed relates to costs to resolve uncertainties regarding the new test bed
design. The $50,000 of costs represents research and development costs
in the experimental or laboratory sense. Because $50,000 of Z's costs to
construct the new test bed was incurred for research and
experimentation, the costs qualify as research or experimental
expenditures under section 174. Paragraph (b)(2) of this section applies
to $50,000 of Z's costs for the test bed because they are expenditures
for research or experimentation that result in depreciable property to
be used in the taxpayer's trade or business. Z's remaining $4,950,000 of
costs is not allowable under section 174 because these costs were not
incurred for research or experimentation.
(c) Exploration expenditures. The provisions of section 174 are not
applicable to any expenditures paid or incurred for the purpose of
ascertaining the existence, location, extent, or quality of any deposit
of ore, oil, gas or other mineral. See sections 617 and 263.
(d) Effective/applicability date. The eighth and ninth sentences of
Sec. 1.174-2(a)(1); Sec. 1.174-2(a)(2); Sec. 1.174-2(a)(4); Sec.
1.174-2(a)(5); Sec. 1.174-2(a)(11) Example 3 through Example 10; Sec.
1.174-2(b)(4); and Sec. 1.174-2(b)(5) apply to taxable years ending on
or after July 21, 2014. Taxpayers may apply the provisions enumerated in
the preceding sentence to taxable years for which the limitations for
assessment of tax has not expired.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 8562, 59 FR
50160, Oct. 3, 1994; T.D. 9680, 79 FR 42195, July 21, 2014]
Sec. 1.174-3 Treatment as expenses.
(a) In general. Research or experimental expenditures paid or
incurred by a taxpayer during the taxable year in connection with his
trade or business are deductible as expenses, and are not chargeable to
capital account, if the taxpayer adopts the method provided in section
174(a). See paragraph (b) of this section. If adopted, the method shall
apply to all research and experimental expenditures paid or incurred in
the taxable year of adoption and all subsequent taxable years, unless a
different method is authorized by the Commissioner under section
174(a)(3) with respect to part or all of the expenditures. See paragraph
(b)(3) of this section. Thus, if a change to the deferred expense method
under section 174(b) is authorized by the Commissioner with respect to
research or experimental expenditures attributable to a particular
project or projects, the taxpayer, for the taxable year of the change
and for subsequent taxable years, must apply the deferred expense method
to all such expenditures paid or incurred during any of those taxable
years in connection with the particular project or projects, even though
all other research and experimental expenditures are required to be
deducted as current expenses under this section. In no event will the
taxpayer be permitted to adopt the method described in this section as
to part of the expenditures relative to a particular project and adopt
for the same taxable year a different method of treating the balance of
the expenditures relating to the same project.
(b) Adoption and change of method--(1) Adoption without consent. The
method described in this section may be adopted for any taxable year
beginning after
[[Page 179]]
December 31, 1953, and ending after August 16, 1954. The consent of the
Commissioner is not required if the taxpayer adopts the method for the
first such taxable year in which he pays or incurs research or
experimental expenditures. The taxpayer may do so by claiming in his
income tax return for such year a deduction for his research or
experimental expenditures. If the taxpayer fails to adopt the method for
the first taxable year in which he incurs such expenditures, he cannot
do so in subsequent taxable years unless he obtains the consent of the
Commissioner under section 174(a)(2)(B) and subparagraph (2) of this
paragraph. See, however, subparagraph (4) of this paragraph, relating to
extensions of time.
(2) Adoption with consent. A taxpayer may, with the consent of the
Commissioner, adopt at any time the method provided in section 174(a).
The method adopted in this manner shall be applicable only to
expenditures paid or incurred during the taxable year for which the
request is made and in subsequent taxable years. A request to adopt this
method shall be in writing and shall be addressed to the Commissioner of
Internal Revenue, Attention: T:R, Washington, DC, 20224. The request
shall set forth the name and address of the taxpayer, the first taxable
year for which the adoption of the method is requested, and a
description of the project or projects with respect to which research or
experimental expenditures are to be, or have already been, paid or
incurred. The request shall be signed by the taxpayer (or his duly
authorized representative) and shall be filed not later than the last
day of the first taxable year for which the adoption of the method is
requested. See, however, subparagraph (4) of this paragraph, relating to
extensions of time.
(3) Change of method. An application for permission to change to a
different method of treating research or experimental expenditures shall
be in writing and shall be addressed to the Commissioner of Internal
Revenue, Attention: T:R, Washington, DC, 20224. The application shall
include the name and address of the taxpayer, shall be signed by the
taxpayer (or his duly authorized representative), and shall be filed not
later than the last day of the first taxable year for which the change
in method is to apply. See, however, subparagraph (4) of this paragraph,
relating to extensions of time. The application shall:
(i) State the first year to which the requested change is to be
applicable;
(ii) State whether the change is to apply to all research or
experimental expenditures paid or incurred by the taxpayer, or only to
expenditures attributable to a particular project or projects;
(iii) Include such information as will identify the project or
projects to which the change is applicable;
(iv) Indicate the number of months (not less than 60) selected for
amortization of the expenditures, if any, which are to be treated as
deferred expenses under section 174(b);
(v) State that, upon approval of the application, the taxpayer will
make an accounting segregation on his books and records of the research
or experimental expenditures to which the change in method is to apply;
and
(vi) State the reasons for the change.
If permission is granted to make the change, the taxpayer shall attach a
copy of the letter granting permission to his income tax return for the
first taxable year in which the different method is effective.
(4) Special rules. If the last day prescribed by law for filing a
return for any taxable year (including extensions thereof) to which
section 174(a) is applicable falls before January 2, 1958, consent is
hereby given for the taxpayer to adopt the expense method or to change
from the expense method to a different method. In the case of a change
from the expense method to a different method, the taxpayer, on or
before January 2, 1958, must submit to the district director for the
internal revenue district in which the return was filed the information
required by subparagraph (3) of this paragraph. For any taxable year for
which the expense method or a different method is adopted pursuant to
this subparagraph, an amended return reflecting such method shall be
filed on or before January 2, 1958, if such return is necessary.
[[Page 180]]
Sec. 1.174-4 Treatment as deferred expenses.
(a) In general. (1) If a taxpayer has not adopted the method
provided in section 174(a) of treating research or experimental
expenditures paid or incurred by him in connection with his trade or
business as currently deductible expenses, he may, for any taxable year
beginning after December 31, 1953, elect to treat such expenditures as
deferred expenses under section 174(b), subject to the limitations of
subparagraph (2) of this paragraph. If a taxpayer has adopted the method
of treating such expenditures as expenses under section 174(a), he may
not elect to defer and amortize any such expenditures unless permission
to do so is granted under section 174(a)(3). See paragraph (b) of this
section.
(2) The election to treat research or experimental expenditures as
deferred expenses under section 174(b) applies only to those
expenditures which are chargeable to capital account but which are not
chargeable to property of a character subject to an allowance for
depreciation or depletion under section 167 or 611, respectively. Thus,
the election under section 174(b) applies only if the property resulting
from the research or experimental expenditures has no determinable
useful life. If the property resulting from the expenditures has a
determinable useful life, section 174(b) is not applicable, and the
capitalized expenditures must be amortized or depreciated over the
determinable useful life. Amounts treated as deferred expenses are
properly chargeable to capital account for purposes of section
1016(a)(1), relating to adjustments to basis of property. See section
1016(a)(14). See section 174(c) and paragraph (b)(1) of Sec. 1.174-2
for treatment of expenditures for the acquisition or improvement of land
or of depreciable or depletable property to be used in connection with
the research or experimentation.
(3) Expenditures which are treated as deferred expenses under
section 174(b) are allowable as a deduction ratably over a period of not
less than 60 consecutive months beginning with the month in which the
taxpayer first realizes benefits from the expenditures. The length of
the period shall be selected by the taxpayer at the time he makes the
election to defer the expenditures. If a taxpayer has two or more
separate projects, he may select a different amortization period for
each project. In the absence of a showing to the contrary, the taxpayer
will be deemed to have begun to realize benefits from the deferred
expenditures in the month in which the taxpayer first puts the process,
formula, invention, or similar property to which the expenditures relate
to an income-producing use. See section 1016(a)(14) for adjustments to
basis of property for amounts allowed as deductions under section 174(b)
and this section. See section 165 and the regulations thereunder for
rules relating to the treatment of losses resulting from abandonment.
(4) If expenditures which the taxpayer has elected to defer and
deduct ratably over a period of time in accordance with section 174(b)
result in the development of depreciable property, deductions for the
unrecovered expenditures, beginning with the time the asset becomes
depreciable in character, shall be determined under section 167
(relating to depreciation) and the regulations thereunder. For example,
for the taxable year 1954, A, who reports his income on the basis of a
calendar year, elects to defer and deduct ratably over a period of 60
months research and experimental expenditures made in connection with a
particular project. In 1956, the total of the deferred expenditures
amounts to $60,000. At that time, A has developed a process which he
seeks to patent. On July 1, 1956, A first realized benefits from the
marketing of products resulting from this process. Therefore, the
expenditures deferred are deductible ratably over the 60-month period
beginning with July 1, 1956 (when A first realized benefits from the
project). In his return for the year 1956. A deducted $6,000; in 1957, A
deducted $12,000 ($1,000 per month). On July 1, 1958, a patent
protecting his process is obtained by A. In his return for 1958, A is
entitled to a deduction of $6,000, representing the amortizable portion
of the deferred expenses attributable to the period prior to July 1,
1958. The balance of the unrecovered expenditures ($60,000 minus
$24,000, or
[[Page 181]]
$36,000) is to be recovered as a depreciation deduction over the life of
the patent commencing with July 1, 1958. Thus, one-half of the annual
depreciation deduction based upon the useful life of the patent is also
deductible for 1958 (from July 1 to December 31).
(5) The election shall be applicable to all research and
experimental expenditures paid or incurred by the taxpayer or, if so
limited by the taxpayer's election, to all such expenditures with
respect to the particular project, subject to the limitations of
subparagraph (2) of this paragraph. The election shall apply for the
taxable year for which the election is made and for all subsequent
taxable years, unless a change to a different treatment is authorized by
the Commissioner under section 174(b)(2). See paragraph (b)(2) of this
section. Likewise, the taxpayer shall adhere to the amortization period
selected at the time of the election unless a different period of
amortization with respect to a part or all of the expenditures is
similarly authorized. However, no change in method will be permitted
with respect to expenditures paid or incurred before the taxable year to
which the change is to apply. In no event will the taxpayer be permitted
to treat part of the expenditures with respect to a particular project
as deferred expenses under section 174(b) and to adopt a different
method of treating the balance of the expenditures relating to the same
project for the same taxable year. The election under this section shall
not apply to any expenditures paid or incurred before the taxable year
for which the taxpayer makes the election.
(b) Election and change of method--(1) Election. The election under
section 174(b) shall be made not later than the time (including
extensions) prescribed by law for filing the return for the taxable year
for which the method is to be adopted. The election shall be made by
attaching a statement to the taxpayer's return for the first taxable
year to which the election is applicable. The statement shall be signed
by the taxpayer (or his duly authorized representative), and shall:
(i) Set forth the name and address of the taxpayer;
(ii) Designate the first taxable year to which the election is to
apply;
(iii) State whether the election is intended to apply to all
expenditures within the permissible scope of the election, or only to a
particular project or projects, and, if the latter, include such
information as will identify the project or projects as to which the
election is to apply;
(iv) Set forth the amount of all research or experimental
expenditures paid or incurred during the taxable year for which the
election is made;
(v) Indicate the number of months (not less than 60) selected for
amortization of the deferred expenses for each project; and
(vi) State that the taxpayer will make an accounting segregation in
his books and records of the expenditures to which the election relates.
(2) Change to a different method or period. Application for
permission to change to a different method of treating research or
experimental expenditures or to a different period of amortization for
deferred expenses shall be in writing and shall be addressed to the
Commissioner of Internal Revenue, Attention: T:R, Washington, DC, 20224.
The application shall include the name and address of the taxpayer,
shall be signed by the taxpayer (or his duly authorized representative),
and shall be filed not later than the end of the first taxable year in
which the different method or different amortization period is to be
used (unless subparagraph (3) of this paragraph, relating to extensions
of time, is applicable). The application shall set forth the following
information with regard to the research or experimental expenditures
which are being treated under section 174(b) as deferred expenses:
(i) Total amount of research or experimental expenditures
attributable to each project;
(ii) Amortization period applicable to each project; and
(iii) Unamortized expenditures attributable to each project at the
beginning of the taxable year in which the application is filed.
In addition, the application shall set forth the length of the new
period or periods proposed, or the new method of treatment proposed, the
reasons for the
[[Page 182]]
proposed change, and such information as will identify the project or
projects to which the expenditures affected by the change relate. If
permission is granted to make the change, the taxpayer shall attach a
copy of the letter granting the permission to his income tax return for
the first taxable year in which the different method or period is to be
effective.
(3) Special rules. If the last day prescribed by law for filing a
return for any taxable year for which the deferred method provided in
section 174(b) has been adopted falls before January 2, 1958, consent is
hereby given for the taxpayer to change from such method and adopt a
different method of treating research or experimental expenditures,
provided that on or before January 2, 1958, he submits to the district
director for the district in which the return was filed the information
required by subparagraph (2) of this paragraph, relating to a change to
a different method or period. For any taxable year for which the
different method is adopted pursuant to this subparagraph, an amended
return reflecting such method shall be filed on or before January 2,
1958.
(c) Example. The application of this section is illustrated by the
following example:
Example. N Corporation is engaged in the business of manufacturing
chemical products. On January 1, 1955, work is begun on a special
research project. N Corporation elects, pursuant to section 174(b), to
defer the expenditures relating to the special project and to amortize
the expenditures over a period of 72 months beginning with the month in
which benefits from the expenditures are first realized. On January 1,
1955, N Corporation also purchased for $57,600 a building having a
remaining useful life of 12 years as of the date of purchase and no
salvage value at the end of the period. Fifty percent of the building's
facilities are to be used in connection with the special research
project. During 1955, N Corporation pays or incurs the following
expenditures relating to the special research project:
Salaries..................................................... $15,000
Heat, light and power........................................ 700
Drawings..................................................... 2,000
Models....................................................... 6,500
Laboratory materials......................................... 8,000
Attorneys' fees.............................................. 1,400
Depreciation on building attributable to project (50 percent 2,400
of $4,800 allowable depreciation)...........................
----------
Total research and development expenditures.............. 36,000
The above expenditures result in a process which is marketable but not
patentable and which has no determinable useful life. N Corporation
first realizes benefits from the process in January 1956. N Corporation
is entitled to deduct the amount of $6,000 ($36,000 x 12 months / 72
months) as deferred expenses under section 174(b) in computing taxable
income for 1956.
Sec. 1.175-1 Soil and water conservation expenditures; in general.
Under section 175, a farmer may deduct his soil or water
conservation expenditures which do not give rise to a deduction for
depreciation and which are not otherwise deductible. The amount of the
deduction is limited annually to 25 percent of the taxpayer's gross
income from farming. Any excess may be carried over and deducted in
succeeding taxable years. As a general rule, once a farmer has adopted
this method of treating soil and water conservation expenditures, he
must deduct all such expenditures (subject to the 25-percent limitation)
for the current and subsequent taxable years. If a farmer does not adopt
this method, such expenditures increase the basis of the property to
which they relate.
Sec. 1.175-2 Definition of soil and water conservation expenditures.
(a) Expenditures treated as a deduction. (1) The method described in
section 175 applies to expenditures paid or incurred for the purpose of
soil or water conservation in respect of land used in farming, or for
the prevention of erosion of land used in farming, but only if such
expenditures are made in the furtherance of the business of farming.
More specifically, a farmer may deduct expenditures made for these
purposes which are for (i) the treatment or moving of earth, (ii) the
construction, control, and protection of diversion channels, drainage
ditches, irrigation ditches, earthen dams, watercourses, outlets, and
ponds, (iii) the eradication of brush, and (iv) the planting of
windbreaks. Expenditures for the treatment or moving of earth include
but are not limited to expenditures for leveling, conditioning, grading,
terracing, contour furrowing, and restoration of soil fertility. For
rules relating to the
[[Page 183]]
allocation of expenditures that benefit both land used in farming and
other land of the taxpayer, see Sec. 1.175-7.
(2) The following are examples of soil and water conservation: (i)
Constructing terraces, or the like, to detain or control the flow of
water, to check soil erosion on sloping land, to intercept runoff, and
to divert excess water to protected outlets; (ii) constructing water
detention or sediment retention dams to prevent or fill gullies, to
retard or reduce run-off of water, or to collect stock water; and (iii)
constructing earthen floodways, levies, or dikes, to prevent flood
damage to farmland.
(b) Expenditures not subject to section 175 treatment. (1) The
method described in section 175 applies only to expenditures for
nondepreciable items. Accordingly, a taxpayer may not deduct
expenditures for the purchase, construction, installation, or
improvement of structures, appliances, or facilities subject to the
allowance for depreciation. Thus, the method does not apply to
depreciable nonearthen items such as those made of masonry or concrete
(see section 167). For example, expenditures in respect of depreciable
property include those for materials, supplies, wages, fuel, hauling,
and dirt moving for making structures such as tanks, reservoirs, pipes,
conduits, canals, dams, wells, or pumps composed of masonry, concrete,
tile, metal, or wood. However, the method applies to expenditures for
earthen items which are not subject to a depreciation allowance. For
example, expenditures for earthen terraces and dams which are
nondepreciable are deductible under section 175. For taxable years
beginning after December 31, 1959, in the case of expenditures paid or
incurred by farmers for fertilizer, lime, etc., for purposes other than
soil or water conservation, see section 180 and the regulations
thereunder.
(2) The method does not apply to expenses deductible apart from
section 175. Adoption of the method is not necessary in order to deduct
such expenses in full without limitation. Thus, the method does not
apply to interest (deductible under section 163), nor to taxes
(deductible under section 164). It does not apply to expenses for the
repair of completed soil or water conservation structures, such as costs
of annual removal of sediment from a drainage ditch. It does not apply
to expenditures paid or incurred primarily to produce an agricultural
crop even though they incidentally conserve soil. Thus, the cost of
fertilizing (the effectiveness of which does not last beyond one year)
used to produce hay is deductible without adoption of the method
prescribed in section 175. For taxable years beginning after December
31, 1959, in the case of expenditures paid or incurred by farmers for
fertilizer, lime, etc., for purposes other than soil or water
conservation, see section 180 and the regulations thereunder. However,
the method would apply to expenses incurred to produce vegetation
primarily to conserve soil or water or to prevent erosion. Thus, for
example, the method would apply to such expenditures as the cost of dirt
moving, lime, fertilizer, seed and planting stock used in gulley
stabilization, or in stabilizing severely eroded areas, in order to
obtain a soil binding stand of vegetation on raw or infertile land.
(c) Assessments. The method applies also to that part of assessments
levied by a soil or water conservation or drainage district to reimburse
it for its expenditures which, if actually paid or incurred during the
taxable year by the taxpayer directly, would be deductible under section
175. Depending upon the farmer's method of accounting, the time when the
farmer pays or incurs the assessment, and not the time when the
expenditures are paid or incurred by the district, controls the time the
deduction must be taken. The provisions of this paragraph may be
illustrated by the following example:
Example. In 1955 a soil and water conservation district levies an
assessment of $700 upon a farmer on the cash method of accounting. The
assessment is to reimburse the district for its expenditures in 1954.
The farmer's share of such expenditures is as follows: $400 for digging
drainage ditches for soil conservation and $300 for assets subject to
the allowance for depreciation. If the farmer pays the assessment in
1955 and has adopted the method of treating expenditures for soil or
water conservation as current expenses under section 175, he may deduct
in 1955 the $400 attributable to the digging of
[[Page 184]]
drainage ditches as a soil conservation expenditure subject to the 25-
percent limitation.
(74 Stat. 1001; 26 U.S.C. 180)
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6548, 26 FR
1487, Feb. 22, 1961; T.D. 7740, 45 FR 78634, Nov. 26, 1980]
Sec. 1.175-3 Definition of ``the business of farming.''
The method described in section 175 is available only to a taxpayer
engaged in ``the business of farming''. A taxpayer is engaged in the
business of farming if he cultivates, operates, or manages a farm for
gain or profit, either as owner or tenant. For the purpose of section
175, a taxpayer who receives a rental (either in cash or in kind) which
is based upon farm production is engaged in the business of farming.
However, a taxpayer who receives a fixed rental (without reference to
production) is engaged in the business of farming only if he
participates to a material extent in the operation or management of the
farm. A taxpayer engaged in forestry or the growing of timber is not
thereby engaged in the business of farming. A person cultivating or
operating a farm for recreation or pleasure rather than a profit is not
engaged in the business of farming. For the purpose of this section, the
term farm is used in its ordinary, accepted sense and includes stock,
dairy, poultry, fish, fruit, and truck farms, and also plantations,
ranches, ranges, and orchards. A fish farm is an area where fish are
grown or raised, as opposed to merely caught or harvested; that is, an
area where they are artificially fed, protected, cared for, etc. A
taxpayer is engaged in ``the business of farming'' if he is a member of
a partnership engaged in the business of farming. See paragraphs
(a)(8)(i) and (c)(1)(iv) of Sec. 1.702-1.
[T.D. 6649, 28 FR 3762, Apr. 18, 1963]
Sec. 1.175-4 Definition of ``land used in farming.''
(a) Requirements. For purposes of section 175, the term land used in
farming means land which is used in the business of farming and which
meets both of the following requirements:
(1) The land must be used for the production of crops, fruits, or
other agricultural products, including fish, or for the sustenance of
livestock. The term livestock includes cattle, hogs, horses, mules,
donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys,
pigeons, and other poultry. Land used for the sustenance of livestock
includes land used for grazing such livestock.
(2) The land must be or have been so used either by the taxpayer or
his tenant at some time before or at the same time as, the taxpayer
makes the expenditures for soil or water conservation or for the
prevention of the erosion of land. The taxpayer will be considered to
have used the land in farming before making such expenditure if he or
his tenant has employed the land in a farming use in the past. If the
expenditures are made by the taxpayer in respect of land newly acquired
from one who immediately prior to the acquisition was using it in
farming, the taxpayer will be considered to be using the land in farming
at the time that such expenditures are made, if the use which is made by
the taxpayer of the land from the time of its acquisition by him is
substantially a continuation of its use in farming, whether for the same
farming use as that of the taxpayer's predecessor or for one of the
other uses specified in paragraph (a)(1) of this section.
(b) Examples. The provisions of paragraph (a) of this section may be
illustrated by the following examples:
Example 1. A purchases an operating farm from B in the autumn after
B has harvested his crops. Prior to spring plowing and planting when the
land is idle because of the season, A makes certain soil and water
conservation expenditures on this farm. At the time such expenditures
are made the land is considered to be used by A in farming, and A may
deduct such expenditures under section 175, subject to the other
requisite conditions of such section.
Example 2. C acquires uncultivated land, not previously used in
farming, which he intends to develop for farming. Prior to putting this
land into production it is necessary for C to clear brush, construct
earthen terraces and ponds, and make other soil and water conservation
expenditures. The land is not used in farming at the same time that such
expenditures are made. Therefore, C may not deduct such expenditures
under section 175.
[[Page 185]]
Example 3. D acquires several tracts of land from persons who had
used such land immediately prior to D's acquisition for grazing cattle.
D intends to use the land for growing grapes. In order to make the land
suitable for this use, D constructs earthen terraces, builds drainage
ditches and irrigation ditches, extensively treats the soil, and makes
other soil and water conservation expenditures. The land is considered
to be used in farming by D at the time he makes such expenditures, even
though it is being prepared for a different type of farming activity
than that engaged in by D's predecessors. Therefore, D may deduct such
expenditures under section 175, subject to the other requisite
conditions of such section.
(c) Cross reference. For rules relating to the allocation of
expenditures that benefit both land used in farming and other land of
the taxpayer, see Sec. 1.175-7.
[T.D. 7740, 45 FR 78634, Nov. 26, 1980]
Sec. 1.175-5 Percentage limitation and carryover.
(a) The limitation--(1) General rule. The amount of soil and water
conservation expenditures which the taxpayer may deduct under section
175 in any one taxable year is limited to 25 percent of his ``gross
income from farming''.
(2) Definition of ``gross income from farming.'' For the purpose of
section 175, the term gross income from farming means the gross income
of the taxpayer, derived in ``the business of farming'' as defined in
Sec. 1.175-3, from the production of crops, fruits, or other
agricultural products, including fish, or from livestock (including
livestock held for draft, breeding, or dairy purposes). It includes such
income from land used in farming other than that upon which expenditures
are made for soil or water conservation or for the prevention of erosion
of land. It does not include gains from sales of assets such as farm
machinery or gains from the disposition of land. A taxpayer shall
compute his ``gross income from farming'' in accordance with his
accounting method used in determining gross income. (See the regulations
under section 61 relating to accounting methods used by farmers in
determining gross income.) The provisions of this subparagraph may be
illustrated by the following example:
Example. A, who uses the cash receipts and disbursements method of
accounting, includes in his ``gross income from farming'' for purposes
of determining the 25-percent limitation the following items:
Proceeds from sale of his 1955 yield of corn................. $10,000
Gain from disposition of old breeding cows replaced by 500
younger cows................................................
----------
Total gross income from farming.......................... 10,500
A must exclude from ``gross income from farming'' the following
items which are included in his gross income:
Gain from sale of tractor.................................... $100
Gain from sale of 40 acres of taxpayer's farm................ 8,000
----------
Interest on loan to neighboring farmer....................... 100
(3) Deduction qualifies for net operating loss deduction. Any amount
allowed as a deduction under section 175, either for the year in which
the expenditure is paid or incurred or for the year to which it is
carried, is taken into account in computing a net operating loss for
such taxable year. If a deduction for soil or water conservation
expenditures has been taken into account in computing a net operating
loss carryback or carryover, it shall not be considered a soil or water
conservation expenditure for the year to which the loss is carried, and
therefore, is not subject to the 25-percent limitation for that year.
The provisions of this subparagraph may be illustrated by the following
example:
Example. Assume that in 1956 A has gross income from farming of
$4,000, soil and water conservation expenditures of $1,600 and
deductible farm expenses of $3,500. Of the soil and water conservation
expenditures $1,000 is deductible in 1956. The $600 in excess of 25
percent of A's gross income from farming is carried over into 1957.
Assuming that A has no other income, his deductions of $4,500 ($1,000
plus $3,500) exceed his gross income of $4,000 by $500. This $500 will
constitute a net operating loss which he must carry back two years and
carry forward five years, until it has offset $500 of taxable income. No
part of this $500 net operating loss carryback or carryover will be
taken into account in determining the amount of soil and water
conservation expenditures in the years to which it is carried.
(b) Carryover of expenditures in excess of deduction. The deduction
for soil and water conservation expenditures in any one taxable year is
limited to 25 percent of the taxpayer's gross income from farming. The
taxpayer may carry over the excess of such expenditures
[[Page 186]]
over 25 percent of his gross income from farming into his next taxable
year, and, if not deductible in that year, into the next year, and so on
without limit as to time. In determining the deductible amount of such
expenditures for any taxable year, the actual expenditures of that year
shall be added to any such expenditures carried over from prior years,
before applying the 25-percent limitation. Any such expenditures in
excess of the deductible amount may be carried over during the
taxpayer's entire existence. For this purpose in a farm partnership,
since the 25-percent limitation is applied to each partner, not the
partnership, the carryover may be carried forward during the life of the
partner. The provisions of this paragraph may be illustrated by the
following example:
Example. Assume the expenditures and income shown in the following
table:
----------------------------------------------------------------------------------------------------------------
Deductible soil and water
conservation expenditures
---------------------------- 25 percent Excess to be
Year Paid or Total of gross carried
incurred Carried income from forward
during forward from farming
taxable year prior year
----------------------------------------------------------------------------------------------------------------
1954...................................... $900 None $900 $800 $100
1955...................................... 1,000 $100 1,100 900 200
1956...................................... None 200 200 1,000 None
----------------------------------------------------------------------------------------------------------------
The deduction for 1954 is limited to $800. The remainder, $100 ($900
minus $800), not being deductible for 1954, is a carryover to 1955. For
1955, accordingly, the total of the expenditures to be taken into
account is $1,100 (the $100 carryover and the $1,000 actually paid in
that year). The deduction for 1955 is limited to $900, and the remainder
of the $1,100 total, or $200, is a carryover to 1956. The deduction for
1956 consists solely of this carryover of $200. Since the total
expenditures, actual and carried-over, for 1956 are less than 25 percent
of gross income from farming, there is no carryover into 1957.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6649, 28 FR
3762, Apr. 18, 1963]
Sec. 1.175-6 Adoption or change of method.
(a) Adoption with consent. A taxpayer may, without consent, adopt
the method of treating expenditures for soil or water conservation as
expenses for the first taxable year:
(1) Which begins after December 31, 1953, and ends after August 16,
1954, and
(2) For which soil or water conservation expenditures described in
section 175(a) are paid or incurred.
Such adoption shall be made by claiming the deduction on his income tax
return. For a taxable year ending prior to May 31, 1957, the adoption of
the method described in section 175 shall be made by claiming the
deduction on such return for that year, or by claiming the deduction on
an amended return filed for that year on or before August 30, 1957.
(b) Adoption with consent. A taxpayer may adopt the method of
treating soil and water conservation expenditures as provided by section
175 for any taxable year to which the section is applicable if consent
is obtained from the district director for the internal revenue district
in which the taxpayer's return is required to be filed.
(c) Change of method. A taxpayer who has adopted the method of
treating expenditures for soil or water conservation, as provided by
section 175, may change from this method and capitalize such
expenditures made after the effective date of the change, if he obtains
the consent of the district director for the internal revenue district
in which his return is required to be filed.
(d) Request for consent to adopt or change method. Where the consent
of the district director is required under paragraph (b) or (c) of this
section, the request for his consent shall be in writing, signed by the
taxpayer or his authorized representative, and shall be filed not later
than the date prescribed by law for filing the income tax return for the
first taxable year to which the adoption of, or change of, method is to
apply, or not later than August 20, 1957, following their adoption,
whichever is later. The request shall:
(1) Set forth the name and address of the taxpayer;
[[Page 187]]
(2) Designate the first taxable year to which the method or change
of method is to apply;
(3) State whether the method or change of method is intended to
apply to all expenditures within the permissible scope of section 175,
or only to a particular project or farm and, if the latter, include such
information as will identify the project or farm as to which the method
or change of method is to apply;
(4) Set forth the amount of all soil and water conservation
expenditures paid or incurred during the first taxable year for which
the method or change of method is to apply; and
(5) State that the taxpayer will make an accounting segregation in
his books and records of the expenditures to which the election relates.
(e) Scope of method. Except with the consent of the district
director as provided in paragraph (b) or (c) of this section, the
taxpayer's method of treating soil and water conservation expenditures
described in section 175 shall apply to all such expenditures for the
taxable year of adoption and all subsequent taxable years. Although a
taxpayer may have elected to deduct soil and water conservation
expenditures, he may request an authorization to capitalize his soil and
water conservation expenditures attributable to a special project or
single farm. Similarly, a taxpayer who has not elected to deduct such
expenditures may request an authorization to deduct his soil and water
conservation expenditures attributable to a special project or single
farm. The authorization with respect to the special project or single
farm will not affect the method adopted with respect to the taxpayer's
regularly incurred soil and water conservation expenditures. No adoption
of, or change of, the method under section 175 will be permitted as to
expenditures actually paid or incurred before the taxable year to which
the method or change of method is to apply. Thus, if a taxpayer adopts
such method for 1956, he cannot deduct any part of such expenditures
which he capitalized, or should have capitalized, in 1955. Likewise, if
a taxpayer who has adopted such method has an unused carryover of such
expenditures in excess of the 25-percent limitation, and is granted
consent to capitalize soil and water conservation expenditures beginning
in 1956, he cannot capitalize any part of the unused carryover. The
excess expenditures carried over continue to be deductible to the extent
of 25 percent of the taxpayer's gross income from farming. No adjustment
to the basis of land shall be made under section 1016 for expenditures
to which the method under section 175 applies. For example, A has an
unused carryover of soil and water conservation expenditures amounting
to $5,000 as of December 31, 1956. On January 1, 1957, A sells his farm
and goes out of the business of farming. The unused carryover of $5,000
cannot be added to the basis of the farm for purposes of determining
gain or loss on its sale. In 1959, A purchases another farm and resumes
the business of farming. In such year, A may deduct the amount of the
unused carryover to the extent of 25 percent of his gross income from
farming and may carry over any excess to subsequent years.
Sec. 1.175-7 Allocation of expenditures in certain circumstances.
(a) General rule. If at the time the taxpayer paid or incurred
expenditures for the purpose of soil or water conservation, or for the
prevention of erosion of land, it was reasonable to believe that such
expenditures would directly and substantially benefit land of the
taxpayer which does not qualify as ``land used in farming,'' as defined
in Sec. 1.175-4, as well as land of the taxpayer which does so qualify,
then, for purposes of section 175, only a part of the taxpayer's total
expenditures is in respect of ``land used in farming.''
(b) Method of allocation. The part of expenditures allocable to
``land used in farming'' generally equals the amount which bears the
same proportion to the total amount of such expenditures as the area of
land of the taxpayer used in farming which it was reasonable to believe
would be directly and substantially benefited as a result of the
expenditures bears to the total area of land of the taxpayer which it
was reasonable to believe would be so benefited. If it is established by
clear and convincing evidence that, in the light
[[Page 188]]
of all the facts and circumstances, another method of allocation is more
reasonable than the method provided in the preceding sentence, the
taxpayer may allocate the expenditures under that other method. For
purposes of this section, the term land of the taxpayer means land with
respect to which the taxpayer has title, leasehold, or some other
substantial interest.
(c) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. A owns a 200-acre tract of land, 80 acres of which
qualify as ``land used in farming.'' A makes expenditures for the
purpose of soil and water conservation which can reasonably be expected
to directly and substantially benefit the entire 200-acre tract. In the
absence of clear and convincing evidence that a different allocation is
more reasonable, A may deduct 40 percent (80/200) of such expenditures
under section 175. The same result would obtain if A had made the
expenditures after newly acquiring the tract from a person who had used
80 of the 200 acres in farming immediately prior to A's acquisition.
Example 2. Assume the same facts as in Example 1, except that A's
expenditures for the purpose of soil and water conservation can
reasonably be expected to directly and substantially benefit only the 80
acres which qualify as land used in farming; any benefit to the other
120 acres would be minor and incidental. A may deduct all of such
expenditures under section 175.
Example 3. Assume the same facts as in Example 1, except that A's
expenditures for the purpose of soil and water conservation can
reasonably be expected to directly and substantially benefit only the
120 acres which do not qualify as land used in farming. A may not deduct
any of such expenditures under section 175. The same result would obtain
even if A had leased the 200-acre tract to B in the expectation that B
would farm the entire tract.
[T.D. 7740, 45 FR 78635, Nov. 26, 1980]
Sec. 1.178-1 Depreciation or amortization of improvements on
leased property and cost of acquiring a lease.
(a) In general. Section 178 provides rules for determining the
amount of the deduction allowable for any taxable year to a lessee for
depreciation or amortization of improvements made on leased property and
as amortization of the cost of acquiring a lease. For purposes of
section 178 the term depreciation means the deduction allowable for
exhaustion, wear and tear, or obsolescence under provisions of the Code
such as section 167 or 611 and the regulations thereunder and the term
amortization means the deduction allowable for amortization of buildings
or other improvements made on leased property or for amortization of the
cost of acquiring a lease under provisions of the Code such as section
162 or 212 and the regulations thereunder. The provisions of section 178
are applicable with respect to costs of acquiring a lease incurred, and
improvements begun, after July 28, 1958, other than improvements which,
on July 28, 1958, and at all times thereafter, the lessee was under a
binding legal obligation to make.
(b) Determination of amount of deduction. (1) In determining the
amount of the deduction allowable to a lessee (other than a lessee who
is related to the lessor within the meaning of Sec. 1.178-2) for any
taxable year for depreciation or amortization of improvements made on
leased property, or for amortization in respect of the cost of acquiring
a lease, the term of the lease shall, except as provided in subparagraph
(2) of this paragraph, be treated as including all periods for which the
lease may be renewed, extended, or continued pursuant to an option or
options exercisable by the lessee (whether or not specifically provided
for in the lease) if:
(i) In the case of any building erected, or other improvements made,
by the lessee on the leased property, the portion of the term of the
lease (excluding all periods for which the lease may subsequently be
renewed, extended, or continued pursuant to an option or options
exercisable by the lessee) remaining upon the completion of such
building or other improvements is less than 60 percent of the estimated
useful life of such building or other improvements; or
(ii) In the case of any cost of acquiring the lease, less than 75
percent of such cost is attributable to the portion of the term of the
lease (excluding all periods for which the lease may be renewed,
extended, or continued pursuant to an option or options exercisable by
the lessee) remaining on the date of its acquisition.
(2) The rules provided in subparagraph (1) of this paragraph shall
not
[[Page 189]]
apply if the lessee establishes that, as of the close of the taxable
year, it is more probable that the lease will not be renewed, extended,
or continued than that the lease will be renewed, extended, or
continued. In such case, the cost of improvements made on leased
property or the cost of acquiring a lease shall be amortized over the
remaining term of the lease without regard to any options exercisable by
the lessee to renew, extend, or continue the lease. The probability test
referred to in the first sentence of this subparagraph shall be
applicable to each option period to which the lease may be renewed,
extended, or continued. The establishment by a lessee as of the close of
the taxable year that it is more probable that the lease will not be
renewed, extended, or continued will ordinarily be effective as of the
close of such taxable year and any subsequent taxable year, and the
deduction for amortization will be based on the term of the lease
without regard to any periods for which the lease may be renewed,
extended, or continued pursuant to an option or options exercisable by
the lessee. However, in appropriate cases, if the facts as of the close
of any subsequent taxable year indicate that it is more probable that
the lease will be renewed, extended, or continued, the deduction for
amortization (or depreciation) shall, beginning with the first day of
such subsequent taxable year, be determined by including in the
remaining term of the lease all periods for which it is more probable
that the lease will be renewed, extended, or continued.
(3) If at any time the remaining term of the lease determined in
accordance with section 178 and this section is equal to or of longer
duration than the then estimated useful life of the improvements made on
the leased property by the lessee, the cost of such improvements shall
be depreciated over the estimated useful life of such improvements under
the provisions of section 167 and the regulations thereunder.
(4) For purposes of section 178(a)(1) and this section, the date on
which the building erected or other improvements made are completed is
the date on which the building or improvements are usable, whether or
not used.
(5)(i) For purposes of section 178(a)(2) and this section, the
portion of the cost of acquiring a lease which is attributable to the
term of the lease remaining on the date of its acquisition without
regard to options exercisable by the lessee to renew, extend, or
continue the lease shall be determined on the basis of the facts and
circumstances of each case. In some cases, it may be appropriate to
determine such portion of the cost of acquiring a lease by applying the
principles used to measure the present value of an annuity. Where that
method is used, such portion shall be determined by multiplying the cost
of the lease by a fraction, the numerator comprised of a factor
representing the present value of an annually recurring savings of $1
per year for the period of the remaining term of the lease (without
regard to options to renew, extend, or continue the lease) at an
appropriate rate of interest (determined on the basis of all the facts
and circumstances in each case), and the denominator comprised of a
factor representing the present value of $1 per year for the period of
the remaining term of the lease including the options to renew, extend,
or continue the lease at an appropriate rate of interest.
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example. Lessee A acquires a lease with respect to unimproved
property at a cost of $100,000 at which time there are 21 years
remaining in the original term of the lease with two renewal options of
21 years each. The lease provides for a uniform annual rental for the
remaining term of the lease and the renewal periods. It has been
determined that this is an appropriate case for the application of the
principles used to measure the present value of an annuity. Assume that
in this case the appropriate rate of interest is 5 percent. By applying
the tables (Inwood) used to measure the present value of an annuity of
$1 per year, the factor representing the present value of $1 per annum
for 21 years at 5% is ascertained to be 12.821, and the factor
representing the present value of $1 per annum for 63 years at 5% is
19.075. The portion of the cost of the lease ($100,000) attributable to
the remaining term of the original lease (21 years) is 67.21% or $67,210
determined as follows:
12.821/19.075 or 67.21%.
[[Page 190]]
(6) The provisions of this paragraph may be illustrated by the
following examples:
Example 1. Lessee A constructs a building on land leased from lessor
B. The construction is commenced on August 1, 1958, and is completed and
placed in service on December 31, 1958, at which time A has 15 years
remaining on his lease with an option to renew for an additional 20
years. Lessee A computes his taxable income on a calendar year basis.
Lessee A was not, on July 28, 1958, under a binding legal obligation to
erect the building. The building has an estimated useful life of 30
years. A is not related to B. Since the portion of the term of the lease
(without regard to any renewals) remaining upon completion of the
building (15 years) is less than 60 percent of the estimated useful life
of the building (60 percent of 30 years, or 18 years), the term of the
lease shall be treated as including the remaining portion of the
original lease period and the renewal period, or 35 years. Since the
estimated useful life of the building (30 years) is less than 35 years,
the cost of the building shall, in accord with paragraph (b)(3) of this
section, be depreciated under the provisions of section 167, over its
estimated useful life. If, however, lessee A establishes, as of the
close of the taxable year 1958, it is more probable that the lease will
not be renewed than that it will be renewed, then in such case the
remaining term of the lease shall be treated as including only the 15-
year period remaining in the original lease. Since this is less than the
estimated useful life of the building, the remaining cost of the
building would be amortized over such 15-year period under the
provisions of section 162 and the regulations thereunder.
Example 2. Assume the same facts as in Example 1, except that A has
21 years remaining on his lease with an option to renew for an
additional 10 years. Section 178(a) and paragraph (b)(1) of this section
do not apply since the term of the lease remaining on the date of
completion of the building (21 years) is not less than 60 percent of the
estimated useful life of the building (60 percent of 30 years, or 18
years).
Example 3. Assume the same facts as in Example 1, except that A has
no renewal option until July 1, 1961, when lessor B grants A an option
to renew the lease for a 10-year period. Because there is no option to
renew the lease, the term of the lease is, for the taxable years 1959
and 1960 and for the first six months of the taxable year 1961,
determined without regard to section 178(a). However, as of July 1,
1961, the date the renewal option is granted, section 178(a) and
paragraph (b)(1) of this section become applicable since the portion of
the term of the lease remaining upon completion of the building (15
years) was less than 60 percent of the estimated useful life of the
building (60 percent of 30 years, or 18 years). As of July 1, 1961, the
term of the lease shall be treated as including the remaining portion of
the original lease period (12\1/2\ years) and the 10-year renewal
period, or 22\1/2\ years, unless lessee A can establish that, as of the
close of 1961, it is more probable that the lease will not be renewed
than that it will be.
Example 4. On January 1, 1959, lessee A pays $10,000 to acquire a
lease for 20 years with two options exercisable by him to renew for
periods of 5 years each. Of the total $10,000 cost to acquire the lease,
$7,000 was paid for the original 20-year lease period and the balance of
$3,000 was paid for the renewal options. Since the $7,000 cost of
acquiring the initial lease is less than 75 percent of the $10,000 cost
of the lease ($7,500), the term of the lease shall be treated as
including the original lease period and the 2 renewal periods, or 30
years. However, if lessee A establishes that, as of the close of the
taxable year 1959, it is more probable that the lease will not be
renewed than that it will be renewed, the term of the lease shall be
treated as including only the original lease period, or 20 years.
Example 5. Assume the same facts as in Example 4, except that the
portion of the total cost ($10,000) paid for the 20-year original lease
period is $8,000. Since the $8,000 cost of acquiring the original lease
is not less than 75 percent of the $10,000 cost of the lease ($7,500),
section 178(a) and paragraph (b)(1) of this section do not apply.
(c) Application of section 178(a) where lessee gives notice to
lessor of intention to exercise option. (1) If the lessee has given
notice to the lessor of his intention to renew, extend, or continue a
lease, the lessee shall, for purposes of applying the provisions of
section 178(a) and paragraph (b)(1) of this section, take into account
such renewal or extension in determining the portion of the term of the
lease remaining upon the completion of the improvements or on the date
of the acquisition of the lease.
(2) The application of the provisions of this paragraph may be
illustrated by the following examples:
Example 1. Lessee A constructs a building on land leased from lessor
B. The construction was commenced on September 1, 1958, and was
completed and placed in service on December 31, 1958. Lessee A was not,
on July 28, 1958, under a binding legal obligation to erect the
building. A and B are not related. At the time the building was
completed (December 31, 1958), lessee A had 3 years remaining on his
lease with 2 options to renew for
[[Page 191]]
periods of 20 years each. The estimated useful life of the building is
50 years. Prior to completion of the building, lessee A gives notice to
lessor B of his intention to exercise the first 20-year option.
Therefore, the portion of the term of the lease remaining on January 1,
1959, shall be the 3 years remaining in the original lease period plus
the 20-year renewal period, or 23 years. Since the term of the lease
remaining upon completion of the building (23 years) is less than 60
percent of the estimated useful life of the building (60 percent of 50
years, or 30 years), the provisions of section 178(a) and paragraph
(b)(1) of this section are applicable. Accordingly, the term of the
lease shall be treated as including the aggregate of the remaining term
of the original lease (23 years) and the second 20-year renewal period
or 43 years, unless lessee A establishes that it is more probable that
the lease will not be renewed, extended, or continued under the second
20-year option than that it will be so renewed, extended, or continued
under such option. If this is established by lessee A, then the term of
the lease shall be treated as including only the remaining portion of
the original lease period and the first 20-year renewal period, or 23
years.
Example 2. Assume the same facts as in Example 1, except that the
estimated useful life of the building is 30 years. Since the term of the
lease remaining upon completion of the building (23 years) is not less
than 60 percent of the estimated life of the building (60 percent of 30
years, or 18 years), the provisions of section 178(a) and paragraph
(b)(1) of this section do not apply.
Example 3. If in Examples 1 and (2, the lessee failed to give notice
of his intention to exercise the renewal option, the renewal period
would not be taken into account in computing the percentage requirements
under section 178(a) and paragraph (b)(1) of this section. Thus, unless
lessee A establishes the required probability, the provisions of section
178(a) and paragraph (b)(1) of this section would apply in both examples
since the term of the lease remaining upon completion of the building (3
years) is less than 60 percent of the estimated useful life of the
building in either example (60 percent of 50 years, or 30 years; 60
percent of 30 years, or 18 years).
(d) Application of section 178 where lessee is related to lessor.
(1)(i) If the lessee and lessor are related persons within the meaning
of section 178(b)(2) and Sec. 1.178-2 at any time during the taxable
year, the lease shall be treated as including a period of not less
duration than the remaining estimated useful life of improvements made
by the lessee on leased property for purposes of determining the amount
of deduction allowable to the lessee for such taxable year for
depreciation or amortization in respect of any building erected or other
improvements made on leased property. If the lessee and lessor cease to
be related persons during any taxable year, then for the immediately
following and subsequent taxable years during which they continue to be
unrelated, the amount allowable to the lessee as a deduction shall be
determined without reference to section 178(b) and in accordance with
section 178(a) or section 178(c), whichever is applicable.
(ii) Although the related lessee and lessor rule of section 178(b)
and Sec. 1.178-2 does not apply in determining the period over which
the cost of acquiring a lease may be amortized, the relationship between
a lessee and lessor will be a significant factor in applying section 178
(a) and (c) in cases in which the lease may be renewed, extended, or
continued pursuant to an option or options exercisable by the lessee.
(2) The application of the provisions of this paragraph may be
illustrated by the following examples:
Example 1. Lessee A constructs a building on land leased from lessor
B. The construction was commenced on August 1, 1958, and was completed
and put in service on December 31, 1958. Lessee A was not on July 28,
1958, under a binding legal obligation to erect the building. On the
completion date of the building, lessee A had 20 years remaining in his
original lease period with an option to renew for an additional 20
years. The building has an estimated useful life of 50 years. During the
taxable years 1959 and 1960, A and B are related persons within the
meaning of section 178(b)(2) and Sec. 1.178-2, but they are not related
persons at any time during the taxable year 1961 or during any
subsequent taxable year. Since A and B are related persons during the
taxable years 1959 and 1960, the term of the lease shall, for each of
those years, be treated as 50 years. Section 178(a) and paragraph (b)(1)
of this section become applicable in the taxable year 1961 since A and B
are not related persons at any time during that year and because the
portion of the original lease period remaining at the time the building
was completed (20 years) is less than 60 percent of the estimated useful
life of the building (60 percent of 50 years, or 30 years). Thus, the
term of the lease shall, beginning on January 1, 1961, be treated as
including the remaining portion of the original lease period (18 years)
and the renewal period (20 years), or 38 years, unless lessee A can
establish that, as of the close of the taxable year 1961 or any
subsequent taxable
[[Page 192]]
year, it is more probable that the lease will not be renewed than that
it will be renewed.
Example 2. Assume the same facts as in Example 1, except that the
estimated useful life of the building is 30 years. During the taxable
years 1959 and 1960, the term of the lease shall be treated as 30 years.
For the taxable year 1961, however, neither section 178(a) nor section
178(b) apply since the percentage requirement of section 178(a) and
paragraph (b) of this section are not satisfied and A and B are not
related persons within the meaning of section 178(b)(2) and Sec. 1.178-
2.
[T.D. 6520, 25 FR 13689, Dec. 24, 1960]
Sec. 1.179-0 Table of contents for section 179 expensing rules.
This section lists captioned paragraphs contained in Sec. Sec.
1.179-1 through 1.179-6.
Sec. 1.179-1 Election to Expense Certain Depreciable Assets
(a) In general.
(b) Cost subject to expense.
(c) Proration not required.
(1) In general.
(2) Example.
(d) Partial business use.
(1) In general.
(2) Example.
(3) Additional rules that may apply.
(e) Change in use; recapture.
(1) In general.
(2) Predominant use.
(3) Basis; application with section 1245.
(4) Carryover of disallowed deduction.
(5) Example.
(f) Basis.
(1) In general.
(2) Special rules for partnerships and S corporations.
(3) Special rules with respect to trusts and estates which are
partners or S corporation shareholders.
(g) Disallowance of the section 38 credit.
(h) Partnerships and S corporations.
(1) In general.
(2) Example.
(i) Leasing of section 179 property.
(1) In general.
(2) Noncorporate lessor.
(j) Application of sections 263 and 263A.
(k) Cross references.
Sec. 1.179-2 Limitations on Amount Subject to Section 179 Election
(a) In general.
(b) Dollar limitation.
(1) In general.
(2) Excess section 179 property.
(3) Application to partnerships.
(i) In general.
(ii) Example.
(iii) Partner's share of section 179 expenses.
(iv) Taxable year.
(v) Example.
(4) S corporations.
(5) Joint returns.
(i) In general.
(ii) Joint returns filed after separate returns.
(iii) Example.
(6) Married individuals filing separately.
(i) In general.
(ii) Example.
(7) Component members of a controlled group.
(i) In general.
(ii) Statement to be filed.
(iii) Revocation.
(c) Taxable income limitation.
(1) In general.
(2) Application to partnerships and partners.
(i) In general.
(ii) Taxable year.
(iii) Example.
(iv) Taxable income of a partnership.
(v) Partner's share of partnership taxable income.
(3) S corporations and S corporation shareholders.
(i) In general.
(ii) Taxable income of an S corporation.
(iii) Shareholder's share of S corporation taxable income.
(4) Taxable income of a corporation other than an S corporation.
(5) Ordering rule for certain circular problems.
(i) In general.
(ii) Example.
(6) Active conduct by the taxpayer of a trade or business.
(i) Trade or business.
(ii) Active conduct.
(iii) Example.
(iv) Employees.
(7) Joint returns.
(i) In general.
(ii) Joint returns filed after separate returns.
(8) Married individuals filing separately.
(d) Examples.
Sec. 1.179-3 Carryover of Disallowed Deduction
(a) In general.
(b) Deduction of carryover of disallowed deduction.
(1) In general.
(2) Cross references.
(c) Unused section 179 expense allowance.
(d) Example.
(e) Recordkeeping requirement and ordering rule.
(f) Dispositions and other transfers of section 179 property.
(1) In general.
(2) Recapture under section 179(d)(10).
(g) Special rules for partnerships and S corporations.
[[Page 193]]
(1) In general.
(2) Basis adjustment.
(3) Dispositions and other transfers of section 179 property by a
partnership or an S corporation.
(4) Example.
(h) Special rules for partners and S corporation shareholders.
(1) In general.
(2) Dispositions and other transfers of a partner's interest in a
partnership or a shareholder's interest in an S corporation.
(3) Examples.
Sec. 1.179-4 Definitions
(a) Section 179 property.
(b) Section 38 property.
(c) Purchase.
(d) Cost.
(e) Placed in service.
(f) Controlled group of corporations and component member of
controlled group.
Sec. 1.179-5 Time and Manner of Making Election
(a) Election.
(b) Revocation.
(c) Section 179 property placed in service by the taxpayer in a
taxable year beginning after 2002 and before 2008.
(d) Election or revocation must not be made in any other manner.
Sec. 1.179-6 Effective dates.
(a) In general.
(b) Section 179 property placed in service by the taxpayer in a
taxable year beginning after 2002 and before 2008.
(c) Application of Sec. 1.179-5(d).
[T.D. 8455, 57 FR 61316, Dec. 24, 1992, as amended by T.D. 9146, 69 FR
46983, Aug. 4, 2004; T.D. 9209, 70 FR 40191, July 13, 2005]
Sec. 1.179-1 Election to expense certain depreciable assets.
(a) In general. Section 179(a) allows a taxpayer to elect to expense
the cost (as defined in Sec. 1.179-4(d)), or a portion of the cost, of
section 179 property (as defined in Sec. 1.179-4(a)) for the taxable
year in which the property is placed in service (as defined in Sec.
1.179-4(e)). The election is not available for trusts, estates, and
certain noncorporate lessors. See paragraph (i)(2) of this section for
rules concerning noncorporate lessors. However, section 179(b) provides
certain limitations on the amount that a taxpayer may elect to expense
in any one taxable year. See Sec. Sec. 1.179-2 and 1.179-3 for rules
relating to the dollar and taxable income limitations and the carryover
of disallowed deduction rules. For rules describing the time and manner
of making an election under section 179, see Sec. 1.179-5. For the
effective date, see Sec. 1.179-6.
(b) Cost subject to expense. The expense deduction under section 179
is allowed for the entire cost or a portion of the cost of one or more
items of section 179 property. This expense deduction is subject to the
limitations of section 179(b) and Sec. 1.179-2. The taxpayer may select
the properties that are subject to the election as well as the portion
of each property's cost to expense.
(c) Proration not required--(1) In general. The expense deduction
under section 179 is determined without any proration based on--
(i) The period of time the section 179 property has been in service
during the taxable year; or
(ii) The length of the taxable year in which the property is placed
in service.
(2) Example. The following example illustrates the provisions of
paragraph (c)(1) of this section.
Example. On December 1, 1991, X, a calendar-year corporation,
purchases and places in service section 179 property costing $20,000.
For the taxable year ending December 31, 1991, X may elect to claim a
section 179 expense deduction on the property (subject to the
limitations imposed under section 179(b)) without proration of its cost
for the number of days in 1991 during which the property was in service.
(d) Partial business use--(1) In general. If a taxpayer uses section
179 property for trade or business as well as other purposes, the
portion of the cost of the property attributable to the trade or
business use is eligible for expensing under section 179 provided that
more than 50 percent of the property's use in the taxable year is for
trade or business purposes. The limitations of section179(b) and Sec.
1.179-2 are applied to the portion of the cost attributable to the trade
or business use.
(2) Example. The following example illustrates the provisions of
paragraph (d)(1) of this section.
Example. A purchases section 179 property costing $10,000 in 1991
for which 80 percent of its use will be in A's trade or business. The
cost of the property adjusted to reflect the business use of the
property is $8,000 (80 percent x $10,000). Thus, A may elect to expense
up to $8,000 of the cost of the property (subject to the limitations
imposed under section 179(b) and Sec. 1.179-2).
[[Page 194]]
(3) Additional rules that may apply. If a section 179 election is
made for ``listed property'' within the meaning of section 280F(d)(4)
and there is personal use of the property, section 280F(d)(1), which
provides rules that coordinate section 179 with the section 280F
limitation on the amount of depreciation, may apply. If section 179
property is no longer predominantly used in the taxpayer's trade or
business, paragraphs (e) (1) through (4) of this section, relating to
recapture of the section 179 deduction, may apply.
(e) Change in use; recapture--(1) In general. If a taxpayer's
section 179 property is not used predominantly in a trade or business of
the taxpayer at any time before the end of the property's recovery
period, the taxpayer must recapture in the taxable year in which the
section 179 property is not used predominantly in a trade or business
any benefit derived from expensing such property. The benefit derived
from expensing the property is equal to the excess of the amount
expensed under this section over the total amount that would have been
allowable for prior taxable years and the taxable year of recapture as a
deduction under section 168 (had section 179 not been elected) for the
portion of the cost of the property to which the expensing relates
(regardless of whether such excess reduced the taxpayer's tax
liability). For purposes of the preceding sentence (i) the ``amount
expensed under this section'' shall not include any amount that was not
allowed as a deduction to a taxpayer because the taxpayer's aggregate
amount of allowable section 179 expenses exceeded the section 179(b)
dollar limitation, and (ii) in the case of an individual who does not
elect to itemize deductions under section 63(g) in the taxable year of
recapture, the amount allowable as a deduction under section 168 in the
taxable year of recapture shall be determined by treating property used
in the production of income other than rents or royalties as being
property used for personal purposes. The amount to be recaptured shall
be treated as ordinary income for the taxable year in which the property
is no longer used predominantly in a trade or business of the taxpayer.
For taxable years following the year of recapture, the taxpayer's
deductions under section 1688(a) shall be determined as if no section
179 election with respect to the property had been made. However, see
section 280F(d)(1) relating to the coordination of section 179 with the
limitation on the amount of depreciation for luxury automobiles and
where certain property is used for personal purposes. If the recapture
rules of both section 280F(b)(2) and this paragraph (e)(1) apply to an
item of section 179 property, the amount of recapture for such property
shall be determined only under the rules of section 280F(b)(2).
(2) Predominant use. Property will be treated as not used
predominantly in a trade or business of the taxpayer if 50 percent or
more of the use of such property during any taxable year within the
recapture period is for a use other than in a trade or business of the
taxpayer. If during any taxable year of the recapture period the
taxpayer disposes of the property (other than in a disposition to which
section 1245(a) applies) or ceases to use the property in a trade or
business in a manner that had the taxpayer claimed a credit under
section 38 for such property such disposition or cessation in use would
cause recapture under section 47, the property will be treated as not
used in a trade or business of the taxpayer. However, for purposes of
applying the recapture rules of section 47 pursuant to the preceding
sentence, converting the use of the property from use in trade or
business to use in the production of income will be treated as a
conversion to personal use.
(3) Basis; application with section 1245. The basis of property with
respect to which there is recapture under paragraph (e)(1) of this
section shall be increased immediately before the event resulting in
such recapture by the amount recaptured. If section 1245(a) applies to a
disposition of property, there is no recapture under paragraph (e)(1) of
this section.
(4) Carryover of disallowed deduction. See Sec. 1.179-3 for rules
on applying the recapture provisions of this paragraph (e) when a
taxpayer has a carryover of disallowed deduction.
[[Page 195]]
(5) Example. The following example illustrates the provisions of
paragraphs (e)(1) through (e)(4) of this section.
Example. A, a calendar-year taxpayer, purchases and places in
service on January 1, 1991, section 179 property costing $15,000. The
property is 5-year property for section 168 purposes and is the only
item of depreciable property placed in service by A during 1991. A
properly elects to expense $10,000 of the cost and elects under section
168(b)(5) to depreciate the remaining cost under the straight-line
method. On January 1, 1992, A converts the property from use in A's
business to use for the production of income, and A uses the property in
the latter capacity for the entire year. A elects to itemize deductions
for 1992. Because the property was not predominantly used in A's trade
or business in 1992, A must recapture any benefit derived from expensing
the property under section 179. Had A not elected to expense the $10,000
in 1991, A would have been entitled to deduct, under section 168, 10
percent of the $10,000 in 1991, and 20 percent of the $10,000 in 1992.
Therefore, A must include $7,000 in ordinary income for the 1992 taxable
year, the excess of $10,000 (the section 179 expense amount) over $3,000
(30 percent of $10,000).
(f) Basis--(1) In general. A taxpayer who elects to expense under
section 179 must reduce the depreciable basis of the section 179
property by the amount of the section 179 expense deduction.
(2) Special rules for partnerships and S corporations. Generally,
the basis of a partnership or S corporation's section 179 property must
be reduced to reflect the amount of section 179 expense elected by the
partnership or S corporation. This reduction must be made in the basis
of partnership or S corporation property even if the limitations of
section 179(b) and Sec. 1.179-2 prevent a partner in a partnership or a
shareholder in an S corporation from deducting all or a portion of the
amount of the section 179 expense allocated by the partnership or S
corporation. See Sec. 1.179-3 for rules on applying the basis
provisions of this paragraph (f) when a person has a carryover of
disallowed deduction.
(3) Special rules with respect to trusts and estates which are
partners or S corporation shareholders. Since the section 179 election
is not available for trusts or estates, a partner or S corporation
shareholder that is a trust or estate may not deduct its allocable share
of the section 179 expense elected by the partnership or S corporation.
The partnership or S corporation's basis in section 179 property shall
not be reduced to reflect any portion of the section 179 expense that is
allocable to the trust or estate. Accordingly, the partnership or S
corporation may claim a depreciation deduction under section 168 or a
section 38 credit (if available) with respect to any depreciable basis
resulting from the trust or estate's inability to claim its allocable
portion of the section 179 expense.
(g) Disallowance of the section 38 credit. If a taxpayer elects to
expense under section 179, no section 38 credit is allowable for the
portion of the cost expensed. In addition, no section 38 credit shall be
allowed under section 48(d) to a lessee of property for the portion of
the cost of the property that the lessor expensed under section 179.
(h) Partnerships and S corporations--(1) In general. In the case of
property purchased and placed in service by a partnership or an S
corporation, the determination of whether the property is section 179
property is made at the partnership or S corporation level. The election
to expense the cost of section 179 property is made by the partnership
or the S corporation. See sections 703(b), 1363(c), 6221, 6231(a)(3),
6241, and 6245.
(2) Example. The following example illustrates the provisions of
paragraph (h)(1) of this section.
Example. A owns certain residential rental property as an
investment. A and others form ABC partnership whose function is to rent
and manage such property. A and ABC partnership file their income tax
returns on a calendar-year basis. In 1991, ABC partnership purchases and
places in service office furniture costing $20,000 to be used in the
active conduct of ABC's business. Although the office furniture is used
with respect to an investment activity of A, the furniture is being used
in the active conduct of ABC's trade or business. Therefore, because the
determination of whether property is section 179 property is made at the
partnership level, the office furniture is section 179 property and ABC
may elect to expense a portion of its cost under section 179.
(i) Leasing of section 179 property--(1) In general. A lessor of
section 179 property who is treated as the owner of the property for
Federal tax purposes will be entitled to the section 179 expense
[[Page 196]]
deduction if the requirements of section 179 and the regulations
thereunder are met. These requirements will not be met if the lessor
merely holds the property for the production of income. For certain
leases entered into prior to January 1, 1984, the safe harbor provisions
of section 168(f)(8) apply in determining whether an agreement is
treated as a lease for Federal tax purposes.
(2) Noncorporate lessor. In determining the class of taxpayers
(other than an estate or trust) for which section 179 is applicable,
section 179(d)(5) provides that if a taxpayer is a noncorporate lessor
(i.e., a person who is not a corporation and is a lessor), the taxpayer
shall not be entitled to claim a section 179 expense for section 179
property purchased and leased by the taxpayer unless the taxpayer has
satisfied all of the requirements of section 179(d)(5) (A) or (B).
(j) Application of sections 263 and 263A. Under section
263(a)(1)(G), expenditures for which a deduction is allowed under
section 179 and this section are excluded from capitalization under
section 263(a). Under this paragraph (j), amounts allowed as a deduction
under section 179 and this section are excluded from the application of
the uniform capitalization rules of section 263A.
(k) Cross references. See section 453(i) and the regulations
thereunder with respect to installment sales of section 179 property.
See section 1033(g)(3) and the regulations thereunder relating to
condemnation of outdoor advertising displays. See section 1245(a) and
the regulations thereunder with respect to recapture rules for section
179 property.
[T.D. 8121, 52 FR 410, Jan. 6, 1987, as amended by T.D. 8455, 57 FR
61316, Dec. 24, 1992]
Sec. 1.179-2 Limitations on amount subject to section 179 election.
(a) In general. Sections 179(b) (1) and (2) limit the aggregate cost
of section 179 property that a taxpayer may elect to expense under
section 179 for any one taxable year (dollar limitation). See paragraph
(b) of this section. Section 179(b)(3)(A) limits the aggregate cost of
section 179 property that a taxpayer may deduct in any taxable year
(taxable income limitation). See paragraph (c) of this section. Any cost
that is elected to be expensed but that is not currently deductible
because of the taxable income limitation may be carried forward to the
next taxable year (carryover of disallowed deduction). See Sec. 1.179-3
for rules relating to carryovers of disallowed deductions. See also
sections 280F(a), (b), and (d)(1) relating to the coordination of
section 179 with the limitations on the amount of depreciation for
luxury automobiles and other listed property. The dollar and taxable
income limitations apply to each taxpayer and not to each trade or
business in which the taxpayer has an interest.
(b) Dollar limitation--(1) In general. The aggregate cost of section
179 property that a taxpayer may elect to expense under section 179 for
any taxable year beginning in 2003 and thereafter is $25,000 ($100,000
in the case of taxable years beginning after 2002 and before 2008 under
section 179(b)(1), indexed annually for inflation under section
179(b)(5) for taxable years beginning after 2003 and before 2008),
reduced (but not below zero) by the amount of any excess section 179
property (described in paragraph (b)(2) of this section) placed in
service during the taxable year.
(2) Excess section 179 property. The amount of any excess section
179 property for a taxable year equals the excess (if any) of--
(i) The cost of section 179 property placed in service by the
taxpayer in the taxable year; over
(ii) $200,000 ($400,000 in the case of taxable years beginning after
2002 and before 2008 under section 179(b)(2), indexed annually for
inflation under section 179(b)(5) for taxable years beginning after 2003
and before 2008).
(3) Application to partnerships--(i) In general. The dollar
limitation of this paragraph (b) applies to the partnership as well as
to each partner. In applying the dollar limitation to a taxpayer that is
a partner in one or more partnerships, the partner's share of section
179 expenses allocated to the partner from each partnership is
aggregated with any nonpartnership section 179 expenses of the taxpayer
for the taxable year. However, in determining the excess section 179
property placed in service by a partner in a taxable
[[Page 197]]
year, the cost of section 179 property placed in service by the
partnership is not attributed to any partner.
(ii) Example. The following example illustrates the provisions of
paragraph (b)(3)(i) of this section.
Example. During 1991, CD, a calendar-year partnership, purchases and
places in service section 179 property costing $150,000 and elects under
section 179(c) and Sec. 1.179-5 to expense $10,000 of the cost of that
property. CD properly allocates to C, a calendar-year taxpayer and a
partner in CD, $5,000 of section 179 expenses (C's distributive share of
CD's section 179 expenses for 1991). In applying the dollar limitation
to C for 1991, C must include the $5,000 of section 179 expenses
allocated from CD. However, in determining the amount of any excess
section 179 property C placed in service during 1991, C does not include
any of the cost of section 179 property placed in service by CD,
including the $5,000 of cost represented by the $5,000 of section 179
expenses allocated to C by the partnership.
(iii) Partner's share of section 179 expenses. Section 704 and the
regulations thereunder govern the determination of a partner's share of
a partnership's section 179 expenses for any taxable year. However, no
allocation among partners of the section 179 expenses may be modified
after the due date of the partnership return (without regard to
extensions of time) for the taxable year for which the election under
section 179 is made.
(iv) Taxable year. If the taxable years of a partner and the
partnership do not coincide, then for purposes of section 179, the
amount of the partnership's section 179 expenses attributable to a
partner for a taxable year is determined under section 706 and the
regulations thereunder (generally the partner's distributive share of
partnership section 179 expenses for the partnership year that ends with
or within the partner's taxable year).
(v) Example. The following example illustrates the provisions of
paragraph (b)(3)(iv) of this section.
Example. AB partnership has a taxable year ending January 31. A, a
partner of AB, has a taxable year ending December 31. AB purchases and
places in service section 179 property on March 10, 1991, and elects to
expense a portion of the cost of that property under section 179. Under
section 706 and Sec. 1.706-1(a)(1), A will be unable to claim A's
distributive share of any of AB's section 179 expenses attributable to
the property placed in service on March 10, 1991, until A's taxable year
ending December 31, 1992.
(4) S Corporations. Rules similar to those contained in paragraph
(b)(3) of this section apply in the case of S corporations (as defined
in section 1361(a)) and their shareholders. Each shareholder's share of
the section 179 expenses of an S corporation is determined under section
1366.
(5) Joint returns--(i) In General. A husband and wife who file a
joint income tax return under section 6013(a) are treated as one
taxpayer in determining the amount of the dollar limitation under
paragraph (b)(1) of this section, regardless of which spouse purchased
the property or placed it in service.
(ii) Joint returns filed after separate returns. In the case of a
husband and wife who elect under section 6013(b) to file a joint income
tax return for a taxable year after the time prescribed by law for
filing the return for such taxable year has expired, the dollar
limitation under paragraph (b)(1) of this section is the lesser of--
(A) The dollar limitation (as determined under paragraph (b)(5)(i)
of this section); or
(B) The aggregate cost of section 179 property elected to be
expensed by the husband and wife on their separate returns.
(iii) Example. The following example illustrates the provisions of
paragraph (b)(5)(ii) of this section.
Example. During 1991, Mr. and Mrs. B, both calendar-year taxpayers,
purchase and place in service section 179 property costing $100,000. On
their separate returns for 1991, Mr. B elects to expense $3,000 of
section 179 property as an expense and Mrs. B elects to expense $4,000.
After the due date of the return they elect under section 6013(b) to
file a joint income tax return for 1991. The dollar limitation for their
joint income tax return is $7,000, the lesser of the dollar limitation
($10,000) or the aggregate cost elected to be expensed under section 179
on their separate returns ($3,000 elected by Mr. B plus $4,000 elected
by Mrs. B, or $7,000).
(6) Married individuals filing separately--(i) In general. In the
case of an individual who is married but files a separate income tax
return for a taxable year, the dollar limitation of this paragraph (b)
for such taxable year is the amount that would be determined
[[Page 198]]
under paragraph (b)(5)(i) of this section if the individual filed a
joint income tax return under section 6013(a) multiplied by either the
percentage elected by the individual under this paragraph (b)(6) or 50
percent. The election in the preceding sentence is made in accordance
with the requirements of section 179(c) and Sec. 1.179-5. However, the
amount determined under paragraph (b)(5)(i) of this section must be
multiplied by 50 percent if either the individual or the individual's
spouse does not elect a percentage under this paragraph (b)(6) or the
sum of the percentages elected by the individual and the individual's
spouse does not equal 100 percent. For purposes of this paragraph
(b)(6), marital status is determined under section 7703 and the
regulations thereunder.
(ii) Example. The following example illustrates the provisions of
paragraph (b)(6)(i) of this section.
Example. Mr. and Mrs. D, both calendar-year taxpayers, file separate
income tax returns for 1991. During 1991, Mr. D places $195,000 of
section 179 property in service and Mrs. D places $9,000 of section 179
property in service. Neither of them elects a percentage under paragraph
(b)(6)(i) of this section. The 1991 dollar limitation for both Mr. D and
Mrs. D is determined by multiplying by 50 percent the dollar limitation
that would apply had they filed a joint income tax return. Had Mr. and
Mrs. D filed a joint return for 1991, the dollar limitation would have
been $6,000, $10,000 reduced by the excess section 179 property they
placed in service during 1991 ($195,000 placed in service by Mr. D plus
$9,000 placed in service by Mrs. D less $200,000, or $4,000). Thus, the
1991 dollar limitation for Mr. and Mrs. D is $3,000 each ($6,000
multiplied by 50 percent).
(7) Component members of a controlled group--(i) In general.
Component members of a controlled group (as defined in Sec. 1.179-4(f))
on December 31 are treated as one taxpayer in applying the dollar
limitation of sections 179(b) (1) and (2) and this paragraph (b). The
expense deduction may be taken by any one component member or allocated
(for the taxable year of each member that includes that December 31)
among the several members in any manner. Any allocation of the expense
deduction must be pursuant to an allocation by the common parent
corporation if a consolidated return is filed for all component members
of the group, or in accordance with an agreement entered into by the
members of the group if separate returns are filed. If a consolidated
return is filed by some component members of the group and separate
returns are filed by other component members, the common parent of the
group filing the consolidated return must enter into an agreement with
those members that do not join in filing the consolidated return
allocating the amount between the group filing the consolidated return
and the other component members of the controlled group that do not join
in filing the consolidated return. The amount of the expense allocated
to any component member, however, may not exceed the cost of section 179
property actually purchased and placed in service by the member in the
taxable year. If the component members have different taxable years, the
term taxable year in sections 179(b) (1) and (2) means the taxable year
of the member whose taxable year begins on the earliest date.
(ii) Statement to be filed. If a consolidated return is filed, the
common parent corporation must file a separate statement attached to the
income tax return on which the election is made to claim an expense
deduction under section 179. See Sec. 1.179-5. If separate returns are
filed by some or all component members of the group, each component
member not included in a consolidated return must file a separate
statement attached to the income tax return on which an election is made
to claim a deduction under section 179. The statement must include the
name, address, employer identification number, and the taxable year of
each component member of the controlled group, a copy of the allocation
agreement signed by persons duly authorized to act on behalf of the
component members, and a description of the manner in which the
deduction under section 179 has been divided among the component
members.
(iii) Revocation. If a consolidated return is filed for all
component members of the group, an allocation among such members of the
expense deduction under section 179 may not be revoked after the due
date of the return (including extensions of time) of the common
[[Page 199]]
parent corporation for the taxable year for which an election to take an
expense deduction is made. If some or all of the component members of
the controlled group file separate returns for taxable years including a
particular December 31 for which an election to take the expense
deduction is made, the allocation as to all members of the group may not
be revoked after the due date of the return (including extensions of
time) of the component member of the controlled group whose taxable year
that includes such December 31 ends on the latest date.
(c) Taxable income limitation--(1) In general. The aggregate cost of
section 179 property elected to be expensed under section 179 that may
be deducted for any taxable year may not exceed the aggregate amount of
taxable income of the taxpayer for such taxable year that is derived
from the active conduct by the taxpayer of any trade or business during
the taxable year. For purposes of section 179(b)(3) and this paragraph
(c), the aggregate amount of taxable income derived from the active
conduct by an individual, a partnership, or an S corporation of any
trade or business is computed by aggregating the net income (or loss)
from all of the trades or businesses actively conducted by the
individual, partnership, or S corporation during the taxable year. Items
of income that are derived from the active conduct of a trade or
business include section 1231 gains (or losses) from the trade or
business and interest from working capital of the trade or business.
Taxable income derived from the active conduct of a trade or business is
computed without regard to the deduction allowable under section 179,
any section 164(f) deduction, any net operating loss carryback or
carryforward, and deductions suspended under any section of the Code.
See paragraph (c)(6) of this section for rules on determining whether a
taxpayer is engaged in the active conduct of a trade or business for
this purpose.
(2) Application to partnerships and partners--(i) In general. The
taxable income limitation of this paragraph (c) applies to the
partnership as well as to each partner. Thus, the partnership may not
allocate to its partners as a section 179 expense deduction for any
taxable year more than the partnership's taxable income limitation for
that taxable year, and a partner may not deduct as a section 179 expense
deduction for any taxable year more than the partner's taxable income
limitation for that taxable year.
(ii) Taxable year. If the taxable year of a partner and the
partnership do not coincide, then for purposes of section 179, the
amount of the partnership's taxable income attributable to a partner for
a taxable year is determined under section 706 and the regulations
thereunder (generally the partner's distributive share of partnership
taxable income for the partnership year that ends with or within the
partner's taxable year).
(iii) Example. The following example illustrates the provisions of
paragraph (c)(2)(ii) of this section.
Example. AB partnership has a taxable year ending January 31. A, a
partner of AB, has a taxable year ending December 31. For AB's taxable
year ending January 31, 1992, AB has taxable income from the active
conduct of its trade or business of $100,000, $90,000 of which was
earned during 1991. Under section 706 and Sec. 1.706-1(a)(1), A
includes A's entire share of partnership taxable income in computing A's
taxable income limitation for A's taxable year ending December 31, 1992.
(iv) Taxable income of a partnership. The taxable income (or loss)
derived from the active conduct by a partnership of any trade or
business is computed by aggregating the net income (or loss) from all of
the trades or businesses actively conducted by the partnership during
the taxable year. The net income (or loss) from a trade or business
actively conducted by the partnership is determined by taking into
account the aggregate amount of the partnership's items described in
section 702(a) (other than credits, tax-exempt income, and guaranteed
payments under section 707(c)) derived from that trade or business. For
purposes of determining the aggregate amount of partnership items,
deductions and losses are treated as negative income. Any limitation on
the amount of a partnership item described in section 702(a) which may
be taken into account for purposes of computing the taxable income of a
partner shall be
[[Page 200]]
disregarded in computing the taxable income of the partnership.
(v) Partner's share of partnership taxable income. A taxpayer who is
a partner in a partnership and is engaged in the active conduct of at
least one of the partnership's trades or businesses includes as taxable
income derived from the active conduct of a trade or business the amount
of the taxpayer's allocable share of taxable income derived from the
active conduct by the partnership of any trade or business (as
determined under paragraph (c)(2)(iv) of this section).
(3) S corporations and S corporation shareholders--(i) In general.
Rules similar to those contained in paragraphs (c)(2) (i) and (ii) of
this section apply in the case of S corporations (as defined in section
1361(a)) and their shareholders. Each shareholder's share of the taxable
income of an S corporation is determined under section 1366.
(ii) Taxable income of an S corporation. The taxable income (or
loss) derived from the active conduct by an S corporation of any trade
or business is computed by aggregating the net income (or loss) from all
of the trades or businesses actively conducted by the S corporation
during the taxable year. The net income (or loss) from a trade or
business actively conducted by an S corporation is determined by taking
into account the aggregate amount of the S corporation's items described
in section 1366(a) (other than credits, tax-exempt income, and
deductions for compensation paid to an S corporation's shareholder-
employees) derived from that trade or business. For purposes of
determining the aggregate amount of S corporation items, deductions and
losses are treated as negative income. Any limitation on the amount of
an S corporation item described in section 1366(a) which may be taken
into account for purposes of computing the taxable income of a
shareholder shall be disregarded in computing the taxable income of the
S corporation.
(iii) Shareholder's share of S corporation taxable income. Rules
similar to those contained in paragraph (c)(2)(v) and (c)(6)(ii) of this
section apply to a taxpayer who is a shareholder in an S corporation and
is engaged in the active conduct of the S corporation's trades or
businesses.
(4) Taxable income of a corporation other than an S corporation. The
aggregate amount of taxable income derived from the active conduct by a
corporation other than an S corporation of any trade or business is the
amount of the corporation's taxable income before deducting its net
operating loss deduction and special deductions (as reported on the
corporation's income tax return), adjusted to reflect those items of
income or deduction included in that amount that were not derived by the
corporation from a trade or business actively conducted by the
corporation during the taxable year.
(5) Ordering rule for certain circular problems--(i) In general. A
taxpayer who elects to expense the cost of section 179 property (the
deduction of which is subject to the taxable income limitation) also may
have to apply another Internal Revenue Code section that has a
limitation based on the taxpayer's taxable income. Except as provided in
paragraph (c)(1) of this section, this section provides rules for
applying the taxable income limitation under section 179 in such a case.
First, taxable income is computed for the other section of the Internal
Revenue Code. In computing the taxable income of the taxpayer for the
other section of the Internal Revenue Code, the taxpayer's section 179
deduction is computed by assuming that the taxpayer's taxable income is
determined without regard to the deduction under the other Internal
Revenue Code section. Next, after reducing taxable income by the amount
of the section 179 deduction so computed, a hypothetical amount of
deduction is determined for the other section of the Internal Revenue
Code. The taxable income limitation of the taxpayer under section
179(b)(3) and this paragraph (c) then is computed by including that
hypothetical amount in determining taxable income.
(ii) Example. The following example illustrates the ordering rule
described in paragraph (c)(5)(i) of this section.
Example. X, a calendar-year corporation, elects to expense $10,000
of the cost of section 179 property purchased and placed in service
during 1991. Assume X's dollar limitation is
[[Page 201]]
$10,000. X also gives a charitable contribution of $5,000 during the
taxable year. X's taxable income for purposes of both sections 179 and
170(b)(2), but without regard to any deduction allowable under either
section 179 or section 170, is $11,000. In determining X's taxable
income limitation under section 179(b)(3) and this paragraph (c), X must
first compute its section 170 deduction. However, section 170(b)(2)
limits X's charitable contribution to 10 percent of its taxable income
determined by taking into account its section 179 deduction. Paragraph
(c)(5)(i) of this section provides that in determining X's section 179
deduction for 1991, X first computes a hypothetical section 170
deduction by assuming that its section 179 deduction is not affected by
the section 170 deduction. Thus, in computing X's hypothetical section
170 deduction, X's taxable income limitation under section 179 is
$11,000 and its section 179 deduction is $10,000. X's hypothetical
section 170 deduction is $100 (10 percent of $1,000 ($11,000 less
$10,000 section 179 deduction)). X's taxable income limitation for
section 179 purposes is then computed by deducting the hypothetical
charitable contribution of $100 for 1991. Thus, X's section 179 taxable
income limitation is $10,900 ($11,000 less hypothetical $100 section 170
deduction), and its section 179 deduction for 1991 is $10,000. X's
section 179 deduction so calculated applies for all purposes of the
Code, including the computation of its actual section 170 deduction.
(6) Active conduct by the taxpayer of a trade or business--(i) Trade
or business. For purposes of this section and Sec. 1.179-4(a), the term
trade or business has the same meaning as in section 162 and the
regulations thereunder. Thus, property held merely for the production of
income or used in an activity not engaged in for profit (as described in
section 183) does not qualify as section 179 property and taxable income
derived from property held for the production of income or from an
activity not engaged in for profit is not taken into account in
determining the taxable income limitation.
(ii) Active conduct. For purposes of this section, the determination
of whether a trade or business is actively conducted by the taxpayer is
to be made from all the facts and circumstances and is to be applied in
light of the purpose of the active conduct requirement of section
179(b)(3)(A). In the context of section 179, the purpose of the active
conduct requirement is to prevent a passive investor in a trade or
business from deducting section 179 expenses against taxable income
derived from that trade or business. Consistent with this purpose, a
taxpayer generally is considered to actively conduct a trade or business
if the taxpayer meaningfully participates in the management or
operations of the trade or business. Generally, a partner is considered
to actively conduct a trade or business of the partnership if the
partner meaningfully participates in the management or operations of the
trade or business. A mere passive investor in a trade or business does
not actively conduct the trade or business.
(iii) Example. The following example illustrates the provisions of
paragraph (c)(6)(ii) of this section.
Example. A owns a salon as a sole proprietorship and employs B to
operate it. A periodically meets with B to review developments relating
to the business. A also approves the salon's annual budget that is
prepared by B. B performs all the necessary operating functions,
including hiring beauticians, acquiring the necessary beauty supplies,
and writing the checks to pay all bills and the beauticians' salaries.
In 1991, B purchased, as provided for in the salon's annual budget,
equipment costing $9,500 for use in the active conduct of the salon.
There were no other purchases of section 179 property during 1991. A's
net income from the salon, before any section 179 deduction, totaled
$8,000. A also is a partner in PRS, a calendar-year partnership, which
owns a grocery store. C, a partner in PRS, runs the grocery store for
the partnership, making all the management and operating decisions. PRS
did not purchase any section 179 property during 1991. A's allocable
share of partnership net income was $6,000. Based on the facts and
circumstances, A meaningfully participates in the management of the
salon. However, A does not meaningfully participate in the management or
operations of the trade or business of PRS. Under section 179(b)(3)(A)
and this paragraph (c), A's aggregate taxable income derived from the
active conduct by A of any trade or business is $8,000, the net income
from the salon.
(iv) Employees. For purposes of this section, employees are
considered to be engaged in the active conduct of the trade or business
of their employment. Thus, wages, salaries, tips, and other compensation
(not reduced by unreimbursed employee business expenses) derived by a
taxpayer as an employee are included in the aggregate amount of taxable
income of the taxpayer under paragraph (c)(1) of this section.
[[Page 202]]
(7) Joint returns--(i) In general. The taxable income limitation of
this paragraph (c) is applied to a husband and wife who file a joint
income tax return under section 6013(a) by aggregating the taxable
income of each spouse (as determined under paragraph (c)(1) of this
section).
(ii) Joint returns filed after separate returns. In the case of a
husband and wife who elect under section 6013(b) to file a joint income
tax return for a taxable year after the time prescribed by law for
filing the return for such taxable year, the taxable income limitation
of this paragraph (c) for the taxable year for which the joint return is
filed is determined under paragraph (c)(7)(i) of this section.
(8) Married individuals filing separately. In the case of an
individual who is married but files a separate tax return for a taxable
year, the taxable income limitation for that individual is determined
under paragraph (c)(1) of this section by treating the husband and wife
as separate taxpayers.
(d) Examples. The following examples illustrate the provisions of
paragraphs (b) and (c) of this section.
Example 1. (i) During 1991, PRS, a calendar-year partnership,
purchases and places in service $50,000 of section 179 property. The
taxable income of PRS derived from the active conduct of all its trades
or businesses (as determined under paragraph (c)(1) of this section) is
$8,000.
(ii) Under the dollar limitation of paragraph (b) of this section,
PRS may elect to expense $10,000 of the cost of section 179 property
purchased in 1991. Assume PRS elects under section 179(c) and Sec.
1.179-5 to expense $10,000 of the cost of section 179 property purchased
in 1991.
(iii) Under the taxable income limitation of paragraph (c) of this
section, PRS may allocate to its partners as a deduction only $8,000 of
the cost of section 179 property in 1991. Under section 179(b)(3)(B) and
Sec. 1.179-3(a), PRS may carry forward the remaining $2,000 it elected
to expense, which would have been deductible under section 179(a) for
1991 absent the taxable income limitation.
Example 2. (i) The facts are the same as in Example 1, except that
on December 31, 1991, PRS allocates to A, a calendar-year taxpayer and a
partner in PRS, $7,000 of section 179 expenses and $2,000 of taxable
income. A was engaged in the active conduct of a trade or business of
PRS during 1991.
(ii) In addition to being a partner in PRS, A conducts a business as
a sole proprietor. During 1991, A purchases and places in service
$201,000 of section 179 property in connection with the sole
proprietorship. A's 1991 taxable income derived from the active conduct
of this business is $6,000.
(iii) Under the dollar limitation, A may elect to expense only
$9,000 of the cost of section 179 property purchased in 1991, the
$10,000 limit reduced by $1,000 (the amount by which the cost of section
179 property placed in service during 1991 ($201,000) exceeds $200,000).
Under paragraph (b)(3)(i) of this section, the $7,000 of section 179
expenses allocated from PRS is subject to the $9,000 limit. Assume that
A elects to expense $2,000 of the cost of section 179 property purchased
by A's sole proprietorship in 1991. Thus, A has elected to expense under
section 179 an amount equal to the dollar limitation for 1991 ($2,000
elected to be expensed by A's sole proprietorship plus $7,000, the
amount of PRS's section 179 expenses allocated to A in 1991).
(iv) Under the taxable income limitation, A may only deduct $8,000
of the cost of section 179 property elected to be expensed in 1991, the
aggregate taxable income derived from the active conduct of A's trades
or businesses in 1991 ($2,000 from PRS and $6,000 from A's sole
proprietorship). The entire $2,000 of taxable income allocated from PRS
is included by A as taxable income derived from the active conduct by A
of a trade or business because it was derived from the active conduct of
a trade or business by PRS and A was engaged in the active conduct of a
trade or business of PRS during 1991. Under section 179(b)(3)(B) and
Sec. 1.179-3(a), A may carry forward the remaining $1,000 A elected to
expense, which would have been deductible under section 179(a) for 1991
absent the taxable income limitation.
[T.D. 8455, 57 FR 61318, Dec. 24, 1992, as amended by T.D. 9146, 69 FR
46983, Aug. 4, 2004; T.D. 9209, 70 FR 40191, July 13, 2005]
Sec. 1.179-3 Carryover of disallowed deduction.
(a) In general. Under section 179(b)(3)(B), a taxpayer may carry
forward for an unlimited number of years the amount of any cost of
section 179 property elected to be expensed in a taxable year but
disallowed as a deduction in that taxable year because of the taxable
income limitation of section 179(b)(3)(A) and Sec. 1.179-2(c)
(``carryover of disallowed deduction''). This carryover of disallowed
deduction may be deducted under section 179(a) and Sec. 1.179-1(a) in a
future taxable year as provided in paragraph (b) of this section.
[[Page 203]]
(b) Deduction of carryover of disallowed deduction--(1) In general.
The amount allowable as a deduction under section 179(a) and Sec.
1.179-1(a) for any taxable year is increased by the lesser of--
(i) The aggregate amount disallowed under section 179(b)(3)(A) and
Sec. 1.179-2(c) for all prior taxable years (to the extent not
previously allowed as a deduction by reason of this section); or
(ii) The amount of any unused section 179 expense allowance for the
taxable year (as described in paragraph (c) of this section).
(2) Cross references. See paragraph (f) of this section for rules
that apply when a taxpayer disposes of or otherwise transfers section
179 property for which a carryover of disallowed deduction is
outstanding. See paragraph (g) of this section for special rules that
apply to partnerships and S corporations and paragraph (h) of this
section for special rules that apply to partners and S corporation
shareholders.
(c) Unused section 179 expense allowance. The amount of any unused
section 179 expense allowance for a taxable year equals the excess (if
any) of--
(1) The maximum cost of section 179 property that the taxpayer may
deduct under section 179 and Sec. 1.179-1 for the taxable year after
applying the limitations of section 179(b) and Sec. 1.179-2; over
(2) The amount of section 179 property that the taxpayer actually
elected to expense under section 179 and Sec. 1.179-1(a) for the
taxable year.
(d) Example. The following example illustrates the provisions of
paragraphs (b) and (c) of this section.
Example. A, a calendar-year taxpayer, has a $3,000 carryover of
disallowed deduction for an item of section 179 property purchased and
placed in service in 1991. In 1992, A purchases and places in service an
item of section 179 property costing $25,000. A's 1992 taxable income
from the active conduct of all A's trades or businesses is $100,000. A
elects, under section 179(c) and Sec. 1.179-5, to expense $8,000 of the
cost of the item of section 179 property purchased in 1992. Under
paragraph (b) of this section, A may deduct $2,000 of A's carryover of
disallowed deduction from 1991 (the lesser of A's total outstanding
carryover of disallowed deductions ($3,000), or the amount of any unused
section 179 expense allowance for 1992 ($10,000 limit less $8,000
elected to be expensed, or $2,000)). For 1993, A has a $1,000 carryover
of disallowed deduction for the item of section 179 property purchased
and placed in service in 1991.
(e) Recordkeeping requirement and ordering rule. The properties and
the apportionment of cost that will be subject to a carryover of
disallowed deduction are selected by the taxpayer in the year the
properties are placed in service. This selection must be evidenced on
the taxpayer's books and records and be applied consistently in
subsequent years. If no selection is made, the total carryover of
disallowed deduction is apportioned equally over the items of section
179 property elected to be expensed for the taxable year. For this
purpose, the taxpayer treats any section 179 expense amount allocated
from a partnership (or an S corporation) for a taxable year as one item
of section 179 property. If the taxpayer is allowed to deduct a portion
of the total carryover of disallowed deduction under paragraph (b) of
this section, the taxpayer must deduct the cost of section 179 property
carried forward from the earliest taxable year.
(f) Dispositions and other transfers of section 179 property--(1) In
general. Upon a sale or other disposition of section 179 property, or a
transfer of section 179 property in a transaction in which gain or loss
is not recognized in whole or in part (including transfers at death),
immediately before the transfer the adjusted basis of the section 179
property is increased by the amount of any outstanding carryover of
disallowed deduction with respect to the property. This carryover of
disallowed deduction is not available as a deduction to the transferor
or the transferee of the section 179 property.
(2) Recapture under section 179(d)(10). Under Sec. 1.179-1(e), if a
taxpayer's section 179 property is subject to recapture under section
179(d)(10), the taxpayer must recapture the benefit derived from
expensing the property. Upon recapture, any outstanding carryover of
disallowed deduction with respect to the property is no longer available
for expensing. In determining the amount subject to recapture under
section 179(d)(10) and Sec. 1.179-1(e), any outstanding carryover of
disallowed deduction with respect to that property is not treated as an
amount expensed under section 179.
[[Page 204]]
(g) Special rules for partnerships and S corporations--(1) In
general. Under section 179(d)(8) and Sec. 1.179-2(c), the taxable
income limitation applies at the partnership level as well as at the
partner level. Therefore, a partnership may have a carryover of
disallowed deduction with respect to the cost of its section 179
property. Similar rules apply to S corporations. This paragraph (g)
provides special rules that apply when a partnership or an S corporation
has a carryover of disallowed deduction.
(2) Basis adjustment. Under Sec. 1.179-1(f)(2), the basis of a
partnership's section 179 property must be reduced to reflect the amount
of section 179 expense elected by the partnership. This reduction must
be made for the taxable year for which the election is made even if the
section 179 expense amount, or a portion thereof, must be carried
forward by the partnership. Similar rules apply to S corporations.
(3) Dispositions and other transfers of section 179 property by a
partnership or an S corporation. The provisions of paragraph (f) of this
section apply in determining the treatment of any outstanding carryover
of disallowed deduction with respect to section 179 property disposed
of, or transferred in a nonrecognition transaction, by a partnership or
an S corporation.
(4) Example. The following example illustrates the provisions of
this paragraph (g).
Example. ABC, a calendar-year partnership, owns and operates a
restaurant business. During 1992, ABC purchases and places in service
two items of section 179 property--a cash register costing $4,000 and
office furniture costing $6,000. ABC elects to expense under section
179(c) the full cost of the cash register and the office furniture. For
1992, ABC has $6,000 of taxable income derived from the active conduct
of its restaurant business. Therefore, ABC may deduct only $6,000 of
section 179 expenses and must carry forward the remaining $4,000 of
section 179 expenses at the partnership level. ABC must reduce the
adjusted basis of the section 179 property by the full amount elected to
be expensed. However, ABC may not allocate to its partners any portion
of the carryover of disallowed deduction until ABC is able to deduct it
under paragraph (b) of this section.
(h) Special rules for partners and S corporation shareholders--(1)
In general. Under section 179(d)(8) and Sec. 1.179-2(c), a partner may
have a carryover of disallowed deduction with respect to the cost of
section 179 property elected to be expensed by the partnership and
allocated to the partner. A partner who is allocated section 179
expenses from a partnership must reduce the basis of his or her
partnership interest by the full amount allocated regardless of whether
the partner may deduct for the taxable year the allocated section 179
expenses or is required to carry forward all or a portion of the
expenses. Similar rules apply to S corporation shareholders.
(2) Dispositions and other transfers of a partner's interest in a
partnership or a shareholder's interest in an S corporation. A partner
who disposes of a partnership interest, or transfers a partnership
interest in a transaction in which gain or loss is not recognized in
whole or in part (including transfers of a partnership interest at
death), may have an outstanding carryover of disallowed deduction of
section 179 expenses allocated from the partnership. In such a case,
immediately before the transfer the partner's basis in the partnership
interest is increased by the amount of the partner's outstanding
carryover of disallowed deduction with respect to the partnership
interest. This carryover of disallowed deduction is not available as a
deduction to the transferor or transferee partner of the section 179
property. Similar rules apply to S corporation shareholders.
(3) Examples. The following examples illustrate the provisions of
this paragraph (h).
Example 1. (i) G is a general partner in GD, a calendar-year
partnership, and is engaged in the active conduct of GD's business.
During 1991, GD purchases and places section 179 property in service and
elects to expense a portion of the cost of the property under section
179. GD allocates $2,500 of section 179 expenses and $15,000 of taxable
income (determined without regard to the section 179 deduction) to G.
The income was derived from the active conduct by GD of a trade or
business.
(ii) In addition to being a partner in GD, G conducts a business as
a sole proprietor. During 1991, G purchases and places in service office
equipment costing $25,000 and a computer costing $10,000 in connection
with the sole proprietorship. G elects under section 179(c) and Sec.
1.179-5 to expense $7,500 of the cost of the office equipment. G has a
taxable
[[Page 205]]
loss (determined without regard to the section 179 deduction) derived
from the active conduct of this business of $12,500.
(iii) G has no other taxable income (or loss) derived from the
active conduct of a trade or business during 1991. G's taxable income
limitation for 1991 is $2,500 ($15,000 taxable income allocated from GD
less $12,500 taxable loss from the sole proprietorship). Therefore, G
may deduct during 1991 only $2,500 of the $10,000 of section 179
expenses. G notes on the appropriate books and records that G expenses
the $2,500 of section 179 expenses allocated from GD and carries forward
the $7,500 of section 179 expenses with respect to the office equipment
purchased by G's sole proprietorship.
(iv) On January 1, 1992, G sells the office equipment G's sole
proprietorship purchased and placed in service in 1991. Under paragraph
(f) of this section, immediately before the sale G increases the
adjusted basis of the office equipment by $7,500, the amount of the
outstanding carryover of disallowed deduction with respect to the office
equipment.
Example 2. (i) Assume the same facts as in Example 1, except that G
notes on the appropriate books and records that G expenses $2,500 of
section 179 expenses relating to G's sole proprietorship and carries
forward the remaining $5,000 of section 179 expenses relating to G's
sole proprietorship and $2,500 of section 179 expenses allocated from
GD.
(ii) On January 1, 1992, G sells G's partnership interest to A.
Under paragraph (h)(2) of this section, immediately before the sale G
increases the adjusted basis of G's partnership interest by $2,500, the
amount of the outstanding carryover of disallowed deduction with respect
to the partnership interest.
[T.D. 8455, 57 FR 61321, Dec. 24, 1992]
Sec. 1.179-4 Definitions.
The following definitions apply for purposes of section 179 and
Sec. Sec. 1.179-1 through 1.179-6:
(a) Section 179 property. The term section 179 property means any
tangible property described in section 179(d)(1) that is acquired by
purchase for use in the active conduct of the taxpayer's trade or
business (as described in Sec. 1.179-2(c)(6)). For taxable years
beginning after 2002 and before 2008, the term section 179 property
includes computer software described in section 179(d)(1) that is placed
in service by the taxpayer in a taxable year beginning after 2002 and
before 2008 and is acquired by purchase for use in the active conduct of
the taxpayer's trade or business (as described in 1.179-2(c)(6)). For
purposes of this paragraph (a), the term trade or business has the same
meaning as in section 162 and the regulations under section 162.
(b) Section 38 property. The term section 38 property shall have the
same meaning assigned to it in section 48(a) and the regulations
thereunder.
(c) Purchase. (1)(i) Except as otherwise provided in paragraph
(d)(2) of this section, the term purchase means any acquisition of the
property, but only if all the requirements of paragraphs (c)(1) (ii),
(iii), and (iv) of this section are satisfied.
(ii) Property is not acquired by purchase if it 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). The property is
considered not acquired by purchase only to the extent that losses would
be disallowed under section 267 or 707(b). Thus, for example, if
property is purchased by a husband and wife jointly from the husband's
father, the property will be treated as not acquired by purchase only to
the extent of the husband's interest in the property. However, in
applying the rules of section 267 (b) and (c) for this purpose, section
267(c)(4) shall be treated as providing that the family of an individual
will include only his spouse, ancestors, and lineal descendants. For
example, a purchase of property from a corporation by a taxpayer who
owns, directly or indirectly, more than 50 percent in value of the
outstanding stock of such corporation does not qualify as a purchase
under section 179(d)(2); nor does the purchase of property by a husband
from his wife. However, the purchase of section 179 property by a
taxpayer from his brother or sister does qualify as a purchase for
purposes of section 179(d)(2).
(iii) The property is not acquired by purchase if acquired from a
component member of a controlled group of corporations (as defined in
paragraph (g) of this section) by another component member of the same
group.
(iv) The property is not acquired by purchase if the basis of the
property in the hands of the person acquiring it is determined in whole
or in part by reference to the adjusted basis of such property in the
hands of the person
[[Page 206]]
from whom acquired, is determined under section 1014(a), relating to
property acquired from a decedent, or is determined under section 1022,
relating to property acquired from certain decedents who died in 2010.
For example, property acquired by gift or bequest does not qualify as
property acquired by purchase for purposes of section 179(d)(2); nor
does property received in a corporate distribution the basis of which is
determined under section 301(d)(2)(B), property acquired by a
corporation in a transaction to which section 351 applies, property
acquired by a partnership through contribution (section 723), or
property received in a partnership distribution which has a carryover
basis under section 732(a)(1).
(2) Property deemed to have been acquired by a new target
corporation as a result of a section 338 election (relating to certain
stock purchases treated as asset acquisitions) or a section 336(e)
election (relating to certain stock dispositions treated as asset
transfers) made for a disposition described in Sec. 1.336-2(b)(1) will
be considered acquired by purchase.
(d) Cost. The cost of section 179 property does not include so much
of the basis of such property as is determined by reference to the basis
of other property held at any time by the taxpayer. For example, X
Corporation purchases a new drill press costing $10,000 in November 1984
which qualifies as section 179 property, and is granted a trade-in
allowance of $2,000 on its old drill press. The old drill press had a
basis of $1,200. Under the provisions of sections 1012 and 1031(d), the
basis of the new drill press is $9,200 ($1,200 basis of oil drill press
plus cash expended of $8,000). However, only $8,000 of the basis of the
new drill press qualifies as cost for purposes of the section 179
expense deduction; the remaining $1,200 is not part of the cost because
it is determined by reference to the basis of the old drill press.
(e) Placed in service. The term placed in service means the time
that property is first placed by the taxpayer in a condition or state of
readiness and availability for a specifically assigned function, whether
for use in a trade or business, for the production of income, in a tax-
exempt activity, or in a personal activity. See Sec. 1.46-3(d)(2) for
examples regarding when property shall be considered in a condition or
state of readiness and availability for a specifically assigned
function.
(f) Controlled group of corporations and component member of
controlled group. 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).
[T.D. 8121, 52 FR 413, Jan. 6, 1987. Redesignated by T.D. 8455, 57 FR
61321, 61323, Dec. 24, 1992, as amended by T.D. 9146, 69 FR 46984, Aug.
4, 2004; T.D. 9209, 70 FR 40191, July 13, 2005; T.D. 9811, 82 FR 6236,
Jan. 19, 2016; T.D. 9874, 84 FR 50149, Sept. 24, 2019]
Sec. 1.179-5 Time and manner of making election.
(a) Election. A separate election must be made for each taxable year
in which a section 179 expense deduction is claimed with respect to
section 179 property. The election under section 179 and Sec. 1.179-1
to claim a section 179 expense deduction for section 179 property shall
be made on the taxpayer's first income tax return for the taxable year
to which the election applies (whether or not the return is timely) or
on an amended return filed within the time prescribed by law (including
extensions) for filing the return for such taxable year. The election
shall be made by showing as a separate item on the taxpayer's income tax
return the following items:
(1) The total section 179 expense deduction claimed with respect to
all section 179 property selected, and
(2) The portion of that deduction allocable to each specific item.
The person shall maintain records which permit specific identification
of each piece of section 179 property and reflect how and from whom such
property was acquired and when such property was placed in service.
However, for this purpose a partner (or an S corporation shareholder)
treats partnership (or S corporation) section 179 property for
[[Page 207]]
which section 179 expenses are allocated from a partnership (or an S
corporation) as one item of section 179 property. The election to claim
a section 179 expense deduction under this section, with respect to any
property, is irrevocable and will be binding on the taxpayer with
respect to such property for the taxable year for which the election is
made and for all subsequent taxable years, unless the Commissioner
consents to the revocation of the election. Similarly, the selection of
section 179 property by the taxpayer to be subject to the expense
deduction and apportionment scheme must be adhered to in computing the
taxpayer's taxable income for the taxable year for which the election is
made and for all subsequent taxable years, unless consent to change is
given by the Commissioner.
(b) Revocation. Any election made under section 179, and any
specification contained in such election, may not be revoked except with
the consent of the Commissioner. Such consent will be granted only in
extraordinary circumstances. Requests for consent must be filed with the
Commissioner of Internal Revenue, Washington, DC 20224. The request must
include the name, address, and taxpayer identification number of the
taxpayer and must be signed by the taxpayer or his duly authorized
representative. It must be accompanied by a statement showing the year
and property involved, and must set forth in detail the reasons for the
request.
(c) Section 179 property placed in service by the taxpayer in a
taxable year beginning after 2002 and before 2008--(1) In general. For
any taxable year beginning after 2002 and before 2008, a taxpayer is
permitted to make or revoke an election under section 179 without the
consent of the Commissioner on an amended Federal tax return for that
taxable year. This amended return must be filed within the time
prescribed by law for filing an amended return for such taxable year.
(2) Election--(i) In general. For any taxable year beginning after
2002 and before 2008, a taxpayer is permitted to make an election under
section 179 on an amended Federal tax return for that taxable year
without the consent of the Commissioner. Thus, the election under
section 179 and Sec. 1.179-1 to claim a section 179 expense deduction
for section 179 property may be made on an amended Federal tax return
for the taxable year to which the election applies. The amended Federal
tax return must include the adjustment to taxable income for the section
179 election and any collateral adjustments to taxable income or to the
tax liability (for example, the amount of depreciation allowed or
allowable in that taxable year for the item of section 179 property to
which the election pertains). Such adjustments must also be made on
amended Federal tax returns for any affected succeeding taxable years.
(ii) Specifications of elections. Any election under section 179
must specify the items of section 179 property and the portion of the
cost of each such item to be taken into account under section 179(a).
Any election under section 179 must comply with the specification
requirements of section 179(c)(1)(A), Sec. 1.179-1(b), and Sec. 1.179-
5(a). If a taxpayer elects to expense only a portion of the cost basis
of an item of section 179 property for a taxable year beginning after
2002 and before 2008 (or did not elect to expense any portion of the
cost basis of the item of section 179 property), the taxpayer is
permitted to file an amended Federal tax return for that particular
taxable year and increase the portion of the cost of the item of section
179 property to be taken into account under section 179(a) (or elect to
expense any portion of the cost basis of the item of section 179
property if no prior election was made) without the consent of the
Commissioner. Any such increase in the amount expensed under section 179
is not deemed to be a revocation of the prior election for that
particular taxable year.
(3) Revocation--(i) In general. Section 179(c)(2) permits the
revocation of an entire election or specification, or a portion of the
selected dollar amount of a specification. The term specification in
section 179(c)(2) refers to both the selected specific item of section
179 property subject to a section 179 election and the selected dollar
amount allocable to the specific item of section 179 property. Any
portion of the cost basis of an item of section 179 property subject to
an election under section 179
[[Page 208]]
for a taxable year beginning after 2002 and before 2008 may be revoked
by the taxpayer without the consent of the Commissioner by filing an
amended Federal tax return for that particular taxable year. The amended
Federal tax return must include the adjustment to taxable income for the
section 179 revocation and any collateral adjustments to taxable income
or to the tax liability (for example, allowable depreciation in that
taxable year for the item of section 179 property to which the
revocation pertains). Such adjustments must also be made on amended
Federal tax returns for any affected succeeding taxable years. Reducing
or eliminating a specified dollar amount for any item of section 179
property with respect to any taxable year beginning after 2002 and
before 2008 results in a revocation of that specified dollar amount.
(ii) Effect of revocation. Such revocation, once made, shall be
irrevocable. If the selected dollar amount reflects the entire cost of
the item of section 179 property subject to the section 179 election, a
revocation of the entire selected dollar amount is treated as a
revocation of the section 179 election for that item of section 179
property and the taxpayer is unable to make a new section 179 election
with respect to that item of property. If the selected dollar amount is
a portion of the cost of the item of section 179 property, revocation of
a selected dollar amount shall be treated as a revocation of only that
selected dollar amount. The revoked dollars cannot be the subject of a
new section 179 election for the same item of property.
(4) Examples. The following examples illustrate the rules of this
paragraph (c):
Example 1. Taxpayer, a sole proprietor, owns and operates a jewelry
store. During 2003, Taxpayer purchased and placed in service two items
of section 179 property--a cash register costing $4,000 (5-year MACRS
property) and office furniture costing $10,000 (7-year MACRS property).
On his 2003 Federal tax return filed on April 15, 2004, Taxpayer elected
to expense under section 179 the full cost of the cash register and,
with respect to the office furniture, claimed the depreciation
allowable. In November 2004, Taxpayer determines it would have been more
advantageous to have made an election under section 179 to expense the
full cost of the office furniture rather than the cash register.
Pursuant to paragraph (c)(1) of this section, Taxpayer is permitted to
file an amended Federal tax return for 2003 revoking the section 179
election for the cash register, claiming the depreciation allowable in
2003 for the cash register, and making an election to expense under
section 179 the cost of the office furniture. The amended return must
include an adjustment for the depreciation previously claimed in 2003
for the office furniture, an adjustment for the depreciation allowable
in 2003 for the cash register, and any other collateral adjustments to
taxable income or to the tax liability. In addition, once Taxpayer
revokes the section 179 election for the entire cost basis of the cash
register, Taxpayer can no longer expense under section 179 any portion
of the cost of the cash register.
Example 2. Taxpayer, a sole proprietor, owns and operates a machine
shop that does specialized repair work on industrial equipment. During
2003, Taxpayer purchased and placed in service one item of section 179
property--a milling machine costing $135,000. On Taxpayer's 2003 Federal
tax return filed on April 15, 2004, Taxpayer elected to expense under
section 179 $5,000 of the cost of the milling machine and claimed
allowable depreciation on the remaining cost. Subsequently, Taxpayer
determines it would have been to Taxpayer's advantage to have elected to
expense $100,000 of the cost of the milling machine on Taxpayer's 2003
Federal tax return. In November 2004, Taxpayer files an amended Federal
tax return for 2003, increasing the amount of the cost of the milling
machine that is to be taken into account under section 179(a) to
$100,000, decreasing the depreciation allowable in 2003 for the milling
machine, and making any other collateral adjustments to taxable income
or to the tax liability. Pursuant to paragraph (c)(2)(ii) of this
section, increasing the amount of the cost of the milling machine to be
taken into account under section 179(a) supplements the portion of the
cost of the milling machine that was already taken into account by the
original section 179 election made on the 2003 Federal tax return and no
revocation of any specification with respect to the milling machine has
occurred.
Example 3. Taxpayer, a sole proprietor, owns and operates a real
estate brokerage business located in a rented storefront office. During
2003, Taxpayer purchases and places in service two items of section 179
property--a laptop computer costing $2,500 and a desktop computer
costing $1,500. On Taxpayer's 2003 Federal tax return filed on April 15,
2004, Taxpayer elected to expense under section 179 the full cost of the
laptop computer and the full cost of the desktop computer. Subsequently,
Taxpayer determines it would have been to Taxpayer's advantage to have
originally elected to expense under section 179 only $1,500 of the cost
of the laptop computer
[[Page 209]]
on Taxpayer's 2003 Federal tax return. In November 2004, Taxpayer files
an amended Federal tax return for 2003 reducing the amount of the cost
of the laptop computer that was taken into account under section 179(a)
to $1,500, claiming the depreciation allowable in 2003 on the remaining
cost of $1,000 for that item, and making any other collateral
adjustments to taxable income or to the tax liability. Pursuant to
paragraph (c)(3)(ii) of this section, the $1,000 reduction represents a
revocation of a portion of the selected dollar amount and no portion of
those revoked dollars may be the subject of a new section 179 election
for the laptop computer.
Example 4. Taxpayer, a sole proprietor, owns and operates a
furniture making business. During 2003, Taxpayer purchases and places in
service one item of section 179 property--an industrial-grade cabinet
table saw costing $5,000. On Taxpayer's 2003 Federal tax return filed on
April 15, 2004, Taxpayer elected to expense under section 179 $3,000 of
the cost of the saw and, with respect to the remaining $2,000 of the
cost of the saw, claimed the depreciation allowable. In November 2004,
Taxpayer files an amended Federal tax return for 2003 revoking the
selected $3,000 amount for the saw, claiming the depreciation allowable
in 2003 on the $3,000 cost of the saw, and making any other collateral
adjustments to taxable income or to the tax liability. Subsequently, in
December 2004, Taxpayer files a second amended Federal tax return for
2003 selecting a new dollar amount of $2,000 for the saw, including an
adjustment for the depreciation previously claimed in 2003 on the
$2,000, and making any other collateral adjustments to taxable income or
to the tax liability. Pursuant to paragraph (c)(2)(ii) of this section,
Taxpayer is permitted to select a new selected dollar amount to expense
under section 179 encompassing all or a part of the initially non-
elected portion of the cost of the elected item of section 179 property.
However, no portion of the revoked $3,000 may be the subject of a new
section 179 dollar amount selection for the saw. In December 2005,
Taxpayer files a third amended Federal tax return for 2003 revoking the
entire selected $2,000 amount with respect to the saw, claiming the
depreciation allowable in 2003 for the $2,000, and making any other
collateral adjustments to taxable income or to the tax liability.
Because Taxpayer elected to expense, and subsequently revoke, the entire
cost basis of the saw, the section 179 election for the saw has been
revoked and Taxpayer is unable to make a new section 179 election with
respect to the saw.
(d) Election or revocation must not be made in any other manner. Any
election or revocation specified in this section must be made in the
manner prescribed in paragraphs (a), (b), and (c) of this section. Thus,
this election or revocation must not be made by the taxpayer in any
other manner (for example, an election or a revocation of an election
cannot be made through a request under section 446(e) to change the
taxpayer's method of accounting), except as otherwise expressly provided
by the Internal Revenue Code, the regulations under the Code, or other
guidance published in the Internal Revenue Bulletin.
[T.D. 8121, 52 FR 414, Jan. 6, 1987. Redesignated by T.D. 8455, 57 FR
61321, 61323, Dec. 24, 1992, as amended by T.D. 9146, 69 FR 46984, Aug.
4, 2004; T.D. 9209, 70 FR 40191, July 13, 2005]
Sec. 1.179-6 Effective/applicability dates.
(a) In general. Except as provided in paragraphs (b), (c), (d), and
(e) of this section, the provisions of Sec. Sec. 1.179-1 through 1.179-
5 apply for property placed in service by the taxpayer in taxable years
ending after January 25, 1993. However, a taxpayer may apply the
provisions of Sec. Sec. 1.179-1 through 1.179-5 to property placed in
service by the taxpayer after December 31, 1986, in taxable years ending
on or before January 25, 1993. Otherwise, for property placed in service
by the taxpayer after December 31, 1986, in taxable years ending on or
before January 25, 1993, the final regulations under section 179 as in
effect for the year the property was placed in service apply, except to
the extent modified by the changes made to section 179 by the Tax Reform
Act of 1986 (100 Stat. 2085), the Technical and Miscellaneous Revenue
Act of 1988 (102 Stat. 3342) and the Revenue Reconciliation Act of 1990
(104 Stat. 1388-400). For that property, a taxpayer may apply any
reasonable method that clearly reflects income in applying the changes
to section 179, provided the taxpayer consistently applies the method to
the property.
(b) Section 179 property placed in service by the taxpayer in a
taxable year beginning after 2002 and before 2008. The provisions of
Sec. 1.179-2(b)(1) and (b)(2)(ii), the second sentence of Sec. 1.179-
4(a), and the provisions of Sec. 1.179-5(c), reflecting changes made to
section 179 by the Jobs and Growth Tax Relief Reconciliation Act of 2003
(117 Stat. 752) and the American Jobs Creation Act of 2004 (118
[[Page 210]]
Stat. 1418), apply for property placed in service in taxable years
beginning after 2002 and before 2008.
(c) Application of Sec. 1.179-5(d). Section 1.179-5(d) applies on
or after July 12, 2005.
(d) Application of Sec. 1.179-4(c)(1)(iv). The provisions of Sec.
1.179-4(c)(1)(iv) relating to section 1022 are effective on and after
January 19, 2017.
(e) Application of Sec. 1.179-4(c)(2)-(1) In general. Except as
provided in paragraphs (e)(2) and (3) of this section, the provisions of
Sec. 1.179-4(c)(2) relating to section 336(e) are applicable on or
after September 24, 2019.
(2) Early application of Sec. 1.179-4(c)(2). A taxpayer may choose
to apply the provisions of Sec. 1.179-4(c)(2) relating to section
336(e) for the taxpayer's taxable years ending on or after September 28,
2017.
(3) Early application of regulation project REG-104397-18. A
taxpayer may rely on the provisions of Sec. 1.179-4(c)(2) relating to
section 336(e) in regulation project REG-104397-18 (2018-41 I.R.B. 558)
(see Sec. 601.601(d)(2)(ii)(b) of this chapter) for the taxpayer's
taxable years ending on or after September 28, 2017, and ending before
September 24, 2019.
[T.D. 9146, 69 FR 46985, Aug. 4, 2004. Redesignated and amended by T.D.
9209, 70 FR 40192, July 13, 2005; T.D. 9811, 82 FR 6236, Jan. 19, 2017;
T.D. 9874, 84 FR 50149, Sept. 24, 2019]
Sec. 1.179A-1 [Reserved]
Sec. 1.179B-1T Deduction for capital costs incurred in complying
with Environmental Protection Agency sulfur regulations (temporary).
(a) Scope and definitions--(1) Scope. This section provides the
rules for determining the amount of the deduction allowable under
section 179B(a) for qualified capital costs paid or incurred by a small
business refiner to comply with the highway diesel fuel sulfur control
requirements of the Environmental Protection Agency (EPA). This section
also provides rules for making elections under section 179B.
(2) Definitions. For purposes of section 179B and this section, the
following definitions apply:
(i) The applicable EPA regulations are the EPA regulations
establishing the highway diesel fuel sulfur control program (40 CFR part
80, subpart I).
(ii) The average daily domestic refinery run for a refinery is the
lesser of--
(A) The total amount of crude oil input (in barrels) to the
refinery's domestic processing units during the 1-year period ending on
December 31, 2002, divided by 365; or
(B) The total amount of refined petroleum product (in barrels)
produced by the refinery's domestic processing units during such 1-year
period divided by 365.
(iii) The aggregate average domestic daily refinery run for a
refiner is the sum of the average daily domestic refinery runs for all
refineries that were owned by the refiner or a related person on April
1, 2003.
(iv) Cooperative owner is a person that--
(A) Directly holds an ownership interest in a cooperative small
business refiner, as defined in paragraph (a)(2)(v) of this section; and
(B) Is a cooperative to which part 1 of subchapter T of the Internal
Revenue Code (Code) applies.
(v) Cooperative small business refiner is a small business refiner
that is a cooperative to which part 1 of subchapter T of the Code
applies.
(vi) Low sulfur diesel fuel has the meaning prescribed in section
45H(c)(5).
(vii) Qualified capital costs are qualified costs as defined in
section 45H(c)(2) that are properly chargeable to capital account.
(viii) Related person has the meaning prescribed in section
613A(d)(3) and the regulations under section 613A(d)(3).
(ix) Small business refiner has the meaning prescribed in section
45H(c)(1).
(b) Section 179B deduction--(1) In general. Section 179B(a) allows a
deduction with respect to the qualified capital costs paid or incurred
by a small business refiner (the section 179B deduction). The deduction
is allowable with respect to the qualified capital costs paid or
incurred during a taxable year only if the small business refiner makes
an election under paragraph (d) of this section for the taxable year.
The certification requirement in section 45H(e) (relating to the
certification required to support a credit under section 45H) does not
apply for
[[Page 211]]
purposes of the section 179B deduction. Accordingly, the section 179B
deduction is allowable with respect to the qualified capital costs of an
electing small business refiner even if the refiner never obtains a
certification under section 45H(e) with respect to those costs.
(2) Computation of section 179B deduction--(i) In general. Except as
provided in paragraphs (b)(2)(ii) and (c)(3) of this section, a small
business refiner that makes an election under paragraph (d) of this
section for a taxable year is allowed a section 179B deduction in an
amount equal to 75 percent of qualified capital costs that are paid or
incurred by the small business refiner during the taxable year.
(ii) Reduced percentage. A small business refiner's section 179B
deduction is reduced if the refiner's aggregate average daily domestic
refinery run is in excess of 155,000 barrels. In that case, the number
of percentage points used in computing the deduction under paragraph
(b)(2)(i) of this section (75) is reduced (not below zero) by the
product of 75 and the ratio of the excess barrels to 50,000 barrels.
(3) Example. The application of this paragraph (b) is illustrated by
the following example:
Example. (i) A, an accrual method taxpayer, is a small business
refiner with a taxable year ending December 31. On April 1, 2003, A owns
a refinery with an average daily domestic refinery run (that is, an
average daily run during calendar year 2002) of 100,000 barrels and a
person related to A owns a refinery with an average daily domestic
refinery run of 85,000 barrels. These are the only domestic refineries
owned by A and persons related to A. A's aggregate average daily
domestic refinery run for the two refineries is 185,000 barrels. A
incurs qualified capital costs of $10 million in the taxable year ended
December 31, 2007. The costs are incurred with respect to property that
is placed in service in year 2008. A makes the election under paragraph
(d) of this section for the 2007 taxable year.
(ii) Because A's aggregate average daily domestic refinery run is
185,000 barrels, the percentage of the qualified capital costs that is
deductible under section 179B(a) is reduced from 75 percent to 30
percent (75 percent reduced by 75 percent multiplied by 0.6 ((185,000
barrels minus 155,000 barrels)/50,000 barrels)). Thus, for 2007, A's
deduction under section 179B(a) is $3,000,000 ($10,000,000 qualified
capital costs multiplied by .30).
(c) Effect on basis--(1) In general. If qualified capital costs are
included in the basis of property, the basis of the property is reduced
by the amount of the section 179B deduction allowed with respect to such
costs.
(2) Treatment as depreciation. If qualified capital costs are
included in the basis of depreciable property, the amount of the section
179B deduction allowed with respect to such costs is treated as a
depreciation deduction for purposes of section 1245.
(d) Election to deduct qualified capital costs--(1) In general--(i)
Section 179B election. This paragraph (d) prescribes rules for the
election to deduct the qualified capital costs paid or incurred by a
small business refiner during a taxable year (the section 179B
election). A small business refiner making the section 179B election for
a taxable year consents to, and agrees to apply, all of the provisions
of section 179B and this section to qualified capital costs paid or
incurred by the refiner during the taxable year. The section 179B
election for a taxable year applies with respect to all qualified
capital costs paid or incurred by the small business refiner during that
taxable year.
(ii) Year-by-year election. A separate section 179B election must be
made for each taxable year in which the taxpayer seeks to deduct
qualified capital costs under section 179B. A small business refiner may
make the section 179B election for some taxable years and not for other
taxable years.
(iii) Elections for cooperative small business refiners. See
paragraph (e) of this section for the rules applicable to the election
provided under section 179B(e), relating to the election to allocate the
section 179B deduction to cooperative owners of a cooperative small
business refiner (the section 179B(e) election).
(2) Time and manner for making section 179B election--(i) Time for
making election. Except as provided in paragraph (d)(2)(iii) of this
section, a taxpayer's section 179B election for a taxable year must be
made by the due date (including extensions) for filing the taxpayer's
Federal income tax return for the taxable year.
[[Page 212]]
(ii) Manner of making election--(A) In general. Except as provided
in paragraph (d)(2)(iii) of this section, the section 179B election for
a taxable year is made by claiming a section 179B deduction on the
taxpayer's original Federal income tax return for the taxable year and
attaching the statement described in paragraph (d)(2)(ii)(B) of this
section to the return. The section 179B election with respect to
qualified capital costs paid or incurred by a partnership is made by the
partnership and the section 179B election with respect to qualified
capital costs paid or incurred by an S corporation is made by the S
corporation. In the case of qualified capital costs paid or incurred by
the members of a consolidated group (within the meaning of Sec. 1.1502-
1(h)), the section 179B election with respect to such costs is made for
each member by the common parent of the group.
(B) Information required in election statement. The election
statement attached to the taxpayer's return must contain the following
information:
(1) The name and identification number of the small business
refiner.
(2) The amount of the qualified capital costs paid or incurred
during the taxable year for which the election is made.
(3) The aggregate average daily domestic refinery run (as determined
under paragraph (a)(2)(iii) of this section).
(4) The date by which the small business refiner must comply with
the applicable EPA regulations. If this date is not June 1, 2006, the
statement also must explain why compliance is not required by June 1,
2006.
(5) The calculation of the section 179B deduction for the taxable
year.
(6) For each property that will have its basis reduced on account of
the section 179B deduction for the taxable year, a description of the
property, the amount included in the basis of the property on account of
qualified capital costs paid or incurred during the taxable year, and
the amount of the basis reduction to that property on account of the
section 179B deduction for the taxable year.
(iii) Except as otherwise expressly provided by the Code, the
regulations under the Code, or other guidance published in the Internal
Revenue Bulletin, a section 179B election is valid only if made at the
time and in the manner prescribed in this paragraph (d)(2). For example,
except as otherwise expressly provided, the 179B election cannot be made
for a taxable year to which this section applies through a request under
section 446(e) to change the taxpayer's method of accounting.
(3) Revocation of election. An election made under this paragraph
(d) may not be revoked without the prior written consent of the
Commissioner of Internal Revenue. To seek the Commissioner's consent,
the taxpayer must submit a request for a private letter ruling (for
further guidance, see, for example, Rev. Proc. 2008-1 (2008-1 IRB 1) and
Sec. 601.601(d)(2)(ii)(b) of this chapter).
(4) Failure to make election. If a small business refiner does not
make the section 179B election for a taxable year at the time and in the
manner prescribed in paragraph (d)(2) of this section, no deduction is
allowed for the qualified capital costs that the refiner paid or
incurred during the year. Instead these qualified capital costs are
chargeable to a capital account in that taxable year, the basis of the
property to which these costs are capitalized is not reduced on account
of section 179B, and the amount of depreciation allowable for the
property attributable to these costs is determined by reference to these
costs unreduced by section 179B.
(5) Elections for taxable years ending before June 26, 2008. This
section does not apply to section 179B elections for taxable years
ending before June 26, 2008. The rules for making the section 179B
election for a taxable year ending before June 26, 2008 are provided in
Notice 2006-47 (2006-20 IRB 892). See Sec. 601.601(d)(2)(ii)(b) of this
chapter.
(e) Election under section 179B(e) to allocate section 179B
deduction to cooperative owners--(1) In general. A cooperative small
business refiner may elect to allocate part or all of its cooperative
owners' ratable shares of the section 179B deduction for a taxable year
to the cooperative owners (the section 179B(e) election). The section
179B deduction allocated to a cooperative owner is equal to the
cooperative owner's ratable share of the total section
[[Page 213]]
179B deduction allocated. A cooperative owner's ratable share is
determined for this purpose on the basis of the cooperative owner's
ownership interest in the cooperative small business refiner during the
cooperative small business refiner's taxable year. If the cooperative
owners' interests vary during the year, the cooperative small business
refiner shall determine the owners' ratable shares under a consistently
applied method that reasonably takes into account the owners' varying
interests during the taxable year.
(2) Cooperative small business refiner denied section 1382 deduction
for allocated portion. In computing taxable income under section 1382, a
cooperative small business refiner must reduce its section 179B
deduction for the taxable year by an amount equal to the section 179B
deduction allocated under this paragraph (e) to the refiner's
cooperative owners for the taxable year.
(3) Time and manner for making election--(i) Time for making
election. The section 179B(e) election for a taxable year must be made
by the due date (including extensions) for filing the cooperative small
business refiner's Federal income tax return for the taxable year.
(ii) Manner of making election. The section 179B(e) election for a
taxable year is made by attaching a statement to the cooperative small
business refiner's Federal income tax return for the taxable year. The
election statement must contain the following information:
(A) The name and identification number of the cooperative small
business refiner.
(B) The amount of the section 179B deduction allowable to the
cooperative small business refiner for the taxable year (determined
before the application of section 179B(e) and this paragraph (e)).
(C) The name and identification number of each cooperative owner to
which the cooperative small business refiner is allocating all or some
of the section 179B deduction.
(D) The amount of the section 179B deduction that is allocated to
each cooperative owner listed in response to paragraph (e)(3)(ii)(C) of
this section.
(4) Irrevocable election. A section 179B(e) election for a taxable
year, once made, is irrevocable for that taxable year.
(5) Written notice to owners. A cooperative small business refiner
that makes a section 179B(e) election for a taxable year must notify
each cooperative owner of the amount of the section 179B deduction that
is allocated to that cooperative owner. This notification must be
provided in a written notice that is mailed by the cooperative small
business refiner to its cooperative owner before the due date (including
extensions) of the cooperative small business refiner's Federal income
tax return for the election year. In addition, the cooperative small
business refiner must report the amount of the cooperative owner's
section 179B deduction on Form 1099-PATR, ``Taxable Distributions
Received From Cooperatives,'' issued to the cooperative owner. If Form
1099-PATR is revised or renumbered, the amount of the cooperative
owner's section 179B deduction must be reported on the revised or
renumbered form.
(f) Effective/applicability date--(1) In general. This section
applies to taxable years ending on or after June 26, 2008.
(2) Application to taxable years ending before June 26, 2008. A
small business refiner may apply this section to a taxable year ending
before June 26, 2008, provided that the small business refiner applies
all provisions in this section, with the modifications described in
paragraph (f)(3) of this section, to the taxable year.
(3) Modifications applicable to taxable years ending before June 26,
2008. The following modifications to the rules of this section apply to
a small business refiner that applies those rules to a taxable year
ending before June 26, 2008:
(i) Rules relating to section 179B election. The section 179B
election for a taxable year ending before June 26, 2008 may be made
under the rules provided in Notice 2006-47, rather than under the rules
set forth in paragraph (d) of this section.
(ii) Rules relating to section 179B(e) election. A section 179B(e)
election for a taxable year ending before June 26, 2008
[[Page 214]]
will be treated as satisfying the requirements of paragraph (f) if the
cooperative small business refiner has calculated its tax liability in a
manner consistent with the election and has used any reasonable method
consistent with the principles of section 179B(e) to inform the Internal
Revenue Service that an election has been made under section 179B(e) and
to inform cooperative owners of the amount of the section 179B deduction
they have been allocated.
(4) Expiration date. The applicability of Sec. 179B-1T expires on
June 24, 2011.
[T.D. 9404, 73 FR 36422, June 27, 2008]
Sec. 1.179C-1 Election to expense certain refineries.
(a) Scope and definitions--(1) Scope. This section provides the
rules for determining the deduction allowable under section 179C(a) for
the cost of any qualified refinery property. The provisions of this
section apply only to a taxpayer that elects to apply section 179C in
the manner prescribed under paragraph (d) of this section.
(2) Definitions. For purposes of section 179C and this section, the
following definitions apply:
(i) Applicable environmental laws are any applicable federal, state,
or local environmental laws.
(ii) Qualified fuels has the meaning set forth in section 45K(c).
(iii) Cost is the unadjusted depreciable basis (as defined in Sec.
1.168(b)-1(a)(3), but without regard to the reduction in basis for any
portion of the basis the taxpayer properly elects to treat as an expense
under section 179C and this section) of the property.
(iv) Throughput is a volumetric rate measuring the flow of crude
oil, qualified fuels, or, in the case of property placed in service
after October 3, 2008, and before January 1, 2014, shale or tar sands,
processed over a given period of time, typically referenced on the basis
of barrels per calendar day.
(v) Barrels per calendar day is the amount of fuels that a facility
can process under usual operating conditions, expressed in terms of
capacity during a 24-hour period and reduced to account for down time
and other limitations.
(vi) United States has the same meaning as that term is defined in
section 7701(a)(9).
(b) Qualified refinery property--(1) In general. Qualified refinery
property is any property that meets the requirements set forth in
paragraphs (b)(2) through (b)(7) of this section.
(2) Description of qualified refinery property--(i) In general.
Property that comprises any portion of a qualified refinery may be
qualified refinery property. For purposes of section 179C and this
section, a qualified refinery is any refinery located in the United
States that--
(A) In the case of property placed in service after August 8, 2005,
and on or before October 3, 2008, is designed to serve the primary
purpose of processing liquid fuel from crude oil or qualified fuels; or
(B) In the case of property placed in service after October 3, 2008,
and before January 1, 2014, is designed to serve the primary purpose of
processing liquid fuel from crude oil, qualified fuels, or directly from
shale or tar sands.
(ii) Nonqualified refinery property. Refinery property is not
qualified refinery property for purposes of this paragraph (b)(2) if--
(A) The primary purpose of the refinery property is for use as a
topping plant, asphalt plant, lube oil facility, crude or product
terminal, or blending facility; or
(B) The refinery property is built solely to comply with consent
decrees or projects mandated by Federal, State, or local governments.
(3) Original use--(i) In general. For purposes of the deduction
allowable under section 179C(a), refinery property will meet the
requirements of this paragraph (b)(3) if the original use of the
property commences with the taxpayer. Except as provided in paragraph
(b)(3)(ii) of this section, original use means the first use to which
the property is put, whether or not that use corresponds to the use of
the property by the taxpayer. Thus, if a taxpayer incurs capital
expenditures to recondition or rebuild property acquired or owned by the
taxpayer, only the capital expenditures incurred by the taxpayer to
recondition or rebuild the
[[Page 215]]
property acquired or owned by the taxpayer satisfy the original use
requirement. However, the cost of reconditioned or rebuilt property
acquired by a taxpayer does not satisfy the original use requirement.
Whether property is reconditioned or rebuilt property is a question of
fact. For purposes of this paragraph (b)(3)(i), acquired or self-
constructed property that contains used parts will be treated as
reconditioned or rebuilt only if the cost of the used parts is more than
20 percent of the total cost of the property.
(ii) Sale-leaseback. If any new portion of a qualified refinery is
originally placed in service by a person after August 8, 2005, and is
sold to a taxpayer and leased back to the person by the taxpayer within
three months after the date the property was originally placed in
service by the person, the taxpayer-lessor is considered the original
user of the property.
(4) Placed-in-service date--(i) In general. Refinery property will
meet the requirements of this paragraph (b)(4) if the property is placed
in service by the taxpayer after August 8, 2005, and before January 1,
2014.
(ii) Sale-leaseback. If a new portion of refinery property is
originally placed in service by a person after August 8, 2005, and is
sold to a taxpayer and leased back to the person by the taxpayer within
three months after the date the property was originally placed in
service by the person, the property is treated as originally placed in
service by the taxpayer-lessor not earlier than the date on which the
property is used by the lessee under the leaseback.
(5) Production capacity--(i) In general. Refinery property is
considered qualified refinery property if--
(A) It enables the existing qualified refinery to increase the total
volume output, determined without regard to asphalt or lube oil, by at
least 5 percent on an average daily basis;
(B) In the case of property placed in service after August 8, 2005,
and on or before October 3, 2008, it enables the existing qualified
refinery to increase the percentage of total throughput attributable to
processing qualified fuels to a rate that is at least 25 percent of
total throughput on an average daily basis; or
(C) In the case of property placed in service after October 3, 2008,
and before January 1, 2014, it enables the existing qualified refinery
to increase the percentage of total throughput attributable to
processing qualified fuels, shale, or tar sands to a rate that is at
least 25 percent of total throughput on an average daily basis.
(ii) When production capacity is tested. The production capacity
requirement of this paragraph (b)(5) is determined as of the date the
property is placed in service by the taxpayer. Any reasonable method may
be used to determine the appropriate baseline for measuring capacity
increases and to demonstrate and substantiate that the capacity of the
existing qualified refinery has been sufficiently increased.
(iii) Multi-stage projects. In the case of multi-stage projects, a
taxpayer must satisfy the reporting requirements of paragraph (f)(2) of
this section, sufficient to establish that the production capacity
requirements of this paragraph (b)(5) will be met as a result of the
taxpayer's overall plan.
(6) Applicable environmental laws--(i) In general. The environmental
compliance requirement applies only with respect to refinery property,
or any portion of refinery property, that is placed in service after
August 8, 2005. A refinery's failure to meet applicable environmental
laws with respect to a portion of the refinery that was in service prior
to August 8, 2005 will not disqualify a taxpayer from making the
election under section 179C(a) with respect to otherwise qualifying
refinery property.
(ii) Waiver under the Clean Air Act. Refinery property must comply
with the Clean Air Act, notwithstanding any waiver received by the
taxpayer under that Act.
(7) Construction of property--(i) In general. Qualified property
will meet the requirements of this paragraph (b)(7) if no written
binding contract for the construction of the property was in effect
before June 14, 2005, and if--
(A) The construction of the property is subject to a written binding
contract entered into before January 1, 2010;
(B) The property is placed in service before January 1, 2010; or
[[Page 216]]
(C) In the case of self-constructed property, the construction of
the property began after June 14, 2005, and before January 1, 2010.
(ii) Definition of binding contract--(A) In general. A contract is
binding only if it is enforceable under state law against the taxpayer
or a predecessor, 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
5 percent of the total contract price will not be treated as limiting
damages to a specified amount. In determining whether a contract limits
damages, the fact that there may be little or no damages because the
contract price does not significantly differ from fair market value will
not be taken into account.
(B) Conditions. A contract is binding even if subject to a
condition, as long as the condition is not within the control of either
party or the predecessor of either party. A contract will continue to be
binding if the parties make insubstantial changes in its terms and
conditions, or if any term is to be determined by a standard beyond the
control of either party. A contract that imposes significant obligations
on the taxpayer or a predecessor will be treated as binding,
notwithstanding the fact that insubstantial terms remain to be
negotiated by the parties to the contract.
(C) Options. An option to either acquire or sell property is not a
binding contract.
(D) Supply agreements. A binding contract does not include a supply
or similar agreement if the payment amount and design specification of
the property to be purchased have not been specified.
(E) Components. A binding contract to acquire one or more components
of a larger property will not be treated as a binding contract to
acquire the larger property. If a binding contract to acquire a
component does not satisfy the requirements of this paragraph (b)(7),
the component is not qualified refinery property.
(iii) Self-constructed property--(A) In general. Except as provided
in paragraph (b)(7)(iii)(B) of this section, if a taxpayer manufactures,
constructs, or produces property for use by the taxpayer in its trade or
business (or for the production of income by the taxpayer), the
construction of property rules in this paragraph (b)(7) are treated as
met for qualified refinery property if the taxpayer begins
manufacturing, constructing, or producing the property after June 14,
2005, and before January 1, 2010. Property that is manufactured,
constructed, or produced for the taxpayer by another person under a
written binding contract (as defined in paragraph (b)(7)(ii) of this
section) that is entered into prior to the manufacture, construction, or
production of the property for use by the taxpayer in its trade or
business (or for the production of income) is considered to be
manufactured, constructed, or produced by the taxpayer.
(B) When construction begins. For purposes of this paragraph
(b)(7)(iii), construction of property generally begins when physical
work of a significant nature begins. Physical work does not include
preliminary activities such as planning or designing, securing
financing, exploring, or researching. The determination of when physical
work of a significant nature begins depends on the facts and
circumstances.
(C) Components of self-constructed property--(1) Acquired
components. If a binding contract (as defined in paragraph (b)(7)(ii) of
this section) to acquire a component of self-constructed property is in
effect on or before June 14, 2005, the component does not satisfy the
requirements of paragraph (b)(7)(i) of this section, and is not
qualified refinery property. However, if construction of the self-
constructed property begins after June 14, 2005, the self-constructed
property may be qualified refinery property if it meets all other
requirements of section 179C and this section (including paragraph
(b)(7)(i) of this section), even though the component is not qualified
refinery property. If the construction of self-constructed property
begins before June 14, 2005, neither the self-constructed property nor
any component related to the self-constructed property is qualified
refinery property. If the component is acquired before January 1, 2010,
but the construction of the self-constructed
[[Page 217]]
property begins after December 31, 2009, the component may qualify as
qualified refinery property even if the self-constructed property is not
qualified refinery property.
(2) Self-constructed components. If the manufacture, construction,
or production of a component fails to meet any of the requirements of
paragraph (b)(7)(iii) of this section, the component is not qualified
refinery property. However, if the manufacture, construction, or
production of a component fails to meet any of the requirements provided
in paragraph (b)(7)(iii) of this section, but the construction of the
self-constructed property begins after June 14, 2005, the self
constructed property may qualify as qualified refinery property if it
meets all other requirements of section 179C and this section (including
paragraph (b)(7)(i) of this section). If the construction of the self-
constructed property begins before June 14, 2005, neither the self-
constructed property nor any components related to the self-constructed
property are qualified refinery property. If the component was self-
constructed before January 1, 2010, but the construction of the self-
constructed property begins after December 31, 2009, the component may
qualify as qualified refinery property, although the self-constructed
property is not qualified refinery property.
(c) Computation of expense deduction for qualified refinery
property. In general, the allowable deduction under paragraph (d) of
this section for qualified refinery property is determined by
multiplying by 50 percent the cost of the qualified refinery property
paid or incurred by the taxpayer.
(d) Election--(1) In general. A taxpayer may make an election to
deduct as an expense 50 percent of the cost of any qualified refinery
property. A taxpayer making this election takes the 50 percent deduction
for the taxable year in which the qualified refinery property is placed
in service.
(2) Time and manner for making election--(i) Time for making
election. An election specified in this paragraph (d) generally must be
made not later than the due date (including extensions) for filing the
original Federal income tax return for the taxable year in which the
qualified refinery property is placed in service by the taxpayer.
(ii) Manner of making election. The taxpayer makes an election under
section 179C(a) and this paragraph (d) by entering the amount of the
deduction at the appropriate place on the taxpayer's timely filed
original Federal income tax return for the taxable year in which the
qualified refinery property is placed in service, and attaching a report
as specified in paragraph (f) of this section to the taxpayer's timely
filed original federal income tax return for the taxable year in which
the qualified refinery property is placed in service.
(3) Revocation of election--(i) In general. An election made under
section 179C(a) and this paragraph (d), and any specification contained
in such election, may not be revoked except with the consent of the
Commissioner of Internal Revenue.
(ii) Revocation prior to the revocation deadline. A taxpayer is
deemed to have requested, and to have been granted, the consent of the
Commissioner to revoke an election under section 179C(a) and this
paragraph (d) if the taxpayer revokes the election before the revocation
deadline. The revocation deadline is 24 months after the due date
(including extensions) for filing the taxpayer's Federal income return
for the taxable year for which the election applies. An election under
section 179C(a) and this paragraph (d) is revoked by attaching a
statement to an amended return for the taxable year for which the
election applies. The statement must specify the name and address of the
refinery for which the election applies and the amount deducted on the
taxpayer's original Federal income tax return for the taxable year for
which the election applies.
(iii) Revocation after the revocation deadline. An election under
section 179C(a) and this paragraph (d) may not be revoked after the
revocation deadline. The revocation deadline may not be extended under
Sec. 301.9100-1.
(iv) Revocation by cooperative taxpayer. A taxpayer that has made an
election to allocate the section 179C deduction to cooperative owners
under section 179C(g) and paragraph (e) of
[[Page 218]]
this section may not revoke its election under section 179C(a).
(e) Election to allocate section 179C deduction to cooperative
owners--(1) In general. If a cooperative taxpayer makes an election
under section 179C(g) and this paragraph (e), the cooperative taxpayer
may elect to allocate all, some, or none of the deduction allowable
under section 179C(a) for that taxable year to the cooperative owner(s).
This allocation is equal to the cooperative owner(s)' ratable share of
the total amount allocated, determined on the basis of each cooperative
owner's ownership interest in the cooperative taxpayer. For purposes of
this section, a cooperative taxpayer is an organization to which part I
of subchapter T applies, and in which another organization to which part
I of subchapter T applies (cooperative owner) directly holds an
ownership interest. No deduction shall be allowed under section 1382 for
any amount allocated under this paragraph (e).
(2) Time and manner for making election--(i) Time for making
election. A cooperative taxpayer must make the election under section
179C(g) and this paragraph (e) by the due date (including extensions)
for filing the cooperative taxpayer's original Federal income tax return
for the taxable year to which the cooperative taxpayer's election under
section 179C(a) and paragraph (d) of this section applies.
(ii) Manner of making election. An election under this paragraph (e)
is made by attaching to the cooperative taxpayer's timely filed Federal
income tax return for the taxable year (including extensions) to which
the cooperative taxpayer's election under section 179C(a) and paragraph
(d) of this section applies a statement providing the following
information:
(A) The name and taxpayer identification number of the cooperative
taxpayer.
(B) The amount of the deduction allowable to the cooperative
taxpayer for the taxable year to which the election under section
179C(a) and paragraph (d) of this section applies.
(C) The name and taxpayer identification number of each cooperative
owner to which the cooperative taxpayer is allocating all or some of the
deduction allowable.
(D) The amount of the allowable deduction that is allocated to each
cooperative owner listed in paragraph (e)(2)(ii)(C) of this section.
(3) Written notice to owners. If any portion of the deduction
allowable under section 179C(a) is allocated to a cooperative owner, the
cooperative taxpayer must notify the cooperative owner of the amount of
the deduction allocated to the cooperative owner in a written notice,
and on Form 1099-PATR, ``Taxable Distributions Received from
Cooperatives.'' This notice must be provided on or before the due date
(including extensions) of the cooperative taxpayer's original federal
income tax return for the taxable year for which the cooperative
taxpayer's election under section 179C(a) and paragraph (d) of this
section applies.
(4) Irrevocable election. A section 179C(g) election, once made, is
irrevocable.
(f) Reporting requirement--(1) In general. A taxpayer may not claim
a deduction under section 179C(a) for any taxable year unless the
taxpayer files a report with the Secretary containing information with
respect to the operation of the taxpayer's refineries.
(2) Information to be included in the report. The taxpayer must
specify--
(i) The name and address of the refinery;
(ii) Under which production capacity requirement under section
179C(e) and paragraph (b)(5)(i)(A), (B), and (C) of this section the
taxpayer's qualified refinery qualifies;
(iii) Whether the refinery is qualified refinery property under
section 179C(d) and paragraph (b)(2) of this section, sufficient to
establish that the primary purpose of the refinery is to process liquid
fuel from crude oil, qualified fuels, or directly from shale or tar
sands.
(iv) The total cost basis of the qualified refinery property at
issue for the taxpayer's current taxable year; and
(v) The depreciation treatment of the capitalized portion of the
qualified refinery property.
(3) Time and manner for submitting report--(i) Time for submitting
report. The
[[Page 219]]
taxpayer is required to submit the report specified in this paragraph
(f) not later than the due date (including extensions) of the taxpayer's
Federal income tax return for the taxable year in which the qualified
refinery property is placed in service.
(ii) Manner of submitting report. The taxpayer must attach the
report specified in this paragraph (f) to the taxpayer's timely filed
original Federal income tax return for the taxable year in which the
qualified refinery property is placed in service.
(g) Effective/applicability date. This section is applicable for
taxable years ending on or after August 22, 2011. For taxable years
ending before August 22, 2011, taxpayers may apply the proposed
regulations published on July 9, 2008, or, in the alternative, may apply
these final regulations.
[T.D. 9547, 76 FR 52558, Aug. 23, 2011]
Sec. 1.180-1 Expenditures by farmers for fertilizer, etc.
(a) In general. A taxpayer engaged in the business of farming may
elect, for any taxable year beginning after December 31, 1959, to treat
as deductible expenses those expenditures otherwise chargeable to
capital account which are paid or incurred by him during the taxable
year for the purchase or acquisition of fertilizer, lime, ground
limestone, marl, or other materials to enrich, neutralize, or condition
land used in farming, and those expenditures otherwise chargeable to
capital account paid or incurred for the application of such items and
materials to such land. No election is required to be made for those
expenditures which are not capital in nature. Section 180, Sec. 1.180-
2, and this section are not applicable to those expenses which are
deductible under section 162 and the regulations thereunder or which are
subject to the method described in section 175 and the regulations
thereunder.
(b) Land used in farming. For purposes of section 180(a) and of
paragraph (a) of this section, the term land used in farming means land
used (before or simultaneously with the expenditures described in such
section and such paragraph) by the taxpayer or his tenant for the
production of crops, fruits, or other agricultural products or for the
sustenance of livestock. See section 180(b). Expenditures for the
initial preparation of land never previously used for farming purposes
by the taxpayer or his tenant (although chargeable to capital account)
are not subject to the election. The principles stated in Sec. Sec.
1.175-3 and 1.175-4 are equally applicable under this section in
determining whether the taxpayer is engaged in the business of farming
and whether the land is used in farming.
(74 Stat. 1001, 26 U.S.C. 180)
[T.D. 6548, 26 FR 1486, Feb. 22, 1961]
Sec. 1.180-2 Time and manner of making election and revocation.
(a) Election. The claiming of a deduction on the taxpayer's return
for an amount to which section 180 applies for amounts (otherwise
chargeable to capital account) expended for fertilizer, lime, etc.,
shall constitute an election under section 180 and paragraph (a) of
Sec. 1.180-1. Such election shall be effective only for the taxable
year for which the deduction is claimed.
(b) Revocation. Once the election is made for any taxable year such
election may not be revoked without the consent of the district director
for the district in which the taxpayer's return is required to be filed.
Such requests for consent shall be in writing and signed by the taxpayer
or his authorized representative and shall set forth:
(1) The name and address of the taxpayer;
(2) The taxable year to which the revocation of the election is to
apply;
(3) The amount of expenditures paid or incurred during the taxable
year, or portions thereof (where applicable), previously taken as a
deduction on the return in respect of which the revocation of the
election is to be applicable; and
(4) The reasons for the request to revoke the election.
(74 Stat. 1001, 26 U.S.C. 180)
[T.D. 6548, 26 FR 1486, Feb. 22, 1961]
Sec. 1.181-0 Table of contents.
This section lists the table of contents for Sec. Sec. 1.181-1
through 1.181-6.
[[Page 220]]
Sec. 1.181-1 Deduction for qualified film and television production
costs.
(a) Deduction.
(1) In general.
(2) Owner.
(3) Production costs.
(4) Aggregate production costs.
(5) Pre-amendment production.
(6) Post-amendment production.
(7) Initial release or broadcast.
(8) Special rule.
(b) Limit on amount of aggregate production costs and amount of
deduction.
(1) In general.
(i) Pre-amendment production.
(ii) Post-amendment production.
(iii) Special rules.
(2) Higher limit for productions in certain areas.
(i) In general.
(ii) Significantly paid or incurred for live action productions.
(iii) Significantly paid or incurred for animated productions.
(iv) Significantly paid or incurred for productions incorporating
both live action and animation.
(v) Establishing qualification.
(vi) Allocation.
(c) Effect on depreciation or amortization of a qualified film or
television production.
(1) Pre-amendment production.
(2) Post-amendment production.
Sec. 1.181-2 Election to deduct production costs.
(a) Election.
(1) In general.
(2) Exception.
(b) Time of making election.
(1) In general.
(2) Special rule.
(3) Six-month extension.
(c) Manner of making election.
(1) In general.
(2) Information required.
(i) Initial election.
(ii) Subsequent taxable years.
(3) Deductions by more than one person.
(d) Revocation of election.
(1) In general.
(2) Consent granted.
Sec. 1.181-3 Qualified film or television production.
(a) In general.
(b) Production.
(1) In general.
(2) Special rules for television productions.
(3) Exception for certain sexually explicit productions.
(c) Compensation.
(d) Qualified compensation.
(e) Special rule for acquired productions.
(f) Other definitions.
(1) Actors.
(2) Production personnel.
(3) United States.
Sec. 1.181-4 Special rules.
(a) Recapture.
(1) Applicability.
(i) In general.
(ii) Special rule.
(2) Principal photography not commencing prior to the date of
expiration of section 181.
(3) Amount of recapture.
(b) Recapture under section 1245.
Sec. 1.181-5 Examples.
Sec. 1.181-6 Effective/applicability date.
(a) In general.
(b) Pre-effective date productions.
[T.D. 9551, 76 FR 60724, Sept. 30, 2011, as amended by T.D. 9603, 77 FR
72924, Dec. 7, 2012]
Sec. 1.181-1 Deduction for qualified film and television production costs.
(a) Deduction--(1) In general. (i) An owner (as defined in paragraph
(a)(2) of this section) of any film or television production
(production, as defined in Sec. 1.181-3(b)) that the owner reasonably
expects will be, upon completion, a qualified film or television
production (as defined in Sec. 1.181-3(a)) may elect to treat
production costs paid or incurred by that owner (subject to the limits
imposed under paragraph (b) of this section) as an expense that is
deductible for the taxable year in which the costs are paid (for an
owner who uses the cash receipts and disbursements method of accounting)
or incurred (for an owner who uses an accrual method of accounting). The
deduction under section 181 is subject to recapture if the owner's
expectations are later determined to be inaccurate.
(ii) This section provides rules for determining the owner of a
production, the production costs (as defined in paragraph (a)(3) of this
section), the maximum amount of aggregate production costs (as defined
in paragraph (a)(4) of this section) that may be paid or incurred for a
pre-amendment production (as defined in paragraph (a)(5) of this
section) for which the owner makes an election under section 181, and
the maximum amount of aggregate production costs that may be claimed as
a deduction for a post-amendment production (as defined in paragraph
(a)(6) of this section) for which the owner makes an election under
section
[[Page 221]]
181. Section 1.181-2 provides rules for making the election under
section 181. Section 1.181-3 provides definitions and rules concerning
qualified film and television productions. Section 1.181-4 provides
special rules, including rules for recapture of the deduction. Section
1.181-5 provides examples of the application of Sec. Sec. 1.181-1
through 1.181-4, while Sec. 1.181-6 provides the effective date of
Sec. Sec. 1.181-1 through 1.181-5.
(2) Owner. (i) For purposes of this section and Sec. Sec. 1.181-2
through 1.181-6, an owner of a production is any person that is required
under section 263A to capitalize the costs of producing the production
into the cost basis of the production, or that would be required to do
so if section 263A applied to that person.
(ii) Further, a person that acquires a finished or partially-
finished production is treated as an owner of that production for
purposes of this section and Sec. Sec. 1.181-2 through 1.181-6, but
only if the production is acquired prior to its initial release or
broadcast (as defined in paragraph (a)(7) of this section). Moreover, a
person that acquires only a limited license or right to exploit a
production, or receives an interest or profit participation in a
production, as compensation for services, is not an owner of the
production for purposes of this section and Sec. Sec. 1.181-2 through
1.181-6.
(3) Production costs. (i) For purposes of this section and
Sec. Sec. 1.181-2 through 1.181-6, the term production costs means all
costs that are paid or incurred by an owner in producing a production
that are required, absent the provisions of section 181, to be
capitalized under section 263A, or that would be required to be
capitalized if section 263A applied to the owner, and, if applicable,
all costs that are paid or incurred by an owner in acquiring a
production prior to its initial release or broadcast. Production costs
include, but are not limited to, participations and residuals paid or
incurred, compensation paid or incurred for services, compensation paid
or incurred for property rights, non-compensation costs, and costs paid
or incurred in connection with obtaining financing for the production
(for example, premiums paid or incurred to obtain a completion bond for
the production).
(ii) Production costs do not include costs paid or incurred to
distribute or exploit a production (including advertising and print
costs).
(iii) Production costs do not include the costs to prepare a new
release or new broadcast of an existing production after the initial
release or broadcast of the production (for example, the preparation of
a DVD release of a theatrically-released film, or the preparation of an
edited version of a theatrically-released film for television
broadcast). Costs paid or incurred to prepare a new release or a new
broadcast of a production after its initial release or broadcast,
therefore, are not taken into account for purposes of paragraph (b)(1)
of this section, and may not be deducted under this paragraph (a).
(iv) If a pre-amendment production is acquired from any person prior
to its initial release or broadcast, the acquiring person must use as
its initial aggregate costs the greater of--
(A) The cost of acquisition; or
(B) The seller's aggregate production costs.
(v) Production costs do not include costs that the owner has
deducted or begun to amortize prior to the taxable year the owner makes
an election under Sec. 1.181-2 for the production (for example, costs
described in Sec. 1.181-2(a)(2)). These costs, however, are included in
aggregate production costs to the extent they would have been treated as
production costs by the owner notwithstanding this paragraph (a)(3)(v).
(4) Aggregate production costs. The term aggregate production costs
means all production costs described in paragraph (a)(3) of this section
paid or incurred by any person, whether paid or incurred directly by an
owner or indirectly on behalf of an owner.
(5) Pre-amendment production. The term pre-amendment production
means a qualified film or television production commencing after October
22, 2004, and before January 1, 2008.
(6) Post-amendment production. The term post-amendment production
means
[[Page 222]]
a qualified film or television production commencing on or after January
1, 2008.
(7) Initial release or broadcast. Solely for purposes of this
section and Sec. Sec. 1.181-2 through 1.181-6, the term initial release
or broadcast means the first commercial exhibition or broadcast of a
production to an audience. However, the term ``initial release or
broadcast'' does not include limited exhibition prior to commercial
exhibition to general audiences if the limited exhibition is primarily
for purposes of publicity, marketing to potential purchasers or
distributors, determining the need for further production activity, or
raising funds for the completion of production. For example, the term
initial release or broadcast does not include exhibition to a test
audience to determine the need for further production activity, or
exhibition at a film festival for promotional purposes, if the
exhibition precedes commercial exhibition to general audiences.
(8) Special rule. The provisions of this paragraph (a) apply
notwithstanding the treatment of participations and residuals permitted
under the income forecast method in section 167(g)(7)(D).
(b) Limit on amount of aggregate production costs and amount of
deduction--(1) In general--(i) Pre-amendment production. Except as
provided under paragraph (b)(2) of this section, no deduction is allowed
under section 181 for any pre-amendment production, the aggregate
production costs of which exceed $15,000,000. See also paragraph
(a)(3)(iv) of this section. For a pre-amendment production for which the
aggregate production costs do not exceed $15,000,000 (or, if applicable
under paragraph (b)(2) of this section, $20,000,000), an owner may
deduct under section 181 all of the production costs paid or incurred by
that owner.
(ii) Post-amendment production. Section 181 permits a deduction for
the first $15,000,000 (or, if applicable under paragraph (b)(2) of this
section, $20,000,000) of the aggregate production costs of any post-
amendment production.
(iii) Special rules. The owner's deduction under section 181 is
limited to the owner's acquisition costs of the production plus any
further production costs paid or incurred by the owner. The deduction
under section 181 is not available for any portion of the acquisition
costs, and any subsequent production costs, of a production with an
initial release or broadcast that is prior to the date of acquisition.
(2) Higher limit for productions in certain areas--(i) In general.
This section is applied by substituting $20,000,000 for $15,000,000 in
paragraph (b)(1) of this section for any production the aggregate
production costs of which are significantly paid or incurred in an area
eligible for designation as--
(A) A low income community under section 45D; or
(B) A distressed county or isolated area of distress by the Delta
Regional Authority established under 7 U.S.C. section 2009aa-1.
(ii) Significantly paid or incurred for live action productions. The
aggregate production costs of a live action production are significantly
paid or incurred within one or more areas specified in paragraph
(b)(2)(i) of this section if--
(A) At least 20 percent of the aggregate production costs paid or
incurred in connection with first-unit principal photography for the
production are paid or incurred in connection with first-unit principal
photography that takes place in such areas; or
(B) At least 50 percent of the total number of days of first-unit
principal photography for the production consists of days during which
first-unit principal photography takes place in such areas.
(iii) Significantly paid or incurred for animated productions. For
purposes of an animated production, the aggregate production costs of
the production are significantly paid or incurred within one or more
areas specified in paragraph (b)(2)(i) of this section if--
(A) At least 20 percent of the aggregate production costs paid or
incurred in connection with keyframe animation, in-between animation,
animation photography, and the recording of voice acting performances
for the production are paid or incurred in connection with such
activities that take place in such areas; or
(B) At least 50 percent of the total number of days of keyframe
animation,
[[Page 223]]
in-between animation, animation photography, and the recording of voice
acting performances for the production consists of days during which
such activities take place in such areas.
(iv) Significantly paid or incurred for productions incorporating
both live action and animation. For purposes of a production
incorporating both live action and animation, the aggregate production
costs of the production are significantly paid or incurred within one or
more areas specified in paragraph (b)(2)(i) of this section if--
(A) At least 20 percent of the aggregate production costs paid or
incurred in connection with first-unit principal photography, keyframe
animation, in-between animation, animation photography, and the
recording of voice acting performances for the production are paid or
incurred in connection with such activities that take place in such
areas; or
(B) At least 50 percent of the total number of days of first-unit
principal photography, keyframe animation, in-between animation,
animation photography, and the recording of voice acting performances
for the production consists of days during which such activities take
place in such areas.
(v) Establishing qualification. An owner intending to utilize the
higher aggregate production costs limit under this paragraph (b)(2) must
establish qualification under this paragraph (b)(2).
(vi) Allocation. Solely for purposes of determining whether a
production qualifies for the higher production cost limit (for pre-
amendment productions) or deduction limit (for post-amendment
productions) provided under this paragraph (b)(2), compensation to
actors (as defined in Sec. 1.181-3(f)(1)), directors, producers, and
other relevant production personnel (as defined in Sec. 1.181-3 (f)(2))
is allocated entirely to first-unit principal photography.
(c) Effect on depreciation or amortization of a qualified film or
television production--(1) Pre-amendment production. Except as provided
in Sec. Sec. 1.181-1(a)(3)(v) and 1.181-2(a)(2), an owner that elects
to deduct production costs under section 181 for a pre-amendment
production may not deduct production costs for that production under any
provision of the Internal Revenue Code other than section 181 unless the
recapture requirements of Sec. 1.181-4(a) apply to the production.
(2) Post-amendment production. Amounts not allowable as a deduction
under section 181 for a post-amendment production may be deducted under
any other applicable provision of the Code.
[T.D. 9551, 76 FR 60724, Sept. 30, 2011, as amended by T.D. 9552, 76 FR
64817, Oct. 19, 2011; T.D. 9603, 77 FR 72924, Dec. 7, 2012]
Sec. 1.181-2 Election to deduct production costs.
(a) Election--(1) In general. Except as provided in paragraph (a)(2)
of this section, an owner may make an election under section 181 to
deduct production costs of a production only if that owner has not
deducted in a previous taxable year any production costs for that
production under any provision of the Internal Revenue Code (Code) other
than section 181.
(2) Exception. An owner may make an election under section 181
despite prior deductions under any other provision of the Code for
amortization of the costs of acquiring or developing screenplays,
scripts, story outlines, motion picture production rights to books and
plays, and other similar properties for purposes of potential future
development or production of a production, if such costs were paid or
incurred before the first taxable year for which an election may be made
under Sec. 1.181-2(b) and are included in aggregate production costs.
(b) Time of making election--(1) In general. The election to deduct
production costs for a production under section 181 must be made by the
due date (including any extension) for filing the owner's Federal income
tax return for the first taxable year in which:
(i) Any aggregate production costs have been paid or incurred;
(ii) The owner reasonably expects (based on all of the facts and
circumstances) that the production will be set for production and will,
upon completion, be a qualified film or television production; and
(iii) For any pre-amendment production, the owner reasonably expects
[[Page 224]]
(based on all of the facts and circumstances) that the aggregate
production costs paid or incurred for the pre-amendment production will,
at no time, exceed the applicable aggregate production costs limit set
forth under Sec. 1.181-1(b)(1)(i) or (b)(2).
(2) Special rule. If paragraph (b)(1) of this section is not
satisfied until a taxable year subsequent to the taxable year in which
any aggregate production costs were first paid or incurred, the owner
must make the election for the taxable year in which paragraph (b)(1) of
this section is first satisfied, and any production costs paid or
incurred prior to the taxable year in which the owner makes the election
and not deducted in a prior taxable year are treated as production costs
(except costs described in Sec. 1.181-2(a)(2)) that are deductible
under Sec. 1.181-1(a)(1)(i) for the taxable year paragraph (b)(1) of
this section is first satisfied and the election is made.
(3) Six-month extension. See Sec. 301.9100-2 for a six-month
extension of time to make the election in certain circumstances.
(c) Manner of making election--(1) In general. An owner must make
the election under section 181 separately for each production. For a
production owned by an entity, the election must be made by the entity.
For example, if the production is owned by a partnership or S
corporation, the partnership or S corporation must make the election.
(2) Information required--(i) Initial election. For each production
to which the election applies, the owner must attach a statement to the
owner's Federal income tax return for the taxable year of the election
stating that the owner is making an election under section 181 and
providing--
(A) The name (or other unique identifying designation) of the
production;
(B) The date aggregate production costs were first paid or incurred
for the production;
(C) The amount of aggregate production costs paid or incurred for
the production during the taxable year (including costs described in
Sec. Sec. 1.181-1(a)(3)(v) and 1.181-2(b)(2));
(D) The amount of qualified compensation (as defined in Sec. 1.181-
3(d)) paid or incurred for the production during the taxable year
(including costs described in Sec. 1.181-2(b)(2));
(E) The amount of compensation (as defined in Sec. 1.181-3(c)) paid
or incurred for the production during the taxable year (including costs
described in Sec. 1.181-2(b)(2));
(F) If the owner expects that the aggregate production costs of the
production will be significantly paid or incurred in (or, if applicable,
if a significant portion of the total number of days of first-unit
principal photography will occur in) one or more of the areas specified
in Sec. 1.181-1(b)(2)(i), the identity of the area or areas, the amount
of aggregate production costs paid or incurred (or the number of days of
first-unit principal photography engaged in) for the applicable
activities described in Sec. 1.181-1(b)(2)(ii), (b)(2)(iii), or
(b)(2)(iv), as applicable, that took place within such areas (including
costs described in Sec. Sec. 1.181-1(a)(3)(v) and 1.181-2(b)(2)), and
the aggregate production costs paid or incurred (or the total number of
days of first-unit principal photography engaged in) for such activities
(whether or not they took place in such areas), for the taxable year
(including costs described in Sec. Sec. 1.181-1(a)(3)(v) and 1.181-
2(b)(2));
(G) A declaration that the owner reasonably expects (based on all of
the facts and circumstances at the time the election is made) both that
the production will be set for production (or has been set for
production) and will be a qualified film or television production; and
(H) For any pre-amendment production, a declaration that the owner
reasonably expects (based on all of the facts and circumstances at the
time the election is made) that the aggregate production costs paid or
incurred for the pre-amendment production will not, at any time, exceed
the applicable aggregate production costs limit set forth under Sec.
1.181-1(b)(1)(i) or (b)(2).
(ii) Subsequent taxable years. If the owner pays or incurs
additional production costs in any taxable year subsequent to the
taxable year for which production costs are first deducted under section
181, the owner must attach a statement to its Federal income
[[Page 225]]
tax return for that subsequent taxable year providing--
(A) The name (or other unique identifying designation) of the
production that was used in the initial election, and any revised name
(or unique identifying designation) subsequently used for the
production;
(B) The date the aggregate production costs were first paid or
incurred for the production;
(C) The amount of aggregate production costs paid or incurred for
the production during the current taxable year;
(D) The amount of qualified compensation paid or incurred for the
production during the current taxable year;
(E) The amount of compensation paid or incurred for the production
during the current taxable year, and the aggregate amount of
compensation paid or incurred for the production in all prior taxable
years;
(F) If the owner expects that the aggregate production costs of the
production will be significantly paid or incurred in (or, if applicable,
if a significant portion of the total number of days of first-unit
principal photography will occur in) one or more of the areas specified
in Sec. 1.181-1(b)(2)(i), the identity of the area or areas, the amount
of aggregate production costs paid or incurred (or the number of days of
first-unit principal photography engaged in) for the applicable
activities described in Sec. 1.181-1(b)(2)(ii), (b)(2)(iii), or
(b)(2)(iv), as applicable, that took place within such areas, and the
aggregate production costs paid or incurred (or the number of days of
first-unit principal photography engaged in) for such activities
(whether or not they took place in such areas), for the current taxable
year;
(G) A declaration that the owner continues to reasonably expect
(based on all of the facts and circumstances at the end of the current
taxable year) both that the production will be set for production (or
has been set for production) and will be a qualified film or television
production; and
(H) For any pre-amendment production, a declaration that the owner
continues to reasonably expect (based on all of the facts and
circumstances at the end of the current taxable year) that the aggregate
production costs paid or incurred for the pre-amendment production will
not, at any time, exceed the applicable aggregate production costs limit
set forth under Sec. 1.181-1(b)(1)(i) or (b)(2).
(3) Deductions by more than one person. If more than one person will
claim deductions under section 181 with respect to the production for
the taxable year, each person claiming the deduction (but not the
members of an entity who are issued a Schedule K-1 by the entity with
respect to their interest in the production) must provide a list of the
names and taxpayer identification numbers of all such persons, the
dollar amount that each such person will deduct under section 181, and
the information required by paragraph (c)(2) of this section for all
such persons. Notwithstanding the preceding sentence, whether or not
multiple persons form a partnership with respect to the production will
be determined in accordance with Sec. 301.7701-3 of this chapter.
(d) Revocation of election--(1) In general. An owner may revoke an
election made under this section only with the consent of the
Commissioner. Except as provided in paragraph (d)(2) of this section, an
owner seeking consent to revoke an election made under this section must
submit a letter ruling request, other than a Form 3115, ``Application
for Change in Accounting Method,'' under the appropriate revenue
procedure. See, for example, Rev. Proc. 2011-1, 2011-1 CB 1 (updated
annually) (see Sec. 601.601(d)(2)(ii)(b) of this chapter).
(2) Consent granted. The Commissioner grants consent to an owner to
revoke an election under this section for a particular production if the
owner--
(i) Complies with the recapture provisions of Sec. 1.181-4(a)(3) on
a timely filed (including any extension) original Federal income tax
return for the taxable year of the revocation; and
(ii) Attaches a statement to that Federal income tax return that
includes the name of the production that was in the owner's original
election statement, and any revised name (or other unique identifying
designation) of the production, and a statement that the owner revokes
the election
[[Page 226]]
under section 181 for that production, pursuant to Sec. 1.181-2(d)(2).
[T.D. 9551, 76 FR 60726, Sept. 30, 2011]
Sec. 1.181-3 Qualified film or television production.
(a) In general. The term qualified film or television production
means any production (as defined in paragraph (b) of this section) for
which not less than 75 percent of the aggregate amount of compensation
(as defined in paragraph (c) of this section) paid or incurred for the
production is qualified compensation (as defined in paragraph (d) of
this section).
(b) Production--(1) In general. Except as provided in paragraph
(b)(3) of this section, for purposes of this section and Sec. Sec.
1.181-1, 1.181-2, 1.181-4, 1.181-5, and 1.181-6, the term production
means any motion picture film or video tape (including digital video)
production the production costs of which are subject to capitalization
under section 263A, or that would be subject to capitalization if
section 263A applied to the owner of the production. If, prior to its
initial release or broadcast, a person acquires a completed motion
picture film or video tape (including digital video) that the seller was
entitled to treat as a production under this paragraph (b)(1), then the
new owner may treat the acquired asset as a production within the
meaning of this paragraph (b)(1).
(2) Special rules for television productions. Each episode of a
television series is a separate production to which the rules, limits,
and election requirements of this section and Sec. Sec. 1.181-1, 1.181-
2, 1.181-4, 1.181-5, and 1.181-6 apply. An owner may elect to deduct
production costs under section 181 only for the first 44 episodes of a
television series (including pilot episodes). A television series may
include more than one season of programming.
(3) Exception for certain sexually explicit productions. A
production does not include property for which records are required to
be maintained under 18 U.S.C. 2257.
(c) Compensation. The term compensation means, for purposes of this
section and Sec. 1.181-2(c)(2), all amounts paid or incurred either
directly by the owner or indirectly on the owner's behalf for services
performed by actors (as defined in paragraph (f)(1) of this section),
directors, producers, and other production personnel (as defined in
paragraph (f)(2) of this section) for the production. Examples of
indirect payments paid or incurred on the owner's behalf are payments by
a partner on behalf of an owner that is a partnership, payments by a
shareholder on behalf of an owner that is a corporation, and payments by
a contract producer on behalf of the owner. Payments for services are
all elements of compensation as provided for in Sec. Sec. 1.263A-
1(e)(2)(i)(B) and (e)(3)(ii)(D). Compensation is not limited to wages
reported on Form W-2, ``Wage and Tax Statement,'' and includes
compensation paid or incurred to independent contractors. However,
solely for purposes of paragraph (a) of this section, the term
``compensation'' does not include participations and residuals (as
defined in section 167(g)(7)(B)). See Sec. 1.181-1(a)(3) for additional
rules concerning participations and residuals.
(d) Qualified compensation. The term qualified compensation means,
for purposes of this section and Sec. 1.181-2(c)(2), all compensation
(as defined in paragraph (c) of this section) paid or incurred for
services performed in the United States (as defined in paragraph (f)(3)
of this section) by actors, directors, producers, and other production
personnel for the production. A service is performed in the United
States for purposes of this paragraph (d) if the principal photography
to which the compensated service relates occurs within the United States
and the person performing the service is physically present in the
United States. For purposes of an animated film or animated television
production, the location where production activities such as keyframe
animation, in-between animation, animation photography, and the
recording of voice acting performances are performed is considered in
lieu of the location of principal photography. For purposes of a
production incorporating both live action and animation, the location
where production activities such as keyframe animation, in-between
animation, animation photography, and the recording of voice acting
performances for the production
[[Page 227]]
is considered in addition to the location of principal photography.
(e) Special rule for acquired productions. A person who acquires a
production from a prior owner must take into account all compensation
paid or incurred by or on behalf of the seller and any previous owners
in determining if the production is a qualified film or television
production as defined in paragraph (a) of this section. Any owner that
elects to deduct as production costs the costs of acquiring a production
and any subsequent production costs must obtain from the seller detailed
records concerning the compensation paid or incurred for the production
and, for a pre-amendment production, concerning aggregate production
costs, in order to demonstrate the eligibility of the production under
section 181.
(f) Other definitions. The following definitions apply for purposes
of this section and Sec. Sec. 1.181-1, 1.181-2, 1.181-4, 1.181-5, and
1.181-6:
(1) Actors. The term actors means players, newscasters, or any other
persons who are compensated for their performance or appearance in a
production.
(2) Production personnel. The term production personnel means
persons who are compensated for providing services directly related to
the production, such as writers, choreographers, composers, casting
agents, camera operators, set designers, lighting technicians, and make-
up artists.
(3) United States. The term United States means the 50 states, the
District of Columbia, the territorial waters of the continental United
States, the airspace or space over the continental United States and its
territorial waters, and the seabed and subsoil of those submarine areas
that are adjacent to the territorial waters of the continental United
States and over which the United States has exclusive rights, in
accordance with international law, for the exploration and exploitation
of natural resources. The term ``United States'' does not include
possessions and territories of the United States (or the airspace or
space over these areas).
[T.D. 9551, 76 FR 60727, Sept. 30, 2011]
Sec. 1.181-4 Special rules.
(a) Recapture--(1) Applicability--(i) In general. The requirements
of this paragraph (a) apply notwithstanding whether an owner has
satisfied the revocation requirements of Sec. 1.181-2(d). An owner that
claimed a deduction under section 181 for a production in any taxable
year in an amount in excess of the amount that would be allowable as a
deduction for that year in the absence of section 181 must recapture the
excess amount as provided for in paragraph (a)(3) of this section for
the production in the first taxable year for which--
(A) For any pre-amendment production, the aggregate production costs
of the production exceed the applicable aggregate production costs limit
under Sec. 1.181-1(b)(1)(i) or (b)(2);
(B) For any pre-amendment production, the owner no longer reasonably
expects (based on all of the facts and circumstances at the end of the
current taxable year) that the aggregate production costs of the
production will not, at any time, exceed the applicable aggregate
production costs limit set forth under Sec. 1.181-1(b)(1)(i) or (b)(2);
(C) The owner no longer reasonably expects (based on all of the
facts and circumstances at the end of the current taxable year) either
that the production will be set for production or that the production
will be a qualified film or television production; or
(D) The owner revokes the election pursuant to Sec. 1.181-2(d).
(ii) Special rule. An owner that claimed a deduction under section
181 and disposes of the production prior to its initial release or
broadcast must recapture the entire amount specified under paragraph
(a)(3) of this section in the year the owner disposes of the production
before computing gain or loss from the disposition.
(2) Principal photography not commencing prior to the date of
expiration of section 181. If an owner claims a deduction under section
181 for a production for which principal photography does not commence
prior to the date of expiration of section 181, the owner must recapture
deductions as provided for in paragraph (a)(3) of this section in the
owner's taxable year that includes the date of expiration of section
181.
[[Page 228]]
(3) Amount of recapture. An owner subject to the recapture
requirements under this section must, for the taxable year in which
recapture is required, include in the owner's gross income as ordinary
income and add to the owner's adjusted basis in the property--
(i) For a production that is placed in service in a taxable year
prior to the taxable year for which recapture is required, the
difference between the aggregate amount the owner claimed as a deduction
under section 181 for the production for all such prior taxable years
and the aggregate depreciation deductions that would have been allowable
for the production for such prior taxable years (or that the owner could
have elected to deduct in the taxable year that the production was
placed in service) for the production under the owner's method of
accounting; or
(ii) For a production that has not been placed in service, the
aggregate amount claimed as a deduction under section 181 for the
production for all such prior taxable years.
(b) Recapture under section 1245. For purposes of recapture under
section 1245, any deduction allowed under section 181 is treated as a
deduction allowable for amortization.
[T.D. 9551, 76 FR 60728, Sept. 30, 2011]
Sec. 1.181-5 Examples.
The following examples illustrate the application of Sec. Sec.
1.181-1 through 1.181-4:
Example 1. X, a corporation that uses an accrual method of
accounting and files Federal income tax returns on a calendar-year
basis, is a producer of films. X is the owner (within the meaning of
Sec. 1.181-1(a)(2)) of film ABC. X incurs production costs in year 1,
but does not commence principal photography for film ABC until year 2.
In year 1, X reasonably expects, based on all of the facts and
circumstances, that film ABC will be set for production and will be a
qualified film or television production. Provided that X satisfies all
other requirements of Sec. Sec. 1.181-1 through 1.181-4 and Sec.
1.181-6, X may deduct in year 1 the production costs for film ABC that X
incurred in year 1.
Example 2. The facts are the same as in Example 1. In year 2, X
begins, but does not complete, principal photography for film ABC. Most
of the scenes that X films in year 2 are shot outside the United States
and, as of December 31, year 2, less than 75 percent of the total
compensation paid for film ABC is qualified compensation. Nevertheless,
X still reasonably expects, based on all of the facts and circumstances,
that film ABC will be a qualified film or television production.
Provided that X satisfies all other requirements of Sec. Sec. 1.181-1
through 1.181-4 and Sec. 1.181-6, X may deduct in year 2 the production
costs for film ABC that X incurred in year 2.
Example 3. The facts are the same as in Example 2. In year 3, X
continues, but does not complete, production of film ABC. Due to changes
in the expected production costs of film ABC, X no longer expects film
ABC to qualify under section 181. X files a statement with its return
for year 3 identifying the film and stating that X revokes its election
under section 181. X includes in income in year 3 the deductions claimed
in year 1 and in year 2 as provided for in Sec. 1.181-4(a)(3). X has
successfully revoked its election pursuant to Sec. 1.181-2(d).
[T.D. 9551, 76 FR 60729, Sept. 30, 2011]
Sec. 1.181-6 Effective/applicability date.
(a) In general. Except as otherwise provided in this section,
Sec. Sec. 1.181-1 through 1.181-5 apply to productions the first day of
principal photography for which occurs on or after September 29, 2011.
Paragraphs 1.181-1(a)(1)(ii), (a)(6), (b)(1)(ii), (b)(2)(vi), and (c)(2)
of Sec. 1.181-1 apply to productions to which section 181 is applicable
and for which the first day of principal photography or in-between
animation occurs on or after December 7, 2012.
(b) Pre-effective date productions. For any taxable year for which
the period of limitation on refund or credit under section 6511 has not
expired, the owner may apply Sec. Sec. 1.181-1 through 1.181-5 to any
production to which section 181 applies and for which the first day of
principal photography (or in-between animation) occurred before December
7, 2012, provided the owner applies all relevant provisions of
Sec. Sec. 1.181-1 through 1.181-5 to the production.
[T.D. 9603, 77 FR 72924, Dec. 7, 2012]
Sec. 1.182-1 Expenditures by farmers for clearing land; in general.
Under section 182, a taxpayer engaged in the business of farming may
elect, in the manner provided in Sec. 1.182-6, to deduct certain
expenditures paid or incurred by him in any taxable year beginning after
December 31, 1962, in the clearing of land. The expenditures to which
the election applies are all expenditures paid or incurred during the
[[Page 229]]
taxable year in clearing land for the purpose of making the ``land
suitable for use in farming'' (as defined in Sec. 1.182-4) which are
not otherwise deductible (exclusive of expenditures for or in connection
with depreciable items referred to in paragraph (b)(1) of Sec. 1.182-
3), but only if such expenditures are made in furtherance of the
taxpayer's business of farming. The term expenditures to which the
election applies also includes a reasonable allowance for depreciation
(not otherwise allowable) on equipment used in the clearing of land
provided such equipment, if used in the carrying on of a trade or
business, would be subject to the allowance for depreciation under
section 167. (See paragraph (c) of Sec. 1.182-3.) (See section 175 and
the regulations thereunder for deductibility of certain expenditures for
treatment or moving of earth by a farmer where the land already
qualifies as land used in farming as defined in Sec. 1.175-4.) The
amount deductible for any taxable year is limited to the lesser of
$5,000 or 25 percent of the taxable income derived from farming (as
defined in paragraph (a)(2) of Sec. 1.182-5) during the taxable year.
Expenditures paid or incurred in a taxable year in excess of the amount
deductible under section 182 for such taxable year shall be treated as
capital expenditures and shall constitute an adjustment to the basis of
the land under section 1016(a).
[T.D. 6794, 30 FR 790, Jan. 26, 1965]
Sec. 1.182-2 Definition of ``the business of farming.''
Under section 182, the election to deduct expenditures incurred in
the clearing of land is applicable only to a taxpayer who is engaged in
``the business of farming'' during the taxable year. A taxpayer is
engaged in the business of farming if he cultivates, operates, or
manages a farm for gain or profit, either as owner or tenant. For
purposes of section 182, a taxpayer who receives a rental (either in
cash or in kind) which is based upon farm production is engaged in the
business of farming. However, a taxpayer who receives a fixed rental
(without reference to production) is engaged in the business of farming
only if he participates to a material extent in the operation or
management of the farm. A taxpayer engaged in forestry or the growing of
timber is not thereby engaged in the business of farming. A person
cultivating or operating a farm for recreation or pleasure rather than
for profit is not engaged in the business of farming. For purposes of
section 182 and this section, the term farm is used in its ordinary,
accepted sense and includes stock, dairy, poultry, fish, fruit, and
truck farms, and also plantations, ranches, ranges, and orchards. A fish
farm is an area where fish are grown or raised, as opposed to merely
caught or harvested; that is, an area where they are artificially fed,
protected, cared for, etc. A taxpayer is engaged in ``the business of
farming'' if he is a member of a partnership engaged in the business of
farming. See Sec. 1.702-1.
[T.D. 6794, 30 FR 790, Jan. 26, 1965]
Sec. 1.182-3 Definition, exceptions, etc., relating to deductible expenditures.
(a) Clearing of land. (1) For purposes of section 182, the term
clearing of land includes (but is not limited to):
(i) The removal of rocks, stones, trees, stumps, brush or other
natural impediments to the use of the land in farming through blasting,
cutting, burning, bulldozing, plowing, or in any other way;
(ii) The treatment or moving of earth, including the construction,
repair or removal of nondepreciable earthen structures, such as dikes or
levies, if the purpose of such treatment or moving of earth is to
protect, level, contour, terrace, or condition the land so as to permit
its use as farming land; and
(iii) The diversion of streams and watercourses, including the
construction of nondepreciable drainage facilities, provided that the
purpose is to remove or divert water from the land so as to make it
available for use in farming.
(2) The following are examples of land clearing activities:
(i) The cutting of trees, the blasting of the resulting stumps, and
the burning of the residual undergrowth;
(ii) The leveling of land so as to permit irrigation or planting;
(iii) The removal of salt or other minerals which might inhibit
cultivation of the soil;
[[Page 230]]
(iv) The draining and filling in of a swamp or marsh; and
(v) The diversion of a stream from one watercourse to another.
(b) Expenditures not allowed as a deduction under section 182. (1)
Section 182 applies only to expenditures for nondepreciable items.
Accordingly, a taxpayer may not deduct expenditures for the purchase,
construction, installation, or improvement of structures, appliances, or
facilities which are of a character which is subject to the allowance
for depreciation under section 167 and the regulations thereunder.
Expenditures in respect of such depreciable property include those for
materials, supplies, wages, fuel, freight, and the moving of earth, paid
or incurred with respect to tanks, reservoirs, pipes, conduits, canals,
dams, wells, or pumps constructed of masonry, concrete, tile, metal,
wood, or other nonearthen material.
(2) Expenditures which are deductible without regard to section 182
are not deductible under section 182. Thus, such expenditures are
deductible without being subject to the limitations imposed by section
182(b) and Sec. 1.182-5. For example, section 182 does not apply to the
ordinary and necessary expenses incurred in the business of farming
which are deductible under section 162 even though they might otherwise
be considered to be clearing of land expenditures. Section 182 also does
not apply to interest (deductible under section 163) nor to taxes
(deductible under section 164). Similarly, section 182 does not apply to
any expenditures (whether or not currently deductible) paid or incurred
for the purpose of soil or water conservation in respect of land used in
farming, or for the prevention of erosion of land used in farming,
within the meaning of section 175 and the regulations thereunder, nor to
expenditures deductible under section 180 and the regulations
thereunder, relating to expenditures for fertilizer, etc.
(c) Depreciation. In addition to expenditures for the activities
described in paragraph (a) of this section, there also shall be treated
as an expenditure to which section 182 applies a reasonable allowance
for depreciation not otherwise deductible on property of the taxpayer
which is used in the clearing of land for the purpose of making such
land suitable for use in farming, provided the property is property
which, if used in a trade or business, would be subject to the allowance
for depreciation under section 167. Depreciation allowable as a
deduction under section 182 is limited to the portion of depreciation
which is attributable to the use of the property in the clearing of
land. The depreciation shall be computed in accordance with section 167
and the regulations thereunder. To the extent an amount representing a
reasonable allowance for depreciation with respect to property used in
clearing land is treated as an expenditure to which section 182 applies,
such depreciation shall, for purposes of chapter 1 of the Code, be
treated as an amount allowed under section 167 for depreciation. Thus,
if a deduction is allowed for depreciation under section 182 in respect
of property used in clearing land, proper adjustment to the basis of the
property so used shall be made under section 1016(a).
[T.D. 6794, 30 FR 791, Jan. 26, 1965]
Sec. 1.182-4 Definition of ``land suitable for use in farming'', etc.
For purposes of section 182, the term land suitable for use in
farming means land which, as a result of the land clearing activities
described in paragraph (a) of Sec. 1.182-3, could be used by the
taxpayer or his tenant for the production of crops, fruits, or other
agricultural products, including fish, or for the sustenance of
livestock. The term livestock includes cattle, hogs, horses, mules,
donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys,
pigeons, and other poultry. Land used for the sustenance of livestock
includes land used for grazing such livestock. Expenditures are
considered to be for the purpose of making land suitable for use in
farming by the taxpayer or his tenant only if made to prepare the land
which is cleared for use by the taxpayer or his tenant in farming. Thus,
if the taxpayer pays or incurs expenditures to clear land for the
purpose of sale (whether or not for use in farming by the purchaser) or
to be held by the taxpayer or his tenant other than for use in farming,
section 182 does not apply to such expenditures. Whether
[[Page 231]]
the land is cleared for the purpose of making it suitable for use in
farming by the taxpayer or his tenant, is a question of fact which must
be resolved on the basis of all the relevant facts and circumstances.
For purposes of section 182, it is not necessary that the land cleared
actually be used in farming following the clearing activities. However,
the fact that following the clearing operation, the land is used by the
taxpayer or his tenant in the business of farming will, in most cases,
constitute evidence that the purpose of the clearing was to make land
suitable for use in farming by the taxpayer or his tenant. On the other
hand, if the land cleared is sold or converted to nonfarming use soon
after the taxpayer has completed his clearing activities, there will be
a presumption that the expenditures were not made for the purpose of
making the land suitable for use in farming by the taxpayer or his
tenant. Other factors which will be considered in determining the
taxpayer's purpose for clearing the land are, for example, the acreage,
location, and character of the land cleared, the nature of the
taxpayer's farming operation, and the use to which adjoining or nearby
land is put.
[T.D. 6794, 30 FR 791, Jan. 26, 1965]
Sec. 1.182-5 Limitation.
(a) Limitation--(1) General rule. The amount of land clearing
expenditures which the taxpayer may deduct under section 182 in any one
taxable year is limited to the lesser of $5,000 or 25 percent of his
``taxable income derived from farming''. Expenditures in excess of the
applicable limitation are to be charged to the capital account and
constitute additions to the taxpayer's basis in the land.
(2) Definition of ``taxable income derived from farming''. For
purposes of section 182, the term taxable income derived from farming
means the gross income derived from the business of farming reduced by
the deductions attributable to such gross income. Gross income derived
from the business of farming is the gross income of the taxpayer derived
from the production of crops, fruits, or other agricultural products,
including fish, or from livestock (including livestock held for draft,
breeding or dairy purposes). It does not include gains from sales of
assets such as farm machinery or gains from the disposition of land. The
deductions attributable to the business of farming are all the
deductions allowed by Chapter 1 of the Code (other than the deduction
allowed by section 182) for expenditures or charges (including
depreciation and amortization) paid or incurred in connection with the
production or raising of crops, fruits, or other agricultural products,
including fish, or livestock. However, the deduction under section 1202
(relating to the capital gains deduction) attributable to gain on the
sale or other disposition of assets (other than draft, breeding, or
dairy stock), and the net operating loss deduction (computed under
section 172) shall not be taken into account in computing ``taxable
income derived from farming.'' Similarly, deductible losses on the sale,
disposition, destruction, condemnation, or abandonment of assets (other
than draft, breeding, or dairy stock) shall not be considered as
deductions attributable to the business of farming. A taxpayer shall
compute his gross income from farming in accordance with his accounting
method used in determining gross income. (See the regulations under
section 61 relating to accounting methods used by farmers in determining
gross income.)
(b) Examples. The provisions of paragraph (a) of this section may be
illustrated by the following examples:
Example 1. For the taxable year 1963, A, who uses the cash receipts
and disbursements method of accounting, incurs expenditures to which
section 182 applies in the amount of $2,000 and makes the election under
section 182. A has the following items of income and deductions (without
regard to section 182 expenditures).
Income:
Proceeds from sale of his 1963 yield of corn...... $10,000
Proceeds from sales of milk....................... 8,000
Gain from disposition of old breeding cows........ 500
Gain from sale of tractor......................... 100
Gain from sale of farmland........................ 5,000
Interest on loan to brother....................... 100
----------
23,700
==========
Deductions:
Cost of labor..................................... 4,000
Cost of feed...................................... 3,000
Depreciation on farm equipment and buildings...... 2,500
Cost of maintenance, fuel, etc.................... 2,000
[[Page 232]]
Interest paid, mortgage on farm buildings......... 1,000
Interest paid, personal loan...................... 500
Loss on destruction of barn....................... 2,000
Loss on sale of truck............................. 300
Section 1202 deduction--gain on sale of cows (500 250
x 1/2)...........................................
Section 1202 deduction--net gain on disposition of 1,400
section 1231 property, other than cows [$2,800
($5,100-$2,300) x \1/2\ ]........................
------ $16,950
---------
Net income before section 182 deduction........... ........ 6,750
For purposes of computing taxable income derived from farming under
section 182, the following items of income and deductions are not taken
into account:
Income:
Gain from the sale of tractor....................... $100
Gain from the sale of farmland...................... 5,000
Interest on loan to brother......................... 100
------ $5,200
Deductions:
Interest paid, personal loan........................ $500
Loss on destruction of barn......................... 2,000
Loss on sale of truck............................... 300
Section 1202 deduction--Net gain from disposition of 1,400
1231 assets other than cows........................
------ $4,200
A's ``taxable income derived from farming'' for purposes of section
182 is $5,750; income of $18,500 ($23,700-$5,200), less deductions of
$12,750 ($16,950-$4,200). A may deduct $1,437.50 (25% of $5,750) under
section 182. The excess expenditures in the amount of $562.50 are to be
charged to capital account and serve to increase the taxpayer's basis of
the land.
Example 2. Assume the same facts as in Example 1 and in addition,
assume that A is allowed a deduction for a net operating loss carryback
from the taxable year 1966 in the amount of $3,000. The net operating
loss deduction will not be taken into account in computing A's ``taxable
income derived from farming'' for 1963 Accordingly, A will not be
required to recompute such taxable income for purposes of applying the
limitation on the deduction provided in section 182 and the deduction of
$1,437.50 will not be reduced.
[T.D. 6794, 30 FR 791, Jan. 26, 1965]
Sec. 1.182-6 Election to deduct land clearing expenditures.
(a) Manner of making election. The election to deduct expenditures
for land clearing provided by section 182(a) shall be made by means of a
statement attached to the taxpayer's income tax return for the taxable
year for which such election is to apply. The statement shall include
the name and address of the taxpayer, shall be signed by the taxpayer
(or his duly authorized representative), and shall be filed not later
than the time prescribed by law for filing the income tax return
(including extensions thereof) for the taxable year for which the
election is to apply. The statement shall also set forth the amount and
description of the expenditures for land clearing claimed as a deduction
under section 182, and shall include a computation of ``taxable income
derived from farming'', if the amount of such income is not the same as
the net income from farming shown on Schedule F of Form 1040, increased
by the amount of the deduction claimed under section 182.
(b) Scope of election. An election under section 182(a) shall apply
only to the taxable year for which made. However, once made, an election
applies to all expenditures described in Sec. 1.182-3 paid or incurred
during the taxable year, and is binding for such taxable year unless the
district director consents to a revocation of such election. Requests
for consent to revoke an election under section 182 shall be made by
means of a letter to the district director for the district in which the
taxpayer is required to file his return, setting forth the taxpayer's
name, address and identification number, the year for which it is
desired to revoke the election, and the reasons therefor. However,
consent will not be granted where the only reason therefor is a change
in tax consequences.
[T.D. 6794, 30 FR 791, Jan. 26, 1965]
Sec. 1.183-1 Activities not engaged in for profit.
(a) In general. Section 183 provides rules relating to the allowance
of deductions in the case of activities (whether active or passive in
character) not engaged in for profit by individuals and electing small
business corporations, creates a presumption that an activity is engaged
in for profit if certain requirements are met, and permits the taxpayer
to elect to postpone determination of whether such presumption applies
until he has engaged in the activity for at least 5 taxable years, or,
in certain cases, 7 taxable years. Whether an activity is engaged in for
profit is determined under section 162 and section 212 (1) and (2)
except insofar as section 183(d) creates
[[Page 233]]
a presumption that the activity is engaged in for profit. If deductions
are not allowable under sections 162 and 212 (1) and (2), the deduction
allowance rules of section 183(b) and this section apply. Pursuant to
section 641(b), the taxable income of an estate or trust is computed in
the same manner as in the case of an individual, with certain exceptions
not here relevant. Accordingly, where an estate or trust engages in an
activity or activities which are not for profit, the rules of section
183 and this section apply in computing the allowable deductions of such
trust or estate. No inference is to be drawn from the provisions of
section 183 and the regulations thereunder that any activity of a
corporation (other than an electing small business corporation) is or is
not a business or engaged in for profit. For rules relating to the
deductions that may be taken into account by taxable membership
organizations which are operated primarily to furnish services,
facilities, or goods to members, see section 277 and the regulations
thereunder. For the definition of an activity not engaged in for profit,
see Sec. 1.183-2. For rules relating to the election contained in
section 183(e), see Sec. 1.183-3.
(b) Deductions allowable--(1) Manner and extent. If an activity is
not engaged in for profit, deductions are allowable under section 183(b)
in the following order and only to the following extent:
(i) Amounts allowable as deductions during the taxable year under
Chapter 1 of the Code without regard to whether the activity giving rise
to such amounts was engaged in for profit are allowable to the full
extent allowed by the relevant sections of the Code, determined after
taking into account any limitations or exceptions with respect to the
allowability of such amounts. For example, the allowability-of-interest
expenses incurred with respect to activities not engaged in for profit
is limited by the rules contained in section 163(d).
(ii) Amounts otherwise allowable as deductions during the taxable
year under Chapter 1 of the Code, but only if such allowance does not
result in an adjustment to the basis of property, determined as if the
activity giving rise to such amounts was engaged in for profit, are
allowed only to the extent the gross income attributable to such
activity exceeds the deductions allowed or allowable under subdivision
(i) of this subparagraph.
(iii) Amounts otherwise allowable as deductions for the taxable year
under Chapter 1 of the Code which result in (or if otherwise allowed
would have resulted in) an adjustment to the basis of property,
determined as if the activity giving rise to such deductions was engaged
in for profit, are allowed only to the extent the gross income
attributable to such activity exceeds the deductions allowed or
allowable under subdivisions (i) and (ii) of this subparagraph.
Deductions falling within this subdivision include such items as
depreciation, partial losses with respect to property, partially
worthless debts, amortization, and amortizable bond premium.
(2) Rule for deductions involving basis adjustments--(i) In general.
If deductions are allowed under subparagraph (1)(iii) of this paragraph,
and such deductions are allowed with respect to more than one asset, the
deduction allowed with respect to each asset shall be determined
separately in accordance with the computation set forth in subdivision
(ii) of this subparagraph.
(ii) Basis adjustment fraction. The deduction allowed under
subparagraph (1)(iii) of this paragraph is computed by multiplying the
amount which would have been allowed, had the activity been engaged in
for profit, as a deduction with respect to each particular asset which
involves a basis adjustment, by the basis adjustment fraction:
(a) The numerator of which is the total of deductions allowable
under subparagraph (1)(iii) of this paragraph, and
(b) The denominator of which is the total of deductions which
involve basis adjustments which would have been allowed with respect to
the activity had the activity been engaged in for profit.
The amount resulting from this computation is the deduction allowed
under subparagraph (1)(iii) of this paragraph with respect to the
particular asset. The basis of such asset is adjusted only to the extent
of such deduction.
[[Page 234]]
(3) Examples. The provisions of subparagraphs (1) and (2) of this
paragraph may be illustrated by the following examples:
Example 1. A, an individual, maintains a herd of dairy cattle, which
is an ``activity not engaged in for profit'' within the meaning of
section 183(c). A sold milk for $1,000 during the year. During the year
A paid $300 State taxes on gasoline used to transport the cows, milk,
etc., and paid $1,200 for feed for the cows. For the year A also had a
casualty loss attributable to this activity of $500. A determines the
amount of his allowable deductions under section 183 as follows:
(i) First, A computes his deductions allowable under subparagraph
(1)(i) of this paragraph as follows:
State gasoline taxes specifically allowed under section $300
164(a)(5) without regard to whether the activity is engaged
in for profit...............................................
Casualty loss specifically allowed under section 165(c)(3) 400
without regard to whether the activity is engaged in for
profit ($500 less $100 limitation)..........................
----------
Deductions allowable under subparagraph (1)(i) of this 700
paragraph...................................................
(ii) Second, A computes his deductions allowable under subparagraph
(1)(ii) of this paragraph (deductions which would be allowed under
chapter 1 of the Code if the activity were engaged in for profit and
which do not involve basis adjustments) as follows:
Maximum amount of deductions allowable under subparagraph (1)(ii) of
this paragraph:
Income from milk sales....................................... $1,000
==========
Gross income from activity................................... 1,000
Less: deductions allowable under subparagraph (1)(i) of this 700
paragraph...................................................
----------
Maximum amount of deductions allowable under subparagraph 300
(1)(ii) of this paragraph...................................
==========
Feed for cows................................................ 1,200
Deduction allowed under subparagraph (1)(ii) of this 300
paragraph...................................................
$900 of the feed expense is not allowed as a deduction under section
183 because the total feed expense ($1,200) exceeds the maximum amount
of deductions allowable under subparagraph (1)(ii) of this paragraph
($300). In view of these circumstances, it is not necessary to determine
deductions allowable under subparagraph (1)(iii) of this paragraph which
would be allowable under chapter 1 of the Code if the activity were
engaged in for profit and which involve basis adjustment (the $100 of
casualty loss not allowable under subparagraph (1)(i) of this paragraph
because of the limitation in section 165(c)(3)) because none of such
amount will be allowed as a deduction under section 183.
Example 2. Assume the same facts as in Example 1, except that A also
had income from sales of hay grown on the farm of $1,200 and that
depreciation of $750 with respect to a barn, and $650 with respect to a
tractor would have been allowed with respect to the activity had it been
engaged in for profit. A determines the amount of his allowable
deductions under section 183 as follows:
(i) First, A computes his deductions allowable under subparagraph
(1)(i) of this paragraph as follows:
State gasoline taxes specifically allowed under section $300
164(a)(5) without regard to whether the activity is engaged
in for profit...............................................
Casualty loss specifically allowed under section 165(c)(3) 400
without regard to whether the activity is engaged in for
profit ($500 less $100 limitation)..........................
----------
Deductions allowable under subparagraph (1)(i) of this 700
paragraph...................................................
(ii) Second, A computes his deductions allowable under subparagraph
(1)(ii) of this paragraph (deductions which would be allowable under
chapter 1 of the Code if the activity were engaged in for profit and
which do not involve basis adjustments) as follows:
Maximum amount of deductions allowable under subparagraph (1)(ii) of
this paragraph:
Income from milk sales....................................... $1,000
Income from hay sales........................................ 1,200
----------
Gross income from activity................................... 2,200
Less: deductions allowable under subparagraph (1)(i) of this 700
paragraph...................................................
----------
Maximum amount of deductions allowable under subparagraph 1,500
(1)(ii) of this paragraph...................................
==========
Feed for cows................................................ 1,200
The entire $1,200 of expenses relating to feed for cows is allowable as
a deduction under subparagraph (1)(ii) of this paragraph, since it does
not exceed the maximum amount of deductions allowable under such
subparagraph.
(iii) Last, A computes the deductions allowable under subparagraph
(1)(iii) of this paragraph (deductions which would be allowable under
chapter 1 of the Code if the activity were engaged in for profit and
which involve basis adjustments) as follows:
Maximum amount of deductions allowable under subparagraph (1)(iii)
of this paragraph:
Gross income from farming......................... ......... $2,200
Less: Deductions allowed under subparagraph (1)(i) $700 .........
of this paragraph................................
Deductions allowed under subparagraph (1)(ii) of 1,200 1,900
this paragraph...................................
---------------------
Maximum amount of deductions allowable under ......... 300
subparagraph (1)(iii) of this paragraph..........
(iv) Since the total of A's deductions under chapter 1 of the Code
(determined as if the activity was engaged in for profit) which involve
basis adjustments ($750 with respect to barn, $650 with respect to
tractor, and $100 with respect to limitation on casualty loss)
[[Page 235]]
exceeds the maximum amount of the deductions allowable under
subparagraph (1)(iii) of this paragraph ($300), A computes his allowable
deductions with respect to such assets as follows:
A first computes his basis adjustment fraction under subparagraph
(2)(ii) of this paragraph as follows:
The numerator of the fraction is the maximum of deductions $300
allowable under subparagraph (1)(iii) of this paragraph
which involve basis adjustments.............................
The denominator of the fraction is the total of deductions 1,500
that involve basis adjustments which would have been allowed
with respect to the activity had the activity been engaged
in for profit...............................................
The basis adjustment fraction is then applied to the amount of each
deduction which would have been allowable if the activity were engaged
in for profit and which involves a basis adjustment as follows:
Depreciation allowed with respect to barn (300/1,500 x $750). $150
Depreciation allowed with respect to tractor (300/1,500 x 130
$650).......................................................
Deduction allowed with respect to limitation on casualty loss 20
(300/1,500 x $100)..........................................
The basis of the barn and of the tractor are adjusted only by the
amount of depreciation actually allowed under section 183 with respect
to each (as determined by the above computation). The basis of the asset
with regard to which the casualty loss was suffered is adjusted only to
the extent of the amount of the casualty loss actually allowed as a
deduction under subparagraph (1) (i) and (iii) of this paragraph.
(4) Rule for capital gains and losses--(i) In general. For purposes
of section 183 and the regulations thereunder, the gross income from any
activity not engaged in for profit includes the total of all capital
gains attributable to such activity determined without regard to the
section 1202 deduction. Amounts attributable to an activity not engaged
in for profit which would be allowable as a deduction under section
1202, without regard to section 183, shall be allowable as a deduction
under section 183(b)(1) in accordance with the rules stated in this
subparagraph.
(ii) Cases where deduction not allowed under section 183. No
deduction is allowable under section 183(b)(1) with respect to capital
gains attributable to an activity not engaged in for profit if:
(a) Without regard to section 183 and the regulations thereunder,
there is no excess of net long-term capital gain over net short-term
capital loss for the year, or
(b) There is no excess of net long-term capital gain attributable to
the activity over net short-term capital loss attributable to the
activity.
(iii) Allocation of deduction. If there is:
(a) An excess of net long-term capital gain over net short-term
capital loss attributable to an activity not engaged in for profit, and
(b) Such an excess attributable to all activities, determined
without regard to section 183 and the regulations thereunder, the
deduction allowable under section 183(b)(1) attributable to capital
gains with respect to each activity not engaged in for profit (with
respect to which there is an excess of net long-term capital gain over
net short-term capital loss for the year) shall be an amount equal to
the deduction allowable under section 1202 for the taxable year
(determined without regard to section 183) multiplied by a fraction the
numerator of which is the excess of the net long-term capital gain
attributable to the activity over the net short-term capital loss
attributable to the activity and the denominator of which is an amount
equal to the total excess of net long-term capital gain over net short-
term capital loss for all activities with respect to which there is such
excess. The amount of the total section 1202 deduction allowable for the
year shall be reduced by the amount determined to be allocable to
activities not engaged in for profit and accordingly allowed as a
deduction under section 183(b)(1).
(iv) Example. The provisions of this subparagraph may be illustrated
by the following example:
Example. A, an individual who uses the cash receipts and
disbursement method of accounting and the calendar year as the taxable
year, has three activities not engaged in for profit. For his taxable
year ending on December 31, 1973, A has a $200 net long-term capital
gain from activity No. 1, a $100 net short-term capital loss from
activity No. 2, and a $300 net long-term capital gain from activity No.
3. In addition, A has a $500 net long-term capital gain from another
activity which he engages in for profit. A computes his deductions for
capital gains for calendar year 1973 as follows:
Section 1202 deduction without regard to section 183 is determined
as follows:
Net long-term capital gain from activity No. 1............... $200
Net long-term capital gain from activity No. 3............... 300
[[Page 236]]
Net long-term capital gain from activity engaged in for 500
profit......................................................
----------
Total net long-term capital gain from all activities..... 1,000
Less: Net short-term capital loss attributable to activity 100
No. 2.......................................................
----------
Aggregate net long-term capital gain over net short-term 900
capital loss from all activities............................
==========
Section 1202 deduction determined without regard to section $450
183 (one-half of $900)......................................
==========
Allocation of the total section 1202 deduction among A's various
activities:
Portion allocable to activity No. 1 which is deductible under 90
section 183(b)(1) (Excess net long-term capital gain
attributable to activity No. 1 ($200) over total excess net
long-term capital gain attributable to all of A's activities
with respect to which there is such an excess ($1,000) times
amount of section 1202 deduction ($450))....................
Portion allocable to activity No. 3 which is deductible under 135
section 183(b)(1) (Excess net long-term capital gain
attributable to activity No. 3 ($300) over total excess net
long-term capital gain attributable to all of A's activities
with respect to which there is such an excess ($1,000) times
amount of section 1202 deduction ($450))....................
Portion allocable to all activities engaged in for profit 225
(total section 1202 deduction ($450) less section 1202
deduction allowable to activities Nos. 1 and 3 ($225))......
----------
Total section 1202 deduction deductible under sections 450
1202 and 183(b)(1)......................................
==========
(c) Presumption that activity is engaged in for profit--(1) In
general. If for:
(i) Any 2 of 7 consecutive taxable years, in the case of an activity
which consists in major part of the breeding, training, showing, or
racing of horses, or
(ii) Any 2 of 5 consecutive taxable years, in the case of any other
activity, the gross income derived from an activity exceeds the
deductions attributable to such activity which would be allowed or
allowable if the activity were engaged in for profit, such activity is
presumed, unless the Commissioner establishes to the contrary, to be
engaged in for profit. For purposes of this determination the deduction
permitted by section 1202 shall not be taken into account. Such
presumption applies with respect to the second profit year and all years
subsequent to the second profit year within the 5- or 7-year period
beginning with the first profit year. This presumption arises only if
the activity is substantially the same activity for each of the relevant
taxable years, including the taxable year in question. If the taxpayer
does not meet the requirements of section 183(d) and this paragraph, no
inference that the activity is not engaged in for profit shall arise by
reason of the provisions of section 183. For purposes of this paragraph,
a net operating loss deduction is not taken into account as a deduction.
For purposes of this subparagraph a short taxable year constitutes a
taxable year.
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following examples, in each of which it is
assumed that the taxpayer has not elected, in accordance with section
183(e), to postpone determination of whether the presumption described
in section 183(d) and this paragraph is applicable.
Example 1. For taxable years 1970-74, A, an individual who uses the
cash receipts and disbursement method of accounting and the calendar
year as the taxable year, is engaged in the activity of farming. In
taxable years 1971, 1973, and 1974, A's deductible expenditures with
respect to such activity exceed his gross income from the activity. In
taxable years 1970 and 1972 A has income from the sale of farm produce
of $30,000 for each year. In each of such years A had expenses for feed
for his livestock of $10,000, depreciation of equipment of $10,000, and
fertilizer cost of $5,000 which he elects to take as a deduction. A also
has a net operating loss carryover to taxable year 1970 of $6,000. A is
presumed, for taxable years 1972, 1973, and 1974, to have engaged in the
activity of farming for profit, since for 2 years of a 5-consecutive-
year period the gross income from the activity ($30,000 for each year)
exceeded the deductions (computed without regard to the net operating
loss) which are allowable in the case of the activity ($25,000 for each
year).
Example 2. For the taxable years 1970 and 1971, B, an individual who
uses the cash receipts and disbursement method of accounting and the
calendar year as taxable year, engaged in raising pure-bred Charolais
cattle for breeding purposes. The operation showed a loss during 1970.
At the end of 1971, B sold a substantial portion of his herd and the
cattle operation showed a profit for that year. For all subsequent
relevant taxable years B continued to keep a few Charolais bulls at
stud. In 1972, B started to raise Tennessee Walking Horses for breeding
and show purposes, utilizing substantially the same pasture land, barns,
and (with structural modifications) the same stalls. The Walking
[[Page 237]]
Horse operations showed a small profit in 1973 and losses in 1972 and
1974 through 1976.
(i) Assuming that under paragraph (d)(1) of this section the raising
of cattle and raising of horses are determined to be separate
activities, no presumption that the Walking Horse operation was carried
on for profit arises under section 183(d) and this paragraph since this
activity was not the same activity that generated the profit in 1971 and
there are not, therefore, 2 profit years attributable to the horse
activity.
(ii) Assuming the same facts as in (i) above, if there were no stud
fees received in 1972 with respect to Charolais bulls, but for 1973 stud
fees with respect to such bulls exceed deductions attributable to
maintenance of the bulls in that year, the presumption will arise under
section 183(d) and this paragraph with respect to the activity of
raising and maintaining Charolais cattle for 1973 and for all subsequent
years within the 5-year period beginning with taxable year 1971, since
the activity of raising and maintaining Charolais cattle is the same
activity in 1971 and in 1973, although carried on by B on a much reduced
basis and in a different manner. Since it has been assumed that the
horse and cattle operations are separate activities, no presumption will
arise with respect to the Walking Horse operation because there are not
2 profit years attributable to such horse operation during the period in
question.
(iii) Assuming, alternatively, that the raising of cattle and
raising of horses would be considered a single activity under paragraph
(d)(1) of this section, B would receive the benefit of the presumption
beginning in 1973 with respect to both the cattle and horses since there
were profits in 1971 and 1973. The presumption would be effective
through 1977 (and longer if there is an excess of income over deductions
in this activity in 1974, 1975, 1976, or 1977 which would extend the
presumption) if, under section 183(d) and subparagraph (3) of this
paragraph, it was determined that the activity consists in major part of
the breeding, training, showing, or racing of horses. Otherwise, the
presumption would be effective only through 1975 (assuming no excess of
income over deductions in this activity in 1974 or 1975 which would
extend the presumption).
(3) Activity which consists in major part of the breeding, training,
showing, or racing of horses. For purposes of this paragraph an activity
consists in major part of the breeding, training, showing, or racing of
horses for the taxable year if the average of the portion of
expenditures attributable to breeding, training, showing, and racing of
horses for the 3 taxable years preceding the taxable year (or, in the
case of an activity which has not been conducted by the taxpayer for 3
years, for so long as it has been carried on by him) was at least 50
percent of the total expenditures attributable to the activity for such
prior taxable years.
(4) Transitional rule. In applying the presumption described in
section 183(d) and this paragraph, only taxable years beginning after
December 31, 1969, shall be taken into account. Accordingly, in the case
of an activity referred to in subparagraph (1) (i) or (ii) of this
paragraph, section 183(d) does not apply prior to the second profitable
taxable year beginning after December 31, 1969, since taxable years
prior to such date are not taken into account.
(5) Cross reference. For rules relating to section 183(e) which
permits a taxpayer to elect to postpone determination of whether any
activity shall be presumed to be ``an activity engaged in for profit''
by operation of the presumption described in section 183(d) and this
paragraph until after the close of the fourth taxable year (sixth
taxable year, in the case of activity which consists in major part of
breeding, training, showing, or racing of horses) following the taxable
year in which the taxpayer first engages in the activity, see Sec.
1.183-3.
(d) Activity defined--(1) Ascertainment of activity. In order to
determine whether, and to what extent, section 183 and the regulations
thereunder apply, the activity or activities of the taxpayer must be
ascertained. For instance, where the taxpayer is engaged in several
undertakings, each of these may be a separate activity, or several
undertakings may constitute one activity. In ascertaining the activity
or activities of the taxpayer, all the facts and circumstances of the
case must be taken into account. Generally, the most significant facts
and circumstances in making this determination are the degree of
organizational and economic interrelationship of various undertakings,
the business purpose which is (or might be) served by carrying on the
various undertakings separately or together in a trade or business or in
an investment setting, and the similarity of various undertakings.
Generally, the Commissioner will accept the characterization by the
[[Page 238]]
taxpayer of several undertakings either as a single activity or as
separate activities. The taxpayer's characterization will not be
accepted, however, when it appears that his characterization is
artificial and cannot be reasonably supported under the facts and
circumstances of the case. If the taxpayer engages in two or more
separate activities, deductions and income from each separate activity
are not aggregated either in determining whether a particular activity
is engaged in for profit or in applying section 183. Where land is
purchased or held primarily with the intent to profit from increase in
its value, and the taxpayer also engages in farming on such land, the
farming and the holding of the land will ordinarily be considered a
single activity only if the farming activity reduces the net cost of
carrying the land for its appreciation in value. Thus, the farming and
holding of the land will be considered a single activity only if the
income derived from farming exceeds the deductions attributable to the
farming activity which are not directly attributable to the holding of
the land (that is, deductions other than those directly attributable to
the holding of the land such as interest on a mortgage secured by the
land, annual property taxes attributable to the land and improvements,
and depreciation of improvements to the land).
(2) Rules for allocation of expenses. If the taxpayer is engaged in
more than one activity, an item of deduction or income may be allocated
between two or more of these activities. Where property is used in
several activities, and one or more of such activities is determined not
to be engaged in for profit, deductions relating to such property must
be allocated between the various activities on a reasonable and
consistently applied basis.
(3) Example. The provisions of this paragraph may be illustrated by
the following example:
Example. (i) A, an individual, owns a small house located near the
beach in a resort community. Visitors come to the area for recreational
purposes during only 3 months of the year. During the remaining 9 months
of the year houses such as A's are not rented. Customarily, A arranges
that the house will be leased for 2 months of 3-month recreational
season to vacationers and reserves the house for his own vacation during
the remaining month of the recreational season. In 1971, A leases the
house for 2 months for $1,000 per month and actually uses the house for
his own vacation during the other month of the recreational season. For
1971, the expenses attributable to the house are $1,200 interest, $600
real estate taxes, $600 maintenance, $300 utilities, and $1,200 which
would have been allowed as depreciation had the activity been engaged in
for profit. Under these facts and circumstances, A is engaged in a
single activity, holding the beach house primarily for personal
purposes, which is an ``activity not engaged in for profit'' within the
meaning of section 183(c). See paragraph (b)(9) of Sec. 1.183-2.
(ii) Since the $1,200 of interest and the $600 of real estate taxes
are specifically allowable as deductions under sections 163 and 164(a)
without regard to whether the beach house activity is engaged in for
profit, no allocation of these expenses between the uses of the beach
house is necessary. However, since section 262 specifically disallows
personal, living, and family expenses as deductions, the maintenance and
utilities expenses and the depreciation from the activity must be
allocated between the rental use and the personal use of the beach
house. Under the particular facts and circumstances, \2/3\ (2 months of
rental use over 3 months of total use) of each of these expenses are
allocated to the rental use, and \1/3\ (1 month of personal use over 3
months of total use) of each of these expenses are allocated to the
personal use as follows:
------------------------------------------------------------------------
Rental use 2/ Personal use
3-- expenses 1/3--
allocable to expenses
section allocable to
183(b)(2) section 262
------------------------------------------------------------------------
Maintenance expense $600.................... $400 $200
Utilities expense $300...................... 200 100
Depreciation $1,200......................... 800 400
---------------------------
Total................................... 1,400 700
------------------------------------------------------------------------
The $700 of expenses and depreciation allocated to the personal use of
the beach house are disallowed as a deduction under section 262. In
addition, the allowability of each of the expenses and the depreciation
allocated to section 183(b)(2) is determined under paragraph (b)(1) (ii)
and (iii) of this section. Thus, the maximum amount allowable as a
deduction under section 183(b)(2) is $200 ($2,000 gross income from
activity, less $1,800 deductions under section 183(b)(1)). Since the
amounts described in section 183(b)(2) ($1,400) exceed the maximum
amount allowable ($200), and since the amounts described in paragraph
(b)(1)(ii) of this section ($600) exceed such maximum amount allowable
($200),
[[Page 239]]
none of the depreciation (an amount described in paragraph (b)(1)(iii)
of this section) is allowable as a deduction.
(e) Gross income from activity not engaged in for profit defined.
For purposes of section 183 and the regulations thereunder, gross income
derived from an activity not engaged in for profit includes the total of
all gains from the sale, exchange, or other disposition of property, and
all other gross receipts derived from such activity. Such gross income
shall include, for instance, capital gains, and rents received for the
use of property which is held in connection with the activity. The
taxpayer may determine gross income from any activity by subtracting the
cost of goods sold from the gross receipts so long as he consistently
does so and follows generally accepted methods of accounting in
determining such gross income.
(f) Rule for electing small business corporations. Section 183 and
this section shall be applied at the corporate level in determining the
allowable deductions of an electing small business corporation.
[T.D. 7198, 37 FR 13680, July 13, 1972]
Sec. 1.183-2 Activity not engaged in for profit defined.
(a) In general. For purposes of section 183 and the regulations
thereunder, the term activity not engaged in for profit means any
activity other than one with respect to which deductions are allowable
for the taxable year under section 162 or under paragraph (1) or (2) of
section 212. Deductions are allowable under section 162 for expenses of
carrying on activities which constitute a trade or business of the
taxpayer and under section 212 for expenses incurred in connection with
activities engaged in for the production or collection of income or for
the management, conservation, or maintenance of property held for the
production of income. Except as provided in section 183 and Sec. 1.183-
1, no deductions are allowable for expenses incurred in connection with
activities which are not engaged in for profit. Thus, for example,
deductions are not allowable under section 162 or 212 for activities
which are carried on primarily as a sport, hobby, or for recreation. The
determination whether an activity is engaged in for profit is to be made
by reference to objective standards, taking into account all of the
facts and circumstances of each case. Although a reasonable expectation
of profit is not required, the facts and circumstances must indicate
that the taxpayer entered into the activity, or continued the activity,
with the objective of making a profit. In determining whether such an
objective exists, it may be sufficient that there is a small chance of
making a large profit. Thus it may be found that an investor in a
wildcat oil well who incurs very substantial expenditures is in the
venture for profit even though the expectation of a profit might be
considered unreasonable. In determining whether an activity is engaged
in for profit, greater weight is given to objective facts than to the
taxpayer's mere statement of his intent.
(b) Relevant factors. In determining whether an activity is engaged
in for profit, all facts and circumstances with respect to the activity
are to be taken into account. No one factor is determinative in making
this determination. In addition, it is not intended that only the
factors described in this paragraph are to be taken into account in
making the determination, or that a determination is to be made on the
basis that the number of factors (whether or not listed in this
paragraph) indicating a lack of profit objective exceeds the number of
factors indicating a profit objective, or vice versa. Among the factors
which should normally be taken into account are the following:
(1) Manner in which the taxpayer carries on the activity. The fact
that the taxpayer carries on the activity in a businesslike manner and
maintains complete and accurate books and records may indicate that the
activity is engaged in for profit. Similarly, where an activity is
carried on in a manner substantially similar to other activities of the
same nature which are profitable, a profit motive may be indicated. A
change of operating methods, adoption of new techniques or abandonment
of unprofitable methods in a manner consistent with an intent to improve
profitability may also indicate a profit motive.
[[Page 240]]
(2) The expertise of the taxpayer or his advisors. Preparation for
the activity by extensive study of its accepted business, economic, and
scientific practices, or consultation with those who are expert therein,
may indicate that the taxpayer has a profit motive where the taxpayer
carries on the activity in accordance with such practices. Where a
taxpayer has such preparation or procures such expert advice, but does
not carry on the activity in accordance with such practices, a lack of
intent to derive profit may be indicated unless it appears that the
taxpayer is attempting to develop new or superior techniques which may
result in profits from the activity.
(3) The time and effort expended by the taxpayer in carrying on the
activity. The fact that the taxpayer devotes much of his personal time
and effort to carrying on an activity, particularly if the activity does
not have substantial personal or recreational aspects, may indicate an
intention to derive a profit. A taxpayer's withdrawal from another
occupation to devote most of his energies to the activity may also be
evidence that the activity is engaged in for profit. The fact that the
taxpayer devotes a limited amount of time to an activity does not
necessarily indicate a lack of profit motive where the taxpayer employs
competent and qualified persons to carry on such activity.
(4) Expectation that assets used in activity may appreciate in
value. The term profit encompasses appreciation in the value of assets,
such as land, used in the activity. Thus, the taxpayer may intend to
derive a profit from the operation of the activity, and may also intend
that, even if no profit from current operations is derived, an overall
profit will result when appreciation in the value of land used in the
activity is realized since income from the activity together with the
appreciation of land will exceed expenses of operation. See, however,
paragraph (d) of Sec. 1.183-1 for definition of an activity in this
connection.
(5) The success of the taxpayer in carrying on other similar or
dissimilar activities. The fact that the taxpayer has engaged in similar
activities in the past and converted them from unprofitable to
profitable enterprises may indicate that he is engaged in the present
activity for profit, even though the activity is presently unprofitable.
(6) The taxpayer's history of income or losses with respect to the
activity. A series of losses during the initial or start-up stage of an
activity may not necessarily be an indication that the activity is not
engaged in for profit. However, where losses continue to be sustained
beyond the period which customarily is necessary to bring the operation
to profitable status such continued losses, if not explainable, as due
to customary business risks or reverses, may be indicative that the
activity is not being engaged in for profit. If losses are sustained
because of unforeseen or fortuitous circumstances which are beyond the
control of the taxpayer, such as drought, disease, fire, theft, weather
damages, other involuntary conversions, or depressed market conditions,
such losses would not be an indication that the activity is not engaged
in for profit. A series of years in which net income was realized would
of course be strong evidence that the activity is engaged in for profit.
(7) The amount of occasional profits, if any, which are earned. The
amount of profits in relation to the amount of losses incurred, and in
relation to the amount of the taxpayer's investment and the value of the
assets used in the activity, may provide useful criteria in determining
the taxpayer's intent. An occasional small profit from an activity
generating large losses, or from an activity in which the taxpayer has
made a large investment, would not generally be determinative that the
activity is engaged in for profit. However, substantial profit, though
only occasional, would generally be indicative that an activity is
engaged in for profit, where the investment or losses are comparatively
small. Moreover, an opportunity to earn a substantial ultimate profit in
a highly speculative venture is ordinarily sufficient to indicate that
the activity is engaged in for profit even though losses or only
occasional small profits are actually generated.
(8) The financial status of the taxpayer. The fact that the taxpayer
does not have substantial income or capital from sources other than the
activity
[[Page 241]]
may indicate that an activity is engaged in for profit. Substantial
income from sources other than the activity (particularly if the losses
from the activity generate substantial tax benefits) may indicate that
the activity is not engaged in for profit especially if there are
personal or recreational elements involved.
(9) Elements of personal pleasure or recreation. The presence of
personal motives in carrying on of an activity may indicate that the
activity is not engaged in for profit, especially where there are
recreational or personal elements involved. On the other hand, a profit
motivation may be indicated where an activity lacks any appeal other
than profit. It is not, however, necessary that an activity be engaged
in with the exclusive intention of deriving a profit or with the
intention of maximizing profits. For example, the availability of other
investments which would yield a higher return, or which would be more
likely to be profitable, is not evidence that an activity is not engaged
in for profit. An activity will not be treated as not engaged in for
profit merely because the taxpayer has purposes or motivations other
than solely to make a profit. Also, the fact that the taxpayer derives
personal pleasure from engaging in the activity is not sufficient to
cause the activity to be classified as not engaged in for profit if the
activity is in fact engaged in for profit as evidenced by other factors
whether or not listed in this paragraph.
(c) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. The taxpayer inherited a farm from her husband in an area
which was becoming largely residential, and is now nearly all so. The
farm had never made a profit before the taxpayer inherited it, and the
farm has since had substantial losses in each year. The decedent from
whom the taxpayer inherited the farm was a stockbroker, and he also left
the taxpayer substantial stock holdings which yield large income from
dividends. The taxpayer lives on an area of the farm which is set aside
exclusively for living purposes. A farm manager is employed to operate
the farm, but modern methods are not used in operating the farm. The
taxpayer was born and raised on a farm, and expresses a strong
preference for living on a farm. The taxpayer's activity of farming,
based on all the facts and circumstances, could be found not to be
engaged in for profit.
Example 2. The taxpayer is a wealthy individual who is greatly
interested in philosophy. During the past 30 years he has written and
published at his own expense several pamphlets, and he has engaged in
extensive lecturing activity, advocating and disseminating his ideas. He
has made a profit from these activities in only occasional years, and
the profits in those years were small in relation to the amounts of the
losses in all other years. The taxpayer has very sizable income from
securities (dividends and capital gains) which constitutes the principal
source of his livelihood. The activity of lecturing, publishing
pamphlets, and disseminating his ideas is not an activity engaged in by
the taxpayer for profit.
Example 3. The taxpayer, very successful in the business of
retailing soft drinks, raises dogs and horses. He began raising a
particular breed of dogs many years ago in the belief that the breed was
in danger of declining, and he has raised and sold the dogs in each year
since. The taxpayer recently began raising and racing thoroughbred
horses. The losses from the taxpayer's dog and horse activities have
increased in magnitude over the years, and he has not made a profit on
these operations during any of the last 15 years. The taxpayer generally
sells the dogs only to friends, does not advertise the dogs for sale,
and shows the dogs only infrequently. The taxpayer races his horses only
at the ``prestige'' tracks at which he combines his racing activities
with social and recreational activities. The horse and dog operations
are conducted at a large residential property on which the taxpayer also
lives, which includes substantial living quarters and attractive
recreational facilities for the taxpayer and his family. Since (i) the
activity of raising dogs and horses and racing the horses is of a
sporting and recreational nature, (ii) the taxpayer has substantial
income from his business activities of retailing soft drinks, (iii) the
horse and dog operations are not conducted in a businesslike manner, and
(iv) such operations have a continuous record of losses, it could be
determined that the horse and dog activities of the taxpayer are not
engaged in for profit.
Example 4. The taxpayer inherited a farm of 65 acres from his
parents when they died 6 years ago. The taxpayer moved to the farm from
his house in a small nearby town, and he operates it in the same manner
as his parents operated the farm before they died. The taxpayer is
employed as a skilled machine operator in a nearby factory, for which he
is paid approximately $8,500 per year. The farm has not been profitable
for the past 15 years because of rising costs of operating farms in
general, and because of the decline in the price of the produce of this
farm in particular. The taxpayer consults the local
[[Page 242]]
agent of the State agricultural service from time to time, and the
suggestions of the agent have generally been followed. The manner in
which the farm is operated by the taxpayer is substantially similar to
the manner in which farms of similar size, and which grow similar crops
in the area, are operated. Many of these other farms do not make
profits. The taxpayer does much of the required labor around the farm
himself, such as fixing fences, planting crops, etc. The activity of
farming could be found, based on all the facts and circumstances, to be
engaged in by the taxpayer for profit.
Example 5. A, an independent oil and gas operator, frequently
engages in the activity of searching for oil on undeveloped and
unexplored land which is not near proven fields. He does so in a manner
substantially similar to that of others who engage in the same activity.
The chances, based on the experience of A and others who engaged in this
activity, are strong that A will not find a commercially profitable oil
deposit when he drills on land not established geologically to be proven
oil bearing land. However, on the rare occasions that these activities
do result in discovering a well, the operator generally realizes a very
large return from such activity. Thus, there is a small chance that A
will make a large profit from his soil exploration activity. Under these
circumstances, A is engaged in the activity of oil drilling for profit.
Example 6. C, a chemist, is employed by a large chemical company and
is engaged in a wide variety of basic research projects for his
employer. Although he does no work for his employer with respect to the
development of new plastics, he has always been interested in such
development and has outfitted a workshop in his home at his own expense
which he uses to experiment in the field. He has patented several
developments at his own expense but as yet has realized no income from
his inventions or from such patents. C conducts his research on a
regular, systematic basis, incurs fees to secure consultation on his
projects from time to time, and makes extensive efforts to ``market''
his developments. C has devoted substantial time and expense in an
effort to develop a plastic sufficiently hard, durable, and malleable
that it could be used in lieu of sheet steel in many major applications,
such as automobile bodies. Although there may be only a small chance
that C will invent new plastics, the return from any such development
would be so large that it induces C to incur the costs of his
experimental work. C is sufficiently qualified by his background that
there is some reasonable basis for his experimental activities. C's
experimental work does not involve substantial personal or recreational
aspects and is conducted in an effort to find practical applications for
his work. Under these circumstances, C may be found to be engaged in the
experimental activities for profit.
[T.D. 7198, 37 FR 13683, July 13, 1972]
Sec. 1.183-3 Election to postpone determination with respect
to the presumption described in section 183(d). [Reserved]
Sec. 1.183-4 Taxable years affected.
The provisions of section 183 and the regulations thereunder shall
apply only with respect to taxable years beginning after December 31,
1969. For provisions applicable to prior taxable years, see section 270
and Sec. 1.270-1.
[T.D. 7198, 37 FR 13685, July 13, 1972]
Sec. 1.186-1 Recoveries of damages for antitrust violations, etc.
(a) Allowance of deduction. Under section 186, when a compensatory
amount which is included in gross income is received or accrued during a
taxable year for a compensable injury, a deduction is allowed in an
amount equal to the lesser of (1) such compensatory amount, or (2) the
unrecovered losses sustained as a result of such compensable injury.
(b) Compensable injury--(1) In general. For purposes of this
section, the term compensable injury means any of the injuries described
in subparagraph (2), (3), or (4) of this paragraph.
(2) Patent infringement. An injury sustained as a result of an
infringement of a patent issued by the United States (whether or not
issued to the taxpayer or another person or persons) constitutes a
compensable injury. The term patent issued by the United States means
any patent issued or granted by the United States under the authority of
the Commissioner of Patents pursuant to 35 U.S.C. 153.
(3) Breach of contract or of fiduciary duty or relationship. An
injury sustained as a result of a breach of contract (including an
injury sustained by a third party beneficiary) or a breach of fiduciary
duty or relationship constitutes a compensable injury.
(4) Injury suffered under certain antitrust law violations. An
injury sustained in business, or to property, by reason of any conduct
forbidden in the antitrust laws for which a civil action may be brought
under section 4 of the Act of
[[Page 243]]
October 15, 1914 (15 U.S.C. 15), commonly known as the Clayton Act,
constitutes a compensable injury.
(c) Compensatory amount--(1) In general. For purposes of this
section, the term, compensatory amount means any amount received or
accrued during the taxable year as damages as a result of an award in,
or in settlement of, a civil action for recovery for a compensable
injury, reduced by any amounts paid or incurred in the taxable year in
securing such award or settlement. The term compensatory amount includes
only amounts compensating for actual economic injury. Thus, additional
amounts representing punitive, exemplary, or treble damages are not
included within the term. Where, for example, a taxpayer recovers treble
damages under section 4 of the Clayton Act, only one-third of the
recovery representing economic injury constitutes a compensatory amount.
In the absence of any indication to the contrary, amounts received in
settlement of an action shall be deemed to be a recovery for an actual
economic injury except to the extent such settlement amounts exceed
actual damages claimed by the taxpayer in such action.
(2) Interest on a compensatory amount. Interest attributable to a
compensatory amount shall not be included within the term compensatory
amount.
(3) Settlement of a civil action for damages--(i) Necessity for an
action. The term compensatory amount does not include an amount received
or accrued in settlement of a claim for a compensable injury if the
amount is received or accrued prior to institution of an action. An
action shall be considered as instituted upon completion of service of
process, in accordance with the laws and rules of the court in which the
action has been commenced or to which the action has been removed, upon
all defendants who pay or incur an obligation to pay a compensatory
amount.
(ii) Specifications of the parties. If an action for a compensable
injury is settled, the specifications of the parties will generally
determine compensatory amounts unless such specifications are not
reasonably supported by the facts and circumstances of the case. For
example, the parties may provide that the sum of $1,000 represents
actual damages sustained as the result of antitrust violations and that
the total amount of the settlement after the trebling of damages is
$3,000. In such case, only the sum of $1,000 would be a compensatory
amount. In the absence of specifications of the parties, the complaint
filed by the taxpayer may be considered in determining what portion of
the amount of the settlement is a compensatory amount.
(4) Amounts paid or incurred in securing the award or settlement.
For purposes of this section, the term amounts paid or incurred in the
taxable year in securing such award or settlement shall include legal
expenses such as attorney's fees, witness fees, accountant fees, and
court costs. Expenses incurred in securing a recovery of both a
compensatory amount and other amounts from the same action shall be
allocated among such amounts in the ratio each of such amounts bears to
the total recovery. For instance, where a taxpayer incurs attorney's
fees and other expenses of $3,000 in recovering $10,000 as a
compensatory amount, $5,000 as a return of capital, and $25,000 as
punitive damages from the same action, the taxpayer shall allocate $750
of the expenses to the compensatory amount (10,000/40,000 x 3,000), $375
to the return of capital (5,000/40,000 x 3,000), and $1,875 to the
punitive damages (25,000/40,000 x 3,000).
(d) Unrecovered losses--(1) In general. For purposes of this
section, the term unrecovered losses sustained as a result of such
compensable injury means the sum of the amounts of the net operating
losses for each taxable year in whole or in part within the injury
period, to the extent that such net operating losses are attributable to
such compensable injury, reduced by (i) the sum of any amounts of such
net operating losses which were allowed as a net operating loss
carryback or carryover for any prior taxable year under the provisions
of section 172, and (ii) the sum of any amounts allowed as deductions
under section 186 (a) and this section for all prior taxable years with
respect to the same compensable injury. Accordingly, a deduction is
permitted under section 186(a) and this section with respect to net
operating losses whether or not the
[[Page 244]]
period for carryover under section 172 has expired.
(2) Injury period. For purposes of this section, the term injury
period means (i) with respect to an infringement of a patent, the period
during which the infringement of the patent continued, (ii) with respect
to a breach of contract or breach of fiduciary duty or relationship, the
period during which amounts would have been received or accrued but for
such breach of contract or breach of fiduciary duty or relationship, or
(iii) with respect to injuries sustained by reason of a violation of
section 4 of the Clayton Act, the period during which such injuries were
sustained. The injury period will be determined on the basis of the
facts and circumstances of the taxpayer's situation. The injury period
may include a periods before and after the period covered by the civil
action instituted.
(3) Net operating losses attributable to compensable injuries. A net
operating loss for any taxable year shall be treated as attributable
(whether actually attributable or not) to a compensable injury to the
extent the compensable injury is sustained during the taxable year. For
purposes of determining the extent of the compensable injury sustained
during a taxable year, a judgment for a compensable injury apportioning
the amount of the recovery (not reduced by any amounts paid or incurred
in securing such recovery) to specific taxable years within the injury
period will be conclusive. If a judgment for a compensable injury does
not apportion the amount of the recovery to specific taxable years
within the injury period, the amount of the recovery will be prorated
among the years within the injury period in the proportion that the net
operating loss sustained in each of such years bear to the total net
operating losses sustained for all such years. If an action is settled,
the specifications of the parties will generally determine the
apportionment of the amount of the recovery unless such specifications
are not reasonably supported by the facts and circumstances of the case.
In the absence of specifications of the parties, the amount of the
recovery will be prorated among the years within the injury period in
the proportion that the net operating loss sustained in each of such
years bears to the total net operating losses sustained for all such
years.
(4) Application of losses attributable to a compensable injury. If
only a portion of a net operating loss for any taxable year is
attributable to a compensable injury, such portion shall (in applying
section 172 for purposes of this section) be considered to be a separate
net operating loss for such year to be applied after the other portion
of such net operating loss. If, for example, in the year of the
compensable injury the net operating loss was $1,000 and the amount of
the compensable injury was $600, the amount of $400 not attributable to
the compensable injury would be used first to offset profits in the
carryover or carryback periods as prescribed by section 172. After the
amount not attributable to the compensable injury is used to offset
profits in other years, then the amount attributable to the compensable
injury will be applied against profits in the carryover or carryback
periods.
(e) Effect on net operating loss carryovers--(1) In general. Under
section 186 (e) if for the taxable year in which a compensatory amount
is received or accrued any portion of the net operating loss carryovers
to such year is attributable to the compensable injury for which such
amount is received or accrued, such portion of the net operating loss
carryovers must be reduced by the excess, if any, of (i) the amount
computed under section 186(e)(1) with respect to such compensatory
amount, over (ii) the amount computed under section 186(e)(2) with
respect to such compensable injury.
(2) Amount computed under section 186(e)(1). The amount computed
under section 186(e)(1) is equal to the deduction allowed under section
186(a) with respect to the compensatory amount received or accrued for
the taxable year.
(3) Amount computed under section 186(e)(2). The amount computed
under section 186(e)(2) is equal to that portion of the unrecovered
losses sustained as a result of the compensable injury with respect to
which, as of the beginning of the taxable year, the period for carryover
under section 172 has expired without benefit to the taxpayer, but
[[Page 245]]
only to the extent that such portion of the unrecovered losses did not
reduce an amount computed under section 186(e)(1) for any prior taxable
year.
(4) Increase in income under section 172(b)(2). If there is a
reduction for any taxable year under subparagraph (1) of this paragraph
in the portion of the net operating loss carryovers to such year
attributable to a compensable injury, then, solely for purposes of
determining the amount of such portion which may be carried to
subsequent taxable years, the income of such taxable year, as computed
under section 172(b)(2), shall be increased by the amount of the
reduction computed under subparagraph (1) of this paragraph, for such
year.
(f) Illustration. The provisions of section 186 and this section may
be illustrated by the following example:
Example. (i) As of the beginning of his taxable year 1969, taxpayer
A has a net operating loss carryover from his taxable year 1966 of $550
of which $250 is attributable to a compensable injury. In addition, he
has a net operating loss attributable to the compensable injury of $150
with respect to which the period for carryover under section 172 has
expired without benefit to the taxpayer. In 1969, he receives a $100
compensatory amount with respect to that injury and he has $75 in other
income. Thus, A has gross income of $175 and he is entitled to a $100
deduction (the compensatory amount received) under section 186(a) and
this section since this amount is less than the unrecovered losses
sustained as a result of the compensable injury ($250 + $150 = $400). No
portion of the net operating loss carryover to the current taxable year
attributable to the compensable injury is reduced under section 186(e)
since the amount determined under section 186(e)(1) ($100) does not
exceed the amount determined under section 186(e)(2) ($150). Therefore,
A applies a net operating loss carryover of $550 against his remaining
income of $75 and retains a net operating loss carryover of $475 to
following years of which amount $250 remains attributable to the
compensable injury. In addition, he retains $50 of net operating losses
attributable to the compensable injury with respect to which the period
for carryover under section 172 has expired without benefit to the
taxpayer.
(ii) In 1970, A receives a $200 compensatory amount with respect to
the same compensable injury and has $75 of other income. Thus, A has
gross income of $275 and he is entitled to a $200 deduction (the
compensatory amount received) under section 186(a) and this section
since this amount is less than the remaining unrecovered loss sustained
as a result of the compensable injury ($250 + $50 = $300). The net
operating loss carryover to the current taxable year of $250
attributable to the compensable injury is reduced under section 186(e)
by $150, which is the excess of the amount determined under section
186(e)(1) ($200) over the amount determined under section 186(e)(2)
($50). Therefore, A applies net operating loss carryovers of $325 ($225
not attributable to the compensable injury, + $100 attributable to such
injury) against his remaining income of $75. A retains net operating
loss carryovers of $250 for following years, of which amount $100 is
attributable to the compensable injury. A has used all of his net
operating losses attributable to the compensable injury with respect to
which the period for carryover under section 172 has expired without
benefit to the taxpayer.
(iii) In 1971, A receives a $200 compensatory amount with respect to
the same compensable injury and has $75 of other income. Thus, A has
gross income of $275 and he is entitled to a $100 deduction (the amount
of unrecovered losses) under section 186(a) and this section since this
amount is less than the compensatory amount received ($200). The net
operating loss carryover to the current taxable year of $100
attributable to the compensable injury is reduced under section 186(e)
by $100, which is the excess of the amount determined under section
186(e)(1) ($100) over the amount determined under section 186(e)(2)
($0). Therefore, A applies net operating loss carryovers of $150 against
his remaining income of $175 ($100 compensatory amount plus $75 other
income) which leaves $25 taxable income. No net operating loss carryover
remains for following years.
(g) Effective date. The provisions of this section are applicable as
to compensatory amounts received or accrued in taxable years beginning
after December 31, 1968, even though the compensable injury was
sustained in taxable years beginning before such date.
[T.D. 7220, 37 FR 24744, Nov. 21, 1972]
Sec. 1.187-1 Amortization of certain coal mine safety equipment.
(a) Allowance of deduction--(1) In general. Under section 187(a),
every person, at his election, shall be entitled to a deduction with
respect to the amortization of the adjusted basis (for determining gain)
of any certified coal mine safety equipment (as defined in Sec. 1.187-
2), based on a period of 60 months. Such 60-month period shall, at the
election of the taxpayer, begin either with the
[[Page 246]]
month following the month in which such equipment was placed in service
or with the succeeding taxable year. For rules as to making or
discontinuing the election, see paragraphs (b) and (c) of this section.
For the computation of the adjusted basis (for determining gain) of any
certified coal mine safety equipment, see paragraph (b) of Sec. 1.187-
2.
(2) Amount of deduction. (i) Such amortization deduction shall be an
amount, with respect to each month of such 60-month period which falls
within the taxable year, equal to the adjusted basis for determining
gain of the certified coal mine safety equipment at the end of such
month divided by the number of months (including the month for which the
deduction is computed) remaining in such 60-month period. Such adjusted
basis at the end of any month shall be computed without regard to the
amortization deduction for such month. The total amortization deduction
with respect to any certified coal mine safety equipment for a
particular taxable year is the sum of the amortization deductions
allowable for each month of the 60-month period which falls within such
taxable year.
(ii) If any certified coal mine safety equipment is sold or
exchanged or otherwise disposed of during a particular month, then the
amortization deduction (if any) allowable to the transferor in respect
of that month shall be that portion of the amount to which such person
would be entitled for a full month which the number of days in such
month during which the equipment was held by such person bears to the
total number of days in such month.
(3) Effect on other deductions. (i) The amortization deduction
provided by section 187(a) with respect to any month shall be in lieu of
the depreciation deduction which would otherwise be allowable with
respect to such equipment under section 167 for such month.
(ii) If the adjusted basis of such coal mine safety equipment as
computed under section 1011 for purposes other than the amortization
deduction provided by section 187(a) is in excess of the adjusted basis,
as computed under paragraph (b) of Sec. 1.187-2, then such excess shall
be recovered through depreciation deductions under the rules of section
167. See section 187(e), and paragraph (b)(2) of Sec. 1.187-2.
(iii) See section 179 and paragraph (e)(1)(ii) of Sec. 1.179-1 for
additional first-year depreciation in respect of certified coal mine
safety equipment.
(4) Special rules. (i) If the assets of a corporation which has
elected to take the amortization deduction under section 187(a) are
acquired by another corporation in a transaction to which section 381
(relating to carryovers in certain corporate acquisitions) applies, the
acquiring corporation is to be treated as if it were the transferor or
distributor corporation for purposes of this section.
(ii) For the right of estates and trusts to take the amortization
deduction provided by section 187 see section 642(f) and Sec. 1.642(f)-
1.
(iii) For the allowance of the amortization deduction in the case of
coal mine safety equipment of partnerships see section 703 and Sec.
1.703-1.
(iv) In the case of certified coal mine safety equipment held by one
person for life with the remainder to another person, the amortization
deduction under section 187(a) shall be computed as if the life tenant
were the absolute owner of the property and shall be allowable to the
life tenant during his life.
(5) Effective date. The provisions of this paragraph shall apply to
taxable years ending after December 31, 1969.
(6) Meaning of terms. Except as otherwise provided in Sec. 1.187-2,
all terms used in section 187 and the regulations thereunder shall have
the meaning provided by this section and Sec. 1.187-2.
(b) Election of amortization--(1) In general. Under section 187(b),
an election by the taxpayer to make amortization deductions with respect
to any certified coal mine safety equipment and to begin the 60-month
amortization period shall be made by a statement to that effect attached
to his return for the taxable year in which falls the first month of the
60-month amortization period so elected. Such statement shall include
the following information:
(i) A description clearly identifying each piece of certified coal
mine safety
[[Page 247]]
equipment for which an amortization deduction is claimed;
(ii) The date on which such equipment was ``placed in service'' (see
paragraph (a)(2)(i) of Sec. 1.187-2);
(iii) The date on which the amortization period began;
(iv) The total costs paid or incurred in the acquisition and
installation of such equipment;
(v) A computation showing the adjusted basis (as defined in
paragraph (b) of Sec. 1.187-2) of the equipment as of the beginning of
the amortization period;
(vi) In the case of electric face equipment which is newly acquired
by the taxpayer, a statement that the equipment has been certified by
the Secretary of the Interior or the Director of the Bureau of Mines as
being permissible within the meaning of section 305(a)(2) of the Federal
Coal Mine Health and Safety Act of 1969; and
(vii) In the case of property placed in service in connection with
used electric face equipment (within the meaning of paragraph (a)(2)(ii)
of Sec. 1.187-2), a statement that such property has resulted in the
used electric face equipment becoming permissible and a copy of the
notification that such property is permissible.
(2) Late certification. If, 90 days before the date on which the
return described in this paragraph is due, a piece of coal mine safety
equipment has not been certified as permissible by the Secretary of the
Interior or the Director of the Bureau of Mines, then the election may
be made by a statement in an amended income tax return for the taxable
year in which falls the first month of the 60-month amortization period
so elected. The statement and amended return in such case must be filed
not later than 90 days after the date the equipment is certified as
permissible by the Secretary of the Interior or the Director of the
Bureau of Mines. Amended income tax returns or claims for credit or
refund should also be filed at this time for other taxable years which
are within the amortization period and which are subsequent to the
taxable year for which the election is made. Nothing in this paragraph
shall be construed as extending the time specified in section 6511
within which a claim for credit or refund may be filed.
(3) Other requirements and considerations. No method of making the
election provided for in section 187(a) other than that prescribed in
this section shall be permitted on or after August 11, 1971. A taxpayer
who does not elect in the manner prescribed in this section to take
amortization deductions with respect to certified coal mine safety
equipment shall not be entitled to such deductions. In the case of a
taxpayer who has elected prior to August 11, 1971 the statement required
by subparagraph (1) of this paragraph shall be attached to his income
tax return for his taxable year in which August 11, 1971 occurs.
(c) Election to discontinue or revoke amortization--(1) Election to
discontinue. (i) Under section 187(c), if a taxpayer has elected to take
the amortization deduction provided by section 187(a) with respect to
any certified coal mine safety equipment, he may, after such election
and prior to the expiration of the 60-month amortization period, elect
to discontinue the amortization deduction for the remainder of the 60-
month period for such equipment.
(ii) An election to discontinue the amortization deduction shall be
made by a statement in writing filed with the District Director or with
the director of the Internal Revenue Service center with whom the return
of the taxpayer is required to be filed for its taxable year in which
falls the first month for which the election terminates. In addition, a
copy of such statement shall be attached to the taxpayer's income tax
return filed for such taxable year. Such statement shall specify the
month as of the beginning of which the taxpayer elects to discontinue
such deductions, and shall be filed before the beginning of the month
specified therein. In addition, such notice shall contain a description
clearly identifying the certified coal mine safety equipment with
respect to which the taxpayer elects to discontinue the amortization
deduction. If the taxpayer so elects to discontinue the amortization
deduction, he shall not be entitled to any further amortization
deductions under section 187 with respect to such equipment.
(2) Revocation of elections made prior to August 11, 1971. If before
August 11, 1971
[[Page 248]]
an election under section 187(a) has been made, consent is hereby given
for the taxpayer to revoke such election without the consent of the
Commissioner. Such election may be revoked by filing a notice of
revocation on or before November 9, 1971. Such notice shall be in the
form and shall be filed in the manner required by subparagraph (1)(ii)
of this paragraph. If such revocation is for a period which falls within
one or more taxable years for which an income tax return has been filed,
an amended income tax return shall be filed for any taxable year in
which a deduction was taken under section 187 on or before November 9,
1971.
(3) Depreciation subsequent to discontinuance or in the case of
revocation of amortization. (i) A taxpayer who elects in the manner
prescribed under subparagraph (1) of this section to discontinue
amortization deductions under section 187(a) or under subparagraph (2)
of this paragraph to revoke an election made prior to August 11, 1971
with respect to an item of certified coal mine safety equipment may be
entitled to a deduction for depreciation with respect to such equipment.
See section 167 and the regulations thereunder.
(ii) In the case of an election to discontinue an amortization
deduction under section 187, the deduction for depreciation shall be
computed beginning with the first month as to which such amortization
deduction is not applicable, and shall be based upon the adjusted basis
(see section 1011 and the regulations thereunder) of the property as of
the beginning of such month. Such depreciation deduction shall be based
upon the remaining portion of the period authorized under section 167
for the facility, as determined as of the first day of the first month
as of which the amortization deduction is not applicable.
(iii) In the case of a revocation of an election under section 187
referred to in paragraph (c)(2) of this section the deduction for
depreciation shall begin as of the time such depreciation deduction
would have been taken but for the election under section 187. See
subparagraph (2) of this section for rules as to filing amended returns
for years for which amortization deductions have been taken.
(d) Examples. This section may be illustrated by the following
examples:
Example 1. On September 30, 1970, the X Corporation, which uses the
calendar year as its taxable year, places in service a piece of coal
mine safety equipment required as a result of the Federal Coal Mine
Health and Safety Act of 1969 which is certified as indicated in
paragraph (a) of Sec. 1.187-2. The cost of the equipment is $120,000.
On its income tax return filed for 1970, the corporation elects to take
the amortization deductions allowed by section 187(a) with respect to
the equipment and to begin the 60-month amortization period with October
1970, the month following the month in which it was placed in service.
The adjusted basis at the end of October 1970 (determined without regard
to the amortization deduction allowed by section 187(a) for that month)
is $120,000. The allowable amortization deduction with respect to such
equipment for the taxable year 1970 is $6,000, computed as follows:
Monthly amortization deductions:
October: $120,000 divided by 60............................ $2,000
November: $118,000 ($120,000 minus $2,000) divided by 59... 2,000
December: $116,000 ($118,000 minus $2,000) divided by 58... 2,000
----------
Total amortization deduction for 1970.................... 6,000
Example 2. Assume the same facts as in Example 1. Assume further
that on May 20, 1972, X properly files notice of its election to
discontinue the amortization deductions with the month of June 1972. The
adjusted basis of the equipment as of June 1, 1972 (assuming no capital
additions or improvements) is $80,000, computed as follows: Yearly
amortization deductions computed in accordance with Example 1:
1970......................................................... $6,000
1971......................................................... 24,000
1972 (for the first 5 months)................................ 10,000
----------
Total amortization deductions for 20 months.............. 40,000
==========
Adjusted basis at beginning of amortization period........... 120,000
Less: Amortization deductions.............................. 40,000
----------
Adjusted basis as of June 1, 1972............................ 80,000
Beginning as of June 1, 1972, the deduction for depreciation under
section 167 is allowable with respect to the property on its adjusted
basis of $80,000.
Example 3. Assume the same facts as in Example 1, except that on its
income tax return filed in 1970, X does not elect to take amortization
deductions allowed by section 187(a) but that on its income tax return
filed for 1971 X elects to begin the amortization period as of January
1, 1971, the taxable year succeeding the taxable year the equipment
[[Page 249]]
was placed in service. Assume further that the only adjustment to basis
for the period October 1, 1970, to January 1, 1971, is $3,000 for
depreciation (the amount allowable, of which $2,000 is for additional
first year depreciation under section 179) for the last 3 months of
1970. The adjusted basis (for determining gain) for purposes of section
187 as of that date is $120,000 less $3,000 or $117,000.
[T.D. 7137, 36 FR 14733, Aug. 11, 1971; 36 FR 16656, Aug. 25, 1971]
Sec. 1.187-2 Definitions.
(a) Certified coal mine safety equipment--(1) In general--(i) The
term certified coal mine safety equipment means property which:
(a) Is electric face equipment (within the meaning of section 305 of
the Federal Coal Mine Health and Safety Act of 1969) required in order
to meet the requirements of section 305(a)(2) of such Act,
(b) The Secretary of the Interior or the Director of the Bureau of
Mines certifies is permissible within the meaning of such section
305(a)(2), and
(c) Is placed in service (as defined in subparagraph (2)(i) of this
paragraph) before January 1, 1975.
(ii) In addition, property placed in service in connection with any
used electric face equipment which the Secretary of the Interior or the
Director of the Bureau of Mines certifies makes such used electric face
equipment permissible shall be treated as a separate item of certified
coal mine safety equipment. See subparagraph (2)(ii) of this paragraph.
(2) Meaning of terms. (i) For purposes of subparagraph (1)(i)(c) of
this paragraph, the term placed in service shall have the meaning
assigned to such term in paragraph (d) of Sec. 1.46-3.
(ii) For purposes of subparagraph (1)(ii) of this paragraph, the
term property includes those costs of converting existing nonpermissible
electric face equipment to a permissible condition which are chargeable
to capital account under the principles of Sec. 1.1016-2. Property is
considered to be placed in service in connection with used electric face
equipment (which was not permissible) if its use causes such electric
face equipment to be certified as permissible.
(b) Adjusted basis--(1) In general. The basis upon which the
deduction with respect to amortization allowed by section 187 is to be
computed with respect to any item of certified coal mine safety
equipment shall be the adjusted basis provided in section 1011 for the
purpose of determining gain on the sale or other disposition of such
property (see part II (section 1011 and following) subchapter O, chapter
1 of the Code) computed as of the first day of the amortization period.
For an example showing the determination of the adjusted basis referred
to in the preceding sentence in the case where the amortization period
begins with the taxable year succeeding the taxable year in which the
property is placed in service see Example 3 in paragraph (d) of Sec.
1.187-1.
(2) Capital additions. The adjusted basis of any certified coal mine
safety equipment, with respect to which an election is made under
section 187(b), shall not be increased, for purposes of section 187, for
amounts chargeable to the capital account for additions or improvements
after the amortization period has begun. However, nothing contained in
this section or Sec. 1.187-1 shall be deemed to disallow a deduction
for depreciation for such capital additions. Thus, for example, if a
taxpayer places a piece of certified coal mine safety equipment in
service in 1971 and in 1972 makes improvements to it the expenditures
for which are chargeable to the capital account, such improvements shall
not increase the adjusted basis of the equipment for purposes of
computing the amortization deduction allowed by section 187(a). However,
the depreciation deduction provided by section 167 shall be allowed with
respect to such improvements in accordance with the principles of
section 167.
[T.D. 7137, 36 FR 14734, Aug. 11, 1971; 36 FR 19251, Oct. 1, 1971]
Sec. 1.188-1 Amortization of certain expenditures for qualified
on-the-job training and child care facilities.
(a) Allowance of deduction--(1) In general. Under section 188, at
the election of the taxpayer, any eligible expenditure (as defined in
paragraph (d)(1) of this section) made by such taxpayer to
[[Page 250]]
acquire, construct, reconstruct, or rehabilitate section 188 property
(as defined in paragraph (d)(2) of this section) shall be allowable as a
deduction ratably over a period of 60 months. Such 60-month period shall
begin with the month in which such property is placed in service. For
rules for making the election, see paragraph (b) of this section. For
rules relating to the termination of an election, see paragraph (c) of
this section.
(2) Amount of deduction--(i) In general. For each eligible
expenditure attributable to an item of section 188 property the
amortization deduction shall be an amount, with respect to each month of
the 60-month amortization period which falls within the taxable year,
equal to the elgible expenditure divided by 60. The total amortization
deduction with respect to each item of section 188 property for a
particular taxable year is the sum of the amortization deductions
allowable for each month of the 60-month period which falls within such
taxable year. The total amortization deduction under section 188 for a
particular taxable year is the sum of the amortization deductions
allowable with respect to each item of section 188 property for that
taxable year.
(ii) Separate amortization period for each expenditure. Each
eligible expenditure attributable to an item of section 188 property to
which an election relates shall be amortized over a 60-month period
beginning with the month in which the item of section 188 property is
placed in service. Thus, if a taxpayer makes an eligible expenditure for
an addition to, or improvement of, section 188 property, such
expenditure must be amortized over a separate 60-month period beginning
with the month in which the section 188 property is placed in service.
(iii) Separate items. The determination of what constitutes a
separate item of section 188 property is to be made on the basis of the
facts and circumstances of each individual case. Additions or
improvements to an existing item of section 188 property are treated as
a separate item of section 188 property. In general, each item of
personal property is a separate item of property and each building, or
separate element or structural component thereof, is a separate item of
property. For purposes of subdivisions (i) and (ii) of this
subparagraph, two or more items of property may be treated as a single
item of property if such items (A) are placed in service within the same
month of the taxable year, (B) have same estimated useful life, and (C)
are to be used in a functionally related manner in the operation of a
qualified on-the-job training or child care facility or are integrally
related facilities (described in paragraph (d) (3) or (4) of this
section.
(iv) Disposition of property or termination of election. If an item
of section 188 property is sold or exchanged or otherwise disposed of
(or if the item of property ceases to be used as section 188 property by
the taxpayer) during a particular month, then the amortization deduction
(if any) allowable to the taxpayer in respect of that item for that
month shall be an amount which bears the same ratio to the amount to
which the taxpayer would be entitled for a full month as the number of
days in such month during which the property was held by him (or used by
him as section 188 property) bears to the total number of days in such
month.
(3) Effect on other deductions. The amortization deduction provided
by section 188(a) with respect to any month shall be in lieu of any
depreciation deduction which would otherwise be allowable under sections
167 or 179 with respect to that portion of the adjusted basis of the
property attributable to an adjustment under section 1016(a)(1) made on
account of an eligible expenditure.
(4) Depreciation with respect to property ceasing to be used as
section 188 property. A taxpayer is entitled to a deduction for the
depreciation (to the extent allowable under section 167) of property
with respect to which the election under section 188 is terminated under
the provisions of paragraph (c) of this section. The deduction for
depreciation shall begin with the date of such termination and shall be
computed on the adjusted basis of the property as of such date. The
depreciation deduction shall be based upon the estimated remaining
useful life and salvage value authorized under section
[[Page 251]]
167 for the property as of the termination date.
(5) Investment credit not to be allowed. Any property with respect
to which an election has been made under section 188(a) shall not be
treated as section 38 property within the meaning of section 48(a).
(6) Special rules--(i) Life estates. In the case of section 188
property held by one person for life with the remainder to another
person, the amortization deduction under section 188(a) shall be
computed as if the life tenant were the absolute owner of the property
and shall be allowable to the life tenant during his life.
(ii) Certain corporate acquistions. If the assets of a corporation
which has elected to take the amortization deduction under section
188(a) are acquired by another corporation in a transaction to which
section 381(a) (relating to carryovers in certain corporate
acquisitions) applies, the acquiring corporation is to be treated as if
it were the distributor or transferor corporation for purposes of this
section.
(iii) Estates and trusts. For the allowance of the amortization
deduction in the case of estates and trusts, see section 642(f) and
Sec. 1.642(f)-(1).
(iv) Partnerships. For the allowance of the amortization deduction
in the case of partnerships, see section 703 and Sec. 1.703-1.
(b) Time and manner of making election--(1) In general. Except as
otherwise provided in subparagraph (2) of this paragraph, an election to
amortize an eligible expenditure under section 188 shall be made by
attaching, to the taxpayer's income tax return for the taxable period
for which the deduction is first allowable to such taxpayer, a written
statement containing:
(i) A description clearly identifying each item of property (or two
or more items of property treated as a single item) forming a part of a
qualified on-the-job training or child care facility to which the
election relates. e.g., building, classroom equipment, etc.;
(ii) The date on which the eligible expenditure was made for such
item of property (or the period during which eligible expenditures were
made for two or more items of property treated as a single item of
property);
(iii) The date on which such item of property was ``placed in
service'' (see paragraph (d)(5) of this section);
(iv) The amount of the eligible expenditure of such item of property
(or the total amount of expenditures for two or more items of property
treated as a single item); and
(v) The annual amortization deduction claimed with respect to such
item of property.
If the taxpayer does not file a timely return (taking into account
extensions of the time for filing) for the taxable year for which the
election is first to be made, the election shall be filed at the time
the taxpayer files his first return for that year. The election may be
made with an amended return only if such amended return is filed no
later than the time prescribed by law (including extensions thereof) for
filing the return for the taxable year of election.
(2) Special rule. With respect to any return filed before (90 days
after the date on which final regulations are filed with the Office of
the Federal Register), the election to amortize an eligible expenditure
for section 188 property shall be made by a statement on, or attached
to, the income tax return (or an amended return) for the taxable year,
indicating that an election is being made under section 188 and setting
forth information to identify the election and the facility or
facilities to which it applies. An election made under the provisions of
this subparagraph, must be made not later than (i) the time, including
extensions thereof, prescribed by law for filing the income tax return
for the first taxable year for which the election is being made or (ii)
before (90 days after the date on which final regulations under section
188 are filed with the Office of the Federal Register), whichever is
later. Nothing in this subparagraph shall be construed as extending the
time specified in section 6511 within which a claim for credit or refund
may be filed.
(3) No other method of making election. No method for making the
election under section 188(a) other than the method prescribed in this
paragraph
[[Page 252]]
shall be permitted. If an election to amortize section 188 property is
not made within the time and in the manner prescribed in this paragraph,
no election may be made (by the filing of an amended return or in any
other manner) with respect to such section 188 property.
(4) Effect of election. An election once made may not be revoked by
a taxpayer with respect to any item of section 188 property to which the
election relates. The election of the amortization deducted for an item
of section 188 property shall not affect the taxpayer's right to elect
or not to elect the amortization deduction as to other items of section
188 property even though the items are part of the same facility. For
rules relating to the termination of an election other than by
revocation by the taxpayer, see paragraph (c) of this section.
(c) Termination of election. If the specific use of an item of
section 188 property in connection with a qualified on-the-job training
or child care facility is discontinued, the election made with respect
to that item of property shall be terminated. The termination shall be
effective with respect to such item of property as of the earliest date
on which the taxpayer's specific use of the item is no longer in
connection with the operation of a qualified on-the-job training or
child care facility. If a facility ceases to meet the applicable
requirements of paragraph (d)(3) of this section, relating to qualified
on-the-job training facilities, or paragraph (d)(4) of this section,
relating to qualified child care facilities, the election or elections
made with respect to the items of section 188 property comprising such
facility shall be terminated. The termination shall be effective with
respect to such items of poperty as of the earliest date on which the
facility is no longer qualified under the applicable rules. For rules
relating to depreciation with respect to property ceasing to be used as
section 188 property, see paragraph (a)(4) of this section.
(d) Definitions and special requirements--(1) Eligible expenditure.
For purposes of this section, the term eligible expenditure means an
expenditure:
(i) Chargeable to capital account;
(ii) Made after December 31, 1971, and before January 1, 1982, to
acquire, construct, reconstruct, or rehabilitate section 188 property
which is a qualified child care center facility (or, made after December
31, 1971, and before January 1, 1977, to acquire, construct,
reconstruct, or rehabilitate section 188 property which is a qualified
on-the-job training facility); and
(iii) For which, but only to the extent that, a grant or other
reimbursement excludable from gross income is not, directly or
indirectly, payable to, or for the benefit of, the taxpayer with respect
to such expenditure under any job training or child care program
established or funded by the United States, a State, or any
instrumentality of the foregoing, or the District of Columbia.
For purposes of this subparagraph, an expenditure is considered to be
made when actually paid by a taxpayer who computes his taxable income
under the cash receipts and disbursements method or when the obligation
therefore is incurred by a taxpayer who computes his taxable income
under the accrual method. See subparagraph (5) of this paragraph for the
determination of when section 188 property is placed in service for
purposes of beginning the 60-month amortization period.
(2) Section 188 property. Section 188 property is tangible property
which is:
(i) Of a character subject to depreciation;
(ii) Located within the United States; and
(iii) Specifically used as an integral part of a qualified on-the-
job training facility (as defined in subparagraph (3) of this paragraph)
or as an integral part of a qualified child care center facility (as
defined in subparagraph (4) of this paragraph.)
(3) Qualified on-the-job training facility. A qualified on-the-job
training facility is a facility specifically used by an employer as an
on-the-job training facility in connection with an occupational training
program for his employees or prospective employees provided that with
respect to such program:
(i) All of the following requirements are met:
[[Page 253]]
(A) There is offered at the training facility a systematic program
comprised of work and training and related instruction;
(B) The occupation, together with a listing of its basic skills, and
the estimated schedule of time for accomplishments of such skills, are
clearly identified;
(C) The content of the training is adequate to qualify the employee,
or prospective employee, for the occupation for which the individual is
being trained;
(D) The skills are to be imparted by competent instructors;
(E) Upon completion of the training, placement is to be based
primarily upon the skills learned through the training program;
(F) The period of training is not less than the time necessary to
acquire minimum job skills nor longer than the usual period of training
for the same occupation; and
(G) There is reasonable certainty that employment will be available
with the employer in the occupation for which the training is provided;
or
(ii) The employer has entered into an agreement with the United
States, or a State agency, under the provisions of the Manpower
Development and Training Act of 1962, as amended and supplemented (42
U.S.C. 2571 et seq.), the Economic Opportunity Act of 1964, as amended
and supplemented (42 U.S.C. 2701 et seq.), section 432(b)(1) of the
Social Security Act, as amended and supplemented (42 U.S.C. 632(b)(1)),
the National Apprenticeship Act of 1937, as amended and supplemented (29
U.S.C. 50 et seq.), or other similar Federal statute.
A facility consists of a building or any portion of a building and its
structural components in which training is conducted, and equipment or
other personal property necessary to teach a trainee the basic skills
required for satisfactory performance in the occupation for which the
training is being given. A facility also includes a building or portion
of a building which provides essential services for trainees during the
course of the training program, such as a dormitory or dining hall. For
purposes of this section, a facility is considered to be specifically
used as an on-the-job training facility if such facility is actually
used for such purposes and is not used in a significant manner for any
purpose other than job training or the furnishing of essential services
for trainees such as meals and lodging. For purposes of the preceding
sentence if a facility is used 20 percent of the time for a purpose
other than on-the-job training or providing trainees with essential
services, it would not satisfy the significant use test. Thus, a
production facility is not an on-the-job training facility for purposes
of section 188 simply because new employees receive training on the
machines they will be using as fully productive employees. A facility is
considered to be used by an employer in connection with an occupational
training program for his employees or prospective employees if at least
80 percent of the trainees participating in the program are employees or
prospective employees. For purposes of this section, a prospective
employee is a trainee with respect to whom it is reasonably expected
that the trainee will be employed by the employer upon successful
completion of the training program.
(4) Qualified child care facility. A qualified child care facility
is a facility which is:
(i) Particulary suited to provide child care services and
specifically used by an employer to provide such services primarily for
his employees' children;
(ii) Operated as a licensed or approved facility under applicable
local law, if any, relating to the day care of children; and
(iii) If directly or indirectly funded to any extent by the United
States, established and operated in compliance with the requirements
contained in Part 71 of title 45 of the Code of Federal Regulations,
relating to Federal Interagency Day Care Requirements. For purposes of
this subparagraph, a facility consists of the buildings, or portions or
structural components thereof, in which children receive such personal
care protection, and supervision in the absence of their parents as may
be required to meet their needs, and the equipment or other personal
property necessary to render such services. Whether or not a facility,
or any component property thereof, is particularly
[[Page 254]]
suited for the needs of the children being cared for depends upon the
facts and circumstances of each individual case. Generally, a building
and its structural component, or a room therein, and equipment are
particulary suitable for furnishing child care service if they are
designed or adapted for such use or satisfy requirements under local law
for such use as a condition to granting a license for the operation of
the facility. For example, such property includes special kitchen or
toilet facilities connected to the building or room in which the
services are rendered and equipment such as children's desks, chairs,
and play or instructional equipment. Such property would not include
general purpose rooms used for many purposes (for example, a room used
as an employee recreation center during the evening) nor would it
include a room or a part of a room which is simply screened off for use
by children during the day. For purposes of this section, a facility is
considered to be specifically used as a child care facility if such
facility is actually used for such purpose and is not used in a
significant manner for any purpose other than child care. For purposes
of this subparagraph, a child care facility is used by an employer to
provide child care services primarily for children of employees of the
employer if, for any month, no more than 20 percent of the average daily
enrolled or attending children for such month are other than children of
such employees.
(5) Placed in service. For purposes of section 188 and this section,
the term placed in service shall have the meaning assigned to such term
in paragraph (d) of Sec. 1.46-3.
(6) Employees. For purposes of section 188 and this section, the
terms employees and prospective employees include employees and
prospective employees of a member of a controlled group of corporations
(within the meaning of section 1563) of which the taxpayer is a member.
(e) Effective date. The provisions of section 188 and this section
apply to taxable years ending after December 31, 1971.
[T.D. 7599, 44 FR 14549, Mar. 13, 1979]
Sec. 1.190-1 Expenditures to remove architectural and transportation
barriers to the handicapped and elderly.
(a) In general. Under section 190 of the Internal Revenue Code of
1954, a taxpayer may elect, in the manner provided in Sec. 1.190-3 of
this chapter, to deduct certain amounts paid or incurred by him in any
taxable year beginning after December 31, 1976, and before January 1,
1980, for qualified architectural and transportation barrier removal
expenses (as defined in Sec. 1.190-2(b) of this chapter). In the case
of a partnership, the election shall be made by the partnership. The
election applies to expenditures paid or incurred during the taxable
year which (but for the election) are chargeable to capital account.
(b) Limitation. The maximum deduction for a taxpayer (including an
affiliated group of corporations filing a consolidated return) for any
taxable year is $25,000. The $25,000 limitation applies to a partnership
and to each partner. Expenditures paid or incurred in a taxable year in
excess of the amount deductible under section 190 for such taxable year
are capital expenditures and are adjustments to basis under section
1016(a). A partner must combine his distributive share of the
partnership's deductible expenditures (after application of the $25,000
limitation at the partnership level) with that partner's distributive
share of deductible expenditures from any other partnership plus that
partner's own section 190 expenditures, if any (if he makes the election
with respect to his own expenditures), and apply the partner's $25,000
limitation to the combined total to determine the aggregate amount
deductible by that partner. In so doing, the partner may allocate the
partner's $25,000 limitation among the partner's own section 190
expenditures and the partner's distributive share of partnership
deductible expenditures in any manner. If such allocation results in all
or a portion of the partner's distributive share of a partnership's
deductible expenditures not being an allowable deduction by the partner,
the partnership may capitalize such unallowable portion by an
appropriate adjustment to the basis of the relevant partnership
[[Page 255]]
property under section 1016. For purposes of adjustments to the basis of
properties held by a partnership, however, it shall be presumed that
each partner's distributive share of partnership deductible expenditures
(after application of the $25,000 limitation at the partnership level)
was allowable in full to the partner. This presumption can be rebutted
only by clear and convincing evidence that all or any portion of a
partner's distributive share of the partnership section 190 deduction
was not allowable as a deduction to the partner because it exceeded that
partner's $25,000 limitation as allocated by him. For example, suppose
for 1978 A's distributive share of the ABC partnership's deductible
section 190 expenditures (after application of the $25,000 limitation at
the partnership level) is $15,000. A also made section 190 expenditures
of $20,000 in 1978 which he elects to deduct. A allocates $10,000 of his
$25,000 limitation to his distributive share of the ABC expenditures and
$15,000 to his own expenditures. A may capitalize the excess $5,000 of
his own expenditures. In addition, if ABC obtains from A evidence which
meets the requisite burden of proof, it may capitalize the $5,000 of A's
distributive share which is not allowable as a deduction to A.
[T.D. 7634, 44 FR 43270, July 24, 1979]
Sec. 1.190-2 Definitions.
For purposes of section 190 and the regulations thereunder:
(a) Architectural and transportation barrier removal expenses. The
term architectural and transportation barrier removal expenses means
expenditures for the purpose of making any facility, or public
transportation vehicle, owned or leased by the taxpayer for use in
connection with his trade or business more accessible to, or usable by,
handicapped individuals or elderly individuals. For purposes of this
section:
(1) The term facility means all or any portion of buildings,
structures, equipment, roads, walks, parking lots, or similar real or
personal property.
(2) The term public transportation vehicle means a vehicle, such as
a bus, a railroad car, or other conveyance, which provides to the public
general or special transportation service (including such service
rendered to the customers of a taxpayer who is not in the trade or
business of rendering transportation services).
(3) The term handicapped individual means any individual who has:
(i) A physical or mental disability (including, but not limited to,
blindness or deafness) which for such individual constitutes or results
in a functional limitation to employment, or
(ii) A physical or mental impairment (including, but not limited to,
a sight or hearing impairment) which substantially limits one or more of
such individual's major life activities, such as performing manual
tasks, walking, speaking, breathing, learning, or working.
(4) The term elderly individual means an individual age 65 or over.
(b) Qualified architectual and transportation barrier removal
expense--(1) In general. The term qualified architectural and
transportation barrier removal expense means an architectural or
transportation barrier removal expense (as defined in paragraph (a) of
this section) with respect to which the taxpayer establishes, to the
satisfaction of the Commissioner or his delegate, that the resulting
removal of any such barrier conforms a facility or public transportation
vehicle to all the requirements set forth in one or more of paragraphs
(b) (2) through (22) of this section or in one or more of the
subdivisions of paragraph (b) (20) or (21). Such term includes only
expenses specifically attributable to the removal of an existing
architectural or transportation barrier. It does not include any part of
any expense paid or incurred in connection with the construction or
comprehensive renovation of a facility or public transportation vehicle
or the normal replacement of depreciable property. Such term may include
expenses of construction, as, for example, the construction of a ramp to
remove the barrier posed for wheelchair users by steps. Major portions
of the standards set forth in this paragraph were adapted from
``American National Standard Specifications for Making Buildings and
Facilities Accessible to, and Usable by, the Physically Handicapped''
(1971), the copyright for which is held by the American National
[[Page 256]]
Standards Institute, 1430 Broadway, New York, New York 10018.
(2) Grading. The grading of ground, even contrary to existing
topography, shall attain a level with a normal entrance to make a
facility accessible to individuals with physical disabilities.
(3) Walks. (i) A public walk shall be at least 48 inches wide and
shall have a gradient not greater than 5 percent. A walk of maximum or
near maximum grade and of considerable length shall have level areas at
regular intervals. A walk or driveway shall have a nonslip surface.
(ii) A walk shall be of a continuing common surface and shall not be
interrupted by steps or abrupt changes in level.
(iii) Where a walk crosses a walk, a driveway, or a parking lot,
they shall blend to a common level. However, the preceding sentence does
not require the elimination of those curbs which are a safety feature
for the handicapped, particularly the blind.
(iv) An inclined walk shall have a level platform at the top and at
the bottom. If a door swings out onto the platform toward the walk, such
platform shall be at least 5 feet deep and 5 feet wide. If a door does
not swing onto the platform or toward the walk, such platform shall be
at least 3 feet deep and 5 feet wide. A platform shall extend at least 1
foot beyond the strike jamb side of any doorway.
(4) Parking lots. (i) At least one parking space that is accessible
and approximate to a facility shall be set aside and identified for use
by the handicapped.
(ii) A parking space shall be open on one side to allow room for
individuals in wheelchairs and individuals on braces or crutches to get
in and out of an automobile onto a level surface which is suitable for
wheeling and walking.
(iii) A parking space for the handicapped, when placed between two
conventional diagonal or head-on parking spaces, shall be at least 12
feet wide.
(iv) A parking space shall be positioned so that individuals in
wheelchairs and individuals on braces or crutches need not wheel or walk
behind parked cars.
(5) Ramps. (i) A ramp shall not have a slope greater than 1 inch
rise in 12 inches.
(ii) A ramp shall have at least one handrail that is 32 inches in
height, measured from the surface of the ramp, that is smooth, and that
extends 1 foot beyond the top and bottom of the ramp. However, the
preceding sentence does not require a handrail extension which is itself
a hazard.
(iii) A ramp shall have a nonslip surface.
(iv) A ramp shall have a level platform at the top and at the
bottom. If a door swings out onto the platform or toward the ramp, such
platform shall be at least 5 feet deep and 5 feet wide. If a door does
not swing onto the platform or toward the ramp, such platform shall be
at least 3 feet deep and 5 feet wide. A platform shall extend at least 1
foot beyond the strike jamb side of any doorway.
(v) A ramp shall have level platforms at not more than 30-foot
intervals and at any turn.
(vi) A curb ramp shall be provided at an intersection. The curb ramp
shall not be less than 4 feet wide; it shall not have a slope greater
than 1 inch rise in 12 inches. The transition between the two surfaces
shall be smooth. A curb ramp shall have a nonslip surface.
(6) Entrances. A building shall have at least one primary entrance
which is usable by individuals in wheelchairs and which is on a level
accessible to an elevator.
(7) Doors and doorways. (i) A door shall have a clear opening of no
less than 32 inches and shall be operable by a single effort.
(ii) The floor on the inside and outside of a doorway shall be level
for a distance of at least 5 feet from the door in the direction the
door swings and shall extend at least 1 foot beyond the strike jamb side
of the doorway.
(iii) There shall be no sharp inclines or abrupt changes in level at
a doorway. The threshold shall be flush with the floor. The door closer
shall be selected, placed, and set so as not to impair the use of the
door by the handicapped.
(8) Stairs. (i) Stairsteps shall have round nosing of between 1 and
1\1/2\ inch radius.
[[Page 257]]
(ii) Stairs shall have a handrail 32 inches high as measured from
the tread at the face of the riser.
(iii) Stairs shall have at least one handrail that extends at least
18 inches beyond the top step and beyond the bottom step. The preceding
sentence does not require a handrail extension which is itself a hazard.
(iv) Steps shall have risers which do not exceed 7 inches.
(9) Floors. (i) Floors shall have a nonslip surface.
(ii) Floors on a given story of a building shall be of a common
level or shall be connected by a ramp in accordance with subparagraph
(5) of this paragraph.
(10) Toilet rooms. (i) A toilet room shall have sufficient space to
allow traffic of individuals in wheelchairs.
(ii) A toilet room shall have at least one toilet stall that:
(A) Is at least 36 inches wide;
(B) Is at least 56 inches deep;
(C) Has a door, if any, that is at least 32 inches wide and swings
out;
(D) Has handrails on each side, 33 inches high and parallel to the
floor, 1\1/2\ inches in outside diameter, 1\1/2\ inches clearance
between rail and wall, and fastened securely at ends and center; and
(E) Has a water closet with a seat 19 to 20 inches from the finished
floor.
(iii) A toilet room shall have, in addition to or in lieu of a
toilet stall described in (ii), at least one toilet stall that:
(A) Is at least 66 inches wide;
(B) Is at least 60 inches deep;
(C) Has a door, if any, that is at least 32 inches wide and swings
out;
(D) Has a handrail on one side, 33 inches high and parallel to the
floor, 1\1/2\ inches in outside diameter, 1\1/2\ inches clearance
between rail and wall, and fastened securely at ends and center; and
(E) Has a water closet with a seat 19 to 20 inches from the finished
floor, centerline located 18 inches from the side wall on which the
handrail is located.
(iv) A toilet room shall have lavatories with narrow aprons. Drain
pipes and hot water pipes under a lavatory shall be covered or
insulated.
(v) A mirror and a shelf above a lavatory shall be no higher than 40
inches above the floor, measured from the top of the shelf and the
bottom of the mirror.
(vi) A toilet room for men shall have wall-mounted urinals with the
opening of the basin 15 to 19 inches from the finished floor or shall
have floor-mounted urinals that are level with the main floor of the
toilet room.
(vii) Towel racks, towel dispensers, and other dispensers and
disposal units shall be mounted no higher than 40 inches from the floor.
(11) Water fountains. (i) A water fountain and a cooler shall have
upfront spouts and controls.
(ii) A water fountain and a cooler shall be hand-operated or hand-
and-foot-operated.
(iii) A water fountain mounted on the side of a floor-mounted cooler
shall not be more than 30 inches above the floor.
(iv) A wall-mounted, hand-operated water cooler shall be mounted
with the basin 36 inches from the floor.
(v) A water fountain shall not be fully recessed and shall not be
set into an alcove unless the alcove is at least 36 inches wide.
(12) Public telephones. (i) A public telephone shall be placed so
that the dial and the headset can be reached by individuals in
wheelchairs.
(ii) A public telephone shall be equipped for those with hearing
disabilities and so identified with instructions for use.
(iii) Coin slots of public telephones shall be not more than 48
inches from the floor.
(13) Elevators. (i) An elevator shall be accessible to, and usable
by the handicapped or the elderly on the levels they use to enter the
building and all levels and areas normally used.
(ii) Cab size shall allow for the turning of a wheelchair. It shall
measure at least 54 by 68 inches.
(iii) Door clear opening width shall be at least 32 inches.
(iv) All essential controls shall be within 48 to 54 inches from cab
floor. Such controls shall be usable by the blind and shall be tactilely
identifiable.
(14) Controls. Switches and controls for light, heat, ventilation,
windows,
[[Page 258]]
draperies, fire alarms, and all similar controls of frequent or
essential use, shall be placed within the reach of individuals in
wheelchairs. Such switches and controls shall be no higher than 48
inches from the floor.
(15) Identification. (i) Raised letters or numbers shall be used to
identify a room or an office. Such identification shall be placed on the
wall to the right or left of the door at a height of 54 inches to 66
inches, measured from the finished floor.
(ii) A door that might prove dangerous if a blind person were to
exit or enter by it (such as a door leading to a loading platform,
boiler room, stage, or fire escape) shall be tactilely identifiable.
(16) Warning signals. (i) An audible warning signal shall be
accompanied by a simultaneous visual signal for the benefit of those
with hearing disabilities.
(ii) A visual warning signal shall be accompanied by a simultaneous
audible signal for the benefit of the blind.
(17) Hazards. Hanging signs, ceiling lights, and similar objects and
fixtures shall be placed at a minimum height of 7 feet, measured from
the floor.
(18) International accessibility symbol. The international
accessibility symbol (see illustration) shall be displayed on routes to
and at wheelchair-accessible entrances to facilities and public
transportation vehicles.
[GRAPHIC] [TIFF OMITTED] TC10OC91.000
(19) Additional standards for rail facilities. (i) A rail facility
shall contain a fare control area with at least one entrance with a
clear opening at least 36 inches wide.
(ii) A boarding platform edge bordering a drop-off or other
dangerous condition shall be marked with a warning device consisting of
a strip of floor material differing in color and texture from the
remaining floor surface. The gap between boarding platform and vehicle
doorway shall be minimized.
(20) Standards for buses. (i) A bus shall have a level change
mechanism (e.g., lift or ramp) to enter the bus and sufficient clearance
to permit a wheelchair user to reach a secure location.
(ii) A bus shall have a wheelchair securement device. However, the
preceding sentence does not require a wheelchair securement device which
is itself a barrier or hazard.
(iii) The vertical distance from a curb or from street level to the
first front door step shall not exceed 8 inches; the riser height for
each front doorstep after the first step up from the curb or street
level shall also not exceed 8 inches; and the tread depth of steps at
front and rear doors shall be no less than 12 inches.
[[Page 259]]
(iv) A bus shall contain clearly legible signs that indicate that
seats in the front of the bus are priority seats for handicapped or
elderly persons, and that encourage other passengers to make such seats
available to handicapped and elderly persons who wish to use them.
(v) Handrails and stanchions shall be provided in the entranceway to
the bus in a configuration that allows handicapped and elderly persons
to grasp such assists from outside the bus while starting to board and
to continue to use such assists throughout the boarding and fare
collection processes. The configuration of the passenger assist system
shall include a rail across the front of the interior of the bus located
to allow passengers to lean against it while paying fares. Overhead
handrails shall be continuous except for a gap at the rear doorway.
(vi) Floors and steps shall have nonslip surfaces. Step edges shall
have a band of bright contrasting color running the full width of the
step.
(vii) A stepwell immediately adjacent to the driver shall have, when
the door is open, at least 2 foot-candles of illumination measured on
the step tread. Other stepwells shall have, at all times, at least 2
foot-candles of illumination measured on the step tread.
(viii) The doorways of the bus shall have outside lighting that
provides at least 1 foot-candle of illumination on the street surface
for a distance of 3 feet from all points on the bottom step tread edge.
Such lighting shall be located below window level and shall be shielded
to protect the eyes of entering and exiting passengers.
(ix) The fare box shall be located as far forward as practicable and
shall not obstruct traffic in the vestibule.
(21) Standards for rapid and light rail vehicles. (i) Passenger
doorways on the vehicle sides shall have clear openings at least 32
inches wide.
(ii) Audible or visual warning signals shall be provided to alert
handicapped and elderly persons of closing doors.
(iii) Handrails and stanchions shall be sufficient to permit safe
boarding, onboard circulation, seating and standing assistance, and
unboarding by handicapped and elderly persons. On a levelentry vehicle,
handrails, stanchions, and seats shall be located so as to allow a
wheelchair user to enter the vehicle and position the wheelchair in a
location which does not obstruct the movement of other passengers. On a
vehicle that requires the use of steps in the boarding process,
handrails and stanchions shall be provided in the entranceway to the
vehicle in a configuration that allows handicapped and elderly persons
to grasp such assists from outside the vehicle while starting to board,
and to continue using such assists throughout the boarding process.
(iv) Floors shall have nonslip surfaces. Step edges on a light rail
vehicle shall have a band of bright contrasting color running the full
width of the step.
(v) A stepwell immediately adjacent to the driver shall have, when
the door is open, at least 2 foot-candles of illumination measured on
the step tread. Other stepwells shall have, at all times, at least 2
foot-candles of illumination measured on the step tread.
(vi) Doorways on a light rail vehicle shall have outside lighting
that provides at least 1 foot-candle of illumination on the street
surface for a distance of 3 feet from all points on the bottom step
tread edge. Such lighting shall be located below window level and shall
be shielded to protect the eyes of entering and exiting passengers.
(22) Other barrier removals. The provisions of this subparagraph
apply to any barrier which would not be removed by compliance with
paragraphs (b)(2) through (21) of this section. The requirements of this
subparagraph are:
(i) A substantial barrier to the access to or use of a facility or
public transportation vehicle by handicapped or elderly individuals is
removed;
(ii) The barrier which is removed had been a barrier for one or more
major classes of such individuals (such as the blind, deaf, or
wheelchair users); and
(iii) The removal of that barrier is accomplished without creating
any new barrier that significantly impairs access to or use of the
facility or vehicle by such class or classes.
[T.D. 7634, 44 FR 43270, July 24, 1979]
[[Page 260]]
Sec. 1.190-3 Election to deduct architectural and transportation
barrier removal expenses.
(a) Manner of making election. The election to deduct expenditures
for removal of architectural and transportation barriers provided by
section 190(a) shall be made by claiming the deduction as a separate
item identified as such on the taxpayer's income tax return for the
taxable year for which such election is to apply (or, in the case of a
partnership, to the return of partnership income for such year). For the
election to be valid, the return must be filed not later than the time
prescribed by law for filing the return (including extensions thereof)
for the taxable year for which the election is to apply.
(b) Scope of election. An election under section 190(a) shall apply
to all expenditures described in Sec. 1.190-2 (or in the case of a
taxpayer whose architectural and transportation barrier removal expenses
exceed $25,000 for the taxable year, to the $25,000 of such expenses
with respect to which the deduction is claimed) paid or incurred during
the taxable year for which made and shall be irrevocable after the date
by which any such election must have been made.
(c) Records to be kept. In any case in which an election is made
under section 190(a), the taxpayer shall have available, for the period
prescribed by paragraph (e) of Sec. 1.6001-1 of this chapter (Income
Tax Regulations), records and documentation, including architectural
plans and blueprints, contracts, and any building permits, of all the
facts necessary to determine the amount of any deduction to which he is
entitled by reason of the election, as well as the amount of any
adjustment to basis made for expenditures in excess of the amount
deductible under section 190.
[T.D. 7634, 44 FR 13273, July 24, 1979]
Sec. 1.193-1 Deduction for tertiary injectant expenses.
(a) In general. Subject to the limitations and restrictions of
paragraphs (c) and (d) of this section, there shall be allowed as a
deduction from gross income an amount equal to the qualified tertiary
injectant expenses of the taxpayer. This deduction is allowed for the
later of:
(1) The taxable year in which the injectant is injected, or
(2) The taxable year in which the expenses are paid or incurred.
(b) Definitions--(1) Qualified tertiary injectant expenses. Except
as otherwise provided in this section, the term qualified tertiary
injectant expense means any cost paid or incurred for any tertiary
injectant which is used as part of a tertiary recovery method.
(2) Tertiary recovery method. Tertiary recovery method means:
(i) Any method which is described in subparagraphs (1) through (9)
of section 212.78(c) of the June 1979 energy regulations (as defined by
section 4996(b)(8)(C)),
(ii) Any method for which the taxpayer has obtained the approval of
the Associate Chief Counsel (Technical), under section 4993(d)(1)(B) for
purposes of Chapter 45 of the Internal Revenue Code,
(iii) Any method which is approved in the regulations under section
4993(d)(1)(B), or
(iv) Any other method to provide tertiary enhanced recovery for
which the taxpayer obtains the approval of the Associate Chief Counsel
(Technical) for purposes of section 193.
(c) Special rules for hydrocarbons--(1) In general. If an injectant
contains more than an insignificant amount of recoverable hydrocarbons,
the amount deductible under section 193 and paragraph (a) of this
section shall be limited to the cost of the injectant reduced by the
lesser of:
(i) The fair market value of the hydrocarbon component in the form
in which it is recovered, or
(ii) The cost to the taxpayer of the hydrocarbon component of the
injectant. Price levels at the time of injection are to be used in
determining the fair market value of the recoverable hydrocarbons.
(2) Presumption of recoverability. Except to the extent that the
taxpayer can demonstrate otherwise, all hydrocarbons shall be presumed
recoverable and shall be presumed to have the same value on recovery
that they would have if separated from the other components
[[Page 261]]
of the injectant before injection. Estimates based on generally accepted
engineering practices may provide evidence of limitations on the amount
or value of recoverable hydrocarbons.
(3) Significant amount. For purposes of section 193 and this
section, an injectant contains more than an insignificant amount of
recoverable hydrocarbons if the fair market value of the recoverable
hydrocarbon component of the injectant, in the form in which it is
recovered, equals or exceeds 25 percent of the cost of the injectant.
(4) Hydrocarbon defined. For purposes of section 193 and this
section, the term hydrocarbon means all forms of natural gas and crude
oil (which includes oil recovered from sources such as oil shale and
condensate).
(5) Injectant defined. For purposes of applying this paragraph (c),
an injectant is the substance or mixture of substances injected at a
particular time. Substances injected at different times are not treated
as components of a single injectant even if the injections are part of a
single tertiary recovery process.
(d) Application with other deductions. No deduction shall be allowed
under section 193 and this section for any expenditure:
(1) With respect to which the taxpayer has made an election under
section 263(c) or
(2) With respect to which a deduction is allowed or allowable under
any other provision of chapter 1 of the Code.
(e) Examples. The application of this section may be illustrated by
the following examples:
Example 1. B, a calendar year taxpayer why uses the cash receipts
and disbursements method of accounting, uses an approved tertiary
recovery method for the enhanced recovery of crude oil from one of B's
oil properties. During 1980, B pays $100x for a tertiary injectant which
contains 1,000y units of hydrocarbon; if separated from the other
components of the injectant before injection, the hydrocarbons would
have a fair market value of $80x. B uses this injectant during the
recovery effort during 1981. B has not made any election under section
263(c) with respect to the expenditures for the injectant, and no
section of chapter 1 of the Code other than section 193 allows a
deduction for the expenditure. B is unable to demonstrate that the value
of the injected hydrocarbons recovered during production will be less
than $80x. B's deduction under section 193 is limited to the excess of
the cost for the injectant over the fair market value of the hydrocarbon
component expected to be recovered ($100x-$80x = $20x). B may claim the
deduction only for 1981, the year of the injection.
Example 2. Assume the same facts as in Example 1 except that through
engineering studies B has shown that 700y units or 70 percent of the
hydrocarbon injected is nonrecoverable. The recoverable hydrocarbons
have a fair market value of $24x (30 percent of $80x). The recoverable
hydrocarbon portion of the injectant is 24 percent of the cost of the
injectant ($24x divided by $100x). The injectant does not contain a
significant amount of recoverable hydrocarbons. B may claim a deduction
for $100x, the entire cost of the injectant.
Example 3. Assume the same facts as in Example 1 except that through
laboratory studies B has shown that because of chemical changes in the
course of production the injected hydrocarbons that are recovered will
have a fair market value of only $40x. B may claim a deduction for $60x,
the excess of the cost of the injectant ($100x) over the fair market
value of the recoverable hydrocarbons ($40x).
Example 4. B prepares an injectant from crude oil and certain non-
hydrocarbon materials purchased by B. The total cost of the injectant to
B is $100x, of which $24x is attributable to the crude oil. The fair
market value of the crude oil used in the injectant is $27x. B is unable
to demonstrate that the value of the crude oil from the injectant that
will be recovered is less than $27x. The injectant contains more than an
insignificant amount of recoverable hydrocarbons because the value of
the recoverable crude oil ($27x) exceeds $25x (25 percent of $100x, the
cost of the injectant). Because the cost to B of the hydrocarbon
component of the injectant ($24x) is less than the fair market value of
the hydrocarbon component in the form in which it is recovered ($27x),
the cost rather than the value is taken into account in the adjustment
required under paragraph (c)(1) of this section. B's deduction under
section 193 is limited to the excess of the cost of the injectant over
the cost of the hydrocarbon component ($100x-$24x = $76x).
(Secs. 193 and 7805, Internal Revenue Code of 1954, 94 Stat. 286, 26
U.S.C. 193; 68A Stat. 917, 26 U.S.C. 7805)
[T.D. 7980, 49 FR 39052, Oct. 3, 1984]
Sec. 1.194-1 Amortization of reforestation expenditures.
(a) In general. Section 194 allows a taxpayer to elect to amortize
over an 84-month period, up to $10,000 of reforestation expenditures (as
defined in Sec. 1.194-3(c)) incurred by the taxpayer in
[[Page 262]]
a taxable year in connection with qualified timber property (as defined
in Sec. 1.194-3(a)). The election is not available to trusts. Only
those reforestation expenditures which result in additions to capital
accounts after December 31, 1979 are eligible for this special
amortization.
(b) Determination of amortization period. The amortization period
must begin on the first day of the first month of the last half of the
taxable year during which the taxpayer incurs the reforestation
expenditures. For example, the 84-month amortization period begins on
July 1 of a taxable year for a calendar year taxpayer, regardless of
whether the reforestation expenditures are incurred in January or
December of that taxable year. Therefore, a taxpayer will be allowed to
claim amortization deductions for only six months of each of the first
and eighth taxable years of the period over which the reforestation
expenditures will be amortized.
(c) Recapture. If a taxpayer disposes of qualified timber property
within ten years of the year in which the amortizable basis was created
and the taxpayer has claimed amortization deductions under section 194,
part or all of any gain on the disposition may be recaptured as ordinary
income. See section 1245.
[T.D. 7927, 48 FR 55849, Dec. 16, 1983]
Sec. 1.194-2 Amount of deduction allowable.
(a) General rule. The allowable monthly deduction with respect to
reforestation expenditures made in a taxable year is determined by
dividing the amount of reforestation expenditures made in such taxable
year (after applying the limitations of paragraph (b) of this section)
by 84. In order to determine the total allowable amortization deduction
for a given month, a taxpayer should add the monthly amortization
deductions computed under the preceding sentence for qualifying
expenditures made by the taxpayer in the taxable year and the preceding
seven taxable years.
(b) Dollar limitation--(1) Maximum amount subject to election. A
taxpayer may elect to amortize up to $10,000 of qualifying reforestation
expenditures each year under section 194. However, the maximum
amortizable amount is $5,000 in the case of a married individual (as
defined in section 143) filing a separate return. No carryover or
carryback of expenditures in excess of $10,000 is permitted. The maximum
annual amortization deduction for expenditures incurred in any taxable
year is $1,428.57 ($10,000/7). The maximum deduction in the first and
eighth taxable years of the amortization period is one-half that amount,
or $714.29, because of the half-year convention provided in Sec. 1.194-
1(b). Total deductions for any one year under this section will reach
$10,000 only if a taxpayer incurs and elects to amortize the maximum
$10,000 of expenditures each year over an 8-year period.
(2) Allocation of amortizable basis among taxpayer's timber
properties. The limit of $10,000 on amortizable reforestation
expenditures applies to expenditures paid or incurred during a taxable
year on all of the taxpayer's timber properties. A taxpayer who incurs
more than $10,000 in qualifying expenditures in connection with more
than one qualified timber property during a taxable year may select the
properties for which section 194 amortization will be elected as well as
the manner in which the $10,000 limitation on amortizable basis is
allocated among such properties. For example, A incurred $10,000 of
qualifying reforestation expenditures on each of four properties in
1981. A may elect under section 194 to amortize $2,500 of the amount
spent on each property, $5,000 of the amount spent on any two
properties, the entire $10,000 spent on any one property, or A may
allocate the $10,000 maximum amortizable basis among some or all of the
properties in any other manner.
(3) Basis--(i) In general. Except as provided in paragraph
(b)(3)(ii) of this section, the basis of a taxpayer's interest in
qualified timber property for which an election is made under section
194 shall be adjusted to reflect the amount of the section 194
amortization deduction allowable to the taxpayer.
(ii) Special rule for trusts. Although a trust may be a partner of a
partnership, income beneficiary of an estate, or (for taxable years
beginning after December 31, 1982) shareholder of an S
[[Page 263]]
corporation, it may not deduct its allocable share of a section 194
amortization deduction allowable to such a partnership, estate, or S
corporation. In addition, the basis of the interest held by the
partnership, estate, or S corporation in the qualified timber property
shall not be adjusted to reflect the portion of the section 194
amortization deduction that is allocable to the trust.
(4) Allocation of amortizable basis among component members of a
controlled group. Component members of a controlled group (as defined in
Sec. 1.194-3(d)) on a December 31 shall be treated as one taxpayer in
applying the $10,000 limitation of paragraph (b)(1) of this section. The
amortizable basis may be allocated to any one such member or allocated
(for the taxable year of each such member which includes such December
31) among the several members in any manner, Provided That the amount of
amortizable basis allocated to any member does not exceed the amount of
amortizable basis actually acquired by the member in the taxable year.
The allocation is to be made (i) by the common parent corporation if a
consolidated return is filed for all component members of the group, or
(ii) in accordance with an agreement entered into by the members of the
group if separate returns are filed. If a consolidated return is filed
by some component members of the group and separate returns are filed by
other component members, then the common parent of the group filing the
consolidated return shall enter into an agreement with those members who
do not join in filing the consolidated return allocating the amount
between the group filing the return and the other component members of
the controlled group who do not join in filing the consolidated return.
If a consolidated return is filed, the common parent corporation shall
file a separate statement attached to the income tax return on which an
election is made to amortize reforestation costs under section 194. See
Sec. 1.194-4. If separate returns are filed by some or all component
members of the group, each component member to which is allocated any
part of the deduction under section 194 shall file a separate statement
attached to the income tax return in which an election is made to
amortize reforestation expenditures. See Sec. 1.194-4. Such statement
shall include the name, address, employer identification number, and the
taxable year of each component member of the controlled group, a copy of
the allocation agreement signed by persons duly authorized to act on
behalf of those members who file separate returns, and a description of
the manner in which the deduction under section 194 has been divided
among them.
(5) Partnerships--(i) Election to be made by partnership. A
partnership makes the election to amortize qualified reforestation
expenditures of the partnership. See section 703(b).
(ii) Dollar limitations applicable to partnerships. The dollar
limitations of section 194 apply to the partnership as well as to each
partner. Thus, a partnership may not elect to amortize more than $10,000
of reforestation expenditures under section 194 in any taxable year.
(iii) Partner's share of amortizable basis. Section 704 and the
regulations thereunder shall govern the determination of a partner's
share of a partnership's amortizable reforestation expenditures for any
taxable year.
(iv) Dollar limitation applicable to partners. A partner shall in no
event be entitled in any taxable year to claim a deduction for
amortization based on more than $10,000 ($5,000 in the case of a married
taxpayer who files a separate return) of amortizable basis acquired in
such taxable year regardless of the source of the amortizable basis. In
the case of a partner who is a member of two or more partnerships that
elect under section 194, the partner's aggregate share of partnership
amortizable basis may not exceed $10,000 or $5,000, whichever is
applicable. In the case of a member of a partnership that elects under
section 194 who also has separately acquired qualified timber property,
the aggregate of the member's partnership and non-partnership
amortizable basis may not exceed $10,000 or $5,000 whichever is
applicable.
(6) S corporations. For taxable years beginning after December 31,
1982, rules similar to those contained in paragraph (b)(5) (ii) and (iv)
of this section
[[Page 264]]
shall apply in the case of S corporations (as defined in section
1361(a)) and their shareholders.
(7) Estates. Estates may elect to amortize in each taxable year up
to a maximum of $10,000 of qualifying reforestation expenditures under
section 194. Any amortizable basis acquired by an estate shall be
apportioned between the estate and the income beneficiary on the basis
of the income of the estate allocable to each. The amount of amortizable
basis apportioned from an estate to a beneficiary shall be taken into
account in determining the $10,000 (or $5,000) amount of amortizable
basis allowable to such beneficiary under this section.
(c) Life tenant and remainderman. If property is held by one person
for life with remainder to another person, the life tenant is entitled
to the full benefit of any amortization allowable under section 194 on
qualifying expenditures he or she makes. Any remainder interest in the
property is ignored for this purpose.
[T.D. 7927, 48 FR 55849, Dec. 16, 1983]
Sec. 1.194-3 Definitions.
(a) Qualified timber property. The term qualified timber property
means property located in the United States which will contain trees in
significant commercial quantities. The property may be a woodlot or
other site but must consist of at least one acre which is planted with
tree seedlings in the manner normally used in forestation or
reforestation. The property must be held by the taxpayer for the growing
and cutting of timber which will either be sold for use in, or used by
the taxpayer in, the commercial production of timber products. A
taxpayer does not have to own the property in order to be eligible to
elect to amortize costs attributable to it under section 194. Thus, a
taxpayer may elect to amortize qualifying reforestation expenditures
incurred by such taxpayer on leased qualified timber property. Qualified
timber property does not include property on which the taxpayer has
planted shelter belts (for which current deductions are allowed under
section 175) or ornamental trees, such as Christmas trees.
(b) Amortizable basis. The term amortizable basis means that portion
of the basis of qualified timber property which is attributable to
reforestation expenditures.
(c) Reforestation expenditures--(1) In general. The term
reforestation expenditures means direct costs incurred to plant or seed
for forestation or reforestation purposes. Qualifying expenditures
include amounts spent for site preparation, seed or seedlings, and labor
and tool costs, including depreciation on equipment used in planting or
seeding. Only those costs which must be capitalized and are included in
the adjusted basis of the property qualify as reforestation
expenditures. Costs which are currently deductible do not qualify.
(2) Cost-sharing programs. Any expenditures for which the taxpayer
has been reimbursed under any governmental reforestation cost-sharing
program do not qualify as reforestation expenditures unless the amounts
reimbursed have been included in the gross income of the taxpayer.
(d) Definitions of controlled group of corporations and component
member of controlled group. For purposes of section 194, 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).
[T.D. 7927, 48 FR 55850, Dec. 16, 1983]
Sec. 1.194-4 Time and manner of making election.
(a) In general. Except as provided in paragraph (b) of this section,
an election to amortize reforestation expenditures under section 194
shall be made by entering the amortization deduction claimed at the
appropriate place on the taxpayer's income tax return for the year in
which the expenditures were incurred, and by attaching a statement to
such return. The statement should state the amounts of the expenditures,
describe the nature of the expenditures, and give the date on which each
was incurred. The statement should also state the type of timber being
grown and the purpose for which it is being grown. A separate statement
[[Page 265]]
must be included for each property for which reforestation expenditures
are being amortized under section 194. The election may only be made on
a timely return (taking into account extensions of the time for filing)
for the taxable year in which the amortizable expenditures were made.
(b) Special rule. With respect to any return filed before March 15,
1984, on which a taxpayer was eligible to, but did not make an election
under section 194, the election to amortize reforestation expenditures
under section 194 may be made by a statement on, or attached to, the
income tax return (or an amended return) for the taxable year,
indicating that an election is being made under section 194 and setting
forth the information required under paragraph (a) of this section. An
election made under the provisions of this paragraph (b) must be made
not later than,
(1) The time prescribed by law (including extensions thereof) for
filing the income tax return for the year in which the reforestation
expenditures were made, or
(2) March 15, 1984, whichever is later. Nothing in this paragraph
shall be construed as extending the time specified in section 6511
within which a claim for credit or refund may be filed.
(c) Revocation. An application for consent to revoke an election
under section 194 shall be in writing and shall be addressed to the
Commissioner of Internal Revenue, Washington, DC 20224. The application
shall set forth the name and address of the taxpayer, state the taxable
years for which the election was in effect, and state the reason for
revoking the election. The application shall be signed by the taxpayer
or a duly authorized representative of the taxpayer and shall be filed
at least 90 days prior to the time prescribed by law (without regard to
extensions thereof) for filing the income tax return for the first
taxable year for which the election is to terminate. Ordinarily, the
request for consent to revoke the election will not be granted if it
appears from all the facts and circumstances that the only reason for
the desired change is to obtain a tax advantage.
[T.D. 7927, 48 FR 55851, Dec. 16, 1983]
Sec. 1.195-1 Election to amortize start-up expenditures.
(a) In general. Under section 195(b), a taxpayer may elect to
amortize start-up expenditures as defined in section 195(c)(1). In the
taxable year in which a taxpayer begins an active trade or business, an
electing taxpayer may deduct an amount equal to the lesser of the amount
of the start-up expenditures that relate to the active trade or
business, or $5,000 (reduced (but not below zero) by the amount by which
the start-up expenditures exceed $50,000). The remainder of the start-up
expenditures is deductible ratably over the 180-month period beginning
with the month in which the active trade or business begins. All start-
up expenditures that relate to the active trade or business are
considered in determining whether the start-up expenditures exceed
$50,000, including expenditures incurred on or before October 22, 2004.
(b) Time and manner of making election. A taxpayer is deemed to have
made an election under section 195(b) to amortize start-up expenditures
as defined in section 195(c)(1) for the taxable year in which the active
trade or business to which the expenditures relate begins. A taxpayer
may choose to forgo the deemed election by affirmatively electing to
capitalize its start-up expenditures on a timely filed Federal income
tax return (including extensions) for the taxable year in which the
active trade or business to which the expenditures relate begins. The
election either to amortize start-up expenditures under section 195(b)
or to capitalize start-up expenditures is irrevocable and applies to all
start-up expenditures that are related to the active trade or business.
A change in the characterization of an item as a start-up expenditure is
a change in method of accounting to which sections 446 and 481(a) apply
if the taxpayer treated the item consistently for two or more taxable
years. A change in the determination of the taxable year in which the
active trade or business begins also is treated as a change in method of
accounting if the taxpayer amortized start-up expenditures for two or
more taxable years.
[[Page 266]]
(c) Examples. The following examples illustrate the application of
this section:
Example 1. Expenditures of $5,000 or less Corporation X, a calendar
year taxpayer, incurs $3,000 of start-up expenditures after October 22,
2004, that relate to an active trade or business that begins on July 1,
2011. Under paragraph (b) of this section, Corporation X is deemed to
have elected to amortize start-up expenditures under section 195(b) in
2011. Therefore, Corporation X may deduct the entire amount of the
start-up expenditures in 2011, the taxable year in which the active
trade or business begins.
Example 2. Expenditures of more than $5,000 but less than or equal
to $50,000 The facts are the same as in Example 1 except that
Corporation X incurs start-up expenditures of $41,000. Under paragraph
(b) of this section, Corporation X is deemed to have elected to amortize
start-up expenditures under section 195(b) in 2011. Therefore,
Corporation X may deduct $5,000 and the portion of the remaining $36,000
that is allocable to July through December of 2011 ($36,000/180 x 6 =
$1,200) in 2011, the taxable year in which the active trade or business
begins. Corporation X may amortize the remaining $34,800 ($36,000 -
$1,200 = $34,800) ratably over the remaining 174 months.
Example 3. Subsequent change in the characterization of an item The
facts are the same as in Example 2 except that Corporation X determines
in 2013 that Corporation X incurred $10,000 for an additional start-up
expenditure erroneously deducted in 2011 under section 162 as a business
expense. Under paragraph (b) of this section, Corporation X is deemed to
have elected to amortize start-up expenditures under section 195(b) in
2011, including the additional $10,000 of start-up expenditures.
Corporation X is using an impermissible method of accounting for the
additional $10,000 of start-up expenditures and must change its method
under Sec. 1.446-1(e) and the applicable general administrative
procedures in effect in 2013.
Example 4. Subsequent redetermination of year in which business
begins The facts are the same as in Example 2 except that, in 2012,
Corporation X deducted the start-up expenditures allocable to January
through December of 2012 ($36,000/180 x 12 = $2,400). In addition, in
2013 it is determined that Corporation X actually began business in
2012. Under paragraph (b) of this section, Corporation X is deemed to
have elected to amortize start-up expenditures under section 195(b) in
2012. Corporation X impermissibly deducted start-up expenditures in
2011, and incorrectly determined the amount of start-up expenditures
deducted in 2012. Therefore, Corporation X is using an impermissible
method of accounting for the start-up expenditures and must change its
method under Sec. 1.446-1(e) and the applicable general administrative
procedures in effect in 2013.
Example 5. Expenditures of more than $50,000 but less than or equal
to $55,000 The facts are the same as in Example 1 except that
Corporation X incurs start-up expenditures of $54,500. Under paragraph
(b) of this section, Corporation X is deemed to have elected to amortize
start-up expenditures under section 195(b) in 2011. Therefore,
Corporation X may deduct $500 ($5,000 - $4,500) and the portion of the
remaining $54,000 that is allocable to July through December of 2011
($54,000/180 x 6 = $1,800) in 2011, the taxable year in which the active
trade or business begins. Corporation X may amortize the remaining
$52,200 ($54,000 - $1,800 = $52,200) ratably over the remaining 174
months.
Example 6. Expenditures of more than $55,000 The facts are the same
as in Example 1 except that Corporation X incurs start-up expenditures
of $450,000. Under paragraph (b) of this section, Corporation X is
deemed to have elected to amortize start-up expenditures under section
195(b) in 2011. Therefore, Corporation X may deduct the amounts
allocable to July through December of 2011 ($450,000/180 x 6 = $15,000)
in 2011, the taxable year in which the active trade or business begins.
Corporation X may amortize the remaining $435,000 ($450,000 - $15,000 =
$435,000) ratably over the remaining 174 months.
(d) Effective/applicability date. This section applies to start-up
expenditures paid or incurred after August 16, 2011. However, taxpayers
may apply all the provisions of this section to start-up expenditures
paid or incurred after October 22, 2004, provided that the period of
limitations on assessment of tax for the year the election under
paragraph (b) of this section is deemed made has not expired. For start-
up expenditures paid or incurred on or before September 8, 2008,
taxpayers may instead apply Sec. 1.195-1, as in effect prior to that
date (Sec. 1.195-1 as contained in 26 CFR part 1 edition revised as of
April 1, 2008).
[T.D. 9542, 76 FR 50888, Aug. 17, 2011]
Sec. 1.195-2 Technical termination of a partnership.
(a) In general. If a partnership that has elected to amortize start-
up expenditures under section 195(b) and Sec. 1.195-1 terminates in a
transaction (or a series of transactions) described in section
708(b)(1)(B) or Sec. 1.708-1(b)(2), the termination shall not be
treated as resulting in a disposition of the partnership's trade or
business for purposes of
[[Page 267]]
section 195(b)(2). See Sec. 1.708-1(b)(6) for rules concerning the
treatment of these start-up expenditures by the new partnership.
(b) Effective/applicability date. This section applies to a
technical termination of a partnership under section 708(b)(1)(B) that
occurs on or after December 9, 2013.
[T.D. 9681, 79 FR 42679, July 23, 2014]
Sec. 1.197-0 Table of contents.
This section lists the headings that appear in Sec. 1.197-2.
Sec. 1.197-2 Amortization of goodwill and certain other intangibles.
(a) Overview.
(1) In general.
(2) Section 167(f) property.
(3) Amounts otherwise deductible.
(b) Section 197 intangibles; in general.
(1) Goodwill.
(2) Going concern value.
(3) Workforce in place.
(4) Information base.
(5) Know-how, etc.
(6) Customer-based intangibles.
(7) Supplier-based intangibles.
(8) Licenses, permits, and other rights granted by governmental
units.
(9) Covenants not to compete and other similar arrangements.
(10) Franchises, trademarks, and trade names.
(11) Contracts for the use of, and term interests in, other section
197 intangibles.
(12) Other similar items.
(c) Section 197 intangibles; exceptions.
(1) Interests in a corporation, partnership, trust, or estate.
(2) Interests under certain financial contracts.
(3) Interests in land.
(4) Certain computer software.
(i) Publicly available.
(ii) Not acquired as part of trade or business.
(iii) Other exceptions.
(iv) Computer software defined.
(5) Certain interests in films, sound recordings, video tapes,
books, or other similar property.
(6) Certain rights to receive tangible property or services.
(7) Certain interests in patents or copyrights.
(8) Interests under leases of tangible property.
(i) Interest as a lessor.
(ii) Interest as a lessee.
(9) Interests under indebtedness.
(i) In general.
(ii) Exceptions.
(10) Professional sports franchises.
(11) Mortgage servicing rights.
(12) Certain transaction costs.
(13) Rights of fixed duration or amount.
(d) Amortizable section 197 intangibles.
(1) Definition.
(2) Exception for self-created intangibles.
(i) In general.
(ii) Created by the taxpayer.
(A) Defined.
(B) Contracts for the use of intangibles.
(C) Improvements and modifications.
(iii) Exceptions.
(3) Exception for property subject to anti-churning rules.
(e) Purchase of a trade or business.
(1) Goodwill or going concern value.
(2) Franchise, trademark, or trade name.
(i) In general.
(ii) Exceptions.
(3) Acquisitions to be included.
(4) Substantial portion.
(5) Deemed asset purchases under section 338.
(6) Mortgage servicing rights.
(7) Computer software acquired for internal use.
(f) Computation of amortization deduction.
(1) In general.
(2) Treatment of contingent amounts.
(i) Amounts added to basis during 15-year period.
(ii) Amounts becoming fixed after expiration of 15-year period.
(iii) Rules for including amounts in basis.
(3) Basis determinations for certain assets.
(i) Covenants not to compete.
(ii) Contracts for the use of section 197 intangibles; acquired as
part of a trade or business.
(A) In general.
(B) Know-how and certain information base.
(iii) Contracts for the use of section 197 intangibles; not acquired
as part of a trade or business.
(iv) Applicable rules.
(A) Franchises, trademarks, and trade names.
(B) Certain amounts treated as payable under a debt instrument.
(1) In general.
(2) Rights granted by governmental units.
(3) Treatment of other parties to transaction.
(4) Basis determinations in certain transactions.
(i) Certain renewal transactions.
(ii) Transactions subject to section 338 or 1060.
(iii) Certain reinsurance transactions.
(g) Special rules.
(1) Treatment of certain dispositions.
(i) Loss disallowance rules.
(A) In general.
(B) Abandonment or worthlessness.
(C) Certain nonrecognition transfers.
[[Page 268]]
(ii) Separately acquired property.
(iii) Disposition of a covenant not to compete.
(iv) Taxpayers under common control.
(A) In general.
(B) Treatment of disallowed loss.
(2) Treatment of certain nonrecognition and exchange transactions.
(i) Relationship to anti-churning rules.
(ii) Treatment of nonrecognition and exchange transactions
generally.
(A) Transfer disregarded.
(B) Application of general rule.
(C) Transactions covered.
(iii) Certain exchanged-basis property.
(iv) Transfers under section 708(b)(1).
(A) In general.
(B) Termination by sale or exchange of interest.
(C) Other terminations.
(3) Increase in the basis of partnership property under section
732(b), 734(b), 743(b), or 732(d).
(4) Section 704(c) allocations.
(i) Allocations where the intangible is amortizable by the
contributor.
(ii) Allocations where the intangible is not amortizable by the
contributor.
(5) Treatment of certain insurance contracts acquired in an
assumption reinsurance transaction.
(i) In general.
(ii) Determination of adjusted basis of amortizable section 197
intangible resulting from an assumption reinsurance transaction.
(A) In general.
(B) Amount paid or incurred by acquirer (reinsurer) under the
assumption reinsurance transaction.
(C) Amount required to be capitalized under section 848 in
connection with the transaction.
(1) In general.
(2) Required capitalization amount.
(3) General deductions allocable to the assumption reinsurance
transaction.
(4) Treatment of a capitalization shortfall allocable to the
reinsurance agreement.
(i) In general.
(ii) Treatment of additional capitalized amounts as the result of an
election under Sec. 1.848-2(g)(8).
(5) Cross references and special rules.
(D) Examples
(E) Effective/applicability date.
(iii) Application of loss disallowance rule upon a disposition of an
insurance contract acquired in an assumption reinsurance transaction.
(A) Disposition.
(1) In general.
(2) Treatment of indemnity reinsurance transactions.
(B) Loss.
(C) Examples.
(iv) Effective dates.
(A) In general.
(B) Application to pre-effective date acquisitions and dispositions.
(C) Change in method of accounting.
(1) In general.
(2) Acquisitions and dispositions on or after effective date.
(3) Acquisitions and dispositions before the effective date.
(6) Amounts paid or incurred for a franchise, trademark, or trade
name.
(7) Amounts properly taken into account in determining the cost of
property that is not a section 197 intangible.
(8) Treatment of amortizable section 197 intangibles as depreciable
property.
(h) Anti-churning rules.
(1) Scope and purpose.
(i) Scope.
(ii) Purpose.
(2) Treatment of section 197(f)(9) intangibles.
(3) Amounts deductible under section 1253(d) or Sec. 1.162-11.
(4) Transition period.
(5) Exceptions.
(6) Related person.
(i) In general.
(ii) Time for testing relationships.
(iii) Certain relationships disregarded.
(iv) De minimis rule.
(A) In general.
(B) Determination of beneficial ownership interest.
(7) Special rules for entities that owned or used property at any
time during the transition period and that are no longer in existence.
(8) Special rules for section 338 deemed acquisitions.
(9) Gain-recognition exception.
(i) Applicability.
(ii) Effect of exception.
(iii) Time and manner of election.
(iv) Special rules for certain entities.
(v) Effect of nonconforming elections.
(vi) Notification requirements.
(vii) Revocation.
(viii) Election Statement.
(ix) Determination of highest marginal rate of tax and amount of
other Federal income tax on gain.
(A) Marginal rate.
(1) Noncorporate taxpayers.
(2) Corporations and tax-exempt entities.
(B) Other Federal income tax on gain.
(x) Coordination with other provisions.
(A) In general.
(B) Section 1374.
(C) Procedural and administrative provisions.
(D) Installment method.
(xi) Special rules for persons not otherwise subject to Federal
income tax.
(10) Transactions subject to both anti-churning and nonrecognition
rules.
(11) Avoidance purpose.
[[Page 269]]
(12) Additional partnership anti-churning rules
(i) In general.
(ii) Section 732(b) adjustments. [Reserved]
(iii) Section 732(d) adjustments.
(iv) Section 734(b) adjustments. [Reserved]
(v) Section 743(b) adjustments.
(vi) Partner is or becomes a user of partnership intangible.
(A) General rule.
(B) Anti-churning partner.
(C) Effect of retroactive elections.
(vii) Section 704(c) elections.
(A) Allocations where the intangible is amortizable by the
contributor.
(B) Allocations where the intangible is not amortizable by the
contributor.
(viii) Operating rule for transfers upon death.
(i) Reserved
(j) General anti-abuse rule.
(k) Examples.
(l) Effective dates.
(1) In general.
(2) Application to pre-effective date acquisitions.
(3) Application of regulation project REG-209709-94 to pre-effective
date acquisitions.
(4) Change in method of accounting.
(i) In general.
(ii) Application to pre-effective date transactions.
(iii) Automatic change procedures.
[T.D. 8867, 65 FR 3826, Jan. 25, 2000, as amended by T.D. 9257, 71 FR
17996, Apr. 10, 2006; T.D. 9377, 73 FR 3869, Jan. 23, 2008]
Sec. 1.197-1T Certain elections for intangible property (temporary).
(a) In general. This section provides rules for making the two
elections under section 13261 of the Omnibus Budget Reconciliation Act
of 1993 (OBRA '93). Paragraph (c) of this section provides rules for
making the section 13261(g)(2) election (the retroactive election) to
apply the intangibles provisions of OBRA '93 to property acquired after
July 25, 1991, and on or before August 10, 1993 (the date of enactment
of OBRA '93). Paragraph (d) of this section provides rules for making
the section 13261(g)(3) election (binding contract election) to apply
prior law to property acquired pursuant to a written binding contract in
effect on August 10, 1993, and at all times thereafter before the date
of acquisition. The provisions of this section apply only to property
for which an election is made under paragraph (c) or (d) of this
section.
(b) Definitions and special rules--(1) Intangibles provisions of
OBRA '93. The intangibles provisions of OBRA '93 are sections 167(f) and
197 of the Internal Revenue Code (Code) and all other pertinent
provisions of section 13261 of OBRA '93 (e.g., the amendment of section
1253 in the case of a franchise, trademark, or trade name).
(2) Transition period property. The transition period property of a
taxpayer is any property that was acquired by the taxpayer after July
25, 1991, and on or before August 10, 1993.
(3) Eligible section 197 intangibles. The eligible section 197
intangibles of a taxpayer are any section 197 intangibles that--
(i) Are transition period property; and
(ii) Qualify as amortizable section 197 intangibles (within the
meaning of section 197(c)) if an election under section 13261(g)(2) of
OBRA '93 applies.
(4) Election date. The election date is the date (determined after
application of section 7502(a)) on which the taxpayer files the original
or amended return to which the election statement described in paragraph
(e) of this section is attached.
(5) Election year. The election year is the taxable year of the
taxpayer that includes August 10, 1993.
(6) Common control. A taxpayer is under common control with the
electing taxpayer if, at any time after August 2, 1993, and on or before
the election date (as defined in paragraph (b)(4) of this section), the
two taxpayers would be treated as a single taxpayer under section
41(f)(1) (A) or (B).
(7) Applicable convention for sections 197 and 167(f) intangibles.
For purposes of computing the depreciation or amortization deduction
allowable with respect to transition period property described in
section 167(f) (1) or (3) or with respect to eligible section 197
intangibles--
(i) Property acquired at any time during the month is treated as
acquired as of the first day of the month and is eligible for
depreciation or amortization during the month; and
(ii) Property is not eligible for depreciation or amortization in
the month of disposition.
[[Page 270]]
(8) Application to adjustment to basis of partnership property under
section 734(b) or 743(b). Any increase in the basis of partnership
property under section 734(b) (relating to the optional adjustment to
basis of undistributed partnership property) or section 743(b) (relating
to the optional adjustment to the basis of partnership property) will be
taken into account under this section by a partner as if the increased
portion of the basis were attributable to the partner's acquisition of
the underlying partnership property on the date the distribution or
transfer occurs. For example, if a section 754 election is in effect
and, as a result of its acquisition of a partnership interest, a
taxpayer obtains an increased basis in an intangible held through the
partnership, the increased portion of the basis in the intangible will
be treated as an intangible asset newly acquired by that taxpayer on the
date of the transaction.
(9) Former member. A former member of a consolidated group is a
corporation that was a member of the consolidated group at any time
after July 25, 1991, and on or before August 2, 1993, but that is not
under common control with the common parent of the group for purposes of
paragraph (c)(1)(ii) of this section.
(c) Retroactive election--(1) Effect of election--(i) On taxpayer.
Except as provided in paragraph (c)(1)(v) of this section, if a taxpayer
makes the retroactive election, the intangibles provisions of OBRA '93
will apply to all the taxpayer's transition period property. Thus, for
example, section 197 will apply to all the taxpayer's eligible section
197 intangibles.
(ii) On taxpayers under common control. If a taxpayer makes the
retroactive election, the election applies to each taxpayer that is
under common control with the electing taxpayer. If the retroactive
election applies to a taxpayer under common control, the intangibles
provisions of OBRA '93 apply to that taxpayer's transition period
property in the same manner as if that taxpayer had itself made the
retroactive election. However, a retroactive election that applies to a
non-electing taxpayer under common control is not treated as an election
by that taxpayer for purposes of re-applying the rule of this paragraph
(c)(1)(ii) to any other taxpayer.
(iii) On former members of consolidated group. A retroactive
election by the common parent of a consolidated group applies to
transition period property acquired by a former member while it was a
member of the consolidated group and continues to apply to that property
in each subsequent consolidated or separate return year of the former
member.
(iv) On transferred assets--(A) In general. If property is
transferred in a transaction described in paragraph (c)(1)(iv)(C) of
this section and the intangibles provisions of OBRA '93 applied to such
property in the hands of the transferor, the property remains subject to
the intangibles provisions of OBRA '93 with respect to so much of its
adjusted basis in the hands of the transferee as does not exceed its
adjusted basis in the hands of the transferor. The transferee is not
required to apply the intangibles provisions of OBRA '93 to any other
transition period property that it owns, however, unless such provisions
are otherwise applicable under the rules of this paragraph (c)(1).
(B) Transferee election. If property is transferred in a transaction
described in paragraph (c)(1)(iv)(C)(1) of this section and the
transferee makes the retroactive election, the transferor is not
required to apply the intangibles provisions of OBRA '93 to any of its
transition period property (including the property transferred to the
transferee in the transaction described in paragraph (c)(1)(iv)(C)(1) of
this section), unless such provisions are otherwise applicable under the
rules of this paragraph (c)(1).
(C) Transactions covered. This paragraph (c)(1)(iv) applies to--
(1) Any transaction described in section 332, 351, 361, 721, 731,
1031, or 1033; and
(2) Any transaction between corporations that are members of the
same consolidated group immediately after the transaction.
(D) Exchanged basis property. In the case of a transaction involving
exchanged basis property (e.g., a transaction subject to section 1031 or
1033)--
[[Page 271]]
(1) Paragraph (c)(1)(iv)(A) of this section shall not apply; and
(2) If the intangibles provisions of OBRA '93 applied to the
property by reference to which the exchanged basis is determined (the
predecessor property), the exchanged basis property becomes subject to
the intangibles provisions of OBRA '93 with respect to so much of its
basis as does not exceed the predecessor property's basis.
(E) Acquisition date. For purposes of paragraph (b)(2) of this
section (definition of transition period property), property (other than
exchanged basis property) acquired in a transaction described in
paragraph (c)(1)(iv)(C)(1) of this section generally is treated as
acquired when the transferor acquired (or was treated as acquiring) the
property (or predecessor property). However, if the adjusted basis of
the property in the hands of the transferee exceeds the adjusted basis
of the property in the hands of the transferor, the property, with
respect to that excess basis, is treated as acquired at the time of the
transfer. The time at which exchanged basis property is considered
acquired is determined by applying similar principles to the
transferee's acquisition of predecessor property.
(v) Special rule for property of former member of consolidated
group--(A) Intangibles provisions inapplicable for certain periods. If a
former member of a consolidated group makes a retroactive election
pursuant to paragraph (c)(1)(i) of this section or if an election
applies to the former member under the common control rule of paragraph
(c)(1)(ii) of this section, the intangibles provisions of OBRA '93
generally apply to all transition period property of the former member.
The intangibles provisions of OBRA '93 do not apply, however, to the
transition period property of a former member (including a former member
that makes or is bound by a retroactive election) during the period
beginning immediately after July 25, 1991, and ending immediately before
the earlier of--
(1) The first day after July 25, 1991, that the former member was
not a member of a consolidated group; or
(2) The first day after July 25, 1991, that the former member was a
member of a consolidated group that is otherwise required to apply the
intangibles provisions of OBRA '93 to its transition period property
(e.g., because the common control election under paragraph (c)(1)(ii) of
this section applies to the group).
(B) Subsequent adjustments. See paragraph (c)(5) of this section for
adjustments when the intangibles provisions of OBRA '93 first apply to
the transition period property of the former member after the property
is acquired.
(2) Making the election--(i) Partnerships, S corporations, estates,
and trusts. Except as provided in paragraph (c)(2)(ii) of this section,
in the case of transition period property of a partnership, S
corporation, estate, or trust, only the entity may make the retroactive
election for purposes of paragraph (c)(1)(i) of this section.
(ii) Partnerships for which a section 754 election is in effect. In
the case of increased basis that is treated as transition period
property of a partner under paragraph (b)(8) of this section, only that
partner may make the retroactive election for purposes of paragraph
(c)(1)(i) of this section.
(iii) Consolidated groups. An election by the common parent of a
consolidated group applies to members and former members as described in
paragraphs (c)(1)(ii) and (iii) of this section. Further, for purposes
of paragraph (c)(1)(ii) of this section, an election by the common
parent is not treated as an election by any subsidiary member. A
retroactive election cannot be made by a corporation that is a
subsidiary member of a consolidated group on August 10, 1993, but an
election can be made on behalf of the subsidiary member under paragraph
(c)(1)(ii) of this section (e.g., by the common parent of the group).
See paragraph (c)(1)(iii) of this section for rules concerning the
effect of the common parent's election on transition period property of
a former member.
(3) Time and manner of election--(i) Time. In general, the
retroactive election must be made by the due date (including extensions
of time) of the electing taxpayer's Federal income tax return for the
election year. If, however, the taxpayer's original Federal income tax
return for the election year
[[Page 272]]
is filed before April 14, 1994, the election may be made by amending
that return no later than September 12, 1994.
(ii) Manner. The retroactive election is made by attaching the
election statement described in paragraph (e) of this section to the
taxpayer's original or amended income tax return for the election year.
In addition, the taxpayer must--
(A) Amend any previously filed return when required to do so under
paragraph (c)(4) of this section; and
(B) Satisfy the notification requirements of paragraph (c)(6) of
this section.
(iii) Effect of nonconforming elections. An attempted election that
does not satisfy the requirements of this paragraph (c)(3) (including an
attempted election made on a return for a taxable year prior to the
election year) is not valid.
(4) Amended return requirements--(i) Requirements. A taxpayer
subject to this paragraph (c)(4) must amend all previously filed income
tax returns as necessary to conform the taxpayer's treatment of
transition period property to the treatment required under the
intangibles provisions of OBRA '93. See paragraph (c)(5) of this section
for certain adjustments that may be required on the amended returns
required under this paragraph (c)(4) in the case of certain consolidated
group member dispositions and tax-free transactions.
(ii) Applicability. This paragraph (c)(4) applies to a taxpayer if--
(A) The taxpayer makes the retroactive election; or
(B) Another person's retroactive election applies to the taxpayer or
to any property acquired by the taxpayer.
(5) Adjustment required with respect to certain consolidated group
member dispositions and tax-free transactions--(i) Application. This
paragraph (c)(5) applies to transition period property if the
intangibles provisions of OBRA '93 first apply to the property while it
is held by the taxpayer but do not apply to the property for some period
(the ``interim period'') after the property is acquired (or considered
acquired) by the taxpayer. For example, this paragraph (c)(5) may apply
to transition period property held by a former member of a consolidated
group if a retroactive election is made by or on behalf of the former
member but is not made by the consolidated group. See paragraph
(c)(1)(v) of this section.
(ii) Required adjustment to income. If this paragraph (c)(5)
applies, an adjustment must be taken into account in computing taxable
income of the taxpayer for the taxable year in which the intangibles
provisions of OBRA '93 first apply to the property. The amount of the
adjustment is equal to the difference for the transition period property
between--
(A) The sum of the depreciation, amortization, or other cost
recovery deductions that the taxpayer (and its predecessors) would have
been permitted if the intangibles provisions of OBRA '93 applied to the
property during the interim period; and
(B) The sum of the depreciation, amortization, or other cost
recovery deductions that the taxpayer (and its predecessors) claimed
during that interim period.
(iii) Required adjustment to basis. The taxpayer also must make a
corresponding adjustment to the basis of its transition period property
to reflect any adjustment to taxable income with respect to the property
under this paragraph (c)(5).
(6) Notification requirements--(i) Notification of commonly
controlled taxpayers. A taxpayer that makes the retroactive election
must provide written notification of the retroactive election (on or
before the election date) to each taxpayer that is under common control
with the electing taxpayer.
(ii) Notification of certain former members, former consolidated
groups, and transferees. This paragraph (c)(6)(ii) applies to a common
parent of a consolidated group that makes or is notified of a
retroactive election that applies to transition period property of a
former member, a corporation that makes or is notified of a retroactive
election that affects any consolidated group of which the corporation is
a former member, or a taxpayer that makes or is notified of a
retroactive election that applies to transition period property the
taxpayer transfers in a transaction described in paragraph
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(c)(1)(iv)(C) of this section. Such common parent, former member, or
transferor must provide written notification of the retroactive election
to any affected former member, consolidated group, or transferee. The
written notification must be provided on or before the election date in
the case of an election by the common parent, former member, or
transferor, and within 30 days of the election date in the case of an
election by a person other than the common parent, former member, or
transferor.
(7) Revocation. Once made, the retroactive election may be revoked
only with the consent of the Commissioner.
(8) Examples. The following examples illustrate the application of
this paragraph (c).
Example 1. (i) X is a partnership with 5 equal partners, A through
E. X acquires in 1989, as its sole asset, intangible asset M. X has a
section 754 election in effect for all relevant years. F, an unrelated
individual, purchases A's entire interest in the X partnership in
January 1993 for $700. At the time of F's purchase, X's inside basis for
M is $2,000, and its fair market value is $3,500.
(ii) Under section 743(b), X makes an adjustment to increase F's
basis in asset M by $300, the difference between the allocated purchase
price and M's inside basis ($700-$400 = $300). Under paragraphs (b)(8)
and (c)(2)(ii) of this section, if F makes the retroactive election, the
section 743(b) basis increase of $300 in M is an amortizable section 197
intangible even though asset M is not an amortizable section 197
intangible in the hands of X. F's increase in the basis of asset M is
amortizable over 15 years beginning with the month of F's acquisition of
the partnership interest. With respect to the remaining $400 of basis, F
is treated as stepping into A's shoes and continues A's amortization (if
any) in asset M. F's retroactive election applies to all other
intangibles acquired by F or a taxpayer under common control with F.
Example 2. A, a calendar year taxpayer, is under common control with
B, a June 30 fiscal year taxpayer. A files its original election year
Federal income tax return on March 15, 1994, and does not make either
the retroactive election or the binding contract election. B files its
election year tax return on September 15, 1994, and makes the
retroactive election. B is required by paragraph (c)(6)(i) of this
section to notify A of its election. Even though A had already filed its
election year return, A is bound by B's retroactive election under the
common control rules. Additionally, if A had made a binding contract
election, it would have been negated by B's retroactive election.
Because of B's retroactive election, A must comply with the requirements
of this paragraph (c), and file amended returns for the election year
and any affected prior years as necessary to conform the treatment of
transition period property to the treatment required under the
intangibles provisions of OBRA '93.
Example 3. (i) P and Y, calendar year taxpayers, are the common
parents of unrelated calendar year consolidated groups. On August 15,
1991, S, a subsidiary member of the P group, acquires a section 197
intangible with an unadjusted basis of $180. Under prior law, no
amortization or depreciation was allowed with respect to the acquired
intangible. On November 1, 1992, a member of the Y group acquires the S
stock in a taxable transaction. On the P group's 1993 consolidated
return, P makes the retroactive election. The P group also files amended
returns for its affected prior years. Y does not make the retroactive
election for the Y group.
(ii) Under paragraph (c)(1)(iii) of this section, a retroactive
election by the common parent of a consolidated group applies to all
transition period property acquired by a former member while it was a
member of the group. The section 197 intangible acquired by S is
transition period property that S, a former member of the P group,
acquired while a member of the P group. Thus, P's election applies to
the acquired asset. P must notify S of the election pursuant to
paragraph (c)(6)(ii) of this section.
(iii) S amortizes the unadjusted basis of its eligible section 197
intangible ($180) over the 15-year amortization period using the
applicable convention beginning as of the first day of the month of
acquisition (August 1, 1991). Thus, the P group amends its 1991
consolidated tax return to take into account $5 of amortization ($180/15
years x \5/12\ year = $5) for S.
(iv) For 1992, S is entitled to $12 of amortization ($180/15).
Assume that under Sec. 1.1502-76, $10 of S's amortization for 1992 is
allocated to the P group's consolidated return and $2 is allocated to
the Y group's return. The P group amends its 1992 consolidated tax
return to reflect the $10 deduction for S. The Y group must amend its
1992 return to reflect the $2 deduction for S.
Example 4. (i) The facts are the same as in Example 3, except that
the retroactive election is made for the Y group, not for the P group.
(ii) The Y group amends its 1992 consolidated return to claim a
section 197 deduction of $2 ($180/15 years x 2/12 year = $2) for S.
(iii) Under paragraph (c)(1)(ii) of this section, the retroactive
election by Y applies to all transition period property acquired by S.
However, under paragraph (c)(1)(v)(A) of this section, the intangibles
provisions of OBRA '93 do not apply to S's transition period property
during the period when it held such
[[Page 274]]
property as a member of P group. Instead, these provisions become
applicable to S's transition period property beginning on November 1,
1992, when S becomes a member of Y group.
(iv) Because the P group did not make the retroactive election,
there is an interim period during which the intangibles provisions of
OBRA '93 do not apply to the asset acquired by S. Thus, under paragraph
(c)(5) of this section, the Y group must take into account in computing
taxable income in 1992 an adjustment equal to the difference between the
section 197 deduction that would have been permitted if the intangibles
provisions of OBRA '93 applied to the property for the interim period
(i.e., the period for which S was included in the P group's 1991 and
1992 consolidated returns) and any amortization or depreciation
deductions claimed by S for the transferred intangible for that period.
The retroactive election does not affect the P group, and the P group is
not required to amend its returns.
Example 5. The facts are the same as in Example 3, except that both
P and Y make the retroactive election. P must notify S of its election
pursuant to paragraph (c)(6)(ii) of this section. Further, both the P
and Y groups must file amended returns for affected prior years. Because
there is no period of time during which the intangibles provisions of
OBRA '93 do not apply to the asset acquired by S, the Y group is
permitted no adjustment under paragraph (c)(5) of this section for the
asset.
(d) Binding contract election--(1) General rule--(i) Effect of
election. If a taxpayer acquires property pursuant to a written binding
contract in effect on August 10, 1993, and at all times thereafter
before the acquisition (an eligible acquisition) and makes the binding
contract election with respect to the contract, the law in effect prior
to the enactment of OBRA '93 will apply to all property acquired
pursuant to the contract. A separate binding contract election must be
made with respect to each eligible acquisition to which the law in
effect prior to the enactment of OBRA '93 is to apply.
(ii) Taxpayers subject to retroactive election. A taxpayer may not
make the binding contract election if the taxpayer or a person under
common control with the taxpayer makes the retroactive election under
paragraph (c) of this section.
(iii) Revocation. A binding contract election, once made, may be
revoked only with the consent of the Commissioner.
(2) Time and manner of election--(i) Time. In general, the binding
contract election must be made by the due date (including extensions of
time) of the electing taxpayer's Federal income tax return for the
election year. If, however, the taxpayer's original Federal income tax
return for the election year is filed before April 14, 1994, the
election may be made by amending that return no later than September 12,
1994.
(ii) Manner. The binding contract election is made by attaching the
election statement described in paragraph (e) of this section to the
taxpayer's original or amended income tax return for the election year.
(iii) Effect of nonconforming election. An attempted election that
does not satisfy the requirements of this paragraph (d)(2) is not valid.
(e) Election statement--(1) Filing requirements. For an election
under paragraph (c) or (d) of this section to be valid, the electing
taxpayer must:
(i) File (with its Federal income tax return for the election year
and with any affected amended returns required under paragraph (c)(4) of
this section) a written election statement, as an attachment to Form
4562 (Depreciation and Amortization), that satisfies the requirements of
paragraph (e)(2) of this section; and
(ii) Forward a copy of the election statement to the Statistics
Branch (QAM:S:6111), IRS Ogden Service Center, ATTN: Chief, Statistics
Branch, P.O. Box 9941, Ogden, UT 84409.
(2) Content of the election statement. The written election
statement must include the information in paragraphs (e)(2) (i) through
(vi) and (ix) of this section in the case of a retroactive election, and
the information in paragraphs (e)(2) (i) and (vii) through (ix) of this
section in the case of a binding contract election. The required
information should be arranged and identified in accordance with the
following order and numbering system--
(i) The name, address and taxpayer identification number (TIN) of
the electing taxpayer (and the common parent if a consolidated return is
filed).
(ii) A statement that the taxpayer is making the retroactive
election.
[[Page 275]]
(iii) Identification of the transition period property affected by
the retroactive election, the name and TIN of the person from which the
property was acquired, the manner and date of acquisition, the basis at
which the property was acquired, and the amount of depreciation,
amortization, or other cost recovery under section 167 or any other
provision of the Code claimed with respect to the property.
(iv) Identification of each taxpayer under common control (as
defined in paragraph (b)(6) of this section) with the electing taxpayer
by name, TIN, and Internal Revenue Service Center where the taxpayer's
income tax return is filed.
(v) If any persons are required to be notified of the retroactive
election under paragraph (c)(6) of this section, identification of such
persons and certification that written notification of the election has
been provided to such persons.
(vi) A statement that the transition period property being amortized
under section 197 is not subject to the anti-churning rules of section
197(f)(9).
(vii) A statement that the taxpayer is making the binding contract
election.
(viii) Identification of the property affected by the binding
contract election, the name and TIN of the person from which the
property was acquired, the manner and date of acquisition, the basis at
which the property was acquired, and whether any of the property is
subject to depreciation under section 167 or to amortization or other
cost recovery under any other provision of the Code.
(ix) The signature of the taxpayer or an individual authorized to
sign the taxpayer's Federal income tax return.
(f) Effective date. These regulations are effective March 15, 1994.
[T.D. 8528, 59 FR 11920, Mar. 15, 1994, as amended by T.D. 9377, 73 FR
3869, Jan. 23, 2008]
Sec. 1.197-2 Amortization of goodwill and certain other intangibles.
(a) Overview--(1) In general. Section 197 allows an amortization
deduction for the capitalized costs of an amortizable section 197
intangible and prohibits any other depreciation or amortization with
respect to that property. Paragraphs (b), (c), and (e) of this section
provide rules and definitions for determining whether property is a
section 197 intangible, and paragraphs (d) and (e) of this section
provide rules and definitions for determining whether a section 197
intangible is an amortizable section 197 intangible. The amortization
deduction under section 197 is determined by amortizing basis ratably
over a 15-year period under the rules of paragraph (f) of this section.
Section 197 also includes various special rules pertaining to the
disposition of amortizable section 197 intangibles, nonrecognition
transactions, anti-churning rules, and anti-abuse rules. Rules relating
to these provisions are contained in paragraphs (g), (h), and (j) of
this section. Examples demonstrating the application of these provisions
are contained in paragraph (k) of this section. The effective date of
the rules in this section is contained in paragraph (l) of this section.
(2) Section 167(f) property. Section 167(f) prescribes rules for
computing the depreciation deduction for certain property to which
section 197 does not apply. See Sec. 1.167(a)-14 for rules under
section 167(f) and paragraphs (c)(4), (6), (7), (11), and (13) of this
section for a description of the property subject to section 167(f).
(3) Amounts otherwise deductible. Section 197 does not apply to
amounts that are not chargeable to capital account under paragraph
(f)(3) (relating to basis determinations for covenants not to compete
and certain contracts for the use of section 197 intangibles) of this
section and are otherwise currently deductible. For this purpose, an
amount described in Sec. 1.162-11 is not currently deductible if,
without regard to Sec. 1.162-11, such amount is properly chargeable to
capital account.
(b) Section 197 intangibles; in general. Except as otherwise
provided in paragraph (c) of this section, the term section 197
intangible means any property described in section 197(d)(1). The
following rules and definitions provide guidance concerning property
that is a section 197 intangible unless an exception applies:
(1) Goodwill. Section 197 intangibles include goodwill. Goodwill is
the value
[[Page 276]]
of a trade or business attributable to the expectancy of continued
customer patronage. This expectancy may be due to the name or reputation
of a trade or business or any other factor.
(2) Going concern value. Section 197 intangibles include going
concern value. Going concern value is the additional value that attaches
to property by reason of its existence as an integral part of an ongoing
business activity. Going concern value includes the value attributable
to the ability of a trade or business (or a part of a trade or business)
to continue functioning or generating income without interruption
notwithstanding a change in ownership, but does not include any of the
intangibles described in any other provision of this paragraph (b). It
also includes the value that is attributable to the immediate use or
availability of an acquired trade or business, such as, for example, the
use of the revenues or net earnings that otherwise would not be received
during any period if the acquired trade or business were not available
or operational.
(3) Workforce in place. Section 197 intangibles include workforce in
place. Workforce in place (sometimes referred to as agency force or
assembled workforce) includes the composition of a workforce (for
example, the experience, education, or training of a workforce), the
terms and conditions of employment whether contractual or otherwise, and
any other value placed on employees or any of their attributes. Thus,
the amount paid or incurred for workforce in place includes, for
example, any portion of the purchase price of an acquired trade or
business attributable to the existence of a highly-skilled workforce, an
existing employment contract (or contracts), or a relationship with
employees or consultants (including, but not limited to, any key
employee contract or relationship). Workforce in place does not include
any covenant not to compete or other similar arrangement described in
paragraph (b)(9) of this section.
(4) Information base. Section 197 intangibles include any
information base, including a customer-related information base. For
this purpose, an information base includes business books and records,
operating systems, and any other information base (regardless of the
method of recording the information) and a customer-related information
base is any information base that includes lists or other information
with respect to current or prospective customers. Thus, the amount paid
or incurred for information base includes, for example, any portion of
the purchase price of an acquired trade or business attributable to the
intangible value of technical manuals, training manuals or programs,
data files, and accounting or inventory control systems. Other examples
include the cost of acquiring customer lists, subscription lists,
insurance expirations, patient or client files, or lists of newspaper,
magazine, radio, or television advertisers.
(5) Know-how, etc. Section 197 intangibles include any patent,
copyright, formula, process, design, pattern, know-how, format, package
design, computer software (as defined in paragraph (c)(4)(iv) of this
section), or interest in a film, sound recording, video tape, book, or
other similar property. (See, however, the exceptions in paragraph (c)
of this section.)
(6) Customer-based intangibles. Section 197 intangibles include any
customer-based intangible. A customer-based intangible is any
composition of market, market share, or other value resulting from the
future provision of goods or services pursuant to contractual or other
relationships in the ordinary course of business with customers. Thus,
the amount paid or incurred for customer-based intangibles includes, for
example, any portion of the purchase price of an acquired trade or
business attributable to the existence of a customer base, a circulation
base, an undeveloped market or market growth, insurance in force, the
existence of a qualification to supply goods or services to a particular
customer, a mortgage servicing contract (as defined in paragraph (c)(11)
of this section), an investment management contract, or other
relationship with customers involving the future provision of goods or
services. (See, however, the exceptions in paragraph (c) of this
section.) In addition, customer-based intangibles include the deposit
base and
[[Page 277]]
any similar asset of a financial institution. Thus, the amount paid or
incurred for customer-based intangibles also includes any portion of the
purchase price of an acquired financial institution attributable to the
value represented by existing checking accounts, savings accounts,
escrow accounts, and other similar items of the financial institution.
However, any portion of the purchase price of an acquired trade or
business attributable to accounts receivable or other similar rights to
income for goods or services provided to customers prior to the
acquisition of a trade or business is not an amount paid or incurred for
a customer-based intangible.
(7) Supplier-based intangibles--(i) In general. Section 197
intangibles include any supplier-based intangible. A supplier-based
intangible is the value resulting from the future acquisition, pursuant
to contractual or other relationships with suppliers in the ordinary
course of business, of goods or services that will be sold or used by
the taxpayer. Thus, the amount paid or incurred for supplier-based
intangibles includes, for example, any portion of the purchase price of
an acquired trade or business attributable to the existence of a
favorable relationship with persons providing distribution services
(such as favorable shelf or display space at a retail outlet), or the
existence of favorable supply contracts. The amount paid or incurred for
supplier-based intangibles does not include any amount required to be
paid for the goods or services themselves pursuant to the terms of the
agreement or other relationship. In addition, see the exceptions in
paragraph 2(c) of this section, including the exception in paragraph
2(c)(6) of this section for certain rights to receive tangible property
or services from another person.
(ii) Applicability date. This section applies to supplier-based
intangibles acquired after July 6, 2011.
(8) Licenses, permits, and other rights granted by governmental
units. Section 197 intangibles include any license, permit, or other
right granted by a governmental unit (including, for purposes of section
197, an agency or instrumentality thereof) even if the right is granted
for an indefinite period or is reasonably expected to be renewed for an
indefinite period. These rights include, for example, a liquor license,
a taxi-cab medallion (or license), an airport landing or takeoff right
(sometimes referred to as a slot), a regulated airline route, or a
television or radio broadcasting license. The issuance or renewal of a
license, permit, or other right granted by a governmental unit is
considered an acquisition of the license, permit, or other right. (See,
however, the exceptions in paragraph (c) of this section, including the
exceptions in paragraph (c)(3) of this section for an interest in land,
paragraph (c)(6) of this section for certain rights to receive tangible
property or services, paragraph (c)(8) of this section for an interest
under a lease of tangible property, and paragraph (c)(13) of this
section for certain rights granted by a governmental unit. See paragraph
(b)(10) of this section for the treatment of franchises.)
(9) Covenants not to compete and other similar arrangements. Section
197 intangibles include any covenant not to compete, or agreement having
substantially the same effect, entered into in connection with the
direct or indirect acquisition of an interest in a trade or business or
a substantial portion thereof. For purposes of this paragraph (b)(9), an
acquisition may be made in the form of an asset acquisition (including a
qualified stock purchase that is treated as a purchase of assets under
section 338), a stock acquisition or redemption, and the acquisition or
redemption of a partnership interest. An agreement requiring the
performance of services for the acquiring taxpayer or the provision of
property or its use to the acquiring taxpayer does not have
substantially the same effect as a covenant not to compete to the extent
that the amount paid under the agreement represents reasonable
compensation for the services actually rendered or for the property or
use of the property actually provided.
(10) Franchises, trademarks, and trade names. (i) Section 197
intangibles include any franchise, trademark, or trade name. The term
franchise has the meaning given in section 1253(b)(1) and includes any
agreement that provides one of the parties to the agreement
[[Page 278]]
with the right to distribute, sell, or provide goods, services, or
facilities, within a specified area. The term trademark includes any
word, name, symbol, or device, or any combination thereof, adopted and
used to identify goods or services and distinguish them from those
provided by others. The term trade name includes any name used to
identify or designate a particular trade or business or the name or
title used by a person or organization engaged in a trade or business. A
license, permit, or other right granted by a governmental unit is a
franchise if it otherwise meets the definition of a franchise. A
trademark or trade name includes any trademark or trade name arising
under statute or applicable common law, and any similar right granted by
contract. The renewal of a franchise, trademark, or trade name is
treated as an acquisition of the franchise, trademark, or trade name.
(ii) Notwithstanding the definitions provided in paragraph
(b)(10)(i) of this section, any amount that is paid or incurred on
account of a transfer, sale, or other disposition of a franchise,
trademark, or trade name and that is subject to section 1253(d)(1) is
not included in the basis of a section 197 intangible. (See paragraph
(g)(6) of this section.)
(11) Contracts for the use of, and term interests in, section 197
intangibles. Section 197 intangibles include any right under a license,
contract, or other arrangement providing for the use of property that
would be a section 197 intangible under any provision of this paragraph
(b) (including this paragraph (b)(11)) after giving effect to all of the
exceptions provided in paragraph (c) of this section. Section 197
intangibles also include any term interest (whether outright or in
trust) in such property.
(12) Other similar items. Section 197 intangibles include any other
intangible property that is similar in all material respects to the
property specifically described in section 197(d)(1)(C)(i) through (v)
and paragraphs (b)(3) through (7) of this section. (See paragraph (g)(5)
of this section for special rules regarding certain reinsurance
transactions.)
(c) Section 197 intangibles; exceptions. The term section 197
intangible does not include property described in section 197(e). The
following rules and definitions provide guidance concerning property to
which the exceptions apply:
(1) Interests in a corporation, partnership, trust, or estate.
Section 197 intangibles do not include an interest in a corporation,
partnership, trust, or estate. Thus, for example, amortization under
section 197 is not available for the cost of acquiring stock,
partnership interests, or interests in a trust or estate, whether or not
the interests are regularly traded on an established market. (See
paragraph (g)(3) of this section for special rules applicable to
property of a partnership when a section 754 election is in effect for
the partnership.)
(2) Interests under certain financial contracts. Section 197
intangibles do not include an interest under an existing futures
contract, foreign currency contract, notional principal contract,
interest rate swap, or other similar financial contract, whether or not
the interest is regularly traded on an established market. However, this
exception does not apply to an interest under a mortgage servicing
contract, credit card servicing contract, or other contract to service
another person's indebtedness, or an interest under an assumption
reinsurance contract. (See paragraph (g)(5) of this section for the
treatment of assumption reinsurance contracts. See paragraph (c)(11) of
this section and Sec. 1.167(a)-14(d) for the treatment of mortgage
servicing rights.)
(3) Interests in land. Section 197 intangibles do not include any
interest in land. For this purpose, an interest in land includes a fee
interest, life estate, remainder, easement, mineral right, timber right,
grazing right, riparian right, air right, zoning variance, and any other
similar right, such as a farm allotment, quota for farm commodities, or
crop acreage base. An interest in land does not include an airport
landing or takeoff right, a regulated airline route, or a franchise to
provide cable television service. The cost of acquiring a license,
permit, or other land improvement right, such as a building construction
or use permit, is taken into account in the same manner as the
underlying improvement.
[[Page 279]]
(4) Certain computer software--(i) Publicly available. Section 197
intangibles do not include any interest in computer software that is (or
has been) readily available to the general public on similar terms, is
subject to a nonexclusive license, and has not been substantially
modified. Computer software will be treated as readily available to the
general public if the software may be obtained on substantially the same
terms by a significant number of persons that would reasonably be
expected to use the software. This requirement can be met even though
the software is not available through a system of retail distribution.
Computer software will not be considered to have been substantially
modified if the cost of all modifications to the version of the software
that is readily available to the general public does not exceed the
greater of 25 percent of the price at which the unmodified version of
the software is readily available to the general public or $2,000. For
the purpose of determining whether computer software has been
substantially modified--
(A) Integrated programs acquired in a package from a single source
are treated as a single computer program; and
(B) Any cost incurred to install the computer software on a system
is not treated as a cost of the software. However, the costs for
customization, such as tailoring to a user's specifications (other than
embedded programming options) are costs of modifying the software.
(ii) Not acquired as part of trade or business. Section 197
intangibles do not include an interest in computer software that is not
acquired as part of a purchase of a trade or business.
(iii) Other exceptions. For other exceptions applicable to computer
software, see paragraph (a)(3) of this section (relating to otherwise
deductible amounts) and paragraph (g)(7) of this section (relating to
amounts properly taken into account in determining the cost of property
that is not a section 197 intangible).
(iv) Computer software defined. For purposes of this section,
computer software is any program or routine (that is, any sequence of
machine-readable code) that is designed to cause a computer to perform a
desired function or set of functions, and the documentation required to
describe and maintain that program or routine. It includes all forms and
media in which the software is contained, whether written, magnetic, or
otherwise. Computer programs of all classes, for example, operating
systems, executive systems, monitors, compilers and translators,
assembly routines, and utility programs as well as application programs,
are included. Computer software also includes any incidental and
ancillary rights that are necessary to effect the acquisition of the
title to, the ownership of, or the right to use the computer software,
and that are used only in connection with that specific computer
software. Such incidental and ancillary rights are not included in the
definition of trademark or trade name under paragraph (b)(10)(i) of this
section. For example, a trademark or trade name that is ancillary to the
ownership or use of a specific computer software program in the
taxpayer's trade or business and is not acquired for the purpose of
marketing the computer software is included in the definition of
computer software and is not included in the definition of trademark or
trade name. Computer software does not include any data or information
base described in paragraph (b)(4) of this section unless the data base
or item is in the public domain and is incidental to a computer program.
For this purpose, a copyrighted or proprietary data or information base
is treated as in the public domain if its availability through the
computer program does not contribute significantly to the cost of the
program. For example, if a word-processing program includes a dictionary
feature used to spell-check a document or any portion thereof, the
entire program (including the dictionary feature) is computer software
regardless of the form in which the feature is maintained or stored.
(5) Certain interests in films, sound recordings, video tapes,
books, or other similar property. Section 197 intangibles do not include
any interest (including an interest as a licensee) in a film, sound
recording, video tape, book, or other similar property (such as the
right to
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broadcast or transmit a live event) if the interest is not acquired as
part of a purchase of a trade or business. A film, sound recording,
video tape, book, or other similar property includes any incidental and
ancillary rights (such as a trademark or trade name) that are necessary
to effect the acquisition of title to, the ownership of, or the right to
use the property and are used only in connection with that property.
Such incidental and ancillary rights are not included in the definition
of trademark or trade name under paragraph (b)(10)(i) of this section.
For purposes of this paragraph (c)(5), computer software (as defined in
paragraph (c)(4)(iv) of this section) is not treated as other property
similar to a film, sound recording, video tape, or book. (See section
167 for amortization of excluded intangible property or interests.)
(6) Certain rights to receive tangible property or services. Section
197 intangibles do not include any right to receive tangible property or
services under a contract or from a governmental unit if the right is
not acquired as part of a purchase of a trade or business. Any right
that is described in the preceding sentence is not treated as a section
197 intangible even though the right is also described in section
197(d)(1)(D) and paragraph (b)(8) of this section (relating to certain
governmental licenses, permits, and other rights) and even though the
right fails to meet one or more of the requirements of paragraph (c)(13)
of this section (relating to certain rights of fixed duration or
amount). (See Sec. 1.167(a)-14(c) (1) and (3) for applicable rules.)
(7) Certain interests in patents or copyrights. Section 197
intangibles do not include any interest (including an interest as a
licensee) in a patent, patent application, or copyright that is not
acquired as part of a purchase of a trade or business. A patent or
copyright includes any incidental and ancillary rights (such as a
trademark or trade name) that are necessary to effect the acquisition of
title to, the ownership of, or the right to use the property and are
used only in connection with that property. Such incidental and
ancillary rights are not included in the definition of trademark or
trade name under paragraph (b)(10)(i) of this section. (See Sec.
1.167(a)-14(c)(4) for applicable rules.)
(8) Interests under leases of tangible property--(i) Interest as a
lessor. Section 197 intangibles do not include any interest as a lessor
under an existing lease or sublease of tangible real or personal
property. In addition, the cost of acquiring an interest as a lessor in
connection with the acquisition of tangible property is taken into
account as part of the cost of the tangible property. For example, if a
taxpayer acquires a shopping center that is leased to tenants operating
retail stores, any portion of the purchase price attributable to
favorable lease terms is taken into account as part of the basis of the
shopping center and in determining the depreciation deduction allowed
with respect to the shopping center. (See section 167(c)(2).)
(ii) Interest as a lessee. Section 197 intangibles do not include
any interest as a lessee under an existing lease of tangible real or
personal property. For this purpose, an airline lease of an airport
passenger or cargo gate is a lease of tangible property. The cost of
acquiring such an interest is taken into account under section 178 and
Sec. 1.162-11(a). If an interest as a lessee under a lease of tangible
property is acquired in a transaction with any other intangible
property, a portion of the total purchase price may be allocable to the
interest as a lessee based on all of the relevant facts and
circumstances.
(9) Interests under indebtedness--(i) In general. Section 197
intangibles do not include any interest (whether as a creditor or
debtor) under an indebtedness in existence when the interest was
acquired. Thus, for example, the value attributable to the assumption of
an indebtedness with a below-market interest rate is not amortizable
under section 197. In addition, the premium paid for acquiring a debt
instrument with an above-market interest rate is not amortizable under
section 197. See section 171 for rules concerning the treatment of
amortizable bond premium.
(ii) Exceptions. For purposes of this paragraph (c)(9), an interest
under an existing indebtedness does not include the deposit base (and
other similar
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items) of a financial institution. An interest under an existing
indebtedness includes mortgage servicing rights, however, to the extent
the rights are stripped coupons under section 1286.
(10) Professional sports franchises. Section 197 intangibles do not
include any franchise to engage in professional baseball, basketball,
football, or any other professional sport, and any item (even though
otherwise qualifying as a section 197 intangible) acquired in connection
with such a franchise.
(11) Mortgage servicing rights. Section 197 intangibles do not
include any right described in section 197(e)(7) (concerning rights to
service indebtedness secured by residential real property that are not
acquired as part of a purchase of a trade or business). (See Sec.
1.167(a)-14(d) for applicable rules.)
(12) Certain transaction costs. Section 197 intangibles do not
include any fees for professional services and any transaction costs
incurred by parties to a transaction in which all or any portion of the
gain or loss is not recognized under part III of subchapter C of the
Internal Revenue Code.
(13) Rights of fixed duration or amount. (i) Section 197 intangibles
do not include any right under a contract or any license, permit, or
other right granted by a governmental unit if the right--
(A) Is acquired in the ordinary course of a trade or business (or an
activity described in section 212) and not as part of a purchase of a
trade or business;
(B) Is not described in section 197(d)(1)(A), (B), (E), or (F);
(C) Is not a customer-based intangible, a customer-related
information base, or any other similar item; and
(D) Either--
(1) Has a fixed duration of less than 15 years; or
(2) Is fixed as to amount and the adjusted basis thereof is properly
recoverable (without regard to this section) under a method similar to
the unit-of-production method.
(ii) See Sec. 1.167(a)-14(c)(2) and (3) for applicable rules.
(d) Amortizable section 197 intangibles--(1) Definition. Except as
otherwise provided in this paragraph (d), the term amortizable section
197 intangible means any section 197 intangible acquired after August
10, 1993 (or after July 25, 1991, if a valid retroactive election under
Sec. 1.197-1T has been made), and held in connection with the conduct
of a trade or business or an activity described in section 212.
(2) Exception for self-created intangibles--(i) In general. Except
as provided in paragraph (d)(2)(iii) of this section, amortizable
section 197 intangibles do not include any section 197 intangible
created by the taxpayer (a self-created intangible).
(ii) Created by the taxpayer--(A) Defined. A section 197 intangible
is created by the taxpayer to the extent the taxpayer makes payments or
otherwise incurs costs for its creation, production, development, or
improvement, whether the actual work is performed by the taxpayer or by
another person under a contract with the taxpayer entered into before
the contracted creation, production, development, or improvement occurs.
For example, a technological process developed specifically for a
taxpayer under an arrangement with another person pursuant to which the
taxpayer retains all rights to the process is created by the taxpayer.
(B) Contracts for the use of intangibles. A section 197 intangible
is not a self-created intangible to the extent that it results from the
entry into (or renewal of) a contract for the use of an existing section
197 intangible. Thus, for example, the exception for self-created
intangibles does not apply to capitalized costs, such as legal and other
professional fees, incurred by a licensee in connection with the entry
into (or renewal of) a contract for the use of know-how or similar
property.
(C) Improvements and modifications. If an existing section 197
intangible is improved or otherwise modified by the taxpayer or by
another person under a contract with the taxpayer, the existing
intangible and the capitalized costs (if any) of the improvements or
other modifications are each treated as a separate section 197
intangible for purposes of this paragraph (d).
(iii) Exceptions. (A) The exception for self-created intangibles
does not apply to any section 197 intangible described in section
197(d)(1)(D) (relating to licenses, permits or other rights granted by a
governmental unit), 197(d)(1)(E)
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(relating to covenants not to compete), or 197(d)(1)(F) (relating to
franchises, trademarks, and trade names). Thus, for example, capitalized
costs incurred in the development, registration, or defense of a
trademark or trade name do not qualify for the exception and are
amortized over 15 years under section 197.
(B) The exception for self-created intangibles does not apply to any
section 197 intangible created in connection with the purchase of a
trade or business (as defined in paragraph (e) of this section).
(C) If a taxpayer disposes of a self-created intangible and
subsequently reacquires the intangible in an acquisition described in
paragraph (h)(5)(ii) of this section, the exception for self-created
intangibles does not apply to the reacquired intangible.
(3) Exception for property subject to anti-churning rules.
Amortizable section 197 intangibles do not include any property to which
the anti-churning rules of section 197(f)(9) and paragraph (h) of this
section apply.
(e) Purchase of a trade or business. Several of the exceptions in
section 197 apply only to property that is not acquired in (or created
in connection with) a transaction or series of related transactions
involving the acquisition of assets constituting a trade or business or
a substantial portion thereof. Property acquired in (or created in
connection with) such a transaction or series of related transactions is
referred to in this section as property acquired as part of (or created
in connection with) a purchase of a trade or business. For purposes of
section 197 and this section, the applicability of the limitation is
determined under the following rules:
(1) Goodwill or going concern value. An asset or group of assets
constitutes a trade or business or a substantial portion thereof if
their use would constitute a trade or business under section 1060 (that
is, if goodwill or going concern value could under any circumstances
attach to the assets). See Sec. 1.1060-1(b)(2). For this purpose, all
the facts and circumstances, including any employee relationships that
continue (or covenants not to compete that are entered into) as part of
the transfer of the assets, are taken into account in determining
whether goodwill or going concern value could attach to the assets.
(2) Franchise, trademark, or trade name--(i) In general. The
acquisition of a franchise, trademark, or trade name constitutes the
acquisition of a trade or business or a substantial portion thereof.
(ii) Exceptions. For purposes of this paragraph (e)(2)--
(A) A trademark or trade name is disregarded if it is included in
computer software under paragraph (c)(4) of this section or in an
interest in a film, sound recording, video tape, book, or other similar
property under paragraph (c)(5) of this section;
(B) A franchise, trademark, or trade name is disregarded if its
value is nominal or the taxpayer irrevocably disposes of it immediately
after its acquisition; and
(C) The acquisition of a right or interest in a trademark or trade
name is disregarded if the grant of the right or interest is not, under
the principles of section 1253, a transfer of all substantial rights to
such property or of an undivided interest in all substantial rights to
such property.
(3) Acquisitions to be included. The assets acquired in a
transaction (or series of related transactions) include only assets
(including a beneficial or other indirect interest in assets where the
interest is of a type described in paragraph (c)(1) of this section)
acquired by the taxpayer and persons related to the taxpayer from
another person and persons related to that other person. For purposes of
this paragraph (e)(3), persons are related only if their relationship is
described in section 267(b) or 707(b) or they are engaged in trades or
businesses under common control within the meaning of section 41(f)(1).
(4) Substantial portion. The determination of whether acquired
assets constitute a substantial portion of a trade or business is to be
based on all of the facts and circumstances, including the nature and
the amount of the assets acquired as well as the nature and amount of
the assets retained by the transferor. The value of the assets acquired
relative to the value of the assets retained by the transferor is not
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determinative of whether the acquired assets constitute a substantial
portion of a trade or business.
(5) Deemed asset purchases under section 338. A qualified stock
purchase that is treated as a purchase of assets under section 338 is
treated as a transaction involving the acquisition of assets
constituting a trade or business only if the direct acquisition of the
assets of the corporation would have been treated as the acquisition of
assets constituting a trade or business or a substantial portion
thereof.
(6) Mortgage servicing rights. Mortgage servicing rights acquired in
a transaction or series of related transactions are disregarded in
determining for purposes of paragraph (c)(11) of this section whether
the assets acquired in the transaction or transactions constitute a
trade or business or substantial portion thereof.
(7) Computer software acquired for internal use. Computer software
acquired in a transaction or series of related transactions solely for
internal use in an existing trade or business is disregarded in
determining for purposes of paragraph (c)(4) of this section whether the
assets acquired in the transaction or series of related transactions
constitute a trade or business or substantial portion thereof.
(f) Computation of amortization deduction--(1) In general. Except as
provided in paragraph (f)(2) of this section, the amortization deduction
allowable under section 197(a) is computed as follows:
(i) The basis of an amortizable section 197 intangible is amortized
ratably over the 15-year period beginning on the later of--
(A) The first day of the month in which the property is acquired; or
(B) In the case of property held in connection with the conduct of a
trade or business or in an activity described in section 212, the first
day of the month in which the conduct of the trade or business or the
activity begins.
(ii) Except as otherwise provided in this section, basis is
determined under section 1011 and salvage value is disregarded.
(iii) Property is not eligible for amortization in the month of
disposition.
(iv) The amortization deduction for a short taxable year is based on
the number of months in the short taxable year.
(2) Treatment of contingent amounts--(i) Amounts added to basis
during 15-year period. Any amount that is properly included in the basis
of an amortizable section 197 intangible after the first month of the
15-year period described in paragraph (f)(1)(i) of this section and
before the expiration of that period is amortized ratably over the
remainder of the 15-year period. For this purpose, the remainder of the
15-year period begins on the first day of the month in which the basis
increase occurs.
(ii) Amounts becoming fixed after expiration of 15-year period. Any
amount that is not properly included in the basis of an amortizable
section 197 intangible until after the expiration of the 15-year period
described in paragraph (f)(1)(i) of this section is amortized in full
immediately upon the inclusion of the amount in the basis of the
intangible.
(iii) Rules for including amounts in basis. See Sec. Sec. 1.1275-
4(c)(4) and 1.483-4(a) for rules governing the extent to which
contingent amounts payable under a debt instrument given in
consideration for the sale or exchange of an amortizable section 197
intangible are treated as payments of principal and the time at which
the amount treated as principal is included in basis. See Sec. 1.461-
1(a)(1) and (2) for rules governing the time at which other contingent
amounts are taken into account in determining the basis of an
amortizable section 197 intangible.
(3) Basis determinations for certain assets--(i) Covenants not to
compete. In the case of a covenant not to compete or other similar
arrangement described in paragraph (b)(9) of this section (a covenant),
the amount chargeable to capital account includes, except as provided in
this paragraph (f)(3), all amounts that are required to be paid pursuant
to the covenant, whether or not any such amount would be deductible
under section 162 if the covenant were not a section 197 intangible.
(ii) Contracts for the use of section 197 intangibles; acquired as
part of a trade or business--(A) In general. Except as provided in this
paragraph (f)(3), any
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amount paid or incurred by the transferee on account of the transfer of
a right or term interest described in paragraph (b)(11) of this section
(relating to contracts for the use of, and term interests in, section
197 intangibles) by the owner of the property to which such right or
interest relates and as part of a purchase of a trade or business is
chargeable to capital account, whether or not such amount would be
deductible under section 162 if the property were not a section 197
intangible.
(B) Know-how and certain information base. The amount chargeable to
capital account with respect to a right or term interest described in
paragraph (b)(11) of this section is determined without regard to the
rule in paragraph (f)(3)(ii)(A) of this section if the right or interest
relates to property (other than a customer-related information base)
described in paragraph (b)(4) or (5) of this section and the acquiring
taxpayer establishes that--
(1) The transfer of the right or interest is not, under the
principles of section 1235, a transfer of all substantial rights to such
property or of an undivided interest in all substantial rights to such
property; and
(2) The right or interest was transferred for an arm's-length
consideration.
(iii) Contracts for the use of section 197 intangibles; not acquired
as part of a trade or business. The transfer of a right or term interest
described in paragraph (b)(11) of this section by the owner of the
property to which such right or interest relates but not as part of a
purchase of a trade or business will be closely scrutinized under the
principles of section 1235 for purposes of determining whether the
transfer is a sale or exchange and, accordingly, whether amounts paid on
account of the transfer are chargeable to capital account. If under the
principles of section 1235 the transaction is not a sale or exchange,
amounts paid on account of the transfer are not chargeable to capital
account under this paragraph (f)(3).
(iv) Applicable rules--(A) Franchises, trademarks, and trade names.
For purposes of this paragraph (f)(3), section 197 intangibles described
in paragraph (b)(11) of this section do not include any property that is
also described in paragraph (b)(10) of this section (relating to
franchises, trademarks, and trade names).
(B) Certain amounts treated as payable under a debt instrument--(1)
In general. For purposes of applying any provision of the Internal
Revenue Code to a person making payments of amounts that are otherwise
chargeable to capital account under this paragraph (f)(3) and are
payable after the acquisition of the section 197 intangible to which
they relate, such amounts are treated as payable under a debt instrument
given in consideration for the sale or exchange of the section 197
intangible.
(2) Rights granted by governmental units. For purposes of applying
any provision of the Internal Revenue Code to any amounts that are
otherwise chargeable to capital account with respect to a license,
permit, or other right described in paragraph (b)(8) of this section
(relating to rights granted by a governmental unit or agency or
instrumentality thereof) and are payable after the acquisition of the
section 197 intangible to which they relate, such amounts are treated,
except as provided in paragraph (f)(4)(i) of this section (relating to
renewal transactions), as payable under a debt instrument given in
consideration for the sale or exchange of the section 197 intangible.
(3) Treatment of other parties to transaction. No person shall be
treated as having sold, exchanged, or otherwise disposed of property in
a transaction for purposes of any provision of the Internal Revenue Code
solely by reason of the application of this paragraph (f)(3) to any
other party to the transaction.
(4) Basis determinations in certain transactions--(i) Certain
renewal transactions. The costs paid or incurred for the renewal of a
franchise, trademark, or trade name or any license, permit, or other
right granted by a governmental unit or an agency or instrumentality
thereof are amortized over the 15-year period that begins with the month
of renewal. Any costs paid or incurred for the issuance, or earlier
renewal, continue to be taken into account over the remaining portion of
the amortization period that began at
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the time of the issuance, or earlier renewal. Any amount paid or
incurred for the protection, expansion, or defense of a trademark or
trade name and chargeable to capital account is treated as an amount
paid or incurred for a renewal.
(ii) Transactions subject to section 338 or 1060. In the case of a
section 197 intangible deemed to have been acquired as the result of a
qualified stock purchase within the meaning of section 338(d)(3), the
basis shall be determined pursuant to section 338(b)(5) and the
regulations thereunder. In the case of a section 197 intangible acquired
in an applicable asset acquisition within the meaning of section
1060(c), the basis shall be determined pursuant to section 1060(a) and
the regulations thereunder.
(iii) Certain reinsurance transactions. See paragraph (g)(5)(ii) of
this section for special rules regarding the adjusted basis of an
insurance contract acquired through an assumption reinsurance
transaction.
(g) Special rules--(1) Treatment of certain dispositions--(i) Loss
disallowance rules--(A) In general. No loss is recognized on the
disposition of an amortizable section 197 intangible if the taxpayer has
any retained intangibles. The retained intangibles with respect to the
disposition of any amortizable section 197 intangible (the transferred
intangible) are all amortizable section 197 intangibles, or rights to
use or interests (including beneficial or other indirect interests) in
amortizable section 197 intangibles (including the transferred
intangible) that were acquired in the same transaction or series of
related transactions as the transferred intangible and are retained
after its disposition. Except as otherwise provided in paragraph
(g)(1)(iv)(B) of this section, the adjusted basis of each of the
retained intangibles is increased by the product of--
(1) The loss that is not recognized solely by reason of this rule;
and
(2) A fraction, the numerator of which is the adjusted basis of the
retained intangible on the date of the disposition and the denominator
of which is the total adjusted bases of all the retained intangibles on
that date.
(B) Abandonment or worthlessness. The abandonment of an amortizable
section 197 intangible, or any other event rendering an amortizable
section 197 intangible worthless, is treated as a disposition of the
intangible for purposes of this paragraph (g)(1), and the abandoned or
worthless intangible is disregarded (that is, it is not treated as a
retained intangible) for purposes of applying this paragraph (g)(1) to
the subsequent disposition of any other amortizable section 197
intangible.
(C) Certain nonrecognition transfers. The loss disallowance rule in
paragraph (g)(1)(i)(A) of this section also applies when a taxpayer
transfers an amortizable section 197 intangible from an acquired trade
or business in a transaction in which the intangible is transferred
basis property and, after the transfer, retains other amortizable
section 197 intangibles from the trade or business. Thus, for example,
the transfer of an amortizable section 197 intangible to a corporation
in exchange for stock in the corporation in a transaction described in
section 351, or to a partnership in exchange for an interest in the
partnership in a transaction described in section 721, when other
amortizable section 197 intangibles acquired in the same transaction are
retained, followed by a sale of the stock or partnership interest
received, will not avoid the application of the loss disallowance
provision to the extent the adjusted basis of the transferred intangible
at the time of the sale exceeds its fair market value at that time.
(ii) Separately acquired property. Paragraph (g)(1)(i) of this
section does not apply to an amortizable section 197 intangible that is
not acquired in a transaction or series of related transactions in which
the taxpayer acquires other amortizable section 197 intangibles (a
separately acquired intangible). Consequently, a loss may be recognized
upon the disposition of a separately acquired amortizable section 197
intangible. However, the termination or worthlessness of only a portion
of an amortizable section 197 intangible is not the disposition of a
separately acquired intangible. For example, neither the loss of several
customers from an acquired customer list nor the worthlessness of only
some information from an acquired data base constitutes the
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disposition of a separately acquired intangible.
(iii) Disposition of a covenant not to compete. If a covenant not to
compete or any other arrangement having substantially the same effect is
entered into in connection with the direct or indirect acquisition of an
interest in one or more trades or businesses, the disposition or
worthlessness of the covenant or other arrangement will not be
considered to occur until the disposition or worthlessness of all
interests in those trades or businesses. For example, a covenant not to
compete entered into in connection with the purchase of stock continues
to be amortized ratably over the 15-year recovery period (even after the
covenant expires or becomes worthless) unless all the trades or
businesses in which an interest was acquired through the stock purchase
(or all the purchaser's interests in those trades or businesses) also
are disposed of or become worthless.
(iv) Taxpayers under common control--(A) In general. Except as
provided in paragraph (g)(1)(iv)(B) of this section, all persons that
would be treated as a single taxpayer under section 41(f)(1) are treated
as a single taxpayer under this paragraph (g)(1). Thus, for example, a
loss is not recognized on the disposition of an amortizable section 197
intangible by a member of a controlled group of corporations (as defined
in section 41(f)(5)) if, after the disposition, another member retains
other amortizable section 197 intangibles acquired in the same
transaction as the amortizable section 197 intangible that has been
disposed of.
(B) Treatment of disallowed loss. If retained intangibles are held
by a person other than the person incurring the disallowed loss, only
the adjusted basis of intangibles retained by the person incurring the
disallowed loss is increased, and only the adjusted basis of those
intangibles is included in the denominator of the fraction described in
paragraph (g)(1)(i)(A) of this section. If none of the retained
intangibles are held by the person incurring the disallowed loss, the
loss is allowed ratably, as a deduction under section 197, over the
remainder of the period during which the intangible giving rise to the
loss would have been amortizable, except that any remaining disallowed
loss is allowed in full on the first date on which all other retained
intangibles have been disposed of or become worthless.
(2) Treatment of certain nonrecognition and exchange transactions--
(i) Relationship to anti-churning rules. This paragraph (g)(2) provides
rules relating to the treatment of section 197 intangibles acquired in
certain transactions. If these rules apply to a section 197(f)(9)
intangible (within the meaning of paragraph (h)(1)(i) of this section),
the intangible is, notwithstanding its treatment under this paragraph
(g)(2), treated as an amortizable section 197 intangible only to the
extent permitted under paragraph (h) of this section.
(ii) Treatment of nonrecognition and exchange transactions
generally--(A) Transfer disregarded. If a section 197 intangible is
transferred in a transaction described in paragraph (g)(2)(ii)(C) of
this section, the transfer is disregarded in determining--
(1) Whether, with respect to so much of the intangible's basis in
the hands of the transferee as does not exceed its basis in the hands of
the transferor, the intangible is an amortizable section 197 intangible;
and
(2) The amount of the deduction under section 197 with respect to
such basis.
(B) Application of general rule. If the intangible described in
paragraph (g)(2)(ii)(A) of this section was an amortizable section 197
intangible in the hands of the transferor, the transferee will continue
to amortize its adjusted basis, to the extent it does not exceed the
transferor's adjusted basis, ratably over the remainder of the
transferor's 15-year amortization period. If the intangible was not an
amortizable section 197 intangible in the hands of the transferor, the
transferee's adjusted basis, to the extent it does not exceed the
transferor's adjusted basis, cannot be amortized under section 197. In
either event, the intangible is treated, with respect to so much of its
adjusted basis in the hands of the transferee as exceeds its adjusted
basis in the hands of the transferor, in the same manner for purposes of
section 197 as an intangible acquired from the transferor in a
transaction that is not described in
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paragraph (g)(2)(ii)(C) of this section. The rules of this paragraph
(g)(2)(ii) also apply to any subsequent transfers of the intangible in a
transaction described in paragraph (g)(2)(ii)(C) of this section.
(C) Transactions covered. The transactions described in this
paragraph (g)(2)(ii)(C) are--
(1) Any transaction described in section 332, 351, 361, 721, or 731;
and
(2) Any transaction between corporations that are members of the
same consolidated group immediately after the transaction.
(iii) Certain exchanged-basis property. This paragraph (g)(2)(iii)
applies to property that is acquired in a transaction subject to section
1031 or 1033 and is permitted to be acquired without recognition of gain
(replacement property). Replacement property is treated as if it were
the property by reference to which its basis is determined (the
predecessor property) in determining whether, with respect to so much of
its basis as does not exceed the basis of the predecessor property, the
replacement property is an amortizable section 197 intangible and the
amortization period under section 197 with respect to such basis. Thus,
if the predecessor property was an amortizable section 197 intangible,
the taxpayer will amortize the adjusted basis of the replacement
property, to the extent it does not exceed the adjusted basis of the
predecessor property, ratably over the remainder of the 15-year
amortization period for the predecessor property. If the predecessor
property was not an amortizable section 197 intangible, the adjusted
basis of the replacement property, to the extent it does not exceed the
adjusted basis of the predecessor property, may not be amortized under
section 197. In either event, the replacement property is treated, with
respect to so much of its adjusted basis as exceeds the adjusted basis
of the predecessor property, in the same manner for purposes of section
197 as property acquired from the transferor in a transaction that is
not subject to section 1031 or 1033.
(iv) Transfers under section 708(b)(1)--(A) In general. Paragraph
(g)(2)(ii) of this section applies to transfers of section 197
intangibles that occur or are deemed to occur by reason of the
termination of a partnership under section 708(b)(1).
(B) Termination by sale or exchange of interest. In applying
paragraph (g)(2)(ii) of this section to a partnership that is terminated
pursuant to section 708(b)(1)(B) (relating to deemed terminations from
the sale or exchange of an interest), the terminated partnership is
treated as the transferor and the new partnership is treated as the
transferee with respect to any section 197 intangible held by the
terminated partnership immediately preceding the termination. (See
paragraph (g)(3) of this section for the treatment of increases in the
bases of property of the terminated partnership under section 743(b).)
(C) Other terminations. In applying paragraph (g)(2)(ii) of this
section to a partnership that is terminated pursuant to section
708(b)(1)(A) (relating to cessation of activities by a partnership), the
terminated partnership is treated as the transferor and the distributee
partner is treated as the transferee with respect to any section 197
intangible held by the terminated partnership immediately preceding the
termination.
(3) Increase in the basis of partnership property under section
732(b), 734(b), 743(b), or 732(d). Any increase in the adjusted basis of
a section 197 intangible under sections 732(b) or 732(d) (relating to a
partner's basis in property distributed by a partnership), section
734(b) (relating to the optional adjustment to the basis of
undistributed partnership property after a distribution of property to a
partner), or section 743(b) (relating to the optional adjustment to the
basis of partnership property after transfer of a partnership interest)
is treated as a separate section 197 intangible. For purposes of
determining the amortization period under section 197 with respect to
the basis increase, the intangible is treated as having been acquired at
the time of the transaction that causes the basis increase, except as
provided in Sec. 1.743-1(j)(4)(i)(B)(2). The provisions of paragraph
(f)(2) of this section apply to the extent that the amount of the basis
increase is determined by reference to contingent payments. For purposes
of the effective date and anti-churning provisions
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(paragraphs (l)(1) and (h) of this section) for a basis increase under
section 732(d), the intangible is treated as having been acquired by the
transferee partner at the time of the transfer of the partnership
interest described in section 732(d).
(4) Section 704(c) allocations--(i) Allocations where the intangible
is amortizable by the contributor. To the extent that the intangible was
an amortizable section 197 intangible in the hands of the contributing
partner, a partnership may make allocations of amortization deductions
with respect to the intangible to all of its partners under any of the
permissible methods described in the regulations under section 704(c).
See Sec. 1.704-3.
(ii) Allocations where the intangible is not amortizable by the
contributor. To the extent that the intangible was not an amortizable
section 197 intangible in the hands of the contributing partner, the
intangible is not amortizable under section 197 by the partnership.
However, if a partner contributes a section 197 intangible to a
partnership and the partnership adopts the remedial allocation method
for making section 704(c) allocations of amortization deductions, the
partnership generally may make remedial allocations of amortization
deductions with respect to the contributed section 197 intangible in
accordance with Sec. 1.704-3(d). See paragraph (h)(12) of this section
to determine the application of the anti-churning rules in the context
of remedial allocations.
(5) Treatment of certain insurance contracts acquired in an
assumption reinsurance transaction--(i) In general. Section 197
generally applies to insurance and annuity contracts acquired from
another person through an assumption reinsurance transaction. See Sec.
1.809-5(a)(7)(ii) for the definition of assumption reinsurance. The
transfer of insurance or annuity contracts and the assumption of related
liabilities deemed to occur by reason of a section 338 election for a
target insurance company is treated as an assumption reinsurance
transaction. The transfer of a reinsurance contract by a reinsurer
(transferor) to another reinsurer (acquirer) is treated as an assumption
reinsurance transaction if the transferor's obligations are extinguished
as a result of the transaction.
(ii) Determination of adjusted basis of amortizable section 197
intangible resulting from an assumption reinsurance transaction--(A) In
general. Section 197(f)(5) determines the basis of an amortizable
section 197 intangible for insurance or annuity contracts acquired in an
assumption reinsurance transaction. The basis of such intangible is the
excess, if any, of--
(1) The amount paid or incurred by the acquirer (reinsurer) under
the assumption reinsurance transaction; over
(2) The amount, if any, required to be capitalized under section 848
in connection with such transaction.
(B) Amount paid or incurred by acquirer (reinsurer) under the
assumption reinsurance transaction. The amount paid or incurred by the
acquirer (reinsurer) under the assumption reinsurance transaction is--
(1) In a deemed asset sale resulting from an election under section
338, the amount of the adjusted grossed-up basis (AGUB) allocable
thereto (see Sec. Sec. 1.338-6 and 1.338-11(b)(2));
(2) In an applicable asset acquisition within the meaning of section
1060, the amount of the consideration allocable thereto (see Sec. Sec.
1.338-6, 1.338-11(b)(2), and 1.1060-1(c)(5)); and
(3) In any other transaction, the excess of the increase in the
reinsurer's tax reserves resulting from the transaction (computed in
accordance with sections 807, 832(b)(4)(B), and 846) over the value of
the net assets received from the ceding company in the transaction.
(C) Amount required to be capitalized under section 848 in
connection with the transaction--(1) In general. The amount required to
be capitalized under section 848 for specified insurance contracts (as
defined in section 848(e)) acquired in an assumption reinsurance
transaction is the lesser of--
(i) The reinsurer's required capitalization amount for the
assumption reinsurance transaction; or
(ii) The reinsurer's general deductions (as defined in section
848(c)(2)) allocable to the transaction.
(2) Required capitalization amount. The reinsurer determines the
required capitalization amount for an assumption
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reinsurance transaction by multiplying the net positive or net negative
consideration for the transaction by the applicable percentage set forth
in section 848(c)(1) for the category of specified insurance contracts
acquired in the transaction. See Sec. 1.848-2(g)(5). If more than one
category of specified insurance contracts is acquired in an assumption
reinsurance transaction, the required capitalization amount for each
category is determined as if the transfer of the contracts in that
category were made under a separate assumption reinsurance transaction.
See Sec. 1.848-2(f)(7).
(3) General deductions allocable to the assumption reinsurance
transaction. The reinsurer determines the general deductions allocable
to the assumption reinsurance transaction in accordance with the
procedure set forth in Sec. 1.848-2(g)(6). Accordingly, the reinsurer
must allocate its general deductions to the amount required under
section 848(c)(1) on specified insurance contracts that the reinsurer
has issued directly before determining the general deductions allocable
to the assumption reinsurance transaction. For purposes of allocating
its general deductions under Sec. 1.848-2(g)(6), the reinsurer includes
premiums received on the acquired specified insurance contracts after
the assumption reinsurance transaction in determining the amount
required under section 848(c)(1) on specified insurance contracts that
the reinsurer has issued directly. If the reinsurer has entered into
multiple reinsurance agreements during the taxable year, the reinsurer
determines the general deductions allocable to each reinsurance
agreement (including the assumption reinsurance transaction) by
allocating the general deductions allocable to reinsurance agreements
under Sec. 1.848-2(g)(6) to each reinsurance agreement with a positive
required capitalization amount.
(4) Treatment of a capitalization shortfall allocable to the
reinsurance agreement--(i) In general. The reinsurer determines any
capitalization shortfall allocable to the assumption reinsurance
transaction in the manner provided in Sec. Sec. 1.848-2(g)(4) and
1.848-2(g)(7). If the reinsurer has a capitalization shortfall allocable
to the assumption reinsurance transaction, the ceding company must
reduce the net negative consideration (as determined under Sec. 1.848-
2(f)(2)) for the transaction by the amount described in Sec. 1.848-
2(g)(3) unless the parties make the election provided in Sec. 1.848-
2(g)(8) to determine the amounts capitalized under section 848 in
connection with the transaction without regard to the general deductions
limitation of section 848(c)(2).
(ii) Treatment of additional capitalized amounts as the result of an
election under Sec. 1.848-2(g)(8). The additional amounts capitalized
by the reinsurer as the result of the election under Sec. 1.848-2(g)(8)
reduce the adjusted basis of any amortizable section 197 intangible with
respect to specified insurance contracts acquired in the assumption
reinsurance transaction. If the additional capitalized amounts exceed
the adjusted basis of the amortizable section 197 intangible, the
reinsurer must reduce its deductions under section 805 or section 832 by
the amount of such excess. The additional capitalized amounts are
treated as specified policy acquisition expenses attributable to the
premiums and other consideration on the assumption reinsurance
transaction and are deducted ratably over a 120-month period as provided
under section 848(a)(2).
(5) Cross references and special rules. In general, for rules
applicable to the determination of specified policy acquisition
expenses, net premiums, and net consideration, see section 848(c) and
(d), and Sec. 1.848-2(a) and (f). However, the following special rules
apply for purposes of this paragraph (g)(5)(ii)(C)--
(i) The amount required to be capitalized under section 848 in
connection with the assumption reinsurance transaction cannot be less
than zero;
(ii) For purposes of determining the company's general deductions
under section 848(c)(2) for the taxable year of the assumption
reinsurance transaction, the reinsurer takes into account a tentative
amortization deduction under section 197(a) as if the entire amount paid
or incurred by the reinsurer for the specified insurance contracts were
allocated to an amortizable section 197 intangible with respect to
insurance contracts acquired in an assumption reinsurance transaction;
and
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(iii) Any reduction of specified policy acquisition expenses
pursuant to an election under Sec. 1.848-2(i)(4) (relating to an
assumption reinsurance transaction with an insolvent insurance company)
is disregarded.
(D) Examples. The following examples illustrate the principles of
this paragraph (g)(5)(ii):
Example 1. (i) Facts. On January 15, 2006, P acquires all of the
stock of T, an insurance company, in a qualified stock purchase and
makes a section 338 election for T. T issues individual life insurance
contracts which are specified insurance contracts as defined in section
848(e)(1). P and new T are calendar year taxpayers. Under Sec. Sec.
1.338-6 and 1.338-11(b)(2), the amount of AGUB allocated to old T's
individual life insurance contracts is $300,000. On the acquisition
date, the tax reserves for old T's individual life insurance contracts
are $2,000,000. After the acquisition date, new T receives $1,000,000 of
net premiums with respect to new and renewal individual life insurance
contracts and incurs $100,000 of general deductions under section
848(c)(2) through December 31, 2006. New T engages in no other
reinsurance transactions other than the assumption reinsurance
transaction treated as occurring by reason of the section 338 election.
(ii) Analysis. The transfer of insurance contracts and the
assumption of related liabilities deemed to occur by reason of the
election under section 338 is treated as an assumption reinsurance
transaction. New T determines the adjusted basis under section 197(f)(5)
for the life insurance contracts acquired in the assumption reinsurance
transaction as follows. The amount paid or incurred for the individual
life insurance contracts is $300,000. To determine the amount required
to be capitalized under section 848 in connection with the assumption
reinsurance transaction, new T compares the required capitalization
amount for the assumption reinsurance transaction with the general
deductions allocable to the transaction. The required capitalization
amount for the assumption reinsurance transaction is $130,900, which is
determined by multiplying the $1,700,000 net positive consideration for
the transaction ($2,000,000 reinsurance premium less $300,000 ceding
commission) by the applicable percentage under section 848(c)(1) for the
acquired individual life insurance contracts (7.7 percent). To determine
its general deductions, new T takes into account a tentative
amortization deduction under section 197(a) as if the entire amount paid
or incurred for old T's individual life insurance contracts ($300,000)
were allocable to an amortizable section 197 intangible with respect to
insurance contracts acquired in the assumption reinsurance transaction.
Accordingly, for the year of the assumption reinsurance transaction, new
T is treated as having general deductions under section 848(c)(2) of
$120,000 ($100,000 + $300,000/15). Under Sec. 1.848-2(g)(6), these
general deductions are first allocated to the $77,000 capitalization
requirement for new T's directly written business ($1,000,000 x .077).
Thus, $43,000 ($120,000 - $77,000) of the general deductions are
allocable to the assumption reinsurance transaction. Because the general
deductions allocable to the assumption reinsurance transaction ($43,000)
are less than the required capitalization amount for the transaction
($130,900), new T has a capitalization shortfall of $87,900 ($130,900 -
$43,000) with regard to the transaction. Under Sec. 1.848-2(g), this
capitalization shortfall would cause old T to reduce the net negative
consideration taken into account with respect to the assumption
reinsurance transaction by $1,141,558 ($87,900 / .077) unless the
parties make the election under Sec. 1.848-2(g)(8) to capitalize
specified policy acquisition expenses in connection with the assumption
reinsurance transaction without regard to the general deductions
limitation. If the parties make the election, the amount capitalized by
new T under section 848 in connection with the assumption reinsurance
transaction would be $130,900. The $130,900 capitalized by new T under
section 848 would reduce new T's adjusted basis of the amortizable
section 197 intangible with respect to the specified insurance contracts
acquired in the assumption reinsurance transaction. Accordingly, new T
would have an adjusted basis under section 197(f)(5) with respect to the
individual life insurance contracts acquired from old T of $169,100
($300,000 - $130,900). New T's actual amortization deduction under
section 197(a) with respect to the amortizable section 197 intangible
for insurance contracts acquired in the assumption reinsurance
transaction would be $11,273 ($169,100 / 15).
Example 2. (i) Facts. The facts are the same as Example 1, except
that T only issues accident and health insurance contracts that are
qualified long-term care contracts under section 7702B. Under section
7702B(a)(5), T's qualified long-term care insurance contracts are
treated as guaranteed renewable accident and health insurance contracts,
and, therefore, are considered specified insurance contracts under
section 848(e)(1). Under Sec. Sec. 1.338-6 and 1.338-11(b)(2), the
amount of AGUB allocable to T's qualified long-term care insurance
contracts is $250,000. The amount of T's tax reserves for the qualified
long-term care contracts on the acquisition date is $7,750,000.
Following the acquisition, new T receives net premiums of $500,000 with
respect to qualified long-term care contracts and incurs general
deductions of $75,000 through December 31, 2006.
[[Page 291]]
(ii) Analysis. The transfer of insurance contracts and the
assumption of related liabilities deemed to occur by reason of the
election under section 338 is treated as an assumption reinsurance
transaction. New T determines the adjusted basis under section 197(f)(5)
for the insurance contracts acquired in the assumption reinsurance
transaction as follows. The amount paid or incurred for the insurance
contracts is $250,000. To determine the amount required to be
capitalized under section 848 in connection with the assumption
reinsurance transaction, new T compares the required capitalization
amount for the assumption reinsurance transaction with the general
deductions allocable to the transaction. The required capitalization
amount for the assumption reinsurance transaction is $577,500, which is
determined by multiplying the $7,500,000 net positive consideration for
the transaction ($7,750,000 reinsurance premium less $250,000 ceding
commission) by the applicable percentage under section 848(c)(1) for the
acquired insurance contracts (7.7 percent). To determine its general
deductions, new T takes into account a tentative amortization deduction
under section 197(a) as if the entire amount paid or incurred for old
T's insurance contracts ($250,000) were allocable to an amortizable
section 197 intangible with respect to insurance contracts acquired in
the assumption reinsurance transaction. Accordingly, for the year of the
assumption reinsurance transaction, new T is treated as having general
deductions under section 848(c)(2) of $91,667 ($75,000 + $250,000 / 15).
Under Sec. 1.848-2(g)(6), these general deductions are first allocated
to the $38,500 capitalization requirement for new T's directly written
business ($500,000 x .077). Thus, $53,167 ($91,667 - $38,500) of general
deductions are allocable to the assumption reinsurance transaction.
Because the general deductions allocable to the assumption reinsurance
transaction ($53,167) are less than the required capitalization amount
for the transaction ($577,500), new T has a capitalization shortfall of
$524,333 ($577,500 - $53,167) with regard to the transaction. Under
Sec. 1.848-2(g), this capitalization shortfall would cause old T to
reduce the net negative consideration taken into account with respect to
the assumption reinsurance transaction by $6,809,519 ($524,333 / .077)
unless the parties make the election under Sec. 1.848-2(g)(8) to
capitalize specified policy acquisition expenses in connection with the
assumption reinsurance transaction without regard to the general
deductions limitation. If the parties make the election, the amount
capitalized by new T under section 848 in connection with the assumption
reinsurance transaction would increase from $53,167 to $577,500.
Pursuant to paragraph (g)(5)(ii)(C)(4) of this section, the additional
$524,333 ($577,500 - $53,167) capitalized by new T under section 848
would reduce new T's adjusted basis of the amortizable section 197
intangible with respect to the insurance contracts acquired in the
assumption reinsurance transaction. Accordingly, new T's adjusted basis
of the section 197 intangible with regard to the insurance contracts is
reduced from $196,833 ($250,000 - $53,167) to $0. Because the additional
$524,333 capitalized pursuant to the Sec. 1.848-2(g)(8) election
exceeds the $196,833 adjusted basis of the section 197 intangible before
the reduction, new T is required to reduce its deductions under section
805 by the $327,500 ($524,333 - $196,833).
(E) Effective/applicability date. This section applies to
acquisitions and dispositions of insurance contracts on or after April
10, 2006.
(iii) Application of loss disallowance rule upon a disposition of an
insurance contract acquired in an assumption reinsurance transaction.
The following rules apply for purposes of applying the loss disallowance
rules of section 197(f)(1)(A) to the disposition of a section 197(f)(5)
intangible. For this purpose, a section 197(f)(5) intangible is an
amortizable section 197 intangible the basis of which is determined
under section 197(f)(5).
(A) Disposition--(1) In general. A disposition of a section 197
intangible is any event as a result of which, absent section 197,
recovery of basis is otherwise allowed for Federal income tax purposes.
(2) Treatment of indemnity reinsurance transactions. The transfer
through indemnity reinsurance of the right to the future income from the
insurance contracts to which a section 197(f)(5) intangible relates does
not preclude the recovery of basis by the ceding company, provided that
sufficient economic rights relating to the reinsured contracts are
transferred to the reinsurer. However, the ceding company is not
permitted to recover basis in an indemnity reinsurance transaction if it
has a right to experience refunds reflecting a significant portion of
the future profits on the reinsured contracts, or if it retains an
option to reacquire a significant portion of the future profits on the
reinsured contracts through the exercise of a recapture provision. In
addition, the ceding company is not permitted to recover basis in an
indemnity reinsurance transaction if the reinsurer assumes only a
limited portion
[[Page 292]]
of the ceding company's risk relating to the reinsured contracts (excess
loss reinsurance).
(B) Loss. The loss, if any, recognized by a taxpayer on the
disposition of a section 197(f)(5) intangible equals the amount by which
the taxpayer's adjusted basis in the section 197(f)(5) intangible
immediately before the disposition exceeds the amount, if any, that the
taxpayer receives from another person for the future income right from
the insurance contracts to which the section 197(f)(5) intangible
relates. In determining the amount of the taxpayer's loss on the
disposition of a section 197(f)(5) intangible through a reinsurance
transaction, any effect of the transaction on the amounts capitalized by
the taxpayer as specified policy acquisition expenses under section 848
is disregarded.
(C) Examples. The following examples illustrate the principles of
this paragraph (g)(5)(iii):
Example 1. (i) Facts. In a prior taxable year, as a result of a
section 338 election with respect to T, new T was treated as purchasing
all of old T's insurance contracts that were in force on the acquisition
date in an assumption reinsurance transaction. Under Sec. Sec. 1.338-6
and 1.338-11(b)(2), the amount of AGUB allocable to the future income
right from the purchased insurance contracts was $15, net of the amounts
required to be capitalized under section 848 as a result of the
assumption reinsurance transaction. At the beginning of the current
taxable year, as a result of amortization deductions allowed by section
197(a), new T's adjusted basis in the section 197(f)(5) intangible
resulting from the assumption reinsurance transaction is $12. During the
current taxable year, new T enters into an indemnity reinsurance
agreement with R, another insurance company, in which R assumes 100
percent of the risk relating to the insurance contracts to which the
section 197(f)(5) intangible relates. In the indemnity reinsurance
transaction, R agrees to pay new T a ceding commission of $10 in
exchange for the future profits on the underlying reinsured policies.
Under the indemnity reinsurance agreement, new T continues to administer
the reinsured policies, but transfers investment assets equal to the
required reserves for the reinsured policies together with all future
premiums to R. The indemnity reinsurance agreement does not contain an
experience refund provision or a provision allowing new T to terminate
the reinsurance agreement at its sole option. New T retains the
insurance licenses and other amortizable section 197 intangibles
acquired in the deemed asset sale and continues to underwrite and issue
new insurance contracts.
(ii) Analysis. The indemnity reinsurance agreement constitutes a
disposition of the section 197(f)(5) intangible because it involves the
transfer of sufficient economic rights attributable to the insurance
contracts to which the section 197(f)(5) intangible relates such that
recovery of basis is allowed. For purposes of applying the loss
disallowance rules of section 197(f)(1) and paragraph (g) of this
section, new T's loss is $2 (new T's adjusted basis in the section
197(f)(5) intangible immediately before the disposition ($12) less the
ceding commission ($10)). Therefore, new T applies $10 of the adjusted
basis in the section 197(f)(5) intangible against the amount received
from R for the future income right on the reinsured policies and
increases its basis in the amortizable section 197 intangibles that it
acquired and retained from the deemed asset sale by $2, the amount of
the disallowed loss. The amount of new T's disallowed loss under section
197(f)(1)(A) is determined without regard to the effect of the indemnity
reinsurance transaction on the amounts capitalized by new T as specified
policy acquisition expenses under section 848.
Example 2. (i) Facts. Assume the same facts as in Example 1, except
that under the indemnity reinsurance agreement R agrees to pay new T a
ceding commission of $5 with respect to the underlying reinsured
contracts. In addition, under the indemnity reinsurance agreement, new T
is entitled to an experience refund equal to any future profits on the
reinsured contracts in excess of the ceding commission plus an annual
risk charge. New T also has a right to recapture the business at any
time after R has recovered an amount equal to the ceding commission.
(ii) Analysis. The indemnity reinsurance agreement between new T and
R does not represent a disposition because it does not involve the
transfer of sufficient economic rights with respect to the future income
on the reinsured contracts. Therefore, new T may not recover its basis
in the section 197(f)(5) intangible to which the contracts relate and
must continue to amortize ratably the adjusted basis of the section
197(f)(5) intangible over the remainder of the 15-year recovery period
and cannot apply any portion of this adjusted basis to offset the ceding
commission received from R in the indemnity reinsurance transaction.
(iv) Effective dates--(A) In general--This paragraph (g)(5) applies
to acquisitions and dispositions on or after April 10, 2006. For rules
applicable to acquisitions and dispositions before that date, see Sec.
1.197-2 in effect before
[[Page 293]]
that date (see 26 CFR part 1, revised April 1, 2001).
(B) Application to pre-effective date acquisitions and dispositions.
A taxpayer may choose, on a transaction-by-transaction basis, to apply
the provisions of this paragraph (g)(5) to property acquired and
disposed of before April 10, 2006.
(C) Change in method of accounting--(1) In general--A change in a
taxpayer's treatment of all property acquired and disposed under
paragraph (g)(5) is a change in method of accounting to which the
provisions of sections 446 and 481 and the regulations thereunder apply.
(2) Acquisitions and dispositions on or after effective date. A
Taxpayer is granted the consent of the Commissioner under section 446(e)
to change its method of accounting to comply with this paragraph (g)(5)
for acquisitions and dispositions on or after April 10, 2006. The change
must be made on a cut-off basis with no section 481(a) adjustment.
Notwithstanding Sec. 1.446-1(e)(3), a taxpayer should not file a Form
3115, ``Application for Change in Accounting Method,'' to obtain the
consent of the Commissioner to change its method of accounting under
this paragraph (g)(5)(iv)(C)(2). Instead, a taxpayer must make the
change by using the new method on its federal income tax returns.
(3) Acquisitions and dispositions before the effective date. For the
first taxable year ending after April 10, 2006, a taxpayer is granted
consent of the Commissioner to change its method of accounting for all
property acquired in transactions described in paragraph (g)(5)(iv)(B)
to comply with this paragraph (g)(5) unless the proper treatment of any
such property is an issue under consideration in an examination, before
an Appeals office, or before a Federal Court. (For the definition of
when an issue is under consideration, see, Rev. Proc. 97-27 (1997-1 C.B.
680); and, Sec. 601.601(d)(2) of this chapter). A taxpayer changing its
method of accounting in accordance with this paragraph (g)(5)(iv)(C)(3)
must follow the applicable administrative procedures for obtaining the
Commissioner's automatic consent to a change in method of accounting
(for further guidance, see, for example, Rev. Proc. 2002-9 (2002-1 C.B.
327) as modified and clarified by Announcement 2002-17 (2002-1 C.B.
561), modified and amplified by Rev. Proc. 2002-19 (2002-1 C.B. 696),
and amplified, clarified and modified by Rev. Proc. 2002-54 (2002-2 C.B.
432); and, Sec. 601.601(d)(2) of this chapter), except, for purposes of
this paragraph (g)(5)(iv)(C)(3), any limitations in such administrative
procedures for obtaining the automatic consent of the Commissioner shall
not apply. However, if the taxpayer is under examination, before an
appeals office, or before a Federal court, the taxpayer must provide a
copy of the application to the examining agent(s), appeals officer, or
counsel for the government, as appropriate, at the same time that it
files the copy of the application with the National Office. The
application must contain the name(s) and telephone number(s) of the
examining agent(s), appeals officer, or counsel for the government, as
appropriate. For purposes of From 3115, ``Application for Change in
Accounting Method,'' the designated number for the automatic accounting
method change authorized by this paragraph (g)(5)(iv)(C)(3) is ``98.'' A
change in method of accounting in accordance with this paragraph
(g)(5)(iv)(C)(3) requires an adjustment under section 481(a).
(6) Amounts paid or incurred for a franchise, trademark, or trade
name. If an amount to which section 1253(d) (relating to the transfer,
sale, or other disposition of a franchise, trademark, or trade name)
applies is described in section 1253(d)(1)(B) (relating to contingent
serial payments deductible under section 162), the amount is not
included in the adjusted basis of the intangible for purposes of section
197. Any other amount, whether fixed or contingent, to which section
1253(d) applies is chargeable to capital account under section
1253(d)(2) and is amortizable only under section 197.
(7) Amounts properly taken into account in determining the cost of
property that is not a section 197 intangible. Section 197 does not
apply to an amount that is properly taken into account in determining
the cost of property that
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is not a section 197 intangible. The entire cost of acquiring the other
property is included in its basis and recovered under other applicable
Internal Revenue Code provisions. Thus, for example, section 197 does
not apply to the cost of an interest in computer software to the extent
such cost is included, without being separately stated, in the cost of
the hardware or other tangible property and is consistently treated as
part of the cost of the hardware or other tangible property.
(8) Treatment of amortizable section 197 intangibles as depreciable
property. An amortizable section 197 intangible is treated as property
of a character subject to the allowance for depreciation under section
167. Thus, for example, an amortizable section 197 intangible is not a
capital asset for purposes of section 1221, but if used in a trade or
business and held for more than one year, gain or loss on its
disposition generally qualifies as section 1231 gain or loss. Also, an
amortizable section 197 intangible is section 1245 property and section
1239 applies to any gain recognized upon its sale or exchange between
related persons (as defined in section 1239(b)).
(h) Anti-churning rules--(1) Scope and purpose--(i) Scope. This
paragraph (h) applies to section 197(f)(9) intangibles. For this
purpose, section 197(f)(9) intangibles are goodwill and going concern
value that was held or used at any time during the transition period and
any other section 197 intangible that was held or used at any time
during the transition period and was not depreciable or amortizable
under prior law.
(ii) Purpose. To qualify as an amortizable section 197 intangible, a
section 197 intangible must be acquired after the applicable date (July
25, 1991, if the acquiring taxpayer has made a valid retroactive
election pursuant to Sec. 1.197-1T; August 10, 1993, in all other
cases). The purpose of the anti-churning rules of section 197(f)(9) and
this paragraph (h) is to prevent the amortization of section 197(f)(9)
intangibles unless they are transferred after the applicable effective
date in a transaction giving rise to a significant change in ownership
or use. (Special rules apply for purposes of determining whether
transactions involving partnerships give rise to a significant change in
ownership or use. See paragraph (h)(12) of this section.) The anti-
churning rules are to be applied in a manner that carries out their
purpose.
(2) Treatment of section 197(f)(9) intangibles. Except as otherwise
provided in this paragraph (h), a section 197(f)(9) intangible acquired
by a taxpayer after the applicable effective date does not qualify for
amortization under section 197 if--
(i) The taxpayer or a related person held or used the intangible or
an interest therein at any time during the transition period;
(ii) The taxpayer acquired the intangible from a person that held
the intangible at any time during the transition period and, as part of
the transaction, the user of the intangible does not change; or
(iii) The taxpayer grants the right to use the intangible to a
person that held or used the intangible at any time during the
transition period (or to a person related to that person), but only if
the transaction in which the taxpayer grants the right and the
transaction in which the taxpayer acquired the intangible are part of a
series of related transactions.
(3) Amounts deductible under section 1253(d) or Sec. 1.162-11. For
purposes of this paragraph (h), deductions allowable under section
1253(d)(2) or pursuant to an election under section 1253(d)(3) (in
either case as in effect prior to the enactment of section 197) and
deductions allowable under Sec. 1.162-11 are treated as deductions
allowable for amortization under prior law.
(4) Transition period. For purposes of this paragraph (h), the
transition period is July 25, 1991, if the acquiring taxpayer has made a
valid retroactive election pursuant to Sec. 1.197-1T and the period
beginning on July 25, 1991, and ending on August 10, 1993, in all other
cases.
(5) Exceptions. The anti-churning rules of this paragraph (h) do not
apply to--
(i) The acquisition of a section 197(f)(9) intangible if the
acquiring taxpayer's basis in the intangible is determined under section
1014(a) or 1022; or
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(ii) The acquisition of a section 197(f)(9) intangible that was an
amortizable section 197 intangible in the hands of the seller (or
transferor), but only if the acquisition transaction and the transaction
in which the seller (or transferor) acquired the intangible or interest
therein are not part of a series of related transactions.
(6) Related person--(i) In general. Except as otherwise provided in
paragraph (h)(6)(ii) of this section, a person is related to another
person for purposes of this paragraph (h) if--
(A) The person bears a relationship to that person that would be
specified in section 267(b) (determined without regard to section
267(e)) and, by substitution, section 267(f)(1), if those sections were
amended by substituting 20 percent for 50 percent; or
(B) The person bears a relationship to that person that would be
specified in section 707(b)(1) if that section were amended by
substituting 20 percent for 50 percent; or
(C) The persons are engaged in trades or businesses under common
control (within the meaning of section 41(f)(1) (A) and (B)).
(ii) Time for testing relationships. Except as provided in paragraph
(h)(6)(iii) of this section, a person is treated as related to another
person for purposes of this paragraph (h) if the relationship exists--
(A) In the case of a single transaction, immediately before or
immediately after the transaction in which the intangible is acquired;
and
(B) In the case of a series of related transactions (or a series of
transactions that together comprise a qualified stock purchase within
the meaning of section 338(d)(3)), immediately before the earliest such
transaction or immediately after the last such transaction.
(iii) Certain relationships disregarded. In applying the rules in
paragraph (h)(7) of this section, if a person acquires an intangible in
a series of related transactions in which the person acquires stock
(meeting the requirements of section 1504(a)(2)) of a corporation in a
fully taxable transaction followed by a liquidation of the acquired
corporation under section 331, any relationship created as part of such
series of transactions is disregarded in determining whether any person
is related to such acquired corporation immediately after the last
transaction.
(iv) De minimis rule--(A) In general. Two corporations are not
treated as related persons for purposes of this paragraph (h) if--
(1) The corporations would (but for the application of this
paragraph (h)(6)(iv)) be treated as related persons solely by reason of
substituting ``more than 20 percent'' for ``more than 50 percent'' in
section 267(f)(1)(A); and
(2) The beneficial ownership interest of each corporation in the
stock of the other corporation represents less than 10 percent of the
total combined voting power of all classes of stock entitled to vote and
less than 10 percent of the total value of the shares of all classes of
stock outstanding.
(B) Determination of beneficial ownership interest. For purposes of
this paragraph (h)(6)(iv), the beneficial ownership interest of one
corporation in the stock of another corporation is determined under the
principles of section 318(a), except that--
(1) In applying section 318(a)(2)(C), the 50-percent limitation
contained therein is not applied; and
(2) Section 318(a)(3)(C) is applied by substituting ``20 percent''
for ``50 percent''.
(7) Special rules for entities that owned or used property at any
time during the transition period and that are no longer in existence. A
corporation, partnership, or trust that owned or used a section 197
intangible at any time during the transition period and that is no
longer in existence is deemed, for purposes of determining whether a
taxpayer acquiring the intangible is related to such entity, to be in
existence at the time of the acquisition.
(8) Special rules for section 338 deemed acquisitions. In the case
of a qualified stock purchase that is treated as a deemed sale and
purchase of assets pursuant to section 338, the corporation treated as
purchasing assets as a result of an election thereunder (new target) is
not considered the person that held or used the assets during any period
in which the assets were held or used by the corporation treated as
selling the
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assets (old target). Thus, for example, if a corporation (the purchasing
corporation) makes a qualified stock purchase of the stock of another
corporation after the transition period, new target will not be treated
as the owner during the transition period of assets owned by old target
during that period even if old target and new target are treated as the
same corporation for certain other purposes of the Internal Revenue Code
or old target and new target are the same corporation under the laws of
the State or other jurisdiction of its organization. However, the anti-
churning rules of this paragraph (h) may nevertheless apply to a deemed
asset purchase resulting from a section 338 election if new target is
related (within the meaning of paragraph (h)(6) of this section) to old
target.
(9) Gain-recognition exception--(i) Applicability. A section
197(f)(9) intangible qualifies for the gain-recognition exception if--
(A) The taxpayer acquires the intangible from a person that would
not be related to the taxpayer but for the substitution of 20 percent
for 50 percent under paragraph (h)(6)(i)(A) of this section; and
(B) That person (whether or not otherwise subject to Federal income
tax) elects to recognize gain on the disposition of the intangible and
agrees, notwithstanding any other provision of law or treaty, to pay for
the taxable year in which the disposition occurs an amount of tax on the
gain that, when added to any other Federal income tax on such gain,
equals the gain on the disposition multiplied by the highest marginal
rate of tax for that taxable year.
(ii) Effect of exception. The anti-churning rules of this paragraph
(h) apply to a section 197(f)(9) intangible that qualifies for the gain-
recognition exception only to the extent the acquiring taxpayer's basis
in the intangible exceeds the gain recognized by the transferor.
(iii) Time and manner of election. The election described in this
paragraph (h)(9) must be made by the due date (including extensions of
time) of the electing taxpayer's Federal income tax return for the
taxable year in which the disposition occurs. The election is made by
attaching an election statement satisfying the requirements of paragraph
(h)(9)(viii) of this section to the electing taxpayer's original or
amended income tax return for that taxable year (or by filing the
statement as a return for the taxable year under paragraph (h)(9)(xi) of
this section). In addition, the taxpayer must satisfy the notification
requirements of paragraph (h)(9)(vi) of this section. The election is
binding on the taxpayer and all parties whose Federal tax liability is
affected by the election.
(iv) Special rules for certain entities. In the case of a
partnership, S corporation, estate or trust, the election under this
paragraph (h)(9) is made by the entity rather than by its owners or
beneficiaries. If a partnership or S corporation makes an election under
this paragraph (h)(9) with respect to the disposition of a section
197(f)(9) intangible, each of its partners or shareholders is required
to pay a tax determined in the manner described in paragraph
(h)(9)(i)(B) of this section on the amount of gain that is properly
allocable to such partner or shareholder with respect to the
disposition.
(v) Effect of nonconforming elections. An attempted election that
does not substantially comply with each of the requirements of this
paragraph (h)(9) is disregarded in determining whether a section
197(f)(9) intangible qualifies for the gain-recognition exception.
(vi) Notification requirements. A taxpayer making an election under
this paragraph (h)(9) with respect to the disposition of a section
197(f)(9) intangible must provide written notification of the election
on or before the due date of the return on which the election is made to
the person acquiring the section 197 intangible. In addition, a
partnership or S corporation making an election under this paragraph
(h)(9) must attach to the Schedule K-1 furnished to each partner or
shareholder a written statement containing all information necessary to
determine the recipient's additional tax liability under this paragraph
(h)(9).
(vii) Revocation. An election under this paragraph (h)(9) may be
revoked only with the consent of the Commissioner.
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(viii) Election Statement. An election statement satisfies the
requirements of this paragraph (h)(9)(viii) if it is in writing and
contains the information listed below. The required information should
be arranged and identified in accordance with the following order and
numbering system:
(A) The name and address of the electing taxpayer.
(B) Except in the case of a taxpayer that is not otherwise subject
to Federal income tax, the taxpayer identification number (TIN) of the
electing taxpayer.
(C) A statement that the taxpayer is making the election under
section 197(f)(9)(B).
(D) Identification of the transaction and each person that is a
party to the transaction or whose tax return is affected by the election
(including, except in the case of persons not otherwise subject to
Federal income tax, the TIN of each such person).
(E) The calculation of the gain realized, the applicable rate of
tax, and the amount of the taxpayer's additional tax liability under
this paragraph (h)(9).
(F) The signature of the taxpayer or an individual authorized to
sign the taxpayer's Federal income tax return.
(ix) Determination of highest marginal rate of tax and amount of
other Federal income tax on gain--(A) Marginal rate. The following rules
apply for purposes of determining the highest marginal rate of tax
applicable to an electing taxpayer:
(1) Noncorporate taxpayers. In the case of an individual, estate, or
trust, the highest marginal rate of tax is the highest marginal rate of
tax in effect under section 1, determined without regard to section
1(h).
(2) Corporations and tax-exempt entities. In the case of a
corporation or an entity that is exempt from tax under section 501(a),
the highest marginal rate of tax is the highest marginal rate of tax in
effect under section 11, determined without regard to any rate that is
added to the otherwise applicable rate in order to offset the effect of
the graduated rate schedule.
(B) Other Federal income tax on gain. The amount of Federal income
tax (other than the tax determined under this paragraph (h)(9)) imposed
on any gain is the lesser of--
(1) The amount by which the taxpayer's Federal income tax liability
(determined without regard to this paragraph (h)(9)) would be reduced if
the amount of such gain were not taken into account; or
(2) The amount of the gain multiplied by the highest marginal rate
of tax for the taxable year.
(x) Coordination with other provisions--(A) In general. The amount
of gain subject to the tax determined under this paragraph (h)(9) is not
reduced by any net operating loss deduction under section 172(a), any
capital loss under section 1212, or any other similar loss or deduction.
In addition, the amount of tax determined under this paragraph (h)(9) is
not reduced by any credit of the taxpayer. In computing the amount of
any net operating loss, capital loss, or other similar loss or
deduction, or any credit that may be carried to any taxable year, any
gain subject to the tax determined under this paragraph (h)(9) and any
tax paid under this paragraph (h)(9) is not taken into account.
(B) Section 1374. No provision of paragraph (h)(9)(iv) of this
section precludes the application of section 1374 (relating to a tax on
certain built-in gains of S corporations) to any gain with respect to
which an election under this paragraph (h)(9) is made. In addition,
neither paragraph (h)(9)(iv) nor paragraph (h)(9)(x)(A) of this section
precludes a taxpayer from applying the provisions of section 1366(f)(2)
(relating to treatment of the tax imposed by section 1374 as a loss
sustained by the S corporation) in determining the amount of tax payable
under paragraph (h)(9) of this section.
(C) Procedural and administrative provisions. For purposes of
subtitle F, the amount determined under this paragraph (h)(9) is treated
as a tax imposed by section 1 or 11, as appropriate.
(D) Installment method. The gain subject to the tax determined under
paragraph (h)(9)(i) of this section may not be reported under the method
described in section 453(a). Any such gain that would, but for the
application of this paragraph (h)(9)(x)(D), be taken into account under
section 453(a) shall be taken into account in the same manner
[[Page 298]]
as if an election under section 453(d) (relating to the election not to
apply section 453(a)) had been made.
(xi) Special rules for persons not otherwise subject to Federal
income tax. If the person making the election under this paragraph
(h)(9) with respect to a disposition is not otherwise subject to Federal
income tax, the election statement satisfying the requirements of
paragraph (h)(9)(viii) of this section must be filed with the
Philadelphia Service Center. For purposes of this paragraph (h)(9) and
subtitle F, the statement is treated as an income tax return for the
calendar year in which the disposition occurs and as a return due on or
before March 15 of the following year.
(10) Transactions subject to both anti-churning and nonrecognition
rules. If a person acquires a section 197(f)(9) intangible in a
transaction described in paragraph (g)(2) of this section from a person
in whose hands the intangible was an amortizable section 197 intangible,
and immediately after the transaction (or series of transactions
described in paragraph (h)(6)(ii)(B) of this section) in which such
intangible is acquired, the person acquiring the section 197(f)(9)
intangible is related to any person described in paragraph (h)(2) of
this section, the intangible is, notwithstanding its treatment under
paragraph (g)(2) of this section, treated as an amortizable section 197
intangible only to the extent permitted under this paragraph (h). (See,
for example, paragraph (h)(5)(ii) of this section.)
(11) Avoidance purpose. A section 197(f)(9) intangible acquired by a
taxpayer after the applicable effective date does not qualify for
amortization under section 197 if one of the principal purposes of the
transaction in which it is acquired is to avoid the operation of the
anti-churning rules of section 197(f)(9) and this paragraph (h). A
transaction will be presumed to have a principal purpose of avoidance if
it does not effect a significant change in the ownership or use of the
intangible. Thus, for example, if section 197(f)(9) intangibles are
acquired in a transaction (or series of related transactions) in which
an option to acquire stock is issued to a party to the transaction, but
the option is not treated as having been exercised for purposes of
paragraph (h)(6) of this section, this paragraph (h)(11) may apply to
the transaction.
(12) Additional partnership anti-churning rules--(i) In general. In
determining whether the anti-churning rules of this paragraph (h) apply
to any increase in the basis of a section 197(f)(9) intangible under
section 732(b), 732(d), 734(b), or 743(b), the determinations are made
at the partner level and each partner is treated as having owned and
used the partner's proportionate share of partnership property. In
determining whether the anti-churning rules of this paragraph (h) apply
to any transaction under another section of the Internal Revenue Code,
the determinations are made at the partnership level, unless under Sec.
1.701-2(e) the Commissioner determines that the partner level is more
appropriate.
(ii) Section 732(b) adjustments--(A) In general. The anti-churning
rules of this paragraph (h) apply to any increase in the adjusted basis
of a section 197(f)(9) intangible under section 732(b) to the extent
that the basis increase exceeds the total unrealized appreciation from
the intangible allocable to--
(1) Partners other than the distributee partner or persons related
to the distributee partner;
(2) The distributee partner and persons related to the distributee
partner if the distributed intangible is a section 197(f)(9) intangible
acquired by the partnership on or before August 10, 1993, to the extent
that--
(i) The distributee partner and related persons acquired an interest
or interests in the partnership after August 10, 1993;
(ii) Such interest or interests were held after August 10, 1993, by
a person or persons other than either the distributee partner or persons
who were related to the distributee partner; and
(iii) The acquisition of such interest or interests by such person
or persons was not part of a transaction or series of related
transactions in which the distributee partner (or persons related to the
distributee partner) subsequently acquired such interest or interests;
and
[[Page 299]]
(3) The distributee partner and persons related to the distributee
partner if the distributed intangible is a section 197(f)(9) intangible
acquired by the partnership after August 10, 1993, that is not
amortizable with respect to the partnership, to the extent that--
(i) The distributee partner and persons related to the distributee
partner acquired an interest or interests in the partnership after the
partnership acquired the distributed intangible;
(ii) Such interest or interests were held after the partnership
acquired the distributed intangible, by a person or persons other than
either the distributee partner or persons who were related to the
distributee partner; and
(iii) The acquisition of such interest or interests by such person
or persons was not part of a transaction or series of related
transactions in which the distributee partner (or persons related to the
distributee partner) subsequently acquired such interest or interests.
(B) Effect of retroactive elections. For purposes of paragraph
(h)(12)(ii)(A) of this section, references to August 10, 1993, are
treated as references to July 25, 1991, if the relevant party made a
valid retroactive election under Sec. 1.197-1T.
(C) Intangible still subject to anti-churning rules. Notwithstanding
paragraph (h)(12)(ii) of this section, in applying the provisions of
this paragraph (h) with respect to subsequent transfers, the distributed
intangible remains subject to the provisions of this paragraph (h) in
proportion to a fraction (determined at the time of the distribution),
as follows--
(1) The numerator of which is equal to the sum of--
(i) The amount of the distributed intangible's basis that is
nonamortizable under paragraph (g)(2)(ii)(B) of this section; and
(ii) The total unrealized appreciation inherent in the intangible
reduced by the amount of the increase in the adjusted basis of the
distributed intangible under section 732(b) to which the anti-churning
rules do not apply; and
(2) The denominator of which is the fair market value of such
intangible.
(D) Partner's allocable share of unrealized appreciation from the
intangible. The amount of unrealized appreciation from an intangible
that is allocable to a partner is the amount of taxable gain that would
have been allocated to that partner if the partnership had sold the
intangible immediately before the distribution for its fair market value
in a fully taxable transaction.
(E) Acquisition of partnership interest by contribution. Solely for
purposes of paragraphs (h)(12)(ii)(A)(2) and (3) of this section, a
partner who acquires an interest in a partnership in exchange for a
contribution of property to the partnership is deemed to acquire a pro
rata portion of that interest in the partnership from each person who is
a partner in the partnership at the time of the contribution based on
each partner's respective proportionate interest in the partnership.
(iii) Section 732(d) adjustments. The anti-churning rules of this
paragraph (h) do not apply to an increase in the basis of a section
197(f)(9) intangible under section 732(d) if, had an election been in
effect under section 754 at the time of the transfer of the partnership
interest, the distributee partner would have been able to amortize the
basis adjustment made pursuant to section 743(b).
(iv) Section 734(b) adjustments--(A) In general. The anti-churning
rules of this paragraph (h) do not apply to a continuing partner's share
of an increase in the basis of a section 197(f)(9) intangible held by a
partnership under section 734(b) to the extent that the continuing
partner is an eligible partner.
(B) Eligible partner. For purposes of this paragraph (h)(12)(iv),
eligible partner means--
(1) A continuing partner that is not the distributee partner or a
person related to the distributee partner;
(2) A continuing partner that is the distributee partner or a person
related to the distributee partner, with respect to any section
197(f)(9) intangible acquired by the partnership on or before August 10,
1993, to the extent that--
(i) The distributee partner's interest in the partnership was
acquired after August 10, 1993;
(ii) Such interest was held after August 10, 1993 by a person or
persons who were not related to the distributee partner; and
[[Page 300]]
(iii) The acquisition of such interest by such person or persons was
not part of a transaction or series of related transactions in which the
distributee partner or persons related to the distributee partner
subsequently acquired such interest; or
(3) A continuing partner that is the distributee partner or a person
related to the distributee partner, with respect to any section
197(f)(9) intangible acquired by the partnership after August 10, 1993,
that is not amortizable with respect to the partnership, to the extent
that--
(i) The distributee partner's interest in the partnership was
acquired after the partnership acquired the relevant intangible;
(ii) Such interest was held after the partnership acquired the
relevant intangible by a person or persons who were not related to the
distributee partner; and
(iii) The acquisition of such interest by such person or persons was
not part of a transaction or series of related transactions in which the
distributee partner or persons related to the distributee partner
subsequently acquired such interest.
(C) Effect of retroactive elections. For purposes of paragraph
(h)(12)(iv)(A) of this section, references to August 10, 1993, are
treated as references to July 25, 1991, if the distributee partner made
a valid retroactive election under Sec. 1.197-1T.
(D) Partner's share of basis increase--(1) In general. Except as
provided in paragraph (h)(12)(iv)(D)(2) of this section, for purposes of
this paragraph (h)(12)(iv), a continuing partner's share of a basis
increase under section 734(b) is equal to--
(i) The total basis increase allocable to the intangible; multiplied
by
(ii) A fraction the numerator of which is the amount of the
continuing partner's post-distribution capital account (determined
immediately after the distribution in accordance with the capital
accounting rules of Sec. 1.704-1(b)(2)(iv)), and the denominator of
which is the total amount of the post-distribution capital accounts
(determined immediately after the distribution in accordance with the
capital accounting rules of Sec. 1.704-1(b)(2)(iv)) of all continuing
partners.
(2) Exception where partnership does not maintain capital accounts.
If a partnership does not maintain capital accounts in accordance with
Sec. 1.704-1(b)(2)(iv), then for purposes of this paragraph
(h)(12)(iv), a continuing partner's share of a basis increase is equal
to--
(i) The total basis increase allocable to the intangible; multiplied
by
(ii) The partner's overall interest in the partnership as determined
under Sec. 1.704-1(b)(3) immediately after the distribution.
(E) Interests acquired by contribution--(1) Application of
paragraphs (h)(12)(iv)(B) (2) and (3) of this section. Solely for
purposes of paragraphs (h)(12)(iv)(B)(2) and (3) of this section, a
partner who acquires an interest in a partnership in exchange for a
contribution of property to the partnership is deemed to acquire a pro
rata portion of that interest in the partnership from each person who is
a partner in the partnership at the time of the contribution based on
each such partner's proportionate interest in the partnership.
(2) Special rule with respect to paragraph (h)(12)(iv)(B)(1) of this
section. Solely for purposes of paragraph (h)(12)(iv)(B)(1) of this
section, if a distribution that gives rise to an increase in the basis
under section 734(b) of a section 197(f)(9) intangible held by the
partnership is undertaken as part of a series of related transactions
that include a contribution of the intangible to the partnership by a
continuing partner, the continuing partner is treated as related to the
distributee partner in analyzing the basis adjustment with respect to
the contributed section 197(f)(9) intangible.
(F) Effect of section 734(b) adjustments on partners' capital
accounts. If one or more partners are subject to the anti-churning rules
under this paragraph (h) with respect to a section 734(b) adjustment
allocable to an intangible asset, taxpayers may use any reasonable
method to determine amortization of the asset for book purposes,
provided that the method used does not contravene the purposes of the
anti-churning rules under section 197 and this
[[Page 301]]
paragraph (h). A method will be considered to contravene the purposes of
the anti-churning rules if the effect of the book adjustments resulting
from the method is such that any portion of the tax deduction for
amortization attributable to the section 734 adjustment is allocated,
directly or indirectly, to a partner who is subject to the anti-churning
rules with respect to such adjustment.
(v) Section 743(b) adjustments--(A) General rule. The anti-churning
rules of this paragraph (h) do not apply to an increase in the basis of
a section 197 intangible under section 743(b) if the person acquiring
the partnership interest is not related to the person transferring the
partnership interest. In addition, the anti-churning rules of this
paragraph (h) do not apply to an increase in the basis of a section 197
intangible under section 743(b) to the extent that--
(1) The partnership interest being transferred was acquired after
August 10, 1993, provided--
(i) The section 197(f)(9) intangible was acquired by the partnership
on or before August 10, 1993;
(ii) The partnership interest being transferred was held after
August 10, 1993, by a person or persons (the post-1993 person or
persons) other than the person transferring the partnership interest or
persons who were related to the person transferring the partnership
interest; and
(iii) The acquisition of such interest by the post-1993 person or
persons was not part of a transaction or series of related transactions
in which the person transferring the partnership interest or persons
related to the person transferring the partnership interest acquired
such interest; or
(2) The partnership interest being transferred was acquired after
the partnership acquired the section 197(f)(9) intangible, provided--
(i) The section 197(f)(9) intangible was acquired by the partnership
after August 10, 1993, and is not amortizable with respect to the
partnership;
(ii) The partnership interest being transferred was held after the
partnership acquired the section 197(f)(9) intangible by a person or
persons (the post-contribution person or persons) other than the person
transferring the partnership interest or persons who were related to the
person transferring the partnership interest; and
(iii) The acquisition of such interest by the post-contribution
person or persons was not part of a transaction or series of related
transactions in which the person transferring the partnership interest
or persons related to the person transferring the partnership interest
acquired such interest.
(B) Acquisition of partnership interest by contribution. Solely for
purposes of paragraph (h)(12)(v)(A) (1) and (2) of this section, a
partner who acquires an interest in a partnership in exchange for a
contribution of property to the partnership is deemed to acquire a pro
rata portion of that interest in the partnership from each person who is
a partner in the partnership at the time of the contribution based on
each such partner's proportionate interest in the partnership.
(C) Effect of retroactive elections. For purposes of paragraph
(h)(12)(v)(A) of this section, references to August 10, 1993, are
treated as references to July 25, 1991, if the transferee partner made a
valid retroactive election under Sec. 1.197-1T.
(vi) Partner is or becomes a user of partnership intangible--(A)
General rule. If, as part of a series of related transactions that
includes a transaction described in paragraph (h)(12)(ii), (iii), (iv),
or (v) of this section, an anti-churning partner or related person
(other than the partnership) becomes (or remains) a direct user of an
intangible that is treated as transferred in the transaction (as a
result of the partners being treated as having owned their proportionate
share of partnership assets), the anti-churning rules of this paragraph
(h) apply to the proportionate share of such intangible that is treated
as transferred by such anti-churning partner, notwithstanding the
application of paragraph (h)(12)(ii), (iii), (iv), or (v) of this
section.
(B) Anti-churning partner. For purposes of this paragraph
(h)(12)(vi), anti-churning partner means--
(1) With respect to all intangibles held by a partnership on or
before August 10, 1993, any partner, but only to the extent that
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(i) The partner's interest in the partnership was acquired on or
before August 10, 1993, or
(ii) The interest was acquired from a person related to the partner
on or after August 10, 1993, and such interest was not held by any
person other than persons related to such partner at any time after
August 10, 1993 (disregarding, for this purpose, a person's holding of
an interest if the acquisition of such interest was part of a
transaction or series of related transactions in which the partner or
persons related to the partner subsequently acquired such interest),
(2) With respect to any section 197(f)(9) intangible acquired by a
partnership after August 10, 1993, that is not amortizable with respect
to the partnership, any partner, but only to the extent that
(i) The partner's interest in the partnership was acquired on or
before the date the partnership acquired the section 197(f)(9)
intangible, or
(ii) The interest was acquired from a person related to the partner
on or after the date the partnership acquired the section 197(f)(9)
intangible, and such interest was not held by any person other than
persons related to such partner at any time after the date the
partnership acquired the section 197(f)(9) intangible (disregarding, for
this purpose, a person's holding of an interest if the acquisition of
such interest was part of a transaction or series of related
transactions in which the partner or persons related to the partner
subsequently acquired such interest).
(C) Effect of retroactive elections. For purposes of paragraph
(h)(12)(vi)(B) of this section, references to August 10, 1993, are
treated as references to July 25, 1991, if the relevant party made a
valid retroactive election under Sec. 1.197-1T.
(vii) Section 704(c) allocations--(A) Allocations where the
intangible is amortizable by the contributor. The anti-churning rules of
this paragraph (h) do not apply to the curative or remedial allocations
of amortization with respect to a section 197(f)(9) intangible if the
intangible was an amortizable section 197 intangible in the hands of the
contributing partner (unless paragraph (h)(10) of this section applies
so as to cause the intangible to cease to be an amortizable section 197
intangible in the hands of the partnership).
(B) Allocations where the intangible is not amortizable by the
contributor. If a section 197(f)(9) intangible was not an amortizable
section 197 intangible in the hands of the contributing partner, a non-
contributing partner generally may receive remedial allocations of
amortization under section 704(c) that are deductible for Federal income
tax purposes. However, such a partner may not receive remedial
allocations of amortization under section 704(c) if that partner is
related to the partner that contributed the intangible or if, as part of
a series of related transactions that includes the contribution of the
section 197(f)(9) intangible to the partnership, the contributing
partner or related person (other than the partnership) becomes (or
remains) a direct user of the contributed intangible. Taxpayers may use
any reasonable method to determine amortization of the asset for book
purposes, provided that the method used does not contravene the purposes
of the anti-churning rules under section 197 and this paragraph (h). A
method will be considered to contravene the purposes of the anti-
churning rules if the effect of the book adjustments resulting from the
method is such that any portion of the tax deduction for amortization
attributable to section 704(c) is allocated, directly or indirectly, to
a partner who is subject to the anti-churning rules with respect to such
adjustment.
(C) Rules for section 721(c) partnerships. See Sec. 1.704-
3(d)(5)(iii) if there is a contribution of a section 197(f)(9)
intangible to a section 721(c) partnership (as defined in Sec.
1.721(c)-1(b)(14)).
(viii) Operating rule for transfers upon death. For purposes of this
paragraph (h)(12), if the basis of a partner's interest in a partnership
is determined under section 1014(a) or 1022, such partner is treated as
acquiring such interest from a person who is not related to such
partner, and such interest is treated as having previously been held by
a person who is not related to such partner.
(i) [Reserved]
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(j) General anti-abuse rule. The Commissioner will interpret and
apply the rules in this section as necessary and appropriate to prevent
avoidance of the purposes of section 197. If one of the principal
purposes of a transaction is to achieve a tax result that is
inconsistent with the purposes of section 197, the Commissioner will
recast the transaction for Federal tax purposes as appropriate to
achieve tax results that are consistent with the purposes of section
197, in light of the applicable statutory and regulatory provisions and
the pertinent facts and circumstances.
(k) Examples. The following examples illustrate the application of
this section:
Example 1. Advertising costs. (i) Q manufactures and sells consumer
products through a series of wholesalers and distributors. In order to
increase sales of its products by encouraging consumer loyalty to its
products and to enhance the value of the goodwill, trademarks, and trade
names of the business, Q advertises its products to the consuming
public. It regularly incurs costs to develop radio, television, and
print advertisements. These costs generally consist of employee costs
and amounts paid to independent advertising agencies. Q also incurs
costs to run these advertisements in the various media for which they
were developed.
(ii) The advertising costs are not chargeable to capital account
under paragraph (f)(3) of this section (relating to costs incurred for
covenants not to compete, rights granted by governmental units, and
contracts for the use of section 197 intangibles) and are currently
deductible as ordinary and necessary expenses under section 162.
Accordingly, under paragraph (a)(3) of this section, section 197 does
not apply to these costs.
Example 2. Computer software. (i) X purchases all of the assets of
an existing trade or business from Y. One of the assets acquired is all
of Y's rights in certain computer software previously used by Y under
the terms of a nonexclusive license from the software developer. The
software was developed for use by manufacturers to maintain a
comprehensive accounting system, including general and subsidiary
ledgers, payroll, accounts receivable and payable, cash receipts and
disbursements, fixed asset accounting, and inventory cost accounting and
controls. The developer modified the software for use by Y at a cost of
$1,000 and Y made additional modifications at a cost of $500. The
developer does not maintain wholesale or retail outlets but markets the
software directly to ultimate users. Y's license of the software is
limited to an entity that is actively engaged in business as a
manufacturer.
(ii) Notwithstanding these limitations, the software is considered
to be readily available to the general public for purposes of paragraph
(c)(4)(i) of this section. In addition, the software is not
substantially modified because the cost of the modifications by the
developer and Y to the version of the software that is readily available
to the general public does not exceed $2,000. Accordingly, the software
is not a section 197 intangible.
Example 3. Acquisition of software for internal use. (i) B, the
owner and operator of a worldwide package-delivery service, purchases
from S all rights to software developed by S. The software will be used
by B for the sole purpose of improving its package-tracking operations.
B does not purchase any other assets in the transaction or any related
transaction.
(ii) Because B acquired the software solely for internal use, it is
disregarded in determining for purposes of paragraph (c)(4)(ii) of this
section whether the assets acquired in the transaction or series of
related transactions constitute a trade or business or substantial
portion thereof. Since no other assets were acquired, the software is
not acquired as part of a purchase of a trade or business and under
paragraph (c)(4)(ii) of this section is not a section 197 intangible.
Example 4. Governmental rights of fixed duration. (i) City M
operates a municipal water system. In order to induce X to locate a new
manufacturing business in the city, M grants X the right to purchase
water for 16 years at a specified price.
(ii) The right granted by M is a right to receive tangible property
or services described in section 197(e)(4)(B) and paragraph (c)(6) of
this section and, thus, is not a section 197 intangible. This exclusion
applies even though the right does not qualify for exclusion as a right
of fixed duration or amount under section 197(e)(4)(D) and paragraph
(c)(13) of this section because the duration exceeds 15 years and the
right is not fixed as to amount. It is also immaterial that the right
would not qualify for exclusion as a self-created intangible under
section 197(c)(2) and paragraph (d)(2) of this section because it is
granted by a governmental unit.
Example 5. Separate acquisition of franchise. (i) S is a franchiser
of retail outlets for specialty coffees. G enters into a franchise
agreement (within the meaning of section 1253(b)(1)) with S pursuant to
which G is permitted to acquire and operate a store using the S
trademark and trade name at the location specified in the agreement. G
agrees to pay S $100,000 upon execution of the agreement and also agrees
to pay, throughout the term of the franchise, additional amounts that
are deductible under section 1253(d)(1). The agreement contains detailed
specifications for the construction and operation of
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the business, but G is not required to purchase from S any of the
materials necessary to construct the improvements at the location
specified in the franchise agreement.
(ii) The franchise is a section 197 intangible within the meaning of
paragraph (b)(10) of this section. The franchise does not qualify for
the exclusion relating to self-created intangibles described in section
197(c)(2) and paragraph (d)(2) of this section because the franchise is
described in section 197(d)(1)(F). In addition, because the acquisition
of the franchise constitutes the acquisition of an interest in a trade
or business or a substantial portion thereof, the franchise may not be
excluded under section 197(e)(4). Thus, the franchise is an amortizable
section 197 intangible, the basis of which must be recovered over a 15-
year period. However, the amounts that are deductible under section
1253(d)(1) are not subject to the provisions of section 197 by reason of
section 197(f)(4)(C) and paragraph (b)(10)(ii) of this section.
Example 6. Acquisition and amortization of covenant not to compete.
(i) As part of the acquisition of a trade or business from C, B and C
enter into an agreement containing a covenant not to compete. Under this
agreement, C agrees that it will not compete with the business acquired
by B within a prescribed geographical territory for a period of three
years after the date on which the business is sold to B. In exchange for
this agreement, B agrees to pay C $90,000 per year for each year in the
term of the agreement. The agreement further provides that, in the event
of a breach by C of his obligations under the agreement, B may terminate
the agreement, cease making any of the payments due thereafter, and
pursue any other legal or equitable remedies available under applicable
law. The amounts payable to C under the agreement are not contingent
payments for purposes of Sec. 1.1275-4. The present fair market value
of B's rights under the agreement is $225,000. The aggregate
consideration paid excluding any amount treated as interest or original
issue discount under applicable provisions of the Internal Revenue Code,
for all assets acquired in the transaction (including the covenant not
to compete) exceeds the sum of the amount of Class I assets and the
aggregate fair market value of all Class II, Class III, Class IV, Class
V, and Class VI assets by $50,000. See Sec. 1.338-6(b) for rules for
determining the assets in each class.
(ii) Because the covenant is acquired in an applicable asset
acquisition (within the meaning of section 1060(c)), paragraph
(f)(4)(ii) of this section applies and the basis of B in the covenant is
determined pursuant to section 1060(a) and the regulations thereunder.
Under Sec. Sec. 1.1060-1(c)(2) and 1.338-6(c)(1), B's basis in the
covenant cannot exceed its fair market value. Thus, B's basis in the
covenant immediately after the acquisition is $225,000. This basis is
amortized ratably over the 15-year period beginning on the first day of
the month in which the agreement is entered into. All of the remaining
consideration after allocation to the convenant and other Class VI
assets ($50,000) is allocated to Class VII assets (goodwill and going
concern value). See Sec. Sec. 1.1060-1(c)(2) and 1.338-6(b).
Example 7. Stand-alone license of technology. (i) X is a
manufacturer of consumer goods that does business throughout the world
through subsidiary corporations organized under the laws of each country
in which business is conducted. X licenses to Y, its subsidiary
organized and conducting business in Country K, all of the patents,
formulas, designs, and know-how necessary for Y to manufacture the same
products that X manufactures in the United States. Assume that the
license is not considered a sale or exchange under the principles of
section 1235. The license is for a term of 18 years, and there are no
facts to indicate that the license does not have a fixed duration. Y
agrees to pay X a royalty equal to a specified, fixed percentage of the
revenues obtained from selling products manufactured using the licensed
technology. Assume that the royalty is reasonable and is not subject to
adjustment under section 482. The license is not entered into in
connection with any other transaction. Y incurs capitalized costs in
connection with entering into the license.
(ii) The license is a contract for the use of a section 197
intangible within the meaning of paragraph (b)(11) of this section. It
does not qualify for the exception in section 197(e)(4)(D) and paragraph
(c)(13) of this section (relating to rights of fixed duration or amount
because it does not have a term of less than 15 years, and the other
exceptions in section 197(e) and paragraph (c) of this section are also
inapplicable. Accordingly, the license is a section 197 intangible.
(iii) The license is not acquired as part of a purchase of a trade
or business. Thus, under paragraph (f)(3)(iii) of this section, the
license will be closely scrutinized under the principles of section 1235
for purposes of determining whether the transfer is a sale or exchange
and, accordingly, whether the payments under the license are chargeable
to capital account. Because the license is not a sale or exchange under
the principles of section 1235, the royalty payments are not chargeable
to capital account for purposes section 197. The capitalized costs of
entering into the license are not within the exception under paragraph
(d)(2) of this section for self-created intangibles, and thus are
amortized under section 197.
Example 8. License of technology and trademarks. (i) The facts are
the same as in Example 7, except that the license also includes the use
of the trademarks and trade names that X uses to manufacture and
distribute its products in the United States. Assume that under the
principles of section 1253 the
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transfer is not a sale or exchange of the trademarks and trade names or
an undivided interest therein and that the royalty payments are
described in section 1253(d)(1)(B).
(ii) As in Example 7, the license is a section 197 intangible.
Although the license conveys an interest in X's trademarks and trade
names to Y, the transfer of the interest is disregarded for purposes of
paragraph (e)(2) of this section unless the transfer is considered a
sale or exchange of the trademarks and trade names or an undivided
interest therein. Accordingly, the licensing of the technology and the
trademarks and trade names is not treated as part of a purchase of a
trade or business under paragraph (e)(2) of this section.
(iii) Because the technology license is not part of the purchase of
a trade or business, it is treated in the manner described in Example 7.
The royalty payments for the use of the trademarks and trade names are
deductible under section 1253(d)(1) and, under section 197(f)(4)(C) and
paragraph (b)(10)(ii) of this section, are not chargeable to capital
account for purposes of section 197. The capitalized costs of entering
into the license are treated in the same manner as in example 7.
Example 9. Disguised sale. (i) The facts are the same as in Example
7, except that Y agrees to pay X, in addition to the contingent royalty,
a fixed minimum royalty immediately upon entering into the agreement and
there are sufficient facts present to characterize the transaction, for
federal tax purposes, as a transfer of ownership of the intellectual
property from X to Y.
(ii) The purported license of technology is, in fact, an acquisition
of an intangible described in section 197(d)(1)(C)(iii) and paragraph
(b)(5) of this section (relating to know-how, etc.). As in Example 7,
the exceptions in section 197(e) and paragraph (c) of this section do
not apply to the transfer. Accordingly, the transferred property is a
section 197 intangible. Y's basis in the transferred intangible includes
the capitalized costs of entering into the agreement and the fixed
minimum royalty payment payable at the time of the transfer. In
addition, except to the extent that a portion of any payment will be
treated as interest or original issue discount under applicable
provisions of the Internal Revenue Code, all of the contingent payments
under the purported license are properly chargeable to capital account
for purposes of section 197 and this section. The extent to which such
payments are treated as payments of principal and the time at which any
amount treated as a payment of principal is taken into account in
determining basis are determined under the rules of Sec. 1.1275-4(c)(4)
or 1.483-4(a), whichever is applicable. Any contingent amount that is
included in basis after the month in which the acquisition occurs is
amortized under the rules of paragraph (f)(2)(i) or (ii) of this
section.
Example 10. License of technology and customer list as part of sale
of a trade or business. (i) X is a computer manufacturer that produces,
in separate operating divisions, personal computers, servers, and
peripheral equipment. In a transaction that is the purchase of a trade
or business for purposes of section 197, Y (who is unrelated to X)
purchases from X all assets of the operating division producing personal
computers, except for certain patents that are also used in the division
manufacturing servers and customer lists that are also used in the
division manufacturing peripheral equipment. As part of the transaction,
X transfers to Y the right to use the retained patents and customer
lists solely in connection with the manufacture and sale of personal
computers. The transfer agreement requires annual royalty payments
contingent on the use of the patents and also requires a payment for
each use of the customer list. In addition, Y incurs capitalized costs
in connection with entering into the licenses.
(ii) The rights to use the retained patents and customer lists are
contracts for the use of section 197 intangibles within the meaning of
paragraph (b)(11) of this section. The rights do not qualify for the
exception in 197(e)(4)(D) and paragraph (c)(13) of this section
(relating to rights of fixed duration or amount) because they are
transferred as part of a purchase of a trade or business and the other
exceptions in section 197(e) and paragraph (c) of this section are also
inapplicable. Accordingly, the licenses are section 197 intangibles.
(iii) Because the right to use the retained patents is described in
paragraph (b)(11) of this section and the right is transferred as part
of a purchase of a trade or business, the treatment of the royalty
payments is determined under paragraph (f)(3)(ii) of this section. In
addition, however, the retained patents are described in paragraph
(b)(5) of this section. Thus, the annual royalty payments are chargeable
to capital account under the general rule of paragraph (f)(3)(ii)(A) of
this section unless Y establishes that the license is not a sale or
exchange under the principles of section 1235 and the royalty payments
are an arm's length consideration for the rights transferred. If these
facts are established, the exception in paragraph (f)(3)(ii)(B) of this
section applies and the royalty payments are not chargeable to capital
account for purposes of section 197. The capitalized costs of entering
into the license are treated in the same manner as in Example 7.
(iv) The right to use the retained customer list is also described
in paragraph (b)(11) of this section and is transferred as part of a
purchase of a trade or business. Thus, the treatment of the payments for
use of the
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customer list is also determined under paragraph (f)(3)(ii) of this
section. The customer list, although described in paragraph (b)(6) of
this section, is a customer-related information base. Thus, the
exception in paragraph (f)(3)(ii)(B) of this section does not apply.
Accordingly, payments for use of the list are chargeable to capital
account under the general rule of paragraph (f)(3)(ii)(A) of this
section and are amortized under section 197. In addition, the
capitalized costs of entering into the contract for use of the customer
list are treated in the same manner as in Example 7.
Example 11. Loss disallowance rules involving related persons. (i)
Assume that X and Y are treated as a single taxpayer for purposes of
paragraph (g)(1) of this section. In a single transaction, X and Y
acquired from Z all of the assets used by Z in a trade or business. Z
had operated this business at two locations, and X and Y each acquired
the assets used by Z at one of the locations. Three years after the
acquisition, X sold all of the assets it acquired, including amortizable
section 197 intangibles, to an unrelated purchaser. The amortizable
section intangibles are sold at a loss of $120,000.
(ii) Because X and Y are treated as a single taxpayer for purposes
of the loss disallowance rules of section 197(f)(1) and paragraph (g)(1)
of this section, X's loss on the sale of the amortizable section 197
intangibles is not recognized. Under paragraph (g)(1)(iv)(B) of this
section, X's disallowed loss is allowed ratably, as a deduction under
section 197, over the remainder of the 15-year period during which the
intangibles would have been amortized, and Y may not increase the basis
of the amortizable section 197 intangibles that it acquired from Z by
the amount of X's disallowed loss.
Example 12. Disposition of retained intangibles by related person.
(i) The facts are the same as in Example 11, except that 10 years after
the acquisition of the assets by X and Y and 7 years after the sale of
the assets by X, Y sells all of the assets acquired from Z, including
amortizable section 197 intangibles, to an unrelated purchaser.
(ii) Under paragraph (g)(1)(iv)(B) of this section, X may recognize,
on the date of the sale by Y, any loss that has not been allowed as a
deduction under section 197. Accordingly, X recognizes a loss of
$50,000, the amount obtained by reducing the loss on the sale of the
assets at the end of the third year ($120,000) by the amount allowed as
a deduction under paragraph (g)(1)(iv)(B) of this section during the 7
years following the sale by X ($70,000).
Example 13. Acquisition of an interest in partnership with no
section 754 election. (i) A, B, and C each contribute $1,500 for equal
shares in general partnership P. On January 1, 1998, P acquires as its
sole asset an amortizable section 197 intangible for $4,500. P still
holds the intangible on January 1, 2003, at which time the intangible
has an adjusted basis to P of $3,000, and A, B, and C each have an
adjusted basis of $1,000 in their partnership interests. D (who is not
related to A) acquires A's interest in P for $1,600. No section 754
election is in effect for 2003.
(ii) Because there is no change in the basis of the intangible under
section 743(b), D merely steps into the shoes of A with respect to the
intangible. D's proportionate share of P's adjusted basis in the
intangible is $1,000, which continues to be amortized over the 10 years
remaining in the original 15-year amortization period for the
intangible.
Example 14. Acquisition of an interest in partnership with a section
754 election. (i) The facts are the same as in Example 13, except that a
section 754 election is in effect for 2003.
(ii) Pursuant to paragraph (g)(3) of this section, for purposes of
section 197, D is treated as if P owns two assets. D's proportionate
share of P's adjusted basis in one asset is $1,000, which continues to
be amortized over the 10 years remaining in the original 15-year
amortization period. For the other asset, D's proportionate share of P's
adjusted basis is $600 (the amount of the basis increase under section
743 as a result of the section 754 election), which is amortized over a
new 15-year period beginning January 2003. With respect to B and C, P's
remaining $2,000 adjusted basis in the intangible continues to be
amortized over the 10 years remaining in the original 15-year
amortization period.
Example 15. Payment to a retiring partner by partnership with a
section 754 election. (i) The facts are the same as in Example 13,
except that a section 754 election is in effect for 2003 and, instead of
D acquiring A's interest in P, A retires from P. A, B, and C are not
related to each other within the meaning of paragraph (h)(6) of this
section. P borrows $1,600, and A receives a payment under section 736
from P of such amount, all of which is in exchange for A's interest in
the intangible asset owned by P. (Assume, for purposes of this example,
that the borrowing by P and payment of such funds to A does not give
rise to a disguised sale of A's partnership interest under section
707(a)(2)(B).) P makes a positive basis adjustment of $600 with respect
to the section 197 intangible under section 734(b).
(ii) Pursuant to paragraph (g)(3) of this section, because of the
section 734 adjustment, P is treated as having two amortizable section
197 intangibles, one with a basis of $3,000 and a remaining amortization
period of 10 years and the other with a basis of $600 and a new
amortization period of 15 years.
Example 16. Termination of partnership under section 708(b)(1)(B).
(i) A and B are partners with equal shares in the capital and profits of
general partnership P. P's only asset is an amortizable section 197
intangible, which P
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had acquired on January 1, 1995. On January 1, 2000, the asset had a
fair market value of $100 and a basis to P of $50. On that date, A sells
his entire partnership interest in P to C, who is unrelated to A, for
$50. At the time of the sale, the basis of each of A and B in their
respective partnership interests is $25.
(ii) The sale causes a termination of P under section 708(b)(1)(B).
Under section 708, the transaction is treated as if P transfers its sole
asset to a new partnership in exchange for the assumption of its
liabilities and the receipt of all of the interests in the new
partnership. Immediately thereafter, P is treated as if it is
liquidated, with B and C each receiving their proportionate share of the
interests in the new partnership. The contribution by P of its asset to
the new partnership is governed by section 721, and the liquidating
distributions by P of the interests in the new partnership are governed
by section 731. C does not realize a basis adjustment under section 743
with respect to the amortizable section 197 intangible unless P had a
section 754 election in effect for its taxable year in which the
transfer of the partnership interest to C occurred or the taxable year
in which the deemed liquidation of P occurred.
(iii) Under section 197, if P had a section 754 election in effect,
C is treated as if the new partnership had acquired two assets from P
immediately preceding its termination. Even though the adjusted basis of
the new partnership in the two assets is determined solely under section
723, because the transfer of assets is a transaction described in
section 721, the application of sections 743(b) and 754 to P immediately
before its termination causes P to be treated as if it held two assets
for purposes of section 197. See paragraph (g)(3) of this section. B's
and C's proportionate share of the new partnership's adjusted basis is
$25 each in one asset, which continues to be amortized over the 10 years
remaining in the original 15-year amortization period. For the other
asset, C's proportionate share of the new partnership's adjusted basis
is $25 (the amount of the basis increase resulting from the application
of section 743 to the sale or exchange by A of the interest in P), which
is amortized over a new 15-year period beginning in January 2000.
(iv) If P did not have a section 754 election in effect for its
taxable year in which the sale of the partnership interest by A to C
occurred or the taxable year in which the deemed liquidation of P
occurred, the adjusted basis of the new partnership in the amortizable
section 197 intangible is determined solely under section 723, because
the transfer is a transaction described in section 721, and P does not
have a basis increase in the intangible. Under section 197(f)(2) and
paragraph (g)(2)(ii) of this section, the new partnership continues to
amortize the intangible over the 10 years remaining in the original 15-
year amortization period. No additional amortization is allowable with
respect to this asset.
Example 17. Disguised sale to partnership. (i) E and F are
individuals who are unrelated to each other within the meaning of
paragraph (h)(6) of this section. E has been engaged in the active
conduct of a trade or business as a sole proprietor since 1990. E and F
form EF Partnership. E transfers all of the assets of the business,
having a fair market value of $100, to EF, and F transfers $40 of cash
to EF. E receives a 60 percent interest in EF and the $40 of cash
contributed by F, and F receives a 40 percent interest in EF, under
circumstances in which the transfer by E is partially treated as a sale
of property to EF under Sec. 1.707-3(b).
(ii) Under Sec. 1.707-3(a)(1), the transaction is treated as if E
had sold to EF a 40 percent interest in each asset for $40 and
contributed the remaining 60 percent interest in each asset to EF in
exchange solely for an interest in EF. Because E and EF are related
persons within the meaning of paragraph (h)(6) of this section, no
portion of any transferred section 197(f)(9) intangible that E held
during the transition period (as defined in paragraph (h)(4) of this
section) is an amortizable section 197 intangible pursuant to paragraph
(h)(2) of this section. Section 197(f)(9)(F) and paragraph (g)(3) of
this section do not apply to any portion of the section 197 intangible
in the hands of EF because the basis of EF in these assets was not
increased under any of sections 732, 734, or 743.
Example 18. Acquisition by related person in nonrecognition
transaction. (i) A owns a nonamortizable intangible that A acquired in
1990. In 2000, A sells a one-half interest in the intangible to B for
cash. Immediately after the sale, A and B, who are unrelated to each
other, form partnership P as equal partners. A and B each contribute
their one-half interest in the intangible to P.
(ii) P has a transferred basis in the intangible from A and B under
section 723. The nonrecognition transfer rule under paragraph (g)(2)(ii)
of this section applies to A's transfer of its one-half interest in the
intangible to P, and consequently P steps into A's shoes with respect to
A's nonamortizable transferred basis. The anti-churning rules of
paragraph (h) of this section apply to B's transfer of its one-half
interest in the intangible to P, because A, who is related to P under
paragraph (h)(6) of this section immediately after the series of
transactions in which the intangible was acquired by P, held B's one-
half interest in the intangible during the transition period. Pursuant
to paragraph (h)(10) of this section, these rules apply to B's transfer
of its one-half interest to P even though the nonrecognition transfer
rule under paragraph (g)(2)(ii) of this section would have permitted P
to step into B's
[[Page 308]]
shoes with respect to B's otherwise amortizable basis. Therefore, P's
entire basis in the intangible is nonamortizable. However, if A (not B)
elects to recognize gain under paragraph (h)(9) of this section on the
transfer of each of the one-half interests in the intangible to B and P,
then the intangible would be amortizable by P to the extent provided in
section 197(f)(9)(B) and paragraph (h)(9) of this section.
Example 19. Acquisition of partnership interest following formation
of partnership. (i) The facts are the same as in Example 18 except that,
in 2000, A formed P with an affiliate, S, and contributed the intangible
to the partnership and except that in a subsequent year, in a
transaction that is properly characterized as a sale of a partnership
interest for Federal tax purposes, B purchases a 50 percent interest in
P from A. P has a section 754 election in effect and holds no assets
other than the intangible and cash.
(ii) For the reasons set forth in Example 16 (iii), B is treated as
if P owns two assets. B's proportionate share of P's adjusted basis in
one asset is the same as A's proportionate share of P's adjusted basis
in that asset, which is not amortizable under section 197. For the other
asset, B's proportionate share of the remaining adjusted basis of P is
amortized over a new 15-year period.
Example 20. Acquisition by related corporation in nonrecognition
transaction. (i) The facts are the same as Example 18, except that A and
B form corporation P as equal owners.
(ii) P has a transferred basis in the intangible from A and B under
section 362. Pursuant to paragraph (h)(10) of this section, the
application of the nonrecognition transfer rule under paragraph
(g)(2)(ii) of this section and the anti-churning rules of paragraph (h)
of this section to the facts of this Example 18 is the same as in
Example 16. Thus, P's entire basis in the intangible is nonamortizable.
Example 21. Acquisition from corporation related to purchaser
through remote indirect interest. (i) X, Y, and Z are each corporations
that have only one class of issued and outstanding stock. X owns 25
percent of the stock of Y and Y owns 25 percent of the outstanding stock
of Z. No other shareholder of any of these corporations is related to
any other shareholder or to any of the corporations. On June 30, 2000, X
purchases from Z section 197(f)(9) intangibles that Z owned during the
transition period (as defined in paragraph (h)(4) of this section).
(ii) Pursuant to paragraph (h)(6)(iv)(B) of this section, the
beneficial ownership interest of X in Z is 6.25 percent, determined by
treating X as if it owned a proportionate (25 percent) interest in the
stock of Z that is actually owned by Y. Thus, even though X is related
to Y and Y is related to Z, X and Z are not considered to be related for
purposes of the anti-churning rules of section 197.
Example 22. Gain recognition election. (i) B owns 25 percent of the
stock of S, a corporation that uses the calendar year as its taxable
year. No other shareholder of B or S is related to each other. S is not
a member of a controlled group of corporations within the meaning of
section 1563(a). S has section 197(f)(9) intangibles that it owned
during the transition period. S has a basis of $25,000 in the
intangibles. In 2001, S sells these intangibles to B for $75,000. S
recognizes a gain of $50,000 on the sale and has no other items of
income, deduction, gain, or loss for the year, except that S also has a
net operating loss of $20,000 from prior years that it would otherwise
be entitled to use in 2001 pursuant to section 172(b). S makes a valid
gain recognition election pursuant to section 197(f)(9)(B) and paragraph
(h)(9) of this section. In 2001, the highest marginal tax rate
applicable to S is 35 percent. But for the election, all of S's taxable
income would be taxed at a rate of 15 percent.
(ii) If the gain recognition election had not been made, S would
have taxable income of $30,000 for 2001 and a tax liability of $4,500.
If the gain were not taken into account, S would have no tax liability
for the taxable year. Thus, the amount of tax (other than the tax
imposed under paragraph (h)(9) of this section) imposed on the gain is
also $4,500. The gain on the disposition multiplied by the highest
marginal tax rate is $17,500 ($50,000 x .35). Accordingly, S's tax
liability for the year is $4,500 plus an additional tax under paragraph
(h)(9) of this section of $13,000 ($17,500--$4,500).
(iii) Pursuant to paragraph (h)(9)(x)(A) of this section, S
determines the amount of its net operating loss deduction in subsequent
years without regard to the gain recognized on the sale of the section
197 intangible to B. Accordingly, the entire $20,000 net operating loss
deduction that would have been available in 2001 but for the gain
recognition election may be used in 2002, subject to the limitations of
section 172.
(iv) B has a basis of $75,000 in the section 197(f)(9) intangibles
acquired from S. As the result of the gain recognition election by S, B
may amortize $50,000 of its basis under section 197. Under paragraph
(h)(9)(ii) of this section, the remaining basis does not qualify for the
gain-recognition exception and may not be amortized by B.
Example 23. Section 338 election. (i) Corporation P makes a
qualified stock purchase of the stock of T corporation from two
shareholders in July 2000, and a section 338 election is made by P. No
shareholder of either T or P owns stock in both of these corporations,
and no other shareholder is related to any other shareholder of either
corporation.
(ii) Pursuant to paragraph (h)(8) of this section, in the case of a
qualified stock purchase that is treated as a deemed sale and purchase
of assets pursuant to section 338,
[[Page 309]]
the corporation treated as purchasing assets as a result of an election
thereunder (new target) is not considered the person that held or used
the assets during any period in which the assets were held or used by
the corporation treated as selling the assets (old target). Because
there are no relationships described in paragraph (h)(6) of this section
among the parties to the transaction, any nonamortizable section
197(f)(9) intangible held by old target is an amortizable section 197
intangible in the hands of new target.
(iii) Assume the same facts as set forth in paragraph (i) of this
Example 23, except that one of the selling shareholders is an individual
who owns 25 percent of the total value of the stock of each of the T and
P corporation.
(iv) Old target and new target (as these terms are defined in Sec.
1.338-2(c)(17)) are members of a controlled group of corporations under
section 267(b)(3), as modified by section 197(f)(9)(C)(i), and any
nonamortizable section 197(f)(9) intangible held by old target is not an
amortizable section 197 intangible in the hands of new target. However,
a gain recognition election under paragraph (h)(9) of this section may
be made with respect to this transaction.
Example 24. Relationship created as part of public offering. (i) On
January 1, 2001, Corporation X engages in a series of related
transactions to discontinue its involvement in one line of business. X
forms a new corporation, Y, with a nominal amount of cash. Shortly
thereafter, X transfers all the stock of its subsidiary conducting the
unwanted business (Target) to Y in exchange for 100 shares of Y common
stock and a Y promissory note. Target owns a nonamortizable section
197(f)(9) intangible. Prior to January 1, 2001, X and an underwriter (U)
had entered into a binding agreement pursuant to which U would purchase
85 shares of Y common stock from X and then sell those shares in a
public offering. On January 6, 2001, the public offering closes. X and Y
make a section 338(h)(10) election for Target.
(ii) Pursuant to paragraph (h)(8) of this section, in the case of a
qualified stock purchase that is treated as a deemed sale and purchase
of assets pursuant to section 338, the corporation treated as purchasing
assets as a result of an election thereunder (new target) is not
considered the person that held or used the assets during any period in
which the assets were held or used by the corporation treated as selling
the assets (old target). Further, for purposes of determining whether
the nonamortizable section 197(f)(9) intangible is acquired by new
target from a related person, because the transactions are a series of
related transactions, the relationship between old target and new target
must be tested immediately before the first transaction in the series
(the formation of Y) and immediately after the last transaction in the
series (the sale to U and the public offering). See paragraph
(h)(6)(ii)(B) of this section. Because there was no relationship between
old target and new target immediately before the formation of Y (because
the section 338 election had not been made) and only a 15% relationship
between old target and new target immediately after, old target is not
related to new target for purposes of applying the anti-churning rules
of paragraph (h) of this section. Accordingly, Target may amortize the
section 197 intangible.
Example 25. Other transfers to controlled corporations. (i) In 2001,
Corporation A transfers a section 197(f)(9) intangible that it held
during the transition period to X, a newly formed corporation, in
exchange for 15% of X's stock. As part of the same transaction, B
transfers property to X in exchange for the remaining 85% of X stock.
(ii) Because the acquisition of the intangible by X is part of a
qualifying section 351 exchange, under section 197(f)(2) and paragraph
(g)(2)(ii) of this section, X is treated in the same manner as the
transferor of the asset. Accordingly, X may not amortize the intangible.
If, however, at the time of the exchange, B has a binding commitment to
sell 25 percent of the X stock to C, an unrelated third party, the
exchange, including A's transfer of the section 197(f)(9) intangible,
would fail to qualify as a section 351 exchange. Because the formation
of X, the transfers of property to X, and the sale of X stock by B are
part of a series of related transactions, the relationship between A and
X must be tested immediately before the first transaction in the series
(the transfer of property to X) and immediately after the last
transaction in the series (the sale of X stock to C). See paragraph
(h)(6)(ii)(B) of this section. Because there was no relationship between
A and X immediately before and only a 15% relationship immediately
after, A is not related to X for purposes of applying the anti-churning
rules of paragraph (h) of this section. Accordingly, X may amortize the
section 197 intangible.
Example 26. Relationship created as part of stock acquisition
followed by liquidation. (i) In 2001, Partnership P purchases 100
percent of the stock of Corporation X. P and X were not related prior to
the acquisition. Immediately after acquiring the X stock, and as part of
a series of related transactions, P liquidates X under section 331. In
the liquidating distribution, P receives a section 197(f)(9) intangible
that was held by X during the transition period.
(ii) Because the relationship between P and X was created pursuant
to a series of related transactions where P acquires stock (meeting the
requirements of section 1504(a)(2)) in a fully taxable transaction
followed by a liquidation under section 331, the relationship
immediately after the last transaction in the series (the liquidation)
is disregarded. See
[[Page 310]]
paragraph (h)(6)(iii) of this section. Accordingly, P is entitled to
amortize the section 197(f)(9) intangible.
Example 27. Section 743(b) adjustment with no change in user. (i) On
January 1, 2001, A forms a partnership (PRS) with B in which A owns a
40-percent, and B owns a 60-percent, interest in profits and capital. A
contributes a nonamortizable section 197(f)(9) intangible with a value
of $80 and an adjusted basis of $0 to PRS in exchange for its PRS
interest and B contributes $120 cash. At the time of the contribution,
PRS licenses the section 197(f)(9) intangible to A. On February 1, 2001,
A sells its entire interest in PRS to C, an unrelated person, for $80.
PRS has a section 754 election in effect.
(ii) The section 197(f)(9) intangible contributed to PRS by A is not
amortizable in the hands of PRS. Pursuant to section (g)(2)(ii) of this
section, PRS steps into the shoes of A with respect to A's
nonamortizable transferred basis in the intangible.
(iii) When A sells the PRS interest to C, C will have a basis
adjustment in the PRS assets under section 743(b) equal to $80. The
entire basis adjustment will be allocated to the intangible because the
only other asset held by PRS is cash. Ordinarily, under paragraph
(h)(12)(v) of this section, the anti-churning rules will not apply to an
increase in the basis of partnership property under section 743(b) if
the person acquiring the partnership interest is not related to the
person transferring the partnership interest. However, A is an anti-
churning partner under paragraph (h)(12)(vi)(B)(2)(i) of this section.
As a result of the license agreement, A remains a direct user of the
section 197(f)(9) intangible after the transfer to C. Accordingly,
paragraph (h)(12)(vi)(A) of this section will cause the anti-churning
rules to apply to the entire basis adjustment under section 743(b).
Example 28. Distribution of section 197(f)(9) intangible to partner
who acquired partnership interest prior to the effective date. (i) In
1990, A, B, and C each contribute $150 cash to form general partnership
ABC for the purpose of engaging in a consulting business and a software
manufacturing business. The partners agree to share partnership profits
and losses equally. In 2000, the partnership distributes the consulting
business to A in liquidation of A's entire interest in ABC. The only
asset of the consulting business is a nonamortizable intangible, which
has a fair market value of $180 and a basis of $0. At the time of the
distribution, the adjusted basis of A's interest in ABC is $150. A is
not related to B or C. ABC does not have a section 754 election in
effect.
(ii) Under section 732(b), A's adjusted basis in the intangible
distributed by ABC is $150, a $150 increase over the basis of the
intangible in ABC's hands. In determining whether the anti-churning
rules apply to any portion of the basis increase, A is treated as having
owned and used A's proportionate share of partnership property. Thus, A
is treated as holding an interest in the intangible during the
transition period. Because the intangible was not amortizable prior to
the enactment of section 197, the section 732(b) increase in the basis
of the intangible may be subject to the anti-churning provisions.
Paragraph (h)(12)(ii) of this section provides that the anti-churning
provisions apply to the extent that the section 732(b) adjustment
exceeds the total unrealized appreciation from the intangible allocable
to partners other than A or persons related to A, as well as certain
other partners whose purchase of their interests meet certain criteria.
Because B and C are not related to A, and A's acquisition of its
partnership interest does not satisfy the necessary criteria, the
section 732(b) basis increase is subject to the anti-churning provisions
to the extent that it exceeds B and C's proportionate share of the
unrealized appreciation from the intangible. B and C's proportionate
share of the unrealized appreciation from the intangible is $120 (2/3 of
$180). This is the amount of gain that would be allocated to B and C if
the partnership sold the intangible immediately before the distribution
for its fair market value of $180. Therefore, $120 of the section 732(b)
basis increase is not subject to the anti-churning rules. The remaining
$30 of the section 732(b) basis increase is subject to the anti-churning
rules. Accordingly, A is treated as having two intangibles, an
amortizable section 197 intangible with an adjusted basis of $120 and a
new amortization period of 15 years and a nonamortizable intangible with
an adjusted basis of $30.
(iii) In applying the anti-churning rules to future transfers of the
distributed intangible, under paragraph (h)(12)(ii)(C) of this section,
one-third of the intangible will continue to be subject to the anti-
churning rules, determined as follows: The sum of the amount of the
distributed intangible's basis that is nonamortizable under paragraph
(g)(2)(ii)(B) of this section ($0) and the total unrealized appreciation
inherent in the intangible reduced by the amount of the increase in the
adjusted basis of the distributed intangible under section 732(b) to
which the anti-churning rules do not apply ($180-$120 = $60), over the
fair market value of the distributed intangible ($180).
Example 29. Distribution of section 197(f)(9) intangible to partner
who acquired partnership interest after the effective date. (i) The
facts are the same as in Example 28, except that B and C form ABC in
1990. A does not acquire an interest in ABC until 1995. In 1995, A
contributes $150 to ABC in exchange for a one-third interest in ABC. At
the time of the distribution, the adjusted basis of A's interest in ABC
is $150.
(ii) As in Example 28, the anti-churning rules do not apply to the
increase in the
[[Page 311]]
basis of the intangible distributed to A under section 732(b) to the
extent that it does not exceed the unrealized appreciation from the
intangible allocable to B and C. Under paragraph (h)(12)(ii) of this
section, the anti-churning provisions also do not apply to the section
732(b) basis increase to the extent of A's allocable share of the
unrealized appreciation from the intangible because A acquired the ABC
interest from an unrelated person after August 10, 1993, and the
intangible was acquired by the partnership before A acquired the ABC
interest. Under paragraph (h)(12)(ii)(E) of this section, A is deemed to
acquire the ABC partnership interest from an unrelated person because A
acquired the ABC partnership interest in exchange for a contribution to
the partnership of property other than the distributed intangible and,
at the time of the contribution, no partner in the partnership was
related to A. Consequently, the increase in the basis of the intangible
under section 732(b) is not subject to the anti-churning rules to the
extent of the total unrealized appreciation from the intangible
allocable to A, B, and C. The total unrealized appreciation from the
intangible allocable to A, B, and C is $180 (the gain the partnership
would have recognized if it had sold the intangible for its fair market
value immediately before the distribution). Because this amount exceeds
the section 732(b) basis increase of $150, the entire section 732(b)
basis increase is amortizable.
(iii) In applying the anti-churning rules to future transfers of the
distributed intangible, under paragraph (h)(12)(ii)(C) of this section,
one-sixth of the intangible will continue to be subject to the anti-
churning rules, determined as follows: The sum of the amount of the
distributed intangible's basis that is nonamortizable under paragraph
(g)(2)(ii)(B) of this section ($0) and the total unrealized appreciation
inherent in the intangible reduced by the amount of the increase in the
adjusted basis of the distributed intangible under section 732(b) to
which the anti-churning rules do not apply ($180-$150 = $30), over the
fair market value of the distributed intangible ($180).
Example 30. Distribution of section 197(f)(9) intangible contributed
to the partnership by a partner. (i) The facts are the same as in
Example 29, except that C purchased the intangible used in the
consulting business in 1988 for $60 and contributed the intangible to
ABC in 1990. At that time, the intangible had a fair market value of
$150 and an adjusted tax basis of $60. When ABC distributes the
intangible to A in 2000, the intangible has a fair market value of $180
and a basis of $60.
(ii) As in Examples 28 and 29, the adjusted basis of the intangible
in A's hands is $150 under section 732(b). However, the increase in the
adjusted basis of the intangible under section 732(b) is only $90 ($150
adjusted basis after the distribution compared to $60 basis before the
distribution). Pursuant to paragraph (g)(2)(ii)(B) of this section, A
steps into the shoes of ABC with respect to the $60 of A's adjusted
basis in the intangible that corresponds to ABC's basis in the
intangible and this portion of the basis is nonamortizable. B and C are
not related to A, A acquired the ABC interest from an unrelated person
after August 10, 1993, and the intangible was acquired by ABC before A
acquired the ABC interest. Therefore, under paragraph (h)(12)(ii) of
this section, the section 732(b) basis increase is amortizable to the
extent of A, B, and C's allocable share of the unrealized appreciation
from the intangible. The total unrealized appreciation from the
intangible that is allocable to A, B, and C is $120. If ABC had sold the
intangible immediately before the distribution to A for its fair market
value of $180, it would have recognized gain of $120, which would have
been allocated $10 to A, $10 to B, and $100 to C under section 704(c).
Because A, B, and C's allocable share of the unrealized appreciation
from the intangible exceeds the section 732(b) basis increase in the
intangible, the entire $90 of basis increase is amortizable by A.
Accordingly, after the distribution, A will be treated as having two
intangibles, an amortizable section 197 intangible with an adjusted
basis of $90 and a new amortization period of 15 years and a
nonamortizable intangible with an adjusted basis of $60.
(iii) In applying the anti-churning rules to future transfers of the
distributed intangible, under paragraph (h)(12)(ii)(C) of this section,
one-half of the intangible will continue to be subject to the anti-
churning rules, determined as follows: The sum of the amount of the
distributed intangible's basis that is nonamortizable under paragraph
(g)(2)(ii)(B) of this section ($60) and the total unrealized
appreciation inherent in the intangible reduced by the amount of the
increase in the adjusted basis of the distributed intangible under
section 732(b) to which the anti-churning rules do not apply ($120-$90 =
$30), over the fair market value of the distributed intangible ($180).
Example 31. Partnership distribution causing section 734(b) basis
adjustment to section 197(f)(9) intangible. (i) On January 1, 2001, A,
B, and C form a partnership (ABC) in which each partner shares equally
in capital and income, gain, loss, and deductions. On that date, A
contributes a section 197(f)(9) intangible with a zero basis and a value
of $150, and B and C each contribute $150 cash. A and B are related, but
neither A nor B is related to C. ABC does not adopt the remedial
allocation method for making section 704(c) allocations of amortization
expenses with respect to the intangible. On December 1, 2004, when the
value of the intangible has increased to $600, ABC distributes $300 to B
in complete redemption of B's interest in the
[[Page 312]]
partnership. ABC has an election under section 754 in effect for the
taxable year that includes December 1, 2004. (Assume that, at the time
of the distribution, the basis of A's partnership interest remains zero,
and the basis of each of B's and C's partnership interest remains $150.)
(ii) Immediately prior to the distribution, the assets of the
partnership are revalued pursuant to Sec. 1.704-1(b)(2)(iv)(f), so that
the section 197(f)(9) intangible is reflected on the books of the
partnership at a value of $600. B recognizes $150 of gain under section
731(a)(1) upon the distribution of $300 in redemption of B's partnership
interest. As a result, the adjusted basis of the intangible held by ABC
increases by $150 under section 734(b). A does not satisfy any of the
tests set forth under paragraph (h)(12)(iv)(B) and thus is not an
eligible partner. C is not related to B and thus is an eligible partner
under paragraph (h)(12)(iv)(B)(1) of this section. The capital accounts
of A and C are equal immediately after the distribution, so, pursuant to
paragraph (h)(12)(iv)(D)(1) of this section, each partner's share of the
basis increase is equal to $75. Because A is not an eligible partner,
the anti-churning rules apply to A's share of the basis increase. The
anti-churning rules do not apply to C's share of the basis increase.
(iii) For book purposes, ABC determines the amortization of the
asset as follows: First, the intangible that is subject to adjustment
under section 734(b) will be divided into three assets: the first, with
a basis and value of $75 will be amortizable for both book and tax
purposes; the second, with a basis and value of $75 will be amortizable
for book, but not tax purposes; and a third asset with a basis of zero
and a value of $450 will not be amortizable for book or tax purposes.
Any subsequent revaluation of the intangible pursuant to Sec. 1.704-
1(b)(2)(iv)(f) will be made solely with respect to the third asset
(which is not amortizable for book purposes). The book and tax
attributes from the first asset (i.e., book and tax amortization) will
be specially allocated to C. The book and tax attributes from the second
asset (i.e., book amortization and non-amortizable tax basis) will be
specially allocated to A. Upon disposition of the intangible, each
partner's share of gain or loss will be determined first by allocating
among the partners an amount realized equal to the book value of the
intangible attributable to such partner, with any remaining amount
realized being allocated in accordance with the partnership agreement.
Each partner then will compare its share of the amount realized with its
remaining basis in the intangible to arrive at the gain or loss to be
allocated to such partner. This is a reasonable method for amortizing
the intangible for book purposes, and the results in allocating the
income, gain, loss, and deductions attributable to the intangible do not
contravene the purposes of the anti-churning rules under section 197 or
paragraph (h) of this section.
(l) Effective dates--(1) In general. This section applies to
property acquired after January 25, 2000, except that paragraph (c)(13)
of this section (exception from section 197 for separately acquired
rights of fixed duration or amount) applies to property acquired after
August 10, 1993 (or July 25, 1991, if a valid retroactive election has
been made under Sec. 1.197-1T), and paragraphs (h)(12)(ii), (iii),
(iv), (v), (vi)(A), and (vii)(B) of this section (anti-churning rules
applicable to partnerships) apply to partnership transactions occurring
on or after November 20, 2000.
(2) Application to pre-effective date acquisitions. A taxpayer may
choose, on a transaction-by-transaction basis, to apply the provisions
of this section and Sec. 1.167(a)-14 to property acquired (or
partnership transactions occurring) after August 10, 1993 (or July 25,
1991, if a valid retroactive election has been made under Sec. 1.197-
1T) and--
(i) On or before January 25, 2000; or
(ii) With respect to paragraphs (h)(12)(ii), (iii), (iv), (v),
(vi)(A), and (vii)(B) of this section, before November 20, 2000.
(3) Application of regulation project REG-209709-94 to pre-effective
date acquisitions. A taxpayer may rely on the provisions of regulation
project REG-209709-94 (1997-1 C.B. 731) for property acquired after
August 10, 1993 (or July 25, 1991, if a valid retroactive election has
been made under Sec. 1.197-1T) and on or before January 25, 2000.
(4) Change in method of accounting--(i) In general. For the first
taxable year ending after January 25, 2000, a taxpayer that has acquired
property to which the exception in Sec. 1.197-2(c)(13) applies is
granted consent of the Commissioner to change its method of accounting
for such property to comply with the provisions of this section and
Sec. 1.167(a)-14 unless the proper treatment of such property is an
issue under consideration (within the meaning of Rev. Proc. 97-27 (1997-
21 IRB 10)(see Sec. 601.601(d)(2) of this chapter)) in an examination,
before an Appeals office, or before a Federal court.
(ii) Application to pre-effective date acquisitions. For the first
taxable year
[[Page 313]]
ending after January 25, 2000, a taxpayer is granted consent of the
Commissioner to change its method of accounting for all property
acquired in transactions described in paragraph (l)(2) of this section
to comply with the provisions of this section and Sec. 1.167(a)-14
unless the proper treatment of any such property is an issue under
consideration (within the meaning of Rev. Proc. 97-27 (1997-21 IRB
10)(see Sec. 601.601(d)(2) of this chapter)) in an examination, before
an Appeals office, or before a Federal court.
(iii) Automatic change procedures. A taxpayer changing its method of
accounting in accordance with this paragraph (l)(4) must follow the
automatic change in accounting method provisions of Rev. Proc. 99-49
(1999-52 IRB 725)(see Sec. 601.601(d)(2) of this chapter) except, for
purposes of this paragraph (l)(4), the scope limitations in section 4.02
of Rev. Proc. 99-49 (1999-52 IRB 725) are not applicable. However, if
the taxpayer is under examination, before an appeals office, or before a
Federal court, the taxpayer must provide a copy of the application to
the examining agent(s), appeals officer, or counsel for the government,
as appropriate, at the same time that it files the copy of the
application with the National Office. The application must contain the
name(s) and telephone number(s) of the examining agent(s), appeals
officer, or counsel for the government, as appropriate.
(5) Applicability dates for section 721(c) partnerships--(i) In
general. Except as provided in paragraph (l)(5)(ii) of this section,
paragraph (h)(12)(vii)(C) of this section applies with respect to
contributions occurring on or after January 18, 2017, and with respect
to contributions that occurred before January 18, 2017 resulting from an
entity classification election made under Sec. 301.7701-3 of this
chapter that was effective on or before January 18, 2017 but was filed
on or after January 18, 2017.
(ii) Application of the provisions described in paragraph
(l)(5)(i)(A) of this section retroactively. Paragraph (h)(12)(vii)(C) of
this section may be applied with respect to a contribution occurring on
or after August 6, 2015, and to a contribution that occurred before
August 6, 2015 resulting from an entity classification election made
under Sec. 301.7701-3 of this chapter that was effective on or before
August 6, 2015 but was filed on or after August 6, 2015. A taxpayer
applying paragraph (h)(12)(vii)(C) of this section retroactively must
apply paragraph (h)(12)(vii)(C) of this section on a timely filed
original return (including extensions) or an amended return filed no
later than July 18, 2017.
[T.D. 8865, 65 FR 3827, Jan. 25, 2000; 65 FR 16318, Mar. 28, 2000; 65 FR
60585, Oct. 12, 2000, as amended by T.D. 8907, 65 FR 69671, Nov. 20,
2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001; 66 FR 17363, Mar. 30, 2001;
67 FR 22286, May 3, 2002; T.D. 9257, 71 FR 17996, Apr. 10, 2006; 73 FR
3869, Jan. 23, 2008; T.D. 9533, 76 FR 39280, July 6, 2011; T.D. 9637, 78
FR 54745, Sept. 6, 2013; T.D. 9811, 82 FR 6237, Jan. 19, 2017; T.D.
9814, 82 FR 7597, Jan. 19, 2017; T.D. 9891, 84 FR 3838, Jan. 23, 2020]
Sec. 1.199A-0 Table of contents.
This section lists the section headings that appear in Sec. Sec.
1.199A-1 through 1.199A-6.
Sec. 1.199A-1 Operational rules.
(a) Overview.
(1) In general.
(2) Usage of term individual.
(b) Definitions.
(1) Aggregated trade or business.
(2) Applicable percentage.
(3) Net capital gain.
(4) Phase-in range.
(5) Qualified business income (QBI).
(6) QBI component.
(7) Qualified PTP income.
(8) Qualified REIT dividends.
(9) Reduction amount.
(10) Relevant passthrough entity (RPE).
(11) Specified service trade or business (SSTB).
(12) Threshold amount.
(13) Total QBI amount.
(14) Trade or business.
(15) Unadjusted basis immediately after the acquisition of qualified
property (UBIA of qualified property).
(16) W-2 wages.
(c) Computation of the section 199A deduction for individuals with
taxable income not exceeding threshold amount.
(1) In general.
(2) Carryover rules.
(i) Negative total QBI amount.
(ii) Negative combined qualified REIT dividends/qualified PTP
income.
(3) Examples.
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(d) Computation of the section 199A deduction for individuals with
taxable income above the threshold amount.
(1) In general.
(2) QBI component.
(i) SSTB exclusion.
(ii) Aggregated trade or business.
(iii) Netting and carryover.
(A) Netting.
(B) Carryover of negative total QBI amount.
(iv) QBI component calculation.
(A) General rule.
(B) Taxpayers with taxable income within phase-in range.
(3) Qualified REIT dividends/qualified PTP income component.
(i) In general.
(ii) SSTB exclusion.
(iii) Negative combined qualified REIT dividends/qualified PTP
income.
(4) Examples.
(e) Special rules.
(1) Effect of deduction.
(2) Disregarded entities.
(3) Self-employment tax and net investment income tax.
(4) Commonwealth of Puerto Rico.
(5) Coordination with alternative minimum tax.
(6) Imposition of accuracy-related penalty on underpayments.
(7) Reduction for income received from cooperatives.
(f) Applicability date.
(1) General rule.
(2) Exception for non-calendar year RPE.
Sec. 1.199A-2 Determination of W-2 Wages and unadjusted basis
immediately after acquisition of qualified property.
(a) Scope.
(1) In general.
(2) W-2 wages.
(3) UBIA of qualified property.
(i) In general.
(ii) UBIA of qualified property held by a partnership.
(iii) UBIA of qualified property held by an S corporation.
(iv) UBIA and section 743(b) basis adjustments.
(A) In general.
(B) Excess section 743(b) basis adjustments.
(C) Computation of partner's share of UBIA with excess section
734(b) basis adjustments.
(D) Examples.
(b) W-2 wages.
(1) In general.
(2) Definition of W-2 wages.
(i) In general.
(ii) Wages paid by a person other than a common law employer.
(iii) Requirement that wages must be reported on return filed with
the Social Security Administration.
(A) In general.
(B) Corrected return filed to correct a return that was filed within
60 days of the due date.
(C) Corrected return filed to correct a return that was filed later
than 60 days after the due date.
(iv) Methods for calculating W-2 Wages.
(A) In general.
(B) Acquisition or disposition of a trade or business.
(1) In general.
(2) Acquisition or disposition.
(C) Application in the case of a person with a short taxable year.
(1) In general.
(2) Short taxable year that does not include December 31.
(D) Remuneration paid for services performed in the Commonwealth of
Puerto Rico.
(3) Allocation of wages to trades or businesses.
(4) Allocation of wages to QBI.
(5) Non-duplication rule.
(c) UBIA of qualified property.
(1) Qualified property.
(i) In general.
(ii) Improvements to qualified property.
(iii) Adjustments under sections 734(b) and 743(b).
(iv) Property acquired at end of year.
(2) Depreciable period.
(i) In general.
(ii) Additional first-year depreciation under section 168.
(iii) Qualified property acquired in transactions subject to section
1031 or section 1033.
(A) Replacement property received in a section 1031 or 1033
transaction.
(B) Other property received in a section 1031 or 1033 transaction.
(iv) Qualified property acquired in transactions subject to section
168(i)(7)(B).
(v) Excess section 743(b) basis adjustment.
(3) Unadjusted basis immediately after acquisition.
(i) In general.
(ii) Qualified property acquired in a like-kind exchange.
(A) In general.
(B) Excess boot.
(iii) Qualified property acquired pursuant to an involuntary
conversion.
(A) In general.
(B) Excess boot.
(iv) Qualified property acquired in transactions described in
section 168(i)(7)(B).
(v) Qualified property acquired from a decedent.
(vi) Property acquired in a nonrecognition transaction with
principal purpose of increasing UBIA.
(4) Examples.
(d) Applicability date.
(1) General rule.
(2) Exceptions.
[[Page 315]]
(i) Anti-abuse rules.
(ii) Non-calendar year RPE.
Sec. 1.199A-3 Qualified business income, qualified REIT dividends, and
qualified PTP income.
(a) In general.
(b) Definition of qualified business income.
(1) In general.
(i) Section 751 gain.
(ii) Guaranteed payments for the use of capital.
(iii) Section 481 adjustments.
(iv) Previously disallowed losses
(A) In general.
(B) Partial allowance.
(C) Attributes of disallowed loss determined in year loss is
incurred.
(1) In general.
(2) Specified service trades or businesses.
(D) Examples.
(v) Net operating losses.
(vi) Other deductions.
(2) Qualified items of income, gain, deduction, and loss.
(i) In general.
(ii) Items not taken into account.
(3) Commonwealth of Puerto Rico.
(4) Wages.
(5) Allocation of items among directly-conducted trades or
businesses.
(c) Qualified REIT dividends and qualified PTP income.
(1) In general.
(2) Qualified REIT dividend.
(3) Qualified PTP income.
(i) In general.
(ii) Special rules.
(d) Section 199A dividends paid by a regulated investment company.
(1) In general.
(2) Definition of section 199A dividend.
(i) In general.
(ii) Reduction in the case of excess reported amounts.
(iii) Allocation of excess reported amount.
(A) In general.
(B) Special rule for noncalendar-year RICs.
(3) Definitions.
(i) Reported section 199A dividend amount.
(ii) Excess reported amount.
(iii) Aggregate reported amount.
(iv) Post-December reported amount.
(v) Qualified REIT dividend income.
(4) Treatment of section 199A dividends by shareholders.
(i) In general.
(ii) Holding period.
(5) Example.
(e) Applicability date.
(1) General rule.
(2) Exceptions.
(i) Anti-abuse rules.
(ii) Non-calendar year RPE.
(iii) Previously disallowed losses.
(iv) Section 199A dividends.
Sec. 1.199A-4 Aggregation.
(a) Scope and purpose.
(b) Aggregation rules.
(1) General rule.
(2) Operating rules.
(i) Individuals.
(ii) RPEs.
(c) Reporting and consistency.
(1) For individual.
(2) Individual disclosure.
(i) Required annual disclosure.
(ii) Failure to disclose.
(3) For RPEs.
(i) Required annual disclosure.
(ii) Failure to disclose.
(d) Examples.
(e) Applicability date.
(1) General rule.
(2) Exception for non-calendar year RPE.
Sec. 1.199A-5 Specified service trades or businesses and the trade or
business of performing services as an employee.
(a) Scope and effect.
(1) Scope.
(2) Effect of being an SSTB.
(3) Trade or business of performing services as an employee.
(b) Definition of specified service trade or business.
(1) Listed SSTBs.
(2) Additional rules for applying section 199A(d)(2) and paragraph
(b) of this section.
(i) In general.
(A) No effect on other tax rules.
(B) Hedging transactions.
(ii) Meaning of services performed in the field of health.
(iii) Meaning of services performed in the field of law.
(iv) Meaning of services performed in the field of accounting.
(v) Meaning of services performed in the field of actuarial science.
(vi) Meaning of services performed in the field of performing arts.
(vii) Meaning of services performed in the field of consulting.
(viii) Meaning of services performed in the field of athletics.
(ix) Meaning of services performed in the field of financial
services.
(x) Meaning of services performed in the field of brokerage
services.
(xi) Meaning of the provision of services in investing and
investment management.
(xii) Meaning of the provision of services in trading.
(xiii) Meaning of the provision of services in dealing.
(A) Dealing in securities.
(B) Dealing in commodities.
(1) Qualified active sale.
(2) Active conduct of a commodities business.
(3) Directly holds commodities as inventory or similar property.
[[Page 316]]
(4) Directly incurs substantial expenses in the ordinary course.
(5) Significant activities for purposes of paragraph
(b)(2)(xiii)(B)(4)(iii) of this section.
(C) Dealing in partnership interests.
(xiv) Meaning of trade or business where the principal asset of such
trade or business is the reputation or skill of one or more of its
employees or owners.
(3) Examples.
(c) Special rules.
(1) De minimis rule.
(i) Gross receipts of $25 million or less.
(ii) Gross receipts of greater than $25 million.
(2) Services or property provided to an SSTB.
(i) In general.
(ii) 50 percent or more common ownership.
(iii) Examples.
(d) Trade or business of performing services as an employee.
(1) In general.
(2) Employer's Federal employment tax classification of employee
immaterial.
(3) Presumption that former employees are still employees.
(i) Presumption.
(ii) Rebuttal of presumption.
(iii) Examples.
(e) Applicability date.
(1) General rule.
(2) Exceptions.
(i) Anti-abuse rules.
(ii) Non-calendar year RPE.
Sec. 1.199A-6 Relevant passthrough entities (RPEs), publicly traded
partnerships (PTPs), trusts, and estates.
(a) Overview.
(b) Computational and reporting rules for RPEs.
(1) In general.
(2) Computational rules.
(3) Reporting rules for RPEs.
(i) Trade or business directly engaged in.
(ii) Other items.
(iii) Failure to report information.
(c) Computational and reporting rules for PTPs.
(1) Computational rules.
(2) Reporting rules.
(d) Application to trusts, estates, and beneficiaries.
(1) In general.
(2) Grantor trusts.
(3) Non-grantor trusts and estates.
(i) Calculation at entity level.
(ii) Allocation among trust or estate and beneficiaries.
(iii) Separate shares.
(iv) Threshold amount.
(v) Charitable remainder trusts.
(vi) Electing small business trusts.
(vii) Anti-abuse rule for creation of a trust to avoid exceeding the
threshold amount.
(viii) Example.
(e) Applicability date.
(1) General rule.
(2) Exceptions.
(i) Anti-abuse rules.
(ii) Non-calendar year RPE.
(iii) Separate shares.
(iv) Charitable remainder trusts.
[T.D. 9847, 84 FR 2988, Feb. 8, 2019; T.D. 9847, 84 FR 15954, Apr. 17,
2019; T.D. 9899, 85 FR 38065, June 25, 2020]
Editorial Note: At 84 FR 15954, Apr. 17, 2019, Sec. 1.199A-0 was
amended be adding an entry for Sec. 1.199A-2(b)(2)(iv), however, this
paragraph already exists and the amendment could not be incorporated due
to inaccurate amendatory instruction.
Sec. 1.199A-1 Operational rules.
(a) Overview--(1) In general. This section provides operational
rules for calculating the section 199A(a) qualified business income
deduction (section 199A deduction) under section 199A of the Internal
Revenue Code (Code). This section refers to the rules in Sec. Sec.
1.199A-2 through 1.199A-6. This paragraph (a) provides an overview of
this section. Paragraph (b) of this section provides definitions that
apply for purposes of section 199A and Sec. Sec. 1.199A-1 through
1.199A-6. Paragraph (c) of this section provides computational rules and
examples for individuals whose taxable income does not exceed the
threshold amount. Paragraph (d) of this section provides computational
rules and examples for individuals whose taxable income exceeds the
threshold amount. Paragraph (e) of this section provides special rules
for purposes of section 199A and Sec. Sec. 1.199A-1 through 1.199A-6.
This section and Sec. Sec. 1.199A-2 through 1.199A-6 do not apply for
purposes of calculating the deduction in section 199A(g) for specified
agricultural and horticultural cooperatives.
(2) Usage of term individual. For purposes of applying the rules of
Sec. Sec. 1.199A-1 through 1.199A-6, a reference to an individual
includes a reference to a trust (other than a grantor trust) or an
estate to the extent that the section 199A deduction is determined by
the trust or estate under the rules of Sec. 1.199A-6.
(b) Definitions. For purposes of section 199A and Sec. Sec. 1.199A-
1 through 1.199A-6, the following definitions apply:
(1) Aggregated trade or business means two or more trades or
businesses that
[[Page 317]]
have been aggregated pursuant to Sec. 1.199A-4.
(2) Applicable percentage means, with respect to any taxable year,
100 percent reduced (not below zero) by the percentage equal to the
ratio that the taxable income of the individual for the taxable year in
excess of the threshold amount, bears to $50,000 (or $100,000 in the
case of a joint return).
(3) Net capital gain means net capital gain as defined in section
1222(11) plus any qualified dividend income (as defined in section
1(h)(11)(B)) for the taxable year.
(4) Phase-in range means a range of taxable income between the
threshold amount and the threshold amount plus $50,000 (or $100,000 in
the case of a joint return).
(5) Qualified business income (QBI) means the net amount of
qualified items of income, gain, deduction, and loss with respect to any
trade or business (or aggregated trade or business) as determined under
the rules of Sec. 1.199A-3(b).
(6) QBI component means the amount determined under paragraph (d)(2)
of this section.
(7) Qualified PTP income is defined in Sec. 1.199A-3(c)(3).
(8) Qualified REIT dividends are defined in Sec. 1.199A-3(c)(2).
(9) Reduction amount means, with respect to any taxable year, the
excess amount multiplied by the ratio that the taxable income of the
individual for the taxable year in excess of the threshold amount, bears
to $50,000 (or $100,000 in the case of a joint return). For purposes of
this paragraph (b)(9), the excess amount is the amount by which 20
percent of QBI exceeds the greater of 50 percent of W-2 wages or the sum
of 25 percent of W-2 wages plus 2.5 percent of the UBIA of qualified
property.
(10) Relevant passthrough entity (RPE) means a partnership (other
than a PTP) or an S corporation that is owned, directly or indirectly,
by at least one individual, estate, or trust. Other passthrough entities
including common trust funds as described in Sec. 1.6032-1T and
religious or apostolic organizations described in section 501(d) are
also treated as RPEs if the entity files a Form 1065, U.S. Return of
Partnership Income, and is owned, directly or indirectly, by at least
one individual, estate, or trust. A trust or estate is treated as an RPE
to the extent it passes through QBI, W-2 wages, UBIA of qualified
property, qualified REIT dividends, or qualified PTP income.
(11) Specified service trade or business (SSTB) means a specified
service trade or business as defined in Sec. 1.199A-5(b).
(12) Threshold amount means, for any taxable year beginning before
2019, $157,500 (or $315,000 in the case of a taxpayer filing a joint
return). In the case of any taxable year beginning after 2018, the
threshold amount is the dollar amount in the preceding sentence
increased by an amount equal to such dollar amount, multiplied by the
cost-of-living adjustment determined under section 1(f)(3) of the Code
for the calendar year in which the taxable year begins, determined by
substituting ``calendar year 2017'' for ``calendar year 2016'' in
section 1(f)(3)(A)(ii). The amount of any increase under the preceding
sentence is rounded as provided in section 1(f)(7) of the Code.
(13) Total QBI amount means the net total QBI from all trades or
businesses (including the individual's share of QBI from trades or
business conducted by RPEs).
(14) Trade or business means a trade or business that is a trade or
business under section 162 (a section 162 trade or business) other than
the trade or business of performing services as an employee. In
addition, rental or licensing of tangible or intangible property (rental
activity) that does not rise to the level of a section 162 trade or
business is nevertheless treated as a trade or business for purposes of
section 199A, if the property is rented or licensed to a trade or
business conducted by the individual or an RPE which is commonly
controlled under Sec. 1.199A-4(b)(1)(i) (regardless of whether the
rental activity and the trade or business are otherwise eligible to be
aggregated under Sec. 1.199A-4(b)(1)).
(15) Unadjusted basis immediately after acquisition of qualified
property (UBIA of qualified property) is defined in Sec. 1.199A-2(c).
(16) W-2 wages means W-2 wages of a trade or business (or aggregated
trade
[[Page 318]]
or business) properly allocable to QBI as determined under Sec. 1.199A-
2(b).
(c) Computation of the section 199A deduction for individuals with
taxable income not exceeding threshold amount--(1) In general. The
section 199A deduction is determined for individuals with taxable income
for the taxable year that does not exceed the threshold amount by adding
20 percent of the total QBI amount (including the individual's share of
QBI from an RPE and QBI attributable to an SSTB) and 20 percent of the
combined amount of qualified REIT dividends and qualified PTP income
(including the individual's share of qualified REIT dividends and
qualified PTP income from RPEs and qualified PTP income attributable to
an SSTB). That sum is then compared to 20 percent of the amount by which
the individual's taxable income exceeds net capital gain. The lesser of
these two amounts is the individual's section 199A deduction.
(2) Carryover rules--(i) Negative total QBI amount. If the total QBI
amount is less than zero, the portion of the individual's section 199A
deduction related to QBI is zero for the taxable year. The negative
total QBI amount is treated as negative QBI from a separate trade or
business in the succeeding taxable years of the individual for purposes
of section 199A and this section. This carryover rule does not affect
the deductibility of the loss for purposes of other provisions of the
Code.
(ii) Negative combined qualified REIT dividends/qualified PTP
income. If the combined amount of REIT dividends and qualified PTP
income is less than zero, the portion of the individual's section 199A
deduction related to qualified REIT dividends and qualified PTP income
is zero for the taxable year. The negative combined amount must be
carried forward and used to offset the combined amount of REIT dividends
and qualified PTP income in the succeeding taxable years of the
individual for purposes of section 199A and this section. This carryover
rule does not affect the deductibility of the loss for purposes of other
provisions of the Code.
(3) Examples. The following examples illustrate the provisions of
this paragraph (c). For purposes of these examples, unless indicated
otherwise, assume that all of the trades or businesses are trades or
businesses as defined in paragraph (b)(14) of this section and all of
the tax items are effectively connected to a trade or business within
the United States within the meaning of section 864(c). Total taxable
income does not include the section 199A deduction.
(i) Example 1. A, an unmarried individual, owns and operates a
computer repair shop as a sole proprietorship. The business generates
$100,000 in net taxable income from operations in 2018. A has no capital
gains or losses. After allowable deductions not relating to the
business, A's total taxable income for 2018 is $81,000. The business's
QBI is $100,000, the net amount of its qualified items of income, gain,
deduction, and loss. A's section 199A deduction for 2018 is equal to
$16,200, the lesser of 20% of A's QBI from the business ($100,000 x 20%
= $20,000) and 20% of A's total taxable income for the taxable year
($81,000 x 20% = $16,200).
(ii) Example 2. Assume the same facts as in Example 1 of paragraph
(c)(3)(i) of this section, except that A also has $7,000 in net capital
gain for 2018 and that, after allowable deductions not relating to the
business, A's taxable income for 2018 is $74,000. A's taxable income
minus net capital gain is $67,000 ($74,000-$7,000). A's section 199A
deduction is equal to $13,400, the lesser of 20% of A's QBI from the
business ($100,000 x 20% = $20,000) and 20% of A's total taxable income
minus net capital gain for the taxable year ($67,000 x 20% = $13,400).
(iii) Example 3. B and C are married and file a joint individual
income tax return. B earns $50,000 in wages as an employee of an
unrelated company in 2018. C owns 100% of the shares of X, an S
corporation that provides landscaping services. X generates $100,000 in
net income from operations in 2018. X pays C $150,000 in wages in 2018.
B and C have no capital gains or losses. After allowable deductions not
related to X, B and C's total taxable income for 2018 is $270,000. B's
and C's wages are not considered to be income from a trade or business
for purposes of the section 199A deduction. Because X is an S
corporation, its QBI is determined at the
[[Page 319]]
S corporation level. X's QBI is $100,000, the net amount of its
qualified items of income, gain, deduction, and loss. The wages paid by
X to C are considered to be a qualified item of deduction for purposes
of determining X's QBI. The section 199A deduction with respect to X's
QBI is then determined by C, X's sole shareholder, and is claimed on the
joint return filed by B and C. B and C's section 199A deduction is equal
to $20,000, the lesser of 20% of C's QBI from the business ($100,000 x
20% = $20,000) and 20% of B and C's total taxable income for the taxable
year ($270,000 x 20% = $54,000).
(iv) Example 4. Assume the same facts as in Example 3 of paragraph
(c)(3)(iii) of this section except that B also earns $1,000 in qualified
REIT dividends and $500 in qualified PTP income in 2018, increasing
taxable income to $271,500. B and C's section 199A deduction is equal to
$20,300, the lesser of:
(A) 20% of C's QBI from the business ($100,000 x 20% = $20,000) plus
20% of B's combined qualified REIT dividends and qualified PTP income
($1,500 x 20% = $300); and
(B) 20% of B and C's total taxable for the taxable year ($271,500 x
20% = $54,300).
(d) Computation of the section 199A deduction for individuals with
taxable income above threshold amount--(1) In general. The section 199A
deduction is determined for individuals with taxable income for the
taxable year that exceeds the threshold amount by adding the QBI
component described in paragraph (d)(2) of this section and the
qualified REIT dividends/qualified PTP income component described in
paragraph (d)(3) of this section (including the individual's share of
qualified REIT dividends and qualified PTP income from RPEs). That sum
is then compared to 20 percent of the amount by which the individual's
taxable income exceeds net capital gain. The lesser of these two amounts
is the individual's section 199A deduction.
(2) QBI component. An individual with taxable income for the taxable
year that exceeds the threshold amount determines the QBI component
using the following computational rules, which are to be applied in the
order they appear.
(i) SSTB exclusion. If the individual's taxable income is within the
phase-in range, then only the applicable percentage of QBI, W-2 wages,
and UBIA of qualified property for each SSTB is taken into account for
all purposes of determining the individual's section 199A deduction,
including the application of the netting and carryover rules described
in paragraph (d)(2)(iii) of this section. If the individual's taxable
income exceeds the phase-in range, then none of the individual's share
of QBI, W-2 wages, or UBIA of qualified property attributable to an SSTB
may be taken into account for purposes of determining the individual's
section 199A deduction.
(ii) Aggregated trade or business. If an individual chooses to
aggregate trades or businesses under the rules of Sec. 1.199A-4, the
individual must combine the QBI, W-2 wages, and UBIA of qualified
property of each trade or business within an aggregated trade or
business prior to applying the netting and carryover rules described in
paragraph (d)(2)(iii) of this section and the W-2 wage and UBIA of
qualified property limitations described in paragraph (d)(2)(iv) of this
section.
(iii) Netting and carryover--(A) Netting. If an individual's QBI
from at least one trade or business (including an aggregated trade or
business) is less than zero, the individual must offset the QBI
attributable to each trade or business (or aggregated trade or business)
that produced net positive QBI with the QBI from each trade or business
(or aggregated trade or business) that produced net negative QBI in
proportion to the relative amounts of net QBI in the trades or
businesses (or aggregated trades or businesses) with positive QBI. The
adjusted QBI is then used in paragraph (d)(2)(iv) of this section. The
W-2 wages and UBIA of qualified property from the trades or businesses
(including aggregated trades or businesses) that produced net negative
QBI are not taken into account for purposes of this paragraph (d) and
are not carried over to the subsequent year.
(B) Carryover of negative total QBI amount. If an individual's QBI
from all trades or businesses (including aggregated trades or
businesses) combined is less than zero, the QBI component is
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zero for the taxable year. This negative amount is treated as negative
QBI from a separate trade or business in the succeeding taxable years of
the individual for purposes of section 199A and this section. This
carryover rule does not affect the deductibility of the loss for
purposes of other provisions of the Code. The W-2 wages and UBIA of
qualified property from the trades or businesses (including aggregated
trades or businesses) that produced net negative QBI are not taken into
account for purposes of this paragraph (d) and are not carried over to
the subsequent year.
(iv) QBI component calculation--(A) General rule. Except as provided
in paragraph (d)(2)(iv)(B) of this section, the QBI component is the sum
of the amounts determined under this paragraph (d)(2)(iv)(A) for each
trade or business (or aggregated trade or business). For each trade or
business (or aggregated trade or business) (including trades or
businesses operated through RPEs) the individual must determine the
lesser of--
(1) 20 percent of the QBI for that trade or business (or aggregated
trade or business); or
(2) The greater of--
(i) 50 percent of W-2 wages with respect to that trade or business
(or aggregated trade or business); or
(ii) The sum of 25 percent of W-2 wages with respect to that trade
or business (or aggregated trade or business) plus 2.5 percent of the
UBIA of qualified property with respect to that trade or business (or
aggregated trade or business).
(B) Taxpayers with taxable income within phase-in range. If the
individual's taxable income is within the phase-in range and the amount
determined under paragraph (d)(2)(iv)(A)(2) of this section for a trade
or business (or aggregated trade or business) is less than the amount
determined under paragraph (d)(2)(iv)(A)(1) of this section for that
trade or business (or aggregated trade or business), the amount
determined under paragraph (d)(2)(iv)(A) of this section for such trade
or business (or aggregated trade or business) is modified. Instead of
the amount determined under paragraph (d)(2)(iv)(A)(2) of this section,
the QBI component for the trade or business (or aggregated trade or
business) is the amount determined under paragraph (d)(2)(iv)(A)(1) of
this section reduced by the reduction amount as defined in paragraph
(b)(9) of this section. This reduction amount does not apply if the
amount determined in paragraph (d)(2)(iv)(A)(2) of this section is
greater than the amount determined under paragraph (d)(2)(iv)(A)(1) of
this section (in which circumstance the QBI component for the trade or
business (or aggregated trade or business) will be the unreduced amount
determined in paragraph (d)(2)(iv)(A)(1) of this section).
(3) Qualified REIT dividends/qualified PTP income component--(i) In
general. The qualified REIT dividend/qualified PTP income component is
20 percent of the combined amount of qualified REIT dividends and
qualified PTP income received by the individual (including the
individual's share of qualified REIT dividends and qualified PTP income
from RPEs).
(ii) SSTB exclusion. If the individual's taxable income is within
the phase-in range, then only the applicable percentage of qualified PTP
income generated by an SSTB is taken into account for purposes of
determining the individual's section 199A deduction, including the
determination of the combined amount of qualified REIT dividends and
qualified PTP income described in paragraph (d)(1) of this section. If
the individual's taxable income exceeds the phase-in range, then none of
the individual's share of qualified PTP income generated by an SSTB may
be taken into account for purposes of determining the individual's
section 199A deduction.
(iii) Negative combined qualified REIT dividends/qualified PTP
income. If the combined amount of REIT dividends and qualified PTP
income is less than zero, the portion of the individual's section 199A
deduction related to qualified REIT dividends and qualified PTP income
is zero for the taxable year. The negative combined amount must be
carried forward and used to offset the combined amount of REIT
dividends/qualified PTP income in the succeeding taxable years of the
individual for purposes of section 199A and this section. This carryover
rule does not
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affect the deductibility of the loss for purposes of other provisions of
the Code.
(4) Examples. The following examples illustrate the provisions of
this paragraph (d). For purposes of these examples, unless indicated
otherwise, assume that all of the trades or businesses are trades or
businesses as defined in paragraph (b)(14) of this section, none of the
trades or businesses are SSTBs as defined in paragraph (b)(11) of this
section and Sec. 1.199A-5(b); and all of the tax items associated with
the trades or businesses are effectively connected to a trade or
business within the United States within the meaning of section 864(c).
Also assume that the taxpayers report no capital gains or losses or
other tax items not specified in the examples. Total taxable income does
not include the section 199A deduction.
(i) Example 1. D, an unmarried individual, operates a business as a
sole proprietorship. The business generates $1,000,000 of QBI in 2018.
Solely for purposes of this example, assume that the business paid no
wages and holds no qualified property for use in the business. After
allowable deductions unrelated to the business, D's total taxable income
for 2018 is $980,000. Because D's taxable income exceeds the applicable
threshold amount, D's section 199A deduction is subject to the W-2 wage
and UBIA of qualified property limitations. D's section 199A deduction
is limited to zero because the business paid no wages and held no
qualified property.
(ii) Example 2. Assume the same facts as in Example 1 of paragraph
(d)(4)(i) of this section, except that D holds qualified property with a
UBIA of $10,000,000 for use in the trade or business. D reports
$4,000,000 of QBI for 2020. After allowable deductions unrelated to the
business, D's total taxable income for 2020 is $3,980,000. Because D's
taxable income is above the threshold amount, the QBI component of D's
section 199A deduction is subject to the W-2 wage and UBIA of qualified
property limitations. Because the business has no W-2 wages, the QBI
component of D's section 199A deduction is limited to the lesser of 20%
of the business's QBI or 2.5% of its UBIA of qualified property. Twenty
percent of the $4,000,000 of QBI is $800,000. Two and one-half percent
of the $10,000,000 UBIA of qualified property is $250,000. The QBI
component of D's section 199A deduction is thus limited to $250,000. D's
section 199A deduction is equal to the lesser of:
(A) 20% of the QBI from the business as limited ($250,000); or
(B) 20% of D's taxable income ($3,980,000 x 20% = $796,000).
Therefore, D's section 199A deduction for 2020 is $250,000.
(iii) Example 3. E, an unmarried individual, is a 30% owner of LLC,
which is classified as a partnership for Federal income tax purposes. In
2018, the LLC has a single trade or business and reports QBI of
$3,000,000. The LLC pays total W-2 wages of $1,000,000, and its total
UBIA of qualified property is $100,000. E is allocated 30% of all items
of the partnership. For the 2018 taxable year, E reports $900,000 of QBI
from the LLC. After allowable deductions unrelated to LLC, E's taxable
income is $880,000. Because E's taxable income is above the threshold
amount, the QBI component of E's section 199A deduction will be limited
to the lesser of 20% of E's share of LLC's QBI or the greater of the W-2
wage or UBIA of qualified property limitations. Twenty percent of E's
share of QBI of $900,000 is $180,000. The W-2 wage limitation equals 50%
of E's share of the LLC's wages ($300,000) or $150,000. The UBIA of
qualified property limitation equals $75,750, the sum of 25% of E's
share of LLC's wages ($300,000) or $75,000 plus 2.5% of E's share of
UBIA of qualified property ($30,000) or $750. The greater of the
limitation amounts ($150,000 and $75,750) is $150,000. The QBI component
of E's section 199A deduction is thus limited to $150,000, the lesser of
20% of QBI ($180,000) and the greater of the limitations amounts
($150,000). E's section 199A deduction is equal to the lesser of 20% of
the QBI from the business as limited ($150,000) or 20% of E's taxable
income ($880,000 x 20% = $176,000). Therefore, E's section 199A
deduction is $150,000 for 2018.
(iv) Example 4. F, an unmarried individual, owns a 50% interest in
Z, an S corporation for Federal income tax purposes that conducts a
single trade or business. In 2018, Z reports QBI of $6,000,000. Z pays
total W-2 wages of
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$2,000,000, and its total UBIA of qualified property is $200,000. For
the 2018 taxable year, F reports $3,000,000 of QBI from Z. F is not an
employee of Z and receives no wages or reasonable compensation from Z.
After allowable deductions unrelated to Z and a deductible qualified net
loss from a PTP of ($10,000), F's taxable income is $1,880,000. Because
F's taxable income is above the threshold amount, the QBI component of
F's section 199A deduction will be limited to the lesser of 20% of F's
share of Z's QBI or the greater of the W-2 wage and UBIA of qualified
property limitations. Twenty percent of F's share of Z's QBI
($3,000,000) is $600,000. The W-2 wage limitation equals 50% of F's
share of Z's W-2 wages ($1,000,000) or $500,000. The UBIA of qualified
property limitation equals $252,500, the sum of 25% of F's share of Z's
W-2 wages ($1,000,000) or $250,000 plus 2.5% of E's share of UBIA of
qualified property ($100,000) or $2,500. The greater of the limitation
amounts ($500,000 and $252,500) is $500,000. The QBI component of F's
section 199A deduction is thus limited to $500,000, the lesser of 20% of
QBI ($600,000) and the greater of the limitations amounts ($500,000). F
reports a qualified loss from a PTP and has no qualified REIT dividend.
F does not net the ($10,000) loss from the PTP against QBI. Instead, the
portion of F's section 199A deduction related to qualified REIT
dividends and qualified PTP income is zero for 2018. F's section is 199A
deduction is equal to the lesser of 20% of the QBI from the business as
limited ($500,000) or 20% of F's taxable income over net capital gain
($1,880,000 x 20% = $376,000). Therefore, F's section 199A deduction is
$376,000 for 2018. F must also carry forward the ($10,000) qualified
loss from a PTP to be netted against F's qualified REIT dividends and
qualified PTP income in the succeeding taxable year.
(v) Example 5: Phase-in range. (A) B and C are married and file a
joint individual income tax return. B is a shareholder in M, an entity
taxed as an S corporation for Federal income tax purposes that conducts
a single trade or business. M holds no qualified property. B's share of
the M's QBI is $300,000 in 2018. B's share of the W-2 wages from M in
2018 is $40,000. C earns wage income from employment by an unrelated
company. After allowable deductions unrelated to M, B and C's taxable
income for 2018 is $375,000. B and C are within the phase-in range
because their taxable income exceeds the applicable threshold amount,
$315,000, but does not exceed the threshold amount plus $100,000, or
$415,000. Consequently, the QBI component of B and C's section 199A
deduction may be limited by the W-2 wage and UBIA of qualified property
limitations but the limitations will be phased in.
(B) Because M does not hold qualified property, only the W-2 wage
limitation must be calculated. In order to apply the W-2 wage
limitation, B and C must first determine 20% of B's share of M's QBI.
Twenty percent of B's share of M's QBI of $300,000 is $60,000. Next, B
and C must determine 50% of B's share of M's W-2 wages. Fifty percent of
B's share of M's W-2 wages of $40,000 is $20,000. Because 50% of B's
share of M's W-2 wages ($20,000) is less than 20% of B's share of M's
QBI ($60,000), B and C must determine the QBI component of their section
199A deduction by reducing 20% of B's share of M's QBI by the reduction
amount.
(C) B and C are 60% through the phase-in range (that is, their
taxable income exceeds the threshold amount by $60,000 and their phase-
in range is $100,000). B and C must determine the excess amount, which
is the excess of 20% of B's share of M's QBI, or $60,000, over 50% of
B's share of M's W-2 wages, or $20,000. Thus, the excess amount is
$40,000. The reduction amount is equal to 60% of the excess amount, or
$24,000. Thus, the QBI component of B and C's section 199A deduction is
equal to $36,000, 20% of B's $300,000 share M's QBI (that is, $60,000),
reduced by $24,000. B and C's section 199A deduction is equal to the
lesser of 20% of the QBI from the business as limited ($36,000) or 20%
of B and C's taxable income ($375,000 x 20% = $75,000). Therefore, B and
C's section 199A deduction is $36,000 for 2018.
(vi) Example 6. (A) Assume the same facts as in Example 5 of
paragraph (d)(4)(v) of this section, except that M is engaged in an
SSTB. Because B and C are within the phase-in range, B
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must reduce the QBI and W-2 wages allocable to B from M to the
applicable percentage of those items. B and C's applicable percentage is
100% reduced by the percentage equal to the ratio that their taxable
income for the taxable year ($375,000) exceeds their threshold amount
($315,000), or $60,000, bears to $100,000. Their applicable percentage
is 40%. The applicable percentage of B's QBI is ($300,000 x 40% =)
$120,000, and the applicable percentage of B's share of W-2 wages is
($40,000 x 40% =) $16,000. These reduced numbers must then be used to
determine how B's section 199A deduction is limited.
(B) B and C must apply the W-2 wage limitation by first determining
20% of B's share of M's QBI as limited by paragraph (d)(4)(vi)(A) of
this section. Twenty percent of B's share of M's QBI of $120,000 is
$24,000. Next, B and C must determine 50% of B's share of M's W-2 wages.
Fifty percent of B's share of M's W-2 wages of $16,000 is $8,000.
Because 50% of B's share of M's W-2 wages ($8,000) is less than 20% of
B's share of M's QBI ($24,000), B and C's must determine the QBI
component of their section 199A deduction by reducing 20% of B's share
of M's QBI by the reduction amount.
(C) B and C are 60% through the phase-in range (that is, their
taxable income exceeds the threshold amount by $60,000 and their phase-
in range is $100,000). B and C must determine the excess amount, which
is the excess of 20% of B's share of M's QBI, as adjusted in paragraph
(d)(4)(vi)(A) of this section or $24,000, over 50% of B's share of M's
W-2 wages, as adjusted in paragraph (d)(4)(vi)(A) of this section, or
$8,000. Thus, the excess amount is $16,000. The reduction amount is
equal to 60% of the excess amount or $9,600. Thus, the QBI component of
B and C's section 199A deduction is equal to $14,400, 20% of B's share
M's QBI of $24,000, reduced by $9,600. B and C's section 199A deduction
is equal to the lesser of 20% of the QBI from the business as limited
($14,400) or 20% of B's and C's taxable income ($375,000 x 20% =
$75,000). Therefore, B and C's section 199A deduction is $14,400 for
2018.
(vii) Example 7. (A) F, an unmarried individual, owns as a sole
proprietor 100 percent of three trades or businesses, Business X,
Business Y, and Business Z. None of the businesses hold qualified
property. F does not aggregate the trades or businesses under Sec.
1.199A-4. For taxable year 2018, Business X generates $1 million of QBI
and pays $500,000 of W-2 wages with respect to the business. Business Y
also generates $1 million of QBI but pays no wages. Business Z generates
$2,000 of QBI and pays $500,000 of W-2 wages with respect to the
business. F also has $750,000 of wage income from employment with an
unrelated company. After allowable deductions unrelated to the
businesses, F's taxable income is $2,722,000.
(B) Because F's taxable income is above the threshold amount, the
QBI component of F's section 199A deduction is subject to the W-2 wage
and UBIA of qualified property limitations. These limitations must be
applied on a business-by-business basis. None of the businesses hold
qualified property, therefore only the 50% of W-2 wage limitation must
be calculated. Because QBI from each business is positive, F applies the
limitation by determining the lesser of 20% of QBI and 50% of W-2 wages
for each business.For Business X, the lesser of 20% of QBI ($1,000,000 x
20 percent = $200,000) and 50% of Business X's W-2 wages ($500,000 x 50%
= $250,000) is $200,000. Business Y pays no W-2 wages. The lesser of 20%
of Business Y's QBI($1,000,000 x 20% = $200,000) and 50% of its W-2
wages (zero) is zero. For Business Z, the lesser of 20% of QBI ($2,000 x
20% = $400) and 50% of W-2 wages ($500,000 x 50% = $250,000) is $400.
(C) Next, F must then combine the amounts determined in paragraph
(d)(4)(vii)(B) of this section and compare that sum to 20% of F's
taxable income. The lesser of these two amounts equals F's section 199A
deduction. The total of the combined amounts in paragraph (d)(4)(vii)(B)
of this section is $200,400 ($200,000 + zero + 400). Twenty percent of
F's taxable income is $544,400 ($2,722,000 x 20%). Thus, F's section
199A deduction for 2018 is $200,400.
(viii) Example 8. (A) Assume the same facts as in Example 7 of
paragraph (d)(4)(vii) of this section, except that F aggregates Business
X, Business Y, and Business Z under the rules of Sec. 1.199A-4.
[[Page 324]]
(B) Because F's taxable income is above the threshold amount, the
QBI component of F's section 199A deduction is subject to the W-2 wage
and UBIA of qualified property limitations. Because the businesses are
aggregated, these limitations are applied on an aggregated basis. None
of the businesses holds qualified property, therefore only the W-2 wage
limitation must be calculated. F applies the limitation by determining
the lesser of 20% of the QBI from the aggregated businesses, which is
$400,400 ($2,002,000 x 20%) and 50% of W-2 wages from the aggregated
businesses, which is $500,000 ($1,000,000 x 50%). F's section 199A
deduction is equal to the lesser of $400,400 and 20% of F's taxable
income ($2,722,000 x 20% = $544,400). Thus, F's section 199A deduction
for 2018 is $400,400.
(ix) Example 9. (A) Assume the same facts as in Example 7 of
paragraph (d)(4)(vii) of this section, except that for taxable year
2018, Business Z generates a loss that results in ($600,000) of negative
QBI and pays $500,000 of W-2 wages. After allowable deductions unrelated
to the businesses, F's taxable income is $2,120,000. Because Business Z
had negative QBI, F must offset the positive QBI from Business X and
Business Y with the negative QBI from Business Z in proportion to the
relative amounts of positive QBI from Business X and Business Y. Because
Business X and Business Y produced the same amount of positive QBI, the
negative QBI from Business Z is apportioned equally among Business X and
Business Y. Therefore, the adjusted QBI for each of Business X and
Business Y is $700,000 ($1 million plus 50% of the negative QBI of
$600,000). The adjusted QBI in Business Z is $0, because its negative
QBI has been fully apportioned to Business X and Business Y.
(B) Because F's taxable income is above the threshold amount, the
QBI component of F's section 199A deduction is subject to the W-2 wage
and UBIA of qualified property limitations. These limitations must be
applied on a business-by-business basis. None of the businesses hold
qualified property, therefore only the 50% of W-2 wage limitation must
be calculated. For Business X, the lesser of 20% of QBI ($700,000 x 20%
= $140,000) and 50% of W-2 wages ($500,000 x 50% = $250,000) is
$140,000. Business Y pays no W-2 wages. The lesser of 20% of Business
Y's QBI ($700,000 x 20% = $140,000) and 50% of its W-2 wages (zero) is
zero.
(C) F must combine the amounts determined in paragraph (d)(4)(ix)(B)
of this section and compare the sum to 20% of taxable income. F's
section 199A deduction equals the lesser of these two amounts. The
combined amount from paragraph (d)(4)(ix)(B) of this section is $140,000
($140,000 + zero) and 20% of F's taxable income is $424,000 ($2,120,000
x 20%). Thus, F's section 199A deduction for 2018 is $140,000. There is
no carryover of any loss into the following taxable year for purposes of
section 199A.
(x) Example 10. (A) Assume the same facts as in Example 9 of
paragraph (d)(4)(ix) of this section, except that F aggregates Business
X, Business Y, and Business Z under the rules of Sec. 1.199A-4.
(B) Because F's taxable income is above the threshold amount, the
QBI component of F's section 199A deduction is subject to the W-2 wage
and UBIA of qualified property limitations. Because the businesses are
aggregated, these limitations are applied on an aggregated basis. None
of the businesses holds qualified property, therefore only the W-2 wage
limitation must be calculated. F applies the limitation by determining
the lesser of 20% of the QBI from the aggregated businesses ($1,400,000
x 20% = $280,000) and 50% of W-2 wages from the aggregated businesses
($1,000,000 x 50% = $500,000), or $280,000. F's section 199A deduction
is equal to the lesser of $280,000 and 20% of F's taxable income
($2,120,000 x 20% = $424,000). Thus, F's section 199A deduction for 2018
is $280,000. There is no carryover of any loss into the following
taxable year for purposes of section 199A.
(xi) Example 11. (A) Assume the same facts as in Example 7 of
paragraph (d)(4)(vii) of this section, except that Business Z generates
a loss that results in ($2,150,000) of negative QBI and pays $500,000 of
W-2 wages with respect to the business in 2018. Thus, F has a negative
combined QBI of ($150,000) when the QBI from all of the businesses are
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added together ($1 million plus $1 million minus the loss of
($2,150,000)). Because F has a negative combined QBI for 2018, F has no
section 199A deduction with respect to any trade or business for 2018.
Instead, the negative combined QBI of ($150,000) carries forward and
will be treated as negative QBI from a separate trade or business for
purposes of computing the section 199A deduction in the next taxable
year. None of the W-2 wages carry forward. However, for income tax
purposes, the $150,000 loss may offset F's $750,000 of wage income
(assuming the loss is otherwise allowable under the Code).
(B) In taxable year 2019, Business X generates $200,000 of net QBI
and pays $100,000 of W-2 wages with respect to the business. Business Y
generates $150,000 of net QBI but pays no wages. Business Z generates a
loss that results in ($120,000) of negative QBI and pays $500 of W-2
wages with respect to the business. F also has $750,000 of wage income
from employment with an unrelated company. After allowable deductions
unrelated to the businesses, F's taxable income is $960,000. Pursuant to
paragraph (d)(2)(iii)(B) of this section, the ($150,000) of negative QBI
from 2018 is treated as arising in 2019 from a separate trade or
business. Thus, F has overall net QBI of $80,000 when all trades or
businesses are taken together ($200,000) plus $150,000 minus $120,000
minus the carryover loss of ($150,000). Because Business Z had negative
QBI and F also has a negative QBI carryover amount, F must offset the
positive QBI from Business X and Business Y with the negative QBI from
Business Z and the carryover amount in proportion to the relative
amounts of positive QBI from Business X and Business Y. Because Business
X produced 57.14% of the total QBI from Business X and Business Y,
57.14% of the negative QBI from Business Z and the negative QBI
carryforward must be apportioned to Business X, and the remaining 42.86%
allocated to Business Y. Therefore, the adjusted QBI in Business X is
$45,722 ($200,000 minus 57.14% of the loss from Business Z ($68,568),
minus 57.14% of the carryover loss ($85,710). The adjusted QBI in
Business Y is $34,278 ($150,000, minus 42.86% of the loss from Business
Z ($51,432) minus 42.86% of the carryover loss ($64,290)). The adjusted
QBI in Business Z is $0, because its negative QBI has been apportioned
to Business X and Business Y.
(C) Because F's taxable income is above the threshold amount, the
QBI component of F's section 199A deduction is subject to the W-2 wage
and UBIA of qualified property limitations. These limitations must be
applied on a business-by-business basis. None of the businesses hold
qualified property, therefore only the 50% of W-2 wage limitation must
be calculated. For Business X, 20% of QBI is $9,144 ($45,722 x 20%) and
50% of W-2 wages is $50,000 ($100,000 x 50%), so the lesser amount is
$9,144. Business Y pays no W-2 wages. Twenty percent of Business Y's QBI
is $6,856 ($34,278 x 20%) and 50% of its W-2 wages (zero) is zero, so
the lesser amount is zero.
(D) F must then compare the combined amounts determined in paragraph
(d)(4)(xi)(C) of this section to 20% of F's taxable income. The section
199A deduction equals the lesser of these amounts. F's combined amount
from paragraph (d)(4)(xi)(C) of this section is $9,144 ($9,144 plus
zero) and 20% of F's taxable income is $192,000 ($960,000 x 20%) Thus,
F's section 199A deduction for 2019 is $9,144. There is no carryover of
any negative QBI into the following taxable year for purposes of section
199A.
(xii) Example 12. (A) Assume the same facts as in Example 11 of
paragraph (d)(4)(xi) of this section, except that F aggregates Business
X, Business Y, and Business Z under the rules of Sec. 1.199A-4. For
2018, F's QBI from the aggregated trade or business is ($150,000).
Because F has a combined negative QBI for 2018, F has no section 199A
deduction with respect to any trade or business for 2018. Instead, the
negative combined QBI of ($150,000) carries forward and will be treated
as negative QBI from a separate trade or business for purposes of
computing the section 199A deduction in the next taxable year. However,
for income tax purposes, the $150,000 loss may offset taxpayer's
$750,000 of wage income (assuming the loss is otherwise allowable under
the Code).
(B) In taxable year 2019, F will have QBI of $230,000 and W-2 wages
of
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$100,500 from the aggregated trade or business. F also has $750,000 of
wage income from employment with an unrelated company. After allowable
deductions unrelated to the businesses, F's taxable income is $960,000.
F must treat the negative QBI carryover loss ($150,000) from 2018 as a
loss from a separate trade or business for purposes of section 199A.
This loss will offset the positive QBI from the aggregated trade or
business, resulting in an adjusted QBI of $80,000 ($230,000 - $150,000).
(C) Because F's taxable income is above the threshold amount, the
QBI component of F's section 199A deduction is subject to the W-2 wage
and UBIA of qualified property limitations. These limitations must be
applied on a business-by-business basis. None of the businesses hold
qualified property, therefore only the 50% of W-2 wage limitation must
be calculated. For the aggregated trade or business, the lesser of 20%
of QBI ($80,000 x 20% = $16,000) and 50% of W-2 wages ($100,500 x 50% =
$50,250) is $16,000. F's section 199A deduction equals the lesser of
that amount ($16,000) and 20% of F's taxable income ($960,000 x 20% =
$192,000). Thus, F's section 199A deduction for 2019 is $16,000. There
is no carryover of any negative QBI into the following taxable year for
purposes of section 199A.
(e) Special rules--(1) Effect of deduction. In the case of a
partnership or S corporation, section 199A is applied at the partner or
shareholder level. The rules of subchapter K and subchapter S of the
Code apply in their entirety for purposes of determining each partner's
or shareholder's share of QBI, W-2 wages, UBIA of qualified property,
qualified REIT dividends, and qualified PTP income or loss. The section
199A deduction has no effect on the adjusted basis of a partner's
interest in the partnership, the adjusted basis of a shareholder's stock
in an S corporation, or an S corporation's accumulated adjustments
account.
(2) Disregarded entities. An entity with a single owner that is
treated as disregarded as an entity separate from its owner under any
provision of the Code is disregarded for purposes of section 199A and
Sec. Sec. 1.199A-1 through 1.199A-6.
(3) Self-employment tax and net investment income tax. The deduction
allowed under section 199A does not reduce net earnings from self-
employment under section 1402 or net investment income under section
1411.
(4) Commonwealth of Puerto Rico. If all of an individual's QBI from
sources within the Commonwealth of Puerto Rico is taxable under section
1 of the Code for a taxable year, then for purposes of determining the
QBI of such individual for such taxable year, the term ``United States''
includes the Commonwealth of Puerto Rico.
(5) Coordination with alternative minimum tax. For purposes of
determining alternative minimum taxable income under section 55, the
deduction allowed under section 199A(a) for a taxable year is equal in
amount to the deduction allowed under section 199A(a) in determining
taxable income for that taxable year (that is, without regard to any
adjustments under sections 56 through 59).
(6) Imposition of accuracy-related penalty on underpayments. For
rules related to the imposition of the accuracy-related penalty on
underpayments for taxpayers who claim the deduction allowed under
section 199A, see section 6662(d)(1)(C).
(7) Reduction for income received from cooperatives. In the case of
any trade or business of a patron of a specified agricultural or
horticultural cooperative, as defined in section 199A(g)(4), the amount
of section 199A deduction determined under paragraph (c) or (d) of this
section with respect to such trade or business must be reduced by the
lesser of:
(i) Nine percent of the QBI with respect to such trade or business
as is properly allocable to qualified payments received from such
cooperative; or
(ii) 50 percent of the W-2 wages with respect to such trade or
business as are so allocable as determined under Sec. 1.199A-2.
(f) Applicability date--(1) General rule. Except as provided in
paragraph (f)(2) of this section, the provisions of this section apply
to taxable years ending after February 8, 2019.
(2) Exception for non-calendar year RPE. For purposes of determining
QBI, W-2 wages, UBIA of qualified property, and the aggregate amount of
qualified
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REIT dividends and qualified PTP income, if an individual receives any
of these items from an RPE with a taxable year that begins before
January 1, 2018, and ends after December 31, 2017, such items are
treated as having been incurred by the individual during the
individual's taxable year in which or with which such RPE taxable year
ends.
[T.D. 9847, 84 FR 2989, Feb. 8, 2019, as amended by T.D. 9847, 84 FR
15954, Apr. 17, 2019]
Sec. 1.199A-2 Determination of W-2 wages and unadjusted basis
immediately after acquisition of qualified property.
(a) Scope--(1) In general. This section provides guidance on
calculating a trade or business's W-2 wages properly allocable to QBI
(W-2 wages) and the trade or business's unadjusted basis immediately
after acquisition of all qualified property (UBIA of qualified
property). The provisions of this section apply solely for purposes of
section 199A of the Internal Revenue Code (Code).
(2) W-2 wages. Paragraph (b) of this section provides guidance on
the determination of W-2 wages. The determination of W-2 wages must be
made for each trade or business by the individual or RPE that directly
conducts the trade or business (or aggregated trade or business). In the
case of W-2 wages paid by an RPE, the RPE must determine and report W-2
wages for each trade or business (or aggregated trade or business)
conducted by the RPE. W-2 wages are presumed to be zero if not
determined and reported for each trade or business (or aggregated trade
or business).
(3) UBIA of qualified property--(i) In general. Paragraph (c) of
this section provides guidance on the determination of the UBIA of
qualified property. The determination of the UBIA of qualified property
must be made for each trade or business (or aggregated trade or
business) by the individual or RPE that directly conducts the trade or
business (or aggregated trade or business). The UBIA of qualified
property is presumed to be zero if not determined and reported for each
trade or business (or aggregated trade or business).
(ii) UBIA of qualified property held by a partnership. In the case
of qualified property held by a partnership, each partner's share of the
UBIA of qualified property is determined in accordance with how the
partnership would allocate depreciation under Sec. 1.704-1(b)(2)(iv)(g)
on the last day of the taxable year.
(iii) UBIA of qualified property held by an S corporation. In the
case of qualified property held by an S corporation, each shareholder's
share of the UBIA of qualified property is the share of the unadjusted
basis proportionate to the ratio of shares in the S corporation held by
the shareholder on the last day of the taxable year over the total
issued and outstanding shares of the S corporation.
(iv) UBIA and section 743(b) basis adjustments--(A) In general. A
partner will be allowed to take into account UBIA with respect to an
item of qualified property in addition to the amount of UBIA with
respect to such qualified property determined under paragraphs (a)(3)(i)
and (c) of this section and allocated to such partner under paragraph
(a)(3)(ii) of this section to the extent of the partner's excess section
743(b) basis adjustment with respect to such item of qualified property.
(B) Excess section 743(b) basis adjustments. A partner's excess
section 743(b) basis adjustment is an amount that is determined with
respect to each item of qualified property and is equal to an amount
that would represent the partner's section 743(b) basis adjustment with
respect to the same item of qualified property, as determined under
Sec. Sec. 1.743-1(b) and 1.755-1, but calculated as if the adjusted
basis of all of the partnership's property was equal to the UBIA of such
property. The absolute value of the excess section 743(b) basis
adjustment cannot exceed the absolute value of the total section 743(b)
basis adjustment with respect to qualified property.
(C) Computation of partner's share of UBIA with excess section
743(b) basis adjustments. The partnership first computes its UBIA with
respect to qualified property under paragraphs (a)(3)(i) and (c) of this
section and allocates such UBIA under paragraph (a)(3)(ii) of this
section. If the sum of the excess
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section 743(b) basis adjustment for all of the items of qualified
property is a negative number, that amount will be subtracted from the
partner's UBIA of qualified property determined under paragraphs
(a)(3)(i) and (c) of this section and allocated under paragraph
(a)(3)(ii) of this section. A partner's UBIA of qualified property may
not be below $0. Excess section 743(b) basis adjustments are computed
with respect to all section 743(b) adjustments, including adjustments
made as a result of a substantial built-in loss under section 743(d).
(D) Examples. The provisions of this paragraph (a)(3)(iv) are
illustrated by the following examples:
(1) Example 1--(i) Facts. A, B, and C are equal partners in
partnership, PRS. PRS has a single trade or business that generates QBI.
PRS has no liabilities and only one asset, a single item of qualified
property with a UBIA equal to $900,000. Each partner's share of the UBIA
is $300,000. A sells its one-third interest in PRS to T for $350,000
when a section 754 election is in effect. At the time of the sale, the
tax basis of the qualified property held by PRS is $750,000. The amount
of gain that would be allocated to T from a hypothetical transaction
under Sec. 1.743-1(d)(2) is $100,000. Thus, T's interest in PRS's
previously taxed capital is equal to $250,000 ($350,000, the amount of
cash T would receive if PRS liquidated immediately after the
hypothetical transaction, decreased by $100,000, T's share of gain from
the hypothetical transaction). The amount of T's section 743(b) basis
adjustment to PRS's qualified property is $100,000 (the excess of
$350,000, T's cost basis for its interest, over $250,000, T's share of
the adjusted basis to PRS of the partnership's property).
(ii) [Reserved]
(iii) Analysis. In order for T to determine its UBIA, T must
calculate its excess section 743(b) basis adjustment. T's excess section
743(b) basis adjustment is equal to an amount that would represent T's
section 743(b) basis adjustment with respect to the same item of
qualified property, as determined under Sec. Sec. 1.743-1(b) and 1.755-
1, but calculated as if the adjusted basis of all of PRS's property was
equal to the UBIA of such property. T's section 743(b) basis adjustment
calculated as if adjusted basis of the qualified property were equal to
its UBIA is $50,000 (the excess of $350,000, T's cost basis for its
interest, over $300,000, T's share of the adjusted basis to PRS of the
partnership's property). Thus, T's excess section 743(b) basis
adjustment is equal to $50,000. For purposes of applying the UBIA
limitation to T's share of QBI from PRS's trade or business, T's UBIA is
equal to $350,000 ($300,000, T's one-third share of the qualified
property's UBIA, plus $50,000, T's excess section 743(b) basis
adjustment).
(2) Example 2--(i) Facts. Assume the same facts as in Example 1 of
paragraph (a)(3)(iv)(D)(1) of this section, except that A sells its one-
third interest in PRS to T for $200,000 when a section 754 election is
in effect. At the time of the sale, the tax basis of the qualified
property held by PRS is $750,000, and the amount of loss that would be
allocated to T from a hypothetical transaction under Sec. 1.743-1(d)(2)
is $50,000. Thus, T's interest in PRS's previously taxed capital is
equal to $250,000 ($200,000, the amount of cash T would receive if PRS
liquidated immediately after the hypothetical transaction, increased by
$50,000, T's share of loss from the hypothetical transaction). The
amount of T's section 743(b) basis adjustment to PRS's qualified
property is negative $50,000 (the excess of $250,000, T's share of the
adjusted basis to PRS of the partnership's property, over $200,000, T's
cost basis for its interest).
(ii) Analysis. In order for T to determine its UBIA, T must
calculate its excess section 743(b) basis adjustment. T's excess section
743(b) basis adjustment is equal to an amount that would represent T's
section 743(b) basis adjustment with respect to the same item of
qualified property, as determined under Sec. Sec. 1.743-1(b) and 1.755-
1, but calculated as if the adjusted basis of all of PRS's property was
equal to the UBIA of such property. T's section 743(b) basis adjustment
calculated as if adjusted basis of the qualified property were equal to
its UBIA is negative $100,000 (the excess of $300,000, T's share of the
adjusted basis to PRS of the partnership's property, over $200,000,
[[Page 329]]
T's cost basis for its interest). T's excess section 743(b) basis
adjustment to the qualified property is limited to the amount of T's
section 743(b) basis adjustment of negative $50,000. Thus, T's excess
section 743(b) basis adjustment is equal to negative $50,000. For
purposes of applying the UBIA limitation to T's share of QBI from PRS's
trade or business, T's UBIA is equal to $250,000 ($300,000, T's one-
third share of the qualified property's UBIA, reduced by T's negative
$50,000 excess section 743(b) basis adjustment).
(b) W-2 wages--(1) In general. Section 199A(b)(2)(B) provides
limitations on the section 199A deduction based on the W-2 wages paid
with respect to each trade or business (or aggregated trade or
business). Section 199A(b)(4)(B) provides that W-2 wages do not include
any amount which is not properly allocable to QBI for purposes of
section 199A(c)(1). This section provides a three step process for
determining the W-2 wages paid with respect to a trade or business that
are properly allocable to QBI. First, each individual or RPE must
determine its total W-2 wages paid for the taxable year under the rules
in paragraph (b)(2) of this section. Second, each individual or RPE must
allocate its W-2 wages between or among one or more trades or businesses
under the rules in paragraph (b)(3) of this section. Third, each
individual or RPE must determine the amount of such wages with respect
to each trade or business, which are allocable to the QBI of the trade
or business (or aggregated trade or business) under the rules in
paragraph (b)(4) of this section.
(2) Definition of W-2 wages--(i) In general. Section 199A(b)(4)(A)
provides that the term W-2 wages means with respect to any person for
any taxable year of such person, the amounts described in section
6051(a)(3) and (8) paid by such person with respect to employment of
employees by such person during the calendar year ending during such
taxable year. Thus, the term W-2 wages includes the total amount of
wages as defined in section 3401(a) plus the total amount of elective
deferrals (within the meaning of section 402(g)(3)), the compensation
deferred under section 457, and the amount of designated Roth
contributions (as defined in section 402A). For this purpose, except as
provided in paragraphs (b)(2)(iv)(C)(2) and (b)(2)(iv)(D) of this
section, the Forms W-2, ``Wage and Tax Statement,'' or any subsequent
form or document used in determining the amount of W-2 wages, are those
issued for the calendar year ending during the individual's or RPE's
taxable year for wages paid to employees (or former employees) of the
individual or RPE for employment by the individual or RPE. For purposes
of this section, employees of the individual or RPE are limited to
employees of the individual or RPE as defined in section 3121(d)(1) and
(2). (For purposes of section 199A, this includes officers of an S
corporation and employees of an individual or RPE under common law.)
(ii) Wages paid by a person other than a common law employer. In
determining W-2 wages, an individual or RPE may take into account any W-
2 wages paid by another person and reported by the other person on Forms
W-2 with the other person as the employer listed in Box c of the Forms
W-2, provided that the W-2 wages were paid to common law employees or
officers of the individual or RPE for employment by the individual or
RPE. In such cases, the person paying the W-2 wages and reporting the W-
2 wages on Forms W-2 is precluded from taking into account such wages
for purposes of determining W-2 wages with respect to that person. For
purposes of this paragraph (b)(2)(ii), persons that pay and report W-2
wages on behalf of or with respect to others can include, but are not
limited to, certified professional employer organizations under section
7705, statutory employers under section 3401(d)(1), and agents under
section 3504.
(iii) Requirement that wages must be reported on return filed with
the Social Security Administration (SSA)--(A) In general. Pursuant to
section 199A(b)(4)(C), the term W-2 wages does not include any amount
that is not properly included in a return filed with SSA on or before
the 60th day after the due date (including extensions) for such return.
Under Sec. 31.6051-2 of this chapter, each Form W-2 and the transmittal
Form W-3, ``Transmittal of Wage and Tax Statements,'' together
constitute an information return to be filed with
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SSA. Similarly, each Form W-2c, ``Corrected Wage and Tax Statement,''
and the transmittal Form W-3 or W-3c, ``Transmittal of Corrected Wage
and Tax Statements,'' together constitute an information return to be
filed with SSA. In determining whether any amount has been properly
included in a return filed with SSA on or before the 60th day after the
due date (including extensions) for such return, each Form W-2 together
with its accompanying Form W-3 will be considered a separate information
return and each Form W-2c together with its accompanying Form W-3 or
Form W-3c will be considered a separate information return. Section
6071(c) provides that Forms W-2 and W-3 must be filed on or before
January 31 of the year following the calendar year to which such returns
relate (but see the special rule in Sec. 31.6071(a)-1T(a)(3)(i) of this
chapter for monthly returns filed under Sec. 31.6011(a)-5(a) of this
chapter). Corrected Forms W-2 are required to be filed with SSA on or
before January 31 of the year following the year in which the correction
is made.
(B) Corrected return filed to correct a return that was filed within
60 days of the due date. If a corrected information return (Return B) is
filed with SSA on or before the 60th day after the due date (including
extensions) of Return B to correct an information return (Return A) that
was filed with SSA on or before the 60th day after the due date
(including extensions) of the information return (Return A) and
paragraph (b)(2)(iii)(C) of this section does not apply, then the wage
information on Return B must be included in determining W-2 wages. If a
corrected information return (Return D) is filed with SSA later than the
60th day after the due date (including extensions) of Return D to
correct an information return (Return C) that was filed with SSA on or
before the 60th day after the due date (including extensions) of the
information return (Return C), and if Return D reports an increase (or
increases) in wages included in determining W-2 wages from the wage
amounts reported on Return C, then such increase (or increases) on
Return D will be disregarded in determining W-2 wages (and only the wage
amounts on Return C may be included in determining W-2 wages). If Return
D reports a decrease (or decreases) in wages included in determining W-2
wages from the amounts reported on Return C, then, in determining W-2
wages, the wages reported on Return C must be reduced by the decrease
(or decreases) reflected on Return D.
(C) Corrected return filed to correct a return that was filed later
than 60 days after the due date. If an information return (Return F) is
filed to correct an information return (Return E) that was not filed
with SSA on or before the 60th day after the due date (including
extensions) of Return E, then Return F (and any subsequent information
returns filed with respect to Return E) will not be considered filed on
or before the 60th day after the due date (including extensions) of
Return F (or the subsequent corrected information return). Thus, if a
Form W-2c is filed to correct a Form W-2 that was not filed with SSA on
or before the 60th day after the due date (including extensions) of the
Form W-2 (or to correct a Form W-2c relating to Form W-2 that had not
been filed with SSA on or before the 60th day after the due date
(including extensions) of the Form W-2), then this Form W-2c will not be
considered to have been filed with SSA on or before the 60th day after
the due date (including extensions) for this Form W-2c (or corrected
Form W-2), regardless of when the Form W-2c is filed.
(iv) Methods for calculating W-2 wages--(A) In general. The
Secretary may provide for methods to be used in calculating W-2 wages,
including W-2 wages for short taxable years by publication in the
Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this
chapter).
(B) Acquisition or disposition of a trade or business--(1) In
general. In the case of an acquisition or disposition of a trade or
business, the major portion of a trade or business, or the major portion
of a separate unit of a trade or business that causes more than one
individual or entity to be an employer of the employees of the acquired
or disposed of trade or business during the calendar year, the W-2 wages
of the individual or entity for the calendar year of the acquisition or
disposition are allocated between each individual or entity
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based on the period during which the employees of the acquired or
disposed of trade or business were employed by the individual or entity,
regardless of which permissible method is used for reporting predecessor
and successor wages on Form W-2, ``Wage and Tax Statement.'' For this
purpose, the period of employment is determined consistently with the
principles for determining whether an individual is an employee
described in paragraph (b) of this section.
(2) Acquisition or disposition. For purposes of this paragraph
(b)(2)(iv)(B), the term acquisition or disposition includes an
incorporation, a formation, a liquidation, a reorganization, or a
purchase or sale of assets.
(C) Application in the case of a person with a short taxable year--
(1) In general. In the case of an individual or RPE with a short taxable
year, subject to the rules of paragraph (b)(2) of this section, the W-2
wages of the individual or RPE for the short taxable year include only
those wages paid during the short taxable year to employees of the
individuals or RPE, only those elective deferrals (within the meaning of
section 402(g)(3)) made during the short taxable year by employees of
the individual or RPE and only compensation actually deferred under
section 457 during the short taxable year with respect to employees of
the individual or RPE.
(2) Short taxable year that does not include December 31. If an
individual or RPE has a short taxable year that does not contain a
calendar year ending during such short taxable year, wages paid to
employees for employment by such individual or RPE during the short
taxable year are treated as W-2 wages for such short taxable year for
purposes of paragraph (b) of this section (if the wages would otherwise
meet the requirements to be W-2 wages under this section but for the
requirement that a calendar year must end during the short taxable
year).
(D) Remuneration paid for services performed in the Commonwealth of
Puerto Rico. In the case of an individual or RPE that conducts a trade
or business in the Commonwealth of Puerto Rico, the determination of W-2
wages of such individual or RPE will be made without regard to any
exclusion under section 3401(a)(8) for remuneration paid for services
performed in the Commonwealth of Puerto Rico. The individual or RPE must
maintain sufficient documentation (for example, Forms 499R-2/W-2PR) to
substantiate the amount of remuneration paid for services performed in
the Commonwealth of Puerto Rico that is used in determining the W-2
wages of such individual or RPE with respect to any trade or business
conducted in the Commonwealth of Puerto Rico.
(3) Allocation of wages to trades or businesses. After calculating
total W-2 wages for a taxable year, each individual or RPE that directly
conducts more than one trade or business must allocate those wages among
its various trades or businesses. W-2 wages must be allocated to the
trade or business that generated those wages. In the case of W-2 wages
that are allocable to more than one trade or business, the portion of
the W-2 wages allocable to each trade or business is determined in the
same manner as the expenses associated with those wages are allocated
among the trades or businesses under Sec. 1.199A-3(b)(5).
(4) Allocation of wages to QBI. Once W-2 wages for each trade or
business have been determined, each individual or RPE must identify the
amount of W-2 wages properly allocable to QBI for each trade or business
(or aggregated trade or business). W-2 wages are properly allocable to
QBI if the associated wage expense is taken into account in computing
QBI under Sec. 1.199A-3. In the case of an RPE, the wage expense must
be allocated and reported to the partners or shareholders of the RPE as
required by the Code, including subchapters K and S of chapter 1 of
subtitle A of the Code. The RPE must also identify and report the
associated W-2 wages to its partners or shareholders.
(5) Non-duplication rule. Amounts that are treated as W-2 wages for
a taxable year under any method cannot be treated as W-2 wages of any
other taxable year. Also, an amount cannot be treated as W-2 wages by
more than one trade or business (or aggregated trade or business).
(c) UBIA of qualified property--(1) Qualified property--(i) In
general. The
[[Page 332]]
term qualified property means, with respect to any trade or business (or
aggregated trade or business) of an individual or RPE for a taxable
year, tangible property of a character subject to the allowance for
depreciation under section 167(a)--
(A) Which is held by, and available for use in, the trade or
business (or aggregated trade or business) at the close of the taxable
year;
(B) Which is used at any point during the taxable year in the trade
or business's (or aggregated trade or business's) production of QBI; and
(C) The depreciable period for which has not ended before the close
of the individual's or RPE's taxable year.
(ii) Improvements to qualified property. In the case of any addition
to, or improvement of, qualified property that has already been placed
in service by the individual or RPE, such addition or improvement is
treated as separate qualified property first placed in service on the
date such addition or improvement is placed in service for purposes of
paragraph (c)(2) of this section.
(iii) Adjustments under sections 734(b) and 743(b). Excess section
743(b) basis adjustments as defined in paragraph (a)(3)(iv)(B) of this
section are treated as qualified property. Otherwise, basis adjustments
under sections 734(b) and 743(b) are not treated as qualified property.
(iv) Property acquired at end of year. Property is not qualified
property if the property is acquired within 60 days of the end of the
taxable year and disposed of within 120 days of acquisition without
having been used in a trade or business for at least 45 days prior to
disposition, unless the taxpayer demonstrates that the principal purpose
of the acquisition and disposition was a purpose other than increasing
the section 199A deduction.
(2) Depreciable period--(i) In general. The term depreciable period
means, with respect to qualified property of a trade or business, the
period beginning on the date the property was first placed in service by
the individual or RPE and ending on the later of--
(A) The date that is 10 years after such date; or
(B) The last day of the last full year in the applicable recovery
period that would apply to the property under section 168(c), regardless
of any application of section 168(g).
(ii) Additional first-year depreciation under section 168. The
additional first-year depreciation deduction allowable under section 168
(for example, under section 168(k) or (m)) does not affect the
applicable recovery period under this paragraph for the qualified
property.
(iii) Qualified property acquired in transactions subject to section
1031 or section 1033. Solely for purposes of paragraph (c)(2)(i) of this
section, the following rules apply to qualified property acquired in a
like-kind exchange or in an involuntary conversion (replacement
property).
(A) Replacement property received in a section 1031 or 1033
transaction. The date on which replacement property that is of like-kind
to relinquished property or is similar or related in service or use to
involuntarily converted property was first placed in service by the
individual or RPE is determined as follows--
(1) For the portion of the individual's or RPE's UBIA, as defined in
paragraph (c)(3) of this section, in such replacement property that does
not exceed the individual's or RPE's UBIA in the relinquished property
or involuntarily converted property, the date such portion in the
replacement property was first placed in service by the individual or
RPE is the date on which the relinquished property or involuntarily
converted property was first placed in service by the individual or RPE;
and
(2) For the portion of the individual's or RPE's UBIA, as defined in
paragraph (c)(3) of this section, in such replacement property that
exceeds the individual's or RPE's UBIA in the relinquished property or
involuntarily converted property, such portion in the replacement
property is treated as separate qualified property that the individual
or RPE first placed in service on the date on which the replacement
property was first placed in service by the individual or RPE.
(B) Other property received in a section 1031 or 1033 transaction.
Other property, as defined in paragraph (c)(3)(ii) or (iii) of this
section, that is qualified property is treated as separate qualified
property that the individual or RPE
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first placed in service on the date on which such other property was
first placed in service by the individual or RPE.
(iv) Qualified property acquired in transactions described in
section 168(i)(7)(B). If an individual or RPE acquires qualified
property in a transaction described in section 168(i)(7)(B) (pertaining
to treatment of transferees in certain nonrecognition transactions), the
individual or RPE must determine the date on which the qualified
property was first placed in service solely for purposes of paragraph
(c)(2)(i) of this section as follows--
(A) For the portion of the transferee's UBIA in the qualified
property that does not exceed the transferor's UBIA in such property,
the date such portion was first placed in service by the transferee is
the date on which the transferor first placed the qualified property in
service; and
(B) For the portion of the transferee's UBIA in the qualified
property that exceeds the transferor's UBIA in such property, such
portion is treated as separate qualified property that the transferee
first placed in service on the date of the transfer.
(v) Excess section 743(b) basis adjustment. Solely for purposes of
paragraph (c)(2)(i) of this section, an excess section 743(b) basis
adjustment with respect to an item of partnership property that is
qualified property is treated as being placed in service when the
transfer of the partnership interest occurs, and the recovery period for
such property is determined under Sec. 1.743-1(j)(4)(i)(B) with respect
to positive basis adjustments and Sec. 1.743-1(j)(4)(ii)(B) with
respect to negative basis adjustments.
(3) Unadjusted basis immediately after acquisition--(i) In general.
Except as provided in paragraphs (c)(3)(ii) through (v) of this section,
the term unadjusted basis immediately after acquisition (UBIA) means the
basis on the placed in service date of the property as determined under
section 1012 or other applicable sections of chapter 1 of the Code,
including the provisions of subchapters O (relating to gain or loss on
dispositions of property), C (relating to corporate distributions and
adjustments), K (relating to partners and partnerships), and P (relating
to capital gains and losses). UBIA is determined without regard to any
adjustments described in section 1016(a)(2) or (3), to any adjustments
for tax credits claimed by the individual or RPE (for example, under
section 50(c)), or to any adjustments for any portion of the basis which
the individual or RPE has elected to treat as an expense (for example,
under sections 179, 179B, or 179C). However, UBIA does reflect the
reduction in basis for the percentage of the individual's or RPE's use
of property for the taxable year other than in the trade or business.
(ii) Qualified property acquired in a like-kind exchange--(A) In
general. Solely for purposes of this section, if property that is
qualified property (replacement property) is acquired in a like-kind
exchange that qualifies for deferral of gain or loss under section 1031,
then the UBIA of such property is the same as the UBIA of the qualified
property exchanged (relinquished property), decreased by excess boot or
increased by the amount of money paid or the fair market value of
property not of a like kind to the relinquished property (other
property) transferred by the taxpayer to acquire the replacement
property. If the taxpayer acquires more than one piece of qualified
property as replacement property that is of a like kind to the
relinquished property in an exchange described in section 1031, UBIA is
apportioned between or among the qualified replacement properties in
proportion to their relative fair market values. Other property received
by the taxpayer in a section 1031 transaction that is qualified property
has a UBIA equal to the fair market value of such other property.
(B) Excess boot. For purposes of paragraph (c)(3)(ii)(A) of this
section, excess boot is the amount of any money or the fair market value
of other property received by the taxpayer in the exchange over the
amount of appreciation in the relinquished property. Appreciation for
this purpose is the excess of the fair market value of the relinquished
property on the date of the exchange over the fair market value of the
relinquished property on the date of the acquisition by the taxpayer.
[[Page 334]]
(iii) Qualified property acquired pursuant to an involuntary
conversion--(A) In general. Solely for purposes of this section, if
qualified property is compulsorily or involuntarily converted (converted
property) within the meaning of section 1033 and qualified replacement
property is acquired in a transaction that qualifies for deferral of
gain under section 1033, then the UBIA of the replacement property is
the same as the UBIA of the converted property, decreased by excess boot
or increased by the amount of money paid or the fair market value of
property not similar or related in service or use to the converted
property (other property) transferred by the taxpayer to acquire the
replacement property. If the taxpayer acquires more than one piece of
qualified replacement property that meets the similar or related in
service or use requirements in section 1033, UBIA is apportioned between
the qualified replacement properties in proportion to their relative
fair market values. Other property acquired by the taxpayer with the
proceeds of an involuntary conversion that is qualified property has a
UBIA equal to the fair market value of such other property.
(B) Excess boot. For purposes of paragraph (c)(3)(iii)(A) of this
section, excess boot is the amount of any money or the fair market value
of other property received by the taxpayer in the conversion over the
amount of appreciation in the converted property. Appreciation for this
purpose is the excess of the fair market value of the converted property
on the date of the conversion over the fair market value of the
converted property on the date of the acquisition by the taxpayer.
(iv) Qualified property acquired in transactions described in
section 168(i)(7)(B). Solely for purposes of this section, if qualified
property is acquired in a transaction described in section 168(i)(7)(B)
(pertaining to treatment of transferees in certain nonrecognition
transactions), the transferee's UBIA in the qualified property shall be
the same as the transferor's UBIA in the property, decreased by the
amount of money received by the transferor in the transaction or
increased by the amount of money paid by the transferee to acquire the
property in the transaction.
(v) Qualified property acquired from a decedent. In the case of
qualified property acquired from a decedent and immediately placed in
service, the UBIA of the property will generally be the fair market
value at the date of the decedent's death under section 1014. See
section 1014 and the regulations thereunder. Solely for purposes of
paragraph (c)(2)(i) of this section, a new depreciable period for the
property commences as of the date of the decedent's death.
(vi) Property acquired in a nonrecognition transaction with
principal purpose of increasing UBIA. If qualified property is acquired
in a transaction described in section 1031, 1033, or 168(i)(7) with the
principal purpose of increasing the UBIA of the qualified property, the
UBIA of the acquired qualified property is its basis as determined under
relevant Code sections and not under the rules described in paragraphs
(c)(3)(i) through (iv) of this section. For example, in a section 1031
transaction undertaken with the principal purpose of increasing the UBIA
of the replacement property, the UBIA of the replacement property is its
basis as determined under section 1031(d).
(4) Examples. The provisions of this paragraph (c) are illustrated
by the following examples:
(i) Example 1. (A) On January 5, 2012, A purchases Real Property X
for $1 million and places it in service in A's trade or business. A's
trade or business is not an SSTB. A's basis in Real Property X under
section 1012 is $1 million. Real Property X is qualified property within
the meaning of section 199A(b)(6). As of December 31, 2018, A's basis in
Real Property X, as adjusted under section 1016(a)(2) for depreciation
deductions under section 168(a), is $821,550.
(B) For purposes of section 199A(b)(2)(B)(ii) and this section, A's
UBIA of Real Property X is its $1 million cost basis under section 1012,
regardless of any later depreciation deductions under section 168(a) and
resulting basis adjustments under section 1016(a)(2).
(ii) Example 2. (A) The facts are the same as in Example 1 of
paragraph
[[Page 335]]
(c)(4)(i) of this section, except that on January 15, 2019, A enters
into a like-kind exchange under section 1031 in which A exchanges Real
Property X for Real Property Y. Real Property Y has a value of $1
million. No cash or other property is involved in the exchange. As of
January 15, 2019, A's basis in Real Property X, as adjusted under
section 1016(a)(2) for depreciation deductions under section 168(a), is
$820,482.
(B) A's UBIA in Real Property Y is $1 million as determined under
paragraph (c)(3)(ii) of this section. Pursuant to paragraph
(c)(2)(iii)(A) of this section, Real Property Y is first placed in
service by A on January 5, 2012, which is the date on which Real
Property X was first placed in service by A.
(iii) Example 3. (A) The facts are the same as in Example 1 of
paragraph (c)(4)(i) of this section, except that on January 15, 2019, A
enters into a like-kind exchange under section 1031, in which A
exchanges Real Property X for Real Property Y. Real Property X has
appreciated in value to $1.3 million, and Real Property Y also has a
value of $1.3 million. No cash or other property is involved in the
exchange. As of January 15, 2019, A's basis in Real Property X, as
adjusted under section 1016(a)(2), is $820,482.
(B) A's UBIA in Real Property Y is $1 million as determined under
paragraph (c)(3)(ii) of this section. Pursuant to paragraph
(c)(2)(iii)(A) of this section, Real Property Y is first placed in
service by A on January 5, 2012, which is the date on which Real
Property X was first placed in service by A.
(iv) Example 4. (A) The facts are the same as in Example 1 of
paragraph (c)(4)(i) of this section, except that on January 15, 2019, A
enters into a like-kind exchange under section 1031, in which A
exchanges Real Property X for Real Property Y. Real Property X has
appreciated in value to $1.3 million, but Real Property Y has a value of
$1.5 million. A therefore adds $200,000 in cash to the exchange of Real
Property X for Real Property Y. On January 15, 2019, A places Real
Property Y in service. As of January 15, 2019, A's basis in Real
Property X, as adjusted under section 1016(a)(2), is $820,482.
(B) A's UBIA in Real Property Y is $1.2 million as determined under
paragraph (c)(3)(ii) of this section ($1 million in UBIA from Real
Property X plus $200,000 cash paid by A to acquire Real Property Y).
Because the UBIA of Real Property Y exceeds the UBIA of Real Property X,
Real Property Y is treated as being two separate qualified properties
for purposes of applying paragraph (c)(2)(iii)(A) of this section. One
property has a UBIA of $1 million (the portion of A's UBIA of $1.2
million in Real Property Y that does not exceed A's UBIA of $1 million
in Real Property X) and it is first placed in service by A on January 5,
2012, which is the date on which Real Property X was first placed in
service by A. The other property has a UBIA of $200,000 (the portion of
A's UBIA of $1.2 million in Real Property Y that exceeds A's UBIA of $1
million in Real Property X) and it is first placed in service by A on
January 15, 2019, which is the date on which Real Property Y was first
placed in service by A.
(v) Example 5. (A) The facts are the same as in Example 1 of
paragraph (c)(4)(i) of this section, except that on January 15, 2019, A
enters into a like-kind exchange under section 1031, in which A
exchanges Real Property X for Real Property Y. Real Property X has
appreciated in value to $1.3 million. Real Property Y has a fair market
value of $1 million. As of January 15, 2019, A's basis in Real Property
X, as adjusted under section 1016(a)(2), is $820,482. Pursuant to the
exchange, A receives Real Property Y and $300,000 in cash.
(B) A's UBIA in Real Property Y is $1 million as determined under
paragraph (c)(3)(ii) of this section ($1 million in UBIA from Real
Property X, less $0 excess boot ($300,000 cash received in the exchange
over $300,000 in appreciation in Property X, which is equal to the
excess of the $1.3 million fair market value of Property X on the date
of the exchange over $1 million fair market value of Property X on the
date of acquisition by the taxpayer)). Pursuant to paragraph
(c)(2)(iii)(A) of this section, Real Property Y is first placed in
service by A on January 5, 2012, which is the date on which Real
Property X was first placed in service by A.
(vi) Example 6. (A) The facts are the same as in Example 1 of
paragraph
[[Page 336]]
(c)(4)(i) of this section, except that on January 15, 2019, A enters
into a like-kind exchange under section 1031, in which A exchanges Real
Property X for Real Property Y. Real Property X has appreciated in value
to $1.3 million. Real Property Y has a fair market value of $900,000.
Pursuant to the exchange, A receives Real Property Y and $400,000 in
cash. As of January 15, 2019, A's basis in Real Property X, as adjusted
under section 1016(a)(2), is $820,482.
(B) A's UBIA in Real Property Y is $900,000 as determined under
paragraph (c)(3)(ii) of this section ($1 million in UBIA from Real
Property X less $100,000 excess boot ($400,000 in cash received in the
exchange over $300,000 in appreciation in Property X, which is equal to
the excess of the $1.3 million fair market value of Property X on the
date of the exchange over the $1 million fair market value of Property X
on the date of acquisition by the taxpayer)). Pursuant to paragraph
(c)(2)(iii)(A) of this section, Real Property Y is first placed in
service by A on January 5, 2012, which is the date on which Real
Property X was first placed in service by A.
(vii) Example 7. (A) The facts are the same as in Example 1 of
paragraph (c)(4)(i) of this section, except that on January 15, 2019, A
enters into a like-kind exchange under section 1031, in which A
exchanges Real Property X for Real Property Y. Real Property X has
declined in value to $900,000, and Real Property Y also has a value of
$900,000. No cash or other property is involved in the exchange. As of
January 15, 2019, A's basis in Real Property X, as adjusted under
section 1016(a)(2), is $820,482.
(B) Even though Real Property Y is worth only $900,000, A's UBIA in
Real Property Y is $1 million as determined under paragraph (c)(3)(ii)
of this section because no cash or other property was involved in the
exchange. Pursuant to paragraph (c)(2)(iii)(A) of this section, Real
Property Y is first placed in service by A on January 5, 2012, which is
the date on which Real Property X was first placed in service by A.
(viii) Example 8. (A) C operates a trade or business that is not an
SSTB as a sole proprietorship. On January 5, 2011, C purchases Machinery
Y for $10,000 and places it in service in C's trade or business. C's
basis in Machinery Y under section 1012 is $10,000. Machinery Y is
qualified property within the meaning of section 199A(b)(6). Assume that
Machinery Y's recovery period under section 168(c) is 10 years, and C
depreciates Machinery Y under the general depreciation system by using
the straight-line depreciation method, a 10-year recovery period, and
the half-year convention. As of December 31, 2018, C's basis in
Machinery Y, as adjusted under section 1016(a)(2) for depreciation
deductions under section 168(a), is $2,500. On January 1, 2019, C
incorporates the sole proprietorship and elects to treat the newly
formed entity as an S corporation for Federal income tax purposes. C
contributes Machinery Y and all other assets of the trade or business to
the S corporation in a non-recognition transaction under section 351.
The S corporation immediately places all the assets in service.
(B) For purposes of section 199A(b)(2)(B)(ii) and this section, C's
UBIA of Machinery Y from 2011 through 2018 is its $10,000 cost basis
under section 1012, regardless of any later depreciation deductions
under section 168(a) and resulting basis adjustments under section
1016(a)(2). The S corporation's basis of Machinery Y is $2,500, the
basis of the property under section 362 at the time the S corporation
places the property in service. Pursuant to paragraph (c)(3)(iv) of this
section, S corporation's UBIA of Machinery Y is $10,000, which is C's
UBIA of Machinery Y. Pursuant to paragraph (c)(2)(iv)(A) of this
section, for purposes of determining the depreciable period of Machinery
Y, the S corporation's placed in service date of Machinery Y will be
January 5, 2011, which is the date C originally placed the property in
service in 2011. Therefore, Machinery Y may be qualified property of the
S corporation (assuming it continues to be used in the business) for
2019 and 2020 and will not be qualified property of the S corporation
after 2020, because its depreciable period will have expired.
(ix) Example 9. (A) LLC, a partnership, operates a trade or business
that is not an SSTB. On January 5, 2011,
[[Page 337]]
LLC purchases Machinery Z for $30,000 and places it in service in LLC's
trade or business. LLC's basis in Machinery Z under section 1012 is
$30,000. Machinery Z is qualified property within the meaning of section
199A(b)(6). Assume that Machinery Z's recovery period under section
168(c) is 10 years, and LLC depreciates Machinery Z under the general
depreciation system by using the straight-line depreciation method, a
10-year recovery period, and the half-year convention. As of December
31, 2018, LLC's basis in Machinery Z, as adjusted under section
1016(a)(2) for depreciation deductions under section 168(a), is $7,500.
On January 1, 2019, LLC distributes Machinery Z to Partner A in full
liquidation of Partner A's interest in LLC. Partner A's outside basis in
LLC is $35,000.
(B) For purposes of section 199A(b)(2)(B)(ii) and this section,
LLC's UBIA of Machinery Z from 2011 through 2018 is its $30,000 cost
basis under section 1012, regardless of any later depreciation
deductions under section 168(a) and resulting basis adjustments under
section 1016(a)(2). Prior to the distribution to Partner A, LLC's basis
of Machinery Z is $7,500. Under section 732(b), Partner A's basis in
Machinery Z is $35,000. Pursuant to paragraph (c)(3)(iv) of this
section, upon distribution of Machinery Z, Partner A's UBIA of Machinery
Z is $30,000, which was LLC's UBIA of Machinery Z.
(d) Applicability date--(1) General rule. Except as provided in
paragraph (d)(2) of this section, the provisions of this section apply
to taxable years ending after February 8, 2019.
(2) Exceptions--(i) Anti-abuse rules. The provisions of paragraph
(c)(1)(iv) of this section apply to taxable years ending after December
22, 2017.
(ii) Non-calendar year RPE. For purposes of determining QBI, W-2
wages, UBIA of qualified property, and the aggregate amount of qualified
REIT dividends and qualified PTP income if an individual receives any of
these items from an RPE with a taxable year that begins before January
1, 2018, and ends after December 31, 2017, such items are treated as
having been incurred by the individual during the individual's taxable
year in which or with which such RPE taxable year ends.
[T.D. 9847, 84 FR 2995, Feb. 8, 2019, as amended by T.D. 9847, 84 FR
15954, Apr. 17, 2019]
Sec. 1.199A-3 Qualified business income, qualified REIT dividends,
and qualified PTP income.
(a) In general. This section provides rules on the determination of
a trade or business's qualified business income (QBI), as well as the
determination of qualified real estate investment trust (REIT) dividends
and qualified publicly traded partnership (PTP) income. The provisions
of this section apply solely for purposes of section 199A of the
Internal Revenue Code (Code). Paragraph (b) of this section provides
rules for the determination of QBI. Paragraph (c) of this section
provides rules for the determination of qualified REIT dividends and
qualified PTP income. QBI must be determined and reported for each trade
or business by the individual or relevant passthrough entity (RPE) that
directly conducts the trade or business before applying the aggregation
rules of Sec. 1.199A-4.
(b) Definition of qualified business income--(1) In general. For
purposes of this section, the term qualified business income or QBI
means, for any taxable year, the net amount of qualified items of
income, gain, deduction, and loss with respect to any trade or business
of the taxpayer as described in paragraph (b)(2) of this section,
provided the other requirements of this section and section 199A are
satisfied (including, for example, the exclusion of income not
effectively connected with a United States trade or business).
(i) Section 751 gain. With respect to a partnership, if section
751(a) or (b) applies, then gain or loss attributable to assets of the
partnership giving rise to ordinary income under section 751(a) or (b)
is considered attributable to the trades or businesses conducted by the
partnership, and is taken into account for purposes of computing QBI.
(ii) Guaranteed payments for the use of capital. Income attributable
to a guaranteed payment for the use of capital is not considered to be
attributable to a trade or business, and thus is not taken into account
for purposes of computing QBI except to the extent
[[Page 338]]
properly allocable to a trade or business of the recipient. The
partnership's deduction associated with the guaranteed payment will be
taken into account for purposes of computing QBI if such deduction is
properly allocable to the trade or business and is otherwise deductible
for Federal income tax purposes.
(iii) Section 481 adjustments. Section 481 adjustments (whether
positive or negative) are taken into account for purposes of computing
QBI to the extent that the requirements of this section and section 199A
are otherwise satisfied, but only if the adjustment arises in taxable
years ending after December 31, 2017.
(iv) Previously disallowed losses--(A) In general. Previously
disallowed losses or deductions allowed in the taxable year generally
are taken into account for purposes of computing QBI to the extent the
disallowed loss or deduction is otherwise allowed by section 199A. These
previously disallowed losses include, but are not limited to losses
disallowed under sections 461(l), 465, 469, 704(d), and 1366(d). These
losses are used for purposes of section 199A and this section in order
from the oldest to the most recent on a first-in, first-out (FIFO) basis
and are treated as losses from a separate trade or business. To the
extent such losses relate to a PTP, they must be treated as a loss from
a separate PTP in the taxable year the losses are taken into account.
However, losses or deductions that were disallowed, suspended, limited,
or carried over from taxable years ending before January 1, 2018
(including under sections 465, 469, 704(d), and 1366(d)), are not taken
into account in a subsequent taxable year for purposes of computing QBI.
(B) Partial allowance. If a loss or deduction attributable to a
trade or business is only partially allowed during the taxable year in
which incurred, only the portion of the allowed loss or deduction that
is attributable to QBI will be considered in determining QBI from the
trade or business in the year the loss or deduction is incurred. The
portion of the allowed loss or deduction attributable to QBI is
determined by multiplying the total amount of the allowed loss by a
fraction, the numerator of which is the portion of the total loss
incurred during the taxable year that is attributable to QBI and the
denominator of which is the amount of the total loss incurred during the
taxable year.
(C) Attributes of disallowed loss or deduction determined in year
loss is incurred--(1) In general. Whether a disallowed loss or deduction
is attributable to a trade or business, and otherwise meets the
requirements of this section, is determined in the year the loss is
incurred.
(2) Specified service trades or businesses. If a disallowed loss or
deduction is attributable to a specified service trade or business
(SSTB), whether an individual has taxable income at or below the
threshold amount as defined in Sec. 1.199A-1(b)(12), within the phase-
in range as defined in Sec. 1.199A-1(b)(4), or in excess of the phase-
in range is determined in the year the loss or deduction is incurred. If
the individual's taxable income is at or below the threshold amount in
the year the loss or deduction is incurred, the entire disallowed loss
or deduction must be taken into account when applying paragraph
(b)(1)(iv)(A) of this section. If the individual's taxable income is
within the phase-in range, then only the applicable percentage, as
defined in Sec. 1.199A-1(b)(2), of the disallowed loss or deduction is
taken into account when applying paragraph (b)(1)(iv)(A) of this
section. If the individual's taxable income exceeds the phase-in range,
none of the disallowed loss or deduction will be taken into account in
applying paragraph (b)(1)(iv)(A) of this section.
(D) Examples. The following examples illustrate the provisions of
this paragraph (b)(1)(iv).
(1) Example 1. A is an unmarried individual and a 50% owner of LLC,
an entity classified as a partnership for Federal income tax purposes.
In 2018, A's allocable share of loss from LLC is $100,000 of which
$80,000 is negative QBI. Under section 465, $60,000 of the allocable
loss is allowed in determining A's taxable income. A has no other
previously disallowed losses under section 465 or any other provision of
the Code for 2018 or prior years. Because 80% of A's allocable loss is
attributable to QBI ($80,000/$100,000), A will reduce the amount A takes
into account in determining QBI proportionately. Thus, A will include
$48,000 of the allowed loss in negative
[[Page 339]]
QBI (80% of $60,000) in determining A's section 199A deduction in 2018.
The remaining $32,000 of negative QBI is treated as negative QBI from a
separate trade or business for purposes of computing the section 199A
deduction in the year the loss is taken into account in determining
taxable income as described in Sec. 1.199A-1(d)(2)(iii).
(2) Example 2. B is an unmarried individual and a 50% owner of LLC,
an entity classified as a partnership for Federal income tax purposes.
After allowable deductions other than the section 199A deduction, B's
taxable income for 2018 is $177,500. In 2018, LLC has a single trade or
business that is an SSTB. B's allocable share of loss is $100,000, all
of which is suspended under section 465. B's allocable share of negative
QBI is also $100,000. B has no other previously disallowed losses under
section 465 or any other provision of the Code for 2018 or prior years.
Because the entire loss is suspended, none of the negative QBI is taken
into account in determining B's section 199A deduction for 2018.
Further, because the negative QBI is from an SSTB and B's taxable income
before the section 199A deduction is within the phase-in range, B must
determine the applicable percentage of the negative QBI that must be
taken into account in the year that the loss is taken into account in
determining taxable income. B's applicable percentage is 100% reduced by
40% (the percentage equal to the amount that B's taxable income for the
taxable year exceeds B's threshold amount ($20,000 = $177,500-$157,500)
over $50,000). Thus, B's applicable percentage is 60%. Therefore, B will
have $60,000 (60% of $100,000) of negative QBI from a separate trade or
business to be applied proportionately to QBI in the year(s) the loss is
taken into account in determining taxable income, regardless of the
amount of taxable income and how rules under Sec. 1.199A-5 apply in the
year the loss is taken into account in determining taxable income.
(v) Net operating losses. Generally, a net operating loss deduction
under section 172 is not considered with respect to a trade or business
and therefore, is not taken into account in computing QBI. However, an
excess business loss under section 461(l) is treated as a net operating
loss carryover to the following taxable year and is taken into account
for purposes of computing QBI in the subsequent taxable year in which it
is deducted.
(vi) Other deductions. Generally, deductions attributable to a trade
or business are taken into account for purposes of computing QBI to the
extent that the requirements of section 199A and this section are
otherwise satisfied. For purposes of section 199A only, deductions such
as the deductible portion of the tax on self-employment income under
section 164(f), the self-employed health insurance deduction under
section 162(l), and the deduction for contributions to qualified
retirement plans under section 404 are considered attributable to a
trade or business to the extent that the individual's gross income from
the trade or business is taken into account in calculating the allowable
deduction, on a proportionate basis to the gross income received from
the trade or business.
(2) Qualified items of income, gain, deduction, and loss--(i) In
general. The term qualified items of income, gain, deduction, and loss
means items of gross income, gain, deduction, and loss to the extent
such items are--
(A) Effectively connected with the conduct of a trade or business
within the United States (within the meaning of section 864(c),
determined by substituting ``trade or business (within the meaning of
section 199A)'' for ``nonresident alien individual or a foreign
corporation'' or for ``a foreign corporation'' each place it appears);
and
(B) Included or allowed in determining taxable income for the
taxable year.
(ii) Items not taken into account. Notwithstanding paragraph
(b)(2)(i) of this section and in accordance with section 199A(c)(3)(B)
and (c)(4), the following items are not taken into account as qualified
items of income, gain, deduction, or loss and thus are not included in
determining QBI:
(A) Any item of short-term capital gain, short-term capital loss,
long-term capital gain, or long-term capital loss, including any item
treated as one of such items under any other provision of the Code. This
provision does not apply to the extent an item is treated as anything
other than short-term capital gain, short-term capital loss, long-term
capital gain, or long-term capital loss.
(B) Any dividend, income equivalent to a dividend, or payment in
lieu of dividends described in section 954(c)(1)(G). Any amount
described in section 1385(a)(1) is not treated as described in this
clause.
[[Page 340]]
(C) Any interest income other than interest income which is properly
allocable to a trade or business. For purposes of section 199A and this
section, interest income attributable to an investment of working
capital, reserves, or similar accounts is not properly allocable to a
trade or business.
(D) Any item of gain or loss described in section 954(c)(1)(C)
(transactions in commodities) or section 954(c)(1)(D) (excess foreign
currency gains) applied in each case by substituting ``trade or business
(within the meaning of section 199A)'' for ``controlled foreign
corporation.''
(E) Any item of income, gain, deduction, or loss described in
section 954(c)(1)(F) (income from notional principal contracts)
determined without regard to section 954(c)(1)(F)(ii) and other than
items attributable to notional principal contracts entered into in
transactions qualifying under section 1221(a)(7).
(F) Any amount received from an annuity which is not received in
connection with the trade or business.
(G) Any qualified REIT dividends as defined in paragraph (c)(2) of
this section or qualified PTP income as defined in paragraph (c)(3) of
this section.
(H) Reasonable compensation received by a shareholder from an S
corporation. However, the S corporation's deduction for such reasonable
compensation will reduce QBI if such deduction is properly allocable to
the trade or business and is otherwise deductible for Federal income tax
purposes.
(I) Any guaranteed payment described in section 707(c) received by a
partner for services rendered with respect to the trade or business,
regardless of whether the partner is an individual or an RPE. However,
the partnership's deduction for such guaranteed payment will reduce QBI
if such deduction is properly allocable to the trade or business and is
otherwise deductible for Federal income tax purposes.
(J) Any payment described in section 707(a) received by a partner
for services rendered with respect to the trade or business, regardless
of whether the partner is an individual or an RPE. However, the
partnership's deduction for such payment will reduce QBI if such
deduction is properly allocable to the trade or business and is
otherwise deductible for Federal income tax purposes.
(3) Commonwealth of Puerto Rico. For the purposes of determining
QBI, the term United States includes the Commonwealth of Puerto Rico in
the case of any taxpayer with QBI for any taxable year from sources
within the Commonwealth of Puerto Rico, if all of such receipts are
taxable under section 1 for such taxable year. This paragraph (b)(3)
only applies as provided in section 199A(f)(1)(C).
(4) Wages. Expenses for all wages paid (or incurred in the case of
an accrual method taxpayer) must be taken into account in computing QBI
(if the requirements of this section and section 199A are satisfied)
regardless of the application of the W-2 wage limitation described in
Sec. 1.199A-1(d)(2)(iv).
(5) Allocation of items among directly-conducted trades or
businesses. If an individual or an RPE directly conducts multiple trades
or businesses, and has items of QBI that are properly attributable to
more than one trade or business, the individual or RPE must allocate
those items among the several trades or businesses to which they are
attributable using a reasonable method based on all the facts and
circumstances. The individual or RPE may use a different reasonable
method with respect to different items of income, gain, deduction, and
loss. The chosen reasonable method for each item must be consistently
applied from one taxable year to another and must clearly reflect the
income and expenses of each trade or business. The overall combination
of methods must also be reasonable based on all facts and circumstances.
The books and records maintained for a trade or business must be
consistent with any allocations under this paragraph (b)(5).
(c) Qualified REIT Dividends and Qualified PTP Income--(1) In
general. Qualified REIT dividends and qualified PTP income are the sum
of qualified REIT dividends as defined in paragraph (c)(2) of this
section earned directly or through an RPE and the net amount of
qualified PTP income as defined in
[[Page 341]]
paragraph (c)(3) of this section earned directly or through an RPE.
(2) Qualified REIT dividend--(i) The term qualified REIT dividend
means any dividend from a REIT received during the taxable year which--
(A) Is not a capital gain dividend, as defined in section 857(b)(3);
and
(B) Is not qualified dividend income, as defined in section
1(h)(11).
(ii) The term qualified REIT dividend does not include any REIT
dividend received with respect to any share of REIT stock--
(A) That is held by the shareholder for 45 days or less (taking into
account the principles of section 246(c)(3) and (4)) during the 91-day
period beginning on the date which is 45 days before the date on which
such share becomes ex-dividend with respect to such dividend; or
(B) To the extent that the shareholder is under an obligation
(whether pursuant to a short sale or otherwise) to make related payments
with respect to positions in substantially similar or related property.
(3) Qualified PTP income--(i) In general. The term qualified PTP
income means the sum of--
(A) The net amount of such taxpayer's allocable share of income,
gain, deduction, and loss from a PTP as defined in section 7704(b) that
is not taxed as a corporation under section 7704(a); plus
(B) Any gain or loss attributable to assets of the PTP giving rise
to ordinary income under section 751(a) or (b) that is considered
attributable to the trades or businesses conducted by the partnership.
(ii) Special rules. The rules applicable to the determination of QBI
described in paragraph (b) of this section also apply to the
determination of a taxpayer's allocable share of income, gain,
deduction, and loss from a PTP. An individual's allocable share of
income from a PTP, and any section 751 gain or loss is qualified PTP
income only to the extent the items meet the qualifications of section
199A and this section, including the requirement that the item is
included or allowed in determining taxable income for the taxable year,
and the requirement that the item be effectively connected with the
conduct of a trade or business within the United States. For example, if
an individual owns an interest in a PTP, and for the taxable year is
allocated a distributive share of net loss which is disallowed under the
passive activity rules of section 469, such loss is not taken into
account for purposes of section 199A. The specified service trade or
business limitations described in Sec. Sec. 1.199A-1(d)(3) and 1.199A-5
also apply to income earned from a PTP. Furthermore, each PTP is
required to determine its qualified PTP income for each trade or
business and report that information to its owners as described in Sec.
1.199A-6(b)(3).
(d) Section 199A dividends paid by a regulated investment company--
(1) In general. If section 852(b) applies to a regulated investment
company (RIC) for a taxable year, the RIC may pay section 199A
dividends, as defined in this paragraph (d).
(2) Definition of section 199A dividend--(i) In general. Except as
provided in paragraph (d)(2)(ii) of this section, a section 199A
dividend is any dividend or part of such a dividend that a RIC pays to
its shareholders and reports as a section 199A dividend in written
statements furnished to its shareholders.
(ii) Reduction in the case of excess reported amounts. If the
aggregate reported amount with respect to the RIC for any taxable year
exceeds the RIC's qualified REIT dividend income for the taxable year,
then a section 199A dividend is equal to--
(A) The reported section 199A dividend amount; reduced by
(B) The excess reported amount that is allocable to that reported
section 199A dividend amount.
(iii) Allocation of excess reported amount--(A) In general. Except
as provided in paragraph (d)(2)(iii)(B) of this section, the excess
reported amount (if any) that is allocable to the reported section 199A
dividend amount is that portion of the excess reported amount that bears
the same ratio to the excess reported amount as the reported section
199A dividend amount bears to the aggregate reported amount.
(B) Special rule for noncalendar-year RICs. In the case of any
taxable year that does not begin and end in the
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same calendar year, if the post-December reported amount equals or
exceeds the excess reported amount for that taxable year, paragraph
(d)(2)(iii)(A) of this section is applied by substituting ``post-
December reported amount'' for ``aggregate reported amount,'' and no
excess reported amount is allocated to any dividend paid on or before
December 31 of that taxable year.
(3) Definitions. For purposes of paragraph (d) of this section--
(i) Reported section 199A dividend amount. The term reported section
199A dividend amount means the amount of a dividend distribution
reported to the RIC's shareholders under paragraph (d)(2)(i) of this
section as a section 199A dividend.
(ii) Excess reported amount. The term excess reported amount means
the excess of the aggregate reported amount over the RIC's qualified
REIT dividend income for the taxable year.
(iii) Aggregate reported amount. The term aggregate reported amount
means the aggregate amount of dividends reported by the RIC under
paragraph (d)(2)(i) of this section as section 199A dividends for the
taxable year (including section 199A dividends paid after the close of
the taxable year and described in section 855).
(iv) Post-December reported amount. The term post-December reported
amount means the aggregate reported amount determined by taking into
account only dividends paid after December 31 of the taxable year.
(v) Qualified REIT dividend income. The term qualified REIT dividend
income means, with respect to a taxable year of a RIC, the excess of the
amount of qualified REIT dividends, as defined in paragraph (c)(2) of
this section, includible in the RIC's taxable income for the taxable
year over the amount of the RIC's deductions that are properly allocable
to such income.
(4) Treatment of section 199A dividends by shareholders--(i) In
general. For purposes of section 199A, and Sec. Sec. 1.199A-1 through
1.199A-6, a section 199A dividend is treated by a taxpayer that receives
the section 199A dividend as a qualified REIT dividend.
(ii) Holding period. Paragraph (d)(4)(i) of this section does not
apply to any dividend received with respect to a share of RIC stock--
(A) That is held by the shareholder for 45 days or less (taking into
account the principles of section 246(c)(3) and (4)) during the 91-day
period beginning on the date which is 45 days before the date on which
the share becomes ex-dividend with respect to such dividend; or
(B) To the extent that the shareholder is under an obligation
(whether pursuant to a short sale or otherwise) to make related payments
with respect to positions in substantially similar or related property.
(5) Example. The following example illustrates the provisions of
this paragraph (d).
(i) X is a corporation that has elected to be a RIC. For its taxable
year ending March 31, 2021, X has $25,000x of net long-term capital
gain, $60,000x of qualified dividend income, $25,000x of taxable
interest income, $15,000x of net short-term capital gain, and $25,000x
of qualified REIT dividends. X has $15,000x of deductible expenses, of
which $3,000x is allocable to the qualified REIT dividends. On December
31, 2020, X pays a single dividend of $100,000x, and reports $20,000x of
the dividend as a section 199A dividend in written statements to its
shareholders. On March 31, 2021, X pays a dividend of $35,000x, and
reports $5,000x of the dividend as a section 199A dividend in written
statements to its shareholders.
(ii) X's qualified REIT dividend income under paragraph (d)(3)(v) of
this section is $22,000x, which is the excess of X's $25,000x of
qualified REIT dividends over $3,000x in allocable expenses. The
reported section 199A dividend amounts for the December 31, 2020, and
March 31, 2021, distributions are $20,000x and $5,000x, respectively.
For the taxable year ending March 31, 2021, the aggregate reported
amount of section 199A dividends is $25,000x, and the excess reported
amount under paragraph (d)(3)(ii) of this section is $3,000x. Because X
is a noncalendar-year RIC and the post-December reported amount of
$5,000x exceeds the excess reported amount of $3,000x, the entire excess
reported amount is allocated under paragraphs (d)(2)(iii)(A) and (B) of
this section to the reported section 199A dividend amount for the March
31, 2021, distribution. No portion of the excess reported amount is
allocated to the reported section 199A dividend amount for the December
31, 2020, distribution. Thus, the section 199A dividend on March 31,
2021, is $2,000x, which is the reported section 199A dividend amount of
$5,000x reduced by the $3,000x of allocable excess reported amount. The
section 199A dividend on December 31, 2020, is
[[Page 343]]
the $20,000x that X reports as a section 199A dividend.
(iii) Shareholder A, a United States person, receives a dividend
from X of $100x on December 31, 2020, of which $20x is reported as a
section 199A dividend. If A meets the holding period requirements in
paragraph (d)(4)(ii) of this section with respect to the stock of X, A
treats $20x of the dividend from X as a qualified REIT dividend for
purposes of section 199A for A's 2020 taxable year.
(iv) A receives a dividend from X of $35x on March 31, 2021, of
which $5x is reported as a section 199A dividend. Only $2x of the
dividend is a section 199A dividend. If A meets the holding period
requirements in paragraph (d)(4)(ii) of this section with respect to the
stock of X, A may treat the $2x section 199A dividend as a qualified
REIT dividend for A's 2021 taxable year.
(e) Applicability date--(1) General rule. Except as provided in
paragraph (e)(2) of this section, the provisions of this section apply
to taxable years ending after February 8, 2019.
(2) Exceptions--(i) Anti-abuse rules. The provisions of paragraph
(c)(2)(ii) of this section apply to taxable years ending after December
22, 2017.
(ii) Non-calendar year RPE. For purposes of determining QBI, W-2
wages, UBIA of qualified property, and the aggregate amount of qualified
REIT dividends and qualified PTP income if an individual receives any of
these items from an RPE with a taxable year that begins before January
1, 2018, and ends after December 31, 2017, such items are treated as
having been incurred by the individual during the individual's taxable
year in which or with which such RPE taxable year ends.
(iii) Previously disallowed losses. The provisions of paragraph
(b)(1)(iv) of this section apply to taxable years beginning after August
24, 2020. Taxpayers may choose to apply the rules in paragraph
(b)(1)(iv) of this section for taxable years beginning on or before
August 24, 2020, so long as the taxpayers consistently apply the rules
in paragraph (b)(1)(iv) of this section for each such year.
(iv) Section 199A dividends. The provisions of paragraph (d) of this
section apply to taxable years beginning after August 24, 2020.
Taxpayers may choose to apply the rules in paragraph (d) of this section
for taxable years beginning on or before August 24, 2020, so long as the
taxpayers consistently apply the rules in paragraph (d) of this section
for each such year.
[T.D. 9847, 84 FR 3000, Feb. 8, 2019, as amended by T.D. 9899, 85 FR
38065, June 25, 2020]
Sec. 1.199A-4 Aggregation.
(a) Scope and purpose. An individual or RPE may be engaged in more
than one trade or business. Except as provided in this section, each
trade or business is a separate trade or business for purposes of
applying the limitations described in Sec. 1.199A-1(d)(2)(iv). This
section sets forth rules to allow individuals and RPEs to aggregate
trades or businesses, treating the aggregate as a single trade or
business for purposes of applying the limitations described in Sec.
1.199A-1(d)(2)(iv). Trades or businesses may be aggregated only to the
extent provided in this section, but aggregation by taxpayers is not
required.
(b) Aggregation rules--(1) General rule. Trades or businesses may be
aggregated only if an individual or RPE can demonstrate that--
(i) The same person or group of persons, directly or by attribution
under sections 267(b) or 707(b), owns 50 percent or more of each trade
or business to be aggregated, meaning in the case of such trades or
businesses owned by an S corporation, 50 percent or more of the issued
and outstanding shares of the corporation, or, in the case of such
trades or businesses owned by a partnership, 50 percent or more of the
capital or profits in the partnership;
(ii) The ownership described in paragraph (b)(1)(i) of this section
exists for a majority of the taxable year, including the last day of the
taxable year, in which the items attributable to each trade or business
to be aggregated are included in income;
(iii) All of the items attributable to each trade or business to be
aggregated are reported on returns with the same taxable year, not
taking into account short taxable years;
(iv) None of the trades or businesses to be aggregated is a
specified service trade or business (SSTB) as defined in Sec. 1.199A-5;
and
(v) The trades or businesses to be aggregated satisfy at least two
of the following factors (based on all of the facts and circumstances):
[[Page 344]]
(A) The trades or businesses provide products, property, or services
that are the same or customarily offered together.
(B) The trades or businesses share facilities or share significant
centralized business elements, such as personnel, accounting, legal,
manufacturing, purchasing, human resources, or information technology
resources.
(C) The trades or businesses are operated in coordination with, or
reliance upon, one or more of the businesses in the aggregated group
(for example, supply chain interdependencies).
(2) Operating rules--(i) Individuals. An individual may aggregate
trades or businesses operated directly or through an RPE to the extent
an aggregation is not inconsistent with the aggregation of an RPE. If an
individual aggregates multiple trades or businesses under paragraph
(b)(1) of this section, QBI, W-2 wages, and UBIA of qualified property
must be combined for the aggregated trades or businesses for purposes of
applying the W-2 wage and UBIA of qualified property limitations
described in Sec. 1.199A-1(d)(2)(iv). An individual may not subtract
from the trades or businesses aggregated by an RPE but may aggregate
additional trades or businesses with the RPE's aggregation if the rules
of this section are otherwise satisfied.
(ii) RPEs. An RPE may aggregate trades or businesses operated
directly or through a lower-tier RPE to the extent an aggregation is not
inconsistent with the aggregation of a lower-tier RPE. If an RPE itself
does not aggregate, multiple owners of an RPE need not aggregate in the
same manner. If an RPE aggregates multiple trades or businesses under
paragraph (b)(1) of this section, the RPE must compute and report QBI,
W-2 wages, and UBIA of qualified property for the aggregated trade or
business under the rules described in Sec. 1.199A-6(b). An RPE may not
subtract from the trades or businesses aggregated by a lower-tier RPE
but may aggregate additional trades or businesses with a lower-tier
RPE's aggregation if the rules of this section are otherwise satisfied.
(c) Reporting and consistency requirements--(1) Individuals. Once an
individual chooses to aggregate two or more trades or businesses, the
individual must consistently report the aggregated trades or businesses
in all subsequent taxable years. A failure to aggregate will not be
considered to be an aggregation for purposes of this rule. An individual
that fails to aggregate may not aggregate trades or businesses on an
amended return (other than an amended return for the 2018 taxable year).
However, an individual may add a newly created or newly acquired
(including through non-recognition transfers) trade or business to an
existing aggregated trade or business (including the aggregated trade or
business of an RPE) if the requirements of paragraph (b)(1) of this
section are satisfied. In a subsequent year, if there is a significant
change in facts and circumstances such that an individual's prior
aggregation of trades or businesses no longer qualifies for aggregation
under the rules of this section, then the trades or businesses will no
longer be aggregated within the meaning of this section, and the
individual must reapply the rules in paragraph (b)(1) of this section to
determine a new permissible aggregation (if any). An individual also
must report aggregated trades or businesses of an RPE in which the
individual holds a direct or indirect interest.
(2) Individual disclosure--(i) Required annual disclosure. For each
taxable year, individuals must attach a statement to their returns
identifying each trade or business aggregated under paragraph (b)(1) of
this section. The statement must contain--
(A) A description of each trade or business;
(B) The name and EIN of each entity in which a trade or business is
operated;
(C) Information identifying any trade or business that was formed,
ceased operations, was acquired, or was disposed of during the taxable
year;
(D) Information identifying any aggregated trade or business of an
RPE in which the individual holds an ownership interest; and
(E) Such other information as the Commissioner may require in forms,
instructions, or other published guidance.
[[Page 345]]
(ii) Failure to disclose. If an individual fails to attach the
statement required in paragraph (c)(2)(i) of this section, the
Commissioner may disaggregate the individual's trades or businesses. The
individual may not aggregate trades or businesses that are disaggregated
by the Commissioner for the subsequent three taxable years.
(3) RPEs. Once an RPE chooses to aggregate two or more trades or
businesses, the RPE must consistently report the aggregated trades or
businesses in all subsequent taxable years. A failure to aggregate will
not be considered to be an aggregation for purposes of this rule. An RPE
that fails to aggregate may not aggregate trades or businesses on an
amended return (other than an amended return for the 2018 taxable year).
However, an RPE may add a newly created or newly acquired (including
through non-recognition transfers) trade or business to an existing
aggregated trade or business (including the aggregated trade or business
of a lower-tier RPE) if the requirements of paragraph (b)(1) of this
section are satisfied. In a subsequent year, if there is a significant
change in facts and circumstances such that an RPE's prior aggregation
of trades or businesses no longer qualifies for aggregation under the
rules of this section, then the trades or businesses will no longer be
aggregated within the meaning of this section, and the RPE must reapply
the rules in paragraph (b)(1) of this section to determine a new
permissible aggregation (if any). An RPE also must report aggregated
trades or businesses of a lower-tier RPE in which the RPE holds a direct
or indirect interest.
(4) RPE disclosure--(i) Required annual disclosure. For each taxable
year, RPEs (including each RPE in a tiered structure) must attach a
statement to each owner's Schedule K-1 identifying each trade or
business aggregated under paragraph (b)(1) of this section. The
statement must contain--
(A) A description of each trade or business;
(B) The name and EIN of each entity in which a trade or business is
operated;
(C) Information identifying any trade or business that was formed,
ceased operations, was acquired, or was disposed of during the taxable
year;
(D) Information identifying any aggregated trade or business of an
RPE in which the RPE holds an ownership interest; and
(E) Such other information as the Commissioner may require in forms,
instructions, or other published guidance.
(ii) Failure to disclose. If an RPE fails to attach the statement
required in paragraph (c)(4)(i) of this section, the Commissioner may
disaggregate the RPE's trades or businesses. The RPE may not aggregate
trades or businesses that are disaggregated by the Commissioner for the
subsequent three taxable years.
(d) Examples. The following examples illustrate the principles of
this section. For purposes of these examples, assume the taxpayer is a
United States citizen, all individuals and RPEs use a calendar taxable
year, there are no ownership changes during the taxable year, all trades
or businesses satisfy the requirements under section 162, all tax items
are effectively connected to a trade or business within the United
States within the meaning of section 864(c), and none of the trades or
businesses is an SSTB within the meaning of Sec. 1.199A-5. Except as
otherwise specified, a single capital letter denotes an individual
taxpayer.
(1) Example 1--(i) Facts. A wholly owns and operates a catering
business and a restaurant through separate disregarded entities. The
catering business and the restaurant share centralized purchasing to
obtain volume discounts and a centralized accounting office that
performs all of the bookkeeping, tracks and issues statements on all of
the receivables, and prepares the payroll for each business. A maintains
a website and print advertising materials that reference both the
catering business and the restaurant. A uses the restaurant kitchen to
prepare food for the catering business. The catering business employs
its own staff and owns equipment and trucks that are not used or
associated with the restaurant.
(ii) Analysis. Because the restaurant and catering business are held
in disregarded entities, A will be treated as
[[Page 346]]
operating each of these businesses directly and thereby satisfies
paragraph (b)(1)(i) of this section. Under paragraph (b)(1)(v) of this
section, A satisfies the following factors: Paragraph (b)(1)(v)(A) of
this section is met as both businesses offer prepared food to customers;
and paragraph (b)(1)(v)(B) of this section is met because the two
businesses share the same kitchen facilities in addition to centralized
purchasing, marketing, and accounting. Having satisfied paragraphs
(b)(1)(i) through (v) of this section, A may treat the catering business
and the restaurant as a single trade or business for purposes of
applying Sec. 1.199A-1(d).
(2) Example 2--(i) Facts. Assume the same facts as in Example 1 of
paragraph (d)(1) of this section, but the catering and restaurant
businesses are owned in separate partnerships and A, B, C, and D each
own a 25% interest in each of the two partnerships. A, B, C, and D are
unrelated.
(ii) Analysis. Because under paragraph (b)(1)(i) of this section A,
B, C, and D together own more than 50% of each of the two partnerships,
they may each treat the catering business and the restaurant as a single
trade or business for purposes of applying Sec. 1.199A-1(d).
(3) Example 3--(i) Facts. W owns a 75% interest in S1, an S
corporation, and a 75% interest in PRS, a partnership. S1 manufactures
clothing and PRS is a retail pet food store. W manages S1 and PRS.
(ii) Analysis. W owns more than 50% of the stock of S1 and more than
50% of PRS thereby satisfying paragraph (b)(1)(i) of this section.
Although W manages both S1 and PRS, W is not able to satisfy the
requirements of paragraph (b)(1)(v) of this section as the two
businesses do not provide goods or services that are the same or
customarily offered together; there are no significant centralized
business elements; and no facts indicate that the businesses are
operated in coordination with, or reliance upon, one another. W must
treat S1 and PRS as separate trades or businesses for purposes of
applying Sec. 1.199A-1(d).
(4) Example 4--(i) Facts. E owns a 60% interest in each of four
partnerships (PRS1, PRS2, PRS3, and PRS4). Each partnership operates a
hardware store. A team of executives oversees the operations of all four
of the businesses and controls the policy decisions involving the
business as a whole. Human resources and accounting are centralized for
the four businesses. E reports PRS1, PRS3, and PRS4 as an aggregated
trade or business under paragraph (b)(1) of this section and reports
PRS2 as a separate trade or business. Only PRS2 generates a net taxable
loss.
(ii) Analysis. E owns more than 50% of each partnership thereby
satisfying paragraph (b)(1)(i) of this section. Under paragraph
(b)(1)(v) of this section, the following factors are satisfied:
Paragraph (b)(1)(v)(A) of this section because each partnership operates
a hardware store; and paragraph (b)(1)(v)(B) of this section because the
businesses share accounting and human resource functions. E's decision
to aggregate only PRS1, PRS3, and PRS4 into a single trade or business
for purposes of applying Sec. 1.199A-1(d) is permissible. The loss from
PRS2 will be netted against the aggregate profits of PRS1, PRS3, and
PRS4 pursuant to Sec. 1.199A-1(d)(2)(iii).
(5) Example 5--(i) Facts. Assume the same facts as Example 4 of
paragraph (d)(4) of this section, and that F owns a 10% interest in
PRS1, PRS2, PRS3, and PRS4.
(ii) Analysis. Because under paragraph (b)(1)(i) of this section E
owns more than 50% of the four partnerships, F may aggregate PRS 1,
PRS2, PRS3, and PRS4 as a single trade or business for purposes of
applying Sec. 1.199A-1(d), provided that F can demonstrate that the
ownership test is met by E.
(6) Example 6--(i) Facts. D owns 75% of the stock of S1, S2, and S3,
each of which is an S corporation. Each S corporation operates a grocery
store in a separate state. S1 and S2 share centralized purchasing
functions to obtain volume discounts and a centralized accounting office
that performs all of the bookkeeping, tracks and issues statements on
all of the receivables, and prepares the payroll for each business. S3
is operated independently from the other businesses.
(ii) Analysis. D owns more than 50% of the stock of each S
corporation
[[Page 347]]
thereby satisfying paragraph (b)(1)(i) of this section. Under paragraph
(b)(1)(v) of this section, the grocery stores satisfy paragraph
(b)(1)(v)(A) of this section because they are in the same trade or
business. Only S1 and S2 satisfy paragraph (b)(1)(v)(B) of this section
because of their centralized purchasing and accounting offices. D is
only able to show that the requirements of paragraph (b)(1)(v)(B) of
this section are satisfied for S1 and S2; therefore, D only may
aggregate S1 and S2 into a single trade or business for purposes of
Sec. 1.199A-1(d). D must report S3 as a separate trade or business for
purposes of applying Sec. 1.199A-1(d).
(7) Example 7--(i) Facts. Assume the same facts as Example 6 of
paragraph (d)(6) of this section except each store is independently
operated and S1 and S2 do not have centralized purchasing or accounting
functions.
(ii) Analysis. Although the stores provide the same products and
services within the meaning of paragraph (b)(1)(v)(A) of this section, D
cannot show that another factor under paragraph (b)(1)(v) of this
section is present. Therefore, D must report S1, S2, and S3 as separate
trades or businesses for purposes of applying Sec. 1.199A-1(d).
(8) Example 8--(i) Facts. G owns 80% of the stock in S1, an S
corporation and 80% of LLC1 and LLC2, each of which is a partnership for
Federal tax purposes. LLC1 manufactures and supplies all of the widgets
sold by LLC2. LLC2 operates a retail store that sells LLC1's widgets. S1
owns the real property leased to LLC1 and LLC2 for use by the factory
and retail store. The entities share common advertising and management.
(ii) Analysis. G owns more than 50% of the stock of S1 and more than
50% of LLC1 and LLC2 thus satisfying paragraph (b)(1)(i) of this
section. LLC1, LLC2, and S1 share significant centralized business
elements and are operated in coordination with, or in reliance upon, one
or more of the businesses in the aggregated group. G can treat the
business operations of LLC1 and LLC2 as a single trade or business for
purposes of applying Sec. 1.199A-1(d). S1 is eligible to be included in
the aggregated group because it leases property to a trade or business
within the aggregated trade or business as described in Sec. 1.199A-
1(b)(14) and meets the requirements of paragraph (b)(1) of this section.
(9) Example 9--(i) Facts. Same facts as Example 8 of paragraph
(d)(8) of this section, except G owns 80% of the stock in S1 and 20% of
each of LLC1 and LLC2. B, G's son, owns a majority interest in LLC2, and
M, G's mother, owns a majority interest in LLC1. B does not own an
interest in S1 or LLC1, and M does not own an interest in S1 or LLC2.
(ii) Analysis. Under the rules in paragraph (b)(1) of this section,
B and M's interest in LLC2 and LLC1, respectively, are attributable to G
and G is treated as owning a majority interest in LLC2 and LLC1; G thus
satisfies paragraph (b)(1)(i) of this section. G may aggregate his
interests in LLC1, LLC2, and S1 as a single trade or business for
purposes of applying Sec. 1.199A-1(d). Under paragraph (b)(1) of this
section, S1 is eligible to be included in the aggregated group because
it leases property to a trade or business within the aggregated trade or
business as described in Sec. 1.199A-1(b)(14) and meets the
requirements of paragraph (b)(1) of this section.
(10) Example 10--(i) Facts. F owns a 75% interest and G owns a 5%
interest in five partnerships (PRS1-PRS5). H owns a 10% interest in PRS1
and PRS2. Each partnership operates a restaurant and each restaurant
separately constitutes a trade or business for purposes of section 162.
G is the executive chef of all of the restaurants and as such he creates
the menus and orders the food supplies.
(ii) Analysis. F owns more than 50% of the partnerships thereby
satisfying paragraph (b)(1)(i) of this section. Under paragraph
(b)(1)(v) of this section, the restaurants satisfy paragraph
(b)(1)(v)(A) of this section because they are in the same trade or
business, and paragraph (b)(1)(v)(B) of this section is satisfied as G
is the executive chef of all of the restaurants and the businesses share
a centralized function for ordering food and supplies. F can show the
requirements under paragraph (b)(1) of this section are satisfied as to
all of the restaurants. Because F owns
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a majority interest in each of the partnerships, G can demonstrate that
paragraph (b)(1)(i) of this section is satisfied. G can also aggregate
all five restaurants into a single trade or business for purposes of
applying Sec. 1.199A-1(d). H, however, only owns an interest in PRS1
and PRS2. Like G, H satisfies paragraph (b)(1)(i) of this section
because F owns a majority interest. H can, therefore, aggregate PRS1 and
PRS2 into a single trade or business for purposes of applying Sec.
1.199A-1(d).
(11) Example 11--(i) Facts. H, J, K, and L own interests in PRS1 and
PRS2, each a partnership, and S1 and S2, each an S corporation. H, J, K,
and L also own interests in C, an entity taxable as a C corporation. H
owns 30%, J owns 20%, K owns 5%, and L owns 45% of each of the five
entities. All of the entities satisfy 2 of the 3 factors under paragraph
(b)(1)(v) of this section. For purposes of section 199A the taxpayers
report the following aggregated trades or businesses: H aggregates PRS1
and S1 together and aggregates PRS2 and S2 together; J aggregates PRS1,
S1 and S2 together and reports PRS2 separately; K aggregates PRS1 and
PRS2 together and aggregates S1 and S2 together; and L aggregates S1,
S2, and PRS2 together and reports PRS1 separately. C cannot be
aggregated.
(ii) Analysis. Under paragraph (b)(1)(i) of this section, because H,
J, and K together own a majority interest in PRS1, PRS2, S1, and S2, H,
J, K, and L are permitted to aggregate under paragraph (b)(1) of this
section. Further, the aggregations reported by the taxpayers are
permitted, but not required for each of H, J, K, and L. C's income is
not eligible for the section 199A deduction and it cannot be aggregated
for purposes of applying Sec. 1.199A-1(d).
(12) Example 12--(i) Facts. L owns 60% of PRS1, a partnership, a
business that sells non-food items to grocery stores. L also owns 55% of
PRS2, a partnership, which owns and operates a distribution trucking
business. The predominant portion of PRS2's business is transporting
goods for PRS1.
(ii) Analysis. L is able to meet paragraph (b)(1)(i) of this section
as the majority owner of PRS1 and PRS2. Under paragraph (b)(1)(v) of
this section, L is only able to show the operations of PRS1 and PRS2 are
operated in reliance of one another under paragraph (b)(1)(v)(C) of this
section. For purposes of applying Sec. 1.199A-1(d), L must treat PRS1
and PRS2 as separate trades or businesses.
(13) Example 13--(i) Facts. C owns a majority interest in a sailboat
racing team and also owns an interest in PRS1 which operates a marina.
PRS1 is a trade or business under section 162, but the sailboat racing
team is not a trade or business within the meaning of section 162.
(ii) Analysis. C has only one trade or business for purposes of
section 199A and, therefore, cannot aggregate the interest in the racing
team with PRS1 under paragraph (b)(1) of this section.
(14) Example 14--(i) Facts. Trust wholly owns LLC1, LLC2, and LLC3.
LLC1 operates a trucking company that delivers lumber and other supplies
sold by LLC2. LLC2 operates a lumber yard and supplies LLC3 with
building materials. LLC3 operates a construction business. LLC1, LLC2,
and LLC3 have a centralized human resources department, payroll, and
accounting department.
(ii) Analysis. Because Trust owns 100% of the interests in LLC1,
LLC2, and LLC3, Trust satisfies paragraph (b)(1)(i) of this section.
Trust can also show that it satisfies paragraph (b)(1)(v)(B) of this
section as the trades or businesses have a centralized human resources
department, payroll, and accounting department. Trust also can show is
meets paragraph (b)(1)(v)(C) of this section as the trades or businesses
are operated in coordination, or reliance upon, one or more in the
aggregated group. Trust can aggregate LLC1, LLC2, and LLC3 for purposes
of applying Sec. 1.199A-1(d).
(15) Example 15--(i) Facts. PRS1, a partnership, directly operates a
food service trade or business and owns 60% of PRS2, which directly
operates a movie theater trade or business and a food service trade or
business. PRS2's movie theater and food service businesses operate in
coordination with, or reliance upon, one another and share a centralized
human resources department, payroll, and accounting department. PRS1's
and PRS2's food service
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businesses provide products and services that are the same and share
centralized purchasing and shipping to obtain volume discounts.
(ii) Analysis. PRS2 may aggregate its movie theater and food service
businesses. Paragraph (b)(1)(v) of this section is satisfied because the
businesses operate in coordination with one another and share
centralized business elements. If PRS2 does aggregate the two
businesses, PRS1 may not aggregate its food service business with PRS2's
aggregated trades or businesses. Because PRS1 owns more than 50% of
PRS2, thereby satisfying paragraph (b)(1)(i) of this section, PRS1 may
aggregate its food service businesses with PRS2's food service business
if PRS2 has not aggregated its movie theater and food service
businesses. Paragraph (b)(1)(v) of this section is satisfied because the
businesses provide the same products and services and share centralized
business elements. Under either alternative, PRS1's food service
business and PRS2's movie theater cannot be aggregated because there are
no factors in paragraph (b)(1)(v) of this section present between the
businesses.
(16) Example 16--(i) Facts. PRS1, a partnership, owns 60% of a
commercial rental office building in state A, and 80% of a commercial
rental office building in state B. Both commercial rental office
building operations share centralized accounting, legal, and human
resource functions. PRS1 treats the two commercial rental office
buildings as an aggregated trade or business under paragraph (b)(1) of
this section.
(ii) Analysis. PRS1 owns more than 50% of each trade or business
thereby satisfying paragraph (b)(1)(i) of this section. Under paragraph
(b)(1)(v) of this section, PRS1 may aggregate its commercial rental
office buildings because the businesses provide the same type of
property and share accounting, legal, and human resource functions.
(17) Example 17--(i) Facts. S, an S corporation owns 100% of the
interests in a residential condominium building and 100% of the
interests in a commercial rental office building. Both building
operations share centralized accounting, legal, and human resource
functions.
(ii) Analysis. S owns more than 50% of each trade or business
thereby satisfying paragraph (b)(1)(i) of this section. Although both
businesses share significant centralized business elements, S cannot
show that another factor under paragraph (b)(1)(v) of this section is
present because the two building operations are not of the same type of
property. S must treat the residential condominium building and the
commercial rental office building as separate trades or businesses for
purposes of applying Sec. 1.199A-1(d).
(18) Example 18--(i) Facts. M owns 75% of a residential apartment
building. M also owns 80% of PRS2. PRS2 owns 80% of the interests in a
residential condominium building and 80% of the interests in a
residential apartment building. PRS2's residential condominium building
and residential apartment building operations share centralized back
office functions and management. M's residential apartment building and
PRS2's residential condominium and apartment building operate in
coordination with each other in renting apartments to tenants.
(ii) Analysis. PRS2 may aggregate its residential condominium and
residential apartment building operations. PRS2 owns more than 50% of
each trade or business thereby satisfying paragraph (b)(1)(i) of this
section. Paragraph (b)(1)(v) of this section is satisfied because the
businesses are of the same type of property and share centralized back
office functions and management. M may also add its residential
apartment building operations to PRS2's aggregated residential
condominium and apartment building operations. M owns more than 50% of
each trade or business thereby satisfying paragraph (b)(1)(i) of this
section. Paragraph (b)(1)(v) of this section is also satisfied because
the businesses operate in coordination with each other.
(e) Applicability date--(1) General rule. Except as provided in
paragraph (e)(2) of this section, the provisions of this section apply
to taxable years ending after February 8, 2019.
(2) Exception for non-calendar year RPE. For purposes of determining
QBI, W-2 wages, and UBIA of qualified property, and the aggregate amount
of
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qualified REIT dividends and qualified PTP income, if an individual
receives any of these items from an RPE with a taxable year that begins
before January 1, 2018, and ends after December 31, 2017, such items are
treated as having been incurred by the individual during the
individual's taxable year in which or with which such RPE taxable year
ends.
[T.D. 9847, 84 FR 3002, Feb. 8, 2019, as amended by T.D. 9847, 84 FR
15955, Apr. 17, 2019]
Sec. 1.199A-5 Specified service trades or businesses and the trade
or business of performing services as an employee.
(a) Scope and effect--(1) Scope. This section provides guidance on
specified service trades or businesses (SSTBs) and the trade or business
of performing services as an employee. This paragraph (a) describes the
effect of a trade or business being an SSTB and the trade or business of
performing services as an employee. Paragraph (b) of this section
provides definitional guidance on SSTBs. Paragraph (c) of this section
provides special rules related to SSTBs. Paragraph (d) of this section
provides guidance on the trade or business of performing services as an
employee. The provisions of this section apply solely for purposes of
section 199A of the Internal Revenue Code (Code).
(2) Effect of being an SSTB. If a trade or business is an SSTB, no
qualified business income (QBI), W-2 wages, or unadjusted basis
immediately after acquisition (UBIA) of qualified property from the SSTB
may be taken into account by any individual whose taxable income exceeds
the phase-in range as defined in Sec. 1.199A-1(b)(4), even if the item
is derived from an activity that is not itself a specified service
activity. The SSTB limitation also applies to income earned from a
publicly traded partnership (PTP). If a trade or business conducted by a
relevant passthrough entity (RPE) or PTP is an SSTB, this limitation
applies to any direct or indirect individual owners of the business,
regardless of whether the owner is passive or participated in any
specified service activity. However, the SSTB limitation does not apply
to individuals with taxable income below the threshold amount as defined
in Sec. 1.199A-1(b)(12). A phase-in rule, provided in Sec. 1.199A-
1(d)(2), applies to individuals with taxable income within the phase-in
range, allowing them to take into account a certain ``applicable
percentage'' of QBI, W-2 wages, and UBIA of qualified property from an
SSTB. The phase-in rule also applies to income earned from a PTP. A
direct or indirect owner of a trade or business engaged in the
performance of a specified service is engaged in the performance of the
specified service for purposes of section 199A and this section,
regardless of whether the owner is passive or participated in the
specified service activity.
(3) Trade or business of performing services as an employee. The
trade or business of performing services as an employee is not a trade
or business for purposes of section 199A and the regulations thereunder.
Therefore, no items of income, gain, deduction, or loss from the trade
or business of performing services as an employee constitute QBI within
the meaning of section 199A and Sec. 1.199A-3. No taxpayer may claim a
section 199A deduction for wage income, regardless of the amount of
taxable income.
(b) Definition of specified service trade or business. Except as
provided in paragraph (c)(1) of this section, the term specified service
trade or business (SSTB) means any of the following:
(1) Listed SSTBs. Any trade or business involving the performance of
services in one or more of the following fields:
(i) Health as described in paragraph (b)(2)(ii) of this section;
(ii) Law as described in paragraph (b)(2)(iii) of this section;
(iii) Accounting as described in paragraph (b)(2)(iv) of this
section;
(iv) Actuarial science as described in paragraph (b)(2)(v) of this
section;
(v) Performing arts as described in paragraph (b)(2)(vi) of this
section;
(vi) Consulting as described in paragraph (b)(2)(vii) of this
section;
(vii) Athletics as described in paragraph (b)(2)(viii) of this
section;
(viii) Financial services as described in paragraph (b)(2)(ix) of
this section;
(ix) Brokerage services as described in paragraph (b)(2)(x) of this
section;
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(x) Investing and investment management as described in paragraph
(b)(2)(xi) of this section;
(xi) Trading as described in paragraph (b)(2)(xii) of this section;
(xii) Dealing in securities (as defined in section 475(c)(2)),
partnership interests, or commodities (as defined in section 475(e)(2))
as described in paragraph (b)(2)(xiii) of this section; or
(xiii) Any trade or business where the principal asset of such trade
or business is the reputation or skill of one or more of its employees
or owners as defined in paragraph (b)(2)(xiv) of this section.
(2) Additional rules for applying section 199A(d)(2) and paragraph
(b) of this section--(i) In general--(A) No effect on other tax rules.
This paragraph (b)(2) provides additional rules for determining whether
a business is an SSTB within the meaning of section 199A(d)(2) and
paragraph (b) of this section only. The rules of this paragraph (b)(2)
apply solely for purposes of section 199A and therefore may not be taken
into account for purposes of applying any provision of law or regulation
other than section 199A and the regulations thereunder, except to the
extent such provision expressly refers to section 199A(d) or this
section.
(B) Hedging transactions. Income, deduction, gain or loss from a
hedging transaction (as defined in Sec. 1.1221-2(b)) entered into by an
individual or RPE in the normal course of the individual's or RPE's
trade or business is treated as income, deduction, gain, or loss from
that trade or business for purposes of this paragraph (b)(2). See also
Sec. 1.446-4.
(ii) Meaning of services performed in the field of health. For
purposes of section 199A(d)(2) and paragraph (b)(1)(i) of this section
only, the performance of services in the field of health means the
provision of medical services by individuals such as physicians,
pharmacists, nurses, dentists, veterinarians, physical therapists,
psychologists, and other similar healthcare professionals performing
services in their capacity as such. The performance of services in the
field of health does not include the provision of services not directly
related to a medical services field, even though the services provided
may purportedly relate to the health of the service recipient. For
example, the performance of services in the field of health does not
include the operation of health clubs or health spas that provide
physical exercise or conditioning to their customers, payment
processing, or the research, testing, and manufacture and/or sales of
pharmaceuticals or medical devices.
(iii) Meaning of services performed in the field of law. For
purposes of section 199A(d)(2) and paragraph (b)(1)(ii) of this section
only, the performance of services in the field of law means the
performance of legal services by individuals such as lawyers,
paralegals, legal arbitrators, mediators, and similar professionals
performing services in their capacity as such. The performance of
services in the field of law does not include the provision of services
that do not require skills unique to the field of law; for example, the
provision of services in the field of law does not include the provision
of services by printers, delivery services, or stenography services.
(iv) Meaning of services performed in the field of accounting. For
purposes of section 199A(d)(2) and paragraph (b)(1)(iii) of this section
only, the performance of services in the field of accounting means the
provision of services by individuals such as accountants, enrolled
agents, return preparers, financial auditors, and similar professionals
performing services in their capacity as such.
(v) Meaning of services performed in the field of actuarial science.
For purposes of section 199A(d)(2) and paragraph (b)(1)(iv) of this
section only, the performance of services in the field of actuarial
science means the provision of services by individuals such as actuaries
and similar professionals performing services in their capacity as such.
(vi) Meaning of services performed in the field of performing arts.
For purposes of section 199A(d)(2) and paragraph (b)(1)(v) of this
section only, the performance of services in the field of the performing
arts means the performance of services by individuals who participate in
the creation of performing arts, such as actors, singers, musicians,
entertainers, directors, and similar professionals performing services
in their capacity as such. The performance of
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services in the field of performing arts does not include the provision
of services that do not require skills unique to the creation of
performing arts, such as the maintenance and operation of equipment or
facilities for use in the performing arts. Similarly, the performance of
services in the field of the performing arts does not include the
provision of services by persons who broadcast or otherwise disseminate
video or audio of performing arts to the public.
(vii) Meaning of services performed in the field of consulting. For
purposes of section 199A(d)(2) and paragraph (b)(1)(vi) of this section
only, the performance of services in the field of consulting means the
provision of professional advice and counsel to clients to assist the
client in achieving goals and solving problems. Consulting includes
providing advice and counsel regarding advocacy with the intention of
influencing decisions made by a government or governmental agency and
all attempts to influence legislators and other government officials on
behalf of a client by lobbyists and other similar professionals
performing services in their capacity as such. The performance of
services in the field of consulting does not include the performance of
services other than advice and counsel, such as sales (or economically
similar services) or the provision of training and educational courses.
For purposes of the preceding sentence, the determination of whether a
person's services are sales or economically similar services will be
based on all the facts and circumstances of that person's business. Such
facts and circumstances include, for example, the manner in which the
taxpayer is compensated for the services provided. Performance of
services in the field of consulting does not include the performance of
consulting services embedded in, or ancillary to, the sale of goods or
performance of services on behalf of a trade or business that is
otherwise not an SSTB (such as typical services provided by a building
contractor) if there is no separate payment for the consulting services.
Services within the fields of architecture and engineering are not
treated as consulting services.
(viii) Meaning of services performed in the field of athletics. For
purposes of section 199A(d)(2) and paragraph (b)(1)(vii) of this section
only, the performance of services in the field of athletics means the
performance of services by individuals who participate in athletic
competition such as athletes, coaches, and team managers in sports such
as baseball, basketball, football, soccer, hockey, martial arts, boxing,
bowling, tennis, golf, skiing, snowboarding, track and field, billiards,
and racing. The performance of services in the field of athletics does
not include the provision of services that do not require skills unique
to athletic competition, such as the maintenance and operation of
equipment or facilities for use in athletic events. Similarly, the
performance of services in the field of athletics does not include the
provision of services by persons who broadcast or otherwise disseminate
video or audio of athletic events to the public.
(ix) Meaning of services performed in the field of financial
services. For purposes of section 199A(d)(2) and paragraph (b)(1)(viii)
of this section only, the performance of services in the field of
financial services means the provision of financial services to clients
including managing wealth, advising clients with respect to finances,
developing retirement plans, developing wealth transition plans, the
provision of advisory and other similar services regarding valuations,
mergers, acquisitions, dispositions, restructurings (including in title
11 of the Code or similar cases), and raising financial capital by
underwriting, or acting as a client's agent in the issuance of
securities and similar services. This includes services provided by
financial advisors, investment bankers, wealth planners, retirement
advisors, and other similar professionals performing services in their
capacity as such. Solely for purposes of section 199A, the performance
of services in the field of financial services does not include taking
deposits or making loans, but does include arranging lending
transactions between a lender and borrower.
(x) Meaning of services performed in the field of brokerage
services. For purposes of section 199A(d)(2) and paragraph
[[Page 353]]
(b)(1)(ix) of this section only, the performance of services in the
field of brokerage services includes services in which a person arranges
transactions between a buyer and a seller with respect to securities (as
defined in section 475(c)(2)) for a commission or fee. This includes
services provided by stock brokers and other similar professionals, but
does not include services provided by real estate agents and brokers, or
insurance agents and brokers.
(xi) Meaning of the provision of services in investing and
investment management. For purposes of section 199A(d)(2) and paragraph
(b)(1)(x) of this section only, the performance of services that consist
of investing and investment management refers to a trade or business
involving the receipt of fees for providing investing, asset management,
or investment management services, including providing advice with
respect to buying and selling investments. The performance of services
of investing and investment management does not include directly
managing real property.
(xii) Meaning of the provision of services in trading. For purposes
of section 199A(d)(2) and paragraph (b)(1)(xi) of this section only, the
performance of services that consist of trading means a trade or
business of trading in securities (as defined in section 475(c)(2)),
commodities (as defined in section 475(e)(2)), or partnership interests.
Whether a person is a trader in securities, commodities, or partnership
interests is determined by taking into account all relevant facts and
circumstances, including the source and type of profit that is
associated with engaging in the activity regardless of whether that
person trades for the person's own account, for the account of others,
or any combination thereof.
(xiii) Meaning of the provision of services in dealing--(A) Dealing
in securities. For purposes of section 199A(d)(2) and paragraph
(b)(1)(xii) of this section only, the performance of services that
consist of dealing in securities (as defined in section 475(c)(2)) means
regularly purchasing securities from and selling securities to customers
in the ordinary course of a trade or business or regularly offering to
enter into, assume, offset, assign, or otherwise terminate positions in
securities with customers in the ordinary course of a trade or business.
Solely for purposes of the preceding sentence, the performance of
services to originate a loan is not treated as the purchase of a
security from the borrower in determining whether the lender is dealing
in securities.
(B) Dealing in commodities. For purposes of section 199A(d)(2) and
paragraph (b)(1)(xii) of this section only, the performance of services
that consist of dealing in commodities (as defined in section 475(e)(2))
means regularly purchasing commodities from and selling commodities to
customers in the ordinary course of a trade or business or regularly
offering to enter into, assume, offset, assign, or otherwise terminate
positions in commodities with customers in the ordinary course of a
trade or business. Solely for purposes of the preceding sentence, gains
and losses from qualified active sales as defined in paragraph
(b)(2)(xiii)(B)(1) of this section are not taken into account in
determining whether a person is engaged in the trade or business of
dealing in commodities.
(1) Qualified active sale. The term qualified active sale means the
sale of commodities in the active conduct of a commodities business as a
producer, processor, merchant, or handler of commodities if the trade or
business is as an active producer, processor, merchant or handler of
commodities. A hedging transaction described in paragraph (b)(2)(i)(B)
of this section is treated as a qualified active sale. The sale of
commodities held by a trade or business other than in its capacity as an
active producer, processor, merchant, or handler of commodities is not a
qualified active sale. For example, the sale by a trade or business of
commodities that were held for investment or speculation would not be a
qualified active sale.
(2) Active conduct of a commodities business. For purposes of
paragraph (b)(2)(xiii)(B)(1) of this section, a trade or business is
engaged in the active conduct of a commodities business as a producer,
processor, merchant, or handler of commodities only with respect to
commodities for which each of the conditions described in paragraphs
[[Page 354]]
(b)(2)(xiii)(B)(3) through (5) of this section are satisfied.
(3) Directly holds commodities as inventory or similar property. The
commodities trade or business holds the commodities directly, and not
through an agent or independent contractor, as inventory or similar
property. The term inventory or similar property means property that is
stock in trade of the trade or business or other property of a kind that
would properly be included in the inventory of the trade or business if
on hand at the close of the taxable year, or property held by the trade
or business primarily for sale to customers in the ordinary course of
its trade or business.
(4) Directly incurs substantial expenses in the ordinary course. The
commodities trade or business incurs substantial expenses in the
ordinary course of the commodities trade or business from engaging in
one or more of the following activities directly, and not through an
agent or independent contractor--
(i) Substantial activities in the production of the commodities,
including planting, tending or harvesting crops, raising or slaughtering
livestock, or extracting minerals;
(ii) Substantial processing activities prior to the sale of the
commodities, including the blending and drying of agricultural
commodities, or the concentrating, refining, mixing, crushing, aerating
or milling of commodities; or
(iii) Significant activities as described in paragraph
(b)(2)(xiii)(B)(5) of this section.
(5) Significant activities for purposes of paragraph
(b)(2)(xiii)(B)(4)(iii) of this section. The commodities trade or
business performs significant activities with respect to the commodities
that consists of--
(i) The physical movement, handling and storage of the commodities,
including preparation of contracts and invoices, arranging
transportation, insurance and credit, arranging for receipt, transfer or
negotiation of shipping documents, arranging storage or warehousing, and
dealing with quality claims;
(ii) Owning and operating facilities for storage or warehousing; or
(iii) Owning, chartering, or leasing vessels or vehicles for the
transportation of the commodities.
(C) Dealing in partnership interests. For purposes of section
199A(d)(2) and paragraph (b)(1)(xii) of this section only, the
performance of services that consist of dealing in partnership interests
means regularly purchasing partnership interests from and selling
partnership interests to customers in the ordinary course of a trade or
business or regularly offering to enter into, assume, offset, assign, or
otherwise terminate positions in partnership interests with customers in
the ordinary course of a trade or business.
(xiv) Meaning of trade or business where the principal asset of such
trade or business is the reputation or skill of one or more employees or
owners. For purposes of section 199A(d)(2) and paragraph (b)(1)(xiii) of
this section only, the term any trade or business where the principal
asset of such trade or business is the reputation or skill of one or
more of its employees or owners means any trade or business that
consists of any of the following (or any combination thereof):
(A) A trade or business in which a person receives fees,
compensation, or other income for endorsing products or services;
(B) A trade or business in which a person licenses or receives fees,
compensation, or other income for the use of an individual's image,
likeness, name, signature, voice, trademark, or any other symbols
associated with the individual's identity; or
(C) Receiving fees, compensation, or other income for appearing at
an event or on radio, television, or another media format.
(D) For purposes of paragraphs (b)(2)(xiv)(A) through (C) of this
section, the term fees, compensation, or other income includes the
receipt of a partnership interest and the corresponding distributive
share of income, deduction, gain, or loss from the partnership, or the
receipt of stock of an S corporation and the corresponding income,
deduction, gain, or loss from the S corporation stock.
(3) Examples. The following examples illustrate the rules in
paragraphs (a) and (b) of this section. The examples do not address all
types of services that
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may or may not qualify as specified services. Unless otherwise provided,
the individual in each example has taxable income in excess of the
threshold amount.
(i) Example 1. B is a board-certified pharmacist who contracts as an
independent contractor with X, a small medical facility in a rural area.
X employs one full time pharmacist, but contracts with B when X's needs
exceed the capacity of its full-time staff. When engaged by X, B is
responsible for receiving and reviewing orders from physicians providing
medical care at the facility; making recommendations on dosing and
alternatives to the ordering physician; performing inoculations,
checking for drug interactions, and filling pharmaceutical orders for
patients receiving care at X. B is engaged in the performance of
services in the field of health within the meaning of section 199A(d)(2)
and paragraphs (b)(1)(i) and (b)(2)(ii) of this section.
(ii) Example 2. X is the operator of a residential facility that
provides a variety of services to senior citizens who reside on campus.
For residents, X offers standard domestic services including housing
management and maintenance, meals, laundry, entertainment, and other
similar services. In addition, X contracts with local professional
healthcare organizations to offer residents a range of medical and
health services provided at the facility, including skilled nursing
care, physical and occupational therapy, speech-language pathology
services, medical social services, medications, medical supplies and
equipment used in the facility, ambulance transportation to the nearest
supplier of needed services, and dietary counseling. X receives all of
its income from residents for the costs associated with residing at the
facility. Any health and medical services are billed directly by the
healthcare providers to the senior citizens for those professional
healthcare services even though those services are provided at the
facility. X does not perform services in the field of health within the
meaning of section 199A(d)(2) and paragraphs (b)(1)(i) and (b)(2)(ii) of
this section.
(iii) Example 3. Y operates specialty surgical centers that provide
outpatient medical procedures that do not require the patient to remain
overnight for recovery or observation following the procedure. Y is a
private organization that owns a number of facilities throughout the
country. For each facility, Y ensures compliance with state and Federal
laws for medical facilities and manages the facility's operations and
performs all administrative functions. Y does not employ physicians,
nurses, and medical assistants, but enters into agreements with other
professional medical organizations or directly with the medical
professionals to perform the procedures and provide all medical care.
Patients are billed by Y for the facility costs relating to their
procedure and by the healthcare professional or their affiliated
organization for the actual costs of the procedure conducted by the
physician and medical support team. Y does not perform services in the
field of health within the meaning of section 199A(d)(2) and paragraphs
(b)(1)(i) and (b)(2)(ii) of this section.
(iv) Example 4. Z is the developer and the only provider of a
patented test used to detect a particular medical condition. Z accepts
test orders only from health care professionals (Z's clients), does not
have contact with patients, and Z's employees do not diagnose, treat, or
manage any aspect of patient care. A, who manages Z's testing
operations, is the only employee with an advanced medical degree. All
other employees are technical support staff and not healthcare
professionals. Z's workers are highly educated, but the skills the
workers bring to the job are not often useful for Z's testing methods.
In order to perform the duties required by Z, employees receive more
than a year of specialized training for working with Z's test, which is
of no use to other employers. Upon completion of an ordered test, Z
analyses the results and provides its clients a report summarizing the
findings. Z does not discuss the report's results, or the patient's
diagnosis or treatment with any health care provider or the patient. Z
is not informed by the healthcare provider as to the healthcare
provider's diagnosis or treatment. Z is not providing services in the
field of health within the meaning of section
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199A(d)(2) and paragraphs (b)(1)(i) and (b)(2)(ii) of this section or
where the principal asset of the trade or business is the reputation or
skill of one or more of its employees within the meaning of paragraphs
(b)(1)(xiii) and (b)(2)(xiv) of this section.
(v) Example 5. A, a singer and songwriter, writes and records a
song. A is paid a mechanical royalty when the song is licensed or
streamed. A is also paid a performance royalty when the recorded song is
played publicly. A is engaged in the performance of services in an SSTB
in the field of performing arts within the meaning of section 199A(d)(2)
or paragraphs (b)(1)(v) and (b)(2)(vi) of this section. The royalties
that A receives for the song are not eligible for a deduction under
section 199A.
(vi) Example 6. B is a partner in Movie LLC, a partnership. Movie
LLC is a film production company. Movie LLC plans and coordinates film
production. Movie LLC shares in the profits of the films that it
produces. Therefore, Movie LLC is engaged in the performance of services
in an SSTB in the field of performing arts within the meaning of section
199A(d)(2) or paragraphs (b)(1)(v) and (b)(2)(vi) of this section. B is
a passive owner in Movie LLC and does not provide any services with
respect to Movie LLC. However, because Movie LLC is engaged in an SSTB
in the field of performing arts, B's distributive share of the income,
gain, deduction, and loss with respect to Movie LLC is not eligible for
a deduction under section 199A.
(vii) Example 7. C is a partner in Partnership, which solely owns
and operates a professional sports team. Partnership employs athletes
and sells tickets and broadcast rights for games in which the sports
team competes. Partnership sells the broadcast rights to Broadcast LLC,
a separate trade or business. Broadcast LLC solely broadcasts the games.
Partnership is engaged in the performance of services in an SSTB in the
field of athletics within the meaning of section 199A(d)(2) or
paragraphs (b)(1)(vii) and (b)(2)(viii) of this section. The tickets
sales and the sale of the broadcast rights are both the performance of
services in the field of athletics. C is a passive owner in Partnership
and C does not provide any services with respect to Partnership or the
sports team. However, because Partnership is engaged in an SSTB in the
field of athletics, C's distributive share of the income, gain,
deduction, and loss with respect to Partnership is not eligible for a
deduction under section 199A. Broadcast LLC is not engaged in the
performance of services in an SSTB in the field of athletics.
(viii) Example 8. D is in the business of providing services that
assist unrelated entities in making their personnel structures more
efficient. D studies its client's organization and structure and
compares it to peers in its industry. D then makes recommendations and
provides advice to its client regarding possible changes in the client's
personnel structure, including the use of temporary workers. D does not
provide any temporary workers to its clients and D's compensation and
fees are not affected by whether D's clients used temporary workers. D
is engaged in the performance of services in an SSTB in the field of
consulting within the meaning of section 199A(d)(2) or paragraphs
(b)(1)(vi) and (b)(2)(vii) of this section.
(ix) Example 9. E is an individual who owns and operates a temporary
worker staffing firm primarily focused on the software consulting
industry. Business clients hire E to provide temporary workers that have
the necessary technical skills and experience with a variety of business
software to provide consulting and advice regarding the proper selection
and operation of software most appropriate for the business they are
advising. E does not have a technical software engineering background
and does not provide software consulting advice herself. E reviews
resumes and refers candidates to the client when the client indicates a
need for temporary workers. E does not evaluate her clients' needs about
whether the client needs workers and does not evaluate the clients'
consulting contracts to determine the type of expertise needed. Rather,
the client provides E with a job description indicating the required
skills for the upcoming consulting project. E is paid a fixed fee for
each temporary worker actually hired by the client and receives a bonus
if
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that worker is hired permanently within a year of referral. E's fee is
not contingent on the profits of its clients. E is not considered to be
engaged in the performance of services in the field of consulting within
the meaning of section 199A(d)(2) or (b)(1)(vi) and (b)(2)(vii) of this
section.
(x) Example 10. F is in the business of licensing software to
customers. F discusses and evaluates the customer's software needs with
the customer. The taxpayer advises the customer on the particular
software products it licenses. F is paid a flat price for the software
license. After the customer licenses the software, F helps to implement
the software. F is engaged in the trade or business of licensing
software and not engaged in an SSTB in the field of consulting within
the meaning of section 199A(d)(2) or paragraphs (b)(1)(vi) and
(b)(2)(vii) of this section.
(xi) Example 11. G is in the business of providing services to
assist clients with their finances. G will study a particular client's
financial situation, including, the client's present income, savings,
and investments, and anticipated future economic and financial needs.
Based on this study, G will then assist the client in making decisions
and plans regarding the client's financial activities. Such financial
planning includes the design of a personal budget to assist the client
in monitoring the client's financial situation, the adoption of
investment strategies tailored to the client's needs, and other similar
services. G is engaged in the performance of services in an SSTB in the
field of financial services within the meaning of section 199A(d)(2) or
paragraphs (b)(1)(viii) and (b)(2)(ix) of this section.
(xii) Example 12. H is in the business of franchising a brand of
personal financial planning offices, which generally provide personal
wealth management, retirement planning, and other financial advice
services to customers for a fee. H does not provide financial planning
services itself. H licenses the right to use the business tradename,
other branding intellectual property, and a marketing plan to third-
party financial planner franchisees that operate the franchised
locations and provide all services to customers. In exchange, the
franchisees compensate H based on a fee structure, which includes a one-
time fee to acquire the franchise. H is not engaged in the performance
of services in the field of financial services within the meaning of
section 199A(d)(2) or paragraphs (b)(1)(viii) and (b)(2)(ix) of this
section.
(xiii) Example 13. J is in the business of executing transactions
for customers involving various types of securities or commodities
generally traded through organized exchanges or other similar networks.
Customers place orders with J to trade securities or commodities based
on the taxpayer's recommendations. J's compensation for its services
typically is based on completion of the trade orders. J is engaged in an
SSTB in the field of brokerage services within the meaning of section
199A(d)(2) or paragraphs (b)(1)(ix) and (b)(2)(x) of this section.
(xiv) Example 14. K owns 100% of Corp, an S corporation, which
operates a bicycle sales and repair business. Corp has 8 employees,
including K.Half of Corp's net income is generated from sales of new and
used bicycles and related goods, such as helmets, and bicycle-related
equipment.The other half of Corp's net income is generated from bicycle
repair servicesperformed by K and Corp's other employees. Corp's assets
consist of inventory, fixtures, bicycle repair equipment, and a
leasehold on its retail location. Several of the employees and K have
worked in the bicycle business for many years, and have acquired
substantial skill and reputation in the field. Customers often consult
with the employees on the best bicycle for purchase. K is in the
business of sales and repairs of bicycles and is not engaged in an SSTB
within the meaning of section 199A(d)(2) or paragraphs (b)(1)(xiii) and
(b)(2)(xiv) of this section.
(xv) Example 15. L is a well-known chef and the sole owner of
multiple restaurants each of which is owned in a disregarded entity. Due
to L's skill and reputation as a chef, L receives an endorsement fee of
$500,000 for the use of L's name on a line of cooking utensils and
cookware. L is in the trade or business of being a chef and owning
restaurants and such trade or business is not an SSTB. However, L is
also in the
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trade or business of receiving endorsement income. L's trade or business
consisting of the receipt of the endorsement fee for L's skill and/or
reputation is an SSTB within the meaning of section 199A(d)(2) or
paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
(xvi) Example 16. M is a well-known actor. M entered into a
partnership with Shoe Company, in which M contributed her likeness and
the use of her name to the partnership in exchange for a 50% interest in
the partnership and a guaranteed payment. M's trade or business
consisting of the receipt of the partnership interest and the
corresponding distributive share with respect to the partnership
interest for M's likeness and the use of her name is an SSTB within the
meaning of section 199A(d)(2) or paragraphs (b)(1)(xiii) and (b)(2)(xiv)
of this section.
(c) Special rules--(1) De minimis rule--(i) Gross receipts of $25
million or less. For a trade or business with gross receipts of $25
million or less for the taxable year, a trade or business is not an SSTB
if less than 10 percent of the gross receipts of the trade or business
are attributable to the performance of services in a field described in
paragraph (b) of this section. For purposes of determining whether this
10 percent test is satisfied, the performance of any activity incident
to the actual performance of services in the field is considered the
performance of services in that field.
(ii) Gross receipts of greater than $25 million. For a trade or
business with gross receipts of greater than $25 million for the taxable
year, the rules of paragraph (c)(1)(i) of this section are applied by
substituting ``5 percent'' for ``10 percent'' each place it appears.
(iii) Examples. The following examples illustrate the provisions of
paragraph (c)(1) of this section.
(A) Example 1. Landscape LLC sells lawn care and landscaping
equipment and also provides advice and counsel on landscape design for
large office parks and residential buildings. The landscape design
services include advice on the selection and placement of trees, shrubs,
and flowers and are considered to be the performance of services in the
field of consulting under paragraphs (b)(1)(vi) and (b)(2)(vii) of this
section. Landscape LLC separately invoices for its landscape design
services and does not sell the trees, shrubs, or flowers it recommends
for use in the landscape design. Landscape LLC maintains one set of
books and records and treats the equipment sales and design services as
a single trade or business for purposes of sections 162 and 199A.
Landscape LLC has gross receipts of $2 million. $250,000 of the gross
receipts is attributable to the landscape design services, an SSTB.
Because the gross receipts from the consulting services exceed 10
percent of Landscape LLC's total gross receipts, the entirety of
Landscape LLC's trade or business is considered an SSTB.
(B) Example 2. Animal Care LLC provides veterinarian services
performed by licensed staff and also develops and sells its own line of
organic dog food at its veterinarian clinic and online. The veterinarian
services are considered to be the performance of services in the field
of health under paragraphs (b)(1)(i) and (b)(2)(ii) of this section.
Animal Care LLC separately invoices for its veterinarian services and
the sale of its organic dog food. Animal Care LLC maintains separate
books and records for its veterinarian clinic and its development and
sale of its dog food. Animal Care LLC also has separate employees who
are unaffiliated with the veterinary clinic and who only work on the
formulation, marketing, sales, and distribution of the organic dog food
products. Animal Care LLC treats its veterinary practice and the dog
food development and sales as separate trades or businesses for purposes
of section 162 and 199A. Animal Care LLC has gross receipts of
$3,000,000. $1,000,000 of the gross receipts is attributable to the
veterinary services, an SSTB. Although the gross receipts from the
services in the field of health exceed 10 percent of Animal Care LLC's
total gross receipts, the dog food development and sales business is not
considered an SSTB due to the fact that the veterinary practice and the
dog food development and sales are separate trades or businesses under
section 162.
(2) Services or property provided to an SSTB--(i) In general. If a
trade or business provides property or services to an
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SSTB within the meaning of this section and there is 50 percent or more
common ownership of the trades or businesses, that portion of the trade
or business of providing property or services to the 50 percent or more
commonly-owned SSTB will be treated as a separate SSTB with respect to
the related parties.
(ii) 50 percent or more common ownership. For purposes of paragraph
(c)(2)(i) and (ii) of this section, 50 percent or more common ownership
includes direct or indirect ownership by related parties within the
meaning of sections 267(b) or 707(b).
(iii) Examples. The following examples illustrate the provisions of
paragraph (c)(2) of this section.
(A) Example 1. Law Firm is a partnership that provides legal
services to clients, owns its own office building and employs its own
administrative staff. Law Firm divides into three partnerships.
Partnership 1 performs legal services to clients. Partnership 2 owns the
office building and rents the entire building to Partnership 1.
Partnership 3 employs the administrative staff and through a contract
with Partnership 1 provides administrative services to Partnership 1 in
exchange for fees. All three of the partnerships are owned by the same
people (the original owners of Law Firm). Because Partnership 2 provides
all of its property to Partnership 1, and Partnership 3 provides all of
its services to Partnership 1, Partnerships 2 and 3 will each be treated
as an SSTB under paragraph (c)(2) of this section.
(B) Example 2. Assume the same facts as in Example 1 of this
paragraph (c)(2), except that Partnership 2, which owns the office
building, rents 50 percent of the building to Partnership 1, which
provides legal services, and the other 50 percent to various unrelated
third party tenants. Because Partnership 2 is owned by the same people
as Partnership 1, the portion of Partnership 2's leasing activity
related to the lease of the building to Partnership 1 will be treated as
a separate SSTB. The remaining 50 percent of Partnership 2's leasing
activity will not be treated as an SSTB.
(d) Trade or business of performing services as an employee--(1) In
general. The trade or business of performing services as an employee is
not a trade or business for purposes of section 199A and the regulations
thereunder. Therefore, no items of income, gain, deduction, and loss
from the trade or business of performing services as an employee
constitute QBI within the meaning of section 199A and Sec. 1.199A-3.
Except as provided in paragraph (d)(3) of this section, income from the
trade or business of performing services as an employee refers to all
wages (within the meaning of section 3401(a)) and other income earned in
a capacity as an employee, including payments described in Sec. 1.6041-
2(a)(1) (other than payments to individuals described in section
3121(d)(3)) and Sec. 1.6041-2(b)(1).
(2) Employer's Federal employment tax classification of employee
immaterial. For purposes of determining whether wages are earned in a
capacity as an employee as provided in paragraph (d)(1) of this section,
the treatment of an employee by an employer as anything other than an
employee for Federal employment tax purposes is immaterial. Thus, if a
worker should be properly classified as an employee, it is of no
consequence that the employee is treated as a non-employee by the
employer for Federal employment tax purposes.
(3) Presumption that former employees are still employees--(i)
Presumption. Solely for purposes of section 199A(d)(1)(B) and paragraph
(d)(1) of this section, an individual that was properly treated as an
employee for Federal employment tax purposes by the person to which he
or she provided services and who is subsequently treated as other than
an employee by such person with regard to the provision of substantially
the same services directly or indirectly to the person (or a related
person), is presumed, for three years after ceasing to be treated as an
employee for Federal employment tax purposes, to be in the trade or
business of performing services as an employee with regard to such
services. As provided in paragraph (d)(3)(ii) of this section, this
presumption may be rebutted upon a showing by the individual that, under
Federal tax law, regulations, and
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principles (including common-law employee classification rules), the
individual is performing services in a capacity other than as an
employee. This presumption applies regardless of whether the individual
provides services directly or indirectly through an entity or entities.
(ii) Rebuttal of presumption. Upon notice from the IRS, an
individual rebuts the presumption in paragraph (d)(3)(i) of this section
by providing records, such as contracts or partnership agreements, that
provide sufficient evidence to corroborate the individual's status as a
non-employee.
(iii) Examples. The following examples illustrate the provision of
paragraph (d)(3) of this section. Unless otherwise provided, the
individual in each example has taxable income in excess of the threshold
amount.
(A) Example 1. A is employed by PRS, a partnership for Federal tax
purposes, as a fulltime employee and is treated as such for Federal
employment tax purposes. A quits his job for PRS and enters into a
contract with PRS under which A provides substantially the same services
that A previously provided to PRS in A's capacity as an employee.
Because A was treated as an employee for services he provided to PRS,
and now is no longer treated as an employee with regard to such
services, A is presumed (solely for purposes of section 199A(d)(1)(B)
and paragraphs (a)(3) and (d) of this section) to be in the trade or
business of performing services as an employee with regard to his
services performed for PRS. Unless the presumption is rebutted with a
showing that, under Federal tax law, regulations, and principles
(including the common-law employee classification rules), A is not an
employee, any amounts paid by PRS to A with respect to such services
will not be QBI for purposes of section 199A. The presumption would
apply even if, instead of contracting directly with PRS, A formed a
disregarded entity, or a passthrough entity, and the entity entered into
the contract with PRS.
(B) Example 2. C is an attorney employed as an associate in a law
firm (Law Firm 1) and was treated as such for Federal employment tax
purposes. C and the other associates in Law Firm 1 have taxable income
below the threshold amount. Law Firm 1 terminates its employment
relationship with C and its other associates. C and the other former
associates form a new partnership, Law Firm 2, which contracts to
perform legal services for Law Firm 1. Therefore, in form, C is now a
partner in Law Firm 2 which earns income from providing legal services
to Law Firm 1. C continues to provide substantially the same legal
services to Law Firm 1 and its clients. Because C was previously treated
as an employee for services she provided to Law Firm 1, and now is no
longer treated as an employee with regard to such services, C is
presumed (solely for purposes of section 199A(d)(1)(B) and paragraphs
(a)(3) and (d) of this section) to be in the trade or business of
performing services as an employee with respect to the services C
provides to Law Firm 1 indirectly through Law Firm 2. Unless the
presumption is rebutted with a showing that, under Federal tax law,
regulations, and principles (including common-law employee
classification rules), C is not an employee, C's distributive share of
Law Firm 2 income (including any guaranteed payments) will not be QBI
for purposes of section 199A. The results in this example would not
change if, instead of contracting with Law Firm 1, Law Firm 2 was
instead admitted as a partner in Law Firm 1.
(C) Example 3. E is an engineer employed as a senior project
engineer in an engineering firm, Engineering Firm. Engineering Firm is a
partnership for Federal tax purposes and structured such that after 10
years, senior project engineers are considered for partner if certain
career milestones are met. After 10 years, E meets those career
milestones and is admitted as a partner in Engineering Firm. As a
partner in Engineering Firm, E shares in the net profits of Engineering
Firm, and also otherwise satisfies the requirements under Federal tax
law, regulations, and principles (including common-law employee
classification rules) to be respected as a partner. E is presumed
(solely for purposes of section 199A(d)(1)(B) and paragraphs (a)(3) and
(d) of this section) to be in the trade or business of performing
services as an
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employee with respect to the services E provides to Engineering Firm.
However, E is able to rebut the presumption by showing that E became a
partner in Engineering Firm as a career milestone, shares in the overall
net profits in Engineering Firm, and otherwise satisfies the
requirements under Federal tax law, regulations, and principles
(including common-law employee classification rules) to be respected as
a partner.
(D) Example 4. F is a financial advisor employed by a financial
advisory firm, Advisory Firm, a partnership for Federal tax purposes, as
a fulltime employee and is treated as such for Federal employment tax
purposes. F has taxable income below the threshold amount. Advisory Firm
is a partnership and offers F the opportunity to be admitted as a
partner. F elects to be admitted as a partner to Advisory Firm and is
admitted as a partner to Advisory Firm. As a partner in Advisory Firm, F
shares in the net profits of Advisory Firm, is obligated to Advisory
Firm in ways that F was not previously obligated as an employee, is no
longer entitled to certain benefits available only to employees of
Advisory Firm, and has materially modified his relationship with
Advisory Firm. F's share of net profits is not subject to a floor or
capped at a dollar amount. F is presumed (solely for purposes of section
199A(d)(1)(B) and paragraphs (a)(3) and (d) of this section) to be in
the trade or business of performing services as an employee with respect
to the services F provides to Advisory Firm. However, F is able to rebut
the presumption by showing that F became a partner in Advisory Firm by
sharing in the profits of Advisory Firm, materially modifying F's
relationship with Advisory Firm, and otherwise satisfying the
requirements under Federal tax law, regulations, and principles
(including common-law employee classification rules) to be respected as
a partner.
(e) Applicability date--(1) General rule. Except as provided in
paragraph (e)(2) of this section, the provisions of this section apply
to taxable years ending after February 8, 2019.
(2) Exceptions-(i) Anti-abuse rules. The provisions of paragraphs
(c)(2) and (d)(3) of this section apply to taxable years ending after
December 22, 2017.
(ii) Non-calendar year RPE. For purposes of determining QBI, W-2
wages, UBIA of qualified property, and the aggregate amount of qualified
REIT dividends and qualified PTP income, if an individual receives any
of these items from an RPE with a taxable year that begins before
January 1, 2018, and ends after December 31, 2017, such items are
treated as having been incurred by the individual during the
individual's taxable year in which or with which such RPE taxable year
ends.
[T.D. 9847, 84 FR 3006, Feb. 8, 2019, as amended by T.D. 9847, 84 FR
15955, Apr. 17, 2019]
Sec. 1.199A-6 Relevant passthrough entities (RPEs), publicly
traded partnerships (PTPs), trusts, and estates.
(a) Overview. This section provides special rules for RPEs, PTPs,
trusts, and estates necessary for the computation of the section 199A
deduction of their owners or beneficiaries. Paragraph (b) of this
section provides computational and reporting rules for RPEs necessary
for individuals who own interests in RPEs to calculate their section
199A deduction. Paragraph (c) of this section provides computational and
reporting rules for PTPs necessary for individuals who own interests in
PTPs to calculate their section 199A deduction. Paragraph (d) of this
section provides computational and reporting rules for trusts (other
than grantor trusts) and estates necessary for their beneficiaries to
calculate their section 199A deduction.
(b) Computational and reporting rules for RPEs--(1) In general. An
RPE must determine and report information attributable to any trades or
businesses it is engaged in necessary for its owners to determine their
section 199A deduction.
(2) Computational rules. Using the following four rules, an RPE must
determine the items necessary for individuals who own interests in the
RPE to calculate their section 199A deduction under Sec. 1.199A-1(c) or
(d). An RPE that chooses to aggregate trades or businesses under the
rules of Sec. 1.199A-4 may determine these items for the aggregated
trade or business.
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(i) First, the RPE must determine if it is engaged in one or more
trades or businesses. The RPE must also determine whether any of its
trades or businesses is an SSTB under the rules of Sec. 1.199A-5.
(ii) Second, the RPE must apply the rules in Sec. 1.199A-3 to
determine the QBI for each trade or business engaged in directly.
(iii) Third, the RPE must apply the rules in Sec. 1.199A-2 to
determine the W-2 wages and UBIA of qualified property for each trade or
business engaged in directly.
(iv) Fourth, the RPE must determine whether it has any qualified
REIT dividends as defined in Sec. 1.199A-3(c)(1) earned directly or
through another RPE. The RPE must also determine the amount of qualified
PTP income as defined in Sec. 1.199A-3(c)(2) earned directly or
indirectly through investments in PTPs.
(3) Reporting rules for RPEs--(i) Trade or business directly engaged
in. An RPE must separately identify and report on the Schedule K-1
issued to its owners for any trade or business (including an aggregated
trade or business) engaged in directly by the RPE--
(A) Each owner's allocable share of QBI, W-2 wages, and UBIA of
qualified property attributable to each such trade or business; and
(B) Whether any of the trades or businesses described in paragraph
(b)(3)(i) of this section is an SSTB.
(ii) Other items. An RPE must also report on an attachment to the
Schedule K-1, any QBI, W-2 wages, UBIA of qualified property, or SSTB
determinations, reported to it by any RPE in which the RPE owns a direct
or indirect interest. The RPE must also report each owner's allocated
share of any qualified REIT dividends received by the RPE (including
through another RPE) as well as any qualified PTP income or loss
received by the RPE for each PTP in which the RPE holds an interest
(including through another RPE). Such information can be reported on an
amended or late filed return to the extent that the period of
limitations remains open.
(iii) Failure to report information. If an RPE fails to separately
identify or report on the Schedule K-1 (or any attachments thereto)
issued to an owner an item described in paragraph (b)(3)(i) of this
section, the owner's share (and the share of any upper-tier indirect
owner) of each unreported item of positive QBI, W-2 wages, or UBIA of
qualified property attributable to trades or businesses engaged in by
that RPE will be presumed to be zero.
(c) Computational and reporting rules for PTPs--(1) Computational
rules. Each PTP must determine its QBI under the rules of Sec. 1.199A-3
for each trade or business in which the PTP is engaged in directly. The
PTP must also determine whether any of the trades or businesses it is
engaged in directly is an SSTB.
(2) Reporting rules. Each PTP is required to separately identify and
report the information described in paragraph (c)(1) of this section on
Schedules K-1 issued to its partners. Each PTP must also determine and
report any qualified REIT dividends or qualified PTP income or loss
received by the PTP including through an RPE, a REIT, or another PTP. A
PTP is not required to determine or report W-2 wages or the UBIA of
qualified property attributable to trades or businesses it is engaged in
directly.
(d) Application to trusts, estates, and beneficiaries--(1) In
general. A trust or estate computes its section 199A deduction based on
the QBI, W-2 wages, UBIA of qualified property, qualified REIT
dividends, and qualified PTP income that are allocated to the trust or
estate. An individual beneficiary of a trust or estate takes into
account any QBI, W-2 wages, UBIA of qualified property, qualified REIT
dividends, and qualified PTP income allocated from a trust or estate in
calculating the beneficiary's section 199A deduction, in the same manner
as though the items had been allocated from an RPE. For purposes of this
section and Sec. Sec. 1.199A-1 through 1.199A-5, a trust or estate is
treated as an RPE to the extent it allocates QBI and other items to its
beneficiaries, and is treated as an individual to the extent it retains
the QBI and other items.
(2) Grantor trusts. To the extent that the grantor or another person
is treated as owning all or part of a trust under sections 671 through
679, such
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person computes its section 199A deduction as if that person directly
conducted the activities of the trust with respect to the portion of the
trust treated as owned by the grantor or other person.
(3) Non-grantor trusts and estates--(i) Calculation at entity level.
A trust or estate must calculate its QBI, W-2 wages, UBIA of qualified
property, qualified REIT dividends, and qualified PTP income. The QBI of
a trust or estate must be computed by allocating qualified items of
deduction described in section 199A(c)(3) in accordance with the
classification of those deductions under Sec. 1.652(b)-3(a), and
deductions not directly attributable within the meaning of Sec.
1.652(b)-3(b) (other deductions) are allocated in a manner consistent
with the rules in Sec. 1.652(b)-3(b). Any depletion and depreciation
deductions described in section 642(e) and any amortization deductions
described in section 642(f) that otherwise are properly included in the
computation of QBI are included in the computation of QBI of the trust
or estate, regardless of how those deductions may otherwise be allocated
between the trust or estate and its beneficiaries for other purposes of
the Code.
(ii) Allocation among trust or estate and beneficiaries. The QBI
(including any amounts that may be less than zero as calculated at the
trust or estate level), W-2 wages, UBIA of qualified property, qualified
REIT dividends, and qualified PTP income of a trust or estate are
allocated to each beneficiary and to the trust or estate based on the
relative proportion of the trust's or estate's distributable net income
(DNI), as defined by section 643(a), for the taxable year that is
distributed or required to be distributed to the beneficiary or is
retained by the trust or estate. For this purpose, the trust's or
estate's DNI is determined with regard to the separate share rule of
section 663(c), but without regard to section 199A. If the trust or
estate has no DNI for the taxable year, any QBI, W-2 wages, UBIA of
qualified property, qualified REIT dividends, and qualified PTP income
are allocated entirely to the trust or estate.
(iii) Separate shares. In the case of a trust or estate described in
section 663(c) with substantially separate and independent shares for
multiple beneficiaries, such trust or estate will be treated as a single
trust or estate for purposes of determining whether the taxable income
of the trust or estate exceeds the threshold amount; determining taxable
income, net capital gain, net QBI, W-2 wages, UBIA of qualified
property, qualified REIT dividends, and qualified PTP income for each
trade or business of the trust and estate; and computing the W-2 wage
and UBIA of qualified property limitations. The allocation of these
items to the separate shares of a trust or estate will be governed by
the rules under Sec. Sec. 1.663(c)-1 through 1.663(c)-5, as they may be
adjusted or clarified by publication in the Internal Revenue Bulletin
(see Sec. 601.601(d)(2)(ii)(b) of this chapter).
(iv) Threshold amount. The threshold amount applicable to a trust or
estate is $157,500 for any taxable year beginning before 2019. For
taxable years beginning after 2018, the threshold amount shall be
$157,500 increased by the cost-of-living adjustment as outlined in Sec.
1.199A-1(b)(12). For purposes of determining whether a trust or estate
has taxable income in excess of the threshold amount, the taxable income
of the trust or estate is determined after taking into account any
distribution deduction under sections 651 or 661.
(v) Charitable remainder trusts. A charitable remainder trust
described in section 664 is not entitled to and does not calculate a
section 199A deduction, and the threshold amount described in section
199A(e)(2) does not apply to the trust. However, any taxable recipient
of a unitrust or annuity amount from the trust must determine and apply
the recipient's own threshold amount for purposes of section 199A taking
into account any annuity or unitrust amounts received from the trust. A
recipient of a unitrust or annuity amount from a trust may take into
account QBI, qualified REIT dividends, or qualified PTP income for
purposes of determining the recipient's section 199A deduction for the
taxable year to the extent that the unitrust or annuity amount
distributed to such recipient consists of such section 199A items under
Sec. 1.664-1(d). For example, if a
[[Page 364]]
charitable remainder trust has investment income of $500, qualified
dividend income of $200, and qualified REIT dividends of $1,000, and
distributes $1,000 to the recipient, the trust would be treated as
having income in two classes within the category of income, described in
Sec. 1.664-1(d)(1)(i)(a)(1), for purposes of Sec. 1.664-
1(d)(1)(ii)(b). Because the annuity amount first carries out income in
the class subject to the highest income tax rate, the entire annuity
payment comes from the class with the investment income and qualified
REIT dividends. Thus, the charitable remainder trust would be treated as
distributing a proportionate amount of the investment income ($500 /
(1,000 + 500) * 1,000 = $333) and qualified REIT dividends ($1000 /
(1,000 + 500) * 1000 = $667) because the investment income and qualified
REIT dividends are taxed at the same rate and within the same class,
which is higher than the rate of tax for the qualified dividend income
in a separate class. The charitable remainder trust in this example
would not be treated as distributing any of the qualified dividend
income until it distributed all the investment income and qualified REIT
dividends (more than $1,500 in total) to the recipient. To the extent
that a trust is treated as distributing QBI, qualified REIT dividends,
or qualified PTP income to more than one unitrust or annuity recipient
in the taxable year, the distribution of such income will be treated as
made to the recipients proportionately, based on their respective shares
of total QBI, qualified REIT dividends, or qualified PTP income
distributed for that year. The trust allocates and reports any W-2 wages
or UBIA of qualified property to the taxable recipient of the annuity or
unitrust interest based on each recipient's share of the trust's total
QBI (whether or not distributed) for that taxable year. Accordingly, if
10 percent of the QBI of a charitable remainder trust is distributed to
the recipient and 90 percent of the QBI is retained by the trust, 10
percent of the W-2 wages and UBIA of qualified property is allocated and
reported to the recipient and 90 percent of the W-2 wages and UBIA of
qualified property is treated as retained by the trust. However, any W-2
wages retained by the trust cannot be used to compute W-2 wages in a
subsequent taxable year for section 199A purposes. Any QBI, qualified
REIT dividends, or qualified PTP income of the trust that is unrelated
business taxable income is subject to excise tax and that tax must be
allocated to the corpus of the trust under Sec. 1.664-1(c).
(vi) Electing small business trusts. An electing small business
trust (ESBT) is entitled to the deduction under section 199A. Any
section 199A deduction attributable to the assets in the S portion of
the ESBT is to be taken into account by the S portion. The S portion of
the ESBT must take into account the QBI and other items from any S
corporation owned by the ESBT, the grantor portion of the ESBT must take
into account the QBI and other items from any assets treated as owned by
a grantor or another person (owned portion) of a trust under sections
671 through 679, and the non-S portion of the ESBT must take into
account any QBI and other items from any other entities or assets owned
by the ESBT. For purposes of determining whether the taxable income of
an ESBT exceeds the threshold amount, the S portion and the non-S
portion of an ESBT are treated as a single trust. See Sec. 1.641(c)-1.
(vii) Anti-abuse rule for creation of a trust to avoid exceeding the
threshold amount. A trust formed or funded with a principal purpose of
avoiding, or of using more than one, threshold amount for purposes of
calculating the deduction under section 199A will not be respected as a
separate trust entity for purposes of determining the threshold amount
for purposes of section 199A. See also Sec. 1.643(f)-1 of the
regulations.
(viii) Example. The following example illustrates the application of
paragraph (d) of this section.
(A) Example--(1) Computation of DNI and inclusion and deduction
amounts--(i) Trust's distributive share of partnership items. Trust, an
irrevocable testamentary complex trust, is a 25% partner in PRS, a
family partnership that operates a restaurant that generates QBI and W-2
wages. A and B, Trust's beneficiaries, own the remaining 75% of
[[Page 365]]
PRS directly. In 2018, PRS properly allocates gross income from the
restaurant of $55,000, and expenses directly allocable to the restaurant
of $45,000 (including W-2 wages of $25,000, and miscellaneous expenses
of $20,000) to Trust. These items are properly included in Trust's DNI.
PRS distributes $10,000 of cash to Trust in 2018.
(ii) Trust's activities. In addition to its interest in PRS, Trust
also operates a family bakery conducted through an LLC wholly-owned by
the Trust that is treated as a disregarded entity. In 2018, the bakery
produces $100,000 of gross income and $155,000 of expenses directly
allocable to operation of the bakery (including W-2 wages of $50,000,
rental expense of $75,000, miscellaneous expenses of $25,000, and
depreciation deductions of $5,000). (The net loss from the bakery
operations is not subject to any loss disallowance provisions outside of
section 199A.) Trust maintains a reserve of $5,000 for depreciation.
Trust also has $125,000 of UBIA of qualified property in the bakery. For
purposes of computing its section 199A deduction, Trust and its
beneficiaries have properly chosen to aggregate the family restaurant
conducted through PRS with the bakery conducted directly by Trust under
Sec. 1.199A-4. Trust also owns various investment assets that produce
portfolio-type income consisting of dividends ($25,000), interest
($15,000), and tax-exempt interest ($15,000). Accordingly, Trust has the
following items which are properly included in Trust's DNI:
Table 1 to Paragraph (d)(3)(viii)(A)(1)(ii)
------------------------------------------------------------------------
------------------------------------------------------------------------
Interest Income............................................ 15,000
Dividends.................................................. 25,000
Tax-exempt interest........................................ 15,000
Net business loss from PRS and bakery...................... (45,000)
Trustee commissions........................................ 3,000
State and local taxes...................................... 5,000
------------------------------------------------------------------------
(iii) Allocation of deductions under Sec. 1.652(b)-3 (Directly
attributable expenses). In computing Trust's DNI for the taxable year,
the distributive share of expenses of PRS are directly attributable
under Sec. 1.652(b)-3(a) to the distributive share of income of PRS.
Accordingly, Trust has gross business income of $155,000 ($55,000 from
PRS and $100,000 from the bakery) and direct business expenses of
$200,000 ($45,000 from PRS and $155,000 from the bakery). In addition,
$1,000 of the trustee commissions and $1,000 of state and local taxes
are directly attributable under Sec. 1.652(b)-3(a) to Trust's business
income. Accordingly, Trust has excess business deductions of $47,000.
Pursuant to its authority recognized under Sec. 1.652(b)-3(d), Trust
allocates the $47,000 excess business deductions as follows: $15,000 to
the interest income, resulting in $0 interest income, $25,000 to the
dividends, resulting in $0 dividend income, and $7,000 to the tax exempt
interest.
(iv) Allocation of deductions under Sec. 1.652(b)-3 (Non-directly
attributable expenses). The trustee must allocate the sum of the balance
of the trustee commissions ($2,000) and state and local taxes ($4,000)
to Trust's remaining tax-exempt interest income, resulting in $2,000 of
tax exempt interest.
(v) Amounts included in taxable income. For 2018, Trust has DNI of
$2,000. Pursuant to Trust's governing instrument, Trustee distributes
50%, or $1,000, of that DNI to A, an individual who is a discretionary
beneficiary of Trust. In addition, Trustee is required to distribute
25%, or $500, of that DNI to B, a current income beneficiary of Trust.
Trust retains the remaining 25% of DNI. Consequently, with respect to
the $1,000 distribution A receives from Trust, A properly excludes
$1,000 of tax-exempt interest income under section 662(b). With respect
to the $500 distribution B receives from Trust, B properly excludes $500
of tax exempt interest income under section 662(b). Because the DNI
consists entirely of tax-exempt income, Trust deducts $0 under section
661 with respect to the distributions to A and B.
(2) Section 199A deduction--(i) Trust's W-2 wages and QBI. For the
2018 taxable year, prior to allocating the beneficiaries' shares of the
section 199A items, Trust has $75,000 ($25,000 from PRS + $50,000 of
Trust) of W-2 wages. Trust also has $125,000 of UBIA of qualified
property. Trust has negative QBI of ($47,000) ($155,000 gross income
from aggregated businesses less the sum of
[[Page 366]]
$200,000 direct expenses from aggregated businesses and $2,000 directly
attributable business expenses from Trust under the rules of Sec.
1.652(b)-3(a)).
(ii) A's Section 199A deduction computation. Because the $1,000
Trust distribution to A equals one-half of Trust's DNI, A has W-2 wages
from Trust of $37,500. A also has W-2 wages of $2,500 from a trade or
business outside of Trust (computed without regard to A's interest in
Trust), which A has properly aggregated under Sec. 1.199A-4 with the
Trust's trade or businesses (the family's restaurant and bakery), for a
total of $40,000 of W-2 wages from the aggregate trade or businesses. A
also has $62,500 of UBIA from Trust and $25,000 of UBIA of qualified
property from the trade or business outside of Trust for $87,500 of
total UBIA of qualified property. A has $100,000 of QBI from the non-
Trust trade or businesses in which A owns an interest. Because the
$1,000 Trust distribution to A equals one-half of Trust's DNI, A has
(negative) QBI from Trust of ($23,500). A's total QBI is determined by
combining the $100,000 QBI from non-Trust sources with the ($23,500) QBI
from Trust for a total of $76,500 of QBI. Assume that A's taxable income
is $357,500, which exceeds A's applicable threshold amount for 2018 by
$200,000. A's tentative deductible amount is $15,300 (20% x $76,500 of
QBI), limited to the greater of (i) $20,000 (50% x $40,000 of W-2
wages), or (ii) $12,187.50 ($10,000, 25% x $40,000 of W-2 wages, plus
$2,187.50, 2.5% x $87,500 of UBIA of qualified property). A's section
199A deduction is equal to the lesser of $15,300, or $71,500 (20% x
$357,500 of taxable income). Accordingly, A's section 199A deduction for
2018 is $15,300.
(iii) B's Section 199A deduction computation. For 2018, B's taxable
income is below the threshold amount so B is not subject to the W-2 wage
limitation. Because the $500 Trust distribution to B equals one-quarter
of Trust's DNI, B has a total of ($11,750) of QBI. B also has no QBI
from non-Trust trades or businesses, so B has a total of ($11,750) of
QBI. Accordingly, B's section 199A deduction for 2018 is zero. The
($11,750) of QBI is carried over to 2019 as a loss from a qualified
business in the hands of B pursuant to section 199A(c)(2).
(iv) Trust's Section 199A deduction computation. For 2018, Trust's
taxable income is below the threshold amount so it is not subject to the
W-2 wage limitation. Because Trust retained 25% of Trust's DNI, Trust is
allocated 25% of its QBI, which is ($11,750). Trust's section 199A
deduction for 2018 is zero. The ($11,750) of QBI is carried over to 2019
as a loss from a qualified business in the hands of Trust pursuant to
section 199A(c)(2).
(B) [Reserved]
(e) Applicability date--(1) General rule. Except as provided in
paragraph (e)(2) of this section, the provisions of this section apply
to taxable years ending after February 8, 2019.
(2) Exceptions--(i) Anti-abuse rules. The provisions of paragraph
(d)(3)(vii) of this section apply to taxable years ending after December
22, 2017.
(ii) Non-calendar year RPE. For purposes of determining QBI, W-2
wages, UBIA of qualified property, and the aggregate amount of qualified
REIT dividends and qualified PTP income, if an individual receives any
of these items from an RPE with a taxable year that begins before
January 1, 2018, and ends after December 31, 2017, such items are
treated as having been incurred by the individual during the
individual's taxable year in which or with which such RPE taxable year
ends.
(iii) Separate shares. The provisions of paragraph (d)(3)(iii) of
this section apply to taxable years beginning after August 24, 2020.
Taxpayers may choose to apply the rules in paragraph (d)(3)(iii) of this
section for taxable years beginning on or before August 24, 2020, so
long as the taxpayers consistently apply the rules in paragraph
(d)(3)(iii) of this section for each such year.
(iv) Charitable remainder trusts. The provisions of paragraph
(d)(3)(v) of this section apply to taxable years beginning after August
24, 2020. Taxpayers may choose to apply the rules in paragraph (d) of
this section for taxable years beginning on or before August 24, 2020,
so long as the taxpayers consistently apply the rules in paragraph
(d)(3)(v) of this section for each such year.
[T.D. 9847, 84 FR 3012, Feb. 8, 2019, as amended by T.D. 9899, 85 FR
38067, June 25, 2020]
[[Page 367]]
Sec. 1.199A-7 Section 199A(a) Rules for Cooperatives and their patrons.
(a) Overview--(1) In general. This section provides guidance and
special rules on the application of the rules of Sec. Sec. 1.199A-1
through 1.199A-6 regarding the deduction for qualified business income
(QBI) under section 199A(a) (section 199A(a) deduction) of the Internal
Revenue Code (Code) by patrons (patrons) of cooperatives to which Part I
of subchapter T of chapter 1 of the Code (subchapter T) applies
(Cooperatives). Unless otherwise provided in this section, all the rules
in Sec. Sec. 1.199A-1 through 1.199A-6 relating to calculating the
section 199A(a) deduction apply to patrons and Cooperatives. Paragraph
(b) of this section provides special rules for patrons relating to
trades or businesses. Paragraph (c) of this section provides special
rules for patrons and Cooperatives relating to the definition of QBI.
Paragraph (d) of this section provides special rules for patrons and
Cooperatives relating to specified service trades or businesses (SSTBs).
Paragraph (e) of this section provides special rules for patrons
relating to the statutory limitations based on W-2 wages and unadjusted
basis immediately after acquisition (UBIA) of qualified property.
Paragraph (f) of this section provides special rules for specified
agricultural or horticultural cooperatives (Specified Cooperatives) and
paragraph (g) of this section provides examples for Specified
Cooperatives and their patrons. Paragraph (h) of this section sets forth
the applicability date of this section and a special transition rule
relating to Specified Cooperatives and their patrons.
(2) At patron level. The section 199A(a) deduction is applied at the
patron level, and patrons who are individuals (as defined in Sec.
1.199A-1(a)(2)) may take the section 199A(a) deduction.
(3) Definitions. For purposes of section 199A and Sec. 1.199A-7,
the following definitions apply--
(i) Individual is defined in Sec. 1.199A-1(a)(2).
(ii) Patron is defined in Sec. 1.1388-1(e).
(iii) Patronage and nonpatronage is defined in Sec. 1.1388-1(f).
(iv) Relevant Passthrough Entity (RPE) is defined in Sec. 1.199A-
1(a)(9).
(v) Qualified payment is defined in Sec. 1.199A-8(d)(2)(ii).
(vi) Specified Cooperative is defined in Sec. 1.199A-8(a)(2) and is
a subset of Cooperatives defined in Sec. 1.199A-7(a)(1).
(b) Trade or business. A patron (whether the patron is an RPE or an
individual), and not a Cooperative, must determine whether it has one or
more trades or businesses that it directly conducts as defined in Sec.
1.199A-1(b)(14). To the extent a patron operating a trade or business
has income directly from that business, the patron must follow the rules
of Sec. Sec. 1.199A-1 through 1.199A-6 to calculate the section 199A(a)
deduction. Patronage dividends or similar payments are considered to be
generated from the trade or business the Cooperative conducts on behalf
of or with the patron. A Cooperative that distributes patronage
dividends or similar payments, as described in paragraph (c)(1) of this
section, must determine and report information to its patrons relating
to qualified items of income, gain, deduction, and loss in accordance
with paragraphs (c)(3) and (d)(3) of this section. A patron that
receives patronage dividends or similar payments, as described in
paragraph (c)(1) of this section, from a Cooperative must follow the
rules of paragraphs (c) through (e) of this section to calculate the
section 199A(a) deduction.
(c) Qualified Business Income--(1) In general. QBI means the net
amount of qualified items of income, gain, deduction, and loss with
respect to any trade or business as determined under the rules of
section 199A(c)(3) and Sec. 1.199A-3(b). A qualified item of income
includes distributions for which the Cooperative is allowed a deduction
under section 1382(b) and (c)(2) (including patronage dividends or
similar payments, such as money, property, qualified written notices of
allocations, and qualified per-unit retain certificates, as well as
money or property paid in redemption of a nonqualified written notice of
allocation (collectively patronage dividends or similar payments)),
provided such distribution is otherwise a qualified item of income,
gain, deduction, or loss. See special rule in paragraph (d)(3) of this
section relating to SSTBs that may affect QBI.
[[Page 368]]
(2) QBI determinations made by patron. A patron must determine QBI
for each trade or business it directly conducts. In situations where the
patron receives distributions described in paragraph (c)(1) of this
section, the Cooperative must determine whether those distributions
include qualified items of income, gain, deduction, and loss as
determined under rules of section 199A(c)(3) and Sec. 1.199A-3(b).
These distributions may be included in the QBI of the patron's trade or
business to the extent that:
(i) The distributions are related to the patron's trade or business
as defined in Sec. 1.199A-1(b)(14);
(ii) The distributions are qualified items of income, gain,
deduction, and loss as determined under rules of section 199A(c)(3) and
Sec. 1.199A-3(b) at the Cooperative's trade or business level;
(iii) The distributions are not items from an SSTB as defined in
section 199A(d)(2) at the Cooperative's trade or business level (except
as permitted by the threshold rules in section 199A(d)(3) and Sec.
1.199A-5(a)(2)); and
(iv) Certain information is reported by the Cooperative about these
payments as provided in paragraphs (c)(3) and (d)(3) of this section.
(3) Qualified items of income, gain, deduction, and loss
determinations made and reported by Cooperatives. In the case of a
Cooperative that makes distributions described in paragraph (c)(1) of
this section to a patron, the Cooperative must determine the amount of
qualified items of income, gain, deduction, and loss as determined under
the rules of section 199A(c)(3) and Sec. 1.199A-3(b) in those
distributions. A patron must determine whether these qualified items
relate to one or more trades or businesses that it directly conducts as
defined in Sec. 1.199A-1(b)(14). Pursuant to this paragraph (c)(3), the
Cooperative must report the net amount of qualified items with respect
to non-SSTBs of the Cooperative in the distributions made to the patron
on an attachment to or on the Form 1099-PATR, Taxable Distributions
Received From Cooperatives, (or any successor form) issued by the
Cooperative to the patron, unless otherwise provided by the instructions
to the Form. If the Cooperative does not report on or before the due
date of the Form 1099-PATR the amount of such qualified items of income,
gain, deduction, and loss in the distributions to the patron, the amount
of distributions from the Cooperative that may be included in the
patron's QBI is presumed to be zero. See special rule in paragraph
(d)(3) of this section relating to reporting of qualified items of
income, gain, deduction, and loss with respect to SSTBs of the
Cooperative.
(d) Specified Service Trades or Businesses--(1) In general. This
section provides guidance on the determination of SSTBs as defined in
section 199A(d)(2) and Sec. 1.199A-5. Unless otherwise provided in this
section, all of the rules in Sec. 1.199A-5 relating to SSTBs apply to
patrons of Cooperatives.
(2) SSTB determinations made by patron. A patron (whether an RPE or
an individual) must determine whether each trade or business it directly
conducts is an SSTB.
(3) SSTB determinations made and reported by Cooperatives--(i) In
general. In the case of a Cooperative that makes distributions described
in paragraph (c)(1) of this section to a patron, the Cooperative must
determine the amount of qualified items of income, gain, deduction, and
loss as determined under the rules of section 199A(c)(3) and Sec.
1.199A-3(b) with respect to SSTBs directly conducted by the Cooperative.
A patron must determine whether these qualified items relate to one or
more trades or businesses that it directly conducts as defined in Sec.
1.199A-1(b)(14). The Cooperative must report the net amount of qualified
items with respect to the SSTBs of the Cooperative in the distributions
made to the patron on an attachment to or on the Form 1099-PATR, Taxable
Distributions Received from Cooperatives, (or any successor form) issued
by the Cooperative to the patron, unless otherwise provided by the
instructions to the Form. If the Cooperative does not report the amount
on or before the due date of the Form 1099-PATR, then only the amount
that a Cooperative reports as qualified items of income, gain,
deduction, and loss under Sec. 1.199A-7(c)(3) may be included in the
patron's QBI, and the remaining amount of distributions from the
Cooperative that may be
[[Page 369]]
included in the patron's QBI is presumed to be zero.
(ii) Patron allocation of expenses paid to Cooperative for SSTB
items of income reported by Cooperative--(A) In general. When a
Cooperative reports SSTB items to a patron, a patron may allocate a
deductible expense that was paid to the Cooperative in connection with
the patron's qualified trade or business between a patron's qualified
trade or business income and the SSTB income reported to it by the
Cooperative only if the SSTB income directly relates to the deductible
expense. A patron can allocate the deductible expense paid by the patron
to the Cooperative only up to the amount of SSTB income reported by the
Cooperative.
(B) Example. Patron allocating expenses between qualified trade or
business and SSTB income from a Cooperative. (1) Cooperative provides to
its patrons a service that is an SSTB under section 199A(d)(2). P, a
patron, runs a qualified trade or business under section 199A(d)(1) and
incurs expenses for the service from the Cooperative in P's qualified
trade or business. P pays the Cooperative $1,000 for the service.
Cooperative later pays P a patronage dividend of $50 related to the
service.
(2) Cooperative reports the $50 as SSTB income on the Form 1099-PATR
issued to P.
(3) Since P's deductible expense for services from the Cooperative
was in connection with a qualified trade or business and the SSTB income
directly relates to that expense, P may allocate the expense under
paragraph (d)(3)(ii) of this section. Accordingly, $50 of the $1,000
expense is allocated to P's SSTB income, and $950 of the expense is
allocated to P's qualified trade or business and is included in P's QBI
calculation.
(e) W-2 wages and unadjusted basis immediately after acquisition of
qualified property--(1) In general. This section provides guidance on
calculating a trade or business's W-2 wages and the UBIA of qualified
property properly allocable to QBI.
(2) Determinations made by patron. The determination of W-2 wages
and UBIA of qualified property must be made for each trade or business
by the patron (whether an RPE or individual) that directly conducts the
trade or business before applying the aggregation rules of Sec. 1.199A-
4. Unlike RPEs, Cooperatives do not compute and allocate their W-2 wages
and UBIA of qualified property to patrons.
(f) Special rules for patrons of Specified Cooperatives--(1) Section
199A(b)(7) reduction. A patron of a Specified Cooperative that receives
a qualified payment must reduce its section 199A(a) deduction as
provided in Sec. 1.199A-1(e)(7). This reduction applies whether the
Specified Cooperative passes through all, some, or none of the Specified
Cooperative's section 199A(g) deduction to the patron in that taxable
year. The rules relating to the section 199A(g) deduction can be found
in Sec. Sec. 1.199A-8 through 1.199A-12.
(2) Reduction calculation--(i) Allocation method. If in any taxable
year, a patron receives income or gain related to qualified payments and
income or gain that is not related to qualified payments in a trade or
business, the patron must allocate the income or gain and related
deductions, losses and W-2 wages using a reasonable method based on all
the facts and circumstances for purposes of calculating the reduction in
Sec. 1.199A-1(e)(7). Different reasonable methods may be used for
different items and related deductions of income, gain, deduction, and
loss. The chosen reasonable method for each item must be consistently
applied from one taxable year of the patron to another, and must clearly
reflect the income and expenses of each trade or business. The overall
combination of methods must also be reasonable based on all the facts
and circumstances. The books and records maintained for a trade or
business must be consistent with any allocations under this paragraph
(f)(2)(i).
(ii) Safe harbor. A patron with taxable income under the threshold
amount set forth in section 199A(e)(2) is eligible to use the safe
harbor set forth in this paragraph (f)(2)(ii) to apportion its
deductions, losses and W-2 wages instead of the allocation method set
forth in paragraph (f)(2)(i) of this section for any taxable year in
which the patron receives income or gain related to qualified payments
and income or gain not related to qualified payments in a
[[Page 370]]
trade or business. Under the safe harbor the patron may apportion its
deductions, losses and W-2 wages ratably between income or gain related
to qualified payments and income or gain that is not related to
qualified payments for purposes of calculating the reduction in
paragraph (f)(1) of this section. Accordingly, the amount of deductions
and losses apportioned to determine QBI allocable to qualified payments
is equal to the proportion of the total deductions and losses that the
amount of income or gain related to qualified payments bears to total
income or gain used to determine QBI. The same proportion applies to
determine the amount of W-2 wages allocable to the portion of the trade
or business that received qualified payments.
(3) Qualified payments notice requirement. A Specified Cooperative
must report the amount of the qualified payments made to the eligible
taxpayer, as defined in section 199A(g)(2)(D), on an attachment to or on
the Form 1099-PATR (or any successor form) issued by the Cooperative to
the patron, unless otherwise provided by the instructions to the Form.
(g) Examples. The following examples illustrate the provisions of
paragraph (f) of this section. For purposes of these examples, assume
that the Specified Cooperative has satisfied the applicable written
notice requirements in paragraphs (c)(3), (d)(3) and (f)(3) of this
section.
(1) Example 1. Patron of Specified Cooperative with W-2 wages. (i)
P, a grain farmer and patron of nonexempt Specified Cooperative C,
delivered to C during 2020 2% of all grain marketed through C during
such year. During 2021, P receives $20,000 in patronage dividends and
$1,000 of allocated section 199A(g) deduction from C related to the
grain delivered to C during 2020.
(ii) P has taxable income of $75,000 for 2021 (determined without
regard to section 199A) and has a filing status of married filing
jointly. P's QBI related to its grain trade or business for 2021 is
$50,000, which consists of gross receipts of $150,000 from sales to an
independent grain elevator, per-unit retain allocations received from C
during 2021 of $80,000, patronage dividends received from C during 2021
related to C's 2020 net earnings of $20,000, and expenses of $200,000
(including $50,000 of W-2 wages).
(iii) The portion of QBI from P's grain trade or business related to
qualified payments received from C during 2021 is $10,000, which
consists of per-unit retain allocations received from C during 2021 of
$80,000, patronage dividends received from C during 2021 related to C's
2020 net earnings of $20,000, and properly allocable expenses of $90,000
(including $25,000 of W-2 wages).
(iv) P's deductible amount related to the grain trade or business is
20% of QBI ($10,000) reduced by the lesser of 9% of QBI related to
qualified payments received from C ($900) or 50% of W-2 wages related to
qualified payments received from C ($12,500), or $9,100. As P does not
have any other trades or businesses, the combined QBI amount is also
$9,100.
(v) P's deduction under section 199A for 2021 is $10,100, which
consists of the combined QBI amount of $9,100, plus P's deduction passed
through from C of $1,000.
(2) Example 2. Patron of Specified Cooperative without W-2 wages.
(i) C and P have the same facts for 2020 and 2021 as Example 1, except
that P has expenses of $200,000 that include zero W-2 wages during 2021.
(ii) P's deductible amount related to the grain trade or business is
20% of QBI ($10,000) reduced by the lesser of 9% of QBI related to
qualified payments received from C ($900) or 50% of W-2 wages related to
qualified payments received from C ($0), or $10,000.
(iii) P's deduction under section 199A for 2021 is $11,000, which
consists of the combined QBI amount of $10,000, plus P's deduction
passed through from C of $1,000.
(3) Example 3. Patron of Specified Cooperative--Qualified Payments
do not equal QBI and no section 199A(g) passthrough. (i) P, a grain
farmer and a patron of a nonexempt Specified Cooperative C, during 2020,
receives $60,000 in patronage dividends, $100,000 in per-unit retain
allocations, and $0 of allocated
[[Page 371]]
section 199A(g) deduction from C related to the grain delivered to C. C
notifies P that only $150,000 of the patronage dividends and per-unit
retain allocations are qualified payments because $10,000 of the
payments are not attributable to C's QPAI.
(ii) P has taxable income of $90,000 (determined without regard to
section 199A) and has a filing status of married filing jointly. P's QBI
related to its grain trade or business is $45,000, which consists of
gross receipts of $95,000 from sales to an independent grain elevator,
plus $160,000 from C (all payments from C qualify as qualified items of
income, gain, deduction, and loss), less expenses of $210,000 (including
$30,000 of W-2 wages).
(iii) The portion of QBI from P's grain trade or business related to
qualified payments received from C is $25,000, which consists of the
qualified payments received from C of $150,000, less the properly
allocable expenses of $125,000 (including $18,000 of W-2 wages), which
were determined using a reasonable method under paragraph (f)(2)(ii) of
this section.
(iv) P's patron reduction is $2,250, which is the lesser of 9% of
QBI related to qualified payments received from C, $2,250 (9% x
$25,000), or 50% of W-2 wages related to qualified payments received
from C, $9,000 (50% x $18,000). As P does not have any other trades or
businesses, the combined QBI amount is $6,750 (20% of P's total QBI,
$9,000 (20% x $45,000), reduced by the patron reduction of $2,250).
(v) P's deduction under section 199A is $6,750, which consists of
the combined QBI amount of $6,750.
(4) Example 4. Patron of Specified Cooperative--Reasonable Method
under paragraph (f)(2)(i) of this section. P is a grain farmer that has
$45,000 of QBI related to P's grain trade or business in 2020. P's QBI
consists of $105,000 of sales to an independent grain elevator, $100,000
of per-unit retain allocations, and $50,000 of patronage dividends from
a nonexempt Specified Cooperative C, for which C reports $150,000 of
qualified payments to P as required by paragraph (f)(3) of this section.
P's grain trade or business has $210,000 of expenses (including $30,000
of W-2 wages). P delivered 65x bushels of grain to C and sold 35x
bushels of comparable grain to the independent grain elevator. To
allocate the expenses between qualified payments ($150,000) and other
income ($105,000), P compares the bushels of grain delivered to C (65x)
to the total bushels of grain delivered to C and sold to the independent
grain elevator (100x). P determines $136,500 (65% x $210,000) of
expenses (including $19,500 of W-2 wages) are properly allocable to the
qualified payments. The portion of QBI from P's grain trade or business
related to qualified payments received from C is $13,500, which consists
of qualified payments of $150,000 less the properly allocable expenses
of $136,500 (including $19,500 of W-2 wages). P's method of allocating
expenses is a reasonable method under paragraph (f)(2)(i) of this
section.
(5) Example 5. Patron of Specified Cooperative using safe harbor to
allocate. (i) P is a grain farmer with taxable income of $100,000 for
2021 (determined without regard to section 199A) and has a filing status
of married filing jointly. P's QBI related to P's grain trade or
business for 2021 is $50,000, which consists of gross receipts of
$180,000 from sales to an independent grain elevator, per-unit retain
allocations received from a Specified Cooperative C during 2021 of
$15,000, patronage dividends received from C during 2021 related to C's
2020 net earnings of $5,000, and expenses of $150,000 (including $50,000
of W-2 wages). C also passed through $1,800 of the section 199A(g)
deduction to P, which related to the grain delivered by P to the
Specified Cooperative during 2020. P uses the safe harbor in paragraph
(f)(2)(ii) of this section to determine the expenses (including W-2
wages) allocable to the qualified payments.
(ii) Using the safe harbor to allocate P's $150,000 of expenses, P
allocates $15,000 of the expenses to the qualified payments ($150,000 of
expenses multiplied by the ratio (0.10) of qualified payments ($20,000)
to total gross receipts ($200,000)). Using the same ratio, P also
determines there are $5,000 of W-2 wages allocable ($50,000 multiplied
by 0.10) to the qualified payments.
(iii) The portion of QBI from P's grain trade or business related to
qualified payments received from C
[[Page 372]]
during 2021 is $5,000, which consists of per-unit retain allocations
received from C during 2021 of $15,000, patronage dividends of $5,000,
and properly allocable expenses of $15,000 (including $5,000 of W-2
wages).
(iv) P's QBI related to the grain trade or business is 20% of QBI
($10,000) reduced by the lesser of 9% of QBI related to qualified
payments received from C ($450) or 50% of W-2 wages related to qualified
payments received from C ($2,500), or $9,550. As P does not have any
other trades or businesses, the combined QBI amount is also $9,550.
(v) P's deduction under section 199A for 2021 is $11,350, which
consists of the combined QBI amount of $9,550, plus P's deduction passed
through from C of $1,800.
(h) Applicability date--(1) General rule. Except as provided in
paragraph (h)(2) of this section, the provisions of this section apply
to taxable years beginning after January 19, 2021. Taxpayers, however,
may choose to apply the rules of Sec. Sec. 1.199A-7 through 1.199A-12
for taxable years beginning on or before that date, provided taxpayers
apply the rules in their entirety and in a consistent manner.
(2) Transition rule for qualified payments of patrons of
Cooperatives. See the transition rule for qualified payments of patrons
of Cooperatives for a taxable year of a Cooperative beginning before
January 1, 2018 in the Consolidated Appropriations Act, 2018 (Pub. L.
115-141, 132 Stat. 348) Division T, section 101(c).
(3) Notice from the Cooperative. If a patron of a Cooperative cannot
claim a deduction under section 199A for any qualified payments
described in the transition rule set forth in paragraph (h)(2) of this
section, the Cooperative must use a reasonable method to identify the
qualified payments to its patrons. A reasonable method includes
reporting this information on an attachment to or on the Form 1099-PATR
(or any successor form) issued by the Cooperative to the patron, unless
otherwise provided by the instructions to the Form.
[T.D. 9947, 86 FR 5569, Jan. 19, 2021, as amended by 87 FR 68898, Nov.
17, 2022]
Sec. 1.199A-8 Deduction for income attributable to domestic
production activities of specified agricultural or horticultural
cooperatives.
(a) Overview--(1) In general. This section provides rules relating
to the deduction for income attributable to domestic production
activities of a specified agricultural or horticultural cooperative
(Specified Cooperative). This paragraph (a) provides an overview and
definitions of certain terms. Paragraph (b) of this section provides
rules explaining the steps a nonexempt Specified Cooperative performs to
calculate its section 199A(g) deduction and includes definitions of
relevant terms. Paragraph (c) of this section provides rules explaining
the steps an exempt Specified Cooperative performs to calculate its
section 199A(g) deduction. Paragraph (d) of this section provides rules
for Specified Cooperatives passing through the section 199A(g) deduction
to patrons. Paragraph (e) of this section provides examples that
illustrate the provisions of paragraphs (b), (c), and (d) of this
section. Paragraph (f) of this section provides guidance for Specified
Cooperatives that are partners in a partnership. Paragraph (g) of this
section provides guidance on the recapture of a claimed section 199A(g)
deduction. Paragraph (h) of this section provides effective dates. For
additional rules addressing an expanded affiliated group (EAG), to which
the principles of this section apply, see Sec. 1.199A-12. The
provisions of this section apply solely for purposes of section 199A of
the Internal Revenue Code (Code).
(2) Specified Cooperative--(i) In general. Specified Cooperative
means a cooperative to which Part I of subchapter T of chapter 1 of the
Code applies and which--
(A) Manufactures, produces, grows, or extracts (MPGE) in whole or
significant part within the United States any agricultural or
horticultural product, or
(B) Is engaged in the marketing of agricultural or horticultural
products that have been MPGE in whole or significant part within the
United States by the patrons of the cooperative.
(C) See Sec. 1.199A-9 for rules to determine if a Specified
Cooperative has MPGE an agricultural or horticultural
[[Page 373]]
product in whole or significant part within the United States.
(ii) Types of Specified Cooperatives. A Specified Cooperative that
is qualified as a farmer's cooperative organization under section 521 is
an exempt Specified Cooperative, while a Specified Cooperative not so
qualified is a nonexempt Specified Cooperative.
(3) Patron is defined in Sec. 1.1388-1(e).
(4) Agricultural or horticultural products are agricultural,
horticultural, viticultural, and dairy products, livestock and the
products thereof, the products of poultry and bee raising, the edible
products of forestry, and any and all products raised or produced on
farms and processed or manufactured products thereof within the meaning
of the Cooperative Marketing Act of 1926, 44 Stat. 802 (1926).
Agricultural or horticultural products also include aquatic products
that are farmed. Some examples of agricultural or horticultural products
include, but are not limited to, fruits, grains, oilseeds, rice,
vegetables, legumes, grasses (including hay), plants of all kinds,
flowers (including hops), seeds, tobacco, cotton, sugar cane and sugar
beets. Some examples of livestock products include, but are not limited
to, wool, fur, hides, eggs, down, honey, and silk. Some examples of
edible forestry products include, but are not limited to, fruits, nuts,
berries and mushrooms. Some examples of aquatic products include, but
are not limited to, fish, crustaceans, shellfish and seaweed. In
addition, agricultural or horticultural products include fertilizer,
diesel fuel, and other supplies (for example, seed, feed, herbicides,
and pesticides) used in agricultural or horticultural production that
are MPGE by a Specified Cooperative. Agricultural or horticultural
products, however, do not include intangible property other than when
incorporated into a tangible agricultural or horticultural product
(other than as provided in the exception in Sec. 1.199A-9(b)(2)).
Intangible property for this purpose includes, for example, the rights
to MPGE and sell an agricultural or horticultural product with certain
characteristics protected by a patent, or the rights to a trademark or
tradename. This exclusion of intangible property does not apply to
intangible characteristics of any particular agricultural or
horticultural product. For example, gross receipts from the sale of
different varieties of oranges would be considered from the disposition
of agricultural or horticultural products. However, gross receipts from
the license of the right to produce and sell a certain variety of an
orange would be considered separate from the orange and not from an
agricultural or horticultural product.
(b) Steps for a nonexempt Specified Cooperative in calculating
deduction--(1) In general. Except as provided in paragraph (c)(3) of
this section, this paragraph (b) applies only to nonexempt Specified
Cooperatives.
(2) Step 1--Gross receipts and related deductions--(i) Identify. To
determine the section 199A(g) deduction, a Specified Cooperative first
identifies its patronage and nonpatronage gross receipts and related
cost of goods sold (COGS), deductible expenses, W-2 wages, etc.
(deductions) and allocates them between patronage and nonpatronage. A
single definition for the term patronage and nonpatronage is found in
Sec. 1.1388-1(f).
(ii) Applicable gross receipts and deductions. Except as described
in this paragraph (b)(ii), for all purposes of the section 199A(g)
deduction, a Specified Cooperative can use only patronage gross receipts
and related deductions to calculate qualified production activities
income (QPAI) as defined in paragraph (b)(4)(ii) of this section, oil-
related QPAI as defined in paragraph (b)(7)(ii) of this section, the W-2
wage limitation in paragraph (b)(5)(ii)(B) of this section, or taxable
income as defined in paragraph (b)(5)(ii)(C) of this section. A
Specified Cooperative cannot use its nonpatronage gross receipts and
related deductions to calculate its section 199A(g) deduction, other
than treating all of its nonpatronage gross receipts as patronage non-
DPGR for purposes of applying the de minimis rules in Sec. 1.199A-
9(c)(3). If a Specified Cooperative treats all nonpatronage gross
receipts as DPGR under Sec. 1.199A-9(c)(3)(i), then a Specified
Cooperative shall also treat its deductions related to the nonpatronage
gross receipts as patronage in calculating QPAI, oil-related QPAI, the
W-2 wage limitation,
[[Page 374]]
or taxable income for purposes of the section 199A(g) deduction.
(iii) Gross receipts are the Specified Cooperative's receipts for
the taxable year that are recognized under the Specified Cooperative's
methods of accounting used for Federal income tax purposes for the
taxable year. See Sec. 1.199A-12 if the gross receipts are recognized
in an intercompany transaction within the meaning of Sec. 1.1502-13.
Gross receipts include total sales (net of returns and allowances) and
all amounts received for services. In addition, gross receipts include
any income from investments and from incidental or outside sources. For
example, gross receipts include interest (except interest under section
103 but including original issue discount), dividends, rents, royalties,
and annuities, regardless of whether the amounts are derived in the
ordinary course of the Specified Cooperative's trade or business. Gross
receipts are not reduced by COGS or by the cost of property sold if such
property is described in section 1221(a)(1), (2), (3), (4), or (5).
Finally, gross receipts do not include amounts received by the Specified
Cooperative with respect to sales tax or other similar state or 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 Specified
Cooperative merely collects and remits the tax to the taxing authority.
If, in contrast, the tax is imposed on the Specified Cooperative under
the applicable law, then gross receipts include the amounts received
that are allocable to the payment of such tax.
(3) Step 2--Determine gross receipts that are DPGR--(i) In general.
A Specified Cooperative examines its patronage gross receipts to
determine which of these are DPGR. A Specified Cooperative does not use
nonpatronage gross receipts to determine DPGR.
(ii) DPGR are the gross receipts of the Specified Cooperative that
are derived from any lease, rental, license, sale, exchange, or other
disposition of an agricultural or horticultural product that is MPGE by
the Specified Cooperative or its patrons in whole or significant part
within the United States. DPGR does not include gross receipts derived
from services or the lease, rental, license, sale, exchange, or other
disposition of land unless a de minimis or other exception applies. See
Sec. 1.199A-9 for additional rules on determining if gross receipts are
DPGR.
(4) Step 3--Determine QPAI--(i) In general. A Specified Cooperative
determines QPAI from patronage DPGR and patronage deductions identified
in paragraphs (b)(3)(ii) and (b)(2)(i) of this section, respectively. A
Specified Cooperative does not use nonpatronage gross receipts or
deductions to determine QPAI.
(ii) QPAI for the taxable year means an amount equal to the excess
(if any) of--
(A) DPGR for the taxable year, over
(B) The sum of--
(1) COGS that are allocable to DPGR, and
(2) Other expenses, losses, or deductions (other than the section
199A(g) deduction) that are properly allocable to DPGR.
(C) QPAI computational rules. QPAI is computed without taking into
account the section 199A(g) deduction or any deduction allowed under
section 1382(b). See Sec. 1.199A-10 for additional rules on calculating
QPAI.
(5) Step 4--Calculate deduction--(i) In general. From QPAI and
taxable income, a Specified Cooperative calculates its section 199A(g)
deduction as provided in paragraph (b)(5)(ii) of this section.
(ii) Deduction--(A) In general. A Specified Cooperative is allowed a
deduction equal to 9 percent of the lesser of--
(1) QPAI of the Specified Cooperative for the taxable year, or
(2) Taxable income of the Specified Cooperative for the taxable
year.
(B) W-2 wage limitation. The deduction allowed under paragraph
(b)(5)(ii)(A) of this section for any taxable year cannot exceed 50
percent of the patronage W-2 wages attributable to DPGR for the taxable
year. See Sec. 1.199A-11 for additional rules on calculating the
patronage W-2 wage limitation.
(C) Taxable income. Taxable income is defined in section 63, and
adjusted under section 1382 and Sec. 1.1382-1 and Sec. 1.1382-2. For
purposes of determining the amount of the deduction allowed
[[Page 375]]
under paragraph (b)(5)(ii) of this section, taxable income is limited to
taxable income and related deductions from patronage sources, other than
as allowed under paragraph (b)(2)(ii) of this section. Taxable income is
computed without taking into account the section 199A(g) deduction or
any deduction allowable under section 1382(b). Patronage net operating
losses (NOLs) reduce taxable income in the amount that the Specified
Cooperative would use to reduce taxable income (no lower than zero)
before using the section 199A(g) deduction, but do not reduce taxable
income that is the result of not taking into account any deduction
allowable under section 1382(b).
(6) Use of patronage section 199A(g) deduction. Except as provided
in Sec. 1.199A-12(c)(2) related to the rules for EAGs, the patronage
section 199A(g) deduction cannot create or increase a patronage or
nonpatronage NOL or the amount of a patronage or nonpatronage NOL
carryover or carryback, if applicable, in accordance with section 172. A
patronage section 199A(g) deduction can be applied only against
patronage income and deductions. A patronage section 199A(g) deduction
that is not used in the appropriate taxable year is lost. To the extent
that a Specified Cooperative passes through the section 199A(g)
deduction to patrons and appropriately adjusts the section 1382
deduction under Sec. 1.199A-8(d), the amount passed through is not
considered to create or increase a patronage or nonpatronage NOL or the
amount of a patronage or nonpatronage NOL carryover or carryback, if
applicable, in accordance with section 172.
(7) Special rules for nonexempt Specified Cooperatives that have
oil-related QPAI--(i) Reduction of section 199A(g) deduction. If a
Specified Cooperative has oil-related QPAI for any taxable year, the
amount otherwise allowable as a deduction under paragraph (b)(5)(ii) of
this section must be reduced by 3 percent of the least of--
(A) Oil-related QPAI of the Specified Cooperative for the taxable
year,
(B) QPAI of the Specified Cooperative for the taxable year, or
(C) Taxable income of the Specified Cooperative for the taxable
year.
(ii) Oil-related QPAI means, for any taxable year, the patronage
QPAI that is attributable to the production, refining, processing,
transportation, or distribution of oil, gas, or any primary product
thereof (within the meaning of section 927(a)(2)(C), as in effect before
its repeal) during such taxable year. Oil-related QPAI for any taxable
year is an amount equal to the excess (if any) of patronage DPGR derived
from the production, refining or processing of oil, gas, or any primary
product thereof (oil-related DPGR) over the sum of--
(A) COGS of the Specified Cooperative that is allocable to such
receipts; and
(B) Other expenses, losses, or deductions (other than the section
199A(g) deduction) that are properly allocable to such receipts.
(iii) Special rule for patronage oil-related DPGR. Oil-related DPGR
does not include gross receipts derived from the transportation or
distribution of oil, gas, or any primary product thereof. However, to
the extent that the nonexempt Specified Cooperative treats gross
receipts derived from transportation or distribution of oil, gas, or any
primary product thereof as part of DPGR under Sec. 1.199A-9(c)(3)(i),
or under Sec. 1.199A-9(j)(3)(i)(B), then the Specified Cooperative must
treat those patronage gross receipts as oil-related DGPR.
(iv) Oil includes oil recovered from both conventional and non-
conventional recovery methods, including crude oil, shale oil, and oil
recovered from tar/oil sands. The primary product from oil includes all
products derived from the destructive distillation of oil, including
volatile products, light oils such as motor fuel and kerosene,
distillates such as naphtha, lubricating oils, greases and waxes, and
residues such as fuel oil. The primary product from gas means all gas
and associated hydrocarbon components from gas wells or oil wells,
whether recovered at the lease or upon further processing, including
natural gas, condensates, liquefied petroleum gases such as ethane,
propane, and butane, and liquid products such as natural gasoline. The
primary products from oil and gas provided in this paragraph (b)(7)(iv)
are not intended to represent either the
[[Page 376]]
only primary products from oil or gas, or the only processes from which
primary products may be derived under existing and future technologies.
Examples of non-primary products include, but are not limited to,
petrochemicals, medicinal products, insecticides, and alcohols.
(c) Exempt Specified Cooperatives--(1) In general. This paragraph
(c) applies only to exempt Specified Cooperatives.
(2) Two section 199A(g) deductions. The Specified Cooperative must
calculate two separate section 199A(g) deductions, one patronage sourced
and the other nonpatronage sourced, unless a Specified Cooperative
treats all of its nonpatronage gross receipts and related deductions as
patronage as described in paragraph (b)(2)(ii) of this section.
Patronage and nonpatronage gross receipts, related COGS that are
allocable to DPGR, and other expenses, losses, or deductions (other than
the section 199A(g) deduction) that are properly allocable to DPGR
(deductions), DPGR, QPAI, NOLs, W-2 wages, etc. are not netted to
calculate these two separate section 199A(g) deductions.
(3) Exempt Specified Cooperative patronage section 199A(g)
deduction. The Specified Cooperative calculates its patronage section
199A(g) deduction following steps 1 through 4 in paragraphs (b)(2)
through (5) of this section as if it were a nonexempt Specified
Cooperative.
(4) Exempt Specified Cooperative nonpatronage section 199A(g)
deduction--(i) In general. The Specified Cooperative calculates its
nonpatronage section 199A(g) deduction following steps 2 through 4 in
paragraphs (b)(2) through (5) of this section using only nonpatronage
gross receipts and related nonpatronage deductions, unless a Specified
Cooperative treats all of its nonpatronage gross receipts and related
deductions as patronage as described in paragraph (b)(2)(ii) of this
section. For purposes of determining the amount of the nonpatronage
section 199A(g) deduction allowed under paragraph (b)(5)(ii) of this
section, taxable income is limited to taxable income and related
deductions from nonpatronage sources. Nonpatronage NOLs reduce taxable
income. Taxable income is computed without taking into account the
section 199A(g) deduction or any deduction allowable under section
1382(c).
(ii) Use of nonpatronage section 199A(g) deduction. Except as
provided in Sec. 1.199A-12(c)(2) related to the rules for EAGs, the
nonpatronage section 199A(g) deduction cannot create or increase a
nonpatronage NOL or the amount of nonpatronage NOL carryover or
carryback, if applicable, in accordance with section 172. A Specified
Cooperative cannot pass through its nonpatronage section 199A(g)
deduction under paragraph (d) of this section and can apply the
nonpatronage section 199A(g) deduction only against its nonpatronage
income and deductions. As is the case for the patronage section 199A(g)
deduction, the nonpatronage section 199A(g) deduction that a Specified
Cooperative does not use in the appropriate taxable year is lost.
(d) Discretion to pass through deduction--(1) Permitted amount (i)
In general. A Specified Cooperative may, at its discretion, pass through
all, some, or none of its patronage section 199A(g) deduction to all
patrons. Only eligible taxpayers as defined in section 199A(g)(2)(D) may
claim the section 199A(g) deduction that is passed through. A Specified
Cooperative member of a federated cooperative may pass through the
patronage section 199A(g) deduction it receives from the federated
cooperative to its member patrons.
(ii) Specified Cooperative identifies eligibility of patron. If a
Specified Cooperative determines that a patron is not an eligible
taxpayer, then the Specified Cooperative may, at its discretion, retain
any of the patronage section 199A(g) deduction attributable to the
patron that would otherwise be passed through and lost under the general
rule in paragraph (d)(1)(i) of this section.
(2) Amount of deduction being passed through--(i) In general. A
Specified Cooperative is permitted to pass through an amount equal to
the portion of the Specified Cooperative's section 199A(g) deduction
that is allowed with respect to the portion of the cooperative's QPAI
that is attributable to the qualified payments the Specified Cooperative
distributed to the patron during
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the taxable year and identified on the notice required in Sec. 1.199A-
7(f)(3) on an attachment to or on the Form 1099-PATR, Taxable
Distributions Received From Cooperatives (Form 1099-PATR), (or any
successor form) issued by the Specified Cooperative to the patron,
unless otherwise provided by the instructions to the Form 1099-PATR. The
notice requirement to pass through the section 199A(g) deduction is in
paragraph (d)(3) of this section.
(ii) Qualified payment means any amount of a patronage dividend or
per-unit retain allocation, as described in section 1385(a)(1) or (3)
received by a patron from a Specified Cooperative that is attributable
to the portion of the Specified Cooperative's QPAI, for which the
cooperative is allowed a section 199A(g) deduction. For this purpose,
patronage dividends include any advances on patronage and per-unit
retain allocations include per-unit retains paid in money during the
taxable year.
(3) Notice requirement to pass through deduction. A Specified
Cooperative must identify in a written notice the amount of the section
199A(g) deduction being passed through to its patrons. This written
notice must be mailed by the Specified Cooperative to the patron no
later than the 15th day of the ninth month following the close of the
taxable year of the Specified Cooperative. The Specified Cooperative may
use the same written notice, if any, that it uses to notify the patron
of the patron's respective allocations of patronage distributions, or
may use a separate timely written notice(s) to comply with this section.
The Specified Cooperative must report the amount of section 199A(g)
deduction passed through to the patron on an attachment to or on the
Form 1099-PATR (or any successor form) issued by the Specified
Cooperative to the patron, unless otherwise provided by the instructions
to the Form 1099-PATR.
(4) Section 199A(g) deduction allocated to eligible taxpayer. An
eligible taxpayer may deduct the lesser of the section 199A(g) deduction
identified on the notice described in paragraph (d)(3) of this section
or the eligible taxpayer's taxable income in the taxable year in which
the eligible taxpayer receives the timely written notice described in
paragraph (d)(3) of this section. For this purpose, the eligible
taxpayer's taxable income is determined without taking into account the
section 199A(g) deduction being passed through to the eligible taxpayer
and after taking into account any section 199A(a) deduction allowed to
the eligible taxpayer. Any section 199A(g) deduction the eligible
taxpayer does not use in the taxable year in which the eligible taxpayer
receives the notice (received on or before the due date of the Form
1099-PATR) is lost and cannot be carried forward or back to other
taxable years. The taxable income limitation for the section 199A(a)
deduction set forth in section 199A(b)(3) and Sec. 1.199A-1(a) and (b)
does not apply to limit the deductibility of the section 199A(g)
deduction passed through to the eligible taxpayer.
(5) Special rules for eligible taxpayers that are Specified
Cooperatives. Any Specified Cooperative that receives a section 199A(g)
deduction as an eligible taxpayer can take the deduction against
patronage gross income and related deductions to the extent it relates
to its patronage gross income and related deductions. Only a patron that
is an exempt Specified Cooperative may take a section 199A(g) deduction
passed through from another Specified Cooperative if the deduction
relates to the patron Specified Cooperative's nonpatronage gross income
and related deductions.
(6) W-2 wage limitation. The W-2 wage limitation described in
paragraph (b)(5)(ii)(B) of this section is applied at the cooperative
level whether or not the Specified Cooperative chooses to pass through
some or all of the section 199A(g) deduction. Any section 199A(g)
deduction that has been passed through by a Specified Cooperative to an
eligible taxpayer is not subject to the W-2 wage limitation a second
time at the eligible taxpayer's level.
(7) Specified Cooperative denied section 1382 deduction for portion
of qualified payments. A Specified Cooperative must reduce its section
1382 deduction by an amount equal to the portion of any qualified
payment that is attributable to the Specified Cooperative's section
199A(g) deduction passed
[[Page 378]]
through. This means the Specified Cooperative must reduce its section
1382 deduction in an amount equal to the section 199A(g) deduction
passed through.
(8) No double counting. A qualified payment received by a Specified
Cooperative that is a patron of a Specified Cooperative is not taken
into account by the patron for purposes of section 199A(g).
(e) Examples. The following examples illustrate the application of
paragraphs (a), (b), (c), and (d) of this section. The examples of this
section apply solely for purposes of section 199A of the Code. Assume
for each example that the Specified Cooperative sent all required
notices to patrons on or before the due date of the Form 1099-PATR.
(1) Example 1. Nonexempt Specified Cooperative calculating section
199A(g) deduction. (i) C is a grain marketing nonexempt Specified
Cooperative, with $5,250,000 in gross receipts during 2020 from the sale
of grain grown by its patrons. C paid $4,000,000 to its patrons at the
time the grain was delivered in the form of per-unit retain allocations
and another $1,000,000 in patronage dividends after the close of the
2020 taxable year. C has other expenses of $250,000 during 2020,
including $100,000 of W-2 wages.
(ii) C has DPGR of $5,250,000 and QPAI as defined in Sec. 1.199A-
8(b)(4)(ii) of $5,000,000 for 2020. C's section 199A(g) deduction is
equal to the least of 9% of QPAI ($450,000), 9% of taxable income
($450,000), or 50% of W-2 wages ($50,000). C passes through the entire
section 199A(g) deduction to its patrons. Accordingly, C reduces its
$5,000,000 deduction allowable under section 1382(b) (relating to the
$1,000,000 patronage dividends and $4,000,000 per-unit retain
allocations) by $50,000.
(2) Example 2. Nonexempt Specified Cooperative determines amounts
included in QPAI and taxable income. (i) C, a nonexempt Specified
Cooperative, offers harvesting services and markets the grain of patrons
and nonpatrons. C had gross receipts from harvesting services and grain
sales, and expenses related to both. All of C's harvesting services were
performed for their patrons, and 75% of the grain sales were for
patrons.
(ii) C identifies 75% of the gross receipts and related expenses
from grain sales and 100% of the gross receipts and related expenses
from the harvesting services as patronage sourced. C identifies 25% of
the gross receipts and related expenses from grain sales as nonpatronage
sourced.
(iii) C does not include any nonpatronage gross receipts or related
expenses from grain sales in either QPAI or taxable income when
calculating the section 199A(g) deduction. C's QPAI includes the
patronage DPGR, less related expenses (allocable COGS, wages and other
expenses). C's taxable income includes the patronage gross receipts,
whether such gross receipts are DPGR or non-DPGR.
(iv) C allocates and reports patronage dividends to its harvesting
patrons and grain marketing patrons. C also notifies its grain marketing
patrons (in accordance with the requirements of Sec. 1.199A-7(f)(3))
that their patronage dividends are qualified payments used in C's
section 199A(g) computation. The patrons must use this information for
purposes of computing their section 199A(b)(7) reduction to their
section 199A(a) deduction (see Sec. 1.199A-7(f)).
(3) Example 3. Nonexempt Specified Cooperative with patronage and
nonpatronage gross receipts and related deductions. (i) C, a nonexempt
Specified Cooperative, markets corn grown by its patrons in the United
States. For the calendar year ending December 31, 2020, C derives gross
receipts from the marketing activity of $1,800. Such gross receipts
qualify as DPGR. Assume C has $800 of expenses (including COGS, other
expenses, and $400 of W-2 wages) properly allocable to DPGR, and a
$1,000 deduction allowed under section 1382(b). C also derives gross
receipts from nonpatronage sources in the amount of $500, and has
nonpatronage deductions in the amount of $400 (including COGS, other
expenses, and $100 of W-2 wages).
(ii) C does not include any gross receipts or deductions from
nonpatronage sources when calculating the deduction under paragraph
(b)(5)(ii) of this section. C's QPAI and taxable income both equal
$1,000 ($1,800-800). C's deduction under paragraph (b)(5)(ii) of this
section for the taxable year is equal to $90 (9% of $1,000), which does
[[Page 379]]
not exceed $200 (50% of C's W-2 wages properly allocable to DPGR).C
passes through $90 of the deduction to patrons and C reduces its section
1382(b) deduction by $90.
(4) Example 4. Exempt Specified Cooperative with patronage and
nonpatronage income and deductions. (i) C, an exempt Specified
Cooperative, markets corn MPGE by its patrons in the United States. For
the calendar year ending December 31, 2020, C derives gross receipts
from the marketing activity of $1,800. For this activity assume C has
$800 of expenses (including COGS, other expenses, and $400 of W-2 wages)
properly allocable to DPGR, and a $1,000 deduction under section
1382(b). C also derives gross receipts from nonpatronage sources in the
amount of $500. Assume the gross receipts qualify as DPGR. For this
activity assume C has $400 of expenses (including COGS, other expenses,
and $20 of W-2 wages) properly allocable to DPGR and no deduction under
section 1382(c).
(ii) C calculates two separate section 199A(g) deduction amounts.
C's section 199A(g) deduction attributable to patronage sources is the
same as the deduction calculated by the nonexempt Specified Cooperative
in Example 3 in paragraph (e)(3) of this section.
(iii) C's nonpatronage QPAI and taxable income is equal to $100
($500-$400). C's deduction under paragraph (c)(4) of this section that
directs C to use paragraph (b)(5)(ii) of this section attributable to
nonpatronage sources is equal to $9 (9% of $100), which does not exceed
$10 (50% of C's W-2 wages properly allocable to DPGR). C cannot pass
through any of the nonpatronage section 199A(g) deduction amount to its
patrons.
(5) Example 5. NOL. (i) In 2021, E, a nonexempt Specified
Cooperative that is not part of an EAG, generates QPAI and taxable
income of $100 (without taking into account any section 1382(b)
deductions, NOLs, or the section 199A(g) deduction). E pays out
patronage dividends of $91 that are deductible under section 1382(b). E
has an NOL carryover of $500 attributable to losses incurred prior to
2018. While taxable income and QPAI do not take into account the section
1382(b) deduction, taxable income does take into account NOLs. When
calculating its section 199A(g) deduction, E must take into account the
NOL carryover when calculating taxable income, unless the taxable income
is the result of not taking into account any deduction allowable under
section 1382(b). In this case $91 of taxable income is the result of not
taking into account the deduction allowed under section 1382(b) and the
remaining $9 should be reduced by the NOL carryover so that taxable
income equals $91. E calculates a section 199A(g) deduction of $8.19
(.09 x $91 (which is the lesser of $100 QPAI or $91 taxable income)).
(ii) E may pass through the entire $8.19 of section 199A(g)
deduction to patrons (which will reduce its section 1382(b) deduction
from $91 to $82.81). However, if E does not pass the deduction through,
paragraph (b)(6) of this section prohibits E from claiming any of the
section 199A(g) deduction in 2021.
(iii) If E passes through the deduction to patrons, E's taxable
income under section 172(b)(2) for NOL absorption purposes is $9 ($100-
$82.81-$9 NOL-$8.19 section 199A(g) deduction). If E does not pass
through the deduction, then E's taxable income under section 172(b)(2)
for NOL absorption purposes is $9 ($100-$91-$9 NOL).
(iv) Assuming E passes through the deduction to patrons, E would use
$9 of the NOL carryover and have a $491 NOL carryover remaining. To the
extent E does not pass through the deduction, E would still use $9 of
the NOL carryover and have a $491 NOL carryover remaining.
(6) Example 6. Nonexempt Specified Cooperative not passing through
the section 199A(g) deduction to patrons. (i) D, a nonexempt Specified
Cooperative, markets corn grown by its patrons within the United States.
For its calendar year ended December 31, 2020, D has gross receipts of
$1,500,000, all derived from the sale of corn grown by its patrons
within the United States. D pays $300,000 for its patrons' corn at the
time the grain was delivered in the form of per-unit retain allocations
and its W-2 wages (as defined in Sec. 1.199A-11) for 2020 total
$300,000. D has no other costs. Patron A is a patron of D. Patron A is a
cash basis taxpayer and files Federal income tax returns on a calendar
year basis. All corn grown by
[[Page 380]]
Patron A in 2020 is sold through D and Patron A is eligible to share in
patronage dividends paid by D for that year.
(ii) All of D's gross receipts from the sale of its patrons' corn
qualify as DPGR (as defined paragraph (8)(b)(3)(ii) of this section).
D's QPAI and taxable income is $1,200,000. D's section 199A(g) deduction
for its taxable year 2020 is $108,000 (.09 x $1,200,000). Because this
amount is less than 50% of D's W-2 wages, the entire amount is allowed
as a section 199A(g) deduction.D decides not to pass any of its section
199A(g) deduction to its patrons. The section 199A(g) deduction of
$108,000 is applied to, and reduces, D's taxable income.
(7) Example 7. Nonexempt Specified Cooperative passing through the
section 199A(g) deduction to patrons paid a patronage dividend. (i) The
facts are the same as in Example 6 except that D decides to pass its
entire section 199A(g) deduction through to its patrons. D declares a
patronage dividend for its 2020 taxable year of $900,000, which it pays
on March 15, 2021.Pursuant to paragraph (d)(3) of this section, D
notifies patrons in written notices that accompany the patronage
dividend notification that D is allocating to them the section 199A(g)
deduction D is entitled to claim in the calendar year 2020.On March 15,
2021, Patron A receives a $9,000 patronage dividend that is a qualified
payment under paragraph (d)(2)(ii) of this section from D. In the notice
that accompanies the patronage dividend, Patron A is designated a $1,080
section 199A(g) deduction. Under paragraph (a) of this section, Patron A
may claim a $1,080 section 199A(g) deduction for the taxable year ending
December 31, 2021, subject to the limitations set forth under paragraph
(d)(4) of this section.
(ii) Under paragraph (d)(7) of this section, D is required to reduce
its section 1382 deduction of $1,200,000 by the $108,000 section 199A(g)
deduction passed through to patrons (whether D pays patronage dividends
on book or Federal income tax net earnings). As a consequence, D is
entitled to a section 1382 deduction for the taxable year ending
December 31, 2020, in the amount of $1,092,000 ($1,200,000-$108,000) and
to a section 199A(g) deduction in the amount of $108,000 ($1,200,000 x
.09).
(8) Example 8. Nonexempt Specified Cooperative passing through the
section 199A(g) deduction to patrons paid a patronage dividend and
advances on expected patronage net earnings. (i) The facts are the same
as in Example 6 except that D paid out $500,000 to its patrons as
advances on expected patronage net earnings. In 2020, D pays its patrons
a $400,000 ($900,000-$500,000 already paid) patronage dividend in cash
or a combination of cash and qualified written notices of allocation.
Under paragraph (d)(7) of this section and section 1382, D is allowed a
deduction of $1,092,000 ($1,200,000-$108,000 section 199A(g) deduction),
whether patronage net earnings are distributed on book or Federal income
tax net earnings.
(ii) The patrons will have received a gross amount of $1,200,000 in
qualified payments under paragraph (d)(2)(ii) of this section from
Cooperative D ($300,000 paid as per-unit retain allocations, $500,000
paid during the taxable year as advances, and the additional $400,000
paid as patronage dividends). If D passes through its entire section
199A(g) deduction to its patrons by providing the notice required by
paragraph (d)(3) of this section, then the patrons will be allowed a
$108,000 section 199A(g) deduction, resulting in a net $1,092,000
taxable distribution from D. Pursuant to paragraph (d)(8) of this
section, any of the $1,200,000 received by patrons that are Specified
Cooperatives from D is not taken into account for purposes of
calculating the patrons' section 199A(g) deduction.Patrons that are not
Specified Cooperatives must include those payments in the section
199A(b)(7) reduction when calculating a section 199A(a) deduction as
applicable.
(9) Example 9. Intangible property transaction as part of
disposition of agricultural or horticultural products. F, a Specified
Cooperative, markets patrons' oranges by processing the oranges into
orange juice, and then bottling and selling the orange juice to
customers. F markets the orange juice under its own brand name, but F
also licenses from G, an unrelated third party, the rights to use G's
brand name on the bottled orange juice. F's gross receipts from the sale
of both brands of
[[Page 381]]
orange juice qualify as DPGR, assuming all other requirements of this
section are met.
(10) Example 10. Intangible property transaction that is not a
disposition of an agricultural or horticultural product. H, a Specified
Cooperative, licenses H's brand name to J, an unrelated third party. J
purchases oranges, produces orange juice, and then bottles and sells the
orange juice to customers. Gross receipts that H derives from the
license of the brand name to J are not DPGR from the disposition of an
agricultural or horticultural product.
(11) Example 11. Allocation rules when Specified Cooperative retains
the section 199A(g) deduction attributable to non-eligible taxpayers. K,
a Specified Cooperative, for the taxable year has $200 of taxable income
and QPAI ($100 is attributable to business done for patrons that are C
corporation patrons and $100 is attributable to business done for
patrons that are eligible taxpayers). K calculates an $18 section
199A(g) deduction. K passes through $9 to its patrons that are eligible
taxpayers, distributes $191 to patrons in distributions that are
deductible under section 1382(b) (including patronage dividends that
were paid out in the same amounts to C corporation patrons and eligible
taxpayer patrons because the value of their business,$100 each, was the
same), and adjusts its deduction under section 1382 by $9 (the amount of
the section 199A(g) deduction passed through). K's taxable income after
the section 199A deduction and distributions is $0.
(f) Special rule for Specified Cooperative partners. In the case
described in section 199A(g)(5)(B), where a Specified Cooperative is a
partner in a partnership, the partnership must separately identify and
report on the Schedule K-1 of the Form 1065, U.S. Return of Partnership
Income (or any successor form) issued to the Specified Cooperative
partner the cooperative's share of gross receipts and related
deductions, W-2 wages, and COGS, unless otherwise provided by the
instructions to the Form. The Specified Cooperative partner determines
what gross receipts reported by the partnership qualify as DPGR and
includes these gross receipts and related deductions, W-2 wages, and
COGS to calculate one section 199A(g) deduction (in the case of a
nonexempt Specified Cooperative) or two section 199A(g) deductions (in
the case of an exempt Specified Cooperative) using the steps set forth
in paragraphs (b) and (c) of this section. For purposes of determining
whether gross receipts are DPGR, the MPGE activities of the Specified
Cooperative partner may be attributed to the partnership, and the
partnership's MPGE activities may be attributed to the Specified
Cooperative partner.
(g) Recapture of section 199A(g) deduction. If the amount of the
section 199A(g) deduction that was passed through to eligible taxpayers
exceeds the amount allowable as a section 199A(g) deduction as
determined on examination or reported on an amended return, then
recapture of the excess will occur at the Specified Cooperative level in
the taxable year the Specified Cooperative took the excess section
199A(g) deduction.
(h) Applicability date. Except as provided in paragraph (h)(2) of
Sec. 1.199A-7, the provisions of this section apply to taxable years
beginning after January 19, 2021. Taxpayers, however, may choose to
apply the rules of Sec. Sec. 1.199A-7 through 1.199A-12 for taxable
years beginning on or before that date, provided the taxpayers apply the
rules in their entirety and in a consistent manner.
[T.D. 9947, 86 FR 5569, Jan. 19, 2021, as amended by 87 FR 68899, Nov.
17, 2022]
Sec. 1.199A-9 Domestic production gross receipts.
(a) Domestic production gross receipts--(1) In general. The
provisions of this section apply solely for purposes of section 199A(g)
of the Internal Revenue Code (Code). The provisions of this section
provide guidance to determine what gross receipts (defined in Sec.
1.199A-8(b)(2)(iii)) are domestic production gross receipts (DPGR)
(defined in Sec. 1.199A-8(b)(3)(ii)). DPGR does not include gross
receipts derived from services or the lease, rental, license, sale,
exchange, or other disposition of land unless a de minimis or other
exception applies. Partners, including partners in an EAG partnership
described in
[[Page 382]]
Sec. 1.199A-12(i)(1), may not treat guaranteed payments under section
707(c) as DPGR.
(2) Application to marketing cooperatives. For purposes of
determining DPGR, a Specified Cooperative (defined in Sec. 1.199A-
8(a)(2)) will be treated as having manufactured, produced, grown, or
extracted (MPGE) (defined in paragraph (f) of this section) in whole or
significant part (defined in paragraph (h) of this section) any
agricultural or horticultural product (defined in Sec. 1.199A-8(a)(4))
within the United States (defined in paragraph (i) of this section)
marketed by the Specified Cooperative which its patrons (defined in
Sec. 1.1388-1(e)) have so MPGE.
(b) Related persons--(1) In general. Pursuant to section
199A(g)(3)(D)(ii), DPGR does not include any gross receipts derived from
agricultural or horticultural products leased, licensed, or rented by
the Specified Cooperative for use by any related person. A person is
treated as related to another person if both persons are treated as a
single employer under either section 52(a) or (b) (without regard to
section 1563(b)), or section 414(m) or (o). Any other person is an
unrelated person for purposes of the section 199A(g) deduction.
(2) Exceptions. Notwithstanding paragraph (b)(1) of this section,
gross receipts derived from any agricultural or horticultural product
leased or rented by the Specified Cooperative to a related person may
qualify as DPGR if the agricultural or horticultural product is held for
sublease or rent, or is subleased or rented, by the related person to an
unrelated person for the ultimate use of the unrelated person.
Similarly, notwithstanding paragraph (b)(1) of this section, gross
receipts derived from a license of the right to reproduce an
agricultural or horticultural product to a related person for
reproduction and sale, exchange, lease, or rental to an unrelated person
for the ultimate use of the unrelated person are treated as gross
receipts from a disposition of an agricultural or horticultural product
and may qualify as DPGR.
(c) Allocating gross receipts--(1) In general. A Specified
Cooperative must determine the portion of its gross receipts for the
taxable year that is DPGR and the portion of its gross receipts that is
non-DPGR using a reasonable method based on all the facts and
circumstances. Applicable Federal income tax principles apply to
determine whether a transaction is, in substance, a lease, rental,
license, sale, exchange, or other disposition the gross receipts of
which may constitute DPGR, whether it is a service the gross receipts of
which may constitute non-DPGR, or some combination thereof. For example,
if a Specified Cooperative sells an agricultural or horticultural
product and, in connection with that sale, also provides services, the
Specified Cooperative must allocate its gross receipts from the
transaction using a reasonable method based on all the facts and
circumstances that accurately identifies the gross receipts that
constitute DPGR and non-DPGR in accordance with the requirements of
Sec. 1.199A-8(b) and/or (c). The chosen reasonable method must be
consistently applied from one taxable year to another and must clearly
reflect the portion of gross receipts for the taxable year that is DPGR
and the portion of gross receipts that is non-DPGR. The books and
records maintained for gross receipts must be consistent with any
allocations under this paragraph (c)(1).
(2) Reasonable method of allocation. If a Specified Cooperative has
the information readily available and can, without undue burden or
expense, specifically identify whether the gross receipts are derived
from an item (and thus, are DPGR), then the Specified Cooperative must
use that specific identification to determine DPGR. If the Specified
Cooperative does not have information readily available to specifically
identify whether gross receipts are derived from an item or cannot,
without undue burden or expense, specifically identify whether gross
receipts are derived from an item, then the Specified Cooperative is not
required to use a method that specifically identifies whether the gross
receipts are derived from an item but can use a reasonable allocation
method. Factors taken into consideration in determining whether the
Specified Cooperative's method of allocating gross receipts between DPGR
and non-DPGR
[[Page 383]]
is reasonable include whether the Specified Cooperative uses the most
accurate information available; the relationship between the gross
receipts and the method used; the accuracy of the method chosen as
compared with other possible methods; whether the method is used by the
Specified Cooperative for internal management or other business
purposes; whether the method is used for other Federal or state income
tax purposes; the time, burden, and cost of using alternative methods;
and whether the Specified Cooperative applies the method consistently
from year to year.
(3) De minimis rules--(i) DPGR. A Specified Cooperative's applicable
gross receipts as provided in Sec. 1.199A-8(b) and/or (c) may be
treated as DPGR if less than 10 percent of the Specified Cooperative's
total gross receipts are non-DPGR (after application of the exceptions
provided in Sec. 1.199A-9(j)(3)). If the amount of the Specified
Cooperative's gross receipts that are non-DPGR equals or exceeds 10
percent of the Specified Cooperative's total gross receipts, then,
except as provided in paragraph (c)(3)(ii) of this section, the
Specified Cooperative is required to allocate all gross receipts between
DPGR and non-DPGR in accordance with paragraph (c)(1) of this section.
If a Specified Cooperative is a member of an expanded affiliated group
(EAG) (defined in Sec. 1.199A-12), but is not a member of a
consolidated group, then the determination of whether less than 10
percent of the Specified Cooperative's total gross receipts are non-DPGR
is made at the Specified Cooperative level. If a Specified Cooperative
is a member of a consolidated group, then the determination of whether
less than 10 percent of the Specified Cooperative's total gross receipts
are non-DPGR is made at the consolidated group level. See Sec. 1.199A-
12(d).
(ii) Non-DPGR. A Specified Cooperative's applicable gross receipts
as provided in Sec. 1.199A-8(b) and/or (c) may be treated as non-DPGR
if less than 10 percent of the Specified Cooperative's total gross
receipts are DPGR. If a Specified Cooperative is a member of an EAG, but
is not a member of a consolidated group, then the determination of
whether less than 10 percent of the Specified Cooperative's total gross
receipts are DPGR is made at the Specified Cooperative level. If a
Specified Cooperative is a member of a consolidated group, then the
determination of whether less than 10 percent of the Specified
Cooperative's total gross receipts are DPGR is made at the consolidated
group level.
(d) Use of historical data for multiple-year transactions. If a
Specified Cooperative recognizes and reports gross receipts from upfront
payments or other similar payments on a Federal income tax return for a
taxable year, then the Specified Cooperative's use of historical data in
making an allocation of gross receipts from the transaction between DPGR
and non-DPGR may constitute a reasonable method. If a Specified
Cooperative makes allocations using historical data, and subsequently
updates the data, then the Specified Cooperative must use the more
recent or updated data, starting in the taxable year in which the update
is made.
(e) Determining DPGR item-by-item--(1) In general. For purposes of
the section 199A(g) deduction, a Specified Cooperative determines, using
a reasonable method based on all the facts and circumstances, whether
gross receipts qualify as DPGR on an item-by-item basis (and not, for
example, on a division-by-division, product line-by-product line, or
transaction-by-transaction basis). The chosen reasonable method must be
consistently applied from one taxable year to another and must clearly
reflect the portion of gross receipts that is DPGR. The books and
records maintained for gross receipts must be consistent with any
allocations under this paragraph (e)(1).
(i) The term item means the agricultural or horticultural product
offered by the Specified Cooperative in the normal course of its trade
or business for lease, rental, license, sale, exchange, or other
disposition (for purposes of this paragraph (e), collectively referred
to as disposition) to customers, if the gross receipts from the
disposition of such product qualify as DPGR; or
(ii) If paragraph (e)(1)(i) of this section does not apply to the
product, then any component of the product described in paragraph
(e)(1)(i) of this
[[Page 384]]
section is treated as the item, provided that the gross receipts from
the disposition of the product described in paragraph (e)(1)(i) of this
section that are attributable to such component qualify as DPGR. Each
component that meets the requirements under this paragraph (e)(1)(ii)
must be treated as a separate item and a component that meets the
requirements under this paragraph (e)(1)(ii) may not be combined with a
component that does not meet these requirements.
(2) Special rules. (i) For purposes of paragraph (e)(1)(i) of this
section, in no event may a single item consist of two or more products
unless those products are offered for disposition, in the normal course
of the Specified Cooperative's trade or business, as a single item
(regardless of how the products are packaged).
(ii) In the case of agricultural or horticultural products
customarily sold by weight or by volume, the item is determined using
the most common custom of the industry (for example, barrels of oil).
(3) Exception. If the Specified Cooperative MPGE agricultural or
horticultural products within the United States that it disposes of, and
the Specified Cooperative leases, rents, licenses, purchases, or
otherwise acquires property that contains or may contain the
agricultural or horticultural products (or a portion thereof), and the
Specified Cooperative cannot reasonably determine, without undue burden
and expense, whether the acquired property contains any of the original
agricultural or horticultural products MPGE by the Specified
Cooperative, then the Specified Cooperative is not required to determine
whether any portion of the acquired property qualifies as an item for
purposes of paragraph (e)(1) of this section. Therefore, the gross
receipts derived from the disposition of the acquired property may be
treated as non-DPGR. Similarly, the preceding sentences apply if the
Specified Cooperative can reasonably determine that the acquired
property contains agricultural or horticultural products (or a portion
thereof) MPGE by the Specified Cooperative, but cannot reasonably
determine, without undue burden or expense, how much, or what type,
grade, etc., of the agricultural or horticultural MPGE by the Specified
Cooperative the acquired property contains.
(f) Definition of manufactured, produced, grown, or extracted
(MPGE)--(1) In general. Except as provided in paragraphs (f)(2) and (3)
of this section, the term MPGE includes manufacturing, producing,
growing, extracting, installing, developing, improving, and creating
agricultural or horticultural products; making agricultural or
horticultural products out of material by processing, manipulating,
refining, or changing the form of an article, or by combining or
assembling two or more articles; cultivating soil, raising livestock,
and farming aquatic products. The term MPGE also includes storage,
handling, or other processing activities (other than transportation
activities) within the United States related to the sale, exchange, or
other disposition of agricultural or horticultural products only if the
products are consumed in connection with or incorporated into the MPGE
of agricultural or horticultural products, whether or not by the
Specified Cooperative. The Specified Cooperative (or the patron if Sec.
1.199A-9(a)(2) applies) must have the benefits and burdens of ownership
of the agricultural or horticultural products under Federal income tax
principles during the period the MPGE activity occurs for the gross
receipts derived from the MPGE of the agricultural or horticultural
products to qualify as DPGR.
(2) Packaging, repackaging, or labeling. If the Specified
Cooperative packages, repackages, or labels agricultural or
horticultural products and engages in no other MPGE activity with
respect to those agricultural or horticultural products, the packaging,
repackaging, or labeling does not qualify as MPGE with respect to those
agricultural or horticultural products.
(3) Installing. If a Specified Cooperative installs agricultural or
horticultural products and engages in no other MPGE activity with
respect to the agricultural or horticultural products, the Specified
Cooperative's installing activity does not qualify as an MPGE activity.
Notwithstanding paragraph (j)(3)(i)(A) of this section, if the
[[Page 385]]
Specified Cooperative installs agricultural or horticultural products
MPGE by the Specified Cooperative and the Specified Cooperative has the
benefits and burdens of ownership of the agricultural or horticultural
products under Federal income tax principles during the period the
installing activity occurs, then the portion of the installing activity
that relates to the agricultural or horticultural products is an MPGE
activity.
(4) Consistency with section 263A. A Specified Cooperative that has
MPGE agricultural or horticultural products for the taxable year must
treat itself as a producer under section 263A with respect to the
agricultural or horticultural products unless the Specified Cooperative
is not subject to section 263A. A Specified Cooperative that currently
is not properly accounting for its production activities under section
263A, and wishes to change its method of accounting to comply with the
producer requirements of section 263A, must follow the applicable
administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for
obtaining the Commissioner's consent to a change in accounting method
(for further guidance, for example, see Rev. Proc. 2015-13, 2015-5 IRB
419, or any applicable subsequent guidance (see Sec. 601.601(d)(2) of
this chapter)).
(5) Examples. The following examples illustrate the application of
paragraphs (f)(1), (2), and (3) of this section.
(i) Example 1. MPGE activities conducted within United States. A, B,
and C are unrelated persons. A is a Specified Cooperative, B is an
individual patron of A, and C is a C corporation. B grows agricultural
products outside of the United States and A markets those agricultural
products for B. A stores the agricultural products in agricultural
storage bins in the United States and has the benefits and burdens of
ownership under Federal income tax principles of the agricultural
products while they are being stored. A sells the agricultural products
to C, who processes them into refined agricultural products in the
United States. The gross receipts from A's activities are DPGR from the
MPGE of agricultural products.
(ii) Example 2. MPGE activities conducted within and outside United
States. The facts are the same as in Example 1 except that B grows the
agricultural products outside the United States and C processes them
into refined agricultural products outside the United States. Pursuant
to paragraph (f)(1) of this section, the gross receipts derived by A
from its sale of the agricultural products to C are DPGR from the MPGE
of agricultural products within the United States.
(g) By the taxpayer. With respect to the exception of the rules
applicable to an EAG and EAG partnerships under Sec. 1.199A-12, only
one Specified Cooperative may claim the section 199A(g) deduction with
respect to any qualifying activity under paragraph (f) of this section
performed in connection with the same agricultural or horticultural
product. If an unrelated party performs a qualifying activity under
paragraph (f) of this section pursuant to a contract with a Specified
Cooperative (or its patron as relevant under paragraph (a)(2) of this
section), then only if the Specified Cooperative (or its patron) has the
benefits and burdens of ownership of the agricultural or horticultural
product under Federal income tax principles during the period in which
the qualifying activity occurs is the Specified Cooperative (or its
patron) treated as engaging in the qualifying activity.
(h) In whole or significant part defined--(1) In general.
Agricultural or horticultural products must be MPGE in whole or
significant part by the Specified Cooperative (or its patrons in the
case described in paragraph (a)(2) of this section) and in whole or
significant part within the United States to qualify under section
199A(g)(3)(D)(i). If a Specified Cooperative enters into a contract with
an unrelated person for the unrelated person to MPGE agricultural or
horticultural products for the Specified Cooperative and the Specified
Cooperative has the benefits and burdens of ownership of the
agricultural or horticultural products under applicable Federal income
tax principles during the period the MPGE activity occurs, then,
pursuant to paragraph (g) of this section, the Specified Cooperative is
considered to MPGE the agricultural
[[Page 386]]
or horticultural products under this section. The unrelated person must
perform the MPGE activity on behalf of the Specified Cooperative in
whole or significant part within the United States in order for the
Specified Cooperative to satisfy the requirements of this paragraph
(h)(1).
(2) Substantial in nature. Agricultural or horticultural products
will be treated as MPGE in whole or in significant part by the Specified
Cooperative (or its patrons in the case described in paragraph (a)(2) of
this section) within the United States for purposes of paragraph (h)(1)
of this section. However, MPGE of the agricultural or horticultural
products by the Specified Cooperative within the United States must be
substantial in nature taking into account all the facts and
circumstances, including the relative value added by, and relative cost
of, the Specified Cooperative's MPGE within the United States, the
nature of the agricultural or horticultural products, and the nature of
the MPGE activity that the Specified Cooperative performs within the
United States. The MPGE of a key component of an agricultural or
horticultural product does not, in itself, meet the substantial-in-
nature requirement with respect to an agricultural or horticultural
product under this paragraph (h)(2). In the case of an agricultural or
horticultural product, research and experimental activities under
section 174 and the creation of intangible assets are not taken into
account in determining whether the MPGE of the agricultural or
horticultural product is substantial in nature.
(3) Safe harbor--(i) In general. A Specified Cooperative (or its
patrons in the case described in paragraph (a)(2) of this section) will
be treated as having MPGE an agricultural or horticultural product in
whole or in significant part within the United States for purposes of
paragraph (h)(1) of this section if the direct labor and overhead of
such Specified Cooperative to MPGE the agricultural or horticultural
product within the United States account for 20 percent or more of the
Specified Cooperative's COGS of the agricultural or horticultural
product, or in a transaction without COGS (for example, a lease, rental,
or license), account for 20 percent or more of the Specified
Cooperative's unadjusted depreciable basis (as defined in paragraph
(h)(3)(ii) of this section) in property included in the definition of
agricultural or horticultural products. For Specified Cooperatives
subject to section 263A, overhead is all costs required to be
capitalized under section 263A except direct materials and direct labor.
For Specified Cooperatives not subject to section 263A, overhead may be
computed using a reasonable method based on all the facts and
circumstances, but may not include any cost, or amount of any cost, that
would not be required to be capitalized under section 263A if the
Specified Cooperative were subject to section 263A. Research and
experimental expenditures under section 174 and the costs of creating
intangible assets are not taken into account in determining direct labor
or overhead for any agricultural or horticultural product. In the case
of agricultural or horticultural products, research and experimental
expenditures under section 174 and any other costs incurred in the
creation of intangible assets may be excluded from COGS or unadjusted
depreciable basis for purposes of determining whether the Specified
Cooperative meets the safe harbor under this paragraph (h)(3). For
Specified Cooperatives not subject to section 263A, the chosen
reasonable method to compute overhead must be consistently applied from
one taxable year to another and must clearly reflect the Specified
Cooperative's portion of overhead not subject to section 263A. The
method must also be reasonable based on all the facts and circumstances.
The books and records maintained for overhead must be consistent with
any allocations under this paragraph (h)(3)(i).
(ii) Unadjusted depreciable basis. The term unadjusted depreciable
basis means the basis of property for purposes of section 1011 without
regard to any adjustments described in section 1016(a)(2) and (3). This
basis does not reflect the reduction in basis for--
(A) Any portion of the basis the Specified Cooperative properly
elects to treat as an expense under sections 179 or 179C; or
[[Page 387]]
(B) Any adjustments to basis provided by other provisions of the
Code and the regulations under the Code (for example, a reduction in
basis by the amount of the disabled access credit pursuant to section
44(d)(7)).
(4) Special rules--(i) Contract with an unrelated person. If a
Specified Cooperative enters into a contract with an unrelated person
for the unrelated person to MPGE an agricultural or horticultural
product within the United States for the Specified Cooperative, and the
Specified Cooperative is considered to MPGE the agricultural or
horticultural product pursuant to paragraph (f)(1) of this section,
then, for purposes of the substantial-in-nature requirement under
paragraph (h)(2) of this section and the safe harbor under paragraph
(h)(3)(i) of this section, the Specified Cooperative's MPGE activities
or direct labor and overhead must include both the Specified
Cooperative's MPGE activities or direct labor and overhead to MPGE the
agricultural or horticultural product within the United States as well
as the MPGE activities or direct labor and overhead of the unrelated
person to MPGE the agricultural or horticultural product within the
United States under the contract.
(ii) Aggregation. In determining whether the substantial-in-nature
requirement under paragraph (h)(2) of this section or the safe harbor
under paragraph (h)(3)(i) of this section is met at the time the
Specified Cooperative disposes of an agricultural or horticultural
product--
(A) An EAG member must take into account all the previous MPGE
activities or direct labor and overhead of the other members of the EAG;
(B) An EAG partnership as defined in Sec. 1.199A-12(i)(1) must take
into account all of the previous MPGE activities or direct labor and
overhead of all members of the EAG in which the partners of the EAG
partnership are members (as well as the previous MPGE activities of any
other EAG partnerships owned by members of the same EAG); and
(C) A member of an EAG in which the partners of an EAG partnership
are members must take into account all of the previous MPGE activities
or direct labor and overhead of the EAG partnership (as well as those of
any other members of the EAG and any previous MPGE activities of any
other EAG partnerships owned by members of the same EAG).
(i) United States defined. For purposes of section 199A(g), the term
United States includes the 50 states, the District of Columbia, the
territorial waters of the United States, and the seabed and subsoil of
those submarine areas that are adjacent to the territorial waters of the
United States and over which the United States has exclusive rights, in
accordance with international law, with respect to the exploration and
exploitation of natural resources. Consistent with its definition in
section 7701(a)(9), the term United States does not include possessions
and territories of the United States or the airspace or space over the
United States and these areas.
(j) Derived from the lease, rental, license, sale, exchange, or
other disposition--(1) In general--(i) Definition. The term derived from
the lease, rental, license, sale, exchange, or other disposition is
defined as, and limited to, the gross receipts directly derived from the
lease, rental, license, sale, exchange, or other disposition of
agricultural or horticultural products even if the Specified Cooperative
has already recognized receipts from a previous lease, rental, license,
sale, exchange, or other disposition of the same agricultural or
horticultural products. Applicable Federal income tax principles apply
to determine whether a transaction is, in substance, a lease, rental,
license, sale, exchange, or other disposition, whether it is a service,
or whether it is some combination thereof.
(ii) Lease income. The financing and interest components of a lease
of agricultural or horticultural products are considered to be derived
from the lease of such agricultural or horticultural products. However,
any portion of the lease income that is attributable to services or non-
qualified property as defined in paragraph (j)(3) of this section is not
derived from the lease of agricultural or horticultural products.
(iii) Income substitutes. The proceeds from business interruption
insurance,
[[Page 388]]
governmental subsidies, and governmental payments not to produce are
treated as gross receipts derived from the lease, rental, license, sale,
exchange, or other disposition to the extent they are substitutes for
gross receipts that would qualify as DPGR.
(iv) Exchange of property--(A) Taxable exchanges. The value of
property received by the Specified Cooperative in a taxable exchange of
agricultural or horticultural products MPGE in whole or in significant
part by the Specified Cooperative within the United States is DPGR for
the Specified Cooperative (assuming all the other requirements of this
section are met). However, unless the Specified Cooperative meets all of
the requirements under this section with respect to any additional MPGE
by the Specified Cooperative of the agricultural or horticultural
products received in the taxable exchange, any gross receipts derived
from the sale by the Specified Cooperative of the property received in
the taxable exchange are non-DPGR, because the Specified Cooperative did
not MPGE such property, even if the property was an agricultural or
horticultural product in the hands of the other party to the
transaction.
(B) Safe harbor. For purposes of paragraph (j)(1)(iv)(A) of this
section, the gross receipts derived by the Specified Cooperative from
the sale of eligible property (as defined in paragraph (j)(1)(iv)(C) of
this section) received in a taxable exchange, net of any adjustments
between the parties involved in the taxable exchange to account for
differences in the eligible property exchanged (for example, location
differentials and product differentials), may be treated as the value of
the eligible property received by the Specified Cooperative in the
taxable exchange. For purposes of the preceding sentence, the taxable
exchange is deemed to occur on the date of the sale of the eligible
property received in the taxable exchange by the Specified Cooperative,
to the extent the sale occurs no later than the last day of the month
following the month in which the exchanged eligible property is received
by the Specified Cooperative. In addition, if the Specified Cooperative
engages in any further MPGE activity with respect to the eligible
property received in the taxable exchange, then, unless the Specified
Cooperative meets the in-whole-or-in-significant-part requirement under
paragraph (h)(1) of this section with respect to the property sold, for
purposes of this paragraph (j)(1)(iv)(B), the Specified Cooperative must
also value the property sold without taking into account the gross
receipts attributable to the further MPGE activity.
(C) Eligible property. For purposes of paragraph (j)(1)(iv)(B) of
this section, eligible property is--
(1) Oil, natural gas, or petrochemicals, or products derived from
oil, natural gas, or petrochemicals; or
(2) Any other property or product designated by publication in the
Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this
chapter).
(3) For this purpose, the term natural gas includes only natural gas
extracted from a natural deposit and does not include, for example,
methane gas extracted from a landfill. In the case of natural gas,
production activities include all activities involved in extracting
natural gas from the ground and processing the gas into pipeline quality
gas.
(2) Hedging transactions--(i) In general. For purposes of this
section, if a transaction is a hedging transaction within the meaning of
section 1221(b)(2)(A) and Sec. 1.1221-2(b), is properly identified as a
hedging transaction in accordance with Sec. 1.1221-2(f), and the risk
being hedged relates to property described in section 1221(a)(1) that
gives rise to DPGR or to property described in section 1221(a)(8) that
is consumed in an activity that gives rise to DPGR, then--
(A) In the case of a hedge of purchases of property described in
section 1221(a)(1), income, deduction, gain, or loss on the hedging
transaction must be taken into account in determining COGS;
(B) In the case of a hedge of sales of property described in section
1221(a)(1), income, deduction, gain, or loss on the hedging transaction
must be taken into account in determining DPGR; and
(C) In the case of a hedge of purchases of property described in
section
[[Page 389]]
1221(a)(8), income, deduction, gain, or loss on the hedging transaction
must be taken into account in determining DPGR.
(ii) Allocation. The income, deduction, gain and loss from hedging
transactions described in paragraph (j)(2) of this section must be
allocated between the patronage and nonpatronage (defined in Sec.
1.1388-1(f)) sourced income and related deductions of the Specified
Cooperatives consistent with the cooperative's method for determining
patronage and nonpatronage income and deductions.
(iii) Effect of identification and nonidentification. The principles
of Sec. 1.1221-2(g) apply to a Specified Cooperative that identifies or
fails to identify a transaction as a hedging transaction, except that
the consequence of identifying as a hedging transaction a transaction
that is not in fact a hedging transaction described in paragraph (j)(2)
of this section, or of failing to identify a transaction that the
Specified Cooperative has no reasonable grounds for treating as other
than a hedging transaction described in paragraph (j)(2) of this
section, is that deduction or loss (but not income or gain) from the
transaction is taken into account under paragraph (j)(2) of this
section.
(iv) Other rules. See Sec. 1.1221-2(e) for rules applicable to
hedging by members of a consolidated group and Sec. 1.446-4 for rules
regarding the timing of income, deductions, gains or losses with respect
to hedging transactions.
(3) Allocation of gross receipts to embedded services and non-
qualified property--(i) Embedded services and non-qualified property--
(A) In general. Except as otherwise provided in paragraph (j)(3)(i)(B)
of this section, gross receipts derived from the performance of services
do not qualify as DPGR. In the case of an embedded service, that is, a
service the price of which, in the normal course of the business, is not
separately stated from the amount charged for the lease, rental,
license, sale, exchange, or other disposition of agricultural or
horticultural products, DPGR includes only the gross receipts derived
from the lease, rental, license, sale, exchange, or other disposition of
agricultural or horticultural products (assuming all the other
requirements of this section are met) and not any receipts attributable
to the embedded service. In addition, DPGR does not include gross
receipts derived from the lease, rental, license, sale, exchange, or
other disposition of property that does not meet all of the requirements
under this section (non-qualified property). The allocation of the gross
receipts attributable to the embedded services or non-qualified property
will be deemed to be reasonable if the allocation reflects the fair
market value of the embedded services or non-qualified property.
(B) Exceptions. There are five exceptions to the rules under
paragraph (j)(3)(i)(A) of this section regarding embedded services and
non-qualified property. A Specified Cooperative may include in DPGR, if
all the other requirements of this section are met with respect to the
underlying item of agricultural or horticultural products to which the
embedded services or non-qualified property relate, the gross receipts
derived from--
(1) A qualified warranty, that is, a warranty that is provided in
connection with the lease, rental, license, sale, exchange, or other
disposition of agricultural or horticultural products if, in the normal
course of the Specified Cooperative's business--
(i)The price for the warranty is not separately stated from the
amount charged for the lease, rental, license, sale, exchange, or other
disposition of the agricultural or horticultural products; and
(ii) The warranty is neither separately offered by the Specified
Cooperative nor separately bargained for with customers (that is, a
customer cannot purchase the agricultural or horticultural products
without the warranty).
2) A qualified delivery, that is, a delivery or distribution service
that is provided in connection with the lease, rental, license, sale,
exchange, or other disposition of agricultural or horticultural products
if, in the normal course of the Specified Cooperative's business--
(i) The price for the delivery or distribution service is not
separately stated from the amount charged for the lease, rental,
license, sale, exchange, or
[[Page 390]]
other disposition of the agricultural or horticultural products; and
(ii) The delivery or distribution service is neither separately
offered by the Specified Cooperative nor separately bargained for with
customers (that is, a customer cannot purchase the agricultural or
horticultural products without the delivery or distribution service).
(3) A qualified operating manual, that is, a manual of instructions
that is provided in connection with the lease, rental, license, sale,
exchange, or other disposition of the agricultural or horticultural
products if, in the normal course of the Specified Cooperative's
business--
(i) The price for the manual is not separately stated from the
amount charged for the lease, rental, license, sale, exchange, or other
disposition of the agricultural or horticultural products;
(ii) The manual is neither separately offered by the Specified
Cooperative nor separately bargained for with customers (that is, a
customer cannot purchase the agricultural or horticultural products
without the manual); and
(iii) The manual is not provided in connection with a training
course for customers.
(4) A qualified installation, that is, an installation service for
agricultural or horticultural products that is provided in connection
with the lease, rental, license, sale, exchange, or other disposition of
the agricultural or horticultural products if, in the normal course of
the Specified Cooperative's business--
(i) The price for the installation service is not separately stated
from the amount charged for the lease, rental, license, sale, exchange,
or other disposition of the agricultural or horticultural products; and
(ii) The installation is neither separately offered by the Specified
Cooperative nor separately bargained for with customers (that is, a
customer cannot purchase the agricultural or horticultural products
without the installation service).
(5) A de minimis amount of gross receipts from embedded services and
non-qualified property for each item of agricultural or horticultural
products may qualify. For purposes of this exception, a de minimis
amount of gross receipts from embedded services and non-qualified
property is less than 5 percent of the total gross receipts derived from
the lease, rental, license, sale, exchange, or other disposition of each
item of agricultural or horticultural products. In the case of gross
receipts derived from the lease, rental, license, sale, exchange, or
other disposition of agricultural or horticultural products that are
received over a period of time (for example, a multi-year lease or
installment sale), this de minimis exception is applied by taking into
account the total gross receipts for the entire period derived (and to
be derived) from the lease, rental, license, sale, exchange, or other
disposition of the item of agricultural or horticultural products. For
purposes of the preceding sentence, if a Specified Cooperative treats
gross receipts as DPGR under this de minimis exception, then the
Specified Cooperative must treat the gross receipts recognized in each
taxable year consistently as DPGR. The gross receipts that the Specified
Cooperative treats as DPGR under paragraphs (j)(3)(i)(B)(1) through (4)
of this section are treated as DPGR for purposes of applying this de
minimis exception. This de minimis exception does not apply if the price
of a service or non-qualified property is separately stated by the
Specified Cooperative, or if the service or non-qualified property is
separately offered or separately bargained for with the customer (that
is, the customer can purchase the agricultural or horticultural products
without the service or non-qualified property).
(ii) Non-DPGR. Applicable gross receipts as provided in Sec. Sec.
1.199A-8(b) and/or (c) derived from the lease, rental, license, sale,
exchange or other disposition of an item of agricultural or
horticultural products may be treated as non-DPGR if less than 5 percent
of the Specified Cooperative's total gross receipts derived from the
lease, rental, license, sale, exchange or other disposition of that item
are DPGR (taking into account embedded services and non-qualified
property included in such disposition, but not part of the item). In the
case of gross receipts derived
[[Page 391]]
from the lease, rental, license, sale, exchange, or other disposition of
agricultural or horticultural products that are received over a period
of time (for example, a multi-year lease or installment sale), this
paragraph (j)(5)(ii) is applied by taking into account the total gross
receipts for the entire period derived (and to be derived) from the
lease, rental, license, sale, exchange, or other disposition of the item
of agricultural or horticultural products. For purposes of the preceding
sentence, if the Specified Cooperative treats gross receipts as non-DPGR
under this de minimis exception, then the Specified Cooperative must
treat the gross receipts recognized in each taxable year consistently as
non-DPGR.
(k) Applicability date. The provisions of this section apply to
taxable years beginning after January 19, 2021. Taxpayers, however, may
choose to apply the rules of Sec. Sec. 1.199A-7 through 1.199A-12 for
taxable years beginning on or before that date, provided the taxpayers
apply the rules in their entirety and in a consistent manner.
[T.D. 9947, 86 FR 5569, Jan. 19, 2021, as amended by 87 FR 68899, Nov.
17, 2022]
Sec. 1.199A-10 Allocation of cost of goods sold (COGS)
and other deductions to domestic production gross receipts
(DPGR), and other rules.
(a) In general. The provisions of this section apply solely for
purposes of section 199A(g) of the Internal Revenue Code (Code). The
provisions of this section provide additional guidance on determining
qualified production activities income (QPAI) as described and defined
in Sec. 1.199A-8(b)(4)(ii).
(b) COGS allocable to DPGR--(1) In general. When determining its
QPAI, the Specified Cooperative (defined in Sec. 1.199A-8(a)(2)) must
subtract from its DPGR (defined in Sec. 1.199A-8(b)(3)(ii)) the COGS
allocable to its DPGR. The Specified Cooperative determines its COGS
allocable to DPGR in accordance with this paragraph (b)(1) or, if
applicable, paragraph (f) of this section. In the case of a sale,
exchange, or other disposition of inventory, COGS is equal to beginning
inventory of the Specified Cooperative plus purchases and production
costs incurred during the taxable year and included in inventory costs
by the Specified Cooperative, less ending inventory of the Specified
Cooperative. In determining its QPAI, the Specified Cooperative does not
include in COGS any payment made, whether during the taxable year, or
included in beginning inventory, for which a deduction is allowed under
section 1382(b) and/or (c), as applicable. See Sec. 1.199A-
8(b)(4)(ii)(C). COGS is determined under the methods of accounting that
the Specified Cooperative uses to compute taxable income. See sections
263A, 471, and 472. If section 263A requires the Specified Cooperative
to include additional section 263A costs (as defined in Sec. 1.263A-
1(d)(3)) in inventory, additional section 263A costs must be included in
determining COGS. COGS also include the Specified Cooperative's
inventory valuation adjustments such as write-downs under the lower of
cost or market method. In the case of a sale, exchange, or other
disposition (including, for example, theft, casualty, or abandonment) by
the Specified Cooperative of non-inventory property, COGS for purposes
of this section includes the adjusted basis of the property.
(2) Allocating COGS--(i) In general. A Specified Cooperative must
use a reasonable method based on all the facts and circumstances to
allocate COGS between DPGR and non-DPGR. Whether an allocation method is
reasonable is based on all the facts and circumstances, including
whether the Specified Cooperative uses the most accurate information
available; the relationship between COGS and the method used; the
accuracy of the method chosen as compared with other possible methods;
whether the method is used by the Specified Cooperative for internal
management or other business purposes; whether the method is used for
other Federal or state income tax purposes; the availability of costing
information; the time, burden, and cost of using alternative methods;
and whether the Specified Cooperative applies the method consistently
from year to year. Depending on the facts and circumstances, reasonable
methods may include methods based on gross receipts (defined in Sec.
1.199A-8(b)(2)(iii)), number of units sold, number of units
[[Page 392]]
produced, or total production costs. Ordinarily, if a Specified
Cooperative uses a method to allocate gross receipts between DPGR and
non-DPGR, then the use of a different method to allocate COGS that is
not demonstrably more accurate than the method used to allocate gross
receipts will not be considered reasonable. However, if a Specified
Cooperative has information readily available to specifically identify
COGS allocable to DPGR and can specifically identify that amount without
undue burden or expense, COGS allocable to DPGR is that amount
irrespective of whether the Specified Cooperative uses another
allocation method to allocate gross receipts between DPGR and non-DPGR.
A Specified Cooperative that does not have information readily available
to specifically identify COGS allocable to DPGR and that cannot, without
undue burden or expense, specifically identify that amount is not
required to use a method that specifically identifies COGS allocable to
DPGR. The chosen reasonable method must be consistently applied from one
taxable year to another and must clearly reflect the portion of COGS
between DPGR and non-DPGR. The method must also be reasonable based on
all the facts and circumstances. The books and records maintained for
COGS must be consistent with any allocations under this paragraph
(b)(2).
(ii) Gross receipts recognized in an earlier taxable year. If the
Specified Cooperative (other than a Specified Cooperative that uses the
small business simplified overall method of paragraph (f) of this
section) recognizes and reports gross receipts on a Federal income tax
return for a taxable year, and incurs COGS related to such gross
receipts in a subsequent taxable year, then regardless of whether the
gross receipts ultimately qualify as DPGR, the Specified Cooperative
must allocate the COGS to--
(A) DPGR if the Specified Cooperative identified the related gross
receipts as DPGR in the prior taxable year; or
(B) Non-DPGR if the Specified Cooperative identified the related
gross receipts as non-DPGR in the prior taxable year or if the Specified
Cooperative recognized under the Specified Cooperative's methods of
accounting those gross receipts in a taxable year to which section
199A(g) does not apply.
(iii) COGS associated with activities undertaken in an earlier
taxable year--(A) In general. A Specified Cooperative must allocate its
COGS between DPGR and non-DPGR under the rules provided in paragraphs
(b)(2)(i) and (iii) of this section, regardless of whether certain costs
included in its COGS can be associated with activities undertaken in an
earlier taxable year (including a year prior to the effective date of
section 199A(g)). A Specified Cooperative may not segregate its COGS
into component costs and allocate those component costs between DPGR and
non-DPGR.
(B) Example. The following example illustrates an application of
paragraph (b)(2)(iii)(A) of this section.
(1) Example 1. During the 2020 taxable year, nonexempt Specified
Cooperative X grew and sold Horticultural Product A. All of the
patronage gross receipts from sales recognized by X in 2020 were from
the sale of Horticultural Product A and qualified as DPGR. Employee 1 of
X was involved in X's production process until he retired in 2013. In
2020, X paid $30 directly from its general assets for Employee 1's
medical expenses pursuant to an unfunded, self-insured plan for retired
X employees. For purposes of computing X's 2020 taxable income, X
capitalized those medical costs to inventory under section 263A. In
2020, the COGS for a unit of Horticultural Product A was $100 (including
the applicable portion of the $30 paid for Employee 1's medical costs
that was allocated to COGS under X's allocation method for additional
section 263A costs). X has information readily available to specifically
identify COGS allocable to DPGR and can identify that amount without
undue burden and expense because all of X's gross receipts from sales in
2020 are attributable to the sale of Horticultural Product A and qualify
as DPGR. The inventory cost of each unit of Horticultural Product A sold
in 2020, including the applicable portion of retiree medical costs, is
related to X's gross receipts from the sale of Horticultural
[[Page 393]]
Product A in 2020. X may not segregate the 2020 COGS by separately
allocating the retiree medical costs, which are components of COGS, to
DPGR and non-DPGR. Thus, even though the retiree medical costs can be
associated with activities undertaken in prior years, $100 of inventory
cost of each unit of Horticultural Product A sold in 2020, including the
applicable portion of the retiree medical expense cost component, is
allocable to DPGR in 2020.
(3) Special allocation rules. Section 199A(g)(3)(C) provides the
following two special rules--
(i) For purposes of determining the COGS that are allocable to DPGR,
any item or service brought into the United States (defined in Sec.
1.199A-9(i)) is treated as acquired by purchase, and its cost is treated
as not less than its value immediately after it entered the United
States. A similar rule applies in determining the adjusted basis of
leased or rented property where the lease or rental gives rise to DPGR.
(ii) In the case of any property described in paragraph (b)(3)(i) of
this section that has been exported by the Specified Cooperative for
further manufacture, the increase in cost or adjusted basis under
paragraph (b)(3)(i) of this section cannot exceed the difference between
the value of the property when exported and the value of the property
when brought back into the United States after the further manufacture.
For the purposes of this paragraph (b)(3), the value of property is its
customs value as defined in section 1059A(b)(1).
(4) Rules for inventories valued at market or bona fide selling
prices. If part of COGS is attributable to the Specified Cooperative's
inventory valuation adjustments, then COGS allocable to DPGR includes
inventory adjustments to agricultural or horticultural products that are
MPGE in whole or significant part within the United States. Accordingly,
a Specified Cooperative that values its inventory under Sec. 1.471-4
(inventories at cost or market, whichever is lower) or Sec. 1.471-2(c)
(subnormal goods at bona fide selling prices) must allocate a proper
share of such adjustments (for example, write-downs) to DPGR based on a
reasonable method based on all the facts and circumstances. Factors
taken into account in determining whether the method is reasonable
include whether the Specified Cooperative uses the most accurate
information available; the relationship between the adjustment and the
allocation base chosen; the accuracy of the method chosen as compared
with other possible methods; whether the method is used by the Specified
Cooperative for internal management or other business purposes; whether
the method is used for other Federal or state income tax purposes; the
time, burden, and cost of using alternative methods; and whether the
Specified Cooperative applies the method consistently from year to year.
If the Specified Cooperative has information readily available to
specifically identify the proper amount of inventory valuation
adjustments allocable to DPGR, then the Specified Cooperative must
allocate that amount to DPGR. The Specified Cooperative that does not
have information readily available to specifically identify the proper
amount of its inventory valuation adjustments allocable to DPGR and that
cannot, without undue burden or expense, specifically identify the
proper amount of its inventory valuation adjustments allocable to DPGR,
is not required to use a method that specifically identifies inventory
valuation adjustments to DPGR. The chosen reasonable method must be
consistently applied from one taxable year to another and must clearly
reflect inventory adjustments. The method must also be reasonable based
on all the facts and circumstances. The books and records maintained for
inventory adjustments must be consistent with any allocations under this
paragraph (b)(4).
(5) Rules applicable to inventories accounted for under the last-in,
first-out inventory method--(i) In general. This paragraph (b)(5)
applies to inventories accounted for using the specific goods last-in,
first-out (LIFO) method or the dollar-value LIFO method. Whenever a
specific goods grouping or a dollar-value pool contains agricultural or
horticultural products that produce DPGR and goods that do not, the
Specified
[[Page 394]]
Cooperative must allocate COGS attributable to that grouping or pool
between DPGR and non-DPGR using a reasonable method based on all the
facts and circumstances. Whether a method of allocating COGS between
DPGR and non-DPGR is reasonable must be determined in accordance with
paragraph (b)(2) of this section. In addition, this paragraph (b)(5)
provides methods that a Specified Cooperative may use to allocate COGS
for a Specified Cooperative's inventories accounted for using the LIFO
method. If the Specified Cooperative uses the LIFO/FIFO ratio method
provided in paragraph (b)(5)(ii) of this section or the change in
relative base-year cost method provided in paragraph (b)(5)(iii) of this
section, then the Specified Cooperative must use that method for all of
the Specified Cooperative's inventory accounted for under the LIFO
method. The chosen reasonable method must be consistently applied from
one taxable year to another and must clearly reflect the inventory
method. The method must also be reasonable based on all the facts and
circumstances. The books and records maintained for the inventory method
must be consistent with any allocations under this paragraph (b)(5).
(ii) LIFO/FIFO ratio method. The LIFO/FIFO ratio method is applied
with respect to the LIFO inventory on a grouping-by-grouping or pool-by-
pool basis. Under the LIFO/FIFO ratio method, a Specified Cooperative
computes the COGS of a grouping or pool allocable to DPGR by multiplying
the COGS of agricultural or horticultural products (defined in Sec.
1.199A-8(a)(4)) in the grouping or pool that produced DPGR computed
using the FIFO method by the LIFO/FIFO ratio of the grouping or pool.
The LIFO/FIFO ratio of a grouping or pool is equal to the total COGS of
the grouping or pool computed using the LIFO method over the total COGS
of the grouping or pool computed using the FIFO method.
(iii) Change in relative base-year cost method. A Specified
Cooperative using the dollar-value LIFO method may use the change in
relative base-year cost method. The change in relative base-year cost
method for a Specified Cooperative using the dollar-value LIFO method is
applied to all LIFO inventory on a pool-by-pool basis. The change in
relative base-year cost method determines the COGS allocable to DPGR by
increasing or decreasing the total production costs (section 471 costs
and additional section 263A costs) of agricultural or horticultural
products that generate DPGR by a portion of any increment or liquidation
of the dollar-value pool. The portion of an increment or liquidation
allocable to DPGR is determined by multiplying the LIFO value of the
increment or liquidation (expressed as a positive number) by the ratio
of the change in total base-year cost (expressed as a positive number)
of agricultural or horticultural products that will generate DPGR in
ending inventory to the change in total base-year cost (expressed as a
positive number) of all goods in ending inventory. The portion of an
increment or liquidation allocable to DPGR may be zero but cannot exceed
the amount of the increment or liquidation. Thus, a ratio in excess of
1.0 must be treated as 1.0.
(6) Specified Cooperative using a simplified method for additional
section 263A costs to ending inventory. A Specified Cooperative that
uses a simplified method specifically described in the section 263A
regulations to allocate additional section 263A costs to ending
inventory must follow the rules in paragraph (b)(2) of this section to
determine the amount of additional section 263A costs allocable to DPGR.
Allocable additional section 263A costs include additional section 263A
costs included in the Specified Cooperative's beginning inventory as
well as additional section 263A costs incurred during the taxable year
by the Specified Cooperative. Ordinarily, if the Specified Cooperative
uses a simplified method specifically described in the section 263A
regulations to allocate its additional section 263A costs to its ending
inventory, the additional section 263A costs must be allocated in the
same proportion as section 471 costs are allocated.
(c) Other deductions properly allocable to DPGR or gross income
attributable to DPGR--(1) In general. In determining its QPAI, the
Specified Cooperative
[[Page 395]]
must subtract from its DPGR (in addition to the COGS), the deductions
that are properly allocable and apportioned to DPGR. A Specified
Cooperative generally must allocate and apportion these deductions using
the rules of the section 861 method provided in paragraph (d) of this
section. In lieu of the section 861 method, an eligible Specified
Cooperative may apportion these deductions using the simplified
deduction method provided in paragraph (e) of this section. Paragraph
(f) of this section provides a small business simplified overall method
that may be used by a qualifying small Specified Cooperative. A
Specified Cooperative using the simplified deduction method or the small
business simplified overall method must use that method for all
deductions. A Specified Cooperative eligible to use the small business
simplified overall method may choose at any time for any taxable year to
use the small business simplified overall method or the simplified
deduction method for a taxable year.
(2) Treatment of net operating losses. A deduction under section 172
for a net operating loss (NOL) is not allocated or apportioned to DPGR
or gross income attributable to DPGR.
(3) W-2 wages. Although only W-2 wages as described in Sec. 1.199A-
11 are taken into account in computing the W-2 wage limitation, all
wages paid (or incurred in the case of an accrual method taxpayer) in
the taxable year are taken into account in computing QPAI for that
taxable year.
(d) Section 861 method. Under the section 861 method, the Specified
Cooperative must allocate and apportion its deductions using the
allocation and apportionment rules provided under the section 861
regulations under which section 199A(g) is treated as an operative
section described in Sec. 1.861-8(f). Accordingly, the Specified
Cooperative applies the rules of the section 861 regulations to allocate
and apportion deductions (including, if applicable, its distributive
share of deductions from passthrough entities) to gross income
attributable to DPGR. If the Specified Cooperative applies the
allocation and apportionment rules of the section 861 regulations for
section 199A(g) and another operative section, then the Specified
Cooperative must use the same method of allocation and the same
principles of apportionment for purposes of all operative sections.
Research and experimental expenditures must be allocated and apportioned
in accordance with Sec. 1.861-17 without taking into account the
exclusive apportionment rule of Sec. 1.861-17(b). Deductions for
charitable contributions (as allowed under section 170 and section
873(b)(2) or 882(c)(1)(B)) must be ratably apportioned between gross
income attributable to DPGR and gross income attributable to non-DPGR
based on the relative amounts of gross income.
(e) Simplified deduction method--(1) In general. An eligible
Specified Cooperative (defined in paragraph (e)(2) of this section) may
use the simplified deduction method to apportion business deductions
between DPGR and non-DPGR. The simplified deduction method does not
apply to COGS. Under the simplified deduction method, the business
deductions (except the NOL deduction) are ratably apportioned between
DPGR and non-DPGR based on relative gross receipts. Accordingly, the
amount of deductions for the current taxable year apportioned to DPGR is
equal to the proportion of the total business deductions for the current
taxable year that the amount of DPGR bears to total gross receipts.
(2) Eligible Specified Cooperative. For purposes of this paragraph
(e), an eligible Specified Cooperative is--
(i) A Specified Cooperative that has average annual total gross
receipts (as defined in paragraph (g) of this section) of $100,000,000
or less; or
(ii) A Specified Cooperative that has total assets (as defined in
paragraph (e)(3) of this section) of $10,000,000 or less.
(3) Total assets.--(i) In general. For purposes of the simplified
deduction method, total assets mean the total assets the Specified
Cooperative has at the end of the taxable year.
(ii) Members of an expanded affiliated group. To compute the total
assets of an expanded affiliated group (EAG) at the end of the taxable
year, the total assets at the end of the taxable year of each member of
the EAG at the end of the taxable year that ends with or
[[Page 396]]
within the taxable year of the computing member (as described in Sec.
1.199A-12(g)) are aggregated.
(4) Members of an expanded affiliated group--(i) In general. Whether
the members of an EAG may use the simplified deduction method is
determined by reference to all the members of the EAG. If the average
annual gross receipts of the EAG are less than or equal to $100,000,000
or the total assets of the EAG are less than or equal to $10,000,000,
then each member of the EAG may individually determine whether to use
the simplified deduction method, regardless of the cost allocation
method used by the other members.
(ii) Exception. Notwithstanding paragraph (e)(4)(i) of this section,
all members of the same consolidated group must use the same cost
allocation method.
(f) Small business simplified overall method--(1) In general. A
qualifying small Specified Cooperative may use the small business
simplified overall method to apportion COGS and deductions between DPGR
and non-DPGR. Under the small business simplified overall method, a
Specified Cooperative's total costs for the current taxable year (as
defined in paragraph (f)(3) of this section) are apportioned between
DPGR and non-DPGR based on relative gross receipts. Accordingly, the
amount of total costs for the current taxable year apportioned to DPGR
is equal to the proportion of total costs for the current taxable year
that the amount of DPGR bears to total gross receipts.
(2) Qualifying small Specified Cooperative. For purposes of this
paragraph (f), a qualifying small Specified Cooperative is a Specified
Cooperative that has average annual total gross receipts (as defined in
paragraph (g) of this section) of $25,000,000 or less.
(3) Total costs for the current taxable year. For purposes of the
small business simplified overall method, total costs for the current
taxable year means the total COGS and deductions for the current taxable
year. Total costs for the current taxable year are determined under the
methods of accounting that the Specified Cooperative uses to compute
taxable income.
(4) Members of an expanded affiliated group--(i) In general. Whether
the members of an EAG may use the small business simplified overall
method is determined by reference to all the members of the EAG. If the
average annual gross receipts of the EAG are less than or equal to
$25,000,000 then each member of the EAG may individually determine
whether to use the small business simplified overall method, regardless
of the cost allocation method used by the other members.
(ii) Exception. Notwithstanding paragraph (f)(4)(i) of this section,
all members of the same consolidated group must use the same cost
allocation method.
(g) Average annual gross receipts--(1) In general. For purposes of
the simplified deduction method and the small business simplified
overall method, average annual gross receipts means the average annual
gross receipts of the Specified Cooperative for the 3 taxable years (or,
if fewer, the taxable years during which the taxpayer was in existence)
preceding the current taxable year, even if one or more of such taxable
years began before the effective date of section 199A(g). In the case of
any taxable year of less than 12 months (a short taxable year), the
gross receipts of the Specified Cooperative are annualized by
multiplying the gross receipts for the short period by 12 and dividing
the result by the number of months in the short period.
(2) Members of an expanded affiliated group--(i) In general. To
compute the average annual gross receipts of an EAG, the gross receipts
for the entire taxable year of each member that is a member of the EAG
at the end of its taxable year that ends with or within the taxable year
are aggregated. For purposes of this paragraph (g)(2), a consolidated
group is treated as one member of an EAG.
(ii) Exception. Notwithstanding paragraph (g)(1)(i) of this section,
all members of the same consolidated group must use the same cost
allocation method.
(h) Cost allocation methods for determining oil-related QPAI--(1)
Section 861 method. A Specified Cooperative that uses the section 861
method to determine deductions that are allocated and
[[Page 397]]
apportioned to gross income attributable to DPGR must use the section
861 method to determine deductions that are allocated and apportioned to
gross income attributable to oil-related DPGR.
(2) Simplified deduction method. A Specified Cooperative that uses
the simplified deduction method to apportion deductions between DPGR and
non-DPGR must determine the portion of deductions allocable to oil-
related DPGR by multiplying the deductions allocable to DPGR by the
ratio of oil-related DPGR to DPGR from all activities.
(3) Small business simplified overall method. A Specified
Cooperative that uses the small business simplified overall method to
apportion total costs (COGS and deductions) between DPGR and non-DPGR
must determine the portion of total costs allocable to oil-related DPGR
by multiplying the total costs allocable to DPGR by the ratio of oil-
related DPGR to DPGR from all activities.
(i) Applicability date. The provisions of this section apply to
taxable years beginning after January 19, 2021. Taxpayers, however, may
choose to apply the rules of Sec. Sec. 1.199A-7 through 1.199A-12 for
taxable years beginning on or before that date, provided the taxpayers
apply the rules in their entirety and in a consistent manner.
[T.D. 9947, 86 FR 5569, Jan. 19, 2021]
Sec. 1.199A-11 Wage limitation for the section 199A(g) deduction.
(a) Rules of application--(1) In general. The provisions of this
section apply solely for purposes of section 199A(g) of the Internal
Revenue Code (Code). The provisions of this section provide guidance on
determining the W-2 wage limitation as defined in Sec. 1.199A-
8(b)(5)(ii)(B). Except as provided in paragraph (d)(2) of this section,
the Form W-2, Wage and Tax Statement, or any subsequent form or document
used in determining the amount of W-2 wages, are those issued for the
calendar year ending during the taxable year of the Specified
Cooperative (defined in Sec. 1.199A-8(a)(2)) for wages paid to
employees (or former employees) of the Specified Cooperative for
employment by the Specified Cooperative. Employees are limited to
employees defined in section 3121(d)(1) and (2) (that is, officers of a
corporate taxpayer and employees of the taxpayer under the common law
rules). See paragraph (a)(5) of this section for the requirement that W-
2 wages must have been included in a return filed with the Social
Security Administration (SSA) within 60 days after the due date
(including extensions) of the return. See also section 199A(a)(4)(C).
(2) Wage limitation for section 199A(g) deduction. The amount of the
deduction allowable under section 199A(g) to the Specified Cooperative
for any taxable year cannot exceed 50 percent of the W-2 wages (as
defined in section 199A(g)(1)(B)(ii) and paragraph (b) of this section)
for the taxable year that are attributable to domestic production gross
receipts (DPGR), defined in Sec. 1.199A-8(b)(3)(ii), of agricultural or
horticultural products defined in Sec. 1.199A-8(a)(4).
(3) Wages paid by entity other than common law employer. In
determining W-2 wages, the Specified Cooperative may take into account
any W-2 wages paid by another entity and reported by the other entity on
Forms W-2 with the other entity as the employer listed in Box c of the
Forms W-2, provided that the W-2 wages were paid to common law employees
or officers of the Specified Cooperative for employment by the Specified
Cooperative. In such cases, the entity paying the W-2 wages and
reporting the W-2 wages on Forms W-2 is precluded from taking into
account such wages for purposes of determining W-2 wages with respect to
that entity. For purposes of this paragraph (a)(4), entities that pay
and report W-2 wages on behalf of or with respect to other taxpayers can
include, but are not limited to, certified professional employer
organizations under section 7705, statutory employers under section
3401(d)(1), and agents under section 3504.
(4) Requirement that wages must be reported on return filed with the
Social Security Administration--(i) In general. Pursuant to section
199A(g)(1)(B)(ii) and section 199A(b)(4)(C), the term W-2 wages does not
include any amount that is not properly included in a return filed with
SSA on or before the
[[Page 398]]
60th day after the due date (including extensions) for such return.
Under Sec. 31.6051-2 of this chapter, each Form W-2 and the transmittal
Form W-3, Transmittal of Wage and Tax Statements, together constitute an
information return to be filed with SSA. Similarly, each Form W-2c,
Corrected Wage and Tax Statement, and the transmittal Form W-3 or W-3c,
Transmittal of Corrected Wage and Tax Statements, together constitute an
information return to be filed with SSA. In determining whether any
amount has been properly included in a return filed with SSA on or
before the 60th day after the due date (including extensions) for such
return, each Form W-2 together with its accompanying Form W-3 is
considered a separate information return and each Form W-2c together
with its accompanying Form W-3 or Form W-3c is considered a separate
information return. Section 6071(c) provides that Forms W-2 and W-3 must
be filed on or before January 31 of the year following the calendar year
to which such returns relate (but see the special rule in Sec.
31.6071(a)-1T(a)(3)(1) of this chapter for monthly returns filed under
Sec. 31.6011(a)-5(a) of this chapter). Corrected Forms W-2 are required
to be filed with SSA on or before January 31 of the year following the
year in which the correction is made.
(ii) Corrected return filed to correct a return that was filed
within 60 days of the due date. If a corrected information return
(Return B) is filed with SSA on or before the 60th day after the due
date (including extensions) of Return B to correct an information return
(Return A) that was filed with SSA on or before the 60th day after the
due date (including extensions) of the information return (Return A) and
paragraph (a)(5)(iii) of this section does not apply, then the wage
information on Return B must be included in determining W-2 wages. If a
corrected information return (Return D) is filed with SSA later than the
60th day after the due date (including extensions) of Return D to
correct an information return (Return C) that was filed with SSA on or
before the 60th day after the due date (including extensions) of the
information return (Return C), then if Return D reports an increase (or
increases) in wages included in determining W-2 wages from the wage
amounts reported on Return C, such increase (or increases) on Return D
is disregarded in determining W-2 wages (and only the wage amounts on
Return C may be included in determining W-2 wages). If Return D reports
a decrease (or decreases) in wages included in determining W-2 wages
from the amounts reported on Return C, then, in determining W-2 wages,
the wages reported on Return C must be reduced by the decrease (or
decreases) reflected on Return D.
(iii) Corrected return filed to correct a return that was filed
later than 60 days after the due date. If an information return (Return
F) is filed to correct an information return (Return E) that was not
filed with SSA on or before the 60th day after the due date (including
extensions) of Return E, then Return F (and any subsequent information
returns filed with respect to Return E) will not be considered filed on
or before the 60th day after the due date (including extensions) of
Return F (or the subsequent corrected information return). Thus, if a
Form W-2c is filed to correct a Form W-2 that was not filed with SSA on
or before the 60th day after the due date (including extensions) of the
Form W-2 (or to correct a Form W-2c relating to a Form W-2 that had not
been filed with SSA on or before the 60th day after the due date
(including extensions) of the Form W-2), then this Form W-2c is not to
be considered to have been filed with SSA on or before the 60th day
after the due date (including extensions) for this Form W-2c, regardless
of when the Form W-2c is filed.
(b) Definition of W-2 wages--(1) In general. Section
199A(g)(1)(B)(ii) provides that the W-2 wages of the Specified
Cooperative must be determined in the same manner as under section
199A(b)(4) (without regard to section 199A(b)(4)(B) and after
application of section 199A(b)(5)). Section 199A(b)(4)(A) provides that
the term W-2 wages means with respect to any person for any taxable year
of such person, the amounts described in paragraphs (3) and (8) of
section 6051(a) paid
[[Page 399]]
by such person with respect to employment of employees by such person
during the calendar year ending during such taxable year. Thus, the term
W-2 wages includes the total amount of wages as defined in section
3401(a); the total amount of elective deferrals (within the meaning of
section 402(g)(3)); the compensation deferred under section 457; and the
amount of designated Roth contributions (as defined in section 402A).
(2) Section 199A(g) deduction. Pursuant to section 199A(g)(3)(A), W-
2 wages do not include any amount which is not properly allocable to
DPGR for purposes of calculating qualified production activities income
(QPAI) as defined in Sec. 1.199A-8(b)(4)(ii). The Specified Cooperative
may determine the amount of wages that is properly allocable to DPGR
using a reasonable method based on all the facts and circumstances. The
chosen reasonable method must be consistently applied from one taxable
year to another and must clearly reflect the wages allocable to DPGR for
purposes of QPAI. The books and records maintained for wages allocable
to DPGR for purposes of QPAI must be consistent with any allocations
under this paragraph (b)(2).
(c) Methods for calculating W-2 wages. The Secretary may provide for
methods that may be used in calculating W-2 wages, including W-2 wages
for short taxable years by publication in the Internal Revenue Bulletin
(see Sec. 601.601(d)(2)(ii)(b) of this chapter).
(d) Wage limitation--acquisitions, dispositions, and short taxable
years--(1) In general. For purposes of computing the deduction under
section 199A(g) of the Specified Cooperative, in the case of an
acquisition or disposition (as defined in section 199A(b)(5) and
paragraph (d)(3) of this section) that causes more than one Specified
Cooperative to be an employer of the employees of the acquired or
disposed of Specified Cooperative during the calendar year, the W-2
wages of the Specified Cooperative for the calendar year of the
acquisition or disposition are allocated between or among each Specified
Cooperative based on the period during which the employees of the
acquired or disposed of Specified Cooperatives were employed by the
Specified Cooperative, regardless of which permissible method is used
for reporting predecessor and successor wages on Form W-2, Wage and Tax
Statement.
(2) Short taxable year that does not include December 31. If the
Specified Cooperative has a short taxable year that does not contain a
calendar year ending during such short taxable year, wages paid to
employees for employment by the Specified Cooperative during the short
taxable year are treated as W-2 wages for such short taxable year for
purposes of paragraph (a) of this section (if the wages would otherwise
meet the requirements to be W-2 wages under this section but for the
requirement that a calendar year must end during the short taxable
year).
(3) Acquisition or disposition. For purposes of paragraph (d)(1) and
(2) of this section, the terms acquisition and disposition include an
incorporation, a liquidation, a reorganization, or a purchase or sale of
assets.
(e) Application in the case of a Specified Cooperative with a short
taxable year. In the case of a Specified Cooperative with a short
taxable year, subject to the rules of paragraph (a) of this section, the
W-2 wages of the Specified Cooperative for the short taxable year can
include only those wages paid during the short taxable year to employees
of the Specified Cooperative, only those elective deferrals (within the
meaning of section 402(g)(3)) made during the short taxable year by
employees of the Specified Cooperative, and only compensation actually
deferred under section 457 during the short taxable year with respect to
employees of the Specified Cooperative.
(f) Non-duplication rule. Amounts that are treated as W-2 wages for
a taxable year under any method cannot be treated as W-2 wages of any
other taxable year. Also, an amount cannot be treated as W-2 wages by
more than one taxpayer. Finally, an amount cannot be treated as W-2
wages by the Specified Cooperative both in determining patronage and
nonpatronage W-2 wages.
(g) Wage expense safe harbor--(1) In general. A Specified
Cooperative using either the section 861 method of cost allocation under
Sec. 1.199A-10(d) or the simplified deduction method under
[[Page 400]]
Sec. 1.199A-10(e) may determine the amount of W-2 wages that are
properly allocable to DPGR for a taxable year by multiplying the amount
of W-2 wages determined under paragraph (b)(1) of this section for the
taxable year by the ratio of the Specified Cooperative's wage expense
included in calculating QPAI for the taxable year to the Specified
Cooperative's total wage expense used in calculating the Specified
Cooperative's taxable income for the taxable year, without regard to any
wage expense disallowed by section 465, 469, 704(d), or 1366(d). A
Specified Cooperative that uses either the section 861 method of cost
allocation or the simplified deduction method to determine QPAI must use
the same expense allocation and apportionment methods that it uses to
determine QPAI to allocate and apportion wage expense for purposes of
this safe harbor. For purposes of this paragraph (g)(1), the term wage
expense means wages (that is, compensation paid by the employer in the
active conduct of a trade or business to its employees) that are
properly taken into account under the Specified Cooperative's method of
accounting.
(2) Wage expense included in cost of goods sold. For purposes of
paragraph (g)(1) of this section, a Specified Cooperative may determine
its wage expense included in cost of goods sold (COGS) using a
reasonable method based on all the facts and circumstances, such as
using the amount of direct labor included in COGS or using section 263A
labor costs (as defined in Sec. 1.263A-1(h)(4)(ii)) included in COGS.
The chosen reasonable method must be consistently applied from one
taxable year to another and must clearly reflect the portion of wage
expense included in COGS. The method must also be reasonable based on
all the facts and circumstances. The books and records maintained for
wage expense included in COGS must be consistent with any allocations
under this paragraph (g)(2).
(3) Small business simplified overall method safe harbor. The
Specified Cooperative that uses the small business simplified overall
method under Sec. 1.199A-10(f) may use the small business simplified
overall method safe harbor for determining the amount of W-2 wages
determined under paragraph (b)(1) of this section that is properly
allocable to DPGR. Under this safe harbor, the amount of W-2 wages
determined under paragraph (b)(1) of this section that is properly
allocable to DPGR is equal to the same proportion of W-2 wages
determined under paragraph (b)(1) of this section that the amount of
DPGR bears to the Specified Cooperative's total gross receipts.
(h) Applicability date. The provisions of this section apply to
taxable years beginning after January 19, 2021. Taxpayers, however, may
choose to apply the rules of Sec. Sec. 1.199A-7 through 1.199A-12 for
taxable years beginning on or before that date, provided the taxpayers
apply the rules in their entirety and in a consistent manner.
[T.D. 9947, 86 FR 5569, Jan. 19, 2021]
Sec. 1.199A-12 Expanded affiliated groups.
(a) In general. The provisions of this section apply solely for
purposes of section 199A(g) of the Internal Revenue Code (Code). Except
as otherwise provided in the Code or regulations issued under the
relevant section of the Code (for example, sections 199A(g)(3)(D)(ii)
and 267, Sec. 1.199A-8(c), paragraph (a)(3) of this section, and the
consolidated return regulations under section 1502), each nonexempt
Specified Cooperative (defined in Sec. 1.199A-8(a)(2)(ii)) that is a
member of an expanded affiliated group (EAG) (defined in paragraph
(a)(1) of this section) computes its own taxable income or loss,
qualified production activities income (QPAI) (defined in Sec. 1.199A-
8(b)(4)(ii)), and W-2 wages (defined in Sec. 1.199A-11(b)). For
purposes of this section unless otherwise specified, the term Specified
Cooperative means a nonexempt Specified Cooperative. If a Specified
Cooperative is also a member of a consolidated group, see paragraph (d)
of this section.
(1) Definition of an expanded affiliated group. An EAG is an
affiliated group as defined in section 1504(a), determined by
substituting ``more than 50 percent'' for ``at least 80 percent'' in
each place it appears and without regard to section 1504(b)(2) and (4).
(2) Identification of members of an expanded affiliated group--(i)
In general.
[[Page 401]]
Each Specified Cooperative must determine if it is a member of an EAG on
a daily basis.
(ii) Becoming or ceasing to be a member of an expanded affiliated
group. If a Specified Cooperative becomes or ceases to be a member of an
EAG, the Specified Cooperative is treated as becoming or ceasing to be a
member of the EAG at the end of the day on which its status as a member
changes.
(3) Attribution of activities--(i) In general. Except as provided in
paragraph (a)(3)(iv) of this section, if a Specified Cooperative that is
a member of an EAG (disposing member) derives gross receipts (defined in
Sec. 1.199A-8(b)(2)(iii)) from the lease, rental, license, sale,
exchange, or other disposition (defined in Sec. 1.199A-9(j)) of
agricultural or horticultural products (defined in Sec. 1.199A-8(a)(4))
that were manufactured, produced, grown or extracted (MPGE) (defined in
Sec. 1.199A-9(f)), in whole or significant part (defined in Sec.
1.199A-9(h)), in the United States (defined in Sec. 1.199A-9(i)) by
another Specified Cooperative, then the disposing member is treated as
conducting the previous activities conducted by such other Specified
Cooperative with respect to the agricultural or horticultural products
in determining whether its gross receipts are domestic production gross
receipts (DPGR) (defined in Sec. 1.199A-8(b)(3)(ii)) if--
(A) Such property was MPGE by such other Specified Cooperative, and
(B) The disposing member is a member of the same EAG as such other
Specified Cooperative at the time that the disposing member disposes of
the agricultural or horticultural products.
(ii) Date of disposition for leases, rentals, or licenses. Except as
provided in paragraph (a)(3)(iv) of this section, with respect to a
lease, rental, or license, the disposing member described in paragraph
(a)(3)(i) of this section is treated as having disposed of the
agricultural or horticultural products on the date or dates on which it
takes into account the gross receipts derived from the lease, rental, or
license under its methods of accounting.
(iii) Date of disposition for sales, exchanges, or other
dispositions. Except as provided in paragraph (a)(3)(iv) of this
section, with respect to a sale, exchange, or other disposition, the
disposing member is treated as having disposed of the agricultural or
horticultural products on the date on which it ceases to own the
agricultural or horticultural products for Federal income tax purposes,
even if no gain or loss is taken into account.
(iv) Exception. A Specified Cooperative is not attributed
nonpatronage activities conducted by another Specified Cooperative. See
Sec. 1.199A-8(b)(2)(ii).
(4) Marketing Specified Cooperatives. A Specified Cooperative is
treated as having MPGE in whole or significant part any agricultural or
horticultural product within the United States marketed by the Specified
Cooperative which its patrons have so MPGE. Patrons are defined in Sec.
1.1388-1(e).
(5) Anti-avoidance rule. If a transaction between members of an EAG
is engaged in or structured with a principal purpose of qualifying for,
or increasing the amount of, the section 199A(g) deduction of the EAG or
the portion of the section 199A(g) deduction allocated to one or more
members of the EAG, the Secretary may make adjustments to eliminate the
effect of the transaction on the computation of the section 199A(g)
deduction.
(b) Computation of EAG's section 199A(g) deduction.--(1) In general.
The section 199A(g) deduction for an EAG is determined by separately
computing the section 199A(g) deduction from the patronage sources of
Specified Cooperatives that are members of the EAG. The section 199A(g)
deduction from patronage sources of Specified Cooperatives is determined
by aggregating the income or loss, QPAI, and W-2 wages, if any, of each
patronage source of a Specified Cooperative that is a member of the EAG.
For purposes of this determination, a member's QPAI may be positive or
negative. A Specified Cooperative's taxable income or loss and QPAI is
determined by reference to the Specified Cooperative's method of
accounting. For purposes of determining the section 199A(g) deduction
for an EAG, taxable income or loss, QPAI, and W-2 wages of a Specified
Cooperative from nonpatronage sources are considered to be zero, other
than as allowed under Sec. 1.199A-8(b)(2)(ii).
[[Page 402]]
(2) Example. The following example illustrates the application of
paragraph (b)(1) of this section.
(i) Facts. Nonexempt Specified Cooperatives X, Y, and Z, calendar
year taxpayers, are the only members of an EAG and are not members of a
consolidated group. X has patronage source taxable income of $50,000,
QPAI of $15,000, and W-2 wages of $0. Y has patronage source taxable
income of ($20,000), QPAI of ($1,000), and W-2 wages of $750. Z has
patronage source taxable income of $0, QPAI of $0, and W-2 wages of
$3,000.
(ii) Analysis. In determining the EAG's section 199A(g) deduction,
the EAG aggregates each member's patronage source taxable income or
loss, QPAI, and W-2 wages. Thus, the EAG has patronage source taxable
income of $30,000, the sum of X's patronage source taxable income of
$50,000, Y's patronage source taxable income of ($20,000), and Z's
patronage source taxable income of $0. The EAG has QPAI of $14,000, the
sum of X's QPAI of $15,000, Y's QPAI of ($1,000), and Z's QPAI of $0.
The EAG has W-2 wages of $3,750, the sum of X's W-2 wages of $0, Y's W-2
wages of $750, and Z's W-2 wages of $3,000. Accordingly, the EAG's
section 199A(g) deduction equals $1,260, 9% of $14,000, the lesser of
the QPAI and patronage source taxable income, but not greater than
$1,875, 50% of its W-2 wages of $3,750. This result would be the same if
X had a nonpatronage source income or loss, because nonpatronage source
income of a nonexempt Specified Cooperative is not taken into account in
determining the section 199A(g) deduction.
(3) Net operating loss carryovers/carrybacks. In determining the
taxable income of an EAG, if a Specified Cooperative has a net operating
loss (NOL) from its patronage sources that may be carried over or
carried back (in accordance with section 172) to the taxable year, then
for purposes of determining the taxable income of the Specified
Cooperative, the amount of the NOL used to offset taxable income cannot
exceed the taxable income of the patronage source of that Specified
Cooperative.
(4) Losses used to reduce taxable income of an expanded affiliated
group. The amount of an NOL sustained by a Specified Cooperative member
of an EAG that is used in the year sustained in determining an EAG's
taxable income limitation under Sec. 1.199A-8(b)(5)(ii)(C) is not
treated as an NOL carryover to any taxable year in determining the
taxable income limitation under Sec. 1.199A-8(b)(5)(ii)(C). For
purposes of this paragraph (b)(4), an NOL is considered to be used if it
reduces an EAG's aggregate taxable income from patronage sources or
nonpatronage sources, as the case may be, regardless of whether the use
of the NOL actually reduces the amount of the section 199A(g) deduction
that the EAG would otherwise derive. An NOL is not considered to be used
to the extent that it reduces an EAG's aggregate taxable income from
patronage sources to an amount less than zero. If more than one
Specified Cooperative has an NOL used in the same taxable year to reduce
the EAG's taxable income from patronage sources, the respective NOLs are
deemed used in proportion to the amount of each Specified Cooperative's
NOL.
(5) Example. The following example illustrates the application of
paragraph (b)(4) of this section.
(i) Facts. Nonexempt Specified Cooperatives A and B are the only two
members of an EAG. A and B are both calendar year taxpayers and they do
not join in the filing of a consolidated Federal income tax return.
Neither A nor B had taxable income or loss prior to 2020. In 2020, A has
patronage QPAI and patronage taxable income of $1,000 and B has
patronage QPAI of $1,000 and a patronage NOL of $1,500. A also has
nonpatronage income of $3,000. B has no activities other than from its
patronage activities. In 2021, A has patronage QPAI of $2,000 and
patronage taxable income of $1,000 and B has patronage QPAI of $2,000
and patronage taxable income prior to the NOL deduction allowed under
section 172 of $2,000. Neither A nor B has nonpatronage activities in
2021. A's and B's patronage activities have aggregate W-2 wages in
excess of the section 199A(g)(1)(B) wage limitation in both 2020 and
2021.
(ii) Section 199A(g) deduction for 2020. In determining the EAG's
section 199A(g) deduction for 2020, A's $1,000 of
[[Page 403]]
QPAI and B's $1,000 of QPAI are aggregated, as are A's $1,000 of taxable
income from its patronage activities and B's $1,500 NOL from its
patronage activities. A's nonpatronage income is not included. Thus, for
2020, the EAG has patronage QPAI of $2,000 and patronage taxable income
of ($500). The EAG's section 199A(g) deduction for 2020 is 9% of the
lesser of its patronage QPAI or its patronage taxable income. Because
the EAG has a taxable loss from patronage sources in 2020, the EAG's
section 199A(g) deduction is $0.
(iii) Section 199A(a) deduction for 2021. In determining the EAG's
section 199A deduction for 2021, A's patronage QPAI of $2,000 and B's
patronage QPAI of $2,000 are aggregated, resulting in the EAG having
patronage QPAI of $4,000. Also, $1,000 of B's patronage NOL from 2020
was used in 2020 to reduce the EAG's taxable income from patronage
sources to $0. The remaining $500 of B's patronage NOL from 2020 is not
considered to have been used in 2020 because it reduced the EAG's
patronage taxable income to less than $0. Accordingly, for purposes of
determining the EAG's taxable income limitation under Sec. 1.199A-
8(b)(5) in 2021, B is deemed to have only a $500 NOL carryover from its
patronage sources from 2020 to offset a portion of its 2021 taxable
income from its patronage sources. Thus, B's taxable income from its
patronage sources in 2021 is $1,500, which is aggregated with A's $1,000
of taxable income from its patronage sources. The EAG's taxable income
limitation in 2021 is $2,500. The EAG's section 199A(g) deduction is 9%
of the lesser of its patronage sourced QPAI of $4,000 and its taxable
income from patronage sources of $2,500. Thus, the EAG's section 199A(g)
deduction in 2021 is 9% of $2,500, or $225. The results for 2021 would
be the same if neither A nor B had patronage sourced QPAI in 2020.
(c) Allocation of an expanded affiliated group's section 199A(g)
deduction among members of the expanded affiliated group--(1) In
general. An EAG's section 199A(g) deduction from its patronage sources,
as determined in paragraph (b) of this section, is allocated among the
Specified Cooperatives that are members of the EAG in proportion to each
Specified Cooperative's patronage QPAI, regardless of whether the
Specified Cooperative has patronage taxable income or W-2 wages for the
taxable year. For these purposes, if a Specified Cooperative has
negative patronage QPAI, such QPAI is treated as zero. Pursuant to Sec.
1.199A-8(b)(6), a patronage section 199A(g) deduction can be applied
only against patronage income and deductions.
(2) Use of section 199A(g) deduction to create or increase a net
operating loss. If a Specified Cooperative that is a member of an EAG
has some or all of the EAG's section 199A(g) deduction allocated to it
under paragraph (c)(1) of this section and the amount allocated exceeds
patronage taxable income, determined as described in this section and
prior to allocation of the section 199A(g) deduction, the section
199A(g) deduction will create an NOL for the patronage source.
Similarly, if a Specified Cooperative that is a member of an EAG, prior
to the allocation of some or all of the EAG's section 199A(g) deduction
to the member, has a patronage NOL for the taxable year, the portion of
the EAG's section 199A(g) deduction allocated to the member will
increase such NOL.
(d) Special rules for members of the same consolidated group--(1)
Intercompany transactions. In the case of an intercompany transaction
between consolidated group members S and B (as the terms intercompany
transaction, S, and B are defined in Sec. 1.1502-13(b)(1)), S takes the
intercompany transaction into account in computing the section 199A(g)
deduction at the same time and in the same proportion as S takes into
account the income, gain, deduction, or loss from the intercompany
transaction under Sec. 1.1502-13.
(2) Application of the simplified deduction method and the small
business simplified overall method. For purposes of applying the
simplified deduction method under Sec. 1.199A-10(e) and the small
business simplified overall method under Sec. 1.199A-10(f), a Specified
Cooperative that is part of a consolidated group determines its QPAI
using its members' DPGR, non-DPGR, cost of goods sold (COGS), and all
other deductions, expenses, or losses (hereinafter deductions),
determined after the application of Sec. 1.1502-13.
[[Page 404]]
(3) Determining the section 199A(g) deduction--(i) Expanded
affiliated group consists of consolidated group and non-consolidated
group members. In determining the section 199A(g) deduction, if an EAG
includes Specified Cooperatives that are members of the same
consolidated group and Specified Cooperatives that are not members of
the same consolidated group, the consolidated taxable income or loss,
QPAI, and W-2 wages, from patronage sources, if any, of the consolidated
group (and not the separate taxable income or loss, QPAI, and W-2 wages
from patronage sources of the members of the consolidated group), are
aggregated with the taxable income or loss, QPAI, and W-2 wages, from
patronage sources, if any, of the non-consolidated group members. For
example, if A, B, C, S1, and S2 are Specified Cooperatives that are
members of the same EAG, and A, S1, and S2 are members of the same
consolidated group (the A consolidated group), then the A consolidated
group is treated as one member of the EAG. Accordingly, the EAG is
considered to have three members--the A consolidated group, B, and C.
The consolidated taxable income or loss, QPAI, and W-2 wages from
patronage sources, if any, of the A consolidated group are aggregated
with the taxable income or loss from patronage sources, QPAI, and W-2
wages, if any, of B and C in determining the EAG's section 199A(g)
deduction from patronage sources. Pursuant to Sec. 1.199A-8(b)(6), a
patronage section 199A(g) deduction can be applied only against
patronage income and deductions.
(ii) Expanded affiliated group consists only of members of a single
consolidated group. If all of the Specified Cooperatives that are
members of an EAG are also members of the same consolidated group, the
consolidated group's section 199A(g) deduction is determined using the
consolidated group's consolidated taxable income or loss, QPAI, and W-2
wages, from patronage sources rather than the separate taxable income or
loss, QPAI, and W-2 wages from patronage sources of its members.
(4) Allocation of the section 199A(g) deduction of a consolidated
group among its members. The section 199A(g) deduction from patronage
sources of a consolidated group (or the section 199A(g) deduction
allocated to a consolidated group that is a member of an EAG) is
allocated among the patronage sources of Specified Cooperatives in
proportion to each Specified Cooperative's patronage QPAI, regardless of
whether the Specified Cooperative has patronage separate taxable income
or W-2 wages for the taxable year. In allocating the section 199A(g)
deduction of a patronage source of a Specified Cooperative that is part
of a consolidated group among patronage sources of other members of the
same group, any redetermination of a member's patronage receipts, COGS,
or other deductions from an intercompany transaction under Sec. 1.1502-
13(c)(1)(i) or (c)(4) is not taken into account for purposes of section
199A(g). Also, for purposes of this allocation, if a patronage source of
a Specified Cooperative that is a member of a consolidated group has
negative QPAI, the QPAI of the patronage source is treated as zero.
(e) Examples. The following examples illustrate the application of
paragraphs (a) through (d) of this section.
(1) Example 1. Specified Cooperatives X, Y, and Z are members of the
same EAG but are not members of a consolidated group. X, Y, and Z each
files Federal income tax returns on a calendar year basis. None of X, Y,
or Z have activities other than from its patronage sources. Prior to
2020, X had no taxable income or loss. In 2020, X has taxable income of
$0, QPAI of $2,000, and W-2 wages of $0, Y has taxable income of $4,000,
QPAI of $3,000, and W-2 wages of $500, and Z has taxable income of
$4,000, QPAI of $5,000, and W-2 wages of $2,500. Accordingly, the EAG's
patronage source taxable income is $8,000, the sum of X's taxable income
of $0, Y's taxable income of $4,000, and Z's taxable income of $4,000.
The EAG has QPAI of $10,000, the sum of X's QPAI of $2,000, Y's QPAI of
$3,000, and Z's QPAI of $5,000. The EAG's W-2 wages are $3,000, the sum
of X's W-2 wages of $0, Y's W-2 wages of $500, and Z's W-2 wages of
$2,500. Thus, the EAG's section 199A(g) deduction for 2020 is $720 (9%
of the lesser of the EAG's patronage source taxable income of $8,000 and
the EAG's QPAI of $10,000, but no greater than 50% of its W-2 wages of
[[Page 405]]
$3,000, that is $1,500). Pursuant to paragraph (c)(1) of this section,
the $720 section 199A(g) deduction is allocated to X, Y, and Z in
proportion to their respective amounts of QPAI, that is $144 to X ($720
x $2,000/$10,000), $216 to Y ($720 x $3,000/$10,000), and $360 to Z
($720 x $5,000/$10,000). Although X's patronage source taxable income
for 2020 determined prior to allocation of a portion of the EAG's
section 199A(g) deduction to it was $0, pursuant to paragraph (c)(2) of
this section, X will have an NOL from its patronage source for 2020
equal to $144, which will be a carryover to 2021.
(2) Example 2. (i) Facts. Corporation X is the common parent of a
consolidated group, consisting of X and Y, which has filed a
consolidated Federal income tax return for many years. Corporation P is
the common parent of a consolidated group, consisting of P and S, which
has filed a consolidated Federal income tax return for many years. The X
and P consolidated groups each file their consolidated Federal income
tax returns on a calendar year basis. X, Y, P, and S are each Specified
Cooperatives, and none of X, Y, P, or S has ever had activities other
than from its patronage sources. The X consolidated group and the P
consolidated group are members of the same EAG in 2021. In 2020, the X
consolidated group incurred a consolidated net operating loss (CNOL) of
$25,000. Neither P nor S (nor the P consolidated group) has ever
incurred an NOL. In 2021, the X consolidated group has (prior to the
deduction under section 172) taxable income of $8,000 and the P
consolidated group has taxable income of $20,000. X's QPAI is $8,000,
Y's QPAI is ($13,000), P's QPAI is $16,000 and S's QPAI is $4,000. There
are sufficient W-2 wages to exceed the section 199A(g)(1)(B) limitation.
(ii) Analysis. The X consolidated group uses $8,000 of its CNOL from
2020 to offset the X consolidated group's taxable income in 2021. None
of the X consolidated group's remaining CNOL may be used to offset
taxable income of the P consolidated group under paragraph (b)(3) of
this section. Accordingly, for purposes of determining the EAG's section
199A(g) deduction for 2021, the EAG has taxable income of $20,000 (the X
consolidated group's taxable income, after the deduction under section
172, of $0 plus the P consolidated group's taxable income of $20,000).
The EAG has QPAI of $15,000 (the X consolidated group's QPAI of ($5,000)
(X's $8,000 + Y's ($13,000)), and the P consolidated group's QPAI of
$20,000 (P's $16,000 + S's $4,000)). The EAG's section 199A(g) deduction
equals $1,350, 9% of the lesser of its taxable income of $20,000 and its
QPAI of $15,000. The section 199A(g) deduction is allocated between the
X and P consolidated groups in proportion to their respective QPAI.
Because the X consolidated group has negative QPAI, all of the section
199A(g) deduction of $1,350 is allocated to the P consolidated group.
This $1,350 is allocated between P and S, the members of the P
consolidated group, in proportion to their QPAI. Accordingly, P is
allocated $1,080 ($1,350 x $16,000/$20,000) and S is allocated $270
($1,350 x $4,000/$20,000).
(f) Allocation of patronage income and loss by a Specified
Cooperative that is a member of the expanded affiliated group for only a
portion of the year--(1) In general. A Specified Cooperative that
becomes or ceases to be a member of an EAG during its taxable year must
allocate its taxable income or loss, QPAI, and W-2 wages between the
portion of the taxable year that the Specified Cooperative is a member
of the EAG and the portion of the taxable year that the Specified
Cooperative is not a member of the EAG. This allocation of items is made
by using the pro rata allocation method described in this paragraph
(f)(1). Under the pro rata allocation method, an equal portion of
patronage taxable income or loss, QPAI, and W-2 wages is assigned to
each day of the Specified Cooperative's taxable year. Those items
assigned to those days that the Specified Cooperative was a member of
the EAG are then aggregated.
(2) Coordination with rules relating to the allocation of income
under Sec. 1.1502-76(b). If Sec. 1.1502-76(b) (relating to items
included in a consolidated return) applies to a Specified Cooperative
that is a member of an EAG, then any allocation of items required under
this paragraph (f) is made only after the allocation of the items
pursuant to Sec. 1.1502-76(b).
[[Page 406]]
(g) Total section 199A(g) deduction for a Specified Cooperative that
is a member of an expanded affiliated group for some or all of its
taxable year--(1) Member of the same EAG for the entire taxable year. If
a Specified Cooperative is a member of the same EAG for its entire
taxable year, the Specified Cooperative's section 199A(g) deduction for
the taxable year is the amount of the section 199A(g) deduction
allocated to it by the EAG under paragraph (c)(1) of this section.
(2) Member of the expanded affiliated group for a portion of the
taxable year. If a Specified Cooperative is a member of an EAG for only
a portion of its taxable year and is either not a member of any EAG or
is a member of another EAG, or both, for another portion of the taxable
year, the Specified Cooperative's section 199A(g) deduction for the
taxable year is the sum of its section 199A(g) deductions for each
portion of the taxable year.
(3) Example. The following example illustrates the application of
paragraphs (f) and (g) of this section.
(i) Facts. Specified Cooperatives X and Y, calendar year taxpayers,
are members of the same EAG for the entire 2020 taxable year. Specified
Cooperative Z, also a calendar year taxpayer, is a member of the EAG of
which X and Y are members for the first half of 2020 and not a member of
any EAG for the second half of 2020. None of X, Y, or Z have activities
other than from its patronage sources. Assume that X, Y, and Z each has
W-2 wages in excess of the section 199A(g)(1)(B) wage limitation for all
relevant periods. In 2020, X has taxable income of $2,000 and QPAI of
$600, Y has taxable loss of $400 and QPAI of ($200), and Z has taxable
income of $1,400 and QPAI of $2,400.
(ii) Analysis. Pursuant to the pro rata allocation method, $700 of
Z's 2020 taxable income and $1,200 of its QPAI are allocated to the
first half of the 2020 taxable year (the period in which Z is a member
of the EAG) and $700 of Z's 2020 taxable income and $1,200 of its QPAI
are allocated to the second half of the 2020 taxable year (the period in
which Z is not a member of any EAG). Accordingly, in 2020, the EAG has
taxable income from patronage sources of $2,300 ($2,000 + ($400) + $700)
and QPAI of $1,600 ($600 + ($200) + $1,200). The EAG's section 199A(g)
deduction for 2020 is $144 (9% of the lesser of the EAG's taxable income
of $2,300 or QPAI of $1,600). Pursuant to Sec. 1.199A-12(c)(1), this
$144 deduction is allocated to X, Y, and Z in proportion to their
respective QPAI. Accordingly, X is allocated $48 of the EAG's section
199A(g) deduction ($144 x ($600/($600 + $0 + $1,200))), Y is allocated
$0 of the EAG's section 199A(g) deduction ($144 x ($0/($600 + $0 +
$1,200))), and Z is allocated $96 of the EAG's section 199A(g) deduction
($144 x ($1,200/($600 + $0 + $1,200))). For the second half of 2020, Z
has taxable income of $700 and QPAI of $1,200. Therefore, for the second
half of 2020, Z has a section 199A(g) deduction of $63 (9% of the lesser
of its taxable income of $700 or its QPAI of $1,200). Accordingly, X's
2020 section 199A(g) deduction is $48 and Y's 2020 section 199A(g)
deduction is $0. Z's 2020 section 199A(g) deduction is $159, the sum of
$96, the portion of the EAG's section 199A(g) deduction allocated to Z
for the first half of 2020 and Z's $63 section 199A(g) deduction for the
second half of 2020.
(h) Computation of section 199A(g) deduction for members of an
expanded affiliated group with different taxable years--(1) In general.
If Specified Cooperatives that are members of an EAG have different
taxable years, in determining the section 199A(g) deduction of a member
(the computing member), the computing member is required to take into
account the taxable income or loss, determined without regard to the
section 199A(g) deduction, QPAI, and W-2 wages of each other group
member that are both--
(i) Attributable to the period that each other member of the EAG and
the computing member are members of the EAG; and
(ii) Taken into account in a taxable year that begins after the
effective date of section 199A(g) and ends with or within the taxable
year of the computing member with respect to which the section 199A(g)
deduction is computed.
(2) Example. The following example illustrates the application of
this paragraph (h).
[[Page 407]]
(i) Facts. Specified Cooperatives X, Y, and Z are members of the
same EAG. Neither X, Y, nor Z is a member of a consolidated group. X and
Y are calendar year taxpayers and Z is a June 30 fiscal year taxpayer. Z
came into existence on July 1, 2020. None of X, Y, or Z have activities
other than from its patronage sources. Each Specified Cooperative has
taxable income that exceeds its QPAI and W-2 wages in excess of the
section 199A(g)(1)(B) wage limitation. For the taxable year ending
December 31, 2020, X's QPAI is $8,000 and Y's QPAI is ($6,000). For its
taxable year ending June 30, 2021, Z's QPAI is $2,000.
(ii) 2020 Computation. In computing X's and Y's respective section
199A(g) deductions for their taxable years ending December 31, 2020, X's
taxable income or loss, QPAI and W-2 wages and Y's taxable income or
loss, QPAI, and W-2 wages from their respective taxable years ending
December 31, 2020, are aggregated. The EAG's QPAI for this purpose is
$2,000 (X's QPAI of $8,000 + Y's QPAI of ($6,000)). Accordingly, the
EAG's section 199A(g) deduction is $180 (9% x $2,000). The $180
deduction is allocated to each of X and Y in proportion to their
respective QPAI as a percentage of the QPAI of each member of the EAG
that was taken into account in computing the EAG's section 199A(g)
deduction. Pursuant to paragraph (c)(1) of this section, in allocating
the section 199A(g) deduction between X and Y, because Y's QPAI is
negative, Y's QPAI is treated as being $0. Accordingly, X's section
199A(g) deduction for its taxable year ending December 31, 2020, is $180
($180 x $8,000/($8,000 + $0)). Y's section 199A(g) deduction for its
taxable year ending December 31, 2020, is $0 ($180 x $0/($8,000 + $0)).
(iii) 2021 Computation. In computing Z's section 199A(g) deduction
for its taxable year ending June 30, 2021, X's and Y's items from their
respective taxable years ending December 31, 2020, are taken into
account. Therefore, X's taxable income or loss and Y's taxable income or
loss, determined without regard to the section 199A(g) deduction, QPAI,
and W-2 wages from their taxable years ending December 31, 2020, are
aggregated with Z's taxable income or loss, QPAI, and W-2 wages from its
taxable year ending June 30, 2021. The EAG's QPAI is $4,000 (X's QPAI of
$8,000 + Y's QPAI of ($6,000) + Z's QPAI of $2,000). The EAG's section
199A(g) deduction is $360 (9% x $4,000). A portion of the $360 deduction
is allocated to Z in proportion to its QPAI as a percentage of the QPAI
of each member of the EAG that was taken into account in computing the
EAG's section 199A(g) deduction. Pursuant to paragraph (c)(1) of this
section, in allocating a portion of the $360 deduction to Z, Y's QPAI is
treated as being $0 because Y's QPAI is negative. Z's section 199A(g)
deduction for its taxable year ending June 30, 2021, is $72 ($360 x
($2,000/($8,000 + $0 + $2,000))).
(i) Partnership owned by expanded affiliated group--(1) In general.
For purposes of section 199A(g)(3)(D) relating to DPGR, if all of the
interests in the capital and profits of a partnership are owned by
members of a single EAG at all times during the taxable year of such
partnership (EAG partnership), then the EAG partnership and all members
of that EAG are treated as a single taxpayer during such period.
(2) Attribution of activities--(i) In general. If a Specified
Cooperative which is a member of an EAG (disposing member) derives gross
receipts from the lease, rental, license, sale, exchange, or other
disposition of property that was MPGE by an EAG partnership, all the
partners of which are members of the same EAG to which the disposing
member belongs at the time that the disposing member disposes of such
property, then the disposing member is treated as conducting the MPGE
activities previously conducted by the EAG partnership with respect to
that property. The previous sentence applies only for those taxable
years in which the disposing member is a member of the EAG of which all
the partners of the EAG partnership are members for the entire taxable
year of the EAG partnership. With respect to a lease, rental, or
license, the disposing member is treated as having disposed of the
property on the date or dates on which it takes into account its gross
receipts from the lease, rental, or license under its method of
accounting. With respect to a sale, exchange, or other disposition, the
disposing member is treated
[[Page 408]]
as having disposed of the property on the date it ceases to own the
property for Federal income tax purposes, even if no gain or loss is
taken into account. Likewise, if an EAG partnership derives gross
receipts from the lease, rental, license, sale, exchange, or other
disposition of property that was MPGE by a member (or members) of the
same EAG (the producing member) to which all the partners of the EAG
partnership belong at the time that the EAG partnership disposes of such
property, then the EAG partnership is treated as conducting the MPGE
activities previously conducted by the producing member with respect to
that property. The previous sentence applies only for those taxable
years in which the producing member is a member of the EAG of which all
the partners of the EAG partnership are members for the entire taxable
year of the EAG partnership. With respect to a lease, rental, or
license, the EAG partnership is treated as having disposed of the
property on the date or dates on which it takes into account its gross
receipts derived from the lease, rental, or license under its method of
accounting. With respect to a sale, exchange, or other disposition, the
EAG partnership is treated as having disposed of the property on the
date it ceases to own the property for Federal income tax purposes, even
if no gain or loss is taken into account.
(ii) Attribution between expanded affiliated group partnerships. If
an EAG partnership (disposing partnership) derives gross receipts from
the lease, rental, license, sale, exchange, or other disposition of
property that was MPGE by another EAG partnership (producing
partnership), then the disposing partnership is treated as conducting
the MPGE activities previously conducted by the producing partnership
with respect to that property, provided that each of these partnerships
(the producing partnership and the disposing partnership) is owned for
its entire taxable year in which the disposing partnership disposes of
such property by members of the same EAG. With respect to a lease,
rental, or license, the disposing partnership is treated as having
disposed of the property on the date or dates on which it takes into
account its gross receipts from the lease, rental, or license under its
method of accounting. With respect to a sale, exchange, or other
disposition, the disposing partnership is treated as having disposed of
the property on the date it ceases to own the property for Federal
income tax purposes, even if no gain or loss is taken into account.
(j) Applicability date. The provisions of this section apply to
taxable years beginning after January 19, 2021. Taxpayers, however, may
choose to apply the rules of Sec. Sec. 1.199A-7 through 1.199A-12 for
taxable years beginning on or before that date, provided the taxpayers
apply the rules in their entirety and in a consistent manner.
[T.D. 9947, 86 FR 5569, Jan. 19, 2021, as amended by 87 FR 68900, Nov.
17, 2022]
Additional Itemized Deductions for Individuals
Sec. 1.211-1 Allowance of deductions.
In computing taxable income under section 63(a), the deductions
provided by sections 212, 213, 214, 215, 216, and 217 shall be allowed
subject to the exceptions provided in Part IX, Subchapter B, Chapter 1
of the Code (section 261 and following, relating to items not
deductible).
[T.D. 6796, 30 FR 1037, Feb. 2, 1965]
Sec. 1.212-1 Nontrade or nonbusiness expenses.
(a) An expense may be deducted under section 212 only if:
(1) It has been paid or incurred by the taxpayer during the taxable
year (i) for the production or collection of income which, if and when
realized, will be required to be included in income for Federal income
tax purposes, or (ii) for the management, conservation, or maintenance
of property held for the production of such income, or (iii) in
connection with the determination, collection, or refund of any tax; and
(2) It is an ordinary and necessary expense for any of the purposes
stated in subparagraph (1) of this paragraph.
(b) The term income for the purpose of section 212 includes not
merely income of the taxable year but also income which the taxpayer has
realized in a prior taxable year or may realize in subsequent taxable
years; and is not
[[Page 409]]
confined to recurring income but applies as well to gains from the
disposition of property. For example, if defaulted bonds, the interest
from which if received would be includible in income, are purchased with
the expectation of realizing capital gain on their resale, even though
no current yield thereon is anticipated, ordinary and necessary expenses
thereafter paid or incurred in connection with such bonds are
deductible. Similarly, ordinary and necessary expenses paid or incurred
in the management, conservation, or maintenance of a building devoted to
rental purposes are deductible notwithstanding that there is actually no
income therefrom in the taxable year, and regardless of the manner in
which or the purpose for which the property in question was acquired.
Expenses paid or incurred in managing, conserving, or maintaining
property held for investment may be deductible under section 212 even
though the property is not currently productive and there is no
likelihood that the property will be sold at a profit or will otherwise
be productive of income and even though the property is held merely to
minimize a loss with respect thereto.
(c) In the case of taxable years beginning before January 1, 1970,
expenses of carrying on transactions which do not constitute a trade or
business of the taxpayer and are not carried on for the production or
collection of income or for the management, conservation, or maintenance
of property held for the production of income, but which are carried on
primarily as a sport, hobby, or recreation are not allowable as nontrade
or nonbusiness expenses. The question whether or not a transaction is
carried on primarily for the production of income or for the management,
conservation, or maintenance of property held for the production or
collection of income, rather than primarily as a sport, hobby, or
recreation, is not to be determined solely from the intention of the
taxpayer but rather from all the circumstances of the case. For example,
consideration will be given to the record of prior gain or loss of the
taxpayer in the activity, the relation between the type of activity and
the principal occupation of the taxpayer, and the uses to which the
property or what it produces is put by the taxpayer. For provisions
relating to activities not engaged in for profit applicable to taxable
years beginning after December 31, 1969, see section 183 and the
regulations thereunder.
(d) Expenses, to be deductible under section 212, must be ``ordinary
and necessary''. Thus, such expenses must be reasonable in amount and
must bear a reasonable and proximate relation to the production or
collection of taxable income or to the management, conservation, or
maintenance of property held for the production of income.
(e) A deduction under section 212 is subject to the restrictions and
limitations in part IX (section 261 and following), subchapter B,
chapter 1 of the Code, relating to items not deductible. Thus, no
deduction is allowable under section 212 for any amount allocable to the
production or collection of one or more classes of income which are not
includible in gross income, or for any amount allocable to the
management, conservation, or maintenance of property held for the
production of income which is not included in gross income. See section
265. Nor does section 212 allow the deduction of any expenses which are
disallowed by any of the provisions of subtitle A of the Code, even
though such expenses may be paid or incurred for one of the purposes
specified in section 212.
(f) Among expenditures not allowable as deductions under section 212
are the following: Commuter's expenses; expenses of taking special
courses or training; expenses for improving personal appearance; the
cost of rental of a safe-deposit box for storing jewelry and other
personal effects; expenses such as those paid or incurred in seeking
employment or in placing oneself in a position to begin rendering
personal services for compensation, campaign expenses of a candidate for
public office, bar examination fees and other expenses paid or incurred
in securing admission to the bar, and corresponding fees and expenses
paid or incurred by physicians, dentists, accountants, and other
taxpayers for securing the right to practice their respective
professions. See, however, section 162 and the regulations thereunder.
[[Page 410]]
(g) Fees for services of investment counsel, custodial fees,
clerical help, office rent, and similar expenses paid or incurred by a
taxpayer in connection with investments held by him are deductible under
section 212 only if (1) they are paid or incurred by the taxpayer for
the production or collection of income or for the management,
conservation, or maintenance of investments held by him for the
production of income; and (2) they are ordinary and necessary under all
the circumstances, having regard to the type of investment and to the
relation of the taxpayer to such investment.
(h) Ordinary and necessary expenses paid or incurred in connection
with the management, conservation, or maintenance of property held for
use as a residence by the taxpayer are not deductible. However, ordinary
and necessary expenses paid or incurred in connection with the
management, conservation, or maintenance of property held by the
taxpayer as rental property are deductible even though such property was
formerly held by the taxpayer for use as a home.
(i) Reasonable amounts paid or incurred by the fiduciary of an
estate or trust on account of administration expenses, including
fiduciaries' fees and expenses of litigation, which are ordinary and
necessary in connection with the performance of the duties of
administration are deductible under section 212, notwithstanding that
the estate or trust is not engaged in a trade or business, except to the
extent that such expenses are allocable to the production or collection
of tax-exempt income. But see section 642 (g) and the regulations
thereunder for disallowance of such deductions to an estate where such
items are allowed as a deduction under section 2053 or 2054 in computing
the net estate subject to the estate tax.
(j) Reasonable amounts paid or incurred for the services of a
guardian or committee for a ward or minor, and other expenses of
guardians and committees which are ordinary and necessary, in connection
with the production or collection of income inuring to the ward or
minor, or in connection with the management, conservation, or
maintenance of property, held for the production of income, belonging to
the ward or minor, are deductible.
(k) Expenses paid or incurred in defending or perfecting title to
property, in recovering property (other than investment property and
amounts of income which, if and when recovered, must be included in
gross income), or in developing or improving property, constitute a part
of the cost of the property and are not deductible expenses. Attorneys'
fees paid in a suit to quiet title to lands are not deductible; but if
the suit is also to collect accrued rents thereon, that portion of such
fees is deductible which is properly allocable to the services rendered
in collecting such rents. Expenses paid or incurred in protecting or
asserting one's right to property of a decedent as heir or legatee, or
as beneficiary under a testamentary trust, are not deductible.
(l) Expenses paid or incurred by an individual in connection with
the determination, collection, or refund of any tax, whether the taxing
authority be Federal, State, or municipal, and whether the tax be
income, estate, gift, property, or any other tax, are deductible. Thus,
expenses paid or incurred by a taxpayer for tax counsel or expenses paid
or incurred in connection with the preparation of his tax returns or in
connection with any proceedings involved in determining the extent of
his tax liability or in contesting his tax liability are deductible.
(m) An expense (not otherwise deductible) paid or incurred by an
individual in determining or contesting a liability asserted against him
does not become deductible by reason of the fact that property held by
him for the production of income may be required to be used or sold for
the purpose of satisfying such liability.
(n) Capital expenditures are not allowable as nontrade or
nonbusiness expenses. The deduction of an item otherwise allowable under
section 212 will not be disallowed simply because the taxpayer was
entitled under Subtitle A of the Code to treat such item as a capital
expenditure, rather than to deduct it as an expense. For example, see
section 266. Where, however, the item may properly be treated only as a
capital expenditure or where it was properly so treated under an option
granted in
[[Page 411]]
Subtitle A of the Code, no deduction is allowable under section 212; and
this is true regardless of whether any basis adjustment is allowed under
any other provision of the Code.
(o) The provisions of section 212 are not intended in any way to
disallow expenses which would otherwise be allowable under section 162
and the regulations thereunder. Double deductions are not permitted.
Amounts deducted under one provision of the Internal Revenue Code of
1954 cannot again be deducted under any other provision thereof.
(p) Frustration of public policy. The deduction of a payment will be
disallowed under section 212 if the payment is of a type for which a
deduction would be disallowed under section 162(c), (f), or (g) and the
regulations thereunder in the case of a business expense.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 12, 1960, as
amended by T.D. 7198, 37 FR 13685, July 13, 1972; T.D. 7345, 40 FR 7439,
Feb. 20, 1975]
Sec. 1.213-1 Medical, dental, etc., expenses.
(a) Allowance of deduction. (1) Section 213 permits a deduction of
payments for certain medical expenses (including expenses for medicine
and drugs). Except as provided in paragraph (d) of this section
(relating to special rule for decedents) a deduction is allowable only
to individuals and only with respect to medical expenses actually paid
during the taxable year, regardless of when the incident or event which
occasioned the expenses occurred and regardless of the method of
accounting employed by the taxpayer in making his income tax return.
Thus, if the medical expenses are incurred but not paid during the
taxable year, no deduction for such expenses shall be allowed for such
year.
(2) Except as provided in subparagraphs (4)(i) and (5)(i) of this
paragraph, only such medical expenses (including the allowable expenses
for medicine and drugs) are deductible as exceed 3 percent of the
adjusted gross income for the taxable year. For taxable years beginning
after December 31, 1966, the amounts paid during the taxable year for
insurance that constitute expenses paid for medical care shall, for
purposes of computing total medical expenses, be reduced by the amount
determined under subparagraph (5)(i) of this paragraph. For the amounts
paid during the taxable year for medicine and drugs which may be taken
into account in computing total medical expenses, see paragraph (b) of
this section. For the maximum deduction allowable under section 213 in
the case of certain taxable years, see paragraph (c) of this section. As
to what constitutes ``adjusted gross income'', see section 62 and the
regulations thereunder.
(3)(i) For medical expenses paid (including expenses paid for
medicine and drugs) to be deductible, they must be for medical care of
the taxpayer, his spouse, or a dependent of the taxpayer and not be
compensated for by insurance or otherwise. Expenses paid for the medical
care of a dependent, as defined in section 152 and the regulations
thereunder, are deductible under this section even though the dependent
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. Where such expenses are paid by two or more
persons and the conditions of section 152(c) and the regulations
thereunder are met, the medical expenses are deductible only by the
person designated in the multiple support agreement filed by such
persons and such deduction is limited to the amount of medical expenses
paid by such person.
(ii) An amount excluded from gross income under section 105 (c) or
(d) (relating to amounts received under accident and health plans) and
the regulations thereunder shall not constitute compensation for
expenses paid for medical care. Exclusion of such amounts from gross
income will not affect the treatment of expenses paid for medical care.
(iii) The application of the rule allowing a deduction for medical
expenses to the extent not compensated for by insurance or otherwise may
be illustrated by the following example in which it is assumed that
neither the taxpayer nor his wife has attained the age of 65:
[[Page 412]]
Example. Taxpayer H, married to W and having one dependent child,
had adjusted gross income for 1956 of $3,000. During 1956 he paid $300
for medical care, of which $100 was for treatment of his dependent child
and $200 for an operation on W which was performed in September 1955. In
1956 he received a payment of $50 for health insurance to cover a
portion of the cost of W's operation performed during 1955. The
deduction allowable under section 213 for the calendar year 1956,
provided the taxpayer itemizes his deductions and does not compute his
tax under section 3 by use of the tax table, is $160, computed as
follows:
Payments in 1956 for medical care............................ $300
Less: Amount of insurance received in 1956................... 50
----------
Payments in 1956 for medical care not compensated for 250
during 1956.............................................
Less: 3 percent of $3,000 (adjusted gross income)............ 90
----------
Excess, allowable as a deduction for 1956................ 160
(4)(i) For taxable years beginning before January 1, 1967, where
either the taxpayer or his spouse has attained the age of 65 before the
close of the taxable year, the 3-percent limitation on the deduction for
medical expenses does not apply with respect to expenses for medical
care of the taxpayer or his spouse. Moreover, for taxable years
beginning after December 31, 1959, and before January 1, 1967, the 3-
percent limitation on the deduction for medical expenses does not apply
to amounts paid for the medical care of a dependent (as defined in sec.
152) who is the mother or father of the taxpayer or his spouse and who
has attained the age of 65 before the close of the taxpayer's taxable
year. For taxable years beginning before January 1, 1964, and for
taxable years beginning after December 31, 1966, all amounts paid by the
taxpayer for medicine and drugs are subject to the 1-percent limitation
provided by section 213(b). For taxable years beginning after December
31, 1963, and before January 1, 1967, the 1-percent limitation provided
by section 213(b) does not apply, under certain circumstances, to
amounts paid by the taxpayer for medicine and drugs for the taxpayer and
his spouse or for a dependent (as defined in sec. 152) who is the mother
or father of the taxpayer or of his spouse. (For additional provisions
relating to the 1-percent limitation with respect to medicine and drugs,
see paragraph (b) of this section.) For taxable years beginning before
January 1, 1967, whether or not the 3-percent or 1-percent limitation
applies, the total medical expenses deductible under section 213 are
subject to the limitations described in section 213(c) and paragraph (c)
of this section and, where applicable, to the limitations described in
section 213(g) and Sec. 1.213-2.
(ii) The age of a taxpayer shall be determined as of the last day of
his taxable year. In the event of the taxpayer's death, his taxable year
shall end as of the date of his death. The age of a taxpayer's spouse
shall be determined as of the last day of the taxpayer's taxable year,
except that, if the spouse dies within such taxable year, her age shall
be determined as of the date of her death. Likewise, the age of the
taxpayer's dependent who is the mother or father of the taxpayer or of
his spouse shall be determined as of the last day of the taxpayer's
taxable year but not later than the date of death of such dependent.
(iii) The application of subdivision (i) of this subparagraph may be
illustrated by the following examples:
Example 1. Taxpayer A, who attained the age of 65 on February 22,
1956, makes his return on the basis of the calendar year. During the
year 1956, A had adjusted gross income of $8,000, and paid the following
medical bills: (a) $560 (7 percent of adjusted gross income) for the
medical care of himself and his spouse, and (b) $160 (2 percent of
adjusted gross income) for the medical care of his dependent son. No
part of these payments was for medicine and drugs nor compensated for by
insurance or otherwise. The allowable deduction under section 213 for
1956 is $560, the full amount of the medical expenses for the taxpayer
and his spouse. No deduction is allowable for the amount of $160 paid
for medical care of the dependent son since the amount of such payment
(determined without regard to the payments for the care of the taxpayer
and his spouse) does not exceed 3 percent of adjusted gross income.
Example 2. H and W, who have a dependent child, made a joint return
for the calendar year 1956. H became 65 years of age on August 15, 1956.
The adjusted gross income of H and W in 1956 was $40,000 and they paid
in such year the following amounts for medical care: (a) $3,000 for the
medical care of H; (b) $2,000 for the medical care of W; and (c) $3,000
for the medical care of the dependent child. No part of these payments
was for medicine and drugs nor compensated for by insurance or
otherwise. The allowable deduction under
[[Page 413]]
section 213 for medical expenses paid in 1956 is $6,800 computed as
follows:
Payments for medical care of H and W in 1956................. $5,000
Payments for medical care of the dependent in 1956 $3,000
Less: 3 percent of $40,000 (adjusted gross income) 1,200
-------- 1,800
----------
Allowable deduction for 1956.................. ......... 6,800
Example 3. D and his wife, E, made a joint income tax return for the
calendar year 1962, and reported adjusted gross income of $30,000. On
December 13, 1962, D attained the age of 65. During the year 1962, D's
father, F, who was 87 years of age, received over half of his support
from, and was a dependent (as defined in section 152) of, D. However, D
could not claim an exemption under section 151 for F because F had gross
income from rents in 1962 of $800. D paid the following medical expenses
in 1962, none of which were compensated for by insurance or otherwise:
hospital and doctor bills for D and E, $6,500; hospital and doctor bills
for F, $4,850; medicine and drugs for D and E, $225, and for F, $225.
Since none of the medical expenses are subject to the 3-percent
limitation, the amount of medical expenses to be taken into account
(before computing the maximum deduction) is $11,500, computed as
follows:
Hospital and doctor bills--for D and E............ ......... $6,500
Hospital and doctor bills--for F.................. ......... 4,850
Medicine and drugs--for D and E................... $225
Medicine and drugs--for F......................... $225
-----------
Total medicine and drugs...................... 450
Less: 1 percent of adjusted gross income ($30,000) 300
-----------
Allowable expenses for medicine and drugs......... ......... $150
----------
Total medical expenses taken into account..... ......... 11,500
Since an exemption cannot be claimed for F on the 1962 return of D and
E, their deduction for medical expenses (assuming that section 213(g)
does not apply) is limited to $10,000 for that year ($5,000 multiplied
by the two exemptions allowed for D and E under section 151(b)). If
these identical facts had occurred in a taxable year beginning before
January 1, 1962, the medical expense deduction for D and E would, for
such taxable year, be limited to $5,000 ($2,500 multiplied by the two
exemptions allowed for D and E under section 151(b)). See paragraph (c)
of this section.
Example 4. Assume the same facts as in Example 3, except that D
furnished the entire support of his father's twin sister, G, who had no
gross income during 1962 and for whom D was entitled to a dependency
exemption. In addition, D paid $4,800 to doctors and hospitals during
1962 for the medical care of G. No part of the $4,800 was for medicine
and drugs, and no amount was compensated for by insurance or otherwise.
For purposes of the maximum limitation under section 213(c), the maximum
deduction for medical expenses on the 1962 return of D and E is limited
to $15,000 ($5,000 multiplied by 3, the number of exemptions allowed
under section 151, exclusive of the exemptions for old age or
blindness). If these identical facts had occurred in a taxable year
beginning before January 1, 1962, the medical expense deduction for D
and E would, for such taxable year, be limited to $7,500 ($2,500
multiplied by the three exemptions allowed under section 151, exclusive
of the exemptions for old age or blindness). The medical expenses to be
taken into account by D and E for 1962 and the maximum deductions
allowable for such expenses are $15,400 and $15,000, respectively,
computed as follows:
Medical expenses per Example 3.................... ......... $11,500
Add: Expenses paid for G.......................... $4,800
Less: 3 percent of adjusted gross income ($30,000) 900
-------- 3,900
----------
Total medical expenses taken into account................ 15,400
Maximum deduction for 1962 ($5,000 multiplied by 3 15,000
exemptions).................................................
----------
Medical expenses not deductible.............................. 400
Example 5. Assume that the facts set forth in Example 3 had occurred
in respect of the calendar year 1964 rather than the calendar year 1962.
Since both D and his father, F, had attained the age of 65 before the
close of the taxable year, the 1-percent limitation does not apply to
the amounts paid for medicine and drugs for D, E, and F. Accordingly,
the total medical expenses taken into account by D and E for 1964 would
be $11,800 (rather than $11,500 as in Example 3) computed as follows:
Hospital and doctor bills--for D and E...................... $6,500
Hospital and doctor bills--for F............................ 4,350
Medicine and drugs--for D and E............................. 225
Medicine and drugs--for F................................... 225
-----------
Total medical expenses taken into account................. 11,800
(5)(i) For taxable years beginning after December 31, 1966, there
may be deducted without regard to the 3-percent limitation the lesser
of--(a) One-half of the amounts paid during the taxable year for
insurance which constitute expenses for medical care for the taxpayer,
his spouse, and dependents; or (b) $150.
(ii) The application of subdivision (i) of this subparagraph may be
illustrated by the following example:
Example. H and W made a joint return for the calendar year 1967. The
adjusted gross income of H and W for 1967 was $10,000 and they
[[Page 414]]
paid in such year $370 for medical care of which amount $350 was paid
for insurance which constitutes medical care for H and W. No part of the
payment was for medicine and drugs or was compensated for by insurance
or otherwise. The allowable deduction under section 213 for medical
expenses paid in 1967 is $150, computed as follows:
(1) Lesser of $175 (one-half of amounts paid for insurance) or $150
$150...........................................................
(2) Payments for medical care................... $370 ...... ......
(3) Less line 1................................. 150 ...... ......
--------
(4) Medical expenses to be taken into account under 3- $220
percent limitation (line 2 minus line 3)...............
(5) Less: 3 percent of $10,000 (adjusted gross income).. 300
--------
(6) Excess allowable as a deduction for 1967 (excess of line 4 0
over line 5)...................................................
-------
(7) Allowable medical expense deduction for 1967 (line 1 plus $150
line 6)........................................................
(b) Limitation with respect to medicine and drugs--(1) Taxable years
beginning before January 1, 1964. (i) Amounts paid during taxable years
beginning before January 1, 1964, for medicine and drugs are to be taken
into account in computing the allowable deduction for medical expenses
paid during the taxable year only to the extent that the aggregate of
such amounts exceeds 1 percent of the adjusted gross income for the
taxable year. Thus, if the aggregate of the amounts paid for medicine
and drugs exceeds 1 percent of adjusted gross income, the excess is
added to other medical expenses for the purpose of computing the medical
expense deduction. The application of this subdivision may be
illustrated by the following example:
Example. The taxpayer, a single individual with no dependents, had
an adjusted gross income of $6,000 for the calendar year 1956. During
1956, he paid a doctor $300 for medical services, a hospital $100 for
hospital care, and also spent $100 for medicine and drugs. These
payments were not compensated for by insurance or otherwise. The
deduction allowable under section 213 for the calendar year 1956 is
$260, computed as follows:
Payments for medical care in 1956:
Doctor.......................................................... $300
Hospital........................................................ 100
Medicine and drugs...................................... $100
Less: 1 percent of $6,000 (adjusted gross income)....... 60 40
---------------
Total medical expenses taken into account..................... 440
Less: 3 percent of $6,000 (adjusted gross income)............... 180
-------
Allowable deduction for 1956.................................... 260
(ii) For taxable years beginning before January 1, 1964, the 1-
percent limitation is applicable to all amounts paid by a taxpayer
during the taxable year for medicine and drugs. Moreover, this
limitation applies regardless of the fact that the amounts paid are for
medicine and drugs for the taxpayer, his spouse, or dependent parent
(the mother or father of the taxpayer or of his spouse) who has attained
the age of 65 before the close of the taxable year. In a case where
either a taxpayer or his spouse has attained the age of 65 and the
taxpayer pays an amount in excess of 1 percent of adjusted gross income
for medicine and drugs for himself, his spouse, and his dependents, it
is necessary to apportion the 1 percent of adjusted gross income (the
portion which is not taken into account as expenses paid for medical
care) between the taxpayer and his spouse on the one hand and his
dependents on the other. The part of the 1 percent allocable to the
taxpayer and his spouse is an amount which bears the same ratio to 1
percent of his adjusted gross income which the amount paid for medicine
and drugs for the taxpayer and his spouse bears to the total amount paid
for medicine and drugs for the taxpayer, his spouse, and his dependents.
The balance of the 1 percent shall be allocated to his dependents. The
amount paid for medicine and drugs in excess of the allocated part of
the 1 percent shall be taken into account as payments for medical care
for the taxpayer and his spouse on the one hand and his dependents on
the other, respectively. A similar apportionment must be made in the
case of a dependent parent (65 years of age or over) of the taxpayer or
his spouse. The application of this subdivision (ii) may be illustrated
by the following example:
Example. H and W, who have a dependent child, made a joint return
for the calendar year 1956. H became 65 years of age on September 15,
1956. The adjusted gross income of H and W for 1956 is $10,000. During
the year, H and W paid the following amounts for medical care: (i)
$1,000 for doctors and hospital expenses and $180 for medicine and drugs
for themselves; and (ii) $500 for doctors and hospital expenses and $140
for medicine and drugs for the dependent child. These payments were not
compensated for by insurance or otherwise. The deduction allowable
[[Page 415]]
under section 213(a)(2) for medical expenses paid in 1956 is $1,420,
computed as follows:
------------------------------------------------------------------------
------------------------------------------------------------------------
H and W:
Payments for doctors and hospital. .......... .......... $1,000.00
Payments for medicine and drugs... .......... $180.00 ..........
Less: Limitation for medicine and .......... 56.25 123.75
drugs (see computation below)....
-----------------------
Medical expenses for H and W to .......... .......... 1,123.75
be taken into account..........
Dependent:
Payments for doctors and hospital. .......... 500.00 ..........
Payments for medicine and drugs. $140.00 .......... ..........
Less: Limitation for medicine 43.75 96.25
and drugs (see computation
below).........................
------------------------
Total medical expenses.......... .......... 596.25
Less: 3 percent of $10,000 .......... 300.00
(adjusted gross income)..........
------------
Medical expenses for the dependent .......... .......... 296.25
to be taken into account.........
Allowable deductions for 1956... .......... .......... 1,420.00
-----------
Payments for medicine and drugs:
H and W........................... .......... .......... 180.00
Dependent......................... .......... .......... 140.00
-----------
Total payments.................. .......... .......... 320.00
Less: 1 percent of $10,000 .......... .......... 100.00
(adjusted gross income)..........
Payments to be taken into account. .......... .......... 20.00
-----------
Allocation of 1-percent exclusion:
H and W (180 / 320 x $100)........ .......... .......... 56.25
Dependent (140 / 320 x $100)...... .......... .......... 43.75
-----------
Total........................... .......... .......... 100.00
------------------------------------------------------------------------
(2) Taxable years beginning after December 31, 1963. (i) Except as
otherwise provided in subdivision (ii) of this subparagraph, amounts
paid during taxable years beginning after December 31, 1963, for
medicine and drugs are to be taken into account in computing the
allowable deduction for medical expenses paid during the taxable year
only to the extent that the aggregate of such amounts exceeds 1 percent
of the adjusted gross income for the taxable year. Thus, if the
aggregate of the amounts paid for medicine and drugs which are subject
to the 1-percent limitation exceeds 1 percent of adjusted gross income,
the excess is added to other medical expenses for the purpose of
computing the medical expense deduction.
(ii) The 1-percent limitation provided by section 213 does not apply
to amounts paid by a taxpayer during a taxable year beginning after
December 31, 1963, and before January 1, 1967, for medicine and drugs
for the medical care of the taxpayer and his spouse if either has
attained the age of 65 before the close of the taxable year. Moreover,
for taxable years beginning after December 31, 1963, and before January
1, 1967, the 1-percent limitation with respect to medicine and drugs
does not apply to amounts paid for the medical care of a dependent (as
defined in sec. 152) who is the mother or father of the taxpayer or of
his spouse and who has attained the age of 65 before the close of the
taxpayer's taxable year. Amounts paid for medicine and drugs which are
not subject to the limitation on medicine and drugs are added to other
medical expenses of a taxpayer and his spouse or the dependent (as the
case may be) for the purpose of computing the medical expense deduction.
(iii) The application of this subparagraph may be illustrated by the
following examples:
Example 1. H and W, who have a dependent child, C, were both under
65 years of age at the close of the calendar year 1964 and made a joint
return for that calendar year. During the year 1964, H's mother, M,
attained the age of 65, and was a dependent (as defined in section 152)
of H. The adjusted gross income of H and W in 1964 was $12,000. During
1964 H and W paid the following amounts for medical care: (i) $600 for
doctors and hospital expenses and $120 for medicine and drugs for
themselves; (ii) $350 for doctors and hospital expenses and $60 for
medicine and drugs for
[[Page 416]]
C; and (iii) $400 for doctors and hospital expenses and $100 for
medicine and drugs for M. These payments were not compensated for by
insurance or otherwise. The deduction allowable under section 213(a) (1)
for medical expenses paid in 1964 is $1,150, computed as follows:
H, W, and C:
Payments for doctors and hospital..................... $950
Payments for medicine and drugs............... $180
Less: 1 percent of $12,000 (adjusted gross 120 60
income)......................................
----------------
Total medical expenses.............................. 1,010
Less: 3 percent of $12,000 (adjusted gross income).... 360
--------
Medical expenses of H, W, and C to be taken into account.... $650
M:
Payments for doctors and hospitals.................... 400
Payments for medicine and drugs....................... 100
--------
Medical expenses of M to be taken into account.............. 500
-------
Allowable deduction for 1964.................................. 1,150
Example 2. H and W, who have a dependent child, C, made a joint
return for the calendar year 1964, and reported adjusted gross income of
$12,000. H became 65 years of age on January 23, 1964. F, the 87 year
old father of W, was a dependent of H. During 1964, H and W paid the
following amounts for medical care: (i) $400 for doctors and hospital
expenses and $75 for medicine and drugs for H; (ii) $200 for doctors and
hospital expenses and $100 for medicine and drugs for W; (iii) $200 for
doctors and hospital expenses and $175 for medicine and drugs for C; and
(iv) $700 for doctors and hospital expenses and $150 for medicine and
drugs for F. These payments were not compensated for by insurance or
otherwise. The deduction allowable under section 213(a) (2) for medical
expenses paid in 1964 is $1,625, computed as follows:
H and W:
Payments for doctors and hospital..................... $600
Payments for medicine and drugs....................... 175
--------
Medical expenses for H and W to be taken into ...... $775
account............................................
F:
Payments for doctors and hospital..................... 700
Payments for medicine and drugs....................... 150
--------
Medical expenses for F to be taken into account..... ...... 850
C:
Payments for doctors and hospital............. ...... 200
Payments for medicine and drugs............... $175
Less: 1 percent of $12,000 (adjusted gross 120 55
income)......................................
----------------
Total medical expenses...................... ...... 255
Less: 3 percent of $12,000 (adjusted gross income).... 360
--------
Medical expenses for C to be taken into account............. 0
-------
Allowable deduction for 1964................................ 1,625
Example 3. Assume the same facts as example (2) except that the
calendar year of the return is 1967 and the amounts paid for medical
care were paid during 1967. The deduction allowable under section 213(a)
for medical expenses paid in 1967 is $1,520, computed as follows:
Payments for doctors and hospitals:
H................................... $400
W................................... 200
C................................... 200
F................................... 700
------ ..... $1,500
Payments for medicine and drugs:
H................................... 75
W................................... 100
C................................... 175
F................................... 150
---- $500
Less: 1 percent of $12,000 (adjusted gross 120 380
income).......................................
----------------
Medical expenses to be taken into account...... ..... ....... $1,880
Less: 3 percent of $12,000 (adjusted gross ..... ....... 360
income).......................................
--------
Allowable medical expense deduction for 1967... ..... ....... 1,520
(3) Definition of medicine and drugs. For definition of medicine and
drugs, see paragraph (e) (2) of this section.
(c) Maximum limitations. (1) For taxable years beginning after
December 31, 1966, there shall be no maximum limitation on the amount of
the deduction allowable for payment of medical expenses.
(2) Except as provided in section 213(g) and Sec. 1.213-2 (relating
to maximum limitations with respect to certain aged and disabled
individuals for taxable years beginning before January 1, 1967), for
taxable years beginning after December 31, 1961, and before January 1,
1967, the maximum deduction allowable for medical expenses paid in any
one taxable year is the lesser of:
(i) $5,000 multiplied by the number of exemptions allowed under
section 151 (exclusive of exemptions allowed under section 151(c) for a
taxpayer or spouse attaining the age of 65, or section 151(d) for a
taxpayer who is blind or a spouse who is blind);
(ii) $10,000, if the taxpayer is single, not the head of a household
(as defined in section 1(b) (2)) and not a surviving
[[Page 417]]
spouse (as defined in section 2(b)), or is married and files a separate
return; or
(iii) $20,000 if the taxpayer is married and files a joint return
with his spouse under section 6013, or is the head of a household (as
defined in section 1(b) (2)), or a surviving spouse (as defined in
section 2(b)).
(3) The application of subparagraph (2) of this paragraph may be
illustrated by the following example:
Example. H and W made a joint return for the calendar year 1962 and
were allowed five exemptions (exclusive of exemptions under sec. 151 (c)
and (d)), one for each taxpayer and three for their dependents. The
adjusted gross income of H and W in 1962 was $80,000. They paid during
such year $26,000 for medical care, no part of which is compensated for
by insurance or otherwise. The deduction allowable under section 213 for
the calendar year 1962 is $20,000, computed as follows:
Payments for medical care in 1962............................ $26,000
Less: 3 percent of $80,000 (adjusted gross income)........... 2,400
----------
Excess of medical expenses in 1962 over 3 percent of adjusted 23,600
gross income................................................
Allowable deduction for 1962 ($5,000 multiplied by five 20,000
exemptions allowed under sec. 151 (b) and (e) but not in
excess of $20,000)..........................................
(4) Except as provided in section 213(g) and Sec. 1.213-2 (relating
to certain aged and disabled individuals), for taxable years beginning
before January 1, 1962, the maximum deduction allowable for medical
expenses paid in any 1 taxable year is the lesser of:
(i) $2,500 multiplied by the number of exemptions allowed under
section 151 (exclusive of exemptions allowed under section 151(c) for a
taxpayer or spouse attaining the age of 65, or section 151(d) for a
taxpayer who is blind or a spouse who is blind);
(ii) $5,000, if the taxpayer is single, not the head of a household
(as defined in section 1(b) (2)) and not a surviving spouse (as defined
in section 2(b)) or is married and files a separate return; or
(iii) $10,000, if the taxpayer is married and files a joint return
with his spouse under section 6013, or is head of a household (as
defined in section 1(b) (2)), or a surviving spouse (as defined in
section 2(b)).
(5) For the maximum deduction allowable for taxable years beginning
before January 1, 1967, if the taxpayer or his spouse is age 65 or over
and is disabled, see Sec. 1.213-2.
(d) Special rule for decedents. (1) For the purpose of section 213
(a), expenses for medical care of the taxpayer which are paid out of his
estate during the 1-year period beginning with the day after the date of
his death shall be treated as paid by the taxpayer at the time the
medical services were rendered. However, no credit or refund of tax
shall be allowed for any taxable year for which the statutory period for
filing a claim has expired. See section 6511 and the regulations
thereunder.
(2) The rule prescribed in subparagraph (1) of this paragraph shall
not apply where the amount so paid is allowable under section 2053 as a
deduction in computing the taxable estate of the decedent unless there
is filed in duplicate (i) a statement that such amount has not been
allowed as a deduction under section 2053 in computing the taxable
estate of the decedent and (ii) a waiver of the right to have such
amount allowed at any time as a deduction under section 2053. The
statement and waiver shall be filed with or for association with the
return, amended return, or claim for credit or refund for the decedent
for any taxable year for which such an amount is claimed as a deduction.
(e) Definitions--(1) General. (i) The term medical care includes the
diagnosis, cure, mitigation, treatment, or prevention of disease.
Expenses paid for ``medical care'' shall include those paid for the
purpose of affecting any structure or function of the body or for
transportation primarily for and essential to medical care. See
subparagraph (4) of this paragraph for provisions relating to medical
insurance.
(ii) Amounts paid for operations or treatments affecting any portion
of the body, including obstetrical expenses and expenses of therapy or
X-ray treatments, are deemed to be for the purpose of affecting any
structure or function of the body and are therefore paid for medical
care. Amounts expended for illegal operations or treatments are not
deductible. Deductions for expenditures for medical care allowable under
section 213 will be confined strictly to expenses incurred primarily for
the prevention or alleviation of a physical or mental defect or illness.
Thus, payments for the following are payments
[[Page 418]]
for medical care: hospital services, nursing services (including nurses'
board where paid by the taxpayer), medical, laboratory, surgical, dental
and other diagnostic and healing services, X-rays, medicine and drugs
(as defined in subparagraph (2) of this paragraph, subject to the 1-
percent limitation in paragraph (b) of this section), artificial teeth
or limbs, and ambulance hire. However, an expenditure which is merely
beneficial to the general health of an individual, such as an
expenditure for a vacation, is not an expenditure for medical care.
(iii) Capital expenditures are generally not deductible for Federal
income tax purposes. See section 263 and the regulations thereunder.
However, an expenditure which otherwise qualifies as a medical expense
under section 213 shall not be disqualified merely because it is a
capital expenditure. For purposes of section 213 and this paragraph, a
capital expenditure made by the taxpayer may qualify as a medical
expense, if it has as its primary purpose the medical care (as defined
in subdivisions (i) and (ii) of this subparagraph) of the taxpayer, his
spouse, or his dependent. Thus, a capital expenditure which is related
only to the sick person and is not related to permanent improvement or
betterment of property, if it otherwise qualifies as an expenditure for
medical care, shall be deductible; for example, an expenditure for eye
glasses, a seeing eye dog, artificial teeth and limbs, a wheel chair,
crutches, an inclinator or an air conditioner which is detachable from
the property and purchased only for the use of a sick person, etc.
Moreover, a capital expenditure for permanent improvement or betterment
of property which would not ordinarily be for the purpose of medical
care (within the meaning of this paragraph) may, nevertheless, qualify
as a medical expense to the extent that the expenditure exceeds the
increase in the value of the related property, if the particular
expenditure is related directly to medical care. Such a situation could
arise, for example, where a taxpayer is advised by a physician to
install an elevator in his residence so that the taxpayer's wife who is
afflicted with heart disease will not be required to climb stairs. If
the cost of installing the elevator is $1,000 and the increase in the
value of the residence is determined to be only $700, the difference of
$300, which is the amount in excess of the value enhancement, is
deductible as a medical expense. If, however, by reason of this
expenditure, it is determined that the value of the residence has not
been increased, the entire cost of installing the elevator would qualify
as a medical expense. Expenditures made for the operation or maintenance
of a capital asset are likewise deductible medical expenses if they have
as their primary purpose the medical care (as defined in subdivisions
(i) and (ii) of this subparagraph) of the taxpayer, his spouse, or his
dependent. Normally, if a capital expenditure qualifies as a medical
expense, expenditures for the operation or maintenance of the capital
asset would also qualify provided that the medical reason for the
capital expenditure still exists. The entire amount of such operation
and maintenance expenditures qualifies, even if none or only a portion
of the original cost of the capital asset itself qualified.
(iv) Expenses paid for transportation primarily for and essential to
the rendition of the medical care are expenses paid for medical care.
However, an amount allowable as a deduction for ``transportation
primarily for and essential to medical care'' shall not include the cost
of any meals and lodging while away from home receiving medical
treatment. For example, if a doctor prescribes that a taxpayer go to a
warm climate in order to alleviate a specific chronic ailment, the cost
of meals and lodging while there would not be deductible. On the other
hand, if the travel is undertaken merely for the general improvement of
a taxpayer's health, neither the cost of transportation nor the cost of
meals and lodging would be deductible. If a doctor prescribes an
operation or other medical care, and the taxpayer chooses for purely
personal considerations to travel to another locality (such as a resort
area) for the operation or the other medical care, neither the cost of
transportation nor the cost of meals and lodging (except where paid as
part of a hospital bill) is deductible.
[[Page 419]]
(v) The cost of in-patient hospital care (including the cost of
meals and lodging therein) is an expenditure for medical care. The
extent to which expenses for care in an institution other than a
hospital shall constitute medical care is primarily a question of fact
which depends upon the condition of the individual and the nature of the
services he receives (rather than the nature of the institution). A
private establishment which is regularly engaged in providing the types
of care or services outlined in this subdivision shall be considered an
institution for purposes of the rules provided herein. In general, the
following rules will be applied:
(a) Where an individual is in an institution because his condition
is such that the availability of medical care (as defined in
subdivisions (i) and (ii) of this subparagraph) in such institution is a
principal reason for his presence there, and meals and lodging are
furnished as a necessary incident to such care, the entire cost of
medical care and meals and lodging at the institution, which are
furnished while the individual requires continual medical care, shall
constitute an expense for medical care. For example, medical care
includes the entire cost of institutional care for a person who is
mentally ill and unsafe when left alone. While ordinary education is not
medical care, the cost of medical care includes the cost of attending a
special school for a mentally or physically handicapped individual, if
his condition is such that the resources of the institution for
alleviating such mental or physical handicap are a principal reason for
his presence there. In such a case, the cost of attending such a special
school will include the cost of meals and lodging, if supplied, and the
cost of ordinary education furnished which is incidental to the special
services furnished by the school. Thus, the cost of medical care
includes the cost of attending a special school designed to compensate
for or overcome a physical handicap, in order to qualify the individual
for future normal education or for normal living, such as a school for
the teaching of braille or lip reading. Similarly, the cost of care and
supervision, or of treatment and training, of a mentally retarded or
physically handicapped individual at an institution is within the
meaning of the term medical care.
(b) Where an individual is in an institution, and his condition is
such that the availability of medical care in such institution is not a
principal reason for his presence there, only that part of the cost of
care in the institution as is attributable to medical care (as defined
in subdivisions (i) and (ii) of this subparagraph) shall be considered
as a cost of medical care; meals and lodging at the institution in such
a case are not considered a cost of medical care for purposes of this
section. For example, an individual is in a home for the aged for
personal or family considerations and not because he requires medical or
nursing attention. In such case, medical care consists only of that part
of the cost for care in the home which is attributable to medical care
or nursing attention furnished to him; his meals and lodging at the home
are not considered a cost of medical care.
(c) It is immaterial for purposes of this subdivision whether the
medical care is furnished in a Federal or State institution or in a
private institution.
(vi) See section 262 and the regulations thereunder for disallowance
of deduction for personal living, and family expenses not falling within
the definition of medical care.
(2) Medicine and drugs. The term medicine and drugs shall include
only items which are legally procured and which are generally accepted
as falling within the category of medicine and drugs (whether or not
requiring a prescription). Such term shall not include toiletries or
similar preparations (such as toothpaste, shaving lotion, shaving cream,
etc.) nor shall it include cosmetics (such as face creams, deodorants,
hand lotions, etc., or any similar preparation used for ordinary
cosmetic purposes) or sundry items. Amounts expended for items which,
under this subparagraph, are excluded from the term medicine and drugs
shall not constitute amounts expended for ``medical care''.
(3) Status as spouse or dependent. In the case of medical expenses
for the care of a person who is the taxpayer's spouse or dependent, the
deduction
[[Page 420]]
under section 213 is allowable if the status of such person as
``spouse'' or ``dependent'' of the taxpayer exists either at the time
the medical services were rendered or at the time the expenses were
paid. In determining whether such status as ``spouse'' exists, a
taxpayer who is legally separated from his spouse under a decree of
separate maintenance is not considered as married. Thus, payments made
in June 1956 by A, for medical services rendered in 1955 to B, his wife,
may be deducted by A for 1956 even though, before the payments were
made, B may have died or in 1956 secured a divorce. Payments made in
July 1956 by C, for medical services rendered to D in 1955 may be
deducted by C for 1956 even though C and D were not married until June
1956.
(4) Medical insurance. (i)(a) For taxable years beginning after
December 31, 1966, expenditures for insurance shall constitute expenses
paid for medical care only to the extent that such amounts are paid for
insurance covering expenses of medical care referred to in subparagraph
(1) of this paragraph. In the case of an insurance contract under which
amounts are payable for other than medical care (as, for example, a
policy providing an indemnity for loss of income or for loss of life,
limb, or sight):
(1) No amount shall be treated as paid for insurance covering
expenses of medical care referred to in subparagraph (1) of this
paragraph unless the charge for such insurance is either separately
stated in the contract or furnished to the policyholder by the insurer
in a separate statement,
(2) The amount taken into account as the amount paid for such
medical insurance shall not exceed such charge, and
(3) No amount shall be treated as paid for such medical insurance if
the amount specified in the contract (or furnished to the policyholder
by the insurer in a separate statement) as the charge for such insurance
is unreasonably large in relation to the total charges under the
contract.
For purposes of the preceding sentence, amounts will be considered
payable for other than medical care under the contract if the contract
provides for the waiver of premiums upon the occurrence of an event. In
determining whether a separately stated charge for insurance covering
expenses of medical care is unreasonably large in relation to the total
premium, the relationship of the coverages under the contract together
with all of the facts and circumstances shall be considered. In
determining whether a contract constitutes an ``insurance'' contract it
is irrelevant whether the benefits are payable in cash or in services.
For example, amounts paid for hospitalization insurance, for membership
in an association furnishing cooperative or so-called free-choice
medical service, or for group hospitalization and clinical care are
expenses paid for medical care. Premiums paid under Part B, title XVIII
of the Social Security Act (42 U.S.C. 1395j-1395w), relating to
supplementary medical insurance benefits for the aged, are amounts paid
for insurance covering expenses of medical care. Taxes imposed by any
governmental unit do not, however, constitute amounts paid for such
medical insurance.
(b) For taxable years beginning after December 31, 1966, subject to
the rules of (a) of this subdivision, premiums paid during a taxable
year by a taxpayer under the age of 65 for insurance covering expenses
of medical care for the taxpayer, his spouse, or a dependent after the
taxpayer attains the age of 65 are to be treated as expenses paid during
the taxable year for insurance covering expenses of medical care if the
premiums for such insurance are payable (on a level payment basis) under
the contract:
(1) For a period of 10 years or more, or
(2) Until the year in which the taxpayer attains the age of 65 (but
in no case for a period of less than 5 years).
For purposes of this subdivision (b), premiums will be considered
payable on a level payment basis if the total premium under the contract
is payable in equal annual or more frequent installments. Thus, a total
premium of $10,000 payable over a period of 10 years at $1,000 a year
shall be considered payable on a level payment basis.
(ii) For taxable years beginning before January 1, 1967, expenses
paid for medical care shall include amounts
[[Page 421]]
paid for accident or health insurance. In determining whether a contract
constitutes an ``insurance'' contract it is irrelevant whether the
benefits are payable in cash or in services. For example, amounts paid
for hospitalization insurance, for membership in an association
furnishing cooperative or so-called free-choice medical service, or for
group hospitalization and clinical care are expenses paid for medical
care.
(f) Exclusion of amounts allowed for care of certain dependents.
Amounts taken into account under section 44A in computing a credit for
the care of certain dependents shall not be treated as expenses paid for
medical care.
(g) Reimbursement for expenses paid in prior years. (1) Where
reimbursement, from insurance or otherwise, for medical expenses is
received in a taxable year subsequent to a year in which a deduction was
claimed on account of such expenses, the reimbursement must be included
in gross income in such subsequent year to the extent attributable to
(and not in excess of) deductions allowed under section 213 for any
prior taxable year. See section 104, relating to compensation for
injuries or sickness, and section 105(b), relating to amounts expended
for medical care, and the regulations thereunder, with regard to amounts
in excess of or not attributable to deductions allowed.
(2) If no medical expense deduction was taken in an earlier year,
for example, if the standard deduction under section 141 was taken for
the earlier year, the reimbursement received in the taxable year for the
medical expense of the earlier year is not includible in gross income.
(3) In order to allow the same aggregate medical expense deductions
as if the reimbursement received in a subsequent year or years had been
received in the year in which the payments for medical care were made,
the following rules shall be followed:
(i) If the amount of the reimbursement is equal to or less than the
amount which was deducted in a prior year, the entire amount of the
reimbursement shall be considered attributable to the deduction taken in
such prior year (and hence includible in gross income); or
(ii) If the amount of the reimbursement received in such subsequent
year or years is greater than the amount which was deducted for the
prior year, that portion of the reimbursement received which is equal in
amount to the deduction taken in the prior year shall be considered as
attributable to such deduction (and hence includible in gross income);
but
(iii) If the deduction for the prior year would have been greater
but for the limitations on the maximum amount of such deduction provided
by section 213 (c), then the amount of the reimbursement attributable to
such deduction (and hence includible in gross income) shall be the
amount of the reimbursement received in a subsequent year or years
reduced by the amount disallowed as a deduction because of the maximum
limitation, but not in excess of the deduction allowed for the previous
year.
(4) The application of subparagraphs (1), (2), and (3) of this
paragraph may be illustrated by the following examples. Examples 1 and 2
reflect the maximum limitation on the medical expense deduction
applicable to taxable years beginning after December 31, 1961. Examples
3 and 4 reflect the maximum limitation on the medical expense deduction
applicable to taxable years beginning prior to January 1, 1962. For
explanation of such maximum medical expense limitations, see paragraph
(c) of this section.
Example 1. Taxpayer A, a single individual (not the head of a
household and not a surviving spouse) with one dependent, is entitled to
two exemptions under the provisions of section 151. He had an adjusted
gross income of $35,000 for the calendar year 1962. During 1962 he paid
$16,000 for medical care. A received no reimbursement for such medical
expenses in 1962, but in 1963 he received $6,000 upon an insurance
policy covering the medical expenses which he paid in 1962. A was
allowed a deduction of $10,000 (the maximum) from his adjusted gross
income for 1962. The amount which A must include in his gross income for
1963 is $1,050, and the amount to be excluded from gross income for 1963
is $4,950, computed as follows:
Payments for medical care in 1962 (not reimbursed in 1962)... $16,000
Less: 3 percent of $35,000 (adjusted gross income)........... 1,050
----------
[[Page 422]]
Excess of medical expenses not reimbursed in 1962 over 3 10,000
percent of adjusted gross income........................
Allowable deduction for 1962................................. 10,000
----------
Amount by which the medical deductions for 1962 would have 4,950
been greater than $10,000 but for the limitations on the
maximum amount provided by section 213......................
==========
Reimbursement received in 1963............................... $6,000
Less: Amount by which the medical deduction for 1962 would 4,950
have been greater than $10,000 but for the limitation on the
maximum amount provided by section 213......................
----------
Reimbursement received in 1963 reduced by the amount by which 1,050
the medical deduction for 1962 would have been greater than
$10,000 but for the limitations on the maximum amount
provided by section 213.....................................
Amount attributed to medical deduction taken for 1962........ 1,050
Amount to be included in gross income for 1963............... 1,050
Amount to be excluded from gross income for 1963 ($6,000 less 4,950
$1,050).....................................................
Example 2. Assuming that A, in example (1), received $15,000 in 1963
as reimbursement for the medical expenses which he paid in 1962, the
amount which A must include in his gross income for 1963 is $10,000, and
the amount to be excluded from gross income for 1963 is $5,000, computed
as follows:
Reimbursement received in 1963............................... $15,000
Less: Amount by which the medical deduction for 1962 would 4,950
have been greater than $10,000 but for the limitations on
the maximum amount provided by section 213..................
----------
Reimbursement received in 1963 reduced by the amount by 10,050
which the medical deduction for 1962 would have been
greater than $10,000 but for the limitations on the
maximum amount provided by section 213..................
Deduction allowable for 1962................................. 10,000
Amount of reimbursement received in 1963 to be included in 10,000
gross income for 1963 as attributable to deduction allowable
for 1962....................................................
Amount to be excluded from gross income for 1963 ($15,000 5,000
less $10,000)...............................................
Example 3. Taxpayer A, a single individual (not the head of a
household and not a surviving spouse) with one dependent, is entitled to
two exemptions under the provisions of section 151. He had an adjusted
gross income of $35,000 for the calendar year 1956. During 1956 he paid
$9,000 for medical care. A received no reimbursement for such medical
expenses in 1956, but in 1957 he received $6,000 upon an insurance
policy covering the medical expenses which he paid in 1956. A was
allowed a deduction of $5,000 (the maximum) from his adjusted gross
income for 1956. The amount which A must include in his gross income for
1957 is $3,050 and the amount to be excluded from gross income for 1957
is $2,950, computed as follows:
Payments for medical care in 1956 (not reimbursed in 1956)... $9,000
Less: 3 percent of $35,000 (adjusted gross income)........... 1,050
----------
Excess of medical expenses not reimbursed in 1956 over 3 7,950
percent of adjusted gross income........................
Allowable deduction for 1956................................. 5,000
----------
Amount by which the medical deductions for 1956 would 2,950
have been greater than $5,000 but for the limitations on
the maximum amount provided by section 213..............
==========
Reimbursement received in 1957............................... 6,000
Less: Amount by which the medical deduction for 1956 would 2,950
have been greater than $5,000 but for the limitations on the
maximum amount provided by section 213......................
----------
Reimbursement received in 1957 reduced by the amount by 8,050
which the medical deduction for 1956 would have been
greater than $5,000 but for the limitations on the
maximum amount provided by section 213..................
Amount attributed to medical deduction taken for 1956.... 3,050
Amount to be included in gross income for 1957........... 3,050
Amount to be excluded from gross income for 1957 ($6,000 2,950
less $3,050)............................................
Example 4. Assuming that A, in example (3), received $8,000 in 1957
as reimbursement for the medical expenses which he paid in 1956, the
amount which A must include in his gross income for 1957 is $5,000 and
the amount to be excluded from gross income for 1957 is $3,000 computed
as follows:
Reimbursement received in 1957............................... $8,000
Less: Amount by which the medical deduction for 1956 would 2,950
have been greater than $5,000 but for the limitations on the
maximum amount provided by section 213......................
----------
Reimbursement received in 1957 reduced by the amount by 5,050
which the medical deduction for 1956 would have been
greater than $5,000 but for the limitations on the
maximum amount provided by section 213..................
Deduction allowable for 1956................................. 5,000
Amount of reimbursement received in 1957 to be included in 5,000
gross income for 1957 as attributable to deduction allowable
for 1956....................................................
Amount to be excluded from gross income for 1957 ($8,000 less 3,000
$5,000).....................................................
(h) Substantiation of deductions. In connection with claims for
deductions under section 213, the taxpayer shall furnish the name and
address of each person to whom payment for medical expenses was made and
the amount and date of the payment thereof in each case. If payment was
made in kind, such fact shall be so reflected. Claims for deductions
must be substantiated, when requested by the district director, by a
statement or itemized invoice from the individual or entity to which
[[Page 423]]
payment for medical expenses was made showing the nature of the service
rendered, and to or for whom rendered; the nature of any other item of
expense and for whom incurred and for what specific purpose, the amount
paid therefor and the date of the payment thereof; and by such other
information as the district director may deem necessary.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960]
Editorial Note: For Federal Register citations affecting Sec.
1.213-1, see the List of CFR Sections Affected, which appears in the
Finding Aids section of the printed volume and at www.govinfo.gov.
Sec. 1.215-1 Periodic alimony, etc., payments.
(a) A deduction is allowable under section 215 with respect to
periodic payments in the nature of, or in lieu of, alimony or an
allowance for support actually paid by the taxpayer during his taxable
year and required to be included in the income of the payee wife or
former wife, as the case may be, under section 71. As to the amounts
required to be included in the income of such wife or former wife, see
section 71 and the regulations thereunder. For definition of husband and
wife see section 7701(a) (17).
(b) The deduction under section 215 is allowed only to the obligor
spouse. It is not allowed to an estate, trust, corporation, or any other
person who may pay the alimony obligation of such obligor spouse. The
obligor spouse, however, is not allowed a deduction for any periodic
payment includible under section 71 in the income of the wife or former
wife, which payment is attributable to property transferred in discharge
of his obligation and which, under section 71(d) or section 682, is not
includible in his gross income.
(c) The following examples, in which both H and W file their income
tax returns on the basis of a calendar year, illustrate cases in which a
deduction is or is not allowed under section 215:
Example 1. Pursuant to the terms of a decree of divorce, H, in 1956,
transferred securities valued at $100,000 in trust for the benefit of W,
which fully discharged all his obligations to W. The periodic payments
made by the trust to W are required to be included in W's income under
section 71. Such payments are stated in section 71(d) not to be
includible in H's income and, therefore, under section 215 are not
deductible from his income.
Example 2. A decree of divorce obtained by W from H incorporated a
previous agreement of H to establish a trust, the trustees of which were
instructed to pay W $5,000 a year for the remainder of her life. The
court retained jurisdiction to order H to provide further payments if
necessary for the support of W. In 1956 the trustee paid to W $4,000
from the income of the trust and $1,000 from the corpus of the trust.
Under the provisions of sections 71 and 682(b), W would include $5,000
in her income for 1956. H would not include any part of the $5,000 in
his income nor take a deduction therefor. If H had paid the $1,000 to W
pursuant to court order rather than allowing the trustees to pay it out
of corpus, he would have been entitled to a deduction of $1,000 under
the provisions of section 215.
(d) For other examples, see sections 71 and 682 and the regulations
thereunder.
Sec. 1.215-1T Alimony, etc., payments (temporary).
Q-1 What information is required by the Internal Revenue Service
when an alimony or separate maintenance payment is claimed as a
deduction by a payor?
A-1 The payor spouse must include on his/her first filed return of
tax (Form 1040) for the taxable year in which the payment is made the
payee's social security number, which the payee is required to furnish
to the payor. For penalties applicable to a payor spouse who fails to
include such information on his/her return of tax or to a payee spouse
who fails to furnish his/her social security number to the payor spouse,
see section 6676.
(98 Stat. 798, 26 U.S.C. 1041(d)(4); 98 Stat. 802, 26 U.S.C.
152(e)(2)(A); 98 Stat. 800, 26 U.S.C. 215(c); 68A Stat. 917, 26 U.S.C.
7805)
[T.D. 7973, 49 FR 34458, Aug. 31, 1984]
Sec. 1.216-1 Amounts representing taxes and interest paid
to cooperative housing corporation.
(a) General rule. A tenant-stockholder of a cooperative housing
corporation may deduct from his gross income amounts paid or accrued
within his taxable year to a cooperative housing corporation
representing his proportionate share of:
(1) The real estate taxes allowable as a deduction to the
corporation under
[[Page 424]]
section 164 which are paid or incurred by the corporation before the
close of the taxable year of the tenant-stockholder on the houses (or
apartment building) and the land on which the houses (or apartment
building) are situated, or
(2) The interest allowable as a deduction to the corporation under
section 163 which is paid or incurred by the corporation before the
close of the taxable year of the tenant-stockholder on its indebtedness
contracted in the acquisition, construction, alteration, rehabilitation,
or maintenance of the houses (or apartment building), or in the
acquisition of the land on which the houses (or apartment building) are
situated.
(b) Limitation. The deduction allowable under section 216 shall not
exceed the amount of the tenant-stockholder's proportionate share of the
taxes and interest described therein. If a tenant-stockholder pays or
incurs only a part of his proportionate share of such taxes and interest
to the corporation, only the amount so paid or incurred which represents
taxes and interest is allowable as a deduction under section 216. If a
tenant-stockholder pays an amount, or incurs an obligation for an
amount, to the corporation on account of such taxes and interest and
other items, such as maintenance, overhead expenses, and reduction of
mortgage indebtedness, the amount representing such taxes and interest
is an amount which bears the same ratio to the total amount of the
tenant-stockholder's payment or liability, as the case may be, as the
total amount of the tenant-stockholder's proportionate share of such
taxes and interest bears to the total amount of the tenant-stockholder's
proportionate share of the taxes, interest, and other items on account
of which such payment is made or liability incurred. No deduction is
allowable under section 216 for that part of amounts representing the
taxes or interest described in that section which are deductible by a
tenant-stockholder under any other provision of the Code.
(c) Disallowance of deduction for certain payments to the
corporation. For taxable years beginning after December 31, 1986, no
deduction shall be allowed to a stockholder during any taxable year for
any amount paid or accrued to a cooperative housing corporation (in
excess of the stockholder's proportionate share of the items described
in paragraphs (a) (1) and (2) of this section) which is allocable to
amounts that are paid or incurred at any time by the cooperative housing
corporation and which is chargeable to the corporation's capital
account. Examples of expenditures chargeable to the corporation's
capital account include the cost of paving a community parking lot, the
purchase of a new boiler or roof, and the payment of the principal of
the corporation's building mortgage. The adjusted basis of the
stockholder's stock in such corporation shall be increased by the amount
of such disallowance. This paragraph may be illustrated by the following
example:
Example. The X corporation is a cooperative housing corporation
within the meaning of section 216. In 1988 X uses $275,000 that it
received from its shareholders in such year to purchase and place in
service a new boiler. The $275,000 will be chargeable to the
corporation's capital account. A owns 10% of the shares of X and uses in
a trade or business the dwelling unit appurtenant to A's shares and was
responsible for paying 10% of the cost of the boiler. A is thus
responsible for $27,500 of the cost of the boiler, which amount A will
not be able to deduct currently. A will, however, add the $27,500 to A's
basis for A's shares in X.
(d) Tenant-stockholder's proportionate share--(1) General rule. The
tenant-stockholder's proportionate share is that proportion which the
stock of the cooperative housing corporation owned by the tenant-
stockholder is of the total outstanding stock of the corporation,
including any stock held by the corporation. For taxable years beginning
after December 31, 1969, if the cooperative housing corporation had
issued stock to a governmental unit, as defined in paragraph (g) of this
section, then in determining the total outstanding stock of the
corporation, the governmental unit shall be deemed to hold the number of
shares that it would have held, with respect to the apartments or houses
it is entitled to occupy, if it had been a tenant-stockholder. That is,
the number of shares the governmental unit is deemed to hold is
determined in the same manner
[[Page 425]]
as if stock had been issued to it as a tenant-stockholder. For example,
if a cooperative housing corporation requires each tenant-stockholder to
buy one share of stock for each one thousand dollars of value of the
apartment he is entitled to occupy, a governmental unit shall be deemed
to hold one share of stock for each one thousand dollars of value of the
apartments it is entitled to occupy, regardless of the number of shares
formally issued to it.
(2) Special rule--(i) In general. For taxable years beginning after
December 31, 1986, if a cooperative housing corporation allocates to
each tenant-stockholder a portion of the real estate taxes or interest
(or both) that reasonably reflects the cost to the corporation of the
taxes or interest attributable to each tenant-stockholder's dwelling
unit (and the unit's share of the common areas), the cooperative housing
corporation may elect to treat the amounts so allocated as the tenant-
stockholders' proportionate shares.
(ii) Time and manner of making election. The election referred to in
paragraph (d)(2)(i) of this section is effective only if, by January 31
of the year following the first calendar year that includes any period
to which the election applies, the cooperative housing corporation
furnishes to each person that is a tenant-stockholder during that period
a written statement showing the amount of real estate taxes or interest
(or both) allocated to the tenant-stockholder with respect to the
tenant-stockholder's dwelling unit or units and share of common areas
for that period. The election must be made by attaching a statement to
the corporation's timely filed tax return (taking extensions into
account) for the first taxable year for which the election is to be
effective. The statement must contain the name, address, and taxpayer
identification number of the cooperative housing corporation, identify
the election as an election under section 216(b)(3)(B)(ii) of the Code,
indicate whether the election is being made with respect to the
allocation of real estate taxes or interest (or both), and include a
description of the method of allocation being elected. The election
applies for the taxable year and succeeding taxable years. It is
revocable only with the consent of the Commissioner and will be binding
on all tenant-stockholders.
(iii) Reasonable allocation. It is reasonable to allocate to each
tenant-stockholder a portion of the real estate taxes or interest (or
both) that bears the same ratio to the cooperative housing corporation's
total interest or real estate taxes as the fair market value of each
dwelling unit (including the unit's share of the common areas) bears to
the fair market value of all the dwelling units with respect to which
stock is outstanding (including stock held by the corporation) at the
time of allocation. If real estate taxes are separately assessed on each
dwelling unit by the relevant taxing authority, an allocation of real
estates taxes to tenant-stockholders based on separate assessments is a
reasonable allocation. If one or more of the tenant-stockholders prepays
any portion of the principal of the indebtedness and gives rise to
interest, an allocation of interest to those tenant-stockholders will be
a reasonable allocation of interest if the allocation is reduced to
reflect the reduction in the debt service attributable to the
prepayment. In addition, similar kinds of allocations may also be
reasonable, depending on the facts and circumstances.
(3) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. The X Corporation is a cooperative housing corporation
within the meaning of section 216. In 1970, it acquires a building
containing 40 category A apartments and 25 category B apartments, for
$750,000. The value of each category A apartment is $12,500, and of each
category B apartment is $10,000. X values each share of stock issued
with respect to the category A apartments at $125, and sells 4,000
shares of its stock, along with the right to occupy the 40 category A
apartments, to 40 tenant-stockholders for $500,000. X also sells 1,000
shares of nonvoting stock to G, a State housing authority qualifying as
a governmental unit under paragraph (f) of this section, for $250,000.
The purchase of this stock gives G the right to occupy all the category
B apartments. G is deemed to hold the number of shares that it would
have held if it had been a tenant-stockholder. G is therefore deemed to
own 2,000 shares of stock of X. All stockholders are required to pay a
specified part
[[Page 426]]
of the corporation's expenses. F, one of the tenant-stockholders,
purchased 100 shares of the category A stock for $12,500 in order to
obtain a right to occupy a category A apartment. Since there are 6,000
total shares deemed outstanding, F's proportionate share is 1/60 (100/
6,000).
Example 2. The X Corporation is a cooperative housing corporation
within the meaning of section 216. In 1960 it acquired a housing
development containing 100 detached houses, each house having the same
value. X issued one share of stock to each of 100 tenant-stockholders,
each share carrying the right to occupy one of the houses. In 1971 X
redeemed 40 of its 100 shares. It then sold to G, a municipal housing
authority qualifying as a governmental unit under paragraph (f) of this
section, 1,000 shares of preferred stock and the right to occupy the 40
houses with respect to which the stock had been redeemed. X sold the
preferred stock to G for an amount equal to the cost of redeeming the 40
shares. G also agreed to pay 40 percent of X's expenses. For purposes of
determining the total stock which X has outstanding, G is deemed to hold
40 shares of X.
Example 3. The X Corporation is a cooperative housing corporation
within the meaning of section 216. In 1987, it acquires for $1,000,000 a
building containing 10 category A apartments, 10 category B apartments,
and 10 category C apartments. The value of each category A apartment is
$20,000, of each category B apartment is $30,000 and of each category C
apartment is $50,000. X issues 1 share of stock to each of the 30
tenant-stockholders, each share carrying the right to occupy one of the
apartments. X allocates the real estate taxes and interest to the
tenant-stockholders on the basis of the fair market value of their
respective apartments. Since the total fair market value of all of the
apartments is $1,000,000, the allocation of taxes and interest to each
tenant-stockholder that has the right to occupy a category A apartment
is 2/100 ($20,000/$1,000,000). Similarly, the allocation of taxes and
interest to each tenant-stockholder who has a right to occupy a category
B apartment is 3/100 ($30,000/$1,000,000) and of a category C apartment
is 5/100 ($50,000/$1,000,000). X may elect in accordance with the rules
described in paragraph (d)(2) of this section to treat the amounts so
allocated as each tenant-stockholder's proportionate share of real
estate taxes and interest.
Example 4. The Y Corporation is a cooperative housing corporation
within the meaning of section 216. In 1987, it acquires a housing
development containing 5 detached houses for $1,500,000, incurring an
indebtedness of $1,000,000 for the purchase of the property. Each house
is valued at $300,000, although the shares appurtenant to those houses
have been sold to tenant-stockholders for $100,000. Y issues one share
of stock to each of the five tenant-stockholders, each share carrying
the right to occupy one of the houses. A, a tenant-stockholder, prepays
all of the corporation's indebtedness allocable to A's house. The
periodic charges payable to Y by A are reduced commensurately with the
reduction in Y's debt service. Because no part of the indebtedness
remains outstanding with respect to A's house, A's share of the interest
expense is $0. The other four tenant-stockholders do not prepay their
share of the indebtedness. Accordingly, \1/4\ of the interest is
allocated to each of the tenant-stockholders other than A. Y may elect
in accordance with the rules described in paragraph (d)(2) of this
section to treat the amounts so allocated as each tenant-stockholder's
proportionate share of interest.
Example 5. The Z Corporation is a cooperative housing corporation
within the meaning of section 216. In 1987, it acquires a building
containing 10 apartments. One of the apartments is occupied by a senior
citizen. Under local law, a senior citizen who owns and occupies a
residential apartment is entitled to a $500 reduction in local property
taxes assessed upon the apartment. As a result, Z corporation is
eligible under local law for a reduction in local property taxes
assessed upon the building. Z's real estate tax assessment for the year
would have been $10,000, however, with the senior citizen reduction, the
assessment is $9,500. The proprietary lease provides for a reduced
maintenance fee to the senior citizen tenant-stockholder in accordance
with the real estate tax reduction. Accordingly, each apartment owner is
assessed $1,000 for local real estate taxes, except the senior citizen
tenant-stockholder, who is assessed $500. Z may elect in accordance with
the rules described in paragraph (d)(2) of this section to treat the
amounts so allocated as each tenant-stockholder's proportionate share of
taxes.
(e) Cooperative housing corporation. In order to qualify as a
``cooperative housing corporation'' under section 216, the requirements
of subparagraphs (1) through (4) of this paragraph must be met.
(1) One class of stock. The corporation shall have one and only one
class of stock outstanding. However, a special classification of
preferred stock, in a nominal amount not exceeding $100, issued to a
Federal housing agency or other governmental agency solely for the
purpose of creating a security device on the mortgage indebtedness of
the corporation, shall be disregarded for purposes of determining
whether the corporation has one class of stock outstanding and such
agency will not
[[Page 427]]
be considered a stockholder for purposes of section 216 and this
section. Furthermore, for taxable years beginning after December 31,
1969, a special class of stock issued to a governmental unit, as defined
in paragraph (g) of this section, shall also be disregarded for purposes
of this paragraph in determining whether the corporation has one class
of stock outstanding.
(2) Right of occupancy. Each stockholder of the corporation, whether
or not the stockholder qualifies as a tenant-stockholder under section
216(b)(2) and paragraph (f) of this section, must be entitled to occupy
for dwelling purposes an apartment in a building or a unit in a housing
development owned or leased by such corporation. The stockholder is not
required to occupy the premises. The right as against the corporation to
occupy the premises is sufficient. Such right must be conferred on each
stockholder solely by reasons of his or her ownership of stock in the
corporation. That is, the stock must entitle the owner thereof either to
occupy the premises or to a lease of the premises. The fact that the
right to continue to occupy the premises is dependent upon the payment
of charges to the corporation in the nature of rentals or assessments is
immaterial. For taxable years beginning after December 31, 1986, the
fact that, by agreement with the cooperative housing corporation, a
person or his nominee may not occupy the house or apartment without the
prior approval of such corporation will not be taken into account for
purposes of this paragraph in the following cases.
(i) In any case where a person acquires stock of the cooperative
housing corporation by operation of law, by inheritance, or by
foreclosure (or by instrument in lieu of foreclosure),
(ii) In any case where a person other than an individual acquires
stock in the cooperative housing corporation, and
(iii) In any case where the person from whom the corporation has
acquired the apartments or houses (or leaseholds therein) acquires any
stock of the cooperative housing corporation from the corporation not
later than one year after the date on which the apartments or houses (or
leaseholds therein) are transferred to the corporation by such person.
For purposes of the preceding sentence, paragraphs (e)(2) (i) and (ii)
of this section will not apply to acquisitions of stock by foreclosure
by the person from whom the corporation has acquired the apartments or
houses (or leaseholds therein).
(3) Distributions. None of the stockholders of the corporation may
be entitled, either conditionally or unconditionally, except upon a
complete or partial liquidation of the corporation, to receive any
distribution other than out of earnings and profits of the corporation.
(4) Gross income. Eighty percent or more of the gross income of the
corporation for the taxable year of the corporation in which the taxes
and interest are paid or incurred must be derived from the tenant-
stockholders. For purposes of the 80-percent test, in taxable years
beginning after December 31, 1969, gross income attributable to any
house or apartment which a governmental unit is entitled to occupy,
pursuant to a lease or stock ownership, shall be disregarded.
(f) Tenant-stockholder. The term tenant-stockholder means a person
that is a stockholder in a cooperative housing corporation, as defined
in section 216(b)(1) and paragraph (e) of this section, and whose stock
is fully paid up in an amount at least equal to an amount shown to the
satisfaction of the district director as bearing a reasonable
relationship to the portion of the fair market value, as of the date of
the original issuance of the stock, of the corporation's equity in the
building and the land on which it is situated that is attributable to
the apartment or housing unit which such person is entitled to occupy
(within the meaning of paragraph (e)(2) of this section).
Notwithstanding the preceding sentence, for taxable years beginning
before January 1, 1987, tenant-stockholders include only individuals,
certain lending institutions, and certain persons from whom the
cooperative housing corporation has acquired the apartments or houses
(or leaseholds thereon).
(g) Governmental unit. For purposes of section 216(b) and this
section, the term governmental unit means the
[[Page 428]]
United States or any of its possessions, a State or any political
subdivision thereof, or any agency or instrumentality of the foregoing
empowered to acquire shares in a cooperative housing corporation for the
purpose of providing housing facilities.
(h) Examples. The application of section 216(a) and (b) and this
section may be illustrated by the following examples, which refer to
apartments but which are equally applicable to housing units:
Example 1. The X Corporation is a cooperative housing corporation
within the meaning of section 216. In 1970, at a total cost of $200,000,
it purchased a site and constructed thereon a building with 15
apartments. The fair market value of the land and building was $200,000
at the time of completion of the building. The building contains five
category A apartment units, each of equal value, and 10 category B
apartment units. The total value of all of the category A apartment
units is $100,000. The total value of all of the category B apartments
is also $100,000. Upon completion of the building, the X Corporation
mortgaged the land and building for $100,000, and sold its total
authorized capital stock for $100,000. The stock attributable to the
category A apartments was purchased by five individuals, each of whom
paid $10,000 for 100 shares, or $100 a share. Each certificate for 100
shares of such stock provides that the holder thereof is entitled to a
lease of a particular apartment in the building for a specified term of
years. The stock attributable to the category B apartments was purchased
by a governmental unit for $50,000. Since the shares sold to the tenant-
stockholders are valued at $100 per share, the governmental unit is
deemed to hold a total of 500 shares. The certificate of such stock
provides that the governmental unit is entitled to a lease of all of the
category B apartments. All leases provide that the lessee shall pay his
proportionate part of the corporation's expenses. In 1970 the original
owner of 100 shares of stock attributable to the category A apartments
and to the lease to apartment No. 1 made a gift of the stock and lease
to A, an individual. The taxable year of A and of the X Corporation is
the calendar year. The corporation computes its taxable income on an
accrual method, while A computes his taxable income on the cash receipts
and disbursements method. In 1971, the X Corporation incurred expenses
aggregating $13,800, including $4,000 for the real estate taxes on the
land and building, and $5,000 for the interest on the mortgage. In 1972,
A pays the X Corporation $1,380, representing his proportionate part of
the expenses incurred by the corporation. The entire gross income of the
X Corporation for 1971 was derived from the five tenant-stockholders and
from the governmental unit. A is entitled under section 216 to a
deduction of $900 in computing his taxable income for 1972. The
deduction is computed as follows:
Shares of X Corporation owned by A........................... 100
Shares of X Corporation owned by four other tenant- 400
stockholders................................................
Shares of X Corporation deemed owned by governmental unit.... 500
----------
Total shares of X Corporation outstanding.............. 1,000
==========
A's proportionate share of the stock of X Corporation (100/ 1/10
1,000)......................................................
Expenses incurred by X Corporation:
Real estate taxes............................... $4,000 .........
Interest........................................ 5,000 .........
Other........................................... 4,800 .........
-----------
Total...................................... ......... $13,800
----------
Amount paid by A............................................. 1,380
A's proportionate share of real estate taxes and interest $900
based on his stock ownership (1/10 of $9,000)...............
A's proportionate share of total corporate expenses based on 1,380
his stock ownership (1/10 of $13,800).......................
Amount of A's payment representing real estate taxes and $900
interest (900/1,380 of $1,380)..............................
A's allowable deduction...................................... $900
Since the stock which A acquired by gift was fully paid up by his donor
in an amount equal to the portion of the fair market value, as of the
date of the original issuance of the stock, of the corporation's equity
in the land and building which is attributable to apartment No. 1, the
requirement of section 216 in this regard is satisfied. The fair market
value at the time of the gift of the corporation's equity attributable
to the apartment is immaterial.
Example 2. The facts are the same as in Example 1 except that the
building constructed by the X Corporation contained, in addition to the
15 apartments, business space on the ground floor, which the corporation
rented at $2,400 for the calendar year 1971. The corporation deducted
the $2,400 from its expenses in determining the amount of the expenses
to be prorated among its tenant-stockholders. The amount paid by A to
the corporation in 1972 is $1,140 instead of $1,380. More than 80
percent of the gross income of the corporation for 1971 was derived from
tenant-stockholders. A is entitled under section 216 to a deduction of
$743.48 in computing his taxable income for 1972. The deduction is
computed as follows:
Expenses incurred by X Corporation............ $13,800.00 ...........
Less: Rent from business space................ 2,400.00 ...........
-------------
Expenses to be prorated among tenant-stockholders.......... $11,400.00
------------
Amount paid by A........................................... 1,140.00
[[Page 429]]
A's proportionate share of real estate taxes and interest 900.00
based on his stock ownership (1/10 of $9,000).............
A's proportionate share of total corporate expenses based 1,380.00
on his stock ownership (1/10 of $13,800)..................
Amount of A's payment representing real estate taxes and 743.48
interest (900/1380 of $1,140).............................
A's allowable deduction.................................... 743.48
Since the portion of A's payment allocable to real estate taxes and
interest is only $743.48, that amount instead of $900 is allowable as a
deduction in computing A's taxable income for 1972.
Example 3. The facts are the same as in Example 1 except that the
amount paid by A to the X Corporation in 1972 is $1,000 instead of
$1,380. A is entitled under section 216 to a deduction of $652.17 in
computing his taxable income for 1972. The deduction is computed as
follows:
Amount paid by A........................................... $1,000.00
A's proportionate share of real estate taxes and interest 900.00
based on his stock ownership (1/10 of $9,000).............
A's proportionate share of total corporate expenses based 1,380.00
on his stock ownership (1/10 of $13,800)..................
Amount of A's payment representing real estate taxes and 652.17
interest (900/1380 of $1,000).............................
A's allowable deduction.................................... 652.17
Since the portion of A's payment allocable to real estate taxes and
interest is only $652.17, that amount instead of $900 is allowable as a
deduction in computing A's taxable income for 1972.
Example 4. The facts are the same as in Example 1 except that X
Corporation leases recreational facilities from Y Corporation for use by
the tenant-stockholders of X. Under the terms of the lease, X is
obligated to pay an annual rental of $5,000 plus all real estate taxes
assessed against the facilities. In 1971 X paid, in addition to the
$13,800 of expenses enumerated in Example 1, $5,000 rent and $1,000 real
estate taxes. In 1972 A pays the X Corporation $2,000, no part of which
is refunded to him in 1972. A is entitled under section 216 to a
deduction of $900 in computing his taxable income for 1972. The
deduction is computed as follows:
Expenses to be prorated among tenant-stockholders.......... $19,800
Amount paid by A........................................... 2,000
A's proportionate share of real estate taxes and interest 900
based on his stock ownership (1/10 of $9,000).............
A's proportionate share of total corporate expenses based 1,980
on his stock ownership (1/10 of $19,800)..................
Amount of A's payment representing real estate taxes and 900
interest (900/1,980 of $1,980)............................
A's allowable deduction.................................... 900
The $1,000 of real estate taxes assessed against the recreational
facilities constitutes additional rent and hence is not deductible by A
as taxes under section 216. A's allowable deduction is limited to his
proportionate share of real estate taxes and interest based on stock
ownership and cannot be increased by the payment of an amount in excess
of his proportionate share.
[T.D. 7092, 36 FR 4597, Mar. 10, 1971; 36 FR 4985, Mar. 16, 1971, as
amended by T.D. 8316, 55 FR 42004, Oct. 17, 1990]
Sec. 1.216-2 Treatment as property subject to depreciation.
(a) General rule. For taxable years beginning after December 31,
1961, stock in a cooperative housing corporation (as defined by section
216(b) (1) and paragraph (c) of Sec. 1.216-1) owned by a tenant-
stockholder (as defined by section 216(b) (2) and paragraph (d) of Sec.
1.216-1) who uses the proprietary lease or right of tenancy, which was
conferred on him solely by reason of his ownership of such stock, in a
trade or business or for the production of income shall be treated as
property subject to the allowance for depreciation under section 167(a)
in the manner and to the extent prescribed in this section.
(b) Determination of allowance for depreciation--(1) In general.
Subject to the special rules provided in subparagraphs (2) and (3) of
this paragraph and the limitation provided in paragraph (c) of this
section, the allowance for depreciation for the taxable year with
respect to stock of a tenant-stockholder, subject to the extent provided
in this section to an allowance for depreciation, shall be determined:
(i) By computing the amount of depreciation (amortization in the
case of a leasehold) which would be allowable under one of the methods
of depreciation prescribed in section 167(b) and the regulations
thereunder (in paragraph (a) of Sec. 1.162-11 and Sec. 1.167(a)-4 in
the case of a leasehold) in respect of the depreciable (amortizable)
real property owned by the cooperative housing corporation in which such
tenant-stockholder has a proprietary lease or right of tenancy,
(ii) By reducing the amount of depreciation (amortization) so
computed in the same ratio as the rentable space in such property which
is not subject to a proprietary lease or right of tenancy by reason of
stock ownership but which is held for rental purposes bears to the total
rentable space in such property, and
[[Page 430]]
(iii) By computing such tenant-stockholder's proportionate share of
such annual depreciation (amortization), so reduced.
As used in this section, the terms depreciation and depreciable real
property include amortization and amortizable leasehold of real
property. As used in this section, the tenant-stockholder's
proportionate share is that proportion which stock of the cooperative
housing corporation owned by the tenant-stockholder is of the total
outstanding stock of the corporation, including any stock held by the
corporation. In order to determine whether a tenant-stockholder may use
one of the methods of depreciation prescribed in section 167(b) (2),
(3), or (4) for purposes of subdivision (i) of this subparagraph, the
limitations provided in section 167(c) on the use of such methods of
depreciation shall be applied with respect to the depreciable real
property owned by the cooperative housing corporation in which the
tenant-stockholder has a proprietary lease or right of tenancy, rather
than with respect to the stock in the cooperative housing corporation
owned by the tenant-stockholder or with respect to the proprietary lease
or right of tenancy conferred on the tenant-stockholder by reason of his
ownership of such stock. The allowance for depreciation determined under
this subparagraph shall be properly adjusted where only a portion of the
property occupied under a proprietary lease or right of tenancy is used
in a trade or business or for the production of income.
(2) Stock acquired subsequent to first offering. Except as provided
in subparagraph (3), in the case of a tenant-stockholder who purchases
stock other than as part of the first offering of stock by the
corporation, the basis of the depreciable real property for purposes of
the computation required by subparagraph (1)(i) of this paragraph shall
be the amount obtained by:
(i) Multiplying the taxpayer's cost per share by the total number of
outstanding shares of stock of the corporation, including any shares
held by the corporation,
(ii) Adding thereto the mortgage indebtedness to which such
depreciable real property is subject on the date of purchase of such
stock, and
(iii) Subtracting from the sum so obtained the portion thereof not
properly allocable as of the date such stock was purchased to the
depreciable real property owned by the cooperative housing corporation
in which such tenant-stockholder has a proprietary lease or right of
tenancy.
In order to prevent an overstatement or understatement of the basis of
the depreciable real property for purposes of the computation required
by subparagraph (1)(i) of this paragraph, appropriate adjustment for
purposes of the computations described in subdivisions (i) and (ii) of
this subparagraph shall be made in respect of prepayments and
delinquencies on account of the corporation's mortgage indebtedness.
Thus, for purposes of subdivision (i) of this subparagraph, the
taxpayer's cost per share shall be reduced by an amount determined by
dividing the total mortgage indebtedness prepayments in respect of the
shares purchased by the taxpayer by the number of such shares. For
purposes of subdivision (ii) of this subparagraph, the mortgage
indebtedness shall be increased by the sum of all prepayments applied in
reduction of the mortgage indebtedness and shall be decreased by any
amount due under the terms of the mortgage and unpaid.
(3) Conversion subsequent to date of acquisition. In the case of a
tenant-stockholder whose proprietary lease or right of tenancy is
converted, in whole or in part, to use in a trade or business or for the
production of income on a date subsequent to the date on which he
acquired the stock conferring on him such lease or right of tenancy, the
basis of the depreciable real property for purposes of the computation
required by subparagraph (1)(i) of this paragraph shall be the fair
market value of such depreciable real property on the date of the
conversion if the fair market value is less than the adjusted basis of
such property in the hands of the cooperative housing corporation
provided in section 1011 without taking into account any adjustment for
depreciation required by section 1016(a)(2). Such fair market value
shall be deemed to be equal to the adjusted basis of
[[Page 431]]
such property, taking into account adjustments required by section
1016(a)(2) computed as if the corporation had used the straight line
method of depreciation, in the absence of evidence establishing that the
fair market value so attributed to the property is unrealistic. In the
case of a tenant-stockholder who purchases stock other than as part of
the first offering of stock of the corporation, and at a later date
converts his proprietary lease to use for business or production of
income:
(i) The adjusted basis of the cooperative housing corporation's
depreciable real property without taking into account any adjustment for
depreciation shall be the amount determined in accordance with
subdivisions (i), (ii), and (iii) of subparagraph (2) of this paragraph,
and
(ii) The fair market value shall be deemed to be equal to such
adjusted basis reduced by the amount of depreciation, computed under the
straight line method, which would have been allowable in respect of
depreciable real property having a cost or other basis equal to the
amount representing such adjusted basis in the absence of evidence
establishing that the fair market value so attributed to the property is
unrealistic.
(c) Limitation. If the allowance for depreciation for the taxable
year determined in accordance with the provisions of paragraph (b) of
this section exceeds the adjusted basis (provided in section 1011) of
the stock described in paragraph (a) of this section allocable to the
tenant-stockholder's proprietary lease or right of tenancy used in a
trade or business or for the production of income, such excess is not
allowable as a deduction. For taxable years beginning after December 31,
1986, such excess, subject to the provisions of this paragraph (c), is
allowable as a deduction for depreciation in the succeeding taxable
year. To determine the portion of the adjusted basis of such stock which
is allocable to such proprietary lease or right of tenancy, the adjusted
basis is reduced by taking into account the same factors as are taken
into account under paragraph (b)(1) of this section in determining the
allowance for depreciation.
(d) Examples. The provisions of section 216(c) and this section may
be illustrated by the following examples:
Example 1. The Y corporation, a cooperative housing corporation
within the meaning of section 216, in 1961 purchased a site and
constructed thereon a building with 10 apartments at a total cost of
$250,000 ($200,000 being allocable to the building and $50,000 being
allocable to the land). Such building was completed on January 1, 1962,
and at that time had an estimated useful life of 50 years, with an
estimated salvage value of $20,000. Each apartment is of equal value.
Upon completion of the building, Y corporation mortgaged the land and
building for $150,000 and sold its total authorized capital stock,
consisting of 1000 shares of common stock, for $100,000. The stock was
purchased by 10 individuals each of whom paid $10,000 for 100 shares.
Each certificate for 100 shares provides that the holder thereof is
entitled to a proprietary lease of a particular apartment in the
building. Each lease provides that the lessee shall pay his
proportionate share of the corporation's expenses including an amount on
account of the curtailment of Y's mortgage indebtedness. B, a calendar
year taxpayer, is the original owner of 100 shares of stock in Y
corporation. On January 1, 1962, B subleases his apartment for a term of
5 years. B's stock in Y corporation is treated as property subject to
the allowance for depreciation under section 167(a), and B, who uses the
straight line method of depreciation for purposes of the computation
prescribed by paragraph (b)(1)(i) of this section, computes the
allowance for depreciation for the taxable year 1962 with respect to
such stock as follows:
Y's basis in the building................................... $200,000
Less: Estimated salvage value............................... $20,000
-----------
Y's basis for depreciation............................ $180,000
===========
Annual straight line depreciation on Y's building (1/50 of $3,600
$180,000)..................................................
Proportion of outstanding shares of stock of Y corporation 1/10
(1,000) owned by B (100)...................................
B's proportionate share of annual depreciation (1/10 of $360
$3,600)....................................................
Depreciation allowance for 1962 with respect to B's stock $360
(if the limitation in paragraph (c) of this section is not
applicable)................................................
Example 2. The facts are the same as in Example 1 except that the
building constructed by Y corporation contained, in addition to the 10
apartments, space on the ground floor for 2 stores which were rented to
persons who do not have a proprietary lease of such space by reason of
stock ownership. Y corporation's building has a total area of 16,000
square feet, the 10 apartments in such building have an area of 10,000
square feet, and the 2 stores on the ground floor have an area of 2,000
square feet. Thus, the total rentable space in Y corporation's building
is 12,000
[[Page 432]]
square feet. B, who uses the straight line method of depreciation for
purposes of the computation prescribed by paragraph (b)(1)(i) of this
section, computes the allowance for depreciation for the taxable year
1962 with respect to his stock in Y corporation as follows:
Y's basis in the building................................... $200,000
Less: Estimated salvage value............................... 20,000
-----------
Y's basis for depreciation.............................. 180,000
===========
Annual straight line depreciation on Y's building (1/50 of 3,600
$180,000)..................................................
Less: Amount representing rentable space not subject to 600
proprietary lease but held for rental purposes over total
rentable space 2,000 / 12,000 (of $3,600)..................
-----------
Annual depreciation, as reduced......................... 3,000
===========
B's proportionate share of annual depreciation (1/10 of 300
$3,000)....................................................
Depreciation allowance for 1962 with respect to B's stock 300
(if the limitation in paragraph (c) of this section is not
applicable)................................................
Example 3. The facts are the same as in Example 1 except that B
occupies his apartment from January 1, 1962, until December 31, 1966,
and that on January 1, 1967, B sells his stock to C, an individual, for
$15,000. C thereby obtains a proprietary lease from Y corporation with
the same rights and obligations as B's lease provided. Y corporation's
records disclose that its outstanding mortgage indebtedness is $135,000
on January 1, 1967. C, a physician, uses the entire apartment solely as
an office. C's stock in Y corporation is treated as property subject to
the allowance for depreciation under section 167(a), and C, who uses the
straight line method of depreciation for purposes of the computation
prescribed by paragraph (b)(1)(i) of this section, computes the
allowance for depreciation for the taxable year 1967 with respect to
such stock as follows:
Price paid for each share of stock in Y corporation $150
purchased by C on 1-1-67 ($15,000 / 100)...................
===========
Per share price paid by C multiplied by total shares of 150,000
stock in Y corporation outstanding on 1-1-67 ($150 x 1,000)
Y's mortgage indebtedness outstanding on 1-1-67............. 135,000
-----------
285,000
Less: Amount attributable to land (assumed to be \1/5\ of 57,000
$285,000)..................................................
-----------
228,000
Less: Estimated salvage value............................... 20,000
-----------
Basis of Y's building for purposes of computing C's 208,000
depreciation...............................................
===========
Annual straight line depreciation (1/45 of $208,000)........ 4,622.22
C's proportionate share of annual depreciation (1/10 of 462.22
$4,622.22).................................................
Depreciation allowance for 1967 with respect to C's stock 462.22
(if the limitation in paragraph (c) of this section is not
applicable)................................................
[T.D. 6725, 29 FR 5665, Apr. 29, 1964, as amended by T.D. 8316, 55 FR
42006, Oct. 17, 1990]
Sec. 1.217-1 Deduction for moving expenses paid or incurred
in taxable years beginning before January 1, 1970.
(a) Allowance of deduction--(1) In general. Section 217(a) allows a
deduction from gross income for moving expenses paid or incurred by the
taxpayer during the taxable year in connection with the commencement of
work as an employee at a new principal place of work. Except as provided
in section 217, no deduction is allowable for any expenses incurred by
the taxpayer in connection with moving himself, the members of his
family or household, or household goods and personal effects. The
deduction allowable under this section is only for expenses incurred
after December 31, 1963, in taxable years ending after such date and
beginning before January 1, 1970, except in cases where a taxpayer makes
an election under paragraph (g) of Sec. 1.217-2 with respect to moving
expenses paid or incurred before January 1, 1971, in connection with the
commencement of work by such taxpayer as an employee at a new principal
place of work of which such taxpayer has been notified by his employer
on or before December 19, 1969. To qualify for the deduction the
expenses must meet the definition of the term ``moving expenses''
provided in section 217(b); the taxpayer must meet the conditions set
forth in section 217(c); and, if the taxpayer receives a reimbursement
or other expense allowance for an item of expense, the deduction for the
portion of the expense reimbursed is allowable only to the extent that
such reimbursement or other expense allowance is included in his gross
income as provided in section 217(e). The deduction is allowable only to
a taxpayer who pays or incurs moving expenses in connection with his
commencement of work as an employee and is not allowable to a taxpayer
who pays or incurs such expenses in connection with his commencement of
work as a self-employed individual.
[[Page 433]]
The term employee as used in this section has the same meaning as in
Sec. 31.3401(c)-1 of this chapter (Employment Tax Regulations). All
references to section 217 in this section are to section 217 prior to
the effective date of section 231 of the Tax Reform Act of 1969 (83
Stat. 577).
(2) Commencement of work. To be deductible, the moving expenses must
be paid or incurred by the taxpayer in connection with the commencement
of work by him at a new principal place of work (see paragraph (c)(3) of
this section for a discussion of the term principal place of work).
While it is not necessary that the taxpayer have a contract or
commitment of employment prior to his moving to a new location, the
deduction is not allowable unless employment actually does occur. The
term commencement includes (i) the beginning of work by a taxpayer for
the first time or after a substantial period of unemployment or part-
time employment, (ii) the beginning of work by a taxpayer for a
different employer, or (iii) the beginning of work by a taxpayer for the
same employer at a new location. To qualify as being in connection with
the commencement of work, the move for which moving expenses are
incurred must bear a reasonable proximity both in time and place to such
commencement. In general, moving expenses incurred within one year of
the date of the commencement of work are considered to be reasonably
proximate to such commencement. Moving expenses incurred in relocating
the taxpayer's residence to a location which is farther from his new
principal place of work than was his former residence are not generally
to be considered as incurred in connection with such commencement of
work. For example, if A is transferred by his employer from place X to
place Y and A's old residence while he worked at place X is 25 miles
from Y, A will not generally be entitled to deduct moving expenses in
moving to a new residence 40 miles from Y even though the minimum
distance limitation contained in section 217(c)(1) is met. If, however,
A is required, as a condition of his employment, to reside at a
particular place, or if such residency will result in an actual decrease
in his commuting time or expense, the expenses of the move may be
considered as incurred in connection with his commencement of work at
place Y.
(b) Definition of moving expenses--(1) In general. Section 217(b)
defines the term moving expenses to mean only the reasonable expenses
(i) of moving household goods and personal effects from the taxpayer's
former residence to his new residence, and (ii) of traveling (including
meals and lodging) from the taxpayer's former residence to his new place
of residence. The test of deductibility thus is whether the expenses are
reasonable and are incurred for the items set forth in (i) and (ii)
above.
(2) Reasonable expenses. (i) The term moving expenses includes only
those expenses which are reasonable under the circumstances of the
particular move. Generally, expenses are reasonable only if they are
paid or incurred for movement by the shortest and most direct route
available from the taxpayer's former residence to his new residence by
the conventional mode or modes of transportation actually used and in
the shortest period of time commonly required to travel the distance
involved by such mode. Expenses paid or incurred in excess of a
reasonable amount are not deductible. Thus, if moving or travel
arrangements are made to provide a circuitous route for scenic,
stopover, or other similar reasons, the additional expenses resulting
therefrom are not deductible since they do not meet the test of
reasonableness.
(ii) The application of this subparagraph may be illustrated by the
following example:
Example. A, an employee of the M Company works and maintains his
principal residence in Boston, Massachusetts. Upon receiving orders from
his employer that he is to be transferred to M's Los Angeles, California
office, A motors to Los Angeles with his family with stopovers at
various cities between Boston and Los Angeles to visit friends and
relatives. In addition, A detours into Mexico for sight-seeing. Because
of the stopovers and tour into Mexico, A's travel time and distance are
increased over what they would have been had he proceeded directly to
Los Angeles. To the extent that A's route of travel between Boston and
Los Angeles is in a generally southwesterly direction it may be said
that he is traveling by the shortest
[[Page 434]]
and most direct route available by motor vehicle. Since A's excursion
into Mexico is away from the usual Boston-Los Angeles route, the portion
of the expenses paid or incurred attributable to such excursion is not
deductible. Likewise, that portion of the expenses attributable to A's
delays en route not necessitated by reasons of rest or repair of his
vehicle are not deductible.
(3) Expenses of moving household goods and personal effects.
Expenses of moving household goods and personal effects include expenses
of transporting such goods and effects owned by the taxpayer or a member
of his household from the taxpayer's former residence to his new
residence, and expenses of packing, crating and in-transit storage and
insurance for such goods and effects. Expenses paid or incurred in
moving household goods and personal effects to a taxpayer's new
residence from a place other than his former residence are allowable,
but only to the extent that such expenses do not exceed the amount which
would be allowable had such goods and effects been moved from the
taxpayer's former residence. Examples of items not deductible as moving
expenses include, but are not limited to, storage charges (other than
in-transit), costs incurred in the acquisition of property, costs
incurred and losses sustained in the disposition of property, penalties
for breaking leases, mortgage penalties, expenses of refitting rugs or
draperies, expenses of connecting or disconnecting utilities, losses
sustained on the disposal of memberships in clubs, tuition fees, and
similar items.
(4) Expenses of traveling. Expenses of traveling include the cost of
transportation and of meals and lodging en route (including the date of
arrival) of both the taxpayer and members of his household, who have
both the taxpayer's former residence and the taxpayer's new residence as
their principal place of abode, from the taxpayer's former residence to
his new place of residence. Expenses of traveling do not include, for
example: living or other expenses of the taxpayer and members of his
household following their date of arrival at the new place of residence
and while they are waiting to enter the new residence or waiting for
their household goods to arrive; expenses in connection with house or
apartment hunting; living expenses preceding the date of departure for
the new place of residence; expenses of trips for purposes of selling
property; expenses of trips to the former residence by the taxpayer
pending the move by his family to the new place of residence; or any
allowance for depreciation. The deduction for traveling expenses is
allowable for only one trip made by the taxpayer and members of his
household; however, it is not necessary that the taxpayer and all
members of his household travel together or at the same time.
(5) Residence. The term former residence refers to the taxpayer's
principal residence before his departure for his new principal place of
work. The term new residence refers to the taxpayer's principal
residence within the general location of his new principal place of
work. Thus, neither term includes other residences owned or maintained
by the taxpayer or members of his family or seasonal residences such as
a summer beach cottage. Whether or not property is used by the taxpayer
as his residence, and whether or not property is used by the taxpayer as
his principal residence (in the case of a taxpayer using more than one
property as a residence), depends upon all the facts and circumstances
in each case. Property used by the taxpayer as his principal residence
may include a houseboat, a house trailer, or similar dwelling. The term
new place of residence generally includes the area within which the
taxpayer might reasonably be expected to commute to his new principal
place of work. The application of the terms former residence, new
residence and new place of residence as defined in this paragraph and as
used in section 217(b)(1) may be illustrated in the following manner:
Expenses of moving household goods and personal effects are moving
expenses when paid or incurred for transporting such items from the
taxpayer's former residence to the taxpayer's new residence (such as
from one street address to another). Expenses of traveling, on the other
hand, are limited to those incurred between the taxpayer's former
residence (a geographic point) and his new place of residence (a
commuting area) up to and including the date of arrival. The
[[Page 435]]
date of arrival is the day the taxpayer secures lodging within that
commuting area, even if on a temporary basis.
(6) Individuals other than taxpayer. In addition to the expenses set
forth in section 217(b)(1) which are attributable to the taxpayer alone,
the same type of expenses attributable to certain individuals other than
the taxpayer, if paid or incurred by the taxpayer, are deductible. Those
other individuals must (i) be members of the taxpayer's household, and
(ii) have both the taxpayer's former residence and his new residence as
their principal place of abode. A member of the taxpayer's household may
not be, for example, a tenant residing in the taxpayer's residence, nor
an individual such as a servant, governess, chauffeur, nurse, valet, or
personal attendant.
(c) Conditions for allowance--(1) In general. Section 217(c)
provides two conditions which must be satisfied in order for a deduction
of moving expenses to be allowed under section 217(a). The first is a
minimum distance requirement prescribed by section 217(c)(1), and the
second is a minimum period of employment requirement prescribed by
section 217(c)(2).
(2) Minimum distance. For purposes of applying the minimum distance
requirement of section 217(c)(1) all taxpayers are divided into one or
the other of the following categories: taxpayers having a former
principal place of work, and taxpayers not having a former principal
place of work. In this latter category are individuals who are seeking
full-time employment for the first time (for example, recent high school
or college graduates), or individuals who are re-entering the labor
force after a substantial period of unemployment or part-time
employment.
(i) In the case of a taxpayer having a former principal place of
work, section 217(c)(1)(A) provides that no deduction is allowable
unless the distance between his new principal place of work and his
former residence exceeds by at least 20 miles the distance between his
former principal place of work and such former residence.
(ii) In the case of a taxpayer not having a former principal place
of work, section 217(c)(1)(B) provides that no deduction is allowable
unless the distance between his new principal place of work and his
former residence is at least 20 miles.
(iii) For purposes of measuring distances under section 217(c)(1)
all computations are to be made on the basis of a straight-line
measurement.
(3) Principal place of work. (i) A taxpayer's ``principal place of
work'' usually is the place at which he spends most of his working time.
Generally, where a taxpayer performs services as an employee, his
principal place of work is his employer's plant, office, shop, store or
other property. However, a taxpayer may have a principal place of work
even if there is no one place at which he spends a substantial portion
of his working time. In such case, the taxpayer's principal place of
work is the place at which his business activities are centered--for
example, because he reports there for work, or is otherwise required
either by his employer or the nature of his employment to ``base'' his
employment there. Thus, while a member of a railroad crew, for example,
may spend most of his working time aboard a train, his principal place
of work is his home terminal, station, or other such central point where
he reports in, checks out, or receives instructions. In those cases
where the taxpayer is employed by a number of employers on a relatively
short-term basis, and secures employment by means of a union hall system
(such as a construction or building trades worker), the taxpayer's
principal place of work would be the union hall.
(ii) In cases where a taxpayer has more than one employment (i.e.,
more than one employer at any particular time) his principal place of
work is usually determined with reference to his principal employment.
The location of a taxpayer's principal place of work is necessarily a
question of fact which must be determined on the basis of the particular
circumstances in each case. The more important factors to be considered
in making a factual determination regarding the location of a taxpayer's
principal place of work are (a) the total time ordinarily spent by the
taxpayer at each place, (b) the degree of the taxpayer's business
activity at
[[Page 436]]
each place, and (c) the relative significance of the financial return to
the taxpayer from each place.
(iii) In general, a place of work is not considered to be the
taxpayer's principal place of work for purposes of this section if the
taxpayer maintains an inconsistent position, for example, by claiming an
allowable deduction under section 162 (relating to trade or business
expenses) for traveling expenses ``while away from home'' with respect
to expenses incurred while he is not away from such place of work and
after he has incurred moving expenses for which a deduction is claimed
under this section.
(4) Minimum period of employment. Under section 217(c)(2), no
deduction is allowed unless, during the 12-month period immediately
following the taxpayer's arrival in the general location of his new
principal place of work, he is a full-time employee, in such general
location, during at least 39 weeks.
(i) The 12-month period and the 39-week period set forth in section
217(c)(2) are measured from the date of the taxpayer's arrival in the
general location of his new principal place of work. Generally, the
taxpayer's date of arrival is the date of the termination of the last
trip preceding the taxpayer's commencement of work on a regular basis,
regardless of the date on which the taxpayer's family or household goods
and effects arrive.
(ii) It is not necessary that the taxpayer remain in the employ of
the same employer for 39 weeks, but only that he be employed in the same
general location of his new principal place of work during such period.
The general location of the new principal place of work refers to the
area within which an individual might reasonably be expected to commute
to such place of work, and will usually be the same area as is known as
the new place of residence; see paragraph (b)(5) of this section.
(iii) Only a week during which the taxpayer is a full-time employee
qualifies as a week of work for purposes of the 39-week requirement of
section 217(c)(2). Whether an employee is a full-time employee during
any particular week depends upon the customary practices of the
occupation in the geographic area in which the taxpayer works. In the
case of occupations where employment is on a seasonal basis, weeks
occuring in the off-season when no work is required or available (as the
case may be) may be counted as weeks of full-time employment only if the
employee's contract or agreement of employment covers the off-season
period and the off-season period is less than 6 months. Thus, a school
teacher whose employment contract covers a 12-month period and who
teaches on a full-time basis for more than 6 months in fulfillment of
such contract is considered a full-time employee during the entire 12-
month period. A taxpayer will not be deemed as other than a full-time
employee during any week merely because of periods of involuntary
temporary absence from work, such as those due to illness, strikes,
shutouts, layoffs, natural disasters, etc.
(iv) In the case of taxpayers filing a joint return, either spouse
may satisfy this 39-week requirement. However, weeks worked by one
spouse may not be added to weeks worked by the other spouse in order to
satisfy such requirement.
(v) The application of this subparagraph may be illustrated by the
following examples:
Example 1. A is an electrician residing in New York City. Having
heard of the possibility of better employment prospects in Denver,
Colorado, he moves himself, his family and his household goods and
personal effects, at his own expense, to Denver where he secures
employment with the M Aircraft Corporation. After working full-time for
30 weeks his job is terminated, and he subsequently moves to and secures
employment in Los Angeles, California, which employment lasts for more
than 39 weeks. Since A was not employed in the general location of his
new principal place of employment while in Denver for at least 39 weeks,
no deduction is allowable for moving expenses paid or incurred between
New York City and Denver. A will be allowed to deduct only those moving
expenses attributable to his move from Denver to Los Angeles, assuming
all other conditions of section 217 are met.
Example 2. Assume the same facts as in Example 1, except that B, A's
wife, secures employment in Denver at the same time as A, and that she
continues to work in Denver for at least 9 weeks after A's departure for
Los Angeles. Since she has met the 39-week requirement in Denver, and
assuming all other requirements of section 217 are met, the
[[Page 437]]
moving expenses paid by A attributable to the move from New York City to
Denver will be allowed as a deduction, provided A and B filed a joint
return.
Example 3. Assume the same facts as in Example 1, except that B, A's
wife, secures employment in Denver on the same day that A departs for
Los Angeles, and continues to work in Denver for 9 weeks thereafter.
Since neither A (who has worked 30 weeks) nor B (who has worked 9 weeks)
has independently satisfied the 39-week requirement, no deduction for
moving expenses attributable to the move from New York City to Denver is
allowable.
(d) Rules for application of section 217(c)(2)--(1) Inapplicability
of 39-week test to reimbursed expenses. (i) Paragraph (1) of section
217(d) provides that the 39-week employment condition of section
217(c)(2) does not apply to any moving expense item to the extent that
the taxpayer receives reimbursement or other allowance from his employer
for such item. A reimbursement or other allowance to an employee for
expenses of moving, in the absence of a specific allocation by the
employer, is allocated first to items deductible under section 217(a)
and then, if a balance remains, to items not so deductible.
(ii) The application of this subparagraph may be illustrated by the
following examples:
Example 1. A, a recent college graduate, with his residence in
Washington, DC, is hired by the M Corporation in San Francisco,
California. Under the terms of the employment contract, M agrees to
reimburse A for three-fifths of his moving expenses from Washington to
San Francisco. A moves to San Francisco, and pays $1,000 for expenses
incurred, for which he is reimbursed $600 by M. After working for M for
a period of 3 months, A becomes dissatisfied with the job and returns to
Washington to continue his education. Since he has failed to satisfy the
39-week requirement of section 217(c)(2) the expenses totaling $400 for
which A has received no reimbursement are not deductible. Under the
special rule of section 217(d)(1), however, the deduction for the $600
reimbursed moving expenses is not disallowed by reason of section
217(c)(2).
Example 2. B, a self-employed accountant, who works and resides in
Columbus, Ohio, is hired by the N Company in St. Petersburg, Florida.
Pursuant to its policy with respect to newly hired employees, N agrees
to reimburse B to the extent of $1,000 of the expenses incurred by him
in connection with his move to St. Petersburg, allocating $700 for the
items specified in section 217(b)(1), and $300 for ``temporary living
expenses.'' B moves to St. Petersburg, and incurs $800 of ``moving
expenses'' and $300 of ``temporary living expenses'' in St. Petersburg.
B receives reimbursement of $1,000 from N, which amount is included in
his gross income. Assuming B fails to satisfy the 39-week test of
section 217(c)(2), he will nevertheless be allowed to deduct $700 as a
moving expense. On the other hand, had N made no allocation between
deductible and non-deductible items, B would have been allowed to deduct
$800 since, in the absence of a specific allocation of the reimbursement
by N, it is presumed that the reimbursement was for items specified in
section 217(b)(1) to the extent thereof.
(2) Election of deduction before 39-week test is satisfied. (i)
Paragraph (2) of section 217(d) provides a special rule which applies in
those cases where a taxpayer paid or incurred, in a particular taxable
year, moving expenses which would be deductible in that taxable year
except for the fact that the 39-week employment condition of section
217(c)(2) has not been satisfied before the time prescribed by law
(including extensions thereof) for filing the return for such taxable
year. The rule provides that where a taxpayer has paid or incurred
moving expenses and as of the date prescribed by section 6072 for filing
his return for such taxable year, including extensions thereof as may be
allowed under section 6081, there remains unexpired a sufficient portion
of the 12-month period so that it is still possible for the taxpayer to
satisfy the 39-week requirement, then the taxpayer may elect to claim a
deduction for such moving expenses on the return for such taxable year.
The election shall be exercised by taking the deduction on the return
filed within the time prescribed by section 6072 (including extensions
as may be allowed under section 6081). It is not necessary that the
taxpayer wait until the date prescribed by law for filing his return in
order to make the election. He may make the election on an early return
based upon the facts known on the date such return is filed. However, an
election made on an early return will become invalid if, as of the date
prescribed by law for filing the return, it is not possible for the
taxpayer to satisfy the 39-week requirement.
[[Page 438]]
(ii) In the event that a taxpayer does not elect to claim a
deduction for moving expenses on the return for the taxable year in
which such expenses were paid or incurred in accordance with (i) of this
subparagraph, and the 39-week employment condition of section 217(c)(2)
(as well as all other requirements of section 217) is subsequently
satisfied, then the taxpayer may file an amended return for the taxable
year in which such moving expenses were paid or incurred on which he may
claim a deduction under section 217. The taxpayer may, in lieu of filing
an amended return, file a claim for refund based upon the deduction
allowable under section 217.
(iii) The application of this subparagraph may be illustrated by the
following examples:
Example 1. A is transferred by his employer, M, from Boston,
Massachusetts, to Cleveland, Ohio, and begins working there on November
1, 1964, followed by his family and household goods and personal effects
on November 15, 1964. Moving expenses are paid or incurred by A in 1964
in connection with this move. On April 15, 1965, when A files his income
tax return for the year 1964, A has been a full-time employee in
Cleveland for approximately 24 weeks. Notwithstanding the fact that as
of April 15, 1965, A has not satisfied the 39-week employment condition
of section 217(c)(2) he may nevertheless elect to claim his 1964 moving
expenses on his 1964 income tax return since there is still sufficient
time remaining before November 1, 1965, within which to satisfy the 39-
week requirement.
Example 2. Assume the facts are the same as in Example 1, except
that as of April 15, 1965, A has left the employ of M, and is in the
process of seeking further employment in Cleveland. Since, under these
conditions, A may be unsure whether or not he will be able to satisfy
the 39-week requirement by November 1, 1965, he may not wish to avail
himself of the election provided by section 217(d)(2). In such event, A
may wait until he has actually satisfied the 39-week requirement, at
which time he may file an amended return claiming as a deduction the
moving expenses paid or incurred in 1964. A may, in lieu of filing an
amended return, file a claim for refund based upon a deduction for such
expenses. Should A fail to satisfy the 39-week requirement on or before
November 1, 1965, no deduction is allowable for moving expenses incurred
in 1964.
(3) Recapture of deduction where 39-week test is not met. Paragraph
(3) of section 217(d) provides a special rule which applies in cases
where a taxpayer has deducted moving expenses under the election
provided in section 217(d)(2) prior to his satisfying the 39-week
employment condition of section 217(c)(2), and the 39-week test is not
satisfied during the taxable year immediately following the taxable year
in which the expenses were deducted. In such cases an amount equal to
the expenses which were deducted must be included in the taxpayer's
gross income for the taxable year immediately following the taxable year
in which the expenses were deducted. In the event the taxpayer has
deducted moving expenses under the election provided in section
217(d)(2) for the taxable year, and subsequently files an amended return
for such year on which he eliminates such deduction, such expenses will
not be deemed to have been deducted for purposes of the recapture rule
of the preceding sentence.
(e) Disallowance of deduction with respect to reimbursements not
included in gross income. Section 217(e) provides that no deduction
shall be allowed under section 217 for any item to the extent that the
taxpayer receives reimbursement or other expense allowance for such item
unless the amount of such reimbursement or other expense allowance is
included in his gross income. A reimbursement or other allowance to an
employee for expenses of moving, in the absence of a specific allocation
by the employer, is allocated first to items deductible under section
217(a) and then, if a balance remains, to items not so deductible. For
purposes of this section, moving services furnished in-kind, directly or
indirectly, by a taxpayer's employer to the taxpayer or members of his
household are considered as being a reimbursement or other allowance
received by the taxpayer for moving expenses. If a taxpayer pays or
incurs moving expenses and either prior or subsequent thereto receives
reimbursement or other expense allowance for such item, no deduction is
allowed for such moving expenses unless the amount of the reimbursement
or other expense allowance is included in his gross income in the year
in which such reimbursement or other expense allowance is received. In
those cases where the reimbursement
[[Page 439]]
or other expense allowance is received by a taxpayer for an item of
moving expense subsequent to his having claimed a deduction for such
item, and such reimbursement or other expense allowance is properly
excluded from gross income in the year in which received, the taxpayer
must file an amended return for the taxable year in which the moving
expenses were deducted and decrease such deduction by the amount of the
reimbursement or other expense allowance not included in gross income.
This does not mean, however, that a taxpayer has an option to include or
not include in his gross income an amount received as reimbursement or
other expense allowance in connection with his move as an employee. This
question remains one which must be resolved under section 61(a)
(relating to the definition of gross income).
[T.D. 6796, 30 FR 1038, Feb. 2, 1965, as amended by T.D. 7195, 37 FR
13535, July 11, 1972]
Sec. 1.217-2 Deduction for moving expenses paid or incurred
in taxable years beginning after December 31, 1969.
(a) Allowance of deduction--(1) In general. Section 217(a) allows a
deduction from gross income for moving expenses paid or incurred by the
taxpayer during the taxable year in connection with his commencement of
work as an employee or as a self-employed individual at a new principal
place of work. For purposes of this section, amounts are considered as
being paid or incurred by an individual whether goods or services are
furnished to the taxpayer directly (by an employer, a client, a
customer, or similar person) or indirectly (paid to a third party on
behalf of the taxpayer by an employer, a client, a customer, or similar
person). A cash basis taxpayer will treat moving expenses as being paid
for purposes of section 217 and this section in the year in which the
taxpayer is considered to have received such payment under section 82
and Sec. 1.82-1. No deduction is allowable under section 162 for any
expenses incurred by the taxpayer in connection with moving from one
residence to another residence unless such expenses are deductible under
section 162 without regard to such change in residence. To qualify for
the deduction under section 217 the expenses must meet the definition of
the term moving expenses provided in section 217(b) and the taxpayer
must meet the conditions set forth in section 217(c). The term employee
as used in this section has the same meaning as in Sec. 31.3401(c)-1 of
this chapter (Employment Tax Regulations). The term self-employed
individual as used in this section is defined in paragraph (f)(1) of
this section.
(2) Expenses paid in a taxable year other than the taxable year in
which reimbursement representing such expenses is received. In general,
moving expenses are deductible in the year paid or incurred. If a
taxpayer who uses the cash receipts and disbursements method of
accounting receives reimbursement for a moving expense in a taxable year
other than the taxable year the taxpayer pays such expense, he may elect
to deduct such expense in the taxable year that he receives such
reimbursement, rather than the taxable year when he paid such expense in
any case where:
(i) The expense is paid in a taxable year prior to the taxable year
in which the reimbursement is received, or
(ii) The expense is paid in the taxable year immediately following
the taxable year in which the reimbursement is received, provided that
such expense is paid on or before the due date prescribed for filing the
return (determined with regard to any extension of time for such filing)
for the taxable year in which the reimbursement is received.
An election to deduct moving expenses in the taxable year that the
reimbursement is received shall be made by claiming the deduction on the
return, amended return, or claim for refund for the taxable year in
which the reimbursement is received.
(3) Commencement of work. (i) To be deductible the moving expenses
must be paid or incurred by the taxpayer in connection with his
commencement of work at a new principal place of work (see paragraph
(c)(3) of this section for a discussion of the term principal place of
work). Except for those expenses described in section 217(b)(1) (C) and
(D) it is not necessary for the taxpayer to have made arrangements to
work prior
[[Page 440]]
to his moving to a new location; however, a deduction is not allowable
unless employment or self-employment actually does occur. The term
commencement includes (a) the beginning of work by a taxpayer as an
employee or as a self-employed individual for the first time or after a
substantial period of unemployment or part-time employment, (b) the
beginning of work by a taxpayer for a different employer or in the case
of a self-employed individual in a new trade or business, or (c) the
beginning of work by a taxpayer for the same employer or in the case of
a self-employed individual in the same trade or business at a new
location. To qualify as being in connection with the commencement of
work, the move must bear a reasonable proximity both in time and place
to such commencement at the new principal place of work. In general,
moving expenses incurred within 1 year of the date of the commencement
of work are considered to be reasonably proximate in time to such
commencement. Moving expenses incurred after the 1-year period may be
considered reasonably proximate in time if it can be shown that
circumstances existed which prevented the taxpayer from incurring the
expenses of moving within the 1-year period allowed. Whether
circumstances existed which prevented the taxpayer from incurring the
expenses of moving within the period allowed is dependent upon the facts
and circumstances of each case. The length of the delay and the fact
that the taxpayer may have incurred part of the expenses of the move
within the 1-year period allowed shall be taken into account in
determining whether expenses incurred after such period are allowable.
In general, a move is not considered to be reasonably proximate in place
to the commencement of work at the new princpal place of work where the
distance between the taxpayer's new residence and his new principal
place of work exceeds the distance between his former residence and his
new principal place of work. A move to a new residence which does not
satisfy this test may, however, be considered reasonably proximate in
place to the commencement of work if the taxpayer can demonstrate, for
example, that he is required to live at such residence as a condition of
employment or that living at such residence will result in an actual
decrease in commuting time or expense. For example, assume that in 1977
A is transferred by his employer to a new principal place of work and
the distance between his former residence and his new principal place of
work is 35 miles greater than was the distance between his former
residence and his former principal place of work. However, the distance
between his new residence and his new principal place of work is 10
miles greater than was the distance between his former residence and his
new principal place of work. Although the minimum distance requirement
of section 217(c)(1) is met the expenses of moving to the new residence
are not considered as incurred in connection with A's commencement of
work at his new principal place of work since the new residence is not
proximate in place to the new place of work. If, however, A can
demonstrate, for example, that he is required to live at such new
residence as a condition of employment or if living at such new
residence will result in an actual decrease in commuting time or
expense, the expenses of the move may be considered as incurred in
connection with A's commencement of work at his new principal place of
work.
(ii) The provisions of subdivision (i) of this subparagraph may be
illustrated by the following examples:
Example 1. Assume that A is tranferred by his employer from Boston,
MA, to Washington, DC. A moves to a new residence in Washington, DC, and
commences work on February 1, 1971. A's wife and his two children remain
in Boston until June 1972 in order to allow A's children to complete
their grade school education in Boston. On June 1, 1972, A sells his
home in Boston and his wife and children move to the new residence in
Washington, DC. The expenses incurred on June 1, 1972, in selling the
old residence and in moving A's family, their household goods, and
personal effects to the new residence in Washington are allowable as a
deduction although they were incurred 16 months after the date of the
commencement of work by A since A has moved to and established a new
residence in Washington, DC, and thus incurred part of the total
expenses of the move prior to the expiration of the 1-year period.
[[Page 441]]
Example 2. Assume that A is transferred by his employer from
Washington, DC, to Baltimore, MD. A commences work on January 1, 1971,
in Baltimore. A commutes from his residence in Washington to his new
principal place of work in Baltimore for a period of 18 months. On July
1, 1972, A decides to move to and establish a new residence in
Baltimore. None of the moving expenses otherwise allowable under section
217 may be deducted since A neither incurred the expenses within 1 year
nor has shown circumstances under which he was prevented from moving
within such period.
(b) Definition of moving expenses--(1) In general. Section 217(b)
defines the term moving expenses to mean only the reasonable expenses
(i) of moving household goods and personal effects from the taxpayer's
former residence to his new residence, (ii) of traveling (including
meals and lodging) from the taxpayer's former residence to his new place
of residence, (iii) of traveling (including meals and lodging), after
obtaining employment, from the taxpayer's former residence to the
general location of his new principal place of work and return, for the
principal purpose of searching for a new residence, (iv) of meals and
lodging while occupying temporary quarters in the general location of
the new principal place of work during any period of 30 consecutive days
after obtaining employment, or (v) of a nature constituting qualified
residence sale, purchase, or lease expenses. Thus, the test of
deductibility is whether the expenses are reasonable and are incurred
for the items set forth in subdivisions (i) through (v) of this
subparagraph.
(2) Reasonable expenses. (i) The term moving expenses includes only
those expenses which are reasonable under the circumstances of the
particular move. Expenses paid or incurred in excess of a reasonable
amount are not deductible. Generally, expenses paid or incurred for
movement of household goods and personal effects or for travel
(including meals and lodging) are reasonable only to the extent that
they are paid or incurred for such movement or travel by the shortest
and most direct route available from the former residence to the new
residence by the conventional mode or modes of transportation actually
used and in the shortest period of time commonly required to travel the
distance involved by such mode. Thus, if moving or travel arrangements
are made to provide a circuitous route for scenic, stopover, or other
similar reasons, additional expenses resulting therefrom are not
deductible since they are not reasonable nor related to the commencement
of work at the new principal place of work. In addition, expenses paid
or incurred for meals and lodging while traveling from the former
residence to the new place of residence or to the general location of
the new principal place of work and return or occupying temporary
quarters in the general location of the new principal place of work are
reasonable only if under the facts and circumstances involved such
expenses are not lavish or extravagant.
(ii) The application of this subparagraph may be illustrated by the
following example:
Example. A, an employee of the M Company works and maintains his
residence in Boston, MA. Upon receiving orders from his employer that he
is to be transferred to M's Los Angeles, CA, office, A motors to Los
Angeles with his family with stopovers at various cities between Boston
and Los Angeles to visit friends and relatives. In addition, A detours
into Mexico for sightseeing. Because of the stopovers and tour into
Mexico, A's travel time and distance are increased over what they would
have been had he proceeded directly to Los Angeles. To the extent that
A's route of travel between Boston and Los Angeles is in a generally
southwesterly direction it may be said that he is traveling by the
shortest and most direct route available by motor vehicle. Since A's
excursion into Mexico is away from the usual Boston-Los Angeles route,
the portion of the expenses paid or incurred attributable to such
excursion is not deductible. Likewise, that portion of the expenses
attributable to A's delay en route in visiting personal friends and
sightseeing are not deductible.
(3) Expense of moving household goods and personal effects. Expenses
of moving household goods and personal effects include expenses of
transporting such goods and effects from the taxpayer's former residence
to his new residence, and expenses of packing, crating, and in-transit
storage and insurance for such goods and effects. Such expenses also
include any costs of connecting or disconnecting utilities required
because of the moving of household goods, appliances, or personal
effects.
[[Page 442]]
Expenses of storing and insuring household goods and personal effects
constitute in-transit expenses if incurred within any consecutive 30-day
period after the day such goods and effects are moved from the
taxpayer's former residence and prior to delivery at the taxpayer's new
residence. Expenses paid or incurred in moving household goods and
personal effects to the taxpayer's new residence from a place other than
his former residence are allowable, but only to the extent that such
expenses do not exceed the amount which would be allowable had such
goods and effects been moved from the taxpayer's former residence.
Expenses of moving household goods and personal effects do not include,
for example, storage charges (other than in-transit), costs incurred in
the acquisition of property, costs incurred and losses sustained in the
disposition of property, penalties for breaking leases, mortgage
penalties, expenses of refitting rugs or draperies, losses sustained on
the disposal of memberships in clubs, tuition fees, and similar items.
The above expenses may, however, be described in other provisions of
section 217(b) and if so a deduction may be allowed for them subject to
the allowable dollar limitations.
(4) Expenses of traveling from the former residence to the new place
of residence. Expenses of traveling from the former residence to the new
place of residence include the cost of transportation and of meals and
lodging en route (including the date of arrival) from the taxpayer's
former residence to his new place of residence. Expenses of meals and
lodging incurred in the general location of the former residence within
1 day after the former residence is no longer suitable for occupancy
because of the removal of household goods and personal effects shall be
considered as expenses of traveling for purposes of this subparagraph.
The date of arrival is the day the taxpayer secures lodging at the new
place of residence, even if on a temporary basis. Expenses of traveling
from the taxpayer's former residence to his new place of residence do
not include, for example, living or other expenses following the date of
arrival at the new place of residence and while waiting to enter the new
residence or waiting for household goods to arrive, expenses in
connection with house or apartment hunting, living expenses preceding
date of departure for the new place of residence (other than expenses of
meals and lodging incurred within 1 day after the former residence is no
longer suitable for occupancy), expenses of trips for purposes of
selling property, expenses of trips to the former residence by the
taxpayer pending the move by his family to the new place of residence,
or any allowance for depreciation. The above expenses may, however, be
described in other provisions of section 217(b) and if so a deduction
may be allowed for them subject to the allowable dollar limitations. The
deduction for traveling expenses from the former residence to the new
place of residence is allowable for only one trip made by the taxpayer
and members of his household; however, it is not necessary that the
taxpayer and all members of his household travel together or at the same
time.
(5) Expenses of traveling for the principal purpose of looking for a
new residence. Expenses of traveling, after obtaining employment, from
the former residence to the general location of the new principal place
of work and return, for the principal purpose of searching for a new
residence include the cost of transportation and meals and lodging
during such travel and while at the general location of the new place of
work for the principal purpose of searching for a new residence.
However, such expenses do not include, for example, expenses of meals
and lodging of the taxpayer and members of his household before
departing for the new principal place of work, expenses for trips for
purposes of selling property, expenses of trips to the former residence
by the taxpayer pending the move by his family to the place of
residence, or any allowance for depreciation. The above expenses may,
however, be described in other provisions of section 217(b) and if so a
deduction may be allowed for them. The deduction for expenses of
traveling for the principal purpose of looking for a new residence is
not limited to any number of trips by the taxpayer and by members of his
household. In addition, the taxpayer
[[Page 443]]
and all members of his household need not travel together or at the same
time. Moreover, a trip need not result in acquisition of a lease of
property or purchase of property. An employee is considered to have
obtained employment in the general location of the new principal place
of work after he has obtained a contract or agreement of employment. A
self-employed individual is considered to have obtained employment when
he has made substantial arrangements to commence work at the new
principal place of work (see paragraph (f)(2) of this section for a
discussion of the term made substantial arrangements to commence to
work).
(6) Expenses of occupying temporary quarters. Expenses of occupying
temporary quarters include only the cost of meals and lodging while
occupying temporary quarters in the general location of the new
principal place of work during any period of 30 consecutive days after
the taxpayer has obtained employment in such general location. Thus,
expenses of occupying temporary quarters do not include, for example,
the cost of entertainment, laundry, transportation, or other personal,
living family expenses, or expenses of occupying temporary quarters in
the general location of the former place of work. The 30 consecutive day
period is any one period of 30 consecutive days which can begin, at the
option of the taxpayer, on any day after the day the taxpayer obtains
employment in the general location of the new principal place of work.
(7) Qualified residence sale, purchase, or lease expenses. Qualified
residence sale, purchase, or lease expenses (hereinafter ``qualified
real estate expenses'') are only reasonable amounts paid or incurred for
any of the following purposes:
(i) Expenses incident to the sale or exchange by the taxpayer or his
spouse of the taxpayer's former residence which, but for section 217 (b)
and (e), would be taken into account in determining the amount realized
on the sale or exchange of the residence. These expenses include real
estate commissions, attorneys' fees, title fees, escrow fees, so called
``points'' or loan placement charges which the seller is required to
pay, State transfer taxes and similar expenses paid or incurred in
connection with the sale or exchange. No deduction, however, is
permitted under section 217 and this section for the cost of physical
improvements intended to enhance salability by improving the condition
or appearance of the residence.
(ii) Expenses incident to the purchase by the taxpayer or his spouse
of a new residence in the general location of the new principal place of
work which, but for section 217 (b) and (e), would be taken into account
in determining either the adjusted basis of the new residence or the
cost of a loan. These expenses include attorney's fees, escrow fees,
appraisal fees, title costs, so-called ``points'' or loan placement
charges not representing payments or prepayments of interest, and
similar expenses paid or incurred in connection with the purchase of the
new residence. No deduction, however, is permitted under section 217 and
this section for any portion of real estate taxes or insurance, so-
called ``points'' or loan placement charges which are, in essence,
prepayments of interest, or the purchase price of the residence.
(iii) Expenses incident to the settlement of an unexpired lease held
by the taxpayer or his spouse on property used by the taxpayer as his
former residence. These expenses include consideration paid to a lessor
to obtain a release from a lease, attorneys' fees, real estate
commissions, or similar expenses incident to obtaining a release from a
lease or to obtaining an assignee or a sublessee such as the difference
between rent paid under a primary lease and rent received under a
sublease. No deduction, however, is permitted under section 217 and this
section for the cost of physical improvement intended to enhance
marketability of the leasehold by improving the condition or appearance
of the residence.
(iv) Expenses incident to the acquisition of a lease by the taxpayer
or his spouse. These expenses include the cost of fees or commissions
for obtaining a lease, a sublease, or an assignment of an interest in
property used by the taxpayer as his new residence in the general
location of the new principal place
[[Page 444]]
of work. No deduction, however, is permitted under section 217 and this
section for payments or prepayments of rent or payments representing the
cost of a security or other similar deposit.
Qualified real estate expenses do not include losses sustained on the
disposition of property or mortgage penalties, to the extent that such
penalties are otherwise deductible as interest.
(8) Residence. The term former residence refers to the taxpayer's
principal residence before his departure for his new principal place of
work. The term new residence refers to the taxpayer's principal
residence within the general location of his new principal place of
work. Thus, neither term includes other residences owned or maintained
by the taxpayer or members of his family or seasonal residences such as
a summer beach cottage. Whether or not property is used by the taxpayer
as his principal residence depends upon all the facts and circumstances
in each case. Property used by the taxpayer as his principal residence
may include a houseboat, a housetrailer, or similar dwelling. The term
new place of residence generally includes the area within which the
taxpayer might reasonably be expected to commute to his new principal
place of work.
(9) Dollar limitations. (i) Expenses described in subparagraphs (A)
and (B) of section 217(b)(1) are not subject to an overall dollar
limitation. Thus, assuming all other requirements of section 217 are
satisfied, a taxpayer who, in connection with his commencement of work
at a new principal place of work, pays or incurs reasonable expenses of
moving household goods and personal effects from his former residence to
his new place of residence and reasonable expenses of traveling,
including meals and lodging, from his former residence to his new place
of residence is permitted to deduct the entire amount of these expenses.
(ii) Expenses described in subparagraphs (C), (D), and (E) of
section 217(b)(1) are subject to an overall dollar limitation for each
commencement of work of 3,000 ($2,500 in the case of a commencement of
work in a taxable year beginning before January 1, 1977), of which the
expenses described in subparagraphs (C) and (D) of section 217(b)(1)
cannot exceed $1,500 ($1,000 in the case of a commencement of work in a
taxable year beginning before January 1, 1977). The dollar limitation
applies to the amount of expenses paid or incurred in connection with
each commencement of work and not to the amount of expenses paid or
incurred in each taxable year. Thus, for example, a taxpayer who paid or
incurred $2,000 of expenses described in subparagraphs (C), (D), and (E)
of section 217(b)(1) in taxable year 1977 in connection with his
commencement of work at a principal place of work and paid or incurred
an additional $2,000 of such expenses in taxable year 1978 in connection
with the same commencement of work is permitted to deduct the $2,000 of
such expenses paid or incurred in taxable year 1977 and only $1,000 of
such expenses paid or incurred in taxable year 1978.
(iii) A taxpayer who pays or incurs expenses described in
subparagraphs (C), (D), and (E) of section 217(b)(1) in connection with
the same commencement of work may choose to deduct any combination of
such expenses within the dollar amounts specified in subdivision (ii) of
this subparagraph. For example, a taxpayer who pays or incurs such
expenses in connection with the same commencement of work may either
choose to deduct: (a) Expenses described in subparagraphs (C) and (D) of
section 217(b)(1) to the extent of $1,500 ($1,000 in the case of a
commencement of work in a taxable year beginning before January 1, 1977)
before deducting any of the expenses described in subparagraph (E) of
such section, or (b) expenses described in subparagraph (E) of section
217(b)(1) to the extent of $3,000 ($2,500 in the case of a commencement
of work in a taxable year beginning before January 1, 1977) before
deducting any of the expenses described in subparagraphs (C) and (D) of
such section.
(iv) For the purpose of computing the dollar limitation contained in
subparagraph (A) of section 217(b)(3) a commencement of work by a
taxpayer at a new principal place of work and a commencement of work by
his spouse at a new principal place of work which are in the same
general location constitute a single commencement of work. Two
[[Page 445]]
principal places of work are treated as being in the same general
location where the taxpayer and his spouse reside together and commute
to their principal places of work. Two principal places of work are not
treated as being in the same general location where, as of the close of
the taxable year, the taxpayer and his spouse have not shared the same
new residence nor made specific plans to share the same new residence
within a determinable time. Under such circumstances, the separate
commencements of work by a taxpayer and his spouse will be considered
separately in assigning the dollar limitations and expenses to the
appropriate return in the manner described in subdivisions (v) and (vi)
of this subparagraph.
(v) Moving expenses (described in subparagraphs (C), (D), and (E) of
section 217(b)(1)), paid or incurred with respect to the commencement of
work by both a husband and wife which is considered a single
commencement of work under subdivision (iv) of this subparagraph are
subject to an overall dollar limitation of $3,000 ($2,500 in the case of
a commencement of work in a taxable year beginning before January 1,
1977), per move of which the expenses described in subparagraphs (C) and
(D) of section 217(b)(1) cannot exceed $1,500 ($1,000 in the case of a
commencement of work in a taxable year beginning before January 1,
1977). If separate returns are filed with respect to the commencement of
work by both a husband and wife which is considered a single
commencement of work under subdivision (iv) of this subparagraph, moving
expenses (described in subparagraphs (C), (D), and (E) of section
217(b)(1)) are subject to an overall dollar limitation of $1,500 ($1,250
in the case of a commencement of work in a taxable year beginning before
January 1, 1977), per move of which the expenses described in
subparagraphs (C) and (D) of section 217(b)(1) cannot exceed $750 ($500
in the case of a commencement of work in a taxable year beginning before
January 1, 1977) with respect to each return. Where moving expenses are
paid or incurred in more than 1 taxable year with respect to a single
commencement of work by a husband and wife they shall, for purposes of
applying the dollar limitations to such move, be subject to a $3,000 and
$1,500 limitation ($2,500 and $1,000, respectively, in the case of a
commencement of work in a taxable year beginning before January 1, 1977)
for all such years that they file a joint return and shall be subject to
a separate $1,500 and $750 limitation ($1,250 and $500, respectively, in
the case of a commencement of work in a taxable year beginning before
January 1, 1977) for all such years that they file separate returns. If
a joint return is filed for the first taxable year moving expenses are
paid or incurred with respect to a move but separate returns are filed
in a subsequent year, the unused portion of the amount which may be
deducted shall be allocated equally between the husband and wife in the
later year. If separate returns are filed for the first taxable year
such moving expenses are paid or incurred but a joint return is filed in
a subsequent year, the deductions claimed on their separate returns
shall be aggregated for purposes of determining the unused portion of
the amount which may be deducted in the later year.
(vi) The application of subdivisions (iv) and (v) of this
subparagraph may be illustrated by the following examples:
Example 1. A, who was transferred by his employer, effective January
15, 1977, moved from Boston, MA, to Washington, DC. A's wife was
transferred by her employer, effective January 15, 1977, from Boston,
MA, to Baltimore, MD. A and his wife reside together at the same new
residence. A and his wife are cash basis taxpayers and file a joint
return for taxable year 1977. Because A and his wife reside together at
the new residence, the commencement of work by both is considered a
single commencement of work under subdivision (iv) of this subparagraph.
They are permitted to deduct with respect to their commencement of work
in Washington and Baltimore up to $3,000 of the expenses described in
subparagraphs (C), (D), and (E) of section 217(b)(1) of which the
expenses described in subparagraphs (C) and (D) of such section cannot
exceed $1,500.
Example 2. Assume the same facts as in Example 1 except that for
taxable year 1977, A and his wife file separate returns. Because A and
his wife reside together, the commencement of work by both is considered
a single commencement of work under subdivision (iv) of this
subparagraph. A is permitted to deduct with respect to his commencement
of
[[Page 446]]
work in Washington up to $1,500 of the expenses described in
subparagraphs (C), (D), and (E) of section 217(b)(1) of which the
expenses described in subparagraphs (C) and (D) cannot exceed $750. A is
not permitted to deduct any of the expenses described in subparagraphs
(C), (D), and (E) of section 217(b)(1) paid by his wife in connection
with her commencement of work at a new principal place of work. A's wife
is permitted to deduct with respect to her commencement of work in
Baltimore up to $1,500 of the expenses described in subparagraphs (C),
(D), and (E) of section 217(b)(1) that are paid by her of which the
expenses described in subparagraphs (C) and (D) cannot exceed $750. A's
wife is not permitted to deduct any of the expenses described in
subparagraphs (C), (D), and (E) of section 217(b)(1) paid by A in
connection with his commencement of work in Washington, DC.
Example 3. Assume the same facts as in Example 1 except that A and
his wife take up separate residences in Washington and Baltimore, do not
reside together during the entire taxable year, and have no specific
plans to reside together. The commencement of work by A in Washington,
DC, and by his wife in Baltimore are considered separate commencements
of work since their principal places of work are not treated as being in
the same general location. If A and his wife file a joint return for
taxable year 1977, the moving expenses described in subparagraphs (C),
(D), and (E) of section 217(b)(1) paid in connection with the
commencement of work by A in Washington, DC, and his wife in Baltimore,
MD, are subject to an overall limitation of $6,000 of which the expenses
described in subparagrahs (C) and (D) cannot exceed $3,000. If A and his
wife file separate returns for taxable year 1977, A may deduct up to
$3,000 of the expenses described in subparagraphs (C), (D), and (E) of
which the expenses described in subparagraphs (C) and (D) cannot exceed
$1,500. A's wife may deduct up to $3,000 of the expenses described in
subparagraphs (C), (D), and (E) of which the expenses described in
subparagraphs (C) and (D) cannot exceed $1,500.
(10) Individuals other than taxpayer. (i) In addition to the
expenses set forth in subparagraphs (A) through (D) of section 217(b)(1)
attributable to the taxpayer alone, the same type of expenses
attributable to certain individuals other than the taxpayer, if paid or
incurred by the taxpayer, are deductible. These other individuals must
be members of the taxpayer's household, and have both the taxpayer's
former residence and his new residence as their principal place of
abode. A member of the taxpayer's household includes any individual
residing at the taxpayer's residence who is neither a tenant nor an
employee of the taxpayer. Thus, for example, a member of the taxpayer's
household may not be an individual such as a servant, governess,
chauffeur, nurse, valet, or personal attendant. However, for purposes of
this paragraph, a tenant or employee will be considered a member of the
taxpayer's household where the tenant or employee is a dependent of the
taxpayer as defined in section 152.
(ii) In addition to the expenses set forth in section 217(b)(2) paid
or incurred by the taxpayer attributable to property sold, purchased, or
leased by the taxpayer alone, the same type of expenses paid or incurred
by the taxpayer attributable to property sold, purchased, or leased by
the taxpayer's spouse or by the taxpayer and his spouse are deductible
providing such property is used by the taxpayer as his principal place
of residence.
(c) Conditions for allowance--(1) In general. Section 217(c)
provides two conditions which must be satisfied in order for a deduction
of moving expenses to be allowed under section 217(a). The first is a
minimum distance condition prescribed by section 217(c)(1), and the
second is a minimum period of employment condition prescribed by section
217(c)(2).
(2) Minimum distance. For purposes of applying the minimum distance
condition of section 217(c)(1) all taxpayers are divided into one or the
other of the following categories: Taxpayers having a former principal
place of work, and taxpayers not having a former principal place of
work. Included in this latter category are individuals who are seeking
fulltime employment for the first time either as an employee or on a
self- employed basis (for example, recent high school or college
graduates), or individuals who are reentering the labor force after a
substantial period of unemployment or part-time employment.
(i) In the case of a taxpayer having a former principal place of
work, section 217(c)(1)(A) provides that no deduction is allowable
unless the distance between the former residence and the new principal
place of work exceeds by at least 35 miles (50 miles in the case of
[[Page 447]]
expenses paid or incurred in taxable years beginning before January 1,
1977) the distance between the former residence and the former principal
place of work.
(ii) In the case of a taxpayer not having a former principal place
of work, section 217(c)(1)(B) provides that no deduction is allowable
unless the distance between the former residence and the new principal
place of work is at least 35 miles (50 miles in the case of expenses
paid or incurred in taxable years beginning before January 1, 1977).
(iii) For purposes of measuring distances under section 217(c)(1)
the distance between two geographic points is measured by the shortest
of the more commonly traveled routes between such points. The shortest
of the more commonly traveled routes refers to the line of travel and
the mode or modes of transportation commonly used to go between two
geographic points comprising the shortest distance between such points
irrespective of the route used by the taxpayer.
(3) Principal place of work. (i) A taxpayer's principal place of
work usually is the place where he spends most of his working time. The
principal place of work of a taxpayer who performs services as an
employee is his employer's plant, office, shop, store, or other
property. The principal place of work of a taxpayer who is self-employed
is the plant, office, shop, store, or other property which serves as the
center of his business activities. However, a taxpayer may have a
principal place of work even if there is no one place where he spends a
substantial portion of his working time. In such case, the taxpayer's
principal place of work is the place where his business activities are
centered--for example, because he reports there for work, or is required
either by his employer or the nature of his employment to ``base'' his
employment there. Thus, while a member of a railroad crew may spend most
of his working time aboard a train, his principal place of work is his
home terminal, station, or other such central point where he reports in,
checks out, or receives instructions. The principal place of work of a
taxpayer who is employed by a number of employers on a relatively short-
term basis, and secures employment by means of a union hall system (such
as a construction or building trades worker) would be the union hall.
(ii) Where a taxpayer has more than one employment (i.e., the
taxpayer is employed by more than one employer, or is self-employed in
more than one trade or business, or is an employee and is self-employed
at any particular time) his principal place of work is determined with
reference to his principal employment. The location of a taxpayer's
principal place of work is a question of fact determined on the basis of
the particular circumstances in each case. The more important factors to
be considered in making this determination are (a) the total time
ordinarily spent by the taxpayer at each place, (b) the degree of the
taxpayer's business activity at each place, and (c) the relative
significance of the financial return to the taxpayer from each place.
(iii) Where a taxpayer maintains inconsistent positions by claiming
a deduction for expenses of meals and lodging while away from home
(incurred in the general location of the new principal place of work)
under section 162 (relating to trade or business expenses) and by
claiming a deduction under this section for moving expenses incurred in
connection with the commencement of work at such place of work, it will
be a question of facts and circumstances as to whether such new place of
work will be considered a principal place of work, and accordingly,
which category of deductions he will be allowed.
(4) Minimum period of employment. (i) Under section 217(c)(2) no
deduction is allowed unless:
(a) Where a taxpayer is an employee, during the 12-month period
immediately following his arrival in the general location of the new
principal place of work, he is a full-time employee, in such general
location, during at least 39 weeks, or
(b) Where a taxpayer is a self-employed individual (including a
taxpayer who is also an employee, but is unable to satisfy the
requirements of the 39-week test of (a) of this subdivision (i)), during
the 24-month period immediately following his arrival in the general
location of the new principal place
[[Page 448]]
of work, he is a full-time employee or performs services as a self-
employed individual on a full-time basis, in such general location,
during at least 78 weeks, of which not less than 39 weeks are during the
12-month period referred to above.
Where a taxpayer works as an employee and at the same time performs
services as a self-employed individual his principal employment
(determined according to subdivision (i) of subparagraph (3) of this
paragraph) governs whether the 39-week or 78-week test is applicable.
(ii) The 12-month period and the 39- week period set forth in
subparagraph (A) of section 217(c)(2) and the 12- and 24-month periods
as well as 39- and 78- week periods set forth in subparagraph (B) of
such section are measured from the date of the taxpayer's arrival in the
general location of the new principal place of work. Generally, date of
arrival is the date of the termination of the last trip preceding the
taxpayer's commencement of work on a regular basis and is not the date
the taxpayer's family or household goods and effects arrive.
(iii) The taxpayer need not remain in the employ of the same
employer or remain self-employed in the same trade or business for the
required number of weeks. However, he must be employed in the same
general location of the new principal place of work during such period.
The general location of the new principal place of work refers to a
general commutation area and is usually the same area as the ``new place
of residence''; see paragraph (b)(8) of this section.
(iv) Only those weeks during which the taxpayer is a full-time
employee or during which he performs services as a self-employed
individual on a full-time basis qualify as a week of work for purposes
of the minimum period of employment condition of section 217(c)(2).
(a) Whether an employee is a full-time employee during any
particular week depends upon the customary practices of the occupation
in the geographic area in which the taxpayer works. Where employment is
on a seasonal basis, weeks occurring in the off-season when no work is
required or available may be counted as weeks of full-time employment
only if the employee's contract or agreement of employment covers the
off-season period and such period is less than 6 months. Thus, for
example, a schoolteacher whose employment contract covers a 12-month
period and who teaches on a full-time basis for more than 6 months is
considered a full-time employee during the entire 12-month period. A
taxpayer will be treated as a full-time employee during any week of
involuntary temporary absence from work because of illness, strikes,
shutouts, layoffs, natural disasters, etc. A taxpayer will, also, be
treated as a full-time employee during any week in which he voluntarily
absents himself from work for leave or vacation provided for in his
contract or agreement of employment.
(b) Whether a taxpayer performs services as a self-employed
individual on a full-time basis during any particular week depends on
the practices of the trade or business in the geographic area in which
the taxpayer works. For example, a self-employed dentist maintaining
office hours 4 days a week is considered to perform services as a self-
employed individual on a full-time basis providing it is not unusual for
other self-employed dentists in the geographic area in which the
taxpayer works to maintain office hours only 4 days a week. Where a
trade or business is seasonal, weeks occurring during the off-season
when no work is required or available may be counted as weeks of
performance of services on a full-time basis only if the off-season is
less than 6 months and the taxpayer performs services on a full-time
basis both before and after the off-season. For example, a taxpayer who
owns and operates a motel at a beach resort is considered to perform
services as a self-employed individual on a full-time basis if the motel
is closed for a period not exceeding 6 months during the off-season and
if he performs services on a full-time basis as the operator of a motel
both before and after the off-season. A taxpayer will be treated as
performing services as a self-employed individual on a full-time basis
during any week of involuntary temporary absence from work because of
illness, strikes, natural disasters, etc.
[[Page 449]]
(v) Where taxpayers file a joint return, either spouse may satisfy
the minimum period of employment condition. However, weeks worked by one
spouse may not be added to weeks worked by the other spouse in order to
satisfy such condition. The taxpayer seeking to satisfy the minimum
period of employment condition must satisfy the condition applicable to
him. Thus, if a taxpayer is subject to the 39-week condition and his
spouse is subject to the 78-week condition and the taxpayer satisfies
the 39-week condition, his spouse need not satisfy the 78-week
condition. On the other hand, if the taxpayer does not satisfy the 39-
week condition, his spouse in such case must satisfy the 78-week
condition.
(vi) The application of this subparagraph may be illustrated by the
following examples:
Example 1. A is an electrician residing in New York City. He moves
himself, his family, and his household goods and personal effects, at
his own expense, to Denver where he commences employment with the M
Aircraft Corporation. After working full-time for 30 weeks he
voluntarily leaves his job, and he subsequently moves to and commences
employment in Los Angeles, CA, which employment lasts for more than 39
weeks. Since A was not employed in the general location of his new
principal place of employment in Denver for at least 39 weeks, no
deduction is allowable for moving expenses paid or incurred between New
York City and Denver. A will be allowed to deduct only those moving
expenses attributable to his move from Denver to Los Angeles, assuming
all other conditions of section 217 are met.
Example 2. Assume the same facts as in Example 1, except that A's
wife commences employment in Denver at the same time as A, and that she
continues to work in Denver for at least 9 weeks after A's departure for
Los Angeles. Since she has met the 39-week requirement in Denver, and
assuming all other requirements of section 217 are met, the moving
expenses paid by A attributable to the move from New York City to Denver
will be allowed as a deduction, provided A and his wife file a joint
return. If A and his wife file separate returns moving expenses paid by
A's wife attributable to the move from New York City to Denver will be
allowed as a deduction on A's wife's return.
Example 3. Assume the same facts as in Example 1, except that A's
wife commences employment in Denver on the same day that A departs for
Los Angeles, and continues to work in Denver for 9 weeks thereafter.
Since neither A (who has worked 30 weeks) nor his wife (who has worked 9
weeks) has independently satisfied the 39-week requirement, no deduction
for moving expenses attributable to the move from New York City to
Denver is allowable.
(d) Rules for application of section 217(c)(2)--(1) Inapplicability
of minimum period of employment condition in certain cases. Section
217(d)(1) provides that the minimum period of employment condition of
section 217(c)(2) does not apply in the case of a taxpayer who is unable
to meet such condition by reason of:
(i) Death or disability, or
(ii) Involuntary separation (other than for willfull misconduct)
from the service of an employer or separation by reason of transfer for
the benefit of an employer after obtaining full-time employment in which
the taxpayer could reasonably have been expected to satisfy such
condition.
For purposes of subdivision (i) of this paragraph disability shall be
determined according to the rules in section 72(m)(7) and Sec. 1.72-
17(f). Subdivision (ii) of this subparagraph applies only where the
taxpayer has obtained full-time employment in which he could reasonably
have been expected to satisfy the minimum period of employment
condition. A taxpayer could reasonably have been expected to satisfy the
minimum period of employment condition if at the time he commences work
at the new principal place of work he could have been expected, based
upon the facts known to him at such time, to satisfy such condition.
Thus, for example, if the taxpayer at the time of transfer was not
advised by his employer that he planned to transfer him within 6 months
to another principal place of work, the taxpayer could, in the absence
of other factors, reasonably have been expected to satisfy the minimum
employment period condition at the time of the first transfer. On the
other hand, a taxpayer could not reasonably have been expected to
satisfy the minimum employment condition if at the time of the
commencement of the move he knew that his employer's retirement age
policy would prevent his satisfying the minimum employment period
condition.
[[Page 450]]
(2) Election of deduction before minimum period of employment
condition is satisfied. (i) Paragraph (2) of section 217(d) provides a
rule which applies where a taxpayer paid or incurred, in a taxable year,
moving expenses which would be deductible in that taxable year except
that the minimum period of employment condition of section 217(c)(2) has
not been satisfied before the time prescribed by law for filing the
return for such taxable year. The rule provides that where a taxpayer
has paid or incurred moving expenses and as of the date prescribed by
section 6072 for filing his return for such taxable year (determined
with regard to extensions of time for filing) there remains unexpired a
sufficient portion of the 12-month or the 24-month period so that it is
still possible for the taxpayer to satisfy the applicable period of
employment condition, the taxpayer may elect to claim a deduction for
such moving expenses on the return for such taxable year. The election
is exercised by taking the deduction on the return.
(ii) Where a taxpayer does not elect to claim a deduction for moving
expenses on the return for the taxable year in which such expenses were
paid or incurred in accordance with subdivision (i) of this subparagraph
and the applicable minimum period of employment condition of section
217(c)(2) (as well as all other requirements of section 217) is
subsequently satisfied, the taxpayer may file an amended return or a
claim for refund for the taxable year such moving expenses were paid or
incurred on which he may claim a deduction under section 217.
(iii) The application of this subparagraph may be illustrated by the
following examples:
Example 1. A is transferred by his employer from Boston, MA, to
Cleveland, OH. He begins working there on November 1, 1970. Moving
expenses are paid by A in 1970 in connection with this move. On April
15, 1971, when he files his income tax return for the year 1970, A has
been a full-time employee in Cleveland for approximately 24 weeks.
Although he has not satisfied the 39-week employment condition at this
time, A may elect to claim his 1970 moving expenses on his 1970 income
tax return as there is still sufficient time remaining before November
1, 1971, to satisfy such condition.
Example 2. Assume the same facts as in Example 1, except that on
April 15, 1971, A has voluntarily left his employer and is looking for
other employment in Cleveland. A may not be sure he will be able to meet
the 39-week employment condition by November 1, 1971. Thus, he may if he
wishes wait until such condition is met and file an amended return
claiming as a deduction the expenses paid in 1970. Instead of filing an
amended return A may file a claim for refund based on a deduction for
such expenses. If A fails to meet the 39-week employment condition on or
before November 1, 1971, no deduction is allowable for such expenses.
Example 3. B is a self-employed accountant. He moves from Rochester,
NY, to New York, NY, and begins to work there on December 1, 1970.
Moving expenses are paid by B in 1970 and 1971 in connection with this
move. On April 15, 1971, when he files his income tax return for the
year 1970, B has been performing services as a self-employed individual
on a full-time basis in New York City for approximately 20 weeks.
Although he has not satisfied the 78-week employment condition at this
time, A may elect to claim his 1970 moving expenses on his 1970 income
tax return as there is still sufficient time remaining before December
1, 1972, to satisfy such condition. On April 15, 1972, when he files his
income tax return for the year 1971, B has been performing services as a
self-employed individual on a full-time basis in New York City for
approximately 72 weeks. Although he has not met the 78-week employment
condition at this time, B may elect to claim his 1971 moving expenses on
his 1971 income tax return as there is still sufficient time remaining
before December 1, 1972, to satisfy such requirement.
(3) Recapture of deduction. Paragraph (3) of section 217(d) provides
a rule which applies where a taxpayer has deducted moving expenses under
the election provided in section 217(d)(2) prior to satisfying the
applicable minimum period of employment condition and such condition
cannot be satisfied at the close of a subsequent taxable year. In such
cases an amount equal to the expenses deducted must be included in the
taxpayer's gross income for the taxable year in which the taxpayer is no
longer able to satisfy such minimum period of employment condition.
Where the taxpayer has deducted moving expenses under the election
provided in section 217(d)(2) for the taxable year and subsequently
files an amended return for such year on which he does not claim the
deduction, such expenses are not treated as having been
[[Page 451]]
deducted for purposes of the recapture rule of the preceding sentence.
(e) Denial of double benefit--(1) In general. Section 217(e)
provides a rule for computing the amount realized and the basis where
qualified real estate expenses are allowed as a deduction under section
217(a).
(2) Sale or exchange of residence. Section 217(e) provides that the
amount realized on the sale or exchange of a residence owned by the
taxpayer, by the taxpayer's spouse, or by the taxpayer and his spouse
and used by the taxpayer as his principal place of residence is not
decreased by the amount of any expenses described in subparagraph (A) of
section 217(b)(2) and deducted under section 217(a). For the purposes of
section 217(e) and of this paragraph the term amount realized'' has the
same meaning as under section 1001(b) and the regulations thereunder.
Thus, for example, if the taxpayer sells a residence used as his
principal place of residence and real estate commissions or similar
expenses described in subparagraph (A) of section 217(b)(2) are deducted
by him pursuant to section 217(a), the amount realized on the sale of
the residence is not reduced by the amount of such real estate
commissions or such similar expenses described in subparagraph (A) of
section 217(b)(2).
(3) Purchase of a residence. Section 217(e) provides that the basis
of a residence purchased or received in exchange for other property by
the taxpayer, by the taxpayer's spouse, or by the taxpayer and his
spouse and used by the taxpayer as his principal place of residence is
not increased by the amount of any expenses described in subparagraph
(B) of section 217(b)(2) and deducted under section 217(a). For the
purposes of section 217(e) and of this paragraph the term basis has the
same meaning as under section 1011 and the regulations thereunder. Thus,
for example, if a taxpayer purchases a residence to be used as his
principal place of residence and attorneys' fees or similar expenses
described in subparagraph (B) of section 217(b)(2) are deducted pursuant
to section 217(a), the basis of such residence is not increased by the
amount of such attorneys' fees or such similar expenses described in
subparagraph (B) of section 217(b)(2).
(4) Inapplicability of section 217(e). (i) Section 217(e) and
subparagraphs (1) through (3) of this paragraph do not apply to any
expenses with respect to which an amount is included in gross income
under section 217(d)(3). Thus, the amount of any expenses described in
subparagraph (A) of section 217(b)(2) deducted in the year paid or
incurred pursuant to the election under section 217(d)(2) and
subsequently recaptured pursuant to section 217(d)(3) may be taken into
account in computing the amount realized on the sale or exchange of the
residence described in such subparagraph. Also, the amount of expenses
described in subparagraph (B) of section 217(b)(2) deducted in the year
paid or incurred pursuant to such election under section 217(d)(2) and
subsequently recaptured pursuant to section 217(d)(3) may be taken into
account as an adjustment to the basis of the residence described in such
subparagraph.
(ii) The application of subdivision (i) of this subparagraph may be
illustrated by the following examples:
Example 1. A was notified of his transfer effective December 15,
1972, from Seattle, WA, to Philadelphia, PA. In connection with the
transfer A sold his house in Seattle on November 10, 1972. Expenses
incident to the sale of the house of $2,500 were paid by A prior to or
at the time of the closing of the contract of sale on December 10, 1972.
The amount realized on the sale of the house was $47,500 and the
adjusted basis of the house was $30,000. Pursuant to the election
provided in section 217(d)(2), A deducted the expenses of moving from
Seattle to Philadelphia including the expenses incident to the sale of
his former residence in taxable year 1972. Dissatisfied with his
position with his employer in Philadelphia, A took a position with an
employer in Chicago, IL, on July 15, 1973. Since A was no longer able to
satisfy the minimum period employment condition at the close of taxable
year 1973 he included an amount equal to the amount deducted as moving
expenses including the expenses incident to the sale of his former
residence in gross income for taxable year 1973. A is permitted to
decrease the amount realized on the sale of the house by the amount of
the expenses incident to the sale of the house deducted from gross
income and subsequently included in gross income. Thus, the amount
realized on the sale of the house is decreased from $47,500 to $45,000
and thus, the gain on the
[[Page 452]]
sale of the house is reduced from $17,500 to $15,000. A is allowed to
file an amended return or a claim for refund in order to reflect the
recomputation of the amount realized.
Example 2. B, who is self-employed decided to move from Washington,
DC, to Los Angeles, CA. In connection with the commencement of work in
Los Angeles on March 1, 1973, B purchased a house in a suburb of Los
Angeles for $65,000. Expenses incident to the purchase of the house in
the amount of $1,500 were paid by B prior to or at the time of the
closing of the contract of sale on September 15, 1973. Pursuant to the
election provided in section 217(d)(2), B deducted the expenses of
moving from Washington to Los Angeles including the expenses incident to
the purchase of his new residence in taxable year 1973. Dissatisfied
with his prospects in Los Angeles, B moved back to Washington on July 1,
1974. Since B was no longer able to satisfy the minimum period of
employment condition at the close of taxable year 1974 he included an
amount equal to the amount deducted as moving expenses incident to the
purchase of the former residence in gross income for taxable year 1974.
B is permitted to increase the basis of the house by the amount of the
expenses incident to the purchase of the house deducted from gross
income and subsequently included in gross income. Thus, the basis of the
house is increased to $66,500.
(f) Rules for self-employed individuals--(1) Definition. Section
217(f)(1) defines the term self-employed individual for purposes of
section 217 to mean an individual who performs personal services either
as the owner of the entire interest in an unincorporated trade or
business or as a partner in a partnership carrying on a trade or
business. The term self-employed individual does not include the
semiretired, part-time students, or other similarly situated taxpayers
who work only a few hours each week. The application of this
subparagraph may be illustrated by the following example:
Example. A is the owner of the entire interest in an unincorporated
construction business. A hires a manager who performs all of the daily
functions of the business including the negotiation of contracts with
customers, the hiring and firing of employees, the purchasing of
materials used on the projects, and other similar services. A and his
manager discuss the operations of the business about once a week over
the telephone. Otherwise A does not perform any managerial services for
the business. For the purposes of section 217, A is not considered to be
a self-employed individual.
(2) Rule for application of subsection (b)(1) (C) and (D). Section
217(f)(2) provides that for purposes of subparagraphs (C) and (D) of
section 217(b)(1) an individual who commences work at a new principal
place of work as a self-employed individual is treated as having
obtained employment when he has made substantial arrangements to
commence such work. Whether the taxpayer has made substantial
arrangements to commence work at a new principal place of work is
determined on the basis of all the facts and circumstances in each case.
The factors to be considered in this determination depend upon the
nature of the taxpayer's trade or business and include such
considerations as whether the taxpayer has: (i) Leased or purchased a
plant, office, shop, store, equipment, or other property to be used in
the trade or business, (ii) made arrangements to purchase inventory or
supplies to be used in connection with the operation of the trade or
business, (iii) entered into commitments with individuals to be employed
in the trade or business, and (iv) made arrangements to contact
customers or clients in order to advertise the business in the general
location of the new principal place of work. The application of this
subparagraph may be illustrated by the following examples:
Example 1. A, a partner in a growing chain of drug stores decided to
move from Houston, TX, to Dallas, TX, in order to open a drug store in
Dallas. A made several trips to Dallas for the purpose of looking for a
site for the drug store. After the signing of a lease on a building in a
shopping plaza, suppliers were contacted, equipment was purchased, and
employees were hired. Shortly before the opening of the store A and his
wife moved from Houston to Dallas and took up temporary quarters in a
motel until the time their apartment was available. By the time he and
his wife took up temporary quarters in the motel A was considered to
have made substantial arrangements to commence work at the new principal
place of work.
Example 2. B, who is a partner in a securities brokerage firm in New
York, NY, decided to move to Rochester, NY, to become the resident
partner in the firm's new Rochester office. After a lease was signed on
an office in downtown Rochester B moved to Rochester and took up
temporary quarters
[[Page 453]]
in a motel until his apartment became available. Before the opening of
the office B supervised the decoration of the office, the purchase of
equipment and supplies necessary for the operation of the office, the
hiring of personnel for the office, as well as other similar activities.
By the time B took up temporary quarters in the motel he was considered
to have made substantial arrangements to commence to work at the new
principal place of work.
Example 3. C, who is about to complete his residency in
ophthalmology at a hospital in Pittsburgh, PA, decided to fly to
Philadelphia, PA, for the purpose of looking into opportunities for
practicing in that city. Following his arrival in Philadelphia C decided
to establish his practice in that city. He leased an office and an
apartment. At the time he departed Pittsburgh for Philadelphia C was not
considered to have made substantial arrangements to commence work at the
new principal place of work, and, therefore, is not allowed to deduct
expenses described in subparagraph (C) of section 217(b)(1) (relating to
expenses of traveling (including meals and lodging), after obtaining
employment, from the former residence to the general location of the new
principal place of work and return, for the principal purpose of
searching for a new residence).
(g) Rules for members of the Armed Forces of the United States--(1)
In general. The rules in paragraphs (a)(1) and (2), (b), and (e) of this
section apply to moving expenses paid or incurred by members of the
Armed Forces of the United States on active duty who move pursuant to a
military order and incident to a permament change of station, except as
provided in this paragraph (g). However, if the moving expenses are not
paid or incurred incident to a permanent change of station, this
paragraph (g) does not apply, but all other paragraphs of this section
do apply. The provisions of this paragraph apply to taxable years
beginning December 31, 1975.
(2) Treatment of services or reimbursement provided by Government--
(i) Services in kind. The value of any moving or storage services
furnished by the United States Government to members of the Armed
Forces, their spouses, or their dependents in connection with a
permanent change of station is not includible in gross income. The
Secretary of Defense and (in cases involving members of the peacetime
Coast Guard) the Secretary of Transportation are not required to report
or withhold taxes with respect to those services. Services furnished by
the Government include services rendered directly by the Government or
rendered by a third party who is compensated directly by the Government
for the services.
(ii) Reimbursements. The following rules apply to reimbursements or
allowances by the Government to members of the Armed Forces, their
spouses, or their dependents for moving or storage expenses paid or
incurred by them in connection with a permanent change of station. If
the reimbursement or allowance exceeds the actual expenses paid or
incurred, the excess is includible in the gross income of the member,
and the Secretary of Defense or Secretary of Transportation must report
the excess as payment of wages and withhold income taxes under section
3402 and the employee taxes under section 3102 with respect to that
excess. If the reimbursement or allowance does not exceed the actual
expenses, the reimbursement or allowance in not includible in gross
income, and no reporting or withholding by the Secretary of Defense or
Secretary of Transportation is required. If the actual expenses, as
limited by paragraph (b)(9) of this section, exceed the reimbursement of
allowance, the member may deduct the excess if the other requirements of
this section, as modified by this paragraph, are met. The determination
of the limitation on actual expenses under paragraph (b)(9) of this
section is made without regard to any services in kind furnished by the
Government.
(3) Permanent change of station. For purposes of this section, the
term permanent change of station includes the following situations.
(i) A move from home to the first post of duty when appointed,
reappointed, reinstated, or inducted.
(ii) A move from the last post of duty to home or a nearer point in
the United States in connection with retirement, discharge, resignation,
separation under honorable conditions, transfer, relief from active
duty, temporary disability retirement, or transfer to a Fleet Reserve,
if such move occurs within 1 year of such termination of
[[Page 454]]
active duty or within the period prescribed by the Joint Travel
Regulations promulgated under the authority contained in sections 404
through 411 of title 37 of the United States Code.
(iii) A move from one permanent post of duty to another permanent
post of duty at a different duty station, even if the member separates
from the Armed Forces immediately or shortly after the move.
The term permanent, post of duty, duty station, and honorable have the
meanings given them in appropriate Department of Defense or Department
of Transportation rules and regulations.
(4) Storage expenses. This paragraph applies to storage expenses as
well as to moving expenses described in paragraph (b)(1) of this
section. the term storage expenses means the cost of storing personal
effects of members of the Armed Forces, their spouses, and their
dependents.
(5) Moves of spouses and dependents. (i) The following special rule
applies for purposes of paragraphs (b)(9) and (10) of this section, if
the spouse or dependents of a member of the Armed Forces move to or from
a different location than does the member. In this case, the spouse is
considered to have commenced work as an employee at a new principal
place of work that is within the same general location as the location
to which the member moves.
(ii) The following special rule applies for purposes of this
paragraph to moves by spouses or dependents of members of the Armed
Forces who die, are imprisoned, or desert while on active duty. In these
cases, a move to a member's place of enlistment or induction or the
member's, spouse's, or dependent's home of record or nearer point in the
United States is considered incident to a permanent change of station.
(6) Disallowance of deduction. No deduction is allowed under this
section for any moving or storage expense reimbursed by an allowance
that is excluded from gross income.
(h) Special rules for foreign moves--(1) Increase in limitations. In
the case of a foreign move (as defined in paragraph (h)(3) of this
section), paragraph (b)(6) of this section shall be applied by
substituting ``90 consecutive'' for ``30 consecutive'' each time it
appears. Paragraph (b)(9) (ii), (iii) and (v) of this section shall be
applied by substituting ``$6,000'' for ``$3,000'' each time it appears
and by substituting ``$4,500'' for ``$1,500'' each time it appears.
Paragraph (b)(9)(ii) of this section shall be applied by substituting
``$5,000'' for ``$2,000'' each time it appears and by substituting
``1979'' for ``1977'' and ``1980'' for ``1978'' each time they appear in
the last sentence. Paragraph (b)(9)(v) of this section shall be applied
by substituting ``$2,250'' for ``$750'' each time it appears. Paragraph
(b)(9)(vi) of this section does not apply.
(2) Allowance of certain storage fees. In the case of a foreign
move, for purposes of this section, the moving expenses described in
paragraph (b)(3) of this section shall include the reasonable expenses
of moving household goods and personal effects to and from storage, and
of storing such goods and effects for part or all of the period during
which the new place of work continues to be the taxpayer's principal
place of work.
(3) Foreign move. For purposes of this paragraph, the term foreign
move means a move in connection with the commencement of work by the
taxpayer at a new principal place of work located outside the United
States. Thus, a move from the United States to a foreign country or from
one foreign country to another foreign country qualifies as a foreign
move. A move within a foreign country also qualifies as a foreign move.
A move from a foreign country to the United States does not qualify as a
foreign move.
(4) United States. For purposes of this paragraph, the term United
States includes the possessions of the United States.
(5) Effective date. The provisions of this paragraph apply to
expenses paid or incurred in taxable years beginning after December 31,
1978. The paragraph also applies to the expenses paid or incurred in the
taxable year beginning during 1978 of taxpayers who do not make an
election pursuant to section 209(c) of the Foreign Earned Income Act of
1978 (Pub. L. 95-615, 92 Stat. 3109) to have section 911 under prior law
apply to that taxable year.
(i) Allowance of deductions in case of retirees or decedents who
were working
[[Page 455]]
abroad--(1) In general. In the case of any qualified retiree moving
expenses or qualified survivor moving expenses, this section (other than
paragraph (h)) shall be applied to such expenses as if they were
incurred in connection with the commencement of work by the taxpayer as
an employee at a new principal place of work located within the United
States and the limitations of paragraph (c)(4) of this section (relating
to the minimum period of employment) shall not apply.
(2) Qualified retiree moving expenses. For purposes of this
paragraph, the term qualified retiree moving expenses means any moving
expenses which are incurred by an individual whose former principal
place of work and former residence were outside the United States and
which are incurred for a move to a new residence in the United States in
connection with the bona fide retirement of the individual. Bona fide
retirement means the permanent withdrawal from gainful full-time
employment and self-employment. An individual who at the time of
withdrawal from gainful full-time employment or self-employment, intends
the withdrawal to be permanent shall be considered to be a bona fide
retiree even though the individual ultimately resumes gainful full-time
employment or self-employment. An individual's intention may be
evidenced by relevant facts and circumstances which include the age and
health of the individual, the customary retirement age of employees
engaged in similar work, whether the individual is receiving a
retirement allowance under a pension annuity, retirement or similar fund
or system, and the length of time before resuming full-time employment
or self-employment.
(3) Qualified survivor moving expenses. (i) For purposes of this
paragraph, the term qualified survivor moving expenses means any moving
expenses:
(A) Which are paid or incurred by the spouse or any dependent (as
defined in section 152) of any decedent who (as of the time of his
death) had a principal place of work outside the United States, and
(B) Which are incurred for a move which begins within 6 months after
the death of the decedent and which is to a residence in the United
States from a former residence outside the United States which (as of
the time of the decedent's death) was the residence of such decedent and
the individual paying or incurring the expense.
(ii) For purposes of paragraph (i)(3) (i) (B) of this section, a
move begins when:
(A) The taxpayer contracts for the moving of his or her household
goods and personal effects to a residence in the United States but only
if the move is completed within a reasonable time thereafter;
(B) The taxpayer's household goods and personal effects are packed
and in transit to a residence in the United States; or
(C) The taxpayer leaves the former residence to travel to a new
place of residence in the United States.
(4) United States. For purposes of this paragraph, the term United
States includes the possessions of the United States.
(5) Effective date. The provisions of this paragraph apply to
expenses paid or incurred in taxable years beginning after December 31,
1978. The paragraph also applies to the expenses paid or incurred in the
taxable year beginning during 1978 of taxpayers who do not make an
election pursuant to section 209(c) of the Foreign Earned Income Act of
1978 (Pub. L. 95-615, 92 Stat. 3109) to have section 911 under prior law
apply to that taxable year.
(j) Effective date--(1) In general. This section, except as provided
in subparagraphs (2) and (3) of this paragraph, is applicable to items
paid or incurred in taxable years beginning after December 31, 1969.
(2) Reimbursement not included in gross income. This section does
not apply to items to the extent that the taxpayer received or accrued
in a taxable year beginning before January 1, 1970, a reimbursement or
other expense allowance for such items which was not included in his
gross income.
(3) Election in cases of expenses paid or incurred before January 1,
1971, in connection with certain moves--(i) In general. A taxpayer who
was notified by his employer on or before December 19, 1969, of a
transfer to a new principal place of work and who pays or incurs moving
expenses after December 31,
[[Page 456]]
1969, but before January 1, 1971, in connection with such transfer may
elect to have the rules governing moving expenses in effect prior to the
effective date of section 231 of the Tax Reform Act of 1969 (83 Stat.
577) govern such expenses. If such election is made, this section and
section 82 and the regulations thereunder do not apply to such expenses.
A taxpayer is considered to have been notified on or before December 19,
1969, by his employer of a transfer, for example, if before such date
the employer has sent a notice to all employees or a reasonably defined
group of employees, which includes such taxpayer, of a relocation of the
operations of such employer from one plant or facility to another plant
or facility. An employee who is transferred to a new principal place of
work for the benefit of his employer and who makes an election under
this paragraph is permitted to exclude amounts received or accrued,
directly or indirectly, as payment for or reimbursement of expenses of
moving household goods and personal effects from the former residence to
the new residence and of traveling (including meals and lodging) from
the former residence to the new place of residence. Such exclusion is
limited to amounts received or accrued, directly or indirectly, as a
payment for or reimbursement of the expenses described above. Amounts in
excess of actual expenses paid or incurred must be included in gross
income. No deduction is allowable under section 217 for expenses
representing amounts excluded from gross income. Also, an employee who
is transferred to a new principal place of work which is less than 50
miles but at least 20 miles farther from his former residence than was
his former principal place of work and who is not reimbursed, either
directly or indirectly, for the expenses described above is permitted to
deduct such expenses providing all of the requirements of section 217
and the regulations thereunder prior to the effective date of section
231 of the Tax Reform Act of 1969 (83 Stat. 577) are satisfied.
(ii) Election made before the date of publication of this notice as
a Treasury decision. An election under this subparagraph made before the
date of publication of this notice as a Treasury decision shall be made
pursuant to the procedure prescribed in temporary income tax regulations
relating to treatment of payments of expenses of moving from one
residence to another residence (Part 13 of this chapter) T.D. 7032 (35
FR 4330), approved Mar. 11, 1970.
(iii) Election made on or after the date of publication of this
notice as a Treasury decision. An election made under this subparagraph
on or after the date of publication of this notice as a Treasury
decision shall be made not later than the time, including extensions
thereof, prescribed by law for filing the income tax return for the year
in which the expenses were paid or 30 days after the date of publication
of this notice as a Treasury decision, whichever occurs last. The
election shall be made by a statement attached to the return (or the
amended return) for the taxable year, setting forth the following
information:
(a) The items to which the election relates;
(b) The amount of each item;
(c) The date each item was paid or incurred; and
(d) The date the taxpayer was informed by his employer of his
transfer to the new principal place of work.
(iv) Revocation of election. An election made in accordance with
this subparagraph is revocable upon the filing by the taxpayer of an
amended return or a claim for refund with the district director, or the
director of the Internal Revenue service center with whom the election
was filed not later than the time prescribed by law, including
extensions thereof, for the filing of a claim for refund with respect to
the items to which the election relates.
[T.D. 7195, 37 FR 13535, July 11, 1972, 37 FR 14230, July 18, 1972, as
amended by T.D. 7578 43 FR 59355, Dec. 20, 1978; T.D. 7605, 44 FR 18970,
Mar. 30, 1979; T.D. 7689, 45 FR 20796, Mar. 31, 1980; T.D. 7810, 47 FR
6003, Feb. 10, 1982; T.D. 8607, 60 FR 40077, Aug. 7, 1995]
Sec. 1.219-1 Deduction for retirement savings.
(a) In general. Subject to the limitations and restrictions of
paragraph (b) and the special rules of paragraph (c)(3) of this section,
there shall be allowed a deduction under section 62 from gross income of
amounts paid for the taxable
[[Page 457]]
year of an individual on behalf of such individual to an individual
retirement account described in section 408(a), for an individual
retirement annuity described in section 408(b), or for a retirement bond
described in section 409. The deduction described in the preceding
sentence shall be allowed only to the individual on whose behalf such
individual retirement account, individual retirement annuity, or
retirement bond is maintained. The first sentence of this paragraph
shall apply only in the case of a contribution of cash. A contribution
of property other than cash is not allowable as a deduction under this
section. In the case of a retirement bond, a deduction will not be
allowed if the bond is redeemed within 12 months of its issue date.
(b) Limitations and restrictions--(1) Maximum deduction. The amount
allowable as a deduction under section 219(a) to an individual for any
taxable year cannot exceed an amount equal to 15 percent of the
compensation includible in the gross income of the individual for such
taxable year, or $1,500, whichever is less.
(2) Restrictions--(i) Individuals covered by certain other plans. No
deduction is allowable under section 219(a) to an individual for the
taxable year if for any part of such year:
(A) He was an active participant in:
(1) A plan described in section 401(a) which includes a trust exempt
from tax under section 501(a),
(2) An annuity plan described in section 403(a),
(3) A qualified bond purchase plan described in section 405(a), or
(4) A retirement plan established for its employees by the United
States, by a State or political subdivision thereof, or by an agency or
instrumentality of any of the foregoing, or
(B) Amounts were contributed by his employer for an annuity contract
described in section 403(b) (whether or not the individual's rights in
such contract are nonforfeitable).
(ii) Contributions after age 70\1/2\. No deduction is allowable
under section 219 (a) to an individual for the taxable year of the
individual, if he has attained the age of 70\1/2\ before the close of
such taxable year.
(iii) Rollover contributions. No deduction is allowable under
section 219 for any taxable year of an individual with respect to a
rollover contribution described in section 402(a)(5), 402(a)(7),
403(a)(4), 403(b)(8), 408(d)(3), or 409(b)(3)(C).
(3) Amounts contributed under endowment contracts. (i) For any
taxable year, no deduction is allowable under section 219(a) for amounts
paid under an endowment contract described in Sec. 1.408-3(e) which is
allocable under subdivision (ii) of this subparagraph to the cost of
life insurance.
(ii) For any taxable year, the cost of current life insurance
protection under an endowment contract described in paragraph (b)(3)(i)
of this section is the product of the net premium cost, as determined by
the Commissioner, and the excess, if any, of the death benefit payable
under the contract during the policy year beginning in the taxable year
over the cash value of the contract at the end of such policy year.
(iii) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. A, an individual who is otherwise entitled to the maximum
deduction allowed under section 219, purchases, at age 20, an endowment
contract described in Sec. 1.408-3(e) which provides for the payment of
an annuity of $100 per month, at age 65, with a minimum death benefit of
$10,000, and an annual premium of $220. The cash value at the end of the
first policy year is 0. The net premium cost, as determined by the
Commissioner, for A's age is $1.61 per thousand dollars of life
insurance protection. The cost of current life insurance protection is
$16.10 ($1.61 x 10). A's maximum deduction under section 219 with
respect to amounts paid under the endowment contract for the taxable
year in which the first policy year begins is $203.90 ($220 - $16.10).
Example 2. Assume the same facts as in Example 1, except that the
cash value at the end of the second policy year is $200 and the net
premium cost is $1.67 per thousand for A's age. The cost of current life
insurance protection is $16.37 ($1.67 x 9.8). A's maximum deduction
under section 219 with respect to amounts paid under the endowment
contract for the taxable year in which the second policy year begins is
$203.63 ($220 - $16.37).
(c) Definitions and special rules--(1) Compensation. For purposes of
this section, the term compensation means wages, salaries, professional
fees, or
[[Page 458]]
other amounts derived from or received for personal service actually
rendered (including, but not limited to, commissions paid salesmen,
compensation for services on the basis of a percentage of profits,
commissions on insurance premiums, tips, and bonuses) and includes
earned income, as defined in section 401 (c) (2), but does not include
amounts derived from or received as earnings or profits from property
(including, but not limited to, interest and dividends) or amounts not
includible in gross income.
(2) Active participant. For the definition of active participant,
see Sec. 1.219-2.
(3) Special rules. (i) The maximum deduction allowable under section
219(b)(1) is computed separately for each individual. Thus, if a husband
and wife each has compensation of $10,000 for the taxable year and they
are each otherwise eligible to contribute to an individual retirement
account and they file a joint return, then the maximum amount allowable
as a deduction under section 219 is $3,000, the sum of the individual
maximums of $1,500. However, if, for example, the husband has
compensation of $20,000, the wife has no compensation, each is otherwise
eligible to contribute to an individual retirement account for the
taxable year, and they file a joint return, the maximum amount allowable
as a deduction under section 219 is $1,500.
(ii) Section 219 is to be applied without regard to any community
property laws. Thus, if, for example, a husband and wife, who are
otherwise eligible to contribute to an individual retirement account,
live in a community property jurisdiction and the husband alone has
compensation of $20,000 for the taxable year, then the maximum amount
allowable as a deduction under section 219 is $1,500.
(4) Employer contributions. For purposes of this chapter, any amount
paid by an employer to an individual retirement account or for an
individual retirement annuity or retirement bond constitutes the payment
of compensation to the employee (other than a self-employed individual
who is an employee within the meaning of section 401(c)(1)) includible
in his gross income, whether or not a deduction for such payment is
allowable under section 219 to such employee after the application of
section 219(b). Thus, an employer will be entitled to a deduction for
compensation paid to an employee for amounts the employer contributes on
the employee's behalf to an individual retirement account, for an
individual retirement annuity, or for a retirement bond if such
deduction is otherwise allowable under section 162.
[T.D. 7714, 45 FR 52788, Aug. 8, 1980]
Sec. 1.219-2 Definition of active participant.
(a) In general. This section defines the term active participant for
individuals who participate in retirement plans described in section
219(b)(2). Any individual who is an active participant in such a plan is
not allowed a deduction under section 219(a) for contributions to an
individual retirement account.
(b) Defined benefit plans--(1) In general. Except as provided in
subparagraphs (2), (3) and (4) of this paragraph, an individual is an
active participant in a defined benefit plan if for any portion of the
plan year ending with or within such individual's taxable year he is not
excluded under the eligibility provisions of the plan. An individual is
not an active participant in a particular taxable year merely because
the individual meets the plan's eligibility requirements during a plan
year beginning in that particular taxable year but ending in a later
taxable year of the individual. However, for purposes of this section,
an individual is deemed not to satisfy the eligibility provisions for a
particular plan year if his compensation is less than the minimum amount
of compensation needed under the plan to accrue a benefit. For example,
assume a plan is integrated with Social Security and only those
individuals whose compensation exceeds a certain amount accrue benefits
under the plan. An individual whose compensation for the plan year
ending with or within his taxable year is less than the amount necessary
under the plan to accrue a benefit is not an active participant in such
plan.
(2) Rules for plans maintained by more than one employer. In the
case of a defined benefit plan described in section 413(a) and funded at
least in part by
[[Page 459]]
service-related contributions, e.g., so many cents-per-hour, an
individual is an active participant if an employer is contributing or is
required to contribute to the plan an amount based on that individual's
service taken into account for the plan year ending with or within the
individual's taxable year. The general rule in paragraph (b)(1) of this
section applies in the case of plans described in section 413(a) and
funded only on some non-service-related unit, e.g., so many cents-per-
ton of coal.
(3) Plans in which accruals for all participants have ceased. In the
case of a defined benefit plan in which accruals for all participants
have ceased, an individual in such a plan is not an active participant.
However, any benefit that may vary with future compensation of an
individual provides additional accruals. For example, a plan in which
future benefit accruals have ceased, but the actual benefit depends upon
final average compensation will not be considered as one in which
accruals have ceased.
(4) No accruals after specified age. An individual in a defined
benefit plan who accrues no additional benefits in a plan year ending
with or within such individual's taxable year by reason of attaining a
specified age is not an active participant by reason of his
participation in that plan.
(c) Money purchase plan. An individual is an active participant in a
money purchase plan if under the terms of the plan employer
contributions must be allocated to the individual's account with respect
to the plan year ending with or within the individual's taxable year.
This rule applies even if an individual is not employed at any time
during the individual's taxable year.
(d) Profit-sharing and stock-bonus plans--(1) In general. This
paragraph applies to profit-sharing and stock bonus plans. An individual
is an active participant in such plans in a taxable year if a forfeiture
is allocated to his account as of a date in such taxable year. An
individual is also an active participant in a taxable year in such plans
if an employer contribution is added to the participant's account in
such taxable year. A contribution is added to a participant's account as
of the later of the following two dates: the date the contribution is
made or the date as of which it is allocated. Thus, if a contribution is
made in an individual's taxable year 2 and allocated as of a date in
individual's taxable year 1, the later of the relevant dates is the date
the contribution is made. Consequently, the individual is an active
participant in year 2 but not in year 1 as a result of that
contribution.
(2) Special rule. An individual is not an active participant for a
particular taxable year by reason of a contribution made in such year
allocated to a previous year if such individual was an active
participant in such previous year by reason of a prior contribution that
was allocated as of a date in such previous year.
(e) Employee contributions. If an employee makes a voluntary or
mandatory contribution to a plan described in paragraphs (b), (c), or
(d) of this section, such employee is an active participant in the plan
for the taxable year in which such contribution is made.
(f) Certain individuals not active participants. For purposes of
this section, an individual is not an active participant under a plan
for any taxable year of such individual for which such individual
elects, pursuant to the plan, not to participate in such plan.
(g) Retirement savings for married individuals. The provisions of
this section apply in determining whether an individual or his spouse is
an active participant in a plan for purposes of section 220 (relating to
retirement savings for certain married individuals).
(h) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. The X Corporation maintains a defined benefit plan which
has the following rules on participation and accrual of benefits. Each
employee who has attained the age of 25 or has completed one year of
service is a participant in the plan. The plan further provides that
each participant shall receive upon retirement $12 per month for each
year of service in which the employee completes 1,000 hours of service.
The plan year is the calendar year. B, a calendar-year taxpayer, enters
the plan on January 2, 1980, when he is 27 years of age. Since B has
attained the age of 25, he is a participant in the plan. However, B
completes less than 1,000 hours of
[[Page 460]]
service in 1980 and 1981. Although B is not accruing any benefits under
the plan in 1980 and 1981, he is an active participant under section
219(b)(2) because he is a participant in the plan. Thus, B cannot make
deductible contributions to an individual retirement arrangement for his
taxable years of 1980 and 1981.
Example 2. The Y Corporation maintains a profit-sharing plan for its
employees. The plan year of the plan is the calendar year. C is a
calendar-year taxpayer and a participant in the plan. On June 30, 1980,
the employer makes a contribution for 1980 which as allocated on July
31, 1980. In 1981 the employer makes a second contribution for 1980,
allocated as of December 31, 1980. Under the general rule stated in
Sec. 1.219-2(d)(1), C is an active participant in 1980. Under the
special rule stated in Sec. 1.219-2(d)(2), however, C is not an active
participant in 1981 by reason of that contribution made in 1981.
(i) Effective date. The provisions set forth in this section are
effective for taxable years beginning after December 31, 1978.
[T.D. 7714, 45 FR 52789, Aug. 8, 1980]
Sec. 1.221-1 Deduction for interest paid on qualified
education loans after December 31, 2001.
(a) In general--(1) Applicability. Under section 221, an individual
taxpayer may deduct from gross income certain interest paid by the
taxpayer during the taxable year on a qualified education loan. See
paragraph (b)(4) of this section for rules on payments of interest by
third parties. The rules of this section are applicable to periods
governed by section 221 as amended in 2001, which relates to deductions
for interest paid on qualified education loans after December 31, 2001,
in taxable years ending after December 31, 2001, and on or before
December 31, 2010. For rules applicable to interest due and paid on
qualified education loans after January 21, 1999, if paid before January
1, 2002, see Sec. 1.221-2. Taxpayers also may apply Sec. 1.221-2 to
interest due and paid on qualified education loans after December 31,
1997, but before January 21, 1999. To the extent that the effective date
limitation (sunset) of the 2001 amendment remains in force unchanged,
section 221 before amendment in 2001, to which Sec. 1.221-2 relates,
also applies to interest due and paid on qualified education loans in
taxable years beginning after December 31, 2010.
(2) Example. The following example illustrates the rules of this
paragraph (a). In the example, assume that the institution the student
attends is an eligible educational institution, the loan is a qualified
education loan, the student is legally obligated to make interest
payments under the terms of the loan, and any other applicable
requirements, if not otherwise specified, are fulfilled. The example is
as follows:
Example. Effective dates. Student A begins to make monthly interest
payments on her loan beginning January 1, 1997. Student A continues to
make interest payments in a timely fashion. However, under the effective
date provisions of section 221, no deduction is allowed for interest
Student A pays prior to January 1, 1998. Student A may deduct interest
due and paid on the loan after December 31, 1997. Student A may apply
the rules of Sec. 1.221-2 to interest due and paid during the period
beginning January 1, 1998, and ending January 20, 1999. Interest due and
paid during the period January 21, 1999, and ending December 31, 2001,
is deductible under the rules of Sec. 1.221-2, and interest paid after
December 31, 2001, is deductible under the rules of this section.
(b) Eligibility--(1) Taxpayer must have a legal obligation to make
interest payments. A taxpayer is entitled to a deduction under section
221 only if the taxpayer has a legal obligation to make interest
payments under the terms of the qualified education loan.
(2) Claimed dependents not eligible--(i) In general. An individual
is not entitled to a deduction under section 221 for a taxable year if
the individual is a dependent (as defined in section 152) for whom
another taxpayer is allowed a deduction under section 151 on a Federal
income tax return for the same taxable year (or, in the case of a fiscal
year taxpayer, the taxable year beginning in the same calendar year as
the individual's taxable year).
(ii) Examples. The following examples illustrate the rules of this
paragraph (b)(2):
Example 1. Student not claimed as dependent. Student B pays $750 of
interest on qualified education loans during 2003. Student B's parents
are not allowed a deduction for her as a dependent for 2003. Assuming
fulfillment of all other relevant requirements, Student B may deduct
under section 221 the $750 of interest paid in 2003.
Example 2. Student claimed as dependent. Student C pays $750 of
interest on qualified
[[Page 461]]
education loans during 2003. Only Student C has the legal obligation to
make the payments. Student C's parent claims him as a dependent and is
allowed a deduction under section 151 with respect to Student C in
computing the parent's 2003 Federal income tax. Student C is not
entitled to a deduction under section 221 for the $750 of interest paid
in 2003. Because Student C's parent was not legally obligated to make
the payments, Student C's parent also is not entitled to a deduction for
the interest.
(3) Married taxpayers. If a taxpayer is married as of the close of a
taxable year, he or she is entitled to a deduction under this section
only if the taxpayer and the taxpayer's spouse file a joint return for
that taxable year.
(4) Payments of interest by a third party--(i) In general. If a
third party who is not legally obligated to make a payment of interest
on a qualified education loan makes a payment of interest on behalf of a
taxpayer who is legally obligated to make the payment, then the taxpayer
is treated as receiving the payment from the third party and, in turn,
paying the interest.
(ii) Examples. The following examples illustrate the rules of this
paragraph (b)(4):
Example 1. Payment by employer. Student D obtains a qualified
education loan to attend college. Upon Student D's graduation from
college, Student D works as an intern for a non-profit organization
during which time Student D's loan is in deferment and Student D makes
no interest payments. As part of the internship program, the non-profit
organization makes an interest payment on behalf of Student D after the
deferment period. This payment is not excluded from Student D's income
under section 108(f) and is treated as additional compensation
includible in Student D's gross income. Assuming fulfillment of all
other requirements of section 221, Student D may deduct this payment of
interest for Federal income tax purposes.
Example 2. Payment by parent. Student E obtains a qualified
education loan to attend college. Upon graduation from college, Student
E makes legally required monthly payments of principal and interest.
Student E's mother makes a required monthly payment of interest as a
gift to Student E. A deduction for Student E as a dependent is not
allowed on another taxpayer's tax return for that taxable year. Assuming
fulfillment of all other requirements of section 221, Student E may
deduct this payment of interest for Federal income tax purposes.
(c) Maximum deduction. The amount allowed as a deduction under
section 221 for any taxable year may not exceed $2,500.
(d) Limitation based on modified adjusted gross income--(1) In
general. The deduction allowed under section 221 is phased out ratably
for taxpayers with modified adjusted gross income between $50,000 and
$65,000 ($100,000 and $130,000 for married individuals who file a joint
return). Section 221 does not allow a deduction for taxpayers with
modified adjusted gross income of $65,000 or above ($130,000 or above
for married individuals who file a joint return). See paragraph (d)(3)
of this section for inflation adjustment of amounts in this paragraph
(d)(1).
(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 United States possessions or Puerto
Rico). Modified adjusted gross income must be determined under this
section after taking into account the inclusions, exclusions,
deductions, and limitations provided by sections 86 (social security and
tier 1 railroad retirement benefits), 135 (redemption of qualified
United States savings bonds), 137 (adoption assistance programs), 219
(deductible qualified retirement contributions), and 469 (limitation on
passive activity losses and credits), but before taking into account the
deductions provided by sections 221 and 222 (qualified tuition and
related expenses).
(3) Inflation adjustment. For taxable years beginning after 2002,
the amounts in paragraph (d)(1) of this section will be increased for
inflation occurring after 2001 in accordance with section 221(f)(1). If
any amount adjusted under section 221(f)(1) is not a multiple of $5,000,
the amount will be rounded to the next lowest multiple of $5,000.
(e) Definitions--(1) Eligible educational institution. In general,
an eligible educational institution means any college, university,
vocational school, or other postsecondary educational institution
described in section 481 of the Higher
[[Page 462]]
Education Act of 1965 (20 U.S.C. 1088), as in effect on August 5, 1997,
and certified by the U.S. Department of Education as eligible to
participate in student aid programs administered by the Department, as
described in section 25A(f)(2) and Sec. 1.25A-2(b). For purposes of
this section, an eligible educational institution also includes an
institution that conducts an internship or residency program leading to
a degree or certificate awarded by an institution, a hospital, or a
health care facility that offers postgraduate training.
(2) Qualified higher education expenses--(i) In general. Qualified
higher education expenses means the cost of attendance (as defined in
section 472 of the Higher Education Act of 1965, 20 U.S.C. 1087ll, as in
effect on August 4, 1997), at an eligible educational institution,
reduced by the amounts described in paragraph (e)(2)(ii) of this
section. Consistent with section 472 of the Higher Education Act of
1965, a student's cost of attendance is determined by the eligible
educational institution and includes tuition and fees normally assessed
a student carrying the same academic workload as the student, an
allowance for room and board, and an allowance for books, supplies,
transportation, and miscellaneous expenses of the student.
(ii) Reductions. Qualified higher education expenses are reduced by
any amount that is paid to or on behalf of a student with respect to
such expenses and that is--
(A) A qualified scholarship that is excludable from income under
section 117;
(B) An educational assistance allowance for a veteran or member of
the armed forces under chapter 30, 31, 32, 34 or 35 of title 38, United
States Code, or under chapter 1606 of title 10, United States Code;
(C) Employer-provided educational assistance that is excludable from
income under section 127;
(D) Any other amount that is described in section 25A(g)(2)(C)
(relating to amounts excludable from gross income as educational
assistance);
(E) Any otherwise includible amount excluded from gross income under
section 135 (relating to the redemption of United States savings bonds);
(F) Any otherwise includible amount distributed from a Coverdell
education savings account and excluded from gross income under section
530(d)(2); or
(G) Any otherwise includible amount distributed from a qualified
tuition program and excluded from gross income under section
529(c)(3)(B).
(3) Qualified education loan--(i) In general. A qualified education
loan means indebtedness incurred by a taxpayer solely to pay qualified
higher education expenses that are--
(A) Incurred on behalf of a student who is the taxpayer, the
taxpayer's spouse, or a dependent (as defined in section 152) of the
taxpayer at the time the taxpayer incurs the indebtedness;
(B) Attributable to education provided during an academic period, as
described in section 25A and the regulations thereunder, when the
student is an eligible student as defined in section 25A(b)(3)
(requiring that the student be a degree candidate carrying at least half
the normal full-time workload); and
(C) Paid or incurred within a reasonable period of time before or
after the taxpayer incurs the indebtedness.
(ii) Reasonable period. Except as otherwise provided in this
paragraph (e)(3)(ii), what constitutes a reasonable period of time for
purposes of paragraph (e)(3)(i)(C) of this section generally is
determined based on all the relevant facts and circumstances. However,
qualified higher education expenses are treated as paid or incurred
within a reasonable period of time before or after the taxpayer incurs
the indebtedness if--
(A) The expenses are paid with the proceeds of education loans that
are part of a Federal postsecondary education loan program; or
(B) The expenses relate to a particular academic period and the loan
proceeds used to pay the expenses are disbursed within a period that
begins 90 days prior to the start of that academic period and ends 90
days after the end of that academic period.
(iii) Related party. A qualified education loan does not include any
indebtedness owed to a person who is related to the taxpayer, within the
meaning of section 267(b) or 707(b)(1). For example, a parent or
grandparent of the
[[Page 463]]
taxpayer is a related person. In addition, a qualified education loan
does not include a loan made under any qualified employer plan as
defined in section 72(p)(4) or under any contract referred to in section
72(p)(5).
(iv) Federal issuance or guarantee not required. A loan does not
have to be issued or guaranteed under a Federal postsecondary education
loan program to be a qualified education loan.
(v) Refinanced and consolidated indebtedness--(A) In general. A
qualified education loan includes indebtedness incurred solely to
refinance a qualified education loan. A qualified education loan
includes a single, consolidated indebtedness incurred solely to
refinance two or more qualified education loans of a borrower.
(B) Treatment of refinanced and consolidated indebtedness.
[Reserved]
(4) Examples. The following examples illustrate the rules of this
paragraph (e):
Example 1. Eligible educational institution. University F is a
postsecondary educational institution described in section 481 of the
Higher Education Act of 1965. The U.S. Department of Education has
certified that University F is eligible to participate in federal
financial aid programs administered by that Department, although
University F chooses not to participate. University F is an eligible
educational institution.
Example 2. Qualified higher education expenses. Student G receives a
$3,000 qualified scholarship for the 2003 fall semester that is
excludable from Student G's gross income under section 117. Student G
receives no other forms of financial assistance with respect to the 2003
fall semester. Student G's cost of attendance for the 2003 fall
semester, as determined by Student G's eligible educational institution
for purposes of calculating a student's financial need in accordance
with section 472 of the Higher Education Act, is $16,000. For the 2003
fall semester, Student G has qualified higher education expenses of
$13,000 (the cost of attendance as determined by the institution
($16,000) reduced by the qualified scholarship proceeds excludable from
gross income ($3,000)).
Example 3. Qualified education loan. Student H borrows money from a
commercial bank to pay qualified higher education expenses related to
his enrollment on a half-time basis in a graduate program at an eligible
educational institution. Student H uses all the loan proceeds to pay
qualified higher education expenses incurred within a reasonable period
of time after incurring the indebtedness. The loan is not federally
guaranteed. The commercial bank is not related to Student H within the
meaning of section 267(b) or 707(b)(1). Student H's loan is a qualified
education loan within the meaning of section 221.
Example 4. Qualified education loan. Student I signs a promissory
note for a loan on August 15, 2003, to pay for qualified higher
education expenses for the 2003 fall and 2004 spring semesters. On
August 20, 2003, the lender disburses loan proceeds to Student I's
college. The college credits them to Student I's account to pay
qualified higher education expenses for the 2003 fall semester, which
begins on August 25, 2003. On January 26, 2004, the lender disburses
additional loan proceeds to Student I's college. The college credits
them to Student I's account to pay qualified higher education expenses
for the 2004 spring semester, which began on January 12, 2004. Student
I's qualified higher education expenses for the two semesters are paid
within a reasonable period of time, as the first loan disbursement
occurred within the 90 days prior to the start of the fall 2003 semester
and the second loan disbursement occurred during the spring 2004
semester.
Example 5. Qualified education loan. The facts are the same as in
Example 4 except that in 2005 the college is not an eligible educational
institution because it loses its eligibility to participate in certain
federal financial aid programs administered by the U.S. Department of
Education. The qualification of Student I's loan, which was used to pay
for qualified higher education expenses for the 2003 fall and 2004
spring semesters, as a qualified education loan is not affected by the
college's subsequent loss of eligibility.
Example 6. Mixed-use loans. Student J signs a promissory note for a
loan secured by Student J's personal residence. Student J will use part
of the loan proceeds to pay for certain improvements to Student J's
residence and part of the loan proceeds to pay qualified higher
education expenses of Student J's spouse. Because Student J obtains the
loan not solely to pay qualified higher education expenses, the loan is
not a qualified education loan.
(f) Interest--(1) In general. Amounts paid on a qualified education
loan are deductible under section 221 if the amounts are interest for
Federal income tax purposes. For example, interest includes--
(i) Qualified stated interest (as defined in Sec. 1.1273-1(c)); and
(ii) Original issue discount, which generally includes capitalized
interest. For purposes of section 221, capitalized interest means any
accrued and unpaid interest on a qualified education loan that, in
accordance with the terms of
[[Page 464]]
the loan, is added by the lender to the outstanding principal balance of
the loan.
(2) Operative rules for original issue discount--(i) In general. The
rules to determine the amount of original issue discount on a loan and
the accruals of the discount are in sections 163(e), 1271 through 1275,
and the regulations thereunder. In general, original issue discount is
the excess of a loan's stated redemption price at maturity (all payments
due under the loan other than qualified stated interest payments) over
its issue price (the amount loaned). Although original issue discount
generally is deductible as it accrues under section 163(e) and Sec.
1.163-7, original issue discount on a qualified education loan is not
deductible until paid. See paragraph (f)(3) of this section to determine
when original issue discount is paid.
(ii) Treatment of loan origination fees by the borrower. If a loan
origination fee is paid by the borrower other than for property or
services provided by the lender, the fee reduces the issue price of the
loan, which creates original issue discount (or additional original
issue discount) on the loan in an amount equal to the fee. See Sec.
1.1273-2(g). For an example of how a loan origination fee is taken into
account, see Example 2 of paragraph (f)(4) of this section.
(3) Allocation of payments. See Sec. Sec. 1.446-2(e) and 1.1275-
2(a) for rules on allocating payments between interest and principal. In
general, these rules treat a payment first as a payment of interest to
the extent of the interest that has accrued and remains unpaid as of the
date the payment is due, and second as a payment of principal. The
characterization of a payment as either interest or principal under
these rules applies regardless of how the parties label the payment
(either as interest or principal). Accordingly, the taxpayer may deduct
the portion of a payment labeled as principal that these rules treat as
a payment of interest on the loan, including any portion attributable to
capitalized interest or loan origination fees.
(4) Examples. The following examples illustrate the rules of this
paragraph (f). In the examples, assume that the institution the student
attends is an eligible educational institution, the loan is a qualified
education loan, the student is legally obligated to make interest
payments under the terms of the loan, and any other applicable
requirements, if not otherwise specified, are fulfilled. The examples
are as follows:
Example 1. Capitalized interest. Interest on Student K's loan
accrues while Student K is in school, but Student K is not required to
make any payments on the loan until six months after he graduates or
otherwise leaves school. At that time, the lender capitalizes all
accrued but unpaid interest and adds it to the outstanding principal
amount of the loan. Thereafter, Student K is required to make monthly
payments of interest and principal on the loan. The interest payable on
the loan, including the capitalized interest, is original issue
discount. See section 1273 and the regulations thereunder. Therefore, in
determining the total amount of interest paid on the loan each taxable
year, Student K may deduct any payments that Sec. 1.1275-2(a) treats as
payments of interest, including any principal payments that are treated
as payments of capitalized interest. See paragraph (f)(3) of this
section.
Example 2. Allocation of payments. The facts are the same as in
Example 1, except that, in addition, the lender charges Student K a loan
origination fee, which is not for any property or services provided by
the lender. Under Sec. 1.1273-2(g), the loan origination fee reduces
the issue price of the loan, which reduction increases the amount of
original issue discount on the loan by the amount of the fee. The amount
of original issue discount (which includes the capitalized interest and
loan origination fee) that accrues each year is determined under section
1272 and Sec. 1.1272-1. In effect, the loan origination fee accrues
over the entire term of the loan. Because the loan has original issue
discount, the payment ordering rules in Sec. 1.1275-2(a) must be used
to determine how much of each payment is interest for federal tax
purposes. See paragraph (f)(3) of this section. Under Sec. 1.1275-2(a),
each payment (regardless of its designation by the parties as either
interest or principal) generally is treated first as a payment of
original issue discount, to the extent of the original issue discount
that has accrued as of the date the payment is due and has not been
allocated to prior payments, and second as a payment of principal.
Therefore, in determining the total amount of interest paid on the
qualified education loan for a taxable year, Student K may deduct any
payments that the parties label as principal but that are treated as
payments of original issue discount under Sec. 1.1275-2(a).
(g) Additional Rules--(1) Payment of interest made during period
when interest
[[Page 465]]
payment not required. Payments of interest on a qualified education loan
to which this section is applicable are deductible even if the payments
are made during a period when interest payments are not required
because, for example, the loan has not yet entered repayment status or
is in a period of deferment or forbearance.
(2) Denial of double benefit. No deduction is allowed under this
section for any amount for which a deduction is allowable under another
provision of Chapter 1 of the Internal Revenue Code. No deduction is
allowed under this section for any amount for which an exclusion is
allowable under section 108(f) (relating to cancellation of
indebtedness).
(3) Examples. The following examples illustrate the rules of this
paragraph (g). In the examples, assume that the institution the student
attends is an eligible educational institution, the loan is a qualified
education loan, and the student is legally obligated to make interest
payments under the terms of the loan:
Example 1. Voluntary payment of interest before loan has entered
repayment status. Student L obtains a loan to attend college. The terms
of the loan provide that interest accrues on the loan while Student L
earns his undergraduate degree but that Student L is not required to
begin making payments of interest until six full calendar months after
he graduates or otherwise leaves school. Nevertheless, Student L
voluntarily pays interest on the loan during 2003, while enrolled in
college. Assuming all other relevant requirements are met, Student L is
allowed a deduction for interest paid while attending college even
though the payments were made before interest payments were required.
Example 2. Voluntary payment during period of deferment or
forbearance. The facts are the same as in Example 2, except that Student
L makes no payments on the loan while enrolled in college. Student L
graduates in June 2003 and begins making monthly payments of principal
and interest on the loan in January 2004, as required by the terms of
the loan. In August 2004, Student L enrolls in graduate school on a
full-time basis. Under the terms of the loan, Student L may apply for
deferment of the loan payments while Student L is enrolled in graduate
school. Student L applies for and receives a deferment on the
outstanding loan. However, Student L continues to make some monthly
payments of interest during graduate school. Student L may deduct
interest paid on the loan during the period beginning in January 2004,
including interest paid while Student L is enrolled in graduate school.
(h) Effective date. This section is applicable to periods governed
by section 221 as amended in 2001, which relates to interest paid on a
qualified education loan after December 31, 2001, in taxable years
ending after December 31, 2001, and on or before December 31, 2010.
[T.D. 9125, 69 FR 25492, May 7, 2004]
Sec. 1.221-2 Deduction for interest due and paid on qualified
education loans before January 1, 2002.
(a) In general. Under section 221, an individual taxpayer may deduct
from gross income certain interest due and paid by the taxpayer during
the taxable year on a qualified education loan. The deduction is allowed
only with respect to interest due and paid on a qualified education loan
during the first 60 months that interest payments are required under the
terms of the loan. See paragraph (e) of this section for rules relating
to the 60-month rule. See paragraph (b)(4) of this section for rules on
payments of interest by third parties. The rules of this section are
applicable to interest due and paid on qualified education loans after
January 21, 1999, if paid before January 1, 2002. Taxpayers also may
apply the rules of this section to interest due and paid on qualified
education loans after December 31, 1997, but before January 21, 1999. To
the extent that the effective date limitation (``sunset'') of the 2001
amendment remains in force unchanged, section 221 before amendment in
2001, to which this section relates, also applies to interest due and
paid on qualified education loans in taxable years beginning after
December 31, 2010. For rules applicable to periods governed by section
221 as amended in 2001, which relates to deductions for interest paid on
qualified education loans after December 31, 2001, in taxable years
ending after December 31, 2001, and before January 1, 2011, see Sec.
1.221-1.
(b) Eligibility--(1) Taxpayer must have a legal obligation to make
interest payments. A taxpayer is entitled to a deduction under section
221 only if the taxpayer has a legal obligation to make interest
payments under the terms of the qualified education loan.
[[Page 466]]
(2) Claimed dependents not eligible--(i) In general. An individual
is not entitled to a deduction under section 221 for a taxable year if
the individual is a dependent (as defined in section 152) for whom
another taxpayer is allowed a deduction under section 151 on a Federal
income tax return for the same taxable year (or, in the case of a fiscal
year taxpayer, the taxable year beginning in the same calendar year as
the individual's taxable year).
(ii) Examples. The following examples illustrate the rules of this
paragraph (b)(2):
Example 1. Student not claimed as dependent. Student A pays $750 of
interest on qualified education loans during 1998. Student A's parents
are not allowed a deduction for her as a dependent for 1998. Assuming
fulfillment of all other relevant requirements, Student A may deduct the
$750 of interest paid in 1998 under section 221.
Example 2. Student claimed as dependent. Student B pays $750 of
interest on qualified education loans during 1998. Only Student B has
the legal obligation to make the payments. Student B's parent claims him
as a dependent and is allowed a deduction under section 151 with respect
to Student B in computing the parent's 1998 Federal income tax. Student
B may not deduct the $750 of interest paid in 1998 under section 221.
Because Student B's parent was not legally obligated to make the
payments, Student B's parent also may not deduct the interest.
(3) Married taxpayers. If a taxpayer is married as of the close of a
taxable year, he or she is entitled to a deduction under this section
only if the taxpayer and the taxpayer's spouse file a joint return for
that taxable year.
(4) Payments of interest by a third party--(i) In general. If a
third party who is not legally obligated to make a payment of interest
on a qualified education loan makes a payment of interest on behalf of a
taxpayer who is legally obligated to make the payment, then the taxpayer
is treated as receiving the payment from the third party and, in turn,
paying the interest.
(ii) Examples. The following examples illustrate the rules of this
paragraph (b)(4):
Example 1. Payment by employer. Student C obtains a qualified
education loan to attend college. Upon Student C's graduation from
college, Student C works as an intern for a non-profit organization
during which time Student C's loan is in deferment and Student C makes
no interest payments. As part of the internship program, the non-profit
organization makes an interest payment on behalf of Student C after the
deferment period. This payment is not excluded from Student C's income
under section 108(f) and is treated as additional compensation
includible in Student C's gross income. Assuming fulfillment of all
other requirements of section 221, Student C may deduct this payment of
interest for Federal income tax purposes.
Example 2. Payment by parent. Student D obtains a qualified
education loan to attend college. Upon graduation from college, Student
D makes legally required monthly payments of principal and interest.
Student D's mother makes a required monthly payment of interest as a
gift to Student D. A deduction for Student D as a dependent is not
allowed on another taxpayer's tax return for that taxable year. Assuming
fulfillment of all other requirements of section 221, Student D may
deduct this payment of interest for Federal income tax purposes.
(c) Maximum deduction. In any taxable year beginning before January
1, 2002, the amount allowed as a deduction under section 221 may not
exceed the amount determined in accordance with the following table:
------------------------------------------------------------------------
Maximum
Taxable year beginning in deduction
------------------------------------------------------------------------
1998....................................................... $1,000
1999....................................................... 1,500
2000....................................................... 2,000
2001....................................................... 2,500
------------------------------------------------------------------------
(d) Limitation based on modified adjusted gross income--(1) In
general. The deduction allowed under section 221 is phased out ratably
for taxpayers with modified adjusted gross income between $40,000 and
$55,000 ($60,000 and $75,000 for married individuals who file a joint
return). Section 221 does not allow a deduction for taxpayers with
modified adjusted gross income of $55,000 or above ($75,000 or above for
married individuals who file a joint return).
(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 United States possessions or Puerto
Rico). Modified adjusted gross income must be determined under this
[[Page 467]]
section after taking into account the inclusions, exclusions,
deductions, and limitations provided by sections 86 (social security and
tier 1 railroad retirement benefits), 135 (redemption of qualified
United States savings bonds), 137 (adoption assistance programs), 219
(deductible qualified retirement contributions), and 469 (limitation on
passive activity losses and credits), but before taking into account the
deduction provided by section 221.
(e) 60-month rule--(1) In general. A deduction for interest paid on
a qualified education loan is allowed only for payments made during the
first 60 months that interest payments are required on the loan. The 60-
month period begins on the first day of the month that includes the date
on which interest payments are first required and ends 60 months later,
unless the 60-month period is suspended for periods of deferment or
forbearance within the meaning of paragraph (e)(3) of this section. The
60-month period continues to run regardless of whether the required
interest payments are actually made. The date on which the first
interest payment is required is determined under the terms of the loan
agreement or, in the case of a loan issued or guaranteed under a federal
postsecondary education loan program (such as loan programs under title
IV of the Higher Education Act of 1965 (20 U.S.C. 1070) and titles VII
and VIII of the Public Health Service Act (42 U.S.C. 292., and 42 U.S.C.
296)) under applicable Federal regulations. For a discussion of
interest, see paragraph (h) of this section. For special rules relating
to loan refinancings, consolidated loans, and collapsed loans, see
paragraph (i) of this section.
(2) Loans that entered repayment status prior to January 1, 1998. In
the case of any qualified education loan that entered repayment status
prior to January 1, 1998, section 221 allows no deduction for interest
paid during the portion of the 60-month period described in paragraph
(e)(1) of this section that occurred prior to January 1, 1998. Section
221 allows a deduction only for interest due and paid during that
portion, if any, of the 60-month period remaining after December 31,
1997.
(3) Periods of deferment or forbearance. The 60-month period
described in paragraph (e)(1) of this section generally is suspended for
any period when interest payments are not required on a qualified
education loan because the lender has granted the taxpayer a period of
deferment or forbearance (including postponement in anticipation of
cancellation). However, in the case of a qualified education loan that
is not issued or guaranteed under a Federal postsecondary education loan
program, the 60-month period will be suspended under this paragraph
(e)(3) only if the promissory note contains conditions substantially
similar to the conditions for deferment or forbearance established by
the U.S. Department of Education for Federal student loan programs under
title IV of the Higher Education Act of 1965, such as half-time study at
a postsecondary educational institution, study in an approved graduate
fellowship program or in an approved rehabilitation program for the
disabled, inability to find full-time employment, economic hardship, or
the performance of services in certain occupations or federal programs,
and the borrower satisfies one of those conditions. For any qualified
education loan, the 60-month period is not suspended if under the terms
of the loan interest continues to accrue while the loan is in deferment
or forbearance and either--
(i) In the case of deferment, the taxpayer agrees to pay interest
currently during the deferment period; or
(ii) In the case of forbearance, the taxpayer agrees to make reduced
payments, or payments of interest only, during the forbearance period.
(4) Late payments. A deduction is allowed for a payment of interest
required in one month but actually made in a subsequent month prior to
the expiration of the 60-month period. A deduction is not allowed for a
payment of interest required in one month but actually made in a
subsequent month after the expiration of the 60-month period. A late
payment made during a period of deferment or forbearance is treated,
solely for purposes of determining whether it is made during the 60-
month period, as made on the date it is due.
[[Page 468]]
(5) Examples. The following examples illustrate the rules of this
paragraph (e). In the examples, assume that the institution the student
attends is an eligible educational institution, the loan is a qualified
education loan and is issued or guaranteed under a federal postsecondary
education loan program, the student is legally obligated to make
interest payments under the terms of the loan, the interest payments
occur after December 31, 1997, but before January 1, 2002, and with
respect to any period after December 31, 1997, but before January 21,
1999, the taxpayer elects to apply the rules of this section. The
examples are as follows:
Example 1. Payment prior to 60-month period. Student E obtains a
loan to attend college. The terms of the loan provide that interest
accrues on the loan while Student E earns his undergraduate degree but
that Student E is not required to begin making payments of interest
until six full calendar months after he graduates. Nevertheless, Student
E voluntarily pays interest on the loan while attending college. Student
E is not allowed a deduction for interest paid during that period,
because those payments were made prior to the start of the 60-month
period. Similarly, Student E would not be allowed a deduction for any
interest paid during the six month grace period after graduation when
interest payments are not required.
Example 2. Deferment option not exercised. The facts are the same as
in Example 1 except that Student E makes no payments on the loan while
enrolled in college. Student E graduates in June 1999, and is required
to begin making monthly payments of principal and interest on the loan
in January 2000. The 60-month period described in paragraph (e)(1) of
this section begins in January 2000. In August 2000, Student E enrolls
in graduate school on a full-time basis. Under the terms of the loan,
Student E may apply for deferment of the loan payments while enrolled in
graduate school. However, Student E elects not to apply for deferment
and continues to make required monthly payments on the loan during
graduate school. Assuming fulfillment of all other relevant
requirements, Student E may deduct interest paid on the loan during the
60-month period beginning in January 2000, including interest paid while
enrolled in graduate school.
Example 3. Late payment, within 60-month period. The facts are the
same as in Example 2 except that, after the loan enters repayment status
in January 2000, Student E makes no interest payments until March 2000.
In March 2000, Student E pays interest required for the months of
January, February, and March 2000. Assuming fulfillment of all other
relevant requirements, Student E may deduct the interest paid in March
for the months of January, February, and March because the interest
payments are required under the terms of the loan and are paid within
the 60-month period, even though the January and February interest
payments may be late.
Example 4. Late payment during deferment but within 60-month period.
The terms of Student F's loan require her to begin making monthly
payments of interest on the loan in January 2000. The 60-month period
described in paragraph (e)(1) of this section begins in January 2000.
Student F fails to make the required interest payments for the months of
November and December 2000. In January 2001, Student F enrolls in
graduate school on a half-time basis. Under the terms of the loan,
Student F obtains a deferment of the loan payments due while enrolled in
graduate school. The deferment becomes effective January 1, 2001. In
March 2001, while the loan is in deferment, Student F pays the interest
due for the months of November and December 2000. Assuming fulfillment
of all other relevant requirements, Student F may deduct interest paid
in March 2001, for the months of November and December 2000, because the
late interest payments are treated, solely for purposes of determining
whether they were made during the 60-month period, as made in November
and December 2000.
Example 5. 60-month period. The terms of Student G's loan require
him to begin making monthly payments of interest on the loan in November
1999. The 60-month period described in paragraph (e)(1) of this section
begins in November 1999. In January 2000, Student G enrolls in graduate
school on a half-time basis. As permitted under the terms of the loan,
Student G applies for deferment of the loan payments due while enrolled
in graduate school. While awaiting formal approval from the lender of
his request for deferment, Student G pays interest due for the month of
January 2000. In February 2000, the lender approves Student G's request
for deferment, effective as of January 1, 2000. Assuming fulfillment of
all other relevant requirements, Student G may deduct interest paid in
January 2000, prior to his receipt of the lender's approval, even though
the deferment was retroactive to January 1, 2000. As of February 2000,
there are 57 months remaining in the 60-month period for that loan.
Because Student G is not required to make interest payments during the
period of deferment, the 60-month period is suspended. After January
2000, Student G may not deduct any voluntary payments of interest made
during the period of deferment.
Example 6. 60-month period. The terms of Student H's loan require
her to begin making monthly payments of interest on the
[[Page 469]]
loan in November 1999. The 60-month period described in paragraph (e)(1)
of this section begins in November 1999. In January 2000, Student H
enrolls in graduate school on a half-time basis. As permitted under the
terms of the loan, Student H applies to make reduced payments of
principal and interest while enrolled in graduate school. After the
lender approves her application, Student H pays principal and interest
due for the month of January 2000 at the reduced rate. Assuming
fulfillment of all other relevant requirements, Student H may deduct
interest paid in January 2000. As of February 2000, there are 57 months
remaining in the 60-month period for that loan.
Example 7. Reduction of 60-month period for months prior to January
1, 1998. The first payment of interest on a loan is due in January 1997.
Thereafter, interest payments are required on a monthly basis. The 60-
month period described in paragraph (e)(1) of this section for this loan
begins on January 1, 1997, the first day of the month that includes the
date on which the first interest payment is required. However, the
borrower may not deduct interest paid prior to January 1, 1998, under
the effective date provisions of section 221. Assuming fulfillment of
all other relevant requirements, the borrower may deduct interest due
and paid on the loan during the 48 months beginning on January 1, 1998
(unless such period is extended for periods of deferment or forbearance
under paragraph (e)(3) of this section).
(f) Definitions--(1) Eligible educational institution. In general,
an eligible educational institution means any college, university,
vocational school, or other post-secondary educational institution
described in section 481 of the Higher Education Act of 1965, 20 U.S.C.
1088, as in effect on August 5, 1997, and certified by the U.S.
Department of Education as eligible to participate in student aid
programs administered by the Department, as described in section
25A(f)(2) and Sec. 1.25A-2(b). For purposes of this section, an
eligible educational institution also includes an institution that
conducts an internship or residency program leading to a degree or
certificate awarded by an institution, a hospital, or a health care
facility that offers postgraduate training.
(2) Qualified higher education expenses--(i) In general. Qualified
higher education expenses means the cost of attendance (as defined in
section 472 of the Higher Education Act of 1965, 20 U.S.C. 1087ll, as in
effect on August 4, 1997), at an eligible educational institution,
reduced by the amounts described in paragraph (f)(2)(ii) of this
section. Consistent with section 472 of the Higher Education Act of
1965, a student's cost of attendance is determined by the eligible
educational institution and includes tuition and fees normally assessed
a student carrying the same academic workload as the student, an
allowance for room and board, and an allowance for books, supplies,
transportation, and miscellaneous expenses of the student.
(ii) Reductions. Qualified higher education expenses are reduced by
any amount that is paid to or on behalf of a student with respect to
such expenses and that is--
(A) A qualified scholarship that is excludable from income under
section 117;
(B) An educational assistance allowance for a veteran or member of
the armed forces under chapter 30, 31, 32, 34 or 35 of title 38, United
States Code, or under chapter 1606 of title 10, United States Code;
(C) Employer-provided educational assistance that is excludable from
income under section 127;
(D) Any other amount that is described in section 25A(g)(2)(C)
(relating to amounts excludable from gross income as educational
assistance);
(E) Any otherwise includible amount excluded from gross income under
section 135 (relating to the redemption of United States savings bonds);
or
(F) Any otherwise includible amount distributed from a Coverdell
education savings account and excluded from gross income under section
530(d)(2).
(3) Qualified education loan--(i) In general. A qualified education
loan means indebtedness incurred by a taxpayer solely to pay qualified
higher education expenses that are--
(A) Incurred on behalf of a student who is the taxpayer, the
taxpayer's spouse, or a dependent (as defined in section 152) of the
taxpayer at the time the taxpayer incurs the indebtedness;
(B) Attributable to education provided during an academic period, as
described in section 25A and the regulations thereunder, when the
student is an eligible student as defined in section 25A(b)(3)
(requiring that the student be a degree candidate carrying at
[[Page 470]]
least half the normal full-time workload); and
(C) Paid or incurred within a reasonable period of time before or
after the taxpayer incurs the indebtedness.
(ii) Reasonable period. Except as otherwise provided in this
paragraph (f)(3)(ii), what constitutes a reasonable period of time for
purposes of paragraph (f)(3)(i)(C) of this section generally is
determined based on all the relevant facts and circumstances. However,
qualified higher education expenses are treated as paid or incurred
within a reasonable period of time before or after the taxpayer incurs
the indebtedness if--
(A) The expenses are paid with the proceeds of education loans that
are part of a federal postsecondary education loan program; or
(B) The expenses relate to a particular academic period and the loan
proceeds used to pay the expenses are disbursed within a period that
begins 90 days prior to the start of that academic period and ends 90
days after the end of that academic period.
(iii) Related party. A qualified education loan does not include any
indebtedness owed to a person who is related to the taxpayer, within the
meaning of section 267(b) or 707(b)(1). For example, a parent or
grandparent of the taxpayer is a related person. In addition, a
qualified education loan does not include a loan made under any
qualified employer plan as defined in section 72(p)(4) or under any
contract referred to in section 72(p)(5).
(iv) Federal issuance or guarantee not required. A loan does not
have to be issued or guaranteed under a federal postsecondary education
loan program to be a qualified education loan.
(v) Refinanced and consolidated indebtedness--(A) In general. A
qualified education loan includes indebtedness incurred solely to
refinance a qualified education loan. A qualified education loan
includes a single, consolidated indebtedness incurred solely to
refinance two or more qualified education loans of a borrower.
(B) Treatment of refinanced and consolidated indebtedness.
[Reserved]
(4) Examples. The following examples illustrate the rules of this
paragraph (f):
Example 1. Eligible educational institution. University J is a
postsecondary educational institution described in section 481 of the
Higher Education Act of 1965. The U.S. Department of Education has
certified that University J is eligible to participate in federal
financial aid programs administered by that Department, although
University J chooses not to participate. University J is an eligible
educational institution.
Example 2. Qualified higher education expenses. Student K receives a
$3,000 qualified scholarship for the 1999 fall semester that is
excludable from Student K's gross income under section 117. Student K
receives no other forms of financial assistance with respect to the 1999
fall semester. Student K's cost of attendance for the 1999 fall
semester, as determined by Student K's eligible educational institution
for purposes of calculating a student's financial need in accordance
with section 472 of the Higher Education Act, is $16,000. For the 1999
fall semester, Student K has qualified higher education expenses of
$13,000 (the cost of attendance as determined by the institution
($16,000) reduced by the qualified scholarship proceeds excludable from
gross income ($3,000)).
Example 3. Qualified education loan. Student L borrows money from a
commercial bank to pay qualified higher education expenses related to
his enrollment on a half-time basis in a graduate program at an eligible
educational institution. Student L uses all the loan proceeds to pay
qualified higher education expenses incurred within a reasonable period
of time after incurring the indebtedness. The loan is not federally
guaranteed. The commercial bank is not related to Student L within the
meaning of section 267(b) or 707(b)(1). Student L's loan is a qualified
education loan within the meaning of section 221.
Example 4. Qualified education loan. Student M signs a promissory
note for a loan on August 15, 1999, to pay for qualified higher
education expenses for the 1999 fall and 2000 spring semesters. On
August 20, 1999, the lender disburses loan proceeds to Student M's
college. The college credits them to Student M's account to pay
qualified higher education expenses for the 1999 fall semester, which
begins on August 23, 1999. On January 25, 2000, the lender disburses
additional loan proceeds to Student M's college. The college credits
them to Student M's account to pay qualified higher education expenses
for the 2000 spring semester, which began on January 10, 2000. Student
M's qualified higher education expenses for the two semesters are paid
within a reasonable period of time, as the first loan disbursement
occurred within the 90 days prior to the start of the fall 1999
semester, and the second loan disbursement occurred during the spring
2000 semester.
Example 5. Qualified education loan. The facts are the same as in
Example 4, except
[[Page 471]]
that in 2001 the college is not an eligible educational institution
because it loses its eligibility to participate in certain federal
financial aid programs administered by the U.S. Department of Education.
The qualification of Student M's loan, which was used to pay for
qualified higher education expenses for the 1999 fall and 2000 spring
semesters, as a qualified education loan is not affected by the
college's subsequent loss of eligibility.
Example 6. Mixed-use loans. Student N signs a promissory note for a
loan that is secured by Student N's personal residence. Student N will
use part of the loan proceeds to pay for certain improvements to Student
N's residence and part of the loan proceeds to pay qualified higher
education expenses of Student N's spouse. Because Student N obtains the
loan not solely to pay qualified higher education expenses, the loan is
not a qualified education loan.
(g) Denial of double benefit. No deduction is allowed under this
section for any amount for which a deduction is allowable under another
provision of Chapter 1 of the Internal Revenue Code. No deduction is
allowed under this section for any amount for which an exclusion is
allowable under section 108(f) (relating to cancellation of
indebtedness).
(h) Interest--(1) In general. Amounts paid on a qualified education
loan are deductible under section 221 if the amounts are interest for
Federal income tax purposes. For example, interest includes--
(i) Qualified stated interest (as defined in Sec. 1.1273-1(c)); and
(ii) Original issue discount, which generally includes capitalized
interest. For purposes of section 221, capitalized interest means any
accrued and unpaid interest on a qualified education loan that, in
accordance with the terms of the loan, is added by the lender to the
outstanding principal balance of the loan.
(2) Operative rules for original issue discount--(i) In general. The
rules to determine the amount of original issue discount on a loan and
the accruals of the discount are in sections 163(e), 1271 through 1275,
and the regulations thereunder. In general, original issue discount is
the excess of a loan's stated redemption price at maturity (all payments
due under the loan other than qualified stated interest payments) over
its issue price (the amount loaned). Although original issue discount
generally is deductible as it accrues under section 163(e) and Sec.
1.163-7, original issue discount on a qualified education loan is not
deductible until paid. See paragraph (h)(3) of this section to determine
when original issue discount is paid.
(ii) Treatment of loan origination fees by the borrower. If a loan
origination fee is paid by the borrower other than for property or
services provided by the lender, the fee reduces the issue price of the
loan, which creates original issue discount (or additional original
issue discount) on the loan in an amount equal to the fee. See Sec.
1.1273-2(g). For an example of how a loan origination fee is taken into
account, see Example 2 of paragraph (h)(4) of this section.
(3) Allocation of payments. See Sec. Sec. 1.446-2(e) and 1.1275-
2(a) for rules on allocating payments between interest and principal. In
general, these rules treat a payment first as a payment of interest to
the extent of the interest that has accrued and remains unpaid as of the
date the payment is due, and second as a payment of principal. The
characterization of a payment as either interest or principal under
these rules applies regardless of how the parties label the payment
(either as interest or principal). Accordingly, the taxpayer may deduct
the portion of a payment labeled as principal that these rules treat as
a payment of interest on the loan, including any portion attributable to
capitalized interest or loan origination fees.
(4) Examples. The following examples illustrate the rules of this
paragraph (h). In the examples, assume that the institution the student
attends is an eligible educational institution, the loan is a qualified
education loan, the student is legally obligated to make interest
payments under the terms of the loan, and any other applicable
requirements, if not otherwise specified, are fulfilled. The examples
are as follows:
Example 1. Capitalized interest. Interest on Student O's qualified
education loan accrues while Student O is in school, but Student O is
not required to make any payments on the loan until six months after he
graduates or otherwise leaves school. At that time, the
[[Page 472]]
lender capitalizes all accrued but unpaid interest and adds it to the
outstanding principal amount of the loan. Thereafter, Student O is
required to make monthly payments of interest and principal on the loan.
The interest payable on the loan, including the capitalized interest, is
original issue discount. Therefore, in determining the total amount of
interest paid on the qualified education loan during the 60-month period
described in paragraph (e)(1) of this section, Student O may deduct any
payments that Sec. 1.1275-2(a) treats as payments of interest,
including any principal payments that are treated as payments of
capitalized interest. See paragraph (h)(3) of this section.
Example 2. Allocation of payments. The facts are the same as in
Example 1 of this paragraph (h)(4), except that, in addition, the lender
charges Student O a loan origination fee, which is not for any property
or services provided by the lender. Under Sec. 1.1273-2(g), the loan
origination fee reduces the issue price of the loan, which reduction
increases the amount of original issue discount on the loan by the
amount of the fee. The amount of original issue discount (which includes
the capitalized interest and loan origination fee) that accrues each
year is determined under section Sec. 1272 and Sec. 1.1272-1. In
effect, the loan origination fee accrues over the entire term of the
loan. Because the loan has original issue discount, the payment ordering
rules in Sec. 1.1275-2(a) must be used to determine how much of each
payment is interest for federal tax purposes. See paragraph (h)(3) of
this section. Under Sec. 1.1275-2(a), each payment (regardless of its
designation by the parties as either interest or principal) generally is
treated first as a payment of original issue discount, to the extent of
the original issue discount that has accrued as of the date the payment
is due and has not been allocated to prior payments, and second as a
payment of principal. Therefore, in determining the total amount of
interest paid on the qualified education loan during the 60-month period
described in paragraph (e)(1) of this section, Student O may deduct any
payments that the parties label as principal but that are treated as
payments of original issue discount under Sec. 1.1275-2(a). The 60-
month period does not begin in the month in which the lender charges
Student O the loan origination fee.
(i) Special rules regarding 60-month limitation--(1) Refinancing. A
qualified education loan and all indebtedness incurred solely to
refinance that loan constitute a single loan for purposes of calculating
the 60-month period described in paragraph (e)(1) of this section.
(2) Consolidated loans. A consolidated loan is a single loan that
refinances more than one qualified education loan of a borrower. For
consolidated loans, the 60-month period described in paragraph (e)(1) of
this section begins on the latest date on which any of the underlying
loans entered repayment status and includes any subsequent month in
which the consolidated loan is in repayment status.
(3) Collapsed loans. A collapsed loan is two or more qualified
education loans of a single taxpayer that constitute a single qualified
education loan for loan servicing purposes and for which the lender or
servicer does not separately account. For a collapsed loan, the 60-month
period described in paragraph (e)(1) of this section begins on the
latest date on which any of the underlying loans entered repayment
status and includes any subsequent month in which any of the underlying
loans is in repayment status.
(4) Examples. The following examples illustrate the rules of this
paragraph (i):
Example 1. Refinancing. Student P obtains a qualified education loan
to pay for an undergraduate degree at an eligible educational
institution. After graduation, Student P is required to make monthly
interest payments on the loan beginning in January 2000. Student P makes
the required interest payments for 15 months. In April 2001, Student P
borrows money from another lender exclusively to repay the first
qualified education loan. The new loan requires interest payments to
start immediately. At the time Student P must begin interest payments on
the new loan, which is a qualified education loan, there are 45 months
remaining of the original 60-month period referred to in paragraph
(e)(1) of this section.
Example 2. Collapsed loans. To finance his education, Student Q
obtains four separate qualified education loans from Lender R. The loans
enter repayment status, and their respective 60-month periods described
in paragraph (e)(1) of this section begin, in July, August, September,
and December of 1999. After all of Student Q's loans have entered
repayment status, Lender R informs Student Q that Lender R will transfer
all four loans to Lender S. Following the transfer, Lender S treats the
loans as a single loan for loan servicing purposes. Lender S sends
Student Q a single statement that shows the total principal and
interest, and does not keep separate records with respect to each loan.
With respect to the single collapsed loan, the 60-month period described
in paragraph (e)(1) of this section begins in December 1999.
[[Page 473]]
(j) Effective date. This section is applicable to interest due and
paid on qualified education loans after January 21, 1999, if paid before
January 1, 2002. Taxpayers also may apply this section to interest due
and paid on qualified education loans after December 31, 1997, but
before January 21, 1999. This section also applies to interest due and
paid on qualified education loans in a taxable year beginning after
December 31, 2010.
[T.D. 9125, 69 FR 25492, May 7, 2004]
Special Deductions for Corporations
Sec. 1.241-1 Allowance of special deductions.
A corporation, in computing its taxable income, is allowed as
deductions the items specified in Part VIII (section 242 and following),
Subchapter B, Chapter 1 of the Code, in addition to the deductions
provided in part VI (section 161 and following) Subchapter B, Chapter 1
of the Code.
Sec. 1.242-1 Deduction for partially tax-exempt interest.
A corporation is allowed a deduction under section 242(a) in an
amount equal to certain interest received on obligations of the United
States, or an obligation of corporations organized under Acts of
Congress which are instrumentalities of the United States. The interest
for which a deduction shall be allowed is interest which is included in
gross income and which is exempt from normal tax under the act, as
amended and supplemented, which authorized the issuance of the
obligations. The deduction allowed by section 242(a) is allowed only for
the purpose of computing normal tax, and therefore, no deduction is
allowed for such interest in the computation of any surtax imposed by
Subtitle A of the Internal Revenue Code of 1954.
[T.D. 7100, 36 FR 5333, Mar. 20, 1971]
Sec. 1.243-1 Deduction for dividends received by corporations.
(a)(1) A corporation is allowed a deduction under section 243 for
dividends received from a domestic corporation which is subject to
taxation under Chapter 1 of the Internal Revenue Code of 1954.
(2) Except as provided in section 243(c) and in section 246, the
deduction is:
(i) For the taxable year, an amount equal to 85 percent of the
dividends received from such domestic corporations during the taxable
year (other than dividends to which subdivision (ii) or (iii) of this
subparagraph applies).
(ii) For a taxable year beginning after September 2, 1958, an amount
equal to 100 percent of the dividends received from such domestic
corporations if at the time of receipt of such dividends the recipient
corporation is a Federal licensee under the Small Business Investment
Act of 1958 (15 U.S.C. ch. 14B). However, to claim the deduction
provided by section 243(a)(2) the company must file with its return a
statement that it was a Federal licensee under the Small Business
Investment Act of 1958 at the time of the receipt of the dividends.
(iii) For a taxable year ending after December 31, 1963, an amount
equal to 100 percent of the dividends received which are qualifying
dividends, as defined in section 243(b) and Sec. 1.243-4.
(3) To determine the amount of the distribution to a recipient
corporation and the amount of the dividend, see Sec. Sec. 1.301-1 and
1.316-1.
(b) For limitation on the dividends received deduction, see section
246 and the regulations thereunder.
[T.D. 6992, 34 FR 817, Jan. 18, 1969]
Sec. 1.243-2 Special rules for certain distributions.
(a) Dividends paid by mutual savings banks, etc. In determining the
deduction provided in section 243(a), any amount allowed as a deduction
under section 591 (relating to deduction for dividends paid by mutual
savings banks, cooperative banks, and domestic building and loan
associations) shall not be considered as a dividend.
(b) Dividends received from regulated investment companies. In
determining the deduction provided in section 243(a), dividends received
from a regulated investment company shall be subject to the limitations
provided in section 854.
(c) Dividends received from real estate investment trusts. See
section 857(c) and paragraph (d) of Sec. 1.857-6 for special
[[Page 474]]
rules which deny a deduction under section 243 in the case of dividends
received from a real estate investment trust with respect to a taxable
year for which such trust is taxable under Part II, Subchapter M,
Chapter 1 of the Code.
(d) Dividends received on preferred stock of a public utility. The
deduction allowed by section 243(a) shall be determined without regard
to any dividends described in section 244 (relating to dividends on the
preferred stock of a public utility). That is, such deduction shall be
determined without regard to any dividends received on the preferred
stock of a public utility which is subject to taxation under Chapter 1
of the Code and with respect to which a deduction is allowed by section
247 (relating to dividends paid on certain preferred stock of public
utilities). For a deduction with respect to such dividends received on
the preferred stock of a public utility, see section 244. If a deduction
for dividends paid is not allowable to the distributing corporation
under section 247 with respect to the dividends on its preferred stock,
such dividends received from a domestic public utility corporation
subject to taxation under Chapter 1 of the Code are includible in
determining the deduction allowed by section 243(a).
[T.D. 6598, 27 FR 4092, Apr. 28, 1962, as amended by T.D. 6992, 34 FR
817, Jan. 18, 1969; T.D. 7767, 46 FR 11264, Feb. 6, 1981]
Sec. 1.243-3 Certain dividends from foreign corporations.
(a) In general. (1) In determining the deduction provided in section
243(a), section 243(d) provides that a dividend received from a foreign
corporation after December 31, 1959, shall be treated as a dividend from
a domestic corporation which is subject to taxation under chapter 1 of
the Code, but only to the extent that such dividend is out of earnings
and profits accumulated by a domestic corporation during a period with
respect to which such domestic corporation was subject to taxation under
Chapter 1 of the Code (or corresponding provisions of prior law). Thus,
for example, if a domestic corporation accumulates earnings and profits
during a period or periods with respect to which it is subject to
taxation under Chapter 1 of the Code (or corresponding provisions of
prior law) and subsequently such domestic corporation reincorporates in
a foreign country, any dividends paid out of such earnings and profits
after such reincorporation are eligible for the deduction provided in
section 243(a) (1) and (2).
(2) Section 243(d) and this section do not apply to dividends paid
out of earnings and profits accumulated (i) by a corporation organized
under the China Trade Act, 1922, (ii) by a domestic corporation during
any period with respect to which such corporation was exempt from
taxation under section 501 (relating to certain charitable, etc.
organizations) or 521 (relating to farmers' cooperative associations),
or (iii) by a domestic corporation during any period to which section
931 (relating to income from sources within possessions of the United
States), as in effect for taxable years beginning before January 1,
1976, applied.
(b) Establishing separate earnings and profits accounts. A foreign
corporation shall, for purposes of section 243(d), maintain a separate
account for earnings and profits to which it succeeds which were
accumulated by a domestic corporation, and such foreign corporation
shall treat such earnings and profits as having been accumulated during
the accounting periods in which earned by such domestic corporation.
Such foreign corporation shall also maintain such a separate account for
the earnings and profits, or deficit in earnings and profits,
accumulated by it or accumulated by any other corporations to the
earnings and profits of which it succeeds.
(c) Effect of dividends on earnings and profits accounts. Dividends
paid out of the accumulated earnings and profits (see section 316(a)(1)
of such foreign corporation shall be treated as having been paid out of
the most recently accumulated earnings and profits of such corporation.
A deficit in an earnings and profits account for any accounting period
shall reduce the most recently accumulated earnings and profits for a
prior accounting period in such account. If there are no accumulated
earnings and profits in an earnings and profits account because of a
deficit incurred in a prior accounting period,
[[Page 475]]
such deficit must be restored before earnings and profits can be
accumulated in a subsequent accounting period. If a dividend is paid out
of earnings and profits of a foreign corporation which maintains two or
more accounts (established under the provisions of paragraph (b) of this
section) with respect to two or more accounting periods ending on the
same day, then the portion of such dividend considered as paid out of
each account shall be the same proportion of the total dividend as the
amount of earnings and profits in that account bears to the sum of the
earnings and profits in all such accounts.
(d) Illustration. The application of the principles of this section
in the determination of the amount of the dividends received deduction
may be illustrated by the following example:
Example. On December 31, 1960, corporation X, a calendar-year
corporation organized in the United States on January 1, 1958,
consolidated with corporation Y, a foreign corporation organized on
January 1, 1958, which used an annual accounting period based on the
calendar year, to form corporation Z, a foreign corporation not engaged
in trade or business within the United States. Corporation Z is a
wholly-owned subsidiary of corporation M, a domestic corporation. On
January 1, 1961, corporation Z's accumulated earnings and profits of
$31,000 are, under the provisions of paragraph (b) of this section,
maintained in separate earnings and profits accounts containing the
following amounts:
------------------------------------------------------------------------
Domestic Foreign
Earnings and profits accumulated for-- corp. X corp. Y
------------------------------------------------------------------------
1958.............................................. ($1,000) $11,000
1959.............................................. 10,000 9,000
1960.............................................. 5,000 (3,000)
------------------------------------------------------------------------
Corporation Z had earnings and profits of $10,000 in each of the
years 1961, 1962, and 1963 and makes distributions with respect to its
stock to corporation M for such years in the following amounts:
1961......................................................... $14,000
1962......................................................... 23,000
1963......................................................... 16,000
(1) For 1961, a deduction of $3,400 is allowable to M with respect
to the $14,000 distribution from Z, computed as follows:
(i) Dividend from current year earnings and profits (1961)... $10,000
(ii) Dividend from earnings and profits of corporation X 4,000
accumulated for 1960........................................
(iii) Deduction: 85 percent of $4,000 (the amount distributed 3,400
from the accumulated earnings and profits of corporation X).
(2) For 1962, a deduction of $6,970 is allowable to corporation M
with respect to the $23,000 distribution from corporation Z, computed as
follows:
(i) Dividend from current year earnings and profits (1962).. $10,000
(ii) Dividend from earnings and profits of
corporation X accumulated for:
1960........................................ $1,000
1959: $9,000 (i.e., $10,000 - $1,000) divided by $15,000 7,200
(i.e., $9,000 + $9,000-$3,000) multiplied by $12,000
(i.e., $23,000-$11,000)................................
------------
Total..................................... 8,200
(iii) Dividend from earnings and profits of
corporation Y accumulated for:
1959: $6,000/$15,000 x $12,000.......................... 4,800
(iv) Deduction: 85 percent of $8,200 (the amount .......... 6,970
distributed from the accumulated earnings and
profits of corporation X)......................
(3) For 1963, a deduction of $1,530 is allowable to M with respect
to the $16,000 distribution from Z, computed as follows:
(i) Dividend from current year earnings and profits (1963)... $10,000
(ii) Dividend from earnings and profits of corporation X
accumulated for 1959:
Earnings and profits remaining after 1962 distribution 1,800
(i.e., $9,000-$7,200).....................................
(iii) Dividend from earnings and profits of corporation Y
accumulated for 1959:
Earnings and profits remaining after 1962 distribution 1,200
(i.e., $6,000-$4,800).....................................
1958....................................................... 8,000
(iv) Deduction: 85 percent of $1,800 (the amount distributed 1,530
from the accumulated earnings and profits of corporation X).
[T.D. 6830, 30 FR 8045, June 23, 1965, as amended by T.D. 9194, 70 FR
18928, Apr. 11, 2005]
Sec. 1.243-4 Qualifying dividends.
(a) Definition of qualifying dividends--(1) General. For purposes of
section 243(a)(3), the term qualifying dividends means dividends
received by a corporation if:
(i) At the close of the day the dividends are received, such
corporation is a member of the same affiliated group of corporations (as
defined in paragraph (b) of this section) as the corporation
distributing the dividends,
(ii) An election by such affiilated group under section 243(b)(2)
and paragraph (c) of this section is effective for the taxable years of
its members which include such day, and
(iii) The dividends are distributed out of earnings and profits
specified in subparagraph (2) of this paragraph.
[[Page 476]]
(2) Earnings and profits. The earnings and profits specified in this
subparagraph are earnings and profits of a taxable year of the
distributing corporation (or a predecessor corporation) which satisfies
each of the following conditions:
(i) Such year must end after December 31, 1963;
(ii) On each day of such year the distributing corporation (or the
predecessor corporation) and the corporation receiving the dividends
must have been members of the affiliated group of which the distributing
corporation and the corporation receiving the dividends are members on
the day the dividends are received; and
(iii) An election under section 1562 (relating to the election of
multiple surtax exmptions) was never effective (or is no longer
effective pursuant to section 1562(c)) for such year.
(3) Special rule for insurance companies. Notwithstanding the
provisions of subparagraph (2) of this paragraph, if an insurance
company subject to taxation under section 802 or 821 distributes a
dividend out of earnings and profits of a taxable year with respect to
which the company would have been a component member of a controlled
group of corporations within the meaning of section 1563 were it not for
the application of section 1563(b)(2)(D), such dividend shall not be
treated as a qualifying dividend unless an election under section
243(b)(2) is effective for such taxable year.
(4) Predecessor corporations. For purposes of this paragraph, a
corporation shall be considered to be a predecessor corporation with
respect to a distributing corporation if the distributing corporation
succeeds to the earnings and profits of such corporation, for example,
as the result of a transaction to which section 381(a) applies. A
distributing corporation shall, for purposes of this section, maintain,
in respect of each predecessor corporation, a separate account for
earnings and profits to which it succeeds, and such earnings and profits
shall be considered to be earnings and profits of the predecessor's
taxable year in which the earnings and profits were accumulated.
(5) Mere change in form. (i) For purposes of subparagraph (2)(ii) of
this paragraph, the affiliated group in existence during the taxable
year out of the earnings and profits of which the dividend is
distributed shall not be considered as a different group from that in
existence on the day on which the dividend is received merely because:
(a) The common parent corporation has undergone a mere change in
identity, form, or place of organization (within the meaning of section
368(a)(1)(F)), or
(b) A newly organized corporation (the ``acquiring corporation'')
has acquired substantially all of the outstanding stock of the common
parent corporation (the ``acquired corporation'') solely in exchange for
stock of such acquiring corporation, and the stockholders (immediately
before the acquisition) of the acquired corporation, as a result of
owning stock of the acquired corporation, own (immediately after the
acquisition) all of the outstanding stock of the acquiring corporation.
If a transaction described in the preceding sentence has occurred, the
acquiring corporation shall be treated as having been a member of the
affiliated group for the entire period during which the acquired
corporation was a member of such group.
(ii) For purposes of subdivision (i) (b) of this subparagraph, if
immediately before the acquisition:
(a) The stockholders of the acquired corporation also owned all of
the outstanding stock of another corporation (the ``second
corporation''), and
(b) Stock of the acquired corporation and of the second corporation
could be acquired or transferred only as a unit (hereinafter referred to
as the ``limitation on transferability''), then the second corporation
shall be treated as an acquired corporation and such second corporation
shall be treated as having been a member of the affiliated group for the
entire period (while such group was in existence) during which the
limitation on transferability was in existence, and if the second
corporation is itself the common parent corporation of an affiliated
group (the ``second group'') any other member of the second group shall
be treated as having been a member of the affiliated group for the
entire period during which it
[[Page 477]]
was a member of the second group while the limitation on transferability
existed. For purposes of (a) of this subdivision and subdivision (i)(b)
of this subparagraph, if the limitation on transferability of stock of
the acquired corporation and the second corporation is achieved by using
a voting trust, then the stock owned by the trust shall be considered as
owned by the holders of the beneficial interests in the trust.
(6) Source of distributions. In determining from what year's
earnings and profits a dividend is treated as having been distributed
for purposes of this section, the principles of paragraph (a) of Sec.
1.316-2 shall apply. A dividend shall be considered to be distributed,
first, out of the earnings and profits of the taxable year which
includes the date the dividend is distributed, second, out of the
earnings and profits accumulated for the immediately preceding taxable
year, third, out of the earnings and profits accumulated for the second
preceding taxable year, etc. A deficit in an earnings and profits
account for any taxable year shall reduce the most recently accumulated
earnings and profits for a prior year in such account. If there are no
accumulated earnings and profits in an earnings and profits account
because of a deficit incurred in a prior year, such deficit must be
restored before earnings and profits can be accumulated in a subsequent
year. If a dividend is distributed out of separate earnings and profits
accounts (established under the provisions of subparagraph (4) of this
paragraph) for two or more taxable years ending on the same day, then
the portion of such dividend considered as distributed out of each
account shall be the same proportion of the total dividend as the amount
of earnings and profits in that account bears to the sum of the earnings
and profits in all such accounts.
(7) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. On March 1, 1965, corporation P, a publicly owned
corporation, acquires all of the stock of corporation S and continues to
hold the stock throughout the remainder of 1965 and all of 1966. P and S
are domestic corporations which file separate returns on the basis of a
calendar year. The affiliated group consisting of P and S makes an
election under section 243(b)(2) which is effective for the 1966 taxable
years of P and S. A multiple surtax exemption election under section
1562 is not effective for their 1965 taxable years. On February 1, 1966,
S distributes $50,000 with respect to its stock which is received by P
on the same date. S had earnings and profits of $40,000 for 1966
(computed without regard to distributions during 1966). S also had
earnings and profits accumulated for 1965 of $70,000. Since $40,000 was
distributed out of earnings and profits for 1966 and since each of the
conditions prescribed in subparagraphs (1) and (2) of this paragraph is
satisfied, P is entitled to a 100-percent dividends received deduction
with respect to $40,000 of the $50,000 distribution. However, since
$10,000 was distributed out of earnings and profits accumulated for
1965, and since on each day of 1965 S and P were not members of the
affiliated group of which S and P were members on February 1, 1966,
$10,000 of the $50,000 distribution does not satisfy the condition
specified in subparagraph (2)(ii) of this paragraph and thus does not
qualify for the 100-percent dividends received deduction.
Example 2. Assume the same facts as in Example 1, except that
corporation P acquires all the stock of corporation S on January 1,
1965, and sells such stock on November 1, 1966. Since $10,000 is
distributed out of earnings and profits for 1965, and since each of the
conditions prescribed in subparagraphs (1) and (2) of this paragraph is
satisfied, P is entitled to a 100-percent dividends received deduction
with respect to $10,000 of the $50,000 distribution. However, since
$40,000 of the $50,000 distribution was made out of earnings and profits
of S for its 1966 taxable year, and on each day of such year S and P
were not members of the affiliated group of which S and P were members
on February 1, 1966, $40,000 of the distribution does not satisfy the
condition specified in subparagraph (2)(ii) of this paragraph and thus
does not qualify for the 100-percent dividends received deduction.
Example 3. Assume the same facts as in Example 1, except that
corporation P acquires all the stock of corporation S on January 1,
1965, and that a multiple surtax exemption election under section 1562
is effective for P's and S's 1965 taxable years. Further assume that the
section 1562 election is terminated effective with respect to their 1966
taxable years, and that an election under section 243(b) (2) is
effective for such taxable years. Since $10,000 of the February 1, 1966,
distribution was made out of earnings and profits of S for its 1965
taxable year and since a multiple surtax exemption election is effective
for such year, $10,000 of the distribution does not satisfy the
condition specified in subparagraph (2) (iii) of this paragraph and thus
does not qualify for the 100-percent dividends received deduction.
However, the portion of the distribution which was distributed out of
earnings and profits of S's 1966 year ($40,000)
[[Page 478]]
qualifies for the 100-percent dividends received deduction.
Example 4. Assume the same facts as in Example 1, except that
corporation P acquires all the stock of corporation S on January 1,
1965, and that S is a life insurance company subject to taxation under
section 802. Accordingly, S would have been a member of a controlled
group of corporations except for the application of section
1563(b)(2)(D). Since $10,000 of the distribution was made out of
earnings and profits of S for its 1965 taxable year, and since with
respect to such year an election under section 243(b)(2) was not
effective, $10,000 of the distribution is not a qualifying dividend by
reason of subparagraph (3) of this paragraph. On the other hand, the
portion of the distribution which was distributed out of earnings and
profits for S's 1966 year ($40,000) does qualify for the 100-percent
dividends received deduction because the distribution was out of
earnings and profits of a year for which an election under section
243(b) (2) is effective, and because the other conditions specified in
subparagraphs (1) and (2) of this paragraph are satisfied. However, if P
were also a life insurance company subject to taxation under section
802, then subparagraph (3) of this paragraph would not result in the
disqualification of the portion of the distribution made out of S's 1965
earnings and profits because S would be a component member of an
insurance group of corporations (as defined in section 1563(a)(4)),
consisting of P and S, with respect to its 1965 year.
Example 5. Corporation X owns all the stock of corporation Y from
January 1, 1965, through December 31, 1969. X and Y are domestic
corporations which file separate returns on the basis of a calendar
year. On June 30, 1965, Y acquired all the stock of domestic corporation
Z, a calendar year taxpayer, and on December 31, 1967, Y acquired the
assets of Z in a transaction to which section 381(a) applied. A multiple
surtax exemption election under section 1562, was not effective for any
taxable year of X, Y, or Z, and an election under section 243(b)(2) is
effective for the 1968 and 1969 taxable years of X and Y. On January 1,
1968, Y's accumulated earnings and profits are, under the provisions of
subparagraph (4) of this paragraph, maintained in separate earnings and
profits accounts containing the following amounts:
------------------------------------------------------------------------
Corp Corp
Earnings and profits accumulated for ---------------------
Y Z
------------------------------------------------------------------------
1964.............................................. $60,000 $40,000
1965.............................................. 30,000 15,000
1966.............................................. (5,000) 2,000
1967.............................................. 12,000 6,000
------------------------------------------------------------------------
Corporation Y had earnings and profits of $10,000 in each of the
years 1968 and 1969, and made distributions during such years in the
following amounts:
1968....................................................... $29,000
1969....................................................... 31,000
(i) The source of the 1968 distribution, determined in accordance
with the rules of subparagraph (6) of this paragraph, is as follows:
(a) Dividend from Y's current year's earnings and profits $10,000
(1968)......................................................
(b) Dividend from earnings and profits of Y accumulated for 12,000
1967........................................................
(c) Dividend from earnings and profits of Z accumulated for:.
1967..................................................... 6,000
1966..................................................... 1,000
----------
29,000
Since the 1968 dividend is considered paid out of earnings and
profits of Y's 1968 and 1967 years, and Z's 1967 and 1966 years, and
since each of these years satisfies each of the conditions specified in
subparagraph (2) of this paragraph, X is entitled to a 100-percent
dividends received deduction with respect to the entire 1968
distribution of $29,000 from Y.
(ii) The source of the 1969 distribution of $31,000, determined in
accordance with the rules of subparagraph (6) of this paragraph, is as
follows:
(a) Dividend from Y's current year's earnings and profits $10,000
(1969)......................................................
(b) Dividend from earnings and profits of Z accumulated for 1,000
1966 (1966 earnings and profits remaining after 1968
distribution, i.e., $2,000-$1,000...........................
(c) Dividend from earnings and profits of Y and Z accumulated
for 1965:
Corporation Y: $25,000 (i.e., $30,000-$5,000 deficit) 12,500
divided by $40,000 (i.e., the sum of the 1965 earnings
and profits of Y and Z) multiplied by $20,000 (the
portion of the distribution from the 1965 earnings and
profits of Y and Z).....................................
Corporation Z: $15,000 divided by $40,000 multiplied by 7,500
$20,000.................................................
----------
31,000
The sum of the dividends from Y's 1969 year ($10,000), Z's 1966 year
($1,000), and Y's 1965 year ($12,500), or $23,500, qualifies for the
100-percent dividends received deduction. However, the dividends paid
out of Z's 1965 year ($7,500) do not qualify because on each day of 1965
Z and X were not members of the affiliated group of which Y (the
distributing corporation) and X (the corporation receiving the
dividends) were members on the day in 1969 when the dividends were
received by X.
(b) Definition of affiliated group. For purposes of this section and
Sec. 1.243-5, the term affiliated group shall have the meaning assigned
to it by section 1504(a), except that insurance companies subject to
taxation under section 802 or 821 shall be treated as includible
[[Page 479]]
corporations (notwithstanding section 1504(b)(2)), and the provisions of
section 1504(c) shall not apply.
(c) Election--(1) Manner and time of making election--(i) General.
The election provided by section 243(b)(2) shall be made for an
affiliated group by the common parent corporation and shall be made for
a particular taxable year of the common parent corporation. Such
election may not be made for any taxable year of the common parent
corporation for which a multiple surtax exemption election under section
1562 is effective. The election shall be made by means of a statement,
signed by any person who is duly authorized to act on behalf of the
common parent corporation, stating that the affiliated group elects
under section 243(b)(2) for such taxable year. The statement shall be
filed with the district director for the internal revenue district in
which is located the principal place of business or principal office or
agency of the common parent. The statement shall set forth the name,
address, taxpayer account number, and taxable year of each corporation
(including wholly-owned subsidiaries) that is a member of the affiliated
group at the time the election is filed. The statement may be filed at
any time, provided that, with respect to each corporation the tax
liability of which for its matching taxable year of election (or for any
subsequent taxable year) would be increased because of the election, at
the time of filing there is at least 1 year remaining in the statutory
period (including any extensions thereof) for the assessment of a
deficiency against such corporation for such year. (If there is less
than 1 year remaining with respect to any taxable year, the district
director for the internal revenue district in which is located the
principal place of business or principal office or agency of the
corporation will ordinarily, upon request, enter into an agreement to
extend such statutory period for assessment and collection of
deficiencies.
(ii) Information statement by common parent. If a corporation
becomes a member of the affiliated group after the date on which the
election is filed and during its matching taxable year of election, then
the common parent shall file, within 60 days after such corporation
becomes a member of the affiliated group, an additional statement
containing the name, address, taxpayer account number, and taxable year
of such corporation. Such additional statement shall be filed with the
internal revenue officer with whom the election was filed.
(iii) Definition of matching taxable year of election. For purposes
of this paragraph and paragraphs (d) and (e) of this section, the term
matching taxable year of election shall mean the taxable year of each
member (including the common parent corporation) of the electing
affiliated group which includes the last day of the taxable year of the
common parent corporation for which an election by the affiiliated group
is made under section 243(b)(2).
(2) Consents by subsidiary corporations--(i) General. Each
corporation (other than the common parent corporation) which is a member
of the electing affiliated group (including any member which joins in
the filing of a consolidated return) at any time during its matching
taxable year of election must consent to such election in the manner and
time provided in subdivision (ii) or (iii) of this subparagraph,
whichever is applicable.
(ii) Wholly owned subsidiary. If all of the stock of a corporation
is owned by a member or members of the affiliated group on each day of
such corporation's matching taxable year of election, then such
corporation (referred to in this paragraph as a ``wholly owned
subsidiary'') shall be deemed to consent to such election.
(iii) Other members. The consent of each member of the affiliated
group (other than a wholly owned subsidiary) shall be made by means of a
statement, signed by any person who is duly authorized to act on behalf
of the consenting member, stating that such member consents to the
election under section 243(b)(2). The statement shall set forth the
name, address, taxpayer account number, and taxable year of the
consenting member and of the common parent corporation, and in the case
of a statement filed after December 31, 1968, the identity of the
internal revenue district in which is located the principal place of
business or principal office or agency of the common parent
[[Page 480]]
corporation. The consent of more than one such member may be
incorporated in a single statement. The statement (or statements) shall
be attached to the election filed by the common parent corporation. The
consent of a corporation that, after the date the election was filed and
during its matching taxable year of election, either (a) becomes a
member, or (b) ceases to be a wholly owned subsidiary but continues to
be a member, shall be filed with the internal revenue officer with whom
the election was filed and shall be filed on or before the date
prescribed by law (including extensions of time) for the filing of the
consenting member's income tax return for such taxable year, or on or
before June 10, 1964, whichever is later.
(iv) Statement attached to return. Each corporation that consents to
an election by means of a statement described in subdivision (iii) of
this subparagraph should attach a copy of the statement to its income
tax return for its matching taxable year of election, or, if such return
has already been filed, to its first income tax return filed on or after
the date on which the statement is filed. However, if such return is
filed on or before June 10, 1964, a copy of such statement should be
filed on or before June 10, 1964, with the district director with whom
such return is filed. Each wholly owned subsidiary should attach a
statement to its income tax return for its matching taxable year of
election, or, if such return has already been filed, to its first income
tax return filed on or after the date on which the statement is filed
stating that it is subject to an election under section 243(b)(2) and
the taxable year to which the election applies, and setting forth the
name, address, taxpayer account number, and taxable year of the common
parent corporation, and in the case of a statement filed after December
31, 1968, the identity of the internal revenue district in which is
located the principal place of business or principal office or agency of
the common parent corporation. However, if the due date for such return
(including extensions of time) is before June 10, 1964, such statement
should be filed on or before June 10, 1964, with the district director
with whom such return is filed.
(3) Information statement by member. If a corporation becomes a
member of the affiliated group during a taxable year that begins after
the last day of the common parent corporation's matching taxable year of
election, then (unless such election has been terminated) such
corporation should attach a statement to its income tax return for such
taxable year stating that it is subject to an election under section
243(b)(2) for such taxable year and setting forth the name, address,
taxpayer account number, and taxable year of the common parent
corporation, and the identity of the internal revenue district in which
is located the principal place of business or principal office or agency
of the common parent corporation. In the case of an affiliated group
that made an election under the rules provided in Treasury Decision
6721, approved April 8, 1964 (29 FR 4997, C.B. 1964-1 (Part 1), 625),
such statement shall be filed, on or before March 15, 1969, with the
district director for the internal revenue district in which is located
such member's principal place of business or principal office or agency.
(4) Years for which election effective--(i) General rule. An
election under section 243(b)(2) by an affiliated group shall be
effective:
(a) In the case of each corporation which is a member of such group
at any time during its matching taxable year of election, for such
taxable year, and
(b) In the case of each corporation which is a member of such group
at any time during a taxable year ending after the last day of the
common parent's taxable year of election but which does not include such
last day, for such taxable year, unless the election is terminated under
section 243(b)(4) and paragraph (e) of this section. Thus, the election
has a continuing effect and need not be renewed annually.
(ii) Special rule for certain taxable years ending in 1964. In the
case of a taxable year of a member (other than the common parent
corporation) of the affiliated group (a) which begins in 1963 and ends
in 1964, and (b) for which an election is not effective under
subdivision (i)(a) of this subparagraph, if an
[[Page 481]]
election under section 243(b)(2) is effective for the taxable year of
the common parent corporation which includes the last day of such
taxable year of such member, then such election shall be effective for
such taxable year of such member if such member files a separate consent
with respect to such taxable year. However, in order for a dividend
distributed by such member during such taxable year to meet the
requirements of section 243(b)(1), an election under section 243(b)(2)
must be effective for the taxable year of each member of the affiliated
group which includes the date such dividend is received. See section
243(b)(1)(A) and paragraph (a)(1) of this section. Accordingly, if the
dividend is to qualify for the 100-percent dividends received deduction
under section 243(a)(3), a consent must be filed under this subdivision
by each member of the affiliated group with respect to its taxable year
which includes the day the dividend is received (unless an election is
effective for such taxable year under subdivision (i)(a) of this
subparagraph). For purposes of this subdivision, a consent shall be made
by means of a statement meeting the requirements of subparagraph
(2)(iii) of this paragraph, and shall be attached to the election made
by the common parent corporation for its taxable year which includes the
last day of the taxable year of the member with respect to which the
consent is made. A copy of the statement should be filed, within 60 days
after such election is filed by the common parent corporation, with the
district director with whom the consenting member filed its income tax
return for such taxable year.
(iii) Examples. The provisions of subdivision (ii) of this
subparagraph, relating to the special rule for certain taxable years
ending in 1964, may be illustrated by the following examples:
Example 1. P Corporation owns all the stock of S-1 Corporation on
each day of 1963, 1964, and 1965. P uses the calendar year as its
taxable year and S-1 uses a fiscal year ending June 30 as its taxable
year. P makes an election under section 243(b)(2) for 1964. Since S-1 is
a wholly owned subsidiary for its taxable year ending June 30, 1965, it
is deemed to consent to the election. However, in order for the election
to be effective with respect to S-1's taxable year ending June 30, 1964,
a statement specifying that S-1 consents to the election with respect to
such taxable year and containing the information required in a statement
of consent under subparagraph (2)(iii) of this paragraph must be
attached to the election.
Example 2. Assume the same facts as in Example 1, except that P also
owns all the stock of S-2 Corporation on each day of 1963, 1964, and
1965. S-2 uses a fiscal year ending May 31 as its taxable year. If S-1
distributes a dividend to P on January 15, 1964, the dividend may
qualify under section 243(a)(3) only if S-1 and S-2 both consent to the
election made by P for 1964 with respect to their taxable years ending
in 1964.
Example 3. Assume the same facts as in Example 1, except that P uses
a fiscal year ending on January 31 as its taxable year and makes an
election under subparagraph (1) of this paragraph for its taxable year
ending January 31, 1964. Since S-1's taxable year beginning in 1963 and
ending in 1964 includes January 31, 1964, the last day of P's taxable
year for which the election was made, the election is effective under
subdivision (i)(a) of this subparagraph, for S-1's taxable year ending
June 30, 1964. Accordingly, the special rule of subdivision (ii) of this
subparagraph has no application.
(d) Effect of election. For restrictions and limitations applicable
to corporations which are members of an electing affiliated group on
each day of their taxable years, see Sec. 1.243-5.
(e) Termination of election--(1) In general. An election under
section 243(b)(2) by an affiliated group may be terminated with respect
to any taxable year of the common parent corporation after the matching
taxable year of election of the common parent corporation. The election
is terminated as a result of one of the occurrences described in
subparagraph (2) or (3) of this paragraph. For years affected by
termination, see subparagraph (4) of this paragraph.
(2) Consent of members--(i) General. An election may be terminated
for an affiliated group by its common parent corporation with respect to
a taxable year of the common parent corporation provided each
corporation (other than the common parent) that was a member of the
affiliated group at any time during its taxable year that includes the
last day of such year of the common parent (the ``matching taxable year
of termination'') consents to such termination. The statement of
termination may be filed by the common
[[Page 482]]
parent corporation at any time, provided that, with respect to each
corporation the tax liability of which for its matching taxable year of
termination (or for any subsequent taxable year) would be increased
because of the termination, at the time of filing there is at least 1
year remaining in the statutory period (including any extensions
thereof) for the assessment of a deficiency against such corporation for
such year. (If there is less than 1 year remaining with respect to any
taxable year, the district director for the internal revenue district in
which is located the principal place of business or principal office or
agency of the corporation will ordinarily, upon request, enter into
agreement to extend such statutory period for assessment and collection
of deficiencies.)
(ii) Statements filed after December 31, 1968. With respect to
statements of termination filed after December 31, 1968:
(a) The statement shall be filed with the district director for the
internal revenue district in which is located the principal place of
business or principal office or agency of the common parent corporation;
(b) The statement shall be signed by any person who is duly
authorized to act on behalf of the common parent corporation and shall
state that the affiliated group terminates the election under section
243(b)(2) for such taxable year;
(c) The statement shall set forth the name, address, taxpayer
account number, and taxable year of each corporation (including wholly
owned subsidiaries) which is a member of the affiliated group at the
time the termination is filed; and
(d) The consents to the termination shall be given in accordance
with the rules prescribed in paragraph (c)(2) of this section, relating
to manner and time for giving consents to an election under section
243(b)(2).
(3) Refusal by new member to consent--(i) Manner of giving refusal.
If any corporation which is a new member of an affiliated group with
respect to a taxable year of the common parent corporation (other than
the matching taxable year of election of the common parent corporation)
files a statement that it does not consent to an election under section
243(b)(2) with respect to such taxable year, then such election shall
terminate with respect to such taxable year. Such statement shall be
signed by any person who is duly authorized to act on behalf of the new
member, and shall be filed with the timely filed income tax return of
such new member for its taxable year within which falls the last day of
such taxable year of the common parent corporation. In the event of a
termination under this subparagraph, each corporation (other than such
new member) that is a member of the affiliated group at any time during
its taxable year which includes such last day should, within 30 days
after such new member files the statement of refusal to consent, notify
the district director of such termination. Such notification should be
filed with the district director for the internal revenue district in
which is located the principal place of business or principal office or
agency of the corporation.
(ii) Corporation considered as new member. For purposes of
subdivision (i) of this subparagraph, a corporation shall be considered
to be a new member of an affiliated group of corporations with respect
to a taxable year of the common parent corporation if such corporation:
(a) Is a member of the affiliated group at any time during such
taxable year of the common parent corporation, and
(b) Was not a member of the affiliated group at any time during the
common parent corporation's immediately preceding taxable year.
(4) Effect of termination. A termination under subparagraph (2) or
(3) of this paragraph is effective with respect to (i) the common parent
corporation's taxable year referred to in the particular subparagraph
under which the termination occurs, and (ii) the taxable years of the
other members of the affiliated group which include the last day of such
taxable year of the common parent. An election, once terminated, is no
longer effective. Accordingly, the termination is also effective with
respect to the succeeding taxable years of the members of the group.
However, the affiliated group may make a new election in accordance
[[Page 483]]
with the provisions of section 243(b)(2) and paragraph (c) of this
section.
[T.D. 6992, 34 FR 817, Jan. 18, 1969]
Sec. 1.243-5 Effect of election.
(a) General--(1) Corporations subject to restrictions and
limitations. If an election by an affiliated group under section
243(b)(2) is effective with respect to a taxable year of the common
parent corporation, then each corporation (including the common parent
corporation) which is a member of such group on each day of its matching
taxable year shall be subject to the restrictions and limitations
prescribed by paragraphs (b), (c), and (d) of this section for such
taxable year. For purposes of this section, the term matching taxable
year shall mean the taxable year of each member (including the common
parent corporation) of an affiliated group which includes the last day
of a particular taxable year of the common parent corporation for which
an election by the affiliated group under section 243(b)(2) is
effective. If a corporation is a member of an affiliated group on each
day of a short taxable year which does not include the last day of a
taxable year of the common parent corporation, and if an election under
section 243(b)(2) is effective for such short year, see paragraph (g) of
this section. In the case of taxable years beginning in 1963 and ending
in 1964 for which an election under section 243(b)(2) is effective under
paragraph (c)(4)(ii) of Sec. 1.243-4, see paragraph (f)(9) of this
section.
(2) Members filing consolidated returns. The restrictions and
limitations prescribed by this section shall apply notwithstanding the
fact that some of the corporations which are members of the electing
affiliated group (within the meaning of section 243(b)(5)) join in the
filing of a consolidated return. Thus, for example, if an electing
affiliated group includes one or more corporations taxable under section
11 of the Code and two or more insurance companies taxable under section
802 of the Code, and if the insurance companies join in the filing of a
consolidated return, the amount of such companies' exemptions from
estimated tax (for purposes of sections 6016 and 6655) shall be the
amounts determined under paragraph (d)(5) of this section and not the
amounts determined pursuant to the regulations under section 1502.
(b) Multiple surtax exemption election--(1) General rule. If an
election by an affiliated group under section 243(b)(2) is effective
with respect to a taxable year of the common parent corporation, then no
corporation which is a member of such affiliated group on each day of
its matching taxable year may consent (or shall be deemed to consent) to
an election under section 1562(a)(1), relating to election of multiple
surtax exemptions, which would be effective for such matching taxable
year. Thus, each corporation which is a component member of the
controlled group of corporations with respect to its matching taxable
year (determined by applying section 1563(b) without regard to paragraph
(2)(D) thereof) shall determine its surtax exemption for such taxable
year in accordance with section 1561 and the regulations thereunder.
(2) Special rule for certain insurance companies. Under section
243(b)(6)(A), if the provisions of subparagraph (1) of this paragraph
apply with respect to the taxable year of an insurance company subject
to taxation under section 802 or 821, then the surtax exemption of such
insurance company for such taxable year shall be determined by applying
part II (section 1561 and following), subchapter B, chapter 6 of the
Code, with respect to such insurance company and the other corporations
which are component members of the controlled group of corporations (as
determined under section 1563 without regard to subsections (a)(4) and
(b)(2)(D) thereof) of which such insurance company is a member, without
regard to section 1563(a)(4) (relating to certain insurance companies
treated as a separate controlled group) and section 1563(b)(2)(D)
(relating to certain insurance companies treated as excluded members).
(3) Example. The provisions of this paragraph may be illustrated by
the following example:
Example. Throughout 1965 corporation M owns all the stock of
corporations L-1, L-2, S-1, and S-2. M is a domestic mutual insurance
company subject to tax under section 821 of the Code, L-1 and L-2 are
domestic life insurance companies subject to tax under
[[Page 484]]
section 802 of the Code, and S-1 and S-2 are domestic corporations
subject to tax under section 11 of the Code. Each corporation uses the
calendar year as its taxable year. M makes a valid election under
section 243(b)(2) for the affiliated group consisting of M, L-1, L-2, S-
1, and S-2. If part II, subchapter B, chapter 6 of the Code were applied
with respect to the 1965 taxable years of the corporations without
regard to section 243(b)(6)(A), the following would result: S-1 and S-2
would be treated as component members of a controlled group of
corporations on such date; L-1 and L-2 would be treated as component
members of a separate controlled group on such date; and M would be
treated as an excluded member. However, since section 243(b)(6)(A)
requires that part II of subchapter B be applied without regard to
section 1563(a)(4) and (b)(2)(D), for purposes of determining the surtax
exemptions of M, L-1, L-2, S-1, and S-2 for their 1965 taxable years,
such corporations are treated for purposes of such part II as component
members of a single controlled group of corporations on December 31,
1965. Moreover, by reason of having made the election under section
243(b)(2), M, L-1, L-2, S-1, and S-2 cannot consent to multiple surtax
exemption elections under section 1562 which would be effective for
their 1965 taxable years. Thus, such corporations are limited to a
single $25,000 surtax exemption for such taxable years (to be
apportioned among such corporations in accordance with section 1561 and
the regulations thereunder).
(c) Foreign tax credit--(1) General. If an election by an affiliated
group under section 243(b)(2) is effective with respect to a taxable
year of the common parent corporation, then:
(i) The credit under section 901 for taxes paid or accrued to any
foreign country or possession of the United States shall be allowed to a
corporation which is a member of such affiliated group for each day of
its matching taxable year only if each other corporation which pays or
accrues such foreign taxes to any foreign country or possession, and
which is a member of such group on each day of its matching taxable
year, does not deduct such taxes in computing its tax liability for its
matching taxable year, and
(ii) A corporation which is a member of such affiliated group on
each day of its matching taxable year may use the overall limitation
provided in section 904(a)(2) for such matching taxable year only if
each other corporation which pays or accrues foreign taxes to any
foreign country or possession, and which is a member of such group on
each day of its matching taxable year, uses such limitation for its
matching taxable year.
(2) Consent of the Commissioner. In the absence of unusual
circumstances, a request by a corporation for the consent of the
Commissioner to the revocation of an election of the overall limitation,
or to a new election of the overall limitation, for the purpose of
satisfying the requirements of subparagraph (1)(ii) of this paragraph
will be given favorable consideration, notwithstanding the fact that
there has been no change in the basic nature of the corporation's
business or changes in conditions in a foreign country which
substantially affect the corporation's business. See paragraph (d)(3) of
Sec. 1.904-1.
(d) Other restrictions and limitations--(1) General rule. If an
election by an affilated group under section 243(b)(2) is effective with
respect to a taxable year of the common parent corporation, then, except
to the extent that an apportionment plan adopted under paragraph (f) of
this section for such taxable year provides otherwise with respect to a
restriction or limitation described in this paragraph, the rules
provided in subparagraphs (2), (3), (4), and (5) of this paragraph shall
apply to each corporation which is a member of such affiliated group on
each day of its matching taxable year for the purpose of computing the
amount of such restriction or limitation for its matching taxable year.
For purposes of this paragraph, each corporation which is a member of an
electing affiliated group (including any member which joins in filing a
consolidated return) shall be treated as a separate corporation for
purposes of determining the amount of such restrictions and limitations.
(2) Accumulated earnings credit--(i) General. Except as provided in
subdivision (ii) of this subparagraph, in determining the minimum
accumulated earnings credit under section 535(c)(2) (or the accumulated
earnings credit of a mere holding or investment company under section
535(c)(3) for each corporation which is a member of the affiliated group
on each day of its matching taxable year, in lieu of the $150,000 amount
($100,000 amount in the case of taxable years beginning before January
[[Page 485]]
1, 1975) mentioned in such sections there shall be substituted an amount
equal to (a) $150,000 ($100,000 in the case of taxable years beginning
before January 1, 1975), divided by (b) the number of such members.
(ii) Allocation of excess. If, with respect to one or more members,
the amount determined under subdivision (i) of this subparagraph exceeds
the sum of (a) such member's accumulated earnings and profits as of the
close of the preceding taxable year, plus (b) such member's earnings and
profits for the taxable year which are retained (within the meaning of
section 535(c)(1), then any such excess shall be subtracted from the
amount determined under subdivision (i) of this subparagraph and shall
be divided equally among those remaining members of the affiliated group
that do not have such an excess (until no such excess remains to be
divided among those remaining members that have not had such an excess).
The excess so divided among such remaining members shall be added to the
amount determined under subdivision (i) with respect to such members.
(iii) Apportionment plan not allowed. An affiliated group may not
adopt an apportionment plan, as provided in paragraph (f) of this
section, with respect to the amounts computed under the provisions of
this subparagraph.
(iv) Example. The provisions of this subparagraph may be illustrated
by the following example;
Example. An affiliated group is composed of four member
corporations, W, X, Y, and Z. The sum of the accumulated earnings and
profits (as of the close of the preceding taxable year ending December
31, 1975) plus the earnings and profits for the taxable year ending
December 31, 1976 which are retained is $15,000, $75,000, $37,500, and
$300,000 in the case of W, X, Y, and Z, respectively. The amounts
determined under this subparagraph for W, X, Y, and Z are $15,000,
$48,750, $37,500 and $48,750, respectively, computed as follows:
----------------------------------------------------------------------------------------------------------------
Component members
---------------------------------------------------
W X Y Z
----------------------------------------------------------------------------------------------------------------
Earnings and profits........................................ $15,000 $75,000 $37,500 $300,000
Amount computed under subpar. (1)........................... 37,500 37,500 37,500 37,500
Excess...................................................... 22,500 0 0 0
Allocation of excess........................................ ........... 7,500 7,500 7,500
New excess.................................................. ........... ........... 7,500 ...........
Reallocation of new excess.................................. ........... 3,750 ........... 3,750
---------------------------------------------------
Amount to be used for purposes of sec. 535(c) (2) and 15,000 48,750 37,500 48,750
(3)....................................................
----------------------------------------------------------------------------------------------------------------
(3) Mine exploration expenditures--(i) Limitation under section
615(a). If the aggregate of the expenditures to which section 615(a)
applies, which are paid or incurred by corporations which are members of
the affiliated group on each day of their matching taxable years (during
such taxable years) exceeds $100,000, then the deduction (or amount
deferrable) under section 615 for any such member for its matching
taxable year shall be limited to an amount equal to the amount which
bears the same ratio to $100,000 as the amount deductible or deferrable
by such member under section 615 (computed without regard to this
subdivision) bears to the aggregate of the amounts deductible or
deferrable under section 615 (as so computed) by all such members.
(ii) Limitation under section 615(c). If the aggregate of the
expenditures to which section 615(a) applies which are paid or incurred
by the corporations which are members of such affiliated group on each
day of their matching taxable years (during such taxable years) would,
when added to the aggregate of the amounts deducted or deferred in prior
taxable years which are taken into account by such corporations in
applying the limitation of section 615(c), exceed $400,000, then section
615 shall not apply to any such expenditure so paid or incurred by any
such member to the extent such expenditure would exceed the amount which
bears the same ratio to (a) the amount, if any, by which $400,000
exceeds the amounts so deducted or deferred in
[[Page 486]]
prior years, as (b) such member's deduction (or amount deferrable) under
section 615 (computed without regard to this subdivision) for such
expenditures paid or incurred by such member during its matching taxable
year, bears to (c) the aggregate of the amounts deductible or deferrable
under section 615 (as so computed) by all such members during their
matching taxable years.
(iii) Treatment of corporations filing consolidated returns. For
purposes of making the computations under subdivisions (i) and (ii) of
this subparagraph, a corporation which joins in the filing of a
consolidated return shall be treated as if it filed a separate return.
(iv) Estimate of exploration expenditures. If, on the date a
corporation (which is a member of an affiliated group on each day of its
matching taxable year) files its income tax return for such taxable
year, it cannot be determined whether or not the $100,000 limitation
prescribed by subdivision (i) of this subparagraph, or the $400,000
limitation prescribed by subdivision (ii) of this subparagraph, will
apply with respect to such taxable year, then such member shall, for
purposes of such return, apply the provisions of such subdivisions (i)
and (ii) with respect to such taxable year on the basis of an estimate
of the aggregate of the exploration expenditures by all such members of
the affiliated group for their matching taxable years. Such estimate
shall be made on the basis of the facts and circumstances known at the
time of such estimate. If an estimate is used by any such member of the
affiliated group pursuant to this subdivision, and if the actual
expenditures by all such members differ from the estimate, then each
such member shall file as soon as possible an original or amended return
reflecting an amended apportionment (either pursuant to an apportionment
plan adopted under paragraph (f) of this section or pursuant to the
application of the rule provided by subdivision (i) or (ii) of this
subparagraph) based upon such actual expenditures.
(v) Amount apportioned under apportionment plan. If an electing
affiliated group adopts an apportionment plan as provided in paragraph
(f) of this section with respect to the limitation under section 615(a)
or 615(c), then the amount apportioned under such plan to any
corporation which is a member of such group may not exceed the amount
which such member could have deducted (or deferred) under section 615
had such affiliated group not filed an election under section 243(b)(2).
(4) Small business deductions of life insurance companies. In the
case of a life insurance company taxable under section 802 which is a
member of such affiliated group on each day of its matching taxable
year, the small business deduction under sections 804(a)(4) and
809(d)(10) shall not exceed an amount equal to $25,000 divided by the
number of life insurance companies taxable under section 802 which are
members of such group on each day of their matching taxable years.
(5) Estimated tax--(i) Exemption from estimated tax. Except as
otherwise provided in subdivision (ii) of this subparagraph, the
exemption from estimated tax (for purposes of estimated tax filing
requirements under section 6016 and the addition to tax under section
6655 for failure to pay estimated tax) of each corporation which is a
member of such affiliated group on each day of its matching taxable year
shall be (in lieu of the $100,000 amount specified in section 6016(a)
and (b)(2)(A) and in section 6655(d)(1) and (e)(2)(A) an amount equal to
$100,000 divided by the number of such members.
(ii) Nonapplication to certain taxable years beginning in 1963 and
ending in 1964. For purposes of this section, if a corporation has a
taxable year beginning in 1963 and ending in 1964 the last day of the
eighth month of which falls on or before April 10, 1964, then
(notwithstanding the fact that an election under section 243(b)(2) is
effective for such taxable year) subdivision (i) of this subparagraph
shall not apply to such corporation for such taxable year. Thus, such
corporation shall be entitled to a $100,000 exemption from estimated tax
for such taxable year. Also, with respect to a taxable year described in
the first sentence of this subdivision, any such corporation shall not
be considered to be a member of
[[Page 487]]
the affiliated group for purposes of determining the number of members
referred to in subdivision (i) of this subparagraph.
(iii) Examples. The provisions of subdivision (i) of this
subparagraph may be illustrated by the following examples:
Example 1. Corporation P owns all the stock of corporation S-1 on
each day of 1965. On March 1, 1965, P acquires all the stock of
corporation S-2. Corporations P, S-1, and S-2 file separate returns on a
calendar year basis. On March 31, 1965, the affiliated group consisting
of P, S-1, and S-2 anticipates making an election under section
243(b)(2) for P's 1965 taxable year. If the affiliated group does make a
valid election under section 243(b)(2) for P's 1965 year, under
subdivision (i) of this subparagraph the exemption from estimated tax of
P for 1965, and the exemption from estimated tax of S-1 for 1965, will
be (assuming an apportionment plan is not filed pursuant to paragraph
(f) of this section) an amount equal to $50,000 ($100,000 / 2). (Since
S-2 is not a member of the affiliated group on each day of 1965, S-2's
exemption from estimated tax will be determined for the year 1965
without regard to subdivision (i) of this subparagraph, whether or not
the affiliated group makes the election under section 243(b)(2).) P and
S-1 file declarations of estimated tax on April 15, 1965, on such basis
and make payments with respect to such declarations on such basis. Thus,
if the affiliated group does make a valid election under section
243(b)(2) for P's 1965 year, P and S-1 will not incur (as a result of
the application of subdivision (i) of this subparagraph to their 1965
years) additions to tax under section 6655 for failure to pay estimated
tax.
Example 2. Assume the same facts as in Example 1, except that, on
March 31, 1965, S-1 anticipates that it will incur a loss for its 1965
year. Accordingly, in anticipation of making an election under section
243(b)(2) for P's 1965 year and adopting an apportionment plan under
paragraph (f) of this section, P computes its estimated tax liability
for 1965 on the basis of a $100,000 exemption, and S-1 computes its
estimated tax liability for 1965 on the basis of a zero exemption.
Assume S-1 incurs a loss for 1965 as anticipated. Thus, if P does make
the election for 1965, and an apportionment plan is adopted apportioning
$100,000 to P and zero to S-1 (for their 1965 years), P and S-1 will not
incur (as a result of the application of subdivision (i) of this
subparagraph to their 1965 years) additions to tax under section 6655
for failure to pay estimated tax.
Example 3. Assume the same facts as in Example 1, except that P and
S-1 file declarations of estimated tax on April 15, 1965, on the basis
of separate $100,000 exemptions from estimated tax for their 1965 years,
and make payments with respect to such declarations on such basis.
Assume that the affiliated group makes an election under section
243(b)(2) for P's 1965 year. Under subdivision (i) of this subparagraph,
P and S-1 are limited in the aggregate to a single $100,000 exemption
from estimated tax for their 1965 years. The provisions of section 6655
will be applied to the 1965 year of P and the 1965 year of S-1 on the
basis of a $50,000 exemption from estimated tax for each corporation,
unless a different apportionment of the $100,000 amount is adopted under
paragraph (f) of this section. Since the election was made under section
243(b)(2), regardless of whether or not the affiliated group anticipated
making the election, P or S-1 (or both) may incur additions to tax under
section 6655 for failure to pay estimated tax.
(e) Effect of election for certain taxable years beginning in 1963
and ending in 1964. If an election under section 243(b)(2) by an
affiliated group is effective for a taxable year of a corporation under
paragraph (c)(4)(ii) of Sec. 1.243-4 (relating to election for certain
taxable years beginning in 1963 and ending in 1964), and if such
corporation is a member of such group on each day of such taxable year,
then the restrictions and limitations prescribed by paragraphs (b), (c),
and (d) of this section shall apply to all such members having such
taxable years (for such taxable years). For purposes of this paragraph,
such paragraphs shall be applied with respect to such taxable years as
if such taxable years included the last day of a taxable year of the
common parent corporation for which an election was effective under
section 243(b)(2), i.e., as if such taxable years were matching taxable
years. For apportionment plans with respect to such taxable years, see
paragraph (f) (9) of this section.
(f) Apportionment plans--(1) In general. In the case of corporations
which are members of an affiliated group of corporations on each day of
their matching taxable years:
(i) The $100,000 amount referred to in paragraph (d)(3)(i) of this
section (relating to limitation under section 615(a)),
(ii) The amount determined under paragraph (d)(3)(ii)(a) of this
section (relating to limitation under section 615(c)),
[[Page 488]]
(iii) The $25,000 amount referred to in paragraph (d)(4) of this
section (relating to small business deduction of life insurance
companies), and
(iv) The $100,000 amount referred to in paragraph (d)(5)(i) of this
section (relating to exemption from estimated tax), may be apportioned
among such members (for such taxable years) if the common parent
corporation files an apportionment plan with respect to such taxable
years in the manner provided in subparagraph (4) of this paragraph, and
if all other members consent to the plan, in the manner provided in
subparagraph (5) or (6) of this paragraph (whichever is applicable). The
plan may provide for the apportionment to one or more of such members,
in fixed dollar amounts, of one or more of the amounts referred to in
subdivisions (i), (ii), (iii), and (iv) of this subparagraph, but in no
event shall the sum of the amounts so apportioned in respect to any such
subdivision exceed the amount referred to in such subdivision. See also
paragraph (d)(3)(v) of this section, relating to the maximum amount that
may be apportioned to a corporation under this subparagraph with respect
to exploration expenditures to which section 615 applies.
(2) Time for adopting plan. An affiliated group may adopt an
apportionment plan with respect to the matching taxable years of its
members only if, at the time such plan is sought to be adopted, there is
at least 1 year remaining in the statutory period (including any
extensions thereof) for the assessment of a deficiency against any
corporation the tax liability of which for any taxable year would be
increased by the adoption of such plan. (If there is less than 1 year
remaining with respect to any taxable year, the district director for
the internal revenue district in which is located the principal place of
business or principal office or agency of the corporation will
ordinarily, upon request, enter into an agreement to extend such
statutory period for assessment and collection of deficiencies.)
(3) Years for which effective. A valid apportionment plan with
respect to matching taxable years of members of an affiliated group
shall be effective for such matching taxable years, and for all
succeeding matching taxable years of such members, unless the plan is
amended in accordance with subparagraph (8) of this paragraph or is
terminated. Thus, the apportionment plan (including any amendments
thereof) has a continuing effect and need not be renewed annually. An
apportionment plan with respect to a particular taxable year of the
common parent shall terminate with respect to the taxable years of the
members of the affiliated group which include the last day of a
succeeding taxable year of the common parent if:
(i) Any corporation which was a member of the affiliated group on
each day of its matching taxable year which included the last day of the
particular taxable year of the common parent is not a member of such
group on each day of its taxable year which includes the last day of
such succeeding taxable year of the common parent, or
(ii) Any corporation which was not a member of such group on each
day of its taxable year which included the last day of the particular
taxable year of the common parent is a member of such group on each day
of its taxable year which includes the last day of such succeeding
taxable year of the common parent.
An apportionment plan, once terminated, is no longer effective.
Accordingly, unless a new apportionment plan is filed and consented to
(or the section 243(b)(2) election is terminated) the amounts referred
to in subparagraph (1) of this paragraph will be apportioned among the
corporations which are members of the affiliated group on each day of
their matching taxable years in accordance with the rules provided in
paragraphs (d)(3)(i), (d)(3)(ii), (d)(4), and (d)(5)(i) of this section.
(4) Filing of plan. The apportionment plan shall be in the form of a
statement filed by the common parent corporation with the district
director for the internal revenue district in which is located the
principal place of business or principal office or agency of such common
parent. The statement shall be signed by any person who is duly
authorized to act on behalf of the common parent corporation and shall
set forth the name, address, internal revenue district, taxpayer account
[[Page 489]]
number, and taxable year of each member to whom the common parent could
apportion an amount under subparagraph (1) of this paragraph (or, in the
case of an apportionment plan referred to in subparagraph (9) of this
paragraph, each member to whom the common parent could apportion an
amount under such subparagraph) and the amount (or amounts) apportioned
to each such member under the plan.
(5) Consent of wholly owned subsidiaries. If all the stock of a
corporation which is a member of the affiliated group on each day of its
matching taxable year is owned on each such day by another corporation
(or corporations) which is a member of such group on each day of its
matching taxable year, such corporation (hereinafter in this paragraph
referred to as a ``wholly owned subsidiary'') shall be deemed to consent
to the apportionment plan. Each wholly owned subsidiary should attach a
copy of the plan filed by the common parent corporation to an income tax
return, amended return, or claim for refund for its matching taxable
year.
(6) Consent of other members. The consent of each member (other than
the common parent corporation and wholly owned subsidiaries) to an
apportionment plan shall be in the form of a statement, signed by any
person who is duly authorized to act on behalf of the member consenting
to the plan, stating that such member consents to the plan. The consent
of more than one such member may be incorporated in a single statement.
The statement (or statements) shall be attached to the apportionment
plan filed by the common parent corporation. The consent of any such
member which, after the date the apportionment plan was filed and during
its matching taxable year referred to in subparagraph (1) of this
paragraph, ceases to be a wholly owned subsidiary but continues to be a
member, shall be filled with the district director with whom the
apportionment plan is filed (as soon as possible after it ceases to be a
wholly owned subsidiary). Each consenting member should attach a copy of
the apportionment plan filed by the common parent to an income tax
return, amended return, or claim for refund for its matching taxable
year which includes the last day of the taxable year of the common
parent corporation for which the apportionment plan was filed.
(7) Members of group filing consolidated return--(i) General rule.
Except as provided in subdivision (ii) of this subparagraph, if the
members of an affiliated group of corporations include one or more
corporations taxable under section 11 of the Code and one or more
insurance companies taxable under section 802 or 821 of the Code and if
the affiliated group includes corporations which join in the filing of a
consolidated return, then, for purposes of determining the amount to be
apportioned to a corporation under an apportionment plan adopted under
this paragraph, the corporations filing the consolidated return shall be
treated as a single member.
(ii) Consenting to an apportionment plan. For purposes of consenting
to an apportionment plan under subparagraphs (5) and (6) of this
paragraph, if the members of an affiliated group of corporations include
corporations which join in the filing of a consolidated return, each
corporation which joins in filing the consolidated return shall be
treated as a separate member.
(8) Amendment of plan. An apportionment plan, which is effective for
the matching taxable years of members of an affiliated group, may be
amended if an amended plan is filed (and consented to) within the time
and in accordance with the rules prescribed in this paragraph for the
adoption of an original plan with respect to such taxable years.
(9) Certain taxable years beginning in 1963 and ending in 1964. In
the case of corporations which are members of an affiliated group of
corporations on each day of their taxable years referred to in paragraph
(e) of this section:
(i) The $100,000 amount referred to in paragraph (d)(3)(i) of this
section (relating to limitation under section 615(a)),
(ii) The amount determined under paragraph (d)(3)(ii)(a) of this
section (relating to limitation under section 615(c)),
[[Page 490]]
(iii) The $25,000 amount referred to in paragraph (d)(4) of this
section (relating to small business deduction of life insurance
companies), and
(iv) The $100,000 amount referred to in paragraph (d)(5)(i) of this
section (relating to exemption from estimated tax), may be apportioned
among such members (for such taxable years) if an apportionment plan is
filed (and consented to) with respect to such taxable years in
accordance with the rules provided in subparagraphs (2), (4), (5), (6),
(7), and (8) of this paragraph. For purposes of this subparagraph, such
subparagraphs shall be applied as if such taxable years included the
last day of a taxable year of the common parent corporation, i.e., as if
such taxable years were matching taxable years. An apportionment plan
adopted under this subparagraph shall be effective only with respect to
taxable years referred to in paragraph (e) of this section. The plan may
provide for the apportionment to one or more of such members, in fixed
dollar amounts, of one or more of the amounts referred to in
subdivisions (i), (ii), (iii), and (iv) of this subparagraph, but in no
event shall the sum of the amounts so apportioned in respect of any such
subdivision exceed the amount referred to in such subdivision. See also
paragraph (d)(3)(v) of this section, relating to the maximum amount that
may be apportioned to a corporation under an apportionment plan
described in this subparagraph with respect to exploration expenditures
to which section 615 applies.
(g) Short taxable years--(1) General. If:
(i) The return of a corporation is for a short period (ending after
December 31, 1963) on each day of which such corporation is a member of
an affiliated group,
(ii) The last day of the common parent's taxable year does not end
with or within such short period, and
(iii) An election under section 243(b)(2) by such group is effective
under paragraph (c) (4) (i) of Sec. 1.243-4 for the taxable year of the
common parent within which falls such short period, then the
restrictions and limitations prescribed by section 243(b)(3) shall be
applied in the manner provided in subparagraph (2) of this paragraph.
(2) Manner of applying restrictions. In the case of a corporation
described in subparagraph (1) of this paragraph having a short period
described in such subparagraph:
(i) Such corporation may not consent to an election under section
1562, relating to election of multiple surtax exemptions, which would be
effective for such short period;
(ii) The credit under section 901 shall be allowed to such
corporation for such short period if, and only if, each corporation,
which pays or accrues foreign taxes and which is a member of the
affiliated group on each day of its taxable year which includes the last
day of the common parent's taxable year within which falls such short
period, does not deduct such taxes in computing its tax liability for
its taxable year which includes such last day;
(iii) The overall limitation provided in section 904(a)(2) shall be
allowed to such corporation for such short period if, and only if, each
corporation, which pays or accrues foreign taxes and which is a member
of the affiliated group on each day of its taxable year which includes
the last day of the common parent's taxable year within which falls such
short period, uses such limitation for its taxable year which includes
such last day;
(iv) The minimum accumulated earnings credit provided by section
535(c)(2) (or in the case of a mere holding or investment company, the
accumulated earnings credit provided by section 535(c)(3)) allowable for
such short period shall be the amount computed by dividing (a) the
amount (if any) by which $100,000 exceeds the aggregate of the
accumulated earnings and profits of the corporations, which are members
of the affiliated group on the last day of such short period, as of the
close of their taxable years preceding the taxable year which includes
the last day of such short period, by (b) the number of such members on
the last day of such short period;
(v) The deduction allowable under section 615(a) for such short
period shall be limited to an amount equal to $100,000 divided by the
number of corporations which are members of the affiliated group on the
last day of such short period;
[[Page 491]]
(vi) If the expenditures to which section 615(a) applies which are
paid or incurred by such corporation during such short period would,
when added to the aggregate of the amounts deducted or deferred (in
taxable years ending before the last day of such short period) which are
taken into account in applying the limitation of section 615(c) by
corporations which are members of the affiliated group on the last day
of such short period exceed $400,000, then section 615 shall not apply
to any such expenditure so paid or incurred by such corporation to the
extent such expenditure would exceed an amount equal to (a) the amount
(if any) by which $400,000 exceeds the aggregate of the amounts so
deducted or deferred in such taxable years (computed as if each member
filed a separate return), divided by (b) the number of corporations in
the group which have taxable years ending on such last day;
(vii) If such corporation is a life insurance company taxable under
section 802, the small business deduction under sections 804(a)(4) and
809(d)(10) shall not exceed an amount equal to (a) $25,000, divided by
(b) the number of life insurance companies taxable under section 802
which are members of the affiliated group on the last day of such short
period; and
(viii) The exemption from estimated tax (for purposes of estimated
tax filing requirements under section 6016 and the addition to tax under
section 6655 for failure to pay estimated tax) for such short period
shall be an amount equal to $100,000 divided by the number of
corporations which are members of the affiliated group on the last day
of such short period.
[T.D. 6992, 34 FR 821, Jan. 18, 1969, as amended by T.D. 7376, 40 FR
42745, Sept. 16, 1975]
Sec. 1.245-1 Dividends received from certain foreign corporations.
(a) General rule. (1) A corporation is allowed a deduction under
section 245(a) for dividends received from a foreign corporation (other
than a foreign personal holding company as defined in section 552) which
is subject to taxation under chapter 1 of the Code if, for an
uninterrupted period of not less than 36 months ending with the close of
the foreign corporation's taxable year in which the dividends are paid,
(i) the foreign corporation is engaged in trade or business in the
United States, and (ii) 50 percent or more of the foreign corporation's
entire gross income is effectively connected with the conduct of a trade
or business in the United States by that corporation. If the foreign
corporation has been in existence less than 36 months as of the close of
the taxable year in which the dividends are paid, then the applicable
uninterrupted period to be taken into consideration in lieu of the
uninterrupted period of 36 or more months is the entire period such
corporation has been in existence as of the close of such taxable year.
An uninterrupted period which satisfied the twofold requirement with
respect to business activity and gross income may start at a date later
than the date on which the foreign corporation first commenced an
uninterrupted period of engaging in trade or business within the United
States, but the applicable uninterrupted period is in any event the
longest uninterrupted period which satisfies such twofold requirement.
The deduction under section 245(a) is allowable to any corporation,
whether foreign or domestic, receiving dividends from a distributing
corporation which meets the requirements of that section.
(2) Any taxable year of a foreign corporation which falls within the
uninterrupted period described in section 245(a)(2) shall not be taken
into account in applying section 245(a)(2) and this paragraph if the 100
percent dividends received deduction would be allowable under paragraph
(b) of this section, whether or not in fact allowed, with respect to any
dividends payable, whether or not in fact paid, out of the earnings and
profits of such foreign corporation for that taxable year. Thus, in such
case the foreign corporation shall be treated as having no earnings and
profits for that taxable year for purposes of determining the dividends
received deduction allowable under section 245(a) and this paragraph.
However, that taxable year may be taken into account for purposes of
determining whether the foreign corporation meets the requirements of
[[Page 492]]
section 245(a) that, for the uninterrupted period specified therein, the
foreign corporation is engaged in trade or business in the United States
and meets the 50 percent gross income requirement.
(b) Dividends from wholly owned foreign subsidiaries. (1) A domestic
corporation is allowed a deduction under section 245(b) for any taxable
year beginning after December 31, 1966, for dividends received from a
foreign corporation (other than a foreign personal holding company as
defined in section 552) which is subject to taxation under Chapter 1 of
the Code if:
(i) The domestic corporation owns either directly or indirectly all
of the outstanding stock of the foreign corporation during the entire
taxable year of the domestic corporation in which the dividends are
received, and
(ii) The dividends are paid out of earnings and profits of a taxable
year of the foreign corporation during which (a) the domestic
corporation receiving the dividends owns directly or indirectly
throughout such year all of the outstanding stock of the foreign
corporation, and (b) all of the gross income of the foreign corporation
from all sources is effectively connected for that year with the conduct
of a trade or business in the United States by that corporation.
(2) The deduction allowed by section 245(b) does not apply if an
election under section 1562, relating to the privilege of a controlled
group of corporations to elect multiple surtax exemptions, is effective
for either the taxable year of the domestic corporation in which the
dividends are received or the taxable year of the foreign corporation
out of the earnings and profits of which the dividends are paid.
(c) Rules of application. (1) Except as provided in section 246, the
deduction provided by section 245 for any taxable year is the sum of the
amounts computed under paragraphs (1) and (2) of section 245(a) plus, in
the case of a domestic corporation for any taxable year beginning after
December 31, 1966, the sum of the amounts computed under section
245(b)(2).
(2) To the extent that a dividend received from a foreign
corporation is treated as a dividend from a domestic corporation in
accordance with section 243(d) and Sec. 1.243-3, it shall not be
treated as a dividend received from a foreign corporation for purposes
of this section.
(3) For purposes of section 245 (a) and (b), the amount of a
distribution shall be determined under subparagraph (B) (without
reference to subparagraph (C)) of section 301(b)(1).
(4) In determining from what year's earnings and profits a dividend
is treated as having been distributed for purposes of this section, the
principles of paragraph (a) of Sec. 1.316-2 shall apply. A dividend
shall be considered to be distributed, first, out of the earnings and
profits of the taxable year which includes the date the dividend is
distributed, second, out of the earnings and profits accumulated for the
immediately preceding taxable year, third, out of the earnings and
profits accumulated for the second preceding taxable year, etc. A
deficit in an earnings and profits account for any taxable year shall
reduce the most recently accumulated earnings and profits for a prior
year in such account. If there are no accumulated earnings and profits
in an earnings and profits account because of a deficit incurred in a
prior year, such deficit must be restored before earnings and profits
can be accumulated in a subsequent accounting year. See also paragraph
(c) of Sec. 1.243-3 and paragraph (a)(6) of Sec. 1.243-4.
(5) For purposes of this section the gross income of a foreign
corporation for any period before its first taxable year beginning after
December 31, 1966, which is from sources within the United States shall
be treated as gross income which is effectively connected for that
period with the conduct of a trade or business in the United States by
that corporation.
(6) For the determination of the source of income and the income
which is effectively connected with the conduct of a trade or business
in the United States, see sections 861 through 864, and the regulations
thereunder.
(d) Illustrations. The application of this section may be
illustrated by the following examples:
Example 1. Corporation A (a foreign corporation filing its income
tax returns on a
[[Page 493]]
calendar year basis) whose stock is 100 percent owned by Corporation B
(a domestic corporation filing its income tax returns on a calendar year
basis) for the first time engaged in trade or business within the United
States on January 1, 1943, and qualifies under section 245 for the
entire period beginning on that date and ending on December 31, 1954.
Corporation A had accumulated earnings and profits of $50,000
immediately prior to January 1, 1943, and had earnings and profits of
$10,000 for each taxable year during the uninterrupted period from
January 1, 1943, through December 31, 1954. It derived for the period
from January 1, 1943, through December 31, 1953, 90 percent of its gross
income from sources within the United States and in 1954 derived 95
percent of its gross income from sources within the United States.
During the calendar years 1943, 1944, 1945, 1946, and 1947 Corporation A
distributed in each year $15,000; during the calendar years 1948, 1949,
1950, 1951, 1952, and 1953 it distributed in each year $5,000; and
during the year 1954, $50,000. An analysis of the accumulated earnings
and profits under the above statement of facts discloses that at
December 31, 1953, the accumulation amounted to $55,000, of which
$25,000 was accumulated prior to the ``uninterrupted period'' and
$30,000 was accumulated during the uninterrupted period. (See section
316(a) and paragraph (c) of this section.) For 1954 a deduction under
section 245 of $31,025 ($8,075 on 1954 earnings of the foreign
corporation, plus $22,950 from the $30,000 accumulation at December 31,
1953) for dividends received from a foreign corporation is allowable to
Corporation B with respect to the $50,000 received from Corporation A,
computed as follows:
(i) $8,075, which is $8,500 (85 percent--the percent specified in
section 243 for the calendar year 1954--of the $10,000 of earnings and
profits of the taxable year) multiplied by 95 percent (the portion of
the gross income of Corporation A derived during the taxable year 1954
from sources within the United States), plus
(ii) $22,950, which is $25,500 (85 percent--the percent specified in
section 243 for the calendar year 1954--of $30,000, the part of the
earnings and profits accumulated after the beginning of the
uninterrupted period) multiplied by 90 percent (the portion of the gross
income of Corporation A derived from sources within the United States
during that portion of the uninterrupted period ending at the beginning
of the taxable year 1954).
Example 2. If in Example 1, Corporation A for the taxable year 1954
had incurred a deficit of $10,000 (shown to have been incurred before
December 31) the amount of the earnings and profits accumulated after
the beginning of the uninterrupted period would be $20,000. If
Corporation A had distributed $50,000 on December 31, 1954, the
deduction under section 245 for dividends received from a foreign
corporation allowable to Corporation B for 1954 would be $15,300,
computed by multiplying $17,000 (85 percent--the percent specified in
section 243 for the calendar year 1954--of $20,000 earnings and profits
accumulated after the beginning of the uninterrupted period) by 90
percent (the portion of the gross income of Corporation A derived from
United States sources during that portion of the uninterrupted period
ending at the beginning of the taxable year 1954).
Example 3. Corporation A (a foreign corporation filing its income
tax returns on a calendar year basis) whose stock is 100 percent owned
by corporation B (a domestic corporation filing its income tax returns
on a calendar year basis) for the first time engaged in trade or
business within the United States on January 1, 1960, and qualifies
under section 245 for the entire period beginning on that date and
ending on December 31, 1963. In 1963, A derived 75 percent of its gross
income from sources within the United States. A's earnings and profits
for 1963 (computed as of the close of the taxable year without
diminution by reason of any distributions made during the taxable year)
are $200,000. On December 31, 1963, corporation A distributes to
corporation B 100 shares of corporation C stock which have an adjusted
basis in A's hands of $40,000 and a fair market value of $100,000. For
purposes of computing the deduction under section 245 for dividends
received from a foreign corporation, the amount of the distribution is
$40,000. B is allowed a deduction under section 245 of $25,500, i.e.,
$34,000 ($40,000 multiplied by 85 percent, the percent specified in
section 243 for 1963), multiplied by 75 percent (the portion of the
gross income of corporation A derived during 1963 from sources within
the United States).
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6752, 29 FR
12701, Sept. 9, 1964; T.D. 6830; 30 FR 8046, June 23, 1965; T.D. 7293,
38 FR 32793, Nov. 28, 1973]
Sec. Sec. 1.245A-1--1.245A-4 [Reserved]
Sec. 1.245A-5 Limitation of section 245A deduction and section 954(c)(6) exception.
(a) Overview. This section provides rules that limit a deduction
under section 245A(a) to the portion of a dividend that exceeds the
ineligible amount of such dividend or the applicability of section
954(c)(6) when a portion of a dividend is paid out of an extraordinary
disposition account or when an extraordinary reduction occurs. Paragraph
(b) of this section provides rules regarding ineligible amounts.
Paragraph (c) of this section
[[Page 494]]
provides rules for determining ineligible amounts attributable to an
extraordinary disposition. Paragraph (d) of this section provides rules
that limit the application of section 954(c)(6) when one or more section
245A shareholders of a lower-tier CFC have an extraordinary disposition
account. Paragraph (e) of this section provides rules for determining
ineligible amounts attributable to an extraordinary reduction. Paragraph
(f) of this section provides rules that limit the application of section
954(c)(6) when a lower-tier CFC has an extraordinary reduction amount.
Paragraph (g) of this section provides special rules for purposes of
applying this section. Paragraph (h) of this section provides an anti-
abuse rule. Paragraph (i) of this section provides definitions.
Paragraph (j) of this section provides examples illustrating the
application of this section. Paragraph (k) of this section provides the
applicability date of this section.
(b) Limitation of deduction under section 245A--(1) In general. A
section 245A shareholder is allowed a section 245A deduction for any
dividend received from an SFC (provided all other applicable
requirements are satisfied) only to the extent that the dividend exceeds
the ineligible amount of the dividend. See paragraphs (j)(2), (4), and
(5) of this section for examples illustrating the application of this
paragraph (b)(1).
(2) Definition of ineligible amount. The term ineligible amount
means, with respect to a dividend received by a section 245A shareholder
from an SFC, an amount equal to the sum of--
(i) 50 percent of the extraordinary disposition amount (as
determined under paragraph (c) of this section); and
(ii) The extraordinary reduction amount (as determined under
paragraph (e) of this section).
(c) Rules for determining extraordinary disposition amount--(1)
Definition of extraordinary disposition amount. The term extraordinary
disposition amount means the portion of a dividend received by a section
245A shareholder from an SFC that is paid out of the extraordinary
disposition account with respect to the section 245A shareholder. See
paragraph (j)(2) of this section for an example illustrating the
application of this paragraph (c).
(2) Determination of portion of dividend paid out of extraordinary
disposition account--(i) In general. For purposes of determining the
portion of a dividend received by a section 245A shareholder from an SFC
that is paid out of the extraordinary disposition account with respect
to the section 245A shareholder, the following rules apply--
(A) The dividend is first considered paid out of non-extraordinary
disposition E&P with respect to the section 245A shareholder; and
(B) The dividend is next considered paid out of the extraordinary
disposition account to the extent of the section 245A shareholder's
extraordinary disposition account balance.
(ii) Definition of non-extraordinary disposition E&P. The term non-
extraordinary disposition E&P means, with respect to a section 245A
shareholder and an SFC, an amount of earnings and profits of the SFC
equal to the excess, if any, of--
(A) The product of--
(1) The amount of the SFC's earnings and profits described in
section 959(c)(3), determined as of the end of the SFC's taxable year
(for purposes of paragraph (c)(2)(ii) of this section, without regard to
distributions during the taxable year other than as provided in this
paragraph (c)(2)(ii)(A)(1)), but, if during the taxable year the SFC
pays more than one dividend, reduced (but not below zero) by the amounts
of any dividends paid by the SFC earlier in the taxable year; and
(2) The percentage of the stock (by value) of the SFC that the
section 245A shareholder owns directly or indirectly immediately before
the distribution; over
(B) The balance of the section 245A shareholder's extraordinary
disposition account with respect to the SFC, determined immediately
before the distribution.
(3) Definitions with respect to extraordinary disposition accounts--
(i) Extraordinary disposition account--(A) In general. The term
extraordinary disposition account means, with respect to a section 245A
shareholder of an SFC, an account, the balance of which is equal to
[[Page 495]]
the product of the extraordinary disposition ownership percentage and
the extraordinary disposition E&P, reduced (but not below zero) by the
prior extraordinary disposition amount and as provided in Sec. 1.245A-7
or Sec. 1.245A-8, and adjusted under paragraph (c)(4) of this section,
as applicable. An extraordinary disposition account is maintained in the
same functional currency as the extraordinary disposition E&P.
(B) Extraordinary disposition ownership percentage. The term
extraordinary disposition ownership percentage means the percentage of
stock (by value) of an SFC that a section 245A shareholder owns directly
or indirectly at the beginning of the disqualified period or, if later,
on the first day during the disqualified period on which the SFC is a
CFC, regardless of whether the section 245A shareholder owns directly or
indirectly such stock of the SFC on the date of an extraordinary
disposition giving rise to extraordinary disposition E&P; if not, see
paragraph (c)(4) of this section.
(C) Extraordinary disposition E&P. The term extraordinary
disposition E&P means an amount of earnings and profits of an SFC equal
to the sum of the net gain recognized by the SFC with respect to
specified property in each extraordinary disposition. In the case of an
extraordinary disposition with respect to the SFC arising as a result of
a disposition of specified property by a specified entity (other than a
foreign corporation), an interest of which is owned directly or
indirectly (through one or more other specified entities that are not
foreign corporations) by the SFC, the net gain taken into account for
purposes of the preceding sentence is the SFC's distributive share of
the net gain recognized by the specified entity with respect to the
specified property.
(D) Prior extraordinary disposition amount--(1) General rule. The
term prior extraordinary disposition amount means, with respect to an
SFC and a section 245A shareholder, the sum of the extraordinary
disposition amount of each prior dividend received by the section 245A
shareholder from the SFC by reason of paragraph (c)(1) of this section
and 200 percent of the sum of the amounts included in the section 245A
shareholder's gross income under section 951(a) by reason of paragraph
(d) of this section (in the case in which the SFC is, or has been, a
lower-tier CFC). A section 245A shareholder's prior extraordinary
disposition amount also includes--
(i) A prior dividend received by the section 245A shareholder from
the SFC to the extent not an extraordinary reduction amount and to the
extent the dividend would have been an extraordinary disposition amount
but for the failure of the dividend to qualify for the section 245A
deduction by reason of one or more of the following: Application of
section 245A(e); the recipient domestic corporation does not satisfy the
holding period requirement of section 246; or the recipient domestic
corporation is not a United States shareholder with respect to the
foreign corporation from whose earnings and profits the dividend is
sourced;
(ii) The portion of a prior dividend (to the extent not a tiered
extraordinary disposition amount by reason of paragraph (d) of this
section) received by an upper-tier CFC from the SFC that by reason of
section 245A(e) or being properly allocable to subpart F income of the
SFC for the taxable year of the dividend pursuant to section
954(c)(6)(A) was included in the upper-tier CFC's foreign personal
holding company income and was included in gross income by the section
245A shareholder under section 951(a) but would have been a tiered
extraordinary disposition amount by reason of paragraph (d) of this
section had paragraph (d) applied to the dividend;
(iii) If a prior dividend received by an upper-tier CFC from a
lower-tier CFC gives rise to a tiered extraordinary disposition amount
with respect to the section 245A shareholder by reason of paragraph (d)
of this section, the qualified portion; and
(iv) 200 percent of an amount included in the gross income of a
domestic corporation under section 951(a)(1)(B) with respect to a CFC
for the taxable year of the domestic corporation in which or with which
the CFC's taxable year ends, to the extent so included by reason of the
application of this section to the hypothetical distribution described
in Sec. 1.956-1(a)(2), or to the extent the
[[Page 496]]
amount would have been so included by reason of the application of this
section to the hypothetical distribution but for the application of
section 245A(e) or the holding period requirement in section 246 to the
hypothetical distribution.
(2) Definition of qualified portion--(i) In general. The term
qualified portion means, with respect to a tiered extraordinary
disposition amount of a section 245A shareholder and a lower-tier CFC,
200 percent of the portion of the disqualified amount with respect to
the tiered extraordinary disposition amount equal to the sum of the
amounts included in gross income by each U.S. tax resident under section
951(a) in the taxable year in which the tiered extraordinary disposition
amount arose with respect to the lower-tier CFC by reason of paragraph
(d) of this section. For purposes of the preceding sentence, the
reference to a U.S. tax resident does not include any section 245A
shareholder with a tiered extraordinary disposition amount with respect
to the lower-tier CFC.
(ii) Determining a qualified portion if multiple section 245A
shareholders have tiered extraordinary disposition amounts. For the
purposes of applying paragraph (c)(3)(i)(D)(2)(i) of this section, if
more than one section 245A shareholder has a tiered extraordinary
disposition amount with respect to a dividend received by an upper-tier
CFC from a lower-tier CFC, then the qualified portion with respect to
each section 245A shareholder is equal to the amount described in
paragraph (c)(3)(i)(D)(2)(i) of this section, without regard to this
paragraph (c)(3)(i)(D)(2)(ii), multiplied by a fraction, the numerator
of which is the section 245A shareholder's tiered extraordinary
disposition amount with respect to the lower-tier CFC and the
denominator of which is the sum of the tiered extraordinary disposition
amounts with respect to each section 245A shareholder and the lower-tier
CFC.
(ii) Extraordinary disposition--(A) In general. Except as provided
in paragraph (c)(3)(ii)(E) of this section, the term extraordinary
disposition means, with respect to an SFC, any disposition of specified
property by the SFC on a date on which it was a CFC and during the SFC's
disqualified period to a related party if the disposition occurs outside
of the ordinary course of the SFC's activities. An extraordinary
disposition also includes a disposition during the disqualified period
on a date on which the SFC is not a CFC if there is a plan, agreement,
or understanding involving a section 245A shareholder to cause the SFC
to recognize gain that would give rise to an extraordinary disposition
if the SFC were a CFC.
(B) Facts and circumstances. A determination as to whether a
disposition is undertaken outside of the ordinary course of an SFC's
activities is made on the basis of facts and circumstances, taking into
account whether the transaction is consistent with the SFC's past
activities, including with respect to quantity and frequency. In
addition, a disposition of specified property by an SFC to a related
party may be considered outside of the ordinary course of the SFC's
activities notwithstanding that the SFC regularly disposes of property
of the same type of, or similar to, the specified property to persons
that are not related parties.
(C) Per se rules--(1) In general. Even if a disposition would
otherwise be considered to be undertaken in the ordinary course of an
SFC's activities under the requirements of paragraph (c)(3)(ii)(B) of
this section, that disposition is treated as occurring outside of the
ordinary course of an SFC's activities if the disposition is undertaken
with a principal purpose of generating earnings and profits during the
disqualified period or, except as provided in paragraph (c)(3)(ii)(C)(2)
of this section, if the disposition is of intangible property, as
defined in section 367(d)(4).
(2) Exception to the per se rule for certain property--(i)
Exception. Paragraph (c)(3)(ii)(C)(1) of this section does not apply to
a disposition of intangible property that is not described in section
367(d)(4)(C) or (F), provided that the property is transferred to a
related person during the disqualified period with a reasonable
expectation that the related person will resell the property to an
unrelated customer within one year. Subject to paragraph
(c)(3)(ii)(C)(2)(ii) of this section, a disposition of intangible
property that
[[Page 497]]
satisfies the requirements of this paragraph (c)(3)(ii)(C)(2)(i) is
determined to be within or without the ordinary course of an SFC's
activities based on the test described in paragraph (c)(3)(ii)(B) of
this section.
(ii) Facts and circumstances presumption for property described in
section 367(d)(4)(A). Notwithstanding paragraph (c)(3)(ii)(B) of this
section, any disposition described in paragraph (c)(3)(ii)(C)(2)(i) of
this section of a copyright right within the meaning of Sec. 1.861-18
or of intangible property described in section 367(d)(4)(A) is presumed
to take place outside of the ordinary course of an SFC's activities for
purposes of paragraph (c)(3)(ii)(A) of this section. The presumption in
the preceding sentence may be rebutted only if the taxpayer can show
that the facts and circumstances clearly establish that the disposition
took place in the ordinary course of the SFC's activities.
(D) Treatment of dispositions by certain specified entities. For
purposes of paragraph (c)(3)(ii)(A) of this section, an extraordinary
disposition with respect to an SFC includes a disposition by a specified
entity other than a foreign corporation, provided that immediately
before or immediately after the disposition the specified entity is a
related party with respect to the SFC, the SFC directly or indirectly
(through one or more other specified entities other than foreign
corporations) owns an interest in the specified entity, and the
disposition would have otherwise qualified as an extraordinary
disposition had the specified entity been a foreign corporation.
(E) De minimis exception to extraordinary disposition. If the sum of
the net gain recognized by an SFC with respect to specified property in
all dispositions otherwise described in paragraph (c)(3)(ii)(A) of this
section does not exceed the lesser of $50 million or 5 percent of the
gross value of all of the SFC's property held immediately before the
beginning of its disqualified period, then no disposition of specified
property by the SFC is an extraordinary disposition.
(iii) Disqualified period. The term disqualified period means, with
respect to an SFC that is a CFC on any day during the taxable year that
includes January 1, 2018, the period beginning on January 1, 2018, and
ending as of the close of the taxable year of the SFC, if any, that
begins before January 1, 2018, and ends after December 31, 2017.
(iv) Specified property. The term specified property means any
property if gain recognized with respect to such property during the
disqualified period is not described in section 951A(c)(2)(A)(i)(I)
through (V). If only a portion of the gain recognized with respect to
property during the disqualified period is gain that is not described in
section 951A(c)(2)(A)(i)(I) through (V), then a portion of the property
is treated as specified property in an amount that bears the same ratio
to the value of the property as the amount of gain not described in
section 951A(c)(2)(A)(i)(I) through (V) bears to the total amount of
gain recognized with respect to such property during the disqualified
period. Specified property is also property with respect to which a loss
was recognized during the disqualified period if the loss is properly
allocable to income not described in section 951A(c)(2)(A)(i)(I) through
(V) under the principles of section 954(b)(5) (specified loss). If only
a portion of the loss recognized with respect to property during the
disqualified period is specified loss, then a portion of the property is
treated as specified property in an amount that bears the same ratio to
the value of the property as the amount of specified loss bears to the
total amount of loss recognized with respect to such property during the
disqualified period.
(4) Successor rules for extraordinary disposition accounts. This
paragraph (c)(4) applies with respect to an extraordinary disposition
account upon certain direct or indirect transfers of stock of an SFC by
a section 245A shareholder.
(i) Another section 245A shareholder succeeds to all or portion of
account. Except as provided in paragraph (c)(4)(vi) of this section,
paragraphs (c)(4)(i)(A) through (D) of this section apply when a section
245A shareholder of an SFC (the transferor) transfers directly or
indirectly a share of stock (or a portion of a share of stock) of the
SFC that it
[[Page 498]]
owns directly or indirectly (the share or portion thereof, a transferred
share).
(A) If immediately after the transfer (taking into account all
transactions related to the transfer) another person is a section 245A
shareholder of the SFC, then such other person's extraordinary
disposition account with respect to the SFC is increased by the person's
proportionate share of the amount allocated to the transferred share.
(B) For purposes of paragraph (c)(4)(i)(A) of this section, the
amount allocated to a transferred share is equal to the product of--
(1) The balance of the transferor's extraordinary disposition
account with respect to the SFC, determined after any reduction pursuant
to paragraph (c)(3) of this section by reason of dividends and before
the application of this paragraph (c)(4)(i)(B); and
(2) A fraction, the numerator of which is the value of the
transferred share and the denominator of which is the value of all of
the stock of the SFC that the transferor owns directly or indirectly
immediately before the transfer.
(C) For purposes of paragraph (c)(4)(i)(A) of this section, a
person's proportionate share of the amount allocated to a transferred
share under paragraph (c)(4)(i)(B) of this section is equal to the
product of--
(1) The amount allocated to the share; and
(2) The percentage of the share (by value) that the person owns
directly or indirectly immediately after the transfer (taking into
account all transactions related to the transfer).
(D) The transferor's extraordinary disposition account with respect
to the SFC is decreased by the amount by which another person's
extraordinary disposition account with respect to the SFC is increased
pursuant to paragraph (c)(4)(i)(A) of this section.
(ii) Certain section 381 transactions--(A) In general. If assets of
an SFC (the acquired corporation) are acquired by another SFC (the
acquiring corporation) pursuant to a transaction described in section
381(a) in which the acquired corporation is the transferor corporation
for purposes of section 381, then a section 245A shareholder's
extraordinary disposition account with respect to the acquiring
corporation is increased by the balance of its extraordinary disposition
account with respect to the acquired corporation, determined after any
reduction pursuant to paragraph (c)(3) of this section by reason of
dividends and before the application of this paragraph (c)(4)(ii)(A).
(B) Certain triangular asset reorganizations. If, in a transaction
described in paragraph (c)(4)(ii)(A) of this section, the section 245A
shareholder receives stock of a domestic corporation that controls
(within the meaning of section 368(c)) the acquiring corporation, the
domestic corporation's extraordinary disposition account with respect to
the acquiring corporation is increased by the balance of the section
245A shareholder's extraordinary disposition account with respect to the
acquired corporation, determined after any reduction pursuant to
paragraph (c)(3) of this section by reason of dividends and before the
application of this paragraph (c)(4)(ii)(B).
(iii) Certain distributions involving section 355 or 356. In the
case of a transaction involving a distribution under section 355 (or so
much of section 356 as it relates to section 355) by an SFC (the
distributing corporation) of stock of another SFC (the controlled
corporation), a section 245A shareholder's extraordinary disposition
account with respect to the distributing corporation is attributed to
(and treated as) an extraordinary disposition account with respect to
the controlled corporation in a manner similar to how earnings and
profits of the distributing corporation and the controlled corporation
are adjusted under Sec. 1.312-10. To the extent that a section 245A
shareholder's extraordinary disposition account with respect to the
distributing CFC is not so attributed to (and treated as) an
extraordinary disposition account with respect to the controlled
corporation, the extraordinary disposition account remains as an
extraordinary disposition account with respect to the distributing
corporation.
(iv) Transfer of all of the stock of the SFC owned by a section 245A
shareholder--(A) In general. If, in a transaction described in paragraph
(c) of this section, a section 245A shareholder
[[Page 499]]
of an SFC transfers directly or indirectly all of the stock of the SFC
that it owns directly or indirectly, then, except as provided in
paragraph (c)(4)(iv)(B) of this section, any remaining balance of the
section 245A shareholder's extraordinary disposition account that is not
allocated or attributed under paragraph (c) of this section is
eliminated and therefore not taken into account by any person.
(B) Related party retains the extraordinary distribution account. If
any related party with respect to the section 245A shareholder described
in paragraph (c)(4)(iv)(A) of this section is a section 245A shareholder
with respect to the SFC immediately after the transfer (taking into
account all transactions related to the transfer), then the remaining
balance of the section 245A shareholder's extraordinary disposition
account with respect to the SFC is added to the related party's
extraordinary disposition account. If multiple related parties are
section 245A shareholders of the SFC, then the remaining balance of the
extraordinary disposition account is allocated between the related
parties in proportion to the value of the stock of the SFC that they own
directly or indirectly immediately after the transfer (taking into
account all transactions related to the transfer).
(v) Effect of section 338(g) election--(A) In general. Except as
provided in paragraph (c)(4)(v)(B) of this section, if an election under
section 338(g) is made with respect to a qualified stock purchase (as
defined in section 338(d)(3)) of stock of an SFC, then a section 245A
shareholder's extraordinary disposition account with respect to the old
target (as defined in Sec. 1.338-2(c)(17)) is not treated as (or
attributed to) an extraordinary disposition account with respect to the
new target (as defined in Sec. 1.338-2(c)(17)). Accordingly, the
remaining balance of the old target's extraordinary disposition account
is eliminated and is not thereafter taken into account by any person.
(B) Special rules regarding carryover foreign target stock. If an
election under section 338(g) is made with respect to a qualified stock
purchase (as described in section 338(d)(3)) of stock of an SFC and
there are one or more shares of carryover foreign target stock (``FT
stock'') (as described in Sec. 1.338-9(b)(3)(i)), then the following
rules apply as to a section 245A shareholder of the new target that
after the qualified stock purchase directly or indirectly owns carryover
FT stock (such shareholder, the carryover FT stock shareholder):
(1) In a case in which before the qualified stock purchase the
carryover FT stock shareholder directly or indirectly owned carryover FT
stock, the carryover FT stock shareholder's extraordinary disposition
account with respect to the old target, determined after any reduction
pursuant to paragraph (c)(3) of this section by reason of dividends, is
treated as its extraordinary disposition account with respect to the new
target.
(2) In a case in which before the qualified stock purchase the
carryover FT stock shareholder did not directly or indirectly own
carryover FT stock, but the stock retains its character as carryover FT
stock (taking into account Sec. 1.338-9(b)(3)(vi)), a ratable portion
of each section 245A shareholder's extraordinary disposition account
with respect to the old target, determined after any reduction pursuant
to paragraph (c)(3) of this section by reason of dividends, is treated
as the carryover FT stock shareholder's extraordinary disposition
account with respect to the new target, based on the value of the
carryover FT stock that the carryover FT stock shareholder owns directly
or indirectly after the qualified stock purchase relative to the value
of all of the stock of the new target.
(vi) Certain transfers described in Sec. 1.1248-8(a)(1)--(A) In
general. If a person transfers stock of an SFC with respect to which a
section 245A shareholder has an extraordinary disposition account to a
foreign acquiring corporation in a transaction described Sec. 1.1248-
8(a)(1) (other than a transfer that is also described in Sec.
1.1248(f)-1(b)(2) or (3)) in which stock of a foreign corporation is
received by the transferor, then, except in the case in which the
transfer is also described in paragraph (c)(4)(ii) or (iii) of this
section, the section 245A shareholder's extraordinary disposition
account is not adjusted under this paragraph (c)(4).
[[Page 500]]
(B) Certain transfers described in Sec. 1.1248(f)-1(b). In the case
of a transfer directly or indirectly of stock of an SFC by a section
245A shareholder described in Sec. 1.1248(f)-1(b)(2) or (3), but which
does not result in an income inclusion, in whole or in part, by reason
of Sec. 1.1248-2, the section 245A shareholder's extraordinary
disposition account with respect to the SFC, determined after any
reduction pursuant to paragraph (c)(3) of this section by reason of
dividends and before the application of this paragraph (c)(4)(vi)(B), is
allocated and adjusted in the same manner as under paragraph (c)(4)(i)
of this section, except that, for purposes of applying paragraphs
(c)(4)(i)(B) and (C) of this section, stock of the SFC that is owned
directly or indirectly by persons who are not section 1248 shareholders
(as defined in Sec. 1.1248(f)-1(c)(12)) is disregarded.
(vii) Anti-abuse rule. Pursuant to paragraph (h) of this section, if
a principal purpose of a transaction or series of transactions is to
shift to another person, or to avoid, an amount of a section 245A
shareholder's extraordinary disposition account with respect to an SFC
or otherwise avoid the purposes of this section, then appropriate
adjustments are made for purposes of this section, including
disregarding the transaction or series of transactions. A principal
purpose described in the preceding sentence is deemed to exist if stock
of an SFC is directly or indirectly acquired by one of more section 245A
shareholders within one year of a transaction or transactions to which
paragraph (c)(4)(iv)(A) of this section would otherwise apply.
(d) Limitation of amount eligible for section 954(c)(6) when there
is an extraordinary disposition account with respect to a lower-tier
CFC--(1) In general. If an upper-tier CFC receives a dividend from a
lower-tier CFC, then the dividend is eligible for the exception to
foreign personal holding company income under section 954(c)(6)
(provided all other applicable requirements are satisfied) with respect
to the portion of the dividend that exceeds the disqualified amount.
With respect to the portion of the dividend that does not exceed the
disqualified amount, the exception to foreign personal holding company
income under section 954(c)(6) is allowed (provided all other applicable
requirements are satisfied) only for the amount equal to 50 percent of
the portion of the dividend that does not exceed the disqualified
amount. The disqualified amount is the quotient of the amounts described
in paragraphs (d)(1)(i) and (ii) of this section.
(i) The sum of each section 245A shareholder's tiered extraordinary
disposition amount with respect to the lower-tier CFC.
(ii) The percentage of stock of the upper-tier CFC (by value) owned,
in the aggregate, by U.S. tax residents that include in gross income
their pro rata share of the upper-tier CFC's subpart F income under
section 951(a) on the last day of the upper-tier CFC's taxable year. If
a U.S. tax resident is a direct or indirect partner in a domestic
partnership that is a United States shareholder of the upper-tier CFC,
the amount of stock owned by the U.S. tax resident for purposes of the
preceding sentence is determined under the principles of paragraph
(g)(3) of this section.
(2) Definition of tiered extraordinary disposition amount--(i) In
general. The term tiered extraordinary disposition amount means, with
respect to a dividend received by an upper-tier CFC from a lower-tier
CFC and a section 245A shareholder, the portion of the dividend that
would be an extraordinary disposition amount if the section 245A
shareholder received as a dividend its pro rata share of the dividend
from the lower-tier CFC. The preceding sentence does not apply to an
amount treated as a dividend received by an upper-tier CFC from a lower-
tier CFC by reason of section 964(e)(4) (in such case, see paragraphs
(b)(1) and (g)(2) of this section).
(ii) Section 245A shareholder's pro rata share of a dividend
received by an upper-tier CFC. For the purposes of paragraph (d)(2)(i)
of this section, a section 245A shareholder's pro rata share of the
amount of a dividend received by an upper-tier CFC from a lower-tier CFC
equals the amount by which the dividend would increase the section 245A
shareholder's pro rata share of the upper-tier CFC's subpart F income
under section 951(a)(2) and Sec. 1.951-1(b)
[[Page 501]]
and (e) if the dividend were included in the upper-tier CFC's foreign
personal holding company income under section 951(a)(1), determined
without regard to section 952(c) and as if the upper-tier CFC had no
deductions properly allocable to the dividend under section 954(b)(5).
(e) Extraordinary reduction amount--(1) In general. Except as
provided in paragraph (e)(3) of this section, the term extraordinary
reduction amount means, with respect to a dividend received by a
controlling section 245A shareholder from a CFC during a taxable year of
the CFC ending after December 31, 2017, in which an extraordinary
reduction occurs with respect to the controlling section 245A
shareholder's ownership of the CFC, the lesser of the amounts described
in paragraph (e)(1)(i) or (ii) of this section. See paragraphs (j)(4)
through (6) of this section for examples illustrating the application of
this paragraph (e).
(i) The amount of the dividend.
(ii) The amount equal to the sum of the controlling section 245A
shareholder's pre-reduction pro rata share of the CFC's subpart F income
(as defined in section 952(a)) and tested income (as defined in section
951A(c)(2)(A)) for the taxable year, reduced, but not below zero, by the
prior extraordinary reduction amount.
(2) Rules regarding extraordinary reduction amounts--(i)
Extraordinary reduction--(A) In general. Except as provided in paragraph
(e)(2)(i)(C) of this section, an extraordinary reduction occurs, with
respect to a controlling section 245A shareholder's ownership of a CFC
during a taxable year of the CFC, if either of the conditions described
in paragraph (e)(2)(i)(A)(1) or (2) of this section is satisfied. See
paragraphs (j)(4) and (5) of this section for examples illustrating an
extraordinary reduction.
(1) The condition of this paragraph (e)(2)(i)(A)(1) requires that
during the taxable year, the controlling section 245A shareholder
transfers directly or indirectly (other than by reason of a transfer
occurring pursuant to an exchange described in section 368(a)(1)(E) or
(F)), in the aggregate, more than 10 percent (by value) of the stock of
the CFC that the section 245A shareholder owns directly or indirectly as
of the beginning of the taxable year of the CFC, provided the stock
transferred, in the aggregate, represents at least 5 percent (by value)
of the outstanding stock of the CFC as of the beginning of the taxable
year of the CFC; or
(2) The condition of this paragraph (e)(2)(i)(A)(2) requires that,
as a result of one or more transactions occurring during the taxable
year, the percentage of stock (by value) of the CFC that the controlling
section 245A shareholder owns directly or indirectly as of the close of
the last day of the taxable year of the CFC is less than 90 percent of
the percentage of stock (by value) that the controlling section 245A
shareholder owns directly or indirectly on either of the dates described
in paragraphs (e)(2)(i)(B)(1) and (2) of this section (such percentage,
the initial percentage), provided the difference between the initial
percentage and percentage at the end of the year is at least five
percentage points.
(B) Dates for purposes of the initial percentage. For purposes of
paragraph (e)(2)(i)(A)(2) of this section, the dates described in
paragraphs (e)(2)(i)(B)(1) and (2) of this section are--
(1) The day of the taxable year on which the controlling section
245A shareholder owns directly or indirectly its highest percentage of
stock (by value) of the CFC; and
(2) The day immediately before the first day on which stock was
transferred directly or indirectly in the preceding taxable year in a
transaction (or a series of transactions) occurring pursuant to a plan
to reduce the percentage of stock (by value) of the CFC that the
controlling section 245A shareholder owns directly or indirectly.
(C) Transactions pursuant to which CFC's taxable year ends. A
controlling section 245A shareholder's direct or indirect transfer of
stock of a CFC that but for this paragraph (e)(2)(i)(C) would give rise
to an extraordinary reduction under paragraph (e)(2)(i)(A) of this
section does not give rise to an extraordinary reduction if the taxable
year of the CFC ends immediately after the transfer, provided that the
controlling section 245A shareholder directly or indirectly owns the
stock on the last day of such year. Thus, for example, if a
[[Page 502]]
controlling section 245A shareholder exchanges all the stock of a CFC
pursuant to a complete liquidation of the CFC, the exchange does not
give rise to an extraordinary reduction.
(ii) Rules for determining pre-reduction pro rata share--(A) In
general. Except as provided in paragraph (e)(2)(ii)(B) of this section,
the term pre-reduction pro rata share means, with respect to a
controlling section 245A shareholder and the subpart F income or tested
income of a CFC, the controlling section 245A shareholder's pro rata
share of the CFC's subpart F income or tested income under section
951(a)(2) and Sec. 1.951-1(b) and (e) or section 951A(e)(1) and Sec.
1.951A-1(d)(1), respectively, determined based on the controlling
section 245A shareholder's direct or indirect ownership of stock of the
CFC immediately before the extraordinary reduction (or, if the
extraordinary reduction occurs by reason of multiple transactions,
immediately before the first transaction) and without regard to section
951(a)(2)(B) and Sec. 1.951-1(b)(1)(ii), but only to the extent that
such subpart F income or tested income is not included in the
controlling section 245A shareholder's pro rata share of the CFC's
subpart F income or tested income under section 951(a)(2) and Sec.
1.951-1(b) and (e) or section 951A(e)(1) and Sec. 1.951A-1(d)(1),
respectively.
(B) Decrease in section 245A shareholder's pre-reduction pro rata
share for amounts taken into account by U.S. tax resident. A controlling
section 245A shareholder's pre-reduction pro rata share of subpart F
income or tested income of a CFC for a taxable year is reduced by an
amount equal to the sum of the amounts by which each U.S. tax resident's
pro rata share of the subpart F income or tested income is increased as
a result of a transfer directly or indirectly of stock of the CFC by the
controlling section 245A shareholder or an issuance of stock by the CFC
(such an amount with respect to a U.S. tax resident, a specified
amount), in either case, during the taxable year in which the
extraordinary reduction occurs. For purposes of this paragraph
(e)(2)(ii)(B), if there are extraordinary reductions with respect to
more than one controlling section 245A shareholder during the CFC's
taxable year, then a U.S. tax resident's specified amount attributable
to an acquisition of stock from the CFC is prorated with respect to each
controlling section 245A shareholder based on its relative decrease in
ownership of the CFC. See paragraph (j)(5) of this section for an
example illustrating a decrease in a section 245A shareholder's pre-
reduction pro rata share for amounts taken into account by a U.S. tax
resident.
(C) Prior extraordinary reduction amount. The term prior
extraordinary reduction amount means, with respect to a CFC and section
245A shareholder and a taxable year of the CFC in which an extraordinary
reduction occurs, the sum of the extraordinary reduction amount of each
prior dividend received by the section 245A shareholder from the CFC
during the taxable year. A section 245A shareholder's prior
extraordinary reduction amount also includes--
(1) A prior dividend received by the section 245A shareholder from
the CFC during the taxable year to the extent the dividend was not
eligible for the section 245A deduction by reason of section 245A(e) or
the holding period requirement of section 246 not being satisfied but
would have been an extraordinary reduction amount had this paragraph (e)
applied to the dividend;
(2) If the CFC is a lower-tier CFC for a portion of the taxable year
during which the lower-tier CFC pays any dividend to an upper tier-CFC,
the portion of a prior dividend received by an upper-tier CFC from the
lower-tier CFC during the taxable year of the lower-tier CFC that, by
reason of section 245A(e), was included in the upper-tier CFC's foreign
personal holding company income and that by reason of section 951(a) was
included in income of the section 245A shareholder, and that would have
given rise to a tiered extraordinary reduction amount by reason of
paragraph (f) of this section had paragraph (f) applied to the dividend
of which the section 245A shareholder would have included a pro rata
share of the tiered extraordinary reduction amount in income by reason
of section 951(a); and
(3) If the CFC is a lower-tier CFC for a portion of the taxable year
during
[[Page 503]]
which the lower-tier CFC pays any dividend to an upper-tier CFC, the sum
of the portion of the tiered extraordinary reduction amount of each
prior dividend received by an upper-tier CFC from the lower-tier CFC
during the taxable year that is included in income of the section 245A
shareholder by reason of section 951(a).
(3) Exceptions--(i) Elective exception to close CFC's taxable year--
(A) In general. For a taxable year of a CFC in which an extraordinary
reduction occurs with respect to a controlling section 245A shareholder
and for which, absent this paragraph (e)(3)(i), there would be an
extraordinary reduction amount or tiered extraordinary reduction amount
greater than zero, no amount is considered an extraordinary reduction
amount or tiered extraordinary reduction amount with respect to the
controlling section 245A shareholder if each controlling section 245A
shareholder elects, and each U.S. tax resident described in paragraph
(e)(3)(i)(C)(2) of this section agrees, pursuant to this paragraph
(e)(3)(i), to close the CFC's taxable year for all purposes of the
Internal Revenue Code (and, therefore, as to all shareholders of the
CFC) as of the end of the date on which the extraordinary reduction
occurs, or, if the extraordinary reduction occurs by reason of multiple
transactions, as of the end of each date on which a transaction forming
a part of the extraordinary reduction occurs. Because the determination
as to whether there would be an extraordinary reduction amount or tiered
extraordinary reduction amount greater than zero is made without regard
to this paragraph (e)(3)(i), this determination is made without taking
into account any elections that may be available, or other events that
may occur, solely by reason of an election described in this paragraph
(e)(3)(i), such as the application of section 954(b)(4) to a short
taxable year created as a result of the election. If an election is made
pursuant to this paragraph (e)(3)(i), all shareholders of the CFC that
are a controlling section 245A shareholder or a U.S. tax resident
described in paragraph (e)(3)(i)(C)(2) of this section must file their
respective U.S. income tax and information returns consistently with the
election. If each controlling section 245A shareholder elects to close
the CFC's taxable year, that closing will be treated as a change in
accounting period for purposes of the notice requirement in Sec. 1.964-
1(c)(3)(iii), treating any controlling section 245A shareholders as
controlling domestic shareholders for this purpose. However, the notice
described in Sec. 1.964-1(c)(3)(iii) does not need to be provided to
persons that are U.S. tax residents described in paragraph (e)(3)(i)(C)
of this section. For purposes of applying this paragraph (e)(3)(i), a
controlling section 245A shareholder that has an extraordinary reduction
(or a transaction forming a part thereof) with respect to a CFC is
treated as owning the same amount of stock it owned in the CFC
immediately before the extraordinary reduction (or a transaction forming
a part thereof) on the end of the date on which the extraordinary
reduction occurs (or such transaction forming a part thereof occurs). To
the extent that shares of a CFC are treated as owned by a controlling
section 245A shareholder as of the close of the CFC's taxable year
pursuant to the preceding sentence, such shares are treated as not being
owned by any other person as of the close of the CFC's taxable year.
(B) Allocation of foreign taxes. If an election is made pursuant to
this paragraph (e)(3) to close a CFC's taxable year and the CFC's
taxable year under foreign law (if any) does not close at the end of the
date on which the CFC's taxable year closes as a result of the election,
foreign taxes paid or accrued with respect to such foreign taxable year
are allocated between the period of the foreign taxable year that ends
with, and the period of the foreign taxable year that begins after, the
date on which the CFC's taxable year closes as a result of the election.
If there is more than one date on which the CFC's taxable year closes as
a result of the election, foreign taxes paid or accrued with respect to
the foreign taxable year are allocated to all such periods. The
allocation is made based on the respective portions of the taxable
income of the CFC (as determined under foreign law) for the foreign
taxable year that are attributable under the principles of Sec. 1.1502-
76(b) to the periods during the
[[Page 504]]
foreign taxable year. Foreign taxes allocated to a period under this
paragraph (e)(3)(i)(B) are treated as paid or accrued by the CFC as of
the close of that period.
(C) Time and manner of making election--(1) Election by controlling
section 245A shareholder. An election pursuant to this paragraph (e)(3)
is made and effective if the statement described in paragraph
(e)(3)(i)(D) of this section is timely filed (including extensions) by
each controlling section 245A shareholder making the election with its
original U.S. tax return for the taxable year in which the extraordinary
reduction occurs. If a controlling section 245A shareholder is a member
of a consolidated group (within the meaning of Sec. 1.1502-1(h)) and
participates in the extraordinary reduction, the agent for such group
(within the meaning of Sec. 1.1502-77(c)(1)) must file the election
described in this paragraph (e)(3) on behalf of such member.
(2) Binding agreement. Before the filing of the statement described
in paragraph (e)(3)(i)(D) of this section, each controlling section 245A
shareholder must enter into a written, binding agreement with each U.S.
tax resident that on the end of the date on which the extraordinary
reduction occurs (or, if the extraordinary reduction occurs by reason of
multiple transactions, each U.S. tax resident that on the end of each
date on which a transaction forming a part of the extraordinary
reduction occurs) owns directly or indirectly, without regard to the
final two sentences of paragraph (e)(3)(i)(A) of this section, stock of
the CFC and is a United States shareholder with respect to the CFC. In
the case of a U.S. tax resident that owns stock of the CFC indirectly
through one or more partnerships, the partnership that directly owns the
stock of the CFC may enter into the binding agreement on behalf of the
U.S. tax resident partner provided that, before the due date of the
partner's original Federal income tax return, including extensions, the
partner delegated the authority to the partnership to enter into the
binding agreement pursuant to a written partnership agreement (within
the meaning of Sec. 1.704-1(b)(2)(ii)(h)). The written, binding
agreement must provide that each controlling section 245A shareholder
will elect to close the taxable year of the CFC.
(3) Transition rule. In the case of an extraordinary reduction
occurring before August 27, 2020, the statement described in paragraph
(e)(3)(i)(D) of this section is considered timely filed if it is
attached by each controlling section 245A shareholder to an original or
amended return for the taxable year in which the extraordinary reduction
occurs. In the case of an amended return, the statement is considered
timely filed only if it is filed with an amended return no later than
February 23, 2021.
(D) Form and content of statement. The statement required by
paragraph (e)(3)(i)(C) of this section is to be titled ``Elective
Section 245A Year-Closing Statement.'' The statement must--
(1) Identify (by name and tax identification number, if any) each
controlling section 245A shareholder, each U.S tax resident described in
paragraph (e)(3)(i)(C) of this section, and the CFC;
(2) State the date of the extraordinary reduction (or, if the
extraordinary reduction includes transactions on more than one date, the
dates of all such transactions) to which the election applies;
(3) State the filing controlling section 245A shareholder's pro rata
share of the subpart F income, tested income, and foreign taxes
described in section 960 with respect to the stock of the CFC subject to
the extraordinary reduction, and, if applicable, the amount of earnings
and profits attributable to such stock within the meaning of section
1248, as of the date of the extraordinary reduction;
(4) State that each controlling section 245A shareholder and each
U.S tax resident described in paragraph (e)(3)(i)(C) of this section
have entered into a written, binding agreement to elect to close the
CFC's taxable year in accordance with paragraph (e)(3)(i)(C) of this
section; and
(5) Be filed in the manner, if any, prescribed by forms,
publications, or other guidance published in the Internal Revenue
Bulletin.
(E) Consistency requirements. If multiple extraordinary reductions
occur with respect to one or more controlling section 245A shareholders'
ownership in
[[Page 505]]
a single CFC during one or more taxable years of the CFC, then to the
extent those extraordinary reductions occur pursuant to a plan or series
of related transactions, the election described in this paragraph (e)(3)
section may be made only if it is made for all such extraordinary
reductions with respect to the CFC for which there was an extraordinary
reduction amount. Furthermore, if an extraordinary reduction occurs with
respect to a controlling section 245A shareholders' ownership in one or
more CFCs, then, to the extent those extraordinary reductions occur
pursuant to a plan or series of related transactions, the election
described in this paragraph (e)(3) may be made only if it is made for
each extraordinary reduction for which there was an extraordinary
reduction amount with respect to all of the CFCs that have the same or
related (within the meaning of section 267(b) or 707(b)) controlling
section 245A shareholders.
(ii) De minimis subpart F income and tested income. For a taxable
year of a CFC in which an extraordinary reduction occurs, no amount is
considered an extraordinary reduction amount (or, with respect to a
lower-tier CFC, a tiered extraordinary reduction amount under paragraph
(f) of this section) with respect to a controlling section 245A
shareholder of the CFC if the sum of the CFC's subpart F income and
tested income (as defined in section 951A(c)(2)(A)) for the taxable year
does not exceed the lesser of $50 million or 5 percent of the CFC's
total income for the taxable year.
(f) Limitation of amount eligible for section 954(c)(6) where
extraordinary reduction occurs with respect to lower-tier CFCs--(1) In
general. If an extraordinary reduction occurs with respect to a lower-
tier CFC and an upper-tier CFC receives a dividend from the lower-tier
CFC in the taxable year in which the extraordinary reduction occurs,
then the dividend is eligible for the exception to foreign personal
holding company income under section 954(c)(6) (provided all other
applicable requirements are satisfied) only with respect to the portion
of the dividend that exceeds the tiered extraordinary reduction amount.
The preceding sentence does not apply to an amount treated as a dividend
received by an upper-tier CFC by reason of section 964(e)(4) (in this
case, see paragraphs (b)(1) and (g)(2) of this section). See paragraph
(j)(7) of this section for an example illustrating the application of
this paragraph (f)(1).
(2) Definition of tiered extraordinary reduction amount. The term
tiered extraordinary reduction amount means, with respect to the portion
of a dividend received by an upper-tier CFC from a lower-tier CFC during
a taxable year of the lower-tier CFC, the amount of such dividend equal
to the excess, if any, of--
(i) The product of--
(A) The sum of the amount of the subpart F income and tested income
of the lower-tier CFC for the taxable year; and
(B) The percentage (by value) of stock of the lower-tier CFC owned
(within the meaning of section 958(a)(2)) by the upper-tier CFC
immediately before the extraordinary reduction (or the first transaction
forming a part thereof); over
(ii) The following amounts--
(A) The sum of each U.S. tax resident's pro rata share of the lower-
tier CFC's subpart F income and tested income under section 951(a) or
951A(a), respectively, that is attributable to shares of the lower-tier
CFC owned (within the meaning of section 958(a)(2)) by the upper-tier
CFC immediately prior to the extraordinary reduction (or the first
transaction forming a part thereof), computed without the application of
this paragraph (f);
(B) The sum of each prior tiered extraordinary reduction amount and
sum of each amount included in an upper-tier CFC's subpart F income by
reason of section 245A(e) with respect to prior dividends from the
lower-tier CFC during the taxable year;
(C) The sum of each U.S. tax resident's pro rata share of an upper-
tier CFC's subpart F income under section 951(a) and Sec. 1.951-1(e)
that is attributable to dividends received from the lower-tier CFC in
the taxable year of the extraordinary reduction that do not qualify for
the exception to foreign personal holding company income under section
954(c)(6) because the dividends, or portions thereof, are properly
[[Page 506]]
allocable to subpart F income of the lower-tier CFC for the taxable year
of the extraordinary reduction pursuant to section 954(c)(6)(A);
(D) The sum of the prior extraordinary reduction amounts (but, for
this purpose, computed without regard to amounts described in paragraphs
(e)(2)(ii)(C)(2) and (3) of this section) of each controlling section
245A shareholder with respect to shares of the lower-tier CFC that were
owned by such controlling section 245A shareholder (including indirectly
through a specified entity other than a foreign corporation) for a
portion of the taxable year but are owned by an upper-tier CFC
(including indirectly through a specified entity other than a foreign
corporation) at the time of the distribution of the dividend; and
(E) The product of the amount described in paragraph (f)(2)(i)(B) of
this section and the sum of the amounts of each U.S. tax resident's pro
rata share of subpart F income and tested income for the taxable year
under section 951(a) or 951A(a), respectively, attributable to shares of
the lower-tier CFC directly or indirectly acquired by the U.S. tax
resident from the lower-tier CFC during the taxable year.
(3) Transition rule for computing tiered extraordinary reduction
amount. Solely for purposes of applying this paragraph (f) in taxable
years of a lower-tier CFC beginning on or after January 1, 2018, and
ending before June 14, 2019, a tiered extraordinary reduction amount is
determined by treating the lower-tier CFC's subpart F income for the
taxable year as if it were neither subpart F income nor tested income.
(g) Special rules. The rules in this paragraph (g) apply for
purposes of this section.
(1) Source of dividends. A dividend received by any person is
considered received directly by such person from the foreign corporation
whose earnings and profits give rise to the dividend. Therefore, for
example, if a section 245A shareholder sells or exchanges stock of an
upper-tier CFC and the gain recognized on the sale or exchange is
included in the gross income of the section 245A shareholder as a
dividend under section 1248(a), then, to the extent the dividend is
attributable under section 1248(c)(2) to the earnings and profits of a
lower-tier CFC owned, within the meaning of section 958(a)(2), by the
section 245A shareholder through the upper-tier CFC, the dividend is
considered received directly by the section 245A shareholder from the
lower-tier CFC.
(2) Certain section 964(e) inclusions treated as dividends. An
amount included in the gross income of a section 245A shareholder under
section 951(a)(1)(A) by reason of section 964(e)(4) is considered a
dividend received by the section 245A shareholder directly from the
foreign corporation whose earnings and profits give rise to the amount
described in section 964(e)(1). Therefore, for example, if an upper-tier
CFC sells or exchanges stock of a lower-tier CFC, and, as a result of
the sale or exchange, a section 245A shareholder with respect to the
upper-tier CFC includes an amount in gross income under section
951(a)(1)(A) by reason of section 964(e)(4), then the inclusion is
treated as a dividend received directly by the section 245A shareholder
from the lower-tier CFC whose earnings and profits give rise to the
dividend, and the section 245A shareholder is not allowed a section 245A
deduction for the dividend to the extent of the ineligible amount of
such dividend.
(3) Rules regarding stock ownership and stock transfers--(i)
Determining indirect ownership of stock of an SFC or a CFC. For purposes
of this section, if a person owns an interest in, or stock of, a
specified entity, including through a chain of ownership of one or more
other specified entities, then the person is considered to own
indirectly a pro rata share of stock of an SFC or a CFC owned by the
specified entity. To determine a person's pro rata share of stock owned
by a specified entity, the principles of section 958(a) apply without
regard to whether the specified entity is foreign or domestic.
(ii) Determining indirect transfers for stock owned indirectly. If,
under paragraph (g)(3)(i) of this section, a person is considered to own
indirectly stock of an SFC or CFC that is owned by a specified entity,
then the following rules apply in determining if the person transfers
stock of the SFC or CFC--
[[Page 507]]
(A) To the extent the specified entity transfers stock that is
considered owned indirectly by the person immediately before the
transfer, the person is considered to transfer indirectly such stock;
(B) If the person transfers an interest in, or stock of, the
specified entity, then the person is considered to transfer indirectly
the stock of the SFC or CFC attributable to the interest in, or the
stock of, the specified entity that is transferred; and
(C) In the case in which the person owns the specified entity
through a chain of ownership of one or more other specified entities, if
there is a transfer of an interest in, or stock of, another specified
entity in the chain of ownership, then the person is considered to
transfer indirectly the stock of the SFC or CFC attributable to the
interest in, or the stock of, the other specified entity transferred.
(iii) Definition of specified entity. The term specified entity
means any partnership, trust (other than a trust treated as a
corporation for U.S. income tax purposes), or estate (in each case,
domestic or foreign), or any foreign corporation.
(4) Coordination rules--(i) General rule. A dividend is first
subject to section 245A(e). To the extent the dividend is not a hybrid
dividend or tiered hybrid dividend under section 245A(e), the dividend
is subject to paragraph (e) or (f) of this section, as applicable, and
then, to the extent the dividend is not subject to paragraph (e) or (f)
of this section, it is subject to paragraph (c) or (d) of this section,
as applicable.
(ii) Coordination rule for paragraphs (c) and (d) and (e) and (f) of
this section, respectively. If an SFC or CFC pays a dividend (or
simultaneous dividends), a portion of which may be subject to paragraph
(c) or (e) of this section and a portion of which may be subject to
paragraph (d) or (f) of this section, the rules of this section apply by
treating the portion of the dividend or dividends that may be subject to
paragraph (c) or (e) of this section as if it occurred immediately
before the portion of the dividend or dividends that may be subject to
paragraph (d) or (f) of this section. For example, if a dividend arising
under section 964(e)(4) occurs at the same time as a dividend that would
be eligible for the exception to foreign personal holding company income
under section 954(c)(6) but for the potential application of paragraph
(d) this section, then the tiered extraordinary disposition amount with
respect to the other dividend is determined as if the dividend arising
under section 964(e)(4) occurs immediately before the other dividend.
(5) Ordering rule for multiple dividends made by an SFC or a CFC
during a taxable year. If an SFC or a CFC pays dividends on more than
one date during its taxable year or at different times on the same date,
this section applies based on the order in which the dividends are paid.
(6) Partner's distributive share of a domestic partnership's pro
rata share of subpart F income or tested income. If a section 245A
shareholder or a U.S. tax resident is a direct or indirect partner in a
domestic partnership that is a United States shareholder with respect to
a CFC and includes in gross income its distributive share of the
domestic partnership's inclusion under section 951(a) or 951A(a) with
respect to the CFC then, solely for purposes of this section, a
reference to the section 245A shareholder's or U.S. tax resident's pro
rata share of the CFC's subpart F income or tested income included in
gross income under section 951(a) or 951A(a), respectively, includes
such person's distributive share of the domestic partnership's pro rata
share of the CFC's subpart F income or tested income. A person is an
indirect partner with respect to a domestic partnership if the person
indirectly owns the domestic partnership through one or more specified
entities (other than a foreign corporation).
(7) Related domestic corporations treated as a single domestic
corporation for certain purposes. For purposes of determining the extent
that a dividend is an extraordinary disposition amount or a tiered
extraordinary disposition amount, as well as for purposes of determining
the extent to which an extraordinary disposition account is reduced by a
prior extraordinary disposition amount, domestic corporations that are
related parties are treated as a single domestic corporation. Thus,
[[Page 508]]
for example, if two domestic corporations are related parties and either
or both of them are section 245A shareholders with respect to an SFC,
then the extent to which a dividend received by either domestic
corporation from the SFC is an extraordinary disposition amount is based
on the sum of each domestic corporation's extraordinary disposition
account with respect to the SFC. When, by reason of this paragraph
(g)(7), the extent to which a dividend is an extraordinary disposition
amount or tiered extraordinary disposition amount is determined based on
the sum of two or more extraordinary disposition accounts, a pro rata
amount in each extraordinary disposition account is considered to give
rise to the extraordinary disposition amount or tiered extraordinary
disposition amount, if any.
(h) Anti-abuse rule. Appropriate adjustments are made pursuant to
this section, including adjustments that would disregard a transaction
or arrangement in whole or in part, to any amounts determined under (or
subject to the application of) this section if a transaction or
arrangement is engaged in with a principal purpose of avoiding the
purposes of this section. For examples illustrating the application of
this paragraph (h), see paragraphs (j)(8) through (10) of this section.
(i) Definitions. The following definitions apply for purposes of
this section.
(1) Controlled foreign corporation. The term controlled foreign
corporation (or CFC) has the meaning provided in section 957.
(2) Controlling section 245A shareholder. The term controlling
section 245A shareholder means, with respect to a CFC, any section 245A
shareholder that owns directly or indirectly more than 50 percent (by
vote or value) of the stock of the CFC. For purposes of determining
whether a section 245A shareholder is a controlling section 245A
shareholder with respect to a CFC, all stock of the CFC owned by a
related party with respect to the section 245A shareholder or by other
persons acting in concert with the section 245A shareholder to undertake
an extraordinary reduction is considered owned by the section 245A
shareholder. If section 964(e)(4) applies to a sale or exchange of a
lower-tier CFC with respect to a controlling section 245A shareholder,
all United States shareholders of the CFC are considered to act in
concert with regard to the sale or exchange. In addition, if all persons
selling stock in a CFC, held directly, sell such stock to the same buyer
or buyers (or a related party with respect to the buyer or buyers) as
part of the same plan, all sellers will be considered to act in concert
with regard to the sale or exchange.
(3) Disqualified amount. The term disqualified amount has the
meaning set forth in paragraph (d)(1) of this section.
(4) Disqualified period. The term disqualified period has the
meaning set forth in paragraph (c)(3)(iii) of this section.
(5) Extraordinary disposition. The term extraordinary disposition
has the meaning set forth in paragraph (c)(3)(ii) of this section.
(6) Extraordinary disposition account. The term extraordinary
disposition amount has the meaning set forth in paragraph (c)(3)(i) of
this section.
(7) Extraordinary disposition amount. The term extraordinary
disposition amount has the meaning set forth in paragraph (c)(1) of this
section.
(8) Extraordinary disposition E&P. The term extraordinary
disposition E&P has the meaning set forth in paragraph (c)(3)(i)(C) of
this section.
(9) Extraordinary disposition ownership percentage. The term
extraordinary disposition ownership percentage has the meaning set forth
in paragraph (c)(3)(i)(B) of this section.
(10) Extraordinary reduction. The term extraordinary reduction has
the meaning set forth in paragraph (e)(2)(i)(A) of this section.
(11) Extraordinary reduction amount. The term extraordinary
reduction amount has the meaning set forth in paragraph (e)(1) of this
section.
(12) Ineligible amount. The term ineligible amount has the meaning
set forth in paragraph (b)(2) of this section.
(13) Lower-tier CFC. The term lower-tier CFC means a CFC whose stock
is owned (within the meaning of section 958(a)(2)), in whole or in part,
by another CFC.
(14) Non-extraordinary disposition E&P. The term non-extraordinary
disposition
[[Page 509]]
E&P has the meaning set forth in paragraph (c)(2)(ii) of this section.
(15) Pre-reduction pro rata share. The term pre-reduction pro rata
share has the meaning set forth in paragraph (e)(2)(ii) of this section.
(16) Prior extraordinary disposition amount. The term prior
extraordinary disposition amount has the meaning set forth in paragraph
(c)(3)(i)(D) of this section.
(17) Prior extraordinary reduction amount. The term prior
extraordinary reduction amount has the meaning set forth in paragraph
(e)(2)(ii)(C) of this section.
(18) Qualified portion. The term qualified portion has the meaning
set forth in paragraph (c)(3)(i)(D)(2)(i) of this section.
(19) Related party. The term related party means, with respect to a
person, another person bearing a relationship described in section
267(b) or 707(b) to the person, in which case such persons are related.
(20) Section 245A deduction. The term section 245A deduction means,
with respect to a dividend received by a section 245A shareholder from
an SFC, the amount of the deduction allowed to the section 245A
shareholder by reason of the dividend.
(21) Section 245A shareholder. The term section 245A shareholder
means a domestic corporation that is a United States shareholder with
respect to an SFC and that owns directly or indirectly stock of the SFC.
(22) Specified 10-percent owned foreign corporation (SFC). The term
specified 10-percent owned foreign corporation (or SFC) has the meaning
provided in section 245A(b)(1).
(23) Specified entity. The term specified entity has the meaning set
forth in paragraph (g)(3)(iii) of this section.
(24) Specified property. The term specified property has the meaning
set forth in paragraph (c)(3)(iv) of this section.
(25) Tiered extraordinary disposition amount. The term tiered
extraordinary disposition amount has the meaning set forth in paragraph
(d)(2)(i) of this section.
(26) Tiered extraordinary reduction amount. The term tiered
extraordinary reduction amount has the meaning set forth in paragraph
(f)(2) of this section.
(27) United States shareholder. The term United States shareholder
has the meaning provided in section 951(b).
(28) Upper-tier CFC. The term upper-tier CFC means a CFC that owns
(within the meaning of section 958(a)(2)) stock in another CFC.
(29) U.S. tax resident. The term U.S. tax resident means a United
States person described in section 7701(a)(30)(A) or (C).
(j) Examples. The application of this section is illustrated by the
examples in this paragraph (j).
(1) Facts. Except as otherwise stated, the facts described in this
paragraph (j)(1) are assumed for purposes of the examples.
(i) US1 and US2 are domestic corporations, each with a calendar
taxable year, and are not related parties with respect to each other.
(ii) CFC1, CFC2, and CFC3 are foreign corporations that are SFCs and
CFCs.
(iii) Each entity uses the U.S. dollar as its functional currency.
(iv) Year 2 begins on or after January 1, 2018 and has 365 days.
(v) Absent application of this section, dividends received by US1
and US2 from a CFC meet the requirements to qualify for the section 245A
deduction, and dividends received by one CFC from another CFC qualify
for the exception to foreign personal holding company income under
section 954(c)(6).
(vi) The de minimis rules in paragraphs (c)(3)(ii)(E) and (e)(3)(ii)
of this section do not apply.
(vii) Section 1059 is not relevant to the tax results described in
the examples in this paragraph (j).
(2) Example 1. Extraordinary disposition--(i) Facts. US1 and US2 own
60% and 40%, respectively, of the single class of stock of CFC1. CFC1
owns all of the single class of stock of CFC2. CFC1 and CFC2 use the
taxable year ending November 30 as their taxable year. On November 1,
2018, CFC1 sells specified property to CFC2 in exchange for $200x of
cash (the ``Property Transfer''). The Property Transfer is outside of
CFC1's ordinary course of activities. The transferred property has a
basis of $100x in the hands of CFC1. CFC1 recognizes $100x of gain as a
result of the Property Transfer ($200x - $100x). On December 1, 2018,
CFC1 distributes $80x pro rata to US1 ($48x) and US2 ($32x), all of
which is a dividend within the meaning of section 316 and
[[Page 510]]
treated as a distribution out of earnings described in section
959(c)(3). No other distributions are made by CFC1 to either US1 or US2
in CFC1's taxable year ending November 30, 2019. For its taxable year
ending on November 30, 2019, CFC1 has $110x of earnings and profits
described in section 959(c)(3), without regard to any distributions
during the taxable year.
(ii) Analysis--(A) Identification of extraordinary disposition.
Because CFC1 is a CFC and uses the taxable year ending on November 30,
under paragraph (c)(3)(iii) of this section, it has a disqualified
period beginning on January 1, 2018, and ending on November 30, 2018. In
addition, under paragraph (c)(3)(ii) of this section, the Property
Transfer is an extraordinary disposition because it: Is a disposition of
specified property by CFC1 on a date on which it was a CFC and during
CFC1's disqualified period; is to CFC2, a related party with respect to
CFC1; occurs outside of the ordinary course of CFC1's activities; and,
is not subject to the de minimis rule in paragraph (c)(3)(ii)(E) of this
section.
(B) Determination of section 245A shareholders and their
extraordinary disposition accounts. Because CFC1 undertook an
extraordinary disposition, under paragraph (c)(3)(i) of this section, a
portion of CFC1's earnings and profits are extraordinary disposition E&P
and, therefore, give rise to an extraordinary disposition account with
respect to each of CFC1's section 245A shareholders. Under paragraph
(i)(21) of this section, US1 and US2 are both section 245A shareholders
with respect to CFC1. The amount of the extraordinary disposition
account with respect to US1 is $60x, which is equal to the product of
the extraordinary disposition E&P (the amount of the net gain recognized
by CFC1 as a result of the Property Transfer ($100x)) and the
extraordinary disposition ownership percentage (the percentage of the
stock of CFC1 owned directly or indirectly by US1 on January 1, 2018
(60%)), reduced by the prior extraordinary disposition amount ($0). See
paragraph (c)(3)(i) of this section. Similarly, the amount of the
extraordinary disposition account with respect to US2 is $40x, which is
equal to the product of the extraordinary disposition E&P (the net gain
recognized by CFC1 as a result of the Property Transfer ($100x)) and
extraordinary disposition ownership percentage (the percentage of the
stock of CFC1 owned directly or indirectly by US2 on January 1, 2018
(40%)), reduced by the prior extraordinary disposition amount ($0).
(C) Determination of extraordinary disposition amount with respect
to US1. The dividend of $48x paid to US1 on December 1, 2018, is an
extraordinary disposition amount to the extent the dividend is paid out
of the extraordinary disposition account with respect to US1. See
paragraph (c)(1) of this section. Under paragraph (c)(2)(i) of this
section, the dividend is first considered paid out of non-extraordinary
disposition E&P with respect to US1, to the extent thereof. With respect
to US1, $6x of CFC1's earnings and profits is non-extraordinary
disposition E&P, calculated as the excess of $66x (the product of $110x
of earnings and profits described in section 959(c)(3), without regard
to the $80x distribution, and 60%) over $60x (the balance of US1's
extraordinary disposition account with respect to CFC1, immediately
before the distribution). See paragraph (c)(2)(ii) of this section.
Thus, $6x of the dividend is considered paid out of non-extraordinary
disposition E&P with respect to US1. Under paragraph (c)(2)(i)(B) of
this section, the remaining $42x of the dividend is next considered paid
out of US1's extraordinary disposition account with respect to CFC1, to
the extent thereof. Accordingly, $42x of the dividend is considered paid
out of the extraordinary disposition account with respect to CFC1 and
gives rise to $42x of an extraordinary disposition amount. As a result,
US1's prior extraordinary disposition amount is increased by $42x under
paragraph (c)(3)(i)(D) of this section, and US1's extraordinary
disposition account is reduced to $18x ($60x - $42x) under paragraph
(c)(3)(i)(A) of this section.
(D) Determination of extraordinary disposition amount with respect
to US2. The dividend of $32x paid to US2, on December 1, 2018, is an
extraordinary disposition amount to the extent the dividend is paid out
of extraordinary disposition E&P with respect to US2. See paragraph
(c)(1) of this section. Under paragraph (c)(2)(i) of this section, the
dividend is first considered paid out of non-extraordinary disposition
E&P with respect to US2, to the extent thereof. With respect to US2, $4x
of CFC1's earnings and profits is non-extraordinary disposition E&P,
calculated as the excess of $44x (the product of $110x of earnings and
profits described in section 959(c)(3), without regard to the $80x
distribution, and 40%) over $40x (the balance of US2's extraordinary
disposition account with respect to CFC1, immediately before the
distribution). See paragraph (c)(2)(ii) of this section. Thus, $4x of
the dividend is considered paid out of non-extraordinary disposition E&P
with respect to US2. Under paragraph (c)(2)(i)(B) of this section, the
remaining $28x of the dividend is next considered paid out of US2's
extraordinary disposition account with respect to CFC1, to the extent
thereof. Accordingly, $28x of the dividend is considered paid out of the
extraordinary disposition account with respect to US2 and gives rise to
$28x of an extraordinary disposition amount. As a result, US2's prior
extraordinary disposition amount is increased by $28x under paragraph
(c)(3)(i)(D) of this section, and US2's extraordinary disposition
account is reduced to $12x ($40x - $28x) under paragraph (c)(3)(i)(A) of
this section.
(E) Determination of ineligible amount with respect to US1 and US2.
Under paragraph
[[Page 511]]
(b)(2) of this section, with respect to US1 and the dividend of $48x,
the ineligible amount is $21x, the sum of 50 percent of the
extraordinary disposition amount ($42x) and extraordinary reduction
amount ($0). Therefore, with respect to the dividend received by US1 of
$48x, $27x is eligible for a section 245A deduction. With respect to US2
and the dividend of $32x, the ineligible amount is $14x, the sum of 50%
of the extraordinary disposition amount ($28x) and extraordinary
reduction amount ($0). Therefore, with respect to the dividend received
by US2 of $32x, $18x is eligible for a section 245A deduction.
(3) Example 2. Application of section 954(c)(6) exception with
extraordinary disposition account--(i) Facts. The facts are the same as
in paragraph (j)(2)(i) of this section (the facts in Example 1) except
that the Property Transfer is a sale by CFC2 to CFC1 instead of a sale
by CFC1 to CFC2, the $80x distribution is by CFC2 to CFC1 in a separate
transaction that is unrelated to the Property Transfer, and the
description of the earnings and profits of CFC1 is applied to CFC2.
Additionally, absent the application of this section, section 954(c)(6)
would apply to the distribution by CFC2 to CFC1. Under section 951(a)(2)
and Sec. 1.951-1(b) and (e), US1's pro rata share of any subpart F
income of CFC1 is 60% and US2's pro rata share of any subpart F income
of CFC2 is 40%.
(ii) Analysis--(A) Identification of extraordinary disposition. The
Property Transfer is an extraordinary disposition under the same
analysis as provided in paragraph (j)(2)(ii)(A) of this section (the
analysis in Example 1).
(B) Determination of section 245A shareholders and their
extraordinary disposition accounts. Both US1 and US2 are section 245A
shareholders with respect to CFC2, US1 has an extraordinary disposition
account of $60x with respect to CFC2, and US2 has an extraordinary
disposition account of $40x with respect to CFC2 under the same analysis
as provided in paragraph (j)(2)(ii)(B) of this section (the analysis in
Example 1).
(C) Determination of tiered extraordinary disposition amount--(1) In
general. US1 and US2 each have a tiered extraordinary disposition amount
with respect to the $80x dividend paid by CFC2 to CFC1 to the extent
that US1 and US2 would have an extraordinary disposition amount if each
had received as a dividend its pro rata share of the dividend from CFC2.
See paragraph (d)(2)(i) of this section. Under paragraph (d)(2)(ii) of
this section, US1's pro rata share of the dividend is $48x (60% x $80x),
that is, the increase to US1's pro rata share of the subpart F income if
the dividend were included in CFC1's foreign personal holding company
income, without regard to section 952(c) and the allocation of expenses.
Similarly, US2's pro rata share of the dividend is $32x (40% x $80x).
(2) Determination of tiered extraordinary disposition amount with
respect to US1. The extraordinary disposition amount with respect to US1
is $42x, under the same analysis provided in paragraph (j)(2)(ii)(C) of
this section (the analysis in Example 1). Accordingly, the tiered
extraordinary disposition amount with respect to US1 is $42x.
(3) Determination of extraordinary disposition amount with respect
to US2. The extraordinary disposition amount with respect to US2 is
$28x, under the same analysis provided in paragraph (j)(2)(ii)(D) of
this section (the analysis in Example 1). Accordingly, the tiered
extraordinary disposition amount with respect to US2 is $28x.
(D) Limitation of section 954(c)(6) exception. The sum of US1 and
US2's tiered extraordinary disposition amounts is $70x ($42x + $28x).
The portion of the stock of CFC1 (by value) owned (within the meaning of
section 958(a)) by U.S. tax residents on the last day of CFC1's taxable
year is 100%. Under paragraph (d)(1) of this section, the disqualified
amount with respect to the dividend is $70x ($70x/100%). Accordingly,
the portion of the $80x dividend from CFC2 to CFC1 that is eligible for
the exception to foreign personal holding company income under section
954(c)(6) is $45x, equal to the sum of $10x (the portion of the $80x
dividend that exceeds the $70x disqualified amount) and $35x (50 percent
of $70x, the portion of the dividend that does not exceed the
disqualified amount). Under section 951(a)(2) and Sec. 1.951-1(b) and
(e), US1 includes $21x (60% x $35x) and US2 includes $14x (40% x $35x)
in income under section 951(a).
(E) Changes in extraordinary disposition account of US1. Under
paragraph (c)(3)(i)(D)(1) of this section, US1's prior extraordinary
disposition amount with respect to CFC2 is increased by $42x, or 200% of
$21x, the amount US1 included in income under section 951(a) with
respect to CFC1. Under paragraph (c)(3)(i)(D)(1)(iii) of this section,
US1 has no qualified portion because all of the owners of CFC2 are
section 245A shareholders with a tiered extraordinary disposition amount
with respect to CFC2. As a result, US1's extraordinary disposition
account is reduced to $18x ($60x-$42x) under paragraph (c)(3)(i)(A) of
this section.
(F) Changes in extraordinary disposition account of US2. Under
paragraph (c)(3)(i)(D)(1) of this section, US2's prior extraordinary
disposition amount with respect to CFC2 is increased by $28x, or 200% of
$14x, the amount US2 included in income under section 951(a) with
respect to CFC1. Under paragraph (c)(3)(i)(D)(1)(iii) of this section,
US2 has no qualified portion because all of the owners of CFC2 are
section 245A shareholders with a tiered extraordinary disposition amount
with respect to CFC2. As a result, US2's extraordinary disposition
account is reduced to $12x ($40x-$28x) under paragraph (c)(3)(i)(A) of
this section.
[[Page 512]]
(4) Example 3. Extraordinary reduction--(i) Facts. At the beginning
of CFC1's taxable year ending on December 31, Year 2, US1 owns all of
the single class of stock of CFC1, and no person transferred any CFC1
stock directly or indirectly in Year 1 pursuant to a plan to reduce the
percentage of stock (by value) of CFC1 owned by US1. Also as of the
beginning of Year 2, CFC1 has no earnings and profits described in
section 959(c)(1) or (2), and US1 does not have an extraordinary
disposition account with respect to CFC1. As of the end of Year 2, CFC1
has $160x of tested income and no other income. CFC1 has $160x of
earnings and profits for Year 2. On October 19, Year 2, US1 sells all of
its CFC1 stock to US2 for $100x in a transaction (the ``Stock Sale'') in
which US1 recognizes $90x of gain. Under section 1248(a), the entire
$90x of gain is included in US1's gross income as a dividend and,
pursuant to section 1248(j), the $90x is treated as a dividend for
purposes of applying section 245A. At the end of Year 2, under section
951A, US2 takes into account $70x of tested income, calculated as $160x
(100% of the $160x of tested income) less $90x, the amount described in
section 951(a)(2)(B). The amount described in section 951(a)(2)(B) is
the lesser of $90x, the amount of dividends received by US1 with respect
to the transferred stock, and $128x, the amount of tested income
attributable to the transferred stock ($160x) multiplied by 292/365 (the
ratio of the number of days in Year 2 that US2 did not own the
transferred stock to the total number of days in Year 2). US1 does not
make an election pursuant to paragraph (e)(3)(i) of this section.
(ii) Analysis--(A) Determination of controlling section 245A
shareholder and extraordinary reduction of ownership. Under paragraph
(i)(2) of this section, US1 is a controlling section 245A shareholder
with respect to CFC1. In addition, the Stock Sale results in an
extraordinary reduction with respect to US1's ownership of CFC1. See
paragraph (e)(2)(i) of this section. The extraordinary reduction occurs
because during Year 2, US1 transferred 100% of the CFC1 stock it owned
at the beginning of the year and such amount is more than 5% of the
total value of the stock of CFC1 at the beginning of Year 2; it also
occurs because on the last day of the year the percentage of stock (by
value) of CFC1 that US1 owns directly or indirectly (0%) (the end of
year percentage) is less than 90% of the stock (by value) of CFC1 that
US1 owns directly or indirectly on the day of the taxable year when it
owned the highest percentage of CFC1 stock by value (100%) (the initial
percentage), no transactions occurred in the preceding year pursuant to
a plan to reduce the percentage of CFC1 stock owned by US1, and the
difference between the initial percentage and the end of year percentage
(100 percentage points) is at least 5 percentage points.
(B) Determination of extraordinary reduction amount. Under paragraph
(e)(1) of this section, the entire $90x dividend to US1 is an
extraordinary reduction amount with respect to US1 because the dividend
is at least equal to US1's pre-reduction pro rata share of CFC1's Year 2
tested income described in paragraph (e)(2)(ii)(A) of this section
($160x), reduced by the amount of tested income taken into account by
US2, a U.S. tax resident, under paragraph (e)(2)(ii)(B) of this section
($70x).
(C) Determination of ineligible amount. Under paragraph (b)(2) of
this section, with respect to US1 and the dividend of $90x, the
ineligible amount is $90x, the sum of 50% of the extraordinary
disposition amount ($0) and extraordinary reduction amount ($90x).
Therefore, with respect to the dividend received of $90x, no portion is
eligible for the dividends received deduction allowed under section
245A(a).
(iii) Alternative facts--election to close CFC's taxable year. The
facts are the same as in paragraph (j)(4)(i) of this section (the facts
of this Example 3), except that, pursuant to paragraph (e)(3)(i) of this
section, US1 elects to close CFC1's Year 2 taxable year for all purposes
of the Code as of the end of October 19, Year 2, the date on which the
Stock Sale occurs; in addition, US1 and US2 enter into a written,
binding agreement that US1 will elect to close CFC1's Year 2 taxable
year. Accordingly, under section 951A(a), US1 takes into account 100% of
CFC1's tested income for the taxable year beginning January 1, Year 2,
and ending October 19, Year 2, and US2 takes into account 100% of CFC1's
tested income for the taxable year beginning October 20, Year 2, and
ending December 31, Year 2. Under paragraph (e)(3)(i)(A) of this
section, no amount is considered an extraordinary reduction amount with
respect to US1.
(5) Example 4. Extraordinary reduction; decrease in section 245A
shareholder's pre-reduction pro rata share for amounts taken into
account by U.S. tax residents--(i) Facts. At the beginning of CFC1's
taxable year ending December 31, Year 2, US1 owns all of the single
class of stock of CFC1, and no person transferred any CFC1 stock
directly or indirectly in Year 1 pursuant to a plan to reduce the
percentage of stock (by value) of CFC1 owned by US1. CFC1 generates
$120x of subpart F income during its taxable year ending on December 31,
Year 2. On October 1, Year 2, CFC1 distributes a $120x dividend to US1.
On October 19, Year 2, US1 sells 100% of its stock of CFC1 to PRS, a
domestic partnership, in a transaction in which no gain or loss is
realized (the ``Stock Sale''). A, an individual who is a citizen of the
United States, and B, a foreign individual who is not a U.S. tax
resident, each own 50% of the capital and profits interests of PRS. On
December 1, Year 2, US2 and FP, a foreign corporation, contribute
property to CFC1; in exchange, each of US2
[[Page 513]]
and FP receives 25% of the stock of CFC1. PRS owns the remaining 50% of
the stock of CFC1. US1 does not make an election pursuant to paragraph
(e)(3)(i) of this section.
(ii) Analysis--(A) Determination of controlling section 245A
shareholder and extraordinary reduction. Under paragraph (i)(2) of this
section, US1 is a controlling section 245A shareholder with respect to
CFC1. In addition, the Stock Sale results in an extraordinary reduction
with respect to US1's ownership of CFC1. See paragraph (e)(2)(i) of this
section. The extraordinary reduction occurs because during Year 2, US1
transferred 100% of the CFC1 stock it owns on the first day of Year 2,
and that amount is more than 5% of the total value of the stock of CFC1
at the beginning of Year 2; it also occurs because on the last day of
Year 2 the percentage of stock (by value) of CFC1 that US1 owns directly
or indirectly (0%) (the end of year percentage) is less than 90% of the
highest percentage of stock (by value) of CFC1 that US1 owns directly or
indirectly on the day of the taxable year when it owned the highest
percentage of CFC1 stock by value (100%) (the initial percentage), no
transactions occurred in the preceding year pursuant to a plan to reduce
the percentage of CFC1 stock owned by US1, and the difference between
the initial percentage and the end of year percentage (100 percentage
points) is at least 5 percentage points.
(B) Determination of pre-reduction pro rata share. Before the
extraordinary reduction, US1 owned 100% of the stock of CFC1. Thus,
under paragraph (e)(2)(ii)(A) of this section, the tentative amount of
US1's pre-reduction pro rata share of CFC1's subpart F income is $120x.
A and US2 are U.S. tax residents pursuant to paragraph (i)(29) of this
section because they are United States persons described in section
7701(a)(30)(A) or (C). Thus, US1's pre-reduction pro rata share amount
is subject to the reduction described in paragraph (e)(2)(ii)(B) of this
section because U.S. tax residents directly or indirectly acquire stock
of CFC1 from US1 or CFC1 during the taxable year in which the
extraordinary reduction occurs. With respect to US1's pre-reduction pro
rata share of CFC1's subpart F income, the reduction equals the amount
of subpart F income of CFC1 taken into account under section 951(a) by
these U.S. tax residents.
(C) Determination of decrease in pre-reduction pro rata share for
amounts taken into account by U.S. tax resident. On December 31, Year 2,
both PRS and US2 will be United States shareholders with respect to CFC1
and will include in gross income their pro rata share of CFC1's subpart
F income under section 951(a). With respect to US2, this amount will be
$30x, which is equal to 25% of CFC1's subpart F income for the taxable
year. With respect to PRS, its pro rata share of $60x under section
951(a)(2)(A) (50% of $120x) will be reduced under section 951(a)(2)(B)
by $48x. The section 951(a)(2)(B) reduction is equal to the lesser of
the $120x dividend paid with respect to those shares to US1 or $48x (50%
x $120x x 292/365, the period during the taxable year that PRS did not
own CFC1 stock). Thus, PRS includes $12x in gross income pursuant to
section 951(a). Of this amount, $6x is allocated to A (as a 50% partner
of PRS) and, therefore, treated as taken into account by A under
paragraphs (e)(2)(ii)(B) and (g)(6) of this section. Thus, A and US2
take into account a total of $36x of CFC1's subpart F income under
section 951(a). This amount reduces US1's pre-reduction pro rata share
of CFC1's subpart F income to $84x ($120x-$36x) under paragraph
(e)(2)(ii)(B) of this section. CFC1 did not generate tested income
during the taxable year and, therefore, no amount is taken into account
under section 951A with respect to CFC1, and US1 has no pre-reduction
pro rata share with respect to tested income of CFC1.
(D) Determination of extraordinary reduction amount. Under paragraph
(e)(1) of this section, the extraordinary reduction amount equals $84x,
which is the lesser of the amount of the dividend received by US1 from
CFC1 during Year 2 ($120x) and the sum of US1's pre-reduction pro rata
share of CFC1's subpart F income ($84x) and tested income ($0).
(E) Determination of ineligible amount. Under paragraph (b)(2) of
this section, with respect to US1 and the dividend of $120x, the
ineligible amount is $84x, the sum of 50% of the extraordinary
disposition amount ($0) and extraordinary reduction amount ($84x).
Therefore, with respect to the dividend received by US1 from CFC1, $36x
($120x-$84x) is eligible for a section 245A deduction.
(6) Example 5. Controlling section 245A shareholder--(i) Facts. US1
and US2 own 30% and 25% of the stock of CFC1, respectively. FP, a
foreign corporation that is not a CFC, owns all of the stock of US1 and
US2. FP owns the remaining 45% of the stock of CFC1. On September 30,
Year 2, US1 sells all of its stock of CFC1 to US3, a domestic
corporation that is not a related party with respect to FP, US1, or US2.
No person transferred any stock of CFC1 directly or indirectly in Year 1
pursuant to a plan to reduce the percentage of stock (by value) of CFC1
owned by US1.
(ii) Analysis. Under paragraph (i)(21) of this section, US1 is a
section 245A shareholder with respect to CFC1, an SFC. Because US1 owns,
together with US2 and FP (related persons with respect to US1), more
than 50% of the stock of CFC1, US1 is a controlling section 245A
shareholder of CFC1. The sale of US1's CFC1 stock results in an
extraordinary reduction occurring with respect to US1's ownership of
CFC1. The extraordinary reduction occurs because during Year 2, US1
transferred 100% of the stock of CFC1 that it owned at the beginning of
the year and that
[[Page 514]]
amount is more than 5% of the total value of the stock of CFC1 at the
beginning of Year 2. The extraordinary disposition also occurs because
on the last day of the year the percentage of stock (by value) of CFC1
that US1 directly or indirectly owns (0%) (the end of year percentage)
is less than 90% of the stock (by value) of CFC1 that US1 directly or
indirectly owned on the day of the taxable year when it owned the
highest percentage of CFC1 stock by value (30%) (the initial
percentage), no transactions occurred in the preceding year pursuant to
a plan to reduce the percentage of CFC1 stock owned by US1, and the
difference between the initial percentage and end of year percentage (30
percentage points) is at least 5 percentage points.
(7) Example 6. Limitation of section 954(c)(6) exception with
respect to an extraordinary reduction--(i) Facts. At the beginning of
CFC1 and CFC2's taxable year ending on December 31, Year 2, US1 and A,
an individual who is a citizen of the United States, own 80% and 20% of
the single class of stock of CFC1, respectively. CFC1 owns 100% of the
stock of CFC2. Both US1 and A are United States shareholders with
respect to CFC1 and CFC2, and US1 and A are not related parties with
respect to each other. No person transferred CFC2 stock directly or
indirectly in Year 2 pursuant to a plan to reduce the percentage of
stock (by value) of CFC2 owned by US1, and US1 does not have an
extraordinary disposition account with respect to CFC2. At the end of
Year 2, and without regard to any distributions during Year 2, CFC2 had
$150x of tested income and no other income, and CFC1 had no income or
expenses. On June 30, Year 2, CFC2 distributed $150x as a dividend to
CFC1, which would qualify for the exception from foreign personal
holding company income under section 954(c)(6) but for the application
of this section. On August 7, Year 2, CFC1 sells all of its CFC2 stock
to US2 for $100x in a transaction (the ``Stock Sale'') in which CFC1
realizes no gain or loss. At the end of Year 2, under section 951A, US2
takes into account $60x of tested income, calculated as $150x (100% of
the $150x of tested income) less $90x, the amount described in section
951(a)(2)(B). The amount described in section 951(a)(2)(B) is the lesser
of $150x, the amount of dividends received by CFC1 during Year 2 with
respect to the transferred stock, and $90x, the amount of tested income
attributable to the transferred stock ($150x) multiplied by 219/365 (the
ratio of the number of days in Year 2 that US2 did not own the
transferred stock to the total number of days in Year 2). US1 does not
make an election pursuant to paragraph (e)(3)(i) of this section.
(ii) Analysis--(A) Determination of controlling section 245A
shareholder and extraordinary reduction of ownership. Under paragraph
(i)(2) of this section, US1 is a controlling section 245A shareholder
with respect to CFC2, but A is not. In addition, the Stock Sale results
in an extraordinary reduction with respect to US1's ownership of CFC2.
See paragraph (e)(2)(i) of this section. The extraordinary reduction
occurs because during Year 2, US1 transferred indirectly 100% of the
CFC2 stock it owned at the beginning of the year and such amount is more
than 5% of the total value of the stock of CFC2 at the beginning of Year
2. The extraordinary disposition also occurs because on the last day of
the year the percentage of stock (by value) of CFC2 that US1 owns
directly or indirectly (0%) (the end of year percentage) is less than
90% of the stock (by value) of CFC2 that US1 owns directly or indirectly
on the day of the taxable year when it owned the highest percentage of
CFC2 stock by value (80%) (the initial percentage), no transactions
occurred in the preceding year pursuant to a plan to reduce the
percentage of CFC2 stock owned by US1, and the difference between the
initial percentage and the end of year percentage (80 percentage points)
is at least 5 percentage points. Because there is an extraordinary
reduction with respect to CFC2 in Year 2 and CFC1 received a dividend
from CFC2 in Year 2, under paragraph (f)(1) of this section, it is
necessary to determine the limitation on the amount of the dividend
eligible for the exception under section 954(c)(6).
(B) Determination of tiered extraordinary reduction amount. The
limitation on the amount of the dividend eligible for the exception
under section 954(c)(6) is based on the tiered extraordinary reduction
amount. The sum of the amount of subpart F income and tested income of
CFC2 for Year 2 is $150x, and immediately before the extraordinary
reduction, CFC1 held 100% of the stock of CFC2. Additionally, US2 is a
U.S. tax resident as defined in paragraph (i)(29) of this section
because it is a United States person described in section 7701(a)(30)(A)
or (C), and US2 has a pro rata share of $60x of tested income under
section 951A with respect to CFC2. Accordingly, under paragraph (f)(2)
of this section, the tiered extraordinary reduction amount is $90x
(($150x x 100%) - $60x).
(C) Limitation of section 954(c)(6) exception. Under paragraph
(f)(1) of this section, the portion of the $150x dividend from CFC2 to
CFC1 that is eligible for the exception to foreign personal holding
company income under section 954(c)(6) is $60x ($150x - $90x). To the
extent that the $90x that does not qualify for the exception gives rise
to additional subpart F income to CFC1, both US1 and A will take into
account their pro rata share of that subpart F income under section
951(a)(2) and Sec. 1.951-1(b) and (e).
(8) Example 7. Application of anti-abuse rule to a prepayment of a
royalty--(i) Facts. US1 owns 100% of the single class of stock of
[[Page 515]]
CFC1 and CFC2. CFC1 has a November 30 taxable year, and CFC2 has a
calendar year taxable year. There is a license agreement between CFC1
and CFC2 pursuant to which CFC2 is obligated to pay annual royalties to
CFC1 for the use of intangible property. As of November 1, 2018, the
remaining term of the agreement is 10 years. On November 1, 2018, CFC1
receives from CFC2, and accrues into income, $100x of pre-paid royalties
that are for the use of the intangible property for the subsequent 10
years. The form of the arrangement as a license, including the
prepayment of the royalty, is respected for U.S. tax purposes; therefore
CFC1's receipt of the $100x royalty prepayment does not constitute a
disposition of the intangible property and is excluded from CFC1's
subpart F income pursuant to section 954(c)(6). A principal purpose of
CFC2 prepaying the royalty is for CFC1 to generate earnings and profits
during the disqualified period that would not be subject to current U.S.
tax yet may be eligible for the section 245A deduction and could, for
example, be used to reduce the amount of gain recognized on a
disposition of the stock of CFC1 that would be subject to U.S. tax by
increasing the portion of such gain treated as a dividend.
(ii) Analysis. Because the royalty prepayment was carried out with a
principal purpose of avoiding the purposes of this section, appropriate
adjustments are required to be made under the anti-abuse rule in
paragraph (h) of this section. CFC1 is a CFC that has a November 30
taxable year, so under paragraph (c)(3)(iii) of this section, CFC1 has a
disqualified period beginning on January 1, 2018, and ending on November
30, 2018. In addition, even though the intangible property licensed by
CFC1 to CFC2 is specified property, CFC2's prepayment of the royalty
would not be treated as a disposition of the specified property by CFC1
and, therefore, would not constitute an extraordinary disposition (and
thus would not give rise to extraordinary disposition E&P), absent the
application of the anti-abuse rule of paragraph (h) of this section.
Pursuant to paragraph (h) of this section, the earnings and profits of
CFC1 generated as a result of the $100x of prepaid royalty are treated
as extraordinary disposition E&P for purposes of this section and,
therefore, US1 has an extraordinary disposition account with respect to
CFC1 of $100x. In addition, the prepaid royalty gives rise to a
disqualified payment (as defined in Sec. 1.951A-2(c)(6)(ii)(A)) of
$100x. As a result, Sec. 1.245A-7(b) or Sec. 1.245A-8(b), as
applicable, applies to reduce the disqualified payment in the same
manner as if the disqualified payment were disqualified basis, and Sec.
1.245A-7(c) or Sec. 1.245A-8(c), as applicable, applies to reduce the
extraordinary disposition account in the same manner as if the
deductions directly or indirectly related to the disqualified payment
were deductions attributable to disqualified basis of an item of
specified property that corresponds to the extraordinary disposition
account.
(9) Example 8. Application of anti-abuse rule to restructuring
transaction--(i) Facts. FP, a foreign corporation with no United States
shareholders, owns 100% of the single class of stock of US1. US1 owns
100% of the single class of stock of CFC1 that, in turn, owns 100% of
the single class of stock of CFC2. CFC2 has $100x of extraordinary
disposition E&P, and US1 has a $100x extraordinary disposition account
with respect to CFC2. In Year 1, FP transfers property to CFC1 in
exchange for newly issued stock of CFC1. After the transfer, FP and US1
own, respectively, 90% and 10% of the single class of stock of CFC1. In
Year 3, CFC2 pays a $100x dividend to CFC1, and the dividend gives rise
to a tiered extraordinary disposition amount with respect to US1 of
$10x. US1 includes $10x in gross income under section 951(a) with
respect to the tiered extraordinary disposition amount. The $10x tiered
extraordinary disposition amount reduces US1's extraordinary disposition
account from $100x to $90x. In Year 5, CFC1 redeems all of the stock of
CFC1 held by US1 in exchange for $100x of cash. Under sections 302(d)
and 301(c)(1), the redemption results in a $100x dividend to US1. Under
section 959(a), $10x of the $100x dividend is not included in US1's
gross income and, but for the application of paragraph (h) of this
section, US1 would claim a section 245A deduction of $90x with respect
to $90x of the dividend. The transfer of property from FP to CFC1 in
exchange for stock of CFC1, the $100x dividend from CFC2 to CFC1, and
CFC1's redemption of all of its stock held by US1 (together, the
``Transaction'') were undertaken with the principal purpose of avoiding
the application of this section to distributions from CFC2. As a result
of the redemption, CFC2 is wholly owned by FP through CFC1, and CFC2's
earnings and profits can be distributed without incurring U.S. tax
irrespective of the availability of the section 245A deduction or the
exception under section 954(c)(6).
(ii) Analysis. Because the Transaction was carried out with a
principal purpose of avoiding the purposes of this section, appropriate
adjustments are required to be made under the anti-abuse rule in
paragraph (h) of this section. Pursuant to paragraph (h) of this
section, all $90x of the dividend included in US1's income in Year 5 is
treated as an extraordinary disposition amount. Therefore, $45x of the
dividend is treated as an ineligible amount for which US1 cannot claim a
section 245A deduction pursuant to paragraph (b)(2)(i) of this section
(that is, 50% of the extraordinary disposition amount) and, accordingly,
US1 is only allowed a section 245A deduction of $45x ($90x dividend
received, less the $45x ineligible amount) with respect to the $90x
dividend from CFC1 that
[[Page 516]]
it included in income. In addition, US1's extraordinary disposition
account with respect to CFC2 is reduced from $90x to zero pursuant to
paragraph (c)(3)(i)(A) and (D) of this section.
(10) Example 9. Application of anti-abuse rule to a related-party
loan--(i) Facts. US1 owns 100% of the single class of stock of CFC1 and
CFC2. US1 does not own stock of any other foreign corporation. US1
intends to repatriate $100x cash from CFC1 at the end of taxable year
Y1. At the end of taxable year Y1, CFC1 has $100x of earnings and
profits described in section 959(c)(3) (all of which is extraordinary
disposition E&P) and $100x of cash, and US1 has an extraordinary
disposition account balance with respect to CFC1 equal to $100x. In
addition, at the end of taxable year Y1, CFC2 has $100x of earnings and
profits described in section 959(c)(3). US1 does not have an
extraordinary disposition account with respect to CFC2. Anticipating the
application of this section to a distribution from CFC1, US1 instead
causes CFC1 to loan $100x of cash to CFC2 during taxable year Y1 in
exchange for a $100x note. The form of the transaction is respected as a
loan for U.S. tax purposes. At the end of taxable Y1, CFC2 distributes
$100x of cash to US1. The loan and distribution are part of a plan a
principal purpose of which is to repatriate CFC1's $100x cash without
triggering the application of this section.
(ii) Analysis. Because the loan from CFC1 to CFC2 and the subsequent
distribution of cash were carried out with a principal purpose of
avoiding the purposes of this section, appropriate adjustments are
required to be made under the anti-abuse rule in paragraph (h) of this
section. Pursuant to that rule, the distribution of $100x of cash is
treated as a distribution out of US1's extraordinary disposition account
with respect to CFC1. Accordingly, the $100x distribution is taxed as a
dividend, and only $50x of the dividend received by US1 is eligible for
the section 245A deduction pursuant to paragraph (b)(1) of this section.
As a result of the distribution, the balance of US1's extraordinary
disposition account with respect to CFC1 is reduced by $100x to zero
pursuant to paragraph (c)(3)(i)(A) of this section.
(k) Applicability date--(1) In general. This section applies to
taxable periods of a foreign corporation ending on or after June 14,
2019, and to taxable periods of section 245A shareholders in which or
with which such taxable periods end. For taxable periods described in
the previous sentence, this section (and not Sec. 1.245A-5T) applies
regardless of whether, but for this paragraph (k)(1), Sec. 1.245A-5T
would apply. See Sec. 1.245A-5T as contained in 26 CFR part 1 edition
revised as of April 1, 2020 for distributions occurring after December
31, 2017, as to which this section does not apply.
(2) Early application of this section. Notwithstanding paragraph
(k)(1) of this section, a taxpayer may choose to apply this section to
taxable periods of a foreign corporation ending before June 14, 2019,
and to taxable periods of section 245A shareholders in which or with
which such taxable periods end, provided that the taxpayer and all
persons bearing a relationship to the taxpayer described in section
267(b) or 707(b) apply this section in its entirety for all such taxable
periods.
[T.D. 9909, 85 FR 53083, Aug. 27, 2020, as amended by 85 FR 60358, Sept.
25, 2020; 85 FR 72564, Nov. 13, 2020; T.D. 9934, 85 FR 76963, Dec. 1,
2020]
Sec. 1.245A-6 Coordination of extraordinary disposition and
disqualified basis rules.
(a) Scope. This section and Sec. Sec. 1.245A-7 through 1.245A-11
coordinate the application of the extraordinary disposition rules of
Sec. 1.245A-5(c) and (d) and the disqualified basis rule of Sec.
1.951A-2(c)(5). Section 1.245A-7 provides coordination rules for simple
cases, and Sec. 1.245A-8 provides coordination rules for complex cases.
Section 1.245A-9 provides definitions and other rules, including rules
of general applicability for purposes of this section and Sec. Sec.
1.245A-7 through 1.245A-11. Section 1.245A-10 provides examples
illustrating the application of this section and Sec. Sec. 1.245A-7
through 1.245A-9. Section 1.245A-11 provides applicability dates.
(b) Conditions to apply coordination rules for simple cases. For a
taxable year of a section 245A shareholder for which the conditions
described in paragraphs (b)(1) and (2) of this section are satisfied,
the section 245A shareholder may apply the coordination rules of Sec.
1.245A-7 (rules for simple cases) to an extraordinary disposition
account of the section 245A shareholder with respect to an SFC and
disqualified basis of an item of specified property that corresponds to
the extraordinary disposition account (as determined pursuant to Sec.
1.245A-9(b)(1)). If the conditions are not satisfied, then the
coordination rules of Sec. 1.245A-8 (rules for complex cases) apply
beginning with the first
[[Page 517]]
day of the first taxable year of the section 245A shareholder for which
the conditions are not satisfied and all taxable years thereafter. If
the conditions are satisfied for a taxable year of the section 245A
shareholder but the section 245A shareholder chooses not to apply the
coordination rules of Sec. 1.245A-7 for that taxable year, then the
coordination rules of Sec. 1.245A-8 apply to that taxable year (though,
for a subsequent taxable year, the section 245A shareholder may apply
the coordination rules of Sec. 1.245A-7, provided that the conditions
described in paragraphs (b)(1) and (2) of this section are satisfied for
such subsequent taxable year and have been satisfied for all earlier
taxable years). For purposes of applying paragraphs (b)(1) and (2) of
this section, a reference to a section 245A shareholder, an SFC, or a
CFC does not include a successor of the section 245A shareholder, the
SFC, or the CFC, respectively.
(1) Requirements related to the SFC. The condition of this paragraph
(b)(1) is satisfied for a taxable year of the section 245A shareholder
if the following requirements are satisfied:
(i) On January 1, 2018, the section 245A shareholder owns (within
the meaning of section 958(a)) all of the stock (by vote and value) of
the SFC.
(ii) On each day of the taxable year of the section 245A
shareholder, the section 245A shareholder owns (within the meaning of
section 958(a)) all of the stock (by vote and value) of the SFC.
(iii) On no day during the taxable year of the section 245A
shareholder was the SFC a distributing or controlled corporation in a
transaction described in a section 355, or did the SFC acquire the
assets of a corporation as to which there is an extraordinary
disposition account pursuant to a transaction described in section 381
(that is, taking into account the requirements of this paragraph (b)(1)
and paragraph (b)(2) of this section, the section 245A shareholder's
extraordinary disposition account with respect to the SFC has not been
not been adjusted pursuant to the rules of Sec. 1.245A-5(c)(4)).
(2) Requirements related to an item of specified property that
corresponds to an extraordinary disposition account and a CFC holding
the item. The condition of this paragraph (b)(2) is satisfied for a
taxable year of a section 245A shareholder if the following requirements
are satisfied:
(i) For each item of specified property with disqualified basis that
corresponds to the extraordinary disposition account, the item of
specified property is held by a CFC immediately after the extraordinary
disposition of the item of specified property.
(ii) For each CFC described in paragraph (b)(2)(i) of this section--
(A) All of the stock (by vote and value) of the CFC is owned (within
the meaning of section 958(a)) by the section 245A shareholder and any
domestic affiliates of the section 245A shareholder immediately after
the extraordinary disposition described in paragraph (b)(2)(i) of this
section;
(B) For each taxable year of the CFC that ends with or within the
taxable year of the section 245A shareholder, there is no extraordinary
disposition account with respect to the CFC, and the sum of the balance
of the hybrid deduction accounts (as described in Sec. 1.245A(e)-
1(d)(1)) with respect to shares of stock of the CFC is zero (determined
as of the end of the taxable year of the CFC and taking into account any
adjustments to the accounts for the taxable year); and
(C) On each day of each taxable year of the CFC that ends with or
within the taxable year of the section 245A shareholder, and on each day
of each taxable year of the CFC that begins with or within the taxable
year of the section 245A shareholder--
(1) The CFC holds the item of specified property described in
paragraph (b)(1)(i) of this section;
(2) The section 245A shareholder and any domestic affiliates own
(within the meaning of section 958(a)) all of the stock (by vote and
value) of the CFC;
(3) The CFC does not hold any item of specified property with
disqualified basis other than an item of specified property that
corresponds to the extraordinary disposition account;
(4) The CFC does not own an interest in a partnership, trust, or
estate (directly or indirectly through one or more other partnerships,
trusts, or estates) that holds an item of specified property with
disqualified basis; and
[[Page 518]]
(5) The CFC is not engaged in the conduct of a trade or business in
the United States and therefore does not have ECTI, and the CFC does not
have any deficit in earnings and profits subject to Sec. 1.381(c)(2)-
1(a)(5).
[T.D. 9934, 85 FR 76963, Dec. 1, 2020]
Sec. 1.245A-7 Coordination rules for simple cases.
(a) Scope. This section applies for a taxable year of a section 245A
shareholder for which the conditions of Sec. 1.245A-6(b)(1) and (2) are
satisfied and for which the section 245A shareholder chooses to apply
this section (in lieu of Sec. 1.245A-8).
(b) Reduction of disqualified basis by reason of an extraordinary
disposition amount or tiered extraordinary disposition amount--(1) In
general. If, for a taxable year of a section 245A shareholder, an
extraordinary disposition account of the section 245A shareholder gives
rise to one or more extraordinary disposition amounts or tiered
extraordinary disposition amounts, then, with respect to an item of
specified property that corresponds to the extraordinary disposition
account, the disqualified basis of the item of specified property is,
solely for purposes of Sec. 1.951A-2(c)(5), reduced (but not below
zero) by an amount (determined in the functional currency in which the
extraordinary disposition account is maintained) equal to the product
of--
(i) The sum of the extraordinary disposition amounts and the tiered
extraordinary disposition amounts; and
(ii) A fraction, the numerator of which is the disqualified basis of
the item of specified property, and the denominator of which is the sum
of the disqualified basis of each item of specified property that
corresponds to the extraordinary disposition account.
(2) Timing rules regarding disqualified basis. See Sec. 1.245A-
9(b)(2) for timing rules regarding the determination of, and reduction
to, disqualified basis of an item of specified property.
(3) Special rule regarding prior extraordinary disposition amounts.
For purposes of paragraph (b)(1) of this section, to the extent that an
extraordinary disposition account of a section 245A shareholder is
reduced under Sec. 1.245A-5(c)(3)(i)(A) by reason of a prior
extraordinary disposition amount described in Sec. 1.245A-
5(c)(3)(i)(D)(1)(i) through (iv), the extraordinary disposition account
is considered to give rise to an extraordinary disposition amount or
tiered extraordinary disposition amount (and the amount by which the
account is reduced is treated as an extraordinary disposition amount or
tiered extraordinary disposition amount).
(c) Reduction of extraordinary disposition account by reason of the
allocation and apportionment of deductions or losses attributable to
disqualified basis--(1) In general. If, for a taxable year of a CFC, the
CFC holds one or more items of specified property that correspond to an
extraordinary disposition account of a section 245A shareholder with
respect to an SFC, then the extraordinary disposition account is reduced
(but not below zero) by the lesser of the amounts described in
paragraphs (c)(1)(i) and (ii) of this section (each determined in the
functional currency of the CFC).
(i) The excess (if any) of the adjusted earnings of the CFC for the
taxable year of the CFC, over the sum of the previously taxed earnings
and profits accounts with respect to the CFC for purposes of section 959
(determined as of the end of the taxable year of the CFC and taking into
account any adjustments to the accounts for the taxable year).
(ii) The balance of the section 245A shareholder's RGI account with
respect to the CFC (determined as of the end of the taxable year of the
CFC, but without regard to the application of paragraph (c)(4)(ii) of
this section for the taxable year).
(2) Timing of reduction to extraordinary disposition account. See
Sec. 1.245A-9(b)(3) for timing rules regarding the reduction to an
extraordinary disposition account.
(3) Adjusted earnings. The term adjusted earnings means, with
respect to a CFC and a taxable year of the CFC, the earnings and profits
of the CFC, determined as of the end of the CFC's taxable year (taking
into account all distributions during the taxable year), and with the
adjustments described in paragraphs (c)(3)(i) through (iii) of this
section.
[[Page 519]]
(i) The earnings and profits are increased by the amount of any
deduction or loss that is or was allocated and apportioned to residual
CFC gross income of the CFC solely by reason of Sec. 1.951A-2(c)(5)(i).
(ii) The earnings and profits are decreased by the amount by which
an RGI account with respect to the CFC has been decreased pursuant to
paragraph (c)(4)(ii) of this section for a prior taxable year of the
CFC.
(iii) The earnings and profits are determined without regard to
income described in section 245(a)(5)(A) or dividends described in
section 245(a)(5)(B) (determined without regard to section 245(a)(12)).
(4) RGI account. For a taxable year of a CFC, the following rules
apply to determine the balance of a section 245A shareholder's RGI
account with respect to the CFC:
(i) The balance of the RGI account is increased by the sum of the
amounts of deductions and losses of the CFC that, but for Sec. 1.951A-
2(c)(5)(i), would have decreased one or more categories of the CFC's
positive subpart F income or the CFC's tested income, or increased or
given rise to a tested loss or one or more qualified deficits of the
CFC.
(ii) The balance of the RGI account is decreased to the extent that,
by reason of the application of paragraph (c)(1) of this section with
respect to the taxable year of the CFC, there is a reduction to the
extraordinary disposition account of the section 245A shareholder.
[T.D. 9934, 85 FR 76963, Dec. 1, 2020]
Sec. 1.245A-8 Coordination rules for complex cases.
(a) Scope. This section applies beginning with the first day of the
first taxable year of a section 245A shareholder for which Sec. 1.245A-
7 does not apply and for all taxable years thereafter, or for a taxable
year of a section 245A shareholder for which the section 245A
shareholder chooses not to apply Sec. 1.245A-7.
(b) Reduction of disqualified basis by reason of an extraordinary
disposition amount or tiered extraordinary disposition amount--(1) In
general. If, for a taxable year of a section 245A shareholder, an
extraordinary disposition account of the section 245A shareholder gives
rise to one or more extraordinary disposition amounts or tiered
extraordinary disposition amounts, then, with respect to an item of
specified property that corresponds to the extraordinary disposition
account and for which the ownership requirement of paragraph (b)(3)(i)
of this section is satisfied for the taxable year of the section 245A
shareholder, solely for purposes of Sec. 1.951A-2(c)(5), the
disqualified basis of the item of specified property is reduced (but not
below zero) by an amount (determined in the functional currency in which
the extraordinary disposition account is maintained) equal to the
product of--
(i) The excess (if any) of--
(A) The sum of the extraordinary disposition amounts and the tiered
extraordinary disposition amounts; over
(B) The basis benefit account with respect to the extraordinary
disposition account (determined as of the end of the taxable year of the
section 245A shareholder, and without regard to the application of
paragraph (b)(4)(i)(B) of this section for the taxable year); and
(ii) A fraction, the numerator of which is the disqualified basis of
the item of specified property, and the denominator of which is the sum
of the disqualified basis of each item of specified property that
corresponds to the extraordinary disposition account and for which the
ownership requirement of paragraph (b)(3)(i) of this section is
satisfied for the taxable year of the section 245A shareholder.
(2) Timing rules regarding disqualified basis. See Sec. 1.245A-
9(b)(2) for timing rules regarding the determination of, and reduction
to, disqualified basis of an item of specified property.
(3) Ownership requirement with respect to an item of specified
property--(i) In general. For a taxable year of a section 245A
shareholder, the ownership requirement of this paragraph (b)(3)(i) is
satisfied with respect to an item of specified property if, on at least
one day that falls within the taxable year, the item of specified
property is held by--
(A) The section 245A shareholder;
(B) A person (other than the section 245A shareholder) that, on at
least one day that falls within the section 245A shareholder's taxable
year, is a related
[[Page 520]]
party with respect to the section 245A shareholder (such a person, a
qualified related party with respect to the section 245A shareholder for
the taxable year of the section 245A shareholder); or
(C) A specified entity at least 10 percent of the interests of which
are, on at least one day that falls within the section 245A
shareholder's taxable year, owned directly or indirectly through one or
more other specified entities by the section 245A shareholder or a
qualified related party.
(ii) Rules for determining an interest in a specified entity. For
purposes of paragraph (b)(3)(i)(C) of this section, the phrase at least
10 percent of the interests means--
(A) If the specified entity is a foreign corporation, at least 10
percent of the stock (by vote or value) of the foreign corporation;
(B) If the specified entity is a partnership, at least 10 percent of
the interests in the capital or profits of the partnership; or
(C) If the specified entity is not a foreign corporation or a
partnership, at least 10 percent of the value of the interests in the
specified entity.
(4) Basis benefit account--(i) General rules. The term basis benefit
account means, with respect to an extraordinary disposition account of a
section 245A shareholder, an account of the section 245A shareholder
(the initial balance of which is zero), adjusted pursuant to the rules
of paragraphs (b)(4)(i)(A) and (B) of this section on the last day of
each taxable year of the section 245A shareholder. The basis benefit
account must be maintained in the same functional currency as the
extraordinary disposition account.
(A) The balance of the basis benefit account is increased to the
extent that a basis benefit amount with respect to an item of specified
property that corresponds to the section 245A shareholder's
extraordinary disposition account is assigned to the taxable year of the
section 245A shareholder. However, if the extraordinary disposition
ownership percentage applicable to the section 245A shareholder's
extraordinary disposition account is less than 100 percent, then, the
basis benefit account is instead increased by the amount equal to the
basis benefit amount multiplied by the extraordinary disposition
ownership percentage.
(B) The balance of the basis benefit account is decreased to the
extent that, for a taxable year that includes the date on which the
section 245A shareholder's taxable year ends, disqualified basis of an
item of specified property would have been reduced pursuant to paragraph
(b)(1) of this section but for an amount in the basis benefit account.
(ii) Rules for determining a basis benefit amount--(A) In general.
The term basis benefit amount means, with respect to an item of
specified property that has disqualified basis, the portion of
disqualified basis that, for a taxable year, is directly (or indirectly
through one or more specified entities that are not corporations) taken
into account for U.S. tax purposes by a U.S. tax resident, a CFC
described in Sec. 1.267A-5(a)(17), or a specified foreign person and--
(1) Reduces the amount of the U.S. tax resident's taxable income,
one or more categories of the CFC's positive subpart F income, the CFC's
tested income, or the specified foreign person's ECTI, as applicable; or
(2) Prevents a decrease or offset of the amount of the CFC's tested
loss or qualified deficits.
(B) Rules for determining whether disqualified basis of an item of
specified property is taken into account. For purposes of paragraph
(b)(4)(ii)(A) of this section, disqualified basis of an item of
specified property is taken into account for U.S. tax purposes without
regard to whether the disqualified basis is reduced or eliminated under
Sec. 1.951A-3(h)(2)(ii)(B)(1).
(C) Timing rules when disqualified basis gives rise to a deferred or
disallowed loss. To the extent disqualified basis of an item of
specified property gives rise to a deduction or loss during a taxable
year that is deferred, then the determination of whether the item of
deduction or loss gives rise to a basis benefit amount under paragraph
(b)(4)(ii)(A) of this section is made when the item of deduction or loss
is no longer deferred. In addition, to the extent disqualified basis of
an item of specified property gives rise to a deduction or loss during a
taxable year that is disallowed under
[[Page 521]]
section 267(a)(1), then a basis benefit amount is treated as occurring
in the taxable year when and to the extent that gain is reduced pursuant
to section 267(d), and provided that the gain is described in paragraph
(b)(4)(ii)(A) of this section.
(iii) Rules for assigning a basis benefit amount to a taxable year
of a section 245A shareholder--(A) In general. For purposes of applying
paragraph (b)(4)(i)(A) of this section with respect to a section 245A
shareholder, a basis benefit amount with respect to an item of specified
property is assigned to a taxable year of the section 245A shareholder
if--
(1) With respect to the item of specified property, the ownership
requirement of paragraph (b)(3)(i) of this section is satisfied for the
taxable year of the section 245A shareholder; and
(2) The basis benefit amount occurs during the taxable year of the
section 245A shareholder, or a taxable year of a U.S. tax resident
(other than the section 245A shareholder), a CFC described in Sec.
1.267A-5(a)(17), or a specified foreign person, as applicable, that--
(i) Ends with or within the taxable year of the section 245A
shareholder; or
(ii) Begins with or within the taxable year of the section 245A
shareholder, but only in a case in which but for this paragraph
(b)(4)(iii)(A)(2)(ii) the basis benefit amount would not be assigned to
a taxable year of the section 245A shareholder.
(B) Anti-duplication rule. For purposes of paragraph (b)(4)(i)(A) of
this section, to the extent that disqualified basis of an item of
specified property gives rise to a basis benefit amount that is assigned
to a taxable year of a section 245A shareholder under paragraph
(b)(4)(iii)(A) of this section, and thereafter such disqualified basis
gives rise to an additional basis benefit amount, the additional basis
benefit amount cannot be assigned to another taxable year of any section
245A shareholder. Thus, for example, if the entire amount of
disqualified basis of an item of specified property gives rise to a
basis benefit amount for a particular taxable year of a CFC and is
assigned to a taxable year of a section 245A shareholder but, pursuant
to Sec. 1.951A-3(h)(2)(ii)(B)(1)(ii), the disqualified basis is not
reduced or eliminated in such taxable year of the CFC (because, for
example, the buyer is a CFC that is a related party) and, as a result,
the disqualified basis thereafter gives rise to an additional basis
benefit amount, then no portion of the additional basis benefit amount
is assigned to a taxable year of any section 245A shareholder.
(iv) Successor rules for basis benefit accounts. To the extent that
an extraordinary disposition account of a section 245A shareholder is
adjusted pursuant to Sec. 1.245A-5(c)(4), a basis benefit account with
respect to the extraordinary disposition account is adjusted in a
similar manner.
(5) Special rules regarding duplicate DQB of an item of exchanged
basis property--(i) Adjustments to certain rules in applying paragraph
(b)(1) of this section. For purposes of paragraph (b)(1) of this section
for a taxable year of a section 245A shareholder, the following rules
apply with respect to duplicate DQB of an item of exchanged basis
property:
(A) Duplicate DQB of the item of exchanged basis property with
respect to an item of specified property to which the item of exchanged
property relates is not taken into account for purposes of paragraph
(b)(1) of this section if the disqualified basis of the item of
specified property is taken into account for purposes of paragraph
(b)(1) of this section. Thus, for example, if for a taxable year of a
section 245A shareholder the ownership requirement of paragraph (b)(3)
of this section is satisfied with respect to an item of specified
property and an item of exchanged basis property that relates to the
item of specified property, all of the disqualified basis of which is
duplicate DQB with respect to the item of specified property, then only
the disqualified basis of the item of specified property is taken into
account for purposes of, and is subject to reduction under, paragraph
(b)(1) of this section.
(B) If, pursuant to paragraph (b)(5)(i)(A) of this section,
duplicate DQB of an item of exchanged basis property with respect to an
item of specified property is not taken into account for purposes of
paragraph (b)(1) of this section, then, solely for purposes of Sec.
1.951A-2(c)(5), the duplicate DQB of the item of exchanged basis
[[Page 522]]
property is reduced (in the same manner as it would be if the
disqualified basis were taken into account for purposes of paragraph
(b)(1) of this section) by the product of the amounts described in
paragraphs (b)(5)(i)(B)(1) and (2) of this section.
(1) The reduction, under paragraph (b)(1) of this section for the
taxable year of the section 245A shareholder, to the disqualified basis
of the item of specified property to which the item of exchanged basis
property relates.
(2) A fraction, the numerator of which is the duplicate DQB of the
item of exchanged basis property with respect to the item of specified
property, and the denominator of which is the sum of the amounts of
duplicate DQB with respect to the item of specified property of each
item of exchanged basis property that relates to the item of specified
property and for which the ownership requirement of paragraph (b)(3)(i)
of this section is satisfied for the taxable year of the section 245A
shareholder. For purposes of determining this fraction, duplicate DQB of
an item of exchanged basis property is determined pursuant to the rules
of paragraph (b)(2)(i) of this section (by replacing the term
``paragraph (b)(1)'' in that paragraph with the term ``paragraph
(b)(5)(i)(B)''). In addition, duplicate DQB of an item of exchanged
basis property is excluded from the denominator of the fraction to the
extent the duplicate DQB is attributable to duplicate DQB of another
item of exchanged basis property that is included in the denominator of
the fraction.
(ii) Adjustments to certain rules in applying paragraph (b)(4) of
this section. For purposes of paragraph (b)(4)(i)(A) of this section, to
the extent that disqualified basis of an item of specified property
gives rise to a basis benefit amount that is assigned to a taxable year
of a section 245A shareholder under paragraph (b)(4)(iii)(A) of this
section, and thereafter duplicate DQB attributable to such disqualified
basis of the item of specified property gives rise to an additional
basis benefit amount, the additional basis benefit amount cannot be
assigned to another taxable year of any section 245A shareholder.
Similarly, for purposes of paragraph (b)(4)(i)(A) of this section, to
the extent that duplicate DQB attributable to disqualified basis of an
item of specified property gives rise to a basis benefit amount that is
assigned to a taxable year of a section 245A shareholder under paragraph
(b)(4)(iii)(A) of this section, and thereafter such disqualified basis
of the item of specified property (or duplicate DQB attributable to such
disqualified basis of the item of specified property) gives rise to an
additional basis benefit amount, the additional basis benefit amount
cannot be assigned to another taxable year of any section 245A
shareholder.
(6) Special rule regarding prior extraordinary disposition amounts.
For purposes of paragraph (b)(1) of this section, to the extent that an
extraordinary disposition account of a section 245A shareholder is
reduced under Sec. 1.245A-5(c)(3)(i)(A) by reason of a prior
extraordinary disposition amount described in Sec. 1.245A-
5(c)(3)(i)(D)(1)(i) through (iv), the extraordinary disposition account
is considered to give rise to an extraordinary disposition amount or
tiered extraordinary disposition amount (and the amount by which the
account is reduced is treated as an extraordinary disposition amount or
tiered extraordinary disposition amount).
(c) Reduction of extraordinary disposition account by reason of the
allocation and apportionment of deductions or losses attributable to
disqualified basis--(1) In general. For a taxable year of a CFC, if
there is an RGI account with respect to the CFC that relates to an
extraordinary disposition account of a section 245A shareholder with
respect to an SFC, and the section 245A shareholder satisfies the
ownership requirement of paragraph (c)(5) of this section for the
taxable year of the CFC, then, subject to the limitations in paragraphs
(c)(6) and (7) of this section, the extraordinary disposition account is
reduced (but not below zero) by the lesser of the following amounts
(each determined in the functional currency of the CFC)--
(i) The excess (if any) of--
(A) The product of--
(1) The adjusted earnings of the CFC for the taxable year of the
CFC; and
(2) The percentage of stock of the CFC (by value) that, in
aggregate, is owned directly or indirectly through
[[Page 523]]
one or more specified entities by the section 245A shareholder and any
domestic affiliates on the last day of the taxable year of the CFC; over
(B) The sum of--
(1) The sum of the balance of the section 245A shareholder's and any
domestic affiliates' previously taxed earnings and profits accounts with
respect to the CFC for purposes of section 959 (determined as of the end
of the taxable year of the CFC and taking into account any adjustments
to the accounts for the taxable year);
(2) The sum of the balance of the hybrid deduction accounts (as
described in Sec. 1.245A(e)-1(d)(1)) with respect to shares of stock of
the CFC that the section 245A shareholder and any domestic affiliates
own (within the meaning of section 958(a), and determined by treating a
domestic partnership as foreign) as of the end of the taxable year of
the CFC and taking into account any adjustments to the accounts for the
taxable year; and
(3) The sum of the balance of the section 245A shareholder's and any
domestic affiliates' extraordinary disposition accounts with respect to
the CFC (determined as of the end of the taxable year of the CFC and
taking into account any adjustments to the accounts for the taxable
year). However, if the section 245A shareholder or a domestic affiliate
has an RGI account with respect to the CFC that relates to an
extraordinary disposition account with respect to the CFC, then only the
excess, if any, of the balance of the extraordinary disposition account
over the balance of the RGI account that relates to the extraordinary
disposition account (determined as of the end of the taxable year of the
CFC, but without regard to the application of paragraph (c)(4)(i)(B) of
this section for the taxable year) is taken into account for purposes of
this paragraph (c)(1)(i)(B)(3). In addition, for purposes of this
paragraph (c)(1)(i)(B)(3), an extraordinary disposition account that but
for paragraph (e)(1) of this section would be with respect to the CFC
for purposes of this section is treated as an extraordinary disposition
account with respect to the CFC and thus is taken into account for
purposes of this paragraph (c)(1)(i)(B)(3).
(ii) The balance of the RGI account with respect to the CFC that
relates to the section 245A shareholder's extraordinary disposition
account with respect to the SFC (determined as of the end of the taxable
year of the CFC, but without regard to the application of paragraph
(c)(4)(i)(B) of this section for the taxable year).
(2) Timing of reduction to extraordinary disposition account. See
Sec. 1.245A-9(b)(3) for timing rules regarding the reduction to an
extraordinary disposition account.
(3) Adjusted earnings. The term adjusted earnings means, with
respect to a CFC and a taxable year of the CFC, the earnings and profits
of the CFC, determined as of the end of the CFC's taxable year (taking
into account all distributions during the taxable year, and not taking
into account any deficit in earnings and profits subject to Sec.
1.381(c)(2)-1(a)(5)) and with the adjustments described in paragraphs
(c)(3)(i) through (iv) of this section.
(i) The earnings and profits are increased by the amount of any
deduction or loss that--
(A) Is or was attributable to disqualified basis of an item of
specified property, but only to the extent that gain recognized on the
extraordinary disposition of the item of specified property was included
in the initial balance of an extraordinary disposition account;
(B) Is or was allocated and apportioned to residual CFC gross income
of the CFC (or a predecessor) solely by reason of Sec. 1.951A-
2(c)(5)(i); and
(C) Does not or has not given rise to or increased a deficit in
earnings and profits subject to Sec. 1.381(c)(2)-1(a)(5), determined as
of the end of the taxable year of the CFC.
(ii) The earnings and profits are decreased by the amount by which
any RGI account with respect to the CFC has been decreased pursuant to
paragraph (c)(4)(i)(B) of this section for a prior taxable year of the
CFC.
(iii) The earnings and profits are determined without regard to
earnings attributable to income described in section 245(a)(5)(A) or
dividends described in section 245(a)(5)(B) (determined without regard
to section 245(a)(12)).
[[Page 524]]
(iv) The earnings and profits are decreased by the amount of any
deduction or loss that, but for paragraph (c)(3)(i)(C) of this section,
would be described in paragraph (c)(3)(i) of this section.
(4) RGI account--(i) In general. For a taxable year of a CFC, the
following rules apply to determine the balance of a section 245A
shareholder's RGI account that is with respect to the CFC and that
relates to an extraordinary disposition account of the section 245A
shareholder with respect to an SFC:
(A) The balance of the RGI account is increased by the product of
the amounts described in paragraphs (c)(4)(i)(A)(1) and (2) of this
section for a taxable year of the CFC.
(1) The sum of the amounts of deductions and losses of the CFC
that--
(i) Are attributable to disqualified basis of one or more items of
specified property that correspond to the extraordinary disposition
account; and
(ii) But for Sec. 1.951A-2(c)(5)(i), would have decreased one or
more categories of the CFC's positive subpart F income, the CFC's tested
income, or the CFC's ECTI, or increased or given rise to a tested loss
or one or more qualified deficits of the CFC.
(2) The lesser of--
(i) A fraction (expressed as a percentage), the numerator of which
is the sum of the portions of the CFC's subpart F income and tested
income or tested loss (expressed as a positive number) taken into
account under sections 951(a)(1)(A) and 951A(a) (as determined under the
rules of Sec. Sec. 1.951-1(b) and (e) and 1.951A-1(d)) by the section
245A shareholder and any domestic affiliates of the section 245A
shareholder and the section 245A shareholder's and any domestic
affiliates' pro rata shares of the CFC's qualified deficits (expressed
as a positive number), and the denominator of which is the sum of the
CFC's subpart F income, tested income or tested loss (expressed as a
positive number), and qualified deficits (expressed as a positive
number), but for purposes of this paragraph (c)(4)(i)(A)(2)(i) treating
ECTI (expressed as a positive number) as if it were subpart F income;
and
(ii) The extraordinary disposition ownership percentage applicable
as to the section 245A shareholder's extraordinary disposition account.
(B) The balance of the RGI account is decreased to the extent that,
by reason of the application of paragraph (c)(1) of this section with
respect to the taxable year of the CFC, there is a reduction to the
extraordinary disposition account of the section 245A shareholder.
(ii) Successor rules for RGI accounts. To the extent that an
extraordinary disposition account of a section 245A shareholder is
adjusted pursuant to Sec. 1.245A-5(c)(4), an RGI account of a CFC with
respect to the extraordinary disposition account is adjusted in a
similar manner.
(5) Ownership requirement with respect to a CFC. For a taxable year
of a CFC, a section 245A shareholder satisfies the ownership requirement
of this paragraph (c)(5) if, on the last day of the CFC's taxable year,
the section 245A shareholder or a domestic affiliate is a United States
shareholder with respect to the CFC.
(6) Allocation of reductions among multiple extraordinary
disposition accounts. This paragraph (c)(6) applies if, by reason of the
application of paragraph (c)(1) of this section with respect to a
taxable year of a CFC (and but for the application of this paragraph
(c)(6) and paragraph (c)(7) of this section), the sum of the reductions
under paragraph (c)(1) of this section to two or more extraordinary
disposition accounts of a section 245A shareholder or a domestic
affiliate of the section 245A shareholder would exceed the amount
described in paragraph (c)(1)(i)(A) of this section (the amount of such
excess, the excess amount). When this paragraph (c)(6) applies, the
reduction to each extraordinary disposition account described in the
previous sentence is equal to the reduction that would occur but for
this paragraph (c)(6) and paragraph (c)(7) of this section, less the
product of the excess amount and a fraction, the numerator of which is
the balance of the extraordinary disposition account, and the
denominator of which is the sum of the balances of all of the
extraordinary dispositions accounts described in the previous sentence.
For purposes of determining this fraction, the balance of an
extraordinary disposition account is determined as of the end of the
taxable
[[Page 525]]
year of the section 245A shareholder or the domestic affiliate, as
applicable, that includes the date on which the CFC's taxable year ends
(and after the determination of any extraordinary disposition amounts or
tiered extraordinary disposition amounts for the taxable year of the
section 245A shareholder or the domestic affiliate, as applicable, and
adjustments to the extraordinary disposition account for prior
extraordinary disposition amounts).
(7) Extraordinary disposition account not reduced below balance of
basis benefit account. An extraordinary disposition account of a section
245A shareholder cannot be reduced pursuant to paragraph (c)(1) of this
section below the balance of the basis benefit account with respect to
the extraordinary disposition account (determined when a reduction to
the extraordinary disposition account would occur under paragraph (c)(1)
of this section).
(d) Special rules for determining when specified property
corresponds to an extraordinary disposition account--(1) Substituted
property--(i) Treatment as specified property that corresponds to an
extraordinary disposition account. For purposes of this section, an item
of substituted property is treated as an item of specified property that
corresponds to an extraordinary disposition account to which the related
item of specified property (that is, the item of specified property to
which the item of substituted property relates, as described in
paragraph (d)(1)(ii) of this section) corresponds. In addition, in a
case in which an item of substituted property relates to an item of
specified property that corresponds to a particular extraordinary
disposition account and an item of specified property that corresponds
to another extraordinary disposition account (such that, pursuant to
this paragraph (d)(1)(i), the item of substituted property is treated as
corresponding to multiple extraordinary disposition accounts), only the
disqualified basis of the item of substituted property attributable to
the first item of specified property is taken into account for purposes
of applying this section as to the first extraordinary disposition
account, and, similarly, only the disqualified basis of the item of
substituted property attributable to the second item of specified
property is taken into account for purposes of applying this section as
to the second extraordinary disposition account.
(ii) Definition of substituted property. The term substituted
property means an item of property the disqualified basis of which is,
pursuant to Sec. 1.951A-3(h)(2)(ii)(B)(2)(i) or (iii), increased by
reason of a reduction under Sec. 1.951A-3(h)(2)(ii)(B)(1) in
disqualified basis of an item of specified property. An item of
substituted property relates to an item of specified property if the
disqualified basis of the item of substituted property was increased by
reason of a reduction in disqualified basis of the item of specified
property.
(2) Exchanged basis property--(i) Treatment as specified property
that corresponds to an extraordinary disposition account for certain
purposes. For purposes of this section, an item of exchanged basis
property is treated as an item of specified property that corresponds to
an extraordinary disposition account to which the related item of
specified property (that is, the item of specified property to which the
item of exchanged basis property relates) corresponds.
(ii) Definition of exchanged basis property. The term exchanged
basis property means an item of property the disqualified basis of
which, pursuant to Sec. 1.951A-3(h)(2)(ii)(B)(2)(ii), includes
disqualified basis of an item of specified property. An item of
exchanged basis property relates to an item of specified property if the
disqualified basis of the item of exchanged basis property includes
disqualified basis of the item of specified property.
(iii) Definition of duplicate DQB--(A) In general. The term
duplicate DQB means, with respect to an item of exchanged basis property
and the item of specified property to which the exchanged basis property
relates, the disqualified basis of the item of exchanged basis property
that includes or is attributable to disqualified basis of the item of
specified property.
(B) Certain nonrecognition transfers involving stock or a
partnership interest. To the extent that an item of exchanged
[[Page 526]]
basis property that is stock or an interest in a partnership (lower-tier
item) includes disqualified basis of an item of specified property to
which the lower-tier item relates (contributed item), and another item
of exchanged basis property that is stock or a partnership interest
(upper-tier item) includes disqualified basis of the lower-tier item
that is attributable to disqualified basis of the contributed item, the
disqualified basis of the upper-tier item is attributable to
disqualified basis of the contributed item and the upper-tier item is an
item of exchanged basis property that relates to the contributed item.
The principles of the preceding sentence apply each time disqualified
basis of an item of exchanged basis property that is stock or an
interest in a partnership is included in disqualified basis of another
item of exchanged basis property that is stock or an interest in a
partnership.
(C) Multiple nonrecognition transfers of an item of specified
property. To the extent that multiple items of exchanged basis property
that are stock or interests in a partnership include disqualified basis
of the same item of specified property (contributed item) to which the
items of exchanged basis property relate, and the issuer of one of the
items of exchanged basis property (upper-tier successor item) receives
the other item of exchanged basis property (lower-tier successor item)
in exchange for the contributed property, the disqualified basis of the
upper-tier successor item is attributable to disqualified basis of the
lower-tier successor item and the upper-tier successor item is an item
of exchanged basis property that relates to the lower-tier successor
item. The principles of the preceding sentence apply each time
disqualified basis of an item of specified property to which an item of
exchanged basis property that is stock or an interest in partnership
relates is included in disqualified basis of another item of exchanged
basis property that is stock or an interest in a partnership.
(e) Special rules when extraordinary disposition accounts are
adjusted pursuant to Sec. 1.245A-5(c)(4)--(1) Extraordinary disposition
account with respect to multiple SFCs. This paragraph (e)(1) applies if,
pursuant to Sec. 1.245A-5(c)(4)(ii) or (iii) (the transaction or
transactions by reason of which Sec. 1.245A-5(c)(4)(ii) or (iii)
applies, the adjustment transaction), an extraordinary disposition
account of a section 245A shareholder with respect to an SFC (such
extraordinary disposition account, the transferor ED account; and such
SFC, the transferor SFC) gives rise to an increase in the balance of an
extraordinary disposition account with respect to another SFC (such
extraordinary disposition account, the transferee ED account; such SFC,
the transferee SFC; and such increase, the adjustment amount). When this
paragraph (e)(1) applies, the following rules apply for purposes of this
section:
(i) A ratable portion of the transferee ED account is treated as
retaining its status as an extraordinary disposition account with
respect to the transferor SFC and is not treated as an extraordinary
disposition account with respect to the transferee SFC (the transferee
ED account to such extent, the deemed transferor ED account), based on
the adjustment amount relative to the balance of the transferee ED
account (without regard to this paragraph (e)(1)) immediately after the
adjustment transaction. Thus, for example, whether or not the transferor
SFC is in existence immediately after the transaction, the items of
specified property that correspond to the deemed transferor ED account
are the same as the items of specified property that correspond to the
transferor ED account. As an additional example, whether or not the
transferor SFC is in existence immediately after the transaction the
extraordinary disposition ownership percentage with respect to the
deemed transferor ED account is the same as the extraordinary
disposition ownership percentage with respect to the transferor ED
account (except to the extent the extraordinary disposition ownership
percentage is adjusted pursuant to the rules of paragraph (e)(2) of this
section).
(ii) In the case of an amount (such as an extraordinary disposition
amount or tiered extraordinary disposition amount) determined by
reference to the transferee ED account (without regard to this paragraph
(e)(1)), the portion of the amount that is considered attributable to
the deemed transferor
[[Page 527]]
ED account (and not the transferee ED account) is equal to the product
of such amount and a fraction, the numerator of which is the balance of
the deemed transferor ED account, and the denominator of which is the
balance of the transferee ED account (determined without regard to this
paragraph (e)(1)). Thus, for example, if after an adjustment transaction
the transferee ED account (without regard to this paragraph (e)(1))
gives rise to an extraordinary disposition amount, and if the fraction
(expressed as a percentage) is 40, then, for purposes of this section,
40 percent of the extraordinary disposition amount is treated as
attributable to the deemed transferor ED account and the remaining 60
percent of the extraordinary disposition amount is attributable to the
transferee ED account, and the balance of each of the deemed transferor
ED account and the transferee ED account is correspondingly reduced.
(2) Extraordinary disposition accounts with respect to a single SFC.
If an extraordinary disposition account of a section 245A shareholder
with respect to an SFC is reduced by reason of Sec. 1.245A-5(c)(4),
then, except as provided in paragraph (e)(1) of this section, for
purposes of this section, the extraordinary disposition ownership
percentage as to the extraordinary disposition account (as well as the
extraordinary disposition ownership percentage as to any extraordinary
disposition account with respect to the SFC that is increased by reason
of the reduction) is adjusted in a similar manner.
[T.D. 9934, 85 FR 76963, Dec. 1, 2020]
Sec. 1.245A-9 Other rules and definitions.
(a) In general. This section provides rules of general applicability
for purposes of Sec. Sec. 1.245A-6 through 1.245A-10, a transition rule
to revoke an election to eliminate disqualified basis, and definitions.
(b) Rules of general applicability--(1) Correspondence. An item of
specified property corresponds to a section 245A shareholder's
extraordinary disposition account if gain was recognized on the
extraordinary disposition of the item and the gain was taken into
account in determining the initial balance of the account. See Sec.
1.245A-8(d) for additional rules regarding when an item of property is
treated as corresponding to an extraordinary disposition account in
certain complex cases.
(2) Timing rules related to disqualified basis for purposes of
applying Sec. Sec. 1.245A-7(b) and 1.245A-8(b)--(i) Determination of
disqualified basis. For purposes of determining the fraction described
in Sec. 1.245A-7(b)(1)(ii) or Sec. 1.245A-8(b)(1)(ii) when applying
Sec. 1.245A-7(b)(1) or Sec. 1.245A-8(b)(1)(ii), respectively, for a
taxable year of a section 245A shareholder, disqualified basis of an
item of specified property is determined as of the beginning of the
taxable year of the CFC that holds the item of specified property (in a
case in which Sec. 1.245A-7(b) applies) or the specified property owner
(in a case in which Sec. 1.245A-8(b) applies), in either case, that
includes the date on which the section 245A shareholder's taxable year
ends (and without regard to any reductions to the disqualified basis of
the item of specified property pursuant to Sec. 1.245A-7(b)(1) or Sec.
1.245A-8(b)(1) for such taxable year of the CFC or the specified
property owner, as applicable). However, if disqualified basis of the
item of specified property arose as a result of an extraordinary
disposition that occurred after the beginning of the taxable year of the
CFC or the specified property owner described in the preceding sentence,
then the disqualified basis of the item of specified property is
determined as of the date on which the extraordinary disposition
occurred (and without regard to any reductions to the disqualified basis
of the item of specified property pursuant to paragraph (b)(1) of this
section for such taxable year of the CFC or the specified property
owner).
(ii) Reduction to disqualified basis of an item of specified
property. The reduction to disqualified basis of an item of specified
property pursuant to Sec. 1.245A-7(b)(1) or Sec. 1.245A-8(b)(1) occurs
on the date described in paragraph (b)(2)(i) of this section.
(iii) Definition of specified property owner. For purposes of
applying Sec. 1.245A-8(b)(1) and paragraphs (b)(2)(i) and (ii) of this
section for a taxable year of a section 245A shareholder, the term
specified property owner means, with respect to an item of specified
[[Page 528]]
property, the person that, on at least one day of the taxable year of
the person that includes the date on which the section 245A
shareholder's taxable year ends, held the item of specified property.
However, if, but for this sentence, there would be more than one
specified property owner with respect to the item of specified property,
then the specified property owner is the person that held the item of
specified property on the earliest date that falls within the section
245A shareholder's taxable year.
(3) Timing rules for reducing an extraordinary disposition account
under Sec. Sec. 1.245A-7(c) and 1.245A-8(c). For purposes of Sec.
1.245A-7(c)(1) or Sec. 1.245A-8(c)(1), as applicable, with respect to a
taxable year of a CFC, the reduction to an extraordinary disposition
account pursuant to Sec. 1.245A-7(c)(1) or Sec. 1.245A-8(c)(1) occurs
as of the end of the taxable year of the section 245A shareholder that
includes the date on which the CFC's taxable year ends (and after the
determination of any extraordinary disposition amounts or tiered
extraordinary amounts, adjustments to the extraordinary disposition
account for prior extraordinary disposition amounts, and the application
of Sec. 1.245A-7(b) or Sec. 1.245A-8(b), as applicable, each for the
taxable year of the section 245A shareholder).
(4) Currency translation. For purposes of applying Sec. Sec.
1.245A-7(b) and 1.245A-8(b), the disqualified basis of (and, if
applicable, a basis benefit amount with respect to) an item of specified
property that corresponds to an extraordinary disposition account are
translated (if necessary) into the functional currency in which the
extraordinary disposition account is maintained, using the spot rate on
the date the extraordinary disposition occurred. A reduction in
disqualified basis of an item of specified property determined under
Sec. 1.245A-7(b)(1) or Sec. 1.245A-8(b)(1) is translated (if
necessary) into the functional currency in which the disqualified basis
of the item of specified property is maintained, and a reduction in an
extraordinary disposition account determined under Sec. 1.245A-7(c) or
Sec. 1.245A-8(c) section is translated (if necessary) into the
functional currency in which the extraordinary disposition account is
maintained, in each case using the spot rate described in the preceding
sentence.
(5) Anti-avoidance rule. Appropriate adjustments are made pursuant
to this paragraph (b)(5), including adjustments that would disregard a
transaction or arrangement in whole or in part, to any amounts
determined under (or subject to application of) this section if a
transaction or arrangement is engaged in with a principal purpose of
avoiding the purposes of Sec. Sec. 1.245A-6 through 1.245A-10.
(c) Transition rule to revoke election to eliminate disqualified
basis--(1) In general. This paragraph (c)(1) applies to an election that
is filed, pursuant to Sec. 1.951A-3(h)(2)(ii)(B)(3), to eliminate the
disqualified basis of an item of specified property. An election to
which this paragraph (c)(1) applies may be revoked if, on or before
March 1, 2021--
(i) All controlling domestic shareholders (as defined in Sec.
1.964-1(c)(5)) of the CFC (or, in the case of an election made by a
partnership, the partnership) each attach a revocation statement (in the
manner described in paragraph (c)(2) of this section) to an amended
return, for the taxable year to which the election applies, that revokes
the election (or, in the case of a partnership subject to subchapter C
of chapter 63 of the Internal Revenue Code, requests administrative
adjustment under section 6227); and
(ii) The controlling domestic shareholders (or the partnership) each
file an amended tax return, for any other taxable years reflecting the
election to eliminate the disqualified basis, that reflects the election
having been revoked (or, in the case of a partnership subject to
subchapter C of chapter 63, requests administrative adjustment under
section 6227).
(2) Revocation statement. Except as otherwise provided in
publications, forms, instructions, or other guidance, a revocation
statement attached by a person to an amended tax return must include the
person's name, taxpayer identification number, and a statement that the
revocation statement is filed pursuant to paragraph (c)(1) of this
section to revoke an election pursuant to Sec. 1.951A-
3(h)(2)(ii)(B)(3). In addition, the
[[Page 529]]
revocation statement must be filed in the manner prescribed in
publications, forms, instructions, or other guidance.
(d) Definitions. In addition to the definitions in Sec. 1.245A-5,
the following definitions apply for purposes of Sec. Sec. 1.245A-6
through 1.245A-11.
(1) The term adjusted earnings has the meaning provided in Sec.
1.245A-7(c)(3) or Sec. 1.245A-8(c)(3), as applicable.
(2) The term basis benefit account has the meaning provided in Sec.
1.245A-8(b)(4)(i).
(3) The term basis benefit amount has the meaning provided in Sec.
1.245A-8(b)(4)(ii).
(4) The term disqualified basis has the meaning provided in Sec.
1.951A-3(h)(2)(ii).
(5) The term domestic affiliate means, with respect to a section
245A shareholder, a domestic corporation that is a related party with
respect to the section 245A shareholder. See also Sec. 1.245A-5(i)(19)
(defining related party).
(6) The term duplicate DQB has the meaning provided in Sec. 1.245A-
8(d)(2)(iii).
(7) The term ECTI means, with respect to a taxable year of a
specified foreign person, the taxable income (or loss) of the specified
foreign person determined by taking into account only items of income
and gain that are, or are treated as, effectively connected with the
conduct of a trade or business in the United States (as described in
Sec. 1.882-4(a)(1)) and are not exempt from U.S. tax pursuant to a
treaty obligation of the United States, and items of deduction and loss
that are allocated and apportioned to such items of income and gain.
(8) The term exchanged basis property has the meaning provided in
Sec. 1.245A-8(d)(2)(ii).
(9) The term qualified deficit has the meaning provided in section
952(c)(1)(B)(ii).
(10) The term qualified related party has the meaning provided in
Sec. 1.245A-8(b)(3)(ii).
(11) The term RGI account means, with respect to a CFC and an
extraordinary disposition account of a section 245A shareholder with
respect to an SFC, an account of the section 245A shareholder with
respect to an SFC (the initial balance of which is zero), adjusted at
the end of each taxable year of the CFC pursuant to the rules of Sec.
1.245A-7(c)(4) or Sec. 1.245A-8(c)(4), as applicable. The RGI account
must be maintained in the functional currency of the CFC.
(12) The term specified foreign person means a nonresident alien
individual (as defined in section 7701(b) and the regulations under
section 7701(b)) or a foreign corporation (including a CFC) that
conducts, or is treated as conducting, a trade or business in the United
States (as described in Sec. 1.882-4(a)(1)).
(13) The term specified property owner has the meaning provided in
Sec. 1.245A-8(b)(2)(iii).
(14) The term subpart F income has the meaning provided in section
952(a).
(15) The term substituted property has the meaning provided in Sec.
1.245A-8(d)(1)(ii).
(16) The term tested income has the meaning provided in section
951A(c)(2)(A).
(17) The term tested loss has the meaning provided in section
951A(c)(2)(B).
[T.D. 9934, 85 FR 76963, Dec. 1, 2020]
Sec. 1.245A-10 Examples.
(a) Scope. This section provides examples illustrating the
application of Sec. Sec. 1.245A-6 through 1.245A-9.
(b) Presumed facts. For purposes of the examples in the section,
except as otherwise stated, the following facts are presumed:
(1) US1 and US2 are both domestic corporations that have calendar
taxable years.
(2) CFC1, CFC2, CFC3, and CFC4 are all SFCs and CFCs that have
taxable years ending November 30.
(3) Each entity uses the U.S. dollar as its functional currency.
(4) There are no items of deduction or loss attributable to an item
of specified property.
(5) Absent the application of Sec. 1.245A-5, any dividends received
by US1 from CFC1 would meet the requirements to qualify for the section
245A deduction.
(6) All dispositions of items of specified property by an SFC during
a disqualified period of the SFC to a related party give rise to an
extraordinary disposition.
(7) None of the CFCs have a deficit subject to Sec. 1.381(c)(2)-
1(a)(5), and none
[[Page 530]]
of the CFCs are engaged in the conduct of a trade or business in the
United States (and therefore none of the CFCs have ECTI).
(8) There is no previously taxed earnings and profits account with
respect to any CFC for purposes of section 959. In addition, each hybrid
deduction account with respect to a share of stock of a CFC has a zero
balance at all times. Further, there is no extraordinary disposition
account with respect to any CFC.
(9) Under Sec. 1.245A-11(b), taxpayers choose to apply Sec. Sec.
1.245A-6 through 1.245A-11 to the relevant taxable years.
(c) Examples--(1) Example 1. Reduction of disqualified basis under
rule for simple cases by reason of dividend paid out of extraordinary
disposition account--(i) Facts. US1 owns 100% of the single class of
stock of CFC1 and CFC2. On November 30, 2018, in a transaction that is
an extraordinary disposition, CFC1 sells two items of specified
property, Item 1 and Item 2, to CFC2 in exchange for $150x of cash (the
``Disqualified Transfer''). Item 1 is sold for $90x and Item 2 is sold
for $60x. Item 1 and Item 2 each has a basis of $0 in the hands of CFC1
immediately before the Disqualified Transfer, and therefore CFC1
recognizes $150x of gain as a result of the Disqualified Transfer
($150x-$0). After the Disqualified Transfer, CFC2's only assets are Item
1 and Item 2. On November 30, 2018, and thus during US1's taxable year
ending December 31, 2018, CFC1 distributes $150x of cash to US1, and all
of the distribution is characterized as a dividend under section
301(c)(1) and treated as a distribution out of earnings and profits
described in section 959(c)(3). For CFC1's taxable year ending on
November 30, 2018, CFC1 has $160x of earnings and profits described in
section 959(c)(3), without regard to any distributions during the
taxable year. CFC2 continues to hold Item 1 and Item 2. Lastly, because
the conditions of Sec. 1.245A-6(b)(1) and (2) are satisfied for US1's
2018 taxable year, US1 chooses to apply Sec. 1.245A-7 (rules for simple
cases) in lieu of Sec. 1.245A-8 (rules for complex cases) for that
taxable year.
(ii) Analysis--(A) Application of Sec. Sec. 1.245A-5 and 1.951A-2
as a result of the Disqualified Transfer. As a result of the
Disqualified Transfer, under Sec. 1.951A-2(c)(5), Item 1 has
disqualified basis of $90x, and Item 2 has disqualified basis of $60x.
In addition, as a result of the Disqualified Transfer, under Sec.
1.245A-5(c)(3)(i)(A), US1 has an extraordinary disposition account with
respect to CFC1 with an initial balance of $150x. Under Sec. 1.245A-
5(c)(2)(i), $10x of the dividend is considered paid out of non-
extraordinary disposition E&P of CFC1 with respect to US1, and $140x of
the dividend is considered paid out of US1's extraordinary disposition
account with respect to CFC1 to the extent of the balance of the
extraordinary disposition account ($150x). Thus, the dividend of $150x
is an extraordinary disposition amount, within the meaning of Sec.
1.245A-5(c)(1), to the extent of $140x. As a result, the balance of the
extraordinary disposition account is reduced to $10x ($150x-$140x).
(B) Correspondence requirement. Under Sec. 1.245A-9(b)(1), each of
Item 1 and Item 2 corresponds to US1's extraordinary disposition account
with respect to CFC1, because as a result of the Disqualified Transfer
CFC1 recognized gain with respect to Item 1 and Item 2, and the gain was
taken into account in determining the initial balance of US1's
extraordinary disposition account with respect to CFC1.
(C) Reduction of disqualified basis of Item 1. Because Item 1
corresponds to US1's extraordinary disposition account, the disqualified
basis of Item 1 is reduced pursuant to Sec. 1.245A-7(b)(1) by reason of
US1's $140x extraordinary disposition amount for US1's 2018 taxable
year. Paragraphs (c)(2)(ii)(C)(1) through (3) of this section describe
the determinations pursuant to Sec. 1.245A-7(b)(1).
(1) To determine the reduction to the disqualified basis of Item 1,
the disqualified basis of Item 1, as well as the disqualified basis of
Item 2, must be determined as of the date described in Sec. 1.245A-
9(b)(2)(i) (and before the application of Sec. 1.245A-7(b)(1)). See
Sec. 1.245A-7(b)(1)(ii). For each of Item 1 and Item 2, that date is
December 1, 2018. December 1, 2018, is the first day of the taxable year
of CFC2 (the CFC that holds Item 1 and Item 2) beginning on December 1,
2018, which is the taxable year of CFC2 that includes December 31, 2018,
the date on which US1's 2018 taxable year ends. See Sec. 1.245A-
9(b)(2)(i).
(2) Pursuant to Sec. 1.245A-7(b)(1), the disqualified basis of Item
1 is reduced by $84x, computed as the product of--
(i) $140x, the extraordinary disposition amount; and
(ii) A fraction, the numerator of which is $90x (the disqualified
basis of Item 1 on December 1, 2018, and before the application of Sec.
1.245A-7(b)(1)), and the denominator of which is $150x (the disqualified
basis of Item 1, $90x, plus the disqualified basis of Item 2, $60x, in
each case determined on December 1, 2018, and before the application of
Sec. 1.245A-7(b)(1)). See Sec. 1.245A-7(b)(1).
(3) The $84x reduction to the disqualified basis of Item 1 occurs on
December 1, 2018, the date on which the disqualified basis of Item 1 is
determined for purposes of determining the reduction pursuant to Sec.
1.245A-7(b)(1). See Sec. 1.245A-9(b)(2)(ii).
(D) Reduction of disqualified basis of Item 2. For reasons similar
to those described in paragraph (c)(2)(ii)(C) of this section, on
December 1, 2018, the disqualified basis of Item
[[Page 531]]
2 is reduced by $56x, the amount equal to the product of $140x, the
extraordinary disposition amount, and a fraction, the numerator of which
is $60x (the disqualified basis of Item 2 on December 1, 2018, and
before the application of Sec. 1.245A-7(b)(1)), and the denominator of
which is $150x (the disqualified basis of Item 1, $90x, plus the
disqualified basis of Item 2, $60x, in each case determined on December
1, 2018, and before the application of Sec. 1.245A-7(b)(1)).
(2) Example 2. Basis benefit amount and impact on reduction to
disqualified basis under rule for complex cases--(i) Facts. The facts
are the same as in paragraph (c)(1)(i) of this section (Example 1) (and
the results are the same as in paragraph (c)(1)(ii)(A) of this section),
except that, on December 1, 2018, CFC2 sells Item 1 for $90x of cash to
an individual that is not a related party with respect to US1 or CFC2
(such transaction, the ``Sale,'' and such individual, ``Individual A'').
At the time of the Sale, CFC2's basis in Item 1 is $90x (all of which is
disqualified basis, as described in Sec. 1.951A-3(h)(2)(ii)(A)). CFC2
takes into the account the disqualified basis of Item 1 for purposes of
determining the amount of gain recognized on the Sale, which is $0
($90x-$90x); but for the disqualified basis, CFC2 would have had $90x of
gain that would have been taken into account in computing its tested
income. As a result of the Sale, the condition of Sec. 1.245A-6(b)(2)
is not satisfied, because on at least one day of CFC2's taxable year
beginning on December 1, 2018 (which begins within US1's 2018 taxable
year) CFC2 does not hold Item 1. See Sec. 1.245A-6(b)(2)(ii)(C)(1). US1
therefore applies Sec. 1.245A-8 (rules for complex cases) for its 2018
taxable year. See Sec. 1.245A-6(b).
(ii) Analysis--(A) Ownership requirement. With respect to each of
Item 1 and Item 2, the ownership requirement of Sec. 1.245A-8(b)(3)(i)
is satisfied for US1's 2018 taxable year. This is because on at least
one day that falls within US1's 2018 taxable year, each of Item 1 and
Item 2 is held by CFC2, and US1 directly owns all of the stock of CFC2
throughout such taxable year (and thus, for purposes of applying Sec.
1.245A-8(b)(3)(i), US1 owns at least 10% of the interests of CFC2 on at
least one day that falls within such taxable year). See Sec. 1.245A-
8(b)(3).
(B) Basis benefit amount with respect to Item 1 as a result of the
Sale. Under Sec. 1.245A-8(b)(4)(i), US1 has a basis benefit account
with respect to its extraordinary disposition account with respect to
CFC1. As described in paragraphs (c)(2)(ii)(B)(1) through (3) of this
section, the balance of the basis benefit account (which is initially
zero) is, on December 31, 2018, increased by $90x, the basis benefit
amount with respect to Item 1 and assigned to US1's 2018 taxable year.
(1) By reason of the Sale, for CFC2's taxable year beginning
December 1, 2018, and ending November 30, 2019, the entire $90x of
disqualified basis of Item 1 is taken into account for U.S. tax purposes
by CFC2 and, as a result, reduces CFC2's tested income or increases
CFC2's tested loss. Accordingly, for such taxable year, there is a $90x
basis benefit amount with respect to Item 1. See Sec. 1.245A-
8(b)(4)(ii)(A). The result would be the same if the Sale were to a
related person and thus, pursuant to Sec. 1.951A-3(h)(2)(ii)(B)(1)(ii),
no portion of the $90x of disqualified basis were eliminated or reduced
by reason of the Sale. See Sec. 1.245A-8(b)(4)(ii)(B).
(2) The $90x basis benefit amount with respect to Item 1 is assigned
to US1's 2018 taxable year. This is because the ownership requirement of
Sec. 1.245A-8(b)(3)(i) is satisfied with respect to Item 1 for US1's
2018 taxable year, and the basis benefit amount occurs in CFC2's taxable
year beginning December 1, 2018, a taxable year of CFC2 that begins
within US1's 2018 taxable year (and, but for Sec. 1.245A-
8(b)(4)(iii)(A)(2)(ii), the basis benefit amount would not be assigned
to a taxable year of US1, such as the taxable year of US1 beginning
January 1, 2019, given that, as result of the Sale, the ownership
requirement of Sec. 1.245A-8(b)(3)(i) would not be satisfied with
respect to Item 1 for such taxable year). See Sec. 1.245A-
8(b)(4)(iii)(A).
(3) On December 31, 2018 (the last day of US1's 2018 taxable year),
US1's basis benefit account with respect to its extraordinary
disposition account with respect to CFC1 is increased by $90x, the $90x
basis benefit amount with respect to Item 1 and assigned to US1's 2018
taxable year. The basis benefit account is increased by such amount
because Item 1 corresponds to US1's extraordinary disposition account
with respect to CFC1, and the extraordinary disposition ownership
percentage applicable to such extraordinary disposition account is 100.
See Sec. 1.245A-8(b)(4)(i)(A).
(C) Basis benefit amount limitation on reduction to disqualified
basis. By reason of US1's $140x extraordinary disposition amount for
US1's 2018 taxable year, the disqualified basis of Item 1 is reduced by
$30x, and the disqualified basis of Item 2 is reduced by $20x, pursuant
to Sec. 1.245A-8(b)(1). See Sec. 1.245A-8(b). Paragraphs
(c)(2)(ii)(C)(1) through (4) of this section describe the determinations
pursuant to Sec. 1.245A-8(b)(1).
(1) For purposes of determining the reduction to the disqualified
bases of Item 1 and Item 2, the disqualified bases of the Items are
determined on December 1, 2018 (and before the application of Sec.
1.245A-8(b)(1)). See Sec. 1.245A-8(b)(1)(ii). The disqualified bases of
the Items are determined on December 1, 2018, because that date is the
first day of the taxable year of CFC2 beginning on December 1, 2018,
which is the taxable year of CFC2 (the specified property owner of each
of Item 1 and Item 2) that includes December 31, 2018, the date on which
US1's 2018 taxable year ends. See Sec. 1.245A-8(b)(2)(i). For purposes
of
[[Page 532]]
applying Sec. Sec. 1.245A-8(b)(1) and Sec. 1.245A-9(b)(2) for US1's
2018 taxable year, CFC2 is the specified property owner of each of Item
1 and Item 2 because, on at least one day of CFC2's taxable year that
includes the date on which US1's 2018 taxable year ends (that is, on at
least one day of CFC2's taxable year beginning December 1, 2018), CFC2
held the Item. See Sec. 1.245A-9(b)(2)(iii). CFC2 is the specified
property owner of Item 1 even though Individual A also held Item 1
during Individual A's taxable year that includes the date on which US1's
2018 taxable year ends because CFC2 held Item 1 on an earlier date than
Individual A. See Sec. 1.245A-9(b)(2)(iii).
(2) Pursuant to Sec. 1.245A-8(b)(1), the disqualified basis of Item
1 is reduced by $30x, computed as the product of--
(i) $50x, the excess of the extraordinary disposition amount ($140x)
over the balance of the basis benefit account with respect to US1's
extraordinary disposition with respect to CFC1 ($90x); and
(ii) A fraction, the numerator of which is $90x (the disqualified
basis of Item 1 on December 1, 2018, and before the application of Sec.
1.245A-8(b)(1)), and the denominator of which is $150x (the disqualified
basis of Item 1, $90x, plus the disqualified basis of Item 2, $60x, in
each case determined on December 1, 2018, and before the application of
Sec. 1.245A-8(b)(1)). See paragraph Sec. 1.245A-8(b)(1).
(3) Pursuant to Sec. 1.245A-8(b)(1), the disqualified basis of Item
2 is reduced by $20x, computed as the product of--
(i) $50x, the excess of the extraordinary disposition amount ($140x)
over the balance of the basis benefit account with respect to US1's
extraordinary disposition with respect to CFC1 ($90x); and
(ii) A fraction, the numerator of which is $60x (the disqualified
basis of Item 2 on December 1, 2018, and before the application of
paragraph (b)(1) of this section), and the denominator of which is $150x
(the disqualified basis of Item 1, $90x, plus the disqualified basis of
Item 2, $60x, in each case determined on December 1, 2018, and before
the application of Sec. 1.245A-8(b)(1)). See Sec. 1.245A-8(b)(1).
(4) The $30x and $20x reductions to the disqualified bases of Item 1
and Item 2, respectively, occur on December 1, 2018, the date on which
the disqualified bases of the Items are determined for purposes of
determining the reductions pursuant to Sec. 1.245A-8(b)(1). See Sec.
1.245A-9(b)(2)(ii).
(D) Reduction of basis benefit account. The balance of the basis
benefit account with respect to US1's extraordinary disposition account
with respect to CFC1 is decreased by $90x, the amount by which, for
CFC2's taxable year beginning December 1, 2018, the disqualified bases
of Item 1 and Item 2 would have been reduced pursuant to Sec. 1.245A-
8(b)(1) but for the $90x balance of the basis benefit account. See Sec.
1.245A-8(b)(4)(i)(B). The reduction to the balance of the basis benefit
account occurs on December 31, 2018, and after the completion of all
other computations pursuant to Sec. 1.245A-8(b). See Sec. 1.245A-
8(b)(4)(i)(B).
(3) Example 3. Reduction in balance of extraordinary disposition
account under rules for simple cases by reason of allocation and
apportionment of deductions to residual CFC gross income--(i) Facts. The
facts are the same as in paragraph (c)(1)(i) of this section (Example 1)
(and the results are the same as in paragraph (c)(1)(ii)(A) of this
section), except that CFC1 does not make a distribution to US1. In
addition, during CFC2's taxable year beginning December 1, 2018, and
ending November 30, 2019, the disqualified basis of Item 1 gives rise to
a $6x amortization deduction, and the disqualified basis of Item 2 gives
rise to a $4x amortization deduction, and each of the amortization
deductions is allocated and apportioned to residual CFC gross income of
CFC2 solely by reason of Sec. 1.951A-2(c)(5) (though, but for Sec.
1.951A-2(c)(5), would have been allocated and apportioned to gross
tested income of CFC2). Further, as of the end of CFC2's taxable year
ending November 30, 2019, CFC2 has $15x of earnings and profits. Lastly,
because the conditions of Sec. 1.245A-6(b)(1) and (2) are satisfied for
US1's 2018 taxable year, US1 chooses to apply Sec. 1.245A-7 (rules for
simple cases) in lieu of Sec. 1.245A-8 (rules for complex cases) for
that taxable year.
(ii) Analysis. Pursuant to Sec. 1.245A-7(c)(1), US1's extraordinary
disposition account with respect to CFC1 is reduced by the lesser of the
amount described in Sec. 1.245A-7(c)(1)(i) with respect to US1, and the
RGI account of US1 with respect to CFC2 that relates to its
extraordinary disposition account with respect to CFC1. See Sec.
1.245A-7(c)(1). Paragraphs (c)(3)(ii)(A) through (D) of this section
describe the determinations pursuant to Sec. 1.245A-8(c)(1).
(A) Computation of adjusted earnings of CFC2, and amount described
in Sec. 1.245A-7(c)(1)(i) with respect to US1. To determine the amount
described in Sec. 1.245A-7(c)(1)(i) with respect to US1, the adjusted
earnings of CFC2 must be computed for CFC2's taxable year ending
November 30, 2019. See Sec. 1.245A-7(c)(1)(i). Paragraphs
(c)(3)(ii)(A)(1) and (2) of this section describe these determinations.
(1) The adjusted earnings of CFC2 for its taxable year ending
November 30, 2019, is $25x, computed as $15x (CFC2's earnings and
profits as of November 30, 2019, the last day of that taxable year),
plus $10x (the sum of the $6x and $4x amortization deductions of CFC2
for that taxable year, which is the amount of all deductions or losses
of CFC2 that is or was attributable to disqualified basis of items of
specified property and allocated and apportioned to residual CFC gross
income of CFC2 solely by reason of Sec. 1.951A-2(c)(5)(i)). See Sec.
1.245A-7(c)(3).
(2) For CFC2's taxable year ending November 30, 2019, the amount
described in Sec. 1.245A-
[[Page 533]]
7(c)(1)(i) with respect to US1 is $25x, computed as the excess of $25x
(the adjusted earnings) over $0 (the sum of the balance of the
previously taxed earnings and profits accounts with respect to CFC2).
(B) Increase to balance of RGI account. Under Sec. 1.245A-9(d)(11),
US1 has an RGI account with respect to CFC2 that relates to its
extraordinary disposition account with respect to CFC1. On November 30,
2019 (the last day of CFC2's taxable year), the balance of the RGI
account (which is initially zero) is increased by $10x, the sum of the
$6x and $4x amortization deductions of CFC2 for its taxable year ending
November 30, 2019. See Sec. 1.245A-7(c)(4)(i). Each of the amortization
deductions is taken into account for this purpose because, but for Sec.
1.951A-2(c)(5)(i), the deduction would have decreased CFC2's tested
income or increased or given rise to a tested loss of CFC2. See Sec.
1.245A-7(c)(4)(i).
(C) Reduction in balance of extraordinary disposition account.
Pursuant to Sec. 1.245A-7(c)(1), US1's extraordinary disposition
account with respect to CFC1 is reduced by $10x, the lesser of the
amount described in Sec. 1.245A-7(c)(1)(i) with respect to US1 for
CFC2's taxable year ending November 30, 2019 ($25x), and the balance of
US1's RGI account with respect to CFC2 that relates to its extraordinary
disposition account with respect to CFC1 ($10x, determined as of
November 30, 2019, but without regard to the application of Sec.
1.245A-7(c)(4)(ii) for the taxable year of CFC2 ending on that date).
See Sec. 1.245A-7(c)(1). The $10x reduction in the balance of US1's
extraordinary disposition account occurs on December 31, 2019, the last
day of US1's taxable year that includes November 30, 2019 (the last day
of CFC2's taxable year). See Sec. 1.245A-9(c)(3).
(D) Reduction in balance of RGI account. On November 30, 2019 (the
last day of CFC2's taxable year), the balance of US1's RGI account with
respect to CFC2 that relates to its extraordinary disposition account
with respect to CFC1 is decreased by $10x, the amount of the reduction,
pursuant to Sec. 1.245A-7(c)(1) section and by reason of the RGI
account, to US1's extraordinary disposition account with respect to
CFC1. See Sec. 1.245A-7(c)(4)(ii). Therefore, following that reduction,
the balance of the RGI account is zero ($10x-$10x).
(iii) Alternative facts in which the reduction is limited by
earnings and profits. The facts are the same as in paragraph (c)(3)(i)
of this section (Example 3), except that CFC2 has a $5x deficit in its
earnings and profits as of the end of its taxable year ending November
30, 2019. In this case--
(A) The adjusted earnings of CFC2 for its taxable year ending
November 30, 2019, is $5x, computed as -$5x (CFC2's deficit in earnings
and profits as of November 30, 2019) plus $10x (the sum of the $6x and
$4x amortization deductions of CFC2), see Sec. 1.245A-7(c)(3);
(B) The amount described in Sec. 1.245A-7(c)(1)(i) with respect to
US1 for CFC's taxable year ending November 30, 2019, is $5x, computed as
the excess of $5x (the adjusted earnings) over $0 (the sum of the
balance of the previously taxed earnings and profits accounts with
respect to CFC2), see Sec. 1.245A-7(c)(1)(i);
(C) On December 31, 2019, US1's extraordinary disposition account
with respect to CFC1 is reduced by $5x, the lesser of the amount
described in Sec. 1.245A-7(c)(1)(i) with respect to US1 for CFC2's
taxable year ending November 30, 2019 ($5x), and the balance of US1's
RGI account with respect to CFC2 that relates to its extraordinary
disposition account with respect to CFC1 ($10x, determined as of
November 30, 2019, but without regard to the application of Sec.
1.245A-8(c)(4)(i)(B) for the taxable year of CFC2 ending on that date),
see Sec. Sec. 1.245A-7(c)(1) and 1.245A-9(c)(3); and
(D) On November 30, 2019 (the last day of CFC2's taxable year), the
balance of US1's RGI account with respect to CFC2 is decreased by $5x
(the amount of the reduction, pursuant to Sec. 1.245A-7(c)(1) and by
reason of the RGI account, to US1's extraordinary disposition account
with respect to CFC1) and, therefore, following such reduction, the
balance of the RGI account is $5x ($10x-$5x), see Sec. 1.245A-
7(c)(4)(ii).
(4) Example 4. Reduction to extraordinary disposition accounts
limited by Sec. 1.245A-8(c)(6)--(i) Facts. The facts are the same as in
paragraph (c)(3)(iii) of this section (Example 3, alternative facts in
which the reduction is limited by earnings and profits) (and the results
are the same as in paragraph (c)(1)(ii)(A) of this section), except that
US1 also owns 100% of the stock of US2, which owns 100% of the stock of
CFC3, and on November 30, 2018, in a transaction that was an
extraordinary disposition, CFC3 sold an item of specified property
(``Item 3'') to CFC2 in exchange for $200x of cash. Item 3 had a basis
of $0 in the hands of CFC3 immediately before the sale and, therefore,
CFC3 recognized $200x of gain as a result of the sale ($200x-$0), Item 3
has $200x of disqualified basis under Sec. 1.951A-2(c)(5), and US2 has
an extraordinary disposition account with respect to CFC3 with an
initial balance of $200x under Sec. 1.245A-5(c)(3)(i)(A). Moreover,
during CFC2's taxable year beginning December 1, 2018, and ending
November 30, 2019, the disqualified basis of Item 3 gives rise to a $20x
amortization deduction, which is allocated and apportioned to residual
CFC gross income of CFC2 solely by reason of Sec. 1.951A-2(c)(5)
(though, but for Sec. 1.951A-2(c)(5), would have been allocated and
apportioned to gross tested income of CFC2). Further, as of the end of
US1's 2018 taxable year, the balance of US1's basis benefit account with
respect to its extraordinary disposition account with respect to CFC1 is
$0; similarly, as of the end of US2's 2018 taxable year, the
[[Page 534]]
balance of US2's basis benefit account with respect to its extraordinary
disposition account with respect to CFC2 is $0. Because CFC2 holds items
of specified property that correspond to more than one extraordinary
disposition account (that is, Item 1 and Item 2 correspond to US1's
extraordinary disposition account with respect to CFC2, and Item 3
corresponds to US2's extraordinary disposition account with respect to
CFC2), the condition of Sec. 1.245A-6(b)(2) is not satisfied. See Sec.
1.245A-6(b)(2)(ii)(C)(3). US1 and US2 therefore apply Sec. 1.245A-8
(rules for complex cases) for their 2018 taxable years.
(ii) Analysis. Pursuant to Sec. 1.245A-8(c)(1), US1's extraordinary
disposition account with respect to CFC1 is, subject to the limitation
in Sec. 1.245A-8(c)(6), reduced by the lesser of the amount described
in Sec. 1.245A-8(c)(1)(i) with respect to US1, and the RGI account of
US1 with respect to CFC2 that relates to its extraordinary disposition
account with respect to CFC1. See Sec. 1.245A-8(c)(1). Similarly, US2's
extraordinary disposition account with respect to CFC3 is, subject to
the limitation in Sec. 1.245A-8(c)(6), reduced by the lesser of the
amount described in Sec. 1.245A-8(c)(1)(i) with respect to US2, and the
RGI account of US2 with respect to CFC2 that relates to its
extraordinary disposition account with respect to CFC3. See Sec.
1.245A-8(c)(1). Paragraphs (c)(4)(ii)(A) through (F) of this section
describe the determinations pursuant to Sec. 1.245A-8(c)(1).
(A) Ownership requirement. Each of US1 and US2 satisfy the ownership
requirement of Sec. 1.245A-8(c)(5) for CFC2's taxable year ending
November 30, 2019, because on the last day of that taxable year each is
a United States shareholder with respect to CFC2. See Sec. 1.245A-
8(c)(5).
(B) Computation of adjusted earnings of CFC2, and amount described
in Sec. 1.245A-8(c)(1)(i) with respect to US1 and US2. The adjusted
earnings of CFC2 for its taxable year ending November 30, 2019, is $25x,
computed as -$5x (CFC2's deficit in earnings and profits as of November
30, 2019), plus $30x (the sum of the $6x, $4x, and $20x amortization
deductions of CFC2). See Sec. 1.245A-8(c)(3). For CFC2's taxable year
ending November 30, 2019, the amount described in Sec. 1.245A-
8(c)(1)(i) with respect to US1 is $25x, computed as the excess of the
product of $25x (the adjusted earnings) and 100% (the percentage of the
stock of CFC2 that US1 and its domestic affiliate, US2, own), over $0
(the sum of the balance of certain previously taxed earnings and profits
accounts and hybrid deduction accounts). See Sec. 1.245A-8(c)(1)(i).
Similarly, for CFC2's taxable year ending November 30, 2019, the amount
described in Sec. 1.245A-8(c)(1)(i) with respect to US2 is $25x,
computed as the excess of the product of $25x (the adjusted earnings)
and 100% (the percentage of the stock of CFC2 that US2 and its domestic
affiliate, US1, own), over $0 (the sum of the balance of certain
previously taxed earnings and profits accounts and hybrid deduction
accounts). See Sec. 1.245A-8(c)(1)(i).
(C) Increase to balance of RGI account. As described in paragraph
(c)(3)(ii)(B) of this section, US1 has an RGI account with respect to
CFC2 that relates to its extraordinary disposition account with respect
to CFC1, and the balance of the RGI account is $10x on November 30, 2019
(the last day of CFC2's taxable year). Similarly, US2 has an RGI account
with respect to CFC2 that relates to its extraordinary disposition
account with respect to CFC3, and the balance of the RGI account is $20x
on November 30, 2019 (reflecting a $20x increase to the balance of the
account for the $20x amortization deduction of CFC2 for its taxable year
ending November 30, 2019). See Sec. 1.245A-8(c)(4)(i).
(D) Reduction in balance of extraordinary disposition accounts but
for Sec. 1.245A-8(c)(6). But for the application of Sec. 1.245A-
8(c)(6), US1's extraordinary disposition account with respect to CFC2
would be reduced by $10x, which is the lesser of $25x, the amount
described in Sec. 1.245A-8(c)(1)(i) with respect to US1 for CFC2's
taxable year ending November 30, 2019, and $10x, the balance of the RGI
account of US1 with respect to CFC2 that relates to its extraordinary
disposition account with respect to CFC1 (determined as of November 30,
2019, but without regard to the application of Sec. 1.245A-
8(c)(4)(i)(B) for the taxable year of CFC2 ending on that date). See
Sec. 1.245A-8(c)(1)(i) and (ii). Similarly, but for the application of
Sec. 1.245A-8(c)(6), US2's extraordinary disposition account with
respect to CFC3 would be reduced by $20x, which is the lesser of $25x,
the amount described in Sec. 1.245A-8(c)(1)(i) with respect to US2 for
CFC2's taxable year ending November 30, 2019, and $20x, the balance of
the RGI account of US2 with respect to CFC2 that relates to its
extraordinary disposition account with respect to CFC3 (determined as of
November 30, 2019, but without regard to the application of Sec.
1.245A-8(c)(4)(i)(B) for the taxable year of CFC2 ending on that date).
See Sec. 1.245A-8(c)(1)(i) and (ii).
(E) Application of limitation of Sec. 1.245A-8(c)(6). As described
in paragraph (c)(4)(ii)(D) of this section, but for the application of
Sec. 1.245A-8(c)(6), there would be a total of $30x of reductions to
US1's extraordinary disposition account with respect to CFC1, and US2's
extraordinary disposition account with respect to CFC3, by reason of the
application of Sec. 1.245A-8(c)(1) with respect to CFC2's taxable year
ending November 30, 2019. Because that $30x exceeds the amount described
in Sec. 1.245A-8(c)(1)(i) with respect to US1 and US2 ($25x)--
(1) US1's extraordinary disposition account with respect to CFC1 is
reduced by $7.86x, computed as $10x (the reduction that would occur but
for Sec. 1.245A-8(c)(6)) less the product
[[Page 535]]
of $5x (the excess amount, computed as $30x, the total reductions that
would occur but for the application of Sec. 1.245A-8(c)(6), less $25x,
the amount described in Sec. 1.245A-8(c)(1)(i)) and a fraction, the
numerator of which is $150x (the balance of US1's extraordinary
disposition account with respect to CFC1) and the denominator of which
is $350x ($150x, the balance of US1's extraordinary disposition account
with respect to CFC1, plus $200x, the balance of US2's extraordinary
disposition account with respect to CFC3), see Sec. 1.245A-8(c)(6); and
(2) US2's extraordinary disposition account with respect to CFC3 is
reduced by $17.14x, computed as $20x (the reduction that would occur but
for Sec. 1.245A-8(c)(6)) less the product of $5x (the excess amount,
computed as $30x, the total reductions that would occur but for the
application of Sec. 1.245A-8(c)(6), less $25x, the amount described in
Sec. 1.245A-8(c)(1)(i)) and a fraction, the numerator of which is $200x
(the balance of US2's extraordinary disposition account with respect to
CFC3) and the denominator of which is $350x ($150x, the balance of US1's
extraordinary disposition account with respect to CFC1, plus $200x, the
balance of US2's extraordinary disposition account with respect to
CFC3), see Sec. 1.245A-8(c)(6) of this section.
(F) Reduction in balance of RGI accounts. On November 30, 2019 (the
last day of CFC2's taxable year)--
(1) The balance of US1's RGI account with respect to CFC2 that
relates to its extraordinary disposition account with respect to CFC1 is
decreased by $7.86x (the amount of the reduction, pursuant to Sec.
1.245A-8(c)(1) and by reason of the RGI account, to US1's extraordinary
disposition account with respect to CFC1) and, thus, following that
reduction, the balance of the RGI account is $2.14x ($10x-$7.86x), see
Sec. 1.245A-8(c)(4)(i)(B); and
(2) The balance of US2's RGI account with respect to CFC2 that
relates to its extraordinary disposition account with respect to CFC3 is
decreased by $17.14x (the amount of the reduction, pursuant to Sec.
1.245A-8(c)(1) and by reason of the RGI account, to US2's extraordinary
disposition account with respect to CFC3) and, thus, following that
reduction, the balance of the RGI account is $2.86x ($20x-$17.14x), see
Sec. 1.245A-8(c)(4)(i)(B).
(5) Example 5. Computation of duplicate DQB--(i) Facts. The facts
are the same as in paragraph (c)(1)(i) of this section (Example 1) (and
the results are the same as in paragraph (c)(1)(ii)(A) of this section),
except that CFC1 does not make any distribution to US1, and on November
30, 2018, immediately after the Disqualified Transfer, CFC2 transfers
Item 1 to newly-formed CFC3 solely in exchange for the sole share of
stock of CFC3 (the contribution, ``Contribution 1,'' and the share of
stock of CFC3, the ``CFC3 Share'') and, immediately after Contribution
1, CFC3 transfers Item 1 to newly-formed CFC4 solely in exchange for the
sole share of stock of CFC4 (the contribution, ``Contribution 2,'' and
the share of stock of CFC4, the ``CFC4 Share''). Pursuant to section
358(a)(1), CFC2's basis in its share of stock of CFC3 is $90x, and
CFC3's basis in its share of stock of CFC4 is $90x basis. As a result of
Contribution 1, the condition of Sec. 1.245A-6(b)(2) is not satisfied,
because on at least one day of CFC2's taxable year ending on November
30, 2018 (which ends within US1's 2018 taxable year), CFC2 does not hold
Item 1. See Sec. 1.245A-6(b)(2)(ii)(C)(1). US1 therefore applies Sec.
1.245A-8 (rules for complex cases) for its 2018 taxable year. See Sec.
1.245A-6(b).
(ii) Analysis--(A) Application of exchanged basis rule under section
951A to Contribution 1 and Contribution 2. As a result of Contribution
1, pursuant to Sec. 1.951A-3(h)(2)(ii)(B)(2)(ii), the disqualified
basis of CFC3 Share includes the disqualified basis of Item 1 ($90x),
and therefore the disqualified basis of CFC3 Share is $90x. Similarly,
as a result of Contribution 2, pursuant to Sec. 1.951A-
3(h)(2)(ii)(B)(2)(ii), the disqualified basis of CFC4 Share also
includes the disqualified basis of Item 1 ($90x), and therefore the
disqualified basis of CFC4 Share is $90x.
(B) Determination of duplicate DQB of CFC3 Share as a result of
Contribution 1. Because the disqualified basis of CFC3 Share includes
the disqualified basis of Item 1, CFC3 Share is an item of exchanged
basis property that relates to Item 1. See Sec. 1.245A-8(d)(2)(ii). In
addition, because CFC3 Share is an item of exchanged basis property that
relates to Item 1 (which corresponds to US1's extraordinary disposition
account with respect to CFC1), CFC3 Share is, for purposes of Sec.
1.245A-8, treated as an item of specified property that corresponds to
US1's extraordinary disposition account with respect to CFC1. See Sec.
1.245A-8(d)(2)(i). Further, the duplicate DQB of CFC3 Share as to Item 1
is $90x, the portion of the disqualified basis of CFC3 Share that
includes Item 1's disqualified basis of $90x. See Sec. 1.245A-
8(d)(2)(iii)(A).
(C) Determination of duplicate DQB of CFC4 Share as a result of
Contribution 2. For reasons similar to those described in paragraph
(c)(5)(ii)(B) of this section, CFC4 Share is an item of exchanged basis
property that relates to Item 1, CFC4 is treated for purposes of Sec.
1.245A-8 as an item of specified property that corresponds to US1's
extraordinary disposition account with respect to CFC1, and the
duplicate DQB of CFC4 Share as to Item 1 is $90x.
(D) Determination of duplicate DQB of CFC3 Share as a result of
Contribution 2. Because the disqualified basis of CFC3 Share and the
disqualified basis of CFC4 Share each includes $90x of the disqualified
basis of Item 1 and CFC3 receives the CFC4 Share in Contribution 2, the
$90x of disqualified basis of CFC3 Share is attributable to the $90x of
disqualified basis of CFC4 Share, and CFC3
[[Page 536]]
Share is an item of exchanged basis property that relates to CFC4 Share.
See Sec. 1.245A-8(d)(2)(i) and (d)(2)(iii)(C). In addition, the
duplicate DQB of CFC3 Share as to CFC4 Share is $90x. See Sec. 1.245A-
8(d)(2)(iii)(A).
(E) Application of duplicate basis rules in Sec. 1.245A-8(b)(5).
For purposes of computing the fraction described in Sec. 1.245A-
8(b)(1)(ii), if US1's extraordinary disposition account with respect to
CFC1 were to give rise to an extraordinary disposition amount or a
tiered extraordinary disposition amount during US1's 2018 taxable year,
then the duplicate DQB of CFC3 Share and the duplicate DQB of CFC4 Share
would not be taken into account, because the disqualified basis of Item
1 (an item of specified property that corresponds to US1's extraordinary
disposition account and as to which each of CFC3 Share and CFC4 share
relates) would be taken into account. See Sec. 1.245A-8(b)(1)(ii) and
(b)(5)(i)(A). Accordingly, in such a case, for US1's 2018 taxable year,
the numerator of the fraction described in Sec. 1.245A-8(b)(1)(ii)
would reflect only the disqualified basis of Item 1 or Item 2, as
applicable, and the denominator would reflect only the sum of the
disqualified basis of each of Item 1 and Item 2. See Sec. 1.245A-
8(b)(1)(ii) and (b)(5)(i)(A). Furthermore, to the extent there were to
be a reduction under Sec. 1.245A-8(b)(1) to the disqualified basis of
Item 1, then the duplicate DQB of CFC4 Share would be reduced (but not
below zero) by the product of the reduction to the disqualified basis of
Item 1 and a fraction, the numerator of which would be $90x (the
duplicate DQB of CFC4 Share), and the denominator of which would also be
$90x (the duplicate DQB of CFC4 Share). See Sec. 1.245A-8(b)(5)(i)(B).
The $90x of duplicate DQB of CFC3 Share would be excluded from the
denominator of the fraction described in the previous sentence because
it is attributable to the $90x of duplicate DQB of CFC4 Share. See Sec.
1.245A-8(b)(5)(i)(B)(2) (last sentence). For reasons similar to those
described in this paragraph (c)(4)(ii)(E) with respect to the
application of Sec. 1.245A-8(b)(5)(i)(B) to CFC4 Share, the duplicate
DQB of CFC3 Share would be reduced (but not below zero) by the product
of the reduction to the disqualified basis of Item 1 and a fraction, the
numerator of which would be $90x, and the denominator of which would
also be $90x.
[T.D. 9934, 85 FR 76963, Dec. 1, 2020]
Sec. 1.245A-11 Applicability dates.
(a) In general. Sections 1.245A-6 through 1.245A-11 apply to taxable
years of a foreign corporation beginning on or after December 1, 2020
and to taxable years of section 245A shareholders in which or with which
such taxable years end.
(b) Exception. Notwithstanding paragraph (a) of this section, a
taxpayer may choose to apply Sec. Sec. 1.245A-6 through 1.245A-11 for a
taxable year of a foreign corporation beginning before December 1, 2020
and to a taxable year of a section 245A shareholder in which or with
which such taxable year ends, provided that the taxpayer and all persons
bearing a relationship to the taxpayer described in section 267(b) or
707(b) apply Sec. Sec. 1.245A-6 through 1.245A-11, in their entirety,
and Sec. 1.6038-2(f)(18) for all such taxable years and any subsequent
taxable years beginning before December 1, 2020.
[T.D. 9934, 85 FR 76963, Dec. 1, 2020]
Sec. 1.245A(d)-1 Disallowance of foreign tax credit or deduction.
(a) No foreign tax credit or deduction allowed under section
245A(d)-(1) Foreign income taxes paid or accrued by domestic
corporations or successors. No credit under section 901 or deduction is
allowed in any taxable year for:
(i) Foreign income taxes paid or accrued by a domestic corporation
that are attributable to section 245A(d) income of the domestic
corporation;
(ii) Foreign income taxes paid or accrued by a successor to a
domestic corporation that are attributable to section 245A(d) income of
the successor; and
(iii) Foreign income taxes paid or accrued by a domestic corporation
that is a United States shareholder of a foreign corporation, other than
a foreign corporation that is a passive foreign investment company (as
defined in section 1297) with respect to the domestic corporation and
that is not a controlled foreign corporation, that are attributable to
non-inclusion income of the foreign corporation and are not otherwise
disallowed under paragraph (a)(1)(i) or (ii) of this section.
(2) Foreign income taxes paid or accrued by foreign corporations. No
credit under section 901 or deduction is allowed in any taxable year for
foreign income taxes paid or accrued by a foreign corporation that are
attributable to section 245A(d) income, and such taxes are not eligible
to be deemed paid under section 960 in any taxable year.
(3) Effect of disallowance on earnings and profits. The disallowance
of a credit
[[Page 537]]
or deduction for foreign income taxes under this paragraph (a) does not
affect whether the foreign income taxes reduce earnings and profits of a
corporation.
(b) Attribution of foreign income taxes--(1) Section 245A(d) income.
Foreign income taxes are attributable to section 245A(d) income to the
extent that the foreign income taxes are allocated and apportioned under
Sec. 1.861-20 to the section 245A(d) income group. For purposes of this
paragraph (b)(1), Sec. 1.861-20 is applied by treating the section
245A(d) income group in each section 904 category of a domestic
corporation, successor, or foreign corporation as a statutory grouping
and treating all other income, including the receipt of a distribution
of previously taxed earnings and profits other than section 245A(d)
PTEP, as income in the residual grouping. See Sec. 1.861-20(d)(2)
through (3) for rules regarding the allocation and apportionment of
foreign income taxes to the statutory and residual groupings if the
taxpayer does not realize, recognize, or take into account a
corresponding U.S. item in the U.S. taxable year in which the foreign
income taxes are paid or accrued. In the case of a foreign law
distribution or foreign law disposition, a corresponding U.S. item is
assigned to the statutory and residual groupings under Sec. 1.861-
20(d)(2)(ii)(B) and (C) without regard to the application of section
246(c), the holding periods described in sections 964(e)(4)(A) and
1248(j), and Sec. 1.245A-5.
(2) Non-inclusion income of a foreign corporation--(i) Scope. This
paragraph (b)(2) provides rules for attributing foreign income taxes
paid or accrued by a domestic corporation that is a United States
shareholder of a foreign corporation to non-inclusion income of the
foreign corporation. It applies only in cases in which the foreign
income taxes are allocated and apportioned under Sec. 1.861-20 by
reference to the characterization of the tax book value of stock,
whether the stock is held directly or indirectly through a partnership
or other passthrough entity, for purposes of allocating and apportioning
the domestic corporation's interest expense, or by reference to the
income of a foreign corporation that is a reverse hybrid or foreign law
CFC.
(ii) Foreign income taxes on a remittance, U.S. return of capital
amount, or U.S. return of partnership basis amount. This paragraph
(b)(2)(ii) applies to foreign income taxes paid or accrued by a domestic
corporation that is a United States shareholder of a foreign corporation
with respect to foreign taxable income that the domestic corporation
includes by reason of a remittance, a distribution (including a foreign
law distribution) that is a U.S. return of capital amount or U.S. return
of partnership basis amount, or a disposition (including a foreign law
disposition) that gives rise to a U.S. return of capital amount or a
U.S. return of partnership basis amount. These foreign income taxes are
attributable to non-inclusion income of the foreign corporation to the
extent that they are allocated and apportioned to the domestic
corporation's section 245A subgroup of general category stock, section
245A subgroup of passive category stock, or section 245A subgroup of
U.S. source category stock in applying Sec. 1.861-20 for purposes of
section 904 as the operative section. For purposes of this paragraph
(b)(2)(ii), Sec. 1.861-20 is applied by treating the domestic
corporation's section 245A subgroup of general category stock, section
245A subgroup of passive category stock, and section 245A subgroup of
U.S. source category stock as the statutory groupings and treating the
tax book value of the non-section 245A subgroup of stock for each
separate category as tax book value in the residual grouping.
(iii) Foreign income taxes on income of a reverse hybrid or a
foreign law CFC. This paragraph (b)(2)(iii) applies to foreign income
taxes paid or accrued by a domestic corporation, other than a regulated
investment company (as defined in section 851), real estate investment
trust (as defined in section 856), or S corporation (as defined in
section 1361), that is a United States shareholder of a foreign
corporation that is a reverse hybrid or foreign law CFC with respect to
the foreign law pass-through income or foreign law inclusion regime
income of the reverse hybrid or foreign law CFC, respectively. These
taxes are attributable to the non-inclusion income
[[Page 538]]
of a reverse hybrid or foreign law CFC to the extent that they are
allocated and apportioned to the non-inclusion income group under Sec.
1.861-20. For purposes of this paragraph (b)(2)(iii), Sec. 1.861-20 is
applied by treating the non-inclusion income group in each section 904
category of the domestic corporation and the foreign corporation as a
statutory grouping and treating all other income as income in the
residual grouping.
(3) Anti-avoidance rule. Foreign income taxes are treated as
attributable to section 245A(d) income of a domestic corporation or
foreign corporation, or non-inclusion income of a foreign corporation,
if a transaction, series of related transactions, or arrangement is
undertaken with a principal purpose of avoiding the purposes of section
245A(d) and this section with respect to such foreign income taxes,
including, for example, by separating foreign income taxes from the
income, or earnings and profits, to which such foreign income taxes
relate or by making distributions (or causing inclusions) under foreign
law in multiple years that give rise to foreign income taxes that are
allocated and apportioned with reference to the same previously taxed
earnings and profits. See paragraph (d)(4) of this section (Example 3).
(c) Definitions. The following definitions apply for purposes of
this section.
(1) Corresponding U.S. item. The term corresponding U.S. item has
the meaning set forth in Sec. 1.861-20(b).
(2) Foreign income tax. The term foreign income tax has the meaning
set forth in Sec. 1.901-2(a).
(3) Foreign law CFC. The term foreign law CFC has the meaning set
forth in Sec. 1.861-20(b).
(4) Foreign law disposition. The term foreign law disposition has
the meaning set forth in Sec. 1.861-20(b).
(5) Foreign law distribution. The term foreign law distribution has
the meaning set forth in Sec. 1.861-20(b).
(6) Foreign law inclusion regime. The term foreign law inclusion
regime has the meaning set forth in Sec. 1.861-20(b).
(7) Foreign law inclusion regime income. The term foreign law
inclusion regime income has the meaning set forth in Sec. 1.861-20(b).
(8) Foreign law pass-through income. The term foreign law pass-
through income has the meaning set forth in Sec. 1.861-20(b).
(9) Foreign taxable income. The term foreign taxable income has the
meaning set forth in Sec. 1.861-20(b).
(10) Gross included tested income. The term gross included tested
income means, with respect to a foreign corporation that is described in
paragraph (b)(2)(iii) of this section, an item of gross tested income
multiplied by the inclusion percentage of a domestic corporation that is
described in paragraph (b)(2)(iii) of this section for the domestic
corporation's U.S. taxable year with or within which the foreign
corporation's taxable year described in Sec. 1.861-20(d)(3)(i)(C) or
Sec. 1.861-20(d)(3)(iii) ends.
(11) Hybrid dividend. The term hybrid dividend has the meaning set
forth in Sec. 1.245A(e)-1(b)(2).
(12) Inclusion percentage. The term inclusion percentage has the
meaning set forth in Sec. 1.960-1(b).
(13) Non-inclusion income. The term non-inclusion income means the
items of gross income of a foreign corporation other than the items that
are described in Sec. 1.960-1(d)(2)(ii)(B)(2) (items of income assigned
to the subpart F income groups) and section 245(a)(5) (without regard to
section 245(a)(12)), and other than gross included tested income.
(14) Non-inclusion income group. The term non-inclusion income group
means the income group within a section 904 category that consists of
non-inclusion income.
(15) Non-section 245A subgroup. The term non-section 245A subgroup
means each non-section 245A subgroup determined under Sec. 1.861-
13(a)(5), applied as if the foreign corporation whose stock is being
characterized were a controlled foreign corporation.
(16) Pass-through entity. The term pass-through entity has the
meaning set forth in Sec. 1.904-5(a)(4).
(17) Remittance. The term remittance has the meaning set forth in
Sec. 1.861-20(d)(3)(v)(E).
(18) Reverse hybrid. The term reverse hybrid has the meaning set
forth in Sec. 1.861-20(b).
(19) Section 245A subgroup. The term section 245A subgroup means
each section 245A subgroup determined under
[[Page 539]]
Sec. 1.861-13(a)(5), applied as if the foreign corporation whose stock
is being characterized were a controlled foreign corporation.
(20) Section 245A(d) income. With respect to a domestic corporation,
the term section 245A(d) income means a dividend (including a section
1248 dividend and a dividend received indirectly through a pass-through
entity) or an inclusion under section 951(a)(1)(A) for which a deduction
under section 245A(a) is allowed, a distribution of section 245A(d)
PTEP, a hybrid dividend, or an inclusion under section 245A(e)(2) and
Sec. 1.245A(e)-1(c)(1) by reason of a tiered hybrid dividend. With
respect to a successor of a domestic corporation, the term section
245A(d) income means the receipt of a distribution of section 245A(d)
PTEP. With respect to a foreign corporation, the term section 245A(d)
income means an item of subpart F income that gave rise to a deduction
under section 245A(a), a tiered hybrid dividend or a distribution of
section 245A(d) PTEP. An item described in this paragraph (c)(20) that
qualifies for the deduction under section 245A(a) is considered section
245A(d) income regardless of whether the domestic corporation claims the
deduction on its return with respect to the item.
(21) Section 245A(d) income group. The term section 245A(d) income
group means an income group within a section 904 category that consists
of section 245A(d) income.
(22) Section 245A(d) PTEP. The term section 245A(d) PTEP means
previously taxed earnings and profits described in Sec. 1.960-
3(c)(2)(v) or (ix) if such previously taxed earnings and profits arose
either as a result of a dividend that gave rise to a deduction under
section 245A(a), or as a result of a tiered hybrid dividend that, by
reason of section 245A(e)(2) and Sec. 1.245A(e)-1(c)(1), gave rise to
an inclusion in the gross income of a United States shareholder. For
purposes of this paragraph (c)(22), a dividend that qualifies for the
deduction under section 245A(a) is considered to have given rise to a
deduction under section 245A(a) regardless of whether the domestic
corporation claims the deduction on its return with respect to the
dividend.
(23) Section 904 category. The term section 904 category has the
meaning set forth in Sec. 1.960-1(b).
(24) Section 1248 dividend. The term section 1248 dividend means an
amount of gain that is treated as a dividend under section 1248.
(25) Successor. The term successor means a person, including an
individual who is a citizen or resident of the United States, that
acquires from any person any portion of the interest of a United States
shareholder in a foreign corporation for purposes of section 959(a).
(26) Tested income. The term tested income has the meaning set forth
in Sec. 1.960-1(b).
(27) Tiered hybrid dividend. The term tiered hybrid dividend has the
meaning set forth in Sec. 1.245A(e)-1(c)(2).
(28) U.S. capital gain amount. The term U.S. capital gain amount has
the meaning set forth in Sec. 1.861-20(b).
(29) U.S. return of capital amount. The term U.S. return of capital
amount has the meaning set forth in Sec. 1.861-20(b).
(30) U.S. return of partnership basis amount. The term U.S. return
of partnership basis amount means, with respect to a partnership in
which a domestic corporation is a partner, the portion of a distribution
by the partnership to the domestic corporation, or the portion of the
proceeds of a disposition of the domestic corporation's interest in the
partnership, that exceeds the U.S. capital gain amount.
(d) Examples. The following examples illustrate the application of
this section.
(1) Presumed facts. Except as otherwise provided, the following
facts are presumed for purposes of the examples:
(i) USP is a domestic corporation;
(ii) CFC is a controlled foreign corporation organized in Country A,
and is not a reverse hybrid or a foreign law CFC;
(iii) USP owns all of the outstanding stock of CFC;
(iv) USP would be allowed a deduction under section 245A(a) for
dividends received from CFC;
(v) All parties have a U.S. dollar functional currency and a U.S.
taxable year and foreign taxable year that correspond to the calendar
year; and
[[Page 540]]
(vi) References to income are to gross items of income, and no party
has deductions for Country A tax purposes or deductions for Federal
income tax purposes (other than foreign income tax expense).
(2) Example 1: Distribution for foreign and Federal income tax
purposes--(i) Facts. As of December 31, Year 1, CFC has $800x of section
951A PTEP (as defined in Sec. 1.960-3(c)(2)(viii)) in a single annual
PTEP account (as defined in Sec. 1.960-3(c)(1)), and $500x of earnings
and profits described in section 959(c)(3). On December 31, Year 1, CFC
distributes $1,000x of cash to USP. For Country A tax purposes, the
entire $1,000x distribution is a dividend and is therefore a foreign
dividend amount (as defined in Sec. 1.861-20(b)). Country A imposes a
withholding tax on USP of $150x with respect to the $1,000x of foreign
gross dividend income under Country A law. For Federal income tax
purposes, USP includes in gross income $200x of the distribution as a
dividend for which a deduction is allowable under section 245A(a). The
remaining $800x of the distribution is a distribution of PTEP that is
excluded from USP's gross income and not treated as a dividend under
section 959(a) and (d), respectively. The entire $1,000x dividend is a
U.S. dividend amount (as defined in Sec. 1.861-20(b)).
(ii) Analysis--(A) In general. The rules of this section are applied
by first determining the portion of the $150x Country A withholding tax
that is attributable under paragraph (b)(1) of this section to the
section 245A(d) income of USP, and then by determining the portion of
the $150x Country A withholding tax that is described in paragraph
(b)(2)(i) of this section and that is attributable under either
paragraph (b)(2)(ii) or (b)(2)(iii) of this section to the non-inclusion
income of CFC. No credit or deduction is allowed in any taxable year
under paragraph (a)(1)(i) of this section for any portion of the $150x
Country A withholding tax that is attributable to the section 245A(d)
income of USP, or, under paragraph (a)(1)(iii) of this section, for any
portion of that tax that is attributable to the non-inclusion income of
CFC, to the extent the tax is not disallowed under paragraph (a)(1)(i)
of this section.
(B) Attribution of foreign income taxes to section 245A(d) income.
Under paragraph (b)(1) of this section, the $150x Country A withholding
tax is attributable to the section 245A(d) income of USP to the extent
that it is allocated and apportioned to the section 245A(d) income group
(the statutory grouping) under Sec. 1.861-20. Section 1.861-20(c)
allocates and apportions foreign income tax to the statutory and
residual groupings to which the items of foreign gross income that were
included in the foreign tax base are assigned under Sec. 1.861-20(d).
Section 1.861-20(d)(3)(i) assigns foreign gross income that is a foreign
dividend amount, to the extent of the U.S. dividend amount, to the
statutory and residual groupings to which the U.S. dividend amount is
assigned. The $1,000x foreign dividend amount is therefore assigned to
the statutory and residual groupings to which the $1,000x U.S. dividend
amount is assigned under Federal income tax law. The $1,000x U.S.
dividend amount comprises a $200x dividend for which a deduction under
section 245A(a) is allowed, which is an item of section 245A(d) income,
and $800x of section 951A PTEP, the receipt of which is income in the
residual grouping. Accordingly, $200x of the $1,000x of foreign gross
dividend income is assigned to the section 245A(d) income group, and
$800x is assigned to the residual grouping. Under Sec. 1.861-20(f),
$30x ($150x x $200x/$1,000x) of the $150x Country A withholding tax is
apportioned to the section 245A(d) income group and is attributable to
the section 245A(d) income of USP. The remaining $120x ($150x x $800x/
$1,000x) of the tax is apportioned to the residual grouping.
(C) Attribution of foreign income taxes to non-inclusion income.
Under paragraph (b)(2) of this section, the $150x Country A withholding
tax may be attributed to non-inclusion income of CFC if the tax is
allocated and apportioned under Sec. 1.861-20 by reference to either
the characterization of the tax book value of stock under Sec. 1.861-9
or the income of a foreign corporation that is a reverse hybrid or
foreign law CFC. CFC is neither a reverse hybrid nor a foreign law CFC.
In addition, no
[[Page 541]]
portion of the $150x Country A withholding tax is allocated and
apportioned under Sec. 1.861-20 by reference to the characterization of
the tax book value of CFC's stock. See Sec. 1.861-20(d)(3)(i).
Therefore, none of the tax is attributable to non-inclusion income of
CFC.
(D) Disallowance. Under paragraph (a)(1)(i) of this section, no
credit under section 901 or deduction is allowed in any taxable year to
USP for the $30x portion of the Country A withholding tax that is
attributable to section 245A(d) income of USP.
(3) Example 2: Distribution for foreign law purposes--(i) Facts. As
of December 31, Year 1, CFC has $800x of section 951A PTEP (as defined
in Sec. 1.960-3(c)(2)(viii)) in a single annual PTEP account (as
defined in Sec. 1.960-3(c)(1)), and $500x of earnings and profits
described in section 959(c)(3). On December 31, Year 1, CFC distributes
$1,000x of its stock to USP. For Country A tax purposes, the entire
$1,000x stock distribution is treated as a dividend to USP and is
therefore a foreign dividend amount (as defined in Sec. 1.861-20(b)).
Country A imposes a withholding tax on USP of $150x with respect to the
$1,000x of foreign gross dividend income that USP includes under Country
A law. For Federal income tax purposes, USP does not recognize gross
income as a result of the stock distribution under section 305(a). The
$1,000x stock distribution is therefore a foreign law distribution.
(ii) Analysis--(A) In general. The rules of this section are applied
by first determining the portion of the $150x Country A withholding tax
that is attributable under paragraph (b)(1) of this section to the
section 245A(d) income of USP, and then by determining the portion of
the $150x Country A withholding tax that is described in paragraph
(b)(2)(i) of this section and that is attributable under either
paragraph (b)(2)(ii) or (b)(2)(iii) of this section to the non-inclusion
income of CFC. No credit or deduction is allowed in any taxable year
under paragraph (a)(1)(i) of this section for any portion of the $150x
Country A withholding tax that is attributable to the section 245A(d)
income of USP or, under paragraph (a)(1)(iii) of this section, for any
portion of that tax that is attributable to the non-inclusion income of
CFC, to the extent the tax is not disallowed under paragraph (a)(1)(i)
of this section.
(B) Attribution of foreign income taxes to section 245A(d) income.
Under paragraph (b)(1) of this section, the $150x Country A withholding
tax is attributable to the section 245A(d) income of USP to the extent
that it is allocated and apportioned to the section 245A(d) income group
(the statutory grouping) under Sec. 1.861-20. Section 1.861-20(c)
allocates and apportions foreign income tax to the statutory and
residual groupings to which the items of foreign gross income that were
included in the foreign tax base are assigned under Sec. 1.861-20(d).
In general, Sec. 1.861-20(d) assigns foreign gross income to the
statutory and residual groupings to which the corresponding U.S. item is
assigned. If a taxpayer does not recognize a corresponding U.S. item in
the year in which it pays or accrues foreign income tax with respect to
foreign gross income that it includes by reason of a foreign law
dividend, Sec. 1.861-20(d)(2)(ii)(B) assigns the foreign dividend
amount to the same statutory or residual groupings to which the foreign
dividend amount would be assigned if a distribution were made for
Federal income tax purposes in the amount of, and on the date of, the
foreign law distribution. Further, Sec. 1.861-20(d)(2)(ii)(B) computes
the U.S. dividend amount (as defined in Sec. 1.861-20(b)) as if the
distribution occurred on the date the distribution occurs for foreign
law purposes. Therefore, the foreign dividend amount is assigned to the
same statutory and residual groupings to which it would be assigned if a
$1,000x distribution occurred on December 31, Year 1 for Federal income
tax purposes. If such a distribution occurred, it would result in a
$200x dividend to USP for which a deduction would be allowed under
section 245A(a). The remaining $800x of the distribution would be
excluded from USP's gross income and not treated as a dividend under
section 959(a) and (d), respectively. Under paragraphs (c)(20) and
(b)(1) of this section, the $1,000x U.S. dividend amount comprises a
$200x dividend for which a deduction under section 245A(a) would be
[[Page 542]]
allowed, which is an item of section 245A(d) income, and $800x of
section 951A PTEP, which is income in the residual grouping.
Accordingly, $200x of the $1,000x foreign gross dividend income is
assigned to the section 245A(d) income group, and $800x is assigned to
the residual grouping. Under Sec. 1.861-20(f), $30x ($150x x $200x/
$1,000x) of the Country A foreign income tax is apportioned to the
section 245A(d) income group and is attributable to the section 245A(d)
income of USP. The remaining $120x ($150x x $800x/$1,000x) of the tax is
apportioned to the residual grouping.
(C) Attribution of foreign income taxes to non-inclusion income.
Under paragraph (b)(2) of this section, the $150x Country A withholding
tax may be attributed to non-inclusion income of CFC if the tax is
allocated and apportioned under Sec. 1.861-20 by reference to either
the characterization of the tax book value of stock under Sec. 1.861-9
or the income of a foreign corporation that is a reverse hybrid or
foreign law CFC. CFC is neither a reverse hybrid nor a foreign law CFC.
In addition, no portion of the $150x Country A withholding tax is
allocated and apportioned under Sec. 1.861-20 by reference to the
characterization of the tax book value of CFC's stock. See Sec. 1.861-
20(d)(3)(i). Therefore, none of the tax is attributable to non-inclusion
income of CFC.
(D) Disallowance. Under paragraph (a)(1)(i) of this section, no
credit under section 901 or deduction is allowed in any taxable year to
USP for the $30x portion of the Country A withholding tax that is
attributable to section 245A(d) income of USP.
(4) Example 3: Successive foreign law distributions subject to anti-
avoidance rule--(i) Facts. For Year 1, CFC earns $500x of subpart F
income that gives rise to a $500x gross income inclusion to USP under
section 951(a), and income that creates $500x of earnings and profits
described in section 959(c)(3). CFC earns no income in Years 2 through
4. As of January 1, Year 2, and through December 31, Year 4, CFC has
$500x of earnings and profits described in section 959(c)(3) and $500x
of section 951(a)(1)(A) PTEP (as defined in Sec. 1.960-3(c)(2)(x)) in a
single annual PTEP account (as defined in Sec. 1.960-3(c)(1)). In each
of Years 2 and 3, USP makes a consent dividend election under Country A
law that, for Country A tax purposes, deems CFC to distribute to USP,
and USP immediately to contribute to CFC, $500x on December 31 of each
year. For Country A tax purposes, each deemed distribution is a dividend
of $500x to USP, and each deemed contribution is a non-taxable
contribution of $500x to the capital of CFC. Each $500x deemed
distribution is therefore a foreign dividend amount (as defined in Sec.
1.861-20(b)). Country A imposes $150x of withholding tax on USP in each
of Years 2 and 3 with respect to the $500x of foreign gross dividend
income that USP includes in income under Country A law. For Federal
income tax purposes, the Country A deemed distributions in Years 2 and 3
are disregarded such that USP recognizes no income, and the deemed
distributions are therefore foreign law distributions. On December 31,
Year 4, CFC distributes $1,000x to USP, which for Country A tax purposes
is treated as a return of contributed capital on which no withholding
tax is imposed. For Federal income tax purposes, $500x of the $1,000x
distribution is a dividend to USP for which a deduction under section
245A(a) is allowed; the remaining $500x of the distribution is a
distribution of section 951(a)(1)(A) PTEP that is excluded from USP's
gross income and not treated as a dividend under section 959(a) and (d),
respectively. The entire $1,000x dividend is a U.S. dividend amount (as
defined in Sec. 1.861-20(b)). The Country A consent dividend elections
in Years 2 and 3 are made with a principal purpose of avoiding the
purposes of section 245A(d) and this section to disallow a credit or
deduction for Country A withholding tax incurred with respect to USP's
section 245A(d) income.
(ii) Analysis--(A) In general. The rules of this section are applied
by first determining the portion of the $150x Country A withholding tax
paid by USP in each of Years 2 and 3 that is attributable under
paragraph (b)(1) of this section to the section 245A(d) income of USP,
and then by determining the portion of the $150x Country A withholding
tax paid by USP in each of Years 2 and 3 that is described in paragraph
(b)(2)(i) of this section and that
[[Page 543]]
is attributable under either paragraph (b)(2)(ii) or (b)(2)(iii) of this
section to the non-inclusion income of CFC. Finally, the anti-avoidance
rule under paragraph (b)(3) of this section applies to treat any portion
of the $150x Country A withholding tax paid by USP in each of Years 2
and 3 as attributable to section 245A(d) income of USP or non-inclusion
income of CFC, if a transaction, series of related transactions, or
arrangement is undertaken with a principal purpose of avoiding the
purposes of section 245A(d) and this section. No credit or deduction is
allowed in any taxable year under paragraph (a)(1)(i) of this section
for any portion of the $150x Country A withholding tax paid by USP in
each of Years 2 and 3 that is attributable to the section 245A(d) income
of USP or, under paragraph (a)(1)(iii) of this section, for any portion
of that tax that is attributable to the non-inclusion income of CFC, to
the extent the tax is not disallowed under paragraph (a)(1)(i) of this
section.
(B) Attribution of foreign income taxes to section 245A(d) income.
Under paragraph (b)(1) of this section, the $150x Country A withholding
tax paid by USP in each of Years 2 and 3 is attributable to the section
245A(d) income of USP to the extent that it is allocated and apportioned
to the section 245A(d) income group (the statutory grouping) under Sec.
1.861-20. Section 1.861-20(c) allocates and apportions foreign income
tax to the statutory and residual groupings to which the items of
foreign gross income that were included in the foreign tax base are
assigned under Sec. 1.861-20(d). In general, Sec. 1.861-20(d) assigns
foreign gross income to the statutory and residual groupings to which
the corresponding U.S. item is assigned. If a taxpayer does not
recognize a corresponding U.S. item in the year in which it pays or
accrues foreign income tax with respect to foreign gross income that it
includes by reason of a foreign law dividend, Sec. 1.861-
20(d)(2)(ii)(B) assigns the foreign dividend amount to the same
statutory or residual groupings to which the foreign dividend amount
would be assigned if a distribution were made for Federal income tax
purposes in the amount of, and on the date of, the foreign law
distribution. Therefore, the $500x foreign dividend amount in each of
Years 2 and 3 is assigned to the same statutory and residual groupings
to which it would be assigned if a $500x distribution occurred on
December 31 of each of those years for Federal income tax purposes.
(1) Year 2 $500x deemed distribution. CFC made no distributions in
Year 1 and earned no income and made no distributions in Year 2 for
Federal income tax purposes. As of December 31, Year 2, CFC has $500x of
earnings and profits described in section 959(c)(3) and $500x of section
951(a)(1)(A) PTEP. If CFC distributed $500x on that date, the
distribution would be a distribution of section 951(a)(1)(A) PTEP. A
distribution of previously taxed earnings and profits is a U.S. dividend
amount. Section 1.861-20(d)(3)(i) assigns the foreign dividend amount,
to the extent of the U.S. dividend amount, to the statutory and residual
groupings to which the U.S. dividend amount is assigned. The receipt of
a distribution of previously taxed earnings and profits is assigned to
the residual grouping under paragraph (b)(1) of this section. Therefore,
all $500x foreign dividend amount would be assigned to the residual
grouping, and none of the $150x withholding tax paid or accrued by USP
in Year 2 would be treated as attributable to section 245A(d) income of
USP.
(2) Year 3 $500x deemed distribution. CFC made no distributions in
Year 1 and earned no income and made no distributions in Year 2 or Year
3 for Federal income tax purposes. Consequently, as of December 31, Year
3, CFC has $500x of earnings and profits described in section 959(c)(3)
and $500x of section 951(a)(1)(A) PTEP. If CFC distributed $500x on that
date, the distribution would be a distribution of section 951(a)(1)(A)
PTEP. For the reasons described in paragraph (d)(4)(ii)(B)(1) of this
section, all $500x of the foreign dividend amount would be assigned to
the residual grouping, and none of the $150x withholding tax paid or
accrued by USP in Year 3 would be treated as attributable to section
245A(d) income of USP.
[[Page 544]]
(3) Year 4 $1,000x distribution. The Year 4 $1,000x distribution is,
for Country A purposes, a return of capital distribution that is not
subject to withholding tax. For Federal income tax purposes, it
comprises a $500x dividend for which a deduction under section 245A(a)
is allowed, which is an item of section 245A(d) income of USP, and a
$500x distribution of section 951(a)(1)(A) PTEP, the receipt of which is
income in the residual grouping.
(C) Attribution of foreign income taxes to non-inclusion income.
Under paragraph (b)(2) of this section, the $150x Country A withholding
tax paid by USP in each of Years 2 and 3 may be attributed to non-
inclusion income of CFC if the tax is allocated and apportioned under
Sec. 1.861-20 by reference to either the characterization of the tax
book value of stock under Sec. 1.861-9 or the income of a foreign
corporation that is a reverse hybrid or foreign law CFC. CFC is neither
a reverse hybrid nor a foreign law CFC. In addition, no portion of the
Country A withholding tax is allocated and apportioned under Sec.
1.861-20 by reference to the characterization of the tax book value of
CFC's stock. See Sec. 1.861-20(d)(3)(i). Therefore, none of the tax is
attributable to non-inclusion income of CFC.
(D) Attribution of foreign income taxes pursuant to anti-avoidance
rule. USP made two successive foreign law distributions in Years 2 and 3
that were subject to Country A withholding tax and that did not
individually exceed, but together exceeded, the section 951(a)(1)(A)
PTEP of CFC. The Country A withholding tax on each consent dividend is
allocated to the residual grouping rather than to the statutory grouping
of section 245A(d) income under Sec. Sec. 1.861-20(d)(2)(ii) and 1.861-
20(d)(3)(i). USP paid no Country A withholding tax on the Year 4
distribution as a result of the Country A consent dividends in Years 2
and 3. If CFC had distributed its earnings and profits in Year 4 without
the prior consent dividends, the distribution would have been subject to
withholding tax, a portion of which would have been attributable to the
section 245A(d) income arising from the distribution. But for the
application of the anti-avoidance rule in paragraph (b)(3) of this
section, USP would avoid the disallowance under section 245A(d) with
respect to this portion of the withholding tax. Because USP made foreign
law distributions that caused withholding tax from multiple foreign law
distributions to be associated with the same previously taxed earnings
and profits with a principal purpose of avoiding the purposes of section
245A(d) and this section, the $150x Country A withholding tax paid by
USP in each of Years 2 and 3 is treated as being attributable to section
245A(d) income of USP.
(E) Disallowance. Under paragraph (a)(1)(i) of this section, no
credit under section 901 or deduction is allowed in any taxable year to
USP for the $150x Country A withholding tax paid by USP in each of Years
2 and 3 that is attributable to section 245A(d) income of USP.
(5) Example 4: Distribution that is in part a dividend and in part a
return of capital--(i) Facts. CFC uses the modified gross income method
to allocate and apportion its interest expense, and its stock has a tax
book value of $10,000x. For Year 1, CFC earns $500x of income that is
specified foreign source general category gross income as that term is
defined in Sec. 1.861-13(a)(1)(i)(A)(9) and is therefore neither tested
income nor subpart F income of CFC. As of December 31, Year 1, CFC has
$500x of earnings and profits described in section 959(c)(3). On that
date, CFC distributes $1,000x of cash to USP. For Country A tax
purposes, the entire $1,000x distribution is a dividend to USP and is
therefore a foreign dividend amount (as defined in Sec. 1.861-20(b)).
Country A imposes a withholding tax on USP of $150x with respect to the
$1,000x of foreign gross dividend income that USP includes under the law
of Country A. For Federal income tax purposes, USP includes $500x of the
distribution in its gross income as a dividend for which a $500x
deduction is allowed to USP under section 245A(a); the remaining $500x
of the distribution is applied against and reduces USP's basis in its
CFC stock under section 301(c)(2). The portion of the distribution that
is a $500x dividend is a U.S. dividend amount (as defined in Sec.
1.861-
[[Page 545]]
20(b)). The remaining $500x of the distribution is a U.S. return of
capital amount.
(ii) Analysis--(A) In general. The rules of this section are applied
by first determining the portion of the $150x Country A withholding tax
that is attributable under paragraph (b)(1) of this section to the
section 245A(d) income of USP, and then by determining the portion of
the $150x Country A withholding tax that is described in paragraph
(b)(2)(i) of this section and that is attributable under either
paragraph (b)(2)(ii) or (b)(2)(iii) of this section to the non-inclusion
income of CFC. No credit or deduction is allowed under paragraph
(a)(1)(i) of this section for any portion of the $150x Country A
withholding tax that is attributable to the section 245A(d) income of
USP or, under paragraph (a)(1)(iii) of this section, for any portion of
that tax that is attributable to the non-inclusion income of CFC, to the
extent the tax is not disallowed under paragraph (a)(1)(i) of this
section.
(B) Attribution of foreign income taxes to section 245A(d) income.
Under paragraph (b)(1) of this section, the $150x Country A withholding
tax is attributable to the section 245A(d) income of USP to the extent
that it is allocated and apportioned to the section 245A(d) income group
(the statutory grouping) under Sec. 1.861-20. Section 1.861-20(c)
allocates and apportions foreign income tax to the statutory and
residual groupings to which the items of foreign gross income that were
included in the foreign tax base are assigned under Sec. 1.861-20(d).
Section 1.861-20(d)(3)(i) assigns foreign gross income that is a foreign
dividend amount, to the extent of the U.S. dividend amount, to the
statutory and residual groupings to which the U.S. dividend amount is
assigned. Of the $1,000x foreign dividend amount, $500x is therefore
assigned to the statutory and residual groupings to which the $500x U.S.
dividend amount is assigned under Federal income tax law. The entire
$500x U.S. dividend amount is a dividend for which a section 245A(a)
deduction is allowed and is therefore section 245A(d) income that is
assigned to the section 245A(d) income group. Accordingly, $500x of the
foreign dividend amount is assigned to the section 245A(d) income group.
Under Sec. 1.861-20(f), $75x ($150x x $500x/$1,000x) of the Country A
withholding tax is allocated to the section 245A(d) income group and so
under paragraph (b)(1) of this section is attributable to the section
245A(d) income of USP.
(C) Attribution of foreign income taxes to non-inclusion income. The
remaining $75x of the Country A withholding tax is described in
paragraph (b)(2)(i) of this section because the $500x of foreign
dividend amount that corresponds to the $500x U.S. return of capital
amount is assigned, and the remaining withholding tax imposed on that
foreign dividend amount is allocated and apportioned, by reference to
the characterization of the tax book value of the stock of CFC. Under
paragraph (b)(2)(ii) of this section, the remaining $75x Country A
withholding tax is attributable to non-inclusion income of CFC to the
extent that the tax is allocated and apportioned under Sec. 1.861-20 to
USP's section 245A subgroup of general category stock, section 245A
subgroup of passive category stock, and section 245A subgroup of U.S.
source category stock (the statutory groupings) for purposes of section
904 as the operative section. Under Sec. 1.861-20(d)(3)(i), the $500x
portion of the foreign dividend amount that corresponds to the $500x
U.S. return of capital amount is assigned to the statutory and residual
groupings to which $500x of earnings of CFC would be assigned if CFC
recognized them in Year 1. Those earnings are deemed to arise in the
statutory and residual groupings in the same proportions as the
proportions of the tax book value of CFC's stock in the groupings for
Year 1 for purposes of applying the asset method of expense allocation
and apportionment under Sec. 1.861-9. Under Sec. 1.861-9, Sec. 1.861-
9T(f), and Sec. 1.861-13, for purposes of section 904 as the operative
section, all of the tax book value of the stock of CFC is assigned to
USP's section 245A subgroup of general category stock because CFC uses
the modified gross income method to allocate and apportion its interest
expense and earns only specified foreign source general category gross
income for Year 1. Under Sec. 1.861-20(d)(3)(i), if CFC recognized
[[Page 546]]
$500x of earnings in Year 1 these earnings would be deemed to arise in
the section 245A subgroup of general category stock. Accordingly, the
remaining $500x of foreign dividend amount is assigned to USP's section
245A subgroup of general category stock. Under Sec. 1.861-20(f), the
remaining $75x of withholding tax is allocated to the section 245A
subgroup and, under paragraph (b)(2)(ii) of this section, is
attributable to the non-inclusion income of CFC.
(D) Disallowance. Under paragraph (a)(1)(i) of this section, no
credit under section 901 or deduction is allowed in any taxable year to
USP for the $75x portion of the Country A withholding tax that is
attributable to section 245A(d) income of USP. Under paragraph
(a)(1)(iii) of this section, no credit under section 901 or deduction is
allowed in any taxable year to USP for the $75x portion of the Country A
withholding tax that is attributable to non-inclusion income of CFC.
(6) Example 5: Income of a reverse hybrid--
(i) Facts. CFC is a reverse hybrid. In Year 1, CFC earns a $500x
item of gain described in section 907(c)(1)(B) that is non-inclusion
income. CFC also earns for Federal income tax purposes and Country A tax
purposes a $1,000x item of royalty income, of which $500x is gross
included tested income and $500x is non-inclusion income. USP includes
the $500x item of foreign gain and the $1,000x item of foreign gross
royalty income in its Country A taxable income, and the items are
foreign law pass-through income. If CFC included these items under
Country A tax law, its $1,000x of royalty income for Federal income tax
purposes would be the corresponding U.S. item for the foreign gross
royalty income, and its $500x of gain for Federal income tax purposes
would be the corresponding U.S. item for the foreign gain. Country A
imposes a $150x foreign income tax on USP with respect to $1,500x of
foreign gross income.
(ii) Analysis--(A) In general. The rules of this section are applied
by first determining the portion of the $150x Country A tax that is
attributable under paragraph (b)(1) of this section to the section
245A(d) income of USP, and then by determining the portion of the $150x
Country A tax that is described in paragraph (b)(2)(i) of this section
and that is attributable under either paragraph (b)(2)(ii) or (iii) of
this section to the non-inclusion income of CFC. No credit or deduction
is allowed under paragraph (a)(1)(i) of this section for any portion of
the $150x Country A tax that is attributable to the section 245A(d)
income of USP or, under paragraph (a)(1)(iii) of this section, for any
portion of that tax that is attributable to the non-inclusion income of
CFC, to the extent the tax is not disallowed under paragraph (a)(1)(i)
of this section.
(B) Attribution of foreign income taxes to section 245A(d) income.
Under paragraph (b)(1) of this section, the $150x Country A tax is
attributable to section 245A(d) income to the extent the tax is
allocated and apportioned to the section 245A(d) income group (the
statutory grouping) under Sec. 1.861-20. Section 1.861-20(c) allocates
and apportions foreign income tax to the statutory and residual
groupings to which the items of foreign gross income that were included
in the foreign tax base are assigned under Sec. 1.861-20(d). In
general, Sec. 1.861-20(d) assigns foreign gross income to the statutory
and residual groupings to which the corresponding U.S. item is assigned.
Section 1.861-20(d)(3)(i)(C) assigns the foreign law pass-through income
that USP includes by reason of its ownership of CFC to the statutory and
residual groupings by treating USP's foreign law pass-through income as
foreign gross income of CFC, and by treating CFC as paying the $150x of
Country A tax in CFC's U.S. taxable year within which its foreign
taxable year ends (Year 1). CFC is therefore treated as including a
$1,000x foreign gross royalty item and a $500x foreign gross income item
of gain and paying $150x of Country A tax in Year 1. These foreign gross
income items are assigned to the statutory and residual groupings to
which the corresponding U.S. items are assigned under Federal income tax
law. No foreign gross income is assigned to the section 245A(d) income
group because neither the corresponding U.S. item of royalty income nor
the corresponding U.S. item of gain is assigned to the section 245A(d)
income group. Therefore,
[[Page 547]]
none of USP's Country A tax is allocated to the section 245A(d) income
group.
(C) Attribution of foreign income taxes to non-inclusion income. The
$150x Country A tax is described in paragraph (b)(2) of this section
because USP is a United States shareholder of CFC, CFC is a reverse
hybrid, and Sec. 1.861-20(d)(3)(i)(C) allocates and apportions the tax
by reference to the income of CFC. Under paragraph (b)(2)(iii) of this
section, the $150x Country A tax is attributable to the non-inclusion
income of CFC to the extent that the foreign income taxes are allocated
and apportioned to the non-inclusion income group under Sec. 1.861-20.
For the reasons described in paragraph (d)(6)(ii)(B) of this section,
under Sec. 1.861-20(d)(3)(i)(C) CFC is treated as including a $1,000x
foreign gross royalty item and a $500x foreign gross income item of gain
and paying $150x of Country A tax in Year 1. These foreign gross income
items are assigned to the statutory and residual groupings to which the
corresponding U.S. items are assigned under Federal income tax law. For
Federal income tax purposes, the $500x item of gain and $500x of the
$1,000x item of royalty income are items of non-inclusion income that
are therefore assigned to the non-inclusion income group. The remaining
$500x of the foreign gross royalty income item is assigned to the
residual grouping. Under Sec. 1.861-20(f), $100x ($150x x $1,000x/
$1,500x) of the Country A tax is apportioned to the non-inclusion income
group, and $50x ($150x x $500x/$1,500x) is apportioned to the residual
grouping. Under paragraph (b)(2)(iii) of this section, the $100x of
Country A tax that is apportioned to the non-inclusion income group
under Sec. 1.861-20(d)(3)(i)(C) is attributable to non-inclusion income
of CFC.
(D) Disallowance. Under paragraph (a)(1)(iii) of this section, no
credit under section 901 or deduction is allowed in any taxable year to
USP for the $100x of Country A foreign income tax that is attributable
to non-inclusion income of CFC.
(e) Applicability date. This section applies to taxable years of a
foreign corporation that begin after December 31, 2019, and end on or
after November 2, 2020, and with respect to a United States person,
taxable years in which or with which such taxable years of the foreign
corporation end.
[T.D. 9959, 87 FR 317, Jan. 4, 2022, as amended by 87 FR 45018, July 27,
2022]
Sec. 1.245A(e)-1 Special rules for hybrid dividends.
(a) Overview. This section provides rules for hybrid dividends.
Paragraph (b) of this section disallows the deduction under section
245A(a) for a hybrid dividend received by a United States shareholder
from a CFC. Paragraph (c) of this section provides a rule for hybrid
dividends of tiered corporations. Paragraph (d) of this section sets
forth rules regarding a hybrid deduction account. Paragraph (e) of this
section provides an anti-avoidance rule. Paragraph (f) of this section
provides definitions. Paragraph (g) of this section illustrates the
application of the rules of this section through examples. Paragraph (h)
of this section provides the applicability date.
(b) Hybrid dividends received by United States shareholders--(1) In
general. If a United States shareholder receives a hybrid dividend,
then--
(i) The United States shareholder is not allowed a deduction under
section 245A(a) for the hybrid dividend; and
(ii) The rules of section 245A(d) and Sec. 1.245A(d)-1
(disallowance of foreign tax credits and deductions) apply to the hybrid
dividend. See paragraph (g)(1) of this section for an example
illustrating the application of paragraph (b) of this section.
(2) Definition of hybrid dividend. The term hybrid dividend means an
amount received by a United States shareholder from a CFC for which,
without regard to section 245A(e) and this section as well as Sec.
1.245A-5, the United States shareholder would be allowed a deduction
under section 245A(a), to the extent of the sum of the United States
shareholder's hybrid deduction accounts (as described in paragraph (d)
of this section) with respect to each share of stock of the CFC,
determined at the close of the CFC's taxable year (or in accordance with
paragraph (d)(5) of this section, as applicable). No other amount
received by a United States shareholder from a CFC is a hybrid dividend
for purposes of section 245A.
[[Page 548]]
(3) Special rule for certain dividends attributable to earnings of
lower-tier foreign corporations. This paragraph (b)(3) applies if a
domestic corporation directly or indirectly (as determined under the
principles of Sec. 1.245A-5(g)(3)(ii)) sells or exchanges stock of a
foreign corporation and, pursuant to section 1248, the gain recognized
on the sale or exchange is included in gross income as a dividend. In
such a case, for purposes of this section--
(i) To the extent that earnings and profits of a lower-tier CFC gave
rise to the dividend under section 1248(c)(2), those earnings and
profits are treated as distributed as a dividend by the lower-tier CFC
directly to the domestic corporation under the principles of Sec.
1.1248-1(d); and
(ii) To the extent the domestic corporation indirectly owns (within
the meaning of section 958(a)(2), and determined by treating a domestic
partnership as foreign) shares of stock of the lower-tier CFC, the
hybrid deduction accounts with respect to those shares are treated as
the domestic corporation's hybrid deduction accounts with respect to
stock of the lower-tier CFC. Thus, for example, if a domestic
corporation sells or exchanges all the stock of an upper-tier CFC and
under this paragraph (b)(3) there is considered to be a dividend paid
directly by the lower-tier CFC to the domestic corporation, then the
dividend is generally a hybrid dividend to the extent of the sum of the
upper-tier CFC's hybrid deduction accounts with respect to stock of the
lower-tier CFC.
(4) Ordering rule. Amounts received by a United States shareholder
from a CFC are subject to the rules of section 245A(e) and this section
based on the order in which they are received. Thus, for example, if on
different days during a CFC's taxable year a United States shareholder
receives dividends from the CFC, then the rules of section 245A(e) and
this section apply first to the dividend received on the earliest date
(based on the sum of the United States shareholder's hybrid deduction
accounts with respect to each share of stock of the CFC), and then to
the dividend received on the next earliest date (based on the remaining
sum).
(c) Hybrid dividends of tiered corporations--(1) In general. If a
CFC (the receiving CFC) receives a tiered hybrid dividend from another
CFC, and a domestic corporation is a United States shareholder with
respect to both CFCs, then, notwithstanding any other provision of the
Code--
(i) For purposes of section 951(a) as to the United States
shareholder, the tiered hybrid dividend is treated for purposes of
section 951(a)(1)(A) as subpart F income of the receiving CFC for the
taxable year of the CFC in which the tiered hybrid dividend is received;
(ii) The United States shareholder includes in gross income an
amount equal to its pro rata share (determined in the same manner as
under section 951(a)(2)) of the subpart F income described in paragraph
(c)(1)(i) of this section; and
(iii) The rules of section 245A(d) and Sec. 1.245A(d)-1
(disallowance of foreign tax credit, including for taxes that would have
been deemed paid under section 960(a) or (b), and deductions) apply to
the amount included under paragraph (c)(1)(ii) of this section in the
United States shareholder's gross income. See paragraph (g)(2) of this
section for an example illustrating the application of paragraph (c) of
this section.
(2) Definition of tiered hybrid dividend. The term tiered hybrid
dividend means an amount received by a receiving CFC from another CFC to
the extent that the amount would be a hybrid dividend under paragraph
(b)(2) of this section if, for purposes of section 245A and the
regulations in this part under section 245A (except for section
245A(e)(2) and this paragraph (c)), the receiving CFC were a domestic
corporation. A tiered hybrid dividend does not include an amount
described in section 959(b). No other amount received by a receiving CFC
from another CFC is a tiered hybrid dividend for purposes of section
245A.
(3) Special rule for certain dividends attributable to earnings of
lower-tier foreign corporations. This paragraph (c)(3) applies if a CFC
directly or indirectly (as determined under the principles of Sec.
1.245A-5(g)(3)(ii)) sells or exchanges
[[Page 549]]
stock of a foreign corporation and pursuant to section 964(e)(1) the
gain recognized on the sale or exchange is included in gross income as a
dividend. In such a case, the rules of paragraph (b)(3) of this section
apply, by treating the CFC as the domestic corporation described in
paragraph (b)(3) of this section and substituting the phrase ``sections
964(e)(1) and 1248(c)(2)'' for the phrase ``section 1248(c)(2)'' in
paragraph (b)(3)(i) of this section.
(4) Interaction with rules under section 964(e). To the extent a
dividend described in section 964(e)(1) (gain on certain stock sales by
CFCs treated as dividends) is a tiered hybrid dividend, the rules of
section 964(e)(4) do not apply as to a domestic corporation that is a
United States shareholder of both of the CFCs described in paragraph
(c)(1) of this section and, therefore, such United States shareholder is
not allowed a deduction under section 245A(a) for the amount included in
gross income under paragraph (c)(1)(ii) of this section.
(d) Hybrid deduction accounts--(1) In general. A specified owner of
a share of CFC stock must maintain a hybrid deduction account with
respect to the share. The hybrid deduction account with respect to the
share must reflect the amount of hybrid deductions of the CFC allocated
to the share (as determined under paragraphs (d)(2) and (3) of this
section), and must be maintained in accordance with the rules of
paragraphs (d)(4) through (6) of this section.
(2) Hybrid deductions--(i) In general. The term hybrid deduction of
a CFC means a deduction or other tax benefit (such as an exemption,
exclusion, or credit, to the extent equivalent to a deduction) for which
the requirements of paragraphs (d)(2)(i)(A) and (B) of this section are
both satisfied.
(A) The deduction or other tax benefit is allowed to the CFC (or a
person related to the CFC) under a relevant foreign tax law, regardless
of whether the deduction or other tax benefit is used, or otherwise
reduces tax, currently under the relevant foreign tax law.
(B) The deduction or other tax benefit relates to or results from an
amount paid, accrued, or distributed with respect to an instrument
issued by the CFC and treated as stock for U.S. tax purposes, or is a
deduction allowed to the CFC with respect to equity. Examples of such a
deduction or other tax benefit include an interest deduction, a
dividends paid deduction, and a notional interest deduction (or similar
deduction determined with respect to the CFC's equity). However, a
deduction or other tax benefit relating to or resulting from a
distribution by the CFC that is a dividend for purposes of the relevant
foreign tax law is considered a hybrid deduction only to the extent it
has the effect of causing the earnings that funded the distribution to
not be included in income (determined under the principles of Sec.
1.267A-3(a)) or otherwise subject to tax under such tax law. Thus, for
example, upon a distribution by a CFC that is treated as a dividend for
purposes of the CFC's tax law to a shareholder of the CFC, a dividends
paid deduction allowed to the CFC under its tax law (or a refund to the
shareholder, including through a credit, of tax paid by the CFC on the
earnings that funded the distribution) pursuant to an integration or
imputation system is not a hybrid deduction of the CFC to the extent
that the shareholder, if a tax resident of the CFC's country, includes
the distribution in income under the CFC's tax law or, if not a tax
resident of the CFC's country, is subject to withholding tax (as defined
in section 901(k)(1)(B)) on the distribution under the CFC's tax law. As
an additional example, upon a distribution by a CFC to a shareholder of
the CFC that is a tax resident of the CFC's country, a dividends
received deduction allowed to the shareholder under the tax law of such
foreign country pursuant to a regime intended to relieve double-taxation
within the group is not a hybrid deduction of the CFC (though if the CFC
were also allowed a deduction or other tax benefit for the distribution
under such tax, such deduction or other tax benefit would be a hybrid
deduction of the CFC). See paragraphs (g)(1) and (2) of this section for
examples illustrating the application of paragraph (d) of this section.
(ii) Coordination with foreign disallowance rules. The following
special rules apply for purposes of determining
[[Page 550]]
whether a deduction or other tax benefit is allowed to a CFC (or a
person related to the CFC) under a relevant foreign tax law:
(A) Whether the deduction or other tax benefit is allowed is
determined without regard to a rule under the relevant foreign tax law
that disallows or suspends deductions if a certain ratio or percentage
is exceeded (for example, a thin capitalization rule that disallows
interest deductions if debt to equity exceeds a certain ratio, or a rule
similar to section 163(j) that disallows or suspends interest deductions
if interest exceeds a certain percentage of income).
(B) Except as provided in this paragraph (d)(2)(ii)(B), whether the
deduction or other tax benefit is allowed is determined without regard
to hybrid mismatch rules, if any, under the relevant foreign tax law
that may disallow such deduction or other tax benefit. However, whether
the deduction or other tax benefit is allowed is determined with regard
to hybrid mismatch rules under the relevant foreign tax law if the
amount giving rise to the deduction or other tax benefit neither gives
rise to a dividend for U.S. tax purposes nor, based on all the facts and
circumstances, is reasonably expected to give rise to a dividend for
U.S. tax purposes that will be paid within 12 months from the end of the
taxable period for which the deduction or other tax benefit would be
allowed but for the hybrid mismatch rules. For purposes of this
paragraph (d)(2)(ii)(B), the term hybrid mismatch rules has the meaning
provided in Sec. 1.267A-5(b)(10).
(iii) Anti-duplication rule. A deduction or other tax benefit
allowed to a CFC (or a person related to the CFC) under a relevant
foreign tax law for an amount paid, accrued, or distributed with respect
to an instrument issued by the CFC is not a hybrid deduction to the
extent that treating it as a hybrid deduction would have the effect of
duplicating a hybrid deduction that is a deduction or other tax benefit
allowed under such tax law for an amount paid, accrued, or distributed
with respect to an instrument that is issued by a CFC at a higher tier
and that has terms substantially similar to the terms of the first
instrument. For example, if an upper tier CFC issues to a corporate
United States shareholder a hybrid instrument (the ``upper tier
instrument''), a lower tier CFC issues to the upper tier CFC a hybrid
instrument that has terms substantially similar to the terms of the
upper tier instrument (the ``mirror instrument''), the CFCs are tax
residents of the same foreign country, and the upper tier CFC includes
in income under its tax law (as determined under the principles of Sec.
1.267A-3(a)) amounts accrued with respect to the mirror instrument, then
a deduction allowed to the lower tier CFC under such foreign tax law for
an amount accrued pursuant to the mirror instrument is not a hybrid
deduction (but a deduction allowed to the upper tier CFC under the
foreign tax law for an amount accrued with respect to the upper tier
instrument is a hybrid deduction).
(iv) Application limited to items allowed in taxable years ending on
or after December 20, 2018; special rule for deductions with respect to
equity. A deduction or other tax benefit, other than a deduction with
respect to equity, allowed to a CFC (or a person related to the CFC)
under a relevant foreign tax law is taken into account for purposes of
this section only if it was allowed with respect to a taxable year under
the relevant foreign tax law ending on or after December 20, 2018. A
deduction with respect to equity allowed to a CFC under a relevant
foreign tax law is taken into account for purposes of this section only
if it was allowed with respect to a taxable year under the relevant
foreign tax law beginning on or after December 20, 2018.
(3) Allocating hybrid deductions to shares. A hybrid deduction is
allocated to a share of stock of a CFC to the extent that the hybrid
deduction (or amount equivalent to a deduction) relates to an amount
paid, accrued, or distributed by the CFC with respect to the share.
However, in the case of a hybrid deduction that is a deduction with
respect to equity (such as a notional interest deduction), the deduction
is allocated to a share of stock of a CFC based on the product of--
(i) The amount of the deduction allowed for all of the equity of the
CFC; and
[[Page 551]]
(ii) A fraction, the numerator of which is the value of the share
and the denominator of which is the value of all of the stock of the
CFC.
(4) Maintenance of hybrid deduction accounts--(i) In general. A
specified owner's hybrid deduction account with respect to a share of
stock of a CFC is, as of the close of the taxable year of the CFC,
adjusted pursuant to the following rules.
(A) First, the account is increased by the amount of hybrid
deductions of the CFC allocated to the share for the taxable year.
(B) Second, the account is decreased (but not below zero) pursuant
to the rules of paragraphs (d)(4)(i)(B)(1) through (3) of this section,
in the order set forth in this paragraph (d)(4)(i)(B).
(1) Adjusted subpart F inclusions--(i) In general. Subject to the
limitation in paragraph (d)(4)(i)(B)(1)(ii) of this section, the account
is reduced by an adjusted subpart F inclusion with respect to the share
for the taxable year, as determined pursuant to the rules of paragraph
(d)(4)(ii) of this section.
(ii) Limitation. The reduction pursuant to paragraph
(d)(4)(i)(B)(1)(i) of this section cannot exceed the hybrid deductions
of the CFC allocated to the share for the taxable year multiplied by a
fraction, the numerator of which is the sum of the items of gross income
of the CFC that give rise to subpart F income (determined without regard
to an amount treated as subpart F income by reason of section
964(e)(4)(A)(i), to the extent that a deduction under section 245A(a) is
allowed for a portion of the amount included under section
964(e)(4)(A)(ii) in the gross income of a domestic corporation) of the
CFC for the taxable year and the denominator of which is the sum of all
the items of gross income of the CFC for the taxable year.
(iii) Special rule allocating otherwise unused adjusted subpart F
inclusions across accounts in certain cases. This paragraph
(d)(4)(i)(B)(1)(iii) applies after each of the specified owner's hybrid
deduction accounts with respect to its shares of stock of the CFC are
adjusted pursuant to paragraph (d)(4)(i)(B)(1)(i) of this section but
before the accounts are adjusted pursuant to paragraph (d)(4)(i)(B)(2)
of this section, to the extent that one or more of the hybrid deduction
accounts would have been reduced by an amount pursuant to paragraph
(d)(4)(i)(B)(1)(i) of this section but for the limitation in paragraph
(d)(4)(i)(B)(1)(ii) of this section (the aggregate of the amounts that
would have been reduced but for the limitation, the unused reduction
amount, and the accounts that would have been reduced by the unused
reduction amount, the unused reduction amount accounts). When this
paragraph (d)(4)(i)(B)(1)(iii) applies, the specified owner's hybrid
deduction accounts other than the unused reduction amount accounts (if
any) are ratably reduced by the lesser of the unused reduction amount
and the difference of the following two amounts: The hybrid deductions
of the CFC allocated to the specified owner's shares of stock of the CFC
for the taxable year multiplied by the fraction described in paragraph
(d)(4)(i)(B)(1)(ii) of this section; and the reductions pursuant to
paragraph (d)(4)(i)(B)(1)(i) of this section with respect to the
specified owner's shares of stock of the CFC.
(2) Adjusted GILTI inclusions--(i) In general. Subject to the
limitation in paragraph (d)(4)(i)(B)(2)(ii) of this section, the account
is reduced by an adjusted GILTI inclusion with respect to the share for
the taxable year, as determined pursuant to the rules of paragraph
(d)(4)(ii) of this section.
(ii) Limitation. The reduction pursuant to paragraph
(d)(4)(i)(B)(2)(i) of this section cannot exceed the hybrid deductions
of the CFC allocated to the share for the taxable year multiplied by a
fraction, the numerator of which is the sum of the items of gross tested
income of the CFC for the taxable year and the denominator of which is
the sum of all the items of gross income of the CFC for the taxable
year.
(iii) Special rule allocating otherwise unused adjusted GILTI
inclusions across accounts in certain cases. This paragraph
(d)(4)(i)(B)(2)(iii) applies after each of the specified owner's hybrid
deduction accounts with respect to its shares of stock of the CFC are
adjusted pursuant to paragraph (d)(4)(i)(B)(2)(i) of this section but
before the accounts are adjusted pursuant to paragraph
[[Page 552]]
(d)(4)(i)(B)(3) of this section, to the extent that one or more of the
hybrid deduction accounts would have been reduced by an amount pursuant
to paragraph (d)(4)(i)(B)(2)(i) of this section but for the limitation
in paragraph (d)(4)(i)(B)(2)(ii) of this section (the aggregate of the
amounts that would have been reduced but for the limitation, the unused
reduction amount, and the accounts that would have been reduced by the
unused reduction amount, the unused reduction amount accounts). When
this paragraph (d)(4)(i)(B)(2)(iii) applies, the specified owner's
hybrid deduction accounts other than the unused reduction amount
accounts (if any) are ratably reduced by the lesser of the unused
reduction amount and the difference of the following two amounts: The
hybrid deductions of the CFC allocated to the specified owner's shares
of stock of the CFC for the taxable year multiplied by the fraction
described in paragraph (d)(4)(i)(B)(2)(ii) of this section; and the
reductions pursuant to paragraph (d)(4)(i)(B)(2)(i) of this section with
respect to the specified owner's shares of stock of the CFC. See
paragraph (g)(1)(v)(C) of this section for an illustration of the
application of this paragraph (d)(4)(i)(B)(2)(iii).
(3) Certain section 956 inclusions. The account is reduced by an
amount included in the gross income of a domestic corporation under
sections 951(a)(1)(B) and 956 with respect to the share for the taxable
year of the domestic corporation in which or with which the CFC's
taxable year ends, to the extent so included by reason of the
application of section 245A(e) and this section to the hypothetical
distribution described in Sec. 1.956-1(a)(2).
(C) Third, the account is decreased by the amount of hybrid
deductions in the account that gave rise to a hybrid dividend or tiered
hybrid dividend during the taxable year. If the specified owner has more
than one hybrid deduction account with respect to its stock of the CFC,
then a pro rata amount in each hybrid deduction account is considered to
have given rise to the hybrid dividend or tiered hybrid dividend, based
on the amounts in the accounts before applying this paragraph
(d)(4)(i)(C).
(ii) Rules regarding adjusted subpart F and GILTI inclusions. (A)
The term adjusted subpart F inclusion means, with respect to a share of
stock of a CFC for a taxable year of the CFC, a domestic corporation's
pro rata share of the CFC's subpart F income included in gross income
under section 951(a)(1)(A) (determined without regard to an amount
included in gross income by the domestic corporation by reason of
section 964(e)(4)(A)(ii), to the extent a deduction under section
245A(a) is allowed for the amount) for the taxable year of the domestic
corporation in which or with which the CFC's taxable year ends, to the
extent attributable to the share (as determined under the principles of
section 951(a)(2) and Sec. 1.951-1(b) and (e)), adjusted (but not below
zero) by--
(1) Adding to the amount the associated foreign income taxes with
respect to the amount; and
(2) Subtracting from such sum the quotient of the associated foreign
income taxes divided by the percentage described in section 11(b).
(B) The term adjusted GILTI inclusion means, with respect to a share
of stock of a CFC for a taxable year of the CFC, a domestic
corporation's GILTI inclusion amount (within the meaning of Sec.
1.951A-1(c)(1)) for the U.S. shareholder inclusion year (within the
meaning of Sec. 1.951A-1(f)(7)), to the extent attributable to the
share (as determined under paragraph (d)(4)(ii)(C) of this section),
adjusted (but not below zero) by--
(1) Adding to the amount the associated foreign income taxes with
respect to the amount;
(2) Multiplying such sum by the difference of 100 percent and the
section 250(a)(1)(B)(i) deduction percentage; and
(3) Subtracting from such product the quotient of 80 percent of the
associated foreign income taxes divided by the percentage described in
section 11(b).
(C) A domestic corporation's GILTI inclusion amount for a U.S.
shareholder inclusion year is attributable to a share of stock of the
CFC based on a fraction--
(1) The numerator of which is the domestic corporation's pro rata
share of the tested income of the CFC for the U.S. shareholder inclusion
year, to the
[[Page 553]]
extent attributable to the share (as determined under the principles of
Sec. 1.951A-1(d)(2)); and
(2) The denominator of which is the aggregate of the domestic
corporation's pro rata share of the tested income of each tested income
CFC (as defined in Sec. 1.951A-2(b)(1)) for the U.S. shareholder
inclusion year.
(D) The term associated foreign income taxes means--
(1) With respect to a domestic corporation's pro rata share of the
subpart F income of the CFC included in gross income under section
951(a)(1)(A) and attributable to a share of stock of a CFC for a taxable
year of the CFC, current year tax (as described in Sec. 1.960-1(b)(4))
allocated and apportioned under Sec. 1.960-1(d)(3)(ii) to the subpart F
income groups (as described in Sec. 1.960-1(b)(30)) of the CFC for the
taxable year, to the extent allocated to the share under paragraph
(d)(4)(ii)(E) of this section; and
(2) With respect to a domestic corporation's GILTI inclusion amount
under section 951A attributable to a share of stock of a CFC for a
taxable year of the CFC, the product of--
(i) Current year tax (as described in Sec. 1.960-1(b)(4)) allocated
and apportioned under Sec. 1.960-1(d)(3)(ii) to the tested income
groups (as described in Sec. 1.960-1(b)(33)) of the CFC for the taxable
year, to the extent allocated to the share under paragraph (d)(4)(ii)(F)
of this section;
(ii) The domestic corporation's inclusion percentage (as described
in Sec. 1.960-2(c)(2)); and
(iii) The section 904 limitation fraction with respect to the
domestic corporation for the U.S. shareholder inclusion year.
(E) Current year tax allocated and apportioned to a subpart F income
group of a CFC for a taxable year is allocated to a share of stock of
the CFC by multiplying the foreign income tax by a fraction--
(1) The numerator of which is the domestic corporation's pro rata
share of the subpart F income of the CFC for the taxable year, to the
extent attributable to the share (as determined under the principles of
section 951(a)(2) and Sec. 1.951-1(b) and (e)); and
(2) The denominator of which is the subpart F income of the CFC for
the taxable year.
(F) Current year tax allocated and apportioned to a tested income
group of a CFC for a taxable year is allocated to a share of stock of
the CFC by multiplying the foreign income tax by a fraction--
(1) The numerator of which is the domestic corporation's pro rata
share of tested income of the CFC for the taxable year, to the extent
attributable to the share (as determined under the principles Sec.
1.951A-1(d)(2)); and
(2) The denominator of which is the tested income of the CFC for the
taxable year.
(G) The term section 904 limitation fraction means, with respect to
a domestic corporation for a U.S. shareholder inclusion year, a
fraction--
(1) The numerator of which is the amount of foreign tax credits for
the U.S. shareholder inclusion year that, by reason of sections 901 and
960(d) and taking into account section 904, the domestic corporation is
allowed for the separate category set forth in section 904(d)(1)(A)
(amounts includible in gross income under section 951A); and
(2) The denominator of which is the amount of foreign tax credits
for the U.S. shareholder inclusion year that, by reason of sections 901
and 960(d) and without regard to section 904, the domestic corporation
would be allowed for the separate category set forth in section
904(d)(1)(A) (amounts includible in gross income under section 951A).
(H) The term section 250(a)(1)(B)(i) deduction percentage means,
with respect to a domestic corporation for a U.S. shareholder inclusion
year, a fraction--
(1) The numerator of which is the amount of the deduction under
section 250 allowed to the domestic corporation for the U.S. shareholder
inclusion year by reason of section 250(a)(1)(B)(i) (taking into account
section 250(a)(2)(B)); and
(2) The denominator of which is the domestic corporation's GILTI
inclusion amount for the U.S. shareholder inclusion year.
(iii) Acquisition of account and certain other adjustments--(A) In
general. The following rules apply when a person (the acquirer) directly
or indirectly
[[Page 554]]
through a partnership, trust, or estate acquires a share of stock of a
CFC from another person (the transferor).
(1) In the case of an acquirer that is a specified owner of the
share immediately after the acquisition, the transferor's hybrid
deduction account, if any, with respect to the share becomes the hybrid
deduction account of the acquirer.
(2) In the case of an acquirer that is not a specified owner of the
share immediately after the acquisition, the transferor's hybrid
deduction account, if any, is eliminated and accordingly is not
thereafter taken into account by any person.
(B) Additional rules. The following rules apply in addition to the
rules of paragraph (d)(4)(iii)(A) of this section.
(1) Certain section 354 or 356 exchanges. The following rules apply
when a shareholder of a CFC (the CFC, the target CFC; the shareholder,
the exchanging shareholder) exchanges stock of the target CFC for stock
of another CFC (the acquiring CFC) pursuant to an exchange described in
section 354 or 356 that occurs in connection with a transaction
described in section 381(a)(2) in which the target CFC is the transferor
corporation.
(i) In the case of an exchanging shareholder that is a specified
owner of one or more shares of stock of the acquiring CFC immediately
after the exchange, the exchanging shareholder's hybrid deduction
accounts with respect to the shares of stock of the target CFC that it
exchanges are attributed to the shares of stock of the acquiring CFC
that it receives in the exchange.
(ii) In the case of an exchanging shareholder that is not a
specified owner of one or more shares of stock of the acquiring CFC
immediately after the exchange, the exchanging shareholder's hybrid
deduction accounts with respect to its shares of stock of the target CFC
are eliminated and accordingly are not thereafter taken into account by
any person.
(2) Section 332 liquidations. If a CFC is a distributor corporation
in a transaction described in section 381(a)(1) (the distributor CFC) in
which a controlled foreign corporation is the acquiring corporation (the
distributee CFC), then each hybrid deduction account with respect to a
share of stock of the distributee CFC is increased pro rata by the sum
of the hybrid deduction accounts with respect to shares of stock of the
distributor CFC.
(3) Recapitalizations. If a shareholder of a CFC exchanges stock of
the CFC pursuant to a reorganization described in section 368(a)(1)(E)
or a transaction to which section 1036 applies, then the shareholder's
hybrid deduction accounts with respect to the stock of the CFC that it
exchanges are attributed to the shares of stock of the CFC that it
receives in the exchange.
(4) Certain distributions involving section 355 or 356. In the case
of a transaction involving a distribution under section 355 (or so much
of section 356 as it relates to section 355) by a CFC (the distributing
CFC) of stock of another CFC (the controlled CFC), the balance of the
hybrid deduction accounts with respect to stock of the distributing CFC
is attributed to stock of the controlled CFC in a manner similar to how
earnings and profits of the distributing CFC and controlled CFC are
adjusted. To the extent the balance of the hybrid deduction accounts
with respect to stock of the distributing CFC is not so attributed to
stock of the controlled CFC, such balance remains as the balance of the
hybrid deduction accounts with respect to stock of the distributing CFC.
(5) Effect of section 338(g) election--(i) In general. If an
election under section 338(g) is made with respect to a qualified stock
purchase (as described in section 338(d)(3)) of stock of a CFC, then a
hybrid deduction account with respect to a share of stock of the old
target is not treated as (or attributed to) a hybrid deduction account
with respect to a share of stock of the new target. Accordingly,
immediately after the deemed asset sale described in Sec. 1.338-1, the
balance of a hybrid deduction account with respect to a share of stock
of the new target is zero; the account must then be maintained in
accordance with the rules of paragraph (d) of this section.
(ii) Special rule regarding carryover FT stock. Paragraph
(d)(4)(iii)(B)(5)(i) of this section does not apply as to a hybrid
deduction account with respect to
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a share of carryover FT stock (as described in Sec. 1.338-9(b)(3)(i)).
A hybrid deduction account with respect to a share of carryover FT stock
is attributed to the corresponding share of stock of the new target.
(5) Determinations and adjustments made during year of transfer in
certain cases. This paragraph (d)(5) applies if on a date other than the
date that is the last day of the CFC's taxable year a United States
shareholder of the CFC or an upper-tier CFC with respect to the CFC
directly or indirectly (as determined under the principles of Sec.
1.245A-5(g)(3)(ii)) transfers a share of stock of the CFC, and, during
the taxable year, but on or before the transfer date, the United States
shareholder or upper-tier CFC receives an amount from the CFC that is
subject to the rules of section 245A(e) and this section. In such a
case, the following rules apply:
(i) As to the United States shareholder or upper-tier CFC and the
United States shareholder's or upper-tier CFC's hybrid deduction
accounts with respect to each share of stock of the CFC (regardless of
whether such share is transferred), the determinations and adjustments
under this section that would otherwise be made at the close of the
CFC's taxable year are made at the close of the date of the transfer.
When making these determinations and adjustments at the close of the
date of the transfer, each hybrid deduction account described in the
previous sentence is pursuant to paragraph (d)(4)(ii)(A) of this section
increased by a ratable portion (based on the number of days in the
taxable year within the pre-transfer period to the total number of days
in the taxable year) of the hybrid deductions of the CFC allocated to
the share for the taxable year, and pursuant to paragraph (d)(4)(ii)(C)
of this section decreased by the amount of hybrid deductions in the
account that gave rise to a hybrid dividend or tiered hybrid dividend
during the portion of the taxable year up to and including the transfer
date. Thus, for example, if a United States shareholder of a CFC
exchanges stock of the CFC in an exchange described in Sec. 1.367(b)-
4(b)(1)(i) and is required to include in income as a deemed dividend the
section 1248 amount attributable to the stock exchanged, then: As of the
close of the date of the exchange, each of the United States
shareholder's hybrid deductions accounts with respect to a share of
stock of the CFC is increased by a ratable portion of the hybrid
deductions of the CFC allocated to the share for the taxable year (based
on the number of days in the taxable year within the pre-transfer period
to the total number of days in the taxable year); the deemed dividend is
a hybrid dividend to the extent of the sum of the United States
shareholder's hybrid deduction accounts with respect to each share of
stock of the CFC; and, as the close of the date of the exchange, each of
the accounts is decreased by the amount of hybrid deductions in the
account that gave rise to a hybrid dividend during the portion of the
taxable year up to and including the date of the exchange.
(ii) As to a hybrid deduction account described in paragraph
(d)(5)(i) of this section, the adjustments to the account as of the
close of the taxable year of the CFC must take into account the
adjustments, if any, occurring with respect to the account pursuant to
paragraph (d)(5)(i) of this section. Thus, for example, if an
acquisition of a share of stock of a CFC occurs on a date other than the
date that is the last day of the CFC's taxable year and pursuant to
paragraph (d)(4)(iii)(A)(1) of this section the acquirer succeeds to the
transferor's hybrid deduction account with respect to the share, then,
as of the close of the taxable year of the CFC, the account is increased
by a ratable portion of the hybrid deductions of the CFC allocated to
the share for the taxable year (based on the number of days in the
taxable year within the post-transfer period to the total number of days
in the taxable year), and, decreased by the amount of hybrid deductions
in the account that gave rise to a hybrid dividend or tiered hybrid
dividend during the portion of the taxable year following the transfer
date.
(6) Effects of CFC functional currency--(i) Maintenance of the
hybrid deduction account. A hybrid deduction account with respect to a
share of CFC stock must be maintained in the functional
[[Page 556]]
currency (within the meaning of section 985) of the CFC. Thus, for
example, the amount of a hybrid deduction and the adjustments described
in paragraphs (d)(4)(i)(A) and (B) of this section are determined based
on the functional currency of the CFC. In addition, for purposes of this
section, the amount of a deduction or other tax benefit allowed to a CFC
(or a person related to the CFC) is determined taking into account
foreign currency gain or loss recognized with respect to such deduction
or other tax benefit under a provision of foreign tax law comparable to
section 988 (treatment of certain foreign currency transactions).
(ii) Determination of amount of hybrid dividend. This paragraph
(d)(6)(ii) applies if a CFC's functional currency is other than the
functional currency of a United States shareholder or upper-tier CFC
that receives an amount from the CFC that is subject to the rules of
section 245A(e) and this section. In such a case, the sum of the United
States shareholder's or upper-tier CFC's hybrid deduction accounts with
respect to each share of stock of the CFC is, for purposes of
determining the extent that a dividend is a hybrid dividend or tiered
hybrid dividend, translated into the functional currency of the United
States shareholder or upper-tier CFC based on the spot rate (within the
meaning of Sec. 1.988-1(d)) as of the date of the dividend.
(e) Anti-avoidance rule. Appropriate adjustments are made pursuant
to this section, including adjustments that would disregard the
transaction or arrangement, if a transaction or arrangement is
undertaken with a principal purpose of avoiding the purposes of section
245A(e) and this section. For example, if a specified owner of a share
of CFC stock transfers the share to another person, and a principal
purpose of the transfer is to shift the hybrid deduction account with
respect to the share to the other person or to cause the hybrid
deduction account to be eliminated, then for purposes of this section
the shifting or elimination of the hybrid deduction account is
disregarded as to the transferor. As another example, if a transaction
or arrangement is undertaken to affirmatively fail to satisfy the
holding period requirement under section 246(c)(5) with a principal
purpose of avoiding the tiered hybrid dividend rules described in
paragraph (c) of this section, the transaction or arrangement is
disregarded for purposes of this section. This paragraph (e) will not
apply, however, to disregard (or make other adjustments with respect to)
a transaction pursuant to which an instrument or arrangement that gives
rise to hybrid deductions is eliminated or otherwise converted into
another instrument or arrangement that does not give rise to hybrid
deductions.
(f) Definitions. The following definitions apply for purposes of
this section.
(1) The term controlled foreign corporation (or CFC) has the meaning
provided in section 957.
(2) The term domestic corporation means an entity classified as a
domestic corporation under section 7701(a)(3) and (4) or otherwise
treated as a domestic corporation by the Internal Revenue Code. However,
for purposes of this section, a domestic corporation does not include a
regulated investment company (as described in section 851), a real
estate investment trust (as described in section 856), or an S
corporation (as described in section 1361).
(3) The term person has the meaning provided in section 7701(a)(1).
(4) The term related has the meaning provided in this paragraph
(f)(4). A person is related to a CFC if the person is a related person
within the meaning of section 954(d)(3). See also Sec. 1.954-
1(f)(2)(iv)(B)(1) (neither section 318(a)(3), nor Sec. 1.958-2(d) or
the principles thereof, applies to attribute stock or other interests).
(5) The term relevant foreign tax law means, with respect to a CFC,
any regime of any foreign country or possession of the United States
that imposes an income, war profits, or excess profits tax with respect
to income of the CFC, other than a foreign anti-deferral regime under
which a person that owns an interest in the CFC is liable to tax. If a
foreign country has an income tax treaty with the United States that
applies to taxes imposed by a political subdivision or other local
authority of that country, then the tax law of the political subdivision
or other local authority is deemed to be a tax law of a
[[Page 557]]
foreign country. Thus, the term includes any regime of a foreign country
or possession of the United States that imposes income, war profits, or
excess profits tax under which--
(i) The CFC is liable to tax as a resident;
(ii) The CFC has a branch that gives rise to a taxable presence in
the foreign country or possession of the United States; or
(iii) A person related to the CFC is liable to tax as a resident,
provided that under such person's tax law the person is allowed a
deduction for amounts paid or accrued by the CFC (because the CFC is
fiscally transparent under the person's tax law).
(6) The term specified owner means, with respect to a share of stock
of a CFC, a person for which the requirements of paragraphs (f)(6)(i)
and (ii) of this section are satisfied.
(i) The person is a domestic corporation that is a United States
shareholder of the CFC, or is an upper-tier CFC that would be a United
States shareholder of the CFC were the upper-tier CFC a domestic
corporation (provided that, for purposes of sections 951 and 951A, a
domestic corporation that is a United States shareholder of the upper-
tier CFC owns (within the meaning of section 958(a), and determined by
treating a domestic partnership as foreign) one or more shares of stock
of the upper-tier CFC).
(ii) The person owns the share directly or indirectly through a
partnership, trust, or estate. Thus, for example, if a domestic
corporation directly owns all the shares of stock of an upper-tier CFC
and the upper-tier CFC directly owns all the shares of stock of another
CFC, the domestic corporation is the specified owner with respect to
each share of stock of the upper-tier CFC and the upper-tier CFC is the
specified owner with respect to each share of stock of the other CFC.
(7) The term United States shareholder has the meaning provided in
section 951(b).
(g) Examples. This paragraph (g) provides examples that illustrate
the application of this section. For purposes of the examples in this
paragraph (g), unless otherwise indicated, the following facts are
presumed. US1 is a domestic corporation. FX and FZ are CFCs formed at
the beginning of year 1, and the functional currency (within the meaning
of section 985) of each of FX and FZ is the dollar. FX is a tax resident
of Country X and FZ is a tax resident of Country Z. US1 is a United
States shareholder with respect to FX and FZ. No distributed amounts are
attributable to amounts which are, or have been, included in the gross
income of a United States shareholder under section 951(a). All
instruments are treated as stock for U.S. tax purposes. Only the tax law
of the United States contains hybrid mismatch rules. No amounts are
included in the gross income of US1 under section 951(a)(1)(A), 951A(a),
or 951(a)(1)(B) and section 956.
(1) Example 1. Hybrid dividend resulting from hybrid instrument--(i)
Facts. US1 holds both shares of stock of FX, which have an equal value.
One share is treated as indebtedness for Country X tax purposes (``Share
A''), and the other is treated as equity for Country X tax purposes
(``Share B''). During year 1, under Country X tax law, FX accrues $80x
of interest to US1 with respect to Share A and is allowed a deduction
for the amount (the ``Hybrid Instrument Deduction''). During year 2, FX
distributes $30x to US1 with respect to each of Share A and Share B. For
U.S. tax purposes, each of the $30x distributions is treated as a
dividend for which, without regard to section 245A(e) and this section
as well as Sec. 1.245A-5, US1 would be allowed a deduction under
section 245A(a). For Country X tax purposes, the $30x distribution with
respect to Share A represents a payment of interest for which a
deduction was already allowed (and thus FX is not allowed an additional
deduction for the amount), and the $30x distribution with respect to
Share B is treated as a dividend (for which no deduction is allowed).
(ii) Analysis. The entire $30x of each dividend received by US1 from
FX during year 2 is a hybrid dividend, because the sum of US1's hybrid
deduction accounts with respect to each of its shares of FX stock at the
end of year 2 ($80x) is at least equal to the amount of the dividends
($60x). See paragraph (b)(2) of this section. This is the case for the
$30x dividend with respect to
[[Page 558]]
Share B even though there are no hybrid deductions allocated to Share B.
See paragraph (b)(2) of this section. As a result, US1 is not allowed a
deduction under section 245A(a) for the entire $60x of hybrid dividends
and the rules of section 245A(d) and Sec. 1.245A(d)-1 (disallowance of
foreign tax credits and deductions) apply. See paragraph (b)(1) of this
section. Paragraphs (g)(1)(ii)(A) through (D) of this section describe
the determinations under this section.
(A) At the end of year 1, US1's hybrid deduction accounts with
respect to Share A and Share B are $80x and $0, respectively, calculated
as follows.
(1) The $80x Hybrid Instrument Deduction allowed to FX under Country
X tax law (a relevant foreign tax law) is a hybrid deduction of FX,
because the deduction is allowed to FX and relates to or results from an
amount accrued with respect to an instrument issued by FX and treated as
stock for U.S. tax purposes. See paragraph (d)(2)(i) of this section.
Thus, FX's hybrid deductions for year 1 are $80x.
(2) The entire $80x Hybrid Instrument Deduction is allocated to
Share A, because the deduction was accrued with respect to Share A. See
paragraph (d)(3) of this section. As there are no additional hybrid
deductions of FX for year 1, there are no additional hybrid deductions
to allocate to either Share A or Share B. Thus, there are no hybrid
deductions allocated to Share B.
(3) At the end of year 1, US1's hybrid deduction account with
respect to Share A is increased by $80x (the amount of hybrid deductions
allocated to Share A). See paragraph (d)(4)(i)(A) of this section.
Because FX did not pay any dividends with respect to either Share A or
Share B during year 1 (and therefore did not pay any hybrid dividends or
tiered hybrid dividends), no further adjustments are made. See paragraph
(d)(4)(i)(C) of this section. Therefore, at the end of year 1, US1's
hybrid deduction accounts with respect to Share A and Share B are $80x
and $0, respectively.
(B) At the end of year 2, and before the adjustments described in
paragraph (d)(4)(i)(C) of this section, US1's hybrid deduction accounts
with respect to Share A and Share B remain $80x and $0, respectively.
This is because there are no hybrid deductions of FX for year 2. See
paragraph (d)(4)(i)(A) of this section.
(C) Because at the end of year 2 (and before the adjustments
described in paragraph (d)(4)(i)(C) of this section) the sum of US1's
hybrid deduction accounts with respect to Share A and Share B ($80x,
calculated as $80x plus $0) is at least equal to the aggregate $60x of
year 2 dividends, the entire $60x dividend is a hybrid dividend. See
paragraph (b)(2) of this section.
(D) At the end of year 2, US1's hybrid deduction account with
respect to Share A is decreased by $60x, the amount of the hybrid
deductions in the account that gave rise to a hybrid dividend or tiered
hybrid dividend during year 2. See paragraph (d)(4)(i)(C) of this
section. Because there are no hybrid deductions in the hybrid deduction
account with respect to Share B, no adjustments with respect to that
account are made under paragraph (d)(4)(i)(C) of this section.
Therefore, at the end of year 2 and taking into account the adjustments
under paragraph (d)(4)(i)(C) of this section, US1's hybrid deduction
account with respect to Share A is $20x ($80x less $60x) and with
respect to Share B is $0.
(iii) Alternative facts--notional interest deductions. The facts are
the same as in paragraph (g)(1)(i) of this section, except that for each
of year 1 and year 2 FX is allowed $10x of notional interest deductions
with respect to its equity, Share B, under Country X tax law (the
``NIDs''). In addition, during year 2, FX distributes $47.5x (rather
than $30x) to US1 with respect to each of Share A and Share B. For U.S.
tax purposes, each of the $47.5x distributions is treated as a dividend
for which, without regard to section 245A(e) and this section as well as
Sec. 1.245A-5, US1 would be allowed a deduction under section 245A(a).
For Country X tax purposes, the $47.5x distribution with respect to
Share A represents a payment of interest for which a deduction was
already allowed (and thus FX is not allowed an additional deduction for
the amount), and the $47.5x distribution with respect to Share B is
treated as a dividend (for which no deduction is allowed). The entire
$47.5x of each dividend received by US1 from FX during year 2 is a
hybrid
[[Page 559]]
dividend, because the sum of US1's hybrid deduction accounts with
respect to each of its shares of FX stock at the end of year 2 ($80x
plus $20x, or $100x) is at least equal to the amount of the dividends
($95x). See paragraph (b)(2) of this section. As a result, US1 is not
allowed a deduction under section 245A(a) for the $95x hybrid dividend
and the rules of section 245A(d) and Sec. 1.245A(d)-1 (disallowance of
foreign tax credits and deductions) apply. See paragraph (b)(1) of this
section. Paragraphs (g)(1)(iii)(A) through (D) of this section describe
the determinations under this section.
(A) The $10x of NIDs allowed to FX under Country X tax law in year 1
are hybrid deductions of FX for year 1. See paragraph (d)(2)(i) of this
section. The $10x of NIDs is allocated equally to each of Share A and
Share B, because the hybrid deduction is with respect to equity and the
shares have an equal value. See paragraph (d)(3) of this section. Thus,
$5x of the NIDs is allocated to each of Share A and Share B for year 1.
For the reasons described in paragraph (g)(1)(ii)(A)(2) of this section,
the entire $80x Hybrid Instrument Deduction is allocated to Share A.
Therefore, at the end of year 1, US1's hybrid deduction accounts with
respect to Share A and Share B are $85x and $5x, respectively.
(B) Similarly, the $10x of NIDs allowed to FX under Country X tax
law in year 2 are hybrid deductions of FX for year 2, and $5x of the
NIDs is allocated to each of Share A and Share B for year 2. See
paragraphs (d)(2)(i) and (d)(3) of this section. Thus, at the end of
year 2 (and before the adjustments described in paragraph (d)(4)(i)(C)
of this section), US1's hybrid deduction account with respect to Share A
is $90x ($85x plus $5x) and with respect to Share B is $10x ($5x plus
$5x). See paragraph (d)(4)(i) of this section.
(C) Because at the end of year 2 (and before the adjustments
described in paragraph (d)(4)(i)(C) of this section) the sum of US1's
hybrid deduction accounts with respect to Share A and Share B ($100x,
calculated as $90x plus $10x) is at least equal to the aggregate $95x of
year 2 dividends, the entire $95x of dividends are hybrid dividends. See
paragraph (b)(2) of this section.
(D) At the end of year 2, US1's hybrid deduction accounts with
respect to Share A and Share B are decreased by the amount of hybrid
deductions in the accounts that gave rise to a hybrid dividend or tiered
hybrid dividend during year 2. See paragraph (d)(4)(i)(C) of this
section. A total of $95x of hybrid deductions in the accounts gave rise
to a hybrid dividend during year 2. For the hybrid deduction account
with respect to Share A, $85.5x in the account is considered to have
given rise to a hybrid deduction (calculated as $95x multiplied by $90x/
$100x). See paragraph (d)(4)(i)(C) of this section. For the hybrid
deduction account with respect to Share B, $9.5x in the account is
considered to have given rise to a hybrid deduction (calculated as $95x
multiplied by $10x/$100x). See paragraph (d)(4)(i)(C) of this section.
Thus, following these adjustments, at the end of year 2, US1's hybrid
deduction account with respect to Share A is $4.5x ($90x less $85.5x)
and with respect to Share B is $0.5x ($10x less $9.5x).
(iv) Alternative facts--deduction in branch country--(A) Facts. The
facts are the same as in paragraph (g)(1)(i) of this section, except
that for Country X tax purposes Share A is treated as equity (and thus
the Hybrid Instrument Deduction does not exist, and under Country X tax
law FX is not allowed a deduction for the $30x distributed in year 2
with respect to Share A). However, FX has a branch in Country Z that
gives rise to a taxable presence under Country Z tax law, and for
Country Z tax purposes Share A is treated as indebtedness and Share B is
treated as equity. Also, during year 1, for Country Z tax purposes, FX
accrues $80x of interest to US1 with respect to Share A and is allowed
an $80x interest deduction with respect to its Country Z branch income.
Moreover, for Country Z tax purposes, the $30x distribution with respect
to Share A in year 2 represents a payment of interest for which a
deduction was already allowed (and thus FX is not allowed an additional
deduction for the amount), and the $30x distribution with respect to
Share B in year 2 is treated as a dividend (for which no deduction is
allowed).
(B) Analysis. The $80x interest deduction allowed to FX under
Country Z
[[Page 560]]
tax law (a relevant foreign tax law) with respect to its Country Z
branch income is a hybrid deduction of FX for year 1. See paragraphs
(d)(2)(i) and (f)(5) of this section. For reasons similar to those
discussed in paragraph (g)(1)(ii) of this section, at the end of year 2
(and before the adjustments described in paragraph (d)(4)(i)(C) of this
section), US1's hybrid deduction accounts with respect to Share A and
Share B are $80x and $0, respectively, and the sum of the accounts is
$80x. Accordingly, the entire $60x of the year 2 dividend is a hybrid
dividend. See paragraph (b)(2) of this section. Further, for the reasons
described in paragraph (g)(1)(ii)(D) of this section, at the end of year
2 and taking into account the adjustments under paragraph (d)(4)(i)(C)
of this section, US1's hybrid deduction account with respect to Share A
is $20x ($80x less $60x) and with respect to Share B is $0.
(v) Alternative facts--account reduced by adjusted GILTI inclusion.
The facts are the same as in paragraph (g)(1)(i) of this section, except
that for taxable year 1 FX has $130x of gross tested income and $10.5x
of current year tax (as described in Sec. 1.960-1(b)(4)) that is
allocated and apportioned under Sec. 1.960-1(d)(3)(ii) to the tested
income groups of FX. US1's ability to credit the $10.5x of current year
tax is not limited under section 904(a). In addition, FX has $119.5x of
tested income ($130x of gross tested income, less the $10.5x of current
year tax deductions properly allocable to the gross tested income).
Further, of US1's pro rata share of the tested income ($119.5x), $80x is
attributable to Share A and $39.5x is attributable to Share B (as
determined under the principles of Sec. 1.951A-1(d)(2)). Moreover,
US1's net deemed tangible income return (as defined in Sec. 1.951A-
1(c)(3)) for taxable year 1 is $71.7x, and US1 does not own any stock of
a CFC other than its stock of FX. Thus, US1's GILTI inclusion amount
(within the meaning of Sec. 1.951A-1(c)(1)) for taxable year 1, the
U.S. shareholder inclusion year, is $47.8x (net CFC tested income of
$119.5x, less net deemed tangible income return of $71.7x) and US1's
inclusion percentage (as described in Sec. 1.960-2(c)(2)) is 40
($47.8x/$119.5x). The deduction allowed to US1 under section 250 by
reason of section 250(a)(1)(B)(i) is not limited as a result of section
250(a)(2)(B). At the end of year 1, US1's hybrid deduction account with
respect to Share A is: First, increased by $80x (the amount of hybrid
deductions allocated to Share A); and second, decreased by $10x (the sum
of the adjusted GILTI inclusion with respect to Share A, and the
adjusted GILTI inclusion with respect to Share B that is allocated to
the hybrid deduction account with respect to Share A) to $70x. See
paragraphs (d)(4)(i)(A) and (B) of this section. In year 2, the entire
$30x of each dividend received by US1 from FX during year 2 is a hybrid
dividend, because the sum of US1's hybrid deduction accounts with
respect to each of its shares of FX stock at the end of year 2 ($70x) is
at least equal to the amount of the dividends ($60x). See paragraph
(b)(2) of this section. At the end of year 2, US1's hybrid deduction
account with respect to Share A is decreased by $60x (the amount of the
hybrid deductions in the account that give rise to a hybrid dividend or
tiered hybrid dividend during year 2) to $10x. See paragraph
(d)(4)(i)(C) of this section. Paragraphs (g)(1)(v)(A) through (C) of
this section describe the computations pursuant to paragraph
(d)(4)(i)(B)(2) of this section.
(A) To determine the adjusted GILTI inclusion with respect to Share
A for taxable year 1, it must be determined to what extent US1's $47.8x
GILTI inclusion amount is attributable to Share A. See paragraph
(d)(4)(ii)(B) of this section. Here, $32x of the inclusion is
attributable to Share A, calculated as $47.8x multiplied by a fraction,
the numerator of which is $80x (US1's pro rata share of the tested
income of FX attributable to Share A) and denominator of which is
$119.5x (US1's pro rata share of the tested income of FX, its only CFC).
See paragraph (d)(4)(ii)(C) of this section. Next, the associated
foreign income taxes with respect to the $32x GILTI inclusion amount
attributable to Share A must be determined. See paragraphs (d)(4)(ii)(B)
and (D) of this section. Such associated foreign income taxes are $2.8x,
calculated as $10.5x (the current year tax allocated and apportioned to
the tested income groups of FX) multiplied by a fraction,
[[Page 561]]
the numerator of which is $80x (US1's pro rata share of the tested
income of FX attributable to Share A) and the denominator of which is
$119.5x (the tested income of FX), multiplied by 40% (US1's inclusion
percentage), multiplied by 1 (the section 904 limitation fraction with
respect to US1's GILTI inclusion amount). See paragraphs (d)(4)(ii)(D),
(F), and (G) of this section. Thus, pursuant to paragraph (d)(4)(ii)(B)
of this section, the adjusted GILTI inclusion with respect to Share A is
$6.7x, computed by--
(1) Adding $2.8x (the associated foreign income taxes with respect
to the $32x GILTI inclusion attributable to Share A) to $32x, which is
$34.8x;
(2) Multiplying $34.8x (the sum of the amounts in paragraph
(g)(1)(v)(A)(1) of this section) by 50% (the difference of 100 percent
and the section 250(a)(1)(B)(i) deduction percentage), which is $17.4x;
and
(3) Subtracting $10.7x (calculated as $2.24x (80% of the $2.8x of
associated foreign income taxes) divided by .21 (the percentage
described in section 11(b)) from $17.4x (the product of the amounts in
paragraph (g)(1)(v)(A)(2) of this section), which is $6.7x.
(B) Pursuant to computations similar to those discussed in paragraph
(g)(1)(v)(A) of this section, the adjusted GILTI inclusion with respect
to Share B is $3.3x. However, the hybrid deduction account with respect
to Share B is not reduced by such $3.3x, because of the limitation in
paragraph (d)(4)(i)(B)(2)(ii) of this section, which, with respect to
Share B, limits the reduction pursuant to paragraph (d)(4)(i)(B)(2)(i)
of this section to $0 (calculated as $0, the hybrid deductions allocated
to the share for the taxable year, multiplied by 1, the fraction
described in paragraph (d)(4)(i)(B)(2)(ii) of this section (computed as
$130x, the sole item of gross tested income, divided by $130x, the sole
item of gross income)). See paragraphs (d)(4)(i)(B)(2)(i) and (ii) of
this section.
(C) US1's hybrid deduction account with respect to Share A is
reduced by the entire $6.7x adjusted GILTI inclusion with respect to the
share, as such $6.7x does not exceed the limit in paragraph
(d)(4)(i)(B)(2)(ii) of this section ($80x, calculated as $80x, the
hybrid deductions allocated to the share for the taxable year,
multiplied by 1, the fraction described in paragraph (d)(4)(i)(B)(2)(ii)
of this section). See paragraphs (d)(4)(i)(B)(2)(i) and (ii) of this
section. In addition, the hybrid deduction account is reduced by another
$3.3x, the amount of the adjusted GILTI inclusion with respect to Share
B that is allocated to the hybrid deduction account with respect to
Share A. See paragraph (d)(4)(i)(B)(2)(iii) of this section. As a
result, pursuant to paragraph (d)(4)(i)(B)(2) of this section, US1's
hybrid deduction account with respect to Share A is reduced by $10x
($6.7x plus $3.3x).
(2) Example 2. Tiered hybrid dividend rule; tax benefit equivalent
to a deduction--(i) Facts. US1 holds all the stock of FX, and FX holds
all 100 shares of stock of FZ (the ``FZ shares''), which have an equal
value. The FZ shares are treated as equity for Country Z tax purposes.
At the end of year 1, the sum of FX's hybrid deduction accounts with
respect to each of its shares of FZ stock is $0. During year 2, FZ
distributes $10x to FX with respect to each of the FZ shares, for a
total of $1,000x. The $1,000x is treated as a dividend for U.S. and
Country Z tax purposes, and is not deductible for Country Z tax
purposes. If FX were a domestic corporation, then, without regard to
section 245A(e) and this section as well as Sec. 1.245A-5, FX would be
allowed a deduction under section 245A(a) for the $1,000x. Under Country
Z tax law, 75% of the corporate income tax paid by a Country Z
corporation with respect to a dividend distribution is refunded to the
corporation's shareholders (regardless of where such shareholders are
tax residents) upon a dividend distribution by the corporation. The
corporate tax rate in Country Z is 20%. With respect to FZ's
distributions, FX is allowed a refundable tax credit of $187.5x. The
$187.5x refundable tax credit is calculated as $1,250x (the amount of
pre-tax earnings that funded the distribution, determined as $1,000x
(the amount of the distribution) divided by 0.8 (the percentage of pre-
tax earnings that a Country Z corporation retains after paying Country Z
corporate tax)) multiplied by 0.2 (the Country Z corporate
[[Page 562]]
tax rate) multiplied by 0.75 (the percentage of the Country Z tax
credit). Under Country Z tax law, FX is not subject to Country Z
withholding tax (or any other tax) with respect to the $1,000x dividend
distribution.
(ii) Analysis. As described in paragraphs (g)(2)(ii)(A) and (B) of
this section, the sum of FX's hybrid deduction accounts with respect to
each of its shares of FZ stock at the end of year 2 is $937.5x and, as a
result, $937.5x of the $1,000x of dividends received by FX from FZ
during year 2 is a tiered hybrid dividend. See paragraphs (b)(2) and
(c)(2) of this section. The $937.5x tiered hybrid dividend is treated
for purposes of section 951(a)(1)(A) as subpart F income of FX and US1
must include in gross income its pro rata share of such subpart F
income, which is $937.5x. See paragraph (c)(1) of this section. This is
the case notwithstanding any other provision of the Code, including
section 952(c) or section 954(c)(3) or (6). In addition, the rules of
section 245A(d) and Sec. 1.245A(d)-1 (disallowance of foreign tax
credits and deductions) apply with respect to US1's inclusion. See
paragraph (c)(1) of this section. Paragraphs (g)(2)(ii)(A) through (C)
of this section describe the determinations under this section. The
characterization of the FZ stock for Country X tax purposes (or for
purposes of any other foreign tax law) does not affect this analysis.
(A) The $187.5x refundable tax credit allowed to FX under Country Z
tax law (a relevant foreign tax law) is equivalent to a $937.5x
deduction, calculated as $187.5x (the amount of the credit) divided by
0.2 (the Country Z corporate tax rate). The $937.5x is a hybrid
deduction of FZ because it is allowed to FX (a person related to FZ), it
relates to or results from amounts distributed with respect to
instruments issued by FZ and treated as stock for U.S. tax purposes, and
it has the effect of causing the earnings that funded the distributions
to not be included in income under Country Z tax law. See paragraph
(d)(2)(i) of this section. $9.375x of the hybrid deduction is allocated
to each of the FZ shares, calculated as $937.5x (the amount of the
hybrid deduction) multiplied by 1/100 (the value of each FZ share
relative to the value of all the FZ shares). See paragraph (d)(3) of
this section. The result would be the same if FX were instead a tax
resident of Country Z (and not Country X), FX were allowed the $187.5x
refundable tax credit under Country Z tax law, and under Country Z tax
law FX were to not include the $1,000x in income (because, for example,
Country Z tax law provides Country Z resident corporations a 100%
exclusion or dividends received deduction with respect to dividends
received from a resident corporation). See paragraph (d)(2)(i) of this
section.
(B) At the end of year 2, and before the adjustments described in
paragraph (d)(4)(i)(C) of this section, the sum of FX's hybrid deduction
accounts with respect to each of its shares of FZ stock is $937.5x,
calculated as $9.375x (the amount in each account) multiplied by 100
(the number of accounts). See paragraph (d)(4)(i) of this section.
Accordingly, $937.5x of the $1,000x dividend received by FX from FZ
during year 2 is a tiered hybrid dividend. See paragraphs (b)(2) and
(c)(2) of this section.
(C) At the end of year 2, each of FX's hybrid deduction accounts
with respect to its shares of FZ is decreased by the $9.375x in the
account that gave rise to a hybrid dividend or tiered hybrid dividend
during year 2. See paragraph (d)(4)(i)(C) of this section. Thus,
following these adjustments, at the end of year 2, each of FX's hybrid
deduction accounts with respect to its shares of FZ stock is $0,
calculated as $9.375x (the amount in the account before the adjustments
described in paragraph (d)(4)(i)(C) of this section) less $9.375x (the
adjustment described in paragraph (d)(4)(i)(C) of this section with
respect to the account).
(iii) Alternative facts--imputation system that taxes shareholders.
The facts are the same as in paragraph (g)(2)(i) of this section, except
that under Country Z tax law the $1,000x dividend to FX is subject to a
30% gross basis withholding tax, or $300x, and the $187.5x refundable
tax credit is applied against and reduces the withholding tax to
$112.5x. The $187.5x refundable tax credit provided to FX is not a
hybrid deduction because FX was subject to Country Z withholding tax of
$300x on the $1,000x dividend (such withholding tax
[[Page 563]]
being greater than the $187.5x credit). See paragraph (d)(2)(i) of this
section. If instead FZ were allowed a $1,000x dividends paid deduction
for the $1,000x dividend (and FX were not allowed the refundable tax
credit) and the dividend were subject to 5% gross basis withholding tax
(or $50x), then $750x of the dividends paid deduction would be a hybrid
deduction, calculated as the excess of $1,000x (the dividends paid
deduction) over $250x (the amount of income that under Country Z tax law
would produce an amount of tax equal to the $50x of withholding tax,
calculated as $50x, the amount of withholding tax, divided by 0.2, the
Country Z corporate tax rate). See paragraph (d)(2)(i) of this section.
(h) Applicability dates--(1) In general. Except as provided in
paragraph (h)(2) of this section, this section applies to distributions
made after December 31, 2017, provided that such distributions occur
during taxable years ending on or after December 20, 2018. However,
taxpayers may apply this section in its entirety to distributions made
after December 31, 2017 and occurring during taxable years ending before
December 20, 2018. In lieu of applying the regulations in this section,
taxpayers may apply the provisions matching this section from the
Internal Revenue Bulletin (IRB) 2019-03 (https://www.irs.gov/pub /irs-
irbs/irb19-03.pdf) in their entirety for all taxable years ending on or
before April 8, 2020.
(2) Special rules. Paragraphs (d)(4)(i)(B) and (d)(4)(ii) of this
section (decrease of hybrid deduction accounts; rules regarding adjusted
subpart F and GILTI inclusions) apply to taxable years ending on or
after November 12, 2020. However, a taxpayer may choose to apply
paragraphs (d)(4)(i)(B) and (d)(4)(ii) of this section to a taxable year
ending before November 12, 2020, so long as the taxpayer consistently
applies paragraphs (d)(4)(i)(B) and (d)(4)(ii) of this section to that
taxable year and any subsequent taxable year ending before November 12,
2020.
[T.D. 9896, 85 FR 19830, Apr. 8, 2020, as amended by T.D. 9909, 85 FR
53096, Aug. 27, 2020; T.D. 9922, 85 FR 72031, Nov. 12, 2020; T.D.9959,
87 FR 324, Jan. 4, 2022]
Sec. 1.246-1 Deductions not allowed for dividends from certain corporations.
The deductions provided in sections 243 (relating to dividends
received by corporations), 244 (relating to dividends received on
certain preferred stock), and 245 (relating to dividends received from
certain foreign corporations), are not allowable with respect to any
dividend received from:
(a) A corporation organized under the China Trade Act, 1922 (15
U.S.C. ch. 4) (see section 941); or
(b) A corporation which is exempt from tax under section 501
(relating to certain charitable, etc., organizations) or section 521
(relating to farmers' cooperative associations) for the taxable year of
the corporation in which the distribution is made or for its next
preceding taxable year; for
(c) A corporation to which section 931 (relating to income from
sources within possessions of the United States) applies for the taxable
year of the corporation in which the distribution is made or for its
next preceding taxable year; or
(d) A real estate investment trust which, for its taxable year in
which the distribution is made, is taxable under Part II, Subchapter M,
Chapter 1 of the Code. See section 243(c)(3), paragraph (c) of Sec.
1.243-2, section 857(c), and paragraph (d) of Sec. 1.857-6.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6598, 27 FR
4092, Apr. 28, 1962; T.D. 7767, 46 FR 11264, Feb. 6, 1981]
Sec. 1.246-2 Limitation on aggregate amount of deductions.
(a) General rule. The sum of the deductions allowed by sections
243(a)(1) (relating to dividends received by corporations), 244(a)
(relating to dividends received on certain preferred stock), and 245
(relating to dividends received from certain foreign corporations),
except as provided in section 246(b)(2) and in paragraph (b) of this
section, is limited to 85 percent of the taxable income of the
corporation. The taxable income of the corporation for this purpose is
computed without regard to the net operating loss deduction allowed by
section 172, the deduction for dividends paid on certain preferred stock
of public utilities allowed by section 247, any
[[Page 564]]
capital loss carryback under section 1212(a)(1), and the deductions
provided in sections 243(a)(1), 244(a), and 245. For definition of the
term taxable income, see section 63.
(b) Effect of net operating loss. If the shareholder corporation has
a net operating loss (as determined under sec. 172) for a taxable year,
the limitation provided in section 246(b)(1) and in paragraph (a) of
this section is not applicable for such taxable year. In that event, the
deductions provided in sections 243(a)(1), 244(a), and 245 shall be
allowable for all tax purposes to the shareholder corporation for such
taxable year without regard to such limitation. If the shareholder
corporation does not have a net operating loss for the taxable year,
however, the limitation will be applicable for all tax purposes for such
taxable year. In determining whether the shareholder corporation has a
net operating loss for a taxable year under section 172, the deductions
allowed by sections 243(a)(1), 244(a), and 245 are to be computed
without regard to the limitation provided in section 246(b)(1) and in
paragraph (a) of this section.
[T.D. 6992, 34 FR 825, Jan. 18, 1969, as amended by T.D. 7301, 39 FR
963, Jan. 4, 1974]
Sec. 1.246-3 Exclusion of certain dividends.
(a) In general. Corporate taxpayers are denied, in certain cases,
the dividends-received deduction provided by section 243 (dividends
received by corporations), section 244 (dividends received on certain
preferred stock), and section 245 (dividends received from certain
foreign corporations). The above-mentioned dividends-received deductions
are denied, under section 246(c)(1), to corporate shareholders:
(1) If the dividend is in respect of any share of stock which is
sold or otherwise disposed of in any case where the taxpayer has held
such share for 15 days or less; or
(2) If and to the extent that the taxpayer is under an obligation to
make corresponding payments with respect to substantially identical
stock or securities. It is immaterial whether the obligation has arisen
pursuant to a short sale or otherwise.
(b) Ninety-day rule for certain preference dividends. In the case of
any stock having a preference in dividends, a special rule is provided
by section 246(c)(2) in lieu of the 15-day rule described in section
246(c)(1) and paragraph (a)(1) of this section. If the taxpayer receives
dividends on such stock which are attributable to a period or periods
aggregating in excess of 366 days, the holding period specified in
section 246(c)(1)(A) shall be 90 days (in lieu of 15 days).
(c) Definitions--(1) ``Otherwise disposed of''. As used in this
section the term otherwise disposed of includes disposal by gift.
(2) ``Substantially identical stock or securities''. The term
substantially identical stock or securities is to be applied according
to the facts and circumstances in each case. In general, the term has
the same meaning as the corresponding terms in sections 1091 and 1233
and the regulations thereunder. See paragraph (d)(1) of Sec. 1.1233-1.
(3) Obligation to make corresponding payments. (i) Section
246(c)(1)(B) of the Code denies the dividends-received deduction to a
corporate taxpayer to the extent that such taxpayer is under an
obligation, with respect to substantially identical stock or securities,
to make payments corresponding to the dividend received. Thus, for
example, where a corporate taxpayer is in both a ``long'' and ``short''
position with respect to the same stock on the date that such stock goes
ex-dividend, the dividend received on the stock owned by the taxpayer
will not be eligible for the dividends-received deduction to the extent
that the taxpayer is obligated to make payments to cover the dividends
with respect to its offsetting short position in the same stock. The
dividends-received deduction is denied in such a case without regard to
the length of time the taxpayer has held the stock on which such
dividends are received.
(ii) The provisions of subdivision (i) of this subparagraph may be
illustrated by the following example:
Example. Y Corporation owns 100 shares of the Z Corporation's common
stock on January 1, 1959. Z Corporation on January 15, 1959, declares a
dividend of $1.00 per share payable to shareholders of record on January
[[Page 565]]
30, 1959. On January 21, 1959, Y Corporation sells short 25 shares of
the Z Corporation's common stock and remains in the short position on
January 31, 1959, the day that Z Corporation's common stock goes ex-
dividend. Y Corporation is therefore obligated to make a payment to the
lender of the 25 shares of Z Corporation's common stock which were sold
short, corresponding to the $1.00 a share dividend that the lender would
have received on those 25 shares, or $25.00. Therefore, $25.00 of the
$100.00 that the Y Corporation receives as dividends from the Z
Corporation with respect to the 100 shares of common stock in which it
has a long position is not eligible for the dividends-received
deduction.
(d) Determination of holding period--(1) In general. Special rules
are provided by paragraph (3) of section 246(c) for determining the
period for which the taxpayer has held any share of stock for purposes
of the restriction provided by such section. In computing the holding
period the day of disposition but not the day of acquisition shall be
taken into account. Also, there shall not be taken into account any day
which is more than 15 days after the date on which the share of stock
becomes ex-dividend. Thus, the holding period is automatically
terminated at the end of such 15-day period without regard to how long
the stock may be held after that date. In the case of stock qualifying
under paragraph (2) of section 246(c) (as having preference in
dividends) a 90-day period is substituted for the 15-day period
prescribed in this subparagraph. Finally, section 1223(4), relating to
holding periods in the case of wash sales, shall not apply. Therefore,
tacking of the holding period of the stock disposed of to the holding
period of the stock acquired where a wash sale occurs is not permitted
for purposes of determining the holding period described in section
246(c).
(2) Special rules. Section 246(c) requires that the holding periods
determined thereunder shall be appropriately reduced for any period that
the taxpayer's stock holding is offset by a corresponding short position
resulting from an option to sell, a contractual obligation to sell, or a
short sale of, substantially identical stock or securities. The holding
periods of stock held for a period of 15 days or less on the date such
short position is created shall accordingly be reduced to the extent of
such short position. Where the amount of stock acquired within such
period exceeds the amount as to which the taxpayer establishes a short
position, the stock the holding period of which must be reduced because
of such short position shall be that most recently acquired within such
period. If, on the date the short position is created, the amount of
stock subject to the short position exceeds the amount, if any, of stock
held by the taxpayer for 15 days or less, the excess shares of stock
sold short shall, to the extent thereof, postpone until the termination
of the short position the commencement of the holding periods of
subsequently acquired stock. Stock having a preference in dividends is
also subject to the rules prescribed in this subparagraph, except that
the 90-day period provided by paragraph (b) of this section shall apply
in lieu of the 15-day period otherwise applicable. The rules prescribed
in this subparagraph may be illustrated by the following examples:
Example 1. L Company purchased 100 shares of Z Corporation's common
stock during January 1959. On November 26, 1959, L Company purchased an
additional 100 shares of the same stock. On December 1, 1959, Z
Corporation declared a dividend payable on its common stock to
shareholders of record on December 20, 1959. Also on December 1, L
Company sold short 150 shares of Z Corporation's common stock. On
December 16, 1959 (before the stock went ex-dividend), L Company closed
its short sale with 150 shares purchased on that date. In determining,
for purposes of section 246(c), whether L Company has held the 100
shares of stock acquired on November 26 for a period in excess of 15
days, the period of the short position (from December 2 through December
16) shall be excluded. Thus, if on or before December 26, 1959, L
Company sold the 100 shares of Z Corporation stock which it purchased on
November 26, 1959, it would not be entitled to a dividends-received
deduction for the dividends received on such shares because it would
have held such shares for 15 days or less on the date of the sale. Since
L Company had held the 100 shares acquired during January 1959 for more
than 15 days on December 2, 1959, and since it was under no obligation
to make payments corresponding to the dividends received thereon,
section 246(c) is inapplicable to the dividends received with respect to
those shares.
Example 2. Assume the same facts as in Example 1 above except that
the additional 100 shares of Z Corporation common stock were purchased
by L Company on December 10,
[[Page 566]]
1959, rather than November 26, 1959. In determining, for purposes of
section 246(c), whether L Company has held such shares for a period in
excess of 15 days, the period from December 11, 1959, until December 16,
1959 (the date the short sale made on December 1 was closed), shall be
excluded.
(e) Effective date. The provisions of this section shall apply to
stock acquired after December 31, 1957, or with respect to stock
acquired before that date where the taxpayer has made a short sale of
substantially identical stock or securities after that date.
Sec. 1.246-4 Dividends from a DISC or former DISC.
The deduction provided in section 243 (relating to dividends
received by corporations) is not allowable with respect to any dividend
(whether in the form of a deemed or actual distribution or an amount
treated as a dividend pursuant to section 995(c)) from a corporation
which is a DISC or former DISC (as defined in section 992(a)(1) or (3)
as the case may be) to the extent such dividend is from the
corporation's accumulated DISC income (as defined in section 996(f)(1))
or previously taxed income (as defined in section 996(f)(2)) or is a
deemed distribution pursuant to section 995(b)(1) in a taxable year for
which the corporation qualifies (or is treated) as a DISC. To the extent
that a dividend is paid out of earnings and profits which are not made
up of accumulated DISC income or previously taxed income, the corporate
recipient is entitled to the deduction provided in section 243 in the
same manner and to the same extent as a dividend from a domestic
corporation which is not a DISC or former DISC.
[T.D. 7283, 38 FR 20824, Aug. 3, 1973]
Sec. 1.246-5 Reduction of holding periods in certain situations.
(a) In general. Under section 246(c)(4)(C), the holding period of
stock for purposes of the dividends received deduction is appropriately
reduced for any period in which a taxpayer has diminished its risk of
loss by holding one or more other positions with respect to
substantially similar or related property. This section provides rules
for applying section 246(c)(4)(C).
(b) Definitions--(1) Substantially similar or related property. The
term substantially similar or related property is applied according to
the facts and circumstances in each case. In general, property is
substantially similar or related to stock when--
(i) The fair market values of the stock and the property primarily
reflect the performance of--
(A) A single firm or enterprise;
(B) The same industry or industries; or
(C) The same economic factor or factors such as (but not limited to)
interest rates, commodity prices, or foreign-currency exchange rates;
and
(ii) Changes in the fair market value of the stock are reasonably
expected to approximate, directly or inversely, changes in the fair
market value of the property, a fraction of the fair market value of the
property, or a multiple of the fair market value of the property.
(2) Diminished risk of loss. A taxpayer has diminished its risk of
loss on its stock by holding positions with respect to substantially
similar or related property if changes in the fair market values of the
stock and the positions are reasonably expected to vary inversely.
(3) Position. For purposes of this section, a position with respect
to property is an interest (including a futures or forward contract or
an option) in property or any contractual right to a payment, whether or
not severable from stock or other property. A position does not include
traditional equity rights to demand payment from the issuer, such as the
rights traditionally provided by mandatorily redeemable preferred stock.
(4) Reasonable expectations. For purposes of paragraphs (b)(1)(i),
(b)(2), or (c)(1)(vi) of this section, reasonable expectations are the
expectations of a reasonable person, based on all the facts and
circumstances at the later of the time the stock is acquired or the
positions are entered into. Reasonable expectations include all explicit
or implicit representations made with respect to the marketing or sale
of the position.
[[Page 567]]
(c) Special rules--(1) Positions in more than one stock--(i) In
general. This paragraph (c)(1) provides rules for the treatment of
positions that reflect the value of more than one stock. In general,
positions that reflect the value of a portfolio of stocks are treated
under the rules of paragraphs (c)(1) (ii) through (iv) of this section,
and positions that reflect the value of more than one stock but less
than a portfolio are treated under the rules of paragraph (c)(1)(v) of
this section. A portfolio for this purpose is any group of stocks of 20
or more unrelated issuers. Paragraph (c)(1)(vi) of this section provides
an anti-abuse rule.
(ii) Portfolios. Notwithstanding paragraph (b)(1) of this section, a
position reflecting the value of a portfolio of stocks is substantially
similar or related to the stocks held by the taxpayer only if the
position and the taxpayer's holdings substantially overlap as of the
most recent testing date. A position may be substantially similar or
related to a taxpayer's entire stock holdings or a portion of a
taxpayer's stock holdings.
(iii) Determining substantial overlap. This paragraph (c)(1)(iii)
provides rules for determining whether a position and a taxpayer's stock
holdings or a portion of a taxpayer's stock holdings substantially
overlap. Paragraphs (c)(1)(iii) (A) through (C) of this section
determine whether there is substantial overlap as of any testing date.
(A) Step One. Construct a subportfolio (the Subportfolio) that
consists of stock in an amount equal to the lesser of the fair market
value of each stock represented in the position and the fair market
value of the stock in the taxpayer's stock holdings. (The Subportfolio
may contain fewer than 20 stocks.)
(B) Step Two. If the fair market value of the Subportfolio is equal
to or greater than 70 percent of the fair market value of the stocks
represented in the position, the position and the Subportfolio
substantially overlap.
(C) Step Three. If the position does not substantially overlap with
the Subportfolio, repeat Steps One and Two (paragraphs (c)(1)(iii)(A)
and (B) of this section) reducing the size of the position. The largest
percentage of the position that results in a substantial overlap is
substantially similar or related to the Subportfolio determined with
respect to that percentage of the position.
(iv) Testing date. A testing date is any day on which the taxpayer
purchases or sells any stock if the fair market value of the stock or
the fair market value of substantially similar or related property is
reflected in the position, any day on which the taxpayer changes the
position, or any day on which the composition of the position changes.
(v) Nonportfolio positions. A position that reflects the fair market
value of more than one stock but not of a portfolio of stocks is treated
as a separate position with respect to each of the stocks the value of
which the position reflects.
(vi) Anti-abuse rule. Notwithstanding paragraphs (c)(1)(i) through
(v) of this section, a position that reflects the value of more than one
stock is a position in substantially similar or related property to the
appropriate portion of the taxpayer's stock holdings if--
(A) Changes in the value of the position or the stocks reflected in
the position are reasonably expected to virtually track (directly or
inversely) changes in the value of the taxpayer's stock holdings, or any
portion of the taxpayer's stock holdings and other positions of the
taxpayer; and
(B) The position is acquired or held as part of a plan a principal
purpose of which is to obtain tax savings (including by deferring tax)
the value of which is significantly in excess of the expected pre-tax
economic profits from the plan.
(2) Options--(i) Options that are significantly out of the money.
For purposes of paragraph (b)(2) of this section, an option to sell that
is significantly out of the money does not diminish the taxpayer's risk
of loss on its stock unless the option is held as part of a strategy to
substantially offset changes in the fair market value of the stock.
(ii) Conversion rights. Notwithstanding paragraphs (b)(1) and (2) of
this section, a taxpayer is treated as diminishing its risk of loss by
holding substantially similar or related property if it engages in the
following
[[Page 568]]
transactions or their substantial equivalents--
(A) A short sale of common stock while holding convertible preferred
stock of the same issuer and the price changes of the convertible
preferred stock and the common stock are related;
(B) A short sale of a convertible debenture while holding
convertible preferred stock into which the debenture is convertible or
common stock; or
(C) A short sale of convertible preferred stock while holding common
stock.
(3) Stacking rule. If a taxpayer diminishes its risk of loss by
holding a position in substantially similar or related property with
respect to only a portion of the shares that the taxpayer holds in a
particular stock, the holding period of those shares having the shortest
holding period is reduced.
(4) Guarantees, surety agreements, or similar arrangements. A
taxpayer has diminished its risk of loss on stock by holding a position
in substantially similar or related property if the taxpayer is the
beneficiary of a guarantee, surety agreement, or similar arrangement and
the guarantee, surety agreement, or similar arrangement provides for
payments that will substantially offset decreases in the fair market
value of the stock.
(5) Hedges counted only once. A position established as a hedge of
one outstanding position, transaction, or obligation of the taxpayer
(other than stock) is not treated as diminishing the risk of loss with
respect to any other position held by the taxpayer. In determining
whether a position is established to hedge an outstanding position,
transaction, or obligation of the taxpayer, substantial deference will
be given to the relationships that are established in its books and
records at the time the position is entered into.
(6) Use of related persons or pass-through entities. Positions held
by a party related to the taxpayer within the meaning of sections 267(b)
or 707(b)(1) are treated as positions held by the taxpayer if the
positions are held with a view to avoiding the application of this
section or Sec. 1.1092(d)-2. In addition, a taxpayer is treated as
diminishing its risk of loss by holding substantially similar or related
property if the taxpayer holds an interest in, or is the beneficiary of,
a pass-through entity, intermediary, or other arrangement with a view to
avoiding the application of this section or Sec. 1.1092(d)-2.
(7) Notional principal contracts. For purposes of this section,
rights and obligations under notional principal contracts are considered
separately even though payments with regard to those rights and
obligations are generally netted for other purposes. Therefore, if a
taxpayer is treated under the preceding sentence as receiving payments
under a notional principal contract when the fair market value of the
taxpayer's stock declines, the taxpayer has diminished its risk of loss
by holding a position in substantially similar or related property
regardless of the netting of the payments under the contract for any
other purposes.
(d) Examples. The following examples illustrate the provisions of
this section:
Example 1. General application to common stock. Corporation A and
Corporation B are both automobile manufacturers. The fair market values
of Corporation A and Corporation B common stock primarily reflect the
value of the same industry. Because Corporation A and Corporation B
common stock are affected not only by the general level of growth in the
industry but also by individual corporate management decisions and
corporate capital structures, changes in the fair market value of
Corporation A common stock are not reasonably expected to approximate
changes in the fair market value of the Corporation B common stock.
Under paragraph (b)(1) of this section, Corporation A common stock is
not substantially similar or related to Corporation B common stock.
Example 2. Common stock value primarily reflects commodity price.
Corporation C and Corporation D both hold gold as their primary asset,
and historically changes in the fair market value of Corporation C
common stock approximated changes in the fair market value of
Corporation D common stock. Corporation M purchased Corporation C common
stock and sold short Corporation D common stock. Corporation C common
stock is substantially similar or related to Corporation D common stock
because their fair market values primarily reflect the performance of
the same economic factor, the price of gold, and changes in the fair
market value of Corporation C common stock are reasonably expected to
approximate changes in the fair market value of Corporation D common
[[Page 569]]
stock. It was reasonably expected that changes in the fair market values
of the Corporation C common stock and the short position in Corporation
D common stock would vary inversely. Thus, Corporation M has diminished
its risk of loss on its Corporation C common stock for purposes of
section 246(c)(4)(C) and this section by holding a position in
substantially similar or related property.
Example 3. Portfolios of stocks. (i) Corporation Z holds a portfolio
of stocks and acquires a short position on a publicly traded index
through a regulated futures contract (RFC) that reflects the value of a
portfolio of stocks as defined in paragraph (c)(1)(i) of this section.
The index reflects the fair market value of stocks A through T. The
values of stocks reflected in the index and the values of the same
stocks in Corporation Z's holdings are as follows:
------------------------------------------------------------------------
Z's
Stock holdings RFC Subportfolio
------------------------------------------------------------------------
A................................... $300 $300 $300
B................................... 300 300 300
C................................... -- 300 --
D................................... 400 500 400
E................................... 300 500 300
F................................... 300 500 300
G................................... 500 600 500
H................................... 300 300 300
I................................... -- 300 --
J................................... 400 450 400
K................................... 200 500 200
L................................... 200 400 200
M................................... 200 500 200
N................................... 100 200 100
O................................... -- 200 --
P................................... 200 200 200
Q................................... 100 300 100
R................................... 200 100 100
S................................... 100 100 100
T................................... 100 200 100
-----------------------------------
Totals........................ $4,200 $6,750 $4,100
------------------------------------------------------------------------
(ii) The position is substantially similar or related to Z's stock
holdings only if they substantially overlap. To determine whether they
substantially overlap, Corporation Z must construct a Subportfolio of
stocks with the lesser of the value of the stock as reflected in the RFC
and its holdings. The Subportfolio is given in the rightmost column
above. The value of the Subportfolio is 60.74 percent of the value of
the stocks represented in the position ($4100 / $6750), so the position
and the Subportfolio do not substantially overlap.
(iii) To determine whether any portion of the position substantially
overlaps with any portion of the Z's stock holdings, the values of the
stocks in the RFC are reduced for purposes of the above steps. Eighty
percent of the position and the corresponding subportfolio (consisting
of stocks with a value of the lesser of the stocks represented in Z's
holdings and in 80 percent of the RFC) substantially overlap, computed
as follows:
------------------------------------------------------------------------
Z's 80% of
Stock holdings RFC Subportfolio
------------------------------------------------------------------------
A................................... $300 $240 $240
B................................... 300 240 240
C................................... -- 240 --
D................................... 400 400 400
E................................... 300 400 300
F................................... 300 400 300
G................................... 500 480 480
H................................... 300 240 240
I................................... -- 240 --
J................................... 400 360 360
K................................... 200 400 200
L................................... 200 320 200
M................................... 200 400 200
N................................... 100 160 100
O................................... -- 160 --
P................................... 200 160 160
Q................................... 100 240 100
R................................... 200 80 80
S................................... 100 80 80
T................................... 100 160 100
-----------------------------------
Totals........................ $4,200 $5,400 $3,780
------------------------------------------------------------------------
(iv) Because $3,780 is 70 percent of $5,400, the Subportfolio
substantially overlaps with 80 percent of the position. Under paragraph
(c)(3) of this section, Z's stocks having the shortest holding period
are treated as included in the Subportfolio. A larger portion of Z's
stocks may be treated as substantially similar or related property under
the anti-abuse rule of paragraph (c)(1)(vi) of this section.
Example 4. Hedges counted only once. January 1, 1996, Corporation X
owns a $100 million portfolio of stocks all of which would substantially
overlap with a $100 million regulated futures contract (RFC) on a
commonly used index (the Index). On January 15, Corporation X enters
into a $100 million short position in an RFC on the Index with a March
delivery date and enters into a $75 million long position in an RFC on
the Index for June delivery. Also on January 15, 1996, Corporation X
indicates in its books and records that the long and short RFC positions
are intended to offset one another. Under paragraph (c)(5) of this
section, $75 million of the short position in the RFC is not treated as
diminishing the risk of loss on the stock portfolio and instead is
treated as a straddle or a hedging transaction, as appropriate, with
respect to the $75 million long position in the RFC, under section 1092.
The remaining $25 million short position is treated as diminishing the
risk of loss on the portfolio by holding a position in substantially
similar or related property. The rules of paragraph (c)(1) determine how
much of the portfolio is subject to this rule and the rules of paragraph
(c)(3) determine which shares have their holding periods tolled.
[[Page 570]]
(e) Effective date--(1) In general. The provisions of this section
apply to dividends received on or after March 17, 1995, on stock
acquired after July 18, 1984.
(2) Special rule for dividends received on certain stock.
Notwithstanding paragraph (e)(1) of this section, this section applies
to any dividends received by a taxpayer on stock acquired after July 18,
1984, if the taxpayer has diminished its risk of loss by holding
substantially similar or related property involving the following types
of transactions--
(i) The short sale of common stock when holding convertible
preferred stock of the same issuer and the price changes of the two
stocks are related, or the short sale of a convertible debenture while
holding convertible preferred stock into which the debenture is
convertible (or common stock), or a short sale of convertible preferred
stock while holding common stock; or
(ii) The acquisition of a short position in a regulated futures
contract on a stock index, or the acquisition of an option to sell the
regulated futures contract or the stock index itself, or the grant of a
deep-in-the-money option to buy the regulated futures contract or the
stock index while holding the stock of an investment company whose
principal holdings mimic the performance of the stocks included in the
stock index; or alternatively, while holding a portfolio composed of
stocks that mimic the performance of the stocks included in the stock
index.
[T.D. 8590, 60 FR 14638, Mar. 20, 1995]
Sec. 1.247-1 Deduction for dividends paid on preferred stock of public utilities.
(a) Amount of deduction. (1) A deduction is provided in section 247
for dividends paid during the taxable year by certain public utility
corporations (see paragraph (b) of this section) on certain preferred
stock (see paragraph (c) of this section). This deduction is an amount
equal to the product of a specified fraction times the lesser of (i) the
amount of the dividends paid during the taxable year by a public utility
on its preferred stock (as defined in paragraph (c) of this section), or
(ii) the taxable income of the public utility for such taxable year
(computed without regard to the deduction allowed by section 247). The
specified fraction for any taxable year is the fraction the numerator of
which is 14 and the denominator of which is the sum of the corporation
normal tax rate and the surtax rate for such taxable year specified in
section 11. Since section 11 provides that for the calendar year 1954
the corporation normal tax rate is 30 percent and the surtax rate is 22
percent, the sum of the two tax rates is 52 percent and the specified
fraction for the calendar year 1954 is 14/52. If, for example, section
11 should specify that the corporation's normal tax rate is 25 percent
and the surtax rate is 22 percent for the calendar year, the sum of the
two tax rates will be 47 percent and the specified fraction for the
calendar year will be 14/47. If Corporation A, a public utility which
files its income tax return on the calendar year basis, pays $100,000
dividends on its preferred stock in the calendar year 1954 and if its
taxable income for such year is greater than $100,000 the deduction
allowable to Corporation A under section 247 for 1954 is $100,000 times
14/52, or $26,923.08. If in 1954 Corporation A's taxable income,
computed without regard to the deduction provided in section 247, had
been $90,000 (that is, less than the amount of the dividends which it
paid on its preferred stock in that year), the deduction allowable under
section 247 for 1954 would have been $90,000 times 14/52, or $24,230.77.
(2) For the purpose of determining the amount of the deduction
provided in section 247(a) and in subparagraph (1) of this paragraph,
the amount of dividends paid in a given taxable year shall not include
any amount distributed in such year with respect to dividends unpaid and
accumulated in any taxable year ending before October 1, 1942. If any
distribution is made in the current taxable year with respect to
dividends unpaid and accumulated for a prior taxable year, such
distribution will be deemed to have been made with respect to the
earliest year or years for which there are dividends unpaid and
accumulated. Thus, if a public utility makes a distribution with respect
to a prior taxable year, it shall be considered that such distribution
was made with respect to the earliest year or
[[Page 571]]
years for which there are dividends unpaid and accumulated, whether or
not the public utility states that the distribution was made with
respect to such year or years and even though the public utility stated
that the distribution was made with respect to a later year. Even though
it has dividends unpaid and accumulated with respect to a taxable year
ending before October 1, 1942, a public utility may, however, include
the dividends paid with respect to the current taxable year in computing
the deduction under section 247. If there are no dividends unpaid and
accumulated with respect to a taxable year ending before October 1,
1942, a public utility may include the dividends paid with respect to a
prior taxable year which ended after October 1, 1942, in computing the
deduction under section 247; such public utility in addition may include
the dividends paid with respect to the current taxable year in computing
the deduction under section 247. However, if local law or its own
charter requires a public utility to pay all unpaid and accumulated
dividends before any dividends can be paid with respect to the current
taxable year, such public utility may not include any distribution in
the current year in computing the deduction under section 247 to the
extent that there are dividends unpaid and accumulated with respect to
taxable years ending before October 1, 1942.
(3) If a corporation which is engaged in one or more of the four
types of business activities (called utility activities in this section)
enumerated in section 247(b)(1) (the furnishing of telephone service or
the sale of electrical energy, gas, or water) is also engaged in some
other business that does not fall within any of the enumerated
categories, the deduction under section 247 is allowable only for such
portion of the amount computed under section 247(a) as is allocable to
the income from utility activities. For this purpose, the allocation may
be made on the basis of the ratio which the total income from the
utility activities bears to total income from all sources (total income
being considered either gross income or gross receipts, whichever method
results in the higher deduction). However, if such an allocation reaches
an inequitable result and the books of the corporation are so kept that
the taxable income attributable to the utility activities can be readily
determined, particularly where the books of the corporation are required
by governmental bodies to be so kept for rate making or other purposes,
the allocation may be made upon the basis of taxable income. No such
apportionment will be required if the income from sources other than
utility activities is less than 20 percent of the total income of the
corporation, irrespective of the method used in determining such total
income.
(b) Public utility. As used in section 247 and this section, public
utility means a corporation engaged in the furnishing of telephone
service, or in the sale of electric energy, gas, or water if the rates
charged by such corporation for such furnishing or sale, as the case may
be, have been established or approved by a State or political
subdivision thereof or by an agency or instrumentality of the United
States or by a public utility or public service commission or other
similar body of the District of Columbia or of any State or political
subdivision thereof. If a schedule of rates has been filed with any of
the above bodies having the power to disapprove such rates, then such
rates shall be considered as established or approved rates even though
such body has taken no action on the filed schedule. Rates fixed by
contract between the corporation and the purchaser, except where the
purchaser is the United States, a State, the District of Columbia, or an
agency or political subdivision of the United States, a State, or the
District of Columbia, shall not be considered as established or approved
rates in those cases where they are not subject to direct control, or
where no maximum rate for such contract rates has been established by
the United States, a State, the District of Columbia, or by an agency or
political subdivision thereof. The deduction provided in section 247
will not be denied solely because part of the gross income of the
corporation consists of revenue derived from such furnishing or sale at
rates which are not so regulated, provided
[[Page 572]]
the corporation establishes to the satisfaction of the Commissioner (1)
that the revenue from regulated rates and the revenue from unregulated
rates are derived from the operation of a single interconnected and
coordinated system within a single area or region in one or more States,
or from the operation of more than one such system and (2) that the
regulation to which it is subject in part of its operating territory in
one such system is effective to control rates within the unregulated
territory of the same system so that the rates within the unregulated
territory have been and are substantially as favorable to users and
consumers as are the rates within the regulated territory.
(c) Preferred stock. (1) For the purposes of section 247 and this
section, preferred stock means stock (i) which was issued before October
1, 1942, (ii) the dividends in respect of which (during the whole of the
taxable year, or the part of the taxable year after the actual date of
the issue of such stock) were cumulative, nonparticipating as to current
distributions, and payable in preference to the payment of dividends on
other stock, and (iii) the rate of return on which is fixed and cannot
be changed by a vote of the board of directors or by some similar
method. However, if there are several classes of preferred stock, all of
which meet the above requirements, the deduction provided in section 247
shall not be denied in the case of a given class of preferred stock
merely because there is another class of preferred stock whose dividends
are to be paid before those of the given class of stock. Likewise, it is
immaterial for the purposes of section 247 and this section whether the
stock be voting or nonvoting stock.
(2) Preferred stock issued on or after October 1, 1942, under
certain circumstances will be considered as having been issued before
October 1, 1942, for purposes of the deduction provided in section 247.
If the new stock is issued on or after October 1, 1942, to refund or
replace bonds or debentures which were issued before October 1, 1942, or
to refund or replace other stock which was preferred stock within the
meaning of section 247(b)(2) (or the corresponding provision of the
Internal Revenue Code of 1939), such new stock shall be considered as
having been issued before October 1, 1942. If preferred stock is issued
to refund or replace stock which was preferred stock within the meaning
of section 247(b)(2) (or the corresponding provision of the Internal
Revenue Code of 1939), it shall be immaterial whether the preferred
stock so refunded or replaced was issued before, on, or after October 1,
1942. If stock issued on or after October 1, 1942, to refund or replace
stock which was issued before October 1, 1942, and which was preferred
stock within the meaning of section 247(b)(2) (or the corresponding
provision of the Internal Revenue Code of 1939), is not itself preferred
stock within the meaning of section 247(b)(2) (or the corresponding
provision of the Internal Revenue Code of 1939), no stock issued to
refund or replace such stock can be considered preferred stock for
purposes of the deduction provided in section 247.
(3) In the case of any preferred stock issued on or after October 1,
1942, to refund or replace bonds or debentures issued before October 1,
1942, or to refund or replace other stock which was preferred stock
within the meaning of section 247(b)(2) (or the corresponding provision
of the Internal Revenue Code of 1939), only that portion of the stock
issued on or after October 1, 1942, will be considered as having been
issued before October 1, 1942, the par or stated value of which does not
exceed the par, stated, or face value of such bonds, debentures, or
other preferred stock which the new stock was issued to refund or
replace. In such case no shares of the new stock issued on or after
October 1, 1942, shall be earmarked in determining the deduction
allowable under section 247, but the appropriate allocable portion of
the total amount of dividends paid on such stock will be considered as
having been paid on stock which was issued before October 1, 1942.
(4) The provisions of section 247(b)(2) may be illustrated by the
following example:
Example. A public utility has outstanding 1,000 bonds which were
issued before October 1, 1942, and each of which has a face value of
$100. On or after October 1, 1942, each of such bonds is retired in
exchange for 1\1/10\ shares of preferred stock issued on or after
October 1,
[[Page 573]]
1942, and having a par value of $100 per share. Only \10/11\ of the
dividends paid on the preferred stock thus issued in exchange for the
bonds will be considered as having been paid on stock which was issued
before October 1, 1942. Likewise, if preferred stock which is issued on
or after October 1, 1942, has no par value but a stated value of $50 per
share and such stock is issued in a ratio of three shares to one share
to refund or replace preferred stock having a par value of $100 per
share, only two-thirds of the dividends paid on the new shares of stock
will be considered as having been paid on stock which was issued before
October 1, 1942.
(5) Whether or not preferred stock issued on or after October 1,
1942, was issued to refund or replace bonds or debentures issued before
October 1, 1942, or to refund or replace other preferred stock, is in
each case a question of fact. Among the factors to be considered is
whether such stock is new in an economic sense to the corporation or
whether it was issued merely to take the place, directly or indirectly,
of bonds, debentures, or other preferred stock of such corporation. It
is not necessary that the new preferred stock be issued in exchange for
such bonds, debentures, or other preferred stock. The mere fact that the
bonds, debentures, or other preferred stock remain in existence for a
short period of time after the issuance of the new stock (or were
retired before the issuance of the new stock) does not necessarily mean
that such new stock was not issued to refund or replace such bonds,
debentures, or other preferred stock. It is necessary to consider the
entire transaction, including the issuance of the new preferred stock,
the date of such issuance, the retirement of the old bonds, debentures,
or preferred stock, and the date of such retirement, in order to
determine whether such new stock really was issued to take the place of
bonds, debentures, or other preferred stock of the corporation or
whether it represents something essentially new in an economic sense in
the corporation's financial structure. If, for example, a public
utility, which has outstanding bonds issued before October 1, 1942,
issues new preferred stock on October 1, 1954, in order to secure funds
with which to retire such bonds and with the money paid in for such
stock retires the bonds on November 1, 1954, such stock may be
considered as having been issued to refund or replace bonds issued
before October 1, 1942. Whether the money used to retire the bonds can
be traced back and identified as the money paid in for the stock will
have evidentiary value, but will not be conclusive, in determining
whether the stock was issued to refund or replace the bonds. Similarly,
whether the amount of money used to retire the bonds was smaller than,
equal to, or greater than that paid in for the stock, or whether the
entire issue of bonds is retired, will be important, but not decisive,
in making such determination.
(6) Preferred stock issued on or after October 1, 1942, by a
corporation to refund or replace bonds or debentures of a second
corporation which were issued before October 1, 1942, or to refund or
replace other preferred stock of such second corporation, may be
considered as having been issued before October 1, 1942, if such new
stock was issued (i) in a transaction which is a reorganization within
the meaning of section 368(a) or the corresponding provisions of the
Internal Revenue Code of 1939; or (ii) in a transaction to which section
371 (relating to insolvency reorganizations), or the corresponding
provisions of the Internal Revenue Code of 1939, is applicable; or (iii)
in a transaction which is subject to the provisions of Part VI,
Subchapter O, Chapter 1 of the Code (relating to exchanges and
distributions in obedience to orders of the Securities and Exchange
Commission) or to the corresponding provisions of the Internal Revenue
Code of 1939. Whether the stock actually was issued to refund or replace
bonds or debentures of the second corporation issued before October 1,
1942, or to refund or replace preferred stock of such second
corporation, shall be determined under the same principles as if only
one corporation were involved. A corporation may issue stock to refund
or replace its own bonds, debentures, or other preferred stock in a
transaction which is a reorganization within the meaning of section
368(a) or the corresponding provisions of the Internal Revenue Code of
1939, in a transaction to which section 371 or the corresponding
provisions of the Internal Revenue Code of 1939 is applicable, or in a
transaction which is
[[Page 574]]
subject to the provisions of Part VI, Subchapter O, Chapter 1 of the
Code, or to the corresponding provisions of the Internal Revenue Code of
1939. The provisions of this paragraph, in addition, are applicable in
case a corporation issues stock on or after October 1, 1942, to refund
or replace its own bonds, debentures, or other preferred stock even
though the issuance of such stock may not fall within one of the
categories enumerated above.
(7) Even though stock issued on or after October 1, 1942, is
considered as having been issued before October 1, 1942, by reason of
having been issued to refund or replace bonds or debentures issued
before October 1, 1942, or to refund or replace other preferred stock,
such stock will not be deemed to be preferred stock within the meaning
of section 247(b)(2), and no deduction will be allowable in respect of
dividends paid on such stock, unless the stock fulfills all the other
requirements of a preferred stock set forth in section 247(b)(2) and in
this paragraph.
Sec. 1.248-1 Election to amortize organizational expenditures.
(a) In general. Under section 248(a), a corporation may elect to
amortize organizational expenditures as defined in section 248(b) and
Sec. 1.248-1(b). In the taxable year in which a corporation begins
business, an electing corporation may deduct an amount equal to the
lesser of the amount of the organizational expenditures of the
corporation, or $5,000 (reduced (but not below zero) by the amount by
which the organizational expenditures exceed $50,000). The remainder of
the organizational expenditures is deducted ratably over the 180-month
period beginning with the month in which the corporation begins
business. All organizational expenditures of the corporation are
considered in determining whether the organizational expenditures exceed
$50,000, including expenditures incurred on or before October 22, 2004.
(b) Organizational expenditures defined. (1) Section 248(b) defines
the term organizational expenditures. Such expenditures, for purposes of
section 248 and this section, are those expenditures which are directly
incident to the creation of the corporation. An expenditure, in order to
qualify as an organizational expenditure, must be (i) incident to the
creation of the corporation, (ii) chargeable to the capital account of
the corporation, and (iii) of a character which, if expended incident to
the creation of a corporation having a limited life, would be
amortizable over such life. An expenditure which fails to meet each of
these three tests may not be considered an organizational expenditure
for purposes of section 248 and this section.
(2) The following are examples of organizational expenditures within
the meaning of section 248 and this section: legal services incident to
the organization of the corporation, such as drafting the corporate
charter, by-laws, minutes of organizational meetings, terms of original
stock certificates, and the like; necessary accounting services;
expenses of temporary directors and of organizational meetings of
directors or stockholders; and fees paid to the State of incorporation.
(3) The following expenditures are not organizational expenditures
within the meaning of section 248 and this section:
(i) Expenditures connected with issuing or selling shares of stock
or other securities, such as commissions, professional fees, and
printing costs. This is so even where the particular issue of stock to
which the expenditures relate is for a fixed term of years;
(ii) Expenditures connected with the transfer of assets to a
corporation.
(4) Expenditures connected with the reorganization of a corporation,
unless directly incident to the creation of a corporation, are not
organizational expenditures within the meaning of section 248 and this
section.
(c) Time and manner of making election. A corporation is deemed to
have made an election under section 248(a) to amortize organizational
expenditures as defined in section 248(b) and Sec. 1.248-1(b) for the
taxable year in which the corporation begins business. A corporation may
choose to forgo the deemed election by affirmatively electing to
capitalize its organizational expenditures on a timely filed Federal
income tax return (including extensions) for the taxable year in which
the corporation begins business. The election
[[Page 575]]
either to amortize organizational expenditures under section 248(a) or
to capitalize organizational expenditures is irrevocable and applies to
all organizational expenditures of the corporation. A change in the
characterization of an item as an organizational expenditure is a change
in method of accounting to which sections 446 and 481(a) apply if the
corporation treated the item consistently for two or more taxable years.
A change in the determination of the taxable year in which the
corporation begins business also is treated as a change in method of
accounting if the corporation amortized organizational expenditures for
two or more taxable years.
(d) Determination of when corporation begins business. The deduction
allowed under section 248 must be spread over a period beginning with
the month in which the corporation begins business. The determination of
the date the corporation begins business presents a question of fact
which must be determined in each case in light of all the circumstances
of the particular case. The words ``begins business,'' however, do not
have the same meaning as ``in existence.'' Ordinarily, a corporation
begins business when it starts the business operations for which it was
organized; a corporation comes into existence on the date of its
incorporation. Mere organizational activities, such as the obtaining of
the corporate charter, are not alone sufficient to show the beginning of
business. If the activities of the corporation have advanced to the
extent necessary to establish the nature of its business operations,
however, it will be deemed to have begun business. For example, the
acquisition of operating assets which are necessary to the type of
business contemplated may constitute the beginning of business.
(e) Examples. The following examples illustrate the application of
this section:
Example 1. Expenditures of $5,000 or less Corporation X, a calendar
year taxpayer, incurs $3,000 of organizational expenditures after
October 22, 2004, and begins business on July 1, 2011. Under paragraph
(c) of this section, Corporation X is deemed to have elected to amortize
organizational expenditures under section 248(a) in 2011. Therefore,
Corporation X may deduct the entire amount of the organizational
expenditures in 2011, the taxable year in which Corporation X begins
business.
Example 2. Expenditures of more than $5,000 but less than or equal
to $50,000 The facts are the same as in Example 1 except that
Corporation X incurs organizational expenditures of $41,000. Under
paragraph (c) of this section, Corporation X is deemed to have elected
to amortize organizational expenditures under section 248(a) in 2011.
Therefore, Corporation X may deduct $5,000 and the portion of the
remaining $36,000 that is allocable to July through December of 2011
($36,000/180 x 6 = $1,200) in 2011, the taxable year in which
Corporation X begins business. Corporation X may amortize the remaining
$34,800 ($36,000 - $1,200 = $34,800) ratably over the remaining 174
months.
Example 3. Subsequent change in the characterization of an item The
facts are the same as in Example 2 except that Corporation X determines
in 2013 that Corporation X incurred $10,000 for an additional
organizational expenditure erroneously deducted in 2011 under section
162 as a business expense. Under paragraph (c) of this section,
Corporation X is deemed to have elected to amortize organizational
expenditures under section 248(a) in 2011, including the additional
$10,000 of organizational expenditures. Corporation X is using an
impermissible method of accounting for the additional $10,000 of
organizational expenditures and must change its method under Sec.
1.446-1(e) and the applicable general administrative procedures in
effect in 2013.
Example 4. Subsequent redetermination of year in which business
begins The facts are the same as in Example 2 except that, in 2012,
Corporation X deducted the organizational expenditures allocable to
January through December of 2012 ($36,000/180 x 12 = $2,400). In
addition, in 2013 it is determined that Corporation X actually began
business in 2012. Under paragraph (c) of this section, Corporation X is
deemed to have elected to amortize organizational expenditures under
section 248(a) in 2012. Corporation X impermissibly deducted
organizational expenditures in 2011, and incorrectly determined the
amount of organizational expenditures deducted in 2012. Therefore,
Corporation X is using an impermissible method of accounting for the
organizational expenditures and must change its method under Sec.
1.446-1(e) and the applicable general administrative procedures in
effect in 2013.
Example 5. Expenditures of more than $50,000 but less than or equal
to $55,000 The facts are the same as in Example 1 except that
Corporation X incurs organizational expenditures of $54,500. Under
paragraph (c) of this section, Corporation X is deemed to have elected
to amortize organizational expenditures under section 248(a) in 2011.
Therefore, Corporation X may deduct $500 ($5,000 - $4,500) and the
portion of the remaining
[[Page 576]]
$54,000 that is allocable to July through December of 2011 ($54,000/180
x 6 = $1,800) in 2011, the taxable year in which Corporation X begins
business. Corporation X may amortize the remaining $52,200 ($54,000 -
$1,800 = $52,200) ratably over the remaining 174 months.
Example 6. Expenditures of more than $55,000 The facts are the same
as in Example 1 except that Corporation X incurs organizational
expenditures of $450,000. Under paragraph (c) of this section,
Corporation X is deemed to have elected to amortize organizational
expenditures under section 248(a) in 2011. Therefore, Corporation X may
deduct the amounts allocable to July through December of 2011 ($450,000/
180 x 6 = $15,000) in 2011, the taxable year in which Corporation X
begins business. Corporation X may amortize the remaining $435,000
($450,000 - $15,000 = $435,000) ratably over the remaining 174 months.
(f) Effective/applicability date. This section applies to
organizational expenditures paid or incurred after August 16, 2011.
However, taxpayers may apply all the provisions of this section to
organizational expenditures paid or incurred after October 22, 2004,
provided that the period of limitations on assessment of tax for the
year the election under paragraph (c) of this section is deemed made has
not expired. For organizational expenditures paid or incurred on or
before September 8, 2008, taxpayers may instead apply Sec. 1.248-1, as
in effect prior to that date (Sec. 1.248-1 as contained in 26 CFR part
1 edition revised as of April 1, 2008).
[T.D. 9411, 73 FR 38913, July 8, 2008, as amended by T.D. 9542, 76 FR
50889, Aug. 17, 2011]
Sec. 1.249-1 Limitation on deduction of bond premium on repurchase.
(a) Limitation--(1) General rule. No deduction is allowed to the
issuing corporation for any ``repurchase premium'' paid or incurred to
repurchase a convertible obligation to the extent the repurchase premium
exceeds a ``normal call premium.''
(2) Exception. Under paragraph (e) of this section, the preceding
sentence shall not apply to the extent the corporation demonstrates that
such excess is attributable to the cost of borrowing and not to the
conversion feature.
(b) Obligations--(1) Definition. For purposes of this section, the
term obligation means any bond, debenture, note, or certificate or other
evidence of indebtedness.
(2) Convertible obligation. Section 249 applies to an obligation
which is convertible into the stock of the issuing corporation or a
corporation which, at the time the obligation is issued or repurchased,
is in control of or controlled by the issuing corporation. For purposes
of this subparagraph, the term control has the meaning assigned to such
term by section 368(c).
(3) Comparable nonconvertible obligation. A nonconvertible
obligation is comparable to a convertible obligation if both obligations
are of the same grade and classification, with the same issue and
maturity dates, and bearing the same rate of interest. The term
comparable nonconvertible obligation does not include any obligation
which is convertible into property.
(c) Repurchase premium. For purposes of this section, the term
repurchase premium means the excess of the repurchase price paid or
incurred to repurchase the obligation over its adjusted issue price
(within the meaning of Sec. 1.1275-1(b)) as of the repurchase date. For
the general rules applicable to the deductibility of repurchase premium,
see Sec. 1.163-7(c). This paragraph (c) applies to convertible
obligations repurchased on or after March 2, 1998.
(d) Normal call premium--(1) In general. Except as provided in
subparagraph (2) of this paragraph, for purposes of this section, a
normal call premium on a convertible obligation is an amount equal to a
normal call premium on a nonconvertible obligation which is comparable
to the convertible obligation. A normal call premium on a comparable
nonconvertible obligation is a call premium specified in dollars under
the terms of such obligation. Thus, if such a specified call premium is
constant over the entire term of the obligation, the normal call premium
is the amount specified. If, however, the specified call premium varies
during the period the comparable nonconvertible obligation is callable
or if such obligation is not callable over its entire term, the normal
call premium is the amount specified for the period during the term of
such comparable nonconvertible obligation which corresponds to the
period
[[Page 577]]
during which the convertible obligation was repurchased.
(2) One-year's interest rule. For a convertible obligation
repurchased on or after March 2, 1998, a call premium specified in
dollars under the terms of the obligation is considered to be a normal
call premium on a nonconvertible obligation if the call premium
applicable when the obligation is repurchased does not exceed an amount
equal to the interest (including original issue discount) that otherwise
would be deductible for the taxable year of repurchase (determined as if
the obligation were not repurchased). The provisions of this
subparagraph shall not apply if the amount of interest payable for the
corporation's taxable year is subject under the terms of the obligation
to any contingency other than repurchase prior to the close of such
taxable year.
(e) Exception--(1) In general. If a repurchase premium exceeds a
normal call premium, the general rule of paragraph (a) (1) of this
section does not apply to the extent that the corporation demonstrates
to the satisfaction of the Commissioner or his delegate that such
repurchase premium is attributable to the cost of borrowing and is not
attributable to the conversion feature. For purposes of this paragraph,
if a normal call premium cannot be established under paragraph (d) of
this section, the amount thereof shall be considered to be zero.
(2) Determination of the portion of a repurchase premium
attributable to the cost of borrowing and not attributable to the
conversion feature. (i) For purposes of subparagraph (1) of this
paragraph, the portion of a repurchase premium which is attributable to
the cost of borrowing and which is not attributable to the conversion
feature is the amount by which the selling price of the convertible
obligation increased between the dates it was issued and repurchased by
reason of a decline in yields on comparable nonconvertible obligations
traded on an established securities market or, if such comparable traded
obligations do not exist, by reason of a decline in yields generally on
nonconvertible obligations which are as nearly comparable as possible.
(ii) In determining the amount under paragraph (e)(2)(i) of this
section, appropriate consideration shall be given to all factors
affecting the selling price or yields of comparable nonconvertible
obligations. Such factors include general changes in prevailing yields
of comparable obligations between the dates the convertible obligation
was issued and repurchased and the amount (if any) by which the selling
price of the nonconvertible obligation was affected by reason of any
change in the issuing corporation's credit quality or the credit quality
of the obligation during such period (determined on the basis of widely
published financial information or on the basis of other relevant facts
and circumstances which reflect the relative credit quality of the
corporation or the comparable obligation).
(iii) The relationship between selling price and yields in
subdivision (i) of this subparagraph shall ordinarily be determined by
means of standard bond tables.
(f) Effective/applicability dates--(1) In general. Under section
414(c) of the Tax Reform Act of 1969, the provisions of section 249 and
this section shall apply to any repurchase of a convertible obligation
occurring after April 22, 1969, other than a convertible obligation
repurchased pursuant to a binding obligation incurred on or before April
22, 1969, to repurchase such convertible obligation at a specified call
premium. A binding obligation on or before such date may arise if, for
example, the issuer irrevocably obligates itself, on or before such
date, to repurchase the convertible obligation at a specified price
after such date, or if, for example, the issuer, without regard to the
terms of the convertible obligation, negotiates a contract which, on or
before such date, irrevocably obligates the issuer to repurchase the
convertible obligation at a specified price after such date. A binding
obligation on or before such date does not include a privilege in the
convertible obligation permitting the issuer to call such convertible
obligation after such date, which privilege was not exercised on or
before such date.
(2) Effect on transactions not subject to this section. No
inferences shall be
[[Page 578]]
drawn from the provisions of section 249 and this section as to the
proper treatment of transactions not subject to such provisions because
of the effective date limitations thereof. For provisions relating to
repurchases of convertible bonds or other evidences of indebtedness to
which section 249 and this section do not apply, see Sec. Sec. 1.163-
3(c) and 1.163-4(c).
(3) Portion of repurchase premium attributable to cost of borrowing.
Paragraph (e)(2)(ii) of this section applies to any repurchase of a
convertible obligation occurring on or after July 6, 2011.
(g) Example. The provisions of this section may be illustrated by
the following example:
Example. On May 15, 1968, corporation A issues a callable 20-year
convertible bond at face for $1,000 bearing interest at 10 percent per
annum. The bond is convertible at any time into 2 shares of the common
stock of corporation A. Under the terms of the bond, the applicable call
price prior to May 15, 1975, is $1,100. On June 1, 1974, corporation A
calls the bond for $1,100. Since the repurchase premium, $100 (i.e.,
$1,100 minus $1,000), was specified in dollars in the obligation and
does not exceed 1 year's interest at the rate fixed in the obligation,
the $100 is considered under paragraph (d) (2) of this section to be a
normal call premium on a comparable nonconvertible obligation.
Accordingly, A may deduct the $100 under Sec. 1.163-3(c).
[T.D. 7259, 38 FR 4254, Feb. 12, 1973, as amended by T.D. 8746, 62 FR
68182, Dec. 31, 1997; T.D. 9533, 76 FR 39281, July 6, 2011; T.D. 9637,
78 FR 54759, Sept. 6, 2013]
Sec. 1.250-0 Table of contents.
This section contains a listing of the headings for Sec. Sec.
1.250-1, 1.250(a)-1, and 1.250(b)-1 through 1.250(b)-6.
Sec. 1.250-1 Introduction.
(a) Overview.
(b) Applicability dates.
Sec. 1.250(a)-1 Deduction for foreign-derived intangible income (FDII)
and global intangible low-taxed income (GILTI).
(a) Scope.
(b) Allowance of deduction.
(1) In general.
(2) Taxable income limitation.
(3) Reduction in deduction for taxable years after 2025.
(4) Treatment under section 4940.
(c) Definitions.
(1) Domestic corporation.
(2) Foreign-derived intangible income (FDII).
(3) Global intangible low-taxed income (GILTI).
(4) Section 250(a)(2) amount.
(5) Taxable income.
(i) In general.
(ii) [Reserved]
(d) Reporting requirement.
(e) Determination of deduction for consolidated groups.
(f) Example: Application of the taxable income limitation.
Sec. 1.250(b)-1 Computation of foreign-derived intangible income
(FDII).
(a) Scope.
(b) Definition of FDII.
(c) Definitions.
(1) Controlled foreign corporation.
(2) Deduction eligible income.
(3) Deemed intangible income.
(4) Deemed tangible income return.
(5) Dividend.
(6) Domestic corporation.
(7) Domestic oil and gas extraction income.
(8) FDDEI sale.
(9) FDDEI service.
(10) FDDEI transaction.
(11) Foreign branch income.
(12) Foreign-derived deduction eligible income.
(13) Foreign-derived ratio.
(14) Gross RDEI.
(15) Gross DEI.
(16) Gross FDDEI.
(17) Modified affiliated group.
(i) In general.
(ii) Special rule for noncorporate entities.
(iii) Definition of control.
(18) Qualified business asset investment.
(19) Related party.
(20) United States shareholder.
(d) Treatment of cost of goods sold and allocation and apportionment
of deductions.
(1) Cost of goods sold for determining gross DEI and gross FDDEI.
(2) Deductions properly allocable to gross DEI and gross FDDEI.
(i) In general.
(ii) Determination of deductions to allocate.
(3) Examples.
(e) Domestic corporate partners.
(1) In general.
(2) Reporting requirement for partnership with domestic corporate
partners.
(3) Examples.
(f) Determination of FDII for consolidated groups.
(g) Determination of FDII for tax-exempt corporations.
Sec. 1.250(b)-2 Qualified business asset investment (QBAI).
(a) Scope.
(b) Definition of qualified business asset investment.
(c) Specified tangible property.
(1) In general.
[[Page 579]]
(2) Tangible property.
(d) Dual use property.
(1) In general.
(2) Definition of dual use property.
(3) Dual use ratio.
(4) Example.
(e) Determination of adjusted basis of specified tangible property.
(1) In general.
(2) Effect of change in law.
(3) Specified tangible property placed in service before enactment
of section 250.
(f) Special rules for short taxable years.
(1) In general.
(2) Determination of when the quarter closes.
(3) Reduction of qualified business asset investment.
(4) Example.
(g) Partnership property.
(1) In general.
(2) Determination of partnership QBAI.
(3) Determination of partner adjusted basis.
(i) In general.
(ii) Sole use partnership property.
(A) In general.
(B) Definition of sole use partnership property.
(iii) Dual use partnership property.
(A) In general.
(B) Definition of dual use partnership property.
(4) Determination of proportionate share of the partnership's
adjusted basis in partnership specified tangible property.
(i) In general.
(ii) Proportionate share ratio.
(5) Definition of partnership specified tangible property.
(6) Determination of partnership adjusted basis.
(7) Determination of partner-specific QBAI basis.
(8) Examples.
(h) Anti-avoidance rule for certain transfers of property.
(1) In general.
(2) Rule for structured arrangements.
(3) Per se rules for certain transactions.
(4) Definitions related to anti-avoidance rule.
(i) Disqualified period.
(ii) FDII-eligible related party.
(iii) Specified related party.
(iv) Transfer.
(5) Transactions occurring before March 4, 2019.
(6) Examples.
Sec. 1.250(b)-3 Foreign-derived deduction eligible income (FDDEI)
transactions.
(a) Scope.
(b) Definitions.
(1) Digital content.
(2) End user.
(3) FDII filing date.
(4) Finished goods.
(5) Foreign person.
(6) Foreign related party.
(7) Foreign retail sale.
(8) Foreign unrelated party.
(9) Fungible mass of general property.
(10) General property.
(11) Intangible property.
(12) International transportation property.
(13) IP address.
(14) Recipient.
(15) Renderer.
(16) Sale.
(17) Seller.
(18) United States.
(19) United States person.
(20) United States territory.
(c) Foreign military sales and services.
(d) Transactions with multiple elements.
(e) Treatment of partnerships.
(1) In general.
(2) Examples.
(f) Substantiation for certain FDDEI transactions.
(1) In general.
(2) Exception for small businesses.
(3) Treatment of certain loss transactions.
(i) In general.
(ii) Reason to know.
(A) Sales to a foreign person for a foreign use.
(B) General services provided to a business recipient located
outside the United States.
(iii) Multiple transactions.
(iv) Example.
Sec. 1.250(b)-4 Foreign-derived deduction eligible income (FDDEI)
sales.
(a) Scope.
(b) Definition of FDDEI sale.
(c) Presumption of foreign person status.
(1) In general.
(2) Sales of property.
(d) Foreign use.
(1) Foreign use for general property.
(i) In general.
(ii) Rules for determining foreign use.
(A) Sales that are delivered to an end user by a carrier or freight
forwarder.
(B) Sales to an end user without the use of a carrier or freight
forwarder.
(C) Sales for resale.
(D) Sales of digital content.
(E) Sales of international transportation property used for
compensation or hire.
(F) Sales of international transportation property not used for
compensation or hire.
(iii) Sales for manufacturing, assembly, or other processing.
(A) In general.
(B) Property subject to a physical and material change.
(C) Property incorporated into a product as a component.
(iv) Sales of property subject to manufacturing, assembly, or other
processing in the United States
(v) Examples.
[[Page 580]]
(2) Foreign use for intangible property.
(i) In general.
(ii) Determination of end users and revenue earned from end users.
(A) Intangible property embedded in general property or used in
connection with the sale of general property.
(B) Intangible property used in providing a service.
(C) Intangible property consisting of a manufacturing method or
process.
(1) In general.
(2) Exception for certain manufacturing arrangements.
(3) Manufacturing method or process.
(D) Intangible property used in research and development.
(iii) Determination of revenue for periodic payments versus lump
sums.
(A) Sales in exchange for periodic payments.
(B) Sales in exchange for a lump sum.
(C) Sales to a foreign unrelated party of intangible property
consisting of a manufacturing method or process.
(iv) Examples.
(3) Foreign use substantiation for certain sales of property.
(i) In general.
(ii) Substantiation of foreign use for resale.
(iii) Substantiation of foreign use for manufacturing, assembly, or
other processing. outside the United States.
(iv) Substantiation of foreign use of intangible property.
(v) Examples.
(e) Sales of interests in a disregarded entity.
(f) FDDEI sales hedging transactions.
(1) In general.
(2) FDDEI sales hedging transaction.
Sec. 1.250(b)-5 Foreign-derived deduction eligible income (FDDEI)
services.
(a) Scope.
(b) Definition of FDDEI service.
(c) Definitions.
(1) Advertising service.
(2) Benefit.
(3) Business recipient.
(4) Consumer.
(5) Electronically supplied service.
(6) General service.
(7) Property service.
(8) Proximate service.
(9) Transportation service.
(d) General services provided to consumers.
(1) In general.
(2) Electronically supplied services.
(3) Example.
(e) General services provided to business recipients.
(1) In general.
(2) Determination of business operations that benefit from the
service.
(i) In general.
(ii) Advertising services.
(iii) Electronically supplied services.
(3) Identification of business recipient's operations.
(i) In general.
(ii) Advertising services and electronically supplied services.
(iii) No office or fixed place of business.
(4) Substantiation of the location of a business recipient's
operations outside the United States.
(5) Examples.
(f) Proximate services.
(g) Property services.
(1) In general.
(2) Exception for service provided with respect to property
temporarily in the United States.
(h) Transportation services.
Sec. 1.250(b)-6 Related party transactions.
(a) Scope.
(b) Definitions.
(1) Related party sale.
(2) Related party service.
(3) Unrelated party transaction.
(c) Related party sales.
(1) In general.
(i) Sale of property in an unrelated party transaction.
(ii) Use of property in an unrelated party transaction.
(2) Treatment of foreign related party as seller or renderer.
(3) Transactions between related parties.
(4) Example.
(d) Related party services.
(1) In general.
(2) Substantially similar services.
(3) Special rules.
(i) Rules for determining the location of and price paid by
recipients of a service provided by a related party.
(ii) Rules for allocating the benefits provided by and price paid to
the renderer of a related party service.
(4) Examples.
[T.D. 9901, 85 FR 43080, July 15, 2020, as amended by 85 FR 60910, Sept.
29, 2020]
Sec. 1.250-1 Introduction.
(a) Overview. Sections 1.250(a)-1 and 1.250(b)-1 through 1.250(b)-6
provide rules to determine a domestic corporation's section 250
deduction. Section 1.250(a)-1 provides rules to determine the amount of
a domestic corporation's deduction for foreign-derived intangible income
and global intangible low-taxed income. Section 1.250(b)-1 provides
general rules and definitions regarding the computation of foreign-
derived intangible income. Section 1.250(b)-2 provides rules for
determining a domestic corporation's qualified business asset
investment. Section 1.250(b)-3 provides general rules and
[[Page 581]]
definitions regarding the determination of gross foreign-derived
deduction eligible income. Section 1.250(b)-4 provides rules regarding
the determination of gross foreign-derived deduction eligible income
from the sale of property. Section 1.250(b)-5 provides rules regarding
the determination of gross foreign-derived deduction eligible income
from the provision of a service. Section 1.250(b)-6 provides rules
regarding the sale of property or provision of a service to a related
party.
(b) Applicability dates. Except as otherwise provided in this
paragraph (b), Sec. Sec. 1.250(a)-1 and 1.250(b)-1 through 1.250(b)-6
apply to taxable years beginning on or after January 1, 2021. Section
1.250(b)-2(h)applies to taxable years ending on or after March 4, 2019.
The last sentence in Sec. 1.250(b)-2(e)(2) applies to taxable years
beginning after December 31, 2017.
[T.D. 9901, 85 FR 43080, July 15, 2020, as amended by 85 FR 68249, Oct.
28, 2020; T.D. 9956, 86 FR 52972, Sept. 24, 2021]
Sec. 1.250(a)-1 Deduction for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI).
(a) Scope. This section provides rules for determining the amount of
a domestic corporation's deduction for foreign-derived intangible income
(FDII) and global intangible low-taxed income (GILTI). Paragraph (b) of
this section provides general rules for determining the amount of the
deduction. Paragraph (c) of this section provides definitions relevant
for determining the amount of the deduction. Paragraph (d) of this
section provides reporting requirements for a domestic corporation
claiming the deduction. Paragraph (e) of this section provides a rule
for determining the amount of the deduction of a member of a
consolidated group. Paragraph (f) of this section provides examples
illustrating the application of this section.
(b) Allowance of deduction--(1) In general. A domestic corporation
is allowed a deduction for any taxable year equal to the sum of--
(i) 37.5 percent of its foreign-derived intangible income for the
year; and
(ii) 50 percent of--
(A) Its global intangible low-taxed income for the year; and
(B) The amount treated as a dividend received by the corporation
under section 78 which is attributable to its GILTI for the year.
(2) Taxable income limitation. In the case of a domestic corporation
with a section 250(a)(2) amount for a taxable year, for purposes of
applying paragraph (b)(1) of this section for the year--
(i) The corporation's FDII for the year (if any) is reduced (but not
below zero) by an amount that bears the same ratio to the corporation's
section 250(a)(2) amount that the corporation's FDII for the year bears
to the sum of the corporation's FDII and GILTI for the year; and
(ii) The corporation's GILTI for the year (if any) is reduced (but
not below zero) by the excess of the corporation's section 250(a)(2)
amount over the amount of the reduction described in paragraph (b)(2)(i)
of this section.
(3) Reduction in deduction for taxable years after 2025. For any
taxable year of a domestic corporation beginning after December 31,
2025, paragraph (b)(1) of this section applies by substituting--
(i) 21.875 percent for 37.5 percent in paragraph (b)(1)(i) of this
section; and
(ii) 37.5 percent for 50 percent in paragraph (b)(1)(ii) of this
section.
(4) Treatment under section 4940. For purposes of section
4940(c)(3)(A), a deduction under section 250(a) is not treated as an
ordinary and necessary expense paid or incurred for the production or
collection of gross investment income.
(c) Definitions. The following definitions apply for purposes of
this section.
(1) Domestic corporation. The term domestic corporation has the
meaning set forth in section 7701(a), but does not include a regulated
investment company (as defined in section 851), a real estate investment
trust (as defined in section 856), or an S corporation (as defined in
section 1361).
(2) Foreign-derived intangible income (FDII). The term foreign-
derived intangible income or FDII has the meaning set forth in Sec.
1.250(b)-1(b).
(3) Global intangible low-taxed income (GILTI). The term global
intangible low-
[[Page 582]]
taxed income or GILTI means, with respect to a domestic corporation for
a taxable year, the corporation's GILTI inclusion amount under Sec.
1.951A-1(c) for the taxable year.
(4) Section 250(a)(2) amount. The term section 250(a)(2) amount
means, with respect to a domestic corporation for a taxable year, the
excess (if any) of the sum of the corporation's FDII and GILTI
(determined without regard to section 250(a)(2) and paragraph (b)(2) of
this section), over the corporation's taxable income. For a corporation
that is subject to the unrelated business income tax under section 511,
taxable income is determined only by reference to that corporation's
unrelated business taxable income defined under section 512.
(5) Taxable income--(i) In general. The term taxable income has the
meaning set forth in section 63(a) determined without regard to the
deduction allowed under section 250 and this section.
(ii) [Reserved]
(d) Reporting requirement. Each domestic corporation (or individual
making an election under section 962) that claims a deduction under
section 250 for a taxable year must make an annual return on Form 8993,
``Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and
Global Intangible Low-Taxed Income (GILTI)'' (or any successor form) for
such year, setting forth the information, in such form and manner, as
Form 8993 (or any successor form) or its instructions prescribe. Returns
on Form 8993 (or any successor form) for a taxable year must be filed
with the domestic corporation's (or in the case of a section 962
election, the individual's) income tax return on or before the due date
(taking into account extensions) for filing the corporation's (or in the
case of a section 962 election, the individual's) income tax return.
(e) Determination of deduction for consolidated groups. A member of
a consolidated group (as defined in Sec. 1.1502-1(h)) determines its
deduction under section 250(a) and this section under the rules provided
in Sec. 1.1502-50(b).
(f) Example: Application of the taxable income limitation. The
following example illustrates the application of this section. For
purposes of the example, it is assumed that DC is a domestic corporation
that is not a member of a consolidated group and the taxable year of DC
begins after 2017 and before 2026.
(1) Facts. For the taxable year, without regard to section 250(a)(2)
and paragraph (b)(2) of this section, DC has FDII of $100x and GILTI of
$300x. DC's taxable income (without regard to section 250(a) and this
section) is $300x.
(2) Analysis. DC has a section 250(a)(2) amount of $100x, which is
equal to the excess of the sum of DC's FDII and GILTI of $400x ($100x +
$300x) over its taxable income of $300x. As a result, DC's FDII and
GILTI are reduced, in the aggregate, by $100x under section 250(a)(2)
and paragraph (b)(2) of this section for purposes of calculating DC's
deduction allowed under section 250(a)(1) and paragraph (b)(1) of this
section. DC's FDII is reduced by $25x, the amount that bears the same
ratio to the section 250(a)(2) amount ($100x) as DC's FDII ($100x) bears
to the sum of DC's FDII and GILTI ($400x). DC's GILTI is reduced by
$75x, which is the remainder of the section 250(a)(2) amount ($100x-
$25x). Therefore, for purposes of calculating its deduction under
section 250(a)(1) and paragraph (b)(1) of this section, DC's FDII is
$75x ($100x-$25x) and its GILTI is $225x ($300x-$75x). Accordingly, DC
is allowed a deduction for the taxable year under section 250(a)(1) and
paragraph (b)(1) of this section of $140.63x ($75x x 0.375 + $225x x
0.50).
[T.D. 9901, 85 FR 43080, July 15, 2020]
Sec. 1.250(b)-1 Computation of foreign-derived intangible income (FDII).
(a) Scope. This section provides rules for computing FDII. Paragraph
(b) of this section defines FDII. Paragraph (c) of this section provides
definitions that are relevant for computing FDII. Paragraph (d) of this
section provides rules for computing gross income and allocating and
apportioning deductions for purposes of computing deduction eligible
income (DEI) and foreign-derived deduction eligible income (FDDEI).
Paragraph (e) of this section provides rules for computing the DEI and
FDDEI of a domestic corporate partner. Paragraph (f) of this section
provides a rule for computing the FDII of
[[Page 583]]
a member of a consolidated group. Paragraph (g) of this section provides
a rule for computing the FDII of a tax-exempt corporation.
(b) Definition of FDII. Subject to the provisions of this section,
the term FDII means, with respect to a domestic corporation for a
taxable year, the corporation's deemed intangible income for the year
multiplied by the corporation's foreign-derived ratio for the year.
(c) Definitions. This paragraph (c) provides definitions that apply
for purposes of this section and Sec. Sec. 1.250(b)-2 through 1.250(b)-
6.
(1) Controlled foreign corporation. The term controlled foreign
corporation has the meaning set forth in section 957(a) and Sec. 1.957-
1(a).
(2) Deduction eligible income. The term deduction eligible income or
DEI means, with respect to a domestic corporation for a taxable year,
the excess (if any) of the corporation's gross DEI for the year over the
deductions properly allocable to gross DEI for the year, as determined
under paragraph (d)(2) of this section.
(3) Deemed intangible income. The term deemed intangible income
means, with respect to a domestic corporation for a taxable year, the
excess (if any) of the corporation's DEI for the year over the
corporation's deemed tangible income return for the year.
(4) Deemed tangible income return. The term deemed tangible income
return means, with respect to a domestic corporation and a taxable year,
10 percent of the corporation's qualified business asset investment for
the year.
(5) Dividend. The term dividend has the meaning set forth in section
316, and includes any amount treated as a dividend under any other
provision of subtitle A of the Internal Revenue Code or the regulations
in this part (for example, under section 78, 356(a)(2), 367(b), or
1248).
(6) Domestic corporation. The term domestic corporation has the
meaning set forth in Sec. 1.250(a)-1(c)(1).
(7) Domestic oil and gas extraction income. The term domestic oil
and gas extraction income means income described in section 907(c)(1),
substituting ``within the United States'' for ``without the United
States.'' A taxpayer must use a consistent method to determine the
amount of its domestic oil and gas extraction income (``DOGEI'') and its
foreign oil and gas extraction income (``FOGEI'') from the sale of oil
or gas that has been transported or processed. For example, a taxpayer
must use a consistent method to determine the amount of FOGEI from the
sale of gasoline from foreign crude oil sources in computing the
exclusion from gross tested income under Sec. 1.951A-2(c)(1)(v) and the
amount of DOGEI from the sale of gasoline from domestic crude oil
sources in computing its section 250 deduction.
(8) FDDEI sale. The term FDDEI sale has the meaning set forth in
Sec. 1.250(b)-4(b).
(9) FDDEI service. The term FDDEI service has the meaning set forth
in Sec. 1.250(b)-5(b).
(10) FDDEI transaction. The term FDDEI transaction means a FDDEI
sale or a FDDEI service.
(11) Foreign branch income. The term foreign branch income has the
meaning set forth in section 904(d)(2)(J) and Sec. 1.904-4(f)(2).
(12) Foreign-derived deduction eligible income. The term foreign-
derived deduction eligible income or FDDEI means, with respect to a
domestic corporation for a taxable year, the excess (if any) of the
corporation's gross FDDEI for the year, over the deductions properly
allocable to gross FDDEI for the year, as determined under paragraph
(d)(2) of this section.
(13) Foreign-derived ratio. The term foreign-derived ratio means,
with respect to a domestic corporation for a taxable year, the ratio
(not to exceed one) of the corporation's FDDEI for the year to the
corporation's DEI for the year. If a domestic corporation has no FDDEI
for a taxable year, the corporation's foreign-derived ratio is zero for
the taxable year.
(14) Gross RDEI. The term gross RDEI means, with respect to a
domestic corporation or a partnership for a taxable year, the portion of
the corporation or partnership's gross DEI for the year that is not
included in gross FDDEI.
(15) Gross DEI. The term gross DEI means, with respect to a domestic
corporation or a partnership for a taxable
[[Page 584]]
year, the gross income of the corporation or partnership for the year
determined without regard to the following items of gross income--
(i) Amounts included in gross income under section 951(a)(1);
(ii) GILTI (as defined in Sec. 1.250(a)-1(c)(3));
(iii) Financial services income (as defined in section 904(d)(2)(D)
and Sec. 1.904-4(e)(1)(ii));
(iv) Dividends received from a controlled foreign corporation with
respect to which the corporation or partnership is a United States
shareholder;
(v) Domestic oil and gas extraction income; and
(vi) Foreign branch income.
(16) Gross FDDEI. The term gross FDDEI means, with respect to a
domestic corporation or a partnership for a taxable year, the portion of
the gross DEI of the corporation or partnership for the year which is
derived from all of its FDDEI transactions.
(17) Modified affiliated group--(i) In general. The term modified
affiliated group means an affiliated group as defined in section 1504(a)
determined by substituting ``more than 50 percent'' for ``at least 80
percent'' each place it appears, and without regard to section
1504(b)(2) and (3).
(ii) Special rule for noncorporate entities. Any person (other than
a corporation) that is controlled by one or more members of a modified
affiliated group (including one or more persons treated as a member or
members of a modified affiliated group by reason of this paragraph
(c)(17)(ii)) or that controls any such member is treated as a member of
the modified affiliated group.
(iii) Definition of control. For purposes of paragraph (c)(17)(ii)
of this section, the term control has the meaning set forth in section
954(d)(3).
(18) Qualified business asset investment. The term qualified
business asset investment or QBAI has the meaning set forth in Sec.
1.250(b)-2(b).
(19) Related party. The term related party means, with respect to
any person, any member of a modified affiliated group that includes such
person.
(20) United States shareholder. The term United States shareholder
has the meaning set forth in section 951(b) and Sec. 1.951-1(g).
(d) Treatment of cost of goods sold and allocation and apportionment
of deductions--(1) Cost of goods sold for determining gross DEI and
gross FDDEI. For purposes of determining the gross income included in
gross DEI and gross FDDEI of a domestic corporation or a partnership,
the cost of goods sold of the corporation or partnership is attributed
to gross receipts with respect to gross DEI or gross FDDEI under any
reasonable method that is applied consistently. Cost of goods sold must
be attributed to gross receipts with respect to gross DEI or gross FDDEI
regardless of whether certain costs included in cost of goods sold can
be associated with activities undertaken in an earlier taxable year
(including a year before the effective date of section 250). A domestic
corporation or partnership may not segregate cost of goods sold with
respect to a particular product into component costs and attribute those
component costs disproportionately to gross receipts with respect to
amounts excluded from gross DEI or gross FDDEI, as applicable.
(2) Deductions properly allocable to gross DEI and gross FDDEI--(i)
In general. For purposes of determining a domestic corporation's
deductions that are properly allocable to gross DEI and gross FDDEI, the
corporation's deductions are allocated and apportioned to gross DEI and
gross FDDEI under the rules of Sec. Sec. 1.861-8 through 1.861-14T and
1.861-17 by treating section 250(b) as an operative section described in
Sec. 1.861-8(f). In allocating and apportioning deductions under
Sec. Sec. 1.861-8 through 1.861-14T and 1.861-17, gross FDDEI and gross
RDEI are treated as separate statutory groupings. The deductions
allocated and apportioned to gross DEI equal the sum of the deductions
allocated and apportioned to gross FDDEI and gross RDEI. All items of
gross income described in paragraphs (c)(15)(i) through (vi) of this
section are in the residual grouping.
(ii) Determination of deductions to allocate. For purposes of
determining the deductions of a domestic corporation for a taxable year
properly allocable to gross DEI and gross FDDEI, the deductions of the
corporation for the taxable year are determined without regard to
[[Page 585]]
sections 163(j), 170(b)(2), 172, 246(b), and 250.
(3) Examples. The following examples illustrate the application of
this paragraph (d).
(i) Assumed facts. The following facts are assumed for purposes of
the examples--
(A) DC is a domestic corporation that is not a member of a
consolidated group.
(B) All sales and services are provided to persons that are not
related parties.
(C) All sales and services to foreign persons qualify as FDDEI
transactions.
(ii) Examples--
(A) Example 1: Allocation of deductions--(1) Facts. For a taxable
year, DC manufactures products A and B in the United States. DC sells
products A and B and provides services associated with products A and B
to United States and foreign persons. DC's QBAI for the taxable year is
$1,000x. DC has $300x of deductible interest expense allowed under
section 163. DC has assets with a tax book value of $2,500x. The tax
book value of DC's assets used to produce products A and B and services
is split evenly between assets that produce gross FDDEI and assets that
produce gross RDEI. DC has $840x of supportive deductions, as defined in
Sec. 1.861-8(b)(3), attributable to general and administrative expenses
incurred for the purpose of generating the class of gross income that
consists of gross DEI. DC apportions the $840x of deductions on the
basis of gross income in accordance with Sec. 1.861-8T(c)(1). For
purposes of determining gross FDDEI and gross DEI under paragraph (d)(1)
of this section, DC attributes $200x of cost of goods sold to Product A
and $400x of cost of goods sold to Product B, and then attributes the
cost of goods sold for each product ratably between the gross receipts
of such product sold to foreign persons and the gross receipts of such
product sold to United States persons. The manner in which DC attributes
the cost of goods sold is a reasonable method. DC has no other items of
income, loss, or deduction. For the taxable year, DC has the following
income tax items relevant to the determination of its FDII:
Table 1 to Paragraph (d)(3)(ii)(A)(1)
----------------------------------------------------------------------------------------------------------------
Product A Product B Services Total
----------------------------------------------------------------------------------------------------------------
Gross receipts from U.S. persons................ $200x $800x $100x $1,100x
Gross receipts from foreign persons............. 200x 800x 100x 1,100x
Total gross receipts............................ 400x 1,600x 200x 2,200x
Cost of goods sold for gross receipts from U.S. 100x 200x 0 300x
persons........................................
Cost of goods sold for gross receipts from 100x 200x 0 300x
foreign persons................................
Total cost of goods sold........................ 200x 400x 0 600x
Gross income.................................... 200x 1,200x 200x 1,600x
Tax book value of assets used to produce 500x 500x 1,500x 2,500x
products/services..............................
----------------------------------------------------------------------------------------------------------------
(2) Analysis--(i) Determination of gross FDDEI and gross RDEI.
Because DC does not have any income described in section
250(b)(3)(A)(i)(I) through (VI) and paragraphs (c)(15)(i) through (vi)
of this section, none of its gross income is excluded from gross DEI.
DC's gross DEI is $1,600x ($2,200x total gross receipts less $600x total
cost of goods sold). DC's gross FDDEI is $800x ($1,100x of gross
receipts from foreign persons minus attributable cost of goods sold of
$300x).
(ii) Determination of foreign-derived deduction eligible income. To
calculate its FDDEI, DC must determine the amount of its deductions that
are allocated and apportioned to gross FDDEI and then subtract those
amounts from gross FDDEI. DC's interest deduction of $300x is allocated
and apportioned to gross FDDEI on the basis of the average total value
of DC's assets in each grouping. DC has assets with a tax book value of
$2,500x split evenly between assets that produce gross FDDEI and assets
that produce gross RDEI. Accordingly, an interest expense deduction of
$150x is apportioned to DC's gross FDDEI. With respect to DC's
supportive deductions of $840x that are related to DC's gross DEI, DC
apportions
[[Page 586]]
such deductions between gross FDDEI and gross RDEI on the basis of gross
income. Accordingly, supportive deductions of $420x are apportioned to
DC's gross FDDEI. Thus, DC's FDDEI is $230x, which is equal to its gross
FDDEI of $800x less $150x of interest expense deduction and $420x of
supportive deductions.
(iii) Determination of deemed intangible income. DC's deemed
tangible income return is $100x, which is equal to 10 percent of its
QBAI of $1,000x. DC's DEI is $460x, which is equal to its gross DEI of
$1,600x less $300x of interest expense deductions and $840x of
supportive deductions. Therefore, DC's deemed intangible income is
$360x, which is equal to the excess of its DEI of $460x over its deemed
tangible income return of $100x.
(iv) Determination of foreign-derived intangible income. DC's
foreign-derived ratio is 50 percent, which is the ratio of DC's FDDEI of
$230x to DC's DEI of $460x. Therefore, DC's FDII is $180x, which is
equal to DC's deemed intangible income of $360x multiplied by its
foreign-derived ratio of 50 percent.
(B) Example 2: Allocation of deductions with respect to a
partnership--(1) Facts--(i) DC's operations. DC is engaged in the
production and sale of products consisting of two separate product
groups in three-digit Standard Industrial Classification (SIC) Industry
Groups, hereafter referred to as Group AAA and Group BBB. All of the
gross income of DC is included in gross DEI. DC incurs $250x of research
and experimental (R&E) expenditures in the United States that are
deductible under section 174. None of the R&E is included in cost of
goods sold. For purposes of determining gross FDDEI and gross DEI under
paragraph (d)(1) of this section, DC attributes $210x of cost of goods
sold to Group AAA products and $900x of cost of goods sold to Group BBB
products, and then attributes the cost of goods sold with respect to
each such product group ratably between the gross receipts with respect
to such product group sold to foreign persons and the gross receipts
with respect to such product group not sold to foreign persons. The
manner in which DC attributes the cost of goods sold is a reasonable
method. For the taxable year, DC has the following income tax items
relevant to the determination of its FDII:
Table 2 to (d)(3)(ii)(B)(1)(i)
----------------------------------------------------------------------------------------------------------------
Group AAA Group BBB
products products Total
----------------------------------------------------------------------------------------------------------------
Gross receipts from U.S. persons................................ $200x $800x $1,000x
Gross receipts from foreign persons............................. 100x 400x 500x
Total gross receipts............................................ 300x 1,200x 1,500x
Cost of goods sold for gross receipts from U.S. persons......... 140x 600x 740x
Cost of goods sold for gross receipts from foreign persons...... 70x 300x 370x
Total cost of goods sold........................................ 210x 900x 1,110x
Gross income.................................................... 90x 300x 390x
R&E deductions.................................................. 40x 210x 250x
----------------------------------------------------------------------------------------------------------------
(ii) PRS's operations. In addition to its own operations, DC is a
partner in PRS, a partnership that also produces products described in
SIC Group AAA. DC is allocated 50 percent of all income, gain, loss, and
deductions of PRS. During the taxable year, PRS sells Group AAA products
solely to foreign persons, and all of its gross income is included in
gross DEI. PRS has $400 of gross receipts from sales of Group AAA
products for the taxable year and incurs $100x of research and
experimental (R&E) expenditures in the United States that are deductible
under section 174. None of the R&E is included in cost of goods sold.
For purposes of determining gross FDDEI and gross DEI under paragraph
(d)(1) of this section, PRS attributes $200x of cost of goods sold to
Group AAA products, and then attributes the cost of goods sold with
respect to such product group ratably between the gross receipts with
respect to such product group sold to foreign persons and the gross
receipts with respect to such product group not sold to foreign persons.
The manner in which PRS attributes the cost of goods
[[Page 587]]
sold is a reasonable method. DC's distributive share of PRS taxable
items is $100x of gross income and $50x of R&E deductions, and DC's
share of PRS's gross receipts from sales of Group AAA products for the
taxable year is $200x under Sec. 1.861-17(f)(3).
(iii) Application of the sales method to allocate and apportion R&E.
DC applies the sales method to apportion its R&E deductions under Sec.
1.861-17. Neither DC nor PRS licenses or sells its intangible property
to controlled or uncontrolled corporations in a manner that necessitates
including the sales by such corporations for purposes of apportioning
DC's R&E deductions.
(2) Analysis--(i) Determination of gross DEI and gross FDDEI. Under
paragraph (e)(1) of this section, DC's gross DEI, gross FDDEI, and
deductions allocable to those amounts include its distributive share of
gross DEI, gross FDDEI, and deductions of PRS. Thus, DC's gross DEI for
the year is $490x ($390x attributable to DC and $100x attributable to
DC's interest in PRS). DC's gross income from sales of Group AAA
products to foreign persons is $30x ($100x of gross receipts minus
attributable cost of goods sold of $70x). DC's gross income from sales
of Group BBB products to foreign persons is $100x ($400x of gross
receipts minus attributable cost of goods sold of $300x). DC's gross
FDDEI for the year is $230x ($30x from DC's sale of Group AAA products
plus $100x from DC's sale of Group BBB products plus DC's distributive
share of PRS's gross FDDEI of $100x).
(ii) Allocation and apportionment of R&E deductions. To determine
FDDEI, DC must allocate and apportion its R&E expense of $300x ($250x
incurred directly by DC and $50x incurred indirectly through DC's
interest in PRS). In accordance with Sec. 1.861-17, R&E expenses are
first allocated to a class of gross income related to a three-digit SIC
group code. DC's R&E expenses related to products in Group AAA are $90x
($40x incurred directly by DC and $50x incurred indirectly through DC's
interest in PRS) and its expenses related to Group BBB are $210x. See
paragraph (d)(2)(i) of this section. Accordingly, all R&E expense
attributable to a particular SIC group code is apportioned on the basis
of the amounts of sales within that SIC group code. Total sales within
Group AAA were $500x ($300x directly by DC and $200x attributable to
DC's interest in PRS), $300x of which were made to foreign persons
($100x directly by DC and $200x attributable to DC's interest in PRS).
Therefore, the $90x of R&E expense related to Group AAA is apportioned
$54x to gross FDDEI ($90x x $300x/$500x) and $36x to gross RDEI ($90x x
$200x/$500x). Total sales within Group BBB were $1,200x, $400x of which
were made to foreign persons. Therefore, the $210x of R&E expense
related to products in Group BBB is apportioned $70x to gross FDDEI
($210x x $400x/$1,200x) and $140x to gross RDEI ($210x x $800x/$1,200x).
Accordingly, DC's FDDEI for the tax year is $106x ($230x gross FDDEI
minus $124x of R&E ($54x + $70x) allocated and apportioned to gross
FDDEI).
(e) Domestic corporate partners--(1) In general. A domestic
corporation's DEI and FDDEI for a taxable year are determined by taking
into account the corporation's share of gross DEI, gross FDDEI, and
deductions of any partnership (whether domestic or foreign) in which the
corporation is a direct or indirect partner. For purposes of the
preceding sentence, a domestic corporation's share of each such item of
a partnership is determined in accordance with the corporation's
distributive share of the underlying items of income, gain, deduction,
and loss of the partnership that comprise such amounts. See Sec.
1.250(b)-2(g) for rules on calculating the increase to a domestic
corporation's QBAI by the corporation's share of partnership QBAI.
(2) Reporting requirement for partnership with domestic corporate
partners. A partnership that has one or more direct partners that are
domestic corporations and that is required to file a return under
section 6031 must furnish to each such partner on or with such partner's
Schedule K-1 (Form 1065 or any successor form) by the due date
(including extensions) for furnishing Schedule K-1 the partner's share
of the partnership's gross DEI, gross FDDEI, deductions that are
properly allocable to the partnership's gross DEI and gross FDDEI, and
partnership QBAI (as determined under Sec. 1.250(b)-2(g)) for
[[Page 588]]
each taxable year in which the partnership has gross DEI, gross FDDEI,
deductions that are properly allocable to the partnership's gross DEI or
gross FDDEI, or partnership specified tangible property (as defined in
Sec. 1.250(b)-2(g)(5)). In the case of tiered partnerships where one or
more partners of an upper-tier partnership are domestic corporations, a
lower-tier partnership must report the amount specified in this
paragraph (e)(2) to the upper-tier partnership to allow reporting of
such information to any partner that is a domestic corporation. To the
extent that a partnership cannot determine the information described in
the first sentence of this paragraph (e)(2), the partnership must
instead furnish to each partner its share of the partnership's
attributes that a partner needs to determine the partner's gross DEI,
gross FDDEI, deductions that are properly allocable to the partner's
gross DEI and gross FDDEI, and the partner's adjusted bases in
partnership specified tangible property.
(3) Examples. The following examples illustrate the application of
this paragraph (e).
(i) Assumed facts. The following facts are assumed for purposes of
the examples--
(A) DC, a domestic corporation, is a partner in PRS, a partnership.
(B) FP and FP2 are foreign persons.
(C) FC is a foreign corporation.
(D) The allocations under PRS's partnership agreement satisfy the
requirements of section 704.
(E) No partner of PRS is a related party of DC.
(F) DC, PRS, and FC all use the calendar year as their taxable year.
(G) PRS has no items of income, loss, or deduction for its taxable
year, except the items of income described.
(ii) Examples--
(A) Example 1: Sale by partnership to foreign person--(1) Facts.
Under the terms of the partnership agreement, DC is allocated 50 percent
of all income, gain, loss, and deductions of PRS. For the taxable year,
PRS recognizes $20x of gross income on the sale of general property (as
defined in Sec. 1.250(b)-3(b)(10)) to FP, a foreign person (as
determined under Sec. 1.250(b)-4(c)), for a foreign use (as determined
under Sec. 1.250(b)-4(d)). The gross income recognized on the sale of
property is not described in section 250(b)(3)(A)(I) through (VI) or
paragraphs (c)(15)(i) through (vi) of this section.
(2) Analysis. PRS's sale of property to FP is a FDDEI sale as
described in Sec. 1.250(b)-4(b). Therefore, the gross income derived
from the sale ($20x) is included in PRS's gross DEI and gross FDDEI, and
DC's share of PRS's gross DEI and gross FDDEI ($10x) is included in DC's
gross DEI and gross FDDEI for the taxable year.
(B) Example 2: Sale by partnership to foreign person attributable to
foreign branch--(1) Facts. The facts are the same as in paragraph
(e)(3)(ii)(A)(1) of this section (the facts in Example 1), except the
income from the sale of property to FP is attributable to a foreign
branch of PRS.
(2) Analysis. PRS's sale of property to FP is excluded from PRS's
gross DEI under section 250(b)(3)(A)(VI) and paragraph (c)(15)(vi) of
this section. Accordingly, DC's share of PRS's gross income of $10x from
the sale is not included in DC's gross DEI or gross FDDEI for the
taxable year.
(C) Example 3: Partnership with a loss in gross FDDEI--(1) Facts.
The facts are the same as in paragraph (e)(3)(ii)(A)(1) of this section
(the facts in Example 1), except that in the same taxable year, PRS also
sells property to FP2, a foreign person (as determined under Sec.
1.250(b)-4(c)), for a foreign use (as determined under Sec. 1.250(b)-
4(d)). After taking into account both sales, PRS has a gross loss of
$30x.
(2) Analysis. Both the sale of property to FP and the sale of
property to FP2 are FDDEI sales because each sale is described in Sec.
1.250(b)-4(b). DC's share of PRS's gross loss ($15x) from the sales is
included in DC's gross DEI and gross FDDEI.
(D) Example 4: Sale by partnership to foreign related party of the
partnership--(1) Facts. Under the terms of the partnership agreement, DC
has 25 percent of the capital and profits interest in the partnership
and is allocated 25 percent of all income, gain, loss, and deductions of
PRS. PRS owns 100 percent of the single class of stock of FC. In the
taxable year, PRS has $20x of gain
[[Page 589]]
on the sale of general property (as defined in Sec. 1.250(b)-3(b)(10))
to FC, and FC makes a physical and material change to the property
within the meaning of Sec. 1.250(b)-4(d)(1)(iii)(B) outside the United
States before selling the property to customers in the United States.
(2) Analysis. The sale of property by PRS to FC is described in
Sec. 1.250(b)-4(b) without regard to the application of Sec. 1.250(b)-
6, since the sale is to a foreign person (as determined under Sec.
1.250(b)-4(c)) for a foreign use (as determined under Sec. 1.250(b)-
4(d)). However, FC is a foreign related party of PRS within the meaning
of section 250(b)(5)(D) and Sec. 1.250(b)-3(b)(6), because FC and PRS
are members of a modified affiliated group within the meaning of
paragraph (c)(17) of this section. Therefore, the sale by PRS to FC is a
related party sale within the meaning of Sec. 1.250(b)-6(b)(1). Under
section 250(b)(5)(C)(i) and Sec. 1.250(b)-6(c), because FC did not sell
the property, or use the property in connection with other property sold
or the provision of a service, to a foreign unrelated party before the
property was subject to a domestic use, the sale by PRS to FC is not a
FDDEI sale. See Sec. 1.250(b)-6(c)(1). Accordingly, the gain from the
sale ($20x) is included in PRS's gross DEI but not its gross FDDEI, and
DC's share of PRS's gain ($5x) is included in DC's gross DEI but not
gross FDDEI. This is the result notwithstanding that FC is not a related
party of DC because FC and DC are not members of a modified affiliated
group within the meaning of paragraph (c)(17) of this section.
(f) Determination of FDII for consolidated groups. A member of a
consolidated group (as defined in Sec. 1.1502-1(h)) determines its FDII
under the rules provided in Sec. 1.1502-50.
(g) Determination of FDII for tax-exempt corporations. The FDII of a
corporation that is subject to the unrelated business income tax under
section 511 is determined only by reference to that corporation's items
of income, gain, deduction, or loss, and adjusted bases in property,
that are taken into account in computing the corporation's unrelated
business taxable income (as defined in section 512). For example, if a
corporation that is subject to the unrelated business income tax under
section 511 has tangible property used in the production of both
unrelated business income and gross income that is not unrelated
business income, only the portion of the basis of such property taken
into account in computing the corporation's unrelated business taxable
income is taken into account in determining the corporation's QBAI.
Similarly, if a corporation that is subject to the unrelated business
income tax under section 511 has tangible property that is used in both
the production of gross DEI and the production of gross income that is
not gross DEI, only the corporation's unrelated business income is taken
into account in determining the corporation's dual use ratio with
respect to such property under Sec. 1.250(b)-2(d)(3).
[T.D. 9901, 85 FR 43080, July 15, 2020, as amended by T.D. 9959, 87 FR
324, Jan. 4, 2022]
Sec. 1.250(b)-2 Qualified business asset investment (QBAI).
(a) Scope. This section provides general rules for determining the
qualified business asset investment of a domestic corporation for
purposes of determining its deemed tangible income return under Sec.
1.250(b)-1(c)(4). Paragraph (b) of this section defines qualified
business asset investment (QBAI). Paragraph (c) of this section defines
tangible property and specified tangible property. Paragraph (d) of this
section provides rules for determining the portion of property that is
specified tangible property when the property is used in the production
of both gross DEI and gross income that is not gross DEI. Paragraph (e)
of this section provides rules for determining the adjusted basis of
specified tangible property. Paragraph (f) of this section provides
rules for determining QBAI of a domestic corporation with a short
taxable year. Paragraph (g) of this section provides rules for
increasing the QBAI of a domestic corporation by reason of property
owned through a partnership. Paragraph (h) of this section provides an
anti-avoidance rule that disregards certain transfers when determining
the QBAI of a domestic corporation.
(b) Definition of qualified business asset investment. The term
qualified business
[[Page 590]]
asset investment (QBAI) means the average of a domestic corporation's
aggregate adjusted bases as of the close of each quarter of the domestic
corporation's taxable year in specified tangible property that is used
in a trade or business of the domestic corporation and is of a type with
respect to which a deduction is allowable under section 167. In the case
of partially depreciable property, only the depreciable portion of the
property is of a type with respect to which a deduction is allowable
under section 167.
(c) Specified tangible property--(1) In general. The term specified
tangible property means, with respect to a domestic corporation for a
taxable year, tangible property of the domestic corporation used in the
production of gross DEI for the taxable year. For purposes of the
preceding sentence, tangible property of a domestic corporation is used
in the production of gross DEI for a taxable year if some or all of the
depreciation or cost recovery allowance with respect to the tangible
property is either allocated and apportioned to the gross DEI of the
domestic corporation for the taxable year under Sec. 1.250(b)-1(d)(2)
or capitalized to inventory or other property held for sale, some or all
of the gross income or loss from the sale of which is taken into account
in determining DEI of the domestic corporation for the taxable year.
(2) Tangible property. The term tangible property means property for
which the depreciation deduction provided by section 167(a) is eligible
to be determined under section 168 without regard to section 168(f)(1),
(2), or (5), section 168(k)(2)(A)(i)(II), (IV), or (V), and the date
placed in service.
(d) Dual use property--(1) In general. The amount of the adjusted
basis in dual use property of a domestic corporation for a taxable year
that is treated as adjusted basis in specified tangible property for the
taxable year is the average of the domestic corporation's adjusted basis
in the property multiplied by the dual use ratio with respect to the
property for the taxable year.
(2) Definition of dual use property. The term dual use property
means, with respect to a domestic corporation and a taxable year,
specified tangible property of the domestic corporation that is used in
both the production of gross DEI and the production of gross income that
is not gross DEI for the taxable year. For purposes of the preceding
sentence, specified tangible property of a domestic corporation is used
in the production of gross DEI and the production of gross income that
is not gross DEI for a taxable year if less than all of the depreciation
or cost recovery allowance with respect to the property is either
allocated and apportioned to the gross DEI of the domestic corporation
for the taxable year under Sec. 1.250(b)-1(d)(2) or capitalized to
inventory or other property held for sale, the gross income or loss from
the sale of which is taken into account in determining the DEI of the
domestic corporation for the taxable year.
(3) Dual use ratio. The term dual use ratio means, with respect to
dual use property, a domestic corporation, and a taxable year, a ratio
(expressed as a percentage) calculated as--
(i) The sum of--
(A) The depreciation deduction or cost recovery allowance with
respect to the property that is allocated and apportioned to the gross
DEI of the domestic corporation for the taxable year under Sec.
1.250(b)-1(d)(2); and
(B) The depreciation or cost recovery allowance with respect to the
property that is capitalized to inventory or other property held for
sale, the gross income or loss from the sale of which is taken into
account in determining the DEI of the domestic corporation for the
taxable year; divided by
(ii) The sum of--
(A) The total amount of the domestic corporation's depreciation
deduction or cost recovery allowance with respect to the property for
the taxable year; and
(B) The total amount of the domestic corporation's depreciation or
cost recovery allowance with respect to the property capitalized to
inventory or other property held for sale, the gross income or loss from
the sale of which is taken into account in determining the income or
loss of the domestic corporation for the taxable year.
(4) Example. The following example illustrates the application of
this paragraph (d).
[[Page 591]]
(i) Facts. DC, a domestic corporation, owns a machine that produces
both gross DEI and income that is not gross DEI. The average adjusted
basis of the machine for the taxable year in the hands of DC is $4,000x.
The depreciation with respect to the machine for the taxable year is
$400x, $320x of which is capitalized to inventory of Product A, gross
income or loss from the sale of which is taken into account in
determining DC's gross DEI for the taxable year, and $80x of which is
capitalized to inventory of Product B, gross income or loss from the
sale of which is not taken into account in determining DC's gross DEI
for the taxable year. DC also owns an office building for its
administrative functions with an average adjusted basis for the taxable
year of $10,000x. DC does not capitalize depreciation with respect to
the office building to inventory or other property held for sale. DC's
depreciation deduction with respect to the office building is $1,000x
for the taxable year, $750x of which is allocated and apportioned to
gross DEI under Sec. 1.250(b)-1(d)(2), and $250x of which is allocated
and apportioned to income other than gross DEI under Sec. 1.250(b)-
1(d)(2).
(ii) Analysis--(A) Dual use property. The machine and office
building are property for which the depreciation deduction provided by
section 167(a) is eligible to be determined under section 168 (without
regard to section 168(f)(1), (2), or (5), section 168(k)(2)(A)(i)(II),
(IV), or (V), and the date placed in service). Therefore, under
paragraph (c)(2) of this section, the machine and office building are
tangible property. Furthermore, because the machine and office building
are used in the production of gross DEI for the taxable year within the
meaning of paragraph (c)(1) of this section, the machine and office
building are specified tangible property. Finally, because the machine
and office building are used in both the production of gross DEI and the
production of gross income that is not gross DEI for the taxable year
within the meaning of paragraph (d)(2) of this section, the machine and
office building are dual use property. Therefore, under paragraph (d)(1)
of this section, the amount of DC's adjusted basis in the machine and
office building that is treated as adjusted basis in specified tangible
property for the taxable year is determined by multiplying DC's adjusted
basis in the machine and office building by DC's dual use ratio with
respect to the machine and office building determined under paragraph
(d)(3) of this section.
(B) Depreciation not capitalized to inventory. Because none of the
depreciation with respect to the office building is capitalized to
inventory or other property held for sale, DC's dual use ratio with
respect to the office building is determined entirely by reference to
the depreciation deduction with respect to the office building.
Therefore, under paragraph (d)(3) of this section, DC's dual use ratio
with respect to the office building for Year 1 is 75 percent, which is
DC's depreciation deduction with respect to the office building that is
allocated and apportioned to gross DEI under Sec. 1.250(b)-1(d)(2) for
Year 1 ($750x), divided by the total amount of DC's depreciation
deduction with respect to the office building for Year 1 ($1000x).
Accordingly, under paragraph (d)(1) of this section, $7,500x ($10,000x x
0.75) of DC's average adjusted bases in the office building is taken
into account under paragraph (b) of this section in determining DC's
QBAI for the taxable year.
(C) Depreciation capitalized to inventory. Because all of the
depreciation with respect to the machine is capitalized to inventory,
DC's dual use ratio with respect to the machine is determined entirely
by reference to the depreciation with respect to the machine that is
capitalized to inventory and included in cost of goods sold. Therefore,
under paragraph (d)(3) of this section, DC's dual use ratio with respect
to the machine for the taxable year is 80 percent, which is DC's
depreciation with respect to the machine that is capitalized to
inventory of Product A, the gross income or loss from the sale of which
is taken into account in determining DC's DEI for the taxable year
($320x), divided by DC's depreciation with respect to the machine that
is capitalized to inventory, the gross income or loss from the sale of
which is taken into account in determining DC's income for Year 1
($400x). Accordingly, under paragraph (d)(1) of this
[[Page 592]]
section, $3,200x ($4,000x x 0.8) of DC's average adjusted basis in the
machine is taken into account under paragraph (b) of this section in
determining DC's QBAI for the taxable year.
(e) Determination of adjusted basis of specified tangible property--
(1) In general. The adjusted basis in specified tangible property for
purposes of this section is determined by using the cost capitalization
methods of accounting used by the domestic corporation for purposes of
determining the gross income and deductions of the domestic corporation
and the alternative depreciation system under section 168(g), and by
allocating the depreciation deduction with respect to such property for
the domestic corporation's taxable year ratably to each day during the
period in the taxable year to which such depreciation relates. For
purposes of the preceding sentence, the period in the taxable year to
which such depreciation relates is determined without regard to the
applicable convention under section 168(d).
(2) Effect of change in law. The adjusted basis in specified
tangible property is determined without regard to any provision of law
enacted after December 22, 2017, unless such later enacted law
specifically and directly amends the definition of QBAI under section
250 or section 951A. For purposes of applying section 250(b)(2)(B) and
this paragraph (e), the technical amendment to section 168(g) (to
provide a recovery period of 20 years for qualified improvement property
for purposes of the alternative depreciation system) enacted in section
2307(a) of the Coronavirus Aid, Relief, and Economic Security Act,
Public Law 116-136 (2020) is treated as enacted on December 22, 2017.
(3) Specified tangible property placed in service before enactment
of section 250. The adjusted basis in specified tangible property placed
in service before December 22, 2017, is determined using the alternative
depreciation system under section 168(g), as if this system had applied
from the date that the property was placed in service.
(f) Special rules for short taxable years--(1) In general. In the
case of a domestic corporation that has a taxable year that is less than
twelve months (a short taxable year), the rules for determining the QBAI
of the domestic corporation under this section are modified as provided
in paragraphs (f)(2) and (3) of this section with respect to the taxable
year.
(2) Determination of when the quarter closes. For purposes of
determining when the quarter closes, in determining the QBAI of a
domestic corporation for a short taxable year, the quarters of the
domestic corporation for purposes of this section are the full quarters
beginning and ending within the short taxable year (if any), determining
quarter length as if the domestic corporation did not have a short
taxable year, plus one or more short quarters (if any).
(3) Reduction of qualified business asset investment. The QBAI of a
domestic corporation for a short taxable year is the sum of--
(i) The sum of the domestic corporation's aggregate adjusted bases
in specified tangible property as of the close of each full quarter (if
any) in the domestic corporation's taxable year divided by four; plus
(ii) The domestic corporation's aggregate adjusted bases in
specified tangible property as of the close of each short quarter (if
any) in the domestic corporation's taxable year multiplied by the sum of
the number of days in each short quarter divided by 365.
(4) Example. The following example illustrates the application of
this paragraph (f).
(i) Facts. A, an individual, owns all of the stock of DC, a domestic
corporation. A owns DC from the beginning of the taxable year. On July
15 of the taxable year, A sells DC to USP, a domestic corporation that
is unrelated to A. DC becomes a member of the consolidated group of
which USP is the common parent and as a result, under Sec. 1.1502-
76(b)(2)(ii), DC's taxable year is treated as ending on July 15. USP and
DC both use the calendar year as their taxable year. DC's aggregate
adjusted bases in specified tangible property for the taxable year are
$250x as of March 31, $300x as of June 30, $275x as of July 15, $500x as
of September 30, and $450x as of December 31.
(ii) Analysis--(A) Determination of short taxable years and
quarters. DC has
[[Page 593]]
two short taxable years during the year. The first short taxable year is
from January 1 to July 15, with two full quarters (January 1 through
March 31 and April 1 through June 30) and one short quarter (July 1
through July 15). The second taxable year is from July 16 to December
31, with one short quarter (July 16 through September 30) and one full
quarter (October 1 through December 31).
(B) Calculation of qualified business asset investment for the first
short taxable year. Under paragraph (f)(2) of this section, for the
first short taxable year, DC has three quarter closes (March 31, June
30, and July 15). Under paragraph (f)(3) of this section, the QBAI of DC
for the first short taxable year is $148.80x, the sum of $137.50x
(($250x + $300x)/4) attributable to the two full quarters and $11.30x
($275x x 15/365) attributable to the short quarter.
(C) Calculation of qualified business asset investment for the
second short taxable year. Under paragraph (f)(2) of this section, for
the second short taxable year, DC has two quarter closes (September 30
and December 31). Under paragraph (f)(3) of this section, the QBAI of DC
for the second short taxable year is $217.98x, the sum of $112.50x
($450x/4) attributable to the one full quarter and $105.48x ($500x x 77/
365) attributable to the short quarter.
(g) Partnership property--(1) In general. If a domestic corporation
holds an interest in one or more partnerships during a taxable year
(including indirectly through one or more partnerships that are partners
in a lower-tier partnership), the QBAI of the domestic corporation for
the taxable year (determined without regard to this paragraph (g)(1)) is
increased by the sum of the domestic corporation's partnership QBAI with
respect to each partnership for the taxable year.
(2) Determination of partnership QBAI. For purposes of paragraph
(g)(1) of this section, the term partnership QBAI means, with respect to
a partnership, a domestic corporation, and a taxable year, the sum of
the domestic corporation's partner adjusted basis in each partnership
specified tangible property of the partnership for each partnership
taxable year that ends with or within the taxable year. If a partnership
taxable year is less than twelve months, the principles of paragraph (f)
of this section apply in determining a domestic corporation's
partnership QBAI with respect to the partnership.
(3) Determination of partner adjusted basis--(i) In general. For
purposes of paragraph (g)(2) of this section, the term partner adjusted
basis means the amount described in paragraph (g)(3)(ii) of this section
with respect to sole use partnership property or paragraph (g)(3)(iii)
of this section with respect to dual use partnership property. The
principles of section 706(d) apply to this determination.
(ii) Sole use partnership property--(A) In general. The amount
described in this paragraph (g)(3)(ii), with respect to sole use
partnership property, a partnership taxable year, and a domestic
corporation, is the sum of the domestic corporation's proportionate
share of the partnership adjusted basis in the sole use partnership
property for the partnership taxable year and the domestic corporation's
partner-specific QBAI basis in the sole use partnership property for the
partnership taxable year.
(B) Definition of sole use partnership property. The term sole use
partnership property means, with respect to a partnership, a partnership
taxable year, and a domestic corporation, partnership specified tangible
property of the partnership that is used in the production of only gross
DEI of the domestic corporation for the taxable year in which or with
which the partnership taxable year ends. For purposes of the preceding
sentence, partnership specified tangible property of a partnership is
used in the production of only gross DEI for a taxable year if all the
domestic corporation's distributive share of the partnership's
depreciation deduction or cost recovery allowance with respect to the
property (if any) for the partnership taxable year that ends with or
within the taxable year is allocated and apportioned to the domestic
corporation's gross DEI for the taxable year under Sec. 1.250(b)-
1(d)(2) and, if any of the partnership's depreciation or cost recovery
allowance with respect to the property is capitalized to inventory or
other property held for sale, all the domestic corporation's
distributive
[[Page 594]]
share of the partnership's gross income or loss from the sale of such
inventory or other property for the partnership taxable year that ends
with or within the taxable year is taken into account in determining the
DEI of the domestic corporation for the taxable year.
(iii) Dual use partnership property--(A) In general. The amount
described in this paragraph (g)(3)(iii), with respect to dual use
partnership property, a partnership taxable year, and a domestic
corporation, is the sum of the domestic corporation's proportionate
share of the partnership adjusted basis in the property for the
partnership taxable year and the domestic corporation's partner-specific
QBAI basis in the property for the partnership taxable year, multiplied
by the domestic corporation's dual use ratio with respect to the
property for the partnership taxable year determined under the
principles of paragraph (d)(3) of this section, except that the ratio
described in paragraph (d)(3) of this section is determined by reference
to the domestic corporation's distributive share of the amounts
described in paragraph (d)(3) of this section.
(B) Definition of dual use partnership property. The term dual use
partnership property means partnership specified tangible property other
than sole use partnership property.
(4) Determination of proportionate share of the partnership's
adjusted basis in partnership specified tangible property--(i) In
general. For purposes of paragraph (g)(3) of this section, the domestic
corporation's proportionate share of the partnership adjusted basis in
partnership specified tangible property for a partnership taxable year
is the partnership adjusted basis in the property multiplied by the
domestic corporation's proportionate share ratio with respect to the
property for the partnership taxable year. Solely for purposes of
determining the proportionate share ratio under paragraph (g)(4)(ii) of
this section, the partnership's calculation of, and a partner's
distributive share of, any income, loss, depreciation, or cost recovery
allowance is determined under section 704(b).
(ii) Proportionate share ratio. The term proportionate share ratio
means, with respect to a partnership, a partnership taxable year, and a
domestic corporation, the ratio (expressed as a percentage) calculated
as--
(A) The sum of--
(1) The domestic corporation's distributive share of the
partnership's depreciation deduction or cost recovery allowance with
respect to the property for the partnership taxable year; and
(2) The amount of the partnership's depreciation or cost recovery
allowance with respect to the property that is capitalized to inventory
or other property held for sale, the gross income or loss from the sale
of which is taken into account in determining the domestic corporation's
distributive share of the partnership's income or loss for the
partnership taxable year; divided by
(B) The sum of--
(1) The total amount of the partnership's depreciation deduction or
cost recovery allowance with respect to the property for the partnership
taxable year; and
(2) The total amount of the partnership's depreciation or cost
recovery allowance with respect to the property capitalized to inventory
or other property held for sale, the gross income or loss from the sale
of which is taken into account in determining the partnership's income
or loss for the partnership taxable year.
(5) Definition of partnership specified tangible property. The term
partnership specified tangible property means, with respect to a
domestic corporation, tangible property (as defined in paragraph (c)(2)
of this section) of a partnership that is--
(i) Used in the trade or business of the partnership;
(ii) Of a type with respect to which a deduction is allowable under
section 167; and
(iii) Used in the production of gross income included in the
domestic corporation's gross DEI.
(6) Determination of partnership adjusted basis. For purposes of
this paragraph (g), the term partnership adjusted basis means, with
respect to a partnership, partnership specified tangible property, and a
partnership taxable year, the amount equal to the average of the
partnership's adjusted basis in the partnership specified tangible
property as of the close of each quarter in
[[Page 595]]
the partnership taxable year determined without regard to any
adjustments under section 734(b) except for adjustments under section
734(b)(1)(B) or section 734(b)(2)(B) that are attributable to
distributions of tangible property (as defined in paragraph (c)(2) of
this section) and for adjustments under section 734(b)(1)(A) or
734(b)(2)(A). The principles of paragraphs (e) and (h) of this section
apply for purposes of determining a partnership's adjusted basis in
partnership specified tangible property and the proportionate share of
the partnership's adjusted basis in partnership specified tangible
property.
(7) Determination of partner-specific QBAI basis. For purposes of
this paragraph (g), the term partner-specific QBAI basis means, with
respect to a domestic corporation, a partnership, and partnership
specified tangible property, the amount that is equal to the average of
the basis adjustment under section 743(b) that is allocated to the
partnership specified tangible property of the partnership with respect
to the domestic corporation as of the close of each quarter in the
partnership taxable year. For this purpose, a negative basis adjustment
under section 743(b) is expressed as a negative number. The principles
of paragraphs (e) and (h) of this section apply for purposes of
determining the partner-specific QBAI basis with respect to partnership
specified tangible property.
(8) Examples. The following examples illustrate the rules of this
paragraph (g).
(i) Assumed facts. Except as otherwise stated, the following facts
are assumed for purposes of the examples:
(A) DC, DC1, DC2, and DC3 are domestic corporations.
(B) PRS is a partnership and its allocations satisfy the
requirements of section 704.
(C) All properties are partnership specified tangible property.
(D) All persons use the calendar year as their taxable year.
(E) There is no partner-specific QBAI basis with respect to any
property.
(ii) Example 1: Sole use partnership property--(A) Facts. DC is a
partner in PRS. PRS owns two properties, Asset A and Asset B. The
average of PRS's adjusted basis as of the close of each quarter of PRS's
taxable year in Asset A is $100x and in Asset B is $500x. In Year 1,
PRS's section 704(b) depreciation deduction is $10x with respect to
Asset A and $5x with respect to Asset B, and DC's section 704(b)
distributive share of the depreciation deduction is $8x with respect to
Asset A and $1x with respect to Asset B. None of the depreciation with
respect to Asset A or Asset B is capitalized to inventory or other
property held for sale. DC's entire distributive share of the
depreciation deduction with respect to Asset A and Asset B is allocated
and apportioned to DC's gross DEI for Year 1 under Sec. 1.250(b)-
1(d)(2).
(B) Analysis--(1) Sole use partnership property. Because all of DC's
distributive share of the depreciation deduction with respect to Asset A
and B is allocated and apportioned to gross DEI for Year 1, Asset A and
Asset B are sole use partnership property within the meaning of
paragraph (g)(3)(ii)(B) of this section. Therefore, under paragraph
(g)(3)(ii)(A) of this section, DC's partner adjusted basis in Asset A
and Asset B is equal to the sum of DC's proportionate share of PRS's
partnership adjusted basis in Asset A and Asset B for Year 1 and DC's
partner-specific QBAI basis in Asset A and Asset B for Year 1,
respectively.
(2) Proportionate share. Under paragraph (g)(4)(i) of this section,
DC's proportionate share of PRS's partnership adjusted basis in Asset A
and Asset B is PRS's partnership adjusted basis in Asset A and Asset B
for Year 1, multiplied by DC's proportionate share ratio with respect to
Asset A and Asset B for Year 1, respectively. Because none of the
depreciation with respect to Asset A or Asset B is capitalized to
inventory or other property held for sale, DC's proportionate share
ratio with respect to Asset A and Asset B is determined entirely by
reference to the depreciation deduction with respect to Asset A and
Asset B. Therefore, DC's proportionate share ratio with respect to Asset
A for Year 1 is 80 percent, which is the ratio of DC's section 704(b)
distributive share of PRS's section 704(b) depreciation deduction with
respect to Asset A for Year 1 ($8x), divided by the total amount of
PRS's section 704(b)
[[Page 596]]
depreciation deduction with respect to Asset A for Year 1 ($10x). DC's
proportionate share ratio with respect to Asset B for Year 1 is 20
percent, which is the ratio of DC's section 704(b) distributive share of
PRS's section 704(b) depreciation deduction with respect to Asset B for
Year 1 ($1x), divided by the total amount of PRS's section 704(b)
depreciation deduction with respect to Asset B for Year 1 ($5x).
Accordingly, under paragraph (g)(4)(i) of this section, DC's
proportionate share of PRS's partnership adjusted basis in Asset A is
$80x ($100x x 0.8), and DC's proportionate share of PRS's partnership
adjusted basis in Asset B is $100x ($500x x 0.2).
(3) Partner adjusted basis. Because DC has no partner-specific QBAI
basis with respect to Asset A and Asset B, DC's partner adjusted basis
in Asset A and Asset B is determined entirely by reference to its
proportionate share of PRS's partnership adjusted basis in Asset A and
Asset B. Therefore, under paragraph (g)(3)(ii)(A) of this section, DC's
partner adjusted basis in Asset A is $80x, DC's proportionate share of
PRS's partnership adjusted basis in Asset A, and DC's partner adjusted
basis in Asset B is $100x, DC's proportionate share of PRS's partnership
adjusted basis in Asset B.
(4) Partnership QBAI. Under paragraph (g)(2) of this section, DC's
partnership QBAI with respect to PRS is $180x, the sum of DC's partner
adjusted basis in Asset A ($80x) and DC's partner adjusted basis in
Asset B ($100x). Accordingly, under paragraph (g)(1) of this section, DC
increases its QBAI for Year 1 by $180x.
(iii) Example 2: Dual use partnership property--(A) Facts. DC owns a
50 percent interest in PRS. All section 704(b) and tax items are
identical and are allocated equally between DC and its other partner.
PRS owns three properties, Asset C, Asset D, and Asset E. PRS sells two
products, Product A and Product B. All of DC's distributive share of the
gross income or loss from the sale of Product A is taken into account in
determining DC's DEI, and none of DC's distributive share of the gross
income or loss from the sale of Product B is taken into account in
determining DC's DEI.
(1) Asset C. The average of PRS's adjusted basis as of the close of
each quarter of PRS's taxable year in Asset C is $100x. In Year 1, PRS's
depreciation is $10x with respect to Asset C, none of which is
capitalized to inventory or other property held for sale. DC's
distributive share of the depreciation deduction with respect to Asset C
is $5x ($10x x 0.5), $3x of which is allocated and apportioned to DC's
gross DEI under Sec. 1.250(b)-1(d)(2).
(2) Asset D. The average of PRS's adjusted basis as of the close of
each quarter of PRS's taxable year in Asset D is $500x. In Year 1, PRS's
depreciation is $50x with respect to Asset D, $10x of which is
capitalized to inventory of Product A and $40x is capitalized to
inventory of Product B. None of the $10x depreciation with respect to
Asset D capitalized to inventory of Product A is capitalized to ending
inventory. However, of the $40x capitalized to inventory of Product B,
$10x is capitalized to ending inventory. Therefore, the amount of
depreciation with respect to Asset D capitalized to inventory of Product
A that is taken into account in determining DC's distributive share of
the income or loss of PRS for Year 1 is $5x ($10x x 0.5), and the amount
of depreciation with respect to Asset D capitalized to inventory of
Product B that is taken into account in determining DC's distributive
share of the income or loss of PRS for Year 1 is $15x ($30x x 0.5).
(3) Asset E. The average of PRS's adjusted basis as of the close of
each quarter of PRS's taxable year in Asset E is $600x. In Year 1, PRS's
depreciation is $60x with respect to Asset E. Of the $60x depreciation
with respect to Asset E, $20x is allowed as a deduction, $24x is
capitalized to inventory of Product A, and $16x is capitalized to
inventory of Product B. DC's distributive share of the depreciation
deduction with respect to Asset E is $10x ($20x x 0.5), $8x of which is
allocated and apportioned to DC's gross DEI under Sec. 1.250(b)-
1(d)(2). None of the $24x depreciation with respect to Asset E
capitalized to inventory of Product A is capitalized to ending
inventory. However, of the $16x depreciation with respect to Asset E
capitalized to inventory of Product B, $10x is capitalized to ending
[[Page 597]]
inventory. Therefore, the amount of depreciation with respect to Asset E
capitalized to inventory of Product A that is taken into account in
determining DC's distributive share of the income or loss of PRS for
Year 1 is $12x ($24x x 0.5), and the amount of depreciation with respect
to Asset E capitalized to inventory of Product B that is taken into
account in determining DC's distributive share of the income or loss of
PRS for Year 1 is $3x ($6x x 0.5).
(B) Analysis. Because Asset C, Asset D, and Asset E are not used in
the production of only gross DEI in Year 1 within the meaning of
paragraph (g)(3)(ii)(B) of this section, Asset C, Asset D, and Asset E
are dual use partnership property within the meaning of paragraph
(g)(3)(iii)(B) of this section. Therefore, under paragraph
(g)(3)(iii)(A) of this section, DC's partner adjusted basis in Asset C,
Asset D, and Asset E is the sum of DC's proportionate share of PRS's
partnership adjusted basis in Asset C, Asset D, and Asset E,
respectively, for Year 1, and DC's partner-specific QBAI basis in Asset
C, Asset D, and Asset E, respectively, for Year 1, multiplied by DC's
dual use ratio with respect to Asset C, Asset D, and Asset E,
respectively, for Year 1, determined under the principles of paragraph
(d)(3) of this section, except that the ratio described in paragraph
(d)(3) of this section is determined by reference to DC's distributive
share of the amounts described in paragraph (d)(3) of this section.
(1) Asset C--(i) Proportionate share. Under paragraph (g)(4)(i) of
this section, DC's proportionate share of PRS's partnership adjusted
basis in Asset C is PRS's partnership adjusted basis in Asset C for Year
1, multiplied by DC's proportionate share ratio with respect to Asset C
for Year 1. Because none of the depreciation with respect to Asset C is
capitalized to inventory or other property held for sale, DC's
proportionate share ratio with respect to Asset C is determined entirely
by reference to the depreciation deduction with respect to Asset C.
Therefore, DC's proportionate share ratio with respect to Asset C is 50
percent, which is the ratio calculated as the amount of DC's section
704(b) distributive share of PRS's section 704(b) depreciation deduction
with respect to Asset C for Year 1 ($5x), divided by the total amount of
PRS's section 704(b) depreciation deduction with respect to Asset C for
Year 1 ($10x). Accordingly, under paragraph (g)(4)(i) of this section,
DC's proportionate share of PRS's partnership adjusted basis in Asset C
is $50x ($100x x 0.5).
(ii) Dual use ratio. Because none of the depreciation with respect
to Asset C is capitalized to inventory or other property held for sale,
DC's dual use ratio with respect to Asset C is determined entirely by
reference to the depreciation deduction with respect to Asset C.
Therefore, DC's dual use ratio with respect to Asset C is 60 percent,
which is the ratio calculated as the amount of DC's distributive share
of PRS's depreciation deduction with respect to Asset C that is
allocated and apportioned to DC's gross DEI under Sec. 1.250(b)-1(d)(2)
for Year 1 ($3x), divided by the total amount of DC's distributive share
of PRS's depreciation deduction with respect to Asset C for Year 1
($5x).
(iii) Partner adjusted basis. Because DC has no partner-specific
QBAI basis with respect to Asset C, DC's partner adjusted basis in Asset
C is determined entirely by reference to DC's proportionate share of
PRS's partnership adjusted basis in Asset C, multiplied by DC's dual use
ratio with respect to Asset C. Under paragraph (g)(3)(iii)(A) of this
section, DC's partner adjusted basis in Asset C is $30x, DC's
proportionate share of PRS's partnership adjusted basis in Asset C for
Year 1 ($50x), multiplied by DC's dual use ratio with respect to Asset C
for Year 1 (60 percent).
(2) Asset D--(i) Proportionate share. Under paragraph (g)(4)(i) of
this section, DC's proportionate share of PRS's partnership adjusted
basis in Asset D is PRS's partnership adjusted basis in Asset D for Year
1, multiplied by DC's proportionate share ratio with respect to Asset D
for Year 1. Because all of the depreciation with respect to Asset D is
capitalized to inventory, DC's proportionate share ratio with respect to
Asset D is determined entirely by reference to the depreciation with
respect to Asset D that is capitalized to inventory and included in cost
of goods sold.
[[Page 598]]
Therefore, DC's proportionate share ratio with respect to Asset D is 50
percent, which is the ratio calculated as the amount of PRS's section
704(b) depreciation with respect to Asset D capitalized to Product A and
Product B that is taken into account in determining DC's section 704(b)
distributive share of PRS's income or loss for Year 1 ($20x), divided by
the total amount of PRS's section 704(b) depreciation with respect to
Asset D capitalized to Product A and Product B that is taken into
account in determining PRS's section 704(b) income or loss for Year 1
($40x). Accordingly, under paragraph (g)(4)(i) of this section, DC's
proportionate share of PRS's partnership adjusted basis in Asset D is
$250x ($500x x 0.5).
(ii) Dual use ratio. Because all of the depreciation with respect to
Asset D is capitalized to inventory, DC's dual use ratio with respect to
Asset D is determined entirely by reference to the depreciation with
respect to Asset D that is capitalized to inventory and included in cost
of goods sold. Therefore, DC's dual use ratio with respect to Asset D is
25 percent, which is the ratio calculated as the amount of depreciation
with respect to Asset D capitalized to inventory of Product A and
Product B that is taken into account in determining DC's DEI for Year 1
($5x), divided by the total amount of depreciation with respect to Asset
D capitalized to inventory of Product A and Product B that is taken into
account in determining DC's income or loss for Year 1 ($20x).
(iii) Partner adjusted basis. Because DC has no partner-specific
QBAI basis with respect to Asset D, DC's partner adjusted basis in Asset
D is determined entirely by reference to DC's proportionate share of
PRS's partnership adjusted basis in Asset D, multiplied by DC's dual use
ratio with respect to Asset D. Under paragraph (g)(3)(iii)(A) of this
section, DC's partner adjusted basis in Asset D is $62.50x, DC's
proportionate share of PRS's partnership adjusted basis in Asset D for
Year 1 ($250x), multiplied by DC's dual use ratio with respect to Asset
D for Year 1 (25 percent).
(3) Asset E--(i) Proportionate share. Under paragraph (g)(4)(i) of
this section, DC's proportionate share of PRS's partnership adjusted
basis in Asset E is PRS's partnership adjusted basis in Asset E for Year
1, multiplied by DC's proportionate share ratio with respect to Asset E
for Year 1. Because the depreciation with respect to Asset E is partly
deducted and partly capitalized to inventory, DC's proportionate share
ratio with respect to Asset E is determined by reference to both the
depreciation that is deducted and the depreciation that is capitalized
to inventory and included in cost of goods sold. Therefore, DC's
proportionate share ratio with respect to Asset E is 50 percent, which
is the ratio calculated as the sum ($25x) of the amount of DC's section
704(b) distributive share of PRS's section 704(b) depreciation deduction
with respect to Asset E for Year 1 ($10x) and the amount of PRS's
section 704(b) depreciation with respect to Asset E capitalized to
inventory of Product A and Product B that is taken into account in
determining DC's section 704(b) distributive share of PRS's income or
loss for Year 1 ($15x), divided by the sum ($50x) of the total amount of
PRS's section 704(b) depreciation deduction with respect to Asset E for
Year 1 ($20x) and the total amount of PRS's section 704(b) depreciation
with respect to Asset E capitalized to inventory of Product A and
Product B that is taken into account in determining PRS's section 704(b)
income or loss for Year 1 ($30x). Accordingly, under paragraph (g)(4)(i)
of this section, DC's proportionate share of PRS's partnership adjusted
basis in Asset E is $300x ($600x x 0.5).
(ii) Dual use ratio. Because the depreciation with respect to Asset
E is partly deducted and partly capitalized to inventory, DC's dual use
ratio with respect to Asset E is determined by reference to the
depreciation that is deducted and the depreciation that is capitalized
to inventory and included in cost of goods sold. Therefore, DC's dual
use ratio with respect to Asset E is 80 percent, which is the ratio
calculated as the sum ($20x) of the amount of DC's distributive share of
PRS's depreciation deduction with respect to Asset E that is allocated
and apportioned to DC's gross DEI under Sec. 1.250(b)-1(d)(2) for Year
1 ($8x) and the amount of depreciation with respect to
[[Page 599]]
Asset E capitalized to inventory of Product A and Product B that is
taken into account in determining DC's DEI for Year 1 ($12x), divided by
the sum ($25x) of the total amount of DC's distributive share of PRS's
depreciation deduction with respect to Asset E for Year 1 ($10x) and the
total amount of depreciation with respect to Asset E capitalized to
inventory of Product A and Product B that is taken into account in
determining DC's income or loss for Year 1 ($15x).
(iii) Partner adjusted basis. Because DC has no partner-specific
QBAI basis with respect to Asset E, DC's partner adjusted basis in Asset
E is determined entirely by reference to DC's proportionate share of
PRS's partnership adjusted basis in Asset E, multiplied by DC's dual use
ratio with respect to Asset E. Under paragraph (g)(3)(iii)(A) of this
section, DC's partner adjusted basis in Asset E is $240x, DC's
proportionate share of PRS's partnership adjusted basis in Asset E for
Year 1 ($300x), multiplied by DC's dual use ratio with respect to Asset
E for Year 1 (80 percent).
(4) Partnership QBAI. Under paragraph (g)(2) of this section, DC's
partnership QBAI with respect to PRS is $332.50x, the sum of DC's
partner adjusted basis in Asset C ($30x), DC's partner adjusted basis in
Asset D ($62.50x), and DC's partner adjusted basis in Asset E ($240x).
Accordingly, under paragraph (g)(1) of this section, DC increases its
QBAI for Year 1 by $332.50x.
(iv) Example 3: Sole use partnership specified tangible property;
section 743(b) adjustments--(A) Facts. The facts are the same as in
paragraph (g)(8)(ii)(A) of this section (the facts in Example 1), except
that there is an average of $40x positive adjustment to the adjusted
basis in Asset A as of the close of each quarter of PRS's taxable year
with respect to DC under section 743(b) and an average of $20x negative
adjustment to the adjusted basis in Asset B as of the close of each
quarter of PRS's taxable year with respect to DC under section 743(b).
(B) Analysis. Under paragraph (g)(3)(ii)(A) of this section, DC's
partner adjusted basis in Asset A is $120x, which is the sum of $80x
(DC's proportionate share of PRS's partnership adjusted basis in Asset A
as illustrated in paragraph (g)(8)(ii)(B)(2) of this section (the
analysis in Example 1)) and $40x (DC's partner-specific QBAI basis in
Asset A). Under paragraph (g)(3)(ii)(A) of this section, DC's partner
adjusted basis in Asset B is $80x, the sum of $100x (DC's proportionate
share of the partnership adjusted basis in the property as illustrated
in paragraph (g)(8)(ii)(B)(2) of this section (the analysis in Example
1)) and (-$20x) (DC's partner-specific QBAI basis in Asset B).
Therefore, under paragraph (g)(2) of this section, DC's partnership QBAI
with respect to PRS is $200x ($120x + $80x). Accordingly, under
paragraph (g)(1) of this section, DC increases its QBAI for Year 1 by
$200x.
(v) Example 4: Sale of partnership interest before close of taxable
year--(A) Facts. DC1 owns a 50 percent interest in PRS on January 1 of
Year 1. PRS does not have an election under section 754 in effect. On
July 1 of Year 1, DC1 sells its entire interest in PRS to DC2. PRS owns
Asset G. The average of PRS's adjusted basis as of the close of each
quarter of PRS's taxable year in Asset G is $100x. DC1's section 704(b)
distributive share of the depreciation deduction with respect to Asset G
is 25 percent with respect to PRS's entire year. DC2's section 704(b)
distributive share of the depreciation deduction with respect to Asset G
is also 25 percent with respect to PRS's entire year. Both DC1's and
DC2's entire distributive shares of the depreciation deduction with
respect to Asset G are allocated and apportioned under Sec. 1.250(b)-
1(d)(2) to DC1's and DC2's gross DEI, respectively, for Year 1. PRS's
allocations satisfy section 706(d).
(B) Analysis--(1) DC1. Because DC1 owns an interest in PRS during
DC1's taxable year and receives a distributive share of partnership
items of the partnership under section 706(d), DC1 has partnership QBAI
with respect to PRS in the amount determined under paragraph (g)(2) of
this section. Under paragraph (g)(3)(i) of this section, DC1's partner
adjusted basis in Asset G is $25x, the product of $100x (the
partnership's adjusted basis in the property)
[[Page 600]]
and 25 percent (DC1's section 704(b) distributive share of depreciation
deduction with respect to Asset G). Therefore, DC1's partnership QBAI
with respect to PRS is $25x. Accordingly, under paragraph (g)(1) of this
section, DC1 increases its QBAI by $25x for Year 1.
(2) DC2. DC2's partner adjusted basis in Asset G is also $25x, the
product of $100x (the partnership's adjusted basis in the property) and
25 percent (DC2's section 704(b) distributive share of depreciation
deduction with respect to Asset G). Therefore, DC2's partnership QBAI
with respect to PRS is $25x. Accordingly, under paragraph (g)(1) of this
section, DC2 increases its QBAI by $25x for Year 1.
(vi) Example 5: Partnership adjusted basis; distribution of property
in liquidation of partnership interest--(A) Facts. DC1, DC2, and DC3 are
equal partners in PRS, a partnership. DC1 and DC2 each has an adjusted
basis of $100x in its partnership interest. DC3 has an adjusted basis of
$50x in its partnership interest. PRS has a section 754 election in
effect. PRS owns Asset H with a fair market value of $50x and an
adjusted basis of $0, Asset I with a fair market value of $100x and an
adjusted basis of $100x, and Asset J with a fair market value of $150x
and an adjusted basis of $150x. Asset H and Asset J are tangible
property, but Asset I is not tangible property. PRS distributes Asset I
to DC3 in liquidation of DC3's interest in PRS. None of DC1, DC2, DC3,
or PRS recognizes gain on the distribution. Under section 732(b), DC3's
adjusted basis in Asset I is $50x. PRS's adjusted basis in Asset H is
increased by $50x to $50x under section 734(b)(1)(B), which is the
amount by which PRS's adjusted basis in Asset I immediately before the
distribution exceeds DC3's adjusted basis in Asset I.
(B) Analysis. Under paragraph (g)(6) of this section, PRS's adjusted
basis in Asset H is determined without regard to any adjustments under
section 734(b) except for adjustments under section 734(b)(1)(B) or
section 734(b)(2)(B) that are attributable to distributions of tangible
property and for adjustments under section 734(b)(1)(A) or 734(b)(2)(A).
The adjustment to the adjusted basis in Asset H is under section
734(b)(1)(B) and is attributable to the distribution of Asset I, which
is not tangible property. Accordingly, for purposes of applying
paragraph (g)(1) of this section, PRS's adjusted basis in Asset H is $0.
(h) Anti-avoidance rule for certain transfers of property--(1) In
general. If, with a principal purpose of decreasing the amount of its
deemed tangible income return, a domestic corporation transfers
specified tangible property (transferred property) to a specified
related party of the domestic corporation and, within the disqualified
period, the domestic corporation or an FDII-eligible related party of
the domestic corporation leases the same or substantially similar
property from any specified related party, then, solely for purposes of
determining the QBAI of the domestic corporation under paragraph (b) of
this section, the domestic corporation is treated as owning the
transferred property from the later of the beginning of the term of the
lease or date of the transfer of the property until the earlier of the
end of the term of the lease or the end of the recovery period of the
property.
(2) Rule for structured arrangements. For purposes of paragraph
(h)(1) of this section, a transfer of specified tangible property to a
person that is not a related party or lease of property from a person
that is not a related party is treated as a transfer to or lease from a
specified related party if the transfer or lease is pursuant to a
structured arrangement. A structured arrangement exists only if either
paragraph (h)(2)(i) or (ii) of this section is satisfied.
(i) The reduction in the domestic corporation's deemed tangible
income return is priced into the terms of the arrangement with the
transferee.
(ii) Based on all the facts and circumstances, the reduction in the
domestic corporation's deemed tangible income return is a principal
purpose of the arrangement. Facts and circumstances that indicate the
reduction in the domestic corporation's deemed tangible income return is
a principal purpose of the arrangement include--
(A) Marketing the arrangement as tax-advantaged where some or all of
[[Page 601]]
the tax advantage derives from the reduction in the domestic
corporation's deemed tangible income return;
(B) Primarily marketing the arrangement to domestic corporations
which earn FDDEI;
(C) Features that alter the terms of the arrangement, including the
return, in the event the reduction in the domestic corporation's deemed
tangible income return is no longer relevant; or
(D) A below-market return absent the tax effects or benefits
resulting from the reduction in the domestic corporation's deemed
tangible income return.
(3) Per se rules for certain transactions. For purposes of paragraph
(h)(1) of this section, a transfer of property by a domestic corporation
to a specified related party (including a party deemed to be a specified
related party under paragraph (h)(2) of this section) followed by a
lease of the same or substantially similar property by the domestic
corporation or an FDII-eligible related party from a specified related
party (including a party deemed to be a specified related party under
paragraph (h)(2) of this section) is treated per se as occurring
pursuant to a principal purpose of decreasing the amount of the domestic
corporation's deemed tangible income return if both the transfer and the
lease occur within a six-month period.
(4) Definitions related to anti-avoidance rule. The following
definitions apply for purpose of this paragraph (h).
(i) Disqualified period. The term disqualified period means, with
respect to a transfer, the period beginning one year before the date of
the transfer and ending the earlier of the end of the remaining recovery
period (under the system described in section 951A(d)(3)(A)) of the
property or one year after the date of the transfer.
(ii) FDII-eligible related party. The term FDII-eligible related
party means, with respect to a domestic corporation, a member of the
same consolidated group as the domestic corporation or a partnership
with respect to which at least 80 percent of the interests in
partnership capital and profits are owned, directly or indirectly, by
the domestic corporation or one or more members of the consolidated
group that includes the domestic corporation.
(iii) Specified related party. The term specified related party
means, with respect to a domestic corporation, a related party other
than an FDII-eligible related party.
(iv) Transfer. The term transfer means any disposition, exchange,
contribution, or distribution of property, and includes an indirect
transfer. For example, a transfer of an interest in a partnership is
treated as a transfer of the assets of the partnership. In addition, if
paragraph (h)(1) of this section applies to treat a domestic corporation
as owning specified tangible property by reason of a lease of property,
the termination or lapse of the lease of the property is treated as a
transfer of the specified tangible property by the domestic corporation
to the lessor.
(5) Transactions occurring before March 4, 2019. Paragraph (h)(1) of
this section does not apply to a transfer of property that occurs before
March 4, 2019.
(6) Examples. The following examples illustrate the application of
this paragraph (h).
(i) Example 1: Sale-leaseback with a related party--(A) Facts. DC, a
domestic corporation, owns Asset A, which is specified tangible
property. DC also owns all the single class of stock of DS, a domestic
corporation, and FS1 and FS2, each a controlled foreign corporation. DC
and DS are members of the same consolidated group. On January 1, Year 1,
DC sells Asset A to FS1. At the time of the sale, Asset A had a
remaining recovery period of 10 years under the alternative depreciation
system. On February 1, Year 1, FS2 leases Asset B, which is
substantially similar to Asset A, to DS for a five-year term ending on
January 31, Year 6.
(B) Analysis. Because DC transfers specified tangible property
(Asset A), to a specified related party of DC (FS1), and, within a six
month period (January 1, Year 1 to February 1, Year 1), an FDII-eligible
related party of DC (DS) leases a substantially similar property (Asset
B) from a specified related party (FS2), DC's transfer of Asset A and
lease of Asset B are treated as per se occurring pursuant to a principal
purpose of decreasing the amount of its
[[Page 602]]
deemed tangible income return. Accordingly, for purposes of determining
DC's QBAI, DC is treated as owning Asset A from February 1, Year 1, the
later of the date of the transfer of Asset A (January 1, Year 1) and the
beginning of the term of the lease of Asset B (February 1, Year 1),
until January 31, Year 6, the earlier of the end of the term of the
lease of Asset B (January 31, Year 6) or the remaining recovery period
of Asset A (December 31, Year 10).
(ii) Example 2: Sale-leaseback with a related party; lapse of
initial lease--(A) Facts. The facts are the same as in paragraph
(h)(6)(i)(A) of this section (the facts in Example 1). In addition, DS
allows the lease of Asset B to expire on February 1, Year 6. On June 1,
Year 6, DS and FS2 renew the lease for a five-year term ending on May
31, Year 11.
(B) Analysis. Because DC is treated as owning Asset A under
paragraph (h)(1) of this section, the lapse of the lease of Asset B is
treated as a transfer of Asset A to FS2 on February 1, Year 6, under
paragraph (h)(4)(iv) of this section. Further, because DC is deemed to
transfer specified tangible property (Asset A) to a specified related
party (FS2) upon the lapse of the lease, and within a six month period
(February 1, Year 6 to June 1, Year 6), an FDII-eligible related party
of DC (DS) leases a substantially similar property (Asset B), DC's
deemed transfer of Asset A under paragraph (h)(4)(iv) of this section
and lease of Asset B are treated as per se occurring pursuant to a
principal purpose of decreasing the amount of its deemed tangible income
return. Accordingly, for purposes of determining DC's QBAI, DC is
treated as owning Asset A from June 1, Year 6, the later of the date of
the deemed transfer of Asset A (February 1, Year 6) and the beginning of
the term of the lease of Asset B (June 1, Year 6), until December 31,
Year 10, the earlier of the end of the term of the lease of Asset B (May
31, Year 11) or the remaining recovery period of Asset A (December 31,
Year 10).
[T.D. 9901, 85 FR 43080, July 15, 2020, as amended by 85 FR 60910, Sept.
29, 2020; T.D. 9956, 86 FR 52972, Sept. 24, 2021]
Sec. 1.250(b)-3 Foreign-derived deduction eligible income (FDDEI)
transactions.
(a) Scope. This section provides rules related to the determination
of whether a sale of property or provision of a service is a FDDEI
transaction. Paragraph (b) of this section provides definitions related
to the determination of whether a sale of property or provision of a
service is a FDDEI transaction. Paragraph (c) of this section provides
rules regarding a sale of property or provision of a service to a
foreign government or an agency or instrumentality thereof. Paragraph
(d) of this section provides a rule for characterizing a transaction
with both sales and services elements. Paragraph (e) of this section
provides a rule for determining whether a sale of property or provision
of a service to a partnership is a FDDEI transaction. Paragraph (f) of
this section provides rules for substantiating certain FDDEI
transactions.
(b) Definitions. This paragraph (b) provides definitions that apply
for purposes of this section and Sec. Sec. 1.250(b)-4 through 1.250(b)-
6.
(1) Digital content. The term digital content means a computer
program or any other content in digital format. For example, digital
content includes books in digital format, movies in digital format, and
music in digital format. For purposes of this section, a computer
program is a set of statements or instructions to be used directly or
indirectly in a computer or other electronic device in order to bring
about a certain result, and includes any media, user manuals,
documentation, data base, or similar item if the media, user manuals,
documentation, data base, or other similar item is incidental to the
operation of the computer program.
(2) End user. Except as modified by Sec. 1.250(b)-4(d)(2)(ii), the
term end user means the person that ultimately uses or consumes property
or a person that acquires property in a foreign retail sale. A person
that acquires property for resale or otherwise as an intermediary is not
an end user.
(3) FDII filing date. The term FDII filing date means, with respect
to a sale of property by a seller or provision of a
[[Page 603]]
service by a renderer, the date, including extensions, by which the
seller or renderer is required to file an income tax return (or in the
case of a seller or renderer that is a partnership, a return of
partnership income) for the taxable year in which the gross income from
the sale of property or provision of a service is included in the gross
income of the seller or renderer.
(4) Finished goods. The term finished goods means general property
that is acquired by an end user.
(5) Foreign person. The term foreign person means a person (as
defined in section 7701(a)(1)) that is not a United States person and
includes a foreign government or an international organization.
(6) Foreign related party. The term foreign related party means,
with respect to a seller or renderer, any foreign person that is a
related party of the seller or renderer.
(7) Foreign retail sale. The term foreign retail sale means a sale
of general property to a recipient that acquires the general property at
a physical retail location (such as a store or warehouse) outside the
United States.
(8) Foreign unrelated party. The term foreign unrelated party means,
with respect to a seller, a foreign person that is not a related party
of the seller.
(9) Fungible mass of general property. The term fungible mass of
general property means multiple units of property for sale with similar
or identical characteristics for which the seller does not know the
specific identity of the recipient or the end user for a particular
unit.
(10) General property. The term general property means any property
other than: Intangible property (as defined in paragraph (b)(11) of this
section); a security (as defined in section 475(c)(2)); an interest in a
partnership, trust, or estate; a commodity described in section
475(e)(2)(A) that is not a physical commodity; or a commodity described
in section 475(e)(2)(B) through (D). A physical commodity described in
section 475(e)(2)(A) is treated as general property, including if it is
sold pursuant to a forward or option contract (including a contract
described in section 475(e)(2)(C), but not a section 1256 contract as
defined in section 1256(b) or other similar contract that is traded on a
U.S. or non-U.S. regulated exchange and cleared by a central clearing
organization in a manner similar to a section 1256 contract) that is
physically settled by delivery of the commodity (provided that the
taxpayer physically settled the contract pursuant to a consistent
practice adopted for business purposes of determining whether to cash or
physically settle such contracts under similar circumstances).
(11) Intangible property. The term intangible property has the
meaning set forth in section 367(d)(4). For purposes of section 250,
intangible property does not include a copyrighted article as defined in
Sec. 1.861-18(c)(3).
(12) International transportation property. The term international
transportation property means aircraft, railroad rolling stock, vessel,
motor vehicle, or similar property that provides a mode of
transportation and is capable of traveling internationally.
(13) IP address. The term IP address means a device's internet
Protocol address.
(14) Recipient. The term recipient means a person that purchases
property or services from a seller or renderer.
(15) Renderer. The term renderer means a person that provides a
service to a recipient.
(16) Sale. The term sale means any sale, lease, license, sublicense,
exchange, or other disposition of property, and includes any transfer of
property in which gain or income is recognized under section 367. In
addition, the term sell (and any form of the word sell) means any
transfer by sale.
(17) Seller. The term seller means a person that sells property to a
recipient.
(18) United States. The term United States has the meaning set forth
in section 7701(a)(9), as expanded by section 638(1) with respect to
mines, oil and gas wells, and other natural deposits.
(19) United States person. The term United States person has the
meaning set forth in section 7701(a)(30), except that the term does not
include an individual that is a bona fide resident of a United States
territory within the meaning of section 937(a).
[[Page 604]]
(20) United States territory. The term United States territory means
American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the
U.S. Virgin Islands.
(c) Foreign military sales and services. If a sale of property or a
provision of a service is made to the United States or an
instrumentality thereof pursuant to 22 U.S.C. 2751 et seq. under which
the United States or an instrumentality thereof purchases the property
or service for resale or on-service to a foreign government or agency or
instrumentality thereof, then the sale of property or provision of a
service is treated as a FDDEI sale or FDDEI service without regard to
Sec. 1.250(b)-4 or Sec. 1.250(b)-5.
(d) Transactions with multiple elements. A transaction is classified
according to its overall predominant character for purposes of
determining whether the transaction is a FDDEI sale under Sec.
1.250(b)-4 or a FDDEI service under Sec. 1.250(b)-5. For example,
whether a transaction that includes both a sales component and a service
component is subject to Sec. 1.250(b)-4 or Sec. 1.250(b)-5 is
determined based on whether the overall predominant character, taking
into account all relevant facts and circumstances, is a sale or service.
In addition, whether a transaction that includes both a sale of general
property and a sale of intangible property is subject to Sec. 1.250(b)-
4(d)(1) or Sec. 1.250(b)-4(d)(2) is determined based on whether the
overall predominant character, taking into account all relevant facts
and circumstances, is a sale of general property or a sale of intangible
property.
(e) Treatment of partnerships--(1) In general. For purposes of
determining whether a sale of property to or by a partnership or a
provision of a service to or by a partnership is a FDDEI transaction, a
partnership is treated as a person. Accordingly, for example, a
partnership may be a seller, renderer, recipient, or related party,
including a foreign related party (as defined in paragraph (b)(6) of
this section).
(2) Examples. The following examples illustrate the application of
this paragraph (e).
(i) Example 1: Domestic partner sale to foreign partnership with a
foreign branch--(A) Facts. DC, a domestic corporation, is a partner in
PRS, a foreign partnership. DC and PRS are not related parties. PRS has
a foreign branch within the meaning of Sec. 1.904-4(f)(3)(iii). DC and
PRS both use the calendar year as their taxable year. For the taxable
year, DC recognizes $20x of gain on the sale of general property to PRS
for a foreign use (as determined under Sec. 1.250(b)-4(d)). During the
same taxable year, PRS recognizes $20x of gain on the sale of other
general property to a foreign person for a foreign use (as determined
under Sec. 1.250(b)-4(d)). PRS's income on the sale of the property is
attributable to its foreign branch.
(B) Analysis. DC's sale of property to PRS, a foreign partnership,
is a FDDEI sale because it is a sale to a foreign person for a foreign
use. Therefore, DC's gain of $20x on the sale to PRS is included in DC's
gross DEI and gross FDDEI. However, PRS's gain of $20x is not included
in the gross DEI or gross FDDEI of PRS because the gain is foreign
branch income within the meaning of Sec. 1.250(b)-1(c)(11).
Accordingly, none of PRS's gain on the sale of property is included in
DC's gross DEI or gross FDDEI under Sec. 1.250(b)-1(e)(1).
(ii) Example 2: Domestic partner sale to domestic partnership
without a foreign branch--(A) Facts. The facts are the same as in
paragraph (e)(2)(i)(A) of this section (the facts in Example 1), except
PRS is a domestic partnership that does not have a foreign branch within
the meaning of Sec. 1.904-4(f)(3)(iii).
(B) Analysis. DC's sale of property to PRS, a domestic partnership,
is not a FDDEI sale because the sale is to a United States person.
Therefore, the gross income from DC's sale to PRS is included in DC's
gross DEI but is not included in its gross FDDEI. However, PRS's sale of
other general property is a FDDEI sale, and therefore the gain of $20x
is included in the gross DEI and gross FDDEI of PRS. Accordingly, DC
includes its distributive share of PRS's gain from the sale in
determining DC's gross DEI and gross FDDEI for the taxable year under
Sec. 1.250(b)-1(e)(1).
(f) Substantiation for certain FDDEI transactions--(1) In general.
Except as provided in paragraph (f)(2) of this section, for purposes of
Sec. 1.250(b)-4(d)(1)(ii)(C) (foreign use for sale of general property
for resale), Sec. 1.250(b)-
[[Page 605]]
4(d)(1)(iii) (foreign use for sale of general property subject to
manufacturing, assembly, or processing outside the United States), Sec.
1.250(b)-4(d)(2) (foreign use for sale of intangible property), and
Sec. 1.250(b)-5(e) (general services provided to business recipients
located outside the United States), a transaction is a FDDEI transaction
only if the taxpayer substantiates its determination of foreign use (in
the case of sales of property) or location outside the United States (in
the case of general services provided to a business recipient) as
described in the applicable paragraph of Sec. 1.250(b)-4(d)(3) or Sec.
1.250(b)-5(e)(4). The substantiating documents must be in existence as
of the FDII filing date with respect to the FDDEI transaction, and a
taxpayer must provide the required substantiating documents within 30
days of a request by the Commissioner or another period as agreed
between the Commissioner and the taxpayer.
(2) Exception for small businesses. Paragraph (f)(1) of this
section, and the specific substantiation requirements described in the
applicable paragraph of Sec. 1.250(b)-4(d)(3) or Sec. 1.250(b)-
5(e)(4), do not apply to a taxpayer if the taxpayer and all related
parties of the taxpayer, in the aggregate, receive less than $25,000,000
in gross receipts during the taxable year prior to the FDDEI
transaction. If the taxpayer's prior taxable year was less than 12
months (a short period), gross receipts are annualized by multiplying
the gross receipts for the short period by 365 and dividing the result
by the number of days in the short period.
(3) Treatment of certain loss transactions--(i) In general. If a
domestic corporation fails to satisfy the substantiation requirements
described in the applicable paragraph of Sec. 1.250(b)-4(d)(3) or Sec.
1.250(b)-5(e)(4) with respect to a transaction (including in connection
with a related party transaction described in Sec. 1.250(b)-6), the
gross income from the transaction will be treated as gross FDDEI if--
(A) In the case of a sale of property, the seller knows or has
reason to know that property is sold to a foreign person for a foreign
use (within the meaning of Sec. 1.250(b)-4(d)(1) or (2));
(B) In the case of the provision of a general service to a business
recipient, the renderer knows or has reason to know that a service is
provided to a business recipient located outside the United States; and
(C) Not treating the transaction as a FDDEI transaction would
increase the amount of the corporation's FDDEI for the taxable year
relative to its FDDEI that would be determined if the transaction were
treated as a FDDEI transaction.
(ii) Reason to know--(A) Sales to a foreign person for a foreign
use. For purposes of paragraph (f)(3)(i)(A) of this section, a seller
has reason to know that a sale is to a foreign person for a foreign use
if the information received as part of the sales process contains
information that indicates that the recipient is a foreign person or
that the sale is for a foreign use, and the seller fails to obtain
evidence establishing that the recipient is not in fact a foreign person
or that the sale is not in fact for a foreign use. Information that
indicates that a recipient is a foreign person or that the sale is for a
foreign use includes, but is not limited to, a foreign phone number,
billing address, shipping address, or place of residence; and, with
respect to an entity, evidence that the entity is incorporated, formed,
or managed outside the United States.
(B) General services provided to a business recipient located
outside the United States. For purposes of paragraph (f)(3)(i)(B) of
this section, a renderer has reason to know that the provision of a
general service is to a business recipient located outside the United
States if the information received as part of the sales process contains
information that indicates that the recipient is a business recipient
located outside the United States and the seller fails to obtain
evidence establishing that the recipient is not in fact a business
recipient located outside the United States. Information that indicates
that a recipient is a business recipient includes, but is not limited
to, indicia of a business status (such as ``LLC'' or ``Company,'' or
similar indicia under applicable domestic or foreign law, in the name)
or statements by the recipient indicating that it is a business.
Information that indicates
[[Page 606]]
that a business recipient is located outside the United States includes,
but is not limited to, a foreign phone number, billing address, and
evidence that the entity or business is incorporated, formed, or managed
outside the United States.
(iii) Multiple transactions. If a seller or renderer engages in more
than one transaction described in paragraph (f)(3)(i) of this section in
a taxable year, paragraph (f)(3)(i) of this section applies by comparing
the corporation's FDDEI if each such transaction were not treated as a
FDDEI transaction to its FDDEI if each such transaction were treated as
a FDDEI transaction.
(iv) Example. The following example illustrates the application of
this paragraph (f)(3).
(A) Facts. During a taxable year, DC, a domestic corporation,
manufactures products A and B in the United States. DC sells product A
and product B to Y, a foreign person that is a distributor, for $200x
and $800x, respectively. DC knows or has reason to know that all of its
sales of product A and product B will ultimately be sold to end users
located outside the United States. Y provides DC with a statement that
satisfies the substantiation requirement of paragraph (f)(1) of this
section and Sec. 1.250(b)-4(d)(3)(ii) that establishes that its sales
of product B are for a foreign use but does not obtain substantiation
establishing that any sales of product A are for a foreign use. DC's
cost of goods sold is $450x. For purposes of determining gross FDDEI,
under Sec. 1.250(b)-1(d)(1) DC attributes $250x of cost of goods sold
to product A and $200x of cost of goods sold to product B, and then
attributes the cost of goods sold for each product ratably between the
gross receipts of such product sold to foreign persons and the gross
receipts of such product not sold to foreign persons. The manner in
which DC attributes the cost of goods sold is a reasonable method. DC
has no other items of income, loss, or deduction.
Table 1 to Paragraph (f)(3)(iv)(A)
----------------------------------------------------------------------------------------------------------------
Product A Product B Total
----------------------------------------------------------------------------------------------------------------
Gross receipts.................................................. $200x $800x $1,000x
Cost of Goods Sold.............................................. 250x 200x 450x
Gross Income (Loss)............................................. (50x) 600x 550x
----------------------------------------------------------------------------------------------------------------
(B) Analysis. By not treating the sales of product A as FDDEI sales,
the amount of DC's FDDEI would increase by $50x relative to its FDDEI if
the sales of product A were treated as FDDEI sales. Accordingly, because
DC knows or has reason to know that its sales of product A are to
foreign persons for a foreign use, the sales of product A constitute
FDDEI sales under paragraph (f)(3) of this section, and thus the $50x
loss from the sale of product A is included in DC's gross FDDEI.
[T.D. 9901, 85 FR 43080, July 15, 2020]
Sec. 1.250(b)-4 Foreign-derived deduction eligible income (FDDEI) sales.
(a) Scope. This section provides rules for determining whether a
sale of property is a FDDEI sale. Paragraph (b) of this section defines
a FDDEI sale. Paragraph (c) of this section provides rules for
determining whether a recipient is a foreign person. Paragraph (d) of
this section provides rules for determining whether property is sold for
a foreign use. Paragraph (e) of this section provides a special rule for
the sale of interests in a disregarded entity. Paragraph (f) of this
section provides a rule regarding certain hedging transactions with
respect to FDDEI sales.
(b) Definition of FDDEI sale. Except as provided in Sec. 1.250(b)-
6(c), the term FDDEI sale means a sale of general property or intangible
property to a recipient that is a foreign person (see paragraph (c) of
this section for presumption rules relating to determining foreign
person status) and that is for a foreign use (as determined under
paragraph (d) of this section). A sale of any property other than
general property or intangible property is not a FDDEI sale.
(c) Presumption of foreign person status--(1) In general. The sale
of property is presumed to be to a recipient that is
[[Page 607]]
a foreign person for purposes of paragraph (b) of this section if the
sale is described in paragraph (c)(2) of this section. However, this
presumption does not apply if the seller knows or has reason to know
that the sale is not to a foreign person. A seller has reason to know
that a sale is not to a foreign person if the information received as
part of the sales process contains information that indicates that the
recipient is not a foreign person and the seller fails to obtain
evidence establishing that the recipient is in fact a foreign person.
Information that indicates that a recipient is not a foreign person
include, but are not limited to, a United States phone number, billing
address, shipping address, or place of residence; and, with respect to
an entity, evidence that the entity is incorporated, formed, or managed
in the United States.
(2) Sales of property. A sale of a property is described in this
paragraph (c)(2) if:
(i) The sale is a foreign retail sale;
(ii) In the case of a sale of general property that is not a foreign
retail sale and the general property is delivered (such as through a
commercial carrier) to the recipient or an end user, the shipping
address of the recipient or end user is outside the United States;
(iii) In the case of a sale of general property that is not
described in either paragraph (c)(2)(i) or (ii) of this section, the
billing address of the recipient is outside the United States; or
(iv) In the case of a sale of intangible property, the billing
address of the recipient is outside the United States.
(d) Foreign use--(1) Foreign use for general property--(i) In
general. The sale of general property is for a foreign use for purposes
of paragraph (b) of this section if the seller determines that the sale
is for a foreign use under the rules of paragraph (d)(1)(ii) or (iii) of
this section and the exception in paragraph (d)(1)(iv) of this section
does not apply.
(ii) Rules for determining foreign use--(A) Sales that are delivered
to an end user by a carrier or freight forwarder. Except as otherwise
provided in this paragraph (d)(1)(ii)(A), a sale of general property
(other than a sale of general property described in paragraphs
(d)(1)(ii)(D) through (F) of this section) that is delivered through a
carrier or freight forwarder to a recipient that is an end user is for a
foreign use if the end user receives delivery of the general property
outside the United States. However, a sale described in the preceding
sentence is not treated as a sale to an end user for a foreign use if
the sale is made with a principal purpose of having the property
transported from its location outside the United States to a location
within the United States for ultimate use or consumption.
(B) Sales to an end user without the use of a carrier or freight
forwarder. With respect to sales that are not delivered through the use
of a carrier or freight forwarder, a sale of general property (other
than a sale of general property described in paragraphs (d)(1)(ii)(D)
through (F) of this section) to a recipient that is an end user is for a
foreign use if the property is located outside the United States at the
time of the sale (including as part of foreign retail sales).
(C) Sales for resale. A sale of general property (other than a sale
of general property described in paragraphs (d)(1)(ii)(D) through (F) of
this section) to a recipient (such as a distributor or retailer) that
will resell the general property is for a foreign use if the general
property will ultimately be sold to end users outside the United States
(including in foreign retail sales) and such sales to end users outside
the United States are substantiated under paragraph (d)(3)(ii) of this
section. In the case of sales of a fungible mass of general property,
the taxpayer may presume that the proportion of its sales that are
ultimately sold to end users outside the United States is the same as
the proportion of the recipient's resales of that fungible mass to end
users outside the United States.
(D) Sales of digital content. A sale of general property that
primarily contains digital content that is transferred electronically
rather than in a physical medium is for a foreign use if the end user
downloads, installs, receives, or accesses the purchased digital content
on the end user's device outside the United States (see Sec. 1.250(b)-
5(d)(2) and (e)(2)(iii) for rules that apply in the case of digital
content that is not purchased in a sale but
[[Page 608]]
is electronically supplied as a service). If information about where the
digital content is downloaded, installed, received, or accessed (such as
the device's IP address) is unavailable, and the gross receipts from all
sales with respect to the end user (which may be a business) are in the
aggregate less than $50,000 for the seller's taxable year, a sale of
general property described in the preceding sentence is for a foreign
use if it is to an end user that has a billing address located outside
the United States.
(E) Sales of international transportation property used for
compensation or hire. A sale of international transportation property
used for compensation or hire is for a foreign use if the end user
registers the property with a foreign jurisdiction.
(F) Sales of international transportation property not used for
compensation or hire. A sale of international transportation property
not used for compensation or hire is for a foreign use if the end user
registers the property in a foreign jurisdiction and hangars or stores
the property primarily outside the United States.
(iii) Sales for manufacturing, assembly, or other processing--(A) In
general. A sale of general property is for a foreign use if the sale is
to a foreign unrelated party that subjects the property to manufacture,
assembly, or other processing outside the United States and such
manufacturing, assembly, or other processing outside the United States
is substantiated under paragraph (d)(3)(iii) of this section. Property
is subject to manufacture, assembly, or other processing only if the
property is physically and materially changed (as described in paragraph
(d)(1)(iii)(B) of this section) or the property is incorporated as a
component into another product (as described in paragraph (d)(1)(iii)(C)
of this section).
(B) Property subject to a physical and material change. The
determination of whether general property is subject to a physical and
material change is made based on all the relevant facts and
circumstances. General property is subject to a physical and material
change if it is substantially transformed and is distinguishable from
and cannot be readily returned to its original state.
(C) Property incorporated into a product as a component. General
property is a component incorporated into another product if the
incorporation of the general property into another product involves
activities that are substantial in nature and generally considered to
constitute the manufacture, assembly, or processing of property based on
all the relevant facts and circumstances. However, general property is
not considered a component incorporated into another product if it is
subject only to packaging, repackaging, labeling, or minor assembly
operations. In addition, general property is treated as a component if
the seller expects, using reliable estimates, that the fair market value
of the property when it is delivered to the recipient will constitute no
more than 20 percent of the fair market value of the finished good into
which the general property is directly or indirectly incorporated when
the finished good is sold to end users (the ``20-percent rule''). If the
property could be incorporated into a number of different finished
goods, a reliable estimate of the fair market value of the finished good
may include the average fair market value of a representative range of
such goods. For purposes of the 20-percent rule, all general property
that is sold by the seller and incorporated into the finished good is
treated as a single item of property if the seller sells the property to
the recipient and the seller knows or has reason to know that the
components will be incorporated into a single item of property (for
example, where multiple components are sold as a kit). A seller knows or
has reason to know that the components will be incorporated into a
single item of property if the information received as part of the sales
process indicates that the components will be included in the same
second product or the nature of the components compels inclusion into
the second product and the seller fails to obtain evidence to the
contrary.
(iv) Sales of property subject to manufacturing, assembly, or other
processing in the United States. If the seller sells general property to
a recipient (other than a related party) for manufacturing, assembly, or
other processing within the
[[Page 609]]
United States, such property is not sold for a foreign use even if the
requirements of paragraph (d)(1)(ii) or (iii) of this section are
subsequently satisfied. See Sec. 1.250(b)-6(c) for rules governing
sales of general property to a foreign person that is a related party.
Property is subject to manufacture, assembly, or other processing only
if the property is physically and materially changed (as described in
paragraph (d)(1)(iii)(B) of this section) or the property is
incorporated as a component into another product (as described in
paragraph (d)(1)(iii)(C) of this section).
(v) Examples. The following examples illustrate the application of
this paragraph (d)(1).
(A) Assumed facts. The following facts are assumed for purposes of
the examples--
(1) DC is a domestic corporation.
(2) FP is a foreign person that is a foreign unrelated party with
respect to DC.
(3) To the extent a sale is for a foreign use, any applicable
substantiation requirements described in paragraph (d)(3)(ii) or (iii)
of this section are satisfied.
(B) Examples--
(1) Example 1: Manufacturing outside the United States--(i) Facts.
DC sells batteries for $18x to FP. DC expects that FP will insert the
batteries into tablets as part of the process of assembling tablets
outside the United States. While the tablets are manufactured in a way
that end users would not easily be able to remove the batteries, the
batteries could be removed from the tablets and would resemble their
original state following the removal. The finished tablets will be sold
to end users within and outside the United States. DC's batteries are
used in two types of tablets, Tablet A and Tablet B. Based on an
economic analysis, DC determines that the fair market value of Tablet A
is $90x and the fair market value of Tablet B is $110x. FP informs DC
that the number of sales of Tablet A is approximately equal to the
number of sales of Tablet B.
(ii) Analysis. Because the batteries could be removed from the
tablets and be returned to their original state, the insertion of the
batteries into the tablets does not constitute a physical and material
change described in paragraph (d)(1)(iii)(B) of this section. However,
the average fair market value of a representative range of tablets that
incorporate the batteries is $100x (the average of $90x for Tablet A and
$110x for Tablet B because their sales are approximately equal), and
$18x is less than 20 percent of $100x. Therefore, the batteries are
considered components of the tablets and treated as subject to
manufacture, assembly, or other processing outside the United States.
See paragraphs (d)(1)(iii)(A) and (C) of this section. As a result,
notwithstanding that some tablets incorporating the batteries may be
sold to an end user in the United States, DC's sale of batteries is
considered for a foreign use. Accordingly, DC's sale of batteries to FP
is for a foreign use under paragraph (d)(1)(iii)(A) and (C) of this
section, and the sale is a FDDEI sale.
(2) Example 2: Manufacturing outside the United States--(i) Facts.
The facts are the same as in paragraph (d)(1)(v)(B)(1) of this section
(the facts in Example 1), except FP purchases the batteries from DC for
$25x. In addition, FP purchased other components of tablets from other
parties. FP has a substantial investment in machinery and tools that are
used to assemble tablets.
(ii) Analysis. Even though the fair market value of the batteries
that FP purchases from DC and incorporates into the tablets exceeds 20
percent of the fair market value of the tablets, because the batteries
are used by FP in activities that are substantial in nature and
generally considered to constitute the manufacture, assembly or other
processing of property, the batteries are components of the tablets. As
a result, DC's sale of property to FP is still for a foreign use under
paragraph (d)(1)(iii)(A) and (C) of this section, and the sale is a
FDDEI sale.
(3) Example 3: Sale of products to distributor outside the United
States--(i) Facts. DC sells smartphones to FP, a distributor of
electronics located within Country A. The sales contract between DC and
FP provides that FP may sell the smartphones it purchases from DC only
to specified retailers located
[[Page 610]]
within Country A. The specified retailers only sell electronics,
including smartphones, in foreign retail sales.
(ii) Analysis. Although FP does not sell the smartphones it
purchases from DC to end users, FP sells to retailers that sell the
smartphones in foreign retail sales. All of the sales of smartphones
from DC to FP are sales of general property for a foreign use under
paragraph (d)(1)(ii)(C) of this section because FP is only allowed to
sell the smartphones to retailers who sell such property in foreign
retail sales. As a result, DC's sales of smartphones to FP are FDDEI
sales.
(4) Example 4: Sale of a fungible mass of products--(i) Facts. DC
and persons other than DC sell multiple units of printer paper that is
considered fungible general property to FP during the taxable year. FP
is a distributor that sells paper to retail stores within and outside
the United States. FP informs DC that approximately 25 percent of FP's
sales of the paper are to retail stores located outside of the United
States for foreign retail sales.
(ii) Analysis. The sale of paper to FP is for a foreign use to the
extent that the paper will be sold to end users located outside the
United States under paragraph (d)(1)(ii)(C) of this section. Because a
portion of DC's sales to FP are not for a foreign use, DC must determine
the amount of paper that is sold for a foreign use. Based on the
information provided by FP about its own sales, DC determines under
paragraph (d)(1)(ii)(C) of this section that 25 percent of the total
units of paper that is fungible general property that FP purchased from
all persons in the taxable year will ultimately be sold to end users
located outside the United States. Accordingly, DC satisfies the test
for a foreign use under paragraph (d)(1)(ii)(C) of this section with
respect to 25 percent of its sales of the paper to FP.
(5) Example 5: Limited use license of copyrighted computer
software--(i) Facts. DC provides FP with a limited use license to
copyrighted computer software in exchange for an annual fee of $100x.
The limited use license restricts FP's use of the computer software to
100 of FP's employees, who download the software onto their computers.
The limited use license prohibits FP from using the computer software in
any way other than as an end user, which includes prohibiting
sublicensing, selling, reverse engineering, or modifying the computer
software. All of FP's employees download the software onto computers
that are physically located outside the United States.
(ii) Analysis. The software licensed to FP is digital content as
defined in Sec. 1.250(b)-3(b)(1), and is downloaded by an end user as
defined in Sec. 1.250(b)-3(b)(2). Accordingly, because the software is
downloaded solely onto computers outside the United States, DC's license
to FP is for a foreign use and therefore a FDDEI sale under paragraph
(d)(1)(ii)(D) of this section. The entire $100x of the license fee is
included in DC's gross FDDEI for the taxable year.
(6) Example 6: Limited use license of copyrighted computer software
used within and outside the United States--(i) Facts. The facts are the
same as in paragraph (d)(1)(v)(B)(5) of this section (the facts in
Example 5), except that FP has offices both within and outside the
United States, and DC's internal records indicates that 50 percent of
the downloads of the software are onto computers located outside the
United States.
(ii) Analysis. Because 50 percent of the downloads of the software
are onto computers located outside the United States, a portion of DC's
license to FP is for a foreign use and therefore such portion is a FDDEI
sale. The $50x of license fee derived with respect to such portion is
included in DC's gross FDDEI for the taxable year.
(7) Example 7: Sale of a copyrighted article--(i) Facts. DC sells
copyrighted music available for download on its website. Once
downloaded, the recipient listens to the music on electronic devices
that do not need to be connected to the internet. DC has data that an
individual accesses the website to purchase a song for download on a
device located outside the United States. The terms of the sale permit
the recipient to use the song for personal use, but convey no other
rights to the copyrighted music to the recipient.
[[Page 611]]
(ii) Analysis. The music acquired through download is digital
content as defined in Sec. 1.250(b)-3(b)(1). Because the recipient
acquires no ownership in copyright rights to the music, the sale is
considered a sale of a copyrighted article, and thus is a sale of
general property. See Sec. 1.250(b)-3(b)(10) and (11). As a result, the
sale is considered for a foreign use under paragraph (d)(1)(ii)(D) of
this section because the digital content was installed, received, or
accessed on the end user's device outside the United States. The income
derived with respect to the sale of the music is included in DC's gross
FDDEI for the taxable year. See Sec. 1.250(b)-5(d)(3) for an example of
digital content provided to consumers as a service rather than as a
sale.
(2) Foreign use for intangible property--(i) In general. A sale of
rights to exploit intangible property solely outside the United States
is for a foreign use. A sale of rights to exploit intangible property
solely within the United States is not for a foreign use. A sale of
rights to exploit intangible property worldwide is partially for a
foreign use and partially not for a foreign use. Whether intangible
property is exploited within versus outside the United States is
determined based on revenue earned from end users located within versus
outside the United States. Therefore, a sale of rights to exploit
intangible property both within and outside the United States is for a
foreign use in proportion to the revenue earned from end users located
outside the United States over the total revenue earned from the
exploitation of the intangible property. A sale of intangible property
will be treated as a FDDEI sale only if the substantiation requirements
of paragraph (d)(3)(iv) of this section are satisfied. For rules
specific to determining end users and revenue earned from end users for
intangible property used in sales of general property, provision of
services, research and development, or consisting of a manufacturing
method or process, see paragraph (d)(2)(ii) of this section.
(ii) Determination of end users and revenue earned from end users--
(A) Intangible property embedded in general property or used in
connection with the sale of general property. If intangible property is
embedded in general property that is sold, or used in connection with a
sale of general property, then the end user of the intangible property
is the end user of the general property. Revenue is earned from the end
user of the general property outside the United States to the extent the
sale of the general property is for a foreign use under paragraph
(d)(1)(ii) or (iii) of this section.
(B) Intangible property used in providing a service. If intangible
property is used to provide a service, then the end user of that
intangible property is the recipient, consumer, or business recipient of
the service or, in the case of a property service or a transportation
service that involves the transportation of property, the end user is
the owner of the property on which such service is being performed. Such
end users are treated as located outside the United States only to the
extent the service qualifies as a FDDEI service under Sec. 1.250(b)-5.
Therefore, in the case of a recipient of a sale of intangible property
that uses such intangible property to provide a property service that
qualifies as a FDDEI service to another person, that person is the end
user and is treated as located outside the United States.
(C) Intangible property consisting of a manufacturing method or
process--(1) In general. Except as provided in paragraph
(d)(2)(ii)(C)(2) of this section, if intangible property consists of a
manufacturing method or process (as defined in paragraph
(d)(2)(ii)(C)(3) of this section) and is sold to a foreign unrelated
party (including in a sale by a foreign related party), then the foreign
unrelated party is treated as an end user located outside the United
States, unless the seller knows or has reason to know that the
manufacturing method or process will be used in the United States, in
which case the foreign unrelated party is treated as an end user located
within the United States. A seller has reason to know that the
manufacturing method or process will be used in the United States if the
information received from the recipient as part of the sales process
contains information that indicates that the recipient intends to use
the manufacturing
[[Page 612]]
method or process in the United States and the seller fails to obtain
evidence establishing that the recipient does not intend to use the
manufacturing method or process in the United States.
(2) Exception for certain manufacturing arrangements. A sale of
intangible property consisting of a manufacturing method or process
(including a sale by a foreign related party) to a foreign unrelated
party for use in manufacturing products for or on behalf of the seller
or any person related to the seller does not qualify as a sale to a
foreign unrelated party for purposes of determining the end user under
paragraph (d)(2)(ii)(C)(1) of this section.
(3) Manufacturing method or process. For purposes of this section, a
manufacturing method or process consists of a sequence of actions or
steps that comprise an overall method or process that is used to
manufacture a product or produce a particular manufacturing result,
which may be in the form of a patent or know-how. Intangible property
consisting of the right to make and sell an item of property is not a
manufacturing method or process, whereas intangible property consisting
of the right to apply a series of actions or steps to be performed to
achieve a particular manufacturing result is a manufacturing method or
process. For example, a utility or design patent on an article of
manufacture, machine, composition of matter, design, or providing the
right to sell equipment to perform a process is not a manufacturing
method or process, whereas a utility patent covering a method or process
of manufacturing is a manufacturing method or process for purposes of
this section.
(D) Intangible property used in research and development. If
intangible property (primary IP) is used to develop new or modify other
intangible property (secondary IP), then the end user of the primary IP
is the end user (applying paragraph (d)(2)(ii)(A), (B), or (C) of this
section) of the secondary IP.
(iii) Determination of revenue for periodic payments versus lump
sums--(A) Sales in exchange for periodic payments. In the case of a sale
of intangible property, other than intangible property consisting of a
manufacturing method or process that is sold to a foreign unrelated
party, to a recipient in exchange for periodic payments, the extent to
which the sale is for a foreign use is determined annually based on the
actual revenue earned by the recipient from any use of the intangible
property for the taxable year in which a periodic payment is received.
If actual revenue earned by the recipient cannot be obtained after
reasonable efforts, then estimated revenue earned by a recipient that is
not a related party of the seller from the use of the intangible
property may be used based on the principles of paragraph (d)(2)(iii)(B)
of this section.
(B) Sales in exchange for a lump sum. In the case of a sale of
intangible property, other than intangible property consisting of a
manufacturing method or process that is sold to a foreign unrelated
party, for a lump sum, the extent to which the sale is for a foreign use
is determined based on the ratio of the total net present value of
revenue the seller would have expected to earn from the exploitation of
the intangible property outside the United States to the total net
present value of revenue the seller would have expected to earn from the
exploitation of the intangible property. In the case of a recipient that
is a foreign unrelated party, net present values of revenue that the
recipient expected to earn from the exploitation of the intangible
property within and outside the United States may also be used if the
seller obtained such revenue data from the recipient near the time of
the sale and such revenue data was used to negotiate the lump sum price
paid for the intangible property. Net present values must be determined
using reliable inputs including, but not limited to, reliable revenue,
expenses, and discount rates. The extent to which the inputs are used by
the parties to determine the sales price agreed to between the seller
and a foreign unrelated party purchasing the intangible property will be
a factor in determining whether such inputs are reliable. If the
intangible property is sold to a foreign related party, the reliability
of the inputs used to determine net present values and the net present
values are determined under section 482.
[[Page 613]]
(C) Sales to a foreign unrelated party of intangible property
consisting of a manufacturing method or process. In the case of a sale
to an unrelated foreign party of intangible property consisting of a
manufacturing method or process, the revenue earned from the end user is
equal to the amount received from the recipient in exchange for the
manufacturing method or process. In the case of a bundled sale of
intangible property consisting of a manufacturing method or process and
intangible property not consisting of a manufacturing method or process,
the revenue earned from the intangible property consisting of the
manufacturing method or process equals the total amount paid for the
bundled sale multiplied by the proportion that the value of the
manufacturing method or process bears to the total value of the
intangible property. The value of the manufacturing method or process to
the total value of the intangible property must be determined using the
principles of section 482.
(iv) Examples. The following examples illustrate the application of
this paragraph (d)(2).
(A) Assumed facts. The following facts are assumed for purposes of
the examples--
(1) DC is a domestic corporation.
(2) Except as otherwise provided, FP and FP2 are foreign persons
that are foreign unrelated parties with respect to DC.
(3) All of DC's income is DEI.
(4) Except as otherwise provided, the substantiation requirements
described in paragraph (d)(3)(iv) of this section are satisfied.
(5) Except as otherwise provided, inputs used to determine the net
present values of the revenue are reliable.
(B) Examples--
(1) Example 1: License of worldwide rights with actual revenue data
from recipient--(i) Facts. DC licenses to FP worldwide rights to the
copyright to composition A in exchange for annual royalties of 60
percent of revenue from FP's sales of composition A. FP sells
composition A to customers through digital downloads from servers. In
the taxable year, FP earns $100x in revenue from sales of copies of
composition A to customers, of which $60x is from customers located in
the United States and the remaining $40x is from customers located
outside the United States. FP provides DC with reliable records showing
the amount of revenue earned in the taxable year from sales of
composition A to establish the royalties owed to DC. These records also
provide DC with the amount of revenue earned from sales of composition A
to customers located within the United States.
(ii) Analysis. FP is not the end user of the copyright to
composition A under paragraph (d)(2)(ii)(A) of this section because the
copyright is used in the sale of general property (the sale of
copyrighted articles to customers). The customers that purchase a copy
of composition A from FP are the end users (as defined in Sec.
1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) because
those customers are the recipients of composition A when sold as general
property. Based on the actual revenue earned by FP from sales of
composition A, 40 percent ($40x/$100x) of the revenue generated by the
copyright during the taxable year is earned outside the United States.
Accordingly, a portion of DC's license to FP is for a foreign use under
paragraph (d)(2) of this section and therefore such portion is a FDDEI
sale. The $24x of royalty (0.40 x $60x of total royalties owed to DC
during the taxable year) derived with respect to such portion is
included in DC's gross FDDEI for the taxable year.
(2) Example 2: Fixed annual payments for worldwide rights without
actual revenue data from recipient--(i) Facts. The facts are the same as
in paragraph (d)(2)(iv)(B)(1)(i) of this section (the facts in Example
1), except FP pays DC a fixed annual payment of $60x each year for the
worldwide rights to the copyright to composition A and does not provide
DC with data showing how much revenue FP earned from sales of
composition A, even after DC requests that FP provide it with such
information. DC also is unable to determine how much revenue FP earned
from sales of composition A to customers within the United States from
the data it has with respect to FP and publicly available data with
respect to FP. However, DC's economic analysis of the
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revenue DC expected it could earn annually from use of composition A as
part of determining the annual payments DC would receive from FP from
the license of composition A supports a determination that 40 percent of
sales of composition A during the tax year would be to customers located
outside the United States. During an examination of DC's return for the
taxable year, DC provides the IRS with data explaining the economic
analysis, inputs, and results from its valuation of composition A used
in determining the amount of annual payments agreed to by DC and FP.
(ii) Analysis. For the same reasons provided in paragraph
(d)(2)(iv)(B)(1)(ii) of this section (the analysis in Example 1), the
customers that purchase copies of composition A from FP are the end
users. DC is allowed to use reliable economic analysis to estimate
revenue earned by FP from the use of the copyright to composition A
under paragraph (d)(2)(iii)(A) of this section because DC was unable to
obtain actual revenue earned by FP from use of the copyright to
composition A during the taxable year after reasonable efforts to obtain
the actual revenue data. Based on DC's economic analysis, a portion of
DC's license to FP is for a foreign use under paragraph (d)(2) of this
section and therefore such portion is a FDDEI sale. $24x of the $60x
fixed payment to DC (0.40 x $60x) is included in DC's gross FDDEI for
the taxable year.
(3) Example 3: Sale of patent rights protected in the United States
and other countries; use of financial projections in sale to foreign
unrelated party--(i) Facts. DC owns a patent for an active
pharmaceutical ingredient (``API'') approved for treatment of disease A
(``indication A'') in the United States and in Countries A, B, and C.
The patent is registered in the United States and in Countries A, B, and
C. DC sells to FP all of its patent rights to the API for indication A
for a lump sum payment of $1,000x. DC has no basis in the patent rights.
To determine the sales price for the patent rights, DC projected that
the net present value of the revenue it would earn from selling a
pharmaceutical product incorporating the API for indication A was
$5,000x, with 15 percent of the net present value of revenue earned from
sales within the United States and 85 percent of the net present value
of revenue earned from sales outside the United States. DC did not
obtain revenue projections from the recipient.
(ii) Analysis. FP is not the end user of the patent under paragraph
(d)(2)(ii)(A) of this section because the patent is used in the sale of
general property (the sale of pharmaceutical products to customers) and
FP is not the recipient of that general property. The unrelated party
customers that purchase the finished pharmaceutical product from FP are
the end users (as defined in Sec. 1.250(b)-3(b)(2) and paragraph
(d)(2)(ii)(A) of this section) because those customers are the unrelated
party recipients of the pharmaceutical product when sold as general
property. Based on the financial projections DC used to determine the
sales price of the patent that FP purchased, a portion of DC's sale to
FP is for a foreign use under paragraph (d)(2) of this section and such
portion is a FDDEI sale. The $850x (85 percent x $1,000x) of gain
derived with respect to such portion is included in DC's gross FDDEI for
the taxable year.
(4) Example 4: Sale of patent rights protected in the United States
and other countries; use of financial projections in sale to foreign
related party--(i) Facts. The facts are the same as in paragraph
(d)(2)(iv)(B)(3)(i) of this section (the facts in Example 3), except
that FP is a foreign related party with respect to DC, and DC projected
that the net present value of the revenue it would earn from selling a
pharmaceutical product incorporating the API for indication A would
result in 1 percent of the revenue earned from sales within the United
States and 99 percent of the revenue earned from sales outside the
United States. During the examination of DC's return for the taxable
year, the IRS determines that DC's substantiation allocating the
projected revenue from sales within the United States and outside the
United States does not reflect reliable inputs to determine the net
present values of revenues under section 482, but determines that the
total lump sum price FP paid for DC's patent rights is an arm's length
price. The IRS determines that
[[Page 615]]
the most reliable net present values of revenue DC would have earned
from sales within the United States and outside the United States is
$750x and $4250x, respectively.
(ii) Analysis. For the same reasons provided in paragraph
(d)(2)(iv)(B)(3)(ii) of this section (the analysis in Example 3), the
customers that purchase the finished pharmaceutical product from FP are
the end users. Under paragraph (d)(2)(iii)(B) of this section, the
reliability of the inputs DC used to determine the net present values
and the net present values are determined under section 482. Based on
the sales price of the patent that FP purchased and the IRS-determined
net present values of revenue DC would have earned from sales within the
United States and outside the United States, a portion of DC's sale to
FP is for a foreign use under paragraph (d)(2) of this section and such
portion is a FDDEI sale. DC is allowed to include $850x (($4250x divided
by $5000x) x $1,000x) of gain in DC's gross FDDEI for the taxable year.
(5) Example 5: Sale of patent of manufacturing method or process
protected in the United States and other countries; foreign unrelated
party--(i) Facts. DC owns the worldwide rights to a patent covering a
process for refining crude oil. DC sells to FP the right to DC's
patented process for refining crude oil for a lump sum payment of $100x.
DC has no basis in the patent rights. DC does not know or have reason to
know that FP will use the patented process to refine crude oil within
the United States or will sell or license the rights to the patent to a
person to refine crude oil within the United States.
(ii) Analysis. DC's patent covering a process for refining crude oil
is a manufacturing method or process as defined in paragraph
(d)(2)(ii)(C)(3) of this section. Under paragraph (d)(2)(ii)(C)(1) of
this section, FP is treated as the end user of the patent, and is
treated as located outside the United States because FP is a foreign
unrelated party and DC does not know or have reason to know that the
patented process will be used in the United States. As a result, all of
the sale to FP is for a foreign use under paragraph (d)(2) of this
section and therefore is a FDDEI sale. The entire $100x lump sum payment
is included in DC's gross FDDEI for the taxable year.
(6) Example 6: License of intangible property that includes a
patented manufacturing method or process protected in the United States
and other countries; foreign unrelated party--(i) Facts. DC owns
worldwide rights to patents, know-how, and a trademark and tradename for
product Z. The patents consist of: a patent covering the right to make,
use, and sell product Z (article of manufacture), a patent covering the
rights to make, use, and sell a composition of substances used in
certain components of product Z (composition of matter), and a patent
covering the right to use a manufacturing process consisting of a series
of manufacturing steps to manufacture product Z (manufacturing method or
process as defined in paragraph (d)(2)(ii)(C)(3) of this section) and to
sell the product Z that FP manufactures using the manufacturing method
or process. The know-how consists entirely of manufacturing know-how
used to implement the manufacturing steps that comprise the
manufacturing method or process. DC licenses the worldwide rights to the
patents, know-how, and the trademark and tradename for product Z to FP
in exchange for annual royalties of 60 percent of revenue from sales of
product Z. FP manufactures product Z in country X and sells product Z to
DC2, a domestic corporation and unrelated party to DC and FP, for resale
to customers located within the United States. FP also sells product Z
to FP2, a foreign unrelated party with respect to DC and FP, for resale
to customers located outside the United States. During the taxable year,
FP sells to DC2 $140x of product Z. Also, during the taxable year, FP
sells to FP2 $60x of product Z. DC determines under the principles of
section 482 that the licensed know-how and the patented manufacturing
method or process comprise 10 percent of the arm's length price of the
intangible property DC licenses to FP.
(ii) Analysis--(A) End users. Under paragraph (d)(2)(ii)(C)(1) of
this section, FP is treated as the end user of the patent covering the
right to use the manufacturing process and the manufacturing know-how
used to implement
[[Page 616]]
the manufacturing method or process, and is treated as located outside
the United States because FP is a foreign unrelated party and DC does
not know or have reason to know that the patented process and know-how
will be used in the United States. DC2, FP, and FP2 are not the end
users of the remaining intangible property under paragraph (d)(2)(ii)(A)
of this section because that intangible property is used in the sale of
general property (the sale of product Z) and DC2, FP, and FP2 are not
the end users of that general property. The unrelated party customers
that purchase product Z from DC2 and FP2 are the end users (as defined
in Sec. 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section)
because those customers are the unrelated party recipients of product Z.
(B) Foreign use. Under paragraph (d)(2)(ii)(A) of this section,
revenue from royalties paid for the intangible property other than the
manufacturing method or process is earned from end users outside the
United States to the extent the sale of the general property is for a
foreign use under paragraph (d)(1) of this section. FP2 is a reseller of
product Z to end users outside the United States, so all sales of
product Z to FP2 are for a foreign use under paragraph (d)(1)(ii)(C) of
this section. Because DC has determined that 10 percent of the value of
the intangible property consists of a manufacturing method or process
(as defined in paragraph (d)(2)(ii)(C)(3) of this section) used to
manufacture product Z, $12x of the $120x royalty FP pays to DC during
the taxable year is for foreign use ($120x total royalty x 0.10) based
on the location of FP's manufacturing utilizing the know-how or all of
the sequence of actions that comprise the manufacturing method or
process under paragraph (d)(2)(ii)(C)(3) of this section. Based on the
sales of product Z within and outside the United States, $32.4x of the
royalties FP pays DC for rights to the licensed intangible property
during the taxable year (($60x of revenue from sales to FP2 for resale
to customers located outside the United States divided by $200x total
worldwide sales revenue FP receives from DC2 and FP2) x ($120x total
royalties less $12 of those royalties attributable to the manufacturing
method or process)) qualifies as income earned from the sale of
intangible property for a foreign use under paragraph (d)(2) of this
section and therefore such portion is a FDDEI sale. As a result, $44.40x
of royalties ($12x + $32.40x) is included in DC's gross FDDEI for the
taxable year.
(7) Example 7: License of intangible property that includes a
patented manufacturing method or process protected in the United States
and other countries; foreign related party with third-party
manufacturer--(i) Facts. The facts are the same as in paragraph
(d)(2)(iv)(B)(6)(i) of this section (the facts in Example 6), except
that FP is a foreign related party with respect to DC and FP engages
FP2, a foreign unrelated party, to manufacture product Z. FP sublicenses
to FP2 the rights to the intangible property FP licenses from DC solely
to manufacture product Z and sell product Z to FP. FP2 manufactures
product Z in country Y and sells all of product Z it manufactures to FP.
During the taxable year, FP sold $80x of product Z to DC2, which DC2
resold to customers located within the United States. Also, during the
taxable year, FP sold $120x of product Z to customers located outside
the United States.
(ii) Analysis--(A) End users. Under paragraph (d)(2)(ii)(C)(1) of
this section, FP is not treated as the end user of the patent covering
the right to use the manufacturing process and the manufacturing know-
how used to implement the manufacturing method or process because FP is
a foreign related party with respect to DC. Under paragraph
(d)(2)(ii)(C)(2) of this section, FP2 is also not treated as the end
user of the patent covering the right to use the manufacturing process
and the manufacturing know-how used to implement the manufacturing
method or process because FP2 is using that intangible property to
manufacture product Z for FP. DC2 is also not treated as the end user of
the patent covering the right to use the manufacturing process and the
manufacturing know-how used to implement the manufacturing method or
process because DC2 does not use the patent or know-how in
manufacturing. DC2, FP, and FP2 are not the end users of the remaining
intangible property under paragraph (d)(2)(ii)(A) of this
[[Page 617]]
section because that intangible property is used in the sale of general
property (the sale of product Z) and DC2, FP, and FP2 are not the end
users of that general property. The unrelated party customers that
purchase the Product Z from DC2 and FP are the end users (as defined in
Sec. 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) of
the intangible property because those customers are the persons that
ultimately use or consume product Z.
(B) Foreign use. Based on the sales of product Z to customers
located within and outside the United States, $72x of the royalties FP
pays DC for rights to the licensed intangible property during the
taxable year (($120x of revenue from sales to customers located outside
the United States divided by $200x total worldwide sales revenue) x
$120x total royalties) qualifies as income earned from the sale of
intangible property for a foreign use under paragraph (d)(2) of this
section and therefore such portion is a FDDEI sale. As a result, $72x of
royalties is included in DC's gross FDDEI for the taxable year.
(8) Example 8: Deemed sale in exchange for contingent payments under
section 367(d)--(i) Facts. DC owns 100 percent of the stock of FP, a
foreign related party with respect to DC. FP manufactures and sells
product A. For the taxable year, DC contributes to FP exclusive
worldwide rights to patents, trademarks, know-how, customer lists, and
goodwill and going concern value (collectively, intangible property)
related to product A in an exchange described in section 351. DC is
required to report an annual income inclusion on its Federal income tax
return based on the productivity, use, or disposition of the contributed
intangible property under section 367(d). DC includes a percentage of
FP's revenue in its gross income under section 367(d) each year. In the
current taxable year, FP earns $1,000x of revenue from sales of product
A. Based on reliable sales records kept by FP for the taxable year,
$300x of FP's revenue is earned from sales of product A to customers
within the United States, and $700x of its revenue is earned from sales
of product A to customers outside the United States.
(ii) Analysis. DC's deemed sale of the intangible property to FP in
exchange for payments contingent upon the productivity, use, or
disposition of the intangible property related to product A under
section 367(d) is a sale for purposes of section 250 and this section.
See Sec. 1.250(b)-3(b)(16). Based on FP's sales records for the taxable
year, 70 percent of DC's deemed sale to FP is for a foreign use, and 70
percent of DC's income inclusion under section 367(d) derived with
respect to such portion is included in DC's gross FDDEI for the taxable
year.
(9) Example 9: License of intangible property followed by a sale of
general property in which the intangible property is embedded; unrelated
parties--(i) Facts. DC owns the worldwide rights to a patent on a
silicon chip used in computers, tablets, and smartphones. The patent
does not qualify as a manufacturing method or process (as defined in
paragraph (d)(2)(ii)(C)(3) of this section). DC licenses the worldwide
rights to the patent to FP in exchange for annual royalties of 30
percent of revenue from sales of the silicon chips. During the taxable
year, FP manufactures silicon chips protected by the patent and sells
all of those chips to FP2 for $1,000x. FP2 also purchases similar
silicon chips from other suppliers. FP2 uses the silicon chips in
computers, tablets, smartphones, and motherboards that FP2 manufactures
in country X and sells to its customers located within the United States
and foreign countries. For purposes of this example, FP2's manufacturing
qualifies as subjecting the silicon chips to manufacture, assembly, or
other processing outside the United States as provided in paragraph
(d)(1)(iii) of this section.
(ii) Analysis. FP is not the end user or treated as an end user (as
defined in Sec. 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this
section) because FP is not the unrelated party recipient of the general
property in which the patent is embedded, and the patent does not
qualify as a manufacturing method or process. Under paragraph
(d)(2)(ii)(A) of this section, revenue from royalties paid for the
patent is earned from end users outside the United States to the extent
the sale of the general property is for a foreign
[[Page 618]]
use under paragraph (d)(1) of this section. Because FP2 is subjecting
the silicon chips to manufacture, assembly, or other processing outside
the United States, the revenue from royalties FP pays to DC qualifies
for foreign use based on the location of FP2's manufacturing and
qualifies as a FDDEI sale. As a result, the entire $300x of annual
royalties paid by FP to DC during the taxable year is included in DC's
gross FDDEI for the taxable year.
(10) Example 10: License of intangible property followed by a sale
of general property in which the intangible property is embedded;
related parties--(i) Facts. The facts are the same as in paragraph
(d)(2)(iv)(B)(9)(i) of this section (the facts in Example 9), except
that FP and FP2 are foreign related parties with respect to DC. FP2
sells and ships computers, tablets, and smartphones it manufactures with
the silicon chips it purchases from FP to unrelated party wholesalers
located within and outside the United States. The wholesalers within the
United States only sell to retailers located within the United States
and the wholesalers outside the United States only sell to retailers
located outside the United States. The retailers within the United
States only sell to customers located within the United States and the
retailers located outside the United States only sell to customers
located outside the United States. FP2 earns $15,000x of revenue from
sales to unrelated party wholesalers located outside the United States
and $10,000x of revenue from sales to unrelated party wholesalers
located within the United States. FP2 also sells and ships motherboards
with the silicon chips it purchases from FP to unrelated party
manufacturers located outside the United States. FP2 does not sell
motherboards with the silicon chips it purchases from FP to unrelated
party manufacturers located within the United States. FP2 earns $5,000x
of revenue from the sales of these motherboards to manufacturers located
outside the United States. For purposes of this example, these
manufacturers subject the motherboards to manufacture, assembly, or
other processing outside the United States as provided in paragraph
(d)(1)(iii) of this section.
(ii) Analysis. FP is not the end user or treated as an end user (as
defined in Sec. 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this
section) of the intangible property because FP is not the end user of
the general property in which the patent is embedded (the silicon
chips). FP2 is also not the end user (as defined in Sec. 1.250(b)-
3(b)(2) and paragraph (d)(2)(ii)(A) of this section) of the intangible
property because FP2 is not the end user of the silicon chips. Under
paragraph (d)(2)(ii)(A) of this section, the customers of the retailers
that purchase from the unrelated party wholesalers are the end users.
Because the wholesalers located outside the United States only sell to
retailers located outside the United States that sell to end users
located outside the United States, the location of the wholesalers is a
reliable basis for determining the location of the end users. Revenue
from royalties paid for the patent is earned from end users outside the
United States to the extent the sale of the general property is for a
foreign use under paragraph (d)(1) of this section. A portion of the
sales to the unrelated party wholesalers qualify as foreign use under
paragraph (d)(1) of this section and the sales to the unrelated party
manufacturers qualify as foreign use under paragraph (d)(1)(iii) of this
section. Accordingly, revenue from royalties FP pays to DC is from a
FDDEI sale to the extent of such sales to the unrelated party
manufacturers and such portion of sales to unrelated party wholesalers
that qualify for foreign use. As a result, $200x of annual royalties
paid by FP to DC during the taxable year ((($15,000x of sales to
wholesalers located outside the United States plus $5,000x of sales to
manufacturers located outside the United States) divided by $30,000x
total sales) x $300x) is included in DC's gross FDDEI for the taxable
year.
(11) Example 11: License of intangible property followed by a sale
of general property that incorporates the intangible property; unrelated
parties with manufacturing within the United States--(i) Facts. The
facts are the same as in paragraph (d)(2)(iv)(B)(9)(i) of this section
(the facts in Example 9), except that FP2 manufactures its computers,
tablets,
[[Page 619]]
smartphones, and motherboards in the United States.
(ii) Analysis. FP is not the end user or treated as an end user (as
defined in Sec. 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this
section) because FP is not the unrelated party recipient of the general
property in which the patent is embedded (the silicon chips) and the
patent does not qualify as a manufacturing method or process. Under
paragraph (d)(2)(ii)(A) of this section, revenue from royalties paid for
the patent is earned from end users outside the United States to the
extent the sale of the general property is for a foreign use under
paragraph (d)(1) of this section. Because FP2 is subjecting the silicon
chips to manufacture, assembly, or other processing within the United
States, the revenue from royalties FP pays to DC does not qualify as
foreign use based on the location of FP2's manufacturing and therefore
does not qualify as a FDDEI sale. As a result, none of the $300x of
annual royalties paid by FP to DC during the taxable year is included in
DC's gross FDDEI for the taxable year.
(12) Example 12: License of intangible property used to provide a
service--(i) Facts. DC licenses to FP worldwide rights to the copyrights
on movies in exchange for an annual royalty of $100x. FP also licenses
copyrights on movies from persons other than DC. FP provides a streaming
service that meets the definition of an electronically supplied service
in Sec. 1.250(b)-5(c)(5) to its customers within the United States and
foreign countries. FP's streaming service provides its customers a
catalog of movies to choose to stream. These movies include the
copyrighted movies FP licenses from DC. FP does not provide DC with data
showing how much revenue FP earned from streaming services during the
taxable year, even after DC requests that FP provide it with such
information. DC also is unable to determine how much revenue FP earned
from streaming services to customers within the United States from the
data it has with respect to FP and publicly available data with respect
to FP. However, DC's economic analysis of the revenue DC expected it
could earn annually from use of the copyrights as part of determining
the annual payments DC would receive from FP from the license of the
copyrights supports a determination that $10,000x of revenue would be
earned during the taxable year from customers worldwide, and that 40
percent of that revenue would be earned from customers located outside
the United States. During an examination of DC's return for the taxable
year, DC provides the IRS with data explaining the economic analysis,
inputs, and results from its valuation of the copyrights used in
determining the amount of annual payments agreed to by DC and FP.
(ii) Analysis. Under paragraph (d)(2)(ii)(B) of this section, FP's
customers are the end users of the copyrights FP licenses from DC
because FP uses those copyrights to provide the general service to FP's
customers. Under paragraph (d)(2)(ii)(B) of this section, revenue from
royalties paid for the copyrights is earned from end users outside the
United States to the extent the service qualifies as a FDDEI service
under Sec. 1.250(b)-5. DC is allowed to use reliable economic analysis
to estimate revenue earned by FP from streaming the licensed movies
under paragraph (d)(2)(iii)(A) of this section because DC was unable to
obtain actual revenue earned by FP from use of the copyrights during the
taxable year after reasonable efforts to obtain the actual revenue data.
Based on DC's reliable economic analysis, $40x of the annual royalty
payment to DC (0.40 x $100x total annual royalty payment) is included in
DC's gross FDDEI for the taxable year.
(13) Example 13: License of intangible property used in research and
development of other intangible property-- (i) Facts. DC owns a patent
(``patent A'') for an active pharmaceutical ingredient (``API'')
approved for treatment of disease A in the United States and in foreign
countries. DC licenses to FP worldwide rights to patent A for an annual
royalty of $100x. FP uses patent A in research and development of a new
API for treatment of disease B. Patent A does not consist of a
manufacturing method or process (as defined in paragraph
(d)(2)(ii)(C)(3) of this section). FP's research and development is
successful, resulting in FP obtaining both
[[Page 620]]
a patent for the new API for treatment of disease B and approval for use
in the United States and foreign countries. FP does not earn any revenue
from sales of finished pharmaceutical products containing the API during
years 1 through 4 of the license of patent A. In year 5 of the license
of patent A, FP earns $800x of revenue from sales of finished
pharmaceutical products containing the API to customers located within
the United States and $200x of revenue from sales to customers located
in foreign countries.
(ii) Analysis. FP is not the end user (as defined in Sec. 1.250(b)-
3(b)(2) and paragraph (d)(2)(ii)(D) of this section) of patent A because
FP is not the end user described in paragraph (d)(2)(ii)(A) of this
section of the product in which the API that was developed from patent A
is embedded. The unrelated party customers that purchase the finished
pharmaceutical product from FP are the end users (as defined in Sec.
1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(D) of this section) because
those customers are the end users described in paragraph (d)(2)(ii)(A)
of this section of the pharmaceutical product in which the newly
developed patent is embedded. During the taxable years that include
years 1 through 4 of the license of patent A, FP earns no revenue from
sales of the API to a foreign person for a foreign use. Under paragraph
(d)(2)(ii)(D) of this section, none of the $100x annual royalty payments
to DC for each of the tax years that include years 1 through 4 of the
license of patent A is included in DC's gross FDDEI. Based on FP's sales
of the API during the tax year that includes year 5 of the license of
patent A, $20x of the annual royalty payment to DC ($200x of revenue
from sales of API to customers located outside the United States divided
by $1,000x total worldwide revenue earned from sales of the API) x $100x
annual royalty) is included in DC's gross FDDEI for the taxable year.
(3) Foreign use substantiation for certain sales of property--(i) In
general. Except as provided in Sec. 1.250(b)-3(f)(3) (relating to
certain loss transactions), a sale of property described in paragraphs
(d)(1)(ii)(C) of this section (foreign use for sale of general property
for resale), (d)(1)(iii) of this section (foreign use for sale of
general property subject to manufacturing, assembly, or processing
outside the United States), or (d)(2) of this section (foreign use for
sale of intangible property) is a FDDEI transaction only if the taxpayer
satisfies the substantiation requirements described in paragraphs
(d)(3)(ii), (iii), or (iv) of this section, as applicable.
(ii) Substantiation of foreign use for resale. A seller satisfies
the substantiation requirements with respect to a sale of property
described in paragraph (d)(1)(ii)(C) of this section (sales of general
property for resale) only if the seller maintains one or more of the
following items--
(A) A binding contract that specifically limits subsequent sales to
sales outside the United States;
(B) Proof that property is specifically designed, labeled, or
adapted for a foreign market;
(C) Proof that the cost of shipping the property back to the United
States relative to the value of the property makes it impractical that
the property will be resold in the United States;
(D) Credible evidence obtained or created in the ordinary course of
business from the recipient evidencing that property will be sold to an
end user outside the United States (or, in the case of sales of fungible
mass property, stating what portion of the property will be sold to end
users outside the United States); or
(E) A written statement prepared by the seller containing the
information described in paragraphs (d)(3)(ii)(E)(1) through (7) of this
section corroborated by evidence that is credible and sufficient to
support the information provided.
(1) The name and address of the recipient;
(2) The date or dates the property was shipped or delivered to the
recipient;
(3) The amount of gross income from the sale;
(4) A full description of the property subject to resale;
(5) A description of the method of sales to the end users, such as
direct sales by the recipient or sales by the recipient to retail
stores;
(6) If known, a description of the end users; and
[[Page 621]]
(7) A description of how the seller determined that property will be
ultimately sold to an end user outside the United States (or, in the
case of sales of fungible mass property, of how the taxpayer determined
what portion of the property that will ultimately be sold to end users
outside the United States).
(iii) Substantiation of foreign use for manufacturing, assembly, or
other processing outside the United States. A seller satisfies the
substantiation requirements with respect to a sale of property described
in paragraph (d)(1)(iii) of this section (sales of general property
subject to manufacturing, assembly, or other processing outside the
United States) if the seller maintains one or more of the following
items--
(A) Credible evidence that the property has been sold to a foreign
unrelated party that is a manufacturer and such property generally
cannot be sold to end users without being subject to a physical and
material change (for example, the sale of raw materials that cannot be
used except in a manufacturing process);
(B) Credible evidence obtained or created in the ordinary course of
business from the recipient to support that the product purchased will
be subject to manufacture, assembly, or other processing outside the
United States within the meaning of paragraph (d)(1)(iii) of this
section; or
(C) A written statement prepared by the seller containing the
information described in paragraphs (d)(3)(iii)(C)(1) through (7) of
this section corroborated by evidence that is credible and sufficient to
support the information provided.
(1) The name and address of the manufacturer of the property;
(2) The date or dates the property was shipped or delivered to the
recipient;
(3) The amount of gross income from the sale;
(4) A full description of the general property sold and the type or
types of finished goods that will incorporate the general property the
taxpayer sold;
(5) A description of the manufacturing, assembly, or other
processing operations, including the location or locations of
manufacture, assembly, or other processing; how the general property
will be used in the finished good; and the nature of the finished good's
manufacturing, assembly, or other processing operations as compared to
the process used to make the general property used to make the finished
good;
(6) A description of how the seller determined the general property
was substantially transformed or the activities were substantial in
nature within the meaning of paragraph (d)(1)(iii)(B) or (C) of this
section, whichever the case may be; and,
(7) If the seller is relying on the rule described in paragraph
(d)(1)(iii)(C) of this section (that the fair market value of the
general property be no more than twenty percent of the fair market value
when incorporated into the finished goods sold to end users), an
explanation of how the seller satisfies the requirements in that
paragraph.
(iv) Substantiation of foreign use of intangible property. A
taxpayer satisfies the substantiation requirements with respect to a
sale of property described in paragraph (d)(2) of this section (foreign
use for intangible property) if the seller maintains one or more of the
following items--
(A) A binding contract that specifically provides that the
intangible property can be exploited solely outside the United States;
(B) Credible evidence obtained or created in the ordinary course of
business from the recipient establishing the portion of its revenue for
a taxable year that was derived from exploiting the intangible property
outside the United States; or
(C) A written statement prepared by the seller containing the
information described in paragraphs (d)(3)(iv)(C)(1) through (9) of this
section corroborated by evidence that is credible and sufficient to
support the information provided.
(1) The name and address of the recipient;
(2) The date of the sale;
(3) The amount of gross income from the sale;
(4) A description of the intangible property;
[[Page 622]]
(5) An explanation of how the intangible property will be used by
the recipient (embedded in general property, used to provide a service,
used as a manufacturing method or process, or used in research and
development);
(6) An explanation of how the seller determined what portion of the
sale is a FDDEI sale;
(7) If the intangible property consists of a manufacturing method or
process, an explanation of how the elements of paragraph (d)(2)(ii)(C)
of this section are satisfied;
(8) If the sale is for periodic payments, an explanation of how the
seller determined the extent of foreign use based on the actual revenue
earned by the recipient from the use of the intangible property for the
taxable year in which a periodic payment is received as required by
paragraph (d)(2)(iii)(A) of this section, or, if actual revenue cannot
be obtained after reasonable efforts, an explanation of why actual
revenue is unavailable and how the seller determined the extent of
foreign use based on estimated revenue; and
(9) If the sale is for a lump sum, an explanation of how the seller
determined the total net present value of revenue it expected to earn
from the exploitation of the intangible property outside the United
States and the total net present value of revenue it expected to earn
from the exploitation of the intangible property as required by
paragraph (d)(2)(iii)(B) of this section.
(v) Examples. The following examples illustrate the application of
this paragraph (d)(3).
(A) Assumed facts. The following facts are assumed for purposes of
the examples--
(1) DC is a domestic corporation.
(2) FP is a foreign person located within Country A that is a
foreign unrelated party with respect to DC.
(3) All of DC's income is DEI.
(4) Except as otherwise provided, the substantive rule for foreign
use as described in paragraphs (d)(1) and (2) of this section are
satisfied.
(B) Examples--
(1) Example 1: Substantiation by seller of sale of products to
distributor outside the United States with taxpayer statement and
corroborating evidence--(i) Facts. DC sells smartphones to FP, a
distributor of electronics that sells property to end users. As part of
their regular business process and pursuant to DC's terms and conditions
of sales, DC issues commercial invoices to FP that contain a condition
that any subsequent sales must be to end users outside the United
States. At or near the time of the FDII filing date, DC prepares a
statement containing the information required in paragraph (d)(3)(ii)(E)
of this section. During an examination of DC's return for the taxable
year, the IRS requests substantiation information of foreign use. DC
submits the commercial invoices issued to FP as supporting information
that FP's customers are end users outside the United States and all
other corroborating evidence to the IRS.
(ii) Analysis. DC's sale to FP is a sale of general property for
resale subject to the substantiation requirements of paragraph
(d)(3)(ii) of this section. DC satisfies the substantiation requirement
by providing the statement that satisfies the requirements of paragraph
(d)(3)(ii)(E) of this section. The commercial invoices issued pursuant
to the terms and conditions of sales sufficiently corroborate DC's
statement that the smartphones will ultimately be sold to end users
outside of the United States.
(2) Example 2: Substantiation of sale of products to distributor
outside the United States with recipient provided information--(i)
Facts. DC sells cameras to FP, a distributor of electronics that sells
property to end users outside the United States. FP issues sales
invoices to its end users. The invoices contain detailed information
about the nature of the subsequent sales of the cameras and the location
of the end users for value added tax (VAT) purposes. DC is able to
obtain copies of FP's VAT invoices with respect to the camera sales that
were maintained and submitted pursuant to Country A law. Rather than
prepare a statement described in paragraph (d)(3)(ii)(E) of this
section, DC submits FP's invoices to the IRS as substantiation of
foreign use.
(ii) Analysis. DC's sale to FP is a sale of general property for
resale subject to the substantiation requirements of paragraph
(d)(3)(ii) of this section. DC
[[Page 623]]
satisfies the substantiation requirements by providing the invoices that
satisfy the requirements of paragraph (d)(3)(ii)(D) of this section. The
VAT invoices issued by FP pursuant to Country A law constitute credible
evidence from FP that ultimate sales are to end users located outside
the United States.
(e) Sales of interests in a disregarded entity. Under Federal income
tax principles, the sale of any interest in an entity that is
disregarded for Federal income tax purposes is considered the sale of
the assets of that entity, and this section applies to the sale of each
such asset that is general property or intangible property for purposes
of determining whether such sale qualifies as a FDDEI sale.
(f) FDDEI sales hedging transactions--(1) In general. The amount of
a corporation's or partnership's gross FDDEI from FDDEI sales of general
property in a taxable year is increased by any gain, or decreased by any
loss, taken into account in that taxable year with respect to any FDDEI
sales hedging transactions (determined by taking into account the
applicable Federal income tax accounting rules, including Sec. 1.446-
4).
(2) FDDEI sales hedging transaction--The term FDDEI sales hedging
transaction means a transaction that meets the requirements of Sec.
1.1221-2(a) through (e) and that is identified in accordance with the
requirements of Sec. 1.1221-2(f), except that the transaction must
manage risk of price changes or currency fluctuations with respect to
ordinary property, as provided in Sec. 1.1221-2(b)(1), and the ordinary
property whose price risk is being hedged must be general property that
is sold in a FDDEI sale.
[T.D. 9901, 85 FR 43080, July 15, 2020, as amended by 85 FR 60910, Sept.
29, 2020; 85 FR 68249, Oct. 28, 2020]
Sec. 1.250(b)-5 Foreign-derived deduction eligible income (FDDEI) services.
(a) Scope. This section provides rules for determining whether a
provision of a service is a FDDEI service. Paragraph (b) of this section
defines a FDDEI service. Paragraph (c) of this section provides
definitions relevant for determining whether a provision of a service is
a FDDEI service. Paragraph (d) of this section provides rules for
determining whether a general service is provided to a consumer located
outside the United States. Paragraph (e) of this section provides rules
for determining whether a general service is provided to a business
recipient located outside the United States. Paragraph (f) of this
section provides rules for determining whether a proximate service is
provided to a recipient located outside the United States. Paragraph (g)
of this section provides rules for determining whether a service is
provided with respect to property located outside the United States.
Paragraph (h) of this section provides rules for determining whether a
transportation service is provided to a recipient, or with respect to
property, located outside the United States.
(b) Definition of FDDEI service. Except as provided in Sec.
1.250(b)-6(d), the term FDDEI service means a provision of a service
described in any one of paragraphs (b)(1) through (5) of this section.
If only a portion of a service is treated as provided to a person, or
with respect to property, outside the United States, the provision of
the service is a FDDEI service only to the extent of the gross income
derived with respect to such portion.
(1) The provision of a general service to a consumer located outside
the United States (as determined under paragraph (d) of this section).
(2) The provision of a general service to a business recipient
located outside the United States (as determined under paragraph (e) of
this section).
(3) The provision of a proximate service to a recipient located
outside the United States (as determined under paragraph (f) of this
section).
(4) The provision of a property service with respect to tangible
property located outside the United States (as determined under
paragraph (g) of this section).
(5) The provision of a transportation service to a recipient, or
with respect to property, located outside the United States (as
determined under paragraph (h) of this section).
(c) Definitions. This paragraph (c) provides definitions that apply
for purposes of this section and Sec. 1.250(b)-6.
[[Page 624]]
(1) Advertising service. The term advertising service means a
general service that consists primarily of transmitting or displaying
content (including via the internet) with a purpose to generate revenue
based on the promotion of a product or service.
(2) Benefit. The term benefit has the meaning set forth in Sec.
1.482-9(l)(3).
(3) Business recipient. The term business recipient means a
recipient other than a consumer and includes all related parties of the
recipient. However, if the recipient is a related party of the taxpayer,
the term does not include the taxpayer.
(4) Consumer. The term consumer means a recipient that is an
individual that purchases a general service for personal use.
(5) Electronically supplied service. The term electronically
supplied service means, with respect to a general service other than an
advertising service, a service that is delivered primarily over the
internet or an electronic network and for which value of the service to
the end user is derived primarily from automation or electronic
delivery. Electronically supplied services include the provision of
access to digital content (as defined in Sec. 1.250(b)-3), such as
streaming content; on-demand network access to computing resources, such
as networks, servers, storage, and software; the provision or support of
a business or personal presence on a network, such as a website or a web
page; online intermediation platform services; services automatically
generated from a computer via the internet or other network in response
to data input by the recipient; and similar services. Electronically
supplied services do not include services that primarily involve the
application of human effort by the renderer (not considering the human
effort involved in the development or maintenance of the technology
enabling the electronically supplied services). Accordingly,
electronically supplied services do not include certain services (such
as legal, accounting, medical, or teaching services) involving primarily
human effort that are provided electronically.
(6) General service. The term general service means any service
other than a property service, proximate service, or transportation
service. The term general service includes advertising services and
electronically supplied services.
(7) Property service. The term property service means a service,
other than a transportation service, provided with respect to tangible
property, but only if substantially all of the service is performed at
the location of the property and results in physical manipulation of the
property such as through manufacturing, assembly, maintenance, or
repair. Substantially all of a service is performed at the location of
property only if the renderer spends more than 80 percent of the time
providing the service at or near the location of the property.
(8) Proximate service. The term proximate service means a service,
other than a property service or a transportation service, provided to a
consumer or business recipient, but only if substantially all of the
service is performed in the physical presence of the consumer or, in the
case of a business recipient, substantially all of the service is
performed in the physical presence of persons working for the business
recipient such as employees, contractors, or agents. Substantially all
of a service is performed in the physical presence of a consumer or
persons working for a business recipient only if the renderer spends
more than 80 percent of the time providing the service in the physical
presence of such persons.
(9) Transportation service. The term transportation service means a
service to transport a person or property using aircraft, railroad
rolling stock, vessel, motor vehicle, or any other mode of
transportation. Transportation services include freight forwarding and
similar services.
(d) General services provided to consumers--(1) In general. A
general service is provided to a consumer located outside the United
States if the consumer of a general service resides outside of the
United States when the service is provided. Except as provided in
paragraph (d)(2) of this section, if the renderer does not have or
cannot after reasonable efforts obtain the consumer's location of
residence when the service is provided, the consumer of a general
[[Page 625]]
service is treated as residing at the location of the consumer's billing
address. However, the rule in the preceding sentence allowing for the
use of a consumer's billing address does not apply if the renderer knows
or has reason to know that the consumer does not reside outside the
United States. A renderer has reason to know that the consumer does not
reside outside the United States if the information received as part of
the provision of the service indicates that the consumer resides in the
United States and the renderer fails to obtain evidence establishing
that the consumer resides outside the United States.
(2) Electronically supplied services. The consumer of an
electronically supplied service is deemed to reside at the location of
the device used to receive the service. Such location may be determined
based on the location of the IP address when the electronically supplied
service is provided. However, if the renderer does not have or cannot
after reasonable efforts obtain the consumer's device location, then the
location of the device is treated as being outside the United States if
the renderer's billing address for the consumer is outside of the United
States, subject to the knowledge and reason to know standards described
in paragraph (d)(1) of this section.
(3) Example. The following example illustrates the application of
paragraph (d) of this section.
(i) Facts. DC, a domestic corporation, provides a streaming movie
service on its website. The terms of the service allow consumers to
watch movies over the internet. The terms of the service permit the
consumer to view the movies for personal use, but convey no ownership of
movies to the consumers.
(ii) Analysis. The streaming service is a FDDEI service under
paragraph (d)(1) of this section to the extent that the service is
provided to consumers that reside outside the United States. The service
that DC provides is a general service, provided to consumers that is an
electronically supplied service under paragraph (c)(5) of this section.
Therefore, the consumers are deemed to reside at the location of the
devices used to receive the service under paragraph (d)(2) of this
section. However, if the renderer cannot reasonably obtain the
consumers' device location (such as IP addresses), the device location
is treated as being outside the United States if their billing addresses
are outside the United States. See Sec. 1.250(b)-4(d)(1)(v)(B)(7) for
an example of digital content provided to consumers as a sale rather
than a service.
(e) General services provided to business recipients--(1) In
general. A general service is provided to a business recipient located
outside the United States to the extent that the service confers a
benefit on the business recipient's operations outside the United States
under the rules in paragraph (e)(2) of this section. The location of
residence, incorporation, or formation of a business recipient is not
relevant to determining the location of the business recipient's
operations that benefit from a general service.
(2) Determination of business operations that benefit from the
service--(i) In general. Except as otherwise provided in paragraph
(e)(2)(ii) and (iii) of this section, the determination of which
operations of the business recipient located outside the United States
benefit from a general service, and the extent to which such operations
benefit, is made under the principles of Sec. 1.482-9 by treating the
taxpayer as one controlled taxpayer, the portions of the business
recipient's operations within the United States (if any) that may
benefit from the general service as one or more controlled taxpayers,
and the portions of the business recipient's operations outside the
United States (if any) that may benefit from the general service, each
as one or more controlled taxpayers. The extent to which a business
recipient's operations within or outside of the United States are
treated as one or more separate controlled taxpayers is determined under
any reasonable method (for example, separate controlled taxpayers may be
determined on a per entity or per country basis, or by aggregating all
of the business recipient's operations outside the United States as one
controlled taxpayer). The determination of the amount of the benefit
conferred on the business recipient's operations that are treated as
controlled taxpayers is determined under a reasonable method consistent
[[Page 626]]
with the principles of Sec. 1.482-9(k), treating the renderer's gross
income from the services provided to the business recipient as if it
were a ``cost'' as that term is used in Sec. 1.482-9(k). Reasonable
methods may include, for example, allocations based on time spent or
costs incurred by the renderer or sales, profits, or assets of the
business recipient. The determination is made when the service is
provided based on information obtained from the business recipient or on
the renderer's own records (such as time spent working with the business
recipient's offices located outside the United States).
(ii) Advertising services. With respect to advertising services, the
operations of the business recipient that benefit from the advertising
service provided by the renderer are deemed to be located where the
advertisements are viewed by individuals. If advertising services are
displayed via the internet, the advertising services are viewed at the
location of the device on which the advertisements are viewed. For this
purpose, the IP address may be used to establish the location of a
device on which an advertisement is viewed.
(iii) Electronically supplied services. With respect to an
electronically supplied service, the operations of the business
recipient that benefit from that service provided by the renderer are
deemed to be located where the business recipient (including employees,
contractors, or agents) accesses or otherwise uses the service. If it
cannot be determined whether the location is within or outside the
United States (such as where the location of access cannot be reliably
determined using the location of the IP address of the device used to
receive the service), and the gross receipts from all services with
respect to the business recipient are in the aggregate less than $50,000
for the renderer's taxable year, the operations of the business
recipient that benefit from the service provided by the renderer are
deemed to be located at the recipient's billing address; otherwise, the
operations of the business recipient that benefit are deemed to be
located in the United States. If the renderer provides a service that is
partially an electronically supplied service and partially a general
service that is not an electronically supplied service (such as a
service that is performed partially online and partially by mail or in
person), the location of the business recipient is determined using the
rule for electronically supplied services in this paragraph (e)(2)(iii)
if the primary purpose of the service is to provide electronically
supplied services; otherwise, the rule for general services described in
paragraph (e)(2)(i) of this section applies.
(3) Identification of business recipient's operations--(i) In
general. For purposes of this paragraph (e), except with respect to
advertising services and electronically supplied services, a business
recipient is treated as having operations where it maintains an office
or other fixed place of business. In general, an office or other fixed
place of business is a fixed facility, that is, a place, site,
structure, or other similar facility, through which the business
recipient engages in a trade or business. For purposes of making the
determination in this paragraph (e)(3)(i), the renderer may make
reliable assumptions based on the information available to it.
(ii) Advertising services and electronically supplied services. The
location of a business recipient that receives advertising services or
electronically supplied services will be determined under the rules of
paragraph (e)(2)(ii) and (iii) of this section, respectively, even if
the business recipient does not maintain an office or other fixed place
of business in the locations where the advertisements are viewed (in the
case of advertising services) or where the general service is accessed
(in the case of electronically supplied services).
(iii) No office or fixed place of business. In the case of general
services other than advertising services and other than electronically
supplied services, if the business recipient does not have an
identifiable office or fixed place of business (including the office of
a principal manager or managing owner), the business recipient is deemed
to be located at its primary billing address.
(4) Substantiation of the location of a business recipient's
operations outside the United States. Except as provided in Sec.
1.250(b)-3(f)(3) (relating to certain loss
[[Page 627]]
transactions), a general service provided to a business recipient is
treated as a FDDEI service only if the renderer substantiates its
determination of the extent to which the service benefits a business
recipient's operations outside the United States. A renderer satisfies
the preceding sentence if the renderer maintains one or more of the
following items--
(i) Credible evidence obtained or created in the ordinary course of
business from the business recipient establishing the extent to which
operations of the business recipient outside the United States benefit
from the service; or
(ii) A written statement prepared by the renderer containing the
information described in paragraphs (e)(4)(ii)(A) through (F) of this
section corroborated by evidence that is credible and sufficient to
support the information provided.
(A) The name of the business recipient;
(B) The date or dates of the service;
(C) The amount of gross income from the service;
(D) A full description of the service;
(E) A description of how the service will benefit the business
recipient; and
(F) An explanation of how the renderer determined what portion of
the service will benefit the business recipient's operations located
outside the United States.
(5) Examples. The following examples illustrate the application of
this paragraph (e).
(i) Assumed facts. The following facts are assumed for purposes of
the examples--
(A) DC is a domestic corporation.
(B) A and R are not related parties of DC.
(C) Except as otherwise provided, the substantiation requirements
described in paragraph (e)(4) of this section are satisfied.
(ii) Examples--
(A) Example 1: Determination of business operations that benefit
from the service--(1) Facts. For the taxable year, DC provides a
consulting service to R, a company that operates restaurants within and
outside of the United States, in exchange for $150x. Fifty percent of
the sales earned by R and its related parties are from customers located
outside of the United States. However, the consulting service that DC
provides relates specifically to a single chain of fast food restaurants
that R operates. Sales information that R provides to DC indicates that
70 percent of the sales of the fast food restaurant chain are from
locations within the United States and 30 percent of the sales are from
Country X. DC determines that the use of sales is a reasonable method
under the principles of Sec. 1.482-9(k) to allocate the benefit of the
consulting service among R's fast food operations.
(2) Analysis. Under paragraph (e)(1) of this section, DC's service
is provided to a person located outside the United States to the extent
that DC's service confers a benefit to R's operations outside the United
States. Under paragraph (e)(2)(i) of this section, DC, R's fast food
operations within the United States, and R's fast food operations in
Country X, are treated as if they were controlled taxpayers because only
these operations may benefit from DC's service. The principles of Sec.
1.482-9(k) apply to determine the amount of DC's service that benefits
R's operations outside the United States. DC's gross income is allocated
based on the sales of the fast food chain of restaurants that benefits
from DC's service because using sales is a reasonable method. Therefore,
30 percent of the provision of the consulting service is treated as the
provision of a service to a person located outside the United States and
a FDDEI service under paragraph (b)(2) of this section. Accordingly,
$45x ($150x x 0.30) of DC's gross income from the provision of the
consulting service is included in DC's gross FDDEI for the taxable year.
(B) Example 2: Determination of business operations that benefit
from the service; alternative facts--(1) Facts. The facts are the same
as in paragraph (e)(5)(ii)(A)(1) of this section (the facts in Example
1), except that DC provides an information technology service to R that
benefits R's entire business. DC determines that the use of sales is a
reasonable method under the principles of Sec. 1.482-9(k) to allocate
the benefit of the information technology service among R's entire
business.
[[Page 628]]
(2) Analysis. DC, R's operations within the United States, and R's
operations in Country X, are treated as if they were controlled
taxpayers because the service that DC provides relates to R's entire
business. DC's gross income is allocated based on sales of the entire
business because using sales is a reasonable method to determine the
amount of DC's service that benefits R's operations outside the United
States under the principles of Sec. 1.482-9(k). Therefore, 50 percent
of the provision of the information technology service is treated as a
service to a person located outside the United States and a FDDEI
service under paragraph (b)(2) of this section. Accordingly, $75x ($150x
x 0.50) of DC's gross income from the provision of the information
technology service is included in DC's gross FDDEI for the taxable year.
(C) Example 3: Advertising services--(1) Facts. The facts are the
same as in paragraph (e)(5)(ii)(A)(1) of this section (the facts in
Example 1), except that DC provides an advertising service to R. DC
displays advertisements for R's restaurant chain on its social media
website and smartphone application. Based on the IP addresses of the
devices on which the advertisements are viewed, 20 percent of the views
of the advertisements were from devices located outside the United
States.
(2) Analysis. Because the service that DC provides is an advertising
service, under paragraph (e)(2)(i) of this section, as modified by
paragraph (e)(2)(ii) of this section, R's operations that benefit from
DC's advertising service are deemed to be where the advertisements are
viewed. Therefore, 20 percent of the provision of the advertising
service is treated as a service to a person located outside the United
States and a FDDEI service under paragraph (b)(2) of this section.
Accordingly, $30x ($150x x 0.20) of DC's gross income from the provision
of the advertising service is included in DC's gross FDDEI for the
taxable year.
(D) Example 4: No reliable information about which operations
benefit from the service or publicly available information--(1) Facts.
For the taxable year, DC provides a consulting service to R, a business-
facing company that does not advertise its business. All of DC's
interaction with R is through R's employees that report to an office in
the United States. Statements made by R's employees indicate that the
service will benefit R's business operations located within and outside
the United States, but do not provide information that would allow DC to
reliably determine the extent to which its service will confer a benefit
on R's business operations located outside the United States.
(2) Analysis. DC is unable to determine the extent to which its
service will confer a benefit on R's business operations located outside
the United States under paragraph (e)(2)(i) of this section.
Accordingly, DC cannot substantiate a determination of the extent to
which the service benefits a business recipient's operations outside the
United States under paragraph (e)(4) of this section. Therefore, no
portion of DC's service is a FDDEI service.
(E) Example 5: Electronically supplied services that are accessed by
the business recipient's employees--(1) Facts. DC provides payroll
services for R. As part of this service, DC maintains a website through
which R can enter payroll information for its employees and through
which R's employees can enter and change their personal information. DC
also causes R's employees' paychecks to be directly deposited into their
bank accounts and pays R's employment taxes on R's behalf. The primary
purpose of the service is to pay R's employees. R has 100 user accounts
that access DC's website. Sixty of the user accounts that access DC's
website access the website from devices that are located outside the
United States and forty of the user accounts access the website from
devices that are located inside the United States.
(2) Analysis. Under paragraph (e)(1) of this section, DC's service
is provided to a person located outside the United States to the extent
that DC's service confers a benefit to R's operations outside the United
States. The service that DC provides to R is an electronically supplied
service under paragraph (c)(5) of this section. Accordingly, under
paragraph (e)(2)(i) of this section, as modified by paragraph
(e)(2)(iii) of this section, R's operations that benefit from DC's
services are
[[Page 629]]
deemed to be located where R accesses the service, which is where R's
employees access the website. See paragraph (e)(2)(iii) of this section.
Accordingly, the portion of the payroll service that is treated as a
service to a person located outside the United States and a FDDEI
service under paragraph (b)(2) of this section is determined based on
the extent to which the locations where R accesses the website are
located outside the United States. Because 60 percent (60/100) of user
accounts access DC's website from locations outside the United States,
60 percent of the provision of the payroll service is treated as a
service to a person located outside the United States and a FDDEI
service under paragraph (b)(2) of this section.
(F) Example 6: Electronically supplied services that are accessed by
the business recipient's customers-- (1) Facts. DC maintains an
inventory management website for R, a company that sells consumer goods
online. R's offices and all of its employees, who use the website, are
located in the United States, but R sells its products to customers both
within and outside the United States.
(2) Analysis. Under paragraph (e)(1) of this section, DC's service
is provided to a person located outside the United States to the extent
that DC's service confers a benefit to R's operations outside the United
States. The service that DC provides to R is an electronically supplied
service under paragraph (c)(5) of this section. Accordingly, under
paragraph (e)(2)(i) of this section, as modified by paragraph
(e)(2)(iii) of this section, R's operations that benefit from DC's
services are deemed to be located where the service is accessed by
employees. Therefore, none of the provision of the inventory management
website is treated as a service to a person located outside the United
States and none is a FDDEI service under paragraph (b)(2) of this
section.
(G) Example 7: Service provided to a domestic person--(1) Facts. A,
a domestic corporation that operates solely in the United States, enters
into a services agreement with R, a company that operates solely outside
the United States. Under the agreement, A agrees to perform a consulting
service for R. A hires DC to provide a service to A that A will use in
the provision of a consulting service to R.
(2) Analysis. Because DC provides a service to A, a person located
within the United States, DC's provision of the service to A is not a
FDDEI service under paragraph (b)(2) of this section, even though the
service is used by A in providing a service to R, a person located
outside the United States. See also section 250(b)(5)(B)(ii). However,
A's provision of the consulting service to R may be a FDDEI service, in
which case A's gross income from the provision of such service would be
included in A's gross FDDEI.
(f) Proximate services. A proximate service is provided to a
recipient located outside the United States if the proximate service is
performed outside the United States. In the case of a proximate service
performed partly within the United States and partly outside of the
United States, a proportionate amount of the service is treated as
provided to a recipient located outside the United States corresponding
to the portion of time the renderer spends providing the service outside
of the United States.
(g) Property services--(1) In general. Except as provided in
paragraph (g)(2) of this section, a property service is provided with
respect to tangible property located outside the United States only if
the property is located outside the United States for the duration of
the period the service is performed.
(2) Exception for services provided with respect to property
temporarily in the United States. A property service is deemed to be
provided with respect to tangible property located outside the United
States if the following conditions are satisfied--
(i) The property is temporarily in the United States for the purpose
of receiving the property service;
(ii) After the completion of the service, the property will be
primarily hangared, stored, or used outside the United States;
(iii) The property is not used to generate revenue in the United
States at any point during the duration of the service; and
[[Page 630]]
(iv) The property is owned by a foreign person that resides or
primarily operates outside the United States.
(h) Transportation services. Except as provided in this paragraph
(h), a transportation service is provided to a recipient, or with
respect to property, located outside the United States only if both the
origin and the destination of the service are outside of the United
States. However, in the case of a transportation service provided to a
recipient, or with respect to property, where either the origin or the
destination of the service is outside of the United States, but not
both, then 50 percent of the gross income from the transportation
service is considered derived from services provided to a recipient, or
with respect to property, located outside the United States.
[T.D. 9901, 85 FR 43080, July 15, 2020, as amended by 85 FR 60910, Sept.
29, 2020; 85 FR 68249, Oct. 28, 2020; T.D. 9959, 87 FR 324, Jan. 4,
2022]
Sec. 1.250(b)-6 Related party transactions.
(a) Scope. This section provides rules for determining whether a
sale of property or a provision of a service to a related party is a
FDDEI transaction. Paragraph (b) of this section provides definitions
relevant for determining whether a sale of property or a provision of a
service to a related party is a FDDEI transaction. Paragraph (c) of this
section provides rules for determining whether a sale of general
property to a foreign related party is a FDDEI sale. Paragraph (d) of
this section provides rules for determining whether the provision of a
general service to a business recipient that is a related party is a
FDDEI service.
(b) Definitions. This paragraph (b) provides definitions that apply
for purposes of this section.
(1) Related party sale. The term related party sale means a sale of
general property to a foreign related party. See Sec. 1.250(b)-
1(e)(3)(ii)(D) (Example 4) for an illustration of a related party sale
in the case of a seller that is a partnership.
(2) Related party service. The term related party service means a
provision of a general service to a business recipient that is a related
party of the renderer and that is described in Sec. 1.250(b)-5(b)(2)
without regard to paragraph (d) of this section.
(3) Unrelated party transaction. The term unrelated party
transaction means, with respect to property purchased by a foreign
related party (the ``purchased property'') in a related party sale from
a seller--
(i) A sale of the purchased property by the foreign related party in
the ordinary course of its business to a foreign unrelated party with
respect to the seller;
(ii) A sale of property by the foreign related party to a foreign
unrelated party with respect to the seller, if the purchased property is
a constituent part of the property sold to the foreign unrelated party;
(iii) A sale of property by the foreign related party to a foreign
unrelated party with respect to the seller, if the purchased property is
not a constituent part of the product sold to the foreign unrelated
party but rather is used in connection with producing the property sold
to the foreign unrelated party; or
(iv) A provision of a service by the foreign related party to a
foreign unrelated party with respect to the seller, if the purchased
property was used in connection with the provision of the service.
(c) Related party sales--(1) In general. A related party sale of
general property is a FDDEI sale only if the requirements described in
either paragraph (c)(1)(i) or (ii) of this section are satisfied with
respect to the related party sale. This paragraph (c) does not apply in
determining whether a sale of intangible property to a foreign related
party is a FDDEI sale.
(i) Sale of property in an unrelated party transaction. A related
party sale is a FDDEI sale if an unrelated party transaction described
in paragraph (b)(3)(i) or (ii) of this section occurs with respect to
the property purchased in the related party sale and such unrelated
party transaction is described in Sec. 1.250(b)-4(b) (definition of
FDDEI sale). The seller in the related party sale may establish that an
unrelated party transaction will occur with respect to the property, or
what portion
[[Page 631]]
of the property will be sold in an unrelated party transaction in the
case of sale of a fungible mass of general property, based on
contractual terms (including, for example, that the related party is
contractually bound to only sell the product to foreign unrelated
parties), past practices of the foreign related party (such as practices
to only sell products to foreign unrelated parties), a showing that the
product sold is designed specifically for a foreign market, or books and
records otherwise evidencing that sales will be made to foreign
unrelated parties.
(ii) Use of property in an unrelated party transaction. A related
party sale is a FDDEI sale if one or more unrelated party transactions
described in paragraph (b)(3)(iii) or (iv) of this section occurs with
respect to the property purchased in the related party sale and such
unrelated party transaction or transactions would be described in Sec.
1.250(b)-4(b) or Sec. 1.250(b)-5(b) (definition of FDDEI service). If
the property purchased in the related party sale will be used in
unrelated party transactions described in the preceding sentence and
other transactions, the amount of gross income from the related party
sale that is attributable to a FDDEI sale is equal to the gross income
from the related party sale multiplied by a fraction, the numerator of
which is the revenue that the related party reasonably expects (as of
the FDII filing date) to earn from all unrelated party transactions with
respect to the property purchased in the related party sale that would
be described in Sec. 1.250(b)-4(b) or Sec. 1.250(b)-5(b) and the
denominator of which is the total revenue that the related party
reasonably expects (as of the FDII filing date) to earn from all
transactions with respect to the property purchased in the related party
sale.
(2) Treatment of foreign related party as seller or renderer. For
purposes of determining whether a sale of property or provision of a
service by a foreign related party is, or would be, described in Sec.
1.250(b)-4(b) or Sec. 1.250(b)-5(b), the foreign related party that
sells the property or provides the service is treated as a seller or
renderer, as applicable, and the foreign unrelated party is treated as
the recipient.
(3) Transactions between related parties. For purposes of
determining whether an unrelated party sale has occurred and satisfies
the requirements of paragraphs (c)(1) or (2) of this section with
respect to a sale to a foreign related party (and not for purposes of
determining whether a sale is to a foreign person as required by Sec.
1.250(b)-4(b)), the seller and all related parties of the seller are
treated as if they are part of a single foreign related party. For
purposes of the preceding sentence, in determining whether a United
States person is a member of the seller's modified affiliated group, and
therefore a related party of the seller, the definition of the term
modified affiliated group in Sec. 1.250(b)-1(c)(17) applies without the
substitution of ``more than 50 percent'' for ``at least 80 percent''
each place it appears. Accordingly, if a foreign related party sells or
uses property purchased in a related party sale in a transaction with a
second related party of the seller, transactions between the second
related party and an unrelated party may be treated as an unrelated
party transaction for purposes of applying paragraph (c)(1) of this
section to a related party sale.
(4) Example. The following example illustrates the application of
this paragraph (c).
(i) Facts. DC, a domestic corporation, sells a machine to FC, a
foreign related party of DC in a transaction described in Sec.
1.250(b)-4(b) (without regard to this paragraph (c)). FC uses the
machine solely to manufacture product A. As of the FDII filing date for
the taxable year, 75 percent of future revenue from sales by FC to
unrelated parties of product A will be from sales that would be
described in Sec. 1.250(b)-4(b).
(ii) Analysis. The sale by DC to FC is a related party sale. Because
FC uses the machine to make product A, but the machine is not a
constituent part of product A because FC does not undertake further
manufacturing with respect to the machine itself, FC's sale of product A
is an unrelated party transaction described in paragraph (b)(3)(iii) of
this section. Therefore, DC's sale of the machine is only a FDDEI sale
if the requirements of paragraph (c)(1)(ii) of this section are
satisfied. Because 75 percent of the revenue from future
[[Page 632]]
sales of product A will be from unrelated party transactions that would
be described in Sec. 1.250(b)-4(b), 75 percent of the revenues from
DC's sale of the machine to FC constitute FDDEI sales.
(d) Related party services--(1) In general. Except as provided in
this paragraph (d)(1), a related party service is a FDDEI service only
if the related party service is not substantially similar to a service
that has been provided or will be provided by the related party to a
person located within the United States. However, if a related party
service is substantially similar to a service provided (in whole or in
part) by the related party to a person located in the United States
solely by reason of paragraph (d)(2)(ii) of this section, the amount of
gross income from the related party service attributable to a FDDEI
service is equal to the difference between the gross income from the
related party service and the amount of the price paid by persons
located within the United States that is attributable to the related
party service. Section 250(b)(5)(C)(ii) and this paragraph (d)(1) apply
only to a general service provided to a related party that is a business
recipient and are not applicable with respect to any other service
provided to a related party.
(2) Substantially similar services. A related party service is
substantially similar to a service provided by the related party to a
person located within the United States only if the related party
service is used by the related party in whole or part to provide a
service to a person located within the United States and either--
(i) 60 percent or more of the benefits conferred by the related
party service are directly used by the related party to confer benefits
on consumers or business recipients located within the United States; or
(ii) 60 percent or more of the price paid by consumers or business
recipients located within the United States for the service provided by
the related party is attributable to the related party service.
(3) Special rules. For purposes of paragraph (d) of this section,
the rules in paragraphs (d)(3)(i) and (ii) of this section apply.
(i) Rules for determining the location of and price paid by
recipients of a service provided by a related party. The location of a
consumer or business recipient with respect to services provided by the
related party is determined under Sec. 1.250(b)-5(d) and (e)(2),
respectively, but treating the related party as the renderer.
Accordingly, if the related party provides a service to a business
recipient, the related party is treated as conferring benefits on a
person located within the United States to the extent that the service
confers a benefit on the business recipient's operations located within
the United States. Similarly, for purposes of applying paragraph
(d)(2)(ii) of this section with respect to business recipients, the
price paid by a business recipient to the related party for services is
allocated proportionally based on the locations of the business
recipient that benefit from the services provided by the related party.
(ii) Rules for allocating the benefits provided by and price paid to
the renderer of a related party service. For purposes of applying
paragraph (d)(2)(i) of this section with respect to benefits that are
directly used by the related party to confer benefits on its recipients,
the benefits provided by the renderer to the related party are allocated
to the related party's consumers or business recipients within the
United States based on the proportion of benefits conferred by the
related party on consumers or business recipients located within the
United States. For purposes of determining the amount of the price paid
by persons located within the United States that is attributable to the
related party service in applying paragraph (d)(2)(ii) of this section,
if the related party provides services that confer benefits on persons
located within the United States and outside the United States, the
price paid for the related party service by the related party to the
renderer is allocated proportionally based on the benefits conferred on
each location by the related party to its recipients.
(4) Examples. The following examples illustrate the application of
this paragraph (d).
[[Page 633]]
(i) Assumed facts. The following facts are assumed for purposes of
the examples--
(A) DC is a domestic corporation.
(B) FC is a foreign corporation and a foreign related party of DC
that operates solely outside the United States.
(C) The service DC provides to FC is a general service provided to a
business recipient located outside the United States as described in
Sec. 1.250(b)-5(b)(2) without regard to the application of paragraph
(d) of this section.
(D) The benefits conferred by DC's service to FC's customers are not
indirect or remote within the meaning of Sec. 1.482-9(l)(3)(ii).
(ii) Examples--
(A) Example 1: Services that are substantially similar services
under paragraph (d)(2)(i) of this section--(1) Facts. FC enters into a
services agreement with R, a company that operates restaurant chains
within and outside the United States. Under the agreement, FC agrees to
furnish a design for the renovation of a chain of restaurants that R
owns; the design will include architectural plans. FC hires DC to
provide an architectural service to FC that FC will use in the provision
of its design service to R. The architectural service that DC provides
to FC will serve no other purpose than to enable FC to provide its
service to R. The service that FC provides will benefit only R's
operations within the United States. FC pays an arm's length price of
$50x to DC for the architectural service and DC recognizes $50x of gross
income from the service. FC incurs additional costs to add additional
design elements to the plans and charges R a total of $100x for its
service.
(2) Analysis. All of the service that DC provides to FC is directly
used in the provision of a service to R because FC uses DC's
architectural service to provide its design service to R, and the
architectural service that DC provides to FC will serve no purpose other
than to enable FC to provide its service to R. In addition, FC is
treated as conferring benefits only to persons located within the United
States under paragraph (d)(3)(i) of this section because only R's
operations within the United States benefit from the service provided by
FC that used the service provided by DC. Therefore, the service provided
by DC to FC is substantially similar to the service provided by FC to R
under paragraph (d)(2)(i) of this section. Accordingly, DC's provision
of the architectural service to FC is not a FDDEI service under
paragraph (d)(1) of this section, and DC's gross income from the
architectural service ($50x) is not included in its gross FDDEI.
(B) Example 2: Services that are not substantially similar services
under paragraph (d)(2)(i) of this section--(1) Facts. The facts are the
same as paragraph (d)(4)(ii)(A)(1) of this section (the facts in Example
1), except that 90 percent of R's operations that will benefit from FC's
service are located outside the United States.
(2) Analysis--(i) Analysis under paragraph (d)(2)(i) of this
section. All of the service that DC provides to FC is directly used in
the provision of a service to R. However, because 90 percent of R's
operations that will benefit from FC's service are located outside the
United States under paragraph (d)(3)(i) of this section, only 10 percent
of the benefits of FC's service are conferred on persons located within
the United States. Further, because FC's service confers a benefit on
R's operations located within and outside the United States, the benefit
provided by DC to FC is allocated proportionately based on the locations
of R that benefit from the services provided by FC under paragraph
(d)(3)(ii) of this section. Therefore, only 10 percent of DC's
architectural service are directly used by FC to confer benefits on
persons located within the United States under paragraph (d)(3)(ii) of
this section. Therefore, the architectural service provided by DC to FC
is not substantially similar to the design service provided by FC to
persons located within the United States under paragraph (d)(2)(i) of
this section.
(C) Example 3: Services that are substantially similar services
under paragraph (d)(2)(ii) of this section--(1) Facts. The facts are the
same as paragraph (d)(4)(ii)(B)(1) of this section (the facts in Example
2), except that FC pays an arm's length price of $75x to DC for the
architectural service and DC recognizes $75x of gross income from the
service. As in paragraph (d)(4)(ii)(A)(1) and
[[Page 634]]
(d)(4)(ii)(B)(1) of this section (the facts in Example 1 and Example 2),
FC charges R a total of $100x for its service.
(2) Analysis--(i) Price paid by persons located within the United
States. Under paragraph (d)(3)(i) of this section, FC is treated as
conferring benefits on a person located within the United States to the
extent that R's operations that will benefit from FC's service are
located within the United States. Further, because FC's service confers
a benefit on R's operations located within and outside the United
States, the price paid by R to FC ($100x) is allocated proportionately
based on the locations of R that benefit from the services provided by
FC under paragraph (d)(3)(i) of this section. Accordingly, because 10
percent of R's operations that will benefit from FC's services are
located within the United States, persons located within the United
States are treated as paying $10x ($100x x 0.10) for FC's services for
purposes of applying the test in paragraph (d)(2)(ii) of this section.
(ii) Amount attributable to the related party service. The service
that FC provides to R is attributable in part to DC's service because FC
uses the architectural plans that DC provides to provide a service to R.
Under paragraph (d)(3)(ii) of this section, because the benefits of the
service provided by FC are conferred on persons located within the
United States and outside the United States, a proportionate amount (10
percent) of the price paid to DC for the related party service ($75x),
or $7.5x, is treated as attributable to the services provided to persons
located within the United States.
(iii) Application of test in paragraph (d)(2)(ii) of this section.
For purposes of applying the test described in paragraph (d)(2)(ii) of
this section, the price paid by persons located within the United States
for the service provided by the related party (FC) is $10x, as
determined in paragraph (d)(4)(ii)(C)(2)(i) of this section (the
analysis of this Example 3). The amount of the price that is
attributable to DC's service is $7.5x, as determined in paragraph
(d)(4)(ii)(C)(2)(ii) of this section (the analysis of this Example 3).
Accordingly, of the price treated as paid to FC by persons located
within the United States, 75 percent ($7.5x/$10x) is attributable to the
related party service. Because more than 60 percent of the price treated
as paid by persons within the United States for FC's service is
attributable to DC's service, the service provided by DC to FC is
substantially similar to the design service provided by FC to persons
located within the United States under paragraph (d)(2)(ii) of this
section.
(iv) Conclusion. Under paragraph (d)(1) of this section, because the
related party service provided by DC is substantially similar to the
service provided by FC to a person located in the United States solely
by reason of paragraph (d)(2)(ii) of this section, the difference
between DC's gross income from the related party service and the amount
of the price paid by persons located within the United States that is
attributable to the related party service is treated as a FDDEI service.
Accordingly, $67.5x ($75x--$7.5x) of DC's gross income from the
provision of the service to FC is treated as a FDDEI service.
[T.D. 9901, 85 FR 43080, July 15, 2020, as amended by 85 FR 60910, Sept.
29, 2020; 85 FR 68250, Oct. 28, 2020]
Items Not Deductible
Sec. 1.261-1 General rule for disallowance of deductions.
In computing taxable income, no deduction shall be allowed, except
as otherwise expressly provided in Chapter 1 of the Code, in respect of
any of the items specified in Part IX (section 262 and following),
Subchapter B, Chapter 1 of the Code, and the regulations thereunder.
Sec. 1.262-1 Personal, living, and family expenses.
(a) In general. In computing taxable income, no deduction shall be
allowed, except as otherwise expressly provided in chapter 1 of the
Code, for personal, living, and family expenses.
(b) Examples of personal, living, and family expenses. Personal,
living, and family expenses are illustrated in the following examples:
(1) Premiums paid for life insurance by the insured are not
deductible. See also section 264 and the regulations thereunder.
[[Page 635]]
(2) The cost of insuring a dwelling owned and occupied by the
taxpayer as a personal residence is not deductible.
(3) Expenses of maintaining a household, including amounts paid for
rent, water, utilities, domestic service, and the like, are not
deductible. A taxpayer who rents a property for residential purposes,
but incidentally conducts business there (his place of business being
elsewhere) shall not deduct any part of the rent. If, however, he uses
part of the house as his place of business, such portion of the rent and
other similar expenses as is properly attributable to such place of
business is deductible as a business expense.
(4) Losses sustained by the taxpayer upon the sale or other
disposition of property held for personal, living, and family purposes
are not deductible. But see section 165 and the regulations thereunder
for deduction of losses sustained to such property by reason of
casualty, etc.
(5) Expenses incurred in traveling away from home (which include
transportation expenses, meals, and lodging) and any other
transportation expenses are not deductible unless they qualify as
expenses deductible under section 162 (relating to trade or business
expenses), section 170 (relating to charitable contributions), section
212 (relating to expenses for production of income), section 213
(relating to medical expenses), or section 217 (relating to moving
expenses), and the regulations under those sections. The taxpayer's
costs of commuting to his place of business or employment are personal
expenses and do not qualify as deductible expenses. For expenses paid or
incurred before October 1, 2014, a taxpayer's expenses for lodging when
not traveling away from home (local lodging) are nondeductible personal
expenses. However, taxpayers may deduct local lodging expenses that
qualify under section 162 and are paid or incurred in taxable years for
which the period of limitation on credit or refund under section 6511
has not expired. For expenses paid or incurred on or after October 1,
2014, a taxpayer's local lodging expenses are personal expenses and are
not deductible unless they qualify as deductible expenses under section
162. Except as permitted under section 162 or 212, the costs of a
taxpayer's meals not incurred in traveling away from home are
nondeductible personal expenses.
(6) Amounts paid as damages for breach of promise to marry, and
attorney's fees and other costs of suit to recover such damages, are not
deductible.
(7) Generally, attorney's fees and other costs paid in connection
with a divorce, separation, or decree for support are not deductible by
either the husband or the wife. However, the part of an attorney's fee
and the part of the other costs paid in connection with a divorce, legal
separation, written separation agreement, or a decree for support, which
are properly attributable to the production or collection of amounts
includible in gross income under section 71 are deductible by the wife
under section 212.
(8) The cost of equipment of a member of the armed services is
deductible only to the extent that it exceeds nontaxable allowances
received for such equipment and to the extent that such equipment is
especially required by his profession and does not merely take the place
of articles required in civilian life. For example, the cost of a sword
is an allowable deduction in computing taxable income, but the cost of a
uniform is not. However, amounts expended by a reservist for the
purchase and maintenance of uniforms which may be worn only when on
active duty for training for temporary periods, when attending service
school courses, or when attending training assemblies are deductible
except to the extent that nontaxable allowances are received for such
amounts.
(9) Expenditures made by a taxpayer in obtaining an education or in
furthering his education are not deductible unless they qualify under
section 162 and Sec. 1.162-5 (relating to trade or business expenses).
(c) Cross references. Certain items of a personal, living, or family
nature are deductible to the extent expressly provided under the
following sections, and the regulations under those sections:
(1) Section 163 (interest).
(2) Section 164 (taxes).
(3) Section 165 (losses).
(4) Section 166 (bad debts).
[[Page 636]]
(5) Section 170 (charitable, etc., contributions and gifts).
(6) Section 213 (medical, dental, etc., expenses).
(7) Section 214 (expenses for care of certain dependents).
(8) Section 215 (alimony, etc., payments).
(9) Section 216 (amounts representing taxes and interest paid to
cooperative housing corporation).
(10) Section 217 (moving expenses).
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 6796, 30 FR
1041, Feb. 2, 1965; T.D. 6918, 32 FR 6681, May 2, 1967; T.D. 7207, 37 FR
20795, Oct. 4, 1972; T.D. 9696, 79 FR 59114, Oct. 1, 2014]
Sec. 1.263(a)-0 Outline of regulations under section 263(a).
This section lists the paragraphs in Sec. Sec. 1.263(a)-1 through
1.263(a)-3 and Sec. 1.263(a)-6.
Sec. 1.263(a)-1 Capital expenditures; in general.
(a) General rule for capital expenditures.
(b) Coordination with other provisions of the Internal Revenue Code.
(c) Definitions.
(1) Amount paid.
(2) Produce.
(d) Examples of capital expenditures.
(e) Amounts paid to sell property.
(1) In general.
(2) Dealer in property.
(3) Examples.
(f) De minimis safe harbor election.
(1) In general.
(i) Taxpayer with applicable financial statement.
(ii) Taxpayer without applicable financial statement.
(iii) Taxpayer with both an applicable financial statement and a
non-qualifying financial statement.
(2) Exceptions to de minimis safe harbor.
(3) Additional rules.
(i) Transaction and other additional costs.
(ii) Materials and supplies.
(iii) Sale or disposition.
(iv) Treatment of de minimis amounts.
(v) Coordination with section 263A.
(vi) Written accounting procedures for groups of entities.
(vii) Combined expensing accounting procedures.
(4) Definition of applicable financial statement.
(5) Time and manner of making election.
(6) Anti-abuse rule.
(7) Examples.
(g) Accounting method changes.
(h) Effective/applicability date.
(1) In general.
(2) Early application of this section.
(i) In general.
(ii) Transition rule for de minimis safe harbor election on 2012 or
2013 returns.
(3) Optional application of TD 9564.
Sec. 1.263(a)-2 Amounts paid to acquire or produce tangible property.
(a) Overview.
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
(4) Produce.
(c) Coordination with other provisions of the Internal Revenue Code.
(1) In general.
(2) Materials and supplies.
(d) Acquired or produced tangible property.
(1) Requirement to capitalize.
(2) Examples.
(e) Defense or perfection of title to property.
(1) In general.
(2) Examples.
(f) Transaction costs.
(1) In general.
(2) Scope of facilitate.
(i) In general.
(ii) Inherently facilitative amounts.
(iii) Special rule for acquisitions of real property.
(A) In general.
(B) Acquisitions of real and personal property in a single
transaction.
(iv) Employee compensation and overhead costs.
(A) In general.
(B) Election to capitalize.
(3) Treatment of transaction costs.
(i) In general.
(ii) Treatment of inherently facilitative amounts allocable to
property not acquired.
(iii) Contingency fees.
(4) Examples.
(g) Treatment of capital expenditures.
(h) Recovery of capitalized amounts.
(1) In general.
(2) Examples.
(i) Accounting method changes.
(j) Effective/applicability date.
(1) In general.
(2) Early application of this section.
(i) In general.
(ii) Transition rule for election to capitalize employee
compensation and overhead costs on 2012 or 2013 returns.
(3) Optional application of TD 9564.
Sec. 1.263(a)-3 Amounts paid to improve tangible property.
(a) Overview.
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
[[Page 637]]
(4) Owner.
(c) Coordination with other provisions of the Internal Revenue Code.
(1) In general.
(2) Materials and supplies.
(3) Example.
(d) Requirement to capitalize amounts paid for improvements.
(e) Determining the unit of property.
(1) In general.
(2) Building.
(i) In general.
(ii) Application of improvement rules to a building.
(A) Building structure.
(B) Building system.
(iii) Condominium.
(A) In general.
(B) Application of improvement rules to a condominium.
(iv) Cooperative.
(A) In general.
(B) Application of improvement rules to a cooperative.
(v) Leased building.
(A) In general.
(B) Application of improvement rules to a leased building.
(1) Entire building.
(2) Portion of building.
(3) Property other than a building.
(i) In general.
(ii) Plant property.
(A) Definition.
(B) Unit of property for plant property.
(iii) Network assets.
(A) Definition.
(B) Unit of property for network assets.
(iv) Leased property other than buildings.
(4) Improvements to property.
(5) Additional rules.
(i) Year placed in service.
(ii) Change in subsequent taxable year.
(6) Examples.
(f) Improvements to leased property.
(1) In general.
(2) Lessee improvements.
(i) Requirement to capitalize.
(ii) Unit of property for lessee improvements.
(3) Lessor improvements.
(i) Requirement to capitalize.
(ii) Unit of property for lessor improvements.
(4) Examples.
(g) Special rules for determining improvement costs.
(1) Certain costs incurred during an improvement.
(i) In general.
(ii) Exception for individuals' residences.
(2) Removal costs.
(i) In general.
(ii) Examples.
(3) Related amounts.
(4) Compliance with regulatory requirements.
(h) Safe harbor for small taxpayers.
(1) In general.
(2) Application with other safe harbor provisions.
(3) Qualifying taxpayer.
(i) In general.
(ii) Application to new taxpayers.
(iii) Treatment of short taxable year.
(iv) Definition of gross receipts.
(4) Eligible building property.
(5) Unadjusted basis.
(i) Eligible building property owned by the taxpayer.
(ii) Eligible building property leased to the taxpayer.
(6) Time and manner of election.
(7) Treatment of safe harbor amounts.
(8) Safe harbor exceeded.
(9) Modification of safe harbor amounts.
(10) Examples.
(i) Safe harbor for routine maintenance.
(1) In general.
(i) Routine maintenance for buildings.
(ii) Routine maintenance for property other than buildings.
(2) Rotable and temporary spare parts.
(3) Exceptions.
(4) Class life.
(5) Coordination with section 263A.
(6) Examples.
(j) Capitalization of betterments.
(1) In general.
(2) Application of betterment rules.
(i) In general.
(ii) Application of betterment rules to buildings.
(iii) Unavailability of replacement parts.
(iv) Appropriate comparison.
(A) In general.
(B) Normal wear and tear.
(C) Damage to property.
(4) Examples.
(k) Capitalization of restorations.
(1) In general.
(2) Application of restorations to buildings.
(3) Exception for losses based on salvage value.
(4) Restoration of damage from casualty.
(i) Limitation.
(ii) Amounts in excess of limitation.
(5) Rebuild to like-new condition.
(6) Replacement of a major component or substantial structural part.
(i) In general.
(A) Major component.
(B) Substantial structural part.
(ii) Major components and substantial structural parts of buildings.
(7) Examples.
(l) Capitalization of amounts to adapt property to a new or
different use.
(1) In general.
(2) Application of adaptation rule to buildings.
(3) Examples.
(m) Optional regulatory accounting method.
[[Page 638]]
(1) In general.
(2) Eligibility for regulatory accounting method.
(3) Description of regulatory accounting method.
(4) Examples.
(n) Election to capitalize repair and maintenance costs.
(1) In general.
(2) Time and manner of election.
(3) Exception.
(4) Examples.
(o) Treatment of capital expenditures.
(p) Recovery of capitalized amounts.
(q) Accounting method changes.
(r) Effective/applicability date.
(1) In general.
(2) Early application of this section.
(i) In general.
(ii) Transition rule for elections on 2012 and 2013 returns.
(3) Optional application of TD 9564.
Sec. 1.263(a)-4 Amounts paid to acquire or create intangibles.
(a) Overview.
(b) Capitalization with respect to intangibles.
(1) In general.
(2) Published guidance.
(3) Separate and distinct intangible asset.
(i) Definition.
(ii) Creation or termination of contract rights.
(iii) Amounts paid in performing services.
(iv) Creation of computer software.
(v) Creation of package design.
(4) Coordination with other provisions of the Internal Revenue Code.
(i) In general.
(ii) Example.
(c) Acquired intangibles.
(1) In general.
(2) Readily available software.
(3) Intangibles acquired from an employee.
(4) Examples.
(d) Created intangibles.
(1) In general.
(2) Financial interests.
(i) In general.
(ii) Amounts paid to create, originate, enter into, renew or
renegotiate.
(iii) Renegotiate.
(iv) Coordination with other provisions of this paragraph (d).
(v) Coordination with Sec. 1.263(a)-5.
(vi) Examples.
(3) Prepaid expenses.
(i) In general.
(ii) Examples.
(4) Certain memberships and privileges.
(i) In general.
(ii) Examples.
(5) Certain rights obtained from a government agency.
(i) In general.
(ii) Examples.
(6) Certain contract rights.
(i) In general.
(ii) Amounts paid to create, originate, enter into, renew or
renegotiate.
(iii) Renegotiate.
(iv) Right.
(v) De minimis amounts.
(vi) Exception for lessee construction allowances.
(vii) Examples.
(7) Certain contract terminations.
(i) In general.
(ii) Certain break-up fees.
(iii) Examples.
(8) Certain benefits arising from the provision, production, or
improvement of real property.
(i) In general.
(ii) Exclusions.
(iii) Real property.
(iv) Impact fees and dedicated improvements.
(v) Examples.
(9) Defense or perfection of title to intangible property.
(i) In general.
(ii) Certain break-up fees.
(iii) Example.
(e) Transaction costs.
(1) Scope of facilitate.
(i) In general.
(ii) Treatment of termination payments.
(iii) Special rule for contracts.
(iv) Borrowing costs.
(v) Special rule for stock redemption costs of open-end regulated
investment companies.
(2) Coordination with paragraph (d) of this section.
(3) Transaction.
(4) Simplifying conventions.
(i) In general.
(ii) Employee compensation.
(iii) De minimis costs.
(iv) Election to capitalize.
(5) Examples.
(f) 12-month rule.
(1) In general.
(2) Duration of benefit for contract terminations.
(3) Inapplicability to created financial interests and self-created
amortizable section 197 intangibles.
(4) Inapplicability to rights of indefinite duration.
(5) Rights subject to renewal.
(i) In general.
(ii) Reasonable expectancy of renewal.
(iii) Safe harbor pooling method.
(6) Coordination with section 461.
(7) Election to capitalize.
(8) Examples.
(g) Treatment of capitalized costs.
(1) In general.
(2) Financial instruments.
(h) Special rules applicable to pooling.
(1) In general.
(2) Method of accounting.
[[Page 639]]
(3) Adopting or changing to a pooling method.
(4) Definition of pool.
(5) Consistency requirement.
(6) Additional guidance pertaining to pooling.
(7) Example.
(i) [Reserved].
(j) Application to accrual method taxpayers.
(k) Treatment of related parties and indirect payments.
(l) Examples.
(m) Amortization.
(n) Intangible interests in land [Reserved]
(o) Effective date.
(p) Accounting method changes.
(1) In general.
(2) Scope limitations.
(3) Section 481(a) adjustment.
Sec. 1.263(a)-5 Amounts paid or incurred to facilitate an acquisition
of a trade or business, a change in the capital structure of a business
entity, and certain other transactions.
(a) General rule.
(b) Scope of facilitate.
(1) In general.
(2) Ordering rules.
(c) Special rules for certain costs.
(1) Borrowing costs.
(2) Costs of asset sales.
(3) Mandatory stock distributions.
(4) Bankruptcy reorganization costs.
(5) Stock issuance costs of open-end regulated investment companies.
(6) Integration costs.
(7) Registrar and transfer agent fees for the maintenance of capital
stock records.
(8) Termination payments and amounts paid to facilitate mutually
exclusive transactions.
(d) Simplifying conventions.
(1) In general.
(2) Employee compensation.
(i) In general.
(ii) Certain amounts treated as employee compensation.
(3) De minimis costs.
(i) In general.
(ii) Treatment of commissions.
(4) Election to capitalize.
(e) Certain acquisitive transactions.
(1) In general.
(2) Exception for inherently facilitative amounts.
(3) Covered transactions.
(f) Documentation of success-based fees.
(g) Treatment of capitalized costs.
(1) Tax-free acquisitive transactions [Reserved].
(2) Taxable acquisitive transactions.
(i) Acquirer.
(ii) Target.
(3) Stock issuance transactions [Reserved].
(4) Borrowings.
(5) Treatment of capitalized amounts by option writer.
(h) Application to accrual method taxpayers.
(i) [Reserved].
(j) Coordination with other provisions of the Internal Revenue Code.
(k) Treatment of indirect payments.
(l) Examples.
(m) Effective date.
(n) Accounting method changes.
(1) In general.
(2) Scope limitations.
(3) Section 481(a) adjustment.
Sec. 1.263(a)-6 Election to deduct or capitalize certain expenditures.
(a) In general.
(b) Election provisions.
(c) Effective/applicability date.
(1) In general.
(2) Early application of this section.
(3) Optional application of TD 9564.
[T.D. 9107, 69 FR 444, Jan. 5, 2004, as amended by T.D. 9564, 76 FR
81100, Dec. 27, 2011; T.D. 9636, 78 FR 57708, Sept. 19, 2013; T.D. 9636,
79 FR 42191, July 21, 2014]
Sec. 1.263(a)-1 Capital expenditures; in general.
(a) General rule for capital expenditures. Except as provided in
chapter 1 of the Internal Revenue Code, no deduction is allowed for--
(1) Any amount paid for new buildings or for permanent improvements
or betterments made to increase the value of any property or estate; or
(2) Any amount paid in restoring property or in making good the
exhaustion thereof for which an allowance is or has been made.
(b) Coordination with other provisions of the Internal Revenue Code.
Nothing in this section changes the treatment of any amount that is
specifically provided for under any provision of the Internal Revenue
Code or the Treasury Regulations other than section 162(a) or section
212 and the regulations under those sections. For example, see section
263A, which requires taxpayers to capitalize the direct and allocable
indirect costs to property produced by the taxpayer and property
acquired for resale. See also section 195 requiring taxpayers to
capitalize certain costs as start-up expenditures.
(c) Definitions. For purposes of this section, the following
definitions apply:
[[Page 640]]
(1) Amount paid. In the case of a taxpayer using an accrual method
of accounting, the terms amount paid and payment mean a liability
incurred (within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability
may not be taken into account under this section prior to the taxable
year during which the liability is incurred.
(2) Produce means construct, build, install, manufacture, develop,
create, raise, or grow. This definition is intended to have the same
meaning as the definition used for purposes of section 263A(g)(1) and
Sec. 1.263A-2(a)(1)(i), except that improvements are excluded from the
definition in this paragraph (c)(2) and are separately defined and
addressed in Sec. 1.263(a)-3.
(d) Examples of capital expenditures. The following amounts paid are
examples of capital expenditures:
(1) An amount paid to acquire or produce a unit of real or personal
tangible property. See Sec. 1.263(a)-2.
(2) An amount paid to improve a unit of real or personal tangible
property. See Sec. 1.263(a)-3.
(3) An amount paid to acquire or create intangibles. See Sec.
1.263(a)-4.
(4) An amount paid or incurred to facilitate an acquisition of a
trade or business, a change in capital structure of a business entity,
and certain other transactions. See Sec. 1.263(a)-5.
(5) An amount paid to acquire or create interests in land, such as
easements, life estates, mineral interests, timber rights, zoning
variances, or other interests in land.
(6) An amount assessed and paid under an agreement between
bondholders or shareholders of a corporation to be used in a
reorganization of the corporation or voluntary contributions by
shareholders to the capital of the corporation for any corporate
purpose. See section 118 and Sec. 1.118-1.
(7) An amount paid by a holding company to carry out a guaranty of
dividends at a specified rate on the stock of a subsidiary corporation
for the purpose of securing new capital for the subsidiary and
increasing the value of its stockholdings in the subsidiary. This amount
must be added to the cost of the stock in the subsidiary.
(e) Amounts paid to sell property--(1) In general. Commissions and
other transaction costs paid to facilitate the sale of property are not
currently deductible under section 162 or 212. Instead, the amounts are
capitalized costs that reduce the amount realized in the taxable year in
which the sale occurs or are taken into account in the taxable year in
which the sale is abandoned if a deduction is permissible. These amounts
are not added to the basis of the property sold or treated as an
intangible asset under Sec. 1.263(a)-4. See Sec. 1.263(a)-5(g) for the
treatment of amounts paid to facilitate the disposition of assets that
constitute a trade or business.
(2) Dealer in property. In the case of a dealer in property, amounts
paid to facilitate the sale of such property are treated as ordinary and
necessary business expenses.
(3) Examples. The following examples, which assume the sale is not
an installment sale under section 453, illustrate the rules of this
paragraph (e):
Example 1. Sales costs of real property A owns a parcel of real
estate. A sells the real estate and pays legal fees, recording fees, and
sales commissions to facilitate the sale. A must capitalize the fees and
commissions and, in the taxable year of the sale, must reduce the amount
realized from the sale of the real estate by the fees and commissions.
Example 2. Sales costs of dealers Assume the same facts as in
Example 1, except that A is a dealer in real estate. The commissions and
fees paid to facilitate the sale of the real estate may be deducted as
ordinary and necessary business expenses under section 162.
Example 3. Sales costs of personal property used in a trade or
business B owns a truck for use in B's trade or business. B decides to
sell the truck on November 15, Year 1. B pays for an appraisal to
determine a reasonable asking price. On February 15, Year 2, B sells the
truck to C. In Year 1, B must capitalize the amount paid to appraise the
truck, and in Year 2, must reduce the amount realized from the sale of
the truck by the amount paid for the appraisal.
Example 4. Costs of abandoned sale of personal property used in a
trade or business Assume the same facts as in Example 3, except that,
instead of selling the truck on February 15, Year 2, B decides on that
date not to sell the truck and takes the truck off the market. In Year
1, B must capitalize the amount paid to appraise the truck. However, B
may recognize the amount paid to appraise the truck as a loss under
section 165 in Year 2, the taxable year when the sale is abandoned.
[[Page 641]]
Example 5. Sales costs of personal property not used in a trade or
business Assume the same facts as in Example 3, except that B does not
use the truck in B's trade or business but instead uses it for personal
purposes. In Year 1, B must capitalize the amount paid to appraise the
truck, and in Year 2, must reduce the amount realized from the sale of
the truck by the amount paid for the appraisal.
Example 6. Costs of abandoned sale of personal property not used in
a trade or business Assume the same facts as in Example 5, except that,
instead of selling the truck on February 15, Year 2, B decides on that
date not to sell the truck and takes the truck off the market. In Year
1, B must capitalize the amount paid to appraise the truck. Although B
abandons the sale in Year 2, B may not treat the amount paid to appraise
the truck as a loss under section 165 because the truck was not used in
B's trade or business or in a transaction entered into for profit.
(f) De minimis safe harbor election--(1) In general. Except as
otherwise provided in paragraph (f)(2) of this section, a taxpayer
electing to apply the de minimis safe harbor under this paragraph (f)
may not capitalize under Sec. 1.263(a)-2(d)(1) or Sec. 1.263(a)-3(d)
any amount paid in the taxable year for the acquisition or production of
a unit of tangible property nor treat as a material or supply under
Sec. 1.162-3(a) any amount paid in the taxable year for tangible
property if the amount specified under this paragraph (f)(1) meets the
requirements of paragraph (f)(1)(i) or (f)(1)(ii) of this section.
However, section 263A and the regulations under section 263A require
taxpayers to capitalize the direct and allocable indirect costs of
property produced by the taxpayer (for example, property improved by the
taxpayer) and property acquired for resale.
(i) Taxpayer with applicable financial statement. A taxpayer
electing to apply the de minimis safe harbor may not capitalize under
Sec. 1.263(a)-2(d)(1) or Sec. 1.263(a)-3(d) nor treat as a material or
supply under Sec. 1.162-3(a) any amount paid in the taxable year for
property described in paragraph (f)(1) of this section if--
(A) The taxpayer has an applicable financial statement (as defined
in paragraph (f)(4) of this section);
(B) The taxpayer has at the beginning of the taxable year written
accounting procedures treating as an expense for non-tax purposes--
(1) Amounts paid for property costing less than a specified dollar
amount; or
(2) Amounts paid for property with an economic useful life (as
defined in Sec. 1.162-3(c)(4)) of 12 months or less;
(C) The taxpayer treats the amount paid for the property as an
expense on its applicable financial statement in accordance with its
written accounting procedures; and
(D) The amount paid for the property does not exceed $5,000 per
invoice (or per item as substantiated by the invoice) or other amount as
identified in published guidance in the Federal Register or in the
Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this
chapter).
(ii) Taxpayer without applicable financial statement. A taxpayer
electing to apply the de minimis safe harbor may not capitalize under
Sec. 1.263(a)-2(d)(1) or Sec. 1.263(a)-3(d) nor treat as a material or
supply under Sec. 1.162-3(a) any amount paid in the taxable year for
property described in paragraph (f)(1) of this section if--
(A) The taxpayer does not have an applicable financial statement (as
defined in paragraph (f)(4) of this section);
(B) The taxpayer has at the beginning of the taxable year accounting
procedures treating as an expense for non-tax purposes--
(1) Amounts paid for property costing less than a specified dollar
amount; or
(2) Amounts paid for property with an economic useful life (as
defined in Sec. 1.162-3(c)(4)) of 12 months or less;
(C) The taxpayer treats the amount paid for the property as an
expense on its books and records in accordance with these accounting
procedures; and
(D) The amount paid for the property does not exceed $500 per
invoice (or per item as substantiated by the invoice) or other amount as
identified in published guidance in the Federal Register or in the
Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this
chapter).
(iii) Taxpayer with both an applicable financial statement and a
non-qualifying financial statement. For purposes of this paragraph
(f)(1), if a taxpayer has an applicable financial statement defined
[[Page 642]]
in paragraph (f)(4) of this section in addition to a financial statement
that does not meet requirements of paragraph (f)(4) of this section, the
taxpayer must meet the requirements of paragraph (f)(1)(i) of this
section to qualify to elect the de minimis safe harbor under this
paragraph (f).
(2) Exceptions to de minimis safe harbor. The de minimis safe harbor
in paragraph (f)(1) of this section does not apply to the following:
(i) Amounts paid for property that is or is intended to be included
in inventory property;
(ii) Amounts paid for land;
(iii) Amounts paid for rotable, temporary, and standby emergency
spare parts that the taxpayer elects to capitalize and depreciate under
Sec. 1.162-3(d); and
(iv) Amounts paid for rotable and temporary spare parts that the
taxpayer accounts for under the optional method of accounting for
rotable parts pursuant to Sec. 1.162-3(e).
(3) Additional rules--(i) Transaction and other additional costs. A
taxpayer electing to apply the de minimis safe harbor under paragraph
(f)(1) of this section is not required to include in the cost of the
tangible property the additional costs of acquiring or producing such
property if these costs are not included in the same invoice as the
tangible property. However, the taxpayer electing to apply the de
minimis safe harbor under paragraph (f)(1) of this section must include
in the cost of such property all additional costs (for example, delivery
fees, installation services, or similar costs) if these additional costs
are included on the same invoice with the tangible property. For
purposes of this paragraph, if the invoice includes amounts paid for
multiple tangible properties and such invoice includes additional
invoice costs related to these multiple properties, then the taxpayer
must allocate the additional invoice costs to each property using a
reasonable method, and each property, including allocable labor and
overhead, must meet the requirements of paragraph (f)(1)(i) or paragraph
(f)(1)(ii) of this section, whichever is applicable. Reasonable
allocation methods include, but are not limited to specific
identification, a pro rata allocation, or a weighted average method
based on the property's relative cost. For purposes of this paragraph
(f)(3)(i), additional costs consist of the costs of facilitating the
acquisition or production of such tangible property under Sec.
1.263(a)-2(f) and the costs for work performed prior to the date that
the tangible property is placed in service under Sec. 1.263(a)-2(d).
(ii) Materials and supplies. If a taxpayer elects to apply the de
minimis safe harbor provided under this paragraph (f), then the taxpayer
must also apply the de minimis safe harbor to amounts paid for all
materials and supplies (as defined under Sec. 1.162-3) that meet the
requirements of Sec. 1.263(a)-1(f). See paragraph (f)(3)(iv) of this
section for treatment of materials and supplies under the de minimis
safe harbor.
(iii) Sale or disposition. Property to which a taxpayer applies the
de minimis safe harbor contained in this paragraph (f) is not treated
upon sale or other disposition as a capital asset under section 1221 or
as property used in the trade or business under section 1231.
(iv) Treatment of de minimis amounts. An amount paid for property to
which a taxpayer properly applies the de minimis safe harbor contained
in this paragraph (f) is not treated as a capital expenditure under
Sec. 1.263(a)-2(d)(1) or Sec. 1.263(a)-3(d) or as a material and
supply under Sec. 1.162-3, and may be deducted under Sec. 1.162-1 in
the taxable year the amount is paid provided the amount otherwise
constitutes an ordinary and necessary expense incurred in carrying on a
trade or business.
(v) Coordination with section 263A. Amounts paid for tangible
property described in paragraph (f)(1) of this section may be subject to
capitalization under section 263A if the amounts paid for tangible
property comprise the direct or allocable indirect costs of other
property produced by the taxpayer or property acquired for resale. See,
for example, Sec. 1.263A-1(e)(3)(ii)(R) requiring taxpayers to
capitalize the cost of tools and equipment allocable to property
produced or property acquired for resale.
[[Page 643]]
(vi) Written accounting procedures for groups of entities. If the
taxpayer's financial results are reported on the applicable financial
statement (as defined in paragraph (f)(4) of this section) for a group
of entities then, for purposes of paragraph (f)(1)(i)(A) of this
section, the group's applicable financial statement may be treated as
the applicable financial statement of the taxpayer, and for purposes of
paragraphs (f)(1)(i)(B) and (f)(1)(i)(C) of this section, the written
accounting procedures provided for the group and utilized for the
group's applicable financial statement may be treated as the written
accounting procedures of the taxpayer.
(vii) Combined expensing accounting procedures. For purposes of
paragraphs (f)(1)(i) and (f)(1)(ii) of this section, if the taxpayer
has, at the beginning of the taxable year, accounting procedures
treating as an expense for non-tax purposes amounts paid for property
costing less than a specified dollar amount and amounts paid for
property with an economic useful life (as defined in Sec. 1.162-
3(c)(4)) of 12 months or less, then a taxpayer electing to apply the de
minimis safe harbor under this paragraph (f) must apply the provisions
of this paragraph (f) to amounts qualifying under either accounting
procedure.
(4) Definition of applicable financial statement. For purposes of
this paragraph (f), the taxpayer's applicable financial statement (AFS)
is the taxpayer's financial statement listed in paragraphs (f)(4)(i)
through (iii) of this section that has the highest priority (including
within paragraph (f)(4)(ii) of this section). The financial statements
are, in descending priority--
(i) A financial statement required to be filed with the Securities
and Exchange Commission (SEC) (the 10-K or the Annual Statement to
Shareholders);
(ii) A certified audited financial statement that is accompanied by
the report of an independent certified public accountant (or in the case
of a foreign entity, by the report of a similarly qualified independent
professional) that is used for--
(A) Credit purposes;
(B) Reporting to shareholders, partners, or similar persons; or
(C) Any other substantial non-tax purpose; or
(iii) A financial statement (other than a tax return) required to be
provided to the federal or a state government or any federal or state
agency (other than the SEC or the Internal Revenue Service).
(5) Time and manner of election. A taxpayer that makes the election
under this paragraph (f) must make the election for all amounts paid
during the taxable year for property described in paragraph (f)(1) of
this section and meeting the requirements of paragraph (f)(1)(i) or
paragraph (f)(1)(ii) of this section, as applicable. A taxpayer makes
the election by attaching a statement to the taxpayer's timely filed
original Federal tax return (including extensions) for the taxable year
in which these amounts are paid. Sections 301.9100-1 through 301.9100-3
of this chapter provide the rules governing extensions of the time to
make regulatory elections. The statement must be titled ``Section
1.263(a)-1(f) de minimis safe harbor election'' and include the
taxpayer's name, address, taxpayer identification number, and a
statement that the taxpayer is making the de minimis safe harbor
election under Sec. 1.263(a)-1(f). In the case of a consolidated group
filing a consolidated income tax return, the election is made for each
member of the consolidated group by the common parent, and the statement
must also include the names and taxpayer identification numbers of each
member for which the election is made. In the case of an S corporation
or a partnership, the election is made by the S corporation or the
partnership and not by the shareholders or partners. An election may not
be made through the filing of an application for change in accounting
method or, before obtaining the Commissioner's consent to make a late
election, by filing an amended Federal tax return. A taxpayer may not
revoke an election made under this paragraph (f). The manner of electing
the de minimis safe harbor under this paragraph (f) may be modified
through guidance of general applicability (see
[[Page 644]]
Sec. Sec. 601.601(d)(2) and 601.602 of this chapter).
(6) Anti-abuse rule. If a taxpayer acts to manipulate transactions
with the intent to achieve a tax benefit or to avoid the application of
the limitations provided under paragraphs (f)(1)(i)(B)(1), (f)(1)(i)(D),
(f)(1)(ii)(B)(1), and (f)(1)(ii)(D) of this section, appropriate
adjustments will be made to carry out the purposes of this section. For
example, a taxpayer is deemed to act to manipulate transactions with an
intent to avoid the purposes and requirements of this section if--
(i) The taxpayer applies the de minimis safe harbor to amounts
substantiated with invoices created to componentize property that is
generally acquired or produced by the taxpayer (or other taxpayers in
the same or similar trade or business) as a single unit of tangible
property; and
(ii) This property, if treated as a single unit, would exceed any of
the limitations provided under paragraphs (f)(1)(i)(B)(1), (f)(1)(i)(D),
(f)(1)(ii)(B)(1), and (f)(1)(ii)(D) of this section, as applicable.
(7) Examples. The following examples illustrate the application of
this paragraph (f). Unless otherwise provided, assume that section 263A
does not apply to the amounts described.
Example 1. De minimis safe harbor; taxpayer without AFS. In Year 1,
A purchases 10 printers at $250 each for a total cost of $2,500 as
indicated by the invoice. Assume that each printer is a unit of property
under Sec. 1.263(a)-3(e). A does not have an AFS. A has accounting
procedures in place at the beginning of Year 1 to expense amounts paid
for property costing less than $500, and A treats the amounts paid for
the printers as an expense on its books and records. The amounts paid
for the printers meet the requirements for the de minimis safe harbor
under paragraph (f)(1)(ii) of this section. If A elects to apply the de
minimis safe harbor under this paragraph (f) in Year 1, A may not
capitalize the amounts paid for the 10 printers or any other amounts
meeting the criteria for the de minimis safe harbor under paragraph
(f)(1). Instead, in accordance with paragraph (f)(3)(iv) of this
section, A may deduct these amounts under Sec. 1.162-1 in the taxable
year the amounts are paid provided the amounts otherwise constitute
deductible ordinary and necessary expenses incurred in carrying on a
trade or business.
Example 2. De minimis safe harbor; taxpayer without AFS. In Year 1,
B purchases 10 computers at $600 each for a total cost of $6,000 as
indicated by the invoice. Assume that each computer is a unit of
property under Sec. 1.263(a)-3(e). B does not have an AFS. B has
accounting procedures in place at the beginning of Year 1 to expense
amounts paid for property costing less than $1,000 and B treats the
amounts paid for the computers as an expense on its books and records.
The amounts paid for the printers do not meet the requirements for the
de minimis safe harbor under paragraph (f)(1)(ii) of this section
because the amount paid for the property exceeds $500 per invoice (or
per item as substantiated by the invoice). B may not apply the de
minimis safe harbor election to the amounts paid for the 10 computers
under paragraph (f)(1) of this section.
Example 3. De minimis safe harbor; taxpayer with AFS. C is a member
of a consolidated group for Federal income tax purposes. C's financial
results are reported on the consolidated applicable financial statements
for the affiliated group. C's affiliated group has a written accounting
policy at the beginning of Year 1, which is followed by C, to expense
amounts paid for property costing $5,000 or less. In Year 1, C pays
$6,250,000 to purchase 1,250 computers at $5,000 each. C receives an
invoice from its supplier indicating the total amount due ($6,250,000)
and the price per item ($5,000). Assume that each computer is a unit of
property under Sec. 1.263(a)-3(e). The amounts paid for the computers
meet the requirements for the de minimis safe harbor under paragraph
(f)(1)(i) of this section. If C elects to apply the de minimis safe
harbor under this paragraph (f) for Year 1, C may not capitalize the
amounts paid for the 1,250 computers or any other amounts meeting the
criteria for the de minimis safe harbor under paragraph (f)(1) of this
section. Instead, in accordance with paragraph (f)(3)(iv) of this
section, C may deduct these amounts under Sec. 1.162-1 in the taxable
year the amounts are paid provided the amounts otherwise constitute
deductible ordinary and necessary expenses incurred in carrying on a
trade or business.
Example 4. De minimis safe harbor; taxpayer with AFS. D is a member
of a consolidated group for Federal income tax purposes. D's financial
results are reported on the consolidated applicable financial statements
for the affiliated group. D's affiliated group has a written accounting
policy at the beginning of Year 1, which is followed by D, to expense
amounts paid for property costing less than $15,000. In Year 1, D pays
$4,800,000 to purchase 800 elliptical machines at $6,000 each. D
receives an invoice from its supplier indicating the total amount due
($4,800,000) and the price per item ($6,000). Assume that each
elliptical machine is a unit of property under Sec. 1.263(a)-3(e). D
may not apply the de minimis safe harbor election to the amounts paid
[[Page 645]]
for the 800 elliptical machines under paragraph (f)(1) of this section
because the amount paid for the property exceeds $5,000 per invoice (or
per item as substantiated by the invoice).
Example 5. De minimis safe harbor; additional invoice costs. E is a
member of a consolidated group for Federal income tax purposes. E's
financial results are reported on the consolidated applicable financial
statements for the affiliated group. E's affiliated group has a written
accounting policy at the beginning of Year 1, which is followed by E, to
expense amounts paid for property costing less than $5,000. In Year 1, E
pays $45,000 for the purchase and installation of wireless routers in
each of its 10 office locations. Assume that each wireless router is a
unit of property under Sec. 1.263(a)-3(e). E receives an invoice from
its supplier indicating the total amount due ($45,000), including the
material price per item ($2,500), and total delivery and installation
($20,000). E allocates the additional invoice costs to the materials on
a pro rata basis, bringing the cost of each router to $4,500 ($2,500
materials + $2,000 labor and overhead). The amounts paid for each
router, including the allocable additional invoice costs, meet the
requirements for the de minimis safe harbor under paragraph (f)(1)(i) of
this section. If E elects to apply the de minimis safe harbor under this
paragraph (f) for Year 1, E may not capitalize the amounts paid for the
10 routers (including the additional invoice costs) or any other amounts
meeting the criteria for the de minimis safe harbor under paragraph
(f)(1) of this section. Instead, in accordance with paragraph (f)(3)(iv)
of this section, E may deduct these amounts under Sec. 1.162-1 in the
taxable year the amounts are paid provided the amounts otherwise
constitute deductible ordinary and necessary expenses incurred in
carrying on a trade or business.
Example 6. De minimis safe harbor; non-invoice additional costs. F
is a corporation that provides consulting services to its customer. F
does not have an AFS, but F has accounting procedures in place at the
beginning of Year 1 to expense amounts paid for property costing less
than $500. In Year 1, F pays $600 to an interior designer to shop for,
evaluate, and make recommendations regarding purchasing new furniture
for F's conference room. As a result of the interior designer's
recommendations, F acquires a conference table for $500 and 10 chairs
for $300 each. In Year 1, F receives an invoice from the interior
designer for $600 for his services, and F receives a separate invoice
from the furniture supplier indicating a total amount due of $500 for
the table and $300 for each chair. For Year 1, F treats the amount paid
for the table and each chair as an expense on its books and records, and
F elects to use the de minimis safe harbor for amounts paid for tangible
property that qualify under the safe harbor. The amount paid to the
interior designer is a cost of facilitating the acquisition of the table
and chairs under Sec. 1.263(a)-2(f). Under paragraph (f)(3)(i) of this
section, F is not required to include in the cost of tangible property
the additional costs of acquiring such property if these costs are not
included in the same invoice as the tangible property. Thus, F is not
required to include a pro rata allocation of the amount paid to the
interior designer to determine the application of the de minimis safe
harbor to the table and the chairs. Accordingly, the amounts paid by F
for the table and each chair meet the requirements for the de minimis
safe harbor under paragraph (f)(1)(ii) of this section, and F may not
capitalize the amounts paid for the table or each chair under paragraph
(f)(1) of this section. In addition, F is not required to capitalize the
amounts paid to the interior designer as a cost that facilitates the
acquisition of tangible property under Sec. 1.263(a)-2(f)(3)(i).
Instead, F may deduct the amounts paid for the table, chairs, and
interior designer under Sec. 1.162-1 in the taxable year the amounts
are paid provided the amounts otherwise constitute deductible ordinary
and necessary expenses incurred in carrying on a trade or business.
Example 7. De minimis safe harbor; 12-month economic useful life. G
operates a restaurant. In Year 1, G purchases 10 hand-held point-of-
service devices at $300 each for a total cost of $3,000 as indicated by
invoice. G also purchases 3 tablet computers at $500 each for a total
cost of $1,500 as indicated by invoice. Assume each point-of-service
device and each tablet computer has an economic useful life of 12 months
or less, beginning when they are used in G's business. Assume that each
device and each tablet is a unit of property under Sec. 1.263(a)-3(e).
G does not have an AFS, but G has accounting procedures in place at the
beginning of Year 1 to expense amounts paid for property costing $300 or
less and to expense amounts paid for property with an economic useful
life of 12 months or less. Thus, G expenses the amounts paid for the
hand-held devices on its books and records because each device costs
$300. G also expenses the amounts paid for the tablet computers on its
books and records because the computers have an economic useful life of
12 months of less, beginning when they are used. The amounts paid for
the hand-held devices and the tablet computers meet the requirements for
the de minimis safe harbor under paragraph (f)(1)(ii) of this section.
If G elects to apply the de minimis safe harbor under this paragraph (f)
in Year 1, G may not capitalize the amounts paid for the hand-held
devices, the tablet computers, or any other amounts meeting the criteria
for the de minimis safe harbor under paragraph (f)(1) of this section.
Instead, in accordance with paragraph
[[Page 646]]
(f)(3)(iv) of this section, G may deduct the amounts paid for the hand-
held devices and tablet computers under Sec. 1.162-1 in the taxable
year the amounts are paid provided the amounts otherwise constitute
deductible ordinary and necessary business expenses incurred in carrying
on a trade or business.
Example 8. De minimis safe harbor; limitation. Assume the facts as
in Example 7, except G purchases the 3 tablet computers at $600 each for
a total cost of $1,800. The amounts paid for the tablet computers do not
meet the de minimis rule safe harbor under paragraphs (f)(1)(ii) and
(f)(3)(vii) of this section because the cost of each computer exceeds
$500. Therefore, the amounts paid for the tablet computers may not be
deducted under the safe harbor.
Example 9. De minimis safe harbor; materials and supplies. H is a
corporation that provides consulting services to its customers. H has an
AFS and a written accounting policy at the beginning of the taxable year
to expense amounts paid for property costing $5,000 or less. In Year 1,
H purchases 1,000 computers at $500 each for a total cost of $500,000.
Assume that each computer is a unit of property under Sec. 1.263(a)-
3(e) and is not a material or supply under Sec. 1.162-3. In addition, H
purchases 200 office chairs at $100 each for a total cost of $20,000 and
250 customized briefcases at $80 each for a total cost of $20,000.
Assume that each office chair and each briefcase is a material or supply
under Sec. 1.162-3(c)(1). H treats the amounts paid for the computers,
office chairs, and briefcases as expenses on its AFS. The amounts paid
for computers, office chairs, and briefcases meet the requirements for
the de minimis safe harbor under paragraph (f)(1)(i) of this section. If
H elects to apply the de minimis safe harbor under this paragraph (f) in
Year 1, H may not capitalize the amounts paid for the 1,000 computers,
the 200 office chairs, and the 250 briefcases under paragraph (f)(1) of
this section. H may deduct the amounts paid for the computers, the
office chairs, and the briefcases under Sec. 1.162-1 in the taxable
year the amounts are paid provided the amounts otherwise constitute
deductible ordinary and necessary expenses incurred in carrying on a
trade or business.
Example 10. De minimis safe harbor; coordination with section 263A.
J is a member of a consolidated group for Federal income tax purposes.
J's financial results are reported on the consolidated AFS for the
affiliated group. J's affiliated group has a written accounting policy
at the beginning of Year 1, which is followed by J, to expense amounts
paid for property costing less than $1,000 or that has an economic
useful life of 12 months or less. In Year 1, J acquires jigs, dies,
molds, and patterns for use in the manufacture of J's products. Assume
each jig, die, mold, and pattern is a unit of property under Sec.
1.263(a)-3(e) and costs less than $1,000. In Year 1, J begins using the
jigs, dies, molds and patterns to manufacture its products. Assume these
items are materials and supplies under Sec. 1.162-3(c)(1)(iii), and J
elects to apply the de minimis safe harbor under paragraph (f)(1)(i) of
this section to amounts qualifying under the safe harbor in Year 1.
Under paragraph (f)(3)(v) of this section, the amounts paid for the
jigs, dies, molds, and patterns may be subject to capitalization under
section 263A if the amounts paid for these tangible properties comprise
the direct or allocable indirect costs of other property produced by the
taxpayer or property acquired for resale.
Example 11. De minimis safe harbor; anti-abuse rule. K is a
corporation that provides hauling services to its customers. In Year 1,
K decides to purchase a truck to use in its business. K does not have an
AFS. K has accounting procedures in place at the beginning of Year 1 to
expense amounts paid for property costing less than $500. K arranges to
purchase a used truck for a total of $1,500. Prior to the acquisition, K
requests the seller to provide multiple invoices for different parts of
the truck. Accordingly, the seller provides K with four invoices during
Year 1--one invoice of $500 for the cab, one invoice of $500 for the
engine, one invoice of $300 for the trailer, and a fourth invoice of
$200 for the tires. K treats the amounts paid under each invoice as an
expense on its books and records. K elects to apply the de minimis safe
harbor under paragraph (f) of this section in Year 1 and does not
capitalize the amounts paid for each invoice pursuant to the safe
harbor. Under paragraph (f)(6) of this section, K has applied the de
minimis rule to amounts substantiated with invoices created to
componentize property that is generally acquired as a single unit of
tangible property in the taxpayer's type of business, and this property,
if treated as single unit, would exceed the limitations provided under
the de minimis rule. Accordingly, K is deemed to manipulate the
transaction to acquire the truck with the intent to avoid the purposes
of this paragraph (f). As a result, K may not apply the de minimis rule
to these amounts and is subject to appropriate adjustments.
(g) Accounting method changes. Except for paragraph (f) of this
section (the de minimis safe harbor election), a change to comply with
this section is a change in method of accounting to which the provisions
of sections 446 and 481 and the accompanying regulations apply. A
taxpayer seeking to change to a method of accounting permitted in this
section must secure the consent of the Commissioner in accordance with
Sec. 1.446-1(e) and follow the administrative procedures issued under
Sec. 1.446-
[[Page 647]]
1(e)(3)(ii) for obtaining the Commissioner's consent to change its
accounting method.
(h) Effective/applicability date--(1) In general. Except for
paragraph (f) of this section, this section generally applies to taxable
years beginning on or after January 1, 2014. Paragraph (f) of this
section applies to amounts paid in taxable years beginning on or after
January 1, 2014. Except as provided in paragraph (h)(1) and paragraph
(h)(2) of this section, Sec. 1.263(a)-1 as contained in 26 CFR part 1
edition revised as of April 1, 2011, applies to taxable years beginning
before January 1, 2014.
(2) Early application of this section--(i) In general. Except for
paragraph (f) of this section, a taxpayer may choose to apply this
section to taxable years beginning on or after January 1, 2012. A
taxpayer may choose to apply paragraph (f) of this section to amounts
paid in taxable years beginning on or after January 1, 2012.
(ii) Transition rule for de minimis safe harbor election on 2012 or
2013 returns. If under paragraph (h)(2)(i) of this section, a taxpayer
chooses to make the election to apply the de minimis safe harbor under
paragraph (f) of this section for amounts paid in its taxable year
beginning on or after January 1, 2012, and ending on or before September
19, 2013 (applicable taxable year), and the taxpayer did not make the
election specified in paragraph (f)(5) of this section on its timely
filed original Federal tax return for the applicable taxable year, the
taxpayer must make the election specified in paragraph (f)(5) of this
section for the applicable taxable year by filing an amended Federal tax
return for the applicable taxable year on or before 180 days from the
due date including extensions of the taxpayer's Federal tax return for
the applicable taxable year, notwithstanding that the taxpayer may not
have extended the due date.
(3) Optional application of TD 9564. A taxpayer may choose to apply
Sec. 1.263(a)-1T as contained in TD 9564 (76 FR 81060) December 27,
2011, to taxable years beginning on or after January 1, 2012, and before
January 1, 2014.
[T.D. 9636, 78 FR 57710, Sept. 19, 2013, as amended by T.D. 9636, 79 FR
42191, July 21, 2014]
Sec. 1.263(a)-2 Amounts paid to acquire or produce tangible property.
(a) Overview. This section provides rules for applying section
263(a) to amounts paid to acquire or produce a unit of real or personal
property. Paragraph (b) of this section contains definitions. Paragraph
(c) of this section contains the rules for coordinating this section
with other provisions of the Internal Revenue Code (Code). Paragraph (d)
of this section provides the general requirement to capitalize amounts
paid to acquire or produce a unit of real or personal property.
Paragraph (e) of this section provides the requirement to capitalize
amounts paid to defend or perfect title to real or personal property.
Paragraph (f) of this section provides the rules for determining the
extent to which taxpayers must capitalize transaction costs related to
the acquisition of tangible property. Paragraphs (g) and (h) of this
section address the treatment and recovery of capital expenditures.
Paragraph (i) of this section provides for changes in methods of
accounting to comply with this section, and paragraph (j) of this
section provides the effective and applicability dates for the rules
under this section.
(b) Definitions. For purposes of this section, the following
definitions apply:
(1) Amount paid. In the case of a taxpayer using an accrual method
of accounting, the terms amount paid and payment mean a liability
incurred (within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability
may not be taken into account under this section prior to the taxable
year during which the liability is incurred.
(2) Personal property means tangible personal property as defined in
Sec. 1.48-1(c).
(3) Real property means land and improvements thereto, such as
buildings or other inherently permanent structures (including items that
are structural components of the buildings or structures) that are not
personal property as defined in paragraph (b)(2) of this section. Any
property that constitutes other tangible property under Sec. 1.48-1(d)
is treated as real property for purposes of this section. Local law is
not controlling in determining whether
[[Page 648]]
property is real property for purposes of this section.
(4) Produce means construct, build, install, manufacture, develop,
create, raise, or grow. This definition is intended to have the same
meaning as the definition used for purposes of section 263A(g)(1) and
Sec. 1.263A-2(a)(1)(i), except that improvements are excluded from the
definition in this paragraph (b)(4) and are separately defined and
addressed in Sec. 1.263(a)-3.
(c) Coordination with other provisions of the Code--(1) In general.
Nothing in this section changes the treatment of any amount that is
specifically provided for under any provision of the Code or the
Treasury Regulations other than section 162(a) or section 212 and the
regulations under those sections. For example, see section 263A
requiring taxpayers to capitalize the direct and allocable indirect
costs of property produced by the taxpayer and property acquired for
resale. See also section 195 requiring taxpayers to capitalize certain
costs as start-up expenditures.
(2) Materials and supplies. Nothing in this section changes the
treatment of amounts paid to acquire or produce property that is
properly treated as materials and supplies under Sec. 1.162-3.
(d) Acquired or produced tangible property--(1) Requirement to
capitalize. Except as provided in Sec. 1.162-3 (relating to materials
and supplies) and in Sec. 1.263(a)-1(f) (providing a de minimis safe
harbor election), a taxpayer must capitalize amounts paid to acquire or
produce a unit of real or personal property (as determined under Sec.
1.263(a)-3(e)), including leasehold improvements, land and land
improvements, buildings, machinery and equipment, and furniture and
fixtures. Section 1.263(a)-3(f) provides the rules for determining
whether amounts are for leasehold improvements. Amounts paid to acquire
or produce a unit of real or personal property include the invoice
price, transaction costs as determined under paragraph (f) of this
section, and costs for work performed prior to the date that the unit of
property is placed in service by the taxpayer (without regard to any
applicable convention under section 168(d)). A taxpayer also must
capitalize amounts paid to acquire real or personal property for resale.
(2) Examples. The following examples illustrate the rules of this
paragraph (d). Unless otherwise provided, assume that the taxpayer does
not elect the de minimis safe harbor under Sec. 1.263(a)-1(f) and that
the property is not acquired for resale under section 263A.
Example 1. Acquisition of personal property. A purchases new cash
registers for use in its retail store located in leased space in a
shopping mall. Assume each cash register is a unit of property as
determined under Sec. 1.263(a)-3(e) and is not a material or supply
under Sec. 1.162-3. A must capitalize under paragraph (d)(1) of this
section the amount paid to acquire each cash register.
Example 2. Acquisition of personal property that is a material or
supply; coordination with Sec. 1.162-3. B operates a fleet of aircraft.
In Year 1, B acquires a stock of component parts, which it intends to
use to maintain and repair its aircraft. Assume that each component part
is a material or supply under Sec. 1.162-3(c)(1) and B does not make
elections under Sec. 1.162-3(d) to treat the materials and supplies as
capital expenditures. In Year 2, B uses the component parts in the
repair and maintenance of its aircraft. Because the parts are materials
and supplies under Sec. 1.162-3, B is not required to capitalize the
amounts paid for the parts under paragraph (d)(1) of this section.
Rather, to determine the treatment of these amounts, B must apply the
rules under Sec. 1.162-3, governing the treatment of materials and
supplies.
Example 3. Acquisition of unit of personal property; coordination
with Sec. 1.162-3. C operates a rental business that rents out a
variety of small individual items to customers (rental items). C
maintains a supply of rental items on hand to replace worn or damaged
items. C purchases a large quantity of rental items to be used in its
business. Assume that each of these rental items is a unit of property
under Sec. 1.263(a)-3(e). Also assume that a portion of the rental
items are materials and supplies under Sec. 1.162-3(c)(1). Under
paragraph (d)(1) of this section, C must capitalize the amounts paid for
the rental items that are not materials and supplies under Sec. 1.162-
3(c)(1). However, C must apply the rules in Sec. 1.162-3 to determine
the treatment of the rental items that are materials and supplies under
Sec. 1.162-3(c)(1).
Example 4. Acquisition or production cost. D purchases and produces
jigs, dies, molds, and patterns for use in the manufacture of D's
products. Assume that each of these items is a unit of property as
determined under Sec. 1.263(a)-3(e) and is not a material and supply
under Sec. 1.162-3(c)(1). D is required to capitalize under paragraph
(d)(1) of this section
[[Page 649]]
the amounts paid to acquire and produce the jigs, dies, molds, and
patterns.
Example 5. Acquisition of land. F purchases a parcel of undeveloped
real estate. F must capitalize under paragraph (d)(1) of this section
the amount paid to acquire the real estate. See paragraph (f) of this
section for the treatment of amounts paid to facilitate the acquisition
of real property.
Example 6. Acquisition of building. G purchases a building. G must
capitalize under paragraph (d)(1) of this section the amount paid to
acquire the building. See paragraph (f) of this section for the
treatment of amounts paid to facilitate the acquisition of real
property.
Example 7. Acquisition of property for resale and production of
property for sale; coordination with section 263A. H purchases goods for
resale and produces other goods for sale. H must capitalize under
paragraph (d)(1) of this section the amounts paid to acquire and produce
the goods. See section 263A for the amounts required to be capitalized
to the property produced or to the property acquired for resale.
Example 8. Production of building; coordination with section 263A. J
constructs a building. J must capitalize under paragraph (d)(1) of this
section the amount paid to construct the building. See section 263A for
the costs required to be capitalized to the real property produced by J.
Example 9. Acquisition of assets constituting a trade or business. K
owns tangible and intangible assets that constitute a trade or business.
L purchases all the assets of K in a taxable transaction. L must
capitalize under paragraph (d)(1) of this section the amount paid for
the tangible assets of K. See Sec. 1.263(a)-4 for the treatment of
amounts paid to acquire or create intangibles and Sec. 1.263(a)-5 for
the treatment of amounts paid to facilitate the acquisition of assets
that constitute a trade or business. See section 1060 for special
allocation rules for certain asset acquisitions.
Example 10. Work performed prior to placing the property in service.
In Year 1, M purchases a building for use as a business office. Prior to
placing the building in service, M pays amounts to repair cement steps,
refinish wood floors, patch holes in walls, and paint the interiors and
exteriors of the building. In Year 2, M places the building in service
and begins using the building as its business office. Assume that the
work that M performs does not constitute an improvement to the building
or its structural components under Sec. 1.263(a)-3. Under Sec. 1.263-
3(e)(2)(i), the building and its structural components is a single unit
of property. Under paragraph (d)(1) of this section, the amounts paid
must be capitalized as amounts to acquire the building unit of property
because they were for work performed prior to M's placing the building
in service.
Example 11. Work performed prior to placing the property in service.
In January Year 1, N purchases a new machine for use in an existing
production line of its manufacturing business. Assume that the machine
is a unit of property under Sec. 1.263(a)-3(e) and is not a material or
supply under Sec. 1.162-3. N pays amounts to install the machine, and
after the machine is installed, N pays amounts to perform a critical
test on the machine to ensure that it will operate in accordance with
quality standards. On November 1, Year 1, the critical test is complete,
and N places the machine in service on the production line. N pays
amounts to perform periodic quality control testing after the machine is
placed in service. Under paragraph (d)(1) of this section, the amounts
paid for the installation and the critical test performed before the
machine is placed in service must be capitalized by N as amounts to
acquire the machine. However, amounts paid for periodic quality control
testing after N placed the machine in service are not required to be
capitalized as amounts paid to acquire the machine.
(e) Defense or perfection of title to property--(1) In general.
Amounts paid to defend or perfect title to real or personal property are
amounts paid to acquire or produce property within the meaning of this
section and must be capitalized.
(2) Examples. The following examples illustrate the rule of this
paragraph (e):
Example 1. Amounts paid to contest condemnation X owns real property
located in County. County files an eminent domain complaint condemning a
portion of X's property to use as a roadway. X hires an attorney to
contest the condemnation. The amounts that X paid to the attorney must
be capitalized because they were to defend X's title to the property.
Example 2. Amounts paid to invalidate ordinance. Y is in the
business of quarrying and supplying for sale sand and stone in a certain
municipality. Several years after Y establishes its business, the
municipality in which it is located passes an ordinance that prohibits
the operation of Y's business. Y incurs attorney's fees in a successful
prosecution of a suit to invalidate the municipal ordinance. Y
prosecutes the suit to preserve its business activities and not to
defend Y's title in the property. Therefore, the attorney's fees that Y
paid are not required to be capitalized under paragraph (e)(1) of this
section.
Example 3. Amounts paid to challenge building line. The board of
public works of a municipality establishes a building line across Z's
business property, adversely affecting the value of the property. Z
incurs legal fees in unsuccessfully litigating the establishment
[[Page 650]]
of the building line. The amounts Z paid to the attorney must be
capitalized because they were to defend Z's title to the property.
(f) Transaction costs--(1) In general. Except as provided in Sec.
1.263(a)-1(f)(3)(i) (for purposes of the de minimis safe harbor), a
taxpayer must capitalize amounts paid to facilitate the acquisition of
real or personal property. See Sec. 1.263(a)-5 for the treatment of
amounts paid to facilitate the acquisition of assets that constitute a
trade or business. See Sec. 1.167(a)-5 for allocations of facilitative
costs between depreciable and non-depreciable property.
(2) Scope of facilitate--(i) In general. Except as otherwise
provided in this section, an amount is paid to facilitate the
acquisition of real or personal property if the amount is paid in the
process of investigating or otherwise pursuing the acquisition. Whether
an amount is paid in the process of investigating or otherwise pursuing
the acquisition is determined based on all of the facts and
circumstances. In determining whether an amount is paid to facilitate an
acquisition, the fact that the amount would (or would not) have been
paid but for the acquisition is relevant but is not determinative.
Amounts paid to facilitate an acquisition include, but are not limited
to, inherently facilitative amounts specified in paragraph (f)(2)(ii) of
this section.
(ii) Inherently facilitative amounts. An amount is paid in the
process of investigating or otherwise pursuing the acquisition of real
or personal property if the amount is inherently facilitative. An amount
is inherently facilitative if the amount is paid for--
(A) Transporting the property (for example, shipping fees and moving
costs);
(B) Securing an appraisal or determining the value or price of
property;
(C) Negotiating the terms or structure of the acquisition and
obtaining tax advice on the acquisition;
(D) Application fees, bidding costs, or similar expenses;
(E) Preparing and reviewing the documents that effectuate the
acquisition of the property (for example, preparing the bid, offer,
sales contract, or purchase agreement);
(F) Examining and evaluating the title of property;
(G) Obtaining regulatory approval of the acquisition or securing
permits related to the acquisition, including application fees;
(H) Conveying property between the parties, including sales and
transfer taxes, and title registration costs;
(I) Finders' fees or brokers' commissions, including contingency
fees (defined in paragraph (f)(3)(iii) of this section);
(J) Architectural, geological, survey, engineering, environmental,
or inspection services pertaining to particular properties; or
(K) Services provided by a qualified intermediary or other
facilitator of an exchange under section 1031.
(iii) Special rule for acquisitions of real property--(A) In
general. Except as provided in paragraph (f)(2)(ii) of this section
(relating to inherently facilitative amounts), an amount paid by the
taxpayer in the process of investigating or otherwise pursuing the
acquisition of real property does not facilitate the acquisition if it
relates to activities performed in the process of determining whether to
acquire real property and which real property to acquire.
(B) Acquisitions of real and personal property in a single
transaction. An amount paid by the taxpayer in the process of
investigating or otherwise pursuing the acquisition of personal property
facilitates the acquisition of such personal property, even if such
property is acquired in a single transaction that also includes the
acquisition of real property subject to the special rule set out in
paragraph (f)(2)(iii)(A) of this section. A taxpayer may use a
reasonable allocation method to determine which costs facilitate the
acquisition of personal property and which costs relate to the
acquisition of real property and are subject to the special rule of
paragraph (f)(2)(iii)(A) of this section.
(iv) Employee compensation and overhead costs--(A) In general. For
purposes of paragraph (f) of this section, amounts paid for employee
compensation (within the meaning of Sec. 1.263(a)-4(e)(4)(ii)) and
overhead are treated as amounts that do not facilitate the acquisition
of real or personal property. However, section 263A provides rules
[[Page 651]]
for employee compensation and overhead costs required to be capitalized
to property produced by the taxpayer or to property acquired for resale.
(B) Election to capitalize. A taxpayer may elect to treat amounts
paid for employee compensation or overhead as amounts that facilitate
the acquisition of property. The election is made separately for each
acquisition and applies to employee compensation or overhead, or both.
For example, a taxpayer may elect to treat overhead, but not employee
compensation, as amounts that facilitate the acquisition of property. A
taxpayer makes the election by treating the amounts to which the
election applies as amounts that facilitate the acquisition in the
taxpayer's timely filed original Federal tax return (including
extensions) for the taxable year during which the amounts are paid.
Sections 301.9100-1 through 301.9100-3 of this chapter provide the rules
governing extensions of the time to make regulatory elections. In the
case of an S corporation or a partnership, the election is made by the S
corporation or by the partnership, and not by the shareholders or
partners. A taxpayer may revoke an election made under this paragraph
(f)(2)(iv)(B) with respect to each acquisition only by filing a request
for a private letter ruling and obtaining the Commissioner's consent to
revoke the election. The Commissioner may grant a request to revoke this
election if the taxpayer acted reasonably and in good faith and the
revocation will not prejudice the interests of Government. See generally
Sec. 301.9100-3 of this chapter. The manner of electing and revoking
the election to capitalize under this paragraph (f)(2)(iv)(B) may be
modified through guidance of general applicability (see Sec. Sec.
606.601(d)(2) and 601.602 of this section). An election may not be made
or revoked through the filing of an application for change in accounting
method or, before obtaining the Commissioner's consent to make the late
election or to revoke the election, by filing an amended Federal tax
return.
(3) Treatment of transaction costs--(i) In general. Except as
provided under Sec. 1.263(a)-1(f)(3)(i) (for purposes of the de minimis
safe harbor), all amounts paid to facilitate the acquisition of real or
personal property are capital expenditures. Facilitative amounts
allocable to real or personal property must be included in the basis of
the property acquired.
(ii) Treatment of inherently facilitative amounts allocable to
property not acquired. Inherently facilitative amounts allocable to real
or personal property are capital expenditures related to such property,
even if the property is not eventually acquired. Except for contingency
fees as defined in paragraph (f)(3)(iii) of this section, inherently
facilitative amounts allocable to real or personal property not acquired
may be allocated to those properties and recovered as appropriate in
accordance with the applicable provisions of the Code and the Treasury
Regulations (for example, sections 165, 167, or 168). See paragraph (h)
of this section for the recovery of capitalized amounts.
(iii) Contingency fees. For purposes of this section, a contingency
fee is an amount paid that is contingent on the successful closing of
the acquisition of real or personal property. Contingency fees must be
included in the basis of the property acquired and may not be allocated
to the property not acquired.
(4) Examples. The following examples illustrate the rules of
paragraph (f) of this section. For purposes of these examples, assume
that the taxpayer does not elect the de minimis safe harbor under Sec.
1.263(a)-1(f):
Example 1. Broker's fees to facilitate an acquisition A decides to
purchase a building in which to relocate its offices and hires a real
estate broker to find a suitable building. A pays fees to the broker to
find property for A to acquire. Under paragraph (f)(2)(ii)(I) of this
section, A must capitalize the amounts paid to the broker because these
costs are inherently facilitative of the acquisition of real property.
Example 2. Inspection and survey costs to facilitate an acquisition
B decides to purchase Building X and pays amounts to third-party
contractors for a termite inspection and an environmental survey of
Building X. Under paragraph (f)(2)(ii)(J) of this section, B must
capitalize the amounts paid for the inspection and the survey of the
building because these costs are inherently facilitative of the
acquisition of real property.
Example 3. Moving costs to facilitate an acquisition C purchases all
the assets of D and, in connection with the purchase, hires a
transportation company to move storage
[[Page 652]]
tanks from D's plant to C's plant. Under paragraph (f)(2)(ii)(A) of this
section, C must capitalize the amount paid to move the storage tanks
from D's plant to C's plant because this cost is inherently facilitative
to the acquisition of personal property.
Example 4. Geological and geophysical costs; coordination with other
provisions E is in the business of exploring, purchasing, and developing
properties in the United States for the production of oil and gas. E
considers acquiring a particular property but first incurs costs for the
services of an engineering firm to perform geological and geophysical
studies to determine if the property is suitable for oil or gas
production. Assume that the amounts that E paid to the engineering firm
constitute geological and geophysical expenditures under section 167(h).
Although the amounts that E paid for the geological and geophysical
services are inherently facilitative to the acquisition of real property
under paragraph (f)(2)(ii)(J) of this section, E is not required to
include those amounts in the basis of the real property acquired.
Rather, under paragraph (c) of this section, E must capitalize these
costs separately and amortize such costs as required under section
167(h) (addressing the amortization of geological and geophysical
expenditures).
Example 5. Scope of facilitate F is in the business of providing
legal services to clients. F is interested in acquiring a new conference
table for its office. F hires and incurs fees for an interior designer
to shop for, evaluate, and make recommendations to F regarding which new
table to acquire. Under paragraphs (f)(1) and (2) of this section, F
must capitalize the amounts paid to the interior designer to provide
these services because they are paid in the process of investigating or
otherwise pursuing the acquisition of personal property.
Example 6. Transaction costs allocable to multiple properties G, a
retailer, wants to acquire land for the purpose of building a new
distribution facility for its products. G considers various properties
on Highway X in State Y. G incurs fees for the services of an architect
to advise and evaluate the suitability of the sites for the type of
facility that G intends to construct on the selected site. G must
capitalize the architect fees as amounts paid to acquire land because
these amounts are inherently facilitative to the acquisition of land
under paragraph (f)(2)(ii)(J) of this section.
Example 7. Transaction costs; coordination with section 263A H, a
retailer, wants to acquire land for the purpose of building a new
distribution facility for its products. H considers various properties
on Highway X in State Y. H incurs fees for the services of an architect
to prepare preliminary floor plans for a building that H could construct
at any of the sites. Under these facts, the architect's fees are not
facilitative to the acquisition of land under paragraph (f) of this
section. Therefore, H is not required to capitalize the architect fees
as amounts paid to acquire land. However, the amounts paid for the
architect's fees may be subject to capitalization under section 263A if
these amounts comprise the direct or allocable indirect cost of property
produced by H, such as the building.
Example 8. Special rule for acquisitions of real property J owns
several retail stores. J decides to examine the feasibility of opening a
new store in City X. In October, Year 1, J hires and incurs costs for a
development consulting firm to study City X and perform market surveys,
evaluate zoning and environmental requirements, and make preliminary
reports and recommendations as to areas that J should consider for
purposes of locating a new store. In December, Year 1, J continues to
consider whether to purchase real property in City X and which property
to acquire. J hires, and incurs fees for, an appraiser to perform
appraisals on two different sites to determine a fair offering price for
each site. In March, Year 2, J decides to acquire one of these two sites
for the location of its new store. At the same time, J determines not to
acquire the other site. Under paragraph (f)(2)(iii) of this section, J
is not required to capitalize amounts paid to the development consultant
in Year 1 because the amounts relate to activities performed in the
process of determining whether to acquire real property and which real
property to acquire, and the amounts are not inherently facilitative
costs under paragraph (f)(2)(ii) of this section. However, J must
capitalize amounts paid to the appraiser in Year 1 because the appraisal
costs are inherently facilitative costs under paragraph (f)(2)(ii)(B) of
this section. In Year 2, J must include the appraisal costs allocable to
property acquired in the basis of the property acquired. In addition, J
may recover the appraisal costs allocable to the property not acquired
in accordance with paragraphs (f)(3)(ii) and (h) of this section. See,
for example, Sec. 1.165-2 for losses on the permanent withdrawal of
non-depreciable property.
Example 9. Contingency fee K owns several restaurant properties. K
decides to open a new restaurant in City X. In October, Year 1, K hires
a real estate consultant to identify potential property upon which K may
locate its restaurant, and is obligated to compensate the consultant
upon the acquisition of property. The real estate consultant identifies
three properties, and K decides to acquire one of those properties. Upon
closing of the acquisition of that property, K pays the consultant its
fee. The amount paid to the consultant constitutes a contingency fee
under paragraph (f)(3)(iii) of this section because the payment is
contingent on the successful closing of the acquisition of property.
Accordingly, under paragraph (f)(3)(iii) of
[[Page 653]]
this section, K must include the amount paid to the consultant in the
basis of the property acquired. K is not permitted to allocate the
amount paid between the properties acquired and not acquired.
Example 10. Employee compensation and overhead L, a freight carrier,
maintains an acquisition department whose sole function is to arrange
for the purchase of vehicles and aircraft from manufacturers or other
parties to be used in its freight carrying business. As provided in
paragraph (f)(2)(iv)(A) of this section, L is not required to capitalize
any portion of the compensation paid to employees in its acquisition
department or any portion of its overhead allocable to its acquisition
department. However, under paragraph (f)(2)(iv)(B) of this section, L
may elect to capitalize the compensation and/or overhead costs allocable
to the acquisition of a vehicle or aircraft by treating these amounts as
costs that facilitate the acquisition of that property in its timely
filed original Federal tax return for the year the amounts are paid.
(g) Treatment of capital expenditures. Amounts required to be
capitalized under this section are capital expenditures and must be
taken into account through a charge to capital account or basis, or in
the case of property that is inventory in the hands of a taxpayer,
through inclusion in inventory costs.
(h) Recovery of capitalized amounts--(1) In general. Amounts that
are capitalized under this section are recovered through depreciation,
cost of goods sold, or by an adjustment to basis at the time the
property is placed in service, sold, used, or otherwise disposed of by
the taxpayer. Cost recovery is determined by the applicable provisions
of the Code and regulations relating to the use, sale, or disposition of
property.
(2) Examples. The following examples illustrate the rule of
paragraph (h)(1) of this section. For purposes of these examples, assume
that the taxpayer does not elect the de minimis safe harbor under Sec.
1.263(a)-1(f).
Example 1. Recovery when property placed in service X owns a 10-unit
apartment building. The refrigerator in one of the apartments stops
functioning, and X purchases a new refrigerator to replace the old one.
X pays for the acquisition, delivery, and installation of the new
refrigerator. Assume that the refrigerator is the unit of property, as
determined under Sec. 1.263(a)-3(e), and is not a material or supply
under Sec. 1.162-3. Under paragraph (d)(1) of this section, X is
required to capitalize the amounts paid for the acquisition, delivery,
and installation of the refrigerator. Under this paragraph (h), the
capitalized amounts are recovered through depreciation, which begins
when the refrigerator is placed in service by X.
Example 2. Recovery when property used in the production of property
Y operates a plant where it manufactures widgets. Y purchases a tractor
loader to move raw materials into and around the plant for use in the
manufacturing process. Assume that the tractor loader is a unit of
property, as determined under Sec. 1.263(a)-3(e), and is not a material
or supply under Sec. 1.162-3. Under paragraph (d)(1) of this section, Y
is required to capitalize the amounts paid to acquire the tractor
loader. Under this paragraph (h), the capitalized amounts are recovered
through depreciation, which begins when Y places the tractor loader in
service. However, because the tractor loader is used in the production
of property, under section 263A the cost recovery (that is, the
depreciation) may also be capitalized to Y's property produced, and,
consequently, recovered through cost of goods sold. See Sec. 1.263A-
1(e)(3)(ii)(I).
(i) Accounting method changes. Unless otherwise provided under this
section, a change to comply with this section is a change in method of
accounting to which the provisions of sections 446 and 481 and the
accompanying regulations apply. A taxpayer seeking to change to a method
of accounting permitted in this section must secure the consent of the
Commissioner in accordance with Sec. 1.446-1(e) and follow the
administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for
obtaining the Commissioner's consent to change its accounting method.
(j) Effective/applicability date--(1) In general. Except for
paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section, this
section generally applies to taxable years beginning on or after January
1, 2014. Paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this
section apply to amounts paid in taxable years beginning on or after
January 1, 2014. Except as provided in paragraphs (j)(1) and (j)(2) of
this section, Sec. 1.263(a)-2 as contained in 26 CFR part 1 edition
revised as of April 1, 2011, applies to taxable years beginning before
January 1, 2014.
(2) Early application of this section--(i) In general. Except for
paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section of
this section, a taxpayer may choose to apply this section to taxable
years beginning on or after January 1,
[[Page 654]]
2012. A taxpayer may choose to apply paragraphs (f)(2)(iii), (f)(2)(iv),
and (f)(3)(ii) of this section to amounts paid in taxable years
beginning on or after January 1, 2012.
(ii) Transition rule for election to capitalize employee
compensation and overhead costs on 2012 or 2013 returns. If under
paragraph (j)(2)(i) of this section, a taxpayer chooses to make the
election to capitalize employee compensation and overhead costs under
paragraph (f)(2)(iv)(B) of this section for amounts paid in its taxable
year beginning on or after January 1, 2012, and ending on or before
September 19, 2013 (applicable taxable year), and the taxpayer did not
make the election specified in paragraph (f)(2)(iv)(B) of this section
on its timely filed original Federal tax return for the applicable
taxable year, the taxpayer must make the election specified in paragraph
(f)(2)(iv)(B) of this section for the applicable taxable year by filing
an amended Federal tax return for the applicable taxable year on or
before 180 days from the due date including extensions of the taxpayer's
Federal tax return for the applicable taxable year, notwithstanding that
the taxpayer may not have extended the due date.
(3) Optional application of TD 9564. Except for Sec. 1.263(a)-
2T(f)(2)(iii), (f)(2)(iv), (f)(3)(ii), and (g), a taxpayer may choose to
apply Sec. 1.263(a)-2T as contained in TD 9564 (76 FR 81060) December
27, 2011, to taxable years beginning on or after January 1, 2012, and
before January 1, 2014. A taxpayer may choose to apply Sec. 1.263(a)-
2T(f)(2)(iii), (f)(2)(iv), (f)(3)(ii) and (g) as contained in TD 9564
(76 FR 81060) December 27, 2011, to amounts paid in taxable years
beginning on or after January 1, 2012, and before January 1, 2014.
[T.D. 9636, 78 FR 57714, Sept. 19, 2013, as amended by T.D. 9636, 79 FR
42191, July 21, 2014]
Sec. 1.263(a)-3 Amounts paid to improve tangible property.
(a) Overview. This section provides rules for applying section
263(a) to amounts paid to improve tangible property. Paragraph (b) of
this section provides definitions. Paragraph (c) of this section
provides rules for coordinating this section with other provisions of
the Internal Revenue Code (Code). Paragraph (d) of this section provides
the requirement to capitalize amounts paid to improve tangible property
and provides the general rules for determining whether a unit of
property is improved. Paragraph (e) of this section provides the rules
for determining the appropriate unit of property. Paragraph (f) of this
section provides rules for leasehold improvements. Paragraph (g) of this
section provides special rules for determining improvement costs in
particular contexts, including indirect costs incurred during an
improvement, removal costs, aggregation of related costs, and regulatory
compliance costs. Paragraph (h) of this section provides a safe harbor
for small taxpayers. Paragraph (i) provides a safe harbor for routine
maintenance costs. Paragraph (j) of this section provides rules for
determining whether amounts are paid for betterments to the unit of
property. Paragraph (k) of this section provides rules for determining
whether amounts are paid to restore the unit of property. Paragraph (l)
of this section provides rules for amounts paid to adapt the unit of
property to a new or different use. Paragraph (m) of this section
provides an optional regulatory accounting method. Paragraph (n) of this
section provides an election to capitalize repair and maintenance costs
consistent with books and records. Paragraphs (o) and (p) of this
section provide for the treatment and recovery of amounts capitalized
under this section. Paragraphs (q) and (r) of this section provide for
accounting method changes and state the effective/applicability date for
the rules in this section.
(b) Definitions. For purposes of this section, the following
definitions apply:
(1) Amount paid. In the case of a taxpayer using an accrual method
of accounting, the terms amounts paid and payment mean a liability
incurred (within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability
may not be taken into account under this section prior to the taxable
year during which the liability is incurred.
(2) Personal property means tangible personal property as defined in
Sec. 1.48-1(c).
[[Page 655]]
(3) Real property means land and improvements thereto, such as
buildings or other inherently permanent structures (including items that
are structural components of the buildings or structures) that are not
personal property as defined in paragraph (b)(2) of this section. Any
property that constitutes other tangible property under Sec. 1.48-1(d)
is also treated as real property for purposes of this section. Local law
is not controlling in determining whether property is real property for
purposes of this section.
(4) Owner means the taxpayer that has the benefits and burdens of
ownership of the unit of property for Federal income tax purposes.
(c) Coordination with other provisions of the Code--(1) In general.
Nothing in this section changes the treatment of any amount that is
specifically provided for under any provision of the Code or the
regulations other than section 162(a) or section 212 and the regulations
under those sections. For example, see section 263A requiring taxpayers
to capitalize the direct and allocable indirect costs of property
produced and property acquired for resale.
(2) Materials and supplies. A material or supply as defined in Sec.
1.162-3(c)(1) that is acquired and used to improve a unit of tangible
property is subject to this section and is not treated as a material or
supply under Sec. 1.162-3.
(3) Example. The following example illustrates the rules of this
paragraph (c):
Example. Railroad rolling stock X is a railroad that properly treats
amounts paid for the rehabilitation of railroad rolling stock as
deductible expenses under section 263(d). X is not required to
capitalize the amounts paid because nothing in this section changes the
treatment of amounts specifically provided for under section 263(d).
(d) Requirement to capitalize amounts paid for improvements. Except
as provided in paragraph (h) or paragraph (n) of this section or under
Sec. 1.263(a)-1(f), a taxpayer generally must capitalize the related
amounts (as defined in paragraph (g)(3) of this section) paid to improve
a unit of property owned by the taxpayer. However, paragraph (f) of this
section applies to the treatment of amounts paid to improve leased
property. Section 263A provides the requirement to capitalize the direct
and allocable indirect costs of property produced by the taxpayer and
property acquired for resale. Section 1016 provides for the addition of
capitalized amounts to the basis of the property, and section 168
governs the treatment of additions or improvements for depreciation
purposes. For purposes of this section, a unit of property is improved
if the amounts paid for activities performed after the property is
placed in service by the taxpayer--
(1) Are for a betterment to the unit of property (see paragraph (j)
of this section);
(2) Restore the unit of property (see paragraph (k) of this
section); or
(3) Adapt the unit of property to a new or different use (see
paragraph (l) of this section).
(e) Determining the unit of property--(1) In general. The unit of
property rules in this paragraph (e) apply only for purposes of section
263(a) and Sec. Sec. 1.263(a)-1, 1.263(a)-2, 1.263(a)-3, and 1.162-3.
Unless otherwise specified, the unit of property determination is based
upon the functional interdependence standard provided in paragraph
(e)(3)(i) of this section. However, special rules are provided for
buildings (see paragraph (e)(2) of this section), plant property (see
paragraph (e)(3)(ii) of this section), network assets (see paragraph
(e)(3)(iii) of this section), leased property (see paragraph (e)(2)(v)
of this section for leased buildings and paragraph (e)(3)(iv) of this
section for leased property other than buildings), and improvements to
property (see paragraph (e)(4) of this section). Additional rules are
provided if a taxpayer has assigned different MACRS classes or
depreciation methods to components of property or subsequently changes
the class or depreciation method of a component or other item of
property (see paragraph (e)(5) of this section). Property that is
aggregated or subject to a general asset account election or accounted
for in a multiple asset account (that is, pooled) may not be treated as
a single unit of property.
(2) Building--(i) In general. Except as otherwise provided in
paragraphs (e)(4), and (e)(5)(ii) of this section, in the case of a
building (as defined in Sec. 1.48-1(e)(1)), each building and its
structural
[[Page 656]]
components (as defined in Sec. 1.48-1(e)(2)) is a single unit of
property (``building''). Paragraph (e)(2)(iii) of this section provides
the unit of property for condominiums, paragraph (e)(2)(iv) of this
section provides the unit of property for cooperatives, and paragraph
(e)(2)(v) of this section provides the unit of property for leased
buildings.
(ii) Application of improvement rules to a building. An amount is
paid to improve a building under paragraph (d) of this section if the
amount is paid for an improvement under paragraphs (j), (k), or
paragraph (l) of this section to any of the following:
(A) Building structure. A building structure consists of the
building (as defined in Sec. 1.48-1(e)(1)), and its structural
components (as defined in Sec. 1.48-1(e)(2)), other than the structural
components designated as buildings systems in paragraph (e)(2)(ii)(B) of
this section.
(B) Building system. Each of the following structural components (as
defined in Sec. 1.48-1(e)(2)), including the components thereof,
constitutes a building system that is separate from the building
structure, and to which the improvement rules must be applied--
(1) Heating, ventilation, and air conditioning (``HVAC'') systems
(including motors, compressors, boilers, furnace, chillers, pipes,
ducts, radiators);
(2) Plumbing systems (including pipes, drains, valves, sinks,
bathtubs, toilets, water and sanitary sewer collection equipment, and
site utility equipment used to distribute water and waste to and from
the property line and between buildings and other permanent structures);
(3) Electrical systems (including wiring, outlets, junction boxes,
lighting fixtures and associated connectors, and site utility equipment
used to distribute electricity from the property line to and between
buildings and other permanent structures);
(4) All escalators;
(5) All elevators;
(6) Fire-protection and alarm systems (including sensing devices,
computer controls, sprinkler heads, sprinkler mains, associated piping
or plumbing, pumps, visual and audible alarms, alarm control panels,
heat and smoke detection devices, fire escapes, fire doors, emergency
exit lighting and signage, and fire fighting equipment, such as
extinguishers, and hoses);
(7) Security systems for the protection of the building and its
occupants (including window and door locks, security cameras, recorders,
monitors, motion detectors, security lighting, alarm systems, entry and
access systems, related junction boxes, associated wiring and conduit);
(8) Gas distribution system (including associated pipes and
equipment used to distribute gas to and from the property line and
between buildings or permanent structures); and
(9) Other structural components identified in published guidance in
the Federal Register or in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii)(b) of this chapter) that are excepted from the
building structure under paragraph (e)(2)(ii)(A) of this section and are
specifically designated as building systems under this section.
(iii) Condominium--(A) In general. In the case of a taxpayer that is
the owner of an individual unit in a building with multiple units (such
as a condominium), the unit of property (``condominium'') is the
individual unit owned by the taxpayer and the structural components (as
defined in Sec. 1.48-1(e)(2)) that are part of the unit.
(B) Application of improvement rules to a condominium. An amount is
paid to improve a condominium under paragraph (d) of this section if the
amount is paid for an improvement under paragraphs (j), (k), or
paragraph (l) of this section to the building structure (as defined in
paragraph (e)(2)(ii)(A) of this section) that is part of the condominium
or to the portion of any building system (as defined in paragraph
(e)(2)(ii)(B) of this section) that is part of the condominium. In the
case of the condominium management association, the association must
apply the improvement rules to the building structure or to any building
system described under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of
this section.
(iv) Cooperative--(A) In general. In the case of a taxpayer that has
an ownership interest in a cooperative housing
[[Page 657]]
corporation, the unit of property (``cooperative'') is the portion of
the building in which the taxpayer has possessory rights and the
structural components (as defined in Sec. 1.48-1(e)(2)) that are part
of the portion of the building subject to the taxpayer's possessory
rights (cooperative).
(B) Application of improvement rules to a cooperative. An amount is
paid to improve a cooperative under paragraph (d) of this section if the
amount is paid for an improvement under paragraphs (j), (k), or (l) of
this section to the portion of the building structure (as defined in
paragraph (e)(2)(ii)(A) of this section) in which the taxpayer has
possessory rights or to the portion of any building system (as defined
in paragraph (e)(2)(ii)(B) of this section) that is part of the portion
of the building structure subject to the taxpayer's possessory rights.
In the case of a cooperative housing corporation, the corporation must
apply the improvement rules to the building structure or to any building
system as described under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of
this section.
(v) Leased building--(A) In general. In the case of a taxpayer that
is a lessee of all or a portion of a building (such as an office, floor,
or certain square footage), the unit of property (``leased building
property'') is each building and its structural components or the
portion of each building subject to the lease and the structural
components associated with the leased portion.
(B) Application of improvement rules to a leased building. An amount
is paid to improve a leased building property under paragraphs (d) and
(f)(2) of this section if the amount is paid for an improvement, under
paragraphs (j), (k), or (l) of this section, to any of the following:
(1) Entire building. In the case of a taxpayer that is a lessee of
an entire building, the building structure (as defined under paragraph
(e)(2)(ii)(A) of this section) or any building system (as defined under
paragraph (e)(2)(ii)(B) of this section) that is part of the leased
building.
(2) Portion of a building. In the case of a taxpayer that is a
lessee of a portion of a building (such as an office, floor, or certain
square footage), the portion of the building structure (as defined under
paragraph (e)(2)(ii)(A) of this section) subject to the lease or the
portion of any building system (as defined under paragraph (e)(2)(ii)(B)
of this section) subject to the lease.
(3) Property other than building--(i) In general. Except as
otherwise provided in paragraphs (e)(3), (e)(4), (e)(5), and (f)(1) of
this section, in the case of real or personal property other than
property described in paragraph (e)(2) of this section, all the
components that are functionally interdependent comprise a single unit
of property. Components of property are functionally interdependent if
the placing in service of one component by the taxpayer is dependent on
the placing in service of the other component by the taxpayer.
(ii) Plant property--(A) Definition. For purposes of this paragraph
(e), the term plant property means functionally interdependent machinery
or equipment, other than network assets, used to perform an industrial
process, such as manufacturing, generation, warehousing, distribution,
automated materials handling in service industries, or other similar
activities.
(B) Unit of property for plant property. In the case of plant
property, the unit of property determined under the general rule of
paragraph (e)(3)(i) of this section is further divided into smaller
units comprised of each component (or group of components) that performs
a discrete and major function or operation within the functionally
interdependent machinery or equipment.
(iii) Network assets--(A) Definition. For purposes of this paragraph
(e), the term network assets means railroad track, oil and gas
pipelines, water and sewage pipelines, power transmission and
distribution lines, and telephone and cable lines that are owned or
leased by taxpayers in each of those respective industries. The term
includes, for example, trunk and feeder lines, pole lines, and buried
conduit. It does not include property that would be included as building
structure or building systems under paragraphs (e)(2)(ii)(A) and
(e)(2)(ii)(B) of this section, nor does it include separate property
that is adjacent to, but not part of a network asset, such as bridges,
culverts, or tunnels.
[[Page 658]]
(B) Unit of property for network assets. In the case of network
assets, the unit of property is determined by the taxpayer's particular
facts and circumstances except as otherwise provided in published
guidance in the Federal Register or in the Internal Revenue Bulletin
(see Sec. 601.601(d)(2)(ii)(b) of this chapter). For these purposes,
the functional interdependence standard provided in paragraph (e)(3)(i)
of this section is not determinative.
(iv) Leased property other than buildings. In the case of a taxpayer
that is a lessee of real or personal property other than property
described in paragraph (e)(2) of this section, the unit of property for
the leased property is determined under paragraphs (e)(3)(i),(ii),
(iii), and (e)(5) of this section except that, after applying the
applicable rules under those paragraphs, the unit of property may not be
larger than the property subject to the lease.
(4) Improvements to property. An improvement to a unit of property
generally is not a unit of property separate from the unit of property
improved. For the unit of property for lessee improvements, see also
paragraph (f)(2)(ii)) of this section. If a taxpayer elects to treat as
a capital expenditure under Sec. 1.162-3(d) the amount paid for a
rotable spare part, temporary spare part, or standby emergency spare
part, and such part is used in an improvement to a unit of property,
then for purposes of applying paragraph (d) of this section to the unit
of property improved, the part is not a unit of property separate from
the unit of property improved.
(5) Additional rules--(i) Year placed in service. Notwithstanding
the unit of property determination under paragraph (e)(3) of this
section, a component (or a group of components) of a unit property must
be treated as a separate unit of property if, at the time the unit of
property is initially placed in service by the taxpayer, the taxpayer
has properly treated the component as being within a different class of
property under section 168(e) (MACRS classes) than the class of the unit
of property of which the component is a part, or the taxpayer has
properly depreciated the component using a different depreciation method
than the depreciation method of the unit of property of which the
component is a part.
(ii) Change in subsequent taxable year. Notwithstanding the unit of
property determination under paragraphs (e)(2), (3), (4), or (5)(i) of
this section, in any taxable year after the unit of property is
initially placed in service by the taxpayer, if the taxpayer or the
Internal Revenue Service changes the treatment of that property (or any
portion thereof) to a proper MACRS class or a proper depreciation method
(for example, as a result of a cost segregation study or a change in the
use of the property), then the taxpayer must change the unit of property
determination for that property (or the portion thereof) under this
section to be consistent with the change in treatment for depreciation
purposes. Thus, for example, if a portion of a unit of property is
properly reclassified to a MACRS class different from the MACRS class of
the unit of property of which it was previously treated as a part, then
the reclassified portion of the property should be treated as a separate
unit of property for purposes of this section.
(6) Examples. The following examples illustrate the application of
this paragraph (e) and assume that the taxpayer has not made a general
asset account election with regard to property or accounted for property
in a multiple asset account. In addition, unless the facts specifically
indicate otherwise, assume that the additional rules in paragraph (e)(5)
of this section do not apply:
Example 1. Building systems A owns an office building that contains
a HVAC system. The HVAC system incorporates ten roof-mounted units that
service different parts of the building. The roof-mounted units are not
connected and have separate controls and duct work that distribute the
heated or cooled air to different spaces in the building's interior. A
pays an amount for labor and materials for work performed on the roof-
mounted units. Under paragraph (e)(2)(i) of this section, A must treat
the building and its structural components as a single unit of property.
As provided under paragraph (e)(2)(ii) of this section, an amount is
paid to improve a building if it is for an improvement to the building
structure or any designated building system. Under paragraph
(e)(2)(ii)(B)(1) of this section, the entire HVAC system, including all
of the roof-
[[Page 659]]
mounted units and their components, comprise a building system.
Therefore, under paragraph (e)(2)(ii) of this section, if an amount paid
by A for work on the roof-mounted units is an improvement (for example,
a betterment) to the HVAC system, A must treat this amount as an
improvement to the building.
Example 2. Building systems B owns a building that it uses in its
retail business. The building contains two elevator banks in different
locations in its building. Each elevator bank contains three elevators.
B pays an amount for labor and materials for work performed on the
elevators. Under paragraph (e)(2)(i) of this section, B must treat the
building and its structural components as a single unit of property. As
provided under paragraph (e)(2)(ii) of this section, an amount is paid
to improve a building if it is for an improvement to the building
structure or any designated building system. Under paragraph
(e)(2)(ii)(B)(5) of this section, all six elevators, including all their
components, comprise a building system. Therefore, under paragraph
(e)(2)(ii) of this section, if an amount paid by B for work on the
elevators is an improvement (for example, a betterment) to the elevator
system, B must treat this amount as an improvement to the building.
Example 3. Building structure and systems; condominium C owns a
condominium unit in a condominium office building. C uses the
condominium unit in its business of providing medical services. The
condominium unit contains two restrooms, each of which contains a sink,
a toilet, water and drainage pipes and other bathroom fixtures. C pays
an amount for labor and materials to perform work on the pipes, sinks,
toilets, and plumbing fixtures that are part of the condominium. Under
paragraph (e)(2)(iii) of this section, C must treat the individual unit
that it owns, including the structural components that are part of that
unit, as a single unit of property. As provided under paragraph
(e)(2)(iii)(B) of this section, an amount is paid to improve the
condominium if it is for an improvement to the building structure that
is part of the condominium or to a portion of any designated building
system that is part of the condominium. Under paragraph (e)(2)(ii)(B)(2)
of this section, the pipes, sinks, toilets, and plumbing fixtures that
are part of C's condominium comprise the plumbing system for the
condominium. Therefore, under paragraph (e)(2)(iii) of this section, if
an amount paid by C for work on pipes, sinks, toilets, and plumbing
fixtures is an improvement (for example, a betterment) to the portion of
the plumbing system that is part of C's condominium, C must treat this
amount as an improvement to the condominium.
Example 4. Building structure and systems; property other than
buildings D, a manufacturer, owns a building adjacent to its
manufacturing facility that contains office space and related facilities
for D's employees that manage and administer D's manufacturing
operations. The office building contains equipment, such as desks,
chairs, computers, telephones, and bookshelves that are not building
structure or building systems. D pays an amount to add an extension to
the office building. Under paragraph (e)(2)(i) of this section, D must
treat the building and its structural components as a single unit of
property. As provided under paragraph (e)(2)(ii) of this section, an
amount is paid to improve a building if it is for an improvement to the
building structure or any designated building system. Therefore, under
paragraph (e)(2)(ii) of this section, if an amount paid by D for the
addition of an extension to the office building is an improvement (for
example, a betterment) to the building structure or any of the building
systems, D must treat this amount as an improvement to the building. In
addition, because the equipment contained within the office building
constitutes property other than the building, the units of property for
the office equipment are initially determined under paragraph (e)(3)(i)
of this section and are comprised of all the components that are
functionally interdependent (for example, each desk, each chair, and
each book shelf).
Example 5. Plant property; discrete and major function E is an
electric utility company that operates a power plant to generate
electricity. The power plant includes a structure that is not a building
under Sec. 1.48-1(e)(1), and, among other things, one pulverizer that
grinds coal, a single boiler that produces steam, one turbine that
converts the steam into mechanical energy, and one generator that
converts mechanical energy into electrical energy. In addition, the
turbine contains a series of blades that cause the turbine to rotate
when affected by the steam. Because the plant is composed of real and
personal tangible property other than a building, the unit of property
for the generating equipment is initially determined under the general
rule in paragraph (e)(3)(i) of this section and is comprised of all the
components that are functionally interdependent. Under this rule, the
initial unit of property is the entire plant because the components of
the plant are functionally interdependent. However, because the power
plant is plant property under paragraph (e)(3)(ii) of this section, the
initial unit of property is further divided into smaller units of
property by determining the components (or groups of components) that
perform discrete and major functions within the plant. Under this
paragraph, E must treat the structure, the boiler, the turbine, the
generator, and the pulverizer each as a separate
[[Page 660]]
unit of property because each of these components performs a discrete
and major function within the power plant. E may not treat components,
such as the turbine blades, as separate units of property because each
of these components does not perform a discrete and major function
within the plant.
Example 6. Plant property; discrete and major function F is engaged
in a uniform and linen rental business. F owns and operates a plant that
utilizes many different machines and equipment in an assembly line-like
process to treat, launder, and prepare rental items for its customers. F
utilizes two laundering lines in its plant, each of which can operate
independently. One line is used for uniforms and another line is used
for linens. Both lines incorporate a sorter, boiler, washer, dryer,
ironer, folder, and waste water treatment system. Because the laundering
equipment contained within the plant is property other than a building,
the unit of property for the laundering equipment is initially
determined under the general rule in paragraph (e)(3)(i) of this section
and is comprised of all the components that are functionally
interdependent. Under this rule, the initial units of property are each
laundering line because each line is functionally independent and is
comprised of components that are functionally interdependent. However,
because each line is comprised of plant property under paragraph
(e)(3)(ii) of this section, F must further divide these initial units of
property into smaller units of property by determining the components
(or groups of components) that perform discrete and major functions
within the line. Under paragraph (e)(3)(ii) of this section, F must
treat each sorter, boiler, washer, dryer, ironer, folder, and waste
water treatment system in each line as a separate unit of property
because each of these components performs a discrete and major function
within the line.
Example 7. Plant property; industrial process G operates a
restaurant that prepares and serves food to retail customers. Within its
restaurant, G has a large piece of equipment that uses an assembly line-
like process to prepare and cook tortillas that G serves only to its
restaurant customers. Because the tortilla-making equipment is property
other than a building, the unit of property for the equipment is
initially determined under the general rule in paragraph (e)(3)(i) of
this section and is comprised of all the components that are
functionally interdependent. Under this rule, the initial unit of
property is the entire tortilla-making equipment because the various
components of the equipment are functionally interdependent. The
equipment is not plant property under paragraph (e)(3)(ii) of this
section because the equipment is not used in an industrial process, as
it performs a small-scale function in G's restaurant operations. Thus, G
is not required to further divide the equipment into separate units of
property based on the components that perform discrete and major
functions.
Example 8. Personal property H owns locomotives that it uses in its
railroad business. Each locomotive consists of various components, such
as an engine, generators, batteries, and trucks. H acquired a locomotive
with all its components. Because H's locomotive is property other than a
building, the initial unit of property is determined under the general
rule in paragraph (e)(3)(i) of this section and is comprised of the
components that are functionally interdependent. Under paragraph
(e)(3)(i) of this section, the locomotive is a single unit of property
because it consists entirely of components that are functionally
interdependent.
Example 9. Personal property J provides legal services to its
clients. J purchased a laptop computer and a printer for its employees
to use in providing legal services. Because the computer and printer are
property other than a building, the initial units of property are
determined under the general rule in paragraph (e)(3)(i) of this section
and are comprised of the components that are functionally
interdependent. Under paragraph (e)(3)(i) of this section, the computer
and the printer are separate units of property because the computer and
the printer are not components that are functionally interdependent
(that is, the placing in service of the computer is not dependent on the
placing in service of the printer).
Example 10. Building structure and systems; leased building K is a
retailer of consumer products. K conducts its retail sales in a building
that it leases from L. The leased building consists of the building
structure (including the floor, walls, and roof) and various building
systems, including a plumbing system, an electrical system, an HVAC
system, a security system, and a fire protection and prevention system.
K pays an amount for labor and materials to perform work on the HVAC
system of the leased building. Under paragraph (e)(2)(v)(A) of this
section, because K leases the entire building, K must treat the leased
building and its structural components as a single unit of property. As
provided under paragraph (e)(2)(v)(B) of this section, an amount is paid
to improve a leased building property if it is for an improvement (for
example, a betterment) to the leased building structure or to any
building system within the leased building. Therefore, under paragraphs
(e)(2)(v)(B)(1) and (e)(2)(ii)(B)(1) of this section, if an amount paid
by K for work on the HVAC system is for an improvement to the HVAC
system in the leased building, K must treat this amount as an
improvement to the entire leased building property.
Example 11. Production of real property related to leased property
Assume the same facts as in Example 10, except that K receives a
[[Page 661]]
construction allowance from L, and K uses the construction allowance to
build a driveway adjacent to the leased building. Assume that under the
terms of the lease, K, the lessee, is treated as the owner of any
property that it constructs on or nearby the leased building. Also
assume that section 110 does not apply to the construction allowance.
Finally, assume that the driveway is not plant property or a network
asset. Because the construction of the driveway consists of the
production of real property other than a building, all the components of
the driveway are functionally interdependent and are a single unit of
property under paragraphs (e)(3)(i) and (e)(3)(iv) of this section.
Example 12. Leasehold improvements; construction allowance used for
lessor-owned improvements Assume the same facts as Example 11, except
that, under the terms of the lease, L, the lessor, is treated as the
owner of any property constructed on the leased premises. Because L, the
lessor, is the owner of the driveway and the driveway is real property
other than a building, all the components of the driveway are
functionally interdependent and are a single unit of property under
paragraph (e)(3)(i) of this section.
Example 13. Buildings and structural components; leased office space
M provides consulting services to its clients. M conducts its consulting
services business in two office spaces in the same building, each of
which it leases from N under separate lease agreements. Each office
space contains a separate HVAC system, which is part of the leased
property. Both lease agreements provide that M is responsible for
maintaining, repairing, and replacing the HVAC system that is part of
the leased property. M pays amounts to perform work on the HVAC system
in each office space. Because M leases two separate office spaces
subject to two leases, M must treat the portion of the building
structure and the structural components subject to each lease as a
separate unit of property under paragraph (e)(2)(v)(A) of this section.
As provided under paragraph (e)(2)(v)(B) of this section, an amount is
paid to improve a leased building property, if it is for an improvement
to the leased portion of the building structure or the portion of any
designated building system subject to each lease. Under paragraphs
(e)(2)(v)(B)(1) and (e)(2)(ii)(B)(1) of this section, M must treat the
HVAC system associated with each leased office space as a building
system of that leased building property. Thus, M must treat the HVAC
system associated with the first leased office space as a building
system of the first leased office space and the HVAC system associated
with the second leased office space as a building system of the second
leased office space. Under paragraph (e)(2)(v)(B) of this section, if
the amount paid by M for work on the HVAC system in one leased office
space is for an improvement (for example, a betterment) to the HVAC
system that is part of that leased space, then M must treat the amount
as an improvement to that individual leased property.
Example 14. Leased property; personal property N is engaged in the
business of transporting passengers on private jet aircraft. To conduct
its business, N leases several aircraft from O. Under paragraph
(e)(3)(iv) of this section (referencing paragraph (e)(3)(i) of this
section), N must treat all of the components of each leased aircraft
that are functionally interdependent as a single unit of property. Thus,
N must treat each leased aircraft as a single unit of property.
Example 15. Improvement property (i) P is a retailer of consumer
products. In Year 1, P purchases a building from Q, which P intends to
use as a retail sales facility. Under paragraph (e)(2)(i) of this
section, P must treat the building and its structural components as a
single unit of property. As provided under paragraph (e)(2)(ii) of this
section, an amount is paid to improve a building if it is for an
improvement to the building structure or any designated building system.
(ii) In Year 2, P pays an amount to construct an extension to the
building to be used for additional warehouse space. Assume that the
extension involves the addition of walls, floors, roof, and doors, but
does not include the addition or extension of any building systems
described in paragraph (e)(2)(ii)(B) of this section. Also assume that
the amount paid to build the extension is a betterment to the building
structure under paragraph (j) of this section, and is therefore treated
as an amount paid for an improvement to the entire building under
paragraph (e)(2)(ii) of this section. Accordingly, P capitalizes the
amount paid as an improvement to the building under paragraph (d) of
this section. Under paragraph (e)(4) of this section, the extension is
not a unit of property separate from the building, the unit of property
improved. Thus, to determine whether any future expenditure constitutes
an improvement to the building under paragraph (e)(2)(ii) of this
section, P must determine whether the expenditure constitutes an
improvement to the building structure, including the building extension,
or to any of the designated building systems.
Example 16. Additional rules; year placed in service R is engaged in
the business of transporting freight throughout the United States. To
conduct its business, R owns a fleet of truck tractors and trailers.
Each tractor and trailer is comprised of various components, including
tires. R purchased a truck tractor with all of its components, including
tires. The tractor tires have an average useful life to R of more than
one year. At the time R placed the tractor in service, it treated the
tractor tires as a separate asset for depreciation purposes under
section 168. R properly treated the tractor (excluding the
[[Page 662]]
cost of the tires) as 3-year property and the tractor tires as 5-year
property under section 168(e). Because R's tractor is property other
than a building, the initial units of property for the tractor are
determined under the general rule in paragraph (e)(3)(i) of this section
and are comprised of all the components that are functionally
interdependent. Under this rule, R must treat the tractor, including its
tires, as a single unit of property because the tractor and the tires
are functionally interdependent (that is, the placing in service of the
tires is dependent upon the placing in service of the tractor). However,
under paragraph (e)(5)(i) of this section, R must treat the tractor and
tires as separate units of property because R properly treated the tires
as being within a different class of property under section 168(e).
Example 17. Additional rules; change in subsequent year S is engaged
in the business of leasing nonresidential real property to retailers. In
Year 1, S acquired and placed in service a building for use in its
retail leasing operation. In Year 5, to accommodate the needs of a new
lessee, S incurred costs to improve the building structure. S
capitalized the costs of the improvement under paragraph (d) of this
section and depreciated the improvement in accordance with section
168(i)(6) as nonresidential real property under section 168(e). In Year
7, S determined that the structural improvement made in Year 5 qualified
under section 168(e)(8) as qualified retail improvement property and,
therefore, was 15-year property under section 168(e). In Year 7, S
changed its method of accounting to use a 15-year recovery period for
the improvement. Under paragraph (e)(5)(ii) of this section, in Year 7,
S must treat the improvement as a unit of property separate from the
building.
Example 18. Additional rules; change in subsequent year In Year 1, T
acquired and placed in service a building and parking lot for use in its
retail operations. Under Sec. 1.263(a)-2 of the regulations, T
capitalized the cost of the building and the parking lot and began
depreciating the building and the parking lot as nonresidential real
property under section 168(e). In Year 3, T completed a cost segregation
study under which it properly determined that the parking lot qualified
as 15-year property under section 168(e). In Year 3, T changed its
method of accounting for the parking lot to use a 15-year recovery
period and the 150-percent declining balance method of depreciation.
Under paragraph (e)(5)(ii) of this section, beginning in Year 3, T must
treat the parking lot as a unit of property separate from the building.
Example 19. Additional rules; change in subsequent year In Year 1, U
acquired and placed in service a building for use in its manufacturing
business. U capitalized the costs allocable to the building's wiring
separately from the building and depreciated the wiring as 7-year
property under section 168(e). U capitalized the cost of the building
and all other structural components of the building and began
depreciating them as nonresidential real property under section 168(e).
In Year 3, U completed a cost segregation study under which it properly
determined that the wiring is a structural component of the building
and, therefore, should have been depreciated as nonresidential real
property. In Year 3, U changed its method of accounting to treat the
wiring as nonresidential real property. Under paragraph (e)(5)(ii) of
this section, U must change the unit of property for the wiring in a
manner that is consistent with the change in treatment for depreciation
purposes. Therefore, U must change the unit of property for the wiring
to treat it as a structural component of the building, and as part of
the building unit of property, in accordance with paragraph (e)(2)(i) of
this section.
(f) Improvements to leased property--(1) In general. Except as
provided in paragraph (h) of this section (safe harbor for small
taxpayers) and under Sec. 1.263(a)-1(f) (de minimis safe harbor), this
paragraph (f) provides the exclusive rules for determining whether
amounts paid by a taxpayer are for an improvement to a leased property
and must be capitalized. In the case of a leased building or a leased
portion of a building, an amount is paid to improve a leased property if
the amount is paid for an improvement to any of the properties specified
in paragraph (e)(2)(ii) of this section (for lessor improvements) or in
paragraph (e)(2)(v)(B) of this section (for lessee improvements, except
as provided in paragraph (f)(2)(ii) of this section). Section 1.263(a)-4
does not apply to amounts paid for improvements to leased property or to
amounts paid for the acquisition or production of leasehold improvement
property.
(2) Lessee improvements--(i) Requirement to capitalize. A taxpayer
lessee must capitalize the related amounts, as determined under
paragraph (g)(3) of this section, that it pays to improve, as defined
under paragraph (d) of this section, a leased property except to the
extent that section 110 applies to a construction allowance received by
the lessee for the purpose of such improvement or when the improvement
constitutes a substitute for rent. See Sec. 1.61-8(c) for the treatment
of lessee expenditures that constitute a substitute for
[[Page 663]]
rent. A taxpayer lessee must also capitalize the related amounts that a
lessor pays to improve, as defined under paragraph (d) of this section,
a leased property if the lessee is the owner of the improvement, except
to the extent that section 110 applies to a construction allowance
received by the lessee for the purpose of such improvement. An amount
paid for a lessee improvement under this paragraph (f)(2)(i) is treated
as an amount paid to acquire or produce a unit of real or personal
property under Sec. 1.263(a)-2(d)(1) of the regulations.
(ii) Unit of property for lessee improvements. For purposes of
determining whether an amount paid by a lessee constitutes a lessee
improvement to a leased property under paragraph (f)(2)(i) of this
section, the unit of property and the improvement rules are applied to
the leased property in accordance with paragraph (e)(2)(v) (leased
buildings) or paragraph (e)(3)(iv) (leased property other than
buildings) of this section and include previous lessee improvements.
However, if a lessee improvement is comprised of an entire building
erected on leased property, then the unit of property for the building
and the application of the improvement rules to the building are
determined under paragraphs (e)(2)(i) and (e)(2)(ii) of this section.
(3) Lessor improvements--(i) Requirement to capitalize. A taxpayer
lessor must capitalize the related amounts, as determined under
paragraph (g)(3) of this section, that it pays directly, or indirectly
through a construction allowance to the lessee, to improve, as defined
in paragraph (d) of this section, a leased property when the lessor is
the owner of the improvement or to the extent that section 110 applies
to the construction allowance. A lessor must also capitalize the related
amounts that the lessee pays to improve a leased property, as defined in
paragraph (e) of this section, when the lessee's improvement constitutes
a substitute for rent. See Sec. 1.61-8(c) for treatment of expenditures
by lessees that constitute a substitute for rent. Amounts capitalized by
the lessor under this paragraph (f)(3)(i) may not be capitalized by the
lessee. If a lessor improvement is comprised of an entire building
erected on leased property, then the amount paid for the building is
treated as an amount paid by the lessor to acquire or produce a unit of
property under Sec. 1.263(a)-2(d)(1). See paragraph (e)(2) of this
section for the unit of property for a building and paragraph (e)(3) of
this section for the unit of property for real or personal property
other than a building.
(ii) Unit of property for lessor improvements. In general, an amount
capitalized as a lessor improvement under paragraph (f)(3)(i) of this
section is not a unit of property separate from the unit of property
improved. See paragraph (e)(4) of this section. However, if a lessor
improvement is comprised of an entire building erected on leased
property, then the unit of property for the building and the application
of the improvement rules to the building are determined under paragraphs
(e)(2)(i) and (e)(2)(ii) of this section.
(4) Examples. The following examples illustrate the application of
this paragraph (f) and do not address whether capitalization is required
under another provision of the Code (for example, section 263A). For
purposes of the following examples, assume that section 110 does not
apply to the lessee and the amounts paid by the lessee are not a
substitute for rent.
Example 1. Lessee improvements; additions to building (i) T is a
retailer of consumer products. In Year 1, T leases a building from L,
which T intends to use as a retail sales facility. The leased building
consists of the building structure under paragraph (e)(2)(ii)(A) of this
section and various building systems under paragraph (e)(2)(ii)(B) of
this section, including a plumbing system, an electrical system, and an
HVAC system. Under the terms of the lease, T is permitted to improve the
building at its own expense. Under paragraph (e)(2)(v)(A) of this
section, because T leases the entire building, T must treat the leased
building and its structural components as a single unit of property. As
provided under paragraph (e)(2)(v)(B)(1) of this section, an amount is
paid to improve a leased building property if the amount is paid for an
improvement to the leased building structure or to any building system
within the leased building. Therefore, under paragraphs (e)(2)(v)(B)(1)
and (e)(2)(ii) of this section, if T pays an amount that improves the
building structure, the plumbing system, the electrical system, or the
HVAC system, then T must treat this amount as an improvement to the
entire leased building property.
[[Page 664]]
(ii) In Year 2, T pays an amount to construct an extension to the
building to be used for additional warehouse space. Assume that this
amount is for a betterment (as defined under paragraph (j) of this
section) to T's leased building structure and does not affect any
building systems. Accordingly, the amount that T pays for the building
extension is for a betterment to the leased building structure, and
thus, under paragraph (e)(2)(v)(B)(1) of this section, is treated as an
improvement to the entire leased building under paragraph (d) of this
section. Because T, the lessee, paid an amount to improve a leased
building property, T is required to capitalize the amount paid for the
building extension as a leasehold improvement under paragraph (f)(2)(i)
of this section. In addition, paragraph (f)(2)(i) of this section
requires T to treat the amount paid for the improvement as the
acquisition or production of a unit of property (leasehold improvement
property) under Sec. 1.263(a)-2(d)(1).
(iii) In Year 5, T pays an amount to add a large overhead door to
the building extension that it constructed in Year 2 to accommodate the
loading of larger products into the warehouse space. Under paragraph
(f)(2)(ii) of this section, to determine whether the amount paid by T is
for a leasehold improvement, the unit of property and the improvement
rules are applied in accordance with paragraph (e)(2)(v) of this section
and include T's previous improvements to the leased property. Therefore,
under paragraph (e)(2)(v)(A) of this section, the unit of property is
the entire leased building, including the extension built in Year 2. In
addition, under paragraph (e)(2)(v)(B) of this section, the leased
building property is improved if the amount is paid for an improvement
to the building structure or any building system. Assume that the amount
paid to add the overhead door is for a betterment, under paragraph (j)
of this section, to the building structure, which includes the
extension. Accordingly, T must capitalize the amounts paid to add the
overhead door as a leasehold improvement to the leased building
property. In addition, paragraph (f)(2)(i) of this section requires T to
treat the amount paid for the improvement as the acquisition or
production of a unit of property (leasehold improvement property) under
Sec. 1.263(a)-2(d)(1). However, to determine whether a future amount
paid by T is for a leasehold improvement to the leased building, the
unit of property and the improvement rules are again applied in
accordance with paragraph (e)(2)(v) of this section and include the new
overhead door.
Example 2. Lessee improvements; additions to certain structural
components of buildings (i) Assume the same facts as Example 1 except
that in Year 2, T also pays an amount to construct an extension of the
HVAC system into the building extension. Assume that the extension is a
betterment, under paragraph (j) of this section, to the leased HVAC
system (a building system under paragraph (e)(2)(ii)(B)(1) of this
section). Accordingly, the amount that T pays for the extension of the
HVAC system is for a betterment to the leased building system, the HVAC
system, and thus, under paragraph (e)(2)(v)(B)(1) of this section, is
treated as an improvement to the entire leased building property under
paragraph (d) of this section. Because T, the lessee, pays an amount to
improve a leased building property, T is required to capitalize the
amount paid as a leasehold improvement under paragraph (f)(2)(i) of this
section. Under paragraph (f)(2)(i) of this section, T must treat the
amount paid for the HVAC extension as the acquisition and production of
a unit of property (leasehold improvement property) under Sec.
1.263(a)-2(d)(1).
(ii) In Year 5, T pays an amount to add an additional chiller to the
portion of the HVAC system that it constructed in Year 2 to accommodate
the climate control requirements for new product offerings. Under
paragraph (f)(2)(ii) of this section, to determine whether the amount
paid by T is for a leasehold improvement, the unit of property and the
improvement rules are applied in accordance with paragraph (e)(2)(v) of
this section and include T's previous improvements to the leased
building property. Therefore, under paragraph (e)(2)(v)(B) of this
section, the leased building property is improved if the amount is paid
for an improvement to the building structure or any building system.
Assume that the amount paid to add the chiller is for a betterment,
under paragraph (j) of this section, to the HVAC system, which includes
the extension of the system in Year 2. Accordingly, T must capitalize
the amounts paid to add the chiller as a leasehold improvement to the
leased building property. In addition, paragraph (f)(2)(i) of this
section requires T to treat the amount paid for the chiller as the
acquisition or production of a unit of property (leasehold improvement
property) under Sec. 1.263(a)-2(d)(1). However, to determine whether a
future amount paid by T is for a leasehold improvement to the leased
building, the unit of property and the improvement rules are again
applied in accordance with paragraph (e)(2)(v) of this section and
include the new chiller.
Example 3. Lessor Improvements; additions to building (i) T is a
retailer of consumer products. In Year 1, T leases a building from L,
which T intends to use as a retail sales facility. Pursuant to the
lease, L provides a construction allowance to T, which T intends to use
to construct an extension to the retail sales facility for additional
warehouse space. Assume that the amount paid for any improvement to the
building does not exceed the construction allowance and that L is
treated as the owner of any improvement to
[[Page 665]]
the building. Under paragraph (e)(2)(i) of this section, L must treat
the building and its structural components as a single unit of property.
As provided under paragraph (e)(2)(ii) of this section, an amount is
paid to improve a building if it is paid for an improvement to the
building structure or to any building system.
(ii) In Year 2, T uses L's construction allowance to construct an
extension to the leased building to provide additional warehouse space
in the building. Assume that the extension is a betterment (as defined
under paragraph (j) of this section) to the building structure, and
therefore, the amount paid for the extension results in an improvement
to the building under paragraph (d) of this section. Under paragraph
(f)(3)(i) of this section, L, the lessor and owner of the improvement,
must capitalize the amounts paid to T to construct the extension to the
retail sales facility. T is not permitted to capitalize the amounts paid
for the lessor-owned improvement. Finally, under paragraph (f)(3)(ii) of
this section, the extension to L's building is not a unit of property
separate from the building and its structural components.
Example 4. Lessee property; personal property added to leased
building T is a retailer of consumer products. T leases a building from
L, which T intends to use as a retail sales facility. Pursuant to the
lease, L provides a construction allowance to T, which T uses to acquire
and construct partitions for fitting rooms, counters, and shelving.
Assume that each partition, counter, and shelving unit is a unit of
property under paragraph (e)(3) of this section. Assume that for Federal
income tax purposes T is treated as the owner of the partitions,
counters, and shelving. T's expenditures for the partitions, counters,
and shelving are not improvements to the leased property under paragraph
(d) of this section, but rather constitute amounts paid to acquire or
produce separate units of personal property under Sec. 1.263(a)-
2(d)(1).
Example 5. Lessor property; buildings on leased property L is the
owner of a parcel of unimproved real property that L leases to T.
Pursuant to the lease, L provides a construction allowance to T of
$500,000, which T agrees to use to construct a building costing not more
than $500,000 on the leased real property and to lease the building from
L after it is constructed. Assume that for Federal income tax purposes,
L is treated as the owner of the building that T will construct. T uses
the $500,000 to construct the building as required under the lease. The
building consists of the building structure and the following building
systems: (1) a plumbing system; (2) an electrical system; and (3) an
HVAC system. Because L provides a construction allowance to T to
construct a building and L is treated as the owner of the building, L
must capitalize the amounts that it pays indirectly to T to construct
the building as a lessor improvement under paragraph (f)(3)(i) of this
section. In addition, the amounts paid by L for the construction
allowance are treated as amounts paid by L to acquire and produce the
building under Sec. 1.263(a)-2(d)(1). Further, under paragraph
(e)(2)(i) of this section, L must treat the building and its structural
components as a single unit of property. Under paragraph (f)(3)(i) of
this section, T, the lessee, may not capitalize the amounts paid (with
the construction allowance received from L) for construction of the
building.
Example 6. Lessee contribution to construction costs Assume the same
facts as in Example 5, except T spends $600,000 to construct the
building. T uses the $500,000 construction allowance provided by L plus
$100,000 of its own funds to construct the building that L will own
pursuant to the lease. Also assume that the additional $100,000 that T
pays is not a substitute for rent. For the reasons discussed in Example
5, L must capitalize the $500,000 it paid T to construct the building
under Sec. 1.263(a)-2(d)(1). In addition, because T spends its own
funds to complete the building, T has a depreciable interest of $100,000
in the building and must capitalize the $100,000 it paid to construct
the building as a leasehold improvement under Sec. 1.263(a)-2(d)(1) of
the regulations. Under paragraph (e)(2)(i) of this section, L must treat
the building as a single unit of property to the extent of its
depreciable interest of $500,000. In addition, under paragraphs
(f)(2)(ii) and (e)(2)(i) of this section, T must also treat the building
as a single unit of property to the extent of its depreciable interest
of $100,000.
(g) Special rules for determining improvement costs--(1) Certain
costs incurred during an improvement--(i) In general. A taxpayer must
capitalize all the direct costs of an improvement and all the indirect
costs (including, for example, otherwise deductible repair costs) that
directly benefit or are incurred by reason of an improvement. Indirect
costs arising from activities that do not directly benefit and are not
incurred by reason of an improvement are not required to be capitalized
under section 263(a), regardless of whether the activities are performed
at the same time as an improvement.
(ii) Exception for individuals' residences. A taxpayer who is an
individual may capitalize amounts paid for repairs and maintenance that
are made at the same time as capital improvements to units of property
not used in the taxpayer's trade or business or for the production of
income if the
[[Page 666]]
amounts are paid as part of an improvement (for example, a remodeling)
of the taxpayer's residence.
(2) Removal costs--(i) In general. If a taxpayer disposes of a
depreciable asset, including a partial disposition under Prop. Reg.
Sec. 1.168(i)-1(e)(2)(ix) (September 19, 2013), or Sec. 1.168(i)-8(d),
for Federal income tax purposes and has taken into account the adjusted
basis of the asset or component of the asset in realizing gain or loss,
then the costs of removing the asset or component are not required to be
capitalized under this section. If a depreciable asset is included in a
general asset account under section 168(i)(4), and neither the
regulations under section 168(i)(4) and Sec. 1.168(i)-1(e)(3), apply to
a disposition of such asset, or a portion of such asset under Sec.
1.168(i)-1(e)(1)(ii), a loss is treated as being realized in the amount
of zero upon the disposition of the asset solely for purposes of this
paragraph (g)(2)(i). If a taxpayer disposes of a component of a unit of
property, but the disposal of the component is not a disposition for
Federal tax purposes, then the taxpayer must deduct or capitalize the
costs of removing the component based on whether the removal costs
directly benefit or are incurred by reason of a repair to the unit of
property or an improvement to the unit of property. But see Sec.
1.280B-1 for the rules applicable to demolition of structures.
(ii) Examples. Thefollowing examples illustrate the application of
paragraph (g)(2)(i) of this section and, unless otherwise stated, do not
address whether capitalization is required under another provision of
this section or another provision of the Code (for example, section
263A). For purposes of the following examples, assume that Sec.
1.168(i)-1(e) or Sec. 1.168(i)-8, applies and that Sec. 1.280B-1 does
not apply.
Example 1. Component removed during improvement; no disposition X
owns a factory building with a storage area on the second floor. X pays
an amount to remove the original columns and girders supporting the
second floor and replace them with new columns and girders to permit
storage of supplies with a gross weight 50 percent greater than the
previous load-carrying capacity of the storage area. Assume that the
replacement of the columns and girders constitutes a betterment to the
building structure and is therefore an improvement to the building unit
of property under paragraphs (d)(1) and (j) of this section. Assume that
X disposes of the original columns and girders and the disposal of these
structural components is not a disposition under Sec. 1.168(i)-1(e) or
Sec. 1.168(i)-8. Under paragraphs (g)(2)(i) and (j) of this section,
the amount paid to remove the columns and girders must be capitalized as
a cost of the improvement, because it directly benefits and is incurred
by reason of the improvement to the building.
Example 2. Component removed during improvement; disposition Assume
the same facts as Example 1, except X disposes of the original columns
and girders and elects to treat the disposal of these structural
components as a partial disposition of the factory building under Sec.
1.168(i)-8(d), taking into account the adjusted basis of the components
in realizing loss on the disposition. Under paragraph (g)(2)(i) of this
section, the amount paid to remove the columns and girders is not
required to be capitalized as part of the cost of the improvement
regardless of their relation to the improvement. However, all the
remaining costs of replacing the columns and girders must be capitalized
as improvements to the building unit of property under paragraphs
(d)(1), (j), and (g)(1) of this section.
Example 3. Component removed during repair or maintenance; no
disposition Y owns a building in which it conducts its retail business.
The roof over Y's building is covered with shingles. Over time, the
shingles begin to wear and Y begins to experience leaks into its retail
premises. However, the building still functions in Y's business. To
eliminate the problems, a contractor recommends that Y remove the
original shingles and replace them with new shingles. Accordingly, Y
pays the contractor to replace the old shingles with new but comparable
shingles. The new shingles are comparable to original shingles but
correct the leakage problems. Assume that replacement of old shingles
with new shingles to correct the leakage is not a betterment or a
restoration of the building structure or systems under paragraph (j) or
(k) of this section and does not adapt the building structure or systems
to a new or different use under paragraph (l) of this section. Thus, the
amounts paid by Y to replace the shingles are not improvements to the
building unit of property under paragraph (d) of this section. Under
paragraph (g)(2)(i) of this section, the amounts paid to remove the
shingles are not required to be capitalized because they directly
benefit and are incurred by reason of repair or maintenance to the
building structure.
Example 4. Component removed with disposition and restoration Assume
the same facts as Example 3 except Y disposes of the original shingles,
and Y elects to treat the disposal of these components as a partial
disposition of
[[Page 667]]
the building under Sec. 1.168(i)-8(d), and deducts the adjusted basis
of the components as a loss on the disposition. Under paragraph
(k)(1)(i) of this section, amounts paid for replacement of the shingles
constitute a restoration of the building structure because the amounts
are paid for the replacement of a component of the structure and the
taxpayer has properly deducted a loss for that component. Thus, under
paragraphs (d)(2) and (k) of this section, Y is required to capitalize
the amounts paid for the replacement of the shingles as an improvement
to the building unit of property. However, under paragraph (g)(2)(i) of
this section, the amounts paid by Y to remove the original shingles are
not required to be capitalized as part of the costs of the improvement,
regardless of their relation to the improvement.
(3) Related amounts. For purposes of paragraph (d) of this section,
amounts paid to improve a unit of property include amounts paid over a
period of more than one taxable year. Whether amounts are related to the
same improvement depends on the facts and circumstances of the
activities being performed.
(4) Compliance with regulatory requirements. For purposes of this
section, a Federal, state, or local regulator's requirement that a
taxpayer perform certain repairs or maintenance on a unit of property to
continue operating the property is not relevant in determining whether
the amount paid improves the unit of property.
(h) Safe harbor for small taxpayers--(1) In general. A qualifying
taxpayer (as defined in paragraph (h)(3) of this section) may elect to
not apply paragraph (d) or paragraph (f) of this section to an eligible
building property (as defined in paragraph (h)(4) of this section) if
the total amount paid during the taxable year for repairs, maintenance,
improvements, and similar activities performed on the eligible building
property does not exceed the lesser of--
(i) 2 percent of the unadjusted basis (as defined under paragraph
(h)(5) of this section) of the eligible building property; or
(ii) $10,000.
(2) Application with other safe harbor provisions. For purposes of
paragraph (h)(1) of this section, amounts paid for repairs, maintenance,
improvements, and similar activities performed on eligible building
property include those amounts not capitalized under the de minimis safe
harbor election under Sec. 1.263(a)-1(f) and those amounts deemed not
to improve property under the safe harbor for routine maintenance under
paragraph (i) of this section.
(3) Qualifying taxpayer--(i) In general. For purposes of this
paragraph (h), the term qualifying taxpayer means a taxpayer whose
average annual gross receipts as determined under this paragraph (h)(3)
for the three preceding taxable years is less than or equal to
$10,000,000.
(ii) Application to new taxpayers. If a taxpayer has been in
existence for less than three taxable years, the taxpayer determines its
average annual gross receipts for the number of taxable years (including
short taxable years) that the taxpayer (or its predecessor) has been in
existence.
(iii) Treatment of short taxable year. In the case of any taxable
year of less than 12 months (a short taxable year), the gross receipts
shall be annualized by--
(A) Multiplying the gross receipts for the short period by 12; and
(B) Dividing the product determined in paragraph (h)(3)(iii)(A) of
this section by the number of months in the short period.
(iv) Definition of gross receipts. For purposes of applying
paragraph (h)(3)(i) of this section, the term gross receipts means the
taxpayer's receipts for the taxable year that are properly recognized
under the taxpayer's methods of accounting used for Federal income tax
purposes for the taxable year. For this purpose, gross receipts include
total sales (net of returns and allowances) and all amounts received for
services. In addition, gross receipts include any income from
investments and from incidental or outside sources. For example, gross
receipts include interest (including original issue discount and tax-
exempt interest within the meaning of section 103), dividends, rents,
royalties, and annuities, regardless of whether such amounts are derived
in the ordinary course of the taxpayer's trade of business. Gross
receipts are not reduced by cost of goods sold or by the cost of
property sold if such property is described in section 1221(a)(1), (3),
(4), or (5). With respect to sales of capital assets as defined in
section 1221, or
[[Page 668]]
sales of property described in section 1221(a)(2) (relating to property
used in a trade or business), gross receipts shall be reduced by the
taxpayer's adjusted basis in such property. Gross receipts do not
include the repayment of a loan or similar instrument (for example, a
repayment of the principal amount of a loan held by a commercial lender)
and, except to the extent of gain recognized, do not include gross
receipts derived from a non-recognition transaction, such as a section
1031 exchange. Finally, gross receipts do not include amounts received
by the taxpayer with respect to sales tax or other similar state and
local taxes if, under the applicable state or local law, the tax is
legally imposed on the purchaser of the good or service, and the
taxpayer merely collects and remits the tax to the taxing authority. If,
in contrast, the tax is imposed on the taxpayer under the applicable
law, then gross receipts include the amounts received that are allocable
to the payment of such tax.
(4) Eligible building property. For purposes of this section, the
term eligible building property refers to each unit of property defined
in paragraph (e)(2)(i) (building), paragraph (e)(2)(iii)(A)
(condominium), paragraph (e)(2)(iv)(A) (cooperative), or paragraph
(e)(2)(v)(A) (leased building or portion of building) of this section,
as applicable, that has an unadjusted basis of $1,000,000 or less.
(5) Unadjusted basis--(i) Eligible building property owned by
taxpayer. For purposes of this section, the unadjusted basis of eligible
building property owned by the taxpayer means the basis as determined
under section 1012, or other applicable sections of Chapter 1, including
subchapters O (relating to gain or loss on dispositions of property), C
(relating to corporate distributions and adjustments), K (relating to
partners and partnerships), and P (relating to capital gains and
losses). Unadjusted basis is determined without regard to any
adjustments described in section 1016(a)(2) or (3) or to amounts for
which the taxpayer has elected to treat as an expense (for example,
under sections 179, 179B, or 179C).
(ii) Eligible building property leased to the taxpayer. For purposes
of this section, the unadjusted basis of eligible building property
leased to the taxpayer is the total amount of (undiscounted) rent paid
or expected to be paid by the lessee under the lease for the entire term
of the lease, including renewal periods if all the facts and
circumstances in existence during the taxable year in which the lease is
entered indicate a reasonable expectancy of renewal. Section 1.263(a)-
4(f)(5)(ii) provides the factors that are significant in determining
whether there exists a reasonable expectancy of renewal for purposes of
this paragraph.
(6) Time and manner of election. A taxpayer makes the election
described in paragraph (h)(1) of this section by attaching a statement
to the taxpayer's timely filed original Federal tax return (including
extensions) for the taxable year in which amounts are paid for repairs,
maintenance, improvements, and similar activities performed on the
eligible building property providing that such amounts qualify under the
safe harbor provided in paragraph (h)(1) of this section. Sections
301.9100-1 through 301.9100-3 of this chapter provide the rules
governing extensions of the time to make regulatory elections. The
statement must be titled, ``Section 1.263(a)-3(h) Safe Harbor Election
for Small Taxpayers'' and include the taxpayer's name, address, taxpayer
identification number, and a description of each eligible building
property to which the taxpayer is applying the election. In the case of
an S corporation or a partnership, the election is made by the S
corporation or by the partnership, and not by the shareholders or
partners. An election may not be made through the filing of an
application for change in accounting method or, before obtaining the
Commissioner's consent to make a late election, by filing an amended
Federal tax return. A taxpayer may not revoke an election made under
this paragraph (h). The time and manner of making the election under
this paragraph (h) may be modified through guidance of general
applicability (see Sec. Sec. 601.601(d)(2) and 601.602 of this
chapter).
(7) Treatment of safe harbor amounts. Amounts paid by the taxpayer
for repairs, maintenance, improvements, and similar activities to which
the taxpayer properly applies the safe harbor
[[Page 669]]
under paragraph (h)(1) of this section and for which the taxpayer
properly makes the election under paragraph (h)(6) of this section are
not treated as improvements under paragraph (d) or (f) of this section
and may be deducted under Sec. 1.162-1 or Sec. 1.212-1, as applicable,
in the taxable year these amounts are paid, provided the amounts
otherwise qualify for a deduction under these sections.
(8) Safe harbor exceeded. If total amounts paid by a qualifying
taxpayer during the taxable year for repairs, maintenance, improvements,
and similar activities performed on an eligible building property exceed
the safe harbor limitations specified in paragraph (h)(1) of this
section, then the safe harbor election is not available for that
eligible building property and the taxpayer must apply the general
improvement rules under this section to determine whether amounts are
for improvements to the unit of property, including the safe harbor for
routine maintenance under paragraph (i) of this section. The taxpayer
may also elect to apply the de minimis safe harbor under Sec. 1.263(a)-
1(f) to amounts qualifying under that safe harbor irrespective of the
application of this paragraph (h).
(9) Modification of safe harbor amounts. The amount limitations
provided in paragraphs (h)(1)(i), (h)(1)(ii), and (h)(3) of this section
may be modified through published guidance in the Federal Register or in
the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this
chapter).
(10) Examples. The following examples illustrate the rules of this
paragraph (h). Assume that Sec. 1.212-1 does not apply to the amounts
paid.
Example 1. Safe harbor for small taxpayers applicable A is a
qualifying taxpayer under paragraph (h)(3) of this section. A owns an
office building in which A provides consulting services. In Year 1, A's
building has an unadjusted basis of $750,000 as determined under
paragraph (h)(5)(i) of this section. In Year 1, A pays $5,500 for
repairs, maintenance, improvements and similar activities to the office
building. Because A's building unit of property has an unadjusted basis
of $1,000,000 or less, A's building constitutes eligible building
property under paragraph (h)(4) of this section. The aggregate amount
paid by A during Year 1 for repairs, maintenance, improvements and
similar activities on this eligible building property does not exceed
the lesser of $15,000 (2 percent of the building's unadjusted basis of
$750,000) or $10,000. Therefore, under paragraph (h)(1) of this section,
A may elect to not apply the capitalization rule of paragraph (d) of
this section to the amounts paid for repair, maintenance, improvements,
or similar activities on the office building in Year 1. If A properly
makes the election under paragraph (h)(6) of this section for the office
building and the amounts otherwise constitute deductible ordinary and
necessary expenses incurred in carrying on a trade or business, A may
deduct these amounts under Sec. 1.162-1 in Year 1.
Example 2. Safe harbor for small taxpayers inapplicable Assume the
same facts as in Example 1, except that A pays $10,500 for repairs,
maintenance, improvements, and similar activities performed on its
office building in Year 1. Because this amount exceeds $10,000, the
lesser of the two limitations provided in paragraph (h)(1) of this
section, A may not apply the safe harbor for small taxpayers under
paragraph (h)(1) of this section to the total amounts paid for repairs,
maintenance, improvements, and similar activities performed on the
building. Therefore, A must apply the general improvement rules under
this section to determine which of the aggregate amounts paid are for
improvements and must be capitalized under paragraph (d) of this section
and which of the amounts are for repair and maintenance under Sec.
1.162-4.
Example 3. Safe harbor applied building-by-building (i) B is a
qualifying taxpayer under paragraph (h)(3) of this section. B owns two
rental properties, Building M and Building N. Building M and Building N
are both multi-family residential buildings. In Year 1, each property
has an unadjusted basis of $300,000 under paragraph (h)(5) of this
section. Because Building M and Building N each have an unadjusted basis
of $1,000,000 or less, Building M and Building N each constitute
eligible building property in Year 1 under paragraph (h)(4) of this
section. In Year 1, B pays $5,000 for repairs, maintenance,
improvements, and similar activities performed on Building M. In Year 1,
B also pays $7,000 for repairs, maintenance, improvements, and similar
activities performed on Building N.
(ii) The total amount paid by B during Year 1 for repairs,
maintenance, improvements and similar activities on Building M ($5,000)
does not exceed the lesser of $6,000 (2 percent of the building's
unadjusted basis of $300,000) or $10,000. Therefore, under paragraph
(h)(1) of this section, for Year 1, B may elect to not apply the
capitalization rule under paragraph (d) of this section to the amounts
it paid for repairs, maintenance, improvements, and similar activities
on Building M. If B properly makes the election under paragraph (h)(6)
of this section for
[[Page 670]]
Building M and the amounts otherwise constitute deductible ordinary and
necessary expenses incurred in carrying on B's trade or business, B may
deduct these amounts under Sec. 1.162-1.
(iii) The total amount paid by B during Year 1 for repairs,
maintenance, improvements and similar activities on Building N ($7,000)
exceeds $6,000 (2 percent of the building's unadjusted basis of
$300,000), the lesser of the two limitations provided under paragraph
(h)(1) of this section. Therefore, B may not apply the safe harbor under
paragraph (h)(1) of this section to the total amounts paid for repairs,
maintenance, improvements, and similar activities performed on Building
N. Instead, B must apply the general improvement rules under this
section to determine which of the total amounts paid for work performed
on Building N are for improvements and must be capitalized under
paragraph (d) of this section and which amounts are for repair and
maintenance under Sec. 1.162-4.
Example 4. Safe harbor applied to leased building property C is a
qualifying taxpayer under paragraph (h)(3) of this section. C is the
lessee of a building in which C operates a retail store. The lease is a
triple-net lease, and the lease term is 20 years, including reasonably
expected renewals. C pays $4,000 per month in rent. In Year 1, C pays
$7,000 for repairs, maintenance, improvements, and similar activities
performed on the building. Under paragraph (h)(5)(ii) of this section,
the unadjusted basis of C's leased unit of property is $960,000 ($4,000
monthly rent x 12 months x 20 years). Because C's leased building has an
unadjusted basis of $1,000,000 or less, the building is eligible
building property for Year 1 under paragraph (h)(4) of this section. The
total amount paid by C during Year 1 for repairs, maintenance,
improvements, and similar activities on the leased building ($7,000)
does not exceed the lesser of $19,200 (2 percent of the building's
unadjusted basis of $960,000) or $10,000. Therefore, under paragraph
(h)(1) of this section, for Year 1, C may elect to not apply the
capitalization rule under paragraph (d) of this section to the amounts
it paid for repairs, maintenance, improvements, and similar activities
on the leased building. If C properly makes the election under paragraph
(h)(6) of this section for the leased building and the amounts otherwise
constitute deductible ordinary and necessary expenses incurred in
carrying on C's trade or business, C may deduct these amounts under
Sec. 1.162-1.
(i) Safe harbor for routine maintenance on property--(1) In general.
An amount paid for routine maintenance (as defined in paragraph
(i)(1)(i) or (i)(1)(ii) of this section, as applicable) on a unit of
tangible property, or in the case of a building, on any of the
properties designated in paragraphs (e)(2)(ii), (e)(2)(iii)(B),
(e)(2)(iv)(B), or paragraph (e)(2)(v)(B) of this section, is deemed not
to improve that unit of property.
(i) Routine maintenance for buildings. Routine maintenance for a
building unit of property is the recurring activities that a taxpayer
expects to perform as a result of the taxpayer's use of any of the
properties designated in paragraphs (e)(2)(ii), (e)(2)(iii)(B),
(e)(2)(iv)(B), or (e)(2)(v)(B) of this section to keep the building
structure or each building system in its ordinarily efficient operating
condition. Routine maintenance activities include, for example, the
inspection, cleaning, and testing of the building structure or each
building system, and the replacement of damaged or worn parts with
comparable and commercially available replacement parts. Routine
maintenance may be performed any time during the useful life of the
building structure or building systems. However, the activities are
routine only if the taxpayer reasonably expects to perform the
activities more than once during the 10-year period beginning at the
time the building structure or the building system upon which the
routine maintenance is performed is placed in service by the taxpayer. A
taxpayer's expectation will not be deemed unreasonable merely because
the taxpayer does not actually perform the maintenance a second time
during the 10-year period, provided that the taxpayer can otherwise
substantiate that its expectation was reasonable at the time the
property was placed in service. Factors to be considered in determining
whether maintenance is routine and whether a taxpayer's expectation is
reasonable include the recurring nature of the activity, industry
practice, manufacturers' recommendations, and the taxpayer's experience
with similar or identical property. With respect to a taxpayer that is a
lessor of a building or a part of the building, the taxpayer's use of
the building unit of property includes the lessee's use of its unit of
property.
(ii) Routine maintenance for property other than buildings. Routine
maintenance for property other than buildings
[[Page 671]]
is the recurring activities that a taxpayer expects to perform as a
result of the taxpayer's use of the unit of property to keep the unit of
property in its ordinarily efficient operating condition. Routine
maintenance activities include, for example, the inspection, cleaning,
and testing of the unit of property, and the replacement of damaged or
worn parts of the unit of property with comparable and commercially
available replacement parts. Routine maintenance may be performed any
time during the useful life of the unit of property. However, the
activities are routine only if, at the time the unit of property is
placed in service by the taxpayer, the taxpayer reasonably expects to
perform the activities more than once during the class life (as defined
in paragraph (i)(4) of this section) of the unit of property. A
taxpayer's expectation will not be deemed unreasonable merely because
the taxpayer does not actually perform the maintenance a second time
during the class life of the unit of property, provided that the
taxpayer can otherwise substantiate that its expectation was reasonable
at the time the property was placed in service. Factors to be considered
in determining whether maintenance is routine and whether the taxpayer's
expectation is reasonable include the recurring nature of the activity,
industry practice, manufacturers' recommendations, and the taxpayer's
experience with similar or identical property. With respect to a
taxpayer that is a lessor of a unit of property, the taxpayer's use of
the unit of property includes the lessee's use of the unit of property.
(2) Rotable and temporary spare parts. Except as provided in
paragraph (i)(3) of this section, for purposes of paragraph (i)(1)(ii)
of this section, amounts paid for routine maintenance include routine
maintenance performed on (and with regard to) rotable and temporary
spare parts.
(3) Exceptions. Routine maintenance does not include the following:
(i) Amounts paid for a betterment to a unit of property under
paragraph (j) of this section;
(ii) Amounts paid for the replacement of a component of a unit of
property for which the taxpayer has properly deducted a loss for that
component (other than a casualty loss under Sec. 1.165-7) (see
paragraph (k)(1)(i) of this section);
(iii) Amounts paid for the replacement of a component of a unit of
property for which the taxpayer has properly taken into account the
adjusted basis of the component in realizing gain or loss resulting from
the sale or exchange of the component (see paragraph (k)(1)(ii) of this
section);
(iv) Amounts paid for the restoration of damage to a unit of
property for which the taxpayer is required to take a basis adjustment
as a result of a casualty loss under section 165, or relating to a
casualty event described in section 165, subject to the limitation in
paragraph (k)(4) of this section (see paragraph (k)(1)(iii) of this
section);
(v) Amounts paid to return a unit of property to its ordinarily
efficient operating condition, if the property has deteriorated to a
state of disrepair and is no longer functional for its intended use (see
paragraph (k)(1)(iv) of this section);
(vi) Amounts paid to adapt a unit of property to a new or different
use under paragraph (l) of this section;
(vii) Amounts paid for repairs, maintenance, or improvement of
network assets (as defined in paragraph (e)(3)(iii)(A) of this section);
or
(viii) Amounts paid for repairs, maintenance, or improvement of
rotable and temporary spare parts to which the taxpayer applies the
optional method of accounting for rotable and temporary spare parts
under Sec. 1.162-3(e).
(4) Class life. The class life of a unit of property is the recovery
period prescribed for the property under sections 168(g)(2) and (3) for
purposes of the alternative depreciation system, regardless of whether
the property is depreciated under section 168(g). For purposes of
determining class life under this section, section 168(g)(3)(A)
(relating to tax-exempt use property subject to lease) does not apply.
If the unit of property is comprised of components with different class
lives, then the class life of the unit of property is deemed to be the
same as the component with the longest class life.
(5) Coordination with section 263A. Amounts paid for routine
maintenance
[[Page 672]]
under this paragraph (i) may be subject to capitalization under section
263A if these amounts comprise the direct or allocable indirect costs of
other property produced by the taxpayer or property acquired for resale.
See, for example, Sec. 1.263A-1(e)(3)(ii)(O) requiring taxpayers to
capitalize the cost of repairing equipment or facilities allocable to
property produced or property acquired for resale.
(6) Examples. The following examples illustrate the application of
this paragraph (i) and, unless otherwise stated, do not address the
treatment under other provisions of the Code (for example, section
263A). In addition, unless otherwise stated, assume that the taxpayer
has not applied the optional method of accounting for rotable and
temporary spare parts under Sec. 1.162-3(e).
Example 1. Routine maintenance on component (i) A is a commercial
airline engaged in the business of transporting passengers and freight
throughout the United States and abroad. To conduct its business, A owns
or leases various types of aircraft. As a condition of maintaining its
airworthiness certification for these aircraft, A is required by the
Federal Aviation Administration (FAA) to establish and adhere to a
continuous maintenance program for each aircraft within its fleet. These
programs, which are designed by A and the aircraft's manufacturer and
approved by the FAA, are incorporated into each aircraft's maintenance
manual. The maintenance manuals require a variety of periodic
maintenance visits at various intervals. One type of maintenance visit
is an engine shop visit (ESV), which A expects to perform on its
aircraft engines approximately every 4 years to keep its aircraft in its
ordinarily efficient operating condition. In Year 1, A purchased a new
aircraft, which included four new engines attached to the airframe. The
four aircraft engines acquired with the aircraft are not materials or
supplies under Sec. 1.162-3(c)(1)(i) because they are acquired as part
of a single unit of property, the aircraft. In Year 5, A performs its
first ESV on the aircraft engines. The ESV includes disassembly,
cleaning, inspection, repair, replacement, reassembly, and testing of
the engine and its component parts. During the ESV, the engine is
removed from the aircraft and shipped to an outside vendor who performs
the ESV. If inspection or testing discloses a discrepancy in a part's
conformity to the specifications in A's maintenance program, the part is
repaired, or if necessary, replaced with a comparable and commercially
available replacement part. After the ESVs, the engines are returned to
A to be reinstalled on another aircraft or stored for later
installation. Assume that the class life for A's aircraft, including the
engines, is 12 years. Assume that none of the exceptions set out in
paragraph (i)(3) of this section apply to the costs of performing the
ESVs.
(ii) Because the ESVs involve the recurring activities that A
expects to perform as a result of its use of the aircraft to keep the
aircraft in ordinarily efficient operating condition and consist of
maintenance activities that A expects to perform more than once during
the 12 year class life of the aircraft, A's ESVs are within the routine
maintenance safe harbor under paragraph (i)(1)(ii) of this section.
Accordingly, the amounts paid for the ESVs are deemed not to improve the
aircraft and are not required to be capitalized under paragraph (d) of
this section.
Example 2. Routine maintenance after class life Assume the same
facts as in Example 1, except that in year 15 A pays amounts to perform
an ESV on one of the original aircraft engines after the end of the
class life of the aircraft. Because this ESV involves the same routine
maintenance activities that were performed on aircraft engines in
Example 1, this ESV also is within the routine maintenance safe harbor
under paragraph (i)(1)(ii) of this section. Accordingly, the amounts
paid for this ESV, even though performed after the class life of the
aircraft, are deemed not to improve the aircraft and are not required to
be capitalized under paragraph (d) of this section.
Example 3. Routine maintenance on rotable spare parts (i) Assume the
same facts as in Example 1, except that in addition to the four engines
purchased as part of the aircraft, A separately purchases four
additional new engines that A intends to use in its aircraft fleet to
avoid operational downtime when ESVs are required to be performed on the
engines previously installed on an aircraft. Later in Year 1, A installs
these four engines on an aircraft in its fleet. In Year 5, A performs
the first ESVs on these four engines. Assume that these ESVs involve the
same routine maintenance activities that were performed on the engines
in Example 1, and that none of the exceptions set out in paragraph
(i)(3) of this section apply to these ESVs. After the ESVs were
performed, these engines were reinstalled on other aircraft or stored
for later installation.
(ii) The additional aircraft engines are rotable spare parts under
Sec. 1.162-3(c)(2) because they were acquired separately from the
aircraft, are removable from the aircraft, and are repaired and
reinstalled on other aircraft or stored for later installation. Assume
the class life of an engine is the same as the airframe, 12 years.
Because the ESVs involve the recurring activities that A expects to
perform as a result of its use of the engines
[[Page 673]]
to keep the engines in ordinarily efficient operating condition, and
consist of maintenance activities that A expects to perform more than
once during the 12 year class life of the engine, the ESVs fall within
the routine maintenance safe harbor under paragraph (i)(1)(ii) of this
section. Accordingly, the amounts paid for the ESVs for the four
additional engines are deemed not to improve these engines and are not
required to be capitalized under paragraph (d) of this section. For the
treatment of amounts paid to acquire the engines, see Sec. 1.162-3(a).
Example 4. Routine maintenance resulting from prior owner's use (i)
In January, Year 1, B purchases a used machine for use in its
manufacturing operations. Assume that the machine is the unit of
property and has a class life of 10 years. B places the machine in
service in January, Year 1, and at that time, B expects to perform
manufacturer recommended scheduled maintenance on the machine
approximately every three years. The scheduled maintenance includes the
cleaning and oiling of the machine, the inspection of parts for defects,
and the replacement of minor items such as springs, bearings, and seals
with comparable and commercially available replacement parts. At the
time B purchased the machine, the machine was approaching the end of a
three-year scheduled maintenance period. As a result, in February, Year
1, B pays amounts to perform the manufacturer recommended scheduled
maintenance. Assume that none of the exceptions set out in paragraph
(i)(3) of this section apply to the amounts paid for the scheduled
maintenance.
(ii) The majority of B's costs do not qualify under the routine
maintenance safe harbor in paragraph (i)(1)(ii) of this section because
the costs were incurred primarily as a result of the prior owner's use
of the property and not B's use. B acquired the machine just before it
had received its three-year scheduled maintenance. Accordingly, the
amounts paid for the scheduled maintenance resulted from the prior
owner's, and not B's, use of the property and must be capitalized if
those amounts result in a betterment under paragraph (i) of this
section, including the amelioration of a material condition or defect,
or otherwise result in an improvement under paragraph (d) of this
section.
Example 5. Routine maintenance resulting from new owner's use Assume
the same facts as in Example 4, except that after B pays amounts for the
maintenance in Year 1, B continues to operate the machine in its
manufacturing business. In Year 4, B pays amounts to perform the next
scheduled manufacturer recommended maintenance on the machine. Assume
that the scheduled maintenance activities performed are the same as
those performed in Example 4 and that none of the exceptions set out in
paragraph (i)(3) of this section apply to the amounts paid for the
scheduled maintenance. Because the scheduled maintenance performed in
Year 4 involves the recurring activities that B performs as a result of
its use of the machine, keeps the machine in an ordinarily efficient
operating condition, and consists of maintenance activities that B
expects to perform more than once during the 10-year class life of the
machine, B's scheduled maintenance costs are within the routine
maintenance safe harbor under paragraph (i)(1)(ii) of this section.
Accordingly, the amounts paid for the scheduled maintenance in Year 4
are deemed not to improve the machine and are not required to be
capitalized under paragraph (d) of this section.
Example 6. Routine maintenance; replacement of substantial
structural part; coordination with section 263A C is in the business of
producing commercial products for sale. As part of the production
process, C places raw materials into lined containers in which a
chemical reaction is used to convert raw materials into the finished
product. The lining, which comprises 60 percent of the total physical
structure of the container, is a substantial structural part of the
container. Assume that each container, including its lining, is the unit
of property and that a container has a class life of 12 years. At the
time that C placed the container into service, C was aware that
approximately every three years, the container lining would need to be
replaced with comparable and commercially available replacement
materials. At the end of three years, the container will continue to
function, but will become less efficient and the replacement of the
lining will be necessary to keep the container in an ordinarily
efficient operating condition. In Year 1, C acquired 10 new containers
and placed them into service. In Year 4, Year 7, Year 9, and Year 12, C
pays amounts to replace the containers' linings with comparable and
commercially available replacement parts. Assume that none of the
exceptions set out in paragraph (i)(3) of this section apply to the
amounts paid for the replacement linings. Because the replacement of the
linings involves recurring activities that C expects to perform as a
result of its use of the containers to keep the containers in their
ordinarily efficient operating condition and consists of maintenance
activities that C expects to perform more than once during the 12-year
class life of the containers, C's lining replacement costs are within
the routine maintenance safe harbor under paragraph (i)(1)(ii) of this
section. Accordingly, the amounts that C paid for the replacement of the
container linings are deemed not to improve the containers and are not
required to be capitalized under paragraph (d) of this section. However,
the amounts paid to replace the lining may be subject to capitalization
under section 263A if the amounts paid for this maintenance comprise the
direct or
[[Page 674]]
allocable indirect costs of the property produced by C. See Sec.
1.263A-1(e)(3)(ii)(O).
Example 7. Routine maintenance once during class life D is a Class I
railroad that owns a fleet of freight cars. Assume that a freight car,
including all its components, is a unit of property and has a class life
of 14 years. At the time that D places a freight car into service, D
expects to perform cyclical reconditioning to the car every 8 to 10
years to keep the freight car in ordinarily efficient operating
condition. During this reconditioning, D pays amounts to disassemble,
inspect, and recondition or replace components of the freight car with
comparable and commercially available replacement parts. Ten years after
D places the freight car in service, D pays amounts to perform a
cyclical reconditioning on the car. Because D expects to perform the
reconditioning only once during the 14 year class life of the freight
car, the amounts D pays for the reconditioning do not qualify for the
routine maintenance safe harbor under paragraph (i)(1)(ii) of this
section. Accordingly, D must capitalize the amounts paid for the
reconditioning of the freight car if these amounts result in an
improvement under paragraph (d) of this section.
Example 8. Routine maintenance; reasonable expectation Assume the
same facts as Example 7, except in Year 1, D acquires and places in
service several refrigerated freight cars, which also have a class life
of 14 years. Because of the special requirements of these cars, at the
time they are placed in service, D expects to perform a reconditioning
of the refrigeration components of the freight car every 6 years to keep
the freight car in an ordinarily efficient operating condition. During
the reconditioning, D pays amounts to disassemble, inspect, and
recondition or replace the refrigeration components of the freight car
with comparable and commercially available replacement parts. Assume
that none of the exceptions set out in paragraph (i)(3) of this section
apply to the amounts paid for the reconditioning of these freight cars.
In Year 6, D pays amounts to perform a reconditioning on the
refrigeration components on one of the freight cars. However, because of
changes in the frequency that D utilizes this freight car, D does not
perform the second reconditioning on the same freight car until Year 15,
after the end of the 14-year class life of the car. Under paragraph
(i)(1)(ii) of this section, D's reasonable expectation that it would
perform the reconditioning every 6 years will not be deemed unreasonable
merely because D did not actually perform the reconditioning a second
time during the 14-year class life, provided that D can substantiate
that its expectation was reasonable at the time the property was placed
in service. If D can demonstrate that its expectation was reasonable in
Year 1 using the factors provided in paragraph (i)(1)(ii) of this
section, then the amounts paid by D to recondition the refrigerated
freight car components in Year 6 and in Year 15 are within the routine
maintenance safe harbor under paragraph (i)(1)(ii) of this section.
Example 9. Routine maintenance on non-rotable part E is a towboat
operator that owns and leases a fleet of towboats. Each towboat is
equipped with two diesel-powered engines. Assume that each towboat,
including its engines, is the unit of property and that a towboat has a
class life of 18 years. At the time that E places its towboats into
service, E is aware that approximately every three to four years E will
need to perform scheduled maintenance on the two towboat engines to keep
the engines in their ordinarily efficient operating condition. This
maintenance is completed while the engines are attached to the towboat
and involves the cleaning and inspecting of the engines to determine
which parts are within acceptable operating tolerances and can continue
to be used, which parts must be reconditioned to be brought back to
acceptable tolerances, and which parts must be replaced. Engine parts
replaced during these procedures are replaced with comparable and
commercially available replacement parts. Assume the towboat engines are
not rotable spare parts under Sec. 1.162-3(c)(2). In Year 1, E acquired
a new towboat, including its two engines, and placed the towboat into
service. In Year 5, E pays amounts to perform scheduled maintenance on
both engines in the towboat. Assume that none of the exceptions set out
in paragraph (i)(3) of this section apply to the scheduled maintenance
costs. Because the scheduled maintenance involves recurring activities
that E expects to perform more than once during the 18-year class life
of the towboat, the maintenance results from E's use of the towboat, and
the maintenance is performed to keep the towboat in an ordinarily
efficient operating condition, the scheduled maintenance on E's towboat
is within the routine maintenance safe harbor under paragraph (i)(1)(ii)
of this section. Accordingly, the amounts paid for the scheduled
maintenance to its towboat engines in Year 5 are deemed not to improve
the towboat and are not required to be capitalized under paragraph (d)
of this section.
Example 10. Routine maintenance with related betterments Assume the
same facts as Example 9, except that in Year 9 E's towboat engines are
due for another scheduled maintenance visit. At this time, E decides to
upgrade the engines to increase their horsepower and propulsion, which
would permit the towboats to tow heavier loads. Accordingly, in Year 9,
E pays amounts to perform many of the same activities that it would
perform during the typical scheduled maintenance activities such as
cleaning, inspecting, reconditioning, and replacing minor parts, but at
the same
[[Page 675]]
time, E incurs costs to upgrade certain engine parts to increase the
towing capacity of the boats in excess of the capacity of the boats when
E placed them in service. In combination with the replacement of parts
with new and upgraded parts, the scheduled maintenance must be completed
to perform the horsepower and propulsion upgrade. Thus, the work done on
the engines encompasses more than the recurring activities that E
expected to perform as a result of its use of the towboats and did more
than keep the towboat in its ordinarily efficient operating condition.
Rather under paragraph (j) of this section, the amounts paid to increase
the horsepower and propulsion of the engines are for a betterment to the
towboat, and such amounts are excepted from the routine maintenance safe
harbor under paragraph (i)(3)(i) of this section. In addition, under
paragraph (g)(1)(i) of this section, the scheduled maintenance
procedures directly benefit the upgrades. Therefore, the amounts that E
paid in Year 9 for the maintenance and upgrade of the engines do not
qualify for the routine maintenance safe harbor described under
paragraph (i)(1)(ii) of this section. Rather, E must capitalize the
amounts paid for maintenance and upgrades of the engines as an
improvement to the towboats under paragraph (d) of this section.
Example 11. Routine maintenance with unrelated improvements Assume
the same facts as Example 9, except in Year 5, in addition to paying
amounts to perform the scheduled engine maintenance on both engines, E
also incurs costs to upgrade the communications and navigation systems
in the pilot house of the towboat with new state-of-the-art systems.
Assume the amounts paid to upgrade the communications and navigation
systems are for betterments under paragraph (j) of this section, and
therefore result in an improvement to the towboat under paragraph (d) of
this section. In contrast with Example 9, the amounts paid for the
scheduled maintenance on E's towboat engines are not otherwise related
to the upgrades to the navigation systems. Because the scheduled
maintenance on the towboat engines does not directly benefit and is not
incurred by reason of the upgrades to the communication and navigation
systems, the amounts paid for the scheduled engine maintenance are not a
direct or indirect cost of the improvement under paragraph (g)(1)(i) of
this section. Accordingly, the amounts paid for the scheduled
maintenance to its towboat engines in Year 5 are routine maintenance
deemed not to improve the towboat and are not required to be capitalized
under paragraph (d) of this section.
Example 12. Exceptions to routine maintenance F owns and operates a
farming and cattle ranch with an irrigation system that provides water
for crops. Assume that each canal in the irrigation system is a single
unit of property and has a class life of 20 years. At the time F placed
the canals into service, F expected to have to perform major maintenance
on the canals every three years to keep the canals in their ordinarily
efficient operating condition. This maintenance includes draining the
canals, and then cleaning, inspecting, repairing, and reconditioning or
replacing parts of the canal with comparable and commercially available
replacement parts. F placed the canals into service in Year 1 and did
not perform any maintenance on the canals until Year 6. At that time,
the canals had fallen into a state of disrepair and no longer functioned
for irrigation. In Year 6, F pays amounts to drain the canals and do
extensive cleaning, repairing, reconditioning, and replacing parts of
the canals with comparable and commercially available replacement parts.
Although the work performed on F's canals was similar to the activities
that F expected to perform, but did not perform, every three years, the
costs of these activities do not fall within the routine maintenance
safe harbor. Specifically, under paragraph (i)(3)(v) of this section,
routine maintenance does not include activities that return a unit of
property to its former ordinarily efficient operating condition if the
property has deteriorated to a state of disrepair and is no longer
functional for its intended use. Accordingly, amounts that F pays for
work performed on the canals in Year 6 must be capitalized if they
result in improvements under paragraph (d) of this section (for example,
restorations under paragraph (k) of this section).
Example 13. Routine maintenance on a building; escalator system In
Year 1, G acquires a large retail mall in which it leases space to
retailers. The mall contains an escalator system with 40 escalators,
which includes landing platforms, trusses, tracks, steps, handrails, and
safety brushes. In Year 1, when G placed its building into service, G
reasonably expected that it would need to replace the handrails on the
escalators approximately every four years to keep the escalator system
in its ordinarily efficient operating condition. After a routine
inspection and test of the escalator system in Year 4, G determines that
the handrails need to be replaced and pays an amount to replace the
handrails with comparable and commercially available handrails. The
escalator system, including the handrails, is a building system under
paragraph (e)(2)(ii)(B)(4) of this section. Assume that none of the
exceptions in paragraph (i)(3) of this section apply to the scheduled
maintenance costs. Because the replacement of the handrails involves
recurring activities that G expects to perform as a result of its use of
the escalator system to keep the escalator system in an ordinarily
efficient operating condition, and G reasonably expects to perform these
activities
[[Page 676]]
more than once during the 10-year period beginning at the time building
system was placed in service, the amounts paid by G for the handrail
replacements are within the routine maintenance safe harbor under
paragraph (i)(1)(i) of this section. Accordingly, the amounts paid for
the replacement of the handrails in Year 4 are deemed not to improve the
building unit of property and are not required to be capitalized under
paragraph (d) of this section.
Example 14. Not routine maintenance; escalator system Assume the
same facts as in Example 13, except that in Year 9, G pays amounts to
replace the steps of the escalators. In Year 1, when G placed its
building into service, G reasonably expected that approximately every 18
to 20 years G would need to replace the steps to keep the escalator
system in its ordinarily efficient operating condition. Because the
replacement does not involve recurring activities that G expects to
perform more than once during the 10-year period beginning at the time
the building structure or the building system was placed in service, the
costs of these activities do not fall within the routine maintenance
safe harbor. Accordingly, amounts that G pays to replace the steps in
Year 9 must be capitalized if they result in improvements under
paragraph (d) of this section (for example, restorations under paragraph
(k) of this section).
Example 15. Routine maintenance on building; reasonable expectation
In Year 1, H acquires a new office building, which it uses to provide
services. The building contains an HVAC system, which is a building
system under paragraph (e)(2)(ii)(B)(1) of this section. In Year 1, when
H placed its building into service, H reasonably expected that every
four years H would need to pay an outside contractor to perform detailed
testing, monitoring, and preventative maintenance on its HVAC system to
keep the HVAC system in its ordinarily efficient operating condition.
This scheduled maintenance includes disassembly, cleaning, inspection,
repair, replacement, reassembly, and testing of the HVAC system and many
of its component parts. If inspection or testing discloses a problem
with any component, the part is repaired, or if necessary, replaced with
a comparable and commercially available replacement part. The scheduled
maintenance at these intervals is recommended by the manufacturer of the
HVAC system and is routinely performed on similar systems in similar
buildings. Assume that none of the exceptions in paragraph (i)(3) of
this section apply to the amounts paid for the maintenance on the HVAC
system. In Year 4, H pays amounts to a contractor to perform the
scheduled maintenance. However, H does not perform this scheduled
maintenance on its building again until Year 11. Under paragraph
(i)(1)(i) of this section, H's reasonable expectation that it would
perform the maintenance every 4 years will not be deemed unreasonable
merely because H did not actually perform the maintenance a second time
during the 10-year period, provided that H can substantiate that its
expectation was reasonable at the time the property was placed in
service. If H can demonstrate that its expectation was reasonable in
Year 1 using the other factors considered in paragraph (i)(1)(i), then
the amounts H paid for the maintenance of the HVAC system in Year 4 and
in Year 11 are within the routine maintenance safe harbor under
paragraph (i)(1)(i) of this section.
(j) Capitalization of betterments--(1) In general. A taxpayer must
capitalize as an improvement an amount paid for a betterment to a unit
of property. An amount is paid for a betterment to a unit of property
only if it--
(i) Ameliorates a material condition or defect that either existed
prior to the taxpayer's acquisition of the unit of property or arose
during the production of the unit of property, whether or not the
taxpayer was aware of the condition or defect at the time of acquisition
or production;
(ii) Is for a material addition, including a physical enlargement,
expansion, extension, or addition of a major component (as defined in
paragraph (k)(6) of this section) to the unit of property or a material
increase in the capacity, including additional cubic or linear space, of
the unit of property; or
(iii) Is reasonably expected to materially increase the
productivity, efficiency, strength, quality, or output of the unit of
property.
(2) Application of betterment rules--(i) In general. The
applicability of each quantitative and qualitative factor provided in
paragraphs (j)(1)(ii) and (j)(1)(iii) of this section to a particular
unit of property depends on the nature of the unit of property. For
example, if an addition or an increase in a particular factor cannot be
measured in the context of a specific type of property, this factor is
not relevant in the determination of whether an amount has been paid for
a betterment to the unit of property.
(ii) Application of betterment rules to buildings. An amount is paid
to improve a building if it is paid for a betterment, as defined under
paragraph (j)(1) of this section, to a property specified under
[[Page 677]]
paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium),
paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased
building or leased portion of building) of this section. For example, an
amount is paid to improve a building if it is paid for an increase in
the efficiency of the building structure or any one of its building
systems (for example, the HVAC system).
(iii) Unavailability of replacement parts. If a taxpayer replaces a
part of a unit of property that cannot reasonably be replaced with the
same type of part (for example, because of technological advancements or
product enhancements), the replacement of the part with an improved, but
comparable, part does not, by itself, result in a betterment to the unit
of property.
(iv) Appropriate comparison--(A) In general. In cases in which an
expenditure is necessitated by normal wear and tear or damage to the
unit of property that occurred during the taxpayer's use of the unit of
property, the determination of whether an expenditure is for the
betterment of the unit of property is made by comparing the condition of
the property immediately after the expenditure with the condition of the
property immediately prior to the circumstances necessitating the
expenditure.
(B) Normal wear and tear. If the expenditure is made to correct the
effects of normal wear and tear to the unit of property that occurred
during the taxpayer's use of the unit of property, the condition of the
property immediately prior to the circumstances necessitating the
expenditure is the condition of the property after the last time the
taxpayer corrected the effects of normal wear and tear (whether the
amounts paid were for maintenance or improvements) or, if the taxpayer
has not previously corrected the effects of normal wear and tear, the
condition of the property when placed in service by the taxpayer.
(C) Damage to property. If the expenditure is made to correct damage
to a unit of property that occurred during the taxpayer's use of the
unit of property, the condition of the property immediately prior to the
circumstances necessitating the expenditure is the condition of the
property immediately prior to damage.
(3) Examples. The following examples illustrate the application of
this paragraph (j) only and do not address whether capitalization is
required under another provision of this section or another provision of
the Internal Revenue Code (for example, section 263A). Unless otherwise
provided, assume that the appropriate comparison in paragraph (j)(2)(iv)
of this section is not applicable under the facts.
Example 1. Amelioration of pre-existing material condition or defect
In Year 1, A purchases a store located on a parcel of land that contains
underground gasoline storage tanks left by prior occupants. Assume that
the parcel of land is the unit of property. The tanks had leaked prior
to A's purchase, causing soil contamination. A is not aware of the
contamination at the time of purchase. In Year 2, A discovers the
contamination and incurs costs to remediate the soil. The remediation
costs are for a betterment to the land under paragraph (j)(1)(i) of this
section because A incurred the costs to ameliorate a material condition
or defect that existed prior to A's acquisition of the land.
Example 2. Not amelioration of pre-existing condition or defect B
owns an office building that was constructed with insulation that
contained asbestos. The health dangers of asbestos were not widely known
when the building was constructed. Several years after B places the
building into service, B determines that certain areas of asbestos-
containing insulation have begun to deteriorate and could eventually
pose a health risk to employees. Therefore, B pays an amount to remove
the asbestos-containing insulation from the building structure and
replace it with new insulation that is safer to employees, but no more
efficient or effective than the asbestos insulation. Under paragraphs
(e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve
a building unit of property if the amount is paid for a betterment to
the building structure or any building system. Although the asbestos is
determined to be unsafe under certain circumstances, the presence of
asbestos insulation in a building, by itself, is not a preexisting
material condition or defect of the building structure under paragraph
(j)(1)(i) of this section. In addition, the removal and replacement of
the asbestos is not for a material addition to the building structure or
a material increase in the capacity of the building structure under
paragraphs (j)(1)(ii) and (j)(2)(iv) of this section as compared to the
condition of the property prior to the deterioration of the insulation.
Similarly, the removal and replacement of asbestos is not
[[Page 678]]
reasonably expected to materially increase the productivity, efficiency,
strength, quality, or output of the building structure under paragraphs
(j)(1)(iii) and (j)(2)(iv) of this section as compared to the condition
of the property prior to the deterioration of the insulation. Therefore,
the amount paid to remove and replace the asbestos insulation is not for
a betterment to the building structure or an improvement to the building
under paragraph (j) of this section.
Example 3. Not amelioration of pre-existing material condition or
defect (i) In January, Year 1, C purchased a used machine for use in its
manufacturing operations. Assume that the machine is a unit of property
and has a class life of 10 years. C placed the machine in service in
January, Year 1 and at that time expected to perform manufacturer
recommended scheduled maintenance on the machine every three years. The
scheduled maintenance includes cleaning and oiling the machine,
inspecting parts for defects, and replacing minor items, such as
springs, bearings, and seals, with comparable and commercially available
replacement parts. The scheduled maintenance does not include any
material additions or materially increase the capacity, productivity,
efficiency, strength, quality, or output of the machine. At the time C
purchased the machine, it was approaching the end of a three-year
scheduled maintenance period. As a result, in February, Year 1, C pays
an amount to perform the manufacturer recommended scheduled maintenance
to keep the machine in its ordinarily efficient operating condition.
(ii) The amount that C pays does not qualify under the routine
maintenance safe harbor in paragraph (i) of this section, because the
cost primarily results from the prior owner's use of the property and
not the taxpayer's use. C acquired the machine just before it had
received its three-year scheduled maintenance. Accordingly, the amount
that C pays for the scheduled maintenance results from the prior owner's
use of the property and ameliorates conditions or defects that existed
prior to C's ownership of the machine. Nevertheless, considering the
purpose and minor nature of the work performed, this amount does not
ameliorate a material condition or defect in the machine under paragraph
(j)(1)(i) of this section, is not for a material addition to or increase
in capacity of the machine under paragraph (j)(1)(ii) of this section,
and is not reasonably expected to materially increase the productivity,
efficiency, strength, quality, or output of the machine under paragraph
(j)(1)(iii) of this section. Therefore, C is not required to capitalize
the amount paid for the scheduled maintenance as a betterment to the
unit of property under this paragraph (j).
Example 4. Not amelioration of pre-existing material condition or
defect D purchases a used ice resurfacing machine for use in the
operation of its ice skating rink. To comply with local regulations, D
is required to routinely monitor the air quality in the ice skating
rink. One week after D places the machine into service, during a routine
air quality check, D discovers that the operation of the machine is
adversely affecting the air quality in the skating rink. As a result, D
pays an amount to inspect and retune the machine, which includes
replacing minor components of the engine that had worn out prior to D's
acquisition of the machine. Assume the resurfacing machine, including
the engine, is the unit of property. The routine maintenance safe harbor
in paragraph (i) of this section does not apply to the amounts paid,
because the activities performed do not relate solely to the taxpayer's
use of the machine. The amount that D pays to inspect, retune, and
replace minor components of the ice resurfacing machine ameliorates a
condition or defect that existed prior to D's acquisition of the
equipment. Nevertheless, considering the purpose and minor nature of the
work performed, this amount does not ameliorate a material condition or
defect in the machine under paragraph (j)(1)(i) of this section. In
addition, the amount is not paid for a material addition to the machine
or a material increase in the capacity of the machine under paragraph
(j)(1)(ii) of this section. Also, the activities are not reasonably
expected to materially increase the productivity, efficiency, strength,
quality, or output of the machine under paragraph (j)(1)(iii) of this
section. Therefore, D is not required to capitalize the amount paid to
inspect, retune, and replace minor components of the machine as a
betterment under this paragraph (j).
Example 5. Amelioration of material condition or defect (i) E
acquires a building for use in its business of providing assisted living
services. Before and after the purchase, the building functions as an
assisted living facility. However, at the time of the purchase, E is
aware that the building is in a condition that is below the standards
that E requires for facilities used in its business. Immediately after
the acquisition and during the following two years, while E continues to
use the building as an assisted living facility, E pays amounts for
extensive repairs and maintenance, and the acquisition of new property
to bring the facility into the high-quality condition for which E's
facilities are known. The work on E's building includes repairing
damaged drywall, repainting, re-wallpapering, replacing windows,
repairing and replacing doors, replacing and regrouting tile, repairing
millwork, and repairing and replacing roofing materials. The work also
involves the replacement of section 1245 property, including window
treatments, furniture, and cabinets. The work that E performs affects
only the building structure under paragraph (e)(2)(ii)(A) of this
[[Page 679]]
section and does not affect any of the building systems described in
paragraph (e)(2)(ii)(B) of this section. Assume that each section 1245
property is a separate unit of property.
(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an
amount is paid to improve a building unit of property if the amount is
paid for a betterment to the building structure or any building system.
Considering the purpose of the expenditure and the effect of the
expenditures on the building structure, the amounts that E paid for
repairs and maintenance to the building structure comprise a betterment
to the building structure under paragraph (j)(1)(i) of this section
because the amounts ameliorate material conditions that existed prior to
E's acquisition of the building. Therefore, E must treat the amounts
paid for the betterment to the building structure as an improvement to
the building and must capitalize the amounts under paragraphs (j) and
(d)(1) of this section. Moreover, E is required to capitalize the
amounts paid to acquire and install each section 1245 property,
including each window treatment, each item of furniture, and each
cabinet, in accordance with Sec. 1.263(a)-2(d)(1).
Example 6. Not a betterment; building refresh (i) F owns a
nationwide chain of retail stores that sell a wide variety of items. To
maintain the appearance and functionality of its store buildings after
several years of wear, F periodically pays amounts to refresh the look
and layout of its stores. The work that F performs during a refresh
consists of cosmetic and layout changes to the store's interiors and
general repairs and maintenance to the store building to modernize the
store buildings and reorganize the merchandise displays. The work to
each store consists of replacing and reconfiguring display tables and
racks to provide better exposure of the merchandise, making
corresponding lighting relocations and flooring repairs, moving one wall
to accommodate the reconfiguration of tables and racks, patching holes
in walls, repainting the interior structure with a new color scheme to
coordinate with new signage, replacing damaged ceiling tiles, cleaning
and repairing wood flooring throughout the store building, and power
washing building exteriors. The display tables and the racks all
constitute section 1245 property. F pays amounts to refresh 50 stores
during the taxable year. Assume that each section 1245 property within
each store is a separate unit of property. Finally, assume that the work
does not ameliorate any material conditions or defects that existed when
F acquired the store buildings or result in any material additions to
the store buildings.
(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an
amount is paid to improve a building unit of property if the amount is
paid for a betterment to the building structure or any building system.
Considering the facts and circumstances including the purpose of the
expenditure, the physical nature of the work performed, and the effect
of the expenditure on the buildings' structure and systems, the amounts
paid for the refresh of each building are not for any material additions
to, or material increases in the capacity of, the buildings' structure
or systems as compared with the condition of the structure or systems
after the previous refresh. Moreover, the amounts paid are not
reasonably expected to materially increase the productivity, efficiency,
strength, quality, or output of any building structure or system under
as compared to the condition of the structures or systems after the
previous refresh. Rather, the work performed keeps F's store buildings'
structures and buildings' systems in their ordinarily efficient
operating condition. Therefore, F is not required to treat the amounts
paid for the refresh of its store buildings' structures and buildings'
systems as betterments under paragraphs (j)(1)(ii), (j)(1)(iii), and
(j)(2)(iv) of this section. However, F is required to capitalize the
amounts paid to acquire and install each section 1245 property in
accordance with Sec. 1.263(a)-2(d)(1).
Example 7. Building refresh; limited improvement (i) Assume the same
facts as Example 6 except, in the course of the refresh to one of its
store buildings, F also pays amounts to increase the building's storage
space, add a second loading dock, and add a second overhead door.
Specifically, at the same time F pays amounts to perform the refresh, F
pays additional amounts to construct an addition to the back of the
store building, including adding a new overhead door and loading dock to
the building. The work also involves upgrades to the electrical system
of the building, including the addition of a second service box with
increased amperage and new wiring from the service box to provide
lighting and power throughout the new space. Although it is performed at
the same time, the construction of the additions does not affect, and is
not otherwise related to, the refresh of the retail space.
(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an
amount is paid to improve a building unit of property if the amount is
paid for a betterment to the building structure or any building system.
Under paragraph (j)(1)(ii) of this section, the amounts paid by F to add
the storage space, loading dock, overhead door, and expand the
electrical system are for betterments to F's building structure and to
the electrical system because they are for material additions to, and a
material increase in capacity of, the structure and the electrical
system of F's store building. Accordingly, F must treat the amounts paid
for these betterments as improvements to the building unit of property
and capitalize these amounts under
[[Page 680]]
paragraphs (d)(1) and (j) of this section. However, for the reasons
discussed in Example 6, F is not required to treat the amounts paid for
the refresh of its store building structure and systems as a betterments
under paragraph (j)(1) of this section. In addition, F is not required
under paragraph (g)(1) of this section to capitalize the refresh costs
described in Example 6 because these costs do not directly benefit and
are not incurred by reason of the additions to the building structure
and electrical system. As in Example 6, F is required to capitalize the
amounts paid to acquire and install each section 1245 property in
accordance with Sec. 1.263(a)-2(d)(1).
Example 8. Betterment; building remodel (i) G owns a large chain of
retail stores that sell a variety of items. G determines that due to
changes in the retail market, it can no longer compete in its current
store class and decides to upgrade its stores to offer higher end
products to a different type of customer. To offer these products and
attract different types of customers, G must substantially remodel its
stores. Thus, G pays amounts to remodel its stores by performing work on
the buildings' structures and systems as defined under paragraphs
(e)(2)(ii)(A) and (e)(2)(ii)(B) of this section. This work includes
replacing large parts of the exterior walls with windows, replacing the
escalators with a monumental staircase, adding a new glass enclosed
elevator, rebuilding the interior and exterior facades, replacing vinyl
floors with ceramic flooring, replacing ceiling tiles with acoustical
tiles, and removing and rebuilding walls to move changing rooms and
create specialty departments. The work also includes upgrades to
increase the capacity of the buildings' electrical system to accommodate
the structural changes and the addition of new section 1245 property,
such as new product information kiosks and point of sale systems. The
work to the electrical system also involves the installation of new more
efficient and mood enhancing lighting fixtures. In addition, the work
includes remodeling all bathrooms by replacing contractor-grade plumbing
fixtures with designer-grade fixtures that conserve water and energy.
Finally, G also pays amounts to clean debris resulting from construction
during the remodel, patch holes in walls that were made to upgrade the
electrical system, repaint existing walls with a new color scheme to
match the new interior construction, and to power wash building
exteriors to enhance the new exterior facade.
(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an
amount is paid to improve a building unit of property if the amount is
paid for a betterment to the building structure or any building system.
Considering the facts and circumstances, including the purpose of the
expenditure, the physical nature of the work performed, and the effect
of the work on the buildings' structures and buildings' systems, the
amounts that G pays for the remodeling of its stores result in
betterments to the buildings' structures and several of its systems
under paragraph (j) of this section. Specifically, the amounts paid to
replace large parts of the exterior walls with windows, replace the
escalators with a monumental staircase, add a new elevator, rebuild the
interior and exterior facades, replace vinyl floors with ceramic
flooring, replace the ceiling tiles with acoustical tiles, and to remove
and rebuild walls are for material additions, that is the addition of
major components, to the building structure under paragraph (j)(1)(ii)
of this section and are reasonably expected to increase the quality of
the building structure under paragraph (j)(1)(iii) of this section.
Similarly, the amounts paid to upgrade the electrical system are to
materially increase the capacity of the electrical system under
paragraph (j)(1)(ii) of this section and are reasonably expected to
increase the quality of this system under paragraph (j)(1)(iii) of this
section. In addition, the amounts paid to remodel the bathrooms with
higher grade and more resource-efficient materials are reasonably
expected to increase the efficiency and quality of the plumbing system
under paragraph (j)(1)(iii) of this section. Finally, the amounts paid
to clean debris, patch and repaint existing walls with a new color
scheme, and to power wash building exteriors, while not betterments by
themselves, directly benefitted and were incurred by reason of the
improvements to G's store buildings' structures and electrical systems
under paragraph (g)(1) of this section. Therefore, G must treat the
amounts paid for betterments to the store buildings' structures and
systems, including the costs of cleaning, patching, repairing, and power
washing the building, as improvements to G's buildings and must
capitalize these amounts under paragraphs (d)(1) and (j) of this
section. Moreover, G is required to capitalize the amounts paid to
acquire and install each section 1245 property in accordance with Sec.
1.263(a)-2(d)(1). For the treatment of amounts paid to remove components
of property, see paragraph (g)(2) of this section.
Example 9. Not betterment; relocation and reinstallation of personal
property In Year 1, H purchases new cash registers for use in its retail
store located in leased space in a shopping mall. Assume that each cash
register is a unit of property as determined under paragraph (e)(3) of
this section. In Year 1, H capitalizes the costs of acquiring and
installing the new cash registers under Sec. 1.263(a)-2(d)(1). In Year
3, H's lease expires, and H decides to relocate its retail store to a
different building. In addition to various other costs, H pays $5,000 to
move the cash registers and $1,000 to reinstall them in the new store.
The cash registers are used for the same purpose and in the same manner
that they were used
[[Page 681]]
in the former location. The amounts that H pays to move and reinstall
the cash registers into its new store do not result in a betterment to
the cash registers under paragraph (j) of this section.
Example 10. Betterment; relocation and reinstallation of equipment J
operates a manufacturing facility in Building A, which contains various
machines that J uses in its manufacturing business. J decides to expand
part of its operations by relocating a machine to Building B to
reconfigure the machine with additional components. Assume that the
machine is a single unit of property under paragraph (e)(3) of this
section. J pays amounts to disassemble the machine, to move the machine
to the new location, and to reinstall the machine in a new configuration
with additional components. Assume that the reinstallation, including
the reconfiguration and the addition of components, is for an increase
in capacity of the machine, and therefore is for a betterment to the
machine under paragraph (j)(1)(ii) of this section. Accordingly, J must
capitalize the costs of reinstalling the machine as an improvement to
the machine under paragraphs (j) and (d)(1) of this section. J is also
required to capitalize the costs of disassembling and moving the machine
to Building B because these costs directly benefit and are incurred by
reason of the improvement to the machine under paragraph (g)(1) of this
section.
Example 11. Betterment; regulatory requirement K owns a building
that it uses in its business. In Year 1, City C passes an ordinance
setting higher safety standards for buildings because of the hazardous
conditions caused by earthquakes. To comply with the ordinance, K pays
an amount to add expansion bolts to its building structure. These bolts
anchor the wooden framing of K's building to its cement foundation,
providing additional structural support and resistance to seismic
forces, making the building more resistant to damage from lateral
movement. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an
amount is paid to improve a building unit of property if the amount is
paid for a betterment to the building structure or any building system.
The framing and foundation are part of the building structure as defined
in paragraph (e)(2)(ii)(A) of this section. Prior to the ordinance, the
old building was in good condition but did not meet City C's new
requirements for earthquake resistance. The amount paid by K for the
addition of the expansion bolts met City C's new requirement, but also
materially increased the strength of the building structure under
paragraph (j)(1)(iii) of this section. Therefore, K must treat the
amount paid to add the expansion bolts as a betterment to the building
structure and must capitalize this amount as an improvement to building
under paragraphs (d)(1) and (j) of this section. Under paragraph (g)(4)
of this section, City C's new requirement that K's building meet certain
safety standards to continue to operate is not relevant in determining
whether the amount paid improved the building.
Example 12. Not a betterment; regulatory requirement L owns a meat
processing plant. After operating the plant for many years, L discovers
that oil is seeping through the concrete walls of the plant. Federal
inspectors advise L that it must correct the seepage problem or shut
down its plant. To correct the problem, L pays an amount to add a
concrete lining to the walls from the floor to a height of about four
feet and also to add concrete to the floor of the plant. Under
paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid
to improve a building unit of property if the amount is paid for a
betterment to the building structure or any building system. The walls
are part of the building structure as defined in paragraph (e)(2)(ii)(A)
of this section. The condition necessitating the expenditure was the
seepage of the oil into the plant. Prior to the seepage, the walls did
not leak and were functioning for their intended use. L is not required
to treat the amount paid as a betterment under paragraphs (j)(1)(ii) and
(j)(2)(iv) of this section because it is not paid for a material
addition to, or a material increase in the capacity of, the building's
structure as compared to the condition of the structure prior to the
seepage of oil. Moreover, the amount paid is not reasonably expected to
materially increase the productivity, efficiency, strength, quality, or
output of the building structure under paragraphs (j)(1)(iii) and
(j)(2)(iv) as compared to the condition of the structure prior to the
seepage of the oil Therefore, L is not required to treat the amount paid
to correct the seepage as a betterment to the building under paragraph
(d)(1) or (j) of this section. The federal inspectors' requirement that
L correct the seepage to continue operating the plant is not relevant in
determining whether the amount paid improves the plant.
Example 13. Not a betterment; new roof membrane M owns a building
that it uses for its retail business. Over time, the waterproof membrane
(top layer) on the roof of M's building begins to wear, and M began to
experience water seepage and leaks throughout its retail premises. To
eliminate the problems, a contractor recommends that M put a new rubber
membrane on the worn membrane. Accordingly, M pays the contractor to add
the new membrane. The new membrane is comparable to the worn membrane
when it was originally placed in service by the taxpayer. Under
paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid
to improve a building unit of property if the amount is paid for a
betterment to the building structure or any building system. The
[[Page 682]]
roof is part of the building structure under paragraph (e)(2)(ii)(A) of
this section. The condition necessitating the expenditure was the normal
wear of M's roof. Under paragraph (j)(2)(iv) of this section, to
determine whether the amounts are for a betterment, the condition of the
building structure after the expenditure must be compared to the
condition of the structure when M placed the building into service
because M has not previously corrected the effects of normal wear and
tear. Under these facts, the amount paid to add the new membrane to the
roof is not for a material addition or a material increase in the
capacity of the building structure under paragraph (j)(1)(ii) of this
section as compared to the condition of the structure when it was placed
in service. Moreover, the new membrane is not reasonably expected to
materially increase the productivity, efficiency, strength, quality, or
output of the building structure under paragraph (j)(1)(iii) of this
section as compared to the condition of the building structure when it
was placed in service. Therefore, M is not required to treat the amount
paid to add the new membrane as a betterment to the building under
paragraph (d)(1) or (j) of this section.
Example 14. Material increase in capacity; building N owns a factory
building with a storage area on the second floor. N pays an amount to
reinforce the columns and girders supporting the second floor to permit
storage of supplies with a gross weight 50 percent greater than the
previous load-carrying capacity of the storage area. Under paragraphs
(e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve
a building unit of property if the amount is paid for a betterment to
the building structure or any building system. The columns and girders
are part of the building structure defined under paragraph (e)(2)(ii)(A)
of this section. N must treat the amount paid to reinforce the columns
and girders as a betterment under paragraphs (j)(1)(ii) and (j)(1)(iii)
of this section because it materially increases the load-carrying
capacity and the strength of the building structure. Therefore, N must
capitalize this amount as an improvement to the building under
paragraphs (d)(1) and (j) of this section.
Example 15. Material increase in capacity; channel O owns harbor
facilities consisting of a slip for the loading and unloading of barges
and a channel leading from the slip to the river. At the time of
purchase, the channel was 150 feet wide, 1,000 feet long, and 10 feet
deep. Several years after purchasing the harbor facilities, to allow for
ingress and egress and for the unloading of larger barges, O decides to
deepen the channel to a depth of 20 feet. O pays a contractor to dredge
the channel to 20 feet. Assume the channel is the unit of property. O
must capitalize the amounts paid for the dredging as an improvement to
the channel because they are for a material increase in the capacity of
the unit of property under paragraph (j)(1)(ii) of this section.
Example 16. Not a material increase in capacity; channel Assume the
same facts as in Example 15, except that the channel was susceptible to
siltation and, after dredging to 20 feet, the channel depth had been
reduced to 18 feet. O pays a contractor to redredge the channel to a
depth of 20 feet. The expenditure was necessitated by the siltation of
the channel. Both prior to the siltation and after the redredging, the
depth of the channel was 20 feet. Applying the comparison rule under
paragraph (j)(2)(iv) of this section, the amounts paid by O to redredge
the channel are not for a betterment under paragraph (j)(1)(ii) of this
section because they are not for a material addition to, or a material
increase in the capacity of, the unit of property as compared to the
condition of the property prior to the siltation. Similarly, these
amounts are not for a betterment under paragraph (j)(1)(iii) of this
section because the amounts are not reasonably expected to increase the
productivity, efficiency, strength, quality, or output of the unit of
property as compared to the condition of the property before the
siltation. Therefore, O is not required to capitalize these amounts as
improvement under paragraphs (d)(1) and (j) of this section.
Example 17. Material increase in capacity; channel Assume the same
facts as in Example 16 except that after the redredging, there is more
siltation, and the channel depth is reduced back to 18 feet. In
addition, to allow for additional ingress and egress and for the
unloading of even larger barges, O decides to deepen the channel to a
depth of 25 feet. O pays a contractor to redredge the channel to 25
feet. O must capitalize the amounts paid for the dredging as an
improvement to the channel because the amounts are for a material
increase in the capacity of the unit of property under paragraph
(j)(1)(ii) of this section as compared to condition of the unit of
property before the siltation. As part of this improvement, O is also
required to capitalize the portion of the redredge costs allocable to
restoring the depth lost to the siltation because, under paragraph
(g)(1)(i) of this section, these amounts directly benefit and are
incurred by reason of the improvement to the unit of property.
Example 18. Not a material increase in capacity; building P owns a
building used in its trade or business. The first floor has a drop-
ceiling. To fully expose windows on the first floor, P pays an amount to
remove the drop-ceiling and repaint the original ceiling. Under
paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid
to improve a building unit of property if the amount is paid for a
betterment to the building structure or any building system. The ceiling
is part of the building structure as defined
[[Page 683]]
under paragraph (e)(2)(ii)(A) of this section. P is not required to
treat the amount paid to remove the drop-ceiling as a betterment to the
building because it was not for a material addition or material increase
in the capacity of the building structure under paragraph (j)(1)(ii) of
this section and it was not reasonably expected to materially increase
to the efficiency, strength, or quality of the building structure under
paragraph (j)(1)(iii) of this section. In addition, under paragraph
(j)(2)(i) of this section, because the effect on productivity and output
of the building structure cannot be measured in this context, these
factors are not relevant in determining whether there is a betterment to
the building structure.
Example 19. Material increase in capacity; building Q owns a
building that it uses in its retail business. The building contains one
floor of retail space with very high ceilings. Q pays an amount to add a
stairway and a mezzanine for the purposes of adding additional selling
space within its building. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of
this section, an amount is paid to improve a building unit of property
if the amount is paid for a betterment to the building structure or any
building system. The stairway and the mezzanine are part of the building
structure as defined under paragraph (e)(2)(ii)(A) of this section. Q is
required to treat the amount paid to add the stairway and mezzanine as a
betterment because it is for a material addition to, and an increase in
the capacity of, the building structure under paragraph (j)(1)(ii) of
this section. Therefore, Q must capitalize this amount as an improvement
to the building unit of property under paragraphs (d)(1) and (j) of this
section.
Example 20. Not material increase in efficiency; HVAC system R owns
an office building that it uses to provide services to customers. The
building contains an HVAC system that incorporates 10 roof-mounted units
that provide heating and air conditioning for different parts of the
building. The HVAC system also consists of controls for the entire
system and duct work that distributes the heated or cooled air to the
various spaces in the building's interior. After many years of use of
the HVAC system, R begins to experience climate control problems in
various offices throughout the office building and consults with a
contractor to determine the cause. The contractor recommends that R
replace two of the roof-mounted units. R pays an amount to replace the
two specified units. The two new units are expected to eliminate the
climate control problems and to be 10 percent more energy efficient than
the replaced units in their original condition. No work is performed on
the other roof-mounted heating/cooling units, the duct work, or the
controls. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an
amount is paid to improve a building unit of property if the amount is
paid for a betterment to the building structure or any building system.
The HVAC system, including the two-roof mounted units, is a building
system under paragraph (e)(2)(ii)(B)(1) of this section. The replacement
of the two roof-mounted units is not a material addition to or a
material increase in the capacity of the HVAC system under paragraphs
(j)(1)(ii) and (j)(3)(ii) of this section as compared to the condition
of the system prior to the climate control problems. In addition, given
the 10 percent efficiency increase in two units of the entire HVAC
system, the replacement is not expected to materially increase the
productivity, efficiency, strength, quality, or output of the HVAC
system under paragraphs (j)(1)(iii) and (j)(2)(iv) of this section as
compared to the condition of the system prior to the climate control
problems. Therefore, R is not required to capitalize the amounts paid
for these replacements as betterments to the building unit of property
under paragraphs (d)(1) and (j) of this section.
Example 21. Material increase in efficiency; building S owns a
building that it uses in its service business. S conducts an energy
assessment and determines that it could significantly reduce its energy
costs by adding insulation to its building. S pays an insulation
contractor to apply a combination of loose-fill, spray foam, and blanket
insulation throughout S's building structure, including within the
attic, walls, and crawl spaces. S reasonably expects the new insulation
to make the building more energy efficient because the contractor
indicated that the new insulation would reduce its annual energy and
power costs by approximately 50 percent of its annual costs during the
last five years. Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this
section, an amount is paid to improve a building if the amount is paid
for a betterment to the building structure or any building system.
Therefore, under paragraphs (d)(1) and (j) of this section, S must
capitalize as a betterment the amount paid to add the insulation because
the insulation is reasonably expected to materially increase the
efficiency of the building structure under paragraph (j)(1)(iii) of this
section.
Example 22. Material addition; building T owns and operates a
restaurant, which provides a variety of prepared foods to its customers.
To better accommodate its customers and increase customer traffic, T
decides to add a drive-through service area. As a result, T pays amounts
to partition an area within its restaurant for a drive-through service
counter, to construct a service window with necessary security features,
to build an overhang for vehicles, and to construct a drive-up menu
board. Assume that the drive-up menu board is section 1245 property that
is a separate unit of property under
[[Page 684]]
paragraph (e)(3) of this section. Under paragraphs (e)(2)(ii) and
(j)(2)(ii) of this section, an amount is paid to improve a building unit
of property if the amount is paid for a betterment to the building
structure or any building system. The amounts paid for the partition,
service window and overhang are betterments to the building structure
because they comprise a material addition (that is, a physical
expansion, extension, and addition of a major component) to the building
structure under paragraph (j)(1)(ii) of this section. Accordingly, T
must capitalize as an improvement the amounts paid to add the partition,
drive-through window, and overhang under paragraphs (d)(1) and (j) of
this section. T is also required to capitalize the amounts paid to
acquire and install each section 1245 property in accordance with Sec.
1.263(a)-2(d)(1).
Example 23. Costs incurred during betterment U owns a building that
it uses in its service business. To accommodate new employees and
equipment, U pays amounts to increase the load capacity of its
electrical system by adding a second electrical panel with additional
circuits and adding wiring and outlets throughout the electrical system
of its building. To complete the upgrades to the electrical system, the
contractor makes several holes in walls. As a result, U also incurs
costs to patch the holes and repaint several walls. Under paragraphs
(e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve
a building unit of property if the amount is paid for a betterment to
the building structure or any building system. The amounts paid to
upgrade the panel and wiring are for betterments to U's electrical
system because they increase the capacity of the electrical system under
paragraph (j)(1)(ii) of this section and increase the strength and
output of the electrical system under paragraph (j)(1)(iii) of this
section. Accordingly, U is required to capitalize the costs of the
upgrade to the electrical system as an improvement to the building unit
of property under paragraphs (d)(1) and (j) of this section. Moreover,
under paragraph (g)(1) of this section, U is required to capitalize the
amounts paid to patch holes and repaint several walls in its building
because these costs directly benefit and are incurred by reason of the
improvement to U's building unit of property.
(k) Capitalization of restorations--(1) In general. A taxpayer must
capitalize as an improvement an amount paid to restore a unit of
property, including an amount paid to make good the exhaustion for which
an allowance is or has been made. An amount restores a unit of property
only if it--
(i) Is for the replacement of a component of a unit of property for
which the taxpayer has properly deducted a loss for that component,
other than a casualty loss under Sec. 1.165-7;
(ii) Is for the replacement of a component of a unit of property for
which the taxpayer has properly taken into account the adjusted basis of
the component in realizing gain or loss resulting from the sale or
exchange of the component;
(iii) Is for the restoration of damage to a unit of property for
which the taxpayer is required to take a basis adjustment as a result of
a casualty loss under section 165, or relating to a casualty event
described in section 165, subject to the limitation in paragraph (k)(4)
of this section;
(iv) Returns the unit of property to its ordinarily efficient
operating condition if the property has deteriorated to a state of
disrepair and is no longer functional for its intended use;
(v) Results in the rebuilding of the unit of property to a like-new
condition as determined under paragraph (k)(5) of this section after the
end of its class life as defined in paragraph (i)(4) of this section; or
(vi) Is for the replacement of a part or combination of parts that
comprise a major component or a substantial structural part of a unit of
property as determined under paragraph (k)(6) of this section.
(2) Application of restorations to buildings. An amount is paid to
improve a building if it is paid to restore, as defined under paragraph
(k)(1) of this section, a property specified under paragraph (e)(2)(ii)
(building), paragraph (e)(2)(iii)(B) (condominium), paragraph
(e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building
or portion of building) of this section. For example, an amount is paid
to improve a building if it is paid for the replacement of a part or
combination of parts that comprise a major component or substantial
structural part of the building structure or any one of its building
systems (for example, the HVAC system). See paragraph (k)(6) of this
section.
(3) Exception for losses based on salvage value. A taxpayer is not
required to treat as a restoration amounts paid under paragraph
(k)(1)(i) or paragraph (k)(1)(ii) of this section if the unit of
property has been fully depreciated and
[[Page 685]]
the loss is attributable only to remaining salvage value as computed for
federal income tax purposes.
(4) Restoration of damage from casualty--(i) Limitation. For
purposes of paragraph (k)(1)(iii) of this section, the amount paid for
restoration of damage to the unit of property that must be capitalized
under this paragraph (k) is limited to the excess (if any) of--
(A) The amount prescribed by Sec. 1.1011-1 as the adjusted basis of
the single, identifiable property (under Sec. 1.167-7(b)(2)(i)) for
determining the loss allowable on account of the casualty, over
(B) The amount paid for restoration of damage to the unit of
property under paragraph (k)(1)(iii) of this section that also
constitutes an improvement under any other provision of paragraph (k)(1)
of this section.
(ii) Amounts in excess of limitation. The amounts paid for
restoration of damage to a unit of property as described in paragraph
(k)(1)(iii) of this section, but that exceed the limitation provided in
paragraph (k)(4)(i) of this section, must be treated in accordance with
the provisions of the Internal Revenue Code and regulations that are
otherwise applicable. See, for example, Sec. 1.162-4 (repairs and
maintenance); Sec. 1.263(a)-2 (costs to acquire and produce units of
property); and Sec. 1.263(a)-3 (costs to improve units of property).
(5) Rebuild to like-new condition. For purposes of paragraph
(k)(1)(v) of this section, a unit of property is rebuilt to a like-new
condition if it is brought to the status of new, rebuilt,
remanufactured, or a similar status under the terms of any federal
regulatory guideline or the manufacturer's original specifications.
Generally, a comprehensive maintenance program, even though substantial,
does not return a unit of property to a like-new condition.
(6) Replacement of a major component or a substantial structural
part--(i) In general. To determine whether an amount is for the
replacement of a part or a combination of parts that comprise a major
component or a substantial structural part of the unit of property under
paragraph (k)(1)(vi) of this section, it is appropriate to consider all
the facts and circumstances. These facts and circumstances include the
quantitative and qualitative significance of the part or combination of
parts in relation to the unit of property.
(A) Major component. A major component is a part or combination of
parts that performs a discrete and critical function in the operation of
the unit of property. An incidental component of the unit of property,
even though such component performs a discrete and critical function in
the operation of the unit of property, generally will not, by itself,
constitute a major component.
(B) Substantial structural part. A substantial structural part is a
part or combination of parts that comprises a large portion of the
physical structure of the unit of property.
(ii) Major components and substantial structural parts of buildings.
In the case of a building, an amount is for the replacement of a major
component or a substantial structural part of the building unit of
property if--
(A) The replacement includes a part or combination of parts that
comprise a major component (as defined in paragraph (k)(6)(i)(A) of this
section), or a significant portion of a major component, of any of the
properties designated in paragraph (e)(2)(ii) (building), paragraph
(e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or
paragraph (e)(2)(v)(B) (leased building or leased portion of a building)
of this section; or
(B) The replacement includes a part or combination of parts that
comprises a large portion of the physical structure of any of the
properties designated in paragraph (e)(2)(ii) (building), paragraph
(e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or
paragraph (e)(2)(v)(B) (leased building or portion of building) of this
section.
(7) Examples. The following examples illustrate the application of
this paragraph (k) only and do not address whether capitalization is
required under another provision of this section or another provision of
the Code (for example, section 263A). Unless otherwise stated, assume
that the taxpayer has not properly deducted a loss for, nor taken into
account the adjusted basis on a sale or exchange of, any unit
[[Page 686]]
of property, asset, or component of a unit of property that is replaced.
Example 1. Replacement of loss component A owns a manufacturing
building containing various types of manufacturing equipment. A does a
cost segregation study of the manufacturing building and properly
determines that a walk-in freezer in the manufacturing building is
section 1245 property as defined in section 1245(a)(3). The freezer is
not part of the building structure or the HVAC system under paragraph
(e)(2)(i) or (e)(2)(ii)(B)(1) of this section. Several components of the
walk-in freezer cease to function, and A decides to replace them. A
abandons the old freezer components and properly recognizes a loss from
the abandonment of the components. A replaces the abandoned freezer
components with new components and incurs costs to acquire and install
the new components. Under paragraph (k)(1)(i) of this section, A must
capitalize the amounts paid to acquire and install the new freezer
components because A replaced components for which it had properly
deducted a loss.
Example 2. Replacement of sold component Assume the same facts as in
Example 1, except that A did not abandon the components but instead sold
them to another party and properly recognized a loss on the sale. Under
paragraph (k)(1)(ii) of this section, A must capitalize the amounts paid
to acquire and install the new freezer components because A replaced
components for which it had properly taken into account the adjusted
basis of the components in realizing a loss from the sale of the
components.
Example 3. Restoration after casualty loss B owns an office building
that it uses in its trade or business. A storm damages the office
building at a time when the building has an adjusted basis of $500,000.
B deducts under section 165 a casualty loss in the amount of $50,000,
and properly reduces its basis in the office building to $450,000. B
hires a contractor to repair the damage to the building, including the
repair of the building roof and the removal of debris from the building
premises. B pays the contractor $50,000 for the work. Under paragraph
(k)(1)(iii) of this section, B must treat the $50,000 amount paid to the
contractor as a restoration of the building structure because B properly
adjusted its basis in that amount as a result of a casualty loss under
section 165, and the amount does not exceed the limit in paragraph
(k)(4) of this section. Therefore, B must treat the amount paid as an
improvement to the building unit of property and, under paragraph (d)(2)
of this section, must capitalize the amount paid.
Example 4. Restoration after casualty event Assume the same facts as
in Example 3, except that B receives insurance proceeds of $50,000 after
the casualty to compensate for its loss. B cannot deduct a casualty loss
under section 165 because its loss was compensated by insurance.
However, B properly reduces its basis in the property by the amount of
the insurance proceeds. Under paragraph (k)(1)(iii) of this section, B
must treat the $50,000 amount paid to the contractor as a restoration of
the building structure because B has properly taken a basis adjustment
relating to a casualty event described in section 165, and the amount
does not exceed the limit in paragraph (k)(4) of this section.
Therefore, B must treat the amount paid as an improvement to the
building unit of property and, under paragraph (d)(2) of this section,
must capitalize the amount paid.
Example 5. Restoration after casualty loss; limitation (i) C owns a
building that it uses in its trade or business. A storm damages the
building at a time when the building has an adjusted basis of $500,000.
C determines that the cost of restoring its property is $750,000,
deducts a casualty loss under section 165 in the amount of $500,000, and
properly reduces its basis in the building to $0. C hires a contractor
to repair the damage to the building and pays the contractor $750,000
for the work. The work involves replacing the entire roof structure of
the building at a cost of $350,000 and pumping water from the building,
cleaning debris from the interior and exterior, and replacing areas of
damaged dry wall and flooring at a cost of $400,000. Although resulting
from the casualty event, the pumping, cleaning, and replacing damaged
drywall and flooring, does not directly benefit and is not incurred by
reason of the roof replacement.
(ii) Under paragraph (k)(1)(vi) of this section, C must capitalize
as an improvement the $350,000 amount paid to the contractor to replace
the roof structure because the roof structure constitutes a major
component and a substantial structural part of the building unit of
property. In addition, under paragraphs (k)(1)(iii) and (k)(4)(i), C
must treat as a restoration the remaining costs, limited to the excess
of the adjusted basis of the building over the amounts paid for the
improvement under paragraph (k)(1)(vi). Accordingly, C must treat as a
restoration $150,000 ($500,000--$350,000) of the $400,000 paid for the
portion of the costs related to repairing and cleaning the building
structure under paragraph (k)(1)(iii) of this section. Thus, in addition
to the $350,000 to replace the roof structure, C must also capitalize
the $150,000 as an improvement to the building unit of property under
paragraph (d)(2) of this section. C is not required to capitalize the
remaining $250,000 repair and cleaning costs under paragraph (k)(1)(iii)
of this section.
Example 6. Restoration of property in a state of disrepair D owns
and operates a farm with several barns and outbuildings. D did not use
[[Page 687]]
or maintain one of the outbuildings on a regular basis, and the
outbuilding fell into a state of disrepair. The outbuilding previously
was used for storage but can no longer be used for that purpose because
the building is not structurally sound. D decides to restore the
outbuilding and pays an amount to shore up the walls and replace the
siding. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an
amount is paid to improve a building if the amount is paid to restore
the building structure or any building system. The walls and siding are
part of the building structure under paragraph (e)(2)(ii)(A) of this
section. Under paragraph (k)(1)(iv) of this section, D must treat the
amount paid to shore up the walls and replace the siding as a
restoration of the building structure because the amounts return the
building structure to its ordinarily efficient operating condition after
it had deteriorated to a state of disrepair and was no longer functional
for its intended use. Therefore, D must treat the amount paid to shore
up the walls and replace the siding as an improvement to the building
unit of property and, under paragraph (d)(2) of this section, must
capitalize the amount paid.
Example 7. Rebuild of property to like-new condition before end of
class life E is a Class I railroad that owns a fleet of freight cars.
Assume the freight cars have a recovery period of 7 years under section
168(c) and a class life of 14 years. Every 8 to 10 years, E rebuilds its
freight cars. Ten years after E places the freight car in service, E
performs a rebuild to the manufacturer's original specification, which
includes a complete disassembly, inspection, and reconditioning or
replacement of components of the suspension and draft systems, trailer
hitches, and other special equipment. E also modifies the car to upgrade
various components to the latest engineering standards. The freight car
is stripped to the frame, with all of its substantial components either
reconditioned or replaced. The frame itself is the longest-lasting part
of the car and is reconditioned. The walls of the freight car are
replaced or are sandblasted and repainted. New wheels are installed on
the car. All the remaining components of the car are restored before
they are reassembled. At the end of the rebuild, the freight car has
been restored to like-new condition under the manufacturer's
specifications. Assume the freight car is the unit of property. E is not
required to treat as an improvement and capitalize the amounts paid to
rebuild the freight car under paragraph (k)(1)(v) of this section
because, although the amounts paid restore the freight car to like-new
condition, the amounts were not paid after the end of the class life of
the freight car. However, paragraphs (k)(1)(vi) and (k)(6) of this
section are applicable for determining whether any amounts must be
capitalized because they are paid for the replacement of a major
component or a substantial structural part of the unit of property.
Example 8. Rebuild of property to like-new condition after end of
class life Assume the same facts as in Example 7, except that E rebuilds
the freight car 15 years after E places it in service. Under paragraph
(k)(1)(v) of this section, E must treat as an improvement and capitalize
the amounts paid to rebuild the freight car because the amounts paid
restore the freight car to like-new condition after the end of the class
life of the freight car.
Example 9. Not a rebuild to a like-new condition F is a commercial
airline engaged in the business of transporting freight and passengers.
To conduct its business, F owns several aircraft. As a condition of
maintaining its airworthiness certificates, F is required by the FAA to
establish and adhere to a continuous maintenance program for each
aircraft in its fleet. F performs heavy maintenance on its airframes
every 8 to 10 years. In Year 1, F purchased an aircraft for $15 million.
In Year 16, F paid $2 million for the labor and materials necessary to
perform the second heavy maintenance visit on the airframe of an
aircraft. To perform the heavy maintenance visit, F extensively
disassembles the airframe, removing items such as engines, landing gear,
cabin and passenger compartment seats, side and ceiling panels, baggage
stowage bins, galleys, lavatories, floor boards, cargo loading systems,
and flight control surfaces. As specified by F's maintenance manual for
the aircraft, F then performs certain tasks on the disassembled airframe
for the purpose of preventing deterioration of the inherent safety and
reliability levels of the airframe. These tasks include lubrication and
service, operational and visual checks, inspection and functional
checks, reconditioning of minor parts and components, and removal,
discard, and replacement of certain life-limited single cell parts, such
as cartridges, canisters, cylinders, and disks. Reconditioning of parts
includes burnishing corrosion, repairing cracks, dents, gouges,
punctures, tightening or replacing loose or missing fasteners, replacing
damaged seals, gaskets, or valves, and similar activities. In addition
to the tasks described above, to comply with certain FAA airworthiness
directives, F inspects specific skin locations, applies doublers over
small areas where cracks were found, adds structural reinforcements, and
replaces skin panels on a small section of the fuselage. However, the
heavy maintenance does not include the replacement of any major
components or substantial structural parts of the aircraft with new
components. In addition, the heavy maintenance visit does not bring the
aircraft to the status of new, rebuilt, remanufactured, or a similar
status under FAA guidelines or the manufacturer's original
specifications. After the
[[Page 688]]
heavy maintenance, the aircraft was reassembled. Assume the aircraft,
including the engines, is a unit of property and has a class life of 12
years under section 168(c). Although the heavy maintenance is performed
after the end of the class life of the aircraft, F is not required to
treat the heavy maintenance as a restoration and improvement of the unit
of property under paragraph (k)(1)(v) of this section because, although
extensive, the amounts paid do not restore the aircraft to like-new
condition. See also paragraph (i)(1)(iii) of this section for the
application of the safe harbor for routine maintenance.
Example 10. Replacement of major component or substantial structural
part; personal property G is a common carrier that owns a fleet of
petroleum hauling trucks. G pays amounts to replace the existing engine,
cab, and petroleum tank with a new engine, cab, and tank. Assume the
tractor of the truck (which includes the cab and the engine) is a single
unit of property and that the trailer (which contains the petroleum
tank) is a separate unit of property. The new engine and the cab each
constitute a part or combination of parts that comprise a major
component of G's tractor, because they perform a discrete and critical
function in the operation of the tractor. In addition, the cab
constitutes a part or combination of parts that comprise a substantial
structural part of G's tractor. Therefore, the amounts paid for the
replacement of the engine and the cab must be capitalized under
paragraph (k)(1)(vi) of this section. Moreover, the new petroleum tank
constitutes a part or combination of parts that comprise a major
component and a substantial structural part of the trailer. Accordingly,
the amounts paid for the replacement of the tank also must be
capitalized under paragraph (k)(1)(vi) of this section.
Example 11. Repair performed during restoration Assume the same
facts as in Example 10, except that, at the same time the engine and cab
of the tractor are replaced, G pays amounts to paint the cab of the
tractor with its company logo and to fix a broken taillight on the
tractor. The repair of the broken taillight and the painting of the cab
generally are deductible expenses under Sec. 1.162-4. However, under
paragraph (g)(1)(i) of this section, a taxpayer must capitalize all the
direct costs of an improvement and all the indirect costs that directly
benefit or are incurred by reason of an improvement. Repairs and
maintenance that do not directly benefit or are not incurred by reason
of an improvement are not required to be capitalized under section
263(a), regardless of whether they are made at the same time as an
improvement. For the amounts paid to paint the logo on the cab, G's need
to paint the logo arose from the replacement of the cab with a new cab.
Therefore, under paragraph (g)(1)(i) of this section, G must capitalize
the amounts paid to paint the cab as part of the improvement to the
tractor because these amounts directly benefit and are incurred by
reason of the restoration of the tractor. The amounts paid to repair the
broken taillight are not for the replacement of a major component, do
not directly benefit, and are not incurred by reason of the replacement
of the cab or the engine under paragraph (g)(1)(i) of this section, even
though the repair was performed at the same time as these replacements.
Thus, G is not required to capitalize the amounts paid to repair the
broken taillight.
Example 12. Related amounts to replace major component or
substantial structural part; personal property (i) H owns a retail
gasoline station, consisting of a paved area used for automobile access
to the pumps and parking areas, a building used to market gasoline, and
a canopy covering the gasoline pumps. The premises also consist of
underground storage tanks (USTs) that are connected by piping to the
pumps and are part of the gasoline pumping system used in the immediate
retail sale of gas. The USTs are components of the gasoline pumping
system. To comply with regulations issued by the Environmental
Protection Agency, H is required to remove and replace leaking USTs. In
Year 1, H hires a contractor to perform the removal and replacement,
which consists of removing the old tanks and installing new tanks with
leak detection systems. The removal of the old tanks includes removing
the paving material covering the tanks, excavating a hole large enough
to gain access to the old tanks, disconnecting any strapping and pipe
connections to the old tanks, and lifting the old tanks out of the hole.
Installation of the new tanks includes placement of a liner in the
excavated hole, placement of the new tanks, installation of a leak
detection system, installation of an overfill system, connection of the
tanks to the pipes leading to the pumps, backfilling of the hole, and
replacement of the paving. H also is required to pay a permit fee to the
county to undertake the installation of the new tanks.
(ii) H pays the permit fee to the county on October 15, Year 1. On
December 15, Year 1, the contractor completes the removal of the old
USTs and bills H for the costs of removal. On January 15, Year 2, the
contractor completes the installation of the new USTs and bills H for
the remainder of the work. Assume that H computes its taxes on a
calendar year basis and H's gasoline pumping system is the unit of
property. Under paragraph (k)(1)(vi) of this section, H must capitalize
the amounts paid to replace the USTs as a restoration to the gasoline
pumping system because the USTs are parts or combinations of parts that
comprise a major component and substantial structural part of the
gasoline pumping system. Moreover, under paragraph (g)(2) of this
section, H must capitalize the costs of removing the old USTs
[[Page 689]]
because H has not taken a loss on the disposition of the USTs, and the
amounts to remove the USTs directly benefit and are incurred by reason
of the restoration of, and improvement to, the gasoline pumping system.
In addition, under paragraph (g)(1) of this section, H must capitalize
the permit fees because they directly benefit and are incurred by reason
of the improvement to the gasoline pumping system. Finally, under
paragraph (g)(3) of this section, H must capitalize the related amounts
paid to improve the gasoline pumping system, including the permit fees,
the amount paid to remove the old USTs, and the amount paid to install
the new USTs, even though the amounts were separately invoiced, paid to
different parties, and incurred in different tax years.
Example 13. Not replacement of major component; incidental J owns a
machine shop in which it makes dies used by manufacturers. In Year 1, J
purchased a drill press for use in its production process. In Year 3, J
discovers that the power switch assembly, which controls the supply of
electric power to the drill press, has become damaged and cannot
operate. To correct this problem, J pays amounts to replace the power
switch assembly with comparable and commercially available replacement
parts. Assume that the drill press is a unit of property under paragraph
(e) of this section and the power switch assembly is a small component
of the drill press that may be removed and installed with relative ease.
The power switch assembly is not a major component of the unit of
property under paragraph (k)(6)(i)(A) of this section because, although
the power assembly may affect the function of J's drill press by
controlling the supply of electric power, the power assembly is an
incidental component of the drill press. In addition, the power assembly
is not a substantial structural part of J's drill press under paragraph
(k)(6)(i)(B) of this section. Therefore, J is not required to capitalize
the costs to replace the power switch assembly under paragraph
(k)(1)(vi) of this section.
Example 14. Replacement of major component or substantial structural
part; roof K owns a manufacturing building. K discovers several leaks in
the roof of the building and hires a contractor to inspect and fix the
roof. The contractor discovers that a major portion of the decking has
rotted and recommends the replacement of the entire roof. K pays the
contractor to replace the entire roof, including the decking,
insulation, asphalt, and various coatings. Under paragraphs (e)(2)(ii)
and (k)(2) of this section, an amount is paid to improve a building if
the amount is paid to restore the building structure or any building
system. The roof is part of the building structure as defined under
paragraph (e)(2)(ii)(A) of this section. Because the entire roof
performs a discrete and critical function in the building structure, the
roof comprises a major component of the building structure under
paragraph (k)(6)(ii)(A) of this section. In addition, because the roof
comprises a large portion of the physical structure of the building
structure, the roof comprises a substantial structural part of the
building structure under paragraph (k)(6)(ii)(B) of this section.
Therefore, under either analysis, K must treat the amount paid to
replace the roof as a restoration of the building under paragraphs
(k)(1)(vi) and (k)(2) of this section and must capitalize the amount
paid as an improvement under paragraph (d)(2) of this section.
Example 15. Not replacement of major component or substantial
structural part; roof membrane L owns a building in which it conducts
its retail business. The roof decking over L's building is covered with
a waterproof rubber membrane. Over time, the rubber membrane begins to
wear, and L begins to experience leaks into its retail premises.
However, the building is still functioning in L's business. To eliminate
the problems, a contractor recommends that L replace the membrane on the
roof with a new rubber membrane. Accordingly, L pays the contractor to
strip the original membrane and replace it with a new rubber membrane.
The new membrane is comparable to the original membrane but corrects the
leakage problems. Under paragraphs (e)(2)(ii) and (k)(2) of this
section, an amount is paid to improve a building if the amount is paid
to restore the building structure or any building system. The roof,
including the membrane, is part of the building structure as defined
under paragraph (e)(2)(ii)(A) of this section. Because the entire roof
performs a discrete and critical function in the building structure, the
roof comprises a major component of the building structure under
paragraph (k)(6)(ii)(A) of this section. Although the replacement
membrane may aid in the function of the building structure, it does not,
by itself, comprise a significant portion of the roof major component
under paragraph (k)(6)(ii)(A) of this section. In addition, the
replacement membrane does not comprise a substantial structural part of
L's building structure under paragraph (k)(6)(ii)(B) of this section.
Therefore, L is not required to capitalize the amount paid to replace
the membrane as a restoration of the building under paragraph (k)(1)(vi)
of this section.
Example 16. Not a replacement of major component or substantial
structural part; HVAC system M owns a building in which it operates an
office that provides medical services. The building contains one HVAC
system, which is comprised of three furnaces, three air conditioning
units, and duct work that runs throughout the building to distribute the
hot or cold air throughout the building. One furnace in M's building
breaks down, and M pays an amount to replace it with a new furnace.
Under paragraphs (e)(2)(ii) and
[[Page 690]]
(k)(2) of this section, an amount is paid to improve a building if the
amount is paid to restore the building structure or any building system.
The HVAC system, including the furnaces, is a building system under
paragraph (e)(2)(ii)(B)(1) of this section. As the parts that provide
the heating function in the system, the three furnaces, together,
perform a discrete and critical function in the operation of the HVAC
system and are therefore a major component of the HVAC system under
paragraph (k)(6)(i)(A) of this section. However, the single furnace is
not a significant portion of this major component of the HVAC system
under paragraph (k)(6)(ii)(A) of this section, or a substantial
structural part of the HVAC system under paragraph (k)(6)(ii)(B) of this
section. Therefore, M is not required to treat the amount paid to
replace the furnace as a restoration of the building under paragraph
(k)(1)(vi) of this section.
Example 17. Replacement of major component or substantial structural
part; HVAC system N owns a large office building in which it provides
consulting services. The building contains one HVAC system, which is
comprised of one chiller unit, one boiler, pumps, duct work, diffusers,
air handlers, outside air intake, and a cooling tower. The chiller unit
includes the compressor, evaporator, condenser, and expansion valve, and
it functions to cool the water used to generate air conditioning
throughout the building. N pays an amount to replace the chiller with a
comparable unit. Under paragraphs (e)(2)(ii) and (k)(2) of this section,
an amount is paid to improve a building if the amount is paid to restore
the building structure or any building system. The HVAC system,
including the chiller unit, is a building system under paragraph
(e)(2)(ii)(B)(1) of this section. The chiller unit performs a discrete
and critical function in the operation of the HVAC system because it
provides the cooling mechanism for the entire system. Therefore, the
chiller unit is a major component of the HVAC system under paragraph
(k)(6)(ii)(A) of this section. Because the chiller unit comprises a
major component of a building system, N must treat the amount paid to
replace the chiller unit as a restoration to the building under
paragraphs (k)(1)(vi) and (k)(2) of this section and must capitalize the
amount paid as an improvement to the building under paragraph (d)(2) of
this section.
Example 18. Not replacement of major component or substantial
structural part; HVAC system O owns an office building that it uses to
provide services to customers. The building contains a HVAC system that
incorporates ten roof-mounted units that provide heating and air
conditioning for the building. The HVAC system also consists of controls
for the entire system and duct work that distributes the heated or
cooled air to the various spaces in the building's interior. O begins to
experience climate control problems in various offices throughout the
office building and consults with a contractor to determine the cause.
The contractor recommends that O replace three of the roof-mounted
heating and cooling units. O pays an amount to replace the three
specified units. No work is performed on the other roof-mounted heating
and cooling units, the duct work, or the controls. Under paragraphs
(e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a
building if the amount restores the building structure or any building
system. The HVAC system, including the 10 roof-mounted heating and
cooling units, is a building system under paragraph (e)(2)(ii)(B)(1) of
this section. As the components that generate the heat and the air
conditioning in the HVAC system, the 10 roof-mounted units, together,
perform a discrete and critical function in the operation of the HVAC
system and, therefore, are a major component of the HVAC system under
paragraph (k)(6)(ii)(A) of this section. The three roof-mounted heating
and cooling units are not a significant portion of a major component of
the HVAC system under (k)(6)(ii)(A) of this section, or a substantial
structural part of the HVAC system, under paragraph (k)(6)(ii)(B) of
this section. Accordingly, O is not required to treat the amount paid to
replace the three roof-mounted heating and cooling units as a
restoration of the building under paragraph (k)(1)(iv) of this section.
Example 19. Replacement of major component or substantial structural
part; fire protection system P owns a building that it uses to operate
its business. P pays an amount to replace the sprinkler system in the
building with a new sprinkler system. Under paragraphs (e)(2)(ii) and
(k)(2) of this section, an amount is paid to improve a building if the
amount restores the building structure or any building system. The fire
protection and alarm system, including the sprinkler system, is a
building system under paragraph (e)(2)(ii)(B)(6) of this section. As the
component that provides the fire suppression mechanism in the system,
the sprinkler system performs a discrete and critical function in the
operation of the fire protection and alarm system and is therefore a
major component of the system under paragraph (k)(6)(ii)(A) of this
section. Because the sprinkler system comprises a major component of a
building system, P must treat the amount paid to replace the sprinkler
system as restoration to the building unit of property under paragraphs
(k)(1)(vi) and (k)(2) of this section and must capitalize the amount
paid as an improvement to the building under paragraph (d)(2) of this
section.
Example 20. Replacement of major component or substantial structural
part; electrical system Q owns a building that it uses to operate its
business. Q pays an amount to replace the wiring throughout the building
with new
[[Page 691]]
wiring that meets building code requirements. Under paragraphs
(e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a
building if the amount restores the building structure or any building
system. The electrical system, including the wiring, is a building
system under paragraph (e)(2)(ii)(B)(3) of this section. As the
component that distributes the electricity throughout the system, the
wiring performs a discrete and critical function in the operation of the
electrical system under paragraph (k)(6)(ii)(A) of this section. The
wiring also comprises a large portion of the physical structure of the
electrical system under paragraph (k)(6)(ii)(B) of this section. Because
the wiring comprises a major component and a substantial structural part
of a building system, Q must treat the amount paid to replace the wiring
as a restoration to the building under paragraphs (k)(1)(vi) and (k)(2)
of this section and must capitalize the amount paid as an improvement to
the building under paragraph (d)(2) of this section.
Example 21. Not a replacement of major component or substantial
structural part; electrical system R owns a building that it uses to
operate its business. R pays an amount to replace 30 percent of the
wiring throughout the building with new wiring that meets building code
requirements. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an
amount is paid to improve a building if the amount restores the building
structure or any building system. The electrical system, including the
wiring, is a building system under paragraph (e)(2)(ii)(B)(3) of this
section. All the wiring in the building comprises a major component
because it performs a discrete and critical function in the operation of
the electrical system. However, the portion of the wiring that was
replaced is not a significant portion of the wiring major component
under paragraph (k)(6)(ii)(A) of this section, nor does it comprise a
substantial structural part of the electrical system under paragraph
(k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this
section, the replacement of 30 percent of the wiring is not the
replacement of a major component or substantial structural part of the
building, and R is not required to treat the amount paid to replace 30
percent of the wiring as a restoration to the building under paragraph
(k)(1)(iv) of this section.
Example 22. Replacement of major component or substantial structural
part; plumbing system S owns a building in which it conducts a retail
business. The retail building has three floors. The retail building has
men's and women's restrooms on two of the three floors. S decides to
update the restrooms by paying an amount to replace the plumbing
fixtures in all of the restrooms, including all the toilets and sinks,
with modern style plumbing fixtures of similar quality and function. S
does not replace the pipes connecting the fixtures to the building's
plumbing system. Under paragraphs (e)(2)(ii) and (k)(2) of this section,
an amount is paid to improve a building if the amount restores the
building structure or any building system. The plumbing system,
including the plumbing fixtures, is a building system under paragraph
(e)(2)(ii)(B)(2) of this section. All the toilets together perform a
discrete and critical function in the operation of the plumbing system,
and all the sinks, together, also perform a discrete and critical
function in the operation of the plumbing system. Therefore, under
paragraph (k)(6)(ii)(A) of this section, all the toilets comprise a
major component of the plumbing system, and all the sinks comprise a
major component of the plumbing system. Accordingly, S must treat the
amount paid to replace all of the toilets and all of the sinks as a
restoration of the building under paragraphs (k)(1)(vi) and (k)(2) of
this section and must capitalize the amount paid as an improvement to
the building under paragraph (d)(2) of this section.
Example 23. Not replacement of major component or substantial
structural part; plumbing system Assume the same facts as Example 22
except that S does not update all the bathroom fixtures. Instead, S only
pays an amount to replace 8 of the total of 20 sinks located in the
various restrooms. The 8 replaced sinks, by themselves, do not comprise
a significant portion of a major component (the 20 sinks) of the
plumbing system under paragraph (k)(6)(ii)(A) of this section nor do
they comprise a large portion of the physical structure of the plumbing
system under paragraph (k)(6)(ii)(B) of this section. Therefore, under
paragraph (k)(6) of this section, the replacement of the eight sinks
does not constitute the replacement of a major component or substantial
structural part of the building, and S is not required to treat the
amount paid to replace the eight sinks as a restoration of a building
under paragraph (k)(1)(iv) of this section.
Example 24. Replacement of major component or substantial structural
part; plumbing system (i) T owns and operates a hotel building. T
decides that, to attract customers and to remain competitive, it needs
to update the guest rooms in its facility. Accordingly, T pays amounts
to replace the bathtubs, toilets, and sinks, and to repair, repaint, and
retile the bathroom walls and floors, which is necessitated by the
installation of the new plumbing components. The replacement bathtubs,
toilets, sinks, and tile are new and in a different style, but are
similar in function and quality to the replaced items. T also pays
amounts to replace certain section 1245 property, such as the guest room
furniture, carpeting, drapes, table lamps, and partition walls
separating the bathroom area. T completes this work on two floors at a
time, closing those floors and leaving the
[[Page 692]]
rest of the hotel open for business. In Year 1, T pays amounts to
perform the updates for 4 of the 20 hotel room floors and expects to
complete the renovation of the remaining rooms over the next two years.
(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an
amount is paid to improve a building if the amount restores the building
structure or any building system. The plumbing system, including the
bathtubs, toilets, and sinks, is a building system under paragraph
(e)(2)(ii)(B)(2) of this section. All the bathtubs, together, all the
toilets, together, and all the sinks together in the hotel building
perform discrete and critical functions in the operation of the plumbing
system under paragraph (k)(6)(ii)(A) of this section and comprise a
large portion of the physical structure of the plumbing system under
paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph
(k)(6)(ii) of this section, these plumbing components comprise major
components and substantial structural parts of the plumbing system, and
T must treat the amount paid to replace these plumbing components as a
restoration of, and improvement to, the building under paragraphs
(k)(1)(vi) and (k)(2) of this section. In addition, under paragraph
(g)(1)(i) of this section, T must treat the costs of repairing,
repainting, and retiling the bathroom walls and floors as improvement
costs because these costs directly benefit and are incurred by reason of
the improvement to the building. Further, under paragraph (g)(3) of this
section, T must treat the costs incurred in Years 1, 2, and 3 for the
bathroom remodeling as improvement costs, even though they are incurred
over a period of several taxable years, because they are related amounts
paid to improve the building unit of property. Accordingly, under
paragraph (d)(2) of this section, T must treat all the amounts it incurs
to update its hotel restrooms as an improvement to the hotel building
and capitalize these amounts. In addition, under Sec. 1.263(a)-2 of the
regulations, T must capitalize the amounts paid to acquire and install
each section 1245 property.
Example 25. Not replacement of major component or substantial
structural part; windows U owns a large office building that it uses to
provide office space for employees that manage U's operations. The
building has 300 exterior windows that represent 25 percent of the total
surface area of the building. In Year 1, U pays an amount to replace 100
of the exterior windows that had become damaged. At the time of these
replacements, U has no plans to replace any other windows in the near
future. Under paragraphs (e)(2)(ii) and (k)(2) of this section, an
amount is paid to improve a building if the amount restores the building
structure or any building system. The exterior windows are part of the
building structure as defined under paragraph (e)(2)(ii)(A) of this
section. The 300 exterior windows perform a discrete and critical
function in the operation of the building structure and are, therefore,
a major component of the building structure under paragraph (k)(6)(i)(A)
of this section. However, the 100 windows do not comprise a significant
portion of this major component of the building structure under
paragraph (k)(6)(ii)(A) of this section or a substantial structural part
of the building structure under paragraph (k)(6)(ii)(B) of this section.
Therefore, under paragraph (k)(6) of this section, the replacement of
the 100 windows does not constitute the replacement of a major component
or substantial structural part of the building, and U is not required to
treat the amount paid to replace the 100 windows as restoration of the
building under paragraph (k)(1)(iv) of this section.
Example 26. Replacement of major component; windows Assume the same
facts as Example 25, except that that U replaces 200 of the 300 windows
on the building. The 300 exterior windows perform a discrete and
critical function in the operation of the building structure and are,
therefore, a major component of the building structure under paragraph
(k)(6)(i)(A) of this section. The 200 windows comprise a significant
portion of this major component of the building structure under
paragraph (k)(6)(ii)(A) of this section. Therefore, under paragraph
(k)(6) of this section, the replacement of the 200 windows comprise the
replacement of a major component of the building structure. Accordingly,
U must treat the amount paid to replace the 200 windows as a restoration
of the building under paragraphs (k)(1)(vi) and (k)(2) of this section
and must capitalize the amount paid as an improvement to the building
under paragraph (d)(2) of this section.
Example 27. Replacement of substantial structural part; windows
Assume the same facts as Example 25, except that the building is a
modern design and the 300 windows represent 90 percent of the total
surface area of the building. U replaces 100 of the 300 windows on the
building. The 300 exterior windows perform a discrete and critical
function in the operation of the building structure and are, therefore,
a major component of the building structure under paragraph (k)(6)(i)(A)
of this section. The 100 windows do not comprise a significant portion
of this major component of the building structure under paragraph
(k)(6)(ii)(A) of this section, however, they do comprise a substantial
structural part of the building structure under paragraph (k)(6)(ii)(B)
of this section. Therefore, under paragraph (k)(6) of this section, the
replacement of the 100 windows comprise the replacement of a substantial
structural part of the building structure. Accordingly, U must treat the
amount paid to replace the 100 windows as a restoration of the building
unit of property under paragraphs (k)(1)(vi) and (k)(2) of this section
and must capitalize the
[[Page 693]]
amount paid as an improvement to the building under paragraph (d)(2) of
this section.
Example 28. Not replacement of major component or substantial
structural part; floors V owns and operates a hotel building. V decides
to refresh the appearance of the hotel lobby by replacing the floors in
the lobby. The hotel lobby comprises less than 10 percent of the square
footage of the entire hotel building. V pays an amount to replace the
wood flooring in the lobby with new wood flooring of a similar quality.
V did not replace any other flooring in the building. Assume that the
wood flooring constitutes section 1250 property. Under paragraphs
(e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a
building if the amount restores the building structure or any building
system. The wood flooring is part of the building structure under
paragraph (e)(2)(ii)(A) of this section. All the floors in the hotel
building comprise a major component of the building structure because
they perform a discrete and critical function in the operation of the
building structure. However, the lobby floors are not a significant
portion of a major component (that is, all the floors) under paragraph
(k)(6)(ii)(A) of this section, nor do the lobby floors comprise a
substantial structural part of the building structure under paragraph
(k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this
section, the replacement of the lobby floors is not the replacement of a
major component or substantial structural part of the building unit of
property, and V is not required to treat the amount paid for the
replacement of the lobby floors as a restoration to the building under
paragraph (k)(1)(iv) of this section.
Example 29. Replacement of major component or substantial structural
part; floors Assume the same facts as Example 28, except that V decides
to refresh the appearance of all the public areas of the hotel building
by replacing all the floors in the public areas. To that end, V pays an
amount to replace all the wood floors in all the public areas of the
hotel building with new wood floors. The public areas include the lobby,
the hallways, the meeting rooms, the ballrooms, and other public rooms
throughout the hotel interiors. The public areas comprise approximately
40 percent of the square footage of the entire hotel building. All the
floors in the hotel building comprise a major component of the building
structure because they perform a discrete and critical function in the
operation of the building structure. The floors in all the public areas
of the hotel comprise a significant portion of a major component (that
is, all the building floors) of the building structure. Therefore, under
paragraph (k)(6)(ii)(A) of this section, the replacement of all the
public area floors constitutes the replacement of a major component of
the building structure. Accordingly, V must treat the amount paid to
replace the public area floors as a restoration of the building unit of
property under paragraphs (k)(1)(vi) and (k)(2) of this section and must
capitalize the amounts as an improvement to the building under paragraph
(d)(2) of this section.
Example 30. Replacement with no disposition (i) X owns an office
building with four elevators serving all floors in the building. X
replaces one of the elevators. The elevator is a structural component of
the office building. X chooses to apply Sec. 1.168(i)-8 to taxable
years beginning on or after January 1, 2012, and before the
applicability date of the final regulations. In accordance with Sec.
1.168(i)-8(c)(4)(ii)(A), the office building (including its structural
components) is the asset for tax disposition purposes. X also does not
make the partial disposition election provided under Sec. 1.168(i)-
8(d)(2) for the elevator. Thus, the retirement of the replaced elevator
is not a disposition under section 168, and no loss is taken into
account for purposes of paragraph (k)(1)(i) of this section.
(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an
amount is paid to improve a building if the amount restores the building
structure or any building system. The elevator system, including all
four elevators, is a building system under paragraph (e)(2)(ii)(B)(5) of
this section. The replacement elevator does not perform a discrete and
critical function in the operation of elevator system under paragraph
(k)(6)(ii)(A) of this section nor does it comprise a large portion of
the physical structure of the elevator system under paragraph
(k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this
section, the replacement elevator does not constitute the replacement of
a major component or substantial structural part of the elevator system.
Accordingly, X is not required to treat the amount paid to replace the
elevator as a restoration to the building under either paragraph
(k)(1)(i) or paragraph (k)(1)(vi) of this section.
Example 31. Replacement with disposition The facts are the same as
in Example 30, except X makes the partial disposition election provided
under paragraph Sec. 1.168(i)-8(d)(2) for the elevator. Although the
office building (including its structural components) is the asset for
disposition purposes, the result of X making the partial disposition
election for the elevator is that the retirement of the replaced
elevator is a disposition. Thus, depreciation for the retired elevator
ceases at the time of its retirement (taking into account the applicable
convention), and X recognizes a loss upon this retirement. Accordingly,
X must treat the amount paid to replace the elevator as a restoration of
the building under paragraphs (k)(1)(i) and (k)(2) of this section and
must capitalize the amount paid as an improvement to the building under
paragraph (d)(2) of this section. In addition,
[[Page 694]]
the replacement elevator is treated as a separate asset for tax
disposition purposes pursuant to Sec. 1.168(i)-8(c)(4)(ii)(D), and for
depreciation purposes pursuant to section 168(i)(6).
(l) Capitalization of amounts to adapt property to a new or
different use--(1) In general. A taxpayer must capitalize as an
improvement an amount paid to adapt a unit of property to a new or
different use. In general, an amount is paid to adapt a unit of property
to a new or different use if the adaptation is not consistent with the
taxpayer's ordinary use of the unit of property at the time originally
placed in service by the taxpayer.
(2) Application of adaption rule to buildings. In the case of a
building, an amount is paid to improve a building if it is paid to adapt
to a new or different use a property specified under paragraph
(e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph
(e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building
or leased portion of building) of this section. For example, an amount
is paid to improve a building if it is paid to adapt the building
structure or any one of its buildings systems to a new or different use.
(3) Examples. The following examples illustrate the application of
this paragraph (l) only and do not address whether capitalization is
required under another provision of this section or under another
provision of the Code (for example, section 263A). Unless otherwise
stated, assume that the taxpayer has not properly deducted a loss for
any unit of property, asset, or component of a unit of property that is
removed and replaced.
Example 1. New or different use; change in building use A is a
manufacturer and owns a manufacturing building that it has used for
manufacturing since Year 1, when A placed it in service. In Year 30, A
pays an amount to convert its manufacturing building into a showroom for
its business. To convert the facility, A removes and replaces various
structural components to provide a better layout for the showroom and
its offices. A also repaints the building interiors as part of the
conversion. When building materials are removed and replaced, A uses
comparable and commercially available replacement materials. Under
paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to
improve A's manufacturing building if the amount adapts the building
structure or any designated building system to a new or different use.
Under paragraph (l)(1) of this section, the amount paid to convert the
manufacturing building into a showroom adapts the building structure to
a new or different use because the conversion to a showroom is not
consistent with A's ordinary use of the building structure at the time
it was placed in service. Therefore, A must capitalize the amount paid
to convert the building into a showroom as an improvement to the
building under paragraphs (d)(3) and (l) of this section.
Example 2. Not a new or different use; leased building B owns and
leases out space in a building consisting of twenty retail spaces. The
space was designed to be reconfigured; that is, adjoining spaces could
be combined into one space. One of the tenants expands its occupancy by
leasing two adjoining retail spaces. To facilitate the new lease, B pays
an amount to remove the walls between the three retail spaces. Assume
that the walls between spaces are part of the building and its
structural components. Under paragraphs (l)(2) and (e)(2)(ii) of this
section, an amount is paid to improve B's building if it adapts the
building structure or any of the building systems to a new or different
use. Under paragraph (l)(1) of this section, the amount paid to convert
three retail spaces into one larger space for an existing tenant does
not adapt B's building structure to a new or different use because the
combination of retail spaces is consistent with B's intended, ordinary
use of the building structure. Therefore, the amount paid by B to remove
the walls does not improve the building under paragraph (l) of this
section and is not required to be capitalized under paragraph (d)(3) of
this section.
Example 3. Not a new or different use; preparing building for sale C
owns a building consisting of twenty retail spaces. C decides to sell
the building. In anticipation of selling the building, C pays an amount
to repaint the interior walls and to refinish the hardwood floors. Under
paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to
improve C's building to a new or different use if it adapts the building
structure or any of the building systems to a new or different use.
Preparing the building for sale does not constitute a new or different
use for the building structure under paragraph (l)(1) of this section.
Therefore, the amount paid by C to prepare the building structure for
sale does not improve the building under paragraph (l) of this section
and is not required to be capitalized under paragraph (d)(3) of this
section.
Example 4. New or different use; land D owns a parcel of land on
which it previously operated a manufacturing facility. Assume that the
land is the unit of property. During the course of D's operation of the
manufacturing facility, the land became contaminated with
[[Page 695]]
wastes from its manufacturing processes. D discontinues manufacturing
operations at the site and decides to develop the property for
residential housing. In anticipation of building residential property, D
pays an amount to remediate the contamination caused by D's
manufacturing process. In addition, D pays an amount to regrade the land
so that it can be used for residential purposes. Amounts that D pays to
clean up wastes do not adapt the land to a new or different use,
regardless of the extent to which the land was cleaned, because this
cleanup merely returns the land to the condition it was in before the
land was contaminated in D's operations. Therefore, D is not required to
capitalize the amount paid for the cleanup under paragraph (l)(1) of
this section. However, the amount paid to regrade the land so that it
can be used for residential purposes adapts the land to a new or
different use that is inconsistent with D's intended ordinary use of the
property at the time it was placed in service. Accordingly, the amounts
paid to regrade the land must be capitalized as improvements to the land
under paragraphs (d)(3) and (l) of this section.
Example 5. New or different use; part of building (i) E owns a
building in which it operates a retail drug store. The store consists of
a pharmacy for filling medication prescriptions and various departments
where customers can purchase food, toiletries, home goods, school
supplies, cards, over-the-counter medications, and other similar items.
E decides to create a walk-in medical clinic where nurse practitioners
and physicians' assistants diagnose, treat, and write prescriptions for
common illnesses and injuries, administer common vaccinations, conduct
physicals and wellness screenings, and provide routine lab tests and
services for common chronic conditions. To create the clinic, E pays
amounts to reconfigure the pharmacy building. E incurs costs to build
new walls creating an examination room, lab room, reception area, and
waiting area. E installs additional plumbing, electrical wiring, and
outlets to support the lab. E also acquires section 1245 property, such
as computers, furniture, and equipment necessary for the new clinic. E
treats the amounts paid for those units of property as costs of
acquiring new units of property under Sec. 1.263(a)-2.
(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an
amount is paid to improve E's building if it adapts the building
structure or any of the building systems to a new or different use.
Under paragraph (l)(1) of this section, the amount paid to convert part
of the retail drug store building structure into a medical clinic adapts
the building structure to a new and different use, because the use of
the building structure to provide clinical medical services is not
consistent with E's intended ordinary use of the building structure at
the time it was placed in service. Similarly, the amounts paid to add to
the plumbing system and the electrical systems to support the new
medical services is not consistent with E's intended ordinary use of
these systems when the systems were placed in service. Therefore, E must
treat the amount paid for the conversion of the building structure,
plumbing system, and electrical system as an improvement to the building
and capitalize the amount under paragraphs (d)(3) and (l) of this
section.
Example 6. Not a new or different use; part of building (i) F owns a
building in which it operates a grocery store. The grocery store
includes various departments for fresh produce, frozen foods, fresh
meats, dairy products, toiletries, and over-the-counter medicines. The
grocery store also includes separate counters for deli meats, prepared
foods, and baked goods, often made to order. To better accommodate its
customers' shopping needs, F decides to add a sushi bar where customers
can order freshly prepared sushi from the counter for take-home or to
eat at the counter. To create the sushi bar, F pays amounts to add a
sushi counter and chairs, add additional wiring and outlets to support
the counter, and install additional pipes and a sink, to provide for the
safe handling of the food. F also pays amounts to replace flooring and
wall coverings in the sushi bar area with decorative coverings to
reflect more appropriate d[eacute]cor. Assume the sushi counter and
chairs are section 1245 property, and F treats the amounts paid for
those units of property as costs of acquiring new units of property
under Sec. 1.263(a)-2.
(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an
amount is paid to improve F's building if it adapts the building
structure or any of the building systems to a new or different use.
Under paragraph (l)(1) of this section, the amount paid to convert a
part of F's retail grocery into a sushi bar area does not adapt F's
building structure, plumbing system, or electrical system to a new or
different use, because the sale of sushi is consistent with F's
intended, ordinary use of the building structure and these systems in
its grocery sales business, which includes selling food to its customers
at various specialized counters. Accordingly, the amount paid by F to
replace the wall and floor finishes, add wiring, and add plumbing to
create the sushi bar space does not improve the building unit of
property under paragraph (l) of this section and is not required to be
capitalized under paragraph (d)(3) of this section.
Example 7. Not a new or different use; part of building (i) G owns a
hospital with various departments dedicated to the provision of clinical
medical care. To better accommodate its patients' needs, G decides to
modify the emergency room space to provide both emergency care and
outpatient surgery. To modify the space, G pays amounts to move
[[Page 696]]
interior walls, add additional wiring and outlets, replace floor tiles
and doors, and repaint the walls. To complete the outpatient surgery
center, G also pays amounts to install miscellaneous medical equipment
necessary for the provision of surgical services. Assume the medical
equipment is section 1245 property, and G treats the amounts paid for
those units of property as costs of acquiring new units of property
under Sec. 1.263(a)-2.
(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an
amount is paid to improve G's building if it adapts the building
structure or any of the building systems to a new or different use.
Under paragraph (l)(1) of this section, the amount paid to convert part
of G's emergency room into an outpatient surgery center does not adapt
G's building structure or electrical system to a new or different use,
because the provision of outpatient surgery is consistent with G's
intended, ordinary use of the building structure and these systems in
its clinical medical care business. Accordingly, the amounts paid by G
to relocate interior walls, add additional wiring and outlets, replace
floor tiles and doors, and repaint the walls to create outpatient
surgery space do not improve the building under paragraph (l) of this
section and are not required to be capitalized under paragraph (d)(3) of
this section.
(m) Optional regulatory accounting method--(1) In general. This
paragraph (m) provides an optional simplified method (the regulatory
accounting method) for regulated taxpayers to determine whether amounts
paid to repair, maintain, or improve tangible property are to be treated
as deductible expenses or capital expenditures. A taxpayer that uses the
regulatory accounting method described in paragraph (m)(3) of this
section must use that method for property subject to regulatory
accounting instead of determining whether amounts paid to repair,
maintain, or improve property are capital expenditures or deductible
expenses under the general principles of sections 162(a), 212, and
263(a). Thus, the capitalization rules in paragraph (d) (and the routine
maintenance safe harbor described in paragraph (i)) of this section do
not apply to amounts paid to repair, maintain, or improve property
subject to regulatory accounting by taxpayers that use the regulatory
accounting method under this paragraph (m).
(2) Eligibility for regulatory accounting method. A taxpayer that is
engaged in a trade or business in a regulated industry is a regulated
taxpayer and may use the regulatory accounting method under this
paragraph (m). For purposes of this paragraph (m), a taxpayer is in a
regulated industry only if the taxpayer is subject to the regulatory
accounting rules of the Federal Energy Regulatory Commission (FERC), the
Federal Communications Commission (FCC), or the Surface Transportation
Board (STB).
(3) Description of regulatory accounting method. Under the
regulatory accounting method, a taxpayer must follow the method of
accounting for regulatory accounting purposes that it is required to
follow for FERC, FCC, or STB (whichever is applicable) in determining
whether an amount paid repairs, maintains, or improves property under
this section. Therefore, a taxpayer must capitalize for Federal income
tax purposes an amount paid that is capitalized as an improvement for
regulatory accounting purposes. A taxpayer may not capitalize for
Federal income tax purposes under this section an amount paid that is
not capitalized as an improvement for regulatory accounting purposes. A
taxpayer that uses the regulatory accounting method must use that method
for all of its tangible property that is subject to regulatory
accounting rules. The method does not apply to tangible property that is
not subject to regulatory accounting rules. The method also does not
apply to property for the taxable years in which the taxpayer elected to
apply the repair allowance under Sec. 1.167(a)-11(d)(2). The regulatory
accounting method is a method of accounting under section 446(a).
(4) Examples. The following examples illustrate the application of
this paragraph (m):
Example 1. Taxpayer subject to regulatory accounting rules of FERC W
is an electric utility company that operates a power plant that
generates electricity and that owns and operates network assets to
transmit and distribute the electricity to its customers. W is subject
to the regulatory accounting rules of FERC, and W uses the regulatory
accounting method under paragraph (m) of this section. W does not
capitalize on its books and records for regulatory accounting purposes
the cost of repairs and maintenance performed on its turbines or its
network assets. Under the regulatory accounting method, W
[[Page 697]]
may not capitalize for Federal income tax purposes amounts paid for
repairs performed on its turbines or its network assets.
Example 2. Taxpayer not subject to regulatory accounting rules of
FERC X is an electric utility company that operates a power plant to
generate electricity. X previously was subject to the regulatory
accounting rules of FERC, but currently X is not required to use FERC's
regulatory accounting rules. X cannot use the regulatory accounting
method provided in this paragraph (m).
Example 3. Taxpayer subject to regulatory accounting rules of FCC Y
is a telecommunications company that is subject to the regulatory
accounting rules of the FCC. Y uses the regulatory accounting method
under this paragraph (m). Y's assets include a telephone central office
switching center, which contains numerous switches and various switching
equipment. Y capitalizes on its books and records for regulatory
accounting purposes the cost of replacing each switch. Under the
regulatory accounting method, Y is required to capitalize for Federal
income tax purposes amounts paid to replace each switch.
Example 4. Taxpayer subject to regulatory accounting rules of STB Z
is a Class I railroad that is subject to the regulatory accounting rules
of the STB. Z uses the regulatory accounting method under this paragraph
(m). Z capitalizes on its books and records for regulatory accounting
purposes the cost of locomotive rebuilds. Under the regulatory
accounting method, Z is required to capitalize for Federal income tax
purposes amounts paid to rebuild its locomotives.
(n) Election to capitalize repair and maintenance costs--(1) In
general. A taxpayer may elect to treat amounts paid during the taxable
year for repair and maintenance (as defined under Sec. 1.162-4) to
tangible property as amounts paid to improve that property under this
section and as an asset subject to the allowance for depreciation if the
taxpayer incurs these amounts in carrying on the taxpayer's trade or
business and if the taxpayer treats these amounts as capital
expenditures on its books and records regularly used in computing income
(``books and records''). A taxpayer that elects to apply this paragraph
(n) in a taxable year must apply this paragraph to all amounts paid for
repair and maintenance to tangible property that it treats as capital
expenditures on its books and records in that taxable year. Any amounts
for which this election is made shall not be treated as amounts paid for
repair or maintenance under Sec. 1.162-4.
(2) Time and manner of election. A taxpayer makes this election
under this paragraph (n) by attaching a statement to the taxpayer's
timely filed original Federal tax return (including extensions) for the
taxable year in which the taxpayer pays amounts described under
paragraph (n)(1) of this paragraph. Sections 301.9100-1 through
301.9100-3 of this chapter provide the rules governing extensions of the
time to make regulatory elections. The statement must be titled
``Section 1.263(a)-3(n) Election'' and include the taxpayer's name,
address, taxpayer identification number, and a statement that the
taxpayer is making the election to capitalize repair and maintenance
costs under Sec. 1.263(a)-3(n). In the case of a consolidated group
filing a consolidated income tax return, the election is made for each
member of the consolidated group by the common parent, and the statement
must also include the names and taxpayer identification numbers of each
member for which the election is made. In the case of an S corporation
or a partnership, the election is made by the S corporation or
partnership and not by the shareholders or partners. A taxpayer making
this election for a taxable year must treat any amounts paid for repairs
and maintenance during the taxable year that are capitalized on the
taxpayer's books and records as improvements to tangible property. The
taxpayer must begin to depreciate the cost of such improvements amounts
when they are placed in service by the taxpayer under the applicable
provisions of the Code and regulations. An election may not be made
through the filing of an application for change in accounting method or,
before obtaining the Commissioner's consent to make a late election, by
filing an amended Federal tax return. The time and manner of electing to
capitalize repair and maintenance costs under this paragraph (n) may be
modified through guidance of general applicability (see Sec. Sec.
601.601(d)(2) and 601.602 of this chapter).
(3) Exception. This paragraph (n) does not apply to amounts paid for
repairs or maintenance of rotable or temporary spare parts to which the
taxpayer applies the optional method of
[[Page 698]]
accounting for rotable and temporary spare parts under Sec. 1.162-3(e).
(4) Examples. The following examples illustrate the application of
this paragraph (n):
Example 1. Election to capitalize routine maintenance on non-rotable
part (i) Q is a towboat operator that owns a fleet of towboats that it
uses in its trade or business. Each towboat is equipped with two diesel-
powered engines. Assume that each towboat, including its engines, is the
unit of property and that a towboat has a class life of 18 years. Assume
the towboat engines are not rotable spare parts under Sec. 1.162-
3(c)(2). In Year 1, Q acquired a new towboat, including its two engines,
and placed the towboat into service. In Year 4, Q pays amounts to
perform scheduled maintenance on both engines in the towboat. Assume
that none of the exceptions set out in paragraph (i)(3) of this section
apply to the scheduled maintenance costs and that the scheduled
maintenance on Q's towboat is within the routine maintenance safe harbor
under paragraph (i)(1)(ii) of this section. Accordingly, the amounts
paid for the scheduled maintenance to its towboat engines in Year 4 are
deemed not to improve the towboat and are not required to be capitalized
under paragraph (d) of this section.
(ii) On its books and records, Q treats amounts paid for scheduled
maintenance on its towboat engines as capital expenditures. For
administrative convenience, Q decides to account for these costs in the
same way for Federal income tax purposes. Under paragraph (n) of this
section, in Year 4, Q may elect to capitalize the amounts paid for the
scheduled maintenance on its towboat engines. If Q elects to capitalize
such amounts, Q must capitalize all amounts paid for repair and
maintenance to tangible property that Q treats as capital expenditures
on its books and records in Year 4.
Example 2. No election to capitalize routine maintenance Assume the
same facts as Example 1, except in Year 8, Q pays amounts to perform
scheduled maintenance for a second time on the towboat engines. On its
books and records, Q treats the amounts paid for this scheduled
maintenance as capital expenditures. However, in Year 8, Q decides not
to make the election to capitalize the amounts paid for scheduled
maintenance under paragraph (n) of this section. Because Q does not make
the election under paragraph (n) for Year 8, Q may apply the routine
maintenance safe harbor under paragraph (i)(1)(ii) of this section to
the amounts paid in Year 8, and not treat these amounts as capital
expenditures. Because the election is made for each taxable year, there
is no effect on the scheduled maintenance costs capitalized by Q on its
Federal tax return for Year 4.
Example 3. Election to capitalize replacement of building component
(i) R owns an office building that it uses to provide services to
customers. The building contains a HVAC system that incorporates ten
roof-mounted units that provide heating and air conditioning for
different parts of the building. In Year 1, R pays an amount to replace
2 of the 10 units to address climate control problems in various offices
throughout the office building. Assume that the replacement of the two
units does not constitute an improvement to the HVAC system, and,
accordingly, to the building unit of property under paragraph (d) of
this section, and that R may deduct these amounts as repairs and
maintenance under Sec. 1.162-4.
(ii) On its books and records, R treats amounts paid for the two
HVAC components as capital expenditures. R determines that it would
prefer to account for these amounts in the same way for Federal income
tax purposes. Under this paragraph (n), in Year 1, R may elect to
capitalize the amounts paid for the new HVAC components. If R elects to
capitalize such amounts, R must capitalize all amounts paid for repair
and maintenance to tangible property that R treats as capital
expenditures on its books and records in Year 1.
(o) Treatment of capital expenditures. Amounts required to be
capitalized under this section are capital expenditures and must be
taken into account through a charge to capital account or basis, or in
the case of property that is inventory in the hands of a taxpayer,
through inclusion in inventory costs.
(p) Recovery of capitalized amounts. Amounts that are capitalized
under this section are recovered through depreciation, cost of goods
sold, or by an adjustment to basis at the time the property is placed in
service, sold, used, or otherwise disposed of by the taxpayer. Cost
recovery is determined by the applicable Code and regulation provisions
relating to the use, sale, or disposition of property.
(q) Accounting method changes. Except as otherwise provided in this
section, a change to comply with this section is a change in method of
accounting to which the provisions of sections 446 and 481 and the
accompanying regulations apply. A taxpayer seeking to change to a method
of accounting permitted in this section must secure the consent of the
Commissioner in accordance with
[[Page 699]]
Sec. 1.446-1(e) and follow the administrative procedures issued under
Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to
change its accounting method.
(r) Effective/applicability date--(1) In general. Except for
paragraphs (h), (m), and (n) of this section, this section applies to
taxable years beginning on or after January 1, 2014. Paragraphs (h),
(m), and (n) of this section apply to amounts paid in taxable years
beginning on or after January 1, 2014. Except as provided in paragraphs
(r)(2) and (r)(3) of this section, Sec. 1.263(a)-3 as contained in 26
CFR part 1 edition revised as of April 1, 2011, applies to taxable years
beginning before January 1, 2014.
(2) Early application of this section--(i) In general. Except for
paragraphs (h), (m), and (n) of this section, a taxpayer may choose to
apply this section to taxable years beginning on or after January 1,
2012. A taxpayer may choose to apply paragraphs (h), (m), and (n) of
this section to amounts paid in taxable years beginning on or after
January 1, 2012.
(ii) Transition rule for certain elections on 2012 or 2013 returns.
If under paragraph (r)(2)(i) of this section, a taxpayer chooses to make
the election to apply the safe harbor for small taxpayers under
paragraph (h) of this section or the election to capitalize repair and
maintenance costs under paragraph (n) of this section for amounts paid
in its taxable year beginning on or after January 1, 2012, and ending on
or before September 19, 2013 (applicable taxable year), and the taxpayer
did not make the election specified in paragraph (h)(6) or paragraph
(n)(2) of this section on its timely filed original Federal tax return
for the applicable taxable year, the taxpayer must make the election
specified in paragraph (h)(6) or paragraph (n)(2) of this section for
the applicable taxable year by filing an amended Federal tax return
(including the required statements) for the applicable taxable year on
or before 180 days from the due date including extensions of the
taxpayer's Federal tax return for the applicable taxable year,
notwithstanding that the taxpayer may not have extended the due date.
(3) Optional application of TD 9564. A taxpayer may choose to apply
Sec. 1.263(a)-3T as contained in TD 9564 (76 FR 81060) December 27,
2011, to taxable years beginning on or after January 1, 2012, and before
January 1, 2014.
[T.D. 9636, 78 FR 57718, Sept. 19, 2013, as amended by T.D. 9636, 79 FR
42191, July 21, 2014; T.D. 9689, 79 FR 48684, Aug. 18, 2014]
Sec. 1.263(a)-4 Amounts paid to acquire or create intangibles.
(a) Overview. This section provides rules for applying section
263(a) to amounts paid to acquire or create intangibles. Except to the
extent provided in paragraph (d)(8) of this section, the rules provided
by this section do not apply to amounts paid to acquire or create
tangible assets. Paragraph (b) of this section provides a general
principle of capitalization. Paragraphs (c) and (d) of this section
identify intangibles for which capitalization is specifically required
under the general principle. Paragraph (e) of this section provides
rules for determining the extent to which taxpayers must capitalize
transaction costs. Paragraph (f) of this section provides a 12-month
rule intended to simplify the application of the general principle to
certain payments that create benefits of a brief duration. Additional
rules and examples relating to these provisions are provided in
paragraphs (g) through (n) of this section. The applicability date of
the rules in this section is provided in paragraph (o) of this section.
Paragraph (p) of this section provides rules applicable to changes in
methods of accounting made to comply with this section.
(b) Capitalization with respect to intangibles--(1) In general.
Except as otherwise provided in this section, a taxpayer must
capitalize--
(i) An amount paid to acquire an intangible (see paragraph (c) of
this section);
(ii) An amount paid to create an intangible described in paragraph
(d) of this section;
(iii) An amount paid to create or enhance a separate and distinct
intangible asset within the meaning of paragraph (b)(3) of this section;
(iv) An amount paid to create or enhance a future benefit identified
in published guidance in the Federal
[[Page 700]]
Register or in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii) of this chapter) as an intangible for which
capitalization is required under this section; and
(v) An amount paid to facilitate (within the meaning of paragraph
(e)(1) of this section) an acquisition or creation of an intangible
described in paragraph (b)(1)(i), (ii), (iii) or (iv) of this section.
(2) Published guidance. Any published guidance identifying a future
benefit as an intangible for which capitalization is required under
paragraph (b)(1)(iv) of this section applies only to amounts paid on or
after the date of publication of the guidance.
(3) Separate and distinct intangible asset--(i) Definition. The term
separate and distinct intangible asset means a property interest of
ascertainable and measurable value in money's worth that is subject to
protection under applicable State, Federal or foreign law and the
possession and control of which is intrinsically capable of being sold,
transferred or pledged (ignoring any restrictions imposed on
assignability) separate and apart from a trade or business. In addition,
for purposes of this section, a fund (or similar account) is treated as
a separate and distinct intangible asset of the taxpayer if amounts in
the fund (or account) may revert to the taxpayer. The determination of
whether a payment creates a separate and distinct intangible asset is
made based on all of the facts and circumstances existing during the
taxable year in which the payment is made.
(ii) Creation or termination of contract rights. Amounts paid to
another party to create, originate, enter into, renew or renegotiate an
agreement with that party that produces rights or benefits for the
taxpayer (and amounts paid to facilitate the creation, origination,
enhancement, renewal or renegotiation of such an agreement) are treated
as amounts that do not create (or facilitate the creation of) a separate
and distinct intangible asset within the meaning of this paragraph
(b)(3). Further, amounts paid to another party to terminate (or
facilitate the termination of) an agreement with that party are treated
as amounts that do not create a separate and distinct intangible asset
within the meaning of this paragraph (b)(3). See paragraphs (d)(2),
(d)(6), and (d)(7) of this section for rules that specifically require
capitalization of amounts paid to create or terminate certain
agreements.
(iii) Amounts paid in performing services. Amounts paid in
performing services under an agreement are treated as amounts that do
not create a separate and distinct intangible asset within the meaning
of this paragraph (b)(3), regardless of whether the amounts result in
the creation of an income stream under the agreement.
(iv) Creation of computer software. Except as otherwise provided in
the Internal Revenue Code, the regulations thereunder, or other
published guidance in the Federal Register or in the Internal Revenue
Bulletin (see Sec. 601.601(d)(2)(ii) of this chapter), amounts paid to
develop computer software are treated as amounts that do not create a
separate and distinct intangible asset within the meaning of this
paragraph (b)(3).
(v) Creation of package design. Amounts paid to develop a package
design are treated as amounts that do not create a separate and distinct
intangible asset within the meaning of this paragraph (b)(3). For
purposes of this section, the term package design means the specific
graphic arrangement or design of shapes, colors, words, pictures,
lettering, and other elements on a given product package, or the design
of a container with respect to its shape or function.
(4) Coordination with other provisions of the Internal Revenue
Code--(i) In general. Nothing in this section changes the treatment of
an amount that is specifically provided for under any other provision of
the Internal Revenue Code (other than section 162(a) or 212) or the
regulations thereunder.
(ii) Example. The following example illustrates the rule of this
paragraph (b)(4):
Example. On January 1, 2004, G enters into an interest rate swap
agreement with unrelated counterparty H under which, for a term of five
years, G is obligated to make annual payments at 11% and H is obligated
to make annual payments at LIBOR on a notional principal amount of $100
million. At the time G and H enter into this swap agreement, the
[[Page 701]]
rate for similar on-market swaps is LIBOR to 10%. To compensate for this
difference, on January 1, 2004, H pays G a yield adjustment fee of
$3,790,786. This yield adjustment fee constitutes an amount paid to
create an intangible and would be capitalized under paragraph (d)(2) of
this section. However, because the yield adjustment fee is a nonperiodic
payment on a notional principal contract as defined in Sec. 1.446-3(c),
the treatment of this fee is governed by Sec. 1.446-3 and not this
section.
(c) Acquired intangibles--(1) In general. A taxpayer must capitalize
amounts paid to another party to acquire any intangible from that party
in a purchase or similar transaction. Examples of intangibles within the
scope of this paragraph (c) include, but are not limited to, the
following (if acquired from another party in a purchase or similar
transaction):
(i) An ownership interest in a corporation, partnership, trust,
estate, limited liability company, or other entity.
(ii) A debt instrument, deposit, stripped bond, stripped coupon
(including a servicing right treated for federal income tax purposes as
a stripped coupon), regular interest in a REMIC or FASIT, or any other
intangible treated as debt for federal income tax purposes.
(iii) A financial instrument, such as--
(A) A notional principal contract;
(B) A foreign currency contract;
(C) A futures contract;
(D) A forward contract (including an agreement under which the
taxpayer has the right and obligation to provide or to acquire property
(or to be compensated for such property, regardless of whether the
taxpayer provides or acquires the property));
(E) An option (including an agreement under which the taxpayer has
the right to provide or to acquire property (or to be compensated for
such property, regardless of whether the taxpayer provides or acquires
the property)); and
(F) Any other financial derivative.
(iv) An endowment contract, annuity contract, or insurance contract.
(v) Non-functional currency.
(vi) A lease.
(vii) A patent or copyright.
(viii) A franchise, trademark or tradename (as defined in Sec.
1.197-2(b)(10)).
(ix) An assembled workforce (as defined in Sec. 1.197-2(b)(3)).
(x) Goodwill (as defined in Sec. 1.197-2(b)(1)) or going concern
value (as defined in Sec. 1.197-2(b)(2)).
(xi) A customer list.
(xii) A servicing right (for example, a mortgage servicing right
that is not treated for Federal income tax purposes as a stripped
coupon).
(xiii) A customer-based intangible (as defined in Sec. 1.197-
2(b)(6)) or supplier-based intangible (as defined in Sec. 1.197-
2(b)(7)).
(xiv) Computer software.
(xv) An agreement providing either party the right to use, possess
or sell an intangible described in paragraphs (c)(1)(i) through (v) of
this section.
(2) Readily available software. An amount paid to obtain a
nonexclusive license for software that is (or has been) readily
available to the general public on similar terms and has not been
substantially modified (within the meaning of Sec. 1.197-2(c)(4)) is
treated for purposes of this paragraph (c) as an amount paid to another
party to acquire an intangible from that party in a purchase or similar
transaction.
(3) Intangibles acquired from an employee. Amounts paid to an
employee to acquire an intangible from that employee are not required to
be capitalized under this section if the amounts are includible in the
employee's income in connection with the performance of services under
section 61 or 83. For purposes of this section, whether an individual is
an employee is determined in accordance with the rules contained in
section 3401(c) and the regulations thereunder.
(4) Examples. The following examples illustrate the rules of this
paragraph (c):
Example 1. Debt instrument. X corporation, a commercial bank,
purchases a portfolio of existing loans from Y corporation, another
financial institution. X pays Y $2,000,000 in exchange for the
portfolio. The $2,000,000 paid to Y constitutes an amount paid to
acquire an intangible from Y and must be capitalized.
Example 2. Option. W corporation owns all of the outstanding stock
of X corporation. Y corporation holds a call option entitling it to
purchase from W all of the outstanding stock
[[Page 702]]
of X at a certain price per share. Z corporation acquires the call
option from Y in exchange for $5,000,000. The $5,000,000 paid to Y
constitutes an amount paid to acquire an intangible from Y and must be
capitalized.
Example 3. Ownership interest in a corporation. Same as Example 2,
but assume Z exercises its option and purchases from W all of the
outstanding stock of X in exchange for $100,000,000. The $100,000,000
paid to W constitutes an amount paid to acquire an intangible from W and
must be capitalized.
Example 4. Customer list. N corporation, a retailer, sells its
products through its catalog and mail order system. N purchases a
customer list from R corporation. N pays R $100,000 in exchange for the
customer list. The $100,000 paid to R constitutes an amount paid to
acquire an intangible from R and must be capitalized.
Example 5. Goodwill. Z corporation pays W corporation $10,000,000 to
purchase all of the assets of W in a transaction that constitutes an
applicable asset acquisition under section 1060(c). Of the $10,000,000
consideration paid in the transaction, $9,000,000 is allocable to
tangible assets purchased from W and $1,000,000 is allocable to
goodwill. The $1,000,000 allocable to goodwill constitutes an amount
paid to W to acquire an intangible from W and must be capitalized.
(d) Created intangibles--(1) In general. Except as provided in
paragraph (f) of this section (relating to the 12-month rule), a
taxpayer must capitalize amounts paid to create an intangible described
in this paragraph (d). The determination of whether an amount is paid to
create an intangible described in this paragraph (d) is to be made based
on all of the facts and circumstances, disregarding distinctions between
the labels used in this paragraph (d) to describe the intangible and the
labels used by the taxpayer and other parties to the transaction.
(2) Financial interests--(i) In general. A taxpayer must capitalize
amounts paid to another party to create, originate, enter into, renew or
renegotiate with that party any of the following financial interests,
whether or not the interest is regularly traded on an established
market:
(A) An ownership interest in a corporation, partnership, trust,
estate, limited liability company, or other entity.
(B) A debt instrument, deposit, stripped bond, stripped coupon
(including a servicing right treated for federal income tax purposes as
a stripped coupon), regular interest in a REMIC or FASIT, or any other
intangible treated as debt for Federal income tax purposes.
(C) A financial instrument, such as--
(1) A letter of credit;
(2) A credit card agreement;
(3) A notional principal contract;
(4) A foreign currency contract;
(5) A futures contract;
(6) A forward contract (including an agreement under which the
taxpayer has the right and obligation to provide or to acquire property
(or to be compensated for such property, regardless of whether the
taxpayer provides or acquires the property));
(7) An option (including an agreement under which the taxpayer has
the right to provide or to acquire property (or to be compensated for
such property, regardless of whether the taxpayer provides or acquires
the property)); and
(8) Any other financial derivative.
(D) An endowment contract, annuity contract, or insurance contract
that has or may have cash value.
(E) Non-functional currency.
(F) An agreement providing either party the right to use, possess or
sell a financial interest described in this paragraph (d)(2).
(ii) Amounts paid to create, originate, enter into, renew or
renegotiate. An amount paid to another party is not paid to create,
originate, enter into, renew or renegotiate a financial interest with
that party if the payment is made with the mere hope or expectation of
developing or maintaining a business relationship with that party and is
not contingent on the origination, renewal or renegotiation of a
financial interest with that party.
(iii) Renegotiate. A taxpayer is treated as renegotiating a
financial interest if the terms of the financial interest are modified.
A taxpayer also is treated as renegotiating a financial interest if the
taxpayer enters into a new financial interest with the same party (or
substantially the same parties) to a terminated financial interest, the
taxpayer could not cancel the terminated financial interest without the
consent of the other party (or parties), and the other party (or
parties) would not have consented to the cancellation unless
[[Page 703]]
the taxpayer entered into the new financial interest. A taxpayer is
treated as unable to cancel a financial interest without the consent of
the other party (or parties) if, under the terms of the financial
interest, the taxpayer is subject to a termination penalty and the other
party (or parties) to the financial interest modifies the terms of the
penalty.
(iv) Coordination with other provisions of this paragraph (d). An
amount described in this paragraph (d)(2) that is also described
elsewhere in paragraph (d) of this section is treated as described only
in this paragraph (d)(2).
(v) Coordination with Sec. 1.263(a)-5. See Sec. 1.263(a)-5 for the
treatment of borrowing costs and the treatment of amounts paid by an
option writer.
(vi) Examples. The following examples illustrate the rules of this
paragraph (d)(2):
Example 1. Loan. X corporation, a commercial bank, makes a loan to A
in the principal amount of $250,000. The $250,000 principal amount of
the loan paid to A constitutes an amount paid to another party to create
a debt instrument with that party under paragraph (d)(2)(i)(B) of this
section and must be capitalized.
Example 2. Option. W corporation owns all of the outstanding stock
of X corporation. Y corporation pays W $1,000,000 in exchange for W's
grant of a 3-year call option to Y permitting Y to purchase all of the
outstanding stock of X at a certain price per share. Y's payment of
$1,000,000 to W constitutes an amount paid to another party to create an
option with that party under paragraph (d)(2)(i)(C)(7) of this section
and must be capitalized.
Example 3. Partnership interest. Z corporation pays $10,000 to P, a
partnership, in exchange for an ownership interest in P. Z's payment of
$10,000 to P constitutes an amount paid to another party to create an
ownership interest in a partnership with that party under paragraph
(d)(2)(i)(A) of this section and must be capitalized.
Example 4. Take or pay contract. Q corporation, a producer of
natural gas, pays $1,000,000 to R during 2005 to induce R corporation to
enter into a 5-year ``take or pay'' gas purchase contract. Under the
contract, R is liable to pay for a specified minimum amount of gas,
whether or not R takes such gas. Q's payment of $1,000,000 is an amount
paid to another party to induce that party to enter into an agreement
providing Q the right and obligation to provide property or be
compensated for such property (regardless of whether the property is
provided) under paragraph (d)(2)(i)(C)(6) of this section and must be
capitalized.
Example 5. Agreement to provide property. P corporation pays R
corporation $1,000,000 in exchange for R's agreement to purchase 1,000
units of P's product at any time within the three succeeding calendar
years. The agreement describes P's $1,000,000 as a sales discount. P's
$1,000,000 payment is an amount paid to induce R to enter into an
agreement providing P the right and obligation to provide property under
paragraph (d)(2)(i)(C)(6) of this section and must be capitalized.
Example 6. Customer incentive payment. S corporation, a computer
manufacturer, seeks to develop a business relationship with V
corporation, a computer retailer. As an incentive to encourage V to
purchase computers from S, S enters into an agreement with V under which
S agrees that, if V purchases $20,000,000 of computers from S within 3
years from the date of the agreement, S will pay V $2,000,000 on the
date that V reaches the $20,000,000 threshold. V reaches the $20,000,000
threshold during the third year of the agreement, and S pays V
$2,000,000. S is not required to capitalize its payment to V under this
paragraph (d)(2) because the payment does not provide S the right or
obligation to provide property and does not create a separate and
distinct intangible asset for S within the meaning of paragraph
(b)(3)(i) of this section.
(3) Prepaid expenses--(i) In general. A taxpayer must capitalize
prepaid expenses.
(ii) Examples. The following examples illustrate the rules of this
paragraph (d)(3):
Example 1. Prepaid insurance. N corporation, an accrual method
taxpayer, pays $10,000 to an insurer to obtain three years of coverage
under a property and casualty insurance policy. The $10,000 is a prepaid
expense and must be capitalized under this paragraph (d)(3). Paragraph
(d)(2) of this section does not apply to the payment because the policy
has no cash value.
Example 2. Prepaid rent. X corporation, a cash method taxpayer,
enters into a 24-month lease of office space. At the time of the lease
signing, X prepays $240,000. No other amounts are due under the lease.
The $240,000 is a prepaid expense and must be capitalized under this
paragraph (d)(3).
(4) Certain memberships and privileges--(i) In general. A taxpayer
must capitalize amounts paid to an organization to obtain, renew,
renegotiate, or upgrade a membership or privilege from that
organization. A taxpayer is not required to capitalize under this
[[Page 704]]
paragraph (d)(4) an amount paid to obtain, renew, renegotiate or upgrade
certification of the taxpayer's products, services, or business
processes.
(ii) Examples. The following examples illustrate the rules of this
paragraph (d)(4):
Example 1. Hospital privilege. B, a physician, pays $10,000 to Y
corporation to obtain lifetime staff privileges at a hospital operated
by Y. B must capitalize the $10,000 payment under this paragraph (d)(4).
Example 2. Initiation fee. X corporation pays a $50,000 initiation
fee to obtain membership in a trade association. X must capitalize the
$50,000 payment under this paragraph (d)(4).
Example 3. Product rating. V corporation, an automobile
manufacturer, pays W corporation, a national quality ratings
association, $100,000 to conduct a study and provide a rating of the
quality and safety of a line of V's automobiles. V's payment is an
amount paid to obtain a certification of V's product and is not required
to be capitalized under this paragraph (d)(4).
Example 4. Business process certification. Z corporation, a
manufacturer, seeks to obtain a certification that its quality control
standards meet a series of international standards known as ISO 9000. Z
pays $50,000 to an independent registrar to obtain a certification from
the registrar that Z's quality management system conforms to the ISO
9000 standard. Z's payment is an amount paid to obtain a certification
of Z's business processes and is not required to be capitalized under
this paragraph (d)(4).
(5) Certain rights obtained from a governmental agency--(i) In
general. A taxpayer must capitalize amounts paid to a governmental
agency to obtain, renew, renegotiate, or upgrade its rights under a
trademark, trade name, copyright, license, permit, franchise, or other
similar right granted by that governmental agency.
(ii) Examples. The following examples illustrate the rules of this
paragraph (d)(5):
Example 1. Business license. X corporation pays $15,000 to state Y
to obtain a business license that is valid indefinitely. Under this
paragraph (d)(5), the amount paid to state Y is an amount paid to a
government agency for a right granted by that agency. Accordingly, X
must capitalize the $15,000 payment.
Example 2. Bar admission. A, an individual, pays $1,000 to an agency
of state Z to obtain a license to practice law in state Z that is valid
indefinitely, provided A adheres to the requirements governing the
practice of law in state Z. Under this paragraph (d)(5), the amount paid
to state Z is an amount paid to a government agency for a right granted
by that agency. Accordingly, A must capitalize the $1,000 payment.
(6) Certain contract rights--(i) In general. Except as otherwise
provided in this paragraph (d)(6), a taxpayer must capitalize amounts
paid to another party to create, originate, enter into, renew or
renegotiate with that party--
(A) An agreement providing the taxpayer the right to use tangible or
intangible property or the right to be compensated for the use of
tangible or intangible property;
(B) An agreement providing the taxpayer the right to provide or to
receive services (or the right to be compensated for services regardless
of whether the taxpayer provides such services);
(C) A covenant not to compete or an agreement having substantially
the same effect as a covenant not to compete (except, in the case of an
agreement that requires the performance of services, to the extent that
the amount represents reasonable compensation for services actually
rendered);
(D) An agreement not to acquire additional ownership interests in
the taxpayer; or
(E) An agreement providing the taxpayer (as the covered party) with
an annuity, an endowment, or insurance coverage.
(ii) Amounts paid to create, originate, enter into, renew or
renegotiate. An amount paid to another party is not paid to create,
originate, enter into, renew or renegotiate an agreement with that party
if the payment is made with the mere hope or expectation of developing
or maintaining a business relationship with that party and is not
contingent on the origination, renewal or renegotiation of an agreement
with that party.
(iii) Renegotiate. A taxpayer is treated as renegotiating an
agreement if the terms of the agreement are modified. A taxpayer also is
treated as renegotiating an agreement if the taxpayer enters into a new
agreement with the same party (or substantially the same parties) to a
terminated agreement, the taxpayer could not cancel the terminated
agreement without the consent of the other party (or parties), and the
other party (or parties) would not
[[Page 705]]
have consented to the cancellation unless the taxpayer entered into the
new agreement. A taxpayer is treated as unable to cancel an agreement
without the consent of the other party (or parties) if, under the terms
of the agreement, the taxpayer is subject to a termination penalty and
the other party (or parties) to the agreement modifies the terms of the
penalty.
(iv) Right. An agreement does not provide the taxpayer a right to
use property or to provide or receive services if the agreement may be
terminated at will by the other party (or parties) to the agreement
before the end of the period prescribed by paragraph (f)(1) of this
section. An agreement is not terminable at will if the other party (or
parties) to the agreement is economically compelled not to terminate the
agreement until the end of the period prescribed by paragraph (f)(1) of
this section. All of the facts and circumstances will be considered in
determining whether the other party (or parties) to an agreement is
economically compelled not to terminate the agreement. An agreement also
does not provide the taxpayer the right to provide services if the
agreement merely provides that the taxpayer will stand ready to provide
services if requested, but places no obligation on another person to
request or pay for the taxpayer's services.
(v) De minimis amounts. A taxpayer is not required to capitalize
amounts paid to another party (or parties) to create, originate, enter
into, renew or renegotiate with that party (or those parties) an
agreement described in paragraph (d)(6)(i) of this section if the
aggregate of all amounts paid to that party (or those parties) with
respect to the agreement does not exceed $5,000. If the aggregate of all
amounts paid to the other party (or parties) with respect to that
agreement exceeds $5,000, then all amounts must be capitalized. For
purposes of this paragraph (d)(6), an amount paid in the form of
property is valued at its fair market value at the time of the payment.
In general, a taxpayer must determine whether the rules of this
paragraph (d)(6)(v) apply by accounting for the specific amounts paid
with respect to each agreement. However, a taxpayer that reasonably
expects to create, originate, enter into, renew or renegotiate at least
25 similar agreements during the taxable year may establish a pool of
agreements for purposes of determining the amounts paid with respect to
the agreements in the pool. Under this pooling method, the amount paid
with respect to each agreement included in the pool is equal to the
average amount paid with respect to all agreements included in the pool.
A taxpayer computes the average amount paid with respect to all
agreements included in the pool by dividing the sum of all amounts paid
with respect to all agreements included in the pool by the number of
agreements included in the pool. See paragraph (h) of this section for
additional rules relating to pooling.
(vi) Exception for lessee construction allowances. Paragraph
(d)(6)(i) of this section does not apply to amounts paid by a lessor to
a lessee as a construction allowance to the extent the lessee expends
the amount for the tangible property that is owned by the lessor for
Federal income tax purposes (see, for example, section 110).
(vii) Examples. The following examples illustrate the rules of this
paragraph (d)(6):
Example 1. New lease agreement. V seeks to lease commercial property
in a prominent downtown location of city R. V pays Z, the owner of the
commercial property, $50,000 in exchange for Z entering into a 10-year
lease with V. V's payment is an amount paid to another party to enter
into an agreement providing V the right to use tangible property.
Because the $50,000 payment exceeds $5,000, no portion of the amount
paid to Z is de minimis for purposes of paragraph (d)(6)(v) of this
section. Under paragraph (d)(6)(i)(A) of this section, V must capitalize
the entire $50,000 payment.
Example 2. Modification of lease agreement. Partnership Y leases a
piece of equipment for use in its business from Z corporation. When the
lease has a remaining term of 3 years, Y requests that Z modify the
existing lease by extending the remaining term by 5 years. Y pays
$50,000 to Z in exchange for Z's agreement to modify the existing lease.
Y's payment of $50,000 is an amount paid to another party to renegotiate
an agreement providing Y the right to use property. Because the $50,000
payment exceeds $5,000, no portion of the amount paid to Z is de minimis
for purposes of paragraph (d)(6)(v) of this section. Under paragraph
(d)(6)(i)(A) of this section, Y must capitalize the entire $50,000
payment.
[[Page 706]]
Example 3. Modification of lease agreement. In 2004, R enters into a
5-year, non-cancelable lease of a mainframe computer for use in its
business. R subsequently determines that the mainframe computer that R
is leasing is no longer adequate for its needs. In 2006, R and P
corporation (the lessor) agree to terminate the 2004 lease and to enter
into a new 5-year lease for a different and more powerful mainframe
computer. R pays P a $75,000 early termination fee. P would not have
agreed to terminate the 2004 lease unless R agreed to enter into the
2006 lease. R's payment of $75,000 is an amount paid to another party to
renegotiate an agreement providing R the right to use property. Because
the $75,000 payment exceeds $5,000, no portion of the amount paid to P
is de minimis for purposes of paragraph (d)(6)(v) of this section. Under
paragraph (d)(6)(i)(A) of this section, R must capitalize the entire
$75,000 payment.
Example 4. Modification of lease agreement. Same as Example 3,
except the 2004 lease agreement allows R to terminate the lease at any
time subject to a $75,000 early termination fee. Because R can terminate
the lease without P's approval, R's payment of $75,000 is not an amount
paid to another party to renegotiate an agreement. Accordingly, R is not
required to capitalize the $75,000 payment under this paragraph (d)(6).
Example 5. Modification of lease agreement. Same as Example 4,
except P agreed to reduce the early termination fee to $60,000. Because
R did not pay an amount to renegotiate the early termination fee, R's
payment of $60,000 is not an amount paid to another party to renegotiate
an agreement. Accordingly, R is not required to capitalize the $60,000
payment under this paragraph (d)(6).
Example 6. Covenant not to compete. R corporation enters into an
agreement with A, an individual, that prohibits A from competing with R
for a period of three years. To encourage A to enter into the agreement,
R agrees to pay A $100,000 upon the signing of the agreement. R's
payment is an amount paid to another party to enter into a covenant not
to compete. Because the $100,000 payment exceeds $5,000, no portion of
the amount paid to A is de minimis for purposes of paragraph (d)(6)(v)
of this section. Under paragraph (d)(6)(i)(C) of this section, R must
capitalize the entire $100,000 payment.
Example 7. Standstill agreement. During 2004 through 2005, X
corporation acquires a large minority interest in the stock of Z
corporation. To ensure that X does not take control of Z, Z pays X
$5,000,000 for a standstill agreement under which X agrees not to
acquire any more stock in Z for a period of 10 years. Z's payment is an
amount paid to another party to enter into an agreement not to acquire
additional ownership interests in Z. Because the $5,000,000 payment
exceeds $5,000, no portion of the amount paid to X is de minimis for
purposes of paragraph (d)(6)(v) of this section. Under paragraph
(d)(6)(i)(D) of this section, Z must capitalize the entire $5,000,000
payment.
Example 8. Signing bonus. Employer B pays a $25,000 signing bonus to
employee C to induce C to come to work for B. C can leave B's employment
at any time to work for a competitor of B and is not required to repay
the $25,000 bonus to B. Because C is not economically compelled to
continue his employment with B, B's payment does not provide B the right
to receive services from C. Accordingly, B is not required to capitalize
the $25,000 payment.
Example 9. Renewal. In 2000, M corporation and N corporation enter
into a 5-year agreement that gives M the right to manage N's investment
portfolio. In 2005, N has the option of renewing the agreement for
another three years. During 2004, M pays $10,000 to send several
employees of N to an investment seminar. M pays the $10,000 to help
develop and maintain its business relationship with N with the
expectation that N will renew its agreement with M in 2005. Because M's
payment is not contingent on N agreeing to renew the agreement, M's
payment is not an amount paid to renew an agreement under paragraph
(d)(6)(ii) of this section and is not required to be capitalized.
Example 10. De minimis payments. X corporation is engaged in the
business of providing wireless telecommunications services to customers.
To induce customer B to enter into a 3-year non-cancelable
telecommunications contract, X provides B with a free wireless
telephone. The fair market value of the wireless telephone is $300 at
the time it is provided to B. X's provision of a wireless telephone to B
is an amount paid to B to induce B to enter into an agreement providing
X the right to provide services, as described in paragraph (d)(6)(i)(B)
of this section. Because the amount of the inducement is $300, the
amount of the inducement is de minimis under paragraph (d)(6)(v) of this
section. Accordingly, X is not required to capitalize the amount of the
inducement provided to B.
(7) Certain contract terminations--(i) In general. A taxpayer must
capitalize amounts paid to another party to terminate--
(A) A lease of real or tangible personal property between the
taxpayer (as lessor) and that party (as lessee);
(B) An agreement that grants that party the exclusive right to
acquire or use the taxpayer's property or services or to conduct the
taxpayer's business (other than an intangible described in paragraph
(c)(1)(i) through (iv) of this
[[Page 707]]
section or a financial interest described in paragraph (d)(2) of this
section); or
(C) An agreement that prohibits the taxpayer from competing with
that party or from acquiring property or services from a competitor of
that party.
(ii) Certain break-up fees. Paragraph (d)(7)(i) of this section does
not apply to the termination of a transaction described in Sec.
1.263(a)-5(a) (relating to an acquisition of a trade or business, a
change in the capital structure of a business entity, and certain other
transactions). See Sec. 1.263(a)-5(c)(8) for rules governing the
treatment of amounts paid to terminate a transaction to which that
section applies.
(iii) Examples. The following examples illustrate the rules of this
paragraph (d)(7):
Example 1. Termination of exclusive license agreement. On July 1,
2005, N enters into a license agreement with R corporation under which N
grants R the exclusive right to manufacture and distribute goods using
N's design and trademarks for a period of 10 years. On June 30, 2007, N
pays R $5,000,000 in exchange for R's agreement to terminate the
exclusive license agreement. N's payment to terminate its license
agreement with R constitutes a payment to terminate an exclusive license
to use the taxpayer's property, as described in paragraph (d)(7)(i)(B)
of this section. Accordingly, N must capitalize its $5,000,000 payment
to R.
Example 2. Termination of exclusive distribution agreement. On March
1, 2005, L, a manufacturer, enters into an agreement with M granting M
the right to be the sole distributor of L's products in state X for 10
years. On July 1, 2008, L pays M $50,000 in exchange for M's agreement
to terminate the distribution agreement. L's payment to terminate its
agreement with M constitutes a payment to terminate an exclusive right
to acquire L's property, as described in paragraph (d)(7)(i)(B) of this
section. Accordingly, L must capitalize its $50,000 payment to M.
Example 3. Termination of covenant not to compete. On February 1,
2005, Y corporation enters into a covenant not to compete with Z
corporation that prohibits Y from competing with Z in city V for a
period of 5 years. On January 31, 2007, Y pays Z $1,000,000 in exchange
for Z's agreement to terminate the covenant not to compete. Y's payment
to terminate the covenant not to compete with Z constitutes a payment to
terminate an agreement that prohibits Y from competing with Z, as
described in paragraph (d)(7)(i)(C) of this section. Accordingly, Y must
capitalize its $1,000,000 payment to Z.
Example 4. Termination of merger agreement. N corporation and U
corporation enter into an agreement under which N agrees to merge into
U. Subsequently, N pays U $10,000,000 to terminate the merger agreement.
As provided in paragraph (d)(7)(ii) of this section, N's $10,000,000
payment to terminate the merger agreement with U is not required to be
capitalized under this paragraph (d)(7). In addition, N's $10,000,000
does not create a separate and distinct intangible asset for N within
the meaning of paragraph (b)(3)(i) of this section. (See Sec. 1.263(a)-
5 for additional rules regarding termination of merger agreements).
(8) Certain benefits arising from the provision, production, or
improvement of real property--(i) In general. A taxpayer must capitalize
amounts paid for real property if the taxpayer transfers ownership of
the real property to another person (except to the extent the real
property is sold for fair market value) and if the real property can
reasonably be expected to produce significant economic benefits to the
taxpayer after the transfer. A taxpayer also must capitalize amounts
paid 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.
(ii) Exclusions. A taxpayer is not required to capitalize an amount
under paragraph (d)(8)(i) of this section if the taxpayer transfers real
property or pays an amount to produce or improve real property owned by
another in exchange for services, the purchase or use of property, or
the creation of an intangible described in paragraph (d) of this section
(other than in this paragraph (d)(8)). The preceding sentence does not
apply to the extent the taxpayer does not receive fair market value
consideration for the real property that is relinquished or for the
amounts that are paid by the taxpayer to produce or improve real
property owned by another.
(iii) Real property. For purposes of this paragraph (d)(8), real
property includes property that is affixed to real property and that
will ordinarily remain affixed for an indefinite period of time, such as
roads, bridges, tunnels,
[[Page 708]]
pavements, wharves and docks, breakwaters and sea walls, elevators,
power generation and transmission facilities, and pollution control
facilities.
(iv) Impact fees and dedicated improvements. Paragraph (d)(8)(i) of
this section does not apply to amounts paid to satisfy one-time charges
imposed by a State or local government against new development (or
expansion of existing development) to finance specific offsite capital
improvements for general public use that are necessitated by the new or
expanded development. In addition, paragraph (d)(8)(i) of this section
does not apply to amounts paid for real property or improvements to real
property constructed by the taxpayer where the real property or
improvements benefit new development or expansion of existing
development, are immediately transferred to a State or local government
for dedication to the general public use, and are maintained by the
State or local government. See section 263A and the regulations
thereunder for capitalization rules that apply to amounts referred to in
this paragraph (d)(8)(iv).
(v) Examples. The following examples illustrate the rules of this
paragraph (d)(8):
Example 1. Amount paid to produce real property owned by another. W
corporation operates a quarry on the east side of a river in city Z and
a crusher on the west side of the river. City Z's existing bridges are
of insufficient capacity to be traveled by trucks in transferring stone
from W's quarry to its crusher. As a result, the efficiency of W's
operations is greatly reduced. W contributes $1,000,000 to city Z to
defray in part the cost of constructing a publicly owned bridge capable
of accommodating W's trucks. W's payment to city Z is an amount paid to
produce or improve real property (within the meaning of paragraph
(d)(8)(iii) of this section) that can reasonably be expected to produce
significant economic benefits for W. Under paragraph (d)(8)(i) of this
section, W must capitalize the $1,000,000 paid to city Z.
Example 2. Transfer of real property to another. K corporation, a
shipping company, uses smaller vessels to unload its ocean-going vessels
at port X. There is no natural harbor at port X, and during stormy
weather the transfer of freight between K's ocean vessels and port X is
extremely difficult and sometimes impossible, which can be very costly
to K. Consequently, K constructs a short breakwater at a cost of
$50,000. The short breakwater, however, is inadequate, so K persuades
the port authority to build a larger breakwater that will allow K to
unload its vessels at any time of the year and during all kinds of
weather. K contributes the short breakwater and pays $200,000 to the
port authority for use in building the larger breakwater. Because the
transfer of the small breakwater and $200,000 is reasonably expected to
produce significant economic benefits for K, K must capitalize both the
adjusted basis of the small breakwater (determined at the time the small
breakwater is contributed) and the $200,000 payment under this paragraph
(d)(8).
Example 3. Dedicated improvements. X corporation is engaged in the
development and sale of residential real estate. In connection with a
residential real estate project under construction by X in city Z, X is
required by city Z to construct ingress and egress roads to and from its
project and immediately transfer the roads to city Z for dedication to
general public use. The roads will be maintained by city Z. X pays its
subcontractor $100,000 to construct the ingress and egress roads. X's
payment is a dedicated improvement within the meaning of paragraph
(d)(8)(iv) of this section. Accordingly, X is not required to capitalize
the $100,000 payment under this paragraph (d)(8). See section 263A and
the regulations thereunder for capitalization rules that apply to
amounts referred to in paragraph (d)(8)(iv) of this section.
(9) Defense or perfection of title to intangible property--(i) In
general. A taxpayer must capitalize amounts paid to another party to
defend or perfect title to intangible property if that other party
challenges the taxpayer's title to the intangible property.
(ii) Certain break-up fees. Paragraph (d)(9)(i) of this section does
not apply to the termination of a transaction described in Sec.
1.263(a)-5(a) (relating to an acquisition of a trade or business, a
change in the capital structure of a business entity, and certain other
transactions). See Sec. 1.263(a)-5 for rules governing the treatment of
amounts paid to terminate a transaction to which that section applies.
Paragraph (d)(9)(i) of this section also does not apply to an amount
paid to another party to terminate an agreement that grants that party
the right to purchase the taxpayer's intangible property.
(iii) Example. The following example illustrates the rules of this
paragraph (d)(9):
[[Page 709]]
Example. Defense of title. R corporation claims to own an exclusive
patent on a particular technology. U corporation brings a lawsuit
against R, claiming that U is the true owner of the patent and that R
stole the technology from U. The sole issue in the suit involves the
validity of R's patent. R chooses to settle the suit by paying U
$100,000 in exchange for U's release of all future claim to the patent.
R's payment to U is an amount paid to defend or perfect title to
intangible property under paragraph (d)(9) of this section and must be
capitalized.
(e) Transaction costs--(1) Scope of facilitate--(i) In general.
Except as otherwise provided in this section, an amount is paid to
facilitate the acquisition or creation of an intangible (the
transaction) if the amount is paid in the process of investigating or
otherwise pursuing the transaction. Whether an amount is paid in the
process of investigating or otherwise pursuing the transaction is
determined based on all of the facts and circumstances. In determining
whether an amount is paid to facilitate a transaction, the fact that the
amount would (or would not) have been paid but for the transaction is
relevant, but is not determinative. An amount paid to determine the
value or price of an intangible is an amount paid in the process of
investigating or otherwise pursuing the transaction.
(ii) Treatment of termination payments. An amount paid to terminate
(or acilitate the termination of) an existing agreement does not
facilitate the acquisition or creation of another agreement under this
section. See paragraph (d)(6)(iii) of this section for the treatment of
termination fees paid to the other party (or parties) of a renegotiated
agreement.
(iii) Special rule for contracts. An amount is treated as not paid
in the process of investigating or otherwise pursuing the creation of an
agreement described in paragraph (d)(2) or (d)(6) of this section if the
amount relates to activities performed before the earlier of the date
the taxpayer begins preparing its bid for the agreement or the date the
taxpayer begins discussing or negotiating the agreement with another
party to the agreement.
(iv) Borrowing costs. An amount paid to facilitate a borrowing does
not facilitate an acquisition or creation of an intangible described in
paragraphs (b)(1)(i) through (iv) of this section. See Sec. Sec.
1.263(a)-5 and 1.446-5 for the treatment of an amount paid to facilitate
a borrowing.
(v) Special rule for stock redemption costs of open-end regulated
investment companies. An amount paid by an open-end regulated investment
company (within the meaning of section 851) to facilitate a redemption
of its stock is treated as an amount that does not facilitate the
acquisition of an intangible under this section.
(2) Coordination with paragraph (d) of this section. In the case of
an amount paid to facilitate the creation of an intangible described in
paragraph (d) of this section, the provisions of this paragraph (e)
apply regardless of whether a payment described in paragraph (d) is
made.
(3) Transaction. For purposes of this section, the term transaction
means all of the factual elements comprising an acquisition or creation
of an intangible and includes a series of steps carried out as part of a
single plan. Thus, a transaction can involve more than one invoice and
more than one intangible. For example, a purchase of intangibles under
one purchase agreement constitutes a single transaction, notwithstanding
the fact that the acquisition involves multiple intangibles and the
amounts paid to facilitate the acquisition are capable of being
allocated among the various intangibles acquired.
(4) Simplifying conventions--(i) In general. For purposes of this
section, employee compensation (within the meaning of paragraph
(e)(4)(ii) of this section), overhead, and de minimis costs (within the
meaning of paragraph (e)(4)(iii) of this section) are treated as amounts
that do not facilitate the acquisition or creation of an intangible.
(ii) Employee compensation--(A) In general. The term employee
compensation means compensation (including salary, bonuses and
commissions) paid to an employee of the taxpayer. For purposes of this
section, whether an individual is an employee is determined in
accordance with the rules contained in section 3401(c) and the
regulations thereunder.
(B) Certain amounts treated as employee compensation. For purposes
of
[[Page 710]]
this section, a guaranteed payment to a partner in a partnership is
treated as employee compensation. For purposes of this section, annual
compensation paid to a director of a corporation is treated as employee
compensation. For example, an amount paid to a director of a corporation
for attendance at a regular meeting of the board of directors (or
committee thereof) is treated as employee compensation for purposes of
this section. However, an amount paid to a director for attendance at a
special meeting of the board of directors (or committee thereof) is not
treated as employee compensation. An amount paid to a person that is not
an employee of the taxpayer (including the employer of the individual
who performs the services) is treated as employee compensation for
purposes of this section only if the amount is paid for secretarial,
clerical, or similar administrative support services. In the case of an
affiliated group of corporations filing a consolidated Federal income
tax return, a payment by one member of the group to a second member of
the group for services performed by an employee of the second member is
treated as employee compensation if the services provided by the
employee are provided at a time during which both members are
affiliated.
(iii) De minimis costs--(A) In general. Except as provided in
paragraph (e)(4)(iii)(B) of this section, the term de minimis costs
means amounts (other than employee compensation and overhead) paid in
the process of investigating or otherwise pursuing a transaction if, in
the aggregate, the amounts do not exceed $5,000 (or such greater amount
as may be set forth in published guidance). If the amounts exceed $5,000
(or such greater amount as may be set forth in published guidance), none
of the amounts are de minimis costs within the meaning of this paragraph
(e)(4)(iii)(A). For purposes of this paragraph (e)(4)(iii), an amount
paid in the form of property is valued at its fair market value at the
time of the payment. In determining the amount of transaction costs paid
in the process of investigating or otherwise pursuing a transaction, a
taxpayer generally must account for the specific costs paid with respect
to each transaction. However, a taxpayer that reasonably expects to
enter into at least 25 similar transactions during the taxable year may
establish a pool of similar transactions for purposes of determining the
amount of transaction costs paid in the process of investigating or
otherwise pursuing the transactions in the pool. Under this pooling
method, the amount of transaction costs paid in the process of
investigating or otherwise pursuing each transaction included in the
pool is equal to the average transaction costs paid in the process of
investigating or otherwise pursuing all transactions included in the
pool. A taxpayer computes the average transaction costs paid in the
process of investigating or otherwise pursuing all transactions included
in the pool by dividing the sum of all transaction costs paid in the
process of investigating or otherwise pursuing all transactions included
in the pool by the number of transactions included in the pool. See
paragraph (h) of this section for additional rules relating to pooling.
(B) Treatment of commissions. The term de minimis costs does not
include commissions paid to facilitate the acquisition of an intangible
described in paragraphs (c)(1)(i) through (v) of this section or to
facilitate the creation, origination, entrance into, renewal or
renegotiation of an intangible described in paragraph (d)(2)(i) of this
section.
(iv) Election to capitalize. A taxpayer may elect to treat employee
compensation, overhead, or de minimis costs paid in the process of
investigating or otherwise pursuing a transaction as amounts that
facilitate the transaction. The election is made separately for each
transaction and applies to employee compensation, overhead, or de
minimis costs, or to any combination thereof. For example, a taxpayer
may elect to treat overhead and de minimis costs, but not employee
compensation, as amounts that facilitate the transaction. A taxpayer
makes the election by treating the amounts to which the election applies
as amounts that facilitate the transaction in the taxpayer's timely
filed original Federal income tax return (including extensions) for the
taxable year during which the
[[Page 711]]
amounts are paid. In the case of an affiliated group of corporations
filing a consolidated return, the election is made separately with
respect to each member of the group, and not with respect to the group
as a whole. In the case of an S corporation or partnership, the election
is made by the S corporation or by the partnership, and not by the
shareholders or partners. An election made under this paragraph
(e)(4)(iv) is revocable with respect to each taxable year for which made
only with the consent of the Commissioner.
(5) Examples. The following examples illustrate the rules of this
paragraph (e):
Example 1. Costs to facilitate. In December 2005, R corporation, a
calendar year taxpayer, enters into negotiations with X corporation to
lease commercial property from X for a period of 25 years. R pays A, its
outside legal counsel, $4,000 in December 2005 for services rendered by
A during December in assisting with negotiations with X. In January
2006, R and X finalize the terms of the lease and execute the lease
agreement. R pays B, another of its outside legal counsel, $2,000 in
January 2006 for services rendered by B during January in drafting the
lease agreement. The agreement between R and X is an agreement providing
R the right to use property, as described in paragraph (d)(6)(i)(A) of
this section. R's payments to its outside counsel are amounts paid to
facilitate the creation of the agreement. As provided in paragraph
(e)(4)(iii)(A) of this section, R must aggregate its transaction costs
for purposes of determining whether the transaction costs are de
minimis. Because R's aggregate transaction costs exceed $5,000, R's
transaction costs are not de minimis costs within the meaning of
paragraph (e)(4)(iii)(A) of this section. Accordingly, R must capitalize
the $4,000 paid to A and the $2,000 paid to B under paragraph (b)(1)(v)
of this section.
Example 2. Costs to facilitate. Partnership X leases its
manufacturing equipment from Y corporation under a 10-year lease. During
2005, when the lease has a remaining term of 4 years, X enters into a
written agreement with Z corporation, a competitor of Y, under which X
agrees to lease its manufacturing equipment from Z, subject to the
condition that X first successfully terminates its lease with Y. X pays
Y $50,000 in exchange for Y's agreement to terminate the equipment
lease. Under paragraph (e)(1)(ii), X's $50,000 payment does not
facilitate the creation of the new lease with Z. In addition, X's
$50,000 payment does not terminate an agreement described in paragraph
(d)(7) of this section. Accordingly, X is not required to capitalize the
$50,000 termination payment under this section.
Example 3. Costs to facilitate. W corporation enters into a lease
agreement with X corporation under which W agrees to lease property to X
for a period of 5 years. W pays its outside counsel $7,000 for legal
services rendered in drafting the lease agreement and negotiating with
X. The agreement between W and X is an agreement providing W the right
to be compensated for the use of property, as described in paragraph
(d)(6)(i)(A) of this section. Under paragraph (e)(1)(i) of this section,
W's payment to its outside counsel is an amount paid to facilitate the
creation of that agreement. As provided by paragraph (e)(2) of this
section, W must capitalize its $7,000 payment to outside counsel
notwithstanding the fact that W made no payment described in paragraph
(d)(6)(i) of this section.
Example 4. Costs to facilitate. U corporation, which owns a majority
of the common stock of T corporation, votes its controlling interest in
favor of a perpetual extension of T's charter. M, a minority shareholder
in T, votes against the extension. Under applicable state law, U is
required to purchase the stock of T held by M. When U and M are unable
to agree on the value of M's shares, U brings an action in state court
to appraise the value of M's stock interest. U pays attorney, accountant
and appraisal fees of $25,000 for services rendered in connection with
the negotiation and litigation with M. Because U's attorney, accountant
and appraisal costs help establish the purchase price of M's stock, U's
$25,000 payment facilitates the acquisition of stock. Accordingly, U
must capitalize the $25,000 payment under paragraph (b)(1)(v) of this
section.
Example 5. Costs to facilitate. For several years, H corporation has
provided services to J corporation whenever requested by J. H wants to
enter into a multiple-year contract with J that would give H the right
to provide services to J. On June 10, 2004, H starts to prepare a bid to
provide services to J and pays a consultant $15,000 to research
potential competitors. On August 10, 2004, H raises the possibility of a
multi-year contract with J. On October 10, 2004, H and J enter into a
contract giving H the right to provide services to J for five years.
During 2004, H pays $7,000 to travel to the city in which J's offices
are located to continue providing services to J under their prior
arrangement and pays $6,000 for travel to the city in which J's offices
are located to further develop H's business relationship with J (for
example, to introduce new employees, update J on current developments
and take J's executives to dinner). H also pays $8,000 for travel costs
to meet with J to discuss and negotiate the contract. Because the
contract gives H the
[[Page 712]]
right to provide services to J, H must capitalize amounts paid to
facilitate the creation of the contract. The $7,000 of travel expenses
paid to provide services to J under their prior arrangement does not
facilitate the creation of the contract and is not required to be
capitalized, regardless of when the travel occurs. The $6,000 of travel
expenses paid to further develop H's business relationship with J is
paid in the process of pursuing the contract (and therefore must be
capitalized) only to the extent the expenses relate to travel on or
after June 10, 2004 (the date H begins to prepare a bid) and before
October 11, 2004 (the date after H and J enter into the contract). The
$8,000 of travel expenses paid to meet with J to discuss and negotiate
the contract is paid in the process of pursuing the contact and must be
capitalized. The $15,000 of consultant fees is paid to investigate the
contract and also must be capitalized.
Example 6. Costs that do not facilitate. X corporation brings a
legal action against Y corporation to recover lost profits resulting
from Y's alleged infringement of X's copyright. Y does not challenge X's
copyright, but argues that it did not infringe upon X's copyright. X
pays its outside counsel $25,000 for legal services rendered in pursuing
the suit against Y. Because X's title to its copyright is not in
question, X's action against Y does not involve X's defense or
perfection of title to intangible property. Thus, the amount paid to
outside counsel does not facilitate the creation of an intangible
described in paragraph (d)(9) of this section. Accordingly, X is not
required to capitalize its $25,000 payment under this section.
Example 7. De minimis rule. W corporation, a commercial bank,
acquires a portfolio containing 100 loans from Y corporation. As part of
the acquisition, W pays an independent appraiser a fee of $10,000 to
appraise the portfolio. The fee is an amount paid to facilitate W's
acquisition of an intangible. The acquisition of the loan portfolio is a
single transaction within the meaning of paragraph (e)(3) of this
section. Because the amount paid to facilitate the transaction exceeds
$5,000, the amount is not de minimis as defined in paragraph
(e)(4)(iii)(A) of this section. Accordingly, W must capitalize the
$10,000 fee under paragraph (b)(1)(v) of this section.
Example 8. Compensation and overhead. P corporation, a commercial
bank, maintains a loan acquisition department whose sole function is to
acquire loans from other financial institutions. As provided in
paragraph (e)(4)(i) of this section, P is not required to capitalize any
portion of the compensation paid to the employees in its loan
acquisition department or any portion of its overhead allocable to the
loan acquisition department.
(f) 12-month rule--(1) In general. Except as otherwise provided in
this paragraph (f), a taxpayer is not required to capitalize under this
section amounts paid to create (or to facilitate the creation of) any
right or benefit for the taxpayer that does not extend beyond the
earlier of--
(i) 12 months after the first date on which the taxpayer realizes
the right or benefit; or
(ii) The end of the taxable year following the taxable year in which
the payment is made.
(2) Duration of benefit for contract terminations. For purposes of
this paragraph (f), amounts paid to terminate a contract or other
agreement described in paragraph (d)(7)(i) of this section prior to its
expiration date (or amounts paid to facilitate such termination) create
a benefit for the taxpayer that lasts for the unexpired term of the
agreement immediately before the date of the termination. If the terms
of a contract or other agreement described in paragraph (d)(7)(i) of
this section permit the taxpayer to terminate the contract or agreement
after a notice period, amounts paid by the taxpayer to terminate the
contract or agreement before the end of the notice period create a
benefit for the taxpayer that lasts for the amount of time by which the
notice period is shortened.
(3) Inapplicability to created financial interests and self-created
amortizable section 197 intangibles. Paragraph (f)(1) of this section
does not apply to amounts paid to create (or facilitate the creation of)
an intangible described in paragraph (d)(2) of this section (relating to
amounts paid to create financial interests) or to amounts paid to create
(or facilitate the creation of) an intangible that constitutes an
amortizable section 197 intangible within the meaning of section 197(c).
(4) Inapplicability to rights of indefinite duration. Paragraph
(f)(1) of this section does not apply to amounts paid to create (or
facilitate the creation of) an intangible of indefinite duration. A
right has an indefinite duration if it has no period of duration fixed
by agreement or by law, or if it is not based on a period of time, such
as a right attributable to an agreement to provide or receive a fixed
amount of
[[Page 713]]
goods or services. For example, a license granted by a governmental
agency that permits the taxpayer to operate a business conveys a right
of indefinite duration if the license may be revoked only upon the
taxpayer's violation of the terms of the license.
(5) Rights subject to renewal--(i) In general. For purposes of
paragraph (f)(1) of this section, the duration of a right includes any
renewal period if all of the facts and circumstances in existence during
the taxable year in which the right is created indicate a reasonable
expectancy of renewal.
(ii) Reasonable expectancy of renewal. The following factors are
significant in determining whether there exists a reasonable expectancy
of renewal:
(A) Renewal history. The fact that similar rights are historically
renewed is evidence of a reasonable expectancy of renewal. On the other
hand, the fact that similar rights are rarely renewed is evidence of a
lack of a reasonable expectancy of renewal. Where the taxpayer has no
experience with similar rights, or where the taxpayer holds similar
rights only occasionally, this factor is less indicative of a reasonable
expectancy of renewal.
(B) Economics of the transaction. The fact that renewal is necessary
for the taxpayer to earn back its investment in the right is evidence of
a reasonable expectancy of renewal. For example, if a taxpayer pays
$14,000 to enter into a renewable contract with an initial 9-month term
that is expected to generate income to the taxpayer of $1,000 per month,
the fact that renewal is necessary for the taxpayer to earn back its
$14,000 payment is evidence of a reasonable expectancy of renewal.
(C) Likelihood of renewal by other party. Evidence that indicates a
likelihood of renewal by the other party to a right, such as a bargain
renewal option or similar arrangement, is evidence of a reasonable
expectancy of renewal. However, the mere fact that the other party will
have the opportunity to renew on the same terms as are available to
others is not evidence of a reasonable expectancy of renewal.
(D) Terms of renewal. The fact that material terms of the right are
subject to renegotiation at the end of the initial term is evidence of a
lack of a reasonable expectancy of renewal. For example, if the parties
to an agreement must renegotiate price or amount, the renegotiation
requirement is evidence of a lack of a reasonable expectancy of renewal.
(E) Terminations. The fact that similar rights are typically
terminated prior to renewal is evidence of a lack of a reasonably
expectancy of renewal.
(iii) Safe harbor pooling method. In lieu of applying the reasonable
expectancy of renewal test described in paragraph (f)(5)(ii) of this
section to each separate right created during a taxable year, a taxpayer
that reasonably expects to enter into at least 25 similar rights during
the taxable year may establish a pool of similar rights for which the
initial term does not extend beyond the period prescribed in paragraph
(f)(1) of this section and may elect to apply the reasonable expectancy
of renewal test to that pool. See paragraph (h) of this section for
additional rules relating to pooling. The application of paragraph
(f)(1) of this section to each pool is determined in the following
manner:
(A) All amounts (except de minimis costs described in paragraph
(d)(6)(v) of this section) paid to create the rights included in the
pool and all amounts paid to facilitate the creation of the rights
included in the pool are aggregated.
(B) If less than 20 percent of the rights in the pool are reasonably
expected to be renewed beyond the period prescribed in paragraph (f)(1)
of this section, all rights in the pool are treated as having a duration
that does not extend beyond the period prescribed in paragraph (f)(1) of
this section, and the taxpayer is not required to capitalize under this
section any portion of the aggregate amount described in paragraph
(f)(5)(iii)(A) of this section.
(C) If more than 80 percent of the rights in the pool are reasonably
expected to be renewed beyond the period prescribed in paragraph (f)(1)
of this section, all rights in the pool are treated as having a duration
that extends beyond the period prescribed in paragraph (f)(1) of this
section, and the taxpayer is required to capitalize under
[[Page 714]]
this section the aggregate amount described in paragraph (f)(5)(iii)(A)
of this section.
(D) If 20 percent or more, but 80 percent or less, of the rights in
the pool are reasonably expected to be renewed beyond the period
prescribed in paragraph (f)(1) of this section, the aggregate amount
described in paragraph (f)(5)(iii)(A) of this section is multiplied by
the percentage of the rights in the pool that are reasonably expected to
be renewed beyond the period prescribed in paragraph (f)(1) of this
section and the taxpayer must capitalize the resulting amount under this
section by treating such amount as creating a separate intangible. The
amount determined by multiplying the aggregate amount described in
paragraph (f)(5)(iii)(A) of this section by the percentage of rights in
the pool that are not reasonably expected to be renewed beyond the
period prescribed in paragraph (f)(1) of this section is not required to
be capitalized under this section.
(6) Coordination with section 461. In the case of a taxpayer using
an accrual method of accounting, the rules of this paragraph (f) do not
affect the determination of whether a liability is incurred during the
taxable year, including the determination of whether economic
performance has occurred with respect to the liability. See Sec. 1.461-
4 for rules relating to economic performance.
(7) Election to capitalize. A taxpayer may elect not to apply the
rule contained in paragraph (f)(1) of this section. An election made
under this paragraph (f)(7) applies to all similar transactions during
the taxable year to which paragraph (f)(1) of this section would apply
(but for the election under this paragraph (f)(7)). For example, a
taxpayer may elect under this paragraph (f)(7) to capitalize its costs
of prepaying insurance contracts for 12 months, but may continue to
apply the rule in paragraph (f)(1) to its costs of entering into non-
renewable, 12-month service contracts. A taxpayer makes the election by
treating the amounts as capital expenditures in its timely filed
original federal income tax return (including extensions) for the
taxable year during which the amounts are paid. In the case of an
affiliated group of corporations filing a consolidated return, the
election is made separately with respect to each member of the group,
and not with respect to the group as a whole. In the case of an S
corporation or partnership, the election is made by the S corporation or
by the partnership, and not by the shareholders or partners. An election
made under this paragraph (f)(7) is revocable with respect to each
taxable year for which made only with the consent of the Commissioner.
(8) Examples. The rules of this paragraph (f) are illustrated by the
following examples, in which it is assumed (unless otherwise stated)
that the taxpayer is a calendar year, accrual method taxpayer that does
not have a short taxable year in any taxable year and has not made an
election under paragraph (f)(7) of this section:
Example 1. Prepaid expenses. On December 1, 2005, N corporation pays
a $10,000 insurance premium to obtain a property insurance policy (with
no cash value) with a 1-year term that begins on February 1, 2006. The
amount paid by N is a prepaid expense described in paragraph (d)(3) of
this section and not paragraph (d)(2) of this section. Because the right
or benefit attributable to the $10,000 payment extends beyond the end of
the taxable year following the taxable year in which the payment is
made, the 12-month rule provided by this paragraph (f) does not apply. N
must capitalize the $10,000 payment.
Example 2. Prepaid expenses. (i) Assume the same facts as in Example
1, except that the policy has a term beginning on December 15, 2005. The
12-month rule of this paragraph (f) applies to the $10,000 payment
because the right or benefit attributable to the payment neither extends
more than 12 months beyond December 15, 2005 (the first date the benefit
is realized by the taxpayer) nor beyond the end of the taxable year
following the taxable year in which the payment is made. Accordingly, N
is not required to capitalize the $10,000 payment.
(ii) Alternatively, assume N capitalizes prepaid expenses for
financial accounting and reporting purposes and elects under paragraph
(f)(7) of this section not to apply the 12-month rule contained in
paragraph (f)(1) of this section. N must capitalize the $10,000 payment
for Federal income tax purposes.
Example 3. Financial interests. On October 1, 2005, X corporation
makes a 9-month loan to B in the principal amount of $250,000. The
[[Page 715]]
principal amount of the loan to B constitutes an amount paid to create
or originate a financial interest under paragraph (d)(2)(i)(B) of this
section. The 9-month term of the loan does not extend beyond the period
prescribed by paragraph (f)(1) of this section. However, as provided by
paragraph (f)(3) of this section, the rules of this paragraph (f) do not
apply to intangibles described in paragraph (d)(2) of this section.
Accordingly, X must capitalize the $250,000 loan amount.
Example 4. Financial interests. X corporation owns all of the
outstanding stock of Z corporation. On December 1, 2005, Y corporation
pays X $1,000,000 in exchange for X's grant of a 9-month call option to
Y permitting Y to purchase all of the outstanding stock of Z. Y's
payment to X constitutes an amount paid to create or originate an option
with X under paragraph (d)(2)(i)(C)(7) of this section. The 9-month term
of the option does not extend beyond the period prescribed by paragraph
(f)(1) of this section. However, as provided by paragraph (f)(3) of this
section, the rules of this paragraph (f) do not apply to intangibles
described in paragraph (d)(2) of this section. Accordingly, Y must
capitalize the $1,000,000 payment.
Example 5. License. (i) On July 1, 2005, R corporation pays $10,000
to state X to obtain a license to operate a business in state X for a
period of 5 years. The terms of the license require R to pay state X an
annual fee of $500 due on July 1, 2005, and each of the succeeding four
years. R pays the $500 fee on July 1 as required by the license.
(ii) R's payment of $10,000 is an amount paid to a governmental
agency for a license granted by that agency to which paragraph (d)(5) of
this section applies. Because R's payment creates rights or benefits for
R that extend beyond 12 months after the first date on which R realizes
the rights or benefits attributable to the payment and beyond the end of
2006 (the taxable year following the taxable year in which the payment
is made), the rules of this paragraph (f) do not apply to R's payment.
Accordingly, R must capitalize the $10,000 payment.
(iii) R's payment of each $500 annual fee is a prepaid expense
described in paragraph (d)(3) of this section. R is not required to
capitalize the $500 fee in each taxable year. The rules of this
paragraph (f) apply to each such payment because each payment provides a
right or benefit to R that does not extend beyond 12 months after the
first date on which R realizes the rights or benefits attributable to
the payment and does not extend beyond the end of the taxable year
following the taxable year in which the payment is made.
Example 6. Lease. On December 1, 2005, W corporation enters into a
lease agreement with X corporation under which W agrees to lease
property to X for a period of 9 months, beginning on December 1, 2005. W
pays its outside counsel $7,000 for legal services rendered in drafting
the lease agreement and negotiating with X. The agreement between W and
X is an agreement providing W the right to be compensated for the use of
property, as described in paragraph (d)(6)(i)(A) of this section. W's
$7,000 payment to its outside counsel is an amount paid to facilitate
W's creation of the lease as described in paragraph (e)(1)(i) of this
section. The 12-month rule of this paragraph (f) applies to the $7,000
payment because the right or benefit that the $7,000 payment facilitates
the creation of neither extends more than 12 months beyond December 1,
2005 (the first date the benefit is realized by the taxpayer) nor beyond
the end of the taxable year following the taxable year in which the
payment is made. Accordingly, W is not required to capitalize its
payment to its outside counsel.
Example 7. Certain contract terminations. V corporation owns real
property that it has leased to A for a period of 15 years. When the
lease has a remaining unexpired term of 5 years, V and A agree to
terminate the lease, enabling V to use the property in its trade or
business. V pays A $100,000 in exchange for A's agreement to terminate
the lease. V's payment to A to terminate the lease is described in
paragraph (d)(7)(i)(A) of this section. Under paragraph (f)(2) of this
section, V's payment creates a benefit for V with a duration of 5 years,
the remaining unexpired term of the lease as of the date of the
termination. Because the benefit attributable to the expenditure extends
beyond 12 months after the first date on which V realizes the rights or
benefits attributable to the payment and beyond the end of the taxable
year following the taxable year in which the payment is made, the rules
of this paragraph (f) do not apply to the payment. V must capitalize the
$100,000 payment.
Example 8. Certain contract terminations. Assume the same facts as
in Example 7, except that the lease is terminated when it has a
remaining unexpired term of 10 months. Under paragraph (f)(2) of this
section, V's payment creates a benefit for V with a duration of 10
months. The 12-month rule of this paragraph (f) applies to the payment
because the benefit attributable to the payment neither extends more
than 12 months beyond the date of termination (the first date the
benefit is realized by V) nor beyond the end of the taxable year
following the taxable year in which the payment is made. Accordingly, V
is not required to capitalize the $100,000 payment.
Example 9. Certain contract terminations. Assume the same facts as
in Example 7, except that either party can terminate the lease upon 12
months notice. When the lease has a remaining unexpired term of 5 years,
V wants to terminate the lease, however, V does not want to wait another
12 months. V pays A $50,000 for the ability to terminate
[[Page 716]]
the lease with one month's notice. V's payment to A to terminate the
lease is described in paragraph (d)(7)(i)(A) of this section. Under
paragraph (f)(2) of this section, V's payment creates a benefit for V
with a duration of 11 months, the time by which the notice period is
shortened. The 12-month rule of this paragraph (f) applies to V's
$50,000 payment because the benefit attributable to the payment neither
extends more than 12 months beyond the date of termination (the first
date the benefit is realized by V) nor beyond the end of the taxable
year following the taxable year in which the payment is made.
Accordingly, V is not required to capitalize the $50,000 payment.
Example 10. Coordination with section 461. (i) U corporation leases
office space from W corporation at a monthly rental rate of $2,000. On
August 1, 2005, U prepays its office rent expense for the first six
months of 2006 in the amount of $12,000. For purposes of this example,
it is assumed that the recurring item exception provided by Sec. 1.461-
5 does not apply and that the lease between W and U is not a section 467
rental agreement as defined in section 467(d).
(ii) Under Sec. 1.461-4(d)(3), U's prepayment of rent is a payment
for the use of property by U for which economic performance occurs
ratably over the period of time U is entitled to use the property.
Accordingly, because economic performance with respect to U's prepayment
of rent does not occur until 2006, U's prepaid rent is not incurred in
2005 and therefore is not properly taken into account through
capitalization, deduction, or otherwise in 2005. Thus, the rules of this
paragraph (f) do not apply to U's prepayment of its rent.
(iii) Alternatively, assume that U uses the cash method of
accounting and the economic performance rules in Sec. 1.461-4 therefore
do not apply to U. The 12-month rule of this paragraph (f) applies to
the $12,000 payment because the rights or benefits attributable to U's
prepayment of its rent do not extend beyond December 31, 2006.
Accordingly, U is not required to capitalize its prepaid rent.
Example 11. Coordination with section 461. N corporation pays R
corporation, an advertising and marketing firm, $40,000 on August 1,
2005, for advertising and marketing services to be provided to N
throughout calendar year 2006. For purposes of this example, it is
assumed that the recurring item exception provided by Sec. 1.461-5 does
not apply. Under Sec. 1.461-4(d)(2), N's payment arises out of the
provision of services to N by R for which economic performance occurs as
the services are provided. Accordingly, because economic performance
with respect to N's prepaid advertising expense does not occur until
2006, N's prepaid advertising expense is not incurred in 2005 and
therefore is not properly taken into account through capitalization,
deduction, or otherwise in 2005. Thus, the rules of this paragraph (f)
do not apply to N's payment.
(g) Treatment of capitalized costs--(1) In general. An amount
required to be capitalized by this section is not currently deductible
under section 162. Instead, the amount generally is added to the basis
of the intangible acquired or created. See section 1012.
(2) Financial instruments. In the case of a financial instrument
described in paragraph (c)(1)(iii) or (d)(2)(i)(C) of this section,
notwithstanding paragraph (g)(1) of this section, if under other
provisions of law the amount required to be capitalized is not required
to be added to the basis of the intangible acquired or created, then the
other provisions of law will govern the tax treatment of the amount.
(h) Special rules applicable to pooling--(1) In general. Except as
otherwise provided, the rules of this paragraph (h) apply to the pooling
methods described in paragraph (d)(6)(v) of this section (relating to de
minimis rules applicable to certain contract rights), paragraph
(e)(4)(iii)(A) of this section (relating to de minimis rules applicable
to transaction costs), and paragraph (f)(5)(iii) of this section
(relating to the application of the 12-month rule to renewable rights).
(2) Method of accounting. A pooling method authorized by this
section constitutes a method of accounting for purposes of section 446.
A taxpayer that adopts or changes to a pooling method authorized by this
section must use the method for the year of adoption and for all
subsequent taxable years during which the taxpayer qualifies to use the
pooling method unless a change to another method is required by the
Commissioner in order to clearly reflect income, or unless permission to
change to another method is granted by the Commissioner as provided in
Sec. 1.446-1(e).
(3) Adopting or changing to a pooling method. A taxpayer adopts (or
changes to) a pooling method authorized by this section for any taxable
year by establishing one or more pools for the taxable year in
accordance with the rules governing the particular pooling method and
the rules prescribed by this paragraph (h), and by using the pooling
[[Page 717]]
method to compute its taxable income for the year of adoption (or
change).
(4) Definition of pool. A taxpayer may use any reasonable method of
defining a pool of similar transactions, agreements or rights, including
a method based on the type of customer or the type of product or service
provided under a contract. However, a taxpayer that pools similar
transactions, agreements or rights must include in the pool all similar
transactions, agreements or rights created during the taxable year. For
purposes of the pooling methods described in paragraph (d)(6)(v) of this
section (relating to de minimis rules applicable to certain contract
rights) and paragraph (e)(4)(iii)(A) of this section (relating to de
minimis rules applicable to transaction costs), an agreement (or a
transaction) is treated as not similar to other agreements (or
transactions) included in the pool if the amount at issue with respect
to that agreement (or transaction) is reasonably expected to differ
significantly from the average amount at issue with respect to the other
agreements (or transactions) properly included in the pool.
(5) Consistency requirement. A taxpayer that uses the pooling method
described in paragraph (f)(5)(iii) of this section for purposes of
applying the 12-month rule to a right or benefit--
(i) Must use the pooling methods described in paragraph (d)(6)(v) of
this section (relating to de minimis rules applicable to certain
contract rights) and paragraph (e)(4)(iii)(A) of this section (relating
to de minimis rules applicable to transaction costs) for purposes of
determining the amount paid to create, or facilitate the creation of,
the right or benefit; and
(ii) Must use the same pool for purposes of paragraph (d)(6)(v) of
this section and paragraph (e)(4)(iii)(A) of this section as is used for
purposes of paragraph (f)(5)(iii) of this section.
(6) Additional guidance pertaining to pooling. The Internal Revenue
Service may publish guidance in the Internal Revenue Bulletin (see Sec.
601.601(d)(2) of this chapter) prescribing additional rules for applying
the pooling methods authorized by this section to specific industries or
to specific types of transactions.
(7) Example. The following example illustrates the rules of this
paragraph (h):
Example. Pooling. (i) In the course of its business, W corporation
enters into 3-year non-cancelable contracts that provide W the right to
provide services to its customers. W generally pays certain amounts in
the process of pursuing an agreement with a customer, including amounts
paid to credit reporting agencies to verify the credit history of the
potential customer and commissions paid to the independent sales agent
who secures the agreement with the customer. In the case of agreements
that W enters into with customers who are individuals, the agreements
contain substantially similar terms and conditions and W typically pays
between $100 and $200 in the process of pursuing each transaction.
During 2005, W enters into agreements with 300 individuals. Also during
2005, W enters into an agreement with X corporation containing terms and
conditions that are substantially similar to those contained in the
agreements W enters into with its customers who are individuals. W pays
certain amounts in the process of pursuing the agreement with X that W
would not typically incur in the process of pursuing an agreement with
its customers who are individuals. For example, W pays amounts to
prepare and submit a bid for the agreement with X and amounts to travel
to X's headquarters to make a sales presentation to X's management. In
the aggregate, W pays $11,000 in the process of obtaining the agreement
with X.
(ii) The agreements between W and its customers are agreements
providing W the right to provide services, as described in paragraph
(d)(6)(i)(B) of this section. Under paragraph (b)(1)(v) of this section,
W must capitalize transaction costs paid to facilitate the creation of
these agreements. Because W enters into at least 25 similar transactions
during 2005, W may pool its transactions for purposes of determining
whether its transaction costs are de minimis within the meaning of
paragraph (e)(4)(iii)(A) of this section. W adopts a pooling method by
establishing one or more pools of similar transactions and by using the
pooling method to compute its taxable income beginning in its 2005
taxable year. If W adopts a pooling method, W must include all similar
transactions in the pool. Under paragraph (h)(4) of this section, the
transaction with X is not similar to the transactions W enters into with
its customers who are individuals. While the agreement with X contains
terms and conditions that are substantially similar to those contained
in the agreements W enters into with its customers who are individuals,
the transaction costs paid in the process of pursuing
[[Page 718]]
the agreement with X are reasonably expected to differ significantly
from the average transaction costs attributable to transactions with its
customers who are individuals. Accordingly, W may not include the
transaction with X in the pool of transactions with customers who are
individuals.
(i) [Reserved]
(j) Application to accrual method taxpayers. For purposes of this
section, the terms amount paid and payment mean, 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 this section prior to the taxable year during
which the liability is incurred.
(k) Treatment of related parties and indirect payments. For purposes
of this section, references to a party other than the taxpayer include
persons related to that party and persons acting for or on behalf of
that party (including persons to whom the taxpayer becomes obligated as
a result of assuming a liability of that party). For this purpose,
persons are related only if their relationship is described in section
267(b) or 707(b) or they are engaged in trades or businesses under
common control within the meaning of section 41(f)(1). References to an
amount paid to or by a party include an amount paid on behalf of that
party.
(l) Examples. The rules of this section are illustrated by the
following examples in which it is assumed that the Internal Revenue
Service has not published guidance that requires capitalization under
paragraph (b)(1)(iv) of this section (relating to amounts paid to create
or enhance a future benefit that is identified in published guidance as
an intangible for which capitalization is required):
Example 1. License granted by a governmental unit. (i) X corporation
pays $25,000 to state R to obtain a license to sell alcoholic beverages
in its restaurant. The license is valid indefinitely, provided X
complies with all applicable laws regarding the sale of alcoholic
beverages in state R. X pays its outside counsel $4,000 for legal
services rendered in preparing the license application and otherwise
representing X during the licensing process. In addition, X determines
that $2,000 of salaries paid to its employees is allocable to services
rendered by the employees in obtaining the license.
(ii) X's payment of $25,000 is an amount paid to a governmental unit
to obtain a license granted by that agency, as described in paragraph
(d)(5)(i) of this section. The right has an indefinite duration and
constitutes an amortizable section 197 intangible. Accordingly, as
provided in paragraph (f)(3) of this section, the provisions of
paragraph (f) of this section (relating to the 12-month rule) do not
apply to X's payment. X must capitalize its $25,000 payment to obtain
the license from state R.
(iii) As provided in paragraph (e)(4) of this section, X is not
required to capitalize employee compensation because such amounts are
treated as amounts that do not facilitate the acquisition or creation of
an intangible. Thus, X is not required to capitalize the $2,000 of
employee compensation allocable to the transaction.
(iv) X's payment of $4,000 to its outside counsel is an amount paid
to facilitate the creation of an intangible, as described in paragraph
(e)(1)(i) of this section. Because X's transaction costs do not exceed
$5,000, X's transaction costs are de minimis within the meaning of
paragraph (e)(4)(iii)(A) of this section. Accordingly, X is not required
to capitalize the $4,000 payment to its outside counsel under this
section.
Example 2. Franchise agreement. (i) R corporation is a franchisor of
income tax return preparation outlets. V corporation negotiates with R
to obtain the right to operate an income tax return preparation outlet
under a franchise from R. V pays an initial $100,000 franchise fee to R
in exchange for the franchise agreement. In addition, V pays its outside
counsel $4,000 to represent V during the negotiations with R. V also
pays $2,000 to an industry consultant to advise V during the
negotiations with R.
(ii) Under paragraph (d)(6)(i)(A) of this section, V's payment of
$100,000 is an amount paid to another party to enter into an agreement
with that party providing V the right to use tangible or intangible
property. Accordingly, V must capitalize its $100,000 payment to R. The
franchise agreement is a self-created amortizable section 197 intangible
within the meaning of section 197(c). Accordingly, as provided in
paragraph (f)(3) of this section, the 12-month rule contained in
paragraph (f)(1) of this section does not apply.
(iii) V's payment of $4,000 to its outside counsel and $2,000 to the
industry consultant are amounts paid to facilitate the creation of an
intangible, as described in paragraph (e)(1)(i) of this section. Because
V's aggregate transaction costs exceed $5,000, V's transaction costs are
not de minimis within the meaning of paragraph (e)(4)(iii)(A) of this
section. Accordingly, V must capitalize the $4,000 payment to its
outside counsel and the $2,000 payment to the industry consultant
[[Page 719]]
under this section into the basis of the franchise, as provided in
paragraph (g) of this section.
Example 3. Covenant not to compete. (i) On December 1, 2005, N
corporation, a calendar year taxpayer, enters into a covenant not to
compete with B, a key employee that is leaving the employ of N. The
covenant not to compete is not entered into in connection with the
acquisition of an interest in a trade or business. The covenant not to
compete prohibits B from competing with N for a period of 9 months,
beginning December 1, 2005. N pays B $25,000 in full consideration for
B's agreement not to compete. In addition, N pays its outside counsel
$6,000 to facilitate the creation of the covenant not to compete with B.
N does not have a short taxable year in 2005 or 2006.
(ii) Under paragraph (d)(6)(i)(C) of this section, N's payment of
$25,000 is an amount paid to another party to induce that party to enter
into a covenant not to compete with N. However, because the covenant not
to compete has a duration that does not extend beyond 12 months after
the first date on which N realizes the rights attributable to its
payment (i.e., December 1, 2005) or beyond the end of the taxable year
following the taxable year in which payment is made, the 12-month rule
contained in paragraph (f)(1) of this section applies. Accordingly, N is
not required to capitalize its $25,000 payment to B or its $6,000
payment to facilitate the creation of the covenant not to compete.
Example 4. Demand-side management. (i) X corporation, a public
utility engaged in generating and distributing electrical energy,
provides programs to its customers to promote energy conservation and
energy efficiency. These programs are aimed at reducing electrical costs
to X's customers, building goodwill with X's customers, and reducing X's
future operating and capital costs. X provides these programs without
obligating any of its customers participating in the programs to
purchase power from X in the future. Under these programs, X pays a
consultant to help industrial customers design energy-efficient
manufacturing processes, to conduct ``energy efficiency audits'' that
serve to identify for customers inefficiencies in their energy usage
patterns, and to provide cash allowances to encourage residential
customers to replace existing appliances with more energy efficient
appliances.
(ii) The amounts paid by X to the consultant are not amounts to
acquire or create an intangible under paragraph (c) or (d) of this
section or to facilitate such an acquisition or creation. In addition,
the amounts do not create a separate and distinct intangible asset
within the meaning of paragraph (b)(3) of this section. Accordingly, the
amounts paid to the consultant are not required to be capitalized under
this section. While the amounts may serve to reduce future operating and
capital costs and create goodwill with customers, these benefits,
without more, are not intangibles for which capitalization is required
under this section.
Example 5. Business process re-engineering. (i) V corporation
manufactures its products using a batch production system. Under this
system, V continuously produces component parts of its various products
and stockpiles these parts until they are needed in V's final assembly
line. Finished goods are stockpiled awaiting orders from customers. V
discovers that this process ties up significant amounts of V's capital
in work-in-process and finished goods inventories. V hires B, a
consultant, to advise V on improving the efficiency of its manufacturing
operations. B recommends a complete re-engineering of V's manufacturing
process to a process known as just-in-time manufacturing. Just-in-time
manufacturing involves reconfiguring a manufacturing plant to a
configuration of ``cells'' where each team in a cell performs the entire
manufacturing process for a particular customer order, thus reducing
inventory stockpiles.
(ii) V incurred three categories of costs to convert its
manufacturing process to a just-in-time system. First, V paid B, a
consultant, $250,000 in professional fees to implement the conversion of
V's plant to a just-in-time system. Second, V paid C, a contractor,
$100,000 to relocate and reconfigure V's manufacturing equipment from an
assembly line layout to a configuration of cells. Third, V paid D, a
consultant, $50,000 to train V's employees in the just-in-time
manufacturing process.
(iii) The amounts paid by V to B, C, and D are not amounts to
acquire or create an intangible under paragraph (c) or (d) of this
section or to facilitate such an acquisition or creation. In addition,
the amounts do not create a separate and distinct intangible asset
within the meaning of paragraph (b)(3) of this section. Accordingly, the
amounts paid to B, C, and D are not required to be capitalized under
this section. While the amounts produce long term benefits to V in the
form of reduced inventory stockpiles, improved product quality, and
increased efficiency, these benefits, without more, are not intangibles
for which capitalization is required under this section.
Example 6. Defense of business reputation. (i) X, an investment
adviser, serves as the fund manager of a money market investment fund.
X, like its competitors in the industry, strives to maintain a constant
net asset value for its money market fund of $1.00 per share. During
2005, in the course of managing the fund assets, X incorrectly predicts
the direction of market interest rates, resulting in significant
investment losses to the fund. Due to these significant losses, X is
faced with the prospect of reporting a net asset value that is less than
$1.00 per share. X is
[[Page 720]]
not aware of any investment adviser in its industry that has ever
reported a net asset value for its money market fund of less than $1.00
per share. X is concerned that reporting a net asset value of less than
$1.00 per share will significantly harm its reputation as an investment
adviser, and could lead to litigation by shareholders. X decides to
contribute $2,000,000 to the fund in order to raise the net asset value
of the fund to $1.00 per share. This contribution is not a loan to the
fund and does not give X any ownership interest in the fund.
(ii) The $2,000,000 contribution is not an amount paid to acquire or
create an intangible under paragraph (c) or (d) of this section or to
facilitate such an acquisition or creation. In addition, the amount does
not create a separate and distinct intangible asset within the meaning
of paragraph (b)(3) of this section. Accordingly, the amount contributed
to the fund is not required to be capitalized under this section. While
the amount serves to protect the business reputation of the taxpayer and
may protect the taxpayer from litigation by shareholders, these
benefits, without more, are not intangibles for which capitalization is
required under this section.
Example 7. Product launch costs. (i) R corporation, a manufacturer
of pharmaceutical products, is required by law to obtain regulatory
approval before selling its products. While awaiting regulatory approval
on Product A, R pays to develop and implement a marketing strategy and
an advertising campaign to raise consumer awareness of the purported
need for Product A. R also pays to train health care professionals and
other distributors in the proper use of Product A.
(ii) The amounts paid by R are not amounts paid to acquire or create
an intangible under paragraph (c) or (d) of this section or to
facilitate such an acquisition or creation. In addition, the amounts do
not create a separate and distinct intangible asset within the meaning
of paragraph (b)(3) of this section. Accordingly, R is not required to
capitalize these amounts under this section. While the amounts may
benefit R by creating consumer demand for Product A and increasing
awareness of Product A among distributors, these benefits, without more,
are not intangibles for which capitalization is required under this
section.
Example 8. Stocklifting costs. (i) N corporation is a wholesale
distributor of Brand A aftermarket automobile replacement parts. In an
effort to induce a retail automobile parts supply store to stock only
Brand A parts, N offers to replace all of the store's inventory of other
branded parts with Brand A parts, and to credit the store for its cost
of other branded parts. The store is under no obligation to continue
stocking Brand A parts or to purchase a minimum volume of Brand A parts
from N in the future.
(ii) The amount paid by N as a credit to the store for the cost of
other branded parts is not an amount paid to acquire or create an
intangible under paragraph (c) or (d) of this section or to facilitate
such an acquisition or creation. In addition, the amount does not create
a separate and distinct intangible asset within the meaning of paragraph
(b)(3) of this section. Accordingly, N is not required to capitalize the
amount under this section. While the amount may create a hope or
expectation by N that the store will continue to stock Brand A parts,
this benefit, without more, is not an intangible for which
capitalization is required under this section.
(iii) Alternatively, assume that N agrees to credit the store for
its cost of other branded parts in exchange for the store's agreement to
purchase all of its inventory requirements for such parts from N for a
period of at least 3 years. The amount paid by N as a credit to the
store for the cost of other branded parts is an amount paid to induce
the store to enter into an agreement providing R the right to provide
property. Accordingly, R must capitalize its payment.
Example 9. Package design costs. (i) Z corporation manufactures and
markets personal care products. Z pays $100,000 to a consultant to
develop a package design for Z's newest product, Product A. Z also pays
a fee to a government agency to obtain trademark and copyright
protection on certain elements of the package design. Z pays its outside
legal counsel $10,000 for services rendered in preparing and filing the
trademark and copyright applications and for other services rendered in
securing the trademark and copyright protection.
(ii) The $100,000 paid by Z to the consultant for development of the
package design is not an amount paid to acquire or create an intangible
under paragraph (c) or (d) of this section or to facilitate such an
acquisition or creation. In addition, as provided in paragraph (b)(3)(v)
of this section, amounts paid to develop a package design are treated as
amounts that do not create a separate and distinct intangible asset.
Accordingly, Z is not required to capitalize the $100,000 payment under
this section.
(iii) The amounts paid by Z to the government agency to obtain
trademark and copyright protection are amounts paid to a government
agency for a right granted by that agency. Accordingly, Z must
capitalize the payment. In addition, the $10,000 paid by Z to its
outside counsel is an amount paid to facilitate the creation of the
trademark and copyright. Because the aggregate amounts paid to
facilitate the transaction exceed $5,000, the amounts are not de minimis
as defined in paragraph (e)(4)(iii)(A) of this section. Accordingly, Z
must capitalize the $10,000 payment to its outside counsel under
paragraph (b)(1)(v) of this section.
[[Page 721]]
(iv) Alternatively, assume that Z acquires an existing package
design for Product A as part of an acquisition of a trade or business
that constitutes an applicable asset acquisition within the meaning of
section 1060(c). Assume further that $100,000 of the consideration paid
by N in the acquisition is properly allocable to the package design for
Product A. Under paragraph (c)(1) of this section, Z must capitalize the
$100,000 payment.
Example 10. Contract to provide services. (i) Q corporation, a
financial planning firm, provides financial advisory services on a fee-
only basis. During 2005, Q and several other financial planning firms
submit separate bids to R corporation for a contract to become one of
three providers of financial advisory services to R's employees. Q pays
$2,000 to a printing company to develop and produce materials for its
sales presentation to R's management. Q also pays $6,000 to travel to
R's corporate headquarters to make the sales presentation, and $20,000
of salaries to its employees for services performed in preparing the bid
and making the presentation to R's management. Q's bid is successful and
Q enters into an agreement with R in 2005 under which Q agrees to
provide financial advisory services to R's employees, and R agrees to
pay Q's fee on behalf of each employee who chooses to utilize such
services. R enters into similar agreements with two other financial
planning firms, and R's employees may choose to use the services of any
one of the three firms. Based on its past experience, Q reasonably
expects to provide services to at least 5 percent of R's employees.
(ii) Q's agreement with R is not an agreement providing Q the right
to provide services, as described in paragraph (d)(6)(i)(B) of this
section. Under paragraph (d)(6)(iv) the agreement places no obligation
on another person to request or pay for Q's services. Accordingly, Q is
not required to capitalize any of the amounts paid in the process of
pursuing the agreement with R.
Example 11. Mutual fund distributor. (i) D incurs costs to enter
into a distribution agreement with M, a mutual fund. The initial term of
the distribution agreement is two years, and afterwards must be approved
annually by M. The distribution agreement can be terminated by either
party on 60 days notice. Although distribution agreements are rarely
terminated in the mutual fund industry, M is not economically compelled
to continue D's distribution agreement. Under the distribution
agreement, D has the exclusive right to sell shares of M and agrees to
use its best efforts to solicit orders for the sale of shares of M. D
sells shares in M directly to the general public as well as through
brokers. When an investor places an order for M shares with a broker, D
pays the broker a commission for selling the shares to the investor.
Under the distribution agreement, D receives compensation from M in the
form of 12b-1 fees (which equal a percentage of M's net asset value
attributable to investors that have held their shares for up to 6 years)
and contingent deferred sales charges (which are paid if the investor
redeems the purchased shares within 6 years).
(ii) The distribution agreement is not an agreement providing D with
the right to provide services, as described in paragraph (d)(6)(i)(B) of
this section, because the distribution agreement can be terminated by M
at will upon 60 days notice and M is not economically compelled to
continue the distribution agreement. Accordingly, D is not required to
capitalize the costs of creating (or facilitating the creation of) the
distribution agreement under paragraphs (b)(1)(ii) or (v) of this
section. In addition, as provided in paragraph (b)(3)(ii) of this
section, amounts paid to create an agreement are treated as amounts that
do not create a separate and distinct intangible asset. Accordingly, D
also is not required to capitalize the costs of creating (or
facilitating the creation of) the distribution agreement under paragraph
(b)(1)(iii) or (v) of this section.
(iii) Under paragraph (b)(3)(iii), the broker commissions paid by D
in performing services under the distribution agreement do not create
(or facilitate the creation of) a separate and distinct intangible
asset. In addition, the broker commissions do not create an intangible
described in paragraph (d) of this section. Accordingly, D is not
required to capitalize the broker commissions under this section.
(m) Amortization. For rules relating to amortization of certain
intangibles, see Sec. 1.167(a)-3.
(n) Intangible interests in land. [Reserved].
(o) Effective date. This section applies to amounts paid or incurred
on or after December 31, 2003.
(p) Accounting method changes--(1) In general. A taxpayer seeking to
change a method of accounting to comply with this section must secure
the consent of the Commissioner in accordance with the requirements of
Sec. 1.446-1(e). For the taxpayer's first taxable year ending on or
after December 31, 2003, the taxpayer is granted the consent of the
Commissioner to change its method of accounting to comply with this
section, provided the taxpayer follows the administrative procedures
issued under Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's
automatic consent to a change in accounting method (for further
guidance, for example, see Rev. Proc. 2002-
[[Page 722]]
9 (2002-1 C.B. 327) and Sec. 601.601(d)(2)(ii)(b) of this chapter).
(2) Scope limitations. Any limitations on obtaining the automatic
consent of the Commissioner do not apply to a taxpayer seeking to change
to a method of accounting to comply with this section for its first
taxable year ending on or after December 31, 2003.
(3) Section 481(a) adjustment. With the exception of a change to a
pooling method authorized by this section, the section 481(a) adjustment
for a change in method of accounting to comply with this section for a
taxpayer's first taxable year ending on or after December 31, 2003 is
determined by taking into account only amounts paid or incurred in
taxable years ending on or after January 24, 2002. A taxpayer seeking to
change to a pooling method authorized by this section on or after the
effective date of these regulations must change to the method using a
cut-off method.
[T.D. 9107, 69 FR 446, Jan. 5, 2004]
Sec. 1.263(a)-5 Amounts paid or incurred to facilitate an acquisition
of a trade or business, a change in the capital structure
of a business entity, and
certain other transactions.
(a) General rule. A taxpayer must capitalize an amount paid to
facilitate (within the meaning of paragraph (b) of this section) each of
the following transactions, without regard to whether the transaction is
comprised of a single step or a series of steps carried out as part of a
single plan and without regard to whether gain or loss is recognized in
the transaction:
(1) An acquisition of assets that constitute a trade or business
(whether the taxpayer is the acquirer in the acquisition or the target
of the acquisition).
(2) An acquisition by the taxpayer of an ownership interest in a
business entity if, immediately after the acquisition, the taxpayer and
the business entity are related within the meaning of section 267(b) or
707(b) (see Sec. 1.263(a)-4 for rules requiring capitalization of
amounts paid by the taxpayer to acquire an ownership interest in a
business entity, or to facilitate the acquisition of an ownership
interest in a business entity, where the taxpayer and the business
entity are not related within the meaning of section 267(b) or 707(b)
immediately after the acquisition).
(3) An acquisition of an ownership interest in the taxpayer (other
than an acquisition by the taxpayer of an ownership interest in the
taxpayer, whether by redemption or otherwise).
(4) A restructuring, recapitalization, or reorganization of the
capital structure of a business entity (including reorganizations
described in section 368 and distributions of stock by the taxpayer as
described in section 355).
(5) A transfer described in section 351 or section 721 (whether the
taxpayer is the transferor or transferee).
(6) A formation or organization of a disregarded entity.
(7) An acquisition of capital.
(8) A stock issuance.
(9) A borrowing. For purposes of this section, a borrowing means any
issuance of debt, including an issuance of debt in an acquisition of
capital or in a recapitalization. A borrowing also includes debt issued
in a debt for debt exchange under Sec. 1.1001-3.
(10) Writing an option.
(b) Scope of facilitate--(1) In general. Except as otherwise
provided in this section, an amount is paid to facilitate a transaction
described in paragraph (a) of this section if the amount is paid in the
process of investigating or otherwise pursuing the transaction. Whether
an amount is paid in the process of investigating or otherwise pursuing
the transaction is determined based on all of the facts and
circumstances. In determining whether an amount is paid to facilitate a
transaction, the fact that the amount would (or would not) have been
paid but for the transaction is relevant, but is not determinative. An
amount paid to determine the value or price of a transaction is an
amount paid in the process of investigating or otherwise pursuing the
transaction. An amount paid to another party in exchange for tangible or
intangible property is not an amount paid to facilitate the exchange.
For example, the purchase price paid to the target of an asset
acquisition in exchange for its assets is not an amount paid to
facilitate the acquisition. Similarly, the purchase price paid by an
acquirer to the target's shareholders in
[[Page 723]]
exchange for their stock in a stock acquisition is not an amount paid to
facilitate the acquisition of the stock. See Sec. 1.263(a)-1, Sec.
1.263(a)-2, and Sec. 1.263(a)-4 for rules requiring capitalization of
the purchase price paid to acquire property.
(2) Ordering rules. An amount paid in the process of investigating
or otherwise pursuing both a transaction described in paragraph (a) of
this section and an acquisition or creation of an intangible described
in Sec. 1.263(a)-4 is subject to the rules contained in this section,
and not to the rules contained in Sec. 1.263(a)-4. In addition, an
amount required to be capitalized by Sec. 1.263(a)-1, Sec. 1.263(a)-2,
or Sec. 1.263(a)-4 does not facilitate a transaction described in
paragraph (a) of this section.
(c) Special rules for certain costs--(1) Borrowing costs. An amount
paid to facilitate a borrowing does not facilitate another transaction
(other than the borrowing) described in paragraph (a) of this section.
(2) Costs of asset sales. An amount paid by a taxpayer to facilitate
a sale of its assets does not facilitate another transaction (other than
the sale) described in paragraph (a) of this section. For example, where
a target corporation, in preparation for a merger with an acquiring
corporation, sells assets that are not desired by the acquiring
corporation, amounts paid to facilitate the sale of the unwanted assets
are not required to be capitalized as amounts paid to facilitate the
merger.
(3) Mandatory stock distributions. An amount paid in the process of
investigating or otherwise pursuing a distribution of stock by a
taxpayer to its shareholders does not facilitate a transaction described
in paragraph (a) of this section if the divestiture of the stock (or of
properties transferred to an entity whose stock is distributed) is
required by law, regulatory mandate, or court order. A taxpayer is not
required to capitalize (under this section or Sec. 1.263(a)-4) an
amount paid to organize (or facilitate the organization of) an entity if
the entity is organized solely to receive properties that the taxpayer
is required to divest by law, regulatory mandate, or court order and if
the taxpayer distributes the stock of the entity to its shareholders. A
taxpayer also is not required to capitalize (under this section or Sec.
1.263(a)-4) an amount paid to transfer property to an entity if the
taxpayer is required to divest itself of that property by law,
regulatory mandate, or court order and if the stock of the recipient
entity is distributed to the taxpayer's shareholders.
(4) Bankruptcy reorganization costs. An amount paid to institute or
administer a proceeding under Chapter 11 of the Bankruptcy Code by a
taxpayer that is the debtor under the proceeding constitutes an amount
paid to facilitate a reorganization within the meaning of paragraph
(a)(4) of this section, regardless of the purpose for which the
proceeding is instituted. For example, an amount paid to prepare and
file a petition under Chapter 11, to obtain an extension of the
exclusivity period under Chapter 11, to formulate plans of
reorganization under Chapter 11, to analyze plans of reorganization
formulated by another party in interest, or to contest or obtain
approval of a plan of reorganization under Chapter 11 facilitates a
reorganization within the meaning of this section. However, amounts
specifically paid to formulate, analyze, contest or obtain approval of
the portion of a plan of reorganization under Chapter 11 that resolves
tort liabilities of the taxpayer do not facilitate a reorganization
within the meaning of paragraph (a)(4) of this section if the amounts
would have been treated as ordinary and necessary business expenses
under section 162 had the bankruptcy proceeding not been instituted. In
addition, an amount paid by the taxpayer to defend against the
commencement of an involuntary bankruptcy proceeding against the
taxpayer does not facilitate a reorganization within the meaning of
paragraph (a)(4) of this section. An amount paid by the debtor to
operate its business during a Chapter 11 bankruptcy proceeding is not an
amount paid to institute or administer the bankruptcy proceeding and
does not facilitate a reorganization. Such amount is treated in the same
manner as it would have been treated had the bankruptcy proceeding not
been instituted.
(5) Stock issuance costs of open-end regulated investment companies.
Amounts
[[Page 724]]
paid by an open-end regulated investment company (within the meaning of
section 851) to facilitate an issuance of its stock are treated as
amounts that do not facilitate a transaction described in paragraph (a)
of this section unless the amounts are paid during the initial stock
offering period.
(6) Integration costs. An amount paid to integrate the business
operations of the taxpayer with the business operations of another does
not facilitate a transaction described in paragraph (a) of this section,
regardless of when the integration activities occur.
(7) Registrar and transfer agent fees for the maintenance of capital
stock records. An amount paid by a taxpayer to a registrar or transfer
agent in connection with the transfer of the taxpayer's capital stock
does not facilitate a transaction described in paragraph (a) of this
section unless the amount is paid with respect to a specific transaction
described in paragraph (a). For example, a taxpayer is not required to
capitalize periodic payments to a transfer agent for maintaining records
of the names and addresses of shareholders who trade the taxpayer's
shares on a national exchange. By comparison, a taxpayer is required to
capitalize an amount paid to the transfer agent for distributing proxy
statements requesting shareholder approval of a transaction described in
paragraph (a) of this section.
(8) Termination payments and amounts paid to facilitate mutually
exclusive transactions. An amount paid to terminate (or facilitate the
termination of) an agreement to enter into a transaction described in
paragraph (a) of this section constitutes an amount paid to facilitate a
second transaction described in paragraph (a) of this section only if
the transactions are mutually exclusive. An amount paid to facilitate a
transaction described in paragraph (a) of this section is treated as an
amount paid to facilitate a second transaction described in paragraph
(a) of this section only if the transactions are mutually exclusive.
(d) Simplifying conventions--(1) In general. For purposes of this
section, employee compensation (within the meaning of paragraph (d)(2)
of this section), overhead, and de minimis costs (within the meaning of
paragraph (d)(3) of this section) are treated as amounts that do not
facilitate a transaction described in paragraph (a) of this section.
(2) Employee compensation--(i) In general. The term employee
compensation means compensation (including salary, bonuses and
commissions) paid to an employee of the taxpayer. For purposes of this
section, whether an individual is an employee is determined in
accordance with the rules contained in section 3401(c) and the
regulations thereunder.
(ii) Certain amounts treated as employee compensation. For purposes
of this section, a guaranteed payment to a partner in a partnership is
treated as employee compensation. For purposes of this section, annual
compensation paid to a director of a corporation is treated as employee
compensation. For example, an amount paid to a director of a corporation
for attendance at a regular meeting of the board of directors (or
committee thereof) is treated as employee compensation for purposes of
this section. However, an amount paid to the director for attendance at
a special meeting of the board of directors (or committee thereof) is
not treated as employee compensation. An amount paid to a person that is
not an employee of the taxpayer (including the employer of the
individual who performs the services) is treated as employee
compensation for purposes of this section only if the amount is paid for
secretarial, clerical, or similar administrative support services (other
than services involving the preparation and distribution of proxy
solicitations and other documents seeking shareholder approval of a
transaction described in paragraph (a) of this section). In the case of
an affiliated group of corporations filing a consolidated federal income
tax return, a payment by one member of the group to a second member of
the group for services performed by an employee of the second member is
treated as employee compensation if the services provided by the
employee are provided at a time during which both members are
affiliated.
(3) De minimis costs--(i) In general. The term de minimis costs
means
[[Page 725]]
amounts (other than employee compensation and overhead) paid in the
process of investigating or otherwise pursuing a transaction described
in paragraph (a) of this section if, in the aggregate, the amounts do
not exceed $5,000 (or such greater amount as may be set forth in
published guidance). If the amounts exceed $5,000 (or such greater
amount as may be set forth in published guidance), none of the amounts
are de minimis costs within the meaning of this paragraph (d)(3). For
purposes of this paragraph (d)(3), an amount paid in the form of
property is valued at its fair market value at the time of the payment.
(ii) Treatment of commissions. The term de minimis costs does not
include commissions paid to facilitate a transaction described in
paragraph (a) of this section.
(4) Election to capitalize. A taxpayer may elect to treat employee
compensation, overhead, or de minimis costs paid in the process of
investigating or otherwise pursuing a transaction described in paragraph
(a) of this section as amounts that facilitate the transaction. The
election is made separately for each transaction and applies to employee
compensation, overhead, or de minimis costs, or to any combination
thereof. For example, a taxpayer may elect to treat overhead and de
minimis costs, but not employee compensation, as amounts that facilitate
the transaction. A taxpayer makes the election by treating the amounts
to which the election applies as amounts that facilitate the transaction
in the taxpayer's timely filed original federal income tax return
(including extensions) for the taxable year during which the amounts are
paid. In the case of an affiliated group of corporations filing a
consolidated return, the election is made separately with respect to
each member of the group, and not with respect to the group as a whole.
In the case of an S corporation or partnership, the election is made by
the S corporation or by the partnership, and not by the shareholders or
partners. An election made under this paragraph (d)(4) is revocable with
respect to each taxable year for which made only with the consent of the
Commissioner.
(e) Certain acquisitive transactions--(1) In general. Except as
provided in paragraph (e)(2) of this section (relating to inherently
facilitative amounts), an amount paid by the taxpayer in the process of
investigating or otherwise pursuing a covered transaction (as described
in paragraph (e)(3) of this section) facilitates the transaction within
the meaning of this section only if the amount relates to activities
performed on or after the earlier of--
(i) The date on which a letter of intent, exclusivity agreement, or
similar written communication (other than a confidentiality agreement)
is executed by representatives of the acquirer and the target; or
(ii) The date on which the material terms of the transaction (as
tentatively agreed to by representatives of the acquirer and the target)
are authorized or approved by the taxpayer's board of directors (or
committee of the board of directors) or, in the case of a taxpayer that
is not a corporation, the date on which the material terms of the
transaction (as tentatively agreed to by representatives of the acquirer
and the target) are authorized or approved by the appropriate governing
officials of the taxpayer. In the case of a transaction that does not
require authorization or approval of the taxpayer's board of directors
(or appropriate governing officials in the case of a taxpayer that is
not a corporation) the date determined under this paragraph (e)(1)(ii)
is the date on which the acquirer and the target execute a binding
written contract reflecting the terms of the transaction.
(2) Exception for inherently facilitative amounts. An amount paid in
the process of investigating or otherwise pursuing a covered transaction
facilitates that transaction if the amount is inherently facilitative,
regardless of whether the amount is paid for activities performed prior
to the date determined under paragraph (e)(1) of this section. An amount
is inherently facilitative if the amount is paid for--
(i) Securing an appraisal, formal written evaluation, or fairness
opinion related to the transaction;
(ii) Structuring the transaction, including negotiating the
structure of
[[Page 726]]
the transaction and obtaining tax advice on the structure of the
transaction (for example, obtaining tax advice on the application of
section 368);
(iii) Preparing and reviewing the documents that effectuate the
transaction (for example, a merger agreement or purchase agreement);
(iv) Obtaining regulatory approval of the transaction, including
preparing and reviewing regulatory filings;
(v) Obtaining shareholder approval of the transaction (for example,
proxy costs, solicitation costs, and costs to promote the transaction to
shareholders); or
(vi) Conveying property between the parties to the transaction (for
example, transfer taxes and title registration costs).
(3) Covered transactions. For purposes of this paragraph (e), the
term covered transaction means the following transactions:
(i) A taxable acquisition by the taxpayer of assets that constitute
a trade or business.
(ii) A taxable acquisition of an ownership interest in a business
entity (whether the taxpayer is the acquirer in the acquisition or the
target of the acquisition) if, immediately after the acquisition, the
acquirer and the target are related within the meaning of section 267(b)
or 707(b).
(iii) A reorganization described in section 368(a)(1)(A), (B), or
(C) or a reorganization described in section 368(a)(1)(D) in which stock
or securities of the corporation to which the assets are transferred are
distributed in a transaction which qualifies under section 354 or 356
(whether the taxpayer is the acquirer or the target in the
reorganization).
(f) Documentation of success-based fees--An amount paid that is
contingent on the successful closing of a transaction described in
paragraph (a) of this section is an amount paid to facilitate the
transaction except to the extent the taxpayer maintains sufficient
documentation to establish that a portion of the fee is allocable to
activities that do not facilitate the transaction. This documentation
must be completed on or before the due date of the taxpayer's timely
filed original federal income tax return (including extensions) for the
taxable year during which the transaction closes. For purposes of this
paragraph (f), documentation must consist of more than merely an
allocation between activities that facilitate the transaction and
activities that do not facilitate the transaction, and must consist of
supporting records (for example, time records, itemized invoices, or
other records) that identify--
(1) The various activities performed by the service provider;
(2) The amount of the fee (or percentage of time) that is allocable
to each of the various activities performed;
(3) Where the date the activity was performed is relevant to
understanding whether the activity facilitated the transaction, the
amount of the fee (or percentage of time) that is allocable to the
performance of that activity before and after the relevant date; and
(4) The name, business address, and business telephone number of the
service provider.
(g) Treatment of capitalized costs--(1) Tax-free acquisitive
transactions. [Reserved]
(2) Taxable acquisitive transactions--(i) Acquirer. In the case of
an acquisition, merger, or consolidation that is not described in
section 368, an amount required to be capitalized under this section by
the acquirer is added to the basis of the acquired assets (in the case
of a transaction that is treated as an acquisition of the assets of the
target for federal income tax purposes) or the acquired stock (in the
case of a transaction that is treated as an acquisition of the stock of
the target for federal income tax purposes).
(ii) Target--(A) Asset acquisition. In the case of an acquisition,
merger, or consolidation that is not described in section 368 and that
is treated as an acquisition of the assets of the target for federal
income tax purposes, an amount required to be capitalized under this
section by the target is treated as a reduction of the target's amount
realized on the disposition of its assets.
(B) Stock acquisition. [Reserved]
(3) Stock issuance transactions. [Reserved]
(4) Borrowings. For the treatment of amounts required to be
capitalized
[[Page 727]]
under this section with respect to a borrowing, see Sec. 1.446-5.
(5) Treatment of capitalized amounts by option writer. An amount
required to be capitalized by an option writer under paragraph (a)(10)
of this section is not currently deductible under section 162 or 212.
Instead, the amount required to be capitalized generally reduces the
total premium received by the option writer. However, other provisions
of law may limit the reduction of the premium by the capitalized amount
(for example, if the capitalized amount is never deductible by the
option writer).
(h) Application to accrual method taxpayers. For purposes of this
section, the terms amount paid and payment mean, 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 this section prior to the taxable year during
which the liability is incurred.
(i) [Reserved]
(j) Coordination with other provisions of the Internal Revenue Code.
Nothing in this section changes the treatment of an amount that is
specifically provided for under any other provision of the Internal
Revenue Code (other than section 162(a) or 212) or regulations
thereunder.
(k) Treatment of indirect payments. For purposes of this section,
references to an amount paid to or by a party include an amount paid on
behalf of that party.
(l) Examples. The following examples illustrate the rules of this
section:
Example 1. Costs to facilitate. Q corporation pays its outside
counsel $20,000 to assist Q in registering its stock with the Securities
and Exchange Commission. Q is not a regulated investment company within
the meaning of section 851. Q's payments to its outside counsel are
amounts paid to facilitate the issuance of stock. Accordingly, Q must
capitalize its $20,000 payment under paragraph (a)(8) of this section
(whether incurred before or after the issuance of the stock and whether
or not the registration is productive of equity capital).
Example 2. Costs to facilitate. Q corporation seeks to acquire all
of the outstanding stock of Y corporation. To finance the acquisition, Q
must issue new debt. Q pays an investment banker $25,000 to market the
debt to the public and pays its outside counsel $10,000 to prepare the
offering documents for the debt. Q's payment of $35,000 facilitates a
borrowing and must be capitalized under paragraph (a)(9) of this
section. As provided in paragraph (c)(1) of this section, Q's payment
does not facilitate the acquisition of Y, notwithstanding the fact that
Q incurred the new debt to finance its acquisition of Y. See Sec.
1.446-5 for the treatment of Q's capitalized payment.
Example 3. Costs to facilitate. (i) Z agrees to pay investment
banker B $1,000,000 for B's services in evaluating four alternative
transactions ($250,000 for each alternative): An initial public
offering; a borrowing of funds; an acquisition by Z of a competitor; and
an acquisition of Z by a competitor. Z eventually decides to pursue a
borrowing and abandons the other options.
(ii) The $250,000 payment to evaluate the possibility of a borrowing
is an amount paid in the process of investigating or otherwise pursuing
a transaction described in paragraph (a)(9) of this section. Accordingly
Z must capitalize that $250,000 payment to B. See Sec. 1.446-5 for the
treatment of Z's capitalized payment.
(iii) The $250,000 payment to evaluate the possibility of an initial
public offering is an amount paid in the process of investigating or
otherwise pursuing a transaction described in paragraph (a)(8) of this
section. Accordingly, Z must capitalize that $250,000 payment to B under
this section. Because the borrowing and the initial public offering are
not mutually exclusive transactions, the $250,000 is not treated as an
amount paid to facilitate the borrowing. When Z abandons the initial
public offering, Z may recover under section 165 the $250,000 paid to
facilitate the initial public offering.
(iv) The $500,000 paid by Z to evaluate the possibilities of an
acquisition of Z by a competitor and an acquisition of a competitor by Z
are amounts paid in the process of investigating or otherwise pursuing
transactions described in paragraphs (a) and (e)(3) of this section.
Accordingly, Z is only required to capitalize under this section the
portion of the $500,000 payment that relates to inherently facilitative
activities under paragraph (e)(2) of this section or to activities
performed on or after the date determined under paragraph (e)(1) of this
section. Because the borrowing and the possible acquisitions are not
mutually exclusive transactions, no portion of the $500,000 is treated
as an amount paid to facilitate the borrowing. When Z abandons the
acquisition transactions, Z may recover under section 165 any portion of
the $500,000 that was paid to facilitate the acquisitions.
Example 4. Corporate acquisition. (i) On February 1, 2005, R
corporation decides to investigate the acquisition of three potential
targets: T corporation, U corporation, and V corporation. R's
consideration of T, U, and V represents the consideration of three
distinct
[[Page 728]]
transactions, any or all of which R might consummate and has the
financial ability to consummate. On March 1, 2005, R enters into an
exclusivity agreement with T and stops pursuing U and V. On July 1,
2005, R acquires all of the stock of T in a transaction described in
section 368. R pays $1,000,000 to an investment banker and $50,000 to
its outside counsel to conduct due diligence on T, U, and V; determine
the value of T, U, and V; negotiate and structure the transaction with
T; draft the merger agreement; secure shareholder approval; prepare SEC
filings; and obtain the necessary regulatory approvals.
(ii) Under paragraph (e)(1) of this section, the amounts paid to
conduct due diligence on T, U and V prior to March 1, 2005 (the date of
the exclusivity agreement) are not amounts paid to facilitate the
acquisition of the stock of T, U or V and are not required to be
capitalized under this section. However, the amounts paid to conduct due
diligence on T on and after March 1, 2005, are amounts paid to
facilitate the acquisition of the stock of T and must be capitalized
under paragraph (a)(2) of this section.
(iii) Under paragraph (e)(2) of this section, the amounts paid to
determine the value of T, negotiate and structure the transaction with
T, draft the merger agreement, secure shareholder approval, prepare SEC
filings, and obtain necessary regulatory approvals are inherently
facilitative amounts paid to facilitate the acquisition of the stock of
T and must be capitalized, regardless of whether those activities occur
prior to, on, or after March 1, 2005.
(iv) Under paragraph (e)(2) of this section, the amounts paid to
determine the value of U and V are inherently facilitative amounts paid
to facilitate the acquisition of U or V and must be capitalized. Because
the acquisition of U, V, and T are not mutually exclusive transactions,
the costs that facilitate the acquisition of U and V do not facilitate
the acquisition of T. Accordingly, the amounts paid to determine the
value of U and V may be recovered under section 165 in the taxable year
that R abandons the planned mergers with U and V.
Example 5. Corporate acquisition; employee bonus. Assume the same
facts as in Example 4, except R pays a bonus of $10,000 to one of its
corporate officers who negotiated the acquisition of T. As provided by
paragraph (d)(1) of this section, Y is not required to capitalize any
portion of the bonus paid to the corporate officer.
Example 6. Corporate acquisition; integration costs. Assume the same
facts as in Example 4, except that, before and after the acquisition is
consummated, R incurs costs to relocate personnel and equipment, provide
severance benefits to terminated employees, integrate records and
information systems, prepare new financial statements for the combined
entity, and reduce redundancies in the combined business operations.
Under paragraph (c)(6) of this section, these costs do not facilitate
the acquisition of T. Accordingly, R is not required to capitalize any
of these costs under this section.
Example 7. Corporate acquisition; compensation to target's
employees. Assume the same facts as in Example 4, except that, prior to
the acquisition, certain employees of T held unexercised options issued
pursuant to T's stock option plan. These options granted the employees
the right to purchase T stock at a fixed option price. The options did
not have a readily ascertainable value (within the meaning of Sec.
1.83-7(b)), and thus no amount was included in the employees' income
when the options were granted. As a condition of the acquisition, T is
required to terminate its stock option plan. T therefore agrees to pay
its employees who hold unexercised stock options the difference between
the option price and the current value of T's stock in consideration of
their agreement to cancel their unexercised options. Under paragraph
(d)(1) of this section, T is not required to capitalize the amounts paid
to its employees. See section 83 for the treatment of amounts received
in cancellation of stock options.
Example 8. Asset acquisition; employee compensation. N corporation
owns tangible and intangible assets that constitute a trade or business.
M corporation purchases all the assets of N in a taxable transaction.
Under paragraph (a)(1) of this section, M must capitalize amounts paid
to facilitate the acquisition of the assets of N. Under paragraph (d)(1)
of this section, no portion of the salaries of M's employees who work on
the acquisition are treated as facilitating the transaction.
Example 9. Corporate acquisition; retainer. Y corporation's outside
counsel charges Y $60,000 for services rendered in facilitating the
friendly acquisition of the stock of Y corporation by X corporation. Y
has an agreement with its outside counsel under which Y pays an annual
retainer of $50,000. Y's outside counsel has the right to offset amounts
billed for any legal services rendered against the annual retainer.
Pursuant to this agreement, Y's outside counsel offsets $50,000 of the
legal fees from the acquisition against the retainer and bills Y for the
balance of $10,000. The $60,000 legal fee is an amount paid to
facilitate the acquisition of an ownership interest in Y as described in
paragraph (a)(3) of this section. Y must capitalize the full amount of
the $60,000 legal fee.
Example 10. Corporate acquisition; antitrust defense costs. On March
1, 2005, V corporation enters into an agreement with X corporation to
acquire all of the outstanding stock of X. On April 1, 2005, federal and
state regulators file suit against V to prevent the acquisition of X on
the ground that the acquisition violates antitrust laws. V enters into a
consent
[[Page 729]]
agreement with regulators on May 1, 2005, that allows the acquisition to
proceed, but requires V to hold separate the business operations of X
pending the outcome of the antitrust suit and subjects V to possible
divestiture. V acquires title to all of the outstanding stock of X on
June 1, 2005. After June 1, 2005, the regulators pursue antitrust
litigation against V seeking rescission of the acquisition. V pays
$50,000 to its outside counsel for services rendered after June 1, 2005,
to defend against the antitrust litigation. V ultimately prevails in the
antitrust litigation. V's costs to defend the antitrust litigation are
costs to facilitate its acquisition of the stock of X under paragraph
(a)(2) of this section and must be capitalized. Although title to the
shares of X passed to V prior to the date V incurred costs to defend the
antitrust litigation, the amounts paid by V are paid in the process of
pursuing the acquisition of the stock of X because the acquisition was
not complete until the antitrust litigation was ultimately resolved. V
must capitalize the $50,000 in legal fees.
Example 11. Corporate acquisition; defensive measures. (i) On
January 15, 2005, Y corporation, a publicly traded corporation, becomes
the target of a hostile takeover attempt by Z corporation. In an effort
to defend against the takeover, Y pays legal fees to seek an injunction
against the takeover and investment banking fees to locate a potential
``white knight'' acquirer. Y also pays amounts to complete a defensive
recapitalization, and pays $50,000 to an investment banker for a
fairness opinion regarding Z's initial offer. Y's efforts to enjoin the
takeover and locate a white knight acquirer are unsuccessful, and on
March 15, 2005, Y's board of directors decides to abandon its defense
against the takeover and negotiate with Z in an effort to obtain the
highest possible price for its shareholders. After Y abandons its
defense against the takeover, Y pays an investment banker $1,000,000 for
a second fairness opinion and for services rendered in negotiating with
Z.
(ii) The legal fees paid by Y to seek an injunction against the
takeover are not amounts paid in the process of investigating or
otherwise pursuing the transaction with Z. Accordingly, these legal fees
are not required to be capitalized under this section.
(iii) The investment banking fees paid to search for a white knight
acquirer do not facilitate an acquisition of Y by a white knight because
none of Y's costs with respect to a white knight were inherently
facilitative amounts and because Y did not reach the date described in
paragraph (e)(1) of this section with respect to a white knight.
Accordingly, these amounts are not required to be capitalized under this
section.
(iv) The amounts paid by Y to investigate and complete the
recapitalization must be capitalized under paragraph (a)(4) of this
section.
(v) The $50,000 paid to the investment bankers for a fairness
opinion during Y's defense against the takeover and the $1,000,000 paid
to the investment bankers after Y abandons its defense against the
takeover are inherently facilitative amounts with respect to the
transaction with Z and must be capitalized under paragraph (a)(3) of
this section.
Example 12. Corporate acquisition; acquisition by white knight. (i)
Assume the same facts as in Example 11, except that Y's investment
bankers identify three potential white knight acquirers: U corporation,
V corporation, and W corporation. Y pays its investment bankers to
conduct due diligence on the three potential white knight acquirers. On
March 15, 2005, Y's board of directors approves a tentative acquisition
agreement under which W agrees to acquire all of the stock of Y, and the
investment bankers stop due diligence on U and V. On June 15, 2005, W
acquires all of the stock of Y.
(ii) Under paragraph (e)(1) of this section, the amounts paid to
conduct due diligence on U, V, and W prior to March 15, 2005 (the date
of board of directors' approval) are not amounts paid to facilitate the
acquisition of the stock of Y and are not required to be capitalized
under this section. However, the amounts paid to conduct due diligence
on W on and after March 15, 2005, facilitate the acquisition of the
stock of Y and are required to be capitalized.
Example 13. Corporate acquisition; mutually exclusive costs. (i)
Assume the same facts as in Example 11, except that Y's investment
banker finds W, a white knight. Y and W execute a letter of intent on
March 10, 2005. Under the terms of the letter of intent, Y must pay W a
$10,000,000 break-up fee if the merger with W does not occur. On April
1, 2005, Z significantly increases the amount of its offer, and Y
decides to accept Z's offer instead of merging with W. Y pays its
investment banker $500,000 for inherently facilitative costs with
respect to the potential merger with W. Y also pays its investment
banker $2,000,000 for due diligence costs with respect to the potential
merger with W, $1,000,000 of which relates to services performed on or
after March 10, 2005.
(ii) Y's $500,000 payment for inherently facilitative costs and Y's
$1,000,000 payment for due diligence activities performed on or after
March 10, 2005 (the date the letter of intent with W is entered into)
facilitate the potential merger with W. Because Y could not merge with
both W and Z, under paragraph (c)(8) of this section the $500,000 and
$1,000,000 payments also facilitate the transaction between Y and Z.
Accordingly, Y must capitalize the $500,000 and $1,000,000 payments as
amounts that facilitate the transaction with Z.
[[Page 730]]
(iii) Similarly, because Y could not merge with both W and Z, under
paragraph (c)(8) of this section the $10,000,000 termination payment
facilitates the transaction between Y and Z. Accordingly, Y must
capitalize the $10,000,000 termination payment as an amount that
facilitates the transaction with Z.
Example 14. Break-up fee; transactions not mutually exclusive. N
corporation and U corporation enter into an agreement under which U
would acquire all the stock or all the assets of N in exchange for U
stock. Under the terms of the agreement, if either party terminates the
agreement, the terminating party must pay the other party $10,000,000. U
decides to terminate the agreement and pays N $10,000,000. Shortly
thereafter, U acquires all the stock of V corporation, a competitor of
N. U had the financial resources to have acquired both N and V. U's
$10,000,000 payment does not facilitate U's acquisition of V.
Accordingly, U is not required to capitalize the $10,000,000 payment
under this section.
Example 15. Corporate reorganization; initial public offering. Y
corporation is a closely held corporation. Y's board of directors
authorizes an initial public offering of Y's stock to fund future
growth. Y pays $5,000,000 in professional fees for investment banking
services related to the determination of the offering price and legal
services related to the development of the offering prospectus and the
registration and issuance of stock. The investment banking and legal
services are performed both before and after board authorization. Under
paragraph (a)(8) of this section, the $5,000,000 is an amount paid to
facilitate a stock issuance.
Example 16. Auction. (i) N corporation seeks to dispose of all of
the stock of its wholly owned subsidiary, P corporation, through an
auction process and requests that each bidder submit a non-binding
purchase offer in the form of a draft agreement. Q corporation hires an
investment banker to assist in the preparation of Q's bid to acquire P
and to conduct a due diligence investigation of P. On July 1, 2005, Q
submits its draft agreement. On August 1, 2005, N informs Q that it has
accepted Q's offer, and presents Q with a signed letter of intent to
sell all of the stock of P to Q. On August 5, 2005, Q's board of
directors approves the terms of the transaction and authorizes Q to
execute the letter of intent. Q executes a binding letter of intent with
N on August 6, 2005.
(ii) Under paragraph (e)(1) of this section, the amounts paid by Q
to its investment banker that are not inherently facilitative and that
are paid for activities performed prior to August 5, 2005 (the date Q's
board of directors approves the transaction) are not amounts paid to
facilitate the acquisition of P. Amounts paid by Q to its investment
banker for activities performed on or after August 5, 2005, and amounts
paid by Q to its investment banker that are inherently facilitative
amounts within the meaning of paragraph (e)(2) of this section are
required to be capitalized under this section.
Example 17. Stock distribution. Z corporation distributes natural
gas throughout state Y. The federal government brings an antitrust
action against Z seeking divestiture of certain of Z's natural gas
distribution assets. As a result of a court ordered divestiture, Z and
the federal government agree to a plan of divestiture that requires Z to
organize a subsidiary to receive the divested assets and to distribute
the stock of the subsidiary to its shareholders. During 2005, Z pays
$300,000 to various independent contractors for the following services:
studying customer demand in the area to be served by the divested
assets, identifying assets to be transferred to the subsidiary,
organizing the subsidiary, structuring the transfer of assets to the
subsidiary to qualify as a tax-free transaction to Z, and distributing
the stock of the subsidiary to the stockholders. Under paragraph (c)(3)
of this section, Z is not required to capitalize any portion of the
$300,000 payments.
Example 18. Bankruptcy reorganization. (i) X corporation is the
defendant in numerous lawsuits alleging tort liability based on X's role
in manufacturing certain defective products. X files a petition for
reorganization under Chapter 11 of the Bankruptcy Code in an effort to
manage all of the lawsuits in a single proceeding. X pays its outside
counsel to prepare the petition and plan of reorganization, to analyze
adequate protection under the plan, to attend hearings before the
Bankruptcy Court concerning the plan, and to defend against motions by
creditors and tort claimants to strike the taxpayer's plan.
(ii) X's reorganization under Chapter 11 of the Bankruptcy Code is a
reorganization within the meaning of paragraph (a)(4) of this section.
Under paragraph (c)(4) of this section, amounts paid by X to its outside
counsel to prepare, analyze or obtain approval of the portion of X's
plan of reorganization that resolves X's tort liability do not
facilitate the reorganization and are not required to be capitalized,
provided that such amounts would have been treated as ordinary and
necessary business expenses under section 162 had the bankruptcy
proceeding not been instituted. All other amounts paid by X to its
outside counsel for the services described above (including all amounts
paid to prepare the bankruptcy petition) facilitate the reorganization
and must be capitalized.
(m) Effective date. This section applies to amounts paid or incurred
on or after December 31, 2003.
(n) Accounting method changes--(1) In general. A taxpayer seeking to
change a method of accounting to comply with
[[Page 731]]
this section must secure the consent of the Commissioner in accordance
with the requirements of Sec. 1.446-1(e). For the taxpayer's first
taxable year ending on or after December 31, 2003, the taxpayer is
granted the consent of the Commissioner to change its method of
accounting to comply with this section, provided the taxpayer follows
the administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for
obtaining the Commissioner's automatic consent to a change in accounting
method (for further guidance, for example, see Rev. Proc. 2002-9 (2002-1
C.B. 327) and Sec. 601.601(d)(2)(ii)(b) of this chapter).
(2) Scope limitations. Any limitations on obtaining the automatic
consent of the Commissioner do not apply to a taxpayer seeking to change
to a method of accounting to comply with this section for its first
taxable year ending on or after December 31, 2003.
(3) Section 481(a) adjustment. The section 481(a) adjustment for a
change in method of accounting to comply with this section for a
taxpayer's first taxable year ending on or after December 31, 2003 is
determined by taking into account only amounts paid or incurred in
taxable years ending on or after January 24, 2002.
[T.D. 9107, 69 FR 446, Jan. 5, 2004]
Sec. 1.263(a)-6 Election to deduct or capitalize certain expenditures.
(a) In general. Under certain provisions of the Internal Revenue
Code (Code), taxpayers may elect to treat capital expenditures as
deductible expenses or as deferred expenses, or to treat deductible
expenses as capital expenditures.
(b) Election provisions. The sections referred to in paragraph (a)
of this section include:
(1) Section 173 (circulation expenditures);
(2) Section 174 (research and experimental expenditures);
(3) Section 175 (soil and water conservation expenditures;
endangered species recovery expenditures);
(4) Section 179 (election to expense certain depreciable business
assets);
(5) Section 179A (deduction for clean-fuel vehicles and certain
refueling property);
(6) Section 179B (deduction for capital costs incurred in complying
with environmental protection agency sulfur regulations);
(7) Section 179C (election to expense certain refineries);
(8) Section 179D (energy efficient commercial buildings deduction);
(9) Section 179E (election to expense advanced mine safety
equipment);
(10) Section 180 (expenditures by farmers for fertilizer);
(11) Section 181 (treatment of certain qualified film and television
productions);
(12) Section 190 (expenditures to remove architectural and
transportation barriers to the handicapped and elderly);
(13) Section 193 (tertiary injectants);
(14) Section 194 (treatment of reforestation expenditures);
(15) Section 195 (start-up expenditures);
(16) Section 198 (expensing of environmental remediation costs);
(17) Section 198A (expensing of qualified disaster expenses);
(18) Section 248 (organization expenditures of a corporation);
(19) Section 266 (carrying charges);
(20) Section 616 (development expenditures); and
(21) Section 709 (organization and syndication fees of a
partnership).
(c) Effective/applicability date--(1) In general. This section
applies to taxable years beginning on or after January 1, 2014. Except
as provided in paragraphs (c)(2) and (c)(3) of this section, Sec.
1.263(a)-3 as contained in 26 CFR part 1 edition revised as of April 1,
2011, applies to taxable years beginning before January 1, 2014. For the
effective dates of the enumerated election provisions, see those Code
sections and the regulations under those sections.
(2) Early application of this section. A taxpayer may choose to
apply this section to taxable years beginning on or after January 1,
2012.
(3) Optional application of TD 9564. A taxpayer may choose to apply
Sec. 1.263(a)-6T as contained in TD 9564 (76 FR 81060) December 27,
2011, to taxable years beginning on or after January 1, 2012, and before
January 1, 2014.
[T.D. 9636, 78 FR 57745, Sept. 19, 2013]
[[Page 732]]
Sec. 1.263(b)-1 Expenditures for advertising or promotion of good will.
See Sec. 1.162-14 for the rules applicable to a corporation which
has elected to capitalize expenditures for advertising or the promotion
of good will under the provisions of section 733 or section 451 of the
Internal Revenue Code of 1939, in computing its excess profits tax
credit under Subchapter E, Chapter 2, or Subchapter D, Chapter 1, of the
Internal Revenue Code of 1939.
Sec. 1.263(c)-1 Intangible drilling and development costs in the
case of oil and gas wells.
For rules relating to the option to deduct as expenses intangible
drilling and development costs in the case of oil and gas wells, see
Sec. 1.612-4.
Sec. 1.263(e)-1 Expenditures in connection with certain
railroad rolling stock.
(a) Allowance of deduction--(1) Election. Under section 263(e), for
any taxable year beginning after December 31, 1969, a taxpayer may elect
to treat certain expenditures paid or incurred during such taxable year
as deductible repairs under section 162 or 212. This election applies
only to expenditures described in paragraph (c) of this section in
connection with the rehabilitation of a unit of railroad rolling stock
(as defined in paragraph (b)(2) of this section) used by a domestic
common carrier by railroad (as defined in paragraph (b) (3) and (4) of
this section). However, an election under section 263(e) may not be made
with respect to expenditures in connection with any unit of railroad
rolling stock for which an election under section 263(f) and the
regulations thereunder is in effect. An election made under section
263(e) is an annual election which may be made with respect to one or
more of the units of railroad rolling stock owned by the taxpayer.
(2) Special 20 percent rule. Section 263(e) shall not apply if,
under paragraph (d) of this section, expenditures paid or incurred
during any period of 12 calendar months in connection with the
rehabilitation of a unit exceed 20 percent of the basis (as defined in
paragraph (b)(1) of this section) of such unit in the hands of the
taxpayer. However, section 263(e) does not constitute a limit on the
deduction of expenditures for repairs which are deductible without
regard to such section. Accordingly, amounts otherwise deductible as
repairs will continue to be deductible even though such amounts exceed
20 percent of the basis of the unit of railroad rolling stock in the
hands of the taxpayer.
(3) Time and manner of making election. (i) An election by a
taxpayer under section 263(e) shall be made by a statement to that
effect attached to its income tax return or amended income tax return
for the taxable year for which the election is made if such return or
amended return is filed no later than the time prescribed by law
(including extensions thereof) for filing the return for the taxable
year of election. An election under section 263(e) may be made with
respect to one or more of the units of railroad rolling stock owned by
the taxpayer. If an election is not made within the time and in the
manner prescribed in this subparagraph, no election may be made (by the
filing of an amended return or in any other manner) with respect to the
taxable year.
(ii) If the taxpayer has filed a return on or before March 14, 1973,
and has claimed a deduction under section 162 or 212 by reason of
section 263(e), and if the taxpayer does not desire to make an election
under section 263(e) for the taxable year with respect to which such
return was filed, the taxpayer shall file an amended return for such
taxable year on or before May 14, 1973, and shall pay any additional tax
due for such year. The taxpayer shall also file an amended return for
each taxable year which is affected by the filing of an amended return
under the preceding sentence and shall pay any additional tax due for
such year. Nothing in this subdivision shall be construed as extending
the time specified in section 6511 within which a claim for credit or
refund may be filed.
(iii) If an election under section 263(e) was not made at the time
the return for a taxable year was filed, and it is subsequently
determined that an expenditure was erroneously treated as
[[Page 733]]
an expenditure which was not in connection with rehabilitation (as
determined under paragraph (c) of this section), an election under
section 263(e) may be made with respect to the unit of railroad rolling
stock for which such expenditure was made for such taxable year,
notwithstanding any provision in this subparagraph (3) to the contrary.
Nothing in this subdivision shall be construed as extending the time
specified in section 6511 within which a claim for credit or refund may
be filed.
(iv) The statement required by subdivision (i) of this subparagraph
shall include the following information:
(a) The total number of units of railroad rolling stock with respect
to which an election is being made under section 263(e).
(b) The aggregate basis (as defined in paragraph (b) (1) of this
section) of the units described in (a) of this subdivision (iv), and
(c) The total deduction being claimed under section 263(e) for the
taxable year.
(b) Definitions--(1) Basis. (i) In general, for purposes of section
263(e) the basis of a unit of railroad rolling stock shall be the
adjusted basis of such unit determined without regard to the adjustments
provided in paragraphs (1), (2), and (3) of section 1016(a) and section
1017. Thus, the basis of property would generally be its cost without
regard to adjustments to basis such as for depreciation or for capital
improvements. If the basis of a unit in the hands of a transferee is
determined in whole or in part by reference to its basis in the hands of
the transferor, for example, by reason of the application of section 362
(relating to basis to corporations), 374 (relating to gain or loss not
recognized in certain railroad reorganizations), or 723 (relating to the
basis of property contributed to a partnership), then the basis of such
unit in the hands of the transferor for purposes of section 263(e) shall
be its basis for purposes of section 263(e) in the hands of the
transferee. Similarly, when the basis of a unit of railroad rolling
stock in the hands of the taxpayer is determined in whole or in part by
reference to the basis of another unit, for example, by reason of the
application of the first sentence of section 1033(c) (relating to
involuntary conversions), then the basis of the latter unit for purposes
of section 263(e) shall be the basis for purposes of section 263(e) of
the former unit. The question whether a capital expenditure in
connection with a unit of railroad rolling stock results in the
retirement of such unit and the creation of another unit of railroad
rolling stock shall be determined without regard to rules under the
uniform system of accounts prescribed by the Interstate Commerce
Commission.
(ii) For example, if a unit of railroad rolling stock has a cost to
M of $10,000 and because of depreciation adjustments of $4,000 and
capital expenditures of $3,000, such unit has an adjusted basis in the
hands of M of $9,000, the basis for purposes of section 263(e) of such
unit in the hands of M is $10,000. Further, if M transfers such unit to
N in a transaction in which no gain or loss is recognized such as, for
example, a transaction to which section 351(a) (relating to a transfer
to a corporation controlled by the transferor) applies, the basis of
such unit for purposes of section 263(e) is $10,000 in the hands of N.
(2) Railroad rolling stock. For purposes of this section, the term
unit or unit of railroad rolling stock means a unit of transportation
equipment the expenditures for which are of a type chargeable (or in the
case of property leased to a domestic common carrier by railroad, would
be chargeable) to the equipment investment accounts in the uniform
system of accounts for railroad companies prescribed by the Interstate
Commerce Commission (49 CFR Part 1201), but only if (i) such unit
exclusively moves on, moves under, or is guided by rail, and (ii) such
unit is not a locomotive. Thus, for example, a unit of railroad rolling
stock includes a box car, a gondola car, a passenger car, a car designed
to carry truck trailers and containerized freight, a wreck crane, and a
bunk car. However, such term does not include equipment which does not
exclusively move on, move under, or is not exclusively guided by rail
such as, for example, a barge, a tugboat, a container which is used on
cars designed to carry containerized freight, a truck trailer, or an
automobile. A locomotive is self-propelled
[[Page 734]]
equipment, the sole function of which is to push or pull railroad
rolling stock. Thus, a self-propelled passenger or freight car is not a
locomotive.
(3) Domestic common carrier by railroad. The term domestic common
carrier by railroad means a railroad subject to regulation under Part I
of the Interstate Commerce Act (49 U.S.C. 1 et seq.) or a railroad which
would be subject to regulation under Part I of the Interstate Commerce
Act if it were engaged in interstate commerce.
(4) Use. For purposes of this section, a unit of railroad rolling
stock is not used by a domestic common carrier by railroad if it is
owned by a person other than a domestic common carrier by railroad and
(i) is exclusively used for transportation by the owner or (ii) is
exclusively used for transportation by another person which is not a
domestic common carrier by railroad. Thus, for example, a unit of
railroad rolling stock which is owned by a person which is not a
domestic common carrier by railroad and is leased to a manufacturing
company by the owner is not a unit of railroad rolling stock used by a
domestic common carrier by railroad.
(c) Expenditures considered in connection with rehabilitation. For
purposes of section 263(e) and this section all expenditures which would
be properly chargeable to capital account but for the application of
section 263 (e) or (f) shall be considered to be expenditures in
connection with the rehabilitation of a unit of railroad rolling stock.
Expenditures which are paid or incurred in connection with incidental
repairs or maintenance of a unit of railroad rolling stock and which are
deductible without regard to section 263 (e) or (f) shall not be
included in any determination or computation under section 263(e) and
shall not be treated as paid or incurred in connection with the
rehabilitation of a unit of railroad rolling stock for purposes of
section 263(e). The determination of whether an item would be, but for
section 263 (e) or (f), properly chargeable to capital account shall be
made in a manner consistent with the principles for classification of
expenditures as between capital and expenses under the Internal Revenue
Code. See, for example, Sec. Sec. 1.162-4, 1.263(a)-1, 1.263(a)-2, and
paragraph (a)(4) (ii) and (iii) of Sec. 1.446-1. An expenditure shall
be classified as capital or as expense without regard to its
classification under the uniform system of accounts prescribed by the
Interstate Commerce Commission.
(d) 20-percent limitation--(1) In general. No expenditures in
connection with the rehabilitation of a unit of railroad rolling stock
shall be treated as a deductible repair by reason of an election under
section 263(e) if, during any period of 12 calendar months in which the
month the expenditure is included falls, all such expenditures exceed an
amount equal to 20 percent of the basis (as defined in paragraph (b)(1)
of this section) of such unit in the hands of the taxpayer. All such
expenditures shall be included in the computation of the 20-percent
limitation even if such expenditures were deducted under section 263(f)
in either the preceding or succeeding taxable year. Solely for purposes
of the 20-percent limitation in this paragraph, such expenditures shall
be deemed to be included in the month in which a rehabilitation of the
unit of railroad rolling stock is completed. For the requirement that
expenditures treated as repairs solely by reason of an election under
section 263(e) be deducted in the taxable year paid or incurred, see
paragraph (a) of this section.
(2) 12-month period. For purposes of this section, any period of 12
calendar months shall consist of any 12 consecutive calendar months
except that calendar months prior to the calendar month of January 1970
shall not be included in determining such period.
(3) Period for certain corporate acquisitions. If a unit of railroad
rolling stock to which section 263(e) applies is sold, exchanged, or
otherwise disposed of in a transaction in which its basis in the hands
of the transferee is determined in whole or in part by reference to its
basis in the hands of the transferor (see paragraph (b)(1) of this
section), calendar months during which such unit is in the hands of the
transferor and in the hands of such transferee shall both be included in
the calendar months
[[Page 735]]
used by the transferor and the transferee to determine any period of 12
calendar months for purposes of section 263(e).
(4) Deduction allowed in year paid or incurred. If, based on the
information available when the income tax return for a taxable year is
filed, an expenditure paid or incurred in such taxable year would be
deductible by reason of the application of section 263(e) but for the
fact that it cannot be established whether the 20-percent limitation in
subparagraph (1) of this paragraph will be exceeded, the expenditure
shall be deducted for such taxable year. If by reason of the application
of such 20-percent limitation it is subsequently determined that such
expenditure is not deductible as a repair, an amended return shall be
filed for the year in which such deduction was treated as a deductible
repair and additional tax, if any, for such year shall be paid.
Appropriate adjustment with respect to the taxpayer's tax liability for
any other affected year shall be made. Nothing in this subparagraph
shall be construed as extending the time specified in section 6511
within which a claim for credit or refund may be filed.
(e) Recordkeeping requirements--(1) In general. Such records as will
enable the accurate determination of the expenditures which may be
subject to the treatment provided in section 263(e) shall be maintained.
No deduction shall be allowed under section 162 or 212 by reason of
section 263(e) with respect to a unit unless the taxpayer substantiates
by adequate records that expenditures in connection with such unit of
railroad rolling stock meet the requirements and limitations of this
section.
(2) Separate records. A separate section 263(e) record shall be
maintained for each unit with respect to which an election under section
263(e) is made. Such record shall:
(i) Identify the unit,
(ii) State the basis (as defined in paragraph (b)(1) of this
section) and the date of acquisition of the unit,
(iii) Enumerate for each unit the amount of all expenditures
incurred in connection with rehabilitation of such unit which would, but
for section 263 (e) or (f), be properly chargeable to capital account
(including expenditures incurred by the taxpayer in connection with
rehabilitation of such unit undertaken by a person other than the
taxpayer) regardless of whether such expenditures during any 12-month
period exceed 20 percent of the basis of such unit,
(iv) Describe the nature of the work in connection with each
expenditure, and
(v) Specify the calendar month in which the rehabilitation is
completed and the taxable year in which each expenditure is paid or
incurred.
A section 263(e) record need only be prepared for a unit of railroad
rolling stock for the period beginning on the first day of the eleventh
calendar month immediately preceding the month in which the
rehabilitation of such unit is completed and ending on the last day of
the eleventh calendar month immediately succeeding such month. No
section 263(e) record need be prepared for calendar months before
January 1970.
(3) Records for certain expenditures: Expenditures determined to be
incidental repairs and maintenance (referred to in paragraph (c) of this
section) shall not be entered in the section 263(e) record. However,
each taxpayer shall maintain records to reflect that such expenditures
are properly deductible.
(4) Convenience rule. In general, expenditures and information
maintained in compliance with subparagraphs (1) and (2) of this
paragraph shall be recorded in the section 263(e) record of the specific
unit with respect to which such expenditures are incurred. However, when
a group of units of the same type are rehabilitated in a single project
and the expenditure for each unit in the project will approximate the
average expenditure per unit for the project, expenditures for the
project may be aggregated without regard to the unit in the project with
respect to which each expenditure is connected, and an amount equal to
the aggregate expenditures for the project divided by the number of
units in the project may be entered in the section 263(e) account of
each unit in the project.
[[Page 736]]
(f) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. M Corporation, a domestic common carrier by railroad,
uses the calendar year as its taxable year. M owns and uses several
gondola cars to which an election under section 263(e) applies for its
taxable years 1970-1972. Gondola car No.1 has a basis (defined in
paragraph (b)(1) of this section) of $10,000. No expenditures properly
chargeable to the section 263(e) record are made on gondola car No. 1 in
1970 and 1971, except in January 1971. In January 1971, M at a cost of
$1,500 performed rehabilitation work on gondola car No. 1. Such amount
was properly entered in the section 263(e) record for gondola car No.1.
Since the expenditures in such record do not exceed an amount equal to
20 percent of the basis of gondola car No. 1 ($2,000) during any period
of 12 calendar months in which January 1971 falls, the expenditures
during January 1971 shall be treated as a deductible expense regardless
of what the treatment would have been if section 263(e) had not been
enacted.
Example 2. Assume the same facts as in Example 1. Assume further
that for 1970, 1971, and 1972, only the following expenditures in
connection with rehabilitation which would, but for section 263(e), be
properly chargeable to capital account were deemed included for gondola
car No. 2:
(a) December 1970.............................................. $1,500
(b) November 1971.............................................. 600
(c) December 1971.............................................. 400
(d) January 1972............................................... 1,050
Assume further that gondola car No. 2 has a basis (as defined in
paragraph (b) (1) of this section) equal to $10,000, that M files its
tax return by September 15 following each taxable year, and that each
rehabilitation was completed in the month in which expenditures in
connection with it were incurred. Any expenditures in connection with
each gondola car (No. 1 or No. 2) have no effect on the treatment of
expenditures in connection with the other gondola car. With respect to
gondola car No. 2, the expenditures of December 1970 are treated as
deductible repairs at the time M's income tax return for 1970 is filed
because, based on the information available when the income tax return
for 1970 is filed, such expenditure would be deductible by reason of
application of section 263(e) but for the fact that it cannot be
established whether the 20-percent limitation in paragraph (d)(1) of
this section will be exceeded. Nevertheless, because such expenditures
during the period of 12 calendar months including calendar months
December 1970 and November 1971 exceed $2,000, the December 1970
rehabilitation expenditures are not subject to the provisions of section
263(e). Because such rehabilitation expenditures during the period of 12
calendar months including calendar months February 1971 and January 1972
exceed $2,000, rehabilitation expenditures in 1971 are not subject to
the provisions of section 263(e). Similarly, the 1972 rehabilitation
expenditures are not subject to the provisions of section 263(e).
[T.D. 7257, 38 FR 4255, Feb. 12, 1973]
Sec. 1.263(f)-1 Reasonable repair allowance.
(a) For rules regarding the election of the repair allowance
authorized by section 263(f), the definition of repair allowance
property, and the conditions under which an election may be made, see
paragraphs (d) (2) and (f) of Sec. 1.167(a)-11. An election may be made
under this section for a taxable year only if the taxpayer makes an
election under Sec. 1.167(a)-11 for such taxable year.
(Sec. 263(f), 85 Stat. 509 (26 U.S.C. 263))
[T.D. 7272, 38 FR 9986, Apr. 23, 1973; 38 FR 12919, May 17, 1973, as
amended by T.D. 7593, 44 FR 5421, Jan. 26, 1979]
Sec. 1.263A-0 Outline of regulations under section 263A.
This section lists the paragraphs in Sec. Sec. 1.263A-1 through
1.263A-4 and Sec. Sec. 1.263A-7 through 1.263A-15 as follows:
Sec. 1.263A-1 Uniform Capitalization of Costs.
(a) Introduction.
(1) In general.
(2) Effective dates.
(3) General scope.
(i) Property to which section 263A applies.
(ii) Property produced.
(iii) Property acquired for resale.
(iv) Inventories valued at market.
(v) Property produced in a farming business.
(vi) Creative property.
(vii) Property produced or property acquired for resale by foreign
persons.
(b) Exceptions.
(1) Small business taxpayers.
(2) Long-term contracts.
(3) Costs incurred in certain farming businesses.
(4) Costs incurred in raising, harvesting, or growing timber.
(5) Qualified creative expenses.
(6) Certain not-for-profit activities.
(7) Intangible drilling and development costs.
(8) Natural gas acquired for resale.
(i) Cushion gas.
(ii) Emergency gas.
(9) Research and experimental expenditures.
[[Page 737]]
(10) Certain property that is substantially constructed.
(11) Certain property provided incident to services.
(i) In general.
(ii) Definition of services.
(iii) De minimis property provided incident to services.
(12) De minimis rule for certain producers with total indirect costs
of $200,000 or less.
(13) Exception for the origination of loans.
(c) General operation of section 263A.
(1) Allocations.
(2) Otherwise deductible.
(3) Capitalize.
(4) Recovery of capitalized costs.
(5) Costs allocable only to property sold.
(d) Definitions.
(1) Self-constructed assets.
(2) Section 471 costs.
(i) In general.
(ii) Inclusion of direct costs.
(A) In general.
(B) Allocation of direct costs.
(iii) Alternative method to determine amounts of section 471 costs
by using taxpayer's financial statement.
(A) In general.
(B) Book-to-tax adjustments.
(C) Exclusion of certain financial statement items.
(D) Changes in method of accounting.
(E) Examples.
(iv) De minimis rule exceptions for certain direct costs.
(A) In general.
(B) De minimis rule for certain direct labor costs.
(C) De minimis rule for certain direct material costs.
(D) Taxpayers using a historic absorption ratio.
(E) Examples.
(v) Safe harbor method for certain variances and under or over-
applied burdens.
(A) In general.
(B) Consistency requirement.
(C) Allocation of variances and under or over-applied burdens
between production and preproduction costs under the modified simplified
production method.
(D) Allocation of variances and under or over-applied burdens
between storage and handling costs absorption ratio and purchasing costs
absorption ratio under the simplified resale method.
(E) Method of accounting.
(vi) Removal of section 471 costs.
(vii) Method changes.
(3) Additional section 263A costs.
(i) In general.
(ii) Negative adjustments.
(A) In general.
(B) Exception for certain taxpayers removing costs from section 471
costs.
(C) No negative adjustments for cash or trade discounts.
(D) No negative adjustments for certain expenses.
(E) Consistency requirement for negative adjustments.
(4) Section 263A costs.
(5) Classification of costs.
(6) Financial statement.
(e) Types of costs subject to capitalization.
(1) In general.
(2) Direct costs.
(i) Producers.
(A) Direct material costs.
(B) Direct labor costs.
(ii) Resellers.
(3) Indirect costs.
(i) In general.
(ii) Examples of indirect costs required to be capitalized.
(A) Indirect labor costs.
(B) Officers' compensation.
(C) Pension and other related costs.
(D) Employee benefit expenses.
(E) Indirect material costs.
(F) Purchasing costs.
(G) Handling costs.
(H) Storage costs.
(I) Cost recovery.
(J) Depletion.
(K) Rent.
(L) Taxes.
(M) Insurance.
(N) Utilities.
(O) Repairs and maintenance.
(P) Engineering and design costs.
(Q) Spoilage.
(R) Tools and equipment.
(S) Quality control.
(T) Bidding costs.
(U) Licensing and franchise costs.
(V) Interest.
(W) Capitalizable service costs.
(iii) Indirect costs not capitalized.
(A) Selling and distribution costs.
(B) Research and experimental expenditures.
(C) Section 179 costs.
(D) Section 165 losses.
(E) Cost recovery allowances on temporarily idle equipment and
facilities.
(1) In general.
(2) Examples.
(F) Taxes assessed on the basis of income.
(G) Strike expenses.
(H) Warranty and product liability costs.
(I) On-site storage costs.
(J) Unsuccessful bidding expenses.
(K) Deductible service costs.
(4) Service costs.
(i) Introduction.
(A) Definition of service costs.
(B) Definition of service departments.
(ii) Various service cost categories.
(A) Capitalizable service costs.
(B) Deductible service costs.
(C) Mixed service costs.
(iii) Examples of capitalizable service costs.
[[Page 738]]
(iv) Examples of deductible service costs.
(f) Cost allocation methods.
(1) Introduction.
(2) Specific identification method.
(3) Burden rate and standard cost methods.
(i) Burden rate method.
(A) In general.
(B) Development of burden rates.
(C) Operation of the burden rate method.
(ii) Standard cost method.
(A) In general.
(B) Treatment of variances.
(4) Reasonable allocation methods.
(g) Allocating categories of costs.
(1) Direct materials.
(2) Direct labor.
(3) Indirect costs.
(4) Service costs.
(i) In general.
(ii) De minimis rule.
(iii) Methods for allocating mixed service costs.
(A) Direct reallocation method.
(B) Step-allocation method.
(C) Examples.
(iv) Illustrations of mixed service cost allocations using
reasonable factors or relationships.
(A) Security services.
(B) Legal services.
(C) Centralized payroll services.
(D) Centralized data processing services.
(E) Engineering and design services.
(F) Safety engineering services.
(v) Accounting method change.
(h) Simplified service cost method.
(1) Introduction.
(2) Eligible property.
(i) In general.
(A) Inventory property.
(B) Non-inventory property held for sale.
(C) Certain self-constructed assets.
(D) Self-constructed assets produced on a repetitive basis.
(ii) Election to exclude self-constructed assets.
(3) General allocation formula.
(4) Labor-based allocation ratio.
(5) Production cost allocation ratio.
(6) Definition of total mixed service costs.
(7) Costs allocable to more than one business.
(8) De minimis rule.
(9) Separate election.
(i) [Reserved]
(j) Exemption for certain small business taxpayers.
(1) In general.
(2) Application of the section 448(c) gross receipts test.
(i) In general.
(ii) Gross receipts of individuals, etc.
(iii) Partners and S corporation shareholders.
(iv) Examples.
(A) Example 1
(B) Example 2
(3) Change in method of accounting.
(i) In general.
(ii) Prior section 263A method change.
(k) Special rules
(1) Costs provided by a related person.
(i) In general
(ii) Exceptions
(2) Optional capitalization of period costs.
(i) In general.
(ii) Period costs eligible for capitalization.
(3) Trade or business application
(4) Transfers with a principal purpose of tax avoidance. [Reserved]
(l) Change in method of accounting.
(1) In general.
(2) Scope limitations.
(3) Audit protection.
(4) Section 481(a) adjustment.
(5) Time for requesting change.
(m) Effective/applicability date.
(1) In general.
(2) Mixed service costs; self-constructed tangible personal property
produced on a routine and repetitive basis.
(3) Costs allocable to property sold; indirect costs; licensing and
franchise costs.
(4) Materials and supplies.
(5) Definitions of section 471 costs and additional section 263A
costs.
(6) Exemption for certain small business taxpayers.
Sec. 1.263A-2 Rules Relating to Property Produced by the Taxpayer.
(a) In general.
(1) Produce.
(i) In general.
(ii) Ownership.
(A) General rule.
(B) Property produced for the taxpayer under a contract.
(1) In general.
(2) Definition of contract.
(C) Home construction contracts.
(2) Tangible personal property.
(i) General rule.
(ii) Intellectual or creative property.
(A) Intellectual or creative property that is tangible personal
property.
(1) Books.
(2) Sound recordings.
(B) Intellectual or creative property that is not tangible personal
property.
(1) Evidences of value.
(2) Property provided incident to services.
(3) Costs required to be capitalized by producers.
(i) In general.
(ii) Pre-production costs.
(iii) Post-production costs.
(4) Practical capacity concept.
(5) Taxpayers required to capitalize costs under this section.
(b) Simplified production method.
(1) Introduction.
(2) Eligible property.
(i) In general.
[[Page 739]]
(A) Inventory property.
(B) Non-inventory property held for sale.
(C) Certain self-constructed assets.
(D) Self-constructed assets produced on a repetitive basis.
(ii) Election to exclude self-constructed assets.
(3) Simplified production method without historic absorption ratio
election.
(i) General allocation formula.
(ii) Definitions.
(A) Absorption ratio.
(1) Additional section 263A costs incurred during the taxable year.
(2) Section 471 costs incurred during the taxable year.
(B) Section 471 costs remaining on hand at year end.
(C) Costs allocable only to property sold.
(iii) LIFO taxpayers electing the simplified production method.
(A) In general.
(B) LIFO increment.
(C) LIFO decrement.
(iv) De minimis rule for producers with total indirect costs of
$200,000 or less.
(A) In general.
(B) Related party and aggregation rules.
(v) Examples.
(4) Simplified production method with historic absorption ratio
election.
(i) In general.
(ii) Operating rules and definitions.
(A) Historic absorption ratio.
(B) Test period.
(1) In general.
(2) Updated test period.
(C) Qualifying period.
(1) In general.
(2) Extension of qualifying period.
(iii) Method of accounting.
(A) Adoption and use.
(B) Revocation of election.
(iv) Reporting and recordkeeping requirements.
(A) Reporting.
(B) Recordkeeping.
(v) Transition rules.
(A) Transition to elect historic absorption ratio.
(B) Transition to revoke historic absorption ratio.
(vi) Example.
(c) Modified simplified production method.
(1) Introduction.
(2) Eligible property.
(i) In general.
(ii) Election to exclude self-constructed assets.
(3) Modified simplified production method without historic
absorption ratio election.
(i) General allocation formula.
(A) In general.
(B) Effect of allocation.
(ii) Definitions.
(A) Direct material costs.
(B) Pre-production absorption ratio.
(1) Pre-production additional section 263A costs.
(2) Pre-production section 471 costs.
(C) Pre-production section 471 costs remaining on hand at year end.
(D) Production absorption ratio.
(1) Production additional section 263A costs.
(2) Residual pre-production additional section 263A costs.
(3) Production section 471 costs.
(4) Direct materials adjustment.
(E) Production section 471 costs remaining on hand at year end.
(F) Costs allocated to property sold.
(iii) Allocable mixed service costs.
(A) In general.
(B) Taxpayer using the simplified service cost method.
(C) De minimis rule.
(iv) LIFO taxpayers electing the modified simplified production
method.
(A) In general.
(B) LIFO increment.
(1) In general.
(2) Combined absorption ratio defined.
(C) LIFO decrement.
(v) De minimis rule for producers with total indirect costs of
$200,000 or less.
(vi) Examples.
(4) Modified simplified production method with historic absorption
ratio election.
(i) In general.
(ii) Operating rules and definitions.
(A) Pre-production historic absorption ratio.
(B) Production historic absorption ratio.
(iii) LIFO taxpayers making the historic absorption ratio election.
(A) In general.
(B) Combined historic absorption ratio.
(1) Total allocable additional section 263A costs incurred during
the test period.
(2) Total section 471 costs remaining on hand at each year end of
the test period.
(iv) Extension of qualifying period.
(v) Examples.
(d) Additional simplified methods for producers.
(e) Cross reference.
(f) Change in method of accounting.
(1) In general.
(2) Scope limitations.
(3) Audit protection.
(4) Section 481(a) adjustment.
(5) Time for requesting change.
(g) Effective/applicability date.
Sec. 1.263A-3 Rules Relating to Property Acquired for Resale
(a) Capitalization rules for property acquired for resale.
(1) In general.
(2) Resellers with production activities.
(i) In general.
(ii) Exemption for small business taxpayers.
[[Page 740]]
(iii) De minimis production activities.
(A) In general.
(B) Example.
(3) Resellers with property produced under a contract.
(4) Use of the simplified resale method.
(i) In general.
(ii) Resellers with de minimis production activities.
(iii) Resellers with property produced under a contract.
(iv) Application of simplified resale method.
(5) De minimis production activities.
(i) In general.
(ii) Definition of gross receipts to determine de minimis production
activities.
(iii) Example.
(b) [Reserved].
(c) Purchasing, handling, and storage costs.
(1) In general.
(2) Costs attributable to purchasing, handling, and storage.
(3) Purchasing costs.
(i) In general.
(ii) Determination of whether personnel are engaged in purchasing
activities.
(A) \1/3\-\2/3\ rule for allocating labor costs.
(B) Example.
(4) Handling costs.
(i) In general.
(ii) Processing costs.
(iii) Assembling costs.
(iv) Repackaging costs.
(v) Transportation costs.
(vi) Costs not considered handling costs.
(A) Distribution costs.
(B) Delivery of custom-ordered items.
(C) Repackaging after sale occurs.
(5) Storage costs.
(i) In general.
(ii) Definitions.
(A) On-site storage facility.
(B) Retail sales facility.
(C) An integral part of a retail sales facility.
(D) On-site sales.
(E) Retail customer.
(1) In general.
(2) Certain non-retail customers treated as retail customers.
(F) Off-site storage facility.
(G) Dual-function storage facility.
(iii) Treatment of storage costs incurred at a dual-function storage
facility.
(A) In general.
(B) Dual-function storage facility allocation ratio.
(1) In general.
(2) Illustration of ratio allocation.
(3) Appropriate adjustments for other uses of a dual-function
storage facility.
(C) De minimis 90-10 rule for dual-function storage facilities.
(iv) Costs not attributable to an off-site storage facility.
(v) Examples.
(d) Simplified resale method.
(1) Introduction.
(2) Eligible property.
(3) Simplified resale method without historic absorption ratio
election.
(i) General allocation formula.
(A) In general.
(B) Effect of allocation.
(C) Definitions.
(1) Combined absorption ratio.
(2) Section 471 costs remaining on hand at year end.
(3) Costs allocable only to property sold.
(D) Storage and handling costs absorption ratio.
(E) Purchasing costs absorption ratio.
(F) Allocable mixed service costs.
(ii) LIFO taxpayers electing simplified resale method.
(A) In general.
(B) LIFO increment.
(C) LIFO decrement.
(iii) Permissible variations of the simplified resale method.
(iv) Examples.
(4) Simplified resale method with historic absorption ratio
election.
(i) In general.
(ii) Operating rules and definitions.
(A) Historic absorption ratio.
(B) Test period.
(1) In general.
(2) Updated test period.
(C) Qualifying period.
(1) In general.
(2) Extension of qualifying period.
(iii) Method of accounting.
(A) Adoption and use.
(B) Revocation of election.
(iv) Reporting and recordkeeping requirements.
(A) Reporting.
(B) Recordkeeping.
(v) Transition rules.
(A) Transition to elect historic absorption ratio.
(B) Transition to revoke historic absorption ratio.
(vi) Example.
(5) Additional simplified methods for resellers.
(e) Cross reference.
(f) Effective/applicability date.
Sec. 1.263A-4 Rules for property produced in a farming business.
(a) Introduction.
(1) In general.
(2) Exception.
(i) In general.
(ii) Tax shelter.
(A) In general.
(B) Presumption.
(iii) Examples.
(3) Exemption for certain small business taxpayers.
[[Page 741]]
(4) Costs required to be capitalized or inventoried under another
provision.
(5) Farming business.
(i) In general.
(A) Plant.
(B) Animal.
(ii) Incidental activities.
(A) In general.
(B) Activities that are not incidental.
(iii) Examples.
(b) Application of section 263A to property produced in a farming
business.
(1) In general.
(i) Plants.
(ii) Animals.
(2) Preproductive period.
(i) Plant.
(A) In general.
(B) Applicability of section 263A.
(C) Actual preproductive period.
(1) Beginning of the preproductive period.
(2) End of the preproductive period.
(i) In general.
(ii) Marketable quantities.
(D) Examples.
(ii) Animal.
(A) Beginning of the preproductive period.
(B) End of the preproductive period.
(C) Allocation of costs between animal and first yield.
(c) Inventory methods.
(1) In general.
(2) Available for property used in a trade or business.
(3) Exclusion of property to which section 263A does not apply.
(d) Election not to have section 263A apply under section
263A(d)(3).
(1) Introduction.
(2) Availability of the election.
(3) Time and manner of making the election.
(i) Automatic election.
(ii) Nonautomatic election.
(4) Special rules.
(i) Section 1245 treatment.
(ii) Required use of alternative depreciation system.
(iii) Related person.
(A) In general.
(B) Members of family.
(5) Revocation of section 263A(d)(3) election to permit exemption
under section 263A(i).
(6) Change from applying exemption under section 263A(i) to making a
section 263A(d)(3) election.
(7) Examples.
(e) Exception for certain costs resulting from casualty losses.
(1) In general.
(2) Ownership.
(3) Examples.
(4) Special rule for citrus and almond groves.
(i) In general.
(ii) Example.
(5) Special temporary rule for citrus plants lost by reason of
casualty.
(f) Change in method of accounting.
(1) Effective date.
(2) Change in method of accounting.
(g) Effective date.
(1) In general.
(2) Changes made by Tax Cuts and Jobs Act (Pub. L. 115-97).
Sec. 1.263A-7 Changing a method of accounting under section 263A.
(a) Introduction.
(1) Purpose.
(2) Taxpayers that adopt a method of accounting under section 263A.
(3) Taxpayers that change a method of accounting under section 263A.
(4) Applicability dates.
(i) In general.
(ii) Changes made by Tax Cuts and Jobs Act (Pub. L. 115-97).
(5) Definition of change in method of accounting.
(b) Rules applicable to a change in method of accounting.
(1) General rules.
(2) Special rules.
(i) Ordering rules when multiple changes in method of accounting
occur in the year of change.
(A) In general.
(B) Exceptions to the general ordering rule.
(1) Change from the LIFO inventory method.
(2) Change from the specific goods LIFO inventory method.
(3) Change in overall method of accounting.
(4) Change in method of accounting for depreciation.
(ii) Adjustment required by section 481(a).
(iii) Base year.
(A) Need for a new base year.
(1) Facts and circumstances revaluation method used.
(2) 3-year average method used.
(i) Simplified method not used.
(ii) Simplified method used.
(B) Computing a new base year.
(c) Inventory.
(1) Need for adjustments.
(2) Revaluing beginning inventory.
(i) In general.
(ii) Methods to revalue inventory.
(iii) Facts and circumstances revaluation method.
(A) In general.
(B) Exception.
(C) Estimates and procedures allowed.
(D) Use by dollar-value LIFO taxpayers.
(E) Examples.
(iv) Weighted average method.
(A) In general.
(B) Weighted average method for FIFO taxpayers.
[[Page 742]]
(1) In general.
(2) Example.
(C) Weighted average method for specific goods LIFO taxpayers.
(1) In general.
(2) Example.
(D) Adjustments to inventory costs from prior years.
(v) 3-year average method.
(A) In general.
(B) Consecutive year requirement.
(C) Example.
(D) Short taxable years.
(E) Adjustments to inventory costs from prior years.
(1) General rule.
(2) Examples of costs eligible for restatement adjustment procedure.
(F) Restatement adjustment procedure.
(1) In general.
(2) Examples of restatement adjustment procedure.
(3) Intercompany items.
(i) Revaluing intercompany transactions.
(ii) Example.
(iii) Availability of revaluation methods.
(4) Anti-abuse rule.
(i) In general.
(ii) Deemed avoidance of this section.
(A) Scope.
(B) General rule.
(iii) Election to use transferor's LIFO layers.
(iv) Tax avoidance intent not required.
(v) Related corporation.
(d) Non-inventory property.
(1) Need for adjustments.
(2) Revaluing property.
Sec. 1.263A-8 Requirement to capitalize interest.
(a) In general.
(1) General rule.
(2) Treatment of interest required to be capitalized.
(3) Methods of accounting under section 263A(f).
(4) Special definitions.
(i) Related person.
(ii) Placed in service.
(b) Designated property.
(1) In general.
(2) Special rules.
(i) Application of thresholds.
(ii) Relevant activities and costs.
(iii) Production period and cost of production.
(3) Excluded property.
(4) De minimis rule.
(i) In general.
(ii) Determination of total production expenditures.
(c) Definition of real property.
(1) In general.
(2) Unsevered natural products of land.
(3) Inherently permanent structures.
(4) Machinery.
(i) Treatment.
(ii) Certain factors not determinative.
(d) Production.
(1) Definition of produce.
(2) Property produced under a contract.
(i) Customer.
(ii) Contractor.
(iii) Definition of a contract.
(iv) Determination of whether thresholds are satisfied.
(A) Customer.
(B) Contractor.
(v) Exclusion for property subject to long-term contract rules.
(3) Improvements to existing property.
(i) In general.
(ii) Real property.
(iii) Tangible personal property.
Sec. 1.263A-9 The avoided cost method.
(a) In general.
(1) Description.
(2) Overview.
(i) In general.
(ii) Rules that apply in determining amounts.
(3) Definitions of interest and incurred.
(4) Definition of eligible debt.
(b) Traced debt amount.
(1) General rule.
(2) Identification and definition of traced debt.
(3) Example.
(c) Excess expenditure amount.
(1) General rule.
(2) Interest required to be capitalized.
(3) Example.
(4) Treatment of interest subject to a deferral provision.
(5) Definitions.
(i) Nontraced debt.
(A) Defined.
(B) Example.
(ii) Average excess expenditures.
(A) General rule.
(B) Example.
(iii) Weighted average interest rate.
(A) Determination of rate.
(B) Interest incurred on nontraced debt.
(C) Average nontraced debt.
(D) Special rules if taxpayer has no nontraced debt or rate is
contingent.
(6) Examples.
(7) Special rules where the excess expenditure amount exceeds
incurred interest.
(i) Allocation of total incurred interest to units.
(ii) Application of related person rules to average excess
expenditures.
(iii) Special rule for corporations.
(d) Election not to trace debt.
(1) General rule.
(2) Example.
(e) Election to use external rate.
(1) In general.
(2) Eligible taxpayer.
[[Page 743]]
(f) Selection of computation period and measurement dates and
application of averaging conventions.
(1) Computation period.
(i) In general.
(ii) Method of accounting.
(iii) Production period beginning or ending during the computation
period.
(2) Measurement dates.
(i) In general.
(ii) Measurement period.
(iii) Measurement dates on which accumulated production expenditures
must be taken into account.
(iv) More frequent measurement dates.
(3) Examples.
(g) Special rules.
(1) Ordering rules.
(i) Provisions preempted by section 263A(f).
(ii) Deferral provisions applied before this section.
(2) Application of section 263A(f) to deferred interest.
(i) In general.
(ii) Capitalization of deferral amount.
(iii) Deferred capitalization.
(iv) Substitute capitalization.
(A) General rule.
(B) Capitalization of amount carried forward.
(C) Method of accounting.
(v) Examples.
(3) Simplified inventory method.
(i) In general.
(ii) Segmentation of inventory.
(A) General rule.
(B) Example.
(iii) Aggregate interest capitalization amount.
(A) Computation period and weighted average interest rate.
(B) Computation of the tentative aggregate interest capitalization
amount.
(C) Coordination with other interest capitalization computations.
(1) In general.
(2) Deferred interest.
(3) Other coordinating provisions.
(D) Treatment of increases or decreases in the aggregate interest
capitalization amount.
(E) Example.
(iv) Method of accounting.
(4) Financial accounting method disregarded.
(5) Treatment of intercompany transactions.
(i) General rule.
(ii) Special rule for consolidated group with limited outside
borrowing.
(iii) Example.
(6) Notional principal contracts and other derivatives. [Reserved]
(7) 15-day repayment rule.
Sec. 1.263A-10 Unit of property.
(a) In general.
(b) Units of real property.
(1) In general.
(2) Functional interdependence.
(3) Common features.
(4) Allocation of costs to unit.
(5) Treatment of costs when a common feature is included in a unit
of real property.
(i) General rule.
(ii) Production activity not undertaken on benefitted property.
(A) Direct production activity not undertaken.
(1) In general.
(2) Land attributable to a benefitted property.
(B) Suspension of direct production activity after clearing and
grading undertaken.
(1) General rule.
(2) Accumulated production expenditures.
(iii) Common feature placed in service before the end of production
of a benefitted property.
(iv) Benefitted property sold before production completed on common
feature.
(v) Benefitted property placed in service before production
completed on common feature.
(6) Examples.
(c) Units of tangible personal property.
(d) Treatment of installations.
Sec. 1.263A-11 Accumulated production expenditures.
(a) General rule.
(b) When costs are first taken into account.
(1) In general.
(2) Dedication rule for materials and supplies.
(c) Property produced under a contract.
(1) Customer.
(2) Contractor.
(d) Property used to produce designated property.
(1) In general.
(2) Example.
(3) Excluded equipment and facilities.
(e) Improvements.
(1) General rule.
(2) De minimis rule.
(f) Mid-production purchases.
(g) Related person costs.
(h) Installation.
Sec. 1.263A-12 Production period.
(a) In general.
(b) Related person activities.
(c) Beginning of production period.
(1) In general.
(2) Real property.
(3) Tangible personal property.
(d) End of production period.
(1) In general.
(2) Special rules.
(3) Sequential production or delivery.
(4) Examples.
[[Page 744]]
(e) Physical production activities.
(1) In general.
(2) Illustrations.
(f) Activities not considered physical production.
(1) Planning and design.
(2) Incidental repairs.
(g) Suspension of production period.
(1) In general.
(2) Special rule.
(3) Method of accounting.
(4) Example.
Sec. 1.263A-13 Oil and gas activities.
(a) In general.
(b) Generally applicable rules.
(1) Beginning of production period.
(i) Onshore activities.
(ii) Offshore activities.
(2) End of production period.
(3) Accumulated production expenditures.
(i) Costs included.
(ii) Improvement unit.
(c) Special rules when definite plan not established.
(1) In general.
(2) Oil and gas units.
(i) First productive well unit.
(ii) Subsequent units.
(3) Beginning of production period.
(i) First productive well unit.
(ii) Subsequent wells.
(4) End of production period.
(5) Accumulated production expenditures.
(i) First productive well unit.
(ii) Subsequent well unit.
(6) Allocation of interest capitalized with respect to first
productive well unit.
(7) Examples.
Sec. 1.263A-14 Rules for related persons.
Sec. 1.263A-15 Effective dates, transitional rules, and anti-abuse
rule.
(a) Effective dates.
(b) Transitional rule for accumulated production expenditures.
(1) In general.
(2) Property used to produce designated property.
(c) Anti-abuse rule.
[T.D. 8482, 58 FR 42207, Aug. 9, 1993, as amended by T.D. 8584, 59 FR
67196, Dec. 29, 1994; 60 FR 16574, Mar. 31, 1995; T.D. 8728, 62 FR
42054, Aug. 5, 1997; T.D. 8897, 65 FR 50643, Aug. 21, 2000; T.D. 9636,
78 FR 57745, Sept. 19, 2013; T.D. 9652, 79 FR 2096, Jan. 13, 2014; T.D.
9843, 83 FR 58485, Nov. 20, 2018; T.D, 9942, 86 FR 264, Jan. 5, 2021; 86
FR 32185, June 17, 2021]
Sec. 1.263A-1 Uniform capitalization of costs.
(a) Introduction--(1) In general. The regulations under Sec. Sec.
1.263A-1 through 1.263A-6 provide guidance to taxpayers that are
required to capitalize certain costs under section 263A. These
regulations generally apply to all costs required to be capitalized
under section 263A except for interest that must be capitalized under
section 263A(f) and the regulations thereunder. Statutory or regulatory
exceptions may provide that section 263A does not apply to certain
activities or costs; however, those activities or costs may nevertheless
be subject to capitalization requirements under other provisions of the
Internal Revenue Code and regulations.
(2) Applicability dates. (i) In general, this section and Sec. Sec.
1.263A-2 and 1.263A-3 apply to costs incurred in taxable years beginning
after December 31, 1993. In the case of property that is inventory in
the hands of the taxpayer, however, these sections are applicable for
taxable years beginning after December 31, 1993. The small business
taxpayer exception described in paragraph (b)(1) of this section and set
forth in paragraph (j) of this section is applicable for taxable years
beginning after December 31, 2017. Changes in methods of accounting
necessary as a result of the rules in this section and Sec. Sec.
1.263A-2 and 1.263A-3 must be made under terms and conditions prescribed
by the Commissioner. Under these terms and conditions, the principles of
Sec. 1.263A-7 must be applied in revaluing inventory property.
(ii) For taxable years beginning before January 1, 1994, taxpayers
must take reasonable positions on their federal income tax returns when
applying section 263A. For purposes of this paragraph (a)(2)(iii), a
reasonable position is a position consistent with the temporary
regulations, revenue rulings, revenue procedures, notices, and
announcements concerning section 263A applicable in taxable years
beginning before January 1, 1994. See Sec. 601.601(d)(2)(ii)(b) of this
chapter.
(3) General scope--(i) Property to which section 263A applies.
Taxpayers subject to section 263A must capitalize all direct costs and
certain indirect costs properly allocable to--
(A) Real property and tangible personal property produced by the
taxpayer; and
[[Page 745]]
(B) Real property and personal property described in section
1221(1), which is acquired by the taxpayer for resale.
(ii) Property produced. Taxpayers that produce real property and
tangible personal property (producers) must capitalize all the direct
costs of producing the property and the property's properly allocable
share of indirect costs (described in paragraphs (e)(2)(i) and (3) of
this section), regardless of whether the property is sold or used in the
taxpayer's trade or business. See Sec. 1.263A-2 for rules relating to
producers.
(iii) Property acquired for resale. Retailers, wholesalers, and
other taxpayers that acquire property described in section 1221(1) for
resale (resellers) must capitalize the direct costs of acquiring the
property and the property's properly allocable share of indirect costs
(described in paragraphs (e)(2)(ii) and (3) of this section). See Sec.
1.263A-3 for rules relating to resellers. See also section
263A(b)(2)(B), which excepts from section 263A personal property
acquired for resale by a small reseller.
(iv) Inventories valued at market. Section 263A does not apply to
inventories valued at market under either the market method or the lower
of cost or market method if the market valuation used by the taxpayer
generally equals the property's fair market value. For purposes of this
paragraph (a)(3)(iv), the term fair market value means the price at
which the taxpayer sells its inventory to its customers (e.g., as in the
market value definition provided in Sec. 1.471-4(b)) less, if
applicable, the direct cost of disposing of the inventory. However,
section 263A does apply in determining the market value of any inventory
for which market is determined with reference to replacement cost or
reproduction cost. See Sec. Sec. 1.471-4 and 1.471-5.
(v) Property produced in a farming business. Section 263A generally
requires taxpayers engaged in a farming business to capitalize certain
costs. See sections 263A(d) and 263A(e) and Sec. 1.263A-4 for rules
relating to taxpayers engaged in a farming business.
(vi) Creative property. Section 263A generally requires taxpayers
engaged in the production and resale of creative property to capitalize
certain costs.
(vii) Property produced or property acquired for resale by foreign
persons. Section 263A generally applies to foreign persons.
(b) Exceptions-- (1) Small business taxpayers. For taxable years
beginning after December 31, 2017, see section 263A(i) and paragraph (j)
of this section for an exemption for certain small business taxpayers
from the requirements of section 263A.
(2) Long-term contracts. Except for certain home construction
contracts described in section 460(e)(1), section 263A does not apply to
any property produced by the taxpayer pursuant to a long-term contract
as defined in section 460(f), regardless of whether the taxpayer uses an
inventory method to account for such production.
(3) Costs incurred in certain farming businesses. See section
263A(d) for an exception for costs paid or incurred in certain farming
businesses. See Sec. 1.263A-4 for specific rules relating to taxpayers
engaged in the trade or business of farming.
(4) Costs incurred in raising, harvesting, or growing timber. See
section 263A(c)(5) for an exception for costs paid or incurred in
raising, harvesting, or growing timber and certain ornamental trees. See
Sec. 1.263A-4, however, for rules relating to taxpayers producing
certain trees to which section 263A applies.
(5) Qualified creative expenses. See section 263A(h) for an
exception for qualified creative expenses paid or incurred by certain
free-lance authors, photographers, and artists.
(6) Certain not-for-profit activities. See section 263A(c)(1) for an
exception for property produced by a taxpayer for use by the taxpayer
other than in a trade or business or an activity conducted for profit.
This exception does not apply, however, to property produced by an
exempt organization in connection with its unrelated trade or business
activities.
(7) Intangible drilling and development costs. See section
263A(c)(3) for an exception for intangible drilling and development
costs. Additionally, section 263A does not apply to any amount allowable
as a deduction under section 59(e) with respect to qualified
expenditures under sections 263(c), 616(a), or 617(a).
[[Page 746]]
(8) Natural gas acquired for resale. Under this paragraph (b)(8),
section 263A does not apply to any costs incurred by a taxpayer relating
to natural gas acquired for resale to the extent such costs would
otherwise be allocable to cushion gas.
(i) Cushion gas. Cushion gas is the portion of gas stored in an
underground storage facility or reservoir that is required to maintain
the level of pressure necessary for operation of the facility. However,
section 263A applies to costs incurred by a taxpayer relating to natural
gas acquired for resale to the extent such costs are properly allocable
to emergency gas.
(ii) Emergency gas. Emergency gas is natural gas stored in an
underground storage facility or reservoir for use during periods of
unusually heavy customer demand.
(9) Research and experimental expenditures. See section 263A(c)(2)
for an exception for any research and experimental expenditure allowable
as a deduction under section 174 or the regulations thereunder.
Additionally, section 263A does not apply to any amount allowable as a
deduction under section 59(e) with respect to qualified expenditures
under section 174.
(10) Certain property that is substantially constructed. Section
263A does not apply to any property produced by a taxpayer for use in
its trade or business if substantial construction occurred before March
1, 1986.
(i) For purposes of this section, substantial construction is deemed
to have occurred if the lesser of--
(A) 10 percent of the total estimated costs of construction; or
(B) The greater of $10 million or 2 percent of the total estimated
costs of construction, was incurred before March 1, 1986.
(ii) For purposes of the provision in paragraph (b)(10)(i) of this
section, the total estimated costs of construction shall be determined
by reference to a reasonable estimate, on or before March 1, 1986, of
such amount. Assume, for example, that on March 1, 1986, the estimated
costs of constructing a facility were $150 million. Assume that before
March 1, 1986, $12 million of construction costs had been incurred.
Based on the above facts, substantial construction would be deemed to
have occurred before March 1, 1986, because $12 million (the costs of
construction incurred before such date) is greater than $10 million (the
lesser of $15 million; or the greater of $10 million or $3 million). For
purposes of this provision, construction costs are defined as those
costs incurred after construction has commenced at the site of the
property being constructed (unless the property will not be located on
land and, therefore, the initial construction of the property must begin
at a location other than the intended site). For example, in the case of
a building, construction commences when work begins on the building,
such as the excavation of the site, the pouring of pads for the
building, or the driving of foundation pilings into the ground.
Preliminary activities such as project engineering and architectural
design do not constitute the commencement of construction, nor are such
costs considered construction costs, for purposes of this paragraph
(b)(10).
(11) Certain property provided incident to services--(i) In general.
Under this paragraph (b)(11), section 263A does not apply to property
that is provided to a client (or customer) incident to the provision of
services by the taxpayer if the property provided to the client is--
(A) De minimis in amount; and
(B) Not inventory in the hands of the service provider.
(ii) Definition of services. For purposes of this paragraph (b)(11),
services is defined with reference to its ordinary and accepted meaning
under federal income tax principles. In determining whether a taxpayer
is a bona-fide service provider under this paragraph (b)(11), the nature
of the taxpayer's trade or business and the facts and circumstances
surrounding the taxpayer's trade or business activities must be
considered. Examples of taxpayers qualifying as service providers under
this paragraph include taxpayers performing services in the fields of
health, law, engineering, architecture, accounting, actuarial science,
performing arts, or consulting.
(iii) De minimis property provided incident to services. In
determining whether property provided to a client by a service provider
is de minimis in amount, all facts and circumstances, such as
[[Page 747]]
the nature of the taxpayer's trade or business and the volume of its
service activities in the trade or business, must be considered. A
significant factor in making this determination is the relationship
between the acquisition or direct materials costs of the property that
is provided to clients and the price that the taxpayer charges its
clients for its services and the property. For purposes of this
paragraph (b)(11), if the acquisition or direct materials cost of the
property provided to a client incident to the services is less than or
equal to five percent of the price charged to the client for the
services and property, the property is de minimis. If the acquisition or
direct materials cost of the property exceeds five percent of the price
charged for the services and property, the property may be de minimis if
additional facts and circumstances so indicate.
(12) De minimis rule for certain producers with total indirect costs
of $200,000 or less. See Sec. 1.263A-2(b)(3)(iv) for a de minimis rule
that treats producers with total indirect costs of $200,000 or less as
having no additional section 263A costs (as defined in paragraph (d)(3)
of this section) for purposes of the simplified production method.
(13) Exception for the origination of loans. For purposes of section
263A(b)(2)(A), the origination of loans is not considered the
acquisition of intangible property for resale. (But section
263A(b)(2)(A) does include the acquisition by a taxpayer of pre-existing
loans from other persons for resale.)
(c) General operation of section 263A--(1) Allocations. Under
section 263A, taxpayers must capitalize their direct costs and a
properly allocable share of their indirect costs to property produced or
property acquired for resale. In order to determine these capitalizable
costs, taxpayers must allocate or apportion costs to various activities,
including production or resale activities. After section 263A costs are
allocated to the appropriate production or resale activities, these
costs are generally allocated to the items of property produced or
property acquired for resale during the taxable year and capitalized to
the items that remain on hand at the end of the taxable year. See
however, the simplified production method, the modified simplified
production method, and the simplified resale method in Sec. Sec.
1.263A-2(b) and (c) and 1.263A-3(d).
(2) Otherwise deductible. (i) Any cost which (but for section 263A
and the regulations thereunder) may not be taken into account in
computing taxable income for any taxable year is not treated as a cost
properly allocable to property produced or acquired for resale under
section 263A and the regulations thereunder. Thus, for example, if a
business meal deduction is limited by section 274(n) to 80 percent of
the cost of the meal, the amount properly allocable to property produced
or acquired for resale under section 263A is also limited to 80 percent
of the cost of the meal.
(ii) The amount of any cost required to be capitalized under section
263A may not be included in inventory or charged to capital accounts or
basis any earlier than the taxable year during which the amount is
incurred within the meaning of Sec. 1.446-1(c)(1)(ii).
(3) Capitalize. Capitalize means, in the case of property that is
inventory in the hands of a taxpayer, to include in inventory costs and,
in the case of other property, to charge to a capital account or basis.
(4) Recovery of capitalized costs. Costs that are capitalized under
section 263A are recovered through depreciation, amortization, cost of
goods sold, or by an adjustment to basis at the time the property is
used, sold, placed in service, or otherwise disposed of by the taxpayer.
Cost recovery is determined by the applicable Internal Revenue Code and
regulation provisions relating to use, sale, or disposition of property.
(5) Costs allocable to property sold. A cost that is allocated under
this section, Sec. 1.263A-2, or Sec. 1.263A-3 entirely to property
sold must be included in cost of goods sold and may not be included in
determining the cost of goods on hand at the end of the taxable year.
(d) Definitions--(1) Self-constructed assets. Self-constructed
assets are assets produced by a taxpayer for use by the taxpayer in its
trade or business. Self-constructed assets are subject to section 263A.
[[Page 748]]
(2) Section 471 costs--(i) In general. Except as otherwise provided
in paragraphs (d)(2)(ii), (iv), (v), and (vi) of this section, for
purposes of section 263A, a taxpayer's section 471 costs are the types
of costs, other than interest, that a taxpayer capitalizes to property
produced or property acquired for resale in its financial statement.
Thus, although section 471 applies only to inventories, section 471
costs include any non-inventory costs, other than interest, that a
taxpayer capitalizes to, or includes in acquisition or production costs
of, property produced or property acquired for resale in its financial
statement. Except as otherwise provided in paragraph (d)(2)(iii) of this
section, a taxpayer determines the amounts of section 471 costs by using
the amounts of such costs that are incurred in the taxable year for
federal income tax purposes.
(ii) Inclusion of direct costs--(A) In general. Notwithstanding the
last sentence of paragraph (g)(2) of this section, a taxpayer's section
471 costs must include all direct costs of property produced and
property acquired for resale, whether or not a taxpayer capitalizes
these costs to property produced or property acquired for resale in its
financial statement. See paragraph (e)(2) of this section for a
description of direct costs of property produced and property acquired
for resale.
(B) Allocation of direct costs. Except for any direct costs that are
treated as additional section 263A costs under paragraphs (d)(2)(iv) and
(v) of this section, a taxpayer's direct costs of property produced and
property acquired for resale must be allocated using a method provided
in paragraph (f) of this section.
(iii) Alternative method to determine amounts of section 471 costs
by using taxpayer's financial statement--(A) In general. In lieu of
determining the amounts of section 471 costs under paragraph (d)(2)(i)
of this section, a taxpayer described in paragraph (d)(3)(ii)(B) of this
section may determine the amounts of section 471 costs by using the
amounts of such costs that are incurred in the taxable year in its
financial statement using the taxpayer's financial statement methods of
accounting if the taxpayer's financial statement is described in
paragraph (d)(6)(i), (ii), or (iii) of this section. If the taxpayer's
financial statement is described only in paragraph (d)(6)(iv) of this
section, the taxpayer may not use the alternative method described in
this paragraph (d)(2)(iii) and must use the method described in
paragraph (d)(2)(i) of this section to determine its amounts of section
471 costs. A taxpayer using the alternative method described in this
paragraph (d)(2)(iii) must remove all section 471 costs described in
paragraph (d)(2)(vi) of this section, if any, by including negative
adjustments in additional section 263A costs. A taxpayer using the
alternative method described in this paragraph (d)(2)(iii) applies the
method to all of its section 471 costs, including costs described under
paragraphs (d)(2)(ii), (iv), (v), and (vi) of this section.
(B) Book-to-tax adjustments. A taxpayer using the alternative method
described in this paragraph (d)(2)(iii) must include as additional
section 263A costs all negative and positive adjustments required to be
made as a result of differences in the book and tax amounts of the
taxpayer's section 471 costs, including adjustments for direct costs
required to be added to section 471 costs under paragraph (d)(2)(ii) of
this section, and costs removed from section 471 costs under paragraphs
(d)(2)(vi) and (d)(3)(ii)(B) of this section. In addition, the taxpayer
must include as additional section 263A costs all negative and positive
adjustments required to be made as a result of differences in the book
and tax amounts of section 471 costs that are treated as additional
section 263A costs (for example, de minimis direct costs described in
paragraph (d)(2)(iv) of this section and certain variances and under or
over-applied burdens described in paragraph (d)(2)(v) of this section).
For purposes of determining the negative and positive adjustments
required to be made as a result of differences in book and tax amounts
for a taxpayer using the burden rate or standard cost methods described
in paragraph (f)(3) of this section, the taxpayer compares the actual
amount of the cost incurred in the taxable year for federal income tax
purposes to the actual amount of the cost incurred in the taxable year
in its
[[Page 749]]
financial statement using the taxpayer's financial statement methods of
accounting, regardless of how the taxpayer treats its variances or under
or over-applied burdens.
(C) Exclusion of certain financial statement items. A taxpayer that
determines the amounts of section 471 costs under this paragraph
(d)(2)(iii) may not include any financial statement write-downs,
reserves, or other financial statement valuation adjustments when
determining the amounts of its section 471 costs.
(D) Changes in method of accounting. The use of this method to
determine the amounts of section 471 costs under this paragraph
(d)(2)(iii) is the adoption of, or a change in, a method of accounting
under section 446 of the Internal Revenue Code.
(E) Examples. The following examples illustrate this paragraph
(d)(2)(iii):
(1) Example 1--Alternative-method taxpayer using de minimis direct
labor costs rule. Taxpayer P uses the modified simplified production
method described in Sec. 1.263A-2(c) and determines its amounts of
section 471 costs by using the alternative method under paragraph
(d)(2)(iii) of this section. Additionally, P uses the de minimis direct
labor costs rule under paragraph (d)(2)(iv)(B) of this section. P does
not capitalize vacation pay or holiday pay to property produced or
property acquired for resale in its financial statement but does
capitalize all other direct labor costs to such property in its
financial statement. On its 2018 financial statement, P incurs
$3,500,000 of total direct labor costs, including $110,000 of vacation
pay costs and $10,000 of holiday pay costs. For federal income tax
purposes, P incurs $150,000 of vacation pay costs and $18,000 of holiday
pay costs in the taxable year. P's uncapitalized direct labor costs are
$120,000 ($110,000 of vacation pay plus $10,000 of holiday pay). For
purposes of the five percent test in paragraph (d)(2)(iv)(B) of this
section, P's uncapitalized direct labor costs are 3.43% of total direct
labor costs ($120,000 divided by $3,500,000). Accordingly, under
paragraph (d)(2)(iv)(B) of this section, P includes $120,000 in its
additional section 263A costs and excludes that amount from its section
471 costs in the taxable year. Additionally, pursuant to paragraph
(d)(2)(iii)(B) of this section, P includes in additional section 263A
costs a positive book-to-tax adjustment of $40,000 for vacation pay
costs ($150,000 tax amount-$110,000 book amount) and a positive book-to-
tax adjustment of $8,000 for holiday pay costs ($18,000 tax amount-
$10,000 book amount).
(2) Example 2--Alternative-method taxpayer with under and over-
applied burdens that uses safe harbor rule for certain variances and
under or over-applied burdens. Taxpayer X uses the modified simplified
production method described in Sec. 1.263A-2(c) and determines its
amounts of section 471 costs by using the alternative method under
paragraph (d)(2)(iii) of this section. In 2018, X uses a burden rate
method for book purposes to allocate costs to Products A and B, and does
not capitalize any under or over-applied burdens to property produced or
property acquired for resale in its financial statement. X does not
allocate costs to any other products using a burden rate method, and X
does not allocate costs to any products using a standard cost method. On
its 2018 financial statement, using X's burden rate, the total amount of
predetermined indirect costs for Product A is $545,000 and the total
amount of actual indirect costs incurred for Product A is $550,000;
accordingly, X has an under-applied burden of $5,000 for Product A. For
federal income tax purposes, the actual indirect costs incurred in 2018
for Product A is $560,000. Additionally, on its 2018 financial
statement, using X's burden rate, the total amount of predetermined
indirect costs for Product B is $250,000 and the total amount of actual
indirect costs incurred for Product B is $225,000; accordingly, X has an
over-applied burden of $25,000 for Product B. For federal income tax
purposes, the actual indirect costs incurred in 2018 for Product B is
$240,000. X uses the safe harbor rule for certain variances and under or
over-applied burdens. Prior to the application of this safe harbor rule,
X's total section 471 costs for 2018 for Products A and B (the only
items to which X allocates costs using a standard cost method or burden
rate method) are $2,000,000, which includes $550,000 actual
[[Page 750]]
indirect costs for Product A, $225,000 actual indirect costs for Product
B, and $1,225,000 of other section 471 costs for Products A and B that
are not allocated under X's burden rate method. For purposes of
determining the amount of uncapitalized variances and uncapitalized
under or over-applied burdens for the five percent test in paragraph
(d)(2)(v)(A) of this section, X's under and over-applied burdens for
Products A and B are treated as positive amounts. Consequently, the sum
of X's uncapitalized variances and uncapitalized under or over-applied
burdens is $30,000 ($5,000 under-applied burden for Product A plus
$25,000 over-applied burden for Product B). Accordingly, under paragraph
(d)(2)(v)(A) of this section, the sum of X's uncapitalized variances and
uncapitalized under or over-applied burdens is 1.5% of X's total section
471 costs for all items to which it allocates costs using a standard
cost method or burden rate method ($30,000 divided by $2,000,000), and X
includes a positive $5,000 under-applied burden for Product A and a
negative $25,000 over-applied burden for Product B in its additional
section 263A costs, and excludes those amounts from its section 471
costs. Additionally, pursuant to paragraph (d)(2)(iii)(B) of this
section, X includes in its additional section 263A costs a positive
book-to-tax adjustment of $10,000 for Product A ($560,000 actual cost
tax amount-$550,000 actual cost book amount) and a positive book-to-tax
adjustment of $15,000 for Product B ($240,000 actual tax amount cost-
$225,000 actual book amount cost) in the taxable year.
(iv) De minimis rule exceptions for certain direct costs--(A) In
general. Notwithstanding paragraph (d)(2)(ii) of this section, a
taxpayer that uses the simplified resale method, the simplified
production method, or the modified simplified production method, and
that does not capitalize certain direct costs to property produced or
property acquired for resale in its financial statement (uncapitalized
direct labor costs or uncapitalized direct material costs), may use
either or both the de minimis direct labor costs rule or the de minimis
direct material costs rule to include in additional section 263A costs,
and exclude from section 471 costs, certain uncapitalized direct labor
costs or uncapitalized direct material costs that are incurred in the
taxable year as provided in paragraphs (d)(2)(iv)(B) and (C) of this
section, respectively. The use of the de minimis rules described in
paragraphs (d)(2)(iv)(B) and (C) of this section is the adoption of, or
a change in, a method of accounting under section 446 of the Internal
Revenue Code.
(B) De minimis rule for certain direct labor costs. A taxpayer
described in paragraph (d)(2)(iv)(A) of this section that uses the de
minimis rule described in this paragraph (d)(2)(iv)(B) includes in
additional section 263A costs, and excludes from section 471 costs, the
sum of the amounts of all of those uncapitalized direct labor costs that
are incurred in the taxable year, if that sum is less than five percent
of total direct labor costs incurred in the taxable year (whether or not
capitalized in the taxpayer's financial statement), or another amount
specified in other published guidance (see Sec. 601.601(d)(2) of this
chapter). For purposes of determining the amount of uncapitalized direct
labor costs for this five percent test, any amounts that constitute a
reduction to costs are treated as a positive amount. The amounts of
uncapitalized direct labor costs used for the five percent test, and the
amounts of uncapitalized direct labor costs included in additional
section 263A costs under this paragraph (d)(2)(iv)(B), must not include
amounts relating to basic compensation or overtime, or the types of
costs included in the taxpayer's standard cost or burden rate methods
used for section 471 costs (but see paragraphs (d)(2)(v) and
(f)(3)(i)(C) of this section for special rules for certain variances and
under or over-applied burdens).
(C) De minimis rule for certain direct material costs. A taxpayer
described in paragraph (d)(2)(iv)(A) of this section that uses the de
minimis rule described in this paragraph (d)(2)(iv)(C) includes in
additional section 263A costs, and excludes from section 471 costs, the
sum of the amounts of all of those uncapitalized direct material costs
that are incurred in the taxable year, if that sum is less than five
percent of total direct material costs incurred in
[[Page 751]]
the taxable year (whether or not capitalized in the taxpayer's financial
statement), or another amount specified in other published guidance (see
Sec. 601.601(d)(2) of this chapter). For purposes of determining the
amount of uncapitalized direct material costs for this five percent
test, any amounts that constitute a reduction to costs, such as cash and
trade discounts, are treated as a positive amount. The amounts of
uncapitalized direct material costs used for the five percent test, and
the amounts of uncapitalized direct material costs included in
additional section 263A costs under this paragraph (d)(2)(iv)(C), must
not include the types of costs included in the taxpayer's standard cost
method used for section 471 costs (but see paragraphs (d)(2)(v) and
(f)(3)(ii)(B) of this section for special rules for certain variances).
(D) Taxpayers using a historic absorption ratio. A taxpayer that
uses the historic absorption ratio provided in Sec. 1.263A-2(b)(4) or
(c)(4) or Sec. 1.263A-3(d)(4), and that uses a de minimis rule
described in paragraph (d)(2)(iv) of this section during its test period
or updated test period, determines whether direct labor costs or direct
material costs, as applicable, are included in any of its section 471
costs remaining on hand at year end during its qualifying period or
extended qualifying period according to how those direct labor costs or
direct material costs, respectively, are identified in at least two of
the three years of the taxpayer's applicable test period or updated test
period. If a taxpayer described in this paragraph (d)(2)(iv)(D) is
required to revise any of its actual absorption ratios for its test
period or updated test period as a result of a change in a method of
accounting, the taxpayer determines whether direct labor costs or direct
material costs, as applicable, are included in any of its section 471
costs on hand at year end during a qualifying period or extended
qualifying period according to how those direct labor costs or direct
material costs, respectively, are identified in the taxpayer's revised
actual absorption ratios during its applicable test period or updated
test period.
(E) Examples. The following examples illustrate this paragraph
(d)(2)(iv):
(1) Example 1--Taxpayer using de minimis direct material costs rule.
Taxpayer R uses the modified simplified production method described in
Sec. 1.263A-2(c) and the de minimis method of accounting under
paragraph (d)(2)(iv)(C) of this section. In 2018, R does not capitalize
freight-in costs or trade discounts to property produced or property
acquired for resale in its financial statement but does capitalize all
other direct material costs to such property in its financial statement.
R incurs total direct material costs of $3,105,000, which represents
invoice price of $3,000,000 on goods purchased, plus $120,000 of
freight-in costs, less $15,000 for trade discounts. For purposes of
determining the amount of uncapitalized direct material costs for the
five percent test in paragraph (d)(2)(iv)(C) of this section, R's trade
discounts are treated as a positive amount. Consequently, R's
uncapitalized direct material costs for purposes of the five percent
test are $135,000 ($120,000 of freight-in plus $15,000 of trade
discounts). Accordingly, under paragraph (d)(2)(iv)(C) of this section,
R's uncapitalized direct material costs are 4.35% of total direct
material costs ($135,000 divided by $3,105,000), and R includes a
positive $120,000 of freight-in and a negative $15,000 of trade
discounts in its additional section 263A costs and excludes those
amounts from its section 471 costs in the taxable year.
(2) Example 2--Taxpayer using de minimis direct labor costs rule and
historic absorption ratio. Taxpayer S uses the historic absorption ratio
provided in Sec. 1.263A-2(c)(4). S uses the de minimis method of
accounting under paragraph (d)(2)(iv)(B). S excludes certain
uncapitalized direct labor costs from its section 471 costs (and
includes them in additional section 263A costs) under paragraph
(d)(2)(iv)(B) of this section in Years 1 and 3 of its applicable test
period. Because S excluded direct labor costs from its section 471 costs
in at least two of the three years of its applicable test period, S must
exclude those same costs from its pre-production and production section
471 costs remaining
[[Page 752]]
on hand at year end during its qualifying period or extended qualifying
period.
(v) Safe harbor method for certain variances and under or over-
applied burdens--(A) In general. Notwithstanding paragraphs (d)(2)(i)
and (ii), (f)(3)(i)(C), and (f)(3)(ii)(B) of this section, a taxpayer
that uses the simplified resale method, the simplified production
method, or the modified simplified production method, may use the safe
harbor method described in this paragraph (d)(2)(v)(A) for all of its
variances and under or over-applied burdens that are not capitalized to
property produced or property acquired for resale in its financial
statement (uncapitalized variances and uncapitalized under or over-
applied burdens). A taxpayer using this safe harbor method must include
in additional section 263A costs, and exclude from section 471 costs,
the sum of the amounts of all of those uncapitalized variances and
uncapitalized under or over-applied burdens for the taxable year, if
that sum is less than five percent of the taxpayer's total section 471
costs for all items to which it allocates costs using a standard cost
method or burden rate method, or another percentage specified in other
published guidance (see Sec. 601.601(d)(2) of this chapter). If the sum
of uncapitalized variances and uncapitalized under or over-applied
burdens is not less than this five percent threshold, the taxpayer may
not exclude such uncapitalized variances and uncapitalized under or
over-applied burdens from section 471 costs, and must reallocate such
uncapitalized variances and uncapitalized under or over-applied burdens
to or among the units of property to which the costs are allocable in
accordance with paragraphs (f)(3)(i)(C) and (f)(3)(ii)(B) of this
section (but see paragraph (d)(2)(v)(B) of this section for a rule that
a taxpayer using the safe harbor method described in this paragraph
(d)(2)(v)(A) may not use the methods of accounting described in
paragraphs (f)(3)(i)(C) and (f)(3)(ii)(B) of this section to treat
certain uncapitalized variances and certain uncapitalized under or over-
applied burdens as not allocable to property). For purposes of
determining the amounts of uncapitalized variances and uncapitalized
under or over-applied burdens for this five percent test, all variances
and under or over-applied burdens are treated as positive amounts.
Additionally, for purposes of this five percent test, a taxpayer's total
section 471 costs for all items to which it allocates costs using a
standard cost method or burden rate method are determined before
application of the safe harbor method described in this paragraph
(d)(2)(v)(A), and therefore this amount must reflect the actual amounts
incurred by the taxpayer for those items during the taxable year, which
includes variances and under or over-applied burdens. The variances
described in this paragraph (d)(2)(v)(A) include any variances on cash
or trade discounts, if those discounts are capitalized as part of the
taxpayer's standard cost method used for section 471 costs.
(B) Consistency requirement. A taxpayer using the safe harbor method
described in paragraph (d)(2)(v)(A) of this section must use the method
consistently for all items to which it allocates costs using a standard
cost method or burden rate method and may not use the methods of
accounting described in paragraphs (f)(3)(i)(C) and (f)(3)(ii)(B) of
this section to treat its uncapitalized variances and uncapitalized
under or over-applied burdens that are not significant in amount
relative to the taxpayer's total indirect costs incurred with respect to
production and resale activities for the year as not allocable to
property produced or property acquired for resale.
(C) Allocation of variances and under or over-applied burdens
between production and preproduction costs under the modified simplified
production method. In the case of a taxpayer using the modified
simplified production method and the safe harbor method described in
paragraph (d)(2)(v)(A) of this section, uncapitalized variances and
uncapitalized under or over-applied burdens treated as additional
section 263A costs under the safe harbor method must be allocated
between production additional section 263A costs, as described in Sec.
1.263A-2(c)(3)(ii)(D)(1), and pre-production additional section 263A
costs, as described in Sec. 1.263A-2(c)(3)(ii)(B)(1), using any
reasonable
[[Page 753]]
method. In the case of a taxpayer using the modified simplified
production method and the safe harbor method described in paragraph
(d)(2)(v)(A) of this section, uncapitalized variances and uncapitalized
under or over-applied burdens that are not excluded from section 471
costs must be allocated between production section 471 costs, as
described in Sec. 1.263A-2(c)(3)(ii)(D)(3), and pre-production section
471 costs, as described in Sec. 1.263A-2(c)(3)(ii)(B)(2) based on the
taxpayer's reallocation of such uncapitalized variances and
uncapitalized under or over-applied burdens to or among the units of
property to which the costs are allocable in accordance with paragraphs
(f)(3)(i)(C) and (f)(3)(ii)(B) of this section, as described in
paragraph (d)(2)(v)(A) of this section.
(D) Allocation of variances and under or over-applied burdens
between storage and handling costs absorption ratio and purchasing costs
absorption ratio under the simplified resale method. In the case of a
taxpayer using the simplified resale method, any uncapitalized variances
and uncapitalized under or over-applied burdens treated as additional
section 263A costs under the safe harbor method described in paragraph
(d)(2)(v)(A) of this section must be allocated between storage and
handling costs, as described in Sec. 1.263A-3(d)(3)(i)(D)(2), and
current year's purchasing costs, as described in Sec. 1.263A-
3(d)(3)(i)(E)(2), using any reasonable method.
(E) Method of accounting. The use of the safe harbor method
described in this paragraph (d)(2)(v) is the adoption of, or a change
in, a method of accounting under section 446 of the Internal Revenue
Code.
(vi) Removal of section 471 costs. A taxpayer must remove those
costs included in its section 471 costs that are not permitted to be
capitalized under either paragraph (c)(2) or (j)(2)(ii) of this section
and those costs included in its section 471 costs that are eligible for
capitalization under paragraph (j)(2) of this section that the taxpayer
does not elect to capitalize under section 263A. Except as otherwise
provided in paragraph (d)(3)(ii)(B) of this section, a taxpayer must
remove costs pursuant to this paragraph (d)(2)(vi) by adjusting its
section 471 costs and may not remove the costs by including a negative
adjustment in its additional section 263A costs. A taxpayer that removes
costs pursuant to this paragraph (d)(2)(vi) by adjusting its section 471
costs must use a reasonable method that approximates the manner in which
the taxpayer originally capitalized the costs to its property produced
or property acquired for resale in its financial statement.
(vii) Method changes. A taxpayer using the simplified production
method, simplified resale method, or the modified simplified production
method and that changes its financial statement practices for a cost in
a manner that would change its section 471 costs is required to change
its method of accounting for federal income tax purposes. A taxpayer may
change its method of accounting for determining section 471 costs only
with the consent of the Commissioner as required under section 446(e)
and the corresponding regulations.
(3) Additional section 263A costs--(i) In general. Additional
section 263A costs are the costs, other than interest, that are not
included in a taxpayer's section 471 costs but that are required to be
capitalized under section 263A. Additional section 263A costs generally
do not include the direct costs that are required to be included in a
taxpayer's section 471 costs under paragraph (d)(2)(ii) of this section;
however, additional section 263A costs must include any direct costs
excluded from section 471 costs under paragraphs (d)(2)(iv) and (v) of
this section. For a taxpayer using the alternative method described in
paragraph (d)(2)(iii) of this section, additional section 263A costs
must also include any negative or positive adjustments required to be
made as a result of differences in the book and tax amounts of the
taxpayer's section 471 costs.
(ii) Negative adjustments--(A) In general. Except as otherwise
provided by regulations or other published guidance (see Sec.
601.601(d)(2) of this chapter), a taxpayer may not include negative
adjustments in additional section 263A costs. However, for a taxpayer
using the alternative method described in paragraph (d)(2)(iii) of this
section, see
[[Page 754]]
paragraph (d)(2)(iii)(B) of this section for negative or positive
adjustments required to be made as a result of differences in the book
and tax amounts of the taxpayer's section 471 costs.
(B) Exception for certain taxpayers removing costs from section 471
costs. Notwithstanding paragraphs (d)(2)(vi) and (d)(3)(ii)(A) of this
section, and except as otherwise provided in paragraphs (d)(3)(ii)(C)
and (D) of this section, the following taxpayers may, but are not
required to, include negative adjustments in additional section 263A
costs to remove the taxpayer's section 471 costs that are described in
paragraph (d)(2)(vi) of this section (costs that are not required to be,
or are not permitted to be, capitalized under section 263A):
(1) A taxpayer using the simplified production method under Sec.
1.263A-2(b) if the taxpayer's (or its predecessor's) average annual
gross receipts for the three previous taxable years (test period) do not
exceed $50,000,000, or another amount specified in other published
guidance (see Sec. 601.601(d)(2) of this chapter). The rules of Sec.
1.263A-1(j) apply for purposes of determining the amount of a taxpayer's
gross receipts and the test period;
(2) A taxpayer using the modified simplified production method under
Sec. 1.263A-2(c); and
(3) A taxpayer using the simplified resale method under Sec.
1.263A-3(d).
(C) No negative adjustments for cash or trade discounts. A taxpayer
may not include negative adjustments in additional section 263A costs
for cash or trade discounts described in Sec. 1.471-3(b). However, see
paragraph (d)(2)(iv)(C) of this section for a de minimis rule for
certain direct material costs that may be included in additional section
263A costs and paragraph (d)(2)(v) of this section for certain variance
amounts that may be included in additional section 263A costs.
(D) No negative adjustments for certain expenses. A taxpayer may not
include negative adjustments in additional section 263A costs for an
amount which is of a type for which a deduction would be disallowed
under section 162(c), (e), (f), or (g) and the regulations thereunder in
the case of a business expense.
(E) Consistency requirement for negative adjustments. A taxpayer
that is permitted to include negative adjustments in additional section
263A costs to remove section 471 costs under paragraph (d)(3)(ii)(B) of
this section and that includes negative adjustments to remove section
471 costs must use that method of accounting to remove all section 471
costs required to be removed under paragraph (d)(2)(vi) of this section.
(4) Section 263A costs. Section 263A costs are defined as the costs
that a taxpayer must capitalize under section 263A. Thus, section 263A
costs are the sum of a taxpayer's section 471 costs, its additional
section 263A costs, and interest capitalizable under section 263A(f).
(5) Classification of costs. A taxpayer must classify section 471
costs, additional section 263A costs, and any permitted adjustments to
section 471 or additional section 263A costs, using the narrower of the
classifications of costs described in paragraphs (e)(2), (3), and (4) of
this section, whether or not the taxpayer is required to maintain
inventories, or the classifications of costs used by a taxpayer in its
financial statement. If a cost is not described in paragraph (e)(2),
(3), or (4) of this section, the cost is to be classified using the
classification of costs used in the taxpayer's financial statement.
(6) Financial statement. For purposes of section 263A, financial
statement means the taxpayer's financial statement listed in paragraphs
(d)(6)(i) through (iv) of this section that has the highest priority,
including within paragraphs (d)(6)(ii) and (iv) of this section. The
financial statements are, in descending priority:
(i) A financial statement required to be filed with the Securities
and Exchange Commission (SEC) (the 10-K or the Annual Statement to
Shareholders);
(ii) A certified audited financial statement that is accompanied by
the report of an independent certified public accountant (or in the case
of a foreign entity, by the report of a similarly qualified independent
professional) that is used for:
(A) Credit purposes;
(B) Reporting to shareholders, partners, or similar persons; or
(C) Any other substantial non-tax purpose;
[[Page 755]]
(iii) A financial statement (other than a tax return) required to be
provided to the federal or a state government or any federal or state
agency (other than the SEC or the Internal Revenue Service); or
(iv) A financial statement that is used for:
(A) Credit purposes;
(B) Reporting to shareholders, partners, or similar persons; or
(C) Any other substantial non-tax purpose.
(e) Types of costs subject to capitalization--(1) In general.
Taxpayers subject to section 263A must capitalize all direct costs and
certain indirect costs properly allocable to property produced or
property acquired for resale. This paragraph (e) describes the types of
costs subject to section 263A.
(2) Direct costs--(i) Producers. Producers must capitalize direct
material costs and direct labor costs.
(A) Direct material costs. Direct materials costs include the cost
of those materials that become an integral part of specific property
produced and those materials that are consumed in the ordinary course of
production and that can be identified or associated with particular
units or groups of units of property produced. For example, a cost
described in Sec. 1.162-3, relating to the cost of a material or
supply, may be a direct material cost.
(B) Direct labor costs include the costs of labor that can be
identified or associated with particular units or groups of units of
specific property produced. For this purpose, labor encompasses full-
time and part-time employees, as well as contract employees and
independent contractors. Direct labor costs include all elements of
compensation other than employee benefit costs described in paragraph
(e)(3)(ii)(D) of this section. Elements of direct labor costs include
basic compensation, overtime pay, vacation pay, holiday pay, sick leave
pay (other than payments pursuant to a wage continuation plan under
section 105(d) as it existed prior to its repeal in 1983), shift
differential, payroll taxes, and payments to a supplemental unemployment
benefit plan.
(ii) Resellers. Resellers must capitalize the acquisition costs of
property acquired for resale. In the case of inventory, the acquisition
cost is the cost described in Sec. 1.471-3(b).
(3) Indirect costs--(i) In general. (A) Indirect costs are defined
as all costs other than direct material costs and direct labor costs (in
the case of property produced) or acquisition costs (in the case of
property acquired for resale). Taxpayers subject to section 263A must
capitalize all indirect costs properly allocable to property produced or
property acquired for resale. Indirect costs are properly allocable to
property produced or property acquired for resale when the costs
directly benefit or are incurred by reason of the performance of
production or resale activities. Indirect costs may directly benefit or
be incurred by reason of the performance of production or resale
activities even if the costs are calculated as a percentage of revenue
or gross profit from the sale of inventory, are determined by reference
to the number of units of property sold, or are incurred only upon the
sale of inventory. Indirect costs may be allocable to both production
and resale activities, as well as to other activities that are not
subject to section 263A. Taxpayers must make a reasonable allocation of
indirect costs between production, resale, and other activities.
(B) Example. The following example illustrates the provisions of
this paragraph (e)(3)(i):
(i) Taxpayer A manufactures tablecloths and other linens. A enters
into a licensing agreement with Company L under which A may label its
tablecloths with L's trademark if the tablecloths meet certain specified
quality standards. In exchange for its right to use L's trademark, the
licensing agreement requires A to pay L a royalty of $X for each
tablecloth carrying L's trademark that A sells. The licensing agreement
does not require A to pay L any minimum or lump-sum royalties.
(ii) The licensing agreement provides A with the right to use L's
intellectual property, a trademark. The licensing agreement also
requires A to conduct its production activities according to certain
standards as a condition of exercising that right. Thus, A's right to
use L's trademark under the licensing agreement is directly related to
A's
[[Page 756]]
production of tablecloths. The royalties the licensing agreement
requires A to pay for using L's trademark are the costs A incurs in
exchange for these rights. Therefore, although A incurs royalty costs
only when A sells a tablecloth carrying L's trademark, the royalty costs
directly benefit production activities and are incurred by reason of
production activities within the meaning of paragraph (e)(3)(i)(A) of
this section.
(ii) Examples of indirect costs required to be capitalized. The
following are examples of indirect costs that must be capitalized to the
extent they are properly allocable to property produced or property
acquired for resale:
(A) Indirect labor costs. Indirect labor costs include all labor
costs (including the elements of labor costs set forth in paragraph
(e)(2)(i) of this section) that cannot be directly identified or
associated with particular units or groups of units of specific property
produced or property acquired for resale (e.g., factory labor that is
not direct labor). As in the case of direct labor, indirect labor
encompasses full-time and part-time employees, as well as contract
employees and independent contractors.
(B) Officers' compensation. Officers' compensation includes
compensation paid to officers of the taxpayer.
(C) Pension and other related costs. Pension and other related costs
include contributions paid to or made under any stock bonus, pension,
profit-sharing or annuity plan, or other plan deferring the receipt of
compensation, whether or not the plan qualifies under section 401(a).
Contributions to employee plans representing past services must be
capitalized in the same manner (and in the same proportion to property
currently being acquired or produced) as amounts contributed for current
service.
(D) Employee benefit expenses. Employee benefit expenses include all
other employee benefit expenses (not described in paragraph
(e)(3)(ii)(C) of this section) to the extent such expenses are otherwise
allowable as deductions under chapter 1 of the Internal Revenue Code.
These other employee benefit expenses include: worker's compensation;
amounts otherwise deductible or allowable in reducing earnings and
profits under section 404A; payments pursuant to a wage continuation
plan under section 105(d) as it existed prior to its repeal in 1983;
amounts includible in the gross income of employees under a method or
arrangement of employer contributions or compensation that has the
effect of a stock bonus, pension, profit-sharing or annuity plan, or
other plan deferring receipt of compensation or providing deferred
benefits; premiums on life and health insurance; and miscellaneous
benefits provided for employees such as safety, medical treatment,
recreational and eating facilities, membership dues, etc. Employee
benefit expenses do not, however, include direct labor costs described
in paragraph (e)(2)(i) of this section.
(E) Indirect material costs. Indirect material costs include the
cost of materials that are not an integral part of specific property
produced and the cost of materials that are consumed in the ordinary
course of performing production or resale activities that cannot be
identified or associated with particular units of property. Thus, for
example, a cost described in Sec. 1.162-3, relating to the cost of a
material or supply, may be an indirect cost.
(F) Purchasing costs. Purchasing costs include costs attributable to
purchasing activities. See Sec. 1.263A-3(c)(3) for a further discussion
of purchasing costs.
(G) Handling costs. Handling costs include costs attributable to
processing, assembling, repackaging and transporting goods, and other
similar activities. See Sec. 1.263A-3(c)(4) for a further discussion of
handling costs.
(H) Storage costs. Storage costs include the costs of carrying,
storing, or warehousing property. See Sec. 1.263A-3(c)(5) for a further
discussion of storage costs.
(I) Cost recovery. Cost recovery includes depreciation,
amortization, and cost recovery allowances on equipment and facilities
(including depreciation or amortization of self-constructed assets or
other previously produced or acquired property to which section 263A or
section 263 applies).
(J) Depletion. Depletion includes allowances for depletion, whether
or not
[[Page 757]]
in excess of cost. Depletion is, however, only properly allocable to
property that has been sold (i.e., for purposes of determining gain or
loss on the sale of the property).
(K) Rent. Rent includes the cost of renting or leasing equipment,
facilities, or land.
(L) Taxes. Taxes include those taxes (other than taxes described in
paragraph (e)(3)(iii)(F) of this section) that are otherwise allowable
as a deduction to the extent such taxes are attributable to labor,
materials, supplies, equipment, land, or facilities used in production
or resale activities.
(M) Insurance. Insurance includes the cost of insurance on plant or
facility, machinery, equipment, materials, property produced, or
property acquired for resale.
(N) Utilities. Utilities include the cost of electricity, gas, and
water.
(O) Repairs and maintenance. Repairs and maintenance include the
cost of repairing and maintaining equipment or facilities.
(P) Engineering and design costs. Engineering and design costs
include pre-production costs, such as costs attributable to research,
experimental, engineering, and design activities (to the extent that
such amounts are not research and experimental expenditures as described
in section 174 and the regulations thereunder).
(Q) Spoilage. Spoilage includes the costs of rework labor, scrap,
and spoilage.
(R) Tools and equipment. Tools and equipment include the costs of
tools and equipment which are not otherwise capitalized.
(S) Quality control. Quality control includes the costs of quality
control and inspection.
(T) Bidding costs. Bidding costs are costs incurred in the
solicitation of contracts (including contracts pertaining to property
acquired for resale) ultimately awarded to the taxpayer. The taxpayer
must defer all bidding costs paid or incurred in the solicitation of a
particular contract until the contract is awarded. If the contract is
awarded to the taxpayer, the bidding costs become part of the indirect
costs allocated to the subject matter of the contract. If the contract
is not awarded to the taxpayer, bidding costs are deductible in the
taxable year that the contract is awarded to another party, or in the
taxable year that the taxpayer is notified in writing that no contract
will be awarded and that the contract (or a similar or related contract)
will not be rebid, or in the taxable year that the taxpayer abandons its
bid or proposal, whichever occurs first. Abandoning a bid does not
include modifying, supplementing, or changing the original bid or
proposal. If the taxpayer is awarded only part of the bid (for example,
the taxpayer submitted one bid to build each of two different types of
products, and the taxpayer was awarded a contract to build only one of
the two types of products), the taxpayer shall deduct the portion of the
bidding costs related to the portion of the bid not awarded to the
taxpayer. In the case of a bid or proposal for a multi-unit contract,
all bidding costs must be included in the costs allocated to the subject
matter of the contract awarded to the taxpayer to produce or acquire for
resale any of such units. For example, where the taxpayer submits one
bid to produce three similar turbines and the taxpayer is awarded a
contract to produce only two of the three turbines, all bidding costs
must be included in the cost of the two turbines. For purposes of this
paragraph (e)(3)(ii)(T), a contract means--
(1) In the case of a specific unit of property, any agreement under
which the taxpayer would produce or sell property to another party if
the agreement is entered into before the taxpayer produces or acquires
the specific unit of property to be delivered to the party under the
agreement; and
(2) In the case of fungible property, any agreement to the extent
that, at the time the agreement is entered into, the taxpayer has on
hand an insufficient quantity of completed fungible items of such
property that may be used to satisfy the agreement (plus any other
production or sales agreements of the taxpayer).
(U) Licensing and franchise costs. (1) Licensing and franchise costs
include fees incurred in securing the contractual right to use a
trademark, corporate plan, manufacturing procedure,
[[Page 758]]
special recipe, or other similar right associated with property produced
or property acquired for resale. These costs include the otherwise
deductible portion (such as amortization) of the initial fees incurred
to obtain the license or franchise and any minimum annual payments and
any royalties that are incurred by a licensee or a franchisee. These
costs also include fees, payments, and royalties otherwise described in
this paragraph (e)(3)(ii)(U) that a taxpayer incurs (within the meaning
of section 461) only upon the sale of property produced or acquired for
resale.
(2) If a taxpayer incurs (within the meaning of section 461) a fee,
payment, or royalty described in this paragraph (e)(3)(ii)(U) only upon
the sale of property produced or acquired for resale and the cost is
required to be capitalized under this paragraph (e)(3), the taxpayer may
properly allocate the cost entirely to property produced or acquired for
resale by the taxpayer that has been sold.
(V) Interest. Interest includes interest on debt incurred or
continued during the production period to finance the production of real
property or tangible personal property to which section 263A(f) applies.
(W) Capitalizable service costs. Service costs that are required to
be capitalized include capitalizable service costs and capitalizable
mixed service costs as defined in paragraph (e)(4) of this section.
(iii) Indirect costs not capitalized. The following indirect costs
are not required to be capitalized under section 263A:
(A) Selling and distribution costs. These costs are marketing,
selling, advertising, and distribution costs.
(B) Research and experimental expenditures. Research and
experimental expenditures are expenditures described in section 174 and
the regulations thereunder.
(C) Section 179 costs. Section 179 costs are expenses for certain
depreciable assets deductible at the election of the taxpayer under
section 179 and the regulations thereunder.
(D) Section 165 losses. Section 165 losses are losses under section
165 and the regulations thereunder.
(E) Cost recovery allowances on temporarily idle equipment and
facilities--(1) In general. Cost recovery allowances on temporarily idle
equipment and facilities include only depreciation, amortization, and
cost recovery allowances on equipment and facilities that have been
placed in service but are temporarily idle. Equipment and facilities are
temporarily idle when a taxpayer takes them out of service for a finite
period. However, equipment and facilities are not considered temporarily
idle--
(i) During worker breaks, non-working hours, or on regularly
scheduled non-working days (such as holidays or weekends);
(ii) During normal interruptions in the operation of the equipment
or facilities;
(iii) When equipment is enroute to or located at a job site; or
(iv) When under normal operating conditions, the equipment is used
or operated only during certain shifts.
(2) Examples. The provisions of this paragraph (e)(3)(iii)(E) are
illustrated by the following examples:
Example 1. Equipment operated only during certain shifts. Taxpayer A
manufactures widgets. Although A's manufacturing facility operates 24
hours each day in three shifts, A only operates its stamping machine
during one shift each day. Because A only operates its stamping machine
during certain shifts, A's stamping machine is not considered
temporarily idle during the two shifts that it is not operated.
Example 2. Facility shut down for retooling. Taxpayer B owns and
operates a manufacturing facility. B closes its manufacturing facility
for two weeks to retool its assembly line. B's manufacturing facility is
considered temporarily idle during this two-week period.
(F) Taxes assessed on the basis of income. Taxes assessed on the
basis of income include only state, local, and foreign income taxes, and
franchise taxes that are assessed on the taxpayer based on income.
(G) Strike expenses. Strike expenses include only costs associated
with hiring employees to replace striking personnel (but not wages of
replacement personnel), costs of security, and legal fees associated
with settling strikes.
[[Page 759]]
(H) Warranty and product liability costs. Warranty costs and product
liability costs are costs incurred in fulfilling product warranty
obligations for products that have been sold and costs incurred for
product liability insurance.
(I) On-site storage costs. On-site storage costs are storage and
warehousing costs incurred by a taxpayer at an on-site storage facility,
as defined in Sec. 1.263A-3(c)(5)(ii)(A), with respect to property
produced or property acquired for resale.
(J) Unsuccessful bidding expenses. Unsuccessful bidding costs are
bidding expenses incurred in the solicitation of contracts not awarded
to the taxpayer.
(K) Deductible service costs. Service costs that are not required to
be capitalized include deductible service costs and deductible mixed
service costs as defined in paragraph (e)(4) of this section.
(4) Service costs--(i) Introduction. This paragraph (e)(4) provides
definitions and categories of service costs. Paragraph (g)(4) of this
section provides specific rules for determining the amount of service
costs allocable to property produced or property acquired for resale. In
addition, paragraph (h) of this section provides a simplified method for
determining the amount of service costs that must be capitalized.
(A) Definition of service costs. Service costs are defined as a type
of indirect costs (e.g., general and administrative costs) that can be
identified specifically with a service department or function or that
directly benefit or are incurred by reason of a service department or
function.
(B) Definition of service departments. Service departments are
defined as administrative, service, or support departments that incur
service costs. The facts and circumstances of the taxpayer's activities
and business organization control whether a department is a service
department. For example, service departments include personnel,
accounting, data processing, security, legal, and other similar
departments.
(ii) Various service cost categories--(A) Capitalizable service
costs. Capitalizable service costs are defined as service costs that
directly benefit or are incurred by reason of the performance of the
production or resale activities of the taxpayer. Therefore, these
service costs are required to be capitalized under section 263A.
Examples of service departments or functions that incur capitalizable
service costs are provided in paragraph (e)(4)(iii) of this section.
(B) Deductible service costs. Deductible service costs are defined
as service costs that do not directly benefit or are not incurred by
reason of the performance of the production or resale activities of the
taxpayer, and therefore, are not required to be capitalized under
section 263A. Deductible service costs generally include costs incurred
by reason of the taxpayer's overall management or policy guidance
functions. In addition, deductible service costs include costs incurred
by reason of the marketing, selling, advertising, and distribution
activities of the taxpayer. Examples of service departments or functions
that incur deductible service costs are provided in paragraph (e)(4)(iv)
of this section.
(C) Mixed service costs. Mixed service costs are defined as service
costs that are partially allocable to production or resale activities
(capitalizable mixed service costs) and partially allocable to non-
production or non-resale activities (deductible mixed service costs).
For example, a personnel department may incur costs to recruit factory
workers, the costs of which are allocable to production activities, and
it may incur costs to develop wage, salary, and benefit policies, the
costs of which are allocable to non-production activities.
(iii) Examples of capitalizable service costs. Costs incurred in the
following departments or functions are generally allocated among
production or resale activities:
(A) The administration and coordination of production or resale
activities (wherever performed in the business organization of the
taxpayer).
(B) Personnel operations, including the cost of recruiting, hiring,
relocating, assigning, and maintaining personnel records or employees.
(C) Purchasing operations, including purchasing materials and
equipment, scheduling and coordinating delivery of materials and
equipment to or from factories or job sites, and expediting and follow-
up.
[[Page 760]]
(D) Materials handling and warehousing and storage operations.
(E) Accounting and data services operations, including, for example,
cost accounting, accounts payable, disbursements, and payroll functions
(but excluding accounts receivable and customer billing functions).
(F) Data processing.
(G) Security services.
(H) Legal services.
(iv) Examples of deductible service costs. Costs incurred in the
following departments or functions are not generally allocated to
production or resale activities:
(A) Departments or functions responsible for overall management of
the taxpayer or for setting overall policy for all of the taxpayer's
activities or trades or businesses, such as the board of directors
(including their immediate staff), and the chief executive, financial,
accounting, and legal officers (including their immediate staff) of the
taxpayer, provided that no substantial part of the cost of such
departments or functions benefits a particular production or resale
activity.
(B) Strategic business planning.
(C) General financial accounting.
(D) General financial planning (including general budgeting) and
financial management (including bank relations and cash management).
(E) Personnel policy (such as establishing and managing personnel
policy in general; developing wage, salary, and benefit policies;
developing employee training programs unrelated to particular production
or resale activities; negotiating with labor unions; and maintaining
relations with retired workers).
(F) Quality control policy.
(G) Safety engineering policy.
(H) Insurance or risk management policy (but not including bid or
performance bonds or insurance related to activities associated with
property produced or property acquired for resale).
(I) Environmental management policy (except to the extent that the
costs of any system or procedure benefits a particular production or
resale activity).
(J) General economic analysis and forecasting.
(K) Internal audit.
(L) Shareholder, public, and industrial relations.
(M) Tax services.
(N) Marketing, selling, or advertising.
(f) Cost allocation methods--(1) Introduction. This paragraph (f)
sets forth various detailed or specific (facts-and-circumstances) cost
allocation methods that taxpayers may use to allocate direct and
indirect costs to property produced and property acquired for resale.
Paragraph (g) of this section provides general rules for applying these
allocation methods to various categories of costs (i.e., direct
materials, direct labor, and indirect costs, including service costs).
In addition, in lieu of a facts-and-circumstances allocation method,
taxpayers may use the simplified methods provided in Sec. Sec. 1.263A-
2(b) and (c) and 1.263A-3(d) to allocate direct and indirect costs to
eligible property produced or eligible property acquired for resale; see
those sections for definitions of eligible property. Paragraph (h) of
this section provides a simplified method for determining the amount of
mixed service costs required to be capitalized to eligible property. The
methodology set forth in paragraph (h) of this section for mixed service
costs may be used in conjunction with either a facts-and-circumstances
or a simplified method of allocating costs to eligible property produced
or eligible property acquired for resale.
(2) Specific identification method. A specific identification method
traces costs to a cost objective, such as a function, department,
activity, or product, on the basis of a cause and effect or other
reasonable relationship between the costs and the cost objective.
(3) Burden rate and standard cost meth- ods--(i) Burden rate
method--(A) In gen- eral. A burden rate method allocates an appropriate
amount of indirect costs to property produced or property acquired for
resale during a taxable year using predetermined rates that approximate
the actual amount of indirect costs incurred by the taxpayer during the
taxable year. Burden rates (such as ratios based on direct costs, hours,
or similar items) may be developed by the taxpayer in accordance with
acceptable accounting principles and applied in a
[[Page 761]]
reasonable manner. A taxpayer may allocate different indirect costs on
the basis of different burden rates. Thus, for example, the taxpayer may
use one burden rate for allocating the cost of rent and another burden
rate for allocating the cost of utilities. Any periodic adjustment to a
burden rate that merely reflects current operating conditions, such as
increases in automation or changes in operation or prices, is not a
change in method of accounting under section 446(e). A change, however,
in the concept or base upon which such rates are developed, such as a
change from basing the rates on direct labor hours to basing them on
direct machine hours, is a change in method of accounting to which
section 446(e) applies.
(B) Development of burden rates. The following factors, among
others, may be used in developing burden rates:
(1) The selection of an appropriate level of activity and a period
of time upon which to base the calculation of rates reflecting operating
conditions for purposes of the unit costs being determined.
(2) The selection of an appropriate statistical base, such as direct
labor hours, direct labor dollars, machine hours, or a combination
thereof, upon which to apply the overhead rate.
(3) The appropriate budgeting, classification, and analysis of
expenses (for example, the analysis of fixed versus variable costs).
(C) Operation of the burden rate method. The purpose of the burden
rate method is to allocate an appropriate amount of indirect costs to
production or resale activities through the use of predetermined rates
intended to approximate the actual amount of indirect costs incurred.
Accordingly, the proper use of the burden rate method under this section
requires that any net negative or net positive difference between the
total predetermined amount of costs allocated to property and the total
amount of indirect costs actually incurred and required to be allocated
to such property (i.e., the under or over-applied burden) must be
treated as an adjustment to the taxpayer's ending inventory or capital
account (as the case may be) in the taxable year in which such
difference arises. However, if such adjustment is not significant in
amount in relation to the taxpayer's total indirect costs incurred with
respect to production or resale activities for the year, such adjustment
need not be allocated to the property produced or property acquired for
resale unless such allocation is made in the taxpayer's financial
statement. The taxpayer must treat both positive and negative
adjustments consistently.
(ii) Standard cost method--(A) In general. A standard cost method
allocates an appropriate amount of direct and indirect costs to property
produced by the taxpayer through the use of preestablished standard
allowances, without reference to costs actually incurred during the
taxable year. A taxpayer may use a standard cost method to allocate
costs, provided variances are treated in accordance with the procedures
prescribed in paragraph (f)(3)(ii)(B) of this section. Any periodic
adjustment to standard costs that merely reflects current operating
conditions, such as increases in automation or changes in operation or
prices, is not a change in method of accounting under section 446(e). A
change, however, in the concept or base upon which standard costs are
developed is a change in method of accounting to which section 446(e)
applies.
(B) Treatment of variances. For purposes of this section, net
positive overhead variance means the excess of total standard indirect
costs over total actual indirect costs and net negative overhead
variance means the excess of total actual indirect costs over total
standard indirect costs. The proper use of a standard cost method
requires that a taxpayer must reallocate to property a pro rata portion
of any net negative or net positive overhead variances and any net
negative or net positive direct cost variances. The taxpayer must
apportion such variances to or among the property to which the costs are
allocable. However, if such variances are not significant in amount
relative to the taxpayer's total indirect costs incurred with respect to
production and resale activities for the year, such variances need not
be allocated to property produced or property acquired for resale unless
such allocation is
[[Page 762]]
made in the taxpayer's financial statement. A taxpayer must treat both
positive and negative variances consistently.
(4) Reasonable allocation methods. A taxpayer may use the methods
described in paragraph (f) (2) or (3) of this section if they are
reasonable allocation methods within the meaning of this paragraph
(f)(4). In addition, a taxpayer may use any other reasonable method to
properly allocate direct and indirect costs among units of property
produced or property acquired for resale during the taxable year. An
allocation method is reasonable if, with respect to the taxpayer's
production or resale activities taken as a whole--
(i) The total costs actually capitalized during the taxable year do
not differ significantly from the aggregate costs that would be properly
capitalized using another permissible method described in this section
or in Sec. Sec. 1.263A-2 and 1.263A-3, with appropriate consideration
given to the volume and value of the taxpayer's production or resale
activities, the availability of costing information, the time and cost
of using various allocation methods, and the accuracy of the allocation
method chosen as compared with other allocation methods;
(ii) The allocation method is applied consistently by the taxpayer;
and
(iii) The allocation method is not used to circumvent the
requirements of the simplified methods in this section or in Sec.
1.263A-2, Sec. 1.263A-3, or the principles of section 263A.
(g) Allocating categories of costs--(1) Direct materials. Direct
material costs (as defined in paragraph (e)(2) of this section) incurred
during the taxable year must be allocated to the property produced or
property acquired for resale by the taxpayer using the taxpayer's d of
accounting for materials (e.g., specific identification; first-in,
first-out (FIFO); or last-in, first-out (LIFO)), or any other reasonable
allocation method (as defined under the principles of paragraph (f)(4)
of this section).
(2) Direct labor. Direct labor costs (as defined in paragraph (e)(2)
of this section) incurred during the taxable year are generally
allocated to property produced or property acquired for resale using a
specific identification method, standard cost method, or any other
reasonable allocation method (as defined under the principles of
paragraph (f)(4) of this section). All elements of compensation, other
than basic compensation, may be grouped together and then allocated in
proportion to the charge for basic compensation. Further, a taxpayer is
not treated as using an erroneous method of accounting if direct labor
costs are treated as indirect costs under the taxpayer's allocation
method, provided such costs are capitalized to the extent required by
paragraph (g)(3) of this section.
(3) Indirect costs. Indirect costs (as defined in paragraph (e)(3)
of this section) are generally allocated to intermediate cost objectives
such as departments or activities prior to the allocation of such costs
to property produced or property acquired for resale. Indirect costs are
allocated using either a specific identification method, a standard cost
method, a burden rate method, or any other reasonable allocation method
(as defined under the principles of paragraph (f)(4) of this section).
(4) Service costs--(i) In general. Service costs are a type of
indirect costs that may be allocated using the same allocation methods
available for allocating other indirect costs described in paragraph
(g)(3) of this section. Generally, taxpayers that use a specific
identification method or another reasonable allocation method must
allocate service costs to particular departments or activities based on
a factor or relationship that reasonably relates the service costs to
the benefits received from the service departments or activities. For
example, a reasonable factor for allocating legal services to particular
departments or activities is the number of hours of legal services
attributable to each department or activity. See paragraph (g)(4)(iv) of
this section for other illustrations. Using reasonable factors or
relationships, a taxpayer must allocate mixed service costs under a
direct reallocation method described in paragraph (g)(4)(iii)(A) of this
section, a step-allocation method described in paragraph (g)(4)(iii)(B)
of this section, or any other reasonable allocation method (as defined
under
[[Page 763]]
the principles of paragraph (f)(4) of this section).
(ii) De minimis rule. For purposes of administrative convenience, if
90 percent or more of a mixed service department's costs are deductible
service costs, a taxpayer may elect not to allocate any portion of the
service department's costs to property produced or property acquired for
resale. For example, if 90 percent of the costs of an electing
taxpayer's industrial relations department benefit the taxpayer's
overall policy-making activities, the taxpayer is not required to
allocate any portion of these costs to a production activity. Under this
election, however, if 90 percent or more of a mixed service department's
costs are capitalizable service costs, a taxpayer must allocate 100
percent of the department's costs to the production or resale activity
benefitted. For example, if 90 percent of the costs of an electing
taxpayer's accounting department benefit the taxpayer's manufacturing
activity, the taxpayer must allocate 100 percent of the costs of the
accounting department to the manufacturing activity. An election under
this paragraph (g)(4)(ii) applies to all of a taxpayer's mixed service
departments and constitutes the adoption of a (or a change in) method of
accounting under section 446 of the Internal Revenue Code.
(iii) Methods for allocating mixed service costs--(A) Direct
reallocation method. Under the direct reallocation method, the total
costs (direct and indirect) of all mixed service departments are
allocated only to departments or cost centers engaged in production or
resale activities and then from those departments to particular
activities. This direct reallocation method ignores benefits provided by
one mixed service department to other mixed service departments, and
also excludes other mixed service departments from the base used to make
the allocation.
(B) Step-allocation method. (1) Under a step-allocation method, a
sequence of allocations is made by the taxpayer. First, the total costs
of the mixed service departments that benefit the greatest number of
other departments are allocated to--
(i) Other mixed service departments;
(ii) Departments that incur only deductible service costs; and
(iii) Departments that exclusively engage in production or resale
activities.
(2) A taxpayer continues allocating mixed service costs in the
manner described in paragraph (g)(4)(iii)(B)(1) of this section (i.e.,
from the service departments benefitting the greatest number of
departments to the service departments benefitting the least number of
departments) until all mixed service costs are allocated to the types of
departments listed in this paragraph (g)(4)(iii). Thus, a step-
allocation method recognizes the benefits provided by one mixed service
department to another mixed service department and also includes mixed
service departments that have not yet been allocated in the base used to
make the allocation.
(C) Examples. The provisions of this paragraph (g)(4)(iii) are
illustrated by the following examples:
Example 1. Direct reallocation method. (i) Taxpayer E has the
following five departments: the Assembling Department, the Painting
Department, and the Finishing Department (production departments), and
the Personnel Department and the Data Processing Department (mixed
service departments). E allocates the Personnel Department's costs on
the basis of total payroll costs and the Data Processing Department's
costs on the basis of data processing hours.
(ii) Under a direct reallocation method, E allocates the Personnel
Department's costs directly to its Assembling, Painting, and Finishing
Department, and not to its Data Processing department.
----------------------------------------------------------------------------------------------------------------
Total Amount of
Department dept. payroll Allocation ratio Amount
costs costs allocated
----------------------------------------------------------------------------------------------------------------
Personnel............................................ $500,000 $50,000 ................. <$500,000
Sec. 1.263A-2 Rules relating to property produced by the taxpayer.
(a) In general. Section 263A applies to real property and tangible
personal property produced by a taxpayer for use in its trade or
business or for sale to its customers. In addition, section 263A applies
to property produced for a taxpayer under a contract with another party.
The principal terms related to the scope of section 263A with respect to
producers are provided in this paragraph (a). See Sec. 1.263A-1(b)(11)
for an exception in the case of certain de minimis property provided to
customers incident to the provision of services. For taxable years
beginning after December 31, 2017, see Sec. 1.263A-1(j) for an
exception in the case of a small business taxpayer that meets the gross
receipts test of section 448(c) and Sec. 1.448-2(c).
(1) Produce--(i) In general. For purposes of section 263A, produce
includes the following: construct, build, install, manufacture, develop,
improve, create, raise, or grow.
(ii) Ownership--(A) General rule. Except as provided in paragraphs
(a)(1)(ii) (B) and (C) of this section, a taxpayer is not considered to
be producing property unless the taxpayer is considered an owner of the
property produced under federal income tax principles. The determination
as to whether a taxpayer is an owner is based on all of the facts and
circumstances, including the various benefits and burdens of ownership
vested with the taxpayer. A taxpayer may be considered an owner of
property produced, even though the taxpayer does not have legal title to
the property.
(B) Property produced for the taxpayer under a contract--(1) In
general. Property produced for the taxpayer under a contract with
another party is treated as property produced by the taxpayer to the
extent the taxpayer makes payments or otherwise incurs costs with
respect to the property. A taxpayer has made payment under this section
if the transaction would be considered payment by a taxpayer using the
cash receipts and disbursements method of accounting.
(2) Definition of a contract--(i) General rule. Except as provided
under paragraph (a)(1)(ii)(B)(2)(ii) of this section, a contract is any
agreement providing for the production of property if the agreement is
entered into before the production of the property to be delivered under
the contract is completed. Whether an agreement exists depends on all
the facts and circumstances. Facts and circumstances indicating an
agreement include, for example, the making of a prepayment, or an
arrangement to make a prepayment, for property prior to the date of the
completion of production of the property,
[[Page 773]]
or the incurring of significant expenditures for property of specialized
design or specialized application that is not intended for self-use.
(ii) Routine purchase order exception. A routine purchase order for
fungible property is not treated as a contract for purposes of this
section. An agreement will not be treated as a routine purchase order
for fungible property, however, if the contractor is required to make
more than de minimis modifications to the property to tailor it to the
customer's specific needs, or if at the time the agreement is entered
into, the customer knows or has reason to know that the contractor
cannot satisfy the agreement within 30 days out of existing stocks and
normal production of finished goods.
(C) Home construction contracts. Section 263A applies to a home
construction contract unless that contract will be completed within two
years of the contract commencement date, and, for contracts entered into
after December 31, 2017, in taxable years ending after December 31,
2017, the taxpayer meets the gross receipts test of section 448(c) and
Sec. 1.448-2(c) for the taxable year in which such contract is entered
into. Except as otherwise provided in this paragraph (a)(1)(ii)(C),
section 263A applies to such a contract even if the contractor is not
considered the owner of the property produced under the contract under
Federal income tax principles.
(2) Tangible personal property--(i) General rule. In general,
section 263A applies to the costs of producing tangible personal
property, and not to the costs of producing intangible property. For
example, section 263A applies to the costs manufacturers incur to
produce goods, but does not apply to the costs financial institutions
incur to originate loans.
(ii) Intellectual or creative property. For purposes of determining
whether a taxpayer producing intellectual or creative property is
producing tangible personal property or intangible property, the term
tangible personal property includes films, sound recordings, video
tapes, books, and other similar property embodying words, ideas,
concepts, images, or sounds by the creator thereof. Other similar
property for this purpose generally means intellectual or creative
property for which, as costs are incurred in producing the property, it
is intended (or is reasonably likely) that any tangible medium in which
the property is embodied will be mass distributed by the creator or any
one or more third parties in a form that is not substantially altered.
However, any intellectual or creative property that is embodied in a
tangible medium that is mass distributed merely incident to the
distribution of a principal product or good of the creator is not other
similar property for these purposes.
(A) Intellectual or creative property that is tangible personal
property. Section 263A applies to tangible personal property defined in
this paragraph (a)(2) without regard to whether such property is treated
as tangible or intangible property under other sections of the Internal
Revenue Code. Thus, for example, section 263A applies to the costs of
producing a motion picture or researching and writing a book even though
these assets may be considered intangible for other purposes of the
Internal Revenue Code. Tangible personal property includes, for example,
the following:
(1) Books. The costs of producing and developing books (including
teaching aids and other literary works) required to be capitalized under
this section include costs incurred by an author in researching,
preparing, and writing the book. (However, see section 263A(h), which
provides an exemption from the capitalization requirements of section
263A in the case of certain free-lance authors.) In addition, the costs
of producing and developing books include prepublication expenditures
incurred by publishers, including payments made to authors (other than
commissions for sales of books that have already taken place), as well
as costs incurred by publishers in writing, editing, compiling,
illustrating, designing, and developing the books. The costs of
producing a book also include the costs of producing the underlying
manuscript, copyright, or license. (These costs are distinguished from
the separately capitalizable costs of printing and binding the tangible
medium embodying the book (e.g., paper and ink).) See Sec. 1.174-
2(a)(1), which provides that
[[Page 774]]
the term research or experimental expenditures does not include
expenditures incurred for research in connection with literary,
historical, or similar projects.
(2) Sound recordings. A sound recording is a work that results from
the fixation of a series of musical, spoken, or other sounds, regardless
of the nature of the material objects, such as discs, tapes, or other
phonorecordings, in which such sounds are embodied.
(B) Intellectual or creative property that is not tangible personal
property. Items that are not considered tangible personal property
within the meaning of section 263A(b) and paragraph (a)(2)(ii) of this
section include:
(1) Evidences of value. Tangible personal property does not include
property that is representative or evidence of value, such as stock,
securities, debt instruments, mortgages, or loans.
(2) Property provided incident to services. Tangible personal
property does not include de minimis property provided to a client or
customer incident to the provision of services, such as wills prepared
by attorneys, or blueprints prepared by architects. See Sec. 1.263A-
1(b)(11).
(3) Costs required to be capitalized by producers--(i) In general.
Except as specifically provided in section 263A(f) with respect to
interest costs, producers must capitalize direct and indirect costs
properly allocable to property produced under section 263A, without
regard to whether those costs are incurred before, during, or after the
production period (as defined in section 263A(f)(4)(B)).
(ii) Pre-production costs. If property is held for future
production, taxpayers must capitalize direct and indirect costs
allocable to such property (e.g., purchasing, storage, handling, and
other costs), even though production has not begun. If property is not
held for production, indirect costs incurred prior to the beginning of
the production period must be allocated to the property and capitalized
if, at the time the costs are incurred, it is reasonably likely that
production will occur at some future date. Thus, for example, a
manufacturer must capitalize the costs of storing and handling raw
materials before the raw materials are committed to production. In
addition, a real estate developer must capitalize property taxes
incurred with respect to property if, at the time the taxes are
incurred, it is reasonably likely that the property will be subsequently
developed.
(iii) Post-production costs. Generally, producers must capitalize
all indirect costs incurred subsequent to completion of production that
are properly allocable to the property produced. Thus, for example,
storage and handling costs incurred while holding the property produced
for sale after production must be capitalized to the property to the
extent properly allocable to the property. However, see Sec. 1.263A-
3(c) for exceptions.
(4) Practical capacity concept. Notwithstanding any provision to the
contrary, the use, directly or indirectly, of the practical capacity
concept is not permitted under section 263A. For purposes of section
263A, the term practical capacity concept means any concept, method,
procedure, or formula (such as the practical capacity concept described
in Sec. 1.471-11(d)(4)) whereunder fixed costs are not capitalized
because of the relationship between the actual production at the
taxpayer's production facility and the practical capacity of the
facility. For purposes of this section, the practical capacity of a
facility includes either the practical capacity or theoretical capacity
of the facility, as defined in Sec. 1.471-11(d)(4), or any similar
determination of productive or operating capacity. The practical
capacity concept may not be used with respect to any activity to which
section 263A applies (i.e., production or resale activities). A taxpayer
shall not be considered to be using the practical capacity concept
solely because the taxpayer properly does not capitalize costs described
in Sec. 1.263A-1(e)(3)(iii)(E), relating to certain costs attributable
to temporarily idle equipment.
(5) Taxpayers required to capitalize costs under this section. This
section generally applies to taxpayers that produce property. If a
taxpayer is engaged in both production activities and resale activities,
the taxpayer applies the principles of this section as if it read
production or resale activities, and by applying appropriate principles
[[Page 775]]
from Sec. 1.263A-3. If a taxpayer is engaged in both production and
resale activities, the taxpayer may elect the simplified production
method or the modified simplified production method provided in this
section, but generally may not elect the simplified resale method
discussed in Sec. 1.263A-3(d). If elected, the simplified production
method or the modified simplified production method must be applied to
all eligible property produced and all eligible property acquired for
resale by the taxpayer.
(b) Simplified production method--(1) Introduction. This paragraph
(b) provides a simplified method for determining the additional section
263A costs properly allocable to ending inventories of property produced
and other eligible property on hand at the end of the taxable year.
(2) Eligible property--(i) In general. Except as otherwise provided
in paragraph (b)(2)(ii) of this section, the simplified production
method, if elected for any trade or business of a producer, must be used
for all production and resale activities associated with any of the
following categories of property to which section 263A applies:
(A) Inventory property. Stock in trade or other property properly
includible in the inventory of the taxpayer.
(B) Non-inventory property held for sale. Non-inventory property
held by a taxpayer primarily for sale to customers in the ordinary
course of the taxpayer's trade or business.
(C) Certain self-constructed assets. Self-constructed assets
substantially identical in nature to, and produced in the same manner
as, inventory property produced by the taxpayer or other property
produced by the taxpayer and held primarily for sale to customers in the
ordinary course of the taxpayer's trade or business.
(D) Self-constructed tangible personal property produced on a
routine and repetitive basis--(1) In general. Self-constructed tangible
personal property produced by the taxpayer on a routine and repetitive
basis in the ordinary course of the taxpayer's trade or business. Self-
constructed tangible personal property is produced by the taxpayer on a
routine and repetitive basis in the ordinary course of the taxpayer's
trade or business when units of tangible personal property (as defined
in Sec. 1.263A-10(c)) are mass-produced, that is, numerous
substantially identical assets are manufactured within a taxable year
using standardized designs and assembly line techniques, and either the
applicable recovery period of the property determined under section
168(c) is not longer than 3 years or the property is a material or
supply that will be used and consumed within 3 years of being produced.
For purposes of this paragraph (b)(2)(i)(D), the applicable recovery
period of the assets will be determined at the end of the taxable year
in which the assets are placed in service for purposes of Sec. 1.46-
3(d). Subsequent changes to the applicable recovery period after the
assets are placed in service will not affect the determination of
whether the assets are produced on a routine and repetitive basis for
purposes of this paragraph (b)(2)(i)(D).
(2) Examples. The following examples illustrate this paragraph
(b)(2)(i)(D):
Example 1. Y is a manufacturer of automobiles. During the taxable
year Y produces numerous substantially identical dies and molds using
standardized designs and assembly line techniques. The dies and molds
have a 3-year applicable recovery period for purposes of section 168(c).
Y uses the dies and molds to produce or process particular automobile
components and does not hold them for sale. The dies and molds are
produced on a routine and repetitive basis in the ordinary course of Y's
business for purposes of this paragraph because the dies and molds are
both mass-produced and have a recovery period of not longer than 3
years.
Example 2. Z is an electric utility that regularly manufactures and
installs identical poles that are used in transmitting and distributing
electricity. The poles have a 20-year applicable recovery period for
purposes of section 168(c). The poles are not produced on a routine and
repetitive basis in the ordinary course of Z's business for purposes of
this paragraph because the poles have an applicable recovery period that
is longer than 3 years.
(ii) Election to exclude self-constructed assets. At the taxpayer's
election, the simplified production method may be applied within a trade
or business to only the categories of inventory property and non-
inventory property held for sale described in paragraphs (b)(2)(i) (A)
and (B) of this section. Taxpayers
[[Page 776]]
electing to exclude the self- constructed assets, defined in paragraphs
(b)(2)(i) (C) and (D) of this section, from application of the
simplified production method must, however, allocate additional section
263A costs to such property in accordance with Sec. 1.263A-1 (f).
(3) Simplified production method without historic absorption ratio
election--(i) General allocation formula--(A) In general. Except as
otherwise provided in paragraph (b)(3)(iv) of this section, the
additional section 263A costs allocable to eligible property remaining
on hand at the close of the taxable year under the simplified production
method are computed as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.004
(B) Effect of allocation. The absorption ratio generally is
multiplied by the section 471 costs remaining in ending inventory or
otherwise on hand at the end of each taxable year in which the
simplified production method is applied. The resulting product is the
additional section 263A costs that are added to the taxpayer's ending
section 471 costs to determine the section 263A costs that are
capitalized. See, however, paragraph (b)(3)(iii) of this section for
special rules applicable to LIFO taxpayers. Except as otherwise provided
in this section or in Sec. 1.263A-1 or 1.263A-3, additional section
263A costs that are allocated to inventories on hand at the close of the
taxable year under the simplified production method of this paragraph
(b) are treated as inventory costs for all purposes of the Internal
Revenue Code.
(ii) Definitions--(A) Absorption ratio. Under the simplified
production method, the absorption ratio is determined as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.005
(1) Additional section 263A costs incurred during the taxable year.
Additional section 263A costs incurred during the taxable year are
defined as the additional section 263A costs described in Sec. 1.263A-
1(d)(3) that a taxpayer incurs during its current taxable year.
(2) Section 471 costs incurred during the taxable year. Section 471
costs incurred during the taxable year are defined as the section 471
costs described in Sec. 1.263A-1(d)(2) that a taxpayer incurs during
its current taxable year.
(B) Section 471 costs remaining on hand at year end. Section 471
costs remaining on hand at year end means the section 471 costs, as
defined in Sec. 1.263A-1(d)(2), that a taxpayer incurs during its
current taxable year which remain in its ending inventory or are
otherwise on hand at year end. For LIFO inventories of a taxpayer, the
section 471 costs remaining on hand at year end means the increment, if
any, for the current year stated in terms of section 471 costs. See
paragraph (b)(3)(iii) of this section.
(C) Costs allocated to property sold. Additional section 263A costs
incurred during the taxable year, as defined in paragraph
(b)(3)(ii)(A)(1) of this section, section 471 costs incurred during the
taxable year, as defined in paragraph (b)(3)(ii)(A)(2) of this section,
and section 471 costs remaining on hand at year end, as defined in
paragraph (b)(3)(ii)(B) of this section, do not include costs described
in Sec. 1.263A-1(e)(3)(ii) or cost reductions described in Sec. 1.471-
3(e) that a taxpayer properly allocates entirely to property that has
been sold.
(iii) LIFO taxpayers electing the simplified production method--(A)
In general. Under the simplified production
[[Page 777]]
method, a taxpayer using a LIFO method must calculate a particular
year's index (e.g., under Sec. 1.472-8(e)) without regard to its
additional section 263A costs. Similarly, a taxpayer that adjusts
current-year costs by applicable indexes to determine whether there has
been an inventory increment or decrement in the current year for a
particular LIFO pool must disregard the additional section 263A costs in
making that determination.
(B) LIFO increment. If the taxpayer determines there has been an
inventory increment, the taxpayer must state the amount of the increment
in current-year dollars (stated in terms of section 471 costs). The
taxpayer then multiplies this amount by the absorption ratio. The
resulting product is the additional section 263A costs that must be
added to the taxpayer's increment for the year stated in terms of
section 471 costs.
(C) LIFO decrement. If the taxpayer determines there has been an
inventory decrement, the taxpayer must state the amount of the decrement
in dollars applicable to the particular year for which the LIFO layer
has been invaded. The additional section 263A costs incurred in prior
years that are applicable to the decrement are charged to cost of goods
sold. The additional section 263A costs that are applicable to the
decrement are determined by multiplying the additional section 263A
costs allocated to the layer of the pool in which the decrement occurred
by the ratio of the decrement (excluding additional section 263A costs)
to the section 471 costs in the layer of that pool.
(iv) De minimis rule for producers with total indirect costs of
$200,000 or less--(A) In general. If a producer using the simplified
production method incurs $200,000 or less of total indirect costs in a
taxable year, the additional section 263A costs allocable to eligible
property remaining on hand at the close of the taxable year are deemed
to be zero. Solely for purposes of this paragraph (b)(3)(iv), taxpayers
are permitted to exclude any category of indirect costs (listed in Sec.
1.263A-1(e)(3)(iii)) that is not required to be capitalized (e.g.,
selling and distribution costs) in determining total indirect costs.
(B) Related party and aggregation rules. In determining whether the
producer incurs $200,000 or less of total indirect costs in a taxable
year, the related party and aggregation rules of Sec. 1.263A-3(b)(3)
are applied by substituting total indirect costs for gross receipts
wherever gross receipts appears.
(v) Examples. The provisions of this paragraph (b) are illustrated
by the following examples.
Example 1. FIFO inventory method. (i) Taxpayer J uses the FIFO
method of accounting for inventories. J's beginning inventory for 1994
(all of which is sold during 1994) is $2,500,000 (consisting of
$2,000,000 of section 471 costs and $500,000 of additional section 263A
costs). During 1994, J incurs $10,000,000 of section 471 costs and
$1,000,000 of additional section 263A costs. J's additional section 263A
costs include capitalizable mixed service costs computed under the
simplified service cost method as well as other allocable costs. J's
section 471 costs remaining in ending inventory at the end of 1994 are
$3,000,000. J computes its absorption ratio for 1994, as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.006
(ii) Under the simplified production method, J determines the
additional section 263A costs allocable to its ending inventory by
multiplying the absorption ratio by the section 471 costs remaining in
its ending inventory:
[GRAPHIC] [TIFF OMITTED] TC10OC91.007
[[Page 778]]
(iii) J adds this $300,000 to the $3,000,000 of section 471 costs
remaining in its ending inventory to calculate its total ending
inventory of $3,300,000. The balance of J's additional section 263A
costs incurred during 1994, $700,000, ($1,000,000 less $300,000) is
taken into account in 1994 as part of J's cost of goods sold.
Example 2. LIFO inventory method. (i) Taxpayer K uses a dollar-value
LIFO inventory method. K's beginning inventory for 1994 is $2,500,000
(consisting of $2,000,000 of section 471 costs and $500,000 of
additional section 263A costs). During 1994, K incurs $10,000,000 of
section 471 costs and $1,000,000 of additional section 263A costs. K's
1994 LIFO increment is $1,000,000 ($3,000,000 of section 471 costs in
ending inventory less $2,000,000 of section 471 costs in beginning
inventory).
(ii) To determine the additional section 263A costs allocable to its
ending inventory, K multiplies the 10% absorption ratio ($1,000,000 of
additional section 263A costs divided by $10,000,000 of section 471
costs) by the $1,000,000 LIFO increment. Thus, K's additional section
263A costs allocable to its ending inventory are $100,000 ($1,000,000
multiplied by 10%). This $100,000 is added to the $1,000,000 to
determine a total 1994 LIFO increment of $1,100,000. K's ending
inventory is $3,600,000 (its beginning inventory of $2,500,000 plus the
$1,100,000 increment). The balance of K's additional section 263A costs
incurred during 1994, $900,000 ($1,000,000 less $100,000), is taken into
account in 1994 as part of K's cost of goods sold.
(iii) In 1995, K sells one-half of the inventory in its 1994 LIFO
increment. K must include in its cost of goods sold for 1995 the amount
of additional section 263A costs relating to this inventory, $50,000
(one-half of the tional section 263A costs capitalized in 1994 ending
inventory, or $100,000).
Example 3. LIFO pools. (i) Taxpayer U begins its business in 1994
and adopts the LIFO inventory method. During 1994, L incurs $10,000 of
section 471 costs and $1,000 of additional section 263A costs. At the
end of 1994, L's ending inventory includes $3,000 of section 471 costs
contained in three LIFO pools (X, Y, and Z) as shown below. Under the
simplified production method, L computes its absorption ratio and
inventory for 1994 as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.008
------------------------------------------------------------------------
Total X Y Z
------------------------------------------------------------------------
1994:
Ending section 471 costs............ $3,000 $1,600 $600 $800
Additional section 263A costs (10%). 300 160 60 80
---------------------------------
1994 ending inventory............. $3,300 $1,760 $660 $880
------------------------------------------------------------------------
(ii) During 1995, L incurs $2,000 of section 471 costs as shown
below and $400 of additional section 263A costs. Moreover, L sells goods
from pools X, Y, and Z having a total cost of $1,000. L computes its
absorption ratio and inventory for 1995:
[GRAPHIC] [TIFF OMITTED] TC10OC91.009
------------------------------------------------------------------------
Total X Y Z
------------------------------------------------------------------------
1995:
Beginning section 471 costs......... $3,000 $1,600 $600 $800
1995 section 471 costs.............. 2,000 1,500 300 200
Section 471 cost of goods sold...... (1,000) (300) (300) (400)
---------------------------------
1995 ending section 471 costs....... $4,000 $2,800 $600 $600
=================================
Consisting of:
1994 layer.......................... $2,800 $1,600 $600 $600
1995 layer.......................... 1,200 1,200 ...... ......
---------------------------------
[[Page 779]]
$4,000 $2,800 $600 $600
=================================
Additional section 263A costs:
1994 (10%).......................... $280 $160 $60 $60
1995 (20%).......................... 240 240 ...... ......
---------------------------------
$520 $400 $60 $60
=================================
1995 ending inventory............. $4,520 $3,200 $660 $660
------------------------------------------------------------------------
(iii) In 1995, L experiences a $200 decrement in pool Z. Thus, L
must charge the additional section 263A costs incurred in prior years
applicable to the decrement to 1995's cost of goods sold. To do so, L
determines a ratio by dividing the decrement by the section 471 costs in
the 1994 layer ($200 divided by $800, or 25%). L then multiplies this
ratio (25%) by the additional section 263A costs in the 1994 layer ($80)
to determine the additional section 263A costs applicable to the
decrement ($20). Therefore, $20 is taken into account by L in 1995 as
part of its cost of goods sold ($80 multiplied by 25%).
(4) Simplified production method with historic absorption ratio
election--(i) In general. This paragraph (b)(4) generally permits
producers using the simplified production method to elect a historic
absorption ratio in determining additional section 263A costs allocable
to eligible property remaining on hand at the close of their taxable
years. Except as provided in paragraph (b)(4)(v) of this section, a
taxpayer may only make a historic absorption ratio election if it has
used the simplified production method for three or more consecutive
taxable years immediately prior to the year of election and has
capitalized additional section 263A costs using an actual absorption
ratio (as defined under
paragraph (b)(3)(ii) of this section) for its three most recent
consecutive taxable years. This method is not available to a taxpayer
that is deemed to have zero additional section 263A costs under
paragraph (b)(3)(iv) of this section. The historic absorption ratio is
used in lieu of an actual absorption ratio computed under paragraph
(b)(3)(ii) of this section and is based on costs capitalized by a
taxpayer during its test period. If elected, the historic absorption
ratio must be used for each taxable year within the qualifying period
described in paragraph (b)(4)(ii)(C) of this section.
(ii) Operating rules and definitions--(A) Historic absorption ratio.
(1) The historic absorption ratio is equal to the following ratio:
[GRAPHIC] [TIFF OMITTED] TC10OC91.010
(2) Additional section 263A costs incurred during the test period
are defined as the additional section 263A costs described in Sec.
1.263A-1(d)(3) that the taxpayer incurs during the test period described
in paragraph (b)(4)(ii)(B) of this section.
(3) Section 471 costs incurred during the test period mean the
section 471 costs described in Sec. 1.263A-1(d)(2) that the taxpayer
incurs during the test period described in paragraph (b)(4)(ii)(B) of
this section.
(4) Additional section 263A costs incurred during the test period,
as defined in paragraph (b)(4)(ii)(A)(2) of this section, and section
471 costs incurred during the test period, as defined in paragraph
(b)(4)(ii)(A)(3) of this section, do not include costs specifically
described in Sec. 1.263A-1(e)(3)(ii) or cost reductions described in
Sec. 1.471-3(e) that a taxpayer properly allocates entirely to property
that has been sold.
(B) Test period--(1) In general. The test period is generally the
three taxable-year period immediately prior to
[[Page 780]]
the taxable year that the historic absorption ratio is elected.
(2) Updated test period. The test period begins again with the
beginning of the first taxable year after the close of a qualifying
period. This new test period, the updated test period, is the three
taxable-year period beginning with the first taxable year after the
close of the qualifying period as defined in paragraph (b)(4)(ii)(C) of
this section.
(C) Qualifying period--(1) In general. A qualifying period includes
each of the first five taxable years beginning with the first taxable
year after a test period (or an updated test period).
(2) Extension of qualifying period. In the first taxable year
following the close of each qualifying period, (e.g., the sixth taxable
year following the test period), the taxpayer must compute the actual
absorption ratio under the simplified production method. If the actual
absorption ratio computed for this taxable year (the recomputation year)
is within one-half of one percentage point (plus or minus) of the
historic absorption ratio used in determining capitalizable costs for
the qualifying period (i.e., the previous five taxable years), the
qualifying period is extended to include the recomputation year and the
following five taxable years, and the taxpayer must continue to use the
historic absorption ratio throughout the extended qualifying period. If,
however, the actual absorption ratio computed for the recomputation year
is not within one-half of one percentage point (plus or minus) of the
historic absorption ratio, the taxpayer must use actual absorption
ratios beginning with the recomputation year under the simplified
production method and throughout the updated test period. The taxpayer
must resume using the historic absorption ratio (determined with
reference to the updated test period) in the third taxable year
following the recomputation year.
(iii) Method of accounting--(A) Adoption and use. The election to
use the historic absorption ratio is a method of accounting. A taxpayer
using the simplified production method may elect the historic absorption
ratio in any taxable year if permitted under this paragraph (b)(4),
provided the taxpayer has not obtained the Commissioner's consent to
revoke the historic absorption ratio election within its prior six
taxable years. The election is to be effected on a cut-off basis, and
thus, no adjustment under section 481(a) is required or permitted. The
use of a historic absorption ratio has no effect on other methods of
accounting adopted by the taxpayer and used in conjunction with the
simplified production method in determining its section 263A costs.
Accordingly, in computing its actual absorption ratios, the taxpayer
must use the same methods of accounting used in computing its historic
absorption ratio during its most recent test period unless the taxpayer
obtains the consent of the Commissioner. Finally, for purposes of this
paragraph (b)(4)(iii), the recomputation of the historic absorption
ratio during an updated test period and the change from a historic
absorption ratio to an actual absorption ratio by reason of the
requirements of this paragraph (b)(4) are not considered changes in
methods of accounting under section 446(e) and, thus, do not require the
consent of the Commissioner or any adjustments under section 481(a).
(B) Revocation of election. A taxpayer may only revoke its election
to use the historic absorption ratio with the consent of the
Commissioner in a manner prescribed under section 446(e) and the
regulations thereunder. Consent to the change for any taxable year that
is included in the qualifying period (or an extended qualifying period)
will be granted only upon a showing of unusual circumstances.
(iv) Reporting and recordkeeping requirements--(A) Reporting. A
taxpayer making an election under this paragraph (b)(4) must attach a
statement to its federal income tax return for the taxable year in which
the election is made showing the actual absorption ratios determined
under the simplified production method during its first test period.
This statement must disclose the historic absorption ratio to be used by
the taxpayer during its qualifying period. A similar statement must be
attached to the federal income tax return for the first taxable year
within any subsequent qualifying period (i.e., after an updated test
period).
[[Page 781]]
(B) Recordkeeping. A taxpayer must maintain all appropriate records
and details supporting the historic absorption ratio until the
expiration of the statute of limitations for the last year for which the
taxpayer applied the particular historic absorption ratio in determining
additional section 263A costs capitalized to eligible property.
(v)(A) Transition to elect historic absorption ratio. Taxpayers will
be permitted to elect a historic absorption ratio in their first,
second, or third taxable year beginning after December 31, 1993, under
such terms and conditions as may be prescribed by the Commissioner.
Taxpayers are eligible to make an election under these transition rules
whether or not they previously used the simplified production method. A
taxpayer making such an election must recompute (or compute) its
additional section 263A costs, and thus, its historic absorption ratio
for its first test period as if the rules prescribed in this section and
Sec. Sec. 1.263A-1 and 1.263A-3 had applied throughout the test period.
(B) Transition to revoke historic absorption ratio. Notwithstanding
the requirements provided in paragraph (b)(4)(iii)(B) of this section
regarding revocations of the historic absorption ratio during a
qualifying period, a taxpayer will be permitted to revoke the historic
absorption ratio in their first, second, or third taxable year ending on
or after November 20, 2018, under such administrative procedures and
with terms and conditions prescribed by the Commissioner.
(vi) Example. The provisions of this paragraph (b)(4) are
illustrated by the following example:
Example. (i) Taxpayer M uses the FIFO method of accounting for
inventories and for 1994 elects to use the historic absorption ratio
with the simplified production method. After recomputing its additional
section 263A costs in accordance with the transition rules of paragraph
(b)(4)(v) of this section, M identifies the following costs incurred
during the test period:
1991:
Add'l section 263A costs--$100
Section 471 costs--$3,000
1992:
Add'l section 263A costs--$200
Section 471 costs--$4,000
1993:
Add'l section 263A costs--$300
Section 471 costs--$5,000
(ii) Therefore, M computes a 5% historic absorption ratio determined
as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.011
(iii) In 1994, M incurs $10,000 of section 471 costs of which $3,000
remain in inventory at the end of the year. Under the simplified
production method using a historic absorption ratio, M determines the
additional section 263A costs allocable to its ending inventory by
multiplying its historic absorption ratio (5%) by the section 471 costs
remaining in its ending inventory as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.012
(iv) To determine its ending inventory under section 263A, M adds
the additional section 263A costs allocable to ending inventory to its
section 471 costs remaining in ending inventory ($3,150 = $150 +
$3,000). The balance of M's additional section 263A costs incurred
during 1994 is taken into account in 1994 as part of M's cost of goods
sold.
(v) M's qualifying period ends with the close of its 1998 taxable
year. Therefore, 1999 is a recomputation year in which M must compute
its actual absorption ratio. M determines its actual absorption ratio
for 1999 to be 5.25% and compares that ratio to its historic absorption
ratio (5.0%). Therefore, M must continue to use its historic absorption
ratio of 5.0% throughout an extended qualifying period, 1999 through
2004 (the recomputation year and the following five taxable years).
[[Page 782]]
(vi) If, instead, M's actual absorption ratio for 1999 were not
between 4.5% and 5.5%, M's qualifying period would end and M would be
required to compute a new historic absorption ratio with reference to an
updated test period of 1999, 2000, and 2001. Once M's historic
absorption ratio is determined for the updated test period, it would be
used for a new qualifying period beginning in 2002.
(c) Modified simplified production method--(1) Introduction. This
paragraph (c) provides a simplified method for determining the
additional section 263A costs properly allocable to ending inventories
of property produced and other eligible property on hand at the end of
the taxable year.
(2) Eligible property--(i) In general. Except as otherwise provided
in paragraph (c)(2)(ii) of this section, the modified simplified
production method, if elected for any trade or business of a producer,
must be used for all production and resale activities associated with
any of the categories of property to which section 263A applies as
described in paragraph (b)(2)(i) of this section.
(ii) Election to exclude-self-constructed assets. A taxpayer using
the modified simplified production method may elect to exclude self-
constructed assets from application of the modified simplified
production method by following the same rules applicable to a taxpayer
using the simplified production method provided in paragraph (b)(2)(ii)
of this section.
(3) Modified simplified production method without historic
absorption ratio election--(i) General allocation formula--(A) In
general. Except as otherwise provided in paragraph (c)(3)(v) of this
section, the additional section 263A costs allocable to eligible
property remaining on hand at the close of the taxable year under the
modified simplified production method are computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.001
(B) Effect of allocation. The pre-production and production
absorption ratios generally are multiplied by the pre-production and
production section 471 costs, respectively, remaining in ending
inventory or otherwise on hand at the end of each taxable year in which
the modified simplified production method is applied. The sum of the
resulting products is the additional section 263A costs that are added
to the taxpayer's ending section 471 costs to determine the section 263A
costs that are capitalized. See, however, paragraph (c)(3)(iv) of this
section for special rules applicable to LIFO taxpayers. Except as
otherwise provided in this section or in Sec. 1.263A-1 or Sec. 1.263A-
3, additional section 263A costs that are allocated to inventories on
hand at the close of the taxable year under the modified simplified
production method of this paragraph (c) are treated as inventory costs
for all purposes of the Internal Revenue Code.
(ii) Definitions--(A) Direct material costs. For purposes of
paragraph (c) of this section, direct material costs has the same
meaning as described in Sec. 1.263A-1(e)(2)(i)(A). For purposes of
paragraph (c) of this section, direct material costs include property
produced for the taxpayer under a contract with another party that are
direct material costs for the taxpayer to be used in an additional
production process of the taxpayer.
(B) Pre-production absorption ratio. Under the modified simplified
production method, the pre-production absorption ratio is determined as
follows:
[[Page 783]]
[GRAPHIC] [TIFF OMITTED] TR20NO18.002
(1) Pre-production additional section 263A costs. Pre-production
additional section 263A costs are defined as the additional section 263A
costs described in Sec. 1.263A-1(d)(3) that are pre-production costs,
as described in paragraph (a)(3)(ii) of this section, that a taxpayer
incurs during its current taxable year, including capitalizable mixed
service costs allocable to pre-production additional section 263A costs,
as described in paragraph (c)(3)(iii) of this section, that a taxpayer
incurs during its current taxable year:
(i) Plus additional section 263A costs properly allocable to
property acquired for resale that a taxpayer incurs during its current
taxable year; and
(ii) Plus additional section 263A costs properly allocable to
property produced for the taxpayer under a contract with another party
that is treated as property produced by the taxpayer, as described in
paragraph (a)(1)(ii)(B) of this section, that a taxpayer incurs during
its current taxable year.
(2) Pre-production section 471 costs. Pre-production section 471
costs are defined as the section 471 costs described in Sec. 1.263A-
1(d)(2) that are direct material costs that a taxpayer incurs during its
current taxable year plus the section 471 costs for property acquired
for resale (see Sec. 1.263A-1(e)(2)(ii)) that a taxpayer incurs during
its current taxable year, including property produced for the taxpayer
under a contract with another party that is acquired for resale.
(C) Pre-production section 471 costs remaining on hand at year end.
Pre-production section 471 costs remaining on hand at year end means the
pre-production section 471 costs, as defined in paragraph
(c)(3)(ii)(B)(2) of this section, that a taxpayer incurs during its
current taxable year which remain in its ending inventory or are
otherwise on hand at year end, excluding the section 471 costs that are
direct material costs that have entered or completed production at year
end (for example, direct material costs in ending work-in-process
inventory and ending finished goods inventory). For LIFO inventories of
a taxpayer, see paragraph (c)(3)(iv) of this section.
(D) Production absorption ratio. Under the modified simplified
production method, the production absorption ratio is determined as
follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.003
(1) Production additional section 263A costs. Production additional
section 263A costs are defined as the additional section 263A costs
described in Sec. 1.263A-1(d)(3) that are not pre-production additional
section 263A costs, as defined in paragraph (c)(3)(ii)(B)(1) of this
section, that a taxpayer incurs during its current taxable year,
including capitalizable mixed service costs not allocable to pre-
production additional section 263A costs, as described in paragraph
(c)(3)(iii) of this section, that a taxpayer incurs during its current
taxable year. For example, production additional section 263A costs
include post-production costs, other than post-production costs included
in section 471 costs, as described in paragraph (a)(3)(iii) of this
section.
(2) Residual pre-production additional section 263A costs. Residual
pre-production additional section 263A costs are defined as the pre-
production additional section 263A costs, as defined in paragraph
(c)(3)(ii)(B)(1) of this section, that a taxpayer incurs during its
current taxable year less the product of the pre-production absorption
ratio, as determined in paragraph (c)(3)(ii)(B) of this section, and the
pre-production section 471 costs remaining on hand at
[[Page 784]]
year end, as defined in paragraph (c)(3)(ii)(C) of this section.
(3) Production section 471 costs. Production section 471 costs are
defined as the section 471 costs described in Sec. 1.263A-1(d)(2) that
a taxpayer incurs during its current taxable year less pre-production
section 471 costs, as defined in paragraph (c)(3)(ii)(B)(2) of this
section, that a taxpayer incurs during its current taxable year.
(4) Direct materials adjustment. The direct materials adjustment is
defined as the section 471 costs that are direct material costs,
including property produced for a taxpayer under a contract with another
party that are direct material costs for the taxpayer to be used in an
additional production process of the taxpayer, that had not entered
production at the beginning of the current taxable year:
(i) Plus the section 471 costs that are direct material costs
incurred during the current taxable year (that is, direct material
purchases); and
(ii) Less the section 471 costs that are direct material costs that
have not entered production at the end of the current taxable year.
(E) Production section 471 costs remaining on hand at year end.
Production section 471 costs remaining on hand at year end means the
section 471 costs, as defined in Sec. 1.263A-1(d)(2), that a taxpayer
incurs during its current taxable year which remain in its ending
inventory or are otherwise on hand at year end, less the pre-production
section 471 costs remaining on hand at year end, as described in
paragraph (c)(3)(ii)(C) of this section. For LIFO inventories of a
taxpayer, see paragraph (c)(3)(iv) of this section.
(F) Costs allocated to property sold. The terms defined in paragraph
(c)(3)(ii) of this section do not include costs described in Sec.
1.263A-1(e)(3)(ii) or cost reductions described in Sec. 1.471-3(e) that
a taxpayer properly allocates entirely to property that has been sold.
(iii) Allocable mixed service costs--(A) In general. If a taxpayer
using the modified simplified production method determines its
capitalizable mixed service costs using a method described in Sec.
1.263A-1(g)(4), the taxpayer must use a reasonable method to allocate
the costs (for example, department or activity costs) between production
and pre-production additional section 263A costs. If the taxpayer's
Sec. 1.263A-1(g)(4) method allocates costs to a department or activity
that is exclusively identified as production or pre-production, those
costs must be allocated to production or pre-production additional
section 263A costs, respectively.
(B) Taxpayer using the simplified service cost method. If a taxpayer
using the modified simplified production method determines its
capitalizable mixed service costs using the simplified service cost
method described in Sec. 1.263A-1(h), the amount of capitalizable mixed
service costs, as computed using the general allocation formula in Sec.
1.263A-1(h)(3)(i), allocated to and included in pre-production
additional section 263A costs in the absorption ratio described in
paragraph (c)(3)(ii)(B) of this section is determined based on either of
the following: The proportion of direct material costs to total section
471 costs that a taxpayer incurs during its current taxable year or the
proportion of pre-production labor costs to total labor costs that a
taxpayer incurs during its current taxable year. The taxpayer must
include the capitalizable mixed service costs that are not allocated to
pre-production additional section 263A costs in production additional
section 263A costs in the absorption ratio described in paragraph
(c)(3)(ii)(D) of this section. A taxpayer that allocates capitalizable
mixed service costs based on labor under this paragraph (c)(3)(iii)(B)
must exclude mixed service labor costs from both pre-production labor
costs and total labor costs.
(C) De minimis rule. Notwithstanding paragraphs (c)(3)(iii)(A) and
(B) of this section, if 90 percent or more of a taxpayer's capitalizable
mixed service costs determined under paragraph (c)(3)(iii)(A) or (B) of
this section are allocated to pre-production additional section 263A
costs or production additional section 263A costs, the taxpayer may
elect to allocate 100 percent of its capitalizable mixed service costs
to that amount. For example, if 90 percent of capitalizable mixed
service costs are allocated to production additional section 263A costs
based on the labor costs that are pre-production
[[Page 785]]
costs in total labor costs incurred in the taxpayer's trade or business
during the taxable year, then 100 percent of capitalizable mixed service
costs may be allocated to production additional section 263A costs. An
election to allocate capitalizable mixed service costs under this
paragraph (c)(3)(iii)(C) is the adoption of, or a change in, a method of
accounting under section 446 of the Internal Revenue Code.
(iv) LIFO taxpayers electing the modified simplified production
method--(A) In general. Under the modified simplified production method,
a taxpayer using a LIFO method must calculate a particular year's index
(for example, under Sec. 1.472-8(e)) without regard to its additional
section 263A costs. Similarly, a taxpayer that adjusts current-year
costs by applicable indexes to determine whether there has been an
inventory increment or decrement in the current year for a particular
LIFO pool must disregard the additional section 263A costs in making
that determination.
(B) LIFO increment--(1) In general. If the taxpayer determines there
has been an inventory increment, the taxpayer must state the amount of
the increment in terms of section 471 costs in current-year dollars. The
taxpayer then multiplies this amount by the combined absorption ratio,
as defined in paragraph (c)(3)(iv)(B)(2) of this section. The resulting
product is the additional section 263A costs that must be added to the
taxpayer's increment in terms of section 471 costs in current-year
dollars for the taxable year.
(2) Combined absorption ratio defined. For purposes of paragraph
(c)(3)(iv)(B)(1) of this section, the combined absorption ratio is the
additional section 263A costs allocable to eligible property remaining
on hand at the close of the taxable year, as described in paragraph
(c)(3)(i)(A) of this section, determined on a non-LIFO basis, divided by
the pre-production and production section 471 costs remaining on hand at
year end, determined on a non-LIFO basis.
(C) LIFO decrement. If the taxpayer determines there has been an
inventory decrement, the taxpayer must state the amount of the decrement
in dollars applicable to the particular year for which the LIFO layer
has been invaded. The additional section 263A costs incurred in prior
years that are applicable to the decrement are charged to cost of goods
sold. The additional section 263A costs that are applicable to the
decrement are determined by multiplying the additional section 263A
costs allocated to the layer of the pool in which the decrement occurred
by the ratio of the decrement, excluding additional section 263A costs,
to the section 471 costs in the layer of that pool.
(v) De minimis rule for producers with total indirect costs of
$200,000 or less. Paragraph (b)(3)(iv) of this section, which provides
that the additional section 263A costs allocable to eligible property
remaining on hand at the close of the taxable year are deemed to be zero
for producers with total indirect costs of $200,000 or less, applies to
the modified simplified production method.
(vi) Examples. The provisions of this paragraph (c) are illustrated
by the following examples:
(A) Example 1--FIFO inventory method.
(1) Taxpayer P uses the FIFO method of accounting for inventories
valued at cost. P's beginning inventory for 2018 (all of which is sold
during 2018) is $2,500,000, consisting of $500,000 of pre-production
section 471 costs (including $400,000 of direct material costs and
$100,000 of property acquired for resale), $1,500,000 of production
section 471 costs, and $500,000 of additional section 263A costs. During
2018, P incurs $2,500,000 of pre-production section 471 costs (including
$1,900,000 of direct material costs and $600,000 of property acquired
for resale), $7,500,000 of production section 471 costs, $200,000 of
pre-production additional section 263A costs, and $800,000 of production
additional section 263A costs. P's additional section 263A costs include
capitalizable mixed service costs under the simplified service cost
method. P's pre-production and production section 471 costs remaining in
ending inventory at the end of 2018 are $1,000,000 (including $800,000
of direct material costs and $200,000 of property acquired for resale)
and $2,000,000, respectively. P computes its pre-production absorption
[[Page 786]]
ratio for 2018 under paragraph (c)(3)(ii)(B) of this section, as
follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.004
(2) Under paragraph (c)(3)(ii)(D)(2) of this section, P's residual
pre-production additional section 263A costs for 2018 are $120,000
($200,000 of pre-production additional section 263A costs less $80,000
(the product of the 8% pre-production absorption ratio and the
$1,000,000 of pre-production section 471 costs remaining on hand at year
end)).
(3) Under paragraph (c)(3)(ii)(D)(4) of this section, P's direct
materials adjustment for 2018 is $1,500,000 ($400,000 of direct material
costs in beginning raw materials inventory, plus $1,900,000 of direct
material costs incurred to acquire raw materials during the taxable
year, less $800,000 direct material costs in ending raw materials
inventory).
(4) P computes its production absorption ratio for 2018 under
paragraph (c)(3)(ii)(D) of this section, as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.005
(5) Under the modified simplified production method, P determines
the additional section 263A costs allocable to its ending inventory
under paragraph (c)(3)(i)(A) of this section by multiplying the pre-
production absorption ratio by the pre-production section 471 costs
remaining on hand at year end and the production absorption ratio by the
production section 471 costs remaining on hand at year end, as follows:
Additional section 263A costs = (8% x $1,000,000) + (10.22% x
$2,000,000) = $284,400
(6) P adds this $284,400 to the $3,000,000 of section 471 costs
remaining on hand at year end to calculate its total ending inventory of
$3,284,400. The balance of P's additional section 263A costs incurred
during 2018, $715,600 ($1,000,000 less $284,400), is taken into account
in 2018 as part of P's cost of goods sold.
(7) P's computation is summarized in the following table:
------------------------------------------------------------------------
Reference Amount
------------------------------------------------------------------------
Beginning Inventory:
Direct material costs......... a................... $ 400,000
Property acquired for resale.. b................... 100,000
---------------
Pre-production section 471 c = a + b........... 500,000
costs.
Production section 471 costs.. d................... 1,500,000
Additional section 263A costs. e................... 500,000
---------------
Total..................... f = c d + e......... 2,500,000
Incurred During 2018:
Direct material costs......... g................... 1,900,000
Property acquired for resale.. h................... 600,000
---------------
Pre-production section 471 i = g + h........... 2,500,000
costs.
Production section 471 costs.. j................... 7,500,000
[[Page 787]]
Pre-production additional k................... 200,000
section 263A costs.
Production additional section l................... 800,000
263A costs.
---------------
Total..................... m = i + j + k + l... 11,000,000
Ending Inventory:
Direct material costs......... n................... 800,000
Property acquired for resale.. o................... 200,000
---------------
Pre-production section 471 p = n + o........... 1,000,000
costs.
Production section 471 costs.. q................... 2,000,000
---------------
Section 471 costs............. r = p + q........... 3,000,000
Additional section 263A costs s = v + z........... 284,400
allocable to ending inventory.
---------------
Total..................... t = r + s........... 3,284,400
Modified Simplified Production
Method:
Pre-production additional k................... 200,000
section 263A costs.
Pre-production section 471 i................... 2,500,000
costs.
Pre-production absorption u = k / i........... 8.00%
ratio.
Pre-production section 471 p................... 1,000,000
costs remaining on hand at
year end.
Pre-production additional v = u * p........... 80,000
section 263A costs allocable
to ending inventory.
Production additional section l................... 800,000
263A costs.
Residual pre-production w = k-(u * p)....... 120,000
additional section 263A costs.
Production section 471 costs.. j................... 7,500,000
Direct materials adjustment... x = a + g-n......... 1,500,000
Production absorption ratio... y = (l + w) / (j + 10.22%
x).
Production section 471 costs q................... 2,000,000
remaining on hand at year end.
Production additional section z = y * q........... 204,400
263A costs allocable to
ending inventory.
Summary:
Pre-production additional v................... 80,000
section 263A costs allocable
to ending inventory.
Production additional section z................... 204,400
263A costs allocable to
ending inventory.
---------------
Additional section 263A costs s................... 284,400
allocable to ending inventory.
Section 471 costs............. r................... 3,000,000
---------------
Total Ending Inventory.... t................... 3,284,400
------------------------------------------------------------------------
(B) Example 2--FIFO inventory method with alternative method to
determine amounts of section 471 costs.
(1) The facts are the same as in Example 1 of paragraph
(c)(3)(vi)(A) of this section, except that P uses the alternative method
to determine amounts of section 471 costs by using its financial
statement under Sec. 1.263A-1(d)(2)(iii) rather than tax amounts under
Sec. 1.263A-1(d)(2)(i). In 2018, P's production section 471 costs
exclude $40,000 of tax depreciation in excess of financial statement
depreciation and include $50,000 of financial statement direct labor in
excess of tax direct labor. These are P's only differences in its book
and tax amounts.
(2) Under Sec. 1.263A-1(d)(2)(iii)(B), the positive $40,000
depreciation adjustment and the negative $50,000 direct labor adjustment
must be included in additional section 263A costs. Accordingly, P's
production additional section 263A costs are $790,000 ($800,000 plus
$40,000 less $50,000).
(3) P computes its production absorption ratio for 2018 under
paragraph (c)(3)(ii)(D) of this section, as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.006
(4) Under the modified simplified production method, P determines
the additional section 263A costs allocable to its ending inventory
under paragraph (c)(3)(i)(A) of this section by multiplying the pre-
production absorption
[[Page 788]]
ratio by the pre-production section 471 costs remaining on hand at year
end and the production absorption ratio by the production section 471
costs remaining on hand at year end, as follows:
Additional section 263A costs = (8.00% x $1,000,000) + (10.11% x
$2,000,000) = $282,200
(5) P adds this $282,200 to the $3,000,000 of section 471 costs
remaining on hand at year end to calculate its total ending inventory of
$3,282,200. The balance of P's additional section 263A costs incurred
during 2018, $717,800 ($1,000,000 less $282,200), is taken into account
in 2018 as part of P's cost of goods sold.
(C) Example 3--LIFO inventory method.
(1) The facts are the same as in Example 1 of paragraph
(c)(3)(vi)(A) of this section, except that P uses a dollar-value LIFO
inventory method rather than the FIFO method. P's 2018 LIFO increment is
$1,500,000.
(2) Under paragraph (c)(3)(iv)(B)(1) of this section, to determine
the additional section 263A costs allocable to its ending inventory, P
multiplies the combined absorption ratio by the $1,500,000 of LIFO
increment. Under paragraph (c)(3)(iv)(B)(2) of this section, the
combined absorption ratio is 9.48% ($284,400 additional section 263A
costs allocable to ending inventory, determined on a non-LIFO basis,
divided by $3,000,000 of section 471 costs on hand at year end,
determined on a non-LIFO basis). Thus, P's additional section 263A costs
allocable to its ending inventory are $142,200 ($1,500,000 multiplied by
9.48%). This $142,200 is added to the $1,500,000 to determine a total
2018 LIFO increment of $1,642,200. The balance of P's additional section
263A costs incurred during 2018, $857,800 ($1,000,000 less $142,200), is
taken into account in 2018 as part of P's cost of goods sold.
(3) In 2019, P sells one-half of the inventory in its 2018
increment. P must include in its cost of goods sold for 2019 the amount
of additional section 263A costs relating to this inventory, $71,100
(one-half of the $142,200 additional section 263A costs capitalized in
2018 ending inventory).
(D) Example 4--Direct materials-based allocation of mixed service
costs.
(1) Taxpayer R computes its capitalizable mixed service costs using
the simplified service cost method described in Sec. 1.263A-1(h).
During 2018, R incurs $200,000 of capitalizable mixed service costs,
computed using the general allocation formula in Sec. 1.263A-1(h).
During 2018, R also incurs $8,000,000 of total section 471 costs,
including $2,000,000 of direct material costs.
(2) Under paragraph (c)(3)(iii)(B) of this section, R determines its
capitalizable mixed service costs allocable to pre-production additional
section 263A costs based on the proportion of direct material costs in
total section 471 costs. R's direct material costs are 25% of total
section 471 costs ($2,000,000 of direct material costs incurred during
the year divided by $8,000,000 of total section 471 costs incurred
during the year). Thus, R allocates $50,000 (25% x $200,000) of mixed
service costs to pre-production additional section 263A costs. R
includes the remaining $150,000 ($200,000 less $50,000) of capitalizable
mixed service costs as production additional section 263A costs.
(E) Example 5--Labor-based allocation of mixed service costs.
(1) Taxpayer S computes its capitalizable mixed service costs using
the simplified service cost method described in Sec. 1.263A-1(h).
During 2018, S incurs $200,000 of capitalizable mixed service costs,
computed using the general allocation formula in Sec. 1.263A-1(h).
During 2018, S also incurs $10,000,000 of total labor costs (excluding
any labor costs included in mixed service costs), including $1,000,000
of labor costs that are pre-production costs as described in paragraph
(a)(3)(ii) of this section (excluding any labor costs included in mixed
service costs).
(2) Under paragraph (c)(3)(iii)(B) of this section, S determines its
capitalizable mixed service costs allocable to pre-production additional
section 263A costs based on the proportion of labor costs that are pre-
production costs in labor costs. S's pre-production labor costs are 10%
of labor costs ($1,000,000 of labor costs incurred during the year that
are pre-production costs (excluding any labor costs included in mixed
service costs), divided by $10,000,000 of total labor costs incurred
during the year (excluding any
[[Page 789]]
labor costs included in mixed service costs). Thus, S allocates $20,000
(10% x $200,000) of mixed service costs to pre-production additional
section 263A costs. S includes the remaining $180,000 ($200,000 less
$20,000) of capitalizable mixed service costs as production additional
section 263A costs.
(F) Example 6--De minimis rule for allocation of mixed service
costs. The facts are the same as in Example 5 in paragraph (c)(3)(vi)(E)
of this section, except that S uses the de minimis rule for mixed
service costs in paragraph (c)(3)(iii)(C) of this section. Because 90%
or more of S's capitalizable mixed service costs are allocated to
production additional section 263A costs, under the de minimis rule, S
allocates all $200,000 of capitalizable mixed service costs to
production additional section 263A costs. None of the capitalizable
mixed service costs are allocated to pre-production additional section
263A costs.
(4) Modified simplified production method with historic absorption
ratio election--(i) In general. This paragraph (c)(4) generally permits
taxpayers using the modified simplified production method to elect a
historic absorption ratio in determining additional section 263A costs
allocable to eligible property remaining on hand at the close of their
taxable years. A taxpayer may only make a historic absorption ratio
election under this paragraph (c)(4) if it has used the modified
simplified production method for three or more consecutive taxable years
immediately prior to the year of election and has capitalized additional
section 263A costs using an actual pre-production absorption ratio, as
defined in paragraph (c)(3)(ii)(B) of this section, and an actual
production absorption ratio, as defined in paragraph (c)(3)(ii)(D) of
this section, or an actual combined absorption ratio, as defined in
paragraph (c)(3)(iv)(B)(2) of this section, for its three most recent
consecutive taxable years. This method is not available to a taxpayer
that is deemed to have zero additional section 263A costs under
paragraph (c)(3)(v) of this section. The historic absorption ratio is
used in lieu of the actual absorption ratios computed under paragraph
(c)(3)(ii) of this section or the actual combined absorption ratio
computed under paragraph (c)(3)(iv) and is based on costs capitalized by
a taxpayer during its test period. If elected, the historic absorption
ratio must be used for each taxable year within the qualifying period
described in paragraph (b)(4)(ii)(C) of this section. Except as
otherwise provided in this paragraph (c)(4), paragraph (b)(4) of this
section applies to the historic absorption ratio election under the
modified simplified production method.
(ii) Operating rules and definitions--(A) Pre-production historic
absorption ratio. The pre-production historic absorption ratio is
computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.007
(1) Pre-production additional section 263A costs incurred during the
test period are defined as the pre-production additional section 263A
costs described in paragraph (c)(3)(ii)(B)(1) of this section that the
taxpayer incurs during the test period described in paragraph
(b)(4)(ii)(B) of this section.
(2) Pre-production section 471 costs incurred during the test period
are defined as the pre-production section 471 costs described in
paragraph (c)(3)(ii)(B)(2) of this section that the taxpayer incurs
during the test period described in paragraph (b)(4)(ii)(B) of this
section.
(B) Production historic absorption ratio. The production historic
absorption ratio is computed as follows:
[[Page 790]]
[GRAPHIC] [TIFF OMITTED] TR20NO18.008
(1) Production additional section 263A costs incurred during the
test period are defined as the production additional section 263A costs
described in paragraph (c)(3)(ii)(D)(1) of this section that the
taxpayer incurs during the test period described in paragraph
(b)(4)(ii)(B) of this section.
(2) Residual pre-production additional section 263A costs incurred
during the test period are defined as the residual pre-production
additional section 263A costs described in paragraph (c)(3)(ii)(D)(2) of
this section that the taxpayer incurs during the test period described
in paragraph (b)(4)(ii)(B) of this section.
(3) Production section 471 costs incurred during the test period are
defined as the production section 471 costs described in paragraph
(c)(3)(ii)(D)(3) of this section that the taxpayer incurs during the
test period described in paragraph (b)(4)(ii)(B) of this section.
(4) Direct materials adjustments made during the test period are
defined as the direct materials adjustments described in paragraph
(c)(3)(ii)(D)(4) of this section that the taxpayer incurs during the
test period described in paragraph (b)(4)(ii)(B) of this section.
(iii) LIFO taxpayers making the historic absorption ratio election--
(A) In general. Instead of the pre-production and production historic
absorption ratios defined in paragraph (c)(4)(ii) of this section, a
LIFO taxpayer making the historic absorption ratio election under the
modified simplified production method calculates a combined historic
absorption ratio based on costs the taxpayer capitalizes during its test
period.
(B) Combined historic absorption ratio. The combined historic
absorption ratio is computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.009
(1) Total allocable additional section 263A costs incurred during
the test period. Total allocable additional section 263A costs incurred
during the test period are the sum of the total additional section 263A
costs allocable to eligible property on hand at year end as described in
paragraph (c)(3)(i)(A) of this section, determined on a non-LIFO basis,
for all taxable years in the test period.
(2) Total section 471 costs remaining on hand at each year end of
the test period. Total section 471 costs remaining on hand at each year
end of the test period are the sum of the total pre-production section
471 costs remaining on hand at year end as described in paragraph
(c)(3)(ii)(C) of this section and the total production section 471 costs
remaining on hand at year end as described in paragraph (c)(3)(ii)(E) of
this section, determined on a non-LIFO basis, for all taxable years in
the test period.
(iv) Extension of qualifying period. In the first taxable year
following the close of each qualifying period (for example, the sixth
taxable year following the test period), a taxpayer must compute the
actual absorption ratios under paragraph (c)(3) of this section (pre-
production and production absorption ratios or, for LIFO taxpayers, the
combined absorption ratio). If the actual combined absorption ratio or
both the actual pre-production and production absorption ratios, as
applicable, computed for this taxable year (the recomputation year) is
within one-half of one percentage point, plus or minus, of the
corresponding historic absorption
[[Page 791]]
ratio or ratios used in determining capitalizable costs for the
qualifying period (the previous five taxable years), the qualifying
period is extended to include the recomputation year and the following
five taxable years, and the taxpayer must continue to use the historic
absorption ratio or ratios throughout the extended qualifying period.
If, however, the actual combined historic absorption ratio or either the
actual pre-production absorption ratio or production absorption ratio,
as applicable, is not within one-half of one percentage point, plus or
minus, of the corresponding historic absorption ratio, the taxpayer must
use the actual combined absorption ratio or ratios beginning with the
recomputation year and throughout the updated test period. The taxpayer
must resume using the historic absorption ratio or ratios based on the
updated test period in the third taxable year following the
recomputation year.
(v) Examples. The provisions of this paragraph (c)(4) are
illustrated by the following examples:
(A) Example 1--HAR and FIFO inventory method.
(1) Taxpayer S uses the FIFO method of accounting for inventories
valued at cost and for 2021 elects to use the historic absorption ratio
with the modified simplified production method. S identifies the
following costs incurred during the test period:
----------------------------------------------------------------------------------------------------------------
2018 2019 2020
----------------------------------------------------------------------------------------------------------------
Pre-production additional section 263A costs.................... $100 $200 $300
Production additional section 263A costs........................ 200 350 450
Pre-production section 471 costs................................ 2,000 2,500 3,000
Production section 471 costs.................................... 2,500 3,500 4,000
Residual pre-production additional section 263A costs........... 60 136 220
Direct materials adjustments.................................... 2,700 3,200 3,700
----------------------------------------------------------------------------------------------------------------
(2) Under paragraph (c)(4)(ii)(A) of this section, S computes the
pre-production historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.010
(3) Under paragraph (c)(4)(ii)(B) of this section, S computes the
production historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.011
(4) In 2021, S incurs $10,000 of section 471 costs of which $1,000
pre-production section 471 costs and $2,000 production 471 costs remain
in ending inventory.
[[Page 792]]
Under the modified simplified production method using a historic
absorption ratio, S determines the pre-production additional section
263A costs allocable to its ending inventory by multiplying its pre-
production historic absorption ratio (8.00%) by the pre-production
section 471 costs remaining on hand at year end ($1,000). Thus, S
allocates $80 of pre-production additional section 263A costs to its
ending inventory (8.00% x $1,000). S determines the production
additional section 263A costs allocable to its ending inventory by
multiplying its production historic absorption ratio (7.22%) by the
production section 471 costs remaining on hand at year end ($2,000).
Thus, S allocates $144 of production additional section 263A costs to
its ending inventory (7.22% x $2,000).
(5) Under paragraph (c)(4)(i) of this section, S's total additional
section 263A costs allocable to ending inventory in 2021 are $224, which
is the sum of the allocable pre-production additional section 263A costs
($80) and the allocable production additional section 263A costs ($144).
S's ending inventory in 2021 is $3,224, which is the sum of S's
additional section 263A costs allocable to ending inventory and S's
section 471 costs remaining in ending inventory ($224 + $3,000). The
balance of S's additional section 263A costs incurred during 2021 is
taken into account in 2021 as part of S's cost of goods sold.
(B) Example 2--HAR and LIFO inventory method. (1)(i) The facts are
the same as in Example 1 in paragraph (c)(4)(v)(A) of this section,
except that S uses a dollar-value LIFO inventory method rather than the
FIFO method. S calculates additional section 263A costs incurred during
the taxable year and allocable to ending inventory under paragraph
(c)(4)(iii) of this section and identifies the following costs incurred
during the test period:
----------------------------------------------------------------------------------------------------------------
2018 2019 2020
----------------------------------------------------------------------------------------------------------------
Additional section 263A costs incurred during the taxable year $90 $137 $167
allocable to ending inventory..................................
Section 471 costs incurred during the taxable year that remain 1,000 1,400 2,100
in ending inventory............................................
----------------------------------------------------------------------------------------------------------------
(ii) In 2021, the LIFO value of S's increment is $1,500.
(2) Under paragraph (c)(4)(iii) of this section, S computes a
combined historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.012
(3) S's additional section 263A costs allocable to its 2021 LIFO
increment are $131 ($1,500 beginning LIFO increment x 8.76% combined
historic absorption ratio). S adds the $131 to the $1,500 LIFO increment
to determine a total 2021 LIFO increment of $1,631.
(d) Additional simplified methods for producers. The Commissioner
may prescribe additional elective simplified methods by revenue ruling
or revenue procedure.
(e) Cross reference. See Sec. 1.6001-1(a) regarding the duty of
taxpayers to keep such records as are sufficient to establish the amount
of gross income, deductions, etc.
(f) Change in method of accounting--(1) In general. A change in a
taxpayer's treatment of additional section 263A costs to comply with
paragraph (b)(2)(i)(D) of this section is a change in method of
accounting to which the provisions of sections 446 and 481 and the
[[Page 793]]
regulations under those sections apply. See Sec. 1.263A-7. For a
taxpayer's first taxable year ending on or after August 2, 2005, the
taxpayer is granted the consent of the Commissioner to change its method
of accounting to comply with paragraph (b)(2)(i)(D) of this section,
provided the taxpayer follows the administrative procedures, as modified
by paragraphs (e)(2) through (4) of this section, issued under Sec.
1.446-1(e)(3)(ii) for obtaining the Commissioner's automatic consent to
a change in accounting method (for further guidance, for example, see
Rev. Proc. 2002-9 (2002-1 CB 327), as modified and clarified by
Announcement 2002-17 (2002-1 CB 561), modified and amplified by Rev.
Proc. 2002-19 (2002-1 CB 696), and amplified, clarified, and modified by
Rev. Proc. 2002-54 (2002-2 CB 432), and Sec. 601.601(d)(2)(ii)(b) of
this chapter). For purposes of Form 3115, ``Application for Change in
Accounting Method,'' the designated number for the automatic accounting
method change authorized by this paragraph (e) is ``95.'' If Form 3115
is revised or renumbered, any reference in this section to that form is
treated as a reference to the revised or renumbered form. Alternatively,
notwithstanding the provisions of any administrative procedures that
preclude a taxpayer from requesting the advance consent of the
Commissioner to change a method of accounting that is required to be
made pursuant to a published automatic change procedure, for its first
taxable year ending on or after August 2, 2005, a taxpayer may request
the advance consent of the Commissioner to change its method of
accounting to comply with paragraph (b)(2)(i)(D) of this section,
provided the taxpayer follows the administrative procedures, as modified
by paragraphs (e)(2) through (5) of this section, for obtaining the
advance consent of the Commissioner (for further guidance, for example,
see Rev. Proc. 97-27 (1997-1 CB 680), as modified and amplified by Rev.
Proc. 2002-19 (2002-1 CB 696), as amplified and clarified by Rev. Proc.
2002-54 (2002-2 CB 432), and Sec. 601.601(d)(2)(ii)(b) of this
chapter). For the taxpayer's second and subsequent taxable years ending
on or after August 2, 2005, requests to secure the consent of the
Commissioner must be made under the administrative procedures, as
modified by paragraphs (e)(3) and (4) of this section, for obtaining the
Commissioner's advance consent to a change in accounting method.
(2) Scope limitations. Any limitations on obtaining the automatic
consent or advance consent of the Commissioner do not apply to a
taxpayer seeking to change its method of accounting to comply with
paragraph (b)(2)(i)(D) of this section for its first taxable year ending
on or after August 2, 2005.
(3) Audit protection. A taxpayer that changes its method of
accounting in accordance with this paragraph (e) to comply with
paragraph (b)(2)(i)(D) of this section does not receive audit protection
if its method of accounting for additional section 263A costs is an
issue under consideration at the time the application is filed with the
national office.
(4) Section 481(a) adjustment. A change in method of accounting to
conform to paragraph (b)(2)(i)(D) of this section requires a section
481(a) adjustment. The section 481(a) adjustment period is two taxable
years for a net positive adjustment for an accounting method change that
is made to conform to paragraph (b)(2)(i)(D) of this section.
(5) Time for requesting change. Notwithstanding the provisions of
Sec. 1.446-1(e)(3)(i) and any contrary administrative procedure, a
taxpayer may submit a request for advance consent to change its method
of accounting to comply with paragraph (b)(2)(i)D) of this section for
its first taxable year ending on or after August 2, 2005, on or before
the date that is 30 days after the end of the taxable year for which the
change is requested.
(g) Applicability dates. (1) Paragraphs (b)(2)(i)(D), (e), and (f)
of this section apply for taxable years ending on or after August 2,
2005.
(2) Paragraphs (b)(3)(ii)(C) and (b)(4)(ii)(A)(4) of this section
apply for taxable years ending on or after January 13, 2014.
(3) Paragraph (c) of this section applies for taxable years
beginning on or after November 20, 2018. For any taxable year that both
begins before November 20, 2018 and ends after November 20, 2018, the
IRS will not challenge
[[Page 794]]
return positions consistent with all of paragraphs (c) of this section.
(4) The rules set forth in the last sentence of the introductory
text of paragraph (a) of this section and in paragraph (a)(1)(ii)(C) of
this section apply for taxable years beginning on or after January 5,
2021. However, for a taxable year beginning after December 31, 2017, and
before January 5, 2021, a taxpayer may apply the paragraphs described in
the first sentence of this paragraph (g)(4), provided that the taxpayer
follows all the applicable rules contained in the regulations under
section 263A for such taxable year and all subsequent taxable years.
[T.D. 8482, 58 FR 42219, Aug. 9, 1993, as amended by 59 FR 3318, 3319,
Jan. 21, 1994; T.D. 8584, 59 FR 67197, Dec. 29, 1994; T.D. 9217, 70 FR
44469, Aug. 3, 2005; T.D. 9318, 72 FR 14677, Mar. 29, 2007; T.D. 9652,
79 FR 2097, Jan. 13, 2014; T.D. 9843, 83 FR 58491, Nov. 20, 2018; T.D.
9942, 86 FR 266, Jan. 5, 2021]
Sec. 1.263A-3 Rules relating to property acquired for resale.
(a) Capitalization rules for property acquired for resale--(1) In
general. Section 263A applies to real property and personal property
described in section 1221(1) acquired for resale by a retailer,
wholesaler, or other taxpayer (reseller). However, for taxable years
beginning after December 31, 2017, a small business taxpayer, as defined
in Sec. 1.263A-1(j), is not required to apply section 263A in that
taxable year.For this purpose, personal property includes both tangible
and intangible property. Property acquired for resale includes stock in
trade of the taxpayer or other property which is includible in the
taxpayer's inventory if on hand at the close of the taxable year, and
property held by the taxpayer primarily for sale to customers in the
ordinary course of the taxpayer's trade or business. See, however, Sec.
1.263A-1(b)(11) for an exception for certain de minimis property
provided to customers incident to the provision of services.
(2) Resellers with production activities--(i) In general. Generally,
a taxpayer must capitalize all direct costs and certain indirect costs
associated with real property and tangible personal property it
produces. See Sec. 1.263A-2(a). Thus, except as provided in paragraphs
(a)(2)(ii) and (3) of this section, a reseller, including a small
reseller, that also produces property must capitalize the additional
section 263A costs associated with any property it produces.
(ii) Exemption for certain small business taxpayers. For taxable
years beginning after December 31, 2017, see Sec. 1.263A-1(j) for an
exception in the case of a small business taxpayer that meets the gross
receipts test of section 448(c) and Sec. 1.448-2(c).
(iii) De minimis production activities. See paragraph (a)(5) of this
section for rules relating to an exception for resellers with de minimis
production activities.
(3) Resellers with property produced under contract. Generally,
property produced for a taxpayer under a contract (within the meaning of
Sec. 1.263A-2(a)(1)(ii)(B)(2)) is treated as property produced by the
taxpayer. See Sec. 1.263A-2(a)(1)(ii)(B). However, a small business
taxpayer is not required to capitalize additional section 263A costs to
personal property produced for it under contract with an unrelated
person if the contract is entered into incident to the resale activities
of the small business taxpayer and the property is sold to its
customers. For purposes of this paragraph, persons are related if they
are described in section 267(b) or 707(b).
(4) Use of the simplified resale method-- (i) In general. Except as
provided in paragraphs (a)(4)(ii) and (iii) of this section, a taxpayer
may elect the simplified production method, as described in Sec.
1.263A-2(b), or the modified simplified production method, as described
in Sec. 1.263A-2(c), but may not elect the simplified resale method, as
described in paragraph (d) of this section, if the taxpayer is engaged
in both production and resale activities with respect to the items of
eligible property listed in Sec. 1.263A-2(b)(2).
(ii) Resellers with de minimis production activities. A reseller
otherwise permitted to use the simplified resale method in paragraph (d)
of this section may use the simplified resale method if its production
activities with respect to the items of eligible property listed in
Sec. 1.263A-2(b)(2) are de minimis (within the meaning of paragraph
(a)(5) of this section) and incident to its resale
[[Page 795]]
of personal property described in section 1221(1).
(iii) Resellers with property produced under a contract. A reseller
otherwise permitted to use the simplified resale method in paragraph (d)
of this section may use the simplified resale method even though it has
personal property produced for it (e.g., private label goods) under a
contract with an unrelated person if the contract is entered into
incident to its resale activities and the property is sold to its
customers. For purposes of this paragraph (a)(4)(iii), persons are
related if they are described in section 267(b) or 707(b).
(iv) Application of simplified resale method. A taxpayer that uses
the simplified resale method and has de minimis production activities
incident to its resale activities or property produced under contract
must capitalize all costs allocable to eligible property produced using
the simplified resale method.
(5) De minimis production activities--(i) In general. In determining
whether a taxpayer's production activities are de minimis, all facts and
circumstances must be considered. For example, the taxpayer must
consider the volume of the production activities in its trade or
business. Production activities are presumed de minimis if--
(A) The gross receipts from the sale of the property produced by the
reseller are less than 10 percent of the total gross receipts of the
trade or business; and
(B) The labor costs allocable to the trade or business's production
activities are less than 10 percent of the reseller's total labor costs
allocable to its trade or business.
(ii) Definition of gross receipts to determine de minimis production
activities. Gross receipts has the same definition as for purposes of
the gross receipts test under Sec. 1.448-2(c), except that gross
receipts are measured at the trade-or-business level rather than at the
single-employer level.
(iii) Example: Reseller with de minimis production activities.
Taxpayer N is in the retail grocery business. In 2019, N's average
annual gross receipts for the three previous taxable years are greater
than the gross receipts test of section 448(c). Thus, N is not exempt
from the requirement to capitalize costs under section 263A. N's grocery
stores typically contain bakeries where customers may purchase baked
goods produced by N. N produces no other goods in its retail grocery
business. N's gross receipts from its bakeries are 5 percent of the
entire grocery business. N's labor costs from its bakeries are 3 percent
of its total labor costs allocable to the entire grocery business.
Because both ratios are less than 10 percent, N's production activities
are de minimis. Further, because N's production activities are incident
to its resale activities, N may use the simplified resale method, as
provided in paragraph (a)(4)(ii) of this section.
(b) [Reserved]
(c) Purchasing, handling, and storage costs--(1) In general.
Generally, Sec. 1.263A-1(e) describes the types of costs that must be
capitalized by taxpayers. Resellers must capitalize the acquisition cost
of property acquired for resale, as well as indirect costs described in
Sec. 1.263A-1(e)(3), which are properly allocable to property acquired
for resale. The indirect costs most often incurred by resellers are
purchasing, handling, and storage costs. This paragraph (c) provides
additional guidance regarding each of these categories of costs. As
provided in Sec. 1.263A-1(e), this paragraph (c) also applies to
producers incurring purchasing, handling, and storage costs.
(2) Costs attributable to purchasing, handling, and storage. The
costs attributable to purchasing, handling, and storage activities
generally consist of direct and indirect labor costs (including the
costs of pension plans and other fringe benefits); occupancy expenses
including rent, depreciation, insurance, security, taxes, utilities and
maintenance; materials and supplies; rent, maintenance, depreciation,
and insurance of vehicles and equipment; tools; telephone; travel; and
the general and administrative costs that directly benefit or are
incurred by reason of the taxpayer's activities.
(3) Purchasing costs--(i) In general. Purchasing costs are costs
associated with operating a purchasing department or office within a
trade or business, including personnel costs (e.g., of
[[Page 796]]
buyers, assistant buyers, and clerical workers), relating to--
(A) The selection of merchandise;
(B) The maintenance of stock assortment and volume;
(C) The placement of purchase orders;
(D) The establishment and maintenance of vendor contacts; and
(E) The comparison and testing of merchandise.
(ii) Determination of whether personnel are engaged in purchasing
activities. The determination of whether a person is engaged in
purchasing activities is based upon the activities performed by that
person and not upon the person's title or job classification. Thus, for
example, although an employee's job function may be described in such a
way as to indicate activities outside the area of purchasing (e.g., a
marketing representative), such activities must be analyzed on the basis
of the activities performed by that employee. If a person performs both
purchasing and non-purchasing activities, the taxpayer must reasonably
allocate the person's labor costs between these activities. For example,
a reasonable allocation is one based on the amount of time the person
spends on each activity.
(A) \1/3\-\2/3\ rule for allocating labor costs. A taxpayer may
elect the \1/3\-\2/3\ rule for allocating labor costs of persons
performing both purchasing and non-purchasing activities. If elected,
the taxpayer must allocate the labor costs of all such persons using the
\1/3\-\2/3\ rule. Under this rule--
(1) If less than one-third of a person's activities are related to
purchasing, none of that person's labor costs are allocated to
purchasing;
(2) If more than two-thirds of a person's activities are related to
purchasing, all of that person's labor costs are allocated to
purchasing; and
(3) In all other cases, the taxpayer must reasonably allocate labor
costs between purchasing and non-purchasing activities.
(B) Example. The application of paragraph (c)(3)(ii)(A) of this
section may be illustrated by the following example:
Example. Taxpayer O is a reseller that employs three persons, A, B,
and C, who perform both purchasing and non- purchasing activities. These
persons spend the following time performing purchasing activities: A-25
%; B-70 %; and C-50 %. Under the \1/3\-\2/3\ rule, Taxpayer O treats
none of A's labor costs as purchasing costs, all of B's labor costs as
purchasing costs, and Taxpayer O allocates 50 % of C's labor costs as
purchasing costs.
(4) Handling costs--(i) In general. Handling costs include costs
attributable to processing, assembling, repackaging, transporting, and
other similar activities with respect to property acquired for resale,
provided the activities do not come within the meaning of the term
produce as defined in Sec. 1.263A-2(a)(1). Handling costs are generally
required to be capitalized under section 263A. Under this paragraph
(c)(4)(i), however, handling costs incurred at a retail sales facility
(as defined in paragraph (c)(5)(ii)(B) of this section) with respect to
property sold to retail customers at the facility are not required to be
capitalized. Thus, for example, handling costs incurred at a retail
sales facility to unload, unpack, mark, and tag goods sold to retail
customers at the facility are not required to be capitalized. In
addition, handling costs incurred at a dual-function storage facility
(as defined in paragraph (c)(5)(ii)(G) of this section) with respect to
property sold to customers from the facility are not required to be
capitalized to the extent that the costs are incurred with respect to
property sold in on-site sales. Handling costs attributable to property
sold to customers from a dual-function storage facility in on-site sales
are determined by applying the ratio in paragraph (c)(5)(iii)(B) of this
section.
(ii) Processing costs. Processing costs are the costs a reseller
incurs in making minor changes or alterations to the nature or form of a
product acquired for resale. Minor changes to a product include, for
example, monogramming a sweater, altering a pair of pants, and other
similar activities.
(iii) Assembling costs. Generally, assembling costs are costs
associated with incidental activities that are necessary in readying
property for resale (e.g., attaching wheels and handlebars to a bicycle
acquired for resale).
(iv) Repackaging costs. Repackaging costs are the costs a taxpayer
incurs to package property for sale to its customers.
[[Page 797]]
(v) Transportation costs. Generally, transportation costs are the
costs a taxpayer incurs moving or shipping property acquired for resale.
These costs include the cost of dispatching trucks; loading and
unloading shipments; and sorting, tagging, and marking property.
Transportation costs may consist of depreciation on trucks and equipment
and the costs of fuel, insurance, labor, and similar costs. Generally,
transportation costs required to be capitalized include costs incurred
in transporting property--
(A) From the vendor to the taxpayer;
(B) From one of the taxpayer's storage facilities to another of its
storage facilities;
(C) From the taxpayer's storage facility to its retail sales
facility;
(D) From the taxpayer's retail sales facility to its storage
facility; and
(E) From one of the taxpayer's retail sales facilities to another of
its retail sales facilities.
(vi) Costs not required to be capitalized as handling costs--(A)
Distribution costs--(1) In general. Distribution costs are not required
to be capitalized. Distribution costs are any transportation costs
incurred outside a storage facility in delivering goods to a customer.
For this purpose, any costs incurred on a loading dock are treated as
incurred outside a storage facility.
(2) Costs incurred in transporting goods to a related person.
Distribution costs do not include costs incurred by a taxpayer in
delivering goods to a related person. Thus, for example, when a taxpayer
sells goods to a related person, the costs of transporting the goods are
included in determining the basis of the goods that are sold, and hence
in determining the resulting gain or loss from the sale, for all
purposes of the Internal Revenue Code and the regulations thereunder.
See, e.g., sections 267, 707, and 1502. For purposes of this provision,
persons are related if they are described in section 267(b) or section
707(b).
(B) Delivery of custom-ordered items. Generally, costs incurred in
transporting goods from a taxpayer's storage facility to its retail
sales facility must be capitalized. However, costs incurred outside a
storage facility in delivering custom-ordered items to a retail sales
facility are not required to be capitalized. For this purpose, any costs
incurred on a loading dock are treated as incurred outside a storage
facility. Delivery of custom-ordered items occurs when a taxpayer can
demonstrate that a delivery to the taxpayer's retail sales facility is
made to fill an identifiable order of a particular customer (placed by
the customer before the delivery of the goods occurs) for the particular
goods in question. Factors that may demonstrate the existence of a
specific, identifiable delivery include the following--
(1) The customer has paid for the item in advance of the delivery;
(2) The customer has submitted a written order for the item;
(3) The item is not normally available at the retail sales facility
for on-site customer purchases; and
(4) The item will be returned to the storage facility (and not held
for sale at the retail sales facility) if the customer cancels an order.
(C) Pick and pack costs--(1) In general. Generally, handling costs
incurred inside a storage or warehousing facility must be capitalized.
However, costs attributable to pick and pack activities inside a storage
or warehousing facility are not required to be capitalized. Pick and
pack activities are activities undertaken in preparation for imminent
shipment to a particular customer after the customer has ordered the
specific goods in question. Examples of pick and pack activities
include:
(i) Moving specific goods from a storage location in preparation for
shipment to the customer;
(ii) Packing or repacking those goods for shipment to the customer;
and
(iii) Staging those goods for shipment to the customer.
(2) Activities that are not pick and pack activities. Pick and pack
activities do not include:
(i) Unloading goods that are received for storage;
(ii) Checking the quantity and quality of goods received;
(iii) Comparing the quantity of goods received to the amounts
ordered and preparing the receiving documents;
(iv) Moving the goods to their storage location, e.g., bins, racks,
containers, etc.; and
[[Page 798]]
(v) Storing the goods.
(3) Costs not attributable to pick and pack activities. Occupancy
costs, such as rent, depreciation, insurance, security, taxes,
utilities, and maintenance costs properly allocable to the storage or
warehousing facility, are not costs attributable to pick and pack
activities.
(5) Storage costs--(i) In general. Generally, storage costs are
capitalized under section 263A to the extent they are attributable to
the operation of an off-site storage or warehousing facility (an off-
site storage facility). However, storage costs attributable to the
operation of an on-site storage facility (as defined in paragraph
(c)(5)(ii)(A) of this section) are not required to be capitalized under
section 263A. Storage costs attributable to a dual-function storage
facility (as defined in paragraph (c)(5)(ii)(G) of this section) must be
capitalized to the extent that the facility's costs are allocable to
off-site storage.
(ii) Definitions--(A) On-site storage facility. An on-site storage
facility is defined as a storage or warehousing facility that is
physically attached to, and an integral part of, a retail sales
facility.
(B) Retail sales facility. (1) A retail sales facility is defined as
a facility where a taxpayer sells merchandise exclusively to retail
customers in on-site sales. For this purpose, a retail sales facility
includes those portions of any specific retail site--
(i) Which are customarily associated with and are an integral part
of the operations of that retail site;
(ii) Which are generally open each business day exclusively to
retail customers;
(iii) On or in which retail customers normally and routinely shop to
select specific items of merchandise; and
(iv) Which are adjacent to or in immediate proximity to other
portions of the specific retail site.
(2) Thus, for example, two lots of an automobile dealership
physically separated by an alley or an access road would generally be
considered one retail sales facility, provided customers routinely shop
on both of the lots to select the specific automobiles that they wish to
acquire.
(C) An integral part of a retail sales facility. A storage facility
is considered an integral part of a retail sales facility when the
storage facility is an essential and indispensable part of the retail
sales facility. For example, if the storage facility is used exclusively
for filling orders or completing sales at the retail sales facility, the
storage facility is an integral part of the retail sales facility.
(D) On-site sales. On-site sales are defined as sales made to retail
customers physically present at a facility. For example, mail order and
catalog sales are made to customers not physically present at the
facility, and thus, are not on-site sales.
(E) Retail customer--(1) In general. A retail customer is defined as
the final purchaser of the merchandise. A retail customer does not
include a person who resells the merchandise to others, such as a
contractor or manufacturer that incorporates the merchandise into
another product for sale to customers.
(2) Certain non-retail customers treated as retail customers. For
purposes of this section, a non-retail customer is treated as a retail
customer with respect to a particular facility if the following
requirements are satisfied--
(i) The non-retail customer purchases goods under the same terms and
conditions as are available to retail customers (e.g., no special
discounts);
(ii) The non-retail customer purchases goods in the same manner as a
retail customer (e.g., the non-retail customer may not place orders in
advance and must come to the facility to examine and select goods);
(iii) Retail customers shop at the facility on a routine basis
(i.e., on most business days), and no special days or hours are reserved
for non-retail customers; and
(iv) More than 50 percent of the gross sales of the facility are
made to retail customers.
(F) Off-site storage facility. An off-site storage facility is
defined as a storage facility that is not an on-site storage facility.
(G) Dual-function storage facility. A dual-function storage facility
is defined as a storage facility that serves as both an off-site storage
facility and
[[Page 799]]
an on-site storage facility. For example, a dual-function storage
facility would include a regional warehouse that serves the taxpayer's
separate retail sales outlets and also contains a sales outlet therein.
A dual-function storage facility also includes any facility where sales
are made to retail customers in on-site sales and to--
(1) Retail customers in sales that are not on-site sales; or
(2) Other customers.
(iii) Treatment of storage costs incurred at a dual-function storage
facility--(A) In general. Storage costs associated with a dual-function
storage facility must be allocated between the off-site storage function
and the on-site storage function. To the extent that the dual-function
storage facility's storage costs are allocable to the off-site storage
function, they must be capitalized. To the extent that the dual-function
storage facility's storage costs are allocable to the on-site storage
function, they are not required to be capitalized.
(B) Dual-function storage facility allocation ratio--(1) In general.
Storage costs associated with a dual-function storage facility must be
allocated between the off-site storage function and the on-site storage
function using the ratio of--
(i) Gross on-site sales of the facility (i.e., gross sales of the
facility made to retail customers visiting the premises in person and
purchasing merchandise stored therein); to
(ii) Total gross sales of the facility. For this purpose, the total
gross sales of the facility include the value of items shipped to other
facilities of the taxpayer.
(2) Illustration of ratio allocation. For example, if a dual-
function storage facility's on-site sales are 40 percent of the total
gross sales of the facility, then 40 percent of the facility's storage
costs are allocable to the on-site storage function and are not required
to be capitalized under section 263A.
(3) Appropriate adjustments for other uses of a dual-function
storage facility. Prior to computing the allocation ratio in paragraph
(c)(5)(iii)(B) of this section, a taxpayer must apply the principles of
paragraph (c)(5)(iv) of this section in determining the portion of the
facility that is a dual-function storage facility (and the costs
attributable to such portion).
(C) De minimis 90-10 rule for dual-function storage facilities. If
90 percent or more of the costs of a facility are attributable to the
on-site storage function, the entire storage facility is deemed to be an
on-site storage facility. In contrast, if 10 percent or less of the
costs of a storage facility are attributable to the on-site storage
function, the entire storage facility is deemed to be an off-site
storage facility.
(iv) Costs not attributable to an off-site storage facility. To the
extent that costs incurred at an off-site storage facility are not
properly allocable to the taxpayer's storage function, the costs are not
accounted for as off-site storage costs. For example, if a taxpayer has
an office attached to its off-site storage facility where work unrelated
to the storage function is performed, such as a sales office, costs
associated with this office are not off-site storage costs. However, if
a taxpayer uses a portion of an off-site storage facility in a manner
related to the storage function, for example, to store equipment or
supplies that are not offered for sale to customers, costs associated
with this portion of the facility are off-site storage costs.
(v) Examples. The provisions of this paragraph (c)(5) are
illustrated by the following examples:
Example 1. Catalog or mail order center. Taxpayer P operates a mail
order catalog business. As part of its business, P stores merchandise
for shipment to customers who purchase the merchandise through orders
placed by telephone or mail. P's storage facility is not an on-site
storage facility because no on-site sales are made at the facility.
Example 2. Pooled-stock facility. Taxpayer Q maintains a pooled-
stock facility, which functions as a back-up regional storage facility
for Q's retail sales outlets in the nearby area. Q's pooled stock
facility is an off-site storage facility because it is neither
physically attached to nor an integral part of a retail sales facility.
Example 3. Wholesale warehouse. Taxpayer R operates a wholesale
warehouse where wholesale sales are made to customers physically present
at the facility. R's customers resell the goods they purchase from R to
final retail customers. Because no retail sales are conducted at the
facility, all storage costs
[[Page 800]]
attributable to R's wholesale warehouse must be capitalized.
(d) Simplified resale method--(1) Introduction. This paragraph (d)
provides a simplified method for determining the additional section 263A
costs properly allocable to property acquired for resale and other
eligible property on hand at the end of the taxable year.
(2) Eligible property. Generally, the simplified resale method is
only available to a trade or business exclusively engaged in resale
activities. However, certain resellers with property produced as a
result of de minimis production activities or property produced under
contract may elect the simplified resale method, as described in
paragraph (a)(4) of this section. Eligible property for purposes of the
simplified resale method, therefore, includes any real or personal
property described in section 1221(1) that is acquired for resale and
any eligible property (within the meaning of Sec. 1.263A-2(b)(2)) that
is described in paragraph (a)(4) of this section.
(3) Simplified resale method without historic absorption ratio
election--(i) General allocation formula--(A) In general. Under the
simplified resale method, the additional section 263A costs allocable to
eligible property remaining on hand at the close of the taxable year are
computed as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.013
(B) Effect of allocation. The resulting product under the general
allocation formula is the additional section 263A costs that are added
to the taxpayer's ending section 471 costs to determine the section 263A
costs that are capitalized.
(C) Definitions--(1) Combined absorption ratio. The combined
absorption ratio is defined as the sum of the storage and handling costs
absorption ratio as defined in paragraph (d)(3)(i)(D) of this section
and the purchasing costs absorption ratio as defined in paragraph
(d)(3)(i)(E) of this section.
(2) Section 471 costs remaining on hand at year end. Section 471
costs remaining on hand at year end mean the section 471 costs, as
defined in Sec. 1.263A-1(d)(2), that the taxpayer incurs during its
current taxable year, which remain in its ending inventory or are
otherwise on hand at year end. For LIFO inventories of a taxpayer, the
section 471 costs remaining on hand at year end means the increment, if
any, for the current year stated in terms of section 471 costs. See
paragraph (d)(3)(ii) of this section for special rules applicable to
LIFO taxpayers. Except as otherwise provided in this section or in Sec.
1.263A-1 or 1.263A-2, additional section 263A costs that are allocated
to inventories on hand at the close of the taxable year under the
simplified resale method of this paragraph (d) are treated as inventory
costs for all purposes of the Internal Revenue Code.
(3) Costs allocable to property sold. Section 471 costs remaining on
hand at year end, as defined in paragraph (d)(3)(i)(C)(2) of this
section, do not include costs that are specifically described in Sec.
1.263A-1(e)(3)(ii) or cost reductions described in Sec. 1.471-3(e) that
a taxpayer properly allocates entirely to property that has been sold.
(D) Storage and handling costs absorption ratio. (1) Under the
simplified resale method, the storage and handling costs absorption
ratio is determined as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.014
[[Page 801]]
(2) Current year's storage and handling costs are defined as the
total storage costs plus the total handling costs incurred during the
taxable year that relate to the taxpayer's property acquired for resale
and other eligible property. See paragraph (c) of this section, which
discusses storage and handling costs. Storage and handling costs must
include the amount of allocable mixed service costs as described in
paragraph (d)(3)(i)(F) of this section. Beginning inventory in the
denominator of the storage and handling costs absorption ratio refers to
the section 471 costs of any property acquired for resale or other
eligible property held by the taxpayer as of the beginning of the
taxable year. Current year's purchases generally mean the taxpayer's
section 471 costs incurred with respect to purchases of property
acquired for resale during the current taxable year. In computing the
denominator of the storage and handling costs absorption ratio, a
taxpayer using a dollar-value LIFO method of accounting, must state
beginning inventory amounts using the LIFO carrying value of the
inventory and not current-year dollars.
(3) Current year's storage and handling costs, beginning inventory,
and current year's purchases, as defined in paragraph (d)(3)(i)(D)(2) of
this section, do not include costs that are specifically described in
Sec. 1.263A-1(e)(3)(ii) or cost reductions described in Sec. 1.471-
3(e) that a taxpayer properly allocates entirely to property that has
been sold.
(E) Purchasing costs absorption ratio. (1) Under the simplified
resale method, the purchasing costs absorption ratio is determined as
follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.015
(2) Current year's purchasing costs are defined as the total
purchasing costs incurred during the taxable year that relate to the
taxpayer's property acquired for resale and eligible property. See
paragraph (c)(3) of this section, which discusses purchasing costs.
Purchasing costs must include the amount of allocable mixed service
costs determined in paragraph (d)(3)(i)(F) of this section. Current
year's purchases generally mean the taxpayer's section 471 costs
incurred with respect to purchases of property acquired for resale
during the current taxable year.
(3) Current year's purchasing costs and current year's purchases, as
defined in paragraph (d)(3)(i)(E)(2) of this section, do not include
costs that are specifically described in Sec. 1.263A-1(e)(3)(ii) or
cost reductions described in Sec. 1.471-3(e) that a taxpayer properly
allocates entirely to property that has been sold.
(F) Allocable mixed service costs. (1) If a taxpayer allocates its
mixed service costs to purchasing costs, storage costs, and handling
costs using a method described in Sec. 1.263A-1(g)(4), the taxpayer is
not required to determine its allocable mixed service costs under this
paragraph (d)(3)(i)(F). However, if the taxpayer uses the simplified
service cost method, the amount of mixed service costs allocated to and
included in purchasing costs, storage costs, and handling costs in the
absorption ratios in paragraphs (d)(3)(i) (D) and (E) of this section is
determined as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.016
(2) Labor costs allocable to activity are defined as the total labor
costs allocable to each particular activity (i.e.,
[[Page 802]]
purchasing, handling, and storage), excluding labor costs included in
mixed service costs. Total labor costs are defined as the total labor
costs (excluding labor costs included in mixed service costs) that are
incurred in the taxpayer's trade or business during the taxable year.
See Sec. 1.263A-1(h)(6) for the definition of total mixed service
costs.
(ii) LIFO taxpayers electing simplified resale method--(A) In
general. Under the simplified resale method, a taxpayer using a LIFO
method must calculate a particular year's index (e.g., under Sec.
1.472-8(e)) without regard its additional section 263A costs. Similarly,
a taxpayer that adjusts current-year costs by applicable indexes to
determine whether there has been an inventory increment or decrement in
the current year for a particular LIFO pool must disregard the
additional section 263A costs in making that determination.
(B) LIFO increment. If the taxpayer determines there has been an
inventory increment, the taxpayer must state the amount of the increment
in current-year dollars (stated in terms of section 471 costs). The
taxpayer then multiplies this amount by the combined absorption ratio.
The resulting product is the additional section 263A costs that must be
added to the taxpayer's increment for the year stated in terms of
section 471 costs.
(C) LIFO decrement. If the taxpayer determines there has been an
inventory decrement, the taxpayer must state the amount of the decrement
in dollars applicable to the particular year for which the LIFO layer
has been invaded. The additional section 263A costs incurred in prior
years that are applicable to the decrement are charged to cost of goods
sold. The additional section 263A costs that are applicable to the
decrement are determined by multiplying the additional section 263A
costs allocated to the layer of the pool in which the decrement occurred
by the ratio of the decrement (excluding additional section 263A costs)
to the section 471 costs in the layer of that pool.
(iii) Permissible variations of the simplified resale method. The
following variations of the simplified resale method are permitted:
(A) The exclusion of beginning inventories from the denominator in
the storage and handling costs absorption ratio formula in paragraph
(d)(3)(i)(D) of this section; or
(B) Multiplication of the storage and handling costs absorption
ratio in paragraph (d)(3)(i)(D) of this section by the total of section
471 costs included in a LIFO taxpayer's ending inventory (rather than
just the increment, if any, experienced by the LIFO taxpayer during the
taxable year) for purposes of determining capitalizable storage and
handling costs.
(iv) Examples. The provisions of this paragraph (d)(3) are
illustrated by the following examples:
Example 1. FIFO inventory method. (i) Taxpayer S uses the FIFO
method of accounting for inventories. S's beginning inventory for 1994
(all of which was sold during 1994) was $2,100,000 (consisting of
$2,000,000 of section 471 costs and $100,000 of additional section 263A
costs). During 1994, S makes purchases of $10,000,000. In addition, S
incurs purchasing costs of $460,000, storage costs of $110,000, and
handling costs of $90,000. S's purchases (section 471 costs) remaining
in ending inventory at the end of 1994 are $3,000,000.
(ii) In 1994, S incurs $400,000 of total mixed service costs and
$1,000,000 of total labor costs (excluding labor costs included in mixed
service costs). In addition, S incurs the following labor costs
(excluding labor costs included in mixed service costs): purchasing--
$100,000, storage--$200,000, and handling--$200,000. Accordingly, the
following mixed service costs must be included in purchasing costs,
storage costs, and handling costs as capitalizable mixed service costs:
purchasing--$40,000 ([$100,000 divided by $1,000,000] multiplied by
$400,000); storage--$80,000 ([$200,000 divided by $1,000,000] multiplied
by $400,000); and handling--$80,000 ([$200,000 divided by $1,000,000]
multiplied by $400,000).
(iii) S computes its purchasing costs absorption ratio for 1994 as
follows:
[[Page 803]]
[GRAPHIC] [TIFF OMITTED] TC10OC91.017
(iv) S computes its storage and handling costs absorption ratio for
1994 as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.018
(v) S's combined absorption ratio is 8.0 %, or the sum of the
purchasing costs absorption ratio (5.0 %) and the storage and handling
costs absorption ratio (3.0 %). Under the simplified resale method, S
determines the additional section 263A costs allocable to its ending
inventory by multiplying the combined absorption ratio by its section
471 costs with respect to current year's purchases remaining in ending
inventory:
[GRAPHIC] [TIFF OMITTED] TC10OC91.019
(vi) S adds this $240,000 to the $3,000,000 of purchases remaining
in its ending inventory to determine its total ending FIFO inventory of
$3,240,000.
Example 2. LIFO inventory method. (i) Taxpayer T uses a dollar-value
LIFO inventory method. T's beginning inventory for 1994 is $2,100,000
(consisting of $2,000,000 of section 471 costs and $100,000 of
additional section 263A costs). During 1994, T makes purchases of
$10,000,000. In addition, T incurs purchasing costs of $460,000, storage
costs of $110,000, and handling costs of $90,000. T's 1994 LIFO
increment is $1,000,000 ($3,000,000 of section 471 costs in ending
inventory less $2,000,000 of section 471 costs in beginning inventory).
(ii) In 1994, T incurs $400,000 of total mixed service costs and
$1,000,000 of total labor costs (excluding labor costs included in mixed
service costs). In addition, T incurs the following labor costs
(excluding labor costs included in mixed service costs): purchasing--
$100,000, storage--$200,000, and handling--$200,000. Accordingly, the
following mixed service costs must be included in purchasing costs,
storage costs, and handling costs as capitalizable mixed service costs:
purchasing--$40,000 ([$100,000 divided by $1,000,000] multiplied by
$400,000); storage--$80,000 ([ $200,000 divided by $1,000,000]
multiplied by $400,000); and handling--$80,000 ([ $200,000 divided by
$1,000,000] multiplied by $400,000).
(iii) Based on these facts, T determines that it has a combined
absorption ratio of 8.0 %. To determine the additional section 263A
costs allocable to its ending inventory, T
[[Page 804]]
multiplies its combined absorption ratio (8.0 %) by the $1,000,000 LIFO
increment. Thus, T's additional section 263A costs allocable to its
ending inventory are $80,000 ($1,000,000 multiplied by 8.0 %). This
$80,000 is added to the $1,000,000 to determine a total 1994 LIFO
increment of $1,080,000. T's ending inventory is $3,180,000 (its
beginning inventory of $2,100,000 plus the $1,080,000 increment).
(iv) In 1995, T sells one-half of the inventory in its 1994 LIFO
increment. T must include in its cost of goods sold for 1995 the amount
of additional section 263A costs relating to this inventory, i.e., one-
half of the $80,000 additional section 263A costs capitalized in 1994
ending inventory, or $40,000.
Example 3. LIFO Pools. (i) Taxpayer U begins its business in 1994,
and adopts the LIFO inventory method. During 1994, U makes purchases of
$10,000, and incurs $400 of purchasing costs, $350 of storage costs and
$250 of handling costs. U's purchasing costs, storage costs, and
handling costs include their proper allocable share of mixed service
costs.
(ii) U computes its purchasing costs absorption ratio for 1994, as
follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.020
(iii) U computes its storage and handling costs absorption ratio for
1994, as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.021
(iv) U's combined absorption ratio is 10%, or the sum of the
purchasing costs absorption ratio (4.0%) and the storage and handling
costs absorption ratio (6.0%). At the end of 1994, U's ending inventory
included $3,000 of current year purchases, contained in three LIFO pools
(X, Y, and Z) as shown below. Under the simplified resale method, U
computes its ending inventory for 1994 as follows:
----------------------------------------------------------------------------------------------------------------
1994 Total X Y Z
----------------------------------------------------------------------------------------------------------------
Ending section 471 costs.................................... $3,000 $1,600 $600 $800
Additional section 263A costs (10%)......................... 300 160 60 80
---------------------------------------------------
1994 ending inventory....................................... 3,300 1,760 660 880
----------------------------------------------------------------------------------------------------------------
(v) During 1995, U makes purchases of $2,000 as shown below, and
incurs $200 of purchasing costs, $325 of storage costs and $175 of
handling costs. U's purchasing costs, storage costs, and handling costs
include their proper share of mixed service costs. Moreover, U sold
goods from pools X, Y, and Z having a total cost of $1,000. U computes
its ending inventory for 1995 as follows.
(vi) U computes its purchasing costs absorption ratio for 1995:
[GRAPHIC] [TIFF OMITTED] TC10OC91.022
(vii) U computes its storage and handling costs absorption ratio for
1995:
[[Page 805]]
[GRAPHIC] [TIFF OMITTED] TC10OC91.023
(viii) U's combined absorption ratio is 20.0%, or the sum of the
purchasing costs absorption ratio (10.0%) and the storage and handling
costs absorption ratio (10.0%).
----------------------------------------------------------------------------------------------------------------
1995 Total X Y Z
----------------------------------------------------------------------------------------------------------------
Beginning section 471 costs................................. $3,000 $1,600 $600 $800
1995 section 471 costs...................................... 2,000 1,500 300 200
Section 471 cost of goods sold.............................. (1,000) (300) (300) (400)
---------------------------------------------------
1995 ending section 471 costs............................... 4,000 2,800 600 600
Consisting of:
1994 layer.............................................. 2,800 1,600 600 600
1995 layer.............................................. 1,200 1,200 ........... ...........
---------------------------------------------------
4,000 2,800 600 600
Additional section 263A costs:
1994 (10%).............................................. 280 160 60 60
1995 (20%).............................................. 240 240 ........... ...........
---------------------------------------------------
520 400 60 60
1995 ending inventory................................... 4,520 3,200 660 660
----------------------------------------------------------------------------------------------------------------
(ix) In 1995, U experiences a $200 decrement in Pool Z. Thus, U must
charge the additional section 263A costs incurred in prior years
applicable to the decrement to 1995's cost of goods sold. To do so, U
determines a ratio by dividing the decrement by the section 471 costs in
the 1994 layer ($200 divided by $800, or 25%). U then multiplies this
ratio (25%) by the additional section 263A costs in the 1994 layer ($80)
to determine the additional section 263A costs applicable to the
decrement ($20). Therefore, $20 is taken into account by U in 1995 as
part of its cost of goods sold ($80 multiplied by 25%).
(4) Simplified resale method with historic absorption ratio
election--(i) In general. This paragraph (d)(4) permits resellers using
the simplified resale method to elect a historic absorption ratio in
determining additional section 263A costs allocable to eligible property
remaining on hand at the close of their taxable years. Except as
provided in paragraph (d)(4)(v) of this section, a taxpayer may only
make a historic absorption ratio election if it has used the simplified
resale method for three or more consecutive taxable years immediately
prior to the year of election. The historic absorption ratio is used in
lieu of an actual combined absorption ratio computed under paragraph
(d)(3)(i)(C)(1) of this section and is based on costs capitalized by a
taxpayer during its test period. If elected, the historic absorption
ratio must be used for the qualifying period described in paragraph
(d)(4)(ii)(C) of this section.
(ii) Operating rules and definitions--(A) Historic absorption ratio.
(1) The historic absorption ratio is equal to the following ratio:
[GRAPHIC] [TIFF OMITTED] TC10OC91.024
[[Page 806]]
(2) Additional section 263A costs incurred during the test period
are defined as the sum of the products of the combined absorption ratios
(defined in paragraph (d)(3)(i)(C)(1) of this section) multiplied by a
taxpayer's section 471 costs incurred with respect to purchases, for
each taxable year of the test period.
(3) Section 471 costs incurred during the test period mean the
section 471 costs described in Sec. 1.263A-1(d)(2) that a taxpayer
incurs generally with respect to its purchases during the test period
described in paragraph (d)(4)(ii)(B) of this section.
(B) Test period--(1) In general. The test period is generally the
three taxable-year period immediately prior to the taxable year that the
historic absorption ratio is elected.
(2) Updated test period. The test period begins again with the
beginning of the first taxable year after the close of a qualifying
period (as defined in paragraph (d)(4)(ii)(C) of this section). This new
test period, the updated test period, is the three taxable-year period
beginning with the first taxable year after the close of the qualifying
period.
(C) Qualifying period--(1) In general. A qualifying period includes
each of the first five taxable years beginning with the first taxable
year after a test period (or updated test period).
(2) Extension of qualifying period. In the first taxable year
following the close of each qualifying period (e.g., the sixth taxable
year following the test period), the taxpayer must compute the actual
combined absorption ratio under the simplified resale method. If the
actual combined absorption ratio computed for this taxable year (the
recomputation year) is within one-half of one percentage point (plus or
minus) of the historic absorption ratio used in determining
capitalizable costs for the qualifying period (i.e., the previous five
taxable years), the qualifying period must be extended to include the
recomputation year and the following five taxable years, and the
taxpayer must continue to use the historic absorption ratio throughout
the extended qualifying period. If, however, the actual combined
absorption ratio computed for the recomputation year is not within one-
half of one percentage point (plus or minus) of the historic absorption
ratio, the taxpayer must use actual combined absorption ratios beginning
with the recomputation year under the simplified resale method and
throughout the updated test period. The taxpayer must resume using the
historic absorption ratio (determined with reference to the updated test
period) in the third taxable year following the recomputation year.
(iii) Method of accounting--(A) Adoption and use. The election to
use the historic absorption ratio is a method of accounting. A taxpayer
using the simplified resale method may elect the historic absorption
ratio in any taxable year if permitted under this paragraph (d)(4),
provided the taxpayer has not obtained the Commissioner's consent to
revoke the historic absorption ratio election within its prior six
taxable years. The election is to be effected on a cut-off basis, and
thus, no adjustment under section 481(a) is required or permitted. The
use of a historic absorption ratio has no effect on other methods of
accounting adopted by the taxpayer and used in conjunction with the
simplified resale method in determining its section 263A costs.
Accordingly, in computing its actual combined absorption ratios, the
taxpayer must use the same methods of accounting used in computing its
historic absorption ratio during its most recent test period unless the
taxpayer obtains the consent of the Commissioner. Finally, for purposes
of this paragraph (d)(4)(iii)(A), the recomputation of the historic
absorption ratio during an updated test period and the change from a
historic absorption ratio to an actual combined absorption ratio during
an updated test period by reason of the requirements of this paragraph
(d)(4) are not considered changes in methods of accounting under section
446(e) and, thus, do not require the consent of the Commissioner or any
adjustments under section 481(a).
(B) Revocation of election. A taxpayer may only revoke its election
to use the historic absorption ratio with the consent of the
Commissioner in a manner prescribed under section 446(e) and the
regulations thereunder. Consent to the change for any taxable year that
is included in the qualifying period (or an
[[Page 807]]
extended qualifying period) will be granted only upon a showing of
unusual circumstances.
(iv) Reporting and recordkeeping requirements--(A) Reporting. A
taxpayer making an election under this paragraph (d)(4) must attach a
statement to its federal income tax return for the taxable year in which
the election is made showing the actual combined absorption ratios
determined under the simplified resale method during its first test
period. This statement must disclose the historic absorption ratio to be
used by the taxpayer during its qualifying period. A similar statement
must be attached to the federal income tax return for the first taxable
year within any subsequent qualifying period (i.e., after an updated
test period).
(B) Recordkeeping. A taxpayer must maintain all appropriate records
and details supporting the historic absorption ratio until the
expiration of the statute of limitations for the last year for which the
taxpayer applied the particular historic absorption ratio in determining
additional section 263A costs capitalized to eligible property.
(v) (A) Transition to elect historic absorption ratio. Taxpayers
will be permitted to elect a historic absorption ratio in their first,
second, or third taxable year beginning after December 31, 1993, under
such terms and conditions as may be prescribed by the Commissioner.
Taxpayers are eligible to make an election under these transition rules
whether or not they previously used the simplified resale method. A
taxpayer making such an election must recompute (or compute) its
additional section 263A costs, and thus, its historic absorption ratio
for its first test period as if the rules prescribed in this section and
Sec. Sec. 1.263A-1 and 1.263A-2 had applied throughout the test period.
(B) Transition to revoke historic absorption ratio. Notwithstanding
the requirements provided in paragraph (d)(4)(iii)(B) of this section
regarding revocations of the historic absorption ratio during a
qualifying period, a taxpayer will be permitted to revoke the historic
absorption ratio in their first, second, or third taxable year ending on
or after November 20, 2018, under such administrative procedures and
with terms and conditions prescribed by the Commissioner.
(vi) Example. The provisions of this paragraph (d)(4) are
illustrated by the following example:
Example. (i) Taxpayer V uses the FIFO method of accounting for
inventories and in 1994 elects to use the historic absorption ratio with
the simplified resale method. After recomputing its additional section
263A costs in accordance with the transition rules of paragraph
(d)(4)(v) of this section, V identifies the following costs incurred
during the test period:
1991:
Add'l section 263A costs--$100
Section 471 costs--$3,000
1992:
Add'l section 263A costs--$200
Section 471 costs--$4,000
1993:
Add'l section 263A costs--$300
Section 471 costs--$5,000
(ii) Therefore, V computes a 5% historic absorption ratio determined
as follows:
[GRAPHIC] [TIFF OMITTED] TC10OC91.025
(iii) In 1994, V incurs $10,000 of section 471 costs of which $3,000
remain in inventory at the end of the year. Under the simplified resale
method using a historic absorption ratio, V determines the additional
section 263A costs allocable to its ending inventory by multiplying its
historic ratio (5%) by the section 471 costs remaining in its ending
inventory:
[GRAPHIC] [TIFF OMITTED] TC10OC91.026
[[Page 808]]
(iv) To determine its ending inventory under section 263A, V adds
the additional section 263A costs allocable to ending inventory to its
section 471 costs remaining in ending inventory ($3,150 = $150 +
$3,000). The balance of V's additional section 263A costs incurred
during 1994 is taken into account in 1994 as part of V's cost of goods
sold.
(v) V's qualifying period ends as of the close of its 1998 taxable
year. Therefore, 1999 is a recomputation year in which V must compute
its actual combined absorption ratio. V determines its actual absorption
ratio for 1999 to be 5.25% and compares that ratio to its historic
absorption ratio (5.0%). Therefore, V must continue to use its historic
absorption ratio of 5.0% throughout an extended qualifying period, 1999
through 2004 (the recomputation year and the following five taxable
years).
(vi) If, instead, V's actual combined absorption ratio for 1999 were
not between 4.5% and 5.5%, V's qualifying period would end and V would
be required to compute a new historic absorption ratio with reference to
an updated test period of 1999, 2000, and 2001. Once V's historic
absorption ratio is determined for the updated test period, it would be
used for a new qualifying period beginning in 2002.
(5) Additional simplified methods for resellers. The Commissioner
may prescribe additional elective simplified methods by revenue ruling
or revenue procedure.
(e) Cross reference. See Sec. 1.6001-1(a) regarding the duty of
taxpayers to keep such records as are sufficient to establish the amount
of gross income, deductions, etc.
(f) Applicability dates. (1) Paragraphs (d)(3)(i)(C)(3),
(d)(3)(i)(D)(3), and (d)(3)(i)(E)(3) of this section apply for taxable
years ending on or after January 13, 2014.
(2) The rules set forth in the second sentence of paragraph (a)(1)
of this section, paragraphs (a)(2)(ii) and (iii) of this section, the
third sentence of paragraph (a)(3) of this section, and paragraphs
(a)(4)(ii) and (a)(5) of this section apply for taxable years beginning
on or after January 5, 2021 . However, for a taxable year beginning
after December 31, 2017, and before January 5, 2021, a taxpayer may
apply the paragraphs described in the first sentence of this paragraph
(f)(2), provided the taxpayer follows all the applicable rules contained
in the regulations under section 263A for such taxable year and all
subsequent taxable years.
[T.D. 8482, 58 FR 42224, Aug. 9, 1993; 58 FR 47784, Sept. 10, 1993; 59
FR 3319, Jan. 21, 1994, as amended by T.D. 8559, 59 FR 39962, Aug. 5,
1994, T.D. 9652, 79 FR 2097, Jan. 13, 2014; T.D. 9843, 83 FR 58498, Nov.
20, 2018; T.D. 9942, 86 FR 266, Jan. 5, 2021]
Sec. 1.263A-4 Rules for property produced in a farming business.
(a) Introduction--(1) In general. This section provides guidance
with respect to the application of section 263A to property produced in
a farming business as defined in paragraph (a)(5) of this section.
Except as otherwise provided by the rules of this section, the general
rules of Sec. Sec. 1.263A-1 through 1.263A-3 and Sec. Sec. 1.263A-7
through 1.263A-15 apply to property produced in a farming business. A
taxpayer that engages in the raising or growing of any agricultural or
horticultural commodity, including both plants and animals, is engaged
in the production of property. Section 263A generally requires the
capitalization of the direct costs and an allocable portion of the
indirect costs that directly benefit or are incurred by reason of the
production of this property. The direct and indirect costs of producing
plants or animals generally include preparatory costs allocable to the
plant or animal and preproductive period costs of the plant or animal.
Except as provided in paragraphs (a)(2), (a)(3), and (e) of this
section, taxpayers must capitalize the costs of producing all plants and
animals unless the election described in paragraph (d) of this section
is made.
(2) Exception--(i) In general. Section 263A does not apply to the
costs of producing plants with a preproductive period of 2 years or less
or the costs of producing animals in a farming business, if the taxpayer
is not--
(A) A corporation or partnership required to use an accrual method
of accounting (accrual method) under section 447 in computing its
taxable income from farming; or
(B) A tax shelter prohibited from using the cash receipts and
disbursements method of accounting (cash method) under section
448(a)(3).
(ii) Tax shelter--(A) In general. A farming business is considered a
tax
[[Page 809]]
shelter, and thus a taxpayer prohibited from using the cash method under
section 448(a)(3), if the farming business is--
(1) A farming syndicate as defined in section 461(k); or
(2) A tax shelter, within the meaning of section 6662(d)(2)(C)(iii).
(B) Presumption. Marketed arrangements in which persons carry on
farming activities using the services of a common managerial or
administrative service will be presumed to have the principal purpose of
tax avoidance, within the meaning of section 6662(d)(2)(C)(iii), if such
persons prepay a substantial portion of their farming expenses with
borrowed funds.
(iii) Examples. The following examples illustrate the provisions of
this paragraph (a)(2):
Example 1. Farmer A grows trees that have a preproductive period in
excess of 2 years, and that produce an annual crop. Farmer A is not
required by section 447 to use an accrual method or prohibited by
section 448(a)(3) from using the cash method. Accordingly, Farmer A
qualifies for the exception described in this paragraph (a)(2). Since
the trees have a preproductive period in excess of 2 years, Farmer A
must capitalize the direct costs and an allocable portion of the
indirect costs that directly benefit or are incurred by reason of the
production of the trees. Since the annual crop has a preproductive
period of 2 years or less, Farmer A is not required to capitalize the
costs of producing the crops.
Example 2. Assume the same facts as Example 1, except that Farmer A
is required by section 447 to use an accrual method or prohibited by
448(a)(3) from using the cash method. Farmer A does not qualify for the
exception described in this paragraph (a)(2). Farmer A is required to
capitalize the direct costs and an allocable portion of the indirect
costs that directly benefit or are incurred by reason of the production
of the trees and crops.
(3) Exemption for certain small business taxpayers. For taxable
years beginning after December 31, 2017, see Sec. 1.263A-1(j) for an
exception in the case of a small business taxpayer that meets the gross
receipts test of section 448(c) and Sec. 1.448-2(c).
(4) Costs required to be capitalized or inventoried under another
provision. The exceptions from capitalization provided in paragraphs
(a)(2), (a)(3), (d) and (e) of this section do not apply to any cost
that is required to be capitalized or inventoried under another Internal
Revenue Code or regulatory provision, such as section 263 or 471.
(5) Farming business--(i) In general. A farming business means a
trade or business involving the cultivation of land or the raising or
harvesting of any agricultural or horticultural commodity. Examples
include the trade or business of operating a nursery or sod farm; the
raising or harvesting of trees bearing fruit, nuts, or other crops; the
raising of ornamental trees (other than evergreen trees that are more
than 6 years old at the time they are severed from their roots); and the
raising, shearing, feeding, caring for, training, and management of
animals. For purposes of this section, the term harvesting does not
include contract harvesting of an agricultural or horticultural
commodity grown or raised by another. Similarly, merely buying and
reselling plants or animals grown or raised entirely by another is not
raising an agricultural or horticultural commodity. A taxpayer is
engaged in raising a plant or animal, rather than the mere resale of a
plant or animal, if the plant or animal is held for further cultivation
and development prior to sale. In determining whether a plant or animal
is held for further cultivation and development prior to sale,
consideration will be given to all of the facts and circumstances,
including: the value added by the taxpayer to the plant or animal
through agricultural or horticultural processes; the length of time
between the taxpayer's acquisition of the plant or animal and the time
that the taxpayer makes the plant or animal available for sale; and in
the case of a plant, whether the plant is kept in the container in which
purchased, replanted in the ground, or replanted in a series of larger
containers as it is grown to a larger size.
(A) Plant. A plant produced in a farming business includes, but is
not limited to, a fruit, nut, or other crop bearing tree, an ornamental
tree, a vine, a bush, sod, and the crop or yield of a plant that will
have more than one crop or yield raised by the taxpayer. Sea plants are
produced in a farming business if they are tended and cultivated as
opposed to merely harvested.
[[Page 810]]
(B) Animal. An animal produced in a farming business includes, but
is not limited to, any stock, poultry or other bird, and fish or other
sea life raised by the taxpayer. Thus, for example, the term animal may
include a cow, chicken, emu, or salmon raised by the taxpayer. Fish and
other sea life are produced in a farming business if they are raised on
a fish farm. A fish farm is an area where fish or other sea life are
grown or raised as opposed to merely caught or harvested.
(ii) Incidental activities--(A) In general. A farming business
includes processing activities that are normally incident to the
growing, raising, or harvesting of agricultural or horticultural
products. For example, a taxpayer in the trade or business of growing
fruits and vegetables may harvest, wash, inspect, and package the fruits
and vegetables for sale. Such activities are normally incident to the
raising of these crops by farmers. The taxpayer will be considered to be
in the trade or business of farming with respect to the growing of
fruits and vegetables and the processing activities incident to their
harvest.
(B) Activities that are not incidental. Farming business does not
include the processing of commodities or products beyond those
activities that are normally incident to the growing, raising, or
harvesting of such products.
(iii) Examples. The following examples illustrate the provisions of
this paragraph (a)(5):
Example 1. Individual A operates a retail nursery. Individual A has
three categories of plants. The first category is comprised of plants
that Individual A grows from seeds or cuttings. The second category is
comprised of plants that Individual A purchases in containers and grows
for a period of from several months to several years. Individual A
replants some of these plants in the ground. The others are replanted in
a series of larger containers as they grow. The third category is
comprised of plants that are purchased by Individual A in containers.
Individual A does not grow these plants to a larger size before making
them available for resale. Instead, Individual A makes these plants
available for resale, in the container in which purchased, shortly after
receiving them. Thus, no value is added to these plants by Individual A
through horticultural processes. Individual A also sells soil, mulch,
chemicals, and yard tools. Individual A is producing property in the
farming business with respect to the first two categories of plants
because these plants are held for further cultivation and development
prior to sale. The plants in the third category are not held for further
cultivation and development prior to sale and, therefore, are not
regarded as property produced in a farming business for purposes of
section 263A. Accordingly, Individual A must account for the third
category of plants, along with the soil, mulch, chemicals, and yard
tools, as property acquired for resale. If Individual A's average annual
gross receipts are less than $10 million,
Example 2. Individual B is in the business of growing and harvesting
wheat and other grains. Individual B also processes grain that
Individual B has harvested in order to produce breads, cereals, and
other similar food products, which Individual B then sells to customers
in the course of its business. Although Individual B is in the farming
business with respect to the growing and harvesting of grain, Individual
B is not in the farming business with respect to the processing of such
grain to produce the food products.
Example 3. Individual C is in the business of raising poultry and
other livestock. Individual C also operates a meat processing operation
in which the poultry and other livestock are slaughtered, processed, and
packaged or canned. The packaged or canned meat is sold to Individual
C's customers. Although Individual C is in the farming business with
respect to the raising of poultry and other livestock, Individual C is
not in the farming business with respect to the slaughtering,
processing, packaging, and canning of such animals to produce the food
products.
(b) Application of section 263A to property produced in a farming
business--(1) In general. Unless otherwise provided in this section,
section 263A requires the capitalization of the direct costs and an
allocable portion of the indirect costs that directly benefit or are
incurred by reason of the production of any property in a farming
business (including animals and plants without regard to the length of
their preproductive period). Section 1.263A-1(e) describes the types of
direct and indirect costs that generally must be capitalized by
taxpayers under section 263A and paragraphs (b)(1)(i) and (ii) of this
section provide specific examples of the types of costs typically
incurred in the trade or business of farming. For purposes of this
section, soil and water
[[Page 811]]
conservation expenditures that a taxpayer has elected to deduct under
section 175 and fertilizer that a taxpayer has elected to deduct under
section 180 are not subject to capitalization under section 263A, except
to the extent these costs are required to be capitalized as a
preproductive period cost of a plant or animal.
(i) Plants. The costs of producing a plant typically required to be
capitalized under section 263A include the costs incurred so that the
plant's growing process may begin (preparatory costs), such as the
acquisition costs of the seed, seedling, or plant, and the costs of
planting, cultivating, maintaining, or developing the plant during the
preproductive period (preproductive period costs). Preproductive period
costs include, but are not limited to, management, irrigation, pruning,
soil and water conservation (including costs that the taxpayer has
elected to deduct under section 175), fertilizing (including costs that
the taxpayer has elected to deduct under section 180), frost protection,
spraying, harvesting, storage and handling, upkeep, electricity, tax
depreciation and repairs on buildings and equipment used in raising the
plants, farm overhead, taxes (except state and Federal income taxes),
and interest required to be capitalized under section 263A(f).
(ii) Animals. The costs of producing an animal typically required to
be capitalized under section 263A include the costs incurred so that the
animal's raising process may begin (preparatory costs), such as the
acquisition costs of the animal, and the costs of raising or caring for
such animal during the preproductive period (preproductive period
costs). Preproductive period costs include, but are not limited to,
management, feed (such as grain, silage, concentrates, supplements,
haylage, hay, pasture and other forages), maintaining pasture or pen
areas (including costs that the taxpayer has elected to deduct under
sections 175 or 180), breeding, artificial insemination, veterinary
services and medicine, livestock hauling, bedding, fuel, electricity,
hired labor, tax depreciation and repairs on buildings and equipment
used in raising the animals (for example, barns, trucks, and trailers),
farm overhead, taxes (except state and Federal income taxes), and
interest required to be capitalized under section 263A(f).
(2) Preproductive period--(i) Plant--(A) In general. The
preproductive period of property produced in a farming business means--
(1) In the case of a plant that will have more than one crop or
yield (for example, an orange tree), the period before the first
marketable crop or yield from such plant;
(2) In the case of the crop or yield of a plant that will have more
than one crop or yield (for example, the orange), the period before such
crop or yield is disposed of; or
(3) In the case of any other plant, the period before such plant is
disposed of.
(B) Applicability of section 263A. For purposes of determining
whether a plant has a preproductive period in excess of 2 years, the
preproductive period of plants grown in commercial quantities in the
United States is based on the nationwide weighted average preproductive
period for such plant. The Commissioner will publish a noninclusive list
of plants with a nationwide weighted average preproductive period in
excess of 2 years. In the case of other plants grown in commercial
quantities in the United States, the nationwide weighted average
preproductive period must be determined based on available statistical
data. For all other plants, the taxpayer is required, at or before the
time the seed or plant is acquired or planted, to reasonably estimate
the preproductive period of the plant. If the taxpayer estimates a
preproductive period in excess of 2 years, the taxpayer must capitalize
the costs of producing the plant. If the estimate is reasonable, based
on the facts in existence at the time it is made, the determination of
whether section 263A applies is not modified at a later time even if the
actual length of the preproductive period differs from the estimate. The
actual length of the preproductive period will, however, be considered
in evaluating the reasonableness of the taxpayer's future estimates. The
nationwide weighted average preproductive period or the estimated
preproductive period is only used for purposes of determining
[[Page 812]]
whether the preproductive period of a plant is greater than 2 years.
(C) Actual preproductive period. The plant's actual preproductive
period is used for purposes of determining the period during which a
taxpayer must capitalize preproductive period costs with respect to a
particular plant.
(1) Beginning of the preproductive period. The actual preproductive
period of a plant begins when the taxpayer first incurs costs that
directly benefit or are incurred by reason of the plant. Generally, this
occurs when the taxpayer plants the seed or plant. In the case of a
taxpayer that acquires plants that have already been permanently
planted, or plants that are tended by the taxpayer or another prior to
permanent planting, the actual preproductive period of the plant begins
upon acquisition of the plant by the taxpayer. In the case of the crop
or yield of a plant that will have more than one crop or yield, the
actual preproductive period begins when the plant has become productive
in marketable quantities and the crop or yield first appears, for
example, in the form of a sprout, bloom, blossom, or bud.
(2) End of the preproductive period--(i) In general. In the case of
a plant that will have more than one crop or yield, the actual
preproductive period ends when the plant first becomes productive in
marketable quantities. In the case of any other plant (including the
crop or yield of a plant that will have more than one crop or yield),
the actual preproductive period ends when the plant, crop, or yield is
sold or otherwise disposed of. Field costs, such as irrigating,
fertilizing, spraying and pruning, that are incurred after the harvest
of a crop or yield but before the crop or yield is sold or otherwise
disposed of are not required to be included in the preproductive period
costs of the harvested crop or yield because they do not benefit and are
unrelated to the harvested crop or yield.
(ii) Marketable quantities. A plant that will have more than one
crop or yield becomes productive in marketable quantities once a crop or
yield is produced in sufficient quantities to be harvested and marketed
in the ordinary course of the taxpayer's business. Factors that are
relevant to determining whether a crop or yield is produced in
sufficient quantities to be harvested and marketed in the ordinary
course include: whether the crop or yield is harvested that is more than
de minimis, although it may be less than expected at the maximum bearing
stage, based on a comparison of the quantities per acre harvested in the
year in question to the quantities per acre expected to be harvested
when the plant reaches full maturity; and whether the sales proceeds
exceed the costs of harvest and make a reasonable contribution to an
allocable share of farm expenses.
(D) Examples. The following examples illustrate the provisions of
this paragraph (b)(2):
Example 1. (i) Farmer A, a taxpayer that qualifies for the exception
in paragraph (a)(2) of this section, grows plants that will have more
than one crop or yield. The plants are grown in commercial quantities in
the United States. Farmer A acquires 1 year-old plants by purchasing
them from an unrelated party, Corporation B, and plants them
immediately. The nationwide weighted average preproductive period of the
plant is 4 years. The particular plants grown by Farmer A do not begin
to produce in marketable quantities until 3 years and 6 months after
they are planted by Farmer A.
(ii) Since the plants are deemed to have a preproductive period in
excess of 2 years, Farmer A is required to capitalize the costs of
producing the plants. See paragraphs (a)(2) and (b)(2)(i)(B) of this
section. In accordance with paragraph (b)(2)(i)(C)(1) of this section,
Farmer A must begin to capitalize the preproductive period costs when
the plants are planted. In accordance with paragraph (b)(2)(i)(C)(2) of
this section, Farmer A must continue to capitalize preproductive period
costs to the plants until the plants begin to produce in marketable
quantities. Thus, Farmer A must capitalize the preproductive period
costs for a period of 3 years and 6 months (that is, until the plants
are 4 years and 6 months old), notwithstanding the fact that the plants,
in general, have a nationwide weighted average preproductive period of 4
years.
Example 2. (i) Farmer B, a taxpayer that qualifies for the exception
in paragraph (a)(2) of this section, grows plants that will have more
than one crop or yield. The plants are grown in commercial quantities in
the United States. The nationwide weighted average preproductive period
of the plant is 2 years and 5 months. Farmer B acquires 1 month-old
plants by purchasing them from an unrelated party, Corporation B. Farmer
B enters into a contract with Corporation B under which Corporation B
will retain and
[[Page 813]]
tend the plants for 7 months following the sale. At the end of 7 months,
Farmer B takes possession of the plants and plants them in the permanent
orchard. The plants become productive in marketable quantities 1 year
and 11 months after they are planted by Farmer B.
(ii) Since the plants are deemed to have a preproductive period in
excess of 2 years, Farmer B is required to capitalize the costs of
producing the plants. See paragraphs (a)(2) and (b)(2)(i)(B) of this
section. In accordance with paragraph (b)(2)(i)(C)(1) of this section,
Farmer B must begin to capitalize the preproductive period costs when
the purchase occurs. In accordance with paragraph (b)(2)(i)(C)(2) of
this section, Farmer B must continue to capitalize the preproductive
period costs to the plants until the plants begin to produce in
marketable quantities. Thus, Farmer B must capitalize the preproductive
period costs of the plants for a period of 2 years and 6 months (the 7
months the plants are tended by Corporation B and the 1 year and 11
months after the plants are planted by Farmer B), that is, until the
plants are 2 years and 7 months old, notwithstanding the fact that the
plants, in general, have a nationwide weighted average preproductive
period of 2 years and 5 months.
Example 3. (i) Assume the same facts as in Example 2, except that
Farmer B acquires the plants by purchasing them from Corporation B when
the plants are 8 months old and that the plants are planted by Farmer B
upon acquisition.
(ii) Since the plants are deemed to have a preproductive period in
excess of 2 years, Farmer B is required to capitalize the costs of
producing the plants. See paragraphs (a)(2) and (b)(2)(i)(B) of this
section. In accordance with paragraph (b)(2)(i)(C)(1) of this section,
Farmer B must begin to capitalize the preproductive period costs when
the plants are planted. In accordance with paragraph (b)(2)(i)(C)(2) of
this section, Farmer B must continue to capitalize the preproductive
period costs to the plants until the plants begin to produce in
marketable quantities. Thus, Farmer B must capitalize the preproductive
period costs of the plants for a period of 1 year and 11 months.
Example 4. (i) Farmer C, a taxpayer that qualifies for the exception
in paragraph (a)(2) of this section, grows plants that will have more
than one crop or yield. The plants are grown in commercial quantities in
the United States. Farmer C acquires 1 month-old plants from an
unrelated party and plants them immediately. The nationwide weighted
average preproductive period of the plant is 2 years and 3 months. The
particular plants grown by Farmer C begin to produce in marketable
quantities 1 year and 10 months after they are planted by Farmer C.
(ii) Since the plants are deemed to have a nationwide weighted
average preproductive period in excess of 2 years, Farmer C is required
to capitalize the costs of producing the plants, notwithstanding the
fact that the particular plants grown by Farmer C become productive in
less than 2 years. See paragraph (b)(2)(i)(B) of this section. In
accordance with paragraph (b)(2)(i)(C)(1) of this section, Farmer C must
begin to capitalize the preproductive period costs when it plants the
plants. In accordance with paragraph (b)(2)(i)(C)(2) of this section,
Farmer C properly ceases capitalization of preproductive period costs
when the plants become productive in marketable quantities (that is, 1
year and 10 months after they are planted, which is when they are 1 year
and 11 months old).
Example 5. (i) Farmer D, a taxpayer that qualifies for the exception
in paragraph (a)(2) of this section, grows plants that will have more
than one crop or yield. The plants are not grown in commercial
quantities in the United States. Farmer D acquires and plants the plants
when they are 1 year old and estimates that they will become productive
in marketable quantities 3 years after planting. Thus, at the time the
plants are acquired and planted Farmer D reasonably estimates that the
plants will have a preproductive period of 4 years. The actual plants
grown by Farmer D do not begin to produce in marketable quantities until
3 years and 6 months after they are planted by Farmer D.
(ii) Since the plants have an estimated preproductive period in
excess of 2 years, Farmer D is required to capitalize the costs of
producing the plants. See paragraph (b)(2)(i)(B) of this section. In
accordance with paragraph (b)(2)(i)(C)(1) of this section, Farmer D must
begin to capitalize the preproductive period costs when it acquires and
plants the plants. In accordance with paragraph (b)(2)(i)(C)(2) of this
section, Farmer D must continue to capitalize the preproductive period
costs until the plants begin to produce in marketable quantities. Thus,
Farmer D must capitalize the preproductive period costs of the plants
for a period of 3 years and 6 months (that is, until the plants are 4
years and 6 months old), notwithstanding the fact that Farmer D
estimated that the plants would become productive after 4 years.
Example 6. (i) Farmer E, a taxpayer that qualifies for the exception
in paragraph (a)(2) of this section grows plants from seed. The plants
are not grown in commercial quantities in the United States. The plants
do not have more than 1 crop or yield. At the time the seeds are planted
Farmer E reasonably estimates that the plants will have a preproductive
period of 1 year and 10 months. The actual plants grown by Farmer E are
not ready for harvesting and disposal until 2 years and 2 months after
the seeds are planted by Farmer E.
(ii) Because Farmer E's estimate of the preproductive period (which
was 2 years or
[[Page 814]]
less) was reasonable at the time made based on the facts, Farmer E will
not be required to capitalize the costs of producing the plants under
section 263A, notwithstanding the fact that the actual preproductive
period of the plants exceeded 2 years. See paragraph (b)(2)(i)(B) of
this section. However, Farmer E must take the actual preproductive
period of the plants into consideration when making future estimates of
the preproductive period of such plants.
Example 7. (i) Farmer F, a calendar year taxpayer that does not
qualify for the exception in paragraph (a)(2) of this section, grows
trees that will have more than one crop. Farmer F acquires and plants
the trees in April, Year 1. On October 1, Year 6, the trees become
productive in marketable quantities.
(ii) The costs of producing the plant, including the preproductive
period costs incurred by Farmer F on or before October 1, Year 6, are
capitalized to the trees. Preproductive period costs incurred after
October 1, Year 6, are capitalized to a crop when incurred during the
preproductive period of the crop and deducted as a cost of maintaining
the tree when incurred between the disposal of one crop and the
appearance of the next crop. See paragraphs (b)(2)(i)(A),
(b)(2)(i)(C)(1) and (b)(2)(i)(C)(2) of this section.
Example 8. (i) Farmer G, a taxpayer that qualifies for the exception
in paragraph (a)(2) of this section, produces fig trees on 10 acres of
land. The fig trees are grown in commercial quantities in the United
States and have a nationwide weighted average preproductive period in
excess of 2 years. Farmer G acquires and plants the fig trees in their
permanent grove during Year 1. When the fig trees are mature, Farmer G
expects to harvest 10x tons of figs per acre. At the end of Year 4,
Farmer G harvests .5x tons of figs per acre that it sells for $100x.
During Year 4, Farmer G incurs expenses related to the fig operation of:
$50x to harvest the figs and transport them to market and other direct
and indirect costs related to the fig operation in the amount of $1000x.
(ii) Since the fig trees have a preproductive period in excess of 2
years, Farmer G is required to capitalize the costs of producing the fig
trees. See paragraphs (a)(2) and (b)(2)(i)(B) of this section. In
accordance with paragraph (b)(2)(i)(C)(2) of this section, Farmer G must
continue to capitalize preproductive period costs to the trees until
they become productive in marketable quantities. The following factors
weigh in favor of a determination that the fig trees did not become
productive in Year 4: the quantity of harvested figs is de minimis based
on the fact that the yield is only 5 percent of the expected yield at
maturity and the proceeds from the sale of the figs are sufficient,
after covering the costs of harvesting and transporting the figs, to
cover only a negligible portion of the allocable farm expenses. Based on
these facts and circumstances, the fig trees did not become productive
in marketable quantities in Year 4.
(ii) Animal. An animal's actual preproductive period is used to
determine the period that the taxpayer must capitalize preproductive
period costs with respect to a particular animal.
(A) Beginning of the preproductive period. The preproductive period
of an animal begins at the time of acquisition, breeding, or embryo
implantation.
(B) End of the preproductive period. In the case of an animal that
will be used in the trade or business of farming (for example, a dairy
cow), the preproductive period generally ends when the animal is (or
would be considered) placed in service for purposes of section 168
(without regard to the applicable convention). However, in the case of
an animal that will have more than one yield (for example, a breeding
cow), the preproductive period ends when the animal produces (for
example, gives birth to) its first yield. In the case of any other
animal, the preproductive period ends when the animal is sold or
otherwise disposed of.
(C) Allocation of costs between animal and yields. In the case of an
animal that will have more than one yield, the costs incurred after the
beginning of the preproductive period of the first yield but before the
end of the preproductive period of the animal must be allocated between
the animal and the yield using any reasonable method. Any depreciation
allowance on the animal may be allocated entirely to the yield. Costs
incurred after the beginning of the preproductive period of the second
yield, but before the first yield is weaned from the animal must be
allocated between the first and second yield using any reasonable
method. However, a taxpayer may elect to allocate these costs entirely
to the second yield. An allocation method used by a taxpayer is a method
of accounting that must be used consistently and is subject to the rules
of section 446 and the regulations thereunder.
(c) Inventory methods--(1) In general. Except as otherwise provided,
the costs required to be allocated to any plant or
[[Page 815]]
animal under this section may be determined using reasonable inventory
valuation methods such as the farm-price method or the unit-livestock-
price method. See Sec. 1.471-6. Under the unit-livestock-price method,
unit prices must include all costs required to be capitalized under
section 263A. A taxpayer using the unit-livestock-price method may elect
to use the cost allocation methods in Sec. 1.263A-1(f) or 1.263A-2(b)
to allocate its direct and indirect costs to the property produced in
the business of farming. In such a situation, section 471 costs are the
costs taken into account by the taxpayer under the unit-livestock-price
method using the taxpayer's standard unit price as modified by this
paragraph (c)(1). Tax shelters, as defined in paragraph (a)(2)(ii) of
this section, that use the unit-livestock-price method for inventories
must include in inventory the annual standard unit price for all animals
that are acquired during the taxable year, regardless of whether the
purchases are made during the last 6 months of the taxable year.
Taxpayers required by section 447 to use an accrual method or prohibited
by section 448(a)(3) from using the cash method that use the unit-
livestock-price method must modify the annual standard price in order to
reasonably reflect the particular period in the taxable year in which
purchases of livestock are made, if such modification is necessary in
order to avoid significant distortions in income that would otherwise
occur through operation of the unit-livestock-price method.
(2) Available for property used in a trade or business. The farm-
price method or the unit-livestock-price method may be used by any
taxpayer to allocate costs to any plant or animal under this section,
regardless of whether the plant or animal is held or treated as
inventory property by the taxpayer. Thus, for example, a taxpayer may
use the unit-livestock-price method to account for the costs of raising
livestock that will be used in the trade or business of farming (for
example, a breeding animal or a dairy cow) even though the property in
question is not inventory property.
(3) Exclusion of property to which section 263A does not apply.
Notwithstanding a taxpayer's use of the farm-price method with respect
to farm property to which the provisions of section 263A apply, that
taxpayer is not required, solely by such use, to use the farm-price
method with respect to farm property to which the provisions of section
263A do not apply. Thus, for example, assume Farmer A raises fruit trees
that have a preproductive period in excess of 2 years and to which the
provisions of section 263A, therefore, apply. Assume also that Farmer A
raises cattle and is not required to use an accrual method by section
447 or prohibited from using the cash method by section 448(a)(3).
Because Farmer A qualifies for the exception in paragraph (a)(2) of this
section, Farmer A is not required to capitalize the costs of raising the
cattle. Although Farmer A may use the farm-price method with respect to
the fruit trees, Farmer A is not required to use the farm-price method
with respect to the cattle. Instead, Farmer A's accounting for the
cattle is determined under other provisions of the Code and regulations.
(d) Election not to have section 263A apply under section
263A(d)(3)--(1) Introduction. This paragraph (d) permits certain
taxpayers to make an election not to have the rules of this section
apply to any plant produced in a farming business conducted by the
electing taxpayer. Except as provided in paragraph (d)(5) and (6) of
this section, the election is a method of accounting under section 446.
An election made under section 263A(d)(3) and this paragraph (d) is
revocable only with the consent of the Commissioner.
(2) Availability of the election. The election described in this
paragraph (d) is available to any taxpayer that produces plants in a
farming business, except that no election may be made by a corporation,
partnership, or tax shelter required to use an accrual method under
section 447 or prohibited from using the cash method by section
448(a)(3). Moreover, the election does not apply to the costs of
planting, cultivation, maintenance, or development of a citrus or almond
grove (or any part thereof) incurred prior to the close of the fourth
taxable year beginning with the taxable year in which the trees were
planted in the permanent
[[Page 816]]
grove (including costs incurred prior to the permanent planting). If a
citrus or almond grove is planted in more than one taxable year, the
portion of the grove planted in any one taxable year is treated as a
separate grove for purposes of determining the year of planting.
(3) Time and manner of making the election--(i) Automatic election.
A taxpayer makes the election under this paragraph (d) by not applying
the rules of section 263A to determine the capitalized costs of plants
produced in a farming business and by applying the special rules in
paragraph (d)(4) of this section on its original return for the first
taxable year in which the taxpayer is otherwise required to capitalize
section 263A costs. Thus, in order to be treated as having made the
election under this paragraph (d), it is necessary to report both income
and expenses in accordance with the rules of this paragraph (d) (for
example, it is necessary to use the alternative depreciation system as
provided in paragraph (d)(4)(ii) of this section). For example, a farmer
who deducts costs that are otherwise required to be capitalized under
section 263A but fails to use the alternative depreciation system under
section 168(g)(2) for applicable property placed in service has not made
an election under this paragraph (d) and is not in compliance with the
provisions of section 263A.
(ii) Nonautomatic election. Except as provided in paragraphs (d)(5)
and (6) of this section, a taxpayer that does not make the election
under this paragraph (d) as provided in paragraph (d)(3)(i) of this
section must obtain the consent of the Commissioner to make the election
by filing a Form 3115, Application for Change in Method of Accounting,
in accordance with Sec. 1.446-1(e)(3).
(4) Special rules. If the election under this paragraph (d) is made,
the taxpayer is subject to the special rules in this paragraph (d)(4).
(i) Section 1245 treatment. The plant produced by the taxpayer is
treated as section 1245 property and any gain resulting from any
disposition of the plant is recaptured (that is, treated as ordinary
income) to the extent of the total amount of the deductions that, but
for the election, would have been required to be capitalized with
respect to the plant. In calculating the amount of gain that is
recaptured under this paragraph (d)(4)(i), a taxpayer may use the farm-
price method or another simplified method permitted under these
regulations in determining the deductions that otherwise would have been
capitalized with respect to the plant.
(ii) Required use of alternative depreciation system. If the
taxpayer or a related person makes an election under this paragraph (d),
the alternative depreciation system (as defined in section 168(g)(2))
must be applied to all property used predominantly in any farming
business of the taxpayer or related person and placed in service in any
taxable year during which the election is in effect. The requirement to
use the alternative depreciation system by reason of an election under
this paragraph (d) will not prevent a taxpayer from making an election
under section 179 to deduct certain depreciable business assets.
(iii) Related person--(A) In general. For purposes of this paragraph
(d)(4), related person means--
(1) The taxpayer and members of the taxpayer's family;
(2) Any corporation (including an S corporation) if 50 percent or
more of the stock (in value) is owned directly or indirectly (through
the application of section 318) by the taxpayer or members of the
taxpayer's family;
(3) A corporation and any other corporation that is a member of the
same controlled group (within the meaning of section 1563(a)(1)); and
(4) Any partnership if 50 percent or more (in value) of the
interests in such partnership is owned directly or indirectly by the
taxpayer or members of the taxpayer's family.
(B) Members of family. For purposes of this paragraph (d)(4)(iii),
the terms ``members of the taxpayer's family'', and ``members of
family'' (for purposes of applying section 318(a)(1)), means the spouse
of the taxpayer (other than a spouse who is legally separated from the
individual under a decree of divorce or separate maintenance) and any of
the taxpayer's children (including legally adopted children) who have
not reached the age of 18 as of the last day of the taxable year in
question.
[[Page 817]]
(5) Revocation of section 263A(d)(3) election to permit exemption
under section 263A(i). A taxpayer that elected under section 263A(d)(3)
and paragraph (d)(3) of this section not to have section 263A apply to
any plant produced in a farming business that wants to revoke its
section 263A(d)(3) election, and in the same taxable year, apply the
small business taxpayer exemption under section 263A(i) and Sec.
1.263A-1(j) may revoke the election in accordance with the applicable
administrative guidance as published in the Internal Revenue Bulletin
(see Sec. 601.601(d)(2)(ii)(b) of this chapter). A revocation of the
taxpayer's section 263A(d)(3) election under this paragraph (d)(5) is
not a change in method of accounting under sections 446 and 481 and
Sec. Sec. 1.446-1 and 1.481-1 through 1.481-5.
(6) Change from applying exemption under section 263A(i) to making a
section 263A(d)(3) election. A taxpayer whose method of accounting is to
not capitalize costs under section 263A based on the exemption under
section 263A(i), that becomes ineligible to use the exemption under
section 263A(i), and is eligible and wants to elect under section
263A(d)(3) for this same taxable year to not capitalize costs under
section 263A for any plant produced in the taxpayer's farming business,
must make the election in accordance with the applicable administrative
guidance as published in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii)(b) of this chapter). An election under section
263A(d)(3) made in accordance with this paragraph (d)(6) is not a change
in method of accounting under sections 446 and 481 and Sec. Sec. 1.446-
1 and 1.481-1 through 1.481-5.
(7) Examples. The following examples illustrate the provisions of
this paragraph (d):
Example 1. (i) Farmer A, an individual, is engaged in the trade or
business of farming. Farmer A grows apple trees that have a
preproductive period greater than 2 years. In addition, Farmer A grows
and harvests wheat and other grains. Farmer A elects under this
paragraph (d) not to have the rules of section 263A apply to the costs
of growing the apple trees.
(ii) In accordance with paragraph (d)(4) of this section, Farmer A
is required to use the alternative depreciation system described in
section 168(g)(2) with respect to all property used predominantly in any
farming business in which Farmer A engages (including the growing and
harvesting of wheat) if such property is placed in service during a year
for which the election is in effect. Thus, for example, all assets and
equipment (including trees and any equipment used to grow and harvest
wheat) placed in service during a year for which the election is in
effect must be depreciated as provided in section 168(g)(2).
Example 2. Assume the same facts as in Example 1, except that Farmer
A and members of Farmer A's family (as defined in paragraph
(d)(4)(iii)(B) of this section) also own 51 percent (in value) of the
interests in Partnership P, which is engaged in the trade or business of
growing and harvesting corn. Partnership P is a related person to Farmer
A under the provisions of paragraph (d)(4)(iii) of this section. Thus,
the requirements to use the alternative depreciation system under
section 168(g)(2) also apply to any property used predominantly in a
trade or business of farming which Partnership P places in service
during a year for which an election made by Farmer A is in effect.
(e) Exception for certain costs resulting from casualty losses--(1)
In general. Section 263A does not require the capitalization of costs
that are attributable to the replanting, cultivating, maintaining, and
developing of any plants bearing an edible crop for human consumption
(including, but not limited to, plants that constitute a grove, orchard,
or vineyard) that were lost or damaged while owned by the taxpayer by
reason of freezing temperatures, disease, drought, pests, or other
casualty (replanting costs). Such replanting costs may be incurred with
respect to property other than the property on which the damage or loss
occurred to the extent the acreage of the property with respect to which
the replanting costs are incurred is not in excess of the acreage of the
property on which the damage or loss occurred. This paragraph (e)
applies only to the replanting of plants of the same type as those lost
or damaged. This paragraph (e) applies to plants replanted on the
property on which the damage or loss occurred or property of the same or
lesser acreage in the United States irrespective of differences in
density between the lost or damaged and replanted plants. Plants bearing
crops for human consumption are those crops normally eaten or drunk by
humans. Thus, for example,
[[Page 818]]
costs incurred with respect to replanting plants bearing jojoba beans do
not qualify for the exception provided in this paragraph (e) because
that crop is not normally eaten or drunk by humans.
(2) Ownership. Replanting costs described in paragraph (e)(1) of
this section generally must be incurred by the taxpayer that owned the
property at the time the plants were lost or damaged. Paragraph (e)(1)
of this section will apply, however, to costs incurred by a person other
than the taxpayer that owned the plants at the time of damage or loss
if--
(i) The taxpayer that owned the plants at the time the damage or
loss occurred owns an equity interest of more than 50 percent in such
plants at all times during the taxable year in which the replanting
costs are paid or incurred; and
(ii) Such other person owns any portion of the remaining equity
interest and materially participates in the replanting, cultivating,
maintaining, or developing of such plants during the taxable year in
which the replanting costs are paid or incurred. A person will be
treated as materially participating for purposes of this provision if
such person would otherwise meet the requirements with respect to
material participation within the meaning of section 2032A(e)(6).
(3) Examples. The following examples illustrate the provisions of
this paragraph (e):
Example 1. (i) Farmer A grows cherry trees that have a preproductive
period in excess of 2 years and produce an annual crop. These cherries
are normally eaten by humans. Farmer A grows the trees on a 100 acre
parcel of land (parcel 1) and the groves of trees cover the entire
acreage of parcel 1. Farmer A also owns a 150 acre parcel of land
(parcel 2) that Farmer A holds for future use. Both parcels are in the
United States. In 2000, the trees and the irrigation and drainage
systems that service the trees are destroyed in a casualty (within the
meaning of paragraph (e)(1) of this section). Farmer A installs new
irrigation and drainage systems on parcel 1, purchases young trees
(seedlings), and plants the seedlings on parcel 1.
(ii) The costs of the irrigation and drainage systems and the
seedlings must be capitalized. In accordance with paragraph (e)(1) of
this section, the costs of planting, cultivating, developing, and
maintaining the seedlings during their preproductive period are not
required to be capitalized by section 263A.
Example 2. (i) Assume the same facts as in Example 1 except that
Farmer A decides to replant the seedlings on parcel 2 rather than on
parcel 1. Accordingly, Farmer A installs the new irrigation and drainage
systems on 100 acres of parcel 2 and plants seedlings on those 100
acres.
(ii) The costs of the irrigation and drainage systems and the
seedlings must be capitalized. Because the acreage of the related
portion of parcel 2 does not exceed the acreage of the destroyed orchard
on parcel 1, the costs of planting, cultivating, developing, and
maintaining the seedlings during their preproductive period are not
required to be capitalized by section 263A. See paragraph (e)(1) of this
section.
Example 3. (i) Assume the same facts as in Example 1 except that
Farmer A replants the seedlings on parcel 2 rather than on parcel 1, and
Farmer A additionally decides to expand its operations by growing 125
rather than 100 acres of trees. Accordingly, Farmer A installs new
irrigation and drainage systems on 125 acres of parcel 2 and plants
seedlings on those 125 acres.
(ii) The costs of the irrigation and drainage systems and the
seedlings must be capitalized. The costs of planting, cultivating,
developing, and maintaining 100 acres of the trees during their
preproductive period are not required to be capitalized by section 263A.
The costs of planting, cultivating, maintaining, and developing the
additional 25 acres are, however, subject to capitalization under
section 263A. See paragraph (e)(1) of this section.
(4) Special rule for citrus and almond groves--(i) In general. The
exception in this paragraph (e) is available with respect to replanting
costs of a citrus or almond grove incurred prior to the close of the
fourth taxable year after replanting, notwithstanding the taxpayer's
election to have section 263A not apply (described in paragraph (d) of
this section).
(ii) Example. The following example illustrates the provisions of
this paragraph (e)(4):
Example. (i) Farmer A, an individual, is engaged in the trade or
business of farming. Farmer A grows citrus trees that have a
preproductive period of 5 years. Farmer A elects, under paragraph (d) of
this section, not to have section 263A apply. This election, however, is
unavailable with respect to the costs of producing a citrus grove
incurred within the first 4 years beginning with the year the trees were
planted. See paragraph
[[Page 819]]
(d)(2) of this section. In year 10, after the citrus grove has become
productive in marketable quantities, the citrus grove is destroyed by a
casualty within the meaning of paragraph (e)(1) of this section. In year
10, Farmer A acquires and plants young citrus trees in the same grove to
replace those destroyed by the casualty.
(ii) Farmer A must capitalize the costs of producing the citrus
grove incurred before the close of the fourth taxable year beginning
with the year in which the trees were permanently planted. As a result
of the election not to have section 263A apply, Farmer A may deduct the
preproductive period costs incurred in the fifth year. In year 10,
Farmer A must capitalize the acquisition cost of the young trees.
However, the costs of planting, cultivating, developing, and maintaining
the young trees that replace those destroyed by the casualty are
exempted from capitalization under this paragraph (e).
(5) Special temporary rule for citrus plants lost by reason of
casualty. Section 263A(d)(2)(A) provides that if plants bearing an
edible crop for human consumption were lost or damaged while in the
hands of the taxpayer by reason of freezing temperatures, disease,
drought, pests, or casualty, section 263A does not apply to any costs of
the taxpayer of replanting plants bearing the same type of crop (whether
on the same parcel of land on which such lost or damaged plants were
located or any other parcel of land of the same acreage in the United
States). The rules of this paragraph (e)(5) apply to certain costs that
are paid or incurred after December 22, 2017, and on or before December
22, 2027, to replant citrus plants after the loss or damage of citrus
plants. Notwithstanding paragraph (e)(2) of this section, in the case of
replanting citrus plants after the loss or damage of citrus plants by
reason of freezing temperatures, disease, drought, pests, or casualty,
section 263A does not apply to replanting costs paid or incurred by a
taxpayer other than the owner described in section 263A(d)(2)(A) if--
(i) The owner described in section 263A(d)(2)(A) has an equity
interest of not less than 50 percent in the replanted citrus plants at
all times during the taxable year in which such amounts were paid or
incurred and the taxpayer holds any part of the remaining equity
interest; or
(ii) The taxpayer acquired the entirety of the equity interest in
the land of that owner described in section 263A(d)(2)(A) and on which
land the lost or damaged citrus plants were located at the time of such
loss or damage, and the replanting is on such land.
(f) Change in method of accounting. Except as provided in paragraphs
(d)(5) and (6) of this section, any change in a taxpayer's method of
accounting necessary to comply with this section is a change in method
of accounting to which the provisions of sections 446 and 481 and Sec.
1.446-1 through 1.446-7 and Sec. 1.481-1 through Sec. 1.481-3 apply.
(g) Applicability dates--(1) In general. In the case of property
that is not inventory in the hands of the taxpayer, this section is
applicable to costs incurred after August 21, 2000 in taxable years
ending after August 21, 2000. In the case of inventory property, this
section is applicable to taxable years beginning after August 21, 2000.
(2) Changes made by Tax Cuts and Jobs Act (Pub. L. 115-97).
Paragraphs (a)(3), (d)(5), (d)(6), and (e)(5) of this section apply for
taxable years beginning on or after January 5, 2021. However, for a
taxable year beginning after December 31, 2017, and before January 5,
2021, a taxpayer may apply the paragraphs described in the first
sentence of this paragraph (g)(2), provided that the taxpayer follows
all the applicable rules contained in the regulations under section 263A
for such taxable year and all subsequent taxable years.
[T.D. 8897, 65 FR 50644, Aug. 21, 2000; 65 FR 61092, Oct. 16, 2000; T.D.
9942, 86 FR 267, Jan. 5, 2021; 86 FR 32186, June 17, 2021]
Sec. 1.263A-5 Exception for qualified creative expenses
incurred by certain free-lance authors, photographers,
and artists. [Reserved]
Sec. 1.263A-6 Rules for foreign persons. [Reserved]
Sec. 1.263A-7 Changing a method of accounting under section 263A.
(a) Introduction--(1) Purpose. These regulations provide guidance to
taxpayers changing their methods of accounting for costs subject to
section 263A. The principal purpose of these regulations is to provide
guidance regarding how taxpayers are to revalue
[[Page 820]]
property on hand at the beginning of the taxable year in which they
change their method of accounting for costs subject to section 263A.
Paragraph (c) of this section provides guidance regarding how items or
costs included in beginning inventory in the year of change must be
revalued. Paragraph (d) of this section provides guidance regarding how
non-inventory property should be revalued in the year of change.
(2) Taxpayers that adopt a method of accounting under section 263A.
Taxpayers may adopt a method of accounting for costs subject to section
263A in the first taxable year in which they engage in resale or
production activities. For purposes of this section, the adoption of a
method of accounting has the same meaning as provided in Sec. 1.446-
1(e)(1). Taxpayers are not subject to the provisions of these
regulations to the extent they adopt, as opposed to change, a method of
accounting.
(3) Taxpayers that change a method of accounting under section 263A.
Taxpayers changing their method of accounting for costs subject to
section 263A are subject to the revaluation and other provisions of this
section. Taxpayers subject to these regulations include, but are not
limited to--
(i) For taxable years beginning after December 31, 2017, resellers
of real or personal property or producers of real or tangible personal
property whose average annual gross receipts for the immediately
preceding 3-taxable-year period, or lesser period if the taxpayer was
not in existence for the three preceding taxable years, annualized as
required, exceed the gross receipts test of section 448(c) and the
accompanying regulations where the taxpayer was not subject to section
263A in the prior taxable year;
(ii) Resellers of real or personal property that are using a method
that fails to comply with section 263A and desire to change to a method
of accounting that complies with section 263A;
(iii) Producers of real or tangible personal property that are using
a method that fails to comply with section 263A and desire to change to
a method of accounting that complies with section 263A; and
(iv) Resellers and producers that desire to change from one
permissible method of accounting for costs subject to section 263A to
another permissible method.
(4) Applicability dates--(i) In general.The provisions of this
section are effective for taxable years beginning on or after August 5,
1997. For taxable years beginning before August 5, 1997, the rules of
Sec. 1.263A-7T contained in the 26 CFR part 1 edition revised as of
April 1, 1997, as modified by other administrative guidance, will apply.
(ii) Changes made by Tax Cuts and Jobs Act (Pub. L. 115-97).
Paragraph (a)(3)(i) of this section applies to taxable years beginning
on or after January 5, 2021. However, for a taxable year beginning after
December 31, 2017, and before January 5, 2021, a taxpayer may apply the
paragraph described in the first sentence of this paragraph (a)(4)(ii),
provided that the taxpayer follows all the applicable rules contained in
the regulations under section 263A for such taxable year and all
subsequent taxable years.
(5) Definition of change in method of accounting. For purposes of
this section, a change in method of accounting has the same meaning as
provided in Sec. 1.446-1(e)(2)(ii). Changes in method of accounting for
costs subject to section 263A include changes to methods required or
permitted by section 263A and the regulations thereunder. Changes in
method of accounting may be described in the preceding sentence
irrespective of whether the taxpayer's previous method of accounting
resulted in the capitalization of more (or fewer) costs than the costs
required to be capitalized under section 263A and the regulations
thereunder, and irrespective of whether the taxpayer's previous method
of accounting was a permissible method under the law in effect when the
method was being used. However, changes in method of accounting for
costs subject to section 263A do not include changes relating to factors
other than those described therein. For example, a change in method of
accounting for costs subject to section 263A does not include a change
from one inventory identification method to another inventory
identification method, such as a change from the last-in, first-
[[Page 821]]
out (LIFO) method to the first-in, first-out (FIFO) method, or vice
versa, or a change from one inventory valuation method to another
inventory valuation method under section 471, such as a change from
valuing inventory at cost to valuing the inventory at cost or market,
whichever is lower, or vice versa. In addition, a change in method of
accounting for costs subject to section 263A does not include a change
within the LIFO inventory method, such as a change from the double
extension method to the link-chain method, or a change in the method
used for determining the number of pools. Further, a change from the
modified resale method set forth in Notice 89-67 (1989-1 C.B. 723), see
Sec. 601.601(d)(2) of this chapter, to the simplified resale method set
forth in Sec. 1.263A-3(d) is not a change in method of accounting
within the meaning of Sec. 1.446-1(e)(2)(ii) and is therefore not
subject to the provisions of this section. However, a change from the
simplified resale method set forth in former Sec. 1.263A-1T(d)(4) to
the simplified resale method set forth in Sec. 1.263A-3(d) is a change
in method of accounting within the meaning of Sec. 1.446-1(e)(2)(ii)
and is subject to the provisions of this section.
(b) Rules applicable to a change in method of accounting--(1)
General rules. All changes in method of accounting for costs subject to
section 263A are subject to the rules and procedures provided by the
Code, regulations, and administrative procedures applicable to such
changes. The Internal Revenue Service has issued specific revenue
procedures that govern certain accounting method changes for costs
subject to section 263A. Where a specific revenue procedure is not
applicable, changes in method of accounting for costs subject to section
263A are subject to the same rules and procedures that govern other
accounting method changes. See Revenue Procedure 2015-13 (2015-5 IRB
419) and Sec. 601.601(d)(2) of this chapter.
(2) Special rules--(i) Ordering rules when multiple changes in
method of accounting occur in the year of change--(A) In general. A
change in method of accounting for costs subject to section 263A is
generally deemed to occur (including the computation of the adjustment
under section 481(a)) before any other change in method of accounting is
deemed to occur for that same taxable year.
(B) Exceptions to the general ordering rule--(1) Change from the
LIFO inventory method. In the case of a taxpayer that is discontinuing
its use of the LIFO inventory method in the same taxable year it is
changing its method of accounting for costs subject to section 263A, the
change from the LIFO method may be made before the change in method of
accounting (and the computation of the corresponding adjustment under
section 481 (a)) under section 263A is made.
(2) Change from the specific goods LIFO inventory method. In the
case of a taxpayer that is changing from the specific goods LIFO
inventory method to the dollar-value LIFO inventory method in the same
taxable year it is changing its method of accounting for costs subject
to section 263A, the change from the specific goods LIFO inventory
method may be made before the change in method of accounting under
section 263A is made.
(3) Change in overall method of accounting. In the case of a
taxpayer that is changing its overall method of accounting from the cash
receipts and disbursements method to an accrual method in the same
taxable year it is changing its method of accounting for costs subject
to section 263A, the taxpayer must change to an accrual method for
capitalizable costs (see Sec. 1.263A-1(c)(2)(ii)) before the change in
method of accounting (and the computation of the corresponding
adjustment under section 481(a)) under section 263A is made.
(4) Change in method of accounting for depreciation. In the case of
a taxpayer that is changing its method of accounting for depreciation in
the same taxable year it is changing its method of accounting for costs
subject to section 263A and any portion of the depreciation is subject
to section 263A, the change in method of accounting for depreciation
must be made before the change in method of accounting (and the
computation of the corresponding adjustment under section 481(a)) under
section 263A is made.
[[Page 822]]
(ii) Adjustment required by section 481(a). In the case of any
taxpayer required or permitted to change its method of accounting for
any taxable year under section 263A and the regulations thereunder, the
change will be treated as initiated by the taxpayer for purposes of the
adjustment required by section 481(a). The taxpayer must take the net
section 481(a) adjustment into account over the section 481(a)
adjustment period as determined under the applicable administrative
procedures issued under Sec. 1.446-1(e)(3)(ii) for obtaining the
Commissioner's consent to a change in accounting method (for example,
see Revenue Procedure 2015-13, 2015-5 IRB 419 (or successor) (also see
Sec. 601.601(d)(2) of this chapter)). This paragraph applies to taxable
years ending on or after June 16, 2004.
(iii) Base year--(A) Need for a new base year. Certain dollar-value
LIFO taxpayers (whether using double extension or link-chain) must
establish a new base year when they revalue their inventories under
section 263A.
(1) Facts and circumstances revaluation method used. A dollar-value
LIFO taxpayer that uses the facts and circumstances revaluation method
is permitted, but not required, to establish a new base year.
(2) 3-year average method used--(i) Simplified method not used. A
dollar-value LIFO taxpayer using the 3-year average method but not the
simplified production method or the simplified resale method to revalue
its inventory is required to establish a new base year.
(ii) Simplified method used. A dollar-value LIFO taxpayer using the
3-year average method and the simplified production method, the modified
simplified production method, or the simplified resale method to revalue
its inventory is permitted, but not required, to establish a new base
year.
(B) Computing a new base year. For purposes of determining future
indexes, the year of change becomes the new base year (that is, the
index at the beginning of the year of change generally must be 1.00) and
all costs are restated in new base year costs for purposes of extending
such costs in future years. However, when a new base year is
established, costs associated with old layers retain their separate
identity within the base year, with such layers being restated in terms
of the new base year index. For example, for purposes of determining
whether a particular layer has been invaded, each layer must retain its
separate identity. Thus, if a decrement in an inventory pool occurs,
layers accumulated in more recent years must be viewed as invaded first,
in order of priority.
(c) Inventory--(1) Need for adjustments. When a taxpayer changes its
method of accounting for costs subject to section 263A, the taxpayer
generally must, in computing its taxable income for the year of change,
take into account the adjustments required by section 481(a). The
adjustments required by section 481(a) relate to revaluations of
inventory property, whether the taxpayer produces the inventory or
acquires it for resale. See paragraph (d) of this section in regard to
the adjustments required by section 481(a) that relate to non-inventory
property.
(2) Revaluing beginning inventory--(i) In general. If a taxpayer
changes its method of accounting for costs subject to section 263A, the
taxpayer must revalue the items or costs included in its beginning
inventory in the year of change as if the new method (that is, the
method to which the taxpayer is changing) had been in effect during all
prior years. In revaluing inventory costs under this procedure, all of
the capitalization provisions of section 263A and the regulations
thereunder apply to all inventory costs accumulated in prior years. The
necessity to revalue beginning inventory as if these capitalization
rules had been in effect for all prior years includes, for example, the
revaluation of costs or layers incurred in taxable years preceding the
transition period to the full absorption method of inventory costing as
described in Sec. 1.471-11(e), regardless of whether a taxpayer
employed a cut-off method under those regulations. The difference
between the inventory as originally valued using the former method (that
is, the method from which the taxpayer is changing) and the inventory as
revalued using the new method is equal to the amount of the adjustment
required under section 481(a).
[[Page 823]]
(ii) Methods to revalue inventory. There are three methods available
to revalue inventory. The first method, the facts and circumstances
revaluation method, may be used by all taxpayers. Under this method, a
taxpayer determines the direct and indirect costs that must be assigned
to each item of inventory based on all the facts and circumstances. This
method is described in paragraph (c)(2)(iii) of this section. The second
method, the weighted average method, is available only in certain
situations to taxpayers using the FIFO inventory method or the specific
goods LIFO inventory method. This method is described in paragraph
(c)(2)(iv) of this section. The third method, the 3-year average method,
is available to all taxpayers using the dollar-value LIFO inventory
method of accounting. This method is described in paragraph (c)(2)(v) of
this section. The weighted average method and the 3-year average method
revalue inventory through processes of estimation and extrapolation,
rather than based on the facts and circumstances of a particular year's
data. All three methods are available regardless of whether the taxpayer
elects to use a simplified method to capitalize costs under section
263A.
(iii) Facts and circumstances revaluation method--(A) In general.
Under the facts and circumstances revaluation method, a taxpayer
generally is required to revalue inventories by applying the
capitalization rules of section 263A and the regulations thereunder to
the production and resale activities of the taxpayer, with the same
degree of specificity as required of inventory manufacturers under the
law immediately prior to the effective date of the Tax Reform Act of
1986 (Pub. L. 99-514, 100 Stat. 2085, 1986-3 C.B. (Vol. 1)). Thus, for
example, with respect to any prior year that is relevant in determining
the total amount of the revalued balance as of the beginning of the year
of change, the taxpayer must analyze the production and resale data for
that particular year and apply the rules and principles of section 263A
and the regulations thereunder to determine the appropriate revalued
inventory costs. However, under the facts and circumstances revaluation
method, a taxpayer may utilize reasonable estimates and procedures in
valuing inventory costs if--
(1) The taxpayer lacks, and is not able to reconstruct from its
books and records, actual financial and accounting data which is
required to apply the capitalization rules of section 263A and the
regulations thereunder to the relevant facts and circumstances
surrounding a particular item of inventory or cost; and
(2) The total amounts of costs for which reasonable estimates and
procedures are employed are not significant in comparison to the total
restated value (including costs previously capitalized under the
taxpayer's former method) of the items or costs for the period in
question.
(B) Exception. A taxpayer that is not able to comply with the
requirement of paragraph (c)(2)(iii)(A)(2) of this section because of
the existence of a significant amount of costs that would require the
use of estimates and procedures must revalue its inventories under the
procedures provided in paragraph (c)(2) (iv) or (v) of this section.
(C) Estimates and procedures allowed. The estimates and procedures
of this paragraph (c)(2)(iii) include--
(1) The use of available information from more recent years to
estimate the amount and nature of inventory costs applicable to earlier
years; and
(2) The use of available information with respect to comparable
items of inventory produced or acquired during the same year in order to
estimate the costs associated with other items of inventory.
(D) Use by dollar-value LIFO taxpayers. Generally, a dollar-value
LIFO taxpayer must recompute its LIFO inventory for each taxable year
that the LIFO inventory method was used.
(E) Examples. The provisions of this paragraph (c)(2)(iii) are
illustrated by the following three examples. The principles set forth in
these examples are applicable both to production and resale activities
and the year of change in all three examples is 1997. The examples read
as follows:
Example 1. Taxpayer X lacks information for the years 1993 and
earlier, regarding the
[[Page 824]]
amount of costs incurred in transporting finished goods from X's factory
to X's warehouse and in storing those goods at the warehouse until their
sale to customers. X determines that, for 1994 and subsequent years,
these transportation and storage costs constitute 4 percent of the total
costs of comparable goods under X's method of accounting for such years.
Under this paragraph (c)(2)(iii), X may assume that transportation and
storage costs for the years 1993 and earlier constitute 4 percent of the
total costs of such goods.
Example 2. Assume the same facts as in Example 1, except that for
the year 1993 and earlier, X used a different method of accounting for
inventory costs whereunder significantly fewer costs were capitalized
than amounts capitalized in later years. Thus, the application of
transportation and storage based on a percentage of costs for 1994 and
later years would not constitute a reasonable estimate for use in
earlier years. X may use the information from 1994 and later years, if
appropriate adjustments are made to reflect the differences in inventory
costs for the applicable years, including, for example--
(i) Increasing the percentage of costs that are intended to
represent transportation and storage costs to reflect the aggregate
differences in capitalized amounts under the two methods of accounting;
or
(ii) Taking the absolute dollar amount of transportation and storage
costs for comparable goods in inventory and applying that amount
(adjusted for changes in general price levels, where appropriate) to
goods associated with 1993 and prior periods.
Example 3. Taxpayer Z lacks information for certain years with
respect to factory administrative costs, subject to capitalization under
section 263A and the regulations thereunder, incurred in the production
of inventory in factory A. Z does have sufficient information to
determine factory administrative costs with respect to production of
inventory in factory B, wherein inventory items were produced during the
same years as factory A. Z may use the information from factory B to
determine the appropriate amount of factory administrative costs to
capitalize as inventory costs for comparable items produced in factory A
during the same years.
(iv) Weighted average method--(A) In general. A taxpayer using the
FIFO method or the specific goods LIFO method of accounting for
inventories may use the weighted average method as provided in this
paragraph (c)(2)(iv) to estimate the change in the amount of costs that
must be allocated to inventories for prior years. The weighted average
method under this paragraph (c)(2)(iv) is only available to a taxpayer
that lacks sufficient data to revalue its inventory costs under the
facts and circumstances revaluation method provided for in paragraph
(c)(2)(iii) of this section. Moreover, a taxpayer that qualifies for the
use of the weighted average method under this paragraph (c)(2)(iv) must
utilize such method only with respect to items or costs for which it
lacks sufficient information to revalue under the facts and
circumstances revaluation method. Particular items or costs must be
revalued under the facts and circumstances revaluation method if
sufficient information exists to make such a revaluation. If a taxpayer
lacks sufficient information to otherwise apply the weighted average
method under this paragraph (c)(2)(iv) (for example, the taxpayer is
unable to revalue the costs of any of its items in inventory due to a
lack of information), then the taxpayer must use reasonable estimates
and procedures, as described in the facts and circumstances revaluation
method, to whatever extent is necessary to allow the taxpayer to apply
the weighted average method.
(B) Weighted average method for FIFO taxpayers--(1) In general. This
paragraph (c)(2)(iv)(B) sets forth the mechanics of the weighted average
method as applicable to FIFO taxpayers. Under the weighted average
method, an item in ending inventory for which sufficient data is not
available for revaluation under section 263A and the regulations
thereunder must be revalued by using the weighted average percentage
increase or decrease with respect to such item for the earliest
subsequent taxable year for which sufficient data is available. With
respect to an item for which no subsequent data exists, such item must
be revalued by using the weighted average percentage increase or
decrease with respect to all reasonably comparable items in the
taxpayer's inventory for the same year or the earliest subsequent
taxable year for which sufficient data is available.
(2) Example. The provisions of this paragraph (c)(2)(iv)(B) are
illustrated by the following example. The principles set forth in this
example are applicable both to production and resale activities and the
year of change in the
[[Page 825]]
example is 1997. The example reads as follows:
Example. Taxpayer A manufactures bolts and uses the FIFO method to
identify inventories. Under A's former method, A did not capitalize all
of the costs required to be capitalized under section 263A. A maintains
inventories of bolts, two types of which it no longer produces. Bolt A
was last produced in 1994. The revaluation of the costs of Bolt A under
this section for bolts produced in 1994 results in a 20 percent increase
of the costs of Bolt A. A portion of the inventory of Bolt A, however,
is attributable to 1993. A does not have sufficient data for revaluation
of the 1993 cost for Bolt A. With respect to Bolt A, A may apply the 20
percent increase determined for 1994 to the 1993 production as an
acceptable estimate. Bolt B was last produced in 1992 and no data exists
that would allow revaluation of the inventory cost of Bolt B. The
inventories of all other bolts for which information is available are
attributable to 1994 and 1995. Revaluation of the costs of these other
bolts using available data results in an average increase in inventory
costs of 15 percent for 1994 production. With respect to Bolt B, the
overall 15 percent increase for A's inventory for 1994 may be used in
revaluing the cost of Bolt B.
(C) Weighted average method for specific goods LIFO taxpayers--(1)
In general. This paragraph (c)(2)(iv)(C) sets forth the mechanics of the
weighted average method as applicable to LIFO taxpayers using the
specific goods method of valuing inventories. Under the weighted average
method, the inventory layers with respect to an item for which data is
available are revalued under this section and the increase or decrease
in amount for each layer is expressed as a percentage of change from the
cost in the layer as originally valued. A weighted average of the
percentage of change for all layers for each type of good is computed
and applied to all earlier layers for each type of good that lack
sufficient data to allow for revaluation. In the case of earlier layers
for which sufficient data exists, such layers are to be revalued using
actual data. In cases where sufficient data is not available to make a
weighted average estimate with respect to a particular item of
inventory, a weighted average increase or decrease is to be determined
using all other inventory items revalued by the taxpayer in the same
specific goods grouping. This percentage increase or decrease is then
used to revalue the cost of the item for which data is lacking. If the
taxpayer lacks sufficient data to revalue any of the inventory items
contained in a specific goods grouping, then the weighted average
increase or decrease of substantially similar items (as determined by
principles similar to the rules applicable to dollar-value LIFO
taxpayers in Sec. 1.472-8(b)(3)) must be applied in the revaluation of
the items in such grouping. If insufficient data exists with respect to
all the items in a specific goods grouping and to all items that are
substantially similar (or such items do not exist), then the weighted
average for all revalued items in the taxpayer's inventory must be
applied in revaluing items for which data is lacking.
(2) Example. The provisions of this paragraph (c)(2)(iv)(C) are
illustrated by the following example. The principles set forth in this
example are applicable both to production and resale activities and the
year of change in the example is 1997. The example reads as follows:
Example. (i) Taxpayer M is a manufacturer that produces two
different parts. Under M's former method, M did not capitalize all of
the costs required to be capitalized under section 263A. Work-in-process
inventory is recorded in terms of equivalent units of finished goods.
M's records show the following at the end of 1996 under the specific
goods LIFO inventory method:
----------------------------------------------------------------------------------------------------------------
Carrying
LIFO Product and layer Number Cost values
----------------------------------------------------------------------------------------------------------------
Product 1:
1993........................................................ 150 $5.00 $750
1994........................................................ 100 6.00 600
1995........................................................ 100 6.50 650
1996........................................................ 50 7.00 350
-----------------------------------------------
$2,350
Product 2:
1993........................................................ 200 $4.00 $800
1994........................................................ 200 4.50 900
1995........................................................ 100 5.00 500
[[Page 826]]
1996........................................................ 100 6.00 600
-----------------------------------------------
2,800
===============================================
Total carrying value of Products 1 and 2 under M's .............. .............. 5,150
former method..........................................
----------------------------------------------------------------------------------------------------------------
(ii) M has sufficient data to revalue the unit costs of Product 1
using its new method for 1994, 1995 and 1996. These costs are: $7.00 in
1994, $7.75 in 1995, and $9.00 in 1996. This data for Product 1 results
in a weighted average percentage change of 20.31 percent ((100 x ($7.00-
$6.00)) + (100 x ($7.75-$6.50)) + (50 x ($9.00-$7.00)) divided by (100 x
$6.00) + (100 x $6.50) + (50 x $7.00)]. M has sufficient data to revalue
the unit costs of Product 2 only in 1995 and 1996. These costs are:
$6.00 in 1995 and $7.00 in 1996. This data for Product 2 results in a
weighted average percentage change of 18.18 percent [(100 x ($6.00-
$5.00)) + (100 x ($7.00-$6.00)) divided by (100 x $5.00) + (100 x
$6.00)].
(iii) M can estimate its revalued costs for Product 1 for 1993 by
applying the weighted average increase computed for Product 1 (20.31
percent) to the unit costs originally carried on M's records for 1993
under M's former method. The estimated revalued unit cost of Product 1
would be $6.02 ($5.00 x 1.2031). M estimates its revalued costs for
Product 2 for 1993 and 1994 in a similar fashion. M applies the
weighted average increase determined for Product 2 (18.18 percent) to
the unit costs of $4.00 and $4.50 for 1993 and 1994 respectively. The
revalued unit costs of Product 2 are $4.73 for 1993 ($4.00 x 1.1818)
and $5.32 for 1994 ($4.50 x 1.1818).
(iv) M's inventory would be revalued as follows:
----------------------------------------------------------------------------------------------------------------
Carrying
LIFO product and layer Number Cost values
----------------------------------------------------------------------------------------------------------------
Product 1:
1993........................................................ 150 $6.02 $903
1994........................................................ 100 7.00 700
1995........................................................ 100 7.75 775
1996........................................................ 50 9.00 450
-----------------------------------------------
$2,828
Product 2:
1993........................................................ 200 4.73 946
1994........................................................ 200 5.32 1,064
1995........................................................ 100 6.00 600
1996........................................................ 100 7.00 700
-----------------------------------------------
3,310
Total value of Products 1 and 2 as revalued under M's .............. .............. 6,138
new method.............................................
===============
Total amount of adjustment required under section 481(a) .............. .............. 988
[$6,138-$5,150]........................................
----------------------------------------------------------------------------------------------------------------
(D) Adjustments to inventory costs from prior years. For special
rules applicable when a revaluation using the weighted average method
includes costs not incurred in prior years, see paragraph (c)(2)(v)(E)
of this section.
(v) 3-year average method--(A) In general. A taxpayer using the
dollar-value LIFO method of accounting for inventories may revalue all
existing LIFO layers of a trade or business based on the 3-year average
method as provided in this paragraph (c)(2)(v). The 3-year average
method is based on the average percentage change (the 3-year revaluation
factor) in the current costs of inventory for each LIFO pool based on
the three most recent taxable years for which the taxpayer has
sufficient information (typically, the three most recent taxable years
of such trade or business). The 3-year revaluation factor is applied to
all layers for each pool in beginning inventory in the year of change.
The 3-year average method is available to any dollar-value taxpayer that
complies with the requirements of this paragraph (c)(2)(v) regardless of
[[Page 827]]
whether such taxpayer lacks sufficient data to revalue its inventory
costs under the facts and circumstances revaluation method prescribed in
paragraph (c)(2)(iii) of this section. The 3-year average method must be
applied with respect to all inventory in a taxpayer's trade or business.
A taxpayer is not permitted to apply the method for the revaluation of
some, but not all, inventory costs on the basis of pools, business
units, or other measures of inventory amounts that do not constitute a
separate trade or business. Generally, a taxpayer revaluing its
inventory using the 3-year average method must establish a new base
year. See, paragraph (b)(2)(iii)(A)(2)(i) of this section. However, a
dollar-value LIFO taxpayer using the 3-year average method and either
the simplified production method or the simplified resale method to
revalue its inventory is permitted, but not required, to establish a new
base year. See, paragraph (b)(2)(iii)(A)(2)(ii) of this section. If a
taxpayer lacks sufficient information to otherwise apply the 3-year
average method under this paragraph (c)(2)(v) (for example, the taxpayer
is unable to revalue the costs of any of its LIFO pools for three years
due to a lack of information), then the taxpayer must use reasonable
estimates and procedures, as described in the facts and circumstances
revaluation method under paragraph (c)(2)(iii) of this section, to
whatever extent is necessary to allow the taxpayer to apply the 3-year
average method.
(B) Consecutive year requirement. Under the 3-year average method,
if sufficient data is available to calculate the revaluation factor for
more than three years, the taxpayer may use data from such additional
years in determining the average percentage increase or decrease only if
the additional years are consecutive to and prior to the year of change.
The requirement under the preceding sentence to use consecutive years is
applicable under this method regardless of whether any inventory costs
in beginning inventory as of the year of change are viewed as incurred
in, or attributable to, those consecutive years under the LIFO inventory
method. Thus, the requirement to use data from consecutive years may
result in using information from a year in which no LIFO increment
occurred. For example, if a taxpayer is changing its method of
accounting in 1997 and has sufficient data to revalue its inventory for
the years 1991 through 1996, the taxpayer may calculate the revaluation
factor using all six years. If, however, the taxpayer has sufficient
data to revalue its inventory for the years 1990 through 1992, and 1994
through 1996, only the three years consecutive to the year of change,
that is, 1994 through 1996, may be used in determining the revaluation
factor. Similarly, for example, a taxpayer with LIFO increments in 1995,
1993, and 1992 may not calculate the revaluation factor based on the
data from those years alone, but instead must use the data from
consecutive years for which the taxpayer has information.
(C) Example. The provisions of this paragraph (c)(2)(v) are
illustrated by the following example. The principles set forth in this
example are applicable both to production and resale activities and the
year of change in the example is 1997. The example reads as follows:
Example. (i) Taxpayer G, a calendar year taxpayer, is a reseller
that is required to change its method of accounting under section 263A.
G will not use either the simplified production method or the simplified
resale method. G adopted the dollar-value LIFO inventory method in 1991,
using a single pool and the double extension method. G's beginning LIFO
inventory as of January 1, 1997, computed using its former method, for
the year of change is as follows:
----------------------------------------------------------------------------------------------------------------
Base year LIFO carrying
costs Index value
----------------------------------------------------------------------------------------------------------------
Base layer $14,000 1.00 $14,000
1991 layer...................................................... 4,000 1.20 4,800
1992 layer...................................................... 5,000 1.30 6,500
1993 layer...................................................... 2,000 1.35 2,700
1994 layer...................................................... 0 1.40 0
1995 layer...................................................... 4,000 1.50 6,000
1996 layer...................................................... 5,000 1.60 8,000
-----------------------------------------------
[[Page 828]]
Total....................................................... 34,000 .............. 42,000
----------------------------------------------------------------------------------------------------------------
(ii) G is able to recompute total inventoriable costs incurred under
its new method for the three preceding taxable years as follows:
----------------------------------------------------------------------------------------------------------------
Current cost
as recorded Current cost Percentage
(former as adjusted change
method) (new method)
----------------------------------------------------------------------------------------------------------------
1994............................................................ $35,000 $45,150 .29
1995............................................................ 43,500 54,375 .25
1996............................................................ 54,400 70,720 .30
-----------------------------------------------
Total....................................................... 132,900 170,245 .28
----------------------------------------------------------------------------------------------------------------
(iii) Applying the average revaluation factor of .28 to each layer,
G's inventory is restated as follows:
----------------------------------------------------------------------------------------------------------------
Restated base Restated LIFO
year costs Index carrying value
----------------------------------------------------------------------------------------------------------------
Base layer...................................................... $17,920 1.00 $17,920
1991 layer...................................................... 5,120 1.20 6,144
1992 layer...................................................... 6,400 1.30 8,320
1993 layer...................................................... 2,560 1.35 3,456
1994 layer...................................................... 0 1.40 0
1995 layer...................................................... 5,120 1.50 7,680
1996 layer...................................................... 6,400 1.60 10,240
-----------------------------------------------
Total....................................................... 43,520 .............. 53,760
----------------------------------------------------------------------------------------------------------------
(iv) The adjustment required by section 481(a) is $11,760. This
amount may be computed by multiplying the average percentage of .28 by
the LIFO carrying value of G's inventory valued using its former method
($42,000). Alternatively, the adjustment required by section 481(a) may
be computed by the difference between--
(A) The revalued costs of the taxpayer's inventory under its new
method ($53,760), and
(B) The costs of the taxpayer's inventory using its former method
($42,000).
(v) In addition, the inventory as of the first day of the year of
change (January 1, 1997) becomes the new base year cost for purposes of
determining the LIFO index in future years. See, paragraphs
(b)(2)(iii)(A)(2)(i) and (b)(2)(iii)(B) of this section. This requires
that layers in years prior to the base year be restated in terms of the
new base year index. The current year cost of G's inventory, as
adjusted, is $70,720. Such cost must be apportioned to each layer in
proportion to the restated base year cost of that layer to total
restated base year costs ($43,520), as follows:
----------------------------------------------------------------------------------------------------------------
Restated base Restated LIFO
year costs Restated index carrying value
----------------------------------------------------------------------------------------------------------------
Old base layer.................................................. $29,120 .615 $17,920
1991 layer...................................................... 8,320 .738 6,144
1992 layer...................................................... 10,400 .80 8,320
1993 layer...................................................... 4,160 .831 3,456
1994 layer...................................................... 0 .............. 0
1995 layer...................................................... 8,320 .923 7,680
1996 layer...................................................... 10,400 .985 10,240
-----------------------------------------------
Total................................................... 70,720 .............. 53,760
----------------------------------------------------------------------------------------------------------------
(D) Short taxable years. A short taxable year is treated as a full
12 months.
(E) Adjustments to inventory costs from prior years--(1) General
rule. (i) The use
[[Page 829]]
of the revaluation factor, based on current costs, to estimate the
revaluation of prior inventory layers under the 3-year average method,
as described in paragraph (c)(2)(v) of this section, may result in an
allocation of costs that include amounts attributable to costs not
incurred during the year in which the layer arose. To the extent a
taxpayer can demonstrate that costs that contributed to the
determination of the revaluation factor could not have affected a prior
year, the revaluation factor as applied to that year may be adjusted
under the restatement adjustment procedure, as described in paragraph
(c)(2)(v)(F) of this section. The determination that a cost could not
have affected a prior year must be made by a taxpayer only upon showing
that the type of cost incurred during the years used to calculate the
revaluation factor (revaluation years) was not present during such prior
year. An item of cost will not be eligible for the restatement
adjustment procedure simply because the cost varies in amount from year
to year or the same type of cost is described or referred to by a
different name from year to year. Thus, the restatement adjustment
procedure allowed under paragraph (c)(2)(v)(F) of this section is not
available in a prior year with respect to a particular cost if the same
type of cost was incurred both in the revaluation years and in such
prior year, although the amount of such cost and the name or description
thereof may vary.
(ii) The provisions of this paragraph (c)(2)(v)(E) are also
applicable to taxpayers using the weighted average method in revaluing
inventories under paragraph (c)(2)(iv) of this section. Thus, to the
extent a taxpayer can demonstrate that costs that contributed to the
determination of the restatement of a particular year or item could not
have affected a prior year or item, the taxpayer may adjust the
revaluation of that prior year or item accordingly under the weighted
average method. All the requirements and definitions, however,
applicable to the restatement adjustment procedure under this paragraph
(c)(2)(v)(E) fully apply to a taxpayer using the weighted average method
to revalue inventories.
(2) Examples of costs eligible for restatement adjustment procedure.
The provisions of this paragraph (c)(2)(v)(E) are illustrated by the
following four examples. The principles set forth in these examples are
applicable both to production and resale activities and the year of
change in the four examples is 1997. The examples read as follows:
Example 1. Taxpayer A is a reseller that introduced a defined
benefit pension plan in 1994, and made the plan available to personnel
whose labor costs were (directly or indirectly) properly allocable to
resale activities. A determines the revaluation factor based on data
available for the years 1994 through 1996, for which the pension plan
was in existence. Based on these facts, the costs of the pension plan in
the revaluation years are eligible for the restatement adjustment
procedure for years prior to 1994.
Example 2. Assume the same facts as in Example 1, except that a
defined contribution plan was available, during prior years, to
personnel whose labor costs were properly allocable to resale
activities. The defined contribution plan was terminated before the
introduction of the defined benefit plan in 1994. Based on these facts,
the costs of the defined benefit pension plan in the revaluation years
are not eligible for the restatement adjustment procedure with respect
to years for which the defined contribution plan existed.
Example 3. Taxpayer C is a manufacturer that established a security
department in 1995 to patrol and safeguard its production and warehouse
areas used in C's trade or business. Prior to 1995, C had not been
required to utilize security personnel in its trade or business; C
established the security department in 1995 in response to increasing
vandalism and theft at its plant locations. Based on these facts, the
costs of the security department are eligible for the restatement
adjustment procedure for years prior to 1995.
Example 4. Taxpayer D is a reseller that established a payroll
department in 1995 to process the company's weekly payroll. In the years
1991 through 1994, D engaged the services of an outside vendor to
process the company's payroll. Prior to 1991, D's payroll processing was
done by D's accounting department, which was responsible for payroll
processing as well as for other accounting functions. Based on these
facts, the costs of the payroll department are not eligible for the
restatement adjustment procedure. D was incurring the same type of costs
in earlier years as D was incurring in the payroll department in 1995
and subsequent years, although these costs were designated by a
different name or description.
[[Page 830]]
(F) Restatement adjustment procedure--(1) In general. (i) This
paragraph (c)(2)(v)(F) provides a restatement adjustment procedure
whereunder a taxpayer may adjust the restatement of inventory costs in
prior taxable years in order to produce a different restated value than
the value that would otherwise occur through application of the
revaluation factor to such prior taxable years.
(ii) Under the restatement adjustment procedure as applied to a
particular prior year, a taxpayer must determine the particular items of
cost that are eligible for the restatement adjustment with respect to
such prior year. The taxpayer must then recompute, using reasonable
estimates and procedures, the total inventoriable costs that would have
been incurred for each revaluation year under the taxpayer's former
method and the taxpayer's new method by making appropriate adjustments
in the data for such revaluation year to reflect the particular costs
eligible for adjustment.
(iii) The taxpayer must then compute the total percentage change
with respect to each revaluation year, using the revised estimates of
total inventoriable costs for such year as described in paragraph
(c)(2)(v)(F)(1)(ii) of this section. The percentage change must be
determined by calculating the ratio of the revised total of the
inventoriable costs for such revaluation year under the taxpayer's new
method to the revised total of the inventoriable costs for such
revaluation year under the taxpayer's former method.
(iv) An average of the resulting percentage change for all
revaluation years is then calculated, and the resulting average is
applied to the prior year in issue.
(2) Examples of restatement adjustment procedure. The provisions of
this paragraph (c)(2)(v)(F) are illustrated by the following two
examples. The principles set forth in these examples are applicable both
to production and resale activities and the year of change in the two
examples is 1997. The examples read as follows:
Example 1. Taxpayer A is a reseller that is eligible to make a
restatement adjustment by reason of the costs of a defined benefit
pension plan that was introduced in 1994, during the revaluation period.
The revaluation factor, before adjustment of data to reflect the pension
costs, is as provided in the example in paragraph (c)(2)(v)(C) of this
section. Thus, for example, with respect to the year 1994, the total
inventoriable costs under A's former method is $35,000, the total
inventoriable costs under A's new method is $45,150, and the percentage
change is .29. Under the method of accounting used by A during 1994 (the
former method), none of the pension costs were included as inventoriable
costs. Thus, under the restatement adjustment procedure, the total
inventoriable cost under A's former method would remain at $35,000 if
the pension plan had not been in existence. Similarly, A determines that
the total inventoriable costs for 1994 under A's new method, if the
pension plan had not been in existence, would have been $42,000. The
restatement adjustment for 1994 determined under this paragraph
(c)(2)(v)(F) would then be equal to .20 ([$42,000-$35,000]/$35,000). A
would make similar calculations with respect to 1995 and 1996. The
average of such amounts for each of the three years in the revaluation
period would then be determined as in the example in paragraph
(c)(2)(v)(C) of this section. Such average would be used to revalue cost
layers for years for which the pension plan was not in existence. Such
revalued layers would then be viewed as restated in compliance with the
requirements of this paragraph. With respect to cost layers incurred
during years for which the pension plan was in existence, no adjustment
of the revaluation factor would occur.
Example 2. Assume the same facts as in Example 1, except that a
portion of the pension costs were included as inventoriable costs under
the method used by A during 1994 (the former method). Under the
restatement adjustment procedure, A determines that the total
inventoriable costs for 1994 under the former method, if the pension
plan had not been in existence, would have been $34,000. Similarly, A
determines that the total inventoriable costs for 1994 under A's new
method, if the pension plan had not been in existence, would have been
$42,000. The restatement adjustment for 1994 determined under this
paragraph (c)(2)(v)(F) would then be equal to .24 ([$42,000-$34,000]/
$34,000). A would make similar calculations with respect to 1995 and
1996. The average of such amounts for each of the three years in the
revaluation period would then be determined as in the example in
paragraph (c)(2)(v)(C) of this section. Such average would be used to
revalue cost layers for years for which the pension plan was not in
existence.
(3) Intercompany items--(i) Revaluing intercompany transactions.
Pursuant to any change in method of accounting
[[Page 831]]
for costs subject to section 263A, taxpayers are required to revalue the
amount of any intercompany item resulting from the sale or exchange of
inventory property in an intercompany transaction to an amount equal to
the intercompany item that would have resulted, had the cost of goods
sold for that inventory property been determined under the taxpayer's
new method. The requirement of the preceding sentence applies with
respect to both inventory produced by a taxpayer and inventory acquired
by the taxpayer for resale. In addition, the requirements of this
paragraph (c)(3) apply only to any intercompany item of the taxpayer as
of the beginning of the year of change in method of accounting. See
Sec. 1.1502-13(b)(2)(ii). A taxpayer must revalue the amount of any
intercompany item only if the inventory property sold in the
intercompany transaction is held as inventory by a buying member as of
the date the taxpayer changes its method of accounting under section
263A. Corresponding changes to the adjustment required under section
481(a) must be made with respect to any adjustment of the intercompany
item required under this paragraph (c)(3). Moreover, the requirements of
this paragraph (c)(3) apply regardless of whether the taxpayer has any
items in beginning inventory as of the year of change in method of
accounting. See Sec. 1.1502-13 for the definition of intercompany
transaction.
(ii) Example. The provisions of this paragraph (c)(3) are
illustrated by the following example. The principles set forth in this
example are applicable both to production and resale activities and the
year of change in the example is 1997. The example reads as follows:
Example. (i) Assume that S, a member of a consolidated group filing
its federal income tax return on a calendar year, manufactures and sells
inventory property to B, a member of the same consolidated group, in
1996. The sale between S and B is an intercompany transaction as defined
under Sec. 1.1502-13(b)(1). The gain from the intercompany transaction
is an intercompany item to S under Sec. 1.1502-13(b)(2). As of the
beginning of the year of change in method of accounting (January 1,
1997), the inventory property is still held by B based on the particular
inventory method of accounting used by B for federal income tax purposes
(for example, the LIFO or FIFO inventory method). The property was sold
by S to B in 1996 for $150; the cost of goods sold with respect to the
property under the method in effect at the time the inventory was
produced was $100, resulting in an intercompany item of $50 to S under
Sec. 1.1502-13. As of January 1, 1997, S still has an intercompany item
of $50.
(ii) S is required to revalue the amount of its intercompany item to
an amount equal to what the intercompany item would have been had the
cost of goods sold for that inventory property been determined under S's
new method. Assume that the cost of the inventory under this method
would have been $110, had the method applied to S's manufacture of the
property in 1996. Thus, S is required to revalue the amount of its
intercompany item to $40 (that is, $150 less $110), necessitating a
negative adjustment to the intercompany item of $10. Moreover, S is
required to increase its adjustment under section 481(a) by $10 in order
to prevent the omission of such amount by virtue of the decrease in the
intercompany item.
(iii) Availability of revaluation methods. In revaluing the amount
of any intercompany item resulting from the sale or exchange of
inventory property in an intercompany transaction to an amount equal to
the intercompany item that would have resulted had the cost of goods
sold for that inventory property been determined under the taxpayer's
new method, a taxpayer may use the other methods and procedures
otherwise properly available to that particular taxpayer in revaluing
inventory under section 263A and the regulations thereunder, including,
if appropriate, the various simplified methods provided in section 263A
and the regulations thereunder and the various procedures described in
this paragraph (c).
(4) Anti-abuse rule--(i) In general. Section 263A(i)(1) provides
that the Secretary shall prescribe such regulations as may be necessary
or appropriate to carry out the purposes of section 263A, including
regulations to prevent the use of related parties, pass-thru entities,
or intermediaries to avoid the application of section 263A and the
regulations thereunder. One way in which the application of section 263A
and the regulations thereunder would be otherwise avoided is through the
use of entities described in the preceding sentence in such a manner as
to effectively avoid the necessity to restate beginning inventory
balances under the
[[Page 832]]
change in method of accounting required or permitted under section 263A
and the regulations thereunder.
(ii) Deemed avoidance of this section--(A) Scope. For purposes of
this paragraph (c), the avoidance of the application of section 263A and
the regulations thereunder will be deemed to occur if a taxpayer using
the LIFO method of accounting for inventories, transfers inventory
property to a related corporation in a transaction described in section
351, and such transfer occurs:
(1) On or before the beginning of the transferor's taxable year
beginning in 1987; and
(2) After September 18, 1986.
(B) General rule. Any transaction described in paragraph
(c)(4)(ii)(A) of this section will be treated in the following manner:
(1) Notwithstanding any provision to the contrary (for example,
section 381), the transferee corporation is required to revalue the
inventories acquired from the transferor under the provisions of this
paragraph (c) relating to the change in method of accounting and the
adjustment required by section 481(a), as if the inventories had never
been transferred and were still in the hands of the transferor; and
(2) Absent an election as described in paragraph (c)(4)(iii) of this
section, the transferee must account for the inventories acquired from
the transferor by treating such inventories as if they were contained in
the transferee's LIFO layer(s).
(iii) Election to use transferor's LIFO layers. If a transferee
described in paragraph (c)(4)(ii) of this section so elects, the
transferee may account for the inventories acquired from the transferor
by allocating such inventories to LIFO layers corresponding to the
layers to which such properties were properly allocated by the
transferor, prior to their transfer. The transferee must account for
such inventories for all subsequent periods with reference to such
layers to which the LIFO costs were allocated. Any such election is to
be made on a statement attached to the timely filed federal income tax
return of the transferee for the first taxable year for which section
263A and the regulations thereunder applies to the transferee.
(iv) Tax avoidance intent not required. The provisions of paragraph
(c)(4)(ii) of this section will apply to any transaction described
therein, without regard to whether such transaction was consummated with
an intention to avoid federal income taxes.
(v) Related corporation. For purposes of this paragraph (c)(4), a
taxpayer is related to a corporation if--
(A) the relationship between such persons is described in section
267(b)(1), or
(B) such persons are engaged in trades or businesses under common
control (within the meaning of paragraphs (a) and (b) of section 52).
(d) Non-inventory property--(1) Need for adjustments. A taxpayer
that changes its method of accounting for costs subject to section 263A
with respect to non-inventory property must revalue the non-inventory
property on hand at the beginning of the year of change as set forth in
paragraph (d)(2) of this section, and compute an adjustment under
section 481(a). The adjustment under section 481(a) will equal the
difference between the adjusted basis of the property as revalued using
the taxpayer's new method and the adjusted basis of the property as
originally valued using the taxpayer's former method.
(2) Revaluing property. A taxpayer must revalue its non-inventory
property as of the beginning of the year of change in method of
accounting. The facts and circumstances revaluation method of paragraph
(c)(2)(iii) of this section must be used to revalue this property. In
revaluing non-inventory property, however, the only additional section
263A costs that must be taken into account are those additional section
263A costs incurred after the later of December 31, 1986, or the date
the taxpayer first becomes subject to section 263A, in taxable years
ending after that date. See Sec. 1.263A-1(d)(3) for the definition of
additional section 263A costs.
[T.D. 8728, 62 FR 42054, Aug. 5, 1997, as amended by T.D. 9131, 69 FR
33572, June 16, 2004; T.D. 9843, 83 FR 58498, Nov. 20, 2018; T.D. 9942,
86 FR 268, Jan. 5, 2021]
[[Page 833]]
Sec. 1.263A-8 Requirement to capitalize interest.
(a) In general--(1) General rule. Capitalization of interest under
the avoided cost method described in Sec. 1.263A-9 is required with
respect to the production of designated property described in paragraph
(b) of this section. However, a taxpayer, other than a tax shelter
prohibited from using the cash receipts and disbursements method of
accounting under section 448(a)(3), that meets the gross receipts test
of section 448(c) for the taxable year is not required to capitalize
costs, including interest, under section 263A. See Sec. 1.263A-1(j).
(2) Treatment of interest required to be capitalized. In general,
interest that is capitalized under this section is treated as a cost of
the designated property and is recovered in accordance with Sec.
1.263A-1(c)(4). Interest capitalized by reason of assets used to produce
designated property (within the meaning of Sec. 1.263A-11(d)) is added
to the basis of the designated property rather than the bases of the
assets used to produce the designated property. Interest capitalized
with respect to designated property that includes both components
subject to an allowance for depreciation or depletion and components not
subject to an allowance for depreciation or depletion is ratably
allocated among, and is treated as a cost of, components that are
subject to an allowance for depreciation or depletion.
(3) Methods of accounting under section 263A(f). Except as otherwise
provided, methods of accounting and other computations under Sec. Sec.
1.263A-8 through 1.263A-15 are applied on a taxpayer, as opposed to a
separate and distinct trade or business, basis.
(4) Special definitions--(i) Related person. Except as otherwise
provided, for purposes of Sec. Sec. 1.263A-8 through 1.263A-15, a
person is related to a taxpayer if their relationship is described in
section 267(b) or 707(b).
(ii) Placed in service. For purposes of Sec. Sec. 1.263A-8 through
1.263A-15, placed in service has the same meaning as set forth in Sec.
1.46-3(d).
(b) Designated property--(1) In general. Except as provided in
paragraphs (b)(3) and (b)(4) of this section, designated property means
any property that is produced and that is either:
(i) Real property; or
(ii) Tangible personal property (as defined in Sec. 1.263A-2(a)(2))
which meets any of the following criteria:
(A) Property with a class life of 20 years or more under section 168
(long-lived property), but only if the property is not property
described in section 1221(l) in the hands of the taxpayer or a related
person,
(B) Property with an estimated production period (as defined in
Sec. 1.263A-12) exceeding 2 years (2-year property), or
(C) Property with an estimated production period exceeding 1 year
and an estimated cost of production exceeding $1,000,000 (1-year
property).
(2) Special rules--(i) Application of thresholds. The thresholds
described in paragraphs (b)(l)(ii)(A), (B), and (C) of this section are
applied separately for each unit of property (as defined in Sec.
1.263A-10).
(ii) Relevant activities and costs. For purposes of determining
whether property is designated property, all activities and costs are
taken into account if they are performed or incurred by, or for, the
taxpayer or any related persons and they directly benefit or are
incurred by reason of the production of the property.
(iii) Production period and cost of production. For purposes of
applying the classification thresholds under paragraphs (b)(l)(ii) (B)
and (C) of this section to a unit of property, the taxpayer is required,
at the beginning of the production period, to reasonably estimate the
production period and the total cost of production for the unit of
property. The taxpayer must maintain contemporaneous written records
supporting the estimates and classification. If the estimates are
reasonable based on the facts in existence at the beginning of the
production period, the taxpayer's classification of the property is not
modified in subsequent periods, even if the actual length of the
production period or the actual cost of production differs from the
estimates. To be considered reasonable, estimates of the production
period and the total
[[Page 834]]
cost of production must include anticipated expense and time for delay,
rework, change orders, and technological, design or other problems. To
the extent that several distinct activities related to the production of
the property are expected to occur simultaneously, the period during
which these distinct activities occur is not counted more than once. The
bases of assets used to produce a unit of property (within the meaning
of Sec. 1.263A-11(d)) and any interest that would be required to be
capitalized if a unit of property were designated property are
disregarded in making estimates of the total cost of production for
purposes of this paragraph (b)(2)(iii).
(3) Excluded property. Designated property does not include:
(i) Timber and evergreen trees that are more than 6 years old when
severed from the roots, or
(ii) Property produced by the taxpayer for use by the taxpayer other
than in a trade or business or an activity conducted for profit.
(4) De minimis rule--(i) In general. Designated property does not
include property for which--
(A) The production period does not exceed 90 days; and
(B) The total production expenditures do not exceed $1,000,000
divided by the number of days in the production period.
(ii) Determination of total production expenditures. For purposes of
determining whether the condition of paragraph (b)(4)(i)(B) of this
section is met with respect to property, the cost of land, the adjusted
basis of property used to produce property, and interest that would be
capitalized with respect to property if it were designated property are
excluded from total production expenditures.
(c) Definition of real property--(1) In general. Real property
includes land, unsevered natural products of land, buildings, and
inherently permanent structures. Any interest in real property of a type
described in this paragraph (c), including fee ownership, co-ownership,
a leasehold, an option, or a similar interest is real property under
this section. Real property includes the structural components of both
buildings and inherently permanent structures, such as walls,
partitions, doors, wiring, plumbing, central air conditioning and
heating systems, pipes and ducts, elevators and escalators, and other
similar property. Tenant improvements to a building that are inherently
permanent or otherwise classified as real property within the meaning of
this paragraph (c)(1) are real property under this section. However,
property produced for sale that is not real property in the hands of the
taxpayer or a related person, but that may be incorporated into real
property by an unrelated buyer, is not treated as real property by the
producing taxpayer (e.g., bricks, nails, paint, and windowpanes).
(2) Unsevered natural products of land. Unsevered natural products
of land include growing crops and plants, mines, wells, and other
natural deposits. Growing crops and plants, however, are real property
only if the preproductive period of the crop or plant exceeds 2 years.
(3) Inherently permanent structures. Inherently permanent structures
include property that is affixed to real property and that will
ordinarily remain affixed for an indefinite period of time, such as
swimming pools, roads, bridges, tunnels, paved parking areas and other
pavements, special foundations, wharves and docks, fences, inherently
permanent advertising displays, inherently permanent outdoor lighting
facilities, railroad tracks and signals, telephone poles, power
generation and transmission facilities, permanently installed
telecommunications cables, broadcasting towers, oil and gas pipelines,
derricks and storage equipment, grain storage bins and silos. For
purposes of this section, affixation to real property may be
accomplished by weight alone. Property may constitute an inherently
permanent structure even though it is not classified as a building for
purposes of former section 48(a)(1)(B) and Sec. 1.48-1. Any property
not othewise described in this paragraph (c)(3) that constitutes other
tangible property under the principles of former section 48(a)(1)(B) and
Sec. 1.48-1(d) is treated for the purposes of this section as an
inherently permanent structure.
[[Page 835]]
(4) Machinery--(i) Treatment. A structure that is property in the
nature of machinery or is essentially an item of machinery or equipment
is not an inherently permanent structure and is not real property. In
the case, however, of a building or inherently permanent structure that
includes property in the nature of machinery as a structural component,
the property in the nature of machinery is real property.
(ii) Certain factors not determinative. A structure may be an
inherently permanent structure, and not property in the nature of
machinery or essentially an item of machinery, even if the structure is
necessary to operate or use, supports, or is otherwise associated with,
machinery.
(d) Production--(1) Definition of produce. Produce is defined as
provided in section 263A(g) and Sec. 1.263A-2(a)(1)(i).
(2) Property produced under a contract--(i) Customer. A taxpayer is
treated as producing any property that is produced for the taxpayer (the
customer) by another party (the contractor) under a contract with the
taxpayer or an intermediary. Property produced under a contract is
designated property to the customer if it is real property or tangible
personal property that satisfies the classification thresholds described
in paragraph (b)(1)(ii) of this section. If property produced under a
contract will become part of a unit of designated property produced by
the customer in the customer's hands, the property produced under the
contract is designated property to the customer.
(ii) Contractor. Property produced under a contract is designated
property to the contractor if it is real property, 2-year property, or
1-year property and the property produced under the contract is not
excluded by reason of paragraph (d)(2)(v) of this section.
(iii) Definition of a contract. For purposes of this paragraph
(d)(2), contract has the same meaning as under Sec. 1.263A-
2(a)(1)(ii)(B)(2).
(iv) Determination of whether thresholds are satisfied. In the case
of tangible personal property produced under a contract, the customer
and the contractor each determine under this paragraph (d)(2), whether
the property satisfies the classification thresholds described in
paragraph (b)(1)(ii) of this section. Thus, tangible personal property
may be designated property with respect to either, or both, the customer
and the contractor. The provisions of paragraph (b)(2)(iii) of this
section are modified as set forth in this paragraph (d)(2)(iv) for
purposes of determining whether tangible personal property produced
under a contract is 2-year property or 1-year property.
(A) Customer. In determining a customer's estimated cost of
production, the customer takes into account costs and payments that are
reasonably expected to be incurred by the customer, but does not take
into account costs incurred (or to be incurred) by an unrelated
contractor. In determining the customer's estimated length of the
production period, the production period is treated as beginning on the
earlier of the date the contract is executed or the date that the
customer's accumulated production expenditures for the unit are at least
5 percent of the customer's total estimated production expenditures for
the unit. The customer, however, may elect to treat the production
period as beginning on the date the sum of the accumulated production
expenditures of the contractor (or contractors if more than one
contractor is producing components for the unit of property) and of the
customer are at least 5 percent of the customer's estimated production
expenditures for the unit.
(B) Contractor. In determining a contractor's estimated cost of
production, the contractor takes into account only the costs that are
reasonably expected to be incurred by the contractor, without any
reduction for payments from the customer. In determining the
contractor's estimated length of the production period, the production
period is treated as beginning on the date the contractor's accumulated
production expenditures (without any reduction for payments from the
customer) are at least 5 percent of the contractor's total estimated
accumulated production expenditures.
(v) Exclusion for property subject to long-term contract rules.
Property described in paragraph (b) of this section is designated
property with respect to a contractor only if--
[[Page 836]]
(A) The contract is not a long-term contract (within the meaning of
section 460(f)); or
(B) The contract is a home construction contract (within the meaning
of section 460(e)(6)(A)) with respect to which the requirements of
section 460(e)(1)(B) (i) and (ii) are not met.
(3) Improvements to existing property--(i) In general. Any
improvement to property described in Sec. 1.263(a)-1(b) constitutes the
production of property. Generally, any improvement to designated
property constitutes the production of designated property. An
improvement is not treated as the production of designated property,
however, if the de minimis exception described in paragraph (b)(4) of
this section applies to the improvement. In addition, paragraph
(d)(3)(iii) of this section provides an exception for certain
improvements to tangible personal property. Incidental maintenance and
repairs are not treated as improvements under this paragraph (d)(3). See
Sec. 1.162-4.
(ii) Real property. The rehabilitation or preservation of a standing
building, the clearing of raw land prior to sale, and the drilling of an
oil well are activities constituting improvements to real property and,
therefore, the production of designated property. Similarly, the
demolition of a standing building generally constitutes an activity that
is an improvement to real property and, therefore, the production of
designated property. See the exceptions, however, in paragraphs (b)(3)
and (b)(4) of this section.
(iii) Tangible personal property. If the taxpayer has treated a unit
of tangible personal property as designated property under this section,
an improvement to such property constitutes the production of designated
property regardless of the remaining useful life of the improved
property (or the improvement) and, except as provided in paragraph
(b)(4) of this section, regardless of the estimated length of the
production period or the estimated cost of the improvement. If the
taxpayer has not treated a unit of tangible personal property as
designated property under this section, an improvement to such property
constitutes the production of designated property only if the
improvement independently meets the classification thresholds described
in paragraph (b)(1)(ii) of this section.
[T.D. 8584, 59 FR 67198, Dec. 29, 1994; 60 FR 16574, Mar. 31, 1995; T.D.
9942, 86 FR 268, Jan. 5, 2021]
Sec. 1.263A-9 The avoided cost method.
(a) In general--(1) Description. The avoided cost method described
in this section must be used to calculate the amount of interest
required to be capitalized under section 263A(f). Generally, any
interest that the taxpayer theoretically would have avoided if
accumulated production expenditures (as defined in Sec. 1.263A-11) had
been used to repay or reduce the taxpayer's outstanding debt must be
capitalized under the avoided cost method. The application of the
avoided cost method does not depend on whether the taxpayer actually
would have used the amounts expended for production to repay or reduce
debt. Instead, the avoided cost method is based on the assumption that
debt of the taxpayer would have been repaid or reduced without regard to
the taxpayer's subjective intentions or to restrictions (including
legal, regulatory, contractual, or other restrictions) against repayment
or use of the debt proceeds.
(2) Overview--(i) In general. For each unit of designated property
(within the meaning of Sec. 1.263A-8(b)), the avoided cost method
requires the capitalization of--
(A) The traced debt amount under paragraph (b) of this section, and
(B) The excess expenditure amount under paragraph (c) of this
section.
(ii) Rules that apply in determining amounts. The traced debt and
excess expenditure amounts are determined for each taxable year or
shorter computation period that includes the production period (as
defined in Sec. 1.263A-12) of a unit of designated property. Paragraph
(d) of this section provides an election not to trace debt to specific
units of designated property. Paragraph (f) of this section provides
rules for selecting the computation period, for calculating averages,
and for determining measurement dates within the computation period.
Special rules are in paragraph (g) of this section.
[[Page 837]]
(3) Definitions of interest and incurred. Except as provided in the
case of certain expenses that are treated as a substitute for interest
under paragraphs (c)(2)(iii) and (g)(2)(iv) of this section, interest
refers to all amounts that are characterized as interest expense under
any provision of the Code, including, for example, sections 482, 483,
1272, 1274, and 7872. Incurred refers to the amount of interest that is
properly accruable during the period of time in question determined by
taking into account the loan agreement and any applicable provisions of
the Internal Revenue laws and regulations such as section 163, Sec.
1.446-2, and sections 1271 through 1275.
(4) Definition of eligible debt. Except as provided in this
paragraph (a)(4), eligible debt includes all outstanding debt (as
evidenced by a contract, bond, debenture, note, certificate, or other
evidence of indebtedness). Eligible debt does not include--
(i) Debt (or the portion thereof) bearing interest that is
disallowed under a provision described in Sec. 1.163-8T(m)(7)(ii);
(ii) Debt, such as accounts payable and other accrued items, that
bears no interest, except to the extent that such debt is traced debt
(as defined in paragraph (b)(2) of this section);
(iii) Debt that is borrowed directly or indirectly from a person
related to the taxpayer and that bears a rate of interest that is less
than the applicable Federal rate in effect under section 1274(d) on the
date of issuance;
(iv) Debt (or the portion thereof) bearing personal interest within
the meaning of section 163(h)(2);
(v) Debt (or the portion thereof) bearing qualified residence
interest within the meaning of section 163(h)(3);
(vi) Debt incurred by an organization that is exempt from Federal
income tax under section 501(a), except to the extent interest on such
debt is directly attributable to an unrelated trade or business of the
organization within the meaning of section 512;
(vii) Reserves, deferred tax liabilities, and similar items that are
not treated as debt for Federal income tax purposes, regardless of the
extent to which the taxpayer's applicable financial accounting or other
regulatory reporting principles require or support treating these items
as debt;
(viii) Federal, State, and local income tax liabilities, deferred
tax liabilities under section 453A, and hypothetical tax liabilities
under the look-back method of section 460(b) or similar provisions; and
(ix) A purchase money obligation given by the lessor to the lessee
(or a party that is related to the lessee) in a sale and leaseback
transaction involving an agreement qualifying as a lease under Sec.
5c.168(f)(8)-1 through Sec. 5c.168(f)(8)-11 of this chapter. See Sec.
5c.168(f)(8)-1(e) Example (2) of this chapter.
(b) Traced debt amount--(1) General rule. Interest must be
capitalized with respect to a unit of designated property in an amount
(the traced debt amount) equal to the total interest incurred on the
traced debt during each measurement period (as defined in paragraph
(f)(2)(ii) of this section) that ends on a measurement date described in
paragraph (f)(2)(iii) of this section. See the example in paragraph
(b)(3) of this section. If any interest incurred on the traced debt is
not taken into account for the taxable year that includes the
measurement period because of a deferral provision, see paragraph (g)(2)
of this section for the time and manner for capitalizing and recovering
that amount. This paragraph (b)(1) does not apply if the taxpayer elects
under paragraph (d) of this section not to trace debt.
(2) Identification and definition of traced debt. On each
measurement date described in paragraph (f)(2)(iii) of this section, the
taxpayer must identify debt that is traced debt with respect to a unit
of designated property. On each such date, traced debt with respect to a
unit of designated property is the outstanding eligible debt (as defined
in paragraph (a)(4) of this section) that is allocated, on that date, to
accumulated production expenditures with respect to the unit of
designated property under the rules of Sec. 1.163-8T. Traced debt also
includes unpaid interest that has been capitalized with respect to such
unit under paragraph (b)(1) of this section and that is included in
accumulated production expenditures on the measurement date.
[[Page 838]]
(3) Example. The provisions of paragraphs (b)(1) and (b)(2) of this
section are illustrated by the following example.
Example. Corporation X, a calendar year taxpayer, is engaged in the
production of a single unit of designated property during 1995 (unit A).
Corporation X adopts a taxable year computation period and quarterly
measurement dates. Production of unit A starts on January 14, 1995, and
ends on June 16, 1995. On March 31, 1995 and on June 30, 1995,
Corporation X has outstanding a $1,000,000 loan that is allocated under
the rules of Sec. 1.163-8T to production expenditures with respect to
unit A. During the period January 1, 1995, through June 30, 1995,
Corporation X incurs $50,000 of interest related to the loan. Under
paragraph (b)(1) of this section, the $50,000 of interest Corporation X
incurs on the loan during the period January 1, 1995, through June 30,
1995, must be capitalized with respect to unit A.
(c) Excess expenditure amount--(1) General rule. If there are
accumulated production expenditures in excess of traced debt with
respect to a unit of designated property on any measurement date
described in paragraph (f)(2)(iii) of this section, the taxpayer must,
for the computation period that includes the measurement date,
capitalize with respect to this unit the excess expenditure amount
calculated under this paragraph (c)(1). However, if the sum of the
excess expenditure amounts for all units of designated property of a
taxpayer exceeds the total interest described in paragraph (c)(2) of
this section, only a prorata amount (as determined under paragraph
(c)(7) of this section) of such interest must be capitalized with
respect to each unit. For each unit of designated property, the excess
expenditure amount for a computation period equals the product of--
(i) The average excess expenditures (as determined under paragraph
(c)(5)(ii) of this section) for the unit of designated property for that
period, and
(ii) The weighted average interest rate (as determined under
paragraph (c)(5)(iii) of this section) for that period.
(2) Interest required to be capitalized. With respect to an excess
expenditure amount, interest incurred during the computation period is
capitalized from the following sources and in the following sequence but
not in excess of the excess expenditure amount for all units of
designated property:
(i) Interest incurred on nontraced debt (as defined in paragraph
(c)(5)(i) of this section);
(ii) Interest incurred on borrowings described in paragraph
(a)(4)(iii) of this section (relating to certain borrowings from related
persons); and
(iii) In the case of a partnership, guaranteed payments for the use
of capital (within the meaning of section 707(c)) that would be
deductible by the partnership if section 263A(f) did not apply.
(3) Example. The provisions of paragraph (c)(1) and (2) of this
section are illustrated by the following example.
Example. (i) P, a partnership owned equally by Corporation A and
Individual B, is engaged in the construction of an office building
during 1995. Average excess expenditures for the office building for
1995 are $2,000,000. When P was formed, A and B agreed that A would be
entitled to an annual guaranteed payment of $70,000 in exchange for A's
capital contribution. The only borrowing of P, A, and B for 1995 is a
loan to P from an unrelated lender of $1,000,000 (loan 1). The loan is
nontraced debt and bears interest at an annual rate of 10 percent. Thus,
P's weighted average interest rate (determined under paragraph
(c)(5)(iii) of this section) is 10 percent and interest incurred during
1995 is $100,000.
(ii) In accordance with paragraph (c)(1) of this section, the excess
expenditure amount is $200,000 ($2,000,000 x 10%). The interest
capitalized under paragraph (c)(2) of this section is $170,000 ($100,000
of interest plus $70,000 of guaranteed payments).
(4) Treatment of interest subject to a deferral provision. If any
interest described in paragraph (c)(2) of this section is not taken into
account for the taxable year that includes the computation period
because of a deferral provision described in paragraph (g)(1)(ii) of
this section, paragraph (c)(2) of this section is first applied without
regard to the amount of the deferred interest. After applying paragraph
(c)(2) without regard to the deferred interest, if the amount of
interest capitalized with respect to all units of designated property
for the computation period is less than the amount that would have been
capitalized if a deferral provision did not apply, see
[[Page 839]]
paragraph (g)(2) of this section for the time and manner for
capitalizing and recovering the difference (the shortfall amount).
(5) Definitions--(i) Nontraced debt--(A) Defined. Nontraced debt
means all eligible debt on a measurement date other than any debt that
is treated as traced debt with respect to any unit of designated
property on that measurement date. For example, nontraced debt includes
eligible debt that is allocated to expenditures that are not capitalized
under section 263A(a) (e.g., expenditures deductible under section
174(a) or 263(c)). Similarly, even if eligible debt is allocated to a
production expenditure for a unit of designated property, the debt is
included in nontraced debt on measurement dates before the first or
after the last measurement date for that unit of designated property.
Thus, nontraced debt may include debt that was previously treated as
traced debt or that will be treated as traced debt on a future
measurement date.
(B) Example. The provisions of paragraph (c)(5)(i)(A) of this
section are illustrated by the following example.
Example. In 1995, Corporation X begins, but does not complete, the
construction of two office buildings that are separate units of
designated property as defined in Sec. 1.263A-10 (Property D and
Property E). At the beginning of 1995, X borrows $2,500,000 (the
$2,500,000 loan), which will be used exclusively to finance production
expenditures for Property D. Although interest is paid currently, the
entire principal amount of the loan remains outstanding at the end of
1995. Corporation X also has outstanding during all of 1995 a long-term
loan with a principal amount of $2,000,000 (the $2,000,000 loan). The
proceeds of the $2,000,000 loan were used exclusively to finance the
production of Property C, a unit of designated property that was
completed in 1994. Under the rules of paragraph (b)(2) of this section,
the portion of the $2,500,000 loan allocated to accumulated production
expenditures for property D at each measurement date during 1995 is
treated as traced debt for that measurement date. The excess, if any, of
$2,500,000 over the amount treated as traced debt at each measurement
date during 1995 is treated as nontraced debt for that measurement date,
even though it is expected that the entire $2,500,000 will be treated as
traced debt with respect to Property D on subsequent measurement dates
as more of the proceeds of the loan are used to finance additional
production expenditures. In addition, the entire principal amount of the
$2,000,000 loan is treated as nontraced debt for 1995, even though it
was treated as traced debt with respect to Property C in a previous
period.
(ii) Average excess expenditures--(A) General rule. The average
excess expenditures for a unit of designated property for a computation
period are computed by--
(1) Determining the amount (if any) by which accumulated production
expenditures exceed traced debt at each measurement date during the
computation period; and
(2) Dividing the sum of these amounts by the number of measurement
dates during the computation period.
(B) Example. The provisions of paragraph (c)(5)(ii)(A) of this
section are illustrated by the following example.
Example. Corporation X, a calendar year taxpayer, is engaged in the
production of a single unit of designated property during 1995 (unit A).
Corporation X adopts the taxable year as the computation period and
quarterly measurement dates. The production period for unit A begins on
January 14, 1995, and ends on June 16, 1995. On March 31, 1995, and on
June 30, 1995, Corporation X has outstanding $1,000,000 of traced debt
with respect to unit A. Accumulated production expenditures for unit A
on March 31, 1995, are $1,400,000 and on June 30, 1995, are $1,600,000.
Accumulated production expenditures in excess of traced debt for unit A
on March 31, 1995, are $400,000 and on June 30, 1995, are $600,000.
Average excess expenditures for unit A during 1995 are therefore
$250,000 ([$400,000 + $600,000 + $0 + $0] / 4).
(iii) Weighted average interest rate--(A) Determination of rate. The
weighted average interest rate for a computation period is determined by
dividing interest incurred on nontraced debt during the period by
average nontraced debt for the period.
(B) Interest incurred on nontraced debt. Interest incurred on
nontraced debt during the computation period is equal to the total
amount of interest incurred during the computation period on all
eligible debt minus the amount of interest incurred during the
computation period on traced debt. Thus, all interest incurred on
nontraced debt
[[Page 840]]
during the computation period is included in the numerator of the
weighted average interest rate, even if the underlying nontraced debt is
repaid before the end of a measurement period and excluded from
nontraced debt outstanding for measurement dates after repayment, in
determining the denominator of the weighted average interest rate.
However, see paragraph (g)(7) of this section for an election to treat
eligible debt that is repaid within the 15-day period immediately
preceding a quarterly measurement date as outstanding on that
measurement date. See paragraph (a)(3) of this section for the
definitions of interest and incurred.
(C) Average nontraced debt. The average nontraced debt for a
computation period is computed by--
(1) Determining the amount of nontraced debt outstanding on each
measurement date during the computation period; and
(2) Dividing the sum of these amounts by the number of measurement
dates during the computation period.
(D) Special rules if taxpayer has no nontraced debt or rate is
contingent. If the taxpayer does not have nontraced debt outstanding
during the computation period, the weighted average interest rate for
purposes of applying paragraphs (c)(1) and (c)(2) of this section is the
highest applicable Federal rate in effect under section 1274(d) during
the computation period. If interest is incurred at a rate that is
contingent at the time the return for the year that includes the
computation period is filed, the amount of interest is determined using
the higher of the fixed rate of interest (if any) on the underlying debt
or the applicable Federal rate in effect under section 1274(d) on the
date of issuance.
(6) Examples. The following examples illustrate the principles of
this paragraph (c):
Example 1. (i) W, a calendar year taxpayer, is engaged in the
production of a unit of designated property during 1995. For purposes of
applying the avoided cost method of this section, W uses the taxable
year as the computation period. During 1995, W's only debt is a
$1,000,000 loan bearing interest at a rate of 7 percent from Y, a person
that is related to W. Assuming the applicable Federal rate in effect
under section 1274(d) on the date of issuance of the loan is 10 percent,
the loan is not eligible debt under paragraph (a)(4) of this section.
However, even though W has no eligible debt, W incurs $70,000
($1,000,000 x 7%) of interest during the computation period. This
interest is described in paragraph (c)(2) of this section and must be
capitalized under paragraph (c)(1) of this section to the extent it does
not exceed W's excess expenditure amount for the unit of property.
(ii) W determines, under paragraph (c)(5)(ii) of this section, that
average excess expenditures for the unit of property are $600,000.
Assuming the highest applicable Federal rate in effect under section
1274(d) during the computation period is 10 percent, W uses 10 percent
as the weighted average interest rate for purposes of determining the
excess expenditure amount. See paragraph (c)(5)(iii)(D) of this section.
In accordance with paragraph (c)(1) of this section, the excess
expenditure amount is therefore $60,000. Because this amount does not
exceed the total amount of interest described in paragraph (c)(2) of
this section ($70,000), W is required to capitalize $60,000 of interest
with respect to the unit of designated property for the 1995 computation
period.
Example 2. (i) Corporation X, a calendar year taxpayer, is engaged
in the production of a single unit of designated property during 1955
(unit A). Corporation X adopts the taxable year as the computation
period and quarterly measurement dates. Production of unit A begins in
1994 and ends on June 30, 1995. On March 31, 1995, and on June 30, 1995,
Corporation X has outstanding $1,000,000 of eligible debt (loan 1) that
is allocated under the rules of Sec. 1.163-8T to production
expenditures for unit A. During each of the first two quarters of 1995,
$30,000 of interest is incurred on loan 1. The loan is repaid on July
1, 1995. Throughout 1995, Corporation X also has outstanding $2,000,000
of eligible debt (loan 2) which is not allocated under the rules of
Sec. 1.163-8T to the production of unit A. During 1995, $200,000 of
interest is incurred on this nontraced debt. Accumulated production
expenditures on March 31, 1995, are $1,400,000 and on June 30, 1995, are
$1,600,000. Accumulated production expenditures in excess of traced debt
on March 31, 1995, are $400,000 and on June 30, 1995, are $600,000.
(ii) Under paragraph (b)(1) of this section, the amount of interest
capitalized with respect to traced debt is $60,000 ($30,000 for the
measurement period ending March 31, 1995, and $30,000 for the
measurement period ending June 30, 1995). Under paragraph (c)(5)(ii) of
this section, average excess expenditures for unit A are $250,000
([($1,400,000-$1,000,000) + ($1,600,000-$1,000,000) + $0 + $0] / 4).
Under paragraph (c)(5)(iii)(C) of this section, average nontraced debt
is $2,000,000 ([$2,000,000 + $2,000,000 + $2,000,000 + $2,000,000] / 4).
Under paragraph (c)(5)(iii)(B) of this section, interest incurred on
nontraced debt is $200,000
[[Page 841]]
($260,000 of interest incurred on all eligible debt less $60,000 of
interest incurred on traced debt). Under paragraph (c)(5)(iii)(A) of
this section, the weighted average interest rate is 10 percent ($200,000
/ $2,000,000). Under paragraph (c)(1) of this section, Corporation X
capitalizes the excess expenditure amount of $25,000 ($250,000 x 10%),
because it does not exceed the total amount of interest subject to
capitalization under paragraph (c)(2) of this section ($200,000). Thus,
the total interest capitalized with respect to unit A during 1995 is
$85,000 ($60,000 + $25,000).
(7) Special rules where the excess expenditure amount exceeds
incurred interest--(i) Allocation of total incurred interest to units.
For a computation period in which the sum of the excess expenditure
amounts under paragraph (c)(1) of this section for all units of
designated property exceeds the total amount of interest (including
deferred interest) available for capitalization, as determined under
paragraph (c)(2) of this section, the amount of interest that is
allocated to a unit of designated property is equal to the product of--
(A) The total amount of interest (including deferred interest)
available for capitalization, as determined under paragraph (c)(2) of
this section; and
(B) A fraction, the numerator of which is the average excess
expenditures for the unit of designated property and the denominator of
which is the sum of the average excess expenditures for all units of
designated property.
(ii) Application of related person rules to average excess
expenditure. Certain excess expenditures must be taken into account by
the persons (if any) required to capitalize interest with respect to
production expenditures of the taxpayer under applicable related person
rules. For each computation period, the amount of average excess
expenditures that must be taken into account by such persons for each
unit of the taxpayer's property is computed by--
(A) Determining, for the computation period, the amount (if any) by
which the excess expenditure amount for the unit exceeds the amount of
interest allocated to the unit under paragraph (c)(7)(i) of this
section; and
(B) Dividing the excess by the weighted average interest rate for
the period.
(iii) Special rule for corporations. If a corporation is related to
another person for the purposes of the applicable related party rules,
the District Director upon examination may require that the corporation
apply this paragraph (c)(7) and other provisions of the regulations by
excluding deferred interest from the total interest available for
capitalization.
(d) Election not to trace debt--(1) General rule. Taxpayers may
elect not to trace debt. If the election is made, the average excess
expenditures and weighted average interest rate under paragraph (c)(5)
of this section are determined by treating all eligible debt as
nontraced debt. For this purpose, debt specified in paragraph (a)(4)(ii)
of this section (e.g., accounts payable) may be included in eligible
debt, provided it would be treated as traced debt but for an election
under this paragraph (d). The election not to trace debt is a method of
accounting that applies to the determination of capitalized interest for
all designated property of the taxpayer. The making or revocation of the
election is a change in method of accounting requiring the consent of
the Commissioner under section 446(e) and Sec. 1.446-1(e).
(2) Example. The provisions of paragraph (d)(1) of this section are
illustrated by the following example.
Example. (i) Corporation X, a calendar year taxpayer, is engaged in
the production of a single unit of designated property during 1995 (unit
A). Corporation X adopts the taxable year as the computation period and
quarterly measurement dates. At each measurement date (March 31, June
30, September 30, and December 31) Corporation X has the following
outstanding indebtedness:
Noninterest-bearing accounts payable traced to unit A........ $100,000
Noninterest-bearing accounts payable that are not traced to $300,000
unit A......................................................
Interest-bearing loans that are eligible debt within the $900,000
meaning of paragraph (a)(4) of this section.................
(ii) Corporation X elects under this paragraph (d) not to trace
debt. Eligible debt at each measurement date for purposes of calculating
the weighted average interest rate under paragraph (c)(5)(iii) of this
section is $1,000,000 ($100,000 + $900,000).
(e) Election to use external rate--(1) In general. An eligible
taxpayer may elect to use the highest applicable Federal rate (AFR)
under section 1274(d) in effect during the computation period
[[Page 842]]
plus 3 percentage points (AFR plus 3) as a substitute for the weighted
average interest rate determined under paragraph (c)(5)(iii) of this
section. A taxpayer that makes this election may not trace debt. The use
of the AFR plus 3 as provided under this paragraph (e)(1) constitutes a
method of accounting. A taxpayer makes the election to use the AFR plus
3 method by using the AFR plus 3 as the taxpayer's weighted average
interest rate, and any change to the AFR plus 3 method by a taxpayer
that has never previously used the method does not require the consent
of the Commissioner. Any other change to or from the use of the AFR plus
3 method under this paragraph (e)(1) (other than by reason of a taxpayer
ceasing to be an eligible taxpayer) is a change in method of accounting
requiring the consent of the Commissioner under section 446(e) and Sec.
1.446-1(e). All changes to or from the AFR plus 3 method are effected on
a cut-off basis.
(2) Eligible taxpayer. A taxpayer is an eligible taxpayer for a
taxable year for purposes of this paragraph (e) if the average annual
gross receipts of the taxpayer for the three previous taxable years do
not exceed $10,000,000 (the $10,000,000 gross receipts test) and the
taxpayer has met the $10,000 gross receipts for all prior taxable years
beginning after December 31, 1994. For purposes of this paragraph
(e)(2), the principles of section 263A(b)(2)(B) and (C) and Sec.
1.263A-3(b) apply in determining whether a taxpayer is an eligible
taxpayer for a taxable year. A taxpayer is an eligible taxpayer for a
taxable year for purposes of this paragraph (e) if the taxpayer is a
small business taxpayer, as defined in Sec. 1.263A-1(j).
(f) Selection of computation period and measurement dates and
application of averaging conventions--(1) Computation period--(i) In
general. A taxpayer may (but is not required to) make the avoided cost
calculation on the basis of a full taxable year. If the taxpayer uses
the taxable year as the computation period, a single avoided cost
calculation is made for each unit of designated property for the entire
taxable year. If the taxpayer uses a computation period that is shorter
than the full taxable year, an avoided cost calculation is made for each
unit of designated property for each shorter computation period within
the taxable year. If the taxpayer uses a shorter computation period, the
computation period may not include portions of more than one taxable
year and, except as provided in the case of short taxable years, each
computation period within a taxable year must be the same length. In the
case of a short taxable year, a taxpayer may treat a period shorter than
the taxpayer's regular computation period as the first or last
computation period, or as the only computation period for the year if
the year is shorter than the taxpayer's regular computation period. A
taxpayer must use the same computation periods for all designated
property produced during a single taxable year.
(ii) Method of accounting. The choice of a computation period is a
method of accounting. Any change in the computation period is a change
in method of accounting requiring the consent of the Commissioner under
section 446(e) and Sec. 1.446-1(e).
(iii) Production period beginning or ending during the computation
period. The avoided cost method applies to the production of a unit of
designated property on the basis of a full computation period,
regardless of whether the production period for the unit of designated
property begins or ends during the computation period.
(2) Measurement dates--(i) In general. If a taxpayer uses the
taxable year as the computation period, measurement dates must occur at
quarterly or more frequent regular intervals. If the taxpayer uses
computation periods that are shorter than the taxable year, measurement
dates must occur at least twice during each computation period and at
least four times during the taxable year (or consecutive 12-month period
in the case of a short taxable year). The taxpayer must use the same
measurement dates for all designated property produced during a
computation period. Except in the case of a computation period that
differs from the taxpayer's regular computation period by reason of a
short taxable year (see paragraph (f)(1)(i) of this section),
measurement dates must occur at equal intervals during each computation
period that falls within a single
[[Page 843]]
taxable year. For any computation period that differs from the
taxpayer's regular computation period by reason of a short taxable year,
the measurement dates used by the taxpayer during that period must be
consistent with the principles and purposes of section 263A(f). A
taxpayer is permitted to modify the frequency of measurement dates from
year to year.
(ii) Measurement period. For purposes of this section, measurement
period means the period that begins on the first day following the
preceding measurement date and that ends on the measurement date.
(iii) Measurement dates on which accumulated production expenditures
must be taken into account. The first measurement date on which
accumulated production expenditures must be taken into account with
respect to a unit of designated property is the first measurement date
following the beginning of the production period for the unit of
designated property. The final measurement date on which accumulated
production expenditures with respect to a unit of designated property
must be taken into account is the first measurement date following the
end of the production period for the unit of designated property.
Accumulated production expenditures with respect to a unit of designated
property must also be taken into account on all intervening measurement
dates. See Sec. 1.263A-12 to determine when the production period
begins and ends.
(iv) More frequent measurement dates. When in the opinion of the
District Director more frequent measurement dates are necessary to
determine capitalized interest consistent with the principles and
purposes of section 263A(f) for a particular computation period, the
District Director may require the use of more frequent measurement
dates. If a significant segment of the taxpayer's production activities
(the first segment) requires more frequent measurement dates than
another significant segment of the taxpayer's production activities, the
taxpayer may request a ruling from the Internal Revenue Service
permitting, for a taxable year and all subsequent taxable years, a
segregation of the two segments and, notwithstanding paragraph (f)(2)(i)
of this section, the use of the more frequent measurement dates for only
the first segment. The request for a ruling must be made in accordance
with any applicable rules relating to submissions of ruling requests.
The request must be filed on or before the due date (including
extensions) of the original Federal income tax return for the first
taxable year to which it will apply.
(3) Examples. The following examples illustrate the principles of
this paragraph (f):
Example 1. Corporation X, a calendar year taxpayer, is engaged in
the production of designated property during 1995. Corporation X adopts
the taxable year as the computation period and quarterly measurement
dates. Corporation X must identify traced debt, accumulated production
expenditures, and nontraced debt at each quarterly measurement date
(March 31, June 30, September 30, and December 31). Under paragraph
(c)(5)(ii) of this section, Corporation X must calculate average excess
expenditures for each unit of designated property by determining the
amount by which accumulated production expenditures exceed traced debt
for each unit at the end of each quarter and dividing the sum of these
amounts by four. Under paragraph (c)(5)(iii) (C) of this section,
Corporation X must calculate average nontraced debt by determining the
amount of nontraced debt outstanding at the end of each quarter and
dividing the sum of these amounts by four.
Example 2. Corporation X, a calendar year taxpayer, is engaged in
the production of designated property during 1995. Corporation X adopts
a 6-month computation period with two measurement dates within each
computation period. Corporation X must identify traced debt, accumulated
production expenditures, and nontraced debt at each measurement date
(March 31 and June 30 for the first computation period and September 30
and December 31 for the second computation period). Under paragraph
(c)(5)(ii) of this section, Corporation X must, for each computation
period, calculate average excess expenditures for each unit of
designated property by determining the amount by which accumulated
production expenditures exceed traced debt for each unit at each
measurement date during the period and dividing the sum of these amounts
by two. Under paragraph (c)(5)(iii)(C) of this section, Corporation X
must calculate average nontraced debt for each computation period by
determining the amount of nontraced debt outstanding at each measurement
date during the period and dividing the sum of these amounts by two.
[[Page 844]]
Example 3. (i) Corporation X, a calendar year taxpayer, is engaged
in the production of two units of designated property during 1995.
Production of Unit A starts in 1994 and ends on June 20, 1995.
Production of Unit B starts on April 15, 1995, but does not end until
1996. Corporation X adopts the taxable year as its computation period
and does not elect under paragraph (d) of this section not to trace
debt. Corporation X uses quarterly measurement dates and pays all
interest on eligible debt in the quarter in which the interest is
incurred. During 1995, Corporation X has two items of eligible debt. The
debt and the manner in which it is used are as follows:
------------------------------------------------------------------------
Annual
No. Principal rate Period Use of proceeds
(percent) outstanding
------------------------------------------------------------------------
1.......... $1,000,000 9 1/01-9/01 Unit A.
2.......... 2,000,000 11 6/01-12/31 Nontraced.
------------------------------------------------------------------------
(ii) Based on the annual 9 percent rate of interest, Corporation X
incurs $7,500 of interest during each month that Loan 1 is outstanding.
(iii) Accumulated production expenditures at the end of each quarter
during 1995 are as follows:
------------------------------------------------------------------------
Measurement date Unit A Unit B
------------------------------------------------------------------------
March 31................................ $1,200,000 $0
June 30................................. 1,800,000 500,000
Sept. 30................................ 0 1,000,000
Dec. 31................................. 0 1,600,000
------------------------------------------------------------------------
(iv) Corporation X must first determine the amount of interest
incurred on traced debt and capitalize the interest incurred on this
debt (the traced debt amount). Loan 1 is allocated to Unit A on the
March 31 and June 30 measurement dates. Accordingly, Loan 1 is treated
as traced debt with respect to unit A for the measurement periods
beginning January 1 and ending June 30. The interest incurred on Loan 1
during the period that Loan 1 is treated as traced debt must be
capitalized with respect to Unit A. Thus, $45,000 ($7,500 per month for
6 months) is capitalized with respect to Unit A.
(v) Second, Corporation X must determine average excess expenditures
for Unit A and Unit B. For Unit A, this amount is $250,000 ([$200,000 +
$800,000 + $0 + $0] / 4). For Unit B, this amount is $775,000 ([$0 +
$500,000 + $1,000,000 + $1,600,000] / 4).
(vi) Third, Corporation X must determine the weighted average
interest rate and apply that rate to the average excess expenditures for
Units A and B. The rate is equal to the total amount of interest
incurred on nontraced debt (i.e., interest incurred on all eligible debt
reduced by interest incurred on traced debt) divided by the average
nontraced debt. The interest incurred on nontraced debt equals $143,333
([$1,000,000 x 9% x \8/12\] + [$2,000,000 x 11% x \7/12\] - $45,000).
The average nontraced debt equals $1,500,000 ([$0 + $2,000,000 +
$2,000,000 + $2,000,000] / 4). The weighted average interest rate of
9.56 percent ($143,333 ' $1,500,000), is then applied to average excess
expenditures for Units A and B. Accordingly, Corporation X capitalizes
an additional $23,900 ($250,000 x 9.56%) with respect to Unit A and
$74,090 ($775,000 x 9.56%) with respect to Unit B (the excess
expenditure amounts).
(g) Special rules--(1) Ordering rules--(i) Provisions preempted by
section 263A(f). Interest must be capitalized under section 263A(f)
before the application of section 163(d) (regarding the investment
interest limitation), section 163(j) (regarding the limitation on
business interest expense), section 266 (regarding the election to
capitalize carrying charges), section 469 (regarding the limitation on
passive losses), and section 861 (regarding the allocation of interest
to United States sources). Any interest that is capitalized under
section 263A(f) is not taken into account as interest under those
sections. However, in applying section 263A(f) with respect to the
excess expenditure amount, the taxpayer must capitalize all interest
that is neither investment interest under section 163(d), business
interest expense under section 163(j), nor passive interest under
section 469 before capitalizing any interest that is either investment
interest, business interest expense, or passive interest. Any interest
that is not required to be capitalized after the application of section
263A(f) is then taken into account as interest subject to sections
163(d), 163(j), 266, 469, and 861. If, after the application of section
263A(f), interest is deferred under sections 163(d), 163(j), 266, or
469, that interest is not subject to capitalization under section
263A(f) in any subsequent taxable year.
[[Page 845]]
(ii) Deferral provisions applied before this section. Interest
(including contingent interest) that is subject to a deferral provision
described in this paragraph (g)(1)(ii) is subject to capitalization
under section 263A(f) only in the taxable year in which it would be
deducted if section 263A(f) did not apply. Deferral provisions include
sections 163(e)(3), 267, 446, and 461, and all other deferral or
limitation provisions that are not described in paragraph (g)(1)(i) of
this section. In contrast to the provisions of paragraph (g)(1)(i) of
this section, deferral provisions are applied before the application of
section 263A(f).
(2) Application of section 263A(f) to deferred interest--(i) In
general. This paragraph (g)(2) describes the time and manner of
capitalizing and recovering the deferral amount. The deferral amount for
any computation period equals the sum of--
(A) The amount of interest that is incurred on traced debt that is
deferred during the computation period and is not deductible for the
taxable year that includes the computation period because of a deferral
provision described in paragraph (g)(1)(ii) of this section, and
(B) The shortfall amount described in paragraph (c)(4) of this
section.
(ii) Capitalization of deferral amount. The rules described in
paragraph (g)(2)(iii) of this section apply to the deferral amount
unless the taxpayer elects under paragraph (g)(2)(iv) of this section to
capitalize substitute costs.
(iii) Deferred capitalization. If the taxpayer does not elect under
paragraph (g)(2)(iv) of this section to capitalize substitute costs,
deferred interest to which the deferral amount is attributable
(determined under any reasonable method) is capitalized in the year or
years in which the deferred interest would have been deductible but for
the application of section 263A(f) (the capitalization year). For this
purpose, any interest that is deferred from a prior computation period
is taken into account in subsequent capitalization years in the same
order in which the interest was deferred. If a unit of designated
property to which previously deferred interest relates is sold before
the capitalization year, the deferred interest applicable to that unit
of property is taken into account in the capitalization year and treated
as if recovered from the sale of the property. If the taxpayer continues
to hold, throughout the capitalization year, a unit of depreciable
property to which previously deferred interest relates, the adjusted
basis and applicable recovery percentages for the unit of property are
redetermined for the capitalization year and subsequent years so that
the increase in basis is accounted for over the remaining recovery
periods beginning with the capitalization year. See Example 2 of
paragraph (g)(2)(v) of this section.
(iv) Substitute capitalization--(A) General rule. In lieu of
deferred capitalization under paragraph (g)(2)(iii) of this section, the
taxpayer may elect the substitute capitalization method described in
this paragraph (g)(2)(iv). Under this method, the taxpayer capitalizes
for the computation period in which interest is incurred and deferred
(the deferral period) costs that would be deducted but for this
paragraph (g)(2)(iv) (substitute costs). The taxpayer must capitalize an
amount of substitute costs equal to the deferral amount for each unit of
designated property, or if less, a prorata amount (determined in
accordance with the principles of paragraph (c)(7)(i) of this section)
of the total substitute costs that would be deducted but for this
paragraph (g)(2)(iv) during the deferral period. If the entire deferral
amount is capitalized pursuant to this paragraph (g)(2)(iv) in the
deferral period, any interest incurred and deferred in the deferral
period is neither capitalized nor deducted during the deferral period
and, unless subsequently capitalized as a substitute cost under this
paragraph (g)(2)(iv), is deductible in the appropriate subsequent period
without regard to section 263A(f).
(B) Capitalization of amount carried forward. If the taxpayer has an
insufficient amount of substitute costs in the deferral period, the
amount by which substitute costs are insufficient with respect to each
unit of designated property is a deferral amount carryforward
[[Page 846]]
to succeeding computation periods beginning with the next computation
period. In any carryforward year, the taxpayer must capitalize an amount
of substitute costs equal to the deferral amount carryforward or, if
less, a prorata amount (determined in accordance with the principles of
paragraph (c)(7)(i) of this section) of the total substitute costs that
would be deducted during the carryforward year or years (the
carryforward capitalization year) but for this paragraph (g)(2)(iv)
(after applying the substitute cost method of this paragraph (g)(2)(iv)
to the production of designated property in the carryforward period). If
a unit of designated property to which the deferral amount carryforward
relates is sold prior to the carryforward capitalization year,
substitute costs applicable to that unit of property are taken into
account in the carryforward capitalization year and treated as if
recovered from the sale of the property. If the taxpayer continues to
hold, throughout the capitalization year, a unit of depreciable property
to which a deferral amount carryforward relates, the adjusted basis and
applicable recovery percentages for the unit of property are
redetermined for the carryforward capitalization year and subsequent
years so that the increase in basis is accounted for over the remaining
recovery periods beginning with the carryforward capitalization year.
See Example 2 of paragraph (g)(2)(v) of this section.
(C) Method of accounting. The substitute capitalization method under
this paragraph (g)(2)(iv) is a method of accounting that applies to all
designated property of the taxpayer. A change to or from the substitute
capitalization method is a change in method of accounting requiring the
consent of the Commissioner under section 446(e) and Sec. 1.446-1(e).
(v) Examples. The following examples illustrate the application of
the avoided cost method when interest is subject to a deferral
provision:
Example 1. (i) Corporation X is a calendar year taxpayer and uses
the taxable year as it computation period. During 1995, X is engaged in
the construction of a warehouse which X will use in its storage
business. The warehouse is completed and placed in service in December
1995. X's average excess expenditures for 1995 equal $1,000,000.
Throughout 1995, X's only outstanding debt is nontraced debt of $900,000
and $1,200,000, bearing interest at 15 percent and 9 percent,
respectively, per year. Of the $243,000 interest incurred during the
year ([$900,000 x 15%] + [$1,200,000 x 9%] = [$135,000 + $108,000]),
$75,000 is deferred under section 267(a)(2).
(ii) X must first determine the amount of interest required to be
capitalized under paragraph (c)(1) of this section for 1995 (the
deferral period) without applying section 267(a)(2). The weighted
average interest rate is 11.6 percent ([$135,000 + $108,000] /
$2,100,000), and the excess expenditure amount under paragraph (c)(1) of
this section is $116,000 ($1,000,000 x 11.6%). Under paragraph (c)(4) of
this section, X must then determine the amount of interest that would be
capitalized by applying paragraph (c)(2) of this section without regard
to the amount of deferred interest. Disregarding deferred interest, the
amount of interest available for capitalization is $168,000 ([$900,000 x
15%] + [$1,200,000 x 9%]- $75,000). Thus, the full excess expenditure
amount ($116,000) is capitalized from interest that is not deferred
under section 267(a)(2) and there is no shortfall amount.
Example 2. (i) The facts are the same as in Example 1, except that
$140,000 of interest is deferred under section 267 (a)(2) in 1995. The
taxpayer does not elect to use the substitute capitalization method.
This interest is also deferred in 1996 but would be deducted in 1997 if
section 263A(f) did not apply. As in Example 1, the excess expenditure
amount is $116,000. However, the amount of interest available for
capitalization after excluding the amount of deferred interest is
$103,000 ([$900,000 x 15%] + [$1,200,000 x 9%]- $140,000). Thus, only
$103,000 of interest is capitalized with respect to the warehouse in
1995. Since $116,000 of interest would be capitalized if section
267(a)(2) did not apply, the deferral amount determined under paragraphs
(c)(2) and (g)(2)(i) of this section is $13,000 ($116,000 -$103,000),
and $13,000 of deferred interest must be capitalized in the year in
which it would be deducted if section 263A(f) did not apply.
(ii) The $140,000 of interest deferred under section 267(a)(2) in
1995 would be deducted in 1997 if section 263A(f) did not apply. X is
therefore required to capitalize an additional $13,000 of interest with
respect to the warehouse in 1997 and must redetermine its basis and
recovery percentage.
(3) Simplified inventory method--(i) In general. This paragraph
(g)(3) provides a simplified method of capitalizing interest expense
with respect to designated property that is inventory.
[[Page 847]]
Under this method, the taxpayer determines beginning and ending
inventory and cost of goods sold applying all other capitalization
provisions, including, for example, the simplified production method of
Sec. 1.263A-2(b), but without regard to the capitalization of interest
with respect to inventory. The taxpayer must establish a separate
capital asset, however, in an amount equal to the aggregate interest
capitalization amount (as defined in paragraph (g)(3)(iii)(C) of this
section). Under the simplified inventory method, increases in the
aggregate interest capitalization amount from one year to the next
generally are treated as reductions in interest expense, and decreases
in the aggregate interest capitalization amount from one year to the
next are treated as increases to cost of goods sold.
(ii) Segmentation of inventory--(A) General rule. Under the
simplified inventory method, the taxpayer first separates its total
ending inventory value into segments that are equal to the total ending
inventory value divided by the inverse inventory turnover rate. Each
inventory segment is then assigned an age starting with one year and
increasing by one year for each additional segment. The inverse
inventory turnover rate is determined by finding the average of
beginning and ending inventory, dividing the average by the cost of
goods sold for the year, and rounding the result to the nearest whole
number. Beginning and ending inventory amounts are determined using
total current cost of inventory for the year (rather than carrying
value). Cost of goods sold, however, may be determined using either
total current cost or the taxpayer's inventory method. In addition, for
purposes of this paragraph (g)(3)(ii), current costs for a year (and, if
applicable, the cost of goods sold for the year under the taxpayer's
inventory method) are determined without regard to the capitalization of
interest with respect to inventory.
(B) Example. The provisions of paragraph (g)(3)(ii)(A) of this
section are illustrated by the following example.
Example. X, a taxpayer using the FIFO inventory method, determines
that total cost of goods sold for 1995 equals $900, and the cost of both
beginning and ending inventory equals $3,000. Thus, X's inverse
inventory turnover rate equals 3 (3.33 rounded to the nearest whole
number). Total ending inventory of $3,000 is divided into three segments
of $1,000 each. One segment is treated as 3-year-old inventory, one
segment is treated as 2-year-old inventory, and one segment is treated
as 1-year-old inventory.
(iii) Aggregate interest capitalization amount--(A) Computation
period and weighted average interest rate. If a taxpayer elects the
simplified inventory method, the taxpayer must use the taxable year as
its computation period and use the weighted average interest rate
determined under this paragraph (g)(3)(iii)(A) in determining the
aggregate interest capitalization amount defined in paragraph
(g)(3)(iii)(C) of this section and in determining the amount of interest
capitalized with respect to any designated property that is not
inventory. Under the simplified inventory method, the taxpayer
determines the weighted average interest rate in accordance with
paragraph (c)(5)(iii) of this section, treating all eligible debt (other
than debt traced to noninventory property in the case of a taxpayer
tracing debt) as nontraced debt (i.e., without tracing debt to
inventory). A taxpayer that has elected under paragraph (e) of this
section to use an external rate as a substitute for the weighted average
interest rate determined under paragraph (c)(5)(iii) of this section
uses the rate described in paragraph (e)(1) as the weighted average
interest rate.
(B) Computation of the tentative aggregate interest capitalization
amount. The weighted average interest rate is compounded annually by the
number of years assigned to a particular inventory segment to produce an
interest factor (applicable interest factor) for that segment. The
amounts determined by multiplying the value of each inventory segment by
its applicable interest factor are then combined to produce a tentative
aggregate interest capitalization amount.
(C) Coordination with other interest capitalization computations--
(1) In general. If the tentative aggregate interest capitalization
amount for a year exceeds the aggregate interest capitalization amount
(defined in paragraph (g)(3)(iii)(D) of this section) as of the
[[Page 848]]
close of the preceding year, then, for purposes of applying the rules of
paragraph (c)(7) of this section, the excess is treated as an excess
expenditure amount and the inventory to which the simplified inventory
method of this paragraph (g)(3) applies is treated as a single unit of
designated property. If, after these modifications, no paragraph (c)(7)
interest allocation is necessary (i.e., the excess expenditure amounts
for all units of designated property do not exceed the total amount of
interest (including deferred interest) available for capitalization),
the aggregate interest capitalization amount generally equals the
tentative aggregate interest capitalization amount. If, on the other
hand, a paragraph (c)(7) allocation is necessary, the tentative
aggregate interest capitalization amount is generally adjusted to
reflect the results of that allocation (i.e., the increase in the
aggregate interest capitalization amount is limited to the amount of
interest allocated to inventory, reduced, however, by any substitute
costs that are capitalized with respect to inventory under applicable
related party rules).
(2) Deferred interest. In determining the aggregate interest
capitalization amount, the tentative aggregate interest capitalization
amount is adjusted (after the application of paragraph (c)(7) of this
section) as appropriate to reflect the deferred interest rules of
paragraph (g)(2) of this section. The tentative aggregate interest
capitalization amount would be reduced, for example, by the amount of a
taxpayer's deferred interest for a taxable year unless the taxpayer has
elected the substitute capitalization method under paragraph (g)(2)(iv).
(3) Other coordinating provisions. The Commissioner may prescribe,
by revenue ruling or revenue procedure, additional provisions to
coordinate the election and use of the simplified inventory method with
other interest capitalization requirements and methods. See Sec.
601.601(d)(2)(ii)(b) of this chapter.
(D) Treatment of increases or decreases in the aggregate interest
capitalization amount. Except as otherwise provided in this paragraph
(g)(3)(iii)(D), increases in the aggregate interest capitalization
amount from one year to the next are treated as reductions in interest
expense, and decreases in the aggregate interest capitalization amount
from one year to the next are treated as increases to cost of goods
sold. To the extent a taxpayer capitalizes substitute costs under either
applicable related party rules or the deferred interest rules in
paragraph (g)(2) of this section, increases in the aggregate interest
capitalization amount are treated as reductions in applicable substitute
costs, rather than interest expense.
(E) Example. The provisions of this paragraph (g)(3)(iii) are
illustrated by the following example.
Example. The facts are the same as in the example in paragraph
(g)(3)(ii)(B) of this section, and, in addition, X determines that its
weighted average interest rate for 1995 is 10 percent. Additionally,
assume that X has no deferred interest in 1995 or 1996 and no deferral
amount carryforward to either 1995 or 1996. (See paragraph (g)(2) of
this section.) Also assume that no allocation is necessary under
paragraph (c)(7) of this section in either 1995 or 1996. Under the rules
of paragraph (g)(3)(ii) of this section, X divides ending inventory into
segments of $1,000 each. One segment is 1-year old inventory, one
segment is 2-year old inventory, and one segment is 3-year old
inventory. Under paragraph (g)(3)(iii)(B) of this section, X must
compute the applicable interest factor for each segment. The applicable
interest factor for the 1-year old inventory is not compounded. The
applicable interest factor for the 2-year old inventory is compounded
for 1 year. The applicable interest factor for the 3-year old inventory
is compounded for 2 years. The interest factor applied to the 1-year old
inventory segment is .1. The interest factor applied to the 2-year old
inventory segment is .21 [(1.1 x 1.1)-1]. The interest factor applied to
the 3-year old inventory is .331 [(1.1 x 1.1 x 1.1)-1]. Thus, the
tentative aggregate interest capitalization amount for 1995 is $641
(1,000 x [.1 + .21 + .331]). Because X has no deferred interest in 1995,
no deferral amount carryforward to 1995, and no required allocation
under paragraph (c)(7) of this section in 1995, X's aggregate interest
capitalization amount equals its $641 tentative aggregate interest
capitalization amount. If, in 1996, X computes an aggregate interest
capitalization amount of $750, the $109 increase in the amount from 1995
to 1996 would be treated as a reduction in interest expense for 1996.
(iv) Method of accounting. The simplified inventory method is a
method
[[Page 849]]
of accounting that must be elected for and applied to all inventory
within a single trade or business of the taxpayer (within the meaning of
section 446(d) and Sec. 1.446-1(d)). This method may be elected only if
the inventory in that trade or business consists only of designated
property and only if the taxpayer's inverse inventory turnover rate for
that trade or business (as defined in paragraph (g)(3)(ii)(A) of this
section) is greater than or equal to one. A change from or to the
simplified inventory method is a change in method of accounting
requiring the consent of the Commissioner under section 446(e) and Sec.
1.446-(1)(e).
(4) Financial accounting method disregarded. The avoided cost method
is applied under this section without regard to any financial or
regulatory accounting principles for the capitalization of interest. For
example, this section determines the amount of interest that must be
capitalized without regard to Financial Accounting Standards Board
(FASB) Statement Nos. 34, 71, and 90, issued by the Financial Accounting
Standards Board, Norwalk, CT 06856-5116. Similarly, taxpayers are not
permitted to net interest income and interest expense in determining the
amount of interest that must be capitalized under this section with
respect to certain restricted tax-exempt borrowings even though netting
is permitted under FASB Statement No. 62.
(5) Treatment of intercompany transactions--(i) General rule. If
interest capitalized under section 263A(f) by a member of a consolidated
group (within the meaning of Sec. 1.1502-1(h)) with respect to a unit
of designated property is attributable to a loan from another member of
the group (the lending member), the intercompany transaction provisions
of the consolidated return regulations do not apply to the lending
member's interest income with respect to that loan, except as provided
in paragraph (g)(5)(ii) of this section. For this purpose, the
capitalized interest expense that is attributable to a loan from another
member is determined under any method that reasonably reflects the
principles of the avoided cost method, including the traced and
nontraced concepts. For purposes of this paragraph (g)(5)(i) and
paragraph (g)(5)(ii) of this section, in order for a method to be
considered reasonable it must be consistently applied.
(ii) Special rule for consolidated group with limited outside
borrowing. If, for any year, the aggregate amount of interest income
described in paragraph (g)(5)(i) of this section for all members of the
group with respect to all units of designated property exceeds the total
amount of interest that is deductible for that year by all members of
the group with respect to debt of a member owed to nonmembers (group
deductible interest) after applying section 263A(f), the intercompany
transaction provisions of the consolidated return regulations are
applied to the excess, and the amount of interest income that must be
taken into account by the group under paragraph (g)(5)(i) of this
section is limited to the amount of the group deductible interest. The
amount to which the intercompany transaction provisions of the
consolidated return regulations apply by reason of this paragraph
(g)(5)(ii) is allocated among the lending members under any method that
reasonably reflects each member's share of interest income described in
paragraph (g)(5)(i) of this section. If a lending member has interest
income that is attributable to more than one unit of designated
property, the amount to which the intercompany transaction provisions of
the consolidated return regulations apply by reason of this paragraph
(g)(5)(ii) with respect to the member is allocated among the units in
accordance with the principles of paragraph (c)(7)(i) of this section.
(iii) Example. The provisions of paragraph (g)(5)(ii) of this
section are illustrated by the following example.
Example. (i) P and S1 are the members of a consolidated group. In
1995, S1 begins and completes the construction of a shopping center and
is required to capitalize interest with respect to the construction.
S1's average excess expenditures for 1995 are $5,000,000. Throughout
1995, S1's only borrowings include a $6,000,000 loan from P bearing
interest at an annual rate of 10 percent ($600,000 per year). Under the
avoided cost method, S1 is required to capitalize interest in the amount
of $500,000 ([$600,000 / $6,000,000 x 5,000,000).
[[Page 850]]
(ii) P's only borrowing from unrelated lenders is a $2,000,000 loan
bearing interest at an annual rate of 10 percent ($200,000 per year).
Under the principles of paragraph (g)(5)(ii) of this section, because
the aggregate amount of interest described in paragraph (g)(5)(i) of
this section ($500,000) exceeds the aggregate amount of currently
deductible interest of the group ($200,000), the intercompany
transaction provisions of the consolidated return regulations apply to
the excess of $300,000 and the amount of P's interest income that is
subject to current inclusion by reason of paragraph (g)(5)(i) of this
section is limited to $200,000.
(6) Notional principal contracts and other derivatives. [Reserved]
(7) 15-day repayment rule. A taxpayer may elect to treat any
eligible debt that is repaid within the 15-day period immediately
preceding a quarterly measurement date as outstanding as of that
measurement date for purposes of determining traced debt, average
nontraced debt, and the weighted average interest rate. This election
may be made or discontinued for any computation period and is not a
method of accounting.
[T.D. 8584, 59 FR 67200, Dec. 29, 1994; 60 FR 16574, Mar. 31, 1995, as
amended by T.D. 8584, 60 FR 47053, Sept. 11, 1995; T.D. 9129, 69 FR
29067, May 20, 2004; T.D. 9179, 70 FR 8730, Feb. 23, 2005; T.D. 9905, 85
FR 56832, Sept. 14, 2020; T.D. 9942, 86 FR 268, Jan. 5, 2021]
Sec. 1.263A-10 Unit of property.
(a) In general. The unit of property as defined in this section is
used as the basis to determine accumulated production expenditures under
Sec. 1.263A-11 and the beginning and end of the production period under
Sec. 1.263A-12. Whether property is 1-year or 2-year property under
Sec. 1.263A-8(b)(1)(ii) is also determined separately with respect to
each unit of property as defined in this section.
(b) Units of real property--(1) In general. A unit of real property
includes any components of real property owned by the taxpayer or a
related person that are functionally interdependent and an allocable
share of any common feature owned by the taxpayer or a related person
that is real property even though the common feature does not meet the
functional interdependence test. When the production period begins with
respect to any functionally interdependent component or any common
feature of the unit of real property, the production period has begun
for the entire unit of real property. See, however, paragraph (b)(5) of
this section for rules under which the costs of a common feature or
benefitted property are excluded from accumulated production
expenditures for one or more measurement dates. The portion of land
included in a unit of real property includes land on which real property
(including a common feature) included in the unit is situated, land
subject to setback restrictions with respect to such property, and any
other contiguous portion of the tract of land other than land that the
taxpayer holds for a purpose unrelated to the unit being produced (e.g.,
investment purposes, personal use purposes, or specified future
development as a separate unit of real property).
(2) Functional interdependence. Components of real property produced
by, or for, the taxpayer, for use by the taxpayer or a related person
are functionally interdependent if the placing in service of one
component is dependent on the placing in service of the other component
by the taxpayer or a related person. In the case of property produced
for sale, components of real property are functionally interdependent if
they are customarily sold as a single unit. For example, the real
property components of a single-family house (e.g., the land,
foundation, and walls) are functionally interdependent. In contrast,
components of real property that are expected to be separately placed in
service or held for resale are not functionally interdependent. Thus,
dwelling units within a multi-unit building that are separately placed
in service or sold (within the meaning of Sec. 1.263A-12(d)(1)) are
treated as functionally independent of any other units, even though the
units are located in the same building.
(3) Common features. For purposes of this section, a common feature
generally includes any real property (as defined in Sec. 1.263A-8(c))
that benefits real property produced by, or for, the taxpayer or a
related person, and that is not separately held for the production of
income. A common feature need not be physically contiguous to the
[[Page 851]]
real property that it benefits. Examples of common features include
streets, sidewalks, playgrounds, clubhouses, tennis courts, sewer lines,
and cables that are not held for the production of income separately
from the units of real property that they benefit.
(4) Allocation of costs to unit. Except as provided in paragraph
(b)(5) of this section, the accumulated production expenditures for a
unit of real property include, in all cases, the costs that directly
benefit, or are incurred by reason of the production of, the unit of
real property. Accumulated production expenditures also include the
adjusted basis of property used to produce the unit of real property.
The accumulated costs of a common feature or land that benefits more
than one unit of real property, or that benefits designated property and
property other than designated property, is apportioned among the units
of designated property, or among the designated property and property
other than designated property, in determining accumulated production
expenditures. The apportionment of the accumulated costs of the common
feature (allocable share) or land (attributable land costs) generally
may be made using any method that is applied on a consistent basis and
that reasonably reflects the benefits provided. For example, an
apportionment based on relative costs to be incurred, relative space to
be occupied, or relative fair market values may be reasonable.
(5) Treatment of costs when a common feature is included in a unit
of real property--(i) General rule. Except as provided in this paragraph
(b)(5), the accumulated production expenditures of a unit of real
property include the costs of functionally interdependent components
(benefitted property) and an allocable share of the cost of common
features throughout the entire production period of the unit. See Sec.
1.263A-12, relating to the production period of a unit of property.
(ii) Production activity not undertaken on benefitted property--(A)
Direct production activity not undertaken--(1) In general. The costs of
land attributable to a benefitted property may be treated as not
included in accumulated production expenditures for a unit of real
property for measurement dates prior to the first date a production
activity (direct production activity), including the clearing and
grading of land, has been undertaken with respect to the land
attributable to the benefitted property. Thus, the costs of land
attributable to a benefitted property (as opposed to land attributable
to the common features) with respect to which no direct production
activities have been undertaken may be treated as not included in the
accumulated production expenditures of a unit of real property even
though a production activity has begun on a common feature allocable to
the unit.
(2) Land attributable to a benefitted property. For purposes of this
paragraph (b)(5)(ii), land attributable to a benefitted property
includes all land in the unit of real property that includes the
benefitted property other than land for a common feature. (Thus, land
attributable to a benefitted property does not include land attributable
to a common feature.)
(B) Suspension of direct production activity after clearing and
grading undertaken--(1) General rule. This paragraph (b)(5)(ii)(B) may
be used to determine the accumulated production expenditures for a unit
of real property, if the only production activity with respect to a
benefitted property has been clearing and grading and no further direct
production activity is undertaken with respect to the benefitted
property for at least 120 consecutive days (i.e., direct production
activity has ceased). Under this paragraph (b)(5)(ii)(B), the
accumulated production expenditures attributable to a benefitted
property qualifying under this paragraph (b)(5)(ii)(B) may be excluded
from the accumulated production expenditures of the unit of real
property even though production continues on a common feature allocable
to the unit. For purposes of this paragraph (b)(5)(ii)(B), production
activity is considered to occur during any time which would not qualify
as a cessation of production activities under the suspension period
rules of Sec. 1.263A-12(g).
[[Page 852]]
(2) Accumulated production expenditures. If this paragraph
(b)(5)(ii)(B) applies, accumulated production expenditures attributable
to the benefitted property of the unit of real property may be treated
as not included in the accumulated production expenditures for the unit
starting with the first measurement period beginning after the first day
of the 120 consecutive day period, but must be included in the
accumulated production expenditures for the unit beginning in the
measurement period in which direct production activity has resumed on
the benefitted property. Accumulated production expenditures with
respect to common features allocable to the unit of real property may
not be excluded under this paragraph (b)(5)(ii)(B).
(iii) Common feature placed in service before the end of production
of a benefitted property. To the extent that a common feature with
respect to which all production activities to be undertaken by, or for,
a taxpayer or a related person are completed is placed in service before
the end of the production period of a unit that includes an allocable
share of the costs of the common feature, the costs of the common
feature are not treated as included in accumulated production
expenditures of the unit for measurement periods beginning after the
date the common feature is placed in service.
(iv) Benefitted property sold before production completed on common
feature. If a unit of real property is sold before common features
included in the unit are completed, the production period of the unit
ends on the date of sale. Thus, common feature costs actually incurred
and properly allocable to the unit as of the date of sale are excluded
from accumulated production expenditures for measurement periods
beginning after the date of sale. Common feature costs properly
allocable to the unit and actually incurred after the sale are not taken
into account in determining accumulated production expenditures.
(v) Benefitted property placed in service before production
completed on common feature. Where production activities remain to be
undertaken on a common feature allocable to a unit of real property that
includes benefitted property, the costs of the benefitted property are
not treated as included in the accumulated production expenditures for
the unit for measurement periods beginning after the date the benefitted
property is placed in service and all production activities reasonably
expected to be undertaken by, or for, the taxpayer or a related person
with respect to the benefitted property are completed.
(6) Examples. The principles of paragraph (b) of this section are
illustrated by the following examples:
Example 1. B, an individual, is in the trade or business of
constructing custom-built houses for sale. B owns a 10-acre tract upon
which B intends to build four houses on 2-acre lots. In addition, on the
remaining 2 acres B plans to construct a perimeter road that benefits
the four houses and is not held for the production of income separately
from the sale of the houses. In 1995, B begins constructing the
perimeter road and clears the land for one house. Under the principles
of paragraph (b)(1) of this section, each planned house (including
attributable land) is part of a separate unit of real property (house
unit). Under the principles of paragraph (b)(3) of this section, the
perimeter road (including attributable land) constitutes a common
feature with respect to each planned house (i.e., benefitted property).
In accordance with paragraph (b)(1), the production period for all four
house units begins when production commences on the perimeter road in
1995. In addition, under the principles of paragraph (b)(4) of this
section, the accumulated production expenditures for the four house
units include the allocable costs of the road. In addition, for the
house with respect to which B has cleared the land, the accumulated
production expenditures for the house unit include the land costs
attributable to the house. See paragraph (b)(5)(i) of this section.
However, the accumulated production expenditures for each of the three
house units that include a house for which B has not yet undertaken a
direct production activity do not include the land costs attributable to
the house. See paragraph (b)(5)(ii) of this section.
Example 2. Assume the same facts as Example 1, except that B
undertakes no further direct production activity with respect to the
house for which the land was cleared for a period of at least 120 days
but continues constructing the perimeter road during this period. In
accordance with paragraph (b)(5)(ii)(B) of this section, B may exclude
the accumulated production expenditures attributable to the benefitted
property from the accumulated production expenditures of the house unit
starting with the first measurement period that begins after the first
[[Page 853]]
day of the 120 consecutive day period. B must include the accumulated
production expenditures attributable to the benefitted property in the
accumulated production expenditures for the house unit beginning with
the measurement period in which direct production resumes on the
benefitted property. The house unit will continue to include the
accumulated production expenditures attributable to the perimeter road
during the period in which direct production activity was suspended on
the benefitted property.
Example 3. (i) D, a corporation, is in the trade or business of
developing commercial real property. D owns a 20-acre tract upon which D
intends to build a shopping center with 150 stores. D intends to lease
the stores. D will also provide on the 20 acres a 1500-car parking lot,
which is not held by D for the production of income separately from the
stores in the shopping center. Additionally, D will not produce any
other common features as part of the project. D intends to complete the
shopping center in phases and expects that each store will be placed in
service independently of any other store.
(ii) Under paragraphs (b)(1) and (b)(2) of this section, each store
(including attributable land) is part of a separate unit of real
property (store unit). The 1500-car parking lot is a common feature
benefitting each store, and D must include an allocable share of the
parking lots in each store unit. See paragraphs (b)(1) and (b)(3). In
accordance with paragraph (b)(5)(i), D includes in the accumulated
production expenditures for each store unit during each store unit's
production period: the costs capitalized with respect to the store
(including attributable land costs in accordance with paragraph (b)(5)
of this section) and an allocable share of the parking lot costs
(including attributable land costs in accordance with paragraph (b)(5)
of this section). Under paragraph (b)(4), the portion of the parking lot
costs that is included in the accumulated production expenditures of a
store unit is determined using a reasonable method of allocation.
Example 4. X, a real estate developer, begins a project to construct
a condominium building and a convenience store for the benefit of the
condominium. X intends to separately lease the convenience store.
Because the convenience store is held for the production of income
separately from the condominium units that it benefits, the convenience
store is not a common feature with respect to the condominium building.
Instead, the convenience store is a separate unit of property with a
separate production period and for which a separate determination of
accumulated production expenditures must be made.
Example 5. (i) In 1995, X, a real estate developer, begins a project
consisting of a condominium building and a common swimming pool that is
not held for the production of income separately from the condominium
sales. The condominium building consists of 10 stories, and each story
is occupied by a single condominium. Production of the swimming pool
begins in January. No direct production activity is undertaken on any
condominium until September, when direct production activity commences
on each condominium. On December 31, 1995, 1 condominium that was
completed in December has been sold, 3 condominiums that were completed
in December have not been sold, and 6 condominiums are only partially
complete; additionally, the swimming pool is completed. X is a calendar
year taxpayer that uses a full taxable year as the computation period,
and quarterly measurement dates.
(ii) Under paragraphs (b)(1) and (b)(2) of this section, each
condominium (including attributable land) is part of a separate unit of
real property. Under the principles of paragraph (b)(3) of this section,
the swimming pool is a common feature with respect to each condominium
and under paragraph (b)(4) of this section the cost of the swimming pool
is allocated equally among the condominiums.
(iii) Under paragraph (b)(1) of this section, the production period
of each of the 10 condominium units begins in January when production of
the swimming pool begins. On X's March 31, 1995, and June 30, 1995,
measurement dates, the accumulated production expenditures for each
condominium unit include the allocable costs of the swimming pool, but
not the land costs attributable to the condominium because no direct
production activity has been undertaken on the condominium. See
paragraph (b)(5)(ii)(A) of this section. On X's September 30, 1995, and
December 31, 1995, measurement dates, the accumulated production
expenditures for each unit include the allocable costs of the swimming
pool, and the costs of the condominium (including attributable land
costs) because a direct production activity has commenced on the
condominium. See paragraph (b)(5)(i) of this section.
(iv) The production period for the condominium unit that includes
the condominium that is sold as of the end of 1995 ends on the date the
condominium is sold. See paragraph (b)(5)(iv) of this section. The
production period of each unit that is ready to be held for sale ends
when all production activities have been completed on the unit, in this
case on December 31, 1995, the date that the swimming pool included in
the unit is completed. See Sec. 1.263A-12(d). Accordingly, interest
capitalization ceases for each such unit that is sold or ready to be
held for sale as of the end of 1995 (including each unit's allocable
share of the completed swimming pool).
(v) The production periods for the condominium units that include
the condominiums that are only partially complete at the
[[Page 854]]
end of 1995 continue after 1995. The accumulated production expenditures
for each partially completed condominium unit continue to include the
costs of the condominium (including attributable land costs) in addition
to the costs of an allocable share of the completed swimming pool
(including attributable land costs).
Example 6. Assume the same facts as in Example 5, except that the
swimming pool is only partially complete as of the end of 1995. Under
these facts, X capitalizes no interest during 1996 for the 1 unit that
includes the condominium sold during 1995 (including the costs of the
allocable share of the swimming pool). See paragraph (b)(5)(iv) of this
section. However, with respect to the 6 condominiums that are partially
complete and the 3 condominiums that are completed but unsold, interest
capitalization continues after the end of 1995. The accumulated
production expenditures for each of these 9 units include the costs of
an allocable share of the swimming pool. See paragraph (b)(5)(i) of this
section. In determining the costs of an allocable share of the swimming
pool included in the accumulated production expenditures for each of the
9 units, X includes all costs of the swimming pool properly allocable to
each unit, including those cost incurred as of the date of the sale of
unit 1 that may have been used under applicable administrative
procedures (e.g., Rev. Proc. 92-29, 1992-1 C.B. 748) in determining the
basis of unit 1 solely for purposes of computing gain or loss on the
sale of unit 1. See Sec. 601.601(d)(2)(ii)(b) of this chapter.
Example 7. (i) Assume the same facts as in Example 5, except that X
intends to lease rather than sell the condominiums and the completed
swimming pool is placed in service for depreciation purposes on December
31, 1995. Additionally, assume that all 10 condominiums are partially
completed at the end of 1995.
(ii) Under these facts, because the swimming pool is a common
feature that is placed in service separately from the condominiums that
it benefits, under paragraph (b)(5)(iii) of this section, the
accumulated production expenditures of each of the condominium units do
not include the costs of the allocable share of the swimming pool after
1995.
(c) Units of tangible personal property. Components of tangible
personal property are a single unit of property if the components are
functionally interdependent. Components of tangible personal property
that are produced by, or for, the taxpayer, for use by the taxpayer or a
related person, are functionally interdependent if the placing in
service of one component is dependent on the placing in service of the
other component by the taxpayer or a related person. In the case of
tangible personal property produced for sale, components of tangible
personal property are functionally interdependent if they are
customarily sold as a single unit. For example, if an aircraft
manufacturer customarily sells completely assembled aircraft, the unit
of property includes all components of a completely assembled aircraft.
If the manufacturer also customarily sells aircraft engines separately,
any engines that are reasonably expected to be sold separately are
treated as single units of property.
(d) Treatment of installations. If the taxpayer produces or is
treated as producing any property that is installed on or in other
property, the production activity and installation activity relating to
each unit of property generally are not aggregated for purposes of this
section. However, if the taxpayer is treated as producing and installing
any property for use by the taxpayer or a related person or if the
taxpayer enters into a contract requiring the taxpayer to install
property for use by a customer, the production activity and installation
activity are aggregated for purposes of this section.
[T.D. 8584, 59 FR 67207, Dec. 29, 1994; 60 FR 16574, 16575, Mar. 31,
1995]
Sec. 1.263A-11 Accumulated production expenditures.
(a) General rule. Accumulated production expenditures generally
means the cumulative amount of direct and indirect costs described in
section 263A(a) that are required to be capitalized with respect to the
unit of property (as defined in Sec. 1.263A-10), including interest
capitalized in prior computation periods, plus the adjusted bases of any
assets described in paragraph (d) of this section that are used to
produce the unit of property during the period of their use. Accumulated
production expenditures may also include the basis of any property
received by the taxpayer in a nontaxable transaction.
(b) When costs are first taken into account--(1) In general. Except
as provided in paragraph (c)(1) of this section, costs are taken into
account in the computation of accumulated production expenditures at the
time and to the extent they would otherwise be
[[Page 855]]
taken into account under the taxpayer's method of accounting (e.g.,
after applying the requirements of section 461, including the economic
performance requirement of section 461(h)). Costs that have been
incurred and capitalized with respect to a unit of property prior to the
beginning of the production period are taken into account as accumulated
production expenditures beginning on the date on which the production
period of the property begins (as defined in Sec. 1.263A-12(c)). Thus,
for example, the cost of raw land acquired for development, the cost of
a leasehold in mineral properties acquired for development, and the
capitalized cost of planning and design activities are taken into
account as accumulated production expenditures beginning on the first
day of the production period. For purposes of determining accumulated
production expenditures on any measurement date during a computation
period, the interest required to be capitalized for the computation
period is deemed to be capitalized on the day immediately following the
end of the computation period. For any subsequent measurement dates and
computation periods, that interest is included in accumulated production
expenditures. If the cost of land or common features is allocated among
planned units of property that are completed in phases, any portion of
the cost properly allocated to completed units is not reallocated to any
incomplete units of property.
(2) Dedication rule for materials and supplies. The costs of raw
materials, supplies, or similar items are taken into account as
accumulated production expenditures when they are incurred and dedicated
to production of a unit of property. Dedicated means the first date on
which the raw materials, supplies, or similar items are specifically
associated with the production of any unit of property, including by
record, assignment to the specific job site, or physical incorporation.
In contrast, in the case of a component or subassembly that is
reasonably expected to be become a part of (e.g., be incorporated into)
any unit of property, costs incurred (including dedicated raw materials)
for the component or subassembly are taken into account as accumulated
production expenditures during the production of any portion of the
component or subassembly and prior to its connection with (e.g.,
incorporation into) any specific unit of property. For purposes of the
preceding sentence, components and subassemblies must be aggregated at
each measurement date in a reasonable manner that is consistent with the
purposes of section 263A(f).
(c) Property produced under a contract--(1) Customer. If a unit of
property produced under a contract is designated property under Sec.
1.263A-8(d)(2)(i) with respect to the customer, the customer's
accumulated production expenditures include any payments under the
contract that represent part of the purchase price of the unit of
designated property or, to the extent costs are incurred earlier than
payments are made (determined on a cumulative basis for each unit of
designated property), any part of such price for which the requirements
of section 461 have been satisfied. The customer has made a payment
under this section if the transaction would be considered a payment by a
taxpayer using the cash receipts and disbursements method of accounting.
The customer's accumulated production expenditures also include any
other costs incurred by the customer, such as interest, or any other
direct or indirect costs that are required to be capitalized under
section 263A(a) and the regulations thereunder with respect to the
production of the unit of designated property.
(2) Contractor. If a unit of property produced under a contract is
designated property under Sec. 1.263A-8(d)(2)(ii) with respect to the
contractor, the contractor must treat the cumulative amount of payments
made by the customer under the contract attributable to the unit of
property as a reduction in the contractor's accumulated production
expenditures. The customer has made a payment under this section if the
transaction would be considered a payment by a taxpayer using the cash
receipts and disbursements method of accounting.
(d) Property used to produce designated property--(1) In general.
Accumulated production expenditures include the adjusted bases (or
portion thereof) of
[[Page 856]]
any equipment, facilities, or other similar assets, used in a reasonably
proximate manner for the production of a unit of designated property
during any measurement period in which the asset is so used. Examples of
assets used in a reasonably proximate manner include machinery and
equipment used directly or indirectly in the production process, such as
assembly-line structures, cranes, bulldozers, and buildings. A taxpayer
apportions the adjusted basis of an asset used in the production of more
than one unit of designated property in a measurement period among such
units of designated property using reasonable criteria corresponding to
the use of the asset, such as machine hours, mileage, or units of
production. If an asset used in a reasonably proximate manner for the
production of a unit of designated property is temporarily idle (within
the meaning of Sec. 1.263A-1(e)(3)(iii)(E)) for an entire measurement
period, the adjusted basis of the asset is excluded from the accumulated
production expenditures for the unit during that measurement period.
Notwithstanding this paragraph (d)(1), the portion of the depreciation
allowance for equipment, facilities, or any other asset that is
capitalized with respect to a unit of designated property in accordance
with Sec. 1.263A-1(e)(3)(ii)(I) is included in accumulated production
expenditures without regard to the extent of use under this paragraph
(d)(1) (i.e., without regard to whether the asset is used in a
reasonably proximate manner for the production of the unit of designated
property).
(2) Example. The following example illustrates how the basis of an
asset is allocated on the basis of time:
Example. In 1995, X uses a bulldozer exclusively to clear the land
on several adjacent real estate development projects, A, B, and C. A, B,
and C are treated as separate units of property under the principles of
Sec. 1.263A-10. X decides to allocate the basis of the bulldozer among
the three projects on the basis of time. At the end of the first quarter
of 1995, the production period has commenced for all three projects. The
bulldozer was operated for 30 hours on project A, 80 hours on project B,
and 10 hours on project C, for a total of 120 hours for the entire
period. For purposes of determining accumulated production expenditures
as of the end of the first quarter, \1/4\ of the adjusted basis of the
bulldozer is allocated to project A, \2/3\ to project B, and \1/12\ to
project C. Nonworking hours, regularly scheduled nonworking days, or
other periods in which the bulldozer is temporarily idle (within the
meaning of Sec. 1.263A-1(e)(3)(iii)(E)) during the measurement period
are not taken into account in allocating the basis of the bulldozer.
(3) Excluded equipment and facilities. The adjusted bases of
equipment, facilities, or other assets that are not used in a reasonably
proximate manner to produce a unit of property are not included in the
computation of accumulated production expenditures. For example, the
adjusted bases of equipment and facilities, including buildings and
other structures, used in service departments performing administrative,
purchasing, personnel, legal, accounting, or similar functions, are
excluded from the computation of accumulated production expenditures
under this paragraph (d)(3).
(e) Improvements--(1) General rule. If an improvement constitutes
the production of designated property under $1.263A-8(d)(3), accumulated
production expenditures with respect to the improvement consist of--
(i) All direct and indirect costs required to be capitalized with
respect to the improvement,
(ii) In the case of an improvement to a unit of real property--
(A) An allocable portion of the cost of land, and
(B) For any measurement period, the adjusted basis of any existing
structure, common feature, or other property that is not placed in
service or must be temporarily withdrawn from service to complete the
improvement (associated property) during any part of the measurement
period if the associated property directly benefits the property being
improved, the associated property directly benefits from the
improvement, or the improvement was incurred by reason of the associated
property. See, however, the de minimis rule under paragraph (e)(2) of
this section that applies in the case of associated property.
(iii) In the case of an improvement to a unit of tangible personal
property, the adjusted basis of the asset being improved if that asset
either is not
[[Page 857]]
placed in service or must be temporarily withdrawn from service to
complete the improvement.
(2) De minimis rule. For purposes of paragraph (e)(1)(ii) of this
section, the total costs of all associated property for an improvement
unit (associated property costs) are excluded from the accumulated
production expenditures for the improvement unit during its production
period if, on the date the production period of the unit begins, the
taxpayer reasonably expects that at no time during the production period
of the unit will the accumulated production expenditures for the unit,
determined without regard to the associated property costs, exceed 5
percent of the associated property costs.
(f) Mid-production purchases. If a taxpayer purchases a unit of
property for further production, the taxpayer's accumulated production
expenditures include the full purchase price of the property plus, in
accordance with the principles of paragraph (e) of this section,
additional direct and indirect costs incurred by the taxpayer.
(g) Related person costs. The activities of a related person are
taken into account in applying the classification thresholds under Sec.
1.263A-8(b)(1)(ii)(B) and (C), and in determining the production period
of a unit of designated property under Sec. 1.263A-12. However, only
those costs incurred by the taxpayer are taken into account in the
taxpayer's accumulated production expenditures under this section
because the related person includes its own capitalized costs in the
related person's accumulated production expenditures with respect to any
unit of designated property upon which the parties engage in mutual
production activities. For purposes of the preceding sentence, the
accumulated production expenditures of any property transferred to a
taxpayer in a nontaxable transaction are treated as accumulated
production expenditures incurred by the taxpayer.
(h) Installation. If the taxpayer installs property that is
purchased by the taxpayer, accumulated production expenditures include
the cost of the property that is installed in addition to the direct and
indirect costs of installation.
[T.D. 8584, 59 FR 67210, Dec. 29, 1994; 60 FR 16575, Mar. 31, 1995]
Sec. 1.263A-12 Production period.
(a) In general. Capitalization of interest is required under Sec.
1.263A-9 for computation periods (within the meaning of Sec. 1.263A-
9(f)(1)) that include the production period of a unit of designated
property. In contrast, section 263A(a) requires the capitalization of
all other direct or indirect costs, such as insurance, taxes, and
storage, that directly benefit or are incurred by reason of the
production of property without regard to whether they are incurred
during a period in which production activity occurs.
(b) Related person activities. Activities performed and costs
incurred by a person related to the taxpayer that directly benefit or
are incurred by reason of the taxpayer's production of designated
property are taken into account in determining the taxpayer's production
period (regardless of whether the related person is performing only a
service or is producing a subassembly or component that the related
person is required to treat as an item of designated property). These
activities and the related person's costs are also taken into account in
determining whether tangible personal property produced by the taxpayer
is 1-year or 2-year property under Sec. 1.263A-8(b)(1)(ii) (B) and (C).
(c) Beginning of production period--(1) In general. A separate
production period is determined for each unit of property defined in
Sec. 1.263A-10. The production period begins on the date that
production of the unit of property begins.
(2) Real property. The production period of a unit of real property
begins on the first date that any physical production activity (as
defined in paragraph (e) of this section) is performed with respect to a
unit of real property. See Sec. 1.263A-10(b)(1). The production period
of a unit of real property produced under a contract begins for the
contractor on the date the contractor begins physical production
activity on the property. The production period of a unit of real
property produced under
[[Page 858]]
a contract begins for the customer on the date either the customer or
the contractor begins physical production activity on the property.
(3) Tangible personal property. The production period of a unit of
tangible personal property begins on the first date by which the
taxpayer's accumulated production expenditures, including planning and
design expenditures, are at least 5 percent of the taxpayer's total
estimated accumulated production expenditures for the property unit.
Thus, the beginning of the production period is determined without
regard to whether physical production activity has commenced. The
production period of a unit of tangible personal property produced under
a contract begins for the contractor when the contractor's accumulated
production expenditures, without any reduction for payments from the
customer, are at least 5 percent of the contractor's total estimated
accumulated production expenditures. The production period for a unit of
tangible personal property produced under a contract begins for the
customer when the customer's accumulated production expenditures are at
least 5 percent of the customer's total estimated accumulated production
expenditures.
(d) End of production period--(1) In general. The production period
for a unit of property produced for self use ends on the date that the
unit is placed in service and all production activities reasonably
expected to be undertaken by, or for, the taxpayer or a related person
are completed. The production period for a unit of property produced for
sale ends on the date that the unit is ready to be held for sale and all
production activities reasonably expected to be undertaken by, or for,
the taxpayer or a related person are completed. See, however, Sec.
1.263A-10(b)(5)(iv) providing an exception for common features in the
case of a benefitted property that is sold. In the case of a unit of
property produced under a contract, the production period for the
customer ends when the property is placed in service by the customer and
all production activities reasonably expected to be undertaken are
complete (i.e., generally, no earlier than when the customer takes
delivery). In the case of property that is customarily aged (such as
tobacco, wine, or whiskey) before it is sold, the production period
includes the aging period.
(2) Special rules. The production period does not end for a unit of
property prior to the completion of physical production activities by
the taxpayer even though the property is held for sale or lease, since
all production activities reasonably expected to be undertaken by the
taxpayer with respect to such property have not in fact been completed.
See, however, Sec. 1.263A-10(b)(5) regarding separation of certain
common features.
(3) Sequential production or delivery. The production period ends
with respect to each unit of property (as defined in Sec. 1.263A-10)
and its associated accumulated production expenditures as the unit of
property is completed within the meaning of paragraph (d)(1) of this
section, without regard to the production activities or costs of any
other units of property. Thus, for example, in the case of separate
apartments in a multi-unit building, each of which is a separate unit of
property within the meaning of Sec. 1.263A-10, the production period
ends for each separate apartment when it is ready to be held for sale or
placed in service within the meaning of paragraph (d)(1) of this
section. In the case of a single unit of property that merely undergoes
separate and distinct stages of production, the production period ends
at the same time (i.e., when all separate stages of production are
completed with respect to the entire amount of accumulated production
expenditures for the property).
(4) Examples. The provisions of paragraph (d) of this section are
illustrated by the following examples:
Example 1. E is engaged in the original construction of a high-rise
office building with two wings. At the end of 1995, Wing 1, but not
Wing 2, is placed in service. Moreover, at the end of 1995, all
production activities reasonably expected to be undertaken on Wing 1
are completed. In accordance with Sec. 1.263A-10(b)(1), Wing 1 and
Wing 2 are separate units of designated property. E may stop
capitalizing interest on Wing 1 but not on Wing 2.
Example 2. F is in the business of constructing finished houses. F
generally paints
[[Page 859]]
and finishes the interior of the house, although this does not occur
until a potential buyer is located. Because F reasonably expects to
undertake production activity (painting and finishing), the production
period of each house does not end until these activities are completed.
(e) Physical production activities--(1) In general. The term
physical production activities includes any physical activity that
constitutes production within the meaning of Sec. 1.263A-8(d)(1). The
production period begins and interest must be capitalized with respect
to real property if any physical production activities are undertaken,
whether alone or in preparation for the construction of buildings or
other structures, or with respect to the improvement of existing
structures. For example, the clearing of raw land constitutes the
production of designated property, even if only cleared prior to resale.
(2) Illustrations. The following is a partial list of activities any
one of which constitutes a physical production activity with respect to
the production of real property:
(i) Clearing, grading, or excavating of raw land;
(ii) Demolishing a building or gutting a standing building;
(iii) Engaging in the construction of infrastructure, such as roads,
sewers, sidewalks, cables, and wiring;
(iv) Undertaking structural, mechanical, or electrical activities
with respect to a building or other structure; or
(v) Engaging in landscaping activities.
(f) Activities not considered physical production. The activities
described in paragraphs (f)(1) and (f)(2) of this section are not
considered physical production activities:
(1) Planning and design. Soil testing, preparing architectural
blueprints or models, or obtaining building permits.
(2) Incidental repairs. Physical activities of an incidental nature
that may be treated as repairs under Sec. 1.162-4.
(g) Suspension of production period--(1) In general. If production
activities related to the production of a unit of designated property
cease for at least 120 consecutive days (cessation period), a taxpayer
may suspend the capitalization of interest with respect to the unit of
designated property starting with the first measurement period that
begins after the first day in which production ceases. The taxpayer must
resume the capitalization of interest with respect to a unit beginning
with the measurement period during which production activities resume.
In addition, production activities are not considered to have ceased if
they cease because of circumstances inherent in the production process,
such as normal adverse weather conditions, scheduled plant shutdowns, or
delays due to design or construction flaws, the obtaining of a permit or
license, or the settlement of groundfill to construct property. Interest
incurred on debt that is traced debt with respect to a unit of
designated property during the suspension period is subject to
capitalization with respect to the production of other units of
designated property as interest on nontraced debt. See Sec. 1.263A-
9(c)(5)(i) of this section. For applications of the avoided cost method
after the end of the suspension period, the accumulated production
expenditures for the unit include the balance of accumulated production
expenditures as of the beginning of the suspension period, plus any
additional capitalized costs incurred during the suspension period. No
further suspension of interest capitalization may occur unless the
requirements for a new suspension period are satisfied.
(2) Special rule. If a cessation period spans more than one taxable
year, the taxpayer may suspend the capitalization of interest with
respect to a unit beginning with the first measurement period of the
taxable year in which the 120-day period is satisfied.
(3) Method of accounting. An election to suspend interest
capitalization under paragraph (g)(1) of this section is a method of
accounting that must be consistently applied to all units that satisfy
the requirements of paragraph (g)(1) of this section. However, the
special rule in paragraph (g)(2) of this section is applied on an annual
basis to all units of an electing taxpayer that satisfy the requirements
of paragraph (g)(2) of this section.
(4) Example. The provisions of paragraph (g)(1) of this section are
illustrated by the following example.
[[Page 860]]
Example. (i) D, a calendar-year taxpayer, began production of a
residential housing development on January 1, 1995. D, in applying the
avoided cost method, chose a taxable year computation period and
quarterly measurement dates. On April 10, 1995, all production
activities ceased with respect to the units in the development until
December 1, 1996. The cessation, which occurred for a period of at least
120 consecutive days, was not attributable to circumstances inherent in
the production process. With respect to the units in the development, D
incurred production expenditures of $2,000,000 from January 1, 1995
through April 10, 1995. D incurred interest of $100,000 on traced debt
with respect to the units for the period beginning January 1, 1995, and
ending June 30, 1995. D did not incur any production expenditures for
the more than 20-month cessation beginning April 10, 1995, and ending
December 1, 1996, but incurred $200,000 of production expenditures from
December 1, 1996, through December 31, 1996.
(ii) D is required to capitalize the $100,000 interest on traced
debt incurred during the two measurement periods beginning January 1,
1995, and ending June 30, 1995. Because D satisfied the 120-day rule
under this paragraph (g), D is not required to capitalize interest with
respect to the accumulated production expenditures for the units for the
measurement period beginning July 1, 1995, and ending September 30,
1995, which is the first measurement period that begins after the date
production activities cease. D is rquired to resume interest
capitalization with respect to the $2,300,000 (2,000,000 + 100,000 +
200,000) of accumulated production expenditures for the units for the
measurement period beginning October 1, 1996, and ending December 31,
1996 (the measurement period during which production activities resume).
Accordingly, D may suspend the capitalization of interest with respect
to the units from July 1, 1995, through September 30, 1996.
[T.D. 8584, 59 FR 67212, Dec. 29, 1994; 60 FR 16575, Mar. 31, 1995]
Sec. 1.263A-13 Oil and gas activities.
(a) In general. This section provides rules that are to be applied
in tandem with Sec. Sec. 1.263A-8 through 1.263A-12, 1.263A-14, and
1.263A-15 in capitalizing interest with respect to the development
(within the meaning of section 263A(g)) of oil or gas property. For this
purpose, oil or gas property consists of each separate operating mineral
interest in oil or gas as defined in section 614(a), or, if a taxpayer
makes an election under section 614(b), the aggregate of two or more
separate operating mineral interests in oil or gas as described in
section 614(b) (section 614 property). Thus, an oil or gas property is
designated property unless the de minimis rule applies. A taxpayer must
apply the rules in paragraph (c) of this section if the taxpayer cannot
establish, at the beginning of the production period of the first well
drilled on the property, a definite plan that identifies the number and
location of other wells planned with respect to the property. If a
taxpayer can establish such a plan at the beginning of the production
period of the first well drilled on the property, the taxpayer may
either apply the rules of paragraph (c) of this section or treat each of
the planned wells as a separate unit and partition the leasehold
acquisition costs and costs of common features based on the number of
planned well units.
(b) Generally applicable rules--(1) Beginning of production period--
(i) Onshore activities. In the case of onshore oil or gas development
activities, the production period for a unit begins on the first date
physical site preparation activities (such as building an access road,
leveling a site for a drilling rig, or excavating a mud pit) are
undertaken with respect to the unit.
(ii) Offshore activities. In the case of offshore development
activities, the production period for a unit begins on the first date
physical site preparation activities, other than activities undertaken
with respect to expendable wells, are undertaken with respect to the
unit. For purposes of the preceding sentence, the first physical site
preparation activity undertaken with respect to a section 614 property
is generally the first activity undertaken with respect to the anchoring
of a platform (e.g., drilling to drive the piles). For purposes of this
section, an expendable well is a well drilled solely to determine the
location and delineation of offshore hydrocarbon deposits.
(2) End of production period. The production period ends for a
productive well unit on the date the well is placed in service and all
production activities reasonably expected to be undertaken by, or for,
the taxpayer or a related person are completed. See Sec. 1.263A-12(d).
[[Page 861]]
(3) Accumulated production expenditures--(i) Costs included.
Accumulated production expenditures for a well unit include the
following costs (to the extent they are not intangible drilling and
development costs allowable as a deduction under section 263(c), 263(i),
or 291(b)(2)): the costs of acquiring the section 614 leasehold and the
costs of taxes and similar items that are required to be capitalized
under section 263A(a) with respect to the section 614 leasehold; the
cost of real property associated with developing the section 614
property (e.g., casing); the basis of real property that constitutes a
common feature within the meaning of Sec. 1.263A-10(b)(3); and the
adjusted basis of property used to produce property (such as a mobile
rig, drilling ship, or an offshore drilling platform).
(ii) Improvement unit. To the extent section 614 costs are allocated
to a well unit, the undepleted portion of those section 614 costs must
also be included in the accumulated production expenditures for any
improvement unit (within the meaning of Sec. 1.263A-8(d)(3)) with
respect to that well unit.
(c) Special rules when definite plan not established--(1) In
general. The special rules of this paragraph (c) must be applied by a
taxpayer that cannot establish, at the beginning of the production
period of the first well drilled on the property, a definite plan that
identifies the number and location of the wells planned with respect to
the property. A taxpayer than can establish such a plan is permitted,
but not required, to apply the rules of this paragraph (c), provided the
rules of this paragraph (c) are consistently applied for all the
taxpayer's oil or gas properties for which a definite plan can be
established.
(2) Oil and gas units--(i) First productive well unit. Until the
first productive well is placed in service and all production activities
reasonably expected to be undertaken by, or for, the taxpayer or a
related person are completed, a first productive well unit includes the
section 614 property and all real property associated with the
development of the section 614 property. Thus, for example, a first
productive well unit includes the section 614 property and real property
associated with any nonproductive well drilled on the section 614
property on or before the date the first productive well is placed in
service and all production activities reasonably expected to be
undertaken by, or for, the taxpayer or a related person are completed.
For purposes of this section, a productive well is a well that produces
in commercial quantities. See paragraph (c)(5) of this section, which
provides a special rule whereby the costs of a section 614 property and
common feature costs for a section 614 property generally are included
only in the accumulated production expenditures for the first productive
well unit.
(ii) Subsequent units. Generally, real property associated with each
productive or nonproductive well with respect to which production
activities begin after the date the first productive well is placed in
service and all production activities reasonably expected to be
undertaken by, or for, the taxpayer or a related person are completed,
constitutes a unit of real property. Additionally, a productive or
nonproductive well that is included in a first productive well unit and
for which development continues after the date the first productive well
is placed in service and all production activities reasonably expected
to be undertaken by, or for, the taxpayer or a related person are
completed, generally is treated as a separate unit of property after
that date. See, however, paragraph (c)(5) of this section, which
provides rules for the treatment of costs included in the accumulated
production expenditures of a first productive well unit.
(3) Beginning of production period--(i) First productive well unit.
The beginning of the production period of the first productive well unit
is determined as provided in paragraph (b) of this section.
(ii) Subsequent wells. In applying paragraph (b) of this section to
subsequent well units (as described in paragraph (c)(2)(ii) of this
section), any activities occurring prior to the date the production
period ends for the first productive well unit are not taken into
account in determining the beginning of the production period for the
subsequent well units.
(4) End of production period. The end of the production period for
both the
[[Page 862]]
first productive well unit and subsequent productive well units is
determined as provided in paragraph (b)(2) of this section. See Sec.
1.263A-12(d). Nonproductive wells included in the first productive well
unit need not be plugged and abandoned for the production period to end
for a first productive well unit.
(5) Accumulated production expenditures--(i) First productive well
unit. The accumulated production expenditures for a first productive
well unit include all costs incurred with respect to the section 614
property and associated real property at any time through the end of the
production period for the first productive well unit. Thus, the costs of
acquiring the section 614 property, the costs of taxes and similar items
that are required to be capitalized under section 263A(a) with respect
to the section 614 property, and the costs of common features, that are
incurred at any time through the end of the production period of the
first productive well unit (section 614 costs) are included in the
accumulated production expenditures for the first productive well unit.
(ii) Subsequent well unit. The accumulated production expenditures
for a subsequent well do not include any costs included in the
accumulated production expenditures for a first productive well unit. In
the event that section 614 costs or common feature costs with respect to
a section 614 property are incurred subsequent to the end of the
production period of the first productive well unit, those common
feature costs and undepleted section 614 costs are allocated among the
accumulated production expenditures of wells being drilled as of the
date such costs are incurred.
(6) Allocation of interest capitalized with respect to first
productive well unit. Interest attributable to any productive or
nonproductive well included in the first productive well unit (within
the meaning of paragraph (c)(2)(ii) of this section) is allocated among
and capitalized to the basis of the property associated with the first
productive well unit. See Sec. 1.263A-8(a)(2).
(7) Example. The provisions of this paragraph (c) are illustrated by
the following example.
Example. (i) Corporation Z, an oil company, acquired a section 614
property in an onshore tract, Tract B, for development. In 1995,
Corporation Z began site preparation activities on Tract B and also
commenced drilling Well 1 on Tract B. Corporation Z was unable to
establish, as provided in paragraph (a) of this section, a definite plan
identifying the number and location of other wells planned on Tract B.
In 1996, Corporation Z began drilling Well 2. On May 1, 1997, Well 2, a
productive well, was placed in service and all production activities
reasonably expected to be undertaken with respect to Well 2 were
completed. By that date, also, Well 1 was abandoned.
(ii) Well 2 is a first productive well (within the meaning of
paragraph (c)(2)(i) of this section). Well 1 is a nonproductive well
drilled prior to a first productive well. Under paragraph (c) of this
section, Corporation Z must treat both Well 1 and Well 2 as part of the
first productive well unit on the section 614 property. In accordance
with paragraphs (c)(3) and (c)(4) of this section, the production period
of the first productive well unit begins on the date physical site
preparation activities are undertaken with respect to Well 1 in 1995 and
ends on May 1, 1997, the date that Well 2 is placed in service and all
production activities reasonably expected to be undertaken are
completed. In accordance with paragraph (c)(5) of this section, the
accumulated production expenditures for the first productive well unit
include, among other capitalized costs, the entire section 614 property
costs capitalized with respect to Tract B and all common feature costs
incurred with respect to the section 614 property through May 1, 1997.
(iii) Any well that Corporation Z begins after May 1, 1997, is a
separate unit of property. See paragraph (c)(2)(ii) of this section.
Under paragraph (c)(3)(ii) of this section, the production period for
any such well unit begins on the first day after May 1, 1997, on which
Corporation Z undertakes physical site preparation activities with
respect to the well unit. Moreover, Corporation Z does not include any
of the section 614 property costs in the accumulated production
expenditures for any well unit begun after May 1, 1997.
[T.D. 8584, 59 FR 67213, Dec. 29, 1994; 60 FR 16575, Mar. 31, 1995]
Sec. 1.263A-14 Rules for related persons.
Taxpayers must account for average excess expenditures allocated to
related persons under applicable administrative pronouncements
interpreting section 263A(f). See Sec. 601.601(d)(2)(ii)(b) of this
chapter.
[T.D. 8584, 59 FR 67215, Dec. 29, 1994]
[[Page 863]]
Sec. 1.263A-15 Effective dates, transitional rules, and anti-abuse rule.
(a) Effective dates--(1) Sections 1.263A-8 through 1.263A-15
generally apply to interest incurred in taxable years beginning on or
after January 1, 1995. In the case of property that is inventory in the
hands of the taxpayer, however, these sections are effective for taxable
years beginning on or after January 1, 1995. Changes in methods of
accounting necessary as a result of the rules in Sec. Sec. 1.263A-8
through 1.263A-15 must be made under the terms and conditions prescribed
by the Commissioner. Under these terms and conditions, the principles of
Sec. 1.263A-7 must be applied in revaluing inventory property.
(2) For taxable years beginning before January 1, 1995, taxpayers
must take reasonable positions on their federal income tax returns when
applying section 263A(f). For purposes of this paragraph (a)(2), a
reasonable position is a position consistent with the temporary
regulations, revenue rulings, revenue procedures, notices, and
announcements concerning section 263A applicable in taxable years
beginning before January 1, 1995. See Sec. 601.601(d)(2)(ii)(b) of this
chapter. For this purpose, Notice 88-99, 1988-2 C.B. 422, applies to
taxable years beginning after August 17, 1988, in the case of inventory,
and to interest incurred in taxable years beginning after August 17,
1988, in all other cases. Finally, under administrative procedures
issued by the Commissioner, taxpayers may elect early application of
Sec. Sec. 1.263A-8 through 1.263A-15 to taxable years beginning on or
after January 1, 1994, in the case of inventory property, and to
interest incurred in taxable years beginning on or after January 1,
1994, in the case of property that is not inventory in the hands of the
taxpayer.
(3) Section 1.263A-9(a)(4)(ix) generally applies to interest
incurred in taxable years beginning on or after May 20, 2004. In the
case of property that is inventory in the hands of the taxpayer, Sec.
1.263A-9(a)(4)(ix) applies to taxable years beginning on or after May
20, 2004. Taxpayers may elect to apply Sec. 1.263A-9(a)(4)(ix) to
interest incurred in taxable years beginning on or after January 1,
1995, or, in the case of property that is inventory in the hands of the
taxpayer, to taxable years beginning on or after January 1, 1995. A
change in a taxpayer's treatment of interest to a method consistent with
Sec. 1.263A-9(a)(4)(ix) is a change in method of accounting to which
sections 446 and 481 apply.
(4) Section 1.263A-9(g)(1)(i) applies to taxable years beginning on
or after November 13, 2020. However, taxpayers and their related
parties, within the meaning of sections 267(b) and 707(b)(1), may choose
to apply the rules of that section to a taxable year beginning after
December 31, 2017, so long as the taxpayers and their related parties
consistently apply the rules of the section 163(j) regulations (as
defined in Sec. 1.163(j)-1(b)(37)), and, if applicable, Sec. Sec.
1.381(c)(20)-1, 1.382-1, 1.382-2, 1.382-5, 1.382-6, 1.382-7, 1.383-0,
1.383-1, 1.469-9, 1.469-11, 1.704-1, 1.882-5, 1.1362-3, 1.1368-1,
1.1377-1, 1.1502-13, 1.1502-21, 1.1502-36, 1.1502-79, 1.1502-91 through
1.1502-99 (to the extent they effectuate the rules of Sec. Sec. 1.382-
2, 1.382-5, 1.382-6, and 1.383-1), and 1.1504-4, to that taxable year.
(5) The last sentence of each of Sec. 1.263A-8(a)(1) and Sec.
1.263A-9(e)(2) apply to taxable years beginning on or after January 5,
2021. However, for a taxable year beginning after December 31, 2017, and
before January 5, 2021, a taxpayer may apply the last sentence of each
of Sec. 1.263A-8(a)(1) and Sec. 1.263A-9(e)(2), provided that the
taxpayer follows all the applicable rules contained in the regulations
under section 263A for such taxable year and all subsequent taxable
years.
(b) Transitional rule for accumulated production expenditures--(1)
In general. Except as provided in paragraph (b)(2) of this section,
costs incurred before the effective date of section 263A are included in
accumulated production expenditures (within the meaning of Sec. 1.263A-
11) with respect to noninventory property only to the extent those costs
were required to be capitalized under section 263 when incurred and
would have been taken into account in determining the amount of interest
required to be capitalized under former section 189 (relating to the
capitalization of real property interest and taxes) or pursuant to an
election that was in effect under section 266 (relating
[[Page 864]]
to the election to capitalize certain carrying charges).
(2) Property used to produce designated property. The basis of
property acquired prior to 1987 and used to produce designated
noninventory property after December 31, 1986, is included in
accumulated production expenditures in accordance with Sec. 1.263A-
11(d) without regard to whether the basis would have been taken into
account under former section 189 or section 266.
(c) Anti-abuse rule. The interest capitalization rules contained in
Sec. Sec. 1.263A-8 through 1.263A-15 must be applied by the taxpayer in
a manner that is consistent with and reasonably carries out the purposes
of section 263A(f). For example, in applying Sec. 1.263A-10, regarding
the definition of a unit of property, taxpayers may not divide a single
unit of property to avoid property classifying the property as
designated property. Similarly, taxpayers may not use loans in lieu of
advance payments, tax-exempt parties, loan restructurings at measurement
dates, or obligations bearing an unreasonably low rate of interest (even
if such rate equals or exceeds the applicable Federal rate under section
1274(d)) to avoid the purposes of section 263A(f). For purposes of this
paragraph (c), the presence of back-to-back loans with different rates
of interest, and other uses of related parties to facilitate an
avoidance of interest capitalization, evidences abuse. In such cases,
the District Director may, based upon all the facts and circumstances,
determine the amount of interest that must be capitalized in a manner
that is consistent with and reasonably carries out the purposes of
section 263A(f).
[T.D. 8584, 59 FR 67215, Dec. 29, 1994, as amended by T.D. 8728, 62 FR
42062, Aug. 5, 1997; T.D. 9179, 70 FR 8730, Feb. 23, 2005; T.D. 9905, 85
FR 56832, Sept. 14, 2020; 86 FR 32186, June 17, 2021]
Sec. 1.264-1 Premiums on life insurance taken out in a trade or business.
(a) When premiums are not deductible. Premiums paid by a taxpayer on
a life insurance policy are not deductible from the taxpayer's gross
income, even though they would otherwise be deductible as trade or
business expenses, if they are paid on a life insurance policy covering
the life of any officer or employee of the taxpayer, or any person
(including the taxpayer) who is financially interested in any trade or
business carried on by the taxpayer, when the taxpayer is directly or
indirectly a beneficiary of the policy. For additional provisions
relating to the nondeductibility of premiums paid on life insurance
policies (whether under section 162 or any other section of the Code),
see section 262, relating to personal, living, and family expenses, and
section 265, relating to expenses allocable to tax-exempt income.
(b) When taxpayer is a beneficiary. If a taxpayer takes out a policy
for the purpose of protecting himself from loss in the event of the
death of the insured, the taxpayer is considered a beneficiary directly
or indirectly under the policy. However, if the taxpayer is not a
beneficiary under the policy, the premiums so paid will not be
disallowed as deductions merely because the taxpayer may derive a
benefit from the increased efficiency of the officer or employee
insured. See section 162 and the regulations thereunder. A taxpayer is
considered a beneficiary under a policy where, for example, he, as a
principal member of a partnership, takes out an insurance policy on his
own life irrevocably designating his partner as the sole beneficiary in
order to induce his partner to retain his investment in the partnership.
Whether or not the taxpayer is a beneficiary under a policy, the
proceeds of the policy paid by reason of the death of the insured may be
excluded from gross income whether the beneficiary is an individual or a
corporation, except in the case of (1) certain transferees, as provided
in section 101(a)(2); (2) portions of amounts of life insurance proceeds
received at a date later than death under the provisions of section
101(d); and (3) life insurance policy proceeds which are includible in
the gross income of a husband or wife under section 71 (relating to
alimony) or section 682 (relating to income of an estate or trust in
case of divorce, etc.). (See section 101(e).) For further reference,
see, generally, section 101 and the regulations thereunder.
[[Page 865]]
Sec. 1.264-2 Single premium life insurance, endowment, or annuity contracts.
Amounts paid or accrued on indebtedness incurred or continued,
directly or indirectly, to purchase or to continue in effect a single
premium life insurance or endowment contract, or to purchase or to
continue in effect a single premium annuity contract purchased (whether
from the insurer, annuitant, or any other person) after March 1, 1954,
are not deductible under section 163 or any other provision of chapter 1
of the Code. This prohibition applies even though the insurance is not
on the life of the taxpayer and regardless of whether or not the
taxpayer is the annuitant or payee of such annuity contract. A contract
is considered a single premium life insurance, endowment, or annuity
contract, for the purposes of this section, if substantially all the
premiums on the contract are paid within four years from the date on
which the contract was purchased, or if an amount is deposited after
March 1, 1954, with the insurer for payment of a substantial number of
future premiums on the contract.
Sec. 1.264-3 Effective date; taxable years ending after March 1, 1954,
subject to the Internal Revenue Code of 1939.
Pursuant to section 7851(a)(1)(C), the regulations prescribed in
Sec. 1.264-2, to the extent that they relate to amounts paid or accrued
on indebtedness incurred or continued to purchase or carry a single
premium annuity contract purchased after March 1, 1954, and to the
extent they consider a contract a single premium life insurance,
endowment, or annuity contract if an amount is deposited after March 1,
1954, with the insurer for payment of a substantial number of future
premiums on the contract, shall also apply to taxable years beginning
before January 1, 1954, and ending after March 1, 1954, and to taxable
years beginning after December 31, 1953, and ending after March 1, 1954,
but before August 17, 1954, although such years are subject to the
Internal Revenue Code of 1939.
Sec. 1.264-4 Other life insurance, endowment, or annuity contracts.
(a) General rule. Except as otherwise provided in paragraphs (d) and
(e) of this section, no deduction shall be allowed under section 163 or
any other provision of chapter 1 of the Code for any amount (determined
under paragraph (b) of this section) paid or accrued during the taxable
year on indebtedness incurred or continued to purchase or continue in
effect a life insurance, endowment, or annuity contract (other than a
single premium contract or a contract treated as a single premium
contract) if such indebtedness is incurred pursuant to a plan of
purchase which contemplates the systematic direct or indirect borrowing
of part or all of the increases in the cash value of such contract
(either from the insurer or otherwise). For the purposes of the
preceding sentence, the term of purchase includes the payment of part or
all of the premiums on a contract, and not merely payment of the premium
due upon inital issuance of the contract. The rule of this paragraph
applies whether or not the taxpayer is the insured, payee, or annuitant
under the contract. the rule of this paragraph does not apply to
contracts purchased by the taxpayer on or before August 6, 1963, even
though there is a substantial increase in premiums after such date. The
rule of this paragraph does not apply to any amount paid or accrued on
indebtedness incurred or continued to purchase or carry a single premium
life insurance, endowment, or annuity contract (including a contract
treated as a single premium contract); the treatment of such amounts is
governed by Sec. 1.264-2.
(b) Determination of amount not allowed. The amount not allowed as a
deduction under paragraph (a) of this section is determined with
reference to the entire amount of borrowing to purchase or carry the
contract, and is not limited with reference to the amount of borrowing
of increases in the cash value. The rule of this paragraph may be
illustrated by the following example:
Example. A, a calendar year taxpayer using the cash receipts and
disbursements method of accounting, on January 1, 1964, purchases from a
life insurance company a policy in
[[Page 866]]
the amount of $100,000 with an annual gross premium of $2,200. For the
first policy year, A pays the annual premium by means other than by
borrowing. For the second, third, fourth, and fifth policy years, A
continues the policy in effect by incurring indebtedness pursuant to a
plan referred to in paragraph (a) of this section. The years and amounts
applicable to the policy are as follows:
------------------------------------------------------------------------
Cumulative Interest
cash value Total loan paid at
Years of outstanding 4.8
contract percent
------------------------------------------------------------------------
1964................................ $370 0 0
1965................................ 2,175 $2,200 $105.60
1966................................ 4,000 4,400 211.20
1967................................ 5,865 6,600 316.80
1968................................ 7,745 8,800 422.40
------------------------------------------------------------------------
On these facts (assuming that none of the exceptions contained in
paragraph (d) of this section are applicable), no deduction is allowed
for the interest paid during the year 1968. Moreover, the interest
deduction will be disallowed for the taxable years 1965 through 1967 if
such taxable years are not closed by reason of the statute of
limitations or other rule of law.
(c) Special rules. For purposes of this section:
(1) Determination of existence of a plan which contemplates
systematic borrowing--(i) In general. The determination of whether
indebtedness is incurred or continued pursuant to a plan referred to in
paragraph (a) of this section shall be made on the basis of all the
facts and circumstances in each case. Unless the taxpayer shows
otherwise, in the case of borrowing in connection with premiums for more
than three years, the existence of a plan referred to in paragraph (a)
of this section will be presumed. The mere fact that a taxpayer does not
borrow to pay a premium in a particular year does not in and of itself
preclude the existence of a plan referred to in paragraph (a) of this
section. A plan referred to in paragraph (a) of this section need not
exist at the time the contract is entered into, but may come into
existence at any time during the 7-year period following the taxpayer's
purchase of the contract or following a substantial increase (referred
to in paragraph (d)(1) of this section) in premiums on the contract.
(ii) Premium attributable to more than one year. For purposes of
subdivision (i) of this subparagraph, if the stated annual premiums due
on a contract vary in amount, borrowing in connection with any premium,
the amount of which exceeds the amount of any other premium, on such
contract may be considered borrowing to pay premiums for more than one
year. The preceding sentence shall not apply where the borrowing is in
connection with a substantially increased premium within the meaning of
paragraph (d)(1) of this section.
(2) Direct or indirect. A plan referred to in paragraph (a) of this
section may contemplate direct or indirect borrowing of increases in
cash value of the contract directly or indirectly to pay premiums and
many contemplate borrowing either from an insurance carrier, from a
bank, or from any other person. Thus, for example, if a taxpayer borrows
$100,000 from a bank and uses the funds to purchase securities, later
borrows $100,000 from a second bank and uses the funds to repay the
first bank, later sells the securities and uses the funds as a part of a
plan referred to in paragraph (a) of this section to pay premiums on a
contract of cash value life insurance, the deduction for interest paid
in continuing the loan from the second bank shall not be allowed
(assuming that none of the exceptions contained in paragraph (d) of this
section are applicable). Moreover, a plan referred to in paragraph (a)
of this section need not involve a pledge of the contract, but may
contemplate unsecured borrowing or the use of other property.
(d) Exceptions. No deduction shall be denied under paragraph (a) of
this section with respect to any amount paid or accrued during a taxable
year on indebtedness incurred or continued as part of a plan referred to
in paragraph (a) of this section if any of the following exceptions
apply.
(1) The 7-year exception--(i) In general. No part of 4 of the annual
premiums due during the 7-year period (beginning with the date the first
premium on the contract to which such plan relates was paid) is paid
under such plan by means of indebtedness. For purposes of this
exception, in the event of a substantial increase in any annual premium
on a contract, a new 7-year period begins on the date such increased
[[Page 867]]
premium is paid. If premiums on a contract are payable other than on an
annual basis (for example, monthly), the annual premium is the aggregate
of premiums due for the year. See paragraph (c)(1)(ii) of this section
for cases where one premium on a contract paid by means of indebtedness
may be considered as more than one annual premium.
(ii) Application of borrowings. For purposes of subdivision (i) of
this subparagraph, if during a 7-year period referred to in such
subdivision the taxpayer, directly or indirectly, borrows with respect
to more than one annual premium on a contract, such borrowing shall be
considered first attributable to the premium for the current policy year
(within the meaning of subdivision (iii) of this subparagraph) and then
attributable to premiums for prior policy years beginning with the most
recent prior policy year (but not including any prior policy year to the
extent that such taxpayer has indebtedness outstanding with respect to
the premium for such prior policy year). If such borrowing exceeds the
premiums paid for the current policy year and for prior policy years and
the taxpayer has, with respect to the current policy year, deposited
premiums in advance of the due date of such premiums, such excess
borrowing shall be considered indebtedness incurred to carry the
contract which is attributable to the premiums deposited for succeeding
policy years beginning with the premium for the next succeeding policy
year. The preceding sentence shall not apply to a single premium
contract referred to in Sec. 1.264-2.
(iii) Current policy year. For purposes of subdivision (ii) of this
subparagraph, the term current policy year refers to the policy year
which begins with or within the taxable year of the taxpayer.
(iv) Illustrations. The provisions of subdivision (ii) of this
subparagraph may be illustrated by the following examples:
Example 1. A, a calendar year taxpayer using the cash receipts and
disbursements method of accounting, on January 1, 1964, purchases from a
life insurance company a policy in the amount of $100,000 with an annual
gross premium of $2,200. For the first four policy years, A initially
pays the annual premium by means other than borrowing. On January 1,
1968, pursuant to a plan referred to in paragraph (a) of this section, A
borrows $10,000 with respect to the policy. Such borrowing is considered
first attributable to paying the premium for the year 1968 and then
attributable to paying the premiums for the years 1967, 1966, 1965, and
1964 (in part). No deduction is allowed for the interest paid by A on
the $10,000 indebtedness during the year 1968.
Example 2. The facts are the same as in Example 1, except that on
January 1, 1964, A pays the first annual premium and deposits an amount
equal to the second and third annual premiums, all such amounts
initially being paid or deposited by means other than borrowing. On
January 1, 1965, A deposits an amount equal to the fourth, fifth, and
sixth annual premiums, and borrows $4,400 pursuant to a plan referred to
in paragraph (a) of this section. Such borrowing is considered
attributable to the premiums paid for the policy years 1965 and 1964. On
January 1, 1966, A deposits an amount equal to the seventh, eighth, and
ninth annual premiums, and borrows $6,600 pursuant to such plan. Such
borrowing is considered attributable to the premium paid for the policy
year 1966 and deposited for the policy years 1967 and 1968. No deduction
is allowed for interest paid by A on the $11,000 indebtedness during
1966. Moreover, the interest deduction will be disallowed for the
taxable year 1965. However, if this contract is treated as a single
premium contract under Sec. 1.264-2 (by reason of deposit with the
insurer of an amount for payment of a substantial number of future
premiums), the deduction for interest on indebtedness incurred or
continued to purchase or carry the contract would be denied without
reference to this section.
(2) The $100 exception. The total amount paid or accrued during the
taxable year by the taxpayer who has entered one or more plans referred
to in paragraph (a) of this section for which (without regard to this
subparagraph) no deduction would be allowable under paragraph (a) of
this section does not exceed $100. Where the amount so paid or accrued
during the taxable year exceeds $100, the entire amount shall be subject
to the general rule of paragraph (a) of this section.
(3) The unforeseen events exception. The amount is paid or accrued
by the taxpayer on indebtedness incurred because of an unforeseen
substantial loss of such taxpayer's income or an unforeseen substantial
increase in such taxpayer's financial obligations. A loss of
[[Page 868]]
income or increase in financial obligations is not unforeseen, within
the meaning of this subparagraph, if at the time of the purchase of the
contract such event was or could have been foreseen. College education
expenses are foreseeable; however, if college expenses substantially
increase, then to the extent that such increases are unforeseen, this
exception will apply. This exception applies only if the plan referred
to in paragraph (a) of this section arises because of the unforeseen
event. Thus, for example, if a taxpayer or his family incur substantial
unexpected medical expenses or the taxpayer is laid off from his job,
and for that reason systematically borrows against the cash value of a
previously purchased contract, the deduction for the interest paid on
the loan will not be denied, whether or not the loan is used to pay a
premium on the contract.
(4) The trade or business exception. The indebtedness is incurred by
the taxpayer in connection with his trade or business. To be within this
exception, the indebtedness must be incurred to finance business
obligations rather than to finance cash value life insurance. Thus, if a
taxpayer pledges a life insurance, endowment, or annuity contract as
part of the collateral for a loan to finance the expansion of inventory
or capital improvements for his business, no part of the deduction for
interest on such loan will be denied under paragraph (a) of this
section. Borrowing by a business taxpayer to finance business life
insurance such as under so-called keyman, split dollar, or stock
retirement plans is not considered to be incurred in connection with the
taxpayer's trade or business within the meaning of this subparagraph.
The determination of whether the indebtedness is incurred in connection
with the taxpayer's trade or business, within the meaning of this
exception, rather than to finance cash value life insurance shall be
made on the basis of all the facts and circumstances. The provisions of
this subparagraph may be illustrated by the following examples:
Example 1. Corporation M each year borrows substantial sums to carry
on its business. Corporation M agrees to provide a retirement plan for
its employees and purchases level premium life insurance to fund its
obligation under the plan. The mere fact that M Corporation purchases a
cash value life insurance policy will not cause its deduction for
interest paid on its normal indebtedness to be denied even though the
policy is later used as part of the collateral for its normal
indebtedness.
Example 2. Corporation R has $200,000 of bonds outstanding and
purchases cash value life insurance policies on several of its key
employees. Such purchase by R Corporation will not, of itself, cause its
deduction for interest on its bonded indebtedness to be denied. If,
however, the premiums on the life insurance policies are $10,000 each
year, the cash value increases by $8,000 each year, and R Corporation
increases its indebtedness by $10,000 each year, its deduction for
interest on such indebtedness will not be allowed under the rule of
paragraph (a) of this section. On the other hand, the absence of such a
directly parallel increase will not of itself establish that the
deduction for interest is allowable.
(e) Applicability of section. The rules of this section apply with
respect to taxable years beginning after December 31, 1963, but only
with respect to contracts purchased after August 6, 1963. With respect
to contracts entered into on or before August 6, 1963, but purchased or
acquired whether from the insurer, insured, or any other person (other
than by gift, bequest, or inheritance, or in a transaction to which
section 381(a) of the Code applies) after such date, the rules of this
section apply after such purchase or acquisition.
[T.D. 6773, 29 FR 15751, Nov. 24, 1964]
Sec. 1.265-1 Expenses relating to tax-exempt income.
(a) Nondeductibility of expenses allocable to exempt income. (1) No
amount shall be allowed as a deduction under any provision of the Code
for any expense or amount which is otherwise allowable as a deduction
and which is allocable to a class or classes of exempt income other than
a class or classes of exempt interest income.
(2) No amount shall be allowed as a deduction under section 212
(relating to expenses for production of income) for any expense or
amount which is otherwise allowable as a deduction and which is
allocable to a class or classes of exempt interest income.
(b) Exempt income and nonexempt income. (1) As used in this section,
the
[[Page 869]]
term class of exempt income means any class of income (whether or not
any amount of income of such class is received or accrued) wholly exempt
from the taxes imposed by Subtitle A of the Code. For purposes of this
section, a class of income which is considered as wholly exempt from the
taxes imposed by subtitle A includes any class of income which is:
(i) Wholly excluded from gross income under any provision of
Subtitle A, or
(ii) Wholly exempt from the taxes imposed by Subtitle A under the
provisions of any other law.
(2) As used in this section the term nonexempt income means any
income which is required to be included in gross income.
(c) Allocation of expenses to a class or classes of exempt income.
Expenses and amounts otherwise allowable which are directly allocable to
any class or classes of exempt income shall be allocated thereto; and
expenses and amounts directly allocable to any class or classes of
nonexempt income shall be allocated thereto. If an expense or amount
otherwise allowable is indirectly allocable to both a class of nonexempt
income and a class of exempt income, a reasonable proportion thereof
determined in the light of all the facts and circumstances in each case
shall be allocated to each.
(d) Statement of classes of exempt income; records. (1) A taxpayer
receiving any class of exempt income or holding any property or engaging
in any activity the income from which is exempt shall submit with his
return as a part thereof an itemized statement, in detail, showing (i)
the amount of each class of exempt income, and (ii) the amount of
expenses and amounts otherwise allowable allocated to each such class
(the amount allocated by apportionment being shown separately) as
required by paragraph (c) of this section. If an item is apportioned
between a class of exempt income and a class of nonexempt income, the
statement shall show the basis of the apportionment. Such statement
shall also recite that each deduction claimed in the return is not in
any way attributable to a class of exempt income.
(2) The taxpayer shall keep such records as will enable him to make
the allocations required by this section. See section 6001 and the
regulations thereunder.
Sec. 1.265-2 Interest relating to tax exempt income.
(a) In general. No amount shall be allowed as a deduction for
interest on any indebtedness incurred or continued to purchase or carry
obligations, the interest on which is wholly exempt from tax under
subtitle A of the Code, such as municipal bonds, Panama Canal loan 3-
percent bonds, or obligations of the United States, the interest on
which is wholly exempt from tax under Subtitle A, and which were issued
after September 24, 1917, and not originally subscribed for by the
taxpayer. Interest paid or accrued within the taxable year on
indebtedness incurred or continued to purchase or carry (1) obligations
of the United States issued after September 24, 1917, the interest on
which is not wholly exempt from the taxes imposed under Subtitle A of
the Code, or (2) obligations of the United States issued after September
24, 1917, and originally subscribed for by the taxpayer, the interest on
which is wholly exempt from the taxes imposed by Subtitle A of the Code,
is deductible. For rules as to the inclusion in gross income of interest
on certain governmental obligations, see section 103 and the regulations
thereunder.
(b) Special rule for certain financial institutions. (1) No
deduction shall be disallowed, for taxable years ending after February
26, 1964, under section 265(2) for interest paid or accrued by a
financial institution which is a face-amount certificate company
registered under the Investment Company Act of 1940 (15 U.S.C. 80a-1 and
following) and which is subject to the banking laws of the State in
which it is incorporated, on face-amount certificates (as defined in
section 2(a)(15) of the Investment Company Act of 1940) issued by such
institution and on amounts received for the purchase of such
certificates to be issued by the institution, if the average amount of
obligations, the interest on which is wholly exempt from the taxes
imposed by Subtitle A of the Code, held
[[Page 870]]
by such institution during the taxable year, does not exceed 15 percent
of the average amount of the total assets of such institution during
such year. See subparagraph (3) of this paragraph for treatment of
interest paid or accrued on face-amount certificates where the figure is
in excess of 15 percent. Interest expense other than that paid or
accrued on face-amount certificates or on amounts received for the
purchase of such certificates does not come within the rules of this
paragraph.
(2) This subparagraph is prescribed under the authority granted the
Secretary or his delegate under section 265(2) to prescribe regulations
governing the determination of the average amount of tax-exempt
obligations and of the total assets held during an institution's taxable
year. The average amount of tax-exempt obligations held during an
institution's taxable year shall be the average of the amounts of tax-
exempt obligations held at the end of each month ending within such
taxable year. The average amount of total assets for a taxable year
shall be the average of the total assets determined at the beginning and
end of the institution's taxable year. If the Commissioner, however,
determines that any such amount is not fairly representative of the
average amount of tax-exempt obligations or total assets, as the case
may be, held by such institution during such taxable year, then the
Commissioner shall determine the amount which is fairly representative
of the average amount of tax-exempt obligations or total assets, as the
case may be. The percentage which the average amount of tax-exempt
obligations is of the average amount of total assets is determined by
dividing the average amount of tax-exempt obligations by the average
amount of total assets, and multiplying by 100. The amount of tax-exempt
obligations means that portion of the total assets of the institution
which consists of obligations the interest on which is wholly exempt
from tax under Subtitle A of the Code, and valued at their adjusted
basis, appropriately adjusted for amortization of premium or discount.
Total assets means the sum of the money, plus the aggregate of the
adjusted basis of the property other than money held by the taxpayer in
good faith for the purpose of the business. Such adjusted basis for any
asset is its adjusted basis for determining gain upon sale or exchange
for Federal income tax purposes.
(3) If the percentage computation required by subparagraph (2) of
this paragraph results in a figure in excess of 15 percent for the
taxable year, there is interest that does not come within the special
rule for certain financial institutions contained in section 265(2). The
amount of such interest is obtained by multiplying the total interest
paid or accrued for the taxable year on face-amount certificates and on
amounts received for the purchase of such certificates by the percentage
figure equal to the excess of the percentage figure computed under
subparagraph (2) of this paragraph over 15 percent. See paragraph (a)
for the disallowance of interest on indebtedness incurred or continued
to purchase or carry obligations the interest on which is wholly exempt
from tax under Subtitle A of the Code.
(4) Every financial institution claiming the benefits of the special
rule for certain financial institutions contained in section 265(2)
shall file with its return for the taxable year:
(i) A statement showing that it is a face-amount certificate company
registered under the Investment Company Act of 1940 (15 U.S.C. 80a-1 and
following) and that it is subject to the banking laws of the State in
which it is incorporated.
(ii) A detailed schedule showing the computation of the average
amount of tax-exempt obligations, the average amount of total assets of
such institutions, and the total amount of interest paid or accrued on
face-amount certificates and on amounts received for the purchase of
such certificates for the taxable year.
[T.D. 6927, 32 FR 13221, Sept. 19, 1967]
Sec. 1.265-3 Nondeductibility of interest relating to exempt-
interest dividends.
(a) In general. No deduction is allowed to a shareholder of a
regulated investment company for interest on indebtedness that relates
to exempt-interest dividends distributed by the
[[Page 871]]
company to the shareholder during the shareholder's taxable year.
(b) Interest relating to exempt-interest dividends. (1) All or a
portion of the interest on an indebtedness relates to exempt-interest
dividends if the indebtedness is either incurred or continued to
purchase or carry shares of stock of a regulated investment company that
distributes exempt-interest dividends (as defined in section 852(b)(5)
of the Code) to the holder of the shares during the shareholder's
taxable year.
(2) To determine the amount of interest that relates to the exempt-
interest dividends the total amount of interest paid or accrued on the
indebtedness is multiplied by a fraction. The numerator of the fraction
is the amount of exempt-interest dividends received by the shareholder.
The denominator of the fraction is the sum of the exempt-interest
dividends and taxable dividends received by the shareholder (excluding
capital gain dividends received by the shareholder and capital gains
required to be included in the shareholder's computation of long-term
capital gains under section 852(b)(3)(D)).
[T.D. 7601, 44 FR 16013, Mar. 16, 1979]
Sec. 1.266-1 Taxes and carrying charges chargeable to
capital account and treated as capital items.
(a)(1) In general. In accordance with section 266, items enumerated
in paragraph (b)(1) of this section may be capitalized at the election
of the taxpayer. Thus, taxes and carrying charges with respect to
property of the type described in this section are chargeable to capital
account at the election of the taxpayer, notwithstanding that they are
otherwise expressly deductible under provisions of Subtitle A of the
Code. No deduction is allowable for any items so treated.
(2) See Sec. Sec. 1.263A-8 through 1.263A-15 for rules regarding
the requirement to capitalize interest, that apply prior to the
application of this section. After applying Sec. Sec. 1.263A-8 through
1.263A-15, a taxpayer may elect to capitalize interest under section 266
with respect to designated property within the meaning of Sec. 1.263A-
8(b), provided a computation under any provision of the Internal Revenue
Code is not thereby materially distorted, including computations
relating to the source of deductions.
(b) Taxes and carrying charges. (1) The taxpayer may elect, as
provided in paragraph (c) of this section, to treat the items enumerated
in this subparagraph which are otherwise expressly deductible under the
provisions of Subtitle A of the Code as chargeable to capital account
either as a component of original cost or other basis, for the purposes
of section 1012, or as an adjustment to basis, for the purposes of
section 1016(a)(1). The items thus chargeable to capital account are:
(i) In the case of unimproved and unproductive real property: Annual
taxes, interest on a mortgage, and other carrying charges.
(ii) In the case of real property, whether improved or unimproved
and whether productive or unproductive:
(a) Interest on a loan (but not theoretical interest of a taxpayer
using his own funds),
(b) Taxes of the owner of such real property measured by
compensation paid to his employees,
(c) Taxes of such owner imposed on the purchase of materials, or on
the storage, use, or other consumption of materials, and
(d) Other necessary expenditures,
paid or incurred for the development of the real property or for the
construction of an improvement or additional improvement to such real
property, up to the time the development or construction work has been
completed. The development or construction work with respect to which
such items are incurred may relate to unimproved and unproductive real
estate whether the construction work will make the property productive
of income subject to tax (as in the case of a factory) or not (as in the
case of a personal residence), or may relate to property already
improved or productive (as in the case of a plant addition or
improvement, such as the construction of another floor on a factory or
the installation of insulation therein).
(iii) In the case of personal property:
(a) Taxes of an employer measured by compensation for services
rendered in transporting machinery or other fixed assets to the plant or
installing them therein,
[[Page 872]]
(b) Interest on a loan to purchase such property or to pay for
transporting or installing the same, and
(c) Taxes of the owner thereof imposed on the purchase of such
property or on the storage, use, or other consumption of such property,
paid or incurred up to the date of installation or the date when such
property is first put into use by the taxpayer, whichever date is later.
(iv) Any other taxes and carrying charges with respect to property,
otherwise deductible, which in the opinion of the Commissioner are,
under sound accounting principles, chargeable to capital account.
(2) The sole effect of section 266 is to permit the items enumerated
in subparagraph (1) of this paragraph to be chargeable to capital
account notwithstanding that such items are otherwise expressly
deductible under the provisions of Subtitle A of the Code. An item not
otherwise deductible may not be capitalized under section 266.
(3) In the absence of a provision in this section for treating a
given item as a capital item, this section has no effect on the
treatment otherwise accorded such item. Thus, items which are otherwise
deductible are deductible notwithstanding the provisions of this
section, and items which are otherwise treated as capital items are to
be so treated. Similarly, an item not otherwise deductible is not made
deductible by this section. Nor is the absence of a provision in this
section for treating a given item as a capital item to be construed as
withdrawing or modifying the right now given to the taxpayer under any
other provisions of subtitle A of the Code, or of the regulations
thereunder, to elect to capitalize or to deduct a given item.
(c) Election to charge taxes and carrying charges to capital
account. (1) If for any taxable year there are two or more items of the
type described in paragraph (b)(1) of this section, which relate to the
same project to which the election is applicable, the taxpayer may elect
to capitalize any one or more of such items even though he does not
elect to capitalize the remaining items or to capitalize items of the
same type relating to other projects. However, if expenditures for
several items of the same type are incurred with respect to a single
project, the election to capitalize must, if exercised, be exercised as
to all items of that type. For purposes of this section, a project
means, in the case of items described in paragraph (b)(1)(ii) of this
section, a particular development of, or construction of an improvement
to, real property, and in the case of items described in paragraph
(b)(1)(iii) of this section, the transportation and installation of
machinery or other fixed assets.
(2)(i) An election with respect to an item described in paragraph
(b)(1)(i) of this section is effective only for the year for which it is
made.
(ii) An election with respect to an item described in:
(a) Paragraph (b)(1)(ii) of this section is effective until the
development or construction work described in that subdivision has been
completed;
(b) Paragraph (b)(1)(iii) of this section is effective until the
later of either the date of installation of the property described in
that subdivision, or the date when such property is first put into use
by the taxpayer;
(c) Paragraph (b)(1)(iv) of this section is effective as determined
by the Commissioner.
Thus, an item chargeable to capital account under this section must
continue to be capitalized for the entire period described in this
subdivision applicable to such election although such period may consist
of more than one taxable year.
(3) If the taxpayer elects to capitalize an item or items under this
section, such election shall be exercised by filing with the original
return for the year for which the election is made a statement
indicating the item or items (whether with respect to the same project
or to different projects) which the taxpayer elects to treat as
chargeable to capital account. Elections filed for taxable years
beginning before January 1, 1954, and for taxable years ending before
August 17, 1954, under section 24(a)(7) of the Internal Revenue Code of
1939, and the regulations thereunder, shall have the same effect as if
they were filed under this section. See section 7807(b)(2).
[[Page 873]]
(d) The following examples are illustrative of the application of
the provisions of this section:
Example 1. In 1956 and 1957 A pays annual taxes and interest on a
mortgage on a piece of real property. During 1956, the property is
vacant and unproductive, but throughout 1957 A operates the property as
a parking lot. A may capitalize the taxes and mortgage interest paid in
1956, but not the taxes and mortgage interest paid in 1957.
Example 2. In February 1957, B began the erection of an office
building for himself. B in 1957, in connection with the erection of the
building, paid $6,000 social security taxes, which in his 1957 return he
elected to capitalize. B must continue to capitalize the social security
taxes paid in connection with the erection of the building until its
completion.
Example 3. Assume the same facts as in Example 2 except that in
November 1957, B also begins to build a hotel. In 1957 B pays $3,000
social security taxes in connection with the erection of the hotel. B's
election to capitalize the social security taxes paid in erecting the
office building started in February 1957 does not bind him to capitalize
the social security taxes paid in erecting the hotel; he may deduct the
$3,000 social security taxes paid in erecting the hotel.
Example 4. In 1957, M Corporation began the erection of a building
for itself, which will take three years to complete. M Corporation in
1957 paid $4,000 social security taxes and $8,000 interest on a building
loan in connection with this building. M Corporation may elect to
capitalize the social security taxes although it deducts the interest
charges.
Example 5. C purchases machinery in 1957 for use in his factory. He
pays social security taxes on the labor for transportation and
installation of the machinery, as well as interest on a loan to obtain
funds to pay for the machinery and for transportation and installation
costs. C may capitalize either the social security taxes or the
interest, or both, up to the date of installation or until the machinery
is first put into use by him, whichever date is later.
(e) Allocation. If any tax or carrying charge with respect to
property is in part a type of item described in paragraph (b) of this
section and in part a type of item or items with respect to which no
election to treat as a capital item is given, a reasonable proportion of
such tax or carrying charge, determined in the light of all the facts
and circumstances in each case, shall be allocated to each item. The
rule of this paragraph may be illustrated by the following example:
Example. N Corporation, the owner of a factory in New York on which
a new addition is under construction, in 1957 pays its general manager,
B, a salary of $10,000 and also pays a New York State unemployment
insurance tax of $81 on B's salary. B spends nine-tenths of his time in
the general business of the firm and the remaining one-tenth in
supervising the construction work. N Corporation treats as expenses
$9,000 of B's salary, and charges the remaining $1,000 to capital
account. N Corporation may elect to capitalize $8.10 of the $81 New York
State unemployment insurance tax paid in 1957 since such tax is
deductible under section 164.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. 8584, 59 FR 67215, Dec. 29, 1994]
Sec. 1.267A-1 Disallowance of certain interest and royalty deductions.
(a) Scope. This section and Sec. Sec. 1.267A-2 through 1.267A-5
provide rules regarding when a deduction for any interest or royalty
paid or accrued is disallowed under section 267A. Section 1.267A-2
describes hybrid and branch arrangements. Section 1.267A-3 provides
rules for determining income inclusions and provides that certain
amounts are not amounts for which a deduction is disallowed. Section
1.267A-4 provides an imported mismatch rule. Section 1.267A-5 sets forth
definitions and special rules that apply for purposes of section 267A.
Section 1.267A-6 illustrates the application of section 267A through
examples. Section 1.267A-7 provides applicability dates.
(b) Disallowance of deduction. This paragraph (b) sets forth the
exclusive circumstances in which a deduction is disallowed under section
267A. Except as provided in paragraph (c) of this section, a specified
party's deduction for any interest or royalty paid or accrued (the
amount paid or accrued with respect to the specified party, a specified
payment) is disallowed under section 267A to the extent that the
specified payment is described in this paragraph (b). See also Sec.
1.267A-5(b)(5) (treating structured payments as interest paid or accrued
for purposes of section 267A and the regulations in this part under
section 267A). A specified payment is described in this paragraph (b) to
the extent that it is--
(1) A disqualified hybrid amount, as described in Sec. 1.267A-2
(hybrid and branch arrangements);
[[Page 874]]
(2) A disqualified imported mismatch amount, as described in Sec.
1.267A-4 (payments offset by a hybrid deduction); or
(3) A specified payment for which the requirements of the anti-
avoidance rule of Sec. 1.267A-5(b)(6) are satisfied.
(c) De minimis exception. Paragraph (b) of this section does not
apply to a specified party for a taxable year in which the sum of the
specified party's specified payments that but for this paragraph (c)
would be described in paragraph (b) of this section is less than
$50,000. For purposes of this paragraph (c), specified parties that are
related (within the meaning of Sec. 1.267A-5(a)(14)) are treated as a
single specified party.
[T.D. 9896, 85 FR 19836, Apr. 8, 2020]
Sec. 1.267A-2 Hybrid and branch arrangements.
(a) Payments pursuant to hybrid transactions--(1) In general. If a
specified payment is made pursuant to a hybrid transaction, then,
subject to Sec. 1.267A-3(b) (amounts included or includible in income),
the payment is a disqualified hybrid amount to the extent that--
(i) A specified recipient of the payment does not include the
payment in income, as determined under Sec. 1.267A-3(a) (to such
extent, a no-inclusion); and
(ii) The specified recipient's no-inclusion is a result of the
payment being made pursuant to the hybrid transaction. For purposes of
this paragraph (a)(1)(ii), the specified recipient's no-inclusion is a
result of the specified payment being made pursuant to the hybrid
transaction to the extent that the no-inclusion would not occur were the
specified recipient's tax law to treat the payment as interest or a
royalty, as applicable. See Sec. 1.267A-6(c)(1) and (2) for examples
illustrating the application of paragraph (a) of this section.
(2) Definition of hybrid transaction--(i) In general. The term
hybrid transaction means any transaction, series of transactions,
agreement, or instrument one or more payments with respect to which are
treated as interest or royalties for U.S. tax purposes but are not so
treated for purposes of the tax law of a specified recipient of the
payment. Examples of a hybrid transaction include an instrument a
payment with respect to which is treated as interest for U.S. tax
purposes but, for purposes of a specified recipient's tax law, is
treated as a distribution with respect to equity or a recovery of
principal with respect to indebtedness.
(ii) Special rules--(A) Long-term deferral. A specified payment is
deemed to be made pursuant to a hybrid transaction if the taxable year
in which a specified recipient of the payment takes the payment into
account in income under its tax law (or, based on all the facts and
circumstances, is reasonably expected to take the payment into account
in income under its tax law) ends more than 36 months after the end of
the taxable year in which the specified party would be allowed a
deduction for the payment under U.S. tax law. In addition, if the tax
law of a specified recipient of the specified payment does not impose an
income tax, then such tax law does not cause the payment to be deemed to
be made pursuant to a hybrid transaction under this paragraph
(a)(2)(ii)(A). See Sec. 1.267A-6(c)(8) for an example illustrating the
application of this paragraph (a)(2)(ii)(A) in the context of the
imported mismatch rule.
(B) Royalties treated as payments in exchange for property under
foreign law. In the case of a specified payment that is a royalty for
U.S. tax purposes and for purposes of the tax law of a specified
recipient of the payment is consideration received in exchange for
property, the tax law of the specified recipient is not treated as
causing the payment to be made pursuant to a hybrid transaction.
(C) Coordination with disregarded payment rule. A specified payment
is not considered made pursuant to a hybrid transaction if the payment
is a disregarded payment, as described in paragraph (b)(2) of this
section.
(3) Payments pursuant to securities lending transactions, sale-
repurchase transactions, or similar transactions. This paragraph (a)(3)
applies if a specified payment is made pursuant to a repo transaction
and is not regarded under a foreign tax law, but another amount
connected to the payment (the connected amount) is regarded under such
foreign tax law. For purposes of this paragraph (a)(3), a repo
transaction
[[Page 875]]
means a transaction one or more payments with respect to which are
treated as interest (as defined in Sec. 1.267A-5(a)(12)) or a
structured payment (as defined in Sec. 1.267A-5(b)(5)(ii)) for U.S. tax
purposes and that is a securities lending transaction or sale-repurchase
transaction (including as described in Sec. 1.861-2(a)(7)), or other
similar transaction or series of related transactions in which legal
title to property is transferred and the property (or similar property,
such as securities of the same class and issue) is reacquired or
expected to be reacquired. For example, this paragraph (a)(3) applies if
a specified payment arising from characterizing a repo transaction of
stock in accordance with its substance (that is, characterizing the
specified payment as interest) is not regarded as such under a foreign
tax law but an amount consistent with the form of the transaction (such
as a dividend) is regarded under such foreign tax law. When this
paragraph (a)(3) applies, the determination of the identity of a
specified recipient of the specified payment under the foreign tax law
is made with respect to the connected amount. In addition, if the
specified recipient includes the connected amount in income (as
determined under Sec. 1.267A-3(a), by treating the connected amount as
the specified payment), then the amount of the specified recipient's no-
inclusion with respect to the specified payment is correspondingly
reduced. Further, the principles of this paragraph (a)(3) apply to cases
similar to repo transactions in which a foreign tax law does not
characterize the transaction in accordance with its substance. See Sec.
1.267A-6(c)(2) for an example illustrating the application of this
paragraph (a)(3).
(4) Payments pursuant to interest-free loans and similar
arrangements. In the case of a specified payment that is interest for
U.S. tax purposes, the following special rules apply:
(i) The payment is deemed to be made pursuant to a hybrid
transaction to the extent that--
(A) Under U.S. tax law, the payment is imputed (for example, under
section 482 or 7872, including because the instrument pursuant to which
it is made is indebtedness but the terms of the instrument provide for
an interest rate equal to or less than the risk-free rate or the rate on
sovereign debt with similar terms in the relevant foreign currency); and
(B) A tax resident or taxable branch to which the payment is made
does not take the payment into account in income under its tax law
because such tax law does not impute any interest. The rules of
paragraph (b)(4) of this section apply for purposes of determining
whether the specified payment is made indirectly to a tax resident or
taxable branch.
(ii) A tax resident or taxable branch the tax law of which causes
the payment to be deemed to be made pursuant to a hybrid transaction
under paragraph (a)(4)(i) of this section is deemed to be a specified
recipient of the payment for purposes of paragraph (a)(1) of this
section.
(b) Disregarded payments--(1) In general. Subject to Sec. 1.267A-
3(b) (amounts included or includible in income), the excess (if any) of
the sum of a specified party's disregarded payments for a taxable year
over its dual inclusion income for the taxable year is a disqualified
hybrid amount. See Sec. 1.267A-6(c)(3) and (4) for examples
illustrating the application of paragraph (b) of this section.
(2) Definition of disregarded payment--(i) In general. The term
disregarded payment means a specified payment to the extent that, under
the tax law of a tax resident or taxable branch to which the payment is
made, the payment is not regarded (for example, because under such tax
law it is a payment involving a single taxpayer or members of a group)
and, were the payment to be regarded (and treated as interest or a
royalty, as applicable) under such tax law, the tax resident or taxable
branch would include the payment in income, as determined under Sec.
1.267A-3(a).
(ii) Special rules--(A) Foreign consolidation and similar regimes. A
disregarded payment includes a specified payment that, under the tax law
of a tax resident or taxable branch to which the payment is made, is a
payment that gives rise to a deduction or similar offset allowed to the
tax resident or taxable branch (or group of entities that include the
tax resident or taxable
[[Page 876]]
branch) under a foreign consolidation, fiscal unity, group relief, loss
sharing, or any similar regime.
(B) Certain payments of a U.S. taxable branch. In the case of a
specified payment of a U.S. taxable branch, the payment is not a
disregarded payment to the extent that under the tax law of the tax
resident to which the payment is made the payment is otherwise taken
into account. See paragraph (c)(2) of this section for an example of
when an amount may be otherwise taken into account.
(C) Coordination with other hybrid and branch arrangements. A
disregarded payment does not include a deemed branch payment described
in paragraph (c)(2) of this section, a specified payment pursuant to a
repo transaction or similar transaction described in paragraph (a)(3) of
this section, or a specified payment pursuant to an interest-free loan
or similar transaction described in paragraph (a)(4) of this section.
(3) Definition of dual inclusion income--(i) In general. With
respect to a specified party, the term dual inclusion income means the
excess, if any, of--
(A) The sum of the specified party's items of income or gain for
U.S. tax purposes that are included in the specified party's income, as
determined under Sec. 1.267A-3(a) (by treating the items of income or
gain as the specified payment; and, in the case of a specified party
that is a CFC, by treating U.S. tax law as the CFC's tax law), to the
extent the items of income or gain are included in the income of the tax
resident or taxable branch to which the disregarded payments are made,
as determined under Sec. 1.267A-3(a) (by treating the items of income
or gain as the specified payment); over
(B) The sum of the specified party's items of deduction or loss for
U.S. tax purposes (other than deductions for disregarded payments), to
the extent the items of deduction or loss are allowable (or have been or
will be allowable during a taxable year that ends no more than 36 months
after the end of the specified party's taxable year) under the tax law
of the tax resident or taxable branch to which the disregarded payments
are made.
(ii) Special rule for certain dividends. An item of income or gain
of a specified party that is included in the specified party's income
but not included in the income of the tax resident or taxable branch to
which the disregarded payments are made is considered described in
paragraph (b)(3)(i)(A) of this section to the extent that, under the tax
resident's or taxable branch's tax law, the item is a dividend that
would have been included in the income of the tax resident or taxable
branch but for an exemption, exclusion, deduction, credit, or other
similar relief particular to the item, provided that the party paying
the item is not allowed a deduction or other tax benefit for it under
its tax law. Similarly, an item of income or gain of a specified party
that is included in the income of the tax resident or taxable branch to
which the disregarded payments are made but not included in the
specified party's income is considered described in paragraph
(b)(3)(ii)(A) of this section to the extent that, under U.S. tax law,
the item is a dividend that would have been included in the income of
the specified party but for a dividends received deduction with respect
to the dividend (for example, a deduction under section 245A(a)),
provided that the party paying the item is not allowed a deduction or
other tax benefit for it under its tax law. See Sec. 1.267A-6(c)(3)(iv)
for an example illustrating the application of this paragraph
(b)(3)(ii).
(4) Payments made indirectly to a tax resident or taxable branch. A
specified payment made to an entity an interest of which is directly or
indirectly (determined under the rules of section 958(a) without regard
to whether an intermediate entity is foreign or domestic, or under
substantially similar rules under a tax resident's or taxable branch's
tax law) owned by a tax resident or taxable branch is considered made to
the tax resident or taxable branch to the extent that, under the tax law
of the tax resident or taxable branch, the entity to which the payment
is made is fiscally transparent (and all intermediate entities, if any,
are also fiscally transparent).
(c) Deemed branch payments--(1) In general. If a specified payment
is a
[[Page 877]]
deemed branch payment, then the payment is a disqualified hybrid amount
if the tax law of the home office provides an exclusion or exemption for
income attributable to the branch. See Sec. 1.267A-6(c)(4) for an
example illustrating the application of this paragraph (c).
(2) Definition of deemed branch payment. The term deemed branch
payment means, with respect to a U.S. taxable branch that is a U.S.
permanent establishment of a treaty resident eligible for benefits under
an income tax treaty between the United States and the treaty country,
any amount of interest or royalties allowable as a deduction in
computing the business profits of the U.S. permanent establishment, to
the extent the amount is deemed paid to the home office (or other branch
of the home office), is not regarded (or otherwise taken into account)
under the home office's tax law (or the other branch's tax law), and,
were the payment to be regarded (and treated as interest or a royalty,
as applicable) under the home office's tax law (or other branch's tax
law), the home office (or other branch) would include the payment in
income, as determined under Sec. 1.267A-3(a). An amount may be
otherwise taken into account for purposes of this paragraph (c)(2) if,
for example, under the home office's tax law a corresponding amount of
interest or royalties is allocated and attributable to the U.S.
permanent establishment and is therefore not deductible.
(d) Payments to reverse hybrids--(1) In general. If a specified
payment is made to a reverse hybrid, then, subject to Sec. 1.267A-3(b)
(amounts included or includible in income), the payment is a
disqualified hybrid amount to the extent that--
(i) An investor, the tax law of which treats the reverse hybrid as
not fiscally transparent, does not include the payment in income, as
determined under Sec. 1.267A-3(a) (to such extent, a no-inclusion); and
(ii) The investor's no-inclusion is a result of the payment being
made to the reverse hybrid. For purposes of this paragraph (d)(1)(ii),
the investor's no-inclusion is a result of the specified payment being
made to the reverse hybrid to the extent that the no-inclusion would not
occur were the investor's tax law to treat the reverse hybrid as
fiscally transparent (and treat the payment as interest or a royalty, as
applicable). See Sec. 1.267A-6(c)(5) for an example illustrating the
application of paragraph (d) of this section.
(2) Definition of reverse hybrid. The term reverse hybrid means an
entity (regardless of whether domestic or foreign) that is fiscally
transparent under the tax law of the country in which it is created,
organized, or otherwise established but not fiscally transparent under
the tax law of an investor of the entity.
(3) Payments made indirectly to a reverse hybrid. A specified
payment made to an entity an interest of which is directly or indirectly
(determined under the rules of section 958(a) without regard to whether
an intermediate entity is foreign or domestic, or under substantially
similar rules under a tax resident's or taxable branch's tax law) owned
by a reverse hybrid is considered made to the reverse hybrid to the
extent that, under the tax law of an investor of the reverse hybrid, the
entity to which the payment is made is fiscally transparent (and all
intermediate entities, if any, are also fiscally transparent).
(4) Exception for inclusion by taxable branch in establishment
country. Paragraph (d)(1) of this section does not apply to a specified
payment made to a reverse hybrid to the extent that a taxable branch
located in the country in which the reverse hybrid is created,
organized, or otherwise established (and the activities of which are
carried on by one or more investors of the reverse hybrid) includes the
payment in income, as determined under Sec. 1.267A-3(a).
(e) Branch mismatch payments--(1) In general. If a specified payment
is a branch mismatch payment, then, subject to Sec. 1.267A-3(b)
(amounts included or includible in income), the payment is a
disqualified hybrid amount to the extent that--
(i) A home office, the tax law of which treats the payment as income
attributable to a branch of the home office, does not include the
payment in income, as determined under Sec. 1.267A-3(a) (to such
extent, a no-inclusion); and
[[Page 878]]
(ii) The home office's no-inclusion is a result of the payment being
a branch mismatch payment. For purposes of this paragraph (e)(1)(ii),
the home office's no-inclusion is a result of the specified payment
being a branch mismatch payment to the extent that the no-inclusion
would not occur were the home office's tax law to treat the payment as
income that is not attributable a branch of the home office (and treat
the payment as interest or a royalty, as applicable). See Sec. 1.267A-
6(c)(6) for an example illustrating the application of paragraph (e) of
this section.
(2) Definition of branch mismatch payment. The term branch mismatch
payment means a specified payment for which the following requirements
are satisfied:
(i) Under a home office's tax law, the payment is treated as income
attributable to a branch of the home office; and
(ii) Either--
(A) The branch is not a taxable branch; or
(B) Under the branch's tax law, the payment is not treated as income
attributable to the branch.
(f) Relatedness or structured arrangement limitation. A specified
recipient, a tax resident or taxable branch to which a specified payment
is made, an investor, or a home office is taken into account for
purposes of paragraphs (a), (b), (d), and (e) of this section,
respectively, only if the specified recipient, the tax resident or
taxable branch, the investor, or the home office, as applicable, is
related (as defined in Sec. 1.267A-5(a)(14)) to the specified party or
is a party to a structured arrangement (as defined in Sec. 1.267A-
5(a)(20)) pursuant to which the specified payment is made.
[T.D. 9896, 85 FR 19836, Apr. 8, 2020]
Sec. 1.267A-3 Income inclusions and amounts not treated
as disqualified hybrid amounts.
(a) Income inclusions--(1) General rule. For purposes of section
267A, a tax resident or taxable branch includes in income a specified
payment to the extent that, under the tax law of the tax resident or
taxable branch--
(i) It takes the payment into account (or has taken the payment into
account, or, based on all the facts and circumstances, is reasonably
expected to take the payment into account during a taxable year that
ends no more than 36 months after the end of the specified party's
taxable year) in its income or tax base at the full marginal rate
imposed on ordinary income (or, if different, the full marginal rate
imposed on interest or a royalty, as applicable); and
(ii) The payment is not reduced or offset by an exemption,
exclusion, deduction, credit (other than for withholding tax imposed on
the payment), or other similar relief particular to such type of
payment. Examples of such reductions or offsets include a participation
exemption, a dividends received deduction, a deduction or exclusion with
respect to a particular category of income (such as income attributable
to a branch, or royalties under a patent box regime), a credit for
underlying taxes paid by a corporation from which a dividend is
received, and a recovery of basis with respect to stock or a recovery of
principal with respect to indebtedness. A specified payment is not
considered reduced or offset by a deduction or other similar relief
particular to the type of payment if it is offset by a generally
applicable deduction or other tax attribute, such as a deduction for
depreciation or a net operating loss. For purposes of this paragraph
(a)(1)(ii), a deduction may be treated as being generally applicable
even if it arises from a transaction related to the specified payment
(for example, if the deduction and payment are in connection with a
back-to-back financing arrangement).
(2) Coordination with foreign hybrid mismatch rules. Whether a tax
resident or taxable branch includes in income a specified payment is
determined without regard to any defensive or secondary rule contained
in hybrid mismatch rules, if any, under the tax law of the tax resident
or taxable branch. For purposes of this paragraph (a)(2), a defensive or
secondary rule means a provision of hybrid mismatch rules that requires
a tax resident or taxable branch to include an amount in income if a
deduction for the amount is not disallowed under the payer's tax law.
However, a defensive or secondary rule does not include a rule pursuant
to
[[Page 879]]
which a participation exemption or similar relief particular to a
dividend is inapplicable as to a dividend for which the payer is allowed
a deduction or other tax benefit under its tax law. Thus, a defensive or
secondary rule does not include a rule consistent with recommendation
2.1 in Chapter 2 of OECD/G-20, Neutralising the Effects of Hybrid
Mismatch Arrangements, Action 2: 2015 Final Report (October 2015).
(3) Inclusions with respect to reverse hybrids. With respect to a
tax resident or taxable branch that is an investor of a reverse hybrid,
whether the investor includes in income a specified payment made to the
reverse hybrid is determined without regard to a distribution from the
reverse hybrid (or the right to a distribution from the reverse hybrid
triggered by the payment). However, if the reverse hybrid distributes
all of its income during a taxable year, then, for that year, the
determination of whether an investor includes in income a specified
payment made to the reverse hybrid is made with regard to one or more
distributions from the reverse hybrid during the year, by treating a
portion of the specified payment as relating to each distribution during
the year. For purposes of this paragraph (a)(3), the portion of the
specified payment that is considered to relate to a distribution is the
lesser of--
(i) The specified payment multiplied by a fraction, the numerator of
which is the amount of the distribution and the denominator of which is
the aggregate amount of distributions from the reverse hybrid during the
taxable year; and
(ii) The amount of the distribution multiplied by a fraction, the
numerator of which is the specified payment and the denominator of which
is the sum of all specified payments made to the reverse hybrid during
the taxable year.
(4) Inclusions with respect to certain payments pursuant to hybrid
transactions. This paragraph (a)(4) applies to a specified payment that
is interest and that is made pursuant to a hybrid transaction, to the
extent that, under the tax law of a specified recipient of the payment,
the payment is a recovery of basis with respect to stock or a recovery
of principal with respect to indebtedness such that, but for this
paragraph (a)(4), a no-inclusion would occur with respect to the
specified recipient. In such a case, an amount that is a repayment of
principal for U.S. tax purposes and that is or has been paid (or, based
on all the facts and circumstances, is reasonably expected to be paid)
by the specified party pursuant to the hybrid transaction (such amount,
the principal payment) is, to the extent included in the income of the
specified recipient, treated as correspondingly reducing the specified
recipient's no-inclusion with respect to the specified payment. For
purposes of this paragraph (a)(4), whether the specified recipient
includes the principal payment in income is determined under paragraph
(a)(1) of this section, by treating the principal payment as the
specified payment and the taxable year period described in paragraph
(a)(1) as being composed of taxable years of the specified recipient
ending no more than 36 months after the end of the specified party's
taxable year during which the specified payment is made (as opposed to,
for example, being composed of taxable years of the specified recipient
ending no more than 36 months after the end of the specified party's
taxable year during which the principal payment is reasonably expected
to be made). Moreover, once a principal payment reduces a no-inclusion
with respect to a specified payment, it is not again taken into account
for purposes of applying this paragraph (a)(4) to another specified
payment. See Sec. 1.267A-6(c)(1)(vi) for an example illustrating the
application of this paragraph (a)(4).
(5) Deemed full inclusions and de minimis inclusions. A preferential
rate, exemption, exclusion, deduction, credit, or similar relief
particular to a type of payment that reduces or offsets 90 percent or
more of the payment is considered to reduce or offset 100 percent of the
payment. In addition, a preferential rate, exemption, exclusion,
deduction, credit, or similar relief particular to a type of payment
that reduces or offsets 10 percent or less of the payment is considered
to reduce or offset none of the payment.
[[Page 880]]
(b) Certain amounts not treated as disqualified hybrid amounts to
extent included or includible in income for U.S. tax purposes--(1) In
general. A specified payment, to the extent that but for this paragraph
(b) it would be a disqualified hybrid amount (such amount, a tentative
disqualified hybrid amount), is reduced under the rules of paragraphs
(b)(2) through (4) of this section, as applicable. The tentative
disqualified hybrid amount, as reduced under such rules, is the
disqualified hybrid amount. See Sec. 1.267A-6(c)(3) and (7) for
examples illustrating the application of paragraph (b) of this section.
(2) Included in income of United States tax resident or U.S. taxable
branch. A tentative disqualified hybrid amount is reduced to the extent
that a specified recipient that is a tax resident of the United States
or a U.S. taxable branch takes the tentative disqualified hybrid amount
into account in determining its gross income.
(3) Includible in income under section 951(a)(1)(A). A tentative
disqualified hybrid amount is reduced to the extent that the tentative
disqualified hybrid amount is received by a CFC and includible under
section 951(a)(1)(A) (determined without regard to properly allocable
deductions of the CFC, qualified deficits under section 952(c)(1)(B),
and the earnings and profits limitation under Sec. 1.952-1(c)) in the
gross income of a United States shareholder of the CFC. However, if the
United States shareholder is a domestic partnership, then the amount
includible under section 951(a)(1)(A) in the gross income of the United
States shareholder reduces the tentative disqualified hybrid amount only
to the extent that a tax resident of the United States would take into
account the amount.
(4) Includible in income under section 951A(a). A tentative
disqualified hybrid amount is reduced to the extent that the tentative
disqualified hybrid amount increases a United States shareholder's pro
rata share of tested income (as determined under Sec. Sec. 1.951A-
1(d)(2) and 1.951A-2(b)(1)) with respect to a CFC, reduces the
shareholder's pro rata share of tested loss (as determined under
Sec. Sec. 1.951A-1(d)(4) and 1.951A-2(b)(2)) of the CFC, or both.
However, to the extent that a deduction for the tentative disqualified
hybrid amount would be allowed to a tax resident of the United States or
a U.S. taxable branch, or would be allowed to a CFC but would be
allocated and apportioned to gross income of the CFC that is gross
income taken into account in determining subpart F income (as described
in section 952) or gross income that is effectively connected (or
treated as effectively connected) with the conduct of a trade or
business in the United States (as described in Sec. 1.882-4(a)(1)), the
reduction provided under this paragraph (b)(4) is equal to the reduction
that would be provided under this paragraph (b)(4) but for this sentence
multiplied by the difference of 100 percent and the percentage described
in section 250(a)(1)(B).
(5) Includible in income under section 1293. A tentative
disqualified hybrid amount is reduced to the extent that the tentative
disqualified hybrid amount is received by a qualified electing fund (as
described in section 1295) and is includible under section 1293 in the
gross income of a United States person that owns stock of that fund.
However, if the United States person is a domestic partnership, then the
amount includible under section 1293 in the gross income of the United
States person reduces the tentative disqualified hybrid amount only to
the extent that a tax resident of the United States would take into
account the amount.
[T.D. 9896, 85 FR 19836, Apr. 8, 2020]
Sec. 1.267A-4 Disqualified imported mismatch amounts.
(a) Disqualified imported mismatch amounts--(1) Rule. An imported
mismatch payment is a disqualified imported mismatch amount to the
extent that, under the set-off rules of paragraph (c) of this section,
the income attributable to the payment is directly or indirectly offset
by a hybrid deduction incurred by a foreign tax resident or foreign
taxable branch that is related to the imported mismatch payer (or that
is a party to a structured arrangement pursuant to which the payment is
made). See Sec. 1.267A-6(c)(8) through (12) for examples illustrating
the application of this section.
[[Page 881]]
(2) Definitions of certain terms. The following definitions apply
for purposes of this section:
(i) A foreign tax resident means a tax resident that is not a tax
resident of the United States.
(ii) A foreign taxable branch means a taxable branch that is not a
U.S. taxable branch.
(iii) An imported mismatch payee means, with respect to an imported
mismatch payment, a foreign tax resident or foreign taxable branch that
includes the payment in income, as determined under Sec. 1.267A-3(a).
(iv) An imported mismatch payer means, with respect to an imported
mismatch payment, the specified party.
(v) An imported mismatch payment means a specified payment to the
extent that it is neither a disqualified hybrid amount nor included or
includible in income in the United States. For purposes of this
paragraph (a)(2)(v), a specified payment is included or includible in
income in the United States to the extent that, if the payment were a
tentative disqualified hybrid amount (as described in Sec. 1.267A-
3(b)(1)), it would be reduced under the rules of Sec. 1.267A-3(b)(2)
through (5).
(b) Hybrid deduction--(1) In general. A hybrid deduction means any
of the following:
(i) A deduction allowed to a foreign tax resident or foreign taxable
branch under its tax law for an amount paid or accrued that is interest
(including an amount that would be a structured payment under the
principles of Sec. 1.267A-5(b)(5)(ii)) or royalty under such tax law,
to the extent that a deduction for the amount would be disallowed if
such tax law contained rules substantially similar to those under
Sec. Sec. 1.267A-1 through 1.267A-3 and 1.267A-5. Such a deduction is a
hybrid deduction regardless of whether or how the amount giving rise to
the deduction would be recognized under U.S. tax law.
(ii) A deduction allowed to a foreign tax resident or foreign
taxable branch under its tax law with respect to equity (including
deemed equity), such as a notional interest deduction (or similar
deduction determined with respect to the foreign tax resident's or
foreign taxable branch's equity). However, a deduction allowed to a
foreign tax resident or foreign taxable branch with respect to equity is
a hybrid deduction only to the extent that an investor of the foreign
tax resident, or the home office of the foreign taxable branch, would
include the amount in income if, for purposes of the investor's or home
office's tax law, the amount were interest paid by the foreign tax
resident ratably (by value) with respect to the interests of the foreign
tax resident, or interest paid by the foreign taxable branch to the home
office. For purposes of this paragraph (b)(1)(ii), the rules of Sec.
1.267A-3(a) apply to determine the extent that an investor or home
office would include an amount in income, by treating the amount as the
specified payment.
(2) Special rules--(i) Foreign tax law contains hybrid mismatch
rules. In the case of a foreign tax resident or foreign taxable branch
the tax law of which contains hybrid mismatch rules, only the following
deductions allowed to the foreign tax resident or foreign taxable branch
under its tax law are hybrid deductions:
(A) A deduction described in paragraph (b)(1)(i) of this section, to
the extent that the deduction would be disallowed if the foreign tax
resident's or foreign taxable branch's tax law--
(1) Contained a rule substantially similar to Sec. 1.267A-2(a)(4)
(payments pursuant to interest-free loans and similar arrangements); or
(2) Did not permit an inclusion in income in a third country to
discharge the application of its hybrid mismatch rules as to the amount
giving rise to the deduction when the amount is not included in income
in another country as a result of a hybrid or branch arrangement.
(B) A deduction described in paragraph (b)(1)(ii) of this section
(deductions with respect to equity).
(ii) Dual inclusion income used to determine hybrid deductions
arising from deemed branch payments in certain cases. In the case of a
foreign taxable branch the tax law of which permits a loss of the
foreign taxable branch to be shared with a tax resident or taxable
branch (without regard to whether it is in fact so shared or whether
there is a tax
[[Page 882]]
resident or taxable branch with which the loss can be shared), a
deduction allowed to the foreign taxable branch for an amount that would
be a deemed branch payment were such tax law to contain a provision
substantially similar to Sec. 1.267A-2(c) is a hybrid deduction to the
extent of the excess (if any) of the sum of all such amounts over the
foreign taxable branch's dual inclusion income (as determined under the
principles of Sec. 1.267A-2(b)(3)). The rule in this paragraph
(b)(2)(ii) applies without regard to whether the tax law of the home
office provides an exclusion or exemption for income attributable to the
branch.
(iii) Certain deductions are hybrid deductions only if allowed for
an accounting period beginning on or after December 20, 2018. A
deduction described in paragraph (b)(1)(ii) of this section (deductions
with respect to equity), or a deduction that would be disallowed if the
foreign tax resident's or foreign taxable branch's tax law contained a
rule substantially similar to Sec. 1.267A-2(a)(4) (payments pursuant to
interest-free loans and similar arrangements), is a hybrid deduction
only if allowed for an accounting period beginning on or after December
20, 2018.
(iv) Certain deductions of a CFC are not hybrid deductions. A
deduction that but for this paragraph (b)(2)(iv) would be a hybrid
deduction is not a hybrid deduction to the extent that the amount paid
or accrued giving rise to the deduction is--
(A) A disqualified hybrid amount (but subject to the special rule of
paragraph (g) of this section); or
(B) Included or includible in income in the United States. For
purposes of this paragraph (b)(2)(iv)(B), an amount is included or
includible in income in the United States to the extent that, if the
amount were a tentative disqualified hybrid amount (as described in
Sec. 1.267A-3(b)(1)), it would be reduced under the rules of Sec.
1.267A-3(b)(2) through (5).
(v) Loss carryovers. A hybrid deduction for a particular accounting
period includes a loss carryover from another accounting period, but
only to the extent that a hybrid deduction incurred in an accounting
period ending on or after December 20, 2018, comprises the loss
carryover.
(c) Set-off rules--(1) In general. In the order described in
paragraph (c)(2) of this section, a hybrid deduction directly or
indirectly offsets the income attributable to an imported mismatch
payment to the extent that, under paragraph (c)(3) of this section, the
payment directly or indirectly funds the hybrid deduction. The rules of
paragraphs (c)(2) and (3) of this section are applied by taking into
account the application of paragraph (c)(4) of this section (adjustments
to ensure that amounts not taken into account more than once).
(2) Ordering rules. The following ordering rules apply for purposes
of determining the extent that a hybrid deduction directly or indirectly
offsets income attributable to imported mismatch payments.
(i) First, the hybrid deduction offsets income attributable to a
factually-related imported mismatch payment that directly or indirectly
funds the hybrid deduction. For purposes of this paragraph (c)(2)(i), a
factually-related imported mismatch payment means an imported mismatch
payment that is made pursuant to a transaction, agreement, or instrument
entered into pursuant to the same plan or series of related transactions
that includes the transaction, agreement, or instrument pursuant to
which the hybrid deduction is incurred, provided that a design of the
plan or series of related transactions was for the hybrid deduction to
offset income attributable to the payment (as determined under the
principles of Sec. 1.267A-5(a)(20)(i), by treating the offset as the
``hybrid mismatch'' described in Sec. 1.267A-5(a)(20)(i)).
(ii) Second, to the extent remaining, the hybrid deduction offsets
income attributable to an imported mismatch payment (other than a
factually-related imported mismatch payment) that directly funds the
hybrid deduction.
(iii) Third, to the extent remaining, the hybrid deduction offsets
income attributable to an imported mismatch payment (other than a
factually-related imported mismatch payment) that indirectly funds the
hybrid deduction.
[[Page 883]]
(3) Funding rules. The following funding rules apply for purposes of
determining the extent that an imported mismatch payment directly or
indirectly funds a hybrid deduction.
(i) The imported mismatch payment directly funds a hybrid deduction
to the extent that the imported mismatch payee incurs the hybrid
deduction.
(ii) The imported mismatch payment indirectly funds a hybrid
deduction to the extent that the imported mismatch payee is allocated
the hybrid deduction, and provided that the imported mismatch payee is
related to the imported mismatch payer (or is a party to a structured
arrangement pursuant to which the imported mismatch payment is made).
(iii) The imported mismatch payee is allocated a hybrid deduction to
the extent that the imported mismatch payee directly or indirectly makes
a funded taxable payment to the foreign tax resident or foreign taxable
branch that incurs the hybrid deduction.
(iv) An imported mismatch payee indirectly makes a funded taxable
payment to the foreign tax resident or foreign taxable branch that
incurs a hybrid deduction to the extent that a chain of funded taxable
payments connects the imported mismatch payee, each intermediary foreign
tax resident or foreign taxable branch, and the foreign tax resident or
foreign taxable branch that incurs the hybrid deduction, and provided
that each intermediary foreign tax resident or foreign taxable branch is
related to the imported mismatch payer (or is a party to a structured
arrangement pursuant to which the imported mismatch payment is made).
(v) The term funded taxable payment means an amount paid or accrued
by a foreign tax resident or foreign taxable branch under its tax law
(other than an amount that gives rise to a hybrid deduction), to the
extent that--
(A) The amount is deductible (but, if such tax law contains hybrid
mismatch rules, determined without regard to a provision substantially
similar to this section);
(B) Another foreign tax resident or foreign taxable branch includes
the amount in income, as determined under Sec. 1.267A-3(a) (by treating
the amount as the specified payment); and
(C) The amount is neither a disqualified hybrid amount (but subject
to the special rule of paragraph (g) of this section) nor included or
includible in income in the United States. For purposes of this
paragraph (c)(3)(v)(C), an amount is included or includible in income in
the United States to the extent that, if the amount were a tentative
disqualified hybrid amount (as described in Sec. 1.267A-3(b)(1)), it
would be reduced under the rules of Sec. 1.267A-3(b)(2) through (5).
(vi) If a deduction or loss that is not incurred by a foreign tax
resident or foreign taxable branch is directly or indirectly made
available to offset income of the foreign tax resident or foreign
taxable branch under its tax law, then, for purposes of this paragraph
(c), the foreign tax resident or foreign taxable branch to which the
deduction or loss is made available and the foreign tax resident or
foreign taxable branch that incurs the deduction or loss are treated as
a single foreign tax resident or foreign taxable branch. For example, if
a deduction or loss of one foreign tax resident is made available to
offset income of another foreign tax resident under a tax consolidation,
fiscal unity, group relief, loss sharing, or any similar regime, then
the foreign tax residents are treated as a single foreign tax resident
for purposes of this paragraph (c).
(vii) An imported mismatch payee that directly makes a funded
taxable payment to the foreign tax resident or foreign taxable branch
that incurs a hybrid deduction is allocated the hybrid deduction before
the hybrid deduction (to the extent remaining) is allocated to an
imported mismatch payee that indirectly makes a funded taxable payment
to the foreign tax resident or foreign taxable branch that incurs the
hybrid deduction.
(viii) An imported mismatch payee that, through a chain of funded
taxable payments consisting of a particular number of funded taxable
payments, indirectly makes a funded taxable payment to the foreign tax
resident or foreign taxable branch that incurs a hybrid deduction is
allocated the hybrid deduction before the hybrid deduction
[[Page 884]]
(to the extent remaining) is allocated to an imported mismatch payee
that, through a chain of funded taxable payments consisting of a greater
number of funded taxable payments, indirectly makes a funded taxable
payment to the foreign tax resident or foreign taxable branch that
incurs the hybrid deduction.
(4) Adjustments to ensure amounts not taken into account more than
once. To the extent that the income attributable to an imported mismatch
payment is directly or indirectly offset by a hybrid deduction, the
imported mismatch payment, the hybrid deduction, and, if applicable,
each funded taxable payment comprising the chain of funded taxable
payments connecting the imported mismatch payee, each intermediary
foreign tax resident or foreign taxable branch, and the foreign tax
resident or foreign taxable branch that incurs the hybrid deduction is
correspondingly reduced; as a result, such amounts are not again taken
into account under this section.
(d) Calculations based on aggregate amounts during accounting
period. For purposes of this section, amounts are determined on an
accounting period basis. Thus, for example, the amount of imported
mismatch payments made by an imported mismatch payer to a particular
imported mismatch payee is equal to the aggregate amount of all such
payments made by the imported mismatch payer during the accounting
period.
(e) Pro rata adjustments. Amounts are allocated on a pro rata basis
if there would otherwise be more than one permissible manner in which to
allocate the amounts. Thus, for example, if multiple imported mismatch
payers make an imported mismatch payment to a single imported mismatch
payee, the sum of such payments exceeds the hybrid deduction incurred by
the imported mismatch payee, and the payments are not factually-related
imported mismatch payments, then a pro rata portion of each imported
mismatch payer's payment is considered to directly fund the hybrid
deduction. See Sec. 1.267A-6(c)(9) and (12) for examples illustrating
the application of this paragraph (e).
(f) Special rules regarding manner in which this section is
applied--(1) Initial application of this section. This section is first
applied without regard to paragraph (f)(2) of this section and by taking
into account only the following hybrid deductions:
(i) A hybrid deduction described in paragraph (b)(1)(i) of this
section, to the extent that--
(A) The deduction would be disallowed if the foreign tax resident's
or foreign taxable branch's tax law contained a rule substantially
similar to Sec. 1.267A-2(a)(4) (payments pursuant to interest-free
loans and similar arrangements); or
(B) The paid or accrued amount giving rise to the deduction is
included in income in a third country but is not included in income in
another country as a result of a hybrid or branch arrangement.
(ii) A hybrid deduction described in paragraph (b)(1)(ii) of this
section (deductions with respect to equity).
(2) Subsequent application of this section takes into account
certain amounts deemed to be imported mismatch payments. After this
section is applied pursuant to the rules of paragraph (f)(1) of this
section, the section is then applied by taking into account only hybrid
deductions other than those described in paragraph (f)(1) of this
section. In addition, when applying this section in the manner described
in the previous sentence, for purposes of determining the extent to
which the income attributable to an imported mismatch payment is
directly or indirectly offset by a hybrid deduction, an amount paid or
accrued by a foreign tax resident or foreign taxable branch that is not
a specified party is deemed to be an imported mismatch payment (and such
foreign tax resident or foreign taxable branch and a foreign tax
resident or foreign taxable branch that includes the amount in income,
as determined under Sec. 1.267A-3(a), by treating the amount as the
specified payment, are deemed to be an imported mismatch payer and an
imported mismatch payee, respectively) to the extent that--
(i) The tax law of such foreign tax resident or foreign taxable
branch contains hybrid mismatch rules; and
[[Page 885]]
(ii) The amount is subject to disallowance under a provision of the
hybrid mismatch rules substantially similar to this section. See Sec.
1.267A-6(c)(10) and (12) for examples illustrating the application of
paragraph (f)(2) of this section.
(g) Special rule regarding extent to which a disqualified hybrid
amount of a CFC prevents a hybrid deduction or a funded taxable payment.
A disqualified hybrid amount of a CFC is taken into account for purposes
of paragraph (b)(2)(iv)(A) or (c)(3)(v)(C) of this section (certain
deductions not hybrid deductions or funded taxable payments to the
extent the amount giving rise to the deduction is a disqualified hybrid
amount) only to the extent of the excess (if any) of the disqualified
hybrid amount over the sum of the amounts described in paragraphs (g)(1)
through (3) of this section. See Sec. 1.267A-6(c)(11) for an example
illustrating the application of this paragraph (g).
(1) The disqualified hybrid amount to the extent that, if allowed as
a deduction, it would be allocated and apportioned to residual CFC gross
income (as described in Sec. 1.951A-2(c)(5)(iii)(B)) of the CFC.
(2) The disqualified hybrid amount to the extent that, if allowed as
a deduction, it would be allocated and apportioned (under the rules of
section 954(b)(5)) to gross income that is taken into account in
determining the CFC's subpart F income (as described in section 952 and
Sec. 1.952-1), multiplied by the difference of 100 percent and the
percentage of stock (by value) of the CFC that, for purposes of sections
951 and 951A, is owned (within the meaning of section 958(a), and
determined by treating a domestic partnership as foreign) by one or more
tax residents of the United States that are United States shareholders
of the CFC.
(3) The disqualified hybrid amount to the extent that, if allowed as
a deduction, it would be allocated and apportioned (under the rules of
Sec. 1.951A-2(c)(3)) to gross tested income of the CFC (as described in
section 951A(c)(2)(A) and Sec. 1.951A-2(c)(1)), multiplied by the
difference of 100 percent and the percentage of stock (by value) of the
CFC that, for purposes of sections 951 and 951A, is owned (within the
meaning of section 958(a), and determined by treating a domestic
partnership as foreign) by one or more tax residents of the United
States that are United States shareholders of the CFC.
[T.D. 9896, 85 FR 19836, Apr. 8, 2020]
Sec. 1.267A-5 Definitions and special rules.
(a) Definitions. For purposes of Sec. Sec. 1.267A-1 through 1.267A-
7 the following definitions apply.
(1) The term accounting period means a taxable year, or a period of
similar length over which, under a provision of hybrid mismatch rules
substantially similar to Sec. 1.267A-4, computations similar to those
under Sec. 1.267A-4 are made under a foreign tax law.
(2) The term branch means a taxable presence of a tax resident in a
country other than its country of residence as determined under either
the tax resident's tax law or such other country's tax law.
(3) The term branch mismatch payment has the meaning provided in
Sec. 1.267A-2(e)(2).
(4) The term controlled foreign corporation (or CFC) has the meaning
provided in section 957.
(5) The term deemed branch payment has the meaning provided in Sec.
1.267A-2(c)(2).
(6) The term disregarded payment has the meaning provided in Sec.
1.267A-2(b)(2).
(7) The term entity means any person as described in section
7701(a)(1), including an entity that under Sec. Sec. 301.7701-1 through
301.7701-3 of this chapter is disregarded as an entity separate from its
owner, other than an individual.
(8) The term fiscally transparent means, with respect to an entity,
fiscally transparent with respect to an item of income as determined
under the principles of Sec. 1.894-1(d)(3)(ii) and (iii), without
regard to whether a tax resident (either the entity or interest holder
in the entity) that derives the item of income is a resident of a
country that has an income tax treaty with the United States. In
addition, the following special rules apply with respect to an item of
income received by an entity:
(i) The entity is fiscally transparent with respect to the item
under the tax law of the country in which the entity
[[Page 886]]
is created, organized, or otherwise established if, under that tax law,
the entity does not take the item into account in its income (without
regard to whether such tax law requires an investor of the entity,
wherever resident, to separately take into account on a current basis
the investor's respective share of the item), and the effect under that
tax law is that an investor of the entity is required to take the item
into account in its income as if the item were realized directly from
the source from which realized by the entity, whether or not
distributed.
(ii) The entity is fiscally transparent with respect to the item
under the tax law of an investor of the entity if, under that tax law,
an investor of the entity takes the item into account in its income
(without regard to whether such tax law requires the investor to
separately take into account on a current basis the investor's
respective share of the item) as if the item were realized directly from
the source from which realized by the entity, whether or not
distributed.
(iii) The entity is fiscally transparent with respect to the item
under the tax law of the country in which the entity is created,
organized, or otherwise established if--
(A) That tax law imposes a corporate income tax; and
(B) Under that tax law, neither the entity is required to take the
item into account in its income nor an investor of the entity is
required to take the item into account in its income as if the item were
realized directly from the source from which realized by the entity,
whether or not distributed.
(9) The term home office means a tax resident that has a branch.
(10) The term hybrid mismatch rules means rules, regulations, or
other tax guidance substantially similar to section 267A, and includes
rules the purpose of which is to neutralize the deduction/no-inclusion
outcome of hybrid and branch mismatch arrangements. Examples of such
rules would include rules based on, or substantially similar to, the
recommendations contained in OECD/G-20, Neutralising the Effects of
Hybrid Mismatch Arrangements, Action 2: 2015 Final Report (October
2015), and OECD/G-20, Neutralising the Effects of Branch Mismatch
Arrangements, Action 2: Inclusive Framework on BEPS (July 2017).
(11) The term hybrid transaction has the meaning provided in Sec.
1.267A-2(a)(2).
(12) The term interest means any amount described in paragraph
(a)(12)(i) or (ii) of this section that is paid or accrued, or treated
as paid or accrued, for the taxable year or that is otherwise designated
as interest expense in paragraph (a)(12)(i) or (ii) of this section.
(i) In general. Interest is an amount paid, received, or accrued as
compensation for the use or forbearance of money under the terms of an
instrument or contractual arrangement, including a series of
transactions, that is treated as a debt instrument for purposes of
section 1275(a) and Sec. 1.1275-1(d), and not treated as stock under
Sec. 1.385-3, or an amount that is treated as interest under other
provisions of the Internal Revenue Code (Code) or the regulations in
this part. Thus, interest includes, but is not limited to, the
following--
(A) Original issue discount (OID);
(B) Qualified stated interest, as adjusted by the issuer for any
bond issuance premium;
(C) OID on a synthetic debt instrument arising from an integrated
transaction under Sec. 1.1275-6;
(D) Repurchase premium to the extent deductible by the issuer under
Sec. 1.163-7(c);
(E) Deferred payments treated as interest under section 483;
(F) Amounts treated as interest under a section 467 rental
agreement;
(G) Forgone interest under section 7872;
(H) De minimis OID taken into account by the issuer;
(I) Amounts paid in connection with a sale-repurchase agreement
treated as indebtedness under Federal tax principles;
(J) Redeemable ground rent treated as interest under section 163(c);
and
(K) Amounts treated as interest under section 636.
(ii) Swaps with significant nonperiodic payments--(A) In general.
Except as provided in paragraphs (a)(12)(ii)(B) and (C) of this section,
a swap with significant nonperiodic payments is treated
[[Page 887]]
as two separate transactions consisting of an on-market, level payment
swap and a loan. The loan must be accounted for by the parties to the
contract independently of the swap. The time value component associated
with the loan, determined in accordance with Sec. 1.446-
3(f)(2)(iii)(A), is recognized as interest expense to the payor.
(B) Exception for cleared swaps. Paragraph (a)(12)(ii)(A) of this
section does not apply to a cleared swap. The term cleared swap means a
swap that is cleared by a derivatives clearing organization, as such
term is defined in section 1a of the Commodity Exchange Act (7 U.S.C.
1a), or by a clearing agency, as such term is defined in section 3 of
the Securities Exchange Act of 1934 (15 U.S.C. 78c), that is registered
as a derivatives clearing organization under the Commodity Exchange Act
or as a clearing agency under the Securities Exchange Act of 1934,
respectively, if the derivatives clearing organization or clearing
agency requires the parties to the swap to post and collect margin or
collateral.
(C) Exception for non-cleared swaps subject to margin or collateral
requirements. Paragraph (a)(12)(ii)(A) of this section does not apply to
a non-cleared swap that requires the parties to meet the margin or
collateral requirements of a Federal regulator or that provides for
margin or collateral requirements that are substantially similar to a
cleared swap or a non-cleared swap subject to the margin or collateral
requirements of a Federal regulator. For purposes of this paragraph
(a)(12)(ii)(C), the term Federal regulator means the Securities and
Exchange Commission (SEC), the Commodity Futures Trading Commission
(CFTC), or a prudential regulator, as defined in section 1a(39) of the
Commodity Exchange Act (7 U.S.C. 1a), as amended by section 721 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,
Public Law 111-203, 124 Stat. 1376, Title VII.
(13) The term investor means, with respect to an entity, any tax
resident or taxable branch that directly or indirectly (determined under
the rules of section 958(a) without regard to whether an intermediate
entity is foreign or domestic, or under substantially similar rules
under a tax resident's or taxable branch's tax law) owns an interest in
the entity.
(14) The term related has the meaning provided in this paragraph
(a)(14). A tax resident or taxable branch is related to a specified
party if the tax resident or taxable branch is a related person within
the meaning of section 954(d)(3), determined by treating the specified
party as the ``controlled foreign corporation'' referred to in section
954(d)(3) and the tax resident or taxable branch as the ``person''
referred to in section 954(d)(3). In addition, for the purposes of this
paragraph (a)(14), a tax resident that under Sec. Sec. 301.7701-1
through 301.7701-3 of this chapter is disregarded as an entity separate
from its owner for U.S. tax purposes, as well as a taxable branch, is
treated as a corporation. See also Sec. 1.954-1(f)(2)(iv)(B)(1)
(neither section 318(a)(3), nor Sec. 1.958-2(d) or the principles
thereof, applies to attribute stock or other interests).
(15) The term reverse hybrid has the meaning provided in Sec.
1.267A-2(d)(2).
(16) The term royalty includes amounts paid or accrued as
consideration for the use of, or the right to use--
(i) Any copyright, including any copyright of any literary,
artistic, scientific or other work (including cinematographic films and
software);
(ii) Any patent, trademark, design or model, plan, secret formula or
process, or other similar property (including goodwill); or
(iii) Any information concerning industrial, commercial or
scientific experience, but does not include--
(A) Amounts paid or accrued for after-sales services;
(B) Amounts paid or accrued for services rendered by a seller to the
purchaser under a warranty;
(C) Amounts paid or accrued for pure technical assistance; or
(D) Amounts paid or accrued for an opinion given by an engineer,
lawyer or accountant.
(17) The term specified party means a tax resident of the United
States, a CFC (other than a CFC with respect to which there is not a tax
resident of the United States that, for purposes of sections 951 and
951A, owns (within the
[[Page 888]]
meaning of section 958(a), and determined by treating a domestic
partnership as foreign) at least ten percent (by vote or value) of the
stock of the CFC), and a U.S. taxable branch. Thus, an entity that is
fiscally transparent for U.S. tax purposes is not a specified party,
though an owner of the entity may be a specified party. For example, in
the case of a payment by a partnership, a domestic corporation that is a
partner of the partnership is a specified party and a deduction for its
allocable share of the payment is subject to disallowance under section
267A.
(18) The term specified payment has the meaning provided in Sec.
1.267A-1(b).
(19) The term specified recipient means, with respect to a specified
payment, any tax resident that derives the payment under its tax law or
any taxable branch to which the payment is attributable under its tax
law (or any tax resident that, based on all the facts and circumstances,
is reasonably expected to derive the payment under its tax law, or any
taxable branch to which, based on all the facts and circumstances, the
payment is reasonably expected to be attributable under its tax law).
The principles of Sec. 1.894-1(d)(1) apply for purposes of determining
whether a tax resident derives (or is reasonably expected to derive) a
specified payment under its tax law, without regard to whether the tax
resident is a resident of a country that has an income tax treaty with
the United States. There may be more than one specified recipient with
respect to a specified payment.
(20) The terms structured arrangement and party to a structured
arrangement have the meaning set forth in this paragraph (a)(20).
(i) Structured arrangement. A structured arrangement means an
arrangement with respect to which one or more specified payments would
be a disqualified hybrid amount (or a disqualified imported mismatch
amount) without regard to the relatedness limitation in Sec. 1.267A-
2(f) (or without regard to the phrase ``that is related to the specified
party'' in Sec. 1.267A-4(a)) (either such outcome, a hybrid mismatch),
provided that, based on all the facts and circumstances (including the
terms of the arrangement), the arrangement is designed to produce the
hybrid mismatch. Facts and circumstances that indicate the arrangement
is designed to produce the hybrid mismatch include the following:
(A) The hybrid mismatch is priced into the terms of the arrangement,
including--
(1) The pricing of the arrangement is different from what the
pricing would have been absent the hybrid mismatch;
(2) Features that alter the terms of the arrangement, including its
return if the hybrid mismatch is no longer available; or
(3) A below-market return absent the tax effects or benefits
resulting from the hybrid mismatch.
(B) The arrangement is marketed as tax-advantaged where some or all
of the tax advantage derives from the hybrid mismatch.
(C) The arrangement is marketed to tax residents of a country the
tax law of which enables the hybrid mismatch.
(ii) Party to a structured arrangement. A party to a structured
arrangement means a tax resident, a taxable branch, or an entity that
participates in the structured arrangement. For purposes of this
paragraph (a)(20)(ii), in the case of an entity, the entity's
participation in a structured arrangement is imputed to its investors.
However, a tax resident, a taxable branch or an entity (the relevant
party) is considered to participate in the structured arrangement only
if--
(A) The relevant party (or a related tax resident or taxable branch,
determined under paragraph (a)(14) of this section by treating the
relevant party as a specified party) could, based on all the facts and
circumstances, reasonably be expected to be aware of the hybrid
mismatch; and
(B) The relevant party or one or more of its investors (or a related
tax resident or taxable branch, determined under paragraph (a)(14) of
this section by treating the relevant party or an investor as a
specified party) shares in the value of the tax benefit resulting from
the hybrid mismatch.
(21) The term tax law of a country includes statutes, regulations,
administrative or judicial rulings, and income tax treaties of the
country. If a country has an income tax treaty with the
[[Page 889]]
United States that applies to taxes imposed by a political subdivision
or other local authority of that country, then the tax law of the
political subdivision or other local authority is deemed to be a tax law
of a country. When used with respect to a tax resident or branch, tax
law refers to--
(i) In the case of a tax resident, the tax law of the country or
countries where the tax resident is resident; and
(ii) In the case of a branch, the tax law of the country where the
branch is located.
(22) The term taxable branch means a branch that has a taxable
presence under its tax law.
(23) The term tax resident means either of the following:
(i) A body corporate or other entity or body of persons liable to
tax under the tax law of a country as a resident. For purposes of this
paragraph (a)(23)(i), an entity that is created, organized, or otherwise
established under the tax law of a country that does not impose a
corporate income tax is treated as liable to tax under the tax law of
such country as a resident if under the corporate or commercial laws of
such country the entity is treated as a body corporate or a company. A
body corporate or other entity or body of persons may be a tax resident
of more than one country.
(ii) An individual liable to tax under the tax law of a country as a
resident. An individual may be a tax resident of more than one country.
(24) The term United States shareholder has the meaning provided in
section 951(b).
(25) The term U.S. taxable branch means a trade or business carried
on in the United States by a tax resident of another country, except
that if an income tax treaty applies, the term means a permanent
establishment of a tax treaty resident eligible for benefits under an
income tax treaty between the United States and the treaty country.
Thus, for example, a U.S. taxable branch includes a U.S. trade or
business of a foreign corporation taxable under section 882(a) or a U.S.
permanent establishment of a tax treaty resident.
(b) Special rules. For purposes of Sec. Sec. 1.267A-1 through
1.267A-7, the following special rules apply.
(1) Coordination with other provisions--(i) In general. Except as
provided in paragraph (b)(1)(ii) of this section, a specified payment is
subject to section 267A after the application of any other applicable
provisions of the Code and regulations in this part. Thus, the
determination of whether a deduction for a specified payment is
disallowed under section 267A is made with respect to the taxable year
for which a deduction for the payment would otherwise be allowed for
U.S. tax purposes. See, for example, sections 163(e)(3) and 267(a)(3)
for rules that may defer the taxable year for which a deduction is
allowed. See also Sec. 1.882-5(a)(5) (providing that provisions that
disallow interest expense apply after the application of Sec. 1.882-5).
In addition, provisions that characterize amounts paid or accrued as
something other than interest or royalties, such as Sec. 1.894-1(d)(2),
govern the treatment of such amounts and therefore such amounts would
not be treated as specified payments. Moreover, to the extent that a
specified payment is not described in Sec. 1.267A-1(b) when it is
subject to section 267A, the payment is not again subject to section
267A at a later time. For example, if for the taxable year in which a
specified payment is paid the payment is not described in Sec. 1.267A-
1(b) but under section 163(j) a deduction for the payment is deferred,
the payment is not again subject to section 267A in the taxable year for
which section 163(j) no longer defers the deduction.
(ii) Section 267A applied before certain provisions. In addition to
the extent provided in any other applicable provision of the Code or
regulations in this part, section 267A applies before the application of
sections 163(j), 461(l), 465, and 469.
(iii) Coordination with capitalization and recovery provisions. To
the extent a specified payment is described in Sec. 1.267A-1(b), a
deduction for the payment is considered permanently disallowed for all
purposes of the Code and regulations in this part and, therefore, the
payment is not taken into account for purposes of computing costs that
[[Page 890]]
are required to be capitalized and recovered through depreciation,
amortization, cost of goods sold, adjustment to basis, or similar forms
of recovery under any applicable provision of the Code or in regulations
in this part. Thus, for example, to the extent an interest or royalty
payment is a specified payment described in Sec. 1.267A-1(b), the
payment is not capitalized and included in inventory cost or added to
basis under section 263A. As an additional example, to the extent that a
debt issuance cost is a specified payment described in Sec. 1.267A-
1(b), it is neither capitalized under section 263 or the regulations in
this part under section 263 nor recoverable under Sec. 1.446-5.
(iv) Specified payments arising in taxable years beginning before
January 1, 2018. Section 267A does not apply to a specified payment that
is paid or accrued in a taxable year beginning before January 1, 2018,
regardless of whether under a provision of the Code or regulations in
this part (for example, section 267(a)(3)) a deduction for the payment
is deferred to a taxable year beginning after December 31, 2017, or
whether the payment is carried over to another taxable year and under
another provision of the Code (for example, section 163(j)) is
considered paid or accrued in such taxable year.
(2) Foreign currency gain or loss. Except as set forth in this
paragraph (b)(2), section 988 gain or loss is not taken into account
under section 267A. Foreign currency gain or loss recognized with
respect to a specified payment is taken into account under section 267A
to the extent that a deduction for the specified payment is disallowed
under section 267A, provided that the foreign currency gain or loss is
described in Sec. 1.988-2(b)(4) (relating to exchange gain or loss
recognized by the issuer of a debt instrument with respect to accrued
interest) or Sec. 1.988-2(c) (relating to items of expense or gross
income or receipts which are to be paid after the date accrued). If a
deduction for a specified payment is disallowed under section 267A, then
a proportionate amount of foreign currency loss under section 988 with
respect to the specified payment is also disallowed, and a proportionate
amount of foreign currency gain under section 988 with respect to the
specified payment reduces the amount of the disallowance. For purposes
of this paragraph (b)(2), the proportionate amount is the amount of the
foreign currency gain or loss under section 988 with respect to the
specified payment multiplied by a fraction, the numerator of which is
the amount of the specified payment for which a deduction is disallowed
under section 267A and the denominator of which is the total amount of
the specified payment.
(3) U.S. taxable branch payments--(i) Amounts considered paid or
accrued by a U.S. taxable branch. For purposes of section 267A, a U.S.
taxable branch is considered to pay or accrue an amount of interest or
royalty equal to either--
(A) The amount of interest or royalty allocable to effectively
connected income of the U.S. taxable branch under section 873(a) or
882(c)(1), as applicable; or
(B) In the case of a U.S. taxable branch that is a U.S. permanent
establishment of a treaty resident eligible for benefits under an income
tax treaty between the United States and the treaty country, the amount
of interest or royalty allowable in computing the business profits
attributable to the U.S. permanent establishment.
(ii) Treatment of U.S. taxable branch payments--(A) Interest.
Interest considered paid or accrued by a U.S. taxable branch of a
foreign corporation under paragraph (b)(3)(i) of this section (the
``U.S. taxable branch interest payment'') is treated as a payment
directly to the person to which the interest is payable, to the extent
it is paid or accrued with respect to a liability described in Sec.
1.882-5(a)(1)(ii)(A) or (B) (resulting in directly allocable interest)
or with respect to a U.S. booked liability, as described in Sec. 1.882-
5(d)(2). If the U.S. taxable branch interest payment exceeds in the
aggregate the interest paid or accrued on the U.S. taxable branch's
directly allocable interest and interest paid or accrued on U.S. booked
liabilities, the excess amount is treated as paid or accrued by the U.S.
taxable branch on a pro-rata basis to the same persons and pursuant to
the same terms that the home office paid or accrued interest, excluding
any directly allocable interest or interest
[[Page 891]]
paid or accrued on a U.S. booked liability. The rules of this paragraph
(b)(3)(ii) for determining to whom interest is paid or accrued apply
without regard to whether the U.S. taxable branch interest payment is
determined under the method described in Sec. 1.882-5(b) through (d) or
the method described in Sec. 1.882-5(e).
(B) Royalties. Royalties considered paid or accrued by a U.S.
taxable branch under paragraph (b)(3)(i) of this section are treated
solely for purposes of section 267A as paid or accrued on a pro-rata
basis by the U.S. taxable branch to the same persons and pursuant to the
same terms that the home office paid or accrued such royalties.
(C) Permanent establishments and interbranch payments. If a U.S.
taxable branch is a permanent establishment in the United States, the
principles of the rules in paragraphs (b)(3)(ii)(A) and (B) of this
section apply with respect to interest and royalties allowed in
computing the business profits of a treaty resident eligible for treaty
benefits. This paragraph (b)(3)(ii)(C) does not apply to interbranch
interest or royalty payments allowed as deduction under certain U.S.
income tax treaties (as described in Sec. 1.267A-2(c)(2)).
(4) Effect on earnings and profits. The disallowance of a deduction
under section 267A does not affect whether the amount paid or accrued
that gave rise to the deduction reduces earnings and profits of a
corporation. However, for purposes of section 952(c)(1) and Sec. 1.952-
1(c), a CFC's earnings and profits are not reduced by a specified
payment a deduction for which is disallowed under section 267A, if a
principal purpose of the transaction pursuant to which the payment is
made is to reduce or limit the CFC's subpart F income.
(5) Application to structured payments--(i) In general. For purposes
of section 267A and the regulations in this part under section 267A, a
structured payment (as defined in paragraph (b)(5)(ii) of this section)
is treated as interest. Thus, a structured payment is treated as subject
to section 267A and the regulations in this part under section 267A to
the same extent as if the payment were an amount of interest paid or
accrued.
(ii) Structured payment. A structured payment means any amount
described in paragraph (b)(5)(ii)(A) or (B) of this section.
(A) Substitute interest payments. A substitute interest payment
described in Sec. 1.861-2(a)(7) is treated as a structured payment for
purposes of section 267A, unless the payment relates to a sale-
repurchase agreement or a securities lending transaction that is entered
into by the payor in the ordinary course of the payor's business. This
paragraph (b)(5)(ii)(A) does not apply to an amount described in
paragraph (a)(12)(i)(I) of this section.
(B) Amounts economically equivalent to interest--(1) Principal
purpose to reduce interest expense. Any expense or loss economically
equivalent to interest is treated as a structured payment for purposes
of section 267A if a principal purpose of structuring the transaction(s)
is to reduce an amount incurred by the taxpayer that otherwise would
have been described in paragraph (a)(12) or (b)(5)(ii)(A) of this
section. For purposes of this paragraph (b)(5)(ii)(B)(1), the fact that
the taxpayer has a business purpose for obtaining the use of funds does
not affect the determination of whether the manner in which the taxpayer
structures the transaction(s) is with a principal purpose of reducing
the taxpayer's interest expense. In addition, the fact that the taxpayer
has obtained funds at a lower pre-tax cost based on the structure of the
transaction(s) does not affect the determination of whether the manner
in which the taxpayer structures the transaction(s) is with a principal
purpose of reducing the taxpayer's interest expense. For purposes of
this paragraph (b)(5)(ii)(B), any expense or loss is economically
equivalent to interest to the extent that the expense or loss is--
(i) Deductible by the taxpayer;
(ii) Incurred by the taxpayer in a transaction or series of
integrated or related transactions in which the taxpayer secures the use
of funds for a period of time;
(iii) Substantially incurred in consideration of the time value of
money; and
(iv) Not described in paragraph (a)(12) or (b)(5)(ii)(A) of this
section.
[[Page 892]]
(2) Principal purpose. Whether a transaction or a series of
integrated or related transactions is entered into with a principal
purpose described in paragraph (b)(5)(ii)(B)(1) of this section depends
on all the facts and circumstances related to the transaction(s). A
purpose may be a principal purpose even though it is outweighed by other
purposes (taken together or separately). Factors to be taken into
account in determining whether one of the taxpayer's principal purposes
for entering into the transaction(s) include the taxpayer's normal
borrowing rate in the taxpayer's functional currency, whether the
taxpayer would enter into the transaction(s) in the ordinary course of
the taxpayer's trade or business, whether the parties to the
transaction(s) are related persons (within the meaning of section 267(b)
or 707(b)), whether there is a significant and bona fide business
purpose for the structure of the transaction(s), whether the
transactions are transitory, for example, due to a circular flow of cash
or other property, and the substance of the transaction(s).
(6) Anti-avoidance rule. A specified party's deduction for a
specified payment is disallowed to the extent that both of the following
requirements are satisfied:
(i) The payment (or income attributable to the payment) is not
included in the income of a tax resident or taxable branch, as
determined under Sec. 1.267A-3(a) (but without regard to the deemed
full inclusion rule in Sec. 1.267A-3(a)(5)).
(ii) A principal purpose of the terms or structure of the
arrangement (including the form and the tax laws of the parties to the
arrangement) is to avoid the application of the regulations in this part
under section 267A in a manner that is contrary to the purposes of
section 267A and the regulations in this part under section 267A.
[T.D. 9896, 85 FR 19836, Apr. 8, 2020, as amended by 85 FR 48651, Aug.
12, 2020]
Sec. 1.267A-6 Examples.
(a) Scope. This section provides examples that illustrate the
application of Sec. Sec. 1.267A-1 through 1.267A-5.
(b) Presumed facts. For purposes of the examples in this section,
unless otherwise indicated, the following facts are presumed:
(1) US1, US2, and US3 are domestic corporations that are tax
residents solely of the United States.
(2) FW, FX, and FZ are bodies corporate established in, and tax
residents of, Country W, Country X, and Country Z, respectively. They
are not fiscally transparent under the tax law of any country. They are
not specified parties.
(3) Under the tax law of each country, interest and royalty payments
are deductible.
(4) The tax law of each country provides a 100 percent participation
exemption for dividends received from non-resident corporations.
(5) The tax law of each country, other than the United States,
provides an exemption for income attributable to a branch.
(6) Except as provided in paragraphs (b)(4) and (5) of this section,
all amounts derived (determined under the principles of Sec. 1.894-
1(d)(1)) by a tax resident, or attributable to a taxable branch, are
included in income, as determined under Sec. 1.267A-3(a).
(7) Only the tax law of the United States contains hybrid mismatch
rules.
(c) Examples--(1) Example 1. Payment pursuant to a hybrid financial
instrument--(i) Facts. FX holds all the interests of US1. FX also holds
an instrument issued by US1 that is treated as equity for Country X tax
purposes and indebtedness for U.S. tax purposes (the FX-US1 instrument).
On date 1, US1 pays $50x to FX pursuant to the instrument. The amount is
treated as an excludible dividend for Country X tax purposes (by reason
of the Country X participation exemption) and as interest for U.S. tax
purposes.
(ii) Analysis. US1 is a specified party and thus a deduction for its
$50x specified payment is subject to disallowance under section 267A. As
described in paragraphs (c)(1)(ii)(A) through (C) of this section, the
entire $50x payment is a disqualified hybrid amount under the hybrid
transaction rule of Sec. 1.267A-2(a) and, as a result, a deduction for
the payment is disallowed under Sec. 1.267A-1(b)(1).
[[Page 893]]
(A) US1's payment is made pursuant to a hybrid transaction because a
payment with respect to the FX-US1 instrument is treated as interest for
U.S. tax purposes but not for purposes of Country X tax law (the tax law
of FX, a specified recipient that is related to US1). See Sec. 1.267A-
2(a)(2) and (f). Therefore, Sec. 1.267A-2(a) applies to the payment.
(B) For US1's payment to be a disqualified hybrid amount under Sec.
1.267A-2(a), a no-inclusion must occur with respect to FX. See Sec.
1.267A-2(a)(1)(i). As a consequence of the Country X participation
exemption, FX includes $0 of the payment in income and therefore a $50x
no-inclusion occurs with respect to FX. See Sec. 1.267A-3(a)(1). The
result is the same regardless of whether, under the Country X
participation exemption, the $50x payment is simply excluded from FX's
taxable income or, instead, is reduced or offset by other means, such as
a $50x dividends received deduction. See Sec. 1.267A-3(a)(1).
(C) Pursuant to Sec. 1.267A-2(a)(1)(ii), FX's $50x no-inclusion
gives rise to a disqualified hybrid amount to the extent that it is a
result of US1's payment being made pursuant to the hybrid transaction.
FX's $50x no-inclusion is a result of the payment being made pursuant to
the hybrid transaction because, were the payment to be treated as
interest for Country X tax purposes, FX would include $50x in income
and, consequently, the no-inclusion would not occur.
(iii) Alternative facts--multiple specified recipients. The facts
are the same as in paragraph (c)(1)(i) of this section, except that FX
holds all the interests of FZ, which is fiscally transparent for Country
X tax purposes, and FZ holds all of the interests of US1. Moreover, the
FX-US1 instrument is held by FZ (rather than by FX) and US1 makes its
$50x payment to FZ (rather than to FX); the payment is derived by FZ
under its tax law and by FX under its tax law and, accordingly, both FZ
and FX are specified recipients of the payment. Further, the payment is
treated as interest for Country Z tax purposes and FZ includes it in
income. For the reasons described in paragraph (c)(1)(ii) of this
section, FX's no-inclusion causes the payment to be a disqualified
hybrid amount. FZ's inclusion in income (regardless of whether Country Z
has a low or high tax rate) does not affect the result, because the
hybrid transaction rule of Sec. 1.267A-2(a) applies if any no-inclusion
occurs with respect to a specified recipient of the payment as a result
of the payment being made pursuant to the hybrid transaction.
(iv) Alternative facts--preferential rate. The facts are the same as
in paragraph (c)(1)(i) of this section, except that for Country X tax
purposes US1's payment is treated as a dividend subject to a 4% tax
rate, whereas the marginal rate imposed on ordinary income is 20%. FX
includes $10x of the payment in income, calculated as $50x multiplied by
0.2 (.04, the rate at which the particular type of payment (a dividend
for Country X tax purposes) is subject to tax in Country X, divided by
0.2, the marginal tax rate imposed on ordinary income). See Sec.
1.267A-3(a)(1). Thus, a $40x no-inclusion occurs with respect to FX
($50x less $10x). The $40x no-inclusion is a result of the payment being
made pursuant to the hybrid transaction because, were the payment to be
treated as interest for Country X tax purposes, FX would include the
entire $50x in income at the full marginal rate imposed on ordinary
income (20%) and, consequently, the no-inclusion would not occur.
Accordingly, $40x of US1's payment is a disqualified hybrid amount.
(v) Alternative facts--no-inclusion not the result of hybridity. The
facts are the same as in paragraph (c)(1)(i) of this section, except
that Country X has a pure territorial regime (that is, Country X only
taxes income with a domestic source). Although US1's payment is pursuant
to a hybrid transaction and a $50x no-inclusion occurs with respect to
FX, FX's no-inclusion is not a result of the payment being made pursuant
to the hybrid transaction. This is because if Country X tax law were to
treat the payment as interest, FX would include $0 in income and,
consequently, the $50x no-inclusion would still occur. Accordingly,
US1's payment is not a disqualified hybrid amount. See Sec. 1.267A-
2(a)(1)(ii). The result would be the same if Country X instead did not
impose a corporate income tax.
(vi) Alternative facts--indebtedness under both tax laws but
different ordering
[[Page 894]]
rules give rise to hybrid transaction; reduction of no-inclusion by
reason of inclusion of a principal payment. The facts are the same as in
paragraph (c)(1)(i) of this section, except that the FX-US1 instrument
is indebtedness for both U.S. and Country X tax purposes. In addition,
the $50x date 1 payment is treated as interest for U.S. tax purposes and
a repayment of principal for Country X tax purposes. On date 1, based on
all the facts and circumstances (including the terms of the FX-US1
instrument, the tax laws of the United States and Country X, and an
absence of a plan pursuant to which FX would dispose of the FX-US1
instrument), it is reasonably expected that on date 2 (a date that is
within 36 months after the end of the taxable year of US1 that includes
date 1), US1 will pay a total of $200x to FX and that, for U.S. tax
purposes, $25x will be treated as interest and $175x as a repayment of
principal, and, for Country X tax purposes, $75x will be treated as
interest (and included in FX's income) and $125x as a repayment of
principal. US1's $50x specified payment is made pursuant to a hybrid
transaction and, but for Sec. 1.267A-3(a)(4), a $50x no-inclusion would
occur with respect to FX. See Sec. Sec. 1.267A-2(a)(2) and 1.267A-
3(a)(1). However, pursuant to Sec. 1.267A-3(a)(4), FX's inclusion in
income with respect to $50x of the date 2 amount that is a repayment of
principal for U.S. tax purposes is treated as correspondingly reducing
FX's no-inclusion with respect to the specified payment. As a result, as
to US1's $50x specified payment, a no-inclusion does not occur with
respect to FX. See Sec. 1.267A-3(a)(4). Therefore, US1's $50x specified
payment is not a disqualified hybrid amount. See Sec. 1.267A-
2(a)(1)(i).
(2) Example 2. Payment pursuant to a repo transaction--(i) Facts. FX
holds all the interests of US1, and US1 holds all the interests of US2.
On date 1, US1 and FX enter into a sale and repurchase transaction.
Pursuant to the transaction, US1 transfers shares of preferred stock of
US2 to FX in exchange for $1,000x, subject to a binding commitment of
US1 to reacquire those shares on date 3 for an agreed price, which
represents a repayment of the $1,000x plus a financing or time value of
money return reduced by the amount of any distributions paid with
respect to the preferred stock between dates 1 and 3 that are retained
by FX. On date 2, US2 pays a $100x dividend on its preferred stock to
FX. For Country X tax purposes, FX is treated as owning the US2
preferred stock and therefore is the beneficial owner of the dividend.
For U.S. tax purposes, the transaction is treated as a loan from FX to
US1 that is secured by the US2 preferred stock. Thus, for U.S. tax
purposes, US1 is treated as owning the US2 preferred stock and is the
beneficial owner of the dividend. In addition, for U.S. tax purposes,
US1 is treated as paying $100x of interest to FX (an amount
corresponding to the $100x dividend paid by US2 to FX). Further, the
marginal tax rate imposed on ordinary income under Country X tax law is
25%. Moreover, instead of a participation exemption, Country X tax law
provides its tax residents a credit for underlying foreign taxes paid by
a non-resident corporation from which a dividend is received; with
respect to the $100x dividend received by FX from US2, the credit is
$10x.
(ii) Analysis. US1 is a specified party and thus a deduction for its
$100x specified payment is subject to disallowance under section 267A.
As described in paragraphs (c)(2)(ii)(A) through (D) of this section,
$40x of the payment is a disqualified hybrid amount under the hybrid
transaction rule of Sec. 1.267A-2(a) and, as a result, $40x of the
deduction is disallowed under Sec. 1.267A-1(b)(1).
(A) Although US1's $100x interest payment is not regarded under
Country X tax law, a connected amount (US2's dividend payment) is
regarded and derived by FX under such tax law. Thus, FX is considered a
specified recipient with respect to US1's interest payment. See Sec.
1.267A-2(a)(3).
(B) US1's payment is made pursuant to a hybrid transaction because a
payment with respect to the sale and repurchase transaction is treated
as interest for U.S. tax purposes but not for purposes of Country X tax
law (the tax law of FX, a specified recipient that is related to US1),
which does not regard the payment. See Sec. 1.267A-2(a)(2) and (f).
Therefore, Sec. 1.267A-2(a) applies to the payment.
[[Page 895]]
(C) For US1's payment to be a disqualified hybrid amount under Sec.
1.267A-2(a), a no-inclusion must occur with respect to FX. See Sec.
1.267A-2(a)(1)(i). As a consequence of Country X tax law not regarding
US1's payment, FX includes $0 of the payment in income and therefore a
$100x no-inclusion occurs with respect to FX. See Sec. 1.267A-3(a).
However, FX includes $60x of a connected amount (US2's dividend payment)
in income, calculated as $100x (the amount of the dividend) less $40x
(the portion of the connected amount that is not included in income in
Country X due to the foreign tax credit, determined by dividing the
amount of the credit, $10x, by 0.25, the tax rate in Country X). See
Sec. 1.267A-3(a). Pursuant to Sec. 1.267A-2(a)(3), FX's inclusion in
income with respect to the connected amount correspondingly reduces the
amount of its no-inclusion with respect to US1's payment. Therefore, for
purposes of Sec. 1.267A-2(a), FX's no-inclusion with respect to US1's
payment is $40x ($100x less $60x). See Sec. 1.267A-2(a)(3).
(D) Pursuant to Sec. 1.267A-2(a)(1)(ii), FX's $40x no-inclusion
gives rise to a disqualified hybrid amount to the extent that FX's no-
inclusion is a result of US1's payment being made pursuant to the hybrid
transaction. FX's $40x no-inclusion is a result of US1's payment being
made pursuant to the hybrid transaction because, were the sale and
repurchase transaction to be treated as a loan from FX to US1 for
Country X tax purposes, FX would include US1's $100x interest payment in
income (because it would not be entitled to a foreign tax credit) and,
consequently, the no-inclusion would not occur.
(iii) Alternative facts--structured arrangement. The facts are the
same as in paragraph (c)(2)(i) of this section, except that FX is a bank
that is unrelated to US1. In addition, the sale and repurchase
transaction is a structured arrangement and FX is a party to the
structured arrangement. The result is the same as in paragraph
(c)(2)(ii) of this section. That is, even though FX is not related to
US1, it is taken into account with respect to the determinations under
Sec. 1.267A-2(a) because it is a party to a structured arrangement
pursuant to which the payment is made. See Sec. 1.267A-2(f).
(3) Example 3. Disregarded payment--(i) Facts. FX holds all the
interests of US1. For Country X tax purposes, US1 is a disregarded
entity of FX. During taxable year 1, US1 pays $100x to FX pursuant to a
debt instrument. The amount is treated as interest for U.S. tax purposes
but is disregarded for Country X tax purposes as a transaction involving
a single taxpayer. During taxable year 1, US1's only other items of
income, gain, deduction, or loss are $125x of gross income (the entire
amount of which is included in US1's income) and a $60x item of
deductible expense. The $125x item of gross income is included in FX's
income, and the $60x item of deductible expense is allowable for Country
X tax purposes.
(ii) Analysis. US1 is a specified party and thus a deduction for its
$100x specified payment is subject to disallowance under section 267A.
As described in paragraphs (c)(3)(ii)(A) and (B) of this section, $35x
of the payment is a disqualified hybrid amount under the disregarded
payment rule of Sec. 1.267A-2(b) and, as a result, $35x of the
deduction is disallowed under Sec. 1.267A-1(b)(1).
(A) US1's $100x payment is not regarded under the tax law of Country
X (the tax law of FX, a related tax resident to which the payment is
made) because under such tax law the payment involves a single taxpayer.
See Sec. 1.267A-2(b)(2) and (f). In addition, were the tax law of
Country X to regard the payment (and treat it as interest), FX would
include it in income. Therefore, the payment is a disregarded payment to
which Sec. 1.267A-2(b) applies. See Sec. 1.267A-2(b)(2).
(B) Under Sec. 1.267A-2(b)(1), the excess (if any) of US1's
disregarded payments for taxable year 1 ($100x) over its dual inclusion
income for the taxable year is a disqualified hybrid amount. US1's dual
inclusion income for taxable year 1 is $65x, calculated as $125x (the
amount of US1's gross income that is included in FX's income) less $60x
(the amount of US1's deductible expenses, other than deductions for
disregarded payments, that are allowable for Country X tax purposes).
See Sec. 1.267A-2(b)(3). Therefore, $35x is a disqualified hybrid
amount ($100x less $65x). See Sec. 1.267A-2(b)(1).
[[Page 896]]
(iii) Alternative facts--non-dual inclusion income arising from
hybrid transaction. The facts are the same as in paragraph (c)(3)(i) of
this section, except that US1 holds all the interests of FZ (a specified
party that is a CFC) and US1's only item of income, gain, deduction, or
loss during taxable year 1 (other than the $100x payment to FX) is $80x
paid to US1 by FZ pursuant to an instrument treated as indebtedness for
U.S. and Country Z tax purposes and equity for Country X tax purposes
(the US1-FZ instrument). The $80x is treated as interest for Country Z
and U.S. tax purposes (the entire amount of which is included in US1's
income) and is treated as an excludible dividend for Country X tax
purposes (by reason of the Country X participation exemption).
Paragraphs (c)(3)(iii)(A) and (B) of this section describe the extent to
which the specified payments by FZ and US1, each of which is a specified
party, are disqualified hybrid amounts.
(A) The hybrid transaction rule of Sec. 1.267A-2(a) applies to FZ's
payment because the payment is made pursuant to a hybrid transaction, as
a payment with respect to the US1-FZ instrument is treated as interest
for U.S. tax purposes but not for purposes of Country X's tax law (the
tax law of FX, a specified recipient that is related to FZ). As a
consequence of the Country X participation exemption, an $80x no-
inclusion occurs with respect to FX, and such no-inclusion is a result
of the payment being made pursuant to the hybrid transaction. Thus, but
for Sec. 1.267A-3(b), the entire $80x of FZ's payment would be a
disqualified hybrid amount. However, because US1 (a tax resident of the
United States that is also a specified recipient of the payment) takes
the entire $80x payment into account in its gross income, no portion of
the payment is a disqualified hybrid amount. See Sec. 1.267A-3(b)(2).
(B) The disregarded payment rule of Sec. 1.267A-2(b) applies to
US1's $100x payment to FX, for the reasons described in paragraph
(c)(3)(ii)(A) of this section. In addition, US1 has no dual inclusion
income for taxable year 1 because, as a result of the Country X
participation exemption, no portion of FZ's $80x payment to US1 (which
is derived by FX under its tax law) is included in FX's income. See
Sec. Sec. 1.267A-2(b)(3) and 1.267A-3(a). Therefore, the entire $100x
payment from US1 to FX is a disqualified hybrid amount, calculated as
$100x (the amount of the payment) less $0 (the amount of dual inclusion
income). See Sec. 1.267A-2(b)(1).
(iv) Alternative facts--dual inclusion income despite participation
exemption. The facts are the same as in paragraph (c)(3)(iii) of this
section, except that the US1-FZ instrument is treated as indebtedness
for U.S. tax purposes and equity for Country Z and Country X tax
purposes. In addition, the $80x paid to US1 by FZ is treated as interest
for U.S. tax purposes (the entire amount of which is included in US1's
income), a dividend for Country Z tax purposes (for which FZ is not
allowed a deduction or other tax benefit), and an excludible dividend
for Country X tax purposes (by reason of the Country X participation
exemption). For the reasons described in paragraph (c)(3)(iii)(A) of
this section, the hybrid transaction rule of Sec. 1.267A-2(a) applies
to FZ's payment but no portion of the payment is a disqualified hybrid
amount. In addition, the disregarded payment rule of Sec. 1.267A-2(b)
applies to US1's $100x payment to FX, for the reasons described in
paragraph (c)(3)(ii)(B) of this section. US1's dual inclusion income for
taxable year 1 is $80x. This is because the $80x paid to US1 by FZ is
included in US1's income and, although not included in FX's income, it
is a dividend for Country X tax purposes that would have been included
in FX's income but for the Country X participation exemption, and FZ is
not allowed a deduction or other tax benefit for it under Country Z tax
law. See Sec. 1.267A-2(b)(3)(ii). Therefore, $20x of US1's $100x
payment is a disqualified hybrid amount ($100x less $80x). See Sec.
1.267A-2(b)(1).
(4) Example 4. Payment allocable to a U.S. taxable branch--(i)
Facts. FX1 and FX2 are foreign corporations that are bodies corporate
established in and tax residents of Country X. FX1 holds all the
interests of FX2, and FX1 and FX2 file a consolidated return under
Country X tax law. FX2 has a U.S. taxable branch (``USB''). During
taxable year 1, FX2 pays $50x to FX1 pursuant to an
[[Page 897]]
instrument (the ``FX1-FX2 instrument''). The amount paid pursuant to the
instrument is treated as interest for U.S. tax purposes but, as a
consequence of the Country X consolidation regime, is treated as a
disregarded transaction between group members for Country X tax
purposes. Also during taxable year 1, FX2 pays $100x of interest to an
unrelated bank that is not a party to a structured arrangement (the
instrument pursuant to which the payment is made, the ``bank-FX2
instrument''). FX2's only other item of income, gain, deduction, or loss
for taxable year 1 is $200x of gross income. Under Country X tax law,
the $200x of gross income is attributable to USB, but is not included in
FX2's income because Country X tax law exempts income attributable to a
branch. Under U.S. tax law, the $200x of gross income is effectively
connected income of USB. Further, under section 882(c)(1), $75x of
interest is, for taxable year 1, allocable to USB's effectively
connected income. USB has neither liabilities that are directly
allocable to it, as described in Sec. 1.882-5(a)(1)(ii)(A), nor U.S.
booked liabilities, as defined in Sec. 1.882-5(d)(2).
(ii) Analysis. USB is a specified party and thus any interest or
royalty allowable as a deduction in determining its effectively
connected income is subject to disallowance under section 267A. Pursuant
to Sec. 1.267A-5(b)(3)(i)(A), USB is treated as paying $75x of
interest, and such interest is thus a specified payment. Of that $75x,
$25x is treated as paid to FX1, calculated as $75x (the interest
allocable to USB under section 882(c)(1)) multiplied by \1/3\ ($50x,
FX2's payment to FX1, divided by $150x, the total interest paid by FX2).
See Sec. 1.267A-5(b)(3)(ii)(A). As described in paragraphs
(c)(4)(ii)(A) and (B) of this section, the $25x of the specified payment
treated as paid by USB to FX1 is a disqualified hybrid amount under the
disregarded payment rule of Sec. 1.267A-2(b) and, as a result, a
deduction for that amount is disallowed under Sec. 1.267A-1(b)(1).
(A) USB's $25x payment to FX1 is not regarded under the tax law of
Country X (the tax law of FX1, a related tax resident to which the
payment is made) because under such tax law it is a disregarded
transaction between group members. See Sec. 1.267A-2(b)(2) and (f). In
addition, were the tax law of Country X to regard the payment (and treat
it as interest), FX1 would include it in income. Therefore, the payment
is a disregarded payment to which Sec. 1.267A-2(b) applies. See Sec.
1.267A-2(b)(2).
(B) Under Sec. 1.267A-2(b)(1), the excess (if any) of USB's
disregarded payments for taxable year 1 ($25x) over its dual inclusion
income for the taxable year is a disqualified hybrid amount. USB's dual
inclusion income for taxable year 1 is $0. This is because, as a result
of the Country X exemption for income attributable to a branch, no
portion of USB's $200x item of gross income is included in FX2's income.
See Sec. 1.267A-2(b)(3). Therefore, the entire $25x of the specified
payment treated as paid by USB to FX1 is a disqualified hybrid amount,
calculated as $25x (the amount of the payment) less $0 (the amount of
dual inclusion income). See Sec. 1.267A-2(b)(1).
(iii) Alternative facts--deemed branch payment. The facts are the
same as in paragraph (c)(4)(i) of this section, except that FX2 does not
pay any amounts during taxable year 1 (thus, it does not pay the $50x to
FX1 or the $100x to the bank). However, under an income tax treaty
between the United States and Country X, USB is a U.S. permanent
establishment and, for taxable year 1, $25x of royalties is allowable as
a deduction in computing the business profits of USB and is deemed paid
to FX2. Under Country X tax law, the $25x is not regarded. Accordingly,
the $25x is a specified payment that is a deemed branch payment. See
Sec. Sec. 1.267A-2(c)(2) and 1.267A-5(b)(3)(i)(B). In addition, the
entire $25x is a disqualified hybrid amount for which a deduction is
disallowed because the tax law of Country X provides an exclusion or
exemption for income attributable to a branch. See Sec. 1.267A-2(c)(1).
(5) Example 5. Payment to a reverse hybrid--(i) Facts. FX holds all
the interests of US1 and FY, and FY holds all the interests of FV. FY is
an entity established in Country Y, and FV is an entity established in
Country V. FY is fiscally transparent for Country Y tax purposes but is
not fiscally transparent
[[Page 898]]
for Country X tax purposes. FV is fiscally transparent for Country X tax
purposes. On date 1, US1 pays $100x to FY. The payment is treated as
interest for U.S. tax purposes and Country X tax purposes.
(ii) Analysis. US1 is a specified party and thus a deduction for its
$100x specified payment is subject to disallowance under section 267A.
As described in paragraphs (c)(5)(ii)(A) through (C) of this section,
the entire $100x payment is a disqualified hybrid amount under the
reverse hybrid rule of Sec. 1.267A-2(d) and, as a result, a deduction
for the payment is disallowed under Sec. 1.267A-1(b)(1).
(A) US1's payment is made to a reverse hybrid because FY is fiscally
transparent under the tax law of Country Y (the tax law of the country
in which it is established) but is not fiscally transparent under the
tax law of Country X (the tax law of FX, an investor that is related to
US1). See Sec. 1.267A-2(d)(2) and (f). Therefore, Sec. 1.267A-2(d)
applies to the payment. The result would be the same if the payment were
instead made to FV. See Sec. 1.267A-2(d)(3).
(B) For US1's payment to be a disqualified hybrid amount under Sec.
1.267A-2(d), a no-inclusion must occur with respect to FX, an investor
the tax law of which treats FY as not fiscally transparent. See Sec.
1.267A-2(d)(1)(i). Because FX does not derive the $100x payment under
Country X tax law (as FY is not fiscally transparent under such tax
law), FX includes $0 of the payment in income and therefore a $100x no-
inclusion occurs with respect to FX. See Sec. 1.267A-3(a).
(C) Pursuant to Sec. 1.267A-2(d)(1)(ii), FX's $100x no-inclusion
gives rise to a disqualified hybrid amount to the extent that it is a
result of US1's payment being made to the reverse hybrid. FX's $100x no-
inclusion is a result of the payment being made to the reverse hybrid
because, were FY to be treated as fiscally transparent for Country X tax
purposes, FX would include $100x in income and, consequently, the no-
inclusion would not occur. The result would be the same if Country X tax
law instead viewed US1's payment as a dividend, rather than interest.
See Sec. 1.267A-2(d)(1)(ii).
(iii) Alternative facts--inclusion under anti-deferral regime. The
facts are the same as in paragraph (c)(5)(i) of this section, except
that, under a Country X anti-deferral regime, FX takes into account
$100x attributable to the $100x payment received by FY. If under the
rules of Sec. 1.267A-3(a) FX includes the entire attributed amount in
income (that is, if FX takes the amount into account in its income at
the full marginal rate imposed on ordinary income and the amount is not
reduced or offset by certain relief particular to the amount), then a
no-inclusion does not occur with respect to FX. As a result, in such a
case, no portion of US1's payment would be a disqualified hybrid amount
under Sec. 1.267A-2(d).
(iv) Alternative facts--multiple investors. The facts are the same
as in paragraph (c)(5)(i) of this section, except that FX holds all the
interests of FZ, which is fiscally transparent for Country X tax
purposes; FZ holds all the interests of FY, which is fiscally
transparent for Country Z tax purposes; and FZ includes the $100x
payment in income. Thus, each of FZ and FX is an investor of FY, as each
directly or indirectly holds an interest of FY. See Sec. 1.267A-
5(a)(13). A $100x no-inclusion occurs with respect to FX, an investor
the tax law of which treats FY as not fiscally transparent. FX's no-
inclusion is a result of the payment being made to the reverse hybrid
because, were FY to be treated as fiscally transparent for Country X tax
purposes, then FX would include $100x in income (as FZ is fiscally
transparent for Country X tax purposes). Accordingly, FX's no-inclusion
is a result of US1's payment being made to the reverse hybrid and,
consequently, the entire $100x payment is a disqualified hybrid amount.
However, if instead FZ were not fiscally transparent for Country X tax
purposes, then FX's no-inclusion would not be a result of US1's payment
being made to the reverse hybrid and, therefore, the payment would not
be a disqualified hybrid amount under Sec. 1.267A-2(d).
(v) Alternative facts--portion of no-inclusion not the result of
hybridity. The facts are the same as in paragraph (c)(5)(i) of this
section, except that the $100x is viewed as a royalty for U.S. tax
purposes and Country X tax purposes,
[[Page 899]]
and Country X tax law contains a patent box regime that provides an 80%
deduction with respect to certain royalty income. If the royalty payment
would qualify for the Country X patent box deduction were FY to be
treated as fiscally transparent for Country X tax purposes, then only
$20x of FX's $100x no-inclusion would be the result of the payment being
paid to a reverse hybrid, calculated as $100x (the no-inclusion with
respect to FX that actually occurs) less $80x (the no-inclusion with
respect to FX that would occur if FY were to be treated as fiscally
transparent for Country X tax purposes). See Sec. 1.267A-2(d)(1)(ii)
and 1.267A-3(a)(1)(ii). Accordingly, in such a case, only $20x of US1's
payment would be a disqualified hybrid amount under Sec. 1.267A-2(d).
(vi) Alternative facts--payment to a discretionary trust--(A) Facts.
The facts are the same as in paragraph (c)(5)(i) of this section, except
that FY is a discretionary trust established in, and a tax resident of,
Country Y (and as a result, FY is generally not fiscally transparent for
Country Y tax purposes under the principles of Sec. 1.894-1(d)(3)(ii)).
In general, under Country Y tax law, FX, an investor of FY, is not
required to separately take into account in its income US1's $100x
payment received by FY; instead, FY is required to take the payment into
account in its income. However, under the trust agreement, the trustee
of FY may, with respect to certain items of income received by FY,
allocate such an item to FY's beneficiary, FX. When this occurs, then,
for Country Y tax purposes, FY does not take the item into account in
its income, and FX is required to take the item into account in its
income as if it received the item directly from the source from which
realized by FY. For Country X tax purposes, FX in all cases does not
take into account in its income any item of income received by FY. With
respect to the $100x paid from US1 to FY, the trustee allocates the
$100x to FX.
(B) Analysis. FY is fiscally transparent with respect to US1's $100x
payment under the tax law of Country Y (the tax law of the country in
which FY is established). See Sec. 1.267A-5(a)(8)(i). In addition, FY
is not fiscally transparent with respect to US1's $100x payment under
the tax law of Country X (the tax law of FX, the investor of FY). See
Sec. 1.267A-5(a)(8)(ii). Thus, FY is a reverse hybrid with respect to
the payment. See Sec. 1.267A-2(d)(2) and (f). Therefore, for reasons
similar to those discussed in paragraphs (c)(5)(ii)(B) and (C) of this
section, the entire $100x payment is a disqualified hybrid amount.
(6) Example 6. Branch mismatch payment--(i) Facts. FX holds all the
interests of US1 and FZ. FZ owns BB, a Country B branch that gives rise
to a taxable presence in Country B under Country Z tax law but not under
Country B tax law. On date 1, US1 pays $50x to FZ. The amount is treated
as a royalty for U.S. tax purposes and Country Z tax purposes. Under
Country Z tax law, the amount is treated as income attributable to BB
and, as a consequence of County Z tax law exempting income attributable
to a branch, is excluded from FZ's income.
(ii) Analysis. US1 is a specified party and thus a deduction for its
$50x specified payment is subject to disallowance under section 267A. As
described in paragraphs (c)(6)(ii)(A) through (C) of this section, the
entire $50x payment is a disqualified hybrid amount under the branch
mismatch rule of Sec. 1.267A-2(e) and, as a result, a deduction for the
payment is disallowed under Sec. 1.267A-1(b)(1).
(A) US1's payment is a branch mismatch payment because under Country
Z tax law (the tax law of FZ, a home office that is related to US1) the
payment is treated as income attributable to BB, and BB is not a taxable
branch (that is, under Country B tax law, BB does not give rise to a
taxable presence). See Sec. 1.267A-2(e)(2) and (f). Therefore, Sec.
1.267A-2(e) applies to the payment. The result would be the same if
instead BB were a taxable branch and, under Country B tax law, US1's
payment were treated as income attributable to FZ, the home office, and
not BB. See Sec. 1.267A-2(e)(2).
(B) For US1's payment to be a disqualified hybrid amount under Sec.
1.267A-2(e), a no-inclusion must occur with respect to FZ. See Sec.
1.267A-2(e)(1)(i). As a consequence of the Country Z branch exemption,
FZ includes $0 of the payment in income and therefore a $50x
[[Page 900]]
no-inclusion occurs with respect to FZ. See Sec. 1.267A-3(a).
(C) Pursuant to Sec. 1.267A-2(e)(1)(ii), FZ's $50x no-inclusion
gives rise to a disqualified hybrid amount to the extent that it is a
result of US1's payment being a branch mismatch payment. FZ's $50x no-
inclusion is a result of the payment being a branch mismatch payment
because, were the payment to not be treated as income attributable to BB
for Country Z tax purposes, FZ would include $50x in income and,
consequently, the no-inclusion would not occur.
(7) Example 7. Reduction of disqualified hybrid amount for certain
amounts includible in income--(i) Facts. US1 and FW hold 60% and 40%,
respectively, of the interests of FX, and FX holds all the interests of
FZ. Each of FX and FZ is a specified party that is a CFC. FX holds an
instrument issued by FZ that it is treated as equity for Country X tax
purposes and as indebtedness for U.S. tax purposes (the FX-FZ
instrument). On date 1, FZ pays $100x to FX pursuant to the FX-FZ
instrument. The amount is treated as a dividend for Country X tax
purposes and as interest for U.S. tax purposes. In addition, pursuant to
section 954(c)(6), the amount is not foreign personal holding company
income of FX and, under section 951A, the amount is gross tested income
(as described in Sec. 1.951A-2(c)(1)) of FX. Further, were FZ allowed a
deduction for the amount, it would be allocated and apportioned to gross
tested income (as described in Sec. 1.951A-2(c)(1)) of FZ. Lastly,
Country X tax law provides an 80% participation exemption for dividends
received from nonresident corporations and, as a result of such
participation exemption, FX includes $20x of FZ's payment in income.
(ii) Analysis. FZ, a CFC, is a specified party and thus a deduction
for its $100x specified payment is subject to disallowance under section
267A. But for Sec. 1.267A-3(b), $80x of FZ's payment would be a
disqualified hybrid amount (such amount, a ``tentative disqualified
hybrid amount''). See Sec. Sec. 1.267A-2(a) and 1.267A-3(b)(1).
Pursuant to Sec. 1.267A-3(b), the tentative disqualified hybrid amount
is reduced by $48x. See Sec. 1.267A-3(b)(4). The $48x is the tentative
disqualified hybrid amount to the extent that it increases US1's pro
rata share of tested income with respect to FX under section 951A
(calculated as $80x multiplied by 60%). See Sec. 1.267A-3(b)(4).
Accordingly, $32x of FZ's payment ($80x less $48x) is a disqualified
hybrid amount under Sec. 1.267A-2(a) and, as a result, $32x of the
deduction is disallowed under Sec. 1.267A-1(b)(1).
(iii) Alternative facts--United States shareholder is a domestic
partnership. The facts are the same as in paragraph (c)(7)(i) of this
section, except that US1 is a domestic partnership, 90% of the interests
of which are held by US2 and the remaining 10% of which are held by an
individual that is a nonresident alien (as defined in section
7701(b)(1)(B)). Thus, although each of US1 and US2 is a United States
shareholder of FX, only US2 has a pro rata share of any tested item of
FX. See Sec. 1.951A-1(e). In addition, $43.2x of the $80x tentative
disqualified hybrid amount increases US2's pro rata share of the tested
income of FX (calculated as $80x multiplied by 60% multiplied by 90%).
Thus, $36.8x of FZ's payment ($80x less $43.2x) is a disqualified hybrid
amount under Sec. 1.267A-2(a). See Sec. 1.267A-3(b)(4).
(8) Example 8. Imported mismatch rule--direct offset--(i) Facts. FX
holds all the interests of FW, and FW holds all the interests of US1. FX
holds an instrument issued by FW that is treated as equity for Country X
tax purposes and indebtedness for Country W tax purposes (the FX-FW
instrument). FW holds an instrument issued by US1 that is treated as
indebtedness for Country W and U.S. tax purposes (the FW-US1
instrument). In accounting period 1, FW pays $100x to FX pursuant to the
FX-FW instrument. The amount is treated as an excludible dividend for
Country X tax purposes (by reason of the Country X participation
exemption) and as interest for Country W tax purposes. Also in
accounting period 1, US1 pays $100x to FW pursuant to the FW-US1
instrument. The amount is treated as interest for Country W and U.S. tax
purposes and is included in FW's income. The FX-FW instrument was not
entered into pursuant to the same plan or series of related transactions
pursuant to which the FW-US1 instrument was entered into.
[[Page 901]]
(ii) Analysis. US1 is a specified party and thus a deduction for its
$100x specified payment is subject to disallowance under section 267A.
US1's $100x payment is neither a disqualified hybrid amount nor included
or includible in income in the United States. See Sec. 1.267A-
4(a)(2)(v). In addition, FW's $100x deduction is a hybrid deduction
because it is a deduction allowed to FW that results from an amount paid
that is interest under Country W tax law, and were Country W law to have
rules substantially similar to those under Sec. Sec. 1.267A-1 through
1.267A-3 and 1.267A-5, a deduction for the payment would be disallowed
(because under such rules the payment would be pursuant to a hybrid
transaction and FX's no-inclusion would be a result of the hybrid
transaction). See Sec. Sec. 1.267A-2(a) and 1.267A-4(b). Under Sec.
1.267A-4(a)(2), US1's payment is an imported mismatch payment, US1 is an
imported mismatch payer, and FW (the foreign tax resident that includes
the imported mismatch payment in income) is an imported mismatch payee.
The imported mismatch payment is a disqualified imported mismatch amount
to the extent that the income attributable to the payment is directly or
indirectly offset by the hybrid deduction incurred by FW (a foreign tax
resident that is related to US1). See Sec. 1.267A-4(a)(1). Under Sec.
1.267A-4(c)(1), the $100x hybrid deduction directly or indirectly
offsets the income attributable to US1's imported mismatch payment to
the extent that the payment directly or indirectly funds the hybrid
deduction. The entire $100x of US1's payment directly funds the hybrid
deduction because FW (the imported mismatch payee) incurs at least that
amount of the hybrid deduction. See Sec. 1.267A-4(c)(3)(i).
Accordingly, the entire $100x payment is a disqualified imported
mismatch amount under Sec. 1.267A-4(a)(1) and, as a result, a deduction
for the payment is disallowed under Sec. 1.267A-1(b)(2).
(iii) Alternative facts--long-term deferral. The facts are the same
as in paragraph (c)(8)(i) of this section, except that the FX-FW
instrument is treated as indebtedness for Country X and Country W tax
purposes, and FW does not pay any amounts pursuant to the instrument
during accounting period 1. In addition, under Country W tax law, FW is
allowed to deduct interest under the FX-FW instrument as it accrues,
whereas under Country X tax law FX does not take into account in its
income interest under the FX-FW instrument until the interest is paid.
Further, FW accrues $100x of interest during accounting period 1, and FW
will not pay such amount to FX for more than 36 months after the end of
accounting period 1. The results are the same as in paragraph (c)(8)(ii)
of this section. That is, FW's $100x deduction for the accrued interest
is a hybrid deduction, see Sec. Sec. 1.267A-2(a), 1.267A-3(a), and
1.267A-4(b), and the income attributable to US1's $100x imported
mismatch payment is offset by the hybrid deduction for the reasons
described in paragraph (c)(8)(ii) of this section. As a result, a
deduction for the payment is disallowed under Sec. 1.267A-1(b)(2). The
result would be the same even if the FX-FW instrument is expected to be
redeemed or capitalized before the $100x of interest is paid such that
FX will never take into account in its income (and therefore will not
include in income) the $100x of interest.
(iv) Alternative facts--notional interest deduction. The facts are
the same as in paragraph (c)(8)(i) of this section, except that there is
no FX-FW instrument and thus FW does not pay any amounts to FX during
accounting period 1. However, during accounting period 1, FW is allowed
a $100x notional interest deduction with respect to its equity under
Country W tax law. Pursuant to Sec. 1.267A-4(b)(1)(ii), FW's notional
interest deduction is a hybrid deduction. The results are the same as in
paragraph (c)(8)(ii) of this section. That is, the income attributable
to US1's $100x imported mismatch payment is offset by FW's hybrid
deduction for the reasons described in paragraph (c)(8)(ii) of this
section. As a result, a deduction for the payment is disallowed under
Sec. 1.267A-1(b)(2). The result would be the same if the tax law of
Country W contains hybrid mismatch rules because FW's deduction is a
deduction with respect to equity. See Sec. 1.267A-4(b)(2)(i).
(v) Alternative facts--foreign hybrid mismatch rules prevent hybrid
deduction. The facts are the same as in paragraph
[[Page 902]]
(c)(8)(i) of this section, except that the tax law of Country W contains
hybrid mismatch rules, and under such rules FW is not allowed a
deduction for the $100x that it pays to FX pursuant to the FX-FW
instrument. The $100x paid by FW therefore does not give rise to a
hybrid deduction. See Sec. 1.267A-4(b). Accordingly, because the income
attributable to US1's payment to FW is not directly or indirectly offset
by a hybrid deduction, the payment is not a disqualified imported
mismatch amount. Therefore, a deduction for the payment is not
disallowed under Sec. 1.267A-1(b)(2).
(9) Example 9. Imported mismatch rule--indirect offsets and pro rata
allocations--(i) Facts. FX holds all the interests of FZ, and FZ holds
all the interests of US1 and US2. FX has a Country B branch that, for
Country X and Country B tax purposes, gives rise to a taxable presence
in Country B and is therefore a taxable branch (``BB''). Under the
Country B-Country X income tax treaty, BB is a permanent establishment
entitled to deduct expenses properly attributable to BB for purposes of
computing its business profits under the treaty. In addition, BB is
deemed to pay a royalty to FX for the right to use intangibles developed
by FX equal to cost plus y%. The deemed royalty is a deductible expense
properly attributable to BB under the Country B-Country X income tax
treaty. For Country X tax purposes, any transactions between BB and X
are disregarded. The deemed royalty is $80x for accounting period 1.
Country B tax law does not permit a loss of a taxable branch to be
shared with a tax resident or another taxable branch. In addition, an
instrument issued by FZ to FX is properly reflected as an asset on the
books and records of BB (the FX-FZ instrument). The FX-FZ instrument is
treated as indebtedness for Country X, Country Z, and Country B tax
purposes. In accounting period 1, FZ pays $80x to FX pursuant to the FX-
FZ instrument; the amount is treated as interest for Country X, Country
Z, and Country B tax purposes, and is treated as income attributable to
BB for Country X and Country B tax purposes (but, for Country X tax
purposes, is excluded from FX's income as a consequence of the Country X
exemption for income attributable to a branch). Further, in accounting
period 1, US1 and US2 pay $60x and $40x, respectively, to FZ pursuant to
instruments that are treated as indebtedness for Country Z and U.S. tax
purposes; the amounts are treated as interest for Country Z and U.S. tax
purposes and are included in FZ's income. Lastly, neither the instrument
pursuant to which US1 pays the $60x nor the instrument pursuant to which
US2 pays the $40x was entered into pursuant to a plan or series of
related transactions that includes the transaction or agreement giving
rise to BB's deduction for the deemed royalty.
(ii) Analysis. US1 and US2 are specified parties and thus deductions
for their specified payments are subject to disallowance under section
267A. Neither of the payments is a disqualified hybrid amount, nor is
either of the payments included or includible in income in the United
States. See Sec. 1.267A-4(a)(2)(v). In addition, BB's $80x deduction
for the deemed royalty is a hybrid deduction because it is a deduction
allowed to BB that results from an amount paid that is treated as a
royalty under Country B tax law (regardless of whether a royalty
deduction would be allowed under U.S. law), and were Country B tax law
to have rules substantially similar to those under Sec. Sec. 1.267A-1
through 1.267A-3 and 1.267A-5, a deduction for the payment would be
disallowed because under such rules the payment would be a deemed branch
payment and Country X has an exclusion for income attributable to a
branch. See Sec. Sec. 1.267A-2(c) and 1.267A-4(b). Under Sec. 1.267A-
4(a)(2), each of US1's and US2's payments is an imported mismatch
payment, US1 and US2 are imported mismatch payers, and FZ (the foreign
tax resident that includes the imported mismatch payments in income) is
an imported mismatch payee. The imported mismatch payments are
disqualified imported mismatch amounts to the extent that the income
attributable to the payments is directly or indirectly offset by the
hybrid deduction incurred by BB (a foreign taxable branch that is
related to US1 and US2). See Sec. 1.267A-4(a). Under Sec. 1.267A-
4(c)(1), the $80x hybrid deduction directly or indirectly offsets
[[Page 903]]
the income attributable to the imported mismatch payments to the extent
that the payments directly or indirectly fund the hybrid deduction.
Paragraphs (c)(9)(ii)(A) and (B) of this section describe the extent to
which the imported mismatch payments directly or indirectly fund the
hybrid deduction.
(A) Neither US1's nor US2's payment directly funds the hybrid
deduction because FZ (the imported mismatch payee) does not incur the
hybrid deduction. See Sec. 1.267A-4(c)(3)(i). To determine the extent
to which the payments indirectly fund the hybrid deduction, the amount
of the hybrid deduction that is allocated to FZ must be determined. See
Sec. 1.267A-4(c)(3)(ii). FZ is allocated the hybrid deduction to the
extent that it directly or indirectly makes a funded taxable payment to
BB (the foreign taxable branch that incurs the hybrid deduction). See
Sec. 1.267A-4(c)(3)(iii). The $80x that FZ pays pursuant to the FX-FZ
instrument is a funded taxable payment of FZ to BB. See Sec. 1.267A-
4(c)(3)(v). Therefore, because FZ makes a funded taxable payment to BB
that is at least equal to the amount of the hybrid deduction, FZ is
allocated the entire amount of the hybrid deduction. See Sec. 1.267A-
4(c)(3)(iii).
(B) But for US2's imported mismatch payment, the entire $60x of
US1's imported mismatch payment would indirectly fund the hybrid
deduction because FZ is allocated at least that amount of the hybrid
deduction. See Sec. 1.267A-4(c)(3)(ii). Similarly, but for US1's
imported mismatch payment, the entire $40x of US2's imported mismatch
payment would indirectly fund the hybrid deduction because FZ is
allocated at least that amount of the hybrid deduction. See Sec.
1.267A-4(c)(3)(ii). However, because the sum of US1's and US2's imported
mismatch payments to FZ ($100x) exceeds the hybrid deduction allocated
to FZ ($80x), pro rata adjustments must be made. See Sec. 1.267A-4(e).
Thus, $48x of US1's imported mismatch payment is considered to
indirectly fund the hybrid deduction, calculated as $80x (the amount of
the hybrid deduction) multiplied by 60% ($60x, the amount of US1's
imported mismatch payment to FZ, divided by $100x, the sum of the
imported mismatch payments that US1 and US2 make to FZ). Similarly, $32x
of US2's imported mismatch payment is considered to indirectly fund the
hybrid deduction, calculated as $80x (the amount of the hybrid
deduction) multiplied by 40% ($40x, the amount of US2's imported
mismatch payment to FZ, divided by $100x, the sum of the imported
mismatch payments that US1 and US2 make to FZ). Accordingly, $48x of
US1's imported mismatch payment, and $32x of US2's imported mismatch
payment, are disqualified imported mismatch amounts under Sec. 1.267A-
4(a)(1) and, as a result, deductions for such amounts are disallowed
under Sec. 1.267A-1(b)(2).
(iii) Alternative facts--loss made available through foreign group
relief regime. The facts are the same as in paragraph (c)(9)(i) of this
section, except that FZ holds all the interests in FZ2, a body corporate
that is a tax resident of Country Z, FZ2 (rather than FZ) holds all the
interests of US1 and US2, and US1 and US2 make their respective $60x and
$40x payments to FZ2 (rather than to FZ). Further, in accounting period
1, a $10x loss of FZ is made available to offset income of FZ2 through a
Country Z foreign group relief regime. Pursuant to Sec. 1.267A-
4(c)(3)(vi), FZ and FZ2 are treated as a single foreign tax resident for
purposes of Sec. 1.267A-4(c) because a loss that is not incurred by FZ2
(FZ's $10x loss) is made available to offset income of FZ2 under the
Country Z group relief regime. Accordingly, the results are the same as
in paragraph (c)(9)(ii) of this section. That is, by treating FZ and FZ2
as a single foreign tax resident for purposes of Sec. 1.267A-4(c), BB's
hybrid deduction offsets the income attributable to US1's and US2's
imported mismatch payments to the same extent as described in paragraph
(c)(9)(ii) of this section.
(10) Example 10. Imported mismatch rule--ordering rules and rule
deeming certain payments to be imported mismatch payments--(i) Facts. FX
holds all the interests of FW, and FW holds all the interests of US1,
US2, and FZ. FZ holds all the interests of US3. FX transfers cash to FW
in exchange for an instrument that is treated as equity for Country X
tax purposes and indebtedness for Country W tax purposes (the
[[Page 904]]
FX-FW instrument). FW transfers cash to US1 in exchange for an
instrument that is treated as indebtedness for Country W and U.S. tax
purposes (the FW-US1 instrument). The FX-FW instrument and the FW-US1
instrument were entered into pursuant to a plan a design of which was
for deductions incurred by FW pursuant to the FX-FW instrument to offset
income attributable to payments by US1 pursuant to the FW-US1
instrument. In accounting period 1, FW pays $125x to FX pursuant to the
FX-FW instrument; the amount is treated as an excludible dividend for
Country X tax purposes (by reason of the Country X participation
exemption regime) and as interest for Country W tax purposes. Also in
accounting period 1, US1 pays $50x to FW pursuant to the FW-US1
instrument; US2 pays $50x to FW pursuant to an instrument treated as
indebtedness for Country W and U.S. tax purposes (the FW-US2
instrument); US3 pays $50x to FZ pursuant to an instrument treated as
indebtedness for Country Z and U.S. tax purposes (the FZ-US3
instrument); and FZ pays $50x to FW pursuant to an instrument treated as
indebtedness for Country W and Country Z tax purposes (FW-FZ
instrument). The amounts paid by US1, US2, US3, and FZ are treated as
interest for purposes of the relevant tax laws and are included in the
income of FW (in the case of US1's, US2's and FZ's payment) or FZ (in
the case of US3's payment). Lastly, neither the FW-US2 instrument, the
FW-FZ instrument, nor the FZ-US3 instrument was entered into pursuant to
a plan or series of related transactions that includes the transaction
pursuant to which the FX-FW instrument was entered into.
(ii) Analysis. US1, US2, and US3 are specified parties (but FZ is
not a specified party, see Sec. 1.267A-5(a)(17)) and thus deductions
for US1's, US2's, and US3's specified payments are subject to
disallowance under section 267A. None of the specified payments is a
disqualified hybrid amount, nor is any of the payments included or
includible in income in the United States. See Sec. 1.267A-4(a)(2)(v).
Under Sec. 1.267A-4(a)(2), each of the payments is an imported mismatch
payment, US1, US2, and US3 are imported mismatch payers, and FW and FZ
(the foreign tax residents that include the imported mismatch payments
in income) are imported mismatch payees. The imported mismatch payments
are disqualified imported mismatch amounts to the extent that the income
attributable to the payments is directly or indirectly offset by FW's
$125x hybrid deduction. See Sec. 1.267A-4(a)(1) and (b). Under Sec.
1.267A-4(c)(1), the $125x hybrid deduction directly or indirectly
offsets the income attributable to the imported mismatch payments to the
extent that the payments directly or indirectly fund the hybrid
deduction. Paragraphs (c)(10)(ii)(A) through (C) of this section
describe the extent to which the imported mismatch payments directly or
indirectly fund the hybrid deduction and are therefore disqualified
hybrid amounts for which a deduction is disallowed under Sec. 1.267A-
1(b)(2).
(A) First, the $125x hybrid deduction offsets the income
attributable to US1's imported mismatch payment, a factually-related
imported mismatch payment that directly funds the hybrid deduction. See
Sec. 1.267A-4(c)(2)(i). The entire $50x of US1's payment directly funds
the hybrid deduction because FW (the imported mismatch payee) incurs at
least that amount of the hybrid deduction. See Sec. 1.267A-4(c)(3)(i).
Accordingly, the entire $50x of the payment is a disqualified imported
mismatch amount under Sec. 1.267A-4(a)(1).
(B) Second, the remaining $75x hybrid deduction offsets the income
attributable to US2's imported mismatch payment, a factually-unrelated
imported mismatch payment that directly funds the remaining hybrid
deduction. See Sec. 1.267A-4(c)(2)(ii). The entire $50x of US2's
payment directly funds the remaining hybrid deduction because FW (the
imported mismatch payee) incurs at least that amount of the remaining
hybrid deduction. See Sec. 1.267A-4(c)(3)(i). Accordingly, the entire
$50x of the payment is a disqualified imported mismatch amount under
Sec. 1.267A-4(a)(1).
(C) Third, the remaining $25x hybrid deduction offsets the income
attributable to US3's imported mismatch
[[Page 905]]
payment, a factually-unrelated imported mismatch payment that indirectly
funds the remaining hybrid deduction. See Sec. 1.267A-4(c)(2)(iii). The
imported mismatch payment indirectly funds the remaining hybrid
deduction to the extent that FZ (the imported mismatch payee) is
allocated the remaining hybrid deduction. See Sec. 1.267A-4(c)(3)(ii).
FZ is allocated the remaining hybrid deduction to the extent that it
directly or indirectly makes a funded taxable payment to FW (the tax
resident that incurs the hybrid deduction). See Sec. 1.267A-
4(c)(3)(iii). The $50x that FZ pays to FW pursuant to the FW-FZ
instrument is a funded taxable payment of FZ to FW. See Sec. 1.267A-
4(c)(3)(v). Therefore, because FZ makes a funded taxable payment to FW
that is at least equal to the amount of the remaining hybrid deduction,
FZ is allocated the remaining hybrid deduction. See Sec. 1.267A-
4(c)(3)(iii). Accordingly, $25x of US3's payment indirectly funds the
$25x remaining hybrid deduction and, consequently, $25x of US3's payment
is a disqualified imported mismatch amount under Sec. 1.267A-4(a)(2).
(iii) Alternative facts--amount deemed to be an imported mismatch
payment. The facts are the same as in paragraph (c)(10)(i) of this
section, except that US1 is not a domestic corporation but instead is a
body corporate that is only a tax resident of Country E (hereinafter,
``FE'') (thus, for purposes of this paragraph (c)(10)(iii), the FW-US1
instrument is instead issued by FE and is the ``FW-FE instrument''). In
addition, the tax law of Country E contains hybrid mismatch rules and
the $50x FE pays to FW pursuant to the FW-FE instrument is subject to
disallowance under a provision of the hybrid mismatch rules
substantially similar to Sec. 1.267A-4. Pursuant to Sec. 1.267A-
4(f)(2), the $50x that FE pays to FW pursuant to the FW-FE instrument is
deemed to be an imported mismatch payment for purposes of determining
the extent to which the income attributable to an imported mismatch
payment is offset by FW's hybrid deduction (a hybrid deduction other
than one described in Sec. 1.267A-4(f)(1)). The results are the same as
in paragraphs (c)(10)(ii)(B) and (C) of this section. That is, by
treating the $50x that FE pays to FW as an imported mismatch payment,
and for reasons similar to those described in paragraphs (c)(10)(ii)(A)
through (C) of this section, $50x of FW's $125x hybrid deduction offsets
income attributable to FE's imported mismatch payment, $50x of the
remaining $75x hybrid deduction offsets income attributable to US2's
imported mismatch payment, and the remaining $25x hybrid deduction
offsets income attributable to US3's imported mismatch payment.
Accordingly, the entire $50x of US2's payment is a disqualified imported
mismatch amount, and $25x of US3's payment is a disqualified imported
mismatch amount.
(iv) Alternative facts--amount deemed to be an imported mismatch
payment and ``waterfall'' approach. The facts are the same as in
paragraph (c)(10)(i) of this section, except that FZ holds all of the
interests of US3 indirectly through FE, a body corporate that is only a
tax resident of Country E (hereinafter, ``FE''), and US3 makes its $50x
payment to FE (rather than to FZ); such amount is treated as interest
for Country E tax purposes and is included in FE's income. In addition,
during accounting period 1, FE pays $50x to FZ pursuant to an
instrument; such amount is treated as interest for Country E and Country
Z tax purposes, and is included in FZ's income. Further, the tax law of
Country E contains hybrid mismatch rules and the $50x FE pays to FZ
pursuant to the instrument is subject to disallowance under a provision
of the hybrid mismatch rules substantially similar to Sec. 1.267A-4.
For purposes of determining the extent to which the income attributable
to an imported mismatch payment is directly or indirectly offset by a
hybrid deduction, the $50x that FE pays to FZ is deemed to be an
imported mismatch payment (and FE and FZ are deemed to be an imported
mismatch payer and imported mismatch payee, respectively). See Sec.
1.267A-4(f)(2). With respect to US1 and US2, the results are the same as
described in paragraphs (c)(10)(ii)(A) and (B) of this section. No
portion of US3's payment is a disqualified imported mismatch amount
because, by treating the $50x that FE pays to FZ as an imported mismatch
payment, the remaining $25x of FW's
[[Page 906]]
hybrid deduction offsets income attributable to FE's imported mismatch
payment. This is because the remaining $25x of FW's hybrid deduction is
indirectly funded solely by FE's imported mismatch payment (as opposed
to also being funded by US3's imported mismatch payment), as FZ (the
imported mismatch payee with respect to FE's payment) directly makes a
funded taxable payment to FW, whereas FE (the imported mismatch payee
with respect to US3's payment) indirectly makes a funded taxable payment
to FW. See Sec. 1.267A-4(c)(3)(ii) through (v) and (vii).
(11) Example 11. Imported mismatch rule--hybrid deduction of a CFC--
(i) Facts. FX holds all the interests of US1, and FX and US1 hold 80%
and 20%, respectively, of the interests of FZ, a specified party that is
a CFC. US1 also holds all the interests of US2, and FX also holds all
the interests of FY. FY is an entity established in Country Y, and is
fiscally transparent for Country Y tax purposes but is not fiscally
transparent for Country X tax purposes. In accounting period 1, US2 pays
$100x to FZ pursuant to an instrument (the FZ-US2 instrument). The
amount is treated as interest for U.S. tax purposes and Country Z tax
purposes, and is included in FZ's income; in addition, for U.S. tax
purposes, the amount is foreign personal holding company income of FZ.
Also in accounting period 1, FZ pays $100x to FY pursuant to an
instrument (the FY-FZ instrument). The amount is treated as interest for
U.S. tax purposes and Country Z tax purposes, and none of the amount is
included in FX's income. Under Country Z tax law, FZ is allowed a
deduction for its entire $100x payment. Under Sec. 1.267A-2(d), the
entire $100x of FZ's payment is a disqualified hybrid amount (by reason
of being made to a reverse hybrid) and, as a result, a deduction for the
payment is disallowed under Sec. 1.267A-1(b)(1); in addition, if a
deduction were allowed for the $100x, it would be allocated and
apportioned (under the rules of section 954(b)(5)) to gross subpart F
income of FZ. Lastly, the FZ-US2 instrument was not entered into
pursuant to a plan or series of related transactions that includes the
transaction pursuant to which the FY-FZ instrument was entered into.
(ii) Analysis. US2 is a specified party and thus a deduction for its
$100x specified payment is subject to disallowance under section 267A.
As described in paragraphs (c)(11)(ii)(A) through (C) of this section,
$80x of US2's payment is a disqualified imported mismatch amount for
which a deduction is disallowed under Sec. 1.267A-1(b)(2).
(A) $80x of US2's specified payment is an imported mismatch payment,
calculated as $100x (the amount of the payment) less $0 (the
disqualified hybrid amount with respect to the payment) less $20 (the
amount of the payment that is included or includible in income in the
United States). See Sec. 1.267A-4(a)(2)(v). US2 is an imported mismatch
payer and FZ (a foreign tax resident that includes the imported mismatch
in income) is an imported mismatch payee. See Sec. 1.267A-4(a)(2).
(B) But for Sec. 1.267A-4(b)(2)(iv), the entire $100x deduction
allowed to FZ under its tax law would be a hybrid deduction. See
Sec. Sec. 1.267A-2(d) and 1.267A-4(b)(1). However, pursuant to Sec.
1.267A-4(b)(2)(iv), only $80x of the deduction is a hybrid deduction,
calculated as $100x (the deduction to the extent that it would be a
hybrid deduction but for Sec. 1.267A-4(b)(2)(iv)) less $20x (the extent
that FZ's payment giving rise to the deduction is a disqualified hybrid
amount that is taken into account for purposes of Sec. 1.267A-
4(b)(2)(iv)(A)), less $0 (the extent that FZ's payment giving rise to
the deduction is included or includible in income in the United States).
See Sec. 1.267A-4(b)(2)(iv). The $20x disqualified hybrid amount that
is taken into account for purposes of Sec. 1.267A-4(b)(2)(iv)(A) is
calculated as $100x (the extent that FZ's payment is a disqualified
hybrid amount) less $80x ($100x, the disqualified hybrid amount to the
extent that, if allowed as a deduction, it would be allocated and
apportioned to gross subpart F income, multiplied by 80%, the difference
of 100% and the percentage of the stock (by value) of FZ that is owned
by US1)). See Sec. 1.267A-4(g).
(C) The $80x hybrid deduction offsets the income attributable to
US2's imported mismatch payment, an imported mismatch payment that
directly funds the hybrid deduction. See Sec. 1.267A-4(c)(2)(ii). The
entire $80x of
[[Page 907]]
US2's imported mismatch payment directly funds the hybrid deduction
because FZ (the imported mismatch payee) incurs at least that amount of
the hybrid deduction. See Sec. 1.267A-4(c)(3)(i). Accordingly, the
entire $80x of US2's imported mismatch payment is a disqualified
imported mismatch amount under Sec. 1.267A-4(a)(1).
(12) Example 12. Imported mismatch rule--application first with
respect to certain hybrid deductions, then with respect to other hybrid
deductions--(i) Facts. FX holds all the interests of FZ, and FZ holds
all the interests of each of US1 and FE. The tax law of Country E
contains hybrid mismatch rules. FX holds an instrument issued by FZ that
is treated as equity for Country X tax purposes and indebtedness for
Country Z tax purposes (the FX-FZ instrument). In accounting period 1,
FZ pays $10x to FX pursuant to the FX-FZ instrument. The amount is
treated as an excludible dividend for Country X tax purposes (by reason
of the Country X participation exemption) and as interest for Country Z
tax purposes. Also in accounting period 1, FZ is allowed a $90x notional
interest deduction with respect to its equity under Country Z tax law.
In addition, in accounting period 1, US1 pays $100x to FZ pursuant to an
instrument (the FZ-US1 instrument); the amount is treated as interest
for U.S. tax purposes and Country Z tax purposes, and is included in
FZ's income. Further, in accounting period 1, FE pays $40x to FZ
pursuant to an instrument (the FZ-FE instrument); the amount is treated
as interest for Country E and Country Z tax purposes, is included in
FZ's income, and is subject to disallowance under a provision of Country
E hybrid mismatch rules substantially similar to Sec. 1.267A-4. Lastly,
neither the FZ-US1 instrument nor the FZ-FE instrument was entered into
pursuant to a plan or series of related transactions that includes the
transaction pursuant to which the FX-FZ instrument was entered into.
(ii) Analysis. US1 is a specified party and thus a deduction for its
$100x specified payment is subject to disallowance under section 267A.
As described in paragraphs (c)(12)(ii)(A) through (D) of this section,
$92x of US1's payment is a disqualified imported mismatch amount for
which a deduction is disallowed under Sec. 1.267A-1(b)(2).
(A) The entire $100x of US1's specified payment is an imported
mismatch payment. See Sec. 1.267A-4(a)(2)(v). US1 is an imported
mismatch payer and FZ (a foreign tax resident that includes the imported
mismatch payment in income) is an imported mismatch payee. See Sec.
1.267A-4(a)(2).
(B) FZ has $100x of hybrid deductions (the $10x deduction for the
payment pursuant to the FX-FZ instrument plus the $90x notional interest
deduction). See Sec. 1.267A-4(b). Pursuant to Sec. 1.267A-4(f)(1),
Sec. 1.267A-4 is first applied by taking into account only the $90x
hybrid deduction consisting of the notional interest deduction; in
addition, for purposes of applying Sec. 1.267A-4 in this manner, FE's
$40x payment is not treated as an imported mismatch payment. Thus, the
$90x hybrid deduction offsets the income attributable to US1's imported
mismatch payment, an imported mismatch payment that directly funds the
hybrid deduction. See Sec. 1.267A-4(c)(2)(ii). Moreover, $90x of US1's
imported mismatch payment directly funds the hybrid deduction because FZ
(the imported mismatch payee) incurs at least that amount of the hybrid
deduction. See Sec. 1.267A-4(c)(3)(i).
(C) Section Sec. 1.267A-4 is next applied by taking into account
only the $10x hybrid deduction consisting of the deduction for the
payment pursuant to the FX-FZ instrument. See Sec. 1.267A-4(f)(2). When
applying Sec. 1.267A-4 in this manner, and for purposes of determining
the extent to which the income attributable to an imported mismatch
payment is directly or indirectly offset by a hybrid deduction, FE's
$40x payment is treated as an imported mismatch payment. See Sec.
1.267A-4(f)(2). In addition, US1's imported mismatch payment is reduced
from $100x to $10x. See Sec. 1.267A-4(c)(4). But for FE's imported
mismatch payment, the entire $10x of US1's imported mismatch payment
would directly fund the $10x hybrid deduction because FZ incurred at
least that amount of the hybrid deduction. See Sec. 1.267A-4(c)(3)(i).
Similarly, but for US1's imported mismatch payment, the entire $40x of
FE's imported mismatch payment would directly fund
[[Page 908]]
the $10x hybrid deduction because FZ incurred at least that amount of
the hybrid deduction. See Sec. 1.267A-4(c)(3)(i). However, because the
sum of US1's and FE's imported mismatch payments to FZ ($50x) exceeds
the hybrid deduction incurred by FZ ($10x), pro rata adjustments must be
made. See Sec. 1.267A-4(e). Thus, $2x of US1's imported mismatch
payment is considered to directly fund the hybrid deduction, calculated
as $10x (the amount of the hybrid deduction) multiplied by 20% ($10x,
the amount of US1's imported mismatch payment to FZ, divided by $50x,
the sum of the imported mismatch payments that US1 and FE make to FZ).
Similarly, $8x of FE's imported mismatch payment is considered to
directly fund the hybrid deduction, calculated as $10x (the amount of
the hybrid deduction) multiplied by 80% ($40x, the amount of FE's
imported mismatch payment to FZ, divided by $50x, the sum of the
imported mismatch payments that US1 and FE make to FZ). Accordingly, $2x
of FZ's $10x hybrid deduction offsets income attributable to US1's $10x
imported mismatch payment, and $8x of the hybrid deduction offsets
income attributable to FE's $40x imported mismatch payment.
(D) Therefore, $92x of US1's imported mismatch payment is a
disqualified imported mismatch amount, calculated as $90x (the amount
that is a disqualified imported mismatch amount determined by applying
Sec. 1.267A-4 in the manner set forth in Sec. 1.267A-4(f)(1)) plus $2x
(the amount that is a disqualified imported mismatch amount determined
by applying Sec. 1.267A-4 in the manner set forth in Sec. 1.267A-
4(f)(2)). See Sec. 1.267A-4(a)(1) and (f).
(iii) Alternative facts--amount deemed to be an imported mismatch
payment solely funds hybrid instrument deduction. The facts are the same
as in paragraph (c)(12)(i) of this section, except that FZ holds all of
the interests of US1 indirectly through FE, and US1 makes its $100x
payment to FE (rather than to FZ); such amount is treated as interest
for U.S. and Country E tax purposes, and is included in FE's income.
Moreover, FE pays $100x to FZ (rather than $40x); such amount is
included in FZ's income, and is subject to disallowance under a
provision of Country E hybrid mismatch rules substantially similar to
Sec. 1.267A-4. As described in paragraphs (c)(12)(iii)(A) through (D)
of this section, $90x of US1's payment is a disqualified imported
mismatch amount for which a deduction is disallowed under Sec. 1.267A-
1(b)(2).
(A) The entire $100x of US1's specified payment is an imported
mismatch payment. See Sec. 1.267A-4(a)(2)(v). US1 is an imported
mismatch payer and FE (a foreign tax resident that includes the imported
mismatch payment in income) is an imported mismatch payee. See Sec.
1.267A-4(a)(2).
(B) FZ has $100x of hybrid deductions. See Sec. 1.267A-4(b).
Pursuant to Sec. 1.267A-4(f)(1), Sec. 1.267A-4 is first applied by
taking into account only the $90x hybrid deduction consisting of the
notional interest deduction; in addition, for purposes of applying Sec.
1.267A-4 in this manner, FE's $100x payment is not treated as an
imported mismatch payment. Thus, the $90x hybrid deduction offsets the
income attributable to US1's imported mismatch payment, an imported
mismatch payment that indirectly funds the hybrid deduction. See Sec.
1.267A-4(c)(2)(iii). The imported mismatch payment indirectly funds the
hybrid deduction because FE (the imported mismatch payee) is allocated
the deduction, as FE makes a funded taxable payment (the $100x payment
to FZ) that is at least equal to the amount of the deduction. See Sec.
1.267A-4(c)(3)(ii), (iii), and (v).
(C) Section Sec. 1.267A-4 is next applied by taking into account
only the $10x hybrid deduction consisting of the deduction for the
payment pursuant to the FX-FZ instrument. See Sec. 1.267A-4(f)(2). For
purposes of applying Sec. 1.267A-4 in this manner, FE's $100x payment
is reduced from $100x to $10x, and similarly US1's imported mismatch
payment is reduced from $100x to $10x. See Sec. 1.267A-4(c)(4).
Further, FE's $10x payment is treated as an imported mismatch payment.
See Sec. 1.267A-4(f)(2). The entire $10x of FE's imported mismatch
payment directly funds the hybrid deduction because FZ (the imported
mismatch payee with respect to FE's imported mismatch payment) incurs at
least that amount of the hybrid
[[Page 909]]
deduction. See Sec. 1.267A-4(c)(3)(i). Accordingly, the $10x hybrid
deduction offsets the income attributable to FE's imported mismatch
payment, and none of the income attributable to US1's imported mismatch
payment.
(D) Therefore, $90x of US1's imported mismatch payment is a
disqualified imported mismatch amount, calculated as $90x (the amount
that is a disqualified imported mismatch amount determined by applying
Sec. 1.267A-4 in the manner set forth in Sec. 1.267A-4(f)(1)) plus $0
(the amount that is a disqualified imported mismatch amount determined
by applying Sec. 1.267A-4 in the manner set forth in Sec. 1.267A-
4(f)(2)). See Sec. 1.267A-4(a)(1) and (f).
[T.D. 9896, 85 FR 19836, Apr. 8, 2020]
Sec. 1.267A-7 Applicability dates.
(a) General rule. Except as provided in paragraph (b) of this
section, Sec. Sec. 1.267A-1 through 1.267A-6 apply to taxable years
ending on or after December 20, 2018, provided that such taxable years
begin after December 31, 2017. However, taxpayers may apply the
regulations in Sec. Sec. 1.267A-1 through 1.267A-6 in their entirety
(including by taking into account paragraph (b) of this section) for
taxable years beginning after December 31, 2017, and ending before
December 20, 2018. In lieu of applying the regulations in Sec. Sec.
1.267A-1 through 1.267A-6 (including paragraph (b) of this section),
taxpayers may apply the provisions matching Sec. Sec. 1.267A-1 through
1.267A-6 (including by taking into account the provision matching
paragraph (b) of this section) from the Internal Revenue Bulletin (IRB)
2019-03 (https://www.irs.gov/pub /irs-irbs/irb19-03.pdf) in their
entirety for all taxable years ending on or before April 8, 2020.
(b) Special rules. The following special rules apply regarding
applicability dates:
(1) Sections 1.267A-2(a)(4) (payments pursuant to interest-free
loans and similar arrangements), (b) (disregarded payments), (c) (deemed
branch payments), and (e) (branch mismatch transactions), 1.267A-4
(imported mismatch rule), and 1.267A-5(b)(5) (structured payments),
except as provided in paragraph (b)(5) of this section, apply to taxable
years beginning on or after December 20, 2018.
(2) Section 1.267A-5(a)(20) (defining structured arrangement), as
well as the portions of Sec. Sec. 1.267A-1 through 1.267A-3 that relate
to structured arrangements and that are not otherwise described in
paragraph (b) of this section, apply to taxable years beginning on or
after December 20, 2018. However, in the case of a specified payment
made pursuant to an arrangement entered into before December 22, 2017,
Sec. 1.267A-5(a)(20), and the portions of Sec. Sec. 1.267A-1 through
1.267A-3 that relate to structured arrangements and that are not
otherwise described in paragraph (b) of this section, apply to taxable
years beginning after December 31, 2020.
(3) Except as provided in paragraph (b)(4) of this section, the
rules provided in Sec. 1.267A-5(a)(12)(ii) (swaps with significant
nonperiodic payments) apply to notional principal contracts entered into
on or after April 8, 2021. However, taxpayers may apply the rules
provided in Sec. 1.267A-5(a)(12)(ii) to notional principal contracts
entered into before April 8, 2021.
(4) For a notional principal contract entered into before April 8,
2021, the interest equivalent rules provided in Sec. 1.267A-
5(b)(5)(ii)(B) (applied without regard to the references to Sec.
1.267A-5(a)(12)(ii)) apply to a notional principal contract entered into
on or after April 8, 2020.
(5) Section 1.267A-5(b)(5)(ii)(B) (interest equivalent rules)
applies to transactions entered into on or after April 8, 2020.
[T.D. 9896, 85 FR 19836, Apr. 8, 2020, as amended by 85 FR 48651, Aug.
12, 2020]
Sec. 1.267(a)-1 Deductions disallowed.
(a) Losses. Except in cases of distributions in corporate
liquidations, no deduction shall be allowed for losses arising from
direct or indirect sales or exchanges of property between persons who,
on the date of the sale or exchange, are within any one of the
relationships specified in section 267(b). See Sec. 1.267(b)-1.
(b) Unpaid expenses and interest. (1) No deduction shall be allowed
a taxpayer for trade or business expenses otherwise deductible under
section 162, for expenses for production of income otherwise deductible
under section 212, or
[[Page 910]]
for interest otherwise deductible under section 163:
(i) If, at the close of the taxpayer's taxable year within which
such items are accrued by the taxpayer or at any time within 2\1/2\
months thereafter, both the taxpayer and the payee are persons within
any one of the relationships specified in section 267(b) (see Sec.
1.267(b)-1); and
(ii) If the payee is on the cash receipts and disbursements method
of accounting with respect to such items of gross income for his taxable
year in which or with which the taxable year of accrual by the debtor-
taxpayer ends; and
(iii) If, within the taxpayer's taxable year within which such items
are accrued by the taxpayer and 2\1/2\ months after the close thereof,
the amount of such items is not paid and the amount of such items is not
otherwise (under the rules of constructive receipt) includible in the
gross income of the payee.
(2) The provisions of section 267(a)(2) and this paragraph do not
otherwise affect the general rules governing the allowance of deductions
under an accrual method of accounting. For example, if the accrued
expenses or interest are paid after the deduction has become disallowed
under section 267(a)(2), no deduction would be allowable for the taxable
year in which payment is made, since an accrual item is deductible only
in the taxable year in which it is properly accruable.
(3) The expenses and interest specified in section 267(a)(2) and
this paragraph shall be considered as paid for purposes of that section
to the extent of the fair market value on the date of issue of notes or
other instruments of similar effect received in payment of such expenses
or interest if such notes or other instruments were issued in such
payment by the taxpayer within his taxable year or within 2\1/2\ months
after the close thereof. The fair market value on the date of issue of
such notes or other instruments of similar effect is includible in the
gross income of the payee for the taxable year in which he receives the
notes or other instruments.
(4) The provisions of this paragraph may be illustrated by the
following example:
Example. A, an individual, is the holder and owner of an interest-
bearing note of the M Corporation, all the stock of which was owned by
him on December 31, 1956. A and the M Corporation make their income tax
returns for a calendar year. The M Corporation uses an accrual method of
accounting. A uses a combination of accounting methods permitted under
section 446(c)(4) in which he uses the cash receipts and disbursements
method in respect of items of gross income. The M Corporation does not
pay any interest on the note to A during the calendar year 1956 or
within 2\1/2\ months after the close of that year, nor does it credit
any interest to A's account in such a manner that it is subject to his
unqualified demand and thus is constructively received by him. M
Corporation claims a deduction for the year 1956 for the interest
accruing on the note in that year. Since A is on the cash receipts and
disbursements method in respect of items of gross income, the interest
is not includible in his return for the year 1956. Under the provisions
of section 267(a)(2) and this paragraph, no deduction for such interest
is allowable in computing the taxable income of the M Corporation for
the taxable year 1956 or for any other taxable year. However, if the
interest had actually been paid to A on or before March 15, 1957, or if
it had been made available to A before that time (and thus had been
constructively received by him), the M Corporation would be allowed to
deduct the amount of the payment in computing its taxable income for
1956.
(c) Scope of section. Section 267(a) requires that deductions for
losses or unpaid expenses or interest described therein be disallowed
even though the transaction in which such losses, expenses, or interest
were incurred was a bona fide transaction. However, section 267 is not
exclusive. No deduction for losses or unpaid expenses or interest
arising in a transaction which is not bona fide will be allowed even
though section 267 does not apply to the transaction.
Sec. 1.267(a)-2T Temporary regulations; questions and answers
arising under the Tax Reform Act of 1984 (temporary).
(a) Introduction--(1) Scope. This section prescribes temporary
question and answer regulations under section 267(a) and related
provisions as amended by
[[Page 911]]
section 174 of the Tax Reform Act of 1984, Pub. L. No. 98-369.
(2) Effective date. Except as otherwise provided by Answer 2 or
Answer 3 in paragraph (c) of this section, the effective date set forth
in section 174(c) of the Tax Reform Act of 1984 applies to this section.
(b) Questions applying section 267(a)(2) and (b) generally. The
following questions and answers deal with the application of section
267(a)(2) and (b) generally:
Question 1: Does section 267(a)(2) ever apply to defer the deduction
of an otherwise deductible amount if the person to whom the payment is
to be made properly uses the completed contract method of accounting
with respect to such amount?
Answer 1: No. Section 267(a)(2) applies only if an otherwise
deductible amount is owed to a related person under whose method of
accounting such amount is not includible in income unless paid to such
person. Regardless of when payment is made, an amount owed to a
contractor using the completed contract method of accounting is
includible in the income of the contractor in accordance with Sec.
1.451-3(d) in the year in which the contract is completed or in which
certain disputes are resolved.
Question 2: Does section 267(a)(2) ever apply to defer the deduction
of otherwise deductible original issue discount as defined in sections
163(e) and 1271 through 1275 (``the OID rules'')?
Answer 2. No. Regardless of when payment is made, an amount owed to
a lender that constitutes original issue discount is included in the
income of the lender periodically in accordance with the OID rules.
Similarly, section 267(a)(2) does not apply to defer an otherwise
deductible amount to the extent section 467 or section 7872 requires
periodic inclusion of such amount in the income of the person to whom
payment is to be made, even though payment has not been made.
Question 3: Does section 267(a)(2) ever apply to defer the deduction
of otherwise deductible unstated interest determined to exist under
section 483?
Answer 3: Yes. If section 483 recharacterizes any amount as unstated
interest and the other requirements of section 267(a)(2) are met, a
deduction for such unstated interest will be deferred under section 267.
Question 4: Does section 267(a)(2) ever apply to defer the deduction
of otherwise deductible cost recovery, depreciation, or amortization?
Answer 4: Yes, in certain cases. In general, section 267(a)(2) does
not apply to defer the deduction of otherwise deductible cost recovery,
depreciation, or amortization. Notwithstanding this general rule, if the
other requirements of section 267(a)(2) are met, section 267(a)(2) does
apply to defer deductions for cost recovery, depreciation, or
amortization of an amount owed to a related person for interest or rent
or for the performance or nonperformance of services, which amount the
taxpayer payor capitalized or treated as a deferred expense (unless the
taxpayer payor elected to capitalize or defer the amount and section
267(a)(2) would not have deferred the deduction of such amount if the
taxpayer payor had not so elected). Amounts owed for services that may
be subject to this provision include, for example, amounts owed for
acquisition, development, or organizational services or for covenants
not to compete. In applying this rule, payments made between persons
described in any of the paragraphs of section 267(b) (as modified by
section 267(e)) will be closely scrutinized to determine whether they
are made in respect of capitalized costs (or costs treated as deferred
expenses) that are subject to deferral under section 267(a)(2), or in
respect of other capitalized costs not so subject.
Question 5: If a deduction in respect of an otherwise deductible
amount is deferred by section 267(a)(2) and, prior to the time the
amount is includible in the gross income of the person to whom payment
is to be made, such person and the payor taxpayer cease to be persons
specified in any of the paragraphs of section 267(b) (as modified by
section 267(e)), is the deduction allowable as of the day on which the
relationship ceases?
Answer 5: No. The deduction is not allowable until the day as of
which the amount is includible in the gross income of the person to whom
payment of the amount is made, even though
[[Page 912]]
the relationship ceases to exist at an earlier time.
Question 6: Do references in other sections to persons described in
section 267(b) incorporate changes made to section 267(b) by section 174
of the Tax Reform Act of 1984?
Answer 6: Yes. References in other sections to persons described in
section 267(b) take into account changes made to section 267(b) by
section 174 of the Tax Reform Act of 1984 (without modification by
section 267(e)(1)). For example, a transfer after December 31, 1983 (the
effective date of the new section 267(b)(3) relationship added by the
Tax Reform Act of 1984) of section 1245 class property placed in service
before January 1, 1981, from one corporation to another corporation, 11
percent of the stock of which is owned by the first corporation, will
not constitute recovery property (as defined in section 168) in the
hands of the second corporation by reason of section 168(e)(4) (A)(i)
and (D).
(c) Questions applying section 267(a) to partnerships. The following
questions and answers deal with the application of section 267(a) to
partnerships:
Question 1: Does section 267(a) disallow losses and defer otherwise
deductible amounts at the partnership (entity) level?
Answer 1: Yes. If a loss realized by a partnership from a sale or
exchange of property is disallowed under section 267(a)(1), that loss
shall not enter into the computation of the partnership's taxable
income. If an amount that otherwise would be deductible by a partnership
is deferred by section 267(a)(2), that amount shall not enter into the
computation of the partnership's taxable income until the taxable year
of the partnership in which falls the day on which the amount is
includible in the gross income of the person to whom payment of the
amount is made.
Question 2: Does section 267(a)(1) ever apply to disallow a loss if
the sale or exchange giving rise to the loss is between two partnerships
even though the two partnerships are not persons specified in any of the
paragraphs of section 267(b)?
Answer 2: Yes. If the other requirements of section 267(a)(1) are
met, section 267(a)(1) applies to such losses arising as a result of
transactions entered into after December 31, 1984 between partnerships
not described in any of the paragraphs of section 267(b) as follows, and
Sec. 1.267(b)-1(b) does not apply. If the two partnerships have one or
more common partners (i.e., if any person owns directly, indirectly, or
constructively any capital or profits interest in each of such
partnerships), or if any partner in either partnership and one or more
partners in the other partnership are persons specified in any of the
paragraphs of section 267(b) (without modification by section 267(e)), a
portion of the selling partnership's loss will be disallowed under
section 267(a)(1). The amount disallowed under this rule is the greater
of: (1) The amount that would be disallowed if the transaction giving
rise to the loss had occurred between the selling partnership and the
separate partners of the purchasing partnership (in proportion to their
respective interests in the purchasing partnership); or (2) the amount
that would be disallowed if such transaction had occurred between the
separate partners of the selling partnership (in proportion to their
respective interests in the selling partnership) and the purchasing
partnership. Notwithstanding the general rule of this paragraph (c)
Answer 2, no disallowance shall occur if the amount that would be
disallowed pursuant to the immediately preceding sentence is less than 5
percent of the loss arising from the sale or exchange.
Question 3: Does section 267(a)(2) ever apply to defer an otherwise
deductible amount if the taxpayer payor is a partnership and the person
to whom payment of such amount is to be made is a partnership even
though the two partnerships are not persons specified in any of the
paragraphs of section 267(b) (as modified by section 267(e))?
Answer 3: Yes. If the other requirements of section 267(a)(2) are
met, section 267(a)(2) applies to such amounts arising as a result of
transactions entered into after December 31, 1984 between partnerships
not described in any of the paragraphs of section 267(b) (as modified by
section 267(e)) as follows, and Sec. 1.267(b)-1(b) does not apply. If
the two partnerships have one or
[[Page 913]]
more common partners (i.e., if any person owns directly, indirectly, or
constructively any capital or profits interest in each of such
partnerships), or if any partner in either partnership and one or more
partners in the other partnership are persons specified in any of the
paragraphs of section 267(b) (without modification by section 267(e)), a
portion of the payor partnership's otherwise allowable deduction will be
deferred under section 267(a)(2). The amount deferred under this rule is
the greater of: (1) The amount that would be deferred if the transaction
giving rise to the otherwise allowable deduction had occurred between
the payor partnership and the separate partners of the payee partnership
(in proportion to their respective interests in the payee partnership);
or (2) the amount that would be deferred if such transaction had
occurred between the separate partners of the payor partnership (in
proportion to their respective interests in the payor partnership) and
the payee partnership. Notwithstanding the general rule of this
paragraph (c) Answer 3, no deferral shall occur if the amount that would
be deferred pursuant to the immediately preceding sentence is less than
5 percent of the otherwise allowable deduction.
Example. On May 1, 1985, partnership AB enters into a transaction
whereby it accrues an otherwise deductible amount to partnership AC. AC
is on the cash receipts and disbursements method of accounting. A holds
a 5 percent capital and profits interest in AB and a 49 percent capital
and profits interest in AC, and A's interest in each item of the income,
gain, loss, deduction, and credit of each partnership is 5 percent and
49 percent, respectively. B and C are not related. Notwithstanding that
AB and AC are not persons specified in section 267(b), 49 percent of the
deduction in respect of such amount will be deferred under section
267(a)(2). The result would be the same if A held a 49 percent interest
in AB and a 5 percent interest in AC. However, if A held more than 50
percent of the capital or profits interest of either AB or AC, the
entire deduction in respect of such amount would be deferred under
section 267(a)(2).
Question 4: What does the phrase incurred at an annual rate not in
excess of 12 percent mean as used in section 267(e)(5)(C)(ii)?
Answer 4: The phrase refers to interest that accrues but is not
includible in the income of the person to whom payment is to be made
during the taxable year of the payor. Thus, in determining whether the
requirements of section 267(e)(5) (providing an exception to certain
provisions of section 267 for certain expenses and interest of
partnerships owning low income housing) are met with respect to a
transaction, the requirement of section 267(e)(5)(C)(ii) will be
satisfied, even though the total interest (both stated and unstated)
paid or accrued in any taxable year of the payor taxpayer exceeds 12
percent, if the interest in excess of 12 percent per annum, compounded
semi-annually, on the outstanding loan balance (principal and accrued
but unpaid interest) is includible in the income of the person to whom
payment is to be made no later than the last day of such taxable year of
the payor taxpayer.
(98 Stat. 704, 26 U.S.C. 267; 98 Stat. 589, 26 U.S.C. 706; 68A Stat.
367, 26 U.S.C. 1502; 68A Stat. 917, 26 U.S.C. 7805)
[T.D. 7991, 49 FR 46995, Nov. 30, 1984]
Sec. 1.267(a)-3 Deduction of amounts owed to related foreign persons.
(a) Purpose and scope. This section provides rules under section
267(a) (2) and (3) governing when an amount owed to a related foreign
person that is otherwise deductible under Chapter 1 may be deducted.
Paragraph (b) of this section provides the general rules, and paragraph
(c) of this section provides exceptions and special rules.
(b) Deduction of amount owed to related foreign person--(1) In
general. Except as provided in paragraph (c) of this section, section
267(a)(3) requires a taxpayer to use the cash method of accounting with
respect to the deduction of amounts owed to a related foreign person. An
amount that is owed to a related foreign person and that is otherwise
deductible under Chapter 1 thus may not be deducted by the taxpayer
until such amount is paid to the related foreign person. For purposes of
this section, a related foreign person is any person that is not a
United States person within the meaning of section 7701(a)(30), and that
is related (within the meaning of section 267(b)) to the taxpayer at the
close of the taxable year in which the amount incurred by
[[Page 914]]
the taxpayer would otherwise be deductible. Section 267(f) defines
controlled group for purposes of section 267(b) without regard to the
limitations of section 1563(b). An amount is treated as paid for
purposes of this section if the amount is considered paid for purposes
of section 1441 or section 1442 (including an amount taken into account
pursuant to section 884(f)).
(2) Amounts covered. This section applies to otherwise deductible
amounts that are of a type described in section 871(a)(1) (A), (B) or
(D), or in section 881(a) (1), (2) or (4). The rules of this section
also apply to interest that is from sources outside the United States.
Amounts other than interest that are from sources outside the United
States, and that are not income of a related foreign person effectively
connected with the conduct by such related foreign person of a trade or
business within the United States, are not subject to the rules of
section 267(a) (2) or (3) or this section. See paragraph (c) of this
section for rules governing the treatment of amounts that are income of
a related foreign person effectively connected with the conduct of a
trade or business within the United States by such related foreign
person.
(3) Change in method of accounting. A taxpayer that uses a method of
accounting other than that required by the rules of this section must
change its method of accounting to conform its method to the rules of
this section. The taxpayer's change in method must be made pursuant to
the rules of section 446(e), the regulations thereunder, and any
applicable administrative procedures prescribed by the Commissioner.
Because the rules of this section prescribe a method of accounting,
these rules apply in the determination of taxpayer's earnings and
profits pursuant to Sec. 1.1312-6(a).
(4) Examples. The provisions of this paragraph (b) may be
illustrated by the following examples:
Example 1. (i) FC, a corporation incorporated in Country X, owns 100
percent of the stock of C, a domestic corporation. C uses the accrual
method of accounting in computing its income and deductions, and is a
calendar year taxpayer. In Year 1, C accrues an amount owed to FC for
interest. C makes an actual payment of the amount owed to FC in Year 2.
(ii) Regardless of its source, the interest owed to FC is an amount
to which this section applies. Pursuant to the rules of this paragraph
(b), the amount owed to FC by C will not be allowable as a deduction in
Year 1. Section 267 does not preclude the deduction of this amount in
Year 2.
Example 2. (i) RS, a domestic corporation, is the sole shareholder
of FSC, a foreign sales corporation. Both RS and FSC use the accrual
method of accounting. In Year 1, RS accrues $z owed to FSC for
commissions earned by FSC in Year 1. Pursuant to the foreign sales
company provisions, sections 921 through 927, a portion of this amount,
$x, is treated as effectively connected income of FSC from sources
outside the United States. Accordingly, the rules of section 267(a)(3)
and paragraph (b) of this section do not apply. See paragraph (c) of
this section for the rules governing the treatment of amounts that are
effectively connected income of FSC.
(ii) The remaining amount of the commission, $y, is classified as
exempt foreign trade income under section 923(a)(3) and is treated as
income of FSC from sources outside the United States that is not
effectively connected income. This amount is one to which the provisions
of this section do not apply, since it is an amount other than interest
from sources outside the United States and is not effectively connected
income. Therefore, a deduction for $y is allowable to RS as of the day
on which it accrues the otherwise deductible amount, without regard to
section 267 (a)(2) and (a)(3) and the regulations thereunder.
(c) Exceptions and special rules--(1) Effectively connected income
subject to United States tax. The provisions of section 267(a)(2) and
the regulations thereunder, and not the provisions of paragraph (b) of
this section, apply to an amount that is income of the related foreign
person that is effectively connected with the conduct of a United States
trade or business of such related foreign person. An amount described in
this paragraph (c)(1) thus is allowable as a deduction as of the day on
which the amount is includible in the gross income of the related
foreign person as effectively connected income under sections 872(a)(2)
or 882(b) (or, if later, as of the day on which the deduction would be
so allowable but for section 267(a)(2)). However, this paragraph (c)(1)
does not apply if the related foreign person is exempt from United
States income tax on the amount owed, or is subject to a reduced rate of
tax, pursuant to a treaty obligation of the United States (such as under
an article
[[Page 915]]
relating to the taxation of business profits).
(2) Items exempt from tax by treaty. Except with respect to
interest, neither paragraph (b) of this section nor section 267 (a)(2)
applies to any amount that is income of a related foreign person with
respect to which the related foreign person is exempt from United States
taxation on the amount owed pursuant to a treaty obligation of the
United States (such as under an article relating to the taxation of
business profits). Interest that is effectively connected income of the
related foreign person under sections 872(a)(2) or 882(b) is an amount
covered by paragraph (c)(1) of this section. Interest that is not
effectively connected income of the related foreign person is an amount
covered by paragraph (b) of this section, regardless of whether the
related foreign person is exempt from United States taxation on the
amount owed pursuant to a treaty obligation of the United States.
(3) Items subject to reduced rate of tax by treaty. Paragraph (b) of
this section applies to amounts that are income of a related foreign
person with respect to which the related foreign person claims a reduced
rate of United States income tax on the amount owed pursuant to a treaty
obligation of the United States (such as under an article relating to
the taxation of royalties).
(4) Certain amounts owed to certain controlled foreign corporations.
An amount that is income of a related foreign person is exempt from the
application of section 267(a)(3)(B)(i) if the related foreign person is
a controlled foreign corporation that does not have any United States
shareholders (as defined in section 951(b)) that own (within the meaning
of section 958(a)) stock of the controlled foreign corporation. However,
in this case, the amount is subject to the application of section
267(a)(3)(A) in the same manner as if the related foreign person were a
foreign corporation that is not a controlled foreign corporation.
(d) Effective date. The rules of this section are effective with
respect to interest that is allowable as a deduction under chapter 1
(without regard to the rules of this section) in taxable years beginning
after December 31, 1983, but are not effective with respect to interest
that is incurred with respect to indebtedness incurred on or before
September 29, 1983, or incurred after that date pursuant to a contract
that was binding on that date and at all times thereafter (unless the
indebtedness or the contract was renegotiated, extended, renewed, or
revised after that date). Except as otherwise provided in this paragraph
(d), the regulations in this section issued under section 267 apply to
all other deductible amounts that are incurred after July 31, 1989, but
do not apply to amounts that are incurred pursuant to a contract that
was binding on September 29, 1983, and at all times thereafter (unless
the contract was renegotiated, extended, renewed, or revised after that
date). Paragraph (c)(2) of this section applies to payments accrued on
or after October 22, 2004. For payments accrued before October 22, 2004,
see Sec. 1.267(a)-3(c)(2), as contained in 26 CFR part 1, revised as of
April 1, 2004. Paragraph (c)(4) of this section applies to payments
accrued on or after October 1, 2019. For payments accrued before October
1, 2019, a taxpayer may apply paragraph (c)(4) of this section for
payments accrued during the last taxable year of a foreign corporation
beginning before January 1, 2018, and each subsequent taxable year of
the foreign corporation, provided that the taxpayer and United States
persons that are related (within the meaning of section 267 or 707) to
the taxpayer consistently apply such paragraph with respect to all
foreign corporations. For payments accrued before October 22, 2004, see
Sec. 1.267(a)-3(c)(4), as contained in 26 CFR part 1, revised as of
April 1, 2004.
[T.D. 8465, 58 FR 237, Jan. 5, 1993, as amended by T.D 9908, 85 FR
59430, Sept. 22, 2020]
Sec. 1.267(b)-1 Relationships.
(a) In general. (1) The persons referred to in section 267(a) and
Sec. 1.267 (a)-1 are specified in section 267(b).
(2) Under section 267(b)(3), it is not necessary that either of the
two corporations be a personal holding company or a foreign personal
holding company for the taxable year in which the sale or exchange
occurs or in which the expenses or interest are properly accruable, but
either one of them must
[[Page 916]]
be such a company for the taxable year next preceding the taxable year
in which the sale or exchange occurs or in which the expenses or
interest are accrued.
(3) Under section 267(b)(9), the control of certain educational and
charitable organizations exempt from tax under section 501 includes any
kind of control, direct or indirect, by means of which a person in fact
controls such an organization, whether or not the control is legally
enforceable and regardless of the method by which the control is
exercised or exercisable. In the case of an individual, control
possessed by the individual's family, as defined in section 267(c)(4)
and paragraph (a)(4) of Sec. 1.267 (c)-1, shall be taken into account.
(b) Partnerships. (1) Since section 267 does not include members of
a partnership and the partnership as related persons, transactions
between partners and partnerships do not come within the scope of
section 267. Such transactions are governed by section 707 for the
purposes of which the partnership is considered to be an entity separate
from the partners. See section 707 and Sec. 1.707-1. Any transaction
described in section 267(a) between a partnership and a person other
than a partner shall be considered as occurring between the other person
and the members of the partnership separately. Therefore, if the other
person and a partner are within any one of the relationships specified
in section 267(b), no deductions with respect to such transactions
between the other person and the partnership shall be allowed:
(i) To the related partner to the extent of his distributive share
of partnership deductions for losses or unpaid expenses or interest
resulting from such transactions, and
(ii) To the other person to the extent the related partner acquires
an interest in any property sold to or exchanged with the partnership by
such other person at a loss, or to the extent of the related partner's
distributive share of the unpaid expenses or interest payable to the
partnership by the other person as a result of such transaction.
(2) The provisions of this paragraph may be illustrated by the
following examples:
Example 1. A, an equal partner in the ABC partnership, personally
owns all the stock of M Corporation. B and C are not related to A. The
partnership and all the partners use an accrual method of accounting,
and are on a calendar year. M Corporation uses the cash receipts and
disbursements method of accounting and is also on a calendar year.
During 1956 the partnership borrowed money from M Corporation and also
sold property to M Corporation, sustaining a loss on the sale. On
December 31, 1956, the partnership accrued its interest liability to the
M Corporation and on April 1, 1957 (more than 2\1/2\ months after the
close of its taxable year), it paid the M Corporation the amount of such
accrued interest. Applying the rules of this paragraph, the transactions
are considered as occurring between M Corporation and the partners
separately. The sale and interest transactions considered as occurring
between A and the M Corporation fall within the scope of section 267 (a)
and (b), but the transactions considered as occurring between partners B
and C and the M Corporation do not. The latter two partners may,
therefore, deduct their distributive shares of partnership deductions
for the loss and the accrued interest. However, no deduction shall be
allowed to A for his distributive shares of these partnership
deductions. Furthermore, A's adjusted basis for his partnership interest
must be decreased by the amount of his distributive share of such
deductions. See section 705(a)(2).
Example 2. Assume the same facts as in Example 1 of this
subparagraph except that the partnership and all the partners use the
cash receipts and disbursements method of accounting, and that M
Corporation uses an accrual method. Assume further, that during 1956 M
Corporation borrowed money from the partnership and that on a sale of
property to the partnership during that year M Corporation sustained a
loss. On December 31, 1956, the M Corporation accrued its interest
liability on the borrowed money and on April 1, 1957 (more than 2\1/2\
months after the close of its taxable year) it paid the accrued interest
to the partnership. The corporation's deduction for the accrued interest
is not allowed to the extent of A's distributive share (one-third) of
such interest income. M Corporation's deduction for the loss on the sale
of the property to the partnership is not allowed to the extent of A's
one-third interest in the purchased property.
Sec. 1.267(c)-1 Constructive ownership of stock.
(a) In general. (1) The determination of stock ownership for
purposes of section 267(b) shall be in accordance with the rules in
section 267(c).
[[Page 917]]
(2) For an individual to be considered under section 267(c)(2) as
constructively owning the stock of a corporation which is owned,
directly or indirectly, by or for members of his family it is not
necessary that he own stock in the corporation either directly or
indirectly. On the other hand, for an individual to be considered under
section 267(c)(3) as owning the stock of a corporation owned either
actually, or constructively under section 267(c)(1), by or for his
partner, such individual must himself actually own, or constructively
own under section 267(c)(1), stock of such corporation.
(3) An individual's constructive ownership, under section 267(c) (2)
or (3), of stock owned directly or indirectly by or for a member of his
family, or by or for his partner, is not to be considered as actual
ownership of such stock, and the individual's constructive ownership of
the stock is not to be attributed to another member of his family or to
another partner. However, an individual's constructive ownership, under
section 267(c)(1), of stock owned directly or indirectly by or for a
corporation, partnership, estate, or trust shall be considered as actual
ownership of the stock, and the individual's ownership may be attributed
to a member of his family or to his partner.
(4) The family of an individual shall include only his brothers and
sisters, spouse, ancestors, and lineal descendants. In determining
whether any of these relationships exist, full effect shall be given to
a legal adoption. The term ancestors includes parents and grandparents,
and the term lineal descendants includes children and grandchildren.
(b) Examples. The application of section 267(c) may be illustrated
by the following examples:
Example 1. On July 1, 1957, A owned 75 percent, and AW, his wife,
owned 25 percent, of the outstanding stock of the M Corporation. The M
Corporation in turn owned 80 percent of the outstanding stock of the O
Corporation. Under section 267(c)(1), A and AW are each considered as
owning an amount of the O Corporation stock actually owned by M
Corporation in proportion to their respective ownership of M Corporation
stock. Therefore, A constructively owns 60 percent (75 percent of 80
percent) of the O Corporation stock and AW constructively owns 20
percent (25 percent of 80 percent) of such stock. Under the family
ownership rule of section 267(c)(2), an individual is considered as
constructively owning the stock actually owned by his spouse. A and AW,
therefore, are each considered as constructively owning the M
Corporation stock actually owned by the other. For the purpose of
applying this family ownership rule, A's and AW's constructive ownership
of O Corporation stock is considered as actual ownership under section
267(c)(5). Thus, A constructively owns the 20 percent of the O
Corporation stock constructively owned by AW, and AW constructively owns
the 60 percent of the O Corporation stock constructively owned by A. In
addition, the family ownership rule may be applied to make AWF, AW's
father, the constructive owner of the 25 percent of the M Corporation
stock actually owned by AW. As noted above, AW's constructive ownership
of 20 percent of the O Corporation stock is considered as actual
ownership for purposes of applying the family ownership rule, and AWF is
thereby considered the constructive owner of this stock also. However,
AW's constructive ownership of the stock constructively and actually
owned by A may not be considered as actual ownership for the purpose of
again applying the family ownership rule to make AWF the constructive
owner of these shares. The ownership of the stock in the M and O
Corporations may be tabulated as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Stock ownership in M Stock ownsership in O
Corporation Total under Corporation Total under
Person -------------------------------- Section 267 -------------------------------- Section 267
Actual Constructive (Percent) Actual Constructive (Percent)
(Percent) (Percent) (Percent) (Percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
A....................................................... 75 25 100 .............. 60 ..............
.............. .............. .............. None .............. 80
.............. .............. .............. .............. 20 ..............
A W (A's wife).......................................... 25 75 100 .............. 20 ..............
.............. .............. .............. None .............. 80
.............. .............. .............. .............. 60 ..............
A W F (AW's father)..................................... None 25 25 None 20 20
M Corporation........................................... .............. .............. .............. 80 None 80
[[Page 918]]
O Corporation........................................... None None None .............. .............. ..............
--------------------------------------------------------------------------------------------------------------------------------------------------------
Assuming that the M Corporation and the O Corporation make their income
tax returns for calendar years, and that there was no distribution in
liquidation of the M or O Corporation, and further assuming that other
corporation was a personal holding company under section 542 for the
calendar year 1956, no deduction is allowable with respect to losses
from sales or exchanges of property made on July 1, 1957, between the
two corporations. Moreover, whether or not either corporation was a
personal holding company, no loss would be allowable on a sale or
exchange between A or AW and either corporation. A deduction would be
allowed, however, for a loss sustained in an arm's length sale or
exchange between A and AWF, and between AWF and the M or O Corporation.
Example 2. On June 15, 1957, all of the stock of the N Corporation
was owned in equal proportions by A and his partner, AP. Except in the
case of distributions in liquidation by the N Corporation, no deduction
is allowable with respect to losses from sales or exchanges of property
made on June 15, 1957, between A and the N Corporation or AP and the N
Corporation since each partner is considered as owning the stock owned
by the other; therefore, each is considered as owning more than 50
percent in value of the outstanding stock of the N Corporation.
Example 3. On June 7, 1957, A owned no stock in X Corporation, but
his wife, AW, owned 20 percent in value of the outstanding stock of X,
and A's partner, AP, owned 60 percent in value of the outstanding stock
of X. The partnership firm of A and AP owned no stock in X Corporation.
The ownership of AW's stock is attributed to A, but not that of AP since
A does not own any X Corporation stock either actually, or
constructively under section 267(c)(1). A's constructive ownership of
AW's stock is not the ownership required for the attribution of AP's
stock. Therefore, deductions for losses from sales or exchanges of
property made on June 7, 1957, between X Corporation and A or AW are
allowable since neither person owned more than 50 percent in value of
the outstanding stock of X, but deductions for losses from sales or
exchanges between X Corporation and AP would not be allowable by section
267(a) (except for distributions in liquidation of X Corporation).
Sec. 1.267(d)-1 Amount of gain where loss previously disallowed.
(a) General rule. (1) If a taxpayer acquires property by purchase or
exchange from a transferor who, on the transaction, sustained a loss not
allowable as a deduction by reason of section 267(a)(1) (or by reason of
section 24(b) of the Internal Revenue Code of 1939), then any gain
realized by the taxpayer on a sale or other disposition of the property
after December 31, 1953, shall be recognized only to the extent that the
gain exceeds the amount of such loss as is properly allocable to the
property sold or otherwise disposed of by the taxpayer.
(2) The general rule is also applicable to a sale or other
disposition of property by a taxpayer when the basis of such property in
the taxpayer's hands is determined directly or indirectly by reference
to other property acquired by the taxpayer from a transferor through a
sale or exchange in which a loss sustained by the transferor was not
allowable. Therefore, section 267(d) applies to a sale or other
disposition of property after a series of transactions if the basis of
the property acquired in each transaction is determined by reference to
the basis of the property transferred, and if the original property was
acquired in a transaction in which a loss to a transferor was not
allowable by reason of section 267(a)(1) (or by reason of section 24(b)
of the Internal Revenue Code of 1939).
(3) The benefit of the general rule is available only to the
original transferee but does not apply to any original transferee (for
example, a donee or a person acquiring property from a decedent where
the basis of property is determined under section 1014 or 1022) who
acquired the property in any manner other than by purchase or exchange.
(4) The application of the provisions of this paragraph may be
illustrated by the following examples:
[[Page 919]]
Example 1. H sells to his wife, W, for $500, certain corporate stock
with an adjusted basis for determining loss to him of $800. The loss of
$300 is not allowable to H by reason of section 267(a)(1) and paragraph
(a) of Sec. 1.267 (a)-1. W later sells this stock for $1,000. Although
W's realized gain is $500 ($1,000 minus $500, her basis), her recognized
gain under section 267(d) is only $200, the excess of the realized gain
of $500 over the loss of $300 not allowable to H. In determining capital
gain or loss W's holding period commences on the date of the sale from H
to W.
Example 2. Assume the same facts as in Example 1 except that W later
sells her stock for $300 instead of $1,000. Her recognized loss is $200
and not $500 since section 267(d) applies only to the nonrecognition of
gain and does not affect basis.
Example 3. Assume the same facts as in Example 1 except that W
transfers her stock as a gift to X. The basis of the stock in the hands
of X for the purpose of determining gain, under the provisions of
section 1015, is the same as W's, or $500. If X later sells the stock
for $1,000 the entire $500 gain is taxed to him.
Example 4. H sells to his wife, W, for $5,500, farmland, with an
adjusted basis for determining loss to him of $8,000. The loss of $2,500
is not allowable to H by reason of section 267(a)(1) and paragraph (a)
of Sec. 1.267 (a)-1. W exchanges the farmland, held for investment
purposes, with S, an unrelated individual, for two city lots, also held
for investment purposes. The basis of the city lots in the hands of W
($5,500) is a substituted basis determined under section 1031(d) by
reference to the basis of the farmland. Later W sells the city lots for
$10,000. Although W's realized gain is $4,500 (10,000 minus $5,500), her
recognized gain under section 267(d) is only $2,000, the excess of the
realized gain of $4,500 over the loss of $2,500 not allowable to H.
(b) Determination of basis and gain with respect to divisible
property--(1) Taxpayer's basis. When the taxpayer acquires divisible
property or property that consists of several items or classes of items
by a purchase or exchange on which loss is not allowable to the
transferor, the basis in the taxpayer's hands of a particular part,
item, or class of such property shall be determined (if the taxpayer's
basis for that part is not known) by allocating to the particular part,
item, or class a portion of the taxpayer's basis for the entire property
in the proportion that the fair market value of the particular part,
item, or class bears to the fair market value of the entire property at
the time of the taxpayer's acquisition of the property.
(2) Taxpayer's recognized gain. Gain realized by the taxpayer on
sales or other dispositions after December 31, 1953, of a part, item, or
class of the property shall be recognized only to the extent that such
gain exceeds the amount of loss attributable to such part, item, or
class of property not allowable to the taxpayer's transferor on the
latter's sale or exchange of such property to the taxpayer.
(3) Transferor's loss not allowable. (i) The transferor's loss on
the sale or exchange of a part, item, or class of the property to the
taxpayer shall be the excess of the transferor's adjusted basis for
determining loss on the part, item, or class of the property over the
amount realized by the transferor on the sale or exchange of the part,
item, or class. The amount realized by the transferor on the part, item,
or class shall be determined (if such amount is not known) in the same
manner that the taxpayer's basis for such part, item, or class is
determined. See subparagraph (1) of this paragraph.
(ii) If the transferor's basis for determining loss on the part,
item, or class cannot be determined, the transferor's loss on the
particular part, item, or class transferred to the taxpayer shall be
determined by allocating to the part, item, or class a portion of his
loss on the entire property in the proportion that the fair market value
of such part, item, or class bears to the fair market value of the
entire property on the date of the taxpayer's acquisition of the entire
property.
(4) Examples. The application of the provisions of this paragraph
may be illustrated by the following examples:
Example 1. During 1953, H sold class A stock which had cost him
$1,100, and common stock which had cost him $2,000, to his wife W for a
lump sum of $1,500. Under section 24(b)(1)(A) of the 1939 Code, the loss
of $1,600 on the transaction was not allowable to H. At the time the
stocks were purchased by W, the fair market value of class A stock was
$900 and the fair market value of common stock was $600. In 1954, W sold
the class A stock for $2,500. W's recognized gain is determined as
follows:
Amount realized by W on sale of class A stock................ $2,500
Less: Basis allocated to class A stock--$900/$1,500 x $1,500. 900
----------
Realized gain on transaction............................. 1,600
[[Page 920]]
Less: Loss sustained by H on sale of class A stock to W not
allowable as a deduction:
Basis to H of class A stock..................... $1,100
Amount realized by H on class A stock--$900/ 900
$1,500 x $1,500................................
-----------
Unallowable loss to H on sale of class A stock........... 200
----------
Recognized gain on sale of class A stock by W.............. 1,400
Example 2. Assume the same facts as those stated in Example 1 of
this subparagraph except that H originally purchased both classes of
stock for a lump sum of $3,100. The unallowable loss to H on the sale of
all the stock to W is $1,600 ($3,100 minus $1,500). An exact
determination of the unallowable loss sustained by H on sale to W of
class A stock cannot be made because H's basis for class A stock cannot
be determined. Therefore, a determination of the unallowable loss is
made by allocating to class A stock a portion of H's loss on the entire
property transferred to W in the proportion that the fair market value
of class A stock at the time acquired by W ($900) bears to the fair
market value of both classes of stock at that time ($1,500). The
allocated portion is $900/$1,500 x $1,600, or $960. W's recognized gain
is, therefore, $640 (W's realized gain of $1,600 minus $960).
(c) Special rules. (1) Section 267(d) does not affect the basis of
property for determining gain. Depreciation and other items which depend
on such basis are also not affected.
(2) The provisions of section 267(d) shall not apply if the loss
sustained by the transferor is not allowable to the transferor as a
deduction by reason of section 1091, or section 118 of the Internal
Revenue Code of 1939, which relate to losses from wash sales of stock or
securities.
(3) In determining the holding period in the hands of the transferee
of property received in an exchange with a transferor with respect to
whom a loss on the exchange is not allowable by reason of section 267,
section 1223(2) does not apply to include the period during which the
property was held by the transferor. In determining such holding period,
however, section 1223(1) may apply to include the period during which
the transferee held the property which he exchanged where, for example,
he exchanged a capital asset in a transaction which, as to him, was
nontaxable under section 1031 and the property received in the exchange
has the same basis as the property exchanged.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 9811, 82 FR
6237, Jan. 19, 2017]
Sec. 1.267(d)-2 Effective/applicability dates.
Pursuant to section 7851(a)(1)(C), the regulations prescribed in
Sec. 1.267(d)-1, to the extent that they relate to determination of
gain resulting from the sale or other disposition of property after
December 31, 1953, with respect to which property a loss was not
allowable to the transferor by reason of section 267(a)(1) (or by reason
of section 24(b) of the Internal Revenue Code of 1939), shall also apply
to taxable years beginning before January 1, 1954, and ending after
December 31, 1953, and taxable years beginning after December 31, 1953,
and ending before August 17, 1954, which years are subject to the
Internal Revenue Code of 1939. The provisions of Sec. 1.267(d)-1(a)(3)
relating to section 1022 are effective on and after January 19, 2017.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960, as amended by T.D. 9811, 82 FR
6237, Jan. 19, 2017]
Sec. 1.267(f)-1 Controlled groups.
(a) In general--(1) Purpose. This section provides rules under
section 267(f) to defer losses and deductions from certain transactions
between members of a controlled group (intercompany sales). The purpose
of this section is to prevent members of a controlled group from taking
into account a loss or deduction solely as the result of a transfer of
property between a selling member (S) and a buying member (B).
(2) Application of consolidated return principles. Under this
section, S's loss or deduction from an intercompany sale is taken into
account under the timing principles of Sec. 1.1502-13 (intercompany
transactions between members of a consolidated group), treating the
intercompany sale as an intercompany transaction. For this purpose:
(i) The matching and acceleration rules of Sec. 1.1502-13 (c) and
(d), the definitions and operating rules of Sec. 1.1502-13 (b) and (j),
and the simplifying rules of
[[Page 921]]
Sec. 1.1502-13(e)(1) apply with the adjustments in paragraphs (b) and
(c) of this section to reflect that this section--
(A) Applies on a controlled group basis rather than consolidated
group basis; and
(B) Generally affects only the timing of a loss or deduction, and
not it's attributes (e.g., its source and character) or the holding
period of property.
(ii) The special rules under Sec. 1.1502-13(f) (stock of members)
and (g) (obligations of members) apply under this section only to the
extent the transaction is also an intercompany transaction to which
Sec. 1.1502-13 applies.
(iii) Any election under Sec. 1.1502-13 to take items into account
on a separate entity basis does not apply under this section. See Sec.
1.1502-13(e)(3).
(3) Other law. The rules of this section apply in addition to other
applicable law (including nonstatutory authorities). For example, to the
extent a loss or deduction deferred under this section is from a
transaction that is also an intercompany transaction under Sec. 1.1502-
13(b)(1), attributes of the loss or deduction are also subject to
recharacterization under Sec. 1.1502-13. See also, sections 269
(acquisitions to evade or avoid income tax) and 482 (allocations among
commonly controlled taxpayers). Any loss or deduction taken into account
under this section can be deferred, disallowed, or eliminated under
other applicable law. See, for example, section 1091 (loss eliminated on
wash sale).
(b) Definitions and operating rules. The definitions in Sec.
1.1502-13(b) and the operating rules of Sec. 1.1502-13(j) apply under
this section with appropriate adjustments, including the following:
(1) Intercompany sale. An intercompany sale is a sale, exchange, or
other transfer of property between members of a controlled group, if it
would be an intercompany transaction under the principles of Sec.
1.1502-13, determined by treating the references to a consolidated group
as references to a controlled group and by disregarding whether any of
the members join in filing consolidated returns.
(2) S's losses or deductions. Except to the extent the intercompany
sale is also an intercompany transaction to which Sec. 1.1502-13
applies, S's losses or deductions subject to this section are determined
on a separate entity basis. For example, the principles of Sec. 1.1502-
13(b)(2)(iii) (treating certain amounts not yet recognized as items to
be taken into account) do not apply. A loss or deduction is from an
intercompany sale whether it is directly or indirectly from the
intercompany sale.
(3) Controlled group; member. For purposes of this section, a
controlled group is defined in section 267(f). Thus, a controlled group
includes a FSC (as defined in section 922) and excluded members under
section 1563(b)(2), but does not include a DISC (as defined in section
992). Corporations remain members of a controlled group as long as they
remain in a controlled group relationship with each other. For example,
corporations become nonmembers with respect to each other when they
cease to be in a controlled group relationship with each other, rather
than by having a separate return year (described in Sec. 1.1502-
13(j)(7)). Further, the principles of Sec. 1.1502-13(j)(6) (former
common parent treated as continuation of group) apply to any corporation
if, immediately before it becomes a nonmember, it is both the selling
member and the owner of property with respect to which a loss or
deduction is deferred (whether or not it becomes a member of a different
controlled group filing consolidated or separate returns). Thus, for
example, if S and B merge together in a transaction described in section
368(a)(1)(A), the surviving corporation is treated as the successor to
the other corporation, and the controlled group relationship is treated
as continuing.
(4) Consolidated taxable income. References to consolidated taxable
income (and consolidated tax liability) include references to the
combined taxable income of the members (and their combined tax
liability). For corporations filing separate returns, it ordinarily will
not be necessary to actually combine their taxable incomes (and tax
liabilities) because the taxable income (and tax liability) of one
corporation does not affect the taxable income (or tax liability) of
another corporation.
(c) Matching and acceleration principles of Sec. 1.1502-13--(1)
Adjustments to the timing rules. Under this section, S's
[[Page 922]]
losses and deductions are deferred until they are taken into account
under the timing principles of the matching and acceleration rules of
Sec. 1.1502-13(c) and (d) with appropriate adjustments. For example, if
S sells depreciable property to B at a loss, S's loss is deferred and
taken into account under the principles of the matching rule of Sec.
1.1502-13(c) to reflect the difference between B's depreciation taken
into account with respect to the property and the depreciation that B
would take into account if S and B were divisions of a single
corporation; if S and B subsequently cease to be in a controlled group
relationship with each other, S's remaining loss is taken into account
under the principles of the acceleration rule of Sec. 1.1502-13(d). For
purposes of this section, the adjustments to Sec. 1.1502-13 (c) and (d)
include the following:
(i) Application on controlled group basis. The matching and
acceleration rules apply on a controlled group basis, rather than a
consolidated group basis. Thus if S and B are wholly-owned members of a
consolidated group and 21% of the stock of S is sold to an unrelated
person, S's loss continues to be deferred under this section because S
and B continue to be members of a controlled group even though S is no
longer a member of the consolidated group. Similarly, S's loss would
continue to be deferred if S and B remain in a controlled group
relationship after both corporations become nonmembers of their former
consolidated group.
(ii) Different taxable years. If S and B have different taxable
years, the taxable years that include a December 31 are treated as the
same taxable years. If S or B has a short taxable year that does not
include a December 31, the short year is treated as part of the
succeeding taxable year that does include a December 31.
(iii) Transfer to a section 267(b) or 707(b) related person. To the
extent S's loss or deduction from an intercompany sale of property is
taken into account under this section as a result of B's transfer of the
property to a nonmember that is a person related to any member,
immediately after the transfer, under sections 267(b) or 707(b), or as a
result of S or B becoming a nonmember that is related to any member
under section 267(b), the loss or deduction is taken into account but
allowed only to the extent of any income or gain taken into account as a
result of the transfer. The balance not allowed is treated as a loss
referred to in section 267(d) if it is from a sale or exchange by B
(rather than from a distribution).
(iv) B's item is excluded from gross income or noncapital and
nondeductible. To the extent S's loss would be redetermined to be a
noncapital, nondeductible amount under the principles of Sec. 1.1502-
13, but is not redetermined under paragraph (c)(2) of this section
(which generally renders the attribute redetermination rule inapplicable
to sales between members of a controlled group), S's loss continues to
be deferred. For purposes of this paragraph, stock held by S, stock held
by B, stock held by all members of S's consolidated group, stock held by
any member of a controlled group of which S is a member that was
acquired from a member of S's consolidated group, and stock issued by T
to a member of the controlled group must be taken into account in
determining whether a loss would be redetermined to be a noncapital,
nondeductible amount under the principles of Sec. 1.1502-13. If the
loss remains deferred, it is taken into account when S and B (including
their successors) are no longer in a controlled group relationship. (If,
however, the property is transferred to certain related persons,
paragraph (c)(1)(iii) of this section will cause the loss to be
permanently disallowed.) For example, if S sells all of the T stock to B
at a loss (in a transaction that is treated as a sale or exchange for
Federal income tax purposes), and T subsequently liquidates in an
unrelated transaction that qualifies under section 332, S's loss is
deferred until S and B are no longer in a controlled group relationship.
Similarly, if S owns all of the T stock and sells 30 percent of T's
stock to B at a loss (in a transaction that is treated as a sale or
exchange for Federal income tax purposes), and T subsequently
liquidates, S's loss on the sale is deferred until S and B (including
their successors) are no longer in a controlled group relationship.
[[Page 923]]
(v) Circularity of references. References to deferral or elimination
under the Internal Revenue Code or regulations do not include references
to section 267(f) or this section. See, e.g., Sec. 1.1502-13(a)(4)
(applicability of other law).
(2) Attributes generally not affected. The matching and acceleration
rules are not applied under this section to affect the attributes of S's
intercompany item, or cause it to be taken into account before it is
taken into account under S's separate entity method of accounting.
However, the attributes of S's intercompany item may be redetermined, or
an item may be taken into account earlier than under S's separate entity
method of accounting, to the extent the transaction is also an
intercompany transaction to which Sec. 1.1502-13 applies. Similarly,
except to the extent the transaction is also an intercompany transaction
to which Sec. 1.1502-13 applies, the matching and acceleration rules do
not apply to affect the timing or attributes of B's corresponding items.
(d) Intercompany sales of inventory involving foreign persons--(1)
General rule. Section 267(a)(1) and this section do not apply to an
intercompany sale of property that is inventory (within the meaning of
section 1221(1)) in the hands of both S and B, if--
(i) The intercompany sale is in the ordinary course of S's trade or
business;
(ii) S or B is a foreign corporation; and
(iii) Any income or loss realized on the intercompany sale by S or B
is not income or loss that is recognized as effectively connected with
the conduct of a trade or business within the United States within the
meaning of section 864 (unless the income is exempt from taxation
pursuant to a treaty obligation of the United States).
(2) Intercompany sales involving related partnerships. For purposes
of paragraph (d)(1) of this section, a partnership and a foreign
corporation described in section 267(b)(10) are treated as members,
provided that the income or loss of the foreign corporation is described
in paragraph (d)(1)(iii) of this section.
(3) Intercompany sales in ordinary course. For purposes of this
paragraph (d), whether an intercompany sale is in the ordinary course of
business is determined under all the facts and circumstances.
(e) Treatment of a creditor with respect to a loan in nonfunctional
currency. Sections 267(a)(1) and this section do not apply to an
exchange loss realized with respect to a loan of nonfunctional currency
if--
(1) The loss is realized by a member with respect to nonfunctional
currency loaned to another member;
(2) The loan is described in Sec. 1.988-1(a)(2)(i);
(3) The loan is not in a hyperinflationary currency as defined in
Sec. 1.988-1(f); and
(4) The transaction does not have as a significant purpose the
avoidance of Federal income tax.
(f) Receivables. If S acquires a receivable from the sale of goods
or services to a nonmember at a gain, and S sells the receivable at fair
market value to B, any loss or deduction of S from its sale to B is not
deferred under this section to the extent it does not exceed S's income
or gain from the sale to the nonmember that has been taken into account
at the time the receivable is sold to B.
(g) Earnings and profits. A loss or deduction deferred under this
section is not reflected in S's earnings and profits before it is taken
into account under this section. See, e.g., Sec. Sec. 1.312-6(a),
1.312-7, and 1.1502-33(c)(2).
(h) Anti-avoidance rule. If a transaction is engaged in or
structured with a principal purpose to avoid the purposes of this
section (including, for example, by avoiding treatment as an
intercompany sale or by distorting the timing of losses or deductions),
adjustments must be made to carry out the purposes of this section.
(i) [Reserved]
(j) Examples. For purposes of the examples in this paragraph (j),
unless otherwise stated, corporation P owns 75% of the only class of
stock of subsidiaries S and B, X is a person unrelated to any member of
the P controlled group, the taxable year of all persons is the calendar
year, all persons use the accrual method of accounting, tax liabilities
are disregarded, the facts set forth the only
[[Page 924]]
activity, and no member has a special status. If a member acts as both a
selling member and a buying member (e.g., with respect to different
aspects of a single transaction, or with respect to related
transactions), the member is referred as to M (rather than as S or B).
This section is illustrated by the following examples.
Example 1. Matching and acceleration rules. (a) Facts. S holds land
for investment with a basis of $130. On January 1 of Year 1, S sells the
land to B for $100. On a separate entity basis, S's loss is long-term
capital loss. B holds the land for sale to customers in the ordinary
course of business. On July 1 of Year 3, B sells the land to X for $110.
(b) Matching rule. Under paragraph (b)(1) of this section, S's sale
of land to B is an intercompany sale. Under paragraph (c)(1) of this
section, S's $30 loss is taken into account under the timing principles
of the matching rule of Sec. 1.1502-13(c) to reflect the difference for
the year between B's corresponding items taken into account and the
recomputed corresponding items. If S and B were divisions of a single
corporation and the intercompany sale were a transfer between the
divisions, B would succeed to S's $130 basis in the land and would have
a $20 loss from the sale to X in Year 3. Consequently, S takes no loss
into account in Years 1 and 2, and takes the entire $30 loss into
account in Year 3 to reflect the $30 difference in that year between the
$10 gain B takes into account and its $20 recomputed loss. The
attributes of S's intercompany items and B's corresponding items are
determined on a separate entity basis. Thus, S's $30 loss is long-term
capital loss and B's $10 gain is ordinary income.
(c) Acceleration resulting from sale of B stock. The facts are the
same as in paragraph (a) of this Example 1, except that on July 1 of
Year 3 P sells all of its B stock to X (rather than B's selling the land
to X). Under paragraph (c)(1) of this section, S's $30 loss is taken
into account under the timing principles of the acceleration rule of
Sec. 1.1502-13(d) immediately before the effect of treating S and B as
divisions of a single corporation cannot be produced. Because the effect
cannot be produced once B becomes a nonmember, S takes its $30 loss into
account in Year 3 immediately before B becomes a nonmember. S's loss is
long-term capital loss.
(d) Subgroup principles applicable to sale of S and B stock. The
facts are the same as in paragraph (a) of this Example 1, except that on
July 1 of Year 3 P sells all of its S and B stock to X (rather than B's
selling the land to X). Under paragraph (b)(3) of this section, S and B
are considered to remain members of a controlled group as long as they
remain in a controlled group relationship with each other (whether or
not in the original controlled group). P's sale of their stock does not
affect the controlled group relationship of S and B with each other.
Thus, S's loss is not taken into account as a result of P's sale of the
stock. Instead, S's loss is taken into account based on subsequent
events (e.g., B's sale of the land to a nonmember).
Example 2. Distribution of loss property. (a) Facts. S holds land
with a basis of $130 and value of $100. On January 1 of Year 1, S
distributes the land to P in a transaction to which section 311 applies.
On July 1 of Year 3, P sells the land to X for $110.
(b) No loss taken into account. Under paragraph (b)(2) of this
section, because P and S are not members of a consolidated group, Sec.
1.1502-13(f)(2)(iii) does not apply to cause S to recognize a $30 loss
under the principles of section 311(b). Thus, S has no loss to be taken
into account under this section. (If P and S were members of a
consolidated group, Sec. 1.1502-13(f)(2)(iii) would apply to S's loss
in addition to the rules of this section, and the loss would be taken
into account in Year 3 as a result of P's sale to X.)
Example 3. Loss not yet taken into account under separate entity
accounting method. (a) Facts. S holds land with a basis of $130. On
January 1 of Year 1, S sells the land to B at a $30 loss but does not
take into account the loss under its separate entity method of
accounting until Year 4. On July 1 of Year 3, B sells the land to X for
$110.
(b) Timing. Under paragraph (b)(2) of this section, S's loss is
determined on a separate entity basis. Under paragraph (c)(1) of this
section, S's loss is not taken into account before it is taken into
account under S's separate entity method of accounting. Thus, although B
takes its corresponding gain into account in Year 3, S has no loss to
take into account until Year 4. Once S's loss is taken into account in
Year 4, it is not deferred under this section because B's corresponding
gain has already been taken into account. (If S and B were members of a
consolidated group, S would be treated under Sec. 1.1502-13(b)(2)(iii)
as taking the loss into account in Year 3.)
Example 4. Consolidated groups. (a) Facts. P owns all of the stock
of S and B, and the P group is a consolidated group. S holds land for
investment with a basis of $130. On January 1 of Year 1, S sells the
land to B for $100. B holds the land for sale to customers in the
ordinary course of business. On July 1 of Year 3, P sells 25% of B's
stock to X. As a result of P's sale, B becomes a nonmember of the P
consolidated group but S and B remain in a controlled group relationship
with each other for purposes of section 267(f). Assume that if S and B
were divisions of a single corporation, the items of S and B from the
land would be ordinary by reason of B's activities.
(b) Timing and attributes. Under paragraph (a)(3) of this section,
S's sale to B is subject to both Sec. 1.1502-13 and this section. Under
[[Page 925]]
Sec. 1.1502-13, S's loss is redetermined to be an ordinary loss by
reason of B's activities. Under paragraph (b)(3) of this section,
because S and B remain in a controlled group relationship with each
other, the loss is not taken into account under the acceleration rule of
Sec. 1.1502-13(d) as modified by paragraph (c) of this section. See
Sec. 1.1502-13(a)(4). Nevertheless, S's loss is redetermined by Sec.
1.1502-13 to be an ordinary loss, and the character of the loss is not
further redetermined under this section. Thus, the loss continues to be
deferred under this section, and will be taken into account as ordinary
loss based on subsequent events (e.g., B's sale of the land to a
nonmember).
(c) Resale to controlled group member. The facts are the same as in
paragraph (a) of this Example 4, except that P owns 75% of X's stock,
and B resells the land to X (rather than P's selling any B stock). The
results for S's loss are the same as in paragraph (b) of this Example 4.
Under paragraph (b) of this section, X is also in a controlled group
relationship, and B's sale to X is a second intercompany sale. Thus, S's
loss continues to be deferred and is taken into account under this
section as ordinary loss based on subsequent events (e.g., X's sale of
the land to a nonmember).
Example 5. Intercompany sale followed by installment sale. (a)
Facts. S holds land for investment with a basis of $130x. On January 1
of Year 1, S sells the land to B for $100x. B holds the land for
investment. On July 1 of Year 3, B sells the land to X in exchange for
X's $110x note. The note bears a market rate of interest in excess of
the applicable Federal rate, and provides for principal payments of $55x
in Year 4 and $55x in Year 5. Section 453A applies to X's note.
(b) Timing and attributes. Under paragraph (c) of this section, S's
$30x loss is taken into account under the timing principles of the
matching rule of Sec. 1.1502-13(c) to reflect the difference in each
year between B's gain taken into account and its recomputed loss. Under
section 453, B takes into account $5x of gain in Year 4 and in Year 5.
Therefore, S takes $20x of its loss into account in Year 3 to reflect
the $20x difference in that year between B's $0 loss taken into account
and its $20x recomputed loss. In addition, S takes $5x of its loss into
account in Year 4 and in Year 5 to reflect the $5x difference in each
year between B's $5x gain taken into account and its $0 recomputed gain.
Although S takes into account a loss and B takes into account a gain,
the attributes of B's $10x gain are determined on a separate entity
basis, and therefore the interest charge under section 453A(c) applies
to B's $10x gain on the installment sale beginning in Year 3.
Example 6. Section 721 transfer to a related nonmember. (a) Facts. S
owns land with a basis of $130. On January 1 of Year 1, S sells the land
to B for $100. On July 1 of Year 3, B transfers the land to a
partnership in exchange for a 40% interest in capital and profits in a
transaction to which section 721 applies. P also owns a 25% interest in
the capital and profits of the partnership.
(b) Timing. Under paragraph (c)(1)(iii) of this section, because the
partnership is a nonmember that is a related person under sections
267(b) and 707(b), S's $30 loss is taken into account in Year 3, but
only to the extent of any income or gain taken into account as a result
of the transfer. Under section 721, no gain or loss is taken into
account as a result of the transfer to the partnership, and thus none of
S's loss is taken into account. Any subsequent gain recognized by the
partnership with respect to the property is limited under section
267(d). (The results would be the same if the P group were a
consolidated group, and S's sale to B were also subject to Sec. 1.1502-
13.)
Example 7. Receivables. (a) Controlled group. S owns goods with a
$60 basis. In Year 1, S sells the goods to X for X's $100 note. The note
bears a market rate of interest in excess of the applicable Federal
rate, and provides for payment of principal in Year 5. S takes into
account $40 of income in Year 1 under its method of accounting. In Year
2, the fair market value of X's note falls to $90 due to an increase in
prevailing market interest rates, and S sells the note to B for its $90
fair market value.
(b) Loss not deferred. Under paragraph (f) of this section, S takes
its $10 loss into account in Year 2. (If the sale were not at fair
market value, paragraph (f) of this section would not apply and none of
S's $10 loss would be taken into account in Year 2.)
(c) Consolidated group. Assume instead that P owns all of the stock
of S and B, and the P group is a consolidated group. In Year 1, S sells
to X goods having a basis of $90 for X's $100 note (bearing a market
rate of interest in excess of the applicable Federal rate, and providing
for payment of principal in Year 5), and S takes into account $10 of
income in Year 1. In Year 2, S sells the receivable to B for its $85
fair market value. In Year 3, P sells 25% of B's stock to X. Although
paragraph (f) of this section provides that $10 of S's loss (i.e., the
extent to which S's $15 loss does not exceed its $10 of income) is not
deferred under this section, S's entire $15 loss is subject to Sec.
1.1502-13 and none of the loss is taken into account in Year 2 under the
matching rule of Sec. 1.1502-13(c). See paragraph (a)(3) of this
section (continued deferral under Sec. 1.1502-13). P's sale of B stock
results in B becoming a nonmember of the P consolidated group in Year 3.
Thus, S's $15 loss is taken into account in Year 3 under the
acceleration rule of Sec. 1.1502-13(d). Nevertheless, B remains in a
controlled group relationship
[[Page 926]]
with S and paragraph (f) of this section permits only $10 of S's loss to
be taken into account in Year 3. See Sec. 1.1502-13(a)(4) (continued
deferral under section 267). The remaining $5 of S's loss continues to
be deferred under this section and taken into account under this section
based on subsequent events (e.g., B's collection of the note or P's sale
of the remaining B stock to a nonmember).
Example 8. Selling member ceases to be a member. (a) Facts. P owns
all of the stock of S and B, and the P group is a consolidated group. S
has several historic assets, including land with a basis of $130 and
value of $100. The land is not essential to the operation of S's
business. On January 1 of Year 1, S sells the land to B for $100. On
July 1 of Year 3, P transfers all of S's stock to newly formed X in
exchange for a 20% interest in X stock as part of a transaction to which
section 351 applies. Although X holds many other assets, a principal
purpose for P's transfer is to accelerate taking S's $30 loss into
account. P has no plan or intention to dispose of the X stock.
(b) Timing. Under paragraph (c) of this section, S's $30 loss
ordinarily is taken into account immediately before P's transfer of the
S stock, under the timing principles of the acceleration rule of Sec.
1.1502-13(d). Although taking S's loss into account results in a $30
negative stock basis adjustment under Sec. 1.1502-32, because P has no
plan or intention to dispose of its X stock, the negative adjustment
will not immediately affect taxable income. P's transfer accelerates a
loss that otherwise would be deferred, and an adjustment under paragraph
(h) of this section is required. Thus, S's loss is never taken into
account, and S's stock basis and earnings and profits are reduced by $30
under Sec. Sec. 1.1502-32 and 1.1502-33 immediately before P's transfer
of the S stock.
(c) Nonhistoric assets. Assume instead that, with a principal
purpose to accelerate taking into account any further loss that may
accrue in the value of the land without disposing of the land outside of
the controlled group, P forms M with a $100 contribution on January 1 of
Year 1 and S sells the land to M for $100. On December 1 of Year 1, when
the value of the land has decreased to $90, M sells the land to B for
$90. On July 1 of Year 3, while B still owns the land, P sells all of
M's stock to X and M becomes a nonmember. Under paragraph (c) of this
section, M's $10 loss ordinarily is taken into account under the timing
principles of the acceleration rule of Sec. 1.1502-13(d) immediately
before M becomes a nonmember. (S's $30 loss is not taken into account
under the timing principles of Sec. 1.1502-13(c) or Sec. 1.1502-13(d)
as a result of M becoming a nonmember, but is taken into account based
on subsequent events such as B's sale of the land to a nonmember or P's
sale of the stock of S or B to a nonmember.) The land is not an historic
asset of M and, although taking M's loss into account reduces P's basis
in the M stock under Sec. 1.1502-32, the negative adjustment only
eliminates the $10 duplicate stock loss. Under paragraph (h) of this
section, M's loss is never taken into account. M's stock basis, and the
earnings and profits of M and P, are reduced by $10 under Sec. Sec.
1.1502-32 and 1.1502-33 immediately before P's sale of the M stock.
Example 9. Sale of stock by consolidated group member to controlled
group member. (a) Facts. P1, a domestic corporation, owns 75% of the
outstanding stock of P, the common parent of a consolidated group. P
owns all of the outstanding stock of subsidiaries M and S, which are
members of P's consolidated group. M and S each own 50% of the only
class of stock of L, a nonmember life insurance company. On January 1 of
Year 1, S sells 25% of L's stock to P1 for $50 cash. At the time of the
sale, S's aggregate basis in the L shares transferred to P1 was $80, and
S recognizes a $30 loss. On February 18 of Year 3, at a time when the L
shares held by P1 are worth $60, L liquidates. As a result of the
liquidation, P1 recognizes a $10 gain.
(b) Timing. Under paragraph (a)(2) of this section, S's loss on the
sale of the L stock to P1 is deferred. Under paragraph (c)(1)(iv) of
this section, upon the liquidation of L, to the extent S's loss would be
redetermined to be a noncapital, nondeductible amount under the
principles of Sec. 1.1502-13, S's loss continues to be deferred. Under
the principles of Sec. 1.1502-13, S's loss is not redetermined to be a
noncapital, nondeductible amount to the extent of P1's $10 of gain
recognized. Accordingly, S takes into account $10 of loss as a result of
the liquidation. In determining whether the remainder of S's $20 loss
would be redetermined to be a noncapital, nondeductible amount, under
paragraph (c)(1)(iv) of this section, stock held by P1, stock held by M,
and stock held by S is taken into account. Accordingly, under the
principles of Sec. 1.1502-13, the liquidation of L would be treated as
a liquidation qualifying under section 332, and the remainder of S's
loss would be redetermined to be a noncapital, nondeductible amount.
Thus, under paragraph (c)(1)(iv), S's remaining $20 loss continues to be
deferred until S and P1 are no longer in a controlled group
relationship.
Example 10. Issuance of stock to controlled group member. (a) Facts.
FP is a foreign corporation that owns all the stock of FS, a foreign
corporation, and all the stock of P, a domestic corporation. P owns all
of the single class of outstanding common stock of T. In Year 1, FS
contributes cash to T in exchange for newly issued stock of T that
constitutes 40 percent of T's outstanding stock. In Year 2, when the
value of the T stock owned by P is less than its basis in P's hands, P
sells all of its T stock to FP. In Year 3, in a transaction unrelated to
the
[[Page 927]]
issuance of the T stock in Year 1, T converts under state law to a
limited liability company that is treated as a partnership for Federal
income tax purposes.
(b) Timing. Under paragraph (a)(2) of this section, P's loss on the
sale of its T stock is deferred. Under paragraph (c)(1)(iv) of this
section, upon the conversion of T, to the extent P's loss would be
redetermined to be a noncapital, nondeductible amount under the
principles of Sec. 1.1502-13, P's loss continues to be deferred. In
determining whether the loss would be redetermined to be a noncapital,
nondeductible amount, stock held by FS (which was acquired from T) and
stock held by FP (the buyer of the T stock from P and a member of P's
controlled group) is taken into account. Accordingly, under the
principles of Sec. 1.1502-13 the deemed liquidation of T resulting from
the conversion of T would be treated as a liquidation qualifying under
section 332, and P's loss would be redetermined to be a noncapital,
nondeductible amount. Thus, under paragraph (c)(1)(iv), P's loss
continues to be deferred until P and FP are no longer in a controlled
group relationship.
(k) Cross-reference. For additional rules applicable to the
disposition, deconsolidation, or transfer of the stock of members of
consolidated groups, see Sec. Sec. 1.337(d)-2, 1.1502-13(f)(6), 1.1502-
35, and 1.1502-36.
(l) Effective dates--(1) In general. This section applies with
respect to transactions occurring in S's years beginning on or after
July 12, 1995. If both this section and prior law apply to a
transaction, or neither applies, with the result that items are
duplicated, omitted, or eliminated in determining taxable income (or tax
liability), or items are treated inconsistently, prior law (and not this
section) applies to the transaction.
(2) Avoidance transactions. This paragraph (l)(2) applies if a
transaction is engaged in or structured on or after April 8, 1994, with
a principal purpose to avoid the rules of this section (and instead to
apply prior law). If this paragraph (l)(2) applies, appropriate
adjustments must be made in years beginning on or after July 12, 1995,
to prevent the avoidance, duplication, omission, or elimination of any
item (or tax liability), or any other inconsistency with the rules of
this section.
(3) Effective/applicability date. Paragraph (c)(1)(iv) of this
section applies to a loss that continues to be deferred pursuant to that
paragraph if the event that would cause the loss to be redetermined as a
noncapital nondeductible amount under the principles of Sec. 1.1502-13
occurs on or after April 16, 2012.
(4) Prior law. For transactions occurring in S's years beginning
before July 12, 1995 see the applicable regulations issued under
sections 267 and 1502. See, e.g., Sec. Sec. 1.267(f)-1, 1.267(f)-1T,
1.267(f)-2T, 1.267(f)-3, 1.1502-13, 1.1502-13T, 1.1502-14, 1.1502-14T,
and 1.1502-31 (as contained in the 26 CFR part 1 edition revised as of
April 1, 1995).
[T.D. 8597, 60 FR 36680, July 18, 1995, as amended by T.D. 8660, 61 FR
10499, Mar. 14, 1996; 62 FR 12097, Mar. 14, 1997; T.D. 9048, 68 FR
12290, Mar. 14, 2003; T.D. 9187, 70 FR 10327, Mar. 3, 2005; T.D. 9254,
71 FR 13018, Mar. 14, 2006; T.D. 9424, 73 FR 53986, Sept. 17, 2008; T.D.
9583, 77 FR 22482, Apr. 16, 2012]
Sec. 1.268-1 Items attributable to an unharvested crop sold with the land.
In computing taxable income no deduction shall be allowed in respect
of items attributable to the production of an unharvested crop which is
sold, exchanged, or involuntarily converted with the land and which is
considered as property used in the trade or business under section
1231(b)(4). Such items shall be so treated whether or not the taxable
year involved is that of the sale, exchange, or conversion of such crop
and whether they are for expenses, depreciation, or otherwise. If the
taxable year involved is not that of the sale, exchange, or conversion
of such crop, a recomputation of the tax liability for such year shall
be made; such recomputation should be in the form of an ``amended
return'' if necessary. For the adjustments to basis as a result of such
disallowance, see section 1016(a)(11) and the regulations thereunder.
Sec. 1.269-1 Meaning and use of terms.
As used in section 269 and Sec. Sec. 1.269-2 through 1.269-7:
(a) Allowance. The term allowance refers to anything in the internal
revenue laws which has the effect of diminishing tax liability. The term
includes, among other things, a deduction, a credit, an adjustment, an
exemption, or an exclusion.
[[Page 928]]
(b) Evasion or avoidance. The phrase evasion or avoidance is not
limited to cases involving criminal penalties, or civil penalties for
fraud.
(c) Control. The term control means the ownership of stock
possessing at least 50 percent of the total combined voting power of all
classes of stock entitled to vote, or at least 50 percent of the total
value of shares of all classes of stock of the corporation. For control
to be ``acquired on or after October 8, 1940'', it is not necessary that
all of such stock be acquired on or after October 8, 1940. Thus, if A,
on October 7, 1940, and at all times thereafter, owns 40 percent of the
stock of X Corporation and acquires on October 8, 1940, an additional 10
percent of such stock, an acquisition within the meaning of such phrase
is made by A on October 8, 1940. Similarly, if B, on October 7, 1940,
owns certain assets and transfers on October 8, 1940, such assets to a
newly organized Y Corporation in exchange for all the stock of Y
Corporation, an acquisition within the meaning of such phrase is made by
B on October 8, 1940. If, under the facts stated in the preceding
sentence, B is a corporation, all of whose stock is owned by Z
Corporation, then an acquisition within the meaning of such phrase is
also made by Z Corporation on October 8, 1940, as well as by the
shareholders of Z Corporation taken as a group on such date, and by any
of such shareholders if such shareholders as a group own 50 percent of
the stock of Z on such date.
(d) Person. The term person includes an individual, a trust, an
estate, a partnership, an association, a company or a corporation.
[T.D. 6595, 27 FR 3596, Apr. 14, 1962, as amended by T.D. 8388, 57 FR
345, Jan. 6, 1992]
Sec. 1.269-2 Purpose and scope of section 269.
(a) General. Section 269 is designed to prevent in the instances
specified therein the use of the sections of the Internal Revenue Code
providing deductions, credits, or allowances in evading or avoiding
Federal income tax. See Sec. 1.269-3.
(b) Disallowance of deduction, credit, or other allowance. Under the
Code, an amount otherwise constituting a deduction, credit, or other
allowance becomes unavailable as such under certain circumstances.
Characteristic of such circumstances are those in which the effect of
the deduction, credit, or other allowance would be to distort the
liability of the particular taxpayer when the essential nature of the
transaction or situation is examined in the light of the basic purpose
or plan which the deduction, credit, or other allowance was designed by
the Congress to effectuate. The distortion may be evidenced, for
example, by the fact that the transaction was not undertaken for reasons
germane to the conduct of the business of the taxpayer, by the unreal
nature of the transaction such as its sham character, or by the unreal
or unreasonable relation which the deduction, credit, or other allowance
bears to the transaction. The principle of law making an amount
unavailable as a deduction, credit, or other allowance in cases in which
the effect of making an amount so available would be to distort the
liability of the taxpayer, has been judicially recognized and applied in
several cases. Included in these cases are Gregory v. Helvering (1935)
(293 U.S. 465; Ct. D. 911, C.B. XIV-1, 193); Griffiths v. Helvering
(1939) (308 U.S. 355; Ct. D. 1431, C.B. 1940-1, 136); Higgins v. Smith
(1940) (308 U.S. 473; Ct. D. 1434, C.B. 1940-1, 127); and J. D. & A. B.
Spreckles Co. v. Commissioner (1940) (41 B.T.A. 370). In order to give
effect to such principle, but not in limitation thereof, several
provisions of the Code, for example, section 267 and section 270,
specify with some particularity instances in which disallowance of the
deduction, credit, or other allowance is required. Section 269 is also
included in such provisions of the Code. The principle of law and the
particular sections of the Code are not mutually exclusive and in
appropriate circumstances they may operate together or they may operate
separately. See, for example, Sec. 1.269-6.
[T.D. 6595, 27 FR 3596, Apr. 14, 1962]
Sec. 1.269-3 Instances in which section 269(a) disallows a deduction,
credit, or other allowance.
(a) Instances of disallowance. Section 269 specifies two instances
in which a deduction, credit, or other allowance is
[[Page 929]]
to be disallowed. These instances, described in paragraphs (1) and (2)
of section 269(a), are those in which:
(1) Any person or persons acquire, or acquired on or after October
8, 1940, directly or indirectly, control of a corporation, or
(2) Any corporation acquires, or acquired on or after October 8,
1940, directly or indirectly, property of another corporation (not
controlled, directly or indirectly, immediately before such acquisition
by such acquiring corporation or its stockholders), the basis of which
property in the hands of the acquiring corporation is determined by
reference to the basis in the hands of the transferor corporation.
In either instance the principal purpose for which the acquisition was
made must have been the evasion or avoidance of Federal income tax by
securing the benefit of a deduction, credit, or other allowance which
such person, or persons, or corporation, would not otherwise enjoy. If
this requirement is satisfied, it is immaterial by what method or by
what conjunction of events the benefit was sought. Thus, an acquiring
person or corporation can secure the benefit of a deduction, credit, or
other allowance within the meaning of section 269 even though it is the
acquired corporation that is entitled to such deduction, credit, or
other allowance in the determination of its tax. If the purpose to evade
or avoid Federal income tax exceeds in importance any other purpose, it
is the principal purpose. This does not mean that only those
acquisitions fall within the provisions of section 269 which would not
have been made if the evasion or avoidance purpose was not present. The
determination of the purpose for which an acquisition was made requires
a scrutiny of the entire circumstances in which the transaction or
course of conduct occurred, in connection with the tax result claimed to
arise therefrom.
(b) Acquisition of control; transactions indicative of purpose to
evade or avoid tax. If the requisite acquisition of control within the
meaning of paragraph (1) of section 269(a) exists, the transactions set
forth in the following subparagraphs are among those which, in the
absence of additional evidence to the contrary, ordinarily are
indicative that the principal purpose for acquiring control was evasion
or avoidance of Federal income tax:
(1) A corporation or other business enterprise (or the interest
controlling such corporation or enterprise) with large profits acquires
control of a corporation with current, past, or prospective credits,
deductions, net operating losses, or other allowances and the
acquisition is followed by such transfers or other action as is
necessary to bring the deduction, credit, or other allowance into
conjunction with the income (see further Sec. 1.269-6). This
subparagraph may be illustrated by the following example:
Example. Individual A acquires all of the stock of L Corporation
which has been engaged in the business of operating retail drug stores.
At the time of the acquisition, L Corporation has net operating loss
carryovers aggregating $100,000 and its net worth is $100,000. After the
acquisition, L Corporation continues to engage in the business of
operating retail drug stores but the profits attributable to such
business after the acquisition are not sufficient to absorb any
substantial portion of the net operating loss carryovers. Shortly after
the acquisition, individual A causes to be transferred to L Corporation
the assets of a hardware business previously controlled by A which
business produces profits sufficient to absorb a substantial portion of
L Corporation's net operating loss carryovers. The transfer of the
profitable business, which has the effect of using net operating loss
carryovers to offset gains of a business unrelated to that which
produced the losses, indicates that the principal purpose for which the
acquisition of control was made is evasion or avoidance of Federal
income tax.
(2) A person or persons organize two or more corporations instead of
a single corporation in order to secure the benefit of multiple surtax
exemptions (see section 11(c)) or multiple minimum accumulated earnings
credits (see section 535(c)(2) and (3)).
(3) A person or persons with high earning assets transfer them to a
newly organized controlled corporation retaining assets producing net
operating losses which are utilized in an attempt to secure refunds.
(c) Acquisition of property; transactions indicative of purpose to
evade or avoid tax. If the requisite acquisition of property within the
meaning of paragraph
[[Page 930]]
(2) of section 269(a) exists, the transactions set forth in the
following subparagraphs are among those which, in the absence of
additional evidence to the contrary, ordinarily are indicative that the
principal purpose for acquiring such property was evasion or avoidance
of Federal income tax:
(1) A corporation acquires property having in its hands an aggregate
carryover basis which is materially greater than its aggregate fair
market value at the time of such acquisition and utilizes the property
to create tax-reducing losses or deductions.
(2) A subsidiary corporation, which has sustained large net
operating losses in the operation of business X and which has filed
separate returns for the taxable years in which the losses were
sustained, acquires high earning assets, comprising business Y, from its
parent corporation. The acquisition occurs at a time when the parent
would not succeed to the net operating loss carryovers of the subsidiary
if the subsidiary were liquidated, and the profits of business Y are
sufficient to offset a substantial portion of the net operating loss
carryovers attributable to business X (see further Example 3 of Sec.
1.269-6).
(d) Ownership changes to which section 382(l)(5) applies;
transactions indicative of purpose to evade or avoid tax--(1) In
general. Absent strong evidence to the contrary, a requisite acquisition
of control or property in connection with an ownership change to which
section 382(l)(5) applies is considered to be made for the principal
purpose of evasion or avoidance of Federal income tax unless the
corporation carries on more than an insignificant amount of an active
trade or business during and subsequent to the title 11 or similar case
(as defined in section 382(l)(5)(G)). The determination of whether the
corporation carries on more than an insignificant amount of an active
trade or business is made without regard to the continuity of business
enterprise set forth in Sec. 1.368-1(d). The determination is based on
all the facts and circumstances, including, for example, the amount of
business assets that continue to be used, or the number of employees in
the work force who continue employment, in an active trade or business
(although not necessarily the historic trade or business). Where the
corporation continues to utilize a significant amount of its business
assets or work force, the requirement of carrying on more than an
insignificant amount of an active trade or business may be met even
though all trade or business activities temporarily cease for a period
of time in order to address business exigencies.
(2) Effective date. The presumption under paragraph (d) of this
section applies to acquisitions of control or property effected pursuant
to a plan of reorganization confirmed by a court in a title 11 or
similar case (within the meaning of section 368(a)(3)(A)) after August
14, 1990.
(e) Relationship of section 269 to 11 U.S.C. 1129(d). In determining
for purposes of section 269 of the Internal Revenue Code whether an
acquisition pursuant to a plan of reorganization in a case under title
11 of the United States Code was made for the principal purpose of
evasion or avoidance of Federal income tax, the fact that a governmental
unit did not seek a determination under 11 U.S.C. 1129(d) is not taken
into account and any determination by a court under 11 U.S.C. 1129(d)
that the principal purpose of the plan is not avoidance of taxes is not
controlling.
[T.D. 6595, 27 FR 3596, Apr. 14, 1962, as amended by T.D. 8388, 57 FR
345, Jan. 6, 1992]
Sec. 1.269-4 Power of district director to allocate deduction,
credit, or allowance in part.
The district director is authorized by section 269(b) to allow a
part of the amount disallowed by section 269(a), but he may allow such
part only if and to the extent that he determines that the amount
allowed will not result in the evasion or avoidance of Federal income
tax for which the acquisition was made. The district director is also
authorized to use other methods to give effect to part of the amount
disallowed under section 269(a), but only to such extent as he
determines will not result in the evasion or avoidance of Federal income
tax for which the acquisition was made. Whenever appropriate to give
proper effect to the deduction, credit, or other allowance, or such part
[[Page 931]]
of it which may be allowed, this authority includes the distribution,
apportionment, or allocation of both the gross income and the
deductions, credits, or other allowances the benefit of which was
sought, between or among the corporations, or properties, or parts
thereof, involved, and includes the disallowance of any such deduction,
credit, or other allowance to any of the taxpayers involved.
[T.D. 6595, 27 FR 3597, Apr. 14, 1962]
Sec. 1.269-5 Time of acquisition of control.
(a) In general. For purposes of section 269, an acquisition of
control occurs when one or more persons acquire beneficial ownership of
stock possessing at least 50 percent of the total combined voting power
of all classes of stock entitled to vote or at least 50 percent of the
total value of share of all classes of stock of the corporation.
(b) Application of general rule to certain creditor acquisitions.
(1) For purposes of section 269, creditors of an insolvent or bankrupt
corporation (by themselves or in conjunction with other persons) acquire
control of the corporation when they acquire beneficial ownership of the
requisite amount of stock. Although insolvency or bankruptcy may cause
the interests of creditors to predominate as a practical matter,
creditor interests do not constitute beneficial ownership of the
corporation's stock. Solely for purposes of section 269, creditors of a
bankrupt corporation are treated as acquiring beneficial ownership of
stock of the corporation no earlier than the time a bankruptcy court
confirms a plan of reorganization.
(2) The provisions of this section are illustrated by the following
example.
Example. Corporation L files a petition under chapter 11 of the
Bankruptcy Code on January 5, 1987. A creditors' committee is formed. On
February 22, 1987, and upon the request of the creditors, the bankruptcy
court removes the debtor-in-possession from business management and
operations and appoints a trustee. The trustee consults regularly with
the creditors' committee in formulating both short-term and long-term
management decisions. After three years, the creditors approve a plan of
reorganization in which the outstanding stock of Corporation L is
canceled and its creditors receive shares of stock constituting all of
the outstanding shares. The bankruptcy court confirms the plan of
reorganization on March 23, 1990, and the plan is put into effect on May
25, 1990. For purposes of section 269, the creditors acquired control of
Corporation L than March 23, 1990. Similarly, the determination of
whether the creditors acquired control of Corporation L no earlier with
the principal purpose of evasion or avoidance of Federal income tax is
made by reference to the creditors' purposes as of no earlier than March
23, 1990.
[T.D. 8388, 57 FR 346, Jan. 6, 1992]
Sec. 1.269-6 Relationship of section 269 to section 382 before
the Tax Reform Act of 1986.
Section 269 and Sec. Sec. 1.269-1 through 1.269-5 may be applied to
disallow a net operating loss carryover even though such carryover is
not disallowed (in whole or in part) under section 382 and the
regulations thereunder. This section may be illustrated by the following
examples:
Example 1. L Corporation has computed its taxable income on a
calendar year basis and has sustained heavy net operating losses for a
number of years. Assume that A purchases all of the stock of L
Corporation on December 31, 1955, for the principal purpose of utilizing
its net operating loss carryovers by changing its business to a
profitable new business. Assume further that A makes no attempt to
revitalize the business of L Corporation during the calendar year 1956
and that during January 1957 the business is changed to an entirely new
and profitable business. The carryovers will be disallowed under the
provisions of section 269(a) without regard to the application of
section 382.
Example 2. L Corporation has sustained heavy net operating losses
for a number of years. In a merger under State law, P Corporation
acquires all of the assets of L Corporation for the principal purpose of
utilizing the net operating loss carryovers of L Corporation against the
profits of P Corporation's business. As a result of the merger, the
former stockholders of L Corporation own, immediately after the merger,
12 percent of the fair market value of the outstanding stock of P
Corporation. If the merger qualifies as a reorganization to which
section 381(a) applies, the entire net operating loss carryovers will be
disallowed under the provisions of section 269(a) without regard to the
application of section 382.
Example 3. L Corporation has been sustaining net operating losses
for a number of years. P Corporation, a profitable corporation, on
December 31, 1955, acquires all the stock of L Corporation for the
purpose of
[[Page 932]]
continuing and improving the operation of L Corporation's business.
Under the provisions of sections 334(b)(2) and 381(a)(1), P Corporation
would not succeed to L Corporation's net operating loss carryovers if L
Corporation were liquidated pursuant to a plan of liquidation adopted
within two years after the date of the acquisition. During 1956, P
Corporation transfers a profitable business to L Corporation for the
principal purpose of using the profits of such business to absorb the
net operating loss carryovers of L Corporation. The transfer is such as
to cause the basis of the transferred assets in the hands of L
Corporation to be determined by reference to their basis in the hands of
P Corporation. L Corporation's net operating loss carryovers will be
disallowed under the provisions of section 269(a) without regard to the
application of section 382.
[T.D. 6595, 27 FR 3597, Apr. 14, 1962, as amended by T.D. 8388, 57 FR
346, Jan. 6, 1992]
Sec. 1.269-7 Relationship of section 269 to sections 382 and 383
after the Tax Reform Act of 1986.
Section 269 and Sec. Sec. 1.269-1 through 1.269-5 may be applied to
disallow a deduction, credit, or other allowance notwithstanding that
the utilization or amount of a deduction, credit, or other allowance is
limited or reduced under section 382 or 383 and the regulations
thereunder. However, the fact that the amount of taxable income or tax
that may be offset by a deduction, credit, or other allowance is limited
under section 382(a) or 383 and the regulations thereunder is relevant
to the determination of whether the principal purpose of an acquisition
is the evasion or avoidance of Federal income tax.
[T.D. 8388, 57 FR 346, Jan. 6, 1992]
Sec. 1.269B-1 Stapled foreign corporations.
(a) Treatment as a domestic corporation--(1) General rule. Except as
otherwise provided, if a foreign corporation is a stapled foreign
corporation within the meaning of paragraph (b)(1) of this section, such
foreign corporation will be treated as a domestic corporation for U.S.
Federal income tax purposes. Accordingly, for example, the worldwide
income of such corporation will be subject to the tax imposed by section
11. For application of the branch profits tax under section 884, and
application of sections 871(a), 881, 1441, and 1442 to dividends and
interest paid by a stapled foreign corporation, see Sec. Sec. 1.884-
1(h) and 1.884-4(d).
(2) Foreign owned exception. Paragraph (a)(1) of this section will
not apply if a foreign corporation and a domestic corporation are
stapled entities (as provided in paragraph (b) of this section) and such
foreign and domestic corporations are foreign owned within the meaning
of this paragraph (a)(2). A corporation will be treated as foreign owned
if it is established to the satisfaction of the Commissioner that United
States persons hold directly (or indirectly applying section 958(a)(2)
and (3) and section 318(a)(4)) less than 50 percent of the total
combined voting power of all classes of stock entitled to vote and less
than 50 percent of the total value of the stock of such corporation. For
the consequences of a stapled foreign corporation becoming or ceasing to
be foreign owned, therefore converting its status as either a foreign or
domestic corporation within the meaning of this paragraph (a)(2), see
paragraph (c) of this section.
(b) Definition of a stapled foreign corporation--(1) General rule. A
foreign corporation is a stapled foreign corporation if such foreign
corporation and a domestic corporation are stapled entities. A foreign
corporation and a domestic corporation are stapled entities if more than
50 percent of the aggregate value of each corporation's beneficial
ownership consists of interests that are stapled. In the case of
corporations with more than one class of stock, it is not necessary for
a class of stock representing more than 50 percent of the beneficial
ownership of the foreign corporation to be stapled to a class of stock
representing more than 50 percent of the beneficial ownership of the
domestic corporation, provided that more than 50 percent of the
aggregate value of each corporation's beneficial ownership (taking into
account all classes of stock) are in fact stapled. Interests are stapled
if a transferor of one or more interests in one entity is required, by
form of ownership, restrictions on transfer, or other terms or
conditions, to transfer interests in the other entity. The determination
of whether interests are stapled for this purpose is based on the
relevant facts and circumstances, including, but not
[[Page 933]]
limited to, the corporations' by-laws, articles of incorporation or
association, and stock certificates, shareholder agreements, agreements
between the corporations, and voting trusts with respect to the
corporations. For the consequences of a foreign corporation becoming or
ceasing to be a stapled foreign corporation (e.g., a corporation that is
no longer foreign owned) under this paragraph (b)(1), see paragraph (c)
of this section.
(2) Related party ownership rule. For purposes of determining
whether a foreign corporation is a stapled foreign corporation, the
Commissioner may, at his discretion, treat interests that otherwise
would be stapled interests as not being stapled if the same person or
related persons (within the meaning of section 267(b) or 707(b)) hold
stapled interests constituting more than 50 percent of the beneficial
ownership of both corporations, and a principal purpose of the stapling
of those interests is the avoidance of U.S. income tax. A stapling of
interests may have a principal purpose of tax avoidance even though the
tax avoidance purpose is outweighed by other purposes when taken
together.
(3) Example. The principles of paragraph (b)(1) of this section are
illustrated by the following example:
Example. USCo, a domestic corporation, and FCo, a foreign
corporation, are publicly traded companies, each having two classes of
stock outstanding. USCo's class A shares, which constitute 75% of the
value of all beneficial ownership in USCo, are stapled to FCo's class B
shares, which constitute 25% of the value of all beneficial ownership in
F Co. USCo's class B shares, which constitute 25% of the value of all
beneficial ownership in USCo, are stapled to FCo class A shares, which
constitute 75% of the value of all beneficial ownership in FCo. Because
more than 50% of the aggregate value of the stock of each corporation is
stapled to the stock of the other corporation, USCo and FCo are stapled
entities within the meaning of section 269B(c)(2).
(c) Changes in domestic or foreign status. The deemed conversion of
a foreign corporation to a domestic corporation under section 269B is
treated as a reorganization under section 368(a)(1)(F). Similarly, the
deemed conversion of a corporation that is treated as a domestic
corporation under section 269B to a foreign corporation is treated as a
reorganization under section 368(a)(1)(F). For the consequences of a
deemed conversion, including the closing of a corporation's taxable
year, see Sec. Sec. 1.367(a)-1(e), (f) and 1.367(b)-2(f).
(d) Includible corporation--(1) Except as provided in paragraph
(d)(2) of this section, a stapled foreign corporation treated as a
domestic corporation under section 269B nonetheless is treated as a
foreign corporation in determining whether it is an includible
corporation within the meaning of section 1504(b). Thus, for example, a
stapled foreign corporation is not eligible to join in the filing of a
consolidated return under section 1501, and a dividend paid by such
corporation is not a qualifying dividend under section 243(b), unless a
valid section 1504(d) election is made with respect to such corporation.
(2) A stapled foreign corporation is treated as a domestic
corporation in determining whether it is an includible corporation under
section 1504(b) for purposes of applying Sec. Sec. 1.904(i)-1 and
1.861-11T(d)(6).
(e) U.S. treaties--(1) A stapled foreign corporation that is treated
as a domestic corporation under section 269B may not claim an exemption
from U.S. income tax or a reduction in U.S. tax rates by reason of any
treaty entered into by the United States.
(2) The principles of this paragraph (e) are illustrated by the
following example:
Example. FCo, a Country X corporation, is a stapled foreign
corporation that is treated as a domestic corporation under section
269B. FCo qualifies as a resident of Country X pursuant to the income
tax treaty between the United States and Country X. Under such treaty,
the United States is permitted to tax business profits of a Country X
resident only to the extent that the business profits are attributable
to a permanent establishment of the Country X resident in the United
States. While FCo earns income from sources within and without the
United States, it does not have a permanent establishment in the United
States within the meaning of the relevant treaty. Under paragraph (e)(1)
of this section, however, FCo is subject to U.S. Federal income tax on
its income as a domestic corporation without regard to the provisions of
the U.S.-Country X treaty and therefore without regard to the fact that
FCo has no permanent establishment in the United States.
[[Page 934]]
(f) Tax assessment and collection procedures--(1) In general. (i)
Any income tax imposed on a stapled foreign corporation by reason of its
treatment as a domestic corporation under section 269B (whether such
income tax is shown on the stapled foreign corporation's U.S. Federal
income tax return or determined as a deficiency in income tax) shall be
assessed as the income tax liability of such stapled foreign
corporation.
(ii) Any income tax assessed as a liability of a stapled foreign
corporation under paragraph (f)(1)(i) of this section shall be
considered as having been properly assessed as an income tax liability
of the stapled domestic corporation (as defined in paragraph (f)(4)(i)
of this section) and all 10-percent shareholders of the stapled foreign
corporation (as defined in paragraph (f)(4)(ii) of this section). The
date of such deemed assessment shall be the date the income tax
liability of the stapled foreign corporation was properly assessed. The
Commissioner may collect such income tax from the stapled domestic
corporation under the circumstances set forth in paragraph (f)(2) of
this section and may collect such income tax from any 10-percent
shareholders of the stapled foreign corporation under the circumstances
set forth in paragraph (f)(3) of this section.
(2) Collection from domestic stapled corporation. If the stapled
foreign corporation does not pay its income tax liability that was
properly assessed, the unpaid balance of such income tax or any portion
thereof may be collected from the stapled domestic corporation, provided
that the following conditions are satisfied--
(i) The Commissioner has issued a notice and demand for payment of
such income tax to the stapled foreign corporation in accordance with
Sec. 301.6303-1 of this Chapter;
(ii) The stapled foreign corporation has failed to pay the income
tax by the date specified in such notice and demand;
(iii) The Commissioner has issued a notice and demand for payment of
the unpaid portion of such income tax to the stapled domestic
corporation in accordance with Sec. 301.6303-1 of this Chapter.
(3) Collection from 10-percent shareholders of the stapled foreign
corporation. The unpaid balance of the stapled foreign corporation's
income tax liability may be collected from a 10-percent shareholder of
the stapled foreign corporation, limited to each such shareholder's
income tax liability as determined under paragraph (f)(4)(iv) of this
section, provided the following conditions are satisfied--
(i) The Commissioner has issued a notice and demand to the stapled
domestic corporation for the unpaid portion of the stapled foreign
corporation's income tax liability, as provided in paragraph (f)(2)(iii)
of this section;
(ii) The stapled domestic corporation has failed to pay the income
tax by the date specified in such notice and demand;
(iii) The Commissioner has issued a notice and demand for payment of
the unpaid portion of such income tax to such 10-percent shareholder of
the stapled foreign corporation in accordance with Sec. 301.6303-1 of
this Chapter.
(4) Special rules and definitions. For purposes of this paragraph
(f), the following rules and definitions apply:
(i) Stapled domestic corporation. A domestic corporation is a
stapled domestic corporation with respect to a stapled foreign
corporation if such domestic corporation and the stapled foreign
corporation are stapled entities as described in paragraph (b)(1) of
this section.
(ii) 10-percent shareholder. A 10-percent shareholder of a stapled
foreign corporation is any person that owned directly 10 percent or more
of the total value or total combined voting power of all classes of
stock in the stapled foreign corporation for any day of the stapled
foreign corporation's taxable year with respect to which the income tax
liability relates.
(iii) 10-percent shareholder in the case of indirect ownership of
stapled foreign corporation stock. [Reserved]
(iv) Determination of a 10-percent shareholder's income tax
liability. The income tax liability of a 10-percent shareholder of a
stapled foreign corporation, for the income tax of the stapled foreign
corporation under section 269B and this section, is determined by
assigning an equal portion of the total
[[Page 935]]
income tax liability of the stapled foreign corporation for the taxable
year to each day in such corporation's taxable year, and then dividing
that portion ratably among the shares outstanding for that day on the
basis of the relative values of such shares. The liability of any 10-
percent shareholder for this purpose is the sum of the income tax
liability allocated to the shares held by such shareholder for each day
in the taxable year.
(v) Income tax. The term income tax means any income tax liability
imposed on a domestic corporation under title 26 of the United States
Code, including additions to tax, additional amounts, penalties, and
interest related to such income tax liability.
(g) Effective dates--(1) Except as provided in this paragraph (g),
the provisions of this section are applicable for taxable years that
begin after July 29, 2005.
(2) Paragraphs (d)(1) and (f) of this section (except as applied to
the collection of tax from any 10-percent shareholder of a stapled
foreign corporation that is a foreign person) are applicable beginning
on--
(i) July 18, 1984, for any foreign corporation that became stapled
to a domestic corporation after June 30, 1983; and
(ii) January 1, 1987, for any foreign corporation that was stapled
to a domestic corporation as of June 30, 1983.
(3) Paragraph (d)(2) of this section is applicable for taxable years
beginning after July 22, 2003, except that in the case of a foreign
corporation that becomes stapled to a domestic corporation on or after
July 22, 2003, paragraph (d)(2) of this section applies for taxable
years ending on or after July 22, 2003.
(4) Paragraph (e) of this section is applicable beginning on July
18, 1984, except as provided in paragraph (g)(5) of this section.
(5) In the case of a foreign corporation that was stapled to a
domestic corporation as of June 30, 1983, which was entitled to claim
benefits under an income tax treaty as of that date, and which remains
eligible for such treaty benefits, paragraph (e) of this section will
not apply to such foreign corporation and for all purposes of the
Internal Revenue Code such corporation will continue to be treated as a
foreign entity. The prior sentence will continue to apply even if such
treaty is subsequently modified by protocol, or superseded by a new
treaty, so long as the stapled foreign corporation continues to be
eligible to claim such treaty benefits. If the treaty benefits to which
the stapled foreign corporation was entitled as of June 30, 1983, are
terminated, then a deemed conversion of the foreign corporation to a
domestic corporation shall occur pursuant to paragraph (c) of this
section as of the date of such termination.
[T.D. 9216, 70 FR 43758, July 29, 2005, as amended by T.D. 9739, 80 FR
56912, Sept. 21, 2015]
Sec. 1.270-1 Limitation on deductions allowable to individuals
in certain cases.
(a) Recomputation of taxable income. (1) Under certain
circumstances, section 270 limits the deductions (other than certain
deductions described in subsection (b) thereof) attributable to a trade
or business carried on by an individual which are otherwise allowable to
such individual under the provisions of chapter 1 of the Code or the
corresponding provisions of prior revenue laws. If, in each of five
consecutive taxable years (including at least one taxable year beginning
after December 31, 1953, and ending after August 16, 1954), the
deductions attributable to a trade or business carried on by an
individual (other than the specially treated deductions described in
paragraph (b) of this section) exceed the gross income derived from such
trade or business by more than $50,000, the taxable income computed
under section 63 (or the net income computed under the corresponding
provisions of prior revenue laws) of such individual shall be recomputed
for each of such taxable years.
(2) In recomputing the taxable income (or the net income, in the
case of taxable years which are otherwise subject to the Internal
Revenue Code of 1939) for each of the five taxable years, the deductions
(other than the specially treated deductions described in paragraph (b)
of this section with the exception of the net operating loss deduction)
attributable to the trade or business carried on by the individual
[[Page 936]]
shall be allowed only to the extent of (i) the gross income derived from
such trade or business, plus (ii) $50,000. The specially treated
deductions described in paragraph (b) of this section (other than the
net operating loss deduction) shall each be allowed in full. The net
operating loss deduction, to the extent attributable to such trade or
business, shall be disallowed in its entirety. Thus, a carryover or a
carryback of a net operating loss so attributable, either from a year
within the period of five consecutive taxable years or from a taxable
year outside of such period, shall be ignored in making the
recomputation of taxable income or net income, as the case may be.
(3) The limitations on deductions provided by section 270 are also
applicable in determining under section 172, or the corresponding
provisions of prior revenue laws, the amount of any net operating loss
carryover or carryback from any year which falls within the provisions
of section 270 to any year which does not fall within such provisions.
Also, in determining under section 172, or the corresponding provisions
of prior revenue laws, the amount of any net operating loss carryover
from a year which falls within the provisions of section 270 to a year
which does not fall within such provisions, the amount of net operating
loss is to be reduced by the taxable income or net income, as the case
may be (computed as provided in Sec. 1.172-5, or 26 CFR (1939) 39.122-
4(c) (Regulations 118), as the case may be and, in the case of any
taxable year which falls within the provisions of section 270,
determined after the application of section 270), of any taxable year
preceding or succeeding the taxable year of the net operating loss to
which such loss must first be carried back or carried over under the
provisions of section 172(b), or the corresponding provisions of prior
revenue laws, even though the net operating loss deduction is not an
allowable deduction for such preceding or succeeding taxable year.
(4) If an individual carries on several trades or businesses, the
deductions attributable to such trades or businesses and the gross
income derived therefrom shall not be aggregated in determining whether
the deductions (other than the specially treated deductions) exceed the
gross income derived from such trades or businesses by more than $50,000
in any taxable year. For the purposes of section 270, each trade or
business shall be considered separately. However, where a particular
business of an individual is conducted in one or more forms such as a
partnership, joint venture, or individual proprietorship, the
individual's share of the profits and losses from each business unit
must be aggregated to determine the applicability of section 270. See
paragraphs (a)(8)(ii) and (b) of Sec. 1.702-1, relating to
applicability of section 270 to a partner. Where it is established that
for tax purposes a husband and wife are partners in the same trade or
business or that each is participating independently of the other in the
same trade or business with his and her own money, the husband's gross
income and deductions from that trade or business shall be considered
separately from the wife's gross income and deductions from that trade
or business even though they file a joint return. Where a taxpayer is
engaged in a trade or business in a community property State under
circumstances such that the income therefrom is considered to be
community income, the taxpayer and his spouse are treated for purposes
of section 270 as two individuals engaged separately in the same trade
or business and the gross income and deductions attributable to the
trade or business are allocated one-half to the taxpayer and one-half to
the spouse. Where several business activities emanate from a single
commodity, such as oil or gas or a tract of land, it does not
necessarily follow that such activities are one business for the
purposes of section 270. However, in order to be treated separately, it
must be established that such business activities are actually conducted
separately and are not closely interrelated with each other. For the
purposes of section 270, the trade or business carried on by an
individual must be the same in each of the five consecutive years in
which the deductions (other than the specially treated deductions)
exceed the gross income derived from such trade or business by more than
$50,000.
[[Page 937]]
(5) For the purposes of section 270, a taxable year may be part of
two or more periods of five consecutive taxable years. Thus, if the
deductions (other than the specially treated deductions) attributable to
a trade or business carried on by an individual exceed the gross income
therefrom by more than $50,000 for each of six consecutive taxable
years, the fifth year of such six consecutive taxable years shall be
considered to be a part both of a five-year period beginning with the
first and ending with the fifth taxable year and of a five-year period
beginning with the second and ending with the sixth taxable year.
(6) For the purposes of section 270, a short taxable year required
to effect a change in accounting period constitutes a taxable year. In
determining the applicability of section 270 in the case of a short
taxable year, items of income and deduction are not annualized.
(b) Specially treated deductions. (1) For the purposes of section
270 and paragraph (a) of this section, the specially treated deductions
are:
(i) Taxes,
(ii) Interest,
(iii) Casualty and abandonment losses connected with a trade or
business deductible under section 165(c)(1) or the corresponding
provisions of prior revenue laws,
(iv) Losses and expenses of the trade or business of farming which
are directly attributable to drought,
(v) The net operating loss deduction allowed by section 172, or the
corresponding provisions of prior revenue laws, and
(vi) Expenditures as to which a taxpayer is given the option, under
law or regulations, either (a) to deduct as expenses when incurred, or
(b) to defer or capitalize.
(2) For the purpose of subparagraph (1)(iv) of this paragraph, an
individual is engaged in the ``trade or business of farming'' if he
cultivates, operates, or manages a farm for gain or profit, either as
owner or tenant. An individual who receives a rental (either in cash or
in kind) which is based upon farm production is engaged in the trade or
business of farming. However, an individual who receives a fixed rental
(without reference to production) is engaged in the trade or business of
farming only if he participates to a material extent in the operation or
management of the farm. An individual engaged in forestry or the growing
of timber is not thereby engaged in the trade or business of farming. An
individual cultivating or operating a farm for recreation or pleasure
rather than a profit is not engaged in the trade or business of farming.
The term farm is used in its ordinarily accepted sense and includes
stock, dairy, poultry, fruit, crop, and truck farms, and also
plantations, ranches, ranges, and orchards. An individual is engaged in
the trade or business of farming if he is a member of a partnership
engaged in the trade or business of farming.
(3) In order for losses and expenses of the trade or business of
farming to qualify as specially treated deductions under subparagraph
(1)(iv) of this paragraph such losses and expenses must be directly
attributable to drought conditions and not to other causes such as
faulty management or unfavorable market conditions. In general, the
following are the types of losses and expenses which, if otherwise
deductible, may qualify as specially treated deductions under
subparagraph (1)(iv) of this paragraph:
(i) Losses for damages to or destruction of property as a result of
drought conditions, if such property is used in the trade or business of
farming or is purchased for resale in the trade or business of farming;
(ii) Expenses directly related to raising crops or livestock which
are destroyed or damaged by drought. Included in this category are, for
example, payments for labor, fertilizer, and feed used in raising such
crops or livestock. If such crops or livestock to which the expenditures
relate are only partially destroyed or damaged by drought then only a
proportionate part of the expenditures is regarded as specially treated
deductions; and
(iii) Expenses which would not have been incurred in the absence of
drought conditions, such as expenses for procuring pasture or additional
supplies of water or feed.
(4) The expenditures referred to in subparagraph (1)(vi) of this
paragraph
[[Page 938]]
include, but are not limited to, intangible drilling and development
costs in the case of oil and gas wells as provided in section 263(c) and
the regulations thereunder, and expenditures for the development of a
mine or other natural deposit (other than an oil or gas well) as
provided in section 616 and the regulations thereunder.
(5) The provisions of section 270(b) do not operate to make an
expenditure a deductible item if it is not otherwise deductible under
the law applicable to the particular year in which it was incurred.
Thus, for example, if it is necessary, pursuant to the provisions of
section 270, to recompute the taxable or net income of an individual for
the taxable years 1950 through 1954, the individual in making the
recomputation may not deduct expenditures paid or incurred in the years
1950 through 1953 which must be capitalized under the law applicable to
those years, even though the expenditures are deductible under the Code.
(c) Applicability to taxable years otherwise subject to the Internal
Revenue Code of 1939. The net income of a taxable year otherwise subject
to the Internal Revenue Code of 1939 shall be recomputed pursuant to
section 270 if (i) such taxable year is included in a period of five
consecutive taxable years which includes at least one taxable year
beginning after December 31, 1953, and ending after August 16, 1954, and
(ii) the deductions (other than the specially treated deductions
specified in section 270(b)) for each taxable year in such five-year
period exceed the $50,000 limitation specified in section 270. As
described in paragraph (a)(5) of this section, a taxable year may be
part of two or more periods of five consecutive taxable years, one
meeting the requirements for recomputation pursuant to section 130 of
the Internal Revenue Code of 1939 and the other meeting the requirements
for recomputation pursuant to section 270 of the Internal Revenue Code
of 1954, then the recomputation for such taxable year shall be made
pursuant to section 270. For example, if a calendar year taxpayer
sustains a loss from a trade or business for each of the years 1949
through 1954, the years 1950, 1951, 1952, and 1953 may be a part of two
such periods of five consecutive taxable years. If, however, a taxable
year is part of a period of five consecutive taxable years which meets
the requirements for recomputation pursuant to section 130 of the
Internal Revenue Code of 1939, but is not part of a period which meets
the requirements for recomputation, pursuant to section 270, then a
recomputation of net income for such taxable year must be made pursuant
to section 130.
(d) Redetermination of tax. The tax imposed by Chapter 1 of the
Code, or by the corresponding provisions of prior revenue laws, for each
of the five consecutive taxable years specified in paragraph (a) of this
section shall be redetermined upon the basis of the taxable income or
net income of the individual, as the case may be, recomputed in the
manner described in paragraph (a) of this section. If the assessment of
a deficiency is prevented (except for the provisions of Part II (section
1311 and following), Subchapter Q, Chapter 1 of the Code, relating to
the effect of limitations and other provisions in income tax cases) by
the operation of any provision of law (e.g., sections 6501 and 6502, or
the corresponding provisions of prior revenue laws, relating to the
period of limitations upon assessment and collection) except section
7122, or the corresponding provisions of prior revenue laws, relating to
compromises, or by any rule of law (e.g., res judicata), then the excess
of the tax for such year as recomputed over the tax previously
determined for such year shall be considered a deficiency for the
purposes of section 270. The term tax previously determined shall have
the same meaning as that assigned to such term by section 1314(a). See
Sec. 1.1314 (a)-1.
(e) Assessment of tax. Any amount determined as a deficiency in the
manner described in paragraph (d) of this section in respect of any
taxable year of the five consecutive taxable years specified in
paragraph (a) of this section may be assessed and collected as if on the
date of the expiration of the period of limitation for the assessment of
a deficiency for the fifth taxable year of such five consecutive taxable
years, one year remained before the expiration of the period of
limitation upon
[[Page 939]]
assessment for the taxable year in respect of which the deficiency is
determined. If the taxable year is one in respect of which an assessment
could be made without regard to section 270, the amount of the actual
deficiency as defined in section 6211(a) (whether it is greater than,
equal to, or less than the deficiency determined under section 270(c))
shall be assessed and collected. However, if the assessment of a
deficiency for such taxable year would be prevented by any provision of
law (e.g., the period of limitation upon the assessment of tax) except
section 7122, or the corresponding provision of prior revenue laws,
relating to compromises, or by the operation of any rule of law (e.g.,
res judicata), then the excess of the tax recomputed as described in
paragraph (d) of this section over the tax previously determined may be
assessed and collected even though in fact there is no actual
deficiency, as defined in section 6211(a), in respect of the given
taxable year.
(f) Effective date; cross reference. The provisions of section 270
and this section apply to taxable years beginning before January 1,
1970. Thus, for instance, if the taxpayer had a profit of $2,000
attributable to a trade or business in 1965, section 270 and this
section would not apply to the taxable years 1966 through 1970, even
though he had losses of more than $50,000 in each of the 5 years ending
with 1970. For provisions relating to activities not engaged in for
profit applicable to taxable years beginning after December 31, 1969,
see section 183 and the regulations thereunder.
[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. 7198, 37 FR 13685, July 13, 1972]
Sec. 1.271-1 Debts owed by political parties.
(a) General rule. In the case of a taxpayer other than a bank (as
defined in section 581 and the regulations thereunder), no deduction
shall be allowed under section 166 (relating to bad debts) or section
165(g) (relating to worthlessness of securities) by reason of the
worthlessness of any debt, regardless of how it arose, owed by a
political party. For example, it is immaterial that the debt may have
arisen as a result of services rendered or goods sold or that the
taxpayer included the amount of the debt in income. In the case of a
bank, no deduction shall be allowed unless, under the facts and
circumstances, it appears that the bad debt was incurred to or purchased
by, or the worthless security was acquired by, the taxpayer in
accordance with its usual commercial practices. Thus, if a bank makes a
loan to a political party not in accordance with its usual commercial
practices but solely because the president of the bank has been active
in the party no bad debt deduction will be allowed with respect to the
loan.
(b) Definitions--(1) Political party. For purposes of this section
and Sec. 1.276-1, the term political party means a political party (as
commonly understood), a National, State, or local committee thereof, or
any committee, association, or organization, whether incorporated or
not, which accepts contributions (as defined in subparagraph (2) of this
paragraph) or makes expenditures (as defined in subparagraph (3) of this
paragraph) for the purpose of influencing or attempting to influence the
election of presidential or vice-presidential electors, or the
selection, nomination, or election of any individual to any Federal,
State, or local elective public office, whether or not such individual
or electors are selected, nominated, or elected. Accordingly, a
political party includes a committee or other group which accepts
contributions or makes expenditures for the purpose of promoting the
nomination of an individual for an elective public office in a primary
election, or in any convention, meeting, or caucus of a political party.
It is immaterial whether the contributions or expenditures are accepted
or made directly or indirectly. Thus, for example, a committee or other
group, is considered to be a political party, if, although it does not
expend any funds, it turns funds over to another organization, which
does expend funds for the purpose of attempting to influence the
nomination of an individual for an elective public office. An
organization which engages in activities which are truly nonpartisan in
nature will not be considered a political party merely because it
conducts
[[Page 940]]
activities with respect to an election campaign if, under all the facts
and circumstances, it is clear that its efforts are not directed to the
election of the candidates of any particular party or parties or to the
selection, nomination or election of any particular candidate. For
example, a committee or group will not be treated as a political party
if it is organized merely to inform the electorate as to the identity
and experience of all candidates involved, to present on a
nonpreferential basis the issues or views of the parties or candidates
as described by the parties or candidates, or to provide a forum in
which the candidates are freely invited on a nonpreferential basis to
discuss or debate the issues.
(2) Contributions. For purposes of this section and Sec. 1.276-1,
the term contributions includes a gift, subscription, loan, advance, or
deposit, of money or anything of value, and includes a contract,
promise, or agreement to make a contribution, whether or not legally
enforceable.
(3) Expenditures. For purposes of this section and Sec. 1.276-1,
the term expenditures includes a payment, distribution, loan, advance,
deposit, or gift, of money or anything of value, and includes a
contract, promise, or agreement to make an expenditure, whether or not
legally enforceable.
[T.D. 6996, 34 FR 832, Jan. 18, 1969]
Sec. 1.272-1 Expenditures relating to disposal of coal or domestic iron ore.
(a) Introduction. Section 272 provides special treatment for certain
expenditures paid or incurred by a taxpayer in connection with a
contract (hereafter sometimes referred to as a ``coal royalty contract''
or ``iron ore royalty contract'') for the disposal of coal or iron ore
the gain or loss from which is treated under section 631(c) as a section
1231 gain or loss on the sale of coal or iron ore. See paragraph (e) of
Sec. 1.631-3 for special rules relating to iron ore. The expenditures
covered by section 272 are those which are attributable to the making
and administering of such a contract or to the preservation of the
economic interest retained under the contract. For examples of such
expenditures, see paragraph (d) of this section. For a taxable year in
which gross royalty income is realized under the contract of disposal,
such expenditures shall not be allowed as a deduction. Instead, they are
to be added to the adjusted depletion basis of the coal or iron ore
disposed of in the taxable year in computing gain or loss under section
631(c). However, where no gross royalty income is realized under the
contract of disposal in a particular taxable year, such expenditure
shall be treated without regard to section 272.
(b) In general. (1) Where the disposal of coal or iron ore is
covered by section 631(c), the provisions of section 272 and this
section shall be applicable for a taxable year in which there is income
under the contract of disposal. (For purposes of section 272 and this
section, the term income means gross amounts received or accrued which
are royalties or bonuses in connection with a contract to which section
631(c) applies.) All expenditures paid or incurred by the taxpayer
during the taxable year which are attributable to the making and
administering of the contract disposing of the coal or iron ore and all
expenditures paid or incurred during the taxable year in order to
preserve the owner's economic interest retained under the contract shall
be disallowed as deductions in computing taxable income for the taxable
year. The sum of such expenditures and the adjusted depletion basis of
the coal or iron ore disposed of in the taxable year shall be used in
determining the amount of gain or loss with respect to the disposal. See
Sec. 1.631-3. For special rule in case of loss, see paragraph (c) of
this section. Section 272 and this section do not apply to capital
expenditures, and such expenditures are not taken into account in
computing gain or loss under section 631(c) except to the extent they
are properly part of the depletable basis of the coal or iron ore.
(2) The expenditures covered under section 272 and this section are
disallowed as a deduction only with respect to a taxable year in which
income is realized under the coal royalty contract (or iron ore royalty
contract) to which such expenditures are attributable. Where no income
is realized under the contract in a taxable year, these expenditures
shall be deducted as expenses for the production of income,
[[Page 941]]
or as a business expense, or they may be treated under section 266
(relating to taxes and carrying charges) if applicable.
(3) The provisions of section 272 and this section apply to a
taxable year in which income from the disposal by the owner of coal or
iron ore held by him for more than 1 year (6 months for taxable years
beginning before 1977; 9 months for taxable years beginning in 1977) is
subject to the provisions of section 631(c) even though the actual
mining of coal or iron ore under the coal royalty contract (or iron ore
royalty contract) does not take place during the taxable year. Where the
right under the contract to mine coal or iron ore for which advance
payment has been made expires, terminates, or is abandoned before the
coal or iron ore is mined, and paragraph (c) of Sec. 1.631-3 requires
the owner to recompute his tax with respect to such payment, the
recomputation must be made without applying the provisions of section
272 and this section.
(c) Losses. If, in any taxable year, the expenditures referred to in
section 272 and this section plus the adjusted depletion basis (as
defined in paragraph (b)(2) of Sec. 1.631-3) of the coal or iron ore
disposed of during the taxable year exceed the amount realized under the
contract which is subject to section 631(c) during the taxable year,
such excess shall be considered under section 1231 as a loss from the
sale of property used in the trade or business and, to the extent not
availed of as a reduction of gain under that section, shall be a loss
deductible under section 165(a) (relating to the deduction of losses
generally).
(d) Examples of expenditures. (1) The expenditures referred to in
section 272 include, but are not limited to, the following items, if
such items are attributable to the making or administering of the
contract or preserving the economic interest therein: Ad valorem taxes
imposed by State or local authorities, costs of fire protection, costs
of insurance (other than liability insurance), costs incurred in
administering the contract (including costs of bookkeeping and technical
supervision), interest on loans, expenses of flood control, legal and
technical expenses, and expenses of measuring and checking quantities of
coal or iron ore disposed of under the contract. Whether the interest on
loans is attributable to the making or administering of the contract or
preserving the economic interest therein will depend upon the use to
which the borrowed monies are put.
(2) Any expenditure referred to in this section which is applicable
to more than one coal royalty contract or iron ore royalty contract
shall be reasonably apportioned to each of such contracts. Furthermore,
if an expenditure applies only in part to the making or administering of
the contract or the preservation of the economic interest, then only
such part shall be treated under section 272. The apportionment of the
expenditure shall be made on a reasonable basis. For example, where a
taxpayer has other income (such as income from oil or gas royalties,
rentals, right of way fees, interest, or dividends) as well as income
under section 631(c), and where the salaries of some of its employees or
other expenses relate to both classes of income, such expenses shall be
allocated reasonably between the income subject to section 631(c) and
the other income. Where a taxpayer has more than one coal royalty
contract or iron ore royalty contract, expenditures under this section
relating to a contract from which no income has been received in the
taxable year may not be allocated to income from another contract from
which income has been received in the taxable year.
(3) The taxpayer may have expenses which are not attributable even
partly to making and administering a coal royalty contract or iron ore
royalty contract or to the preservation of the economic interest
retained under the contract and, accordingly, are not included in the
expenditures described in section 272. These include such items as ad
valorem taxes imposed by State or local authorities on property not
covered by the contract, salaries, wages, or other expenses entirely
incident to the ownership and protection of such property and
depreciation of improvements thereon, fire insurance on such property,
charitable contributions, and similar expenses unrelated to the making
or to the administering
[[Page 942]]
of coal royalty contracts or iron ore royalty contracts or preserving
the taxpayer's economic interest retained therein.
(e) Nonapplication of section. For purposes of section 543, the
provisions of section 272 shall have no application. For example, the
taxpayer may, for the purposes of section 543(a)(3)(C) or the
corresponding provisions of prior income tax laws, include in the sum of
the deductions which are allowable under section 162 an amount paid to
an attorney as compensation for legal services rendered in connection
with the making of a coal royalty contract or iron ore royalty contract
(assuming the expenditure otherwise qualifies under section 162 as an
ordinary and necessary expense incurred in the taxpayer's trade or
business), even though such expenditure is disallowed as a deduction
under section 272.
[T.D. 6841, 30 FR 9304, July 27, 1965, as amended by T.D. 7728, 45 FR
72650, Nov. 3, 1980]
Sec. 1.273-1 Life or terminable interests.
(a) In general. Amounts paid as income to the holder of a life or a
terminable interest acquired by gift, bequest, or inheritance shall not
be subject to any deduction for shrinkage (whether called by
depreciation or any other name) in the value of such interest due to the
lapse of time. In other words, the holder of such an interest so
acquired may not set up the value of the expected future payments as
corpus or principal and claim deduction for shrinkage or exhaustion
thereof due to the passage of time. For the treatment generally of
distributions to beneficiaries of an estate or trust, see Subparts A, B,
C, and D (section 641 and following), Subchapter J, Chapter 1 of the
Code, and the regulations thereunder. For basis of property acquired
from a decedent and by gifts and transfers in trust, see sections 1014,
1015, and 1022, and the regulations thereunder.
(b) Effective/applicability date. The provisions in this section are
applicable for taxable years beginning on or after September 16, 1958.
The provisions of this section relating to section 1022 are effective on
and after January 19, 2017.
[T.D. 9811, 82 FR 6237, Jan. 19, 2017]
Sec. 1.274-1 Disallowance of certain entertainment, gift
and travel expenses.
Section 274 disallows in whole, or in part, certain expenditures for
entertainment, gifts and travel which would otherwise be allowable under
Chapter 1 of the Code. The requirements imposed by section 274 are in
addition to the requirements for deductibility imposed by other
provisions of the Code. If a deduction is claimed for an expenditure for
entertainment, gifts, or travel, the taxpayer must first establish that
it is otherwise allowable as a deduction under Chapter 1 of the Code
before the provisions of section 274 become applicable. An expenditure
for entertainment, to the extent it is lavish or extravagant, shall not
be allowable as a deduction. The taxpayer should then substantiate such
an expenditure in accordance with the rules under section 274(d). See
Sec. 1.274-5. Section 274 is a disallowance provision exclusively, and
does not make deductible any expense which is disallowed under any other
provision of the Code. Similarly, section 274 does not affect the
includability of an item in, or the excludability of an item from, the
gross income of any taxpayer. For specific provisions with respect to
the deductibility of expenditures: for an activity of a type generally
considered to constitute entertainment, amusement, or recreation, and
for a facility used in connection with such an activity, as well as
certain travel expenses of a spouse, etc., see Sec. 1.274-2; for
expenses for gifts, see Sec. 1.274-3; for expenses for foreign travel,
see Sec. 1.274-4; for expenditures deductible without regard to
business activity, see Sec. 1.274-6; and for treatment of personal
portion of entertainment facility, see Sec. 1.274-7.
[T.D. 6659, 28 FR 6499, June 25, 1963, as amended by T.D. 8666, 61 FR
27006, May 30, 1996]
Sec. 1.274-2 Disallowance of deductions for certain expenses for
entertainment, amusement, recreation, or travel.
(a) General rules--(1) Entertainment activity. Except as provided in
this section, no deduction otherwise allowable under Chapter 1 of the
Code shall be allowed for any expenditure with respect
[[Page 943]]
to entertainment unless the taxpayer establishes:
(i) That the expenditure was directly related to the active conduct
of the taxpayer's trade or business, or
(ii) In the case of an expenditure directly preceding or following a
substantial and bona fide business discussion (including business
meetings at a convention or otherwise), that the expenditure was
associated with the active conduct of the taxpayer's trade or business.
Such deduction shall not exceed the portion of the expenditure directly
related to (or in the case of an expenditure described in subdivision
(ii) of this subparagraph, the portion of the expenditure associated
with) the active conduct of the taxpayer's trade or business.
(2) Entertainment facilities--(i) Expenditures paid or incurred
after December 31, 1978, and not with respect to a club. Except as
provided in this section with respect to a club, no deduction otherwise
allowable under chapter 1 of the Code shall be allowed for any
expenditure paid or incurred after December 31, 1978, with respect to a
facility used in connection with entertainment.
(ii) Expenditures paid or incurred before January 1, 1979, with
respect to entertainment facilities, or paid or incurred before January
1, 1994, with respect to clubs--(a) Requirements for deduction. Except
as provided in this section, no deduction otherwise allowable under
chapter 1 of the Internal Revenue Code shall be allowed for any
expenditure paid or incurred before January 1, 1979, with respect to a
facility used in connection with entertainment, or for any expenditure
paid or incurred before January 1, 1994, with respect to a club used in
connection with entertainment, unless the taxpayer establishes--
(1) That the facility or club was used primarily for the furtherance
of the taxpayer's trade or business; and
(2) That the expenditure was directly related to the active conduct
of that trade or business.
(b) Amount of deduction. The deduction allowable under paragraph
(a)(2)(ii)(a) of this section shall not exceed the portion of the
expenditure directly related to the active conduct of the taxpayer's
trade or business.
(iii) Expenditures paid or incurred after December 31, 1993, with
respect to a club--(a) In general. No deduction otherwise allowable
under chapter 1 of the Internal Revenue Code shall be allowed for
amounts paid or incurred after December 31, 1993, for membership in any
club organized for business, pleasure, recreation, or other social
purpose. The purposes and activities of a club, and not its name,
determine whether it is organized for business, pleasure, recreation, or
other social purpose. Clubs organized for business, pleasure,
recreation, or other social purpose include any membership organization
if a principal purpose of the organization is to conduct entertainment
activities for members of the organization or their guests or to provide
members or their guests with access to entertainment facilities within
the meaning of paragraph (e)(2) of this section. Clubs organized for
business, pleasure, recreation, or other social purpose include, but are
not limited to, country clubs, golf and athletic clubs, airline clubs,
hotel clubs, and clubs operated to provide meals under circumstances
generally considered to be conducive to business discussion.
(b) Exceptions. Unless a principal purpose of the organization is to
conduct entertainment activities for members or their guests or to
provide members or their guests with access to entertainment facilities,
business leagues, trade associations, chambers of commerce, boards of
trade, real estate boards, professional organizations (such as bar
associations and medical associations), and civic or public service
organizations will not be treated as clubs organized for business,
pleasure, recreation, or other social purpose.
(3) Cross references. For definition of the term entertainment, see
paragraph (b)(1) of this section. For the disallowance of deductions for
the cost of admission to a dinner or program any part of the proceeds of
which inures to the use of a political party or political candidate, and
cost of admission to an inaugural event or similar event identified with
any political party or political candidate, see Sec. 1.276-1. For rules
and definitions with respect to:
(i) ``Directly related entertainment'', see paragraph (c) of this
section,
[[Page 944]]
(ii) ``Associated entertainment'', see paragraph (d) of this
section,
(iii) ``Expenditures paid or incurred before January 1, 1979, with
respect to entertainment facilities or before January 1, 1994, with
respect to clubs'', see paragraph (e) of this section, and
(iv) ``Specific exceptions'' to the disallowance rules of this
section, see paragraph (f) of this section.
(b) Definitions--(1) Entertainment defined--(i) In general. For
purposes of this section, the term entertainment means any activity
which is of a type generally considered to constitute entertainment,
amusement, or recreation, such as entertaining at night clubs, cocktail
lounges, theaters, country clubs, golf and athletic clubs, sporting
events, and on hunting, fishing, vacation and similar trips, including
such activity relating solely to the taxpayer or the taxpayer's family.
The term entertainment may include an activity, the cost of which is
claimed as a business expense by the taxpayer, which satisfies the
personal, living, or family needs of any individual, such as providing
food and beverages, a hotel suite, or an automobile to a business
customer or his family. The term entertainment does not include
activities which, although satisfying personal, living, or family needs
of an individual, are clearly not regarded as constituting
entertainment, such as (a) supper money provided by an employer to his
employee working overtime, (b) a hotel room maintained by an employer
for lodging of his employees while in business travel status, or (c) an
automobile used in the active conduct of trade or business even though
used for routine personal purposes such as commuting to and from work.
On the other hand, the providing of a hotel room or an automobile by an
employer to his employee who is on vacation would constitute
entertainment of the employee.
(ii) Objective test. An objective test shall be used to determine
whether an activity is of a type generally considered to constitute
entertainment. Thus, if an activity is generally considered to be
entertainment, it will constitute entertainment for purposes of this
section and section 274(a) regardless of whether the expenditure can
also be described otherwise, and even though the expenditure relates to
the taxpayer alone. This objective test precludes arguments such as that
entertainment means only entertainment of others or that an expenditure
for entertainment should be characterized as an expenditure for
advertising or public relations. However, in applying this test the
taxpayer's trade or business shall be considered. Thus, although
attending a theatrical performance would generally be considered
entertainment, it would not be so considered in the case of a
professional theater critic, attending in his professional capacity.
Similarly, if a manufacturer of dresses conducts a fashion show to
introduce his products to a group of store buyers, the show would not be
generally considered to constitute entertainment. However, if an
appliance distributor conducts a fashion show for the wives of his
retailers, the fashion show would be generally considered to constitute
entertainment.
(iii) Special definitional rules--(a) In general. Except as
otherwise provided in (b) or (c) of this subdivision, any expenditure
which might generally be considered either for a gift or entertainment,
or considered either for travel or entertainment, shall be considered an
expenditure for entertainment rather than for a gift or travel.
(b) Expenditures deemed gifts. An expenditure described in (a) of
this subdivision shall be deemed for a gift to which this section does
not apply if it is:
(1) An expenditure for packaged food or beverages transferred
directly or indirectly to another person intended for consumption at a
later time.
(2) An expenditure for tickets of admission to a place of
entertainment transferred to another person if the taxpayer does not
accompany the recipient to the entertainment unless the taxpayer treats
the expenditure as entertainment. The taxpayer may change his treatment
of such an expenditure as either a gift or entertainment at any time
within the period prescribed for assessment of tax as provided in
section 6501 of the Code and the regulations thereunder.
(3) Such other specific classes of expenditure generally considered
to be
[[Page 945]]
for a gift as the Commissioner, in his discretion, may prescribe.
(c) Expenditures deemed travel. An expenditure described in (a) of
this subdivision shall be deemed for travel to which this section does
not apply if it is:
(1) With respect to a transportation type facility (such as an
automobile or an airplane), even though used on other occasions in
connection with an activity of a type generally considered to constitute
entertainment, to the extent the facility is used in pursuit of a trade
or business for purposes of transportation not in connection with
entertainment. See also paragraph (e)(3)(iii)(b) of this section for
provisions covering nonentertainment expenditures with respect to such
facilities.
(2) Such other specific classes of expenditure generally considered
to be for travel as the Commissioner, in his discretion, may prescribe.
(2) Other definitions--(i) Expenditure. The term expenditure as used
in this section shall include expenses paid or incurred for goods,
services, facilities, and items (including items such as losses and
depreciation).
(ii) Expenses for production of income. For purposes of this
section, any reference to trade or business shall include any activity
described in section 212.
(iii) Business associate. The term business associate as used in
this section means a person with whom the taxpayer could reasonably
expect to engage or deal in the active conduct of the taxpayer's trade
or business such as the taxpayer's customer, client, supplier, employee,
agent, partner, or professional adviser, whether established or
prospective.
(c) Directly related entertainment--(1) In general. Except as
otherwise provided in paragraph (d) of this section (relating to
associated entertainment) or under paragraph (f) of this section
(relating to business meals and other specific exceptions), no deduction
shall be allowed for any expenditure for entertainment unless the
taxpayer establishes that the expenditure was directly related to the
active conduct of his trade or business within the meaning of this
paragraph.
(2) Directly related entertainment defined. Any expenditure for
entertainment, if it is otherwise allowable as a deduction under chapter
1 of the Code, shall be considered directly related to the active
conduct of the taxpayer's trade or business if it meets the requirements
of any one of subparagraphs (3), (4), (5), or (6) of this paragraph.
(3) Directly related in general. Except as provided in subparagraph
(7) of this paragraph, an expenditure for entertainment shall be
considered directly related to the active conduct of the taxpayer's
trade or business if it is established that it meets all of the
requirements of subdivisions (i), (ii), (iii) and (iv) of this
subparagraph.
(i) At the time the taxpayer made the entertainment expenditure (or
committed himself to make the expenditure), the taxpayer had more than a
general expectation of deriving some income or other specific trade or
business benefit (other than the goodwill of the person or persons
entertained) at some indefinite future time from the making of the
expenditure. A taxpayer, however, shall not be required to show that
income or other business benefit actually resulted from each and every
expenditure for which a deduction is claimed.
(ii) During the entertainment period to which the expenditure
related, the taxpayer actively engaged in a business meeting,
negotiation, discussion, or other bona fide business transaction, other
than entertainment, for the purpose of obtaining such income or other
specific trade or business benefit (or, at the time the taxpayer made
the expenditure or committed himself to the expenditure, it was
reasonable for the taxpayer to expect that he would have done so,
although such was not the case solely for reasons beyond the taxpayer's
control).
(iii) In light of all the facts and circumstances of the case, the
principal character or aspect of the combined business and entertainment
to which the expenditure related was the active conduct of the
taxpayer's trade or business (or at the time the taxpayer made the
expenditure or committed himself to the expenditure, it was reasonable
[[Page 946]]
for the taxpayer to expect that the active conduct of trade or business
would have been the principal character or aspect of the entertainment,
although such was not the case solely for reasons beyond the taxpayer's
control). It is not necessary that more time be devoted to business than
to entertainment to meet this requirement. The active conduct of trade
or business is considered not to be the principal character or aspect of
combined business and entertainment activity on hunting or fishing trips
or on yachts and other pleasure boats unless the taxpayer clearly
establishes to the contrary.
(iv) The expenditure was allocable to the taxpayer and a person or
persons with whom the taxpayer engaged in the active conduct of trade or
business during the entertainment or with whom the taxpayer establishes
he would have engaged in such active conduct of trade or business if it
were not for circumstances beyond the taxpayer's control. For
expenditures closely connected with directly related entertainment, see
paragraph (d)(4) of this section.
(4) Expenditures in clear business setting. An expenditure for
entertainment shall be considered directly related to the active conduct
of the taxpayer's trade or business if it is established that the
expenditure was for entertainment occurring in a clear business setting
directly in furtherance of the taxpayer's trade or business. Generally,
entertainment shall not be considered to have occurred in a clear
business setting unless the taxpayer clearly establishes that any
recipient of the entertainment would have reasonably known that the
taxpayer had no significant motive, in incurring the expenditure, other
than directly furthering his trade or business. Objective rather than
subjective standards will be determinative. Thus, entertainment which
occurred under any circumstances described in subparagraph (7)(ii) of
this paragraph ordinarily will not be considered as occurring in a clear
business setting. Such entertainment will generally be considered to be
socially rather than commercially motivated. Expenditures made for the
furtherance of a taxpayer's trade or business in providing a
``hospitality room'' at a convention (described in paragraph
(d)(3)(i)(b) of this section) at which goodwill is created through
display or discussion of the taxpayer's products, will, however, be
treated as directly related. In addition, entertainment of a clear
business nature which occurred under circumstances where there was no
meaningful personal or social relationship between the taxpayer and the
recipients of the entertainment may be considered to have occurred in a
clear business setting. For example, entertainment of business
representatives and civic leaders at the opening of a new hotel or
theatrical production, where the clear purpose of the taxpayer is to
obtain business publicity rather than to create or maintain the goodwill
of the recipients of the entertainment, would generally be considered to
be in a clear business setting. Also, entertainment which has the
principal effect of a price rebate in connection with the sale of the
taxpayer's products generally will be considered to have occurred in a
clear business setting. Such would be the case, for example, if a
taxpayer owning a hotel were to provide occasional free dinners at the
hotel for a customer who patronized the hotel.
(5) Expenditures for services performed. An expenditure shall be
considered directly related to the active conduct of the taxpayer's
trade or business if it is established that the expenditure was made
directly or indirectly by the taxpayer for the benefit of an individual
(other than an employee), and if such expenditure was in the nature of
compensation for services rendered or was paid as a prize or award which
is required to be included in gross income under section 74 and the
regulations thereunder. For example, if a manufacturer of products
provides a vacation trip for retailers of his products who exceed sales
quotas as a prize or award which is includible in gross income, the
expenditure will be considered directly related to the active conduct of
the taxpayer's trade or business.
(6) Club dues, etc., allocable to business meals. An expenditure
shall be considered directly related to the active conduct of the
taxpayer's trade or business if it is established that the expenditure
[[Page 947]]
was with respect to a facility (as described in paragraph (e) of this
section) used by the taxpayer for the furnishing of food or beverages
under circumstances described in paragraph (f)(2)(i) of this section
(relating to business meals and similar expenditures), to the extent
allocable to the furnishing of such food or beverages. This paragraph
(c)(6) applies to club dues paid or incurred before January 1, 1987.
(7) Expenditures generally considered not directly related.
Expenditures for entertainment, even if connected with the taxpayer's
trade or business, will generally be considered not directly related to
the active conduct of the taxpayer's trade or business, if the
entertainment occurred under circumstances where there was little or no
possibility of engaging in the active conduct of trade or business. The
following circumstances will generally be considered circumstances where
there was little or no possibility of engaging in the active conduct of
a trade or business:
(i) The taxpayer was not present;
(ii) The distractions were substantial, such as:
(a) A meeting or discussion at night clubs, theaters, and sporting
events, or during essentially social gatherings such as cocktail
parties, or
(b) A meeting or discussion, if the taxpayer meets with a group
which includes persons other than business associates, at places such as
cocktail lounges, country clubs, golf and athletic clubs, or at vacation
resorts.
An expenditure for entertainment in any such case is considered not to
be directly related to the active conduct of the taxpayer's trade or
business unless the taxpayer clearly establishes to the contrary.
(d) Associated entertainment--(1) In general. Except as provided in
paragraph (f) of this section (relating to business meals and other
specific exceptions) and subparagraph (4) of this paragraph (relating to
expenditures closely connected with directly related entertainment), any
expenditure for entertainment which is not directly related to the
active conduct of the taxpayer's trade or business will not be allowable
as a deduction unless:
(i) It was associated with the active conduct of trade or business
as defined in subparagraph (2) of this paragraph, and
(ii) The entertainment directly preceded or followed a substantial
and bona fide business discussion as defined in subparagraph (3) of this
paragraph.
(2) Associated entertainment defined. Generally, any expenditure for
entertainment, if it is otherwise allowable under Chapter 1 of the Code,
shall be considered associated with the active conduct of the taxpayer's
trade or business if the taxpayer establishes that he had a clear
business purpose in making the expenditure, such as to obtain new
business or to encourage the continuation of an existing business
relationship. However, any portion of an expenditure allocable to a
person who was not closely connected with a person who engaged in the
substantial and bona fide business discussion (as defined in
subparagraph (3)(i) of this paragraph) shall not be considered
associated with the active conduct of the taxpayer's trade or business.
The portion of an expenditure allocable to the spouse of a person who
engaged in the discussion will, if it is otherwise allowable under
chapter 1 of the Code, be considered associated with the active conduct
of the taxpayer's trade or business.
(3) Directly preceding or following a substantial and bona fide
business discussion defined--(i) Substantial and bona fide business
discussion--(a) In general. Whether any meeting, negotiation or
discussion constitutes a ``substantial and bona fide business
discussion'' within the meaning of this section depends upon the facts
and circumstances of each case. It must be established, however, that
the taxpayer actively engaged in a business meeting, negotiation,
discussion, or other bona fide business transaction, other than
entertainment, for the purpose of obtaining income or other specific
trade or business benefit. In addition, it must be established that such
a business meeting, negotiation, discussion, or transaction was
substantial in relation to the entertainment. This requirement will be
satisfied if the principal character or aspect of the combined
entertainment and business activity was the active
[[Page 948]]
conduct of business. However, it is not necessary that more time be
devoted to business than to entertainment to meet this requirement.
(b) Meetings at conventions, etc. Any meeting officially scheduled
in connection with a program at a convention or similar general
assembly, or at a bona fide trade or business meeting sponsored and
conducted by business or professional organizations, shall be considered
to constitute a substantial and bona fide business discussion within the
meaning of this section provided:
(1) Expenses necessary to taxpayer's attendance. The expenses
necessary to the attendance of the taxpayer at the convention, general
assembly, or trade or business meeting, were ordinary and necessary
within the meaning of section 162 or 212;
(2) Convention program. The organization which sponsored the
convention, or trade or business meeting had scheduled a program of
business activities (including committee meetings or presentation of
lectures, panel discussions, display of products, or other similar
activities), and that such program was the principal activity of the
convention, general assembly, or trade or business meeting.
(ii) Directly preceding or following. Entertainment which occurs on
the same day as a substantial and bona fide business discussion (as
defined in subdivision (i) of this subparagraph) will be considered to
directly precede or follow such discussion. If the entertainment and the
business discussion do not occur on the same day, the facts and
circumstances of each case are to be considered, including the place,
date and duration of the business discussion, whether the taxpayer or
his business associates are from out of town, and, if so, the date of
arrival and departure, and the reasons the entertainment did not take
place on the day of the business discussion. For example, if a group of
business associates comes from out of town to the taxpayer's place of
business to hold a substantial business discussion, the entertainment of
such business guests and their wives on the evening prior to, or on the
evening of the day following, the business discussion would generally be
regarded as directly preceding or following such discussion.
(4) Expenses closely connected with directly related entertainment.
If any portion of an expenditure meets the requirements of paragraph
(c)(3) of this section (relating to directly related entertainment in
general), the remaining portion of the expenditure, if it is otherwise
allowable under Chapter 1 of the Code, shall be considered associated
with the active conduct of the taxpayer's trade or business to the
extent allocable to a person or persons closely connected with a person
referred to in paragraph (c)(3)(iv) of this section. The spouse of a
person referred to in paragraph(c)(3)(iv) of this section will be
considered closely connected to such a person for purposes of this
subparagraph. Thus, if a taxpayer and his wife entertain a business
customer and the customer's wife under circumstances where the
entertainment of the customer is considered directly related to the
active conduct of the taxpayer's trade or business (within the meaning
of paragraph (c)(3) of this section) the portion of the expenditure
allocable to both wives will be considered associated with the active
conduct of the taxpayer's trade or business under this subparagraph.
(e) Expenditures paid or incurred before January 1, 1979, with
respect to entertainment facilities or before January 1, 1994, with
respect to clubs--(1) In general. Any expenditure paid or incurred
before January 1, 1979, with respect to a facility, or paid or incurred
before January 1, 1994, with respect to a club, used in connection with
entertainment shall not be allowed as a deduction except to the extent
it meets the requirements of paragraph (a)(2)(ii) of this section.
(2) Facilities used in connection with entertainment--(i) In
general. Any item of personal or real property owned, rented, or used by
a taxpayer shall (unless otherwise provided under the rules of
subdivision (ii) of this subparagraph) be considered to constitute a
facility used in connection with entertainment if it is used during the
taxable year for, or in connection with, entertainment (as defined in
paragraph (b)(1) of this section). Examples of facilities which might be
used for, or in connection with, entertainment include yachts,
[[Page 949]]
hunting lodges, fishing camps, swimming pools, tennis courts, bowling
alleys, automobiles, airplanes, apartments, hotel suites, and homes in
vacation resorts.
(ii) Facilities used incidentally for entertainment. A facility used
only incidentally during a taxable year in connection with
entertainment, if such use is insubstantial, will not be considered a
``facility used in connection with entertainment'' for purposes of this
section or for purposes of the recordkeeping requirements of section
274(d). See Sec. 1.274-5(c)(6)(iii).
(3) Expenditures with respect to a facility used in connection with
entertainment--(i) In general. The phrase expenditures with respect to a
facility used in connection with entertainment includes depreciation and
operating costs, such as rent and utility charges (for example, water or
electricity), expenses for the maintenance, preservation or protection
of a facility (for example, repairs, painting, insurance charges), and
salaries or expenses for subsistence paid to caretakers or watchmen. In
addition, the phrase includes losses realized on the sale or other
disposition of a facility.
(ii) Club dues--(a) Club dues paid or incurred before January 1,
1994. Dues or fees paid before January 1, 1994, to any social, athletic,
or sporting club or organization are considered expenditures with
respect to a facility used in connection with entertainment. The
purposes and activities of a club or organization, and not its name,
determine its character. Generally, the phrase social, athletic, or
sporting club or organization has the same meaning for purposes of this
section as that phrase had in section 4241 and the regulations
thereunder, relating to the excise tax on club dues, prior to the repeal
of section 4241 by section 301 of Public Law 89-44. However, for
purposes of this section only, clubs operated solely to provide lunches
under circumstances of a type generally considered to be conducive to
business discussion, within the meaning of paragraph (f)(2)(i) of this
section, will not be considered social clubs.
(b) Club dues paid or incurred after December 31, 1993. See
paragraph (a)(2)(iii) of this section with reference to the disallowance
of deductions for club dues paid or incurred after December 31, 1993.
(iii) Expenditures not with respect to a facility. The following
expenditures shall not be considered to constitute expenditures with
respect to a facility used in connection with entertainment:
(a) Out of pocket expenditures. Expenses (exclusive of operating
costs and other expenses referred to in subdivision (i) of this
subparagraph) incurred at the time of an entertainment activity, even
though in connection with the use of facility for entertainment
purposes, such as expenses for food and beverages, or expenses for
catering, or expenses for gasoline and fishing bait consumed on a
fishing trip;
(b) Non-entertainment expenditures. Expenses or items attributable
to the use of a facility for other than entertainment purposes such as
expenses for an automobile when not used for entertainment; and
(c) Expenditures otherwise deductible. Expenses allowable as a
deduction without regard to their connection with a taxpayer's trade or
business such as taxes, interest, and casualty losses. The provisions of
this subdivision shall be applied in the case of a taxpayer which is not
an individual as if it were an individual. See also Sec. 1.274-6.
(iv) Cross reference. For other rules with respect to treatment of
certain expenditures for entertainment-type facilities, see Sec. 1.274-
7.
(4) Determination of primary use--(i) In general. A facility used in
connection with entertainment shall be considered as used primarily for
the furtherance of the taxpayer's trade or business only if it is
established that the primary use of the facility during the taxable year
was for purposes considered ordinary and necessary within the meaning of
sections 162 and 212 and the regulations thereunder. All of the facts
and circumstances of each case shall be considered in determining the
primary use of a facility. Generally, it is the actual use of the
facility which establishes the deductibility of expenditures with
respect to the facility; not its availability for use and not the
taxpayer's principal purpose in acquiring the facility. Objective rather
than subjective standards will be determinative. If
[[Page 950]]
membership entitles the member's entire family to use of a facility,
such as a country club, their use will be considered in determining
whether business use of the facility exceeds personal use. The factors
to be considered include the nature of each use, the frequency and
duration of use for business purposes as compared with other purposes,
and the amount of expenditures incurred during use for business compared
with amount of expenditures incurred during use for other purposes. No
single standard of comparison, or quantitative measurement, as to the
significance of any such factor, however, is necessarily appropriate for
all classes or types of facilities. For example, an appropriate standard
for determining the primary use of a country club during a taxable year
will not necessarily be appropriate for determining the primary use of
an airplane. However, a taxpayer shall be deemed to have established
that a facility was used primarily for the furtherance of his trade or
business if he establishes such primary use in accordance with
subdivision (ii) or (iii) of this subparagraph. Subdivisions (ii) and
(iii) of this subparagraph shall not preclude a taxpayer from otherwise
establishing the primary use of a facility under the general provisions
of this subdivision.
(ii) Certain transportation facilities. A taxpayer shall be deemed
to have established that a facility of a type described in this
subdivision was used primarily for the furtherance of his trade or
business if:
(a) Automobiles. In the case of an automobile, the taxpayer
establishes that more than 50 percent of mileage driven during the
taxable year was in connection with travel considered to be ordinary and
necessary within the meaning of section 162 or 212 and the regulations
thereunder.
(b) Airplanes. In the case of an airplane, the taxpayer establishes
that more than 50 percent of hours flown during the taxable year was in
connection with travel considered to be ordinary and necessary within
the meaning of section 162 or 212 and the regulations thereunder.
(iii) Entertainment facilities in general. A taxpayer shall be
deemed to have established that:
(a) A facility used in connection with entertainment, such as a
yacht or other pleasure boat, hunting lodge, fishing camp, summer home
or vacation cottage, hotel suite, country club, golf club or similar
social, athletic, or sporting club or organization, bowling alley,
tennis court, or swimming pool, or,
(b) A facility for employees not falling within the scope of section
274(e) (2) or (5) was used primarily for the furtherance of his trade or
business if he establishes that more than 50 percent of the total
calendar days of use of the facility by, or under authority of, the
taxpayer during the taxable year were days of business use. Any use of a
facility (of a type described in this subdivision) during one calendar
day shall be considered to constitute a ``day of business use'' if the
primary use of the facility on such day was ordinary and necessary
within the meaning of section 162 or 212 and the regulations thereunder.
For the purposes of this subdivision, a facility shall be deemed to have
been primarily used for such pruposes on any one calendar day if the
facility was used for the conduct of a substantial and bona fide
business discussion (as defined in paragraph (d)(3)(i) of this section)
notwithstanding that the facility may also have been used on the same
day for personal or family use by the taxpayer or any member of the
taxpayer's family not involving entertainment of others by, or under the
authority of, the taxpayer.
(f) Specific exceptions to application of this section--(1) In
general. The provisions of paragraphs (a) through (e) of this section
(imposing limitations on deductions for entertainment expenses) are not
applicable in the case of expenditures set forth in subparagraph (2) of
this paragraph. Such expenditures are deductible to the extent allowable
under chapter 1 of the Code. This paragraph shall not be construed to
affect the allowability or nonallowability of a deduction under section
162 or 212 and the regulations thereunder. The fact that an expenditure
is not covered by a specific exception provided for in this paragraph
shall not be determinative of the allowability or nonallowability of the
expenditure under paragraphs (a)
[[Page 951]]
through (e) of this section. Expenditures described in subparagraph (2)
of this paragraph are subject to the substantiation requirements of
section 274(d) to the extent provided in Sec. 1.274-5.
(2) Exceptions. The expenditures referred to in subparagraph (1) of
this paragraph are set forth in subdivisions (i) through (ix) of this
subparagraph.
(i) Business meals and similar expenditures paid or incurred before
January 1, 1987--(a) In general. Any expenditure for food or beverages
furnished to an individual under circumstances of a type generally
considered conducive to business discussion (taking into account the
surroundings in which furnished, the taxpayer's trade, business, or
income-producing activity, and the relationship to such trade, business
or activity of the persons to whom the food or beverages are furnished)
is not subject to the limitations on allowability of deductions provided
for in paragraphs (a) through (e) of this section. There is no
requirement that business actually be discussed for this exception to
apply.
(b) Surroundings. The surroundings in which the food or beverages
are furnished must be such as would provide an atmosphere where there
are no substantial distractions to discussion. This exception applies
primarily to expenditures for meals and beverages served during the
course of a breakfast, lunch or dinner meeting of the taxpayer and his
business associates at a restaurant, hotel dining room, eating club or
similar place not involving distracting influences such as a floor show.
This exception also applies to expenditures for beverages served apart
from meals if the expenditure is incurred in surroundings similarly
conducive to business discussion, such as an expenditure for beverages
served during the meeting of the taxpayer and his business associates at
a cocktail lounge or hotel bar not involving distracting influences such
as a floor show. This exception may also apply to expenditures for meals
or beverages served in the taxpayer's residence on a clear showing that
the expenditure was commercially rather than socially motivated.
However, this exception, generally, is not applicable to any expenditure
for meals or beverages furnished in circumstances where there are major
distractions not conducive to business discussion, such as at night
clubs, sporting events, large cocktail parties, sizeable social
gatherings, or other major distracting influences.
(c) Taxpayer's trade or business and relationship of persons
entertained. The taxpayer's trade, business, or income-producing
activity and the relationship of the persons to whom the food or
beverages are served to such trade, business or activity must be such as
will reasonably indicate that the food or beverages were furnished for
the primary purpose of furthering the taxpayer's trade or business and
did not primarily serve a social or personal purpose. Such a business
purpose would be indicated, for example, if a salesman employed by a
manufacturing supply company meets for lunch during a normal business
day with a purchasing agent for a manufacturer which is a prospective
customer. Such a purpose would also be indicated if a life insurance
agent meets for lunch during a normal business day with a client.
(d) Business programs. Expenditures for business luncheons or
dinners which are part of a business program, or banquets officially
sponsored by business or professional associations, will be regarded as
expenditures to which the exception of this subdivision (i) applies. In
the case of such a business luncheon or dinner it is not always
necessary that the taxpayer attend the luncheon or dinner himself. For
example, if a dental equipment supplier purchased a table at a dental
association banquet for dentists who are actual or prospective customers
for his equipment, the cost of the table would not be disallowed under
this section. See also paragraph (c)(4) of this section relating to
expenditures made in a clear business setting.
(ii) Food and beverages for employees. Any expenditure by a taxpayer
for food and beverages (or for use of a facility in connection
therewith) furnished on the taxpayer's business premises primarily for
his employees is not subject to the limitations on allowability of
deductions provided for in paragraphs
[[Page 952]]
(a) through (e) of this section. This exception applies not only to
expenditures for food or beverages furnished in a typical company
cafeteria or an executive dining room, but also to expenditures with
respect to the operation of such facilities. This exception applies even
though guests are occasionally served in the cafeteria or dining room.
(iii) Certain entertainment and travel expenses treated as
compensation--(A) In general. Any expenditure by a taxpayer for
entertainment (or for use of a facility in connection therewith) or for
travel described in section 274(m)(3), if an employee is the recipient
of the entertainment or travel, is not subject to the limitations on
allowability of deductions provided for in paragraphs (a) through (e) of
this section to the extent that the expenditure is treated by the
taxpayer--
(1) On the taxpayer's income tax return as originally filed, as
compensation paid to the employee; and
(2) As wages to the employee for purposes of withholding under
chapter 24 (relating to collection of income tax at source on wages).
(B) Expenses includible in income of persons who are not employees.
Any expenditure by a taxpayer for entertainment (or for use of a
facility in connection therewith), or for travel described in section
274(m)(3), is not subject to the limitations on allowability of
deductions provided for in paragraphs (a) through (e) of this section to
the extent the expenditure is includible in gross income as compensation
for services rendered, or as a prize or award under section 74, by a
recipient of the expenditure who is not an employee of the taxpayer. The
preceding sentence shall not apply to any amount paid or incurred by the
taxpayer if such amount is required to be included (or would be so
required except that the amount is less that $600) in any information
return filed by such taxpayer under part III of subchapter A of chapter
61 and is not so included. See section 274(e)(9).
(C) Example. The following example illustrates the provisions this
paragraph (f):
Example. If an employer rewards the employee (and the employee's
spouse) with an expense paid vacation trip, the expense is deductible by
the employer (if otherwise allowable under section 162 and the
regulations thereunder) to the extent the employer treats the expenses
as compensation and as wages. On the other hand, if a taxpayer owns a
yacht which the taxpayer uses for the entertainment of business
customers, the portion of salary paid to employee members of the crew
which is allocable to use of the yacht for entertainment purposes (even
though treated on the taxpayer's tax return as compensation and treated
as wages for withholding tax purposes) would not come within this
exception since the members of the crew were not recipients of the
entertainment. If an expenditure of a type described in this subdivision
properly constitutes a dividend paid to a shareholder or if it
constitutes unreasonable compensation paid to an employee, nothing in
this exception prevents disallowance of the expenditure to the taxpayer
under other provisions of the Internal Revenue Code.
(iv) Reimbursed entertainment, food, or beverage expenses--(A)
Introduction. In the case of any expenditure for entertainment,
amusement, recreation, food, or beverages made by one person in
performing services for another person (whether or not the other person
is an employer) under a reimbursement or other expense allowance
arrangement, the limitations on deductions in paragraphs (a) through (e)
of this section and section 274(n)(1) apply either to the person who
makes the expenditure or to the person who actually bears the expense,
but not to both. If an expenditure of a type described in this paragraph
(f)(2)(iv) properly constitutes a dividend paid to a shareholder,
unreasonable compensation paid to an employee, a personal expense, or
other nondeductible expense, nothing in this exception prevents
disallowance of the expenditure to the taxpayer under other provisions
of the Code.
(B) Reimbursement arrangements involving employees. In the case of
an employee's expenditure for entertainment, amusement, recreation,
food, or beverages in performing services as an employee under a
reimbursement or other expense allowance arrangement with a payor (the
employer, its agent, or a third party), the limitations on deductions in
paragraphs (a) through (e) of this section and section 274(n)(1) apply--
[[Page 953]]
(1) To the employee to the extent the employer treats the
reimbursement or other payment of the expense on the employer's income
tax return as originally filed as compensation paid to the employee and
as wages to the employee for purposes of withholding under chapter 24
(relating to collection of income tax at source on wages); or
(2) To the payor to the extent the reimbursement or other payment of
the expense is not treated as compensation and wages paid to the
employee in the manner provided in paragraph (f)(2)(iv)(B)(1) of this
section (however, see paragraph (f)(2)(iv)(C) of this section if the
payor receives a payment from a third party that may be treated as a
reimbursement arrangement under that paragraph).
(C) Reimbursement arrangements involving persons that are not
employees. In the case of an expense for entertainment, amusement,
recreation, food, or beverages of a person who is not an employee
(referred to as an independent contractor) in performing services for
another person (a client or customer) under a reimbursement or other
expense allowance arrangement with the person, the limitations on
deductions in paragraphs (a) through (e) of this section and section
274(n)(1) apply to the party expressly identified in an agreement
between the parties as subject to the limitations. If an agreement
between the parties does not expressly identify the party subject to the
limitations, the limitations apply--
(1) To the independent contractor (which may be a payor described in
paragraph (f)(2)(iv)(B) of this section) to the extent the independent
contractor does not account to the client or customer within the meaning
of section 274(d) and the associated regulations; or
(2) To the client or customer if the independent contractor accounts
to the client or customer within the meaning of section 274(d) and the
associated regulations. See also Sec. 1.274-5.
(D) Reimbursement or other expense allowance arrangement. The term
reimbursement or other expense allowance arrangement means--
(1) For purposes of paragraph (f)(2)(iv)(B) of this section, an
arrangement under which an employee receives an advance, allowance, or
reimbursement from a payor (the employer, its agent, or a third party)
for expenses the employee pays or incurs; and
(2) For purposes of paragraph (f)(2)(iv)(C) of this section, an
arrangement under which an independent contractor receives an advance,
allowance, or reimbursement from a client or customer for expenses the
independent contractor pays or incurs if either--
(a) A written agreement between the parties expressly states that
the client or customer will reimburse the independent contractor for
expenses that are subject to the limitations on deductions in paragraphs
(a) through (e) of this section and section 274(n)(1); or
(b) A written agreement between the parties expressly identifies the
party subject to the limitations.
(E) Examples. The following examples illustrate the application of
this paragraph (f)(2)(iv).
Example 1. (i) Y, an employee, performs services under an
arrangement in which L, an employee leasing company, pays Y a per diem
allowance of $10x for each day that Y performs services for L's client,
C, while traveling away from home. The per diem allowance is a
reimbursement of travel expenses for food and beverages that Y pays in
performing services as an employee. L enters into a written agreement
with C under which C agrees to reimburse L for any substantiated
reimbursements for travel expenses, including meals, that L pays to Y.
The agreement does not expressly identify the party that is subject to
the deduction limitations. Y performs services for C while traveling
away from home for 10 days and provides L with substantiation that
satisfies the requirements of section 274(d) of $100x of meal expenses
incurred by Y while traveling away from home. L pays Y $100x to
reimburse those expenses pursuant to their arrangement. L delivers a
copy of Y's substantiation to C. C pays L $300x, which includes $200x
compensation for services and $100x as reimbursement of L's payment of
Y's travel expenses for meals. Neither L nor C treats the $100x paid to
Y as compensation or wages.
(ii) Under paragraph (f)(2)(iv)(D)(1) of this section, Y and L have
established a reimbursement or other expense allowance arrangement for
purposes of paragraph (f)(2)(iv)(B) of this section. Because the
reimbursement payment is not treated as compensation and wages paid to
Y, under section 274(e)(3)(A) and paragraph (f)(2)(iv)(B)(1) of this
section, Y is not subject to the section 274 deduction limitations.
Instead, under
[[Page 954]]
paragraph (f)(2)(iv)(B)(2) of this section, L, the payor, is subject to
the section 274 deduction limitations unless L can meet the requirements
of section 274(e)(3)(B) and paragraph (f)(2)(iv)(C) of this section.
(iii) Because the agreement between L and C expressly states that C
will reimburse L for substantiated reimbursements for travel expenses
that L pays to Y, under paragraph (f)(2)(iv)(D)(2)(a) of this section, L
and C have established a reimbursement or other expense allowance
arrangement for purposes of paragraph (f)(2)(iv)(C) of this section. L
accounts to C for C's reimbursement in the manner required by section
274(d) by delivering to C a copy of the substantiation L received from
Y. Therefore, under section 274(e)(3)(B) and paragraph (f)(2)(iv)(C)(2)
of this section, C and not L is subject to the section 274 deduction
limitations.
Example 2. (i) The facts are the same as in Example 1 except that,
under the arrangements between Y and L and between L and C, Y provides
the substantiation of the expenses directly to C, and C pays the per
diem directly to Y.
(ii) Under paragraph (f)(2)(iv)(D)(1) of this section, Y and C have
established a reimbursement or other expense allowance arrangement for
purposes of paragraph (f)(2)(iv)(C) of this section. Because Y
substantiates directly to C and the reimbursement payment was not
treated as compensation and wages paid to Y, under section 274(e)(3)(A)
and paragraph (f)(2)(iv)(C)(1) of this section Y is not subject to the
section 274 deduction limitations. Under paragraph (f)(2)(iv)(C)(2) of
this section, C, the payor, is subject to the section 274 deduction
limitations.
Example 3. (i) The facts are the same as in Example 1, except that
the written agreement between L and C expressly provides that the
limitations of this section will apply to C.
(ii) Under paragraph (f)(2)(iv)(D)(2)(b) of this section, L and C
have established a reimbursement or other expense allowance arrangement
for purposes of paragraph (f)(2)(iv)(C) of this section. Because the
agreement provides that the 274 deduction limitations apply to C, under
section 274(e)(3)(B) and paragraph (f)(2)(iv)(C) of this section, C and
not L is subject to the section 274 deduction limitations.
Example 4. (i) The facts are the same as in Example 1, except that
the agreement between L and C does not provide that C will reimburse L
for travel expenses.
(ii) The arrangement between L and C is not a reimbursement or other
expense allowance arrangement within the meaning of section 274(e)(3)(B)
and paragraph (f)(2)(iv)(D)(2) of this section. Therefore, even though L
accounts to C for the expenses, L is subject to the section 274
deduction limitations.
(F) Effective/applicability date. This paragraph (f)(2)(iv) applies
to expenses paid or incurred in taxable years beginning after August 1,
2013.
(v) Recreational expenses for employees generally. Any expenditure
by a taxpayer for a recreational, social, or similar activity (or for
use of a facility in connection therewith), primarily for the benefit of
his employees generally, is not subject to the limitations on
allowability of deductions provided for in paragraphs (a) through (e) of
this section. This exception applies only to expenditures made primarily
for the benefit of employees of the taxpayer other than employees who
are officers, shareholders on other owners who own a 10-percent or
greater interest in the business, or other highly compensated employees.
For purposes of the preceding sentence, an employee shall be treated as
owning any interest owned by a member of his family (within the meaning
of section 267(c)(4) and the regulations thereunder). Ordinarily, this
exception applies to usual employee benefit programs such as expenses of
a taxpayer (a) in holding Christmas parties, annual picnics, or summer
outings, for his employees generally, or (b) of maintaining a swimming
pool, baseball diamond, bowling alley, or golf course available to his
employees generally. Any expenditure for an activity which is made under
circumstances which discriminate in favor of employees who are officers,
shareholders or other owners, or highly compensated employees shall not
be considered made primarily for the benefit of employees generally. On
the other hand, an expenditure for an activity will not be considered
outside of this exception merely because, due to the large number of
employees involved, the activity is intended to benefit only a limited
number of such employees at one time, provided the activity does not
discriminate in favor of officers, shareholders, other owners, or highly
compensated employees.
(vi) Employee, stockholder, etc., business meetings. Any expenditure
by a taxpayer for entertainment which is directly related to bona fide
business meetings of the taxpayer's employees, stockholders, agents, or
directors held principally for discussion of trade or
[[Page 955]]
business is not subject to the limitations on allowability of deductions
provided for in paragraphs (a) through (e) of this section. For purposes
of this exception, a partnership is to be considered a taxpayer and a
member of a partnership is to be considered an agent. For example, an
expenditure by a taxpayer to furnish refreshments to his employees at a
bona fide meeting, sponsored by the taxpayer for the principal purpose
of instructing them with respect to a new procedure for conducting his
business, would be within the provisions of this exception. A similar
expenditure made at a bona fide meeting of stockholders of the taxpayer
for the election of directors and discussion of corporate affairs would
also be within the provisions of this exception. While this exception
will apply to bona fide business meetings even though some social
activities are provided, it will not apply to meetings which are
primarily for social or nonbusiness purposes rather than for the
transaction of the taxpayer's business. A meeting under circumstances
where there was little or no possibility of engaging in the active
conduct of trade or business (as described in paragraph (c)(7) of this
section) generally will not be considered a business meeting for
purposes of this subdivision. This exception will not apply to a meeting
or convention of employees or agents, or similar meeting for directors,
partners or others for the principal purpose of rewarding them for their
services to the taxpayer. However, such a meeting or convention of
employees might come within the scope of subdivisions (iii) or (v) of
this subparagraph.
(vii) Meetings of business leagues, etc. Any expenditure for
entertainment directly related and necessary to attendance at bona fide
business meetings or conventions of organizations exempt from taxation
under section 501(c)(6) of the Code, such as business leagues, chambers
of commerce, real estate boards, boards of trade, and certain
professional associations, is not subject to the limitations on
allowability of deductions provided in paragraphs (a) through (e) of
this section.
(viii) Items available to the public. Any expenditure by a taxpayer
for entertainment (or for a facility in connection therewith) to the
extent the entertainment is made available to the general public is not
subject to the limitations on allowability of deductions provided for in
paragraphs (a) through (e) of this section. Expenditures for
entertainment of the general public by means of television, radio,
newspapers and the like, will come within this exception, as will
expenditures for distributing samples to the general public. Similarly,
expenditures for maintaining private parks, golf courses and similar
facilities, to the extent that they are available for public use, will
come within this exception. For example, if a corporation maintains a
swimming pool which it makes available for a period of time each week to
children participating in a local public recreational program, the
portion of the expense relating to such public use of the pool will come
within this exception.
(ix) Entertainment sold to customers. Any expenditure by a taxpayer
for entertainment (or for use of a facility in connection therewith) to
the extent the entertainment is sold to customers in a bona fide
transaction for an adequate and full consideration in money or money's
worth is not subject to the limitations on allowability of deductions
provided for in paragraphs (a) through (e) of this section. Thus, the
cost of producing night club entertainment (such as salaries paid to
employees of night clubs and amounts paid to performers) for sale to
customers or the cost of operating a pleasure cruise ship as a business
will come within this exception.
(g) Additional provisions of section 274--travel of spouse,
dependent or others. Section 274(m)(3) provides that no deduction shall
be allowed under this chapter (except section 217) for travel expenses
paid or incurred with respect to a spouse, dependent, or other
individual accompanying the taxpayer (or an officer or employee of the
taxpayer) on business travel, unless certain conditions are met. As
provided in section 274(m)(3), the term other individual does
[[Page 956]]
not include a business associate (as defined in paragraph (b)(2)(iii) of
this section) who otherwise meets the requirements of sections
274(m)(3)(B) and (C).
[T.D. 6659, 28 FR 6499, June 25, 1963, as amended by T.D. 6996, 34 FR
835, Jan. 18, 1969; T.D. 8051, 50 FR 36576, Sept. 9, 1985; T.D. 8601, 60
FR 36994, July 19, 1995; T.D. 8666, 61 FR 27006, May 30, 1996; T.D.
9625, 78 FR 46503, Aug. 1, 2013]
Sec. 1.274-3 Disallowance of deduction for gifts.
(a) In general. No deduction shall be allowed under section 162 or
212 for any expense for a gift made directly or indirectly by a taxpayer
to any individual to the extent that such expense, when added to prior
expenses of the taxpayer for gifts made to such individual during the
taxpayer's taxable year, exceeds $25.
(b) Gift defined--(1) In general. Except as provided in subparagraph
(2) of this paragraph the term gift, for purposes of this section, means
any item excludable from the gross income of the recipient under section
102 which is not excludable from his gross income under any other
provision of chapter 1 of the Code. Thus, a payment by an employer to a
deceased employee's widow is not a gift, for purposes of this section,
to the extent the payment constitutes an employee's death benefit
excludable by the recipient under section 101(b). Similarly, a
scholarship which is excludable from a recipient's gross income under
section 117, and a prize or award which is excludable from a recipient's
gross income under section 74(b), are not subject to the provisions of
this section.
(2) Items not treated as gifts. The term gift, for purposes of this
section, does not include the following:
(i) An item having a cost to the taxpayer not in excess of $4.00 on
which the name of the taxpayer is clearly and permanently imprinted and
which is one of a number of identical items distributed generally by
such a taxpayer.
(ii) A sign, display rack, or other promotional material to be used
on the business premises of the recipient, or
(iii) In the case of a taxable year of a taxpayer ending on or after
August 13, 1981, an item of tangible personal property which is awarded
before January 1, 1987, to an employee of the taxpayer by reason of the
employee's length of service (including an award upon retirement),
productivity, or safety achievement, but only to the extent that--
(A) The cost of the item to the taxpayer does not exceed $400; or
(B) The item is a qualified plan award (as defined in paragraph (d)
of this section); or
(iv) In the case of a taxable year of a taxpayer ending before
August 13, 1981, an item of tangible personal property having a cost to
the taxpayer not in excess of $100 which is awarded to an employee of
the taxpayer by reason of the employee's length of service (including an
award upon retirement) or safety achievement.
For purposes of paragraphs (b)(2) (iii) and (iv) of this section, the
term tangible personal property does not include cash or any gift
certificate other than a nonnegotiable gift certificate conferring only
the right to receive tangible personal property. Thus, for example, if a
nonnegotiable gift certificate entitles an employee to choose between
selecting an item of merchandise or receiving cash or reducing the
balance due on his account with the issuer of the gift certificate, the
gift certificate is not tangible personal property for purposes of this
section. To the extent that an item is not treated as a gift for
purposes of this section, the deductibility of the expense of the item
is not governed by this section, and the taxpayer need not take such
item into account in determining whether the $25 limitation on gifts to
any individual has been exceeded. For example, if an employee receives
by reason of his length of service a gift of an item of tangible
personal property that costs the employer $450, the deductibility of
only $50 ($450 minus $400) is governed by this section, and the employer
takes the $50 into account for purposes of the $25 limitation on gifts
to that employee. The fact that an item is wholly or partially excepted
from the applicability of this section has no effect in determining
whether the value of the item is includible in the gross income of the
recipient. For rules relating to the taxability to the recipient of any
item described in this subparagraph, see sections 61,
[[Page 957]]
74, and 102 and the regulations thereunder. For rules relating to the
deductibility of employee achievement awards awarded after December 31,
1986, see section 274 (j).
(c) Expense for a gift. For purposes of this section, the term
expense for a gift means the cost of the gift to the taxpayer, other
than incidental costs such as for customary engraving on jewelry, or for
packaging, insurance, and mailing or other delivery. A related cost will
be considered ``incidental'' only if it does not add substantial value
to the gift. Although the cost of customary gift wrapping will be
considered an incidental cost, the purchase of an ornamental basket for
packaging fruit will not be considered an incidental cost of packaging
if the basket has a value which is substantial in relation to the value
of the fruit.
(d) Qualified plan award--(1) In general. Except as provided in
subparagraph (2) of this paragraph the term qualified plan award, for
purposes of this section, means an item of tangible personal property
that is awarded to an employee by reason of the employee's length of
service (including retirement), productivity, or safety achievement, and
that is awarded pursuant to a permanent, written award plan or program
of the taxpayer that does not discriminate as to eligibility or benefits
in favor of employees who are officers, shareholders, or highly
compensated employees. The ``permanency'' of an award plan shall be
determined from all the facts and circumstances of the particular case,
including the taxpayer's ability to continue to make the awards as
required by the award plan. Although the taxpayer may reserve the right
to change or to terminate an award plan, the actual termination of the
award plan for any reason other than business necessity within a few
years after it has taken effect may be evidence that the award plan from
its inception was not a ``permanent'' award plan. Whether or not an
award plan is discriminatory shall be determined from all the facts and
circumstances of the particular case. An award plan may fail to qualify
because it is discriminatory in its actual operation even though the
written provisions of the award plan are not discriminatory.
(2) Items not treated as qualified plan awards. The term qualified
plan award, for purposes of this section, does not include an item
qualifying under paragraph (d)(1) of this section to the extent that the
cost of the item exceeds $1,600. In addition, that term does not include
any items qualifying under paragraph (d)(1) of this section if the
average cost of all items (whether or not tangible personal property)
awarded during the taxable year by the taxpayer under any plan described
in paragraph (d)(1) of this section exceeds $400. The average cost of
those items shall be computed by dividing (i) the sum of the costs for
those items (including amounts in excess of the $1,600 limitation) by
(ii) the total number of those items.
(e) Gifts made indirectly to an individual--(1) Gift to spouse or
member of family. If a taxpayer makes a gift to the wife of a man who
has a business connection with the taxpayer, the gift generally will be
considered as made indirectly to the husband. However, if the wife has a
bona fide business connection with the taxpayer independently of her
relationship to her husband, a gift to her generally will not be
considered as made indirectly to her husband unless the gift is intended
for his eventual use or benefit. Thus, if a taxpayer makes a gift to a
wife who is engaged with her husband in the active conduct of a
partnership business, the gift to the wife will not be considered an
indirect gift to her husband unless it is intended for his eventual use
or benefit. The same rules apply to gifts to any other member of the
family of an individual who has a business connection with the taxpayer.
(2) Gift to corporation or other business entity. If a taxpayer
makes a gift to a corporation or other business entity intended for the
eventual personal use or benefit of an individual who is an employee,
stockholder, or other owner of the corporation or business entity, the
gift generally will be considered as made indirectly to such individual.
Thus, if a taxpayer provides theater tickets to a closely held
corporation for eventual use by any one of the stockholders of the
corporation, and if
[[Page 958]]
such tickets are gifts, the gifts will be considered as made indirectly
to the individual who eventually uses such ticket. On the other hand, a
gift to a business organization of property to be used in connection
with the business of the organization (for example, a technical manual)
will not be considered as a gift to an individual, even though, in
practice, the book will be used principally by a readily identifiable
individual employee. A gift for the eventual personal use or benefit of
some undesignated member of a large group of individuals generally will
not be considered as made indirectly to the individual who eventually
uses, or benefits from, such gifts unless, under the circumstances of
the case, it is reasonably practicable for the taxpayer to ascertain the
ultimate recipient of the gift. Thus, if a taxpayer provides several
baseball tickets to a corporation for the eventual use by any one of a
large number of employees or customers of the corporation, and if such
tickets are gifts, the gifts generally will not be treated as made
indirectly to the individuals who use such tickets.
(f) Special rules--(1) Partnership. In the case of a gift by a
partnership, the $25 annual limitation contained in paragraph (a) of
this section shall apply to the partnership as well as to each member of
the partnership. Thus, in the case of a gift made by a partner with
respect to the business of the partnership, the $25 limitation will be
applied at the partnership level as well as at the level of the
individual partner. Consequently, deductions for gifts made with respect
to partnership business will not exceed $25 annually for each recipient,
regardless of the number of partners.
(2) Husband and wife. For purposes of applying the $25 annual
limitation contained in paragraph (a) of this section, a husband and
wife shall be treated as one taxpayer. Thus, in the case of gifts to an
individual by a husband and wife, the spouses will be treated as one
donor; and they are limited to a deduction of $25 annually for each
recipient. This rule applies regardless of whether the husband and wife
file a joint return or whether the husband and wife make separate gifts
to an individual with respect to separate businesses. Since the term
taxpayer in paragraph (a) of this section refers only to the donor of a
gift, this special rule does not apply to treat a husband and wife as
one individual where each is a recipient of a gift. See paragraph (e)(1)
of this section.
(g) Cross reference. For rules with respect to whether this section
or Sec. 1.274-2 applies, see Sec. 1.274-2(b)(1) (iii).
[T.D. 6659, 28 FR 6505, June 25, 1963, as amended by T.D. 8230, 53 FR
36451, Sept. 20, 1988]
Sec. 1.274-4 Disallowance of certain foreign travel expenses.
(a) Introductory. Section 274(c) and this section impose certain
restrictions on the deductibility of travel expenses incurred in the
case of an individual who, while traveling outside the United States
away from home in the pursuit of trade or business (hereinafter termed
``business activity''), engages in substantial personal activity not
attributable to such trade or business (hereinafter termed ``nonbusiness
activity''). Section 274(c) and this section are limited in their
application to individuals (whether or not an employee or other person
traveling under a reimbursement or other expense allowance arrangement)
who engage in nonbusiness activity while traveling outside the United
States away from home, and do not impose restrictions on the
deductibility of travel expenses incurred by an employer or client under
an advance, reimbursement, or other arrangement with the individual who
engages in nonbusiness activity. For purposes of this section, the term
United States includes only the States and the District of Columbia, and
any reference to ``trade or business'' or ``business activity'' includes
any activity described in section 212. For rules governing the
determination of travel outside the United States away from home, see
paragraph (e) of this section. For rules governing the disallowance of
travel expense to which this section applies, see paragraph (f) of this
section.
(b) Limitations on application of section. The restrictions on
deductibility of travel expenses contained in paragraph (f) of this
section are applicable only if:
[[Page 959]]
(1) The travel expense is otherwise deductible under section 162 or
212 and the regulations thereunder,
(2) The travel expense is for travel outside the United States away
from home which exceeds 1 week (as determined under paragraph (c) of
this section), and
(3) The time outside the United States away from home attributable
to nonbusiness activity (as determined under paragraph (d) of this
section) constitutes 25 percent or more of the total time on such
travel.
(c) Travel in excess of 1 week. This section does not apply to an
expense of travel unless the expense is for travel outside the United
States away from home which exceeds 1 week. For purposes of this
section, 1 week means 7 consecutive days. The day in which travel
outside the United States away from home begins shall not be considered,
but the day in which such travel ends shall be considered, in
determining whether a taxpayer is outside the United States away from
home for more than 7 consecutive days. For example, if a taxpayer
departs on travel outside the United States away from home on a
Wednesday morning and ends such travel the following Wednesday evening,
he shall be considered as being outside the United States away from home
only 7 consecutive days. In such a case, this section would not apply
because the taxpayer was not outside the United States away from home
for more than 7 consecutive days. However, if the taxpayer travels
outside the United States away from home for more than 7 consecutive
days, both the day such travel begins and the day such travel ends shall
be considered a ``business day'' or a ``nonbusiness day'', as the case
may be, for purposes of determining whether nonbusiness activity
constituted 25 percent or more of travel time under paragraph (d) of
this section and for purposes of allocating expenses under paragraph (f)
of this section. For purposes of determining whether travel is outside
the United States away from home, see paragraph (e) of this section.
(d) Nonbusiness activity constituting 25 percent or more of travel
time--(1) In general. This section does not apply to any expense of
travel outside the United States away from home unless the portion of
time outside the United States away from home attributable to
nonbusiness activity constitutes 25 percent or more of the total time on
such travel.
(2) Allocation on per day basis. The total time traveling outside
the United States away from home will be allocated on a day-by-day basis
to (i) days of business activity or (ii) days of nonbusiness activity
(hereinafter termed ``business days'' or ``nonbusiness days''
respectively) unless the taxpayer establishes that a different method of
allocation more clearly reflects the portion of time outside the United
States away from home which is attributable to nonbusiness activity. For
purposes of this section, a day spent outside the United States away
from home shall be deemed entirely a business day even though spent only
in part on business activity if the taxpayer establishes:
(i) Transportation days. That on such day the taxpayer was traveling
to or returning from a destination outside the United States away from
home in the pursuit of trade or business. However, if for purposes of
engaging in nonbusiness activity, the taxpayer while traveling outside
the United States away from home does not travel by a reasonably direct
route, only that number of days shall be considered business days as
would be required for the taxpayer, using the same mode of
transportation, to travel to or return from the same destination by a
reasonably direct route. Also, if, while so traveling, the taxpayer
interrupts the normal course of travel by engaging in substantial
diversions for nonbusiness reasons of his own choosing, only that number
of days shall be considered business days as equals the number of days
required for the taxpayer, using the same mode of transportation, to
travel to or return from the same destination without engaging in such
diversion. For example, if a taxpayer residing in New York departs on an
evening on a direct flight to Quebec for a business meeting to be held
in Quebec the next morning, for purposes of determining whether
nonbusiness activity constituted 25 percent or more of his travel time,
the entire day of his
[[Page 960]]
departure shall be considered a business day. On the other hand, if a
taxpayer travels by automobile from New York to Quebec to attend a
business meeting and while en route spends 2 days in Ottawa and 1 day in
Montreal on nonbusiness activities of his personal choice, only that
number of days outside the United States shall be considered business
days as would have been required for the taxpayer to drive by a
reasonably direct route to Quebec, taking into account normal periods
for rest and meals.
(ii) Presence required. That on such day his presence outside the
United States away from home was required at a particular place for a
specific and bona fide business purpose. For example, if a taxpayer is
instructed by his employer to attend a specific business meeting, the
day of the meeting shall be considered a business day even though,
because of the scheduled length of the meeting, the taxpayer spends more
time during normal working hours of the day on nonbusiness activity than
on business activity.
(iii) Days primarily business. That during hours normally considered
to be appropriate for business activity, his principal activity on such
day was the pursuit of trade or business.
(iv) Circumstances beyond control. That on such day he was prevented
from engaging in the conduct of trade or business as his principal
activity due to circumstances beyond his control.
(v) Weekends, holidays, etc. That such day was a Saturday, Sunday,
legal holiday, or other reasonably necessary standby day which
intervened during that course of the taxpayer's trade or business while
outside the United States away from home which the taxpayer endeavored
to conduct with reasonable dispatch. For example, if a taxpayer travels
from New York to London to take part in business negotiations beginning
on a Wednesday and concluding on the following Tuesday, the intervening
Saturday and Sunday shall be considered business days whether or not
business is conducted on either of such days. Similarly, if in the above
case the meetings which concluded on Tuesday evening were followed by
business meetings with another business group in London on the
immediately succeeding Thursday and Friday, the intervening Wednesday
will be deemed a business day. However, if at the conclusion of the
business meetings on Friday, the taxpayer stays in London for an
additional week for personal purposes, the Saturday and Sunday following
the conclusion of the business meeting will not be considered business
days.
(e) Domestic travel excluded--(1) In general. For purposes of this
section, travel outside the United States away from home does not
include any travel from one point in the United States to another point
in the United States. However, travel which is not from one point in the
United States to another point in the United States shall be considered
travel outside the United States. If a taxpayer travels from a place
within the United States to a place outside the United States, the
portion, if any, of such travel which is from one point in the United
States to another point in the United States is to be disregarded for
purposes of determining:
(i) Whether the taxpayer's travel outside the United States away
from home exceeds 1 week (see paragraph (c) of this section),
(ii) Whether the time outside the United States away from home
attributable to nonbusiness activity constitutes 25 percent or more of
the total time on such travel (see paragraph (d) of this section), or
(iii) The amount of travel expense subject to the allocation rules
of this section (see paragraph (f) of this section).
(2) Determination of travel from one point in the United States to
another point in the United States. In the case of the following means
of transportation, travel from one point in the United States to another
point in the United States shall be determined as follows:
(i) Travel by public transportation. In the case of travel by public
transportation, any place in the United States at which the vehicle
makes a scheduled stop for the purpose of adding or discharging
passengers shall be considered a point in the United States.
(ii) Travel by private automobile. In the case of travel by private
automobile,
[[Page 961]]
any such travel which is within the United States shall be considered
travel from one point in the United States to another point in the
United States.
(iii) Travel by private airplane. In the case of travel by private
airplane, any flight, whether or not constituting the entire trip, where
both the takeoff and the landing are within the United States shall be
considered travel from one point in the United States to another point
in the United States.
(3) Examples. The provisions of subparagraph (2) may be illustrated
by the following examples:
Example 1. Taxpayer A flies from Los Angeles to Puerto Rico with a
brief scheduled stopover in Miami for the purpose of adding and
discharging passengers and A returns by airplane nonstop to Los Angeles.
The travel from Los Angeles to Miami is considered travel from one point
in the United States to another point in the United States. The travel
from Miami to Puerto Rico and from Puerto Rico to Los Angeles is not
considered travel from one point in the United States to another point
in the United States and, thus, is considered to be travel outside the
United States away from home.
Example 2. Taxpayer B travels by train from New York to Montreal.
The travel from New York to the last place in the United States where
the train is stopped for the purpose of adding or discharging passengers
is considered to be travel from one point in the United States to
another point in the United States.
Example 3. Taxpayer C travels by automobile from Tulsa to Mexico
City and back. All travel in the United States is considered to be
travel from one point in the United States to another point in the
United States.
Example 4. Taxpayer D flies nonstop from Seattle to Juneau. Although
the flight passes over Canada, the trip is considered to be travel from
one point in the United States to another point in the United States.
Example 5. If in Example 4 above, the airplane makes a scheduled
landing in Vancouver, the time spent in traveling from Seattle to Juneau
is considered to be travel outside the United States away from home.
However, the time spent in Juneau is not considered to be travel outside
the United States away from home.
(f) Application of disallowance rules--(1) In general. In the case
of expense for travel outside the United States away from home by an
individual to which this section applies, except as otherwise provided
in subparagraph (4) or (5) of this paragraph, no deduction shall be
allowed for that amount of travel expense specified in subparagraph (2)
or (3) of this paragraph (whichever is applicable) which is obtained by
multiplying the total of such travel expense by a fraction:
(i) The numerator of which is the number of nonbusiness days during
such travel, and
(ii) The denominator of which is the total number of business days
and nonbusiness days during such travel.
For determination of ``business days'' and ``nonbusiness days'', see
paragraph (d)(2) of this section.
(2) Nonbusiness activity at, near, or beyond business destination.
If the place at which the individual engages in nonbusiness activity
(hereinafter termed ``nonbusiness destination'') is at, near, or beyond
the place to which he travels in the pursuit of a trade or business
(hereinafter termed ``business destination''), the amount of travel
expense referred to in subparagraph (1) of this paragraph shall be the
amount of travel expense, otherwise allowable as a deduction under
section 162 or section 212, which would have been incurred in traveling
from the place where travel outside the United States away from home
begins to the business destination, and returning. Thus, if the
individual travels from New York to London on business, and then takes a
vacation in Paris before returning to New York, the amount of the travel
expense subject to allocation is the expense which would have been
incurred in traveling from New York to London and returning.
(3) Nonbusiness activity on the route to or from business
destination. If the nonbusiness destination is on the route to or from
the business destination, the amount of the travel expense referred to
in subparagraph (1) of this paragraph shall be the amount of travel
expense, otherwise allowable as a deduction under section 162 or 212,
which would have been incurred in traveling from the place where travel
outside the United States away from home begins to the nonbusiness
destination and returning. Thus, if the individual travels on business
from Chicago to Rio de Janeiro, Brazil with a scheduled stop in New York
for the purpose of adding and discharging passengers, and while en route
stops in Caracas, Venezuela for a
[[Page 962]]
vacation and returns to Chicago from Rio de Janeiro with another
scheduled stop in New York for the purpose of adding and discharging
passengers, the amount of travel expense subject to allocation is the
expense which would have been incurred in traveling from New York to
Caracas and returning.
(4) Other allocation method. If a taxpayer establishes that a method
other than allocation on a day-by-day basis (as determined under
paragraph (d)(2) of this section) more clearly reflects the portion of
time outside the United States away from home which is attributable to
nonbusiness activity, the amount of travel expense for which no
deduction shall be allowed shall be determined by such other method.
(5) Travel expense deemed entirely allocable to business activity.
Expenses of travel shall be considered allocable in full to business
activity, and no portion of such expense shall be subject to
disallowance under this section, if incurred under circumstances
provided for in subdivision (i) or (ii) of this subparagraph.
(i) Lack of control over travel. Expenses of travel otherwise
deductible under section 162 or 212 shall be considered fully allocable
to business activity if, considering all the facts and circumstances,
the individual incurring such expenses did not have substantial control
over the arranging of the business trip. A person who is required to
travel to a business destination will not be considered to have
substantial control over the arranging of the business trip merely
because he has control over the timing of the trip. Any individual who
travels on behalf of his employer under a reimbursement or other expense
allowance arrangement shall be considered not to have had substantial
control over the arranging of his business trip, provided the employee
is not:
(a) A managing executive of the employer for whom he is traveling
(and for this purpose the term managing executive includes only an
employee who, by reason of his authority and responsibility, is
authorized, without effective veto procedures, to decide upon the
necessity for his business trip), or
(b) Related to his employer within the meaning of section 267(b) but
for this purpose the percentage referred to in section 267(b)(2) shall
be 10 percent.
(ii) Lack of major consideration to obtain a vacation. Any expense
of travel, which qualifies for deduction under section 162 or 212, shall
be considered fully allocable to business activity if the individual
incurring such expenses can establish that, considering all the facts
and circumstances, he did not have a major consideration, in determining
to make the trip, of obtaining a personal vacation or holiday. If such a
major consideration were present, the provisions of subparagraphs (1)
through (4) of this paragraph shall apply. However, if the trip were
primarily personal in nature, the traveling expenses to and from the
destination are not deductible even though the taxpayer engages in
business activities while at such destination. See paragraph (b) of
Sec. 1.162-2.
(g) Examples. The application of this section may be illustrated by
the following examples:
Example 1. Individual A flew from New York to Paris where he
conducted business for 1 day. He spent the next 2 days sightseeing in
Paris and then flew back to New York. The entire trip, including 2 days
for travel en route, took 5 days. Since the time outside the United
States away from home during the trip did not exceed 1 week, the
disallowance rules of this section do not apply.
Example 2. Individual B flew from Tampa to Honolulu (from one point
in the United States to another point in the United States) for a
business meeting which lasted 3 days and for personal matters which took
10 days. He then flew to Melbourne, Australia where he conducted
business for 2 days and went sightseeing for 1 day. Immediately
thereafter he flew back to Tampa, with a scheduled landing in Honolulu
for the purpose of adding and discharging passengers. Although the trip
exceeded 1 week, the time spent outside the United States away from
home, including 2 days for traveling from Honolulu to Melbourne and
return, was 5 days. Since the time outside the United States away from
home during the trip did not exceed 1 week, the disallowance rules of
this section do not apply.
Example 3. Individual C flew from Los Angeles to New York where he
spent 5 days. He then flew to Brussels where he spent 14 days on
business and 5 days on personal matters. He then flew back to Los
Angeles by way of New York. The entire trip, including 4 days for travel
en route, took 28 days. However, the 2 days spent traveling from Los
Angeles
[[Page 963]]
to New York and return, and the 5 days spent in New York are not
considered travel outside the United States away from home and, thus,
are disregarded for purposes of this section. Although the time spent
outside the United States away from home exceeded 1 week, the time
outside the United States away from home attributable to nonbusiness
activities (5 days out of 21) was less than 25 percent of the total time
outside the United States away from home during the trip. Therefore, the
disallowance rules of this section do not apply.
Example 4. D, an employee of Y Company, who is neither a managing
executive of, nor related to, Y Company within the meaning of paragraph
(f)(5)(i) of this section, traveled outside the United States away from
home on behalf of his employer and was reimbursed by Y for his traveling
expense to and from the business destination. The trip took more than a
week and D took advantage of the opportunity to enjoy a personal
vacation which exceeded 25 percent of the total time on the trip. Since
D, traveling under a reimbursement arrangement, is not a managing
executive of, or related to, Y Company, he is not considered to have
substantial control over the arranging of the business trip, and the
travel expenses shall be considered fully allocable to business
activity.
Example 5. E, a managing executive and principal shareholder of X
Company, travels from New York to Stockholm, Sweden, to attend a series
of business meetings. At the conclusion of the series of meetings, which
last 1 week, E spends 1 week on a personal vacation in Stockholm. If E
establishes either that he did not have substantial control over the
arranging of the trip or that a major consideration in his determining
to make the trip was not to provide an opportunity for taking a personal
vacation, the entire travel expense to and from Stockholm shall be
considered fully allocable to business activity.
Example 6. F, a self-employed professional man, flew from New York
to Copenhagen, Denmark, to attend a convention sponsored by a
professional society. The trip lasted 3 weeks, of which 2 weeks were
spent on vacation in Europe. F generally would be regarded as having
substantial control over arranging this business trip. Unless F can
establish that obtaining a vacation was not a major consideration in
determining to make the trip, the disallowance rules of this section
apply.
Example 7. Taxpayer G flew from Chicago to New York where he spent 6
days on business. He then flew to London where he conducted business for
2 days. G then flew to Paris for a 5 day vacation after which he flew
back to Chicago, with a scheduled landing in New York for the purpose of
adding and discharging passengers. G would not have made the trip except
for the business he had to conduct in London. The travel outside the
United States away from home, including 2 days for travel en route,
exceeded a week and the time devoted to nonbusiness activities was not
less than 25 percent of the total time on such travel. The 2 days spent
traveling from Chicago to New York and return, and the 6 days spent in
New York are disregarded for purposes of determining whether the travel
outside the United States away from home exceeded a week and whether the
time devoted to nonbusiness activities was less than 25 percent of the
total time outside the United States away from home. If G is unable to
establish either that he did not have substantial control over the
arranging of the business trip or that an opportunity for taking a
personal vacation was not a major consideration in his determining to
make the trip, 5/9ths (5 days devoted to nonbusiness activities out of a
total 9 days outside the United States away from home on the trip) of
the expenses attributable to transportation and food from New York to
London and from London to New York will be disallowed (unless G
establishes that a different method of allocation more clearly reflects
the portion of time outside the United States away from home which is
attributable to nonbusiness activity).
(h) Cross reference. For rules with respect to whether an expense is
travel or entertainment, see paragraph (b)(1)(iii) of Sec. 1.274-2.
[T.D. 6758, 29 FR 12768, Sept. 10, 1964]
Sec. 1.274-5 Substantiation requirements.
(a)-(b) [Reserved]. For further guidance, see Sec. 1.274-5T(a) and
(b).
(c) Rules of substantiation--(1) [Reserved]. For further guidance,
see Sec. 1.274-5T(c)(1).
(2) Substantiation by adequate records--(i) and (ii) [Reserved]. For
further guidance, see Sec. 1.274-5T(c)(2)(i) and (ii).
(iii) Documentary evidence--(A) Except as provided in paragraph
(c)(2)(iii)(B), documentary evidence, such as receipts, paid bills, or
similar evidence sufficient to support an expenditure, is required for--
(1) Any expenditure for lodging while traveling away from home, and
(2) Any other expenditure of $75 or more except, for transportation
charges, documentary evidence will not be required if not readily
available.
(B) The Commissioner, in his or her discretion, may prescribe rules
waiving
[[Page 964]]
the documentary evidence requirements in circumstances where it is
impracticable for such documentary evidence to be required. Ordinarily,
documentary evidence will be considered adequate to support an
expenditure if it includes sufficient information to establish the
amount, date, place, and the essential character of the expenditure. For
example, a hotel receipt is sufficient to support expenditures for
business travel if it contains the following: name, location, date, and
separate amounts for charges such as for lodging, meals, and telephone.
Similarly, a restaurant receipt is sufficient to support an expenditure
for a business meal if it contains the following: name and location of
the restaurant, the date and amount of the expenditure, the number of
people served, and, if a charge is made for an item other than meals and
beverages, an indication that such is the case. A document may be
indicative of only one (or part of one) element of an expenditure. Thus,
a cancelled check, together with a bill from the payee, ordinarily would
establish the element of cost. In contrast, a cancelled check drawn
payable to a named payee would not by itself support a business
expenditure without other evidence showing that the check was used for a
certain business purpose.
(iv)-(v) [Reserved]. For further guidance, see Sec. 1.274-
5T(c)(2)(iv) and (v).
(3)-(7) [Reserved]. For further guidance, see Sec. 1.274-5T(c)(3)
through (7).
(d)-(e) [Reserved]. For further guidance, see Sec. 1.274-5T(d) and
(e).
(f) Reporting and substantiation of expenses of certain employees
for travel, entertainment, gifts, and with respect to listed property--
(1) through (3) [Reserved]. For further guidance, see Sec. 1.274-
5T(f)(1) through (3).
(4) Definition of an adequate accounting to the employer--(i) In
general. For purposes of this paragraph (f) an adequate accounting means
the submission to the employer of an account book, diary, log, statement
of expense, trip sheet, or similar record maintained by the employee in
which the information as to each element of an expenditure or use
(described in paragraph (b) of this section) is recorded at or near the
time of the expenditure or use, together with supporting documentary
evidence, in a manner that conforms to all the adequate records
requirements of paragraph (c)(2) of this section. An adequate accounting
requires that the employee account for all amounts received from the
employer during the taxable year as advances, reimbursements, or
allowances (including those charged directly or indirectly to the
employer through credit cards or otherwise) for travel, entertainment,
gifts, and the use of listed property. The methods of substantiation
allowed under paragraph (c)(4) or (c)(5) of this section also will be
considered to be an adequate accounting if the employer accepts an
employee's substantiation and establishes that such substantiation meets
the requirements of paragraph (c)(4) or (c)(5). For purposes of an
adequate accounting, the method of substantiation allowed under
paragraph (c)(3) of this section will not be permitted.
(ii) Procedures for adequate accounting without documentary
evidence. The Commissioner may, in his or her discretion, prescribe
rules under which an employee may make an adequate accounting to an
employer by submitting an account book, log, diary, etc., alone, without
submitting documentary evidence.
(iii) Employer. For purposes of this section, the term employer
includes an agent of the employer or a third party payor who pays
amounts to an employee under a reimbursement or other expense allowance
arrangement.
(5) [Reserved]. For further guidance, see Sec. 1.274-5T(f)(5).
(g) Substantiation by reimbursement arrangements or per diem,
mileage, and other traveling allowances--(1) In general. The
Commissioner may, in his or her discretion, prescribe rules in
pronouncements of general applicability under which allowances for
expenses described in paragraph (g)(2) of this section will, if in
accordance with reasonable business practice, be regarded as equivalent
to substantiation by adequate records or other sufficient evidence, for
purposes of paragraph (c) of this section, of the amount of the expenses
and as satisfying, with respect to the amount of the expenses, the
requirements of an adequate accounting
[[Page 965]]
to the employer for purposes of paragraph (f)(4) of this section. If the
total allowance received exceeds the deductible expenses paid or
incurred by the employee, such excess must be reported as income on the
employee's return. See paragraph (j)(1) of this section relating to the
substantiation of meal expenses while traveling away from home, and
paragraph (j)(2) of this section relating to the substantiation of
expenses for the business use of a vehicle.
(2) Allowances for expenses described. An allowance for expenses is
described in this paragraph (g)(2) if it is a--
(i) Reimbursement arrangement covering ordinary and necessary
expenses of traveling away from home (exclusive of transportation
expenses to and from destination);
(ii) Per diem allowance providing for ordinary and necessary
expenses of traveling away from home (exclusive of transportation costs
to and from destination); or
(iii) Mileage allowance providing for ordinary and necessary
expenses of local transportation and transportation to, from, and at the
destination while traveling away from home.
(h) [Reserved]. For further guidance, see Sec. 1.274-5T(h).
(i) [Reserved]
(j) Authority for optional methods of computing certain expenses--
(1) Meal expenses while traveling away from home. The Commissioner may
establish a method under which a taxpayer may use a specified amount or
amounts for meals while traveling away from home in lieu of
substantiating the actual cost of meals. The taxpayer will not be
relieved of the requirement to substantiate the actual cost of other
travel expenses as well as the time, place, and business purpose of the
travel. See paragraphs (b)(2) and (c) of this section.
(2) Use of mileage rates for vehicle expenses. The Commissioner may
establish a method under which a taxpayer may use mileage rates to
determine the amount of the ordinary and necessary expenses of using a
vehicle for local transportation and transportation to, from, and at the
destination while traveling away from home in lieu of substantiating the
actual costs. The method may include appropriate limitations and
conditions in order to reflect more accurately vehicle expenses over the
entire period of usage. The taxpayer will not be relieved of the
requirement to substantiate the amount of each business use (i.e., the
business mileage), or the time and business purpose of each use. See
paragraphs (b)(2) and (c) of this section.
(3) Incidental expenses while traveling away from home. The
Commissioner may establish a method under which a taxpayer may use a
specified amount or amounts for incidental expenses paid or incurred
while traveling away from home in lieu of substantiating the actual cost
of incidental expenses. The taxpayer will not be relieved of the
requirement to substantiate the actual cost of other travel expenses as
well as the time, place, and business purpose of the travel.
(k) Exceptions for qualified nonpersonal use vehicles--(1) In
general. The substantiation requirements of section 274(d) and this
section do not apply to any qualified nonpersonal use vehicle (as
defined in paragraph (k)(2) of this section).
(2) Qualified nonpersonal use vehicle--(i) In general. For purposes
of section 274(d) and this section, the term qualified nonpersonal use
vehicle means any vehicle which, by reason of its nature (that is,
design), is not likely to be used more than a de minimis amount for
personal purposes.
(ii) List of vehicles. Vehicles which are qualified nonpersonal use
vehicles include the following:
(A) Clearly marked police, fire, and public safety officer vehicles
(as defined and to the extent provided in paragraph (k)(3) of this
section).
(B) Ambulances used as such or hearses used as such.
(C) Any vehicle designed to carry cargo with a loaded gross vehicle
weight over 14,000 pounds.
(D) Bucket trucks (cherry pickers).
(E) Cement mixers.
(F) Combines.
(G) Cranes and derricks.
(H) Delivery trucks with seating only for the driver, or only for
the driver plus a folding jump seat.
(I) Dump trucks (including garbage trucks).
(J) Flatbed trucks.
[[Page 966]]
(K) Forklifts.
(L) Passenger buses used as such with a capacity of at least 20
passengers.
(M) Qualified moving vans (as defined in paragraph (k)(4) of this
section).
(N) Qualified specialized utility repair trucks (as defined in
paragraph (k)(5) of this section).
(O) Refrigerated trucks.
(P) School buses (as defined in section 4221(d)(7)(c)).
(Q) Tractors and other special purpose farm vehicles.
(R) Unmarked vehicles used by law enforcement officers (as defined
in paragraph (k)(6) of this section) if the use is officially
authorized.
(S) Such other vehicles as the Commissioner may designate.
(3) Clearly marked police, fire, or public safety officer vehicles.
A police, fire, or public safety officer vehicle is a vehicle, owned or
leased by a governmental unit, or any agency or instrumentality thereof,
that is required to be used for commuting by a police officer, fire
fighter, or public safety officer (as defined in section 402(l)(4)(C) of
this chapter) who, when not on a regular shift, is on call at all times,
provided that any personal use (other than commuting) of the vehicle
outside the limit of the police officer's arrest powers or the fire
fighter's or public safety officer's obligation to respond to an
emergency is prohibited by such governmental unit. A police, fire, or
public safety officer vehicle is clearly marked if, through painted
insignia or words, it is readily apparent that the vehicle is a police,
fire, or public safety officer vehicle. A marking on a license plate is
not a clear marking for purposes of this paragraph (k).
(4) Qualified moving van. The term qualified moving van means any
truck or van used by a professional moving company in the trade or
business of moving household or business goods if--
(i) No personal use of the van is allowed other than for travel to
and from a move site (or for de minimis personal use, such as a stop for
lunch on the way between two move sites);
(ii) Personal use for travel to and from a move site is an irregular
practice (that is, not more than five times a month on average); and
(iii) Personal use is limited to situations in which it is more
convenient to the employer, because of the location of the employee's
residence in relation to the location of the move site, for the van not
to be returned to the employer's business location.
(5) Qualified specialized utility repair truck. The term qualified
specialized utility repair truck means any truck (not including a van or
pickup truck) specifically designed and used to carry heavy tools,
testing equipment, or parts if--
(i) The shelves, racks, or other permanent interior construction
which has been installed to carry and store such heavy items is such
that it is unlikely that the truck will be used more than a de minimis
amount for personal purposes; and
(ii) The employer requires the employee to drive the truck home in
order to be able to respond in emergency situations for purposes of
restoring or maintaining electricity, gas, telephone, water, sewer, or
steam utility services.
(6) Unmarked law enforcement vehicles--(i) In general. The
substantiation requirements of section 274(d) and this section do not
apply to officially authorized uses of an unmarked vehicle by a ``law
enforcement officer''. To qualify for this exception, any personal use
must be authorized by the Federal, State, county, or local governmental
agency or department that owns or leases the vehicle and employs the
officer, and must be incident to law-enforcement functions, such as
being able to report directly from home to a stakeout or surveillance
site, or to an emergency situation. Use of an unmarked vehicle for
vacation or recreation trips cannot qualify as an authorized use.
(ii) Law enforcement officer. The term law enforcement officer means
an individual who is employed on a full-time basis by a governmental
unit that is responsible for the prevention or investigation of crime
involving injury to persons or property (including apprehension or
detention of persons for such crimes), who is authorized by law to carry
firearms, execute search warrants, and to make arrests (other than
[[Page 967]]
merely a citizen's arrest), and who regularly carries firearms (except
when it is not possible to do so because of the requirements of
undercover work). The term ``law enforcement officer'' may include an
arson investigator if the investigator otherwise meets the requirements
of this paragraph (k)(6)(ii), but does not include Internal Revenue
Service special agents.
(7) Trucks and vans. The substantiation requirements of section
274(d) and this section apply generally to any pickup truck or van,
unless the truck or van has been specially modified with the result that
it is not likely to be used more than a de minimis amount for personal
purposes. For example, a van that has only a front bench for seating, in
which permanent shelving that fills most of the cargo area has been
installed, that constantly carries merchandise or equipment, and that
has been specially painted with advertising or the company's name, is a
vehicle not likely to be used more than a de minimis amount for personal
purposes.
(8) Examples. The following examples illustrate the provisions of
paragraph (k)(3) and (6) of this section:
Example 1. Detective C, who is a ``law enforcement officer''
employed by a state police department, headquartered in City M, is
provided with an unmarked vehicle (equipped with radio communication)
for use during off-duty hours because C must be able to communicate with
headquarters and be available for duty at any time (for example, to
report to a surveillance or crime site). The police department generally
has officially authorized personal use of the vehicle by C but has
prohibited use of the vehicle for recreational purposes or for personal
purposes outside the state. Thus, C's use of the vehicle for commuting
between headquarters or a surveillance site and home and for personal
errands is authorized personal use as described in paragraph (k)(6)(i)
of this section. With respect to these authorized uses the vehicle is
not subject to the substantiation requirements of section 274(d) and the
value of these uses is not included in C's gross income.
Example 2. Detective T is a ``law enforcement officer'' employed by
City M. T is authorized to make arrests only within M's city limits. T,
along with all other officers of the force, is ordinarily on duty for
eight hours each work day and on call during the other sixteen hours. T
is provided with the use of a clearly marked police vehicle in which T
is required to commute to his home in City M. The police department's
official policy regarding marked police vehicles prohibits its personal
use (other than commuting) of the vehicles outside the city limits. When
not using the vehicle on the job, T uses the vehicle only for commuting,
personal errands on the way between work and home, and personal errands
within City M. All use of the vehicle by T conforms to the requirements
of paragraph (k)(3) of this section. Therefore, the value of that use is
excluded from T's gross income as a working condition fringe and the
vehicle is not subject to the substantiation requirements of section
274(d).
Example 3. Director C is employed by City M as the director of the
City's rescue squad and is provided with a vehicle for use in responding
to emergencies. Director C is trained in rescue activity and has the
legal authority and legal responsibility to engage in rescue activity.
The city's rescue squad is not a part of City M's police or fire
departments. The director's vehicle is a sedan which is painted with
insignia and words identifying the vehicle as being owned by the City's
rescue squad. C, when not on a regular shift, is on call at all times.
The City's official policy regarding clearly marked public safety
officer vehicles prohibits personal use (other than for commuting) of
the vehicle outside of the limits of the public safety officer's
obligation to respond to an emergency. When not using the vehicle to
respond to emergencies, City M authorizes C to use the vehicle only for
commuting, personal errands on the way between work and home, and
personal errands within the limits of C's obligation to respond to
emergencies. With respect to these authorized uses, the vehicle is not
subject to the substantiation requirements of section 274(d) and the
value of these uses is not includable in C's gross income.
Example 4. Coroner D is employed by County N to investigate and
determine the cause, time, and manner of certain deaths occurring in the
County. Coroner D also safeguards the property of the deceased, notifies
the next of kin, conducts inquests, and arranges for the burial of
indigent persons. D is provided with a vehicle for use by County N. The
vehicle is to be used in County N business and for commuting. Personal
use other than for commuting purposes is forbidden. D is trained in
rescue activity but has no legal authority or legal responsibility to
engage in rescue activity. D's vehicle is a sedan which is painted with
insignia and words identifying it as a County N vehicle. D, when not on
a regular shift, is on call at all times. D does not satisfy the
criteria of a public safety officer under 28 CFR 32.3 (2008). Thus, D's
vehicle cannot qualify as a clearly marked public safety officer
vehicle. Accordingly, business use of the vehicle is subject to the
substantiation requirements of section
[[Page 968]]
274(d), and the value of any personal use of the vehicle, such as
commuting, is includable in D's gross income.
(l) Definitions. For purposes of section 274(d) and this section,
the terms automobile and vehicle have the same meanings as prescribed in
Sec. 1.61-21(d)(1)(ii) and (e)(2), respectively. Also, for purposes of
section 274(d) and this section, the terms employer, employee and
personal use have the same meanings as prescribed in Sec. 1.274-6T(e).
(m) Effective date. This section applies to expenses paid or
incurred after December 31, 1997. However, paragraph (j)(3) of this
section applies to expenses paid or incurred after September 30, 2002,
and paragraph (k) applies to clearly marked public safety officer
vehicles, as defined in Sec. 1.274-5(k)(3), only with respect to uses
occurring after May 19, 2010.
[T.D. 8864, 65 FR 4122, Jan. 26, 2000; 65 FR 15547, Mar. 23, 2000, as
amended by T.D. 9020, 67 FR 68513, Nov. 12, 2002; T.D. 9064, 68 FR
39011, July 1, 2003; T.D. 9483, 75 FR 27936, May 19, 2010]
Sec. 1.274-5T Substantiation requirements (temporary).
(a) In general. For taxable years beginning on or after January 1,
1986, no deduction or credit shall be allowed with respect to--
(1) Traveling away from home (including meals and lodging),
(2) Any activity which is of a type generally considered to
constitute entertainment, amusement, or recreation, or with respect to a
facility used in connection with such an activity, including the items
specified in section 274(e),
(3) Gifts defined in section 274(b), or
(4) Any listed property (as defined in section 280F(d)(4) and Sec.
1.280F-6T(b)), unless the taxpayer substantiates each element of the
expenditure or use (as described in paragraph (b) of this section) in
the manner provided in paragraph (c) of this section. This limitation
supersedes the doctrine found in Cohan v. Commissioner, 39 F. 2d 540 (2d
Cir. 1930). The decision held that, where the evidence indicated a
taxpayer incurred deductible travel or entertainment expenses but the
exact amount could not be determined, the court should make a close
approximation and not disallow the deduction entirely. Section 274(d)
contemplates that no deduction or credit shall be allowed a taxpayer on
the basis of such approximations or unsupported testimony of the
taxpayer. For purposes of this section, the term entertainment means
entertainment, amusement, or recreation, and use of a facility therefor;
and the term expenditure includes expenses and items (including items
such as losses and depreciation).
(b) Elements of an expenditure or use--(1) In general. Section
274(d) and this section contemplate that no deduction or credit shall be
allowed for travel, entertainment, a gift, or with respect to listed
property unless the taxpayer substantiates the requisite elements of
each expenditure or use as set forth in this paragraph (b).
(2) Travel away from home. The elements to be provided with respect
to an expenditure for travel away from home are--
(i) Amount. Amount of each separate expenditure for traveling away
from home, such as cost of transportation or lodging, except that the
daily cost of the traveler's own breakfast, lunch, and dinner and of
expenditures incidental to such travel may be aggregated, if set forth
in reasonable categories, such as for meals, for gasoline and oil, and
for taxi fares;
(ii) Time. Dates of departure and return for each trip away from
home, and number of days away from home spent on business;
(iii) Place. Destinations or locality of travel, described by name
of city or town or other similar designation; and
(iv) Business purpose. Business reason for travel or nature of the
business benefit derived or expected to be derived as a result of
travel.
(3) Entertainment in general. The elements to be proved with respect
to an expenditure for entertainment are--
(i) Amount. Amount of each separate expenditure for entertainment,
except that such incidental items as taxi fares or telephone calls may
be aggregated on a daily basis;
(ii) Time. Date of entertainment;
(iii) Place. Name, if any, address or location, and destination of
type of entertainment, such as dinner or theater,
[[Page 969]]
if such information is not apparent from the designation of the place;
(iv) Business purpose. Business reason for the entertainment or
nature of business benefit derived or expected to be derived as a result
of the entertainment and, except in the case of business meals described
in section 274(e)(1), the nature of any business discussion or activity;
(v) Business relationship. Occupation or other information relating
to the person or persons entertained, including name, title, or other
designation, sufficient to establish business relationship to the
taxpayer.
(4) Entertainment directly preceding or following a substantial and
bona fide business discussion. If a taxpayer claims a deduction for
entertainment directly preceding or following a substantial and bona
fide business discussion on the ground that such entertainment was
associated with the active conduct of the taxpayer's trade or business,
the elements to be proved with respect to such expenditure, in addition
to those enumerated in paragraph (b)(3) (i), (ii), (iii), and (v) of
this section are--
(i) Time. Date and duration of business discussion;
(ii) Place. Place of business discussion;
(iii) Business purpose. Nature of business discussion, and business
reason for the entertainment or nature of business benefit derived or
expected to be derived as the result of the entertainment.
(iv) Business relationship. Identification of those persons
entertained who participated in the business discussion.
(5) Gifts. The elements to be proved with respect to an expenditure
for a gift are--
(i) Amount. Cost of the gift to the taxpayer;
(ii) Time. Date of the gift;
(iii) Description. Description of the gift;
(iv) Business purpose. Business reason for the gift or nature of
business benefit derived or expected to be derived as a result of the
gift; and
(v) Business relationship. Occupation or other information relating
to the recipient of the gift, including name, title, or other
designation, sufficient to establish business relationship to the
taxpayer.
(6) Listed property. The elements to be proved with respect to any
listed property are--
(i) Amount--(A) Expenditures. The amount of each separate
expenditure with respect to an item of listed property, such as the cost
of acquisition, the cost of capital improvements, lease payments, the
cost of maintenance and repairs, or other expenditures, and
(B) Uses. The amount of each business/investment use (as defined in
Sec. 1.280F-6T (d)(3) and (e)), based on the appropriate measure (i.e.,
mileage for automobiles and other means of transportation and time for
other listed property, unless the Commissioner approves an alternative
method), and the total use of the listed property for the taxable
period.
(ii) Time. Date of the expenditure or use with respect to listed
property, and
(iii) Business or investment purpose. The business purpose for an
expenditure or use with respect to any listed property (see Sec. 1.274-
5T(c)(6)(i) (B) and (C) for special rules for the aggregation of
expenditures and business use and Sec. 1.280F-6T(d)(2) for the
distinction between qualified business use and business/investment use).
See also Sec. 1.274-5T(e) relating to the substantiation of business
use of employer-provided listed property and Sec. 1.274-6T for special
rules for substantiating the business/investment use of certain types of
listed property.
(c) Rules of substantiation--(1) In general. Except as otherwise
provided in this section and Sec. 1.274-6T, a taxpayer must
substantiate each element of an expenditure or use (described in
paragraph (b) of this section) by adequate records or by sufficient
evidence corroborating his own statement. Section 274(d) contemplates
that a taxpayer will maintain and produce such substantiation as will
constitute proof of each expenditure or use referred to in section 274.
Written evidence has considerably more probative value than oral
evidence alone. In addition, the probative value of written evidence is
greater the closer in time it relates to the expenditure or use. A
contemporaneous log is not required, but a record of the elements of an
expenditure or of
[[Page 970]]
a business use of listed property made at or near the time of the
expenditure or use, supported by sufficient documentary evidence, has a
high degree of credibility not present with respect to a statement
prepared subsequent thereto when generally there is a lack of accurate
recall. Thus, the corroborative evidence required to support a statement
not make at or near the time of the expenditure or use must have a high
degree of probative value to elevate such statement and evidence to the
level of credibility reflected by a record made at or near the time of
the expenditure or use supported by sufficient documentary evidence. The
substantiation requirements of section 274(d) are designed to encourage
taxpayers to maintain the records, together with documentary evidence,
as provided in paragraph (c)(2) of this section.
(2) Substantiation by adequate records--(i) In general. To meet the
``adequate records'' requirements of section 274(d), a taxpayer shall
maintain an account book, diary, log, statement of expense, trip sheets,
or similar record (as provided in paragraph (c)(2)(ii) of this section),
and documentary evidence (as provided in paragraph (c)(2)(iii) of this
section) which, in combination, are sufficient to establish each element
of an expenditure or use specified in paragraph (b) of this section. It
is not necessary to record information in an account book, diary, log,
statement of expense, trip sheet, or similar record which duplicates
information reflected on a receipt so long as the account book, etc. and
receipt complement each other in an orderly manner.
(ii) Account book, diary, etc. An account book, diary, log,
statement of expense, trip sheet, or similar record must be prepared or
maintained in such manner that each recording of an element of an
expenditure or use is made at or near the time of the expenditure or
use.
(A) Made at or near the time of the expenditure or use. For purposes
of this section, the phrase made at or near the time of the expenditure
or use means the element of an expenditure or use are recorded at a time
when, in relation to the use or making of an expenditure, the taxpayer
has full present knowledge of each element of the expenditure or use,
such as the amount, time, place, and business purpose of the expenditure
and business relationship. An expense account statement which is a
transcription of an account book, diary, log, or similar record prepared
or maintained in accordance with the provisions of this paragraph
(c)(2)(ii) shall be considered a record prepared or maintained in the
manner prescribed in the preceding sentence if such expense account
statement is submitted by an employee to his employer or by an
independent contractor to his client or customer in the regular course
of good business practice. For example, a log maintained on a weekly
basis, which accounts for use during the week, shall be considered a
record made at or near the time of such use.
(B) Substantiation of business purpose. In order to constitute an
adequate record of business purpose within the meaning of section 274(d)
and this paragraph (c)(2), a written statement of business purpose
generally is required. However, the degree of substantiation necessary
to establish business purpose will vary depending upon the facts and
circumstances of each case. Where the business purpose is evident from
the surrounding facts and circumstances, a written explanation of such
business purpose will not be required. For example, in the case of a
salesman calling on customers on an established sales route, a written
explanation of the business purpose of such travel ordinarily will not
be required. Similarly, in the case of a business meal described in
section 274(e)(1), if the business purpose of such meal is evident from
the business relationship to the taxpayer of the persons entertained and
other surrounding circumstances, a written explanation of such business
purpose will not be required.
(C) Substantiation of business use of listed property--(1) Degree of
substantiation. In order to constitute an adequate record (within the
meaning of section 274(d) and this paragraph (c)(2)(ii)), which
substantiates business/investment use of listed property (as defined in
Sec. 1.280F-6T(d)(3)), the record must contain sufficient information
as
[[Page 971]]
to each element of every business/investment use. However, the level of
detail required in an adequate record to substantiate business/
investment use may vary depending upon the facts and circumstances. For
example, a taxpayer who uses a truck for both business and personal
purposes and whose only business use of a truck is to make deliveries to
customers on an established route may satisfy the adequate record
requirement by recording the total number miles driven during the
taxable year, the length of the delivery route once, and the date of
each trip at or near the time of the trips. Alternatively, the taxpayer
may establish the date of each trip with a receipt, record of delivery,
or other documentary evidence.
(2) Written record. Generally, an adequate record must be written.
However, a record of the business use of listed property, such as a
computer or automobile, prepared in a computer memory device with the
aid of a logging program will constitute an adequate record.
(D) Confidential information. If any information relating to the
elements of an expenditure or use, such as place, business purpose, or
business relationship, is of a confidential nature, such information
need not be set forth in the account book, diary, log, statement of
expense, trip sheet, or similar record, provided such information is
recorded at or near the time of the expenditure or use and is elsewhere
available to the district director to substantiate such element of the
expenditure or use.
(iii) [Reserved]. For further guidance, see Sec. 1.274-
5(c)(2)(iii).
(iv) Retention of written evidence. The Commissioner may, in his
discretion, prescribe rules under which an employer may dispose of the
adequate records and documentary evidence submitted to him by employees
who are required to, and do, make an adequate accounting to the employer
(within the meaning of paragraph (f)(4) of this section) if the employer
maintains adequate accounting procedures with respect to such employees
(within the meaning of paragraph (f)(5) of this section.
(v) Substantial compliance. If a taxpayer has not fully
substantiated a particular element of an expenditure or use, but the
taxpayer establishes to the satisfaction of the district director that
he has substantially complied with the ``adequate records'' requirements
of this paragraph (c)(2) with respect to the expenditure or use, the
taxpayer may be permitted to establish such element by evidence which
the district director shall deem adequate.
(3) Substantiation by other sufficient evidence--(i) In general. If
a taxpayer fails to establish to the satisfaction of the district
director that he has substantially complied with the ``adequate
records'' requirements of paragraph (c)(2) of this section with respect
to an element of an expenditure or use, then, except as otherwise
provided in this paragraph, the taxpayer must establish such element--
(A) By his own statement, whether written or oral, containing
specific information in detail as to such element; and
(B) By other corrobative evidence sufficient to establish such
element.
If such element is the description of a gift, or the cost or amount,
time, place, or date of an expenditure or use, the corrobative evidence
shall be direct evidence, such as a statement in writing or the oral
testimony of persons entertained or other witnesses setting forth
detailed information about such element, or the documentary evidence
described in paragraph (c)(2) of this section. If such element is either
the business relationship to the taxpayer of persons entertained, or the
business purpose of an expenditure, the corrobative evidence may be
circumstantial evidence.
(ii) Sampling--(A) In general. Except as provided in paragraph
(c)(3)(ii)(B) of this section, a taxpayer may maintain an adequate
record for portions of a taxable year and use that record to
substantiate the business/investment use of listed property for all or a
portion of the taxable year if the taxpayer can demonstrate by other
evidence that the periods for which an adequate record is maintained are
representative of the use for the taxable year or a portion thereof.
[[Page 972]]
(B) Exception for pooled vehicles. The sampling method of paragraph
(c)(3)(ii)(A) of this section may not be used to substantiate the
business/investment use of an automobile or other vehicle of an employer
that is made available for use by more than one employee for all or a
portion of a taxable year.
(C) Examples. The following examples illustrate this paragraph
(c)(3)(ii).
Example 1. A, a sole proprietor and calendar year taxpayer, operates
an interior decorating business out of her home. A uses an automobile
for local business travel to visit the homes or offices of clients, to
meet with suppliers and other subcontractors, and to pick up and deliver
certain items to clients when feasible. There is no other business use
of the automobile but A and other members of her family also use the
automobile for personal purposes. A maintains adequate records for the
first three months of 1986 that indicate that 75 percent of the use of
the automobile was in A's business. Invoices from subcontractors and
paid bills indicate that A's business continued at approximately the
same rate for the remainder of 1986. If other circumstances do not
change (e.g., A does not obtain a second car for exclusive use in her
business), the determination that the business/investment use of the
automobile for the taxable year is 75 percent is based on sufficient
corroborative evidence.
Example 2. The facts are the same as in Example 1, except that A
maintains adequate records during the first week of every month, which
indicate that 75 percent of the use of the automobile is in A's
business. The invoices from A's business indicate that A's business
continued at the same rate during the subsequent weeks of each month so
that A's weekly records are representative of each month's business use
of the automobile. Thus, the determination that the business/investment
use of the automobile for the taxable year is 75 percent is based on
sufficient corroborative evidence.
Example 3. B, a sole proprietor and calendar year taxpayer, is a
salesman in a large metropolitan area for a company that manufactures
household products. For the first three weeks of each month, B uses his
own automobile occasionally to travel within the metropolitan area on
business. During these three weeks, B's use of the automobile for
business purposes does not follow a consistent pattern from day to day
or week to week. During the fourth week of each month, B delivers to his
customers all the orders taken during the previous month. B's use of his
automobile for business purposes, as substantiated by adequate records,
is 70 percent of the total use during that fourth week. In this example,
a determination based on the records maintained during that fourth week
that the business/investment use of the automobile for the taxable year
is 70 percent is not based on sufficient corroborative evidence because
use during this week is not representative of use during other periods.
(iii) Special rules. See Sec. 1.274-6T for special rules for
substantiation by sufficient corroborating evidence with respect to
certain listed property.
(4) Substantiation in exceptional circumstances. If a taxpayer
establishes that, by reason of the inherent nature of the situation--
(i) He was unable to obtain evidence with respect to an element of
the expenditure or use which conforms fully to the ``adequate records''
requirements of paragraph (c)(2) of this section,
(ii) He is unable to obtain evidence with respect to such element
which conforms fully to the ``other sufficient evidence'' requirements
of paragraph (c)(3) of this section, and
(iii) He has presented other evidence, with respect to such element,
which possesses the highest degree of probative value possible under the
circumstances, such other evidence shall be considered to satisfy the
substantiation requirements of section 274(d) and this paragraph.
(5) Loss of records due to circumstances beyond control of the
taxpayer. Where the taxpayer establishes that the failure to produce
adequate records is due to the loss of such records through
circumstances beyond the taxpayer's control, such as destruction by
fire, flood, earthquake, or other casualty, the taxpayer shall have a
right to substantiate a deduction by reasonable reconstruction of his
expenditures or use.
(6) Special rules--(i) Separate expenditure or use--(A) In general.
For the purposes of this section, each separate payment or use by the
taxpayer shall ordinarily be considered to constitute a separate
expenditure. However, concurrent or repetitious expenses or uses may be
substantiated as a single item. To illustrate the above rules, where a
taxpayer entertains a business guest at dinner and thereafter at the
theater, the payment for dinner shall be considered to constitute one
expenditure and the payment for the tickets for the
[[Page 973]]
theater shall be considered to constitute a separate expenditure.
Similarly, if during a day of business travel a taxpayer makes separate
payments for breakfast, lunch, and dinner, he shall be considered to
have made three separate expenditures. However, if during entertainment
at a cocktail lounge the taxpayer pays separately for each serving of
refreshments, the total amount expended for the refreshments will be
treated as a single expenditure. A tip may be treated as a separate
expenditure.
(B) Aggregation of expenditures. Except as otherwise provided in
this section, the account book, diary, log, statement of expense, trip
sheet, or similar record required by paragraph (c)(2)(ii) of this
section shall be maintained with respect to each separate expenditure
and not with respect to aggregate amounts for two or more expenditures.
Thus, each expenditure for such items as lodging and air or rail travel
shall be recorded as a separate item and not aggregated. However, at the
option of the taxpayer, amounts expended for breakfast, lunch, or
dinner, may be aggregated. A tip or gratuity which is related to an
underlying expense may be aggregated with such expense. In addition,
amounts expended in connection with the use of listed property during a
taxable year, such as for gasoline or repairs for an automobile, may be
aggregated. If these expenses are aggregated, the taxpayer must
establish the date and amount, but need not prove the business purpose
of each expenditure. Instead, the taxpayer may prorate the expenses
based on the total business use of the listed property. For other
provisions permitting recording of aggregate amounts in an account book,
diary, log, statement of expense, trip sheet, or similar record, see
paragraphs (b)(2)(i) and (b)(3) of this section (relating to incidental
costs of travel and entertainment).
(C) Aggregation of business use. Uses which may be considered part
of a single use, for example, a round trip or uninterrupted business
use, may be accounted for by a single record. For example, use of a
truck to make deliveries at several different locations which begins and
ends at the business premises and which may include a stop at the
business premises in between two deliveries may be accounted for by a
single record of miles driven. In addition, use of a passenger
automobile by a salesman for a business trip away from home over a
period of time may be accounted for by a single record of miles
traveled. De minimis personal use (such as a stop for lunch on the way
between two business stops) is not an interruption of business use.
(ii) Allocation of expenditure. For purposes of this section, if a
taxpayer has established the amount of an expenditure, but is unable to
establish the portion of such amount which is attributable to each
person participating in the event giving rise to the expenditure, such
amount shall ordinarily be allocated to each participant on a pro rata
basis, if such determination is material. Accordingly, the total number
of persons for whom a travel or entertainment expenditure is incurred
must be established in order to compute the portion of the expenditure
allocable to such person.
(iii) Primary use of a facility. Section 274(a) (1)(B) and (2)(C)
deny a deduction for any expenditure paid or incurred before January 1,
1979, with respect to a facility, or paid or incurred before January 1,
1994, with respect to a club, used in connection with an entertainment
activity unless the taxpayer establishes that the facility (including a
club) was used primarily for the furtherance of the taxpayer's trade or
business. A determination whether a facility before January 1, 1979, or
a club before January 1, 1994, was used primarily for the furtherance of
the taxpayer's trade or business will depend upon the facts and
circumstances of each case. In order to establish that a facility was
used primarily for the furtherance of his trade or business, the
taxpayer shall maintain records of the use of the facility, the cost of
using the facility, mileage or its equivalent (if appropriate), and such
other information as shall tend to establish such primary use. Such
records of use shall contain--
(A) For each use of the facility claimed to be in furtherance of the
taxpayer's trade or business, the elements
[[Page 974]]
of an expenditure specified in paragraph (b)(3) of this section, and
(B) For each use of the facility not in furtherance of the
taxpayer's trade or business, an appropriate description of such use,
including cost, date, number of persons entertained, nature of
entertainment and, if applicable, information such as mileage or its
equivalent. A notation such as ``personal use'' or ``family use'' would,
in the case of such use, be sufficient to describe the nature of
entertainment.
If a taxpayer fails to maintain adequate records concerning a facility
which is likely to serve the personal purposes of the taxpayer, it shall
be presumed that the use of such facility was primarily personal.
(iv) Additional information. In a case where it is necessary to
obtain additional information, either--
(A) To clarify information contained in records, statements,
testimony, or documentary evidence submitted by a taxpayer under the
provisions of paragraph (c)(2) or (c)(3) of this section, or
(B) To establish the reliability or accuracy of such records,
statements, testimony, or documentary evidence, the district director
may, notwithstanding any other provision of this section, obtain such
additional information by personal interview or otherwise as he
determines necessary to implement properly the provisions of section 274
and the regulations thereunder.
(7) Specific exceptions. Except as otherwise prescribed by the
Commissioner, substantiation otherwise required by this paragraph is not
required for--
(i) Expenses described in section 274(e)(2) relating to food and
beverages for employees, section 274(e)(3) relating to expenses treated
as compensation, section 274(e)(8) relating to items available to the
public, and section 274(e)(9) relating to entertainment sold to
customers, and
(ii) Expenses described in section 274(e)(5) relating to
recreational, etc., expenses for employees, except that a taxpayer shall
keep such records or other evidence as shall establish that such
expenses were for activities (or facilities used in connection
therewith) primarily for the benefit of employees other than employees
who are officers, shareholders or other owners (as defined in section
274(e)(5)), or highly compensated employees.
(d) Disclosure on returns--(1) In general. The Commissioner may, in
his discretion, prescribe rules under which any taxpayer claiming a
deduction or credit for entertainment, gifts, travel, or with respect to
listed property, or any other person receiving advances, reimbursements,
or allowances for such items, shall make disclosure on his tax return
with respect to such items. The provisions of this paragraph shall apply
notwithstanding the provisions of paragraph (f) of this section.
(2) Business use of passenger automobiles and other vehicles. (i) On
returns for taxable years beginning after December 31, 1984, taxpayers
that claim a deduction or credit with respect to any vehicle are
required to answer certain questions providing information about the use
of the vehicle. The information required on the tax return relates to
mileage (total, business, commuting, and other personal mileage),
percentage of business use, date placed in service, use of other
vehicles, after-work use, whether the taxpayer has evidence to support
the business use claimed on the return, and whether or not the evidence
is written.
(ii) Any employer that provides the use of a vehicle to an employee
must obtain information from the employee sufficient to complete the
employer's tax return. Any employer that provides more than five
vehicles to its employees need not include any information on its
return. The employer, instead, must obtain the information from its
employees, indicate on its return that it has obtained the information,
and retain the information received. Any employer--
(A) That can satisfy the requirements of Sec. 1.274-6T(a)(2),
relating to vehicles not used for personal purposes,
(B) That can satisfy the requirements of Sec. 1.274-6T(a)(3),
relating to vehicles not used for personal purposes other than
commuting, or
(C) That treats all use of vehicles by employees as personal use
need not obtain information with respect to those vechicles, but instead
must indicate on its return that it has vehicles exempt
[[Page 975]]
from the requirements of this paragraph (d)(2).
(3) Business use of other listed property. On returns for taxable
years beginning after December 31, 1984, taxpayers that claim a
deduction or credit with respect to any listed property other than a
vehicle (for example, a yacht, airplane, or certain computers) are
required to provide the following information:
(i) The date that the property was placed in service,
(ii) The percentage of business use,
(iii) Whether evidence is available to support the percentage of
business use claimed on the return, and
(iv) Whether the evidence is written.
(e) Substantiation of the business use of listed property made
available by an employer for use by an employee--(1) Employee--(i) In
general. An employee may not exclude from gross income as a working
condition fringe any amount of the value of the availability of listed
property provided by an employer to the employee, unless the employee
substantiates for the period of availability the amount of the exclusion
in accordance with the requirements of section 274(d) and either this
section or Sec. 1.274-6T.
(ii) Vehicles treated as used entirely for personal purposes. If an
employer includes the value of the availability of a vehicle (as defined
in Sec. 1.61-21(e)(2)) in an employee's gross income without taking
into account any exclusion for a working condition fringe allowable
under section 132 and the regulations thereunder with respect to the
vehicle, the employee must substantiate any deduction claimed under
Sec. Sec. 1.162-25 and 1.162-25T for the business/investment use of the
vehicle in accordance with the requirements of section 274(d) and either
this section or Sec. 1.274-6T.
(2) Employer--(i) In general. An employer substantiates its
business/investment use of listed property by showing either--
(A) That, based on evidence that satisfies the requirements of
section 274(d) or statements submitted by employees that summarize such
evidence, all or a portion of the use of the listed property is by
employees in the employer's trade or business and, if any employee used
the property for personal purposes, the employer included an appropriate
amount in the employee's income, or
(B) In the case of a vehicle, the employer treats all use by
employees as personal use and includes an appropriate amount in the
employees' income.
(ii) Reliance on employee records. For purposes of substantiating
the business/investment use of listed property that an employer provides
to an employee and for purposes of the information required by paragraph
(d)(2) and (3) of this section, the employer may rely on adequate
records maintained by the employee or on the employee's own statement if
corroborated by other sufficient evidence unless the employer knows or
has reason to know that the statement, records, or other evidence are
not accurate. The employer must retain a copy of the adequate records
maintained by the employee or the other sufficient evidence, if
available. Alternatively, the employer may rely on a statement submitted
by the employee that provides sufficient information to allow the
employer to determine the business/investment use of the property unless
the employer knows or has reason to know that the statement is not based
on adequate records or on the employee's own statement corroborated by
other sufficient evidence. If the employer relies on the employee's
statement, the employer must retain only a copy of the statement. The
employee must retain a copy of the adequate records or other evidence.
(f) Reporting and substantiation of expenses of certain employees
for travel, entertainment, gifts, and with respect to listed property--
(1) In general. The purpose of this paragraph is to provide rules for
reporting and substantiation of certain expenses paid or incurred by
employees in connection with the performance of services as employees.
For purposes of this paragraph, the term business expenses means
ordinary and necessary expenses for travel, entertainment, gifts, or
with respect to listed property which are deductible under section 162,
and the regulations thereunder, to the extent not disallowed by section
262, 274(c), and 280F. Thus, the term business expenses does not include
personal, living, or family expenses disallowed by
[[Page 976]]
section 262, travel expenses disallowed by section 274(c), or cost
recovery deductions and credits with respect to listed property
disallowed by section 280F(d)(3) because the use of such property is not
for the convenience of the employer and required as a condition of
employment. Except as provided in paragraph (f)(2), advances,
reimbursements, or allowances for such expenditures must be reported as
income by the employee.
(2) Reporting of expenses for which the employee is required to make
an adequate accounting to his employer--(i) Reimbursements equal to
expenses. For purposes of computing tax liability, an employee need not
report on his tax return business expenses for travel, transportation,
entertainment, gifts, or with respect to listed property, paid or
incurred by him solely for the benefit of his employer for which he is
required to, and does, make an adequate accounting to his employer (as
defined in paragraph (f)(4) of this section) and which are charged
directly or indirectly to the employer (for example, through credit
cards) or for which the employee is paid through advances,
reimbursements, or otherwise, provided that the total amount of such
advances, reimbursements, and charges is equal to such expenses.
(ii) Reimbursements in excess of expenses. In case the total of the
amounts charged directly or indirectly to the employer or received from
the employer as advances, reimbursements, or otherwise, exceeds the
business expenses paid or incurred by the employee and the employee is
required to, and does, make an adequate accounting to his employer for
such expenses, the employee must include such excess (including amounts
received for expenditures not deductible by him) in income.
(iii) Expenses in excess of reimbursements. If an employee incurs
deductible business expenses on behalf of his employer which exceed the
total of the amounts charged directly or indirectly to the employer and
received from the employer as advances, reimbursements, or otherwise,
and the employee makes an adequate accounting to his employer, the
employee must be able to substantiate any deduction for such excess with
such records and supporting evidence as will substantiate each element
of an expenditure (described in paragraph (b) of this section) in
accordance with paragraph (c) of this section.
(3) Reporting of expenses for which the employee is not required to
make an adequate accounting to his employer. If the employee is not
required to make an adequate accounting to his employer for his business
expenses or, though required, fails to make an adequate accounting for
such expenses, he must submit, as a part of his tax return, the
appropriate form issued by the Internal Revenue Service for claiming
deductions for employee business expenses (e.g., Form 2106, Employee
Business Expenses, for 1985) and provide the information requested on
that form, including the information required by paragraph (d)(2) and
(3) of this section if the employee's business expenses are with respect
to the use of listed property. In addition, the employee must maintain
such records and supporting evidence as will substantiate each element
of an expenditure or use (described in paragraph (b) of this section) in
accordance with paragraph (c) of this section.
(4) [Reserved]. For further guidance, see Sec. 1.274-5(f)(4).
(5) Substantiation of expenditures by certain employees. An employee
who makes an adequate accounting to his employer within the meaning of
this paragraph will not again be required to substantiate such expense
account information except in the following cases:
(i) An employee whose business expenses exceed the total of amounts
charged to his employer and amounts received through advances,
reimbursements or otherwise and who claims a deduction on his return for
such excess,
(ii) An employee who is related to his employer within the meaning
of section 267(b), but for this purpose the percentage referred to in
section 267(b)(2) shall be 10 percent, and
(iii) Employees in cases where it is determined that the accounting
procedures used by the employer for the reporting and substantiation of
expenses by such employees are not adequate, or where it cannot be
determined that
[[Page 977]]
such procedures are adequate. The district director will determine
whether the employer's accounting procedures are adequate by considering
the facts and circumstances of each case, including the use of proper
internal controls. For example, an employer should require that an
expense account be verified and approved by a reasonable person other
than the person incurring such expenses. Accounting procedures will be
considered inadequate to the extent that the employer does not require
an adequate accounting from his employees as defined in paragraph (f)(4)
of this section, or does not maintain such substantiation. To the extent
an employer fails to maintain adequate accounting procedures he will
thereby obligate his employees to substantiate separately their expense
account information.
(g) [Reserved]. For further guidance, see Sec. 1.274-5(g).
(h) Reporting and substantiation of certain reimbursements of
persons other than employees--(1) In general. The purpose of this
paragraph is to provide rules for the reporting and substantiation of
certain expenses for travel, entertainment, gifts, or with respect to
listed property paid or incurred by one person (hereinafter termed
``independent contractor'') in connection with services performed for
another person other than an employer (hereinafter termed ``client or
customer'') under a reimbursement or other expense allowance arrangement
with such client or customer. For purposes of this paragraph, the term
business expenses means ordinary and necessary expenses for travel,
entertainment, gifts, or with respect to listed property which are
deductible under section 162, and the regulations thereunder, to the
extent not disallowed by sections 262 and 274(c). Thus, the term
business expenses does not include personal, living, or family expenses
disallowed by section 262 or travel expenses disallowed by section
274(c), and reimbursements for such expenditures must be reported as
income by the independent contractor. For purposes of this paragraph,
the term reimbursements means advances, allowances, or reimbursements
received by an independent contractor for travel, entertainment, gifts,
or with respect to listed property in connection with the performance by
him of services for his client or customer, under a reimbursement or
other expense allowance arrangement with his client or customer, and
includes amounts charged directly or indirectly to the client or
customer through credit card systems or otherwise. See paragraph (j) of
this section relating to the substantiation of meal expenses while
traveling away from home.
(2) Substantiation by independent contractors. An independent
contractor shall substantiate, with respect to his reimbursements, each
element of an expenditure (described in paragraph (b) of this section)
in accordance with the requirements of paragraph (c) of this section;
and, to the extent he does not so substantiate, he shall include such
reimbursements in income. An independent contractor shall so
substantiate a reimbursement for entertainment regardless of whether he
accounts (within the meaning of paragraph (h)(3) of this section) for
such entertainment.
(3) Accounting to a client or customer under section 274(e)(4)(B).
Section 274(e)(4)(B) provides that section 274(a) (relating to
disallowance of expenses for entertainment) shall not apply to
expenditures for entertainment for which an independent contractor has
been reimbursed if the independent contractor accounts to his client or
customer, to the extent provided by section 274(d). For purposes of
section 274(e)(4)(B), an independent contractor shall be considered to
account to his client or customer for an expense paid or incurred under
a reimbursement or other expense allowance arrangement with his client
or customer if, with respect to such expense for entertainment, he
submits to his client or customer adequate records or other sufficient
evidence conforming to the requirements of paragraph (c) of this
section.
(4) Substantiation by client or customer. A client or customer shall
not be required to substantiate, in accordance with the requirements of
paragraph (c) of this section, reimbursements to an independent
contractor for travel and gifts, or for entertainment unless the
independent contractor has accounted to him (within the meaning of
section
[[Page 978]]
274(e)(4)(B) and paragraph (h)(3) of this section) for such
entertainment. If an independent contractor has so accounted to a client
or customer for entertainment, the client or customer shall substantiate
each element of the expenditure (as described in paragraph (b) of this
section) in accordance with the requirements of paragraph (c) of this
section.
(i) [Reserved]
(j) [Reserved]. For further guidance, see Sec. 1.274-5(j).
(k) and (l) [Reserved] For further guidance, see Sec. 1.274-5(k)
and (l).
(m) Effective date. Section 274(d), as amended by the Tax Reform Act
of 1984 and Public Law 99-44, and this section (except as provided in
paragraph (d)(2) and (3) of this section) apply with respect to taxable
years beginning after December 31, 1985. Section 274(d) and this section
apply to any deduction or credit claimed in a taxable year beginning
after December 31, 1985, with respect to any listed property, regardless
of the taxable year in which the property was placed in service.
However, except as provided in Sec. 1.132-5(h) with respect to
qualified nonpersonal use vehicles, the substantiation requirements of
section 274(d) and this section do not apply to the determination of an
employee's working condition fringe exclusion or to the determination
under Sec. 1.162-25(b) of an employee's deduction before the date that
those requirements apply, under this paragraph (m), to the employer, if
the employer is taxable. Paragraph (j)(3) of this section applies to
expenses paid or incurred after September 30, 2002.
[T.D. 8061, 50 FR 46014, Nov. 6, 1985, as amended by T.D. 8063, 50 FR
52312, Dec. 23, 1985; T.D. 8276, 54 FR 51027, Dec. 12, 1989; T.D. 8451,
57 FR 57669, Dec. 7, 1992; T.D. 8601, 60 FR 36995, July 19, 1995; T.D.
8715, 62 FR 13990, Mar. 25, 1997; T.D. 8864, 65 FR 4123, Jan. 26, 2000;
T.D. 9020, 67 FR 68513, Nov. 12, 2002; T.D. 9020, 67 FR 72273, Dec. 4,
2002; T.D. 9064, July 1, 2003; T.D. 9483, 75 FR 27937, May 19, 2010]
Sec. 1.274-6 Expenditures deductible without regard to trade or
business or other income producing activity.
The provisions of Sec. Sec. 1.274-1 through 1.274-5, inclusive, do
not apply to any deduction allowable to the taxpayer without regard to
its connection with the taxpayer's trade or business or other income
producing activity. Examples of such items are interest, taxes such as
real property taxes, and casualty losses. Thus, if a taxpayer owned a
fishing camp, the taxpayer could still deduct mortgage interest and real
property taxes in full even if deductions for its use are not allowable
under section 274(a) and Sec. 1.274-2. In the case of a taxpayer which
is not an individual, the provisions of this section shall be applied as
if it were an individual. Thus, if a corporation sustains a casualty
loss on an entertainment facility used in its trade or business, it
could deduct the loss even though deductions for the use of the facility
are not allowable.
[T.D. 8051, 50 FR 36576, Sept. 9, 1985]
Sec. 1.274-6T Substantiation with respect to certain types of listed
property for taxable years beginning after 1985 (temporary).
(a) Written policy statements as to vehicles--(1) In general. Two
types of written policy statements satisfying the conditions described
in paragraph (a)(2) and (3) of this section, if initiated and kept by an
employer to implement a policy of no personal use, or no personal use
except for commuting, of a vehicle provided by the employer, qualify as
sufficient evidence corroborating the taxpayer's own statement and
therefore will satisfy the employer's substantiation requirements under
section 274(d). Therefore, the employee need not keep a separate set of
records for purposes of the employer's substantiation requirements under
section 274(d) with respect to use of a vehicle satisfying these written
policy statement rules. A written policy statement adopted by a
governmental unit as to employee use of its vehicles is eligible for
these exceptions to the section 274(d) substantiation rules. Thus, a
resolution of a city council or a provision of state law or a state
constitution would qualify as a written policy statement, as long as the
conditions described in paragraph (a)(2) and (3) of this section are
met.
(2) Vehicles not used for personal purposes--(i) Employers. A policy
statement that prohibits personal use by an employee satisfies an
employer's substantiation requirements under section
[[Page 979]]
274(d) if all the following conditions are met--
(A) The vehicle is owned or leased by the employer and is provided
to one or more employees for use in connection with the employer's trade
or business,
(B) When the vehicle is not used in the employer's trade or
business, it is kept on the employer's business premises, unless it is
temporarily located elsewhere, for example, for maintenance or because
of a mechanical failure,
(C) No employee using the vehicle lives at the employer's business
premises,
(D) Under a written policy of the employer, neither an employee, nor
any individual whose use would be taxable to the employee, may use the
vehicle for personal purposes, except for de minimis personal use (such
as a stop for lunch between two business deliveries), and
(E) The employer reasonably believes that, except for de minimis
use, neither the employee, nor any individual whose use would be taxable
to the employee, uses the vehicle for any personal purpose.
There must also be evidence that would enable the Commissioner to
determine whether the use of the vehicle meets the preceding five
conditions.
(ii) Employees. An employee, in lieu of substantiating the business/
investment use of an employer-provided vehicle under Sec. 1.274-5T, may
treat all use of the vehicle as business/investment use if the following
conditions are met--
(A) The vehicle is owned or leased by the employer and is provided
to one or more employees for use in connection with the employer's trade
or business,
(B) When the vehicle is not used in the employer's trade or
business, it is kept on the employer's business premises, unless it is
temporarily located elsewhere, for example, for maintenance or because
of a mechanical failure,
(C) No employee using the vehicle lives at the employer's business
premises,
(D) Under a written policy of the employer, neither the employee,
nor any individual whose use would be taxable to the employee, may use
the vehicle for personal purposes, except for de minimis personal use
(such as a stop for lunch between two business deliveries), and
(E) Except for de minimis personal use, neither the employee, nor
any individual whose use would be taxable to the employee, uses the
vehicle for any personal purpose.
There must also be evidence that would enable the Commissioner to
determine whether the use of the vehicle meets the preceding five
conditions.
(3) Vehicles not used for personal purposes other than commuting--
(i) Employers. A policy statement that prohibits personal use by an
employee, other than commuting, satisfies an employer's substantiation
requirements under section 274(d) if all the following conditions are
met--
(A) The vehicle is owned or leased by the employer and is provided
to one or more employees for use in connection with the employer's trade
or business and is used in the employer's trade or business,
(B) For bona fide noncompensatory business reasons, the employer
requires the employee to commute to and/or from work in the vehicle,
(C) The employer has established a written policy under which
neither the employee, nor any individual whose use would be taxable to
the employee, may use the vehicle for personal purposes, other than for
commuting or de minimis personal use (such as a stop for a personal
errand on the way between a business delivery and the employee's home),
(D) The employer reasonably believes that, except for de minimis
personal use, neither the employee, nor any individual whose use would
be taxable to the employee, uses the vehicle for any personal purpose
other than commuting,
(E) The employee required to use the vehicle for commuting is not a
control employee (as defined in Sec. 1.61-21(f)(5) and (6)) required to
use an automobile (as defined in Sec. 1.61-21(d)(1)(ii)), and
(F) The employer accounts for the commuting use by including in the
employee's gross income the commuting value provided in Sec. 1.61-
21(f)(3) (to the extent not reimbursed by the employee).
[[Page 980]]
There must be evidence that would enable the Commissioner to determine
whether the use of the vehicle met the preceding six conditions.
(ii) Employees. An employee, in lieu of substantiating the business/
investment use of an employer-provided vehicle under Sec. 1.274-5T, may
substantiate any exclusion allowed under section 132 for a working
condition fringe by including in income the commuting value of the
vehicle (determined by the employer pursuant to Sec. 1.61-21(f)(3)) if
all the following conditions are met:
(A) The vehicle is owned or leased by the employer and is provided
to one or more employees for use in connection with the employer's trade
or business and is used in the employer's trade or business,
(B) For bona fide noncompensatory business reasons, the employer
requires the employee to commute to and/or from work in the vehicle,
(C) Under a written policy of the employer, neither the employee,
nor any individual whose use would be taxable to the employee, may use
the vehicle for personal purposes, other than for commuting or de
minimis personal use (such as a stop for a personal errand on the way
between a business delivery and the employee's home),
(D) Except for de minimis personal use, neither the employee, nor
any individual whose use would be taxable to the employee, uses the
vehicle for any personal purpose other than commuting,
(E) The employee required to use the vehicle for commuting is not a
control employee (as defined in Sec. 1.61-21(f)(5) and (6) required to
use an automobile (as defined in Sec. 1.61-21(d)(1)(ii)), and
(F) The employee includes in gross income the commuting value
determined by the employer as provided in Sec. 1.61-21(f)(3)(to the
extent that the employee does not reimburse the employer for the
commuting use).
There must also be evidence that would enable the Commissioner to
determine whether the use of the vehicle met the preceding six
conditions.
(b) Vehicles used in connection with the business of farming--(1) In
general. If, during a taxable year or shorter period, a vehicle, not
otherwise described in section 274(i), Sec. 1.274-5T(k), or paragraph
(a) (2) or (3) of this section, is owned or leased by an employer and
used during most of a normal business day directly in connection with
the business of farming (as defined in paragraph (b)(2) of this
section), the employer, in lieu of substantiating the use of the vehicle
as prescribed in Sec. 1.274-5T(b)(6)(i)(B), may determine any deduction
or credit with respect to the vehicle as if the business/investment use
(as defined in Sec. 1.280F-6T(d)(3)(i)) and the qualified business use
(as defined in Sec. 1.280F-6T(d)(2)) of the vehicle in the business of
farming for the taxable year or shorter period were 75 percent plus that
percentage, if any, attributable to an amount included in an employee's
gross income. If the vehicle is also available for personal use by
employees, the employer must include the value of that personal use in
the gross income of the employees, allocated among them in the manner
prescribed in Sec. 1.132-5(g).
(2) Directly in connection with the business of farming. The phrase
directly in connection with the business of farming means that the
vehicle must be used directly in connection with the business of
operating a farm (i.e., cultivating land or raising or harvesting any
agricultural or horticultural commodity, or the raising, shearing,
feeding, caring for, training, and management of animals) or incidental
thereto (for example, trips to the feed and supply store).
(3) Substantiation by employees. If an employee is provided with the
use of a vehicle to which this paragraph (b) applies, the employee may,
in lieu of substantiating the business/investment use of the vehicle in
the manner prescribed in Sec. 1.274-5T, substantiate any exclusion
allowed under section 132 for a working condition fringe as if the
business/investment use of the vehicle were 75 percent, plus that
percentage, if any, determined by the employer to be attributable to the
use of the vehicle by individuals other than the employee, provided that
the employee includes in gross income the amount determined by the
employer as includible in the employee's gross income. See Sec. 1.132-
5(g)(3) for examples illustrating the allocation of use of a vehicle
among employees.
[[Page 981]]
(c) Vehicles treated as used entirely for personal purposes. An
employer may satisfy the substantiation requirements under section
274(d) for a taxable year or shorter period with respect to the business
use of a vehicle that is provided to an employee by including the value
of the availability of the vehicle during the relevant period in the
employee's gross income without any exclusion for a working condition
fringe with respect to the vehicle and, if required, by withholding any
taxes. Under these circumstances, the employer's business/investment use
of the vehicle during the relevant period is 100 percent. The employer's
qualified business use of the vehicle is dependent upon the relationship
of the employee to the employer (see Sec. 1.280F-6T(d)(2)).
(d) Limitation. If a taxpayer chooses to satisfy the substantiation
requirements of section 274(d) and Sec. 1.274-5T by using one of the
methods prescribed in paragraphs (a) (2) or (3), (b), or (c) of this
section and files a return with the Internal Revenue Service for a
taxable year consistent with such choice, the taxpayer may not later use
another of these methods. Similarly, if a taxpayer chooses to satisfy
the substantiation requirements of section 274(d) in the manner
prescribed in Sec. 1.274-5T and files a return with the Internal
Revenue Service for a taxable year consistent with such choice, the
taxpayer may not later use a method prescribed in paragraph (a) (2) or
(3), (b), or (c) of this section. This rule applies to an employee for
purposes of substantiating any working condition fringe exclusion as
well as to an employer. For example, if an employee excludes on his
federal income tax return for a taxable year 90 percent of the value of
the availability of an employer-provided automobile on the basis of
records that allegedly satisfy the ``adequate records'' requirement of
Sec. 1.274-5T(c)(2), and that requirement is not satisfied, then the
employee may not satisfy the substantiation requirements of section
274(d) for the taxable year by any method prescribed in this section,
but may present other corroborative evidence as prescribed in Sec.
1.274-5T(c)(3).
(e) Definitions--(1) In general. The definitions provided in this
paragraph (e) apply for purposes of section 274(d), Sec. 1.274-5T, and
this section.
(2) Employer and employee. The terms employer and employee include
the following:
(i) A sole proprietor shall be treated as both an employer and
employee,
(ii) A partnership shall be treated as an employer of its partners,
and
(iii) A partner shall be treated as an employee of the partnership.
(3) Automobile. The term automobile has the same meaning as
prescribed in Sec. 1.61-21(d)(1)(ii).
(4) Vehicle. The term vehicle has the same meaning as prescribed in
Sec. 1.61-21(e)(2).
(5) Personal use. Personal use by an employee of an employer-
provided vehicle includes use in any trade or business other than the
trade or business of being the employee of the employer providing the
vehicle.
(f) Effective date. This section is effective for taxable years
beginning after December 31, 1985.
[T.D. 8061, 50 FR 46037, Nov. 6, 1985, as amended by T.D. 8063, 50 FR
52312, Dec. 23, 1985; T.D. 9849, 84 FR 9233, Mar. 14, 2019]
Sec. 1.274-7 Treatment of certain expenditures with respect to
entertainment-type facilities.
If deductions are disallowed under Sec. 1.274-2 with respect to any
portion of a facility, such portion shall be treated as an asset which
is used for personal, living, and family purposes (and not as an asset
used in a trade or business). Thus, the basis of such a facility will be
adjusted for purposes of computing depreciation deductions and
determining gain or loss on the sale of such facility in the same manner
as other property (for example, a residence) which is regarded as used
partly for business and partly for personal purposes.
[T.D. 6659, 28 FR 6507, June 25, 1963]
Sec. 1.274-8 Effective/applicability date.
Except as provided in Sec. Sec. 1.274-2(a), 1.274-2(e), 1.274-
2(f)(2)(iv)(F), and 1.274-5, Sec. Sec. 1.274-1 through 1.274-7 apply to
taxable years ending after December 31, 1962.
[T.D. 9625, 78 FR 46504, Aug. 1, 2013]
[[Page 982]]
Sec. 1.274-9 Entertainment provided to specified individuals.
(a) In general. Paragraphs (e)(2) and (e)(9) of section 274 provide
exceptions to the disallowance of section 274(a) for expenses for
entertainment, amusement, or recreation activities, or for an
entertainment facility. In the case of a specified individual (as
defined in paragraph (b) of this section), the exceptions of paragraphs
(e)(2) and (e)(9) of section 274 apply only to the extent that the
expenses do not exceed the amount of the expenses treated as
compensation (under section 274(e)(2)) or as income (under section
274(e)(9)) to the specified individual. The amount disallowed is reduced
by any amount that the specified individual reimburses a taxpayer for
the entertainment.
(b) Specified individual defined. (1) A specified individual is an
individual who is subject to section 16(a) of the Securities Act of 1934
in relation to the taxpayer, or an individual who would be subject to
section 16(a) if the taxpayer were an issuer of equity securities
referred to in that section. Thus, for example, a specified individual
is an officer, director, or more than 10 percent owner of a corporation
taxed under subchapter C or subchapter S or a personal service
corporation. A specified individual includes every individual who--
(i) Is the direct or indirect beneficial owner of more than 10
percent of any class of any registered equity (other than an exempted
security);
(ii) Is a director or officer of the issuer of the security;
(iii) Would be the direct or indirect beneficial owner of more than
10 percent of any class of a registered security if the taxpayer were an
issuer of equity securities; or
(iv) Is comparable to an officer or director of an issuer of equity
securities.
(2) For partnership purposes, a specified individual includes any
partner that holds more than a 10 percent equity interest in the
partnership, or any general partner, officer, or managing partner of a
partnership.
(3) For purposes of this section, officer has the same meaning as in
17 CFR Sec. 240.16a-1(f).
(4) A specified individual includes a director or officer of a tax-
exempt entity.
(5) A specified individual of a taxpayer includes a specified
individual of a party related to the taxpayer within the meaning of
section 267(b) or section 707(b).
(c) Specified individual treated as recipient of entertainment
provided to others. For purposes of section 274(a), a specified
individual is treated as the recipient of entertainment provided to
another individual because of the relationship of the other individual
to the specified individual if the entertainment is a fringe benefit to
the specified individual under section 61(a)(1) (without regard to any
exclusions from gross income). Thus, expenses allocable to entertainment
provided to the other individual are attributed to the specified
individual for purposes of determining the amount of disallowed
expenses.
(d) Entertainment use of aircraft by specified individuals. For
rules relating to entertainment use of aircraft by specified
individuals, see Sec. 1.274-10.
(e) Effective/applicability date. This section applies to taxable
years beginning after August 1, 2012.
[T.D. 9597, 77 FR 45483, Aug. 1, 2012]
Sec. 1.274-10 Special rules for aircraft used for entertainment.
(a) Use of an aircraft for entertainment--(1) In general. Section
274(a) disallows a deduction for certain expenses for entertainment,
amusement, or recreation activities, or for an entertainment facility.
Under section 274(a) and this section, no deduction otherwise allowable
under chapter 1 is allowed for expenses for the use of a taxpayer-
provided aircraft for entertainment, except as provided in paragraph
(a)(2) of this section.
(2) Exceptions--(i) In general. Paragraph (a)(1) of this section
does not apply to deductions for expenses for business entertainment air
travel or to deductions for expenses that meet the exceptions of section
274(e), Sec. 1.274-2(f), and this section. Section 274(e)(2) and (e)(9)
provides certain exceptions to the
[[Page 983]]
disallowance of section 274(a) for expenses for goods, services, and
facilities for entertainment, recreation, or amusement.
(ii) Expenses treated as compensation--(A) Employees who are not
specified individuals. Section 274(a), Sec. 1.274-2(a) through (d), and
paragraph (a)(1) of this section, in accordance with section
274(e)(2)(A), do not apply to expenses for entertainment air travel
provided to an employee who is not a specified individual to the extent
that a taxpayer--
(1) Properly treats the expenses relating to the recipient of
entertainment as compensation to an employee under chapter 1 and as
wages to the employee for purposes of chapter 24; and
(2) Treats the proper amount as compensation to the employee under
Sec. 1.61-21.
(B) Persons who are not employees and are not specified individuals.
Section 274(a), Sec. 1.274-2(a) through (d), and paragraph (a)(1) of
this section, in accordance with section 274(e)(9), do not apply to
expenses for entertainment air travel provided to a person who is not an
employee and is not a specified individual to the extent that the
expenses are includible in the income of that person. This exception
does not apply to any amount paid or incurred by the taxpayer that is
required to be included in any information return filed by the taxpayer
under part III of subchapter A of chapter 61 and is not so included.
(C) Specified individuals. Section 274(a), Sec. 1.274-2(a) through
(d), and paragraph (a)(1) of this section, in accordance with section
274(e)(2)(B), do not apply to expenses for entertainment air travel of a
specified individual to the extent that the amount of the expenses do
not exceed the sum of--
(1) The amount treated as compensation to or included in the income
of the specified individual in the manner specified under paragraph
(a)(2)(ii)(A)(1) of this section (if the specified individual is an
employee) or under paragraph (a)(2)(ii)(B) of this section (if the
specified individual is not an employee); and
(2) Any amount the specified individual reimburses the taxpayer.
(iii) Travel on regularly scheduled commercial airlines. Section
274(a), Sec. 1.274-2(a) through (d), and paragraph (a)(1) of this
section do not apply to expenses for entertainment air travel that a
taxpayer that is a commercial passenger airline provides to specified
individuals of the taxpayer on the taxpayer's regularly scheduled
flights on which at least 90 percent of the seats are available for sale
to the public to the extent the expenses are includible in the income of
the recipient of the entertainment in the manner specified under
paragraph (a)(2)(ii)(A)(1) of this section (if the specified individual
is an employee) or under paragraph (a)(2)(ii)(B) of this section (if the
specified individual is not an employee).
(b) Definitions. The definitions in this paragraph (b) apply for
purposes of this section.
(1) Entertainment. For the definition of entertainment for purposes
of this section, see Sec. 1.274-2(b)(1). Entertainment does not include
personal travel that is not for entertainment purposes. For example,
travel to attend a family member's funeral is not entertainment.
(2) Entertainment air travel. Entertainment air travel is any travel
aboard a taxpayer-provided aircraft for entertainment purposes.
(3) Business entertainment air travel. Business entertainment air
travel is any entertainment air travel aboard a taxpayer-provided
aircraft that is directly related to the active conduct of the
taxpayer's trade or business or related to an expenditure directly
preceding or following a substantial and bona fide business discussion
and associated with the active conduct of the taxpayer's trade or
business. See Sec. 1.274-2(a)(1)(i) and (ii). Air travel is not
business entertainment air travel merely because a taxpayer-provided
aircraft is used for the travel as a result of a bona fide security
concern under Sec. 1.132-5(m).
(4) Taxpayer-provided aircraft. A taxpayer-provided aircraft is any
aircraft owned by, leased to, or chartered to, a taxpayer or any party
related to the taxpayer (within the meaning of section 267(b) or section
707(b)).
(5) Specified individual. For rules relating to the definition of a
specified individual, see Sec. 1.274-9.
[[Page 984]]
(c) Amount disallowed. Except as otherwise provided, the amount
disallowed under this section for an entertainment flight by a specified
individual is the amount of expenses allocable to the entertainment
flight of the specified individual under paragraph (e)(2), (e)(3), or
(f)(3) of this section, reduced (but not below zero) by the amount the
taxpayer treats as compensation or reports as income under paragraph
(a)(2)(ii)(C)(1) of this section to the specified individual, plus any
amount the specified individual reimburses the taxpayer.
(d) Expenses subject to disallowance under this section--(1)
Definition of expenses. In determining the amount of expenses subject to
disallowance under this section, a taxpayer must include all of the
expenses of operating the aircraft, including all fixed and variable
expenses the taxpayer deducts in the taxable year. These expenses
include, but are not limited to, salaries for pilots, maintenance
personnel, and other personnel assigned to the aircraft; meal and
lodging expenses of flight personnel; take-off and landing fees; costs
for maintenance flights; costs of on-board refreshments, amenities and
gifts; hangar fees (at home or away); management fees; costs of fuel,
tires, maintenance, insurance, registration, certificate of title,
inspection, and depreciation; interest on debt secured by or properly
allocated (within the meaning of Sec. 1.163-8T) to an aircraft; and all
costs paid or incurred for aircraft leased or chartered to the taxpayer.
(2) Leases or charters to third parties. Expenses allocable to a
lease or charter of a taxpayer's aircraft to an unrelated (as determined
under section 267(b) or 707(b)) third-party in a bona-fide business
transaction for adequate and full consideration are excluded from the
definition of expenses in paragraph (d)(1) of this section. Only
expenses allocable to the lease or charter period are excluded under
this paragraph (d)(2).
(3) Straight-line method permitted for determining depreciation
disallowance under this section--(i) In general. In lieu of the amount
of depreciation deducted in the taxable year, solely for purposes of
paragraph (d)(1) of this section, a taxpayer may elect to treat as its
depreciation deduction the amount that would result from using the
straight-line method of depreciation over the class life (as defined by
section 168(i)(1) and using the applicable convention under section
168(d)) of an aircraft, even if the taxpayer uses a different
methodology to calculate depreciation for the aircraft under other
sections of the Internal Revenue Code (for example, section 168). If the
property qualifies for the additional first-year depreciation deduction
provided by, for example, section 168(k), 168(n), 1400L(b), or 1400N(d),
depreciation for purposes of this straight-line election is determined
on the unadjusted depreciable basis (as defined in Sec. 1.168(b)-
1(a)(3)) of the property. However, the amount of depreciation disallowed
as a result of this paragraph (d)(3) for any taxable year cannot exceed
a taxpayer's allowable depreciation for that taxable year. For purposes
of this section, a taxpayer that elects to use the straight-line method
and class life under this paragraph (d)(3) for any aircraft it operates
must use that methodology for all depreciable aircraft it operates and
must continue to use the methodology for the entire period the taxpayer
uses any depreciable aircraft.
(ii) Aircraft placed in service in earlier taxable years. The amount
of depreciation for purposes of this paragraph (d)(3) for aircraft
placed in service in taxable years before the taxable year of the
election is determined by applying the straight-line method of
depreciation to the unadjusted depreciable basis (or, for property
acquired in an exchange to which section 1031 applies, the basis of the
aircraft as determined under section 1031(d)) and over the class life
(using the applicable convention under section 168(d)) of the aircraft
as though the taxpayer used that methodology from the year the aircraft
was placed in service.
(iii) Manner of making and revoking election. A taxpayer makes the
election under this paragraph (d)(3) by filing an income tax return for
the taxable year that determines the taxpayer's expenses for purposes of
paragraph (d)(1) of this section by computing depreciation under this
paragraph (d)(3). A taxpayer may revoke an election only for
[[Page 985]]
compelling circumstances upon consent of the Commissioner by private
letter ruling.
(4) Aggregation of aircraft--(i) In general. A taxpayer may
aggregate the expenses of aircraft of similar cost profiles for purposes
of calculating disallowed expenses under paragraph (c) of this section.
(ii) Similar cost profiles. Aircraft are of similar cost profiles if
their operating costs per mile or per hour of flight are comparable.
Aircraft must have the same engine type (jet or propeller) and the same
number of engines to have similar cost profiles. Other factors to be
considered in determining whether aircraft have similar cost profiles
include, but are not limited to, maximum take-off weight, payload,
passenger capacity, fuel consumption rate, age, maintenance costs, and
depreciable basis.
(5) Authority for establishing safe harbors for determining
expenses. The Commissioner may establish in published guidance, see
Sec. 601.601(d)(2) of this chapter, one or more safe harbor methods
under which a taxpayer may determine the amount of expenses paid or
incurred for entertainment flights.
(e) Allocation of expenses--(1) General rule. For purposes of
determining the expenses allocated to entertainment air travel of a
specified individual under paragraph (a)(2)(ii)(C) of this section, a
taxpayer must use either the occupied seat hours or miles method of
paragraph (e)(2) of this section or the flight-by-flight method of
paragraph (e)(3) of this section. A taxpayer must use the chosen method
for all flights of all aircraft for the taxable year.
(2) Occupied seat hours or miles method--(i) In general. The
occupied seat hours or miles method determines the amount of expenses
allocated to a particular entertainment flight of a specified individual
based on the occupied seat hours or miles for an aircraft for the
taxable year. Under this method, a taxpayer may choose to use either
occupied seat hours or miles for the taxable year to determine the
amount of expenses allocated to entertainment flights of specified
individuals, but must use occupied seat hours or miles consistently for
all flights of all aircraft for the taxable year.
(ii) Computation under the occupied seat hours or miles method. The
amount of expenses allocated to an entertainment flight taken by a
specified individual is computed under the occupied seat hours or miles
method by determining--
(A) The total expenses for the year under paragraph (d) of this
section for the aircraft or group of aircraft (if aggregated under
paragraph (d)(4) of this section), as applicable;
(B) The number of occupied seat hours or miles for the taxable year
for the aircraft or group of aircraft by totaling the occupied seat
hours or miles of all flights in the taxable year flown by the aircraft
or group of aircraft, as applicable. The occupied seat hours or miles
for a flight is the number of hours or miles flown for the flight
multiplied by the number of seats occupied on that flight. For example,
a flight of 6 hours with three passengers results in 18 occupied seat
hours;
(C) The cost per occupied seat hour or mile for the aircraft or
group of aircraft, as applicable, by dividing the total expenses under
paragraph (e)(2)(ii)(A) of this section by the total number of occupied
seat hours or miles under paragraph (e)(2)(ii)(B) of this section; and
(D) The amount of expenses allocated to an entertainment flight
taken by a specified individual by multiplying the number of hours or
miles of the flight by the cost per occupied hour or mile for that
aircraft or group of aircraft, as applicable, as determined under
paragraph (e)(2)(ii)(C) of this section.
(iii) Allocation of expenses of multi-leg trips involving both
business and entertainment legs. A taxpayer that uses the occupied seat
hours or miles allocation method must allocate the expenses of a trip by
a specified individual that involves at least one segment for business
and one segment for entertainment between the business travel and the
entertainment travel unless none of the expenses for the entertainment
segment are disallowed. The entertainment cost of a multi-leg trip is
the total cost of the flights (by occupied seat hours or miles) minus
the cost of the flights that would have been taken without the
entertainment segment or segments.
[[Page 986]]
(iv) Examples. The following examples illustrate the provisions of
this paragraph (e)(2):
Example 1. (i) A taxpayer-provided aircraft is used for Flights 1,
2, and 3, of 5 hours, 5 hours, and 4 hours, respectively, during the
Taxpayer's taxable year. Each flight carries four passengers. On Flight
1, none of the passengers is a specified individual. On Flight 2,
passengers A and B are specified individuals traveling for entertainment
purposes and passengers C and D are not specified individuals. For
Flight 2, Taxpayer treats $1,200 as compensation to A, and B reimburses
Taxpayer $500. On Flight 3, all four passengers (A, B, E, and F) are
specified individuals traveling for entertainment purposes. For Flight
3, Taxpayer treats $1,300 each as compensation to A, B, E, and F.
Taxpayer incurs $56,000 in expenses for the operation of the aircraft
for the taxable year. The aircraft is operated for 56 occupied seat
hours for the period (four passengers times 5 hours (20 occupied seat
hours) for Flight 1, plus four passengers times 5 hours (20 occupied
seat hours) for Flight 2, plus four passengers times 4 hours (16
occupied seat hours) for Flight 3. The cost per occupied seat hour is
$1,000 ($56,000/56 hours).
(ii) For purposes of determining the amount disallowed (to the
extent not treated as compensation or reimbursed) for entertainment
provided to specified individuals, $5,000 ($1,000 x 5 hours) each is
allocable to A and B for Flight 2, and $4,000 ($1,000 x 4 hours) each is
allocable to A, B, E, and F for Flight 3.
(iii) For Flight 2, because Taxpayer treats $1,200 as compensation
to A, and B reimburses Taxpayer $500, Taxpayer may deduct $1,700 of the
cost of Flight 2 allocable to A and B. The deduction for the remaining
$8,300 cost allocable to entertainment provided to A and B on Flight 2
is disallowed (for A, $5,000 less the $1,200 treated as compensation,
and for B, $5,000 less the $500 reimbursed).
(iv) For Flight 3, because Taxpayer treats $1,300 each as
compensation to A, B, E, and F, Taxpayer may deduct $5,200 of the cost
of Flight 3. The deduction for the remaining $10,800 cost allocable to
entertainment provided to A, B, E, and F on Flight 3 is disallowed
($4,000 less the $1,300 treated as compensation to each specified
individual).
Example 2. (i) G, a specified individual, is the sole passenger on
an aircraft that makes three flights. First, G travels on a two-hour
flight from City A to City B for business purposes. G then travels on a
three-hour flight from City B to City C for entertainment purposes, and
returns from City C to City A on a four-hour flight. G's flights have
resulted in nine occupied seat hours (two for the first segment, plus
three for the second segment, plus four for the third segment). If G had
returned directly to City A from City B, the flights would have resulted
in four occupied seat hours.
(ii) Under paragraph (e)(2)(iii) of this section, five occupied seat
hours are allocable to G's entertainment (nine total occupied seat hours
minus the four occupied seat hours that would have resulted if the
travel had been a roundtrip business trip without the entertainment
segment). If Taxpayer's cost per occupied seat hour for the year is
$1,000, $5,000 is allocated to G's entertainment use of the aircraft
($1,000 x five occupied seat hours). The amount disallowed is $5,000
minus the total of any amount the Taxpayer treats as compensation to G
plus any amount that G reimburses Taxpayer.
(3) Flight-by-flight method--(i) In general. The flight-by-flight
method determines the amount of expenses allocated to a particular
entertainment flight of a specified individual on a flight-by-flight
basis by allocating expenses to individual flights and then to a
specified individual traveling for entertainment purposes on that
flight.
(ii) Allocation of expenses. A taxpayer using the flight-by-flight
method must combine all expenses (as defined in paragraph (d)(1) of this
section) for the taxable year for the aircraft or group of aircraft (if
aggregated under paragraph (d)(4) of this section), as applicable, and
divide the total amount of expenses by the number of flight hours or
miles for the taxable year for that aircraft or group of aircraft, as
applicable, to determine the cost per hour or mile. Expenses are
allocated to each flight by multiplying the number of miles for the
flight by the cost per mile or the number of hours for the flight by the
cost per hour. The expenses for the flight then are allocated to the
passengers on the flight per capita. Thus, if five passengers are
traveling on a flight, and the total expense allocated to the flight is
$10,000, the expense allocable to each passenger is $2,000.
(f) Special rules--(1) Determination of basis. (i) If any deduction
for depreciation is disallowed under this section, the rules of Sec.
1.274-7 apply. In that case, the basis of an aircraft is not reduced for
the amount of depreciation disallowed under this section.
(ii) The provisions of this paragraph (f)(1) are illustrated by the
following examples:
[[Page 987]]
Example 1. (i) B Co. is a calendar-year taxpayer that owns an
aircraft not used in commercial or contract carrying of passengers or
freight. The aircraft is placed in service on July 1 of Year 1 and has
an unadjusted depreciable basis of $1,000,000. The class life of the
aircraft for depreciation purposes is 6 years. For determining
depreciation under section 168, B Co. uses the optional depreciation
table that corresponds with the general depreciation system, the 200
percent declining balance method of depreciation, a 5-year recovery
period, and the half-year convention. For determining the depreciation
disallowance for each year under paragraph (d)(3) of this section, B Co.
elects to use the straight-line method of depreciation and the class
life of 6 years and, therefore, uses the optional depreciation table for
purposes of section 168 that corresponds with the straight-line method
of depreciation, a recovery period of 6 years, and the half-year
convention. In each year, the aircraft entertainment use subject to
disallowance under this section is 10 percent of the total use.
(ii) B Co. calculates the depreciation and basis of the aircraft as
follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
200 Percent
declining Straight Depreciation
balance line disallowance under Depreciation Sec. 1.274-7 Basis Suspended basis.
depreciation depreciation section 274 deduction of aircraft
amount amount
--------------------------------------------------------------------------------------------------------------------------------------------------------
Year 1............................ 200,000 83,300 8,330. (.10 x 83,300) 191,670 (200,000 808,330 (1,000,000 8,330.
minus 8,330). minus 191,670).
Year 2............................ 320,000 166,700 16,670 (.10 x 303,330 (320,000 505,000 (808,330 25,000 (8,300 plus
166,700). minus 16,670). minus 303,330). 16,670).
Year 3............................ 192,000 166,700 16,670 (.10 x 175,330 (192,000 329,670 (505,000 41,670 (25,000 plus
166,700). minus 16,670). minus 175,330). 16,670).
Year 4............................ 115,200 166,700 16,670 (.10 x 98,530 (115,200 minus 231,140 (329,670 58,340 (41,670 plus
166,700). 16,670). minus 98,530). 16,670).
Year 5............................ 115,200 166,600 16,660 (.10 x 98,540 (115,200 minus 132,600 (231,140 75,000 (58,340 plus
166,600). 16,660). minus 98,540). 16,660).
Year 6............................ 57,600 166,700 16,670 (.10 x 40,930 (57,600 minus 91,670 (132,600 91,670 (75,000 plus
166,700). 16,670). minus 40,930). 16,670).
Year 7............................ ............ 83,300 8,330 (.10 x 83,300). ..................... 91,670.............. 91,670.
--------------------------------------------------------------------------------------------------------------------------------------------------------
(iii) In Year 7, there is no further deduction for depreciation of
the aircraft, therefore, under paragraph (d)(3) of this section, no
depreciation expense is disallowed. Under Sec. 1.274-7 and this
paragraph (f)(1), basis is not reduced for disallowed depreciation.
Therefore, at the end of Year 7, the basis of the aircraft for purposes
of Sec. 1.274-7 is $91,670, which is the total amount of disallowed
depreciation in Years 1 through 6. B Co.'s deductions for depreciation
total $908,330, which added to $91,670 equals $1,000,000.
Example 2. (i) The facts are the same as in Example 1, except that B
Co. does not elect to use the straight-line method of depreciation under
paragraph (d)(3) of this section until Year 3.
(ii) B Co. calculates the depreciation and basis of the aircraft as
follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
200 Percent
declining Straight Depreciation
balance line disallowance under Depreciation Sec. 1.274 Basis Suspended basis.
depreciation depreciation section 274 deduction of aircraft
amount amount
--------------------------------------------------------------------------------------------------------------------------------------------------------
Year 1............................ 200,000 ............ 20,000 (.10 x 180,000.............. 820,000 (1,000,000 20,000.
200,000). minus 180,000).
Year 2............................ 320,000 ............ 32,000 (.10 x 288,000 (320,000 532,000 (820,000 52,000 (20,000 plus
320,000). minus 32,000). minus 288,000). 32,000).
Year 3............................ 192,000 166,700 16,670 (.10 x 175,330 (192,000 356,670 (532,000 68,670 (52,000 plus
166,700). minus 16,670). minus 175,330). 16,670).
Year 4............................ 115,200 166,700 16,670 (.10 x 98,530 (115,200 minus 258,140 (356,670 85,340 (68,670 plus
166,700). 16,670). minus 98,530). 16,670).
Year 5............................ 115,200 166,600 16,660 (.10 x 98,540 (115,200 minus 159,600 (258,140 102,000 (85,340 plus
166,600). 16,660). minus 98,540). 16,660).
Year 6............................ 57,600 166,700 16,670 (.10 x 40,930 (57,600 minus 118,670 (159,600 118,670 (102,000
166,700). 16,670). minus 40,930). plus 16,670).
Year 7............................ ............ 83,300 8,330 (.10 x 83,300). 0.................... 118,670............. 118,670.
--------------------------------------------------------------------------------------------------------------------------------------------------------
[[Page 988]]
(iii) In Year 7, there is no further deduction for depreciation of
the aircraft, therefore, under paragraph (d)(3) of this section, no
depreciation expense is disallowed. Under Sec. 1.274-7 and this
paragraph (f)(1), basis is not reduced for disallowed depreciation.
Therefore, at the end of Year 7, the basis of the aircraft for purposes
of Sec. 1.274-7 is $118,670, which is the total amount of disallowed
depreciation in Years 1 through 6. B Co.'s deductions for depreciation
total $881,330, which added to $118,670 equals $1,000,000.
(2) Pro rata disallowance. (i) The amount of disallowed expenses,
and any amounts reimbursed or treated as compensation, under this
section are applied on a pro rata basis to all of the categories of
expenses subject to disallowance under this section.
(ii) The provisions of this paragraph (f)(2) are illustrated by the
following example:
Example. (i) C Co. owns an aircraft that it uses for business and
other purposes. The expenses of operating the aircraft in the current
year total $1,000,000. This amount includes $250,000 for depreciation
(25 percent of total expenses).
(ii) In the same year, the aircraft entertainment use subject to
disallowance under this section is 20 percent of the total use and C Co.
treats $80,000 as compensation to specified individuals. Thus, the
amount of the disallowance under this section is $120,000 ($1,000,000 x
20 percent ($200,000) less $80,000).
(iii) Under paragraph (f)(2) of this section, C Co. may calculate
the amount by which a category of expense, such as depreciation, is
disallowed by multiplying the total disallowance of $120,000 by the
ratio of the amount of the expense to total expenses. Thus, $30,000 of
the $120,000 total disallowed expenses is depreciation ($250,000/
$1,000,000 (25 percent) x $120,000).
(iv) The result is the same if C Co. separately calculates the
amount of depreciation in total disallowed expenses and in the amount
treated as compensation and nets the result. Depreciation is 25 percent
of total expenses, thus, the amount of depreciation in disallowed
expenses is $50,000 (25 percent x $200,000 total disallowed expenses)
and the amount of depreciation treated as compensation is $20,000 (25
percent x $80,000). Disallowed depreciation is $50,000 less $20,000, or
$30,000.
(3) Deadhead flights. (i) For purposes of this section, an aircraft
returning without passengers after discharging passengers or flying
without passengers to pick up passengers (deadheading) is treated as
having the same number and character of passengers as the leg of the
trip on which passengers are aboard for purposes of allocating expenses
under paragraphs (e)(2) or (e)(3) of this section. For example, when an
aircraft travels from point A to point B and then back to point A, and
one of the legs is a deadhead flight, for determination of disallowed
expenses, the aircraft is treated as having made both legs of the trip
with the same passengers aboard for the same purposes.
(ii) When a deadhead flight does not occur within a roundtrip
flight, but occurs between two unrelated flights involving more than two
destinations (such as an occupied flight from point A to point B,
followed by a deadhead flight from point B to point C, and then an
occupied flight from point C to point A), the allocation of passengers
and expenses to the deadhead flight occurring between the two occupied
trips must be based solely on the number of passengers on board for the
two occupied legs of the flight, the character of the travel of the
passengers on board (entertainment or nonentertainment) and the length
in hours or miles of the two occupied legs of the flight.
(iii) The provisions of this paragraph (f)(3) are illustrated by the
following examples:
Example 1. (i) Aircraft flies from City A to City B, a 6-hour trip,
with 12 passengers aboard. Eight of the passengers are traveling for
business and four of the passengers are specified individuals traveling
for entertainment purposes. The aircraft flies empty (deadheads) from
City B to City C, a 4-hour trip. At City C it picks up 12 passengers,
six of whom are traveling for business and six of whom are specified
individuals traveling for entertainment purposes, for a 2-hour trip to
City A. The taxpayer uses the occupied seat hour method of allocating
expenses.
(ii) The two legs of the trip on which the aircraft is occupied
comprise 96 occupied seat hours (12 passengers x 6 hours (72) for the
first leg plus 12 passengers x 2 hours (24) for the third leg). Sixty
occupied seat hours are for business (8 passengers x 6 hours (48) for
the first leg plus 6 passengers x 2 (12) hours for the third leg) and 36
occupied seat hours are for entertainment purposes (4 passengers x 6
hours (24) for the first leg plus 6 passengers x 2 (12) hours for the
third leg). Dividing the 36 occupied seat entertainment hours by 96
total occupied seat hours, 37.5 percent of the total occupied seat hours
of the two occupied flights are for entertainment.
[[Page 989]]
(iii) The 4-hour deadhead leg comprises one-third of the total
flight time of 12 hours. Therefore, the deadhead flight is deemed to
have provided one-third of the total 96 occupied seat hours, or 32
occupied seat hours (96 x \1/3\ = 32). Of the 32 deemed occupied seat
hours, 37.5 percent, or 12 deemed occupied seat hours, are treated as
entertainment under paragraph (f)(3)(ii) of this section. The 32 deemed
occupied seat hours for the deadhead flight are included in the
calculation under paragraph (e)(2)(ii)(B) of this section and expenses
are allocated under paragraph (e)(2)(ii)(D) of this section to the 12
deemed occupied seat hours treated as entertainment.
Example 2. (i) The facts are the same as for Example 1, but the
taxpayer uses the flight-by-flight method of allocation.
(ii) Of the 24 passengers on the occupied flights, 10 passengers, or
41.7 percent, are traveling for entertainment purposes. If the annual
cost per flight hour calculated under paragraph (e)(3)(ii) of this
section is $1,000, $4,000 is allocated to the 4-hour deadhead leg. Under
paragraph (f)(3)(ii) of this section, 41.7 percent of the $4,000, or
$1,667, is treated as an expense for entertainment. The calculation of
the cost per mile or hour for the year under paragraph (e)(3)(ii) of
this section includes the expenses and number of miles or hours flown
for the deadhead leg.
(g) Effective/applicability date. This section applies to taxable
years beginning after August 1, 2012.
[T.D. 9597, 77 FR 45483, Aug. 1, 2012]
Sec. 1.274-11 Disallowance of deductions for certain entertainment,
amusement, or recreation expenditures paid or incurred after
December 31, 2017.
(a) In general. Except as provided in this section, no deduction
otherwise allowable under chapter 1 of the Internal Revenue Code (Code)
is allowed for any expenditure with respect to an activity that is of a
type generally considered to be entertainment, or with respect to a
facility used in connection with an entertainment activity. For this
purpose, dues or fees to any social, athletic, or sporting club or
organization are treated as items with respect to facilities and, thus,
are not deductible. In addition, no deduction otherwise allowable under
chapter 1 of the Code is allowed for amounts paid or incurred for
membership in any club organized for business, pleasure, recreation, or
other social purpose.
(b) Definitions--(1) Entertainment--(i) In general. For section 274
purposes, the term entertainment means any activity which is of a type
generally considered to constitute entertainment, amusement, or
recreation, such as entertaining at bars, theaters, country clubs, golf
and athletic clubs, sporting events, and on hunting, fishing, vacation
and similar trips, including such activity relating solely to the
taxpayer or the taxpayer's family. These activities are treated as
entertainment under this section, subject to the objective test,
regardless of whether the expenditure for the activity is related to or
associated with the active conduct of the taxpayer's trade or business.
The term entertainment may include an activity, the cost of which
otherwise is a business expense of the taxpayer, which satisfies the
personal, living, or family needs of any individual, such as providing a
hotel suite or an automobile to a business customer or the customer's
family. The term entertainment does not include activities which,
although satisfying personal, living, or family needs of an individual,
are clearly not regarded as constituting entertainment, such as the
providing of a hotel room maintained by an employer for lodging of
employees while in business travel status or an automobile used in the
active conduct of a trade or business even though used for routine
personal purposes such as commuting to and from work. On the other hand,
the providing of a hotel room or an automobile by an employer to an
employee who is on vacation would constitute entertainment of the
employee.
(ii) Food or beverages. Under this section, the term entertainment
does not include food or beverages unless the food or beverages are
provided at or during an entertainment activity. Food or beverages
provided at or during an entertainment activity generally are treated as
part of the entertainment activity. However, in the case of food or
beverages provided at or during an entertainment activity, the food or
beverages are not considered entertainment if the food or beverages are
purchased separately from the entertainment, or the cost of the food or
beverages is stated separately from the
[[Page 990]]
cost of the entertainment on one or more bills, invoices, or receipts.
The amount charged for food or beverages on a bill, invoice, or receipt
must reflect the venue's usual selling cost for those items if they were
to be purchased separately from the entertainment or must approximate
the reasonable value of those items. If the food or beverages are not
purchased separately from the entertainment, or the cost of the food or
beverages is not stated separately from the cost of the entertainment on
one or more bills, invoices, or receipts, no allocation between
entertainment and food or beverage expenses may be made and, except as
further provided in this section and section 274(e), the entire amount
is a nondeductible entertainment expenditure under this section and
section 274(a).
(iii) Objective test. An objective test is used to determine whether
an activity is of a type generally considered to be entertainment. Thus,
if an activity is generally considered to be entertainment, it will be
treated as entertainment for purposes of this section and section 274(a)
regardless of whether the expenditure can also be described otherwise,
and even though the expenditure relates to the taxpayer alone. This
objective test precludes arguments that entertainment means only
entertainment of others or that an expenditure for entertainment should
be characterized as an expenditure for advertising or public relations.
However, in applying this test the taxpayer's trade or business is
considered. Thus, although attending a theatrical performance generally
would be considered entertainment, it would not be so considered in the
case of a professional theater critic attending in a professional
capacity. Similarly, if a manufacturer of dresses conducts a fashion
show to introduce its products to a group of store buyers, the show
generally would not be considered entertainment. However, if an
appliance distributor conducts a fashion show, the fashion show
generally would be considered to be entertainment.
(2) Expenditure. The term expenditure as used in this section
includes amounts paid or incurred for goods, services, facilities, and
other items, including items such as losses and depreciation.
(3) Expenditures for production of income. For purposes of this
section, any reference to trade or business includes an activity
described in section 212.
(c) Exceptions. Paragraph (a) of this section does not apply to any
expenditure described in section 274(e)(1), (2), (3), (4), (5), (6),
(7), (8), or (9).
(d) Examples. The following examples illustrate the application of
paragraphs (a) and (b) of this section. In each example, assume that the
taxpayer is engaged in a trade or business for purposes of section 162
and that neither the taxpayer nor any business associate is engaged in a
trade or business that relates to the entertainment activity. Also
assume that none of the exceptions under section 274(e) and paragraph
(c) of this section apply.
(1) Example 1. Taxpayer A invites, B, a business associate, to a
baseball game to discuss a proposed business deal. A purchases tickets
for A and B to attend the game. The baseball game is entertainment as
defined in Sec. 1.274-11(b)(1) and thus, the cost of the game tickets
is an entertainment expenditure and is not deductible by A.
(2) Example 2. The facts are the same as in paragraph (d)(1) of this
section (Example 1), except that A also buys hot dogs and drinks for A
and B from a concession stand. The cost of the hot dogs and drinks,
which are purchased separately from the game tickets, is not an
entertainment expenditure and is not subject to the disallowance under
Sec. 1.274-11(a) and section 274(a)(1). Therefore, A may deduct 50
percent of the expenses associated with the hot dogs and drinks
purchased at the game if the expenses meet the requirements of section
162 and Sec. 1.274-12.
(3) Example 3. Taxpayer C invites D, a business associate, to a
basketball game. C purchases tickets for C and D to attend the game in a
suite, where they have access to food and beverages. The cost of the
basketball game tickets, as stated on the invoice, includes the food or
beverages. The basketball game is entertainment as defined in Sec.
1.274-11(b)(1), and, thus, the cost of the game tickets is an
entertainment expenditure and is not deductible by C. The cost of the
food and beverages,
[[Page 991]]
which are not purchased separately from the game tickets, is not stated
separately on the invoice. Thus, the cost of the food and beverages is
an entertainment expenditure that is subject to disallowance under
section 274(a)(1) and paragraph (a) of this section, and C may not
deduct the cost of the tickets or the food and beverages associated with
the basketball game.
(4) Example 4. The facts are the same as in paragraph (d)(3) of this
section (Example 3), except that the invoice for the basketball game
tickets separately states the cost of the food and beverages and
reflects the venue's usual selling price if purchased separately. As in
paragraph (d)(3) of this section (Example 3), the basketball game is
entertainment as defined in Sec. 1.274-11(b)(1), and, thus, the cost of
the game tickets, other than the cost of the food and beverages, is an
entertainment expenditure and is not deductible by C. However, the cost
of the food and beverages, which is stated separately on the invoice for
the game tickets and reflects the venue's usual selling price of the
food and beverages if purchased separately, is not an entertainment
expenditure and is not subject to the disallowance under section
274(a)(1) and paragraph (a) of this section. Therefore, C may deduct 50
percent of the expenses associated with the food and beverages provided
at the game if the expenses meet the requirements of section 162 and
Sec. 1.274-12.
(e) Applicability date. This section applies for taxable years that
begin on or after October 9, 2020.
[T.D. 9925, 85 FR 64033, Oct. 9, 2020]
Sec. 1.274-12 Limitation on deductions for certain food or beverage
expenses paid or incurred after December 31, 2017.
(a) Food or beverage expenses--(1) In general. Except as provided in
this section, no deduction is allowed for the expense of any food or
beverages provided by the taxpayer (or an employee of the taxpayer)
unless--
(i) The expense is not lavish or extravagant under the
circumstances;
(ii) The taxpayer, or an employee of the taxpayer, is present at the
furnishing of such food or beverages; and
(iii) The food or beverages are provided to the taxpayer or a
business associate.
(2) Only 50 percent of food or beverage expenses allowed as
deduction. Except as provided in this section, the amount allowable as a
deduction for any food or beverage expense described in paragraph (a)(1)
of this section may not exceed 50 percent of the amount of the expense
that otherwise would be allowable.
(3) Examples. The following examples illustrate the application of
paragraph (a)(1) and (2) of this section. In each example, assume that
the food or beverage expenses are ordinary and necessary expenses under
section 162(a) that are paid or incurred during the taxable year in
carrying on a trade or business and are not lavish or extravagant under
the circumstances. Also assume that none of the exceptions in paragraph
(c) of this section apply.
(i) Example 1. Taxpayer A takes client B out to lunch. Under section
274(k) and (n) and paragraph (a) of this section, A may deduct 50
percent of the food or beverage expenses.
(ii) Example 2. Taxpayer C takes employee D out to lunch. Under
section 274(k) and (n) and paragraph (a) of this section, C may deduct
50 percent of the food or beverage expenses.
(iii) Example 3. Taxpayer E holds a business meeting at a hotel
during which food and beverages are provided to attendees. Expenses for
the business meeting, other than the cost of food and beverages, are not
subject to the deduction limitations in section 274 and are deductible
if they meet the requirements for deduction under section 162. Under
section 274(k) and (n) and paragraph (a) of this section, E may deduct
50 percent of the food and beverage expenses.
(iv) Example 4. The facts are the same as in paragraph (a)(3)(iii)
of this section (Example 3), except that all the attendees of the
meeting are employees of E. Expenses for the business meeting, other
than the cost of food and beverages, are not subject to the deduction
limitations in section 274 and are deductible if they meet the
requirements for deduction under section 162. Under section 274(k) and
(n) and paragraph (a) of this section, E may deduct
[[Page 992]]
50 percent of the food and beverage expenses. The exception in section
274(e)(5) does not apply to food and beverage expenses under section
274(k) and (n).
(4) Special rules for travel meals. (i) In general. Food or beverage
expenses paid or incurred while traveling away from home in pursuit of a
trade or business generally are subject to the deduction limitations in
section 274(k) and (n) and paragraph (a)(1) and (2) of this section, as
well as the substantiation requirements in section 274(d). In addition,
travel expenses generally are subject to the limitations in section
274(m)(1), (2), and (3).
(ii) Substantiation. Except as provided in this section, no
deduction is allowed for the expense of any food or beverages paid or
incurred while traveling away from home in pursuit of a trade or
business unless the taxpayer meets the substantiation requirements in
section 274(d).
(iii) Travel meal expenses of spouse, dependent or others. No
deduction is allowed under chapter 1 of the Internal Revenue Code
(Code), except under section 217 for certain members of the Armed Forces
of the United States, for the expense of any food or beverages paid or
incurred with respect to a spouse, dependent, or other individual
accompanying the taxpayer, or an officer or employee of the taxpayer, on
business travel, unless--
(A) The spouse, dependent, or other individual is an employee of the
taxpayer;
(B) The travel of the spouse, dependent, or other individual is for
a bona fide business purpose of the taxpayer; and
(C) The expenses would otherwise be deductible by the spouse,
dependent or other individual.
(D) Example. The following example illustrates the application of
paragraph (a)(4)(iii) of this section:
(1) Example. Taxpayer F, a sole proprietor, and Taxpayer F's spouse
travel from New York to Boston to attend a series of business meetings
related to F's trade or business. F's spouse is not an employee of F,
does not travel to Boston for a bona fide business purpose of F, and the
expenses would not otherwise be deductible. While in Boston, F and F's
spouse go out to dinner. Under section 274(m)(3) and paragraph
(a)(4)(iii) of this section, the expenses associated with the food and
beverages consumed by F's spouse are not deductible. Therefore, the cost
of F's spouse's dinner is not deductible. F may deduct 50 percent of the
expense associated with the food and beverages F consumed while on
business travel if F meets the requirements in sections 162 and 274,
including section 274(k) and (d).
(2) [Reserved]
(b) Definitions. Except as otherwise provided in this section, the
following definitions apply for purposes of section 274(k) and (n),
Sec. 1.274-11(b)(1)(ii) and (d), and this section:
(1) Food or beverages. Food or beverages means all food and beverage
items, regardless of whether characterized as meals, snacks, or other
types of food and beverages, and regardless of whether the food and
beverages are treated as de minimis fringes under section 132(e).
(2) Food or beverage expenses. Food or beverage expenses mean the
full cost of food or beverages, including any delivery fees, tips, and
sales tax. In the case of employer-provided meals furnished at an eating
facility on the employer's business premises, food or beverage expenses
do not include expenses for the operation of the eating facility such as
salaries of employees preparing and serving meals and other overhead
costs.
(3) Business associate. Business associate means a person with whom
the taxpayer could reasonably expect to engage or deal in the active
conduct of the taxpayer's trade or business such as the taxpayer's
customer, client, supplier, employee, agent, partner, or professional
adviser, whether established or prospective.
(4) Independent contractor. For purposes of the reimbursement or
other expense allowance arrangements described in paragraph (c)(2)(ii)
of this section, independent contractor means a person who is not an
employee of the payor.
(5) Client or customer. For purposes of the reimbursement or other
expense allowance arrangements described in
[[Page 993]]
paragraph (c)(2)(ii) of this section, client or customer of an
independent contractor means a person who receives services from an
independent contractor and enters into a reimbursement or other expense
allowance arrangement with the independent contractor.
(6) Payor. For purposes of the reimbursement or other expense
allowance arrangements described in paragraph (c)(2)(ii) of this
section, payor means a person that enters into a reimbursement or other
expense allowance arrangement with an employee and may include an
employer, its agent, or a third party.
(7) Reimbursement or other expense allowance arrangement. For
purposes of the reimbursement or other expense allowance arrangements
described in paragraph (c)(2)(ii) of this section, reimbursement or
other expense allowance arrangement means--
(i) For purposes of paragraph (c)(2)(ii)(B) of this section, an
arrangement under which an employee receives an advance, allowance, or
reimbursement from a payor for expenses the employee pays or incurs; and
(ii) For purposes of paragraph (c)(2)(ii)(C) of this section, an
arrangement under which an independent contractor receives an advance,
allowance, or reimbursement from a client or customer for expenses the
independent contractor pays or incurs if either--
(A) A written agreement between the parties expressly states that
the client or customer will reimburse the independent contractor for
expenses that are subject to the limitations on deductions described in
paragraph (a) of this section; or
(B) A written agreement between the parties expressly identifies the
party subject to the limitations.
(8) Primarily consumed. For purposes of paragraph (c)(2)(iv) of this
section, primarily consumed means greater than 50 percent of actual or
reasonably estimated consumption.
(9) General public. For purposes of paragraph (c)(2)(iv) of this
section, the general public includes, but is not limited to, customers,
clients, and visitors. The general public does not include employees,
partners, 2-percent shareholders of S corporations (as defined in
section 1372(b)), or independent contractors of the taxpayer. Also, the
guests on an exclusive list of guests are not the general public.
(c) Exceptions--(1) In general. The limitations on the deduction of
food or beverage expenses in paragraph (a) of this section do not apply
to any expense described in paragraph (c)(2) of this section. These
expenses are deductible to the extent allowable under chapter 1 of the
Code (chapter 1).
(2) Exceptions--(i) Expenses treated as compensation--(A) Expenses
includible in income of persons who are employees and are not specified
individuals. In accordance with section 274(e)(2)(A), and except as
provided in paragraph (c)(2)(i)(D) of this section, an expense paid or
incurred by a taxpayer for food or beverages, if an employee who is not
a specified individual is the recipient of the food or beverages, is not
subject to the deduction limitations in paragraph (a) of this section to
the extent that the taxpayer--
(1) Properly treats the expense relating to the recipient of food or
beverages as compensation to an employee under chapter 1 and as wages to
the employee for purposes of chapter 24 of the Code (chapter 24).; and
(2) Treats the proper amount as compensation to the employee under
Sec. 1.61-21.
(B) Expenses includible in income of persons who are not employees
and are not specified individuals. In accordance with section 274(e)(9),
and except as provided in paragraph (c)(2)(i)(D) of this section, an
expense paid or incurred by a taxpayer for food or beverages is not
subject to the deduction limitations in paragraph (a) of this section to
the extent that the expenses are properly included in income as
compensation for services rendered by, or as a prize or award under
section 74 to, a recipient of the expense who is not an employee of the
taxpayer and is not a specified individual. The preceding sentence does
not apply to any amount paid or incurred by the taxpayer if the amount
is required to be included, or would be so required except that the
amount is less than $600, in any information return filed by such
taxpayer under part III of subchapter A
[[Page 994]]
of chapter 61 of the Code and is not so included.
(C) Specified Individuals. In accordance with section 274(e)(2)(B),
in the case of a specified individual (as defined in section
274(e)(2)(B)(ii)), the deduction limitations in paragraph (a) of this
section do not apply to an expense for food or beverages of the
specified individual to the extent that the amount of the expense does
not exceed the sum of--
(1) The amount treated as compensation to the specified individual
under chapter 1 and as wages to the specified individual for purposes of
chapter 24 (if the specified individual is an employee) or as
compensation for services rendered by, or as a prize or award under
section 74 to, a recipient of the expense (if the specified individual
is not an employee); and
(2) Any amount the specified individual reimburses the taxpayer.
(D) Expenses for which an amount is excluded from income or is less
than the proper amount. Notwithstanding paragraphs (c)(2)(i)(A) and (B)
of this section, in the case of an expense paid or incurred by a
taxpayer for food or beverages for which an amount is wholly or
partially excluded from a recipients' income under any section of
subtitle A of the Code (other than because the amount is reimbursed by
the recipient), or for which an amount included in compensation and
wages to an employee (or as income to a nonemployee) is less than the
amount required to be included under Sec. 1.61-21, the deduction
limitations in paragraph (a) of this section do not apply to the extent
that the amount of the expense does not exceed the sum of--
(1) The amount treated as compensation to the employee under chapter
1 (or as income to a nonemployee) and as wages to the employee for
purposes of chapter 24; and
(2) Any amount the recipient reimburses the taxpayer.
(E) Examples. The following examples illustrate the application of
paragraph (c)(2)(i) of this section. In each example, assume that the
food or beverage expenses are ordinary and necessary expenses under
section 162(a) that are paid or incurred during the taxable year in
carrying on a trade or business.
(1) Example 1. Employer G provides food and beverages to its non-
specified individual employees without charge at a company cafeteria on
its premises. The food and beverages do not meet the definition of a de
minimis fringe under section 132(e). Thus, G treats the full fair market
value of the food and beverage expenses as compensation and wages, and
properly determines this amount under Sec. 1.61-21. Under section
274(e)(2) and paragraph (c)(2)(i)(A) of this section, the expenses
associated with the food and beverages provided to the employees are not
subject to the 50 percent deduction limitation in paragraph (a) of this
section. Thus, G may deduct 100 percent of the food and beverage
expenses.
(2) Example 2. The facts are the same as in paragraph
(c)(2)(i)(E)(1) of this section (Example 1), except that each employee
pays $8 per day for the food and beverages. The fair market value of the
food and beverages is $10 per day, per employee. G incurs $9 per day,
per employee for the food and beverages. G treats the food and beverage
expenses as compensation and wages, and properly determines the amount
of the inclusion under Sec. 1.61-21 to be $2 per day, per employee ($10
fair market value-$8 reimbursed by the employee = $2). Therefore, under
paragraph (c)(2)(i)(A) of this section, G may deduct 100 percent of the
food and beverage expenses, or $9 per day, per employee.
(3) Example 3. Employer H provides meals to its employees without
charge. The meals are properly excluded from the employees' income under
section 119 as meals provided for the convenience of the employer. Under
Sec. 1.61-21(b)(1), an employee must include in gross income the amount
by which the fair market value of a fringe benefit exceeds the sum of
the amount, if any, paid for the benefit by or on behalf of the
recipient, and the amount, if any, specifically excluded from gross
income by some other section of subtitle A of the Code. Because the
entire value of the employees' meals is excluded from the employees'
income under section 119, the fair market value of the fringe benefit
does not exceed the amount excluded from gross income under subtitle A
of the Code, so there
[[Page 995]]
is nothing to be included in the employees' income under Sec. 1.61-21.
Thus, the exception in section 274(e)(2) and paragraph (c)(2)(i) of this
section does not apply and, assuming no other exceptions provided under
section 274(n)(2) and paragraph (c)(2) of this section apply, H may
deduct only 50 percent of the expenses for the food and beverages
provided to employees. In addition, the limitations in section 274(k)(1)
and paragraph (a)(1) of this section apply because none of the
exceptions in section 274(k)(2) and paragraph (c)(2) of this section
apply.
(ii) Reimbursed food or beverage expenses--(A) In general. In
accordance with section 274(e)(3), in the case of expenses for food or
beverages paid or incurred by one person in connection with the
performance of services for another person, whether or not the other
person is an employer, under a reimbursement or other expense allowance
arrangement, the deduction limitations in paragraph (a) of this section
apply either to the person who makes the expenditure or to the person
who actually bears the expense, but not to both. If an expense of a type
described in paragraph (c)(2)(ii) of this section properly constitutes a
dividend paid to a shareholder, unreasonable compensation paid to an
employee, a personal expense, or other nondeductible expense, nothing in
this exception prevents disallowance of the deduction to the taxpayer
under other provisions of the Code.
(B) Reimbursement arrangements involving employees. In the case of
expenses paid or incurred by an employee for food or beverages in
performing services as an employee under a reimbursement or other
expense allowance arrangement with a payor, the limitations on
deductions in paragraph (a) of this section apply--
(1) To the employee to the extent the employer treats the
reimbursement or other payment of the expense on the employer's income
tax return as originally filed as compensation paid to the employee and
as wages to the employee for purposes of withholding under chapter 24
relating to collection of income tax at source on wages; or
(2) To the payor to the extent the reimbursement or other payment of
the expense is not treated as compensation and wages paid to the
employee in the manner provided in paragraph (c)(2)(ii)(B)(1) of this
section. However, see paragraph (c)(2)(ii)(C) of this section if the
payor receives a payment from a third party that may be treated as a
reimbursement arrangement under that paragraph.
(C) Reimbursement arrangements involving persons that are not
employees. In the case of expenses for food or beverages paid or
incurred by an independent contractor in connection with the performance
of services for a client or customer under a reimbursement or other
expense allowance arrangement with the independent contractor, the
limitations on deductions in paragraph (a) of this section apply to the
party expressly identified in an agreement between the parties as
subject to the limitations. If an agreement between the parties does not
expressly identify the party subject to the limitations, then the
deduction limitations in paragraph (a) of this section apply--
(1) To the independent contractor (which may be a payor) to the
extent the independent contractor does not account to the client or
customer within the meaning of section 274(d); or
(2) To the client or customer if the independent contractor accounts
to the client or customer within the meaning of section 274(d).
(D) Section 274(d) substantiation. If the reimbursement or other
expense allowance arrangement involves persons who are not employees and
the agreement between the parties does not expressly identify the party
subject to the limitations on deductions in paragraph (a) of this
section, the limitations on deductions in paragraph (a) of this section
apply to the independent contractor unless the independent contractor
accounts to the client or customer with substantiation that satisfies
the requirements of section 274(d).
(E) Examples. The following examples illustrate the application of
paragraph (c)(2)(ii) of this section.
(1) Example 1. (i) Employee I performs services under an arrangement
in which J, an employee leasing company, pays I a per diem allowance of
$10x for each day that I performs services for J's client, K, while
traveling away
[[Page 996]]
from home. The per diem allowance is a reimbursement of travel expenses
for food or beverages that I pays in performing services as an employee.
J enters into a written agreement with K under which K agrees to
reimburse J for any substantiated reimbursements for travel expenses,
including meal expenses, that J pays to I. The agreement does not
expressly identify the party that is subject to the limitations on
deductions in paragraph (a) of this section. I performs services for K
while traveling away from home for 10 days and provides J with
substantiation that satisfies the requirements of section 274(d) of
$100x of meal expenses incurred by I while traveling away from home. J
pays I $100x to reimburse those expenses pursuant to their arrangement.
J delivers a copy of I's substantiation to K. K pays J $300x, which
includes $200x compensation for services and $100x as reimbursement of
J's payment of I's travel expenses for meals. Neither J nor K treats the
$100x paid to I as compensation or wages.
(ii) Under paragraph (b)(7)(i) of this section, I and J have
established a reimbursement or other expense allowance arrangement for
purposes of paragraph (c)(2)(ii)(B) of this section. Because the
reimbursement payment is not treated as compensation and wages paid to
I, under section 274(e)(3)(A) and paragraph (c)(2)(ii)(B)(1) of this
section, I is not subject to the limitations on deductions in paragraph
(a) of this section. Instead, under paragraph (c)(2)(ii)(B)(2) of this
section, J, the payor, is subject to limitations on deductions in
paragraph (a) of this section unless J can meet the requirements of
section 274(e)(3)(B) and paragraph (c)(2)(ii)(C) of this section.
(iii) Because the agreement between J and K expressly states that K
will reimburse J for substantiated reimbursements for travel expenses
that J pays to I, under paragraph (b)(7)(ii)(A) of this section, J and K
have established a reimbursement or other expense allowance arrangement
for purposes of paragraph (c)(2)(ii)(C) of this section. J accounts to K
for K's reimbursement in the manner required by section 274(d) by
delivering to K a copy of the substantiation J received from I.
Therefore, under section 274(e)(3)(B) and paragraph (c)(2)(ii)(C)(2) of
this section, K and not J is subject to the deduction limitations in
paragraph (a) of this section.
(2) Example 2. (i) The facts are the same as in paragraph
(c)(2)(ii)(E)(1) of this section (Example 1) except that, under the
arrangements between I and J and between J and K, I provides the
substantiation of the expenses directly to K, and K pays the per diem
directly to I.
(ii) Under paragraph (b)(7)(i) of this section, I and K have
established a reimbursement or other expense allowance arrangement for
purposes of paragraph (c)(2)(ii)(C) of this section. Because I
substantiates directly to K and the reimbursement payment was not
treated as compensation and wages paid to I, under section 274(e)(3)(A)
and paragraph (c)(2)(ii)(C)(1) of this section, I is not subject to the
limitations on deductions in paragraph (a) of this section. Under
paragraph (c)(2)(ii)(C)(2) of this section, K, the payor, is subject to
the limitations on deductions in paragraph (a) of this section.
(3) Example 3. (i) The facts are the same as in paragraph
(c)(2)(ii)(E)(1) of this section (Example 1), except that the written
agreement between J and K expressly provides that the limitations of
this section will apply to K.
(ii) Under paragraph (b)(7)(ii)(B) of this section, J and K have
established a reimbursement or other expense allowance arrangement for
purposes of paragraph (c)(2)(ii)(C) of this section. Because the
agreement provides that the 274 deduction limitations apply to K, under
section 274(e)(3)(B) and paragraph (c)(2)(ii)(C) of this section, K and
not J is subject to the limitations on deductions in paragraph (a) of
this section.
(4) Example 4. (i) The facts are the same as in (c)(2)(ii)(E)(1) of
this section (Example 1), except that the agreement between J and K does
not provide that K will reimburse J for travel expenses.
(ii) The arrangement between J and K is not a reimbursement or other
expense allowance arrangement within the meaning of section 274(e)(3)(B)
and paragraph (b)(7)(ii) of this section. Therefore, even though J
accounts to K for the expenses, J is subject to the
[[Page 997]]
limitations on deductions in paragraph (a) of this section.
(iii) Recreational expenses for employees--(A) In general. In
accordance with section 274(e)(4), any food or beverage expense paid or
incurred by a taxpayer for a recreational, social, or similar activity,
primarily for the benefit of a taxpayer's employees (other than
employees who are highly compensated employees (within the meaning of
section 414(q))) is not subject to the deduction limitations in
paragraph (a) of this section. For purposes of this paragraph
(c)(2)(iii), an employee owning less than a 10-percent interest in the
taxpayer's trade or business is not considered a shareholder or other
owner, and for such purposes an employee is treated as owning any
interest owned by a member of the employee's family (within the meaning
of section 267(c)(4)). Any expense for food or beverages that is made
under circumstances which discriminate in favor of highly compensated
employees is not considered to be made primarily for the benefit of
employees generally. An expense for food or beverages is not to be
considered outside of the exception of this paragraph (c)(2)(iii) merely
because, due to the large number of employees involved, the provision of
food or beverages is intended to benefit only a limited number of
employees at one time, provided the provision of food or beverages does
not discriminate in favor of highly compensated employees. This
exception applies to expenses paid or incurred for events such as
holiday parties, annual picnics, or summer outings. This exception does
not apply to expenses for meals the value of which is excluded from
employees' income under section 119 because the meals are provided for
the convenience of the employer and are therefore not primarily for the
benefit of the taxpayer's employees.
(B) Examples. The following examples illustrate the application of
this paragraph (c)(2)(iii). In each example, assume that the food or
beverage expenses are ordinary and necessary expenses under section
162(a) that are paid or incurred during the taxable year in carrying on
a trade or business.
(1) Example 1. Employer L invites all employees to a holiday party
in a hotel ballroom that includes a buffet dinner and an open bar. Under
section 274(e)(4), this paragraph (c)(2)(iii), and Sec. 1.274-11(c),
the cost of the party, including food and beverage expenses, is not
subject to the deduction limitations in paragraph (a) of this section
because the holiday party is a recreational, social, or similar activity
primarily for the benefit of non-highly compensated employees. Thus, L
may deduct 100 percent of the cost of the party.
(2) Example 2. The facts are the same as in paragraph
(c)(2)(iii)(B)(1) of this section (Example 1), except that Employer L
invites only highly-compensated employees to the holiday party, and the
invoice provided by the hotel lists the costs for food and beverages
separately from the cost of the rental of the ballroom. The costs
reflect the venue's usual selling price for food or beverages. The
exception in this paragraph (c)(2)(iii) does not apply to the rental of
the ballroom or the food and beverage expenses because L invited only
highly-compensated employees to the holiday party. However, under Sec.
1.274-11(b)(1)(ii), the food and beverage expenses are not treated as
entertainment. Therefore, L is not subject to the full disallowance for
its separately stated food and beverage expense under section 274(a)(1)
and Sec. 1.274-11(a). Unless another exception in section 274(n)(2) and
paragraph (c)(2) of this section applies, L may deduct only 50 percent
of the food and beverage costs under paragraph (a)(2) of this section.
In addition, the limitations in section 274(k)(1) and paragraph (a)(1)
of this section apply because none of the exceptions in section
274(k)(2) and paragraph (c)(2) of this section apply.
(3) Example 3. Employer M provides free coffee, soda, bottled water,
chips, donuts, and other snacks in a break room available to all
employees. A break room is not a recreational, social, or similar
activity primarily for the benefit of the employees, even if some
socializing related to the food and beverages provided occurs. Thus, the
exception in section 274(e)(4) and this paragraph (c)(2)(iii) does not
apply and unless another exception in section 274(n)(2) and paragraph
(c)(2) of this section applies, M may deduct only 50
[[Page 998]]
percent of the expenses for food and beverages provided in the break
room under paragraph (a)(2) of this section. In addition, the
limitations in section 274(k)(1) and paragraph (a)(1) of this section
apply because none of the exceptions in section 274(k)(2) and paragraph
(c)(2) of this section apply.
(4) Example 4. Employer N has a written policy that employees in a
certain medical services-related position must be available for
emergency calls due to the nature of the position that requires frequent
emergency responses. Because these emergencies can and do occur during
meal periods, N furnishes food and beverages to employees in this
position without charge in a cafeteria on N's premises. N excludes food
and beverage expenses from the employees' income as meals provided for
the convenience of the employer excludable under section 119. Because
these food and beverages are furnished for the employer's convenience,
and therefore are not primarily for the benefit of the employees, the
exception in section 274(e)(4) and this paragraph (c)(2)(iii) does not
apply, even if some socializing related to the food and beverages
provided occurs. Further, the exception in section 274(e)(2) and
paragraph (c)(2)(i) of this section does not apply. Thus, unless another
exception in section 274(n)(2) and paragraph (c)(2) of this section
applies, N may deduct only 50 percent of the expenses for food and
beverages provided to employees in the cafeteria under paragraph (a)(2)
of this section. In addition, the limitations in section 274(k)(1) and
paragraph (a)(1) of this section apply because none of the exceptions in
section 274(k)(2) and paragraph (c)(2) of this section apply.
(5) Example 5. Employer O invites an employee and a client to dinner
at a restaurant. Because it is the birthday of the employee, O orders a
special dessert in celebration. Because the meal is a business meal, and
therefore not primarily for the benefit of the employee, the exception
in section 274(e)(4) and this paragraph (c)(2)(iii) does not apply, even
though an employee social activity in the form of a birthday celebration
occurred during the meal. Thus, unless another exception in section
274(n)(2) and paragraph (c)(2) of this section applies, O may deduct
only 50 percent of the meal expense. In addition, the limitations in
section 274(k)(1) and paragraph (a)(1) of this section apply because
none of the exceptions in section 274(k)(2) and paragraph (c)(2) of this
section apply.
(iv) Items available to the public--(A) In general. In accordance
with section 274(e)(7), any expense paid or incurred by a taxpayer for
food or beverages to the extent the food or beverages are made available
to the general public is not subject to the deduction limitations in
paragraph (a) of this section. If a taxpayer provides food or beverages
to employees, this exception applies to the entire amount of expenses
for those food or beverages if the same type of food or beverages is
provided to, and are primarily consumed by, the general public.
(B) Examples. The following examples illustrate the application of
this paragraph (c)(2)(iv). In each example, assume that the food and
beverage expenses are ordinary and necessary expenses under section
162(a) that are paid or incurred during the taxable year in carrying on
a trade or business.
(1) Example 1. Employer P is a real estate agent and provides
refreshments at an open house for a home available for sale to the
public. The refreshments are consumed by P's employees, potential buyers
of the property, and other real estate agents. Under section 274(e)(7)
and this paragraph (c)(2)(iv), the expenses associated with the
refreshments are not subject to the deduction limitations in paragraph
(a) of this section if P determines that over 50 percent of the food and
beverages are actually or reasonably estimated to be consumed by
potential buyers and other real estate agents. If more than 50 percent
of the food and beverages are not actually or reasonably estimated to be
consumed by the general public, only the costs attributable to the food
and beverages provided to the general public are excepted under section
274(e)(7) and this paragraph (c)(2)(iv). In addition, the limitations in
section 274(k)(1) and paragraph (a)(1) of this section apply to the
expenses associated with the refreshments that are not excepted under
section 274(e)(7) and this paragraph (c)(2)(iv).
[[Page 999]]
(2) Example 2. Employer Q is an automobile service center and
provides refreshments in its waiting area. The refreshments are consumed
by Q's employees and customers, and Q reasonably estimates that more
than 50 percent of the refreshments are consumed by customers. Under
section 274(e)(7) and this paragraph (c)(2)(iv), the expenses associated
with the refreshments are not subject to the deduction limitations
provided for in paragraph (a) of this section because the food and
beverages are primarily consumed by customers. Thus, Q may deduct 100
percent of the food and beverage expenses.
(3) Example 3. Employer R operates a summer camp open to the general
public for children and provides breakfast and lunch, as part of the fee
to attend camp, both to camp counselors, who are employees, and to camp
attendees, who are customers. There are 20 camp counselors and 100 camp
attendees. The same type of meal is available to each counselor and
attendee, and attendees consume more than 50 percent of the food and
beverages. Under section 274(e)(7) and this paragraph (c)(2)(iv), the
expenses associated with the food and beverages are not subject to the
deduction limitations in paragraph (a) of this section, because over 50
percent of the food and beverages are consumed by camp attendees and the
food and beverages are therefore primarily consumed by the general
public. Thus, R may deduct 100 percent of the food and beverage
expenses.
(4) Example 4. Employer S provides food and beverages to its
employees without charge at a company cafeteria on its premises.
Occasionally, customers or other visitors also eat without charge in the
cafeteria. The occasional consumption of food and beverages at the
company cafeteria by customers and visitors is less than 50 percent of
the total amount of food and beverages consumed at the cafeteria.
Therefore, the food and beverages are not primarily consumed by the
general public, and only the costs attributable to the food and
beverages provided to the general public are excepted under section
274(e)(7) and this paragraph (c)(2)(iv). In addition, the limitations in
section 274(k)(1) and paragraph (a)(1) of this section apply to the
expenses associated with the food and beverages that are not excepted
under section 274(e)(7) and this paragraph (c)(2)(iv).
(v) Goods or services sold to customers--(A) In general. In
accordance with section 274(e)(8), an expense paid or incurred for food
or beverages, to the extent the food or beverages are sold to customers
in a bona fide transaction for an adequate and full consideration in
money or money's worth, is not subject to the deduction limitations in
paragraph (a) of this section. However, money or money's worth does not
include payment through services provided. Under this paragraph
(c)(2)(v), a restaurant or catering business may deduct 100 percent of
its costs for food or beverage items, purchased in connection with
preparing and providing meals to its paying customers, which are also
consumed at the worksite by employees who work in the employer's
restaurant or catering business. In addition, for purposes of this
paragraph (c)(2)(v), the term customer includes anyone, including an
employee of the taxpayer, who is sold food or beverages in a bona fide
transaction for an adequate and full consideration in money or money's
worth.
(B) Example. The following example illustrates the application of
this paragraph (c)(2)(v):
Example. Employer T operates a restaurant. T provides food and
beverages to its food service employees before, during, and after their
shifts for no consideration. Under section 274(e)(8) and this paragraph
(c)(2)(v), the expenses associated with the food and beverages provided
to the employees are not subject to the 50 percent deduction limitation
in paragraph (a) of this section because the restaurant sells food and
beverages to customers in a bona fide transaction for an adequate and
full consideration in money or money's worth. Thus, T may deduct 100
percent of the food and beverage expenses.
(d) Applicability date. This section applies for taxable years that
begin on or after October 9, 2020.
[T.D. 9925, 85 FR 64035, Oct. 9, 2020]
[[Page 1000]]
Sec. 1.274-13 Disallowance of deductions for certain qualified
transportation fringe expenditures.
(a) In general. Except as provided in this section, no deduction
otherwise allowable under chapter 1 of the Internal Revenue Code (Code)
is allowed for any expense of any qualified transportation fringe as
defined in paragraph (b)(1) of this section.
(b) Definitions. The following definitions apply for purposes of
this section:
(1) Qualified transportation fringe. The term qualified
transportation fringe means any of the following provided by an employer
to an employee:
(i) Transportation in a commuter highway vehicle if such
transportation is in connection with travel between the employee's
residence and place of employment (as described in sections 132(f)(1)(A)
and 132(f)(5)(B));
(ii) Any transit pass (as described in sections 132(f)(1)(B) and
132(f)(5)(A)); or
(iii) Qualified parking (as described in sections 132(f)(1)(C) and
132(f)(5)(C)).
(2) Employee. The term employee means a common law employee or other
statutory employee, such as an officer of a corporation, who is
currently employed by the taxpayer. See Sec. 1.132-9 Q/A-5. Partners,
2-percent shareholders of S corporations (as defined in section
1372(b)), sole proprietors, and independent contractors are not
employees of the taxpayer for purposes of this section. See Sec. 1.132-
9 Q/A-24.
(3) General public. (i) In general. The term general public
includes, but is not limited to, customers, clients, visitors,
individuals delivering goods or services to the taxpayer, students of an
educational institution, and patients of a health care facility. The
term general public does not include individuals that are employees,
partners, 2-percent shareholders of S corporations (as defined in
section 1372(b)), sole proprietors, or independent contractors of the
taxpayer. Also, an exclusive list of guests of a taxpayer is not the
general public. Parking spaces that are available to the general public
but empty are treated as provided to the general public. Parking spaces
that are used to park vehicles owned by the general public while the
vehicles await repair or service by the taxpayer are also treated as
provided to the general public.
(ii) Multi-tenant building. If a taxpayer owns or leases space in a
multi-tenant building, the term general public includes employees,
partners, 2-percent shareholders of S corporations (as defined in
section 1372(b)), sole proprietors, independent contractors, clients, or
customers of unrelated tenants in the building.
(4) Parking facility. The term parking facility includes indoor and
outdoor garages and other structures, as well as parking lots and other
areas, where a taxpayer provides qualified parking (as defined in
section 132(f)(5)(C)) to one or more of its employees. The term parking
facility may include one or more parking facilities but does not include
parking spaces on or near property used by an employee for residential
purposes.
(5) Geographic location. The term geographic location means
contiguous tracts or parcels of land owned or leased by the taxpayer.
Two or more tracts or parcels of land are contiguous if they share
common boundaries or would share common boundaries but for the
interposition of a road, street, railroad, stream, or similar property.
Tracts or parcels of land which touch only at a common corner are not
contiguous.
(6) Total parking spaces. The term total parking spaces means the
total number of parking spaces, or the taxpayer's portion thereof, in
the parking facility.
(7) Reserved employee spaces. The term reserved employee spaces
means the spaces in the parking facility, or the taxpayer's portion
thereof, exclusively reserved for the taxpayer's employees. Employee
spaces in the parking facility, or portion thereof, may be exclusively
reserved for employees by a variety of methods, including, but not
limited to, specific signage (for example, ``Employee Parking Only'') or
a separate facility or portion of a facility segregated by a barrier to
entry or limited by terms of access. Inventory/unusable spaces are not
included in reserved employee spaces.
(8) Reserved nonemployee spaces. The term reserved nonemployee
spaces means the spaces in the parking facility, or
[[Page 1001]]
the taxpayer's portion thereof, exclusively reserved for nonemployees.
Such parking spaces may include, but are not limited to, spaces reserved
exclusively for visitors, customers, partners, sole proprietors, 2-
percent shareholders of S corporations (as defined in section 1372(b)),
vendor deliveries, and passenger loading/unloading. Nonemployee spaces
in the parking facility, or portion thereof, may be exclusively reserved
for nonemployees by a variety of methods, including, but not limited to,
specific signage (for example, ``Customer Parking Only'') or a separate
facility, or portion of a facility, segregated by a barrier to entry or
limited by terms of access. Inventory/unusable spaces are not included
in reserved nonemployee spaces.
(9) Inventory/unusable spaces. The term inventory/unusable spaces
means the spaces in the parking facility, or the taxpayer's portion
thereof, exclusively used or reserved for inventoried vehicles,
qualified nonpersonal use vehicles described in Sec. 1.274-5(k), or
other fleet vehicles used in the taxpayer's business, or that are
otherwise not usable for parking by employees or the general public.
Examples of such parking spaces include, but are not limited to, parking
spaces for vehicles that are intended to be sold or leased at a car
dealership or car rental agency, parking spaces for vehicles owned by an
electric utility used exclusively to maintain electric power lines, or
parking spaces occupied by trash dumpsters (or similar property).
Taxpayers may use any reasonable methodology to determine the number of
inventory/unusable spaces in the parking facility. A reasonable
methodology may include using the average of monthly inventory counts.
(10) Available parking spaces. The term available parking spaces
means the total parking spaces, less reserved employee spaces and less
inventory/unusable spaces, that are available to employees and the
general public.
(11) Primary use. The term primary use means greater than 50 percent
of actual or estimated usage of the available parking spaces in the
parking facility.
(12) Total parking expenses--(i) In general. The term total parking
expenses means all expenses of the taxpayer related to total parking
spaces in a parking facility including, but not limited to, repairs,
maintenance, utility costs, insurance, property taxes, interest, snow
and ice removal, leaf removal, trash removal, cleaning, landscape costs,
parking lot attendant expenses, security, and rent or lease payments or
a portion of a rent or lease payment (if not broken out separately). A
taxpayer may use any reasonable methodology to allocate mixed parking
expenses to a parking facility. A deduction for an allowance for
depreciation on a parking facility owned by a taxpayer and used for
parking by the taxpayer's employees is an allowance for the exhaustion,
wear and tear, and obsolescence of property, and not included in total
parking expenses for purposes of this section. Expenses paid or incurred
for nonparking facility property, including items related to property
next to the parking facility, such as landscaping or lighting, also are
not included in total parking expenses.
(ii) Optional rule for allocating certain mixed parking expenses. A
taxpayer may choose to allocate 5 percent of any the following mixed
parking expenses to a parking facility: Lease or rental agreement
expenses, property taxes, interest expense, and expenses for utilities
and insurance.
(13) Mixed parking expense. The term mixed parking expense means a
single expense amount paid or incurred by a taxpayer that includes both
parking facility and nonparking facility expenses for a property that a
taxpayer owns or leases.
(14) Peak demand period--(i) In general. The term peak demand period
refers to the period of time on a typical business day during the
taxable year when the greatest number of the taxpayer's employees are
utilizing parking spaces in the taxpayer's parking facility. If a
taxpayer's employees work in shifts, the peak demand period would take
into account the shift during which the largest number of employees park
in the taxpayer's parking facility. However, a brief transition period
during which two shifts overlap in their use of parking spaces, as one
shift of employees is getting ready to leave and the next shift is
reporting to work, may be disregarded. Taxpayers may
[[Page 1002]]
use any reasonable methodology to determine the total number of spaces
used by employees during the peak demand period on a typical business
day. A reasonable methodology may include periodic inspections or
employee surveys.
(ii) Optional rule for federally declared disasters. If a taxpayer
owns or leases a parking facility that is located in a federally
declared disaster area, as defined in section 165(i)(5), the taxpayer
may choose to identify a typical business day for the taxable year in
which the disaster occurred by reference to a typical business day in
that taxable year prior to the date that the taxpayer's operations were
impacted by the federally declared disaster. Alternatively, a taxpayer
may choose to identify a typical business day during the month(s) of the
taxable year in which the disaster occurred by reference to a typical
business day during the same month(s) of the taxable year immediately
preceding the taxable year in which the disaster first occurred. For
purposes of applying the optional rule for federally declared disasters,
the taxable year in which the disaster occurs is determined without
regard to whether an election under section 165(i) is made with respect
to the disaster.
(c) Optional aggregation rule for calculating total parking spaces;
taxpayer owned or leased parking facilities. For purposes of determining
total parking spaces in calculating the disallowance of deductions for
qualified transportation fringe parking expenses under the general rule
in paragraph (d)(2)(i) of this section, the primary use methodology in
paragraph (d)(2)(ii)(B) of this section, or the cost per space
methodology in paragraph (d)(2)(ii)(C) of this section, a taxpayer that
owns or leases more than one parking facility in a single geographic
location may aggregate the number of spaces in those parking facilities.
For example, parking spaces at an office park or an industrial complex
in the geographic location may be aggregated. However, a taxpayer may
not aggregate parking spaces in parking facilities that are in different
geographic locations. A taxpayer that chooses to aggregate its parking
spaces under this paragraph (c) must determine its total parking
expenses, including the allocation of mixed parking expenses, as if the
aggregated parking spaces constitute one parking facility.
(d) Calculation of disallowance of deductions for qualified
transportation fringe expenses--(1) Taxpayer pays a third party for
parking qualified transportation fringe. If a taxpayer pays a third
party an amount for its employees' parking qualified transportation
fringe, the section 274(a)(4) disallowance generally is calculated as
the taxpayer's total annual cost of employee parking qualified
transportation fringes paid to the third party.
(2) Taxpayer provides parking qualified transportation fringe at a
parking facility it owns or leases. If a taxpayer owns or leases all or
a portion of one or more parking facilities where its employees park,
the section 274(a)(4) disallowance may be calculated using the general
rule in paragraph (d)(2)(i) of this section or any of the simplified
methodologies in paragraph (d)(2)(ii) of this section. A taxpayer may
choose to use the general rule or any of the following methodologies for
each taxable year and for each parking facility.
(i) General rule. A taxpayer that uses the general rule in this
paragraph (d)(2)(i) must calculate the disallowance of deductions for
qualified transportation fringe parking expenses for each employee
receiving the qualified transportation fringe based on a reasonable
interpretation of section 274(a)(4). A taxpayer that uses the general
rule in this paragraph (d)(2)(i) may use the aggregation rule in
paragraph (c) of this section for determining total parking spaces. An
interpretation of section 274(a)(4) is not reasonable unless the
taxpayer applies the following rules when calculating the disallowance
under this paragraph (d)(2)(i).
(A) A taxpayer must not use value to determine expense. A taxpayer
may not use the value of employee parking to determine expenses
allocable to employee parking that is either owned or leased by the
taxpayer because section 274(a)(4) disallows a deduction for the expense
of providing a qualified transportation fringe, regardless of its value.
[[Page 1003]]
(B) A taxpayer must not deduct expenses related to reserved employee
spaces. A taxpayer must determine the allocable portion of total parking
expenses that relate to any reserved employee spaces. No deduction is
allowed for the parking expenses that relate to reserved employee
spaces.
(C) A taxpayer must not improperly apply the exception for qualified
parking made available to the public. A taxpayer must not improperly
apply the exception in section 274(e)(7) or paragraph (e)(2)(ii) of this
section to parking facilities, for example, by treating a parking
facility regularly used by employees as available to the general public
merely because the general public has access to the parking facility.
(ii) Additional simplified methodologies. Instead of using the
general rule in paragraph (d)(2)(i) of this section for a taxpayer owned
or leased parking facility, a taxpayer may use a simplified methodology
under paragraph (d)(2)(ii)(A), (B), or (C) of this section.
(A) Qualified parking limit methodology. A taxpayer that uses the
qualified parking limit methodology in this paragraph (d)(2)(ii)(A) must
calculate the disallowance of deductions for qualified transportation
fringe parking expenses by multiplying the total number of spaces used
by employees during the peak demand period, or the total number of
taxpayer's employees, by the section 132(f)(2) monthly per employee
limitation on exclusion (adjusted for inflation), for each month in the
taxable year. The result is the amount of the taxpayer's expenses that
are disallowed under section 274(a)(4). In applying this methodology, a
taxpayer calculates the disallowed amount as required under this
paragraph (d)(2)(ii)(A), regardless of the actual amount of the
taxpayer's total parking expenses. This methodology may be used only if
the taxpayer includes the value of the qualified transportation fringe
in excess of the sum of the amount, if any, paid by the employee for the
qualified transportation fringe and the applicable statutory monthly
limit in section 132(f)(2) as compensation paid to the employee under
chapter 1 of the Code (chapter 1) and as wages to the employee for
purposes of withholding under chapter 24 of the Code (chapter 24),
relating to collection of Federal income tax at source on wages. In
addition, the exception to the disallowance for amounts treated as
employee compensation provided for in section 274(e)(2) and in paragraph
(e)(2)(i) of this section cannot be applied to reduce a section
274(a)(4) disallowance calculated using this methodology. A taxpayer
using this methodology may not use the aggregation rule in paragraph (c)
of this section.
(B) Primary use methodology. A taxpayer that uses the primary use
methodology in this paragraph (d)(2)(ii)(B) must use the following four-
step methodology to calculate the disallowance of deductions for
qualified transportation fringe parking expenses for each parking
facility for which the taxpayer uses the primary use methodology. A
taxpayer using this methodology may use the aggregation rule in
paragraph (c) of this section for determining total parking spaces.
(1) Step 1--Calculate the disallowance for reserved employee spaces.
A taxpayer must identify the total parking spaces in the parking
facility, or the taxpayer's portion thereof, exclusively reserved for
the taxpayer's employees. The taxpayer must then determine the
percentage of reserved employee spaces in relation to total parking
spaces and multiply that percentage by the taxpayer's total parking
expenses for the parking facility. The product is the amount of the
deduction for total parking expenses that is disallowed under section
274(a)(4) for reserved employee spaces. There is no disallowance for
reserved employee spaces if the following conditions are met:
(i) The primary use (as defined in paragraphs (b)(11) and
(d)(2)(ii)(B)(2) of this section) of the available parking spaces is to
provide parking to the general public;
(ii) There are five or fewer reserved employee spaces in the parking
facility; and
(iii) The reserved employee spaces are 5 percent or less of the
total parking spaces.
(2) Step 2--Determine the primary use of available parking spaces. A
taxpayer must identify the available parking
[[Page 1004]]
spaces in the parking facility and determine whether their primary use
is to provide parking to the general public. If the primary use of the
available parking spaces in the parking facility is to provide parking
to the general public, then total parking expenses allocable to
available parking spaces at the parking facility are excepted from the
section 274(a)(4) disallowance by the general public exception under
section 274(e)(7) and paragraph (e)(2)(ii) of this section. Primary use
of available parking spaces is based on the number of available parking
spaces used by employees during the peak demand period.
(3) Step 3--Calculate the allowance for reserved nonemployee spaces.
If the primary use of a taxpayer's available parking spaces is not to
provide parking to the general public, the taxpayer must identify the
number of available parking spaces in the parking facility, or the
taxpayer's portion thereof, exclusively reserved for nonemployees. A
taxpayer that has no reserved nonemployee spaces may proceed to Step 4
in paragraph (d)(2)(ii)(B)(4) of this section. If the taxpayer has
reserved nonemployee spaces, it may determine the percentage of reserved
nonemployee spaces in relation to remaining total parking spaces and
multiply that percentage by the taxpayer's remaining total parking
expenses. The product is the amount of the deduction for remaining total
parking expenses that is not disallowed because the spaces are not
available for employee parking.
(4) Step 4--Determine remaining use of available parking spaces and
allocable expenses. If a taxpayer completes Steps 1--3 in paragraph
(d)(2)(ii)(B) of this section and has any remaining total parking
expenses not specifically categorized as deductible or nondeductible,
the taxpayer must reasonably allocate such expenses by determining the
total number of available parking spaces used by employees during the
peak demand period.
(C) Cost per space methodology. A taxpayer using the cost per space
methodology in this paragraph (d)(2)(ii)(C) must calculate the
disallowance of deductions for qualified transportation fringe parking
expenses by multiplying the cost per space by the number of total
parking spaces used by employees during the peak demand period. The
product is the amount of the deduction for total parking expenses that
is disallowed under section 274(a)(4). A taxpayer may calculate cost per
space by dividing total parking expenses by total parking spaces. This
calculation may be performed on a monthly basis. A taxpayer using this
methodology may use the aggregation rule in paragraph (c) of this
section for determining total parking spaces.
(3) Expenses for transportation in a commuter highway vehicle or
transit pass. If a taxpayer pays a third party an amount for its
employees' commuter highway vehicle or a transit pass qualified
transportation fringe, the section 274(a)(4) disallowance generally is
equal to the taxpayer's total annual cost of employee commuter highway
vehicle or a transit pass qualified transportation fringes paid to the
third party. If a taxpayer provides transportation in a commuter highway
vehicle or transit pass qualified transportation fringes in kind
directly to its employees, the taxpayer must calculate the disallowance
of deductions for expenses for such fringes based on a reasonable
interpretation of section 274(a)(4). However, a taxpayer may not use the
value of the qualified commuter highway vehicle or transit pass fringe
to the employee to determine expenses allocable to such fringe because
section 274(a)(4) disallows a deduction for the expense of providing a
qualified transportation fringe, regardless of its value to the
employee.
(e) Specific exceptions to disallowance of deduction for qualified
transportation fringe expenses--(1) In general. The provisions of
section 274(a)(4) and paragraph (a) of this section (imposing
limitations on deductions for qualified transportation fringe expenses)
are not applicable in the case of expenditures set forth in paragraph
(e)(2) of this section. Such expenditures are deductible to the extent
allowable under chapter 1 of the Code. This paragraph (e) cannot be
construed to affect whether a deduction under section 162 or 212 is
allowed or allowable. The fact that an expenditure is not covered by a
specific exception provided for in this paragraph (e)
[[Page 1005]]
is not determinative of whether a deduction for the expenditure is
disallowed under section 274(a)(4) and paragraph (a) of this section.
(2) Exceptions to disallowance. The expenditures referred to in
paragraph (e)(1) of this section are set forth in paragraphs (e)(2)(i)
through (iii) of this section.
(i) Certain qualified transportation fringe expenses treated as
compensation--(A) Expenses includible in income of persons who are
employees and are not specified individuals. In accordance with section
274(e)(2)(A), and except as provided in paragraph (e)(2)(i)(C) of this
section, an expense paid or incurred by a taxpayer for a qualified
transportation fringe, if an employee who is not a specified individual
is the recipient of the qualified transportation fringe, is not subject
to the disallowance of deductions provided for in paragraph (a) of this
section to the extent that the taxpayer--
(1) Properly treats the expense relating to the recipient of the
qualified transportation fringe as compensation to an employee under
chapter 1 and as wages to the employee for purposes of chapter 24; and
(2) Treats the proper amount as compensation to the employee under
Sec. 1.61-21.
(B) Specified Individuals. In accordance with section 274(e)(2)(B),
in the case of a specified individual (as defined in section
274(e)(2)(B)(ii)), the disallowance of deductions provided for in
paragraph (a) of this section does not apply to an expense for a
qualified transportation fringe of the specified individual to the
extent that the amount of the expense does not exceed the sum of--
(1) The amount treated as compensation to the specified individual
under chapter 1 and as wages to the specified individual for purposes of
chapter 24; and
(2) Any amount the specified individual reimburses the taxpayer.
(C) Expenses for which an amount is excluded from income or is less
than the proper amount. Notwithstanding paragraph (e)(2)(i)(A) of this
section, in the case of an expense paid or incurred by a taxpayer for a
qualified transportation fringe for which an amount is wholly or
partially excluded from a recipient's income under subtitle A of the
Code (other than because the amount is reimbursed by the recipient), or
for which an amount included in compensation and wages to an employee is
less than the amount required to be included under Sec. 1.61-21, the
disallowance of deductions provided for in paragraph (a) of this section
does not apply to the extent that the amount of the expense does not
exceed the sum of--
(1) The amount treated as compensation to the recipient under
chapter 1 and as wages to the recipient for purposes of chapter 24; and
(2) Any amount the recipient reimburses the taxpayer.
(ii) Expenses for transportation in a commuter highway vehicle,
transit pass, or parking made available to the public. Under section
274(e)(7) and this paragraph (e)(2)(ii), any expense paid or incurred by
a taxpayer for transportation in a commuter highway vehicle, a transit
pass, or parking that otherwise qualifies as a qualified transportation
fringe is not subject to the disallowance of deductions provided for in
paragraph (a) of this section to the extent that such transportation,
transit pass, or parking is made available to the general public. With
respect to parking, this exception applies to the entire amount of the
taxpayer's parking expense, less any expenses specifically attributable
to employees (for example, expenses allocable to reserved employee
spaces), if the primary use of the parking is by the general public. If
the primary use of the parking is not by the general public, this
exception applies only to the costs attributable to the parking used by
the general public.
(iii) Expenses for transportation in a commuter highway vehicle,
transit pass, or parking sold to customers. Under section 274(e)(8) and
this paragraph (e)(2)(iii), any expense paid or incurred by a taxpayer
for transportation in a commuter highway vehicle, a transit pass, or
parking that otherwise qualifies as a qualified transportation fringe to
the extent such transportation, transit pass, or parking is sold to
customers in a bona fide transaction for an adequate and full
consideration in
[[Page 1006]]
money or money's worth, is not subject to the disallowance of deductions
provided for in paragraph (a) of this section. For purposes of this
paragraph (e)(2)(iii), the term customer includes an employee of the
taxpayer who purchases transportation in a commuter highway vehicle, a
transit pass, or parking in a bona fide transaction for an adequate and
full consideration in money or money's worth. If in a bona fide
transaction, the adequate and full consideration for qualified parking
is zero, the exception in this paragraph (e)(2)(iii) applies even though
the taxpayer does not actually sell the parking to its employees. To
apply the exception in this case, the taxpayer bears the burden of
proving that the fair market value of the qualified parking is zero.
However, solely for purposes of this paragraph (e)(2)(iii), a taxpayer
will be treated as satisfying this burden if the qualified parking is
provided in a rural, industrial, or remote area in which no commercial
parking is available and an individual other than an employee ordinarily
would not pay to park in the parking facility.
(f) Examples. The following examples illustrate the provisions of
this section related to parking expenses for qualified transportation
fringes. For each example, unless otherwise stated, assume the parking
expenses are otherwise deductible expenses paid or incurred during the
2020 taxable year; all or some portion of the expenses relate to a
qualified transportation fringe under section 132(f); the section
132(f)(2) monthly per employee limitation on an employee's exclusion is
$270; the fair market value of the qualified parking is not $0; all
taxpayers are calendar-year taxpayers; and the length of the 2020
taxable year is 12 months.
(1) Example 1. Taxpayer A pays B, a third party who owns a parking
garage adjacent to A's place of business, $100 per month per parking
space for each of A's 10 employees to park in B's garage, or $12,000 for
parking in 2020 (($100 x 10) x 12 = $12,000). The $100 per month paid
for each of A's 10 employees for parking is excludible from the
employees' gross income under section 132(a)(5), and none of the
exceptions in section 274(e) or paragraph (e) of this section are
applicable. Thus, the entire $12,000 is subject to the section 274(a)(4)
disallowance under paragraphs (a) and (d)(1) of this section.
(2) Example 2. (i) Assume the same facts as in paragraph (f)(1) of
this section (Example 1), except A pays B $300 per month for each
parking space, or $36,000 for parking for 2020 (($300 x 10) x 12 =
$36,000). Of the $300 per month paid for parking for each of 10
employees, $270 is excludible under section 132(a)(5) for 2020 and none
of the exceptions in section 274(e) or paragraph (e) of this section are
applicable to this amount. A properly treats the excess amount of $30
($300-$270) per employee per month as compensation and wages. Thus,
$32,400 (($270 x 10) x 12 = $32,400) is subject to the section 274(a)(4)
disallowance under paragraphs (a) and (d)(1) of this section.
(ii) The excess amount of $30 per employee per month is not
excludible under section 132(a)(5). As a result, the exceptions in
section 274(e)(2) and paragraph (e)(2)(i) of this section are applicable
to this amount. Thus, $3,600 ($36,000-$32,400 = $3,600) is not subject
to the section 274(a)(4) disallowance and remains deductible.
(3) Example 3. (i) Taxpayer C leases from a third party a parking
facility that includes 200 parking spaces at a rate of $500 per space,
per month in 2020. C's annual lease payment for the parking spaces is
$1,200,000 ((200 x $500) x 12 = $1,200,000). The number of available
parking spaces used by C's employees during the peak demand period is
200.
(ii) C uses the qualified parking limit methodology described in
paragraph (d)(2)(ii)(A) of this section to determine the disallowance
under section 274(a)(4). Under this methodology, the section 274(a)(4)
disallowance is calculated by multiplying the number of available
parking spaces used by employees during the peak demand period, 200, the
section 132(f)(2) monthly per employee limitation on exclusion, $270,
and 12, the number of months in the applicable taxable year. The amount
subject to the section 274(a)(4) disallowance is $648,000 (200 x $270 x
12 = $648,000). This amount is excludible from C's employees' gross
incomes under section 132(a)(5) and none of the
[[Page 1007]]
exceptions in section 274(e) or paragraph (e) of this section are
applicable to this amount. The excess $552,000 ($1,200,000-$648,000) for
which C is not disallowed a deduction under 274(a)(4) is included in C's
employees' gross incomes because it exceeds the section 132(f)(2)
monthly per employee limitation on exclusion.
(4) Example 4. (i) Facts. Taxpayer D, a big box retailer, owns a
surface parking facility adjacent to its store. D incurs $10,000 of
total parking expenses for its store in the 2020 taxable year. D's
parking facility has 510 spaces that are used by its customers,
employees, and its fleet vehicles. None of D's parking spaces are
reserved. The number of available parking spaces used by D's employees
during the peak demand period is 50. Approximately 30 nonreserved
parking spaces are empty during D's peak demand period. D's fleet
vehicles occupy 10 parking spaces.
(ii) Methodology. D uses the primary use methodology in paragraph
(d)(2)(ii)(B) of this section to determine the amount of parking
expenses that are disallowed under section 274(a)(4).
(iii) Step 1. Because none of D's parking spaces are exclusively
reserved for employees, there is no amount to be specifically allocated
to reserved employee spaces under paragraph (d)(2)(ii)(B)(1) of this
section.
(iv) Step 2. D's number of available parking spaces is the total
parking spaces reduced by the number of reserved employee spaces and
inventory/unusable spaces or 500 (510-0-10 = 500). The number of
available parking spaces used by D's employees during the peak demand
period is 50. Of the 500 available parking spaces, 450 are used to
provide parking to the general public, including the 30 empty
nonreserved parking spaces that are treated as provided to the general
public. The primary use of D's available parking spaces is to provide
parking to the general public because 90% (450/500 = 90%) of the
available parking spaces are used by the general public under paragraph
(d)(2)(ii)(B)(2) of this section. Because the primary use of the
available parking spaces is to provide parking to the general public,
the exception in section 274(e)(7) and paragraph (e)(2)(ii) of this
section applies and none of the $10,000 of total parking expenses is
subject to the section 274(a)(4) disallowance.
(5) Example 5. (i) Facts. Taxpayer E, a manufacturer, owns a surface
parking facility adjacent to its plant. E incurs $10,000 of total
parking expenses in 2020. E's parking facility has 500 spaces that are
used by its visitors and employees. E reserves 25 of these spaces for
nonemployee visitors. The number of available parking spaces used by E's
employees during the peak demand period is 400.
(ii) Methodology. E uses the primary use methodology in paragraph
(d)(2)(ii)(B) of this section to determine the amount of parking
expenses that are disallowed under section 274(a)(4).
(iii) Step 1. Because none of E's parking spaces are exclusively
reserved for employees, there is no amount to be specifically allocated
to reserved employee spaces under paragraph (d)(2)(ii)(B)(1) of this
section.
(iv) Step 2. The primary use of E's parking facility is not to
provide parking to the general public because 80% (400/500 = 80%) of the
available parking spaces are used by its employees. Thus, expenses
allocable to those spaces are not excepted from the section 274(a)
disallowance by section 274(e)(7) and paragraph (e)(2)(ii) of this
section under the primary use test in paragraph (d)(2)(ii)(B)(2) of this
section.
(v) Step 3. Because 5% (25/500 = 5%) of E's available parking spaces
are reserved nonemployee spaces, up to $9,500 ($10,000 x 95% = $9,500)
of E's total parking expenses are subject to the section 274(a)(4)
disallowance under this step as provided in paragraph (d)(2)(ii)(B)(3)
of this section. The remaining $500 ($10,000 x 5% = $500) of expenses
allocable to reserved nonemployee spaces is excepted from the section
274(a) disallowance and continues to be deductible.
(vi) Step 4. E must reasonably determine the employee use of the
remaining parking spaces by using the number of available parking spaces
used by E's employees during the peak demand period and determine the
expenses allocable to employee parking spaces under paragraph
(d)(2)(ii)(B)(4) of this section.
[[Page 1008]]
(6) Example 6. (i) Facts. Taxpayer F, a manufacturer, owns a surface
parking facility adjacent to its plant. F incurs $10,000 of total
parking expenses in 2020. F's parking facility has 500 spaces that are
used by its visitors and employees. F reserves 50 spaces for management.
All other employees park in nonreserved spaces in F's parking facility;
the number of available parking spaces used by F's employees during the
peak demand period is 400. Additionally, F reserves 10 spaces for
nonemployee visitors.
(ii) Methodology. F uses the primary use methodology in paragraph
(d)(2)(ii)(B) of this section to determine the amount of parking
expenses that are disallowed under section 274(a)(4).
(iii) Step 1. Because F reserved 50 spaces for management, $1,000
((50/500) x $10,000 = $1,000) is the amount of total parking expenses
that is nondeductible for reserved employee spaces under section
274(a)(4) and paragraphs (a) and (d)(2)(ii)(B)(1) of this section. None
of the exceptions in section 274(e) or paragraph (e) of this section are
applicable to this amount.
(iv) Step 2. The primary use of the remainder of F's parking
facility is not to provide parking to the general public because 89%
(400/450 = 89%) of the available parking spaces in the facility are used
by its employees. Thus, expenses allocable to these spaces are not
excepted from the section 274(a)(4) disallowance by section 274(e)(7)
and paragraph (e)(2)(ii) of this section under the primary use test in
paragraph (d)(2)(ii)(B)(2) of this section.
(v) Step 3. Because 2% (10/450 = 2.22%) of F's available parking
spaces are reserved nonemployee spaces, the $180 allocable to those
spaces (($10,000-$1,000) x 2%) is not subject to the section 274(a)(4)
disallowance and continues to be deductible under paragraph
(d)(2)(ii)(B)(3) of this section.
(vi) Step 4. F must reasonably determine the employee use of the
remaining parking spaces by using the number of available parking spaces
used by F's employees during the peak demand period and determine the
expenses allocable to employee parking spaces under paragraph
(d)(2)(ii)(B)(4) of this section.
(7) Example 7. (i) Facts. Taxpayer G, a financial services
institution, owns a multi-level parking garage adjacent to its office
building. G incurs $10,000 of total parking expenses in 2020. G's
parking garage has 1,000 spaces that are used by its visitors and
employees. However, one floor of the parking garage is segregated by an
electronic barrier that can only be accessed with a card provided by G
to its employees. The segregated parking floor contains 100 spaces. The
other floors of the parking garage are not used by employees for parking
during the peak demand period.
(ii) Methodology. G uses the primary use methodology in paragraph
(d)(2)(ii)(B) of this section to determine the amount of parking
expenses that are disallowed under section 274(a)(4).
(iii) Step 1. Because G has 100 reserved spaces for employees,
$1,000 ((100/1,000) x $10,000 = $1,000) is the amount of total parking
expenses that is nondeductible for reserved employee spaces under
section 274(a)(4) and paragraph (d)(2)(ii)(B)(1) of this section. None
of the exceptions in section 274(e) or paragraph (e) of this section are
applicable to this amount.
(iv) Step 2. The primary use of the available parking spaces in G's
parking facility is to provide parking to the general public because
100% (900/900 = 100%) of the available parking spaces are used by the
public. Thus, expenses allocable to those spaces, $9,000, are excepted
from the section 274(a)(4) disallowance by section 274(e)(7) and
paragraph (e)(2)(ii) of this section under the primary use test in
paragraph (d)(2)(ii)(B)(2).
(8) Example 8. (i) Facts. Taxpayer H, an accounting firm, leases a
parking facility adjacent to its office building. H incurs $10,000 of
total parking expenses related to the lease payments in 2020. H's leased
parking facility has 100 spaces that are used by its clients and
employees. None of the parking spaces are reserved. The number of
available parking spaces used by H's employees during the peak demand
period is 60.
(ii) Methodology. H uses the primary use methodology in paragraph
(d)(2)(ii)(B) of this section to determine the amount of parking
expenses that are disallowed under section 274(a)(4).
[[Page 1009]]
(iii) Step 1. Because none of H's leased parking spaces are
exclusively reserved for employees, there is no amount to be
specifically allocated to reserved employee spaces under paragraph
(d)(2)(ii)(B)(1) of this section.
(iv) Step 2. The primary use of H's leased parking facility under
paragraph (d)(2)(ii)(B)(2) of this section is not to provide parking to
the general public because 60% (60/100 = 60%) of the lot is used by its
employees. Thus, H may not utilize the general public exception from the
section 274(a)(4) disallowance provided by section 274(e)(7) and
paragraph (e)(2)(ii) of this section.
(v) Step 3. Because none of H's parking spaces are exclusively
reserved for nonemployees, there is no amount to be specifically
allocated to reserved nonemployee spaces under paragraph
(d)(2)(ii)(B)(3) of this section.
(vi) Step 4. H must reasonably determine the use of the parking
spaces and the related expenses allocable to employee parking. Because
the number of available parking spaces used by H's employees during the
peak demand period is 60, H reasonably determines that 60% (60/100 =
60%) of H's total parking expenses or $6,000 ($10,000 x 60% = $6,000) is
subject to the section 274(a)(4) disallowance under paragraph
(d)(2)(ii)(B)(4) of this section.
(9) Example 9. (i) Facts. Taxpayer I, a large manufacturer, owns
multiple parking facilities adjacent to its manufacturing plant,
warehouse, and office building at its complex in the city of X. All of
I's tracts or parcels of land at its complex in city X are located in a
single geographic location. I owns parking facilities in other cities. I
incurs $50,000 of total parking expenses related to the parking
facilities at its complex in city X in 2020. I's parking facilities at
its complex in city X have 10,000 total parking spaces that are used by
its visitors and employees of which 500 are reserved for management. All
other spaces at parking facilities in I's complex in city X are
nonreserved. The number of nonreserved spaces used by I's employees
other than management during the peak demand period at I's parking
facilities in city X is 8,000.
(ii) Methodology. I uses the primary use methodology in paragraph
(d)(2)(ii)(B) of this section to determine the amount of parking
expenses that are disallowed under section 274(a)(4). I chooses to apply
the aggregation rule in paragraph (c) of this section to aggregate all
parking facilities in the geographic location that comprises its complex
in city X. However, I may not aggregate parking facilities in other
cities with its parking facilities in city X because they are in
different geographic locations.
(iii) Step 1. Because 500 spaces are reserved for management, $2,500
((500/10,000) x $50,000 = $2,500) is the amount of total parking
expenses that is nondeductible for reserved employee spaces for I's
parking facilities in city X under section 274(a)(4) and paragraphs (a)
and (d)(2)(ii)(B)(1) of this section.
(iv) Step 2. The primary use of the remainder of I's parking
facility is not to provide parking to the general public because 84%
(8,000/9,500 = 84%) of the available parking spaces in the facility are
used by its employees. Thus, expenses allocable to these spaces are not
excepted from the section 274(a)(4) disallowance by section 274(e)(7) or
paragraph (e)(2)(ii) of this section under the primary use test in
paragraph (d)(2)(ii)(B)(2) of this section.
(v) Step 3. Because none of I's parking spaces in its parking
facilities in city X are exclusively reserved for nonemployees, there is
no amount to be specifically allocated to reserved nonemployee spaces
under paragraph (d)(2)(ii)(B)(3) of this section.
(vi) Step 4. I must reasonably determine the use of the remaining
parking spaces and the related expenses allocable to employee parking
for its parking facilities in city X. Because the number of available
parking spaces used by I's employees during the peak demand period in
city X during an average workday is 8,000, I reasonably determines that
84.2% (8,000/9,500 = 84.2%) of I's remaining parking expense or $39,900
(($50,000-$2,500) x 84% = $39,900) is subject to the section 274(a)(4)
disallowance under paragraph (d)(2)(ii)(B)(4) of this section.
(10) Example 10. (i) Taxpayer J, a manufacturer, owns a parking
facility and incurs the following mixed parking
[[Page 1010]]
expenses (along with other parking expenses): Property taxes, utilities,
insurance, security expenses, and snow removal expenses. In accordance
with paragraph (b)(12)(i) and (ii) of this section, J determines its
total parking expenses by allocating 5% of its property tax, utilities,
and insurance expenses to its parking facility. J uses a reasonable
methodology to allocate to its parking facility an applicable portion of
its security and snow removal expenses. J determines that it incurred
$100,000 of total parking expenses in 2020. J's parking facility has 500
spaces that are used by its visitors and employees. The number of total
parking spaces used by J's employees during the peak demand period is
475.
(ii) J uses the cost per space methodology described in paragraph
(d)(2)(ii)(C) of this section to determine the amount of parking
expenses that are disallowed under section 274(a)(4). Under this
methodology, J multiplies the cost per space by the number of total
parking spaces used by J's employees during the peak demand period. J
calculates the cost per space by dividing total parking expenses by the
number of total parking spaces ($100,000/500 = $200). J determines that
$95,000 ($200 x 475 = $95,000) of J's total parking expenses is subject
to the section 274(a)(4) disallowance and none of the exceptions in
section 274(e) or paragraph (e) of this section are applicable.
(11) Example 11. Taxpayer K operates an industrial plant with a
parking facility in a rural area in which no commercial parking is
available. K provides qualified parking at the plant to its employees
free of charge. Further, an individual other than an employee ordinarily
would not consider paying any amount to park in the plant's parking
facility. Although K does not charge its employees for the qualified
parking, the exception in section 274(e)(8) and this paragraph
(e)(3)(iii) will apply to K's total parking expenses if in a bona fide
transaction, the adequate and full consideration for the qualified
parking is zero. In order to treat the adequate and full consideration
as zero, K bears the burden of proving that the parking has no objective
value. K is treated as satisfying this burden because the parking is
provided in a rural area in which no commercial parking is available and
in which an individual other than an employee ordinarily would not
consider paying any amount to park in the parking facility. Therefore,
the exception in paragraph (e)(2)(iii) of this section applies to K's
total parking expenses and a deduction for the expenses is not
disallowed by reason of section 274(a)(4).
(g) Applicability date. This section applies to taxable years
beginning on or after December 16, 2020. However, taxpayers may choose
to apply Sec. 1.274-13(b)(14)(ii) to taxable years ending after
December 31, 2019.
[T.D. 9939, 85 FR 81402, Dec. 16, 2020, as amended by 86 FR 22345, Apr.
28, 2021]
Sec. 1.274-14 Disallowance of deductions for certain transportation
and commuting benefit expenditures.
(a) General rule. Except as provided in this section, no deduction
is allowed for any expense incurred for providing any transportation, or
any payment or reimbursement, to an employee of the taxpayer in
connection with travel between the employee's residence and place of
employment. The disallowance is not subject to the exceptions provided
in section 274(e). The disallowance applies regardless of whether the
travel between the employee's residence and place of employment includes
more than one mode of transportation, and regardless of whether the
taxpayer provides, or pays or reimburses the employee for, all modes of
transportation used during the trip. For example, the disallowance
applies if an employee drives a personal vehicle to a location where a
different mode of transportation is used to complete the trip to the
place of employment, even though the taxpayer may not incur any expense
for the portion of travel in the employee's personal vehicle. The rules
in section 274(l) and this section do not apply to business expenses
under section 162(a)(2) paid or incurred while traveling away from home.
The rules in section 274(l) and this section also do not apply to any
expenditure for any qualified transportation fringe (as defined in
section 132(f)) provided to an employee of the taxpayer. All qualified
transportation
[[Page 1011]]
fringe expenses are required to be analyzed under section 274(a)(4) and
Sec. 1.274-13.
(b) Exception. The disallowance for the deduction for expenses
incurred for providing any transportation or commuting in paragraph (a)
of this section does not apply if the transportation or commuting
expense is necessary for ensuring the safety of the employee. The
transportation or commuting expense is necessary for ensuring the safety
of the employee if unsafe conditions, as described in Sec. 1.61-
21(k)(5), exist for the employee.
(c) Definitions. The following definitions apply for purposes of
this section:
(1) Employee. The term employee means an employee of the taxpayer as
defined in section 3121(d)(1) and (2) (that is, officers of a corporate
taxpayer and employees of the taxpayer under the common law rules).
(2) Residence. The term residence means a residence as defined in
Sec. 1.121-1(b)(1). An employee's residence is not limited to the
employee's principal residence.
(3) Place of employment. The term place of employment means the
employee's regular or principal (if more than one regular) place of
business. An employee's place of employment does not include temporary
or occasional places of employment. An employee must have at least one
regular or principal place of business.
(d) Applicability date. This section applies to taxable years
beginning on or after December 16, 2020.
[T.D. 9939, 85 FR 81408, Dec. 16, 2020]
Sec. 1.275-1 Deduction denied in case of certain taxes.
For description of the taxes for which a deduction is denied under
section 275, see paragraphs (a), (b), (c), (e), and (h) of Sec. 1.164-
2.
[T.D. 6780, 29 FR 18148, Dec. 22, 1964, as amended by T.D. 7767, 46 FR
11264, Feb. 6, 1981]
Sec. 1.276-1 Disallowance of deductions for certain indirect
contributions to political parties.
(a) In general. Notwithstanding any other provision of law, no
deduction shall be allowed for income tax purposes in respect of any
amount paid or incurred after March 15, 1966, in a taxable year of the
taxpayer beginning after December 31, 1965, for any expenditure to which
paragraph (b)(1), (c), (d), or (e) of this section is applicable.
Section 276 is a disallowance provision exclusively and does not make
deductible any expenses which are not otherwise allowed under the Code.
For certain other rules in respect of deductions for expenditures for
political purposes, see Sec. Sec. 1.162-15(b), 1.162-20, and 1.271-1.
(b) Advertising in convention program--(1) General rule. (i) Except
as provided in subparagraph (2) of this paragraph, no deduction shall be
allowed for an expenditure for advertising in a convention program of a
political party. For purposes of this subparagraph it is immaterial who
publishes the convention program or to whose use the proceeds of the
program inure (or are intended to inure). A convention program is any
written publication (as defined in paragraph (c) of this section) which
is distributed or displayed in connection with or at a political
convention, conclave, or meeting. Under certain conditions payments to a
committee organized for the purpose of bringing a political convention
to an area are deductible under paragraph (b) of Sec. 1.162-15. This
rule is not affected by the provisions of this section. For example,
such payments may be deductible notwithstanding the fact that the
committee purchases from a political party the right to publish a
pamphlet in connection with a convention and that the deduction of costs
of advertising in the pamphlet is prohibited under this section.
(ii) The application of the provisions of this subparagraph may be
illustrated by the following example:
Example. M Corporation publishes the convention program of the Y
political party for a convention not described in subparagraph (2) of
this paragraph. The corporation makes no payment of any kind to or on
behalf of the party or any of its candidates and no part of the proceeds
of the publication and sale of the program inures directly or indirectly
to the benefit of any political party or candidate. P Corporation
purchases an advertisement in the program. P Corporation may not deduct
the cost of such advertisement.
[[Page 1012]]
(2) Amounts paid or incurred on or after January 1, 1968, for
advertising in programs of certain national political conventions. (i)
Subject to the limitations in subdivision (ii) of this subparagraph, a
deduction may be allowed for any amount paid or incurred on or after
January 1, 1968, for advertising in a convention program of a political
party distributed in connection with a convention held for the purpose
of nominating candidates for the offices of President and Vice President
of the United States, if the proceeds from the program are actually used
solely to defray the costs of conducting the convention (or are set
aside for such use at the next convention of the party held for such
purpose) and if the amount paid or incurred for the advertising is
reasonable. If such amount is not reasonable or if any part of the
proceeds is used for a purpose other than that of defraying such
convention costs, no part of the amount is deductible. Whether or not an
amount is reasonable shall be determined in light of the business the
taxpayer may expect to receive either directly as a result of the
advertising or as a result of the convention being held in an area in
which the taxpayer has a principal place of business. For these
purposes, an amount paid or incurred for advertising will not be
considered as reasonable if it is greater than the amount which would be
paid for comparable advertising in a comparable convention program of a
nonpolitical organization. Institutional advertising (e.g., advertising
of a type not designed to sell specific goods or services to persons
attending the convention) is not advertising which may be expected to
result directly in business for the taxpayer sufficient to make the
expenditures reasonable. Accordingly, an amount spent for institutional
advertising in a convention program may be deductible only if the
taxpayer has a principal place of business in the area where the
convention is held. An official statement made by a political party
after a convention as to the use made of the proceeds from its
convention program shall constitute prima facie evidence of such use.
(ii) No deduction may be taken for any amount described in this
subparagraph which is not otherwise allowable as a deduction under
section 162, relating to trade or business expenses. Therefore, in order
for any such amount to be deductible, it must first satisfy the
requirements of section 162, and, in addition, it must also satisfy the
more restrictive requirements of this subparagraph.
(c) Advertising in publication other than convention program. No
deduction shall be allowed for an expenditure for advertising in any
publication other than a convention program if any part of the proceeds
of such publication directly or indirectly inures (or is intended to
inure) to or for the use of a political party or a political candidate.
For purposes of this paragraph, a publication includes a book, magazine,
pamphlet, brochure, flier, almanac, newspaper, newsletter, handbill,
billboard, menu, sign, scorecard, program, announcement, radio or
television program or announcement, or any similar means of
communication. For the definition of inurement of proceeds to a
political party or a political candidate, see paragraph (f)(3) of this
section.
(d) Admission to dinner or program. No deduction shall be allowed
for an expenditure for admission to any dinner or program, if any part
of the proceeds of such event directly or indirectly inures (or is
intended to inure) to or for the use of a political party or a political
candidate. For purposes of this paragraph, a dinner or program includes
a gala, dance, ball, theatrical or film presentation, cocktail or other
party, picnic, barbecue, sporting event, brunch, tea, supper, auction,
bazaar, reading, speech, forum, lecture, fashion show, concert, opening,
meeting, gathering, or any similar event. For the definition of
inurement of proceeds to a political party or a political candidate and
of admission to a dinner or program, see paragraph (f) of this section.
(e) Admission to inaugural event. (1) No deduction shall be allowed
for an expenditure for admission to an inaugural ball, inaugural gala,
inaugural parade, or inaugural concert, or to any similar event (such as
a dinner or program, as defined in paragraph (d) of this section), in
connection with the inauguration or installation in office of
[[Page 1013]]
any official, or any equivalent event for an unsuccessful candidate, if
the event is identified with a political party or a political candidate.
For purposes of this paragraph, the sponsorship of the event and the use
to which the proceeds of the event are or may be put are irrelevant,
except insofar as they may tend to identify the event with a political
party or a political candidate. For the definition of admission to an
inaugural event, see paragraph (f)(4) of this section.
(2) The application of the provisions of this paragraph may be
illustrated by the following example:
Example. An inaugural reception for A, a prominent member of Y party
who has been recently elected judge of the municipal court of F city, is
held with the proceeds going to the city treasury. The price of
admission to such affair is not deductible.
(f) Definitions--(1) Political party. For purposes of this section
the term political party has the same meaning as that provided for in
paragraph (b)(1) of Sec. 1.271-1.
(2) Political candidate. For purposes of this section, the term
political candidate is to be construed in accordance with the purpose of
section 276 to deny tax deductions for certain expenditures which may be
used directly or indirectly to finance political campaigns. The term
includes a person who, at the time of the event or publication with
respect to which the deduction is being sought, has been selected or
nominated by a political party for any elective office. It also includes
an individual who is generally believed, under the facts and
circumstances at the time of the event or publication, by the persons
making expenditures in connection therewith to be an individual who is
or who in the reasonably foreseeable future will be seeking selection,
nomination, or election to any public office. For purposes of the
preceding sentence, the facts and circumstances to be considered
include, but are not limited to, the purpose of the event or publication
and the disposition to be made of the proceeds. In the absence of
evidence to the contrary it shall be presumed that persons making
expenditures in connection with an event or publication generally
believe that an incumbent of an elective public office will run for
reelection to his office or for election to some other public office.
(3) Inurement of proceeds to political party or political
candidate--(i) In general. Subject to the special rules presented in
subdivision (iii) of this subparagraph (relating to a political
candidate), proceeds directly or indirectly inure to or for the use of a
political party or a political candidate (a) if the party or candidate
may order the disposition of any part of such proceeds, regardless of
what use is actually made thereof, or (b) if any part of such proceeds
is utilized by any person for the benefit of the party or candidate.
These conditions are equally applicable in determining whether the
proceeds are intended to inure. Accordingly, it is immaterial whether
the event or publication operates at a loss if, had there been a profit,
any part of the proceeds would have inured to or for the use of a
political party or a political candidate. Moreover, it shall be presumed
that where a dinner, program, or publication is sponsored by or
identified with a political party or political candidate, the proceeds
of such dinner, program, or publication directly or indirectly inure (or
are intended to inure) to or for the use of the party or candidate. On
the other hand, proceeds are not considered to directly or indirectly
inure to the benefit of a political party or political candidate if the
benefit derived is so remote as to be negligible or merely a coincidence
of the relationship of a political candidate to a trade or business
profiting from an expenditure of funds. For example, the proceeds of
expenditures made by a taxpayer in the ordinary course of his trade or
business for advertising in a publication, such as a newspaper or
magazine, are not considered as inuring to the benefit of a political
party or political candidate merely because the publication endorses a
particular political candidate or candidates of a particular political
party, the publisher independently contributes to the support of a
political party or candidate out of his own personal funds, or the
principal stockholder of the publishing firm is a candidate for public
office.
(ii) Proceeds to political party. If a political party may order the
disposition
[[Page 1014]]
of any part of the proceeds of a publication or event described in
paragraph (c) or (d) of this section, such proceeds inure to the use of
the party regardless of what the proceeds are to be used for or that
their use is restricted to a particular purpose unrelated to the
election of specific candidates for public office. Accordingly, where a
political party holds a dinner for the purpose of raising funds to be
used in a voter registration drive, voter education program, or
nonprofit political research program, partisan or nonpartisan, the
proceeds are considered to directly or indirectly inure to or for the
use of the political party. Proceeds may inure to or for the use of a
political party even though they are to be used for purposes which may
not be directly related to any particular election (such as to pay
office rent for its permanent quarters, salaries to permanent employees,
or utilities charges, or to pay the cost of an event such as a dinner or
program as defined in paragraph (d) of this section).
(iii) Proceeds to political candidate. Proceeds directly or
indirectly inure (or are intended to inure) to or for the use of a
political candidate if, in addition to meeting the conditions described
in subdivision (i) of this subparagraph, (a) some part of the proceeds
is or may be used directly or indirectly for the purpose of furthering
his candidacy for selection, nomination, or election to any elective
public office, and (b) they are not received by him in the ordinary
course of a trade or business (other than the trade or business of
holding public office). Proceeds may so inure whether or not the
expenditure sought to be deducted was paid or incurred before the
commencement of political activities with respect to the selection,
nomination, or election referred to in (a) of this subdivision, or after
such selection, nomination, or election has been made or has taken
place. For example, proceeds of an event which may be used by an
individual who, under the facts and circumstances at the time of the
event, the persons making expenditures in connection therewith generally
believe will in the reasonably foreseeable future run for a public
office, and which may be used in furtherance of such individual's
candidacy, generally will be deemed to inure (or to be intended to
inure) to or for the use of a political candidate for the purpose of
furthering such individual's candidacy. Or, as another example, proceeds
of an event occurring after an election, which may be used by a
candidate in that election to repay loans incurred in directly or
indirectly furthering his candidacy, or in reimbursement of expenses
incurred in directly or indirectly furthering his candidacy, will be
deemed to directly or indirectly inure (or to be intended to inure) to
or for the use of a political candidate for the purpose of furthering
his candidacy. For purposes of this subdivision, if the proceeds
received by a candidate exceed substantially the fair market value of
the goods furnished or services rendered by him, the proceeds are not
received by the candidate in the ordinary course of his trade or
business.
(iv) The application of the provisions of this subparagraph may be
illustrated by the following examples:
Example 1. Corporation O pays the Y political party $100,000 per
annum for the right to publish the Y News, and retains the entire
proceeds from the sale of the publication. Amounts paid or incurred for
advertising in the Y News are not deductible because a part of the
proceeds thereof indirectly inures to or for the use of a political
party.
Example 2. The X political party holds a highly publicized ball
honoring one of its active party members and admission tickets are
offered to all. The guest of honor is a prominent national figure and a
former incumbent of a high public office. The price of admission is
designed to cover merely the cost of entertainment, food, and the
ballroom, and all proceeds are paid to the hotel where the function is
held, with the political party bearing the cost of any deficit. No
deduction may be taken for the price of admission to the ball since the
proceeds thereof inure to or for the use of a political party.
Example 3. Taxpayer A, engaged in a trade or business, purchases a
number of tickets for admission to a fundraising affair held on behalf
of political candidate B. The funds raised by this affair can be used by
B for the purpose of furthering his candidacy. These expenditures are
not deductible by A notwithstanding that B donates the proceeds of the
affair to a charitable organization.
Example 4. A, an individual taxpayer who publishes a newspaper, is a
candidate for elective public office. X Corporation advertises its
products in A's newspaper, paying substantially more than the normal
rate for
[[Page 1015]]
such advertising. X Corporation may not deduct any portion of the cost
of that advertising.
(4) Admission to dinners, programs, inaugural events. For purposes
of this section, the cost of admission to a dinner, program, or
inaugural event includes all charges, whether direct or indirect, for
attendance and participation at such function. Thus, for example,
amounts spent to be eligible for door prizes, for the privilege of
sitting at the head table, or for transportation furnished as part of
such an event, or any separate charges for food or drink, are amounts
paid for admission.
[T.D. 6996, 34 FR 833, Jan. 18, 1969, as amended by T.D. 7010, 34 FR
7145, May 1, 1969]