[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

[[Page iv]]





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

                     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

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2023), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
dates and effective dates are usually not the same and care must be 
exercised by the user in determining the actual effective date. In 
instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
inserted following the text.

OMB CONTROL NUMBERS

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

[[Page vi]]

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

PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 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

``[RESERVED]'' TERMINOLOGY

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

INCORPORATION BY REFERENCE

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

    A subject index to the Code of Federal Regulations is contained in a 
separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Authorities 
and Rules. A list of CFR titles, chapters, subchapters, and parts and an 
alphabetical list of agencies publishing in the CFR are also included in 
this volume.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.

[[Page vii]]

    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

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in the Code of Federal Regulations.

INQUIRIES

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

SALES

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ELECTRONIC SERVICES

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

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







[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations codified 
under this title by the Internal Revenue Service, Department of the 
Treasury, as of April 1, 2023. The first fifteen volumes comprise part 1 
(Subchapter A--Income Tax) and are arranged by sections as follows: 
Sec. Sec.  1.0-1.60; Sec. Sec.  1.61-1.139; Sec. Sec.  1.140-1.169; 
Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; Sec. Sec.  1.401-1.409; 
Sec. Sec.  1.410-1.440; Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; 
Sec. Sec.  1.641-1.850; Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; 
Sec. Sec.  1.1001-1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to 
end of part 1. The sixteenth volume containing parts 2-29, includes the 
remainder of subchapter A and all of Subchapter B--Estate and Gift 
Taxes. The last six volumes contain parts 30-39 (Subchapter C--
Employment Taxes and Collection of Income Tax at Source); parts 40-49; 
parts 50-299 (Subchapter D--Miscellaneous Excise Taxes); parts 300-499 
(Subchapter F--Procedure and Administration); parts 500-599 (Subchapter 
G--Regulations under Tax Conventions); and part 600 to end (Subchapter 
H--Internal Revenue Practice).

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

    For this volume, 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)

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

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

[[Page 3]]



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




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

                  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

[[Page 62]]

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

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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

[[Page 118]]

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,

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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.

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    (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

[[Page 124]]

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

[[Page 125]]

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:

[[Page 126]]

    (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

[[Page 127]]

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

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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

[[Page 130]]

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

[[Page 131]]

    (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

[[Page 273]]

(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

[[Page 280]]

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

[[Page 281]]

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)

[[Page 282]]

(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

[[Page 290]]

    (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.

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    (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

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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

[[Page 295]]

    (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

[[Page 296]]

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

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    (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

[[Page 302]]

    (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]

[[Page 303]]

    (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

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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.

[[Page 314]]

    (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.

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    (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

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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

[[Page 320]]

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

[[Page 321]]

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

[[Page 325]]

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

[[Page 326]]

$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

[[Page 327]]

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,

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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

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(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

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(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,

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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

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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

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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):

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    (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

[[Page 348]]

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

[[Page 349]]

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

[[Page 350]]

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;

[[Page 351]]

    (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

[[Page 352]]

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

[[Page 355]]

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

[[Page 356]]

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.

[[Page 362]]

    (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

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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

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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

[[Page 377]]

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

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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

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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

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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

[[Page 555]]

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

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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

[[Page 614]]

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]



Sec. 1.278-1  Capital expenditures incurred in planting and developing
citrus and almond groves.

    (a) General rule. (1)(i) Except as provided in subparagraph (2)(iii) 
of this paragraph and paragraph (b) of this section, there shall be 
charged to capital account any amount (allowable as a deduction without 
regard to section 278 or this section) which is attributable to the 
planting, cultivation, maintenance, or development of any citrus or 
almond grove (or part thereof), and which is incurred before the close 
of the fourth taxable year beginning with the taxable year in which the 
trees were planted. For purposes of section 278 and this section, such 
an amount shall be considered as ``incurred'' in accordance with the 
taxpayer's regular tax accounting method used in reporting income and 
expenses connected with the citrus or almond grove operation. For 
purposes of this paragraph, the portion of a citrus or almond grove 
planted in 1 taxable year shall be treated separately from the portion 
of such grove planted in another taxable year. The provisions of section 
278 and this section apply to taxable years beginning after December 31, 
1969, in the case of a citrus grove, and to taxable years beginning 
after January 12, 1971, in the case of an almond grove.
    (ii) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. T, a fiscal year taxpayer plants a citrus grove 5 weeks 
before the close of his taxable year ending in 1971. T is required to 
capitalize any amount (allowable as a deduction without regard to 
section 278 or this section) attributable to the planting, cultivation, 
maintenance, or development of such grove until the close of his taxable 
year ending in 1974.
    Example 2. Assume the same facts as in Example 1, except that T 
plants one portion of such grove 5 weeks before the close of his taxable 
year ending in 1971 and another portion of such grove at the beginning 
of his taxable year ending in 1972. The required capitalization period 
for expenses attributable to the first portion of such grove shall run 
until the close of T's taxable year ending in 1974. The required 
capitalization period for expenses attributable to the second portion of 
such grove shall run until the close of T's taxable year ending in 1975.

    (2)(i) For purposes of section 278 and this section a citrus grove 
is defined as one or more trees of the rue family, often thorny and 
bearing large fruit with hard, usually thick peel and pulpy flesh, such 
as the orange, grapefruit, lemon, lime, citron, tangelo, and tangerine.
    (ii) For purposes of section 278 and this section, an almond grove 
is defined as one or more trees of the species Prunus amygdalus.
    (iii) An amount attributable to the cultivation, maintenance, or 
development of a citrus or almond grove (or part thereof) shall include, 
but shall not be limited to, the following developmental or cultural 
practices expenditures: Irrigation, cultivation, pruning, fertilizing, 
management fees, frost protection, spraying, and upkeep of the citrus or 
almond grove. The provisions of section 278(a) and this paragraph shall 
apply to expenditures for fertilizer and related materials 
notwithstanding the provisions of section 180, but shall not apply to 
expenditures attributable to real estate taxes or interest, to soil and 
water conservation expenditures allowable as a deduction under section 
175, or to expenditures for clearing land allowable as a deduction under 
section 182. Further, the provisions of section 278(a) and this 
paragraph apply only to expenditures allowable as deductions without 
regard to section 278 and have no application to expenditures otherwise 
chargeable to capital account, such as the cost of the land and 
preparatory expenditures

[[Page 1016]]

incurred in connection with the citrus or almond grove.
    (iv) For purposes of section 278 and this section, a citrus or 
almond tree shall be considered to be ``planted'' on the date on which 
the tree is placed in the permanent grove from which production is 
expected.
    (3)(i) The period during which expenditures described in section 
278(a) and this paragraph are required to be capitalized shall, once 
determined, be unaffected by a sale or other disposition of the citrus 
or almond grove. Such period shall, in all cases, be computed by 
reference to the taxable years of the owner of the grove at the time 
that the citrus or almond trees were planted. Therefore, if a citrus or 
almond grove subject to the provisions of section 278 or this paragraph 
is sold or otherwise transferred by the original owner of the grove 
before the close of his fourth taxable year beginning with the taxable 
year in which the trees were planted, expenditures described in section 
278(a) or this paragraph made by the purchaser or other transferee of 
the citrus or almond grove from the date of his acquisition until the 
close of the original holder's fourth such taxable year are required to 
be capitalized.
    (ii) The provisions of this subparagraph may be illustrated by the 
following example:

    Example. T, a fiscal year taxpayer, plants a citrus grove at the 
beginning of his taxable year ending in 1971. At the beginning of his 
taxable year ending in 1972, T sells the grove to X. The required period 
during which expenditures described in section 278 (a) are required to 
be capitalized runs from the date on which T planted the grove until the 
end of T's taxable year ending in 1974. Therefore, X must capitalize any 
such expenditures incurred by him from the time he purchased the grove 
from T until the end of T's taxable year ending in 1974.

    (b) Exceptions. (1) Paragraph (a) of this section shall not apply to 
amounts allowable as deductions (without regard to section 278 or this 
section) and attributable to a citrus or almond grove (or part thereof) 
which is replanted by a taxpayer after having been lost or damaged 
(while in the hands of such taxpayer) by reason of freeze, disease, 
drought, pests, or casualty.
    (2)(i) Paragraph (a) of this section shall not apply to amounts 
allowable as deductions (without regard to section 278 or this section), 
and attributable to a citrus grove (or part thereof) which was planted 
or replanted prior to December 30, 1969, or to an almond grove (or part 
thereof) which was planted or replanted prior to December 30, 1970.
    (ii) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. T, a fiscal year taxpayer with a taxable year of July 1, 
1969, through v June 30, 1970, plants a citrus grove on August 1, 1969. 
Since the grove was planted prior to December 30, 1969, no expenses 
incurred with respect to the grove shall be subject to the provisions of 
paragraph (a).
    Example 2. Assume the same facts as in Example 1, except that T 
plants the grove on March 1, 1970. Since the grove was planted after 
December 30, 1969, all amounts allowable as deductions (without regard 
to section 278 or this section) and attributable to the grove shall be 
subject to the provisions of paragraph (a). However, since paragraph (a) 
applies only to taxable years beginning after December 31, 1969, T must 
capitalize only those amounts incurred during his taxable years ending 
in 1971, 1972, and 1973.

[T.D. 7098, 36 FR 5214, Mar. 18, 1971, as amended by T.D. 7136, 36 FR 
14731, Aug. 11, 1971]



Sec. 1.279-1  General rule; purpose.

    An obligation issued to provide a consideration directly or 
indirectly for a corporate acquisition, although constituting a debt 
under section 385, may have characteristics which make it more 
appropriate that the participation in the corporation which the 
obligation represents be treated for purposes of the deduction of 
interest as if it were a stockholder interest rather than a creditors 
interest. To deal with such cases, section 279 imposes certain 
limitations on the deductibility of interest paid or incurred on 
obligations which have certain equity characteristics and are classified 
as corporate acquisition indebtedness. Generally, section 279 provides 
that no deduction will be allowed for any interest paid or incurred by a 
corporation during the taxable year with respect to its corporate 
acquisition indebtedness to the extent

[[Page 1017]]

such interest exceeds $5 million. However, the $5 million limitation is 
reduced by the amount of interest paid or incurred on obligations issued 
under the circumstances described in section 279(a)(2) but which are not 
corporate acquisition indebtedness. Section 279(b) provides that an 
obligation will be corporate acquisition indebtedness if it was issued 
under certain circumstances and meets the four tests enumerated therein. 
Although an obligation may satisfy the conditions referred to in the 
preceding sentence, it may still escape classification as corporate 
acquisition indebtedness if the conditions as described in sections 
279(d) (3), (4), and (5), 279(f), or 279(i) are present. However, no 
inference should be drawn from the rules of section 279 as to whether a 
particular instrument labeled a bond, debenture, note, or other evidence 
of indebtedness is in fact a debt. Before the determination as to 
whether the deduction for payments pursuant to an obligation as 
described in this section is to be disallowed, the obligation must first 
qualify as debt in accordance with section 385. If the obligation is not 
debt under section 385, it will be unnecessary to apply section 279 to 
any payments pursuant to such obligation.

[T.D. 7262, 38 FR 5844, Mar. 5, 1973]



Sec. 1.279-2  Amount of disallowance of interest on corporate 
acquisition indebtedness.

    (a) In general. Under section 279(a), no deduction is allowed for 
any interest paid or incurred by a corporation during the taxable year 
with respect to its corporate acquisition indebtedness to the extent 
that such interest exceeds:
    (1) $5 million, reduced by
    (2) The amount of interest paid or incurred by such corporation 
during such year on any obligation issued after December 31, 1967, to 
provide consideration directly or indirectly for an acquisition 
described in section 279(b)(1) but which is not corporate acquisition 
indebtedness. Such an obligation is not corporate acquisition 
indebtedness if it:
    (i) Was issued prior to October 10, 1969, or
    (ii) Was issued after October 9, 1969, but does not meet any one or 
more of the tests of section 279(b) (2), (3), or (4), or
    (iii) Was originally deemed to be corporate acquisition indebtedness 
but is no longer so treated by virtue of the application of paragraphs 
(3) or (4) of section 279(d) or
    (iv) Is specifically excluded from treatment as corporate 
acquisition indebtedness by virtue of sections 279(d)(5), (f), or (i).

The computation of the amount by which the $5 million limitation 
described in this paragraph is to be reduced with respect to any taxable 
year is to be made as of the last day of the taxable year in which an 
acquisition described in section 279(b)(1) occurs. In no case shall the 
$5 million limitation be reduced below zero.
    (b) Certain terms defined. When used in section 279 and the 
regulations thereunder:
    (1) The term issued includes the giving of a note or other evidence 
of indebtedness to a bank or other lender as well as an issuance of a 
bond or debenture. In the case of obligations which are registered with 
the Securities and Exchange Commission, the date of issue is the date on 
which the issue is first offered to the public. In the case of 
obligations which are not so registered, the date of issue is the date 
on which the obligation is sold to the first purchaser.
    (2) The term interest includes both stated interest and unstated 
interest (such as original issue discount as defined in paragraph (a)(1) 
of Sec. 1.163-4 and amounts treated as interest under section 483).
    (3) The term money means cash and its equivalent.
    (4) The term control shall have the meaning assigned to such term by 
section 368(c).
    (5) The term affiliated group shall have the meaning assigned to 
such term by section 1504(a), except that all corporations other than 
the acquired corporation shall be treated as includible corporations 
(without any exclusion under section 1504(b)) and the acquired 
corporation shall not be treated as an includible corporation. This 
definition shall apply whether or not some or all of the members of the 
affiliated group file a consolidated return.

[[Page 1018]]

    (c) Examples. The provisions of paragraph (a) of this section may be 
illustrated by the following examples:

    Example 1. On March 4, 1973, X Corporation, a calendar year 
taxpayer, issues an obligation which satisfies the test of section 
279(b)(1) but fails to satisfy either of the tests of section 279(b) (2) 
or (3). Since at least one of the tests of section 279(b) is not 
satisfied the obligation is not corporate acquisition indebtedness. 
However, since the test of section 279(b)(1) is satisfied, the interest 
on the obligation will reduce the $5 million limitation provided by 
section 279 (a)(1).
    Example 2. On January 1, 1969, X Corporation, a calendar year 
taxpayer, issues an obligation, which satisfies all the tests of section 
279(b), requiring it to pay $3.5 million of interest each year. Since 
the obligation was issued before October 10, 1969, the obligation cannot 
be corporate acquisition indebtedness, and a deduction for the $3.5 
million of interest attributable to such obligation is not subject to 
disallowance under section 279(a). However, since the obligation was 
issued after December 31, 1967, in an acquisition described in section 
279(b)(1), under section 279(a)(2) the $3.5 million of interest 
attributable to such obligation reduces the $5 million limitation 
provided by section 279(a)(1) to $1.5 million.
    Example 3. Assume the same facts as in Example 2. Assume further 
that on January 1, 1970, X Corporation issues more obligations which are 
classified as corporate acquisition indebtedness and which require X 
Corporation to pay $4 million of interest each year. For 1970 the amount 
of interest paid or accrued on corporate acquisition indebtedness, which 
may be deducted is $1.5 million ($5 million maximum provided by section 
279(a)(1) less $3.5 million, the reduction required under section 
279(a)(2)). Thus, $2.5 million of the $4 million interest incurred on a 
corporate acquisition indebtedness is subject to disallowance under 
section 279(a) for the taxable year 1970.
    Example 4. Assume the same facts as in Example 3. Assume further 
that on the last day of each of the taxable years 1971, 1972, and 1973 
of X Corporation neither of the conditions described in section 
279(b)(4) was present.
    Under these circumstances, such obligations for all taxable years 
after 1973 are not corporate acquisition indebtedness under section 
279(d)(4). Therefore, the $2.5 million of interest previously not 
deductible is not deductible for all taxable years after 1973. Although 
such obligations are no longer treated as corporate acquisition 
indebtedness, the interest attributable thereto must be applied in 
further reduction of the $5 million limitation. The $5 million 
limitation of section 279(a)(1) is therefore reduced to zero. While the 
limitation is at the zero level any interest paid or incurred on 
corporate acquisition indebtedness will be disallowed.

[T.D. 7262, 38 FR 5844, Mar. 5, 1973]



Sec. 1.279-3  Corporate acquisition indebtedness.

    (a) Corporate acquisition indebtedness. For purposes of section 279, 
the term corporate acquisition indebtedness means any obligation 
evidenced by a bond, debenture, note, or certificate or other evidence 
of indebtedness issued after October 9, 1969, by a corporation (referred 
to in section 279 and the regulations thereunder as ``issuing 
corporation'') if the obligation is issued to provide consideration 
directly or indirectly for the acquisition of stock in, or certain 
assets of, another corporation (as described in paragraph (b) of this 
Sec. 1.279-3), is ``subordinated'' (as described in paragraph (c) of 
this Sec. 1.279-3), is ``convertible'' (as described in paragraph (d) 
of this Sec. 1.279-3), and satisfies either the ratio of debt to equity 
test (as described in paragraph (f) of Sec. 1.279-5) or the projected 
earnings test (as described in paragraph (d) of Sec. 1.279-5).
    (b) Acquisition of stock or assets. (1) Section 279(b)(1) describes 
one of the tests to be satisfied if an obligation is to be classified as 
corporate acquisition indebtedness. Under section 279(b)(1), the 
obligation must be issued to provide consideration directly or 
indirectly for the acquisition of:
    (i) Stock (whether voting or nonvoting) in another corporation 
(referred to in section 279 and the regulations thereunder as ``acquired 
corporation''), or
    (ii) Assets of another corporation (referred to in section 279 and 
the regulations thereunder as ``acquired corporation'') pursuant to a 
plan under which at least two-thirds (in value) of all the assets 
(excluding money) used in trades or businesses carried on by such 
corporation are acquired.

The fact that the corporation that issues the obligation is not the same 
corporation that acquires the acquired corporation does not prevent the 
application of section 279. For example, if X Corporation acquires all 
the stock of Y Corporation through the utilization of

[[Page 1019]]

an obligation of Z Corporation, a wholly owned subsidiary of X 
Corporation, this section will apply.
    (2) Direct or indirect consideration. Obligations are issued to 
provide direct consideration for an acquisition within the meaning of 
section 279(b)(1) where the obligations are issued to the shareholders 
of an acquired corporation in exchange for stock in such acquired 
corporation or where the obligations are issued to the acquired 
corporation in exchange for its assets. The application of the 
provisions of this subsection relating to indirect consideration for an 
acquisition of stock or assets depends upon the facts and circumstances 
surrounding the acquisition and the issuance of the obligations. 
Obligations are issued to provide indirect consideration for an 
acquisition of stock or assets within the meaning of section 279(b)(1) 
where (i) at the time of the issuance of the obligations the issuing 
corporation anticipated the acquisition of such stock or assets and the 
obligations would not have been issued if the issuing corporation had 
not so anticipated such acquisition, or where (ii) at the time of the 
acquisition the issuing corporation foresaw or reasonably should have 
foreseen that it would be required to issue obligations, which it would 
not have otherwise been required to issue if the acquisition had not 
occurred, in order to meet its future economic needs.
    (3) Stock acquisition. (i) For purposes of section 279, an 
acquisition in which the issuing corporation issues an obligation to 
provide consideration directly or indirectly for the acquisition of 
stock in the acquired corporation shall be treated as a stock 
acquisition within the meaning of section 279(b)(1)(A). Where the stock 
of one corporation is acquired from another corporation and such stock 
constitutes at least two-thirds (in value) of all the assets (excluding 
money) of the latter corporation, such acquisition shall be deemed an 
asset acquisition as described in section 279(b)(1)(B) and subparagraph 
(4) of this section. If the issuing corporation acquires less than two-
thirds (in value) of all the assets (excluding money) used in trades or 
businesses carried on by the acquired corporation within the meaning of 
section 279(b)(1)(B) and subparagraph (4) of this paragraph and such 
assets include stock of another corporation, the acquisition of such 
stock is a stock acquisition within the meaning of section 279(b)(1)(A) 
and of this subparagraph. In such a case the amount of the obligation 
which is characterized as corporate acquisition indebtedness shall bear 
the same relationship to the total amount of the obligation issued as 
the fair market value of the stock acquired bears to the total of the 
fair market value of the assets acquired and stock acquired, as of the 
date of acquisition. For rules with respect to acquisitions of stock, 
where the total amount of stock of the acquired corporation held by the 
issuing corporation never exceeded 5 percent of the total combined 
voting power of all classes of stock of the acquired corporation 
entitled to vote, see Sec. 1.279-4(b)(1).
    (ii) If the issuing corporation acquired stock of an acquired 
corporation in an acquisition described in section 279(b)(1)(A), and 
liquidated the acquired corporation under section 334(b)(2) and the 
regulations thereunder before the last day of the taxable year in which 
such stock acquisition is made, such obligation issued to provide 
consideration directly or indirectly to acquire such stock of the 
acquired corporation shall be considered as issued in an acquisition 
described in section 279(b)(1)(B).
    (4) Asset acquisition. (i) For purposes of section 279, an 
acquisition in which the issuing corporation issues an obligation to 
provide consideration directly or indirectly for the acquisition of 
assets of an acquired corporation pursuant to a plan under which at 
least two-thirds of the gross value of all the assets (excluding money) 
used in trades and businesses carried on by such acquired corporation 
are acquired shall be treated as an asset acquisition within the meaning 
of section 279(b)(1)(B). For purposes of section 279(b)(1)(B), the gross 
value of any acquired asset shall be its fair market value as of the day 
of its acquisition. In determining the fair market value of an asset, no 
reduction shall be made for any liabilities, mortgages, liens, or other 
encumbrances to which the asset or any part thereof may be subjected. 
For purposes of this

[[Page 1020]]

subparagraph, an asset which has been actually used in the trades and 
businesses of a corporation but which is temporarily not being used in 
such trades and businesses shall be treated as if it is being used in 
such manner. For purposes of this paragraph, the day of acquisition will 
be determined by reference to the facts and circumstances surrounding 
the transaction.
    (ii) For purposes of the two-thirds test described in section 
279(b)(1)(B), the stock of any corporation which is controlled by the 
acquired corporation shall be considered as an asset used in the trades 
and businesses of such acquired corporation.
    (5) Certain nontaxable transactions. (i) Under section 279(e), an 
acquisition of stock of a corporation of which the issuing corporation 
is in control in a transaction in which gain or loss is not recognized 
shall be deemed an acquisition described in section 279(b)(1)(A) only if 
immediately before such transaction the acquired corporation was in 
existence, and the issuing corporation was not in control of such 
corporation. If the issuing corporation is a member of an affiliated 
group, then in accordance with section 279(g), the affiliated group 
shall be treated as the issuing corporation. Thus, any stock of the 
acquired corporation, owned by members of the affiliated group, shall be 
aggregated in determining whether the issuing corporation was in control 
of the acquired corporation.
    (ii) The $5 million limitation provided by section 279(a)(1) is not 
reduced by the interest on an obligation issued in a transaction which, 
under section 279 (e), is deemed not to be an acquisition described in 
section 279(b)(1).
    (iii) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. On January 1, 1973, W Corporation, a calendar year 
taxpayer, issues to the public 10,000 10 year convertible bonds each 
with a principal of $1,000 for $9 million. On June 6, 1973, W 
Corporation transfers the $9 million proceeds of such bond issue to X 
Corporation in exchange for X Corporation's common stock in a 
transaction that satisfies the provisions of section 351(a). On December 
31, 1973, W Corporation's ratio of debt to equity is 1\1/2\ to 1 and its 
project earnings exceed three times the annual interest to be paid or 
incurred. Immediately prior to the transaction between the two 
corporations W Corporation owned no stock in X Corporation which had 
been in existence for several years. However, immediately after this 
transaction W Corporation is in control of X Corporation. Since X 
Corporation, the acquired corporation, was in existence and W 
Corporation, the issuing corporation, was not in control of X 
Corporation immediately before the section 351 transaction (a 
transaction in which gain or loss is not recognized) and since W 
Corporation is now in control of X Corporation, the acquisition of X 
Corporation's common stock by W Corporation is not protected from 
treatment as an acquisition described in section 279(b)(1)(A). However, 
the obligation will not be deemed to be corporate acquisition 
indebtedness since the test of section 279(b)(4) is not met. The 
interest on the obligation will reduce the $5 million limitation of 
section 279(a).
    Example 2. Assume the facts are the same as described in Example 1, 
except that X Corporation was not in existence prior to June 6, 1973, 
but rather is newly created by W Corporation on such date. Since X 
Corporation, the acquired corporation, was not in existence before June 
6, 1973, the date on which W Corporation, the issuing corporation, 
acquired control of X Corporation in a transaction on which gain or loss 
is not recognized, the acquisition is not deemed to be an acquisition 
described in section 279(b)(1)(A). Thus, under the provisions of 
subdivision (ii) of this subparagraph, the $5 million limitation 
provided by section 279(a)(1) will not be reduced by the yearly interest 
incurred on the convertible bonds issued by W Corporation.
    Example 3. Assume that the facts are the same as described in 
Example 1, except that W Corporation was in control of X Corporation 
immediately before the transaction. Since W Corporation was in control 
of X Corporation immediately before the section 351(a) transaction and 
is in control of X Corporation after such transaction, the result will 
be the same as in Example 2.

    (c) Subordinated obligation--(1) In general. An obligation which is 
issued to provide consideration for an acquisition described in section 
279(b)(1) is subordinated within the meaning of section 279(b)(2) if it 
is either:
    (i) Subordinated to the claims of trade creditors of the issuing 
corporation generally, or

[[Page 1021]]

    (ii) Expressly subordinated in right of payment to the payment of 
any substantial amount of unsecured indebtedness, whether outstanding or 
subsequently issued, of the issuing corporation, irrespective of whether 
such subordination relates to payment of interest, or principal, or 
both. In applying section 279 (b)(2) and this paragraph in any case 
where the issuing corporation is a member of an affiliated group of 
corporations, the affiliated group shall be treated as the issuing 
corporation.
    (2) Expressly subordinated obligation. In applying subparagraph 
(1)(ii) of this paragraph, an obligation is considered expressly 
subordinated whether the terms of the subordination are provided in the 
evidence of indebtedness itself, or in another agreement between the 
parties to such obligation. An obligation shall be considered to be 
expressly subordinated within the meaning of subparagraph (1)(ii) of 
this paragraph if such obligation by its terms can become subordinated 
in right of payment to the payment of any substantial amount of 
unsecured indebtedness which is outstanding or which may be issued 
subsequently. However, an obligation shall not be considered expressly 
subordinated if such subordination occurs solely by operation of law, 
such as in the case of bankruptcy laws. For purposes of this paragraph, 
the term substantial amount of unsecured indebtedness means an amount of 
unsecured indebtedness equal to 5 percent or more of the face amount of 
the obligations issued within the meaning of section 279(b)(1).
    (d) Convertible obligation. An obligation which is issued to provide 
consideration directly or indirectly for an acquisition described in 
section 279 (b)(1) is convertible within the meaning of section 
279(b)(3) if it is either--(1) Convertible directly or indirectly into 
stock of the issuing corporation, or (2) Part of an investment unit or 
other arrangement which includes, in addition to such bond or other 
evidence of indebtedness, an option to acquire directly or indirectly 
stock in the issuing corporation. Stock warrants or convertible 
preferred stock included as part of an investment unit constitute 
options within the meaning of the preceding sentence. Indebtedness is 
indirectly convertible if the conversion feature gives the holder the 
right to convert into another bond of the issuing corporation which is 
then convertible into the stock of the issuing corporation. In any case 
where the corporation which in fact issues an obligation to provide 
consideration for an acquisition described in section 279(b)(1) is a 
member of an affiliated group, the provisions of section 279(b)(3) and 
this paragraph are deemed satisfied if the stock into which either the 
obligation or option which is part of an investment unit or other 
arrangement is convertible, directly or indirectly, is stock of any 
member of the affiliated group.
    (e) Ratio of debt to equity and projected earnings test. For rules 
with respect to the application of section 279(b)(4) (relating to the 
ratio of debt to equity and the ratio of projected earnings to annual 
interest to be paid or incurred), see paragraphs (d), (e), and (f) of 
Sec. 1.279-5.
    (f) Certain obligations issued after October 9, 1969--(1) In 
general. Under section 279(i), an obligation shall not be corporate 
acquisition indebtedness if such obligation is issued after October 9, 
1969, to provide consideration for the acquisition of:
    (i) Stock or assets pursuant to a binding written contract which was 
in effect on October 9, 1969, and at all times thereafter before such 
acquisition, or
    (ii) Stock in any corporation where the issuing corporation, on 
October 9, 1969, and at all times thereafter before such acquisition, 
owned at least 50 percent of the total combined voting power of all 
classes of stock entitled to vote of the acquired corporation.

Subdivision (ii) of this subparagraph shall cease to apply when (at any 
time on or after October 9, 1969) the issuing corporation has acquired 
control of the acquired corporation. The interest attributable to any 
obligation which satisfies the conditions stated in the first sentence 
of this subparagraph shall reduce the $5 million limitation of section 
279(a)(1).
    (2) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. On September 5, 1969, M Corporation, a calendar year 
taxpayer, entered

[[Page 1022]]

into a binding written contract with N Corporation to purchase 20 
percent of the voting stock of N Corporation. The contract was in effect 
on October 9, 1969, and at all times thereafter before the acquisition 
of the stock on January 1, 1970. Pursuant to such contract M Corporation 
issued on January 1, 1970, to N Corporation an obligation which 
satisfies the tests of section 279(b) requiring it to pay $1 million of 
interest each year. However, under the provisions of subparagraph (1)(i) 
of this paragraph, such obligation is not corporate acquisition 
indebtedness since it was issued to provide consideration for the 
acquisition of stock pursuant to a binding written contract which was in 
effect on October 9, 1969, and at all times thereafter before such 
acquisition. The $1 million of yearly interest on the obligation reduces 
the $5 million limitation provided for in section 279(a)(1) to $4 
million since such interest is attributable to an obligation which was 
issued to provide consideration for the acquisition of stock in an 
acquired corporation.
    Example 2. On October 9, 1969, O Corporation, a calendar year 
taxpayer, owned 50 percent of the total combined voting power of all 
classes of stock entitled to vote of P Corporation. P Corporation has no 
other class of stock. On January 1, 1970, while still owning such voting 
stock O Corporation issued to the shareholders of P Corporation to 
provide consideration for an additional 40 percent of P Corporation's 
voting stock an obligation which satisfied the tests of section 279(b) 
requiring it to pay $4 million of interest each year. Hence, O 
Corporation acquired control of P Corporation, and the provisions of 
subparagraph (1)(ii) of this paragraph ceased to apply to O Corporation. 
Thus, 75 percent of the obligation issued by O Corporation to provide 
consideration for the stock of P Corporation is not corporate 
acquisition indebtedness (that is, of the 40 percent of the voting stock 
of P Corporation which was acquired, only 30 percent was needed to give 
O Corporation control). Since 25 percent of the obligation is corporate 
acquisition indebtedness, $1 million of interest attributable to such 
obligation is subject to disallowance under section 279(a) for the 
taxable year 1970. The remaining $3 million of interest attributable to 
the obligation will reduce the $5 million limitation provided by in 
section 279(a)(1).

    (g) Exemptions for certain acquisitions of foreign corporations--(1) 
In general. Under section 279(f), the term corporate acquisition 
indebtedness does not include any indebtedness issued to any person to 
provide consideration directly or indirectly for the acquisition of 
stock in, or assets of, any foreign corporation substantially all the 
income of which, for the 3-year period ending with the date of such 
acquisition or for such part of such period as the foreign corporation 
was in existence, is from sources without the United States. The 
interest attributable to any obligation excluded from treatment as 
corporate acquisition indebtedness by reason of this paragraph shall 
reduce the $5 million limitation of 279(a)(1).
    (2) Foreign corporation. For purposes of this paragraph, the term 
foreign corporation shall have the same meaning as in section 
7701(a)(5).
    (3) Income from sources without the United States. For purposes of 
this paragraph, the term income from sources without the United States 
shall be determined in accordance with sections 862 and 863. If more 
than 80 percent of a foreign corporation's gross income is derived from 
sources without the United States, such corporation shall be considered 
to be deriving substantially all of its income from sources without the 
United States.

[T.D. 7262, 38 FR 5845, Mar. 5, 1973]



Sec. 1.279-4  Special rules.

    (a) Special 3-year rule. Under section 279(d)(4), if an obligation 
which has been deemed to be corporate acquisition indebtedness for any 
taxable year would not be such indebtedness for each of any 3 
consecutive taxable years thereafter if the ratio of debt to equity and 
the ratio of projected earnings to annual interest to be paid or 
incurred of section 279 (b)(4) were applied as of the close of each of 
such 3 years, then such obligation shall not be corporate acquisition 
indebtedness for any taxable years after such 3 consecutive taxable 
years. The test prescribed by section 279(b)(4) shall be applied as of 
the close of any taxable year whether or not the issuing corporation 
issues any obligation to provide consideration for an acquisition 
described in section 279(b)(1) in such taxable year. Thus, for example, 
if a corporation, reporting income on a calendar year basis, has an 
obligation outstanding as of December 31, 1975, which was classified as 
a corporate acquisition indebtedness as of the close of 1972 and such 
obligation would not have been classified as corporate acquisition 
indebtedness as of the close of 1973, 1974, and 1975 because

[[Page 1023]]

neither of the conditions of section 279(b)(4) were present as of such 
dates, then such obligation shall not be corporate acquisition 
indebtedness for 1976 and all taxable years thereafter. Such obligation 
shall not be reclassified as corporate acquisition indebtedness in any 
taxable year following 1975, even if the issuing corporation issues more 
obligations (whether or not found to be corporate acquisition 
indebtedness) in such later years to provide consideration for the 
acquisition of additional stock in, or assets of, the same acquired 
corporation with respect to which the original obligation was issued. 
The interest attributable to such obligation shall reduce the $5 million 
limitation provided by section 279(a)(1) for 1976 and all taxable years 
thereafter.
    (b) Five percent stock rule--(1) In general. Under section 
279(d)(5), if an obligation issued to provide consideration for an 
acquisition of stock in another corporation meets the tests of section 
279(b), such obligation shall be corporate acquisition indebtedness for 
a taxable year only if at sometime after October 9, 1969, and before the 
close of such year the issuing corporation owns or has owned 5 percent 
or more of the total combined voting power of all classes of stock 
entitled to vote in the acquired corporation. If the issuing corporation 
is a member of an affiliated group, then in accordance with section 
279(g) the affiliated group shall be treated as the issuing corporation. 
Thus, any stock of the acquired corporation owned by members of the 
affiliated group shall be aggregated to determine if the percentage 
limitation provided by this subparagraph is exceeded. Once an obligation 
is deemed to be corporate acquisition indebtedness such obligation will 
continue to be deemed corporate acquisition indebtedness for all taxable 
years thereafter unless the provisions of section 279(d) (3) or (4) 
apply, notwithstanding the fact that the issuing corporation owns less 
than 5 percent of the combined voting power of all classes of stock 
entitled to vote of the acquired corporation in any or all taxable years 
thereafter.
    (2) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. Corporation Y uses the calendar year as its taxable year 
and has only one class of stock outstanding. On June 1, 1972, X 
Corporation which is also a calendar year taxpayer and which has never 
been a shareholder of Y Corporation acquires from the shareholders of Y 
Corporation 4 percent of the stock of Y Corporation in exchange for 
obligations which satisfy the conditions of section 279(b). At no time 
during 1972 does X Corporation own 5 percent or more of the stock of Y 
Corporation. Accordingly, under the provisions of subparagraph (1) of 
this paragraph, for 1972 the obligations issued by X Corporation to 
provide consideration for the acquisition of Y Corporation's stock do 
not constitute corporate acquisition indebtedness.
    Example 2. Assume the same facts as in Example 1. Assume further 
that on February 24, 1973, X Corporation acquires from the shareholders 
of Y Corporation an additional 7 percent of the stock of Y Corporation 
in exchange for obligations which satisfy all of the tests of section 
279(b). On December 28, 1973, X Corporation sells all of its stock in Y 
Corporation. For 1973, the obligations issued by X Corporation in 1972 
and in 1973 constitute corporate acquisition indebtedness since X 
Corporation at some time after October 9, 1969, and before the close of 
1973 owned 5 percent or more of the voting stock of Y Corporation. 
Furthermore, such obligations shall be corporate acquisition 
indebtedness for all taxable years thereafter unless the special 
provisions of section 279(d) (3) or (4) could apply.

    (c) Changes in obligation--(1) In general. Under section 279(h), for 
purposes of section 279:
    (i) Any extension, renewal, or refinancing of an obligation 
evidencing a preexisting indebtedness shall not be deemed to be the 
issuance of a new obligation, and
    (ii) Any obligation which is corporate acquisition indebtedness of 
the issuing corporation is also corporate acquisition indebtedness of 
any corporation which in any transaction or by operation of law assumes 
liability for such obligation or becomes liable for such obligation as 
guarantor, endorser, or indemnitor.
    (2) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. On January 1, 1971, X Corporation, which files its return 
on the basis of a calendar year, issues an obligation, which satisfies 
the tests of section 279(b), and is deemed to be corporate acquisition 
indebtedness. On January 1, 1973, an agreement is

[[Page 1024]]

concluded between X Corporation and the holder of the obligation whereby 
the maturity date of such obligation is extended until December 31, 
1979. Under the provisions of subparagraph (1)(i) of this paragraph such 
extended obligation is not deemed to be a new obligation, and still 
constitutes corporate acquisition indebtedness.
    Example 2. On June 12, 1971, X Corporation, a calendar year 
taxpayer, issued convertible and subordinated obligations to acquire the 
stock of Z Corporation. The obligations were deemed corporate 
acquisition indebtedness on December 31, 1971. On March 4, 1973, X 
Corporation and Y Corporation consolidated to form XY Corporation in 
accordance with State law. Corporation XY is liable for the obligations 
issued by X Corporation by operation of law and the obligations continue 
to be corporate acquisition indebtedness. In 1975 XY Corporation 
exchanges its own nonconvertible obligations for the obligations X 
Corporation issued. The obligations of XY Corporation issued in exchange 
for those of X Corporation will be deemed to be corporate acquisition 
indebtedness.

[T.D. 7262, 38 FR 5847, Mar. 5, 1973; 38 FR 6893, Mar. 14, 1973]



Sec. 1.279-5  Rules for application of section 279(b).

    (a) Taxable years to which applicable--(1) First year of 
disallowance. Under section 279(d)(1), the deduction of interest on any 
obligation shall not be disallowed under section 279(a) before the first 
taxable year of the issuing corporation as of the last day of which the 
application of either section 279(b)(4) (A) or (B) results in such 
obligation being classified as corporate acquisition indebtedness. See 
section 279(c)(1) and paragraph (b)(2) of this section for the time when 
an obligation is subjected to the test of section 279(b)(4).
    (2) General rule for succeeding years. Under section 279(d)(2), 
except as provided in paragraphs (3), (4), and (5) of section 279(d), if 
an obligation is determined to be corporate acquisition indebtedness as 
of the last day of any taxable year of the issuing corporation, such 
obligation shall be corporate acquisition indebtedness for such taxable 
year and all subsequent taxable years.
    (b) Time of determination--(1) In general. The determination of 
whether an obligation meets the conditions of section 279(b) (1), (2), 
and (3) shall be made as of the day on which the obligation is issued.
    (2) Ratio of debt to equity, projected earnings, and annual interest 
to be paid or incurred. (i) Under section 279(c)(1), the determination 
of whether an obligation meets the conditions of section 279(b)(4) is 
first to be made as of the last day of the taxable year of the issuing 
corporation in which it issues the obligation to provide consideration 
directly or indirectly for an acquisition described in section 279(b)(1) 
of stock in, or assets of, the acquired corporation. An obligation which 
is not corporate acquisition indebtedness only because it does not 
satisfy the test of section 279(b)(4) in the taxable year of the issuing 
corporation in which the obligation is issued for stock in, or assets 
of, the acquired corporation may be subjected to the test of section 
279(b)(4) again. A retesting will occur in any subsequent taxable year 
of the issuing corporation in which the issuing corporation issues any 
obligation to provide consideration directly or indirectly for an 
acquisition described in section 279(b)(1) with respect to the same 
acquired corporation, irrespective of whether such subsequent obligation 
is itself classified as corporate acquisition indebtedness. If the 
issuing corporation is a member of an affiliated group, then in 
accordance with section 279(g) the affiliated group shall be treated as 
the issuing corporation. Thus, if any member of the affiliated group 
issues an obligation to acquire additional stock in, or assets of, the 
acquired corporation, this paragraph shall apply.
    (ii) For purposes of section 279(b)(4) and this paragraph, in any 
case where the issuing corporation is a member of an affiliated group 
(see section 279(g) and Sec. 1.279-6 for rules regarding application of 
section 279 to certain affiliated groups) which does not file a 
consolidated return and all the members of which do not have the same 
taxable year, determinations with respect to the ratio of debt to equity 
of, and projected earnings of, and annual interest to be paid or 
incurred by, any member of the affiliated group shall be made as of the 
last day of the taxable year of the corporation which in fact issues the 
obligation to provide consideration for an acquisition described in 
section 279(b)(1).

[[Page 1025]]

    (3) Redetermination where control or substantially all the 
properties have been acquired. Under section 279(d)(3), if an obligation 
is determined to be corporate acquisition indebtedness as of the close 
of a taxable year of the issuing corporation in which section 
279(c)(3)(A)(i) (relating to the projected earnings of the issuing 
corporation only) applied, but would not be corporate acquisition 
indebtedness if the determination were made as of the close of the first 
taxable year of such corporation thereafter in which section 
279(c)(3)(A)(ii) (relating to the projected earnings of both the issuing 
corporation and the acquired corporation) could apply, such obligation 
shall be considered not to be corporate acquisition indebtedness for 
such later taxable year and all taxable years thereafter. Where an 
obligation ceases to be corporate acquisition indebtedness as a result 
of the application of this paragraph, the interest on such obligation 
shall not be disallowed under section 279(a) as a deduction for the 
taxable year in which the obligation ceases to be corporate acquisition 
indebtedness and all taxable years thereafter. However, under section 
279(a)(2) the interest paid or incurred on such obligation which is 
allowed as a deduction will reduce the $5 million limitation provided by 
section 279(a)(1).
    (4) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. In 1971, X Corporation, which files its Federal income 
tax return on the basis of a calendar year, issues its obligations to 
provide consideration for the acquisition of 15 percent of the voting 
stock of both Y Corporation and Z Corporation. Y Corporation and Z 
Corporation each have only one class of stock. When issued, such 
obligations satisfied the tests prescribed in section 279(b) (1), (2), 
and (3) and would have constituted corporate acquisition indebtedness 
but for the test prescribed in section 279(b)(4). On December 31, 1971, 
the application of section 279(b)(4) results in X Corporation's 
obligations issued in 1971 not being treated as corporate acquisition 
indebtedness for that year.
    Example 2. Assume the same facts as in Example 1, except that in 
1972, X Corporation issues more obligations which come within the tests 
of section 279(b) (1), (2), and (3) to acquire an additional 10 percent 
of the voting stock of Y Corporation. No stock of Z Corporation is 
acquired after 1971. The application of section 279(b)(4)(B) (relating 
to the projected earnings of X Corporation) as of the end of 1972 
results in the obligations issued in 1972 to provide consideration for 
the acquisition of the stock of Y Corporation being treated as corporate 
acquisition indebtedness. Since X Corporation during 1972 did issue 
obligations to acquire more stock of Y Corporation, under the provisions 
of section 279(c)(1) and subparagraph (2) of this paragraph the 
obligations issued by X Corporation in 1971 to acquire stock in Y 
Corporation are again tested to determine whether the test of section 
279(b)(4) with respect to such obligations is satisfied for 1972. Thus, 
since such obligations issued by X Corporation to acquire Y 
Corporation's stock in 1971 previously came within the provisions of 
section 279(b) (1), (2), and (3) and the projected earnings test of 
section 279(b)(4)(B) is satisfied for 1972, all of such obligations are 
to be deemed to constitute corporate acquisition indebtedness for 1972 
and subsequent taxable years. The obligations issued in 1971 to acquire 
stock in Z Corporation continue not to constitute corporate acquisition 
indebtedness.
    Example 3. Assume the same facts as in Examples 1 and 2. In 1973, X 
Corporation issues more obligations which come within the tests of 
section 279(b) (1), (2), and (3) to acquire more stock (but not control) 
in Y Corporation. On December 31, 1973, it is determined with respect to 
X Corporation that neither of the conditions described in section 
279(b)(4) are present. Thus, the obligations issued in 1973 do not 
constitute corporate acquisition indebtedness. However, the obligations 
issued in 1971 and 1972 by X Corporation to acquire stock in Y 
Corporation continue to be treated as corporate acquisition 
indebtedness.
    Example 4. Assume the same facts as in Example 3, except that X 
Corporation acquires control of Y Corporation in 1973. Since X 
Corporation has acquired control of Y Corporation, the average annual 
earnings (as defined in section 279(c)(3)(B) and the annual interest to 
be paid or incurred (as provided by section 279(c)(4)) of both X 
Corporation and Y Corporation under section 279(c)(3)(A)(ii) are taken 
into account in computing for 1973 the ratio of projected earnings to 
annual interest to be paid or incurred described in section 
279(b)(4)(B). Assume further that after applying section 279(b)(4)(B) 
the obligations issued in 1973 escape treatment as corporate acquisition 
indebtedness for 1973. Under section 279(d)(3), all of the obligations 
issued by X Corporation to acquire stock in Y Corporation in 1971 and 
1972 are removed from classification as corporate acquisition 
indebtedness for 1973 and all subsequent taxable years.
    Example 5. In 1975, M Corporation, which files its Federal income 
tax return on the

[[Page 1026]]

basis of a calendar year, issues its obligations to acquire 30 percent 
of the voting stock of N Corporation. N Corporation has only one class 
of stock. Such obligations satisfy the tests prescribed in section 
279(b) (1), (2), and (3). Additionally, as of the close of 1975, M 
Corporation's ratio of debt to equity exceeds the ratio of 2 to 1 and 
its projected earnings do not exceed three times the annual interest to 
be paid or incurred. The obligations issued by M Corporation are 
corporate acquisition indebtedness for 1975 since all the provisions of 
section 279(b) are satisfied. In 1976 M Corporation issues its 
obligations to acquire from the shareholders of N Corporation an 
additional 60 percent of the voting stock of N Corporation, thereby 
acquiring control of N Corporation. However, with respect to the 
obligations issued by M Corporation in 1975, there is no redetermination 
under section 279(d)(3) and subparagraph (3) of this paragraph as to 
whether such obligations may escape classification as corporate 
acquisition indebtedness because in 1975 it was the ratio of debt to 
equity test which caused such obligations to be corporate acquisition 
indebtedness. If in 1975, M Corporation met the conditions of section 
279(b)(4) solely because of the ratio of projected earnings to annual 
interest to be paid or incurred described in section 279(b)(4)(B), its 
obligation issued in 1975 could be retested in 1976.

    (c) Acquisition of stock or assets of several corporations. An 
issuing corporation which acquires stock in, or assets of, more than one 
corporation during any taxable year must apply the tests described in 
section 279(b) (1), (2), and (3) separately with respect to each 
obligation issued to provide consideration for the acquisition of the 
stock in, or assets of, each such acquired corporation. Thus, if an 
acquisition is made with obligations of the issuing corporation that 
satisfy the tests described in section 279(b) (2) and (3) and 
obligations that fail to satisfy such tests, only those obligations 
satisfying such tests need be further considered to determine whether 
they constitute corporate acquisition indebtedness. Those obligations 
which meet the test of section 279(b)(1) but which are not deemed 
corporate acquisition indebtedness shall be taken into account for 
purposes of determining the reduction in the $5 million limitation of 
section 279(a)(1).
    (d) Ratio of debt to equity and projected earnings--(1) In general. 
One of the four tests to determine whether an obligation constitutes 
corporate acquisition indebtedness is contained in section 279(b)(4). An 
obligation will meet the test of section 279(b)(4) if, as of a day 
determined under section 279(c)(1) and paragraph (b)(2) of this section, 
either:
    (i) The ratio of debt to equity (as defined in paragraph (f) of this 
section) of the issuing corporation exceeds 2 to 1, or
    (ii) The projected earnings (as defined in subparagraph (2) of this 
paragraph) of the issuing corporation, or of both the issuing 
corporation and acquired corporation in any case where subparagraph 
(2)(ii) of this paragraph is applicable, do not exceed three times the 
annual interest to be paid or incurred (as defined in paragraph (e) of 
this section) by such issuing corporation, or, where applicable, by such 
issuing corporation and acquired corporation. Where paragraphs 
(d)(2)(ii) and (e)(1)(ii) of this section are applicable in computing 
projected earnings and annual interest to be paid or incurred, 100 
percent of the acquired corporation's projected earnings and annual 
interest to be paid or incurred shall be included in such computation, 
even though less than all of the stock or assets of the acquired 
corporation have been acquired.
    (2) Projected earnings. The term projected earnings means the 
``average annual earnings'' (as defined in subparagraph (3) of this 
paragraph) of:
    (i) The issuing corporation only, if subdivision (ii) of this 
subparagraph, does not apply, or
    (ii) Both the issuing corporation and the acquired corporation, in 
any case where the issuing corporation as of the close of its taxable 
year has acquired control, or has acquired substantially all of the 
properties, of the acquired corporation.

For purposes of subdivision (ii) of this subparagraph, an acquisition of 
``substantially all of the properties'' of the acquired corporation 
means the acquisition of assets representing at least 90 percent of the 
fair market value of the net assets and at least 70 percent of the fair 
market value of the gross assets held by the acquired corporation 
immediately prior to the acquisition.
    (3) Average annual earnings. (i) The term average annual earnings 
referred

[[Page 1027]]

to in subparagraph (2) of this paragraph is, for any corporation, the 
amount of its earnings and profits for any 3-year period ending with the 
last day of a taxable year of the issuing corporation in which it issues 
any obligation to provide consideration for an acquisition described in 
section 279(b)(1), computed without reduction for:
    (a) Interest paid or incurred,
    (b) Depreciation or amortization allowed under Chapter 1 of the 
Code,
    (c) Liability for tax under Chapter 1 of the Code, and
    (d) Distributions to which section 301(c)(1) apply (other than such 
distributions from the acquired corporation to the issuing corporation), 
and reduced to an annual average for such 3-year period. For the rules 
to determine the amount of earnings and profits of any corporation, see 
section 312 and the regulations thereunder.
    (ii) Except as provided for in subdivision (iii) of this 
subparagraph, for purposes of subdivision (i) of this subparagraph in 
the case of any corporation, the earnings and profits for such 3-year 
period shall be reduced to an annual average by dividing such earnings 
and profits by 36 and multiplying the quotient by 12. If a corporation 
was not in existence during the entire 36-month period as of the close 
of the taxable year referred to in subdivision (i) of this subparagraph, 
its average annual earnings shall be determined by dividing its earnings 
and profits for the period of its existence by the number of whole 
calendar months in such period and multiplying the quotient by 12.
    (iii) Where the issuing corporation acquires substantially all of 
the properties of an acquired corporation, the computation of earnings 
and profits of such acquired corporation shall be made for the period of 
such corporation beginning with the first day of the 3-year period of 
the issuing corporation and ending with the last day prior to the date 
on which substantially all of the properties were acquired. In 
determining the number of whole calendar months for such acquired 
corporation where the period for determining its earnings and profits 
includes 2 months which are not whole calendar months and the total 
number of days in such 2 fractional months exceeds 30 days, the number 
of whole calendar months for such period shall be increased by one. 
Where the number of days in the 2 fractional months total 30 days or 
less such fractional months shall be disregarded. After the number of 
whole calendar months is determined, the calculation for average annual 
earnings shall be made in the same manner as described in the last 
sentence of subdivision (ii) of this subparagraph.
    (e) Annual interest to be paid or incurred--(1) In general. For 
purposes of section 279(b)(4)(B), the term annual interest to be paid or 
incurred means:
    (i) If subdivision (ii) of this subparagraph does not apply, the 
annual interest to be paid or incurred by the issuing corporation only, 
for the taxable year beginning immediately after the day described in 
section 279(c)(1), determined by reference to its total indebtedness 
outstanding as of such day, or
    (ii) If projected earnings are determined under paragraph (d)(2)(ii) 
of this section, the annual interest to be paid or incurred by both the 
issuing corporation and the acquired corporation for 1 year beginning 
immediately after the day described in section 279(c)(1), determined by 
reference to their combined total indebtedness outstanding as of such 
day. However, where the issuing corporation acquires substantially all 
of the properties of the acquired corporation, the annual interest to be 
paid or incurred will be determined by reference to the total 
indebtedness outstanding of the issuing corporation only (including any 
indebtedness it assumed in the acquisition) as of the day described in 
section 279(c)(1).

The term annual interest to be paid or incurred refers to both actual 
interest and unstated interest. Such unstated interest includes original 
issue discount as defined in paragraph (a)(1) of Sec. 1.163-4 and 
amounts treated as interest under section 483. For purposes of this 
paragraph and paragraph (f) of this section (relating to the ratio of 
debt to equity), the indebtedness of any corporation shall be determined 
in accordance with generally accepted accounting principles. Thus, for 
example, the indebtedness of a corporation includes short-term 
liabilities, such as accounts payable to suppliers, as well as long-

[[Page 1028]]

term indebtedness. Contingent liabilities, such as those arising out of 
discounted notes, the assignment of accounts receivable, or the 
guarantee of the liability of another, shall be included in the 
determination of the indebtedness of a corporation if the contingency is 
likely to become a reality. In addition, the indebtedness of a 
corporation includes obligations issued by the corporation, secured only 
by property of the corporation, and with respect to which the 
corporation is not personally liable. See section 279(g) and Sec. 
1.279-6 for rules with respect to the computation of annual interest to 
be paid or incurred in regard to members of an affiliated group of 
corporations.
    (2) Examples. The provisions of these paragraphs may be illustrated 
by the following examples:

    Example 1. Corporation X's earnings and profits calculated in 
accordance with section 279(c)(3)(B) for 1972, 1971, and 1970 
respectively were $29 million, $23 million, and $20 million. The 
interest to be paid or incurred during the calendar year of 1973 as 
determined by reference to the issuing corporation's total outstanding 
indebtedness as of December 31, 1972, was $10 million. By dividing the 
sum of the earnings and profits for the 3 years by 36 (the number of 
whole calendar months in the 3-year period) and multiplying the quotient 
by 12, the average annual earnings for X Corporation is $24 million. 
Since the projected earnings of X Corporation do not exceed by three 
times the annual interest to be paid or incurred (they exceed by only 
2.4 times), one of the circumstances described in section 279(b)(4) is 
present.
    Example 2. On March 1, 1972, W Corporation acquires substantially 
all of the properties of Z Corporation in exchange for W Corporation's 
bonds which satisfy the tests of section 279(b) (2) and (3). W 
Corporation files its income tax returns on the basis of fiscal years 
ending June 30. Z Corporation, which was formed on September 1, 1969, is 
a calendar year taxpayer. The earnings and profits of W Corporation for 
the last 3 fiscal years ending June 30, 1972, calculated in accordance 
with the provisions of section 279(c)(3)(B) were $300 million, $400 
million, and $380 million, respectively. The average annual earnings of 
W Corporation is $360 million ($1,080 million / 36 x 12). The earnings 
and profits of Z Corporation calculated in accordance with the 
provisions of section 279(c)(3)(B) were $4 million for the period of 
September 1, 1969 to December 31, 1969, $10 million and $14 million for 
the calendar years of 1970 and 1971, respectively, and $2 million for 
the period of January 1, 1972, through February 29, 1972, or a total of 
$30 million. To arrive at the average annual earnings, the sum of the 
earnings and profits, $30 million, must be divided by 30 (the number of 
whole calendar months that Z Corporation was in existence during W 
Corporation's 3-year period ending with the day prior to the date 
substantially all the assets were acquired) and the quotient is 
multiplied by 12, which results in an average annual earnings of $12 
million ($30 million / 30 x 12) for Z Corporation. The combined average 
annual earnings of W Corporation and Z Corporation is $372 million. The 
interest for the fiscal year ending June 30, 1973, to be paid or 
incurred by W Corporation on its outstanding indebtedness as of June 30, 
1972, is $110 million. Since the projected earnings exceed the annual 
interest to be paid or incurred by more than three times, the obligation 
will not be corporate acquisition indebtedness, unless the issuing 
corporation's debt to equity ratio exceeds 2 to 1.

    (f) Ratio of debt to equity--(1) In general. The condition described 
in section 279(b)(4)(A) is present if the ratio of debt to equity of the 
issuing corporation exceeds 2 to 1. Under section 279(c)(2), the term 
ratio of debt to equity means the ratio which the total indebtedness of 
the issuing corporation bears to the sum of its money and all its other 
assets (in an amount equal to adjusted basis for determining gain) less 
such total indebtedness. For the meaning of the term indebtedness, see 
paragraph (e)(1) of this section. See section 279(g) and Sec. 1.279-6 
for rules with respect to the computation of the ratio of debt to equity 
in regard to an affiliated group of corporations.
    (2) Examples. The provisions of section 279(b)(4)(A) and this 
paragraph may be illustrated by the following example:

[$5 million interest to be paid or incurred x $80 million owed to X Bank 
    by its customers/$100 million total indebtedness]

    Example 1. On June 1, 1971, X Corporation, which files its federal 
income tax returns on a calendar year basis, issues an obligation for 
$45 million to the shareholders of Y Corporation to provide 
consideration for the acquisition of all of the stock of Y Corporation. 
Such obligation has the characteristics of corporate acquisition 
indebtedness described in section 279(b) (2) and (3). The projected 
earnings of X Corporation and Y Corporation exceed 3 times the annual 
interest to be paid

[[Page 1029]]

or incurred by those corporations and, accordingly, the condition 
described in section 279(b)(4)(B) is not present. Also, on December 31, 
1971, X Corporation has total assets with an adjusted basis of $150 
million (including the newly acquired stock of Y Corporation having a 
basis of $45 million) and total indebtedness of $90 million. Hence, X 
Corporation's equity is $60 million computed by subtracting its $90 
million of total indebtedness from its $150 million of total assets. 
Since X Corporation's ratio of debt to equity of 1.5 to 1 ($90 million 
of total indebtedness over $60 million equity) does not exceed 2 to 1, 
the condition described in section 279(b)(4)(A) is not present. 
Therefore, X Corporation's obligation for $45 million is not corporate 
acquisition indebtedness because on December 31, 1971, neither of the 
conditions specified in section 279(b)(4) existed.

    (g) Special rules for banks and lending or finance companies--(1) 
Debt to equity and projected earnings. Under section 279(c)(5), with 
respect to any corporation which is a bank (as defined in section 581) 
or is primarily engaged in a lending or finance business, the following 
rules are to be applied:
    (i) In determining under paragraph (f) of this section the ratio of 
debt to equity of such corporation (or of the affiliated group of which 
such corporation is a member), the total indebtedness of such 
corporation (and the assets of such corporation) shall be reduced by an 
amount equal to the total indebtedness owed to such corporation which 
arises out of the banking business of such corporation, or out of the 
lending or finance business of such corporation, as the case may be;
    (ii) In determining under paragraph (e) of this section the annual 
interest to be paid or incurred by such corporation (or by the issuing 
corporation and acquired corporation referred to in section 279(c)(4)(B) 
or by the affiliated group of corporations of which such corporation is 
a member), the amount of such interest (determined without regard to 
this subparagraph) shall be reduced by an amount which bears the same 
ratio to the amount of such interest as the amount of the reduction for 
the taxable year under subdivision (i) of this subparagraph bears to the 
total indebtedness of such corporation; and
    (iii) In determining under section 279(c)(3)(B) the average annual 
earnings, the amount of the earnings and profits for the 3-year period 
shall be reduced by the sum of the reductions under subdivision (ii) of 
this subparagraph for such period.

For purposes of this paragraph, the term lending or finance business 
means a business of making loans or purchasing or discounting accounts 
receivable, notes, or installment obligations. Additionally, the rules 
stated in this paragraph regarding the application of the ratio of debt 
to equity, the determination of the annual interest to be paid or 
incurred, and the determination of the average annual earnings also 
apply if the bank or lending or finance company is a member of an 
affiliated group of corporations. However, the rules are to be applied 
only for purposes of determining the debt, equity, projected earnings 
and annual interest of the bank or lending or finance company which then 
are taken into account in determining the debt to equity ratio and ratio 
of projected earnings to annual interest to be paid or incurred by the 
affiliated group as a whole. Thus, these rules are to be applied to 
reduce the bank's or lending or finance corporation's indebtedness, 
annual interest to be paid or incurred, and average annual earnings 
which are taken into account with respect to the group, but are not to 
reduce the indebtedness of, annual interest to be paid or incurred by, 
and average annual earnings of, any corporation in the affiliated group 
which is not a bank or a lending or finance company. In determining 
whether any corporation which is a member of an affiliated group is 
primarily engaged in a lending or finance business, only the activities 
of such corporation, and not those of the whole group, are to be taken 
into account. See Sec. 1.279-6 for the application of section 279 to 
certain affiliated groups of corporations.
    (2) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. As of the close of the taxable year, X Bank has a total 
indebtedness of $100 million, total assets of $115 million, and $80 
million is owed to X Bank by its customers. Bank X's indebtedness is $20 
million ($100 million total indebtedness less $80 million owed to the X 
Bank by its customers) and its assets are $35 million ($115 million 
total assets less $80 million owed to the bank by its customers). If its 
annual interest to be paid

[[Page 1030]]

or incurred is $5 million, such amount is reduced by $4 million. Thus, X 
Bank's annual interest to be paid or incurred is $1 million.
    Example 2. Assume the same facts as in Example 1. X Bank has 
earnings and profits of $23 million for the 3-year period used to 
determine projected earnings. In computing the average annual earnings, 
the $23 million amount will be reduced by $12 million (three times the 
$4 million reduction of interest in Example 1, assuming that the 
reduction was the same for each year). Thus X Bank's earnings and 
profits for such 3-year period are $11 million ($23 million total 
earnings and profits less $12 million reduction).


[T.D. 7262, 38 FR 5847, Mar. 7, 1973, as amended by T.D. 9264, 71 FR 
30593, May 30, 2006]



Sec. 1.279-6  Application of section 279 to certain affiliated groups.

    (a) In general. Under section 279(g), in any case in which the 
issuing corporation is a member of an affiliated group, the application 
of section 279 shall be determined by treating all of the members of the 
affiliated group in the aggregate as the issuing corporation, except 
that the ratio of debt to equity of, projected earnings of, and the 
annual interest to be paid or incurred by any corporation (other than 
the issuing corporation determined without regard to this paragraph) 
shall be included in the determinations required under section 279(b)(4) 
as of any day only if such corporation is a member of the affiliated 
group on such day, and, in determining projected earnings of such 
corporation under section 279(c)(3), there shall be taken into account 
only the earnings and profits of such corporation for the period during 
which it was a member of the affiliated group. The total amount of an 
affiliated member's assets, indebtedness, projected earnings, and 
interest to be paid or incurred will enter into the computation required 
by this section, irrespective of any minority ownership in such member.
    (b) Aggregate money and other assets. In determining the aggregate 
money and all the other assets of the affiliated group, the money and 
all the other assets of each member of such group shall be separately 
computed and such separately computed amounts shall be added together, 
except that adjustments shall be made, as follows:
    (1) There shall be eliminated from the aggregate money and all the 
other assets of the affiliated group intercompany receivables as of the 
date described in section 279(c)(1);
    (2) There shall be eliminated from the total assets of the 
affiliated group any amount which represents stock ownership in any 
member of such group;
    (3) In any case where gain or loss is not recognized on transactions 
between members of an affiliated group under paragraph (d)(3) of this 
section, the basis of any asset involved in such transaction shall be 
the transferor's basis;
    (4) The basis of property in a transaction to which Sec. 1.1502-13 
applies is the basis of the property determined under that section; and
    (5) There shall be eliminated from the money and all the other 
assets of the affiliated group any other amount which, if included, 
would result in a duplication of amounts in the aggregate money and all 
the other assets of the affiliated group.
    (c) Aggregate indebtedness. For purposes of applying section 279(c), 
in determining the aggregate indebtedness of an affiliated group of 
corporations the total indebtedness of each member of such group shall 
be separately determined, and such separately determined amounts shall 
be added together, except that there shall be eliminated from such total 
indebtedness as of the date described in section 279(c)(1):
    (1) The amount of intercompany accounts payable,
    (2) The amount of intercompany bonds or other evidences of 
indebtedness, and
    (3) The amount of any other indebtedness which, if included, would 
result in a duplication of amounts in the aggregate indebtedness of such 
affiliated group.
    (d) Aggregate projected earnings. In the case of an affiliated group 
of corporations (whether or not such group files a consolidated return 
under section 1501), the aggregate projected earnings of such group 
shall be computed by separately determining the projected earnings of 
each member of such group under paragraph (d) of Sec. 1.279-5, and

[[Page 1031]]

then adding together such separately determined amounts, except that:
    (1) A dividend (a distribution which is described in section 
301(c)(1) other than a distribution described in section 243(c)(1)) 
distributed by one member to another member shall be eliminated, and
    (2) In determining the earnings and profits of any member of an 
affiliated group, there shall be eliminated any amount of interest 
income received or accrued, and of interest expense paid or incurred, 
which is attributable to intercompany indebtedness,
    (3) No gain or loss shall be recognized in any transaction between 
members of the affiliated group, and
    (4) Members of an affiliated group who file a consolidated return 
shall not apply the provisions of Sec. 1.1502-18 dealing with inventory 
adjustments in determining earnings and profits for purposes of this 
section.
    (e) Aggregate interest to be paid or incurred. For purposes of 
section 279(c)(4), in determining the aggregate annual interest to be 
paid or incurred by an affiliated group of corporations, the annual 
interest to be paid or incurred by each member of such affiliated group 
shall be separately calculated under paragraph (e) of Sec. 1.279-5, and 
such separately calculated amounts shall be added together, except that 
any amount of annual interest to be paid or incurred on any intercompany 
indebtedness shall be eliminated from such aggregate interest.

[T.D. 7262, 38 FR 5850, Mar. 5, 1973, as amended by T.D. 8560, 59 FR 
41675, Aug. 15, 1994; T.D. 8597, 60 FR 36679, July 18, 1995]



Sec. 1.279-7  Effect on other provisions.

    Under section 279(j), no inference is to be drawn from any provision 
in section 279 and the regulations thereunder that any instrument 
designated as a bond, debenture, note, or certificate or other evidence 
of indebtedness by its issuer represents an obligation or indebtedness 
of such issuer in applying any other provision of this title. Thus, for 
example, an instrument, the interest on which is not subject to 
disallowance under section 279 could, under section 385 and the 
regulations thereunder, be found to constitute a stock interest, so that 
any amounts paid or payable thereon would not be deductible.

[T.D. 7262, 38 FR 5851, Mar. 5, 1973]



Sec. 1.280B-1  Demolition of structures.

    (a) In general. Section 280B provides that, in the case of the 
demolition of any structure, no deduction otherwise allowable under 
chapter 1 of subtitle A shall be allowed to the owner or lessee of such 
structure for any amount expended for the demolition or any loss 
sustained on account of the demolition, and that the expenditure or loss 
shall be treated as properly chargeable to the capital account with 
respect to the land on which the demolished structure was located.
    (b) Definition of structure. For purposes of section 280B, the term 
structure means a building, as defined in Sec. 1.48-1(e)(1), including 
the structural components of that building, as defined in Sec. 1.48-
1(e)(2).
    (c) Effective date. This section is effective for demolitions 
commencing on or after December 30, 1997.

[T.D. 8745, 62 FR 67726, Dec. 30, 1997]



Sec. 1.280C-1  Disallowance of certain deductions for wage or salary expenses.

    If an employer elects to claim the targeted jobs credit under 
section 44B (as amended by the Revenue Act of 1978), or elects to claim 
the new jobs credit under section 44B (as in effect prior to enactment 
of the Revenue Act of 1978), the employer must reduce its deduction for 
wage or salary expenses paid or incurred in the year the credit is 
earned by the amount allowable as credit (determined without regard to 
the provisions of section 53). In the case in which wages and salaries 
are capitalized the amount subject to depreciation must be reduced by an 
amount equal to the amount of the credit (determined without regard to 
the provisions of section 53) in determining the depreciation deduction. 
In the case of an employer who uses the full absorption method of 
inventory costing under Sec. 1.471-11, the portion of the basis of the 
inventory attributable to the wage or salary expenses giving rise to the 
credit and paid or incurred in the year the credit is earned must be

[[Page 1032]]

reduced by the amount of the credit allowable (determined without regard 
to the provisions of section 53). If the employer is an organization 
that is under common control (as described in Sec. 1.52-1), it must 
reduce its deduction for wage or salary expenses by the amount of the 
credit apportioned to it under Sec. 1.52-1 (a) or (b). The deduction 
for wage and salary expenses must be reduced in the year the credit is 
earned, even if the employer is unable to use the credit in that year 
because of the limitations imposed by section 53.

(Secs. 44B, 381, and 7805 of the Internal Revenue Code of 1954, 92 Stat. 
2834 (28 U.S.C. 44B); 91 Stat. 148 (26 U.S.C. 381(c)(26)); 68A Stat. 917 
(28 U.S.C. 7805))

[T.D. 7921, 48 FR 52908, Nov. 23, 1983]



Sec. 1.280C-3  Disallowance of certain deductions for qualified
clinical testing expenses when section 28 credit is allowable.

    (a) In general. If a taxpayer is entitled to a credit under section 
28 for qualified clinical testing expenses (as defined in section 
28(b)), it must reduce the amount of any deduction for qualified 
clinical testing expenses paid or incurred in the year the credit is 
earned by the amount allowable as credit for such expenses (determined 
without regard to section 28(d)(2)).
    (b) Capitalization of qualified clinical testing expenses. In a case 
in which qualified clinical testing expenses are capitalized, the amount 
chargeable to the capital account for a taxable year must be reduced by 
the excess of the amount of the credit allowable for the taxable year 
under section 28 (determined without regard to section 28(d)(2)) over 
the amount allowable as a deduction for qualified clinical testing 
expenses (determined without regard to paragraph (a) of this section) 
for the taxable year. See section 174 and the regulations thereunder.
    (c) Controlled group of corporations; organizations under common 
control. In the case of a taxpayer described in paragraph (d)(5) of 
Sec. 1.28-1 of this chapter (relating to controlled groups of 
corporations and organizations under common control), paragraphs (a) and 
(b) of this section shall be applied in accordance with the rules 
prescribed for aggregation of expenditures under that paragraph.
    (d) Example. The following example illustrates the application of 
paragraphs (a) and (b) of this section:

    Example. A incurs $1,000 in clinical testing expenses for which a 
$500 credit is allowable under section 28. A also elects under section 
174 of the Code to amortize these expenses over a 5-year period 
beginning in the year the credit is claimed. Under paragraph (a), the 
current year amortization deduction of $200 ($1,000 / 5) is disallowed. 
Moreover, the amount which would otherwise be capitalized, $800, is 
reduced by the excess of the amount of the section 28 credit claimed for 
the taxable year over the amount of the allowable section 174 
amortization deduction for the taxable year, or $300 ($500-$200). Thus, 
the amount chargeable to the capital account for the taxable year is 
$500 ($800-$300). A is entitled to amortize $500 over the remaining 
amortization period resulting in a deduction of $125 for each of the 
remaining four years.

[T.D. 8232, 53 FR 38715, Oct. 3, 1988]



Sec. 1.280C-4  Credit for increasing research activities.

    (a) In general. An election under section 280C(c)(3) to have the 
provisions of section 280C(c)(1) and (c)(2) not apply and elect the 
reduced research credit under section 280C(c)(3)(B) shall be made on 
Form 6765, ``Credit for Increasing Research Activities'' (or any 
successor form). In order for the election to be effective, the Form 
6765 must clearly indicate the taxpayer's intent to make the section 
280C(c)(3) election, and must be filed with an original return for the 
taxable year filed on or before the due date (including extensions) for 
filing the income tax return for such year, regardless of whether any 
research credits are claimed on the original return. An election, once 
made for any taxable year, is irrevocable for that taxable year.
    (b) Controlled groups of corporations; trades or businesses under 
common control--(1) In general. A member of a controlled group of 
corporations (within the meaning of section 41(f)(5)), or a trade or 
business which is treated as being under common control with other 
trades or businesses (within the meaning of section 41(f)(1)(B)), may 
make the election under section 280C(c)(3). However, only the common 
parent (within the meaning of Sec. 1.1502-

[[Page 1033]]

77(a)(1)(i)) of a consolidated group may make the election on behalf of 
the members of a consolidated group. A member or trade or business shall 
make the election on Form 6765 and by the time prescribed in paragraph 
(a) of this section.
    (2) Example. The following example illustrates an application of 
paragraph (b) of this section: A, B, and C, all of which are calendar 
year taxpayers, are members of a controlled group of corporations 
(within the meaning of section 41(f)(5)). A, B, and C each attach a 
statement to the 2012 Form 6765, ``Credit for Increasing Research 
Activities,'' showing A and C were the only members of the controlled 
group to have qualified research expenses when calculating the group 
credit. A and C report their allocated portions of the group credit on 
the 2012 Form 6765 and B reports no research credit on Form 6765. 
Pursuant to paragraph (a) of this section, A and B, but not C, each make 
an election for the reduced credit under section 280C(c)(3)(B) on the 
2012 Form 6765. In December 2013, B determines it had qualified research 
expenses in 2012 resulting in an increased group credit. On an amended 
2012 Form 6765, A, B, and C each report their allocated portions of the 
group credit. B reports its credit as a regular credit under section 
41(a) and reduces the credit under section 280C(c)(3)(B). C may not 
reduce its credit under section 280C(c)(3)(B) because C did not make an 
election for the reduced credit with its original return.
    (c)(1) Effective/applicability date. This section applies to taxable 
years ending on or after July 27, 2011.
    (2) Taxable years beginning after December 31, 2011. Paragraphs 
(b)(2) and (c)(2) and (3) of this section apply to taxable years 
beginning on or after April 2, 2018. For taxable years ending before 
April 2, 2018, see Sec. 1.280C-4T as contained in 26 CFR part 1, as 
revised April 1, 2017.
    (3) For taxable years ending before January 1, 2012. See Sec. 
1.280C-4 as contained in 26 CFR part 1, revised April 1, 2014.

[T.D. 9539, 76 FR 44801, July 27, 2011, as amended by T.D. 9717, 80 FR 
18099, Apr. 3, 2015; T.D. 9832, 83 FR 13185, Mar. 28, 2018]



Sec. 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).

    (a) In general. Section 280F(a) limits the amount of investment tax 
credit determined under section 46(a) and recovery deductions under 
section 168 for passenger automobiles. Section 280F(b) denies the 
investment tax credit and requires use of the straight line method of 
recovery for listed property that is not predominantly used in a 
qualified business use. In certain circumstances, section 280F(b) 
requires the recapture of an amount of cost recovery deductions 
previously claimed by the taxpayer. Section 280F(c) provides that 
lessees are to be subject to restrictions substantially equivalent to 
those imposed on owners of such property under section 280F (a) and (b). 
Section 280F(d) provides definitions and special rules; note that 
section 280F(d) (2) and (3) apply with respect to all listed property, 
even if the other provisions of section 280F do not affect the treatment 
of the property.
    (b) Key to Code provisions. The following table identifies the 
provisions of section 280F under which regulations are provided, and 
lists each provision below with its corresponding regulation section:

 
                                                      Sections
                                Section    Section   1.280F-5T   Section
      Section 1.280F-2T        1.280F-3T  1.280F-4T     and     1.280F-6
                                                      1.280F-7
 
             (a)                  (b)       (d)(2)      (c)      (d)(3)
            (d)(1)               (d)(1)   .........  .........   (d)(4)
            (d)(8)             .........  .........  .........   (d)(5)
           (d)(10)             .........  .........  .........   (d)(6)
 


Sections 1.280F-2T(f) and 1.280F-4T(b) also provide special rules for 
improvements to passenger automobiles and other listed property that 
qualify as capital expenditures.
    (c) Effective dates--(1) In general. This section and Sec. Sec. 
1.280F-2T through 1.280F-6 apply to property placed in service or leased 
after June 18, 1984, in taxable years ending after that date. Section 
1.280F-7 applies to property leased after December 31, 1986, in taxable 
years ending after that date.

[[Page 1034]]

    (2) Exception. This section and Sec. Sec. 1.280F-2T through 1.280F-
6 shall not apply to any property:
    (i) Acquired pursuant to a binding contract in effect on June 18, 
1984, and at all times thereafter, or under construction by the taxpayer 
on that date, but only if the property is placed in service before 
January 1, 1985 (January 1, 1987, in the case of 15-year real property), 
or
    (ii) Leased pursuant to a binding contract in effect on June 18, 
1984, and at all times thereafter, but only if the lessee first uses 
such property under the lease before January 1, 1985 (January 1, 1987, 
in the case of 15-year real property).
    (3) Leased passenger automobiles. Section 1.280F-5T(e) generally 
applies to passenger automobiles leased after April 2, 1985, and before 
January 1, 1987, in taxable years ending after April 2, 1985. Section 
1.280F-5T(e) generally applies to passenger automobiles leased after 
April 2, 1985, in taxable years ending after that date. Section 1.280F-
5T(e) does not apply to any passenger automobile that is leased pursuant 
to a binding contract, which is entered into no later than April 2, 
1985, and which is in effect at all times thereafter, but only if the 
automobile is used under the lease before August 1, 1985. If Sec. 
1.280F-5T(e) does not apply to a passenger automobile, see paragraph (c) 
(1) and (2) of this section. Section 1.280F-7(a) applies to passenger 
automobiles leased after December 31, 1986, in taxable years ending 
after that date.

[T.D. 7986, 49 FR 42704, Oct. 24, 1984, as amended by T.D. 8061, 50 FR 
46038, Nov. 6, 1985; T.D. 8218, 53 FR 29881, Aug. 9, 1988; T.D. 8473, 58 
FR 19060, Apr. 12, 1993; T.D. 9133, 69 FR 35514, June 25, 2004]



Sec. 1.280F-2T  Limitations on recovery deductions and the investment
tax credit for certain passenger automobiles (temporary).

    (a) Limitation on amount of investment tax credit--(1) General rule. 
The amount of the investment tax credit determined under section 46(a) 
for any passenger automobile shall not exceed $1,000. For a passenger 
automobile placed in service after December 31, 1984, the $1,000 amount 
shall be increased by the automobile price inflation adjustment (as 
defined in section 280F(d)(7)) for the calendar year in which the 
automobile is placed in service.
    (2) Election of reduced investment tax credit. If the taxpayer 
elects under section 48(q)(4) to reduce the amount of the investment tax 
credit in lieu of adjusting the basis of the passenger automobile under 
section 48(q)(1), the amount of the investment tax credit for any 
passenger automobile shall not exceed two-thirds of the amount 
determined under paragraph (a)(1) of this section.
    (b) Limitations on allowable recovery deductions--(1) Recovery 
deduction for year passenger automobile is placed in service. For the 
taxable year that a taxpayer places a passenger automobile in service, 
the allowable recovery deduction under section 168(a) shall not exceed 
$4,000. See paragraph (b)(3) of this section for the adjustment to this 
limitation.
    (2) Recovery deduction for remaining taxable years during the 
recovery period. For any taxable year during the recovery period 
remaining after the year that the property is placed in service, the 
allowable recovery deduction under section 168(a) shall not exceed 
$6,000. See paragraph (b)(3) of this section for the adjustment to this 
limitation.
    (3) Adjustment to limitation by reason of automobile price inflation 
adjustment. The limitations on the allowable recovery deductions 
prescribed in paragraph (b) (1) and (2) of this section are increased by 
the automobile price inflation adjustment (as defined in section 
280F(d)(7)) for the calendar year in which the automobile is placed in 
service.
    (4) Coordination with section 179. For purposes of section 280F(a) 
and this section, any deduction allowable under section 179 (relating to 
the election to expense certain depreciable trade or business assets) is 
treated as if that deduction were a recovery deduction under section 
168. Thus, the amount of the section 179 deduction is subject to the 
limitations described in paragraph (b) (1) and (2) of this section.
    (c) Disallowed recovery deductions allowed for years subsequent to 
the recovery period--(1) In general. (i) Except as otherwise provided in 
this paragraph (c),

[[Page 1035]]

the ``unrecovered basis'' (as defined in paragraph (c)(1)(ii) of this 
section) of any passenger automobile is treated as a deductible expense 
in the first taxable year succeeding the end of the recovery period.
    (ii) The term unrecovered basis means the excess (if any) of:
    (A) The unadjusted basis (as defined in section 168(d)(1)(A), except 
that there is no reduction by reason of an election to expense a portion 
of the basis under section 179) of the passenger automobile, over
    (B) The amount of the recovery deductions (including any section 179 
deduction elected by the taxpayer) which would have been allowable for 
taxable years in the recovery period (determined after the application 
of section 280F (a) and paragraph (b) of this section and as if all use 
during the recovery period were used described in section 168(c)(1)).
    (2) Special rule when taxpayer elects to use the section 168(b)(3) 
optional recovery percentages. If the taxpayer elects to use the 
optional recovery percentages under section 168(b)(3) or must use the 
straight line method over the earnings and profits life (as defined and 
described in Sec. 1.280F-3T(f)), the second succeeding taxable year 
after the end of the recovery period is treated as the first succeeding 
taxable year after the end of the recovery period for purposes of this 
paragraph (c) because of the half-year convention. For example, assume a 
calendar-year taxpayer places in service on July 1, 1984, a passenger 
automobile (i.e., 3-year recovery property) and elects under section 
168(b)(3) to recover its cost over 5 years using the straight line 
optional percentages. Based on these facts, calendar year 1990 is 
treated as the first succeeding taxable year after the end of the 
recovery period.
    (3) Deduction limited to $6,000 for any taxable year. The amount 
that may be treated as a deductible expense under this paragraph (c) in 
the first taxable year succeeding the recovery period shall not exceed 
$6,000. Any excess shall be treated as an expense for the succeeding 
taxable years. However, in no event may any deduction in a succeeding 
taxable year exceed $6,000. The limitation on amounts deductible as an 
expense under this paragraph (c) with respect to any passenger 
automobile is increased by the automobile price inflation adjustment (as 
defined in section 280F(d)(7)) for the calendar year in which such 
automobile is placed in service.
    (4) Deduction treated as a section 168 recovery deduction. Any 
amount allowable as an expense in a taxable year after the recovery 
period by reason of this paragraph (c) shall be treated as a recovery 
deduction allowable under section 168. However, a deduction is allowable 
by reason of this paragraph (c) with respect to any passenger automobile 
for a taxable year only to the extent that a deduction under section 168 
would be allowable with respect to the automobile for that year. For 
example, no recovery deduction is allowable for a year during which a 
passenger automobile is disposed of or is used exclusively for personal 
purposes.
    (d) Additional reduction in limitations by reason of personal use of 
passenger automobile or by reason of a short taxable year. See paragraph 
(i) of this section for rules regarding the additional reduction in the 
limitations prescribed by paragraphs (a) through (c) of this section by 
reason of the personal use of a passenger automobile or by reason of a 
short taxable year.
    (e) Examples. The provisions of paragraphs (a) through (c) of this 
section may be illustrated by the following examples. For purposes of 
these examples, assume that all taxpayers use the calendar year and that 
no short taxable years are involved.

    Example 1. (i) On July 1, 1984, B purchases for $45,000 and places 
in service a passenger automobile which is 3-year recovery property 
under section 168. In 1984, B does not elect under section 179 to 
expense a portion of the cost of the automobile. The automobile is used 
exclusively in B's business during taxable years 1984 through 1990.
    (ii) The maximum amount of B's investment tax credit is $1,000 
(i.e., the lesser of $1,000 or .06 x $45,000). B's unadjusted basis for 
purposes of section 168 is $44,500 (i.e., $45,000 reduced under section 
48(q)(1) by $500). B selects the use of the accelerated recovery 
percentages under section 168(b)(1).
    (iii) The maximum amount of B's recovery deduction for 1984 is 
$4,000 (i.e, the lesser of $4,000 or .25 x $44,500); for 1985, $6,000 
(i.e., the lesser of $6,000 or .38 x $44,500); and for 1986, $6,000 
(i.e., the lesser of $6,000 or .37 x $44,500).

[[Page 1036]]

    (iv) At the beginning of taxable year 1987, B's unrecovered basis in 
the automobile is $28,500 (i.e., $44,500-$16,000). Under paragraph (c) 
of this section, B may expense $6,000 of the unrecovered basis in the 
automobile in 1987. This expense is treated as a recovery deduction 
under section 168. For taxable years 1988 through 1990, B may deduct 
$6,000 of the unrecovered basis per year. At the beginning of 1991, B's 
unrecovered basis in the automobile is $4,500. During that year, B 
disposes of the automobile. B is not allowed a deduction for 1991 
because no deduction would be allowable under section 168 based on these 
facts.
    Example 2. (i) On July 1, 1984, C purchases for $50,000 and places 
in service a passenger automobile which is 3-year recovery property 
under section 168. The automobile is used exclusively in C's business 
during taxable years 1984 through 1992. In 1984, C does not elect under 
section 179 to expense a portion of the automobile's cost. C elects 
under section 48(q)(4) to take a reduced investment tax credit in lieu 
of the section 48(q)(1) basis adjustment.
    (ii) The maximum amount of C's investment tax credit is $666.67 
(i.e., the lesser of \2/3\ of $1,000 or .04 x $50,000). C's unadjusted 
basis for purposes of section 168 is $50,000. C elects to use the 
optional recovery percentages under section 168(b)(3) based on a 5-year 
recovery period.
    (iii) The maximum amount of C's recovery deduction for 1984 is 
$4,000 (i.e., the lesser of $4,000 or .10 x $50,000); for taxable years 
1985 through 1988, $6,000 per year (i.e., the lesser of $6,000 or .20 of 
$50,000). C's recovery deduction for 1989 is $5,000 (i.e., the lesser of 
.10 x $50,000 or $6,000).
    (iv) At the beginning of taxable year 1990, C's unrecovered basis in 
the automobile is $17,000. Under paragraph (c) of this section, C may 
expense $6,000 of the unrecovered basis in the automobile in 1990. this 
expense is treated as a recovery deduction under section 168. For 
taxable years 1991 and 1992, C may deduct $6,000, and $5,000, 
respectively of the unrecovered basis per year.
    Example 3. Assume the same facts as in Example 2, except that C 
disposes of the passenger automobile on July 1, 1990. Under paragraph 
(c) of this section, C is not allowed a deduction for 1990 or for any 
succeeding taxable year because no deduction would be allowable under 
section 168 based on these facts.
    Example 4. (i) On July 1, 1984, G purchases for $15,000 and places 
in service a passenger automobile which is 3-year recovery property 
under section 168. The automobile is used exclusively in G's business 
during taxable years 1984 through 1987. In 1984, G elects under section 
179 to expense $5,000 of the cost of the property.
    (ii) The maximum amount of G's investment tax credit is $600 (i.e., 
the lesser of .06 x $10,000 or $1,000).
    (iii) G's unadjusted basis for purposes of section 168 is $9,700 
(i.e., $15,000 minus the sum of $5,000 (the amount of the expense 
elected under section 179) and $300 (one-half of the investment tax 
credit under section 48(q)(1))). Under paragraph (b)(4) of this section, 
the allowable deduction under section 179 is treated as a recovery 
deduction under section 168 for purposes of this section. Thus, the 
maximum amount of G's section 179 deduction is $4,000 (i.e., the lesser 
of $4,000 or $5,000 + .25 x $9,700). G is entitled to no further 
recovery deduction under section 168 for 1984. The amount of G's 1985 
and 1986 recovery deductions are $3,686 (i.e., the lesser of .38 x 
$9,700 or $6,000) and $3,589 (i.e., the lesser of .37 x $9,700 or 
$6,000), respectively. At the beginning of 1987, G's unrecovered basis 
in the automobile is $3,425 (i.e., $14,700 - $11,275). Under paragraph 
(c) of this section, G may expense the remaining $3,425 in 1987.
    Example 5. (i) On July 1, 1984, D purchases for $55,000 and places 
in service a passenger automobile which is 3-year recovery property 
under section 168. The automobile is used exclusvely in D's business 
during taxable years 1984 through 1993. In 1984, D elects under section 
179 to expense $5,000 of the cost of the property.
    (ii) The maximum amount of D's investment tax credit is $1,000 
(i.e., the lesser of $1,000 or .06 x $50,000).
    (iii) D's unadjusted basis for purposes of section 168 is $49,500 
(i.e., $55,000 minus the sum of $5,000 (the amount of the expense 
elected under section 179) and $500 (one-half of the investment tax 
credit under section 48 (q)(1))). Under paragraph (b)(4) of this 
section, the allowable deduction under section 179 is treated as a 
recovery deduction under section 168 for purposes of this section. Thus, 
the maximum amount of D's section 179 deduction is $4,000 (i.e., the 
lesser of $4,000 or $5,000 + .25 x $49,500). D is entitled to no further 
recovery deduction under section 168 for 1984. The maximum amount of D's 
1985 recovery deduction is $6,000 (i.e., the lesser of $6,000 or .38 x 
$49,500); and for 1986, $6,000 (i.e., the lesser of $6,000 or .37 of 
$49,500).
    (iv) At the beginning of 1987, D's unrecovered basis is $38,500. D 
may expense the remaining unrecovered basis at the rate of $6,000 per 
year through 1992 and $2,500 in 1993.
    Example 6. Assume the same facts as in Example 5, except that in 
1993, D uses the automobile only 60 percent in his business. Under 
paragraph (c)(4) of this section for 1993, D may expense $1,500 (i.e., 
.60 x $2,500). D is entitled to no further deductions with respect to 
the automobile in any later year.
    Example 7. (i) On July 1, 1984, F purchases for $44,500 and places 
in service a passenger automobile which is 3-year recovery property 
under section 168. The automobile is

[[Page 1037]]

used exclusively in F's business during taxable years 1984 through 1992. 
In 1984, F elects under section 179 to expense $5,000 of the cost of the 
property.
    (ii) F elects under section 48(q)(4) to take a reduced investment 
tax credit in lieu of the section 48(q)(1) basis adjustment. The maximum 
amount of F's investment tax credit is $666.67 (i.e., the lesser of \2/
3\ of $1,000 or .04 x $39,500).
    (iii) F's unadjusted basis for purposes of section 168 is $39,500 
(i.e., $44,500 - $5,000 (the amount of the expense elected under section 
179)). F elects to use the optional recovery percentage under section 
168(b)(3) based on a 5-year recovery period. Under paragraph (b)(4) of 
this section, the allowable section 179 deduction is treated as a 
recovery deduction under section 168 for purposes of this section. Thus, 
the maximum amount of F's section 179 deduction is $4,000 (i.e., the 
lesser of $4,000 or $5,000 + .10 x $39,500). F is entitled to no further 
recovery deduction under section 168 for 1984. The maximum amounts of 
F's recovery deductions for 1985 through 1988 are $6,000 per year (i.e., 
the lesser of $6,000 or .20 x $39,500). F's recovery deduction for 1989 
(the first taxable year after the 5-year recovery period but the sixth 
recovery year for purposes of section 168) is $3,950 (i.e., the lesser 
of .10 x $39,500 or $6,000).
    (iv) Under paragraph (c), taxable year 1990 is considered to be the 
first taxable year succeeding the end of the recovery period. At the 
beginning of taxable year 1990, F's unrecovered basis in the automobile 
is $12,550 (i.e., $44,500 - $31,950). Under paragraph (c), F may expense 
$6,000 of his unrecovered basis in the automobile in 1990 and in 1991. 
This expense is treated as a recovery deduction under section 168. For 
taxable year 1992, F may expense the remaining $550 of his unrecovered 
basis in the automobile.

    (f) Treatment of improvements that qualify as capital expenditures. 
An improvement to a passenger automobile that qualifies as a capital 
expenditure under section 263 is treated as a new item of recovery 
property placed in service in the year the improvement is made. However, 
the limitations in paragraph (b) of this section on the amount of 
recovery deductions allowable are determined by taking into account as a 
whole both the improvement and the property of which the improvement is 
a part. If that improvement also qualifies as an investment in new 
section 38 property under section 48(b) and Sec. 1.48-2(b)(2), the 
limitation in paragraph (a)(1) of this section on the amount of the 
investment tax credit for that improvement is determined by taking into 
account any investment tax credit previously allowed for the passenger 
automobile (including any prior improvement considered part of the 
passenger automobile). Thus, the maximum credit allowable for the 
automobile (including the improvement) will be $1,000 (or \2/3\ of 
$1,000, in the case of an election to take a reduced credit under 
section 48(q)(4)) (adjusted under section 280F(d)(7) to reflect the 
automobile price inflation adjustment for the year the property of which 
the improvement is a part is placed in service).
    (g) Treatment of section 1031 or section 1033 transactions--(1) 
Treatment of exchanged passenger automobile. For a taxable year in which 
a transaction described in section 1031 or section 1033 occurs, the 
unadjusted basis of an exchanged or converted passenger automobile shall 
cease to be taken into account in determining any recovery deductions 
allowable under section 168 as of the beginning of the taxable year in 
which the exchange or conversion occurs. Thus, no recovery deduction is 
allowable for the exchanged or converted automobile in the year of the 
exchange or conversion.
    (2) Treatment of acquired passenger automobile--(i) In general. The 
acquired automobile is treated as new property placed in service in the 
year of the exchange (or in the replacement year) and that year is its 
first recovery year.
    (ii) Limitations on recovery deductions. If the exchanged (or 
converted) automobile was acquired after the effective date of section 
280F (as set out in Sec. 1.280F-1(c)), the basis of that automobile as 
determined under section 1031(d) or section 1033(b) (whichever is 
applicable) must be reduced for purposes of computing recovery 
deductions with respect to the acquired automobile (but not for purposes 
of determining the amount of the investment tax credit and gain or loss 
on the sale or other disposition of the property) by the excess (if any) 
of:
    (A) The sum of the amounts that would have been allowable as 
recovery deductions with respect to the exchanged (or converted) 
automobile during taxable years preceding the year of the exchange (or 
conversion) if all of the use of the automobile during those

[[Page 1038]]

years was use described in section 168(c), over
    (B) The sum of the amounts allowable as recovery deductions during 
those years.
    (3) Examples. The provisions of this paragraph (g) may be 
illustrated by the following examples:

    Example 1. (i) In 1982, F purchases and places in service a 
passenger automobile which is 3-year recovery property under section 
168. The automobile is used exclusively in F's business.
    (ii) On July 1, 1984, F exchanges the passenger automobile and 
$1,000 cash for a new passenger automobile (``like kind'' property). 
Under paragraph (g)(1) of this section, no recovery deduction is allowed 
in 1984 for the exchanged automobile. Any investment tax credit claimed 
with respect to that automobile is subject to recapture under section 
47.
    (iii) F's basis in the acquired property (as determined under 
section 1031(d) and F's qualified investment are $20,000. Under the 
provisions of paragraph (g)(2)(i) of this section, the acquired property 
is treated as new recovery property placed in service in 1984 to the 
extent of the full $20,000 of basis. The maximum amount of F's 
investment tax credit is limited to $1,000 (i.e., the lesser of $1,000 
or .06 x $20,000). Cost recovery deductions are computed pursuant to 
paragraph (b) of this section.
    Example 2. (i) On July 1, 1984, E purchases for $30,000 and places 
in service a passenger automobile which is 3-year recovery property 
under section 168. In 1984, E's business use percentage is 80 percent 
and such use constitutes his total business/investment use.
    (ii) E elects under section 48(q)(4) to take a reduced investment 
tax credit in lieu of the section 48 (q)(1) basis adjustment. The 
maximum amount of E's investment tax credit is $533.33 (i.e., the lesser 
of \2/3\ of $1,000 x .80 or .80 x .04 x $30,000).
    (iii) E's unadjusted basis for purposes of section 168 is $30,000. E 
selects the use of the accelerated recovery percentages under section 
168(b)(1). The maximum amount of E's recovery deduction for 1984 is 
$3,200 (i.e., the lesser of .80 x $4,000 or .80 x .25 x $30,000).
    (iv) On June 10, 1985, E exchanges the passenger automobile and 
$1,000 cash for a new passenger automobile (``like kind'' property). 
Under paragraph (g)(1) of this section, no recovery deduction is 
allowable in 1985 for the exchanged automobile. The investment tax 
credit claimed is subject to recapture under section 47. Under paragraph 
(g)(2)(ii) of this section, E's basis in the acquired property for 
purposes of computing recovery deductions under section 280F is $27,000 
(i.e., $27,800 (section 1031(d) basis) - $800). The acquired automobile 
is used exclusively in F's business during taxable years 1985 through 
1988. Under paragraph (g)(2) of this section, the acquired property is 
treated as new recovery property placed in service in 1985. Assume that 
the automobile price inflation adjustment (as described under section 
280F(d)(7)) is zero. E's qualified investment in the property, as 
determined under Sec. 1.46-3(c)(1), is $27,800. The maximum amount of 
E's investment tax credit is $1,000 (i.e., the lesser of $1,000 or .06 x 
$27,800). E's unadjusted basis for purposes of section 168 is $26,500 
(i.e., $27,000 reduced under section 48(q)(1) by $500). Cost recovery 
deductions are computed pursuant to paragraph (b) of this section.

    (h) Other nonrecognition transactions. [Reserved]
    (i) Limitation under this section applies before other limitations--
(1) Personal use. The limitations imposed upon the maximum amount of the 
allowable investment tax credit and the allowable recovery deductions 
(as described in paragraphs (a) through (c) of this section) must be 
adjusted during any taxable year in which a taxpayer makes any use of a 
passenger automobile other than for business/investment use (as defined 
in Sec. 1.280F-6(d)(3)). The limitations on the amount of the allowable 
investment tax credit (as described in paragraph (a) of this section) 
and the allowable cost recovery deductions (as described in paragraphs 
(b) and (c) of this section) are redetermined by multiplying the 
limitations by the percentage of business/investment use (determined on 
an annual basis) during the taxable year.
    (2) Short taxable year. The limitations imposed upon the maximum 
amount of the allowable recovery deductions (as described in paragraphs 
(a) through (c) of this section) must be adjusted during any taxable 
year in which a taxpayer has a short taxable year. In this case, the 
limitation is adjusted by multiplying the limitation that would have 
been applied if the taxable year were not a short taxable year by a 
fraction, the numerator of which is the number of months and part-months 
in the short taxable year and the denominator of which is 12.
    (3) Examples. The provisions of this paragraph (i) may be 
illustrated by the following examples:

    Example 1. On July 1, 1984, A purchases and places in service a 
passenger automobile and

[[Page 1039]]

uses it 80 percent for business/investment use during 1984. Under 
paragraph (i)(1) of this section, the maximum amount of the investment 
tax credit that A may claim for the automobile is $800 (i.e., .80 x 
$1,000).
    Example 2. Assume the same facts as in Example 1, except that A 
elects under section 48(q)(4) to take a reduced investment tax credit in 
lieu of the section 48(q)(1) basis adjustment. Under paragraph (i)(1) of 
this section, the maximum amount of the investment tax credit that A may 
claim for the automobile is $533.33 (i.e., .80 x \2/3\ x $1,000).
    Example 3. On July 1, 1984, B purchases and places in service a 
passenger automobile and uses it 60 percent for business/investment use 
during 1984. Under paragraph (i)(1) of this section, the maximum amount 
of the investment tax credit that B may claim for the automobile is $600 
(i.e., .60 x $1,000). B uses the car 70 percent for business/investment 
use during 1985 and 80 percent during 1986. Under paragraph (i)(1) of 
this section, the maximum amount of recovery deductions that B may claim 
for 1984, 1985, and 1986 are $2,400 (i.e., .60 x $4,000), $4,200 (i.e., 
.70 x $6,000), and $4,800 (i.e., .80 x $6,000), respectively.
    Example 4. Assume the same facts as in Example 3 with the added 
facts that B's unrecovered basis at the beginning of 1987 is $6,000 and 
that B uses the automobile 85 percent for business/investment use during 
1987. Under paragraph (i)(1) of this section, the maximum amount that B 
may claim as an expense for 1987 is $5,000 (i.e., .85 x $6,000).
    Example 5. On August 1, 1984, C purchases and places in service a 
passenger automobile and uses it exclusively for business. Taxable year 
1984 for C is a short taxable year which consists of 6 months. Under 
paragraph (i)(2) of this section, the maximum amount that C may claim as 
a recovery deduction for 1984 is $2,000 (i.e., \6/12\ x $4,000).
    Example 6. Assume the same facts as in Example 5, except that C uses 
the passenger automobile 70 percent for business/investment use during 
1984. Under paragraph (i) (1) and (2) of this section, the maximum 
amount that C may claim as a recovery deduction for 1984 is $1,400 
(i.e., .70 x \6/12\ x $4,000).

(98 Stat. 494, 26 U.S.C. 280F; 68A Stat. 917, 26 U.S.C. 7805)

[T.D. 7986, 49 FR 42704, Oct. 24, 1984, as amended by T.D. 9133, 69 FR 
35514, June 25, 2004]



Sec. 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).

    (a) In general. Section 280F(b), generally, imposes limitations with 
respect to the amount allowable as an investment tax credit under 
section 46(a) and the amount allowable as a recovery deduction under 
section 168 in the case of listed property (as defined in Sec. 1.280F-
6(b)) if certain business use of the property (referred to as 
``qualified business use'') does not exceed 50 percent during a taxable 
year. Qualified business use generally means use in a trade or business, 
rather than use in an investment or other activity conducted for the 
production of income within the meaning of section 212. See Sec. 
1.280F-6(d) for the distinction between ``business/ investment use'' and 
``qualified business use.''
    (b) Limitation on the amount of investment tax credit--(1) Denial of 
investment tax credit when business use percentage not greater than 50 
percent. Listed property is not treated as section 38 property to any 
extent unless the business use percentage (as defined in section 
280F(d)(6) and Sec. 1.280F-6(d)(1)) is greater than 50 percent. For 
example, if a taxpayer uses listed property in a trade or business in 
the taxable year in which it is placed in service, but the business use 
percentage is not greater than 50 percent, no investment tax credit is 
allowed for that listed property. If, in the taxable year in which 
listed property is placed in service, the only business/investment use 
(as defined in Sec. 1.280F-6(d)(3)) of that property is qualified 
business use (as defined in Sec. 1.280F-6(d)(2)(i)), and the business 
use percentage is 55 percent, the investment tax credit is allowed for 
the 55 percent of the listed property that is treated as section 38 
property. The credit allowed is unaffected by any increase in the 
business use percentage in a subsequent taxable year.
    (2) Recapture of investment tax credit. Listed property ceases to be 
section 38 property to the extent that the business/investment use (as 
defined in Sec. 1.280F-6(d)(3)) for any taxable year is less than the 
business/investment use for the taxable year in which the property is 
placed in service. See Sec. 1.47-2(c). If the business use percentage 
(as defined in Sec. 1.280F-6(d)(1)) of listed property is greater than 
50 percent for the taxable year in which the property is placed in 
service, and less than or equal to 50 percent for any subsequent taxable 
year, that property ceases to

[[Page 1040]]

be section 38 property in its entirety in that subsequent taxable year. 
Under Sec. 1.47-1(c)(1)(ii)(b), the property (or a portion thereof) is 
treated as ceasing to be section 38 property on the first day of the 
taxable year in which the cessation occurs.
    (c) Limitation on the method of cost recovery under section 168 when 
business use of property not greater than 50 percent--(1) Year of 
acquisition. If any listed property (as defined in Sec. 1.280F-6(b)) is 
not predominantly used in a qualified business use (as defined in Sec. 
1.280F-6(d)(4)) in the year it is acquired, the recovery deductions 
allowed under section 168 for the property for that taxable year and for 
succeeding taxable years are to be determined using the straight line 
method over its earnings and profits life (as defined in paragraph (f) 
of this section). Additionally, the taxpayer is not entitled to make any 
election under section 179 with respect to the property for that year.
    (2) Subsequent years. If any listed property is not subject to 
paragraph (c)(1) of this section because such property is predominantly 
used in a qualified business use (as defined in Sec. 1.280F-6(d)(4)) 
during the year it is acquired but is not predominantly used in a 
qualified business use during a subsequent taxable year, the rules of 
this paragraph (c)(2) apply. In such a case, the taxpayer must determine 
the recovery deductions allowed under section 168 for the taxable year 
that the listed property is not predominantly used in a qualified 
business use and for any subsequent taxable year as if such property was 
not predominantly used in a qualified business use in the year in which 
it was acquired and there had been no section 179 election with respect 
to the property. Thus, the recovery deductions allowable under section 
168 for the remaining taxable years are computed by determining the 
applicable recovery percentage that would apply if the taxpayer had used 
the straight line method over the property's earnings and profits life 
beginning with the year the property was placed in service.
    (3) Effect of rule on recovery property that is not listed property. 
The mandatory use of the straight line method over the property's 
earnings and profits life under paragraphs (d) (1) and (2) of this 
section does not have any effect on the proper method of cost recovery 
for other recovery property of that same class placed in service in the 
same taxable year by the taxpayer and does not constitute an election to 
use an optional recovery period under section 168(b)(3).
    (d) Recapture of excess recovery deductions claimed--(1) In general. 
If paragraph (c)(2) of this section is applicable, any excess 
depreciation (as defined in paragraph (d)(2) of this section) must be 
included in the taxpayer's gross income and added to the property's 
adjusted basis for the first taxable year in which the property is not 
predominantly used in a qualified business use (as defined in Sec. 
1.280F-6(d)(4)).
    (2) Definition of excess depreciation. For purposes of this section, 
the term excess depreciation means the excess (if any) of:
    (i) The amount of the recovery deductions allowable with respect to 
the property for taxable years before the first taxable year in which 
the property was not predominantly used in a qualified business use, 
over
    (ii) The amount of the recovery deductions which would have been 
allowable for those years if the property had not been predominantly 
used in a qualified business use for the year it was acquired and there 
had been no section 179 election with respect to the property.

For purposes of paragraph (d)(2)(i), any deduction allowable under 
section 179 (relating to the election to expense certain depreciable 
trade or business assets) is treated as if that deduction was a recovery 
deduction under section 168.
    (3) Recordkeeping requirement. A taxpayer must be able to 
substantiate the use of any listed property, as prescribed in section 
274(d)(4) and Sec. 1.274-5T or Sec. 1.274-6T, for any taxable year for 
which recapture under section 280F(b)(3) and paragraph (d) (1) and (2) 
of this section may occur even if the taxpayer has fully depreciated (or 
expensed) the listed property in a prior year. For example, in the case 
of 3-year recovery property, the taxpayer shall maintain a log, journal, 
etc. for six years even though the taxpayer fully

[[Page 1041]]

depreciated the property in the first three years.
    (e) Earnings and profits life--(1) Definition. The earnings and 
profits life with respect to any listed property is generally the 
following:

------------------------------------------------------------------------
                                               The applicable recovery
              In the case of--                       period is--
------------------------------------------------------------------------
3-year property............................  5 years.
5-year property............................  12 years.
10-year property...........................  25 years.
18-year real property and low-income         40 years.
 housing.
15-year public utility property............  35 years.
------------------------------------------------------------------------


However, if the recovery period applicable to any recovery property 
under section 168 is longer than the above assigned recovery period, 
such longer recovery period shall be used. For example, generally, the 
recovery period for recovery property used predominantly outside the 
United States is the property's present class life (as defined in 
section 168(g)(2)). In many cases, a property's present class life is 
longer than the recovery period assigned to the property under the above 
table. Pursuant to this paragraph (e)(1), the property's recovery period 
is its present class life.
    (2) Applicable recovery percentages. If the applicable recovery 
period is determined pursuant to the table prescribed in paragraph 
(e)(1) of this section, the applicable recovery percentage is:
    (i) For property other than 18-year real property or low-income 
housing:

------------------------------------------------------------------------
                                           And the recovery period is--
        If the recovery year is--        -------------------------------
                                             5      12      25      35
------------------------------------------------------------------------
1.......................................      10       4       2       1
2.......................................      20       9       4       3
3.......................................      20       9       4       3
4.......................................      20       9       4       3
5.......................................      10       8       4       3
7.......................................  ......       8       4       3
8.......................................  ......       8       4       3
9.......................................  ......       8       4       3
10......................................  ......       8       4       3
11......................................  ......       8       4       3
12......................................  ......       8       4       3
13......................................  ......       4       4       3
14......................................  ......  ......       4       3
15......................................  ......  ......       4       3
16......................................  ......  ......       4       3
17......................................  ......  ......       4       3
18......................................  ......  ......       4       3
19......................................  ......  ......       4       3
20......................................  ......  ......       4       3
21......................................  ......  ......       4       3
22......................................  ......  ......       4       3
23......................................  ......  ......       4       3
24......................................  ......  ......       4       3
25......................................  ......  ......       4       3
26......................................  ......  ......       2       3
27......................................  ......  ......  ......       3
28......................................  ......  ......  ......       3
29......................................  ......  ......  ......       3
30......................................  ......  ......  ......       3
31......................................  ......  ......  ......       3
32......................................  ......  ......  ......       2
33......................................  ......  ......  ......       2
34......................................  ......  ......  ......       2
35......................................  ......  ......  ......       2
36......................................  ......  ......  ......       1
------------------------------------------------------------------------

    (ii) For 18-year real property: [Reserved]
    (iii) For low-income housing: [Reserved]
    (f) Examples. The provisions of this section may be illustrated by 
the following examples. For purposes of these examples, assume that all 
taxpayers use the calendar year and that no short taxable years are 
involved.

    Example 1. On July 1, 1984, B purchases for $50,000 and places in 
service an item of listed property (other than a passenger automobile) 
which is 3-year recovery property under section 168. For the first 
taxable year that the property is in service, B used the property 40 
percent in a trade or business, 40 percent for the production of income, 
and 20 percent for personal purposes. Although B's total business/
investment use is greater than 50 percent, the business use percentage 
for that taxable year is only 40 percent. Under paragraph (b)(1) of this 
section, no investment tax credit is allowed for the property.
    Example 2. (i) On January 1, 1985, C purchases for $40,000 and 
places in service an item of listed property (other than a passenger 
automobile) that is 3-year recovery property under section 168. Seventy 
percent of the use of the property is in C's trade or business and 30 
percent of the use is for personal purposes. C does not elect a reduced 
investment tax credit under section 48(q)(4). The amount of C's 
investment tax credit is $1,680 (i.e., $40,000 x .60 x .10 x .70).
    (ii) In addition, in 1986, only 55 percent of the use of the 
property is in C's trade or business and 45 percent of the use is for 
personal purposes. Under paragraph (b)(2) of this section, the property 
ceases to be section 38 property to the extent that the use in a trade 
or business decreased below 70 percent. As a result, a portion of the 
investment tax credit must be recaptured as an increase in tax liability 
for 1986 under the rules of section 47 (relating to the recapture of 
investment tax credit). See section 47(a)(5) and Sec. 1.47-2(e) for 
rules relating to the computation of the recapture amount.

[[Page 1042]]

    Example 3. On July 1, 1984, B purchases and places in service an 
item of listed property (other than a passenger automobile) that is 3-
year recovery property. B elects to take a reduced investment tax credit 
under section 48(q)(4). In 1984, B uses the property exclusively in his 
business. Assume that B's 1984 allowable recovery deduction is $12,500. 
In 1985 and 1986, the property is not predominantly used in a qualified 
business use. The investment tax credit claimed is subject to recapture 
in full under section 47 in 1985 since the property ceases to be section 
38 property in its entirety on January 1, 1985. Under paragraph (c)(2) 
of this section, B must treat the property for 1985 and subsequent 
taxable years as if he recovered its cost over a 5-year recovery period 
(i.e., its earnings and profits life) using the straight line method 
(with the half-year convention) from the time it was placed in service. 
Therefore, taxable year 1985 is treated as the property's second 
recovery year (of its 5-year recovery period) and the applicable 
recovery deduction using the straight line method must be used to 
determine the recovery deduction. Under paragraph (d) of this section, B 
must recapture any excess depreciation claimed for taxable year 1984. If 
B had used the straight line method over a 5-year recovery period his 
recovery deduction for 1984 would have been $5,000. Under paragraph 
(d)(2) of this section, B's excess depreciation is $7,500 (i.e., $12,500 
- $5,000) and that amount must be included in B's 1985 gross income and 
added to the property's basis. The taxable years 1986 through 1989 are 
the property's second through sixth recovery years, respectively, of 
such property's 5-year recovery period.
    Example 4. Assume the same facts as in Example 3, except that in 
1986 B used the property exclusively in his business. B is entitled to 
no investment tax credit with respect to the property in 1986 and must 
continue to recover the property's cost over a 5-year recovery period 
using the straight line method.
    Example 5. On July 1, 1984, H purchases and places in service listed 
property (other than a passenger automobile) which is 3-year recovery 
property under section 168. H selects the use of the accelerated 
recovery percentages under section 168. In 1984 through 1986, H uses the 
property exclusively for business. In 1987, the property is not 
predominantly used in a qualified business use. Under paragraph (c)(2) 
of this section, H must compute his 1987 and subsequent taxable year's 
recovery deductions using the straight line method over a 5-year 
recovery period with 1987 treated as the fourth recovery year. Under 
paragraph (d) of this section, H must recapture any excess depreciation 
claimed for taxable years 1984 through 1986 even though by 1987 the full 
cost of the property had already been recovered.
    Example 6. Assume the same facts as in Example 5, except that H uses 
the property exclusively for personal purposes in 1987. Under paragraph 
(d) of this section, H must recapture any excess depreciation claimed 
for taxable years 1984 through 1986. H is entitled to no cost recovery 
deduction under the 5-year straight line method for 1987. Assume further 
that in 1988 H uses the property 70 percent in his business. Thus, H's 
business use percentage for that year is 70 percent. Under paragraph 
(c)(2) of this section, H must compute his 1988 cost recovery deduction 
using the straight line method over a 5-year recovery period with 1988 
treated as the fifth recovery year.
    Example 7. (i) On July 1, 1984, F purchases for $70,000 and places 
in service listed property (other than a passenger automobile) which is 
3-year recovery property under section 168. F's business use percentage 
for 1984 through 1986 is 60 percent. F elects under section 179 to 
expense $5,000 of the cost of the property.
    (ii) F elects a reduced investment tax credit under section 
48(q)(4). The maximum amount of F's investment tax credit is $1,560 
(i.e., $65,000 x .04 x .60).
    (iii) F's unadjusted basis for purposes of section 168 is $65,000 
(i.e., $70,000 reduced by the $5,000 section 179 expense). F selects the 
use of the accelerated recovery percentages under section 168(b)(1). F's 
recovery deduction for 1984 is $9,750 (i.e., $65,000 x .25 x .60).
    (iv) In 1985, the property is not predominantly used in a qualified 
business use. The investment tax credit claimed is subject to recapture 
in full under section 47 in 1985 since the property ceases to be section 
38 property in its entirety on January 1, 1985. Under paragraph (c)(2) 
of this section, F must treat the property for 1985 and subsequent 
taxable years as if he recovered its cost over a 5-year recovery period 
(i.e., its earnings and profits life) using the straight line method 
(with the half year convention) from the time it was placed in service. 
Under paragraph (d) of this section, F must recapture any excess 
depreciation claimed for taxable year 1984. F's excess depreciation is 
$10,550 [i.e., ($65,000 x .25 x .60 + $5,000)-($70,000 x .10 x .60)]. 
This amount must be included in F's 1985 gross income and added to the 
property's adjusted basis.
    Example 8. (i) On July 1, 1984, G purchases for $60,000 and places 
in service a passenger automobile which is 3-year recovery property 
under section 168.
    (ii) In 1984, G's business use percentage is 80 percent and such use 
constitutes his total business/investment use. G elects under section 
48(q)(4) to take a reduced investment tax credit in lieu of the basis 
adjustment under section 48(q)(1). The maximum amount of G's investment 
tax credit is $533.33 (i.e., the lesser of .80 x \2/3\ x $1,000 or 
$60,000 x .80 x .04).

[[Page 1043]]

    (iii) In 1984, G does not elect under section 179 to expense a 
portion of the automobile's cost. G selects the use of the accelerated 
recovery percentages under section 168. G's unadjusted basis for 
purposes of section 168 is $60,000. The maximum amount of G's 1984 
recovery deduction is $3,200 (i.e., the lesser of .80 x $4,000 or .80 x 
.25 x $60,000).
    (iv) In 1985, G's business use percentage is 80 percent and such use 
constitutes his total business/investment use. The maximum amount of G's 
1985 recovery deduction is $4,800 (i.e., the lesser of .80 x $6,000 or 
.80 x .38 x $60,000).
    (v) In 1986, G's business use percentage is 45 percent and such use 
constitutes his total business/investment use. Under paragraph (b)(2) of 
this section, as a result of the decline in the business use percentage 
to 50 percent or less, the automobile ceases to be section 38 property 
in its entirety and G must recapture (pursuant to Sec. Sec. 1.47-1(c) 
and 1.47-2(e)) the investment tax credit previously claimed. Since G's 
business use percentage in 1986 is not greater than 50 percent, under 
the provisions of paragraph (d) of this section, G must recompute (for 
recapture purposes) his recovery deductions for 1984 and 1985 using the 
straight line method over a 5-year recovery period (i.e., earnings and 
profits life for 3-year recovery property using the half-year 
convention) to determine if any excess depreciation must be included in 
his 1986 taxable income. G's recomputed recovery deductions for 1984 and 
1985 are $3,200 (i.e., the lesser of .80 x $4,000 or .80 x .10 x 
$60,000), and $4,800 (i.e., the lesser of .80 x $6,000 or .80 x .20 x 
$60,000), respectively. G does not have to recapture any excess 
depreciation since his recovery deductions for 1984 and 1985 computed 
using the straight line method over a 5-year recovery period are the 
same as the amounts actually claimed during those years.
    (vi) Under paragraph (c)(2) of this section, for 1986 and succeeding 
taxable years G must compute his remaining recovery deductions using the 
straight line method over a 5-year recovery period beginning with the 
third recovery year. The maximum amount of G's 1986 recovery deduction 
is $2,700 (i.e., the lesser of .45 x $6,000 or .45 x .20 x $60,000). For 
taxable years 1987 through 1993, G's business use percentage is 55 
percent and such use constitutes his total business/investment use. G's 
1987 and 1988 recovery deductions are $3,300 per year (i.e., the lesser 
of .55 x $6,000 or .55 x .20 x $60,000). For taxable year 1989 (the last 
recovery year), G's recovery deduction is $3,300 (i.e., .55 x .10 x 
$60,000 or .55 x $6,000).
    (vii) As of the beginning of 1990, G will have claimed a total of 
$20,600 of recovery deductions. Under Sec. 1.280F-2T(c), G may expense 
his remaining unrecovered basis (up to a certain amount per year) in the 
first succeeding taxable year after the end of the recovery period and 
in taxable years thereafter. If G had used his automobile for 100 
percent business use in taxable years 1984 through 1989, G could have 
claimed a recovery deduction of $4,000 in 1984 and a recovery deduction 
of $6,000 in each of those remaining years. At the beginning of 1990, 
therefore, G's unrecovered basis (as defined in section 280F(d)(8)) is 
$26,000 (i.e., $60,000-$34,000). The maximum amount of G's 1990 recovery 
deduction is $3,300 (i.e., .55 x $6,000). At the beginning of 1991, G's 
unrecovered basis is $20,000 (i.e., $26,000 adjusted under section 
280F(d)(2) and Sec. 1.280F-4T(a) to account for the amount that would 
have been claimed in 1990 for 100 percent business/investment use during 
that year). The maximum amount of G's 1991 recovery deduction is $3,300 
(i.e., .55 x $6,000) and his unrecovered basis as of the beginning of 
1992 is $14,000 (i.e., $20,000-$6,000). In 1992, G disposes of the 
automobile. G is not allowed a recovery deduction for 1992.

(98 Stat. 494, 26 U.S.C. 280F; 68A Stat. 917, 26 U.S.C. 7805)

[T.D. 7986, 49 FR 42707, Oct. 24, 1984, as amended by T.D. 8061, 50 FR 
46038, Nov. 6, 1985; T.D. 9133, 69 FR 35514, June 25, 2004]



Sec. 1.280F-4T  Special rules for listed property (temporary).

    (a) Limitations on allowable recovery deductions in subsequent 
taxable years--(1) Subsequent taxable years affected by reason of 
personal use in prior years. For purposes of computing the amount of the 
recovery deduction for ``listed property'' for a subsequent taxable 
year, the amount that would have been allowable as a recovery deduction 
during an earlier taxable year if all of the use of the property was use 
described in section 168(c) is treated as the amount of the recovery 
deduction allowable during that earlier taxable year. The preceding 
sentence applies with respect to all earlier taxable years, beginning 
with the first taxable year in which some or all use of the ``listed 
property'' is use described in section 168(c). For example, on July 1, 
1984, B purchases and places in service listed property (other than a 
passenger automobile) which is 5-year recovery property under section 
168. B selects the use of the accelerated percentages under section 168. 
B's business/investment use of the property (all of which is qualified 
business use as defined in section 280F(d)(6)(B) and Sec. 1.280F-

[[Page 1044]]

6(d)(2)) in 1984 through 1988 is 80 percent, 70 percent, 60 percent, and 
55 percent, respectively, and B claims recovery deductions for those 
years based on those percentages. B's qualified business use for the 
property for 1989 and taxable years thereafter increases to 100 percent. 
Pursuant to this rule, B may not claim a recovery deduction in 1989 (or 
for any subsequent taxable year) for the increase in business use 
because there is no adjusted basis remaining to be recovered for cost 
recovery purposes after 1988.
    (2) Special rule for passenger automobiles. In the case of a 
passenger automobile that is subject to the limitations of Sec. 1.280F-
2T, the amount treated as the amount that would have been allowable as a 
recovery deduction if all of the use of the automobile was use described 
in section 168(c) shall not exceed $4,000 for the year the passenger 
automobile is placed in service and $6,000 for each succeeding taxable 
year (adjusted to account for the automobile price inflation adjustment, 
if any, under section 280F(d)(7) and for short taxable year under Sec. 
1.280F-2T(i)(2)). See. Sec. 1.280F-3T(g). Example 8.
    (b) Treatment of improvements that qualify as capital expenditures--
(1) In general. In the case of any improvement that qualifies as a 
capital expenditure under section 263 made to any listed property other 
than a passenger automobile, the rules of this paragraph (b) apply. See 
Sec. 1.280F-2T(f) for the treatment of an improvement made to a 
passenger automobile.
    (2) Investment tax credit allowed for the improvement. If the 
improvement qualifies as an investment in new section 38 property under 
section 48(b) and Sec. 1.48-2(b), the investment tax credit for that 
improvement is limited by paragraph (b)(1) of Sec. 1.280F-3T, as 
applied to the item of listed property as a whole.
    (3) Cost recovery of the improvement. The improvement is treated as 
a new item of recovery property. The method of cost recovery with 
respect to that improvement is limited by Sec. 1.280F-3T(c), as applied 
to the item of listed property as a whole.

(98 Stat. 494, 26 U.S.C. 280F; 68A Stat. 917, 26 U.S.C. 7805)

[T.D. 7986, 49 FR 42710, Oct. 24, 1984, as amended by T.D. 9133, 69 FR 
35514, June 25, 2004]



Sec. 1.280F-5T  Leased property (temporary).

    (a) In general. Except as otherwise provided in this section, the 
limitation on cost recovery deductions and the investment tax credit 
provided in section 280F (a) and (b) and Sec. Sec. 1.280F-2T and 
1.280F-3T do not apply to any listed property leased or held for leasing 
by any person regularly engaged in the business of leasing listed 
property. If a person is not regularly engaged in the business of 
leasing listed property, the limitations on cost recovery deductions and 
the investment tax credit provided in section 280F and Sec. Sec. 
1.280F-2T and 1.280F-3T apply to such property leased or held for 
leasing by such person. The special rules for lessees set out in this 
section apply with respect to all lessees of listed property, even those 
whose lessors are not regularly engaged in the business of leasing 
listed property. For rules on determining inclusion amounts with respect 
to passenger automobiles, see paragraphs (d), (e) and (g) of this 
section, and see Sec. 1.280F-7(a). For rules on determining inclusion 
amounts with respect to other listed property, see paragraphs (f) and 
(g) of this section, and see Sec. 1.280F-7(b).
    (b) Section 48(d) election. If a lessor elects under section 48(d) 
with respect to any listed property to treat the lessee as having 
acquired such property, the amount of the investment tax credit allowed 
to the lessee is subject to the limitation prescribed in Sec. 1.280F-
3T(b) (1) and (2). If a lessor elects under section 48(d) with respect 
to any passenger automobile to treat the lessee as having acquired such 
automobile, the amount of the investment tax credit allowed to the 
lessee is also subject to the limitations prescribed in Sec. 1.280F-2T 
(a) and (i).
    (c) Regularly engaged in the business of leasing. For purposes of 
paragraph (a)

[[Page 1045]]

of this section, a person shall be considered regularly engaged in the 
business of leasing listed property only if contracts to lease such 
property are entered into with some frequency over a continuous period 
of time. The determination shall be made on the basis of the facts and 
circumstances in each case, taking into account the nature of the 
person's business in its entirety. Occasional or incidental leasing 
activity is insufficient. For example, a person leasing only one 
passenger automobile during a taxable year is not regularly engaged in 
the business of leasing automobiles. In addition, an employer that 
allows an employee to use the employer's property for personal purposes 
and charges such employee for the use of the property is not regularly 
engaged in the business of leasing with respect to the property used by 
the employee.
    (d) Inclusions in income of lessees of passenger automobiles leased 
after June 18, 1984, and before April 3, 1985--(1) In general. If a 
taxpayer leases a passenger automobile after June 18, 1984, but before 
April 3, 1985, for each taxable year (except the last taxable year) 
during which the taxpayer leases the automobile, the taxpayer must 
include in gross income an inclusion amount (prorated for the number of 
days of the lease term included in that taxable year), determined under 
this paragraph (d)(1), and multiplied by the business/investment use (as 
defined in Sec. 1.280F-6(d)(3)(i)) for the particular taxable year. The 
inclusion amount:
    (i) Is 7.5 percent of the excess (if any) of the automobile's fair 
market value over $16,500 for each of the first three taxable years 
during which a passenger automobile is leased.
    (ii) Is 6 percent of the excess (if any) of the automobile's fair 
market value over $22,500 for the fourth taxable year during which a 
passenger automobile is leased.
    (iii) Is 6 percent of the excess (if any) of the automobile's fair 
market value over $28,500 for the fifth taxable year during which a 
passenger automobile is leased.
    (iv) Is 6 percent of the excess (if any) of the automobile's fair 
market value over $34,500 for the sixth taxable year during which a 
passenger automobile is leased.

For the seventh and subsequent taxable years during which a passenger 
automobile is leased, the inclusion amount is 6 percent of the excess 
(if any) of the automobile's fair market value over the sum of (A) 
$16,500 and (B) $6,000 multiplied by the number of such taxable years in 
excess of three years. See paragraph (g)(2) of this section for the 
definition of fair market value.
    (2) Additional inclusion amount when less than predominant use in a 
qualified business use. (i) If a passenger automobile, which is leased 
after June 18, 1984, and before April 3, 1985, is not used predominantly 
in a qualified business use during a taxable year, the lessee must add 
to gross income in the first taxable year that the automobile is not so 
used (and only in that year) an inclusion amount determined under this 
paragraph (d)(2). This inclusion amount is in addition to the amount 
required to be included in gross income under paragraph (d)(1) of this 
section.
    (ii) If the fair market value (as defined in paragraph (h)(2) of 
this section) of the automobile is greater than $16,500, the inclusion 
amount is determined by multiplying the average of the business/
investment use (as defined in paragraph (h)(3) of this section) by the 
appropriate dollar amount from the table in paragraph (d)(2)(iii) of 
this section. If the fair market value (as defined in paragraph (h)(2) 
of this section) of the automobile is $16,500 or less, the inclusion 
amount is the product of the fair market value of the automobile, the 
average business/investment use, and the applicable percentage from the 
table in paragraph (d)(2)(iv) of this section.
    (iii) The dollar amount is determined under the following table:

[[Page 1046]]



------------------------------------------------------------------------
                                          The dollar amount:
If a passenger automobile is -------------------------------------------
 not predominantly used in a              Lease term (years)
   qualified business use    -------------------------------------------
          during--                1          2          3      4 or more
------------------------------------------------------------------------
The first taxable year of          $350       $700     $1,350     $1,850
 the lease term.............
The second taxable year of    .........  .........        650      1,250
 the lease term.............
The third taxable year of     .........  .........  .........        650
 the lease term.............
------------------------------------------------------------------------

    (iv) The applicable percentage is determined under the following 
table:

------------------------------------------------------------------------
                                           The applicable percentage:
                                       ---------------------------------
   If a passenger automobile is not            Lease term (years)
   predominantly used in a qualified   ---------------------------------
         business use during--                                     4 or
                                           1       2        3      more
------------------------------------------------------------------------
The first taxable year of the lease        3.0     6.0     10.2     13.2
 term.................................
The second taxable year of the lease    ......     1.25     6.2     10.4
 term.................................
The third taxable year of the lease     ......  .......     2.25     6.5
 term.................................
The fourth taxable year of the lease    ......  .......  .......     1.7
 term.................................
The fifth taxable year of the lease     ......  .......  .......     0.5
 term.................................
------------------------------------------------------------------------

    (e) Inclusions in income of lessees of passenger automobiles leased 
after April 2, 1985, and before January 1, 1987--(1) In general. For any 
passenger automobile that is leased after April 2, 1985, and before 
January 1, 1987, for each taxable year (except the last taxable year) 
during which the taxpayer leases the automobile, the taxpayer must 
include in gross income an inclusion amount determined under 
subparagraphs (2) through (5) of this paragraph (e). Additional 
inclusion amounts when a passenger automobile is not used predominantly 
in a qualified business use during a taxable year are determined under 
paragraph (e)(6) of this section. See paragraph (h)(2) of this section 
for the definition of fair market value.
    (2) Fair market value not greater than $50,000: years one through 
three. For any passenger automobile that has a fair market value not 
greater than $50,000, the inclusion amount for each of the first three 
taxable years during which the automobile is leased is determined as 
follows:
    (i) For the appropriate range of fair market values in the table in 
paragraph (e)(2)(iv) of this section, select the dollar amount from the 
column for the quarter of the taxable year in which the automobile is 
first used under the lease,
    (ii) Prorate the dollar amount for the number of days of the lease 
term included in the taxable year, and
    (iii) Multiply the prorated dollar amount by the business/investment 
use for the taxable year.
    (iv) Dollar amounts: Years 1-3:

                        Dollar Amounts: Years 1-3
------------------------------------------------------------------------
    Fair market value                  Taxable year quarter
------------------------------------------------------------------------
               But not
  Greater      greater        4th         3d          2d          1st
   than--       than--
------------------------------------------------------------------------
  $11,250      $11,500           $8          $7          $6          $6
   11,500       11,750           24          21          19          17
   11,750       12,000           40          35          32          29
   12,000       12,250           56          49          44          40
   12,250       12,500           72          64          57          52
   12,500       12,750           88          78          70          63
   12,750       13,000          104          92          83          75
   13,000       13,250          120         106          95          86
   13,250       13,500          144         128         115         104
   13,500       13,750          172         153         137         124
   13,750       14,000          200         177         159         145
   14,000       14,250          228         202         182         165
   14,250       14,500          256         227         204         185
   14,500       14,750          284         252         226         206
   14,750       15,000          312         277         249         226
   15,000       15,250          340         302         271         246
   15,250       15,500          369         327         293         266
   15,500       15,750          397         352         316         287
   15,750       16,000          425         377         338         307
   16,000       16,250          453         402         360         327
   16,250       16,500          481         426         383         348
   16,500       16,750          509         451         405         368
   16,750       17,000          537         476         428         388
   17,000       17,500          579         514         461         419
   17,500       18,000          635         563         506         459
   18,000       18,500          691         613         550         500
   18,500       19,000          748         663         595         541
   19,000       19,500          804         713         640         581
   19,500       20,000          860         763         685         622
   20,000       20,500          916         812         729         662
   20,500       21,000          972         862         774         703
   21,000       21,500        1,028         912         819         744
   21,500       22,000        1,084         962         863         784
   22,000       23,000        1,169       1,036         930         845
   23,000       24,000        1,281       1,136       1,020         926
   24,000       25,000        1,393       1,236       1,109       1,007
   25,000       26,000        1,506       1,335       1,199       1,089
   26,000       27,000        1,618       1,435       1,288       1,170
   27,000       28,000        1,730       1,534       1,377       1,251
   28,000       29,000        1,842       1,634       1,467       1,332
   29,000       30,000        1,955       1,734       1,556       1,413
   30,000       31,000        2,067       1,833       1,646       1,495
   31,000       32,000        2,179       1,933       1,735       1,576
   32,000       33,000        2,292       2,032       1,824       1,657
   33,000       34,000        2,404       2,132       1,914       1,738

[[Page 1047]]

 
   34,000       35,000        2,516       2,232       2,003       1,819
   35,000       36,000        2,629       2,331       2,093       1,901
   36,000       37,000        2,741       2,431       2,182       1,982
   37,000       38,000        2,853       2,530       2,271       2,063
   38,000       39,000        2,965       2,630       2,361       2,144
   39,000       40,000        3,078       2,730       2,450       2,225
   40,000       41,000        3,190       2,829       2,540       2,307
   41,000       42,000        3,302       2,929       2,629       2,388
   42,000       43,000        3,415       3,028       2,718       2,469
   43,000       44,000        3,527       3,128       2,808       2,550
   44,000       45,000        3,639       3,228       2,897       2,631
   45,000       46,000        3,752       3,327       2,987       2,713
   46,000       47,000        3,864       3,427       3,076       2,794
   47,000       48,000        3,976       3,526       3,165       2,875
   48,000       49,000        4,088       3,626       3,255       2,956
   49,000       50,000        4,201       3,726       3,344       3,037
------------------------------------------------------------------------

    (3) Fair market value not greater than $50,000: years four through 
six. For any passenger automobile that has a fair market value greater 
than $18,000, but not greater than $50,000, the inclusion amount for the 
fourth, fifth, and sixth taxable years during which the automobile is 
leased is determined as follows:
    (i) For the appropriate range of fair market values in the table in 
paragraph (e)(3)(iv) of this section, select the dollar amount from the 
column for the taxable year in which the automobile is used under the 
lease,
    (ii) Prorate the dollar amount for the number of days of the lease 
term included in the taxable year, and
    (iii) Multiply this dollar amount by the business/investment use for 
the taxable year.
    (iv) Dollar Amounts: Years 4-6:

                        Dollar Amounts: Years 4-6
------------------------------------------------------------------------
      Fair market value                          Year
------------------------------------------------------------------------
                  But not
Greater than-- greater than--       4              5              6
 
------------------------------------------------------------------------
   $18,000        $18,500            $15     .............  ............
    18,500         19,000             45     .............  ............
    19,000         19,500             75     .............  ............
    19,500         20,000            105     .............  ............
    20,000         20,500            135     .............  ............
    20,500         21,000            165     .............  ............
    21,000         21,500            195     .............  ............
    21,500         22,000            225     .............  ............
    22,000         23,000            270     .............  ............
    23,000         24,000            330            $42     ............
    24,000         25,000            390            102     ............
    25,000         26,000            450            162     ............
    26,000         27,000            510            222     ............
    27,000         28,000            570            282     ............
    28,000         29,000            630            342            $54
    29,000         30,000            690            402            114
    30,000         31,000            750            462            174
    31,000         32,000            810            522            234
    32,000         33,000            870            582            294
    33,000         34,000            930            642            354
    34,000         35,000            990            702            414
    35,000         36,000          1,050            762            474
    36,000         37,000          1,110            822            534
    37,000         38,000          1,170            882            594
    38,000         39,000          1,230            942            654
    39,000         40,000          1,290          1,002            714
    40,000         41,000          1,350          1,062            774
    41,000         42,000          1,410          1,122            834
    42,000         43,000          1,470          1,182            894
    43,000         44,000          1,530          1,242            954
    44,000         45,000          1,590          1,302          1,014
    45,000         46,000          1,650          1,362          1,074
    46,000         47,000          1,710          1,422          1,134
    47,000         48,000          1,770          1,482          1,194
    48,000         49,000          1,830          1,542          1,254
    49,000         50,000         11,890          1,602          1,314
------------------------------------------------------------------------

    (4) Fair market value greater than $50,000: years one through six. 
(i) For any passenger automobile that has a fair market value greater 
than $50,000, the inclusion amount for the first six taxable years 
during which the automobile is leased is determined as follows:
    (A) Determine the dollar amount by using the appropriate formula in 
paragraph (e)(4)(ii) of this section,
    (B) Prorate the dollar amount for the number of days of the lease 
term included in the taxable year, and
    (C) Multiply this dollar amount by the business/investment use for 
the taxable year.
    (ii) The dollar amount is computed as follows:
    (A) If the automobile is first used under the lease in the fourth 
quarter of a taxable year, the dollar amount for each of the first three 
taxable years during which the automobile is leased is the sum of--
    (1) $124, and
    (2) 11 percent of the excess of the automobile's fair market value 
over $13,200.
    (B) If the automobile is first used under the lease in the third 
quarter of a taxable year, the dollar amount for each of the first three 
taxable years during which the automobile is leased is the sum of--
    (1) $110, and

[[Page 1048]]

    (2) 10 percent of the excess of the automobile's fair market value 
over $13,200.
    (C) If the automobile is first used under the lease in the second 
quarter of a taxable year, the dollar amount for each of the first three 
taxable years during which the automobile is leased is the sum of--
    (1) $100, and
    (2) 9 percent of the excess of the automobile's fair market value 
over $13,200.
    (D) If the automobile is first used under the lease in the first 
quarter of a taxable year, the dollar amount for each of the first three 
taxable years during which the automobile is leased is the sum of--
    (1) $90, and
    (2) 8 percent of the excess of the automobile's fair market value 
over $13,200.
    (E) For the fourth taxable year during which the automobile is 
leased, the dollar amount is 6 percent of the excess of the automobile's 
fair market value over $18,000.
    (F) For the fifth taxable year during which the automobile is 
leased, the dollar amount is 6 percent of the excess of the automobile's 
fair market value over $22,800.
    (G) For the sixth taxable year during which the automobile is 
leased, the dollar amount is 6 percent of the excess of the automobile's 
fair market value over $27,600.
    (5) Seventh and subsequent taxable years. (i) For any passenger 
automobile that has a fair market value less than or equal to $32,400, 
the inclusion amount for the seventh and subsequent taxable years during 
which the automobile is leased is zero.
    (ii) For any passenger automobile that has a fair market value 
greater than $32,400, the inclusion amount for the seventh and 
subsequent taxable years during which the automobile is leased is 6 
percent of--
    (A) The excess (if any) of the automobile's fair market value, over
    (B) The sum of--
    (1) $13,200 and
    (2) $4,800 multiplied by the number of taxable years in excess of 
three years.
    (6) Additional inclusion amount when less than predominant use in a 
qualified business use. (i) If a passenger automobile, which is leased 
after April 2, 1985, and before January 1, 1987, is not predominantly 
used in a qualified business use during a taxable year, the lessee must 
add to gross income in the first taxable year that the automobile is not 
so used (and only in that year) an inclusion amount determined under 
this paragraph (e)(6). This inclusion amount is in addition to the 
amount required to be included in gross income under paragraph (e) (2), 
(3), (4), and (5) of this section.
    (ii) If the fair market value (as defined in paragraph (h)(2) of 
this section) of the automobile is greater than $11,250, the inclusion 
amount is determined by multiplying the average of the business/
investment use (as defined in paragraph (h)(3) of this section) by the 
appropriate dollar amount from the table in paragraph (e)(6)(iii) of 
this section. If the fair market value of the automobile is $11,250 or 
less, the inclusion amount is the product of the fair market value of 
the automobile, the average business/investment use, and the applicable 
percentage from the table in paragraph (e)(6)(iv) of this section.
    (iii) The dollar amount is determined under the following table:

------------------------------------------------------------------------
                                         The dollar amount is:
If a passenger automobile is -------------------------------------------
 not predominantly used in a             Lease term (years)--
   qualified business use    -------------------------------------------
          during--                1          2          3      4 or more
------------------------------------------------------------------------
The first taxable year of          $350       $700     $1,150     $1,500
 the lease term.............
The second taxable year of    .........        150        700      1,200
 the lease term.............
The third taxable year of     .........  .........        250        750
 the lease term.............
------------------------------------------------------------------------

    (iv) The applicable percentage is determined under the following 
table:

[[Page 1049]]



------------------------------------------------------------------------
                                           The applicable percentage:
                                       ---------------------------------
   If a passenger automobile is not           Lease term (years)--
   predominantly used in a qualified   ---------------------------------
         business use during--                                     4 or
                                           1       2        3      more
------------------------------------------------------------------------
The first taxable year of the lease        3.0     6.0     10.2     13.2
 term.................................
The second taxable year of the lease    ......     1.25     6.2     10.4
 term.................................
The third taxable year of the lease     ......  .......     2.25     6.5
 term.................................
The fourth taxable year of the lease    ......  .......  .......     1.7
 term.................................
The fifth taxable year of the lease     ......  .......  .......     0.5
 term.................................
------------------------------------------------------------------------

    (f) Inclusions in income of lessees of listed property other than 
passenger automobiles--(1) In general. If listed property other than a 
passenger automobile is not used predominantly in a qualified business 
use in any taxable year in which such property is leased, the lessee 
must add an inclusion amount to gross income in the first taxable year 
in which such property is not so predominantly used (and only in that 
year). This inclusion amount is determined under paragraph (f)(2) of 
this section for property leased after June 18, 1984, and before January 
1, 1987. The inclusion amount is determined under Sec. 1.280F-7(b) for 
property leased after December 31, 1986.
    (2) Inclusion amount for property leased after June 18, 1984, and 
before January 1, 1987. The inclusion amount for property leased after 
June 18, 1984, and before January 1, 1987, is the product of the 
following amounts:
    (i) The fair market value (as defined in paragraph (h)(2) of this 
section) of the property,
    (ii) The average business/investment use (as defined in paragraph 
(h)(3) of this section), and
    (iii) The applicable percentage (as determined under paragraph 
(f)(3) of this section).
    (3) Applicable percentages. The applicable percentages for 3-, 5-, 
and 10-year recovery property are determined according to the following 
tables:
    (i) In the case of 3-year recovery property:

----------------------------------------------------------------------------------------------------------------
                                                           For the first taxable year in which the business use
                                                             percentage is 50 percent or less, the applicable
                                                                   percentage for such taxable year is--
             Taxable year during lease term              -------------------------------------------------------
                                                                                                          6 and
                                                             1         2         3        4        5      later
----------------------------------------------------------------------------------------------------------------
For a lease term of:
  1 year................................................      3.0  ........  ........  .......  .......  .......
  2 years...............................................      6.0      1.25  ........  .......  .......  .......
  3 years...............................................     10.2      6.2       2.25  .......  .......  .......
  4 or more years.......................................     13.2     10.4       6.5       1.7      0.5        0
----------------------------------------------------------------------------------------------------------------

    (ii) In the case of 5-year recovery property:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                  For the first taxable year in which the business use percentage is 50 percent or less,
                                                                                   the applicable percentage for such taxable year is--
                 Taxable year during lease term                  ---------------------------------------------------------------------------------------
                                                                     1       2       3       4      5      6      7      8      9      10     11     12
--------------------------------------------------------------------------------------------------------------------------------------------------------
For a lease term of:
    1 year......................................................     2.7  ......  ......  ......  .....  .....  .....  .....  .....  .....  .....  .....
    2 years.....................................................     5.3     1.2  ......  ......  .....  .....  .....  .....  .....  .....  .....  .....
    3 years.....................................................     9.9     6.1     1.6  ......  .....  .....  .....  .....  .....  .....  .....  .....
    4 years.....................................................    14.4    11.1     7.3     2.3  .....  .....  .....  .....  .....  .....  .....  .....
    5 years.....................................................    18.4    15.7    12.4     8.2    3.0  .....  .....  .....  .....  .....  .....  .....
    6 or more years.............................................    21.8    19.6    16.7    13.5    9.6   5.25    4.4    3.6    2.8    1.8    1.0      0
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (iii) In the case of 10-year recovery property:

[[Page 1050]]



--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                    For the first taxable year in which the business use percentage is 50 pct or less, the applicable
                                                                                  percentage for such taxable year is--
         Taxable year during lease term         --------------------------------------------------------------------------------------------------------
                                                   1      2      3      4      5      6      7      8      9      10     11     12     13     14     15
--------------------------------------------------------------------------------------------------------------------------------------------------------
For a lease term of:
    1 year.....................................    2.5  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....
    2 years....................................    5.1     .6  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....
    3 years....................................    9.8    5.6    1.0  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....
    4 years....................................   14.0   10.3    6.2    1.4  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....
    5 years....................................   17.9   14.5   10.9    6.7    1.8  .....  .....  .....  .....  .....  .....  .....  .....  .....  .....
    6 years....................................   21.3   18.3   15.1   11.4    7.1    2.1  .....  .....  .....  .....  .....  .....  .....  .....  .....
    7 years....................................   21.9   19.0   15.9   12.4    8.4    3.9    2.4  .....  .....  .....  .....  .....  .....  .....  .....
    8 years....................................   22.4   19.6   16.7   13.4    9.7    5.5    4.5    2.7  .....  .....  .....  .....  .....  .....  .....
    9 years....................................   22.9   20.2   17.4   14.3   10.9    7.0    6.4    5.1    3.0  .....  .....  .....  .....  .....  .....
    10 years...................................   23.5   20.9   18.2   15.2   11.9    8.3    8.1    7.2    5.7    3.3  .....  .....  .....  .....  .....
    11 years...................................   23.9   21.4   18.8   16.0   12.8    9.3    9.4    8.9    7.7    5.9    3.1  .....  .....  .....  .....
    12 years...................................   24.3   21.9   19.3   16.5   13.4   10.1   10.3   10.0    9.3    7.8    5.5    2.9  .....  .....  .....
    13 years...................................   24.7   22.2   19.7   16.9   14.0   10.7   11.1   11.0   10.4    9.2    7.4    5.2    2.7  .....  .....
    14 years...................................   25.0   22.5   20.1   17.3   14.4   11.1   11.6   11.7   11.3   10.3    8.8    6.9    4.8    2.5  .....
    15 or more years...........................   25.3   22.8   20.3   17.5   14.7   11.5   12.0   12.2   11.9   11.1    9.8    8.2    6.5    4.5    2.3
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (g) Special rules applicable to inclusions in income of lessees. 
This paragraph (g) applies to the inclusions in gross income of lessees 
prescribed under paragraphs (d)(2), (e)(6), or (f) of this section, or 
prescribed under Sec. 1.280F-7(b).
    (1) Lease term commences within 9 months of the end of lessee's 
taxable year. If:
    (i) The lease term commences within 9 months before the close of the 
lessee's taxable year,
    (ii) The property is not predominantly used in a qualified business 
use during that portion of the taxable year, and
    (iii) The lease term continues into the lessee's subsequent taxable 
year, then the inclusion amount is added to gross income in the lessee's 
subsequent taxable year and the amount is determined by taking into 
account the average of the business/investment use for both taxable 
years and the applicable percentage for the taxable year in which the 
lease term begins (or, in the case of a passenger automobile with a fair 
market value greater than $16,500, the appropriate dollar amount for the 
taxable year in which the lease term begins).
    (2) Lease term less than one year. If the lease term is less than 
one year, the amount which must be added to gross income is an amount 
that bears the same ratio to the inclusion amount determined before the 
application of this paragraph (g)(2) as the number of days in the lease 
term bears to 365.
    (3) Maximum inclusion amount. The inclusion amount shall not exceed 
the sum of all deductible amounts in connection with the use of the 
listed property properly allocable to the lessee's taxable year in which 
the inclusion amount must be added to gross income.
    (h) Definitions--(1) Lease term. In determining the term of any 
lease for purposes of this section, the rules of section 168(i)(3)(A) 
shall apply.
    (2) Fair market value. For purposes of this section, the fair market 
value of listed property is such value on the first day of the lease 
term. If the capitalized cost of listed property is specified in the 
lease agreement, the lessee shall treat such amount as the fair market 
value of the property.
    (3) Average business/investment use. For purposes of this section, 
the average business/investment use of any listed property is the 
average of the business/investment use for the first taxable year in 
which the business use percentage is 50 percent or less and all 
preceding taxable years in which such property is leased. See paragraph 
(g)(1) of this section for special rule when lease term commences within 
9 months before the end of the lessee's taxable year.
    (i) Examples. This section may be illustrated by the following 
examples.

    Example 1. On January 1, 1985, A, a calendar year taxpayer, leases 
and places in service a passenger automobile with a fair market value of 
$55,000. The lease is to be for a period of four years. During taxable 
years 1985

[[Page 1051]]

and 1986, A uses the automobile exclusively in a trade or business. 
Under paragraph (d)(1) of this section, A must include in gross income 
in both 1985 and 1986, $2,887.50 (i.e., ($55,000-$16,500) x 7.5%).
    Example 2. The facts are the same as in Example 1, and in addition, 
A uses the automobile only 45 percent in a trade or business during 
1987. Under paragraph (d)(1) of this section for 1987, A must include in 
gross income $1,299.38 (i.e., ($55,000-$16,500) x 7.5% x 45%). In 
addition, under paragraph (d)(2) of this section, A must also include in 
gross income in 1987, $530.85 (i.e., $650 x 81.67%, average business/
investment use).
    Example 3. On August 1, 1985, B, a calendar year taxpayer, leases 
and places in service an item of listed property which is 5-year 
recovery property, with a fair market value of $10,000. The lease is to 
be for a period of 5 years. B's qualified business use of the property 
is 40 percent in 1985, 100 percent in 1986, and 90 percent in 1987. 
Under paragraphs (f)(1) and (g)(1) of this section, before the 
application of paragraph (g)(3) of this section, B must include in gross 
income in 1986, $1,288.00 (i.e., $10,000 x 70% x 18.4%, the product of 
the fair market value, the average business use for both taxable years, 
and the applicable percentage for year one from the table in paragraph 
(f)(3)(iii) of this section).
    Example 4. On October 1, 1985, C, a calendar year taxpayer, leases 
and places in service an item of listed property which is 3-year 
recovery property with a fair market value of $15,000. The lease term is 
6 months (ending March 31, 1986) during which C uses the property 45 
percent in a trade or business, the only business/investment use. Under 
paragraphs (f)(1) and (g) (1) and (2) of this section, before the 
application of paragraph (g)(3) of this section, C must include in gross 
income in 1986, $100.97 (i.e., $15,000 x 45% x 3% x 182/365, the product 
of the fair market value, the average business use for both taxable 
years, and the applicable percentage for year one from the table in 
paragraph (f)(3)(i) of this section, prorated for the length of the 
lease term).
    Example 5. On July 15, 1985, A, a calendar year taxpayer, leases and 
places in service a passenger automobile with a fair market value of 
$45,300. The lease is for a period of 5 years, during which A uses the 
automobile exclusively in a trade or business. Under paragraph (e) (2) 
and (3) of this section, for taxable years 1985 through 1989, A must 
include the following amounts in gross income:

------------------------------------------------------------------------
                                                     Business
          Taxable year           Dollar  Proration     use     Inclusion
                                 amount             (percent)
------------------------------------------------------------------------
1985...........................  $3,327    170/365       100      $1,550
1986...........................   3,327    365/365       100       3,327
1987...........................   3,327    365/365       100       3,327
1988...........................   1,650    366/366       100       1,650
1989...........................   1,362    365/365       100       1,362
------------------------------------------------------------------------

    Example 6. The facts are the same as in Example 1, except that A 
uses the automobile only 45 percent in a trade or business during 1987 
through 1990. Under Sec. 1.280F-5T(e)(6), A must include in gross 
income for taxable year 1987, the first taxable year in which the 
automobile is not used predominantly in a trade or business, an 
additional amount based on the average business/investment use for 
taxable years 1985 through 1987. For taxable years 1985 through 1989, A 
must include the following amounts in gross income:

------------------------------------------------------------------------
                                                     Business
          Taxable year           Dollar  Proration     use     Inclusion
                                 amount             (percent)
------------------------------------------------------------------------
1985...........................  $3,327    170/365    100         $1,550
1986...........................   3,327    365/365    100          3,327
1987...........................   3,327    365/365     45          1,497
                                    750  .........     81.67         612
1988...........................   1,650    366/366     45            743
1989...........................   1,362    365/365     45            613
------------------------------------------------------------------------


(98 Stat. 494, 26 U.S.C. 280F; 68A Stat. 917, 26 U.S.C. 7805)

[T.D. 7986, 49 FR 42710, Oct. 24, 1984, as amended by T.D. 8061, 50 FR 
46038, Nov. 6, 1985; T.D. 8218, 53 FR 29881, Aug. 9, 1988; T.D. 8473, 58 
FR 19060, Apr. 12, 1993; T.D. 9133, 69 FR 35514, June 25, 2004]



Sec. 1.280F-6  Special rules and definitions.

    (a) Deductions of employee--(1) In general. Employee use of listed 
property shall not be treated as business/investment use (as defined in 
paragraph (d)(3) of this section) for purposes of determining the amount 
of any recovery deduction allowable (including any deduction under 
section 179) to the employee unless that use is for the convenience of 
the employer and required as a condition of employment.
    (2) ``Convenience of the employer'' and ``condition of employment'' 
requirements--(i) In general. The terms convenience of the employer and 
condition of employment generally have the same meaning for purposes of 
section 280F as they have for purposes of section 119 (relating to the 
exclusion from gross income for meals or lodging furnished for the 
convenience of the employer).

[[Page 1052]]

    (ii) ``Condition of employment.'' In order to satisfy the 
``condition of employment'' requirement, the use of the property must be 
required in order for the employee to perform the duties of his or her 
employment properly. Whether the use of the property is so required 
depends on all the facts and circumstances. Thus, the employer need not 
explicitly require the employee to use the property. Similarly, a mere 
statement by the employer that the use of the property is a condition of 
employment is not sufficient.
    (iii) ``Convenience of employer''. [Reserved]
    (3) Employee use. For purposes of this section, the term employee 
use means any use in connection with the performance of services by the 
employee as an employee.
    (4) Examples. The principles of this paragraph are illustrated in 
the following examples:

    Example 1. A is employed as a courier with W, which provides local 
courier services. A owns and uses a motorcycle to deliver packages to 
downtown offices for W. W does not provide delivery vehicles and 
explicitly requires all of its couriers to own a car or motorcycle for 
use in their employment with the company. A's use of the motorcycle for 
delivery purposes is for the convenience of W and is required as a 
condition of employment.
    Example 2. B is an inspector for X, a construction company with many 
construction sites in the local area. B is required to travel to the 
various construction sites on a regular basis; B uses her automobile to 
make these trips. Although X does not furnish B an automobile, X does 
not explicitly require B to use here own automobile. However, X 
reimburses B for any costs she incurs in traveling to the various job 
sites. B's use of here automobile in here employment is for the 
convenience of X and is required as a condition of employment.
    Example 3. Assume the same facts as in Example 2, except that X 
makes an automobile available to B who chooses to use her own automobile 
and receive reimbursement. B's use of her own automobile is not for the 
convenience of X and is not required as a condition of employment.
    Example 4. C is a pilot for Y, a small charter airline. Y requires 
its pilots to obtain x hours of flight time annually in addition to the 
number of hours of flight time spent with the airline. Pilots can 
usually obtain these hours by flying with a military reserve unit or by 
flying part-time with another airline. C owns his own airplane. C's use 
of his airplane to obtain the required flight hours is not for the 
convenience of the employer and is not required as a condition of 
employment.
    Example 5. D is employed as an engineer with Z, an engineering 
contracting firm. D occasionally takes work home at night rather than 
working late in the office. D owns and uses a computer which is 
virtually identical to the one she uses at the office to complete her 
work at home. D's use of the computer is not for the convenience of here 
employer and is not required as a condition of employment.

    (b) Listed property--(1) In general. Except as otherwise provided in 
paragraph (b)(5) of this section, the term listed property means:
    (i) Any passenger automobile (as defined in paragraph (c) of this 
section),
    (ii) Any other property used as a means of transportation (as 
defined in paragraph (b)(2) of this section),
    (iii) Any property of a type generally used for purposes of 
entertainment, recreation, or amusement, and
    (iv) Any computer or peripheral equipment (as defined in section 
168(i)(2)(B)), and
    (v) Any other property specified in paragraph (b)(4) of this 
section.
    (2) Means of transportation--(i) In general. Except as otherwise 
provided in paragraph (b)(2)(ii) of this section, property used as a 
means of transportation includes trucks, buses, trains, boats, 
airplanes, motorcycles, and any other vehicles for transporting persons 
or goods.
    (ii) Exception. The term ``listed property'' does not include any 
vehicle that is a qualified nonpersonal use vehicle as defined in 
section 274(i) and Sec. 1.274-5(k).
    (3) Property used for entertainment, etc.--(i) In general. Property 
of a type generally used for purposes of entertainment, recreation, or 
amusement includes property such as photographic, phonographic, 
communication, and video recording equipment.
    (ii) Exception. The term listed property does not include any 
photographic, phonographic, communication, or video recording equipment 
of a taxpayer if the equipment is use either exclusively at the 
taxpayer's regular business establishment or in connection with the 
taxpayer's principal trade or business.

[[Page 1053]]

    (iii) Regular business establishment. The regular business 
establishment of an employee is the regular business establishment of 
the employer of the employee. For purposes of this paragraph (b)(3), a 
portion of a dwelling unit is treated as a regular business 
establishment if the requirements of section 280A(c)(1) are met with 
respect to that portion.
    (4) Other property. [Reserved]
    (5) Exception for computers. The term listed property shall not 
include any computer (including peripheral equipment) used exclusively 
at a regular business establishment. For purposes of the preceding 
sentence, a portion of a dwelling unit shall be treated as a regular 
business establishment if (and only if) the requirements of section 
280A(c)(1) are met with respect to that portion.
    (c) Passenger automobile--(1) In general. Except as provided in 
paragraph (c)(3) of this section, the term passenger automobile means 
any 4-wheeled vehicle which is:
    (i) Manufactured primarily for use on public streets, roads, and 
highways, and
    (ii) Rated at 6,000 pounds gross vehicle weight or less.
    (2) Parts, etc. of automobile. The term passenger automobile 
includes any part, component, or other item that is physically attached 
to the automobile or is traditionally included in the purchase price of 
an automobile. The term does not include repairs that are not capital 
expenditures within the meaning of section 263.
    (3) Exception for certain vehicles. The term passenger automobile 
shall not include any:
    (i) Ambulance, hearse, or combination ambulance-hearse used by the 
taxpayer directly in a trade or business,
    (ii) Vehicle used by the taxpayer directly in the trade or business 
of transporting persons or property for compensation or hire, or
    (iii) Truck or van that is a qualified nonpersonal use vehicle as 
defined under Sec. 1.274-5T(k).
    (d) Business use percentage--(1) In general. The term business use 
percentage means the percentage of the use of any listed property which 
is qualified business use as described in paragraph (d)(2) of this 
section.
    (2) Qualified business use--(i) In general. Except as provided in 
paragraph (d)(2)(ii) of this section, the term qualified business use 
means any use in a trade or business of the taxpayer. The term qualified 
business use does not include use for which a deduction is allowable 
under section 212. Whether the amount of qualified business use exceeds 
50 percent is determinative of whether the investment tax credit and the 
accelerated percentages under section 168 are available for listed 
property (or must be recaptured). See Sec. 1.280F-3T.
    (ii) Exception for certain use by 5-percent owners and related 
persons--(A) In general. The term qualified business use shall not 
include:
    (1) Leasing property to any 5-percent owner or related person,
    (2) Use of property provided as compensation for the performance of 
services by a 5-percent owner or related person, or
    (3) Use of property provided as compensation for the performance of 
services by any person not described in paragraph (d)(2)(ii)(A)(2) of 
this section unless an amount is properly reported by the taxpayer as 
income to such person and, where required, there was withholding under 
chapter 24.

Paragraph (d)(2)(ii)(A)(1) of this section shall apply only to the 
extent that the use of the listed property is by an individual who is a 
related party or a 5-percent owner with respect to the owner or lessee 
of the property.
    (B) Special rule for aircraft. Paragraph (d)(2)(ii)(A) of this 
section shall not apply with respect to any aircraft if at least 25 
percent of the total use of the aircraft during the taxable year 
consists of qualified business use not described in paragraph 
(d)(2)(ii)(A).
    (C) Definitions. For purposes of this paragraph:
    (1) 5-percent owner. The term 5-percent owner means any person who 
is a 5-percent owner with respect to the taxpayer (as defined in section 
416 (i)(1)(B)(i)).
    (2) Related person. The term related person means any person related 
to the taxpayer (within the meaning of section 267(b)).

[[Page 1054]]

    (3) Business/investment use--(i) In general. The term business/
investment use means the total business or investment use of listed 
property that may be taken into account for purposes of computing 
(without regard to section 280F(b)) the percentage of cost recovery 
deduction for a passenger automobile or other listed property for the 
taxable year. Whether the accelerated percentages under section 168 (as 
opposed to use of the straight line method of cost recovery) are 
available with respect to listed property or must be recaptured is 
determined, however, by reference to qualified business use (as defined 
in paragraph (d)(2) of this section) rather than by reference to 
business/investment use. Whether a particular use of property is a 
business or investment use shall generally be determined under the rules 
of section 162 or 212.
    (ii) Entertainment use. The use of listed property for 
entertainment, recreation, or amusement purposes shall be treated as 
business use to the extent that expenses (other than interest and 
property tax expenses) attributable to that use are deductible after 
application of section 274.
    (iii) Employee use. See paragraph (a) of this section for 
requirements to be satisfied for employee use of listed property to be 
considered business/investment use of the property.
    (iv) Use of taxpayer's automobile by another person. Any use of the 
taxpayer's automobile by another person shall not be treated, for 
purposes of section 280F, as use in a trade or business under section 
162 unless that use:
    (A) Is directly connected with the business of the taxpayer,
    (B) Is properly reported by the taxpayer as income to the other 
person and, where required, there was withholding under chapter 24, or
    (C) Results in a payment of fair market rent.

For purposes of this paragraph (d)(4)(iv)(C), payment to the owner of 
the automobile in connection with such use is treated as the payment of 
rent.
    (4) Predominantly used in qualified business use--(i) Definition. 
Property is predominantly used in a qualified business use for any 
taxable year if the business use percentage (as defined in paragraph 
(d)(1) of this section) is greater than 50 percent.
    (ii) Special rule for transfers at death. Property does not cease to 
be used predominantly in a qualified business use by reason of a 
transfer at death.
    (iii) Other dispositions of property. [Reserved]
    (5) Examples. The following examples illustrate the principles set 
forth in this paragraph.

    Example 1. E uses a home computer 50 percent of the time to manage 
her investments. The computer is listed property within the meaning of 
section 280F(d)(4). E also uses the computer 40 percent of the time in 
her part-time consumer research business. Because E's business use 
percentage for the computer does not exceed 50 percent, the computer is 
not predominantly used in a qualified business use for the taxable year. 
Her aggregate business/investment use for purposes of determining the 
percent of the total allowable straight line depreciation that she can 
claim is 90 percent.
    Example 2. Assume that E in Example 1 uses the computer 30 percent 
of the time to manage her investments and 60 percent of the time in her 
consumer research business. E's business use percentage exceeds 50 
percent. Her aggregrate business/investment use for purposes of 
determining her allowable investment tax credit and cost recovery 
deductions is 90 percent.
    Example 3. F is the proprietor of a plumbing contracting business. 
F's brother is employed with F's company. As part of his compensation, 
F's brother is allowed to use one of the company automobiles for 
personal use. The use of the company automobiles by F's brother is not a 
qualified business use because F and F's brother are related parties 
within the meaning of section 267(b).
    Example 4. F, in Example 3, allows employees unrelated to him to use 
company automobiles as part of their compensation. F, however, does not 
include the value of these automobiles in the employees' gross income 
and F does not withhold with respect to the use of these automobiles. 
The use of the company automobiles by the employees in this case is not 
business/investment use.
    Example 5. X Corporation owns several automobiles which its 
employees use for business purposes. The employees are also allowed to 
take the automobiles home at night. However, the fair market value of 
the use of the automobile for any personal purpose, e.g., commuting to 
work, is reported by X as income to the employee and is withheld upon by 
X. The use of the automobile by the employee, even for personal 
purposes, is a qualified business use the respect to X.


[[Page 1055]]


    (e) Method of allocating use of property--(1) In general. For 
purposes of section 280F, the taxpayer shall allocate the use of any 
listed property that is used for more than one purpose during the 
taxable year to the various uses in the manner prescribed in paragraph 
(e) (2) and (3) of this section.
    (2) Passenger automobiles and other means of transportation. In the 
case of a passenger automobile or any other means of transportation, the 
taxpayer shall allocate the use of the property on the basis of mileage. 
Thus, the percentage of use in a trade or business for the year shall be 
determined by dividing the number of miles the vehicle is driven for 
purposes of that trade or business during the year by the total number 
of miles the vehicle is driven during the year for any purpose.
    (3) Other listed property. In the case of other listed property, the 
taxpayer shall allocate the use of that property on the basis of the 
most appropriate unit of time the property is actually used (rather than 
merely being available for use). For example, the percentage of use of a 
computer in a trade or business for a taxable year is determined by 
dividing the number of hours the computer is used for business purposes 
during the year by the total number of hours the computer is used for 
any purpose during the year.
    (f) Effective date--(1) In general. Except as provided in paragraph 
(f)(2) of this section, this section applies to property placed in 
service by a taxpayer on or after July 7, 2003. For regulations 
applicable to property placed in service before July 7, 2003, see Sec. 
1.280F-6T as in effect prior to July 7, 2003 (Sec. 1.280F-6T as 
contained in 26 CFR part 1, revised as of April 1, 2003).
    (2) Property placed in service before July 7, 2003. The following 
rules apply to property that is described in paragraph (c)(3)(iii) of 
this section, was placed in service by the taxpayer before July 7, 2003, 
and was treated by the taxpayer as a passenger automobile under Sec. 
1.280F-6T as in effect prior to July 7, 2003 (pre-effective date 
vehicle):
    (i) Except as provided in paragraphs (f)(2)(ii), (iii), and (iv) of 
this section, a pre-effective date vehicle will be treated as a 
passenger automobile to which section 280F(a) applies.
    (ii) A pre-effective date vehicle will be treated as property to 
which section 280F(a) does not apply if the taxpayer adopts that 
treatment in determining depreciation deductions on the taxpayer's 
original return for the year in which the vehicle is placed in service.
    (iii) A pre-effective date vehicle will be treated, to the extent 
provided in this paragraph (f)(2)(iii), as property to which section 
280F(a) does not apply if the taxpayer adopts that treatment on an 
amended Federal tax return in accordance with this paragraph 
(f)(2)(iii). This paragraph (f)(2)(iii) applies only if, on or before 
December 31, 2004, the taxpayer files, for all applicable taxable years, 
amended Federal tax returns (or qualified amended returns, if applicable 
(for further guidance, see Rev. Proc. 94-69 (1994-2 C.B. 804) and Sec. 
601.601(d)(2)(ii)(b) of this chapter)) treating the vehicle as property 
to which section 280F(a) does not apply. The applicable taxable years 
for this purpose are the taxable year in which the vehicle was placed in 
service by the taxpayer (or, if the period of limitation for assessment 
under section 6501 has expired for such year or any subsequent year (a 
closed year), the first taxable year following the most recent closed 
year) and all subsequent taxable years in which the vehicle was treated 
on the taxpayer's return as property to which section 280F(a) applies. 
If the earliest applicable taxable year is not the year in which the 
vehicle was placed in service, the adjusted depreciable basis of the 
property as of the beginning of the first applicable taxable year is 
recovered over the remaining recovery period. If the remaining recovery 
period as of the beginning of the first applicable taxable year is less 
than 12 months, the entire adjusted depreciable basis of the property as 
of the beginning of the first applicable taxable year is recovered in 
that year.
    (iv) A pre-effective date vehicle will be treated, to the extent 
provided in this paragraph (f)(2)(iv), as property to which section 
280F(a) does not apply if the taxpayer adopts that treatment on Form 
3115, Application for Change in Accounting Method, in accordance with 
this paragraph (f)(2)(iv). The taxpayer must follow the applicable 
administrative procedures issued under

[[Page 1056]]

Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's automatic 
consent to a change in method of accounting (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). If the taxpayer files a Form 3115 
treating the vehicle as property to which section 280F(a) does not 
apply, the taxpayer will be permitted to treat the change as a change in 
method of accounting under section 446(e) of the Internal Revenue Code 
and to take into account the section 481 adjustment resulting from the 
method change. For purposes of Form 3115, the designated number for the 
automatic accounting method change authorized for this paragraph 
(f)(2)(iv) is 89.

[T.D. 7986, 49 FR 42713, Oct. 24, 1984, as amended by T.D. 8061, 50 FR 
46041, Nov. 6, 1985; T.D. 9069, 68 FR 40130, July 7, 2003; T.D. 9133, 69 
FR 35514, June 25, 2004; T.D. 9483, 75 FR 27937, May 19, 2010]



Sec. 1.280F-7  Property leased after December 31, 1986.

    (a) Inclusions in income of lessees of passenger automobiles leased 
after December 31, 1986--(1) In general. If a taxpayer leases a 
passenger automobile after December 31, 1986, the taxpayer must include 
in gross income an inclusion amount determined under this paragraph (a), 
for each taxable year during which the taxpayer leases the automobile. 
This paragraph (a) applies only to passenger automobiles for which the 
taxpayer's lease term begins after December 31, 1986. See Sec. Sec. 
1.280F-5T(d) and 1.280F-5T(e) for rules on determining inclusion amounts 
for passenger automobiles for which the taxpayer's lease term begins 
before January 1, 1987. See Sec. 1.280F-5T(h)(2) for the definition of 
fair market value.
    (2) Inclusion Amount. For any passenger automobile leased after 
December 31, 1986, the inclusion amount for each taxable year during 
which the automobile is leased is determined as follows:
    (i) For the appropriate range of fair market values in the 
applicable table, select the dollar amount from the column for the 
taxable year in which the automobile is used under the lease (but for 
the last taxable year during any lease that does not begin and end in 
the same taxable year, use the dollar amount for the preceding taxable 
year).
    (ii) Prorate the dollar amount for the number of days of the lease 
term included in the taxable year.
    (iii) Multiply the prorated dollar amount by the business/investment 
use (as defined in Sec. 1.280F-6(d)(3)(i)) for the taxable year.
    (iv) The following table is the applicable table in the case of a 
passenger automobile leased after December 31, 1986, and before January 
1, 1989:

            Dollar Amounts for Automobiles With a Lease Term Beginning in Calendar Year 1987 or 1988
----------------------------------------------------------------------------------------------------------------
  Fair market                               Taxable year during lease
    value of    ---------------------------------------------------------------------------------
   automobile          1st              2nd             3rd             4th         5 and later
----------------------------------------------------------------------------------------------------------------
      Over           Not over
 
      $12,800          $13,100              $2              $5              $7              $8              $9
       13,100           13,400               6              14              20              24              28
       13,400           13,700              10              23              34              41              47
       13,700           14,000              15              32              47              57              65
       14,000           14,300              19              41              61              73              84
       14,300           14,600              23              50              74              89             103
       14,600           14,900              27              59              88             105             122
       14,900           15,200              31              68             101             122             140
       15,200           15,500              35              77             115             138             159
       15,500           15,800              40              87             128             154             178
       15,800           16,100              44              96             142             170             196
       16,100           16,400              48             105             155             186             215
       16,400           16,700              52             114             169             203             234
       16,700           17,000              56             123             182             219             253
       17,000           17,500              62             135             200             240             277
       17,500           18,000              69             150             223             267             309
       18,000           18,500              76             166             246             294             340
       18,500           19,000              83             181             268             321             371
       19,000           19,500              90             196             291             348             402
       19,500           20,000              97             211             313             375             433

[[Page 1057]]

 
       20,000           20,500             104             226             336             402             465
       20,500           21,000             111             242             358             429             496
       21,000           21,500             117             257             381             456             527
       21,500           22,000             124             272             403             483             558
       22,000           23,000             135             295             437             524             605
       23,000           24,000             149             325             482             578             667
       24,000           25,000             163             356             527             632             729
       25,000           26,000             177             386             572             686             792
       26,000           27,000             190             416             617             740             854
       27,000           28,000             204             447             662             794             917
       28,000           29,000             218             477             707             848             979
       29,000           30,000             232             507             752             902           1,041
       30,000           31,000             246             538             797             956           1,104
       31,000           32,000             260             568             842           1,010           1,166
       32,000           33,000             274             599             887           1,064           1,228
       33,000           34,000             288             629             933           1,118           1,291
       34,000           35,000             302             659             978           1,172           1,353
       35,000           36,000             316             690           1,023           1,226           1,415
       36,000           37,000             329             720           1,068           1,280           1,478
       37,000           38,000             343             751           1,113           1,334           1,540
       38,000           39,000             357             781           1,158           1,388           1,602
       39,000           40,000             371             811           1,203           1,442           1,665
       40,000           41,000             385             842           1,248           1,496           1,727
       41,000           42,000             399             872           1,293           1,550           1,789
       42,000           43,000             413             902           1,338           1,604           1,852
       43,000           44,000             427             933           1,383           1,658           1,914
       44,000           45,000             441             963           1,428           1,712           1,976
       45,000           46,000             455             994           1,473           1,766           2,039
       46,000           47,000             468           1,024           1,518           1,820           2,101
       47,000           48,000             482           1,054           1,563           1,874           2,164
       48,000           49,000             496           1,085           1,608           1,928           2,226
       49,000           50,000             510           1,115           1,653           1,982           2,288
       50,000           51,000             524           1,146           1,698           2,036           2,351
       51,000           52,000             538           1,176           1,743           2,090           2,413
       52,000           53,000             552           1,206           1,788           2,144           2,475
       53,000           54,000             566           1,237           1,834           2,198           2,538
       54,000           55,000             580           1,267           1,879           2,252           2,600
       55,000           56,000             594           1,297           1,924           2,306           2,662
       56,000           57,000             607           1,328           1,969           2,360           2,725
       57,000           58,000             621           1,358           2,014           2,414           2,787
       58,000           59,000             635           1,389           2,059           2,468           2,849
       59,000           60,000             649           1,419           2,104           2,522           2,912
       60,000           62,000             670           1,465           2,171           2,603           3,005
       62,000           64,000             698           1,525           2,262           2,711           3,130
       64,000           66,000             726           1,586           2,352           2,819           3,255
       66,000           68,000             753           1,647           2,442           2,927           3,379
       68,000           70,000             781           1,708           2,532           3,035           3,504
       70,000           72,000             809           1,768           2,622           3,143           3,629
       72,000           74,000             837           1,829           2,712           3,251           3,753
       74,000           76,000             865           1,890           2,802           3,359           3,878
       76,000           78,000             892           1,951           2,892           3,468           4,003
       78,000           80,000             920           2,012           2,982           3,576           4,128
       80,000           85,000             969           2,118           3,140           3,765           4,346
       85,000           90,000           1,038           2,270           3,365           4,035           4,658
       90,000           95,000           1,108           2,422           3,590           4,305           4,969
       95,000          100,000           1,177           2,574           3,816           4,575           5,281
      100,000          110,000           1,282           2,802           4,154           4,980           5,749
      110,000          120,000           1,421           3,105           4,604           5,520           6,372
      120,000          130,000           1,560           3,409           5,055           6,060           6,996
      130,000          140,000           1,699           3,713           5,505           6,600           7,619
      140,000          150,000           1,838           4,017           5,956           7,140           8,243
      150,000          160,000           1,977           4,321           6,406           7,680           8,866
      160,000          170,000           2,116           4,625           6,857           8,221           9,490
      170,000          180,000           2,255           4,929           7,307           8,761          10,113
      180,000          190,000           2,394           5,232           7,758           9,301          10,737
      190,000          200,000           2,533           5,536           8,208           9,841          11,360
----------------------------------------------------------------------------------------------------------------


[[Page 1058]]

    (v) The applicable table in the case of a passenger automobile first 
leased after December 31, 1988, will be contained in a revenue ruling or 
revenue procedure published in the Internal Revenue Bulletin.
    (3) Example. The following example illustrates the application of 
this paragraph (a):

    Example. On April 1, 1987, A, a calendar year taxpayer, leases and 
places in service a passenger automobile with a fair market value of 
$31,500. The lease is to be for a period of three years. During taxable 
years 1987 and 1988, A uses the automobile exclusively in a trade or 
business. During 1989 and 1990, A's business/investment use is 45 
percent. The appropriate dollar amounts from the table in paragraph 
(a)(2)(iv) of this section are $260 for 1987 (first taxable year during 
the lease), $568 for 1988 (second taxable year during the lease), $842 
for 1989 (third taxable year during the lease), and $842 for 1990. Since 
1990 is the last taxable year during the lease, the dollar amount for 
the preceding year (the third year) is used, rather than the dollar 
amount for the fourth year. For taxable years 1987 through 1990, A's 
inclusion amounts are determined as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                          Business
                          Tax year                               Dollar     Proration       use       Inclusion
                                                                 amount                  (percent)      amount
----------------------------------------------------------------------------------------------------------------
1987........................................................         $260      275/365          100         $196
1988........................................................          568      366/366          100          568
1989........................................................          842      365/365           45          379
1990........................................................          842       90/365           45           93
----------------------------------------------------------------------------------------------------------------

    (b) Inclusions in income of lessees of listed property (other than 
passenger automobiles) leased after December 31, 1986--(1) In general. 
If listed property other than a passenger automobile is not used 
predominantly in a qualified business use in any taxable year in which 
such property is leased, the lessee must add an inclusion amount to 
gross income in the first taxable year in which such property is not so 
predominantly used (and only in that year). This year is the first 
taxable year in which the business use percentage (as defined in Sec. 
1.280F-6(d)(1)) of the property is 50 percent or less. This inclusion 
amount is determined under this paragraph (b) for property for which the 
taxpayer's lease term begins after December 31, 1986 (and under Sec. 
1.280F-5T(f) for property for which the taxpayer's lease term begins 
before January 1, 1987). See also Sec. 1.280F-5T(g).
    (2) Inclusion amount. The inclusion amount for any listed property 
(other than a passenger automobile) leased after December 31, 1986, is 
the sum of the amounts determined under subdivisions (i) and (ii) of 
this subparagraph (2).
    (i) The amount determined under this subdivision (i) is the product 
of the following amounts:
    (A) The fair market value (as defined in Sec. 1.280F-5T(h)(2)) of 
the property,
    (B) The business/investment use (as defined in Sec. 1.280F-
6(d)(3)(i)) for the first taxable year in which the business use 
percentage (as defined in Sec. 1.280F-6(d)(1)) is 50 percent or less, 
and
    (C) The applicable percentage from the following table:

[[Page 1059]]



------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                         First taxable year during lease in which business use percentage is 50% or less
                                                               ---------------------------------------------------------------------------------------------------------------------------------
                       Type of property                                                                                                                                                  12 and
                                                                    1         2         3          4          5          6          7          8          9          10         11       Later
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Property with a recovery period of less than 7 years under the       2.1      -7.2      -19.8      -20.1      -12.4      -12.4      -12.4      -12.4      -12.4      -12.4      -12.4      -12.4
 alternative depreciation system (such as computers, trucks
 and airplanes)...............................................
Property with a 7- to 10-year recovery period under the              3.9      -3.8      -17.7      -25.1      -27.8      -27.2      -27.1      -27.6      -23.7      -14.7      -14.7      -14.7
 alternative depreciation system (such as recreation property)
Property with a recovery period of more than 10 years under          6.6      -1.6      -16.9      -25.6      -29.9      -31.1      -32.8      -35.1      -33.3      -26.7      -19.7      -12.2
 the alternative depreciation system (such as certain property
 with no class life)..........................................
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------


[[Page 1060]]

    (ii) The amount determined under this subdivision (ii) is the 
product of the following amounts:
    (A) The fair market value of the property,
    (B) The average of the business/investment use for all taxable years 
(in which such property is leased) that precede the first taxable year 
in which the business use percentage is 50 percent or less, and
    (C) The applicable percentage from the following table:

----------------------------------------------------------------------------------------------------------------
                                First taxable year during lease in which business use percentage is 50% or less
                             -----------------------------------------------------------------------------------
      Type of property                                                                                       12
                                1      2      3      4      5      6      7      8      9      10     11    and
                                                                                                           Later
----------------------------------------------------------------------------------------------------------------
Property with a recovery        0.0   10.0   22.0   21.2   12.7   12.7   12.7   12.7   12.7   12.7   12.7   12.7
 period of less than 7 years
 under the alternative
 depreciation system (Such
 as computers, trucks and
 airplanes).................
Property with a 7- to 10-       0.0    9.3   23.8   31.3   33.8   32.7   31.6   30.5   25.0   15.0   15.0   15.0
 year recovery period under
 the alternative
 depreciation system (such
 as recreation property)....
Property with a recovery        0.0   10.1   26.3   35.4   39.6   40.2   40.8   41.4   37.5   29.2   20.8   12.5
 period of more than 10
 years under the alternative
 depreciation system (such
 as certain property with no
 class life)................
----------------------------------------------------------------------------------------------------------------

    (3) Example. The following example illustrates the application of 
this paragraph (b):

    Example. On February 1, 1987, B, a calendar year taxpayer, leases 
and places in service a computer with a fair market value of $3,000. The 
lease is to be for a period of two years. B's qualified business use of 
the property, which is the only business/investment use, is 80 percent 
in taxable year 1987, 40 percent in taxable year 1988, and 35 percent in 
taxable year 1989. B must add an inclusion amount to gross income for 
taxable year 1988, the first taxable year in which B does not use the 
computer predominantly for business (i.e., the first taxable year in 
which B's business use percentage is 50 percent or less). Since 1988 is 
the second taxable year during the lease, and since the computer has a 
5-year recovery period under the General and Alternative Depreciation 
Systems, the applicable percentage from the table in subdivision (i) of 
paragraph (b)(2) is -7.2%, and the applicable percentage from the table 
in subdivision (ii) is 10%. B's inclusion amount is $154, which is the 
sum of the amounts determined under subdivisions (i) and (ii) of 
subparagraph (b)(2) of this paragraph. The amount determined under 
subdivision (i) is -$86 [$3,000 x 40% x (-7.2%)], and the amount 
determined under subdivision (ii) is $240 [$3,000 x 80% x 10%].

[T.D. 8218, 53 FR 29881, Aug. 9, 1988; 53 FR 32821, Aug. 26, 1988, as 
amended by T.D. 8298, 55 FR 13370, Apr. 12, 1990; Redesignated and 
amended at T.D. 8473, 58 FR 19060, Apr. 12, 1993; T.D. 9133, 69 FR 
35515, June 25, 2004; T.D. 9483, 75 FR 27937, May 19, 2010]



Sec. 1.280G-1  Golden parachute payments.

    The following questions and answers relate to the treatment of 
golden parachute payments under section 280G of the Internal Revenue 
Code of 1986, as added by section 67 of the Tax Reform Act of 1984 (Pub. 
L. No. 98-369; 98 Stat. 585) and amended by section 1804(j) of the Tax 
Reform Act of 1986 (Pub. L. No. 99-514; 100 Stat. 2807), section 
1018(d)(6)-(8) of the Technical and Miscellaneous Revenue Act of 1988 
(Pub. L. No. 100-647; 102 Stat. 3581), and section 1421 of the Small 
Business Job Protection Act of 1996 (Pub. L. No. 104-188; 110 Stat. 
1755). The following is a table of subjects covered in this section:

                                Overview

Effect of section 280G--Q/A-1
Meaning of ``parachute payment''--Q/A-2
Meaning of ``excess parachute payment''--Q/A-3
Effective date of section 280G--Q/A-4

                             Exempt Payments

Exempt payments generally--Q/A-5
Exempt payments with respect to certain corporations--Q/A-6
Shareholder approval requirements--Q/A-7
Exempt payments under a qualified plan--Q/A-8
Exempt payments of reasonable compensation--Q/A-9
Payor of Parachute Payments--Q/A-10

[[Page 1061]]

                 Payments in the Nature of Compensation

The nature of compensation--Q/A-11
Property transfers--Q/A-12
Stock options--Q/A-13
Reduction of amount of payment by consideration paid--Q/A-14

                        Disqualified Individuals

Meaning of ``disqualified individual''--Q/A-15
Personal service corporation treated as individual--Q/A-16
Meaning of ``shareholder''--Q/A-17
Meaning of ``officer''--Q/A-18
Meaning of ``highly-compensated individual''--Q/A-19
Meaning of ``disqualified individual determination period''--Q/A-20
Meaning of ``compensation''--Q/A-21

              Contingent on Change in Ownership or Control

General rules for determining payments contingent on change--Q/A-22
Payments under agreement entered into after change--Q/A-23
Amount of payment contingent on change--Q/A-24
Presumption that payment is contingent on change--Q/A-25, 26
Change in ownership or control--Q/A-27, 28, 29

           Three-Times-Base-Amount Test for Parachute Payments

Three-times-base-amount test--Q/A-30
Determination of present value--Q/A-31, 32, 33
Meaning of ``base amount''--Q/A-34
Meaning of ``base period''--Q/A-35
Special rule for determining base amount--Q/A-36
Securities Violation Parachute Payments--Q/A-37

         Computation and Reduction of Excess Parachute Payments

Computation of excess parachute payments--Q/A-38
Reduction by reasonable compensation--Q/A-39

                Determination of Reasonable Compensation

General criteria for determining reasonable compensation--Q/A-40
Types of payments generally considered reasonable compensation--Q/A-41, 
42, 43
Treatment of severance payments--Q/A-44

                           Miscellaneous Rules

Definition of corporation--Q/A-45
Treatment of affiliated group as one corporation--Q/A-46

                             Effective Date

General effective date of section 280G--Q/A-47
Effective date of regulations--Q/A-48

                                Overview

    Q-1: What is the effect of Internal Revenue Code section 280G?
    A-1: (a) Section 280G disallows a deduction for any excess parachute 
payment paid or accrued. For rules relating to the imposition of a 
nondeductible 20-percent excise tax on the recipient of any excess 
parachute payment, see Internal Revenue Code sections 4999, 275(a)(6), 
and 3121(v)(2)(A).
    (b) The disallowance of a deduction under section 280G is not 
contingent on the imposition of the excise tax under section 4999. The 
imposition of the excise tax under section 4999 is not contingent on the 
disallowance of a deduction under section 280G. Thus, for example, 
because the imposition of the excise tax under section 4999 is not 
contingent on the disallowance of a deduction under section 280G, a 
payee may be subject to the 20-percent excise tax under section 4999 
even though the disallowance of the deduction for the excess parachute 
payment may not directly affect the federal taxable income of the payor.
    Q-2: What is a parachute payment for purposes of section 280G?
    A-2: (a) The term parachute payment means any payment (other than an 
exempt payment described in Q/A-5) that--
    (1) Is in the nature of compensation;
    (2) Is made or is to be made to (or for the benefit of) a 
disqualified individual;
    (3) Is contingent on a change--
    (i) In the ownership of a corporation;
    (ii) In the effective control of a corporation; or
    (iii) In the ownership of a substantial portion of the assets of a 
corporation; and
    (4) Has (together with other payments described in paragraphs 
(a)(1), (2), and (3) of this A-2 with respect to the same disqualified 
individual) an aggregate present value of at least 3 times the 
individual's base amount.
    (b) Hereinafter, a change referred to in paragraph (a)(3) of this A-
2 is generally referred to as a change in ownership or control. For a 
discussion of the application of paragraph (a)(1), see Q/A-11 through Q/
A-14; paragraph (a)(2), Q/A-15 through Q/A-21; paragraph (a)(3), Q/A-22 
through Q/A-29; and paragraph (a)(4), Q/A-30 through Q/A-36.
    (c) The term parachute payment also includes any payment in the 
nature of compensation to (or for the benefit of) a disqualified 
individual that is pursuant to an agreement that violates a generally 
enforced securities law or regulation. This type of parachute payment is 
referred to in this section as a securities violation parachute payment. 
See Q/A-37 for the definition and treatment of securities violation 
parachute payments.
    Q-3: What is an excess parachute payment for purposes of section 
280G?

[[Page 1062]]

    A-3: The term excess parachute payment means an amount equal to the 
excess of any parachute payment over the portion of the base amount 
allocated to such payment. Subject to certain exceptions and 
limitations, an excess parachute payment is reduced by any portion of 
the payment which the taxpayer establishes by clear and convincing 
evidence is reasonable compensation for personal services actually 
rendered by the disqualified individual before the date of the change in 
ownership or control. For a discussion of the nonreduction of a 
securities violation parachute payment by reasonable compensation, see 
Q/A-37. For a discussion of the computation of excess parachute payments 
and their reduction by reasonable compensation, see Q/A-38 through Q/A-
44.
    Q-4: What is the effective date of section 280G and this section?
    A-4: In general, section 280G applies to payments under agreements 
entered into or renewed after June 14, 1984. Section 280G also applies 
to certain payments under agreements entered into on or before June 14, 
1984, and amended or supplemented in significant relevant respect after 
that date. This section applies to any payment that is contingent on a 
change in ownership or control and the change in ownership or control 
occurs on or after January 1, 2004. For a discussion of the application 
of the effective date, see Q/A-47 and Q/A-48.

                             Exempt Payments

    Q-5: Are some types of payments exempt from the definition of the 
term parachute payment?
    A-5: (a) Yes, the following five types of payments are exempt from 
the definition of parachute payment--
    (1) Payments with respect to a small business corporation (described 
in Q/A-6 of this section);
    (2) Certain payments with respect to a corporation no stock in which 
is readily tradeable on an established securities market (or otherwise) 
(described in Q/A-6 of this section);
    (3) Payments to or from a qualified plan (described in Q/A-8 of this 
section);
    (4) Certain payments made by a corporation undergoing a change in 
ownership or control that is described in any of the following sections 
of the Internal Revenue Code: section 501(c) (but only if such 
organization is subject to an express statutory prohibition against 
inurement of net earnings to the benefit of any private shareholder or 
individual, or if the organization is described in section 501(c)(1) or 
section 501(c)(21)), section 501(d), or section 529, collectively 
referred to as tax-exempt organizations (described in Q/A-6 of this 
section); and
    (5) Certain payments of reasonable compensation for services to be 
rendered on or after the change in ownership or control (described in Q/
A-9 of this section).
    (b) Deductions for payments exempt from the definition of parachute 
payment are not disallowed by section 280G, and such exempt payments are 
not subject to the 20-percent excise tax of section 4999. In addition, 
such exempt payments are not taken into account in applying the 3-times-
base-amount test of Q/A-30 of this section.
    Q-6: Which payments with respect to a corporation referred to in 
paragraph (a)(1), (a)(2), or (a)(4) of Q/A-5 of this section are exempt 
from the definition of parachute payment?
    A-6: (a) The term parachute payment does not include--
    (1) Any payment to a disqualified individual with respect to a 
corporation which (immediately before the change in ownership or 
control) would qualify as a small business corporation (as defined in 
section 1361(b) but without regard to section 1361(b)(1)(C) thereof), 
without regard to whether the corporation had an election to be treated 
as a corporation under section 1361 in effect on the date of the change 
in ownership or control;
    (2) Any payment to a disqualified individual with respect to a 
corporation (other than a small business corporation described in 
paragraph (a)(1) of this A-6) if--
    (i) Immediately before the change in ownership or control, no stock 
in such corporation was readily tradeable on an established securities 
market or otherwise; and
    (ii) The shareholder approval requirements described in Q/A-7 of 
this section are met with respect to such payment; or
    (3) Any payment to a disqualified individual made by a corporation 
which is a tax-exempt organization (as defined in paragraph (a)(4) of Q/
A-5 of this section), but only if the corporation meets the definition 
of a tax-exempt organization both immediately before and immediately 
after the change in ownership or control.
    (b) For purposes of paragraph (a)(1) of this A-6, the members of an 
affiliated group are not treated as one corporation.
    (c) The requirements of paragraph (a)(2)(i) of this A-6 are not met 
with respect to a corporation if a substantial portion of the assets of 
any entity consists (directly or indirectly) of stock in such 
corporation and any ownership interest in such entity is readily 
tradeable on an established securities market or otherwise. For this 
purpose, such stock constitutes a substantial portion of the assets of 
an entity if the total fair market value of the stock is equal to or 
exceeds one third of the total gross fair market value of all of the 
assets of the entity. For this purpose, gross fair market value means 
the value of the assets of the entity, determined without regard to any 
liabilities associated with such assets. If a corporation is a member of 
an affiliated group (which group is

[[Page 1063]]

treated as one corporation under A-46 of this section), the requirements 
of paragraph (a)(2)(i) of this A-6 are not met if any stock in any 
member of such group is readily tradeable on an established securities 
market or otherwise.
    (d) For purposes of paragraph (a)(2)(i) of this A-6, the term stock 
does not include stock described in section 1504(a)(4) if the payment 
does not adversely affect the redemption and liquidation rights of any 
shareholder owning such stock.
    (e) For purposes of paragraph (a)(2)(i) of this A-6, stock is 
treated as readily tradeable if it is regularly quoted by brokers or 
dealers making a market in such stock.
    (f) For purposes of paragraph (a)(2)(i) of this A-6, the term 
established securities market means an established securities market as 
defined in Sec. 1.897-1(m).
    (g) The following examples illustrate the application of this 
exemption:

    Example 1. A small business corporation (within the meaning of 
paragraph (a)(1) of this A-6) operates two businesses. The corporation 
sells the assets of one of its businesses, and these assets represent a 
substantial portion of the assets of the corporation. Because of the 
sale, the corporation terminates its employment relationship with 
persons employed in the business the assets of which are sold. Several 
of these employees are highly-compensated individuals to whom the owners 
of the corporation make severance payments in excess of 3 times each 
employee's base amount. Since the corporation is a small business 
corporation immediately before the change in ownership or control, the 
payments are not parachute payments.
    Example 2. Assume the same facts as in Example 1, except that the 
corporation is not a small business corporation within the meaning of 
paragraph (a)(1) of this A-6. If no stock in the corporation is readily 
tradeable on an established securities market (or otherwise) immediately 
before the change in ownership or control and the shareholder approval 
requirements described in Q/A-7 of this section are met, the payments 
are not parachute payments.
    Example 3. Stock of Corporation S is owned by Corporation P, stock 
in which is readily tradeable on an established securities market. The 
Corporation S stock equals or exceeds one third of the total gross fair 
market value of the assets of Corporation P, and thus, represents a 
substantial portion of the assets of Corporation P. Corporation S makes 
severance payments to several of its highly-compensated individuals that 
are parachute payments under section 280G and Q/A-2 of this section. 
Because stock in Corporation P is readily tradeable on an established 
securities market, the payments are not exempt from the definition of 
parachute payments under this A-6.
    Example 4. A is a corporation described in section 501(c)(3), and 
accordingly, its net earnings are prohibited from inuring to the benefit 
of any private shareholder or individual. A transfers substantially all 
of its assets to another corporation resulting in a change in ownership 
or control. Contingent on the change in ownership or control, A makes a 
payment that, but for the potential application of the exemption 
described in A-5(a)(4), would constitute a parachute payment. However, 
one or more aspects of the transaction that constitutes the change in 
ownership or control causes A to fail to be described in section 
501(c)(3). Accordingly, A fails to meet the definition of a tax-exempt 
organization both immediately before and immediately after the change in 
ownership or control, as required by this A-6. As a result, the payment 
made by A that was contingent on the change in ownership or control is 
not exempt from the definition of parachute payment under this A-6.
    Example 5. B is a corporation described in section 501(c)(15). B 
does not meet the definition of a tax-exempt organization because 
section 501(c)(15) does not expressly prohibit inurement of B's net 
earnings to the benefit of any private shareholder or individual. 
Accordingly, if B has a change in ownership or control and makes a 
payment that would otherwise meet the definition of a parachute payment, 
such payment is not exempt from the definition of the term parachute 
payment for purposes of this A-6.

    Q-7: How are the shareholder approval requirements referred to in 
paragraph (a)(2)(ii) of Q/A-6 of this section met?
    A-7: (a) General rule. The shareholder approval requirements 
referred to in paragraph (a)(2)(ii) of Q/A-6 of this section are met 
with respect to any payment if--
    (1) Such payment is approved by more than 75 percent of the voting 
power of all outstanding stock of the corporation entitled to vote (as 
described in this A-7) immediately before the change in ownership or 
control; and
    (2) Before the vote, there was adequate disclosure to all persons 
entitled to vote (as described in this A-7) of all material facts 
concerning all material payments which (but for Q/A-6 of this section) 
would be parachute payments with respect to a disqualified individual.
    (b) Voting requirements--(1) General rule. The vote described in 
paragraph (a)(1) of this A-7 must determine the right of the 
disqualified individual to receive the payment, or, in the case of a 
payment made before the vote, the right of the disqualified individual 
to retain the payment. Except as otherwise provided in this A-7, the 
normal voting rules of the corporation are applicable. Thus, for 
example, an optionholder is generally not permitted to vote for purposes 
of this A-7. For

[[Page 1064]]

purposes of this A-7, the vote can be on less than the full amount of 
the payment(s) to be made. Shareholder approval can be a single vote on 
all payments to any one disqualified individual, or on all payments to 
more than one disqualified individual. The total payment(s) submitted 
for shareholder approval, however, must be separately approved by the 
shareholders. The requirements of this paragraph (b)(1) are not 
satisfied if approval of the change in ownership or control is 
contingent, or otherwise conditioned, on the approval of any payment to 
a disqualified individual that would be a parachute payment but for Q/A-
6 of this section.
    (2) Special rule. A vote to approve the payment does not fail to be 
a vote of the outstanding stock of the corporation entitled to vote 
immediately before the change in ownership or control merely because the 
determination of the shareholders entitled to vote on the payment is 
based on the shareholders of record as of any day within the six-month 
period immediately prior to and ending on date of the change in 
ownership or control, provided the disclosure requirements described in 
paragraph (c) of this A-7 are met.
    (3) Entity shareholder. (i) Approval of a payment by any shareholder 
that is not an individual (an entity shareholder) generally must be made 
by the person authorized by the entity shareholder to approve the 
payment. See paragraph (b)(4) of this A-7 if the person so authorized by 
the entity shareholder is a disqualified individual who would receive a 
parachute payment if the shareholder approval requirements of this A-7 
are not met.
    (ii) However, if a substantial portion of the assets of an entity 
shareholder consists (directly or indirectly) of stock in the 
corporation undergoing the change in ownership or control, approval of 
the payment by that entity shareholder must be made by a separate vote 
of the persons who hold, immediately before the change in ownership or 
control, more than 75 percent of the voting power of the entity 
shareholder entitled to vote. The preceding sentence does not apply if 
the value of the stock of the corporation owned, directly or indirectly, 
by or for the entity shareholder does not exceed 1 percent of the total 
value of the outstanding stock of the corporation undergoing a change in 
ownership or control. Where approval of a payment by an entity 
shareholder must be made by a separate vote of the owners of the entity 
shareholder, the normal voting rights of the entity shareholder 
determine which owners shall vote. For purposes of this (b)(3)(ii), 
stock represents a substantial portion of the assets of an entity 
shareholder if the total fair market value of the stock held by the 
entity shareholder in the corporation undergoing the change in ownership 
or control is equal to or exceeds one third of the total gross fair 
market value of all of the assets of the entity shareholder. For this 
purpose, gross fair market value means the value of the assets of the 
entity, determined without regard to any liabilities associated with 
such assets.
    (4) Disqualified individuals and attribution of stock ownership. In 
determining the persons entitled to vote referred to in paragraph (a)(1) 
or (b)(3) of this A-7, stock that would otherwise be entitled to vote is 
not counted as outstanding stock and is not considered in determining 
whether the more than 75 percent vote has been obtained under this A-7 
if the stock is actually owned or constructively owned under section 
318(a) by or for a disqualified individual who receives (or is to 
receive) payments that would be parachute payments if the shareholder 
approval requirements described in paragraph (a) of this A-7 are not 
met. Likewise, stock is not counted as outstanding stock if the owner is 
considered under section 318(a) to own any part of the stock owned 
directly or indirectly by or for a disqualified individual described in 
the preceding sentence. In addition, if the person authorized to vote 
the stock of an entity shareholder is a disqualified individual who 
would receive a parachute payment if the shareholder approval 
requirements described in this A-7 are not met, such person is not 
permitted to vote such shares, but the entity shareholder is permitted 
to appoint an equity interest holder in the entity shareholder, or in 
the case of a trust another person eligible to vote on behalf of the 
trust, to vote the otherwise eligible shares. However, if all persons 
who hold voting power in the corporation undergoing the change in 
ownership or control are disqualified individuals or related persons 
described in this paragraph (b)(4), then such stock is counted as 
outstanding stock and votes by such persons are considered in 
determining whether the more than 75 percent vote has been obtained.
    (c) Adequate disclosure. To be adequate disclosure for purposes of 
paragraph (a)(2) of this A-7, disclosure must be full and truthful 
disclosure of the material facts and such additional information as is 
necessary to make the disclosure not materially misleading at the time 
the disclosure is made. Disclosure of such information must be made to 
every shareholder of the corporation entitled to vote under this A-7. 
For each disqualified individual, material facts that must be disclosed 
include, but are not limited to, the event triggering the payment or 
payments, the total amount of the payments that would be parachute 
payments if the shareholder approval requirements described in paragraph 
(a) of this A-7 are not met, and a brief description of each payment 
(e.g., accelerated vesting of options, bonus, or salary). An omitted 
fact is considered a material fact if there is a substantial likelihood 
that a

[[Page 1065]]

reasonable shareholder would consider it important.
    (d) Corporation without shareholders. If a corporation does not have 
shareholders, the exemption described in Q/A-6(a)(2) of this section and 
the shareholder approval requirements described in this A-7 do not 
apply. Solely for purposes of this paragraph (d), a shareholder does not 
include a member in an association, joint stock company, or insurance 
company.
    (e) Examples. The following examples illustrate the application of 
this A-7:

    Example 1. Corporation S has two shareholders--Corporation P, which 
owns 76 percent of the stock of Corporation S, and A, a disqualified 
individual who would receive a parachute payment if the shareholder 
approval requirements of this A-7 are not met. No stock of Corporation P 
or S is readily tradeable on an established securities market (or 
otherwise). The value of the stock of Corporation S equals or exceeds 
one third of the gross fair market value of the assets of Corporation P, 
and thus, represents a substantial portion of the assets of Corporation 
P. All of the stock of Corporation S is sold to Corporation M. 
Contingent on the change in ownership of Corporation S, severance 
payments are made to certain officers of Corporation S in excess of 3 
times each officer's base amount. If the payments are approved by a 
separate vote of the persons who hold, immediately before the sale, more 
than 75 percent of the voting power of the outstanding stock entitled to 
vote of Corporation P and the disclosure rules of paragraph (a)(2) of 
this A-7 are complied with, the shareholder approval requirements of 
this A-7 are met, and the payments are exempt from the definition of 
parachute payment pursuant to A-6 of this section.
    Example 2. (i) Stock of Corporation X, none of which is traded on an 
established market, is acquired by Corporation Y. In the voting ballot 
concerning the sale, the Corporation X shareholders are asked to vote 
either ``yes'' on the sale and ``yes'' to paying parachute payments to 
A, a disqualified individual with respect to Corporation A, or ``no'' on 
the sale and ``no'' to paying parachute payments to A.
    (ii) Because the approval of the change in ownership or control is 
conditioned on the approval of the payments to A, the shareholder 
approval requirements of this A-7 are not satisfied. If the payments are 
made to A, the payments are not exempt from the definition of parachute 
payment pursuant to Q/A-6 of this section.
    (iii) Assume the same facts as in paragraph (i) of this Example 2, 
except that the acquisition agreement between Corporation X and 
Corporation Y states that the acquisition is approved only if there are 
no parachute payments made to A. If the shareholder approval and the 
disclosure requirements described in this A-7 are met, the payments will 
not be parachute payments. Alternatively, if the shareholders do not 
approve the payments, the payments cannot be made (or retained). Thus, 
the transaction is not conditioned on the approval of the parachute 
payments. If the payments are made and the requirements of this A-7 are 
met, the payments are exempt from the definition of parachute payment 
pursuant to Q/A-6 of this section.
    Example 3. Corporation M is wholly owned by Partnership P. No 
interest in either M or P is readily tradeable on an established 
securities market (or otherwise). The value of the stock of Corporation 
M equals or exceeds one third of the gross fair market value of the 
assets of Partnership P, and thus, represents a substantial portion of 
the assets of Partnership P. Corporation M undergoes a change in 
ownership or control. Partnership P has one general partner and 200 
limited partners. The general partner is not a disqualified individual. 
None of the limited partners are entitled to vote on issues involving 
the management of the partnership investments. If the payments that 
would be parachute payments if the shareholder approval requirements of 
this A-7 are not met are approved by the general partner and the 
disclosure rules of paragraph (a)(2) of this A-7 are complied with, the 
shareholder approval requirements of this A-7 are met, and the payments 
are exempt from the definition of parachute payment pursuant to A-6 of 
this section.
    Example 4. Corporation A has several shareholders including X and Y, 
who are disqualified individuals with respect to Corporation A and would 
receive parachute payments if the shareholder approval requirements of 
this A-7 are not met. No stock of Corporation A is readily tradeable on 
an established securities market (or otherwise). Corporation A undergoes 
a change in ownership or control. Contingent on the change in ownership 
or control, severance payments are payable to X and Y that are in excess 
of 3 times each individual's base amount. To determine whether the 
shareholder approval requirements of paragraph (a)(1) of this A-7 are 
satisfied regarding the payments to X and Y, the stock of X and Y is not 
considered outstanding, and X and Y are not entitled to vote.
    Example 5. Assume the same facts as in Example 4, except that after 
adequate disclosure of all material facts (within the meaning of 
paragraph (a)(2) of this A-7) to all shareholders entitled to vote, 60 
percent of the shareholders who are entitled to vote approve the 
payments to X and Y. Because more than 75 percent of the shareholders 
holding outstanding stock who were entitled to vote did not approve the 
payments to X and Y, the payments cannot be made.

[[Page 1066]]

    Example 6. Assume the same facts as in Example 4 except that 
disclosure of all the material facts (within the meaning of paragraph 
(a)(2) of this A-7) regarding the payments to X and Y is made to two of 
Corporation A's shareholders, who collectively own 80 percent of 
Corporation A's stock entitled to vote and approve the payment. Both 
shareholders approve the payments. Assume further that no adequate 
disclosure of the material facts regarding the payments to X and Y is 
made to other Corporation A shareholders who are entitled to vote within 
the meaning of this A-7. Notwithstanding that 80 percent of the 
shareholders entitled to vote approve the payments, because disclosure 
regarding the payments to X and Y is not made to all of Corporation A's 
shareholders who were entitled to vote, the disclosure requirements of 
paragraph (a)(2) of this A-7 are not met, and the payments are not 
exempt from the definition of parachute payment pursuant to Q/A-6.
    Example 7. Corporation C has three shareholders--Partnership, which 
owns 20 percent of the stock of Corporation C; A, an individual who owns 
60 percent of the stock of Corporation C; and B, an individual who owns 
20 percent of Corporation C. Stock of Corporation C does not represent a 
substantial portion of the assets of Partnership. No interest in either 
Partnership or Corporation C is readily tradeable on an established 
securities market (or otherwise). P, a one-third partner in Partnership, 
is a disqualified individual with respect to Corporation C. Corporation 
C undergoes a change in ownership or control. Contingent on the change, 
a severance payment is payable to P in excess of 3 times P's base 
amount. To determine the persons who are entitled to vote referred to in 
paragraph (a)(1) of this A-7, one-third of the stock held by Partnership 
is not considered outstanding stock. If P is the person authorized by 
Partnership to approve the payment, none of the shares of Partnership 
are considered outstanding stock. However, Partnership is permitted to 
appoint an equity interest holder in Partnership (who is not a 
disqualified individual who would receive a parachute payment if the 
requirements of this A-7 are not met), to vote the two-thirds of the 
shares held by Partnership that are otherwise entitled to be voted.
    Example 8. X, Y, and Z are all employees and disqualified 
individuals with respect to Corporation E. No stock in Corporation E is 
readily tradeable on an established securities market (or otherwise). 
Each individual has a base amount of $100,000. Corporation E undergoes a 
change in ownership or control. Contingent on the change, a severance 
payment of $400,000 is payable to X; $600,000 is payable to Y; and 
$1,000,000 is payable to Z. Corporation E provides each Corporation E 
shareholder entitled to vote (as determined under this A-7) with a 
ballot listing and describing the payments of $400,000 to X; $600,000 to 
Y; and $1,000,000 to Z and the triggering event that generated the 
payments. Next to each name and corresponding amount on the ballot, 
Corporation E requests approval (with a ``yes'' and ``no'' box) of each 
total payment to be made to each individual and states that if the 
payment is not approved the payment will not be made. Adequate 
disclosure, within the meaning of this A-7 is made to each shareholder 
entitled to vote under this A-7. More than 75 percent of the Corporation 
E shareholders who are entitled to vote under paragraph (a)(1) of this 
A-7 approve each payment to each individual. The shareholder approval 
requirements of this A-7 are met, and the payments are exempt from the 
definition of parachute payment pursuant to A-6 of this section.
    Example 9. Assume the same facts as in Example 8 except that the 
ballot does not request approval of each total payment to each 
individual separately. Instead, the ballot states that $2,000,000 in 
payments will be made to X, Y, and Z and requests approval of the 
$2,000,000 payments. Assuming the triggering event and amount of the 
payments to X, Y, and Z are separately described to the shareholders 
entitled to vote under this A-7, the shareholder approval requirements 
of paragraph (a)(1) of this A-7 are met, and the payments are exempt 
from the definition of parachute payment pursuant to A-6 of this 
section.
    Example 10. B, an employee of Corporation X, is a disqualified 
individual with respect to Corporation X. Stock of Corporation X is not 
readily tradeable on an established securities market (or otherwise). 
Corporation X undergoes a change in ownership or control. B's base 
amount is $205,000. Under B's employment agreement with Corporation X, 
in the event of a change in ownership or control, B's stock options will 
vest and B will receive severance and bonus payments. Contingent on the 
change in ownership or control, B's stock options with a fair market 
value of $500,000 immediately vest, $200,000 of which is contingent on 
the change, and B will receive a $200,000 bonus payment and a $400,000 
severance payment. Corporation X distributes a ballot to every 
shareholder of Corporation X who immediately before the change is 
entitled to vote as described in this A-7. The ballot contains adequate 
disclosure of all material facts and lists the following payments to be 
made to B: The contingent payment of $200,000 attributable to options, a 
$200,000 bonus payment, and a $400,000 severance payment. The ballot 
requests shareholder approval of the $200,000 bonus payment to B and 
states that whether or not the $200,000 bonus payment is approved, B 
will receive $200,000 attributable to options and a $400,000 severance 
payment. More than 75 percent of the shareholders entitled to vote as 
described by this A-7 approve the $200,000

[[Page 1067]]

bonus payment to B. The shareholder approval requirements of this A-7 
are met, and the $200,000 payment is exempt from the definition of 
parachute payment pursuant to A-6 of this section.

    Q-8: Which payments under a qualified plan are exempt from the 
definition of parachute payment?
    A-8: The term parachute payment does not include any payment to or 
from--
    (a) A plan described in section 401(a) which includes a trust exempt 
from tax under section 501(a);
    (b) An annuity plan described in section 403(a);
    (c) A simplified employee pension (as defined in section 408(k)); or
    (d) A simple retirement account (as defined in section 408(p)).
    Q-9: Which payments of reasonable compensation are exempt from the 
definition of parachute payment?
    A-9: Except in the case of securities violation parachute payments, 
the term parachute payment does not include any payment (or portion 
thereof) which the taxpayer establishes by clear and convincing evidence 
is reasonable compensation for personal services to be rendered by the 
disqualified individual on or after the date of the change in ownership 
or control. See Q/A-37 of this section for the definition and treatment 
of securities violation parachute payments. See Q/A-40 through Q/A-44 of 
this section for rules on determining amounts of reasonable 
compensation.

                       Payor of Parachute Payments

    Q-10: Who may be the payor of parachute payments?
    A-10: Parachute payments within the meaning of Q/A-2 of this section 
may be paid, directly or indirectly, by--
    (i) The corporation referred to in paragraph (a)(3) of Q/A-2 of this 
section;
    (ii) A person acquiring ownership or effective control of that 
corporation or ownership of a substantial portion of that corporation's 
assets; or
    (iii) Any person whose relationship to such corporation or other 
person is such as to require attribution of stock ownership between the 
parties under section 318(a).

                 Payments in the Nature of Compensation

    Q-11: What types of payments are in the nature of compensation?
    A-11: (a) General rule. For purposes of this section, all payments--
in whatever form--are payments in the nature of compensation if they 
arise out of an employment relationship or are associated with the 
performance of services. For this purpose, the performance of services 
includes holding oneself out as available to perform services and 
refraining from performing services (such as under a covenant not to 
compete or similar arrangement). Payments in the nature of compensation 
include (but are not limited to) wages and salary, bonuses, severance 
pay, fringe benefits, life insurance, pension benefits, and other 
deferred compensation (including any amount characterized by the parties 
as interest thereon). A payment in the nature of compensation also 
includes cash when paid, the value of the right to receive cash, 
(including the value of accelerated vesting under Q/A-24(c), or a 
transfer of property. However, payments in the nature of compensation do 
not include attorney's fees or court costs paid or incurred in 
connection with the payment of any amount described in paragraphs 
(a)(1), (2), and (3) of Q/A-2 of this section or a reasonable rate of 
interest accrued on any amount during the period the parties contest 
whether a payment will be made.
    (b) When payment is considered to be made. Except as otherwise 
provided in A-11 through Q/A-13 of this section, a payment in the nature 
of compensation is considered made (and is subject to the excise tax 
under section 4999) in the taxable year in which it is includible in the 
disqualified individual's gross income or, in the case of fringe 
benefits and other benefits excludible from income, in the taxable year 
the benefits are received.
    (c) Prepayment rule. Notwithstanding the general rule described in 
paragraph (b) of this A-11, a disqualified individual may, in the year 
of the change in ownership or control, or any later year, prepay the 
excise tax under section 4999, provided that the payor and disqualified 
individual treat the payment of the excise tax consistently and the 
payor satisfies its obligations under section 4999(c) in the year of 
prepayment. The prepayment of the excise tax for purposes of section 
4999 must be based on the present value of the excise tax that would be 
due in the year the excess parachute payment would actually be paid 
(calculated using the discount rate equal to 120 percent of the 
applicable Federal rate (determined under section 1274(d) and 
regulations thereunder; see Q/A-32)). For purposes of projecting the 
future value of a payment that provides for interest to be credited at a 
variable interest rate, it is permissible to make a reasonable 
assumption regarding this variable rate. A disqualified individual is 
not required to adjust the excise tax paid under this paragraph (c) 
merely because the interest rates in the future are not the same as the 
rate used for purposes of projecting the future value of the payment. 
However, a disqualified individual may not apply this paragraph (c) of 
this A-11 to a payment to be made in cash if the present value of the 
payment would be considered not reasonably ascertainable under section 
3121(v) and Sec. 31.3121(v)(2)-1(e)(4) of this Chapter or to a payment 
related to

[[Page 1068]]

health benefits or coverage. The Commissioner may provide additional 
guidance regarding the applicability of this paragraph (c) to certain 
payments in published guidance of general applicability under Sec. 
601.601(d)(2) of this Chapter.
    (d) Transfers of property. Transfers of property are treated as 
payments for purposes of this A-11. See Q/A-12 of this section for rules 
on determining when such payments are considered made and the amount of 
such payments. See Q/A-13 of this section for special rules on transfers 
of stock options.
    (e) The following example illustrates the principles of this A-11:

    Example. D is a disqualified individual with respect to Corporation 
X. D has a base amount of $100,000 and is entitled to receive two 
parachute payments, one of $200,000 and the other of $400,000. A change 
in ownership or control of Corporation X occurs on May 1, 2005, and the 
$200,000 payment is made to D at the time of the change in ownership or 
control. The $400,000 payment is to be made on October 1, 2010. 
Corporation X and D agree that D will prepay the excise tax and X will 
satisfy its obligations under section 4999(c) with respect to the 
$400,000 payment. Using discount rate determined under Q/A-32, 
Corporation X and D determine that the present value of the $400,000 
payment is $300,000 on the date of the change in ownership or control. 
The portions of the base amount allocated to these payments are $40,000 
(($200,000/$500,000) x $100,000) and $60,000 (($300,000/$500,000 x 
$100,000), respectively. Thus, the amount of the first excess parachute 
payment is $160,000 ($200,000-$40,000) and that of the second excess 
parachute payment is $340,000 ($400,000-$60,000). The excise tax on the 
$400,000 payment is $68,000 ($340,000 x 20 percent). Assume the present 
value (calculated in accordance with paragraph (c) of this A-11) of 
$68,000 is $50,000. To prepay the excise tax due on the $400,000 
payment, Corporation X must satisfy its obligations under section 4999 
with respect to the $50,000, in addition to the $32,000 withholding 
required with respect to the $200,000 payment.

    Q-12: If a property transfer to a disqualified individual is a 
payment in the nature of compensation, when is the payment considered 
made (or to be made), and how is the amount of the payment determined?
    A-12: (a) Except as provided in this A-12 and Q/A-13 of this 
section, a transfer of property is considered a payment made (or to be 
made) in the taxable year in which the property transferred is 
includible in the gross income of the disqualified individual under 
section 83 and the regulations thereunder. Thus, in general, such a 
payment is considered made (or to be made) when the property is 
transferred (as defined in Sec. 1.83-3(a)) to the disqualified 
individual and becomes substantially vested (as defined in Sec. 1.83-
3(b) and (j)) in such individual. The amount of the payment is 
determined under section 83 and the regulations thereunder. Thus, in 
general, the amount of the payment is equal to the excess of the fair 
market value of the transferred property (determined without regard to 
any lapse restriction, as defined in Sec. 1.83-3(i)) at the time that 
the property becomes substantially vested, over the amount (if any) paid 
for the property.
    (b) An election made by a disqualified individual under section 
83(b) with respect to transferred property will not apply for purposes 
of this A-12. Thus, even if such an election is made with respect to a 
property transfer that is a payment in the nature of compensation, for 
purposes of this section, the payment is generally considered made (or 
to be made) when the property is transferred to and becomes 
substantially vested in such individual.
    (c) See Q/A-13 of this section for rules on applying this A-12 to 
transfers of stock options.
    (d) The following example illustrates the principles of this A-12:

    Example. On January 1, 2006, Corporation M gives to A, a 
disqualified individual, a bonus of 100 shares of Corporation M stock in 
connection with the performance of services to Corporation M. Under the 
terms of the bonus arrangement A is obligated to return the Corporation 
M stock to Corporation M unless the earnings of Corporation M double by 
January 1, 2009, or there is a change in ownership or control of 
Corporation M before that date. A's rights in the stock are treated as 
substantially nonvested (within the meaning of Sec. 1.83-3(b)) during 
that period because A's rights in the stock are subject to a substantial 
risk of forfeiture (within the meaning of Sec. 1.83-3(c)) and are 
nontransferable (within the meaning of Sec. 1.83-3(d)). On January 1, 
2008, a change in ownership or control of Corporation M occurs. On that 
day, the fair market value of the Corporation M stock is $250 per share. 
Because A's rights in the Corporation M stock become substantially 
vested (within the meaning of Sec. 1.83-3(b)) on that day, the payment 
is considered made on that day, and the amount of the payment for 
purposes of this section is equal to $25,000 (100 x $250). See Q/A-38 
through 41 for rules relating to the reduction of the excess parachute 
payment by the portion of the payment which is established to be 
reasonable compensation for personal services actually rendered before 
the date of a change in ownership or control.

    Q-13: How are transfers of statutory and nonstatutory stock options 
treated?
    A-13: (a) For purposes of this section, an option (including an 
option to which section 421 applies) is treated as property that is 
transferred when the option becomes vested

[[Page 1069]]

(regardless of whether the option has a readily ascertainable fair 
market value as defined in Sec. 1.83-7(b)). For purposes of this A-13, 
vested means substantially vested within the meaning of Sec. 1.83-3(b) 
and (j) or the right to the payment is not otherwise subject to a 
substantial risk of forfeiture within the meaning of section 83(c). 
Thus, for purposes of this section, the vesting of such an option is 
treated as a payment in the nature of compensation. The value of an 
option at the time the option vests is determined under all the facts 
and circumstances in the particular case. Factors relevant to such a 
determination include, but are not limited to: The difference between 
the option's exercise price and the value of the property subject to the 
option at the time of vesting; the probability of the value of such 
property increasing or decreasing; and the length of the period during 
which the option can be exercised. Thus, an option is treated as a 
payment in the nature of compensation on the date of grant or vesting, 
as applicable, without regard to whether such option has an 
ascertainable fair market value. For purposes of this A-13, valuation 
may be determined by any method prescribed by the Commissioner in 
published guidance of general applicability under Sec. 601.601(d)(2) of 
this Chapter.
    (b) Any money or other property transferred to the disqualified 
individual on the exercise, or as consideration on the sale or other 
disposition, of an option described in paragraph (a) of this A-13 after 
the time such option vests is not treated as a payment in the nature of 
compensation to the disqualified individual under Q/A-11 of this 
section. Nonetheless, the amount of the otherwise allowable deduction 
under section 162 or 212 with respect to such transfer is reduced by the 
amount of the payment described in paragraph (a) of this A-13 treated as 
an excess parachute payment.
    Q-14: Are payments in the nature of compensation reduced by 
consideration paid by the disqualified individual?
    A-14: Yes, to the extent not otherwise taken into account under Q/A-
12 and Q/A-13 of this section, the amount of any payment in the nature 
of compensation is reduced by the amount of any money or the fair market 
value of any property (owned by the disqualified individual without 
restriction) that is (or will be) transferred by the disqualified 
individual in exchange for the payment. For purposes of the preceding 
sentence, the fair market value of property is determined as of the date 
the property is transferred by the disqualified individual.

                        Disqualified Individuals

    Q-15: Who is a disqualified individual?
    A-15: (a) For purposes of this section, an individual is a 
disqualified individual with respect to a corporation if, at any time 
during the disqualified individual determination period (as defined in 
Q/A-20 of this section), the individual is an employee or independent 
contractor of the corporation and is, with respect to the corporation--
    (1) A shareholder (but see Q/A-17 of this section);
    (2) An officer (see Q/A-18 of this section); or
    (3) A highly-compensated individual (see Q/A-19 of this section).
    (b) For purposes of this A-15, a director is a disqualified 
individual with respect to a corporation if, at any time during the 
disqualified individual determination period, the director is, with 
respect to the corporation, a shareholder (see Q/A-17 of this section), 
an officer (see Q/A-18 of this section), or a highly-compensated 
individual (see Q/A-19 of this section).
    (c) For purposes of this A-15, an individual who is an employee or 
independent contractor of a corporation other than the corporation 
undergoing a change in ownership or control is disregarded for purposes 
of determining who is a disqualified individual if such individual is 
employed by the corporation undergoing the change in ownership or 
control only on the last day of the disqualified individual 
determination period. Thus, for example, assume that E is an employee of 
Corporation X, that Y is acquired by Corporation X, and that Y undergoes 
a change in ownership or control. If E becomes an employee of Y on the 
date of the acquisition, in determining the disqualified individuals 
with respect to Y, E is disregarded under this paragraph (c).
    Q-16: Is a personal service corporation treated as an individual?
    A-16: (a) Yes. For purposes of this section, a personal service 
corporation (as defined in section 269A(b)(1)), or a noncorporate entity 
that would be a personal service corporation if it were a corporation, 
is treated as an individual.
    (b) The following example illustrates the principles of this A-16:

    Example. Corporation N, a personal service corporation (as defined 
in section 269A(b)(1)), has a single individual as its sole shareholder 
and employee. Corporation N performs personal services for Corporation 
M. The compensation paid to Corporation N by Corporation M puts 
Corporation N within the group of highly-compensated individuals of 
Corporation M as determined under A-19 of this section. Thus, 
Corporation N is treated as a highly-compensated individual with respect 
to Corporation M.

    Q-17: Are all shareholders of a corporation considered shareholders 
for purposes of paragraphs (a)(1) and (b) of Q/A-15 of this section?
    A-17: (a) No. Only an individual who owns stock of a corporation 
with a fair market value that exceeds 1 percent of the fair market value 
of the outstanding shares of all classes of the corporation's stock is 
treated

[[Page 1070]]

as a disqualified individual with respect to the corporation by reason 
of stock ownership. An individual who owns a lesser amount of stock may, 
however, be a disqualified individual with respect to the corporation if 
such individual is an officer (see Q/A-18) or highly-compensated 
individual (see Q/A-19) with respect to the corporation.
    (b) For purposes of determining the amount of stock owned by an 
individual for purposes of paragraph (a) of this A-17, the constructive 
ownership rules of section 318(a) apply. Stock underlying a vested 
option is considered owned by an individual who holds the vested option 
(and the stock underlying an unvested option is not considered owned by 
an individual who holds the unvested option). For purposes of the 
preceding sentence, however, if the option is exercisable for stock that 
is not substantially vested (as defined by Sec. Sec. 1.83-3(b) and 
(j)), the stock underlying the option is not treated as owned by the 
individual who holds the option. Solely for purposes of determining the 
amount of stock owned by an individual for purposes of this A-17, mutual 
and cooperative corporations are treated as having stock.
    (c) The following examples illustrates the principles of this A-17:

    Example 1. E, an employee of Corporation A, received options under 
Corporation A's Stock Option Plan. E's stock options vest three years 
after the date of grant. E is not an officer or highly compensated 
individual during the disqualified individual determination period. E 
does not own, and is not considered to own under section 318, any other 
Corporation A stock. Two years after the options are granted to E, all 
of Corporation A's stock is acquired by Corporation B. Under Corporation 
A's Stock Option Plan, E's options are converted to Corporation B 
options and the vesting schedule remains the same. Under paragraph (b) 
of this A-17, the stock underlying the unvested options held by E on the 
date of the change in ownership or control is not considered owned by E. 
Because E is not considered to own Corporation A stock with a fair 
market value exceeding 1 percent of the total fair market value of all 
of the outstanding shares of all classes of Corporation A and E is not 
an officer or highly-compensated individual during the disqualified 
individual determination period, E is not a disqualified individual 
within the meaning of Q&A-15 of this section with respect to Corporation 
A.
    Example 2. Assume the same facts as in Example 1, except that 
Corporation A's Stock Option Plan provides that all unvested options 
will vest immediately on a change in ownership or control. Under 
paragraph (b) of this A-17, the stock underlying the options that vest 
on the change in ownership or control is considered owned by E. If the 
stock considered owned by E exceeds 1 percent of the total fair market 
value of all of the outstanding shares of all classes of Corporation A 
stock (including for this purpose, all stock owned or constructively 
owned by all shareholders, provided that no share of stock is counted 
more than once), E is a disqualified individual within the meaning of Q/
A-15 of this section with respect to Corporation A.
    Example 3. Assume the same facts as in Example 1 except that E 
received nonstatutory stock options that are exercisable for stock 
subject to a substantial risk of forfeiture under section 83. Assume 
further that under Corporation A's Stock Option Plan, the nonstatutory 
options will vest on a change in ownership or control. Under paragraph 
(b) of this A-17, E is not considered to own the stock underlying the 
options that vest on the change in ownership or control because the 
options are exercisable for stock subject to a substantial risk of 
forfeiture within the meaning of section 83. Because E is not considered 
to own Corporation A stock with a fair market value exceeding 1 percent 
of the total fair market value of all of the outstanding shares of all 
classes of Corporation A stock and E is not an officer or highly 
compensated individual during the disqualified individual determination 
period, E is not a disqualified individual within the meaning of Q/A-15 
of this section with respect to Corporation A.

    Q-18: Who is an officer?
    A-18: (a) For purposes of this section, whether an individual is an 
officer with respect to a corporation is determined on the basis of all 
the facts and circumstances in the particular case (such as the source 
of the individual's authority, the term for which the individual is 
elected or appointed, and the nature and extent of the individual's 
duties). Any individual who has the title of officer is presumed to be 
an officer unless the facts and circumstances demonstrate that the 
individual does not have the authority of an officer. However, an 
individual who does not have the title of officer may nevertheless be 
considered an officer if the facts and circumstances demonstrate that 
the individual has the authority of an officer. Generally, the term 
officer means an administrative executive who is in regular and 
continued service. The term officer implies continuity of service and 
excludes those employed for a special and single transaction.
    (b) An individual who is an officer with respect to any member of an 
affiliated group that is treated as one corporation pursuant to Q/A-46 
of this section is treated as an officer of such one corporation.
    (c) No more than 50 employees (or, if less, the greater of 3 
employees, or 10 percent of the employees (rounded up to the nearest 
integer)) of the corporation (in the case of an affiliated group treated 
as one corporation, each member of the affiliated group) are

[[Page 1071]]

treated as disqualified individuals with respect to a corporation by 
reason of being an officer of the corporation. For purposes of the 
preceding sentence, the number of employees of the corporation is the 
greatest number of employees the corporation has during the disqualified 
individual determination period (as defined in Q/A-20 of this section). 
If the number of officers of the corporation exceeds the number of 
employees who may be treated as officers under the first sentence of 
this paragraph (c), then the employees who are treated as officers for 
purposes of this section are the highest paid 50 employees (or, if less, 
the greater of 3 employees, or 10 percent of the employees (rounded up 
to the nearest integer)) of the corporation when ranked on the basis of 
compensation (as determined under Q/A-21 of this section) paid during 
the disqualified individual determination period.
    (d) In determining the total number of employees of a corporation 
for purposes of this A-18, employees are not counted if they normally 
work less than 17\1/2\ hours per week (as defined in section 
414(q)(5)(B) and the regulations thereunder) or if they normally work 
during not more than 6 months during any year (as defined in section 
414(q)(5)(C) and the regulations thereunder). However, an employee who 
is not counted for purposes of the preceding sentence may still be an 
officer.
    Q-19: Who is a highly-compensated individual?
    A-19: (a) For purposes of this section, a highly-compensated 
individual with respect to a corporation is any individual who is, or 
would be if the individual were an employee, a member of the group 
consisting of the lesser of the highest paid 1 percent of the employees 
of the corporation (rounded up to the nearest integer), or the highest 
paid 250 employees of the corporation, when ranked on the basis of 
compensation (as determined under Q/A-21 of this section) earned during 
the disqualified individual determination period (as defined in Q/A-20 
of this section). For purposes of the preceding sentence, the number of 
employees of the corporation is the greatest number of employees the 
corporation has during the disqualified individual determination period 
(as defined in Q/A-20 of this section). However, no individual whose 
annualized compensation during the disqualified individual determination 
period is less than the amount described in section 414(q)(1)(B)(i) for 
the year in which the change in ownership or control occurs will be 
treated as a highly-compensated individual.
    (b) An individual who is not an employee of the corporation is not 
treated as a highly-compensated individual with respect to the 
corporation on account of compensation received for performing services 
(such as brokerage, legal, or investment banking services) in connection 
with a change in ownership or control of the corporation, if the 
services are performed in the ordinary course of the individual's trade 
or business and the individual performs similar services for a 
significant number of clients unrelated to the corporation.
    (c) The total number of employees of a corporation for purposes of 
this A-19 is determined in accordance with Q/A-18(d) of this section. 
However, an employee who is not counted for purposes of the preceding 
sentence may still be a highly-compensated individual.
    Q-20: What is the disqualified individual determination period?
    A-20: The disqualified individual determination period is the 
twelve-month period prior to and ending on the date of the change in 
ownership or control of the corporation.
    Q-21: How is compensation defined for purposes of determining who is 
a disqualified individual?
    A-21: (a) For purposes of determining who is a disqualified 
individual, the term compensation means the compensation which was 
earned by the individual for services performed for the corporation with 
respect to which the change in ownership or control occurs (changed 
corporation), for a predecessor entity, or for a related entity. Such 
compensation is determined without regard to sections 125, 132(f)(4), 
402(e)(3), and 402(h)(1)(B). Thus, for example, compensation includes 
elective or salary reduction contributions to a cafeteria plan, cash or 
deferred arrangement or tax-sheltered annuity, and amounts credited 
under a nonqualified deferred compensation plan.
    (b) For purposes of this A-21, a predecessor entity is any entity 
which, as a result of a merger, consolidation, purchase or acquisition 
of property or stock, corporate separation, or other similar business 
transaction transfers some or all of its employees to the changed 
corporation or to a related entity or to a predecessor entity of the 
changed corporation. The term related entity includes--
    (1) All members of a controlled group of corporations (as defined in 
section 414(b)) that includes the changed corporation or a predecessor 
entity;
    (2) All trades or businesses (whether or not incorporated) that are 
under common control (as defined in section 414(c)) if such group 
includes the changed corporation or a predecessor entity;
    (3) All members of an affiliated service group (as defined in 
section 414(m)) that includes the changed corporation or a predecessor 
entity; and
    (4) Any other entities required to be aggregated with the changed 
corporation or a predecessor entity pursuant to section 414(o) and the 
regulations thereunder (except leasing organizations as defined in 
section 414(n)).

[[Page 1072]]

    (c) For purposes of Q/A-18 and Q/A-19 of this section, compensation 
that was contingent on the change in ownership or control and that was 
payable in the year of the change is not treated as compensation.

              Contingent on Change in Ownership or Control

    Q-22: When is a payment contingent on a change in ownership or 
control?
    A-22: (a) In general, a payment is treated as contingent on a change 
in ownership or control if the payment would not, in fact, have been 
made had no change in ownership or control occurred, even if the payment 
is also conditioned on the occurrence of another event. A payment 
generally is treated as one which would not, in fact, have been made in 
the absence of a change in ownership or control unless it is 
substantially certain, at the time of the change, that the payment would 
have been made whether or not the change occurred. (But see Q/A-23 of 
this section regarding payments under agreements entered into after a 
change in ownership or control.) A payment that becomes vested as a 
result of a change in ownership or control is not treated as a payment 
which was substantially certain to have been made whether or not the 
change occurred. For purposes of this A-22, vested means the payment is 
substantially vested within the meaning of Sec. 1.83-3(b) and (j) or 
the right to the payment is not otherwise subject to a substantial risk 
of forfeiture as defined by section 83(c).
    (b)(1) For purposes of paragraph (a), a payment is treated as 
contingent on a change in ownership or control if--
    (i) The payment is contingent on an event that is closely associated 
with a change in ownership or control;
    (ii) A change in ownership or control actually occurs; and
    (iii) The event is materially related to the change in ownership or 
control.
    (2) For purposes of paragraph (b)(1)(i) of this A-22, a payment is 
treated as contingent on an event that is closely associated with a 
change in ownership or control unless it is substantially certain, at 
the time of the event, that the payment would have been made whether or 
not the event occurred. An event is considered closely associated with a 
change in ownership or control if the event is of a type often 
preliminary or subsequent to, or otherwise closely associated with, a 
change in ownership or control. For example, the following events are 
considered closely associated with a change in the ownership or control 
of a corporation: The onset of a tender offer with respect to the 
corporation; a substantial increase in the market price of the 
corporation's stock that occurs within a short period (but only if such 
increase occurs prior to a change in ownership or control); the 
cessation of the listing of the corporation's stock on an established 
securities market; the acquisition of more than 5 percent of the 
corporation's stock by a person (or more than one person acting as a 
group) not in control of the corporation; the voluntary or involuntary 
termination of the disqualified individual's employment; a significant 
reduction in the disqualified individual's job responsibilities; and a 
change in ownership or control as defined in the disqualified 
individual's employment agreement (or elsewhere) that does not meet the 
definition of a change in ownership or control described in Q/A-27, 28, 
or 29 of this section. Whether other events are treated as closely 
associated with a change in ownership or control is based on all the 
facts and circumstances of the particular case.
    (3) For purposes of determining whether an event (as described in 
paragraph (b)(2) of this A-22) is materially related to a change in 
ownership or control, the event is presumed to be materially related to 
a change in ownership or control if such event occurs within the period 
beginning one year before and ending one year after the date of the 
change in ownership or control. If such event occurs outside of the 
period beginning one year before and ending one year after the date of 
change in ownership or control, the event is presumed not materially 
related to the change in ownership or control. A payment does not fail 
to be contingent on a change in ownership or control merely because it 
is also contingent on the occurrence of a second event (without regard 
to whether the second event is closely associated with or materially 
related to a change in ownership or control). Similarly, a payment that 
is treated as contingent on a change in ownership or control because it 
is contingent on a closely associated event does not fail to be treated 
as contingent on a change in ownership or control merely because it is 
also contingent on the occurrence of a second event (without regard to 
whether the second event is closely associated with or materially 
related to a change in ownership or control).
    (c) A payment that would in fact have been made had no change in 
ownership or control occurred is treated as contingent on a change in 
ownership or control if the change in ownership or control (or the 
occurrence of an event that is closely associated with and materially 
related to a change in ownership or control within the meaning of 
paragraph (b)(1) of this A-22), accelerates the time at which the 
payment is made. Thus, for example, if a change in ownership or control 
accelerates the time of payment of deferred compensation that is vested 
without regard to the change in ownership or control, the payment may be 
treated as contingent on the change. See Q/A-24 of this section 
regarding the portion of a payment that is so treated. See also Q/A-8 of 
this section regarding the exemption for certain payments under

[[Page 1073]]

qualified plans and Q/A-40 of this section regarding the treatment of a 
payment as reasonable compensation.
    (d) A payment is treated as contingent on a change in ownership or 
control even if the employment or independent contractor relationship of 
the disqualified individual is not terminated (voluntarily or 
involuntarily) as a result of the change.
    (e) The following examples illustrate the principles of this A-22:

    Example 1. A corporation grants a stock appreciation right to a 
disqualified individual, A, more than one year before a change in 
ownership or control. After the stock appreciation right vests and 
becomes exercisable, a change in ownership or control of the corporation 
occurs, and A exercises the right. Assuming neither the granting nor the 
vesting of the stock appreciation right is contingent on a change in 
ownership or control, the payment made on exercise is not contingent on 
the change in ownership or control.
    Example 2. A contract between a corporation and B, a disqualified 
individual, provides that a payment will be made to B if the corporation 
undergoes a change in ownership or control and B's employment with the 
corporation is terminated at any time over the succeeding 5 years. 
Eighteen months later, a change in the ownership of the corporation 
occurs. Two years after the change in ownership, B's employment is 
terminated and the payment is made to B. Because it was not 
substantially certain that the corporation would have made the payment 
to B on B's termination of employment if there had not been a change in 
ownership, the payment is treated as contingent on the change in 
ownership under paragraph (a) of this A-22. This is true even though B's 
termination of employment is presumed not to be, and in fact may not be, 
materially related to the change in ownership or control.
    Example 3. A contract between a corporation and C, a disqualified 
individual, provides that a payment will be made to C if C's employment 
is terminated at any time over the succeeding 3 years (without regard to 
whether or not there is a change in ownership or control). Eighteen 
months after the contract is entered into, a change in the ownership or 
control of the corporation occurs. Six months after the change in 
ownership or control, C's employment is terminated and the payment is 
made to C. Termination of employment is considered an event closely 
associated with a change in ownership or control. Because the 
termination occurred within one year after the date of the change in 
ownership or control, the termination of C's employment is presumed to 
be materially related to the change in ownership or control under 
paragraph (b)(3) of this A-22. If this presumption is not successfully 
rebutted, the payment will be treated as contingent on the change in 
ownership or control under paragraph (b) of this A-22.
    Example 4. A contract between a corporation and a disqualified 
individual, D, provides that a payment will be made to D upon the onset 
of a tender offer for shares of the corporation's stock. A tender offer 
is made on December 1, 2008, and the payment is made to D. Although the 
tender offer is unsuccessful, it leads to a negotiated merger with 
another entity on June 1, 2009, which results in a change in the 
ownership or control of the corporation. It was not substantially 
certain, at the time of the onset of the tender offer, that the payment 
would have been made had no tender offer taken place. The onset of a 
tender offer is considered closely associated with a change in ownership 
or control. Because the tender offer occurred within one year before the 
date of the change in ownership or control of the corporation, the onset 
of the tender offer is presumed to be materially related to the change 
in ownership or control. If this presumption is not rebutted, the 
payment will be treated as contingent on the change in ownership or 
control. If no change in ownership or control had occurred, the payment 
would not be treated as contingent on a change in ownership or control; 
however, the payment still could be a parachute payment under Q/A-37 of 
this section if the contract violated a generally enforced securities 
law or regulation.
    Example 5. A contract between a corporation and a disqualified 
individual, E, provides that a payment will be made to E if the 
corporation's level of product sales or profits reaches a specified 
level. At the time the contract was entered into, the parties had no 
reason to believe that such an increase in the corporation's level of 
product sales or profits would be preliminary or subsequent to, or 
otherwise closely associated with, a change in ownership or control of 
the corporation. Eighteen months later, a change in the ownership or 
control of the corporation occurs and within one year after the date of 
the change of ownership or control, the corporation's level of product 
sales or profits reaches the specified level. Under these facts and 
circumstances (and in the absence of contradictory evidence), the 
increase in product sales or profits of the corporation is not an event 
closely associated with the change in ownership or control of the 
corporation. Accordingly, even if the increase is materially related to 
the change in ownership or control, the payment will not be treated as 
contingent on a change in ownership or control.

    Q-23: May a payment be treated as contingent on a change in 
ownership or control if the payment is made under an agreement entered 
into after the change?

[[Page 1074]]

    A-23: (a) No. Payments are not treated as contingent on a change in 
ownership or control if they are made (or are to be made) pursuant to an 
agreement entered into after the change (a post-change agreement). For 
this purpose, an agreement that is executed after a change in ownership 
or control pursuant to a legally enforceable agreement that was entered 
into before the change is considered to have been entered into before 
the change. (See Q/A-9 of this section regarding the exemption for 
reasonable compensation for services rendered on or after a change in 
ownership or control.) If an individual has a right to receive a payment 
that would be a parachute payment if made under an agreement entered 
into prior to a change in ownership or control (pre-change agreement) 
and gives up that right as bargained-for consideration for benefits 
under a post-change agreement, the agreement is treated as a post-change 
agreement only to the extent the value of the payments under the 
agreement exceed the value of the payments under the pre-change 
agreement. To the extent payments under the agreement have the same 
value as the payments under the pre-change agreement, such payments 
retain their character as parachute payments subject to this section.
    (b) The following examples illustrate the principles of this A-23:

    Example 1. Assume that a disqualified individual is an employee of a 
corporation. A change in ownership or control of the corporation occurs, 
and thereafter the individual enters into an employment agreement with 
the acquiring company. Because the agreement is entered into after the 
change in ownership or control occurs, payments to be made under the 
agreement are not treated as contingent on the change.
    Example 2. Assume the same facts as in Example 1, except that the 
agreement between the disqualified individual and the acquiring company 
is executed after the change in ownership or control, pursuant to a 
legally enforceable agreement entered into before the change. Payments 
to be made under the agreement may be treated as contingent on the 
change in ownership or control pursuant to Q/A-22 of this section. 
However, see Q/A-9 of this section regarding the exemption from the 
definition of parachute payment for certain amounts of reasonable 
compensation.
    Example 3. Assume the same facts as in Example 1, except that prior 
to the change in ownership or control, the individual and corporation 
enter into an agreement under which the individual will receive 
parachute payments in the event of a change in ownership or control of 
the corporation. After the change, the individual agrees to give up the 
right to payments under the pre-change agreement that would be parachute 
payments if made, in exchange for compensation under a new agreement 
with the acquiring corporation. Because the individual gave up the right 
to parachute payments under the pre-change agreement in exchange for 
other payments under the post-change agreement, payments in an amount 
equal to the parachute payments under the pre-change agreement are 
treated as contingent on the change in ownership or control under this 
A-23. Because the post-change agreement was entered into after the 
change, payments in excess of this amount are not treated as parachute 
payments.

    Q-24: If a payment is treated as contingent on a change in ownership 
or control, is the full amount of the payment so treated?
    A-24: (a)(1) General rule. Yes. If the payment is a transfer of 
property, the amount of the payment is determined under Q/A-12 or Q/A-13 
of this section. For all other payments, the amount of the payment is 
determined under Q/A-11 of this section. However, in certain 
circumstances, described in paragraphs (b) and (c) of this A-24, only a 
portion of the payment is treated as contingent on the change. Paragraph 
(b) of this A-24 applies to a payment that is vested, without regard to 
the change in ownership or control, and is treated as contingent on the 
change in ownership or control because the change accelerates the time 
at which the payment is made. Paragraph (c) of this A-24 applies to a 
payment that becomes vested as a result of the change in ownership or 
control if, without regard to the change in ownership or control, the 
payment was contingent only on the continued performance of services for 
the corporation for a specified period of time and if the payment is 
attributable, at least in part, to services performed before the date 
the payment becomes vested. Paragraph (b) or (c) does not apply to any 
payment (or portion thereof) if the payment is treated as contingent on 
the change in ownership or control pursuant to Q/A-25 of this section. 
For purposes of this A-24, vested has the same meaning as provided in Q/
A-22(a).
    (2) Reduction by reasonable compensation. The amount of a payment 
under paragraph (a)(1) of this A-24 is reduced by any portion of such 
payment that the taxpayer establishes by clear and convincing evidence 
is reasonable compensation for personal services rendered by the 
disqualified individual on or after the date of the change of control. 
See Q/A-9 and Q/A-38 through 44 of this section for rules concerning 
reasonable compensation. The portion of an amount treated as contingent 
under paragraph (b) or (c) of this A-24 may not be reduced by reasonable 
compensation.
    (b) Vested payments. This paragraph (b) applies if a payment is 
vested, without regard to the change in ownership or control, and is

[[Page 1075]]

treated as contingent on the change in ownership or control because the 
change accelerates the time at which the payment is made. In such a 
case, the portion of the payment, if any, that is treated as contingent 
on the change in ownership or control is the amount by which the amount 
of the accelerated payment exceeds the present value of the payment 
absent the acceleration. If the value of such a payment absent the 
acceleration is not reasonably ascertainable, and the acceleration of 
the payment does not significantly increase the present value of the 
payment absent the acceleration, the present value of the payment absent 
the acceleration is treated as equal to the amount of the accelerated 
payment. If the value of the payment absent the acceleration is not 
reasonably ascertainable, but the acceleration significantly increases 
the present value of the payment, the future value of such payment is 
treated as equal to the amount of the accelerated payment. For rules on 
determining present value, see paragraph (e) of this A-24, Q/A-32, and 
Q/A-33 of this section.
    (c)(1) Nonvested payments. This paragraph (c) applies to a payment 
that becomes vested as a result of the change in ownership or control to 
the extent that--
    (i) Without regard to the change in ownership or control, the 
payment was contingent only on the continued performance of services for 
the corporation for a specified period of time; and
    (ii) The payment is attributable, at least in part, to the 
performance of services before the date the payment is made or becomes 
certain to be made.
    (2) The portion of the payment subject to paragraph (c) of this A-24 
that is treated as contingent on the change in ownership or control is 
the amount described in paragraph (b) of this A-24, plus an amount, as 
determined in paragraph (c)(4) of this A-24, to reflect the lapse of the 
obligation to continue to perform services. In no event can the portion 
of the payment treated as contingent on the change in ownership or 
control under this paragraph (c) exceed the amount of the accelerated 
payment, or, if the payment is not accelerated, the present value of the 
payment.
    (3) For purposes of this paragraph (c) of this A-24, the 
acceleration of the vesting of a stock option or the lapse of a 
restriction on restricted stock is considered to significantly increase 
the value of a payment.
    (4) The amount reflecting the lapse of the obligation to continue to 
perform services (described in paragraph (c)(2) of this A-24) is 1 
percent of the amount of the accelerated payment multiplied by the 
number of full months between the date that the individual's right to 
receive the payment is vested and the date that, absent the 
acceleration, the payment would have been vested. This paragraph (c)(4) 
applies to the accelerated vesting of a payment in the nature of 
compensation even if the time at which the payment is made is not 
accelerated. In such a case, the amount reflecting the lapse of the 
obligation to continue to perform services is 1 percent of the present 
value of the future payment multiplied by the number of full months 
between the date that the individual's right to receive the payment is 
vested and the date that, absent the acceleration, the payment would 
have been vested.
    (d) Application of this A-24 to certain payments--(1) Benefits under 
a nonqualified deferred compensation plan. In the case of a payment of 
benefits under a nonqualified deferred compensation plan, paragraph (b) 
of this A-24 applies to the extent benefits under the plan are vested 
without regard to the change in ownership or control. Paragraph (c) of 
this A-24 applies to the extent benefits under the plan become vested as 
a result of the change in ownership or control and are attributable, at 
least in part, to the performance of services prior to vesting. Any 
other payment of benefits under a nonqualified deferred compensation 
plan is a payment in the nature of compensation subject to the general 
rule of paragraph (a) of this A-24 and the rules in Q/A-11 of this 
section.
    (2) Employment agreements. The general rule of paragraph (a) of this 
A-24 (and not the rules in paragraphs (b) or (c)) applies to the payment 
of amounts due under an employment agreement on a termination of 
employment or a change in ownership or control that otherwise would be 
attributable to the performance of services (or refraining from the 
performance of services) during any period that begins after the date of 
termination of employment or change in ownership or control, as 
applicable. For purposes of this paragraph (d)(2) of this A-24, an 
employment agreement means an agreement between an employee or 
independent contractor and employer or service recipient which 
describes, among other things, the amount of compensation or 
remuneration payable to the employee or independent contractor. See Q/A-
42(b) and 44 of this section for the treatment of the remaining amounts 
of salary under an employment agreement.
    (3) Vesting due to an event other than services. Neither paragraph 
(b) nor (c) of this A-24 applies to a payment if (without regard to the 
change in ownership or control) vesting of the payment depends on an 
event other than the performance of services, such as the attainment of 
a performance goal, and the event does not occur prior to the change in 
ownership or control. In such circumstances, the full amount of the 
accelerated payment is treated as contingent on the change in ownership 
or control under paragraph (a) of this A-24. However, see Q/A-39 of this 
section for rules relating to the reduction of the excess parachute 
payment by the portion of

[[Page 1076]]

the payment which is established to be reasonable compensation for 
personal services actually rendered before the date of a change in 
ownership or control.
    (e) Present value. For purposes of this A-24, the present value of a 
payment is determined as of the date on which the accelerated payment is 
made.
    (f) Examples. The following examples illustrate the principles of 
this A-24:

    Example 1. (i) Corporation maintains a qualified plan and a 
nonqualified supplemental retirement plan (SERP) for its executives. 
Benefits under the SERP are not paid to participants until retirement. 
E, a disqualified individual with respect to Corporation, has a vested 
account balance of $500,000 under the SERP. A change in ownership or 
control of Corporation occurs. The SERP provides that in the event of a 
change in ownership or control, all vested accounts will be paid to SERP 
participants.
    (ii) Because E was vested in $500,000 of benefits under the SERP 
prior to the change in ownership or control and the change merely 
accelerated the time at which the payment was made to E, only a portion 
of the payment, as determined under paragraph (b) of this A-24, is 
treated as contingent on the change. Thus, the portion of the payment 
that is treated as contingent on the change is the amount by which the 
amount of the accelerated payment ($500,000) exceeds the present value 
of the payment absent the acceleration.
    (iii) Assume the same facts as in paragraph (i) of this Example 1, 
except that E's account balance of $500,000 is not vested. Instead, 
assume that E will vest in E's account balance of $500,000 in 2 years if 
E continues to perform services for the next 2 years. Assume further 
that the SERP provides that all unvested SERP benefits vest immediately 
on a change in ownership or control and are paid to the participants. 
Because the vesting of the SERP payment, without regard to the change, 
depends only on the performance of services for a specified period of 
time and the payment is attributable, in part, to the performance of 
services before the change in ownership or control, only a portion of 
the $500,000 payment, as determined under paragraph (c) of this A-24, is 
treated as contingent on the change. The portion of the payment that is 
treated as contingent on the change is the lesser of the amount of the 
accelerated payment or the amount by which the accelerated payment 
exceeds the present value of the payment absent the acceleration, plus 
an amount to reflect the lapse of the obligation to continue to perform 
services.
    (iv) Assume the same facts as in paragraph (i) of this Example 1, 
except that in addition to the pay out of the vested account balance of 
$500,000 on the change in ownership or control, an additional $70,000 
will be credited to E's account and included in the payment to E. 
Because the $500,000 was vested without regard to the change in 
ownership or control, paragraph (b) of this A-24 applies to the $500,000 
payment. Because the $70,000 is not vested, without regard to the 
change, and is not attributable to the performance of services prior to 
the change, the entire $70,000 payment is contingent on the change in 
ownership or control under paragraph (a) of this A-24.
    (v) Assume the same facts as in paragraph (i) of this Example 1, 
except that the benefit under the SERP is calculated using a percentage 
of final average compensation multiplied by years of service. If, 
contingent on the change in ownership or control, E is credited with 
additional years of service, an adjustment to final average 
compensation, or an increase in the applicable percentage, any increase 
in the benefit payable under the SERP is not attributable to the 
performance of services prior to the change, and the entire increase in 
the benefit is contingent on the change in ownership or control under 
paragraph (a) of this A-24.
    Example 2. As a result of a change in the effective control of a 
corporation D, a disqualified individual with respect to the 
corporation, receives accelerated payment of D's vested account balance 
in a nonqualified deferred compensation account plan. Actual interest 
and other earnings on the plan assets are credited to each account as 
earned before distribution. Investment of the plan assets is not 
restricted in such a manner as would prevent the earning of a market 
rate of return on the plan assets. The date on which D would have 
received D's vested account balance absent the change in ownership or 
control is uncertain, and the rate of earnings on the plan assets is not 
fixed. Thus, the amount of the payment absent the acceleration is not 
reasonably ascertainable. Under these facts, acceleration of the payment 
does not significantly increase the present value of the payment absent 
the acceleration, and the present value of the payment absent the 
acceleration is treated as equal to the amount of the accelerated 
payment. Accordingly, no portion of the payment is treated as contingent 
on the change.
    Example 3. (i) On January 15, 2006, a corporation and a disqualified 
individual, F, enter into a contract providing for a retention bonus of 
$500,000 to be paid to F on January 15, 2011. The payment of the bonus 
will be forfeited by F if F does not remain employed by the corporation 
for the entire 5-year period. However, the contract provides that the 
full amount of the payment will be made immediately on a change in 
ownership or control of the corporation during the 5-year period. On 
January 15, 2009, a change in ownership or control of the corporation 
occurs and the full amount of the payment

[[Page 1077]]

($500,000) is made on that date to F. Under these facts, the payment of 
$500,000 was contingent only on F's performance of services for a 
specified period and is attributable, in part, to the performance of 
services before the change in ownership or control. Therefore, only a 
portion of the payment, as determined under paragraph (c) of this A-24 
is treated as contingent on the change. The portion of the payment that 
is treated as contingent on the change is the amount by which the amount 
of the accelerated payment (i.e., $500,000, the amount paid to the 
individual because of the change in ownership) exceeds the present value 
of the payment that was expected to have been made absent the 
acceleration (i.e., $406,838, the present value on January 15, 2009, of 
a $500,000 payment on January 15, 2011), plus $115,000 (1 percent x 23 
months x $500,000) which is the amount reflecting the lapse of the 
obligation to continue to perform services. Accordingly, the amount of 
the payment treated as contingent on the change in ownership or control 
is $208,162, the sum of $93,162 ($500,000-$406,838) + $115,000). This 
result does not change if F actually remains employed until the end of 
the 5-year period.
    (ii) Assume the same facts as in paragraph (i) of this Example 3, 
except that the retention bonus will vest on the change in ownership or 
control, but will not be paid until January 15, 2011 (the original date 
in the contract). Because the payment of $500,000 was contingent only on 
F's performance of services for a specified period and is attributable, 
in part, to the performance of services before the change in ownership 
or control, only a portion of the $500,000 payment is treated as 
contingent on the change in ownership or control as determined under 
paragraph (c) of this A-24. Because there is accelerated vesting of the 
bonus, the portion of the payment treated as contingent on the change is 
the amount described in paragraph (b) of this A-27, which is $0 under 
these facts, plus an amount reflecting the lapse of the obligation to 
continue to perform services which is $93,573 (1 percent x 23 months x 
$406,838 (the present value of a $500,000 payment).
    Example 4. (i) On January 15, 2006, a corporation gives to a 
disqualified individual, in connection with her performance of services 
to the corporation, a bonus of 1,000 shares of the corporation's stock. 
Under the terms of the bonus arrangement, the individual is obligated to 
return the stock to the corporation if she terminates her employment for 
any reason prior to January 15, 2011. However, if there is a change in 
the ownership or effective control of the corporation prior to January 
15, 2011, she ceases to be obligated to return the stock. The 
individual's rights in the stock are treated as substantially nonvested 
(within the meaning of Sec. 1.83-3(b) and (j)) during that period. On 
January 15, 2009, a change in the ownership of the corporation occurs. 
On that day, the fair market value of the stock is $500,000.
    (ii) Under these facts, the payment was contingent only on 
performance of services for a specified period and is attributable, in 
part, to the performance of services before the change in ownership or 
control. Thus, only a portion of the payment, as determined under 
paragraph (c) of this A-24, is treated as contingent on the change in 
ownership or control. The portion of the payment that is treated as 
contingent on the change is the amount by which the present value of the 
accelerated payment on January 15, 2009 ($500,000), exceeds the present 
value of the payment that was expected to have been made on January 15, 
2011, plus an amount reflecting the lapse of the obligation to continue 
to perform services. At the time of the change, it cannot be reasonably 
ascertained what the value of the stock would have been on January 15, 
2011. The acceleration of the lapse of a restriction on stock is treated 
as significantly increasing the value of the payment. Therefore, the 
value of such stock on January 15, 2011, is deemed to be $500,000, the 
amount of the accelerated payment. The present value on January 15, 
2009, of a $500,000 payment to be made on January 15, 2011, is $406,838. 
Thus, the portion of the payment treated as contingent on the change is 
$208,162, the sum of $93,162 ($500,000-$406,838), plus $115,000 (1 
percent x 23 months x $500,000), the amount reflecting the lapse of the 
obligation to continue to perform services.
    Example 5. (i) On January 15, 2006, a corporation grants to a 
disqualified individual nonqualified stock options to purchase 30,000 
shares of the corporation's stock. The options will be forfeited by the 
individual if he fails to perform personal services for the corporation 
until January 15, 2009. The options will, however, vest in the 
individual at an earlier date if there is a change in ownership or 
control of the corporation. On January 16, 2008, a change in the 
ownership or control of the corporation occurs and the options become 
vested in the individual. The value of the options on January 16, 2008, 
determined in accordance with Q/A-13, is $600,000.
    (ii) The payment of the options to purchase 30,000 shares was 
contingent only on performance of services for the corporation until 
January 15, 2009, and is attributable, in part, to the performance of 
services before the change in ownership or control. Therefore, only a 
portion of the payment is treated as contingent on the change. The 
portion of the payment that is treated as contingent on the change is 
the amount by which the accelerated payment on January 16, 2008 
($600,000) exceeds the present value on January 16, 2008, of the payment 
that was expected to have been made on January 15, 2009, absent the 
acceleration, plus an amount

[[Page 1078]]

reflecting the lapse of the obligation to continue to perform services. 
At the time of the change, it cannot be reasonably ascertained what the 
value of the options would have been on January 15, 2009. The 
acceleration of vesting in the options is treated as significantly 
increasing the value of the payment. Therefore, the value of such 
options on January 15, 2009, is deemed to be $600,000, the amount of the 
accelerated payment. The present value on January 16, 2008, of a 
$600,000 payment to be made on January 15, 2009, is $549,964. Thus, the 
portion of the payment treated as contingent on the change is $116,036, 
the sum of $50,036 ($600,000-$549,964), plus an amount reflecting the 
lapse of the obligation to continue to perform services which is $66,000 
(1 percent x 11 months x $600,000).
    Example 6. (i) Assume the same facts as in Example 5, except that 
the options become vested periodically (absent a change in ownership or 
control), with one-third of the options vesting on January 15, 2007, 
2008, and 2009, respectively. Thus, options to purchase 20,000 shares 
vest independently of the January 16, 2008, change in ownership or 
control and the options to purchase the remaining 10,000 shares vest as 
a result of the change in ownership or control.
    (ii) The payment of the options to purchase 10,000 shares was 
contingent only on performance of services for the corporation until 
January 15, 2009, and is attributable, in part, to the performance of 
services before the change in ownership or control. Therefore, only a 
portion of the payment as determined under paragraph (c) of this A-24 is 
treated as contingent on the change in ownership or control. The portion 
of the payment that is treated as contingent on the change in ownership 
or control is the amount by which the accelerated payment on January 16, 
2008 ($200,000) exceeds the present value on January 16, 2008, of the 
payment that was expected to have been made on January 15, 2009, absent 
the acceleration, plus an amount reflecting the lapse of the obligation 
to perform services. At the time of the change in ownership or control, 
it cannot be reasonably ascertained what the value of the options would 
have been on January 15, 2009. The acceleration of vesting in the 
options is treated as significantly increasing the value of the payment. 
Therefore, the value of such options on January 15, 2009, is deemed to 
be $200,000, the amount of the accelerated payment. The present value on 
January 16, 2008, of a $200,000 payment to be made on January 15, 2009, 
is $183,328.38. Thus, the portion of the payment treated as contingent 
on the change is $38,671.62, the sum of $16,671.62 ($200,000-
$183,328.38), plus an amount reflecting the lapse of the obligation to 
continue to perform services which is $22,000 (1 percent x 11 months x 
$200,000).
    Example 7. Assume the same facts as in Example 5, except that the 
option agreement provides that the options will vest either on the 
corporation's level of profits reaching a specified level, or if 
earlier, on the date on which there is a change in ownership or control 
of the corporation. The corporation's level of profits do not reach the 
specified level prior to January 16, 2008. In such case, the full amount 
of the payment, $600,000, is treated as contingent on the change in 
ownership or control under paragraph (a) of this A-24. Because the 
payment was not contingent only on the performance of services for the 
corporation for a specified period, the rules of paragraph (b) and (c) 
of this A-24 do not apply. See Q/A-39 of this section for rules relating 
to the reduction of the excess parachute payment by the portion of the 
payment which is established to be reasonable compensation for personal 
services actually rendered before the date of a change in ownership or 
control.
    Example 8. On January 1, 2005, E, a disqualified individual with 
respect to Corporation X, enters into an employment agreement with 
Corporation X under which E will be paid wages of $200,000 each year 
during the 5-year employment agreement. The employment agreement 
provides that if a change in ownership or control of Corporation X 
occurs, E will be paid the present value of the remaining salary under 
the employment agreement. On January 1, 2006, a change in ownership or 
control of Corporation X occurs, E is terminated, and E receives a 
payment of the present value of $200,000 for each of the 4 years 
remaining under the employment agreement. Because the payment represents 
future salary under an employment agreement (i.e., amounts otherwise 
attributable to the performance of services for periods that begin after 
the termination of employment), the general rule of paragraph (a) of 
this A-24 applies to the payment and not the rules of paragraphs (b) and 
(c) of this A-24. See Q/A-42(c) and 44 of this section for the treatment 
of the remaining payments under an employment agreement.

            Presumption That Payment Is Contingent on Change

    Q-25: Is there a presumption that certain payments are contingent on 
a change in ownership or control?
    A-25: Yes, for purposes of this section, any payment is presumed to 
be contingent on such a change unless the contrary is established by 
clear and convincing evidence if the payment is made pursuant to--
    (a) An agreement entered into within one year before the date of a 
change in ownership or control; or
    (b) An amendment that modifies a previous agreement in any 
significant respect, if the amendment is made within one year before the 
date of a change in ownership or control.

[[Page 1079]]

In the case of an amendment described in paragraph (b) of this A-25, 
only the portion of any payment that exceeds the amount of such payment 
that would have been made in the absence of the amendment is presumed, 
by reason of the amendment, to be contingent on the change in ownership 
or control.
    Q-26: How may the presumption described in Q/A-25 of this section be 
rebutted?
    A-26: (a) To rebut the presumption described in Q/A-25 of this 
section, the taxpayer must establish by clear and convincing evidence 
that the payment is not contingent on the change in ownership or 
control. Whether the payment is contingent on such change is determined 
on the basis of all the facts and circumstances of the particular case. 
Factors relevant to such a determination include, but are not limited 
to, the content of the agreement or amendment and the circumstances 
surrounding the execution of the agreement or amendment, such as whether 
it was entered into at a time when a takeover attempt had commenced and 
the degree of likelihood that a change in ownership or control would 
actually occur. However, even if the presumption is rebutted with 
respect to an agreement, some or all of the payments under the agreement 
may still be contingent on the change in ownership or control pursuant 
to Q/A-22 of this section.
    (b) In the case of an agreement described in Q/A-25 of this section, 
clear and convincing evidence that the agreement is one of the three 
following types will generally rebut the presumption that payments under 
the agreement are contingent on the change in ownership or control--
    (1) A nondiscriminatory employee plan or program as defined in 
paragraph (c) of this A-26;
    (2) A contract between a corporation and an individual that replaces 
a prior contract entered into by the same parties more than one year 
before the change in ownership or control, if the new contract does not 
provide for increased payments (apart from normal increases attributable 
to increased responsibilities or cost of living adjustments), accelerate 
the payment of amounts due at a future time, or modify (to the 
individual's benefit) the terms or conditions under which payments will 
be made; or
    (3) A contract between a corporation and an individual who did not 
perform services for the corporation prior to the one year period before 
the change in ownership or control occurs, if the contract does not 
provide for payments that are significantly different in amount, timing, 
terms, or conditions from those provided under contracts entered into by 
the corporation (other than contracts that themselves were entered into 
within one year before the change in ownership or control and in 
contemplation of the change) with individuals performing comparable 
services.
    (c) For purposes of this section, the term nondiscriminatory 
employee plan or program means: a group term life insurance plan that 
meets the requirements of section 79(d); a self insured medical 
reimbursement plan that meets the requirements of section 105(h); a 
cafeteria plan (within the meaning of section 125); an educational 
assistance program (within the meaning of section 127); a dependent care 
assistance program (within the meaning of section 129); a no-additional-
cost service (within the meaning of section 132(b)) or qualified 
employee discount (within the meaning of section 132(c)); a qualified 
retirement planning services program under section 132(m); an adoption 
assistance program (within the meaning of section 137); and such other 
items as provided by the Commissioner in published guidance of general 
applicability under Sec. 601.601(d)(2). Payments under certain other 
plans are exempt from the definition of parachute payment under Q/A-8 of 
this section.
    (d) The following examples illustrate the application of the 
presumption:

    Example 1. A corporation and a disqualified individual who is an 
employee of the corporation enter into an employment contract. The 
contract replaces a prior contract entered into by the same parties more 
than one year before the change in ownership or control and the new 
contract does not provide for any increased payments other than a cost 
of living adjustment, does not accelerate the payment of amounts due at 
a future time, and does not modify (to the individual's benefit) the 
terms or conditions under which payments will be made. Clear and 
convincing evidence of these facts rebuts the presumption described in 
A-25 of this section. However, payments under the contract still may be 
contingent on the change in ownership or control pursuant to Q/A-22 of 
this section.
    Example 2. Assume the same facts as in Example 1, except that the 
contract is entered into after a tender offer for the corporation's 
stock had commenced and it was likely that a change in ownership or 
control would occur and the contract provides for a substantial bonus 
payment to the individual upon his signing the contract. The individual 
has performed services for the corporation for many years, but previous 
employment contracts between the corporation and the individual did not 
provide for a similar signing bonus. One month after the contract is 
entered into, a change in the ownership or control of the corporation 
occurs. All payments under the contract are presumed to be contingent on 
the change in ownership or control even though the bonus payment would 
have been legally required even if no change had occurred. Clear and 
convincing

[[Page 1080]]

evidence of these facts rebuts the presumption described in A-25 of this 
section with respect to all of the payments under the contract with the 
exception of the bonus payment (which is treated as contingent on the 
change). However, payments other than the bonus under the contract still 
may be contingent on the change in ownership or control pursuant to Q/A-
22 of this section.
    Example 3. A corporation and a disqualified individual, who is an 
employee of the corporation, enter into an employment contract within 
one year of a change in ownership or control of the corporation. Under 
the contract, in the event of a change in ownership or control and 
subsequent termination of employment, certain payments will be made to 
the individual. A change in ownership or control occurs, but the 
individual is not terminated until 2 years after the change in ownership 
or control. If clear and convincing evidence does not rebut the 
presumption described in A-25 of this section, because the payment is 
made pursuant to an agreement entered into within one year of the date 
of the change in ownership or control, the payment is presumed 
contingent on the change under A-25 of this section. This is true even 
though A's termination of employment is presumed not to be materially 
related to the change in ownership or control under Q/A-22 of this 
section.

                     Change in Ownership or Control

    Q-27: When does a change in the ownership of a corporation occur?
    A-27: (a) For purposes of this section, a change in the ownership of 
a corporation occurs on the date that any one person, or more than one 
person acting as a group (as defined in paragraph (b) of this A-27), 
acquires ownership of stock of the corporation that, together with stock 
held by such person or group, has more than 50 percent of the total fair 
market value or total voting power of the stock of such corporation. 
However, if any one person, or more than one person acting as a group, 
is considered to own more than 50 percent of the total fair market value 
or total voting power of the stock of a corporation, the acquisition of 
additional stock by the same person or persons is not considered to 
cause a change in the ownership of the corporation (or to cause a change 
in the effective control of the corporation (within the meaning of Q/A-
28 of this section)). An increase in the percentage of stock owned by 
any one person, or persons acting as a group, as a result of a 
transaction in which the corporation acquires its stock in exchange for 
property will be treated as an acquisition of stock for purposes of this 
section. This A-27 applies only when there is a transfer of stock of a 
corporation (or issuance of stock of a corporation) and stock in such 
corporation remains outstanding after the transaction. (See Q/A-29 for 
rules regarding the transfer of assets of a corporation).
    (b) For purposes of paragraph (a) of this A-27, persons will not be 
considered to be acting as a group merely because they happen to 
purchase or own stock of the same corporation at the same time, or as a 
result of the same public offering. However, persons will be considered 
to be acting as a group if they are owners of a corporation that enters 
into a merger, consolidation, purchase or acquisition of stock, or 
similar business transaction with the corporation. If a person, 
including an entity shareholder, owns stock in both corporations that 
enter into a merger, consolidation, purchase or acquisition of stock, or 
similar transaction, such shareholder is considered to be acting as a 
group with other shareholders in a corporation only with respect to the 
ownership in that corporation prior to the transaction giving rise to 
the change and not with respect to the ownership interest in the other 
corporation.
    (c) For purposes of this A-27 (and Q/A-28 and 29), section 318(a) 
applies to determine stock ownership. Stock underlying a vested option 
is considered owned by the individual who holds the vested option (and 
the stock underlying an unvested option is not considered owned by the 
individual who holds the unvested option). For purposes of the preceding 
sentence, however, if the option is exercisable for stock that is not 
substantially vested (as defined by sections 1.83-3(b) and (j)), the 
stock underlying the option is not treated as owned by the individual 
who holds the option. In addition, mutual and cooperative corporations 
are treated as having stock for purposes of this A-27.
    (d) The following examples illustrate the principles of this A-27:

    Example 1. Corporation M has owned stock with a fair market value 
equal to 19 percent of the value of the stock of Corporation N (an 
otherwise unrelated corporation) for many years prior to 2006. 
Corporation M acquires additional stock with a fair market value equal 
to 15 percent of the value of the stock of Corporation N on January 1, 
2006, and an additional 18 percent on February 21, 2007. As of February 
21, 2007, Corporation M has acquired stock with a fair market value 
greater than 50 percent of the value of the stock of Corporation N. 
Thus, a change in the ownership of Corporation N is considered to occur 
on February 21, 2007 (assuming that Corporation M did not have effective 
control of Corporation N immediately prior to the acquisition on that 
date).
    Example 2. All of the corporation's stock is owned by the founders 
of the corporation. The board of directors of the corporation decides to 
offer shares of the corporation to the

[[Page 1081]]

public. After the public offering, the founders of the corporation own a 
total of 40 percent of the corporation's stock, and members of the 
public own 60 percent. If no one person (or more than one person acting 
as a group) owns more than 50 percent of the corporation's stock (by 
value or voting power) after the public offering, there is no change in 
the ownership of the corporation.
    Example 3. Corporation P merges into Corporation O (a previously 
unrelated corporation). In the merger, the shareholders of Corporation P 
receive Corporation O stock in exchange for their Corporation P stock. 
Immediately after the merger, the former shareholders of Corporation P 
own stock with a fair market value equal to 60 percent of the value of 
the stock of Corporation O, and the former shareholders of Corporation O 
own stock with a fair market value equal to 40 percent of the value of 
the stock of Corporation O. The former shareholders of Corporation P 
will be treated as acting as a group in their acquisition of Corporation 
O stock. Thus, a change in the ownership of Corporation O occurs on the 
date of the merger. See Q/A-29, Example 3, regarding whether there is a 
change in ownership or control of P.
    Example 4. Assume the same facts as in Example 3, except that 
immediately after the change, the former shareholders of Corporation P 
own stock with a fair market value of 51 percent of the value of 
Corporation O stock and the former shareholders of Corporation O own 
stock with a fair market value equal to 49 percent of the value of 
Corporation O stock. Assume further that prior to the merger several 
Corporation O shareholders also owned Corporation P stock (overlapping 
shareholders). In the merger, those O shareholders received additional O 
stock by virtue of their ownership of P stock with a fair market value 
of 5 percent of the value of Corporation O stock. Including the O stock 
attributable to the P shares, the O shareholders hold 54 percent of O 
after the transaction. However, those overlapping shareholders that 
owned both Corporation O stock and Corporation P stock prior to the 
merger are treated as acting as a group with the Corporation O 
shareholders only with respect to their ownership interest in 
Corporation O prior to the transaction. Therefore, because the 
Corporation O shareholders owned 49 percent of the value of Corporation 
O stock, a change in the ownership of Corporation O occurs on the date 
of the merger. See Q/A-29, Example 3, regarding whether there is a 
change in ownership or control of P.
    Example 5. A, an individual, owns stock with a fair market value 
equal to 20 percent of the value of the stock of Corporation Q. On 
January 1, 2007, Corporation Q acquires in a redemption for cash all of 
the stock held by shareholders other than A. Thus, A is left as the sole 
shareholder of Corporation O. A change in ownership of Corporation O is 
considered to occur on January 1, 2007 (assuming that A did not have 
effective control of Corporation Q immediately prior to the redemption).
    Example 6. Assume the same facts as in Example 5, except that A owns 
stock with a fair market value equal to 51 percent of the value of all 
the stock of Corporation Q immediately prior to the redemption. There is 
no change in the ownership of Corporation Q as a result of the 
redemption.

    Q-28: When does a change in the effective control of a corporation 
occur?
    A-28: (a) Notwithstanding that a corporation has not undergone a 
change in ownership under Q/A-27, for purposes of this section, a change 
in the effective control of a corporation is presumed to occur on the 
date that either--
    (1) Any one person, or more than one person acting as a group (as 
determined under paragraph (e) of this A-28), acquires (or has acquired 
during the 12-month period ending on the date of the most recent 
acquisition by such person or persons) ownership of stock of the 
corporation possessing 20 percent or more of the total voting power of 
the stock of such corporation; or
    (2) A majority of members of the corporation's board of directors is 
replaced during any 12-month period by directors whose appointment or 
election is not endorsed by a majority of the members of the 
corporation's board of directors prior to the date of the appointment or 
election.
    (b) The presumption of paragraph (a) of this A-28 may be rebutted by 
establishing that such acquisition or acquisitions of the corporation's 
stock, or such replacement of the majority of the members of the 
corporation's board of directors, does not transfer the power to control 
(directly or indirectly) the management and policies of the corporation 
from any one person (or more than one person acting as a group) to 
another person (or group). For purposes of this section, in the absence 
of an event described in paragraph (a)(1) or (2) of this A-28, a change 
in the effective control of a corporation is presumed not to have 
occurred.
    (c) In no event does a change in effective control under this A-28 
occur in any transaction in which either of the two corporations 
involved in the transaction has a change in ownership or control under 
Q/A-27 or 29 of this section. Thus, for example, assume Corporation P 
transfers more than one-third of the total gross fair market value of 
its assets to Corporation O in exchange for 20 percent of O's stock. 
Because P has undergone a change in ownership of a substantial portion 
of its assets under Q/A-29 of this section, O does not have a change in 
effective control under Q/A-28.

[[Page 1082]]

    (d) If any one person, or more than one person acting as a group, is 
considered to effectively control a corporation (within the meaning of 
this A-28), the acquisition of additional control of the corporation by 
the same person or persons is not considered to cause a change in the 
effective control of the corporation (or to cause a change in the 
ownership of the corporation within the meaning of Q/A-27 of this 
section).
    (e) For purposes of this A-28, persons will not be considered to be 
acting as a group merely because they happen to purchase or own stock of 
the same corporation at the same time, or as a result of the same public 
offering. However, persons will be considered to be acting as a group if 
they are owners of a corporation that enters into a merger, 
consolidation, purchase or acquisition of stock, or similar business 
transaction with the corporation. If a person, including an entity 
shareholder, owns stock in both corporations that enter into a merger, 
consolidation, purchase or acquisition of stock, or similar transaction, 
such shareholder is considered to be acting as a group with other 
shareholders in a corporation only with respect to the ownership in that 
corporation prior to the transaction giving rise to the change and not 
with respect to the ownership interest in the other corporation.
    (f) For purposes of determining stock ownership, see Q/A-27(c).
    (g) The following examples illustrate the principles of this A-28:

    Example 1. Shareholder A acquired the following percentages of the 
voting stock of Corporation M (an otherwise unrelated corporation) on 
the following dates: 16 percent on January 1, 2005; 10 percent on 
January 10, 2006; 8 percent on February 10, 2006; 11 percent on March 1, 
2007; and 8 percent on March 10, 2007. Thus, on March 10, 2007, A owns a 
total of 53 percent of M's voting stock. Because A did not acquire 20 
percent or more of M's voting stock during any 12-month period, there is 
no presumption of a change in effective control pursuant to paragraph 
(a)(1) of this A-28. In addition, under these facts there is a 
presumption that no change in the effective control of Corporation M 
occurred. If this presumption is not rebutted (and thus no change in 
effective control of Corporation M is treated as occurring prior to 
March 10, 2007), a change in the ownership of Corporation M is treated 
as having occurred on March 10, 2007 (pursuant to Q/A-27 of this 
section) because A had acquired more than 50 percent of Corporation M's 
voting stock as of that date.
    Example 2. A minority group of shareholders of a corporation opposes 
the practices and policies of the corporation's current board of 
directors. A proxy contest ensues. The minority group presents its own 
slate of candidates for the board at the next annual meeting of the 
corporation's shareholders, and candidates of the minority group are 
elected to replace a majority of the current members of the board. A 
change in the effective control of the corporation is presumed to have 
occurred on the date the election of the new board of directors becomes 
effective.

    Q-29: When does a change in the ownership of a substantial portion 
of a corporation's assets occur?
    A-29: (a) For purposes of this section, a change in the ownership of 
a substantial portion of a corporation's assets occurs on the date that 
any one person, or more than one person acting as a group (as determined 
in paragraph (c) of this A-29), acquires (or has acquired during the 12-
month period ending on the date of the most recent acquisition by such 
person or persons) assets from the corporation that have a total gross 
fair market value equal to or more than one-third of the total gross 
fair market value of all of the assets of the corporation immediately 
prior to such acquisition or acquisitions. For this purpose, gross fair 
market value means the value of the assets of the corporation, or the 
value of the assets being disposed of, determined without regard to any 
liabilities associated with such assets. This A-29 applies in any 
situation other than one involving the transfer of stock (or issuance of 
stock) in a parent corporation and stock in such corporation remains 
outstanding after the transaction. Thus, this A-29 applies to the sale 
of stock in a subsidiary (when that subsidiary is treated as a single 
corporation with the parent pursuant to Q/A-46) and to mergers involving 
the creation of a new corporation or with respect to the corporation 
that is not surviving entity.
    (b) (1) There is no change in ownership or control under this A-29 
when there is a transfer to an entity that is controlled by the 
shareholders of the transferring corporation immediately after the 
transfer, as provided in this paragraph (b). A transfer of assets by a 
corporation is not treated as a change in the ownership of such assets 
if the assets are transferred to--
    (i) A shareholder of the corporation (immediately before the asset 
transfer) in exchange for or with respect to its stock;
    (ii) An entity, 50 percent or more of the total value or voting 
power of which is owned, directly or indirectly, by the corporation;
    (iii) A person, or more than one person acting as a group, that 
owns, directly or indirectly, 50 percent or more of the total value or 
voting power of all the outstanding stock of the corporation; or
    (iv) An entity, at least 50 percent of the total value or voting 
power is owned, directly or indirectly, by a person described in 
paragraph (b)(1)(iii) of this A-29.

[[Page 1083]]

    (2) For purposes of paragraph (b) and except as otherwise provided, 
a person's status is determined immediately after the transfer of the 
assets. For example, a transfer to a corporation in which the transferor 
corporation has no ownership interest in before the transaction, but 
which is a majority-owned subsidiary of the transferor corporation after 
the transaction is not treated as a change in the ownership of the 
assets of the transferor corporation.
    (c) For purposes of this A-29, persons will not be considered to be 
acting as a group merely because they happen to purchase assets of the 
same corporation at the same time, or as a result of the same public 
offering. However, persons will be considered to be acting as a group if 
they are owners of a corporation that enters into a merger, 
consolidation, purchase or acquisition of assets, or similar business 
transaction with the corporation. If a person, including an entity 
shareholder, owns stock in both corporations that enter into a merger, 
consolidation, purchase or acquisition of stock, or similar transaction, 
such shareholder is considered to be acting as a group with other 
shareholders in a corporation only to the extent of the ownership in 
that corporation prior to the transaction giving rise to the change and 
not with respect to the ownership interest in the other corporation.
    (d) For purposes of determining stock ownership, see Q/A-27(c).
    (e) The following examples illustrate the principles of this A-29:

    Example 1. Corporation M acquires assets having a gross fair market 
value of $500,000 from Corporation N (an unrelated corporation) on 
January 1, 2006. The total gross fair market value of Corporation N's 
assets immediately prior to the acquisition was $3 million. Since the 
value of the assets acquired by Corporation M is less than one-third of 
the total gross fair market value of Corporation N's total assets 
immediately prior to the acquisition, the acquisition does not represent 
a change in the ownership of a substantial portion of Corporation N's 
assets.
    Example 2. Assume the same facts as in Example 1. Also assume that 
on November 1, 2006, Corporation M acquires from Corporation N 
additional assets having a fair market value of $700,000. Thus, 
Corporation M has acquired from Corporation N assets worth a total of 
$1.2 million during the 12-month period ending on November 1, 2006. 
Since $1.2 million is more than one-third of the total gross fair market 
value of all of Corporation N's assets immediately prior to the earlier 
of these acquisitions ($3 million), a change in the ownership of a 
substantial portion of Corporation N's assets is considered to have 
occurred on November 1, 2006.
    Example 3. (i) All of the assets of Corporation P are transferred to 
Corporation O (an unrelated corporation). In exchange, the shareholders 
of Corporation P receive Corporation O stock. Immediately after the 
transfer, the former shareholders of Corporation P own 60 percent of the 
fair market value of the outstanding stock of Corporation O and the 
former shareholders of Corporation O own 40 percent of the fair market 
value of the outstanding stock of Corporation O. Because Corporation O 
is an entity more than 50 percent of the fair market value of the 
outstanding stock of which is owned by the former shareholders of 
Corporation P (based on ownership of Corporation P prior the change), 
the transfer of assets is not treated as a change in ownership of a 
substantial portion of the assets of Corporation P. However, a change in 
the ownership (within the meaning of Q/A-27) of Corporation O occurs.
    (ii) The result in paragraph (i) would be the same if immediately 
after the change, the former shareholders of Corporation P own stock 
with a fair market value of 51 percent of the value of Corporation O 
stock because Corporation O is an entity more than 50 percent of the 
fair market value of the outstanding stock of which is owned by the 
former shareholders of Corporation P. See Q/A-27, Example 4, regarding 
whether there is a change in ownership or control of O.
    Example 4. Corporation P sells all of the stock of its wholly-owned 
subsidiary, S, to Corporation Y. The fair market value of the affiliated 
group, determined without regard to its liabilities, is $210 million. 
The fair market value of S, determined without regard to its 
liabilities, is $80 million. Because there is a change in more than one-
third of the gross fair market value of the total assets of the 
affiliated group, there is a change in the ownership of a substantial 
portion of the assets of the affiliated group.

           Three-Times-Base-Amount Test for Parachute Payments

    Q-30: Are all payments that are in the nature of compensation, are 
made to a disqualified individual, and are contingent on a change in 
ownership or control, parachute payments?
    A-30: (a) No. To determine whether such payments are parachute 
payments, they must be tested against the individual's base amount (as 
defined in Q/A-34 of this section). To do this, the aggregate present 
value of all payments in the nature of compensation that are made or to 
be made to (or for the benefit of) the same disqualified individual and 
are contingent on the change in ownership or control must be determined. 
If this aggregate present value equals or exceeds the amount equal to 3 
times the individual's base amount, the payments are parachute payments. 
If this aggregate present value is

[[Page 1084]]

less than the amount equal to 3 times the individual's base amount, no 
portion of the payment is a parachute payment. See Q/A-31, Q/A-32, and 
Q/A-33 of this section for rules on determining present value. Parachute 
payments that are securities violation parachute payments are not 
included in the foregoing computation if they are not contingent on a 
change in ownership or control. See Q/A-37 of this section for the 
definition and treatment of securities violation parachute payments.
    (b) The following examples illustrate the principles of this A-30:

    Example 1. A is a disqualified individual with respect to 
Corporation M. A's base amount is $100,000. Payments in the nature of 
compensation that are contingent on a change in the ownership or control 
of Corporation M totaling $400,000 are made to A on the date of the 
change in ownership or control. The payments are parachute payments 
because they have an aggregate present value at least equal to 3 times 
A's base amount of $100,000 (3 x x$100,000 = $300,000).
    Example 2. Assume the same facts as in Example 1, except that the 
payments contingent on the change in the ownership or control of 
Corporation M total $290,000. Because the payments do not have an 
aggregate present value at least equal to 3 times A's base amount, no 
portion of the payments is a parachute payment.

    Q-31: As of what date is the present value of a payment determined?
    A-31: (a) Except as provided in this section, the present value of a 
payment is determined as of the date on which the change in ownership or 
control occurs, or, if a payment is made prior to such date, the date on 
which the payment is made.
    (b)(1) For purposes of determining whether a payment is a parachute 
payment, if a payment in the nature of compensation is the right to 
receive payments in a year (or years) subsequent to the year of the 
change in ownership or control, the value of the payment is the present 
value of such payment (or payments) calculated in accordance with Q/A-32 
of this section and based on reasonable actuarial assumptions.
    (2) If the payment in the nature of compensation is an obligation to 
provide health care, then for purposes of this A-31 and for applying the 
3-times-base-amount test under Q/A-30 of this section, the present value 
of such obligation should be calculated in accordance with generally 
accepted accounting principles. For purposes of Q/A-30 and this A-31, 
the obligation to provide health care is permitted to be measured by 
projecting the cost of premiums for purchased health care insurance, 
even if no health care insurance is actually purchased. If the 
obligation to provide health care is made in coordination with a health 
care plan that the corporation makes available to a group, then the 
premiums used for this purpose may be group premiums.
    Q-32: What discount rate is to be used to determine present value?
    A-32: For purposes of this section, present value generally is 
determined by using a discount rate equal to 120 percent of the 
applicable Federal rate (determined under section 1274(d) and the 
regulations thereunder) compounded semiannually. The applicable Federal 
rate to be used for this purpose is the Federal rate that is in effect 
on the date as of which the present value is determined, using the 
period until the payment would have been made without regard to the 
change in ownership or control as the term of the debt instrument under 
section 1274(d). See Q/A-24 and 31 of this section. However, for any 
payment, the corporation and the disqualified individual may elect to 
use the applicable Federal rate that is in effect on the date that the 
contract which provides for the payment is entered into, if such 
election is made in the contract.
    Q-33: If the present value of a payment to be made in the future is 
contingent on an uncertain future event or condition, how is the present 
value of the payment determined?
    A-33: (a) In certain cases, it may be necessary to apply the 3-
times-base-amount test of Q/A-30 of this section, or to allocate a 
portion of the base amount to a payment described in paragraphs (a)(1), 
(2), and (3) of Q/A-2 of this section, at a time when the aggregate 
present value of all such payments cannot be determined with certainty 
because the time, amount, or right to receive one or more such payments 
is contingent on the occurrence of an uncertain future event or 
condition. For example, a disqualified individual's right to receive a 
payment may be contingent on the involuntary termination of such 
individual's employment with the corporation. In such a case, it must be 
reasonably estimated whether the payment will be made. If it is 
reasonably estimated that there is a 50-percent or greater probability 
that the payment will be made, the full amount of the payment is 
considered for purposes of the 3-times-base-amount test and the 
allocation of the base amount. Conversely, if it is reasonably estimated 
that there is a less than 50-percent probability that the payment will 
be made, the payment is not considered for either purpose.
    (b) If the estimate made under paragraph (a) of this A-33 is later 
determined to be incorrect, the 3-times-base-amount test described in Q/
A-30 of this section must be reapplied (and the portion of the base 
amount allocated to previous payments must be reallocated (if necessary) 
to such payments) to reflect the actual time and amount of the payment. 
Whenever the 3-times-base-amount test is applied (or whenever the base 
amount is allocated), the aggregate present value of

[[Page 1085]]

the payments received or to be received by the disqualified individual 
is redetermined as of the date described in A-31 of this section, using 
the discount rate described in A-32 of this section. This 
redetermination may affect the amount of any excess parachute payment 
for a prior taxable year. Alternatively, if, based on the application of 
the 3-times-base-amount test without regard to the payment described in 
paragraph (a) of this A-33, a disqualified individual is determined to 
have an excess parachute payment or payments, then the 3-times-base-
amount test does not have to be reapplied when a payment described in 
paragraph (a) of this A-33 is made (or becomes certain to be made) if no 
base amount is allocated to such payment.
    (c) To the extent provided in published guidance of general 
applicability under Sec. 601.601(d)(2) of this Chapter, an initial 
estimate of the value of an option subject to Q/A-13 of this section is 
permitted to be made, with the valuation subsequently re-determined, and 
the 3-times-base-amount test reapplied.
    (d) The following examples illustrate the principles of this A-33:

    Example 1. A, a disqualified individual with respect to Corporation 
M, has a base amount of $100,000. Under A's employment agreement with 
Corporation M, A is entitled to receive a payment in the nature of 
compensation in the amount of $250,000 contingent on a change in 
ownership or control of Corporation M. In addition, the agreement 
provides that if A's employment is terminated within 1 year after the 
change in ownership or control, A will receive an additional payment in 
the nature of compensation in the amount of $150,000, payable 1 year 
after the date of the change in ownership or control. A change in 
ownership or control of Corporation M occurs and A receives the first 
payment of $250,000. Corporation M reasonably estimates that there is a 
50-percent probability that, as a result of the change, A's employment 
will be terminated within 1 year of the date of the change. For purposes 
of applying the 3-times-base-amount test (and if the first payment is 
determined to be a parachute payment, for purposes of allocating a 
portion of A's base amount to that payment), because M reasonably 
estimates that there is a 50-percent or greater probability that, as a 
result of the change, A's employment will be terminated within 1 year of 
the date of the change, Corporation M must assume that the $150,000 
payment will be made to A as a result of the change in ownership or 
control. The present value of the additional payment is determined under 
Q/A-31 and Q/A-32 of this section.
    Example 2. Assume the same facts as in Example 1, except that 
Corporation M reasonably estimates that there is a less than 50-percent 
probability that, as a result of the change, A's employment will be 
terminated within 1 year of the date of the change. For purposes of 
applying the 3-times-base-amount test, because Corporation M reasonably 
estimates that there is a less than 50-percent probability that, as a 
result of the change, A's employment will be terminated within 1 year of 
the date of the change, Corporation M must assume that the $150,000 
payment will not be made to A as a result of the change in ownership or 
control.
    Example 3. B, a disqualified individual with respect to Corporation 
P, has a base amount of $200,000. Under B's employment agreement with 
Corporation P, if there is a change in ownership or control of 
Corporation P, B will receive a severance payment of $600,000 and a 
bonus payment of $400,000. In addition, the agreement provides that if 
B's employment is terminated within 1 year after the change, B will 
receive an additional payment in the nature of compensation of $500,000. 
A change in ownership or control of Corporation P occurs, and B receives 
the $600,000 and $400,000 payments. At the time of the change in 
ownership or control, Corporation P reasonably estimates that there is a 
less than 50-percent probability that B's employment will be terminated 
within 1 year of the change. For purposes of applying the 3-times-base-
amount test, because Corporation P reasonably estimates that there is a 
less than 50-percent probability that B's employment will be terminated 
within 1 year of the date of the change, Corporation P assumes that the 
$500,000 payment will not be made to B. Eleven months after the change 
in ownership or control, B's employment is terminated, and the $500,000 
payment is made to B. Because B was determined to have excess parachute 
payments without regard to the $500,000 payment, the 3-times-base-amount 
test is not reapplied and the base amount is not reallocated to include 
the $500,000 payment. The entire $500,000 payment is treated as an 
excess parachute payment.

    Q-34: What is the base amount?
    A-34: (a) The base amount of a disqualified individual is the 
average annual compensation for services performed for the corporation 
with respect to which the change in ownership or control occurs (or for 
a predecessor entity or a related entity as defined in Q/A-21 of this 
section) which was includible in the gross income of such individual for 
taxable years in the base period (including amounts that were excluded 
under section 911), or which would have been includible in such gross 
income if such person had been a United States citizen or resident. See 
Q/A-35 of this section for the definition of base period and for 
examples of base amount computations.
    (b) If the base period of a disqualified individual includes a short 
taxable year or less than all of a taxable year, compensation for

[[Page 1086]]

such short or incomplete taxable year must be annualized before 
determining the average annual compensation for the base period. In 
annualizing compensation, the frequency with which payments are expected 
to be made over an annual period must be taken into account. Thus, any 
amount of compensation for such a short or incomplete taxable year that 
represents a payment that will not be made more often than once per year 
is not annualized.
    (c) Because the base amount includes only compensation that is 
includible in gross income, the base amount does not include certain 
items that constitute parachute payments. For example, payments in the 
form of excludible fringe benefits are not included in the base amount 
but may be treated as parachute payments.
    (d) The base amount includes the amount of compensation included in 
income under section 83(b) during the base period. See Q/A-35 for the 
definition of base period.
    (e) The following example illustrates the principles of this A-34:

    Example. A disqualified individual, D, receives an annual salary of 
$500,000 per year during the 5-year base period. D defers $100,000 of 
D's salary each year under the corporation's nonqualified deferred 
compensation plan. D's base amount is $400,000 ($400,000 x (5/5)).

    Q-35: What is the base period?
    A-35: (a) The base period of a disqualified individual is the most 
recent 5 taxable years of the individual ending before the date of the 
change in ownership or control. For this purpose, the date of the change 
in ownership or control is the date the corporation experiences one of 
the events described in Q/A-27, Q/A-28, or Q/A-29 of this section. 
However, if the disqualified individual was not an employee or 
independent contractor of the corporation with respect to which the 
change in ownership or control occurs (or a predecessor entity or a 
related entity as defined in Q/A-21 of this section) for this entire 5-
year period, the individual's base period is the portion of such 5-year 
period during which the individual performed personal services for the 
corporation or predecessor entity or related entity.
    (b) The following examples illustrate the principles of Q/A-34 of 
this section and this Q/A-35:

    Example 1. A disqualified individual, D, was employed by a 
corporation for 2 years and 4 months preceding the taxable year in which 
a change in ownership or control of the corporation occurs. D's 
includible compensation income from the corporation was $30,000 for the 
4-month period, $120,000 for the first full year, and $150,000 for the 
second full year. D's base amount is $120,000, ((3 x $30,000) + $120,000 
+ $150,000)/3.
    Example 2. Assume the same facts as in Example 1, except that D also 
received a $60,000 signing bonus when D's employment with the 
corporation commenced at the beginning of the 4-month period. D's base 
amount is $140,000, (($60,000 + (3 x $30,000)) + $120,000 + $150,000) / 
3. Since the bonus will not be paid more often than once per year, the 
amount of the bonus is not increased in annualizing D's compensation for 
the 4-month period.
    Example 3. E is a disqualified individual with respect to 
Corporation X who was not an employee or independent contractor for the 
full 5-year base period. In 2004 and 2005, E is a director of X and 
receives $30,000 per year for E's services. In 2006, E becomes an 
officer of X. E's includible compensation from Corporation X is $250,000 
for 2006 and 2007, and $300,000 for 2008. In 2008, X undergoes a change 
in ownership or control. E's base amount is $140,000 ((2 x $250,000) + 
(2 x $30,000) / 4).

    Q-36: How is the base amount determined in the case of a 
disqualified individual who did not perform services for the corporation 
(or a predecessor entity or a related entity as defined in Q/A-21 of 
this section), prior to the individual's taxable year in which the 
change in ownership or control occurs?
    A-36: (a) In such a case, the individual's base amount is the 
annualized compensation for services performed for the corporation (or a 
predecessor entity or related entity) which--
    (1) Was includible in the individual's gross income for that 
portion, prior to such change, of the individual's taxable year in which 
the change occurred (including amounts that were excluded under section 
911), or would have been includible in such gross income if such person 
had been a United States citizen or resident;
    (2) Was not contingent on the change in ownership or control; and
    (3) Was not a securities violation parachute payment.
    (b) The following examples illustrate the principles of this A-36:

    Example 1. On January 1, 2006, A, an individual whose taxable year 
is the calendar year, enters into a 4-year employment contract with 
Corporation M as an officer of the corporation. A has not previously 
performed services for Corporation M (or any predecessor entity or 
related entity as defined in Q/A-21 of this section). Under the 
employment contract, A is to receive an annual salary of $120,000 for 
each of the 4 years that he remains employed by Corporation M with any 
remaining unpaid balance to be paid immediately in the event that A's 
employment is terminated without cause. On July 1, 2006, after A has 
received compensation of $60,000, a change in the ownership or control 
of Corporation M occurs. Because of the change, A's employment is 
terminated without

[[Page 1087]]

cause, and he receives a payment of $420,000. It is established by clear 
and convincing evidence that the $60,000 in compensation is not 
contingent on the change in ownership or control, but the presumption 
that the $420,000 payment is contingent on the change is not rebutted. 
Thus, the payment of $420,000 is treated as contingent on the change in 
ownership or control of Corporation M. In this case, A's base amount is 
$120,000 (2 x $60,000). Since the present value of the payment which is 
contingent on the change in ownership of Corporation M ($420,000) is 
more than 3 times A's base amount of $120,000 (3 x $120,000 = $360,000), 
the payment is a parachute payment.
    Example 2. Assume the same facts as in Example 1, except that A also 
receives a signing bonus of $50,000 from Corporation M on January 1, 
2006. It is established by clear and convincing evidence that the bonus 
is not contingent on the change in ownership or control. When the change 
in ownership or control occurs on July 1, 2006, A has received 
compensation of $110,000 (the $50,000 bonus plus $60,000 in salary). In 
this case, A's base amount is $170,000 ($50,000 + (2 x $60,000)). 
Because the $50,000 bonus will not be paid more than once per year, the 
amount of the bonus is not increased in annualizing A's compensation. 
The present value of the potential parachute payment ($420,000) is less 
than 3 times A's base amount of $170,000 (3 x $170,000 = $510,000), and 
therefore no portion of the payment is a parachute payment.

                 Securities Violation Parachute Payments

    Q-37: Must a payment be contingent on a change in ownership or 
control in order to be a parachute payment?
    A-37: (a) No, the term parachute payment also includes any payment 
(other than a payment exempted under Q/A-6 or Q/A-8 of this section) 
that is in the nature of compensation and is to (or for the benefit of) 
a disqualified individual, if such payment is a securities violation 
payment. A securities violation payment is a payment made or to be 
made--
    (1) Pursuant to an agreement that violates any generally enforced 
Federal or state securities laws or regulations; and
    (2) In connection with a potential or actual change in ownership or 
control.
    (b) A violation is not taken into account under paragraph (a)(1) of 
this A-37 if it is merely technical in character or is not materially 
prejudicial to shareholders or potential shareholders. Moreover, a 
violation will be presumed not to exist unless the existence of the 
violation has been determined or admitted in a civil or criminal action 
(or an administrative action by a regulatory body charged with enforcing 
the particular securities law or regulation) which has been resolved by 
adjudication or consent. Parachute payments described in this A-37 are 
referred to in this section as securities violation payments.
    (c) Securities violation parachute payments that are not contingent 
on a change in ownership or control within the meaning of Q/A-22 of this 
section are not taken into account in applying the 3-times-base-amount 
test of Q/A-30 of this section. Such payments are considered parachute 
payments regardless of whether such test is met with respect to the 
disqualified individual (and are included in allocating base amount 
under Q/A-38 of this section). Moreover, the amount of a securities 
violation parachute payment treated as an excess parachute payment shall 
not be reduced by the portion of such payment that is reasonable 
compensation for personal services actually rendered before the date of 
a change in ownership or control if such payment is not contingent on 
such change. Likewise, the amount of a securities violation parachute 
payment includes the portion of such payment that is reasonable 
compensation for personal services to be rendered on or after the date 
of a change in ownership or control if such payment is not contingent on 
such change.
    (d) The rules in paragraph (b) of this A-37 also apply to securities 
violation parachute payments that are contingent on a change in 
ownership or control if the application of these rules results in 
greater total excess parachute payments with respect to the disqualified 
individual than would result if the payments were treated simply as 
payments contingent on a change in ownership or control (and hence were 
taken into account in applying the 3-times-base-amount test and were 
reduced by, or did not include, any applicable amount of reasonable 
compensation).
    (e) The following examples illustrate the principles of this A-37:

    Example 1. A, a disqualified individual with respect to Corporation 
M, receives two payments in the nature of compensation that are 
contingent on a change in the ownership or control of Corporation M. The 
present value of the first payment is equal to A's base amount and is 
not a securities violation parachute payment. The present value of the 
second payment is equal to 1.5 times A's base amount and is a securities 
violation parachute payment. Neither payment includes any reasonable 
compensation. If the second payment is treated simply as a payment 
contingent on a change in ownership or control, the amount of A's total 
excess parachute payments is zero because the aggregate present value of 
the payments does not equal or exceed 3 times A's base amount. If the 
second payment is treated as a securities violation parachute payment 
subject to the rules of paragraph (b) of this A-37, the amount of A's 
total excess parachute payments is 0.5 times A's base amount. Thus, the 
second

[[Page 1088]]

payment is treated as a securities violation parachute payment.
    Example 2. Assume the same facts as in Example 1, except that the 
present value of the first payment is equal to 2 times A's base amount. 
If the second payment is treated simply as a payment contingent on a 
change in ownership or control, the total present value of the payments 
is 3.5 times A's base amount, and the amount of A's total excess 
parachute payments is 2.5 times A's base amount. If the second payment 
is treated as a securities violation parachute payment, the amount of 
A's total excess parachute payments is 0.5 times A's base amount. Thus, 
the second payment is treated simply as a payment contingent on a change 
in ownership or control.
    Example 3. B, a disqualified individual with respect to Corporation 
N, receives two payments in the nature of compensation that are 
contingent on a change in the control of Corporation N. The present 
value of the first payment is equal to 4 times B's base amount and is a 
securities violation parachute payment. The present value of the second 
payment is equal to 2 times B's base amount and is not a securities 
violation parachute payment. B establishes by clear and convincing 
evidence that the entire amount of the first payment is reasonable 
compensation for personal services to be rendered after the change in 
ownership or control. If the first payment is treated simply as a 
payment contingent on a change in ownership or control, it is exempt 
from the definition of parachute payment pursuant to Q/A-9 of this 
section. Thus, the amount of B's total excess parachute payment is zero 
because the present value of the second payment does not equal or exceed 
3 times B's base amount. However, if the first payment is treated as a 
securities violation parachute payment, the amount of B's total excess 
parachute payments is 3 times B's base amount. Thus, the first payment 
is treated as a securities violation parachute payment.
    Example 4. Assume the same facts as in Example 3, except that B does 
not receive the second payment and B establishes by clear and convincing 
evidence that the first payment is reasonable compensation for services 
actually rendered before the change in the control of Corporation N. If 
the payment is treated simply as a payment contingent on a change in 
ownership or control, the amount of B's excess parachute payment is zero 
because the amount treated as an excess parachute payment is reduced by 
the amount that B establishes as reasonable compensation. However, if 
the payment is treated as a securities violation parachute payment, the 
amount of B's excess parachute payment is 3 times B's base amount. Thus, 
the payment is treated as a securities violation parachute payment.

         Computation and Reduction of Excess Parachute Payments

    Q-38: How is the amount of an excess parachute payment computed?
    A-38: (a) The amount of an excess parachute payment is the excess of 
the amount of any parachute payment over the portion of the disqualified 
individual's base amount that is allocated to such payment. For this 
purpose, the portion of the base amount allocated to any parachute 
payment is the amount that bears the same ratio to the base amount as 
the present value of such parachute payment bears to the aggregate 
present value of all parachute payments made or to be made to (or for 
the benefit of) the same disqualified individual. Thus, the portion of 
the base amount allocated to any parachute payment is determined by 
multiplying the base amount by a fraction, the numerator of which is the 
present value of such parachute payment and the denominator of which is 
the aggregate present value of all such payments. See Q/A-31, Q/A-32, 
and Q/A-33 of this section for rules on determining present value and Q/
A-34 of this section for the definition of base amount.
    (b) The following example illustrates the principles of this A-38:

    Example. An individual with a base amount of $100,000 is entitled to 
receive two parachute payments, one of $200,000 and the other of 
$400,000. The $200,000 payment is made at the time of the change in 
ownership or control, and the $400,000 payment is to be made at a future 
date. The present value of the $400,000 payment is $300,000 on the date 
of the change in ownership or control. The portions of the base amount 
allocated to these payments are $40,000 (($200,000/$500,000) x $100,000) 
and $60,000 (($300,000/$500,000) x $100,000), respectively. Thus, the 
amount of the first excess parachute payment is $160,000 ($200,000-
$40,000) and that of the second is $340,000 ($400,000-$60,000).

    Q-39: May the amount of an excess parachute payment be reduced by 
reasonable compensation for personal services actually rendered before 
the change in ownership or control?
    A-39: (a) Generally, yes. Except in the case of payments treated as 
securities violation parachute payments or when the portion of a payment 
that is treated as contingent on the change in ownership or control is 
determined under paragraph (b) or (c) of Q/A-24 of this section, the 
amount of an excess parachute payment is reduced by any portion of the 
payment that the taxpayer establishes by clear and convincing evidence 
is reasonable compensation for personal services actually rendered by 
the disqualified individual before the date of the change in ownership 
or control. Services reasonably compensated

[[Page 1089]]

for by payments that are not parachute payments (for example, because 
the payments are not contingent on a change in ownership or control and 
are not securities violation parachute payments, or because the payments 
are exempt from the definition of parachute payment under Q/A-6 through 
Q/A-9 of this section) are not taken into account for this purpose. The 
portion of any parachute payment that is established as reasonable 
compensation is first reduced by the portion of the disqualified 
individual's base amount that is allocated to such parachute payment; 
any remaining portion of the parachute payment established as reasonable 
compensation then reduces the excess parachute payment.
    (b) The following examples illustrate the principles of this A-39:

    Example 1. Assume that a parachute payment of $600,000 is made to a 
disqualified individual, and the portion of the individual's base amount 
that is allocated to the parachute payment is $100,000. Also assume that 
$300,000 of the $600,000 parachute payment is established as reasonable 
compensation for personal services actually rendered by the disqualified 
individual before the date of the change in ownership or control. Before 
the reasonable compensation is taken into account, the amount of the 
excess parachute payment is $500,000 ($600,000--$100,000). In reducing 
the excess parachute payment by reasonable compensation, the portion of 
the parachute payment that is established as reasonable compensation 
($300,000) is first reduced by the portion of the disqualified 
individual's base amount that is allocated to the parachute payment 
($100,000), and the remainder ($200,000) then reduces the excess 
parachute payment. Thus, in this case, the excess parachute payment of 
$500,000 is reduced by $200,000 of reasonable compensation.
    Example 2. Assume the same facts as in Example 1, except that the 
full amount of the $600,000 parachute payment is established as 
reasonable compensation. In this case, the excess parachute payment of 
$500,000 is reduced to zero by $500,000 of reasonable compensation. As a 
result, no portion of any deduction for the payment is disallowed by 
section 280G, and no portion of the payment is subject to the 20-percent 
excise tax of section 4999.

                Determination of Reasonable Compensation

    Q-40: How is it determined whether payments are reasonable 
compensation?
    A-40: (a) In general, whether payments are reasonable compensation 
for personal services actually rendered, or to be rendered, by the 
disqualified individual is determined on the basis of all the facts and 
circumstances of the particular case. Factors relevant to such a 
determination include, but are not limited to, the following--
    (1) The nature of the services rendered or to be rendered;
    (2) The individual's historic compensation for performing such 
services; and
    (3) The compensation of individuals performing comparable services 
in situations where the compensation is not contingent on a change in 
ownership or control.
    (b) For purposes of section 280G, reasonable compensation for 
personal services includes reasonable compensation for holding oneself 
out as available to perform services and refraining from performing 
services (such as under a covenant not to compete).
    Q-41: Is any particular type of evidence generally considered clear 
and convincing evidence of reasonable compensation for personal 
services?
    A-41: Yes. A showing that payments are made under a 
nondiscriminatory employee plan or program (as defined in Q/A-26 of this 
section) generally is considered to be clear and convincing evidence 
that the payments are reasonable compensation. This is true whether the 
personal services for which the payments are made are actually rendered 
before, or are to be rendered on or after, the date of the change in 
ownership or control. Q/A-46 of this section (relating to the treatment 
of an affiliated group as one corporation) does not apply for purposes 
of this A-41. No determination of reasonable compensation is needed for 
payments under qualified plans to be exempt from the definition of 
parachute payment under Q/A-8 of this section.
    Q-42: Is any particular type of evidence generally considered clear 
and convincing evidence of reasonable compensation for personal services 
to be rendered on or after the date of a change in ownership or control?
    A-42: (a) Yes, if payments are made or to be made to (or on behalf 
of) a disqualified individual for personal services to be rendered on or 
after the date of a change in ownership or control, a showing of the 
following generally is considered to be clear and convincing evidence 
that the payments are reasonable compensation for services to be 
rendered on or after the date of the change in ownership or control--
    (1) The payments were made or are to be made only for the period the 
individual actually performs such personal services; and
    (2) If the individual's duties and responsibilities are 
substantially the same after the change in ownership or control, the 
individual's annual compensation for such services is not significantly 
greater than such individual's annual compensation prior to the change 
in ownership or control, apart from normal increases attributable to 
increased responsibilities or cost of living adjustments. If the scope 
of the individual's duties and responsibilities are not substantially 
the

[[Page 1090]]

same, the annual compensation after the change is not significantly 
greater than the annual compensation customarily paid by the employer or 
by comparable employers to persons performing comparable services. 
However, except as provided in paragraph (b) and (c) of this A-42, such 
clear and convincing evidence will not exist if the individual does not, 
in fact, perform the services contemplated in exchange for the 
compensation.
    (b) Generally, an agreement under which the disqualified individual 
must refrain from performing services (e.g., a covenant not to compete) 
is an agreement for the performance of personal services for purposes of 
this A-42 to the extent that it is demonstrated by clear and convincing 
evidence that the agreement substantially constrains the individual's 
ability to perform services and there is a reasonable likelihood that 
the agreement will be enforced against the individual. In the absence of 
clear and convincing evidence, payments under the agreement are treated 
as severance payments under Q/A-44 of this section.
    (c) If the employment of a disqualified individual is involuntarily 
terminated before the end of a contract term and the individual is paid 
damages for breach of contract, a showing of the following factors 
generally is considered clear and convincing evidence that the payment 
is reasonable compensation for personal services to be rendered on or 
after the date of change in ownership or control--
    (1) The contract was not entered into, amended, or renewed in 
contemplation of the change in ownership or control;
    (2) The compensation the individual would have received under the 
contract would have qualified as reasonable compensation under section 
162;
    (3) The damages do not exceed the present value (determined as of 
the date of receipt) of the compensation the individual would have 
received under the contract if the individual had continued to perform 
services for the employer until the end of the contract term;
    (4) The damages are received because an offer to provide personal 
services was made by the disqualified individual but was rejected by the 
employer (including involuntary termination or constructive discharge); 
and
    (5) The damages are reduced by mitigation. Mitigation will be 
treated as occurring when such damages are reduced (or any payment of 
such damages is returned) to the extent of the disqualified individual's 
earned income (within the meaning of section 911(d)(2)(A)) during the 
remainder of the period in which the contract would have been in effect. 
See Q/A-44 of this section for rules regarding damages for a failure to 
make severance payments.
    (d) The following examples illustrate the principles of this A-42:

    Example 1. A, a disqualified individual, has a three-year employment 
contract with Corporation M, a publicly traded corporation. Under this 
contract, A is to receive a salary for $100,000 for the first year of 
the contract and, for each succeeding year, an annual salary that is 10 
percent higher than the prior year's salary. During the third year of 
the contract, Corporation N acquires all the stock of Corporation M. 
Prior to the change in ownership, Corporation N arranges to retain A's 
services by entering into an employment contract with A that is 
essentially the same as A's contract with Corporation M. Under the new 
contract, Corporation N is to fulfill Corporation M's obligations for 
the third year of the old contract, and, for each of the succeeding 
years, pay A an annual salary that is 10 percent higher than A's prior 
year's salary. Amounts are payable under the new contract only for the 
portion of the contract term during which A remains employed by 
Corporation N. A showing of the facts described above (and in the 
absence of contradictory evidence) is regarded as clear and convincing 
evidence that all payments under the new contract are reasonable 
compensation for personal services to be rendered on or after the date 
of the change in ownership. Therefore, the payments under this agreement 
are exempt from the definition of parachute payment pursuant to Q/A-9 of 
this section.
    Example 2. Assume the same facts as in Example 1, except that A does 
not perform the services described in the new contract, but receives 
payment under the new contract. Because services were not rendered after 
the change, the payments under this contract are not exempt from the 
definition of parachute payment pursuant to Q/A-9 of this section.
    Example 3. Assume the same facts as in Example 1, except that under 
the new contract A agrees to perform consulting services to Corporation 
N, when and if Corporation N requires A's services. Assume further that 
when Corporation N does not require A's services, the contract provides 
that A must not perform services for any other competing company. 
Corporation N previously enforced similar contracts against former 
employees of Corporation N. Because A is substantially constrained under 
this contract and Corporation N is reasonably likely to enforce the 
contract against A, the agreement is an agreement for the performance of 
services under paragraph (b) of this A-42. Assuming the requirements of 
paragraph (a) of this A-42 are met and there is clear and convincing 
evidence that all payments under the new contract are reasonable 
compensation for personal services to be rendered on or after

[[Page 1091]]

the date of the change in ownership, the payments under this contract 
are exempt from the definition of parachute payment pursuant to Q/A-9 of 
this section.
    Example 4. Assume the same facts as in Example 1, except that 
instead of agreeing not to compete with Corporation N, under the new 
agreement A agrees not to disparage either Corporation M or Corporation 
N. Because the nondisparagement agreement does not substantially 
constrain A's ability to perform services, no amount of the payments 
under this contract are reasonable compensation for the nondisparagement 
agreement.
    Example 5. Assume the same facts as in Example 1, except that the 
employment contract with Corporation N does not provide that amounts are 
payable under the contract only for the portion of the term for which A 
remains employed by Corporation N. Shortly after the change in 
ownership, and despite A's request to remain employed by Corporation N, 
A's employment with Corporation N is involuntarily terminated. Shortly 
thereafter, A obtains employment with Corporation O. A commences a civil 
action against Corporation N, alleging breach of the employment 
contract. In settlement of the litigation, A receives an amount equal to 
the present value of the compensation A would have received under the 
contract with Corporation N, reduced by the amount of compensation A 
otherwise receives from Corporation O during the period that the 
contract would have been in effect. A showing of the facts described 
above (and in the absence of contradictory evidence) is regarded as 
clear and convincing evidence that the amount A receives as damages is 
reasonable compensation for personal services to be rendered on or after 
the date of the change in ownership. Therefore, the amount received by A 
is exempt from the definition of parachute payment pursuant to Q/A-9 of 
this section.

    Q-43: Is any particular type of payment generally considered 
reasonable compensation for personal services actually rendered before 
the date of a change in ownership or control?
    A-43: Yes, payments of compensation earned before the date of a 
change in ownership or control generally are considered reasonable 
compensation for personal services actually rendered before the date of 
a change in ownership or control if they qualify as reasonable 
compensation under section 162.
    Q-44: May severance payments be treated as reasonable compensation?
    A-44: (a) No, severance payments are not treated as reasonable 
compensation for personal services actually rendered before, or to be 
rendered on or after, the date of a change in ownership or control. 
Moreover, any damages paid for a failure to make severance payments are 
not treated as reasonable compensation for personal services actually 
rendered before, or to be rendered on or after, the date of such change. 
For purposes of this section, the term severance payment means any 
payment that is made to (or for the benefit of) a disqualified 
individual on account of the termination of such individual's employment 
prior to the end of a contract term, but does not include any payment 
that otherwise would be made to (or for the benefit of) such individual 
on the termination of such individual's employment, whenever occurring.
    (b) The following example illustrates the principles of this A-44:

    Example. A, a disqualified individual, has a three-year employment 
contract with Corporation X. Under the contract, A will receive a salary 
of $200,000 for the first year of the contract, and for each succeeding 
year, an annual salary that is $100,000 higher than the previous year. 
In the event of A's termination of employment following a change in 
ownership or control, the contract provides that A will receive the 
remaining salary due under the employment contract. At the beginning of 
the second year of the contract, Corporation Y acquires all of the stock 
of Corporation X, A's employment is terminated, and A receives $700,000 
($300,000 for the second year of the contract plus $400,000 for the 
third year of the contract) representing the remaining salary due under 
the employment contract. Because the $700,000 payment is treated as a 
severance payment, it is not reasonable compensation for personal 
services on or after the date of the change in ownership or control. 
Thus, the full amount of the $700,000 is a parachute payment.

                           Miscellaneous Rules

    Q-45: How is the term corporation defined?
    A-45: For purposes of this section, the term corporation has the 
meaning prescribed by section 7701(a)(3) and Sec. 301.7701-2(b) of this 
Chapter. For example, a corporation, for purposes of this section, 
includes a publicly traded partnership treated as a corporation under 
section 7704(a); an entity described in Sec. 301.7701-3(c)(1)(v)(A) of 
this Chapter; a real estate investment trust under section 856(a); a 
corporation that has mutual or cooperative (rather than stock) 
ownership, such as a mutual insurance company, a mutual savings bank, or 
a cooperative bank (as defined in section 7701(a)(32)), and a foreign 
corporation as defined under section 7701(a)(5).
    Q-46: How is an affiliated group treated?
    A-46: For purposes of this section, and except as otherwise provided 
in this section, all members of the same affiliated group (as defined in 
section 1504, determined without regard to section 1504(b)) are treated 
as one corporation. Rules affected by this treatment of an affiliated 
group include (but are

[[Page 1092]]

not limited to) rules relating to exempt payments of certain 
corporations (Q/A-6, Q/A-7 of this section (except as provided 
therein)), payor of parachute payments (Q/A-10 of this section), 
disqualified individuals (Q/A-15 through Q/A-21 of this section (except 
as provided therein)), rebuttal of the presumption that payments are 
contingent on a change (Q/A-26 of this section (except as provide 
therein)), change in ownership or control (Q/A-27, 28, and 29 of this 
section), and reasonable compensation (Q/A-42, 43, and 44 of this 
section).

                             Effective Date

    Q-47: What is the general effective date of section 280G?
    A-47: (a) Generally, section 280G applies to payments under 
agreements entered into or renewed after June 14, 1984. Any agreement 
that is entered into before June 15, 1984, and is renewed after June 14, 
1984, is treated as a new contract entered into on the day the renewal 
takes effect.
    (b) For purposes of paragraph (a) of this A-47, a contract that is 
terminable or cancellable unconditionally at will by either party to the 
contract without the consent of the other, or by both parties to the 
contract, is treated as a new contract entered into on the date any such 
termination or cancellation, if made, would be effective. However, a 
contract is not treated as so terminable or cancellable if it can be 
terminated or cancelled only by terminating the employment relationship 
or independent contractor relationship of the disqualified individual.
    (c) Section 280G applies to payments under a contract entered into 
on or before June 14, 1984, if the contract is amended or supplemented 
after June 14, 1984, in significant relevant respect. For this purpose, 
a supplement to a contract is defined as a new contract entered into 
after June 14, 1984, that affects the trigger, amount, or time of 
receipt of a payment under an existing contract.
    (d)(1) Except as otherwise provided in paragraph (e) of this A-47, a 
contract is considered to be amended or supplemented in significant 
relevant respect if provisions for payments contingent on a change in 
ownership or control (parachute provisions), or provisions in the nature 
of parachute provisions, are added to the contract, or are amended or 
supplemented to provide significant additional benefits to the 
disqualified individual. Thus, for example, a contract generally is 
treated as amended or supplemented in significant relevant respect if it 
is amended or supplemented--
    (i) To add or modify, to the disqualified individual's benefit, a 
change in ownership or control trigger;
    (ii) To increase amounts payable that are contingent on a change in 
ownership or control (or, where payment is to be made under a formula, 
to modify the formula to the disqualified individual's advantage); or
    (iii) To accelerate, in the event of a change in ownership or 
control, the payment of amounts otherwise payable at a later date.
    (2) For purposes of paragraph (a) of this A-47, a payment is not 
treated as being accelerated in the event of a change in ownership or 
control if the acceleration does not increase the present value of the 
payment.
    (e) A contract entered into on or before June 14, 1984, is not 
treated as amended or supplemented in significant relevant respect 
merely by reason of normal adjustments in the terms of employment 
relationship or independent contractor relationship of the disqualified 
individual. Whether an adjustment in the terms of such a relationship is 
considered normal for this purpose depends on all of the facts and 
circumstances of the particular case. Relevant factors include, but are 
not limited to, the following--
    (1) The length of time between the adjustment and the change in 
ownership or control;
    (2) The extent to which the corporation, at the time of the 
adjustment, viewed itself as a likely takeover candidate;
    (3) A comparison of the adjustment with historical practices of the 
corporation;
    (4) The extent of overlap between the group receiving the benefits 
of the adjustment and those members of that group who are the 
beneficiaries of pre-June 15, 1984, parachute contracts; and
    (5) The size of the adjustment, both in absolute terms and in 
comparison with the benefits provided to other members of the group 
receiving the benefits of the adjustment.
    Q-48: What is the effective date of this section?
    A-48: This section applies to any payments that are contingent on a 
change in ownership or control if the change in ownership or control 
occurs on or after January 1, 2004. Taxpayers may rely on these 
regulations after August 4, 2003, for the treatment of any parachute 
payment.

[T.D. 9083, 68 FR 45750, Aug. 4, 2003; T.D. 9083, 68 FR 59114, Oct. 14, 
2003]



Sec. 1.280H-0T  Table of contents (temporary).

    This section lists the captions that appear in the temporary 
regulations under section 280H.

Sec. 1.280H-1T Limitation on certain amounts paid to employee-owners by 
    personal service corporations electing alternative taxable years 
                              (temporary).

    (a) Introduction.
    (b) Limitations on certain deductions of a personal service 
corporation.

[[Page 1093]]

    (1) In general.
    (2) Carryover of nondeductible amounts.
    (3) Disallowance inapplicable for certain purposes.
    (4) Definition of applicable amount.
    (i) In general.
    (ii) Special rule for certain indirect payments.
    (iii) Examples.
    (c) Minimum distribution requirement.
    (1) Determination of whether requirement satisfied.
    (i) In general.
    (ii) Employee-owner defined.
    (2) Preceding year test.
    (i) In general.
    (ii) Example.
    (3) 3-year average test.
    (i) In general.
    (ii) Applicable percentage.
    (iii) Adjusted taxable income.
    (A) In general.
    (B) Determination of adjusted taxable income for the deferral period 
of the applicable election year.
    (C) NOL carryovers.
    (D) Examples.
    (d) Maximum deductible amount.
    (1) In general.
    (2) Example.
    (e) Special rules and definition.
    (1) Newly organized personal service corporations.
    (2) Existing corporations that become personal service corporations.
    (3) Disallowance of NOL carryback.
    (4) Deferral period.
    (5) Examples.
    (f) Effective date.

[T.D. 8205, 53 FR 19711, May 27, 1988]



Sec. 1.280H-1T  Limitation on certain amounts paid to employee-owners 
by personal service corporations electing alternative taxable years
(temporary).

    (a) Introduction. This section applies to any taxable year that a 
personal service corporation has a section 444 election in effect (an 
``applicable election year''). For purposes of this section, the term 
personal service corporation has the same meaning given such term in 
Sec. 1.441-3(c).
    (b) Limitation on certain deductions of personal service 
corporations--(1) In general. If, for any applicable election year, a 
personal service corporation does not satisfy the minimum distribution 
requirement in paragraph (c) of this section, the deduction otherwise 
allowable under chapter 1 of the Internal Revenue Code of 1986 (the 
Code) for applicable amounts, as defined in paragraph (b)(4) of this 
section, shall not exceed the maximum deductible amount, as defined in 
paragraph (d) of this section.
    (2) Carryover of nondeductible amounts. Any amount not allowed as a 
deduction in an applicable election year under paragraph (b)(1) of this 
section shall be allowed as a deduction in the succeeding taxable year.
    (3) Disallowance inapplicable for certain purposes. The disallowance 
of deductions under paragraph (b)(1) of this section shall not apply for 
purposes of subchapter G of chapter 1 of the Code (relating to 
corporations used to avoid income tax on shareholders) nor for 
determining whether the compensation of employee-owners is reasonable. 
Thus, for example, in determining whether a personal service corporation 
is subject to the accumulated earnings tax imposed by section 531, 
deductions disallowed under paragraph (b)(1) of this section are treated 
as allowed in computing accumulated taxable income.
    (4) Definition of applicable amount--(i) In general. For purposes of 
section 280H and the regulations thereunder, the term applicable amount 
means, with respect to a taxable year, any amount that is otherwise 
deductible by a personal service corporation in such year and includable 
at any time, directly or indirectly, in the gross income of a taxpayer 
that during such year is an employee-owner. Thus, an amount includable 
in the gross income of an employee-owner will be considered an 
applicable amount even though such employee owns no stock of the 
corporation on the date the employee includes the amount in income. See 
Example 1 in paragraph (b)(4)(iii) of this section.
    (ii) Special rule for certain indirect payments. For purposes of 
paragraph (b)(4)(i) of this section, amounts are indirectly includable 
in the gross income of an employee-owner of a personal service 
corporation that has made a section 444 election (an electing personal 
service corporation) if the amount is includable in the gross income 
of--
    (A) The spouse (other than a spouse who is legally separated from 
the partner or shareholder under a decree of divorce or separate 
maintenance) or

[[Page 1094]]

child (under age 14) of such employee-owner, or
    (B) A corporation more than 50 percent (measured by fair market 
value) of which is owned in the aggregate by employee-owners (and 
individuals related under paragraph (b)(4)(ii)(A) of this section to 
such employee-owners), of the electing personal service corporation, or
    (C) A partnership more than 50 percent of the profits and capital of 
which is owned by employee-owners (and individuals related under 
paragraph (b)(4)(ii)(A) of this section to such employee-owners) of the 
electing personal service corporation, or
    (D) A trust more than 50 percent of the beneficial ownership of 
which is owned in the aggregate by employee-owners (and individuals 
related under paragraph (b)(4)(ii)(A) of this section to any such 
employee-owners), of the electing personal service corporation.

For purposes of this paragraph (b)(4)(ii), ownership by any person 
described in this paragraph (b)(4)(ii) shall be treated as ownership by 
the employee-owners of the electing personal service corporation. 
Paragraph (b)(4)(ii)(B) of this section will not apply if the 
corporation has made a section 444 election to use the same taxable year 
as that of the electing personal service corporation. Similarly, 
paragraph (b)(4)(ii)(C) of this section will not apply if the 
partnership has made a section 444 election to use the same taxable year 
as that of the electing personal service corporation. Notwithstanding 
the general effective date provision of paragraph (f) of this section, 
this paragraph (b)(4)(ii) is effective for amounts deductible on or 
after June 1, 1988.
    (iii) Example. The provisions of paragraph (b)(4) of this section 
may be illustrated by the following examples.

    Example 1. A is an employee of P, an accrual basis personal service 
corporation with a taxable year ending September 30. P makes a section 
444 election for its taxable year beginning October 1, 1987. On October 
1, 1987, A owns no stock of P; However, on March 31, 1988, A acquires 10 
of the 200 outstanding shares of P stock. During the period October 1, 
1987 to March 31, 1988, A earned $40,000 of compensation as an employee 
of P. During the period April 1, 1988 to September 30 1988, A earned 
$60,000 of compensation as an employee-owner of P. If paragraph (b) of 
this section does not apply, P would deduct for its taxable year ended 
September 30, 1988 the $100,000 earned by A during such year. Based upon 
these facts, the $100,000 otherwise deductable amount is considered an 
applicable amount under this section.
    Example 2. I1 and I2, calendar year individuals, are employees of 
PSC1, a personal service corporation that has historically used a 
taxable year ending January 31. I1 and I2 also own all the stock, and 
are employees, of PSC2, a calendar year personal service corporation. 
For its taxable years beginning February 1, 1987, 1988, and 1989, PSC1 
has a section 444 election in effect to use a January 31 taxable year. 
During its taxable years beginning February 1, 1986, 1987, and 1988, 
PSC1 deducted $10,000, $11,000, and $12,000, respectively, that was 
included in PSC2's gross income. Furthermore, of the $12,000 deducted by 
PSC1 for its taxable year beginning February 1, 1988, $7,000 was 
deducted during the period June 1, 1988 to January 31, 1989. Pursuant to 
paragraph (b)(4)(ii)(B) of this section, the $7,000 deducted by PSC1 on 
or after June 1, 1988, and included in PSC2's gross income is considered 
an applicable amount for PSC1's taxable year beginning February 1, 1988. 
Amounts deducted by PSC1 prior to June 1, 1988, are not subject to 
paragraph (b)(4)(ii)(B) of this section.
    Example 3. The facts are the same as in Example 2, except that for 
its taxable years beginning February 1, 1987, 1988, and 1989, PSC2 has a 
section 444 election in effect to use a January 31 taxable year. Since 
both PSC1 and PSC2 have the same taxable year and both have section 444 
elections in effect, paragraph (b)(4)(ii)(B) of this section does not 
apply to the $7,000 deducted by PSC1 for its taxable year beginning 
February 1, 1988.

    (c) Minimum distribution requirement--(1) Determination of whether 
requirement satisfied--(i) In general. A personal service corporation 
meets the minimum distribution requirement of this paragraph (c) for an 
applicable election year if, during the deferral period of such taxable 
year, the applicable amounts (determined without regard to paragraph 
(b)(2) of this section) for all employee-owners in the aggregate equal 
or exceed the lesser of--
    (A) The amount determined under the ``preceding year test'' (see 
paragraph (c)(2) of this section), or
    (B) The amount determined under the ``3-year average test'' (see 
paragraph (c)(3) of this section).

The following example illustrates the application of this paragraph 
(c)(1)(i).


[[Page 1095]]


    Example. Q, an accrual-basis personal service corporation, makes a 
section 444 election to retain a year ending January 31 for its taxable 
year beginning February 1, 1987. Q has 4 employee-owners, B, C, D, and 
E. For Q's applicable election year beginning February 1, 1987 and 
ending January 31, 1988, B earns $6,000 a month plus a $45,000 bonus on 
January 15, 1988; C earns $5,000 a month plus a $40,000 bonus on January 
15, 1988; D and E each earn $4,500 a month plus a $4,000 bonus on 
January 15, 1988. Q meets the minimum distribution requirement for such 
applicable election year if the applicable amounts during the deferral 
period (i.e., $220,000) equal or exceed the amount determined under the 
preceding year test or the 3-year average test.

    (ii) Employee-owner defined. For purposes of section 280H and the 
regulations thereunder, a person is an employee-owner of a corporation 
for a taxable year if--
    (A) On any day of the corporation's taxable year, the person is an 
employee of the corporation or performs personal services for or on 
behalf of the corporation, even if the legal form of that person's 
relationship to the corporation is that of an independent contractor, 
and
    (B) On any day of the corporation's taxable year, the person owns 
any outstanding stock of the corporation.
    (2) Preceding year test--(i) In general. The amount determined under 
the preceding year test is the product of--
    (A) The applicable amounts during the taxable year preceding the 
applicable election year (the ``preceding taxable year''), divided by 
the number of months (but not less than one) in the preceding taxable 
year, multiplied by
    (B) The number of months in the deferral period of the applicable 
election year.
    (ii) Example. The provisions of paragraph (c)(2) of this section may 
be illustrated by the following example.

    Example. R, a personal service corporation, has historically used a 
taxable year ending January 31. For its taxable year beginning February 
1, 1987, R makes a section 444 election to retain its January 31 taxable 
year. R is an accrual basis taxpayer and has one employee-owner, F. For 
R's taxable year ending January 31, 1987, F earns $5,000 a month plus a 
$40,000 bonus on January 15, 1987. The amount determined under the 
preceding year test for R's applicable election year beginning February 
1, 1987 is $91,667 ($100,000, the applicable amounts during R's taxable 
year ending January 31, 1987, divided by 12, the number of months in R's 
taxable year ending January 31, 1987, multiplied by 11, the number of 
months in R's deferral period for such year).

    (3) 3-year average test--(i) In general. The amount determined under 
the 3-year average test is the applicable percentage multiplied by the 
adjusted taxable income for the deferral period of the applicable 
election year.
    (ii) Applicable percentage. The term applicable percentage means the 
percentage (not in excess of 95 percent) determined by dividing--
    (A) The applicable amounts during the 3 taxable years of the 
corporation (or, if fewer, the taxable years the corporation has been in 
existence) immediately preceding the applicable election year, by
    (B) The adjusted taxable income of such corporation for such 3 
taxable years (or, if fewer, the taxable years of existence).
    (iii) Adjusted taxable income--(A) In general. The term adjusted 
taxable income means taxable income determined without regard to 
applicable amounts.
    (B) Determination of adjusted taxable income for the deferral period 
of the applicable election year. Adjusted taxable income for the 
deferral period of the applicable election year equals the adjusted 
taxable income that would result if the personal service corporation 
filed an income tax return for the deferral period of the applicable 
election year under its normal method of accounting. However, a personal 
service corporation may make a reasonable estimate of such amount.
    (C) NOL carryovers. For purposes of determining adjusted taxable 
income for any period, any NOL carryover shall be reduced by the amount 
of such carryover that is attributable to the deduction of applicable 
amounts. The portion of the NOL carryover attributable to the deduction 
of applicable amounts is the difference between the NOL carryover 
computed with the deduction of such amounts and the NOL carryover 
computed without the deduction of such amounts. For purposes of 
determining the adjusted taxable income for the deferral period, an NOL 
carryover to the applicable election year, reduced as provided in this 
paragraph (c)(3)(iii)(C), shall be allowed

[[Page 1096]]

first against the income of the deferral period.
    (D) Examples. The provisons of this paragraph (c)(3)(iii) may be 
illustrated by the following examples.

    Example 1. S is a personal service corporation that has historically 
used a taxable year ending January 31. For its taxable year beginning 
February 1, 1987, S makes a section 444 election to retain its taxable 
year ending January 31. S does not satisfy the minimum distribution 
requirement for its first applicable election year, and the applicable 
amounts for that year exceed the maximum deductible amount by $54,000. 
Under paragraph (b)(2) of this section, the $54,000 excess is carried 
over to S's taxable year beginning February 1, 1988. Furthermore, if S 
continues its section 444 election for its taxable year beginning 
February 1, 1988, and desires to use the 3-year average test provided in 
this paragraph for such year, pursuant to paragraph (c)(3)(iii)(A) of 
this section the $54,000 will not be allowed to reduce adjusted taxable 
income for such year. See also section 280H(e) regarding the 
disallowance of net operating loss carrybacks to (or from) any taxable 
year of a corporation personal service election under section 444 
applies.
    Example 2. T, a personal service corporation with a section 444 
election in effect, is determining whether it satisfies the 3-year 
average test for its second applicable election year. T had a net 
operating loss (NOL) for its first applicable election year of $45,000. 
The NOL resulted from $150,000 of gross income less the sum of $96,000 
of salary, $45,000 of other expenses, and $54,000 of deductible 
applicable amounts. Pursuant to paragraph (c)(3)(iii)(C) of this 
section, the entire amount of the $45,000 NOL is attributable to 
applicable amounts since the applicable amounts deducted in arriving at 
the NOL (i.e., $54,000) were greater than the NOL (i.e., $45,000). Thus, 
for purposes of computing the adjusted taxable income for the deferral 
period of T's second applicable election year, the NOL carryover to that 
year is $0 ($45,000 NOL less $45,000 amount of NOL attributable to 
applicable amounts).

    (d) Maximum deductible amount--(1) In general. For purposes of this 
section, the term maximum deductible amount means the sum of--
    (i) The applicable amounts during the deferral period of the 
applicable election year, plus
    (ii) An amount equal to the product of--
    (A) The amount determined under paragraph (d)(1)(i) of this section 
divided by the number of months in the deferral period of the applicable 
election year, multiplied by
    (B) The number of months in the nondeferral period of the applicable 
election year. For purposes of the preceding sentence, the term 
nondeferral period means the portion of the applicable election year 
that occurs after the portion of such year constituting the deferral 
period.
    (2) Example. The provisions of paragraph (d)(1) of this section may 
be illustrated by the following example.

    Example. U, an accrual basis personal service corporation with a 
taxable year ending January 31, makes a section 444 election to retain a 
year ending January 31 for its taxable year beginning February 1, 1987. 
For its applicable election year beginning February 1, 1987, U does not 
satisfy the minimum distribution requirement in paragraph (c) of this 
section. Furthermore, U has 3 employee-owners, G, H, and I. G and H have 
been employee-owners of U for 10 years. Although I has been an employee 
of U for 4 years, I did not become an employee-owner until December 1, 
1987, when I acquired 5 of the 20 outstanding shares of U stock. For U's 
applicable election year beginning February 1, 1987, G earns $5,000 a 
month plus a $40,000 bonus on January 15, 1988, and H and I each earn 
$4,000 a month plus a $32,000 bonus on January 15, 1988. Thus, the total 
of the applicable amounts during the deferral period of the applicable 
election year beginning February 1, 1987 is $143,000. Based on these 
facts, U's deduction for applicable amounts is limited to $156,000, 
determined as follows--$143,000 (applicable amounts during the deferral 
period) plus $13,000 (applicable amounts during the deferral period, 
divided by the number of months in the deferral period, multiplied by 
the number of months in the nondeferral period).

    (e) Special rules and definition--(1) Newly organized personal 
service corporations. A personal service corporation is deemed to 
satisfy the preceding year test and the 3-year average test for the 
first year of the corporation's existence.
    (2) Existing corporations that become personal service corporations. 
If an existing corporation becomes a personal service corporation and 
makes a section 444 election, the determination of whether the 
corporation satisfies the preceding year test and the 3-year average 
test is made by treating the corporation as though it were a personal 
service corporation for each of the 3

[[Page 1097]]

years preceding the applicable election year.
    (3) Disallowance of NOL carryback. No net operating loss carryback 
shall be allowed to (or from) any applicable election year of a personal 
service corporation.
    (4) Deferral period. For purposes of section 280H and the 
regulations thereunder, the term deferral period has the same meaning as 
under Sec. 1.444-1T(b)(4).
    (5) Examples. The provisions of this paragraph (e) may be 
illustrated by the following examples.

    Example 1. V is a personal service corporation with a taxable year 
ending September 30. V makes a section 444 election for its taxable year 
beginning October 1, 1987, and incurs a net operating loss (NOL) for 
such year. Because an NOL is not allowed to be carried back from an 
applicable election year, V may not carry back the NOL from its first 
applicable election year to reduce its 1985, 1986, or 1987 taxable 
income.
    Example 2. W, a personal service corporation, commences operations 
on July 1, 1990. Furthermore, for its taxable year beginning July 1, 
1990, W makes a section 444 election to use a year ending September 30. 
Pursuant to paragraph (e)(1) of this section, W satisfies the preceding 
year test and the 3-year average test for its first year in existence. 
Thus, W may deduct, without limitation under this section, any 
applicable amounts for its taxable year beginning July 1, 1990.
    Example 3. The facts are the same as in Example 2. For its taxable 
year beginning October 1, 1990, W incurs an NOL and is not a personal 
service corporation. Furthermore, W desires to carry back the NOL to its 
preceding taxable year (a year that was an applicable election year). 
Pursuant to paragraph (e)(3) of this section, W may not carry back an 
NOL ``to'' its taxable year beginning July 1, and ending September 30, 
1990, because such year was an applicable election year.

    (f) Effective date. The provisions of this section are effective for 
taxable years beginning after December 31, 1986.

[T.D. 8205, 53 FR 19711, May 27, 1988]

            Taxable Years Beginning Prior to January 1, 1986



Sec. 1.274-5A  Substantiation requirements.

    (a) In general. No deduction shall be allowed for any expenditure 
with respect to:
    (1) Traveling away from home (including meals and lodging) 
deductible under section 162 or 212,
    (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), or
    (3) Gifts defined in section 274, unless the taxpayer substantiates 
such expenditure as provided in paragraph (c) of this section. This 
limitation supersedes with respect to any such expenditure the doctrine 
of Cohan v. Commissioner (C.C.A. 2d 1930) 39 F. 2d 540. The decision 
held that, where the evidence indicated a taxpayer incurred deductible 
travel or entertainment expense 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 
shall be allowed a taxpayer for such expenditures 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 therefore; and the term expenditure 
includes expenses and items (including items such as losses and 
depreciation).
    (b) Elements of an expenditure--(1) In general. Section 274(d) and 
this section contemplate that no deduction shall be allowed for any 
expenditure for travel, entertainment, or a gift unless the taxpayer 
substantiates the following elements for each such expenditure:
    (i) Amount;
    (ii) Time and place of travel or entertainment (or use of a facility 
with respect to entertainment), or date and description of a gift;
    (iii) Business purpose; and
    (iv) Business relationship to the taxpayer of each person 
entertained, using an entertainment facility or receiving a gift.
    (2) Travel. The elements to be proved with respect to an expenditure 
for travel 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

[[Page 1098]]

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. 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 designation of 
type of entertainment, such as dinner or theater, 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 subparagraph (3)(i), (ii), (iii), and (v) of this 
paragraph, 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. 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.
    (c) Rules for substantiation--(1) In general. A taxpayer must 
substantiate each element of an expenditure (described in paragraph (b) 
of this section) by adequate records or by sufficient evidence 
corroborating his own statement except as otherwise provided in this 
section. Section 274(d) contemplates that a taxpayer will maintain and 
produce such substantiation as will constitute clear proof of an 
expenditure for travel, entertainment, or gifts referred to in section 
274. A record of the elements of an expenditure made at or near the time 
of the expenditure, 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 made at or near the time of the expenditure 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 supported by sufficient documentary

[[Page 1099]]

evidence. The substantiation requirements of section 274(d) are designed 
to encourage taxpayers to maintain the records, together with 
documentary evidence, as provided in subparagraph (2) of this paragraph. 
To obtain a deduction for an expenditure for travel, entertainment, or 
gifts, a taxpayer must substantiate, in accordance with the provisions 
of this paragraph, each element of such an expenditure.
    (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, statement of expense or similar record 
(as provided in subdivision (ii) of this subparagraph) and documentary 
evidence (as provided in subdivision (iii) of this subparagraph) which, 
in combination, are sufficient to establish each element of an 
expenditure specified in paragraph (b) of this section. It is not 
necessary to record information in an account book, diary, statement of 
expense or similar record which duplicates information reflected on a 
receipt so long as such account book and receipt complement each other 
in an orderly manner.
    (ii) Account book, diary, etc. An account book, diary, statement of 
expense or similar record must be prepared or maintained in such manner 
that each recording of an element of an expenditure is made at or near 
the time of the expenditure.
    (a) Made at or near the time of the expenditure. For purposes of 
this section, the phrase made at or near the time of the expenditure 
means the elements of an expenditure are recorded at a time when, in 
relation to the making of an expenditure, the taxpayer has full present 
knowledge of each element of the expenditure, such as the amount, time, 
place and business purpose of the expenditure and business relationship 
to the taxpayer of any person entertained. An expense account statement 
which is a transcription of an account book, diary, or similar record 
prepared or maintained in accordance with the provisions of this 
subdivision 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.
    (b) Substantiation of business purpose. In order to constitute an 
adequate record of business purpose within the meaning of section 274(d) 
and this subparagraph, 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 of an expenditure 
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) Confidential information. If any information relating to the 
elements of an expenditure, 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, statement of expense or similar 
record, provided such information is recorded at or near the time of the 
expenditure and is elsewhere available to the district director to 
substantiate such element of the expenditure.
    (iii) Documentary evidence. Documentary evidence, such as receipts, 
paid bills, or similar evidence sufficient to support an expenditure 
shall be required for:
    (a) Any expenditure for lodging while traveling away from home, and
    (b) Any other expenditure of $25 or more, except, for transportation 
charges, documentary evidence will not be required if not readily 
available.

Provided, however, that the Commissioner, in his discretion, may 
prescribe rules waiving such requirements in circumstances where he 
determines it is

[[Page 1100]]

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, 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) Retention of documentary evidence. The Commissioner may, in his 
discretion, prescribe rules under which an employer may dispose of 
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 (e)(4) of this section) if the employer maintains adequate 
accounting procedures with respect to such employees (within the meaning 
of paragraph (e)(5) of this section).
    (v) Substantial compliance. If a taxpayer has not fully 
substantiated a particular element of an expenditure, but the taxpayer 
establishes to the satisfaction of the district director that he has 
substantially complied with the adequate records requirements of this 
subparagraph with respect to the expenditure, the taxpayer may be 
permitted to establish such element by evidence which the district 
director shall deem adequate.
    (3) Substantiation by other sufficient evidence. If a taxpayer fails 
to establish to the satisfaction of the district director that he has 
substantially complied with the ``adequate records'' requirements of 
subparagraph (2) of this paragraph with respect to an element of an 
expenditure, then, except as otherwise provided in this paragraph, the 
taxpayer must establish such element:
    (i) By his own statement, whether written or oral, containing 
specific information in detail as to such element; and
    (ii) By other corroborative evidence sufficient to establish such 
element.

If such element is the description of a gift, or the cost, time, place, 
or date of an expenditure, the corroborative evidence shall be direct 
evidence, such as a statement in writing or the oral testimony of 
persons entertained or other witness setting forth detailed information 
about such element, or the documentary evidence described in 
subparagraph (2) of this paragraph. If such element is either the 
business relationship to the taxpayer of persons entertained or the 
business purpose of an expenditure, the corroborative evidence may be 
circumstantial evidence.
    (4) Substantiation in exceptional circumstances. If a taxpayer 
establishes that, by reason of the inherent nature of the situation in 
which an expenditure was made:
    (i) He was unable to obtain evidence with respect to an element of 
the expenditure which conforms fully to the ``adequate records'' 
requirements of subparagraph (2) of this paragraph,
    (ii) He is unable to obtain evidence with respect to such element 
which conforms fully to the ``other sufficient evidence'' requirements 
of subparagraph (3) of this paragraph, 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 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,

[[Page 1101]]

earthquake, or other casualty, the taxpayer shall have a right to 
substantiate a deduction by reasonable reconstruction of his 
expenditures.
    (6) Special rules--(i) Separate expenditure--(a) In general. For the 
purposes of this section, each separate payment by the taxpayer shall 
ordinarily be considered to constitute a separate expenditure. However, 
concurrent or repetitious expenses of a similar nature occurring during 
the course of a single event shall be considered a single expenditure. 
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 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. Except as otherwise provided in this section, the 
account book, diary, statement of expense, or similar record required by 
subparagraph (2)(ii) of this paragraph 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. For other provisions permitting recording of aggregate amounts 
in an account book, diary, statement of expense or similar record see 
paragraph (b)(2)(i) and (b)(3) of this section (relating to incidental 
costs of travel and entertainment).
    (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 each such person.
    (iii) Primary use of a facility. Section 274(a) (1)(B) and (2)(C) 
denies a deduction for any expenditure paid or incurred before January 
1, 1979, with respect to a facility, or paid or incurred at any time 
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 his trade or business. A 
determination whether a facility before January 1, 1979, or a club at 
any time was used primarily for the futherance 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 of an expenditure specified 
in paragraph (b) 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

[[Page 1102]]

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 as he determines necessary to properly implement 
the provisions of section 274 and the regulations thereunder by personal 
interview or otherwise.
    (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. The Commissioner may, in his discretion, 
prescribe rules under which any taxpayer claiming a deduction for 
entertainment, gifts, or travel 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 (e) of 
this section.
    (e) Reporting and substantiation of expenses of certain employees 
for travel, entertainment, and gifts--(1) In general. The purpose of 
this paragraph is to provide rules for reporting and substantiation of 
certain expenses paid or incurred by taxpayers 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, or gifts which are deductible under section 162, 
and the regulations thereunder, to the extent not disallowed by section 
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 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, and similar purposes, 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 
subparagraph (4) of this paragraph) 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) Expense in excess of reimbursements. If an employee incurs 
deductible

[[Page 1103]]

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 wishes to claim a deduction for such excess, he must:
    (a) Submit a statement as part of his tax return showing all of the 
information required by subparagraph (3) of this paragraph, and,
    (b) Maintain 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, a statement 
showing the following information:
    (i) The total of all amounts received as advances or reimbursements 
from his employer, including amounts charged directly or indirectly to 
the employer through credit cards or otherwise; and
    (ii) The nature of his occupation, the number of days away from home 
on business, and the total amount of business expenses paid or incurred 
by him (including those charged directly or indirectly to the employer 
through credit cards or otherwise) broken down into such categories as 
transportation, meals and lodging while away from home overnight, 
entertainment, gifts, and other business expenses.

In addition, he must maintain 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.
    (4) Definition of an ``adequate accounting'' to the employer. For 
purposes of this paragraph an adequate accounting means the submission 
to the employer of an account book, diary, statement of expense, or 
similar record maintained by the employee in which the information as to 
each element of an expenditure (described in paragraph (b) of this 
section) is recorded at or near the time of the expenditure, together 
with supporting documentary evidence, in a manner which 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 his 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, and gifts. 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 such 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.
    (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 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.

[[Page 1104]]

For example, an employer should require that an expense account must be 
verified and approved by a responsible 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 subparagraph (4) of this 
paragraph, or does not maintain such substantiation. To the extent an 
employer fails to maintain adequate accounting procedures he will 
thereby obligate his employees to separately substantiate their expense 
account information.
    (f) Substantiation by reimbursement arrangements or per diem, 
mileage, and other traveling allowances. The Commissioner may, in his 
discretion, prescribe rules under which:
    (1) Reimbursement arrangements covering ordinary and necessary 
expenses of traveling away from home (exclusive of transportation 
expenses to and from destination),
    (2) Per diem allowances providing for ordinary and necessary 
expenses of traveling away from home (exclusive of transportation costs 
to and from destination), and
    (3) Mileage allowances providing for ordinary and necessary expenses 
of transportation while traveling away from home, 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 such 
traveling expenses and as satisfying, with respect to the amount of such 
traveling expenses, the requirements of an adequate accounting to the 
employer for purposes of paragraph (e)(4) of this section. If the total 
travel allowance received exceeds the deductible traveling expenses paid 
or incurred by the employee, such excess must be reported as income on 
the employee's return. See paragraph (h) of this section relating to the 
substantiation of meal expenses while traveling.
    (g) 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, and gifts 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, or 
gifts which are deductible under section 162, and the regulations 
thereunder, to the extent not disallowed by section 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, or gifts, 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 (h) of this section 
relating to the substantiation of meal expenses while traveling.
    (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 subparagraph (3) of this paragraph) 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

[[Page 1105]]

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 274(e)(4)(B) and subparagraph (3) of this paragraph) 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.
    (h) Authority for an optional method of computing meal expenses 
while traveling. The Commissioner may establish a method under which a 
taxpayer may elect to use a specified amount or amounts for meals while 
traveling in lieu of substantiating the actual cost of meals. The 
taxpayer would not be relieved of substantiating the actual cost of 
other travel expenses as well as the time, place, and business purpose 
of the travel. See paragraph (b)(2) and (c) of this section.
    (i) Effective date--(1) In general. Section 274(d) and this section 
apply with respect to taxable years ending after December 31, 1962, but 
only with respect to period after that date.
    (2) Certain meal expenses. Paragraph (h) of this section is 
effective for expenses paid or incurred after December 31, 1982.

[T.D. 6630, 27 FR 12931, Dec. 29, 1972, as amended by T.D. 7226, 37 FR 
26711, Dec. 15, 1972; T.D. 7909, 48 FR 40370, Sept. 7, 1983; 48 FR 
41017, Sept. 13, 1983; T.D. 8051, 50 FR 36576, Sept. 9, 1985. 
Redesignated by T.D. 8715, 62 FR 13990, Mar. 25, 1997; T.D. 8996, 67 FR 
35008, May 17, 2002]

          Terminal Railroad Corporations and Their Shareholders



Sec. 1.281-1  In general.

    Section 281 provides special rules for the computation of the 
taxable incomes of a terminal railroad corporation and its shareholders 
when the terminal railroad corporation, as a result of taking related 
terminal income into account, reduces a charge which was made or which 
would be made for related terminal services furnished to a railroad 
corporation. Section 281 and paragraphs (a) and (b) of Sec. 1.281-2 
provide that the ``reduced amount'' described in paragraph (c) of Sec. 
1.281-2 is not includable in gross income of the terminal railroad 
corporation, is not treated as a dividend or other distribution to its 
railroad shareholders, and is not treated as an amount paid -or incurred 
by the railroad shareholders to the terminal railroad corporation. 
Section 281 and paragraph (a)(2) of Sec. 1.281-2 provide that no 
deduction otherwise allowable to a terminal railroad corporation shall 
be disallowed as a result of the ``reduced amount'' described in 
paragraph (c) of Sec. 1.281-2. Section 1.281-3 defines the terms 
terminal railroad corporation, related terminal income, related terminal 
services, agreement, and railroad corporation. Section 1.281-4 describes 
the effective dates and special rules for application of section 281 to 
taxable years ending before October 23, 1962.

[T.D. 7356, 40 FR 23732, June 2, 1975]



Sec. 1.281-2  Effect of section 281 upon the computation of taxable income.

    (a) Computation of taxable income of terminal railroad 
corporations--(1) Income not considered received or accrued. A terminal 
railroad corporation (as defined in paragraph (a) of Sec. 1.281-3) 
shall not be considered to have received or accrued the ``reduced 
amount'' described in paragraph (c) of this section

[[Page 1106]]

in the computation of its taxable income. Thus, income is not to be 
considered accrued or actually or constructively received by a terminal 
railroad corporation where, in the manner described in paragraph (c) of 
this section, (i) a charge which would be made to any railroad 
corporation for related terminal services is not made, or (ii) a portion 
of any liability payable by any railroad corporation with respect to 
related terminal services is discharged.
    (2) Deduction not disallowed. In the computation of the taxable 
income of a terminal railroad corporation, a deduction relating to a 
``reduced amount'', described in paragraph (c) of this section, which is 
otherwise allowable to it under chapter 1 of the Code (without regard to 
sec. 277) shall not be disallowed by reason of section 281. Thus, 
deductions for expenses attributable to services rendered to a 
shareholder are not to be disallowed to a terminal railroad corporation 
merely because, in the manner described in paragraph (c) of this 
section, (i) a charge which would be made to any railroad corporation 
for related terminal services is not made, or (ii) a portion of any 
liability payable by any railroad corporation with respect to related 
terminal services is discharged. To the extent that section 281 applies 
to a deduction relating to a ``reduced amount'', such deduction shall 
not be disallowed under section 277.
    (b) Computation of taxable income of shareholders--(1) Income not 
considered received or accrued. A shareholder of a terminal railroad 
corporation shall not be considered to have received or accrued any 
``reduced amount'' (described in paragraph (c) of this section) in the 
computation of the shareholder's taxable income. Thus a dividend is not 
to be considered actually or constructively received by a shareholder of 
a terminal railroad corporation merely because, in the manner described 
in paragraph (c) of this section, (i) a charge which would be made to 
the shareholder or any other railroad corporation for related terminal 
services is not made, or (ii) a portion of any liability payable by it 
or any other railroad corporation with respect to related terminal 
services is discharged.
    (2) Expenses not considered paid or incurred. In the computation of 
the taxable income of a shareholder of a terminal railroad corporation, 
the shareholder shall not be considered to have paid or incurred any 
``reduced amount'' (described in paragraph (c) of this section). Thus, a 
shareholder of the terminal railroad corporation may not deduct as an 
expense for related terminal services (as defined in paragraph (c) of 
Sec. 1.281-3) an amount in excess of the net cost to it of such 
services.
    (c) Amounts to which section 281 applies--(1) Reduced amount. For 
purposes of this section, the term reduced amount means, subject to the 
limitation of paragraph (c)(4) of this section, the amount by which:
    (i) A charge which would be made by a terminal railroad corporation 
for its taxable year for related terminal services provided to a 
railroad corporation; or
    (ii) A liability of a railroad corporation, resulting from a charge 
made by a terminal railroad corporation for its taxable year, with 
respect to related terminal services provided by the terminal railroad 
corporation, is reduced by reason of the terminal railroad corporation's 
taking into account, pursuant to an agreement (as defined in paragraph 
(d) of Sec. 1.281-3), related terminal income (as defined in paragraph 
(b) of Sec. 1.281-3) received or accrued (without regard to section 
281) during such taxable year.
    (2) Charge which would be made. For purposes of this section, a 
``charge which would be made'' by a terminal railroad corporation is the 
amount that would be charged to any railroad corporation for related 
terminal services provided if the terminal railroad corporation made the 
charge without taking related terminal income into account.
    (3) Reduction resulting from related terminal income. For purposes 
of subparagraph (1) of this section, a charge or a liability is reduced 
by taking related terminal income into account to the extent that:
    (i) Related terminal income is received or accrued (without regard 
to section 281) by the terminal railroad corporation for its taxable 
year in

[[Page 1107]]

which the charge or liability is reduced; and
    (ii) The charge or liability in question would have been larger than 
it is had such income not been received or accrued (without regard to 
section 281).

The reduction must be made (directly or indirectly) on the books of the 
terminal railroad corporation, and in fact, for the same taxable year 
for which the charge would be made or for which the liability is 
incurred. The reduction of the charge or liability must be taken into 
account by the terminal railroad corporation in ascertaining the income, 
profit, or loss for such taxable year for the purpose of reports to 
shareholders and the Interstate Commerce Commission, and for credit 
purposes.
    (4) Limitation. To the extent that a reduced amount (as described in 
paragraph (c)(1) of this section but without regard to the limitation 
under this subparagraph) would operate either to create or to increase a 
net operating loss for the terminal railroad corporation, this section 
shall not apply. Therefore, if a portion of a liability is discharged 
(in the manner described in this paragraph) and the discharged portion 
of the liability exceeds an amount equal to the terminal railroad 
corporation's gross income minus the deductions allowed by chapter 1 of 
the Code (computed with regard to the modifications specified in section 
172(d) but without regard to section 281 and this section), then section 
281 and this section shall not apply to such excess. The limitation 
described in this subparagraph shall apply only to taxable years of 
terminal railroad corporations ending after October 23, 1962.
    (d) Examples. The provisions of this section may be illustrated by 
the following examples. In these examples, references to ``before the 
application of section 281'', ``after the application of section 281'', 
``taxable income'', and ``allowable deductions'' take no account of 
section 277, which may apply to deductions to which section 281 does not 
apply.

    Example 1. (i) Facts. The T Company is a terminal railroad 
corporation which charges its three equal shareholders, the X, Y, and Z 
railroad corporations, a rental calculated monthly on a wheelage or user 
basis for the use of its services and facilities. The T Company and each 
of its shareholders report income on the calendar year basis. A written 
lease agreement to which all of the shareholders were parties was 
entered into in 1947. The agreement provides that at the end of each 
year the liabilities of each of the shareholders resulting from charges 
for rental obligations with respect to related terminal services shall 
be reduced by the shareholder's one-third share of the net income from 
each source of revenue that produced income (computed before reduction 
for Federal income taxes). For the calendar year 1973, the T Company's 
charges to its shareholders include the following charges for related 
terminal services: $35,000 to the X Company, $25,000 to the Y Company, 
and $20,000 to the Z Company. Thus, prior to reduction, total 
shareholder liabilities to the T Company for related terminal services 
are $80,000 at the end of 1973. The T Company's net income from all 
sources (before reduction of liabilities pursuant to the 1947 agreement 
and before reduction for Federal income taxes) and its taxable income, 
before the application of section 281, for 1973 are $36,000 determined 
as follows:

------------------------------------------------------------------------
                                                                 Income
                 Source                     Gross    Allowable     (or
                                           income   deductions    loss)
------------------------------------------------------------------------
Related terminal services performed:
    For shareholders....................   $80,000     $65,000   $15,000
    For nonshareholders.................    46,000      37,000     9,000
                                         -------------------------------
  Related terminal income...............   126,000     102,000    24,000
  Nonrelated terminal income............    30,000      18,000    12,000
                                         -------------------------------
      Total.............................   156,000     120,000    36,000
------------------------------------------------------------------------


The liability of each shareholder is, pursuant to the agreement, 
discharged in part by the T Company crediting $12,000 against the rental 
due from each shareholder for a total discharge of liabilities of 
$36,000 (the net income from all sources), resulting in net shareholder 
liabilities owing to the T Company at the end of 1973 of $44,000 
($80,000 less $36,000): $23,000 from the X Company, $13,000 from the Y 
Company, and $8,000 from the Z Company.
    (ii) Effect on terminal railroad corporation. The reduced amount to 
which this section applies is $24,000 (related terminal income of $9,000 
from nonshareholders and $15,000 from shareholders). Thus, to the extent 
of $24,000, the T Company is not considered to have received or accrued 
income from the discharged liabilities of $36,000. Similarly, to the 
extent of the same $24,000, the T Company is not disallowed deductions 
for expenses merely by reason of the discharge. The T Company's taxable 
income for 1973 after application of section 281 is $12,000, computed as 
follows:

[[Page 1108]]



Gross income ($156,000 less $24,000).........................   $132,000
Less allowable deductions....................................    120,000
                                                              ----------
    Taxable income...........................................     12,000
 

    (iii) Effect on shareholders--The reduced amount of $24,000 shall 
not be deemed to constitute either a dividend to the shareholders of the 
T Company or an expense paid or incurred by them. Thus, under the facts 
described, neither the X Company, the Y Company, nor the Z Company shall 
be considered to have received or accrued a dividend of $8,000, or to 
have paid or incurred an expense of $8,000. Assuming the X Company's 
taxable income for 1973 before the application of section 281 would have 
been $43,200, computed in the following manner, its taxable income for 
1973 after the application of section 281 is $50,000, determined as 
follows:

------------------------------------------------------------------------
                                                 Before the   After the
                                                application  application
                                                of sec. 281  of sec. 281
------------------------------------------------------------------------
Gross income:
  From sources other than T Co................    $146,000     $146,000
  Dividend considered received because of T         12,000        4,000
   Co.'s discharge of liabilities of $12,000..
                                               -------------------------
    Total.....................................     158,000      150,000
                                               =========================
Less allowable deductions:
  From sources other than T Co................      69,600       69,600
  85 percent dividend received deduction under      10,200        3,400
   sec. 243 attributable to dividend
   considered received because of T Co.'s
   discharge of liabilities...................
  Expenses for accrued charges for related          35,000       27,000
   terminal services performed by T Co........
                                               -------------------------
                                                   114,800      100,000
                                               =========================
  Taxable income..............................      43,200       50,000
------------------------------------------------------------------------

    Example 2. Assume the same facts as in Example 1, except that the 
charges to each of the shareholders for related terminal services for 
1973 were as follows: $35,000 to the X Company, $40,000 to the Y 
Company, and $5,000 to the Z Company. Assume further that the Z Company, 
prior to the reduction in liabilities at the end of 1973, owed the T 
Company an additional $4,000 resulting from charges for 1972 for related 
terminal services and $6,000 resulting from the purchase of equipment. 
Since only $21,000 (X Company $8,000, Y Company $8,000, Z Company 
$5,000) of the liabilities which were discharged resulted from charges 
made for 1973 for related terminal services, the reduced amount to which 
this section applies is $21,000 (instead of $24,000 as in Example 1). 
Thus, the T Company's taxable income for 1973 would be $15,000 ($36,000 
less $21,000 reduced amount) and the amount which shall be considered 
not to have been received or accrued as a dividend nor paid or incurred 
as an expense of each shareholder is $8,000 for the X Company, $8,000 
for the Y Company, and $5,000 for the Z Company.
    Example 3. Assume the same facts as in Example 1, except that the 
allowable deductions with respect to nonrelated terminal activities were 
$39,000 instead of $18,000. The T Company's net income from all sources 
(before reduction for Federal income taxes) and its taxable income, 
before the application of section 281, is therefore $15,000, determined 
as follows:

------------------------------------------------------------------------
                                          Gross     Allowable    Income
                Source                    income   deductions  (or loss)
------------------------------------------------------------------------
Related terminal income...............   $126,000    $102,000    $24,000
Nonrelated terminal income............     30,000      39,000    (9,000)
                                       ---------------------------------
    Total.............................    156,000     141,000     15,000
------------------------------------------------------------------------


The liability of each shareholder is nevertheless discharged in part, 
pursuant to the agreement, by the T Company crediting $8,000 against the 
rental due from each shareholder for a total discharge of liabilities of 
$24,000 (the net income from each source of revenue that produced 
income). Assume further that none of the modifications specified in 
section 172(d) apply. If the limitation under paragraph (c)(4) of this 
section were not applied, the reduced amount for the purposes of this 
section would be $24,000, and the operation of this section would result 
in a net operating loss of $9,000, since the allowable deductions of 
$141,000 would exceed the gross income of $132,000 ($156,000 less 
discharged liabilities of $24,000) by that amount. Because of the 
limitation under paragraph (c)(4) of this section, however, $9,000 is 
not included in the reduced amount to which this section applies. 
Accordingly, the reduced amount is $15,000 (instead of $24,000 as in 
Example 1). Thus, the T Company's taxable income for 1973 would be zero 
($15,000 less the $15,000 reduced amount), and the amount which each 
shareholder shall be considered not to have received or accrued as a 
dividend nor paid or incurred as an expense is $5,000.
    Example 4. Assume the same facts as in Example 1, except that under 
the agreement income from the terminal parking lot would not reduce the 
shareholders' liabilities. Assume further that such income amounted to 
$3,000 of the total related terminal income of $24,000 for the taxable 
year 1973. The liability of each shareholder therefore is discharged by 
crediting $11,000 against its rental due for a total discharge of 
liabilities of $33,000. The reduced amount to which this section applies 
is $21,000 ($24,000 less $3,000) since only to the extent of $21,000 
would there have been no such reduction under the agreement if there 
were no related terminal income.

[[Page 1109]]

    Example 5. Assume the same facts as in Example 1, except that, 
pursuant to the agreement, the A Company, a nonshareholder railroad 
corporation, is to have its liabilities resulting from charges for 
rental obligations reduced equally with each of the shareholders. Assume 
further that the T Company's charges to the A Company for the calendar 
year 1973 included $15,000 for related terminal services and that the 
liability of each shareholder and the A Company is discharged in part 
pursuant to the agreement by the T Company crediting $9,000 against the 
rental due from each. The reduced amount to which this section applies 
is $24,000. Thus, the T Company's taxable income for 1973 is $12,000, 
and each shareholder shall not be considered to have received or accrued 
as a dividend nor paid or incurred as an expense $6,000 ($24,000/ 
$36,000 x $9,000) merely because of the discharge of its own liability. 
Similarly, each shareholder shall not be considered to have received or 
accrued as a dividend nor paid or incurred as an expense $2,000 (1/3 x 
($24,000/$36,000 x $9,000)) merely because of the discharge of the 
liability of the A Company. Section 281 does not apply to the 
determination of the tax consequences of the transaction to the A 
Company. Similarly, the section does not apply to the determination of 
the tax consequences to the shareholders resulting from that portion of 
the discharge of the liability of the A Company which is attributable to 
the application of income which is not related terminal income ($3,000). 
Hence, such consequences shall be determined under the sections of the 
Internal Revenue Code which govern in the absence of section 281.
    Example 6. (i) Facts. The TR Company is a terminal railroad 
corporation with three equal shareholders, the M, N, and O Railroad 
Corporations. The TR Company and each of its shareholders report income 
on the calendar year basis. Pursuant to a written agreement entered into 
in 1947 to which all shareholders were parties, the TR Company makes one 
annual charge to each of the three shareholders at the end of each year 
for the difference between the cost of operations, allocated on a 
wheelage or user basis for the use of its services and facilities 
provided to the shareholder during the year, and one-third of its net 
income from all other sources (computed before reduction for Federal 
income taxes). The TR Company's taxable income, before the application 
of section 281, for 1973 is $21,000 determined as follows:

------------------------------------------------------------------------
                                          Gross     Allowable    Income
                Source                    income   deductions  (or loss)
------------------------------------------------------------------------
Related terminal services performed:
    For shareholders..................    $65,000     $65,000          0
    For nonshareholders...............     46,000      37,000     $9,000
                                       ---------------------------------
Related terminal income...............    111,000     102,000      9,000
Nonrelated terminal income from            30,000      18,000     12,000
 nonshareholders......................
                                       ---------------------------------
    Total.............................    141,000     120,000     21,000
------------------------------------------------------------------------


For the calendar year 1973, the TR company's charges to its shareholders 
are $23,000 ($30,000 less $7,000) to the M company, $13,000 ($20,000 
less $7,000) to the N company, and $8,000 ($15,000 less $7,000) to the O 
company for a total of $44,000 for related terminal services.
    (ii) Effect on terminal railroad corporation. The reduced amount to 
which this section applies is $9,000. The TR company is not considered 
to have received or accrued income of $9,000 (related terminal income) 
merely because the charge of $21,000 (net income from all sources other 
than shareholders) was not made. Similarly, to the extent of $9,000, the 
TR company is not disallowed deductions for expenses merely because the 
full cost of services was not charged. The TR company's taxable income 
for 1973 after application of section 281, is $12,000, computed as 
follows:

Gross income ($141,000 less $9,000 charges not made).........   $132,000
Less allowable deductions....................................    120,000
                                                              ----------
  Taxable income.............................................     12,000
 

    (iii) Effect on shareholders. Neither the M company, the N company, 
nor the O company shall be considered to have received or accrued a 
dividend of $3,000 nor to have paid or incurred an expense of $3,000 
merely by reason of the reduced charges. Thus, assuming the M company's 
taxable income for 1973 before the application of section 281 would have 
been $47,450, computed in the following manner, its taxable income for 
1973 after the application of section 281 is $50,000, determined as 
follows:

------------------------------------------------------------------------
                                                 Before the   After the
                                                application  application
                                                of sec. 281  of sec. 281
------------------------------------------------------------------------
Gross income:
  From sources other than TR Co...............    $146,000     $146,000
  Dividend considered received because of TR         7,000        4,000
   Co.'s reduction of charges.................
                                               -------------------------
    Total.....................................     153,000      150,000
                                               =========================
Less allowable deductions:
  From sources other than TR Co...............      69,600       69,600

[[Page 1110]]

 
85 percent dividend received deduction under         5,950        3,400
 sec. 243 attributable to dividend considered
 received because of TR Co.'s reduction of
 charges......................................
Expenses for accrued charges for related            30,000       27,000
 terminal services performed by TR Co.........
                                               -------------------------
                                                   105,550      100,000
                                               =========================
  Taxable income..............................      47,450       50,000
------------------------------------------------------------------------


[T.D. 7356, 40 FR 23733, June 2, 1975]



Sec. 1.281-3  Definitions.

    (a) Terminal railroad corporation. The term terminal railroad 
corporation means a corporation which, in the taxable year, meets all of 
the following conditions:
    (1) The corporation and each of its shareholders must be domestic 
corporations. Thus, all of the shareholders of the corporation, as well 
as the corporation itself, must be corporations which were organized or 
created in the United States, including only the States and the District 
of Columbia, or under the law of the United States or of any State or 
territory.
    (2) All of the shareholders must be railroad corporations which are 
subject to Part I of the Interstate Commerce Act. Thus, if any 
shareholder of the corporation, regardless of the class or percentage of 
stock owned, is not subject to the jurisdiction of the Interstate 
Commerce Commission under part I of that Act, the corporation cannot 
qualify as a terminal railroad corporation.
    (3) The corporation must not be a member of an affiliated group of 
corporations (as defined in section 1504), other than as a common parent 
corporation. For this purpose it is immaterial whether or not the 
affiliated group has ever made a consolidated income tax return. Thus, 
if the X railroad corporation owns 80 percent of all of the outstanding 
stock of the Y railroad corporation, the X railroad corporation may 
qualify, but the Y railroad corporation cannot qualify, as a terminal 
railroad corporation.
    (4) The primary business of the corporation must be that of 
providing to domestic railroad corporations subject to Part I of the 
Interstate Commerce Act and to the shippers and passengers of such 
railroad corporations one or more of the following facilities or 
services: (i) Railroad terminal facilities, (ii) railroad switching 
facilities, (iii) railroad terminal services, or (iv) railroad switching 
services. The designated facilities and services include the furnishing 
of terminal trackage, the operation of stockyards or a union passenger 
or freight station, and the operation of railroad bridges and ferries. 
The providing of the designated facilities includes the leasing of those 
facilities. A corporation shall be considered as having established that 
its primary business is that of providing the designated facilities and 
services if more than 50 percent of its gross income (computed without 
regard to section 281, and excluding dividends and gains and losses from 
the disposition of capital assets or property described in section 
1231(b)) for the taxable year is derived from those sources. The fact 
that income from a service or facility is included within the definition 
of related terminal income is immaterial for purposes of determining 
whether that service or facility is one which is designated in this 
subparagraph. Thus, although income from the operation of a commuter 
railroad line may be related terminal income, a corporation whose 
primary business is the operation of that facility is not a terminal 
railroad corporation, since its primary business is not the providing of 
the designated facilities or services.
    (5) A substantial part of the services rendered by the corporation 
for the taxable year must be rendered to one or more of its 
shareholders. For purposes of this requirement, providing the use of 
facilities shall be considered the rendering of services.
    (6) Each shareholder of the corporation must compute its taxable 
income on the basis of a taxable year which either begins or ends on the 
same day as the taxable year of the corporation.
    (b) Related terminal income--(1) In general. Related terminal income 
is, generally, the type of income normally earned from the operation of 
a railroad

[[Page 1111]]

terminal. The term related terminal income means the taxable income 
(computed without regard to sections 172, 277, or 281) which the 
terminal railroad corporation derives for the taxable year from the 
sources enumerated in paragraph (b)(2) of this section. Related terminal 
income must be derived from direct provision of the specified facilities 
or services by the terminal corporation itself. Thus, income consisting 
of rent from a lease of a terminal facility by a terminal corporation to 
a railroad user would qualify; but dividends from a corporation in which 
the terminal corporation owned stock and which provided such facilities 
or services to others would not qualify. The term does not include gain 
or loss derived from the sale, exchange, or other disposition of capital 
assets or section 1231 assets, whether or not section 1245 or section 
1250 applies to part or all of that gain. For example, the term does not 
apply to gain from the sale of a terminal building or terminal 
equipment. All direct and indirect expenses and other deductible items 
attributable to related terminal services or facilities shall be 
deducted in determining related terminal income. Attribution shall be 
determined in accordance with customary railroad accounting practices 
accepted by the Interstate Commerce Commission, except that interest 
paid with respect to the indebtedness of a terminal railroad corporation 
shall be deducted from related terminal income to the extent that the 
proceeds from the indebtedness were directly or indirectly applied to 
facilities or activities producing such income. The district director 
may either accept the use of the taxpayer's method of determining the 
application of the proceeds of all indebtedness of such corporation or 
prescribe the use of another method which, under all the facts and 
circumstances, appears to reflect more accurately the probable 
application of such proceeds.
    (2) Sources of related terminal income. The term related terminal 
income includes only income derived from one or more of the following 
sources:
    (i) From services or facilities of a character ordinarily and 
regularly provided by terminal railroad corporations for railroad 
corporations or for the employees, passengers, or shippers of railroad 
corporations. Whether the services or facilities are of a character 
ordinarily and regularly provided by terminal railroad corporations is 
to be determined by accepted industry practice. The fact that 
nonterminal businesses may also provide such services or facilities is 
immaterial. However, there must be a direct relationship between the 
service or facility provided and the operation of the terminal, 
including the operation of its trackage and switching facilities. Thus, 
the term related terminal income includes income derived from operating 
or leasing switching facilities and terminal facilities, such as income 
from charges to railroad corporations for the use of a union passenger 
or freight station. Also included for this purpose is income derived 
from charges to railroad shippers, including express companies and 
freight forwarders, for the use of sheds or warehouses, even though not 
directly intended for railroad use. The term includes income derived 
from leasing or operating restaurants, drugstores, barbershops, 
newsstands, ticket agencies, banking facilities, car rental facilities, 
or other similar facilities for passengers, in waiting rooms or along 
passenger concourses. Similarly, the term includes income derived from 
operating or leasing passenger parking facilities, and from renting 
taxicab space, located on or adjacent to the terminal premises. Although 
the term does include income derived from the operation of a small hotel 
operated primarily for and usually occupied primarily by the employees 
of the railroad corporations, it does not include income derived from 
the operation of a hotel for passengers or other persons.
    (ii) From any railroad corporation for services or facilities 
provided by the terminal railroad corporation in connection with 
railroad operations. A service or a facility is provided in connection 
with railroad operations if it is of a character ordinarily and 
regularly availed of by railroad corporations. For purposes of this 
subdivision, the income must be derived from railroad corporations. 
Thus, in addition to the income derived from sources described in 
paragraph (b)(2)(i) of this section,

[[Page 1112]]

the term related terminal income includes income derived from switching 
facilities or leasing to any railroad corporation, or operating for the 
benefit of such corporation, a beltline or bypass railroad leading to or 
from the terminal premises. Also included are income derived from the 
rental of office space (whether or not services are provided to the 
occupants) in the terminal building to any railroad corporation for that 
corporation's administrative or operating divisions, and income derived 
from tolls charged to any railroad corporation for the use of a railroad 
bridge or ferry.
    (iii) From the use by persons other than railroad corporations of a 
portion of a facility, or of a service, which is used primarily for 
railroad purposes. A facility or service is used primarily for railroad 
purposes if the predominant reason for its continued operation or 
provision is the furnishing of facilities or services described in 
either subdivision (i) or (ii) of this subparagraph. The determination 
required by this subdivision is to be made independently for each 
separate facility or service. Two substantial portions of a single 
structure may be considered separate facilities, depending upon the 
respective uses made of each. Moreover, any substantial addition, 
constructed after October 23, 1962, to a facility shall be considered a 
separate facility.

The term related terminal income includes income produced by operating a 
commuter service or by renting tracks and facilities for a commuter 
service to an independent operator. The term also includes the sale or 
rental of advertising space at a terminal facility. If the conditions 
described in this subdivision are satisfied, the term related terminal 
income may include income which has no connection with the operation of 
the terminal. Thus, if a terminal railroad corporation operates a 
railroad bridge primarily to provide railroad corporations a means of 
crossing a river and the lower level of the bridge contains a roadway 
for similar use by automobiles, the term includes income derived from 
the tolls charged to the automobiles for the use of the bridge roadway. 
However, upon the discontinuance of operations of the railroad level of 
the bridge, the term would cease to include the automobile tolls. If 
excess steam from a steam plant operated primarily to supply steam to 
the terminal is sold to another business in the neighborhood, the term 
would include the income derived from such sale. However, because an oil 
or gas well or a mine constitutes a separate facility, the term related 
terminal income does not include income derived in any form from a 
deposit of oil, natural gas, or any other mineral located on property 
owned or leased by the terminal railroad corporation.

Similarly, while the term includes income derived from the rental of a 
small number of offices located in the terminal building (whether or not 
the lessees are railroad corporations), it does not include income 
derived from the leasing or operation, for the use of the general 
public, of a large number of offices or a large number of rooms for 
lodging, whether or not the space is physically part of the same 
structure as the terminal. Moreover, the term does not include income 
derived from the rental of offices to the general public in an addition 
to the terminal building constructed after October 23, 1962, unless the 
addition is primarily used for railroad purposes and the offices rented 
to the general public do not constitute a separate facility in the 
addition. Whether or not income from the addition is determined to be 
related terminal income, the income from the small number of offices 
which were included in the terminal building before the addition was 
constructed shall continue to be related terminal income.
    (iv) From the United States in payment for facilities or services in 
connection with mail handling. The income must be derived directly from 
the U.S. Government, or any agency thereof (including for this purpose 
the U.S. Postal Service), through the receipt of payments for mail-
handling facilities or services. Thus, the term would include income 
derived from the rental of space for a post office for use by the 
general public on the terminal premises or from the sorting of mail in a 
railroad box car.
    (3) Illustration. The provisions of this paragraph may be 
illustrated by the following example:


[[Page 1113]]


    Example. For its calendar year 1973, the R Company, a terminal 
railroad corporation, has taxable income of $36,000, before the 
application of section 281 and taking no account of section 277, 
determined as follows:

Gross income:
  Switching charges.........................................     $50,000
  Express companies.........................................       2,000
  Commuter line.............................................       4,000
  U.S. mail handling........................................       4,000
  Railroad bridge tolls:....................................
    From railroads..........................................       2,000
    From automobiles........................................       1,000
                                                             -----------
      Total.................................................       3,000
  Station and train charges.................................      47,000
  Terminal parking lot......................................       4,000
  Rent from terminal building:
    Passenger facilities (ground level).....................       8,000
    Offices leased to railroads (2d floor)..................       3,000
    Offices leased to others (2d floor).....................       1,000
    Hotel open to public (3d through 6th floors)............      14,000
      Total.................................................      26,000
  Interest received from bond investments...................       1,500
  Dividends received from wholly owned subsidiary...........      10,000
  Amount realized from sale of equipment....................       6,000
  Less:
    Adjusted basis..........................................       1,000
    Expenses of sale........................................         500
                                                             -----------
                                                                   1,500
                                                             -----------
                                                                   4,500
                                                             -----------
                                                                 156,000
Allowable deductions:
  Dividend received deduction...............................       8,500
  Interest paid:
    On loan for hotel furnishings...........................       1,500
    On loan for rolling stock...............................       2,000
                                                             -----------
                                                                   3,500
  Maintenance, depreciation, management and other expenses:
    Attributable to hotel...................................       3,000
    Attributable to parking lot.............................       1,000
    Attributable to U.S. mail handling......................       1,000
    All other...............................................      98,000
                                                             -----------
                                                                 103,000
  Loss from sale of securities..............................       3,000
  Charitable contribution...................................         500
  Net operating loss deduction..............................       1,500
                                                             -----------
                                                                 120,000
                                                             -----------
  Taxable income before the application of sec. 281.........      36,000
                                                             ===========
  The R Co.'s related terminal income for 1973 is $24,000,
   computed as follows:
  Taxable income (before the application of sec. 281).......      36,000
  Less:
    Dividend received.......................................      10,000
    Minus dividend received deduction.......................       8,500
                                                             -----------
                                                                   1,500
  Interest received.........................................       1,500
  Amount realized from sale of equipment....................       6,000
  Less:
    Adjusted basis..........................................       1,000
    Expense of sale.........................................         500
                                                             -----------
                                                                   1,500
                                                             -----------
                                                                   4,500
  Hotel income..............................................      14,000
  Less:
    Interest paid on loan for hotel.........................       1,500
    Other hotel expenses....................................       3,000
                                                             -----------
                                                                   4,500
                                                             -----------
                                                                   9,500
                                                             -----------
                                                                  17,000
                                                             -----------
                                                                  19,000
  Add:
    Loss from sale of securities............................       3,000
    Charitable contribution.................................         500
    Net operating loss deduction............................       1,500
                                                                   5,000
                                                             -----------
  Related terminal income...................................      24,000
                                                             ===========
 

    (c) Related terminal services. The term related terminal services 
means only the services or the use of facilities, provided by the 
terminal railroad corporation, which are taken into account in computing 
related terminal income. Thus, the term includes the providing of 
terminal and switching services, the furnishing of terminal and 
switching facilities including the furnishing of terminal trackage, and 
the operation of bridges and ferries for railroad purposes. For example, 
upon the facts of the example in the preceding paragraph, the charges 
for related terminal services are $126,000, determined as follows:

Switching charges...........................................     $50,000
Express companies...........................................       2,000
Commuter line...............................................       4,000
U.S. mail handling..........................................       4,000
Railroad bridge tolls.......................................       3,000
Station and train charges...................................      47,000
Terminal parking lot........................................       4,000
Rent from:
  Passenger facilities......................................       8,000
  Offices...................................................       4,000
                                                             -----------
    Total...................................................     126,000
 

    (d) Agreement. As used in section 281 and Sec. 1.281-2 the term 
agreement means a written contract, entered into before the beginning of 
the terminal railroad corporation's taxable year in question, to which 
all shareholders of the terminal railroad corporation are parties. The 
fact that other railroad corporations or persons are also parties will 
not disqualify an agreement. Section 281 applies only if, and to the 
extent that, the reduction of the liability or charge that would be 
made, as described in paragraph (c) of Sec. 1.281-2, results from the 
agreement. Thus, where

[[Page 1114]]

the other conditions of the statute are met, section 281 applies if a 
written agreement, to which all of the shareholders were parties and 
which was entered into prior to the beginning of the terminal railroad 
corporation's taxable year, provides that the net revenues of the 
terminal railroad corporation are to be applied as a reduction of what 
would otherwise be the charge for the taxable year for related terminal 
services provided to the shareholders. Similarly, section 281 applies, 
where its other requirements are fulfilled, if the agreement provides 
that the net revenues are to be credited against rental obligations 
resulting from related terminal services furnished to shareholders. 
However, section 281 does not apply where the agreement provides that 
the net revenues are to be divided among the shareholders and 
distributed to them in cash or held subject to their unconditional right 
of withdrawal instead of being applied to the computation of charges, or 
in reduction of liabilities incurred, for related terminal services.
    (e) Railroad corporation. For purposes of section 281, Sec. 1.281-
2, and this section, the term railroad corporation means any corporation 
(regardless of whether it is a shareholder of the terminal railroad 
corporation) that is engaged as a common carrier in the furnishing or 
sale of transportation by railroad, or is a lessor of railroad equipment 
or facilities. For purposes of the preceding sentence, a corporation is 
a lessor of railroad equipment or facilities only if (1) it is subject 
to part I of the Interstate Commerce Act, (2) substantially all of its 
railroad properties have been leased to a railroad corporation or 
corporations, (3) each lease is for a term of more than 20 years, and 
(4) 80 percent or more of its gross income for the taxable year is 
derived for such leases.

[T.D. 7356, 40 FR 23735, June 2, 1975]



Sec. 1.281-4  Taxable years affected.

    (a) In general. Except as provided in paragraph (b) of this section, 
the provisions of section 281 and Sec. Sec. 1.281-2 and 1.281-3 shall 
apply to all taxable years to which either the Internal Revenue Code of 
1954 or the Internal Revenue Code of 1939 apply.
    (b) Taxable years ending before October 23, 1962. (1)(i) In the case 
of a taxable year of a terminal railroad corporation ending before 
October 23, 1962, section 281 (a) shall apply only to the extent that 
the terminal railroad corporation (a) computed its taxable income on its 
return for such taxable year as if the ``reduced amount'', described in 
paragraph (c) of Sec. 1.281-2, were not received or accrued, and (b) 
did not decrease its otherwise allowable deductions for such taxable 
year on account of that ``reduced amount''. Similarly, in the case of a 
taxable year of a shareholder of a terminal railroad corporation ending 
before October 23, 1962, section 281(b) shall apply only to the extent 
that such shareholder computed its taxable income on its return for such 
taxable year as if the shareholder had neither received or accrued as a 
dividend nor paid or incurred as an expense the ``reduced amount'' 
described in paragraph (c) of Sec. 1.281-2. Such return must have been 
filed on or before the due date (including the period of any extension 
of time) for filing the return for the applicable taxable year. The fact 
that an amended return or claim for refund or credit of overpayment was 
subsequently filed, or a deficiency subsequently assessed, based upon a 
computation of taxable income which is inconsistent with the manner in 
which the taxable income was computed on the timely filed return, is 
immaterial.
    (ii) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. The G Company is a terminal railroad corporation which in 
1960 reduced the liabilities resulting from charges to its shareholders, 
pursuant to a 1947 written agreement, by its income from nonshareholder 
sources. For the calendar year 1960, the G Company's related terminal 
income was $24,000, of which $3,000 is attributable to income from the 
United States in payment for facilities and services in connection with 
mail handling. Although the shareholders' liabilities were reduced by 
$24,000 as a result of taking related terminal income earned during the 
taxable year into account, on its timely filed 1960 income tax return 
the G Company treated the $3,000 of liabilities which were reduced on 
account of income from mail handling as gross income received or accrued 
during the year. Assuming that the provisions of Sec. 1.281-2 otherwise 
apply,

[[Page 1115]]

their application to the determination of the 1960 tax liability of the 
G Company shall not extend to the entire ``reduced amount'' of $24,000, 
but shall be limited to $21,000 of that amount.
    Example 2. Assume the same facts as in Example 1, and the following 
additional facts. The G Company had three shareholders in 1960, and an 
equal discharge of liability of $8,000 resulted for each of them on 
account of related terminal income. Each shareholder treated, on its 
timely filed 1960 income tax return, $1,000 of its liabilities, which 
were so reduced and were attributable to income from the United States 
in payment for facilities and services in connection with mail handling, 
as if it had received $1,000 from the G Company as a dividend and paid 
that $1,000 to the G Company for services. Each shareholder treated the 
remaining $7,000 of its liabilities which were so reduced as if the 
liabilities which were reduced had never been incurred. Assuming that 
the provisions of Sec. 1.281-2 otherwise apply, each shareholder shall 
not be considered to have received or accrued as a dividend, nor to have 
paid or incurred as an expense $7,000 (instead of $8,000).

    (2) For any taxable year of a terminal railroad corporation ending 
before October 23, 1962, a claim for refund or credit of overpayment of 
income tax based upon section 281 may be filed, even though such refund 
or credit of overpayment was otherwise barred by operation of any law or 
rule of law on October 23, 1962, subject to the conditions set forth in 
paragraph (b)(2)(i) through (v) of this section.
    (i) The claim for refund or credit of overpayment must not have been 
barred by a closing agreement (under either section 3760 of the Internal 
Revenue Code of 1939 or section 7121 of the Internal Revenue Code of 
1954), or by a compromise (under section 3761 of the Internal Revenue 
Code of 1939 or section 7122 of the Internal Revenue Code of 1954);
    (ii) The claim for refund or credit of overpayment shall be allowed 
only to the extent that the overpayment of income tax results from the 
recomputation of the terminal railroad corporation's taxable income in 
the manner described in paragraph (a) of Sec. 1.281-2;
    (iii) The claim for refund or credit of the overpayment must have 
been filed prior to October 23, 1963;
    (iv) The claim for refund or credit of overpayment shall be allowed 
only to the extent that the manner in which the terminal railroad 
corporation's taxable income is recomputed is the manner in which the 
terminal railroad corporation's taxable income was computed on its 
timely filed income tax return for such taxable year; and
    (v) Each railroad corporation which was a shareholder of the 
terminal railroad corporation during such taxable year must consent in 
writing to the assessment, within such period as may be agreed upon with 
the district director, of any deficiency for any year (even though 
assessment of the deficiency would otherwise be prevented by the 
operation of any law or rule of law at the time of filing the consent) 
to the extent that:
    (A) The deficiency is attributable to the recomputation of the 
shareholder's taxable income in the manner described in paragraph (b) of 
Sec. 1.281-2, and
    (B) The deficiency results from the shareholder's allocable portion 
of the ``reduced amount'' (described in paragraph (c) of Sec. 1.281-2) 
which gives rise to the refund or credit granted to the terminal 
railroad corporation under this subparagraph.

[T.D. 7356, 40 FR 23737, June 2, 1975]



Sec. Sec. 1.282-1.300  [Reserved]

[[Page 1117]]



                              FINDING AIDS




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

  A list of CFR titles, subtitles, chapters, subchapters and parts and 
an alphabetical list of agencies publishing in the CFR are included in 
the CFR Index and Finding Aids volume to the Code of Federal Regulations 
which is published separately and revised annually.


  Table of CFR Titles and Chapters
  Alphabetical List of Agencies Appearing in the CFR
  Table of OMB Control Numbers
  List of CFR Sections Affected

[[Page 1119]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2023)

                      Title 1--General Provisions

         I  Administrative Committee of the Federal Register 
                (Parts 1--49)
        II  Office of the Federal Register (Parts 50--299)
       III  Administrative Conference of the United States (Parts 
                300--399)
        IV  Miscellaneous Agencies (Parts 400--599)
        VI  National Capital Planning Commission (Parts 600--699)

                    Title 2--Grants and Agreements

            Subtitle A--Office of Management and Budget Guidance 
                for Grants and Agreements
         I  Office of Management and Budget Governmentwide 
                Guidance for Grants and Agreements (Parts 2--199)
        II  Office of Management and Budget Guidance (Parts 200--
                299)
            Subtitle B--Federal Agency Regulations for Grants and 
                Agreements
       III  Department of Health and Human Services (Parts 300--
                399)
        IV  Department of Agriculture (Parts 400--499)
        VI  Department of State (Parts 600--699)
       VII  Agency for International Development (Parts 700--799)
      VIII  Department of Veterans Affairs (Parts 800--899)
        IX  Department of Energy (Parts 900--999)
         X  Department of the Treasury (Parts 1000--1099)
        XI  Department of Defense (Parts 1100--1199)
       XII  Department of Transportation (Parts 1200--1299)
      XIII  Department of Commerce (Parts 1300--1399)
       XIV  Department of the Interior (Parts 1400--1499)
        XV  Environmental Protection Agency (Parts 1500--1599)
     XVIII  National Aeronautics and Space Administration (Parts 
                1800--1899)
        XX  United States Nuclear Regulatory Commission (Parts 
                2000--2099)
      XXII  Corporation for National and Community Service (Parts 
                2200--2299)
     XXIII  Social Security Administration (Parts 2300--2399)
      XXIV  Department of Housing and Urban Development (Parts 
                2400--2499)
       XXV  National Science Foundation (Parts 2500--2599)
      XXVI  National Archives and Records Administration (Parts 
                2600--2699)

[[Page 1120]]

     XXVII  Small Business Administration (Parts 2700--2799)
    XXVIII  Department of Justice (Parts 2800--2899)
      XXIX  Department of Labor (Parts 2900--2999)
       XXX  Department of Homeland Security (Parts 3000--3099)
      XXXI  Institute of Museum and Library Services (Parts 3100--
                3199)
     XXXII  National Endowment for the Arts (Parts 3200--3299)
    XXXIII  National Endowment for the Humanities (Parts 3300--
                3399)
     XXXIV  Department of Education (Parts 3400--3499)
      XXXV  Export-Import Bank of the United States (Parts 3500--
                3599)
     XXXVI  Office of National Drug Control Policy, Executive 
                Office of the President (Parts 3600--3699)
    XXXVII  Peace Corps (Parts 3700--3799)
     LVIII  Election Assistance Commission (Parts 5800--5899)
       LIX  Gulf Coast Ecosystem Restoration Council (Parts 5900--
                5999)
        LX  Federal Communications Commission (Parts 6000--6099)

                        Title 3--The President

         I  Executive Office of the President (Parts 100--199)

                           Title 4--Accounts

         I  Government Accountability Office (Parts 1--199)

                   Title 5--Administrative Personnel

         I  Office of Personnel Management (Parts 1--1199)
        II  Merit Systems Protection Board (Parts 1200--1299)
       III  Office of Management and Budget (Parts 1300--1399)
        IV  Office of Personnel Management and Office of the 
                Director of National Intelligence (Parts 1400--
                1499)
         V  The International Organizations Employees Loyalty 
                Board (Parts 1500--1599)
        VI  Federal Retirement Thrift Investment Board (Parts 
                1600--1699)
      VIII  Office of Special Counsel (Parts 1800--1899)
        IX  Appalachian Regional Commission (Parts 1900--1999)
        XI  Armed Forces Retirement Home (Parts 2100--2199)
       XIV  Federal Labor Relations Authority, General Counsel of 
                the Federal Labor Relations Authority and Federal 
                Service Impasses Panel (Parts 2400--2499)
       XVI  Office of Government Ethics (Parts 2600--2699)
       XXI  Department of the Treasury (Parts 3100--3199)
      XXII  Federal Deposit Insurance Corporation (Parts 3200--
                3299)
     XXIII  Department of Energy (Parts 3300--3399)
      XXIV  Federal Energy Regulatory Commission (Parts 3400--
                3499)
       XXV  Department of the Interior (Parts 3500--3599)

[[Page 1121]]

      XXVI  Department of Defense (Parts 3600--3699)
    XXVIII  Department of Justice (Parts 3800--3899)
      XXIX  Federal Communications Commission (Parts 3900--3999)
       XXX  Farm Credit System Insurance Corporation (Parts 4000--
                4099)
      XXXI  Farm Credit Administration (Parts 4100--4199)
    XXXIII  U.S. International Development Finance Corporation 
                (Parts 4300--4399)
     XXXIV  Securities and Exchange Commission (Parts 4400--4499)
      XXXV  Office of Personnel Management (Parts 4500--4599)
     XXXVI  Department of Homeland Security (Parts 4600--4699)
    XXXVII  Federal Election Commission (Parts 4700--4799)
        XL  Interstate Commerce Commission (Parts 5000--5099)
       XLI  Commodity Futures Trading Commission (Parts 5100--
                5199)
      XLII  Department of Labor (Parts 5200--5299)
     XLIII  National Science Foundation (Parts 5300--5399)
       XLV  Department of Health and Human Services (Parts 5500--
                5599)
      XLVI  Postal Rate Commission (Parts 5600--5699)
     XLVII  Federal Trade Commission (Parts 5700--5799)
    XLVIII  Nuclear Regulatory Commission (Parts 5800--5899)
      XLIX  Federal Labor Relations Authority (Parts 5900--5999)
         L  Department of Transportation (Parts 6000--6099)
       LII  Export-Import Bank of the United States (Parts 6200--
                6299)
      LIII  Department of Education (Parts 6300--6399)
       LIV  Environmental Protection Agency (Parts 6400--6499)
        LV  National Endowment for the Arts (Parts 6500--6599)
       LVI  National Endowment for the Humanities (Parts 6600--
                6699)
      LVII  General Services Administration (Parts 6700--6799)
     LVIII  Board of Governors of the Federal Reserve System 
                (Parts 6800--6899)
       LIX  National Aeronautics and Space Administration (Parts 
                6900--6999)
        LX  United States Postal Service (Parts 7000--7099)
       LXI  National Labor Relations Board (Parts 7100--7199)
      LXII  Equal Employment Opportunity Commission (Parts 7200--
                7299)
     LXIII  Inter-American Foundation (Parts 7300--7399)
      LXIV  Merit Systems Protection Board (Parts 7400--7499)
       LXV  Department of Housing and Urban Development (Parts 
                7500--7599)
      LXVI  National Archives and Records Administration (Parts 
                7600--7699)
     LXVII  Institute of Museum and Library Services (Parts 7700--
                7799)
    LXVIII  Commission on Civil Rights (Parts 7800--7899)
      LXIX  Tennessee Valley Authority (Parts 7900--7999)
       LXX  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 8000--8099)
      LXXI  Consumer Product Safety Commission (Parts 8100--8199)

[[Page 1122]]

    LXXIII  Department of Agriculture (Parts 8300--8399)
     LXXIV  Federal Mine Safety and Health Review Commission 
                (Parts 8400--8499)
     LXXVI  Federal Retirement Thrift Investment Board (Parts 
                8600--8699)
    LXXVII  Office of Management and Budget (Parts 8700--8799)
      LXXX  Federal Housing Finance Agency (Parts 9000--9099)
   LXXXIII  Special Inspector General for Afghanistan 
                Reconstruction (Parts 9300--9399)
    LXXXIV  Bureau of Consumer Financial Protection (Parts 9400--
                9499)
    LXXXVI  National Credit Union Administration (Parts 9600--
                9699)
     XCVII  Department of Homeland Security Human Resources 
                Management System (Department of Homeland 
                Security--Office of Personnel Management) (Parts 
                9700--9799)
    XCVIII  Council of the Inspectors General on Integrity and 
                Efficiency (Parts 9800--9899)
      XCIX  Military Compensation and Retirement Modernization 
                Commission (Parts 9900--9999)
         C  National Council on Disability (Parts 10000--10049)
        CI  National Mediation Board (Parts 10100--10199)
       CII  U.S. Office of Special Counsel (Parts 10200--10299)
       CIV  Office of the Intellectual Property Enforcement 
                Coordinator (Part 10400--10499)

                      Title 6--Domestic Security

         I  Department of Homeland Security, Office of the 
                Secretary (Parts 1--199)
         X  Privacy and Civil Liberties Oversight Board (Parts 
                1000--1099)

                         Title 7--Agriculture

            Subtitle A--Office of the Secretary of Agriculture 
                (Parts 0--26)
            Subtitle B--Regulations of the Department of 
                Agriculture
         I  Agricultural Marketing Service (Standards, 
                Inspections, Marketing Practices), Department of 
                Agriculture (Parts 27--209)
        II  Food and Nutrition Service, Department of Agriculture 
                (Parts 210--299)
       III  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 300--399)
        IV  Federal Crop Insurance Corporation, Department of 
                Agriculture (Parts 400--499)
         V  Agricultural Research Service, Department of 
                Agriculture (Parts 500--599)
        VI  Natural Resources Conservation Service, Department of 
                Agriculture (Parts 600--699)
       VII  Farm Service Agency, Department of Agriculture (Parts 
                700--799)

[[Page 1123]]

      VIII  Agricultural Marketing Service (Federal Grain 
                Inspection Service, Fair Trade Practices Program), 
                Department of Agriculture (Parts 800--899)
        IX  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Fruits, Vegetables, Nuts), Department 
                of Agriculture (Parts 900--999)
         X  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Milk), Department of Agriculture 
                (Parts 1000--1199)
        XI  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Miscellaneous Commodities), Department 
                of Agriculture (Parts 1200--1299)
       XIV  Commodity Credit Corporation, Department of 
                Agriculture (Parts 1400--1499)
        XV  Foreign Agricultural Service, Department of 
                Agriculture (Parts 1500--1599)
       XVI  [Reserved]
      XVII  Rural Utilities Service, Department of Agriculture 
                (Parts 1700--1799)
     XVIII  Rural Housing Service, Rural Business-Cooperative 
                Service, Rural Utilities Service, and Farm Service 
                Agency, Department of Agriculture (Parts 1800--
                2099)
        XX  [Reserved]
       XXV  Office of Advocacy and Outreach, Department of 
                Agriculture (Parts 2500--2599)
      XXVI  Office of Inspector General, Department of Agriculture 
                (Parts 2600--2699)
     XXVII  Office of Information Resources Management, Department 
                of Agriculture (Parts 2700--2799)
    XXVIII  Office of Operations, Department of Agriculture (Parts 
                2800--2899)
      XXIX  Office of Energy Policy and New Uses, Department of 
                Agriculture (Parts 2900--2999)
       XXX  Office of the Chief Financial Officer, Department of 
                Agriculture (Parts 3000--3099)
      XXXI  Office of Environmental Quality, Department of 
                Agriculture (Parts 3100--3199)
     XXXII  Office of Procurement and Property Management, 
                Department of Agriculture (Parts 3200--3299)
    XXXIII  Office of Transportation, Department of Agriculture 
                (Parts 3300--3399)
     XXXIV  National Institute of Food and Agriculture (Parts 
                3400--3499)
      XXXV  Rural Housing Service, Department of Agriculture 
                (Parts 3500--3599)
     XXXVI  National Agricultural Statistics Service, Department 
                of Agriculture (Parts 3600--3699)
    XXXVII  Economic Research Service, Department of Agriculture 
                (Parts 3700--3799)
   XXXVIII  World Agricultural Outlook Board, Department of 
                Agriculture (Parts 3800--3899)
       XLI  [Reserved]

[[Page 1124]]

      XLII  Rural Business-Cooperative Service and Rural Utilities 
                Service, Department of Agriculture (Parts 4200--
                4299)
         L  Rural Business-Cooperative Service, and Rural 
                Utilities Service, Department of Agriculture 
                (Parts 5000--5099)

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (Parts 1--499)
         V  Executive Office for Immigration Review, Department of 
                Justice (Parts 1000--1399)

                 Title 9--Animals and Animal Products

         I  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 1--199)
        II  Agricultural Marketing Service (Fair Trade Practices 
                Program), Department of Agriculture (Parts 200--
                299)
       III  Food Safety and Inspection Service, Department of 
                Agriculture (Parts 300--599)

                           Title 10--Energy

         I  Nuclear Regulatory Commission (Parts 0--199)
        II  Department of Energy (Parts 200--699)
       III  Department of Energy (Parts 700--999)
         X  Department of Energy (General Provisions) (Parts 
                1000--1099)
      XIII  Nuclear Waste Technical Review Board (Parts 1300--
                1399)
      XVII  Defense Nuclear Facilities Safety Board (Parts 1700--
                1799)
     XVIII  Northeast Interstate Low-Level Radioactive Waste 
                Commission (Parts 1800--1899)

                      Title 11--Federal Elections

         I  Federal Election Commission (Parts 1--9099)
        II  Election Assistance Commission (Parts 9400--9499)

                      Title 12--Banks and Banking

         I  Comptroller of the Currency, Department of the 
                Treasury (Parts 1--199)
        II  Federal Reserve System (Parts 200--299)
       III  Federal Deposit Insurance Corporation (Parts 300--399)
        IV  Export-Import Bank of the United States (Parts 400--
                499)
         V  [Reserved]
        VI  Farm Credit Administration (Parts 600--699)
       VII  National Credit Union Administration (Parts 700--799)
      VIII  Federal Financing Bank (Parts 800--899)
        IX  (Parts 900--999)[Reserved]

[[Page 1125]]

         X  Consumer Financial Protection Bureau (Parts 1000--
                1099)
        XI  Federal Financial Institutions Examination Council 
                (Parts 1100--1199)
       XII  Federal Housing Finance Agency (Parts 1200--1299)
      XIII  Financial Stability Oversight Council (Parts 1300--
                1399)
       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        XV  Department of the Treasury (Parts 1500--1599)
       XVI  Office of Financial Research, Department of the 
                Treasury (Parts 1600--1699)
      XVII  Office of Federal Housing Enterprise Oversight, 
                Department of Housing and Urban Development (Parts 
                1700--1799)
     XVIII  Community Development Financial Institutions Fund, 
                Department of the Treasury (Parts 1800--1899)

               Title 13--Business Credit and Assistance

         I  Small Business Administration (Parts 1--199)
       III  Economic Development Administration, Department of 
                Commerce (Parts 300--399)
        IV  Emergency Steel Guarantee Loan Board (Parts 400--499)
         V  Emergency Oil and Gas Guaranteed Loan Board (Parts 
                500--599)

                    Title 14--Aeronautics and Space

         I  Federal Aviation Administration, Department of 
                Transportation (Parts 1--199)
        II  Office of the Secretary, Department of Transportation 
                (Aviation Proceedings) (Parts 200--399)
       III  Commercial Space Transportation, Federal Aviation 
                Administration, Department of Transportation 
                (Parts 400--1199)
         V  National Aeronautics and Space Administration (Parts 
                1200--1299)
        VI  Air Transportation System Stabilization (Parts 1300--
                1399)

                 Title 15--Commerce and Foreign Trade

            Subtitle A--Office of the Secretary of Commerce (Parts 
                0--29)
            Subtitle B--Regulations Relating to Commerce and 
                Foreign Trade
         I  Bureau of the Census, Department of Commerce (Parts 
                30--199)
        II  National Institute of Standards and Technology, 
                Department of Commerce (Parts 200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  Foreign-Trade Zones Board, Department of Commerce 
                (Parts 400--499)
       VII  Bureau of Industry and Security, Department of 
                Commerce (Parts 700--799)

[[Page 1126]]

      VIII  Bureau of Economic Analysis, Department of Commerce 
                (Parts 800--899)
        IX  National Oceanic and Atmospheric Administration, 
                Department of Commerce (Parts 900--999)
        XI  National Technical Information Service, Department of 
                Commerce (Parts 1100--1199)
      XIII  East-West Foreign Trade Board (Parts 1300--1399)
       XIV  Minority Business Development Agency (Parts 1400--
                1499)
        XV  Office of the Under-Secretary for Economic Affairs, 
                Department of Commerce (Parts 1500--1599)
            Subtitle C--Regulations Relating to Foreign Trade 
                Agreements
        XX  Office of the United States Trade Representative 
                (Parts 2000--2099)
            Subtitle D--Regulations Relating to Telecommunications 
                and Information
     XXIII  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                2300--2399) [Reserved]

                    Title 16--Commercial Practices

         I  Federal Trade Commission (Parts 0--999)
        II  Consumer Product Safety Commission (Parts 1000--1799)

             Title 17--Commodity and Securities Exchanges

         I  Commodity Futures Trading Commission (Parts 1--199)
        II  Securities and Exchange Commission (Parts 200--399)
        IV  Department of the Treasury (Parts 400--499)

          Title 18--Conservation of Power and Water Resources

         I  Federal Energy Regulatory Commission, Department of 
                Energy (Parts 1--399)
       III  Delaware River Basin Commission (Parts 400--499)
        VI  Water Resources Council (Parts 700--799)
      VIII  Susquehanna River Basin Commission (Parts 800--899)
      XIII  Tennessee Valley Authority (Parts 1300--1399)

                       Title 19--Customs Duties

         I  U.S. Customs and Border Protection, Department of 
                Homeland Security; Department of the Treasury 
                (Parts 0--199)
        II  United States International Trade Commission (Parts 
                200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  U.S. Immigration and Customs Enforcement, Department 
                of Homeland Security (Parts 400--599) [Reserved]

[[Page 1127]]

                     Title 20--Employees' Benefits

         I  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 1--199)
        II  Railroad Retirement Board (Parts 200--399)
       III  Social Security Administration (Parts 400--499)
        IV  Employees' Compensation Appeals Board, Department of 
                Labor (Parts 500--599)
         V  Employment and Training Administration, Department of 
                Labor (Parts 600--699)
        VI  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 700--799)
       VII  Benefits Review Board, Department of Labor (Parts 
                800--899)
      VIII  Joint Board for the Enrollment of Actuaries (Parts 
                900--999)
        IX  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 1000--1099)

                       Title 21--Food and Drugs

         I  Food and Drug Administration, Department of Health and 
                Human Services (Parts 1--1299)
        II  Drug Enforcement Administration, Department of Justice 
                (Parts 1300--1399)
       III  Office of National Drug Control Policy (Parts 1400--
                1499)

                      Title 22--Foreign Relations

         I  Department of State (Parts 1--199)
        II  Agency for International Development (Parts 200--299)
       III  Peace Corps (Parts 300--399)
        IV  International Joint Commission, United States and 
                Canada (Parts 400--499)
         V  United States Agency for Global Media (Parts 500--599)
       VII  U.S. International Development Finance Corporation 
                (Parts 700--799)
        IX  Foreign Service Grievance Board (Parts 900--999)
         X  Inter-American Foundation (Parts 1000--1099)
        XI  International Boundary and Water Commission, United 
                States and Mexico, United States Section (Parts 
                1100--1199)
       XII  United States International Development Cooperation 
                Agency (Parts 1200--1299)
      XIII  Millennium Challenge Corporation (Parts 1300--1399)
       XIV  Foreign Service Labor Relations Board; Federal Labor 
                Relations Authority; General Counsel of the 
                Federal Labor Relations Authority; and the Foreign 
                Service Impasse Disputes Panel (Parts 1400--1499)
        XV  African Development Foundation (Parts 1500--1599)
       XVI  Japan-United States Friendship Commission (Parts 
                1600--1699)
      XVII  United States Institute of Peace (Parts 1700--1799)

[[Page 1128]]

                          Title 23--Highways

         I  Federal Highway Administration, Department of 
                Transportation (Parts 1--999)
        II  National Highway Traffic Safety Administration and 
                Federal Highway Administration, Department of 
                Transportation (Parts 1200--1299)
       III  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 1300--1399)

                Title 24--Housing and Urban Development

            Subtitle A--Office of the Secretary, Department of 
                Housing and Urban Development (Parts 0--99)
            Subtitle B--Regulations Relating to Housing and Urban 
                Development
         I  Office of Assistant Secretary for Equal Opportunity, 
                Department of Housing and Urban Development (Parts 
                100--199)
        II  Office of Assistant Secretary for Housing-Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 200--299)
       III  Government National Mortgage Association, Department 
                of Housing and Urban Development (Parts 300--399)
        IV  Office of Housing and Office of Multifamily Housing 
                Assistance Restructuring, Department of Housing 
                and Urban Development (Parts 400--499)
         V  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 500--599)
        VI  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 600--699) [Reserved]
       VII  Office of the Secretary, Department of Housing and 
                Urban Development (Housing Assistance Programs and 
                Public and Indian Housing Programs) (Parts 700--
                799)
      VIII  Office of the Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Section 8 Housing Assistance 
                Programs, Section 202 Direct Loan Program, Section 
                202 Supportive Housing for the Elderly Program and 
                Section 811 Supportive Housing for Persons With 
                Disabilities Program) (Parts 800--899)
        IX  Office of Assistant Secretary for Public and Indian 
                Housing, Department of Housing and Urban 
                Development (Parts 900--1699)
         X  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Interstate Land Sales 
                Registration Program) (Parts 1700--1799) 
                [Reserved]
       XII  Office of Inspector General, Department of Housing and 
                Urban Development (Parts 2000--2099)
        XV  Emergency Mortgage Insurance and Loan Programs, 
                Department of Housing and Urban Development (Parts 
                2700--2799) [Reserved]

[[Page 1129]]

        XX  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 3200--3899)
      XXIV  Board of Directors of the HOPE for Homeowners Program 
                (Parts 4000--4099) [Reserved]
       XXV  Neighborhood Reinvestment Corporation (Parts 4100--
                4199)

                           Title 25--Indians

         I  Bureau of Indian Affairs, Department of the Interior 
                (Parts 1--299)
        II  Indian Arts and Crafts Board, Department of the 
                Interior (Parts 300--399)
       III  National Indian Gaming Commission, Department of the 
                Interior (Parts 500--599)
        IV  Office of Navajo and Hopi Indian Relocation (Parts 
                700--899)
         V  Bureau of Indian Affairs, Department of the Interior, 
                and Indian Health Service, Department of Health 
                and Human Services (Part 900--999)
        VI  Office of the Assistant Secretary, Indian Affairs, 
                Department of the Interior (Parts 1000--1199)
       VII  Office of the Special Trustee for American Indians, 
                Department of the Interior (Parts 1200--1299)

                      Title 26--Internal Revenue

         I  Internal Revenue Service, Department of the Treasury 
                (Parts 1--End)

           Title 27--Alcohol, Tobacco Products and Firearms

         I  Alcohol and Tobacco Tax and Trade Bureau, Department 
                of the Treasury (Parts 1--399)
        II  Bureau of Alcohol, Tobacco, Firearms, and Explosives, 
                Department of Justice (Parts 400--799)

                   Title 28--Judicial Administration

         I  Department of Justice (Parts 0--299)
       III  Federal Prison Industries, Inc., Department of Justice 
                (Parts 300--399)
         V  Bureau of Prisons, Department of Justice (Parts 500--
                599)
        VI  Offices of Independent Counsel, Department of Justice 
                (Parts 600--699)
       VII  Office of Independent Counsel (Parts 700--799)
      VIII  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 800--899)
        IX  National Crime Prevention and Privacy Compact Council 
                (Parts 900--999)

[[Page 1130]]

        XI  Department of Justice and Department of State (Parts 
                1100--1199)

                            Title 29--Labor

            Subtitle A--Office of the Secretary of Labor (Parts 
                0--99)
            Subtitle B--Regulations Relating to Labor
         I  National Labor Relations Board (Parts 100--199)
        II  Office of Labor-Management Standards, Department of 
                Labor (Parts 200--299)
       III  National Railroad Adjustment Board (Parts 300--399)
        IV  Office of Labor-Management Standards, Department of 
                Labor (Parts 400--499)
         V  Wage and Hour Division, Department of Labor (Parts 
                500--899)
        IX  Construction Industry Collective Bargaining Commission 
                (Parts 900--999)
         X  National Mediation Board (Parts 1200--1299)
       XII  Federal Mediation and Conciliation Service (Parts 
                1400--1499)
       XIV  Equal Employment Opportunity Commission (Parts 1600--
                1699)
      XVII  Occupational Safety and Health Administration, 
                Department of Labor (Parts 1900--1999)
        XX  Occupational Safety and Health Review Commission 
                (Parts 2200--2499)
       XXV  Employee Benefits Security Administration, Department 
                of Labor (Parts 2500--2599)
     XXVII  Federal Mine Safety and Health Review Commission 
                (Parts 2700--2799)
        XL  Pension Benefit Guaranty Corporation (Parts 4000--
                4999)

                      Title 30--Mineral Resources

         I  Mine Safety and Health Administration, Department of 
                Labor (Parts 1--199)
        II  Bureau of Safety and Environmental Enforcement, 
                Department of the Interior (Parts 200--299)
        IV  Geological Survey, Department of the Interior (Parts 
                400--499)
         V  Bureau of Ocean Energy Management, Department of the 
                Interior (Parts 500--599)
       VII  Office of Surface Mining Reclamation and Enforcement, 
                Department of the Interior (Parts 700--999)
       XII  Office of Natural Resources Revenue, Department of the 
                Interior (Parts 1200--1299)

                 Title 31--Money and Finance: Treasury

            Subtitle A--Office of the Secretary of the Treasury 
                (Parts 0--50)
            Subtitle B--Regulations Relating to Money and Finance

[[Page 1131]]

         I  Monetary Offices, Department of the Treasury (Parts 
                51--199)
        II  Fiscal Service, Department of the Treasury (Parts 
                200--399)
        IV  Secret Service, Department of the Treasury (Parts 
                400--499)
         V  Office of Foreign Assets Control, Department of the 
                Treasury (Parts 500--599)
        VI  Bureau of Engraving and Printing, Department of the 
                Treasury (Parts 600--699)
       VII  Federal Law Enforcement Training Center, Department of 
                the Treasury (Parts 700--799)
      VIII  Office of Investment Security, Department of the 
                Treasury (Parts 800--899)
        IX  Federal Claims Collection Standards (Department of the 
                Treasury--Department of Justice) (Parts 900--999)
         X  Financial Crimes Enforcement Network, Department of 
                the Treasury (Parts 1000--1099)

                      Title 32--National Defense

            Subtitle A--Department of Defense
         I  Office of the Secretary of Defense (Parts 1--399)
         V  Department of the Army (Parts 400--699)
        VI  Department of the Navy (Parts 700--799)
       VII  Department of the Air Force (Parts 800--1099)
            Subtitle B--Other Regulations Relating to National 
                Defense
       XII  Department of Defense, Defense Logistics Agency (Parts 
                1200--1299)
       XVI  Selective Service System (Parts 1600--1699)
      XVII  Office of the Director of National Intelligence (Parts 
                1700--1799)
     XVIII  National Counterintelligence Center (Parts 1800--1899)
       XIX  Central Intelligence Agency (Parts 1900--1999)
        XX  Information Security Oversight Office, National 
                Archives and Records Administration (Parts 2000--
                2099)
       XXI  National Security Council (Parts 2100--2199)
      XXIV  Office of Science and Technology Policy (Parts 2400--
                2499)
     XXVII  Office for Micronesian Status Negotiations (Parts 
                2700--2799)
    XXVIII  Office of the Vice President of the United States 
                (Parts 2800--2899)

               Title 33--Navigation and Navigable Waters

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Corps of Engineers, Department of the Army, Department 
                of Defense (Parts 200--399)
        IV  Great Lakes St. Lawrence Seaway Development 
                Corporation, Department of Transportation (Parts 
                400--499)

[[Page 1132]]

                          Title 34--Education

            Subtitle A--Office of the Secretary, Department of 
                Education (Parts 1--99)
            Subtitle B--Regulations of the Offices of the 
                Department of Education
         I  Office for Civil Rights, Department of Education 
                (Parts 100--199)
        II  Office of Elementary and Secondary Education, 
                Department of Education (Parts 200--299)
       III  Office of Special Education and Rehabilitative 
                Services, Department of Education (Parts 300--399)
        IV  Office of Career, Technical, and Adult Education, 
                Department of Education (Parts 400--499)
         V  Office of Bilingual Education and Minority Languages 
                Affairs, Department of Education (Parts 500--599) 
                [Reserved]
        VI  Office of Postsecondary Education, Department of 
                Education (Parts 600--699)
       VII  Office of Educational Research and Improvement, 
                Department of Education (Parts 700--799) 
                [Reserved]
            Subtitle C--Regulations Relating to Education
        XI  [Reserved]
       XII  National Council on Disability (Parts 1200--1299)

                          Title 35 [Reserved]

             Title 36--Parks, Forests, and Public Property

         I  National Park Service, Department of the Interior 
                (Parts 1--199)
        II  Forest Service, Department of Agriculture (Parts 200--
                299)
       III  Corps of Engineers, Department of the Army (Parts 
                300--399)
        IV  American Battle Monuments Commission (Parts 400--499)
         V  Smithsonian Institution (Parts 500--599)
        VI  [Reserved]
       VII  Library of Congress (Parts 700--799)
      VIII  Advisory Council on Historic Preservation (Parts 800--
                899)
        IX  Pennsylvania Avenue Development Corporation (Parts 
                900--999)
         X  Presidio Trust (Parts 1000--1099)
        XI  Architectural and Transportation Barriers Compliance 
                Board (Parts 1100--1199)
       XII  National Archives and Records Administration (Parts 
                1200--1299)
        XV  Oklahoma City National Memorial Trust (Parts 1500--
                1599)
       XVI  Morris K. Udall Scholarship and Excellence in National 
                Environmental Policy Foundation (Parts 1600--1699)

             Title 37--Patents, Trademarks, and Copyrights

         I  United States Patent and Trademark Office, Department 
                of Commerce (Parts 1--199)
        II  U.S. Copyright Office, Library of Congress (Parts 
                200--299)

[[Page 1133]]

       III  Copyright Royalty Board, Library of Congress (Parts 
                300--399)
        IV  National Institute of Standards and Technology, 
                Department of Commerce (Parts 400--599)

           Title 38--Pensions, Bonuses, and Veterans' Relief

         I  Department of Veterans Affairs (Parts 0--199)
        II  Armed Forces Retirement Home (Parts 200--299)

                       Title 39--Postal Service

         I  United States Postal Service (Parts 1--999)
       III  Postal Regulatory Commission (Parts 3000--3099)

                  Title 40--Protection of Environment

         I  Environmental Protection Agency (Parts 1--1099)
        IV  Environmental Protection Agency and Department of 
                Justice (Parts 1400--1499)
         V  Council on Environmental Quality (Parts 1500--1599)
        VI  Chemical Safety and Hazard Investigation Board (Parts 
                1600--1699)
       VII  Environmental Protection Agency and Department of 
                Defense; Uniform National Discharge Standards for 
                Vessels of the Armed Forces (Parts 1700--1799)
      VIII  Gulf Coast Ecosystem Restoration Council (Parts 1800--
                1899)
        IX  Federal Permitting Improvement Steering Council (Part 
                1900)

          Title 41--Public Contracts and Property Management

            Subtitle A--Federal Procurement Regulations System 
                [Note]
            Subtitle B--Other Provisions Relating to Public 
                Contracts
        50  Public Contracts, Department of Labor (Parts 50-1--50-
                999)
        51  Committee for Purchase From People Who Are Blind or 
                Severely Disabled (Parts 51-1--51-99)
        60  Office of Federal Contract Compliance Programs, Equal 
                Employment Opportunity, Department of Labor (Parts 
                60-1--60-999)
        61  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 61-1--61-999)
   62--100  [Reserved]
            Subtitle C--Federal Property Management Regulations 
                System
       101  Federal Property Management Regulations (Parts 101-1--
                101-99)
       102  Federal Management Regulation (Parts 102-1--102-299)
  103--104  [Reserved]
       105  General Services Administration (Parts 105-1--105-999)

[[Page 1134]]

       109  Department of Energy Property Management Regulations 
                (Parts 109-1--109-99)
       114  Department of the Interior (Parts 114-1--114-99)
       115  Environmental Protection Agency (Parts 115-1--115-99)
       128  Department of Justice (Parts 128-1--128-99)
  129--200  [Reserved]
            Subtitle D--Federal Acquisition Supply Chain Security
       201  Federal Acquisition Security Council (Parts 201-1--
                201-99).
            Subtitle E [Reserved]
            Subtitle F--Federal Travel Regulation System
       300  General (Parts 300-1--300-99)
       301  Temporary Duty (TDY) Travel Allowances (Parts 301-1--
                301-99)
       302  Relocation Allowances (Parts 302-1--302-99)
       303  Payment of Expenses Connected with the Death of 
                Certain Employees (Part 303-1--303-99)
       304  Payment of Travel Expenses from a Non-Federal Source 
                (Parts 304-1--304-99)

                        Title 42--Public Health

         I  Public Health Service, Department of Health and Human 
                Services (Parts 1--199)
   II--III  [Reserved]
        IV  Centers for Medicare & Medicaid Services, Department 
                of Health and Human Services (Parts 400--699)
         V  Office of Inspector General-Health Care, Department of 
                Health and Human Services (Parts 1000--1099)

                   Title 43--Public Lands: Interior

            Subtitle A--Office of the Secretary of the Interior 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Lands
         I  Bureau of Reclamation, Department of the Interior 
                (Parts 400--999)
        II  Bureau of Land Management, Department of the Interior 
                (Parts 1000--9999)
       III  Utah Reclamation Mitigation and Conservation 
                Commission (Parts 10000--10099)

             Title 44--Emergency Management and Assistance

         I  Federal Emergency Management Agency, Department of 
                Homeland Security (Parts 0--399)
        IV  Department of Commerce and Department of 
                Transportation (Parts 400--499)

[[Page 1135]]

                       Title 45--Public Welfare

            Subtitle A--Department of Health and Human Services 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Welfare
        II  Office of Family Assistance (Assistance Programs), 
                Administration for Children and Families, 
                Department of Health and Human Services (Parts 
                200--299)
       III  Office of Child Support Enforcement (Child Support 
                Enforcement Program), Administration for Children 
                and Families, Department of Health and Human 
                Services (Parts 300--399)
        IV  Office of Refugee Resettlement, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 400--499)
         V  Foreign Claims Settlement Commission of the United 
                States, Department of Justice (Parts 500--599)
        VI  National Science Foundation (Parts 600--699)
       VII  Commission on Civil Rights (Parts 700--799)
      VIII  Office of Personnel Management (Parts 800--899)
        IX  Denali Commission (Parts 900--999)
         X  Office of Community Services, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 1000--1099)
        XI  National Foundation on the Arts and the Humanities 
                (Parts 1100--1199)
       XII  Corporation for National and Community Service (Parts 
                1200--1299)
      XIII  Administration for Children and Families, Department 
                of Health and Human Services (Parts 1300--1399)
       XVI  Legal Services Corporation (Parts 1600--1699)
      XVII  National Commission on Libraries and Information 
                Science (Parts 1700--1799)
     XVIII  Harry S. Truman Scholarship Foundation (Parts 1800--
                1899)
       XXI  Commission of Fine Arts (Parts 2100--2199)
     XXIII  Arctic Research Commission (Parts 2300--2399)
      XXIV  James Madison Memorial Fellowship Foundation (Parts 
                2400--2499)
       XXV  Corporation for National and Community Service (Parts 
                2500--2599)

                          Title 46--Shipping

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Maritime Administration, Department of Transportation 
                (Parts 200--399)
       III  Coast Guard (Great Lakes Pilotage), Department of 
                Homeland Security (Parts 400--499)
        IV  Federal Maritime Commission (Parts 500--599)

[[Page 1136]]

                      Title 47--Telecommunication

         I  Federal Communications Commission (Parts 0--199)
        II  Office of Science and Technology Policy and National 
                Security Council (Parts 200--299)
       III  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                300--399)
        IV  National Telecommunications and Information 
                Administration, Department of Commerce, and 
                National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 400--499)
         V  The First Responder Network Authority (Parts 500--599)

           Title 48--Federal Acquisition Regulations System

         1  Federal Acquisition Regulation (Parts 1--99)
         2  Defense Acquisition Regulations System, Department of 
                Defense (Parts 200--299)
         3  Department of Health and Human Services (Parts 300--
                399)
         4  Department of Agriculture (Parts 400--499)
         5  General Services Administration (Parts 500--599)
         6  Department of State (Parts 600--699)
         7  Agency for International Development (Parts 700--799)
         8  Department of Veterans Affairs (Parts 800--899)
         9  Department of Energy (Parts 900--999)
        10  Department of the Treasury (Parts 1000--1099)
        12  Department of Transportation (Parts 1200--1299)
        13  Department of Commerce (Parts 1300--1399)
        14  Department of the Interior (Parts 1400--1499)
        15  Environmental Protection Agency (Parts 1500--1599)
        16  Office of Personnel Management, Federal Employees 
                Health Benefits Acquisition Regulation (Parts 
                1600--1699)
        17  Office of Personnel Management (Parts 1700--1799)
        18  National Aeronautics and Space Administration (Parts 
                1800--1899)
        19  Broadcasting Board of Governors (Parts 1900--1999)
        20  Nuclear Regulatory Commission (Parts 2000--2099)
        21  Office of Personnel Management, Federal Employees 
                Group Life Insurance Federal Acquisition 
                Regulation (Parts 2100--2199)
        23  Social Security Administration (Parts 2300--2399)
        24  Department of Housing and Urban Development (Parts 
                2400--2499)
        25  National Science Foundation (Parts 2500--2599)
        28  Department of Justice (Parts 2800--2899)
        29  Department of Labor (Parts 2900--2999)
        30  Department of Homeland Security, Homeland Security 
                Acquisition Regulation (HSAR) (Parts 3000--3099)
        34  Department of Education Acquisition Regulation (Parts 
                3400--3499)

[[Page 1137]]

        51  Department of the Army Acquisition Regulations (Parts 
                5100--5199) [Reserved]
        52  Department of the Navy Acquisition Regulations (Parts 
                5200--5299)
        53  Department of the Air Force Federal Acquisition 
                Regulation Supplement (Parts 5300--5399) 
                [Reserved]
        54  Defense Logistics Agency, Department of Defense (Parts 
                5400--5499)
        57  African Development Foundation (Parts 5700--5799)
        61  Civilian Board of Contract Appeals, General Services 
                Administration (Parts 6100--6199)
        99  Cost Accounting Standards Board, Office of Federal 
                Procurement Policy, Office of Management and 
                Budget (Parts 9900--9999)

                       Title 49--Transportation

            Subtitle A--Office of the Secretary of Transportation 
                (Parts 1--99)
            Subtitle B--Other Regulations Relating to 
                Transportation
         I  Pipeline and Hazardous Materials Safety 
                Administration, Department of Transportation 
                (Parts 100--199)
        II  Federal Railroad Administration, Department of 
                Transportation (Parts 200--299)
       III  Federal Motor Carrier Safety Administration, 
                Department of Transportation (Parts 300--399)
        IV  Coast Guard, Department of Homeland Security (Parts 
                400--499)
         V  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 500--599)
        VI  Federal Transit Administration, Department of 
                Transportation (Parts 600--699)
       VII  National Railroad Passenger Corporation (AMTRAK) 
                (Parts 700--799)
      VIII  National Transportation Safety Board (Parts 800--999)
         X  Surface Transportation Board (Parts 1000--1399)
        XI  Research and Innovative Technology Administration, 
                Department of Transportation (Parts 1400--1499) 
                [Reserved]
       XII  Transportation Security Administration, Department of 
                Homeland Security (Parts 1500--1699)

                   Title 50--Wildlife and Fisheries

         I  United States Fish and Wildlife Service, Department of 
                the Interior (Parts 1--199)
        II  National Marine Fisheries Service, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 200--299)
       III  International Fishing and Related Activities (Parts 
                300--399)

[[Page 1138]]

        IV  Joint Regulations (United States Fish and Wildlife 
                Service, Department of the Interior and National 
                Marine Fisheries Service, National Oceanic and 
                Atmospheric Administration, Department of 
                Commerce); Endangered Species Committee 
                Regulations (Parts 400--499)
         V  Marine Mammal Commission (Parts 500--599)
        VI  Fishery Conservation and Management, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 600--699)

[[Page 1139]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2023)

                                                  CFR Title, Subtitle or 
                     Agency                               Chapter

Administrative Conference of the United States    1, III
Advisory Council on Historic Preservation         36, VIII
Advocacy and Outreach, Office of                  7, XXV
Afghanistan Reconstruction, Special Inspector     5, LXXXIII
     General for
African Development Foundation                    22, XV
  Federal Acquisition Regulation                  48, 57
Agency for International Development              2, VII; 22, II
  Federal Acquisition Regulation                  48, 7
Agricultural Marketing Service                    7, I, VIII, IX, X, XI; 9, 
                                                  II
Agricultural Research Service                     7, V
Agriculture, Department of                        2, IV; 5, LXXIII
  Advocacy and Outreach, Office of                7, XXV
  Agricultural Marketing Service                  7, I, VIII, IX, X, XI; 9, 
                                                  II
  Agricultural Research Service                   7, V
  Animal and Plant Health Inspection Service      7, III; 9, I
  Chief Financial Officer, Office of              7, XXX
  Commodity Credit Corporation                    7, XIV
  Economic Research Service                       7, XXXVII
  Energy Policy and New Uses, Office of           2, IX; 7, XXIX
  Environmental Quality, Office of                7, XXXI
  Farm Service Agency                             7, VII, XVIII
  Federal Acquisition Regulation                  48, 4
  Federal Crop Insurance Corporation              7, IV
  Food and Nutrition Service                      7, II
  Food Safety and Inspection Service              9, III
  Foreign Agricultural Service                    7, XV
  Forest Service                                  36, II
  Information Resources Management, Office of     7, XXVII
  Inspector General, Office of                    7, XXVI
  National Agricultural Library                   7, XLI
  National Agricultural Statistics Service        7, XXXVI
  National Institute of Food and Agriculture      7, XXXIV
  Natural Resources Conservation Service          7, VI
  Operations, Office of                           7, XXVIII
  Procurement and Property Management, Office of  7, XXXII
  Rural Business-Cooperative Service              7, XVIII, XLII
  Rural Development Administration                7, XLII
  Rural Housing Service                           7, XVIII, XXXV
  Rural Utilities Service                         7, XVII, XVIII, XLII
  Secretary of Agriculture, Office of             7, Subtitle A
  Transportation, Office of                       7, XXXIII
  World Agricultural Outlook Board                7, XXXVIII
Air Force, Department of                          32, VII
  Federal Acquisition Regulation Supplement       48, 53
Air Transportation Stabilization Board            14, VI
Alcohol and Tobacco Tax and Trade Bureau          27, I
Alcohol, Tobacco, Firearms, and Explosives,       27, II
     Bureau of
AMTRAK                                            49, VII
American Battle Monuments Commission              36, IV
American Indians, Office of the Special Trustee   25, VII
Animal and Plant Health Inspection Service        7, III; 9, I
Appalachian Regional Commission                   5, IX
Architectural and Transportation Barriers         36, XI
   Compliance Board
[[Page 1140]]

Arctic Research Commission                        45, XXIII
Armed Forces Retirement Home                      5, XI; 38, II
Army, Department of                               32, V
  Engineers, Corps of                             33, II; 36, III
  Federal Acquisition Regulation                  48, 51
Benefits Review Board                             20, VII
Bilingual Education and Minority Languages        34, V
     Affairs, Office of
Blind or Severely Disabled, Committee for         41, 51
     Purchase from People Who Are
  Federal Acquisition Regulation                  48, 19
Career, Technical, and Adult Education, Office    34, IV
     of
Census Bureau                                     15, I
Centers for Medicare & Medicaid Services          42, IV
Central Intelligence Agency                       32, XIX
Chemical Safety and Hazard Investigation Board    40, VI
Chief Financial Officer, Office of                7, XXX
Child Support Enforcement, Office of              45, III
Children and Families, Administration for         45, II, III, IV, X, XIII
Civil Rights, Commission on                       5, LXVIII; 45, VII
Civil Rights, Office for                          34, I
Coast Guard                                       33, I; 46, I; 49, IV
Coast Guard (Great Lakes Pilotage)                46, III
Commerce, Department of                           2, XIII; 44, IV; 50, VI
  Census Bureau                                   15, I
  Economic Affairs, Office of the Under-          15, XV
       Secretary for
  Economic Analysis, Bureau of                    15, VIII
  Economic Development Administration             13, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 13
  Foreign-Trade Zones Board                       15, IV
  Industry and Security, Bureau of                15, VII
  International Trade Administration              15, III; 19, III
  National Institute of Standards and Technology  15, II; 37, IV
  National Marine Fisheries Service               50, II, IV
  National Oceanic and Atmospheric                15, IX; 50, II, III, IV, 
       Administration                             VI
  National Technical Information Service          15, XI
  National Telecommunications and Information     15, XXIII; 47, III, IV
       Administration
  National Weather Service                        15, IX
  Patent and Trademark Office, United States      37, I
  Secretary of Commerce, Office of                15, Subtitle A
Commercial Space Transportation                   14, III
Commodity Credit Corporation                      7, XIV
Commodity Futures Trading Commission              5, XLI; 17, I
Community Planning and Development, Office of     24, V, VI
     Assistant Secretary for
Community Services, Office of                     45, X
Comptroller of the Currency                       12, I
Construction Industry Collective Bargaining       29, IX
     Commission
Consumer Financial Protection Bureau              5, LXXXIV; 12, X
Consumer Product Safety Commission                5, LXXI; 16, II
Copyright Royalty Board                           37, III
Corporation for National and Community Service    2, XXII; 45, XII, XXV
Cost Accounting Standards Board                   48, 99
Council on Environmental Quality                  40, V
Council of the Inspectors General on Integrity    5, XCVIII
     and Efficiency
Court Services and Offender Supervision Agency    5, LXX; 28, VIII
     for the District of Columbia
Customs and Border Protection                     19, I
Defense, Department of                            2, XI; 5, XXVI; 32, 
                                                  Subtitle A; 40, VII
  Advanced Research Projects Agency               32, I
  Air Force Department                            32, VII
  Army Department                                 32, V; 33, II; 36, III; 
                                                  48, 51
  Defense Acquisition Regulations System          48, 2
  Defense Intelligence Agency                     32, I

[[Page 1141]]

  Defense Logistics Agency                        32, I, XII; 48, 54
  Engineers, Corps of                             33, II; 36, III
  National Imagery and Mapping Agency             32, I
  Navy, Department of                             32, VI; 48, 52
  Secretary of Defense, Office of                 2, XI; 32, I
Defense Contract Audit Agency                     32, I
Defense Intelligence Agency                       32, I
Defense Logistics Agency                          32, XII; 48, 54
Defense Nuclear Facilities Safety Board           10, XVII
Delaware River Basin Commission                   18, III
Denali Commission                                 45, IX
Disability, National Council on                   5, C; 34, XII
District of Columbia, Court Services and          5, LXX; 28, VIII
     Offender Supervision Agency for the
Drug Enforcement Administration                   21, II
East-West Foreign Trade Board                     15, XIII
Economic Affairs, Office of the Under-Secretary   15, XV
     for
Economic Analysis, Bureau of                      15, VIII
Economic Development Administration               13, III
Economic Research Service                         7, XXXVII
Education, Department of                          2, XXXIV; 5, LIII
  Bilingual Education and Minority Languages      34, V
       Affairs, Office of
  Career, Technical, and Adult Education, Office  34, IV
       of
  Civil Rights, Office for                        34, I
  Educational Research and Improvement, Office    34, VII
       of
  Elementary and Secondary Education, Office of   34, II
  Federal Acquisition Regulation                  48, 34
  Postsecondary Education, Office of              34, VI
  Secretary of Education, Office of               34, Subtitle A
  Special Education and Rehabilitative Services,  34, III
       Office of
Educational Research and Improvement, Office of   34, VII
Election Assistance Commission                    2, LVIII; 11, II
Elementary and Secondary Education, Office of     34, II
Emergency Oil and Gas Guaranteed Loan Board       13, V
Emergency Steel Guarantee Loan Board              13, IV
Employee Benefits Security Administration         29, XXV
Employees' Compensation Appeals Board             20, IV
Employees Loyalty Board                           5, V
Employment and Training Administration            20, V
Employment Policy, National Commission for        1, IV
Employment Standards Administration               20, VI
Endangered Species Committee                      50, IV
Energy, Department of                             2, IX; 5, XXIII; 10, II, 
                                                  III, X
  Federal Acquisition Regulation                  48, 9
  Federal Energy Regulatory Commission            5, XXIV; 18, I
  Property Management Regulations                 41, 109
Energy, Office of                                 7, XXIX
Engineers, Corps of                               33, II; 36, III
Engraving and Printing, Bureau of                 31, VI
Environmental Protection Agency                   2, XV; 5, LIV; 40, I, IV, 
                                                  VII
  Federal Acquisition Regulation                  48, 15
  Property Management Regulations                 41, 115
Environmental Quality, Office of                  7, XXXI
Equal Employment Opportunity Commission           5, LXII; 29, XIV
Equal Opportunity, Office of Assistant Secretary  24, I
     for
Executive Office of the President                 3, I
  Environmental Quality, Council on               40, V
  Management and Budget, Office of                2, Subtitle A; 5, III, 
                                                  LXXVII; 14, VI; 48, 99
  National Drug Control Policy, Office of         2, XXXVI; 21, III
  National Security Council                       32, XXI; 47, II
  Presidential Documents                          3
  Science and Technology Policy, Office of        32, XXIV; 47, II
  Trade Representative, Office of the United      15, XX
     States
[[Page 1142]]

Export-Import Bank of the United States           2, XXXV; 5, LII; 12, IV
Family Assistance, Office of                      45, II
Farm Credit Administration                        5, XXXI; 12, VI
Farm Credit System Insurance Corporation          5, XXX; 12, XIV
Farm Service Agency                               7, VII, XVIII
Federal Acquisition Regulation                    48, 1
Federal Acquisition Security Council              41, 201
Federal Aviation Administration                   14, I
  Commercial Space Transportation                 14, III
Federal Claims Collection Standards               31, IX
Federal Communications Commission                 2, LX; 5, XXIX; 47, I
Federal Contract Compliance Programs, Office of   41, 60
Federal Crop Insurance Corporation                7, IV
Federal Deposit Insurance Corporation             5, XXII; 12, III
Federal Election Commission                       5, XXXVII; 11, I
Federal Emergency Management Agency               44, I
Federal Employees Group Life Insurance Federal    48, 21
     Acquisition Regulation
Federal Employees Health Benefits Acquisition     48, 16
     Regulation
Federal Energy Regulatory Commission              5, XXIV; 18, I
Federal Financial Institutions Examination        12, XI
     Council
Federal Financing Bank                            12, VIII
Federal Highway Administration                    23, I, II
Federal Home Loan Mortgage Corporation            1, IV
Federal Housing Enterprise Oversight Office       12, XVII
Federal Housing Finance Agency                    5, LXXX; 12, XII
Federal Labor Relations Authority                 5, XIV, XLIX; 22, XIV
Federal Law Enforcement Training Center           31, VII
Federal Management Regulation                     41, 102
Federal Maritime Commission                       46, IV
Federal Mediation and Conciliation Service        29, XII
Federal Mine Safety and Health Review Commission  5, LXXIV; 29, XXVII
Federal Motor Carrier Safety Administration       49, III
Federal Permitting Improvement Steering Council   40, IX
Federal Prison Industries, Inc.                   28, III
Federal Procurement Policy Office                 48, 99
Federal Property Management Regulations           41, 101
Federal Railroad Administration                   49, II
Federal Register, Administrative Committee of     1, I
Federal Register, Office of                       1, II
Federal Reserve System                            12, II
  Board of Governors                              5, LVIII
Federal Retirement Thrift Investment Board        5, VI, LXXVI
Federal Service Impasses Panel                    5, XIV
Federal Trade Commission                          5, XLVII; 16, I
Federal Transit Administration                    49, VI
Federal Travel Regulation System                  41, Subtitle F
Financial Crimes Enforcement Network              31, X
Financial Research Office                         12, XVI
Financial Stability Oversight Council             12, XIII
Fine Arts, Commission of                          45, XXI
Fiscal Service                                    31, II
Fish and Wildlife Service, United States          50, I, IV
Food and Drug Administration                      21, I
Food and Nutrition Service                        7, II
Food Safety and Inspection Service                9, III
Foreign Agricultural Service                      7, XV
Foreign Assets Control, Office of                 31, V
Foreign Claims Settlement Commission of the       45, V
     United States
Foreign Service Grievance Board                   22, IX
Foreign Service Impasse Disputes Panel            22, XIV
Foreign Service Labor Relations Board             22, XIV
Foreign-Trade Zones Board                         15, IV
Forest Service                                    36, II
General Services Administration                   5, LVII; 41, 105
  Contract Appeals, Board of                      48, 61
  Federal Acquisition Regulation                  48, 5

[[Page 1143]]

  Federal Management Regulation                   41, 102
  Federal Property Management Regulations         41, 101
  Federal Travel Regulation System                41, Subtitle F
  General                                         41, 300
  Payment From a Non-Federal Source for Travel    41, 304
       Expenses
  Payment of Expenses Connected With the Death    41, 303
       of Certain Employees
  Relocation Allowances                           41, 302
  Temporary Duty (TDY) Travel Allowances          41, 301
Geological Survey                                 30, IV
Government Accountability Office                  4, I
Government Ethics, Office of                      5, XVI
Government National Mortgage Association          24, III
Grain Inspection, Packers and Stockyards          7, VIII; 9, II
     Administration
Great Lakes St. Lawrence Seaway Development       33, IV
     Corporation
Gulf Coast Ecosystem Restoration Council          2, LIX; 40, VIII
Harry S. Truman Scholarship Foundation            45, XVIII
Health and Human Services, Department of          2, III; 5, XLV; 45, 
                                                  Subtitle A
  Centers for Medicare & Medicaid Services        42, IV
  Child Support Enforcement, Office of            45, III
  Children and Families, Administration for       45, II, III, IV, X, XIII
  Community Services, Office of                   45, X
  Family Assistance, Office of                    45, II
  Federal Acquisition Regulation                  48, 3
  Food and Drug Administration                    21, I
  Indian Health Service                           25, V
  Inspector General (Health Care), Office of      42, V
  Public Health Service                           42, I
  Refugee Resettlement, Office of                 45, IV
Homeland Security, Department of                  2, XXX; 5, XXXVI; 6, I; 8, 
                                                  I
  Coast Guard                                     33, I; 46, I; 49, IV
  Coast Guard (Great Lakes Pilotage)              46, III
  Customs and Border Protection                   19, I
  Federal Emergency Management Agency             44, I
  Human Resources Management and Labor Relations  5, XCVII
       Systems
  Immigration and Customs Enforcement Bureau      19, IV
  Transportation Security Administration          49, XII
HOPE for Homeowners Program, Board of Directors   24, XXIV
     of
Housing and Urban Development, Department of      2, XXIV; 5, LXV; 24, 
                                                  Subtitle B
  Community Planning and Development, Office of   24, V, VI
       Assistant Secretary for
  Equal Opportunity, Office of Assistant          24, I
       Secretary for
  Federal Acquisition Regulation                  48, 24
  Federal Housing Enterprise Oversight, Office    12, XVII
       of
  Government National Mortgage Association        24, III
  Housing--Federal Housing Commissioner, Office   24, II, VIII, X, XX
       of Assistant Secretary for
  Housing, Office of, and Multifamily Housing     24, IV
       Assistance Restructuring, Office of
  Inspector General, Office of                    24, XII
  Public and Indian Housing, Office of Assistant  24, IX
       Secretary for
  Secretary, Office of                            24, Subtitle A, VII
Housing--Federal Housing Commissioner, Office of  24, II, VIII, X, XX
     Assistant Secretary for
Housing, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office of
Immigration and Customs Enforcement Bureau        19, IV
Immigration Review, Executive Office for          8, V
Independent Counsel, Office of                    28, VII
Independent Counsel, Offices of                   28, VI
Indian Affairs, Bureau of                         25, I, V
Indian Affairs, Office of the Assistant           25, VI
     Secretary
Indian Arts and Crafts Board                      25, II

[[Page 1144]]

Indian Health Service                             25, V
Industry and Security, Bureau of                  15, VII
Information Resources Management, Office of       7, XXVII
Information Security Oversight Office, National   32, XX
     Archives and Records Administration
Inspector General
  Agriculture Department                          7, XXVI
  Health and Human Services Department            42, V
  Housing and Urban Development Department        24, XII, XV
Institute of Peace, United States                 22, XVII
Intellectual Property Enforcement Coordinator,    5, CIV
     Office of
Inter-American Foundation                         5, LXIII; 22, X
Interior, Department of                           2, XIV
  American Indians, Office of the Special         25, VII
       Trustee
  Endangered Species Committee                    50, IV
  Federal Acquisition Regulation                  48, 14
  Federal Property Management Regulations System  41, 114
  Fish and Wildlife Service, United States        50, I, IV
  Geological Survey                               30, IV
  Indian Affairs, Bureau of                       25, I, V
  Indian Affairs, Office of the Assistant         25, VI
       Secretary
  Indian Arts and Crafts Board                    25, II
  Land Management, Bureau of                      43, II
  National Indian Gaming Commission               25, III
  National Park Service                           36, I
  Natural Resource Revenue, Office of             30, XII
  Ocean Energy Management, Bureau of              30, V
  Reclamation, Bureau of                          43, I
  Safety and Environmental Enforcement, Bureau    30, II
       of
  Secretary of the Interior, Office of            2, XIV; 43, Subtitle A
  Surface Mining Reclamation and Enforcement,     30, VII
       Office of
Internal Revenue Service                          26, I
International Boundary and Water Commission,      22, XI
     United States and Mexico, United States 
     Section
International Development, United States Agency   22, II
     for
  Federal Acquisition Regulation                  48, 7
International Development Cooperation Agency,     22, XII
     United States
International Development Finance Corporation,    5, XXXIII; 22, VII
     U.S.
International Joint Commission, United States     22, IV
     and Canada
International Organizations Employees Loyalty     5, V
     Board
International Trade Administration                15, III; 19, III
International Trade Commission, United States     19, II
Interstate Commerce Commission                    5, XL
Investment Security, Office of                    31, VIII
James Madison Memorial Fellowship Foundation      45, XXIV
Japan-United States Friendship Commission         22, XVI
Joint Board for the Enrollment of Actuaries       20, VIII
Justice, Department of                            2, XXVIII; 5, XXVIII; 28, 
                                                  I, XI; 40, IV
  Alcohol, Tobacco, Firearms, and Explosives,     27, II
       Bureau of
  Drug Enforcement Administration                 21, II
  Federal Acquisition Regulation                  48, 28
  Federal Claims Collection Standards             31, IX
  Federal Prison Industries, Inc.                 28, III
  Foreign Claims Settlement Commission of the     45, V
       United States
  Immigration Review, Executive Office for        8, V
  Independent Counsel, Offices of                 28, VI
  Prisons, Bureau of                              28, V
  Property Management Regulations                 41, 128
Labor, Department of                              2, XXIX; 5, XLII
  Benefits Review Board                           20, VII
  Employee Benefits Security Administration       29, XXV
  Employees' Compensation Appeals Board           20, IV
  Employment and Training Administration          20, V
  Federal Acquisition Regulation                  48, 29

[[Page 1145]]

  Federal Contract Compliance Programs, Office    41, 60
       of
  Federal Procurement Regulations System          41, 50
  Labor-Management Standards, Office of           29, II, IV
  Mine Safety and Health Administration           30, I
  Occupational Safety and Health Administration   29, XVII
  Public Contracts                                41, 50
  Secretary of Labor, Office of                   29, Subtitle A
  Veterans' Employment and Training Service,      41, 61; 20, IX
       Office of the Assistant Secretary for
  Wage and Hour Division                          29, V
  Workers' Compensation Programs, Office of       20, I, VI
Labor-Management Standards, Office of             29, II, IV
Land Management, Bureau of                        43, II
Legal Services Corporation                        45, XVI
Libraries and Information Science, National       45, XVII
     Commission on
Library of Congress                               36, VII
  Copyright Royalty Board                         37, III
  U.S. Copyright Office                           37, II
Management and Budget, Office of                  5, III, LXXVII; 14, VI; 
                                                  48, 99
Marine Mammal Commission                          50, V
Maritime Administration                           46, II
Merit Systems Protection Board                    5, II, LXIV
Micronesian Status Negotiations, Office for       32, XXVII
Military Compensation and Retirement              5, XCIX
     Modernization Commission
Millennium Challenge Corporation                  22, XIII
Mine Safety and Health Administration             30, I
Minority Business Development Agency              15, XIV
Miscellaneous Agencies                            1, IV
Monetary Offices                                  31, I
Morris K. Udall Scholarship and Excellence in     36, XVI
     National Environmental Policy Foundation
Museum and Library Services, Institute of         2, XXXI
National Aeronautics and Space Administration     2, XVIII; 5, LIX; 14, V
  Federal Acquisition Regulation                  48, 18
National Agricultural Library                     7, XLI
National Agricultural Statistics Service          7, XXXVI
National and Community Service, Corporation for   2, XXII; 45, XII, XXV
National Archives and Records Administration      2, XXVI; 5, LXVI; 36, XII
  Information Security Oversight Office           32, XX
National Capital Planning Commission              1, IV, VI
National Counterintelligence Center               32, XVIII
National Credit Union Administration              5, LXXXVI; 12, VII
National Crime Prevention and Privacy Compact     28, IX
     Council
National Drug Control Policy, Office of           2, XXXVI; 21, III
National Endowment for the Arts                   2, XXXII
National Endowment for the Humanities             2, XXXIII
National Foundation on the Arts and the           45, XI
     Humanities
National Geospatial-Intelligence Agency           32, I
National Highway Traffic Safety Administration    23, II, III; 47, VI; 49, V
National Imagery and Mapping Agency               32, I
National Indian Gaming Commission                 25, III
National Institute of Food and Agriculture        7, XXXIV
National Institute of Standards and Technology    15, II; 37, IV
National Intelligence, Office of Director of      5, IV; 32, XVII
National Labor Relations Board                    5, LXI; 29, I
National Marine Fisheries Service                 50, II, IV
National Mediation Board                          5, CI; 29, X
National Oceanic and Atmospheric Administration   15, IX; 50, II, III, IV, 
                                                  VI
National Park Service                             36, I
National Railroad Adjustment Board                29, III
National Railroad Passenger Corporation (AMTRAK)  49, VII
National Science Foundation                       2, XXV; 5, XLIII; 45, VI
  Federal Acquisition Regulation                  48, 25
National Security Council                         32, XXI; 47, II

[[Page 1146]]

National Technical Information Service            15, XI
National Telecommunications and Information       15, XXIII; 47, III, IV, V
     Administration
National Transportation Safety Board              49, VIII
Natural Resource Revenue, Office of               30, XII
Natural Resources Conservation Service            7, VI
Navajo and Hopi Indian Relocation, Office of      25, IV
Navy, Department of                               32, VI
  Federal Acquisition Regulation                  48, 52
Neighborhood Reinvestment Corporation             24, XXV
Northeast Interstate Low-Level Radioactive Waste  10, XVIII
     Commission
Nuclear Regulatory Commission                     2, XX; 5, XLVIII; 10, I
  Federal Acquisition Regulation                  48, 20
Occupational Safety and Health Administration     29, XVII
Occupational Safety and Health Review Commission  29, XX
Ocean Energy Management, Bureau of                30, V
Oklahoma City National Memorial Trust             36, XV
Operations Office                                 7, XXVIII
Patent and Trademark Office, United States        37, I
Payment From a Non-Federal Source for Travel      41, 304
     Expenses
Payment of Expenses Connected With the Death of   41, 303
     Certain Employees
Peace Corps                                       2, XXXVII; 22, III
Pennsylvania Avenue Development Corporation       36, IX
Pension Benefit Guaranty Corporation              29, XL
Personnel Management, Office of                   5, I, IV, XXXV; 45, VIII
  Federal Acquisition Regulation                  48, 17
  Federal Employees Group Life Insurance Federal  48, 21
       Acquisition Regulation
  Federal Employees Health Benefits Acquisition   48, 16
       Regulation
  Human Resources Management and Labor Relations  5, XCVII
       Systems, Department of Homeland Security
Pipeline and Hazardous Materials Safety           49, I
     Administration
Postal Regulatory Commission                      5, XLVI; 39, III
Postal Service, United States                     5, LX; 39, I
Postsecondary Education, Office of                34, VI
President's Commission on White House             1, IV
     Fellowships
Presidential Documents                            3
Presidio Trust                                    36, X
Prisons, Bureau of                                28, V
Privacy and Civil Liberties Oversight Board       6, X
Procurement and Property Management, Office of    7, XXXII
Public and Indian Housing, Office of Assistant    24, IX
     Secretary for
Public Contracts, Department of Labor             41, 50
Public Health Service                             42, I
Railroad Retirement Board                         20, II
Reclamation, Bureau of                            43, I
Refugee Resettlement, Office of                   45, IV
Relocation Allowances                             41, 302
Research and Innovative Technology                49, XI
     Administration
Rural Business-Cooperative Service                7, XVIII, XLII, L
Rural Development Administration                  7, XLII
Rural Housing Service                             7, XVIII, XXXV, L
Rural Utilities Service                           7, XVII, XVIII, XLII, L
Safety and Environmental Enforcement, Bureau of   30, II
Science and Technology Policy, Office of          32, XXIV; 47, II
Secret Service                                    31, IV
Securities and Exchange Commission                5, XXXIV; 17, II
Selective Service System                          32, XVI
Small Business Administration                     2, XXVII; 13, I
Smithsonian Institution                           36, V
Social Security Administration                    2, XXIII; 20, III; 48, 23
Soldiers' and Airmen's Home, United States        5, XI
Special Counsel, Office of                        5, VIII
Special Education and Rehabilitative Services,    34, III
     Office of
State, Department of                              2, VI; 22, I; 28, XI

[[Page 1147]]

  Federal Acquisition Regulation                  48, 6
Surface Mining Reclamation and Enforcement,       30, VII
     Office of
Surface Transportation Board                      49, X
Susquehanna River Basin Commission                18, VIII
Tennessee Valley Authority                        5, LXIX; 18, XIII
Trade Representative, United States, Office of    15, XX
Transportation, Department of                     2, XII; 5, L
  Commercial Space Transportation                 14, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 12
  Federal Aviation Administration                 14, I
  Federal Highway Administration                  23, I, II
  Federal Motor Carrier Safety Administration     49, III
  Federal Railroad Administration                 49, II
  Federal Transit Administration                  49, VI
  Great Lakes St. Lawrence Seaway Development     33, IV
       Corporation
  Maritime Administration                         46, II
  National Highway Traffic Safety Administration  23, II, III; 47, IV; 49, V
  Pipeline and Hazardous Materials Safety         49, I
       Administration
  Secretary of Transportation, Office of          14, II; 49, Subtitle A
  Transportation Statistics Bureau                49, XI
Transportation, Office of                         7, XXXIII
Transportation Security Administration            49, XII
Transportation Statistics Bureau                  49, XI
Travel Allowances, Temporary Duty (TDY)           41, 301
Treasury, Department of the                       2, X; 5, XXI; 12, XV; 17, 
                                                  IV; 31, IX
  Alcohol and Tobacco Tax and Trade Bureau        27, I
  Community Development Financial Institutions    12, XVIII
       Fund
  Comptroller of the Currency                     12, I
  Customs and Border Protection                   19, I
  Engraving and Printing, Bureau of               31, VI
  Federal Acquisition Regulation                  48, 10
  Federal Claims Collection Standards             31, IX
  Federal Law Enforcement Training Center         31, VII
  Financial Crimes Enforcement Network            31, X
  Fiscal Service                                  31, II
  Foreign Assets Control, Office of               31, V
  Internal Revenue Service                        26, I
  Investment Security, Office of                  31, VIII
  Monetary Offices                                31, I
  Secret Service                                  31, IV
  Secretary of the Treasury, Office of            31, Subtitle A
Truman, Harry S. Scholarship Foundation           45, XVIII
United States Agency for Global Media             22, V
United States and Canada, International Joint     22, IV
     Commission
United States and Mexico, International Boundary  22, XI
     and Water Commission, United States Section
U.S. Copyright Office                             37, II
U.S. Office of Special Counsel                    5, CII
Utah Reclamation Mitigation and Conservation      43, III
     Commission
Veterans Affairs, Department of                   2, VIII; 38, I
  Federal Acquisition Regulation                  48, 8
Veterans' Employment and Training Service,        41, 61; 20, IX
     Office of the Assistant Secretary for
Vice President of the United States, Office of    32, XXVIII
Wage and Hour Division                            29, V
Water Resources Council                           18, VI
Workers' Compensation Programs, Office of         20, I, VII
World Agricultural Outlook Board                  7, XXXVIII

[[Page 1149]]







                      Table of OMB Control Numbers



The OMB control numbers for chapter I of title 26 were consolidated into 
Sec. Sec.  601.9000 and 602.101 at 50 FR 10221, Mar. 14, 1985. At 61 FR 
58008, Nov. 12, 1996, Sec.  601.9000 was removed. Section 602.101 is 
reprinted below for the convenience of the user.



PART 602_OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT--Table of Contents



    Authority: 26 U.S.C. 7805.



Sec.  602.101  OMB Control numbers.

    (a) Purpose. This part collects and displays the control numbers 
assigned to collections of information in Internal Revenue Service 
regulations by the Office of Management and Budget (OMB) under the 
Paperwork Reduction Act of 1980. The Internal Revenue Service intends 
that this part comply with the requirements of Sec. Sec.  1320.7(f), 
1320.12, 1320.13, and 1320.14 of 5 CFR part 1320 (OMB regulations 
implementing the Paperwork Reduction Act), for the display of control 
numbers assigned by OMB to collections of information in Internal 
Revenue Service regulations. This part does not display control numbers 
assigned by the Office of Management and Budget to collections of 
information of the Bureau of Alcohol, Tobacco, and Firearms.
    (b) Display.

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
1.1(h)-1(e)................................................    1545-1654
1.25-1T....................................................    1545-0922
                                                               1545-0930
1.25-2T....................................................    1545-0922
                                                               1545-0930
1.25-3T....................................................    1545-0922
                                                               1545-0930
1.25-4T....................................................    1545-0922
1.25-5T....................................................    1545-0922
1.25-6T....................................................    1545-0922
1.25-7T....................................................    1545-0922
1.25-8T....................................................    1545-0922
1.25A-1....................................................    1545-1630
1.28-1.....................................................    1545-0619
1.31-2.....................................................    1545-0074
1.32-2.....................................................    1545-0074
1.32-3.....................................................    1545-1575
1.36B-5....................................................    1545-2232
1.37-1.....................................................    1545-0074
1.37-3.....................................................    1545-0074
1.41-2.....................................................    1545-0619
1.41-3.....................................................    1545-0619
1.41-4A....................................................    1545-0074
1.41-4 (b) and (c).........................................    1545-0074
1.41-8(b)..................................................    1545-1625
1.41-8(d)..................................................    1545-0732
1.41-9.....................................................    1545-0619
1.42-1T....................................................    1545-0984
                                                               1545-0988
1.42-5.....................................................    1545-1357
1.42-6.....................................................    1545-1102
1.42-8.....................................................    1545-1102
1.42-10....................................................    1545-1102
1.42-13....................................................    1545-1357
1.42-14....................................................    1545-1423
1.42-17....................................................    1545-1357
1.42-18....................................................    1545-2088
1.43-3(a)(3)...............................................    1545-1292
1.43-3(b)(3)...............................................    1545-1292
1.44B-1....................................................    1545-0219
1.45D-1....................................................    1545-1765
1.45G-1....................................................    1545-2031
1.46-1.....................................................    1545-0123
                                                               1545-0155
1.46-3.....................................................    1545-0155
1.46-4.....................................................    1545-0155
1.46-5.....................................................    1545-0155
1.46-6.....................................................    1545-0155
1.46-8.....................................................    1545-0155
1.46-9.....................................................    1545-0155
1.46-10....................................................    1545-0118
1.47-1.....................................................    1545-0155
                                                               1545-0166
1.47-3.....................................................    1545-0155
                                                               1545-0166
1.47-4.....................................................    1545-0123
1.47-5.....................................................    1545-0092
1.47-6.....................................................    1545-0099
1.48-3.....................................................    1545-0155
1.48-4.....................................................    1545-0155
                                                               1545-0808
1.48-5.....................................................    1545-0155
1.48-6.....................................................    1545-0155
1.48-12....................................................    1545-0155
                                                               1545-1783
1.50A-1....................................................    1545-0895
1.50A-2....................................................    1545-0895
1.50A-3....................................................    1545-0895
1.50A-4....................................................    1545-0895
1.50A-5....................................................    1545-0895
1.50A-6....................................................    1545-0895
1.50A-7....................................................    1545-0895
1.50B-1....................................................    1545-0895
1.50B-2....................................................    1545-0895
1.50B-3....................................................    1545-0895
1.50B-4....................................................    1545-0895

[[Page 1150]]

 
1.50B-5....................................................    1545-0895
1.51-1.....................................................    1545-0219
                                                               1545-0241
                                                               1545-0244
                                                               1545-0797
1.52-2.....................................................    1545-0219
1.52-3.....................................................    1545-0219
1.56(g)-1..................................................    1545-1233
1.57-5.....................................................    1545-0227
1.58-1.....................................................    1545-0175
1.59-1.....................................................    1545-1903
1.61-2.....................................................    1545-0771
1.61-4.....................................................    1545-0187
1.61-15....................................................    1545-0074
1.62-2.....................................................    1545-1148
1.63-1.....................................................    1545-0074
1.66-4.....................................................    1545-1770
1.67-2T....................................................    1545-0110
1.67-3.....................................................    1545-1018
1.67-3T....................................................    1545-0118
1.71-1T....................................................    1545-0074
1.72-4.....................................................    1545-0074
1.72-6.....................................................    1545-0074
1.72-9.....................................................    1545-0074
1.72-17....................................................    1545-0074
1.72-17A...................................................    1545-0074
1.72-18....................................................    1545-0074
1.74-1.....................................................    1545-1100
1.79-2.....................................................    1545-0074
1.79-3.....................................................    1545-0074
1.83-2.....................................................    1545-0074
1.83-5.....................................................    1545-0074
1.83-6.....................................................    1545-1448
1.103-10...................................................    1545-0123
                                                               1545-0940
1.103A-2...................................................    1545-0720
1.105-4....................................................    1545-0074
1.105-5....................................................    1545-0074
1.105-6....................................................    1545-0074
1.108-4....................................................    1545-1539
1.108-5....................................................    1545-1421
1.108-7....................................................    1545-2155
1.108(i)-1.................................................    1545-2147
1.108(i)-2.................................................    1545-2147
1.110-1....................................................    1545-1661
1.117-5....................................................    1545-0869
1.118-2....................................................    1545-1639
1.119-1....................................................    1545-0067
1.120-3....................................................    1545-0057
1.121-1....................................................    1545-0072
1.121-2....................................................    1545-0072
1.121-3....................................................    1545-0072
1.121-4....................................................    1545-0072
                                                               1545-0091
1.121-5....................................................    1545-0072
1.127-2....................................................    1545-0768
1.132-2....................................................    1545-0771
1.132-5....................................................    1545-0771
1.132-9(b).................................................    1545-1676
1.141-1....................................................    1545-1451
1.141-12...................................................    1545-1451
1.142-2....................................................    1545-1451
1.142(f)(4)-1..............................................    1545-1730
1.148-0....................................................    1545-1098
1.148-1....................................................    1545-1098
1.148-2....................................................    1545-1098
                                                               1545-1347
1.148-3....................................................    1545-1098
                                                               1545-1347
1.148-4....................................................    1545-1098
                                                               1545-1347
1.148-5....................................................    1545-1098
                                                               1545-1490
1.148-6....................................................    1545-1098
                                                               1545-1451
1.148-7....................................................    1545-1098
                                                               1545-1347
1.148-8....................................................    1545-1098
1.148-11...................................................    1545-1098
                                                               1545-1347
1.149(e)-1.................................................    1545-0720
1.150-1....................................................    1545-1347
1.151-1....................................................    1545-0074
1.152-3....................................................    1545-0071
                                                               1545-1783
1.152-4....................................................    1545-0074
1.152-4T...................................................    1545-0074
1.162-1....................................................    1545-0139
1.162-2....................................................    1545-0139
1.162-3....................................................    1545-0139
1.162-4....................................................    1545-0139
1.162-5....................................................    1545-0139
1.162-6....................................................    1545-0139
1.162-7....................................................    1545-0139
1.162-8....................................................    1545-0139
1.162-9....................................................    1545-0139
1.162-10...................................................    1545-0139
1.162-11...................................................    1545-0139
1.162-12...................................................    1545-0139
1.162-13...................................................    1545-0139
1.162-14...................................................    1545-0139
1.162-15...................................................    1545-0139
1.162-16...................................................    1545-0139
1.162-17...................................................    1545-0139
1.162-18...................................................    1545-0139
1.162-19...................................................    1545-0139
1.162-20...................................................    1545-0139
1.162-24...................................................    1545-2115
1.162-27...................................................    1545-1466
1.163-5....................................................    1545-0786
                                                               1545-1132
1.163-8T...................................................    1545-0995
1.163-10T..................................................    1545-0074
1.163-13...................................................    1545-1491
1.163(d)-1.................................................    1545-1421
1.165-1....................................................    1545-0177
1.165-2....................................................    1545-0177
1.165-3....................................................    1545-0177
1.165-4....................................................    1545-0177
1.165-5....................................................    1545-0177
1.165-6....................................................    1545-0177
1.165-7....................................................    1545-0177
1.165-8....................................................    1545-0177
1.165-9....................................................    1545-0177
1.165-10...................................................    1545-0177
1.165-11...................................................    1545-0074
                                                               1545-0177
                                                               1545-0786
1.165-12...................................................    1545-0786
1.166-1....................................................    1545-0123
1.166-2....................................................    1545-1254
1.166-4....................................................    1545-0123
1.166-10...................................................    1545-0123
1.167(a)-5T................................................    1545-1021
1.167(a)-7.................................................    1545-0172
1.167(a)-11................................................    1545-0152
                                                               1545-0172
1.167(a)-12................................................    1545-0172
1.167(d)-1.................................................    1545-0172
1.167(e)-1.................................................    1545-0172
1.167(f)-11................................................    1545-0172
1.167(l)-1.................................................    1545-0172
1.168(d)-1.................................................    1545-1146
1.168(i)-1.................................................    1545-1331

[[Page 1151]]

 
1.168-5....................................................    1545-0172
1.169-4....................................................    1545-0172
1.170-1....................................................    1545-0074
1.170-2....................................................    1545-0074
1.170-3....................................................    1545-0123
1.170A-1...................................................    1545-0074
1.170A-2...................................................    1545-0074
1.170A-4(A)(b).............................................    1545-0123
1.170A-8...................................................    1545-0074
1.170A-9...................................................    1545-0052
                                                               1545-0074
1.170A-11..................................................    1545-0074
                                                               1545-0123
                                                               1545-1868
1.170A-12..................................................    1545-0020
                                                               1545-0074
1.170A-13..................................................    1545-0074
                                                               1545-0754
                                                               1545-0908
                                                               1545-1431
1.170A-13(f)...............................................    1545-1464
1.170A-14..................................................    1545-0763
1.170A-15..................................................    1545-1953
1.170A-16..................................................    1545-1953
1.170A-17..................................................    1545-1953
1.170A-18..................................................    1545-1953
1.171-4....................................................    1545-1491
1.171-5....................................................    1545-1491
1.172-1....................................................    1545-0172
1.172-13...................................................    1545-0863
1.173-1....................................................    1545-0172
1.174-3....................................................    1545-0152
1.174-4....................................................    1545-0152
1.175-3....................................................    1545-0187
1.175-6....................................................    1545-0152
1.179-2....................................................    1545-1201
1.179-3....................................................    1545-1201
1.179-5....................................................    1545-0172
                                                               1545-1201
1.179B-1T..................................................    1545-2076
1.179C-1...................................................    1545-2103
1.179C-1T..................................................    1545-2103
1.180-2....................................................    1545-0074
1.181-1....................................................    1545-2059
1.181-2....................................................    1545-2059
1.181-3....................................................    1545-2059
1.182-6....................................................    1545-0074
1.183-1....................................................    1545-0195
1.183-2....................................................    1545-0195
1.183-3....................................................    1545-0195
1.183-4....................................................    1545-0195
1.190-3....................................................    1545-0074
1.194-2....................................................    1545-0735
1.194-4....................................................    1545-0735
1.195-1....................................................    1545-1582
1.197-1T...................................................    1545-1425
1.197-2....................................................    1545-1671
1.199-6....................................................    1545-1966
1.213-1....................................................    1545-0074
1.215-1T...................................................    1545-0074
1.217-2....................................................    1545-0182
1.243-3....................................................    1545-0123
1.243-4....................................................    1545-0123
1.243-5....................................................    1545-0123
1.248-1....................................................    1545-0172
1.261-1....................................................    1545-1041
1.263(a)-1.................................................    1545-2248
1.263(a)-3.................................................    1545-2248
1.263(a)-5.................................................    1545-1870
1.263(e)-1.................................................    1545-0123
1.263A-1...................................................    1545-0987
1.263A-1T..................................................    1545-0187
1.263A-2...................................................    1545-0987
1.263A-3...................................................    1545-0987
1.263A-8(b)(2)(iii)........................................    1545-1265
1.263A-9(d)(1).............................................    1545-1265
1.263A-9(f)(1)(ii).........................................    1545-1265
1.263A-9(f)(2)(iv).........................................    1545-1265
1.263A-9(g)(2)(iv)(C)......................................    1545-1265
1.263A-9(g)(3)(iv).........................................    1545-1265
1.265-1....................................................    1545-0074
1.265-2....................................................    1545-0123
1.266-1....................................................    1545-0123
1.267(f)-1.................................................    1545-0885
1.268-1....................................................    1545-0184
1.274-1....................................................    1545-0139
1.274-2....................................................    1545-0139
1.274-3....................................................    1545-0139
1.274-4....................................................    1545-0139
1.274-5....................................................    1545-0771
1.274-5A...................................................    1545-0139
                                                               1545-0771
1.274-5T...................................................    1545-0074
                                                               1545-0172
                                                               1545-0771
1.274-6....................................................    1545-0139
                                                               1545-0771
1.274-6T...................................................    1545-0074
                                                               1545-0771
1.274-7....................................................    1545-0139
1.274-8....................................................    1545-0139
1.279-6....................................................    1545-0123
1.280C-4...................................................    1545-1155
1.280F-3T..................................................    1545-0074
1.280G-1...................................................    1545-1851
1.281-4....................................................    1545-0123
1.302-4....................................................    1545-0074
1.305-3....................................................    1545-0123
1.305-5....................................................    1545-1438
1.307-2....................................................    1545-0074
1.312-15...................................................    1545-0172
1.316-1....................................................    1545-0123
1.331-1....................................................    1545-0074
1.332-4....................................................    1545-0123
1.332-6....................................................    1545-2019
1.336-2....................................................    1545-2125
1.336-4....................................................    1545-2125
1.337(d)-1.................................................    1545-1160
1.337(d)-2.................................................    1545-1160
                                                               1545-1774
1.337(d)-4.................................................    1545-1633
1.337(d)-5.................................................    1545-1672
1.337(d)-6.................................................    1545-1672
1.337(d)-7.................................................    1545-1672
1.338-2....................................................    1545-1658
1.338-5....................................................    1545-1658
1.338-10...................................................    1545-1658
1.338-11...................................................    1545-1990
1.338(h)(10)-1.............................................    1545-1658
1.338(i)-1.................................................    1545-1990
1.351-3....................................................    1545-2019
1.355-5....................................................    1545-2019
1.362-2....................................................    1545-0123
1.362-4....................................................    1545-2247
1.367(a)-1T................................................    1545-0026
1.367(a)-2T................................................    1545-0026
1.367(a)-3.................................................    1545-0026
                                                               1545-1478
1.367(a)-3T................................................    1545-2183
1.367(a)-6T................................................    1545-0026
1.367(a)-7.................................................    1545-2183
1.367(a)-7T................................................    1545-2183
1.367(a)-8.................................................    1545-1271
                                                               1545-2056

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                                                               1545-2183
1.367(b)-1.................................................    1545-1271
1.367(b)-3T................................................    1545-1666
1.367(d)-1T................................................    1545-0026
1.367(e)-1.................................................    1545-1487
1.367(e)-2.................................................    1545-1487
1.368-1....................................................    1545-1691
1.368-3....................................................    1545-2019
1.371-1....................................................    1545-0123
1.371-2....................................................    1545-0123
1.374-3....................................................    1545-0123
1.381(b)-1.................................................    1545-0123
1.381(c)(4)-1..............................................    1545-0123
                                                               1545-0152
                                                               1545-0879
1.381(c)(5)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(6)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(8)-1..............................................    1545-0123
1.381(c)(10)-1.............................................    1545-0123
1.381(c)(11)-1(k)..........................................    1545-0123
1.381(c)(13)-1.............................................    1545-0123
1.381(c)(17)-1.............................................    1545-0045
1.381(c)(22)-1.............................................    1545-1990
1.381(c)(25)-1.............................................    1545-0045
1.382-1T...................................................    1545-0123
1.382-2....................................................    1545-0123
1.382-2T...................................................    1545-0123
1.382-3....................................................    1545-1281
                                                               1545-1345
1.382-4....................................................    1545-1120
1.382-6....................................................    1545-1381
1.382-8....................................................    1545-1434
1.382-9....................................................    1545-1120
                                                               1545-1260
                                                               1545-1275
                                                               1545-1324
1.382-11...................................................    1545-2019
1.382-91...................................................    1545-1260
                                                               1545-1324
1.383-1....................................................    1545-0074
                                                               1545-1120
1.401-1....................................................    1545-0020
                                                               1545-0197
                                                               1545-0200
                                                               1545-0534
                                                               1545-0710
1.401(a)-11................................................    1545-0710
1.401(a)-20................................................    1545-0928
1.401(a)-31................................................    1545-1341
1.401(a)-50................................................    1545-0710
1.401(a)(9)-1..............................................    1545-1573
1.401(a)(9)-3..............................................    1545-1466
1.401(a)(9)-4..............................................    1545-1573
1.401(a)(9)-6..............................................    1545-2234
1.401(a)(31)-1.............................................    1545-1341
1.401(b)-1.................................................    1545-0197
1.401(f)-1.................................................    1545-0710
1.401(k)-1.................................................    1545-1039
                                                               1545-1069
                                                               1545-1669
                                                               1545-1930
1.401(k)-2.................................................    1545-1669
1.401(k)-3.................................................    1545-1669
1.401(k)-4.................................................    1545-1669
1.401(m)-3.................................................    1545-1699
1.401-14...................................................    1545-0710
1.402(c)-2.................................................    1545-1341
1.402(f)-1.................................................    1545-1341
                                                               1545-1632
1.402A-1...................................................    1545-1992
1.403(b)-1.................................................    1545-0710
1.403(b)-3.................................................    1545-0996
1.403(b)-7.................................................    1545-1341
1.403(b)-10................................................    1545-2068
1.404(a)-12................................................    1545-0710
1.404A-2...................................................    1545-0123
1.404A-6...................................................    1545-0123
1.408-2....................................................    1545-0390
1.408-5....................................................    1545-0747
1.408-6....................................................    1545-0203
                                                               1545-0390
1.408-7....................................................    1545-0119
1.408(q)-1.................................................    1545-1841
1.408A-2...................................................    1545-1616
1.408A-4...................................................    1545-1616
1.408A-5...................................................    1545-1616
1.408A-7...................................................    1545-1616
1.410(a)-2.................................................    1545-0710
1.410(d)-1.................................................    1545-0710
1.411(a)-11................................................    1545-1471
                                                               1545-1632
1.411(d)-4.................................................    1545-1545
1.411(d)-6.................................................    1545-1477
1.412(c)(1)-2..............................................    1545-0710
1.412(c)(2)-1..............................................    1545-0710
1.412(c)(3)-2..............................................    1545-0710
1.414(c)-5.................................................    1545-0797
1.414(r)-1.................................................    1545-1221
1.415-2....................................................    1545-0710
1.415-6....................................................    1545-0710
1.417(a)(3)-1..............................................    1545-0928
1.417(e)-1.................................................    1545-1471
                                                               1545-1724
1.417(e)-1T................................................    1545-1471
1.419A(f)(6)-1.............................................    1545-1795
1.422-1....................................................    1545-0820
1.430(f)-1.................................................    1545-2095
1.430(g)-1.................................................    1545-2095
1.430(h)(2)-1..............................................    1545-2095
1.432(e)(9)-1T.............................................    1545-2260
1.436-1....................................................    1545-2095
1.441-2....................................................    1545-1748
1.442-1....................................................    1545-0074
                                                               1545-0123
                                                               1545-0134
                                                               1545-0152
                                                               1545-0820
                                                               1545-1748
1.443-1....................................................    1545-0123
1.444-3T...................................................    1545-1036
1.444-4....................................................    1545-1591
1.446-1....................................................    1545-0074
                                                               1545-0152
1.446-4(d).................................................    1545-1412
1.448-1(g).................................................    1545-0152
1.448-1(h).................................................    1545-0152
1.448-1(i).................................................    1545-0152
1.448-2....................................................    1545-1855
1.448-2T...................................................    1545-0152
                                                               1545-1855
1.451-1....................................................    1545-0091
1.451-4....................................................    1545-0123
1.451-6....................................................    1545-0074
1.451-7....................................................    1545-0074
1.453-1....................................................    1545-0152
1.453-2....................................................    1545-0152
1.453-8....................................................    1545-0152
                                                               1545-0228
1.453A-1...................................................    1545-0152
                                                               1545-1134
1.453A-3...................................................    1545-0963
1.454-1....................................................    1545-0074

[[Page 1153]]

 
1.455-2....................................................    1545-0152
1.455-6....................................................    1545-0123
1.456-2....................................................    1545-0123
1.456-6....................................................    1545-0123
1.456-7....................................................    1545-0123
1.457-8....................................................    1545-1580
1.458-1....................................................    1545-0879
1.458-2....................................................    1545-0152
1.460-1....................................................    1545-1650
1.460-6....................................................    1545-1031
                                                               1545-1572
                                                               1545-1732
1.461-1....................................................    1545-0074
1.461-2....................................................    1545-0096
1.461-4....................................................    1545-0917
1.461-5....................................................    1545-0917
1.463-1T...................................................    1545-0916
1.465-1T...................................................    1545-0712
1.466-1T...................................................    1545-0152
1.466-4....................................................    1545-0152
1.468A-3...................................................    1545-1269
                                                               1545-1378
                                                               1545-1511
1.468A-3(h), 1.468A-7, and 1.468A-8(d).....................    1545-2091
1.468A-4...................................................    1545-0954
1.468A-7...................................................    1545-0954
                                                               1545-1511
1.468A-8...................................................    1545-1269
1.468B-1...................................................    1545-1631
1.468B-1(j)................................................    1545-1299
1.468B-2(k)................................................    1545-1299
1.468B-2(l)................................................    1545-1299
1.468B-3(b)................................................    1545-1299
1.468B-3(e)................................................    1545-1299
1.468B-5(b)................................................    1545-1299
1.468B-9...................................................    1545-1631
1.469-1....................................................    1545-1008
1.469-2T...................................................    1545-0712
                                                               1545-1091
1.469-4T...................................................    1545-0985
                                                               1545-1037
1.469-7....................................................    1545-1244
1.471-2....................................................    1545-0123
1.471-5....................................................    1545-0123
1.471-6....................................................    1545-0123
1.471-8....................................................    1545-0123
1.471-11...................................................    1545-0123
                                                               1545-0152
1.472-1....................................................    1545-0042
                                                               1545-0152
1.472-2....................................................    1545-0152
1.472-3....................................................    1545-0042
1.472-5....................................................    1545-0152
1.472-8....................................................    1545-0028
                                                               1545-0042
                                                               1545-1767
1.475(a)-4.................................................    1545-1945
1.481-4....................................................    1545-0152
1.481-5....................................................    1545-0152
1.482-1....................................................    1545-1364
1.482-4....................................................    1545-1364
1.482-7....................................................    1545-1364
                                                               1545-1794
1.482-9(b).................................................    1545-2149
1.501(a)-1.................................................    1545-0056
                                                               1545-0057
1.501(c)(3)-1..............................................    1545-0056
1.501(c)(9)-5..............................................    1545-0047
1.501(c)(17)-3.............................................    1545-0047
1.501(e)-1.................................................    1545-0814
1.501(r)-3.................................................    1545-0047
1.501(r)-4.................................................    1545-0047
1.501(r)-6.................................................    1545-0047
1.503(c)-1.................................................    1545-0047
                                                               1545-0052
1.505(c)-1T................................................    1545-0916
1.506-1....................................................    1545-2268
1.507-1....................................................    1545-0052
1.507-2....................................................    1545-0052
1.508-1....................................................    1545-0052
                                                               1545-0056
1.509(a)-3.................................................    1545-0047
1.509(a)-4.................................................    1545-2157
1.509(a)-5.................................................    1545-0047
1.509(c)-1.................................................    1545-0052
1.512(a)-1.................................................    1545-0687
1.512(a)-4.................................................    1545-0047
                                                               1545-0687
1.521-1....................................................    1545-0051
                                                               1545-0058
1.527-2....................................................    1545-0129
1.527-5....................................................    1545-0129
1.527-6....................................................    1545-0129
1.527-9....................................................    1545-0129
1.528-8....................................................    1545-0127
1.529A-2...................................................    1545-2293
1.529A-5...................................................    1545-2262
1.529A-6...................................................    1545-2262
1.529A-7...................................................    1545-2262
1.533-2....................................................    1545-0123
1.534-2....................................................    1545-0123
1.542-3....................................................    1545-0123
1.545-2....................................................    1545-0123
1.545-3....................................................    1545-0123
1.547-2....................................................    1545-0045
                                                               1545-0123
1.547-3....................................................    1545-0123
1.561-1....................................................    1545-0044
1.561-2....................................................    1545-0123
1.562-3....................................................    1545-0123
1.563-2....................................................    1545-0123
1.564-1....................................................    1545-0123
1.565-1....................................................    1545-0043
                                                               1545-0123
1.565-2....................................................    1545-0043
1.565-3....................................................    1545-0043
1.565-5....................................................    1545-0043
1.565-6....................................................    1545-0043
1.585-1....................................................    1545-0123
1.585-3....................................................    1545-0123
1.585-8....................................................    1545-1290
1.597-2....................................................    1545-1300
1.597-4....................................................    1545-1300
1.597-6....................................................    1545-1300
1.597-7....................................................    1545-1300
1.611-2....................................................    1545-0099
1.611-3....................................................    1545-0007
                                                               1545-0099
                                                               1545-1784
1.612-4....................................................    1545-0074
1.612-5....................................................    1545-0099
1.613-3....................................................    1545-0099
1.613-4....................................................    1545-0099
1.613-6....................................................    1545-0099
1.613-7....................................................    1545-0099
1.613A-3...................................................    1545-0919
1.613A-3(e)................................................    1545-1251
1.613A-3(l)................................................    1545-0919
1.613A-5...................................................    1545-0099
1.613A-6...................................................    1545-0099
1.614-2....................................................    1545-0099
1.614-3....................................................    1545-0099
1.614-5....................................................    1545-0099
1.614-6....................................................    1545-0099

[[Page 1154]]

 
1.614-8....................................................    1545-0099
1.617-1....................................................    1545-0099
1.617-3....................................................    1545-0099
1.617-4....................................................    1545-0099
1.631-1....................................................    1545-0007
1.631-2....................................................    1545-0007
1.641(b)-2.................................................    1545-0092
1.642(c)-1.................................................    1545-0092
1.642(c)-2.................................................    1545-0092
1.642(c)-5.................................................    1545-0074
1.642(c)-6.................................................    1545-0020
                                                               1545-0074
                                                               1545-0092
1.642(g)-1.................................................    1545-0092
1.642(i)-1.................................................    1545-0092
1.645-1....................................................    1545-1578
1.663(b)-2.................................................    1545-0092
1.664-1....................................................    1545-0196
1.664-1(a)(7)..............................................    1545-1536
1.664-1(c).................................................    1545-2101
1.664-2....................................................    1545-0196
1.664-3....................................................    1545-0196
1.664-4....................................................    1545-0020
                                                               1545-0196
1.665(a)-0A through
1.665(g)-2A................................................    1545-0192
1.666(d)-1A................................................    1545-0092
1.671-4....................................................    1545-1442
1.671-5....................................................    1545-1540
1.701-1....................................................    1545-0099
1.702-1....................................................    1545-0074
1.703-1....................................................    1545-0099
1.704-2....................................................    1545-1090
1.706-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0134
1.706-1T...................................................    1545-0099
1.706-4(f).................................................    1545-0123
1.707-3(c)(2)..............................................    1545-1243
1.707-5(a)(7)(ii)..........................................    1545-1243
1.707-6(c).................................................    1545-1243
1.707-8....................................................    1545-1243
1.708-1....................................................    1545-0099
1.732-1....................................................    1545-0099
                                                               1545-1588
1.736-1....................................................    1545-0074
1.743-1....................................................    1545-0074
                                                               1545-1588
1.751-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0941
1.752-2....................................................    1545-1905
1.752-5....................................................    1545-1090
1.752-7....................................................    1545-1843
1.754-1....................................................    1545-0099
1.755-1....................................................    1545-0099
1.761-2....................................................    1545-1338
1.801-1....................................................    1545-0123
                                                               1545-0128
1.801-3....................................................    1545-0123
1.801-5....................................................    1545-0128
1.801-8....................................................    1545-0128
1.804-4....................................................    1545-0128
1.811-2....................................................    1545-0128
1.812-2....................................................    1545-0128
1.815-6....................................................    1545-0128
1.818-4....................................................    1545-0128
1.818-5....................................................    1545-0128
1.818-8....................................................    1545-0128
1.819-2....................................................    1545-0128
1.822-5....................................................    1545-1027
1.822-6....................................................    1545-1027
1.822-8....................................................    1545-1027
1.822-9....................................................    1545-1027
1.826-1....................................................    1545-1027
1.826-2....................................................    1545-1027
1.826-3....................................................    1545-1027
1.826-4....................................................    1545-1027
1.826-6....................................................    1545-1027
1.831-3....................................................    1545-0123
1.832-4....................................................    1545-1227
1.832-5....................................................    1545-0123
1.848-2(g)(8)..............................................    1545-1287
1.848-2(h)(3)..............................................    1545-1287
1.848-2(i)(4)..............................................    1545-1287
1.851-2....................................................    1545-1010
1.851-4....................................................    1545-0123
1.852-1....................................................    1545-0123
1.852-4....................................................    1545-0123
                                                               1545-0145
1.852-6....................................................    1545-0123
                                                               1545-0144
1.852-7....................................................    1545-0074
1.852-9....................................................    1545-0074
                                                               1545-0123
                                                               1545-0144
                                                               1545-0145
                                                               1545-1783
1.852-11...................................................    1545-1094
1.853-3....................................................    1545-2035
1.853-4....................................................    1545-2035
1.854-2....................................................    1545-0123
1.855-1....................................................    1545-0123
1.856-2....................................................    1545-0123
                                                               1545-1004
1.856-6....................................................    1545-0123
1.856-7....................................................    1545-0123
1.856-8....................................................    1545-0123
1.857-8....................................................    1545-0123
1.857-9....................................................    1545-0074
1.858-1....................................................    1545-0123
1.860-2....................................................    1545-0045
1.860-4....................................................    1545-0045
                                                               1545-1054
                                                               1545-1057
1.860E-1...................................................    1545-1675
1.860E-2(a)(5).............................................    1545-1276
1.860E-2(a)(7).............................................    1545-1276
1.860E-2(b)(2).............................................    1545-1276
1.860G-2...................................................    1545-2110
1.861-2....................................................    1545-0089
1.861-3....................................................    1545-0089
1.861-4....................................................    1545-1900
1.861-8....................................................    1545-0126
1.861-8(e)(6) and (g)......................................    1545-1224
1.861-9T...................................................    1545-0121
                                                               1545-1072
1.861-18...................................................    1545-1594
1.863-1....................................................    1545-1476
1.863-3....................................................    1545-1476
                                                               1545-1556
1.863-3A...................................................    1545-0126
1.863-4....................................................    1545-0126
1.863-7....................................................    1545-0132
1.863-8....................................................    1545-1718
1.863-9....................................................    1545-1718
1.864-4....................................................    1545-0126
1.871-1....................................................    1545-0096
1.871-6....................................................    1545-0795
1.871-7....................................................    1545-0089
1.871-10...................................................    1545-0089
                                                               1545-0165
1.874-1....................................................    1545-0089
1.881-4....................................................    1545-1440

[[Page 1155]]

 
1.882-4....................................................    1545-0126
1.883-0....................................................    1545-1677
1.883-1....................................................    1545-1677
1.883-2....................................................    1545-1677
1.883-3....................................................    1545-1677
1.883-4....................................................    1545-1677
1.883-5....................................................    1545-1677
1.884-0....................................................    1545-1070
1.884-1....................................................    1545-1070
1.884-2....................................................    1545-1070
1.884-2T...................................................    1545-0126
                                                               1545-1070
1.884-4....................................................    1545-1070
1.884-5....................................................    1545-1070
1.892-1T...................................................    1545-1053
1.892-2T...................................................    1545-1053
1.892-3T...................................................    1545-1053
1.892-4T...................................................    1545-1053
1.892-5T...................................................    1545-1053
1.892-6T...................................................    1545-1053
1.892-7T...................................................    1545-1053
1.897-2....................................................    1545-0123
                                                               1545-0902
1.897-3....................................................    1545-0123
1.897-5T...................................................    1545-0902
1.897-6T...................................................    1545-0902
1.901-2....................................................    1545-0746
1.901-2A...................................................    1545-0746
1.901-3....................................................    1545-0122
1.902-1....................................................    1545-0122
                                                               1545-1458
1.904-1....................................................    1545-0121
                                                               1545-0122
1.904-2....................................................    1545-0121
                                                               1545-0122
1.904-3....................................................    1545-0121
1.904-4....................................................    1545-0121
1.904-5....................................................    1545-0121
1.904-7....................................................    1545-2104
1.904-7T...................................................    1545-2104
1.904(f)-1.................................................    1545-0121
                                                               1545-0122
1.904(f)-2.................................................    1545-0121
1.904(f)-3.................................................    1545-0121
1.904(f)-4.................................................    1545-0121
1.904(f)-5.................................................    1545-0121
1.904(f)-6.................................................    1545-0121
1.904(f)-7.................................................    1545-1127
1.905-2....................................................    1545-0122
1.905-3T...................................................    1545-1056
1.905-4T...................................................    1545-1056
1.905-5T...................................................    1545-1056
1.911-1....................................................    1545-0067
                                                               1545-0070
1.911-2....................................................    1545-0067
                                                               1545-0070
1.911-3....................................................    1545-0067
                                                               1545-0070
1.911-4....................................................    1545-0067
                                                               1545-0070
1.911-5....................................................    1545-0067
                                                               1545-0070
1.911-6....................................................    1545-0067
                                                               1545-0070
1.911-7....................................................    1545-0067
                                                               1545-0070
1.913-13...................................................    1545-0067
1.921-1T...................................................    1545-0190
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1.921-2....................................................    1545-0884
1.927(a)-1T................................................    1545-0935
1.927(d)-2T................................................    1545-0935
1.931-1....................................................    1545-0074
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1.934-1....................................................    1545-0782
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1.936-7....................................................    1545-0215
1.936-10(c)................................................    1545-1138
1.937-1....................................................    1545-1930
1.952-2....................................................    1545-0126
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1.954-1....................................................    1545-1068
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1.955A-2...................................................    1545-0755
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1.1042-1T..................................................    1545-0916
1.1044(a)-1................................................    1545-1421
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1.1092(b)-1T...............................................    1545-0644
1.1092(b)-2T...............................................    1545-0644
1.1092(b)-3T...............................................    1545-0644
1.1092(b)-4T...............................................    1545-0644
1.1092(b)-5T...............................................    1545-0644
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1.1244(e)-1................................................    1545-0123
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1.1248-7...................................................    1545-0074
1.1248(f)-2................................................    1545-2183
1.1248(f)-3T...............................................    1545-2183
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1.1252-2...................................................    1545-0184
1.1254-1(c)(3).............................................    1545-1352
1.1254-4...................................................    1545-1493
1.1254-5(d)(2).............................................    1545-1352
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1.1272-3...................................................    1545-1353
1.1273-2(f)(9).............................................    1545-1353
1.1273-2(h)(2).............................................    1545-1353
1.1274-3(d)................................................    1545-1353
1.1274-5(b)................................................    1545-1353
1.1274A-1(c)...............................................    1545-1353
1.1275-2...................................................    1545-1450
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1.1294-1T..................................................    1545-1002
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1.1298-3...................................................    1545-1507
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1.1311(a)-1................................................    1545-0074
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1.1366-1...................................................    1545-1613
1.1367-1(f)................................................    1545-1139
1.1368-1(f)(2).............................................    1545-1139
1.1368-1(f)(3).............................................    1545-1139
1.1368-1(f)(4).............................................    1545-1139
1.1368-1(g)(2).............................................    1545-1139
1.1374-1A..................................................    1545-0130
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1.1397E-1..................................................    1545-1908
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1.1402(a)-16...............................................    1545-0074
1.1402(b)-1................................................    1545-0171
1.1402(c)-2................................................    1545-0074
1.1402(e)(1)-1.............................................    1545-0074
1.1402(e)(2)-1.............................................    1545-0074
1.1402(e)-1A...............................................    1545-0168
1.1402(e)-2A...............................................    1545-0168
1.1402(e)-3A...............................................    1545-0168
1.1402(e)-4A...............................................    1545-0168
1.1402(e)-5A...............................................    1545-0168
1.1402(f)-1................................................    1545-0074
1.1402(h)-1................................................    1545-0064
1.1411-10(g)...............................................    1545-2227
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1.1502-9A..................................................    1545-0121
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1.1502.21T.................................................    1545-0123
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1.1502-76..................................................    1545-1344
1.1502-76T.................................................    1545-2019
1.1502-77..................................................    1545-1699
1.1502-77A.................................................    1545-0123
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1.1502-77B.................................................    1545-1699
1.1502-78..................................................    1545-0582
1.1502-95..................................................    1545-1218
1.1502-95A.................................................    1545-1218
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1.1503-2...................................................    1545-1583
1.1503-2A..................................................    1545-1083
1.1503(d)-1................................................    1545-1946
1.1503(d)-3................................................    1545-1946
1.1503(d)-4................................................    1545-1946
1.1503(d)-5................................................    1545-1946
1.1503(d)-6................................................    1545-1946
1.1552-1...................................................    1545-0123
1.1561-3...................................................    1545-0123
1.1563-1...................................................    1545-0123
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1.5000A-3..................................................    1545-0074
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1.5000C-2..................................................    1545-0096
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1.6015(a)-1................................................    1545-0087
1.6015(b)-1................................................    1545-0087
1.6015(d)-1................................................    1545-0087
1.6015(e)-1................................................    1545-0087
1.6015(f)-1................................................    1545-0087
1.6015(g)-1................................................    1545-0087
1.6015(h)-1................................................    1545-0087
1.6015(i)-1................................................    1545-0087
1.6017-1...................................................    1545-0074
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1.6031(a)-1................................................    1545-1583
1.6031(b)-1T...............................................    1545-0099
1.6031(c)-1T...............................................    1545-0099
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1.6038A-3..................................................    1545-1191
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1.6038B-1..................................................    1545-1617
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1.6038B-1T.................................................    1545-0026
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1.6038B-2..................................................    1545-1617
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1.6041-1...................................................    1545-0008
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1.6045-1...................................................    1545-0715
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1.6045-1(c)(3)(xi)(C)......................................    1545-2186
1.6045-1(n)(5).............................................    1545-2186
1.6045A-1..................................................    1545-2186
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1.6046A....................................................    1545-1646
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1.6050D-1..................................................    1545-0120
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1.6072-2...................................................    1545-0123
                                                               1545-0807
1.6073-1...................................................    1545-0087
1.6073-2...................................................    1545-0087
1.6073-3...................................................    1545-0087
1.6073-4...................................................    1545-0087
1.6074-1...................................................    1545-0123
1.6074-2...................................................    1545-0123
1.6081-1...................................................    1545-0066
                                                               1545-0148
                                                               1545-0233
                                                               1545-1057
                                                               1545-1081
1.6081-2...................................................    1545-0148
                                                               1545-1036
                                                               1545-1054
1.6081-3...................................................    1545-0233
1.6081-4...................................................    1545-0188
                                                               1545-1479
1.6081-6...................................................    1545-0148
                                                               1545-1054
1.6081-7...................................................    1545-0148
                                                               1545-1054
1.6091-3...................................................    1545-0089
1.6107-1...................................................    1545-0074
                                                               1545-1231
1.6109-1...................................................    1545-0074
1.6109-2...................................................    1545-2176
1.6115-1...................................................    1545-1464
1.6151-1...................................................    1545-0074
1.6153-1...................................................    1545-0087
1.6153-4...................................................    1545-0087
1.6161-1...................................................    1545-0087
1.6162-1...................................................    1545-0087
1.6164-1...................................................    1545-0135
1.6164-2...................................................    1545-0135
1.6164-3...................................................    1545-0135
1.6164-5...................................................    1545-0135
1.6164-6...................................................    1545-0135
1.6164-7...................................................    1545-0135
1.6164-8...................................................    1545-0135
1.6164-9...................................................    1545-0135
1.6302-1...................................................    1545-0257
1.6302-2...................................................    1545-0098
                                                               1545-0257
1.6411-1...................................................    1545-0098
                                                               1545-0135
                                                               1545-0582
1.6411-2...................................................    1545-0098
                                                               1545-0582
1.6411-3...................................................    1545-0098
                                                               1545-0582
1.6411-4...................................................    1545-0582
1.6414-1...................................................    1545-0096
1.6425-1...................................................    1545-0170
1.6425-2...................................................    1545-0170
1.6425-3...................................................    1545-0170
1.6654-1...................................................    1545-0087
                                                               1545-0140
1.6654-2...................................................    1545-0087
1.6654-3...................................................    1545-0087
1.6655(e)-1................................................    1545-1421
1.6662-3(c)................................................    1545-0889
1.6662-4(e) and (f)........................................    1545-0889
1.6662-6...................................................    1545-1426
1.6694-1...................................................    1545-0074
1.6694-2...................................................    1545-0074
1.6694-2(c)................................................    1545-1231
1.6694-2(c)(3).............................................    1545-1231
1.6694-3(e)................................................    1545-1231
1.6695-1...................................................    1545-0074
                                                               1545-1385
1.6696-1...................................................    1545-0074
                                                               1545-0240
1.6851-1...................................................    1545-0086
                                                               1545-0138
1.6851-2...................................................    1545-0086
                                                               1545-0138
1.7476-1...................................................    1545-0197
1.7476-2...................................................    1545-0197
1.7519-2T..................................................    1545-1036
1.7520-1...................................................    1545-1343
1.7520-2...................................................    1545-1343
1.7520-3...................................................    1545-1343
1.7520-4...................................................    1545-1343
1.7701(l)-3................................................    1545-1642
1.7872-15..................................................    1545-1792
1.9100-1...................................................    1545-0074
1.9101-1...................................................    1545-0008
2.1-4......................................................    1545-0123
2.1-5......................................................    1545-0123
2.1-6......................................................    1545-0123
2.1-10.....................................................    1545-0123
2.1-11.....................................................    1545-0123
2.1-12.....................................................    1545-0123
2.1-13.....................................................    1545-0123
2.1-20.....................................................    1545-0123
2.1-22.....................................................    1545-0123
2.1-26.....................................................    1545-0123
3.2........................................................    1545-0123
4.954-1....................................................    1545-1068
4.954-2....................................................    1545-1068
5.6411-1...................................................    1545-0042
                                                               1545-0074
                                                               1545-0098
                                                               1545-0129
                                                               1545-0172
                                                               1545-0582
                                                               1545-0619

[[Page 1160]]

 
5c.44F-1...................................................    1545-0619
5c.128-1...................................................    1545-0123
5c.305-1...................................................    1545-0110
5c.442-1...................................................    1545-0152
5f.103-1...................................................    1545-0720
5f.6045-1..................................................    1545-0715
6a.103A-2..................................................    1545-0123
                                                               1545-0720
6a.103A-3..................................................    1545-0720
7.465-1....................................................    1545-0712
7.465-2....................................................    1545-0712
7.465-3....................................................    1545-0712
7.465-4....................................................    1545-0712
7.465-5....................................................    1545-0712
7.936-1....................................................    1545-0217
7.999-1....................................................    1545-0216
7.6039A-1..................................................    1545-0015
7.6041-1...................................................    1545-0115
11.410-1...................................................    1545-0710
11.412(c)-7................................................    1545-0710
11.412(c)-11...............................................    1545-0710
12.7.......................................................    1545-0190
12.8.......................................................    1545-0191
12.9.......................................................    1545-0195
14a.422A-1.................................................    1545-0123
15A.453-1..................................................    1545-0228
16A.126-2..................................................    1545-0074
16A.1255-1.................................................    1545-0184
16A.1255-2.................................................    1545-0184
18.1371-1..................................................    1545-0130
18.1378-1..................................................    1545-0130
18.1379-1..................................................    1545-0130
18.1379-2..................................................    1545-0130
20.2010-2..................................................    1545-0015
20.2011-1..................................................    1545-0015
20.2014-5..................................................    1545-0015
                                                               1545-0260
20.2014-6..................................................    1545-0015
20.2016-1..................................................    1545-0015
20.2031-2..................................................    1545-0015
20.2031-3..................................................    1545-0015
20.2031-4..................................................    1545-0015
20.2031-6..................................................    1545-0015
20.2031-7..................................................    1545-0020
20.2031-10.................................................    1545-0015
20.2032-1..................................................    1545-0015
20.2032A-3.................................................    1545-0015
20.2032A-4.................................................    1545-0015
20.2032A-8.................................................    1545-0015
20.2039-4..................................................    1545-0015
20.2051-1..................................................    1545-0015
20.2053-3..................................................    1545-0015
20.2053-9..................................................    1545-0015
20.2053-10.................................................    1545-0015
20.2055-1..................................................    1545-0015
20.2055-2..................................................    1545-0015
                                                               1545-0092
20.2055-3..................................................    1545-0015
20.2056(b)-4...............................................    1545-0015
20.2056(b)-7...............................................    1545-0015
                                                               1545-1612
20.2056A-2.................................................    1545-1443
20.2056A-3.................................................    1545-1360
20.2056A-4.................................................    1545-1360
20.2056A-10................................................    1545-1360
20.2106-1..................................................    1545-0015
20.2106-2..................................................    1545-0015
20.2204-1..................................................    1545-0015
20.2204-2..................................................    1545-0015
20.6001-1..................................................    1545-0015
20.6011-1..................................................    1545-0015
20.6018-1..................................................    1545-0015
                                                               1545-0531
20.6018-2..................................................    1545-0015
20.6018-3..................................................    1545-0015
20.6018-4..................................................    1545-0015
                                                               1545-0022
20.6036-2..................................................    1545-0015
20.6060-1(a)(1)............................................    1545-1231
20.6061-1..................................................    1545-0015
20.6065-1..................................................    1545-0015
20.6075-1..................................................    1545-0015
20.6081-1..................................................    1545-0015
                                                               1545-0181
                                                               1545-1707
20.6091-1..................................................    1545-0015
20.6107-1..................................................    1545-1231
20.6161-1..................................................    1545-0015
                                                               1545-0181
20.6161-2..................................................    1545-0015
                                                               1545-0181
20.6163-1..................................................    1545-0015
20.6166-1..................................................    1545-0181
20.6166A-1.................................................    1545-0015
20.6166A-3.................................................    1545-0015
20.6324A-1.................................................    1545-0754
20.7520-1..................................................    1545-1343
20.7520-2..................................................    1545-1343
20.7520-3..................................................    1545-1343
20.7520-4..................................................    1545-1343
22.0.......................................................    1545-0015
25.2511-2..................................................    1545-0020
25.2512-2..................................................    1545-0020
25.2512-3..................................................    1545-0020
25.2512-5..................................................    1545-0020
25.2512-9..................................................    1545-0020
25.2513-1..................................................    1545-0020
25.2513-2..................................................    1545-0020
                                                               1545-0021
25.2513-3..................................................    1545-0020
25.2518-2..................................................    1545-0959
25.2522(a)-1...............................................    1545-0196
25.2522(c)-3...............................................    1545-0020
                                                               1545-0196
25.2523(a)-1...............................................    1545-0020
                                                               1545-0196
25.2523(f)-1...............................................    1545-0015
25.2701-2..................................................    1545-1241
25.2701-4..................................................    1545-1241
25.2701-5..................................................    1545-1273
25.2702-5..................................................    1545-1485
25.2702-6..................................................    1545-1273
25.6001-1..................................................    1545-0020
                                                               1545-0022
25.6011-1..................................................    1545-0020
25.6019-1..................................................    1545-0020
25.6019-2..................................................    1545-0020
25.6019-3..................................................    1545-0020
25.6019-4..................................................    1545-0020
25.6060-1(a)(1)............................................    1545-1231
25.6061-1..................................................    1545-0020
25.6065-1..................................................    1545-0020
25.6075-1..................................................    1545-0020
25.6081-1..................................................    1545-0020
25.6091-1..................................................    1545-0020
25.6091-2..................................................    1545-0020
25.6107-1..................................................    1545-1231
25.6151-1..................................................    1545-0020
25.6161-1..................................................    1545-0020
25.7520-1..................................................    1545-1343
25.7520-2..................................................    1545-1343
25.7520-3..................................................    1545-1343
25.7520-4..................................................    1545-1343
26.2601-1..................................................    1545-0985

[[Page 1161]]

 
26.2632-1..................................................    1545-0985
                                                               1545-1892
26.2642-1..................................................    1545-0985
26.2642-2..................................................    1545-0985
26.2642-3..................................................    1545-0985
26.2642-4..................................................    1545-0985
26.2642-6..................................................    1545-1902
26.2652-2..................................................    1545-0985
26.2654-1..................................................    1545-1902
26.2662-1..................................................    1545-0015
                                                               1545-0985
26.2662-2..................................................    1545-0985
26.6060-1(a)(1)............................................    1545-1231
26.6107-1..................................................    1545-1231
31.3102-3..................................................    1545-0029
                                                               1545-0059
                                                               1545-0065
31.3121(b)(19)-1...........................................    1545-0029
31.3121(d)-1...............................................    1545-0004
31.3121(i)-1...............................................    1545-0034
31.3121(r)-1...............................................    1545-0029
31.3121(s)-1...............................................    1545-0029
31.3121(v)(2)-1............................................    1545-1643
31.3302(a)-2...............................................    1545-0028
31.3302(a)-3...............................................    1545-0028
31.3302(b)-2...............................................    1545-0028
31.3302(e)-1...............................................    1545-0028
31.3306(c)(18)-1...........................................    1545-0029
31.3401(a)-1...............................................    1545-0029
31.3401(a)(6)..............................................    1545-1484
31.3401(a)(6)-1............................................    1545-0029
                                                               1545-0096
                                                               1545-0795
31.3401(a)(7)-1............................................    1545-0029
31.3401(a)(8)(A)-1 ........................................    1545-0029
                                                               1545-0666
31.3401(a)(8)(C)-1 ........................................    1545-0029
31.3401(a)(15)-1...........................................    1545-0182
31.3401(c)-1...............................................    1545-0004
31.3402(b)-1...............................................    1545-0010
31.3402(c)-1...............................................    1545-0010
31.3402(f)(1)-1............................................    1545-0010
31.3402(f)(2)-1............................................    1545-0010
                                                               1545-0410
31.3402(f)(3)-1............................................    1545-0010
31.3402(f)(4)-1............................................    1545-0010
31.3402(f)(4)-2............................................    1545-0010
31.3402(f)(5)-1............................................    1545-0010
                                                               1545-1435
31.3402(h)(1)-1............................................    1545-0029
31.3402(h)(3)-1............................................    1545-0010
                                                               1545-0029
31.3402(h)(4)-1............................................    1545-0010
31.3402(i)-(1).............................................    1545-0010
31.3402(i)-(2).............................................    1545-0010
31.3402(k)-1...............................................    1545-0065
31.3402(l)-(1).............................................    1545-0010
31.3402(m)-(1).............................................    1545-0010
31.3402(n)-(1).............................................    1545-0010
31.3402(o)-2...............................................    1545-0415
31.3402(o)-3...............................................    1545-0008
                                                               1545-0010
                                                               1545-0415
                                                               1545-0717
31.3402(p)-1...............................................    1545-0415
                                                               1545-0717
31.3402(q)-1...............................................    1545-0238
                                                               1545-0239
31.3404-1..................................................    1545-0029
31.3405(c)-1...............................................    1545-1341
31.3406(a)-1...............................................    1545-0112
31.3406(a)-2...............................................    1545-0112
31.3406(a)-3...............................................    1545-0112
31.3406(a)-4...............................................    1545-0112
31.3406(b)(2)-1............................................    1545-0112
31.3406(b)(2)-2............................................    1545-0112
31.3406(b)(2)-3............................................    1545-0112
31.3406(b)(2)-4............................................    1545-0112
31.3406(b)(2)-5............................................    1545-0112
31.3406(b)(3)-1............................................    1545-0112
31.3406(b)(3)-2............................................    1545-0112
31.3406(b)(3)-3............................................    1545-0112
31.3406(b)(3)-4............................................    1545-0112
31.3406(b)(4)-1............................................    1545-0112
31.3406(c)-1...............................................    1545-0112
31.3406(d)-1...............................................    1545-0112
31.3406(d)-2...............................................    1545-0112
31.3406(d)-3...............................................    1545-0112
31.3406(d)-4...............................................    1545-0112
31.3406(d)-5...............................................    1545-0112
31.3406(e)-1...............................................    1545-0112
31.3406(f)-1...............................................    1545-0112
31.3406(g)-1...............................................    1545-0096
                                                               1545-0112
                                                               1545-1819
31.3406(g)-2...............................................    1545-0112
31.3406(g)-3...............................................    1545-0112
31.3406(h)-1...............................................    1545-0112
31.3406(h)-2...............................................    1545-0112
31.3406(h)-3...............................................    1545-0112
31.3406(i)-1...............................................    1545-0112
31.3501(a)-1T..............................................    1545-0771
31.3503-1..................................................    1545-0024
31.3504-1..................................................    1545-0029
31.3511-1..................................................    1545-2266
31.6001-1..................................................    1545-0798
31.6001-2..................................................    1545-0034
                                                               1545-0798
31.6001-3..................................................    1545-0798
31.6001-4..................................................    1545-0028
31.6001-5..................................................    1545-0798
31.6001-6..................................................    1545-0029
                                                               1459-0798
31.6011(a)-1...............................................    1545-0029
                                                               1545-0034
                                                               1545-0035
                                                               1545-0059
                                                               1545-0074
                                                               1545-0256
                                                               1545-0718
                                                               1545-2097
31.6011(a)-2...............................................    1545-0001
                                                               1545-0002
31.6011(a)-3...............................................    1545-0028
31.6011(a)-3A..............................................    1545-0955
31.6011(a)-4...............................................    1545-0034
                                                               1545-0035
                                                               1545-0718
                                                               1545-1413
                                                               1545-2097
31.6011(a)-5...............................................    1545-0028
                                                               1545-0718
                                                               1545-2097
31.6011(a)-6...............................................    1545-0028
31.6011(a)-7...............................................    1545-0074
31.6011(a)-8...............................................    1545-0028
31.6011(a)-9...............................................    1545-0028
31.6011(a)-10..............................................    1545-0112
31.6011(b)-1...............................................    1545-0003
31.6011(b)-2...............................................    1545-0029
31.6051-1..................................................    1545-0008
                                                               1545-0182
                                                               1545-0458
                                                               1545-1729

[[Page 1162]]

 
31.6051-2..................................................    1545-0008
31.6051-3..................................................    1545-0008
31.6053-1..................................................    1545-0029
                                                               1545-0062
                                                               1545-0064
                                                               1545-0065
                                                               1545-1603
31.6053-2..................................................    1545-0008
31.6053-3..................................................    1545-0065
                                                               1545-0714
31.6053-4..................................................    1545-0065
                                                               1545-1603
31.6060-1(a)(1)............................................    1545-1231
31.6065(a)-1...............................................    1545-0029
31.6071(a)-1...............................................    1545-0001
                                                               1545-0028
                                                               1545-0029
31.6071(a)-1A..............................................    1545-0955
31.6081(a)-1...............................................    1545-0008
                                                               1545-0028
31.6091-1..................................................    1545-0028
                                                               1545-0029
31.6107-1..................................................    1545-1231
31.6157-1..................................................    1545-0955
31.6205-1..................................................    1545-0029
                                                               1545-2097
31.6301(c)-1AT.............................................    1545-0035
                                                               1545-0112
                                                               1545-0257
31.6302-1..................................................    1545-1413
31.6302-2..................................................    1545-1413
31.6302-3..................................................    1545-1413
31.6302-4..................................................    1545-1413
31.6302(c)-2...............................................    1545-0001
                                                               1545-0257
31.6302(c)-2A..............................................    1545-0955
31.6302(c)-3...............................................    1545-0257
31.6402(a)-2...............................................    1545-0256
                                                               1545-2097
31.6413(a)-1...............................................    1545-0029
                                                               1545-2097
31.6413(a)-2...............................................    1545-0029
                                                               1545-0256
                                                               1545-2097
31.6413(c)-1...............................................    1545-0029
                                                               1545-0171
31.6414-1..................................................    1545-0029
                                                               1545-2097
32.1.......................................................    1545-0029
                                                               1545-0415
32.2.......................................................    1545-0029
35a.3406-2.................................................    1545-0112
35a.9999-5.................................................    1545-0029
36.3121(l)(1)-1............................................    1545-0137
36.3121(l)(1)-2............................................    1545-0137
36.3121(l)(3)-1............................................    1545-0123
36.3121(1)(7)-1............................................    1545-0123
36.3121(1)(10)-1...........................................    1545-0029
36.3121(1)(10)-3...........................................    1545-0029
36.3121(1)(10)-4...........................................    1545-0257
40.6060-1(a)(1)............................................    1545-1231
40.6107-1..................................................    1545-1231
40.6302(c)-3(b)(2)(ii).....................................    1545-1296
40.6302(c)-3(b)(2)(iii)....................................    1545-1296
40.6302(c)-3(e)............................................    1545-1296
40.6302(c)-3(f)(2)(ii).....................................    1545-1296
41.4481-1..................................................    1545-0143
41.4481-2..................................................    1545-0143
41.4483-3..................................................    1545-0143
41.6001-1..................................................    1545-0143
41.6001-2..................................................    1545-0143
41.6001-3..................................................    1545-0143
41.6060-1(a)(1)............................................    1545-1231
41.6071(a)-1...............................................    1545-0143
41.6081(a)-1...............................................    1545-0143
41.6091-1..................................................    1545-0143
41.6107-1..................................................    1545-1231
41.6109-1..................................................    1545-0143
41.6151(a)-1...............................................    1545-0143
41.6156-1..................................................    1545-0143
41.6161(a)(1)-1............................................    1545-0143
44.4401-1..................................................    1545-0235
44.4403-1..................................................    1545-0235
44.4412-1..................................................    1545-0236
44.4901-1..................................................    1545-0236
44.4905-1..................................................    1545-0236
44.4905-2..................................................    1545-0236
44.6001-1..................................................    1545-0235
44.6011(a)-1...............................................    1545-0235
                                                               1545-0236
44.6060-1(a)(1)............................................    1545-1231
44.6071-1..................................................    1545-0235
44.6091-1..................................................    1545-0235
44.6107-1..................................................    1545-1231
44.6151-1..................................................    1545-0235
44.6419-1..................................................    1545-0235
44.6419-2..................................................    1545-0235
46.4371-4..................................................    1545-0023
46.4374-1..................................................    1545-0023
46.4375-1..................................................    1545-2238
46.4376-1..................................................    1545-2238
46.4701-1..................................................    1545-0023
                                                               1545-0257
48.4041-4..................................................    1545-0023
48.4041-5..................................................    1545-0023
48.4041-6..................................................    1545-0023
48.4041-7..................................................    1545-0023
48.4041-9..................................................    1545-0023
48.4041-10.................................................    1545-0023
48.4041-11.................................................    1545-0023
48.4041-12.................................................    1545-0023
48.4041-13.................................................    1545-0023
48.4041-19.................................................    1545-0023
48.4041-20.................................................    1545-0023
48.4041-21.................................................    1545-1270
48.4042-2..................................................    1545-0023
48.4052-1..................................................    1545-1418
48.4061(a)-1...............................................    1545-0023
48.4061(a)-2...............................................    1545-0023
48.4061(b)-3...............................................    1545-0023
48.4064-1..................................................    1545-0014
                                                               1545-0242
48.4071-1..................................................    1545-0023
48.4073-1..................................................    1545-0023
48.4073-3..................................................    1545-0023
                                                               1545-1074
                                                               1545-1087
48.4081-2..................................................    1545-1270
                                                               1545-1418
48.4081-3..................................................    1545-1270
                                                               1545-1418
                                                               1545-1897
48.4081-4(b)(2)(ii)........................................    1545-1270
48.4081-4(b)(3)(i).........................................    1545-1270
48.4081-4(c)...............................................    1545-1270
48.4081-6(c)(1)(ii)........................................    1545-1270
48.4081-7..................................................    1545-1270
                                                               1545-1418
48.4082-1T.................................................    1545-1418
48.4082-2..................................................    1545-1418
48.4082-6..................................................    1545-1418
48.4082-7..................................................    1545-1418
48.4101-1..................................................    1545-1418
48.4101-1T.................................................    1545-1418

[[Page 1163]]

 
48.4101-2..................................................    1545-1418
48.4161(a)-1...............................................    1545-0723
48.4161(a)-2...............................................    1545-0723
48.4161(a)-3...............................................    1545-0723
48.4161(b)-1...............................................    1545-0723
48.4216(a)-2...............................................    1545-0023
48.4216(a)-3...............................................    1545-0023
48.4216(c)-1...............................................    1545-0023
48.4221-1..................................................    1545-0023
48.4221-2..................................................    1545-0023
48.4221-3..................................................    1545-0023
48.4221-4..................................................    1545-0023
48.4221-5..................................................    1545-0023
48.4221-6..................................................    1545-0023
48.4221-7..................................................    1545-0023
48.4222(a)-1...............................................    1545-0014
                                                               1545-0023
48.4223-1..................................................    1545-0023
                                                               1545-0257
                                                               1545-0723
48.6302(c)-1...............................................    1545-0023
                                                               1545-0257
48.6412-1..................................................    1545-0723
48.6416(a)-1...............................................    1545-0023
                                                               1545-0723
48.6416(a)-2...............................................    1545-0723
48.6416(a)-3...............................................    1545-0723
48.6416(b)(1)-1............................................    1545-0723
48.6416(b)(1)-2............................................    1545-0723
48.6416(b)(1)-3............................................    1545-0723
48.6416(b)(1)-4............................................    1545-0723
48.6416(b)(2)-1............................................    1545-0723
48.6416(b)(2)-2............................................    1545-0723
48.6416(b)(2)-3............................................    1545-0723
                                                               1545-1087
48.6416(b)(2)-4............................................    1545-0723
48.6416(b)(3)-1............................................    1545-0723
48.6416(b)(3)-2............................................    1545-0723
48.6416(b)(3)-3............................................    1545-0723
48.6416(b)(4)-1............................................    1545-0723
48.6416(b)(5)-1............................................    1545-0723
48.6416(c)-1...............................................    1545-0723
48.6416(e)-1...............................................    1545-0023
                                                               1545-0723
48.6416(f)-1...............................................    1545-0023
                                                               1545-0723
48.6416(g)-1...............................................    1545-0723
48.6416(h)-1...............................................    1545-0723
48.6420(c)-2...............................................    1545-0023
48.6420(f)-1...............................................    1545-0023
48.6420-1..................................................    1545-0162
                                                               1545-0723
48.6420-2..................................................    1545-0162
                                                               1545-0723
48.6420-3..................................................    1545-0162
                                                               1545-0723
48.6420-4..................................................    1545-0162
                                                               1545-0723
48.6420-5..................................................    1545-0162
                                                               1545-0723
48.6420-6..................................................    1545-0162
                                                               1545-0723
48.6421-0..................................................    1545-0162
                                                               1545-0723
48.6421-1..................................................    1545-0162
                                                               1545-0723
48.6421-2..................................................    1545-0162
                                                               1545-0723
48.6421-3..................................................    1545-0162
                                                               1545-0723
48.6421-4..................................................    1545-0162
                                                               1545-0723
48.6421-5..................................................    1545-0162
                                                               1545-0723
48.6421-6..................................................    1545-0162
                                                               1545-0723
48.6421-7..................................................    1545-0162
                                                               1545-0723
48.6424-0..................................................    1545-0723
48.6424-1..................................................    1545-0723
48.6424-2..................................................    1545-0723
48.6424-3..................................................    1545-0723
48.6424-4..................................................    1545-0723
48.6424-5..................................................    1545-0723
48.6424-6..................................................    1545-0723
48.6427-0..................................................    1545-0723
48.6427-1..................................................    1545-0023
                                                               1545-0162
                                                               1545-0723
48.6427-2..................................................    1545-0162
                                                               1545-0723
48.6427-3..................................................    1545-0723
48.6427-4..................................................    1545-0723
48.6427-5..................................................    1545-0723
48.6427-8..................................................    1545-1418
48.6427-9..................................................    1545-1418
48.6427-10.................................................    1545-1418
48.6427-11.................................................    1545-1418
49.4251-1..................................................    1545-1075
49.4251-2..................................................    1545-1075
49.4251-4(d)(2)............................................    1545-1628
49.4253-3..................................................    1545-0023
49.4253-4..................................................    1545-0023
49.4264(b)-1...............................................    1545-0023
                                                               1545-0224
                                                               1545-0225
                                                               1545-0226
                                                               1545-0230
                                                               1545-0257
                                                               1545-0912
49.4271-1(d)...............................................    1545-0685
49.5000B-1.................................................    1545-2177
51.2(f)(2)(ii).............................................    1545-2209
51.7.......................................................    1545-2209
52.4682-1(b)(2)(iii).......................................    1545-1153
52.4682-2(b)...............................................    1545-1153
                                                               1545-1361
52.4682-2(d)...............................................    1545-1153
                                                               1545-1361
52.4682-3(c)(2)............................................    1545-1153
52.4682-3(g)...............................................    1545-1153
52.4682-4(f)...............................................    1545-0257
                                                               1545-1153
52.4682-5(d)...............................................    1545-1361
52.4682-5(f)...............................................    1545-1361
53.4940-1..................................................    1545-0052
                                                               1545-0196
53.4942(a)-1...............................................    1545-0052
53.4942(a)-2...............................................    1545-0052
53.4942(a)-3...............................................    1545-0052
53.4942(b)-3...............................................    1545-0052
53.4945-1..................................................    1545-0052
53.4945-4..................................................    1545-0052
53.4945-5..................................................    1545-0052
53.4945-6..................................................    1545-0052
53.4947-1..................................................    1545-0196
53.4947-2..................................................    1545-0196
53.4948-1..................................................    1545-0052
53.4958-6..................................................    1545-1623
53.4961-2..................................................    1545-0024
53.4963-1..................................................    1545-0024
53.6001-1..................................................    1545-0052
53.6011-1..................................................    1545-0049
                                                               1545-0052

[[Page 1164]]

 
                                                               1545-0092
                                                               1545-0196
53.6060-1(a)(1)............................................    1545-1231
53.6065-1..................................................    1545-0052
53.6071-1..................................................    1545-0049
53.6081-1..................................................    1545-0066
                                                               1545-0148
53.6107-1..................................................    1545-1231
53.6161-1..................................................    1545-0575
54.4975-7..................................................    1545-0575
54.4977-1T.................................................    1545-0771
54.4980B-6.................................................    1545-1581
54.4980B-7.................................................    1545-1581
54.4980B-8.................................................    1545-1581
54.4980F-1.................................................    1545-1780
54.6011-1..................................................    1545-0575
54.6011-1T.................................................    1545-0575
54.6060-1(a)(1)............................................    1545-1231
54.6107-1..................................................    1545-1231
54.9801-3..................................................    1545-1537
54.9801-4..................................................    1545-1537
54.9801-5..................................................    1545-1537
54.9801-6..................................................    1545-1537
54.9812-1T.................................................    1545-2165
54.9815-1251T..............................................    1545-2178
54.9815-2711T..............................................    1545-2179
54.9815-2712T..............................................    1545-2180
54.9815-2714T..............................................    1545-2172
54.9815-2715...............................................    1545-2229
54.9815-2719AT.............................................    1545-2181
54.9815-2719T..............................................    1545-2182
55.6001-1..................................................    1545-0123
55.6011-1..................................................    1545-0123
                                                               1545-0999
                                                               1545-1016
55.6060-1(a)(1)............................................    1545-1231
55.6061-1..................................................    1545-0999
55.6071-1..................................................    1545-0999
55.6107-1..................................................    1545-1231
56.4911-6..................................................    1545-0052
56.4911-7..................................................    1545-0052
56.4911-9..................................................    1545-0052
56.4911-10.................................................    1545-0052
56.6001-1..................................................    1545-1049
56.6011-1..................................................    1545-1049
56.6060-1(a)(1)............................................    1545-1231
56.6081-1..................................................    1545-1049
56.6107-1..................................................    1545-1231
56.6161-1..................................................    1545-0257
                                                               1545-1049
57.2(e)(2)(i)..............................................    1545-2249
145.4051-1.................................................    1545-0745
145.4052-1.................................................    1545-0120
                                                               1545-0745
                                                               1545-1076
145.4061-1.................................................    1545-0224
                                                               1545-0230
                                                               1545-0257
                                                               1545-0745
156.6001-1.................................................    1545-1049
156.6011-1.................................................    1545-1049
156.6060-1(a)(1)...........................................    1545-1231
156.6081-1.................................................    1545-1049
156.6107-1.................................................    1545-1231
156.6161-1.................................................    1545-1049
157.6001-1.................................................    1545-1824
157.6011-1.................................................    1545-1824
157.6060-1(a)(1)...........................................    1545-1231
157.6081-1.................................................    1545-1824
157.6107-1.................................................    1545-1231
157.6161-1.................................................    1545-1824
301.6011-2.................................................    1545-0225
                                                               1545-0350
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
301.6011(g)-1..............................................    1545-2079
301.6017-1.................................................    1545-0090
301.6034-1.................................................    1545-0092
301.6036-1.................................................    1545-0013
                                                               1545-0773
301.6047-1.................................................    1545-0367
                                                               1545-0957
301.6056-1.................................................    1545-2251
301.6056-2.................................................    1545-2251
301.6057-1.................................................    1545-0710
301.6057-2.................................................    1545-0710
301.6058-1.................................................    1545-0710
301.6059-1.................................................    1545-0710
301.6103(c)-1..............................................    1545-1816
301.6103(n)-1..............................................    1545-1841
301.6103(p)(2)(B)-1........................................    1545-1757
301.6104(a)-1..............................................    1545-0495
301.6104(a)-5..............................................    1545-0056
301.6104(a)-6..............................................    1545-0056
301.6104(b)-1..............................................    1545-0094
                                                               1545-0742
301.6104(d)-1..............................................    1545-1655
301.6104(d)-2..............................................    1545-1655
301.6104(d)-3..............................................    1545-1655
301.6109-1.................................................    1545-0003
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
                                                               1545-1461
                                                               1545-2242
301.6109-3.................................................    1545-1564
301.6110-3.................................................    1545-0074
301.6110-5.................................................    1545-0074
301.6111-1T................................................    1545-0865
                                                               1545-0881
301.6111-2.................................................    1545-0865
                                                               1545-1687
301.6112-1.................................................    1545-0865
                                                               1545-1686
301.6112-1T................................................    1545-0865
                                                               1545-1686
301.6114-1.................................................    1545-1126
                                                               1545-1484
301.6222(a)-2..............................................    1545-0790
301.6222(b)-1..............................................    1545-0790
301.6222(b)-2..............................................    1545-0790
301.6222(b)-3..............................................    1545-0790
301.6223(b)-1..............................................    1545-0790
301.6223(c)-1..............................................    1545-0790
301.6223(e)-2..............................................    1545-0790
301.6223(g)-1..............................................    1545-0790
301.6223(h)-1..............................................    1545-0790
301.6224(b)-1..............................................    1545-0790
301.6224(c)-1..............................................    1545-0790
301.6224(c)-3..............................................    1545-0790
301.6227(c)-1..............................................    1545-0790
301.6227(d)-1..............................................    1545-0790
301.6229(b)-2..............................................    1545-0790
301.6230(b)-1..............................................    1545-0790
301.6230(e)-1..............................................    1545-0790
301.6231(a)(1)-1...........................................    1545-0790
301.6231(a)(7)-1...........................................    1545-0790
301.6231(c)-1..............................................    1545-0790
301.6231(c)-2..............................................    1545-0790
301.6316-4.................................................    1545-0074
301.6316-5.................................................    1545-0074
301.6316-6.................................................    1545-0074

[[Page 1165]]

 
301.6316-7.................................................    1545-0029
301.6324A-1................................................    1545-0015
301.6361-1.................................................    1545-0024
                                                               1545-0074
301.6361-2.................................................    1545-0024
301.6361-3.................................................    1545-0074
301.6402-2.................................................    1545-0024
                                                               1545-0073
                                                               1545-0091
301.6402-3.................................................    1545-0055
                                                               1545-0073
                                                               1545-0091
                                                               1545-0132
                                                               1545-1484
301.6402-5.................................................    1545-0928
301.6404-1.................................................    1545-0024
301.6404-2T................................................    1545-0024
301.6404-3.................................................    1545-0024
301.6405-1.................................................    1545-0024
301.6501(c)-1..............................................    1545-1241
                                                               1545-1637
301.6501(d)-1..............................................    1545-0074
                                                               1545-0430
301.6511(d)-1..............................................    1545-0024
                                                               1545-0582
301.6511(d)-2..............................................    1545-0024
                                                               1545-0582
301.6511(d)-3..............................................    1545-0024
                                                               1545-0582
301.6652-2.................................................    1545-0092
301.6685-1.................................................    1545-0092
301.6689-1T................................................    1545-1056
301.6707-1T................................................    1545-0865
                                                               1545-0881
301.6708-1T................................................    1545-0865
301.6712-1.................................................    1545-1126
301.6903-1.................................................    1545-0013
                                                               1545-1783
301.6905-1.................................................    1545-0074
301.7001-1.................................................    1545-0123
301.7101-1.................................................    1545-1029
301.7207-1.................................................    1545-0092
301.7216-2.................................................    1545-0074
301.7216-2(o)..............................................    1545-1209
301.7425-3.................................................    1545-0854
301.7430-2(c)..............................................    1545-1356
301.7502-1.................................................    1545-1899
301.7507-8.................................................    1545-0123
301.7507-9.................................................    1545-0123
301.7513-1.................................................    1545-0429
301.7517-1.................................................    1545-0015
301.7605-1.................................................    1545-0795
301.7623-1.................................................    1545-0409
                                                               1545-1534
301.7654-1.................................................    1545-0803
301.7701-3.................................................    1545-1486
301.7701-4.................................................    1545-1465
301.7701-7.................................................    1545-1600
301.7701-16................................................    1545-0795
301.7701(b)-1..............................................    1545-0089
301.7701(b)-2..............................................    1545-0089
301.7701(b)-3..............................................    1545-0089
301.7701(b)-4..............................................    1545-0089
301.7701(b)-5..............................................    1545-0089
301.7701(b)-6..............................................    1545-0089
301.7701(b)-7..............................................    1545-0089
                                                               1545-1126
301.7701(b)-9..............................................    1545-0089
301.7705-1.................................................    1545-2266
301.7705-2.................................................    1545-2266
301.7805-1.................................................    1545-0805
301.9000-5.................................................    1545-1850
301.9001-1.................................................    1545-0220
301.9100-2.................................................    1545-1488
301.9100-3.................................................    1545-1488
301.9100-4T................................................    1545-0016
                                                               1545-0042
                                                               1545-0074
                                                               1545-0129
                                                               1545-0172
                                                               1545-0619
301.9100-6T................................................    1545-0872
301.9100-7T................................................    1545-0982
301.9100-8.................................................    1545-1112
301.9100-11T...............................................    1545-0123
301.9100-12T...............................................    1545-0026
                                                               1545-0074
                                                               1545-0172
                                                               1545-1027
301.9100-14T...............................................    1545-0046
301.9100-15T...............................................    1545-0046
301.9100-16T...............................................    1545-0152
302.1-7....................................................    1545-0024
305.7701-1.................................................    1545-0823
305.7871-1.................................................    1545-0823
420.0-1....................................................    1545-0710
Part 509...................................................    1545-0846
Part 513...................................................    1545-0834
Part 514...................................................    1545-0845
Part 521...................................................    1545-0848
601.104....................................................    1545-0233
601.105....................................................    1545-0091
601.201....................................................    1545-0019
                                                               1545-0819
601.204....................................................    1545-0152
601.401....................................................    1545-0257
601.504....................................................    1545-0150
601.601....................................................    1545-0800
601.602....................................................    1545-0295
                                                               1545-0387
                                                               1545-0957
601.702....................................................    1545-0429
------------------------------------------------------------------------


[T.D. 8011, 50 FR 10222, Mar. 14, 1985]

    Editorial Note: For Federal Register citations affecting Sec.  
602.101, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.

[[Page 1167]]



List of CFR Sections Affected



All changes in this volume of the Code of Federal Regulations (CFR) that 
were made by documents published in the Federal Register since January 
1, 2018 are enumerated in the following list. Entries indicate the 
nature of the changes effected. Page numbers refer to Federal Register 
pages. The user should consult the entries for chapters, parts and 
subparts as well as sections for revisions.
For changes to this volume of the CFR prior to this listing, consult the 
annual edition of the monthly List of CFR Sections Affected (LSA). The 
LSA is available at www.govinfo.gov. For changes to this volume of the 
CFR prior to 2001, see the ``List of CFR Sections Affected, 1949-1963, 
1964-1972, 1973-1985, and 1986-2000'' published in 11 separate volumes. 
The ``List of CFR Sections Affected 1986-2000'' is available at 
www.govinfo.gov.

                                  2018

26 CFR
                                                                   83 FR
                                                                    Page
Chapter I
1.170-0 Removed....................................................36421
1.170-1 Removed....................................................36421
1.170-2 Removed....................................................36421
1.170A-1 (a) and (k) amended.......................................36421
1.170A-1 (a) amended...............................................45827
1.170A-13 Heading revised..........................................36422
1.170A-14 (i) and (j) revised......................................36422
1.170A-15 Added....................................................36422
1.170A-16 Added....................................................36423
1.170A-17 Added....................................................36425
1.170A-18 Added....................................................36427
1.263A-0 Amended...................................................58485
1.263A-1 (c)(1), (f)(1), (3)(i)(C), and (ii)(B) amended; (d)(2), 
        (3), and (h)(9) revised; (d)(5), (6), and (l)(5) added.....58487
1.263A-2 (a)(5) revised; (b)(4)(v) redesignated as (b)(4)(v)(A); 
        (c) through (f) redesignated as (d) through (g); new 
        (b)(4)(v)(A) heading, (B), new (c), and (g)(3) added.......58491
1.263A-3 (a)(4)(i) revised; (d)(4)(v) redesignated as 
        (d)(4)(v)(A); new (d)(4)(v)(A) heading and (B) added.......58498
1.263A-7 (b)(2)(iii)(A)(2)(ii) revised.............................58498
1.280C-4 (b)(2), (c)(2) and (3) revised; eff. 4-2-18...............13185
1.280C-4T Removed; eff. 4-2-18.....................................13185

                                  2019

26 CFR
                                                                   84 FR
                                                                    Page
Chapter I
1.170A-1 (h)(3), (4), (5) redesignated as (h)(4), (5), (6); new 
        (h)(3) added...............................................27530
1.170A-13 (f)(7) amended...........................................27530
1.177-1 Removed.....................................................9233
1.178-2 Removed.....................................................9233
1.178-3 Removed.....................................................9233
1.179-4 (c)(2) revised.............................................50149
1.179-6 (a) amended; (e) added.....................................50149
1.179A-1 Removed....................................................9233
1.199A-0 Added......................................................2988
    Amended........................................................15954
1.199A-1 Added......................................................2989
    (b)(10) and (d)(4)(xi)(B) amended..............................15954
1.199A-2 Added......................................................2995
    (b)(2)(iii)(A) amended.........................................15955
1.199A-3 Added......................................................3000
1.199A-4 Added......................................................3002
    (c)(3), (4)(ii), and (d)(15)(ii) amended.......................15955
1.199A-5 Added......................................................3006
    (b)(3)(xiv) and (d)(3)(iii)(B) amended.........................15955
1.199A-6 Added......................................................3012
1.244-1 Removed.....................................................9233

[[Page 1168]]

1.244-2 Removed.....................................................9233
1.245A-5T Added (temporary)........................................28413
    (c)(3)(i)(B), (iv), (e)(3)(i)(C)(1), (2), (D), and (ii) 
amended............................................................38866
1.274-6T (a)(3)(i)(E), (F), (ii) introductory text, (E), (F), 
        (b)(1), (3), (e)(3), and (4) amended........................9233

                                  2020

26 CFR
                                                                   85 FR
                                                                    Page
Chapter I
1.170A-1 (c)(5), (h)(2)(i)(B), and (3)(iii) revised; (h)(1) 
        introductory text amended; (h)(3)(viii) and (4) through 
        (6) redesignated as (h)(3)(x) and (5) through (7); 
        (h)(3)(viii), (ix), and new (4) added......................48474
1.170A-9 (f)(7)(v) and (k)(3) added................................77978
1.170A-13 (f)(7) amended...........................................48474
1.197-2 (h)(12)(vii)(C) and (l)(5) revised..........................3838
1.197-2T Removed....................................................3838
1.199A-0 Table amended.............................................38065
1.199A-3 (b)(1)(iv) revised; (d), (e)(2)(iii), and (iv) added......38065
1.199A-6 (d)(3)(iii), (v), (e)(2)(iii), and (iv) added.............38067
1.245A-5 Correction: (e)(3)(i)(A) and (j)(10)(ii) amended; (i)(8) 
        and (9) revised............................................72564
1.245A-5 Added.....................................................53083
1.245A-5 Correction: amended.......................................60358
1.245A-5 (c)(3)(i)(A) amended; (j)(8)(ii) revised..................76963
1.245A-5T Removed..................................................53096
1.245A-6 Added.....................................................76963
1.245A-7 Added.....................................................76963
1.245A-8 Added.....................................................76963
1.245A-9 Added.....................................................76963
1.245A-10 Added....................................................76963
1.245A-11 Added....................................................76963
1.245A(e)-1 Added..................................................19830
1.245A(e)-1 Table amended..........................................53096
1.245A(e)-1 (d)(4)(i)(B), (ii), (g)(1)(v), and (h)(2) added; (g) 
        introductory text amended..................................72031
1.245A-1T Removed..................................................53096
1.245A-2T Removed..................................................53096
1.245A-3T Removed..................................................53096
1.245A-4T Removed..................................................53096
1.250-0 Added......................................................43080
1.250-0 Correction: Amended........................................60910
1.250(b)-2 Correction: (d)(4)(ii)(C) amended.......................60910
1.250(b)-4 Correction: (d)(2)(iv)(B)(13) heading revised...........60910
1.250(b)-4 (d)(1)(ii)(D), (2)(ii)(A), and (iv)(B)(10)(ii) amended 
                                                                   68249
1.250(b)-5 Correction: (e)(2)(iii) amended.........................60910
1.250(b)-5 (c)(1), (e)(2)(iii), (5)(ii)(F)(1), and (2).............68249
1.250(b)-6 Correction: (d)(4)(ii)(B)(2)(i) and(C)(2)(i) amended....60910
1.250(b)-6 (c)(3) amended..........................................68250
1.250-1 Added......................................................43080
1.250-1 (b) amended................................................68249
1.250(a)-1 Added...................................................43080
1.250(b)-1 Added...................................................43080
1.250(b)-2 Added...................................................43080
1.250(b)-3 Added...................................................43080
1.250(b)-4 Added...................................................43080
1.250(b)-5 Added...................................................43080
1.250(b)-6 Added...................................................43080
1.263A-9 (g)(1)(i) amended.........................................56832
1.263A-15 (a)(4) added.............................................56832
1.267 (a)-3 (c)(2) and (d) amended; (c)(4) revised.................59430
1.267A-1 Added.....................................................19836
1.267A-5 Correction: (a)(20)(ii) revised...........................48651
1.267A-7 Correction: (a) revised...................................48651
1.267A-2 Added.....................................................19836
1.267A-3 Added.....................................................19836
1.267A-4 Added.....................................................19836
1.267A-5 Added.....................................................19836
1.267A-6 Added.....................................................19836
1.267A-7 Added.....................................................19836
1.274-11 Added.....................................................64033
1.274-12 Added.....................................................64035
1.274-13 Added.....................................................81402
1.274-14 Added.....................................................81408

                                  2021

26 CFR
                                                                   86 FR
                                                                    Page
Chapter I
1.199-0 Removed.....................................................5569
1.199-1 Removed.....................................................5569
1.199-2 Removed.....................................................5569
1.199-3 Removed.....................................................5569
1.199-4 Removed.....................................................5569
1.199-5 Removed.....................................................5569
1.199-6 Removed.....................................................5569
1.199-7 Removed.....................................................5569
1.199A-7 Added......................................................5569

[[Page 1169]]

1.199A-8 Added......................................................5569
1.199A-9 Added......................................................5569
1.199A-10 Added.....................................................5569
1.199A-11 Added.....................................................5569
1.199A-12 Added.....................................................5569
1.199-8 Removed.....................................................5569
1.199-9 Removed.....................................................5569
1.250-1 (b) amended................................................52972
1.250(b)-2 (e)(2) amended..........................................52972
1.263A-0 Amended.....................................................264
1.263A-0 Correction: Table amended.................................32185
1.263A-1 (a)(2) heading, (b)(1) revised; (a)(2)(i) and 
        (d)(3)(ii)(B)(1) amended; (j) through (l) redesignated as 
        (k) through (m); new (j) and (m)(6) added....................265
1.263A-2 (a) introductory text amended; (a)(1)(ii)(C), (g) 
        heading, and (4) added.......................................266
1.263A-3 (a)(1), (3), and (4)(ii) amended; (a)(2)(ii), (iii), and 
        (f) revised; (a)(5) added; (b) removed.......................266
1.263A-4 (a)(1), (2)(ii)(A)(1), (d)(1), and (3)(i) amended; 
        (a)(3), (4), (d)(5), and (f) redesignated as (a)(4), (5), 
        (d)(7), and (g); new (a)(3), new (d)(5), new (6), (e)(5), 
        and new (f) added; (d) heading, (3)(ii), new (g) heading, 
        new (g)(1) heading, and new (2) revised......................267
1.263A-4 Correction: (a)(1), (4), and (5)(iii) amended.............32186
1.263A-7 (a)(4) redesignated as (a)(4)(i); (a)(4) heading and (ii) 
        added; (a)(3)(i) and new (4)(i) heading revised; (b)(1) 
        and (2)(ii) amended..........................................268
1.263A-8 (a)(1) amended..............................................268
1.263A-9 (e)(2) amended..............................................268
1.263A-15 (a)(4) added...............................................268
1.263A-15 Correction: (a)(5) added.................................32186
1.274-13 Correction: (d)(2)(ii)(A) and (f)(8)(iv) amended..........22345

                                  2022

26 CFR
                                                                   87 FR
                                                                    Page
Chapter I
1.199A-7 Correction: (c)(1), (2) introductory text, (3), (d)(1), 
        and (3)(i) amended; (c)(2)(ii) and (iii) revised; 
        (d)(3)(ii)(B)(i2) redesignated as (d)(3)(ii)(B)(2).........68898
1.199A-8 Correction: (d)(1) heading added; (d)(2)(i), (3), 
        (e)(3)(ii), (4)(ii), (6)(i), (ii), (7)(i), (ii), (8)(i), 
        (ii), and (f) amended......................................68899
1.199A-9 Correction: (c)(3)(ii) amended; (j)(3)(i)(B)(1) 
        introductory text, (i), (ii), (2) introductory text, (i), 
        (ii), (3) introductory text, (i) through (iii), (4) 
        introductory text, (i), (ii), and (5) redesignated as 
        (j)(3)(i)(B)(1) introductory text, (i), (ii), (2) 
        introductory text, (i), (ii), (3) introductory text, (i) 
        through (iii), (4) introductory text, (i), (ii), and (5); 
        new (j)(3)(i)(B)(1)(ii) revised............................68899
1.199A-12 Correction: (e)(i) and (ii) redesignated as (e)(1) and 
        (2); new (e)(2)(A) and (B) redesignated as (e)(2)(i) and 
        (ii); new (e)(2)(ii) amended...............................68900
1.245A(d)-1 Added....................................................317
1.245A(d)-1 Correction: (c)(26), (d)(4)(i), (ii)(B)(2), and 
        (6)(ii)(B) amended; (d)(6)(i) revised......................45018
1.245A(e)-1 (b)(1)(ii), (c)(1)(iii), (g)(1)(ii) introductory text, 
        (iii) introductory text, and (2)(ii) introductory text 
        amended......................................................324
1.250(b)-1 (c)(7) amended............................................324
1.250(b)-5 (c)(5) revised............................................324

                                  2023

  (No regulations published from January 1, 2023 through April 1, 2023)


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