[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2024 Edition]
[From the U.S. Government Publishing Office]
[[Page i]]
Title 26
Internal Revenue
________________________
Part 1 (Sec. Sec. 1.501 to 1.640)
Revised as of April 1, 2024
Containing a codification of documents of general
applicability and future effect
As of April 1, 2024
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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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........................ 589
Alphabetical List of Agencies Appearing in the CFR...... 609
Table of OMB Control Numbers............................ 619
List of CFR Sections Affected........................... 637
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Cite this Code: CFR
To cite the regulations in
this volume use title,
part and section number.
Thus, 26 CFR 1.501(a)-1
refers to title 26, part
1, section 501(a)-1.
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[[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
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HOW TO USE THE CODE OF FEDERAL REGULATIONS
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To determine whether a Code volume has been amended since its
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EFFECTIVE AND EXPIRATION DATES
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OMB CONTROL NUMBERS
The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires
Federal agencies to display an OMB control number with their information
collection request.
[[Page vi]]
Many agencies have begun publishing numerous OMB control numbers as
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PAST PROVISIONS OF THE CODE
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``[RESERVED]'' TERMINOLOGY
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INCORPORATION BY REFERENCE
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This material, like any other properly issued regulation, has the force
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Federal Register will approve an incorporation by reference only when
the requirements of 1 CFR part 51 are met. Some of the elements on which
approval is based are:
(a) The incorporation will substantially reduce the volume of
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(b) The matter incorporated is in fact available to the extent
necessary to afford fairness and uniformity in the administrative
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(c) The incorporating document is drafted and submitted for
publication in accordance with 1 CFR part 51.
What if the material incorporated by reference cannot be found? If
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CFR INDEXES AND TABULAR GUIDES
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this volume.
An index to the text of ``Title 3--The President'' is carried within
that volume.
[[Page vii]]
The Federal Register Index is issued monthly in cumulative form.
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the revision dates of the 50 CFR titles.
REPUBLICATION OF MATERIAL
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INQUIRIES
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The eCFR is a regularly updated, unofficial editorial compilation of
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available at www.ecfr.gov.
Oliver A. Potts,
Director,
Office of the Federal Register
April 1, 2024
[[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, 2024. 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, Christine Colaninno was Chief Editor. The Code of
Federal Regulations publication program is under the direction of John
Hyrum Martinez, assisted by Stephen J. Frattini.
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TITLE 26--INTERNAL REVENUE
(This book contains part 1, Sec. Sec. 1.501 to 1.640)
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Part
chapter i--Internal Revenue Service, Department of the
Treasury (Continued)...................................... 1
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CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
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SUBCHAPTER A--INCOME TAX (CONTINUED)
Part Page
1 Income taxes (Continued).................... 5
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SUBCHAPTER A_INCOME TAX (CONTINUED)
PART 1_INCOME TAXES (CONTINUED)--Table of Contents
Normal Taxes and Surtaxes (Continued)
Exempt Organizations
General Rule
Sec.
1.501(a)-1 Exemption from taxation.
1.501(c)(2)-1 Corporations organized to hold title to property for
exempt organizations.
1.501(c)(3)-1 Organizations organized and operated for religious,
charitable, scientific, testing for public safety, literary,
or educational purposes, or for the prevention of cruelty to
children or animals.
1.501(c)(4)-1 Civic organizations and local associations of employees.
1.501(c)(5)-1 Labor, agricultural, and horticultural organizations.
1.501(c)(6)-1 Business leagues, chambers of commerce, real estate
boards, and boards of trade.
1.501(c)(7)-1 Social clubs.
1.501(c)(8)-1 Fraternal beneficiary societies.
1.501(c)(9)-1 Voluntary employees' beneficiary associations, in general.
1.501(c)(9)-2 Membership in a voluntary employees' beneficiary
association; employees; voluntary association of employees.
1.501(c)(9)-3 Voluntary employees' beneficiary associations; life, sick,
accident, or other benefits.
1.501(c)(9)-4 Voluntary employees' beneficiary associations; inurement.
1.501(c)(9)-5 Voluntary employees' beneficiary associations;
recordkeeping requirements.
1.501(c)(9)-6 Voluntary employees' beneficiary associations; benefits
includible in gross income.
1.501(c)(9)-7 Voluntary employees' beneficiary associations; section
3(4) of ERISA.
1.501(c)(9)-8 Voluntary employees' beneficiary associations; effective
date.
1.501(c)(10)-1 Certain fraternal beneficiary societies.
1.501(c)(12)-1 Local benevolent life insurance associations, mutual
irrigation and telephone companies, and like organizations.
1.501(c)(13)-1 Cemetery companies and crematoria.
1.501(c)(14)-1 Credit unions and mutual insurance funds.
1.501(c)(15)-1 Mutual insurance companies or associations.
1.501(c)(16)-1 Corporations organized to finance crop operations.
1.501(c)(17)-1 Supplemental unemployment benefit trusts.
1.501(c)(17)-2 General rules.
1.501(c)(17)-3 Relation to other sections of the Code.
1.501(c)(18)-1 Certain funded pension trusts.
1.501(c)(19)-1 War veterans organizations.
1.501(c)(21)-1 Black lung trusts--certain terms.
1.501(c)(21)-2 Same--trust instrument.
1.501(c)(29)-1 CO-OP Health Insurance Issuers.
1.501(d)-1 Religious and apostolic associations or corporations.
1.501(e)-1 Cooperative hospital service organizations.
1.501(h)-1 Application of the expenditure test to expenditures to
influence legislation; introduction.
1.501(h)-2 Electing the expenditure test.
1.501(h)-3 Lobbying or grass roots expenditures normally in excess of
ceiling amount.
1.501(r)-0 Outline of regulations.
1.501(r)-1 Definitions.
1.501(r)-2 Failures to satisfy section 501(r).
1.501(r)-3 Community health needs assessments.
1.501(r)-4 Financial assistance policy and emergency medical care
policy.
1.501(r)-5 Limitation on charges.
1.501(r)-6 Billing and collection.
1.501(r)-7 Effective/applicability dates.
1.502-1 Feeder organizations.
1.503(a)-1 Denial of exemption to certain organizations engaged in
prohibited transactions.
1.503(b)-1 Prohibited transactions.
1.503(c)-1 Future status of organizations denied exemption.
1.503(d)-1 Cross references.
1.503(e)-1 Special rules.
1.503(e)-2 Requirements.
1.503(e)-3 Effective dates.
1.503(f)-1 Loans by employers who are prohibited from pledging assets.
1.504-1 Attempts to influence legislation; certain organizations
formerly described in section 501(c)(3) denied exemption.
1.504-2 Certain transfers made to avoid section 504(a).
1.505(c)-1T Questions and answers relating to the notification
requirement for recognition of exemption under paragraphs (9),
(17) and (20) of Section 501(c) (temporary).
1.506-1 Organizations required to notify Commissioner of intent to
operate under section 501(c)(4).
Private Foundations
1.507-1 General rule.
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1.507-2 Special rules; transfer to, or operation as, public charity.
1.507-3 Special rules; transferee foundations.
1.507-4 Imposition of tax.
1.507-5 Aggregate tax benefit; in general.
1.507-6 Substantial contributor defined.
1.507-7 Value of assets.
1.507-8 Liability in case of transfers.
1.507-9 Abatement of taxes.
1.508-1 Notices.
1.508-2 Disallowance of certain charitable, etc., deductions.
1.508-3 Governing instruments.
1.508-4 Effective date.
1.509(a)-1 Definition of private foundation.
1.509(a)-2 Exclusion for certain organizations described in section
170(b)(1)(A).
1.509(a)-3 Broadly, publicly supported organizations.
1.509(a)-4 Supporting organizations.
1.509(a)-5 Special rules of attribution.
1.509(a)-6 Classification under section 509(a).
1.509(a)-7 Reliance by grantors and contributors to section 509(a) (1),
(2), and (3) organizations.
1.509(b)-1 Continuation of private foundation status.
1.509(c)-1 Status of organization after termination of private
foundation status.
1.509(d)-1 Definition of support.
1.509(e)-1 Definition of gross investment income.
Taxation of Business Income of Certain Exempt Organizations
1.511-1 Imposition and rates of tax.
1.511-2 Organizations subject to tax.
1.511-3 Provisions generally applicable to the tax on unrelated business
income.
1.511-4 Minimum tax for tax preferences.
1.512(a)-1 Definition.
1.512(a)-2 Definition applicable to taxable years beginning before
December 13, 1967.
1.512(a)-3 [Reserved]
1.512(a)-4 Special rules applicable to war veterans organizations.
1.512(a)-5 Questions and answers relating to the unrelated business
taxable income of organizations described in paragraphs (9) or
(17) of section 501(c).
1.512(a)-6 Special rule for organizations with more than one unrelated
trade or business.
1.512(b)-1 Modifications.
1.512(c)-1 Special rules applicable to partnerships; in general.
1.513-1 Definition of unrelated trade or business.
1.513-2 Definition of unrelated trade or business applicable to taxable
years beginning before December 13, 1967.
1.513-3 Qualified convention and trade show activity.
1.513-4 Certain sponsorship not unrelated trade or business.
1.513-5 Certain bingo games not unrelated trade or business.
1.513-6 Certain hospital services not unrelated trade or business.
1.513-7 Travel and tour activities of tax exempt organizations.
1.514(a)-1 Unrelated debt-financed income and deductions.
1.514(a)-2 Business lease rents and deductions for taxable years
beginning before January 1, 1970.
1.514(b)-1 Definition of debt-financed property.
1.514(c)-1 Acquisition indebtedness.
1.514(c)-2 Permitted allocations under section 514(c)(9)(E).
1.514(d)-1 Basis of debt-financed property acquired in corporate
liquidation.
1.514(e)-1 Allocation rules.
1.514(f)-1 Definition of business lease.
1.514(g)-1 Business lease indebtedness.
Farmers' Cooperatives
1.521-1 Farmers' cooperative marketing and purchasing associations;
requirements for exemption under section 521.
1.522-1 Tax treatment of farmers' cooperative marketing and purchasing
associations exempt under section 521.
1.522-2 Manner of taxation of cooperative associations subject to
section 522.
1.522-3 Patronage dividends, rebates, or refunds; treatment as to
cooperative associations entitled to tax treatment under
section 522.
1.522-4 Taxable years affected.
1.527-1 Political organizations; generally.
1.527-2 Definitions.
1.527-3 Exempt function income.
1.527-4 Special rules for computation of political organization taxable
income.
1.527-5 Activities resulting in gross income to an individual or
political organization.
1.527-6 Inclusion of certain amounts in the gross income of an exempt
organization which is not a political organization.
1.527-7 Newsletter funds.
1.527-8 Effective date; filing requirements; and miscellaneous
provisions.
1.527-9 Special rule for principal campaign committees.
Homeowners Associations
1.528-1 Homeowners associations.
1.528-2 Organized and operated to provide for the acquisition,
construction, management, maintenance and care of association
property.
1.528-3 Association property.
1.528-4 Substantiality test.
1.528-5 Source of income test.
1.528-6 Expenditure test.
1.528-7 Inurement.
1.528-8 Election to be treated as a homeowners association.
[[Page 7]]
1.528-9 Exempt function income.
1.528-10 Special rules for computation of homeowners association taxable
income and tax.
Qualified ABLE Programs
1.529A-0 Table of contents.
1.529A-1 Exempt status of qualified ABLE program and definitions.
1.529A-2 Qualified ABLE program.
1.529A-3 Tax treatment.
1.529A-4 Gift, estate, and generation-skipping transfer taxes.
1.529A-5 Reporting of the establishment of and contributions to an ABLE
account.
1.529A-6 Reporting of distributions from and termination of an ABLE
account.
1.529A-7 Electronic furnishing of statements to designated beneficiaries
and contributors.
1.529A-8 Applicability dates and transition relief.
Corporations Used To Avoid Income Tax on Shareholders
Corporations Improperly Accumulating Surplus
1.531-1 Imposition of tax.
1.532-1 Corporations subject to accumulated earnings tax.
1.533-1 Evidence of purpose to avoid income tax.
1.533-2 Statement required.
1.534-1 Burden of proof as to unreasonable accumulations generally.
1.534-2 Burden of proof as to unreasonable accumulations in cases before
the Tax Court.
1.534-3 Jeopardy assessments in Tax Court cases.
1.535-1 Definition.
1.535-2 Adjustments to taxable income.
1.535-3 Accumulated earnings credit.
1.536-1 Short taxable years.
1.537-1 Reasonable needs of the business.
1.537-2 Grounds for accumulation of earnings and profits.
1.537-3 Business of the corporation.
Personal Holding Companies
1.541-1 Imposition of tax.
1.542-1 General rule.
1.542-2 Gross income requirement.
1.542-3 Stock ownership requirement.
1.542-4 Corporations filing consolidated returns.
1.543-1 Personal holding company income.
1.543-2 Limitation on gross income and personal holding company income
in transactions involving stocks, securities, and commodities.
1.544-1 Constructive ownership.
1.544-2 Constructive ownership by reason of indirect ownership.
1.544-3 Constructive ownership by reason of family and partnership
ownership.
1.544-4 Options.
1.544-5 Convertible securities.
1.544-6 Constructive ownership as actual ownership.
1.544-7 Option rule in lieu of family and partnership rule.
1.545-1 Definition.
1.545-2 Adjustments to taxable income.
1.545-3 Special adjustment to taxable income.
1.547-1 General rule.
1.547-2 Requirements for deficiency dividends.
1.547-3 Claim for credit or refund.
1.547-4 Effect on dividends paid deduction.
1.547-5 Deduction denied in case of fraud or wilful failure to file
timely return.
1.547-6 Suspension of statute of limitations and stay of collection.
1.547-7 Effective date.
Foreign Personal Holding Companies
1.551-1 General rule.
1.551-2 Amount included in gross income.
Deduction for Dividends Paid
1.561-1 Deduction for dividends paid.
1.561-2 When dividends are considered paid.
1.562-1 Dividends for which the dividends paid deduction is allowable.
1.562-2 Preferential dividends.
1.562-3 Distributions by a member of an affiliated group.
1.563-1 Accumulated earnings tax.
1.563-2 Personal holding company tax.
1.563-3 Dividends considered as paid on last day of taxable year.
1.564-1 Dividend carryover.
1.565-1 General rule.
1.565-2 Limitations.
1.565-3 Effect of consent.
1.565-4 Consent dividends and other distributions.
1.565-5 Nonresident aliens and foreign corporations.
1.565-6 Definitions.
Banking Institutions
Rules of General Application to Banking Institutions
1.581-1 Banks.
1.581-2 Mutual savings banks, building and loan associations, and
cooperative banks.
1.581-3 Definition of bank prior to September 28, 1962.
1.582-1 Bad debts, losses, and gains with respect to securities held by
financial institutions.
1.584-1 Common trust funds.
1.584-2 Income of participants in common trust fund.
1.584-3 Computation of common trust fund income.
1.584-4 Admission and withdrawal of participants in the common trust
fund.
[[Page 8]]
1.584-5 Returns of banks with respect to common trust funds.
1.584-6 Net operating loss deduction.
1.585-1 Reserve for losses on loans of banks.
1.585-2 Addition to reserve.
1.585-3 Special rules.
1.585-4 Reorganizations and asset acquisitions.
1.585-5 Denial of bad debt reserves for large banks.
1.585-6 Recapture method of changing from the reserve method of section
585.
1.585-7 Elective cut-off method of changing from the reserve method of
section 585.
1.585-8 Rules for making and revoking elections under Sec. Sec. 1.585-6
and 1.585-7.
Mutual Savings Banks, Etc.
1.591-1 Deduction for dividends paid on deposits.
1.592-1 Repayment of certain loans by mutual savings banks, building and
loan associations, and cooperative banks.
1.594-1 Mutual savings banks conducting life insurance business.
1.596-1 Limitation on dividends received deduction.
1.597-1 Definitions.
1.597-2 Taxation of FFA.
1.597-3 Other rules.
1.597-4 Bridge Banks and Agency Control.
1.597-5 Taxable Transfers.
1.597-6 Limitation on collection of federal income tax.
1.597-7 Effective/applicability dates.
1.597-8 Transitional rules for Federal financial assistance.
Bank Affiliates
1.601-1 Special deduction for bank affiliates.
Natural Resources
Deductions
1.611-0 Regulatory authority.
1.611-1 Allowance of deduction for depletion.
1.611-2 Rules applicable to mines, oil and gas wells, and other natural
deposits.
1.611-3 Rules applicable to timber.
1.611-4 Depletion as a factor in computing earnings and profits for
dividend purposes.
1.611-5 Depreciation of improvements.
1.612-1 Basis for allowance of cost depletion.
1.612-2 Allowable capital additions in case of mines.
1.612-3 Depletion; treatment of bonus and advanced royalty.
1.612-4 Charges to capital and to expense in case of oil and gas wells.
1.612-5 Charges to capital and to expense in case of geothermal wells.
1.613-1 Percentage depletion; general rule.
1.613-2 Percentage depletion rates.
1.613-3 Gross income from the property.
1.613-4 Gross income from the property in the case of minerals other
than oil and gas.
1.613-5 Taxable income from the property.
1.613-6 Statement to be attached to return when depletion is claimed on
percentage basis.
1.613-7 Application of percentage depletion rates provided in section
613(b) to certain taxable years ending in 1954.
1.613A-0 Limitations on percentage depletion in the case of oil and gas
wells; table of contents.
1.613A-1 Post-1974 limitations on percentage depletion in case of oil
and gas wells; general rule.
1.613A-2 Exemption for certain domestic gas wells.
1.613A-3 Exemption for independent producers and royalty owners.
1.613A-4 Limitations on application of Sec. 1.613A-3 exemption.
1.613A-5 Election under section 613A(c)(4).
1.613A-6 Recordkeeping requirements.
1.613A-7 Definitions.
1.614-0 Introduction.
1.614-1 Definition of property.
1.614-2 Election to aggregate separate operating mineral interests under
section 614(b) prior to its amendment by Revenue Act of 1964.
1.614-3 Rules relating to separate operating mineral interests in the
case of mines.
1.614-4 Treatment under the Internal Revenue Code of 1939 with respect
to separate operating mineral interests for taxable years
beginning before January 1, 1964, in the case of oil and gas
wells.
1.614-5 Special rules as to aggregating nonoperating mineral interests.
1.614-6 Rules applicable to basis, holding period, and abandonment
losses where mineral interests have been aggregated or
combined.
1.614-7 Extension of time for performing certain acts.
1.614-8 Elections with respect to separate operating mineral interests
for taxable years beginning after December 31, 1963, in the
case of oil and gas wells.
1.615-1 Pre-1970 exploration expenditures.
1.615-2 Deduction of pre-1970 exploration expenditures in the year paid
or incurred.
1.615-3 Election to defer pre-1970 exploration expenditures.
1.615-4 Limitation of amount deductible.
1.615-5 Time for making election with respect to returns due on or
before May 2, 1960.
1.615-6 Election to deduct under section 615.
1.615-7 Effect of transfer of mineral property.
1.615-8 Termination of section 615.
1.615-9 Notification under Tax Reform Act of 1969.
1.616-1 Development expenditures.
1.616-2 Election to defer.
[[Page 9]]
1.616-3 Time for making election with respect to returns due on or
before May 2, 1960.
1.617-1 Exploration expenditures.
1.617-2 Limitation on amount deductible.
1.617-3 Recapture of exploration expenditures.
1.617-4 Treatment of gain from disposition of certain mining property.
1.617-5 Effective/applicability date.
Sales and Exchanges
1.631-1 Election to consider cutting as sale or exchange.
1.631-2 Gain or loss upon the disposal of timber under cutting contract.
1.631-3 Gain or loss upon the disposal of coal or domestic iron ore with
a retained economic interest.
1.632-1 Tax on sale of oil or gas properties.
Mineral Production Payments
1.636-1 Treatment of production payments as loans.
1.636-2 Production payments retained in leasing transactions.
1.636-3 Definitions.
1.636-4 Effective dates of section 636.
Continental Shelf Areas
1.638-1 Continental Shelf areas.
1.638-2 Effective date.
1.639-1.640 [Reserved]
Authority: 26 U.S.C. 7805, unless otherwise noted.
Section 1.501(c)(29)-1 also issued under 26 U.S.C. 501(c)(29)(B)(i).
Section 1.501(c)(29)-1T also issued under 26 U.S.C.
501(c)(29)(B)(i).
Sections 1.504-1 and 1.504-2 also issued under 26 U.S.C. 504(b).
Section 1.514(c)-2 also issued under 26 U.S.C. 514(c)(9)(E)(iii).
Section 1.527-9 also issued under 26 U.S.C. 527(h)(2)(B)(i).
Sections 1.529A-0 through 1.529A-8 also issued under 26 U.S.C.
529A(g).
Section1.585-5 through 1.585-8 also issued under 26 U.S.C.
585(b)(3).
Section1.597-1 through 1.597-7 also issued under 26 U.S.C. 597 and
1502.
Section1.597-8 also issued under 26 U.S.C. 597.
Source: T.D. 6500, 25 FR 11737, Nov. 26, 1960; 25 FR 14021, Dec. 31,
1960, unless otherwise noted.
Exempt Organizations
General Rule--Table of Contents
Sec. 1.501(a)-1 Exemption from taxation.
(a) In general; proof of exemption. (1) Section 501(a) provides an
exemption from income taxes for organizations which are described in
section 501 (c) or (d) and section 401(a), unless such organization is a
feeder organization (see section 502), or unless it engages in a
transaction described in section 503. However, the exemption does not
extend to unrelated business taxable income of such an organization (see
part III (Section 511 and following), subchapter F, chapter 1 of the
Code).
(2) An organization, other than an employees' trust described in
section 401(a), is not exempt from tax merely because it is not
organized and operated for profit. In order to establish its exemption,
it is necessary that every such organization claiming exemption file an
application form as set forth below with the appropriate office as
designated by the Commissioner in guidance published in the Internal
Revenue Bulletin, forms, or instructions to the applicable forms.
Subject only to the Commissioner's inherent power to revoke rulings,
including with retroactive effect as permitted under section 7805(b),
because of a change in the law or regulations or for other good cause,
an organization that has been determined by the Commissioner (or
previously by a district director) to be exempt under section 501(a) or
the corresponding provision of prior law may rely upon such
determination so long as there are no substantial changes in the
organization's character, purposes, or methods of operation. An
organization that has been determined to be exempt under the provisions
of the Internal Revenue Code of 1939 or prior law is not required to
secure a new determination of exemption merely because of the enactment
of the Internal Revenue Code of 1954 unless affected by substantive
changes in law made by such Code.
(3) An organization claiming exemption under section 501(a) and
described in any paragraph of section 501(c) (other than section
501(c)(1) shall file the form of application prescribed by the
Commissioner and shall include thereon such information as required by
such form and the instructions issued with respect thereto. For rules
relating to the obtaining of a determination of exempt status by an
employees' trust described in section
[[Page 10]]
401(a), see the regulations under section 401.
(b) Additional proof by particular classes of organizations. (1)
Unless otherwise prescribed by applicable regulations or other guidance
published in the Internal Revenue Bulletin, organizations mentioned
below shall submit with and as a part of their applications the
following information:
(i) Mutual insurance companies shall submit copies of the policies
or certificates of membership issued by them.
(ii) In the case of title holding companies described in section
501(c)(2), if the organization for which title is held has not been
specifically notified in writing by the Internal Revenue Service that it
is held to be exempt under section 501(a), the title holding company
shall submit the information indicated herein as necessary for a
determination of the status of the organization for which title is held.
(iii) An organization described in section 501(c)(3) shall submit
with, and as a part of, an application filed after July 26, 1959, a
detailed statement of its proposed activities.
(2) In addition to the information specifically called for by this
section, the Commissioner may require any additional information deemed
necessary for a proper determination of whether a particular
organization is exempt under section 501(a), and when deemed advisable
in the interest of an efficient administration of the internal revenue
laws, he may in the cases of particular types of organizations prescribe
the form in which the proof of exemption shall be furnished.
(3) An organization claiming to be specifically exempted by section
6033(a) from filing annual returns shall submit with and as a part of
its application (or in such other manner as is prescribed in guidance
published in the Internal Revenue Bulletin) a statement of all the facts
on which it bases its claim.
(c) Private shareholder or individual defined. The words private
shareholder or individual in section 501 refer to persons having a
personal and private interest in the activities of the organization.
(d) Requirement of annual returns. For the annual return
requirements of organizations exempt under section 501(a), see section
6033 and Sec. 1.6033-1.
(e) Certain Puerto Rican pension, etc., trusts. Effective for
taxable years beginning after December 31, 1973, section 1022(i)(1) of
the Employee Retirement Income Security Act of 1974 (ERISA) (88 Stat.
942) provides that trusts under certain Puerto Rican pension, etc.,
plans (as defined under P.R. Laws Ann. tit. 13, section 3165, and the
articles thereunder), all of the participants of which are residents of
the Commonwealth of Puerto Rico, are to be treated only for purposes of
section 501(a) as trusts described in section 401(a). The practical
effect of section 1022(i)(1) is to exempt these trusts from U.S. income
tax on income from their U.S. investments. For purposes of section
1022(i)(1), the term residents of the Commonwealth of Puerto Rico means
bona fide residents of Puerto Rico, and persons who perform labor or
services primarily within the Commonwealth of Puerto Rico, regardless of
residence for other purposes, and the term participants is restricted to
current employees who are not excluded under the eligibility provisions
of the plan.
(f) Effective/applicability date. Paragraphs (a)(2), (b)(1), and
(b)(3) of this section apply on and after July 1, 2014.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7428, 41 FR
34619, Aug. 16, 1976; T.D. 7859, 47 FR 54298, Dec. 2, 1982; T.D. 9674,
79 FR 37631, July 2, 2014; T.D. 9819, 82 FR 29732, June 30, 2017]
Sec. 1.501(c)(2)-1 Corporations organized to hold title to property
for exempt organizations.
(a) A corporation described in section 501(c)(2) and otherwise
exempt from tax under section 501(a) is taxable upon its unrelated
business taxable income. For taxable years beginning before January 1,
1970, see Sec. 1.511-2(c)(4). Since a corporation described in section
501(c)(2) cannot be exempt under section 501(a) if it engages in any
business other than that of holding title to property and collecting
income therefrom, it cannot have unrelated business taxable income as
defined in section 512 other than income which is treated as unrelated
business taxable income solely because of the applicability of section
512(a)(3)(C); or debt financed income
[[Page 11]]
which is treated as unrelated business taxable income solely because of
section 514; or certain interest, annuities, royalties, or rents which
are treated as unrelated business taxable income solely because of
section 512(b) (3)(B)(ii) or (13). Similarly, exempt status under
section 501(c)(2) shall not be affected where certain rents from
personal property leased with real property are treated as unrelated
business taxable income under section 512(b)(3)(A)(ii) solely because
such rents attributable to such personal property are more than
incidental when compared to the total rents received or accrued under
the lease, or under section 512(b)(3)(B)(i) solely because such rents
attributable to such personal property exceed 50 percent of the total
rents received or accrued under the lease.
(b) A corporation described in section 501(c)(2) cannot accumulate
income and retain its exemption, but it must turn over the entire amount
of such income, less expenses, to an organization which is itself exempt
from tax under section 501(a).
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7658, 45 FR
33972, May 21, 1980]
Sec. 1.501(c)(3)-1 Organizations organized and operated for religious,
charitable, scientific, testing for public safety, literary, or
educational purposes, or for the prevention of cruelty to children or
animals.
(a) Organizational and operational tests. (1) In order to be exempt
as an organization described in section 501(c)(3), an organization must
be both organized and operated exclusively for one or more of the
purposes specified in such section. If an organization fails to meet
either the organizational test or the operational test, it is not
exempt.
(2) The term exempt purpose or purposes, as used in this section,
means any purpose or purposes specified in section 501(c)(3), as defined
and elaborated in paragraph (d) of this section.
(b) Organizational test--(1) In general. (i) An organization is
organized exclusively for one or more exempt purposes only if its
articles of organization (referred to in this section as its articles)
as defined in subparagraph (2) of this paragraph:
(a) Limit the purposes of such organization to one or more exempt
purposes; and
(b) Do not expressly empower the organization to engage, otherwise
than as an insubstantial part of its activities, in activities which in
themselves are not in furtherance of one or more exempt purposes.
(ii) In meeting the organizational test, the organization's
purposes, as stated in its articles, may be as broad as, or more
specific than, the purposes stated in section 501(c)(3). Therefore, an
organization which, by the terms of its articles, is formed for literary
and scientific purposes within the meaning of section 501(c)(3) of the
Code shall, if it otherwise meets the requirements in this paragraph, be
considered to have met the organizational test. Similarly, articles
stating that the organization is created solely to receive contributions
and pay them over to organizations which are described in section
501(c)(3) and exempt from taxation under section 501(a)) are sufficient
for purposes of the organizational test. Moreover, it is sufficient if
the articles set for the purpose of the organization to be the operation
of a school for adult education and describe in detail the manner of the
operation of such school. In addition, if the articles state that the
organization is formed for charitable purposes, such articles ordinarily
shall be sufficient for purposes of the organizational test (see
subparagraph (5) of this paragraph for rules relating to construction of
terms).
(iii) An organization is not organized exclusively for one or more
exempt purposes if its articles expressly empower it to carry on,
otherwise than as an insubstantial part of its activities, activities
which are not in furtherance of one or more exempt purposes, even though
such organization is, by the terms of such articles, created for a
purpose that is no broader than the purposes specified in section
501(c)(3). Thus, an organization that is empowered by its articles to
engage in a manufacturing business, or to engage in the operation of a
social club does not meet the organizational test regardless of the fact
that its articles may state
[[Page 12]]
that such organization is created for charitable purposes within the
meaning of section 501(c)(3) of the Code.
(iv) In no case shall an organization be considered to be organized
exclusively for one or more exempt purposes, if, by the terms of its
articles, the purposes for which such organization is created are
broader than the purposes specified in section 501(c)(3). The fact that
the actual operations of such an organization have been exclusively in
furtherance of one or more exempt purposes shall not be sufficient to
permit the organization to meet the organizational test. Similarly, such
an organization will not meet the organizational test as a result of
statements or other evidence that the members thereof intend to operate
only in furtherance of one or more exempt purposes.
(v) Unless otherwise prescribed by applicable regulations or other
guidance published in the Internal Revenue Bulletin, an organization
must, in order to establish its exemption, submit a detailed statement
of its proposed activities with and as a part of its application for
exemption (see Sec. 1.501(a)-1(b)).
(2) Articles of organization. For purposes of this section, the term
articles of organization or articles includes the trust instrument, the
corporate charter, the articles of association, or any other written
instrument by which an organization is created.
(3) Authorization of legislative or political activities. An
organization is not organized exclusively for one or more exempt
purposes if its articles expressly empower it:
(i) To devote more than an insubstantial part of its activities to
attempting to influence legislation by propaganda or otherwise; or
(ii) Directly or indirectly to participate in, or intervene in
(including the publishing or distributing of statements), any political
campaign on behalf of or in opposition to any candidate for public
office; or
(iii) To have objectives and to engage in activities which
characterize it as an action organization as defined in paragraph (c)(3)
of this section.
The terms used in subdivisions (i), (ii), and (iii) of this subparagraph
shall have the meanings provided in paragraph (c)(3) of this section. An
organization's articles will not violate the provisions of paragraph
(b)(3)(i) of this section even though the organization's articles
expressly empower it to make the election provided for in section 501(h)
with respect to influencing legislation and, only if it so elects, to
make lobbying or grass roots expenditures that do not normally exceed
the ceiling amounts prescribed by section 501(h)(2) (B) and (D).
(4) Distribution of assets on dissolution. An organization is not
organized exclusively for one or more exempt purposes unless its assets
are dedicated to an exempt purpose. An organization's assets will be
considered dedicated to an exempt purpose, for example, if, upon
dissolution, such assets would, by reason of a provision in the
organization's articles or by operation of law, be distributed for one
or more exempt purposes, or to the Federal Government, or to a State or
local government, for a public purpose, or would be distributed by a
court to another organization to be used in such manner as in the
judgment of the court will best accomplish the general purposes for
which the dissolved organization was organized. However, an organization
does not meet the organizational test if its articles or the law of the
State in which it was created provide that its assets would, upon
dissolution, be distributed to its members or shareholders.
(5) Construction of terms. The law of the State in which an
organization is created shall be controlling in construing the terms of
its articles. However, any organization which contends that such terms
have under State law a different meaning from their generally accepted
meaning must establish such special meaning by clear and convincing
reference to relevant court decisions, opinions of the State attorney-
general, or other evidence of applicable State law.
(6) Applicability of the organizational test. A determination by the
Commissioner that an organization is described in section 501(c)(3) and
exempt under section 501(a) will not be granted after July 26, 1959,
regardless of when the application is filed, unless such organization
meets the organizational test prescribed by this paragraph (b). If,
before
[[Page 13]]
July 27, 1959, an organization has been determined by the Commissioner
or district director to be exempt as an organization described in
section 501(c)(3) or in a corresponding provision of prior law and such
determination has not been revoked before such date, the fact that such
organization does not meet the organizational test prescribed by this
paragraph (b) shall not be a basis for revoking such determination.
Accordingly, an organization that has been determined to be exempt
before July 27, 1959, and which does not seek a new determination of
exemption is not required to amend its articles of organization to
conform to the rules of this paragraph (b), but any organization that
seeks a determination of exemption after July 26, 1959, must have
articles of organization that meet the rules of this paragraph (b). For
the rules relating to whether an organization determined to be exempt
before July 27, 1959, is organized exclusively for one or more exempt
purposes, see 26 CFR (1939) 39.101(6)-1 (Regulations 118) as made
applicable to the Code by Treasury Decision 6091, approved August 16,
1954 (19 FR 5167; 1954-2 CB 47).
(c) Operational test--(1) Primary activities. An organization will
be regarded as operated exclusively for one or more exempt purposes only
if it engages primarily in activities which accomplish one or more of
such exempt purposes specified in section 501(c)(3). An organization
will not be so regarded if more than an insubstantial part of its
activities is not in furtherance of an exempt purpose.
(2) Distribution of earnings. An organization is not operated
exclusively for one or more exempt purposes if its net earnings inure in
whole or in part to the benefit of private shareholders or individuals.
For the definition of the words private shareholder or individual, see
paragraph (c) of Sec. 1.501(a)-1.
(3) Action organizations. (i) An organization is not operated
exclusively for one or more exempt purposes if it is an action
organization as defined in subdivisions (ii), (iii), or (iv) of this
subparagraph.
(ii) An organization is an action organization if a substantial part
of its activities is attempting to influence legislation by propaganda
or otherwise. For this purpose, an organization will be regarded as
attempting to influence legislation if the organization:
(a) Contacts, or urges the public to contact, members of a
legislative body for the purpose of proposing, supporting, or opposing
legislation; or
(b) Advocates the adoption or rejection of legislation.
The term legislation, as used in this subdivision, includes action by
the Congress, by any State legislature, by any local council or similar
governing body, or by the public in a referendum, initiative,
constitutional amendment, or similar procedure. An organization will not
fail to meet the operational test merely because it advocates, as an
insubstantial part of its activities, the adoption or rejection of
legislation. An organization for which the expenditure test election of
section 501(h) is in effect for a taxable year will not be considered an
action organization by reason of this paragraph (c)(3)(ii) for that year
if it is not denied exemption from taxation under section 501(a) by
reason of section 501(h).
(iii) An organization is an action organization if it participates
or intervenes, directly or indirectly, in any political campaign on
behalf of or in opposition to any candidate for public office.
The term candidate for public office means an individual who offers
himself, or is proposed by others, as a contestant for an elective
public office, whether such office be national, State, or local.
Activities which constitute participation or intervention in a political
campaign on behalf of or in opposition to a candidate include, but are
not limited to, the publication or distribution of written or printed
statements or the making of oral statements on behalf of or in
opposition to such a candidate.
(iv) An organization is an action organization if it has the
following two characteristics: (a) Its main or primary objective or
objectives (as distinguished from its incidental or secondary
objectives) may be attained only by legislation or a defeat of proposed
legislation; and (b) it advocates, or campaigns for, the attainment of
[[Page 14]]
such main or primary objective or objectives as distinguished from
engaging in nonpartisan analysis, study, or research and making the
results thereof available to the public. In determining whether an
organization has such characteristics, all the surrounding facts and
circumstances, including the articles and all activities of the
organization, are to be considered.
(v) An action organization, described in subdivisions (ii) or (iv)
of this subparagraph, though it cannot qualify under section 501(c)(3),
may nevertheless qualify as a social welfare organization under section
501(c)(4) if it meets the requirements set out in paragraph (a) of Sec.
1.501(c)(4)-1.
(d) Exempt purposes--(1) In general. (i) An organization may be
exempt as an organization described in section 501(c)(3) if it is
organized and operated exclusively for one or more of the following
purposes:
(a) Religious,
(b) Charitable,
(c) Scientific,
(d) Testing for public safety,
(e) Literary,
(f) Educational, or
(g) Prevention of cruelty to children or animals.
(ii) An organization is not organized or operated exclusively for
one or more of the purposes specified in subdivision (i) of this
subparagraph unless it serves a public rather than a private interest.
Thus, to meet the requirement of this subdivision, it is necessary for
an organization to establish that it is not organized or operated for
the benefit of private interests such as designated individuals, the
creator or his family, shareholders of the organization, or persons
controlled, directly or indirectly, by such private interests.
(iii) Examples. The following examples illustrate the requirement of
paragraph (d)(1)(ii) of this section that an organization serve a public
rather than a private interest:
Example 1. (i) O is an educational organization the purpose of which
is to study history and immigration. O's educational activities include
sponsoring lectures and publishing a journal. The focus of O's
historical studies is the genealogy of one family, tracing the descent
of its present members. O actively solicits for membership only
individuals who are members of that one family. O's research is directed
toward publishing a history of that family that will document the
pedigrees of family members. A major objective of O's research is to
identify and locate living descendants of that family to enable those
descendants to become acquainted with each other.
(ii) O's educational activities primarily serve the private
interests of members of a single family rather than a public interest.
Therefore, O is operated for the benefit of private interests in
violation of the restriction on private benefit in paragraph (d)(1)(ii)
of this section. Based on these facts and circumstances, O is not
operated exclusively for exempt purposes and, therefore, is not
described in section 501(c)(3).
Example 2. (i) O is an art museum. O's principal activity is
exhibiting art created by a group of unknown but promising local
artists. O's activity, including organized tours of its art collection,
promotes the arts. O is governed by a board of trustees unrelated to the
artists whose work O exhibits. All of the art exhibited is offered for
sale at prices set by the artist. Each artist whose work is exhibited
has a consignment arrangement with O. Under this arrangement, when art
is sold, the museum retains 10 percent of the selling price to cover the
costs of operating the museum and gives the artist 90 percent.
(ii) The artists in this situation directly benefit from the
exhibition and sale of their art. As a result, the principal activity of
O serves the private interests of these artists. Because O gives 90
percent of the proceeds from its sole activity to the individual
artists, the direct benefits to the artists are substantial and O's
provision of these benefits to the artists is more than incidental to
its other purposes and activities. This arrangement causes O to be
operated for the benefit of private interests in violation of the
restriction on private benefit in paragraph (d)(1)(ii) of this section.
Based on these facts and circumstances, O is not operated exclusively
for exempt purposes and, therefore, is not described in section
501(c)(3).
Example 3. (i) O is an educational organization the purpose of which
is to train individuals in a program developed by P, O's president. The
program is of interest to academics and professionals, representatives
of whom serve on an advisory panel to O. All of the rights to the
program are owned by Company K, a for-profit corporation owned by P.
Prior to the existence of O, the teaching of the program was conducted
by Company K. O licenses, from Company K, the right to conduct seminars
and lectures on the program and to use the name of the program as part
of O's name, in exchange for specified royalty payments. Under the
license agreement, Company K provides O with the services of trainers
and with course materials on the program. O may develop and copyright
new course materials on the program but all such
[[Page 15]]
materials must be assigned to Company K without consideration if and
when the license agreement is terminated. Company K sets the tuition for
the seminars and lectures on the program conducted by O. O has agreed
not to become involved in any activity resembling the program or its
implementation for 2 years after the termination of O's license
agreement.
(ii) O's sole activity is conducting seminars and lectures on the
program. This arrangement causes O to be operated for the benefit of P
and Company K in violation of the restriction on private benefit in
paragraph (d)(1)(ii) of this section, regardless of whether the royalty
payments from O to Company K for the right to teach the program are
reasonable. Based on these facts and circumstances, O is not operated
exclusively for exempt purposes and, therefore, is not described in
section 501(c)(3).
(iv) Since each of the purposes specified in subdivision (i) of this
subparagraph is an exempt purpose in itself, an organization may be
exempt if it is organized and operated exclusively for any one or more
of such purposes. If, in fact, an organization is organized and operated
exclusively for an exempt purpose or purposes, exemption will be granted
to such an organization regardless of the purpose or purposes specified
in its application for exemption. For example, if an organization claims
exemption on the ground that it is educational, exemption will not be
denied if, in fact, it is charitable.
(2) Charitable defined. The term charitable is used in section
501(c)(3) in its generally accepted legal sense and is, therefore, not
to be construed as limited by the separate enumeration in section
501(c)(3) of other tax-exempt purposes which may fall within the broad
outlines of charity as developed by judicial decisions. Such term
includes: Relief of the poor and distressed or of the underprivileged;
advancement of religion; advancement of education or science; erection
or maintenance of public buildings, monuments, or works; lessening of
the burdens of Government; and promotion of social welfare by
organizations designed to accomplish any of the above purposes, or (i)
to lessen neighborhood tensions; (ii) to eliminate prejudice and
discrimination; (iii) to defend human and civil rights secured by law;
or (iv) to combat community deterioration and juvenile delinquency. The
fact that an organization which is organized and operated for the relief
of indigent persons may receive voluntary contributions from the persons
intended to be relieved will not necessarily prevent such organization
from being exempt as an organization organized and operated exclusively
for charitable purposes. The fact that an organization, in carrying out
its primary purpose, advocates social or civic changes or presents
opinion on controversial issues with the intention of molding public
opinion or creating public sentiment to an acceptance of its views does
not preclude such organization from qualifying under section 501(c)(3)
so long as it is not an action organization of any one of the types
described in paragraph (c)(3) of this section.
(3) Educational defined--(i) In general. The term educational, as
used in section 501(c)(3), relates to:
(a) The instruction or training of the individual for the purpose of
improving or developing his capabilities; or
(b) The instruction of the public on subjects useful to the
individual and beneficial to the community.
An organization may be educational even though it advocates a particular
position or viewpoint so long as it presents a sufficiently full and
fair exposition of the pertinent facts as to permit an individual or the
public to form an independent opinion or conclusion. On the other hand,
an organization is not educational if its principal function is the mere
presentation of unsupported opinion.
(ii) Examples of educational organizations. The following are
examples of organizations which, if they otherwise meet the requirements
of this section, are educational:
Example 1. An organization, such as a primary or secondary school, a
college, or a professional or trade school, which has a regularly
scheduled curriculum, a regular faculty, and a regularly enrolled body
of students in attendance at a place where the educational activities
are regularly carried on.
Example 2. An organization whose activities consist of presenting
public discussion groups, forums, panels, lectures, or other similar
programs. Such programs may be on radio or television.
Example 3. An organization which presents a course of instruction by
means of correspondence or through the utilization of television or
radio.
[[Page 16]]
Example 4. Museums, zoos, planetariums, symphony orchestras, and
other similar organizations.
(4) Testing for public safety defined. The term testing for public
safety, as used in section 501(c)(3), includes the testing of consumer
products, such as electrical products, to determine whether they are
safe for use by the general public.
(5) Scientific defined. (i) Since an organization may meet the
requirements of section 501(c)(3) only if it serves a public rather than
a private interest, a scientific organization must be organized and
operated in the public interest (see subparagraph (1)(ii) of this
paragraph). Therefore, the term scientific, as used in section
501(c)(3), includes the carrying on of scientific research in the public
interest. Research when taken alone is a word with various meanings; it
is not synonymous with scientific; and the nature of particular research
depends upon the purpose which it serves. For research to be scientific,
within the meaning of section 501(c)(3), it must be carried on in
furtherance of a scientific purpose. The determination as to whether
research is scientific does not depend on whether such research is
classified as fundamental or basic as contrasted with applied or
practical. On the other hand, for purposes of the exclusion from
unrelated business taxable income provided by section 512(b)(9), it is
necessary to determine whether the organization is operated primarily
for purposes of carrying on fundamental, as contrasted with applied,
research.
(ii) Scientific research does not include activities of a type
ordinarily carried on as an incident to commercial or industrial
operations, as, for example, the ordinary testing or inspection of
materials or products or the designing or construction of equipment,
buildings, etc.
(iii) Scientific research will be regarded as carried on in the
public interest:
(a) If the results of such research (including any patents,
copyrights, processes, or formulae resulting from such research) are
made available to the public on a nondiscriminatory basis;
(b) If such research is performed for the United States, or any of
its agencies or instrumentalities, or for a State or political
subdivision thereof; or
(c) If such research is directed toward benefiting the public. The
following are examples of scientific research which will be considered
as directed toward benefiting the public, and, therefore, which will be
regarded as carried on in the public interest: (1) Scientific research
carried on for the purpose of aiding in the scientific education of
college or university students; (2) scientific research carried on for
the purpose of obtaining scientific information, which is published in a
treatise, thesis, trade publication, or in any other form that is
available to the interested public; (3) scientific research carried on
for the purpose of discovering a cure for a disease; or (4) scientific
research carried on for the purpose of aiding a community or
geographical area by attracting new industry to the community or area or
by encouraging the development of, or retention of, an industry in the
community or area. Scientific research described in this subdivision
will be regarded as carried on in the public interest even though such
research is performed pursuant to a contract or agreement under which
the sponsor or sponsors of the research have the right to obtain
ownership or control of any patents, copyrights, processes, or formulae
resulting from such research.
(iv) An organization will not be regarded as organized and operated
for the purpose of carrying on scientific research in the public
interest and, consequently, will not qualify under section 501(c)(3) as
a scientific organization, if:
(a) Such organization will perform research only for persons which
are (directly or indirectly) its creators and which are not described in
section 501(c)(3), or
(b) Such organization retains (directly or indirectly) the ownership
or control of more than an insubstantial portion of the patents,
copyrights, processes, or formulae resulting from its research and does
not make such patents, copyrights, processes, or formulae available to
the public. For purposes of this subdivision, a patent, copyright,
process, or formula shall be considered as made available to the
[[Page 17]]
public if such patent, copyright, process, or formula is made available
to the public on a nondiscriminatory basis. In addition, although one
person is granted the exclusive right to the use of a patent, copyright,
process, or formula, such patent, copyright, process, or formula shall
be considered as made available to the public if the granting of such
exclusive right is the only practicable manner in which the patent,
copyright, process, or formula can be utilized to benefit the public. In
such a case, however, the research from which the patent, copyright,
process, or formula resulted will be regarded as carried on in the
public interest (within the meaning of subdivision (iii) of this
subparagraph) only if it is carried on for a person described in
subdivision (iii)(b) of this subparagraph or if it is scientific
research described in subdivision (iii)(c) of this subparagraph.
(v) The fact that any organization (including a college, university,
or hospital) carries on research which is not in furtherance of an
exempt purpose described in section 501(c)(3) will not preclude such
organization from meeting the requirements of section 501(c)(3) so long
as the organization meets the organizational test and is not operated
for the primary purpose of carrying on such research (see paragraph (e)
of this section, relating to organizations carrying on a trade or
business). See paragraph (a)(5) of Sec. 1.513-2, with respect to
research which constitutes an unrelated trade or business, and section
512(b) (7), (8), and (9), with respect to income derived from research
which is excludable from the tax on unrelated business income.
(vi) The regulations in this subparagraph are applicable with
respect to taxable years beginning after December 31, 1960.
(e) Organizations carrying on trade or business--(1) In general. An
organization may meet the requirements of section 501(c)(3) although it
operates a trade or business as a substantial part of its activities, if
the operation of such trade or business is in furtherance of the
organization's exempt purpose or purposes and if the organization is not
organized or operated for the primary purpose of carrying on an
unrelated trade or business, as defined in section 513. In determining
the existence or nonexistence of such primary purpose, all the
circumstances must be considered, including the size and extent of the
trade or business and the size and extent of the activities which are in
furtherance of one or more exempt purposes. An organization which is
organized and operated for the primary purpose of carrying on an
unrelated trade or business is not exempt under section 501(c)(3) even
though it has certain religious purposes, its property is held in
common, and its profits do not inure to the benefit of individual
members of the organization. See, however, section 501(d) and Sec.
1.501(d)-1, relating to religious and apostolic organizations.
(2) Taxation of unrelated business income. For provisions relating
to the taxation of unrelated business income of certain organizations
described in section 501(c)(3), see sections 511 to 515, inclusive, and
the regulations thereunder.
(f) Interaction with section 4958--(1) Application process. An
organization that applies for recognition of exemption under section
501(a) as an organization described in section 501(c)(3) must establish
its eligibility under this section. The Commissioner may deny an
application for exemption for failure to establish any of section
501(c)(3)'s requirements for exemption. Section 4958 does not apply to
transactions with an organization that has failed to establish that it
satisfies all of the requirements for exemption under section 501(c)(3).
See Sec. 53.4958-2.
(2) Substantive requirements for exemption still apply to applicable
tax-exempt organizations described in section 501(c)(3)--(i) In general.
Regardless of whether a particular transaction is subject to excise
taxes under section 4958, the substantive requirements for tax exemption
under section 501(c)(3) still apply to an applicable tax-exempt
organization (as defined in section 4958(e) and Sec. 53.4958-2)
described in section 501(c)(3) whose disqualified persons or
organization managers are subject to excise taxes under section 4958.
Accordingly, an organization will no longer meet the requirements for
tax-exempt status under section 501(c)(3) if
[[Page 18]]
the organization fails to satisfy the requirements of paragraph (b), (c)
or (d) of this section. See Sec. 53.4958-8(a).
(ii) Determination of whether revocation of tax-exempt status is
appropriate when section 4958 excise taxes also apply. In determining
whether to continue to recognize the tax-exempt status of an applicable
tax-exempt organization (as defined in section 4958(e) and Sec.
53.4958-2) described in section 501(c)(3) that engages in one or more
excess benefit transactions (as defined in section 4958(c) and Sec.
53.4958-4) that violate the prohibition on inurement under section
501(c)(3), the Commissioner will consider all relevant facts and
circumstances, including, but not limited to, the following--
(A) The size and scope of the organization's regular and ongoing
activities that further exempt purposes before and after the excess
benefit transaction or transactions occurred;
(B) The size and scope of the excess benefit transaction or
transactions (collectively, if more than one) in relation to the size
and scope of the organization's regular and ongoing activities that
further exempt purposes;
(C) Whether the organization has been involved in multiple excess
benefit transactions with one or more persons;
(D) Whether the organization has implemented safeguards that are
reasonably calculated to prevent excess benefit transactions; and
(E) Whether the excess benefit transaction has been corrected
(within the meaning of section 4958(f)(6) and Sec. 53.4958-7), or the
organization has made good faith efforts to seek correction from the
disqualified person(s) who benefited from the excess benefit
transaction.
(iii) All factors will be considered in combination with each other.
Depending on the particular situation, the Commissioner may assign
greater or lesser weight to some factors than to others. The factors
listed in paragraphs (f)(2)(ii)(D) and (E) of this section will weigh
more heavily in favor of continuing to recognize exemption where the
organization discovers the excess benefit transaction or transactions
and takes action before the Commissioner discovers the excess benefit
transaction or transactions. Further, with respect to the factor listed
in paragraph (f)(2)(ii)(E) of this section, correction after the excess
benefit transaction or transactions are discovered by the Commissioner,
by itself, is never a sufficient basis for continuing to recognize
exemption.
(iv) Examples. The following examples illustrate the principles of
paragraph (f)(2)(ii) of this section. For purposes of each example,
assume that O is an applicable tax-exempt organization (as defined in
section 4958(e) and Sec. 53.4958-2) described in section 501(c)(3). The
examples read as follows:
Example 1. (i) O was created as a museum for the purpose of
exhibiting art to the general public. In Years 1 and 2, O engages in
fundraising and in selecting, leasing, and preparing an appropriate
facility for a museum. In Year 3, a new board of trustees is elected.
All of the new trustees are local art dealers. Beginning in Year 3 and
continuing to the present, O uses a substantial portion of its revenues
to purchase art solely from its trustees at prices that exceed fair
market value. O exhibits and offers for sale all of the art it
purchases. O's Form 1023, ``Application for Recognition of Exemption,''
did not disclose the possibility that O would purchase art from its
trustees.
(ii) O's purchases of art from its trustees at more than fair market
value constitute excess benefit transactions between an applicable tax-
exempt organization and disqualified persons under section 4958.
Therefore, these transactions are subject to the applicable excise taxes
provided in that section. In addition, O's purchases of art from its
trustees at more than fair market value violate the proscription against
inurement under section 501(c)(3) and paragraph (c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of this
section to these facts is as follows. Beginning in Year 3, O does not
engage primarily in regular and ongoing activities that further exempt
purposes because a substantial portion of O's activities consists of
purchasing art from its trustees and dealing in such art in a manner
similar to a commercial art gallery. The size and scope of the excess
benefit transactions collectively are significant in relation to the
size and scope of any of O's ongoing activities that further exempt
purposes. O has been involved in multiple excess benefit transactions,
namely, purchases of art from its trustees at more than fair market
value. O has not implemented safeguards that are reasonably calculated
to prevent such improper purchases in the future. The excess benefit
transactions have not been corrected, nor has O made good faith efforts
to seek
[[Page 19]]
correction from the disqualified persons who benefited from the excess
benefit transactions (the trustees). The trustees continue to control
O's Board. Based on the application of the factors to these facts, O is
no longer described in section 501(c)(3) effective in Year 3.
Example 2. (i) The facts are the same as in Example 1, except that
in Year 4, O's entire board of trustees resigns, and O no longer offers
all exhibited art for sale. The former board is replaced with members of
the community who are not in the business of buying or selling art and
who have skills and experience running charitable and educational
programs and institutions. O promptly discontinues the practice of
purchasing art from current or former trustees, adopts a written
conflicts of interest policy, adopts written art valuation guidelines,
hires legal counsel to recover the excess amounts O had paid its former
trustees, and implements a new program of activities to further the
public's appreciation of the arts.
(ii) O's purchases of art from its former trustees at more than fair
market value constitute excess benefit transactions between an
applicable tax-exempt organization and disqualified persons under
section 4958. Therefore, these transactions are subject to the
applicable excise taxes provided in that section. In addition, O's
purchases of art from its trustees at more than fair market value
violate the proscription against inurement under section 501(c)(3) and
paragraph (c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of this
section to these facts is as follows. In Year 3, O does not engage
primarily in regular and ongoing activities that further exempt
purposes. However, in Year 4, O elects a new board of trustees comprised
of individuals who have skills and experience running charitable and
educational programs and implements a new program of activities to
further the public's appreciation of the arts. As a result of these
actions, beginning in Year 4, O engages in regular and ongoing
activities that further exempt purposes. The size and scope of the
excess benefit transactions that occurred in Year 3, taken collectively,
are significant in relation to the size and scope of O's regular and
ongoing exempt function activities that were conducted in Year 3.
Beginning in Year 4, however, as O's exempt function activities grow,
the size and scope of the excess benefit transactions that occurred in
Year 3 become less and less significant as compared to the size and
scope of O's regular and ongoing exempt function activities. O was
involved in multiple excess benefit transactions in Year 3. However, by
discontinuing its practice of purchasing art from its current and former
trustees, by replacing its former board with independent members of the
community, and by adopting a conflicts of interest policy and art
valuation guidelines, O has implemented safeguards that are reasonably
calculated to prevent future violations. In addition, O has made a good
faith effort to seek correction from the disqualified persons who
benefited from the excess benefit transactions (its former trustees).
Based on the application of the factors to these facts, O continues to
meet the requirements for tax exemption under section 501(c)(3).
Example 3. (i) O conducts educational programs for the benefit of
the general public. Since its formation, O has employed its founder, C,
as its Chief Executive Officer. Beginning in Year 5 of O's operations
and continuing to the present, C caused O to divert significant portions
of O's funds to pay C's personal expenses. The diversions by C
significantly reduced the funds available to conduct O's ongoing
educational programs. The board of trustees never authorized C to cause
O to pay C's personal expenses from O's funds. Certain members of the
board were aware that O was paying C's personal expenses. However, the
board did not terminate C's employment and did not take any action to
seek repayment from C or to prevent C from continuing to divert O's
funds to pay C's personal expenses. C claimed that O's payments of C's
personal expenses represented loans from O to C. However, no
contemporaneous loan documentation exists, and C never made any payments
of principal or interest.
(ii) The diversions of O's funds to pay C's personal expenses
constitute excess benefit transactions between an applicable tax-exempt
organization and a disqualified person under section 4958. Therefore,
these transactions are subject to the applicable excise taxes provided
in that section. In addition, these transactions violate the
proscription against inurement under section 501(c)(3) and paragraph
(c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of this
section to these facts is as follows. O has engaged in regular and
ongoing activities that further exempt purposes both before and after
the excess benefit transactions occurred. However, the size and scope of
the excess benefit transactions engaged in by O beginning in Year 5,
collectively, are significant in relation to the size and scope of O's
activities that further exempt purposes. Moreover, O has been involved
in multiple excess benefit transactions. O has not implemented any
safeguards that are reasonably calculated to prevent future diversions.
The excess benefit transactions have not been corrected, nor has O made
good faith efforts to seek correction from C, the disqualified person
who benefited from the excess benefit transactions. Based on the
application of the factors to these facts, O is no longer described in
section 501(c)(3) effective in Year 5.
[[Page 20]]
Example 4. (i) O conducts activities that further exempt purposes. O
uses several buildings in the conduct of its exempt activities. In Year
1, O sold one of the buildings to Company K for an amount that was
substantially below fair market value. The sale was a significant event
in relation to O's other activities. C, O's Chief Executive Officer,
owns all of the voting stock of Company K. When O's board of trustees
approved the transaction with Company K, the board did not perform due
diligence that could have made it aware that the price paid by Company K
to acquire the building was below fair market value. Subsequently, but
before the IRS commences an examination of O, O's board of trustees
determines that Company K paid less than the fair market value for the
building. Thus, O concludes that an excess benefit transaction occurred.
After the board makes this determination, it promptly removes C as Chief
Executive Officer, terminates C's employment with O, and hires legal
counsel to recover the excess benefit from Company K. In addition, O
promptly adopts a conflicts of interest policy and new contract review
procedures designed to prevent future recurrences of this problem.
(ii) The sale of the building by O to Company K at less than fair
market value constitutes an excess benefit transaction between an
applicable tax-exempt organization and a disqualified person under
section 4958 in Year 1. Therefore, this transaction is subject to the
applicable excise taxes provided in that section. In addition, this
transaction violates the proscription against inurement under section
501(c)(3) and paragraph (c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of this
section to these facts is as follows. O has engaged in regular and
ongoing activities that further exempt purposes both before and after
the excess benefit transaction occurred. Although the size and scope of
the excess benefit transaction were significant in relation to the size
and scope of O's activities that further exempt purposes, the
transaction with Company K was a one-time occurrence. By adopting a
conflicts of interest policy and new contract review procedures and by
terminating C, O has implemented safeguards that are reasonably
calculated to prevent future violations. Moreover, O took corrective
actions before the IRS commenced an examination of O. In addition, O has
made a good faith effort to seek correction from Company K, the
disqualified person who benefited from the excess benefit transaction.
Based on the application of the factors to these facts, O continues to
be described in section 501(c)(3).
Example 5. (i) O is a large organization with substantial assets and
revenues. O conducts activities that further its exempt purposes. O
employs C as its Chief Financial Officer. During Year 1, O pays $2,500
of C's personal expenses. O does not make these payments pursuant to an
accountable plan, as described in Sec. 53.4958-4(a)(4)(ii). In
addition, O does not report any of these payments on C's Form W-2,
``Wage and Tax Statement,'' or on a Form 1099-MISC, ``Miscellaneous
Income,'' for C for Year 1, and O does not report these payments as
compensation on its Form 990, ``Return of Organization Exempt From
Income Tax,'' for Year 1. Moreover, none of these payments can be
disregarded as nontaxable fringe benefits under Sec. 53.4958-4(c)(2)
and none consisted of fixed payments under an initial contract under
Sec. 53.4958-4(a)(3). C does not report the $2,500 of payments as
income on his individual Federal income tax return for Year 1. O does
not repeat this reporting omission in subsequent years and, instead,
reports all payments of C's personal expenses not made under an
accountable plan as income to C.
(ii) O's payment in Year 1 of $2,500 of C's personal expenses
constitutes an excess benefit transaction between an applicable tax-
exempt organization and a disqualified person under section 4958.
Therefore, this transaction is subject to the applicable excise taxes
provided in that section. In addition, this transaction violates the
proscription against inurement in section 501(c)(3) and paragraph (c)(2)
of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of this
section to these facts is as follows. O engages in regular and ongoing
activities that further exempt purposes. The payment of $2,500 of C's
personal expenses represented only a de minimis portion of O's assets
and revenues; thus, the size and scope of the excess benefit transaction
were not significant in relation to the size and scope of O's activities
that further exempt purposes. The reporting omission that resulted in
the excess benefit transaction in Year 1 occurred only once and is not
repeated in subsequent years. Based on the application of the factors to
these facts, O continues to be described in section 501(c)(3).
Example 6. (i) O is a large organization with substantial assets and
revenues. O furthers its exempt purposes by providing social services to
the population of a specific geographic area. O has a sizeable workforce
of employees and volunteers to conduct its work. In Year 1, O's board of
directors adopted written procedures for setting executive compensation
at O. O's executive compensation procedures were modeled on the
procedures for establishing a rebuttable presumption of reasonableness
under Sec. 53.4958-6. In accordance with these procedures, the board
appointed a compensation committee to gather data on compensation levels
paid by similarly situated organizations for functionally comparable
positions. The members of the compensation committee were disinterested
within the meaning of Sec. 53.4958-
[[Page 21]]
6(c)(1)(iii). Based on its research, the compensation committee
recommended a range of reasonable compensation for several of O's
existing top executives (the Top Executives). On the basis of the
committee's recommendations, the board approved new compensation
packages for the Top Executives and timely documented the basis for its
decision in board minutes. The board members were all disinterested
within the meaning of Sec. 53.4958-6(c)(1)(iii). The Top Executives
were not involved in setting their own compensation. In Year 1, even
though payroll expenses represented a significant portion of O's total
operating expenses, the total compensation paid to O's Top Executives
represented only an insubstantial portion of O's total payroll expenses.
During a subsequent examination, the IRS found that the compensation
committee relied exclusively on compensation data from organizations
that perform similar social services to O. The IRS concluded, however,
that the organizations were not similarly situated because they served
substantially larger geographic regions with more diverse populations
and were larger than O in terms of annual revenues, total operating
budget, number of employees, and number of beneficiaries served.
Accordingly, the IRS concluded that the compensation committee did not
rely on ``appropriate data as to comparability'' within the meaning of
Sec. 53.4958-6(c)(2) and, thus, failed to establish the rebuttable
presumption of reasonableness under Sec. 53.4958-6. Taking O's size and
the nature of the geographic area and population it serves into account,
the IRS concluded that the Top Executives' compensation packages for
Year 1 were excessive. As a result of the examination, O's board added
new members to the compensation committee who have expertise in
compensation matters and also amended its written procedures to require
the compensation committee to evaluate a number of specific factors,
including size, geographic area, and population covered by the
organization, in assessing the comparability of compensation data. O's
board renegotiated the Top Executives' contracts in accordance with the
recommendations of the newly constituted compensation committee on a
going forward basis. To avoid potential liability for damages under
state contract law, O did not seek to void the Top Executives'
employment contracts retroactively to Year 1 and did not seek correction
of the excess benefit amounts from the Top Executives. O did not
terminate any of the Top Executives.
(ii) O's payments of excessive compensation to the Top Executives in
Year 1 constituted excess benefit transactions between an applicable
tax-exempt organization and disqualified persons under section 4958.
Therefore, these payments are subject to the applicable excise taxes
provided under that section, including second-tier taxes if there is no
correction by the disqualified persons. In addition, these payments
violate the proscription against inurement under section 501(c)(3) and
paragraph (c)(2) of this section.
(iii) The application of the factors in paragraph (f)(2)(ii) of this
section to these facts is as follows. O has engaged in regular and
ongoing activities that further exempt purposes both before and after
the excess benefit transactions occurred. The size and scope of the
excess benefit transactions, in the aggregate, were not significant in
relation to the size and scope of O's activities that further exempt
purposes. O engaged in multiple excess benefit transactions.
Nevertheless, prior to entering into these excess benefit transactions,
O had implemented written procedures for setting the compensation of its
top management that were reasonably calculated to prevent the occurrence
of excess benefit transactions. O followed these written procedures in
setting the compensation of the Top Executives for Year 1. Despite the
board's failure to rely on appropriate comparability data, the fact that
O implemented and followed these written procedures in setting the
compensation of the Top Executives for Year 1 is a factor favoring
continued exemption. The fact that O amended its written procedures to
ensure the use of appropriate comparability data and renegotiated the
Top Executives' compensation packages on a going-forward basis are also
factors favoring continued exemption, even though O did not void the Top
Executives' existing contracts and did not seek correction from the Top
Executives. Based on the application of the factors to these facts, O
continues to be described in section 501(c)(3).
(3) Applicability. The rules in paragraph (f) of this section will
apply with respect to excess benefit transactions occurring after March
28, 2008.
(g) Applicability of regulations in this section. The regulations in
this section are, except as otherwise expressly provided, applicable
with respect to taxable years beginning after July 26, 1959. For the
rules applicable with respect to taxable years beginning before July 27,
1959, see 26 CFR (1939) 39.101(6)-1 (Regulations 118) as made applicable
to the Code by Treasury Decision 6091, approved August 16, 1954 (19 FR
5167; C.B. 1954-2, 47).
[[Page 22]]
(h) Effective/applicability date. Paragraphs (b)(1)(v) and (b)(6) of
this section apply on and after July 1, 2014.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6525, 26 FR
189, Jan. 11, 1961; T.D. 6939, 32 FR 17661, Dec. 12, 1967; T.D. 7428, 41
FR 34620, Aug. 16, 1976; T.D. 8308, 55 FR 35587, Aug. 31, 1990; T.D.
9390, 73 FR 16521, Mar. 28, 2008; T.D. 9390, 73 FR 23069, Apr. 29, 2008;
T.D. 9674, 79 FR 37631, July 2, 2014; T.D. 9819, 82 FR 29732, June 30,
2017]
Sec. 1.501(c)(4)-1 Civic organizations and local associations of
employees.
(a) Civic organizations--(1) In general. A civic league or
organization may be exempt as an organization described in section
501(c)(4) if--
(i) It is not organized or operated for profit; and
(ii) It is operated exclusively for the promotion of social welfare.
(2) Promotion of social welfare--(i) In general. An organization is
operated exclusively for the promotion of social welfare if it is
primarily engaged in promoting in some way the common good and general
welfare of the people of the community. An organization embraced within
this section is one which is operated primarily for the purpose of
bringing about civic betterments and social improvements. A social
welfare organization will qualify for exemption as a charitable
organization if it falls within the definition of charitable set forth
in paragraph (d)(2) of Sec. 1.501(c)(3)-1 and is not an action
organization as set forth in paragraph (c)(3) of Sec. 1.501(c)(3)-1.
(ii) Political or social activities. The promotion of social welfare
does not include direct or indirect participation or intervention in
political campaigns on behalf of or in opposition to any candidate for
public office. Nor is an organization operated primarily for the
promotion of social welfare if its primary activity is operating a
social club for the benefit, pleasure, or recreation of its members, or
is carrying on a business with the general public in a manner similar to
organizations which are operated for profit. See, however, section
501(c)(6) and Sec. 1.501(c)(6)-1, relating to business leagues and
similar organizations. A social welfare organization that is not, at any
time after October 4, 1976, exempt from taxation as an organization
described in section 501(c)(3) may qualify under section 501(c)(4) even
though it is an action organization described in Sec. 1.501(c)(3)-
1(c)(3)(ii) or (iv), if it otherwise qualifies under this section. For
rules relating to an organization that is, after October 4, 1976, exempt
from taxation as an organization described in section 501(c)(3), see
section 504 and Sec. 1.504-1.
(b) Local associations of employees. Local associations of employees
described in section 501(c)(4) are expressly entitled to exemption under
section 501(a). As conditions to exemption, it is required (1) that the
membership of such an association be limited to the employees of a
designated person or persons in a particular municipality, and (2) that
the net earnings of the association be devoted exclusively to
charitable, educational, or recreational purposes. The word local is
defined in paragraph (b) of Sec. 1.501(c)(12)-1. See paragraph (d) (2)
and (3) of Sec. 1.501(c)(3)-1 with reference to the meaning of
charitable and educational as used in this section.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. 8308, 55 FR 35588, Aug. 31, 1990]
Sec. 1.501(c)(5)-1 Labor, agricultural, and horticultural organizations.
(a) The organizations contemplated by section 501(c)(5) as entitled
to exemption from income taxation are those which:
(1) Have no net earnings inuring to the benefit of any member, and
(2) Have as their objects the betterment of the conditions of those
engaged in such pursuits, the improvement of the grade of their
products, and the development of a higher degree of efficiency in their
respective occupations.
(b)(1) General rule. An organization is not an organization
described in section 501(c)(5) if the principal activity of the
organization is to receive, hold, invest, disburse or otherwise manage
funds associated with savings or investment plans or programs, including
pension or other retirement savings plans or programs.
(2) Exception. Paragraph (b)(1) of this section shall not apply to
an organization which--
[[Page 23]]
(i) Is established and maintained by another labor organization
described in section 501(c)(5) (determined without regard to this
paragraph (b)(2));
(ii) Is not directly or indirectly established or maintained in
whole or in part by one or more--
(A) Employers;
(B) Governments or agencies or instrumentalities thereof; or
(C) Government controlled entities;
(iii) Is funded by membership dues from members of the labor
organization described in this paragraph (b)(2) and earnings thereon;
and
(iv) Has not at any time after September 2, 1974 (the date of
enactment of the Employee Retirement Income Security Act of 1974, Pub.
L. 93-406, 88 Stat. 829) provided for, permitted or accepted employer
contributions.
(3) Example. The principles of this paragraph (b) are illustrated by
the following example:
Example. Trust A is organized in accordance with a collective
bargaining agreement between labor union K and multiple employers. Trust
A forms part of a plan that is established and maintained pursuant to
the agreement and which covers employees of the signatory employers who
are members of K. Representatives of both the employers and K serve as
trustees. A receives contributions from the employers who are subject to
the agreement. Retirement benefits paid to K's members as specified in
the agreement are funded exclusively by the employers' contributions and
accumulated earnings. A also provides information to union members about
their retirement benefits and assists them with administrative tasks
associated with the benefits. Most of A's activities are devoted to
these functions. From time to time, A also participates in the
renegotiation of the collective bargaining agreement. A's principal
activity is to receive, hold, invest, disburse, or otherwise manage
funds associated with a retirement savings plan. In addition, A does not
satisfy all the requirements of the exception described in paragraph
(b)(2) of this section. (For example, A accepts contributions from
employers.) Therefore, A is not a labor organization described in
section 501(c)(5).
(c) Organizations described in section 501(c)(5) and otherwise
exempt from tax under section 501(a) are taxable upon their unrelated
business taxable income. See part II (section 511 and following),
subchapter F, chapter 1 of the Code, and the regulations thereunder.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. 8726, 62 FR 40449, July 29, 1997]
Sec. 1.501(c)(6)-1 Business leagues, chambers of commerce, real estate
boards, and boards of trade.
A business league is an association of persons having some common
business interest, the purpose of which is to promote such common
interest and not to engage in a regular business of a kind ordinarily
carried on for profit. It is an organization of the same general class
as a chamber of commerce or board of trade. Thus, its activities should
be directed to the improvement of business conditions of one or more
lines of business as distinguished from the performance of particular
services for individual persons. An organization whose purpose is to
engage in a regular business of a kind ordinarily carried on for profit,
even though the business is conducted on a cooperative basis or produces
only sufficient income to be self-sustaining, is not a business league.
An association engaged in furnishing information to prospective
investors, to enable them to make sound investments, is not a business
league, since its activities do not further any common business
interest, even though all of its income is devoted to the purpose
stated. A stock or commodity exchange is not a business league, a
chamber of commerce, or a board of trade within the meaning of section
501(c)(6) and is not exempt from tax. Organizations otherwise exempt
from tax under this section are taxable upon their unrelated business
taxable income. See part II (section 511 and following), subchapter F,
chapter 1 of the Code, and the regulations thereunder.
Sec. 1.501(c)(7)-1 Social clubs.
(a) The exemption provided by section 501(a) for organizations
described in section 501(c)(7) applies only to clubs which are organized
and operated exclusively for pleasure, recreation, and other
nonprofitable purposes, but does not apply to any club if any part of
its net earnings inures to the benefit of any private shareholder. In
general, this exemption extends to social and
[[Page 24]]
recreation clubs which are supported solely by membership fees, dues,
and assessments. However, a club otherwise entitled to exemption will
not be disqualified because it raises revenue from members through the
use of club facilities or in connection with club activities.
(b) A club which engages in business, such as making its social and
recreational facilities available to the general public or by selling
real estate, timber, or other products, is not organized and operated
exclusively for pleasure, recreation, and other nonprofitable purposes,
and is not exempt under section 501(a). Solicitation by advertisement or
otherwise for public patronage of its facilities is prima facie evidence
that the club is engaging in business and is not being operated
exclusively for pleasure, recreation, or social purposes. However, an
incidental sale of property will not deprive a club of its exemption.
Sec. 1.501(c)(8)-1 Fraternal beneficiary societies.
(a) A fraternal beneficiary society is exempt from tax only if
operated under the lodge system or for the exclusive benefit of the
members so operating. Operating under the lodge system means carrying on
its activities under a form of organization that comprises local
branches, chartered by a parent organization and largely self-governing,
called lodges, chapters, or the like. In order to be exempt it is also
necessary that the society have an established system for the payment to
its members or their dependents of life, sick, accident, or other
benefits.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7061, 35 FR
14770, Sept. 23, 1970]
Sec. 1.501(c)(9)-1 Voluntary employees' beneficiary associations, in general.
To be described in section 501(c)(9) an organization must meet all
of the following requirements:
(a) The organization is an employees' association,
(b) Membership in the association is voluntary,
(c) The organization provides for the payment of life, sick,
accident, or other benefits to its members or their dependents or
designated beneficiaries, and substantially all of its operations are in
furtherance of providing such benefits, and
(d) No part of the net earnings of the organization inures, other
than by payment of the benefits referred to in paragraph (c) of this
section, to the benefit of any private shareholder or individual.
[T.D. 7750, 45 FR 1721, Jan. 7, 1981]
Sec. 1.501(c)(9)-2 Membership in a voluntary employees' beneficiary
association; employees; voluntary association of employees.
(a) Membership--(1) In general. The membership of an organization
described in section 501(c)(9) must consist of individuals who become
entitled to participate by reason of their being employees and whose
eligibility for membership is defined by reference to objective
standards that constitute an employment-related common bond among such
individuals. Typically, those eligible for membership in an organization
described in section 501(c)(9) are defined by reference to a common
employer (or affiliated employers), to coverage under one or more
collective bargaining agreements (with respect to benefits provided by
reason of such agreement(s)), to membership in a labor union, or to
membership in one or more locals of a national or international labor
union. For example, membership in an association might be open to all
employees of a particular employer, or to employees in specified job
classifications working for certain employers at specified locations and
who are entitled to benefits by reason of one or more collective
bargaining agreements. In addition, employees of one or more employers
engaged in the same line of business in the same geographic locale will
be considered to share an employment-related bond for purposes of an
organization through which their employers provide benefits. Employees
of a labor union also will be considered to share an employment-related
common bond with members of the union, and employees of an association
will be considered to share an employment-related common bond with
members of the association. Whether a
[[Page 25]]
group of individuals is defined by reference to a permissible standard
or standards is a question to be determined with regard to all the facts
and circumstances, taking into account the guidelines set forth in this
paragraph. Exemption will not be denied merely because the membership of
an association includes some individuals who are not employees (within
the meaning of paragraph (b) of this section), provided that such
individuals share an employment-related bond with the employee-members.
Such individuals may include, for example, the proprietor of a business
whose employees are members of the association. For purposes of the
preceding two sentences, an association will be considered to be
composed of employees if 90 percent of the total membership of the
association on one day of each quarter of the association's taxable year
consists of employees (within the meaning of paragraph (b) of this
section).
(2) Restrictions--(i) In general. Eligibility for membership may be
restricted by geographic proximity, or by objective conditions or
limitations reasonably related to employment, such as a limitation to a
reasonable classification of workers, a limitation based on a reasonable
minimum period of service, a limitation based on maximum compensation,
or a requirement that a member be employed on a full-time basis.
Similarly, eligibility for benefits may be restricted by objective
conditions relating to the type or amount of benefits offered. Any
objective criteria used to restrict eligibility for membership or
benefits may not, however, be selected or administered in a manner that
limits membership or benefits to officers, shareholders, or highly
compensated employees of an employer contributing to or otherwise
funding the employees' association. Similarly, eligibility for benefits
may not be subject to conditions or limitations that have the effect of
entitling officers, shareholders, or highly compensated employees of an
employer contributing to or otherwise funding the employees' association
to benefits that are disproportionate in relation to benefits to which
other members of the association are entitled. See Sec. 1.501(c)(9)-
4(b). Whether the selection or administration of objective conditions
has the effect of providing disproportionate benefits to officers,
shareholders, or highly compensated employees generally is to be
determined on the basis of all the facts and circumstances.
(ii) Generally permissible restrictions or conditions. In general
the following restrictions will not be considered to be inconsistent
with Sec. 1.501(c)(9)-2(a)(2)(i) or Sec. 1.501(c)(9)-4(b):
(A) In the case of an employer-funded organization, a provision that
excludes or has the effect of excluding from membership in the
organization or participation in a particular benefit plan employees who
are members of another organization or covered by a different plan,
funded or contributed to by the employer, to the extent that such other
organization or plan offers similar benefits on comparable terms to the
excluded employees.
(B) In the case of an employer funded-organization, a provision that
excludes from membership, or limits the type or amount of benefits
provided to, individuals who are included in a unit of employees covered
by an agreement which the Secretary of Labor finds to be a collective
bargaining agreement between employee representatives and one or more
employers, if there is evidence that the benefit or benefits provided by
the organization were the subject of good faith bargaining between such
employee representatives and such employer or employers.
(C) Restrictions or conditions on eligibility for membership or
benefits that are determined through collective bargaining, by trustees
designated pursuant to a collective bargaining agreement, or by the
collective bargaining agents of the members of an association or
trustees named by such agent or agents.
(D) The allowance of benefits only on condition that a member or
recipient contribute to the cost of such benefits, or the allowance of
different benefits based solely on differences in contributions,
provided that those making equal contributions are entitled to
comparable benefits.
[[Page 26]]
(E) A requirement that a member (or a member's dependents) meet a
reasonable health standard related to eligibility for a particular
benefit.
(F) The provision of life benefits in amounts that are a uniform
percentage of the compensation received by the individual whose life is
covered.
(G) The provision of benefits in the nature of wage replacement in
the event of disability in amounts that are a uniform percentage of the
compensation of the covered individuals (either before or after taking
into account any disability benefits provided through social security or
any similar plan providing for wage replacement in the event of
disability).
(3) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. Pursuant to a collective bargaining agreement entered
into by X Corporation and W, a labor union which represents all of X
Corporation's hourly-paid employees, the X Corporation Union Benefit
Plan is established to provide life insurance benefits to employees of X
represented by W. The Plan is funded by contributions from X, and is
jointly administered by X and W. In order to provide its non-unionized
employees with comparable life insurance benefits, X also establishes
and funds the X Corporation Life Insurance Trust. The Trust will not be
ineligible for exemption as an organization described in section
501(c)(9) solely because membership is restricted to those employees of
X who are not members of W.
Example 2. The facts are the same as in Example 1 except that the
life insurance benefit provided to the non-unionized employees of X
differs from the life insurance benefit provided to the unionized
employees of X pursuant to the collective bargaining agreement. The
trust will not be ineligible for exemption as an organization described
in section 501(c)(9) solely because the life insurance benefit provided
to X's nonunionized employees is not same as the life insurance benefit
provided to X's unionized employees.
Example 3. S corporation established a plan to provide health
benefits to all its employees. In accordance with the provisions of the
plan each employee may secure insurance coverage by making an election
under which the employee agrees to contribute periodically to the plan
an amount which is determined solely by whether the employee elects a
high option coverage or a low option coverage and on whether the
employee is unmarried or has a family. As an alternative, the employee
may elect high or low options, self only or self and family, coverage
through a local prepaid group medical plan. The contributions required
of those electing the prepaid group medical plan also vary with the type
of coverage selected, and differ from those required of employees
electing insurance. The difference between the amount contributed by
employees electing the various coverages and the actual cost of
purchasing the coverage is made up through contributions by S to the
plan, and under the plan, S provides approximately the same proportion
of the cost for each coverage. To fund the plan, S established an
arrangement in the nature of a trust under applicable local law and
contributes all employee contributions, and all amounts which by the
terms of the plan it is required to contribute, to the trust. The terms
of the plan do not provide for disproportionate benefits to the
employees of S and will not be considered inconsistent with Sec.
1.501(c)(9)-2(a)(2)(i).
Example 4. The facts are the same as in Example 3 except that, for
those employees or former employees covered by Medicare, the plan
provides a distinct coverage which supplements Medicare benefits.
Eligibility for Medicare is an objective condition relating to a type of
benefit offered, and the provision of separate coverage for those
eligible for Medicare will not be considered inconsistent with Sec.
1.501(c)(9)-2(a)(2)(i).
(b) Meaning of employee. Whether an individual is an employee is
determined by reference to the legal and bona fide relationship of
employer and employee. The term employee includes the following:
(1) An individual who is considered an employee:
(i) For employment tax purposes under subtitle C of the Internal
Revenue Code and the regulations thereunder, or
(ii) For purposes of a collective bargaining agreement,
whether or not the individual could qualify as an employee under
applicable common law rules. This would include any person who is
considered an employee for purposes of the Labor Management Relations
Act of 1947, 61 Stat. 136, as amended, 29 U.S.C. 141 (1979).
(2) An individual who became entitled to membership in the
association by reason of being or having been an employee. Thus, an
individual who would otherwise qualify under this paragraph will
continue to qualify as an employee even though such individual is on
leave of absence, works temporarily for another employer or as
[[Page 27]]
an independent contractor, or has been terminated by reason of
retirement, disability or layoff. For example, an individual who in the
normal course of employment is employed intermittently by more than one
employer in an industry characterized by short-term employment by
several different employers will not, by reason of temporary
unemployment, cease to be an employee within the meaning of this
paragraph.
(3) The surviving spouse and dependents of an employee (if, for
purposes of the 90-percent test of Sec. 1.501(c)(9)-2(a)(1) they are
considered to be members of the association).
(c) Description of voluntary association of employees--(1)
Association. To be described in section 501(c)(9) and this section there
must be an entity, such as a corporation or trust established under
applicable local law, having an existence independent of the member-
employees or their employer.
(2) Voluntary. Generally, membership in an association is voluntary
if an affirmative act is required on the part of an employee to become a
member rather than the designation as a member due to employee status.
However, an association shall be considered voluntary although
membership is required of all employees, provided that the employees do
not incur a detriment (for example, in the form of deductions from pay)
as the result of membership in the association. An employer is not
deemed to have imposed involuntary membership on the employee if
membership is required as the result of a collective bargaining
agreement or as an incident of membership in a labor organization.
(3) Of employees. To be described in this section, an organization
must be controlled--
(i) By its membership,
(ii) By independent trustee(s) (such as a bank), or
(iii) By trustees or other fiduciaries at least some of whom are
designated by, or on behalf of, the membership. Whether control by or on
behalf of the membership exists is a question to be determined with
regard to all of the facts and circumstances, but generally such control
will be deemed to be present when the membership (either directly or
through its representative) elects, appoints or otherwise designates a
person or persons to serve as chief operating officer(s),
administrator(s), or trustee(s) of the organization. For purposes of
this paragraph an organization will be considered to be controlled by
independent trustees if it is an employee welfare benefit plan, as
defined in section 3(1) of the Employee Retirement Income Security Act
of 1974 (ERISA), and, as such, is subject to the requirements of parts 1
and 4 of subtitle B, title I of ERISA. Similarly, a plan will be
considered to be controlled by its membership if it is controlled by one
or more trustees designated pursuant to a collective bargaining
agreement (whether or not the bargaining agent of the represented
employees bargained for and obtained the right to participate in
selecting the trustees).
(4) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. X, a labor union, represents all the hourly-paid
employees of Y Corporation. A health insurance benefit plan was
established by X and Y as the result of a collective bargaining
agreement entered into by them. The plan established the terms and
conditions of membership in, and the benefits to be provided by, the
plan. In accordance with the terms of the agreement, Y Corporation is
obligated to establish a trust fund and make contributions thereto at
specified rates. The trustees, some of whom are designated by X and some
by Y, are authorized to hold and invest the assets of the trust and to
make payments on instructions issued by Y Corporation in accordance with
the conditions contained in the plan. The interdependent benefit plan
agreement and trust indenture together create a voluntary employees'
beneficiary association over which the employees posses the requisite
control through the trustees designated by their representative, X.
Example 2. Z Corporation unilaterally established an educational
benefit plan for its employees. The purpose of the plan is to provide
payments for job-related educational or training courses, such as
apprenticeship training programs, for Z Corporation employees, according
to objective criteria set forth in the plan. Z establishes a separate
bank account which it uses to fund payments to the plan. Contributions
to the account are to be made at the discretion of and solely by Z
Corporation, which also administers the plan and retains control over
the assets in the fund. Z Corporation's educational benefit
[[Page 28]]
plan and the related account do not constitute an association having an
existence independent of Z Corporation and therefore do not constitute a
voluntary employees' beneficiary association.
Example 3. A, an individual, is the incorporator and chief operating
officer of Lawyers' Beneficiary Association (LBA). LBA is engaged in the
business of providing medical benefits to members of the Association and
their families. Membership is open only to practicing lawyers located in
a particular metropolitan area who are neither self-employed nor
partners in a law firm. Membership in LBA is solicited by insurance
agents under the control of X Corporation (owned by A) which, by
contract with LBA, is the exclusive sales agent. Medical benefits are
paid from a trust account containing periodic contributions paid by the
members, together with proceeds from the investment of those
contributions. Contribution and benefit levels are set by LBA. The
members of LBA do not hold meetings, have no right to elect officers or
directors of the Association, and no right to replace trustees.
Collectively, the subscribers for medical benefits from LBA cannot be
said to control the association and membership is neither more than nor
different from the purchase of an insurance policy from a stock
insurance company. LBA is not a voluntary employees' beneficiary
association.
Example 4. U corporation unilaterally established a plan to provide
benefits to its employees. In accordance with the provisions of the
plan, each employee may secure insurance or benefit coverage by making
an election under which the employee agrees to contribute to the plan an
amount which is determined solely by whether the employee elects a high
option coverage or a low option coverage and on whether the employee
elects self only or self and family coverage. The difference between the
amount contributed by employees electing the various coverages and the
actual cost of the coverage is made up through contributions by U to the
plan. To fund the plan, U established an arrangement in the nature of a
trust under applicable local law and contributed all employee
contributions, and all amounts which by the term of the plan it was
required to provide to the plan, to the trust. The trust constitutes an
employee welfare benefit plan within the meaning of, and subject to
relevant requirements of, ERISA. It will be considered to meet the
requirements of Sec. 1.501(c)(9)-2(c)(3).
[T.D. 7750, 46 FR 1723, Jan. 7, 1981]
Sec. 1.501(c)(9)-3 Voluntary employees' beneficiary associations; life,
sick, accident, or other benefits.
(a) In general. The life, sick, accident, or other benefits provided
by a voluntary employees' beneficiary association must be payable to its
members, their dependents, or their designated beneficiaries. For
purposes of section 501(c)(9), dependent means the member's spouse; any
child of the member or the member's spouse who is a minor or a student
(within the meaning of section 151(e)(4)); any other minor child
residing with the member; and any other individual who an association,
relying on information furnished to it by a member, in good faith
believes is a person described in section 152(a). Life, sick, accident,
or other benefits may take the form of cash or noncash benefits. A
voluntary employees' beneficiary association is not operated for the
purpose of providing life, sick, accident, or other benefits unless
substantially all of its operations are in furtherance of the provision
of such benefits. Further, an organization is not described in this
section if it systematically and knowingly provides benefits (of more
than a de minimis amount) that are not permitted by paragraphs (b), (c),
(d), or (e) of this section.
(b) Life benefits. The term life benefits means a benefit (including
a burial benefit or a wreath) payable by reason of the death of a member
or dependent. A life benefit may be provided directly or through
insurance. It generally must consist of current protection, but also may
include a right to convert to individual coverage on termination of
eligibility for coverage through the association, or a permanent benefit
as defined in, and subject to the conditions in, the regulations under
section 79. A life benefit also includes the benefit provided under any
life insurance contract purchased directly from an employee-funded
association by a member or provided by such an association to a member.
The term life benefit does not include a pension, annuity or similar
benefit, except that a benefit payable by reason of the death of an
insured may be settled in the form of an annuity to the beneficiary in
lieu of a lump-sum death benefit (whether or not the contract provides
for settlement in a lump sum).
(c) Sick and accident benefits. The term sick and accident benefits
means amounts furnished to or on behalf of a member or a member's
dependents in
[[Page 29]]
the event of illness or personal injury to a member or dependent. Such
benefits may be provided through reimbursement to a member or a member's
dependents for amounts expended because of illness or personal injury,
or through the payment of premiums to a medical benefit or health
insurance program. Similarly, a sick and accident benefit includes an
amount paid to a member in lieu of income during a period in which the
member is unable to work due to sickness or injury. Sick benefits also
include benefits designed to safeguard or improve the health of members
and their dependents. Sick and accident benefits may be provided
directly by an association to or on behalf of members and their
dependents, or may be provided indirectly by an association through the
payment of premiums or fees to an insurance company, medical clinic, or
other program under which members and their dependents are entitled to
medical services or to other sick and accident benefits. Sick and
accident benefits may also be furnished in noncash form, such as, for
example, benefits in the nature of clinical care services by visiting
nurses, and transportation furnished for medical care.
(d) Other benefits. The term other benefits includes only benefits
that are similar to life, sick, or accident benefits. A benefit is
similar to a life, sick, or accident benefit if:
(1) It is intended to safeguard or improve the health of a member or
a member's dependents, or
(2) It protects against a contingency that interrupts or impairs a
member's earning power.
(e) Examples of other benefits. Paying vacation benefits, providing
vacation facilities, reimbursing vacation expenses, and subsidizing
recreational activities such as athletic leagues are considered other
benefits. The provision of child-care facilities for preschool and
school-age dependents are also considered other benefits. The provision
of job readjustment allowances, income maintenance payments in the event
of economic dislocation, temporary living expense loans and grants at
times of disaster (such as fire or flood), supplemental unemployment
compensation benefits (as defined in section 501(c)(17)(D)(i) of the
Code), severance benefits (under a severance pay plan within the meaning
of 29 CFR 2510.3-2(b)) and education or training benefits or courses
(such as apprentice training programs) for members, are considered other
benefits because they protect against a contingency that interrupts
earning power. Personal legal service benefits which consist of payments
or credits to one or more organizations or trusts described in section
501(c)(20) are considered other benefits. Except to the extent otherwise
provided in these regulations, as amended from time to time, other
benefits also include any benefit provided in the manner permitted by
paragraphs (5) et seq. of section 302(c) of the Labor Management
Relations Act of 1947, 61 Stat. 136, as amended, 29 U.S.C. 186(c)
(1979).
(f) Examples of nonqualifying benefits. Benefits that are not
described in paragraphs (d) or (e) of this section are not other
benefits. Thus, other benefits do not include the payment of commuting
expenses, such as bridge tolls or train fares, the provision of accident
or homeowner's insurance benefits for damage to property, the provision
of malpractice insurance, or the provision of loans to members except in
times of distress (as permitted by Sec. 1.501(c)(9)-3(e)). Other
benefits also do not include the provision of savings facilities for
members. The term other benefits does not include any benefit that is
similar to a pension or annuity payable at the time of mandatory or
voluntary retirement, or a benefit that is similar to the benefit
provided under a stock bonus or profit-sharing plan. For purposes of
section 501(c)(9) and these regulations, a benefit will be considered
similar to that provided under a pension, annuity, stock bonus or
profit-sharing plan if it provides for deferred compensation that
becomes payable by reason of the passage of time, rather than as the
result of an unanticipated event. Thus, for example, supplemental
unemployment benefits, which generally become payable by reason of
unanticipated layoff, are not, for purposes of these regulations,
considered similar to the benefit provided under a pension, annuity,
stock bonus or profit-sharing plan.
[[Page 30]]
(g) Examples. The provisions of this section may be further
illustrated by the following examples:
Example 1. V was organized in connection with a vacation plan
created pursuant to a collective bargaining agreement between M, a labor
union, which represents certain hourly paid employees of T corporation,
and T. The agreement calls for the payment by T to V of a specified sum
per hour worked by T employees who are covered by the collective
bargaining agreement. T includes the amounts in the covered employees'
wages and withholds income and FICA taxes. The amounts are paid by T to
V to provide vacation benefits provided under the collective bargaining
agreement. Generally, each covered employee receives a check in payment
of his or her vacation benefit during the year following the year in
which contributions were made by T to V. The amount of the vacation
benefit is determined by reference to the contributions during the prior
year to V by T on behalf of each employee, and is distributed in cash to
each such employee. If the earnings on investments by V during the year
preceding distribution are sufficient after deducting the expenses of
administering the plan, each recipient of a vacation benefit is paid an
amount, in addition to the contributions on his or her behalf, equal to
his/her ratable share of the net earnings of V during such year. The
plan provides a vacation benefit that constitutes an eligible other
benefit described in section 501(c)(9) and Sec. 1.501(c)(9)-3(e).
Example 2. The facts are the same as in Example 1, except that each
covered employee of T is entitled, at his or her discretion, to
contribute up to an additional $1,000 each year to V, which agrees in
respect of such sum to pay interest at a stated rate from the time of
contribution until the time at which the contributing employee's
vacation benefit is distributed. In addition, each employee may elect to
leave all or a portion of his/her distributable benefit on deposit past
the time of distribution, in which case interest will continue to
accrue. Because the plan more closely resembles a savings arrangement
than a vacation plan, the benefit payable to the covered employees of T
is not a vacation benefit and is not an eligible other benefit described
in section 501(c)(9) and Sec. 1.501(c)(9)-3 (d) or (e).
[T.D. 7750, 46 FR 1724, Jan. 7, 1981]
Sec. 1.501(c)(9)-4 Voluntary employees' beneficiary associations;
inurement.
(a) General rule. No part of the net earnings of an employees'
association may inure to the benefit of any private shareholder or
individual other than through the payment of benefits permitted by Sec.
1.501(c)(9)-3. The disposition of property to, or the performance of
services for, a person for less than the greater of fair market value or
cost (including indirect costs) to the association, other than as a
life, sick, accident or other permissible benefit, constitutes
prohibited inurement. Generally, the payment of unreasonable
compensation to the trustees or employees of the association, or the
purchase of insurance or services for amounts in excess of their fair
market value from a company in which one or more of the association's
trustees, officers or fiduciaries has an interest, will constitute
prohibited inurement. Whether prohibited inurement has occurred is a
question to be determined with regard to all of the facts and
circumstances, taking into account the guidelines set forth in this
section. The guidelines and examples contained in this section are not
an exhaustive list of the activities that may constitute prohibited
inurement, or the persons to whom the association's earnings could
impermissibly inure. See Sec. 1.501(a)-1(c).
(b) Disproportionate benefits. For purposes of subsection (a), the
payment to any member of disproportionate benefits, where such payment
is not pursuant to objective and nondiscriminatory standards, will not
be considered a benefit within the meaning of Sec. 1.501(c)(9)-3 even
though the benefit otherwise is one of the type permitted by that
section. For example, the payment to highly compensated personnel of
benefits that are disproportionate in relation to benefits received by
other members of the association will constitute prohibited inurement.
Also, the payment to similarly situated employees of benefits that
differ in kind or amount will constitute prohibited inurement unless the
difference can be justified on the basis of objective and reasonable
standards adopted by the association or on the basis of standards
adopted pursuant to the terms of a collective bargaining agreement. In
general, benefits paid pursuant to standards or subject to conditions
that do not provide for disproportionate benefits to officers,
shareholders, or highly compensated employees will not be considered
disproportionate. See Sec. 1.501(c)(9)-2(a) (2) and (3).
[[Page 31]]
(c) Rebates. The rebate of excess insurance premiums, based on the
mortality or morbidity experience of the insurer to which the premiums
were paid, to the person or persons whose contributions were applied to
such premiums, does not constitute prohibited inurement. A voluntary
employees' beneficiary association may also make administrative
adjustments strictly incidental to the provision of benefits to its
members.
(d) Termination of plan or dissolution of association. It will not
constitute prohibited inurement if, on termination of a plan established
by an employer and funded through an association described in section
501(c)(9), any assets remaining in the association, after satisfaction
of all liabilities to existing beneficiaries of the plan, are applied to
provide, either directly or through the purchase of insurance, life,
sick, accident or other benefits within the meaning of Sec.
1.501(c)(9)-3 pursuant to criteria that do not provide for
disproportionate benefits to officers, shareholders, or highly
compensated employees of the employer. See Sec. 1.501(c)(9)-2(a)(2).
Similarly, a distribution to members upon the dissolution of the
association will not constitute prohibited inurement if the amount
distributed to members are determined pursuant to the terms of a
collective bargaining agreement or on the basis of objective and
reasonable standards which do not result in either unequal payments to
similarly situated members or in disproportionate payments to officers,
shareholders, or highly compensated employees of an employer
contributing to or otherwise funding the employees' association. Except
as otherwise provided in the first sentence of this paragraph, if the
association's corporate charter, articles of association, trust
instrument, or other written instrument by which the association was
created, as amended from time to time, provides that on dissolution its
assets will be distributed to its members' contributing employers, or if
in the absence of such provision the law of the state in which the
association was created provides for such distribution to the
contributing employers, the association is not described in section
501(c)(9).
(e) Example. The provisions of this section may be illustrated by
the following example:
Example. Employees A, B and C, members of the X voluntary employees'
beneficiary association, are unemployed. They receive unemployment
benefits from X. Those to A include an amount in addition to those
provided to B and C, to provide for A's retraining. B has been found
pursuant to objective and reasonable standards not to qualify for the
retraining program. C, although eligible for retraining benefits has
declined. X's additional payment to A for retraining does not constitute
prohibited inurement.
[T.D. 7750, 46 FR 1725, Jan. 7, 1981]
Sec. 1.501(c)(9)-5 Voluntary employees' beneficiary associations;
recordkeeping requirements.
(a) Records. In addition to such other records which may be required
(for example, by section 512(a)(3) and the regulations thereunder),
every organization described in section 501(c)(9) must maintain records
indicating the amount contributed by each member and contributing
employer, and the amount and type of benefits paid by the organization
to or on behalf of each member.
(b) Cross reference. For provisions relating to annual information
returns with respect to payments, see section 6041 and the regulations
thereunder.
[T.D. 7750, 46 FR 1725, Jan. 7, 1981]
Sec. 1.501(c)(9)-6 Voluntary employees' beneficiary associations;
benefits includible in gross income.
(a) In general. Cash and noncash benefits realized by a person on
account of the activities of an organization described in section
501(c)(9) shall be included in gross income to the extent provided in
the Internal Revenue Code of 1954, including, but not limited to,
sections 61, 72, 101, 104 and 105 of the Code and regulations
thereunder.
(b) Availability of statutory exclusions from gross income. The
availability of any statutory exclusion from gross income with respect
to contributions to, or the payment of benefits from, an organization
described in section 501(c)(9) is determined by the statutory provision
conferring the exclusion, and the regulations and rulings thereunder,
not by whether an individual is eligible for
[[Page 32]]
membership in the organization or by the permissibility of the benefit
paid. Thus, for example, if a benefit is paid by an employer-funded
organization described in section 501(c)(9) to a member who is not an
employee, a statutory exclusion from gross income that is available only
for employees would be unavailable in the case of a benefit paid to such
individual. Similarly, the fact that, for example, under some
circumstances educational benefits constitute other benefits does not of
itself mean that such benefits are eligible for the exclusion of either
section 117 or section 127 of the Code.
[T.D. 7750, 46 FR 1725, Jan. 7, 1981]
Sec. 1.501(c)(9)-7 Voluntary employees' beneficiary associations;
section 3(4) of ERISA.
The term voluntary employees' beneficiary association in section
501(c)(9) of the Internal Revenue Code is not necessarily coextensive
with the term employees' beneficiary association as used in section 3(4)
of the Employee Retirement Income Security Act of 1974 (ERISA), 29
U.S.C. 1002(4), and the requirements which an organization must meet to
be an employees' beneficiary association within the meaning of section
3(4) of ERISA are not necessarily identical to the requirements that an
organization must meet in order to be a voluntary employees' beneficiary
association within the meaning of section 501(c)(9) of the Code.
[T.D. 7750, 46 FR 1725, Jan. 7, 1981]
Sec. 1.501(c)(9)-8 Voluntary employees' beneficiary associations;
effective date.
(a) General rule. Except as otherwise provided in this section, the
provisions of Sec. Sec. 1.501(c)(9)-1 through 1.501(c)(9)-7 shall apply
with respect to taxable years beginning after December 31, 1954.
(b) Pre-1970 taxable years. For taxable years beginning before
January 1, 1970, section 501(c)(9)(B) (relating to the requirement that
85 percent or more of the association's income consist of amounts
collected from members and contributed by employers), as in effect for
such years, shall apply.
(c) Existing associations. Except as otherwise provided in paragraph
(d), the provisions of Sec. 1.501(c)(9)-2(a)(1) and (c)(3) shall apply
with respect to taxable years beginning after December 31, 1980.
(d) Collectively-bargained plans. In the case of a voluntary
employees' beneficiary association which receives contributions from one
or more employers pursuant to one or more collective bargaining
agreements in effect on December 31, 1980, the provisions of Sec. Sec.
1.501(c)(9)-1 through 1.501(c)(9)-5 shall apply with respect to taxable
years beginning after the date on which the agreement terminates
(determined without regard to any extension thereof agreed to after
December 31, 1980).
(e) Election. Notwithstanding paragraphs (c) and (d) of this
section, an organization may choose to be subject to all or a portion of
one or more of the provisions of these regulations for any taxable year
beginning after December 31, 1954.
[T.D. 7750, 46 FR 1725, Jan. 7, 1981; 46 FR 11971, Feb. 12, 1981]
Sec. 1.501(c)(10)-1 Certain fraternal beneficiary societies.
(a) For taxable years beginning after December 31, 1969, an
organization will qualify for exemption under section 501(c)(10) if it:
(1) Is a domestic fraternal beneficiary society order, or
association, described in section 501(c)(8) and the regulations
thereunder except that it does not provide for the payment of life,
sick, accident, or other benefits to its members, and
(2) Devotes its net earnings exclusively to religious, charitable,
scientific, literary, educational, and fraternal purposes
Any organization described in section 501(c)(7), such as, for example, a
national college fraternity, is not described in section 501(c)(10) and
this section.
[T.D. 7172, 37 FR 5618, Mar. 17, 1972]
Sec. 1.501(c)(12)-1 Local benevolent life insurance associations,
mutual irrigation and telephone companies, and like organizations.
(a) An organization described in section 501(c)(12) must receive at
least 85 percent of its income from amounts
[[Page 33]]
collected from members for the sole purpose of meeting losses and
expenses. If an organization issues policies for stipulated cash
premiums, or if it requires advance deposits to cover the cost of the
insurance and maintains investments from which more than 15 percent of
its income is derived, it is not entitled to exemption. On the other
hand, an organization may be entitled to exemption, although it makes
advance assessments for the sole purpose of meeting future losses and
expenses, provided that the balance of such assessments remaining on
hand at the end of the year is retained to meet losses and expenses or
is returned to members.
(b) The phrase of a purely local character applies to benevolent
life insurance associations, and not to the other organizations
specified in section 501(c)(12). It also applies to any organization
seeking exemption on the ground that it is an organization similar to a
benevolent life insurance association. An organization of a purely local
character is one whose business activities are confined to a particular
community, place, or district, irrespective, however, of political
subdivisions. If the activities of an organization are limited only by
the borders of a State it cannot be considered to be purely local in
character.
(c) For taxable years of a mutual or cooperative telephone company
beginning after December 31, 1974, the 85 percent member-income test
described in paragraph (a) of this section is applied without taking
into account income received or accrued from another telephone company
for the performance of communication services involving the completion
of long distance calls to, from, or between members of the mutual or
cooperative telephone company. For example, if, in one year, a
cooperative telephone company receives $85x from its members for
telephone calls, $15x as interest income, and $20x as credits under long
distance interconnection agreements with other telephone companies for
the performance of communication services involving the completion of
long distance calls to, from, or between the cooperative's members
(whether or not the credits may be offset, in whole or in part, by
amounts due the other companies under the interconnection agreements),
the member-income fraction is calculated without taking into account,
either in the numerator or denominator, the $20x credits received from
the other telephone companies. In this example, the 85 percent member-
income test is satisfied because at least 85 percent
[GRAPHIC] [TIFF OMITTED] TC14NO91.158
of the cooperative's total income is derived from member income.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended at 44 FR 59523, Oct. 16, 1979]
Sec. 1.501(c)(13)-1 Cemetery companies and crematoria.
(a) Nonprofit mutual cemetery companies. A nonprofit cemetery
company may be entitled to exemption if it is owned by and operated
exclusively for the benefit of its lot owners who hold such lots for
bona fide burial purposes and not for the purpose of fesale. A mutual
cemetery company which also engages in charitable activities, such as
burial of paupers, will be regarded as operating in conformity with this
standard. Further, the fact that a mutual cemetery company limits its
membership to a particular class of individuals, such as members of a
family, will not affect its status as mutual so long as all the other
requirements of section 501(c)(13) are met.
(b) Nonprofit cemetery companies and crematoria. Any nonprofit
corporation, chartered solely for the purpose of the burial, or (for
taxable years beginning after December 31, 1970) the cremation of
bodies, and not permitted by its charter to engage in any business not
necessarily incident to that purpose, is exempt from income tax,
provided that no part of its net earnings inures to the benefit of any
private shareholder or individual.
(c) Preferred stock--(1) In general. Except as provided in
subparagraph (3) of this paragraph, a cemetery company or crematorium is
not described in section 501(c)(13) if it issues preferred stock on or
after November 28, 1978.
[[Page 34]]
(2) Transitional rule for preferred stock issued prior to November
28, 1978. In the case of preferred stock issued prior to November 28,
1978, a cemetery company or crematorium which issued such stock shall
not fail to be exempt from income tax solely because it issued preferred
stock which entitled the holders to dividends at a fixed rate, not
exceeding the legal rage of interest in the State of incorporation or 8
percent per annum, whichever is greater, on the value of the
consideration for which the stock was issued, if its articles of
incorporation require:
(i) That the preferred stock be retired at par as rapidly as funds
therefor become available from operations, and
(ii) That all funds not required for the payment of dividends upon
or for the retirement of preferred stock be used by the company for the
care and inprovement of the cemetery property. The term legal rate of
interest shall mean the rate of interest prescribed by law in the State
of incorporation which prevails in the absence of an agreement between
contracting parties fixing a rate.
(3) Transitional rule for preferred stock issued on or after
November 28, 1978. In the case of preferred stok issued on or after
November 28, 1978, a cemetery company or crematorium shall not fail to
be exempt from income tax if its articles of incorporation and the
preferred stock meet the requirements of paragraph (c)(2) and if such
stock is issued pursuant to a plan which has been reduced to writing and
adopted prior to November 28, 1978. The adoption of the plan must be
shown by the acts of the duly constituted responsible officers and
appear upon the official records of the cemetery company or crematorium.
(d) Sales to exempt cemetery companies and crematoria. Except as
provided in paragraph (c)(2) or (c)(3) of this section (relating to
transitional rules for preferred stock), no person may have any interest
in the net earnings of a tax-exempt cemetery company or crematorium.
Thus, a cemetery company or crematorium is not exempt from tax if
property is transferred to such organization in exchange for an interest
in the net earnings of the organization so long as such interest remains
outstanding. An interest in a cemetery company or crematorium that
constitutes an equity interest within the meaning of section 385 will be
considered an interest in the net earnings of the cemetery. However, an
interest in a cemetery company or crematorium that does not constitute
an equity interest within the meaning of section 385 may nevertheless
constitute an interest in the net earning of the organization. Thus, for
example, a bond or other evidence of indebtedness issued by a cemetery
company or crematorium which provides for a fixed rate of interest but
which, in addition, provides for additional interest payments contingent
upon the revenues or income of the organization is considered an
interest in the net earnings of the organization. Similarly, a
convertible debt obligation issued by a cemetery company or crematorium
after July 7, 1975, is considered an interest in the net earnings of the
organization.
[T.D. 7698, 45 FR 33972, May 21, 1980]
Sec. 1.501(c)(14)-1 Credit unions and mutual insurance funds.
Credit unions (other than Federal credit unions described in section
501(c)(1)) without capital stock, organized and operated for mutual
purposes and without profit, are exempt from tax under section 501(a).
Corporations or associations without capital stock organized before
September 1, 1951 and operated for mutual purposes and without profit
for the purpose of providing reserve funds for, and insurance of, shares
or deposits in:
(a) Domestic building and loan associations as defined in section
7701(a)(19),
(b) Cooperative banks without capital stock organized and operated
for mutual purposes and without profit, or
(c) Mutual savings banks not having capital stock represented by
shares
are also exempt from tax under section 501(a). In addition, corporations
or associations of the type described in the preceding sentence which
were organized on or after September 1, 1951, but before September 1,
1957, are exempt
[[Page 35]]
from tax under section 501(a) for taxable years beginning after December
31, 1959.
[T.D. 6493, 25 FR 9219, Sept. 27, 1960]
Sec. 1.501(c)(15)-1 Mutual insurance companies or associations.
(a) Taxable years beginning after December 31, 1962. An insurance
company or association described in section 501(c)(15) is exempt under
section 501(a) if it is a mutual company or association (other than life
or marine) or if it is a mutual interinsurer or reciprocal underwriter
(other than life or marine) and if the gross amount received during the
taxable year from the sum of the following items does not exceed
$150,000:
(1) The gross amount of income during the taxable year from:
(i) Interest (including tax-exempt interest and partially tax-exempt
interest), as described in Sec. 1.61-7. Interest shall be adjusted for
amortization of premium and accrual of discount in accordance with the
rules prescribed in section 822(d)(2) and the regulations thereunder.
(ii) Dividends, as described in Sec. 1.61-9.
(iii) Rents and royalties, as described in Sec. 1.61-8.
(iv) The entering into of any lease, mortgage, or other instrument
or agreement from which the company may derive interest, rents, or
royalties.
(v) The alteration or termination of any instrument or agreement
described in subdivision (iv) of this subparagraph.
(2) The gross income from any trade or business (other than an
insurance business) carried on by the company or association, or by a
partnership of which the company or association is a partner.
(3) Premiums (including deposits and assessments).
(b) Taxable years beginning after December 31, 1954, and before
January 1, 1963. An insurance company or association described in
section 501(c)(15) and paragraph (a) of this section is exempt under
section 501(a) if the gross amount received during the taxable year from
the sum of the items described in paragraph (a) (1), (2), and (3) of
this section does not exceed $75,000.
(c) No double inclusion of income. In computing the gross income
from any trade or business (other than an insurance business) carried on
by the company or association, or by a partnership of which the company
or association is a partner, any item described in section 822(b)(1)
(A), (B), or (C) and paragraph (a)(1) of this section shall not be
considered as gross income arising from the conduct of such trade or
business, but shall be taken into account under section 822(b)(1) (A),
(B), or (C) and paragraph (a)(1) of this section.
(d) Taxable years beginning after December 31, 1953, and before
January 1, 1955. An insurance company or association described in
section 501(c)(15) is exempt under section 501(a) if it is a mutual
company or association (other than life or marine) or if it is a mutual
interinsurer or reciprocal underwriter (other than life or marine) and
if the gross amount received during the taxable year from the sum of the
following items does not exceed $75,000:
(1) The gross amount of income during the taxable year from--
(i) Interest (including tax-exempt interest and partially tax-exempt
interest), as described in Sec. 1.61-7. Interest shall be adjusted for
amortization of premium and accrual of discount in accordance with the
rules prescribed in section 822(d)(2) and Sec. 1.822-3.
(ii) Dividends, as described in Sec. 1.61-9.
(iii) Rents (but excluding royalties), as described in Sec. 1.61-8.
(2) Premiums (including deposits and assessments).
(e) Exclusion of capital gains. Gains from sales or exchanges of
capital assets to the extent provided in subchapter P (section 1201 and
following, relating to capital gains and losses), chapter 1 of the Code,
shall be excluded from the amounts described in this section.
[T.D. 6662, 28 FR 6972, July 29, 1963]
Sec. 1.501(c)(16)-1 Corporations organized to finance crop operations.
A corporation organized by a farmers' cooperative marketing or
purchasing association, or the members thereof, for the purpose of
financing the ordinary crop operations of such members or other
producers is exempt, provided the marketing or purchasing
[[Page 36]]
association is exempt under section 521 and the financing corporation is
operated in conjunction with the marketing or purchasing association.
The provisions of Sec. 1.521-1 relating to a reserve or surplus and to
capital stock shall also apply to corporations coming under this
section.
Sec. 1.501(c)(17)-1 Supplemental unemployment benefit trusts.
(a) Requirements for qualification. (1) A supplemental unemployment
benefit trust may be exempt as an organization described in section
501(c)(17) if the requirements of subparagraphs (2) through (6) of this
paragraph are satisfied.
(2) The trust is a valid, existing trust under local law and is
evidenced by an executed written document.
(3) The trust is part of a written plan established and maintained
by an employer, his employees, or both the employer and his employees,
solely for the purpose of providing supplemental unemployment
compensation benefits (as defined in section 501(c)(17)(D) and paragraph
(b)(1) of Sec. 1.501(c)(17)-1).
(4) The trust is part of a plan which provides that the corpus and
income of the trust cannot (in the taxable year, and at any time
thereafter, before the satisfaction of all liabilities to employees
covered by the plan) be used for, or diverted to, any purpose other than
the providing of supplemental unemployment compensation benefits. Thus,
if the plan provides for the payment of any benefits other than
supplemental unemployment compensation benefits as defined in paragraph
(b) of this section, the trust will not be entitled to exemption as an
organization described in section 501(c)(17). However, the payment of
any necessary or appropriate expenses in connection with the
administration of a plan providing supplemental unemployment
compensation benefits shall be considered a payment to provide such
benefits and shall not affect the qualification of the trust.
(5) The trust is part of a plan whose eligibility conditions and
benefits do not discriminate in favor of employees who are officers,
shareholders, persons whose principal duties consist of supervising the
work of other employees, or highly compensated employees. See sections
401(a)(3)(B) and 401(a)(4) and Sec. Sec. 1.401-3 and 1.401(a)(4)-0
through 1.401(a)(4)-13. However, a plan is not discriminatory within the
meaning of section 501(c)(17)(A)(iii), relating to the requirement that
the benefits paid under the plan be nondiscriminatory, merely because
the benefits received under the plan bear a uniform relationship to the
total compensation, or the basic or regular rate of compensation, of the
employees covered by the plan. Accordingly, the benefits provided for
highly paid employees may be greater than the benefits provided for
lower paid employees if the benefits are determined by reference to
their compensation; but, in such a case, the plan will not qualify if
the benefits paid to the higher paid employees bear a larger ratio to
their compensation than the benefits paid to the lower paid employees
bear to their compensation. In addition, section 501(c)(17)(B) sets
forth certain other instances in which a plan will not be considered
discriminatory (see paragraph (c) of Sec. 1.501(c)(17)-2).
(6) The trust is part of a plan which requires that benefits are to
be determined according to objective standards. Thus, a plan may provide
similarly situated employees with benefits which differ in kind and
amount, but may not permit such benefits to be determined solely in the
discretion of the trustees.
(b) Meaning of terms. The following terms are defined for purposes
of section 501(c)(17):
(1) Supplemental unemployment compensation benefits. The term
supplemental unemployment compensation benefits means only:
(i) Benefits paid to an employee because of his involuntary
separation from the employment of the employer, whether or not such
separation is temporary, but only when such separation is one resulting
directly from a reduction in force, the discontinuance of a plant or
operation, or other similar conditions; and
(ii) Sick and accident benefits subordinate to the benefits
described in subdivision (i) of this subparagraph.
(2) Employee. The term employee means an individual whose status is
that of an employee under the usual
[[Page 37]]
common-law rules applicable in determining the employer-employee
relationship. The term employee also includes an individual who
qualifies as an employee under the State or Federal unemployment
compensation law covering his employment, whether or not such an
individual could qualify as an employee under such common-law rules.
(3) Involuntary separation from the employment of the employer.
Whether a separation from the employment of the employer occurs is a
question to be decided with regard to all the facts and circumstances.
However, for purposes of section 501(c)(17), the term separation
includes both a temporary separation and a permanent severance of the
employment relationship. Thus, for example, an employee may be separated
from the employment of his employer even though at the time of
separation it is believed that he will be reemployed by the same
employer. Whether or not an employee is involuntarily separated from the
employment of the employer is a question of fact. However, normally, an
employee will not be deemed to have separated himself voluntarily from
the employment of his employer merely because his collective bargaining
agreement provides for the termination of his services upon the
happening of a condition subsequent and that condition does in fact
occur. For example, if the collective bargaining agreement provides that
the employer may automate a given department and thereby dislocate
several employees, the fact that the employees' collective bargaining
agent has consented to such a condition will not render any employee's
subsequent unemployment for such cause voluntary.
(4) Other similar conditions. Involuntary separation directly
resulting from other similar conditions includes, for example,
involuntary separation from the employment of the employer resulting
from cyclical, seasonal, or technological causes. Some causes of
involuntary separation from the employment of the employer which are not
similar to those enumerated in section 501(c)(17)(D)(i) are separation
for disciplinary reasons or separation because of age.
(5) Subordinate sick and accident benefits. In general, a sick and
accident benefit payment is an amount paid to an employee in the event
of his illness or personal injury (whether or not such illness or injury
results in the employee's separation from the service of his employer).
In addition, the phrase sick and accident benefits includes amounts
provided under the plan to reimburse an employee for amounts he expends
because of the illness or injury of his spouse or a dependent (as
defined in section 152). Sick and accident benefits may be paid by a
trust described in section 501(c)(17) only if such benefits are
subordinate to the separation payments provided under the plan of which
the trust forms a part. Whether the sick and accident benefits provided
under a supplemental unemployment compensation benefit plan are
subordinate to the separation benefits provided under such plan is a
question to be decided with regard to all the facts and circumstances.
[T.D. 6972, 33 FR 12900, Sept. 12, 1968, as amended by T.D. 9849, 84 FR
9235, Mar. 14, 2019]
Sec. 1.501(c)(17)-2 General rules.
(a) Supplemental unemployment compensation benefits. Supplemental
unemployment compensation benefits as defined in section 501(c)(17)(D)
and paragraph (b)(1) of Sec. 1.501(c)(17)-1 may be paid in a lump sum
or installments. Such benefits may be paid to an employee who has,
subsequent to his separation from the employment of the employer,
obtained other part-time, temporary, or permanent employment.
Furthermore, such payments may be made in cash, services, or property.
Thus, supplemental unemployment compensation benefits provided to
involuntarily separated employees may include, for example, the
following: Furnishing of medical care at an established clinic,
furnishing of food, job training and schooling, and job counseling. If
such benefits are furnished in services or property, the fair market
value of the benefits must satisfy the requirements of section
501(c)(17)(A)(iii), relating to nondiscrimination as to benefits.
However, supplemental unemployment compensation benefits may be provided
[[Page 38]]
only to an employee and only under circumstances described in paragraph
(b)(1) of Sec. 1.501(c)(17)-1. Thus, a trust described in section
501(c)(17) may not provide, for example, for the payment of a death,
vacation, or retirement benefit.
(b) Sick and accident benefits. If a trust described in section
501(c)(17) provides for the payment of sick and accident benefits, such
benefits may only be provided for employees who are eligible for receipt
of separation benefits under the plan of which the trust is a part.
However, the sick and accident benefits need not be provided for all the
employees who are eligible for receipt of separation benefits, so long
as the plan does not discriminate in favor of persons with respect to
whom discrimination is proscribed in section 501(c)(17)(A) (ii) and
(iii). Furthermore, the portion of the plan which provides for the
payment of sick and accident benefits must satisfy the nondiscrimination
requirements of section 501(c)(17)(A) (ii) and (iii) without regard to
the portion of the plan which provides for the payment of benefits
because of involuntary separation.
(c) Correlation with other plans. (1) In determining whether a plan
meets the requirements of section 501(c)(17)(A) (ii) and (iii), any
benefits provided under any other plan shall not be taken into
consideration except in the particular instances enumerated in section
501(c)(17)(B) (i), (ii), and (iii). In general, these three exceptions
permit a plan providing for the payment of supplemental unemployment
compensation benefits to satisfy the nondiscrimination requirements in
section 501(c)(17)(A) (ii) and (iii) if the plan is able to satisfy such
requirements when it is correlated with one or more of the plans
described in section 501(c)(17)(B).
(2) Under section 501(c)(17)(B)(i), a plan will not be considered
discriminatory merely because the benefits under the plan which are
first determined in a nondiscriminatory manner (within the meaning of
section 501(c)(17)(A)) are then reduced by any sick, accident, or
unemployment compensation benefits received under State or Federal law,
or are reduced by a portion of these benefits if determined in a
nondiscriminatory manner. Under this exception, a plan may, for example,
satisfy the requirements of section 501(c)(17)(A)(iii) if it provides
for the payment of an unemployment benefit and the amount of such
benefit is determined as a percentage of the employee's compensation
which is then reduced by any unemployment benefit which the employee
receives under a State plan. In addition, a plan could provide for the
reduction of such a plan benefit by a percentage of the State benefit.
Furthermore, a plan may also satisfy the requirements of section
501(c)(17)(A) if it provides for the payment to an employee of an amount
which when added to any State unemployment benefit equals a percentage
of the employee's compensation.
(3) Under section 501(c)(17)(B)(ii), a plan will not be considered
discriminatory merely because the plan provides benefits only for
employees who are not eligible to receive sick, accident, or
unemployment compensation benefits under State or Federal law. In such a
case, however, the benefits provided under the plan seeking to satisfy
the requirements of section 501(c)(17) must be the same benefits, or a
portion of the same benefits if determined in a nondiscriminatory
manner, which such ineligible employees would receive under State or
Federal law if they were eligible for such benefits. Under this
exception, for example, an employer may establish a plan only for
employees who have exhausted their benefits under the State law, and, if
the plan provides for such employees the same benefits which they would
receive under the State plan, the State plan and the plan of the
employer will be considered as one plan in determining whether the
requirements relating to nondiscrimination in section 501(c)(17)(A) are
satisfied. Furthermore, such a plan could also qualify even though it
does not provide all of the benefits provided under the State plan.
Thus, a plan could provide for the payment of a reduced amount of the
benefits, or for the payment of only certain of the types of benefits,
provided by the State plan. For example, if the State plan provides for
the payment of sick, accident, and separation benefits, the plan of the
employer may provide for
[[Page 39]]
the payment of only separation benefits, or for the payment of an amount
equal to only one-half of the State provided benefit. However, if a plan
provides benefits for employees who are not eligible to receive the
benefits provided under a State plan and such benefits are greater or of
a different type than those under the State plan, the plan of the
employer must satisfy the requirements of section 501(c)(17)(A) without
regard to the benefits and coverage provided by the State plan.
(4) Under section 501(c)(17)(B)(iii), a plan is not considered
discriminatory merely because the plan provides benefits only for
employees who are not eligible to receive benefits under another plan
which satisfies the requirements of section 501(c)(17)(A) and which is
funded solely by contributions of the employer. In such a case, the plan
seeking to qualify under section 501(c)(17) must provide the same
benefits, or a portion of such benefits if determined in a
nondiscriminatory manner, as are provided for the employees under the
plan funded solely by employer contributions. Furthermore, this
exception only applies if the employees eligible to receive benefits
under both plans would satisfy the requirements in section
501(c)(17)(A)(ii), relating to nondiscrimination as to coverage. The
plan of the employer which is being correlated with the plan seeking to
satisfy the requirements of section 501(c)(17) may be a plan which forms
part of a voluntary employees' beneficiary association described in
section 501(c)(9), if such plan satisfies all the requirements of
section 501(c)(17)(A). Under this exception, for example, if an employer
has established a plan providing for the payment of supplemental
unemployment compensation benefits for his hourly wage employees and
such plan satisfies the requirements of section 501(c)(17)(A) (even
though the plan forms part of a voluntary employees' beneficiary
association described in section 501(c)(9)), the salaried employees of
such employee may establish a plan for themselves, and, if such plan
provides for the same benefits as the plan covering hourly-wage
employees, both plans may be considered as one plan in determining
whether the plan covering the salaried employees satisfies the
requirement that is be nondiscriminatory as to coverage. The foregoing
example would also be applicable if the benefits provided for the
salaried employees were funded solely or in part by employer
contributions.
(d) Permanency of the plan. A plan providing for the payment of
supplemental unemployment compensation benefits contemplates a permanent
as distinguished from a temporary program. Thus, although there may be
reserved the right to change or terminate the plan, and to discontinue
contributions thereunder, the abandonment of the plan for any reason
other than business necessity within a few years after it has taken
effect will be evidence that the plan from its inception was not a bona
fide program for the purpose of providing supplemental unemployment
compensation benefits to employees. Whether or not a particular plan
constitutes a permanent arrangement will be determined by all of the
surrounding facts and circumstances. However, merely because a
collective bargaining agreement provides that a plan may be modified at
the termination of such agreement, or that particular provisions of the
plan are subject to renegotiation during the duration of such agreement,
does not necessarily imply that the plan is not a permanent arrangement.
Moreover, the fact that the plan provides that the assets remaining in
the trust after the satisfaction of all liabilities (including
contingent liabilities) under the plan may be returned to the employer
does not imply that the plan is not a permanent arrangement nor preclude
the trust from qualifying under section 501(c)(17).
(e) Portions of years. A plan must satisfy the requirements of
section 501(c)(17) throughout the entire taxable year of the trust in
order for the trust to be exempt for such year. However, section
501(c)(17)(C) provides that a plan will satisfy the nondiscrimination as
to classification requirements of section 501(c)(17)(A) if on at least
one day in each quarter of the taxable year of the trust it satisfies
such requirements.
(f) Several trusts constituting one plan. Several trusts may be
designated as
[[Page 40]]
constituting part of one plan which is intended to satisfy the
requirements of section 501(c)(17), in which case all of such trusts
taken as a whole must meet the requirements of such section. The fact
that a combination of trusts fails to satisfy the requirements of
section 501(c)(17) as one plan does not prevent such of the trusts as
satisfy the requirements of section 501(c)(17) from qualifying for
exemption under that section.
(g) Plan of several employers. A trust forming part of a plan of
several employers, or the employees of several employers, will be a
supplemental unemployment benefit trust described in section 501(c)(17)
if all the requirements of that section are otherwise satisfied.
(h) Investment of trust funds. No specific limitations are provided
in section 501(c)(17) with respect to investments which may be made by
the trustees of a trust qualifying under that section. Generally, the
contributions may be used by the trustees to purchase any investments
permitted by the trust agreement to the extent allowed by local law.
However, the tax-exempt status of the trust will be forfeited if the
investments made by the trustees constitute prohibited transactions
within the meaning of section 503. See section 503 and the regulations
thereunder. In addition, such a trust will be subject to tax under
section 511 with respect to any unrelated business taxable income (as
defined in section 512) realized by it from its investments. See
sections 511 to 515, inclusive, and the regulations thereunder.
(i) Allocations. If a plan which provides sick and accident benefits
is financed solely by employer contributions to the trust, and such sick
and accident benefits are funded by payment of premiums on an accident
or health insurance policy (whether on a group or individual basis) or
by contributions to a separate fund which pays such sick and accident
benefits, the plan must specify that portion of the contributions to be
used to fund such benefits. If a plan which is financed in whole or in
part by employee contributions provides sick and accident benefits, the
plan must specify the portion, if any, of employee contributions
allocated to the cost of funding such benefits, and must allocate the
cost of funding such benefits between employer contributions and
employee contributions.
(j) Required records and returns. Every trust described in section
501(c)(17) must maintain records indicating the amount of separation
benefits and sick and accident benefits which have been provided to each
employee. If a plan is financed, in whole or in part, by employee
contributions to the trust, the trust must maintain records indicating
the amount of each employee's total contributions allocable to
separation benefits. In addition, every trust described in section
501(c)(17) which makes one or more payments totaling $600 or more in 1
year to an individual must file an annual information return in the
manner described in paragraph (b)(1) of Sec. 1.6041-2. However, if the
payments from such trust are subject to income tax withholding under
section 3402(o) and the regulations thereunder, the trust must file, in
lieu of such annual information return, the returns of income tax
withheld from wages required by section 6011 and the regulations
thereunder. In such circumstances, the trust must also furnish the
statements to the recipients of trust distributions required by section
6051 and the regulations thereunder.
[T.D. 6972, 33 FR 12901, Sept. 12, 1968, as amended by T.D. 7068, 35 FR
17328, Nov. 11, 1970]
Sec. 1.501(c)(17)-3 Relation to other sections of the Code.
(a) Taxability of benefit distributions--(1) Separation benefits. If
the separation benefits described in section 501(c)(17)(D)(i) are funded
entirely by employer contributions, then the full amount of any
separation benefit payment received by an employee is includible in his
gross income under section 61(a). If any such separation benefit is
funded by both employer and employee contributions, or solely by
employee contributions, the amount of any separation benefit payment
which is includible in the gross income of the employee is the amount by
which such
[[Page 41]]
distribution and any prior distributions of such separation payments
exceeds the employee's total contributions to fund such separation
benefits.
(2) Sick and accident benefits. Any benefit payment received from
the trust under the part of the plan, if any, which provides for the
payment of sick and accident benefits must be included in gross income
under section 61(a), unless specifically excluded under section 104 or
105 and the regulations thereunder. See section 105(b) and Sec. 1.105-2
for benefit payments expended for medical care, benefit payments in
excess of actual medical expenses, and benefit payments which an
employee is entitled to receive irrespective of whether or not he incurs
expenses for medical care. See section 213 and Sec. 1.213-1(g) for
benefit payments representing reimbursement for medical expenses paid in
prior years. See Sec. 1.501(c)(17)-2(i) for the requirement that a
trust described in section 501(c)(17) which receives employee
contributions must be part of a written plan which provides for the
allocation of the cost of funding sick and accident benefits.
(b) Exemption as a voluntary employees' beneficiary association.
Section 501(c)(17)(E) contemplates that a trust forming part of a plan
providing for the payment of supplemental unemployment compensation
benefits may, if it qualifies, apply for exemption from income tax under
section 501(a) either as a voluntary employees' beneficiary association
described in section 501(c)(9) or as a trust described in section
501(c)(17).
(c) Returns. A trust which is described in section 501(c)(17) and
which is exempt from tax under section 501(a) must file a return in
accordance with section 6033 and the regulations thereunder. If such a
trust realizes any unrelated business taxable income, as defined in
section 512, the trust is also required to file a return with respect to
such income.
(d) Effective date. Section 501(c)(17) shall apply to taxable years
beginning after December 31, 1959, and shall apply to supplemental
unemployment benefit trusts regardless of when created or organized.
[T.D. 6972, 33 FR 12902, Sept. 12, 1968]
Sec. 1.501(c)(18)-1 Certain funded pension trusts.
(a) In general. Organizations described in section 501(c)(18) are
trusts created before June 25, 1959, forming part of a plan for the
payment of benefits under a pension plan funded only by contributions of
employees. In order to be exempt, such trusts must also meet the
requirements set forth in section 501(c)(18) (A), (B), and (C), and in
paragraph (b) of this section.
(b) Requirements for qualification. A trust described in section
501(c)(18) must meet the following requirements:
(1) Local law. The trust must be a valid, existing trust under local
law, and must be evidenced by an executed written document.
(2) Funding. The trust must be funded solely from contributions of
employees who are members of the plan. For purposes of this section, the
term contributions of employees shall include earnings on, and gains
derived from, the assets of the trust which were contributed by
employees.
(3) Creation before June 25, 1959--(i) In general. The trust must
have been created before June 25, 1959. A trust created before June 25,
1959 is described in section 501(c)(18) and this section even though
changes in the makeup of the trust have occurred since that time so long
as these are not fundamental changes in the character of the trust or in
the character of the beneficiaries of the trust. Increases in the
beneficiaries of the trust by the addition of employees in the same or
related industries, whether such additions are of individuals or of
units (such as local units of a union) will generally not be considered
a fundamental change in the character of the trust. A merger of a trust
created after June 25, 1959 into a trust created before such date is not
in itself a fundamental change in the character of the latter trust if
the two trusts are for the benefit of employees of the same or related
industries.
(ii) Examples. The provisions of this subparagraph may be
illustrated by the following examples:
Example 1. Assume that trust C, for the benefit of members of
participating locals of National Union X, was established in 1950 and
adopted by 29 locals before June 25, 1959.
[[Page 42]]
The subsequent adoption of trust C by additional locals of National
Union X in 1962 will not constitute a fundamental change in the
character of trust C, since such subsequent adoption is by employees in
a related industry.
Example 2. Assume the facts as stated in example 1, except that in
1965 National Union X merged with National Union Y, whose members are
engaged in trades related to those engaged in by X's members. Assume
further that trust D, the employee funded pension plan and fund for
employees of Y, was subsequently merged into trust C. The merger of
trust D into trust C would not in itself constitute a fundamental change
in the character of trust C, since both C and D are for the benefit of
employees of related industries.
(4) Payment of benefits. The trust must provide solely for the
payment of pension or retirement benefits to its beneficiaries. For
purposes of this section, the term retirement benefits is intended to
include customary and incidental benefits, such as death benefits within
the limits permissible under section 401.
(5) Diversion. The trust must be part of a plan which provides that,
before the satisfaction of all liabilities to employees covered by the
plan, the corpus and income of the trust cannot (within the taxable year
and at any time thereafter) be used for, or diverted to, any purpose
other than the providing of pension or retirement benefits. Payment of
expenses in connection with the administration of a plan providing
pension or retirement benefits shall be considered a payment to provide
such benefits and shall not affect the qualification of the trust.
(6) Discrimination. The trust must be part of a plan whose
eligibility conditions and benefits do not discriminate in favor of
employees who are officers, shareholders, persons whose principal duties
consist of supervising the work of other employees, or highly
compensated employees. See sections 401(a)(3)(B) and 401(a)(4) and
Sec. Sec. 1.401-3 and 1.401(a)(4)-0 through 1.401(a)(4)-13. However, a
plan is not discriminatory within the meaning of section 501(c)(18)
merely because the benefits received under the plan bear a uniform
relationship to the total compensation, or the basic or regular rate of
compensation, of the employees covered by the plan. Accordingly, the
benefits provided for highly paid employees may be greater than the
benefits provided for lower paid employees if the benefits are
determined by reference to their compensation; but, in such a case, the
plan will not qualify if the benefits paid to the higher paid employees
are a larger portion of compensation than the benefits paid to lower
paid employees.
(7) Objective standards. The trust must be part of a plan which
requires that benefits be determined according to objective standards.
Thus, while a plan may provide similarly situated employees with
benefits which differ in kind and amount, these benefits may not be
determined solely in the discretion of the trustees.
(c) Effective date. The provisions of section 501(c)(18) and this
section shall apply with respect to taxable years beginning after
December 31, 1969.
[T.D. 7172, 37 FR 5618, Mar. 17, 1972, as amended by T.D. 9849, 84 FR
9235, Mar. 14, 2019]
Sec. 1.501(c)(19)-1 War veterans organizations.
(a) In general. (1) For taxable years beginning after December 31,
1969, a veterans post or organization which is organized in the United
States or any of its possessions may be exempt as an organization
described in section 501(c)(19) if the requirements of paragraphs (b)
and (c) of this section are met and if no part of its net earnings
inures to the benefit of any private shareholder or individual.
Paragraph (b) of this section contains the membership requirements such
a post or organization must meet in order to qualify under section
501(c)(19). Paragraph (c) of this section outlines the purposes, at
least one of which such a post or organization must have in order to so
qualify.
(2) In addition, an auxiliary unit or society described in paragraph
(d) of this section of such a veterans post or organization and a trust
or foundation described in paragraph (e) of this section for such post
or organization may be exempt as an organization described in section
501(c)(19).
(b) Membership requirements. (1) In order to be described in section
501(c)(19) under paragraph (a)(1) of this section, an organization must
meet the membership requirements of section
[[Page 43]]
501(c)(19)(B) and this paragraph. There are two requirements that must
be met under this paragraph. The first requirement is that at least 75
percent of the members of the organization must be war veterans. For
purposes of this section the term war veterans means persons, whether or
not present members of the United States Armed Forces, who have served
in the Armed Forces of the United States during a period of war
(including the Korean and Vietnam conflicts).
(2) The second requirement of this paragraph is that at least 97.5
percent of all members of the organization must be described in one or
more of the following categories:
(i) War veterans,
(ii) Present or former members of the United States Armed Forces,
(iii) Cadets (including only students in college or university ROTC
programs or at Armed Services academies), or
(iv) Spouses, widows, or widowers of individuals referred to in
paragraph (b)(2) (i), (ii) or (iii) of this section.
(c) Exempt purposes. In addition to the requirements of paragraphs
(a)(1) and (b) of this section, in order to be described in section
501(c)(19) under paragraph (a)(1) of this section an organization must
be operated exclusively for one or more of the following purposes:
(1) To promote the social welfare of the community as defined in
Sec. 1.501(c)(4)-1(a)(2).
(2) To assist disabled and needy war veterans and members of the
United States Armed Forces and their dependents, and the widows and
orphans of deceased veterans,
(3) To provide entertainment, care, and assistance to hospitalized
veterans or members of the Armed Forces of the United States,
(4) To carry on programs to perpetuate the memory of deceased
veterans and members of the Armed Forces and to comfort their survivors,
(5) To conduct programs for religious, charitable, scientific,
literary, or educational purposes,
(6) To sponsor or participate in activities of a patriotic nature,
(7) To provide insurance benefits for their members or dependents of
their members or both, or
(8) To provide social and recreational activities for their members.
(d) Auxiliary units or societies for war veterans organizations. A
unit or society may be exempt as an organization described in section
501(c)(19) and paragraph (a)(2) of this section if it is an auxiliary
unit or society of a post or organization of war veterans described in
paragraph (a)(1) of this section. A unit or society is an auxiliary unit
or society or such a post or organization if it meets the following
requirements:
(1) It is affiliated with, and organized in accordance with, the
bylaws and regulations formulated by an organization described in
paragraph (a)(1) of this section,
(2) At least 75 percent of its members are either war veterans, or
spouses of war veterans, or are related to a war veteran within two
degrees of consanguinity (i.e., grandparent, brother, sister,
grandchild, represent the most distant allowable relationships),
(3) All of its members are either members of an organization
described in paragraph (a)(1) of this section, or spouses of a member of
such an organization or are related to a member of such an organization,
within two degrees of consanguinity, and
(4) No part of its net earnings inures to the benefit of any private
shareholder or individual.
(e) Trusts or foundations. A trust or foundation may be exempt as an
organization described in section 501(c)(19) and paragraph (a)(2) of
this section if it is a trust or foundation for a post or organization
of war veterans described in paragraph (a)(1) of this section. A trust
or foundation is a trust or foundation for such a post or organization
if it meets the following requirements:
(1) The trust or foundation is in existence under local law and, if
organized for charitable purposes, has a dissolution provision described
in Sec. 1.501(c)(3)-1(b)(4).
(2) The corpus or income cannot be diverted or used other than for
the funding of a post or organization of war veterans described in
paragraph (a)(1) of this section, for section 170(c)(4) purposes, or as
an insurance set aside (as defined in Sec. 1.512(a)-4(b)).
(3) The trust income is not unreasonably accumulated and, if the
trust or
[[Page 44]]
foundation is not an insurance set aside, a substantial portion of the
income is in fact distributed to such post or organization or for
section 170(c)(4) charitable purposes, and
(4) It is organized exclusively for one or more of those purposes
enumerated in paragraph (c) of this section.
[T.D. 7438, 41 FR 44392, Oct. 8, 1976]
Sec. 1.501(c)(21)-1 Black lung trusts--certain terms.
(a) Created or organized in the United States. A trust is not
created or organized in the United States unless it is maintained at all
times as a domestic trust in the United States. For this purpose,
section 7701(a)(9) limits the term United States to the District of
Columbia and States of the United States.
(b) Insurance company. The term insurance company means an
insurance, surety, bonding or other company whose liability for the
kinds of claims to which section 501(c)(21)(A)(i) applies is as an
insurer or guarantor of the liabilities of another.
(c) Black Lung Acts. The term Black Lung Acts includes any State law
providing compensation for disability or death due to pneumoconiosis
even though the State law compensates for other kinds of injuries. In
such a case, section 501(c)(21) applies only to the extent that the
liability is attributable to disability or death due to pneumoconiosis.
For this purpose, the term pneumoconiosis has the same meaning as it has
under federal law. See 30 U.S.C. 902.
(d) Insurance exclusively covering such liability. The term
insurance exclusively covering such liability includes insurance that
covers risk for liabilities in addition to the liabilities to which
section 501(c)(21)(A)(i) applies. In such a case, payment for premiums
may be made from the trust only to the extent of that portion of the
premiums that has been separately allocated and stated by the insurer as
attributable solely to coverage of the liabilities to which section
501(c)(21)(A)(i) applies.
(e) Administrative and other incidental expenses. The term
administrative and other incidental expenses means expenditures that are
appropriate and helpful to the trust making them in carrying out the
purposes for which its assets may be used under section 501(c)(21)(B).
The term includes any exicse tax imposed on the trust under section 4952
(relating to taxes on taxable expenditures) and reasonable expenses,
such as legal expenses, incurred by the trust in connection with an
assertion against the trust of liability for a taxable expenditure. The
term does not include an excise tax imposed on the trustee or on other
disqualified persons under section 4951 (relating to taxes on self-
dealing) or under section 4953 (relating to tax on excess contributions
to black lung benefit trusts) or any expenses incurred in connection
with the assertion of these taxes other than expenses that are treated
as part of reasonable compensation under section 4951(d)(2)(C). See
Sec. Sec. 53.4941 (d)-2(f)(3) and (d)-3(c) for interpretations of
similar provisions under section 4941(d)(2)(E), relating to reasonable
compensation for private foundation disqualified persons.
(f) Public debt securities of the United States. The term public
debt securities of the United States means obligations that are taken
into consideration for purposes of the public debt limit. See, for
example 31 U.S.C. 757b.
(g) Obligations of a State or local government. The term obligations
of a State or local government means the obligations of a State or local
governmental unit the interest on which is exempt from tax under section
103(a). See Sec. 1.103-1(a).
(h) Time or demand deposits. The term time or demand deposits
includes checking accounts, savings accounts, certificates of deposit or
other time or demand deposits. The term does not include common or
collective trust funds such as a common trust fund as defined in section
584.
[44 FR 52197, Sept. 7, 1979]
Sec. 1.501(c)(21)-2 Same--trust instrument.
As trust does not meet the requirements of section 501(c)(21) if it
is not established and maintained pursuant to a written instrument. The
trust instrument must definitely and affirmatively prohibit a diversion
or use of trust assets that is not permitted under section 501(c)(21)(B)
or section
[[Page 45]]
4953(c), whether by operation or natural termination of the trust, by
power of revocation or amendment by the happening of a contingency by
collateral arrangement, or by any other means. No particular form for
the trust instrument is required. A trust may meet the requirements of
section 501(c)921) although the trust instrument fails to contain
provisions the effects of which are to prohibit acts that are subject to
section 4951 (relating to taxes on self-dealing), section 4952 (relating
to taxes on taxable expenditures) or the retention of contributions
subject to section 4953 (relating to tax on excess contributions to
black lung benefit trusts).
[44 FR 52197, Sept. 7, 1979]
Sec. 1.501(c)(29)-1 CO-OP Health Insurance Issuers.
(a) Organizations must notify the Commissioner that they are
applying for recognition of section 501(c)(29) status. An organization
will not be treated as described in section 501(c)(29) unless the
organization has given notice to the Commissioner that it is applying
for recognition as an organization described in section 501(c)(29) in
the manner prescribed by the Commissioner in published guidance.
(b) Effective date of recognition of section 501(c)(29) status. An
organization may be recognized as an organization described in section
501(c)(29) as of a date prior to the date of the notice required by
paragraph (a) of this section if the notice is given in the manner and
within the time prescribed by the Commissioner and the organization's
purposes and activities prior to giving such notice were consistent with
the requirements for exempt status under section 501(c)(29). However, an
organization may not be recognized as an organization described in
section 501(c)(29) before the later of its formation or March 23, 2010.
(c) Effective/applicability date. Paragraphs (a) and (b) of this
section are applicable beginning February 7, 2012.
[T.D. 9709, 80 FR 4793, Jan. 29, 2015]
Sec. 1.501(d)-1 Religious and apostolic associations or corporations.
(a) Religious or apostolic associations or corporations are
described in section 501(d) and are exempt from taxation under section
501(a) if they have a common treasury or community treasury, even though
they engage in business for the common benefit of the members, provided
each of the members includes (at the time of filing his return) in his
gross income his entire pro rata share, whether distributed or not, of
the net income of the association or corporation for the taxable year of
the association or corporation ending with or during his taxable year.
Any amount so included in the gross income of a member shall be treated
as a dividend received.
(b) For annual return requirements of organizations described in
section 501(d), see section 6033 and paragraph (a)(5) of Sec. 1.6033-1.
Sec. 1.501(e)-1 Cooperative hospital service organizations.
(a) General rule. Section 501(e) is the exclusive and controlling
section under which a cooperative hospital service organization can
qualify as a charitable organization. A cooperative hospital service
organization which meets the requirements of section 501(e) and this
section shall be treated as an organization described in section
501(c)(3), exempt from taxation under section 501(a), and referred to in
section 170(b)(1)(A) (iii) (relating to percentage limitations on
charitable contributions). In order to qualify for tax exempt status, a
cooperative hospital service organization must--
(1) Be organized and operated on a cooperative basis,
(2) Perform, on a centralized basis, only one or more specifically
enumerated services which, if performed directly by a tax exempt
hospital, would constitute activities in the exercise or performance of
the purpose or function constituting the basis for its exemption, and
(3) Perform such service or services solely for two or more patron-
hospitals as described in paragraph (d) of this section.
(b) Organized and operated on a cooperative basis--(1) In general.
In order to
[[Page 46]]
meet the requirements of section 501(e), the organization must be
organized and operated on a cooperative basis (whether or not under a
specific statute on cooperatives) and must allocate or pay all of its
net earnings within 8\1/2\ months after the close of the taxable year to
its patron-hospitals on the basis of the percentage of its services
performed for each patron. To allocate its net earnings to its patron-
hospitals, the organization must make appropriate bookkeeping entries
and provide timely written notice to each patron-hospital disclosing to
the patron-hospital the amount allocated to it on the books of the
organization. For the recordkeeping requirements of a section 501(e)
organization, see Sec. 1.521-1(a)(1).
(2) Percentage of services defined. The percentage of services
performed for each patron-hospital may be determined on the basis of
either the value or the quantity of the services provided by the
organization to the patron-hospital, provided such basis is realistic in
terms of the actual cost of the services to the organization.
(3) Retention of net earnings. Exemption will not be denied a
cooperative hospital service organization solely because the
organization, instead of paying all net earnings to its patron-
hospitals, retains an amount for such purposes as retiring indebtedness,
expanding the services of the organization, or for any other necessary
purpose and allocates such amounts to its patrons. However, such funds
may not be accumulated beyond the reasonably anticipated needs of the
organization. See, Sec. 1.537-1(b). Whether there is an improper
accumulation of funds depends upon the particular circumstances of each
case. Moreover, where an organization retains net earnings for necessary
purposes, the organization's records must show each patron's rights and
interests in the funds retained. For purposes of this paragraph, the
term net earnings does not include capital contributions to the
organization and such contributions need not satisfy the allocation or
payment requirements.
(4) Nonpatronage and other income. An organization described in
section 501(e) may, in addition to net earnings, receive membership dues
and related membership assessment fees, gifts, grants and income from
nonpatronage sources such as investment of retained earnings. However,
such an organization cannot be exempt if it engages in any business
other than that of providing the specified services, described in
paragraph (c), for the specified patron-hospitals, described in
paragraph (d). Thus, an organization described in section 501(e)
generally cannot have unrelated business taxable income as defined in
section 512, although it may earn certain interest, annuities,
royalties, and rents which are excluded from unrelated business taxable
income because of the modifications contained in sections 512(b) (1),
(2) or (3). An organization described in section 501(e) may, however,
have debt-financed income which is treated as unrelated business taxable
income solely because of the applicability of section 514. In addition,
exempt status under section 501(e) will not be affected where rent from
personal property leased with real property is treated as unrelated
business taxable income under section 512(b)(3)(A)(ii) solely because
the rent attributable to the personal property is more than incidental
or under section 512(b)(3)(B)(i) solely because the rent attributable to
the personal property exceeds 50 percent of the total rent received or
accrued under the lease. Exemption will not be affected solely because
the determination of the amount of rent depends in whole or in part on
the income or profits derived from the property leased. See, section
512(b)(3)(B)(ii). An organization described in section 501(e) may also
derive nonpatronage income from sources that are incidental to the
conduct of its exempt purposes or functions. For example, income derived
from the operation of a cafeteria or vending machines primarily for the
convenience of its employees or the disposition of by-products in
substantially the same state they were in on completion of the exempt
function (e.g., the sale of silver waste produced in the processing of
x-ray film) will not be considered unrelated business taxable income.
See, section 513(a)(2) and Sec. 1.513-1(d)(4)(ii). The nonpatronage and
other income permitted under this subparagraph (4) must be allocated or
paid as provided
[[Page 47]]
in subparagraph (1) or retained as provided in subparagraph (3).
(5) Stock ownership--(i) Capital stock of organization. An
organization does not meet the requirements of section 501(e) unless all
of the organization's outstanding capital stock, if there is such stock,
is held solely by its patron-hospitals. However, no amount may be paid
as dividends on the capital stock of the organization. For purposes of
the preceding sentence, the term capital stock includes common stock
(whether voting or nonvoting), preferred stock, or any other form
evidencing a proprietary interest in the organization.
(ii) Stock ownership as a condition for obtaining credit. If by
statutory requirement a cooperative hospital service organization must
be a shareholder in a United States or state chartered corporation as a
condition for obtaining credit from that corporate-lender, the ownership
of shares and the payment of dividends thereon will not for such reason
be a basis for the denial of exemption to the organization. See, e.g.,
National Consumer Cooperative Bank, 12 U.S.C. 3001 et seq.
(c) Scope of services--(1) Permissible services. An organization
meets the requirements of section 501(e) only if the organization
performs, on a centralized basis, one or more of the following services
and only such services: data processing, purchasing (including the
purchasing and dispensing of drugs and pharmaceuticals to patron-
hospitals), warehousing, billing and collection, food, clinical
(including radiology), industrial engineering (including the
installation, maintenance and repair of biomedical and similar
equipment), laboratory, printing, communications, record center, and
personnel (including recruitment, selection, testing, training,
education and placement of personnel) services. An organization is not
described in section 501(e) if, in addition to or instead of one or more
of these specified services, the organization performs any other service
(other than services referred to under paragraph (b)(4) that are
incidental to the conduct of exempt purposes or functions).
(2) Illustration. The provisions of this subparagraph may be
illustrated by the following example.
Example. An organization performs industrial engineering services on
a cooperative basis solely for patron-hospitals each of which is an
organization described in section 501(c)(3) and exempt from taxation
under section 501(a). However, in addition to this service, the
organization operates laundry services for its patron-hospitals. This
cooperative organization does not meet the requirements of this
paragraph because it performs laundry services not specified in this
paragraph.
(d) Patron-hospitals--(1) Defined. Section 501(e) only applies if
the organization performs its services solely for two or more patron-
hospitals each of which is--
(i) An organization described in section 501(c)(3) which is exempt
from taxation under section 501(a),
(ii) A constituent part of an organization described in section
501(c)(3) which is exempt from taxation under section 501(a) and which,
if organized and operated as a separate entity, would constitute an
organization described in section 501(c)(3), or
(iii) Owned and operated by the United States, a State, the District
of Columbia, or a possession of the United States, or a political
subdivision or an agency or instrumentality of any of the foregoing.
(2) Business with nonvoting patron-hospitals. Exemption will not be
denied a cooperative hospital service organization solely because the
organization (whether organized on a stock or membership basis)
transacts business with patron-hospitals which do not have voting rights
in the organization and therefore do not participate in the decisions
affecting the operation of the organization. Where the organization has
both patron-hospitals with voting rights and patron-hospitals without
such rights, the organization must provide at least 50 percent of its
services to patron-hospitals with voting rights in the organization.
Thus, the percentage of services provided to nonvoting patrons may not
exceed the percentage of such services provided to voting patrons. A
patron-hospital will be deemed to have voting rights in the cooperative
hospital service organization if the patron-hospital may vote directly
on matters affecting the operation of the organization or if the patron-
hospital may vote in the election of cooperative
[[Page 48]]
board members. Notwithstanding that an organization may have both voting
and nonvoting patron-hospitals, patronage refunds must nevertheless be
allocated or paid to all patron-hospitals solely on the basis specified
in paragraph (b) of this section.
(3) Services to other organizations. An organization does not meet
the requirements of section 501(e) if, in addition to performing
services for patron-hospitals (entities described in subdivisions (i),
(ii) or (iii) of subparagraph (1)), the organization performs any
service for any other organization. For example, a cooperative hospital
service organization is not exempt if it performs services for
convalescent homes for children or the aged, vocational training
facilities for the handicapped, educational institutions which do not
provide hospital care in their facilities, and proprietary hospitals.
However, the provision of the specified services between or among
cooperative hospital service organizations meeting the requirements of
section 501(e) and this section is permissible. Also permissible is the
provision of the specified services to entities which are not patron-
hospitals, but only if such services are de minimis and are mandated by
a governmental unit as, for example, a condition for licensing.
(e) Effective dates. An organization, other than an organization
performing clinical services, may meet the requirements of section
501(e) and be a tax exempt organization for taxable years ending after
June 28, 1968. An organization performing clinical services may meet the
requirements of section 501(e) and be a tax exempt organization for
taxable years ending after December 31, 1976. However, pursuant to the
authority contained in section 7805(b) of the Internal Revenue Code,
these regulations shall not become effective with respect to an
organization which has received a ruling or determination letter from
the Internal Revenue Service recognizing its exemption under section
501(e) until January 2, 1987.
[T.D. 8100, 51 FR 31615, Sept. 4, 1986; 51 FR 33593, Sept. 22, 1986]
Sec. 1.501(h)-1 Application of the expenditure test to expenditures
to influence legislation; introduction.
(a) Scope. (1) There are certain requirements an organization must
meet in order to be a charity described in section 501(c)(3). Among
other things, section 501(c)(3) states that ``no substantial part of the
activities of [a charity may consist of] carrying on propaganda, or
otherwise attempting to influence legislation, (except as otherwise
provided in subsection (h)).'' This requirement is called the
substantial part test.
(2) Under section 501(h), many public charities may elect the
expenditure test as a substitute for the substantial part test. The
expenditure test is described in section 501(h) and this Sec. 1.501(h).
A public charity is any charity that is not a private foundation under
section 509(a). (Unlike a public charity, a private foundation may not
make any lobbying expenditures: If a private foundation does make a
lobbying expenditure, it is subject to an excise tax under section
4945). Section 1.501(h)-2 lists which public charities are eligible to
make the expenditure test election. Section 1.501(h)-2 also provides
information about how a public charity makes and revokes the election to
be covered by the expenditure test.
(3) A public charity that makes the election may make lobbying
expenditures within specified dollar limits. If an electing public
charity's lobbying expenditures are within the dollar limits determined
under section 4911(c), the electing public charity will not owe tax
under section 4911 nor will it lose its tax exempt status as a charity
by virtue of section 501(h). If, however, that electing public charity's
lobbying expenditures exceed its section 4911 lobbying limit, the
organization is subject to an excise tax on the excess lobbying
expenditures. Further, under section 501(h), if an electing public
charity's lobbying expenditures normally are more than 150 percent of
its section 4911 lobbying limit, the organization will cease to be a
charity described in section 501(c)(3).
(4) A public charity that elects the expenditure test may
nevertheless lose its tax exempt status if it is an action organization
under Sec. 1.501(c)(3)-
[[Page 49]]
1(c)(3)(iii) or (iv). A public charity that does not elect the
expenditure test remains subject to the substantial part test. The
substantial part test is applied without regard to the provisions of
section 501(h) and 4911 and the related regulations.
(b) Effective date. The provisions of Sec. 1.501(h)-1 through Sec.
1.501(h)-3, are effective for taxable years beginning after August 31,
1990. An election made before August 31, 1990, under the provisions of
Sec. 7.0(c)(4) or the instructions to Form 5768, will be effective
under these regulations without again filing Form 5768.
[T.D. 8308, 55 FR 35588, Aug. 31, 1990]
Sec. 1.501(h)-2 Electing the expenditure test.
(a) In general. The election to be governed by section 501(h) may be
made by an eligible organization (as described in paragraph (b) of this
section) for any taxable year of the organization beginning after
December 31, 1976, other than the first taxable year for which a
voluntary revocation of the election is effective (see paragraph (d) of
this section). The election is made by filing a completed Form 5768,
Election/Revocation of Election by an Eligible Section 501(c)(3)
Organization to Make Expenditures to Influence Legislation, with the
appropriate Internal Revenue Service Center listed on that form. Under
section 501(h)(6), the election is effective with the beginning of the
taxable year in which the form is filed. For example, if an eligible
organization whose taxable year is the calendar year files Form 5768 on
December 31, 1979, the organization is governed by section 501(h) for
its taxable year beginning January 1, 1979. Once made, the expenditure
test election is effective (without again filing Form 5768) for each
succeeding taxable year for which the organization is an eligible
organization and which begins before a notice of revocation is filed
under paragraph (d) of this section.
(b) Organizations eligible to elect the expenditure test--(1) In
general. For purposes of section 501(h) and the regulations thereunder,
an organization is an eligible organization for a taxable year if, for
that taxable year, it is--
(i) Described in section 501(c)(3) (determined, in any year for
which an election is in effect, without regard to the substantial part
test of section 501(c)(3)),
(ii) Described in section 501(h)(4) and paragraph (b)(2) of this
section, and
(iii) Not a disqualified organization described in section 501(h)(5)
and paragraph (b)(3) of this section.
(2) Certain organizations listed. An organization is described in
section 501(h)(4) and this paragraph (b)(2) if it is an organization
described in--
(i) Section 170(b)(1)(A)(ii) (relating to educational institutions),
(ii) Section 170(b)(1)(A)(iii) (relating to hospitals and medical
research organizations),
(iii) Section 170(b)(1)(A)(iv) (relating to organizations supporting
government schools),
(iv) Section 170(b)(1)(A)(vi) (relating to organizations publicly
supported by charitable contributions),
(v) Section 509(a)(2) (relating to organizations publicly supported
by admissions, sales, etc.), or
(vi) Section 509(a)(3) (relating to organizations supporting public
charities), except that for purposes of this paragraph (b)(2), section
509(a)(3) shall be applied without regard to the last sentence of
section 509(a).
(3) Disqualified organizations. An organization is a disqualified
organization described in section 501(h)(5) and this paragraph (b)(3) if
the organization is--
(i) Described in section 170(b)(1)(A)(i) (relating to churches),
(ii) An integrated auxiliary of a church or of a convention or
association of churches see (Sec. 1.6033-2(g)(5)), or
(iii) Described in section 501(c)(3) and affiliated (within the
meaning of Sec. 56.4911-7) with one or more organizations described in
paragraph (b)(3) (i) or (ii) of this section.
(4) Other organizations ineligible to elect. Under section
501(h)(4), certain organizations, although not disqualified
organizations, are not eligible to elect the expenditure test. For
example, organizations described in section 509(a)(4) are not listed in
section 501(h)(4) and therefore are not eligible to elect. Similarly,
private foundations (within the meaning of section 509(a))
[[Page 50]]
are not eligible to elect. For the treatment of expenditures by a
private foundation for the purpose of carrying on propaganda, or
otherwise attempting, to influence legislation, see Sec. 53.4945-2.
(c) New organizations. A newly created organization may submit Form
5768 to elect the expenditure test under section 501(h) before it is
determined to be an eligible organization and may submit Form 5768 at
the time it submits its application for recognition of exemption (Form
1023). If the newly created organization is determined to be an eligible
organization, the election will be effective under the provisions of
paragraph (a) of this section, that is, with the beginning of the
taxable year in which the Form 5768 is filed by the eligible
organization. However, if a newly created organization is determined by
the Service not to be an eligible organization, the organization's
election will not be effective and the substantial part test will apply
from the effective date of its section 501(c)(3) classification.
(d) Voluntary revocation of expenditure test election--(1)
Revocation effective. An organization may voluntarily revoke an
expenditure test election by filing a notice of voluntary revocation
with the appropriate Internal Revenue Service Center listed on Form
5768. Under section 501(h)(6)(B), a voluntary revocation is effective
with the beginning of the first taxable year after the taxable year in
which the notice is filed. If an organization voluntarily revokes its
election, the substantial part test of section 501(c)(3) will apply with
respect to the organization's activities in attempting to influence
legislation beginning with the taxable year for which the voluntary
revocation is effective.
(2) Re-election of expenditure test. If an organization's
expenditure test election is voluntarily revoked, the organization may
again make the expenditure test election, effective no earlier than for
the taxable year following the first taxable year for which the
revocation is effective.
(3) Example. X, an organization whose taxable year is the calendar
year, plans to voluntarily revoke its expenditure test election
effective beginning with its taxable year 1985. X must file its notice
of voluntary revocation on Form 5768 after December 31, 1983, and before
January 1, 1985. If X files a notice of voluntary revocation on December
31, 1984, the revocation is effective beginning with its taxable year
1985. The organization may again elect the expenditure test by filing
Form 5768. Under paragraph (d)(2) of this section, the election may not
be made for taxable year 1985. Under paragraph (a) of this section, a
new expenditure test election will be effective for taxable years
beginning with taxable year 1986, if the Form 5768 is filed after
December 31, 1985, and before January 1, 1987.
(e) Involuntary revocation of expenditure test election. If, while
an election by an eligible organization is in effect, the organization
ceases to be an eligible organization, its election is automatically
revoked. The revocation is effective with the beginning of the first
full taxable year for which it is determined that the organization is
not an eligible organization. If an organization's expenditure test
election is involuntarily revoked under this paragraph (e) but the
organization continues to be described in section 501(c)(3), the
substantial part test of section 501(c)(3) will apply with respect to
the organization's activities in attempting to influence legislation
beginning with the first taxable year for which the involuntary
revocation is effective.
(f) Supersession. This section supersedes Sec. 7.0(c)(4) of the
Temporary Income Tax Regulations under the Tax Reform Act of 1976,
effective August 31, 1990.
[T.D. 8308, 55 FR 35588, Aug. 31, 1990]
Sec. 1.501(h)-3 Lobbying or grass roots expenditures normally in
excess of ceiling amount.
(a) Scope. This section provides rules under section 501(h) for
determining whether an organization that has elected the expenditure
test and that is not a member of an affiliated group of organizations
(as defined in Sec. 56.4911-7(e)) either normally makes lobbying
expenditures in excess of its lobbying ceiling amount or normally makes
grass roots expenditures in excess of its
[[Page 51]]
grass roots ceiling amount. Under section 501(h) and this section, an
organization that has elected the expenditure test and that normally
makes expenditures in excess of the corresponding ceiling amount will
cease to be exempt from tax under section 501(a) as an organization
described in section 501(c)(3). For similar rules relating to members of
an affiliated group of organizations, see Sec. 56.4911-9.
(b) Loss of exemption--(1) In general. Under section 501(h)(1), an
organization that has elected the expenditure test shall be denied
exemption from taxation under section 501(a) as an organization
described in section 501(c)(3) for the taxable year following a
determination year if--
(i) The sum of the organization's lobbying expenditures for the base
years exceeds 150 percent of the sum of its lobbying nontaxable amounts
for the base years, or (ii) The sum of the organization's grass roots
expenditures for its base years exceeds 150 percent of the sum of its
grass roots nontaxable amounts for the base years.
The organization thereafter shall not be exempt from tax under section
501(a) as an organization described in section 501(c)(3) unless,
pursuant to paragraph (d) of this section, the organization reapplies
for recognition of exemption and is recognized as exempt.
(2) Special exception for organization's first election. For the
first, second, or third consecutive determination year for which an
organization's first expenditure test election is in effect, no
determination is required under paragraph (b)(1) of this section, and
the organization will not be denied exemption from tax by reason of
section 501(h) and this section if, taking into account as base years
only those years for which the expenditure test election is in effect--
(i) The sum of the organization's lobbying expenditures for such
base years does not exceed 150 percent of the sum of its lobbying
nontaxable amounts for the same base years, and
(ii) The sum of the organization's grass roots expenditure for those
base years does not exceed 150 percent of the sum of its grass roots
nontaxable amounts for such base years. If an organization does not
satisfy the requirements of this paragraph (b)(2), paragraph (b)(1) of
this section will apply.
(c) Definitions. For purposes of this section--
(1) The term lobbying expenditures means lobbying expenditures as
defined in section 4911(c)(1) or section 4911(f)(4)(A) and Sec.
56.4911-2(a).
(2) The term lobbying nontaxable amount is defined in Sec. 56.4911-
1(c)(1).
(3) An organization's lobbying ceiling amount is 150 percent of the
organization's lobbying nontaxable amount for a taxable year.
(4) The term grass roots expenditures means expenditures for grass
roots lobbying communications as defined in section 4911(c)(3) or
section 4911(f)(4)(A) and Sec. Sec. 56.4911-2 and 56.4911-3.
(5) The term grass roots nontaxable amount is defined in Sec.
56.4911-1(c)(2).
(6) An organization's grass roots ceiling amount is 150 percent of
the organization's grass roots nontaxable amount for a taxable year.
(7) In general, the term base years means the determination year and
the three taxable years immediately preceding the determination year.
The base years, however, do not include any taxable year preceding the
taxable year for which the organization is first treated as described in
section 501(c)(3).
(8) A taxable year is a determination year if it is a year for which
the expenditure test election is in effect, other than the taxable year
for which the organization is first treated as described in section
501(c)(3).
(d) Reapplication for recognition of exemption--(1) Time of
application. An organization that is denied exemption from taxation
under section 501(a) by reason of section 501(h) and this section may
apply on Form 1023 for recognition of exemption as an organization
described in section 501(c)(3) for any taxable year following the first
taxable year for which exemption is so denied. See paragraphs (d)(2) and
(d)(3) of this section for material to be included with an application
described in the preceding sentence.
(2) Section 501(h) calculation. An application described in
paragraph (d)(1) of this section must demonstrate that the organization
would not be denied exemption from taxation under section 501(a) by
reason of section 501(h) if the
[[Page 52]]
expenditure test election has been in effect for all of its last taxable
year ending before the application is made by providing the
calculations, described either in paragraphs (b)(1) (i) and (ii) of this
section or in Sec. 56.4911-9(b), that would have applied to the
organization for that year.
(3) Operations not disqualifying. An application described in
paragraph (d)(1) of this section must include information that
demonstrates to the satisfaction of the Commissioner that the
organization will not knowingly operate in a manner that would
disqualify the organization for tax exemption under section 501(c)(3) by
reason of attempting to influence legislation.
(4) Reelection of expenditure test. If an organization is denied
exemption from tax for a taxable year by reason of section 501(h) and
this section, and thereafter is again recognized as an organization
described in section 501(c)(3) pursuant to this paragraph (d), it may
again elect the expenditure test under section 501(h) in accordance with
Sec. 1.501(h)-2(a).
(e) Examples. The provisions of this section are illustrated by the
following examples, which also illustrate the operation of the tax
imposed by section 4911.
Example 1. (1) The following table contains information used in this
example concerning organization X.
----------------------------------------------------------------------------------------------------------------
Lobbying
Exempt purpose -------------------------------
Year expenditures Calculation Lobbying
(EPE) Nontaxable expenditures
amount (LNTA) (LE)
----------------------------------------------------------------------------------------------------------------
1979.......................... $400,000 (20% of $400,000=).............. $80,000 $100,000
1980.......................... 300,000 (20% of $300,000=).............. 60,000 100,000
1981.......................... 600,000 (20% of $500,000 + 15% of 115,000 120,000
$100,000=).
1982.......................... 500,000 (20% of $500,000=).............. 100,000 100,000
----------------------------------------------- -------------------------------
Totals...................... 1,800,000 ................................ 355,000 420,000
----------------------------------------------------------------------------------------------------------------
(2) Organization X, whose taxable year is the calendar year, was
organized in 1971. X first made the expenditure test election under
section 501(h) effective for taxable years beginning with 1979 and has
not revoked the election. None of X's lobbying expenditures for its
taxable years 1979 through 1982 are grass roots expenditures. Under
section 4911(a) and Sec. 56.4911-1(a), X must determine for each year
for which the expenditure test election is effective whether it is
liable for the 25 percent excise tax imposed by section 4911(a) on
excess lobbying expenditures. X is liable for this tax for each of its
taxable years 1979, 1980, and 1981, because in each year its lobbying
expenditures exceeded its lobbying nontaxable amount for the year. For
1979, the tax imposed by section 4911(a) is $5,000 {25% x ($100,000-
$80,000) = $5,000{time} . For 1980, the tax is $10,000. For 1981, the
tax is $1,250.
(3) The taxable years 1979 through 1981 are all determination years
under paragraph (c)(8) of this section. On its annual return for
determination year 1979, the first year of its first election, X can
demonstrate, under paragraph (b)(2) of this section, that its lobbying
expenditures during 1979 ($100,000) do not exceed 150 percent of its
lobbying nontaxable amount for 1979 ($120,000). For determination year
1980, under paragraph (b)(2), X can demonstrate that the sum of its
lobbying expenditures for 1979 and 1980 ($200,000) does not exceed 150
percent of the sum of its lobbying nontaxable amounts for 1979 and 1980
($210,000). For 1981, under paragraph (b)(2), X can demonstrate that the
sum of its lobbying expenditures for 1979, 1980, and 1981 ($320,000)
does not exceed 150 percent of the sum of its lobbying nontaxable
amounts for 1979, 1980, and 1981 ($382,500). For each of the
determination years 1979, 1980, and 1981, the first three years of its
first election, X satisfies the requirements of paragraph (b)(2).
Accordingly, no determination under paragraph (b)(1) of this section is
required for those years, and X is not denied tax exemption by reason of
section 501(h).
(4) Under paragraph (b)(1) of this section, X must determine for its
determination year 1982 whether it has normally made lobbying
expenditures in excess of the lobbying ceiling amount. This
determination takes into account expenditures in base years 1979 through
1982. The sum of X's lobbying expenditures for the base years ($420,000)
does not exceed 150 percent of the sum of the lobbying nontaxable
amounts for the base years (150% x $355,000 = $532,500). Accordingly, X
is not denied tax exemption by reason of section 501(h).
Example 2. (1) The following table contains information used in this
example concerning W.
[[Page 53]]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Grass roots
Exempt purpose Lobbying nontaxable
expenditures nontaxable Lobbying amount (25 Grass roots
Year (EPE) Calculation amount (LNTA) expenditures percent of expenditures
(dollars) (dollars) (LE) (dollars) LNTA) (dollars)
(dollars)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1979................................ 700,000 (20% of $500,000 + 15% of 130,000 120,000 32,500 30,000
$200,000=).
1980................................ 800,000 (20% of $500,000 + 15% of 145,000 100,000 36,250 60,000
$300,000=).
1981................................ 800,000 (20% of $500,000 + 15% of 145,000 100,000 36,250 65,000
$300,000=).
1982................................ 900,000 (20% of $500,000 + 15% of 160,000 150,000 40,000 65,000
$400,000=).
---------------- ---------------------------------------------------------------
Total............................. 3,200,000 .................................. 580,000 470,000 145,000 220,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
(2) Organization W, whose taxable year is the calendar year, made
the expenditure test election under section 501(h) effective for taxable
years beginning with 1979 and has not revoked the election. W has been
treated as an organization described in section 501(c)(3) for each of
its taxable years beginning within its taxable year 1974.
(3) Under section 4911(a) and Sec. 56.4911-1(a), W must determine
for each year for which the expenditure test election is effective
whether it is liable for the 25 percent excise tax imposed by section
4911(a) on excess lobbying expenditures. In 1980, 1981, and 1982, W has
excess lobbying expenditures because its grass roots expenditures in
each of those years exceeded its grass roots nontaxable amount for the
year. Therefore, W is liable for the excise tax under section 4911(a)
for those years. The tax imposed by section 4911(a) for 1980 is
$5,937.50 {25% x ($60,000-$36,250)= $5,937.50{time} . For 1981, the tax
is $7,187.50. For 1982, the tax is $6,250.
(4) On its annual return for its determination years 1979, 1980, and
1981, the first three years of its first election, W demonstrates that
it satisfies the requirements of paragraph (b)(2) of this section.
Accordingly, no determination under paragraph (b)(1) of this section is
required for those years, and W is not denied tax exemption by reason of
section 501(h).
(5) On its annual return for its determination year 1982, W must
determine under paragraph (b)(1) whether it has normally made lobbying
expenditures or grass roots expenditures in excess of the corresponding
ceiling amount. This determination takes into account expenditures in
base years 1979 through 1982. The sum of W's lobbying expenditures for
the base years ($470,000) does not exceed 150% of the sum of W's
lobbying nontaxable amounts for those years (150% x $580,000 =
$870,000). However, the sum of W's grass roots expenditures for the base
years ($220,000) does exceed 150% of the sum of W's grass roots
nontaxable amonts for those years (150% x $145,000 = $217,500). Under
section 501(h), W is denied tax exemption under section 501(a) as an
organization described in section 501(c)(3) for its taxable year 1983.
For its taxable year 1984 and any taxable year thereafter, W is exempt
from tax as an organization described in section 501(c)(3) only if W
applies for recognition of its exempt status under paragraph (d) of this
section and is recognized as exempt from tax.
Example 3. (1) The following table contains information used in this
example concerning organization Y.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Grass roots
Exempt purpose Lobbying Lobbying nontaxable Grass roots
Taxable Year expenditures Calculation nontaxable expenditures amount (25 expenditures
(EPE) amount (LNTA) (LE)(dollars) percent of (dollars)
(dollars) (dollars) LNTA)(dollars)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1977................................ 700,000 (20% of $500,000 + 15% of 130,000 182,000 32,500 30,000
$200,000=).
1978................................ 800,000 (20% of $500,000 + 15% of 145,000 224,750 36,250 35,000
$300,000=).
---------------- ---------------------------------------------------------------
Subtotal.......................... 1,500,000 .................................. 275,000 406,750 68,750 65,000
1979................................ 900,000 (20% of $500,000 + 15% of 160,000 264,000 40,000 50,000
$400,000=).
---------------- ---------------------------------------------------------------
Totals:........................... 2,400,000 .................................. 435,000 670,750 108,750 115,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
(2) Organization Y, whose taxable year is the calendar year, was
first treated as an organization described in section 501(c)(3) on
February 1, 1977. Y made the expenditure
[[Page 54]]
test election under section 501(h) effective for taxable years beginning
with 1977 and has not revoked the election.
(3) For 1977, Y has excess lobbying expenditures of $52,000 because
its lobbying expenditures ($182,000) exceed its lobbying nontaxable
amount ($130,000) for the taxable year. Accordingly, Y is liable for the
25 percent excise tax imposed by section 4911(a). The amount of the tax
is $13,000 [25% x ($182,000-$130,000) = $13,000].
(4) For 1978, Y again has excess lobbying expenditures and is again
liable for the 25 percent excise tax imposed by section 4911(a). The
amount of the tax is $19,937.50 [25% x ($224,750-$145,000) =
$19,937.50].
(5) For 1979, Y's lobbying expenditures ($264,000) exceed its
lobbying nontaxable amount ($160,000) by $104,000, and its grass roots
expenditures ($50,000) exceed its grass roots nontaxable amount
($40,000) by $10,000. Under Sec. 56.4911-1(b), Y's excess lobbying
expenditures are the greater of $104,000 or $10,000. The amount of the
tax, therefore, is $26,000 [25% x $104,000 = $26,000].
(6) Under paragraph (c)(8) of this section, 1977 is not a
determination year because it is the first year for which the
organization is treated as described in section 501(c)(3). For 1977, Y
need not determine whether it has normally made lobbying expenditures or
grass roots expenditures in excess of the corresponding ceiling amount
for purposes of determining whether it is denied exemption under section
501(h) for its taxable year 1978.
(7) For determination year 1978, Y must determine whether it has
normally made lobbying or grass roots expenditures in excess of the
corresponding ceiling amount, taking into account expenditures for the
base years 1977 and 1978. For Y, the determination under paragraph
(b)(2) of this section considers the same base years as the
determination under paragraph (b)(1) of this section and is, therefore,
redundant. Accordingly, Y proceeds to determine, under (b)(1), whether
it is denied exemption. Y's grass roots expenditures for 1977 and 1978
($65,000) did not exceed 150 percent of the sum of its grass roots
nontaxable amounts for those years ($103,125). Y's lobbying expenditures
for 1977 and 1978 ($406,750) did not exceed 150% of its lobbying
nontaxable amount for those years (150% x $275,000 = $412,500).
Therefore, Y is not denied tax exemption under section 501(h) for its
taxable year 1979.
(8) For determination year 1979, the sum of Y's grass roots
expenditures in base years 1977, 1978, and 1979 does not exceed 150
percent of its grass roots nontaxable amount (calculation omitted).
However, the sum of Y's lobbying expenditures for the base years
($670,750) does exceed 150% of the sum of the lobbying nontaxable
amounts for those years (150% x $435,000 = $652,500). Since Y was not
described in section 501(c)(3) prior to 1977, only the years 1977, 1978,
and 1979 may be considered in determining whether Y has normally made
lobbying expenditures in excess of its lobbying ceiling. Therefore, Y
determines that it has normally made lobbying expenditures in excess of
its lobbying ceiling. Under section 501(h), Y is denied tax exemption
under section 501(a) as an organization described in section 501(c)(3)
for its taxable year 1980. For its taxable year 1981, and any taxable
year thereafter, Y is exempt from tax as an organization described in
section 501(c)(3) only if Y applies for recognition of its exempt status
under paragraph (d) of this section and is recognized as exempt from
tax.
Example 4. Organization M made the expenditure test election under
section 501(h) effective for taxable years beginning with 1977 and has
not revoked the election. M has $500,000 of exempt purpose expenditures
during each of the years 1981 through 1984. In addition, during each of
those years, M spends $75,000 for direct lobbying and $25,000 for grass
roots lobbying. Since the amount expended for M's lobbying (both total
lobbying and grass roots lobbying) is within the respective nontaxable
expenditure limitations, M is not liable for the 25 percent excise tax
imposed under section 4911(a) upon excess lobbying expenditures, nor is
M denied tax-exempt status by reason of section 501 (h).
Example 5. Assume the same facts as in Example 4, except that, on
behalf of M, numerous unpaid volunteers conduct substantial lobbying
activities with no reimbursement. Since the substantial lobbying
activities of the unpaid volunteers are not counted towards the
expenditure limitations and the amount expended for M's lobbying is
within the respective nontaxable expenditure limitations, M is not
liable for the 25 percent excise tax under section 4911, nor is M denied
tax-exempt status by reason of section 501(h).
[T.D. 8308, 55 FR 35589, Aug. 31, 1990]
Sec. 1.501(r)-0 Outline of regulations.
This section lists the table of contents for Sec. Sec. 1.501(r)-1
through 1.501(r)-7.
Sec. 1.501(r)-1 Definitions.
(a) Application.
(b) Definitions.
(1) Amounts generally billed (AGB).
(2) AGB percentage.
(3) Application period.
(4) Authorized body of a hospital facility.
(5) Billing and collections policy.
(6) Date provided.
(7) Discharge.
(8) Disregarded entity.
(9) Emergency medical care.
(10) Emergency medical conditions.
(11) Extraordinary collection action (ECA).
(12) Financial assistance policy (FAP).
[[Page 55]]
(13) FAP application.
(14) FAP application form.
(15) FAP-eligible.
(16) Gross charges.
(17) Hospital facility.
(18) Hospital organization.
(19) Medicaid.
(20) Medicare fee-for-service.
(21) Noncompliant facility income.
(22) Operating a hospital facility.
(23) Partnership agreement.
(24) Plain language summary of the FAP.
(25) Presumptive FAP-eligibility determination.
(26) Private health insurer.
(27) Referring.
(28) Substantially-related entity.
(29) Widely available on a Web site.
Sec. 1.501(r)-2 Failures to satisfy section 501(r).
(a) Revocation of section 501(c)(3) status.
(b) Minor omissions and errors.
(1) In general.
(2) Minor.
(3) Inadvertent.
(4) Reasonable cause.
(c) Excusing certain failures if hospital facility corrects and
discloses.
(d) Taxation of noncompliant hospital facilities.
(1) In general.
(2) Noncompliant facility income.
(3) No aggregation.
(4) Interaction with other Code provisions.
(e) Instances in which a hospital organization is not required to
meet section 501(r).
Sec. 1.501(r)-3 Community health needs assessments.
(a) In general.
(b) Conducting a CHNA.
(1) In general.
(2) Date a CHNA is conducted.
(3) Community served by a hospital facility.
(4) Assessing community health needs.
(5) Persons representing the broad interests of the community.
(6) Documentation of a CHNA.
(7) Making the CHNA report widely available to the public.
(c) Implementation strategy.
(1) In general.
(2) Description of how the hospital facility plans to address a
significant health need.
(3) Description of why a hospital facility is not addressing a
significant health need.
(4) Joint implementation strategies.
(5) When the implementation strategy must be adopted.
(d) Exception for acquired, new, and terminated hospital facilities.
(1) Acquired hospital facilities.
(2) New hospital organizations.
(3) New hospital facilities.
(4) Transferred or terminated hospital facilities.
(e) Transition rule for CHNAs conducted in taxable years beginning
before March 23, 2012.
Sec. 1.501(r)-4 Financial assistance policy and emergency medical care
policy.
(a) In general.
(b) Financial assistance policy.
(1) In general.
(2) Eligibility criteria and basis for calculating amounts charged
to patients.
(3) Method for applying for financial assistance.
(4) Actions that may be taken in the event of nonpayment.
(5) Widely publicizing the FAP.
(6) Readily obtainable information.
(7) Providing documents electronically.
(8) Medically necessary care.
(c) Emergency medical care policy.
(1) In general.
(2) Interference with provision of emergency medical care.
(3) Relation to federal law governing emergency medical care.
(4) Examples.
(d) Establishing the FAP and other policies.
(1) In general.
(2) Implementing a policy.
(3) Establishing a policy for more than one hospital facility.
Sec. 1.501(r)-5 Limitation on charges.
(a) In general.
(b) Amounts generally billed.
(1) In general.
(2) Meaning of charged.
(3) Look-back method.
(4) Prospective Medicare or Medicaid method.
(5) Examples.
(c) Gross charges.
(d) Safe harbor for certain charges in excess of AGB.
(e) Medically necessary care.
Sec. 1.501(r)-6 Billing and collection.
(a) In general.
(b) Extraordinary collection actions.
(1) In general.
(2) Certain debt sales that are not ECAs.
(3) Liens on certain judgments, settlements, or compromises.
(4) Bankruptcy claims.
(c) Reasonable efforts.
(1) In general.
(2) Presumptive FAP-eligibility determinations based on third-party
information or prior FAP-eligibility determinations.
(3) Reasonable efforts based on notification and processing of
applications.
(4) Notification.
(5) Incomplete FAP applications.
(6) Complete FAP applications.
(7) When no FAP application is submitted.
[[Page 56]]
(8) Suspending ECAs while a FAP application is pending.
(9) Waiver does not constitute reasonable efforts.
(10) Agreements with other parties.
(11) Clear and conspicuous placement.
(12) Providing documents electronically.
Sec. 1.501(r)-7 Effective/applicability date.
(a) Effective/applicability date.
(b) Reasonable interpretation for taxable years beginning on or
before December 29, 2015.
[T.D. 9708, 79 FR 78997, Dec. 31, 2014; 80 FR 12762, Mar. 11, 2015]
Sec. 1.501(r)-1 Definitions.
(a) Application. The definitions set forth in this section apply to
Sec. Sec. 1.501(r)-2 through 1.501(r)-7.
(b) Definitions--(1) Amounts generally billed (AGB) means the
amounts generally billed for emergency or other medically necessary care
to individuals who have insurance covering such care, determined in
accordance with Sec. 1.501(r)-5(b).
(2) AGB percentage means a percentage of gross charges that a
hospital facility uses under Sec. 1.501(r)-5(b)(3) to determine the AGB
for any emergency or other medically necessary care it provides to an
individual who is eligible for assistance under its financial assistance
policy (FAP).
(3) Application period means the period during which a hospital
facility must accept and process an application for financial assistance
under its FAP submitted by an individual in order to have made
reasonable efforts to determine whether the individual is FAP-eligible
under Sec. 1.501(r)-6(c). A hospital facility may accept and process an
individual's FAP application submitted outside of the application
period. With respect to any care provided by a hospital facility to an
individual, the application period begins on the date the care is
provided and ends on the later of the 240th day after the date that the
first post-discharge billing statement for the care is provided or
either--
(i) In the case of an individual who the hospital facility is
notifying as described in Sec. 1.501(r)-6(c)(4), the deadline specified
by a written notice described in Sec. 1.501(r)-6(c)(4); or
(ii) In the case of an individual who the hospital facility has
presumptively determined to be eligible for less than the most generous
assistance available under the FAP as described in Sec. 1.501(r)-
6(c)(2), the end of the reasonable period of time described in Sec.
1.501(r)-6(c)(2)(i)(B).
(4) Authorized body of a hospital facility means--
(i) The governing body (that is, the board of directors, board of
trustees, or equivalent controlling body) of the hospital organization
that operates the hospital facility or a committee of, or other party
authorized by, that governing body to the extent such committee or other
party is permitted under state law to act on behalf of the governing
body; or
(ii) The governing body of an entity that is disregarded or treated
as a partnership for federal tax purposes that operates the hospital
facility or a committee of, or other party authorized by, that governing
body to the extent such committee or other party is permitted under
state law to act on behalf of the governing body.
(5) Billing and collections policy means a written policy that
includes all of the elements described in Sec. 1.501(r)-4(b)(4)(i).
(6) Date provided means, in the case of any billing statement,
written notice, or other written communication that is mailed, the date
of mailing. The date that a billing statement, written notice, or other
written communication is provided can also be the date such
communication is sent electronically or delivered by hand.
(7) Discharge means to release from a hospital facility after the
care at issue has been provided, regardless of whether that care has
been provided on an inpatient or outpatient basis. Thus, a billing
statement for care is considered ``post-discharge'' if it is provided to
an individual after the care has been provided and the individual has
left the hospital facility.
(8) Disregarded entity means an entity that is generally disregarded
as separate from its owner for federal tax purposes under Sec.
301.7701-3 of this chapter. One example of a disregarded entity is a
domestic single member limited liability company that does not elect to
be classified as an association taxable
[[Page 57]]
as a corporation for federal tax purposes.
(9) Emergency medical care means care provided by a hospital
facility for emergency medical conditions.
(10) Emergency medical conditions means emergency medical conditions
as defined in section 1867 of the Social Security Act (42 U.S.C.
1395dd).
(11) Extraordinary collection action (ECA) means an action described
in Sec. 1.501(r)-6(b)(1).
(12) Financial assistance policy (FAP) means a written policy that
meets the requirements described in Sec. 1.501(r)-4(b).
(13) FAP application means the information and accompanying
documentation that an individual submits to apply for financial
assistance under a hospital facility's FAP. An individual is considered
to have submitted a complete FAP application if he or she provides
information and documentation sufficient for the hospital facility to
determine whether the individual is FAP-eligible and an incomplete FAP
application if he or she provides some, but not sufficient, information
and documentation to determine FAP-eligibility. The term ``FAP
application'' does not refer only to written submissions, and a hospital
facility may obtain information from an individual in writing or orally
(or a combination of both).
(14) FAP application form means the application form (and any
accompanying instructions) that a hospital facility makes available for
individuals to submit as part of a FAP application.
(15) FAP-eligible means eligible for financial assistance under a
hospital facility's FAP for care covered by the FAP, without regard to
whether an individual has applied for assistance under the FAP.
(16) Gross charges, or the chargemaster rate, means a hospital
facility's full, established price for medical care that the hospital
facility consistently and uniformly charges patients before applying any
contractual allowances, discounts, or deductions.
(17) Hospital facility means a facility that is required by a state
to be licensed, registered, or similarly recognized as a hospital.
Multiple buildings operated under a single state license are considered
to be a single hospital facility. For purposes of this paragraph
(b)(17), the term ``state'' includes only the 50 states and the District
of Columbia and not any U.S. territory or foreign country. References to
a hospital facility taking actions include instances in which the
hospital organization operating the hospital facility takes actions
through or on behalf of the hospital facility.
(18) Hospital organization means an organization recognized (or
seeking to be recognized) as described in section 501(c)(3) that
operates one or more hospital facilities. If the section 501(c)(3)
status of such an organization is revoked, the organization will, for
purposes of section 4959, continue to be treated as a hospital
organization during the taxable year in which such revocation becomes
effective.
(19) Medicaid means any medical assistance program administered by
the state in which a hospital facility is licensed in accordance with
Title XIX of the Social Security Act (42 U.S.C. 1396 through 1396w-5),
including programs in which such medical assistance is provided through
a contract between the state and a Medicaid managed care organization or
a prepaid inpatient health plan.
(20) Medicare fee-for-service means health insurance available under
Medicare Part A and Part B of Title XVIII of the Social Security Act (42
U.S.C. 1395c through 1395w-5).
(21) Noncompliant facility income means income that a hospital
organization operating more than one hospital facility derives from a
hospital facility that fails to meet one or more of the requirements of
section 501(r) during a taxable year as determined in accordance with
Sec. 1.501(r)-2(d).
(22) Operating a hospital facility--(i) In general. Operating a
hospital facility includes operating the facility through the
organization's own employees or contracting out to another organization
to operate the facility. For example, if an organization hires a
management company to operate the facility, the hiring organization is
considered to operate the facility. An organization also operates a
hospital facility if it is
[[Page 58]]
the sole member or owner of a disregarded entity that operates the
hospital facility. In addition, an organization operates a hospital
facility if it owns a capital or profits interest in an entity treated
as a partnership for federal tax purposes that operates the hospital
facility, unless paragraph (b)(22)(ii) of this section applies. For
purposes of this paragraph (b)(22), an organization is considered to own
a capital or profits interest in an entity treated as a partnership for
federal tax purposes if it owns such an interest directly or indirectly
through one or more lower-tier entities treated as partnerships for
federal tax purposes.
(ii) Exception for certain partnerships. An organization does not
operate a hospital facility despite owning a capital or profits interest
in an entity treated as a partnership for federal tax purposes that
operates the hospital facility if--
(A) The organization does not have control over the operation of the
hospital facility operated by the partnership sufficient to ensure that
the operation of the hospital facility furthers an exempt purpose
described in section 501(c)(3) and thus treats the operation of the
hospital facility, including the facility's provision of medical care,
as an unrelated trade or business described in section 513 with respect
to the hospital organization; or
(B) At all times since March 23, 2010, the organization has been
organized and operated primarily for educational or scientific purposes
and has not engaged primarily in the operation of one or more hospital
facilities and, pursuant to a partnership agreement entered into before
March 23, 2010--
(1) Does not own more than 35 percent of the capital or profits
interest in the partnership (determined in accordance with section
707(b)(3));
(2) Does not own a general partner interest, managing-member
interest, or similar interest in the partnership; and
(3) Does not have control over the operation of the hospital
facility sufficient to ensure that the hospital facility complies with
the requirements of section 501(r).
(23) Partnership agreement means, for purposes of paragraph
(b)(22)(ii)(B) of this section, all written agreements among the
partners, or between one or more partners and the partnership, and
concerning affairs of the partnership and responsibilities of the
partners, whether or not embodied in a document referred to by the
partners as the partnership agreement. A partnership agreement also
includes any modifications to the agreement agreed to by all partners,
or adopted in any other manner provided by the partnership agreement,
except for modifications adopted on or after March 23, 2010, that affect
whether or not the agreement is described in paragraph (b)(22)(ii)(B) of
this section. In addition, a partnership agreement includes provisions
of federal, state, or local law that were in effect before March 23,
2010, and continue to be in effect that govern the affairs of the
partnership or are considered under such law to be part of the
partnership agreement.
(24) Plain language summary of the FAP means a written statement
that notifies an individual that the hospital facility offers financial
assistance under a FAP and provides the following additional information
in language that is clear, concise, and easy to understand:
(i) A brief description of the eligibility requirements and
assistance offered under the FAP.
(ii) A brief summary of how to apply for assistance under the FAP.
(iii) The direct Web site address (or URL) and physical locations
where the individual can obtain copies of the FAP and FAP application
form.
(iv) Instructions on how the individual can obtain a free copy of
the FAP and FAP application form by mail.
(v) The contact information, including telephone number and physical
location, of the hospital facility office or department that can provide
information about the FAP and of either--
(A) The hospital facility office or department that can provide
assistance with the FAP application process; or
(B) If the hospital facility does not provide assistance with the
FAP application process, at least one nonprofit organization or
government agency that the hospital facility has identified as an
available source of assistance with FAP applications.
[[Page 59]]
(vi) A statement of the availability of translations of the FAP, FAP
application form, and plain language summary of the FAP in other
languages, if applicable.
(vii) A statement that a FAP-eligible individual may not be charged
more than AGB for emergency or other medically necessary care.
(25) Presumptive FAP-eligibility determination means a determination
that an individual is FAP-eligible based on information other than that
provided by the individual or based on a prior FAP-eligibility
determination, as described in Sec. 1.501(r)-6(c)(2).
(26) Private health insurer means any organization that is not a
governmental unit that offers health insurance, including
nongovernmental organizations administering a health insurance plan
under Medicare Advantage (Part C of Title XVIII of the Social Security
Act, 42 U.S.C. 1395w-21 through 1395w-29). For purposes of Sec.
1.501(r)-5(b), medical assistance provided through a contract between
the state and a Medicaid managed care organization or a prepaid
inpatient health plan is not considered to be a reimbursement from or a
claim allowed by a private health insurer.
(27) Referring an individual's debt to a debt collection agency or
other party means contracting with, delegating to, or otherwise using
the debt collection agency or other party to collect amounts owed by the
individual to the hospital facility while still maintaining ownership of
the debt.
(28) Substantially-related entity means, with respect to a hospital
facility operated by a hospital organization, an entity treated as a
partnership for federal tax purposes in which the hospital organization
owns a capital or profits interest, or a disregarded entity of which the
hospital organization is the sole member or owner, that provides
emergency or other medically necessary care in the hospital facility,
unless the provision of such care is an unrelated trade or business
described in section 513 with respect to the hospital organization.
Notwithstanding the preceding sentence, a partnership that qualifies for
the exception described in paragraph (b)(22)(ii)(B) of this section is
not considered a substantially-related entity within the meaning of this
paragraph (b)(28).
(29) Widely available on a Web site means--
(i) The hospital facility conspicuously posts a complete and current
version of the document on--
(A) The hospital facility's Web site;
(B) If the hospital facility does not have its own Web site separate
from the hospital organization that operates it, the hospital
organization's Web site; or
(C) A Web site established and maintained by another entity, but
only if the Web site of the hospital facility or hospital organization
(if the facility or organization has a Web site) provides a
conspicuously-displayed link to the Web page where the document is
posted, along with clear instructions for accessing the document on that
Web site;
(ii) Individuals with access to the Internet can access, download,
view, and print a hard copy of the document from the Web site--
(A) Without requiring special computer hardware or software (other
than software that is readily available to members of the public without
payment of any fee);
(B) Without paying a fee to the hospitality facility, hospital
organization, or other entity maintaining the Web site; and
(C) Without creating an account or being otherwise required to
provide personally identifiable information; and
(iii) The hospital facility provides individuals who ask how to
access a copy of the document online with the direct Web site address,
or URL, of the Web page where the document is posted.
[T.D. 9708, 79 FR 78998, Dec. 31, 2014; 80 FR 12762, Mar. 11, 2015]
Sec. 1.501(r)-2 Failures to satisfy section 501(r).
(a) Revocation of section 501(c)(3) status. Except as otherwise
provided in paragraphs (b) and (c) of this section, a hospital
organization failing to meet one or more of the requirements of section
501(r) separately with respect to one or more hospital facilities it
operates may have its section 501(c)(3) status revoked as of the first
day of the
[[Page 60]]
taxable year in which the failure occurs. In determining whether to
continue to recognize the section 501(c)(3) status of a hospital
organization that fails to meet one or more of the requirements of
section 501(r) with respect to one or more hospital facilities, the
Commissioner will consider all relevant facts and circumstances
including, but not limited to, the following:
(1) Whether the organization has previously failed to meet the
requirements of section 501(r), and, if so, whether the same type of
failure previously occurred.
(2) The size, scope, nature, and significance of the organization's
failure(s).
(3) In the case of an organization that operates more than one
hospital facility, the number, size, and significance of the facilities
that have failed to meet the section 501(r) requirements relative to
those that have complied with these requirements.
(4) The reason for the failure(s).
(5) Whether the organization had, prior to the failure(s),
established practices or procedures (formal or informal) reasonably
designed to promote and facilitate overall compliance with the section
501(r) requirements.
(6) Whether the practices or procedures had been routinely followed
and the failure(s) occurred through an oversight or mistake in applying
them.
(7) Whether the organization has implemented safeguards that are
reasonably calculated to prevent similar failures from occurring in the
future.
(8) Whether the organization corrected the failure(s) as promptly
after discovery as is reasonable given the nature of the failure(s).
(9) Whether the organization took the measures described in
paragraphs (a)(7) and (a)(8) of this section before the Commissioner
discovered the failure(s).
(b) Minor omissions and errors--(1) In general. A hospital
facility's omission of required information from a policy or report
described in Sec. 1.501(r)-3 or Sec. 1.501(r)-4, or error with respect
to the implementation or operational requirements described in
Sec. Sec. 1.501(r)-3 through 1.501(r)-6, will not be considered a
failure to meet a requirement of section 501(r) if the following
conditions are satisfied:
(i) Such omission or error was minor and either inadvertent or due
to reasonable cause.
(ii) The hospital facility corrects such omission or error as
promptly after discovery as is reasonable given the nature of the
omission or error. Such correction must include establishment (or review
and, if necessary, revision) of practices or procedures (formal or
informal) that are reasonably designed to promote and facilitate overall
compliance with the requirements of section 501(r).
(2) Minor. In the case of multiple omissions or errors, the
omissions or errors are considered minor for purposes of this paragraph
(b) only if they are minor in the aggregate.
(3) Inadvertent. For purposes of this paragraph (b), the fact that
the same omission or error has been made and corrected previously is a
factor tending to show that an omission or error is not inadvertent.
(4) Reasonable cause. For purposes of this paragraph (b), the fact
that a hospital facility has established practices or procedures (formal
or informal) reasonably designed to promote and facilitate overall
compliance with the section 501(r) requirements prior to the occurrence
of an omission or error is a factor tending to show that the omission or
error is due to reasonable cause.
(c) Excusing certain failures if hospital facility corrects and
discloses. A hospital facility's failure to meet one or more of the
requirements described in Sec. Sec. 1.501(r)-3 through 1.501(r)-6 that
is neither willful nor egregious shall be excused for purposes of this
section if the hospital facility corrects and makes disclosure in
accordance with rules set forth by revenue procedure, notice, or other
guidance published in the Internal Revenue Bulletin. For purposes of
this paragraph (c), a ``willful'' failure includes a failure due to
gross negligence, reckless disregard, or willful neglect, and an
``egregious'' failure includes only a very serious failure, taking into
account the severity of the impact and the number of affected persons.
Whether a failure is willful or egregious will be determined based on
[[Page 61]]
all of the facts and circumstances. A hospital facility's correction and
disclosure of a failure in accordance with the relevant guidance is a
factor tending to show that the failure was not willful.
(d) Taxation of noncompliant hospital facilities--(1) In general.
Except as otherwise provided in paragraphs (b) and (c) of this section,
if a hospital organization that operates more than one hospital facility
fails to meet one or more of the requirements of section 501(r)
separately with respect to a hospital facility during a taxable year,
the income derived from the noncompliant hospital facility
(``noncompliant facility income'') during that taxable year will be
subject to tax computed as provided in section 11 (or as provided in
section 1(e) if the hospital organization is a trust described in
section 511(b)(2)), but substituting the term ``noncompliant facility
income'' for ``taxable income,'' if--
(i) The hospital organization continues to be recognized as
described in section 501(c)(3) during the taxable year; but
(ii) The hospital organization would not continue to be recognized
as described in section 501(c)(3) during the taxable year based on the
facts and circumstances described in paragraph (a) of this section (but
disregarding paragraph (a)(3) of this section) if the noncompliant
hospital facility were the only hospital facility operated by the
organization.
(2) Noncompliant facility income--(i) In general. For purposes of
this paragraph (d), the noncompliant facility income derived from a
hospital facility during a taxable year will be the gross income derived
from that hospital facility during the taxable year, less the deductions
allowed by chapter 1 that are directly connected to the operation of
that hospital facility during the taxable year, excluding any gross
income and deductions taken into account in computing any unrelated
business taxable income described in section 512 that is derived from
the facility during the taxable year.
(ii) Directly connected deductions. For purposes of this paragraph
(d), to be directly connected with the operation of a hospital facility
that has failed to meet the requirements of section 501(r), an item of
deduction must have proximate and primary relationship to the operation
of the hospital facility. Expenses, depreciation, and similar items
attributable solely to the operation of a hospital facility are
proximately and primarily related to such operation, and therefore
qualify for deduction to the extent that they meet the requirements of
section 162, section 167, or other relevant provisions of the Internal
Revenue Code (Code). Where expenses, depreciation, and similar items are
attributable to a noncompliant hospital facility and other hospital
facilities operated by the hospital organization (and/or to other
activities of the hospital organization unrelated to the operation of
hospital facilities), such items shall be allocated among the hospital
facilities (and/or other activities) on a reasonable basis. The portion
of any such item so allocated to a noncompliant hospital facility is
proximately and primarily related to the operation of that facility and
shall be allowable as a deduction in computing the facility's
noncompliant facility income in the manner and to the extent it would
meet the requirements of section 162, section 167, or other relevant
provisions of the Code.
(3) No aggregation. In computing the noncompliant facility income of
a hospital facility, the gross income from (and the deductions allowed
with respect to) the hospital facility may not be aggregated with the
gross income from (and the deductions allowed with respect to) the
hospital organization's other noncompliant hospital facilities subject
to tax under this paragraph (d) or its unrelated trade or business
activities described in section 513.
(4) Interaction with other Code provisions--(i) Hospital
organization operating a noncompliant hospital facility continues to be
treated as tax-exempt. A hospital organization operating a noncompliant
hospital facility subject to tax under this paragraph (d) shall continue
to be treated as an organization that is exempt from tax under section
501(a) because it is described in section 501(c)(3) for all purposes of
the Code. In addition, the application of this paragraph (d) shall not,
by itself, result in the operation of the noncompliant hospital
[[Page 62]]
facility being considered an unrelated trade or business described in
section 513 with respect to the hospital organization. Thus, for
example, the application of this paragraph (d) shall not, by itself,
affect the tax-exempt status of bonds issued to finance the noncompliant
hospital facility.
(ii) Noncompliant hospital facility operated by a tax-exempt
hospital organization is subject to tax. A noncompliant hospital
facility described in paragraph (d)(1) of this section is subject to tax
under this paragraph (d), notwithstanding the fact that the hospital
organization operating the hospital facility is otherwise exempt from
tax under section 501(a) and subject to tax under section 511(a) and
that Sec. 1.11-1(a) of this chapter states such organizations are not
liable for the tax imposed under section 11.
(iii) Noncompliant hospital facility not a business entity. A
noncompliant hospital facility subject to tax under this paragraph (d)
is not considered a business entity for purposes of Sec. 301.7701-
2(b)(7) of this chapter.
(e) Instances in which a hospital organization is not required to
meet section 501(r). A hospital organization is not required to meet the
requirements of section 501(r) (and, therefore, is not subject to any
consequence described in this section for failing to meet the
requirements of section 501(r)) with respect to--
(1) Any hospital facility it is not ``operating'' within the meaning
of Sec. 1.501(r)-1(b)(22);
(2) The operation of a facility that is not required by a state to
be licensed, registered, or similarly recognized as a hospital; or
(3) Any activities that constitute an unrelated trade or business
described in section 513 with respect to the hospital organization.
[T.D. 9708, 79 FR 78998, Dec. 31, 2014; 80 FR 12762, Mar. 11, 2015]
Sec. 1.501(r)-3 Community health needs assessments.
(a) In general. With respect to any taxable year, a hospital
organization meets the requirements of section 501(r)(3) with respect to
a hospital facility it operates only if--
(1) The hospital facility has conducted a community health needs
assessment (CHNA) that meets the requirements of paragraph (b) of this
section in such taxable year or in either of the two taxable years
immediately preceding such taxable year (except as provided in paragraph
(d) of this section); and
(2) An authorized body of the hospital facility (as defined in Sec.
1.501(r)-1(b)(4)) has adopted an implementation strategy to meet the
community health needs identified through the CHNA, as described in
paragraph (c) of this section, on or before the 15th day of the fifth
month after the end of such taxable year.
(b) Conducting a CHNA--(1) In general. To conduct a CHNA for
purposes of paragraph (a) of this section, a hospital facility must
complete all of the following steps:
(i) Define the community it serves.
(ii) Assess the health needs of that community.
(iii) In assessing the health needs of the community, solicit and
take into account input received from persons who represent the broad
interests of that community, including those with special knowledge of
or expertise in public health.
(iv) Document the CHNA in a written report (CHNA report) that is
adopted for the hospital facility by an authorized body of the hospital
facility.
(v) Make the CHNA report widely available to the public.
(2) Date a CHNA is conducted. For purposes of this section, a
hospital facility will be considered to have conducted a CHNA on the
date it has completed all of the steps described in paragraph (b)(1) of
this section. Solely for purposes of determining the taxable year in
which a CHNA has been conducted under this paragraph (b)(2), a hospital
facility will be considered to have completed the step of making a CHNA
report widely available to the public on the date it first makes the
CHNA report widely available to the public as described in paragraph
(b)(7)(i) of this section.
(3) Community served by a hospital facility. In defining the
community it serves for purposes of paragraph
[[Page 63]]
(b)(1)(i) of this section, a hospital facility may take into account all
of the relevant facts and circumstances, including the geographic area
served by the hospital facility, target population(s) served (for
example, children, women, or the aged), and principal functions (for
example, focus on a particular specialty area or targeted disease).
However, a hospital facility may not define its community to exclude
medically underserved, low-income, or minority populations who live in
the geographic areas from which the hospital facility draws its patients
(unless such populations are not part of the hospital facility's target
patient population(s) or affected by its principal functions) or
otherwise should be included based on the method the hospital facility
uses to define its community. In addition, in determining its patient
populations for purposes of defining its community, a hospital facility
must take into account all patients without regard to whether (or how
much) they or their insurers pay for the care received or whether they
are eligible for assistance under the hospital facility's financial
assistance policy. In the case of a hospital facility consisting of
multiple buildings that operate under a single state license and serve
different geographic areas or populations, the community served by the
hospital facility is the aggregate of such areas or populations.
(4) Assessing community health needs. To assess the health needs of
the community it serves for purposes of paragraph (b)(1)(ii) of this
section, a hospital facility must identify significant health needs of
the community, prioritize those health needs, and identify resources
(such as organizations, facilities, and programs in the community,
including those of the hospital facility) potentially available to
address those health needs. For these purposes, the health needs of a
community include requisites for the improvement or maintenance of
health status both in the community at large and in particular parts of
the community (such as particular neighborhoods or populations
experiencing health disparities). These needs may include, for example,
the need to address financial and other barriers to accessing care, to
prevent illness, to ensure adequate nutrition, or to address social,
behavioral, and environmental factors that influence health in the
community. A hospital facility may determine whether a health need is
significant based on all of the facts and circumstances present in the
community it serves. In addition, a hospital facility may use any
criteria to prioritize the significant health needs it identifies,
including, but not limited to, the burden, scope, severity, or urgency
of the health need; the estimated feasibility and effectiveness of
possible interventions; the health disparities associated with the need;
or the importance the community places on addressing the need.
(5) Persons representing the broad interests of the community--(i)
In general. For purposes of paragraph (b)(1)(iii) of this section, a
hospital facility must solicit and take into account input received from
all of the following sources in identifying and prioritizing significant
health needs and in identifying resources potentially available to
address those health needs:
(A) At least one state, local, tribal, or regional governmental
public health department (or equivalent department or agency), or a
State Office of Rural Health described in section 338J of the Public
Health Service Act (42 U.S.C. 254r), with knowledge, information, or
expertise relevant to the health needs of that community.
(B) Members of medically underserved, low-income, and minority
populations in the community served by the hospital facility, or
individuals or organizations serving or representing the interests of
such populations. For purposes of this paragraph (b), medically
underserved populations include populations experiencing health
disparities or at risk of not receiving adequate medical care as a
result of being uninsured or underinsured or due to geographic,
language, financial, or other barriers.
(C) Written comments received on the hospital facility's most
recently conducted CHNA and most recently adopted implementation
strategy.
(ii) Additional sources of input. In addition to the sources
described in paragraph (b)(5)(i) of this section, a hospital
[[Page 64]]
facility may solicit and take into account input received from a broad
range of persons located in or serving its community, including, but not
limited to, health care consumers and consumer advocates, nonprofit and
community-based organizations, academic experts, local government
officials, local school districts, health care providers and community
health centers, health insurance and managed care organizations, private
businesses, and labor and workforce representatives.
(6) Documentation of a CHNA--(i) In general. For purposes of
paragraph (b)(1)(iv) of this section, the CHNA report adopted for the
hospital facility by an authorized body of the hospital facility must
include--
(A) A definition of the community served by the hospital facility
and a description of how the community was determined;
(B) A description of the process and methods used to conduct the
CHNA;
(C) A description of how the hospital facility solicited and took
into account input received from persons who represent the broad
interests of the community it serves;
(D) A prioritized description of the significant health needs of the
community identified through the CHNA, along with a description of the
process and criteria used in identifying certain health needs as
significant and prioritizing those significant health needs;
(E) A description of the resources potentially available to address
the significant health needs identified through the CHNA; and
(F) An evaluation of the impact of any actions that were taken,
since the hospital facility finished conducting its immediately
preceding CHNA, to address the significant health needs identified in
the hospital facility's prior CHNA(s).
(ii) Process and methods used to conduct the CHNA. A hospital
facility's CHNA report will be considered to describe the process and
methods used to conduct the CHNA for purposes of paragraph (b)(6)(i)(B)
of this section if the CHNA report describes the data and other
information used in the assessment, as well as the methods of collecting
and analyzing this data and information, and identifies any parties with
whom the hospital facility collaborated, or with whom it contracted for
assistance, in conducting the CHNA. In the case of data obtained from
external source material, the CHNA report may cite the source material
rather than describe the method of collecting the data.
(iii) Input from persons who represent the broad interests of the
community served by the hospital facility. A hospital facility's CHNA
report will be considered to describe how the hospital facility took
into account input received from persons who represent the broad
interests of the community it serves for purposes of paragraph
(b)(6)(i)(C) of this section if the CHNA report summarizes, in general
terms, any input provided by such persons and how and over what time
period such input was provided (for example, whether through meetings,
focus groups, interviews, surveys, or written comments and between what
approximate dates); provides the names of any organizations providing
input and summarizes the nature and extent of the organization's input;
and describes the medically underserved, low-income, or minority
populations being represented by organizations or individuals that
provided input. A CHNA report does not need to name or otherwise
identify any specific individual providing input on the CHNA. In the
event a hospital facility solicits, but cannot obtain, input from a
source described in paragraph (b)(5)(i) of this section, the hospital
facility's CHNA report also must describe the hospital facility's
efforts to solicit input from such source.
(iv) Separate CHNA reports. While a hospital facility may conduct
its CHNA in collaboration with other organizations and facilities
(including, but not limited to, related and unrelated hospital
organizations and facilities, for-profit and government hospitals,
governmental departments, and nonprofit organizations), every hospital
facility must document the information described in this paragraph
(b)(6) in a separate CHNA report to satisfy paragraph (b)(1)(iv) of this
section unless it adopts a joint CHNA report as described in paragraph
(b)(6)(v) of this section. However, if a hospital facility
[[Page 65]]
is collaborating with other facilities and organizations in conducting
its CHNA or if another organization (such as a state or local public
health department) has conducted a CHNA for all or part of the hospital
facility's community, portions of the hospital facility's CHNA report
may be substantively identical to portions of a CHNA report of a
collaborating hospital facility or other organization conducting a CHNA,
if appropriate under the facts and circumstances. For example, if two
hospital facilities with overlapping, but not identical, communities are
collaborating in conducting a CHNA, the portions of each hospital
facility's CHNA report relevant to the shared areas of their communities
might be identical. Similarly, if the state or local public health
department with jurisdiction over the community served by a hospital
facility conducts a CHNA for an area that includes the hospital
facility's community, the hospital facility's CHNA report might include
portions of the state or local public health department's CHNA report
that are relevant to its community.
(v) Joint CHNA reports--(A) In general. A hospital facility that
collaborates with other hospital facilities or other organizations (such
as state or local public health departments) in conducting its CHNA will
satisfy paragraph (b)(1)(iv) of this section if an authorized body of
the hospital facility adopts for the hospital facility a joint CHNA
report produced for the hospital facility and one or more of the
collaborating facilities and organizations, provided that the following
conditions are met:
(1) The joint CHNA report meets the requirements of paragraph
(b)(6)(i) of this section.
(2) The joint CHNA report is clearly identified as applying to the
hospital facility.
(3) All of the collaborating hospital facilities and organizations
included in the joint CHNA report define their community to be the same.
(B) Example. The following example illustrates this paragraph
(b)(6)(v):
Example. P is one of 10 hospital facilities located in and serving
the populations of a particular Metropolitan Statistical Area (MSA). P
and seven other facilities in the MSA, some of which are unrelated to P,
decide to collaborate in conducting a CHNA for the MSA and to each
define their community as constituting the entire MSA. The eight
hospital facilities work together with the state and local health
departments of jurisdictions in the MSA to assess the health needs of
the MSA and collaborate in conducting surveys and holding public forums
to solicit and receive input from the MSA's residents, including its
medically underserved, low-income, and minority populations. The
hospital facilities also consider the written comments received on their
most recently conducted CHNAs and most recently adopted implementation
strategies. The hospital facilities then work together to prepare a
joint CHNA report documenting this joint CHNA process that contains all
of the elements described in paragraph (b)(6)(i) of this section. The
joint CHNA report identifies all of the collaborating hospital
facilities included in the report, including P, by name, both within the
report itself and on the cover page. The board of directors of the
hospital organization operating P adopts the joint CHNA report for P. P
has complied with the requirements of this paragraph (b)(6)(v) and,
accordingly, has satisfied paragraph (b)(1)(iv) of this section.
(7) Making the CHNA report widely available to the public--(i) In
general. For purposes of paragraph (b)(1)(v) of this section, a hospital
facility's CHNA report is made widely available to the public only if
the hospital facility--
(A) Makes the CHNA report widely available on a Web site, as defined
in Sec. 1.501(r)-1(b)(29), at least until the date the hospital
facility has made widely available on a Web site its two subsequent CHNA
reports; and
(B) Makes a paper copy of the CHNA report available for public
inspection upon request and without charge at the hospital facility at
least until the date the hospital facility has made available for public
inspection a paper copy of its two subsequent CHNA reports.
(ii) Making draft CHNA reports widely available. Notwithstanding
paragraph (b)(7)(i) of this section, if a hospital facility makes widely
available on a Web site (and/or for public inspection) a version of the
CHNA report that is expressly marked as a draft on which the public may
comment, the hospital facility will not be considered to have made the
CHNA report widely available to the public for purposes of determining
the date on which the hospital
[[Page 66]]
facility has conducted a CHNA under paragraph (b)(2) of this section.
(c) Implementation strategy--(1) In general. For purposes of
paragraph (a)(2) of this section, a hospital facility's implementation
strategy to meet the community health needs identified through the
hospital facility's CHNA is a written plan that, with respect to each
significant health need identified through the CHNA, either--
(i) Describes how the hospital facility plans to address the health
need; or
(ii) Identifies the health need as one the hospital facility does
not intend to address and explains why the hospital facility does not
intend to address the health need.
(2) Description of how the hospital facility plans to address a
significant health need. A hospital facility's implementation strategy
will have described a plan to address a significant health need
identified through a CHNA for purposes of paragraph (c)(1)(i) of this
section if the implementation strategy--
(i) Describes the actions the hospital facility intends to take to
address the health need and the anticipated impact of these actions;
(ii) Identifies the resources the hospital facility plans to commit
to address the health need; and
(iii) Describes any planned collaboration between the hospital
facility and other facilities or organizations in addressing the health
need.
(3) Description of why a hospital facility is not addressing a
significant health need. In explaining why it does not intend to address
a significant health need for purposes of paragraph (c)(1)(ii) of this
section, a brief explanation of the hospital facility's reason for not
addressing the health need is sufficient. Such reasons may include, for
example, resource constraints, other facilities or organizations in the
community addressing the need, a relative lack of expertise or
competency to effectively address the need, the need being a relatively
low priority, and/or a lack of identified effective interventions to
address the need.
(4) Joint implementation strategies. A hospital facility may develop
an implementation strategy in collaboration with other hospital
facilities or other organizations, including, but not limited to,
related and unrelated hospital organizations and facilities, for-profit
and government hospitals, governmental departments, and nonprofit
organizations. In general, a hospital facility that collaborates with
other facilities or organizations in developing its implementation
strategy must still document its implementation strategy in a separate
written plan that is tailored to the particular hospital facility,
taking into account its specific resources. However, a hospital facility
that adopts a joint CHNA report described in paragraph (b)(6)(v) of this
section may also adopt a joint implementation strategy that, with
respect to each significant health need identified through the joint
CHNA, either describes how one or more of the collaborating facilities
or organizations plan to address the health need or identifies the
health need as one the collaborating facilities or organizations do not
intend to address and explains why they do not intend to address the
health need. For a collaborating hospital facility to meet the
requirements of paragraph (a)(2) of this section, such a joint
implementation strategy adopted for the hospital facility must--
(i) Be clearly identified as applying to the hospital facility;
(ii) Clearly identify the hospital facility's particular role and
responsibilities in taking the actions described in the implementation
strategy and the resources the hospital facility plans to commit to such
actions; and
(iii) Include a summary or other tool that helps the reader easily
locate those portions of the joint implementation strategy that relate
to the hospital facility.
(5) When the implementation strategy must be adopted--(i) In
general. For purposes of paragraph (a)(2) of this section, an authorized
body of the hospital facility must adopt the implementation strategy on
or before the 15th day of the fifth month after the end of the taxable
year in which the hospital facility completes the final step for the
CHNA described in paragraph (b)(1) of this section, regardless of
whether the hospital facility began working on the CHNA in a prior
taxable year.
(ii) Example. The following example illustrates this paragraph
(c)(5):
[[Page 67]]
Example. M is a hospital facility that last conducted a CHNA and
adopted an implementation strategy in Year 1. In Year 3, M defines the
community it serves, assesses the significant health needs of that
community, and solicits and takes into account input received from
persons who represent the broad interests of that community. In Year 4,
M documents its CHNA in a CHNA report that is adopted by an authorized
body of M, makes the CHNA report widely available on a Web site, and
makes paper copies of the CHNA report available for public inspection.
To meet the requirements of paragraph (a)(2) of this section, an
authorized body of M must adopt an implementation strategy to meet the
health needs identified through the CHNA completed in Year 4 by the 15th
day of the fifth month of Year 5.
(d) Exception for acquired, new, and terminated hospital
facilities--(1) Acquired hospital facilities. A hospital organization
that acquires a hospital facility (whether through merger or
acquisition) must meet the requirements of section 501(r)(3) with
respect to the acquired hospital facility by the last day of the
organization's second taxable year beginning after the date on which the
hospital facility was acquired. In the case of a merger between two
organizations that results in the liquidation of one organization and
the survival of the other organization, the hospital facility or
facilities formerly operated by the liquidated organization will be
considered ``acquired'' for purposes of this paragraph (d)(1).
(2) New hospital organizations. An organization that becomes newly
subject to the requirements of section 501(r) because it is recognized
as described in section 501(c)(3) and is operating a hospital facility
must meet the requirements of section 501(r)(3) with respect to any
hospital facility by the last day of the second taxable year beginning
after the later of the effective date of the determination letter or
ruling recognizing the organization as described in section 501(c)(3) or
the first date that a facility operated by the organization was
licensed, registered, or similarly recognized by a state as a hospital.
(3) New hospital facilities. A hospital organization must meet the
requirements of section 501(r)(3) with respect to a new hospital
facility it operates by the last day of the second taxable year
beginning after the date the facility was licensed, registered, or
similarly recognized by its state as a hospital.
(4) Transferred or terminated hospital facilities. A hospital
organization is not required to meet the requirements of section
501(r)(3) with respect to a hospital facility in a taxable year if,
before the end of that taxable year, the hospital organization transfers
all ownership of the hospital facility to another organization or
otherwise ceases its operation of the hospital facility or the facility
ceases to be licensed, registered, or similarly recognized as a hospital
by a state.
(e) Transition rule for CHNAs conducted in taxable years beginning
before March 23, 2012. A hospital facility that conducted a CHNA
described in section 501(r)(3) in either its first taxable year
beginning after March 23, 2010, or its first taxable year beginning
after March 23, 2011, does not need to meet the requirements of section
501(r)(3) again until the third taxable year following the taxable year
in which the hospital facility conducted that CHNA, provided that the
hospital facility adopted an implementation strategy to meet the
community health needs identified through that CHNA on or before the
15th day of the fifth calendar month following the close of its first
taxable year beginning after March 23, 2012.
[T.D. 9708, 79 FR 78998, Dec. 31, 2014; 80 FR 12762, Mar. 11, 2015]
Sec. 1.501(r)-4 Financial assistance policy and emergency medical
care policy.
(a) In general. A hospital organization meets the requirements of
section 501(r)(4) with respect to a hospital facility it operates only
if the hospital organization establishes for that hospital facility--
(1) A written financial assistance policy (FAP) that meets the
requirements of paragraph (b) of this section; and
(2) A written emergency medical care policy that meets the
requirements of paragraph (c) of this section.
(b) Financial assistance policy--(1) In general. To satisfy
paragraph (a)(1) of this section, a hospital facility's FAP must--
(i) Apply to all emergency and other medically necessary care
provided by the hospital facility, including all such
[[Page 68]]
care provided in the hospital facility by a substantially-related entity
(as defined in Sec. 1.501(r)-1(b)(28));
(ii) Be widely publicized as described in paragraph (b)(5) of this
section; and
(iii) Include--
(A) The eligibility criteria for financial assistance and whether
such assistance includes free or discounted care;
(B) The basis for calculating amounts charged to patients;
(C) The method for applying for financial assistance;
(D) In the case of a hospital facility that does not have a separate
billing and collections policy, the actions that may be taken in the
event of nonpayment;
(E) If applicable, any information obtained from sources other than
an individual seeking financial assistance that the hospital facility
uses, and whether and under what circumstances it uses prior FAP-
eligibility determinations, to presumptively determine that the
individual is FAP-eligible, as described in Sec. 1.501(r)-6(c)(2); and
(F) A list of any providers, other than the hospital facility
itself, delivering emergency or other medically necessary care in the
hospital facility that specifies which providers are covered by the
hospital facility's FAP and which are not.
(2) Eligibility criteria and basis for calculating amounts charged
to patients--(i) In general. To satisfy paragraphs (b)(1)(iii)(A) and
(b)(1)(iii)(B) of this section, the FAP must specify the following:
(A) All financial assistance available under the FAP, including all
discounts and free care available under the FAP and, if applicable, the
amount(s) (for example, gross charges) to which any discount percentages
available under the FAP will be applied.
(B) The eligibility criteria that an individual must satisfy to
receive each discount, free care, or other level of assistance available
under the FAP.
(C) The method under Sec. 1.501(r)-5(b) the hospital facility uses
to determine the amounts generally billed to individuals who have
insurance covering emergency or other medically necessary care (AGB). If
the hospital facility uses the look-back method described in Sec.
1.501(r)-5(b)(3), the FAP also must state the AGB percentage(s) that the
hospital facility uses to determine AGB and describe how the hospital
facility calculated such percentage(s) or, alternatively, explain how
members of the public may readily obtain such percentage(s) and
accompanying description of the calculation in writing and free of
charge. In addition, the FAP must indicate that, following a
determination of FAP-eligibility, a FAP-eligible individual may not be
charged more than AGB for emergency or other medically necessary care.
(ii) Examples. The following examples illustrate this paragraph
(b)(2):
Example 1. (i) Q is a hospital facility that establishes a FAP that
provides assistance to all uninsured and underinsured individuals whose
family income is less than or equal to x% of the Federal Poverty Level
(FPL), with the level of discount for which an individual is eligible
under Q's FAP determined based upon the individual's family income as a
percentage of FPL. Q's FAP defines the meaning of ``uninsured,''
``underinsured,'' ``family income,'' and ``Federal Poverty Level.'' Q's
FAP also states that Q determines AGB by multiplying the gross charges
for any emergency or other medically necessary care it provides to a
FAP-eligible individual by an AGB percentage of 56%. The FAP states,
further, that Q calculated the AGB percentage of 56% based on all claims
allowed by Medicare and private health insurers over a specified 12-
month period, divided by the associated gross charges for those claims.
Q's FAP contains the following chart, specifying each discount available
under the FAP, the amounts (gross charges) to which these discounts will
be applied, and the specific eligibility criteria for each such
discount:
------------------------------------------------------------------------
Discount off of gross
Family income as % of FPL charges
------------------------------------------------------------------------
y% - x%........................ 50%.
z% - y%........................ 75%.
<=z%...................................... Free.
------------------------------------------------------------------------
(ii) Q's FAP also contains a statement that no FAP-eligible
individual will be charged more for emergency or other medically
necessary care than AGB because Q's AGB percentage is 56% of gross
charges and the most a FAP-eligible individual will be charged is 50% of
gross charges. Q's FAP satisfies the requirements of this paragraph
(b)(2).
Example 2. (i) R is a hospital facility that establishes a FAP that
provides assistance based on household income. R's FAP defines the
meaning of ``household income.'' R's FAP contains the following chart
specifying the assistance available under the FAP and
[[Page 69]]
the specific eligibility criteria for each level of assistance offered,
which R updates occasionally to account for inflation:
------------------------------------------------------------------------
Maximum amount individual will
Household income be responsible for paying
------------------------------------------------------------------------
$b - $a..................... 40% of gross charges, up to the
lesser of AGB or x% of
household income.
$c - $b..................... 20% of gross charges, up to the
lesser of AGB or y% of
household income.
<=$c................................... $0 (free).
------------------------------------------------------------------------
(ii) R's FAP contains a statement that no FAP-eligible individual
will be charged more for emergency or other medically necessary care
than AGB. R's FAP also states that R determines AGB by multiplying the
gross charges for any emergency or other medically necessary care it
provides by AGB percentages, which are based on claims allowed under
Medicare. In addition, the FAP provides a Web site address individuals
can visit, and a telephone number they can call, if they would like to
obtain an information sheet stating R's AGB percentages and explaining
how these AGB percentages were calculated. This information sheet, which
R makes available on its Web site and provides to any individual who
requests it, states that R's AGB percentages are 35% of gross charges
for inpatient care and 61% of gross charges for outpatient care. It also
states that these percentages were based on all claims allowed for R's
emergency or other medically necessary inpatient and outpatient care by
Medicare over a specified 12-month period, divided by the associated
gross charges for those claims. R's FAP satisfies the requirements of
this paragraph (b)(2).
(3) Method for applying for financial assistance--(i) In general. To
satisfy paragraph (b)(1)(iii)(C) of this section, a hospital facility's
FAP must describe how an individual applies for financial assistance
under the FAP. In addition, either the hospital facility's FAP or FAP
application form (including accompanying instructions) must describe the
information and documentation the hospital facility may require an
individual to provide as part of his or her FAP application and provide
the contact information described in Sec. 1.501(r)-1(b)(24)(v). A
hospital facility may not deny financial assistance under its FAP based
on an applicant's failure to provide information or documentation unless
that information or documentation is described in the FAP or FAP
application form. However, a hospital facility may grant financial
assistance under its FAP notwithstanding an applicant's failure to
provide information or documentation described in the FAP or FAP
application form and may, for example, rely on other evidence of
eligibility or an attestation by the applicant to determine that the
applicant is FAP-eligible.
(ii) Example. The following example illustrates this paragraph
(b)(3):
Example. S is a hospital facility with a FAP that bases eligibility
solely on an individual's household income. S's FAP provides that an
individual may apply for financial assistance by completing and
submitting S's FAP application form. S's FAP also describes how
individuals can obtain copies of the FAP application form. S's FAP
application form contains lines on which the applicant lists all items
of household income received by the applicant's household over the last
month and the names of the applicant's household members. The
instructions to S's FAP application form tell applicants where to submit
the application and provide that an applicant must attach to his or her
FAP application form proof of household income in the form of payroll
check stubs from the last month or, if last month's wages are not
representative of the applicant's annual income, a copy of the
applicant's most recent federal tax return. Alternatively, the
instructions state that an applicant may provide documentation of his or
her qualification for certain specified state means-tested programs. The
instructions also state that if an applicant does not have any of the
listed documents proving household income, he or she may call S's
financial assistance office and discuss other evidence that may be
provided to demonstrate eligibility. S does not deny financial
assistance to FAP applicants based on a failure to submit any
information or documentation not mentioned in the FAP application form
or instructions. S's FAP application form instructions also provide the
contact information of the hospital facility office that can provide an
applicant with information about the FAP and assistance with the FAP
application process. S's FAP satisfies the requirements of this
paragraph (b)(3).
(4) Actions that may be taken in the event of nonpayment--(i) In
general. To satisfy paragraph (b)(1)(iii)(D) of this section, either a
hospital facility's FAP or a separate written billing and collections
policy established for the hospital facility must describe--
(A) Any actions that the hospital facility (or other authorized
party) may take related to obtaining payment of a bill for medical care,
including, but not
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limited to, any extraordinary collection actions (ECAs) described in
Sec. 1.501(r)-6(b);
(B) The process and time frames the hospital facility (or other
authorized party) uses in taking the actions described in paragraph
(b)(4)(i)(A) of this section, including, but not limited to, the
reasonable efforts it will make to determine whether an individual is
FAP-eligible before engaging in any ECAs, as described in Sec.
1.501(r)-6(c); and
(C) The office, department, committee, or other body with the final
authority or responsibility for determining that the hospital facility
has made reasonable efforts to determine whether an individual is FAP-
eligible and may therefore engage in ECAs against the individual.
(ii) Separate billing and collections policy. In the case of a
hospital facility that satisfies paragraph (b)(1)(iii)(D) of this
section by establishing a separate written billing and collections
policy, the hospital facility's FAP must state that the actions the
hospital facility may take in the event of nonpayment are described in a
separate billing and collections policy and explain how members of the
public may readily obtain a free copy of this separate policy.
(5) Widely publicizing the FAP--(i) In general. To satisfy the
requirement in paragraph (b)(1)(ii) of this section to widely publicize
its FAP, a hospital facility must--
(A) Make the FAP, FAP application form, and plain language summary
of the FAP (as defined in Sec. 1.501(r)-1(b)(24)) widely available on a
Web site (as defined in Sec. 1.501(r)-1(b)(29));
(B) Make paper copies of the FAP, FAP application form, and plain
language summary of the FAP available upon request and without charge,
both by mail and in public locations in the hospital facility,
including, at a minimum, in the emergency room (if any) and admissions
areas;
(C) Notify and inform members of the community served by the
hospital facility about the FAP in a manner reasonably calculated to
reach those members who are most likely to require financial assistance
from the hospital facility; and
(D) Notify and inform individuals who receive care from the hospital
facility about the FAP by--
(1) Offering a paper copy of the plain language summary of the FAP
to patients as part of the intake or discharge process;
(2) Including a conspicuous written notice on billing statements
that notifies and informs recipients about the availability of financial
assistance under the hospital facility's FAP and includes the telephone
number of the hospital facility office or department that can provide
information about the FAP and FAP application process and the direct Web
site address (or URL) where copies of the FAP, FAP application form, and
plain language summary of the FAP may be obtained; and
(3) Setting up conspicuous public displays (or other measures
reasonably calculated to attract patients' attention) that notify and
inform patients about the FAP in public locations in the hospital
facility, including, at a minimum, the emergency room (if any) and
admissions areas.
(ii) Accessibility to limited English proficient individuals. To
widely publicize its FAP, a hospital facility must accommodate all
significant populations that have limited English proficiency (LEP) by
translating its FAP, FAP application form, and plain language summary of
the FAP into the primary language(s) spoken by such populations. A
hospital facility will satisfy this translation requirement in a taxable
year if it makes available translations of its FAP, FAP application
form, and plain language summary of the FAP in the language spoken by
each LEP language group that constitutes the lesser of 1,000 individuals
or 5 percent of the community served by the hospital facility or the
population likely to be affected or encountered by the hospital
facility. For purposes of this paragraph (b)(5)(ii), a hospital facility
may determine the percentage or number of LEP individuals in the
hospital facility's community or likely to be affected or encountered by
the hospital facility using any reasonable method.
(iii) Meaning of notify and inform. For purposes of paragraphs
(b)(5)(i)(C) and (b)(5)(i)(D)(3) of this section, a measure
[[Page 71]]
will notify and inform members of a community or patients about the
hospital facility's FAP if the measure, at a minimum, notifies the
reader or listener that the hospital facility offers financial
assistance under a FAP and informs him or her about how or where to
obtain more information about the FAP and FAP application process and to
obtain copies of the FAP, FAP application form, and plain language
summary of the FAP.
(iv) Meaning of reasonably calculated. Whether one or more measures
to widely publicize a hospital facility's FAP are reasonably calculated
to notify and inform members of a community or patients about the
hospital facility's FAP in the manner described in paragraphs
(b)(5)(i)(C) and (b)(5)(i)(D)(3) of this section will depend on all of
the facts and circumstances, including the primary language(s) spoken by
the members of the community served by the hospital facility and other
attributes of the community and the hospital facility.
(v) Examples. The following examples illustrate this paragraph
(b)(5):
Example 1. (i) Z is a hospital facility. The home page and main
billing page of Z's Web site conspicuously display the following
message: ``Need help paying your bill? You may be eligible for financial
assistance. Click here for more information.'' When readers click on the
link, they are taken to a Web page that explains the various discounts
available under Z's FAP and the specific eligibility criteria for each
such discount. This Web page also provides all of the other information
required to be included in a plain language summary of the FAP (as
defined in Sec. 1.501(r)-1(b)(24)), including a telephone number of Z
that individuals can call and a room number of Z that individuals can
visit for more information about the FAP and assistance with FAP
applications. In addition, the Web page contains prominently-displayed
links that allow readers to download PDF files of the FAP and the FAP
application form, free of charge and without being required to create an
account or provide personally identifiable information. Z provides any
individual who asks how to access a copy of the FAP, FAP application
form, or plain language summary of the FAP online with the URL of this
Web page. By implementing these measures, Z has made its FAP widely
available on a Web site within the meaning of paragraph (b)(5)(i)(A) of
this section.
(ii) Z distributes copies of the plain language summary of its FAP
and its FAP application form to all of its referring staff physicians
and to the community health centers serving its community. Z also
distributes copies of these documents to the local health department and
to numerous public agencies and nonprofit organizations in its community
that address the health issues and other needs of low-income
populations, in quantities sufficient to meet demand. In addition, every
issue of the quarterly newsletter that Z mails to the individuals in its
customer database contains a prominently-displayed advertisement
informing readers that Z offers financial assistance and that people
having trouble paying their hospital bills may be eligible for financial
assistance. The advertisement provides readers with the URL of the Web
page where Z's FAP and FAP application form can be accessed and a
telephone number of Z that individuals can call and a room number of Z
that individuals can visit with questions about the FAP or assistance
with the FAP application process. By implementing these measures, Z
notifies and informs members of its community about the FAP within the
meaning of paragraph (b)(5)(i)(C) of this section.
(iii) Z makes paper copies of the FAP, FAP application form, and
plain language summary of the FAP available upon request and without
charge, both by mail and in its admissions areas and emergency room. Z
also conspicuously displays a sign in large font regarding the FAP in
its admissions areas and emergency room. The sign says: ``Uninsured?
Having trouble paying your hospital bill? You may be eligible for
financial assistance.'' The sign also provides the URL of the Web page
where Z's FAP and FAP application form can be accessed. In addition, the
sign provides a telephone number of Z that individuals can call and a
room number of Z that individuals can visit with questions about the FAP
or assistance with the FAP application process. Underneath each sign, Z
conspicuously displays copies of a brochure that contains all of the
information required to be included in a plain language summary of the
FAP (as defined in Sec. 1.501(r)-1(b)(24)). Z makes these brochures
available in quantities sufficient to meet visitor demand. Z also offers
a plain language summary of the FAP as part of its intake process. Z's
billing statements include a conspicuously-placed statement in large
font containing the same information that Z includes on its signs. By
implementing these measures, Z makes a paper copy of the FAP, FAP
application form, and plain language summary of the FAP available upon
request within the meaning of paragraph (b)(5)(i)(B) of this section and
notifies and informs individuals who receive care from the hospital
facility about the FAP within the meaning of paragraph (b)(5)(i)(D) of
this section.
(iv) Because Z takes measures to widely publicize the FAP described
in paragraphs (b)(5)(i)(A), (b)(5)(i)(B), (b)(5)(i)(C), and
[[Page 72]]
(b)(5)(i)(D) of this section, Z meets the requirement to widely
publicize its FAP under paragraph (b)(1)(ii) of this section.
Example 2. Assume the same facts as Example 1, except that Z serves
a community in which 6% of the members speak Spanish and have limited
proficiency in English. Z translates its FAP, FAP application form, and
FAP brochure (which constitutes a plain language summary of the FAP)
into Spanish, and displays and distributes both Spanish and English
versions of these documents in its hospital facility using all of the
measures described in Example 1. Z also distributes Spanish versions of
its FAP application form and FAP brochure to organizations serving
Spanish-speaking members of its community. Moreover, the home page and
main billing page of Z's Web site conspicuously display an
``[iquest]Habla Espa[ntilde]ol?'' link that takes readers to a Web page
that summarizes the FAP in Spanish and contains links that allow readers
to download PDF files of the Spanish versions of the FAP and FAP
application form, free of charge and without being required to create an
account or provide personally identifiable information. Z meets the
requirement to widely publicize its FAP under paragraph (b)(1)(ii) of
this section.
(6) Readily obtainable information. For purposes of paragraphs
(b)(2)(i)(C) and (b)(4)(ii) of this section, information is readily
obtainable by members of the public if a hospital facility--
(i) Makes the information available free of charge on a Web site and
via a paper copy upon request in a manner similar to that described in
paragraphs (b)(5)(i)(A) and (b)(5)(i)(B) of this section; and
(ii) Provides translations of the information as described in
paragraph (b)(5)(ii) of this section.
(7) Providing documents electronically. A hospital facility may
provide electronically (for example, on an electronic screen, by email,
or by providing the direct Web site address, or URL, of the Web page
where the document or information is posted) any document or information
that is required by this paragraph (b) to be provided in the form of a
paper copy to any individual who indicates he or she prefers to receive
or access the document or information electronically.
(8) Medically necessary care. For purposes of meeting the
requirements of this section, a hospital facility may (but is not
required to) use a definition of medically necessary care applicable
under the laws of the state in which it is licensed, including the
Medicaid definition, or a definition that refers to the generally
accepted standards of medicine in the community or to an examining
physician's determination.
(c) Emergency medical care policy--(1) In general. To satisfy
paragraph (a)(2) of this section, a hospital organization must establish
a written policy for a hospital facility that requires the hospital
facility to provide, without discrimination, care for emergency medical
conditions to individuals regardless of whether they are FAP-eligible.
(2) Interference with provision of emergency medical care. A
hospital facility's emergency medical care policy will not be described
in paragraph (c)(1) of this section unless it prohibits the hospital
facility from engaging in actions that discourage individuals from
seeking emergency medical care, such as by demanding that emergency
department patients pay before receiving treatment for emergency medical
conditions or by permitting debt collection activities that interfere
with the provision, without discrimination, of emergency medical care.
(3) Relation to federal law governing emergency medical care.
Subject to paragraph (c)(2) of this section, a hospital facility's
emergency medical care policy will be described in paragraph (c)(1) of
this section if it requires the hospital facility to provide the care
for emergency medical conditions that the hospital facility is required
to provide under Subchapter G of Chapter IV of Title 42 of the Code of
Federal Regulations (or any successor regulations).
(4) Examples. The following examples illustrate this paragraph (c):
Example 1. F is a hospital facility with a dedicated emergency
department that is subject to the Emergency Medical Treatment and Labor
Act (EMTALA) and is not a critical access hospital. F establishes a
written emergency medical care policy requiring F to comply with EMTALA
by providing medical screening examinations and stabilizing treatment
and referring or transferring an individual to another facility, when
appropriate, and providing emergency services in accordance with 42 CFR
482.55 (or any successor regulation). F's emergency medical care policy
also states that F prohibits any actions that would discourage
individuals from seeking emergency medical care, such as by demanding
that emergency department patients pay before receiving treatment for
[[Page 73]]
emergency medical conditions or permitting debt collection activities
that interfere with the provision, without discrimination, of emergency
medical care. F's emergency medical care policy is described in
paragraph (c)(1) of this section.
Example 2. G is a rehabilitation hospital facility. G does not have
a dedicated emergency department, nor does it have specialized
capabilities that would make it appropriate to accept transfers of
individuals who need stabilizing treatment for an emergency medical
condition. G establishes a written emergency medical care policy that
addresses how it appraises emergencies, provides initial treatment, and
refers or transfers an individual to another facility, when appropriate,
in a manner that complies with 42 CFR 482.12(f)(2) (or any successor
regulation). G's emergency medical care policy also prohibits G from
engaging in actions that discourage individuals from seeking emergency
medical care, such as by demanding that patients pay before receiving
initial treatment for emergency medical conditions or permitting debt
collection activities that interfere with the facility's appraisal and
provision, without discrimination, of such initial treatment. G's
emergency medical care policy is described in paragraph (c)(1) of this
section.
(d) Establishing the FAP and other policies--(1) In general. A
hospital organization has established a FAP, a billing and collections
policy, or an emergency medical care policy for a hospital facility only
if an authorized body of the hospital facility (as defined in Sec.
1.501(r)-1(b)(4)) has adopted the policy for the hospital facility and
the hospital facility has implemented the policy.
(2) Implementing a policy. For purposes of this paragraph (d), a
hospital facility will be considered to have implemented a policy if the
hospital facility has consistently carried out the policy.
(3) Establishing a policy for more than one hospital facility. A
hospital organization may establish a FAP, billing and collections
policy, and/or emergency medical care policy for a hospital facility
that is identical to that of other hospital facilities or a joint policy
that is shared with multiple hospital facilities provided that any joint
policy clearly identifies each facility to which it applies. However,
hospital facilities that have different AGB percentages or use different
methods to determine AGB must include in their FAPs (or, in the case of
information related to AGB percentages, otherwise make readily
obtainable) different information regarding AGB to meet the requirements
of paragraph (b)(2)(i)(C) of this section.
[T.D. 9708, 79 FR 78998, Dec. 31, 2014]
Sec. 1.501(r)-5 Limitation on charges.
(a) In general. A hospital organization meets the requirements of
section 501(r)(5) with respect to a hospital facility it operates only
if the hospital facility (and any substantially-related entity, as
defined in Sec. 1.501(r)-1(b)(28)) limits the amount charged for care
it provides to any individual who is eligible for assistance under its
financial assistance policy (FAP) to--
(1) In the case of emergency or other medically necessary care, not
more than the amounts generally billed to individuals who have insurance
covering such care (AGB), as determined under paragraph (b) of this
section; and
(2) In the case of all other medical care covered under the FAP,
less than the gross charges for such care, as described in paragraph (c)
of this section.
(b) Amounts generally billed--(1) In general. For purposes of
meeting the requirements of paragraph (a)(1) of this section, a hospital
facility must determine AGB for emergency or other medically necessary
care using a method described in paragraph (b)(3) or (b)(4) of this
section or any other method specified in regulations or other guidance
published in the Internal Revenue Bulletin. A hospital facility may use
only one of these methods to determine AGB at any one time, but
different hospital facilities operated by the same hospital organization
may use different methods. A hospital facility may change the method it
uses to determine AGB at any time.
(2) Meaning of charged. For purposes of paragraph (a)(1) of this
section, a FAP-eligible individual is considered to be ``charged'' only
the amount he or she is personally responsible for paying, after all
deductions, discounts (including discounts available under the FAP), and
insurance reimbursements have been applied. Thus, in the case of a FAP-
eligible individual who has health insurance coverage, a hospital
facility will meet the requirements of paragraph (a)(1) of this section
if the
[[Page 74]]
FAP-eligible individual is not personally responsible for paying (for
example, in the form of co-payments, co-insurance, and deductibles) more
than AGB for the care after all reimbursements by the health insurer
have been applied, even if the total amount paid by the FAP-eligible
individual and his or her health insurer together exceeds AGB.
(3) Look-back method--(i) In general. A hospital facility may
determine AGB for any emergency or other medically necessary care it
provides to a FAP-eligible individual by multiplying the hospital
facility's gross charges for the care by one or more percentages of
gross charges (AGB percentage(s)). A hospital facility using this method
must calculate its AGB percentage(s) at least annually by dividing the
sum of the amounts of all of its claims for emergency and other
medically necessary care that have been allowed by health insurers
described in paragraph (b)(3)(ii) of this section during a prior 12-
month period by the sum of the associated gross charges for those
claims. Whether a claim is used in calculating a hospital facility's AGB
percentage(s) depends on whether the claim was allowed by a health
insurer during the 12-month period used in the calculation, not on
whether the care resulting in the claim was provided during that 12-
month period. If the amount a health insurer will allow for a claim has
not been finally determined as of the last day of the 12-month period
used to calculate the AGB percentage(s), a hospital facility should
exclude the amount of the claim from that calculation and include it in
the subsequent 12-month period during which the amount allowed is
finally determined. When including allowed claims in calculating its AGB
percentage(s), the hospital facility should include the full amount that
has been allowed by the health insurer, including both the amount the
insurer will pay or reimburse and the amount (if any) the individual is
personally responsible for paying in the form of co-payments, co-
insurance, and deductibles, regardless of whether or when the full
amount allowed is actually paid and disregarding any discounts applied
to the individual's portion.
(ii) Health insurers used in calculating AGB percentage(s). In
calculating its AGB percentage(s), a hospital facility must include the
claims allowed during a prior 12-month period by--
(A) Medicare fee-for-service;
(B) Medicare fee-for-service and all private health insurers that
pay claims to the hospital facility; or
(C) Medicaid, either alone or in combination with the insurer(s)
described in paragraph (b)(3)(ii)(A) or (b)(3)(ii)(B) of this section.
(iii) One or multiple AGB percentages. A hospital facility's AGB
percentage that is calculated using the method described in this
paragraph (b)(3) may be one average percentage of gross charges for all
emergency and other medically necessary care provided by the hospital
facility. Alternatively, a hospital facility may calculate multiple AGB
percentages for separate categories of care (such as inpatient and
outpatient care or care provided by different departments) or for
separate items or services, as long as the hospital facility calculates
AGB percentages for all emergency and other medically necessary care
provided by the hospital facility.
(iv) Start date for applying AGB percentages. For purposes of
determining AGB under this paragraph (b)(3), with respect to any AGB
percentage that a hospital facility has calculated, the hospital
facility must begin applying the AGB percentage by the 120th day after
the end of the 12-month period the hospital facility used in calculating
the AGB percentage.
(v) Use of all claims for medical care. A hospital facility
determining AGB under this paragraph (b)(3) may use claims allowed for
all medical care during a prior 12-month period rather than just those
allowed for emergency and other medically necessary care.
(vi) Determining AGB percentages for more than one hospital
facility. Although generally a hospital organization must calculate AGB
percentage(s) separately for each hospital facility it operates,
hospital facilities that are covered under the same Medicare provider
agreement (as defined in 42 CFR 489.3
[[Page 75]]
or any successor regulations) may calculate one AGB percentage (or
multiple AGB percentages for separate categories of care or for separate
items or services) using the method described in this paragraph (b)(3)
based on the claims and gross charges for all such hospital facilities
and implement the AGB percentage(s) across all such hospital facilities.
(4) Prospective Medicare or Medicaid method. A hospital facility may
determine AGB for any emergency or other medically necessary care
provided to a FAP-eligible individual by using the billing and coding
process the hospital facility would use if the FAP-eligible individual
were a Medicare fee-for-service or Medicaid beneficiary and setting AGB
for the care at the amount the hospital facility determines would be the
total amount Medicare or Medicaid would allow for the care (including
both the amount that would be reimbursed by Medicare or Medicaid and the
amount the beneficiary would be personally responsible for paying in the
form of co-payments, co-insurance, and deductibles). A hospital facility
using the method described in this paragraph (b)(4) may base AGB on
Medicare fee-for-service or Medicaid or both, provided that, if it uses
both, its FAP describes the circumstance under which it will use
Medicare fee-for-service or Medicaid in determining AGB.
(5) Examples. The following examples illustrate this paragraph (b):
Example 1. On March 15 of Year 1, Y, a hospital facility, generates
data on the amount of all of Y's claims for emergency and other
medically necessary care that were allowed by all private health
insurers and Medicare fee-for-service over the immediately preceding
calendar year. Y determines that the private health insurers allowed a
total amount of $250 million and Medicare fee-for-service allowed a
total amount of $150 million, with the total allowed amounts including
both the portion the insurers agreed to reimburse and the portion that
the insured patients were personally responsible for paying. Y's gross
charges for these claims totaled $800 million. Y calculates that its AGB
percentage is 50% of gross charges ($400 million/$800 million). Y
updates its FAP to reflect the new AGB percentage of 50% and makes the
updated FAP widely available (both on its Web site and via paper copies
upon request) on April 1 of Year 1. Between April 1 of Year 1 (less than
120 days after the end of the preceding calendar year) and March 31 of
Year 2, Y determines AGB for any emergency or other medically necessary
care it provides to a FAP-eligible individual by multiplying the gross
charges for the care provided to the individual by 50%. Y has determined
AGB between April 1 of Year 1 and March 31 of Year 2 in accordance with
this paragraph (b) by using the look-back method described in paragraph
(b)(3) of this section.
Example 2. On August 20 of Year 1, X, a hospital facility, generates
data on the amount of all of X's claims for emergency and other
medically necessary care that were allowed by Medicare fee-for-service
over the 12 months ending on July 31 of Year 1. X determines that, of
these claims for inpatient services, Medicare allowed a total amount of
$100 million (including both the portion Medicare agreed to reimburse
and the portion Medicare beneficiaries were personally responsible for
paying). X's gross charges for these inpatient claims totaled $250
million. Of the claims for outpatient services, Medicare allowed a total
amount of $125 million. X's gross charges for these outpatient claims
totaled $200 million. X calculates that its AGB percentage for inpatient
services is 40% of gross charges ($100 million/$250 million) and its AGB
percentage for outpatient services is 62.5% of gross charges ($125
million/$200 million). Y discloses its AGB percentages and describes how
they were calculated on the Web page where its FAP can be accessed, and
it updates this Web page to reflect the new AGB percentages on November
1. Y also starts making an updated information sheet with the new AGB
percentages available upon request on and after November 1. Between
November 1 of Year 1 (less than 120 days after the end of the 12-month
claim period) and October 31 of Year 2, X determines AGB for any
emergency or other medically necessary inpatient care it provides to a
FAP-eligible individual by multiplying the gross charges for the
inpatient care it provides to the individual by 40% and AGB for any
emergency or other medically necessary outpatient care it provides to a
FAP-eligible individual by multiplying the gross charges for the
outpatient care it provides to the individual by 62.5%. X has determined
AGB between November 1 of Year 1 and October 31 of Year 2 in accordance
with this paragraph (b) by using the look-back method described in
paragraph (b)(3) of this section.
Example 3. Whenever Z, a hospital facility, provides emergency or
other medically necessary care to a FAP-eligible individual, Z
determines the AGB for the care by using the billing and coding process
it would use if the individual were a Medicare fee-for-service
beneficiary and setting AGB for the care at the amount it determines
Medicare and the Medicare beneficiary together would be
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expected to pay for the care. Z has determined AGB in accordance with
this paragraph (b) by using the prospective Medicare method described in
paragraph (b)(4) of this section.
Example 4. Using the look-back method described in paragraph (b)(3)
of this section, W, a hospital facility, calculates that its AGB
percentage for Year 1 is 60% of gross charges. Under W's FAP, which
applies to all emergency and other medically necessary care provided by
W and which has been updated to reflect the AGB percentage for Year 1,
the most that W charges a FAP-eligible individual is 50% of gross
charges. W properly implements its FAP and charges no FAP-eligible
individual more for emergency or other medically necessary care than 50%
of gross charges in Year 1. W has met the requirements of paragraphs
(a)(1) and (b) of this section in Year 1.
Example 5. A, an individual, receives medically necessary care from
hospital facility V for which the AGB is $3y. A is insured by U, a
health insurer. Under U's contracts with V and A, the amount allowed for
the care V provided to A is $5y. Of that amount allowed, A is personally
responsible for paying $1y (in co-payments and deductibles) while U is
responsible for paying $4y. Based on the eligibility criteria specified
in its FAP, V determines that A is FAP-eligible. Pursuant to paragraph
(b)(2) of this section, V may charge U and A collectively $5y while
still meeting the requirements of paragraph (a)(1) of this section
because the amount A is personally responsible for paying in co-payments
and deductibles ($1y) is less than the AGB for the care ($3y).
Example 6. Assume the same facts as Example 5, except that under U's
contracts with V and A, A is personally responsible for paying $4y (in
co-payments and deductibles) for the care while U is responsible for
paying V $1y. Because A is FAP-eligible under V's FAP, paragraph (a)(1)
of this section requires that A not be personally responsible for paying
V more than $3y (the AGB for the care provided).
(c) Gross charges. A hospital facility must charge a FAP-eligible
individual less than the gross charges for any medical care covered
under the hospital facility's FAP. A billing statement issued by a
hospital facility to a FAP-eligible individual for medical care covered
under the FAP may state the gross charges for such care and apply
contractual allowances, discounts, or deductions to the gross charges,
provided that the actual amount the individual is personally responsible
for paying is less than the gross charges for such care.
(d) Safe harbor for certain charges in excess of AGB. A hospital
facility will be deemed to meet the requirements of paragraph (a) of
this section, even if it charges more than AGB for emergency or other
medically necessary care (or gross charges for any medical care covered
under the FAP) provided to a FAP-eligible individual, if--
(1) The charge in excess of AGB was not made or requested as a pre-
condition of providing medically necessary care to the FAP-eligible
individual (for example, an upfront payment that a hospital facility
requires before providing medically necessary care);
(2) As of the time of the charge, the FAP-eligible individual has
not submitted a complete FAP application to the hospital facility to
obtain financial assistance for the care or has not otherwise been
determined by the hospital facility to be FAP-eligible for the care; and
(3) If the individual subsequently submits a complete FAP
application and is determined to be FAP-eligible for the care, the
hospital facility refunds any amount the individual has paid for the
care (whether to the hospital facility or any other party to whom the
hospital facility has referred or sold the individual's debt for the
care) that exceeds the amount he or she is determined to be personally
responsible for paying as a FAP-eligible individual, unless such excess
amount is less than $5 (or such other amount set by notice or other
guidance published in the Internal Revenue Bulletin).
(e) Medically necessary care. For purposes of meeting the
requirements of this section, a hospital facility may (but is not
required to) use a definition of medically necessary care applicable
under the laws of the state in which it is licensed, including the
Medicaid definition, or a definition that refers to the generally
accepted standards of medicine in the community or to an examining
physician's determination.
[T.D. 9708, 79 FR 78998, Dec. 31, 2014]
Sec. 1.501(r)-6 Billing and collection.
(a) In general. A hospital organization meets the requirements of
section 501(r)(6) with respect to a hospital facility it operates only
if the hospital
[[Page 77]]
facility does not engage in extraordinary collection actions (ECAs), as
defined in paragraph (b) of this section, against an individual to
obtain payment for care before the hospital facility has made reasonable
efforts to determine whether the individual is eligible for assistance
for the care under its financial assistance policy (FAP), as described
in paragraph (c) of this section. For purposes of this section, with
respect to any debt owed by an individual for care provided by a
hospital facility--
(1) ECAs against the individual include ECAs to obtain payment for
the care against any other individual who has accepted or is required to
accept responsibility for the individual's hospital bill for the care;
and
(2) The hospital facility will be deemed to have engaged in an ECA
against the individual to obtain payment for the care, or to have taken
one or more of the steps necessary to have made reasonable efforts to
determine whether the individual is FAP-eligible for the care, if any
purchaser of the individual's debt, any debt collection agency or other
party to which the hospital facility has referred the individual's debt,
or any substantially-related entity (as defined in Sec. 1.501(r)-
1(b)(28)) has engaged in such an ECA or taken such steps (whichever is
applicable).
(b) Extraordinary collection actions--(1) In general. Except as
otherwise provided in this paragraph (b), the following actions taken by
a hospital facility against an individual related to obtaining payment
of a bill for care covered under the hospital facility's FAP are ECAs:
(i) Selling an individual's debt to another party (other than debt
sales described in paragraph (b)(2) of this section).
(ii) Reporting adverse information about the individual to consumer
credit reporting agencies or credit bureaus.
(iii) Deferring or denying, or requiring a payment before providing,
medically necessary care because of an individual's nonpayment of one or
more bills for previously provided care covered under the hospital
facility's FAP (which is considered an ECA to obtain payment for the
previously provided care, not the care being potentially deferred or
denied). If a hospital facility requires a payment before providing
medically necessary care to an individual with one or more outstanding
bills for previously provided care, such a requirement for payment will
be presumed to be because of the individual's nonpayment of such bill(s)
unless the hospital facility can demonstrate that it required the
payment from the individual based on factors other than, and without
regard to, the individual's nonpayment of past bills.
(iv) Actions that require a legal or judicial process, including but
not limited to--
(A) Placing a lien on an individual's property (other than a lien
described in paragraph (b)(3) of this section);
(B) Foreclosing on an individual's real property;
(C) Attaching or seizing an individual's bank account or any other
personal property;
(D) Commencing a civil action against an individual;
(E) Causing an individual's arrest;
(F) Causing an individual to be subject to a writ of body
attachment; and
(G) Garnishing an individual's wages.
(2) Certain debt sales that are not ECAs. A hospital facility's sale
of an individual's debt for care provided by the hospital facility will
not be considered an ECA if, prior to the sale, the hospital facility
has entered into a legally binding written agreement with the purchaser
of the debt pursuant to which--
(i) The purchaser is prohibited from engaging in any ECAs to obtain
payment for the care;
(ii) The purchaser is prohibited from charging interest on the debt
in excess of the rate in effect under section 6621(a)(2) at the time the
debt is sold (or such other interest rate set by notice or other
guidance published in the Internal Revenue Bulletin);
(iii) The debt is returnable to or recallable by the hospital
facility upon a determination by the hospital facility or the purchaser
that the individual is FAP-eligible; and
(iv) If the individual is determined to be FAP-eligible and the debt
is not returned to or recalled by the hospital facility, the purchaser
is required to adhere to procedures specified in the
[[Page 78]]
agreement that ensure that the individual does not pay, and has no
obligation to pay, the purchaser and the hospital facility together more
than he or she is personally responsible for paying as a FAP-eligible
individual.
(3) Liens on certain judgments, settlements, or compromises. Any
lien that a hospital facility is entitled to assert under state law on
the proceeds of a judgment, settlement, or compromise owed to an
individual (or his or her representative) as a result of personal
injuries for which the hospital facility provided care is not an ECA.
(4) Bankruptcy claims. The filing of a claim in any bankruptcy
proceeding is not an ECA.
(c) Reasonable efforts--(1) In general. A hospital facility will
have made reasonable efforts to determine whether an individual is FAP-
eligible for care only if the hospital facility meets the requirements
described in paragraph (c)(2) or (c)(3) of this section.
(2) Presumptive FAP-eligibility determinations based on third-party
information or prior FAP-eligibility determinations--(i) In general.
With respect to any care provided by a hospital facility to an
individual, the hospital facility will have made reasonable efforts to
determine whether the individual is FAP-eligible for the care if it
determines that the individual is FAP-eligible for the care based on
information other than that provided by the individual or based on a
prior FAP-eligibility determination and, if the individual is
presumptively determined to be eligible for less than the most generous
assistance available under the FAP, the hospital facility--
(A) Notifies the individual regarding the basis for the presumptive
FAP-eligibility determination and the way to apply for more generous
assistance available under the FAP;
(B) Gives the individual a reasonable period of time to apply for
more generous assistance before initiating ECAs to obtain the discounted
amount owed for the care; and
(C) If the individual submits a complete FAP application seeking
more generous assistance during the application period (as defined in
Sec. 1.501(r)-1(b)(3)), determines whether the individual is eligible
for a more generous discount and otherwise meets the requirements
described in paragraph (c)(6) of this section with respect to that
complete FAP application.
(ii) Examples. The following examples illustrate this paragraph
(c)(2):
Example 1. V is a hospital facility with a FAP under which the
specific assistance for which an individual is eligible depends
exclusively upon that individual's household income. The most generous
assistance offered for care under V's FAP is free care. V's FAP states
that V uses enrollment in certain specified means-tested public programs
to presumptively determine that individuals are FAP-eligible. D, an
individual, receives care from V. Although D does not submit a FAP
application to V, V learns that D is eligible for certain benefits under
a state program that bases eligibility on household income. Based on
this knowledge, V presumptively determines that D is eligible to receive
free care under its FAP. V notifies D that it has determined he is
eligible for free care based on his eligibility for the benefits under
the state program and therefore does not owe V anything for the care he
received. V has made reasonable efforts to determine whether D is FAP-
eligible under this paragraph (c)(2).
Example 2. X is a hospital facility with a FAP that describes the
data, including both hospital and publicly-available data, X uses to
make presumptive FAP-eligibility determinations. On January 16, F, an
individual, receives care from X. Using the hospital and publicly-
available data described in its FAP, X presumptively determines that F
is eligible for a 50% discount under its FAP, a discount that is not the
most generous discount available under the FAP. The first billing
statement that X sends to F indicates that F has been given a 50%
discount under X's FAP, explains the basis for this presumptive FAP-
eligibility determination, and informs F that she may apply for
financial assistance if she believes she is eligible for a more generous
discount. The billing statement indicates that F may call 1-800-888-xxxx
or visit X's Web site at www.hospitalX.org/FAP to learn more about the
FAP or the FAP application process. X sends F three more billing
statements, each of which contains the standard written notice about the
FAP that X includes on all of its billing statements in accordance with
Sec. 1.501(r)-4(b)(5), but F neither pays the amount she is personally
responsible for paying nor applies for more generous financial
assistance. The time between the first and fourth billing statement
constitutes a reasonable period of time for F to apply for more generous
assistance. V has made reasonable efforts to determine whether D is FAP-
eligible under this paragraph (c)(2).
[[Page 79]]
(3) Reasonable efforts based on notification and processing of
applications. With respect to any care provided by a hospital facility
to an individual, the hospital facility will have made reasonable
efforts to determine whether the individual is FAP-eligible for the care
if it--
(i) Notifies the individual about the FAP as described in paragraph
(c)(4) of this section before initiating any ECAs to obtain payment for
the care and refrains from initiating such ECAs (with the exception of
an ECA described in paragraph (b)(1)(iii) of this section) for at least
120 days from the date the hospital facility provides the first post-
discharge billing statement for the care;
(ii) In the case of an individual who submits an incomplete FAP
application during the application period, notifies the individual about
how to complete the FAP application and gives the individual a
reasonable opportunity to do so as described in paragraph (c)(5) of this
section; and
(iii) In the case of an individual who submits a complete FAP
application during the application period, determines whether the
individual is FAP-eligible for the care and otherwise meets the
requirements described in paragraph (c)(6) of this section.
(4) Notification--(i) In general. With respect to any care provided
by a hospital facility to an individual and except as provided in
paragraph (c)(4)(iii) of this section, a hospital facility will have
notified an individual about its FAP for purposes of paragraph (c)(3)(i)
of this section only if the hospital facility does the following at
least 30 days before first initiating one or more ECA(s) to obtain
payment for the care:
(A) Provides the individual with a written notice that indicates
financial assistance is available for eligible individuals, that
identifies the ECA(s) that the hospitality facility (or other authorized
party) intends to initiate to obtain payment for the care, and that
states a deadline after which such ECA(s) may be initiated that is no
earlier than 30 days after the date that the written notice is provided.
(B) Provides the individual with a plain language summary of the FAP
(as defined in Sec. 1.501(r)-1(b)(24)) with the written notice
described in paragraph (c)(4)(i)(A) of this section (or, if applicable,
paragraph (c)(4)(iii) of this section).
(C) Makes a reasonable effort to orally notify the individual about
the hospital facility's FAP and about how the individual may obtain
assistance with the FAP application process.
(ii) Notification in the event of multiple episodes of care. A
hospital facility may satisfy the notification requirements described in
paragraph (c)(4)(i) of this section simultaneously for multiple episodes
of care and notify the individual about the ECA(s) the hospital facility
intends to initiate to obtain payment for multiple outstanding bills for
care. However, if a hospital facility aggregates an individual's
outstanding bills for multiple episodes of care before initiating one or
more ECAs to obtain payment for those bills, it will have not have made
reasonable efforts to determine whether the individual is FAP-eligible
under paragraph (c)(3) of this section unless it refrains from
initiating the ECA(s) until 120 days after it provided the first post-
discharge billing statement for the most recent episode of care included
in the aggregation.
(iii) Notification before deferring or denying care due to
nonpayment for prior care. In the case of an ECA described in paragraph
(b)(1)(iii) of this section, a hospital facility may notify the
individual about its FAP less than 30 days before initiating the ECA,
provided that the hospital facility does the following:
(A) Otherwise meets the requirements of paragraph (c)(4)(i) of this
section but, instead of the notice described in paragraph (c)(4)(i)(A)
of this section, provides the individual with a FAP application form and
a written notice indicating that financial assistance is available for
eligible individuals and stating the deadline, if any, after which the
hospital facility will no longer accept and process a FAP application
submitted (or, if applicable, completed) by the individual for the
previously provided care at issue. This deadline must be no earlier than
the later of 30 days after the date that the written notice is provided
or 240 days
[[Page 80]]
after the date that the first post-discharge billing statement for the
previously provided care was provided.
(B) If the individual submits a FAP application for the previously
provided care on or before the deadline described in paragraph
(c)(4)(iii)(A) of this section (or at any time, if the hospital facility
didn't provide any such deadline to the individual), processes the FAP
application on an expedited basis.
(iv) Examples. The following example illustrates this paragraph
(c)(4):
Example 1. A, an individual, receives care from T, a hospital
facility, in February. T provides A with the first post-discharge
billing statement for that care on March 3. This and subsequent billing
statements that T sends to A contain the standard written notice about
the FAP that X includes on all of its billing statements in accordance
with Sec. 1.501(r)-4(b)(5). A has not paid her bill or submitted a FAP
application when T provides her with the third billing statement for the
care, postmarked June 1. With this third billing statement, T includes a
plain language summary of the FAP and a letter informing A that if she
does not pay the amount owed or submit a FAP application by July 1, T
intends to report A's delinquency to credit reporting agencies. T also
calls A and informs her about the financial assistance available to
eligible patients under T's FAP and about how to obtain assistance with
the FAP application process. A does not pay her bill or submit a FAP
application by July 1. T has made reasonable efforts to determine
whether A is FAP-eligible, and thus may report A's delinquency to credit
reporting agencies, as of July 2.
Example 2. G, an individual, receives care from Y, a hospital
facility, on May 25 of Year 1. Y also makes numerous attempts to
encourage G to apply for financial assistance, including by calling G to
inform her about the financial assistance available to eligible patients
under Y's FAP and to offer assistance with the FAP application process.
By June 24 of Year 2, Y, which had not previously initiated any ECAs
against G to obtain payment for the care, notifies G in writing that if
G does not pay or complete a FAP application by July 24 of Year 2, Y
intends to file a lawsuit seeking a judgment for the amount G owes for
the care and to seek court permission to enforce the judgment by either
seizing G's bank account or garnishing G's wages. The written notice
also includes a plain language summary of the FAP. G fails to pay or
submit a FAP application by July 24 of Year 2. Y has made reasonable
efforts to determine whether G is FAP-eligible, and may seek a judgment
for the amount G owes and court permission to enforce the judgment by
seizing G's bank account or garnishing G's wages, as of July 25 of Year
2.
(5) Incomplete FAP applications--(i) In general. With respect to any
care provided by a hospital facility to an individual, if an individual
submits an incomplete FAP application during the application period, the
hospital facility will have notified the individual about how to
complete the FAP application and given the individual a reasonable
opportunity to do so for purposes of paragraph (c)(3)(ii) of this
section only if the hospital facility--
(A) Suspends any ECAs to obtain payment for the care as described in
paragraph (c)(8) of this section; and
(B) Provides the individual with a written notice that describes the
additional information and/or documentation required under the FAP or
FAP application form that must be submitted to complete the FAP
application and that includes the contact information described in Sec.
1.501(r)-1(b)(24)(v).
(ii) FAP application completed. If an individual who has submitted
an incomplete FAP application during the application period subsequently
completes the FAP application during the application period (or, if
later, within a reasonable timeframe given to respond to requests for
additional information and/or documentation), the individual will be
considered to have submitted a complete FAP application during the
application period, and the hospital facility will have made reasonable
efforts to determine whether the individual is FAP-eligible only if it
meets the requirements for complete FAP applications described in
paragraph (c)(6) of this section.
(iii) Examples. The following examples illustrate this paragraph
(c)(5):
Example 1. (i) Assume the same facts as Example 1 in paragraph
(c)(4)(iv) of this section and the following additional facts: A submits
an incomplete FAP application to T on July 15, which is before the last
day of the application period on October 29 but after T has already
initiated ECAs. Eligibility for assistance under T's FAP is based solely
on an individual's family income and the instructions to T's FAP
application form require applicants to attach to their application forms
certain documentation verifying family income. The FAP application form
that A
[[Page 81]]
submits to T on July 15 includes all of the required income information,
but A fails to attach the required documentation verifying her family
income. On July 22, a member of T's staff calls A to inform her that she
failed to attach any of the required documentation of her family income
and explains what kind of documentation A needs to submit and how she
can submit it. T indicates that the documentation should be provided by
September 22. T also sends A a letter that describes the missing
documentation that A must submit by September 22 (and how to submit it)
and provides a telephone number A can call and room number she can visit
to get assistance with the FAP application process. T does not initiate
any new ECAs against A and does not take any further action on the ECAs
T previously initiated against A between July 15 and September 22. A
does not respond to T's letter and does not submit any missing
documentation by September 22. T has made reasonable efforts to
determine whether A is FAP-eligible, and may initiate or resume ECAs
against A, as of September 23.
(ii) On October 10, before the last day of the application period on
October 29, A provides T with the missing documentation. Because A has
submitted a complete FAP application during the application period, to
meet the requirements of paragraph (a) of this section, T must process
the FAP application documentation to determine whether A is FAP-eligible
and otherwise meet the requirements for complete FAP applications
described in paragraph (c)(6) of this section.
Example 2. (i) B, an individual, receives care from U, a hospital
facility, on January 10. U has established a FAP that provides
assistance to all individuals whose household income is less than $y,
and the instructions to U's FAP application form specify the
documentation that applicants must provide to verify their household
income. Shortly after receiving care, B submits a FAP application form
to U indicating that he has household income of less than $y. B's FAP
application form includes all of the required income information, but B
fails to attach the required documentation verifying household income.
(ii) On February 9, U sends B the first post-discharge billing
statement for the care that contains the standard written notice about
the FAP that U includes on all of its billing statements in accordance
with Sec. 1.501(r)-4(b)(5). With this first post-discharge billing
statement, U includes a letter informing B that the income information
he provided on his FAP application form indicates that he may be
eligible to pay only x% of the amount stated on the billing statement if
he can provide documentation that verifies his household income. In
addition, this letter describes the type of documentation (which is also
described in the instructions to U's FAP application form) that B needs
to provide to complete his FAP application and provides a telephone
number that B may call and room number he may visit if he has questions
or needs assistance with the FAP application process. By the time U is
getting ready to send B a third billing statement for the care, B has
not provided any response to U's request for the missing documentation.
Accordingly, with the third billing statement postmarked May 10, U
includes a plain language summary of the FAP plus a written notice
informing B that U intends to report B's delinquency to credit reporting
agencies if B does not submit the missing documentation or pay the
amount due by June 9. U also calls B to inform B about the impending ECA
and to see if he has questions about the missing documentation that U
has requested. B does not provide any response to U's request for the
missing documentation by June 9. U has made reasonable efforts to
determine whether B is FAP-eligible, and thus may report B's delinquency
to credit reporting agencies, as of June 10.
(6) Complete FAP applications--(i) In general. With respect to any
care provided by a hospital facility to an individual, if an individual
submits a complete FAP application during the application period, the
hospital facility will have made reasonable efforts to determine whether
the individual is FAP-eligible for the care only if the hospital
facility does the following in a timely manner:
(A) Suspends any ECAs to obtain payment for the care as described in
paragraph (c)(8) of this section.
(B) Makes a determination as to whether the individual is FAP-
eligible for the care and notifies the individual in writing of this
eligibility determination (including, if applicable, the assistance for
which the individual is eligible) and the basis for this determination.
(C) If the hospital facility determines the individual is FAP-
eligible for the care, does the following:
(1) If the individual is determined to be eligible for assistance
other than free care, provides the individual with a billing statement
that indicates the amount the individual owes for the care as a FAP-
eligible individual and how that amount was determined and that states,
or describes how the individual can get information regarding, the AGB
for the care.
(2) Refunds to the individual any amount he or she has paid for the
care (whether to the hospital facility or any
[[Page 82]]
other party to whom the hospital facility has referred or sold the
individual's debt for the care) that exceeds the amount he or she is
determined to be personally responsible for paying as a FAP-eligible
individual, unless such excess amount is less than $5 (or such other
amount set by notice or other guidance published in the Internal Revenue
Bulletin).
(3) Takes all reasonably available measures to reverse any ECA (with
the exception of a sale of debt and an ECA described in paragraph
(b)(1)(iii) of this section) taken against the individual to obtain
payment for the care. Such reasonably available measures generally
include, but are not limited to, measures to vacate any judgment against
the individual, lift any levy or lien (other than a lien described in
paragraph (b)(3) of this section) on the individual's property, and
remove from the individual's credit report any adverse information that
was reported to a consumer reporting agency or credit bureau.
(ii) Anti-abuse rule for complete FAP applications. A hospital
facility will not have made reasonable efforts to determine whether an
individual is FAP-eligible if the hospital facility bases its
determination that the individual is not FAP-eligible on information
that the hospital facility has reason to believe is unreliable or
incorrect or on information obtained from the individual under duress or
through the use of coercive practices. For purposes of this paragraph
(c)(6)(ii), a coercive practice includes delaying or denying emergency
medical care to an individual until the individual has provided
information requested to determine whether the individual is FAP-
eligible for the care being delayed or denied.
(iii) Determination based on complete FAP applications sufficient
for reasonable efforts. A hospital facility will have made reasonable
efforts to determine whether an individual is FAP-eligible with respect
to any ECAs it initiates to obtain payment for care if, before
initiating any such ECAs, it determines whether the individual is FAP-
eligible for the care based on a complete FAP application and otherwise
meets the requirements described in this paragraph (c)(6). If these
conditions are satisfied, the hospital facility will have made
reasonable efforts to determine whether the individual is FAP-eligible
for the care regardless of whether it has notified the individual as
described in paragraph (c)(4) of this section or, if applicable, in
paragraph (c)(5)(i)(B) of this section.
(iv) Determining Medicaid eligibility. A hospital facility will not
fail to have made reasonable efforts to determine whether an individual
is FAP-eligible for care if, upon receiving a complete FAP application
from an individual who the hospital facility believes may qualify for
Medicaid, the hospital facility postpones determining whether the
individual is FAP-eligible for the care until after the individual's
Medicaid application has been completed and submitted and a
determination as to the individual's Medicaid eligibility has been made.
(v) Examples. The following examples illustrate this paragraph
(c)(6):
Example 1. C, an individual, receives care from W, a hospital
facility, on September 1. W has established a FAP that provides
assistance only to individuals whose family income is less than or equal
to x% of the Federal Poverty Level (FPL), which, in the case of C's
family size, is $y. Upon discharge, W's staff gives C a plain language
summary of the FAP and informs C that if she needs assistance filling
out a FAP application form, W has a social worker on staff who can
assist her. C expresses interest in getting assistance with a FAP
application while she is still on site and is directed to K, one of W's
social workers. K explains the eligibility criteria in W's FAP to C, and
C realizes that to determine her family income as a percentage of FPL
she needs to look at her prior year's tax returns. On September 20,
after returning home and obtaining the necessary information, C submits
a FAP application to W that contains all of the information and
documentation required in the FAP application form instructions. W's
staff promptly examines C's FAP application and, based on the
information and documentation therein, determines that C's family income
is well in excess of $y. On October 1, W sends C her first post-
discharge billing statement for the care she received on September 1.
With the billing statement, W includes a letter informing C that she is
not eligible for financial assistance because her FAP application
indicates that she has family income in excess of x% of FPL ($y for a
family the size of C's family) and W only provides financial assistance
to individuals with family income
[[Page 83]]
that is less than x% of FPL. W has made reasonable efforts to determine
whether C is FAP-eligible as of October 1.
Example 2. E, an individual, receives care from P, a hospital
facility, from February 24 to 28. E pays a co-payment of $30 at
discharge and is determined by her insurer to be personally responsible
for paying another $550 in deductibles. P sends E several billing
statements starting on March 20 indicating that E owes $550. By July 30,
E has not paid the $550 or submitted a FAP application. On July 30, P
notifies E in writing that if E does not pay or complete a FAP
application by August 30, P intends to report B's delinquency to credit
reporting agencies. The written notice also includes a plain language
summary of the FAP. In addition, P calls E and informs her about the
financial assistance available to eligible patients under P's FAP and
about how to obtain assistance with the FAP application process. E fails
to pay or submit a FAP application by August 30. P subsequently reports
E's delinquency to credit reporting agencies. E then provides a complete
FAP application to P on November 10, before the last day of the
application period on November 15. P promptly examines the application
and determines that E is eligible for free care under P's FAP. P
contacts the credit reporting agencies to which it had reported E's
delinquency and asks them to remove the adverse information from E's
credit report. P also sends E a letter that informs her that she is
eligible for free care under P's FAP and explains the basis for this
eligibility determination and includes with this letter a check for $30
(the co-payment E had paid). P has made reasonable efforts to determine
whether E is FAP-eligible.
Example 3. R, a hospital facility, has established a FAP that
provides financial assistance only to individuals whose family income is
less than or equal to x% of the Federal Poverty Level (FPL), based on
their prior year's federal tax return. L, an individual, receives care
from R. While L is being discharged from R, she is approached by M, an
employee of a debt collection company that has a contract with R to
handle all of R's patient billing. M asks L for her family income
information, telling L that this information is needed to determine
whether L is eligible for financial assistance. L tells M that she does
not know what her family income is and would need to consult her tax
returns to determine it. M tells L that she can just provide a ``rough
estimate'' of her family income. L states that her family income may be
around $y, an amount slightly above the amount that would allow her to
qualify for financial assistance. M enters $y on the income line of a
FAP application form with L's name on it and marks L as not FAP-
eligible. Based on M's information collection, R determines that L is
not FAP-eligible and notifies L of this determination with her first
billing statement. Because M had reason to believe that the income
estimate provided by L was unreliable, R has violated the anti-abuse
rule described in paragraph (c)(6)(ii) of this section. Thus, R has not
made reasonable efforts to determine whether L is FAP-eligible.
(7) When no FAP application is submitted. Unless and until an
individual submits a FAP application during the application period, any
paragraphs of this section that are conditioned on an individual's
submitting a FAP application (namely, paragraphs (c)(2)(i)(C),
(c)(3)(ii), and (c)(3)(iii) of this section) do not apply, and the
hospital facility will have made reasonable efforts to determine whether
the individual is FAP-eligible for care, and may initiate one or more
ECAs to obtain payment for the care, once it has met the requirements of
this section that are not contingent on an individual's submission of a
FAP application. For example, unless and until a hospital facility
receives a FAP application from an individual during the application
period, the hospital facility has made reasonable efforts to determine
whether the individual is FAP-eligible for care (and thus may initiate
ECAs to obtain payment for the care) once it has notified the individual
about the FAP as described in paragraph (c)(3)(i) of this section.
(8) Suspending ECAs while a FAP application is pending. With respect
to any care provided by a hospital facility to an individual, if an
individual submits a FAP application during the application period, the
hospital facility (or other authorized party) will have suspended ECAs
for purposes of this paragraph (c) only if, after receiving the
application, the hospital facility (or other authorized party) does not
initiate, or take further action on any previously-initiated, ECAs (with
the exception of an ECA described in paragraph (b)(1)(iii) of this
section) to obtain payment for the care until either--
(i) The hospital facility has determined whether the individual is
FAP-eligible based on a complete FAP application and otherwise met the
requirements of paragraph (c)(6) of this section; or
(ii) In the case of an incomplete FAP application, the individual
has failed to
[[Page 84]]
respond to requests for additional information and/or documentation
within a reasonable period of time given to respond to such requests.
(9) Waiver does not constitute reasonable efforts. For purposes of
this paragraph (c), obtaining a signed waiver from an individual, such
as a signed statement that the individual does not wish to apply for
assistance under the FAP or receive the information described in
paragraphs (c)(4) or (c)(5) of this section, will not itself constitute
a determination that the individual is not FAP-eligible and will not
satisfy the requirement to make reasonable efforts to determine whether
the individual is FAP-eligible before engaging in ECAs against the
individual.
(10) Agreements with other parties. With the exception of sales
described in paragraph (b)(2) of this section, if a hospital facility
sells or refers an individual's debt related to care to another party,
the hospital facility will have made reasonable efforts to determine
whether the individual is FAP-eligible for the care only if it first
enters into (and, to the extent applicable, enforces) a legally binding
written agreement with the party that is reasonably designed to ensure
that no ECAs are taken to obtain payment for the care until reasonable
efforts have been made to determine whether the individual is FAP-
eligible for the care. At a minimum, such an agreement must provide the
following:
(i) If the individual submits a FAP application after the referral
or sale of the debt but before the end of the application period, the
party will suspend ECAs to obtain payment for the care as described in
paragraph (c)(8) of this section.
(ii) If the individual submits a FAP application after the referral
or sale of the debt but before the end of the application period and is
determined to be FAP-eligible for the care, the party will do the
following in a timely manner:
(A) Adhere to procedures specified in the agreement that ensure that
the individual does not pay, and has no obligation to pay, the party and
the hospital facility together more than he or she is required to pay
for the care as a FAP-eligible individual.
(B) If applicable and if the party (rather than the hospital
facility) has the authority to do so, take all reasonably available
measures to reverse any ECA (other than the sale of a debt or an ECA
described in paragraph (b)(1)(iii) of this section) taken against the
individual as described in paragraph (c)(6)(i)(C)(3) of this section.
(iii) If the party refers or sells the debt to yet another party
during the application period, the party will obtain a written agreement
from that other party including all of the elements described in this
paragraph (c)(10).
(11) Clear and conspicuous placement. A hospital facility may print
any written notice or communication described in this paragraph (c),
including any plain language summary of the FAP, on a billing statement
or along with other descriptive or explanatory matter, provided that the
required information is conspicuously placed and of sufficient size to
be clearly readable.
(12) Providing documents electronically. A hospital facility may
provide any written notice or communication described in this paragraph
(c) electronically (for example, by email) to any individual who
indicates he or she prefers to receive the written notice or
communication electronically.
[T.D. 9708, 79 FR 78998, Dec. 31, 2014; 80 FR 12762, Mar. 11, 2015]
Sec. 1.501(r)-7 Effective/applicability dates.
(a) Effective/applicability date. The rules of Sec. Sec. 1.501(r)-1
through 1.501(r)-6 apply to taxable years beginning after December 29,
2015.
(b) Reasonable interpretation for taxable years beginning on or
before December 29, 2015. For taxable years beginning on or before
December 29, 2015, a hospital facility may rely on a reasonable, good
faith interpretation of section 501(r). A hospital facility will be
deemed to have operated in accordance with a reasonable, good faith
interpretation of section 501(r) if it has complied with the provisions
of the proposed or final regulations under section 501(r) (REG-130266-11
and/or REG-106499-12). Accordingly, a hospital facility may rely on
Sec. 1.501(r)-3 of the proposed or final regulations, or another
[[Page 85]]
reasonable interpretation of section 501(r)(3), for any CHNA conducted
or implementation strategy adopted before the first day of the hospital
organization's first taxable year beginning after December 29, 2015.
[T.D. 9708, 79 FR 78998, Dec. 31, 2014]
Sec. 1.502-1 Feeder organizations.
(a) In the case of an organization operated for the primary purpose
of carrying on a trade or business for profit, exemption is not allowed
under section 501 on the ground that all the profits of such
organization are payable to one or more organizations exempt from
taxation under section 501. In determining the primary purpose of an
organization, all the circumstances must be considered, including the
size and extent of the trade or business and the size and extent of
those activities of such organization which are specified in the
applicable paragraph of section 501.
(b) If a subsidiary organization of a tax-exempt organization would
itself be exempt on the ground that its activities are an integral part
of the exempt activities of the parent organization, its exemption will
not be lost because, as a matter of accounting between the two
organizations, the subsidiary derives a profit from its dealings with
its parent organization, for example, a subsidiary organization which is
operated for the sole purpose of furnishing electric power used by its
parent organization, a tax-exempt educational organization, in carrying
on its educational activities. However, the subsidiary organization is
not exempt from tax if it is operated for the primary purpose of
carrying on a trade or business which would be an unrelated trade or
business (that is, unrelated to exempt activities) if regularly carried
on by the parent organization. For example, if a subsidiary organization
is operated primarily for the purpose of furnishing electric power to
consumers other than its parent organization (and the parent's tax-
exempt subsidiary organizations), it is not exempt since such business
would be an unrelated trade or business if regularly carried on by the
parent organization. Similarly, if the organization is owned by several
unrelated exempt organizations, and is operated for the purpose of
furnishing electric power to each of them, it is not exempt since such
business would be an unrelated trade or business if regularly carried on
by any one of the tax-exempt organizations. For purposes of this
paragraph, organizations are related only if they consist of:
(1) A parent organization and one or more of its subsidiary
organizations; or
(2) Subsidiary organizations having a common parent organization
An exempt organization is not related to another exempt organization
merely because they both engage in the same type of exempt activities.
(c) In certain cases an organization which carries on a trade or
business for profit but is not operated for the primary purpose of
carrying on such trade or business is subject to the tax imposed under
section 511 on its unrelated business taxable income.
(d) Exception--(1) Taxable years beginning before January 1, 1970.
For purposes of section 502 and this section, for taxable years
beginning before January 1, 1970, the term trade or business does not
include the rental by an organization of its real property (including
personal property leased with the real property).
(2) Taxable years beginning after December 31, 1969. For purposes of
section 502 and this section, for taxable years beginning after December
31, 1969, the term trade or business does not include:
(i) The deriving of rents described in section 512(b)(3)(A),
(ii) Any trade or business in which substantially all the work in
carrying on such trade or business is performed for the organization
without compensation, or
(iii) Any trade or business (such as a thrift shop) which consists
of the selling of merchandise, substantially all of which has been
received by the organization as gifts or contributions
For purposes of the exception described in subdivision (i) of this
subparagraph, if the rents derived by an organization would not be
excluded from unrelated business income pursuant to section 512(b)(3)
and the regulations thereunder, the deriving of such rents shall be
considered a trade or business.
[[Page 86]]
(3) Cross references and special rules. (i) For determination of
when rents are excluded from the tax on unrelated business income see
section 512(b)(3) and the regulations thereunder.
(ii) The rules contained in Sec. 1.513-1(e)(1) shall apply in
determining whether a trade or business is described in section
502(b)(2) and subparagraph (2)(ii) of this paragraph.
(iii) The rules contained in Sec. 1.513-1(e)(3) shall apply in
determining whether a trade or business is described in section
502(b)(3) and subparagraph (2)(iii) of this paragraph.
[T.D. 6500, 25 FR 11737, No. 26, 1960, as amended by T.D. 6662, 28 FR
6973, July 29, 1963; T.D. 7033, 35 FR 19997, Dec. 31, 1970]
Sec. 1.503(a)-1 Denial of exemption to certain organizations engaged
in prohibited transactions.
(a)(1) Prior to January 1, 1970, section 503 applies to those
organizations described in sections 501(c)(3), 501(c)(17), and section
401(a) except:
(i) A religious organization (other than a trust);
(ii) An educational organization which normally maintains a regular
faculty and curriculum and normally has a regularly enrolled body of
pupils or students in attendance at the place where its educational
activities are regularly carried on;
(iii) An organization which normally receives a substantial part of
its support (exclusive or income received in the exercise or performance
by such organization of its charitable, educational, or other purpose or
function constituting the basis for its exemption under section 501(a))
from the United States or any State or political subdivision thereof or
from direct of indirect contributions from the general public,
(iv) An organization which is operated, supervised, controlled or
principally supported by a religious organization (other than a trust)
which is itself not subject to the provisions of this section; and
(v) An organization the principal purposes or functions of which are
the providing of medical or hospital care or medical education or
medical research or agricultural research.
(2) Effective January 1, 1907, and prior to January 1, 1975, section
503 shall apply only to organizations described in section 501(c) (17)
or (18) or section 401(a).
(3) Effective January 1, 1975, section 503 shall apply only to
organization described in section 501(c) (17) or (18) or described in
section 401(a) and referred to in section 4975(g) (2) or (3).
(b) The prohibited transactions enumerated in section 503(b) are in
addition to and not in limitation of the restrictions contained in
section 501(c) (3), (17), or (18) or section 401(a). Even though an
organization has not engaged in any of the prohibited transactions
referred to in section 503(b), it still may not qualify for tax
exemptions in view of the general provisions of section 501(c) (3),
(17), or (18) or section 401(a). Thus, if a trustee or other fiduciary
of the organization (whether or not he is also a creater or such
organization) enters into a transaction with the organization, such
transaction will be closely scrutinized in the light of the fiduciary
principle requiring undivided loyalty to ascertain whether the
organization is in fact being operated for the stated exempt purpose.
(c) An organization--
(1) Described in section 501(c)(3) which after July 1, 1950, but
before January 1, 1970, has engaged in any prohibited transaction as
defined in section 503(b), unless it is excepted by the provisions of
paragraph (a)(1) of this section;
(2) Described in section 401(a) and referred to in section 4975(g)
(2) or (3) which after March 1, 1954, has engaged in any prohibited
transaction as defined in section 503(b);
(3) Described in section 401(a) and not referred to in section
4975(g) (2) or (3) which after March 1, 1954, but before January 1,
1975, has engaged in any prohibited transaction as defined in section
503(b) or which after December 31, 1962, but before January 1, 1975, has
engaged in any prohibited transaction as defined in section 503(g) prior
to its repeal by section 2003(b)(5) of the Employee Retirement Income
Security Act of 1974 (88 Stat. 978);
[[Page 87]]
(4) Described in section 501(c)(17) which after December 31, 1959,
has engaged in any prohibited transaction as defined in section 503(b);
or
(5) Described in section 501(c)(18) which after December 31, 1969,
has engaged in any prohibited transaction described in section 503(b)
Shall not be exempt from taxation under section 501(a) for any taxable
year subsequent to the taxable year in which there is mailed to it a
notice in writing by the Commissioner that it has engaged in such
prohibited transactions. Such notification by the Commissioner shall be
by registered or certified mail to the last known name and address of
the organization. However, notwithstanding the requirement of
notification by the Commissioner, the exemption shall be denied with
respect to any taxable year if such organization during or prior to such
taxable year commenced the prohibited transaction with the purpose of
diverting income or corpus from its exempt purposes and such transaction
involved a substantial party of the income or corpus of such
organization. For the purpose of this section, the term taxable year
means the established annual accounting period of the organization; or,
if the organization has no such established annual accounting period,
the taxable year of the organizations means a calendar year. See 26 CFR
Sec. 1.503(j)-1 (rev. as of Apr. 1, 1974) for provisions relating to
the definition of prohibited transactions in the case of trusts
benefitting certain owner-employees after December 31, 1962, but prior
to January 1, 1975. See also section 2003 (c)(1)(B) of the Employee
Retirement Income Security Act of 1974 (88 Stat. 978) in the case of an
organization described in section 401(a) with respect to which a
disqualified person elects to pay a tax in the amount and manner
provided with respect to the tax imposed by section 4975 of the Code so
that the organization may avoid denial of exemption under section 503.
For further guidance regarding the definition of last known address, see
Sec. 301.6212-2 of this chapter.
(d) The application of section 503(b) may be illustrated by the
following examples:
Example 1. A creates a foundation in 1954 ostensibly for educational
purposes. B, a trustee, accumulates the foundation's income from 1957
until 1959 and then uses a substantial part of this accumulated income
to send A's children to college. The foundation would lose its exemption
for the taxable years 1957 through 1959 and for subsequent taxable years
until it regains its exempt status.
Example 2. If under the facts in Example 1 such private benefit was
the purpose of the foundation from its inception, such foundation is not
exempt by reason of the general provisions of section 501(c)(3), without
regard to the provisions of section 503, for all years since its
inception, that is, for the taxable years 1954 through 1959 and
subsequent taxable years, since under section 501(c)(3) the organization
must be organized and operated exclusively for exempt purposes. See
Sec. 1.501(c)(3)-1.
[T.D. 7428, 41 FR 34621, Aug. 16, 1976, as amended by T.D. 8939, 66 FR
2819, Jan. 12, 2001]
Sec. 1.503(b)-1 Prohibited transactions.
(a) In general. The term prohibited transaction means any
transaction set forth in section 503(b) engaged in by any organization
described in paragraph (a) of Sec. 1.503(a)-1. Whether a transaction is
a prohibited transaction depends on the facts and circumstances of the
particular case. This section is intended to deny tax-exempt status to
such organizations which engage in certain transactions which inure to
the private advantage of (1) the creator of such organization (if it is
a trust); (2) any substantial contributor to such organization; (3) a
member of the family (as defined in section 267(c)(4) of an individual
who is such creator of or such substantial contributor to such
organization; or (4) a corporation controlled, as set forth in section
503(b), by such creator or substantial contributor.
(b) Loans as prohibited transactions under section 503(b)(1)--(1)
Adequate security. For the purposes of section 503(b)(1), which treats
as prohibited transactions certain loans by an organization without
receipt of adequate security and a reasonable rate of interest, the term
adequate security means something in addition to and supporting a
promise to pay, which is so pledged to the organization that it may be
sold, foreclosed upon, or otherwise disposed of in default of repayment
of
[[Page 88]]
the loan, the value and liquidity of which security is such that it may
reasonably be anticipated that loss of principal or interest will not
result from the loan. Mortgages or liens on property, accommodation
endorsements of those financially capable of meeting the indebtedness,
and stock or securities issued by corporations other than the borrower
may constitute security for a loan to the persons or organizations
described in section 503(b). Stock of a borrowing corporation does not
constitute adequate security. A borrower's evidence of indebtedness,
irrespective of its name, is not security for a loan, whether or not it
was issued directly to the exempt organization. However, if any such
evidence of indebtedness provides for security that may be sold,
foreclosed upon, or otherwise disposed of in default of repayment of the
loan, there may be adequate security for such loan. If an organization
subject to section 503(b) purchases debentures issued by a person
specified in section 503(b), the purchase is considered, for purposes of
section 503(b)(1), as a loan made by the purchaser to the issuer on the
date of such purchase. For example, if an exempt organization subject to
section 503(b) makes a purchase through a registered security exchange
of debentures issued by a person described in section 503(b), and owned
by an unknown third party, the purchase will be considered as a loan to
the issuer by the purchaser. For rules relating to loan of funds to, or
investment of funds in stock or securities of, persons described in
section 503(b) by an organization described in section 401(a), see
paragraph (b)(5) of Sec. 1.401-1.
(2) Effective dates. The effective dates for the application of the
definition of adequate security in paragraph (b)(1) of this paragraph
are:
(i) March 15, 1956, for loans (other than debentures) made after
March 15, 1956;
(ii) January 31, 1957, for loans (other than debentures) made before
March 16, 1956, and continued after January 31, 1957;
(iii) November 8, 1956, for debentures which were purchased after
November 8, 1956;
(iv) December 1, 1958, for debentures which were purchased before
November 9, 1956, and held after December 1, 1958;
(v) If an employees' pension, stock bonus, or profit-sharing trust
described in section 401(a) made a loan before March 1, 1954, repayable
by its terms after December 31, 1955, and which would constitute a
prohibited transaction if made on or after March 1, 1954, the loan shall
not constitute a prohibited transaction if held until maturity
(determined without regard to any extension or renewal thereof);
(vi) January 1, 1960, for loans (including the purchase of
debentures) made by supplemental unemployment benefit trusts, described
in section 501 (c)(17);
(vii) January 1, 1970, for loans (including the purchase of
debentures) made by employees' contribution pension plan trusts
described in section 501(c)(18).
(3) Certain exceptions to section 503(b)(1). See section 503(e) and
Sec. 1.503(e)-1, 1.503(e)-2, and 1.503(e)-3 for special rules providing
that certain obligations acquired by trusts described in section 401(a)
or section 501(c) (17) or (18) shall not be treated as loans made
without the receipt of adequate security for purposes of section
503(b)(1). See section 503(f) and Sec. 1.503(f)-1 for an exception to
the application of sections 503(b)(1) for certain loans made by
employees' trusts described in section 401(a).
(c) Examples. The principles of this section are illustrated by the
following examples: (Assume that section 503 (e) and (f) are not
applicable.)
Example 1. A, creator of an exempt trust subject to section 503,
borrows $100,000 from such trust in 1960, giving his unsecured
promissory note. The net worth of A is $1,000,000. The net worth of A is
not security for such loan and the transaction is a prohibited
transaction. If, however, the note is secured by a mortgage on property
of sufficient value, or is accompanied by acceptable collateral of
sufficient value, or carries with it the secondary promise of repayment
by an accommodation endorser financially capable of meeting the
indebtedness, it may be adequately secured. However, subordinated
debentures bonds of a partnership which are guaranteed by the general
partners are not adequately secured since the general partners are
liable for the firm's debt and their guaranty adds no additional
security.
[[Page 89]]
Example 2. Assume the same facts as in example 1 except that A's
promissory note in the amount of $100,000 to the trust is secured by
property which has a fair market value of $75,000. A's promissory note
secured to the extent of $75,000 is not adequately secured within the
meaning of section 503(b)(1) since the security at the time of the
transaction must be sufficient to repay the indebtedness, interest, and
charges which may pertain thereto.
Example 3. Corporation M, a substantial contributor to an exempt
organization subject to section 503, borrows $150,000 from such
organization in 1960, giving its promissory note accompanied by stock of
the borrowing corporation with a fair market value of $200,000. Since
promissory notes and debentures have priority over stock in the event of
liquidation of the corporation, stock of a borrowing corporation is not
adequate security. Likewise, debenture bonds which are convertible on
default into voting stock of the issuing corporation do not constitute
adequate security under section 503(b)(1).
Example 4. B, creator of an exempt trust subject to section 503,
borrows $100,000 from such trust in 1960, giving his secured promissory
note at the rate of 3 percent interest. The prevailing rate of interest
charged by financial institutions in the community where the transaction
takes place is 5 percent for a loan of the same duration and similarly
secured. The loan by the trust to the grantor is a prohibited
transaction since section 503(b)(1) requires both adequate security and
a reasonable rate of interest. Further, a promise to repay the loan plus
a percentage of future profits which may be greater than the prevailing
rate of interest does not meet the reasonable rate of interest
requirement.
Example 5. N Corporation, a substantial contributor to an exempt
organization subject to section 503 borrows $50,000 on or after March
16, 1956, from the organization. If the loan is not adequately secured,
the organization has committed a prohibited transaction at the time the
loan was made. If the loan had been made on or before March 15, 1956,
and is continued after January 31, 1957, it must be adequately secured
on February 1, 1957, or it will be considered a prohibited transaction
on that date. However, if the exempt organization were an employees'
trust, described in section 401(a), and the loan were made before March
1, 1954, repayable by its terms after December 31, 1955, it would not
have to be adequately secured on February 1, 1957. Moreover, if the
exempt organization were a supplemental unemployment benefit trust,
described in section 501(c)(17), and the loan were made before January
1, 1960, repayable by its terms after December 31, 1959, it would not
have to be adequately secured on January 1, 1960.
Example 6. An exempt organization subject to section 503 purchases a
debenture issued by O Corporation, which is a substantial contributor to
the organization. The organization purchases the debenture in an arm's
length transaction from a third person on or after November 9, 1956. The
purchase is considered as a loan by the organization to O Corporation.
The loan must be adequately secured when it is made, or it is considered
as a prohibited transaction at that time. If the organization purchased
the debenture before November 9, 1956, and holds it after December 1,
1958, the debenture must be adequately secured on December 2, 1958, or
it will then be considered as a prohibited transaction. However, if the
organization were an employees' trust described in section 401(a), and
if the debenture were purchased before March 1, 1954, and its maturity
date is after December 31, 1955, the debenture does not have to be
adequately secured. Moreover, if the organization were an employees'
contribution pension plan trust described in section 501(c)(18), and if
the debenture were purchased before January 1, 1970, and its maturity
date is after December 31, 1969, the debenture does not have to be
adequately secured.
[T.D. 7428, 41 FR 34621, Aug. 16, 1976]
Sec. 1.503(c)-1 Future status of organizations denied exemption.
(a) Any organization described in section 501(c) (3), (17), or (18),
or an employees' trust described in section 401(a), which is denied
exemption under section 501(a) by reason of the provisions of section
503(a), may file, in any taxable year following the taxable year in
which notice of denial was issued, a claim for exemption. In the case of
organizations described in section 501(c) (3), (17), or (18), the
appropriate exemption application shall be used for this purpose, and
shall be filed with the district director. In the case of an enmployees'
trust described in section 401(a), the information described in Sec.
1.404(a)-2 shall be submitted with a letter claiming exemption. All
employees' trust described in section 401(a) shall submit this
information to the district director with whom a request for a
determination as to its qualification under section 401 and exemption
under section 501 may be submitted under paragraph (s) of Sec. 601.201
of this chapter (Statement of Procedural Rules). A claim for exemption
must
[[Page 90]]
contain or have attached to it, in addition to the information generally
required of such an organization claiming exemption as an organization
described in section 501(c) (17), or (18), or section 401(a) (or section
501(c)(3) prior to January 1, 1970), a written declaration made under
the penalities of perjury by principal officer of such organization
authorized to make such declaration that the organization will not
knowingly again engage in a prohibited transaction, (as defined in
section 503(b) (or 4975(c) if such section applies to such
organization)). In the case of section 501(c)(3) organizations which
have lost their exemption after December 31, 1969, pursuant to section
503, a claim for exemption must contain or have attached to it a written
agreement made under penalities of perjury by a principal officer of
such organization authorized to make such agreement that the
organization will not violate the provisions of chapter 42. In addition,
such organization must comply with the rules for governing instruments
as prescribed in Sec. 1.508-3. See Sec. 1.501(a)-1 for proof of
exemption requirements in general.
(b) If the Commissioner is satisfied that such organization will not
knowingly again engage in a prohibited transaction (as defined under
section 503(b) or 4975(c), as applicable to such organization) or in the
case of a section 501(c)(3) organization, will not violate the
provisions of chapter 42, and the organization also satisfied all the
other requirements under section 501(c) (3), (17), or (18), or section
401(a), the organization will be so notified in writing. In such case
the organization will be exempt (subject to the provisions of section
501(c)(3), or sections 501(c) (17), (18) or 401(a), and 503, and 504
when applicable) with respect to the taxable years subsequent to the
taxable year in which the claim described in section 503(c) is filed.
Section 503 contemplates that an organization denied exemption because
of the terms of such section will be subject to taxation for at least
one full taxable year. For the purpose of this section, the term taxable
year means the established annual accounting period of the organization;
or, if the organization has no such established annual accounting
period, the taxable year of the organization means the calendar year.
(c) For taxable years beginning after December 31, 1969, the denial
of an exemption pursuant to this section, for a taxable year prior to
January 1, 1970, of an organization described in section 501(c)(3) shall
not cause such organization to cease to be described in section
501(c)(3) for purposes of part II of subchapter F, chapter 1 and for
purposes of the application of chapter 42 taxes.
(d) In the case of an organization described in section 501(c)(3),
which has lost its exemption pursuant to section 503, and which has not
notified the Commissioner that it is applying for recognition of its
exempt status under section 508(a) and this section, no gift or
contribution made after December 31, 1969, which would otherwise be
deductible under section 170, 642(c), or 545(b)(2) shall be allowed as a
deduction.
[T.D. 7428, 41 FR 34622, Aug. 16, 1976, as amended by T.D. 7896, 48 FR
23817, May 27, 1983; T.D. 9849, 84 FR 9235, Mar. 14, 2019]
Sec. 1.503(d)-1 Cross references.
For provisions relating to loans described in section 503(b)(1) by a
trust described in section 401(a), see Sec. 1.503(b)-1 and section 503
(e) and (f) and the regulations thereunder.
[T.D. 7428, 41 FR 34623, Aug. 16, 1976]
Sec. 1.503(e)-1 Special rules.
(a) In general. (1) Section 503(e) provides that for purposes of
section 503(b)(1) (relating to loans made without the receipt of
adequate security and a reasonable rate of interest) the acquisition of
a bond, debenture, note, or certificate or other evidence of
indebtedness shall not be treated as a loan made without the receipt of
adequate security if certain requirements are met. Those requirements
are described in Sec. 1.503(e)-2.
(2) Section 503(e) does not affect the requirement in section
503(b)(1) of a reasonable rate of interest. Thus, although the
acquistion of a certificate of indebtedness which meets all of the
requirements of section 503(e) and of Sec. 1.503(e)-2 will not be
considered as a loan made without the receipt of adequate security, the
acquisition of such
[[Page 91]]
an indebtedness does consitute a prohibited transaction if the
indebtedness does not bear a reasonable rate of interest.
(3) The provisions of section 503(e) do not limit the effect of
section 401(a) and Sec. 1.401-2, section 501(c)(17)(A)(i), or section
501(c)(18)(A), all relating to the use of diversion of corpus or incopme
of the respective employee trusts. Furthermore, the provisions of
section 503(e) do not limit the effect of any of the provisions of
section 503 other than section 503(b)(1). Thus, for example, although a
loan made by employees' trust described in section 503(a)(1)(B) meets
all the requirements of section 503(e) and therefore is not treated as a
loan made without the receipt of adequate security, such an employees'
trust making such a loan will lose its exempt status if the loan is not
considered as made for the exclusive benefit of the employees or their
beneficiaries. Similarly, a loan which meets the requirements of section
503(e) will constitute a prohibited transaction within the meaning of
section 503(b)(6) if it results in a substantial diversion of the
trust's income or corpus to a person described in section 503(b).
(b) Definitions. For purposes of section 503(e):
(1) The term obligation means bond, debenture, note, or certificate
or other evidence of indebtedness.
(2) The term issuer includes any person described in section 503(b)
who issues an obligation.
(3)(i) The term person independent of the issuer means a person who
is not related to the issuer by blood, by marriage, or by reason of any
substantial business interests. Persons who will be considered not to be
independent of the issuer include but are not limited to:
(a) The spouse, ancestor, lineal descendant, or brother or sister
(whether by whole or half blood) of an individual who is the issuer of
an obligation;
(b) A corporation controlled directly or indirectly by an individual
who is the issuer, or directly or indirectly by the spouse, ancestor,
lineal descendant, or brother or sister (whether by whole or half blood)
of an individual who is the issuer;
(c) A corporation which directly or indirectly controls, or is
controlled by, a corporate issuer;
(d) A controlling shareholder of a corporation which is the issuer,
or which controls the issuer;
(e) An officer, director, or other employee of the issuer, of a
corporation controlled by the issuer, or of a corporation which controls
the issuer;
(f) A fiduciary of any trust created by the issuer, by a corporation
which controls the issuer, or by a corporation which is controlled by
the issuer; or
(g) A corporation controlled by a person who controls a corporate
issuer.
(ii) For purposes of paragraph (b)(3)(i) of this section, the term
control means, with respect to a corporation, direct or indirect
ownership of 50 percent or more of the total combined voting power of
all voting stock or 50 percent or more of the total value of shares of
all classes of stock. If the aggregate amount of stock in a corporation
owned by an individual and by the spouse, ancestors, lineal descendants,
brothers and sisters (whether by whole of half blood) of the individual
is 50 percent or more of the total combined voting power of all voting
stock or is 50 percent or more of the total value of all classes of
stock, then each of these persons shall be considered as the controlling
shareholder of the corporation.
(iii) In determining family relationships for purposes of paragraph
(b)(3)(i) of this section, a legally adopted child of an individual
shall be treated as a child of such individual by blood.
(4) The term issue means all the obligations of an issuer which are
offered for sale on substantially the same terms. Obligations shall be
considered offered for sale on substantially the same terms if such
obligation would, at the same time and under the same circumstances, be
traded on the market at the same price. On the other hand, if the terms
on which obligations are offered for sale differ in such manner as would
cause such obligations to be traded on the market at different prices,
then such obligations are not part of the same issue. The following are
examples of terms which, if different, would cause obligations to be
traded on the market at different prices: (i) Interest rate; (ii)
Maturity
[[Page 92]]
date; (iii) Collateral; and (iv) Conversion provisions
The fact that obligations are offered for sale on different dates will
not preclude such obligations from being part of the same issue if they
all mature on the same date and if the terms on which they are offered
for sale are otherwise the same, since such obligations would, at the
same time and under the same conditions, be traded on the market at the
same price. Obligations shall not be considered part of the same issue
merely because they are part of the same authorization or because they
are registered as part of the same issue with the Securities and
Exchange Commission.
[T.D. 7428, 41 FR 34623, Aug. 16, 1976]
Sec. 1.503(e)-2 Requirements.
(a) In general. The requirements which must be met under section
503(e) for an obligation not to be treated as a loan made without the
receipt of adequate security for purposes of section 503(b)(1) are
described in paragraphs (b), (c), and (d) of this section. For purposes
of this section, the term employee trust shall mean any of the three
kinds of organizations described in section 503(a)(1).
(b) Methods of acquisition--(1) In general. The employee trust must
acquire the obligation of the market, by purchase from an underwriter,
or by purchase from the issuer, in the manner described in subparagraph
(2), (3), or (4) of this paragraph.
(2) On the market. (i) An obligation is acquired on the market when
it is purchased through a national securities exchange which is
registered with the Securities and Exchange Commission, or when it is
purchased in an over-the-counter transaction. For purposes of the
preceding sentence, securities purchased through an exchange which is
not a national securities exchange registered with the Securities and
Exchange Commission shall be treated as securities purchased in an over-
the-counter transaction.
(ii)(a) If the obligation is listed on a national securities
exchange registered with the Securities and Exchange Commission, it must
be purchased through such an exchange or in an over-the-counter
transaction at a price not greater than the price of the obligation
prevailing on such an exchange at the time of the purchase by the
employee trust.
(b) For purposes of section 503(e), the price of the obligation
prevailing at the time of the purchase means the price which accurately
reflects the market value of the obligation. In the case of an
obligation purchased through a national securities exchange which is
registered with the Securities and Exchange Commission, the price paid
for the obligation will be considered the prevailing price of the
obligation. In the case of an obligation purchased in an over-the-
counter transaction, the prevailing price may be the price at which the
last sale of the obligation was affected on such national securities
exchange immediately before the employee trust's purchase of such
obligation on the same day or may be the mean between the highest and
lowest prices at which sales were effected on such exchange on the same
day or on the immediately preceding day or on the last day during which
there were sales of such obligation or may be a price determined by any
other method which accurately reflects the market value of the
obligation.
(iii)(a) If the obligation is not listed on a national securities
exchange which is registered with the Securities and Exchange
Commission, it must be purchased in an over-the-counter transaction at a
price not greater than the offering price for the obligation as
established by current bid and asked prices quoted by persons
independent of the issuer.
(b) For purposes of section 503(e) the offering price for the
obligation at the time of the purchase means the price which accurately
reflects the market value of the obligation. The offering price may be
the price at which the last sale of the obligation to a person
independent of the issuer was effected immediately before the employee
trust's purchase of such obligation on the same day or may be the mean
between the highest and lowest prices at which sales to persons
independent of the issuer were effected on the same day or on the last
day during which they were sales of such obligation or
[[Page 93]]
may be a price determinated by any other method which accurately
reflects the market value of the obligation. The offering price for an
obligation must be a valid price for the amount of the obligations which
the trust is purchasing. For example, if an employees' trust described
in section 503(a)(1)(B) purchases 1,000 bonds of the employer
corporation at the offering price established by current prices for a
lot of 10 such bonds, such offering price may not be a valid price for
1,000 bonds and the purchase may therefore not meet the requirements of
this subdivision. For a purchase of an obligation to qualify under this
subdivision, there must be sufficient current prices quoted by persons
independent of the issuer to establish accurately the current value of
the obligation. Thus, if there are no current prices quoted by persons
independent of the issuer, an over-the-counter transaction will not
qualify under this subparagraph even though the obligation was purchased
in an arms's length transaction from a person independent of the issuer.
(iv) For purposes of this section, an over-the-counter transaction
is one not executed on a national securities exchange which is
registered with the Securities and Exchange Commission. An over-the-
counter transaction may be made through a dealer or an exchange which is
not such a national securities exchange or may be made directly from the
seller to the purchaser.
(3) From an underwriter. An obligation may be purchased from an
underwriter if it is purchased at a price not greater than:
(i) The public offering price for the obligation as set forth in a
prospectus or offering circular filed with the Securities and Exchange
Commission, or
(ii) The price at which a substantial portion of the issue including
such obligation is acquired by persons independent of the issuer
whichever is the lesser price. For purposes of this subparagraph, a
portion of the issue will be considered substantial if the purchasers of
such portion by persons independent of the issuer are sufficient to
establish that fair market value of the obligations included in such
issue. In determining whether the purchases are sufficient to establish
the fair market value, all the surrounding facts and circumstances will
be considered, including the number of independent purchasers, the
aggregate amount purchased by each such independent purchaser, and the
number of transactions. In the case of a large issue, purchases of a
small percentage of the outstanding obligations may be considered
purchases of a substantial portion of the issue; whereas, in the case of
a small issue, purchases of a larger percentage of the outstanding
obligations will ordinarily be required. The requirement in paragraph
(b)(3)(ii) of this section contemplates purchase of the obligations by
persons independent of the issuer contemporaneously with the purchase by
the employee trust. If a substantial portion has been purchased at
different prices, the price of the portion may be based on the average
of such prices, and if several substantial portions have been sold to
persons independent of the issuer, the price of any of the substantial
portions may be used for pusposes of this subparagraph.
(4) From the issuer. An obligation may be purchased directly from
the issuer at a price not greater than the price paid currently for a
substantial portion of the same issue by persons independent of the
issuer. This requirement contemplates purchase of a substantial portion
of the same issue by persons independent of the issuer contemporaneously
with the purchase by the employee trust. For purposes of this
subparagraph, a portion of the issue will be considered substantial if
the purchases of such portion by persons independent of the issuer are
sufficient to establish the fair market value of the obligations
included in such issue. In determining whether the purchases are
sufficient to establish the fair market value, all the surrounding facts
and circumstances will be considered, including the number of
independent purchasers, the aggregage amount purchased by each such
independent purchaser, and the number of transactions. In the case of a
large issue, purchases of a small percentage of the outstanding
obligations may be considered purchases of a substantial portion of the
issue; whereas, in the case of a
[[Page 94]]
small issue, purchases of a larger percentage of the outstanding
obligations will ordinarily be required. The price paid for a
substantial portion of the issue may be determined in the manner
privided in paragraph (b)(3) of this section.
(c) Limitations on holdings of obligations. (1) Immediately
following acquisition of the obligation by the employee trust:
(i) Not more than 25 percent of the aggregate amount of the
obligations issued in such issue and outstanding immediately after
acquisition by the trust may be held by the trust, and
(ii) At least 50 percent of such aggregate amount must be held by
persons independent of the issuer.
(2)(i) For purposes of paragraph (c)(1) of this section, an
obligation is not considered as outstanding if it is held by the issuer.
For example, if an obligation which has been issued and outstanding is
repurchased and held by the issuer, without cancellation or retirement,
such an obligation is not considered outstanding.
(ii) For purposes of paragraph (c)(1) of this section, the amounts
of the obligations held by the trust and by persons independent of the
issuer shall be computed on the basis of the face amount of the
obligations.
(d) Limitation on amount invested in obligations. (1)(i) Immediately
following acquisition of the obligation, not more 25 percent of the
assets of the employee trust may be invested in all obligations of all
persons described in section 503(b). For purposes of determining the
amount of the trust's assets which are invested in obligations of
persons described in section 503(b) immediately following acquisition of
the obligation, those obligations shall be valued as follows:
(a) Those obligations included in the acquisition in respect of
which the percentage test in the first sentence of this subdivision is
being applied shall be valued at their adjusted basis, as provided in
section 1011, relating to adjusted basis for determining gain or loss;
and
(b) All other obligations of persons described in section 503(b)
which were part of the trust's assets immediately before the acquisition
of the obligations described in (d)(1)(i)(a) of this section shall be
valued at their fair market value on the day that the obligations
described in (d)(1)(i)(a) of this section were acquired. For purposes of
determining the total amount of the assets of the trust (including
obligations of persons described in section 503(b)), there shall be used
the fair market value of those assets on the day the obligation is
acquired.
(ii) The application of the rules in paragraph (d)(1)(i) of this
section may be illustrated by the following example:
Example. On February 1, 1960, an exempt employees' trust described
in section 401(a) purchases unsecured debentures issued by the employer
corporation for $1,000. At the time of this purchase, such debentures
have a fair market value of $1,200. Immediately after the purchase of
such unsecured debentures, the assets of the trust consist of the
following:
------------------------------------------------------------------------
Fair
market
Cost value on
Feb. 1,
1960
------------------------------------------------------------------------
(a) Assets other than obligations of persons $5,000 $7,800
described in sec. 503(b).......................
(b) Obligations of persons described in sec. 500 1,000
503(b) acquired before Feb. 1, 1960............
(c) Unsecured debentures of employer purchased 1,000 1,200
on Feb. 1, 1960................................
------------------------------------------------------------------------
Immediately following acquisition of the unsecured debentures by the
trust, the percent of the assets of the trust that are invested in all
obligations of all persons described in section 503(b) is computed as
follows:
(1) Obligations of persons described in section 503(b) $1,000
acquired before Feb. 1, 1960 (valued at fair market value).
(2) Unsecured debentures of employer purchased on Feb. 1, 1,000
1960 (valued at cost)......................................
-----------
(3) Total amount of trust's assets invested in obligations 2,000
of persons described in section 503(b) ((1) plus (2))......
===========
(4) Assets of the trust other than obligations of persons 7,800
described in section 503(b) (valued at fair market value on
Feb. 1, 1960)..............................................
(5) Obligations of persons described in section 503(b) 1,000
acquired before Feb. 1, 1960 (valued at fair market value
on Feb. 1, 1960)...........................................
(6) Unsecured debentures of employer purchased on Feb. 1, $1,200
1960 (valued at fair market value on Feb. 1, 1960).........
-----------
(7) Total assets of the trust valued at fair market value on 10,000
Feb. 1, 1960 (sum of (4), (5), and (6))....................
[[Page 95]]
(8) Percent of assets of the trust invested in all 20%
obligations of all persons described in section 503(b)
immediately following purchase of unsecured debentures on
Feb. 1, 1960 ((3) / (7), that is, $2,000 / $10,000)........
(2) In determining for purposes of subparagraph (1) of this
paragraph the amount invested in obligations of persons described in
section 503(b), there shall be included amounts invested in any
obligations issued by any such person, irrespective of whether the
obligation is secured, and irrespective of whether the obligation meets
the conditions of section 503(e) or section 503(f). Obligations of
persons described in section 503(b) other than the issuer of the
obligation to which section 503(e) applies are also included within the
25 percent limitation. For example, if on February 19, 1959, an exempt
employees' trust described in section 401(a) purchases unsecured
debentures issued by the employer corporation in a transaction effected
on the New York Stock Exchange, and if immediately after the purchase 10
percent of the trust's assets is invested in such debentures and 20
percent of its assets is invested in a loan made with adequate security
on January 12, 1959, to the wholly-owned subsidiary of the employer
corporation, then the purchase of the employer's debentures will not
qualify under section 503(e), since 30 percent of the trust's assets are
then invested in obligations of persons described in section 503(b).
(e) Change of terms of an obligation. A change in terms of an
obligation is considered as the acquisition of a new obligation. If such
new obligation is not adequately secured, the requirements of section
503(e) must be met at the time the terms of the obligation are changed
for such section to be applicable to such new loan.
[T.D. 7428, 41 FR 34624, Aug. 16, 1976]
Sec. 1.503(e)-3 Effective dates.
(a) Section 503(e) and Sec. Sec. 1.503(e)-1 and 1.503(e)-3 are
effective in the case of an employees' trust described in section 401(a)
for taxable years ending after March 15, 1956. Thus, if during a taxable
year ending before March 16, 1956, an employees' trust made a loan which
meets the requirements of section 503(e), such loan will not be treated
as made without the receipt of adequate security and will not cause the
loss of exemption for taxable years ending after March 15, 1956,
although such loan was not considered adequately secured when made.
(However, section 503 does not apply to organizations described in
section 401(a) not referred to in section 4975(g) (2) or (3) for
transactions occurring after December 31, 1974.)
(b)(1) In the case of obligations acquired by an employees' trust
described in section 401(a) before September 2, 1958, which were held on
that date, the requirements described in paragraphs (c) and (d) of Sec.
1.503(e)-2 which were not satisfied immediately following the
acquisition shall be treated as satisfied at that time if those
requirements would have been satisfied had the obligations been acquired
on September 2, 1958. For example, on January 3, 1955, an employees'
trust described in section 401(a) purchased through the New York Stock
Exchange unsecured debentures issued by the employer corporation. Under
section 503(e) the acquisition of such debentures by the trust will not
be treated for taxable years ending after March 15, 1956, as a loan made
without the receipt of adequate security if the debentures were held by
the employees' trust on September 2, 1958, and if the requirements of
paragraphs (c) and (d) of Sec. 1.503(e)-2 which were not met on January
3, 1955, were met on September 2, 1958, as if that date were the date of
acquisition.
(2) In the case of obligations acquired before September 2, 1958,
which were not held by the employees' trust described in section 401(a)
on that date, only the requirements described in paragraph (b) of Sec.
1.503(e)-2 must be satisfied for section 503(e) to be applicable to such
acquisition. For example, if on December 5, 1956, an employees' trust
lent money to the employer corporation by purchasing a debenture issued
by the employer and if the trust sold the debenture on August 1, 1958,
such loan would not be treated as made without the receipt of adequate
security if the requirement described in paragraph (b) of Sec.
1.503(e)-2 was met on December 5, 1956.
(c) Section 503(e) and Sec. Sec. 1.503(e)-1 and 1.503(e)-2 are
effective in the case of trusts described in section 501(c)(17)
[[Page 96]]
with respect to loans made, renewed, or, in the case of demand loans,
continued after December 31, 1959, and in the case of trusts described
in section 501(c)(18) with respect to loans made, renewed or, in the
case of demand loans, continued after December 31, 1969.
(d) See paragraph (b)(2) of Sec. 1.503(b)-1 for the effective dates
for the application of the definition of adequate security.
[T.D. 7428, 41 FR 34626, Aug. 16, 1976]
Sec. 1.503(f)-1 Loans by employers who are prohibited from pledging
assets.
(a) In general. (1) Section 503(f) provides that section 503(b)(1)
shall not apply to a loan made to the employer by an employees' trust
described in section 401(a) if the loan bears a reasonable rate of
interest and certain conditions are met. Section 503(f) also applies to
the renewal of loans to the employer and, in the case of demand loans,
to the continuation of such loans.
(2) The provisions of section 503(f) do not limit the effect of
section 401(a) and Sec. 1.401-2, relating to use or diversion of corpus
or income of an employees' trust, or the effect of any of the provisions
of section 503 other than section 503(b)(1). Consequently, although a
loan made by an employees' trust described in section 503(a)(1)(B) meets
all the requirements of section 503(f) and therefore is not treated as a
loan made without the receipt of adequate security, an employees' trust
making such a loan will lose its exempt status if the loan is not
considered as made for the exclusive benefit of the employees or their
beneficiaries. Similarly, a loan which meets the requirements of section
503(f) will constitute a prohibited transaction within the meaning of
section 503(b)(6) if it results in a substantial diversion of the
trust's income or corpus to a person described in section 503(b).
(b) Conditions. (1) Section 503(f) applies to a loan only if, with
respect to the making or renewal of the loan, the conditions described
in paragraphs (b) (2), (3), and (4) of this section are met. For purpose
of this paragraph, the mere continuance of a demand loan is not
considered as the making or renewal of such a loan.
(2) The employer must be prohibited (at the time of the making or
renewal of the loan) by any law of the United States or regulations
thereunder from directly or indirectly pledging, as security for such a
loan, a particular class or classes of his assets the value of which (at
such time) represents more than one-half of the value of all his assets.
If a loan is made or renewed when the employer is prohibited by a law of
the United States (or the regulations thereunder) from pledging a class
of his assets, the qualification of such a loan under section 503(f)
will not be affected by a subsequent change in such law or regulations
permitting the employer to pledge such assets, unless such loan is
renewed after such change. See section 8(a) of the Securities Exchange
Act of 1934, as amended (15 U.S.C. 78h(a)), which prohibits certain
persons from pledging a class of assets as security for loans, and 12
CFR 220.5(a) (credit by brokers, dealers, and members of national
securities exchanges).
(3) The making or renewal, as the case may be, must be approved in
writing as an investment which is consistent with the exempt purposes of
the trust by a trustee who is independent of the employer, and such
written approval must not have been previously refused by any other such
trustee. A trustee is independent of the employer, for purposes of this
subparagraph, if he is entirely free of influence or controlled by the
employer. For example, if the employer is a partnership, then a partner
in such partnership, or a member of a partner's family would not be
considered independent of the employer. Similarly, an employee of the
employer would not be considered independent of the employer. For
purposes of this subparagraph, the term trustee means, with respect to
any trust for which there are two trustees who are independent of the
employer, both of such trustees and, with respect to any trust for which
there are more than two such independent trustees, a majority of the
trustees independent of the employer.
(4)(i) Immediately following the making or renewal, as the case may
be, the aggregate amount lent by the trust to
[[Page 97]]
the employer, without the receipt of adequate security must not exceed
25 percent of the value of all the assets of the trust.
(ii) For purposes of paragraph (b)(4)(i) of this section, the
determination as to whether any amount lent by the trust to the employer
is a loan made without the receipt of adequate security shall be made
without regard to section 503(e). Thus, if an employees' trust makes a
loan on January 2, 1959, to the employer without adequate security (but
which loan is not considered as made without adequate security under
section 503(e)), and if immediately after making such loan 10 percent of
the value of all its assets is invested in such loan, then the trust may
on that day invest not more than an additional 15 percent of its assets
in a loan which would be considered made without adequate security if it
were not for the provisions of section 503(f).
(iii) For purposes of paragraph (b)(4)(i) of this section, in
determining the value of all the assets of the trust, there shall be
used the fair market value of those assets on the day of the making or
renewal.
(c) Reasonable rate of interest. Section 503(f) only applies if, in
addition to meeting the conditions described in paragraph (b) of this
section, the loan bears a reasonable rate of interest when it is made,
renewed, or, in the case of demand loans, during the period of its
existence.
(d) Change of terms of loan. A change in the terms of a loan
(including a reduction in the security for a loan) is considered as the
making of a new loan. If such a new loan is not adequately secured, the
requirements of section 503(f) must be met at the time the terms of the
loan are changed for such section to be applicable to such new loan.
(e) Effective date. (1) This section and section 503(f) are
effective for taxable years ending after September 2, 1958, but only
with respect to periods after such date. Thus, if a loan was made on or
before September 2, 1958, without the receipt of adequate security and
if, when such loan was made, it met all of the requirements of section
503(f) and this section, then the loan is not subject to section
503(b)(1) after September 2, 1958, and would not consitite a prohibited
transaction after that date because of a lack of adequate security.
(2) See paragraph (b)(2) of Sec. 1.503(b)-1 for the effective dates
for application of the definition of adequate security.
[T.D. 7428, 41 FR 34626, Aug. 16, 1976]
Sec. 1.504-1 Attempts to influence legislation; certain organizations
formerly described in section 501(c)(3) denied exemption.
Section 504(a) and this section apply to an organization that is
exempt from taxation at any time after October 4, 1976, as an
organization described in section 501(c)(3), and that ceases to be
described in that section because it--
(a) Is an action organization within the meaning of Sec.
1.501(c)(3)-1(c)(3)(ii) or (iv), on account of activities occurring
after October 4, 1976, or
(b) Is denied exemption under the provisions of section 501(h) (see
Sec. 1.501(h)-3 or Sec. 56.4911-9).
This section does not apply, however, to an organization that was
described in section 501(h)(5) and Sec. 1.501(h)-2(b)(3) (relating
generally to churches) for its taxable year immediately preceding the
first taxable year for which it is no longer an organization described
in section 501(c)(3). An organization to which section 504(a) and this
section apply shall not be treated as described in section 501(c)(4) at
any time after the organization ceases to be described in section
501(c)(3). Further, an organization denied treatment as an organization
described in section 501(c)(4) under this section may not be treated as
an organization described in section 501(c) other than as an
organization described in section 501(c)(3). For rules relating to
recognition of exemption after exemption is denied under section 501(h),
Sec. 1.501(h)-3(d).
[T.D. 8308, 55 FR 35592, Aug. 31, 1990]
Sec. 1.504-2 Certain transfers made to avoid section 504(a).
(a) Scope. Under section 504(b), a transfer described in paragraph
(b) or (c) of this section to an organization exempt from tax under
section 501(a) may result in loss of exemption by the
[[Page 98]]
transferee unless the Commissioner determines, under paragraph (e) of
this section, that the original transfer did not effect an avoidance of
section 504(a). For purposes of this section, the term transfer includes
any use by, or for the benefit of, the recipient of the transfer, but
does not include any transfer made for adequate and full consideration.
(b) Transferor and transferee commonly controlled--(1) Loss of
exemption. A transfer is described in this paragraph (b) if it is
described in paragraphs (b)(2) through (b)(6). The transferee of a
transfer described in this paragraph will cease to be exempt from tax
under section 501(a), unless the provisions of paragraph (e) of this
section apply.
(2) Transferor organization. A transfer is described in this
paragraph (b)(2) only if it is from an organization that--
(i) Is or was described in section 501(c)(3), but not in section
501(h)(5), and
(ii) Is determined to be an ``action'' organization (as defined in
Sec. 1.501(c)(3)-1(c)(3)(ii) or (iv)), or is denied exemption from tax
by reason of section 501(h) and either Sec. 1.501(h)-3 or Sec.
56.4911-9.
(3) Transferor and transferee commonly controlled. A transfer is
described in this paragraph (b)(3) only if, at the time of the transfer
or at any time during the transferee's ten taxable years following the
year in which the transfer was made, the transferee is controlled
(directly or indirectly), as defined in paragraph (f) of this section,
by the same person or persons who control the transferor.
(4) Time of transfer. A transfer is described in this paragraph
(b)(4) only if the transfer is made--
(i) After the date that is 24 months before the earliest of the
effective date of the determination under section 501(h) that the
transferor is not exempt, the effective date of the Commissioner's
determination that the transferor is an ``action'' organization (as
defined in Sec. 1.501(c)(3)(ii) or (iv)), or the date on which the
Commissioner proposes to treat it as no longer described in section
501(c)(3), and
(ii) Before the transferor again is recognized as an organization
described in section 501(c)(3).
(5) Transferee. A transfer is described in this paragraph (b)(5)
only if the transferee is exempt from tax under section 501(a) but the
transferee is neither--
(i) An organization described in section 501(c)(3), nor
(ii) An organization described in section 401(a) to which the
transferor contributes as an employer.
(6) Amount of transfer. A transfer is described in this paragraph
(b)(6) only if the amount of the transfer exceeds the lesser of 30
percent of the net fair market value of the transferor's assets or 50
percent of the net fair market value of the transferee's assets,
computed immediately before the transfer. For purposes of this paragraph
(b)(6)--
(i) The amount of a transfer by a transferor is the sum of the
amounts transferred to any number of transferees in any number of
transfers, all of which are described in paragraphs (b)(2) through
(b)(5) of this section, and the time of the transfer is the time of the
first transfer so taken into account; and
(ii) The amount of a transfer to a transferee is the sum of the
amounts transferred by a transferor to the transferee in any number of
transfers, all of which are described in paragraphs (b)(2) through
(b)(5) of this section, and the time of the transfer is the time of the
first transfer so taken into account.
(c) Other transfers--(1) Transfers included. A transfer is described
in this paragraph (c) if it would be described in paragraph (b) of this
section except that either--
(i) The amount of the transfer is less than the amount determined in
paragraph (b)(6) of this section, or
(ii) The transferor and transferee are not commonly controlled as
described in paragraph (b)(3) of this section, or
(iii) The transferee is an organization described in sections
501(c)(3) and 501(h)(4).
(2) Loss of exemption. The transferee of a transfer described in
this paragraph (c) will cease to be exempt under
[[Page 99]]
section 501(a) if the Commissioner determines on all the facts and
circumstances that the transfer effected an avoidance of section 504(a).
In determining whether a transfer effected an avoidance of section
504(a), the Commissioner may consider whether the transferee engages, or
has engaged, in attempts to influence legislation and may also consider
any factors enumerated in paragraph (e) of this section.
(d) Date of loss of exempt status. A transferee of a transfer
described in paragraph (b), (c)(1)(ii), or (c)(1)(iii) of this section
will cease to be exempt from tax under section 501(a) on the date that
all requirements of paragraph (b), (c)(1)(ii), or (c)(1)(iii) (other
than the determination by the Commissioner) are satisfied. A transferee
of a transfer described in paragraph (c)(1)(i) of this section will
cease to be exempt from tax under section 501(a) on the date of the last
transfer preceding notification of the transferee that the Commissioner
proposes to treat the transferee as other than an exempt organization.
(e) Transfers not in avoidance of section 504(a). Notwithstanding
paragraph (b) of this section, if, based on all the facts and
circumstances, the Commissioner determines that a transfer described in
paragraph (b) did not effect an avoidance of section 504(a), the
transferee will not be denied exemption from tax by reason of section
504(b) and this section. In making the determination called for in the
preceding sentence, the Commissioner may consider all relevant factors
including:
(1) Whether enforceable and effective conditions on the transfer
preclude use of any of the transferred assets for any purpose that, if
it were a substantial part of an organization's activities, would be
inconsistent with exemption as an organization described in section
501(c)(3);
(2) In the absence of conditions described in paragraph (e)(1) of
this section, whether the transferred assets are used exclusively for
purposes that are consistent with the transferor's exemption as an
organization described in section 501(c)(3);
(3) Whether the assets transferred would be describe in Sec.
53.4942(a)(-2(c)(3) before, as well as after, the transfer if both the
transferor and transferee were private foundations;
(4) Whether and to what extent the transfer would satisfy the
provisions of Sec. 1.507-2(a) (7) and (8) if the transferor were a
private foundation;
(5) Whether all of the transferred assets have been expended during
a period when the transferee was not controlled (directly or indirectly)
by the same person or persons who controlled the transferor; and
(6) Whether the entire amount of the transferred assets were in turn
transferred, before the close of the transferee's taxable year following
the taxable year in which the transferred assets were received, to one
or more organizations described in section 507(b)(1)(A) none of which
are controlled (directly or indirectly) by the same persons who control
either the original transferor or transferee.
(f) Control. For purposes of section 504 and the regulations
thereunder--
(1) The transferor will be presumed to control any organization with
which it is affiliated within the meaning of Sec. 56.4911-7(a), or
would be if both organizations were described in section 501(c)(3), and
(2) The transferee will be treated as controlled (directly of
indirectly) by the same person or persons who control the transferor if
the transferee would be treated as controlled under Sec. 53.4942(a)-
3(a)(3), for which purpose the transferor shall be treated as a private
foundation.
[T.D. 8308, 55 FR 35592, Aug. 31, 1990]
Sec. 1.505(c)-1T Questions and answers relating to the notification
requirement for recognition of exemption under paragraphs (9), (17) and
(20) of Section 501(c) (temporary).
Q-1: What does section 505(c) of the Internal Revenue Code provide?
A-1: Section 505(c) provides that an organization will not be
recognized as exempt under section 501(c)(9) as a voluntary employees'
beneficiary association, under section 501(c)(17) as a trust forming
part of a plan providing for the payment of supplemental unemployment
compensation benefits, or under section 501(c)(20) as a trust forming
part of a qualified group legal services plan unless notification is
given to the Internal Revenue Service. The notification
[[Page 100]]
required of a trust created pursuant to section 501(c)(20) and forming
part of a qualified group legal services plan is set forth in Q&A-2. The
notification required of an organization organized after July 18, 1984,
and applying for exempt status as an organization described in section
501(c) (9) or (17) is set forth in Q&A-3 through Q&A-8. The notification
required of an organization organized on or before July 18, 1984, and
claiming exemption as an organization described in section 501(c) (9) or
(17) is set forth in Q&A-9 through Q&A-11. However, an organization that
has previously notified the Internal Revenue Service of its claim to
exemption under section 501(c) (9), (17), or (20) or its claim to
exemption under those sections pursuant to another provision of the
Code, is not required, under section 505(c), to submit a renotification
(See Q&A-2 and Q&A-12).
Section 501(c)(20) Trusts
Q-2: What is the notice required of a trust created pursuant to
section 501(c)(20) and forming part of a qualified group legal services
plan under section 120?
A-2: (a) A trust claiming exemption as an organization described in
section 501(c)(20) will be recognized as exempt if the exclusive
function of the trust is to form part of a qualified group legal
services plan or plans. Exemption of the trust under section 501(c)(20)
will generally be dependent upon and coextensive with recognition of the
plan as a qualified group legal services plan. Therefore, a trust
organized pursuant to section 501(c)(20) after July 18, 1984, need not
file a separate notice with the Internal Revenue Service of its claim to
exemption because the notice required by section 120(c)(4) will suffice
for purposes of section 505(c), provided a copy of the trust instrument
is filed with the Form 1024 submitted by the group legal services plan.
If the trust instrument has not been filed with the Form 1024 submitted
by the group legal services plan, the trust must comply with (and
exemption will be dependent upon) the filing applicable to a trust
organized on or before July 18, 1984. For the notice required and
effective dates of exemption of a qualified group legal services plan
under section 120, see Sec. 1.120-3.
(b) A trust organized on or before July 18, 1984, that claims exempt
status as a trust described in section 501(c)(20) and that forms part of
a qualified group legal services plan which has been recognized as
exempt under section 120, must file a copy of its trust instrument with
the Internal Revenue Service before February 4, 1987. If a copy of the
trust instrument is filed within the time provided, the trust's
exemption will be recognized retroactively to the date the qualified
group legal services plan was recognized as exempt under section 120.
However, if a copy of the trust instrument is filed after the time
provided, exemption will be recognized only for the period after the
copy of the trust instrument is filed with the Internal Revenue Service.
See Q&A-7 for a further discussion of date of filing. A trust that has
previously filed a copy of its trust instrument with the Service need
not refile that document.
Section 501(c)(9) and (17) Organizations Organized After July 18, 1984
Q-3: What is the notice required of an organization or trust,
organized after July 18, 1984, that is applying for recognition of tax
exempt status under section 501(c) (9) or (17)?
A-3: An organization or trust that is organized after July 18, 1984,
will not be treated as described in paragraphs (9) or (17) of section
501(c), unless the organization notifies the Internal Revenue Service
that it is applying for recognition of exemption. In addition, unless
the required notice is given in the manner and within the time
prescribed by these regulations, an organization will not be treated as
exempt for any period before the giving of the required notice. The
notice is filed by submitting a properly completed and executed Form
1024, ``Application for Recognition of Exemption Under Section 501(a) or
for Determination Under Section 120'' together with the additional
information required under Q&A-4 and Q&A-5. The notice is filed with the
district director for the key district in which the organization's
principal place of business or principal office is located.
The notice may be filed by either the plan administrator (as defined
in section 414(g)) or the trustee. The Internal Revenue Service will not
accept a Form 1024 for any organization or trust before such entity has
been organized.
Q-4: What information, in addition to the information required by
Form 1024, must be submitted by an organization or trust seeking
recognition of exemption under section 501(c) (9) or (17)?
A-4: A notice will not be considered complete unless, in addition to
a properly completed and executed Form 1024, the organization or trust
submits a full description of the benefits available to participants
under section 501(c) (9) or (17). Moreover, both the terms and
conditions of eligibility for membership and the terms and conditions of
eligibility for benefits must be set forth. This information may be
contained in a separate document, such as a plan document, or it may be
contained in the creating document of the entity (e.g., the articles of
incorporation or association, or a trust indenture). For benefits
provided through a policy or policies of insurance, all such policies
must be included with the notice. Where individual policies of insurance
are provided to the participants, single exemplar copies, typical of
policies generally issued to participants, are acceptable, provided they
adequately describe all
[[Page 101]]
forms of insurance available to participants. In providing a full
description of the benefits available, the benefits provided must be
sufficiently described so that each benefit is definitely determinable.
A benefit is definitely determinable if the amount of the benefit, its
duration, and the persons eligible to receive it are ascertainable from
the plan document or other instrument. Thus, a benefit is not definitely
determinable if the rules governing either its amount, its duration, or
its recipients are not ascertainable from the plan document or other
instrument but are instead subject to the discretion of a person or
committee. Likewise, a benefit is not definitely determinable if the
amount for any individual is based upon a percentage share of any item
that is within the discretion of the employer. However, a disability
benefit will not fail to be considered definitely determinable merely
because the determination of whether an individual is disabled is made
under established guidelines by an authorized person or committee.
Q-5: What is the notice required of collectively bargained plans?
A-5: If an organization or trust claiming exemption under section
501(c) (9) or (17) is organized and maintained pursuant to a collective
bargaining agreement between employee representatives and one or more
employer, only one Form 1024 is required to be filed for the
organization or trust, regardless of the number of employers originally
participating in the agreement. Moreover, once a Form 1024 is filed
pursuant to a collective bargaining areement, an additional Form 1024 is
not required to be filed by an employer who thereafter participates in
that agreement. When benefits are provided pursuant to a collective
bargaining agreement, the notice will not be considered complete unless,
in addition to a properly completed and executed Form 1024, a copy of
the collective bargaining agreement is also submitted together with the
additional information delineated in Q&A-4.
Q-6: When must the required notice be filed by an organization or
trust, organized after July 18, 1984, that seeks recognition of
exemption under section 501(c) (9) or (17)?
A-6: An organization or trust applying for exemption must file the
required notice by the later of February 4, 1987 or 15 months from the
end of the month in which the organization or trust was organized. An
extension of time for filing the required notice may be granted by the
district director if the request is submitted before the end of the
applicable period and it is demonstrated that additional time is needed.
Q-7: What is the effective date of exemption for a new organization
or trust, organized after July 18, 1984, that has submitted the required
notice?
A-7: If the required notice is filed within the time provided by
these regulations, the organization's exemption will be recognized
retroactively to the date the organization was organized, provided its
purpose, organization and operation (including compliance with the
applicable nondiscrimination requirements) during the period prior to
the date of the determination letter are in accordance with the
applicable law. However, if the required notice is filed after the time
provided by these regulations, exemption will be recognized only for the
period after the application is filed with the Internal Revenue Service.
The date of filing is the date of the United States postmark on the
cover in which an exemption application is mailed or, if no postmark
appears on the cover, the date the application is stamped as received by
the Service. If an extension for filing the required notice has been
granted to the organization, a notice filed on or before the last day
specified in the extension will be considered timely and not the
otherwise applicable date under Q&A-6.
Q-8: What is the effect on exemption of the filing of an incomplete
notice?
A-8: Although a properly completed and executed Form 1024 together
with the required additional information (See Q&A-4 and Q&A-5) must be
submitted to satisfy the notice required by section 505(c), the failure
to file, within the time specified, all of the information necessary to
complete such notice will not alone be sufficient to deny recognition of
exemption from the date of organization to the date the completed
information is submitted to the Service. If the notice which is filed
with the Service within the required time is substantially complete, and
the organization supplies the necessary additional information requested
by the Service within the additional time allowed, the original notice
will be considered timely. However, if the notice is not substantially
complete or the additional information is not provided within the
additional time allowed, exemption will be recognized only from the date
of filing of the additional information.
Section 501(c)(9) and (17) Organizations Organized on or Before July 18,
1984
Q-9: What is the notice required of an organization or trust
organized on or before July 18, 1984, that claims exempt status as an
organization described in section 501(c) (9) or (17)?
A-9: Section 505(c) provides a special rule for existing
organizations and trusts organized on or before July 18, 1984. Such an
organization or trust will not be treated as described in paragraphs (9)
or (17) of section 501(c) unless the organization or trust notifies the
Internal Revenue Service in the manner and within the time prescribed in
these regulations that it is claiming exemption under the particular
section. The type of notice, the manner for filing that notice,
[[Page 102]]
and the additional information required is the same as that set forth in
Q&A-3 through Q&A-5 for new organizations.
Q-10: When must the required notice be filed by an organization or
trust organized on or before July 18, 1984?
A-10: An organization or trust organized on or before July 18, 1984,
that claims exempt status as an organization described in section 501(c)
(9) or (17), must file the required notice before February 4, 1987. An
extension of time for filing the required notice may be granted by the
district director if the request is submitted before the due date of the
notice and it is demonstrated that additional time is needed.
Q-11: What is the effective date of exemption for an organization or
trust organized on or before July 18, 1984, that has submitted the
required notice?
A-11: If the required notice is filed within the time provided by
these regulations, the organization's exemption will be recognized
retroactively to the date the organization was organized, provided its
purpose, organization and operation (including compliance with the
applicable nondiscrimination requirements) during the period prior to
the date of the determination letter are in accordance with the
applicable law. If, on the other hand, the required notice is filed
after the time provided by these regulations, exemption will be
recognized only for the period after the notice is received by the
Internal Revenue Service. See Q&A-7 for a further discussion of date of
filing. See also Q&A-8 for the effect on exemption of a notice that has
been timely filed but is incomplete.
Exceptions to Notice Requirement
Q-12: Are any organizations or trusts claiming recognition of
exemption as an organization described in section 501(c) (9) or (17)
excepted from the notice requirement of section 505(c)?
A-12: An organization or trust that has previously notified the
Internal Revenue Service of its claim to exemption by filing Form 1024
is not required, under section 505(c), to renotify the Service. Thus, an
organization that has filed a Form 1024 that is pending with the Service
need not refile that form. Also, an organization that has received a
ruling or determination letter from the Service recognizing its
exemption from taxation need not submit the notification required by
section 505(c).
[T.D. 8073, 51 FR 4330, Feb. 4, 1986]
Sec. 1.506-1 Organizations required to notify Commissioner of intent
to operate under section 501(c)(4).
(a) Notification requirement--(1) In general. Except as provided in
paragraph (b) of this section, an organization (whether domestic or
foreign) described in section 501(c)(4) must, no later than 60 days
after the date the organization is organized, notify the Commissioner
that it is operating as an organization described in section 501(c)(4)
by submitting a completed Form 8976, ``Notice of Intent to Operate Under
Section 501(c)(4),'' or its successor (the notification). The
notification must be submitted in accordance with the form and its
instructions. The notification must include the information specified in
paragraph (a)(2) of this section and be accompanied by payment of the
user fee described in paragraph (a)(3) of this section. Additional
guidance on the procedure for submitting the notification may be
provided in published guidance in the Internal Revenue Bulletin (see
Sec. 601.601(d)(2) of this chapter) or in other guidance, such as forms
or instructions, issued with respect to the notification.
(2) Contents of the notification. The notification must include the
following information:
(i) The name, address, and taxpayer identification number of the
organization.
(ii) The date on which, and the state or other jurisdiction under
the laws of which, the organization was organized (that is, formed as a
legal entity). For an organization formed outside the United States, the
jurisdiction is the foreign country under the laws of which it is
organized.
(iii) A statement of the purpose of the organization.
(iv) Such additional information as may be specified in published
guidance in the Internal Revenue Bulletin (see Sec. 601.601(d)(2) of
this chapter) or in other guidance, such as forms or instructions,
issued with respect to the notification.
(3) User fee. The notification must be accompanied by payment of the
user fee set forth by published guidance in the Internal Revenue
Bulletin (see Sec. 601.601(d)(2) of this chapter) or in other guidance,
such as forms or instructions, issued with respect to the notification.
(4) Extension for reasonable cause. The Commissioner may, for
reasonable cause, extend the 60-day period for submitting the
notification.
[[Page 103]]
(b) Special rules for organizations that were organized on or before
July 8, 2016--(1) Notification requirement does not apply to
organizations that filed with the IRS on or before December 18, 2015.
The requirement to submit the notification does not apply to any
organization described in section 501(c)(4) that, on or before December
18, 2015, either--
(i) Applied for a written determination of recognition as an
organization described in section 501(c)(4) in accordance with Sec.
1.501(a)-1 and all applicable guidance published in the Internal Revenue
Bulletin (see Sec. 601.601(d)(2) of this chapter), forms, and
instructions; or
(ii) Filed at least one annual information return or annual
electronic notification required under section 6033(a)(1) or (i).
(2) Transition relief available for organizations that filed with
the IRS on or before July 8, 2016. An organization described in section
501(c)(4) is not required to submit the notification if, on or before
July 8, 2016, the organization either--
(i) Applied for a written determination of recognition as an
organization described in section 501(c)(4) in accordance with Sec.
1.501(a)-1 and all applicable guidance published in the Internal Revenue
Bulletin (see Sec. 601.601(d)(2) of this chapter), forms, and
instructions; or
(ii) Filed at least one annual information return or annual
electronic notification required under section 6033(a)(1) or (i).
(3) Extended due date. An organization that was organized on or
before July 8, 2016, and is not described in paragraph (b)(1) or (2) of
this section, satisfies the requirement to submit the notification if
the notification was submitted on or before September 6, 2016.
(c) Failure to submit the notification. For information on the
penalties for failure to submit the notification, the applicable
reasonable cause exception, and applicable special rules, see section
6652(c)(4) through (6).
(d) Acknowledgment of receipt. Within 60 days after receipt of the
notification, the Commissioner will send the organization an
acknowledgment of such receipt. This acknowledgment is not a
determination by the Commissioner that the organization qualifies for
exemption under section 501(a) as an organization described in section
501(c)(4). See paragraph (e) of this section.
(e) Separate procedure by which an organization may request an IRS
determination that it qualifies for section 501(c)(4) tax-exempt status.
Submission of the notification does not constitute a request by an
organization for a determination by the Commissioner that the
organization qualifies for exemption under section 501(a) as an
organization described in section 501(c)(4). An organization seeking IRS
recognition of its tax-exempt status must separately request such a
determination in accordance with Sec. 1.501(a)-1 and all applicable
guidance published in the Internal Revenue Bulletin (see Sec.
601.601(d)(2) of this chapter), forms, and instructions.
(f) Applicability date. This section applies on and after July 8,
2016.
[T.D. 9873, 84 FR 35306, July 23, 2019]
Private Foundations
Sec. 1.507-1 General rule.
(a) In general. Except as provided in Sec. 1.507-2, the status of
any organization as a private foundation shall be terminated only if:
(1) Such organization notifies the district director of its intent
to accomplish such termination, or
(2)(i) With respect to such organization, there have been either
willful repeated acts (or failures to act), or a willful and flagrant
act (or failure to act), giving rise to liability for tax under chapter
42, and
(ii) The Commissioner notifies such organization that, by reason of
subdivision (i) of this subparagraph, such organization is liable for
the tax imposed by section 507(c)
and either such organization pays the tax imposed by section 507(c) (or
any portion not abated under section 507(g)) or the entire amount of
such tax is abated under section 507(g).
(b) Termination under section 507(a)(1). (1) In order to terminate
its private foundation status under paragraph (a)(1) of this section, an
organization must submit a statement to the district director of its
intent to terminate its private foundation status under section
507(a)(1). Such statement must set
[[Page 104]]
forth in detail the computation and amount of tax imposed under section
507(c). Unless the organization requests abatement of such tax pursuant
to section 507(g), full payment of such tax must be made at the time the
statement is filed under section 507(a)(1). An organization may request
the abatement of all of the tax imposed under section 507(c), or may pay
any part thereof and request abatement of the unpaid portion of the
amount of tax assessed. If the organization requests abatement of the
tax imposed under section 507(c) and such request is denied, the
organization must pay such tax in full upon notification by the Internal
Revenue Service that such tax will not be abated. For purposes of
subtitle F of the Code, the statement described in this subparagraph,
once filed, shall be treated as a return.
(2) Termination of private foundation status under section 507(a)(1)
does not relieve a private foundation, or any disqualified person with
respect thereto, of liability for tax under chapter 42 with respect to
acts or failures to act prior to termination or for any additional taxes
imposed for failure to correct such acts or failures to act. See
subparagraph (8) of this paragraph as to the possible imposition of
transferee liability in cases not involving termination of private
foundation status.
(3) In the case of an organization which has terminated its private
foundation status under section 507(a) and continues in operation
thereafter, if such organization wishes to be treated as described in
section 501(c)(3), then pursuant to section 509(c) and Sec. 1.509(c)-1
such organization must apply for recognition of exemption as an
organization described in section 501(c)(3) in accordance with the
provisions of section 508(a).
(4) See Sec. 53.4947-1(c)(7) of this chapter as to the application
of section 507(a) to certain split-interest trusts.
(5) For purposes of section 508(d)(1), the Internal Revenue Service
shall make notice to the public (such as by publication in the Internal
Revenue Bulletin) of any notice received from a private foundation
pursuant to section 507(a)(1) or of any notice given to a private
foundation pursuant to section 507(a)(2).
(6) If a private foundation transfers all or part of its assets to
one or more other private foundations (or one or more private
foundations and one or more section 509(a) (1), (2), (3), or (4)
organizations) pursuant to a transfer described in section 507(b)(2) and
Sec. 1.507-3(c), such transferor foundation will not have terminated
its private foundation status under section 507(a)(1). See Sec. 1.507-
3, however, for the special rules applicable to private foundations
participating in section 507(b)(2) transfers.
(7) Neither a transfer of all of the assets of a private foundation
nor a significant disposition of assets (as defined in Sec. 1.507-
3(c)(2)) by a private foundation (whether or not any portion of such
significant disposition of assets is made to another private foundation)
shall be deemed to result in a termination of the transferor private
foundation under section 507(a) unless the transferor private foundation
elects to terminate pursuant to section 507(a)(1) or section 507(a)(2)
is applicable. Thus, if a private foundation transfers all of its assets
to one or more persons, but less than all of its net assets to one or
more organizations described in section 509(a)(1) which have been in
existence and so described for a continuous period of 60 calendar
months, for purposes of this paragraph such transferor foundation will
not be deemed by reason of such transfer to have terminated its private
foundation status under section 507 (a) or (b) unless section 507(a)(2)
is applicable. Such foundation will continue to be treated as a private
foundation for all purposes. For example, if a private foundation
transfers all of its net assets to a section 509(a)(2) organization in
1971 and receives a bequest in 1973, the bequest will be regarded as
having been made to a private foundation and the foundation will be
subject to the provisions of chapter 42 with respect to such funds. If a
private foundation makes a transfer of all of its net assets to a
section 509(a) (2) or (3) organization, for example, it must retain
sufficient income or assets to pay the tax imposed under section 4940
for that portion of its taxable year prior to such transfer. For
additional rules applicable to a transfer by a private foundation of all
of its
[[Page 105]]
net assets to a section 509(a)(1) organization which has not been in
existence and so described for a continuous period of 60 calendar
months, see Sec. 1.507-3(e).
(8) If a private foundation makes a transfer described in
subparagraph (7) of this paragraph and prior to, or in connection with,
such transfer, liability for any tax under chapter 42 is incurred by the
transferor foundation, transferee liability may be applied against the
transferee organization for payment of such taxes. For purposes of this
subparagraph, liability for any tax imposed under chapter 42 for failure
to correct any act or failure to act shall be deemed incurred on the
date on which the act or failure to act giving rise to the initial tax
liability occurred.
(9) A private foundation which transfers all of its net assets is
required to file the annual information return required by section 6033,
and the foundation managers are required to file the annual report of a
private foundation required by section 6056, for the taxable year in
which such transfer occurs. However, neither such foundation nor its
foundation managers will be required to file such returns for any
taxable year following the taxable year in which the last of any such
transfers occurred, if at no time during the subsequent taxable years in
question the foundation has either legal or equitable title to any
assets or engages in any activity.
(c) Involuntary termination under section 507(a)(2). (1) For
purposes of section 507(a)(2)(A), the term willful repeated acts (or
failures to act) means at least two acts or failures to act both of
which are voluntary, conscious, and intentional.
(2) For purposes of section 507(a)(2)(A), a willful and flagrant act
(or failure to act) is one which is voluntarily, consciously, and
knowingly committed in violation of any provision of chapter 42 (other
than section 4940 or 4948(a)) and which appears to a reasonable man to
be a gross violation of any such provision.
(3) An act (or failure to act) may be treated as an act (or failure
to act) by the private foundation for purposes of section 507(a)(2) even
though tax is imposed upon one or more foundation managers rather than
upon the foundation itself.
(4) For purposes of section 507(a)(2), the failure to correct the
act or acts (or failure or failures to act) which gave rise to liability
for tax under any section of chapter 42 by the close of the correction
period for such section may be a willful and flagrant act (or failure to
act).
(5) No motive to avoid the restrictions of the law or the incurrence
of any tax is necessary to make an act (or failure to act) willful.
However, a foundation's act (or failure to act) is not willful if the
foundation (or a foundation manager, if applicable) does not know that
it is an act of self-dealing, a taxable expenditure, or other act (or
failure to act) to which chapter 42 applies. Rules similar to the
regulations under chapter 42 (see, for example, Sec. 53.4945-
1(a)(2)(iii) of this chapter) shall apply in determining whether a
foundation or a foundation manager knows that an act (or failure to act)
is an act of self-dealing a taxable expenditure or other such act (or
failure to act).
[T.D. 7233, 37 FR 28157, Dec. 21, 1972, as amended by T.D. 7290, 38 FR
31833, Nov. 19, 1973]
Sec. 1.507-2 Special rules; transfer to, or operation as, public charity.
(a) Transfer to public charities--(1) General rule. Under section
507(b)(1)(A) a private foundation, with respect to which there have not
been either willful repeated acts (or failures to act) or a willful and
flagrant act (or failure to act) giving rise to liability for tax under
Chapter 42, may terminate its private foundation status by distributing
all of its net assets to one or more organizations described in section
170(b)(1)(A) (other than in clauses (vii) and (viii)) each of which has
been in existence and so described for a continuous period of at least
60 calendar months immediately preceding such distribution. Because
section 507(a) does not apply to such a termination, a private
foundation which makes such a termination is not required to give the
notification described in section 507(a)(1). A private foundation that
terminates its private foundation status
[[Page 106]]
under section 507(b)(1)(A) does not incur tax under section 507(c) and,
therefore, no abatement of such tax under section 507(g) is required.
(2) Effect of current ruling. A private foundation seeking to
terminate its private foundation status pursuant to section 507(b)(1)(A)
may rely on a ruling or determination letter issued to a potential
distributee organization that such distributee organization is an
organization described in section 170(b)(1)(A)(i), 170(b)(1)(A)(ii),
170(b)(1)(A)(iii), 170(b)(1)(A)(iv), 170(b)(1)(A)(v), or
170(b)(1)(A)(vi) in accordance with the provisions of Sec. 1.509(a)-7.
(3) Organizations described in more than one clause of section
170(b)(1)(A). For purposes of this paragraph and section 507(b)(1)(A),
the parenthetical term ``other than in clauses (vii) and (viii)'' shall
refer only to an organization that is described only in section
170(b)(1)(A)(vii) or section 170(b)(1)(A) (viii). Thus, an organization
described in section 170(b)(1)(A)(i), 170(b)(1)(A)(ii),
170(b)(1)(A)(iii), 170(b)(1)(A)(iv), 170(b)(1)(A)(v), or
170(b)(1)(A)(vi) will not be precluded from being a distributee
described in section 507(b)(1)(A) merely because it also appears to meet
the description of an organization described in section
170(b)(1)(A)(vii) or section 170(b)(1)(A)(viii).
(4) Applicability of Chapter 42 to foundations terminating under
section 507(b)(1)(A). An organization that terminates its private
foundation status pursuant to section 507(b)(1)(A) will remain subject
to the provisions of Chapter 42 until the distribution of all of its net
assets to distributee organizations described in section 507(b)(1)(A)
has been completed.
(5) Return required from organizations terminating private
foundation status under section 507(b)(1)(A)--(i) An organization that
terminates its private foundation status under section 507(b)(1)(A) is
required to file a return under the provisions of section 6043(b).
(ii) An organization that terminates its private foundation status
under section 507(b)(1)(A) is not required to comply with section
6104(d) for the taxable year in which such termination occurs.
(6) Distribution of net assets. A private foundation will meet the
requirement to ``distribute all of its net assets'' within the meaning
of section 507(b)(1)(A) only if it transfers all of its right, title,
and interest in and to all of its net assets to one or more
organizations referred to in section 507(b)(1)(A).
(7) Effect of restrictions and conditions upon distributions of net
assets--(i) In general. In order to effectuate a transfer of ``all of
its right, title, and interest in and to all of its net assets'' within
the meaning of paragraph (a)(6) of this section, a transferor private
foundation may not impose any material restriction or condition that
prevents the transferee organization referred to in section 507(b)(1)(A)
(herein sometimes referred to as the ``public charity'') from freely and
effectively employing the transferred assets, or the income derived
therefrom, in furtherance of its exempt purposes. Whether or not a
particular condition or restriction imposed upon a transfer of assets is
material (within the meaning of this paragraph (a)(7)) must be
determined from all of the facts and circumstances of the transfer. Some
of the more significant facts and circumstances to be considered in
making such a determination are--
(A) Whether the public charity (including a participating trustee,
custodian, or agent in the case of a community trust) is the owner in
fee of the assets it receives from the private foundation;
(B) Whether such assets are to be held and administered by the
public charity in a manner consistent with one or more of its exempt
purposes;
(C) Whether the governing body of the public charity has the
ultimate authority and control over such assets, and the income derived
therefrom; and
(D) Whether, and to what extent, the governing body of the public
charity is organized and operated so as to be independent from the
transferor.
(ii) Independent governing body. As provided in paragraph
(a)(7)(i)(D) of this section, one of the more significant facts and
circumstances to be considered in making the determination whether a
particular condition or restriction imposed upon a transfer of assets is
material within the meaning of
[[Page 107]]
this paragraph (a)(7) is whether, and the extent to which, the governing
body is organized and operated so as to be independent from the
transferor. In turn, the determination as to such factor must be
determined from all of the facts and circumstances. Some of the more
significant facts and circumstances to be considered in making such a
determination are--
(A) Whether, and to what extent, members of the governing body are
comprised of persons selected by the transferor private foundation or
disqualified persons with respect thereto or are themselves such
disqualified persons;
(B) Whether, and to what extent, members of the governing body are
selected by public officials acting in their capacities as such; and
(C) How long a period of time each member of the governing body may
serve in such capacity. In the case of a transfer that is to a community
trust, the community trust shall meet this paragraph (a)(7)(ii)(C) if--
(1) Its governing body is comprised of members who may serve a
period of not more than ten consecutive years; and
(2) Upon completion of a period of service (beginning before or
after the date of transfer), no member may serve again within a period
consisting of the lesser of five years or the number of consecutive
years the member has immediately completed serving.
(iii) Factors not adversely affecting determination. The presence of
some or all of the following factors will not be considered as
preventing the transferee ``from freely and effectively employing the
transferred assets, or the income derived therefrom, in furtherance of
its exempt purposes'' (within the meaning of paragraph (a)(7)(i) of this
section):
(A) Name. The fund is given a name or other designation which is the
same as or similar to that of the transferor private foundation or
otherwise memorializes the creator of the foundation or his family.
(B) Purpose. The income and assets of the fund are to be used for a
designated purpose or for one or more particular section 509(a)(1),
section 509(a)(2), or section 509(a)(3) organization, and such use is
consistent with the charitable, educational, or other basis for the
exempt status of the public charity under section 501(c)(3).
(C) Administration. The transferred assets are administered in an
identifiable or separate fund, some or all of the principal of which is
not to be distributed for a specified period, if the public charity
(including a participating trustee, custodian, or agent in the case of a
community trust) is the legal and equitable owner of the fund and the
governing body exercises ultimate and direct authority and control over
such fund, as, for example, a fund to endow a chair at a university or a
medical research fund at a hospital. In the case of a community trust,
the transferred assets must be administered in or as a component part of
the community trust within the meaning of Sec. 1.170A-9(f)(11).
(D) Restrictions on disposition. The transferor private foundation
transfers property the continued retention of which by the transferee is
required by the transferor if such retention is important to the
achievement of charitable or other similar purposes in the community
because of the peculiar features of such property, as, for example,
where a private foundation transfers a woodland preserve which is to be
maintained by the public charity as an arboretum for the benefit of the
community. Such a restriction does not include a restriction on the
disposition of an investment asset or the distribution of income.
(iv) Adverse factors. The presence of any of the following factors
will be considered as preventing the transferee ``from freely and
effectively employing the transferred assets, or the income derived
therefrom, in furtherance of its exempt purposes'' (within the meaning
of paragraph (a)(7)(i) of this section):
(A) Distributions. (1) With respect to distributions made after
April 19, 1977, the transferor private foundation, a disqualified person
with respect thereto, or any person or committee designated by, or
pursuant to the terms of an agreement with, such a person (hereinafter
referred to as donor), reserves the right, directly or indirectly, to
name (other than by designation in the instrument of transfer of
particular section 509(a)(1), section 509(a)(2), or
[[Page 108]]
section 509(a)(3) organizations) the persons to which the transferee
public charity must distribute, or to direct the timing of such
distributions (other than by direction in the instrument of transfer
that some or all of the principal, as opposed to specific assets, not be
distributed for a specified period) as, for example, by a power of
appointment. The IRS will examine carefully whether the seeking of
advice by the transferee from, or the giving of advice by, any donor
after the assets have been transferred to the transferee constitutes an
indirect reservation of a right to direct such distributions. In any
such case, the reservation of such a right will be considered to exist
where the only criterion considered by the public charity in making a
distribution of income or principal from a donor's fund is advice
offered by the donor. Whether there is a reservation of such a right
will be determined from all of the facts and circumstances, including,
but not limited to, the factors contained in paragraphs (a)(7)(iv)(A)(2)
and (a)(7)(iv)(A)(3) of this section.
(2) The presence of some or all of the following factors will
indicate that the reservation of a right to direct distributions does
not exist:
(i) There has been an independent investigation by the staff of the
public charity evaluating whether the donor's advice is consistent with
specific charitable needs most deserving of support by the public
charity (as determined by the public charity).
(ii) The public charity has promulgated guidelines enumerating
specific charitable needs consistent with the charitable purposes of the
public charity and the donor's advice is consistent with such
guidelines.
(iii) The public charity has instituted an educational program
publicizing to donors and other persons the guidelines enumerating
specific charitable needs consistent with the charitable purposes of the
public charity.
(iv) The public charity distributes funds in excess of amounts
distributed from the donor's fund to the same or similar types of
organizations or charitable needs as those recommended by the donor.
(v) The public charity's solicitations (written or oral) for funds
specifically state that such public charity will not be bound by advice
offered by the donor.
(3) The presence of some or all of the following factors will
indicate the reservation of a right to direct distributions does exist:
(i) The solicitations (written or oral) of funds by the public
charity state or imply, or a pattern of conduct on the part of the
public charity creates an expectation, that the donor's advice will be
followed.
(ii) The advice of a donor (whether or not restricted to a
distribution of income or principal from the donor's trust or fund) is
limited to distributions of amounts from the donor's fund, and the
factors described in paragraph (a)(7)(iv)(A)(2)(i) or paragraph
(a)(7)(iv)(A)(2)(ii) of this section are not present.
(iii) Only the advice of the donor as to distributions of such
donor's fund is solicited by the public charity and no procedure is
provided for considering advice from persons other than the donor with
respect to such fund.
(iv) For the taxable year and all prior taxable years the public
charity follows the advice of all donors with respect to their funds
substantially all of the time.
(B) Other action or withholding of action. The terms of the transfer
agreement, or any expressed or implied understanding, required the
public charity to take or withhold action with respect to the
transferred assets which is not designed to further one or more of the
exempt purposes of the public charity, and such action or withholding of
action would, if performed by the transferor private foundation with
respect to such assets, have subjected the transferor to tax under
Chapter 42 (other than with respect to the minimum investment return
requirement of section 4942(e)).
(C) Assumption of leases, contractual obligations, or liabilities.
The public charity assumes leases, contractual obligations, or
liabilities of the transferor private foundation, or takes the assets
thereof subject to such liabilities (including obligations under
commitments or pledges to donees of the transferor private foundation),
for purposes inconsistent with the purposes or
[[Page 109]]
best interests of the public charity, other than the payment of the
transferor's Chapter 42 taxes incurred prior to the transfer to the
public charity to the extent of the value of the assets transferred.
(D) Retention of investment assets. The transferee public charity is
required by any restriction or agreement (other than a restriction or
agreement imposed or required by law or regulatory authority), express
or implied, to retain any securities or other investment assets
transferred to it by the private foundation. In a case where such
transferred assets consistently produce a low annual return of income,
the IRS will examine carefully whether the transferee is required by any
such restriction or agreement to retain such assets.
(E) Right of first refusal. An agreement is entered into in
connection with the transfer of securities or other property which
grants directly or indirectly to the transferor private foundation or
any disqualified person with respect thereto a right of first refusal
with respect to the transferred securities or other property when and if
disposed of by the public charity, unless such securities or other
property was acquired by the transferor private foundation subject to
such right of first refusal prior to October 9, 1969.
(F) Relationships. An agreement is entered into between the
transferor private foundation and the transferee public charity which
establishes irrevocable relationships with respect to the maintenance or
management of assets transferred to the public charity, such as
continuing relationships with banks, brokerage firms, investment
counselors, or other advisors with regard to the investments or other
property transferred to the public charity (other than a relationship
with a trustee, custodian, or agent for a community trust acting as
such). The transfer of property to a public charity subject to
contractual obligations which were established prior to November 11,
1976, between the transferor private foundation and persons other than
disqualified persons with respect to such foundation will not be treated
as prohibited under the preceding sentence, but only if such contractual
obligations were not entered into pursuant to a plan to terminate the
private foundation status of the transferor under section 507(b)(1)(A)
and if the continuation of such contractual obligations is in the best
interests of the public charity.
(G) Other conditions. Any other condition is imposed on action by
the public charity which prevents it from exercising ultimate control
over the assets received from the transferor private foundation for
purposes consistent with its exempt purposes.
(v) Examples. The provisions of this paragraph (a)(7) may be
illustrated by the following examples:
Example 1. The M Private Foundation transferred all of its net
assets to the V Cancer Institute, a public charity described in section
170(b)(1)(A)(iii). Prior to the transfer, M's activities consisted of
making grants to hospitals and universities to further research into the
causes of cancer. Under the terms of the transfer, V is required to keep
M's assets in a separate fund and use the income and principal to
further cancer research. Although the assets may be used only for a
limited purpose, this purpose is consistent with and in furtherance of
V's exempt purposes, and does not prevent the transfer from being a
distribution for purposes of section 507(b)(1)(A).
Example 2. The N Private Foundation transferred all of its net
assets to W University, a public charity described in section
170(b)(1)(A)(ii). Under the terms of the transfer, W is required to use
the income and principal to endow a chair at the university to be known
as the ``John J. Doe Memorial Professorship,'' named after N's creator.
Although the transferred assets are to be used for a specified purpose
by W, this purpose is in furtherance of W's exempt educational purposes,
and there are no conditions on investment or reinvestment of the
principal or income. The use of the name of the foundation's creator for
the chair is not a restriction which would prevent the transfer from
being a distribution for purposes of section 507(b)(1)(A).
Example 3. The O Private Foundation transferred all of its net
assets to X Bank as trustee for the Q Community Trust, a community trust
that is a public charity described in section 170(b)(1)(A)(vi). Under
the terms of the transfer, X is to hold the assets in trust for Q and is
directed to distribute the income annually to the Y Church, a public
charity described in section 170(b)(1)(A)(i). The distribution of income
to Y Church is consistent with Q's exempt purposes. If the trust created
by this transfer otherwise meets the requirements of Sec. 1.170A-
[[Page 110]]
9(f)(11) as a component part of the Q Community Trust, the assets
transferred by O to X will be treated as distributed to one or more
public charities within the meaning of section 507(b)(1)(A). The
direction to distribute the income to Y Church meets the conditions of
paragraph (a)(7)(iii)(B) of this section and will therefore not
disqualify the transfer under section 507(b)(1)(A).
Example 4. (i) The P Private Foundation transferred all of its net
assets to Z Bank as trustee for the R Community Trust, a community trust
that is a public charity described in section 170(b)(1)(A)(vi). Under
the terms of the transfer, Z is to hold the assets in trust for R and
distribute the income to those public charities described in section
170(b)(1)(A)(i) through (b)(1)(A)(vi) that are designated by B, the
creator of P. R's governing body has no authority during B's lifetime to
vary B's direction. Under the terms of the transfer, it is intended that
Z retain the transferred assets in their present form for a period of 20
years, or until the date of B's death if it occurs before the expiration
of such period. Upon the death of B, R will have the power to distribute
the income to such public charities as it selects and may dispose of the
corpus as it sees fit.
(ii) Under paragraph (a)(7)(iv)(A) or paragraph (a)(7)(iv)(D) of
this section, as a result of the restrictions imposed with respect to
the transferred assets, there has been no distribution of all P's net
assets within the meaning of section 507(b)(1)(A) at the time of the
transfer. In addition, P has not transferred its net assets to a
component part of R Community Trust, but rather to a separate trust
described in Sec. 1.170A-9(f)(12).
(b) Operation as a public charity--(1) In general. Under section
507(b)(1)(B), an organization can terminate its private foundation
status if the organization--
(i) Meets the requirements of section 509(a)(1), section 509(a)(2)
or section 509(a)(3) for a continuous period of 60 calendar months
beginning with the first day of any taxable year that begins after
December 31, 1969;
(ii) In compliance with section 507(b)(1)(B)(ii) and paragraph
(b)(3) of this section, properly notifies the IRS, in such manner as may
be provided by published guidance, publication, form or instructions,
before the commencement of such 60-month period, that it is terminating
its private foundation status; and
(iii) Properly establishes immediately after the expiration of such
60-month period that such organization has complied with the
requirements of section 509(a)(1), section 509(a)(2) or section
509(a)(3) during the 60-month period, in the manner described in
paragraph (b)(4) of this section.
(2) Relationship of section 507(b)(1)(B) to sections 507(a), 507(c),
and 507(g). Because section 507(a) does not apply to a termination
described in section 507(b)(1)(B), a private foundation's notification
that it is commencing a termination pursuant to section 507(b)(1)(B)
will not be treated as a notification described in section 507(a) even
if the private foundation does not successfully terminate its private
foundation status pursuant to section 507(b)(1)(B). A private foundation
that terminates its private foundation status under section 507(b)(1)(B)
does not incur tax under section 507(c) and, therefore, no abatement of
such tax under section 507(g) is required.
(3) Notification of termination. In order to comply with the
requirements under section 507(b)(1)(B)(ii), an organization shall
before the commencement of the 60-month period under section
507(b)(1)(B)(i) notify the IRS, in such manner as may be provided by
published guidance, publication, form or instructions, of its intention
to terminate its private foundation status. Such notification shall
contain the following information--
(i) The name and address of the private foundation;
(ii) Its intention to terminate its private foundation status;
(iii) The Code section under which it seeks classification (section
509(a)(1), section 509(a)(2) or section 509(a)(3));
(iv) If section 509(a)(1) is applicable, the clause of section
170(b)(1)(A) involved;
(v) The date its regular taxable year begins; and
(vi) The date of commencement of the 60-month period.
(4) Establishment of termination. In order to comply with the
requirements under section 507(b)(1)(B)(iii), an organization shall
within 90 days after the expiration of the 60-month period file such
information with the IRS, in such manner as may be provided by published
guidance, publication, form or instructions, as is necessary to make a
determination as to the organization's status as an organization
described
[[Page 111]]
under section 509(a)(1), section 509(a)(2) or section 509(a)(3) and the
related regulations. See paragraph (c) of this section as to the
information required to be submitted under this paragraph (b)(4).
(5) Incomplete information. The failure to supply, within the
required time, all of the information required by paragraph (b)(3) or
paragraph (b)(4) of this section is not alone sufficient to constitute a
failure to satisfy the requirements of section 507(b)(1)(B). If the
information that is submitted within the required time is incomplete and
the organization supplies the necessary additional information at the
request of the Commissioner within the additional time period allowed by
him, the original submission will be considered timely.
(6) Application of special rules and filing requirements. An
organization that has terminated its private foundation status under
section 507(b)(1)(B) is not required to comply with the special rules
set forth in sections 508(a) and 508(b). Such organization is also not
required to file a return under the provisions of section 6043(b) by
reason of termination of its private foundation status under the
provisions of section 507(b)(1)(B).
(7) Extension of time to assess deficiencies. If a private
foundation files a notification (described in paragraph (b)(3) of this
section) that it intends to begin a 60-month termination pursuant to
section 507(b)(1)(B) and does not file a request for an advance ruling
pursuant to paragraph (d) of this section, such private foundation may
file with the notification described in paragraph (b)(3) of this section
a consent under section 6501(c)(4) to the effect that the period of
limitation upon assessment under section 4940 for any taxable year
within the 60-month termination period shall not expire prior to one
year after the date of expiration of the time prescribed by law for the
assessment of a deficiency for the last taxable year within the 60-month
period. Such consents, if filed, will ordinarily be accepted by the
Commissioner. See paragraph (e)(3) of this section for an illustration
of the procedure required to obtain a refund of the tax imposed by
section 4940 in a case where such a consent is not in effect.
(c) Sixty-month terminations--(1) Method of determining normal
sources of support. (i) In order to meet the requirements of section
507(b)(1)(B) for the 60-month termination period as a section 509(a)(1)
or section 509(a)(2) organization, an organization must meet the
requirements of section 509(a)(1) or section 509(a)(2), as the case may
be, for a continuous period of at least 60 calendar months. In
determining whether an organization seeking status under section
509(a)(1) as an organization described in section 170(b)(1)(A)(iv) or
section 170(b)(1)(A)(vi) or under section 509(a)(2) normally meets the
requirements set forth under such sections, support received in taxable
years prior to the commencement of the 60-month period shall not be
taken into consideration, except as otherwise provided in this section.
(ii) For purposes of section 507(b)(1)(B), an organization will be
considered to be a section 509(a)(1) organization described in section
170(b)(1)(A)(vi) for a continuous period of 60 calendar months only if
the organization satisfies the provisions of Sec. 1.170A-9(f), other
than Sec. 1.170A-9(f)(4)(v), based upon aggregate data for such entire
period. The calculation of public support shall be made over the period
beginning with the date of the commencement of the 60-month period, and
ending with the last day of the 60-month period.
(iii) For purposes of section 507(b)(1)(B), an organization will be
considered to be a section 509(a)(2) organization only if such
organization meets the support requirements set forth in sections
509(a)(2)(A) and 509(a)(2)(B) and the related regulations, other than
Sec. 1.509(a)-3(d), for the continuous period of 60 calendar months
prescribed under section 507(b)(1)(B). The calculation of public support
shall be made over the period beginning with the date of the
commencement of the 60-month period, and ending with the last day of the
60-month period.
(2) Organizational and operational tests. In order to meet the
requirements of section 507(b)(1)(B) for the 60-month termination period
as an organization described in section 170(b)(1)(A)(i),
[[Page 112]]
170(b)(1)(A)(ii), 170(b)(1)(A)(iii), 170(b)(1)(A)(iv), or
170(b)(1)(A)(v) or section 509(a)(3), as the case may be, an
organization must meet the requirements of the applicable provisions for
a continuous period of at least 60 calendar months. For purposes of
section 507(b)(1)(B), an organization will be considered to be such an
organization only if it satisfies the requirements of the applicable
provision (including with respect to section 509(a)(3), the
organizational and operational test set forth in section 509(a)(3)(A))
at the commencement of such 60-month period and continuously thereafter
during such period.
(d) Advance rulings for 60-month terminations--(1) In general. An
organization that files the notification required by section
507(b)(1)(B)(ii) that it is commencing a 60-month termination may obtain
an advance ruling from the Commissioner that it can be expected to
satisfy the requirements of section 507(b)(1)(B)(i) during the 60-month
period. Such an advance ruling may be issued if the organization can
reasonably be expected to meet the requirements of section
507(b)(1)(B)(i) during the 60-month period. The issuance of a ruling
will be discretionary with the Commissioner.
(2) Basic consideration. In determining whether an organization can
reasonably be expected (within the meaning of paragraph (d)(1) of this
section) to meet the requirements of section 507(b)(1)(B)(i) for the 60-
month period, the basic consideration is whether its organizational
structure (taking into account any revisions made prior to the beginning
of the 60-month period), current or proposed programs or activities,
actual or intended method of operation, and current or projected sources
of support are such as to indicate that the organization is likely to
satisfy the requirements of section 509(a)(1), section 509(a)(2), or
section 509(a)(3) and paragraph (c) of this section during the 60-month
period. In making such a determination, all pertinent facts and
circumstances shall be considered.
(3) Reliance by grantors and contributors. For purposes of sections
170, 545(b)(2), 642(c), 4942, 4945, 4966, 2055, 2106(a)(2), and 2522,
grants or contributions to an organization which has obtained a ruling
referred to in this paragraph will be treated as made to an organization
described in section 509(a)(1), section 509(a)(2), or section 509(a)(3),
as the case may be, until the IRS publishes notice that such advance
ruling is being revoked (such as by publication in the Internal Revenue
Bulletin). However, a grantor or contributor may not rely on such an
advance ruling if the grantor or contributor was responsible for, or
aware of, the act or failure to act that resulted in the organization's
failure to meet the requirements of section 509(a)(1), section
509(a)(2), or section 509(a)(3), or acquired knowledge that the IRS had
given notice to such organization that its advance ruling would be
revoked. Prior to the making of any grant or contribution which
allegedly will not result in the grantee's failure to meet the
requirements of section 509(a)(1), section 509(a)(2), or section
509(a)(3), a potential grantee organization may request a ruling whether
such grant or contribution may be made without such failure. A request
for such ruling may be filed by the grantee organization with the IRS.
The issuance of such ruling 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 (d)(2) of
this section. If a favorable ruling is issued, such ruling 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.
(4) Reliance by organization. An organization obtaining an advance
ruling pursuant to this paragraph cannot rely on such a ruling.
Consequently, if the organization does not pay the tax imposed by
section 4940 for any taxable year or years during the 60-month period,
and it is subsequently determined that such tax is due for such year or
years (because the organization did not in fact complete a successful
termination pursuant to section 507(b)(1)(B) and was not treated as an
organization described in section 509(a)(1), section 509(a)(2), or
section 509(a)(3) for such
[[Page 113]]
year or years), the organization is liable for interest in accordance
with section 6601 if any amount of tax under section 4940 has not been
paid on or before the last date prescribed for payment. However, because
any failure to pay such tax during the 60-month period (or prior to the
revocation of such ruling) is due to reasonable cause, the penalty under
section 6651 with respect to the tax imposed by section 4940 shall not
apply.
(5) Extension of time to assess deficiencies. The advance ruling
described in paragraph (d)(1) of this section shall be issued only if
such organization's request for an advance ruling is filed with a
consent under section 6501(c)(4) to the effect that the period of
limitations upon assessment under section 4940 for any taxable year
within the advance ruling period shall not expire prior to one year
after the date of the expiration of the time prescribed by law for the
assessment of a deficiency for the last taxable year within the 60-month
period.
(e) Effect on grantors or contributors and on the organization
itself--(1) Effect of satisfaction of requirements for termination;
treatment during the termination period. In the event that an
organization satisfies the requirements of section 507(b)(1)(B) for
termination of its private foundation status during the continuous 60-
month period, such organization shall be treated for such entire 60-
month period in the same manner as an organization described in section
509(a)(1), section 509(a)(2), or section 509(a)(3), as the case may be.
(2) Failure to meet termination requirements--(i) In general. Except
as otherwise provided in paragraphs (d) and (e)(2)(ii) of this section,
any organization that fails to satisfy the requirements of section
507(b)(1)(B) for termination of its private foundation status during the
continuous 60-month period shall be treated as a private foundation for
the entire 60-month period, for purposes of sections 507 through 509 and
Chapter 42, and grants or contributions to such an organization shall be
treated as made to a private foundation for purposes of sections 170,
507(b)(1)(A), 4942, and 4945.
(ii) Certain 60-month terminations. Notwithstanding paragraph
(e)(2)(i) of this section, if an organization fails to satisfy the
requirements of section 509(a)(1), section 509(a)(2), or section
509(a)(3) for the continuous 60-month period but does satisfy the
requirements of section 509(a)(1), section 509(a)(2), or section
509(a)(3), as the case may be, for any taxable year or years during such
60-month period, the organization shall be treated as a section
509(a)(1), section 509(a)(2), or section 509(a)(3) organization for such
taxable year or years, and grants or contributions made during such
taxable year or years shall be treated as made to an organization
described in section 509(a)(1), section 509(a)(2), or section 509(a)(3).
In addition, sections 507 through 509 and Chapter 42 shall not apply to
such organization for any taxable year within such 60-month period for
which it does meet such requirements. For purposes of determining
whether an organization satisfies the requirements of section 509(a)(1),
section 509(a)(2), or section 509(a)(3) for any taxable year in the 60-
month period, the calculation of public support shall be made over the
period beginning with the date of the commencement of the 60-month
period, and ending with the last day of the taxable year being tested.
The organization shall not be treated as a section 509(a)(1) or section
509(a)(2) organization for any taxable year during the 60-month period
solely by reason of having met a public support test for the preceding
year. In addition, the transition rules in Sec. Sec. 1.170-
9(f)(14)(iii) and 1.509(a)-3(n)(iii) shall not apply.
(iii) Aggregate tax benefit. For purposes of section 507(d), the
organization's aggregate tax benefit resulting from the organization's
section 501(c)(3) status shall continue to be computed from the date
from which such computation would have been made, but for the notice
filed under section 507(b)(1)(B)(ii), except that any taxable year
within such 60-month period for which such organization meets the
requirements of section 509(a)(1), section 509(a)(2), or section
509(a)(3) shall be excluded from such computations.
(iv) Excess business holdings. See section 4943 and the related
regulations
[[Page 114]]
for rules relating to decreases in a private foundation's holdings in a
business enterprise which are caused by the foundation's failure to
terminate its private foundation status after giving the notification
for termination under section 507(b)(1)(B)(ii).
(3) Example. The provisions of this paragraph (e) may be illustrated
by the following example:
Example 1. Y, a calendar year private foundation, notifies the IRS
that it intends to terminate its private foundation status by converting
into a publicly supported organization described in section
170(b)(1)(A)(vi) and that its 60-month termination period will commence
on January 1, 2010. Y does not obtain a ruling described in paragraph
(d) of this section. Based upon its support for 2010, Y does not qualify
as a publicly supported organization within the meaning of Sec. 1.170A-
9(f) and this paragraph for 2010. Consequently, in order to avoid the
risks of penalties and interest if Y fails to terminate within the 60-
month period, Y files its 2010 return as a private foundation and pays
the tax imposed by section 4940. Because a consent (described in
paragraph (b)(7) of this section), which would prevent the period of
limitations for all years in the 60-month period from expiring, is not
in effect, in order to be able to file a claim for refund, Y and the IRS
must agree to extend the period of limitation for all taxes imposed
under Chapter 42 for 2010. Based on the aggregate data for the entire
60-month period (2010 through 2014), Y does qualify as a publicly-
supported organization for the entire 60-month period. Consequently, Y
is treated as a publicly-supported organization for the entire 60-month
period. Y files a claim for refund for the taxes paid under section 4940
for 2010, and such taxes are refunded.
(f) Effective/applicability date--(1) Effective date. These
regulations are effective on September 8, 2011.
(2) Applicability date. The regulations in this section shall apply
to tax years beginning on or after January 1, 2008. For taxable years
beginning after December 31, 1969, and beginning before January 1, 2008,
see Sec. 1.507-2 (as contained in 26 CFR part 1 revised April 1, 2008).
[T.D. 9549, 76 FR 55760, Sept. 8, 2011]
Sec. 1.507-3 Special rules; transferee foundations.
(a) General rule. (1) For purposes of part II, subchapter F, chapter
1 of the Code, in the case of a transfer of assets of any private
foundation to another private foundation pursuant to any liquidation,
merger, redemption, recapitalization, or other adjustment, organization,
or reorganization, the transferee organization shall not be treated as a
newly created organization. Thus, in the case of a significant
disposition of assets to one or more private foundations within the
meaning of paragraph (c) of this section, the transferee organization
shall not be treated as a newly created organization. A transferee
organization to which this paragraph applies shall be treated as
possessing those attributes and characteristics of the transferor
organization which are described in subparagraphs (2), (3), and (4) of
this paragraph.
(2)(i) A transferee organization to which this paragraph applies
shall succeed to the aggregate tax benefit of the transferor
organization in an amount determined as follows: Such amount shall be an
amount equal to the amount of such aggregate tax benefit multiplied by a
fraction the numerator of which is the fair market value of the assets
(less encumbrances) transferred to such transferee and the denominator
of which is the fair market value of the assets of the transferor (less
encumbrances) immediately before the transfer. Fair market value shall
be determined as of the time of the transfer.
(ii) Notwithstanding subdivision (i) of this subparagraph, a
transferee organization which is not effectively controlled (within the
meaning of Sec. 1.482-1(a)(3)), directly or indirectly, by the same
person or persons who effectively control the transferor organization
shall not succeed to an aggregate tax benefit in excess of the fair
market value of the assets transferred at the time of the transfer.
(iii) This subparagraph may be illustrated by the following
examples:
Example 1. Pursuant to a transfer described in section 507(b)(2), F,
a private foundation, transfers to G, a private foundation, all of its
assets, which have a fair market value of $400,000. Immediately before
the transfer F's aggregate tax benefit was $200,000, and G's aggregate
tax benefit was $300,000. After the transfer G's aggregate tax benefit
is $500,000 ($200,000 + $300,000).
Example 2. Pursuant to a transfer described in section 507(b)(2), M,
a private foundation, transfers all of its assets, which immediately
prior to the transfer have a fair market
[[Page 115]]
value of $100,000. The assets were transferred to the following
organizations at the following fair market values (determined at the
time of transfer) $40,000 to N, a private foundation, $30,000 to O, a
private foundation, and $30,000 to P, an organization described in
section 170(b)(1)(A)(vi). Immediately before the transfer M's aggregate
tax benefit was $50,000. Therefore, N succeeds to M's aggregate tax
benefit to the extent of $20,000 ($50,000 x $40,000/$100,000) and O
succeeds to M's aggregate tax benefit to the extent of $15,000 ($50,000
x $30,000/$100,000). The remaining $15,000 of M's aggregate tax benefit
is retained by M as M has not terminated under section 507.
Example 3. Assume the same facts as in Example 2 except that the
transfers were made as follows: M transferred $30,000 to N on January 1,
1972, $40,000 to P on July 1, 1972, and $30,000 to O on December 31,
1972. Further, assume that the fair market value of the assets and the
aggregate tax benefit do not change during 1972 and that O is not
effectively controlled (directly or indirectly) by the same person or
persons who effectively control M. N succeeds to M's aggregate tax
benefit to the extent of $15,000 ($50,000 x $30,000/$100,000). However,
since $40,000 of the remaining $70,000 ($100,000-$30,000) of assets of M
was transferred to P on July 1, 1972, immediately before the transfer to
O, the fair market value of the assets held by M is $30,000 ($70,000-
$40,000). On the other hand, because P is not a private foundation, M's
aggregate tax benefit immediately before the transfer to O remains
$35,000 ($50,000-$15,000). Therefore, before applying subdivision (ii)
of this subparagraph, O would succeed to $35,000 ($35,000 x $30,000/
$30,000) of M's aggregate tax benefit. However, applying subdivision
(ii) of this subparagraph since M transferred only $30,000 to O, O shall
succeed to only $30,000 of M's aggregate tax benefit. The remaining
$5,000 ($35,000-$30,000) of M's aggregate tax benefit is retained by M
as M has not terminated under section 507.
(3) For purposes of section 507(d)(2), in the event of a transfer of
assets described in section 507(b)(2), any person who is a substantial
contributor (within the meaning of section 507(d)(2)) with respect to
the transferor foundation shall be treated as a substantial contributor
with respect to the transferee foundation, regardless of whether such
person meets the $5,000-two percent test with respect to the transferee
organization at any time. If a private foundation makes a transfer
described in section 507(b)(2) to two or more transferee private
foundations, any person who is a substantial contributor with respect to
the transferor foundation prior to such transfer shall be considered a
substantial contributor with respect to each transferee private
foundation.
(4) If a private foundation incurs liability for one or more of the
taxes imposed under chapter 42 (or any penalty resulting therefrom)
prior to, or as a result of, making a transfer of assets described in
section 507(b)(2) to one or more private foundations, in any case where
transferee liability applies each transferee foundation shall be treated
as receiving the transferred assets subject to such liability to the
extent that the transferor foundation does not satisfy such liability.
(5) Except as provided in subparagraph (9) of this paragraph, a
private foundation is required to meet the distribution requirements of
section 4942 for any taxable year in which it makes a section 507(b)(2)
transfer of all or part of its net assets to another private foundation.
Such transfer shall itself be counted toward satisfaction of such
requirements to the extent the amount transferred meets the requirements
of section 4942(g). However, where the transferor has disposed of all of
its assets, the recordkeeping requirements of section 4942(g)(3)(B)
shall not apply during any period in which it has no assets. Such
requirements are applicable for any taxable year other than a taxable
year during which the transferor has no assets.
(6) For purposes of section 4943(c) (4), (5), and (6), whenever a
private foundation makes a section 507(b)(2) transfer of all or part of
its net assets to another private foundation, the applicable period of
time described in section 4943(c) (4), (5), or (6) shall include both
the period during which the transferor foundation held such assets and
the period during which the transferee foundation holds such assets.
(7) Except as provided in subparagraph (9) of this paragraph, where
the transferor has disposed of all of its assets, during any period in
which the transferor has no assets, section 4945 (d)(4) and (h) shall
not apply to the transferee or the transferor with respect to any
expenditure responsibility grants made by the transferor. However, the
exception contained in this
[[Page 116]]
subparagraph shall not apply with respect to any information reporting
requirements imposed by section 4945 and the regulations thereunder for
any year in which any such transfer is made.
(8)(i) Except as provided in subdivision (ii) of this subparagraph
or subparagraph (6) or (9) of this paragraph or whenever a private
foundation makes a transfer of assets described in section 507(b)(2) to
one or more private foundations, the transferee foundation:
(a) Will not be treated as being in existence prior to January 1,
1970, with respect to any transferred assets;
(b) Will not be treated as holding the transferred assets prior to
January 1, 1970; and
(c) Will not be treated as having engaged in, or become subject to,
any transaction, lease, contract, or other obligation with respect to
the transferred assets prior to January 1, 1970.
(ii) Notwithstanding subdivision (i) of this subparagraph, the
provisions enumerated in (a) through (g) of this subdivision shall apply
to the transferee foundation with respect to the assets transferred to
the same extent and in the same manner that they would have applied to
the transferor foundation had the transfer described in section
507(b)(2) not been effected:
(a) Section 4940(c)(4)(B) and the regulations thereunder with
respect to basis of property,
(b) Section 4942(f)(4) and the regulations thereunder with respect
to distributions of income,
(c) Section 101(l)(2) of the Tax Reform Act of 1969 (83 Stat. 533),
as amended by sections 1301 and 1309 of the Tax Reform Act of 1976 (90
Stat. 1713, 1729), with respect to the provisions of section 4941,
(d) Section 101(l)(3)(A) of the Tax Reform Act of 1969 (83 Stat.
534) with respect to the provisions of section 4942, but only if the
transferor qualified for the application of such section immediately
before the transfer, and at least 85 percent of the fair market value of
the net assets of the transferee immediately after the transfer was
received pursuant to the transfer,
(e) Section 101(l)(3) (B) through (E) of the Tax Reform Act of 1969
(83 Stat. 534) with respect to the provisions of section 4942,
(f) Section 101(l)(5) of the Tax Reform Act of 1969 (83 Stat. 535)
with respect to the provisions of section 4945, and
(g) Section 101(l)(6) of the Tax Reform Act of 1969 (83 Stat. 535)
with respect to the provisions of section 508(e).
(9) (i) If a private foundation transfers all of its net assets to
one or more private foundations which are effectively controlled (within
the meaning of Sec. 1.482-1(a)(3)), directly or indirectly, by the same
person or persons which effectively controlled the transferor private
foundation, for purposes of chapter 42 (section 4940 et seq.) and part
II of subchapter F of chapter 1 of the Code (sections 507 through 509)
such a transferee private foundation shall be treated as if it were the
transferor. However, where proportionality is appropriate, such a
transferee private foundation shall be treated as if it were the
transferor in the proportion which the fair market value of the assets
(less encumbrances) transferred to such transferee bears to the fair
market value of the assets (less encumbrances) of the transferor
immediately before the transfer.
(ii) Subdivision (i) of this subparagraph shall not apply to the
requirements under sections 6033, 6056, and 6104 which must be complied
with by the transferor private foundation, nor to the requirement under
section 6043 that the transferor file a return with respect to its
liquidation, dissolution, or termination.
(iii) This subparagraph may be illustrated by the following
examples:
Example 1. The trustees of X charitable trust, a private foundation,
form the Y charitable corporation, also a private foundation, in order
to facilitate the conduct of their activities. The trustees of X are
also the directors of Y. Y has the same charitable purposes as X. All of
the assets of X are transferred to Y, and Y continues to carry on X's
charitable activities. Under such circumstances, Y shall be treated as
if it were X for the purposes of subdivision (i) of this subparagraph.
Thus, for example, Y will be permitted to take advantage of any special
rules or savings provisions with respect to chapter 42 to the same
extent as X could have if X had continued in existence.
Example 2. A and B are the trustees of the P charitable trust, a
private foundation, and are the only substantial contributors to P.
[[Page 117]]
On July 1, 1973, in order to facilitate accomplishment of diverse
charitable purposes, A and B create and control the R Foundation, the S
Foundation and the T Foundation and transfer the net assets of P to R,
S, and T. As of the end of 1973, P has an outstanding grant to
Foundation W and has been required to exercise expenditure
responsibility with respect to this grant under sections 4945 (d)(4) and
(h). Under these circumstances, R, S, and T shall each be treated as if
they are P in the proportion the fair market value of the assets
transferred to each bears to the fair market value of the assets of P
immediately before the transfer. Since R, S, and T are treated as P,
absent a specific provision for exercising expenditure responsibility
with respect to the grant to W, each of them is required to exercise
expenditure responsibility with respect to such grant. If, as a part of
the transfer to R, P assigned, and R assumed, P's duties with respect to
the expenditure responsibility grant to W, only R would be required to
exercise expenditure responsibility with respect to the grant to W.
Since R, S, and T are treated as P rather than as recipients of
expenditure responsibility grants, there are no expenditure
responsibility requirements which must be exercised under sections 4945
(d)(4) and (h) with respect to the transfers of assets to R, S, and T.
(10) For certain rules relating to filing requirements where a
private foundation has transferred all its net assets, see Sec. 1.507-
1(b)(9).
(b) Status of transferee organization under section 507(b)(2). Since
a transfer of assets pursuant to any liquidation, merger, redemption,
recapitalization, or other adjustment, organization or reorganization to
an organization not described in section 501(c)(3) (other than an
organization described in section 509(a)(4)) or 4947 is a taxable
expenditure under section 4945(d)(5), in order for such a transfer of
assets not to be a taxable expenditure, it must be to an organization
described in section 501(c)(3) (other than an organization described in
section 509(a)(4)) or treated as described in section 501(c)(3) under
section 4947. See Sec. 53.4945-6(c)(3) of this chapter. Consequently,
unless such a transferee is an organization described in section 509(a)
(1), (2), or (3), the transferee is a private foundation and the rules
of section 507(b)(2) and paragraph (a) of this section apply. On the
other hand, if such a transfer of assets is made to a transferee
organization which is not described in either section 501(c)(3) (other
than an organization described in section 509(a)(4)) or 4947, and in
order to correct the making of a taxable expenditure, such assets are
transferred to a private foundation, section 507(b)(2) and paragraph (a)
of this section shall apply as if the transfer of assets had been made
directly to such private foundation.
(c) Section 507(b)(2) transfers. (1) A transfer of assets is
described in section 507(b)(2) if it is made by a private foundation to
another private foundation pursuant to any liquidation, merger,
redemption, recapitalization, or other adjustment, organization, or
reorganization. This shall include any organization or reorganization
described in subchapter C of chapter 1. For purposes of section
507(b)(2), the terms other adjustment, organization, or reorganization
shall include any partial liquidation or any other significant
disposition of assets to one or more private foundations, other than
transfers for full and adequate consideration or distributions out of
current income. For purposes of this paragraph, a distribution out of
current income shall include any distribution described in section
4942(h)(1) (A) and (B).
(2) The term significant disposition of assets to one or more
private foundations shall include any disposition for a taxable year
where the aggregate of:
(i) The dispositions to one or more private foundations for the
taxable year, and
(ii) Where any disposition to one or more private foundations for
the taxable year is part of a series of related dispositions made during
prior taxable years, the total of the related dispositions made during
such prior taxable years, is 25 percent or more of the fair market value
of the net assets of the foundation at the beginning of the taxable year
(in the case of subdivision (i) of this subparagraph) or at the
beginning of the first taxable year in which any of the series of
related dispositions was made (in the case of subdivision (ii) of this
subparagraph). A significant disposition of assets may occur in a single
taxable year (as in subdivision (i) of this subparagraph) or over the
course of two or more taxable years (as in subdivision (ii) of this
subparagraph). The determination whether a significant
[[Page 118]]
disposition has occurred through a series of related distributions
(within the meaning of subdivision (ii) of this subparagraph) will be
made on the basis of all the facts and circumstances of the particular
case. However, if one or more persons who are disqualified persons
(within the meaning of section 4946) with respect to the transferor
private foundation are also disqualified persons with respect to any of
the transferee private foundations, such fact shall be evidence that the
transfer is part of a series of related dispositions (within the meaning
of subdivision (ii) of this subparagraph). In the case of a series of
related dispositions described in subdivision (ii) of this subparagraph,
each transferee private foundation shall (on any date) be subject to the
provisions of section 507(b)(2) (with respect to all such dispositions
made to it on or before such date) to the extent described in paragraphs
(a) and (b) of this section.
(3) A private foundation which fails to meet the requirements of
section 507(b)(1)(A) for a taxable year may be required to file a return
under section 6043(b) by reason of a transfer of assets to one or more
sections 509(a) (1), (2), or (3) organizations. Hence, such filing does
not necessarily mean that a section 507(b)(2) transfer has occurred. See
Sec. 1.6043-3(f)(1).
(4) This paragraph applies to any section 507(b)(2) transfer made by
a private foundation referred to in section 170(b)(1)(E) (i), (ii), or
(iii).
(5) The provisions of this paragraph may be illustrated by the
following examples:
Example 1. M is a private foundation on the calendar year basis. It
has net assets worth $100,000 as of January 1, 1971. In 1971, in
addition to distributions out of current income, M transfers $10,000 to
N, $10,000 to O, and $10,000 to P. N, O, and P are all private
foundations. Under subparagraph (2)(i) of this paragraph, M has made a
significant disposition of its assets in 1971 since M has disposed of
more than 25 percent of its net assets (with respect to the fair market
value of such assets as of January 1, 1971). M has therefore made
section 507(b)(2) transfers within the meaning of this paragraph, and
section 507(b)(2) applies to the transfers made to N, O, and P.
Example 2. U, a tax-exempt private foundation on the calendar year
basis, has net assets worth $100,000 as of January 1, 1971. As part of a
series of related dispositions in 1971 and 1972, U transfers in 1971, in
addition to distributions out of current income, $10,000 to private
foundation X and $10,000 to private foundation Y, and in 1972, in
addition to distributions out of current income, U transfers $10,000 to
private foundation Z. Under subparagraph (2)(ii) of this paragraph, U is
treated as having made a series of related dispositions in 1971 and
1972. The aggregate of the 1972 disposition (under subparagraph (2)(i)
of this paragraph) and the series of related dispositions (under
subparagraph (2)(ii) of this paragraph) is $30,000, which is more than
25 percent of the fair market value of U's net assets as of the
beginning of 1971 ($100,000), the first year in which any such
disposition was made. Thus, U has made a significant disposition of its
assets and has made transfers described in section 507(b)(2). The
provisions of paragraphs (a) and (b) of this section apply to each of
the transferees as of the date on which it received assets from U.
(d) Inapplicability of section 507(a) to section 507(b)(2)
transfers. Unless a private foundation voluntarily gives notice pursuant
to section 507(a)(1), a transfer of assets described in section
507(b)(2) will not constitute a termination of the transferor's private
foundation status under section 507(a)(1). Such transfer must,
nevertheless, satisfy the requirements of any pertinent provisions of
chapter 42. See subparagraphs (5) through (7) of paragraph (a) of this
section. However, if such transfer constitutes an act or failure to act
which is described in section 507(a)(2)(A), then such transfer will be
subject to the provisions of section 507(a)(2) rather than section
507(b)(2). For example, X, a private nonoperating foundation, transfers
all of its net assets to Y, a private operating foundation, in 1971. X
does not file the notice referred to in section 507(a)(1) and the
transfer does not constitute either a willful and flagrant act (or
failure to act), or one of a series of willful repeated acts (or
failures to act), giving rise to liability for tax under chapter 42.
Under these circumstances, the transfer is described in section
507(b)(2) and the provisions of paragraph (a) of this section apply with
respect to Y. The private foundation status of X has not been terminated
under section 507(a).
(e) Transfers to certain section 509(a) (1), (2), or (3)
organizations. If a private
[[Page 119]]
foundation transfers all or part of its assets to one or more
organizations described in section 509(a) (1), (2), or (3) and, within a
period of 3 years from the date of such transfers, one or more of the
transferee organizations lose their section 509(a) (1), (2), or (3)
status and become private foundations, then for purposes of this
section, a transfer of assets within the meaning of paragraph (c) of
this section to such an organization which becomes a private foundation
will be treated as a transfer described in section 507(b)(2), and the
provisions of paragraph (a) of this section shall be treated as applying
to such a transferee organization from the date on which any such
transfer was made to it.
(f) Certain transfers made during section 507(b)(1)(B) terminations.
If:
(1) During the course of the 12-month or 60-month period described
in section 507(b)(1)(B), a private foundation makes one or more
transfers to one or more private foundations;
(2) Such transfers are described in Sec. 1.507-3(c)(1); and
(3) Even though the transferor foundation thereafter meets the
requirements of section 507(b)(1)(B)
then for purposes of this section, the provisions of Sec. 1.507-2(e)
shall not apply with respect to such transfers, and such transfers will
be treated as transfers described in section 507(b)(2) and Sec. 1.507-3
rather than as transfers from an organization described in section
509(a) (1), (2), or (3).
[T.D. 7233, 37 FR 28158, Dec. 21, 1972; 38 FR 3189, Feb. 2, 1973, as
amended by T.D. 7678, 45 FR 12415, Feb. 26, 1980]
Sec. 1.507-4 Imposition of tax.
(a) General rule. Section 507(c) imposes on each organization the
private foundation status of which is terminated under section 507(a) a
tax equal to the lower of:
(1) The amount which such organization substantiates by adequate
records (or other corroborating evidence which may be required by the
Commissioner) as the aggregate tax benefit (as defined in section
507(d)) resulting from the section 501(c)(3) status of such
organization, or
(2) The value of the net assets of such organization.
(b) Transfers not subject to section 507(c). Private foundations
which make transfers described in section 507(b)(1)(A) or (2) are not
subject to the tax imposed under section 507(c) with respect to such
transfers unless the provisions of section 507(a) become applicable. See
Sec. Sec. 1.507-1(b), 1.507-2(a)(6) and 1.507-3(d).
[T.D. 7233, 37 FR 28161, Dec. 21, 1972]
Sec. 1.507-5 Aggregate tax benefit; in general.
(a) General rule. For purposes of section 507(c)(1), the aggregate
tax benefit resulting from the section 501(c)(3) status of any private
foundation is the sum of:
(1) The aggregate increases in tax under chapters 1, 11, and 12 (or
the corresponding provisions of prior law) which would have been imposed
with respect to all substantial contributors to the foundation if
deductions for all contributions made by such contributors to the
foundation after February 28, 1913, had been disallowed,
(2) The aggregate increases in tax under chapter 1 (or the
corresponding provisions of prior law) which would have been imposed
with respect to the income of the private foundation for taxable years
beginning after December 31, 1912, if (i) it had not been exempt from
tax under section 501(a) (or the corresponding provisions of prior law),
and (ii) in the case of a trust, deductions under section 642(c) (or the
corresponding provisions of prior law) had been limited to 20 percent of
the taxable income of the trust (computed without the benefit of section
642(c) but with the benefit of section 170(b)(1)(A)),
(3) The amount succeeded to from transferors under Sec. 1.507-3(a)
and section 507(b)(2), and
(4) Interest on the increases in tax determined under subparagraphs
(1), (2), and (3) of this paragraph from the first date on which each
such increase would have been due and payable to the date on which the
organization ceases to be a private foundation.
(b) Contributions. In computing the amount of the aggregate
increases in tax under subparagraph (1) of this paragraph, all
deductions attributable to a
[[Page 120]]
particular contribution shall be included. For example, if a substantial
contributor has taken deductions under sections 170 and 2522 (or the
corresponding provisions of prior law) with respect to the same
contribution, the amount of each deduction shall be included in the
computations under section 507(d)(1)(A). Accordingly, the aggregate tax
benefit may exceed the fair market value of the property transferred.
[T.D. 7233, 37 FR 28161, Dec. 21, 1972]
Sec. 1.507-6 Substantial contributor defined.
(a) Definition--(1) In general. Except as provided in subparagraph
(2) of this paragraph, the term substantial contributor means, with
respect to a private foundation, any person (within the meaning of
section 7701(a)(1)), whether or not exempt from taxation under section
501(a), who contributed or bequeathed an aggregate amount of more than
$5,000 to the private foundation, if such amount is more than 2 percent
of the total contributions and bequests received by the private
foundation before the close of the taxable year of the private
foundation in which a contribution or bequest is received by the
foundation from such person. In the case of a trust, the term
substantial contributor also means the creator of the trust. Such term
does not include a governmental unit described in section 170(c)(1).
(2) Special rules. For purposes of sections 170(b)(1)(E)(iii),
507(d)(1), 508(d), 509(a) (1) and (3), and chapter 42, the term
substantial contributor shall not include an organization which is
described in section 509(a) (1), (2), or (3) or any other organization
which is wholly owned by such section 509(a) (1), (2), or (3)
organization. Furthermore, taking section 4941 (relating to taxes on
self-dealing) in context, it would unduly restrict the activities of
private foundations if the term substantial contributor were to include
any section 501(c)(3) organizations. It was not intended, for example,
that a large grant for charitable purposes from one private foundation
to another world forever preclude the latter from making any grants to,
or otherwise dealing with, the former. Accordingly, for purposes of
section 4941 only, the term substantial contributor shall not only
include any organization which is described in section 501(c)(3) (other
than an organization described in section 509(a)(4)).
(b) Determination of substantial contributor--(1) In general. In
determining under paragraph (a) of this section whether the aggregate of
contributions and bequests from a person exceeds 2 percent of the total
contributions and bequests received by a private foundation, both the
total of such amounts received by the private foundation, and the
aggregate of such amounts contributed and bequeathed by such person,
shall be determined as of the last day of each taxable year commencing
with the first taxable year ending after October 9, 1969. Generally,
under section 507(d)(2) and this section, except for purposes of
valuation under section 507(d)(2)(B)(i), all contributions and bequests
made before October 9, 1969, are deemed to have been made on October 9,
1969. For purposes of section 509(a)(2) and the support test described
in Sec. 1.509(a)-3(c), contributions and bequests before October 9,
1969, will be taken into account in the year when actually made. For
example, in the case of a contribution or bequest of $6,000 in 1967,
such contribution or bequest shall be treated as made by a substantial
contributor in 1967 for purposes of section 509(a)(2) and Sec.
1.509(a)-3(c) if such person met the $5,000--2 percent test as of
December 31, 1967, and December 31, 1969 (in the case of a calendar year
accounting period). Although the determination of the percentage of
total contributions and bequests represented by a given donor's
contributions and bequests is not made until the end of the foundation's
taxable year, a donor is a substantial contributor as of the first date
when the foundation received from him an amount sufficient to make him a
substantial contributor. Except as otherwise provided in this
subparagraph, such amount is treated for all purposes as made by a
substantial contributor. Thus, the total contributions and bequests
received by the private foundation from all persons, and the aggregate
contributions and bequests made by a particular person, are to be
determined as of December 31, 1969 (in the
[[Page 121]]
case of a calendar year organization which was in existence on that
date), and the amounts included in each respective total would be all
contributions and bequests received by the organization on or before
that date, and all contributions and bequests made by the person on or
before that date. Thereafter, a similar determination is to be made with
respect to such private foundation as of the end of each of its
succeeding taxable years. Status as a substantial contributor, however,
will date from the time when the donor first met the $5,000 and 2
percent test. Once a person is a substantial contributor with respect to
a private foundation, he remains a substantial contributor even though
he might not be so classified if a determination were first made at some
later date. For instance, even though the aggregate contributions and
bequests of a person become less than 2 percent of the total received by
a private foundation (for example, because of subsequent contributions
and bequests by other persons), such person remains a substantial
contributor with respect to the foundation.
(2) Examples. The provisions of paragraph (a) of this section and
this paragraph (b) may be illustrated by the following examples:
Example 1. On January 1, 1968, A, an individual, gave $4,500 to M, a
private foundation on a calendar year basis. On June 1, 1969, A gave M
the further sum of $1,500. Throughout its existence, through December
31, 1969, M has received $250,000 in contributions and bequests from all
sources. As of June 1, 1969, A is a substantial contributor to M for
purposes of section 509(a)(2).
Example 2. On September 9, 1966, B, an individual, gave $3,500 to N,
a private foundation on a calendar year basis. On March 15, 1970, B gave
N the further sum of $3,500. Throughout its existence, through December
31, 1970, N has received $200,000 in contributions and bequests from all
sources. B is a substantial contributor to N as of March 15, 1970, since
that is the first date on which his contributions met the 2 percent-
$5,000 test.
Example 3. On July 21, 1964, X, a corporation, gave $2,000 to O, a
private foundation on a calendar year basis. As of December 31, 1969, O
had received $150,000 from all sources. On September 17, 1970, X gave O
the further sum of $3,100. Through September 17, 1970, O had received
$245,000 from all sources as total contributions and bequests. Between
September 17, 1970, and December 31, 1970, however, O received $50,000
in contributions and bequests from others. X is not a substantial
contributor to O, since X's contributions to O were not more than 2
percent of the total contributions and bequests received by O by
December 31, 1970, the end of O's taxable year, even though X's
contributions met that test at one point during the year.
Example 4. On September 16, 1970, C, an individual, gave $10,000 to
P, a private foundation on a calendar year basis. Throughout its
existence, and through December 31, 1970, the close of its taxable year,
P had received a total of $100,000 in contributions and bequests. On
January 3, 1971, P received a bequest of $1 million. C is a substantial
contributor to P since he was a substantial contributor as of September
16, 1970, and therefore remains one even though he no longer meets the
2-percent test on a later date after the end of the taxable year of the
foundation in which he first became a substantial contributor.
(c) Special rules--(1) Contributions defined. The term contribution
shall, for purposes of section 507(d)(2), have the same meaning as such
term has under section 170(c) and also include bequests, legacies,
devises, and transfers within the meaning of section 2055 or 2106(a)(2).
Thus, for purposes of section 507(d)(2), any payment of money or
transfer of property without adequate consideration shall be considered
a contribution. Where payment is made or property transferred as
consideration for admissions, sales of merchandise, performance of
services, or furnishing of facilities to the donor, the qualification of
all or any part of such payment or transfer as a contribution under
section 170(c) shall determine whether and to what extent such payment
or transfer constitutes a contribution under section 507(d)(2).
(2) Valuation of contributions and bequests. Each contribution or
bequest to a private foundation shall be valued at fair market value
when actually received by the private foundation.
(3) Contributions and bequests by a spouse. An individual shall be
considered, for purposes of this section, to have made all contributions
and bequests made by his spouse during the period of their marriage.
Thus, for example, where W contributed $500,000 to P, a private
foundation, in 1941 and that amount exceeded 2 percent of the total
contributions received by P as of the end of P's first taxable year
ending after October 9, 1969, H (W's spouse at
[[Page 122]]
the time of the 1941 gift) is considered to have made such contribution
(even if W died prior to October 9, 1969, or their marriage was
otherwise terminated prior to such date). Similarly, any bequest or
devise shall be treated as having been made by the decedent's surviving
spouse.
[T.D. 7241, 37 FR 28743, Dec. 29, 1972; 38 FR 24206, Sept. 6, 1973]
Sec. 1.507-7 Value of assets.
(a) In general. For purposes of section 507(c), the value of the net
assets shall be determined at whichever time such value is higher:
(1) The first day on which action is taken by the organization which
culminates in its ceasing to be a private foundation, or
(2) The date on which it ceases to be a private foundation.
(b) Valuation dates. (1) In the case of a termination under section
507(a)(1), the date referred to in paragraph (a)(1) of this section
shall be the date on which the terminating foundation gives the
notification described in section 507(a)(1).
(2) In the case of a termination under section 507(a)(2), the date
referred to in paragraph (a)(1) of this section shall be the date of
occurrence of the willful and flagrant act (or failure to act) or the
first of the series of willful repeated acts (or failures to act) giving
rise to liability for tax under chapter 42 and the imposition of tax
under section 507(a)(2).
(c) Fair market value. For purposes of this section, fair market
value shall be determined pursuant to the provisions of Sec.
53.4942(a)-2(c)(4) of this chapter.
(d) Net assets. For purposes of section 507 and the regulations
thereunder, the term net assets shall mean the gross assets of a private
foundation reduced by all liabilities of the foundation, including
appropriate estimated and contingent liabilities. Thus, a determination
of net assets may reflect reductions for any liability or contingent
liability for tax imposed upon the private foundation under chapter 42
with respect to acts or failures to act prior to termination, for any
liability or contingent liability for failures to correct such acts or
failures to act, or for any liability or estimated or contingent
liability with respect to expenses associated with winding up the
organization. If a private foundation's determination of net assets
reflects any reduction for any estimated or contingent liability, such
private foundation must establish, to the satisfaction of the
Commissioner, the reasonableness of such reduction. If the amount of net
assets reflects a reduction for any estimated or contingent liability,
at the earlier of the final determination of the contingency or the
termination of a reasonable time, any excess of the amount by which the
gross assets was reduced over the amount of the liability shall be
treated in the same manner as if such excess had been considered part of
the net assets.
[T.D. 7233, 37 FR 28161, Dec. 21, 1972]
Sec. 1.507-8 Liability in case of transfers.
For purposes of determining liability for the tax imposed under
section 507(c) in the case of assets transferred by the private
foundation, such tax shall be deemed to have been imposed on the first
day on which action is taken by the organization which culminates in its
ceasing to be a private foundation. If an organization's private
foundation status is terminated under section 507(a)(2), the first day
on which action is taken which culminates in its ceasing to be a private
foundation (within the meaning of section 507(f)) shall be the date
described in Sec. 1.507-7(b)(2). If an organization terminates its
private foundation status under section 507(a)(1), the first day on
which action is taken which culminates in its ceasing to be a private
foundation (within the meaning of section 507(f)) shall be the date
described in Sec. 1.507-7(b)(1).
[T.D. 7233, 37 FR 28161, Dec. 21, 1972]
Sec. 1.507-9 Abatement of taxes.
(a) General rule. The Commissioner may at his discretion abate the
unpaid portion of the assessment of any tax imposed by section 507(c),
or any liability in respect thereof, if:
(1) The private foundation distributes all of its net assets to one
or more organizations described in section 170(b)(1)(A) (other than in
clauses (vii)
[[Page 123]]
or (viii)) each of which has been in existence and so described for a
continuous period of at least 60 calendar months, or
(2) Effective assurance is given to the Commissioner in accordance
with paragraphs (b) and (c) of this section that the assets of the
organization which are dedicated to charitable purposes will, in fact,
be used for charitable purposes
The provisions of Sec. 1.507-2(a) (2), (3), and (7) shall apply to
distributions under subparagraph (1) of this paragraph. Since section
507(g) provides only for the abatement of tax imposed under section
507(c), no tax imposed under any provision of chapter 42 shall be abated
under section 507(g). Where the taxpayer files a petition with the Tax
Court with respect to a notice of deficiency regarding any tax under
section 507(c), such tax shall be treated as having been assessed for
the purposes of abatement of such tax under section 507(g) and the
regulations thereunder.
(b) State proceedings. (1) The Commissioner may at his discretion
abate the unpaid portion of the assessment of any tax imposed by section
507(c), or any liability in respect thereof, under the procedures
outlined in subparagraphs (2) and (3) of this paragraph. Such tax may
not be abated by the Commissioner unless he determines that corrective
action as defined in paragraph (c) of this section has been taken. The
Commissioner may not abate by reason of section 507(g) any amount of
such tax which has already been collected since only the unpaid portion
thereof can be abated.
(2) The appropriate State officer shall have 1 year from the date of
notification prescribed in section 6104(c) that a notice of deficiency
of tax imposed under section 507(c) has been issued with respect to a
foundation, to advise the Commissioner that corrective action has been
initiated pursuant to State law as may be ordered or approved by a court
of competent jurisdiction. Corrective action may be initiated either by
the appropriate State officer or by an organization described in section
509(a) (1), (2), or (3) which is a beneficiary of the private foundation
and has enforceable rights against such foundation under State law.
Copies of all pleadings and other documents filed with the court at the
initial stages of the proceedings shall be attached to the notification
made by the State officer to the Commissioner. Prior to notification by
the appropriate State officer that corrective action has been initiated,
the Commissioner shall follow those procedures which would apply with
respect to the assessment and collection of the tax imposed under
section 507(c) without regard to section 507(g)(2). Subsequent to
notification by the appropriate State officer that corrective action has
been initiated, the Commissioner shall suspend action with respect to
the assessment or collection of tax imposed under section 507(c) until
notified of the final determination of such corrective action, as long
as any such resulting delay does not jeopardize the collection of such
tax and does not cause collection to be barred by operation of law or
any rule of law. In any case where collection of such tax is about to be
barred by operation of section 6502 and the Commissioner has not been
advised of the final determination of corrective action, the
Commissioner should make every effort to obtain appropriate agreements
with the foundation subject to such tax to extend the period of
limitations under section 6502(a)(2). Where such agreements are
obtained, action with respect to the assessment and collection of such
tax may be suspended to the extent not inconsistent with this
subparagraph.
(3) Upon receipt of certification from the appropriate State officer
that action has been ordered or approved by a court of competent
jurisdiction, the Commissioner may abate the unpaid portion of the
assessment of tax imposed by section 507(c), or any liability in respect
thereof, if in his judgment such action is corrective action within the
meaning of paragraph (c) of this section. In the event that such action
is not corrective action, the Commissioner may in his discretion again
suspend action on the assessment and collection of such tax until
corrective action is obtained, or if in his judgment corrective action
cannot be obtained, he may resume the assessment and collection of such
tax.
[[Page 124]]
(c) Corrective action. The term corrective action referred to in
paragraph (b) of this section means vigorous enforcement of State laws
sufficient to assure implementation of the provisions of chapter 42 and
insure that the assets of such private foundation are preserved for such
charitable or other purposes specified in section 501(c)(3). Except
where assets of the terminated private foundation are transferred to an
organization described in section 509(a) (1) through (4) the State is
required to take such action to assure that the provisions of section
508(e)(1) (A) and (B) are applicable to the terminated foundation (or
any transferee) with respect to such assets as if such organization were
a private foundation. Thus, the governing instrument of such
organization must include provisions with respect to such assets:
(1) Requiring its income therefrom for each taxable year to be
distributed at such time and in such manner as not to subject such
organization to tax under section 4942 (as if the organization were a
private foundation),
(2) Prohibiting such organization from engaging in any act of self-
dealing (as defined in section 4941(d) as if the organization were a
private foundation),
(3) Prohibiting such organization from retaining any excess business
holdings (as defined in section 4943(c) as if the organization were a
private foundation),
(4) Prohibiting such organization from making any investments in
such manner as to subject such organization to tax under section 4944
(as if the organization were a private foundation), and
(5) Prohibiting such organization from making any taxable
expenditures (as defined in section 4945(d) as if the organization were
a private foundation). Consequently, in cases where the preceding
sentence applies, although the private foundation status of an
organization is terminated for tax purposes, it is contemplated that its
status under State law would remain unchanged, because the tax under
section 507(c) has been abated solely because the Commissioner has been
given effective assurance that there is vigorous enforcement of State
laws sufficient to assure implementation of the provisions of chapter
42. Therefore, in such a case while chapter 42 will not apply to acts
occurring subsequent to termination which previously would have resulted
in the imposition of tax under chapter 42, it is contemplated that there
will be vigorous enforcement of State laws (including laws made
applicable by the provisions in the governing instrument) with respect
to such acts. Notwithstanding the preceding three sentences, no
amendment to the organization's governing instrument is necessary where
there are provisions of State law which have the effect of requiring a
terminated private foundation to which the rules of subparagraphs (1)
through (5) of this paragraph apply to be subject to such rules whether
or not there are such provisions in such terminated private foundation's
governing instrument.
[T.D. 7233, 37 FR 28161, Dec. 21, 1972]
Sec. 1.508-1 Notices.
(a) New organizations must notify the Commissioner that they are
applying for recognition of section 501(c)(3) status--(1) In general.
Except as provided in subparagraph (3) of this paragraph, an
organization that is organized after October 9, 1969, will not be
treated as described in section 501(c)(3):
(i) Unless such organization has given the Commissioner notice in
the manner prescribed in subparagraph (2) of this paragraph; or
(ii) For any period before the giving of such notice, unless such
notice is given in the manner and within the time prescribed in
subparagraph (2) of this paragraph
No organization shall be exempt from taxation under section 501(a) by
reason of being described in section 501(c)(3) whenever such
organization is not treated as described in section 501(c)(3) by reason
of section 508(a) and this paragraph. See section 508(d)(2)(B) and Sec.
1.508-2(b) regarding the deductibility of charitable contributions to an
organization during the period such organization is not exempt under
section 501(a) as an organization described in section 501(c)(3) by
reason of failing to file a notice under section 508(a) and this
subparagraph. See also Sec. 1.508-
[[Page 125]]
2(b)(1)(viii) regarding the deductibility of charitable contributions to
trusts described in section 4947(a)(1).
(2) Filing of notice. (i) For purposes of paragraph (a)(1) of this
section, except as provided in paragraph (a)(3) of this section, an
organization seeking exemption under section 501(c)(3) must file the
notice described in section 508(a) within 15 months from the end of the
month in which the organization was organized. Such notice is filed by
submitting a properly completed and executed Form 1023 (or, if
applicable, Form 1023-EZ) exemption application. Notice should be filed
with the appropriate office as designated by the Commissioner in
guidance published in the Internal Revenue Bulletin, forms, or
instructions to the applicable forms. A request for extension of time
for the filing of such notice should be submitted to such appropriate
office. Such request may be granted if it demonstrates that additional
time is required.
(ii) Although the information required by either Form 1023 or Form
1023-EZ must be submitted to satisfy the notice required by this
section, the failure to supply, within the required time, all of the
information required to complete such form is not alone sufficient to
deny exemption from the date of organization to the date such complete
information for such form is submitted by the organization. If the
information that is submitted within the required time is incomplete,
and the organization supplies the necessary additional information
requested by the Commissioner within the additional time period allowed,
the original notice will be considered timely.
(iii) For purposes of subdivision (i) of this subparagraph and
paragraph (b)(2)(i) of this section, an organization shall be considered
organized on the date it becomes an organization described in section
501(c)(3) (determined without regard to section 508(a)).
(iv) Since a trust described in section 4947(a)(2) is not an
organization described in section 501(c)(3), it is not required to file
a notice described in section 508(a).
(v) For the treatment of community trusts, and the trusts or funds
comprising them, under section 508, see the special rules under Sec.
1.170A-9(e).
(vi) A foreign organization shall, for purposes of section 508, be
treated in the same manner as a domestic organization, except that
section 508 shall not apply to a foreign organization which is described
in section 4948(b).
(3) Exceptions from notice. (i) Paragraphs (a) (1) and (2) of this
section are inapplicable to the following organizations:
(a) Churches, interchurch organizations of local units of a church,
conventions or associations of churches, or integrated auxiliaries of a
church. See Sec. 1.6033-2(h) regarding the definition of integrated
auxiliary of a church;
(b) Any organization which is not a private foundation (as defined
in section 509(a)) and the gross receipts of which in each taxable year
are normally not more than $5,000 (as described in subdivision (ii) of
this subparagraph);
(c) Subordinate organizations (other than private foundations)
covered by a group exemption letter;
(d) Solely for purposes of sections 507, 508(d)(1), 508(d)(2)(A) and
508(d)(3), 508(e), 509 and chapter 42, a trust described in section
4947(a)(1). (However, a trust described in section 501(c)(3) which was
organized after October 9, 1969, shall be exempt under section 501(a) by
reason of being described in section 501(c)(3) only if it files such
notice); and
(e) Any other class of organization that the Commissioner from time
to time excludes from the requirement of filing notice under section
508(a).
(ii) For purposes of subdivision (i) (b) of this subparagraph and
paragraph (b)(7)(ii) of this section, the gross receipts (as defined in
subdivision (iii) of this subparagraph) of an organization are normally
not more than $5,000 if:
(a) During the first taxable year of the organization the
organization has received gross receipts of $7,500 or less;
(b) During its first 2 taxable years the aggregate gross receipts
received by the organization are $12,000 or less; and
(c) In the case of an organization which has been in existence for
at least 3 taxable years, the aggregate gross receipts received by the
organization
[[Page 126]]
during the immediately preceding 2 taxable years, plus the current year
are $15,000 or less
If an organization fails to meet the requirements of (a), (b), or (c) of
this subdivision, then with respect to the organization, such
organization shall be required to file the notices described in section
508 (a) and (b) within 90 days after the end of the period described in
(a), (b), or (c) of this subdivision or before March 22, 1973, whichever
is later, in lieu of the period prescribed in subparagraph (2)(i) of
this paragraph. Thus, for example, if an organization meets the $7,500
requirement of (a) of this subdivision for its first taxable year, but
fails to meet the $12,000 requirement of (b) of this subdivision for the
period ending with its second taxable year, then such organization shall
meet the notification requirements of section 508(a)(1) and 508(b) and
subparagraph (2)(i) of this paragraph if it files such notification
within 90 days after the close of its second taxable year. If an
organization which has been in existence at least 3 taxable years meets
the requirements of (a), (b), and (c) with respect to all prior taxable
years, but fails to meet the requirements of (c) of this subdivision
with respect to the current taxable year, then even if the organization
fails to make such notification within 90 days after the close of the
current taxable year, section 508(a)(1) and 508(b) shall not apply with
respect to its prior years. In such a case, the organization shall not
be treated as described in section 501(c)(3) for a period beginning with
such current taxable year and ending when such notice is given under
section 508(a)(2).
(iii) For a definition of gross receipts for purposes of subdivision
(i)(b) of this subparagraph and paragraph (b)(7)(ii) of this section,
see Sec. 1.6033-2(g)(4).
(4) Voluntary filings by new organizations excepted from filing
notice. Any organization excepted from the requirement of filing notice
under section 508(a) will be exempt from taxation under section
501(c)(3) if it meets the requirements of that section, whether or not
it files such notice. However, in order to establish its exemption with
the Internal Revenue Service and receive a ruling or determination
letter recognizing its exempt status, an organization excepted from the
notice requirement by reason of subparagraph (3) of this paragraph
should file proof of its exemption in the manner prescribed in Sec.
1.501(a)-1.
(b) Presumption that old and new organizations are private
foundations--(1) In general. Except as provided in subparagraph (7) of
this paragraph, any organization (including an organization in existence
on October 9, 1969) which is described in section 501(c)(3), and which
does not notify the Commissioner within the time and in the manner
prescribed in subparagraph (2) that it is not a private foundation, will
be presumed to be a private foundation.
(2) Filing of notice. (i) Except as provided in subparagraph (7) of
this paragraph, an organization must file the notice described in
section 508(b) and subparagraph (1) of this paragraph within 15 months
from the end of the month in which such organization was organized, or
before March 22, 1973, whichever comes later. See paragraph (a)(2)(iii)
of this section, for rules pertaining to when an organization is
organized.
(ii) Any organization filing notice under this paragraph that has
received a ruling or determination letter from the Internal Revenue
Service dated on or before July 13, 1970, recognizing its exemption from
taxation under section 501(c)(3) (or the corresponding provisions of
prior law), shall file the notice described in section 508(b) by
submitting a properly completed and executed Form 4653, Notification
Concerning Foundation Status.
(iii) The financial schedule on Form 4653 need be completed only if
the organization is, or thinks it might be, described in section
170(b)(1)(A) (iv) or (vi) or section 509(a)(2).
(iv) Any organization filing notice under this paragraph (b)(2)(iv)
shall file its notice by submitting a properly completed and executed
Form 1023 (or, if applicable, Form 1023-EZ) and providing information
that it is not a private foundation. The organization shall also submit
all information required by the regulations under section 170 or 509
(whichever is applicable) necessary to establish recognition of its
classification as an organization described in
[[Page 127]]
section 509(a)(1), (2), (3), or (4). The notice required by this
paragraph (b)(2)(iv) should be filed with the appropriate office as
designated by the Commissioner in guidance published in the Internal
Revenue Bulletin, forms, or instructions to the applicable forms.
(v) An extension of time for the filing of a notice under this
paragraph (b)(2) may be granted by the office with which the notice is
filed upon timely request by the organization, if the organization
demonstrates that additional time is required.
(3) Effect of notice upon the filing organization. (i) The notice
filed under this paragraph may not be relied upon by the organization so
filing unless and until the Internal Revenue Service notifies the
organization that it is an organization described in paragraph (1), (2),
(3), or (4), of section 509(a). For purposes of the preceding sentence,
an organization that has filed notice under section 508(b), and has
previously received a ruling that it is an organization described in
section 170(b)(1)(A) (other than clauses (vii) and (viii) thereof), will
be considered to have been notified by the Internal Revenue Service that
it is an organization described in paragraph (1) of section 509(a) if
(a) the facts and circumstances forming the basis for the issuance of
such ruling have not substantially changed, and (b) the ruling issued
under that section has not been revoked expressly or by a subsequent
change of the law or regulations under which the ruling was issued.
(ii) If an organization has filed a notice under section 508(b)
stating that it is not a private foundation and designating only one
paragraph of section 509(a) under which it claims recognition of its
classification (such as an organization described in section 509(a)(2)),
and if it has received a ruling or determination letter which recognizes
that it is not a private foundation but which fails to designate the
paragraph under section 509(a) in which it is described, then such
organization will be treated as described under the paragraph designated
by it, until such ruling or determination letter is modified or revoked.
The rule in the preceding sentence shall not apply to an organization
which indicated that it does not know its status under section 509(a) or
which claimed recognition of its status under more than one paragraph of
section 509(a).
(4) Effect of notice upon grantors or contributors to the filing
organization. In the case of grants, contributions, or distributions
made prior to:
(i) In the case of community trusts, 6 months after the date on
which corrective and clarifying regulations designated as Sec. 1.170A-
9(e)(10) become final;
(ii) In the case of medical research organizations, 6 months after
the date on which corrective and clarifying regulations designated as
Sec. 1.170A-9(b)(2), become final, and
(iii) In all other cases, January 1, 1976, any organization which
has properly filed the notice described in section 508(b) prior to March
22, 1973 will not be treated as a private foundation for purposes of
making any determination under the internal revenue laws with respect to
a grantor, contributor or distributor (as for example, a private
foundation distributing all of its net assets pursuant to a section
507(b)(1)(A) termination) thereto, unless the organization is controlled
directly or indirectly by such grantor, contributor or distributor, if
by the 30th day after the day on which such notice is filed, the
organization has not been notified by the Commissioner that the notice
filed by such organization has failed to establish that such
organization is not a private foundation. See subparagraph (6) of this
paragraph for the effect of an adverse notice by the Internal Revenue
Service. For purposes of this subparagraph, an organization which has
properly filed notice described in section 508(b) prior to March 22,
1973, and which has claimed recognition of its status under only one
paragraph of section 509(a) in such notice, will be treated only for
purposes of grantors, contributors or distributors as having the
classification claimed in the notice if the provisions of this
subparagraph are otherwise satisfied.
(5) Statement that old and new organizations are operating
foundations. (i) Any organization (including an organization in
existence on October 9, 1969) which is described in section 501(c)(3)
[[Page 128]]
may submit a statement, in the form and manner provided for notice in
subparagraph (2) of this paragraph, that it is an operating foundation
(as defined in section 4942(j)(3)) and include in such statement:
(a) Necessary supporting information as required by the regulations
under section 4942(j)(3) to confirm such determination (including a
statement identifying the clause of section 4942(j)(3)(B) that is
applicable); and
(b) A written declaration by the principal officer, manager, or
authorized trustee that there is a reasonable basis in law and in fact
that the organization so filing is an operating foundation, and that to
the best of the knowledge and belief of such officer, manager or
trustee, the information submitted is complete and correct.
(ii) The statement filed under this subparagraph may not be relied
upon by the organization so filing unless and until the Internal Revenue
Service notifies the organization that it is an operating foundation
described in section 4942(j)(3).
(iii) In the case of grants, contributions, or distributions made
prior to March 22, 1973, any organization which has properly filed the
statement described in this subparagraph prior to such date will be
treated as an operating foundation for purposes of making any
determination under the internal revenue laws with respect to a grantor,
contributor, or distributor thereto, unless the organization is
controlled directly or indirectly by such grantor, contributor, or
distributor, if by the 30th day after the day on which such statement is
filed, the organization has not been notified by the Commissioner or his
delegate that its statement has failed to establish that such
organization is an operating foundation. See subparagraph (6) of this
paragraph for the effect of an adverse notice by the Internal Revenue
Service.
(6) Effect of notice by Internal Revenue Service concerning
organization's notice or statement. Subparagraph (4) and subdivision
(iii) of subparagrph (5) of this paragraph shall have no effect:
(i) With respect to a grantor, contributor, or distributor to any
organization for any period after the date on which the Internal Revenue
Service makes notice to the public (such as by publication in the
Internal Revenue Bulletin) that a grantor, contributor, or distributor
to such organization can no longer rely upon the notice or statement
submitted by such organization; and
(ii) Upon any grant, contribution, or distribution made to an
organization on or after the date on which a grantor, contributor, or
distributor acquired knowledge that the Internal Revenue Service has
given notice to such organization that its notice or statement has
failed to establish that such organization either is not a private
foundation, or is an operating foundation, as the case may be.
(7) Exceptions from notice. Subparagraphs (1) and (2) of this
paragraph are inapplicable to the following organizations:
(i) Churches, interchurch organizations of local units of a church,
conventions or associations of churches, or integrated auxiliaries of a
church, such as a men's or women's organization, religious school,
mission society, or youth group;
(ii) Any organization which is not a private foundation (as defined
in section 509(a)) and the gross receipts of which in each taxable year
are normally not more than $5,000 (as determined under paragraph
(a)(3)(ii) of this section);
(iii) Subordinate organizations (other than private foundations)
covered by a group exemption letter but only if the parent or
supervisory organization submits a notice covering the subordinates;
(iv) Trusts described in section 4947(a)(1); and
(v) Any other class of organization that the Commissioner from time
to time excludes from the notification requirements of section 508(b).
(8) Voluntary filings by organizations excepted from filing notice.
Any organization excepted from the requirement of filing notice under
section 508(b) by reason of subdivisions (i), (ii), and (v) of
subparagraph (7) of this paragraph may receive the benefits of
subparagraph (4) of this paragraph by filing such notice.
(c) Effective/applicability date. Paragraphs (a)(2)(i), (a)(2)(ii),
(b)(2)(iv), and
[[Page 129]]
(b)(2)(v) of this section apply on and after July 1, 2014.
(Secs. 508 and 7805 of the Internal Revenue Code of 1954 (68A Stat. 917;
26 U.S.C. 7805))
[T.D. 7232, 37 FR 28289, Dec. 22, 1972, as amended by T.D. 7342, 40 FR
1237, Jan. 7, 1975; T.D. 7395, 41 FR 1063, Jan. 6, 1976; T.D. 8640, 60
FR 65552, Dec. 20, 1995; T.D. 9674, 79 FR 37632, July 2, 2014; T.D.
9819, 82 FR 29733, June 30, 2017]
Sec. 1.508-2 Disallowance of certain charitable, etc., deductions.
(a) Gift or bequest to organizations subject to section 507(c) tax--
(1) General rule. No gift or bequest made to an organization upon which
the tax provided by section 507(c) has been imposed shall be allowed as
a deduction under section 170, 545(b)(2), 556(b)(2), 642(c), 2055,
2106(a)(2), or 2522, if such gift or bequest is made:
(i) By any person after notification has been made by the
organization under section 507(a)(1) or after notification has been made
by the Commissioner under section 507(a)(2)(B), or
(ii) By a substantial contributor (as defined in section 507(d)(2))
in his taxable year which includes the first day on which action is
taken by such organization which culminates in the imposition of tax
under section 507(c) and any subsequent taxable year
For purposes of subdivision (ii) of this subparagraph, the first day on
which action is taken by an organization which culminates in the
imposition of tax under section 507(c) shall be determined under the
rules set forth in Sec. 1.507-7(b) (1) and (2).
(2) Exception. Subparagraph (1) of this paragraph shall not apply if
the entire amount of the unpaid portion of the tax imposed by section
507(c) is abated by the Commissioner under section 507(g).
(b) Gift or bequest to taxable private foundation, section 4947
trust, etc.--(1) General rule. (i) Except as provided in subparagraph
(2) of this paragraph, no gift or bequest made to an organization shall
be allowed as a deduction under section 170, 545(b)(2), 556(b)(2),
642(c), 2055, 2106(a)(2), or 2522, if such gift or bequest is made:
(a) To a private foundation or a trust described in section
4947(a)(2) in a taxable year for which it fails to meet the requirements
of section 508(e) (determined without regard to section 508(e)(2) (B)
and (C), or
(b) To any organization in a period for which it is not treated as
an organization described in section 501(c)(3) by reason of section
508(a).
(ii) For purposes of subdivision (i)(a) of this subparagraph the
term taxable year refers to the taxable year of the donee or beneficiary
organization. In the event a bequest is made to a private foundation or
trust described in section 4947(a)(2) which is not in existence at the
date of the testator's death (but which is created under the terms of
the testator's will), the term taxable year shall mean the first taxable
year of the private foundation or trust.
(iii) For purposes of subdivision (i)(a) of this subparagraph, an
organization does not fail to meet the requirements of section 508(e)
for a taxable year, unless it fails to meet such requirements for the
entire year. Therefore, even if a donee organization fails to meet the
requirements of section 508(e) on the date it receives a grant from a
donor, the donor's grant will not be disallowed by operation of section
508(d)(2)(A) and subdivision (i)(a) of this subparagraph, if the
organization meets the requirements of section 508(e) (determined
without regard to section 508(e)(2) (B) or (C)) by the end of its
taxable year.
(iv) No deduction will be disallowed under section 508(d)(2)(A) with
respect to a deduction under section 170, 545(b)(2), 556(b)(2), 642(c),
2055, 2106(a)(2), or 2522 if during the taxable year in question, the
private foundation or trust described in section 4947(a)(2) has
instituted a judicial proceeding which is necessary to reform its
governing instrument or other instrument in order to meet the
requirements of section 508(e)(1). This subdivision shall not apply
unless within a reasonable time such judicial proceedings succeed in so
reforming such instrument.
(v) No deduction will be disallowed under section 508(d)(2)(A) and
subdivision (i)(a) of this subparagraph for any taxable year beginning
before January 1, 1972, with respect to a private foundation or trust
described in section 4947 organized before January 1, 1970. See also
Sec. 1.508-3(g) regarding transitional
[[Page 130]]
rules for extending compliance with section 508(e)(1).
(vi)(a) In the case of a contribution or bequest to a trust
described in section 4947(a)(2) other than to a trust to which
subdivision (vii) of this subparagraph applies, no deduction shall be
disallowed by reason of section 508(d)(2)(A) on the grounds that such
trust's governing instrument contains no provisions with respect to
section 4942. Similarly, if for a taxable year such trust is also a
trust described in section 4947(b)(3), no deduction for such year shall
be so disallowed on the grounds that the governing instrument contains
no provision with respect to section 4943 or 4944.
(b) This subdivision may be illustrated by the following example:
Example. H executes a will on January 1, 1977, establishing a
charitable remainder trust (as described in section 664) with income
payable to W, his wife, for life, remainder to X university, an
organization described in section 170(b)(1)(A)(ii). The will provides
that the trust is prohibited from engaging in activities which would
subject itself, its foundation manager or a disqualified person to taxes
under section 4941 or 4945 of the Code. The will is silent as to
sections 4942, 4943, and 4944. H dies February 12, 1978. Section
508(d)(2)(A) will not operate to disallow any deduction to H's estate
under section 2055 with respect to such trust.
(vii)(a) In the case of a trust described in section 4947(a)(2)
which by its terms will become a trust described in section 4947(a)(1)
and the governing instrument of which is executed after March 22, 1973,
the governing instrument shall not meet the requirements of section
508(e)(1) if it does not contain provisions to the effect that the trust
must comply with the provisions of section 4942, or sections 4942, 4943,
and 4944 (as the case may be) to the extent such section or sections
shall become applicable to such trust.
(b) This subdivision may be illustrated by the following example:
Example. H executes a will on January 1, 1977, establishing a
charitable remainder trust (as described in section 664) with income
payable to W, his wife, for life, remainder in trust in perpetuity for
the benefit of an organization described in section 170(c). By its terms
the trust will become a trust described in section 4947(a)(1), and will
become a private foundation. The will provides that the trust is
prohibited from engaging in activities which would subject itself, its
foundation manager or a disqualified person to taxes under sections 4941
or 4945 of the Code. The will is silent as to sections 4942, 4943, and
4944. H dies February 12, 1978. Unless the trust's governing instrument
is amended prior to the end of the trust's first taxable year, or
judicial proceedings have been instituted under subdivision (iv) of this
subparagraph, section 508(d)(2)(A) will operate to disallow any
deduction to H's estate under section 2055 with respect to such trust.
(viii) Since a charitable trust described in section 4947(a)(1) is
not required to file a notice under section 508(a), section 508(d)(2)(B)
and subdivision (i)(b) of this subparagraph are not applicable to such a
trust.
(2) Transitional rules. Any deduction which would otherwise be
allowable under section 642(c)(2), 2106(a)(2), or 2055 shall not be
disallowed under section 508(d)(2)(A) if such deduction is attributable
to:
(i) Property passing under the terms of a will executed on or before
October 9, 1969,
(a) If the decedent dies after October 9, 1969, but before October
9, 1972, without having amended any dispositive provision of the will
after October 9, 1969, by codicil or otherwise,
(b) If the decedent dies after October 9, 1969, and at no time after
that date had the right to change the portions of the will which
pertains to the passing of property to, or for the use of, an
organization described in section 170(c)(2)(B) or 2055(a), or
(c) If no dispositive provision of the will is amended by the
decedent, by codicil or otherwise, before October 9, 1972, and the
decedent is on October 9, 1972, and at all times thereafter under a
mental disability (as defined in Sec. 1.642(c)-2(b)(3)(ii)) to amend
the will by codicil or otherwise, or
(ii) Property transferred in trust on or before October 9, 1969,
(a) If the grantor dies after October 9, 1969, but before October 9,
1972, without having amended, after October 9, 1969, any dispositive
provision of the instrument governing the disposition of the property,
(b) If the property transferred was an irrevocable interest to, or
for the use of, an organization described in section 170(c)(2)(B) or
2055(a),
[[Page 131]]
(c) In the case of a deduction under section 2106(a)(2) or 2055; if
no dispositive provision of the instrument governing the disposition of
the property is amended by the grantor before October 9, 1972, and the
grantor is on October 9, 1972, and at all times thereafter under a
mental disability (as defined in Sec. 1.642(c)-2(b)(3)(ii)) to change
the disposition of the property, or
(d) In the case of a deduction under section 642(c)(2)(A), if the
grantor is at all times after October 9, 1969, and up to, and including,
the last day of the taxable year for which the deduction under such
section is claimed, under a mental disability (as defined in Sec.
1.642(c)-2(b)(3)(ii)) to change the terms of the trust
See also Sec. 1.508-3(g) regarding the extension of time for compliance
with section 508(e), Sec. 1.664-1(f)(3) (ii) and (g) regarding the
special transitional rules for charitable remainder annuity and
unitrusts described in section 664 which were created prior to December
31, 1972, and Sec. 20.2055-2(e)(4) of this chapter regarding the rules
for determining if the dispositive provisions have been amended.
[T.D. 7232, 37 FR 28291, Dec. 22, 1972]
Sec. 1.508-3 Governing instruments.
(a) General rule. A private foundation shall not be exempt from
taxation under section 501(a) for a taxable year unless by the end of
such taxable year its governing instrument includes provisions the
effects of which are:
(1) To require distributions at such times and in such manner as not
to subject the foundation to tax under section 4942, and
(2) To prohibit the foundation from engaging in any act of self-
dealing (as defined in section 4941(d)), from retaining any excess
business holdings (as defined in section 4943(c)), from making any
investments in such manner as to subject the foundation to tax under
section 4944, and from making any taxable expenditures (as defined in
section 4945(d)).
(b) Effect and nature of governing instrument--(1) In general.
Except as provided in paragraph (d) of this section, the provisions of a
foundation's governing instrument must require or prohibit, as the case
may be, the foundation to act or refrain from acting so that the
foundation, and any foundation managers or other disqualified persons
with respect thereto, shall not be liable for any of the taxes imposed
by sections 4941, 4942, 4943, 4944, and 4945 of the Code or, in the case
of a split-interest trust described in section 4947(a)(2), any of the
taxes imposed by those sections of chapter 42 made applicable under
section 4947. Specific reference to these sections of the Code will
generally be required to be included in the governing instrument, unless
equivalent language is used which is deemed by the Commissioner to have
the same full force and effect. However, a governing instrument which
contains only language sufficient to satisfy the requirements of the
organizational test under Sec. 1.501(c)(3)-1(b) will not be considered
as meeting the requirements of this subparagraph, regardless of the
interpretation placed on such language as a matter of law by a State
court in a particular jurisdiction, unless the requirements of paragraph
(d) of this section are satisfied.
(2) Corpus. A governing instrument does not meet the requirements of
paragraph (a)(1) of this section if it expressly prohibits the
distribution of capital or corpus.
(3) Savings provisions. For purposes of sections 508(d)(2) (A) and
(e), a governing instrument need not include any provision which is
inconsistent with section 101(l) (2), (3), (4), or (5) of the Tax Reform
Act of 1969 (83 Stat. 533), as amended by sections 1301 and 1309 of the
Tax Reform Act of 1976 (90 Stat. 1713, 1729), with respect to the
organization. Accordingly, a governing instrument complying with the
requirements of subparagraph (1) of this paragraph may incorporate any
savings provision contained in section 101(l) (2), (3), (4), or (5) of
the Tax Reform Act of 1969, as amended by sections 1301 and 1309 of the
Tax Reform Act of 1976, as a specific exception to the general
provisions of paragraph (a) of this section. In addition, in the absence
of any express provisions to the contrary, the exceptions contained in
such savings provisions will generally be regarded as contained in a
governing instrument
[[Page 132]]
meeting the requirements of subparagraph (1) of this paragraph.
(4) Excess holdings. For purposes of paragraph (a)(2) of this
section, the prohibition against retaining any excess business holdings
(as defined in section 4943(c)) shall be deemed only to prohibit the
foundation from retaining any excess business holdings when such
holdings would subject the foundation to tax under section 4943(a).
(5) Revoked ruling on status. In the case of an organization which:
(i) Has been classified as an organization described in section
509(a) (1), (2), (3), or (4), and
(ii) Subsequently receives a ruling or determination letter stating
that it is no longer described in section 509(a) (1), (2), (3), or (4),
but is a private foundation within the meaning of section 509,
such organization shall have 1 year from the date of receipt of such
ruling or determination letter, or the final ruling or determination
letter if a protest is filed to an earlier one, to meet the requirements
of section 508(e). Section 508(d)(2)(A) shall not be applicable with
respect to gifts and bequests made during this 1-year period if such
requirements are met within the 1-year period.
(6) Judicial proceeding. For purposes of paragraphs (a), (b)(5),
(d)(2), and (e)(3) of this section, an organization shall be deemed to
have met the requirements of section 508(e) within a year, if a judicial
proceeding which is necessary to reform its governing instrument or
other instrument is instituted within the year and within a reasonable
time the organization, in fact, meets the requirements of section
508(e). For purposes only of paragraphs (b)(5), (d)(2), and (e)(3) of
this section, if an organization organized before January 1, 1970,
institutes such a judicial proceeding within such 1-year period, section
508 (e)(2)(C) shall be applied as if such proceeding had been instituted
prior to January 1, 1972.
(c) Meaning of governing instrument. For purposes of section 508(e),
the term governing instrument shall have the same meaning as the term
articles of organization under Sec. 1.501(c)(3)-1(b)(2). The bylaws of
an organization shall not constitute its governing instrument for
purposes of section 508(e).
(d) Effect of State law--(1) In general. A private foundation's
governing instrument shall be deemed to conform with the requirements of
paragraph (a) of this section if valid provisions of State law have been
enacted which:
(i) Require it to act or refrain from acting so as not to subject
the foundation to the taxes imposed by section 4941 (relating to taxes
on self-dealing), 4942 (relating to taxes on failure to distribute
income), 4943 (relating to taxes on excess business holdings), 4944
(relating to taxes on investments which jeopardize charitable purpose),
and 4945 (relating to taxable expenditures); or
(ii) Treat the required provisions as contained in the foundation's
governing instrument.
(2) Validity. (i) Any provision of State law described in
subparagraph (1) of this paragraph shall be presumed valid as enacted,
and in the absence of State provisions to the contrary, to apply with
respect to any foundation that does not specifically disclaim coverage
under State law (either by notification to the appropriate State
official or by commencement of judicial proceedings) except as provided
in subdivisions (ii) and (iii) of this subparagraph.
(ii) If such provision is declared invalid or inapplicable with
respect to a class of foundations by the highest appellate court of the
State or by the Supreme Court of the United States, the foundations
covered by the determination must meet the requirements of section
508(e) within 1 year from the date on which the time for perfecting an
application for review by the Supreme Court expires. If such application
is filed, the requirements of section 508(e) must be met within a year
from the date on which the Supreme Court disposes of the case, whether
by denial of the application for review or decision on the merits.
(iii) In addition, if such provision of State law is declared
invalid or inapplicable with respect to a class of foundations by any
court of competent jurisdiction which decision is not reviewed by a
court referred to in subdivision (ii)
[[Page 133]]
of this subparagraph, and the Commissioner makes notice to the general
public (such as by publication in the Internal Revenue Bulletin) that
such provision has been so declared invalid or inapplicable, then all
foundations in such State must meet the requirements of section 508(e),
without reliance upon such statute to the extent declared invalid or
inapplicable by such decision, within 1 year from the date such notice
is made public.
(iv) This subparagraph shall not apply to any foundation that is
subject to a final judgment entered by a court of competent
jurisdiction, holding the law invalid or inapplicable with respect to
such foundation. See paragraph (b)(6) of this section for the effect of
certain judicial proceedings that are brought within 1 year.
(3) Conflicting instrument. For taxable years beginning after March
22, 1973 in order for a private foundation or trust described in section
4947(a)(2) to receive the benefit of coverage under any State statute
which makes applicable the requirements of section 508(e)(1) (A) and
(B), where the statute by its terms does not apply to a governing
instrument which contains a mandatory direction conflicting with any of
such requirements, such organization must indicate on its annual return
required to be filed under section 6033 (or section 6012 in the case of
a trust described in section 4947(a)) that its governing instrument
contains no mandatory directions which conflict with the requirements of
section 508(e)(1) (A) or (B), as incorporated by the State statute.
General language in a governing instrument empowering the trustee to
make investments without being limited to those investments authorized
by law will not be regarded as a mandatory conflicting direction.
(4) Exclusion from statute. (i) For any taxable year beginning after
March 22, 1973 in the case of a private foundation or trust described in
section 4947(a)(2) subject to a State statute which makes applicable the
requirements of section 508(e)(1) (A) and (B) to the governing
instruments of such organizations, other than those which take action to
be excluded therefrom (such as by filing a notice of exclusion or by
instituting appropriate judicial proceedings), an organization will
receive the benefit of such State statute only if it indicates on its
annual return required to be filed under section 6033 (or section 6012
in the case of a trust described in section 4947(a)) that it has not so
taken action to be excluded.
(ii) This paragraph permits certain organizations that are subject
to the provisions of such a State law, to avoid changing their governing
instruments in order to meet the requirements of section 508(e)(1).
Since an organization which avoids the application of a provision or
provisions of State law, such as by filing a notice of exclusion, is not
entitled to the benefits of this paragraph, such an organization must
meet the requirements of section 508(e)(1) without regard to this
paragraph and except as provided in section 508(e)(2)(C) or paragraph
(g)(1)(iii) of this section must change its governing instrument to the
extent inconsistent with section 508(e)(1).
(5) Treatment of prevailing conflicting clause. If provisions of
State law are inapplicable to a clause in a governing instrument which
is contrary to the provisions of section 508(e)(1), the requirements of
section 508(e)(2)(C) and paragraph (g)(1)(iii) of this section are not
satisfied by a provision of State law which purports to eliminate the
need for litigation under such circumstances. Therefore, except as
otherwise provided in this section unless the governing instrument is
changed or litigation is commenced pursuant to section 508(e)(2)(B) by
an organization organized before January 1, 1970, or pursuant to
paragraph (g)(1)(ii) of this section, to amend the nonconforming
provision to meet the requirements of section 508(e)(1) (A) and (B),
then pursuant to section 508(e), such organization will not be exempt
from taxation.
(6) Retroactive application to grants or bequests. If valid
provisions of such a State law apply retroactively to a taxable year
within which an organization has received a grant or request, section
508(d)(2)(A) shall not apply so as to disallow such grant or bequest,
but only if such valid provisions of State law are enacted within 2
years of such grant or bequest.
(e) Effect of section 508(e) upon section 4947 trusts--(1) Section
4947(a)(1) trusts. A
[[Page 134]]
charitable trust described in section 4947(a)(1) (unless also described
in a paragraph of section 509(a)) is subject to all the provisions of
paragraph (a) of this section.
(2) Section 4947(a)(2) trusts. A split-interest trust described in
section 4947(a)(2), as long as it is so described, is subject to the
provisions of paragraph (a)(2) of this section, except to the extent
that section 4947 makes any such provisions inapplicable to certain
trusts and certain amounts in trust. The governing instrument of a trust
described in section 4947(a)(2) may except amounts described in section
4947(a)(2) (A), (B), and (C) from the requirements of paragraph (a)(2)
of this section. In the case of a trust having amounts transferred to it
both before May 27, 1969, and after May 26, 1969, its governing
instrument may except from the provisions of paragraph (a)(2) of this
section only those segregated amounts excluded from the application of
section 4947(a)(2) by reason of section 4947(a)(2)(C) and the
regulations thereunder. Also, the governing instrument of such a trust
may exclude the application of sections 4943 and 4944 for any period
during which such trust is described in section 4947(b)(3) (A) or (B).
See Sec. 53.4947-1(c) of this chapter for rules relating to the
applicability of section 4947 to split-interest trusts and Sec. 1.508-
2(b)(1) (vi) and (vii) for rules relating to the deductibility of grants
or bequests to such trusts.
(3) A section 4947(a)(2) trust becoming a section 4947(a)(1) trust.
If the governing instrument of a trust described in section 4947(a)(2)
meets the applicable requirements of paragraph (a)(2) of this section
and such trust ceases to be so described and becomes instead a trust
described in section 4947(a)(1), then such governing instrument must
meet, prior to the end of 12 months from the date such trust first
becomes described in section 4947(a)(1) (except as otherwise provided in
this section) all the requirements of paragraph (a) of this section in
order to comply with section 508(e).
(f) Special rules for existing private foundations. (1) Pursuant to
section 508(e)(2), section 508(e)(1) and paragraph (a) of this section
shall not apply in the case of any organization whose governing
instrument was executed before January 1, 1970:
(i) To any taxable year beginning before January 1, 1972;
(ii) To any period after December 31, 1971, during the pendency of
any judicial proceeding begun before January 1, 1972, by the private
foundation which is necessary to reform, or to excuse such foundation
from compliance with, its governing instrument or any other instrument
in order to meet the requirements of section 508(e)(1); and
(iii) To any period after the termination of any judicial proceeding
described in subdivision (ii) of this subparagraph during which its
governing instrument or any other instrument does not permit it to meet
the requirements of section 508(e)(1).
(2) For purposes of subparagraph (1) of this paragraph, and Sec.
1.508-2(b)(1)(vi)(a), a governing instrument will not be treated as
executed before the applicable date, if, after such date the dispositive
provisions of the instrument are amended (determined under rules similar
to the rules set forth in Sec. 20.2055-2(e)(4) of this chapter).
(3) For purposes of subparagraph (1) (ii) and (iii) of this
paragraph, a private foundation will be treated as meeting the
requirements of section 508(e)(2) (B) and (C) if it has commenced a
necessary and timely proceeding in an appropriate court of original
jurisdiction and such court has ruled that the foundation's governing
instrument or any other instrument does not permit it to meet the
requirements of section 508(e)(1). Such foundation is not required to
commence proceedings in any court of appellate jurisdiction in order to
comply with section 508(e)(2)(C). See also Sec. 1.508-2(b)(2).
(g) Extension of time for compliance with section 508(e). (1) Except
as provided in subparagraph (2) of this paragraph, section 508(e)(1)
shall not apply to any private foundation (regardless of when organized)
with respect:
(i) To any taxable year beginning before the transitional date,
(ii) To any period on or after the transitional date during the
pendency of any judicial proceeding begun before the transitional date
by the private foundation which is necessary to reform, or to excuse
such foundation
[[Page 135]]
from compliance with, its governing instrument or any other instrument
in order to meet the requirements of section 508(e)(1), and
(iii) To any period after the termination of any judicial proceeding
described in subdivision (ii) of this subparagraph during which its
governing instrument or any other instrument does not permit it to meet
the requirements of section 508(e)(1).
(2) Subparagraph (1) of this paragraph shall apply only to gifts or
bequests referred to in section 508(d)(2)(A) that are made before the
transitional date.
(3) For purposes of this paragraph the term transitional dates means
the earlier of the following dates:
(i) In the case of a medical research organization, May 21, 1976 or
in the case of a community trust February 10, 1977, or
(ii) The 91st day after the date an organization receives a final
ruling or determination letter that it is a private foundation under
section 509(a).
[T.D. 7232, 37 FR 28292, Dec. 22, 1972, as amended by T.D. 7440, 41 FR
50656, Nov. 17, 1976; T.D. 7678, 45 FR 12415, Feb. 26, 1980]
Sec. 1.508-4 Effective date.
Except as otherwise provided, Sec. Sec. 1.508-1 through 1.508-3
shall take effect on January 1, 1970.
(Sec. 7805 of the Internal Revenue Code of 1954, 68A Stat. 917; 26
U.S.C. 7805)
[T.D. 7232, 37 FR 28294, Dec. 22, 1972]
Sec. 1.509(a)-1 Definition of private foundation.
In general. Section 509(a) defines the term private foundation to
mean any domestic or foreign organization described in section 501(c)(3)
other than an organization described in section 509(a) (1), (2), (3), or
(4). Organizations which fall into the categories excluded from the
definition of private foundation are generally those which either have
broad public support or actively function in a supporting relationship
to such organizations. Organizations which test for public safety are
also excluded.
[T.D. 7212, 37 FR 21907, Oct. 17, 1972]
Sec. 1.509(a)-2 Exclusion for certain organizations described in
section 170(b)(1)(A).
(a) General rule. Organizations described in section 170(b)(1)(A)
(other than in clauses (vii) and (viii)) are excluded from the
definition of private foundation by section 509(a)(1). For the
requirements to be met by organizations described in section
170(b)(1)(A) (i) through (vi), see Sec. 1.170A-9 (a) through (e) and
paragraph (b) of this section. For purposes of this section, the
parenthetical language other than in clauses (vii) and (viii) used in
section 509(a)(1) means other than an organization which is described
only in clause (vii) or (viii). For purposes of this section, an
organization may qualify as a section 509(a)(1) organization regardless
of the fact that it does not satisfy section 170(c)(2) because:
(1) Its funds are not used within the United States or its
possessions, or
(2) It was created or organized other than in, or under the law of,
the United States, any State or territory, the District of Columbia, or
any possession of the United States.
(b) Medical research organizations. In order to qualify under
section 509(a)(1) as a medical research organization described in
section 170(b)(1)(A)(iii), an organization must meet the requirements of
section 170(b)(1)(A)(iii) and Sec. 1.170A-9(c)(2), except that, solely
for purposes of classification as a section 509(a)(1) organization, such
organization need not be committed to spend every contribution for
medical research before January 1 of the fifth calendar year which
begins after the date such contribution is made.
[T.D. 7212, 37 FR 21907, Oct. 17, 1972]
Sec. 1.509(a)-3 Broadly, publicly supported organizations.
(a) In general--(1) General rule. Section 509(a)(2) excludes certain
types of broadly, publicly supported organizations from private
foundation status. An organization will be excluded under section
509(a)(2) if it meets the one-third support test under section
509(a)(2)(A) and the not-more-than-one-third support test under section
509(a)(2)(B).
(2) One-third support test. An organization will meet the one-third
support
[[Page 136]]
test if it normally (within the meaning of paragraph (c) or paragraph
(d) of this section) receives from permitted sources more than one-third
of its support in each taxable year from any combination of--
(i) Gifts, grants, contributions, or membership fees; and
(ii) Gross receipts from admissions, sales of merchandise,
performance of services, or furnishing of facilities, in an activity
that is not an unrelated trade or business (within the meaning of
section 513), subject to certain limitations described in paragraph (b)
of this section. For purposes of this section, governmental units,
organizations described in section 509(a)(1), and persons other than
disqualified persons with respect to the organization shall be referred
to as permitted sources. For purposes of this section, the amount of
support received from the sources described in paragraph (a)(2)(i) of
this section and this paragraph (a)(2)(ii) (subject to the limitations
referred to in this paragraph (a)(2)) will be referred to as the
numerator of the one-third support fraction, and the total amount of
support received (as defined in section 509(d)) will be referred to as
the denominator of the one-third support fraction. Section 1.509(a)-3(f)
distinguishes gifts and contributions from gross receipts; Sec.
1.509(a)-3(g) distinguishes grants from gross receipts; Sec. 1.509(a)-
3(h) defines membership fees; Sec. 1.509(a)-3(i) defines ``any bureau
or similar agency of a governmental unit''; Sec. 1.509(a)-3(j)
describes the treatment of certain indirect forms of support; paragraph
(k) of this section describes the method of accounting for support;
Sec. 1.509(a)-3(l) describes the treatment of gross receipts from
section 513(a)(1), section 513(a)(2), or section 513(a)(3) activities;
Sec. 1.509(a)-3(m) distinguishes gross receipts from gross investment
income; and Sec. 1.509(a)-3(n) describes transition rules for
organizations that received advance rulings that expire on or after June
9, 2008.
(3) Not-more-than-one-third support test--(i) In general. An
organization will meet the not-more-than-one-third support test under
section 509(a)(2)(B) if it normally (within the meaning of paragraph (c)
or (d) of this section) receives not more than one-third of its support
in each taxable year from the sum of its gross investment income (as
defined in section 509(e)) and the excess (if any) of the amount of its
unrelated business taxable income (as defined in section 512, without
regard to section 512(a)(6), or with regard to section 512(a)(6), if the
organization so chooses) derived from trades or businesses that were
acquired by the organization after June 30, 1975, over the amount of tax
imposed on such income by section 511.For purposes of this section the
amount of support received from items described in section 509(a)(2)(B)
will be referred to as the numerator of the not-more-than-one-third
support fraction, and the total amount of support (as defined in section
509(d)) will be referred to as the denominator of the not-more-than-one-
third support fraction. For purposes of section 509(a)(2), paragraph (m)
of this section distinguishes gross receipts from gross investment
income. For purposes of section 509(e), gross investment income includes
the items of investment income described in Sec. 1.512(b)-1(a).
(ii) Trade or business. For purposes of section 509(a)(2)(B)(ii), a
trade or business acquired after June 30, 1975, by an organization shall
include, in addition to other trades or businesses:
(A) A trade or business acquired after such date from, or as a
result of the liquidation of, an organization's subsidiary which is
described in section 502 whether or not the subsidiary was held on June
30, 1975.
(B) A new trade or business commenced by an organization after such
date.
(iii) Allocation of deductions between businesses acquired before,
and businesses acquired after, June 30, 1975. Deductions which are
allowable under section 512 but are not directly connected to a
particular trade or business, such as deductions referred to in
paragraphs (10) and (12) of section 512(b), shall be allocated in the
proportion that the unrelated trade or business taxable income derived
from trades or businesses acquired after June 30, 1975, bears to the
organization's total unrelated business taxable income, both amounts
being determined without regard to such deductions.
[[Page 137]]
(iv) Allocation of tax. The tax imposed by section 511 shall be
allocated in the same proportion as in paragraph (a)(3)(iii) of this
section.
(4) Unrelated business activities. The denominator of the one-third
support fraction and the denominator of the not-more-than-one-third
support fraction both include net income from unrelated business
activities, whether or not such activities are carried on regularly as a
trade or business. The term net income from unrelated business
activities 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 the
denominator of both support fractions, 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.
(5) Purposes. The one-third support test and the not-more-than-one-
third support test are designed to insure that an organization which is
excluded from private foundation status under section 509(a)(2) is
responsive to the general public, rather than to the private interests
of a limited number of donors or other persons.
(b) Limitation on gross receipts--(1) General rule. In computing the
amount of support received from gross receipts under section
509(a)(2)(A)(ii) for purposes of the one-third support test of section
509(a)(2)(A), gross receipts from related activities received from any
person, or from any bureau or similar agency of a governmental unit, are
includible in any taxable year only to the extent that such receipts do
not exceed the greater of $5,000 or 1 percent of the organization's
support in such taxable year.
(2) Examples. The application of this paragraph may be illustrated
by the examples set forth below. For purposes of these examples, the
term general public is defined as persons other than disqualified
persons and other than persons from whom the foundation receives gross
receipts in excess of the greater of $5,000 or 1 percent of its support
in any taxable year, and the term gross receipts is limited to receipts
from activities which are not unrelated trade or business (within the
meaning of section 513).
Example 1. For the taxable year 1970, X, an organization described
in section 501(c)(3), received support of $10,000 from the following
sources:
Bureau M (a governmental bureau from which X received gross $25,000
receipts for services rendered)............................
Bureau N (a governmental bureau from which X received gross 25,000
receipts for services rendered)............................
General public (gross receipts for services rendered)....... 20,000
Gross investment income..................................... 15,000
Contributions from individual substantial contributors 15,000
(defined as disqualified persons under section 4946(a)(2)).
-----------
Total support........................................... 100,000
Since the $25,000 received from each bureau amounts to more than the
greater of $5,000 or 1 percent of X's support for 1970 (1% of $100,000 =
$1,000) under section 509(a)(2)(A)(ii), each amount is includible in the
numerator of the one-third support fraction only to the extent of
$5,000. Thus, for the taxable year 1970, X received support from sources
which are taken into account in meeting the one-third support test of
section 509(a)(2)(A) computed as follows:
Bureau M.................................................... $5,000
Bureau N.................................................... 5,000
General public.............................................. 20,000
-----------
Total................................................... 30,000
Therefore, in making the computations required under paragraph (c), (d),
or (e) of this section, only $30,000 is includible in the aggregate
numerator and $100,000 is includible in the aggregate denominator of the
support fraction.
Example 2. For the taxable year 1970, Y, an organization described
in section 501(c)(3), received support of $600,000 from the following
sources:
Bureau O (gross receipts for services rendered)............. $10,000
Bureau P (gross receipts for services rendered)............. 10,000
General public (gross receipts for services rendered)....... 150,000
General public (contributions).............................. 40,000
Gross investment income..................................... 150,000
Contributions from substantial contributors................. 240,000
-----------
Total support........................................... 600,000
Since the $10,000 received from each bureau amounts to more than the
greater of $5,000 or
[[Page 138]]
1 percent of Y's support for 1970 (1% of $600,000 = $6,000), each amount
is includible in the numerator of the one-third support fraction only to
the extent of $6,000. Thus, for the taxable year 1970, Y received
support from sources required to meet the one-third support test of
section 509(a)(2)(A) computed as follows:
Bureau O.................................................... $6,000
Bureau P.................................................... 6,000
General public (gross receipts)............................. 150,000
General public (contributions).............................. 40,000
-----------
Total................................................... 202,000
Therefore, in making the computations required under paragraph (c), (d),
or (e) of this section, $202,000 is includible in the aggregate
numerator and $600,000 is includible in the aggregate denominator of the
support fraction.
(c) Normally--(1) In general--(i) Definition. The support tests set
forth in section 509(a)(2) are to be computed on the basis of the nature
of the organization's normal sources of support. An organization will be
considered as ``normally'' receiving one third of its support from any
combination of gifts, grants, contributions, membership fees, and gross
receipts from permitted sources (subject to the limitations described in
Sec. 1.509(a)-3(b)) and not more than one third of its support from
items described in section 509(a)(2)(B) for a taxable year and the
taxable year immediately succeeding such year, if, for such taxable year
and the four taxable years immediately preceding such taxable year, the
aggregate amount of the support received during the applicable period
from gifts, grants, contributions, membership fees, and gross receipts
from permitted sources (subject to the limitations described in Sec.
1.509(a)-3(b)) is more than one third, and the aggregate amount of the
support received from items described in section 509(a)(2)(B) is not
more than one third, of the total support of the organization for such
five-year period. A publicly supported organization described under
section 509(a)(2) that has failed to meet either the one-third support
test of paragraph (a)(2) of this section or the not-more-than-one-third
support test of paragraph (a)(3) of this section for two consecutive
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 that second
consecutive failed year. For the succeeding years, the organization will
be treated as a private foundation for all purposes.
(ii) First five years of an organization's existence. See paragraph
(d)(1) of this section for the definition of ``normally'' for
organizations in the first five years of their existence.
(2) Terminations under section 507(b)(1)(B). For the special rules
applicable to the term normally as applied to private foundations that
elect to terminate their private foundation status pursuant to the 60-
month procedure provided in section 507(b)(1)(B), see the regulations
under such section.
(3) Exclusion of unusual grants. For purposes of applying the tests
for support set forth in paragraphs (a)(2) and (a)(3) of this section,
one or more contributions may be excluded from the numerator of the one-
third support fraction and from the denominator of both the one-third
support and not-more-than-one-third support fractions only if such a
contribution meets the requirements of this paragraph (c)(3). The
exclusion provided by this paragraph (c)(3) is generally intended to
apply to substantial contributions and bequests from disinterested
parties, which contributions or bequests--
(i) Are attracted by reason of the publicly supported nature of the
organization;
(ii) Are unusual or unexpected with respect to the amount thereof;
and
(iii) Would by reason of their size, adversely affect the status of
the organization as normally meeting the one-third support test for any
of the applicable periods described in this paragraph (c) or paragraph
(d) of this section. In the case of a grant (as defined in Sec.
1.509(a)-3(g)) that meets the requirements of this paragraph (c)(3), if
the terms of the granting instrument require that the funds be paid to
the recipient organization over a period of
[[Page 139]]
years, the grant amounts 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
described in section 509(a)(2)(B) may be excluded under this paragraph
(c)(3). The provisions of this paragraph (c)(3) shall apply to exclude
unusual grants made during any of the applicable periods described in
this paragraph (c) or paragraph (d) of this section. See paragraph
(c)(5) of this section as to reliance by a grantee organization upon an
unusual grant ruling under this paragraph (c)(3).
(4) Determining factors. In determining whether a particular
contribution may be excluded under paragraph (c)(3) of this section, all
pertinent facts and circumstances will be taken into consideration. No
single factor will necessarily be determinative. Among the factors to be
considered are--
(i) Whether the contribution was made by any person (or persons
standing in a relationship to such person which is described in section
4946(a)(1)(C) through 4946(a)(1)(G)) who created the organization,
previously contributed a substantial part of its support or endowment,
or stood in a position of authority, such as a foundation manager
(within the meaning of section 4946(b)), with respect to the
organization. A contribution made by a person other than those persons
described in this paragraph (c)(4)(i) will ordinarily be given more
favorable consideration than a contribution made by a person described
in this paragraph (c)(4)(i);
(ii) Whether the contribution was a bequest or an inter vivos
transfer. A bequest will ordinarily be given more favorable
consideration than an inter vivos transfer;
(iii) Whether the contribution was in the form of cash, readily
marketable securities, or assets which further the exempt purposes of
the organization, such as a gift of a painting to a museum;
(iv) Except in the case of a new organization, whether, prior to the
receipt of the particular contribution, the organization has carried on
an actual program of public solicitation and exempt activities and has
been able to attract a significant amount of public support;
(v) Whether the organization may reasonably be expected to attract a
significant amount of public support subsequent to the particular
contribution. In this connection, continued reliance on unusual grants
to fund an organization's current operating expenses (as opposed to
providing new endowment funds) may be evidence that the organization
cannot reasonably be expected to attract future support from the general
public;
(vi) Whether, prior to the year in which the particular contribution
was received, the organization met the one-third support test described
in paragraph (a)(2) of this section without the benefit of any
exclusions of unusual grants pursuant to paragraph (c)(3) of this
section;
(vii) Whether neither the contributor nor any person standing in a
relationship to such contributor which is described in section
4946(a)(1)(C) through 4946(a)(1)(G) continues directly or indirectly to
exercise control over the organization;
(viii) Whether the organization has a representative governing body
as described in Sec. 1.509(a)-3(d)(3)(i); and
(ix) Whether material restrictions or conditions (within the meaning
of Sec. 1.507-2(a)(7)) have been imposed by the transferor upon the
transferee in connection with such transfer.
(5) Grantors and contributors. Prior to the making of any grant or
contribution expected to meet the requirements for exclusion under
paragraph (c)(3) 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 of the applicability of paragraph (c)(3) of this
section, including
[[Page 140]]
all information relating to the factors described in paragraph (c)(4) 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 (c)(3) of this section.
(6) Examples. The application of the principles set forth in this
paragraph is illustrated by the examples as follows. For purposes of
these examples, the term general public is defined as persons other than
disqualified persons and other than persons from whom the foundation
received gross receipts in excess of the greater of $5,000 or 1 percent
of its support in any taxable year, the term gross investment income is
as defined in section 509(e), and the term gross receipts is limited to
receipts from activities which are not unrelated trades or businesses
(within the meaning of section 513).
Example 1. (i) For the years 2008 through 2012, X, an organization
exempt under section 501(c)(3) that makes scholarship grants to needy
students of a particular city, received support from the following
sources:
2008:
Gross receipts (general public).......................... $35,000
Contributions (substantial contributors)................. 36,000
Gross investment income.................................. 29,000
----------
Total support........................................ 100,000
2009:
Gross receipts (general public).......................... 34,000
Contributions (substantial contributors)................. 35,000
Gross investment income.................................. 31,000
----------
Total support........................................ 100,000
2010:
Gross receipts (general public).......................... 35,000
Contributions (substantial contributors)................. 30,000
Gross investment income.................................. 35,000
----------
Total support........................................ 100,000
2011:
Gross receipts (general public).......................... 33,000
Contributions (substantial contributors)................. 32,000
Gross investment income.................................. 35,000
----------
Total support........................................ 100,000
2012:
Gross receipts (general public).......................... 31,000
Contributions (substantial contributors)................. 39,000
Gross investment income.................................. 30,000
----------
Total support........................................ 100,000
(ii) In applying section 509(a)(2) to the taxable year 2012, on the
basis of paragraph (c)(1)(i) of this section, the total amount of
support from gross receipts from the general public ($168,000) for the
period 2008 through 2012, was more than one third, and the total amount
of support from gross investment income ($160,000) was less than one
third, of X's total support for the same period ($500,000). For the
taxable years 2012 and 2013, X is therefore considered normally to
receive more than one third of its support from the public sources
described in section 509(a)(2)(A) and less than one third of its support
from items described in section 509(a)(2)(B). The fact that X received
less than one third of its support from section 509(a)(2)(A) sources in
2012 and more than one third of its support from items described in
section 509(a)(2)(B) in 2011 does not affect its status because it
normally met the applicable tests over a five-year period.
[[Page 141]]
Example 2. Assume the same facts as in Example 1 except that in
2012, X also received an unexpected bequest of $50,000 from A, an
elderly widow who was interested in encouraging the work of X, but had
no other relationship to it. Solely by reason of the bequest, A became a
disqualified person. X used the bequest to create five new scholarships.
Its operations otherwise remained the same. Under these circumstances,
if A's bequest is included in X's support calculation, X could not meet
the five-year support test because the total amount received from gross
receipts from the general public ($168,000) would not be more than one-
third of its total support for the five-year period ($550,000). Because
A is a disqualified person, her bequest cannot be included in the
numerator of the one-third support test under section 509(a)(2)(A).
However, based on the factors set forth in paragraph (c)(4) of this
section, A's bequest may be excluded as an unusual grant under paragraph
(c)(3) of this section. Therefore, X will be considered to have met the
support test for the taxable years 2012 and 2013.
Example 3. Y, an organization described in section 501(c)(3), was
created by A, the holder of all the common stock in M corporation; B,
A's wife; and C, A's business associate. The purpose of Y was to sponsor
and equip athletic teams for underprivileged children in the community.
Each of the three creators makes small cash contributions to Y. A, B,
and C have been active participants in the affairs of Y since its
creation. Y regularly raises small amounts of contributions through
fundraising drives and selling admission to some of the sponsored
sporting events. The operations of Y are carried out on a small scale,
usually being restricted to the sponsorship of two to four baseball
teams of underprivileged children. In 2009, M recapitalizes and creates
a first and second class of 6 percent nonvoting preferred stock, most of
which is held by A and B. In 2010, A contributes 49 percent of his
common stock in M to Y. A's contribution of M's common stock was
substantial and constitutes 90 percent of Y's total support for 2010. A
combination of the facts and circumstances described in paragraph (c)(4)
of this section preclude A's contribution of M's common stock in 2010
from being excluded as an unusual grant under paragraph (c)(3) of this
section for purposes of determining whether Y meets the one-third
support test under section 509(a)(2).
Example 4. (i) M is organized in 2009 to promote the appreciation of
ballet in a particular region of the United States. Its principal
activities consist of erecting a theater for the performance of ballet
and the organization and operation of a ballet company. M receives a
determination letter that it is an organization described in section
501(c)(3) and that it is a public charity described in section
509(a)(2). The governing body of M consists of nine prominent unrelated
citizens residing in the region who have either an expertise in ballet
or a strong interest in encouraging appreciation of the art form.
(ii) In 2010, Z, a private foundation, proposes to makes a grant of
$500,000 in cash to M to provide sufficient capital for M to commence
its activities. Although A, the creator of Z, is one of the nine members
of M's governing body, was one of M's original founders, and continues
to lend his prestige to M's activities and fund raising efforts, A does
not, directly or indirectly, exercise any control over M. M also
receives a significant amount of support from a number of smaller
contributions and pledges from other members of the general public. M
charges admission to the ballet performances to the general public.
(iii) Although the support received in 2010 will not impact M's
status as a public charity for its first five taxable years, it will be
relevant to the determination of whether M meets the one-third support
test under section 509(a)(2) for the 2014 taxable year, using the
computation period 2010 through 2014. Within the appropriate timeframe,
M may submit a request for a private letter ruling that the $500,000
contribution from Z qualifies as an unusual grant.
(iv) Under the above circumstances, even though A was a founder and
member of the governing body of M, M may exclude Z's contribution of
$500,000 in 2010 as an unusual grant under paragraph (c)(3) of this
section for purposes of determining whether M meets the one-third
support test under section 509(a)(2) for 2014.
Example 5. (i) Assume the same facts as Example 4(i) except that, in
addition, in 2013, B, a widow, passes away and bequeaths $4 million to
M. During 2009 through 2013, B made small contributions to M, none
exceeding $10,000 in any year. During 2009 through 2013, M received
approximately $450,000 from receipts for admissions and contributions
from the general public. At the time of B's death, no person standing in
a relationship to B described in section 4946(a)(1)(C) through
4946(a)(1)(G) was a member of M's governing body. B's bequest was in the
form of cash and readily marketable securities. The only condition
placed upon the bequest was that it be used by M to advance the art of
ballet.
(ii) Although the support received in 2013 will not impact M's
status as a public charity for its first five taxable years, it will be
relevant to the determination of whether M meets the one-third support
test under section 509(a)(2) for future years. Within the appropriate
timeframe, M may submit a request for a private letter ruling that the
$4 million bequest from B qualifies as an unusual grant.
(iii) Under the above circumstances, M may exclude B's bequest of $4
million in 2013 as an unusual grant under paragraph (c)(3) of
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this section for purposes of determining whether M meets the one-third
support test under section 509(a)(2) for 2014 and subsequent years.
Example 6. (i) N is a research organization that was created by A in
2009 for the purpose of carrying on economic studies primarily through
persons receiving grants from N and engaging in the sale of economic
publications. N received a determination letter that it is described in
section 501(c)(3) and that it is a public charity described in
509(a)(2). N's five-member governing body consists of A; A's sons, B and
C; and two unrelated economists. In 2009, A made a contribution to N of
$100,000 to help establish the organization. During 2009 through 2013, A
made annual contributions to N averaging $20,000 a year. During the same
period, N received annual contributions from members of the general
public averaging $15,000 per year and receipts from the sale of its
publications averaging $50,000 per year. In 2013, B made an inter vivos
contribution to N of $600,000 in cash and readily marketable securities.
(ii) Although the support received in 2013 will not impact N's
status as a public charity for its first five taxable years, it will be
relevant to the determination of whether N meets the one-third support
test under section 509(a)(2) for future years. In determining whether
B's contribution of $600,000 in 2013 may be excluded as an unusual
grant, the support N received in 2009 through 2013 is relevant in
considering the factor described in paragraph (c)(4)(vi) of this
section, notwithstanding that N received a determination letter that it
is described in section 509(a)(2).
(iii) Under the above circumstances, in particular the facts that B
is a disqualified person described in section 4946(a)(1)(D) and N does
not have a representative governing body as described in paragraphs
(c)(4)(viii) and (d)(3)(i) of this section, N cannot exclude B's
contribution of $600,000 in 2013 as an unusual grant under paragraph
(c)(3) of this section for purposes of determining whether N meets the
one-third support test under section 509(a)(2) for 2014 and future
years.
Example 7. (i) O is an educational organization created in 2009. O
received a determination letter that it is described in section
501(c)(3) and that it is a public charity described in section
509(a)(2). The governing body of O has 9 members, consisting of A, a
prominent civic leader, and 8 other unrelated civic leaders and
educators in the community, all of whom participated in the creation of
O. During 2009 through 2013, the principal source of income for O has
been receipts from the sale of its educational periodicals. These sales
have amounted to $200,000 for this period. Small contributions amounting
to $50,000 have also been received during the same period from members
of the governing body, including A, as well as other members of the
general public.
(ii) In 2013, A contributed $750,000 of the nonvoting stock of S, a
closely held corporation, to O. A retained a substantial portion of the
voting stock of S. By a majority vote, the governing body of O decided
to retain the S stock for a period of at least five years.
(iii) Although the support received in 2013 will not impact O's
status as a public charity for its first five taxable years, it will be
relevant to the determination of whether O meets the one-third support
test under section 509(a)(2) for future years. In determining whether
A's contribution of the S stock in 2013 may be excluded as an unusual
grant, the support O received in 2009 through 2013 is relevant in
considering the factor described in paragraph (c)(4)(vi) of this
section, notwithstanding that O received a determination letter that it
is described in section 509(a)(2).
(iv) Under the above circumstances, in particular the facts that A
is a foundation manager within the meaning of section 4946(b) and A's
contribution is in the form of closely held stock, O cannot exclude A's
contribution of the S stock in 2013 as an unusual grant under paragraph
(c)(3) of this section for purposes of determining whether O meets the
one-third support test under section 509(a)(2) for 2014 and future
years.
(d) Definition of normally; first five years of an organization's
existence--(1) In general. An organization will ``normally'' meet the
one-third support test and the not-more-than-one-third support 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 one-third support test and the not-more-than-one-third support
test during that period. With respect to an organization's sixth taxable
year, the general definition of normally in paragraph (c)(1) of this
section applies. Alternatively, the organization shall be treated as
normally meeting the one-third support test and the not-more-than-one-
third support test for its sixth taxable year (but not its seventh
taxable year) if it meets the one-third support test and the not-more-
than-one-third support test under the definition of normally set forth
in paragraph (c)(1)(i) of this section for its fifth taxable year (based
on support received in its first through fifth taxable years). If a new
publicly supported organization described under section 509(a)(2) cannot
meet the requirements of the one-third support test or the not-more-
than-one-third support test for its sixth taxable
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year using either the general definition of normally in paragraph (c)(1)
of this section or the alternate rule above (effectively failing to meet
a public support test for both its fifth and sixth years), it will be
reclassified 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 is 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. Beginning the
first day of its seventh taxable year, the organization will be treated
as a private foundation for all purposes.
(2) Basic consideration. In determining whether an organization can
reasonably be expected (within the meaning of paragraph (c)(1)(i) of
this section) to meet the one-third support test under section
509(a)(2)(A) and the not-more-than-one-third support test under section
509(a)(2)(B) described in paragraph (a) of this section 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 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. An organization cannot reasonably be
expected to meet the one-third support test and the not-more-than-one-
third support test where the facts indicate that an organization is
likely during its first five taxable years to receive less than one-
third of its support from permitted sources (subject to the limitations
of paragraph (b) of this section) or to receive more than one-third of
its support from items described in section 509(a)(2)(B).
(3) Factors taken into account. All pertinent facts and
circumstances shall be taken into account under paragraph (d)(2) of this
section in determining whether the organizational structure, programs or
activities, and method of operation of an organization are such as to
enable it to meet the tests under section 509(a)(2) during its first
five taxable years. Some of the pertinent factors are:
(i) Whether the organization has or will have a representative
governing body which is comprised of public officials, or individuals
chosen by public officials acting in their capacity as such; of persons
having special knowledge in the particular field or discipline in which
the organization is operating; of community leaders, such as elected
officials, clergymen, and educators; or, in the case of a membership
organization, of individuals elected pursuant to the organization's
governing instrument or bylaws by a broadly based membership. This
characteristic does not exist if the membership of the organization's
governing body is such as to indicate that it represents the personal or
private interests of disqualified persons, rather than the interests of
the community or the general public.
(ii) Whether a substantial portion of the organization's initial
funding is to be provided by the general public, by public charities, or
by government grants, rather than by a limited number of grantors or
contributors who are disqualified persons with respect to the
organization. The fact that the organization plans to limit 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 will be
taken into consideration in determining whether those persons providing
the initial support for the organization are representative of the
general public. On the other hand, the subsequent sources of funding
which the organization can reasonably expect to receive after it has
become established and fully operational will also be taken into
account.
(iii) Whether a substantial proportion of the organization's initial
funds are placed, or will remain, in an endowment, and whether the
investment of such funds is unlikely to result in more than one third of
its total support
[[Page 144]]
being received from items described in section 509(a)(2)(B).
(iv) In the case of an organization that carries on fundraising
activities, whether the organization has developed a concrete plan for
solicitation of funds from the general public on a community or area-
wide basis; whether any steps have been taken to implement such plan;
whether any firm commitments of financial or other support have been
made to the organization by civic, religious, charitable, or similar
groups within the community; and whether the organization has made any
commitments to, or established any working relationships with, those
organizations or classes of persons intended as the future recipients of
its funds.
(v) In the case of an organization that carries on community
services, such as combating community deterioration in an economically
depressed area that has suffered a major loss of population and jobs,
whether the organization has a concrete program to carry out its work in
the community; whether any steps have been taken to implement that
program; whether it will receive any 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 or contribution; and whether it
has enlisted the sponsorship or support of other civic or community
leaders involved in community service programs similar to those of the
organization.
(vi) In the case of an organization that carries on educational or
other exempt activities for, or on behalf of, members, whether the
solicitation for dues-paying members is designed to enroll a substantial
number of persons in the community, area, profession, or field of
special interest (depending on the size of the area and the nature of
the organization's activities); 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 public rather
than to restrict membership to a limited number of persons; and 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.
(vii) In the case of an organization that provides goods, services,
or facilities, whether the organization is or will be required to make
its services, facilities, performances, or products available
(regardless of whether a fee is charged) to the general public, public
charities, or governmental units, rather than to a limited number of
persons or organizations; whether the organization will avoid executing
contracts to perform services for a limited number of firms or
governmental agencies or bureaus; and whether the service to be provided
is one which can be expected to meet a special or general need among a
substantial portion of the general public.
(4) Example. The application of this paragraph (d) may be
illustrated by the following example:
Example. (i) Organization X was formed in January 2008 and uses a
taxable year ending December 31. After September 9, 2008, and before
December 31, 2008, Organization X filed Form 1023 requesting recognition
of exemption as an organization described in section 501(c)(3) and in
section 509(a)(2). In its application, Organization X established that
it can reasonably be expected to operate as a publicly supported
organization under paragraph (d) of this section. Subsequently,
Organization X received a ruling or determination letter that it is an
organization described in sections 501(c)(3) and 509(a)(2) effective as
of the date of its formation.
(ii) Organization X is described in section 509(a)(2) for its first
five taxable years (for the taxable years ending December 31, 2008,
through December 31, 2012).
(iii) Organization X can qualify as a publicly supported
organization beginning with the taxable year ending December 31, 2013,
if Organization X can meet the requirements of either Sec. 1.170A-
9(f)(2) or Sec. 1.170A-9(f)(3) or paragraphs (a) and (b) of this
section 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.
(e) Determinations on foundation classification and reliance. (1) A
ruling or determination letter that an organization is described in
section 509(a)(2) may be issued to an organization. Such
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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 509(a)(2). The ruling
or determination letter that the organization is described in section
509(a)(2) may be revoked if, upon examination, the organization has not
met the requirements of this section. The ruling or determination letter
that the organization is described in section 509(a)(2) 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
such application was part of a scheme or plan to avoid or evade any
provision of the Code. The revocation of the determination that an
organization is described in section 509(a)(2) does not preclude
revocation of the determination that the organization is described in
section 501(c)(3).
(2) Status of grantors or contributors. (i) For purposes of sections
170, 507, 545(b)(2), 642(c), 4942, 4945, 4966, 2055, 2106(a)(2), and
2522, grantors and contributors may rely upon a determination letter or
ruling that an organization is described in section 509(a)(2) 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 may also 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 509(a)(2) or acquired knowledge that the
IRS had given notice to such organization that it would be deleted from
such classification.
(ii) 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 509(a)(2)
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 not a private foundation under section 509(a). 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 under section 509(a). 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 for requesting a determination letter
set forth in paragraph (c)(5) of this section may be followed by the
grantee organization for the protection of the grantor or contributor.
(3) Examples. The provisions of this paragraph (e) may be
illustrated by the following examples:
Example 1. Y, a calendar year organization described in section
501(c)(3), is created in February 2008 for the purpose of displaying
African art. On its exemption application Y shows, under penalties of
perjury, that it can reasonably, in accordance with the requirements of
paragraph (d) of this section, expect to receive support from the public
in 2008 through 2012 that will satisfy the one-third support and not-
more-than-one-third support tests described in section 509(a)(2) for its
first five taxable years, 2008 through 2012. Y may therefore receive a
determination that it meets the requirements of paragraph (a) of this
section for its first five taxable years (2008, 2009, 2010, 2011, and
2012), regardless of the public support Y in fact receives during this
period.
Example 2. Z, a calendar year organization described in section
501(c)(3), is created in July 2008. On its exemption application Z
shows, under penalties of perjury, that it can reasonably, in accordance
with the requirements of paragraph (d) of this section, expect to
receive support from the public in 2008 through 2012 that will satisfy
the one-third support and not-more-than-one-third support
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tests described in section 509(a)(2) for its first five taxable years,
2008 through 2012. Z receives a determination that it is described in
section 509(a)(2). However, the support actually received from the
public over Z's first five taxable years (2008 through 2012) does not
satisfy the one-third support and not-more-than-one-third support tests
described in section 509(a)(2). Moreover, the support Z receives from
2009 through 2013, also does not meet the one-third support and not-
more-than-one-third support tests described in section 509(a)(2). Z is
described in section 509(a)(2) during its first five years for all
purposes. However, because Z has not met the requirements of paragraph
(a) of this section for either 2008 through 2012 or 2009 through 2013, Z
is not described in section 509(a)(2) for its taxable year 2013. If Z is
not described in section 509(a)(1), section 509(a)(3), or section
509(a)(4), then Z will be reclassified as a private foundation as of the
first day of 2013. However, for 2013, Z will be treated as a private
foundation only for purposes of sections 507, 4940 and 6033. Z must file
Form 990-PF 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 2013. For 2014 and succeeding years, Z
will be treated as a private foundation for all purposes (except as
provided in paragraph (e)(2) of this section with respect to grantors
and contributors).
(f) Gifts and contributions distinguished from gross receipts--(1)
In general. In determining whether an organization normally receives
more than one-third of its support from permitted sources, all gifts and
contributions (within the meaning of section 509(a)(2)(A)(i)) received
from permitted sources, are includible in the numerator of the support
fraction in each taxable year. However, gross receipts (within the
meaning of section 509(a)(2)(A)(ii)) from admissions, sales of
merchandise, performance of services, or furnishing of facilities, in an
activity which is not an unrelated trade or business, are includible in
the numerator of the support fraction in any taxable year only to the
extent that such gross receipts do not exceed the limitation with
respect to the greater of $5,000 or 1 percent of support which is
describing paragraph (b) of this section. The terms gifts and
contributions shall, for purposes of section 509(a)(2), have the same
meaning as such terms have under section 170(c) and also include
bequests, legacies, devises, and transfers within the meaning of section
2055 or 2106(a)(2). Thus, for purposes of section 509(a)(2)(A), any
payment of money or transfer of property without adequate consideration
shall be considered a gift or contribution. Where payment is made or
property transferred as consideration for admissions, sales of
merchandise, performance of services, or furnishing of facilities to the
donor, the status of the payment or transfer under section 170(c) shall
determine whether and to what extent such payment or transfer
constitutes a gift or contribution under section 509(a)(2)(A)(i) as
distinguished from gross receipts from related activities under section
509(a)(2)(A)(ii). For purposes of section 509(a)(2), the term
contributions includes qualified sponsorship payments (as defined in
Sec. 1.513-4) in the form of money or property (but not services).
(2) Valuation of property. For purposes of section 509(a)(2), the
amount includible in computing support with respect to gifts, grants or
contributions of property or use of such property shall be the fair
market or rental value of such property at the date of such gift or
contribution.
(3) Examples. The provisions of this paragraph (f) may be
illustrated by the following examples:
Example 1. P is a local agricultural club described in section
501(c)(3). In order to encourage interest and proficiency by young
people in farming and raising livestock, it makes awards at its annual
fair for outstanding specimens of produce and livestock. Most of these
awards are cash or other property donated by local businessmen. When the
awards are made, the donors are given recognition for their donations by
being identified as the donor of the award. The recognition given to
donors is merely incidental to the making of the award to worthy
youngsters. For these reasons, the donations will constitute
contributions for purposes of section 509(a)(2)(A)(i). The amount
includible in computing support with respect to such contributions is
equal to the cash contributed or the fair market value of other property
on the dates contributed.
Example 2. Q, a performing arts center, enters into a contract with
a large company to be the exclusive sponsor of the center's theatrical
events. The company makes a payment of cash and products in the amount
of $100,000 to Q, and in return, Q agrees to make a broadcast
announcement thanking the company before each show and to provide $2,000
of advertising in the show's program
[[Page 147]]
(2% of $100,000 is $2,000). The announcement constitutes use or
acknowledgment pursuant to section 513(i)(2). Because the value of the
advertising does not exceed 2% of the total payment, the entire $100,000
is a qualified sponsorship payment under section 513(i), and $100,000 is
treated as a contribution for purposes of section 509(a)(2)(A)(i).
Example 3. R, a charity, enters into a contract with a law firm to
be the exclusive sponsor of the charity's outreach program. Instead of
making a cash payment, the law firm agrees to perform $100,000 of legal
services for the charity. In return, R agrees to acknowledge the law
firm in all its informational materials. The total fair market value of
the legal services, or $100,000, is a qualified sponsorship payment
under section 513(i), but no amount is treated as a contribution under
section 509(a)(2)(A)(i) because the contribution is of services.
(g) Grants distinguished from gross receipts--(1) In general. In
determining whether an organization normally receives more than one-
third of its support from public sources, all grants (within the meaning
of section 509(a)(2)(A)(i)) received from permitted sources are
includible in full in the numerator of the support fraction in each
taxable year. However, gross receipts (within the meaning of section
509(a)(2)(A)(ii)) from admissions, sales of merchandise, performance of
services, or furnishing of facilities, in an activity which is not an
unrelated trade or business, are includible in the numerator of the
support fraction in any taxable year only to the extent that such gross
receipts do not exceed the limitation with respect to the greater of
$5,000 or 1 percent of support which is described in paragraph (b) of
this section. A grant is normally made to encourage the grantee
organization to carry on certain programs or activities in furtherance
of its exempt purposes. It may contain certain terms and conditions
imposed by the grantor to insure that the grantee's programs or
activities are conducted in a manner compatible with the grantor's own
programs and policies and beneficial to the public. The grantee may also
perform a service or produce a work product which incidentally benefits
the grantor. Because of the imposition of terms and conditions, the
frequent similarlity of public purposes of grantor and grantee, and the
possibility of benefit resulting to the grantor, amounts received as
grants for the carrying on of exempt activities are sometimes difficult
to distinguish from amounts received as gross receipts from the carrying
on of exempt activities. The fact that the agreement, pursuant to which
payment is made, is designated a contract or a grant is not controlling
for purposes of classifying the payment under section 509(a)(2).
(2) Distinguishing factors. For purposes of section
509(a)(2)(A)(ii), in distinguishing the term gross receipts from the
term grants, the term gross receipts means amounts received from an
activity which is not an unrelated trade or business, if a specific
service, facility, or product is provided to serve the direct and
immediate needs of the payor, rather than primarily to confer a direct
benefit upon the general public. In general, payments made primarily to
enable the payor to realize or receive some economic or physical benefit
as a result of the service, facility, or product obtained will be
treated as gross receipts with respect to the payee. The fact that a
profitmaking organization would, primarily for its own economic or
physical betterment, contract with a nonprofit organization for the
rendition of a comparable service, facility or product from such
organization constitutes evidence that any payments received by the
nonprofit payee organization (whether from a governmental unit, a
nonprofit or a profitmaking organization) for such services, facilities
or products are primarily for the economic or physical benefit of the
payor and would therefore be considered gross receipts, rather than
grants with respect to the payee organization. For example, if a
nonprofit hospital described in section 170(b)(1)(A)(iii) engages an
exempt research and development organization to develop a more
economical system of preparing food for its own patients and personnel,
and it can be established that a hospital operated for profit might
engage the services of such an organization to perform a similar benefit
for its economic betterment, such fact would constitute evidence that
the payments received by the research and development organization
constitute gross receipts, rather than grants. Research leading to the
development of tangible products for the
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use or benefit of the payor will generally be treated as a service
provided to serve the direct and immediate needs of the payor, while
basic research or studies carried on in the physical or social sciences
will generally be treated as primarily to confer a direct benefit upon
the general public.
(3) Examples. The application of this paragraph may be illustrated
by the following examples:
Example 1. M, a nonprofit research organization described in section
501(c)(3), engages in some contract research. It receives funds from the
government to develop a specific electronic device needed to perfect
articles of space equipment. The initiative for the project came solely
from the government. Furthermore, the government could have contracted
with profitmaking research organizations which carry on similar
activities. The funds received from the government for this project are
gross receipts and do not constitute grants within the meaning of
section 509(a)(2)(A)(i). M provided a specific product at the
government's request and thus was serving the direct and immediate needs
of the payor within the meaning of subparagraph (2) of this paragraph.
Example 2. N is a nonprofit educational organization described in
section 501(c)(3). Its principal activity is to operate institutes to
train employees of various industries in the principles of management
and administration. The government pays N to set up a special institute
for certain government employees and to train them over a 2-year period.
Management training is also provided by profitmaking organizations. The
funds received are included as gross receipts. The particular services
rendered were to serve the direct and immediate needs of the government
in the training of its employees within the meaning of subparagraph (2)
of this paragraph.
Example 3. The Office of Economic Opportunity makes a community
action program grant to O, an organization described in section
509(a)(1). O serves as a delegate agency of OEO for purposes of
financing a local community action program. As part of this program, O
signs an agreement with X, an educational and charitable organization
described in section 501(c)(3), to carry out a housing program for the
benefit of poor families. Pursuant to this agreement, O pays X out of
the funds provided by OEO to build or rehabilitate low income housing
and to provide advisory services to other nonprofit organizations in
order for them to meet similar housing objectives, all on a nonprofit
basis. Payments made from O to X constitute grants for purposes of
section 509(a)(2)(A) because such program is carried on primarily for
the direct benefit of the community.
Example 4. P is an educational institute described in section
501(c)(3). It carries on studies and seminars to assist institutions of
higher learning. It receives funds from the government to research and
develop a program of black studies for institutions of higher learning.
The performance of such a service confers a direct benefit upon the
public. Because such program is carried on primarily for the direct
benefit of the public, the funds are considered a grant.
Example 5. Q is an organization described in section 501(c)(3) which
carries on medical research. Its efforts have primarily been directed
toward cancer research. Q sought funds from the government for a
particular project being contemplated in connection with its work. In
order to encourage its activities, the government gives Q the sum of
$25,000. The research project sponsored by government funds is primarily
to provide direct benefit to the general public, rather than to serve
the direct and immediate needs of the government. The funds are
therefore considered a grant.
Example 6. R is a public service organization described in section
501(c)(3) and composed of State and local officials involved in public
works activities. The Bureau of Solid Waste, Management of the
Department of Health, Education, and Welfare paid R to study the
feasibility of a particular system for disposal of solid waste. Upon
completion of the study, R was required to prepare a final report
setting forth its findings and conclusions. Although R is providing the
Bureau of Solid Waste Management with a final report, such report is the
result of basic research and study in the physical sciences and is
primarily to provide direct benefit to the general public by serving to
further the general functions of government, rather than a direct and
immediate governmental needs. The funds paid to R are therefore a grant
within the meaning of section 509(a)(2).
Example 7. R is the public service organization referred to in
example 6. W, a municipality described in section 170(c)(1), decides to
construct a sewage disposal plant. W pays R to study a number of
possible locations for such plant and to make recommendations to W,
based upon a number of factors, as to the best location. W instructed R
that in making its recommendation, primary consideration should be given
to minimizing the costs of the project to W. Since the study
commissioned by W was primarily directed toward producing an economic
benefit to W in the form of minimizing the costs of its project, the
services rendered are treated as serving W's direct and immediate needs
and are includible as gross receipts by R.
Example 8. S in an organization described in section 501(c)(3). It
was organized and is operated to further African development and
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strengthen understanding between the United States and Africa. To
further these purposes, S receives funds from the Agency for
International Development and the Department of State under which S is
required to carry out the following programs: Selection, transportation,
orientation, counseling, and language training of African students
admitted to American institutions of higher learning; payment of
tuition, other fees, and maintenance of such students; and operation of
schools and vocational training programs in underdeveloped countries for
residents of those countries. Since the programs carried on by S are
primarily to provide direct benefit to the general public, all of the
funds received by S from the Federal agencies are considered grants
within the meaning of section 509(a)(2).
(h) Definition of membership fees--(1) General rule. For purposes of
section 509(a)(2), the fact that a membership organization provides
services, admissions, facilities, or merchandise to its members as part
of its overall activities will not, in itself, result in the
classification of fees received from members as gross receipts rather
than membership fees. If an organization uses membership fees as a means
of selling admissions, merchandise, services, or the use of facilities
to members of the general public who have no common goal or interest
(other than the desire to purchase such admissions, merchandise,
services, or use of facilities), then the income received from such fees
shall not constitute membership fees under section 509(a)(2)(A)(i), but
shall, if from a related activity, constitute gross receipts under
section 509(a)(2)(A)(ii). On the other hand, to the extent the basic
purpose for making the payment is to provide support for the
organization rather than to purchase admissions, merchandise, services,
or the use of facilities, the income received from such payment shall
constitute membership fees.
(2) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. M is a symphony society described in section 501(c)(3).
Its primary purpose is to support the local symphony orchestra. The
organization has three classes of membership. Contributing members pay
annual dues of $10, sustaining members pay $25, and honorary members pay
$100. The dues are placed in a maintenance fund which is used to provide
financial assistance in underwriting the orchestra's annual deficit.
Members have the privilege of purchasing subscriptions to the concerts
before they go on sale to the general public, but must pay the same
price as any other member of the public. They also are entitled to
attend a number of rehearsals each season without charge. Under these
circumstances, M's receipts from the members constitute membership fees
for purposes of section 509(a)(2)(A)(i).
Example 2. N is a theater association described in section
501(c)(3). Its purpose is to support a repertory company in the
community in order to make live theatrical performances available to the
public. The organization sponsors six plays each year. Members of the
organization are entitled to a season subscription to the plays. The fee
paid as dues approximates the retail price of the six plays, less a 10-
percent discount. Tickets to each performance are also sold directly to
the general public. The organization also holds a series of lectures on
the theater which members may attend. Under these circumstances, the
fees paid by members as dues will be considered gross receipts from a
related activity. Although the fees are designated as membership fees,
they are actually admissions to a series of plays.
(i) Bureau defined--(1) In general. The term any bureau or similar
agency of a governmental unit (within the meaning of section
509(a)(2)(A)(ii)), refers to a specialized operating unit of the
executive, judicial, or legislative branch of government where business
is conducted under certain rules and regulations. Since the term bureau
refers to a unit functioning at the operating, as distinct from the
policymaking, level of government, it is normally descriptive of a
subdivision of a department of government. The term bureau, for purposes
of section 509(a)(2)(A)(ii), would therefore not usually include those
levels of government which are basically policymaking or administrative,
such as the office of the Secretary or Assistant Secretary of a
department, but would consist of the highest operational level under
such policymaking or administrative levels. Each subdivision of a larger
unit within the Federal Government, which is headed by a Presidential
appointee holding a position at or above Level V of the Executive
Schedule under 5 U.S.C. 5316, will normally be considered an
administrative or policymaking, rather than an operating, unit. Amounts
received from a unit functioning at the policymaking
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or administrative level of government will be treated as received from
one bureau or similar agency of such unit. Units of a governmental
agency above the operating level shall be aggregated and considered a
separate bureau for this purpose. Thus, an organization receiving gross
receipts from both a policymaking or administrative unit and an
operational unit of a department will be treated as receiving gross
receipts from two bureaus within the meaning of section
509(a)(2)(A)(ii). For purposes of this subparagraph, the Departments of
Air Force, Army, and Navy are separate departments and each is
considered as having its own policymaking, administrative, and operating
units.
(2) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. The Bureau of Health Insurance is considered a bureau
within the meaning of section 509(a)(2)(A)(ii). It is a part of the
Department of Health, Education, and Welfare, whose Secretary performs a
policymaking function, and is under the Social Security Administration,
which is basically an administrative unit. The Bureau of Health
Insurance is in the first operating level within the Social Security
Administration. Similarly, the National Cancer Institute would be
considered a bureau, as it is an operating part of the National
Institutes of Health within the Department of Health, Education, and
Welfare.
Example 2. The Bureau for Africa and the Bureau for Latin America
are considered bureaus within the meaning of section 509(a)(2)(A)(ii).
Both are separate operating units under the administrator of the Agency
for International development, a policymaking official. If an
organization received gross receipts from both of these bureaus, the
amount of gross receipts received from each would be subject to the
greater of $5,000 or 1 percent limitation under section
509(a)(2)(A)(ii).
Example 3. The Bureau of International Affairs of the Civil
Aeronautics Board is considered a bureau within the meaning of section
509(a)(2)(A)(ii). It is an operating unit under the administrative
office of the Executive Director. The subdivisions of the Bureau of
International Affairs are Geographic Areas and Project Development
Staff. If an organization received gross receipts from these
subdivisions, the total gross receipts from these subdivisions would be
considered gross receipts from the same bureau, the Bureau of
International Affairs, and would be subject to the greater of $5,000 or
1 percent limitation under section 509(a)(2)(A)(ii).
Example 4. The Department of Mental Health, a State agency which is
an operational part of State X's Department of Public Health, is
considered a bureau. The Department of Public Health is basically an
administrative agency and the Department of Mental Health is at the
first operational level within it.
Example 5. The Aeronautical Systems Division of the Air Force
Systems Command, and other units on the same level, are considered
separate bureaus with the meaning of section 509(a)(2)(A)(ii). They are
part of the Department of the Air Force which is a separate department
for this purpose, as are the Army and Navy. The Secretary and the Under
Secretary of the Air Force perform the policymaking function, the Chief
of Staff and the Air Force Systems Command are basically administrative,
having a comprehensive complement of staff functions to provide
administration for the various divisions. The Aeronautical Systems
Division and other units on the same level are thus the first operating
level, as evidenced by the fact that they are the units that let
contracts and perform the various operating functions.
Example 6. The Division of Space Nuclear Systems, the Division of
Biology and Medicine, and other units on the same level within the
Atomic Energy Commission are each separate bureaus within the meaning of
section 509(a)(2)(A)(ii). The Commissioners (which make up the
Commission) are the policymakers. The general manager and the various
assistant general managers perform the administrative function. The
various divisions perform the operating function as evidenced by the
fact that each has separate programs to pursue and contracts
specifically for these various programs.
(j) Grants from public charities--(1) General rule. For purposes of
the one-third support test in section 509(a)(2)(A), grants (as defined
in paragraph (g) of this section) received from an organization
described in section 509(a)(1) (hereinafter referred to in this
subparagraph as a public charity) are generally includible in full in
computing the numerator of the recipient's support fraction of the
taxable year in question. It is sometimes necessary to determine whether
the recipient of a grant from a public charity has received such support
from the public charity as a grant, or whether the recipient has in fact
received such support as an indirect contribution from a donor to the
public charity. If the amount received is considered a grant
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from the public charity, it is fully includible in the numerator of the
support fraction under section 509(a)(2)(A). However, if the amount
received is considered to be an indirect contribution from one of the
public charity's donors which has passed through the public chairty to
the recipient organization, such amount will retain its character as a
contribution from such donor and, if, for example, the donor is a
substantial contributor (as defined in section 507(d)(2)) with respect
to the ultimate recipient, such amount shall be excluded from the
numerator of the support fraction under section 509(a)(2). If a public
charity makes both an indirect contribution from its donor and an
additional grant to the ultimate recipient, the indirect contribution
shall be treated as made first.
(2) Indirect contributions. For purposes of subparagraph (1) of this
paragraph, an indirect contribution is one which is expressly or
impliedly ear-marked by the donor as being for, or for the benefit of, a
particular recipient (rather than for a particular purpose).
(3) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. M, a national foundation for the encouragement of the
musical arts, is an organization described in section 170(b)(1)(A)(vi).
A gives M a donation of $5,000 without imposing any restrictions or
conditions upon the gift. M subsequently makes a $5,000 grant to X, an
organization devoted to giving public performances of chamber music.
Since the grant to X is treated as being received from M, it is fully
includible in the numerator of X's support fraction for the taxable year
of receipt.
Example 2. Assume M is the same organization described in example 1.
B gives M a donation of $10,000, but requires that M spend the money for
the purpose of supporting organizations devoted to the advancement of
contemporary American music. M has complete discretion as to the
organizations of the type described to which it will make a grant. M
decides to make grants of $5,000 each to Y and Z, both being
organizations described in section 501(c)(3) and devoted to furthering
contemporary American music. Since the grants to Y and Z are treated as
being received from M, Y and Z may each include one of the $5,000 grants
in the numerator of its support fraction for purposes of section
509(a)(2)(A). Although the donation to M was conditioned upon the use of
the funds for a particular purpose, M was free to select the ultimate
recipient.
Example 3. N is a national foundation for the encouragement of art
and is an organization described in section 170(b)(1)(A)(vi). Grants to
N are permitted to be earmarked for particular purposes. O, which is an
art workshop devoted to training young artists and claiming status under
section 509(a)(2), persuades C, a private foundation, to make a grant of
$25,000 to N. C is a disqualified person with respect to O. C made the
grant to N with the understanding that N would be bound to make a grant
to O in the sum of $25,000, in addition to a matching grant of N's funds
to O in the sum of $25,000. Only the $25,000 received directly from N is
considered a grant from N. The other $25,000 is deemed an indirect
contribution from C to O and is to be excluded from the numerator of O's
support fraction.
(k) Method of accounting. For purposes of section 509(a)(2), 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 the support fraction of the grantee organization under
the method of accounting on the basis of which it regularly computes its
income in keeping its books under section 446.
(l) Gross receipts from section 513(a) (1), (2), or (3) activities.
For purposes of section 509(a)(2)(A)(ii), gross receipts from activities
described in section 513(a) (1), (2), or (3) will be considered gross
receipts from activities which are not unrelated trade or business.
(m) Gross receipts distinguished from gross investment income. (1)
For purposes of section 509(a)(2), where the charitable purpose of an
organization described in section 501(c)(3) is accomplished through the
furnishing of facilities for a rental fee or loans to a particular class
of persons, such as aged, sick, or needy persons, the support received
from such persons will be considered gross receipts (within the meaning
of section 509(d)(2)) from an activity which is not an unrelated trade
or business, rather than gross investment income. However, if such
organization also furnishes facilities or loans to persons who are not
members of such class
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and such furnishing does not contribute importantly to the
accomplishment of such organization's exempt purposes (aside from the
need of such organization for income or funds or the use it makes of the
profits derived), the support received from such furnishing will be
considered rents or interest and therefore will be treated as gross
investment income within the meaning of section 509(d)(4), unless such
income is included in computing the tax imposed by section 511.
(2) The provisions of this paragraph may be illustrated by the
following example:
Example. X, an organization described in section 501(c)(3), is
organized and operated to provide living facilities for needy widows of
deceased servicemen. X charges such widows a small rental fee for the
use of such facilities. Since X is accomplishing its exempt purpose
through the rental of such facilities, the support received from the
widows is considered gross receipts within the meaning of section
509(d)(2). However, if X rents part of its facilities to persons having
no relationship to X's exempt purpose, the support received from such
rental will be considered gross investment income within the meaning of
section 509(d)(4), unless such income is included in computing the tax
imposed by section 511.
(n) Transition rules. (1) 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 section 509(a)(2) will be treated as
meeting the requirements of paragraph (d)(1) 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).
(2) Paragraph (d)(1) of this section shall not apply to an
organization that received an advance ruling that expired prior to June
9, 2008, and that did not timely file with the IRS 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).
(3) 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 test set forth in
Sec. Sec. 1.509(a)-3(a)(2) and 1.509(a)-3(a)(3) or Sec. 1.170A-9(e)(2)
or Sec. 1.170A-9(e)(3) as in effect before September 9, 2008, (as
contained in 26 CFR part 1 revised April 1, 2008) to determine whether
the organization may be 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.
(4) Examples. The application of this paragraph (n) may be
illustrated by the following examples:
Example 1. (i) Organization M was formed in January 2004, and uses a
taxable year ending June 30. Organization M 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 section 509(a)(2)
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 M is a publicly
supported organization described in section 509(a)(2) for the taxable
years ending June 30, 2004, through June 30, 2008. Organization M 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 M can qualify as a public charity beginning with
the taxable year ending June 30, 2009, if Organization M can meet the
requirements of Sec. 1.170A-9(f)(2) or Sec. 1.170A-9(f)(3) or
paragraphs (a)(2) and (a)(3) of this section 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 M may qualify as a
publicly supported organization by availing itself of the transition
rule contained in paragraph (n)(iii) of this section, which looks to
support received by M in the taxable years ending June 30, 2004, through
June 30, 2007.
Example 2. (i) Organization N was formed in January 2000 and uses a
December 31 taxable year. Organization N received a final determination
that it was recognized as tax-exempt under section 501(c)(3) and as a
public charity prior to September 9, 2008.
(ii) For taxable year 2008, Organization N will qualify as publicly
supported if it meets the requirements under either Sec. 1.170A-9(f)(2)
or Sec. 1.170A-9(f)(3) or paragraphs (a)(2) and (a)(3) of this section
for the five-year period January 1, 2004, through December 31, 2008.
Organization N will also qualify as publicly
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supported for taxable year 2008 if it meets the requirements under
either Sec. 1.170A-9(e)(2) or Sec. 1.170A-9(e)(3) or 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.
(o) Applicability date. This section generally applies to taxable
years beginning after December 31, 1969, except paragraphs (a)(3)(i) and
(a)(4) of this section apply 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. Otherwise, for taxable years beginning before December 2, 2020,
see these paragraphs as in effect and contained in 26 CFR part 1 revised
as of April 1, 2020.
[T.D. 7212, 37 FR 21907, Oct. 17, 1972, as amended by T.D. 7784, 46 FR
37889, July 23, 1981; T.D. 8423, 57 FR 33443, July 29, 1992; T.D. 8991,
67 FR 20437, Apr. 25, 2002; T.D. 9423, 73 FR 52549, Sept. 9, 2008; T.D.
9549, 76 FR 55764, Sept. 8, 2011; T.D. 9549, 76 FR 61946, Oct. 6, 2011;
T.D. 9933, 85 FR 77979, Dec. 2, 2020]
Sec. 1.509(a)-4 Supporting organizations.
(a) In general. (1) Section 509(a)(3) excludes from the definition
of private foundation those organizations which meet the requirements of
subparagraphs (A), (B), and (C) thereof.
(2) Section 509(a)(3)(A) provides that a section 509(a)(3)
organization must be organized, and at all times thereafter operated,
exclusively for the benefit of, to perform the functions of, or to carry
out the purposes of one or more specified organizations described in
section 509(a) (1) or (2). Section 509(a)(3)(A) describes the nature of
the support or benefit which a section 509(a)(3) organization must
provide to one or more section 509(a) (1) or (2) organizations. For
purposes of section 509(a)(3)(A), paragraph (b) of this section
generally describes the organizational and operational tests; paragraph
(c) of this section describes permissible purposes under the
organizational test; paragraph (d) of this section describes the
requirement of supporting or benefiting one or more specified publicly
supported organizations; and paragraph (e) of this section describes
permissible beneficiaries and activities under the operational test.
(3) Section 509(a)(3)(B) provides that a section 509(a)(3)
organization must be operated, supervised, or controlled by or in
connection with one or more organizations described in section 509(a)
(1) or (2). Section 509(a)(3)(B) and paragraph (f) of this section
describe the nature of the relationship which must exist between the
section 509(a)(3) and section 509(a) (1) or (2) organizations. For
purposes of section 509(a)(3)(B), paragraph (g) of this section defines
operated, supervised, or controlled by; paragraph (h) of this section
defines supervised or controlled in connection with; and paragraph (i)
of this section defines operated in connection with.
(4) Section 509(a)(3)(C) provides that a section 509(a)(3)
organization must not be controlled directly or indirectly by
disqualified persons (other than foundation managers or organizations
described in section 509(a) (1) or (2)). Section 509(a)(3)(C) and
paragraph (j) of this section prescribe a limitation on the control over
the section 509(a)(3) organization.
(5) For purposes of this section, the term supporting organization
means either an organization described in section 509(a)(3) or an
organization seeking section 509(a)(3) status, depending upon its
context. For purposes of this section, the term publicly supported
organization means an organization described in section 509(a) (1) or
(2).
(6) For purposes of paragraph (i) of this section, the term
``supported organization'' means a specified publicly supported
organization described in paragraphs (d)(2)(iv) or (d)(4) of this
section.
(b) Organizational and operational tests. (1) Under subparagraph (A)
of section 509(a)(3), in order to qualify as a supporting organization,
an organization must be both organized and operated exclusively for the
benefit of, to perform the functions of, or to carry out the purposes of
(hereinafter referred to in this section as being organized and operated
to support or benefit) one or more specified publicly supported
organizations. If an organization fails to meet either the
organizational or the operational test, it cannot qualify as a
supporting organization.
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(2) In the case of supporting organizations created prior to January
1, 1970, the organizational and operational tests shall apply as of
January 1, 1970. Therefore, even though the original articles of
organization did not limit its purposes to those required under section
509(a)(3)(A) and even though it operated before January 1, 1970, for
some purpose other than those required under section 509(a)(3)(A), an
organization will satisfy the organizational and operational tests if,
on January 1, 1970, and at all times thereafter, it is so constituted as
to comply with these tests. For the special rules pertaining to the
application of the organizational and operational tests to organizations
terminating their private foundation status under the 12-month or 60-
month termination period provided under section 507(b)(1)(B) by becoming
public under section 509(a)(3), see the regulations under section
507(b).
(c) Organizational test--(1) In general. An organization is
organized exclusively for one or more of the purposes specified in
section 509(a)(3)(A) only if its articles of organization (as defined in
Sec. 1.501(c)(3)-1(b)(2)):
(i) Limit the purposes of such organization to one or more of the
purposes set forth in section 509(a)(3)(A);
(ii) Do not expressly empower the organization to engage in
activities which are not in furtherance of the purposes referred to in
subdivision (i) of this subparagraph;
(iii) State the specified publicly supported organizations on whose
behalf such organization is to be operated (within the meaning of
paragraph (d) of this section); and
(iv) Do not expressly empower the organization to operate to support
or benefit any organization other than the specified publicly supported
organizations referred to in subdivision (iii) of this subparagraph.
(2) Purposes. In meeting the organizational test, the organization's
purposes, as stated in its articles, may be as broad as, or more
specific than, the purposes set forth in section 509(a)(3)(A).
Therefore, an organization which, by the terms of its articles, is
formed for the benefit of one or more specified publicly supported
organizations shall, if it otherwise meets the other requirements of
this paragraph, be considered to have met the organizational test.
Similarly, articles which state that an organization is formed to
perform the publishing functions of a specified university are
sufficient to comply with the organizational test. An organization which
is operated, supervised, or controlled by (within the meaning of
paragraph (g) of this section) or supervised or controlled in connection
with (within the meaning of paragraph (h) of this section) one or more
sections 509(a) (1) or (2) organizations to carry out the purposes of
such organizations, will be considered as meeting the requirements of
this paragraph if the purposes set forth in its articles are similar to,
but no broader than, the purposes set forth in the articles of its
controlling section 509(a) (1) or (2) organizations. If, however, the
organization by which it is operated, supervised, or controlled is a
publicly supported section 501(c) (4), (5), or (6) organization (deemed
to be a section 509(a)(2) organization for purposes of section 509(a)(3)
under the provisions of section 509(a)), the supporting organization
will be considered as meeting the requirements of this paragraph if its
articles require it to carry on charitable, etc., activities within the
meaning of section 170(c)(2).
(3) Limitations. An organization is not organized exclusively for
the purposes set forth in section 509(a)(3)(A) if its articles expressly
permit it to operate to support or benefit any organization other than
those specified publicly supported organizations referred to in
subparagraph (1)(iii) of this paragraph. Thus, for example, an
organization will not meet the organizational test under section
509(a)(3)(A) if its articles expressly empower it to pay over any part
of its income to, or perform any service for, any organization other
than those publicly supported organizations specified in its articles
(within the meaning of paragraph (d) of this section). The fact that the
actual operations of such organization have been exclusively for the
benefit of the specified publicly supported organizations shall not be
sufficient to permit it to meet the organizational test.
(d) Specified organizations--(1) In general. In order to meet the
requirements
[[Page 155]]
of section 509(a)(3)(A), an organization must be organized and operated
exclusively to support or benefit one or more specified publicly
supported organizations. The manner in which the publicly supported
organizations must be specified in the articles for purposes of section
509(a)(3)(A) will depend upon whether the supporting organization is
operated, supervised, or controlled by or supervised or controlled in
connection with (within the meaning of paragraphs (g) and (h) of this
section) such organizations or whether it is operated in connection with
(within the meaning of paragraph (i) of this section) such
organizations.
(2) Nondesignated publicly supported organizations; requirements.
(i) Except as provided in paragraph (d)(2)(iv) of this section, in order
to meet the requirements of paragraph (d)(1) of this section, the
articles of the supporting organization must designate each of the
specified organizations by name unless:
(A) The supporting organization is operated, supervised, or
controlled by (within the meaning of paragraph (g) of this section), or
is supervised or controlled in connection with (within the meaning of
paragraph (h) of this section) one or more publicly supported
organizations; and
(B) The articles of organization of the supporting organization
require that it be operated to support or benefit one or more
beneficiary organizations which are designated by class or purpose and
which include:
(1) The publicly supported organizations referred to in paragraph
(d)(2)(i)(A) of this section (without designating such organizations by
name); or
(2) Publicly supported organizations which are closely related in
purpose or function to those publicly supported organizations referred
to in paragraph (d)(2)(i)(A) of this section or this paragraph
(d)(2)(i)(B)(2) (without designating such organization by name).
(ii) If a supporting organization is described in paragraph
(d)(2)(i)(A) of this section, it will not be considered as failing to
meet the requirements of paragraph (d)(1) of this section that the
publicly supported organizations be specified merely because its
articles of organization permit the conditions described in paragraphs
(d)(3)(i) through (iii) and (d)(4)(i)(A) and (B) of this section.
(iii) This paragraph (d)(2) may be illustrated by the following
examples:
(A) Example 1. X is an organization described in section 501(c)(3)
which operates for the benefit of institutions of higher learning in the
State of Y. X is controlled by these institutions (within the meaning of
paragraph (g) of this section) and such institutions are all section
509(a)(1) organizations. X's articles will meet the organizational test
if they require X to operate for the benefit of institutions of higher
learning or educational organizations in the State of Y (without naming
each institution). X's articles would also meet the organizational test
if they provided for the giving of scholarships to enable students to
attend institutions of higher learning but only in the State of Y.
(B) Example 2. M is an organization described in section 501(c)(3)
which was organized and operated by representatives of N church to run a
home for the aged. M is controlled (within the meaning of paragraph (g)
of this section) by N church, a section 509(a)(1) organization. The care
of the sick and the aged are longstanding temporal functions and
purposes of organized religion. By operating a home for the aged, M is
operating to support or benefit N church in carrying out one of its
temporal purposes. Thus M's articles will meet the organizational test
if they require M to care for the aged since M is operating to support
one of N church's purposes (without designating N church by name).
(iv) A supporting organization will meet the requirements of
paragraph (d)(1) of this section even though its articles do not
designate each of the specified organizations by name if:
(A) There has been an historic and continuing relationship between
the supporting organization and the section 509(a) (1) or (2)
organizations; and
(B) By reason of such relationship, there has developed a
substantial identity of interests between such organizations.
(3) Nondesignated publicly supported organizations; scope of rule.
If the requirements of paragraph (d)(2)(i)(A) of
[[Page 156]]
this section are met, a supporting organization will not be considered
as failing the test of being organized for the benefit of specified
organizations solely because its articles:
(i) Permit the substitution of one publicly supported organization
within a designated class for another publicly supported organization
either in the same or a different class designated in the articles;
(ii) Permit the supporting organization to operate for the benefit
of new or additional publicly supported organizations of the same or a
different class designated in the articles; or
(iii) Permit the supporting organization to vary the amount of its
support among different publicly supported organizations within the
class or classes of organizations designated by the articles
For example, X is an organization which operates for the benefit of
private colleges in the State of Y. If X is controlled by these colleges
(within the meaning of paragraph (g) of this section) and such colleges
are all section 509(a)(1) organizations, X's articles will meet the
organization test even if they permit X to operate for the benefit of
any new colleges created in State Y in addition to the existing colleges
or in lieu of one which has ceased to operate, or if they permit X to
vary its support by paying more to one college than to another in a
particular year.
(4) Designated publicly supported organizations. (i) If an
organization is organized and operated to support one or more publicly
supported organizations and it is operated in connection with such
organization or organizations, then, except as provided in paragraph
(d)(2)(iv) of this section, its articles of organization must, for
purposes of satisfying the organizational test under section
509(a)(3)(A), designate the specified organizations by name. Under the
circumstances described in this paragraph (d)(4), a supporting
organization which has one or more specified organizations designated by
name in its articles, will not be considered as failing the test of
being organized for the benefit of specified organizations solely
because its articles:
(A) Permit a publicly supported organization which is designated by
class or purpose, rather than by name, to be substituted for the
publicly supported organization or organizations designated by name in
the articles, but only if such substitution is conditioned upon the
occurrence of an event which is beyond the control of the supporting
organization, such as loss of exemption, substantial failure or
abandonment of operations, or dissolution of the publicly supported
organization or organizations designated in the articles;
(B) Permit the supporting organization to operate for the benefit of
a beneficiary organization which is not a publicly supported
organization, but only if such supporting organization is currently
operating for the benefit of a publicly supported organization and the
possibility of its operating for the benefit of other than a publicly
supported organization is a remote contingency; or
(C) Permit the supporting organization to vary the amount of its
support between different designated organizations, so long as it meets
the requirements of the integral part test set forth in paragraph
(i)(1)(iii) of this section with respect to at least one beneficiary
organization.
(ii) If the beneficiary organization referred to in paragraph
(d)(4)(i)(B) of this section is not a publicly supported organization,
the supporting organization will not then meet the operational test of
paragraph (e)(1) of this section. Therefore, if a supporting
organization substituted in accordance with such paragraph (d)(4)(i)(B)
a beneficiary other than a publicly supported organization and operated
in support of such beneficiary organization, the supporting organization
would not be described in section 509(a)(3).
(iii) This paragraph (d)(4) may be illustrated by the following
example:
(A) Example. X is a charitable trust described in section 4947(a)(1)
organized in 1968. Under the terms of its trust instrument, X's trustees
are required to pay over all of X's annual income to M University
Medical School for urological research. If M University Medical School
is unable or unwilling to devote these funds to urological research, the
trustees are required to pay all of such income to N University
[[Page 157]]
Medical School. However if N University Medical School is also unable or
unwilling to devote these funds to urological research, X's trustees are
directed to choose a similar organization willing to apply X's funds for
urological research. From 1968 to 1973, X pays all of its net income to
M University Medical School pursuant to the terms of the trust. M and N
are publicly supported organizations. Although the contingent
remainderman may not be a publicly supported organization, the
possibility that X may operate for the benefit of other than a publicly
supported organization is, in 1973, a remote possibility, and X will be
considered as operating for the benefit of a specified publicly
supported organization under subdivision (i)(b) of this subparagraph.
However, if, at some future date, X actually substituted a nonpublicly
supported organization as beneficiary, X would fail the requirements of
the operational test set forth in paragraph (e)(1) of this section.
(B) [Reserved]
(e) Operational test--(1) Permissible beneficiaries. A supporting
organization will be regarded as operated exclusively to support one or
more specified publicly supported organizations (hereinafter referred to
as the operational test) only if it engages solely in activities which
support or benefit the specified publicly supported organizations. Such
activities may include making payments to or for the use of, or
providing services or facilities for, individual members of the
charitable class benefited by the specified publicly supported
organization. A supporting organization may also, for example, make a
payment indirectly through another unrelated organization to a member of
a charitable class benefited by the specified publicly supported
organization, but only if such a payment constitutes a grant to an
individual rather than a grant to an organization. In determining
whether a grant is indirectly to an individual rather than to an
organization the same standard shall be applied as in Sec. 53.4945-
4(a)(4) of this chapter. Similarly, an organization will be regarded as
operated exclusively to support or benefit one or more specified
publicly supported organizations even if it supports or benefits an
organization, other than a private foundation, which is described in
section 501(c)(3) and is operated, supervised, or controlled directly by
or in connection with such publicly supported organizations, or which is
described in section 511(a)(2)(B). However, an organization will not be
regarded as operated exclusively if any part of its activities is in
furtherance of a purpose other than supporting or benefiting one or more
specified publicly supported organizations.
(2) Permissible activities. A supporting organization is not
required to pay over its income to the publicly supported organizations
in order to meet the operational test. It may satisfy the test by using
its income to carry on an independent activity or program which supports
or benefits the specified publicly supported organizations. All such
support must, however, be limited to permissible beneficiaries in
accordance with subparagraph (1) of this paragraph. The supporting
organization may also engage in fund raising activities, such as
solicitations, fund raising dinners, and unrelated trade or business to
raise funds for the publicly supported organizations, or for the
permissible beneficiaries.
(3) Examples. The provisions of this paragraph (e) may be
illustrated by the following examples:
(i) Example 1. M is a separately incorporated alumni association of
X University and is an organization described in section 501(c)(3). X
University is designated in M's articles as the sole beneficiary of its
support. M uses all of its dues and income to support its own program of
educational activities for alumni, faculty, and students of X University
and to encourage alumni to maintain a close relationship with the
university and to make contributions to it. M does not distribute any of
its income directly to X for the latter's general purposes. M pays no
part of its funds to, or for the benefit of, any organization other than
X. Under these circumstances, M is considered as operated exclusively to
perform the functions and carry out the purpose of X. Although it does
not pay over any of its funds to X, it carries on a program which both
supports and benefits X.
[[Page 158]]
(ii) Example 2. N is a separately incorporated religious and
educational organization described in section 501(c)(3). It was formed
and is operated by Y Church to provide religious training for the
members of the church. While it does not maintain a regular faculty, N
conducts a Sunday school, weekly adult education lectures on religious
subjects, and other similar activities for the benefit of the church
members. All of its funds are disbursed in furtherance of such
activities and no part of its funds is paid to, or for the benefit of,
any organization other than Y Church. N is considered as operated
exclusively to perform the educational functions of Y Church and to
carry out its religious purposes by providing various forms of religious
instruction.
(iii) Example 3. P is an organization described in section
501(c)(3). Its primary activity is providing financial assistance to S,
a publicly supported organization which aids underdeveloped nations in
Central America. P's articles of organization designate S as the
principal recipient of P's assistance. However, P also makes a small
annual general purpose grant to T, a private foundation engaged in work
similar to that carried on by S. T performs a particular function that
assists in the overall aid program carried on by S. Even though P is
operating primarily for the benefit of S, a specified publicly supported
organization, it is not considered as operated exclusively for the
purposes set forth in section 509(a)(3)(A). The grant to T, a private
foundation, prevents it from complying with the operational test under
section 509(a)(3)(A).
(iv) Example 4. Assume the same facts as example 3, except that T is
a section 501(c)(3) organization other than a private foundation and is
operated in connection with S. Under these circumstances, P will be
considered as operated exclusively to support S within the meaning of
section 509(a)(3)(A).
(v) Example 5. Assume the same facts as example 3 except that
instead of the annual general purpose grant made to T, each grant made
by P to T is specifically earmarked for the training of social workers
and teachers, designated by name, from Central America. Under these
circumstances, P's grants to T would be treated as grants to the
individual social workers and teachers under section 4945(d)(3) and
Sec. 53.4945-4(a)(4), rather than as grants to T under section
4945(d)(4). These social workers and teachers are part of the charitable
class benefitted by S. P would thus be considered as operating
exclusively to support S within the meaning of section 509(a)(3)(A).
(f) Nature of relationship required between organizations--(1) In
general. Section 509(a)(3)(B) describes the nature of the relationship
required between a section 501(c)(3) organization and one or more
publicly supported organizations in order for such section 501(c)(3)
organization to qualify under the provisions of section 509(a)(3). To
meet the requirements of section 509(a)(3), an organization must be
operated, supervised, or controlled by or in connection with one or more
publicly supported organizations. If an organization does not stand in
one of such relationships (as provided in this paragraph) to one or more
publicly supported organizations, it is not an organization described in
section 509(a)(3).
(2) Types of relationships. Section 509(a)(3)(B) sets forth three
different types of relationships, one of which must be met in order to
meet the requirements of subparagraph (1) of this paragraph. Thus, a
supporting organization may be:
(i) Operated, supervised, or controlled by,
(ii) Supervised or controlled in connection with, or
(iii) Operated in connection with, one or more publicly supported
organizations.
(3) Requirements of relationships. Although more than one type of
relationship may exist in any one case, any relationship described in
section 509(a)(3)(B) must insure that:
(i) The supporting organization will be responsive to the needs of
demands of one or more publicly supported organizations; and
(ii) The supporting organization will constitute an integral part
of, or maintain a significant involvement in, the operations of one or
more publicly supported organizations.
(4) General description of relationships. In the case of supporting
organizations
[[Page 159]]
which are operated, supervised, or controlled by one or more publicly
supported organizations, the distinguishing feature of this type of
relationship is the presence of a substantial degree of direction by the
publicly supported organizations over the conduct of the supporting
organization, as described in paragraph (g) of this section. In the case
of supporting organizations which are supervised or controlled in
connection with one or more publicly supported organizations, the
distinguishing feature is the presence of common supervision or control
among the governing bodies of all organizations involved, such as the
presence of common directors, as described in paragraph (h) of this
section. In the case of a supporting organization which is operated in
connection with one or more publicly supported organizations, the
distinguishing feature is that the supporting organization is responsive
to, and significantly involved in the operations of, the publicly
supported organization, as described in paragraph (i) of this section.
(5) Contributions from controlling donors--(i) In general. For any
taxable year, a supporting organization shall not be considered to be
operated, supervised, or controlled by, or operated in connection with,
one or more publicly supported organizations, if the supporting
organization accepts any gift or contribution from any person who is--
(A) A person (other than an organization described in section
509(a)(1), (2), or (4)) who directly or indirectly controls, either
alone or together with persons described in paragraphs (f)(5)(i)(B) or
(f)(5)(i)(C) of this section, the governing body of a specified publicly
supported organization supported by such supporting organization;
(B) A member of the family (determined under section 4958(f)(4)) of
an individual described in paragraph (f)(5)(i)(A) of this section; or
(C) A 35-percent controlled entity (as defined in section 4958(f)(3)
by substituting ``clause (i) or (ii) of section 509(f)(2)(B)'' for
``subparagraph (A) or (B) of paragraph (1)'' in paragraph (f)(3)(A)(i)
thereof).
(ii) Meaning of control. For purposes of paragraph (f)(5)(i) of this
section, the governing body of a supported organization will be
considered controlled by a person described in paragraph (f)(5)(i)(A) of
this section if that person, alone or by aggregating the person's votes
or positions of authority with persons described in paragraph
(f)(5)(i)(B) or (C) of this section, may require the governing body of
the supported organization to perform any act that significantly affects
its operations or may prevent the governing body of the supported
organization from performing any such act. The governing body of a
supported organization will be considered to be controlled directly or
indirectly by one or more persons described in paragraph (f)(5)(i)(A),
(B), or (C) of this section if the voting power of such persons is 50
percent or more of the total voting power of such governing body or if
one or more of such persons have the right to exercise veto power over
the actions of the governing body of the supported organization. Thus,
if the governing body of a supported organization is composed of five
members, none of whom has a veto power over the actions of the supported
organization, and no more than two members are at any time described in
paragraph (f)(5)(i)(A), (B), or (C) of this section, such supported
organization will not be considered to be controlled directly or
indirectly by such persons by reason of this fact alone. However, all
pertinent facts and circumstances will be taken into consideration in
determining whether one or more persons do in fact directly or
indirectly control the governing body of a supported organization.
(g) Meaning of operated, supervised, or controlled by. (1)(i) Each
of the items operated by, supervised by, and controlled by, as used in
section 509(a)(3)(B), presupposes a substantial degree of direction over
the policies, programs, and activities of a supporting organization by
one or more publicly supported organizations. The relationship required
under any one of these terms is comparable to that of a parent and
subsidiary, where the subsidiary is under the direction of, and
accountable or responsible to, the parent organization. This
relationship is established by the fact that a majority of the officers,
directors, or trustees of the supporting
[[Page 160]]
organization are appointed or elected by the governing body, members of
the governing body, officers acting in their official capacity, or the
membership of one or more publicly supported organizations.
(ii) A supporting organization may be operated, supervised, or
controlled by one or more publicly supported organizations within the
meaning of section 509(a)(3)(B) even though its governing body is not
comprised of representatives of the specified publicly supported
organizations for whose benefit it is operated within the meaning of
section 509(a)(3)(A). A supporting organization may be operated,
supervised, or controlled by one or more publicly supported
organizations (within the meaning of section 509(a)(3)(B)) and be
operated for the benefit of one or more different publicly supported
organizations (within the meaning of section 509(a)(3)(A)) only if it
can be demonstrated that the purposes of the former organizations are
carried out by benefitting the latter organizations.
(2) The provisions of this paragraph (g) may be illustrated by the
following examples:
(i) Example 1. X is a university press which is organized and
operated as a nonstock educational corporation to perform the publishing
and printing for M University, a publicly supported organization.
Control of X is vested in a Board of Governors appointed by the Board of
Trustees of M University upon the recommendation of the president of the
university. X is considered to be operated, supervised, or controlled by
M University within the meaning of section 509(a)(3)(B).
(ii) Example 2. Y Council was organized under the joint sponsorship
of seven independent publicly supported organizations, each of which is
dedicated to the advancement of knowledge in a particular field of
social science. The sponsoring organizations organized Y Council as a
means of pooling their ideas and resources for the attainment of common
objectives, including the conducting of scholarly studies and formal
discussions in various fields of social science. Under Y Council's by-
laws, each of the seven sponsoring organizations elects three members to
Y's board of trustees for 3-year terms. Y's board also includes the
president of Y Council and eight other individuals elected at large by
the board. Pursuant to policies established or approved by the board, Y
Council engages in research, planning, and evaluation in the social
sciences and sponsors or arranges conferences, seminars, and similar
programs for scholars and social scientists. It carries out these
activities through its own full-time professional staff, through a part-
time committee of scholars, and through grant recipients. Under the
above circumstances, Y Council is subject to a substantial degree of
direction by the sponsoring publicly supported organizations. It is
therefore considered to be operated, supervised, or controlled by such
sponsoring organizations within the meaning of section 509(a)(3)(B).
(iii) Example 3. Z is a charitable trust created by A in 1972. It
has three trustees, all of whom are appointed by M University, a
publicly supported organization. The trust was organized and is operated
to pay over all of its net income for medical research to N, O, and P,
each of which is specified in the trust, is a hospital described in
section 509(a)(1), and is located in the same city as M. Members of M's
biology department are permitted to use the research facilities of N, O,
and P. Under paragraph (g)(1)(ii) of this section, Z is considered to be
operated, supervised, or controlled by M within the meaning of section
509(a)(3)(B), even though it is operated for the benefit of N, O, and P
within the meaning of section 509(a)(3)(A).
(h) Meaning of supervised or controlled in connection with. (1) In
order for a supporting organization to be supervised or controlled in
connection with one or more publicly supported organizations, there must
be common supervision or control by the persons supervising or
controlling both the supporting organization and the publicly supported
organizations to insure that the supporting organization will be
responsive to the needs and requirements of the publicly supported
organizations. Therefore, in order to meet such requirement, the control
or management of the supporting organization must be vested in the same
persons
[[Page 161]]
that control or manage the publicly supported organizations.
(2) A supporting organization will not be considered to be
supervised or controlled in connection with one or more publicly
supported organizations if such organization merely makes payments
(mandatory or discretionary) to one or more named publicly supported
organizations, even if the obligation to make payments to the named
beneficiaries is enforceable under State law by such beneficiaries and
the supporting organization's governing instrument contains provisions
whose effect is described in section 508(e)(1) (A) and (B). Such
arrangements do not provide a sufficient connection between the payor
organization and the needs and requirements of the publicly supported
organizations to constitute supervision or control in connection with
such organizations.
(3) The provisions of this paragraph (h) may be illustrated by the
following examples:
(i) Example 1. A, a philanthropist, founded X school for orphan boys
(a publicly supported organization). At the same time A founded X
school, he also established Y trust into which he transferred all of the
operating assets of the school, together with a substantial endowment
for it. Under the provisions of the trust instrument, the same persons
who control and manage the school also control and manage the trust. The
sole function of Y trust is to hold legal title to X school's operating
and endowment assets, to invest the endowment assets and to apply the
income from the endowment to the benefit of the school in accordance
with direction from the school's governing body. Under these
circumstances, Y trust is organized and operated for the benefit of X
school and is supervised or controlled in connection with such
organization within the meaning of section 509(a)(3). The fact that the
same persons control both X and Y insures Y's responsiveness to X's
needs.
(ii) Example 2. In 1972, B, a philanthropist, created P, a
charitable trust for the benefit of Z, a symphony orchestra described in
section 509(a)(2). B transferred 100 shares of common stock to P. Under
the terms of the trust instrument, the trustees (none of whom is under
the control of B) were required to pay over all of the income produced
by the trust assets to Z. The governing instrument of P contains certain
provisions whose effect is described in section 508(e)(1) (A) and (B).
Under applicable State law, Z can enforce the provisions of the trust
instrument and compel payment to Z in a court of equity. There is no
relationship between the trustees of P and the governing body of Z.
Under these circumstances P is not supervised or controlled in
connection with a publicly supported organization. Because of the lack
of any common supervision or control by the trustees of P and the
governing body of Z, P is not supervised or controlled in connection
with Z within the meaning of section 509(a)(3)(B).
(iii) Example 3. T is a charitable trust described in section
501(c)(3) and created under the will of D. Prior to his death, D was a
leader and very active in C church, a publicly supported organization. D
created T to perpetuate his interest in, and assistance to, C. The sole
purpose of T was to provide financial support for C and its related
institutions. All of the original named trustees of T are members of C,
are leaders in C, and hold important offices in one or more of C's
related institutions. Successor trustees of T are by the terms of the
charitable trust instrument to be chosen by the remaining trustees and
are also to be members of C. All of the original trustees have
represented that any successor trustee will be a leader in C and will
hold an important office in one or more of C's related institutions. By
reason of the foregoing relationship T and its trustees are responsive
to the needs and requirements of C and its related institutions. Under
these circumstances, T trust is organized and operated for the benefit
of C and is supervised or controlled in connection with C and its
related institutions within the meaning of section 509(a)(3)(B).
(i) Meaning of operated in connection with--(1) General rule. For
each taxable year, a supporting organization is operated in connection
with one or more supported organizations (that is, is a ``Type III
supporting organization'') only if it is not disqualified by reason
[[Page 162]]
of paragraph (f)(5) (relating to acceptance of contributions from
controlling donors) or paragraph (i)(10) (relating to foreign supported
organizations) of this section, and it satisfies--
(i) The notification requirement, which is set forth in paragraph
(i)(2) of this section;
(ii) The responsiveness test, which is set forth in paragraph (i)(3)
of this section; and
(iii) The integral part test, which is satisfied by maintaining
significant involvement in the operations of one or more supported
organizations and providing support on which the supported
organization(s) are dependent; in order to satisfy this test, the
supporting organization must meet the requirements either for--
(A) Functionally integrated Type III supporting organizations set
forth in paragraph (i)(4) of this section; or
(B) Non-functionally integrated Type III supporting organizations
set forth in paragraph (i)(5) of this section.
(2) Notification requirement--(i) Annual notification. For each
taxable year (Reporting Year), a Type III supporting organization must
provide the following documents to each of its supported organizations:
(A) A written notice addressed to a principal officer of the
supported organization describing the type and amount of all of the
support (including all of the distributions described in paragraph
(i)(6) of this section, if applicable) the supporting organization
provided to the supported organization during the supporting
organization's taxable year immediately preceding the Reporting Year
(and during any other taxable year of the supporting organization ending
after December 28, 2012, for which such support information has not
previously been provided), including a brief narrative description of
the support provided and sufficient financial detail for the recipient
to identify the types and amounts of support being reported;
(B) A copy of the supporting organization's Form 990, ``Return of
Organization Exempt from Income Tax,'' or other annual information
return required to be filed under section 6033 (although the supporting
organization may redact from the return the name and address of any
contributor to the organization) that was most recently filed as of the
date the notification is provided (and any such return for any other
taxable year of the supporting organization ending after December 28,
2012, that has not previously been provided to the supported
organization); and
(C) A copy of the supporting organization's governing documents as
in effect on the date the notification is provided, including its
articles of organization and bylaws (if any) and any amendments to such
documents, unless such documents have been previously provided and not
subsequently amended.
(ii) Electronic media. The notification documents required by this
paragraph (i)(2) may be provided by electronic media.
(iii) Due date. The notification documents required by this
paragraph (i)(2) must be delivered or electronically transmitted by the
last day of the fifth calendar month of the Reporting Year.
(iv) Principal officer. For purposes of paragraph (i)(2)(i)(A) of
this section, a principal officer includes, but is not limited to, a
person who, regardless of title, has ultimate responsibility for--
(A) Implementing the decisions of the governing body of a supported
organization;
(B) Supervising the management, administration, or operation of the
supported organization; or
(C) Managing the finances of the supported organization.
(3) Responsiveness test--(i) General rule. A supporting organization
meets the responsiveness test only if it is responsive to the needs or
demands of each of its supported organizations. Except as provided in
paragraph (i)(3)(v) of this section, in order to meet this test, a
supporting organization must satisfy the requirements of paragraphs
(i)(3)(ii) and (iii) of this section with respect to each of its
supported organizations.
(ii) Relationship of officers, directors, or trustees. A supporting
organization satisfies the requirements of this paragraph (i)(3)(ii)
with respect to a supported organization only if--
(A) One or more officers, directors, or trustees of the supporting
organization
[[Page 163]]
are elected or appointed by the officers, directors, trustees, or
membership of the supported organization;
(B) One or more members of the governing body of the supported
organization are also officers, directors, or trustees of, or hold other
important offices in, the supporting organization; or
(C) The officers, directors, or trustees of the supporting
organization maintain a close and continuous working relationship with
the officers, directors, or trustees of the supported organization.
(iii) Significant voice. A supporting organization satisfies the
requirements of this paragraph (i)(3)(iii) only if, by reason of
paragraphs (i)(3)(ii)(A), (i)(3)(ii)(B), or (i)(3)(ii)(C) of this
section, the officers, directors, or trustees of the supported
organization have a significant voice in the investment policies of the
supporting organization, the timing of grants, the manner of making
grants, and the selection of grant recipients by such supporting
organization, and in otherwise directing the use of the income or assets
of the supporting organization.
(iv) Examples. The provisions of this paragraph (i)(3) may be
illustrated by the following examples:
(A) Example 1. X, an organization described in section 501(c)(3), is
a trust created under the last will and testament of Decedent. The
trustee of X (Trustee) is a bank. Under the trust instrument, X supports
M, a private university described in section 509(a)(1). The trust
instrument provides that Trustee has discretion regarding the timing and
amount of distributions consistent with the Trustee's fiduciary duties.
Representatives of Trustee and an officer of M have quarterly face-to-
face or telephonic meetings during which they discuss M's projected
needs and ways in which M would like X to use its income and invest its
assets. Additionally, Trustee communicates regularly with that officer
of M regarding X's investments and plans for distributions from X.
Trustee provides the officer of M with quarterly investment statements,
the information required under paragraph (i)(2) of this section, and an
annual accounting statement. Based on these facts, X meets the
responsiveness test of this paragraph (i)(3) with respect to M.
(B) Example 2. Y is an organization described in section 501(c)(3)
and is a trust under State law. The trustee of Y (Trustee) is a bank. Y
supports charities P, Q, and R, each an organization described in
section 509(a)(1). Y makes annual cash payments to P, Q, and R. Once a
year, Trustee sends to P, Q, and R the cash payment, the information
required under paragraph (i)(2) of this section, and an accounting
statement. Trustee has no other communication with P, Q, or R. Y does
not meet the responsiveness test of this paragraph (i)(3).
(C) Example 3. Z is described in section 501(c)(3). Z's
organizational documents provide that it supports ten different
organizations, each of which is described in section 509(a)(1). One of
the directors of S (one of the supported organizations) is a voting
member of Z's board of directors and participates in Z's regular board
meetings. Officers of Z hold regularly scheduled face-to-face or
telephonic meetings during the year, to which officers of all the
supported organizations are invited. Z's meetings with the supported
organizations may be held jointly or separately. Prior to the meetings,
Z makes available to the supported organizations (including by email)
up-to-date information about its activities, including its assets and
liabilities, receipts and distributions, and investment policies and
returns. In the meetings, officers of each of the supported
organizations have an opportunity to ask questions and discuss with
officers of Z the projected needs of their organizations, as well as Z's
investment and grant making policies and practices. In addition to
holding these meetings with the supported organizations, Z provides the
contact information of one of its officers to each of the supported
organizations and encourages them to contact that officer if they have
questions, or if they wish to schedule additional meetings to discuss
the projected needs of their organization and how Z should distribute
its income and invest its assets. Z provides the information required
under paragraph (i)(2) of this
[[Page 164]]
section and a copy of its annual audited financial statements to the
principal officers of the supported organizations. Z meets the
relationship requirement of paragraph (i)(3)(ii)(B) or (C) of this
section with respect to each of its supported organizations. Based on
these facts, Z also satisfies the significant voice requirement of
paragraph (i)(3)(iii) of this section, and therefore meets the
responsiveness test of this paragraph (i)(3) with respect to each of its
ten supported organizations.
(v) Exception for pre-November 20, 1970 organizations. In the case
of a supporting organization that was supporting or benefiting a
supported organization before November 20, 1970, additional facts and
circumstances, such as a historic and continuing relationship between
the organizations, may be taken into account, in addition to the factors
described in paragraphs (i)(3)(ii) and (i)(3)(iii) of this section, to
establish compliance with the responsiveness test.
(4) Integral part test--functionally integrated Type III supporting
organization--(i) General rule. A supporting organization meets the
integral part test and will be considered functionally integrated within
the meaning of section 4943(f)(5)(B), if it--
(A) Engages in activities substantially all of which directly
further the exempt purposes of one or more supported organizations and
otherwise meets the requirements described in paragraph (i)(4)(ii) of
this section;
(B) Is the parent of each of its supported organizations, as
described in paragraph (i)(4)(iii) of this section; or
(C) Supports a governmental supported organization and otherwise
meets the requirements of paragraph (i)(4)(iv) of this section.
(ii) Substantially all activities directly further exempt purposes--
(A) In general. A supporting organization meets the requirements of this
paragraph (i)(4)(ii) if it engages in activities substantially all of
which--
(1) Directly further the exempt purposes of one or more supported
organizations by performing the functions of, or carrying out the
purposes of, such supported organization(s); and
(2) But for the involvement of the supporting organization, would
normally be engaged in by such supported organization(s).
(B) Meaning of substantially all. For purposes of paragraph
(i)(4)(ii)(A) of this section, in determining whether substantially all
of a supporting organization's activities directly further the exempt
purposes of one or more supported organization(s), all pertinent facts
and circumstances will be taken into consideration.
(C) Meaning of directly further. Activities ``directly further'' the
exempt purposes of one or more supported organizations for purposes of
this paragraph (i)(4) only if they are conducted by the supporting
organization itself, rather than by a supported organization. Holding
title to and managing exempt-use assets described in paragraph
(i)(8)(ii) of this section are activities that directly further the
exempt purposes of the supported organization within the meaning of this
paragraph (i)(4). Conversely, except as provided in paragraph
(i)(4)(ii)(D) of this section, fundraising, making grants (whether to
the supported organization or to third parties), and investing and
managing non-exempt-use assets are not activities that directly further
the exempt purposes of the supported organization within the meaning of
this paragraph (i)(4).
(D) Payments to individual beneficiaries. The making or awarding of
grants, scholarships, or other payments to individual beneficiaries who
are members of the charitable class benefited by a supported
organization will be treated as an activity that directly furthers the
exempt purposes of that supported organization for purposes of this
paragraph (i)(4) only if--
(1) The individual beneficiaries are selected on an objective and
nondiscriminatory basis (as described in Sec. 53.4945-4(b));
(2) The officers, directors, or trustees of the supported
organization have a significant voice in the timing of the payments, the
manner of making them, and the selection of recipients; and
(3) The making or awarding of such payments is part of an active
program of the supporting organization that directly furthers the exempt
purposes of the supported organization and in which the supporting
organization
[[Page 165]]
maintains significant involvement, as defined in Sec. 53.4942(b)-
1(b)(2)(ii) (except that ``supporting organization'' shall be
substituted for ``foundation'').
(iii) Parent of supported organization(s)--(A) In general. For
purposes of paragraph (i)(4)(i)(B) of this section, in order for a
supporting organization to qualify as the parent of each of its
supported organizations--
(1) The supporting organization and its supported organizations must
be part of an integrated system (such as, for example, a hospital
system);
(2) The supporting organization must direct the overall policies,
programs, and activities of the supported organizations (such as, for
example, coordinating the activities of the supported organizations and
engaging in overall planning, policy development, budgeting, and
resource allocation); and
(3) The supporting organization's governing body, members of the
governing body, or officers (acting in their official capacities) must
appoint or elect, directly or indirectly, a majority of the officers,
directors, or trustees of each supported organization and have the power
to remove and replace such directors, officers, or trustees, or
otherwise have an ongoing power to appoint or elect such directors,
officers or trustees with reasonable frequency.
(B) Subsidiary organizations. A supporting organization may meet the
requirements of paragraph (i)(4)(iii)(A)(3) of this section with respect
to a second-tier (or lower) subsidiary provided that the supporting
organization, by control of its first-tier subsidiary, has the power to
appoint or elect (as described in paragraph (i)(4)(iii)(A)(3) of this
section) a majority of the officers, directors, or trustees of the
lower-tier subsidiary. For example, if the board of directors of
supporting organization A elects a majority of the directors of
supported organization B, and the board of directors of B, in turn
elect, by a simple majority vote, a majority of the directors of
supported organization C, the directors of supporting organization A
will be treated as electing a majority of the directors of both
supported organization B and supported organization C.
(iv) Supporting a governmental supported organization--(A) In
general. A supporting organization satisfies the requirements of this
paragraph (i)(4)(iv) if--
(1) The supporting organization only supports one or more
governmental supported organizations;
(2) In any case in which the supporting organization supports more
than one governmental supported organization, all of the governmental
supported organizations either--
(i) Operate within the same city, county, or metropolitan area; or
(ii) Work in close coordination or collaboration with one another to
conduct a service, program, or activity that the supporting organization
supports; and
(3) A substantial part of the supporting organization's total
activities are activities that directly further, as defined by paragraph
(i)(4)(ii)(C) of this section, the exempt purposes of at least one
governmental supported organization.
(B) Governmental supported organization defined. For purposes of
paragraph (i)(4)(iv)(A) of this section, the term governmental supported
organization means a supported organization that is:
(1) A governmental unit described in section 170(c)(1), including
all of its agencies, departments, and divisions (all of which will be
treated as one governmental supported organization for purposes of this
paragraph (i)(4)(iv)); or
(2) An organization described in section 170(c)(2) and (b)(1)(A)
(other than in clauses (vii) and (viii)) that is an instrumentality of
one or more governmental units described in section 170(c)(1).
(C) Close coordination or collaboration. To satisfy the close
coordination or collaboration requirement of paragraph (i)(4)(iv)(A)(2)
of this section, the supporting organization must maintain on file a
letter from each of the governmental supported organizations (or a joint
letter from all of them) describing their coordination or collaboration
efforts with respect to the particular service, program, or activity.
[[Page 166]]
(D) Substantial part. For purposes of paragraph (i)(4)(iv)(A)(3) of
this section, in determining whether a substantial part of a supporting
organization's activities directly further the exempt purposes of one or
more governmental supported organization(s), all pertinent facts and
circumstances will be taken into consideration.
(E) Exception for organizations supporting a governmental supported
organization on or before February 19, 2016. A Type III supporting
organization in existence on or before February 19, 2016, will be
treated as meeting the requirements of this paragraph (i)(4)(iv) if it
met and continues to meet the following requirements:
(1) It supports one or more governmental supported organizations
described in paragraph (i)(4)(iv)(B) of this section and does not
support more than one supported organization that is not a governmental
supported organization;
(2) Each of the supported organizations is designated by the
supporting organization as provided in paragraph (d)(4) of this section
on or before February 19, 2016; and
(3) A substantial part (as defined in paragraph (i)(4)(iv)(D) of
this section) of the supporting organization's total activities are
activities that directly further (as defined by paragraph (i)(4)(ii)(C)
of this section) the exempt purposes of its governmental supported
organization(s).
(F) Transition rule for supporting organizations in existence on or
before February 19, 2016. Until the first day of the organization's
second taxable year beginning after February 19, 2016, a Type III
supporting organization in existence on or before February 19, 2016,
will be treated as meeting the requirements of this paragraph (i)(4)(iv)
if it continuously met the following requirements prior to the first day
of the organization's second taxable year beginning after February 19,
2016--
(1) It supported at least one supported organization that was a
governmental entity to which the supporting organization was responsive
within the meaning of paragraph (i)(3) of this section; and
(2) It engaged in activities for or on behalf of the governmental
supported organization described in paragraph (i)(4)(iv)(E)(1) of this
section that performed the functions of, or carried out the purposes of,
that governmental supported organization and that, but for the
involvement of the supporting organization, would normally have been
engaged in by the governmental supported organization itself.
(v) Examples. The provisions of this paragraph (i)(4) may be
illustrated by the following examples:
(A) Example 1. N, an organization described in section 501(c)(3), is
the parent organization of a healthcare system consisting of two
hospitals (Q and R) and an outpatient clinic (S), each of which is
described in section 509(a)(1), and a taxable subsidiary (T). N is the
sole member of each of Q, R, and S. Under the charter and bylaws of each
of Q, R, and S, N appoints all members of the board of directors of each
corporation. N engages in the overall coordination and supervision of
the healthcare system's exempt subsidiary corporations Q, R, and S in
approval of their budgets, strategic planning, marketing, resource
allocation, securing tax-exempt bond financing, and community education.
N also manages and invests assets that serve as endowments of Q, R, and
S. Based on these facts, N qualifies as a functionally integrated Type
III supporting organization under paragraph (i)(4)(i)(B) of this
section.
(B) Example 2. V, an organization described in section 501(c)(3), is
organized and operated as a supporting organization to L, a church
described in section 509(a)(1). V meets the responsiveness test
described in paragraph (i)(3) of this section with respect to L. L
transferred to V title to the buildings in which L conducts religious
services, Bible study, and community enrichment programs. Substantially
all of V's activities consist of holding and maintaining these
buildings, which L continues to use, free of charge, to further its
exempt purposes. But for the activities of V, L would hold and maintain
the buildings. Based on these facts, V satisfies the requirements of
paragraph (i)(4)(ii) of this section.
(C) Example 3. O is a local nonprofit food pantry described in
section 501(c)(3). O collects donated food from
[[Page 167]]
local growers, grocery stores, and individuals and distributes this food
free of charge to poor and needy people in O's community. O is organized
and operated as a supporting organization to eight churches of a
particular denomination located in O's community, each of which is
described in section 509(a)(1). Control of O is vested in a five-member
Board of Directors, which includes an official from one of the churches
as well as four lay members of the churches' congregations. The officers
of O maintain a close and continuing working relationship with each of
the eight churches and as a result of such relationship, each of the
eight churches has a significant voice in directing the use of the
income and assets of O. As a result, O is responsive to its supported
organizations. All of O's activities directly further the exempt
purposes of the eight supported organizations to which it is responsive.
Additionally, but for the activities of O, the churches would normally
operate food pantries themselves. Based on these facts, O satisfies the
requirements of paragraph (i)(4)(ii) of this section.
(D) Example 4. M, an organization described in section 501(c)(3),
was created by B, an individual, to provide scholarships for students of
U, a private secondary school and an organization described in section
509(a)(1). U establishes the scholarship criteria, publicizes the
scholarship program, solicits and reviews applications, and selects the
scholarship recipients. M invests its assets and disburses the funds for
scholarships to the recipients selected by U. M does not provide the
scholarships as part of an active program in which it maintains
significant involvement, as defined in Sec. 53.4942(b)-1(b)(2)(ii).
Based on these facts, M does not satisfy the requirements of paragraph
(i)(4)(ii) of this section.
(E) Example 5. J, an organization described in section 501(c)(3), is
organized as a supporting organization to community foundation G, an
organization described in section 509(a)(1). J meets the responsiveness
test described in paragraph (i)(3) of this section with respect to G. In
addition to maintaining field-of-interest funds, sponsoring donor
advised funds, and conducting general grantmaking activities, G also
engages in activities to beautify and maintain local parks.
Substantially all of J's activities consist of maintaining all of the
local parks in the area of community foundation G by performing
activities such as establishing and maintaining trails, planting trees,
and removing trash. But for the activities of J, G would normally engage
in these efforts to beautify and maintain the local parks. Based on
these facts, J satisfies the requirements of paragraph (i)(4)(ii) of
this section.
(F) Example 6. X, an organization described in section 501(c)(3), is
organized and operated as a supporting organization to two
organizations, City and Park. X meets the responsiveness test described
in paragraph (i)(3) of this section with respect to both City and Park.
City and Park are both governmental units described in section
170(c)(1). Park maintains a state park located within the same county as
City. X does not support any other organizations. X supports Park by
operating an information center for visitors to Park. The information
center provides educational material and informational sessions to
visitors to Park. X's activities related to operating the Park
information center constitute a substantial part of X's activities. X
also makes grants directly to City to fund City's other programs. X's
grant making activities constitute a substantial part of X's activities.
X meets the requirements of paragraph (i)(4)(iv)(A)(1) of this section
because X only supports City and Park, both of which are governmental
supported organizations described in paragraph (i)(4)(iv)(B) of this
section. X meets the requirements of paragraph (i)(4)(iv)(A)(2) of this
section because City and Park operate within the same county in
accordance with paragraph (i)(4)(iv)(A)(2)(i) of this section. Finally,
X meets the requirements of paragraph (i)(4)(iv)(A)(3) of this section
because a substantial part of X's activities directly further (within
the meaning of paragraph (i)(4)(ii)(C) of this section) Park's exempt
purposes, even though X's grants to City are also a substantial part of
X's activities. Based on these facts, X qualifies as functionally
integrated under paragraph (i)(4)(iv) of this section.
[[Page 168]]
(5) Integral part test--non-functionally integrated Type III
supporting organization--(i) General rule. A supporting organization
meets the integral part test and will be considered non-functionally
integrated if it satisfies either--
(A) The distribution requirement of paragraph (i)(5)(ii) of this
section and the attentiveness requirement of paragraph (i)(5)(iii) of
this section; or
(B) The pre-November 20, 1970 trust requirements of paragraph (i)(9)
of this section.
(ii) Distribution requirement--(A) Annual distribution. With respect
to each taxable year, a supporting organization must make distributions
described in paragraph (i)(6) of this section in a total amount equaling
or exceeding the supporting organization's distributable amount for the
taxable year, as defined in paragraph (i)(5)(ii)(B) of this section, on
or before the last day of the taxable year.
(B) Distributable amount. Except as provided in paragraphs
(i)(5)(ii)(D) and (E) of this section, the distributable amount for a
taxable year is an amount equal to the greater of 85 percent of the
supporting organization's adjusted net income (as determined by applying
the principles of section 4942(f) and Sec. 53.4942(a)-2(d) of this
chapter) for the taxable year immediately preceding the taxable year of
the required distribution (immediately preceding taxable year) or its
minimum asset amount (as defined in paragraph (i)(5)(ii)(C) of this
section) for the immediately preceding taxable year.
(C) Minimum asset amount. For purposes of this paragraph (i)(5), a
supporting organization's minimum asset amount for the immediately
preceding taxable year is 3.5 percent of the excess of the aggregate
fair market value of all of the supporting organization's non-exempt-use
assets (determined under paragraph (i)(8) of this section) in that
immediately preceding taxable year over the acquisition indebtedness
with respect to such non-exempt-use assets (determined under section
514(c)(1) without regard to the taxable year in which the indebtedness
was incurred), increased by--
(1) Amounts received or accrued during the immediately preceding
taxable year as repayments of amounts which were taken into account by
the organization to meet the distribution requirement imposed in this
paragraph (i)(5)(ii) for any taxable year;
(2) Amounts received or accrued during the immediately preceding
taxable year from the sale or other disposition of property to the
extent that the acquisition of such property was taken into account by
the organization to meet the distribution requirement imposed in this
paragraph (i)(5)(ii) for any taxable year; and
(3) Any amount set aside under paragraph (i)(6)(v) of this section
to the extent it is determined during the immediately preceding taxable
year that such amount is not necessary for the purposes for which it was
set aside and such amount was taken into account by the organization to
meet the distribution requirement imposed in this paragraph (i)(5)(ii)
for any taxable year.
(D) First taxable year. The distributable amount for the first
taxable year an organization is treated as a non-functionally integrated
Type III supporting organization is zero. Notwithstanding the foregoing,
for purposes of determining whether an excess amount is created under
paragraph (i)(7)(ii) of this section, the distributable amount for the
first taxable year an organization is treated as a non-functionally
integrated Type III supporting organization is the distributable amount
that would apply under paragraph (i)(5)(ii)(B) of this section in the
absence of this paragraph (i)(5)(ii)(D).
(E) Emergency temporary reduction. The Secretary may provide by
publication in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii)(b) of this chapter) for a temporary reduction in the
distributable amount in the case of a disaster or emergency.
(F) Reasonable cause exception. A non-functionally integrated Type
III supporting organization that fails to meet the distribution
requirement of this paragraph (i)(5)(ii) will not be classified as a
private foundation for the taxable year in which it fails to meet the
distribution requirement if the organization establishes to the
satisfaction of the Secretary that--
(1) The failure was due solely to unforeseen events or circumstances
that
[[Page 169]]
are beyond the organization's control, a clerical error, or an incorrect
valuation of assets;
(2) The failure was due to reasonable cause and not to willful
neglect; and
(3) The distribution requirement is met within 180 days after the
organization is first able to distribute its distributable amount
notwithstanding the unforeseen events or circumstances, or 180 days
after the date the incorrect valuation or clerical error was or should
have been discovered; however, no amounts paid to meet a distribution
requirement for a prior taxable year under this paragraph
(i)(5)(ii)(F)(3) may be counted toward the distribution requirement for
the taxable year in which such amounts are paid.
(iii) Attentiveness requirement--(A) General rule. With respect to
each taxable year, a non-functionally integrated Type III supporting
organization must distribute one-third or more of its distributable
amount to one or more supported organizations that are attentive to the
operations of the supporting organization (within the meaning of
paragraph (i)(5)(iii)(B) of this section).
(B) Attentiveness. A supported organization is attentive to the
operations of the supporting organization during a taxable year if, in
the taxable year, at least one of the following requirements is
satisfied:
(1) The supporting organization distributes to the supported
organization amounts equaling or exceeding 10 percent of the supported
organization's total support (or, in the case of a particular department
or school of a university, hospital, or church, the total support of the
department or school) received during the supported organization's last
taxable year ending before the beginning of the supporting
organization's taxable year.
(2) The amount of support received from the supporting organization
is necessary to avoid the interruption of the carrying on of a
particular function or activity of the supported organization. The
support is necessary if the supporting organization or the supported
organization earmarks the support for a particular program or activity
of the supported organization, even if such program or activity is not
the supported organization's primary program or activity, as long as
such program or activity is a substantial one.
(3) Based on the consideration of all pertinent factors, including
the number of supported organizations, the length and nature of the
relationship between the supported organization and supporting
organization, and the purpose to which the funds are put, the amount of
support received from the supporting organization is a sufficient part
of a supported organization's total support (or, in the case of a
particular department or school of a university, hospital, or church,
the total support of the department or school) to ensure attentiveness.
Normally the attentiveness of a supported organization is influenced by
the amounts received from the supporting organization. Thus, the more
substantial the amount involved in terms of a percentage of the
supported organization's total support, the greater the likelihood that
the required degree of attentiveness will be present. However, in
determining whether the amount received from the supporting organization
is sufficient to ensure the attentiveness of the supported organization
to the operations of the supporting organization (including
attentiveness to the nature and yield of the supporting organization's
investments), evidence of actual attentiveness by the supported
organization is of almost equal importance. A supported organization is
not considered to be attentive solely because it has enforceable rights
against the supporting organization under state law.
(C) Distribution to donor advised fund disregarded. Notwithstanding
paragraph (i)(5)(iii)(B) of this section, in determining whether a
supported organization will be considered attentive to the operations of
a supporting organization, any amount received from the supporting
organization that is held by the supported organization in a donor
advised fund described in section 4966(d)(2) will be disregarded.
(D) Examples. This paragraph (i)(5)(iii) is illustrated by the
following examples:
(1) Example 1. K, an organization described in section 501(c)(3),
annually pays an aggregate amount equaling or
[[Page 170]]
exceeding its distributable amount described in paragraph (i)(5)(ii)(B)
of this section to L, a museum described in section 509(a)(2). K meets
the responsiveness test described in paragraph (i)(3) of this section
with respect to L. In recent years, L has earmarked the income received
from K to underwrite the cost of carrying on a chamber music series
consisting of 12 performances a year that are performed for the general
public free of charge at its premises. The chamber music series is not
L's primary activity but it is a substantial activity. L could not
continue the performances without K's support. Based on these facts, K
meets the requirements of paragraph (i)(5)(iii)(B)(2) of this section.
(2) Example 2. M, an organization described in section 501(c)(3),
annually pays an aggregate amount equaling or exceeding its
distributable amount described in paragraph (i)(5)(ii)(B) of this
section to the Law School of N University, an organization described in
section 509(a)(1). M meets the responsiveness test described in
paragraph (i)(3) of this section with respect to N. M has earmarked the
income paid over to N's Law School to endow a chair in International
Law. Without M's continued support, N could not continue to maintain
this chair. The chair is not N's primary activity but it is a
substantial activity. Based on these facts, M meets the requirements of
paragraph (i)(5)(iii)(B)(2) of this section.
(3) Example 3. R is a charitable trust created under the will of B,
who died in 1969. R's purpose is to hold assets as an endowment for S (a
hospital), T (a university), and U (a national medical research
organization), all organizations described in section 509(a)(1) and
specifically named in the trust instrument, and to distribute all of the
income each year in equal shares among the three named beneficiaries.
Each year, R pays to S, T, and U an aggregate amount equaling or
exceeding its distributable amount described in paragraph (i)(5)(ii)(B)
of this section. Such payments equal less than one percent of the total
support that each supported organization received in its most recently
completed taxable year. Based on these facts, R does not meet the
requirements of paragraph (i)(5)(iii)(B)(1) of this section. However,
because B died prior to November 20, 1970, R could meet the requirements
of paragraph (i)(5)(i)(B) of this section upon meeting all of the
requirements of paragraph (i)(9) of this section.
(4) Example 4. O is an organization described in section 501(c)(3).
O is organized to support five private universities, V, W, X, Y, and Z,
each of which is described in section 509(a)(1). O meets the
responsiveness test described in paragraph (i)(3) of this section with
respect to each of its supported organizations. Each year, O distributes
an aggregate amount that equals its distributable amount described in
paragraph (i)(5)(ii)(B) of this section and distributes an equal amount
to each of the five universities. O distributes annually to each of V
and W an amount that equals more than 10 percent of each university's
total annual support received in its most recently completed taxable
year. Based on these facts, O meets the requirements of paragraph
(i)(5)(iii) of this section because it distributes two-fifths (more than
the required one-third) of its distributable amount to supported
organizations that are attentive to O.
(6) Distributions that count toward distribution requirement. For
purposes of this paragraph (i)(6), the amount of a distribution made to
a supported organization is the amount of cash distributed or the fair-
market value of the property distributed as of the date the distribution
is made. The amount of a distribution will be determined solely on the
cash receipts and disbursements method of accounting described in
section 446(c)(1). Distributions by the supporting organization that
count toward the distribution requirement imposed in paragraph
(i)(5)(ii) of this section are limited to--
(i) Any amount paid to a supported organization to accomplish the
supported organization's exempt purposes;
(ii) Any amount paid by the supporting organization to perform an
activity that satisfies the requirements of paragraph (i)(4)(ii) of this
section, but only to the extent such amount exceeds any income derived
by the supporting organization from the activity;
(iii) Any reasonable and necessary--
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(A) Administrative expenses paid to accomplish the exempt purposes
of the supported organization, which do not include expenses incurred in
the production of investment income or expenses incurred in the conduct
of fundraising activities (except solicitation expenses described in
paragraph (i)(6)(iii)(B) of this section); and
(B) Expenses incurred to solicit contributions that are received
directly by a supported organization (rather than by the supporting
organization), but only to the extent the amount of the reasonable and
necessary expenses the supporting organization incurs for each
solicitation does not exceed the amount of contributions that are
actually received by the supported organization directly from donors as
a result of each such solicitation, as substantiated in a written report
by the supported organization to the supporting organization that is
postmarked or electronically transmitted by the due date of the
supporting organization's Form 990 (or successor form) for the year of
the solicitation(s) (without regard to extensions);
(iv) Any amount paid to acquire an exempt-use asset described in
paragraph (i)(8)(ii) of this section; and
(v) Any amount set aside for a specific project that accomplishes
the exempt purposes of a supported organization, with such set-aside
counting toward the distribution requirement for the taxable year in
which the amount is set aside but not in the year in which it is
actually paid, if at the time of the set-aside, the supporting
organization--
(A) Obtains a written statement from each supported organization
whose exempt purposes the specific project accomplishes, signed under
penalty of perjury by one of the supported organization's principal
officers, as defined in paragraph (i)(2)(iv) of this section, stating
that the supported organization approves the project as one that
accomplishes one or more of the supported organization's exempt purposes
and also approves the supporting organization's determination that the
project is one that can be better accomplished by such a set-aside than
by the immediate payment of funds;
(B) Establishes to the satisfaction of the Commissioner, by meeting
the approval and information requirements described in Sec. 53.4942(a)-
3(b)(7)(i) of this chapter and by providing the written statement
described in paragraph (i)(6)(v)(A) of this section, that the amount set
aside will be paid for the specific project within 60 months after it is
set aside and that the project is one that can better be accomplished by
the set-aside than by the immediate payment of funds; and
(C) Evidences the set-aside by the entry of a dollar amount on the
books and records of the supporting organization as a pledge or
obligation to be paid at a future date or dates within 60 months of the
set aside.
(7) Carryover of excess amounts--(i) In general. If with respect to
any taxable year, an excess amount, as defined in paragraph (i)(7)(ii)
of this section, is created, such excess amount may be used to reduce
the distributable amount in any of the five taxable years immediately
following the taxable year in which the excess amount is created. An
excess amount created in a taxable year can only be carried over for
five taxable years.
(ii) Excess amount. An excess amount is created for any taxable year
beginning after December 28, 2012, if the total distributions made in
that taxable year that count toward the distribution requirement exceed
the supporting organization's distributable amount for the taxable year,
as determined under paragraph (i)(5)(ii)(B) of this section. With
respect to any taxable year to which an excess amount is carried over,
in determining whether an excess amount is created in that taxable year,
the distributable amount is first reduced by any excess amounts carried
over (with the oldest excess amounts applied first) and then by any
distributions made in that taxable year.
(8) Valuation of non-exempt-use assets. For purposes of determining
its distributable amount for a taxable year, a supporting organization
determines its minimum asset amount, as defined in paragraph
(i)(5)(ii)(C) of this section, by determining the aggregate fair market
value of all of its non-exempt-use assets in the immediately preceding
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taxable year. For these purposes, the determination of the aggregate
fair market value of all non-exempt-use assets shall be made using the
valuation methods described in Sec. 53.4942(a)-2(c) of this chapter.
The aggregate fair market value of the supporting organization's non-
exempt-use assets shall not be reduced by any amount that is set aside
under paragraph (i)(6)(v) of this section. For these purposes, the non-
exempt use assets of the supporting organization are all assets of the
supporting organization other than--
(i) Assets described in Sec. 53.4942(a)-2(c)(2)(i) through (iv) of
this chapter (with the term ``supporting organization'' being
substituted for ``foundation'' or ``private foundation'' and the date
``August 17, 2006'' being substituted for ``December 31, 1969''); and
(ii) Exempt-use assets, which are assets that are used (or held for
use) directly in carrying out the exempt purposes of the supporting
organization's supported organization(s) (determined by applying the
principles described in Sec. 53.4942(a)-2(c)(3) of this chapter) by
either--
(A) The supporting organization; or
(B) One or more supported organizations, but only if the supporting
organization makes the asset available to the supported organization(s)
at no cost (or nominal rent) to the supported organization(s).
(9) Alternate integral part test for certain trusts. A trust
(whether or not exempt from taxation under section 501(a)) that on
November 20, 1970, met and continues to meet the requirements of
paragraphs (i)(9)(i) through (i)(9)(v) of this section, shall be treated
as meeting the requirements of paragraph (i)(5) of this section if for
taxable years beginning after October 16, 1972, the trustee of such
trust makes annual written reports to all of the trust's supported
organizations, setting forth a description of the trust's assets,
including a detailed list of the assets and the income produced by such
assets. A trust that meets the requirements of this paragraph (i)(9) may
request a ruling that it is described in section 509(a)(3) in such
manner as the Commissioner may prescribe. The requirements of this
paragraph (i)(9) are as follows:
(i) All the unexpired interests in the trust are devoted to one or
more purposes described in section 170(c)(1) or (c)(2)(B) and a
deduction was allowed with respect to such interests under sections 170,
545(b)(2), 556(b)(2), 642(c), 2055, 2106(a)(2), 2522, or corresponding
provisions of prior law (or would have been allowed such a deduction if
the trust had not been created before 1913).
(ii) The trust was created prior to November 20, 1970, and did not
receive any grant, contribution, bequest or other transfer on or after
such date. For purposes of this paragraph (i)(9)(ii), a split-interest
trust described in section 4947(a)(2) that was created prior to November
20, 1970, was irrevocable on such date, and that becomes a charitable
trust described in section 4947(a)(1) after such date shall be treated
as having been created prior to such date.
(iii) The trust is required by its governing instrument to
distribute all of its net income currently to a designated beneficiary
supported organization. If more than one beneficiary supported
organization is designated in the governing instrument of a trust, all
of the net income must be distributable and must be distributed
currently to each of such supported organizations in fixed shares
pursuant to such governing instrument. For purposes of this paragraph
(i)(9)(iii), the governing instrument of a charitable trust shall be
treated as requiring distribution to a designated supported organization
when the trust instrument describes the charitable purpose of the trust
so completely that such description can apply to only one existing
supported organization and is of sufficient particularity as to vest in
such organization rights against the trust enforceable in a court
possessing equitable powers.
(iv) The trustee of the trust does not have discretion to vary
either the beneficiary supported organizations or the amounts payable to
the supported organizations. For purposes of this paragraph (i)(9)(iv),
a trustee shall not be treated as having such discretion if the trustee
has discretion to make payments of principal to the single supported
organization that is currently
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entitled to receive all of the trust's income or if the trust instrument
provides that the trustee may cease making income payments to a
particular supported organization in the event of certain specific
occurrences, such as the loss of exemption under section 501(c)(3) or
classification under section 509(a)(1) or (a)(2) by the supported
organization or the failure of the supported organization to carry out
its charitable purpose properly.
(v) None of the trustees would be disqualified persons within the
meaning of section 4946(a) (other than foundation managers under section
4946(a)(1)(B)) with respect to the trust if such trust were treated as a
private foundation.
(10) Foreign supported organizations. A supporting organization is
not operated in connection with one or more supported organizations if
it supports any supported organization organized outside of the United
States.
(11) Transition rules--(i) Notification requirement. A Type III
supporting organization will be treated as having satisfied the
notification requirement described in paragraph (i)(2) of this section
for its taxable year that includes December 28, 2012, if the required
notification is postmarked or electronically transmitted by the later of
the last day of the fifth calendar month following the close of that
taxable year or the due date (including extensions) of the supporting
organization's annual information return described in section 6033 for
that taxable year.
(ii) Integral part test--(A) Qualification as a functionally
integrated Type III supporting organization. A Type III supporting
organization in existence on December 28, 2012, that met and continues
to meet the requirements of Treas. Reg. Sec. 1.509(a)-4(i)(3)(ii), as
in effect prior to December 28, 2012, will be treated as meeting the
requirements of paragraph (i)(4) of this section until the first day of
the organization's second taxable year beginning after December 28,
2012.
(B) Qualification as a non-functionally integrated Type III
supporting organization. A Type III supporting organization in existence
on December 28, 2012, that met and continues to meet the requirements of
Treas. Reg. Sec. 1.509(a)-4(i)(3)(iii), as in effect prior to December
28, 2012, will be treated as meeting the requirements of paragraph
(i)(5)(i)(A) of this section until the first day of its second taxable
year beginning after December 28, 2012. Notwithstanding the foregoing,
in determining whether an excess amount is created under paragraph
(i)(7)(ii) of this section in the first taxable year beginning after
December 28, 2012, the distributable amount for that taxable year of a
Type III supporting organization treated as meeting the requirements of
paragraph (i)(5)(i)(A) of this section under this paragraph
(i)(11)(ii)(B) is the amount described in Sec. 1.509(a)-
4T(i)(5)(ii)(B).
(C) Transitioning to a non-functionally integrated Type III
supporting organization in the first taxable year after effective date.
A Type III supporting organization in existence on December 28, 2012,
that meets the requirements of Treas. Reg. Sec. 1.509(a)-4(i)(3)(ii),
as in effect prior to December 28, 2012, in its taxable year including
December 28, 2012, but not in its first taxable year beginning after
December 28, 2012, is a non-functionally integrated Type III supporting
organization and will be treated as having a distributable amount of
zero for purposes of meeting the requirements of paragraph (i)(5)(i)(A)
of this section during the organization's first taxable year beginning
after December 28, 2012. Notwithstanding the foregoing, in determining
whether an excess amount is created under paragraph (i)(7)(ii) of this
section in the first taxable year beginning after December 28, 2012, the
distributable amount for that taxable year of a Type III supporting
organization described in this paragraph (i)(11)(ii)(C) is the amount
described in Sec. 1.509(a)-4T(i)(5)(ii)(B), determined without regard
to paragraph (i)(5)(ii)(D) of this section.
(D) Second taxable year after effective date. Beginning in the
second taxable year beginning after December 28, 2012, and in all
succeeding taxable years, all Type III supporting organizations
described in this paragraph (i)(11)(ii) must meet either the
requirements of paragraph (i)(4) or (i)(5) of this section. If a Type
III supporting organization described in paragraph (i)(11)(ii)(A) of
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this section does not meet the requirements of paragraph (i)(4) of this
section during its second taxable year beginning after December 28,
2012, its distributable amount for that second taxable year will be
determined under Sec. 1.509(a)-4T(i)(5)(ii)(B), without regard to
paragraph (i)(5)(ii)(D) of this section. Any Type III supporting
organization intending to meet the requirements of paragraph (i)(5) of
this section in its second taxable year beginning after December 28,
2012, must value its assets in accordance with Sec. 1.509(a)-4T(i)(8)
beginning in its first taxable year beginning after December 28, 2012.
(E) Judicial proceedings to reform instruments. During any taxable
years in which there is pending a judicial proceeding that meets the
requirements of this paragraph (i)(11)(ii)(E), a non-functionally
integrated Type III supporting organization organized before September
24, 2009, will not have to comply with the distribution requirement
under paragraph (i)(5)(ii) of this section to the extent such compliance
would be inconsistent with mandatory provisions of a governing
instrument or other instrument executed before September 24, 2009, that
prohibits distributing capital or corpus. Beginning with the first
taxable year following the taxable year in which such judicial
proceeding is terminated, such a non-functionally integrated Type III
supporting organization must satisfy the distribution requirement under
paragraph (i)(5)(ii) of this section, regardless of the outcome of the
judicial proceeding. Thus, if, during a taxable year after such a
judicial proceeding, an organization fails to comply with paragraph
(i)(5)(ii) of this section, the organization will not qualify as a non-
functionally integrated Type III supporting organization, regardless of
whether such failure to comply was a result of the organization
operating in accordance with its governing instrument or other
instrument. To meet the requirements of this paragraph (i)(11)(ii)(E), a
judicial proceeding must be--
(1) Necessary to reform, or to excuse the supporting organization
from compliance with, a governing instrument or other instrument (as in
effect on September 24, 2009, and all times thereafter) in order to
permit the organization to satisfy paragraph (i)(5)(ii) of this section;
(2) Commenced before June 26, 2013; and
(3) Not subject to any unreasonable delay for which the supporting
organization is responsible.
(j) Control by disqualified persons--(1) In general. Under the
provisions of section 509(a)(3)(C) a supporting organization may not be
controlled directly or indirectly by one or more disqualified persons
(as defined in section 4946) other than foundation managers and other
than one or more publicly supported organizations. If a person who is a
disqualified person with respect to a supporting organization, such as a
substantial contributor to the supporting organization, is appointed or
designated as a foundation manager of the supporting organization by a
publicly supported beneficiary organization to serve as the
representative of such publicly supported organization, then for
purposes of this paragraph such person will be regarded as a
disqualified person, rather than as a representative of the publicly
supported organization. An organization will be considered controlled,
for purposes of section 509(a)(3)(C), if the disqualified persons, by
aggregating their votes or positions of authority, may require such
organization to perform any act which significantly affects its
operation or may prevent such organization from performing such act.
This includes, but is not limited to, the right of any substantial
contributor or his spouse to designate annually the recipients, from
among the publicly supported organizations of the income attributable to
his contribution to the supporting organization. Except as provided in
subparagraph (2) of this paragraph, a supporting organization will be
considered to be controlled directly or indirectly by one or more
disqualified persons if the voting power of such persons is 50 percent
or more of the total voting power of the organization's governing body
or if one or more of such persons have the right to exercise veto power
over the actions of the organization. Thus, if the governing body of a
foundation is composed of five trustees, none of whom has a veto power
over the actions of the foundation, and no
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more than two trustees are at any time disqualified persons, such
foundation will not be considered to be controlled directly or
indirectly by one or more disqualified persons by reason of this fact
alone. However, all pertinent facts and circumstances including the
nature, diversity, and income yield of an organization's holdings, the
length of time particular stocks, securities, or other assets are
retained, and its manner of exercising its voting rights with respect to
stocks in which members of its governing body also have some interest,
will be taken into consideration in determining whether a disqualified
person does in fact indirectly control an organization.
(2) Proof of independent control. Notwithstanding subparagraph (1)
of this paragraph, an organization shall be permitted to establish to
the satisfaction of the Commissioner that disqualified persons do not
directly or indirectly control it. For example, in the case of a
religious organization operated in connection with a church, the fact
that the majority of the organization's governing body is composed of
lay persons who are substantial contributors to the organization will
not disqualify the organization under section 509(a)(3)(C) if a
representative of the church, such as a bishop or other official, has
control over the policies and decisions of the organization.
(k) Organizations operated in conjunction with certain section
501(c) (4), (5), or (6) organizations. (1) For purposes of section
509(a)(3), an organization which is operated in conjunction with an
organization described in section 501(c) (4), (5), or (6) (such as a
social welfare organization, labor or agricultural organization,
business league, or real estate board) shall, if it otherwise meets the
requirements of section 509(a)(3), be considered an organization
described in section 509(a)(3) if such section 501(c) (4), (5), or (6)
organization would be described in section 509(a)(2) if it were an
organization described in section 501(c)(3). The section 501(c) (4),
(5), or (6) organization, which the supporting organization is operating
in conjunction with, must therefore meet the one-third tests of a
publicly supported organization set forth in section 509(a)(2).
(2) This paragraph (k) may be illustrated by the following example:
(i) Example. X medical association, described in section 501(c)(6),
is supported by membership dues and funds resulting from the performance
of its exempt activities. This support, which is entirely from permitted
sources, constitutes more than one-third of X's support. X does not
normally receive more than one-third of its support from items described
in section 509(a)(2)(B). X organized and operated an endowment fund for
the sole purpose of furthering medical education. The fund is an
organization described in section 501(c)(3). Since more than one-third
of X's support is derived from membership dues and from funds resulting
from the performance of exempt purposes (all of which are from permitted
sources) and not more than one-third of its support is from items
described in section 509(a)(2)(B), it would be a publicly supported
organization described in section 509(a)(2) if it were described in
section 501(c)(3) rather than section 501(c)(6). Accordingly, if the
fund otherwise meets the requirements of section 509(a)(3) with respect
to X, it will be considered an organization described in section
509(a)(3).
(ii) [Reserved]
(l) Applicability dates. (1) Paragraphs (a)(6), (f)(5), and (i) of
this section are applicable on December 28, 2012, except--
(i) Paragraphs (i)(4)(ii)(C), (i)(5)(ii)(C) and (D), (i)(6)(iv),
(i)(7)(ii), and (i)(8) of this section are applicable on December 21,
2015; and
(ii) Paragraphs (d)(4)(i)(C), (f)(5)(ii), (i)(2)(i) and (iii),
(i)(3)(i), (i)(3)(iv)(C) (Example 3), (i)(4)(ii)(A)(1), (i)(4)(ii)(B),
(i)(4)(iii) and (iv), (i)(4)(v)(F) (Example 6), (i)(5)(ii)(A) and (B),
(i)(5)(iii)(A), (i)(5)(iii)(D)(4) (Example 4), (i)(6) introductory text,
and (i)(6)(iii) and (v) of this section are applicable to taxable years
beginning on or after October 16, 2023.
(2) Taxpayers may choose to apply the paragraphs listed in paragraph
(I)(1)(ii) of this section to taxable years beginning on or after
February 19, 2016, and before October 16, 2023, provided the taxpayer
applies the provisions
[[Page 176]]
listed in paragraph (l)(1)(ii) of this section in their entirety and in
a consistent manner.
(3) See paragraphs (i)(5)(ii)(B) and (C) and (i)(8) of Sec.
1.509(a)-4T contained in 26 CFR part 1, revised as of April 1, 2015, for
certain rules regarding non-functionally integrated Type III supporting
organizations effective before December 21, 2015. See paragraphs
(i)(5)(ii)(A) and (B) and (i)(5)(iii)(D) of Sec. 1.509(a)-4 contained
in 26 CFR part 1, revised as of April 1, 2023, for certain rules
regarding non-functionally integrated Type III supporting organizations
effective before October 16, 2023.
[T.D. 7212, 37 FR 21916, Oct. 17, 1972, as amended by T.D. 7784, 46 FR
37890, July 23, 1981; 77 FR 76394, Dec. 28, 2012; T.D. 9746, 80 FR
79686, Dec. 23, 2015; T.D. 9981, 88 FR 71298, Oct. 16, 2023]
Sec. 1.509(a)-5 Special rules of attribution.
(a) Retained character of gross investment income. (1) For purposes
of determining whether an organization meets the not-more-than-one-third
support test set forth in section 509(a)(2)(B), amounts received by such
organization from:
(i) An organization which seeks to be described in section 509(a)(3)
by reason of its support of such organization; or
(ii) A charitable trust, corporation, fund, or association described
in section 501(c)(3) (including a charitable trust described in section
4947(a)(1)) or a split interest trust described in section 4947(a)(2),
which is required by its governing instrument or otherwise to
distribute, or which normally does distribute, at least 25 percent of
its adjusted net income (within the meaning of section 4942(f)) to such
organization, and such distribution normally comprises at least 5
percent of such distributee organization's adjusted net income
will retain their character as gross investment income (rather than
gifts or contributions) to the extent that such amounts are
characterized as gross investment income in the possession of the
distributing organization described in subdivision (i) or (ii) of this
subparagraph or, if the distributing organization is a split interest
trust described in section 4947(a)(2), to the extent that such amounts
would be characterized as gross investment income attributable to
transfers in trust after May 26, 1969, if such trust were a private
foundation. For purposes of this section, all income which is
characterized as gross investment income in the possession of the
distributing organization shall be deemed to be distributed first by
such organization and shall retain its character as such in the
possession of the recipient of amounts described in this paragraph. If
an organization described in subdivision (i) or (ii) of this
subparagraph makes distributions to more than one organization, the
amount of gross investment income deemed distributed shall be prorated
among the distributees.
(2) For purposes of subparagraph (1) of this paragraph, amounts paid
by an organization to provide goods, services, or facilities for the
direct benefit of an organization seeking section 509(a)(2) status
(rather than for the direct benefit of the general public) shall be
treated in the same manner as amounts received by the latter
organization. Such amounts will be treated as gross investment income to
the extent that such amounts are characterized as gross investment
income in the possession of the organization spending such amounts. For
example, X is an organization described in subparagraph (1)(i) of this
paragraph. It uses part of its funds to provide Y, an organization
seeking section 509(a)(2) status, with certain services which Y would
otherwise be required to purchase on its own. To the extent that the
funds used by X to provide such services for Y are characterized as
gross investment income in the possession of X, such funds will be
treated as gross investment income received by Y.
(3) An organization seeking section 509(a)(2) status shall file a
separate statement with its return required by section 6033, setting
forth all amounts received from organizations described in paragraph
(a)(1) (i) or (ii) of this section.
(b) Relationships created for avoidance purposes. (1) If a
relationship between an organization seeking section 509(a)(3) status
and an organization seeking section 509(a)(2) status:
[[Page 177]]
(i) Is established or availed of after October 9, 1969, and
(ii) One of the purposes of establishing or utilizing such
relationship is to avoid classification as a private foundation with
respect to either organization, the character and amount of support
received by the section 509(a)(3) organization will be attributed to the
section 509(a)(2) organization for purposes of determining whether the
latter meets the one-third support test and the not-more-than-one-third
support test under section 509(a)(2). If a relationship described in
this subparagraph is established or utilized by an organization seeking
section 509(a)(3) status and two or more organizations seeking section
509(a)(2) status, the amount of support received by the former
organization will be prorated among the latter organizations and the
character of each class of support (as defined in section 509(d)) will
be attributed pro rata to each such organization. The provisions of this
paragraph and of paragraph (a) of this section are not mutually
exclusive.
(2) In determining whether a relationship between one or more
organizations seeking section 509(a)(2) status (hereinafter referred to
as beneficiary organizations) and an organization seeking section
509(a)(3) status (hereinafter referred to as the supporting
organization) has been established or availed of to avoid classification
as a private foundation (within the meaning of subparagraph (1) of this
paragraph), all pertinent facts and circumstances, including the
following, shall be taken into account as evidence that a relationship
was not established or availed of to avoid classification as a private
foundation:
(i) The supporting organization is operated to support or benefit
several specified beneficiary organizations.
(ii) The beneficiary organization has a substantial number of dues-
paying members (in relation to the public it serves and the nature of
its activities) and such members have an effective voice in the
management of both the supporting and beneficiary organizations.
(iii) The beneficiary organization is composed of several membership
organizations, each of which has a substantial number of members (in
relation to the public it serves and the nature of its activities), and
such membership organizations have an effective voice in the management
of the supporting and beneficiary organizations.
(iv) The beneficiary organization receives a substantial amount of
support from the general public, public charities, or governmental
grants.
(v) The supporting organization uses its funds to carry on a
meaningful program of activities to support or benefit the beneficiary
organization and such use would, if such supporting organization were a
private foundation, be sufficient to avoid the imposition of any tax
upon such organization under section 4942.
(vi) The supporting organization is not able to exercise substantial
control or influence over the beneficiary organization by reason of the
former's receiving support or holding assets which are
disproportionately large in comparison with the support received or the
assets held by the latter.
(vii) Different persons manage the operations of the beneficiary and
supporting organizations and each organization performs a different
function.
(3) The provisions of this paragraph may be illustrated by the
following examples:
Example 1. M, an organization described in section 509(a)(2), is a
council composed of 10 learned societies. Each member society has a
large membership of scholars interested in a particular academic area.
In 1970 M established N, an organization seeking section 509(a)(3)
status, for the purpose of carrying on research and study projects of
interest to the member societies. The principal source of funds for N's
activities is from foundation and government grants and contracts. The
principal source of funds for M's activities after the creation of N is
membership dues. M continued to maintain a wide variety of activities
for its members, such as publishing periodicals and carrying on seminars
and conferences. N is subject to complete control by the governing body
of M. Under these circumstances, the relationship between these
organizations is not one which is described in subparagraph (1) of this
paragraph.
Example 2. Q is a local medical research organization described in
section 509(a)(2). Its fixed assets are negligible and it carries on
research activities on a limited scale. It also
[[Page 178]]
makes a limited number of grants to scientists and doctors who are
engaged in medical research of interest to Q. It receives support
through small government grants and a few research contracts from
private foundations. R is an organization described in section
501(c)(3). As of January 1, 1970, R was classified as a private
foundation under section 509. It has a substantial endowment which it
uses to make grants to various charitable and scientific organizations
described in section 501(c)(3). During 1970, R agrees to subsidize the
research activities of Q. R amends its governing instrument to provide
specifically that all of R's support will be used for research
activities which are approved and supervised by Q. R also amends its
bylaws to permit a minority of Q's board of directors to be members of
R's governing body. R then gives timely notification under section
507(b)(1)(B)(ii) that R is terminating its private foundation status by
meeting the requirements of section 509(a)(3) by the end of the 12-month
period described in section 507(b)(1)(B)(i). For purposes of determining
whether R has met the requirements of section 509(a)(3) by the end of
the 12-month period, as well as determining Q's status under section
509(a)(2), the character and amount of support received by R will be
attributed to Q.
(c) Effect on organizations claiming section 509(a)(3) status. If an
organization claiming section 509(a)(2) status fails to meet either the
one-third support test or the not-more-than-one-third support test under
section 509(a)(2) by reason of the application of the provisions of
paragraph (a) or (b) of this section, and such organization is one of
the specified organizations (within the meaning of section 509(a)(3)(A))
for whose support or benefit an organization claiming section 509(a)(3)
status is operated, the organization claiming section 509(a)(3) status
will not be considered to be operated exclusively to support or benefit
one or more section 509(a) (1) or (2) organizations.
[T.D. 7212, 37 FR 21922, Oct. 17, 1972, as amended by T.D. 7290, 38 FR
31834, Nov. 19, 1973; T.D. 7784, 46 FR 37890, July 23, 1981]
Sec. 1.509(a)-6 Classification under section 509(a).
If an organization is described in section 509(a)(1) and also in
another paragraph of section 509(a), it will be treated as described in
section 509(a)(1). For purposes of this section, the parenthetical
language other than in clauses (vii) and (viii) used in section
509(a)(1) shall be construed to mean other than an organization which is
described only in clause (vii) or (viii). For example, X is an
organization which is described in section 170(b)(1)(A)(vi), but could
also meet the description of section 170(b)(1)(A)(viii) as an
organization described in section 509(a)(2). For purposes of the one-
third support test in section 509(a)(2)(A), contributions from X to
other organizations will be treated as support from an organization
described in section 170(b)(1)(A)(vi) rather than from an organization
described in section 170(b)(1)(A)(viii).
[T.D. 7212, 37 FR 21923, Oct. 17, 1972]
Sec. 1.509(a)-7 Reliance by grantors and contributors to
section 509(a) (1), (2), and (3) organizations.
(a) General rule. Once an organization has received a final ruling
or determination letter classifying it as an organization described in
section 509(a) (1), (2), or (3), the treatment of grants and
contributions and the status of grantors and contributors to such
organization under sections 170, 507, 545(b)(2), 556(b)(2), 642(c),
4942, 4945, 2055, 2106(a)(2), and 2522 will not be affected by reason of
a subsequent revocation by the service of the organization's
classification as described in section 509(a) (1), (2), or (3) until the
date on which notice of change of status is made to the public (such as
by publication in the Internal Revenue Bulletin) or another applicable
date, if any, specified in such public notice. In appropriate cases,
however, the treatment of grants and contributions and the status of
grantors and contributors to an organization described in section 509(a)
(1), (2), or (3) may be affected pending verification of the continued
classification of such organization under section 509(a) (1), (2), or
(3). Notice to this affect will be made in a public announcement by the
service. In such cases the effect of grants and contributions made after
the date of the announcement will depend upon the statutory
qualification of the organization as an organization described in
section 509(a) (1), (2), or (3).
(b) Exceptions. (1) Paragraph (a) of this section shall not apply if
the grantor or contributor:
[[Page 179]]
(i) Had knowledge of the revocation of the ruling or determination
letter classifying the organization as an organization described in
section 509(a) (1), (2), or (3), or
(ii) Was in part responsible for, or was aware of, the act, the
failure to act, or the substantial and material change on the part of
the organization which gave rise to the revocation of the ruling or
determination letter classifying the organization as an organization
described in section 509(a) (1), (2), or (3).
(2) Paragraph (a) of this section shall not apply where a different
rule is otherwise expressly provided in the regulations under sections
170(b)(1)(A), 507(b)(1)(B), or 509.
[T.D. 7212, 37 FR 21923, Oct. 17, 1972]
Sec. 1.509(b)-1 Continuation of private foundation status.
(a) In general. If an organization is a private foundation (within
the meaning of section 509(a)) on October 9, 1969, or becomes a private
foundation on any subsequent date, such organization shall be treated as
a private foundation for all periods after October 9, 1969, or after
such subsequent date, unless its status as such is terminated under
section 507. Therefore, if an organization was described in section
501(c)(3) and was a private foundation within the meaning of section
509(a) on October 9, 1969, it shall be treated as a private foundation
for all periods thereafter, even though it may also satisfy the
requirements of an organization described in some other paragraph of
section 501(c). For example, if on October 9, 1969, an organization was
described in section 501(c)(3), but because of its activities, it could
also have qualified as an organization described in section 501(c)(4),
such organization will continue to be treated as a private foundation,
if it was a private foundation within the meaning of section 509(a) on
October 9, 1969.
(b) Taxable private foundations. If an organization is a private
foundation on October 9, 1969, and it is determined that it is not
exempt under section 501(a) as an organization described in section
501(c)(3) as of any date after October 9, 1969, such organization, even
though it may operate thereafter as a taxable entity, will continue to
be treated as a private foundation unless its status as such is
terminated under section 507. For example, X organization is a private
foundation on October 9, 1969. It is subsequently determined that, as of
July 1, 1972, X is no longer exempt under section 501(a) as an
organization described in section 501(c)(3) because, for example, it has
not conformed its governing instrument pursuant to section 508(e). X
will continue to be treated as a private foundation after July 1, 1972,
unless its status as such is terminated under section 507. However, if
an organization is not exempt under section 501(a) as an organization
described in section 501(c)(3) on October 9, 1969, then it will not be
treated as a private foundation within the meaning of section 509(a) by
reason of section 509(b), unless it becomes a private foundation on a
subsequent date.
[T.D. 7212, 37 FR 21924, Oct. 17, 1972]
Sec. 1.509(c)-1 Status of organization after termination of private
foundation status.
(a) In general. For purposes of part II of subchapter F of this
chapter, an organization whose status as a private foundation is
terminated under section 507 shall be treated as an organization created
on the day after the date of such termination. An organization whose
private foundation status has been terminated under the provisions of
section 507(a) will, if it continues to operate, be treated as a new
organization and must, if it desires to be classified under section
501(c)(3), give notification that it is applying for recognition of
section 501(c)(3) status pursuant to the provisions of section 508(a).
(b) Effect upon section 507(d)(1). If the private foundation status
of an organization has been terminated under section 507(b)(1)(B) and
the regulations thereunder, and:
(1) Such organization does not continue at all times thereafter to
meet the requirements of section 509(a) (1), (2), or (3) (and is
therefore no longer excluded from the definition of a private
foundation); and
(2) The status of such organization as a private foundation is
thereafter terminated under section 507(a)
[[Page 180]]
then the tax imposed under section 507(c)(1) upon the aggregate tax
benefit (described in section 507(d)(1)) resulting from section
501(c)(3) status shall be computed only upon the aggregate tax benefit
resulting after the date on which the organization again becomes a
private foundation under subparagraph (1) of this paragraph.
[T.D. 7212, 37 FR 21924, Oct. 17, 1972]
Sec. 1.509(d)-1 Definition of support.
For purposes of section 509(a)(2), the term support does not include
amounts received in repayment of the principal of a loan or other
indebtedness. See, however, section 509(e) as to amounts received as
interest on a loan or other indebtedness.
[T.D. 7212, 37 FR 21924, Oct. 17, 1972]
Sec. 1.509(e)-1 Definition of gross investment income.
For the distinction between gross receipts and gross investment
income, see Sec. 1.509(a)-3(m).
(Sec. 7805, Internal Revenue Code of 1954, 68A Stat. 917; 26 U.S.C.
7805)
[T.D. 7212, 37 FR 21925, Oct. 17, 1972]
Taxation of Business Income of Certain Exempt Organizations
Sec. 1.511-1 Imposition and rates of tax.
Section 511(a) imposes a tax upon the unrelated business taxable
income of certain organizations otherwise exempt from Federal income
tax. Under section 511(a)(1), organizations described in section
511(a)(2)(A) and in paragraph (a) of Sec. 1.511-2 and organizations
described in section 511(a)(2)(B) are subject to normal tax and surtax
at the corporate rates provided by section 11. Under section 511(b)(1),
trusts described in section 511(b)(2) are subject to tax at the
individual rates prescribed in section 1(d) of the Code as amended by
the Tax Reform Act of 1969 (section 1 for taxable years ending before
Jan. 1, 1971). The deduction for personal exemption provided in section
642(b) in the case of a trust taxable under subchapter J, chapter 1 of
the Code, is not allowed in computing unrelated business taxable income.
[T.D. 7117, 36 FR 9421, May 25, 1971]
Sec. 1.511-2 Organizations subject to tax.
(a) Organizations other than trusts and title holding companies.
(1)(i) The taxes imposed by section 511(a)(1) apply in the case of any
organization (other than a trust described in section 511(b)(2) or an
organization described in section 501(c)(1)) which is exempt from
taxation under section 501(a) (except as provided in sections 507
through 515). For special rules concerning corporations described in
section 501(c)(2), see paragraph (c) of this section.
(ii) In the case of an organization described in section 501(c)(4),
(7), (8), (9), (10), (11), (12), (13), (14)(A), (15), (16), or (18), the
taxes imposed by section 511(a)(1) apply only for taxable years
beginning after December 31, 1969. In the case of an organization
described in section 501(c)(14) (B) or (C), the taxes imposed by section
511(a)(1) apply only for taxable years beginning after February 2, 1966.
(2) The taxes imposed by section 511(a) apply in the case of any
college or university which is an agency or instrumentality of any
government or any political subdivision thereof, or which is owned or
operated by a government or any political subdivision thereof or by any
agency or instrumentality of any one or more governments or political
subdivisions. Such taxes also apply in the case of any corporation
wholly owned by one or more such colleges or universities. As here used,
the word government includes any foreign government (to the extent not
contrary to any treaty obligation of the United States) and all domestic
governments (the United States and any of its Territories or
possessions, any State, and the District of Columbia). Elementary and
secondary schools operated by such governments are not subject to the
tax on unrelated business income.
(3)(i) For taxable years beginning before January 1, 1970, churches
and associations or conventions of churches are exempt from the taxes
imposed by section 511. The exemption is applicable only to an
organization which itself is a church or an association or convention of
churches. Subject to the provisions of subdivision (ii) of this
subparagraph, religious organizations, including religious orders, if
not themselves
[[Page 181]]
churches or associations or conventions of churches, and all other
organizations which are organized or operated under church auspices, are
subject to the tax imposed by section 511, whether or not they engage in
religious, educational, or charitable activities approved by a church.
(ii) The term church includes a religious order or a religious
organization if such order or organization (a) is an integral part of a
church, and (b) is engaged in carrying out the functions of a church,
whether as a civil law corporation or otherwise. In determining whether
a religious order or organization is an integral part of a church,
consideration will be given to the degree to which it is connected with,
and controlled by, such church. A religious order or organization shall
be considered to be engaged in carrying out the functions of a church if
its duties include the ministration of sacerdotal functions and the
conduct of religious worship. If a religious order or organization is
not an integral part of a church, or if such an order or organization is
not authorized to carry out the functions of a church (ministration of
sacerdotal functions and conduct of religious worship) then it is
subject to the tax imposed by section 511 whether or not it engages in
religious, educational, or charitable activities approved by a church.
What constitutes the conduct of religious worship or the ministration of
sacerdotal functions depends on the tenets and practices of a particular
religious body constituting a church. If a religious order or
organization can fully meet the requirements stated in this subdivision,
exemption from the tax imposed by section 511 will apply to all its
activities, including those which it conducts through a separate
corporation (other than a corporation described in section 501(c)(2)) or
other separate entity which it wholly owns and which is not operated for
the primary purpose of carrying on a trade or business for profit. Such
exemption from tax will also apply to activities conducted through a
separate corporation (other than a corporation described in section
501(c)(2)) or other separate entity which is wholly owned by more than
one religious order or organization, if all such orders or organizations
fully meet the requirements stated in this subdivision and if such
corporation or other entity is not operated for the primary purpose of
carrying on a trade or business for profit.
(iii) For taxable years beginning after December 31, 1969, churches
and conventions or associations of churches are subject to the taxes
imposed by section 511, unless otherwise entitled to the benefit of the
transitional rules of section 512(b)(14) and Sec. 1.512(b)-1(i).
(b) Trusts--(1) In general. The taxes imposed by section 511(b)
apply in the case of any trust which is exempt from taxation under
section 501(a) (except as provided in sections 507 through 515), and
which, if it were not for such exemption, would be subject to the
provisions of subchapter J, chapter 1, of the Code. An organization
which is considered as trustee of a stock bonus, pension, or profit-
sharing plan described in section 401(a), a supplemental unemployment
benefit trust described in section 501(c)(17), or a pension plan
described in section 501(c)(18) (regardless of the form of such
organization) is subject to the taxes imposed by section 511(b)(1) on
its unrelated business income. However, if such an organization conducts
a business which is a separate taxable entity on the basis of all the
facts and circumstances, for example, an association taxable as a
corporation, the business will be taxable as a feeder organization
described in section 502.
(2) Effective dates. In the case of a trust described in section
501(c)(3), the taxes imposed by section 511(b) apply for taxable years
beginning after December 31, 1953. In the case of a trust described in
section 401(a), the taxes imposed by section 511(b) apply for taxable
years beginning after June 30, 1954. In the case of a trust described in
section 501(c)(17), the taxes imposed by section 511(b) apply for
taxable years beginning after December 31, 1959. In the case of any
other trust described in subparagraph (1) of this paragraph, the taxes
imposed by section 511(b) apply for taxable years beginning after
December 31, 1969.
(c) Title Holding Companies--(1) In general. If a corporation
described in section 501(c)(2) pays any amount of its
[[Page 182]]
net income for a taxable year to an organization exempt from taxation
under section 501(a) (or would pay such an amount but for the fact that
the expenses of collecting its income exceed its income), and if such
corporation and such organization file a consolidated income tax return
for such taxable year, then such corporation shall be treated, for
purposes of the tax imposed by section 511(a), as being organized and
operated for the same purposes as such organization, as well as for its
title-holding purpose. Therefore, if an item of income of the section
501(c)(2) corporation is derived from a source which is related to the
exempt function of the exempt organization to which such income is
payable and with which such corporation files a consolidated return,
such item is, together with all deductions directly connected therewith,
excluded from the determination of unrelated business taxable income
under section 512 and shall not be subject to the tax imposed by section
511(a). If, however, such item of income is derived from a source which
is not so related, then such item, less all deductions directly
connected therewith, is, subject to the modifications provided in
section 512(b), unrelated business taxable income subject to the tax
imposed by section 511(a).
(2) The provisions of subparagraph (1) of this paragraph may be
illustrated by the following example:
Example. The income of X, a section 501(c)(2) corporation, is
required to be distributed to exempt organization A. During the taxable
year X realizes net income of $900,000 from source M and $100,000 from
source N. Source M is related to A's exempt function, while source N is
not so related. X and A file a consolidated return for such taxable
year. X has net unrelated business income of $100,000, subject to the
modifications in section 512(b).
(3) Cross reference. For rules relating generally to the filing of
consolidated returns by certain organizations exempt from taxation under
section 501(a), see section 1504(e) of the Code and Sec. 1.1502-100.
(4) Effective dates. Subparagraphs (1) through (3) of this paragraph
apply with respect to taxable years beginning after December 31, 1969.
For taxable years beginning before January 1, 1970, a corporation
described in section 501(c)(2) and otherwise exempt from taxation under
section 501(a) is taxable upon its unrelated business taxable income
only if such income is payable either:
(i) To a church or convention or association of churches, or
(ii) To any organization subject, for taxable years beginning before
January 1, 1970, to the tax imposed by section 511(a)(1).
(d) The fact that any class of organizations exempt from taxation
under section 501(a) is subject to the unrelated business income tax
under section 511 and this section does not in any way enlarge the
permissible scope of business activities of such class for purposes of
the continued qualification of such class under section 501(a).
(e) ABLE programs--(1) Unrelated business taxable income. A
qualified ABLE program described in section 529A and Sec. 1.529A-
1(b)(14) generally is exempt from Federal income taxation, but is
subject to taxes imposed by section 511 relating to the imposition of
tax on unrelated business income. A qualified ABLE program is required
to file Form 990-T, ``Exempt Organization Business Income Tax Return,''
if such filing would be required under the rules of Sec. Sec. 1.6012-
2(e) and 1.6012-3(a)(5) if the ABLE program were an organization
described in those sections.
(2) Applicability date. This paragraph (e) applies to taxable years
beginning after December 31, 2020.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7183, 37 FR
7884, Apr. 21, 1972; T.D. 7632, 44 FR 42681, July 20, 1979; T.D. 9923,
85 FR 74034, Nov. 19, 2020]
Sec. 1.511-3 Provisions generally applicable to the tax on unrelated
business income.
(a) Assessment and collections. Since the taxes imposed by section
511 are taxes imposed by subtitle A of the Code, all provisions of law
and of the regulations applicable to the taxes imposed by subtitle A are
applicable to the assessment and collection of the taxes imposed by
section 511. Organizations subject to the tax imposed by section
511(a)(1) are subject to the same provisions, including penalties, as
are provided in the case of the income tax
[[Page 183]]
of other corporations. In the case of a trust subject to the tax imposed
by section 511(b)(1), the fiduciaries for such trust are subject to the
same provisions, including penalties, as are applicable to fiduciaries
in the case of the income tax of other trusts. See section 6151, et
seq., and the regulations prescribed thereunder, for provisions relating
to payment of tax.
(b) Returns. For requirements of filing annual returns with respect
to unrelated business taxable income by organizations subject to the tax
on such income, see section 6012, paragraph (e) of Sec. 1.6012-2, and
paragraph (a)(5) of Sec. 1.6012-3.
(c) Taxable years, method of accounting, etc. The taxable year
(fiscal year or calendar year, as the case may be) of an organization
shall be determined without regard to the fact that such organization
may have been exempt from tax during any prior period. See sections 441
and 446, and the regulations thereunder in this part, and section 7701
and the regulations in part 301 of this chapter (Regulations on
Procedure and Administration). Similarly, in computing unrelated
business taxable income, the determination of the taxable year for which
an item of income or expense is taken into account shall be made under
the provisions of sections 441, 446, 451, and 461, and the regulations
thereunder, whether or not the item arose during a taxable year
beginning before, on, or after the effective date of the provisions
imposing a tax upon unrelated business taxable income. If a method for
treating bad debts was selected in a return of income (other than an
information return) for a previous taxable year, the taxpayer must
follow such method in its returns under section 511, unless such method
is changed in accordance with the provisions of Sec. 1.166-1. A
taxpayer which has not previously selected a method for treating bad
debts may, in its first return under section 511, exercise the option
granted in Sec. 1.166-1.
(d) Foreign tax credit. See section 515 for provisions applicable to
the credit for foreign taxes provided in section 901.
Sec. 1.511-4 Minimum tax for tax preferences.
The tax imposed by section 56 applies to an organization subject to
tax under section 511 with respect to items of tax preference which
enter into the computation of unrelated business taxable income. For
this purpose, only those items of income and those deductions entering
into the determination of the tax imposed by this section are considered
in the determination of the items of tax preference under section 57.
For rules relating to the minimum tax for tax preferences, see sections
56 through 58 and the regulations thereunder.
[T.D. 7564, 43 FR 40494, Sept. 12, 1978]
Sec. 1.512(a)-1 Definition.
(a) In general. Except as otherwise provided in Sec. 1.512(a)-3,
Sec. 1.512(a)-4, or paragraph (f) of this section, section 512(a)(1)
defines unrelated business taxable income as the gross income derived
from any unrelated trade or business regularly carried on, less those
deductions allowed by chapter 1 of the Internal Revenue Code (Code)
which are directly connected with the carrying on of such trade or
business, subject to certain modifications referred to in Sec.
1.512(b)-1. To be deductible in computing unrelated business taxable
income, therefore, expenses, depreciation, and similar items not only
must qualify as deductions allowed by chapter 1 of the Code, but also
must be directly connected with the carrying on of unrelated trade or
business. Except as provided in paragraph (d)(2) of this section, to be
directly connected with the conduct of unrelated business for purposes
of section 512, an item of deduction must have proximate and primary
relationship to the carrying on of that business. In the case of an
organization with more than one unrelated trade or business, unrelated
business taxable income is calculated separately with respect to each
such trade or business. See Sec. 1.512(a)-6. For the treatment of
amounts of income or loss of common trust funds, see Sec. 1.584-
2(c)(3).
(b) Expenses attributable solely to unrelated business activities.
Expenses, depreciation, and similar items attributable
[[Page 184]]
solely to the conduct of unrelated business activities are proximately
and primarily related to that business activity, and therefore qualify
for deduction to the extent that they meet the requirements of section
162, section 167, or other relevant provisions of the Code. Thus, for
example, salaries of personnel employed full-time in carrying on
unrelated business activities are directly connected with the conduct of
that activity and are deductible in computing unrelated business taxable
income if they otherwise qualify for deduction under the requirements of
section 162.
(c) Dual use of facilities or personnel. Where facilities are used
both to carry on exempt activities and to conduct unrelated trade or
business activities, expenses, depreciation and similar items
attributable to such facilities (as, for example, items of overhead),
shall be allocated between the two uses on a reasonable basis.
Similarly, where personnel are used both to carry on exempt activities
and to conduct unrelated trade or business activities, expenses and
similar items attributable to such personnel (as, for example, items of
salary) shall be allocated between the two uses on a reasonable basis.
The portion of any such item so allocated to the unrelated trade or
business activity is proximately and primarily related to that business
activity, and shall be allowable as a deduction in computing unrelated
business taxable income in the manner and to the extent permitted by
section 162, section 167, or other relevant provisions of the Code.
Thus, for example, assume that X, an exempt organization subject to the
provisions of section 511, pays its president a salary of $20,000 a
year. X derives gross income from the conduct of unrelated trade or
business activities. The president devotes approximately 10 percent of
his time during the year to the unrelated business activity. For
purposes of computing X's unrelated business taxable income, a deduction
of $2,000 (10 percent of $20,000), would be allowable for the salary
paid to its president. However, allocation of expenses, depreciation,
and similar items is not reasonable if the cost of providing a good or
service in a related and an unrelated activity is substantially the
same, but the price charged for that good or service in the unrelated
activity is greater than the price charged in the related activity and
no adjustment is made to equalize the price difference for purposes of
allocating expenses, depreciation, and similar items based on revenue
between related and unrelated activities. For example, if a social club
described in section 501(c)(7) charges nonmembers a higher price than it
charges members for the same good or service but does not adjust the
price of the good or service provided to members for purposes of
allocating expenses, depreciation, and similar items attributable to the
provision of that good or service, the allocation method is not
reasonable.
(d) Exploitation of exempt activities--(1) In general. In certain
cases, gross income is derived from an unrelated trade or business
activity which exploits an exempt activity. One example of such
exploitation is the sale of advertising in a periodical of an exempt
organization which contains editorial material related to the
accomplishment of the organization's exempt purpose. Except as specified
in subparagraph (2) of this paragraph and paragraph (f) of this section,
in such cases, expenses, depreciation and similar items attributable to
the conduct of the exempt activities are not deductible in computing
unrelated business taxable income. Since such items are incident to an
activity which is carried on in furtherance of the exempt purpose of the
organization, they do not possess the necessary proximate and primary
relationship to the unrelated trade or business activity and are
therefore not directly connected with that business activity.
(2) Allowable deductions. Where an unrelated trade or business
activity is of a kind carried on for profit by taxable organizations and
where the exempt activity exploited by the business is a type of
activity normally conducted by taxable organizations in pursuance of
such business, expenses, depreciation, and similar items which are
attributable to the exempt activity qualify as directly connected with
the carrying on of the unrelated trade or business activity to the
extent that:
[[Page 185]]
(i) The aggregate of such items exceeds the income (if any) derived
from or attributable to the exempt activity; and
(ii) The allocation of such excess to the unrelated trade or
business activity does not result in a loss from such unrelated trade or
business activity
Under the rule of the preceding sentence, expenses, depreciation and
similar items paid or incurred in the performance of an exempt activity
must be allocated first to the exempt activity to the extent of the
income derived from or attributable to the performance of that activity.
Furthermore, such items are in no event allocable to the unrelated trade
or business activity exploiting such exempt activity to the extent that
their deduction would result in a loss carryover or carryback with
respect to that trade or business activity. Similarly, they may not be
taken into account in computing unrelated business taxable income
attributable to any unrelated trade or business activity not exploiting
the same exempt activity. See paragraph (f) of this section for the
application of these rules to periodicals published by exempt
organizations.
(e) Examples. This section is illustrated by the following examples:
Example 1. W is an exempt business league with a large membership.
Under an arrangement with an advertising agency W regularly mails
brochures, pamphlets and other advertising materials to its members,
charging the agency an agreed amount per enclosure. The distribution of
the advertising materials does not contribute importantly to the
accomplishment of the purpose for which W is granted exemption.
Accordingly, the payments made to W by the advertising agency constitute
gross income from an unrelated trade or business activity. In computing
W's unrelated business taxable income, the expenses attributable solely
to the conduct of the business, or allocable to such business under the
rule of paragraph (c) of this section, are allowable as deductions in
accordance with the provisions of section 162. Such deductions include
the costs of handling and mailing, the salaries of personnel used full-
time in the unrelated business activity and an allocable portion of the
salaries of personnel used both to carry on exempt activities and to
conduct the unrelated business activity. However, costs of developing
W's membership and carrying on its exempt activities are not deductible.
Those costs are necessary to the maintenance of the intangible asset
exploited in the unrelated business activity--W's membership--but are
incurred primarily in connection with W's fundamental purpose as an
exempt organization. As a consequence, they do not have proximate and
primary relationship to the conduct of the unrelated business activity
and do not qualify as directly connected with it.
Example 2. (i) P, a manufacturer of photographic equipment,
underwrites a photography exhibition organized by M, an art museum
described in section 501(c)(3). In return for a payment of $100,000, M
agrees that the exhibition catalog sold by M in connection with the
exhibit will advertise P's product. The exhibition catalog will also
include educational material, such as copies of photographs included in
the exhibition, interviews with photographers, and an essay by the
curator of M's department of photography. For purposes of this example,
assume that none of the $100,000 is a qualified sponsorship payment
within the meaning of section 513(i) and Sec. 1.513-4, that M's
advertising activity is regularly carried on, and that the entire amount
of the payment is unrelated business taxable income to M. Expenses
directly connected with generating the unrelated business taxable income
(i.e., direct advertising costs) total $25,000. Expenses directly
connected with the preparation and publication of the exhibition catalog
(other than direct advertising costs) total $110,000. M receives $60,000
of gross revenue from sales of the exhibition catalog. Expenses directly
connected with the conduct of the exhibition total $500,000.
(ii) The computation of unrelated business taxable income is as
follows:
(A) Unrelated trade or business (sale of
advertising):
Income....................................... $100,000 .........
Directly-connected expenses.................. (25,000) .........
----------------------
Subtotal................................... 75,000 $75,000
======================
(B) Exempt function (publication of exhibition
catalog):
Income (from catalog sales).................. 60,000 .........
Directly-connected expenses.................. (110,000) .........
----------------------
Net exempt function income (loss).......... (50,000) (50,000)
======================
Unrelated business taxable income.......... .......... 25,000
(iii) Expenses related to publication of the exhibition catalog
exceed revenues by $50,000. Because the unrelated business activity (the
sale of advertising) exploits an exempt activity (the publication of the
exhibition catalog), and because the publication of editorial material
is an activity normally
[[Page 186]]
conducted by taxable entities that sell advertising, the net loss from
the exempt publication activity is allowed as a deduction from unrelated
business income under paragraph (d)(2) of this section. In contrast, the
presentation of an exhibition is not an activity normally conducted by
taxable entities engaged in advertising and publication activity for
purposes of paragraph (d)(2) of this section. Consequently, the $500,000
cost of presenting the exhibition is not directly connected with the
conduct of the unrelated advertising activity and does not have a
proximate and primary relationship to that activity. Accordingly, M has
unrelated business taxable income of $25,000.
(f) Determination of unrelated business taxable income derived from
sale of advertising in exempt organization periodicals--(1) In general.
Under section 513 (relating to the definition of unrelated trade or
business) and Sec. 1.513-1, amounts realized by an exempt organization
from the sale of advertising in a periodical constitute gross income
from an unrelated trade or business activity involving the exploitation
of an exempt activity; namely, the circulation and readership of the
periodical developed through the production and distribution of the
readership content of the periodical. Paragraph (d) of this section
provides for the allowance of deductions attributable to the production
and distribution of the readership content of the periodical. Thus,
subject to the limitations of paragraph (d)(2) of this section, where
the circulation and readership of an exempt organization periodical are
utilized in connection with the sale of advertising in the periodical,
expenses, depreciation, and similar items of deductions attributable to
the production and distribution of the editorial or readership content
of the periodical shall qualify as items of deductions directly
connected with the unrelated advertising activity. Subparagraphs (2)
through (6) of this paragraph provide rules for determining the amount
of unrelated business taxable income attributable to the sale of
advertising in exempt organization periodicals. Subparagraph (7) of this
paragraph provides rules for determining when the unrelated business
taxable income of two or more exempt organization periodicals may be
determined on a consolidated basis.
(2) Computation of unrelated business taxable income attributable to
sale of advertising--(i) Excess advertising costs. If the direct
advertising costs of an exempt organization periodical (determined under
subparagraph (6)(ii) of this paragraph) exceed gross advertising income
(determined under subparagraph (3)(ii) of this paragraph), such excess
shall be allowable as a deduction in determining unrelated business
taxable income from any unrelated trade or business activity carried on
by the organization.
(ii) Excess advertising income. If the gross advertising income of
an exempt organization periodical exceeds direct advertising costs,
paragraph (d)(2) of this section provides that items of deduction
attributable to the production and distribution of the readership
content of an exempt organization periodical shall qualify as items of
deduction directly connected with unrelated advertising activity in
computing the amount of unrelated business taxable income derived from
the advertising activity to the extent that such items exceed the income
derived from or attributable to such production and distribution, but
only to the extent that such items do not result in a loss from such
advertising activity. Furthermore, such items of deduction shall not
qualify as directly connected with such advertising activity to the
extent that their deduction would result in a loss carryback or
carryover with respect to such advertising activity. Similarly, such
items of deduction shall not be taken into account in computing
unrelated business taxable income attributable to any unrelated trade or
business activity other than such advertising activity. Thus:
(a) If the circulation income of the periodical (determined under
subparagraph (3)(iii) of this paragraph) equals or exceeds the
readership costs of such periodical (determined under subparagraph
(6)(iii) of this paragraph), the unrelated business taxable income
attributable to the periodical is the excess of the gross advertising
income of the periodical over direct advertising costs; but
(b) If the readership costs of an exempt organization periodical
exceed the circulation income of the periodical, the unrelated business
taxable income is the excess, if any, of the
[[Page 187]]
total income attributable to the periodical (determined under
subparagraph (3) of this paragraph) over the total periodical costs (as
defined in subparagraph (6)(i) of this paragraph)
See subparagraph (7) of this paragraph for rules relating to the
consolidation of two or more periodicals.
(iii) Examples. The application of this paragraph may be illustrated
by the following examples. For purposes of these examples it is assumed
that the production and distribution of the readership content of the
periodical is related to the organization's exempt purpose.
Example 1. X, an exempt trade association, publishes a single
periodical which carries advertising. During 1971, X realizes a total of
$40,000 from the sale of advertising in the periodical (gross
advertising income) and $60,000 from the sales of the periodical to
members and nonmembers (circulation income). The total periodical costs
are $90,000 of which $50,000 is directly connected with the sale and
publication of advertising (direct advertising costs) and $40,000 is
attributable to the production and distribution of the readership
content (readership costs). Since the direct advertising costs of the
periodical ($50,000) exceed gross advertising income ($40,000), pursuant
to subdivision (i) of this subparagraph, the unrelated business taxable
income attributable to advertising is determined solely on the basis of
the income and deductions directly connected with the production and
sale of the advertising:
Gross advertising revenue.................................. $40,000
Direct advertising costs................................... (50,000)
------------
Loss attributable to advertising........................... (10,000)
============
X has realized a loss of $10,000 from its advertising activity. This
loss is an allowable deduction in computing X's unrelated business
taxable income derived from any other unrelated trade or business
activity.
Example 2. Assume the facts as stated in example 1, except that the
circulation income of X periodical is $100,000 instead of $60,000, and
that of the total periodical costs, $25,000 are direct advertising
costs, and $65,000 are readership costs. Since the circulation income
($100,000) exceeds the total readership costs ($65,000), pursuant to
subdivision (ii)(a) of this subparagraph the unrelated business taxable
income attributable to the advertising activity is $15,000, the excess
of gross advertising income ($40,000) over direct advertising costs
($25,000).
Example 3. Assume the facts as stated in example 1, except that of
the total periodical costs, $20,000 are direct advertising costs and
$70,000 are readership costs. Since the readership costs of the
periodical ($70,000), exceed the circulation income ($60,000), pursuant
to subdivision (ii) (b) of this subparagraph the unrelated business
taxable income attributable to advertising is the excess of the total
income attributable to the periodical over the total periodical costs.
Thus, X has unrelated business taxable income attributable to the
advertising activity of $10,000 ($100,000 total income attributable to
the periodical less $90,000 total periodical costs).
Example 4. Assume the facts as stated in example 1, except that the
total periodical costs are $120,000 of which $30,000 are direct
advertising costs and $90,000 are readership costs. Since the readership
costs of the periodical ($90,000), exceed the circulation income
($60,000), pursuant to subdivision (ii) (b) of this subparagraph the
unrelated business taxable income attributable to advertising is the
excess, if any, of the total income attributable to the periodical over
the total periodical costs. Since the total income of the periodical
($100,000) does not exceed the total periodical costs ($120,000), X has
not derived any unrelated business taxable income from the advertising
activity. Further, only $70,000 of the $90,000 of readership costs may
be deducted in computing unrelated business taxable income since as
provided in subdivision (ii) of this subparagraph, such costs may be
deducted, to the extent they exceed circulation income, only to the
extent they do not result in a loss from the advertising activity. Thus,
there is no loss from such activity, and no amount may be deducted on
this account in computing X's unrelated trade or business income derived
from any other unrelated trade or business activity.
(3) Income attributable to exempt organization periodicals--(i) In
general. For purposes of this paragraph the total income attributable to
an exempt organization periodical is the sum of its gross advertising
income and its circulation income.
(ii) Gross advertising income. The term gross advertising income
means all amounts derived from the unrelated advertising activities of
an exempt organization periodical (or for purposes of this paragraph in
the case of a taxable organization, all amounts derived from the
advertising activities of the taxable organization).
(iii) Circulation income. The term circulation income means the
income attributable to the production, distribution or circulation of a
periodical (other than gross advertising income) including all amounts
realized from or attributable to the sale or distribution
[[Page 188]]
of the readership content of the periodical, such as amounts realized
from charges made for reprinting or republishing articles and special
items in the periodical and amounts realized from sales of back issues.
Where the right to receive an exempt organization periodical is
associated with membership or similar status in such organization for
which dues, fees or other charges are received (hereinafter referred to
as membership receipts), circulation income includes the portion of such
membership receipts allocable to the periodical (hereinafter referred to
as allocable membership receipts). Allocable membership receipts is the
amount which would have been charged and paid if:
(a) The periodical was that of a taxable organization.
(b) The periodical was published for profit, and
(c) The member was an unrelated party dealing with the taxable
organization at arm's length
See subparagraph (4) of this paragraph for a discussion of the factors
to be considered in determining allocable membership receipts of an
exempt organization periodical under the standard described in the
preceding sentence.
(4) Allocable membership receipts. The allocable membership receipts
of an exempt organization periodical shall be determined in accordance
with the following rules:
(i) Subscription price charged to nonmembers. If 20 percent or more
of the total circulation of a periodical consist of sales to nonmembers,
the subscription price charged to such nonmembers shall determine the
price of the periodical for purposes of allocating membership receipts
to the periodical.
(ii) Subscription price to nonmembers. If paragraph (f)(4)(i) of
this section does not apply and if the membership dues from 20 percent
or more of the members of an exempt organization are less than those
received from the other members because the former members do not
receive the periodical, the amount of the reduction in membership dues
for a member not receiving the periodical shall determine the price of
the periodical for purposes of allocating membership receipts to the
periodical.
(iii) Pro rata allocation of membership receipts. Since it may
generally be assumed that membership receipts and gross advertising
income are equally available for all the exempt activities (including
the periodical) of the organization, the share of membership receipts
allocated to the periodical, where paragraphs (f)(4) (i) and (ii) of
this section do not apply, shall be an amount equal to the
organization's membership receipts multiplied by a fraction the
numerator of which is the total periodical costs and the denominator of
which is such costs plus the cost of other exempt activities of the
organization. For example, assume that an exempt organization has total
periodical costs of $30,000 and other exempt costs of $70,000. Further
assume that the membership receipts of the organization are $60,000 and
that paragraphs (f)(4) (i) and (ii) of this section do not apply. Under
these circumstances $18,000 ($60,000 times $30,000/$100,000) is
allocated to the periodical's circulation income.
(5) Examples. The rules set forth in paragraph (f)(4) of this
section may be illustrated by the following examples. For purposes of
these examples it is assumed that the exempt organization periodical
contains advertising, and that the production and distribution of the
readership content of the periodical is related to the organization's
exempt purpose.
Example 1. U is an exempt scientific organization with 10,000
members who pay annual dues of $15 per year. One of U's activities is
the publication of a monthly periodical which is distributed to all of
its members. U also distributes 5,000 additional copies of its
periodical to nonmember subscribers at a cost of $10 per year. Pursuant
to paragraph (f)(4)(i) of this section, since the nonmember circulation
of U's periodical represents 33\1/3\ percent of its total circulation
the subscription price charged to nonmembers will be used to determine
the portion of U's membership receipts allocable to the periodical.
Thus, U's allocable membership receipts will be $100,000 ($10 times
10,000 members), and U's total circulation income for the periodical
will be $150,000 ($100,000 from members plus $50,000 from sales to
nonmembers).
Example 2. Assume the facts as stated in example 1, except that U
sells only 500 copies of its periodical to nonmembers, at a price of $10
per year. Assume further that U's members may elect not to receive the
periodical,
[[Page 189]]
in which case their annual dues are reduced from $15 per year to $6 per
year, and that only 3,000 members elect to receive the periodical and
pay the full dues of $15 per year. U's stated subscription price to
members of $9 consistently results in an excess of total income
(including gross advertising income) attributable to the periodical over
total costs of the periodical. Since the 500 copies of the periodical
distributed to nonmembers represents only 14 percent of the 3,500 copies
distributed, pursuant to paragraph (f)(4)(i) of this section, the $10
subscription price charged to nonmembers will not be used in determining
the portion of membership receipts allocable to the periodical. On the
other hand, since 70 percent of the members elect not to receive the
periodical and pay $9 less per year in dues, pursuant to paragraph
(f)(4)(ii) of this section, such $9 price will be used in determining
the subscription price charged to members. Thus, the allocable
membership receipts will be $9 per member, or $27,000 ($9 times 3,000
copies) and U's total circulation income will be $32,000 ($27,000 plus
$5,000).
Example 3. (a) W, an exempt trade association, has 800 members who
pay annual dues of $50 per year. W publishes a monthly journal the
editorial content and advertising of which are directed to the business
interests of its own members. The journal is distributed to all of W's
members and no receipts are derived from nonmembers.
(b) W has total receipts of $100,000 of which $40,000 ($50 x 800)
are membership receipts and $60,000 are gross advertising income. W's
total costs for the journal and other exempt activities is $100,000. W
has total periodical costs of $76,000 of which $41,000 are direct
advertising costs and $35,000 are readership costs.
(c) Paragraph (f)(4)(i) of this section will not apply since no
copies are available to nonmembers. Therefore, the allocation of
membership receipts shall be made in accordance with paragraph
(f)(4)(iii) of this section. Based upon pro rata allocation of
membership receipts (40,000) by a fraction the numerator of which is
total periodical costs ($76,000) and the denominator of which is the
total costs of the journal and the other exempt activities ($100,000),
$30,400 ($76,000/$100,000 times $40,000) of membership receipts is
circulation income.
(6) Deductions attributable to exempt organization periodicals--(i)
In general. For purposes of this paragraph the term total periodical
costs means the total deductions attributable to the periodical. For
purposes of this paragraph the total periodical costs of an exempt
organization periodical are the sum of the direct advertising costs of
the periodical (determined under subdivision (ii) of this subparagraph)
and the readership costs of the periodical (determined under subdivision
(iii) of this subparagraph). Items of deduction properly attributable to
exempt activities other than the publication of an exempt organization
periodical may not be allocated to such periodical. Where items are
attributable both to an exempt organization periodical and to other
activities of an exempt organization, the allocation of such items must
be made on a reasonable basis which fairly reflects the portion of such
item properly attributable to each such activity. The method of
allocation will vary with the nature of the item, but once adopted, a
reasonable method of allocation with respect to an item must be used
consistently. Thus, for example, salaries may generally be allocated
among various activities on the basis of the time devoted to each
activity; occupancy costs such as rent, heat and electricity may be
allocated on the basis of the portion of space devoted to each activity;
and depreciation may be allocated on the basis of space occupied and the
portion of the particular asset utilized in each activity. Allocations
based on dollar receipts from various exempt activities will generally
not be reasonable since such receipts are usually not an accurate
reflection of the costs associated with activities carried on by exempt
organizations.
(ii) Direct advertising costs. (a) The direct advertising costs of
an exempt organization periodical include all expenses, depreciation,
and similar items of deduction which are directly connected with the
sale and publication of advertising as determined in accordance with
paragraphs (a), (b), and (c) of this section. These items are allowable
as deductions in the computation of unrelated business income of the
organization for the taxable year to the extent they meet the
requirements of section 162, section 167, or other relevant provisions
of the Code. The items allowable as deductions under this subdivision do
not include any items of deduction attributable to the production or
distribution of the readership content of the periodical.
(b) The items allowable as deductions under this subdivision would
include agency commissions and other direct
[[Page 190]]
selling costs, such as transportation and travel expenses, office
salaries, promotion and research expenses, and direct office overhead
directly connected with the sale of advertising lineage in the
periodical. Also included would be other items of deduction commonly
classified as advertising costs under standard account classification,
such as art work and copy preparation, telephone, telegraph, postage,
and similar costs directly connected with advertising.
(c) In addition to the items of deduction normally included in
standard account classifications relating to advertising costs, it is
also necessary to ascertain the portion of mechanical and distribution
costs attributable to advertising lineage. For this purpose, the general
account classifications of items includible in mechanical and
distribution costs ordinarily employed in business-paper and consumer
publication accounting provide a guide for the computation. Thus, the
mechanical and distribution costs in such cases would include the
portion of the costs and other expenses of composition, presswork,
binding, mailing (including paper and wrappers used for mailing), and
the bulk postage attributable to the advertising lineage of the
publication. The portion of mechanical and distribution costs
attributable to advertising lineage of the periodical will be determined
on the basis of the ratio of advertising lineage to total lineage of the
periodical, and the application of that ratio to the total mechanical
and distribution costs of the periodical, where records are not kept in
such a manner as to reflect more accurately the allocation of mechanical
and distributions costs to advertising lineage of the periodical, and
where there is no factor in the character of the periodical to indicate
that such an allocation would be unreasonable.
(iii) Readership costs. The readership costs of an exempt
organization periodical include expenses, depreciation or similar items
which are directly connected with the production and distribution of the
readership content of the periodical and which would otherwise be
allowable as deductions in determining unrelated business taxable income
under section 512 and the regulations thereunder if such production and
distribution constituted an unrelated trade or business activity. Thus,
readership costs include all the items of deduction attributable to an
exempt organization periodical which are not allocated to direct
advertising costs under subdivision (ii) of this subparagraph, including
the portion of such items attributable to the readership content of the
periodical, as opposed to the advertising content, and the portion of
mechanical and distribution costs which is not attributable to
advertising lineage in the periodical.
(7) Consolidation--(i) In general. Where an exempt organization
subject to unrelated business income tax under section 511 publishes two
or more periodicals for the production of income, it may treat the gross
income from all (but not less than all) of such periodicals and the
items of deduction directly connected with such periodicals (including
readership costs of such periodicals), on a consolidated basis as if
such periodicals were one periodical in determining the amount of
unrelated business taxable income derived from the sale of advertising
in such periodical. Such treatment must, however, be followed
consistently and once adopted shall be binding unless the consent of the
Commissioner is obtained as provided in sections 446(e) and Sec. 1.446-
1(e).
(ii) Production of income. For purposes of this subparagraph, an
exempt organization periodical is published for the production of income
if:
(a) The organization generally receives gross advertising income
from the periodical equal to at least 25 percent of the readership costs
of such periodical, and
(b) The publication of such periodical is an activity engaged in for
profit
For purposes of the preceding sentence, the determination whether the
publication of a periodical is an activity engaged in for profit is to
be made by reference to objective standards taking into account all the
facts and circumstances involved in each case. The facts and
circumstances must indicate that the organization carries on the
activity with the objective that the publication of the periodical will
result in economic profit (without regard to tax
[[Page 191]]
consequences), although not necessarily in a particular year. Thus, an
exempt organization periodical may be treated as having been published
with such an objective even though in a particular year its total
periodical costs exceed its total income. Similarly, if an exempt
organization begins publishing a new periodical, the fact that the total
periodical costs exceed the total income for the startup years because
of a lack of advertising sales does not mean that the periodical was
published without an objective of economic profit. The organization may
establish that the activity was carried on with such an objective. This
might be established by showing, for example, that there is a reasonable
expectation that the total income, by reason of an increase in
advertising sales, will exceed costs within a reasonable time. See Sec.
1.183-2 for additional factors bearing on this determination.
(iii) Example. This subparagraph may be illustrated by the following
example:
Example. Y, an exempt trade association, publishes three periodicals
which it distributes to its members: a weekly newsletter, a monthly
magazine, and quarterly journal. Both the monthly magazine and the
quarterly journal contain advertising which accounts for gross
advertising income equal to more than 25 percent of their respective
readership costs. Similarly, the total income attributable to each such
periodical has exceeded the total deductions attributable to each such
periodical for substantially all the years they have been published. The
newsletter carries no advertising and its annual subscription price is
not intended to cover the cost of publication. The newsletter is a
service of Y distributed to all of its members in an effort to keep them
informed of changes occurring in the business world and is not engaged
in for profit. Under these circumstances, Y may consolidate the income
and deductions from the monthly and quarterly journals in computing its
unrelated business taxable income, but may not consolidate the income
and deductions attributable to the publication of the newsletter with
the income and deductions of its other periodicals since the newsletter
is not published for the production of income.
(g) Foreign organizations--(1) In general. The unrelated business
taxable income of a foreign organization exempt from taxation under
section 501(a) consists of:
(i) The organization's unrelated business taxable income which is
derived from sources within the United States but which is not
effectively connected with the conduct of a trade or business within the
United States, plus
(ii) The organization's unrelated business taxable income
effectively connected with the conduct of a trade or business within the
United States (whether or not such income is derived from sources within
the United States)
To determine whether income realized by a foreign organization is
derived from sources within the United States or is effectively
connected with the conduct of a trade or business within the United
States, see part 1, subchapter N, chapter 1 of the Code (section 861 and
following) and the regulations thereunder.
(2) Effective dates. Subparagraph (1) of this paragraph applies to
taxable years beginning after December 31, 1969. For taxable years
beginning on or before December 31, 1969, the unrelated business taxable
income of a foreign organization exempt from taxation under section
501(a) consists of the organization's unrelated business taxable income
which:
(i) For taxable years beginning after December 31, 1966, is
effectively connected with the conduct of a trade or business within the
United States, whether or not such income is derived from sources within
the United States;
(ii) For taxable years beginning on or before December 31, 1966, is
derived from sources within the United States.
(h) Applicability date. This section generally applies to taxable
years beginning after December 12, 1967, except as provided in paragraph
(g)(2) of this section, and except that paragraphs (a) through (c) of
this section apply to taxable years beginning on or after December 2,
2020. For taxable years beginning before December 2, 2020, see these
paragraphs as in effect and contained in 26 CFR part 1 revised as of
April 1, 2020.
[T.D. 7392, 40 FR 58638, Dec. 18, 1975, as amended by T.D. 7438, 41 FR
44392, Oct. 8, 1976; T.D. 7935, 49 FR 1694, Jan. 13, 1984; T.D. 8991, 67
FR 20437, Apr. 25, 2002; T.D. 9933, 85 FR 77979, Dec. 2, 2020]
[[Page 192]]
Sec. 1.512(a)-2 Definition applicable to taxable years beginning before
December 13, 1967.
(a) In general. The unrelated business taxable income which is
subject to the tax imposed by section 511 is the gross income, derived
by any organization to which section 511 applies, from any unrelated
trade or business regularly carried on by it, less the deductions
allowed by chapter 1 of the Code which are directly connected with the
carrying on of such trade or business, subject to certain exceptions,
additions, and limitations referred to below. In the case of an
organization which regularly carries on two or more unrelated
businesses, its unrelated business taxable income is the aggregate of
its gross income from all such unrelated businesses, less the aggregate
of the deductions allowed with respect to all such unrelated businesses.
For provisions generally applicable to the unrelated business tax, see
Sec. 1.511-3, and for rules applicable to the determination of the
adjusted basis of property, see paragraph (a)(2) of Sec. 1.514(a)-1.
(b) Effective date. Except as provided in paragraph (f) of Sec.
1.512(a)-1, this section is applicable with respect to taxable years
beginning before December 13, 1967.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6939, 32 FR
17660, Dec. 12, 1967]
Sec. 1.512(a)-3 [Reserved]
Sec. 1.512(a)-4 Special rules applicable to war veterans organizations.
(a) In general. For taxable years beginning after December 31, 1969,
this section provides special rules for the determination of the
unrelated business taxable income of an organization described in
section 501(c)(19). In general, the rules contained in sections 511
through 514 which are applicable to any organization listed in section
501(c) apply in determining the unrelated business taxable income of an
organization described in section 501(c)(19). However, that amount which
is paid by members to the organization for the purpose described in
paragraph (b)(1) of this section, if set aside from other organizational
monies and accounts in an insurance set aside, may be excluded from the
unrelated business taxable income of the organization. The insurance set
aside shall be used exclusively for providing insurance benefits, for
the purposes specified in section 170(c)(4) of the Code, for the
reasonable costs of administering the insurance program that are
directly related to such set aside, or for the reasonable costs of
distributing funds for section 170(c)(4) purposes. If an amount so set
aside is used for any purposes other than those described in the
preceding sentence, it shall be included in unrelated business taxable
income without regard to any modifications provided by section 512(b),
in the taxable year in which it is withdrawn from such set aside.
Amounts will be considered to have been withdrawn from an insurance set
aside if they are used in any manner inconsistent with providing
insurance benefits, paying the reasonable costs of administering the
insurance program for section 170(c)(4) purposes and for costs of
distributing funds for section 170(c)(4) purposes. An example of a use
of funds which would be considered a withdrawal would be the use of such
funds as security for a loan.
(b) Insurance set aside--(1) Purpose of payments by members.
Payments by members (including commissions on such payments earned by
the set aside as agent for an insurance company) into an insurance set
aside must be for the sole purpose of obtaining life, sick, accident or
health insurance benefits from the organization or for the reasonable
costs of administration of the insurance program, except that such
purpose is not violated when excess funds from an experience gain are
utilized for those purposes specified in section 170(c)(4) or the
reasonable costs of distributing funds for such purposes. Funds for any
other purpose may not be set aside in the insurance set aside.
(2) Income from set aside. In addition to the payments by members
described in paragraph (b)(1) of this section, only income from amounts
in the insurance set aside (including commissions earned as agent for an
insurance company) may be so set aside. Moreover unless such income is
used for providing insurance benefits, for those purposes specified in
section 170(c)(4),
[[Page 193]]
or for reasonable costs of administration, such income must be set aside
within the period described in paragraph (b)(3) of this section in order
to avoid being included as an item of unrelated business taxable income
under section 512(a)(4).
(3) Time within which income must be set aside. Income from amounts
in the insurance set aside generally must be set aside in the taxable
year in which it would be includible in gross income but for this
section. However, income set aside on or before the date prescribed for
filing the organization's return of unrelated business taxable income
(whether or not it had such income) for the taxable year (including any
extension of time) may, at the election of the organization, be treated
as having been set aside in such taxable year.
(4) Computation of income from set aside. Income from amounts in the
insurance set aside shall consist solely of items of investment income
from, and other gains derived from dealings in, property in the set
aside. The deductions allowed against such items of income or other
gains are those amounts which are related to the production of such
income or other gains. Only the amounts of income or other gain which
are in excess of such deductions may be set aside in the insurance set
aside.
(5) Requirements for set aside. An amount is not properly set aside
if the organization commingles it with any amount which is not to be set
aside. However, adequate records describing the amount set aside and
indicating that it is to be used for the designated purpose are
sufficient. Amounts that are set aside need not be permanently committed
to such use either under state law or by contract. Thus, for example, it
is not necessary that the organization place these funds in an
irrevocable trust. Although set aside income may be accumulated, any
accumulation which is unreasonable in amount or duration is evidence
that the income was not accumulated for the purposes set forth. For
purposes of the preceding sentence, accumulations which are reasonably
necessary for the purpose of providing life, sick, health, or accident
insurance benefits on the basis of recognized mortality or morbidity
tables and assumed rates of interest under an actuarially acceptable
method would not be unreasonable even though such accumulations are
quite large and the time between the receipt by the organization of such
amounts and the date of payment of the benefits is quite long. For
example, an accumulation of income for 20 years or longer which is
determined to be reasonable necessary to pay life insurance benefits to
members, their dependents or designated beneficiaries, generally would
not be an unreasonable accumulation. Income which has been set aside may
be invested, pending the action contemplated by the set aside, without
being regarded as having been used for other purposes.
[T.D. 7438, 41 FR 44393, Oct. 8, 1976]
Sec. 1.512(a)-5 Questions and answers relating to the unrelated business
taxable income of organizations described in paragraphs (9) or (17)
of section 501(c).
(a)(1) Q-1. What does section 512(a)(3) provide with respect to
organizations described in paragraphs (9) or (17) of section 501(c)?
(2) A-1. (i) In general, section 512(a)(3) provides rules for
determining the unrelated business income tax of voluntary employees'
beneficiary associations (VEBAs) and supplemental unemployment benefit
trusts (SUBs). Under section 512(a)(3)(A), a Covered Entity's
``unrelated business taxable income'' (UBTI) means all income except
exempt function income. Under section 512(a)(3)(B), exempt function
income includes income that is set aside for exempt purposes, as
described in paragraph (b) of this section, subject to certain limits,
as described in paragraph (c) of this section.
(ii) For purposes of this section, a ``Covered Entity'' means a VEBA
or a SUB, and, to the extent provided in section 512(a)(3)(C), a
corporation described in section 501(c)(2).
(b)(1) Q-2. What is exempt function income?
(2) A-2. (i) Under section 512(a)(3)(B), the exempt function income
of a Covered Entity for a taxable year means the sum of--
(A) Amounts referred to in the first sentence of section
512(a)(3)(B) that are
[[Page 194]]
paid by members of the Covered Entity and employer contributions to the
Covered Entity (collectively ``member contributions'');
(B) Other income of the Covered Entity (including earnings on member
contributions) that is set aside for a purpose specified in section
170(c)(4) and reasonable costs of administration directly connected with
such purpose; and
(C) Other income of the Covered Entity (including earnings on member
contributions) that, subject to the limitation of section 512(a)(3)(E)
(as described in paragraph (c) of this section), is set aside for the
payment of life, sick, accident, or other benefits and reasonable costs
of administration directly connected with such purpose.
(ii) The other income described in paragraphs (b)(2)(i)(B) and (C)
of this section does not include the gross income derived from any
unrelated trade or business (as defined in section 513) regularly
carried on by the Covered Entity, computed as if the organization were
subject to section 512(a)(1).
(c)(1) Q-3. What are the limits on the amount that may be set aside?
(2) A-3. (i) Pursuant to section 512(a)(3)(E)(i), and except as
provided in paragraph (c)(2)(ii) of this section, the amount of
investment income (as defined in paragraph (c)(2)(iii) of this section)
set aside by a Covered Entity as of the close of a taxable year of such
Covered Entity to provide for the payment of life, sick, accident, or
other benefits (and administrative costs associated with the provision
of such benefits) is not taken into account for purposes of determining
the amount of that income that constitutes ``exempt function income'' to
the extent that the total amount of the assets of the Covered Entity at
the end of the taxable year set aside to provide for the payment of
life, sick, accident, or other benefits (and related administrative
costs) exceeds the applicable account limit for such taxable year of the
Covered Entity (as described in paragraph (c)(2)(iv) of this section).
Accordingly, any investment income a Covered Entity earns during the
taxable year is subject to unrelated business income tax to the extent
the Covered Entity's year-end assets exceed the applicable account
limit. The rule in this paragraph (c)(2) applies regardless of whether
the Covered Entity spends or retains (or is deemed to spend or deemed to
retain) that investment income during the course of the year. Thus, in
addition to the unrelated business taxable income derived by a Covered
Entity from any unrelated trade or business (as defined in section 513)
regularly carried on by it, computed as if the organization were subject
to section 512(a)(1), the unrelated business taxable income of a Covered
Entity for a taxable year of such an organization includes the lesser
of--
(A) The investment income of the Covered Entity for the taxable
year; and
(B) The excess (if any) of--
(1) The total amount of the assets of the Covered Entity (excluding
amounts set aside for a purpose described in section 170(c)(4)) as of
the close of the taxable year; over
(2) The applicable account limit for the taxable year.
(ii) In accordance with section 512(a)(3)(E)(iii), a Covered Entity
is not subject to the limits described in this paragraph (c) if
substantially all of the contributions to the Covered Entity are made by
employers who were tax exempt throughout the five year taxable period
ending with the taxable year in which the contributions are made.
(iii) For purposes of this section, a Covered Entity's ``investment
income''--
(A) Means all income except--
(1) Member contributions described in paragraph (b)(2)(i)(A) of this
section;
(2) Income set aside as described in paragraph (b)(2)(i)(B) of this
section; or
(3) Income from any unrelated trade or business described in
paragraph (b)(2)(ii) of this section; and
(B) Includes gain realized by the Covered Entity on the sale or
disposition of any asset during such year (other than gain on the sale
or disposition of assets of an unrelated trade or business described in
paragraph (b)(2)(ii) of this section), except to the extent provided in
section 512(a)(3)(D).
(C) For purposes of paragraph (c)(2)(iii)(B) of this section, the
gain realized by a Covered Entity on the sale
[[Page 195]]
or disposition of an asset is equal to the amount realized by the
organization over the basis of such asset in the hands of the
organization reduced by any qualified direct costs attributable to such
asset (under paragraphs (b), (c), and (d) of Q&A-6 of Sec. 1.419A-1T).
(iv) In calculating the total amount of the assets of a Covered
Entity as of the close of the taxable year, certain assets with useful
lives extending substantially beyond the end of the taxable year (for
example, buildings and licenses) are not to be taken into account to the
extent they are used in the provision of life, sick, accident, or other
benefits. By contrast, cash and securities (and other similar
investments) held by a Covered Entity are taken into account in
calculating the total amount of the assets of a Covered Entity as of the
close of the taxable year because they may be used to pay welfare
benefits, rather than merely used in the provision of such benefits.
(v) The determination of the applicable account limit for purposes
of this paragraph (c) is made under the rules of sections 419A(c) and
419A(f)(7), except that a reserve for post-retirement medical benefits
under section 419A(c)(2)(A) is not to be taken into account. See Sec.
1.419A-2T for special rules relating to collectively bargained welfare
benefit funds.
(vi) The limits of this paragraph (c) apply to a Covered Entity that
is part of a 10 or more employer plan, as defined in section 419A(f)(6).
For purposes of this paragraph (c), the account limit is determined as
if the plan is not subject to the exception under section 419A(f)(6).
(vii) The following examples illustrate the calculation of a VEBA's
UBTI.
(A) Example 1. (1) Employer X establishes a VEBA as of January 1,
2015, through which it provides health benefits to active employees. The
plan year is the calendar year. The VEBA has no employee contributions
or member dues, receives no income from an unrelated trade or business
regularly carried on by the VEBA, and has no income set aside for a
purpose specified in section 170(c)(4). The VEBA's investment income in
2020 is $1,000. As of December 31, 2020, the applicable account limit
under section 512(a)(3)(E)(i) is $5,000 and the total amount of assets
of the VEBA is $7,000.
(2) The VEBA's UBTI for 2020 is $1,000. This is because the UBTI is
the lesser of the investment income for the year ($1,000) and the excess
of the VEBA assets over the account limit at the end of the year ($7,000
over $5,000, or $2,000).
(B) Example 2. (1) The facts are the same as in the example in
paragraph (c)(2)(vii)(A) of this section (Example 1), except that the
VEBA's applicable account limit under section 512(a)(3)(E)(i) as of
December 31, 2020, is $6,500.
(2) The VEBA's UBTI for 2020 is $500. This is because the UBTI for
2020 is the lesser of the investment income for the year ($1,000) and
the excess of the VEBA assets over the account limit at the end of the
year ($7,000 over $6,500, or $500).
(C) Example 3. (1) Employer Y contributes to a VEBA through which Y
provides health benefits to active and retired employees. The plan year
is the calendar year. At the end of 2020, there was no carryover of
excess contributions within the meaning of section 419(d), the balance
in the VEBA was $25,000, the Incurred but Unpaid (IBU) claims reserve
was $6,000, the reserve for post-retirement medical benefits (PRMB)
(computed in accordance with section 419A(c)(2)) was $19,000, and there
were no existing reserves within the meaning of section
512(a)(3)(E)(ii). During 2021, the VEBA receives $70,000 in employer
contributions and $5,000 in investment income, pays $72,000 in benefit
payments and $7,000 in administrative expenses, and receives no income
from an unrelated trade or business regularly carried on by the VEBA.
All the 2021 benefit payments are with respect to active employees and
the IBU claims reserve (that is, the account limit under section
419A(c)(1)) at the end of 2021 was $7,200. The reserve for PRMB at the
end of 2021 is $20,000. All amounts designated as ``administrative
expenses'' are expenses incurred in connection with the administration
of the employee health benefits. ``Investment income'' is net of
administrative costs incurred in the production of the investment income
(for example, investment management and/or brokerage
[[Page 196]]
fees). Only employers contributed to the VEBA (that is, there were no
employee contributions or member dues/fees). The VEBA does not set aside
any income for the purpose specified in section 170(c)(4).
(2) The total amount of assets of the VEBA at the end of 2021 is
$21,000 (that is, $25,000 beginning of year balance + $70,000
contributions + $5,000 investment income-($72,000 in benefit payments +
$7,000 in administrative expenses)).
(3) The applicable account limit under section 512(a)(3)(E)(i) (that
is, the account limit under section 419A(c), excluding the reserve for
post-retirement medical benefits) is the IBU claims reserve ($7,200).
(4) The total amount of assets of the VEBA as of the close of the
year ($21,000) exceeds the applicable account limit ($7,200) by $13,800.
(5) The unrelated business taxable income of the VEBA is $5,000
(that is, the lesser of investment income ($5,000) and the excess of the
amount of assets of the VEBA as of the close of the taxable year over
the applicable account limit ($13,800)).
(D) Example 4. (1) The facts are the same as in the example in
paragraph (c)(2)(vii)(C) of this section (Example 3) except that the
2020 year-end balance was $15,000.
(2) The total amount of assets in the VEBA at the end of 2021 is
$11,000 (that is, $15,000 beginning of year balance + $70,000
contributions + $5,000 investment income-($72,000 in benefit payments +
$7,000 in administrative expenses)).
(3) The applicable account limit under section 512(a)(3)(E)(i)
remains $7,200.
(4) The total amount of assets of the VEBA as of the close of the
year ($11,000) exceeds the applicable account limit ($7,200) by $3,800.
(5) The VEBA's unrelated business taxable income is $3,800 (that is,
the lesser of investment income ($5,000) and the excess of the total
amount of assets of the VEBA at the close of the taxable year over the
applicable account limit ($3,800)).
(d)(1) Q-4. What is the effective date of the amendments to section
512(a)(3) and what transition rules apply to ``existing reserves for
post-retirement medical or life insurance benefits''?
(2) A-4. (i) The amendments to section 512(a)(3), made by the Tax
Reform Act of 1984, apply to income earned by a Covered Entity after
December 31, 1985, in the taxable years of such an organization ending
after such date.
(ii) Section 512(a)(3)(E)(ii)(I) provides that income that is
attributable to ``existing reserves for post-retirement medical or life
insurance benefits'' will not be treated as unrelated business taxable
income. This includes income that is either directly or indirectly
attributable to existing reserves. An ``existing reserve for post-
retirement medical or life insurance benefits'' (as defined in section
512(a)(3)(E)(ii)(II)) is the total amount of assets actually set aside
by a Covered Entity on July 18, 1984 (calculated in the manner set forth
in paragraph (c) of this section, and adjusted under paragraph (c) of
Q&A-11 of Sec. 1.419-1T), reduced by employer contributions to the fund
on or before such date to the extent such contributions are not
deductible for the taxable year of the employer including July 18, 1984,
and for any prior taxable year of the employer, for purposes of
providing such post-retirement benefits. For purposes of the preceding
sentence only, an amount that was not actually set aside on July 18,
1984, will be treated as having been actually set aside on such date if
the amount was--
(A) Incurred by the employer (without regard to section 461(h)) as
of the close of the last taxable year of the Covered Entity ending
before July 18, 1984; and
(B) Actually contributed to the Covered Entity within 8 \1/2\ months
following the close of such taxable year.
(iii) In addition, section 512(a)(3)(E)(ii)(I) applies to existing
reserves for such post-retirement benefits only to the extent that such
``existing reserves'' do not exceed the amount that could be accumulated
under the principles set forth in Revenue Rulings 69-382, 1969-2 CB 28;
69-478, 1969-2 CB 29; and 73-599, 1973-2 CB 40. Thus, amounts
attributable to any such excess ``existing reserves'' are not within the
transition rule of section 512(a)(3)(E)(ii)(I) even though they were
[[Page 197]]
actually set aside on July 18, 1984. See Sec. 601.601(d)(2)(ii)(b) of
this chapter.
(iv) All post-retirement medical or life insurance benefits (or
other benefits to the extent paid with amounts set aside to provide
post-retirement medical or life insurance benefits) provided after July
18, 1984 (whether or not the employer has maintained a reserve or fund
for such benefits) are to be charged, first, against the ``existing
reserves'' within the transition rule of section 512(a)(3)(E)(ii)(I)
(including amounts attributable to ``existing reserves'' within the
transition rule of section 512(a)(3)(E)(ii)(I) for post-retirement
medical benefits or for post-retirement life insurance benefits (as the
case may be)) and, second, against all other amounts. For purposes of
this paragraph (d)(2)(iv), the qualified direct cost of an asset with a
useful life extending substantially beyond the end of the taxable year
(as determined under Q&A-6 of Sec. 1.419-1T) will be treated as a
benefit provided and thus charged against the ``existing reserve'' based
on the extent to which such asset is used in the provision of post-
retirement medical benefits or post-retirement life insurance benefits
(as the case may be). All plans of an employer providing post-retirement
medical benefits are to be treated as one plan for purposes of section
512(a)(3)(E)(ii)(III), and all plans of an employer providing post-
retirement life insurance benefits are to be treated as one plan for
purposes of section 512(a)(3)(E)(ii)(III).
(v) In calculating the unrelated business taxable income of a
Covered Entity for a taxable year of such organization, the total income
of the Covered Entity for the taxable year is reduced by the income
attributable to ``existing reserves'' within the transition rule of
section 512(a)(3)(E)(ii)(I) before such income is compared to the excess
of the total amount of the assets of the Covered Entity as of the close
of the taxable year over the applicable account limit for the taxable
year.
(vi) The following example illustrates the calculation of UBTI for a
VEBA that has existing reserves.
(A) Example. Assume that the total income of a VEBA for a taxable
year is $1,000, and that the excess of the total amount of the assets of
the VEBA as of the close of the taxable year over the applicable account
limit is $600. Assume also that of the $1,000 of total income, $540 is
attributable to ``existing reserves'' within the transition rule of
section 512(a)(3)(E)(ii)(I). The unrelated business taxable income of
this VEBA for the taxable year is $460, determined as the lesser of the
following two amounts:
(1) The total income of the VEBA for the taxable year, reduced by
the extent to which such income is attributable to ``existing reserves''
within the meaning of the transition rule of section 512(a)(3)(E)(ii)(I)
($1,000-$540 = $460); and
(2) The excess of the total amount of the assets of the VEBA as of
the close of the taxable year over the applicable account limit ($600).
(B) [Reserved]
(e)(1) Q-5. What is the applicability date of this section?
(2) A-5. Except as otherwise provided in this paragraph (e)(2), this
section is applicable to taxable years beginning on or after December
10, 2019. For rules that apply to earlier periods, see Sec. 1.512(a)-
5T, as contained in 26 CFR part 1, revised April 1, 2019.
[T.D. 9886, 84 FR 67373, Dec. 10, 2019]
Sec. 1.512(a)-6 Special rule for organizations with more than one
unrelated trade or business.
(a) More than one unrelated trade or business--(1) In general. An
organization with more than one unrelated trade or business must compute
unrelated business taxable income (UBTI) separately with respect to each
such trade or business, without regard to the specific deduction in
section 512(b)(12), including for purposes of determining any net
operating loss (NOL) deduction. An organization with more than one
unrelated trade or business computes its total UBTI under paragraph (g)
of this section.
(2) Separate trades or businesses. An organization determines
whether it regularly carries on unrelated trades or businesses by
applying sections 511 through 514. For purposes of section 512(a)(6)(A)
and paragraph (a)(1) of this section, an organization identifies its
separate unrelated trades or businesses
[[Page 198]]
using the methods described in paragraphs (b) through (e) of this
section.
(3) Reporting changes in identification. An organization that
changes the identification of a separate unrelated trade or business
under paragraph (a)(2) of this section must report the change in the
taxable year of that change in accordance with forms and instructions.
For this purpose, a change in identification of a separate unrelated
trade or business includes the changed identification of the separate
unrelated trade or business with respect to a partnership interest that
was incorrectly designated as a qualifying partnership interest (QPI).
In the case of an incorrect designation of a QPI, paragraph (c)(2)(iii)
of this section (regarding designation of qualifying partnership
interests) does not apply. In all cases, to report the change in
identification, an organization must provide the following information
with respect to each separate change in identification--
(i) The identification of the separate unrelated trade or business
in the previous taxable year;
(ii) The identification of the separate unrelated trade or business
in the current taxable year; and
(iii) The reason for the change.
(b) North American Industry Classification System--(1) In general.
Except as provided in paragraphs (c) through (e) of this section, an
organization identifies each of its separate unrelated trades or
businesses using the first two digits of the North American Industry
Classification System code (NAICS 2-digit code) that most accurately
describes the unrelated trade or business based on the more specific
NAICS code, such as at the 6-digit level, that describes the activity it
conducts and subject to the requirements of paragraph (b)(2) and (3) of
this section. The descriptions in the current NAICS manual (available at
www.census.gov) of trades or businesses using more than two digits of
the NAICS codes are relevant in this determination. In the case of the
sale of goods, both online and in stores, the separate unrelated trade
or business is identified by the goods sold in stores if the same goods
generally are sold both online and in stores.
(2) Codes must identify the unrelated trade or business. The NAICS
2-digit code must identify the unrelated trade or business in which the
organization engages (directly or indirectly) and not activities the
conduct of which are substantially related to the exercise or
performance by such organization of its charitable, educational, or
other purpose or function constituting the basis for its exemption under
section 501 (or, in the case of an organization described in section
511(a)(2)(B), to the exercise or performance of any purpose or function
described in section 501(c)(3)). For example, a college or university
described in section 501(c)(3) cannot use the NAICS 2-digit code for
educational services to identify all its separate unrelated trades or
businesses, and a qualified retirement plan described in section 401(a)
cannot use the NAICS 2-digit code for finance and insurance to identify
all of its unrelated trades or businesses.
(3) Codes only reported once. An organization will report each NAICS
2-digit code only once. For example, a hospital organization that
operates several hospital facilities in a geographic area (or multiple
geographic areas), all of which include pharmacies that sell goods to
the general public, would include all the pharmacies under the NAICS 2-
digit code for retail trade, regardless of whether the hospital
organization keeps separate books and records for each pharmacy.
(c) Activities in the nature of investments--(1) In general. An
organization's activities in the nature of investments (investment
activities) are treated collectively as a separate unrelated trade or
business for purposes of section 512(a)(6) and paragraph (a) of this
section. Except as provided in paragraphs (c)(7) and (c)(8) of this
section, an organization's investment activities are limited to its--
(i) Qualifying partnership interests (described in paragraph (c)(2)
of this section);
(ii) Qualifying S corporation interests (described in paragraph
(e)(2)(i) of this section); and
(iii) Debt-financed property or properties (within the meaning of
section 514).
[[Page 199]]
(2) Qualifying partnership interests--(i) Directly-held partnership
interests. An interest in a partnership is a qualifying partnership
interest (QPI) if the exempt organization holds a direct interest in the
partnership (directly-held partnership interest) that meets the
requirements of either the de minimis test (described in paragraph
(c)(3) of this section) or the participation test (described in
paragraph (c)(4) of this section).
(ii) Indirectly-held partnership interests--(A) Look through rule.
If an organization holds a direct interest in a partnership but that
directly-held partnership interest is not a QPI because it does not meet
the requirements of the de minimis test (described in paragraph (c)(3)
of this section) or the participation test (described in paragraph
(c)(4) of this section), any partnership in which the organization holds
an indirect interest through the directly-held partnership interest
(indirectly-held partnership interest) may be a QPI if the indirectly-
held partnership interest meets the requirements of paragraph
(c)(2)(ii)(B) or (c)(2)(ii)(C) of this section.
(B) Indirectly-held partnership interests that meet the requirements
of the de minimis test. An indirectly-held partnership interest meets
the requirements of this paragraph (c)(2)(ii)(B) if the indirectly-held
partnership interest meets the requirements of the de minimis test
described in paragraph (c)(3) of this section with regard to the
organization. For example, if an organization directly holds 50 percent
of the capital interests of a partnership and the directly-held
partnership holds 4 percent of the capital and profits interest of
lower-tier partnership A, the organization may aggregate its interest in
lower-tier partnership A with its other QPIs because the organization
indirectly holds 2 percent of the capital and profits interests of
lower-tier partnership A (4 percent x 50 percent).
(C) Indirectly-held partnership interests that meet the requirements
of the participation test. An indirectly-held partnership interest meets
the requirements of this paragraph (c)(2)(ii)(C) if the indirectly-held
partnership interest meets the requirements of the participation test
(described in paragraph (c)(4) of this section) with respect to the
partnership that directly owns the interest in the indirectly-held
partnership. For purposes of applying the participation test to a
partnership, the term organization in paragraph (c)(4) of this section
refers to the partnership that directly holds the indirectly-held
partnership interest being tested for QPI status. Additionally, the list
of officers, directors, trustees, or employees of an organization found
in paragraphs (c)(4)(iii)(B) and (C) includes a general partner that
directly owns an interest in the lower-tier partnership.
(D) Example. (1) Organization D is described in section 501(c) and
is exempt from Federal income tax under section 501(a). Organization D
owns 50 percent of the capital interest in Partnership A. Partnership A
owns 30 percent of the capital interest in Partnership B, but
Partnership A does not significantly participate in Partnership B within
the meaning of paragraph (c)(4)(iii) of this section. Further,
Partnership B owns 15 percent of the capital interest in Partnership C,
in which Partnership B does not significantly participate within the
meaning of paragraph (c)(4)(iii) of this section. No other organizations
related (within the meaning of paragraph (c)(4)(ii) of this section) to
either Organization D or the partnerships owns an interest in any of the
lower-tier partnerships.
(2) Neither the interest in Partnership A nor B is a QPI.
Organization D's interest in Partnership A does not meet the
requirements of either the de minimis test or the participation test
because it owns 50 percent of the interest in the partnership.
Organization D's indirect interest in Partnership B (50 percent of 30
percent, or 15 percent) does not meet the de minimis test. Additionally,
because Partnership A owns greater than 20 percent interest in
Partnership B, Partnership A's interest in Partnership B does not meet
the participation test. However, Organization D's interest in
Partnership C is a QPI because Partnership C meets the participation
test. That is, Partnership B holds a 15 percent interest in Partnership
C and does not significantly participate in Partnership C.
(iii) Designation. An organization that has a partnership interest
meeting
[[Page 200]]
the requirements of paragraph (c)(2)(i) or (ii) of this section in a
taxable year may designate that partnership interest as a QPI by
including its share of partnership gross income (and directly connected
deductions) with the gross income (and directly connected deductions)
from its other investment activities (see paragraph (c)(1) of this
section) in accordance with forms and instructions. Any partnership
interest that is designated as a QPI remains a QPI unless and until it
no longer meets the requirements of paragraph (c)(2)(i) or (ii) of this
section. For example, if an organization designates a directly-held
partnership interest that meets the requirements of the de minimis rule
as a QPI in one taxable year, the organization cannot, in the next
taxable year, use NAICS 2-digit codes to describe the partnership trades
or businesses that are unrelated trades or businesses with respect to
the organization unless the directly-held partnership interest fails to
meet the requirements of both the de minimis test and the participation
test (after application of the grace period described in paragraph
(c)(6) of this section, if appropriate).
(3) De minimis test. A partnership interest is a QPI that meets the
requirements of the de minimis test if the organization holds directly
(within the meaning of paragraph (c)(2)(i) of this section) or
indirectly (within the meaning of paragraph (c)(2)(ii) of this section)
no more than 2 percent of the profits interest and no more than 2
percent of the capital interest during the organization's taxable year
with which or in which the partnership's taxable year ends.
(4) Participation test--(i) In general. A partnership interest is a
QPI that meets the requirements of the participation test if the
organization holds directly (within the meaning of paragraph (c)(2)(i)
of this section) or indirectly (within the meaning of paragraph
(c)(2)(ii) of this section) no more than 20 percent of the capital
interest during the organization's taxable year with which or in which
the partnership's taxable year ends and the organization does not
significantly participate in the partnership within the meaning of
paragraph (c)(4)(iii) of this section.
(ii) Combining related interests. When determining an organization's
percentage interest in a partnership for purposes of paragraph (c)(4)(i)
of this section, the interests of a supporting organization (as defined
in section 509(a)(3) and Sec. 1.509(a)-4), other than a Type III
supporting organization (as defined in Sec. 1.509(a)-4(i)) that is not
a parent of its supported organization, or of a controlled entity (as
defined in section 512(b)(13)(D) and Sec. 1.512(b)-1(l)) in the same
partnership will be taken into account. For example, if an organization
owns 10 percent of the capital interests in a partnership, and its Type
I supporting organization owns an additional 15 percent capital interest
in that partnership, the organization would not meet the requirements of
the participation test because its aggregate percentage interest exceeds
20 percent (10 percent + 15 percent = 25 percent).
(iii) Significant Participation. An organization significantly
participates in a partnership if--
(A) The organization, by itself, may require the partnership to
perform, or may prevent the partnership from performing (other than
through a unanimous voting requirement or through minority consent
rights), any act that significantly affects the operations of the
partnership;
(B) Any of the organization's officers, directors, trustees, or
employees have rights to participate in the management of the
partnership at any time;
(C) Any of the organization's officers, directors, trustees, or
employees have rights to conduct the partnership's business at any time;
or
(D) The organization, by itself, has the power to appoint or remove
any of the partnership's officers or employees or a majority of
directors.
(5) Determining percentage interest--(i) Profits interest. For
purposes of the de minimis test described in paragraph (c)(3) of this
section, an organization's profits interest in a partnership is
determined in the same manner as its
[[Page 201]]
distributive share of partnership taxable income. See section 704(b)
(relating to the determination of the distributive share by the income
or loss ratio) and Sec. Sec. 1.704-1 through 1.704-4.
(ii) Capital interest. For purposes of the de minimis test
(described in paragraph (c)(3) of this section) and the participation
test (described in paragraph (c)(4)(i) of this section), in the absence
of a provision in the partnership agreement, an organization's capital
interest in a partnership is determined on the basis of its interest in
the assets of the partnership which would be distributable to such
organization upon its withdrawal from the partnership, or upon
liquidation of the partnership, whichever is the greater.
(iii) Average percentage interest. For purposes of the de minimis
test (described in paragraph (c)(3) of this section) and the
participation test (described in paragraph (c)(4)(i) of this section),
an organization determines its percentage interest by taking the average
of the organization's percentage interest at the beginning and the end
of the partnership's taxable year, or, in the case of a partnership
interest held for less than a year, the percentage interest held at the
beginning and end of the period of ownership within the partnership's
taxable year. For example, if an organization acquires an interest in a
partnership that files on a calendar year basis in May and the
partnership reports on Schedule K-1 (Form 1065) that the partner held a
3 percent profits interest at the date of acquisition but held a 1
percent profits interest at the end of the calendar year, the
organization will be considered to have held 2 percent of the profits
interest in that partnership for that year ((3 percent + 1 percent)/2).
(iv) Reliance on Schedule K-1 (Form 1065). When determining the
organization's average percentage interest (described in paragraph
(c)(5)(iii) of this section) in a partnership for purposes of the de
minimis test (described in paragraph (c)(3) of this section) and the
participation test (described in paragraph (c)(4) of this section), an
organization may rely on the Schedule K-1 (Form 1065) (or its successor)
it receives from the partnership if the form lists the organization's
percentage profits interest or its percentage capital interest, or both,
at the beginning and end of the year. However, the organization may not
rely on the form to the extent that any information about the
organization's percentage interest is not specifically provided. For
example, if the Schedule K-1 (Form 1065) an organization receives from a
partnership lists the organization's profits interest as ``variable''
but lists its percentage capital interest at the beginning and end of
the year, the organization may rely on the form only with respect to its
percentage capital interest.
(6) Changes in percentage interest. A partnership interest that
fails to meet the requirements of the de minimis test (described in
paragraph (c)(3) of this section) or the participation test (described
in paragraph (c)(4) of this section) because of an increase in
percentage interest in the organization's current taxable year may be
treated for the taxable year of the change as meeting the requirements
of the test it met in the prior taxable year if--
(i) The partnership interest met the requirements of the de minimis
test or participation test, respectively, in the organization's prior
taxable year without application of this paragraph (c)(6);
(ii) The increase in percentage interest is solely due to the
actions of one or more partners other than the organization; and
(iii) In the case of a partnership interest that met the
requirements of the participation test in the prior taxable year, the
interest of the partner or partners that caused the increase in
paragraph (c)(6)(ii) of this section was not combined for the prior
taxable year and is not combined for the taxable year of the change with
the organization's partnership interest for purposes of paragraph
(c)(4)(ii) of this section.
(7) UBTI from the investment activities of organizations subject to
section 512(a)(3). For purposes of paragraph (c)(1) of this section,
UBTI from the investment activities of an organization subject to
section 512(a)(3) includes any amount that--
(i) Would be excluded from the calculation of UBTI under section
512(b)(1), (2), (3), or (5) if the organization were subject to section
512(a)(1);
[[Page 202]]
(ii) Is attributable to income set aside (and not in excess of the
set aside limit described in section 512(a)(3)(E)), but not used, for a
purpose described in section 512(a)(3)(B)(i) or (ii); or
(iii) Is in excess of the set aside limit described in section
512(a)(3)(E).
(8) Limitations--(i) Social clubs. Paragraphs (c)(2) (regarding
QPIs) and (c)(9) (transition rule for certain partnership interests) of
this section do not apply to social clubs described in section
501(c)(7).
(ii) General partnership interests. Any partnership in which an
organization, or an organization whose interest is combined with that
organization's interest for purposes of paragraph (c)(4)(ii) of this
section, is a general partner under applicable state law is not a QPI
within the meaning of paragraph (c)(2) of this section, regardless of
the organization's percentage interest. Such partnership interest cannot
be a QPI for any organization or for any of the organizations whose
interest is combined with that organization's interest for purposes of
paragraph (c)(4)(ii) of this section.
(iii) Application of other sections. This paragraph (c) does not
otherwise impact application of section 512(c) and the fragmentation
rule under section 513(c).
(9) Transition rule for certain partnership interests--(i) In
general. If a directly-held partnership interest acquired prior to
August 21, 2018, is not a QPI, an organization may treat such
partnership interest as a separate unrelated trade or business for
purposes of section 512(a)(6) regardless of the number of unrelated
trades or businesses directly or indirectly conducted by the
partnership. For example, if an organization has a 35 percent capital
interest in a partnership acquired prior to August 21, 2018, it can
treat the partnership as a single trade or business even if the
partnership's investments generated UBTI from lower-tier partnerships
that were engaged in multiple trades or businesses. A partnership
interest acquired prior to August 21, 2018, will continue to meet the
requirement of this rule even if the organization's percentage interest
in such partnership changes before the end of the transition period (see
paragraph (c)(9)(iii) of this section).
(ii) Exclusivity. An organization may apply either the transition
rule in paragraph (c)(9)(i) of this section or the look-through rule in
paragraph (c)(2)(ii) of this section, but not both, to a partnership
interest described in paragraph (c)(9)(i) of this section that also
qualifies for application of the look-through rule described in
paragraph (c)(2)(ii).
(iii) Transition period. An organization may rely on this transition
rule until the first day of the organization's first taxable year
beginning after December 2, 2020.
(d) Income from certain controlled entities--(1) Specified payments
from controlled entities. If an organization (controlling organization)
controls another entity (within the meaning of section 512(b)(13)(D))
(controlled entity), all specified payments (as defined in section
512(b)(13)(C)) received by a controlling organization from that
controlled entity are treated as gross income from a separate unrelated
trade or business for purposes of paragraph (a) of this section. If a
controlling organization receives specified payments from two different
controlled entities, the payments from each controlled entity are
treated as a separate unrelated trade or business. For example, a
controlling organization that receives rental payments from two
controlled entities has two separate unrelated trades or businesses, one
for each controlled entity. The specified payments from a controlled
entity are treated as gross income from one trade or business regardless
of whether the controlled entity engages in more than one unrelated
trade or business or whether the controlling organization receives more
than one type of specified payment from that controlled entity.
(2) Certain amounts derived from controlled foreign corporations.
All amounts included in UBTI under section 512(b)(17) are treated as
income derived from a separate unrelated trade or business for purposes
of paragraph (a) of this section.
(e) S corporation interests--(1) In general. Except as provided in
paragraph (e)(2) of this section, if an organization
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owns stock in an S corporation (S corporation interest), such S
corporation interest is treated as an interest in a separate unrelated
trade or business for purposes of paragraph (a) of this section. Thus,
if an organization owns two S corporation interests, neither of which is
described in paragraph (e)(2) of this section, the exempt organization
reports two separate unrelated trades or businesses, one for each S
corporation interest. The UBTI from an S corporation interest is the
amount described in section 512(e)(1)(B).
(2) Exception for a qualifying S corporation interest.
Notwithstanding paragraph (e)(1) of this section, an organization may
aggregate its UBTI from an S corporation interest with its UBTI from
other investment activities (described in paragraph (c)(1) of this
section) if the organization's ownership interest in the S corporation
meets the criteria for a QPI as described in paragraph (c)(2)(i) of this
section (substituting ``S corporation'' for ``partnership'' and
``shareholder'' or ``shareholders'' for ``partner'' or ``partners,'' as
applicable, throughout paragraphs (c)(2)(i), (c)(3), (c)(4),
(c)(5)(iii), (c)(5)(iv), and (c)(6) of this section; ``no more than 2
percent of stock ownership'' for ``no more than 2 percent of the profits
interest and no more than 2 percent of the capital interest'' in
paragraph (c)(3) of this section; ``no more than 20 percent of stock
ownership'' in place of ``no more than 20 percent of the capital
interest'' in paragraph (c)(4)(i) of this section; and ``Schedule K-1
(Form 1120-S)'' for ``Schedule K-1 (Form 1065)'' for purposes of
paragraph (c)(5)(iv) of this section). Paragraphs (c)(5)(i) and
(c)(5)(ii) do not apply for purposes of determining an organization's
ownership interest in an S corporation; rather, the average percentage
stock ownership determined under paragraph (c)(5)(iii) of this section
applies for purposes of this paragraph (e)(2). For purposes of paragraph
(c)(5)(iv) of this section, an organization can rely on the Schedule K-1
(Form 1120-S) (or its successor) it receives from the S corporation only
if the form lists information sufficient to determine the organization's
percentage of stock ownership for the year. A Schedule K-1 (Form 1120-S)
that reports ``zero'' as the organization's number of shares of stock in
either the beginning or end of the S corporation's taxable year does not
list information sufficient to determine the organization's percentage
of stock ownership for the year. The grace period described in paragraph
(c)(6) of this section applies to changes in an exempt organization's
percentage of stock ownership in an S corporation.
(f) Allocation of deductions. An organization must allocate
deductions between separate unrelated trades or businesses using the
method described in Sec. 1.512(a)-1(c).
(g) Total UBTI--(1) In general. The total UBTI of an organization
with more than one unrelated trade or business is the sum of the UBTI
computed with respect to each separate unrelated trade or business (as
identified under paragraph (a)(2) of this section and subject to the
limitation described in paragraph (g)(2) of this section), less a
charitable contribution deduction, an NOL deduction for losses arising
in taxable years beginning before January 1, 2018 (pre-2018 NOLs), and a
specific deduction under section 512(b)(12), as applicable.
(2) UBTI not less than zero. For purposes of paragraph (g)(1) of
this section, the UBTI with respect to any separate unrelated trade or
business identified under paragraph (a)(2) of this section cannot be
less than zero.
(h) Net operating losses--(1) In general. For taxable years
beginning after December 31, 2017, an exempt organization with more than
one unrelated trade or business determines the NOL deduction allowed by
sections 172(a) and 512(b)(6) separately with respect to each of its
unrelated trades or businesses. Accordingly, if an exempt organization
has more than one unrelated trade or business, Sec. 1.512(b)-1(e)
applies separately with respect to each such unrelated trade or
business.
(2) Coordination of pre-2018 and post-2017 NOLs. An organization
with pre-2018 NOLs, and with losses arising in a taxable year beginning
after December 31, 2017 (post-2017 NOLs), deducts its pre-2018 NOLs from
total UBTI before deducting any post-2017 NOLs with regard to a separate
unrelated trade or
[[Page 204]]
business against the UBTI from such trade or business. Pre-2018 NOLs are
taken against the total UBTI as determined under paragraph (g) of this
section in a manner that allows for maximum utilization of post-2017
NOLs in a taxable year. For example, an organization could choose to
allocate all of its pre-2018 NOLs to one of its separate unrelated
trades or businesses or it could allocate its pre-2018 NOLs ratably
among its separate unrelated trades or businesses, whichever results in
the greatest utilization of the post-2017 NOLs in that taxable year.
(3) Treatment of NOLs upon the termination, sale, exchange, or other
disposition of a separate unrelated trade or business. After offsetting
any gain resulting from the termination, sale, exchange, or disposition
of a separate unrelated trade or business, any NOL remaining is
suspended. However, the suspended NOLs may be used if that previous
separate unrelated trade or business is later resumed or if a new
unrelated trade or business that is accurately identified using the same
NAICS 2-digit code as the previous separate unrelated trade or business
is commenced or acquired in a future taxable year.
(4) Treatment of NOLs when the identification of a separate
unrelated trade or business changes--(i) In general. For purposes of
section 512(a)(6) and this section, a separate unrelated trade or
business for which the appropriate identification (within the meaning of
paragraph (a) of this section) changes is treated as if the originally
identified separate unrelated trade or business is terminated and a new
separate unrelated trade or business is commenced. None of the NOLs from
the previously identified separate unrelated trade or business will be
carried over to the newly identified separate unrelated trade or
business. For example, if the nature of a separate unrelated trade or
business changes such that it is more accurately described by another
NAICS 2-digit code, the separate unrelated trade or business is treated
as a new separate unrelated trade or business with no NOLs. The change
in identification may apply to all or a part of the originally
identified separate unrelated trade or business. If the change in
identification applies to the originally identified separate trade or
business in its entirety, any NOLs attributable to that separate
unrelated trade or business are suspended in accordance with paragraph
(h)(3) of this section. If the change in identification applies to the
originally identified separate unrelated trade or business in part, the
originally identified separate unrelated trade or business that is not
changing retains the full NOLs attributable to the originally identified
separate unrelated trade or business, without allocation to the portion
that became a newly identified separate unrelated trade or business.
This paragraph (h)(4) also applies to each QPI that becomes a non-QPI.
In this case, any NOLs attributable to the QPI that became a non-QPI are
retained with the organization's investment activities described in
paragraph (c) of this section.
(ii) Exception for non-material changes. In the case of a separate
unrelated trade or business that is accidentally identified using the
wrong NAICS 2-digit code or if an organization has determined that a
separate unrelated trade or business that has not materially changed is
more accurately identified by another NAICS 2-digit code, any NOL
attributable to the originally identified separate unrelated trade or
business becomes an NOL of the newly identified separate unrelated trade
or business.
(iii) Effective date of change in identification. A change in
identification described in this paragraph (h)(4) is effective on the
first day of the taxable year in which the change in identification is
made. Accordingly, the newly identified separate unrelated trade or
business is treated as commencing on this date.
(iv) Examples--(A) In general. The following examples illustrate the
rules described in this paragraph (h)(4).
(B) Example 1. Erroneous code. (1) Organization G is described in
section 501(c) and is exempt from Federal income tax under section
501(a). In addition to its investment activities, Organization G has two
separate unrelated trades or businesses--Q and R--that are identified
with different NAICS 2-digit codes. Both Q and R have NOLs carried over
from post-2017 taxable years.
[[Page 205]]
(2) In Year 2 (a post-2017 taxable year), Organization G realizes
that it accidentally used the wrong NAICS 2-digit code to identify R.
The NOLs attributable to R under the old NAICS 2-digit code become the
NOLs of R under the new NAICS 2-digit code as of the first day of Year
2.
(C) Example 2. Material change. (1) Same facts as Example 1, except
assume that, in addition to its investment activities, Organization G
has three separate unrelated trades or businesses--Q, R, and S--that are
identified with different NAICS 2-digit codes. Q, R, and S all have NOLs
carried over from post-2017 taxable years.
(2) Organization G changes the NAICS 2-digit code identifying R to
the same NAICS 2-digit code identifying S because the nature of the
unrelated trade or business materially changed. Any post-2017 NOLs
attributable to R are suspended (see paragraph (h)(4)(i) of this
section). Organization G now has two separate unrelated trades or
businesses--Q and S--as of the first day of Year 2.
(D) Example 3. Partial material change. Same facts as Example 1,
except assume that Organization G determines that a part of R has
materially changed such that R should be identified as two separate
unrelated trades or businesses--R1 and R2. R1 retains the NAICS 2-digit
code originally identifying R, and R2 is identified with a new NAICS 2-
digit code that is not the same NAICS 2-digit code identifying Q. R2 is
treated as a new separate unrelated trade or business with no NOLs as of
the first day of Year 2. Any post-2017 NOLs attributable to R remain
with R1.
(E) Example 4. QPI to non-QPI. (1) Same facts as Example 1, but
assume that Organization G has a partnership interest in T that was, for
prior taxable years, a QPI included with Organization G's investment
activities. In Year 3 (a post-2017 taxable year), Organization G
acquires more than 20 percent of the capital interests in T. The grace
period described in paragraph (c)(6) of this section does not apply
because the increase in percentage interest was not due to the actions
of other partners.
(2) T conducts two trade or business activities that are unrelated
trade or business activities with respect to Organization G--T1 and T2.
Both T1 and T2 will be treated as new separate unrelated trades or
business as of the first day of Year 2. Organization G identifies T1
with the same NAICS 2-digit code used to identify Q and T2 with a NAICS
2-digit code that is different than the NAICS 2-digit codes used to
identify Q and R. In addition to its investment activities, Organization
G has three separate unrelated trades or businesses--Q, R, and T2. Any
post-2017 NOLs attributable to the QPI remain with Organization G's
other investment activities separate unrelated trade or business.
(i) Applicability dates. This section is applicable 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. 9933, 85 FR 77979, Dec. 2, 2020; 86 FR 9286, Feb. 12, 2021]
Sec. 1.512(b)-1 Modifications.
Whether a particular item of income falls within any of the
modifications provided in section 512(b) shall be determined by all the
facts and circumstances of each case. For example, if a payment termed
rent by the parties is in fact a return of profits by a person operating
the property for the benefit of the tax-exempt organization or is a
share of the profits retained by such organization as a partner or joint
venturer, such payment is not within the modification for rents. The
modifications provided in section 512(b) are as follows:
(a) Certain Investment Income. (1) Dividends (including an inclusion
of subpart F income under section 951(a)(1)(A) or an inclusion of global
intangible low-taxed income (GILTI) under section 951A(a), both of which
are treated in the same manner as a dividend for purposes of section
512(b)(1)), interest, payments with respect to securities loans (as
defined in section 512(a)(5)), annuities, income from notional principal
contracts (as defined in Sec. 1.837-7 or regulations issued under
section 446), other substantially
[[Page 206]]
similar income from ordinary and routine investments to the extent
determined by the Commissioner, and all deductions directly connected
with any of the foregoing items of income must be excluded in computing
unrelated business taxable income.
(2) Limitations. The exclusions under paragraph (a)(1) of this
section do not apply to income derived from and deductions in connection
with debt-financed property (as defined in section 514(b)). Moreover,
the exclusions under paragraph (a)(1) of this section do not apply to
gains or losses from the sale, exchange, or other disposition of any
property, or to gains or losses from the lapse or termination of options
to buy or sell securities. For rules regarding the treatment of these
gains and losses, see section 512(b)(5) and Sec. 1.512(b)-1(d).
Furthermore, the exclusions under paragraph (a)(1) of this section do
not apply to interest and annuities derived from and deductions in
connection with controlled organizations. For rules regarding the
treatment of such amounts, see section 512(b)(13) and Sec. 1.512(b)-
1(l). Finally, the exclusions under paragraph (a)(1) of this section of
income from notional principal contracts and income that the
Commissioner determines to be substantially similar income from ordinary
and routine investments do not apply to income earned by brokers or
dealers (including organizations that make a market in derivative
financial products, as described in Treasury Regulations 26 CFR 1.954-
2T(a)(4)(iii)(B)).
(3) Effective dates. The effective dates of the rules of paragraphs
(a)(1) and (a)(2) of this section that were in effect prior to August
30, 1991, remain the same. The exclusion under paragraph (a)(1) of this
section of income from notional principal contracts is effective for
amounts received after August 30, 1991. However, an organization may
apply the exclusion under paragraph (a)(1) of this section of income
from notional principal contracts prior to that date, provided that such
amounts are treated consistently for all open taxable years. Unless
otherwise provided by the Commissioner, the exclusion under paragraph
(a)(1) of this section of income that the Commissioner determines to be
substantially similar income from ordinary and routine investments is
effective for amounts received after the date of the Commissioner's
determination. The exclusion under paragraph (a)(1) of this section of
an inclusion of subpart F income under section 951(a)(1)(A) or an
inclusion of GILTI under section 951A(a) from income (both inclusions
being treated in the same manner as dividends) is applicable to taxable
years beginning on or after December 2, 2020. However, an organization
may choose to apply this exclusion to taxable years beginning before
December 2, 2020.
(b) Royalties. Royalties, including overriding royalties, and all
deductions directly connected with such income shall be excluded in
computing unrelated business taxable income. However, for taxable years
beginning after December 31, 1969, certain royalties from and certain
deductions in connection with either, debt-financed property (as defined
in section 514(b)) or controlled organizations (as defined in paragraph
(l) of this section) shall be included in computing unrelated business
taxable income. Mineral royalties shall be excluded whether measured by
production or by gross or taxable income from the mineral property.
However, where an organization owns a working interest in a mineral
property, and is not relieved of its share of the development costs by
the terms of any agreement with an operator, income received from such
an interest shall not be excluded. To the extent not treated as a loan
under section 636, payments in discharge of mineral production payments
shall be treated in the same manner as royalty payments for the purpose
of computing unrelated business taxable income. To the extent treated as
a loan under section 636, the amount of any payment in discharge of a
production payment which is the equivalent of interest shall be treated
as interest for purposes of section 512(b)(1) and paragraph (a) of this
section.
(c) Rents--(1) Taxable years beginning before January 1, 1970. For
taxable years beginning before January 1, 1970, rents from real property
(including personal property leased with the real property) and the
deductions directly connected
[[Page 207]]
therewith shall be excluded in computing unrelated business taxable
income, except that certain rents from, and certain deductions in
connection with, a business lease (as defined in section 514(f)) shall
be included in computing unrelated business taxable income. See
subparagraph (5) of this paragraph for rules governing amounts received
for the rendering of services.
(2) Taxable years beginning after December 31, 1969--(i) In general.
For taxable years beginning after December 31, 1969, except as provided
in subdivision (iii) of this subparagraph, rents from property described
in subdivision (ii) of this subparagraph, and the deductions directly
connected therewith, shall be excluded in computing unrelated business
taxable income. However, notwithstanding subdivision (ii) of this
subparagraph, certain rents from and certain deductions in connection
with either debt-financed property (as defined in section 514(b)) or
property rented to controlled organizations (as defined in paragraph (l)
of this section) shall be included in computing unrelated business
taxable income.
(ii) Excluded rents. The rents which are excluded from unrelated
business income under section 512(b)(3)(A) and this paragraph are:
(a) Real property. All rents from real property; and
(b) Personal property. All rents from personal property leased with
real property if the rents attributable to such personal property are an
incidental amount of the total rents received or accrued under the
lease, determined at the time sonal property are an incidental amount
service by the lessee
For purposes of the preceding sentence, rents attributable to personal
property generally are not an incidental amount of the total rents if
such rents exceed 10 percent of the total rents from all the property
leased. For example, if the rents attributable to the personal property
leased are determined to be $3,000 per year, and the total rents from
all property leased are $10,000 per year, then such $3,000 amount is not
to be excluded from the computation of unrelated business taxable income
by operation of section 512(b)(3)(A)(ii) and this paragraph, since such
amount is not an incidental portion of the total rents.
(iii) Exception. Subdivision (ii) of this subparagraph shall not
apply, if either:
(a) Excess personal property rents. More than 50 percent of the
total rents are attributable to personal property, determined at the
time such personal property is first placed in service by the lessee; or
(b) Net profits. The determination of the amount of such rents
depends in whole or in part on the income or profits derived by any
person from the property leased, other than an amount based on a fixed
percentage or percentages of the gross receipts or sales. For purposes
of the preceding sentence, the rules contained in paragraph (b) (3) and
(6) (other than paragraph (b)(6)(ii)) of Sec. 1.856-4 shall apply.
(iv) Illustration. This subparagraph may be illustrated by the
following example:
Example. A, an exempt organization, owns a printing factory which
consists of a building housing two printing presses and other equipment
necessary for printing. On January 1, 1971, A rents the building and the
printing equipment to B for $10,000 a year. The lease states that $9,000
of such rent is for the building and $1,000 for the printing equipment.
However, it is determined that notwithstanding the terms of the lease
$4,000, or 40 percent ($4,000/$10,000), of the rent is actually
attributable to the printing equipment. During 1971, A has $3,000 of
deductions, all of which are properly allocable to the land and
building. Under these circumstances, A shall not take into account in
computing its unrelated business taxable income the $6,000 of rent
attributable to the building and the $3,000 of deductions directly
connected with such rent. However, the $4,000 of rent attributable to
the printing equipment is not excluded from the computation of A's
unrelated business taxable income by operation of section
512(b)(3)(A)(ii) or this paragraph since such rent represents more than
an incidental portion of the total rents.
(3) Definitions and special rules. For purposes of subparagraph (2)
of this paragraph:
(i) Real property defined. The term real property means all real
property, including any property described in sections 1245(a)(3)(C) and
1250(c) and the regulations thereunder.
(ii) Personal property defined. The term personal property means all
personal property, including any property
[[Page 208]]
described in section 1245(a)(3)(B) and the regulations thereunder.
(iii) Multiple leases. If separate leases are entered into with
respect to real and personal property, and such properties have an
integrated use (e.g., one or more leases for real property and another
lease or leases for personal property to be used upon such real
property), all such leases shall be considered as one lease.
(iv) Placed in service. Property is placed in service by the lessee
when it is first subject to his use in accordance with the terms of the
lease. For example, property subject to a lease entered into on November
1, 1971, for a term commencing on January 1, 1972, shall be considered
as placed in service on January 1, 1972, regardless of when the property
is first actually used by the lessee.
(v) Changes in rent charged or personal property rented. If:
(a) By reason of the placing of additional or substitute personal
property in service, there is an increase of 100 percent or more in the
rent attributable to all the personal property leased, or
(b) There is a modification of the lease by which there is a change
in the rent charged (whether or not there is a change in the amount of
personal property rented), the rent attributable to personal property
shall be recomputed to determine whether the exclusion under
subparagraph (2)(ii)(b) of this paragraph or the exception under
subparagraph (2)(iii)(a) of this paragraph applies. Any change in the
treatment of rents, attributable to a recomputation under this
subdivision, shall be effective only with respect to rents for the
period beginning with the event which occasioned the recomputation.
(4) Examples. Subparagraphs (2) and (3) of this paragraph may be
illustrated by the following examples:
Example 1. On January 1, 1971, A, an exempt organization, executes
two leases with B. One is for the rental of a computer, with a stated
annual rent of $750. The other is for the rental of office space in
which to use the computer, at a stated annual rent of $7,250. The total
annual rent under both leases for 1971 is $8,000. At the time the
computer is first placed in service, however, taking both leases into
consideration, it is determined that notwithstanding the terms of the
leases $3,000, or 37.5 percent ($3,000/$8,000), of the rent is actually
attributable to the computer. Therefore, for 1971, only the $5,000
($8,000-$3,000) attributable to the rental of the office space is
excluded from the computation of A's unrelated business taxable income
by operation of section 512(b)(3).
Example 2. Assume the facts as stated in example 1. Assume further
that the leases to which the computer and office space are subject in
example 1 provide that the rent may be increased or decreased, depending
upon the prevailing rental value for similar computers and office space.
On January 1, 1972, the total annual rent is increased in the computer
lease to $2,000, and in the office space lease to $9,000. For 1972, it
is determined that notwithstanding the terms of the leases $6,000, or
54.5 percent ($6,000/$11,000), of the total rent is actually
attributable to the computer as of that time. Even though the rent
attributable to personal property now exceeds 50 percent of the total
rent, the rent attributable to real property will continue to be
excluded, since there was no modification of the terms of the leases and
since the increase in the rent was not attributable to the placing of
new personal property in service. See subparagraph (3)(v) of this
paragraph. Thus, for 1972 the $5,000 of rent attributable to the office
space continues to be excluded from the computation of A's unrelated
business taxable income by operation of section 512(b)(3).
Example 3. Assume the facts as stated in example 1, except that on
January 1, 1973, B rents a second computer from A, which is placed in
service on that date. The total rent is increased to $2,000 for the
computer lease and to $10,000 for the office space lease. It is
determined at the time the second computer is first placed in service
that notwithstanding the terms of the leases $7,000 of the rent is
actually attributable to the computers. Since the rent attributable to
personal property has increased by more than 100 percent ($4,000 /
$3,000 = 133 percent), a redetermination must be made pursuant to
subparagraph (3)(v) (a) of this paragraph. As a result, 58.3 percent
($7,000/$12,000) of the total rent is determined to be attributable to
personal property. Accordingly, since more than 50 percent of the total
rent A receives is attributable to the personal property leased, none of
the rents are excluded from the computation of A's unrelated business
taxable income by operation of section 512(b)(3).
Example 4. Assume the facts as stated in example 3, except that on
June 30, 1975, the lease between B and A is modified. The total rent for
the computer lease is reduced to $1,500 and the total rent for the
office space lease is reduced to $7,500. Pursuant to subdivision
(3)(v)(b) of this paragraph, a redetermination is made as of June 30,
1975. As of the modification date, it is determined that
[[Page 209]]
notwithstanding the terms of the leases, the rent actually attributable
to the computers is $4,000, or 44.4 percent ($4,000/$9,000), of the
total rent. Since less than 50 percent of the total rent is now
attributable to personal property, the rent attributable to real
property ($5,000), for periods after June 30, 1975, is excluded from the
computation of A's unrelated business taxable income by operation of
section 512(b)(3). However, the rent attributable to personal property
($4,000) is not excluded from unrelated business taxable income for such
periods by operation of section 512(b)(3), since it represents more than
an incidental portion of the total rent.
(5) Rendering of services. For purposes of this paragraph, payments
for the use or occupancy of rooms and other space where services are
also rendered to the occupant, such as for the use or occupancy of rooms
or other quarters in hotels, boarding houses, or apartment houses
furnishing hotel services, or in tourist camps or tourist homes, motor
courts, or motels, or for the use of occupancy of space in parking lots,
warehouses, or storage garages, does not constitute rent from real
property. Generally, services are considered rendered to the occupant if
they are primarily for his convenience and are other than those usually
or customarily rendered in connection with the rental of rooms or other
space for occupancy only. The supplying of maid service, for example,
constitutes such service; whereas the furnishing of heat and light, the
cleaning of public entrances, exists, stairways, and lobbies, the
collection of trash, etc., are not considered as services rendered to
the occupant. Payments for the use or occupancy of entire private
residences or living quarters in duplex or multiple housing units, of
offices in any office building, etc., are generally treated as rent from
real property.
(d)(1) Gains and losses from the sale, etc. of property. There shall
also be excluded from the computation of unrelated business taxable
income gains or losses from the sale, exchange, or other disposition of
property other than (i) stock in trade or other property of a kind which
would properly be included in the inventory of the organization if on
hand at the close of the taxable year, or (ii) property held primarily
for sale to customers in the ordinary course of the trade or business.
This exclusion does not apply with respect to the cutting of timber
which is considered, upon the application of section 631(a), as a sale
or exchange of such timber. In addition, for taxable years beginning
after December 31, 1969, this exclusion does not apply to the gain
derived from the sale or other disposition of debt-financed property (as
defined in section 514(b)). Otherwise, the exclusion under section
512(b)(5) applies with respect to gains and losses from involuntary
conversions, casualties, etc.
(2) There shall be excluded from the computation of unrelated
business taxable income any gain from the lapse or termination after
December 31, 1975, of options to buy or sell securities (as that term is
defined in section 1236(c)). An option is considered terminated when the
organization's obligation under the option ceases by any means other
than by reason of the exercise or lapse of such option. If the exclusion
is otherwise available it will apply whether or not the organization
owns the securities upon which the option is written, that is, whether
or not the option is covered. However, income from the lapse or
termination of an option is excludable only if the option is written in
connection with the organization's investment activities. Thus, for
example, if the securities upon which the options are written are held
by the organization as inventory or for sale to customers in the
ordinary course of a trade or business, the income from the lapse or
termination will not be excludable under the provisions of this
paragraph. Similarly, if an organization is engaged in the trade or
business of writing options (whether or not such options are covered)
the exclusion will not be available.
(e) Net operating losses. (1) The net operating loss deduction
provided in section 172 shall be allowed in computing unrelated business
taxable income. However, the net operating loss carryback or carryover
(from a taxable year for which the taxpayer is subject to the provisions
of section 511) shall be determined under section 172 without taking
into account any amount of income or deduction which is not included
under section 511 in computing unrelated business taxable income. For
[[Page 210]]
example, a loss attributable to an unrelated trade or business shall not
be diminished by reason of the receipt of dividend income.
(2) For the purpose of computing the net operating loss deduction
provided by section 172, any prior taxable year for which an
organization was not subject to the provisions of section 511, or a
corresponding provision of prior law, shall not be taken into account.
Thus, if the organization was not subject to the provisions of section
511 or supplement U of the Internal Revenue Code of 1939 for a preceding
taxable year, the net operating loss is not a carryback to such
preceding taxable year, and the net operating loss carryover to
succeeding taxable years is not reduced by the taxable income for such
preceding taxable year.
(3) A net operating loss carryback or carryover shall be allowed
only from a taxable year for which the taxpayer is subject to the
provisions of section 511, or a corresponding provision of prior law.
(4) In determining the span of years for which a net operating loss
may be carried for purposes of section 172, taxable years in which an
organization was not subject to the provisions of section 511 or a
corresponding provision of prior law shall be taken into account. Thus,
for example, if an organization is subject to the provisions of section
511 for the taxable year 1955 and has a net operating loss for that
year, the last taxable year to which any part thereof may be carried
over is the year 1960 regardless of whether the organization is subject
to the provisions of section 511 in any of the intervening taxable
years.
(5) See Sec. 1.512(a)-6(h) regarding the computation of the net
operating loss deduction when an organization has more than one
unrelated trade or business.
(f) Research. (1) Income derived from research for the United States
or any of its agencies or instrumentalities or a State or political
subdivision thereof, and all deductions directly connected with such
income, shall be excluded in computing unrelated business taxable
income.
(2) In the case of a college, university, or hospital, all income
derived from research performed for any person and all deductions
directly connected with such income, shall be excluded in computing
unrelated business taxable income.
(3) In the case of an organization operated primarily for the
purpose of carrying on fundamental research (as distinguished from
applied research) the results of which are freely available to the
general public, all income derived from research performed for any
person and all deductions directly connected with such income shall be
excluded in computing unrelated business taxable income.
(4) For the purpose of Sec. Sec. 1.512(a)-1, 1.512(a)-2, and this
section, the term research does not include activities of a type
ordinarily carried on as an incident to commercial or industrial
operations, for example, the ordinary testing or inspection of materials
or products or the designing or construction of equipment, buildings,
etc. The term fundamental research does not include research carried on
for the primary purpose of commercial or industrial application.
(g) Charitable, etc., contributions. (1) In computing the unrelated
business taxable income of an organization described in section
511(a)(2) the deduction from gross income allowed by section 170
(relating to charitable contributions and gifts) shall be allowed,
whether or not the contribution is directly connected with the carrying
on of the trade or business. Section 512(b)(10) provides that this
deduction shall not exceed 5 percent of the organization's unrelated
business taxable income computed without regard to that deduction. The
provisions of section 170(b)(2) are not applicable to contributions by
the organizations described in section 511(a)(2).
(2) In computing the unrelated business taxable income of a trust
described in section 511(b)(2), the deduction allowed by section 170
(relating to charitable contributions and gifts) shall be allowed
whether or not the contribution is directly connected with the carrying
on of the trade or business. The deduction is limited as provided in
section 170(b)(1) (A) and (B), except that the amounts so allowed are
determined on the basis of unrelated
[[Page 211]]
business taxable income computed without regard to this deduction
(rather than on the basis of adjusted gross income). For purposes of
this deduction, a distribution by a trust described in section 511(b)(2)
made pursuant to the trust instrument to a beneficiary described in
section 170 shall be treated in the same manner as gifts or
contributions.
(3) The contribution, whether made by a trust or other exempt
organization, must be paid to another organization to be allowable. For
example, a university described in section 501(c)(3) which is exempt
from tax and which operates an unrelated business, shall be allowed a
deduction, not in excess of 5 percent of its unrelated business taxable
income, for gifts or contributions to another university described in
section 501(c)(3) for educational work but shall not be allowed any
deduction for amounts expended in administering its own educational
program.
(4) The term unrelated business taxable income as used in section
512(b)(10) and (11) refers to unrelated business taxable income after
application of section 512(a)(6).
(5) Paragraph (g)(4) of this section is applicable 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.
(h) Specific deduction--(1) In general. In computing unrelated
business taxable income a specific deduction from gross income of $1,000
is allowed. However, for taxable years beginning after December 31,
1969, such specific deduction is not allowed in computing the net
operating loss under section 172 and paragraph (6) of section 512(b).
(2) Special rule for a diocese, province of a religious order, or a
convention or association of churches. (i) In the case of a diocese,
province of a religious order, or a convention or association of
churches, there shall be allowed with respect to each parish, individual
church, district, or other local unit a specific deduction equal to the
lower of $1,000 or the gross income derived from an unrelated trade or
business regularly conducted by such local unit. However, a diocese,
province of a religious order, or a convention or association of
churches shall not be entitled to a specific deduction for a local unit
which, for a taxable year, files a separate return. In the case of a
local unit which, for a taxable year, files a separate return, such
local unit may claim a specific deduction equal to the lower of $1,000
or the gross income derived from any unrelated trade or business which
it regularly conducts.
(ii) The provisions of this subparagraph may be illustrated by the
following example:
Example. X is an association of churches on the calendar year basis.
X is divided into local units A, B, C, and D. During 1973, A, B, C, and
D derive gross income of, respectively, $1,200, $800, $1,500, and $700
from unrelated businesses which they regularly conduct. Furthermore, for
such taxable year, D files a separate return. X may claim a specific
deduction of $1,000 with respect to A, $800 with respect to B, and
$1,000 with respect to C. X may not claim a specific deduction with
respect to D. D, however, may claim a specific deduction of $700 on its
return.
(i) Transitional period for churches. (1)(i) In the case of an
unrelated trade or business (as defined in section 513) carried on
before May 27, 1969, by a church or convention or association of
churches (as defined in Sec. 1.511-2(a)(3)(ii)), or by the predecessor
of a church or convention or association of churches which predecessor
was itself a church or convention or association of churches, all gross
income derived from such unrelated trade or business and all deductions
directly connected with the carrying on of such unrelated trade or
business shall be excluded from the determination of unrelated business
taxable income under section 512(a) for all taxable years beginning
before January 1, 1976. Notwithstanding the preceding sentence, in the
case of income from debt-financed property (and the deductions
attributable thereto), as defined in section 514, of a church or
convention or association of churches or by the predecessor of a church
or convention or association of churches, the provisions of paragraphs
(a) through (e) of section 514 and paragraph (4) of section 512(b) shall
apply for taxable years beginning after December 31, 1969.
[[Page 212]]
(ii) The provisions of subdivision (i) may be illustrated by the
following example:
Example. X, a church as defined in Sec. 1.511-2(a)(3)(ii), realizes
gross income from an unrelated business (as defined in section 513) of
$100,000 for calendar year 1972. X's predecessor church, Y, began
conducting such unrelated business in January 1, 1968. Of the $100,000
realized for calendar year 1972, $40,000 is attributable to debt-
financed property (as defined in section 514). Since the unrelated
business was conducted by Y prior to May 27, 1969, and since X's taxable
year begins before January 1, 1976, that amount of the income realized
from such business (and all deductions directly connected therewith)
which is not attributable to debt-financed property shall be excluded
from the determination of unrelated business taxable income under
section 512(a). Therefore, of the $100,000 realized, $60,000 ($100,000
less $40,000 attributable to debt-financed property), and all deductions
directly connected therewith shall be excluded from the determination of
such unrelated business taxable income for purposes of imposition of the
tax under section 511(a). The remaining $40,000 and the deductions
attributable thereto shall be subject to the provisions of paragraphs
(a) through (e) of section 514 and paragraph (4) of section 512(b).
(2) This paragraph shall not apply in the case of income from
property, or deductions directly connected with such income, if title to
the property is held by a corporation described in section 501(c)(2) for
a church or convention or association of churches. Thus, if such income
is derived from an unrelated trade or business, the corporation shall be
liable for tax imposed by section 511(a) on such income.
(j) Special rule for certain unrelated trades or businesses carried
on by a religious order or by an educational institution maintained by
such order. (1) Except as provided in subparagraph (2) of this
paragraph, gross income realized by a religious order (or an educational
organization described in section 170(b)(1)(A)(ii) maintained by such
order) from an unrelated trade or business, together with all deductions
directly connected therewith, shall be excluded from the determination
of unrelated business taxable income under section 512(a), if:
(i) The trade or business has been operated by such order or by such
institution since before May 27, 1959,
(ii) The trade or business consists of providing services under a
license issued by a Federal regulatory agency,
(iii) More than 90 percent of the net income from the business is,
for each taxable year for which gross income from such business is so
excluded by reason of section 512(b)(15) and this paragraph, devoted to
religious, charitable, or educational purposes, and
(iv) It is established to the satisfaction of an officer no lower
than the Regional Commissioner that the rates or other charges for such
services are fully competitive with rates or other charges charged for
such services by persons not exempt from taxation. Rates or other
charges for such services shall be considered as fully competitive with
rates or other charges charged for such services by persons not exempt
from taxation if the rates charged by such unrelated trade or business
are neither materially higher nor materially lower than the rates
charged by similar businesses operating in the same general area.
(2) The provisions of this paragraph shall not apply with respect to
income from debt-financed property (as defined in section 514) and the
deductions attributable thereto. For taxable years beginning after
December 31, 1969, such income and deductions are subject to the
provisions of paragraphs (a) through (e) of section 514 and paragraph
(4) of section 512(b).
(k) Income and deductions from debt-financed property. For taxable
years beginning after December 31, 1969, in the case of debt-financed
property (as defined in section 514(b)), there shall be included in the
unrelated business taxable income of an exempt organization, as an item
of gross income derived from an unrelated trade or business, the amount
of unrelated debt-financed income determined under section 514(a)(1) and
Sec. 1.514(a)-1(a), and there shall be allowed, as a deduction with
respect to such income, the amount determined under section 514(a)(2)
and Sec. 1.514(a)-1(b).
(l) Interest, annuities, royalties, and rents from controlled
organizations--(1) In general. For taxable years beginning after
December 31, 1969, if an exempt organization (hereinafter referred to as
the controlling organization) has control
[[Page 213]]
(as defined in subparagraph (4) of this paragraph) of another
organization (hereinafter referred to as the controlled organization),
the controlling organization shall include as an item of gross income in
computing its unrelated business taxable income, the amount of interest,
annuities, royalties, and rents derived from the controlled organization
determined under subparagraph (2) or (3) of this paragraph. The
preceding sentence shall apply whether or not the activity conducted by
the controlling organization to derive such amounts represents a trade
or business or is regularly carried on. Thus, amounts received by a
controlling organization from the rental of its real property to a
controlled organization may be included in the unrelated business
taxable income of the controlling organization, even though the rental
of such property is not an activity regularly carried on by the
controlling organization.
(2) Exempt controlled organization--(i) In general. If the
controlled organization is exempt from taxation under section 501(a),
the amount referred to in subparagraph (1) of this paragraph is an
amount which bears the same ratio to the interest, annuities, royalties,
and rents received by the controlling organization from the controlled
organization as the unrelated business taxable income of the controlled
organization bears to whichever of the following amounts is the greater:
(a) The taxable income of the controlled organization, computed as
though the controlled organization were not exempt from taxation under
section 501(a), or
(b) The unrelated business taxable income of the controlled
organization
both determined without regard to any amounts paid directly or
indirectly to the controlling organization. The controlling organization
shall be allowed all deductions directly connected with amounts included
in gross income under the preceding sentence.
(ii) Examples. This subparagraph may be illustrated by the following
examples:
Example 1. A, an exempt scientific organization described in section
501(c)(3), owns all the stock of B, another exempt scientific
organization described in section 501(c)(3). During 1971, A rents space
for a laboratory to B for $15,000 a year. A's total deductions for 1971
with respect to the leased property are $3,000: $1,000 for maintenance
and $2,000 for depreciation. If B were not an exempt organization, its
total taxable income would be $300,000, disregarding rent paid to A. B's
unrelated business taxable income, disregarding rent paid to A, is
$100,000. Under these circumstances, $4,000 of the rent paid by B will
be included by A as net rental income in determining its unrelated
business taxable income, computed as follows:
B's unrelated business taxable income (disregarding rent $100,000
paid to A)................................................
B's taxable income (computed as though B were not exempt 300,000
and disregarding rent paid to A)..........................
Ratio ($100,000/$300,000).................................. \1/3\
Total rent................................................. 15,000
Total deductions........................................... 3,000
Rental income treated as gross income from an unrelated 5,000
trade or business (\1/3\ of $15,000)......................
Less deductions directly connected with such income (\1/3\ 1,000
of $3,000)................................................
------------
Net rental income included by A in computing its unrelated $4,000
business taxable income...................................
Example 2. Assume the facts as stated in example 1, except that B's
taxable income is $90,000 (computed as though B were not an exempt
organization, and disregarding rents paid to A). B's unrelated business
taxable income ($100,000) is therefore greater than its taxable income
($90,000). Thus, the ratio used to determine the portion of rent
received by A which is to be taken into account is one since both the
numerator and denominator of such ratio is B's unrelated business
taxable income. Consequently, all the rent received by A from B
($15,000), and all the deductions directly connected therewith ($3,000),
are included by A in computing its unrelated business taxable income.
(3) Nonexempt controlled organization--(i) In general. If the
controlled organization is not exempt from taxation under section
501(a), the amount referred to in subparagraph (1) of this paragraph is
an amount which bears the same ratio to the interest, annuities,
royalties, and rents received by the controlling organization from the
controlled organization as the excess taxable income (as defined in
subdivision (ii) of this subparagraph) of the controlled organization
bears to whichever of the following amounts is the greater:
(a) The taxable income of the controlled organization, or
(b) The excess taxable income of the controlled organization
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both determined without regard to any amount paid directly or indirectly
to the controlling organization. The controlling organization shall be
allowed all deductions which are directly connected with amounts
included in gross income under the preceding sentence.
(ii) Excess taxable income. For purposes of this paragraph, the term
excess taxable income means the excess of the controlled organization's
taxable income over the amount of such taxable income which, if derived
directly by the controlling organization, would not be unrelated
business taxable income.
(iii) Examples. This subparagraph may be illustrated by the
following examples:
Example 1. A, an exempt university described in section 501(c)(3),
owns all the stock of M, a nonexempt organization. During 1971, M leases
a factory and a dormitory from A for a total annual rent of $100,000.
During the taxable year, M has $500,000 of taxable income, disregarding
the rent paid to A: $150,000 from a dormitory for students of A
university, and $350,000 from the operation of a factory which is a
business unrelated to A's exempt purpose. A's deductions for 1971 with
respect to the leased property are $4,000 for the dormitory and $16,000
for the factory. Under these circumstances, $56,000 of the rent paid by
M will be included by A as net rental income in determining its
unrelated business taxable income, computed as follows:
M's taxable income (disregarding rent paid to A)........... $500,000
Less taxable income from dormitory......................... 150,000
------------
Excess taxable income...................................... $350,000
============
Ratio ($350,000/$500,000).................................. \7/10\
Total rent paid to A....................................... $100,000
Total deductions ($4,000 + $16,000)........................ 20,000
Rental income treated as gross income from an unrelated 70,000
trade or business (\7/10\ of $100,000)....................
Less deductions directly connected with such income (\7/10\ 14,000
of $20,000)...............................................
------------
Net rental income included by A in computing its unrelated $56,000
business taxable income...................................
Example 2. Assume the facts as stated in example 1, except that M's
taxable income (disregarding rent paid to A) is $300,000, consisting of
$350,000 from the operation of the factory and a $50,000 loss from the
operation of the dormitory. Thus, M's excess taxable income is also
$300,000, since none of M's taxable income would be excluded from the
computation of A's unrelated business taxable income if received
directly by A. The ratio of M's excess taxable income to its taxable
income is therefore one ($300,000/$300,000). Thus, all the rent received
by A from M ($100,000), and all the deductions directly connected
therewith ($20,000), are included in the computation of A's unrelated
business taxable income.
(4) Control--(i) In general. For purposes of this paragraph--
(a) Stock corporation. In the case of an organization which is a
stock corporation, the term control means ownership by an exempt
organization of stock possessing at least 80 percent of the total
combined voting power of all classes of stock entitled to vote and at
least 80 percent of the total number of shares of all other classes of
stock of such corporation.
(b) Nonstock organization. In the case of a nonstock organization,
the term control means that at least 80 percent of the directors or
trustees of such organization are either representatives of or directly
or indirectly controlled by an exempt organization. A trustee or
director is a representative of an exempt organization if he is a
trustee, director, agent, or employee of such exempt organization. A
trustee or director is controlled by an exempt organization if such
organization has the power to remove such trustee or director and
designate a new trustee or director.
(ii) Gain or loss of control. If control of an organization (as
defined in subdivision (i) of this subparagraph) is acquired or
relinquished during the taxable year, only the interest, annuities,
royalties, and rents paid or accrued to the controlling organization in
accordance with its method of accounting for that portion of the taxable
year it has control shall be subject to the tax on unrelated business
income.
(5) Amounts taxable under other provisions of the Code--(i) In
general. Except as provided in subdivision (ii) of this subparagraph,
section 512(b)(13) and this paragraph do not apply to amounts which are
included in the computation of unrelated business taxable income by
operation of any other provision of the Code. However, amounts which are
not included in unrelated business taxable income by operation of
section 512(a)(1), or which are excluded by operation of section 512(b)
(1), (2), or (3), may be included in unrelated business taxable income
by
[[Page 215]]
operation of section 512(b)(13) and this paragraph.
(ii) Debt-financed property. Rents deprived from the lease of debt-
financed property by a controlling organization to a controlled
organization are subject to the rules contained in section 512(b)(13)
and this paragraph. Thus, if a controlling organization leases debt-
financed property to a controlled organization, the amount of rents
includible in the controlling organization's unrelated business taxable
income shall first be determined under section 512(b)(13) and this
paragraph, and only the portion of such rents not taken into account by
operation of section 512(b)(13) are taken into account by operation of
section 514. See example 3 of Sec. 1.514(b)-1(b)(3).
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6939, 32 FR
17661, Dec. 12, 1967; T.D. 7177, 37 FR 7089, Apr. 8, 1972; T.D. 7183, 37
FR 7885, Apr. 21, 1972; T.D. 7261, 38 FR 5466, Mar. 1, 1973; 38 FR 6387,
Mar. 9, 1973; T.D. 7632, 44 FR 42681, July 20, 1979; T.D. 7767, 46 FR
11265, Feb. 6, 1981; T.D. 8423, 57 FR 33443, July 29, 1992; 57 FR 42490,
Sept. 15, 1992; T.D. 9933, 85 FR 77984, Dec. 2, 2020]
Sec. 1.512(c)-1 Special rules applicable to partnerships; in general.
In the event an organization to which section 511 applies is a
member of a partnership regularly engaged in a trade or business which
is an unrelated trade or business with respect to such organization, the
organization shall include in computing its unrelated business taxable
income so much of its share (whether or not distributed) of the
partnership gross income as is derived from that unrelated business and
its share of the deductions attributable thereto. For this purpose, both
the gross income and the deductions shall be computed with the necessary
adjustments for the exceptions, additions, and limitations referred to
in section 512(b) and in Sec. 1.512(b)-1. For example, if an exempt
educational institution is a partner in a partnership which operates a
factory and if such partnership also holds stock in a corporation, the
exempt organization shall include in computing its unrelated business
taxable income its share of the gross income from the operation of the
factory, but not its share of any dividends received by the partnership
from the corporation. If the taxable year of the organization differs
from that of the partnership, the amounts included or deducted in
computing unrelated business taxable income shall be based upon the
income and deductions of the partnership for each taxable year of the
partnership ending within or with the taxable year of the organization.
Sec. 1.513-1 Definition of unrelated trade or business.
(a) In general. As used in section 512 the term unrelated business
taxable income means the gross income derived by an organization from
any unrelated trade or business regularly carried on by it, less the
deductions and subject to the modifications provided in section 512.
Section 513 specifies with certain exceptions that the phrase unrelated
trade or business means, in the case of an organization subject to the
tax imposed by section 511, any trade or business the conduct of which
is not substantially related (aside from the need of such organization
for income or funds or the use it makes of the profits derived) to the
exercise or performance by such organization of its charitable,
educational, or other purpose or function constituting the basis for its
exemption under section 501 (or, in the case of an organization
described in section 511(a)(2)(B), to the exercise or performance of any
purpose or function described in section 501(c)(3)). For certain
exceptions from this definition, see paragraph (e) of this section. For
a special definition of unrelated trade or business applicable to
certain trusts, see paragraph (f) of this section. Therefore, unless one
of the specific exceptions of section 512 or 513 is applicable, gross
income of an exempt organization subject to the tax imposed by section
511 is includible in the computation of unrelated business taxable
income if: (1) It is income from trade or business; (2) such trade or
business is regularly carried on by the organization; and (3) the
conduct of such trade or business is not substantially related (other
than through the production of funds) to the organization's performance
of its exempt functions.
(b) Trade or business. The primary objective of adoption of the
unrelated business income tax was to eliminate a
[[Page 216]]
source of unfair competition by placing the unrelated business
activities of certain exempt organizations upon the same tax basis as
the nonexempt business endeavors with which they compete. On the other
hand, where an activity does not possess the characteristics of a trade
or business within the meaning of section 162, such as when an
organization sends out low-cost articles incidental to the solicitation
of charitable contributions, the unrelated business income tax does not
apply since the organization is not in competition with taxable
organizations. However, in general, any activity of a section 511
organization which is carried on for the production of income and which
otherwise possesses the characteristics required to constitute trade or
business within the meaning of section 162--and which, in addition, is
notsubstantially related to the performance of exempt functions--
presents sufficient likelihood of unfair competition to be within the
policy of the tax. Accordingly, for purposes of section 513 the term
trade or business has the same meaning it has in section 162, and
generally includes any activity carried on for the production of income
from the sale of goods or performance of services. Thus, the term trade
or business in section 513 is not limited to integrated aggregates of
assets, activities and good will which comprise businesses for the
purposes of certain other provisions of the Internal Revenue Code.
Activities of producing or distributing goods or performing services
from which a particular amount of gross income is derived do not lose
identity as trade or business merely because they are carried on within
a larger aggregate of similar activities or within a larger complex of
other endeavors which may, or may not, be related to the exempt purposes
of the organization. Thus, for example, the regular sale of
pharmaceutical supplies to the general public by a hospital pharmacydoes
not lose identity as trade or business merely because the pharmacy also
furnishes supplies to the hospital and patients of the hospital in
accordance with its exempt purposes or in compliance with the terms of
section 513(a)(2). Similarly, activities of soliciting, selling, and
publishing commercial advertising do not lose identity as a trade or
business even though the advertising is published in an exempt
organization periodical which contains editorial matter related to the
exempt purposes of the organization. However, where an activity carried
on for the production of income constitutes an unrelated trade or
business, no part of such trade or business shall be excluded from such
classification merely because it does not result in profit.
(c) Regularly carried on--(1) General principles. In determining
whether trade or business from which a particular amount of gross income
derives is regularly carried on, within the meaning of section 512,
regard must be had to the frequency and continuity with which the
activities productive of the income are conducted and the manner in
which they are pursued. This requirement must be applied in light of the
purpose of the unrelated business income tax to place exempt
organization business activities upon the same tax basis as the
nonexempt business endeavors with which they compete. Hence, for
example, specific business activities of an exempt organization will
ordinarily be deemed to be regularly carried on if they manifest a
frequency and continuity, and are pursued in a manner, generally similar
to comparable commercial activities of nonexempt organizations.
(2) Application of principles in certain cases--(i) Normal time span
of activities. Where income producing activities are of a kind normally
conducted by nonexempt commercial organizations on a year-round basis,
the conduct of such activities by an exempt organization over a period
of only a few weeks does not constitute the regular carrying on of trade
or business. For example, the operation of a sandwich stand by a
hospital auxiliary for only 2 weeks at a state fair would not be the
regular conduct of trade or business. However, the conduct of year-round
business activities for one day each week would constitute the regular
carrying on of trade or business. Thus, the operation of a commercial
parking lot on Saturday of each week would be the regular conduct of
trade or business. Where income producing activities are of a kind
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normally undertaken by nonexempt commercial organizations only on a
seasonal basis, the conduct of such activities by an exempt organization
during a significant portion of the season ordinarilyconstitutes the
regular conduct of trade or business. For example, the operation of a
track for horse racing for several weeks of a year would be considered
the regular conduct of trade or business because it is usual to carry on
such trade or business only during a particular season.
(ii) Intermittent activities; in general. In determining whether or
not intermittently conducted activities are regularly carried on, the
manner of conduct of the activities must be compared with the manner in
which commercial activities are normally pursued by nonexempt
organizations. In general, exempt organization business activities which
are engaged in only discontinuously or periodically will not be
considered regularly carried on if they are conducted without the
competitive and promotional efforts typical of commercial endeavors. For
example, the publication of advertising in programs for sports events or
music or drama performances will not ordinarily be deemed to be the
regular carrying on of business. Similarly, where an organization sells
certain types of goods or services to a particular class of persons in
pursuance of its exempt functions or primarily for the convenience of
such persons within the meaning of section 513(a)(2) (as, for example,
the sale of books by a college bookstore to students or the sale of
pharmaceutical supplies by a hospital pharmacy to patients of the
hospital), casual sales in the course of such activity which do not
qualify as related to the exempt function involved or as described in
section 513(a)(2) will not be treated as regular. On the other hand,
where the nonqualifyingsales are not merely casual, but are
systematically and consistently promoted and carried on by the
organization, they meet the section 512 requirement of regularity.
(iii) Intermittent activities; special rule in certain cases of
infrequent conduct. Certain intermittent income producing activities
occur so infrequently that neither their recurrence nor the manner of
their conduct will cause them to be regarded as trade or business
regularly carried on. For example, income producing or fund raising
activities lasting only a short period of time will not ordinarily be
treated as regularly carried on if they recur only occasionally or
sporadically. Furthermore, such activities will not be regarded as
regularly carried on merely because they are conducted on an annually
recurrent basis. Accordingly, income derived from the conduct of an
annual dance or similar fund raising event for charity would not be
income from trade or business regularly carried on.
(d) Substantially related--(1) In general. Gross income derives from
unrelated trade or business, within the meaning of section 513(a), if
the conduct of the trade or business which produces the income is not
substantially related (other than through the production of funds) to
the purposes for which exemption is granted. The presence of this
requirement necessitates an examination of the relationship between the
business activities which generate the particular income in question--
the activities, that is, of producing or distributing the goods or
performing the services involved--and the accomplishment of the
organization's exempt purposes.
(2) Type of relationship required. Trade or business is related to
exempt purposes, in the relevant sense, only where the conduct of the
business activities has causal relationship to the achievement of exempt
purposes (other than through the production of income); and it is
substantially related, for purposes of section 513, only if the causal
relationship is a substantial one. Thus, for the conduct of trade or
business from which a particular amount of gross income is derived to be
substantially related to purposes for which exemption is granted, the
production or distribution of the goods or the performance of the
services from which the gross income is derived must contribute
importantly to the accomplishment of those purposes. Where the
production or distribution of the goods or the performance of the
services does not contribute importantly to the accomplishment of the
exempt purposes of an organization, the income from the sale of the
goods or the performance of the services does not derive from the
conduct
[[Page 218]]
of related trade or business. Whether activities productive of gross
income contribute importantly to the accomplishment of any purpose for
which an organization is granted exemption depends in each case upon the
facts and circumstances involved.
(3) Size and extent of activities. In determining whether activities
contribute importantly to the accomplishment of an exempt purpose, the
size and extent of the activities involved must be considered in
relation to the nature and extent of the exempt function which they
purport to serve. Thus, where income is realized by an exempt
organization from activities which are in part related to the
performance of its exempt functions, but which are conducted on a larger
scale than is reasonably necessary for performance of such functions,
the gross income attributable to that portion of the activities in
excess of the needs of exempt functions constitutes gross income from
the conduct of unrelated trade or business. Such income is not derived
from the production or distribution of goods or the performance of
services which contribute importantly to the accomplishment of any
exempt purpose of the organization.
(4) Application of principles--(i) Income from performance of exempt
functions--(A) In general. Gross income derived from charges for the
performance of exempt functions does not constitute gross income from
the conduct of unrelated trade or business.
(B) Examples. The following examples illustrate the application of
this paragraph (d)(4)(i):
(1) Example 1. M, an organization described in section 501(c)(3),
operates a school for training children in the performing arts, such as
acting, singing, and dancing. It presents performances by its students
and derives gross income from admission charges for the performances.
The students' participation in performances before audiences is an
essential part of their training. Since the income realized from the
performances derives from activities which contribute importantly to the
accomplishment of M's exempt purposes, it does not constitute gross
income from unrelated trade or business. (For specific exclusion
applicable in certain cases of contributed services, see section
513(a)(1) and paragraph (e)(1) of this section.)
(2) Example 2. N is a trade union qualified for exemption under
section 501(c)(5). To improve the trade skills of its members, N
conducts refresher training courses and supplies handbooks and technical
manuals. N receives payments from its members for these services and
materials. However, the development and improvement of the skills of its
members is one of the purposes for which exemption is granted N; and the
activities described contribute importantly to that purpose. Therefore,
the income derived from these activities does not constitute gross
income from unrelated trade or business.
(3) Example 3. O is an industry trade association qualified for
exemption under section 501(c)(6). It presents a trade show in which
members of its industry join in an exhibition of industry products. O
derives income from charges made to exhibitors for exhibit space and
admission fees charged patrons or viewers of the show. The show is not a
sales facility for individual exhibitors; its purpose is the promotion
and stimulation of interest in, and demand for, the industry's products
in general, and it is conducted in a manner reasonably calculated to
achieve that purpose. The stimulation of demand for the industry's
products in general is one of the purposes for which exemption is
granted O. Consequently, the activities productive of O's gross income
from the show--that is, the promotion, organization and conduct of the
exhibition--contribute importantly to the achievement of an exempt
purpose, and the income does not constitute gross income from unrelated
trade or business. See also section 513(d) and regulations thereunder
regarding sales activity.
(4) Example 4. P is a qualified ABLE program described in section
529A and Sec. 1.529A-1(b)(14). P receives amounts in order to establish
or maintain ABLE accounts, as administrative or maintenance fees and
other similar fees including service charges. Because the payment of
these amounts is essential to the operation of a qualified ABLE program,
the income generated from
[[Page 219]]
the activity does not constitute gross income from an unrelated trade or
business.
(ii) Disposition of product of exempt functions. Ordinarily, gross
income from the sale of products which result from the performance of
exempt functions does not constitute gross income from the conduct of
unrelated trade or business if the product is sold in substantially the
same state it is in on completion of the exempt functions. Thus, in the
case of an organization described in section 501(c)(3) and engaged in a
program of rehabilitation of handicapped persons, income from sale of
articles made by such persons as a part of their rehabilitation training
would not be gross income from conduct of unrelated trade or business.
The income in such case would be from sale of products, the production
of which contributed importantly to the accomplishment of purposes for
which exemption is granted the organization--namely, rehabilitation of
the handicapped. On the other hand, if a product resulting from an
exempt function is utilized or exploitedin further business endeavor
beyond that reasonably appropriate or necessary for disposition in the
state it is in upon completion of exempt functions, the gross income
derived therefrom would be from conduct of unrelated trade or business.
Thus, in the case of an experimental dairy herd maintained for
scientific purposes by a research organization described in section
501(c)(3), income from sale of milk and cream produced in the ordinary
course of operation of the project would not be gross income from
conduct of unrelated trade or business. On the other hand, if the
organization were to utilize the milk and cream in the further
manufacture of food items such as ice cream, pastries, etc., the gross
income from the sale of such products would be from the conduct of
unrelated trade or business unless the manufacturing activities
themselves contribute importantly to the accomplishment of an exempt
purpose of the organization.
(iii) Dual use of assets or facilities. In certain cases, an asset
or facility necessary to the conduct of exempt functions may also be
employed in a commercial endeavor. In such cases, the mere fact of the
use of the asset or facility in exempt functions does not, by itself,
make the income from the commercial endeavor gross income from related
trade or business. The test, instead, is whether the activities
productive of the income in question contribute importantly to the
accomplishment of exempt purposes. Assume, for example, that a museum
exempt under section 501(c)(3) has a theater auditorium which is
specially designed and equipped for showing of educational films in
connection with its program of public education in the arts and
sciences. The theater is a principal feature of the museum and is in
continuous operation during the hours the museum is open to the public.
If the organization were to operate the theater as an ordinary motion
picture theater for public entertainment during the evening hours when
the museum was closed, gross income from such operation would be gross
income from conduct of unrelated trade or business.
(iv) Exploitation of exempt functions. In certain cases, activities
carried on by an organization in the performance of exempt functions may
generate good will or other intangibles which are capable of being
exploited in commercial endeavors. Where an organization exploits such
an intangible in commercial activities, the mere fact that the resultant
income depends in part upon an exempt function of the organization does
not make it gross income from related trade or business. In such cases,
unless the commercial activities themselves contribute importantly to
the accomplishment of an exempt purpose, the income which they produce
is gross income from the conduct of unrelated trade or business. The
application of this subdivision is illustrated in the following
examples:
Example 1. U, an exempt scientific organization, enjoys an excellent
reputation in the field of biological research. It exploits this
reputation regularly by selling endorsements of various items of
laboratory equipment to manufacturers. The endorsing of laboratory
equipment does not contribute importantly to the accomplishment of any
purpose for which exemption is granted U. Accordingly, the income
derived from the sale of endorsements is gross income from unrelated
trade or business.
[[Page 220]]
Example 2. V, an exempt university, has a regular faculty and a
regularly enrolled student body. During the school year, V sponsors the
appearance of professional theater companies and symphony orchestras
which present drama and musical performances for the students and
faculty members. Members of the general public are also admitted. V
advertises these performances and supervises advance ticket sales at
various places, including such university facilities as the cafeteria
and the university bookstore. V derives gross income from the conduct of
the performances. However, while the presentation of the performances
makes use of an intangible generated by V's exempt educational
functions--the presence of the student body and faculty--the
presentation of such drama and music events contributes importantly to
the overall educational and cultural function of the university.
Therefore, the income which V receives does not constitute gross income
from the conduct of unrelated trade or business.
Example 3. W is an exempt business league with a large membership.
Under an arrangement with an advertising agency, W regularly mails
brochures, pamphlets and other commercial advertising materials to its
members, for which service W charges the agency an agreed amount per
enclosure. The distribution of the advertising materials does not
contribute importantly to the accomplishment of any purpose for which W
is granted exemption. Accordingly, the payments made to W by the
advertising agency constitute gross income from unrelated trade or
business.
Example 4. X, an exempt organization for the advancement of public
interest in classical music, owns a radio station and operates it in a
manner which contributes importantly to the accomplishment of the
purposes for which the organization is granted exemption. However, in
the course of the operation of the station the organization derives
gross income from the regular sale of advertising time and services to
commercial advertisers in the manner of an ordinary commercial station.
Neither the sale of such time nor the performance of such services
contributes importantly to the accomplishment of any purpose for which
the organization is granted exemption. Notwithstanding the fact that the
production of the advertising income depends upon the existence of the
listening audience resulting from performance of exempt functions, such
income is gross income from unrelated trade or business.
Example 5. Y, an exempt university, provides facilities, instruction
and faculty supervision for a campus newspaper operated by its students.
In addition to news items and editorial commentary, the newspaper
publishes paid advertising. The solicitation, sale, and publication of
the advertising are conducted by students, under the supervision and
instruction of the university. Although the services rendered to
advertisers are of a commercial character, the advertising business
contributes importantly to the university's educational program through
the training of the students involved. Hence, none of the income derived
from publication of the newspaper constitutes gross income from
unrelated trade or business. The same result would follow even though
the newspaper is published by a separately incorporated section
501(c)(3) organization, qualified under the university rules for
recognition of student activities, and even though such organization
utilizes its own facilities and is independent of faculty supervision,
but carries out its educational purposes by means of student instruction
of other students in the editorial and advertising activities and
student participation in those activities.
Example 6. Z is an association exempt under section 501(c)(6),
formed to advance the interests of a particular profession and drawing
its membership from the members of that profession. Z publishes a
monthly journal containing articles and other editorial material which
contribute importantly to the accomplishment of purposes for which
exemption is granted the organization. Income from the sale of
subscriptions to members and others in accordance with the
organization's exempt purposes, therefore, does not constitute gross
income from unrelated trade or business. In connection with the
publication of the journal, Z also derives income from the regular sale
of space and services for general consumer advertising,including
advertising of such products as soft drinks, automobiles, articles of
apparel, and home appliances. Neither the publication of such
advertisements nor the performance of services for such commercial
advertisers contributes importantly to the accomplishment of any purpose
for which exemption is granted. Therefore, notwithstanding the fact that
the production of income from advertising utilizes the circulation
developed and maintained in performance of exempt functions, such income
is gross income from unrelated trade or business.
Example 7. The facts are as described in the preceding example,
except that the advertising in Z's journal promotes only products which
are within the general area of professional interest of its members.
Following a practice common among taxable magazines which publish
advertising, Z requires its advertising to comply with certain general
standards of taste, fairness, and accuracy; but within those limits the
form, content, and manner of presentation of the advertising messages
are governed by the basic objective of the advertisers to promote the
sale
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of the advertised products. While the advertisements contain certain
information, the informational function of the advertising is incidental
to the controlling aim of stimulating demand for the advertised products
and differs in no essential respect from the informational function of
any commercial advertising. Like taxable publishers of advertising, Z
accepts advertising only from those who are willing to pay its
prescribed rates. Although continuing education of itsmembers in matters
pertaining to their profession is one of the purposes for which Z is
granted exemption, the publication of advertising designed and selected
in the manner of ordinary commercial advertising is not an educational
activity of the kind contemplated by the exemption statute; it differs
fundamentally from such an activity both in its governing objective and
in its method. Accordingly, Z's publication of advertising does not
contribute importantly to the accomplishment of its exempt purposes; and
the income which it derives from advertising constitutes gross income
from unrelated trade or business.
(e) Exceptions. Section 513(a) specifically states that the term
unrelated trade or business does not include:
(1) Any trade or business in which substantially all the work in
carrying on such trade or business is performed for the organization
without compensation; or
(2) Any trade or business carried on by an organization described in
section 501(c)(3) or by a governmental college or university described
in section 511(a)(2)(B), primarily for the convenience of its members,
students, patients, officers, or employees; or, any trade or business
carried on by a local association of employees described in section
501(c)(4) organized before May 27, 1969, which consists of the selling
by the organization of items of work-related clothes and equipment and
items normally sold through vending machines, through food dispensing
facilities, or by snack bars, for the convenience of its members at
their usual places of employment; or
(3) Any trade or business which consists of selling merchandise,
substantially all of which has been received by the organization as
gifts or contributions
An example of the operation of the first of the exceptions mentioned
above would be an exempt orphanage operating a retail store and selling
to the general public, where substantially all the work in carrying on
such business is performed for the organization by volunteers without
compensation. An example of the first part of the second exception,
relating to an organization described in section 501(c)(3) or a
governmental college or university described in section 511(a)(2)(B),
would be a laundry operated by a college for the purpose of laundering
dormitory linens and the clothing of students. The latter part of the
second exception, dealing with certain sales by local employee
associations, will not apply to sales of these items at locations other
than the usual place of employment of the employees; therefore sales at
such other locations will continue to be treated as unrelated trade or
business. The third exception applies to so-called thrift shops operated
by a tax-exempt organization where those desiring to benefit such
organization contribute old clothes, books, furniture, et cetera, to be
sold to the general public with the proceeds going to the exempt
organization.
(f) Special definition of ``unrelated trade or business'' for
trusts. In the case of a trust computing its unrelated business taxable
income under section 512 for purposes of section 681, or a trust
described in section 401(a) or section 501(c)(17), which is exempt from
tax under section 501(a), section 513(b) provides that the term
unrelated trade or business means any trade or business regularly
carried on by such trust or by a partnership of which it is a member.
This definition also applies to an individual retirement account
described in section 408 that, under section 408(e), is subject to the
tax imposed by section 511.
(g) Special rule respecting publishing businesses prior to 1970. For
a special rule for taxable years beginning before January 1, 1970, with
respect to publishing businesses carried on by an organization, see
section 513(c) of the Code prior to its amendment by section 121(c) of
the Tax Reform Act of 1969 (83 Stat. 542).
(h) Effective date. This section is applicable with respect to
taxable years beginning after December 12, 1967. However, if a taxpayer
wishes to rely on
[[Page 222]]
the rules stated in this section for taxable years beginning before
December 13, 1967, it may do so. Paragraph (f) of this section applies
to taxable years beginning on or after December 2, 2020.
[T.D. 6939, 32 FR 17657, Dec. 12, 1967; 32 FR 17890, Dec. 14, 1967; 32
FR 17938, Dec. 15, 1967; T.D. 7107, 36 FR 6421, Apr. 3, 1971; T.D. 7392,
40 FR 58642, Dec. 18, 1975; T.D. 7896, 48 FR 23817, May 27, 1983; T.D.
9923, 85 FR 74034, Nov. 19, 2020; T.D. 9933, 85 FR 77984, Dec. 2, 2020]
Sec. 1.513-2 Definition of unrelated trade or business applicable to
taxable years beginning before December 13, 1967.
(a) In general. (1) As used in section 512(a), the term unrelated
business taxable income includes only income from an unrelated trade or
business regularly carried on, and the term trade or business has the
same meaning as it has in section 162.
(2) The income of an exempt organization is subject to the tax on
unrelated business income only if two conditions are present with
respect to such income. The first condition is that the income must be
from a trade or business which is regularly carried on by the
organization. The second condition is that the trade or business must
not be substantially related (aside from the need of the organization
for income or funds or the use it makes of the profits derived) to the
exercise or performance by such organization of its charitable,
educational, or other purpose or function constituting the basis for its
exemption under section 501, or in the case ofan organization described
in section 511(a)(2)(B) (governmental colleges, etc.) to the exercise or
performance of any purpose or function described in section 501(c)(3).
Whether or not an organization is subject to the tax imposed by section
511 shall be determined by the application of these tests to the
particular circumstances involved in each individual case. For certain
exceptions from the term unrelated trade or business, see paragraph (b)
of this section.
(3) A trade or business is regularly carried on when the activity is
conducted with sufficient consistency to indicate a continuing purpose
of the organization to derive some of its income from such activity. An
activity may be regularly carried on even though its performance is
infrequent or seasonal.
(4) Ordinarily, a trade or business is substantially related to the
activities for which an organization is granted exemption if the
principal purpose of such trade or business is to further (other than
through the production of income) the purpose for which the organization
is granted exemption. In the usual case the nature and size of the trade
or business must be compared with the nature and extent of the
activities for which the organization is granted exemption in order to
determine whether the principal purpose of such trade or business is to
further (other than through the production of income) the purpose for
which the organization is granted exemption. For example, the operation
of a wheat farm is substantially related to the exempt activity of an
agricultural college if the wheat farm isoperated as a part of the
educational program of the college, and is not operated on a scale
disproportionately large when compared with the educational program of
the college. Similarly, a university radio station or press is
considered a related trade or business if operated primarily as an
integral part of the educational program of the university, but is
considered an unrelated trade or business if operated in substantially
the same manner as a commercial radio station or publishing house. A
trade or business not otherwise related does not become substantially
related to an organization's exempt purpose merely because incidental
use is made of the trade or business in order to further the exempt
purpose. For example, the manufacture and sale of a product by an exempt
college would not become substantially related merely because students
as part of their educational program perform clerical or bookkeeping
functions in the business. In some cases, the business may be
substantially related because it is a necessary part of the exempt
activity. For example, in the case of an organization described in
section 501(c)(3) and engaged in the rehabilitation of handicapped
persons, the business of selling articles made by such persons as a part
of their rehabilitation training would not be considered an unrelated
business
[[Page 223]]
since such business is a necessary part of the rehabilitation program.
(5) If an organization receives a payment pursuant to a contract or
agreement under which such organization is to perform research which
constitutes an unrelated trade or business, the entire amount of such
payment is income from an unrelated trade or business. See, however,
section 512(b), (7), (8), and (9), relating to the exclusion from
unrelated business taxable income of income derived from research for
the United States, or any State, and of income derived from research
performed for any person by a college, university, hospital, or
organization operated primarily for the purpose of carrying on
fundamental research the results of which are freely available to the
general public.
(b) Exceptions. Section 513(a) specifically states that the term
unrelated trade or business does not include:
(1) Any trade or business in which substantially all the work in
carrying on such trade or business is performed for the organization
without compensation; or
(2) Any trade or business carried on by an organization described in
section 501(c)(3) or by a governmental college or university described
in section 511(a)(2)(B), primarily for the convenience of its members,
students, patients, officers, or employees; or
(3) Any trade or business which consists of selling merchandise,
substantially all of which has been received by the organization as
gifts or contributions
An example of the operation of the first of the exceptions mentioned
above would be an exempt orphanage operating a retail store and selling
to the general public, where substantially all the work in carrying on
such business is performed for the organization by volunteers without
compensation. An example of the second exception would be a laundry
operated by a college for the purpose of laundering dormitory linens and
the clothing of students. The third exception applies to so-called
thrift shops operated by a tax-exempt organization where those desiring
to benefit such organization contribute old clothes, books, furniture,
etc., to be sold to the general public with the proceeds going to the
exempt organization.
(c) Special rules respecting publishing businesses. For a special
rule with respect to publishing businesses carried on by an
organization, see section 513(c) of the Code prior to its amendment by
section 121(c) of the Tax Reform Act of 1969 (83 Stat. 542).
(d) Effective date. Except as provided in paragraph (g) of Sec.
1.513-1, this section is applicable with respect to taxable years
beginning before December 13, 1967.
(Sec. 513 as amended by sec. 4, Act of July 14, 1960 (P.L. 86-667, 74
Stat. 536); secs. 121 (b)(4) and (c), Tax Reform Act of 1969 (83 Stat.
536, 542))
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6525, 26 FR
190, Jan. 11, 1961; T.D. 6939, 32 FR 17657, Dec. 12, 1967; T.D. 7392, 40
FR 58643, Dec. 18, 1975; 40 FR 60053, Dec. 31, 1975]
Sec. 1.513-3 Qualified convention and trade show activity.
(a) Introduction--(1) In general. Section 513(d) and Sec. 1.513-
3(b) provide that convention and trade show activities carried on by a
qualifying organization in connection with a qualified convention or
trade show will not be treated as unrelated trade or business.
Consequently, income from qualified convention and trade show
activities, derived by a qualifying organization that sponsors the
qualified convention or trade show, will not be subject to the tax
imposed by section 511. Section 1.513-3(c) defines qualifying
organizations and qualified conventions or trade shows. Section 1.513-
3(d) concerns the treatment of income derived from certain activities,
including rental of exhibition space at a qualified convention or trade
show where sales activity is permitted, and the treatment of supplier
exhibits at qualified conventions and trade shows.
(2) Effective date. This section is effective for taxable years
beginning after October 4, 1976.
(b) Qualified activities not unrelated. A convention or trade show
activity, as defined in section 513(d)(3)(A) and Sec. 1.513-3(c)(4),
will not be considered unrelated trade or business if it is conducted by
a qualifying organization described in section 513(d)(3)(C) and
[[Page 224]]
Sec. 1.513-3(c)(1), in conjunction with a qualified convention or trade
show, as defined in section 513(d)(3)(B) and Sec. 1.513-3(c)(2),
sponsored by the qualifying organization. Such an activity is a
qualified convention or trade show activity. A convention or trade show
activity which is conducted by an organization described in section
501(c) (5) or (6), but which otherwise is not so qualified under this
section, will be considered unrelated trade or business.
(c) Definitions--(1) Qualifying organization. Under section
513(d)(3)(C), a qualifying organization is one which:
(i) Is described in either section 501(c) (5) or (6), and
(ii) Regularly conducts as one of its substantial exempt purposes a
qualified convention or trade show.
(2) Qualified convention or trade show. For purposes of this
section, the term qualified convention or trade show means a show that
meets the following requirements:
(i) It is conducted by a qualifying organization described in
section 513(d)(3)(C);
(ii) At least one purpose of the sponsoring organization in
conducting the show is the education of its members, or the promotion
and stimulation of interest in, and demand for, the products or services
of the industry (or segment thereof) of the members of the qualifying
organization; and
(iii) The show is designed to achieve that purpose through the
character of a significant portion of the exhibits or the character of
conferences and seminars held at a convention or meeting.
(3) Show. For purposes of this section, the term show includes an
international, national, state, regional, or local convention, annual
meeting or show.
(4) Convention and trade show activity. For purposes of this
section, convention and trade show activity means any activity of a kind
traditionally carried on at shows. It includes, but is not limited to--
(i) Activities designed to attract to the show members of the
sponsoring organization, members of an industry in general, and members
of the public, to view industry products or services and to stimulate
interest in, and demand for such products or services;
(ii) Activities designed to educate persons in the industry about
new products or services or about new rules and regulations affecting
the industry; and
(iii) Incidental activities, such as furnishing refreshments, of a
kind traditionally carried on at such shows.
(d) Certain activities--(1) Rental of exhibition space. The rental
of display space to exhibitors (including exhibitors who are suppliers)
at a qualified trade show or at a qualified convention and trade show
will not be considered unrelated trade or business even though the
exhibitors who rent the space are permitted to sell or solicit orders.
(2) Suppliers defined. For purposes of subparagraph (1), a
supplier's exhibit is one in which the exhibitor displays goods or
services that are supplied to, rather than by, the members of the
qualifying organization in the conduct of such members' own trades or
businesses.
(e) Example. The provisions of this section may be illustrated by
the following examples:
Example 1. X, an organization described in section 501(c)(6), was
formed to promote the construction industry. Its membership is made up
of manufacturers of heavy construction machinery many of whom own, rent,
or lease one or more digital computers produced by various computer
manufacturers. X is a qualifying organization under section 513(d)(3)(C)
that regularly holds an annual meeting. At this meeting a national
industry sales campaign and methods of consumer financing for heavy
construction machinery are discussed. In addition, new construction
machinery developed for use in the industry is on display with
representatives of the various manufacturers present to promote their
machinery. Both members and nonmembers attend this portion of the
conference. In addition, manufacturers of computers are present to
educate X's members. While this aspect of the conference is a supplier
exhibit (as defined in paragraph (d) of this section), income earned
from such activity by X will not constitute unrelated business taxable
income to X because the activity is conducted as part of a qualified
trade show described in Sec. 1.513-3(c).
Example 2. Assume the same facts as in Example 1, but the only goods
or services displayed are those of suppliers, the computer
manufacturers. Selling and order taking are permitted. No member
exhibits are maintained. Standing alone, this supplier exhibit
[[Page 225]]
(as defined in paragraph (d)(2) of this section) would constitute a
supplier show and not a qualified convention or trade show. In this
situation, however, the rental of exhibition space to suppliers is not
unrelated trade or business. It is conducted by a qualifying
organization in conjunction with a qualified convention or trade show.
The show (the annual meeting) is a qualified convention or trade show
because one of its purposes is the promotion and stimulation of interest
in, and demand for, the products or services of the industry through the
character of the annual meeting.
Example 3. Y is an organization described in section 501(c)(6). The
organization conducts an annual show at which its members exhibit their
products and services in order to promote public interest in the line of
business. Potential customers are invited to the show, and sales and
order taking are permitted. The organization secures the exhibition
facility, undertakes the planning and direction of the show, and
maintains exhibits designed to promote the line of business in general.
The show is a qualified convention or trade show described in paragraph
(c)(2) of this section. The provision of exhibition space to individual
members is a qualified trade show activity, and is not unrelated trade
or business.
Example 4. Z is an organization described in section 501(c)(6) that
sponsors an annual show. As the sole activity at the show, suppliers to
the members of Z exhibit their products and services for the purpose of
stimulating the sale of their products. Selling and order taking are
permitted. The show is a supplier show and does not meet the definition
of a qualified convention show as it does not satisfy any of the three
alternative bases for qualification. First, the show does not stimulate
interest in the members' products through the character of product
exhibits as the only products exhibited are those of suppliers rather
than members. Second, the show does not stimulate interest in members'
products through conferences or seminars as no such conferences are held
at the show. Third, the show does not meet the definition of a qualified
show on the basis of educational activities as the exhibition of
suppliers' products is designed primarily to stimulate interest in, and
sale of, suppliers' products. Thus, the organization's provision of
exhibition space is not a qualified convention or trade show activity.
Income derived from rentals of exhibition space to suppliers will be
unrelated business taxable income under section 512.
[T.D. 7896, 48 FR 23817, May 27, 1983]
Sec. 1.513-4 Certain sponsorship not unrelated trade or business.
(a) In general. Under section 513(i), the receipt of qualified
sponsorship payments by an exempt organization which is subject to the
tax imposed by section 511 does not constitute receipt of income from an
unrelated trade or business.
(b) Exception. The provisions of this section do not apply with
respect to payments made in connection with qualified convention and
trade show activities. For rules governing qualified convention and
trade show activity, see Sec. 1.513-3. The provisions of this section
also do not apply to income derived from the sale of advertising or
acknowledgments in exempt organization periodicals. For this purpose,
the term periodical means regularly scheduled and printed material
published by or on behalf of the exempt organization that is not related
to and primarily distributed in connection with a specific event
conducted by the exempt organization. For this purpose, printed material
includes material that is published electronically. For rules governing
the sale of advertising in exempt organization periodicals, see Sec.
1.512(a)-1(f).
(c) Qualified sponsorship payment--(1) Definition. The term
qualified sponsorship payment means any payment by any person engaged in
a trade or business with respect to which there is no arrangement or
expectation that the person will receive any substantial return benefit.
In determining whether a payment is a qualified sponsorship payment, it
is irrelevant whether the sponsored activity is related or unrelated to
the recipient organization's exempt purpose. It is also irrelevant
whether the sponsored activity is temporary or permanent. For purposes
of this section, payment means the payment of money, transfer of
property, or performance of services.
(2) Substantial return benefit--(i) In general. For purposes of this
section, a substantial return benefit means any benefit other than a use
or acknowledgment described in paragraph (c)(2)(iv) of this section, or
disregarded benefits described in paragraph (c)(2)(ii) of this section.
(ii) Certain benefits disregarded. For purposes of paragraph
(c)(2)(i) of this section, benefits are disregarded if the aggregate
fair market value of all the
[[Page 226]]
benefits provided to the payor or persons designated by the payor in
connection with the payment during the organization's taxable year is
not more than 2% of the amount of the payment. If the aggregate fair
market value of the benefits exceeds 2% of the amount of the payment,
then (except as provided in paragraph (c)(2)(iv) of this section) the
entire fair market value of such benefits, not merely the excess amount,
is a substantial return benefit. Fair market value is determined as
provided in paragraph (d)(1) of this section.
(iii) Benefits defined. For purposes of this section, benefits
provided to the payor or persons designated by the payor may include:
(A) Advertising as defined in paragraph (c)(2)(v) of this section.
(B) Exclusive provider arrangements as defined in paragraph
(c)(2)(vi)(B) of this section.
(C) Goods, facilities, services or other privileges.
(D) Exclusive or nonexclusive rights to use an intangible asset
(e.g., trademark, patent, logo, or designation) of the exempt
organization.
(iv) Use or acknowledgment. For purposes of this section, a
substantial return benefit does not include the use or acknowledgment of
the name or logo (or product lines) of the payor's trade or business in
connection with the activities of the exempt organization. Use or
acknowledgment does not include advertising as described in paragraph
(c)(2)(v) of this section, but may include the following: exclusive
sponsorship arrangements; logos and slogans that do not contain
qualitative or comparative descriptions of the payor's products,
services, facilities or company; a list of the payor's locations,
telephone numbers, or Internet address; value-neutral descriptions,
including displays or visual depictions, of the payor's product-line or
services; and the payor's brand or trade names and product or service
listings. Logos or slogans that are an established part of a payor's
identity are not considered to contain qualitative or comparative
descriptions. Mere display or distribution, whether for free or
remuneration, of a payor's product by the payor or the exempt
organization to the general public at the sponsored activity is not
considered an inducement to purchase, sell or use the payor's product
for purposes of this section and, thus, will not affect the
determination of whether a payment is a qualified sponsorship payment.
(v) Advertising. For purposes of this section, the term advertising
means any message or other programming material which is broadcast or
otherwise transmitted, published, displayed or distributed, and which
promotes or markets any trade or business, or any service, facility or
product. Advertising includes messages containing qualitative or
comparative language, price information or other indications of savings
or value, an endorsement, or an inducement to purchase, sell, or use any
company, service, facility or product. A single message that contains
both advertising and an acknowledgment is advertising. This section does
not apply to activities conducted by a payor on its own. For example, if
a payor purchases broadcast time from a television station to advertise
its product during commercial breaks in a sponsored program, the exempt
organization's activities are not thereby converted to advertising.
(vi) Exclusivity arrangements--(A) Exclusive sponsor. An arrangement
that acknowledges the payor as the exclusive sponsor of an exempt
organization's activity, or the exclusive sponsor representing a
particular trade, business or industry, generally does not, by itself,
result in a substantial return benefit. For example, if in exchange for
a payment, an organization announces that its event is sponsored
exclusively by the payor (and does not provide any advertising or other
substantial return benefit to the payor), the payor has not received a
substantial return benefit.
(B) Exclusive provider. An arrangement that limits the sale,
distribution, availability, or use of competing products, services, or
facilities in connection with an exempt organization's activity
generally results in a substantial return benefit. For example, if in
exchange for a payment, the exempt organization agrees to allow only the
payor's products to be sold in connection with an activity, the payor
has received a substantial return benefit.
[[Page 227]]
(d) Allocation of payment--(1) In general. If there is an
arrangement or expectation that the payor will receive a substantial
return benefit with respect to any payment, then only the portion, if
any, of the payment that exceeds the fair market value of the
substantial return benefit is a qualified sponsorship payment. However,
if the exempt organization does not establish that the payment exceeds
the fair market value of any substantial return benefit, then no portion
of the payment constitutes a qualified sponsorship payment.
(i) Treatment of payments other than qualified sponsorship payments.
The unrelated business income tax (UBIT) treatment of any payment (or
portion thereof) that is not a qualified sponsorship payment is
determined by application of sections 512, 513 and 514. For example,
payments related to an exempt organization's providing facilities,
services, or other privileges to the payor or persons designated by the
payor, advertising, exclusive provider arrangements described in
paragraph (c)(2)(vi)(B) of this section, a license to use intangible
assets of the exempt organization, or other substantial return benefits,
are evaluated separately in determining whether the exempt organization
realizes unrelated business taxable income.
(ii) Fair market value. The fair market value of any substantial
return benefit provided as part of a sponsorship arrangement is the
price at which the benefit would be provided between a willing recipient
and a willing provider of the benefit, neither being under any
compulsion to enter into the arrangement and both having reasonable
knowledge of relevant facts, and without regard to any other aspect of
the sponsorship arrangement.
(iii) Valuation date. In general, the fair market value of the
substantial return benefit is determined when the benefit is provided.
However, if the parties enter into a binding, written sponsorship
contract, the fair market value of any substantial return benefit
provided pursuant to that contract is determined on the date the parties
enter into the sponsorship contract. If the parties make a material
change to a sponsorship contract, it is treated as a new sponsorship
contract as of the date the material change is effective. A material
change includes an extension or renewal of the contract, or a more than
incidental change to any amount payable (or other consideration)
pursuant to the contract.
(iv) Examples. The following examples illustrate the provisions of
this section:
Example 1. On June 30, 2001, a national corporation and Z, a
charitable organization, enter into a five-year binding, written
contract effective for years 2002 through 2007. The contract provides
that the corporation will make an annual payment of $5,000 to Z, and in
return the corporation will receive no benefit other than advertising.
On June 30, 2001, the fair market value of the advertising to be
provided to the corporation in each year of the agreement is $75, which
is less than the disregarded benefit amount provided for in paragraph
(c)(2)(ii) of this section (2% of $5,000 is $100). In 2002, pursuant to
the sponsorship contract, the corporation makes a payment to Z of
$5,000, and receives the specified benefit (advertising). As of January
1, 2002, the fair market value of the advertising to be provided by Z
each year has increased to $110. However, for purposes of this section,
the fair market value of the advertising benefit is determined on June
30, 2001, the date the parties entered into the sponsorship contract.
Therefore, the entire $5,000 payment received in 2002 is a qualified
sponsorship payment.
Example 2. The facts are the same as Example 1, except that the
contract provides for an initial payment by the corporation to Z of
$5,000 in 2002, followed by annual payments of $1,000 during each of
years 2003-2007. In 2003, pursuant to the sponsorship contract, the
corporation makes a payment to Z of $1,000, and receives the specified
advertising benefit. In 2003, the fair market value of the benefit
provided ($75, as determined on June 30, 2001) exceeds 2% of the total
payment received (2% of $1,000 is $20). Therefore, only $925 of the
$1,000 payment received in 2003 is a qualified sponsorship payment.
(2) Anti-abuse provision. To the extent necessary to prevent
avoidance of the rule stated in paragraphs (d)(1) and (c)(2) of this
section, where the exempt organization fails to make a reasonable and
good faith valuation of any substantial return benefit, the Commissioner
(or the Commissioner's delegate) may determine the portion of a payment
allocable to such substantial return benefit and may treat two or more
related payments as a single payment.
[[Page 228]]
(e) Special rules--(1) Written agreements. The existence of a
written sponsorship agreement does not, in itself, cause a payment to
fail to be a qualified sponsorship payment. The terms of the agreement,
not its existence or degree of detail, are relevant to the determination
of whether a payment is a qualified sponsorship payment. Similarly, the
terms of the agreement and not the title or responsibilities of the
individuals negotiating the agreement determine whether a payment (or
any portion thereof) made pursuant to the agreement is a qualified
sponsorship payment.
(2) Contingent payments. The term qualified sponsorship payment does
not include any payment the amount of which is contingent, by contract
or otherwise, upon the level of attendance at one or more events,
broadcast ratings, or other factors indicating the degree of public
exposure to the sponsored activity. The fact that a payment is
contingent upon sponsored events or activities actually being conducted
does not, by itself, cause the payment to fail to be a qualified
sponsorship payment.
(3) Determining public support. Qualified sponsorship payments in
the form of money or property (but not services) are treated as
contributions received by the exempt organization for purposes of
determining public support to the organization under section
170(b)(1)(A)(vi) or 509(a)(2). See Sec. Sec. 1.509(a)-3(f)(1) and
1.170A-9(e)(6)(i). The fact that a payment is a qualified sponsorship
payment that is treated as a contribution to the payee organization does
not determine whether the payment is deductible by the payor under
section 162 or 170.
(f) Examples. The provisions of this section are illustrated by the
following examples. The tax treatment of any payment (or portion of a
payment) that does not constitute a qualified sponsorship payment is
governed by general UBIT principles. In these examples, the recipients
of the payments at issue are section 501(c) organizations. The
expectations or arrangements of the parties are those specifically
indicated in the example. The examples are as follows:
Example 1. M, a local charity, organizes a marathon and walkathon at
which it serves to participants drinks and other refreshments provided
free of charge by a national corporation. The corporation also gives M
prizes to be awarded to winners of the event. M recognizes the
assistance of the corporation by listing the corporation's name in
promotional fliers, in newspaper advertisements of the event and on T-
shirts worn by participants. M changes the name of its event to include
the name of the corporation. M's activities constitute acknowledgment of
the sponsorship. The drinks, refreshments and prizes provided by the
corporation are a qualified sponsorship payment, which is not income
from an unrelated trade or business.
Example 2. N, an art museum, organizes an exhibition and receives a
large payment from a corporation to help fund the exhibition. N
recognizes the corporation's support by using the corporate name and
established logo in materials publicizing the exhibition, which include
banners, posters, brochures and public service announcements. N also
hosts a dinner for the corporation's executives. The fair market value
of the dinner exceeds 2% of the total payment. N's use of the corporate
name and logo in connection with the exhibition constitutes
acknowledgment of the sponsorship. However, because the fair market
value of the dinner exceeds 2% of the total payment, the dinner is a
substantial return benefit. Only that portion of the payment, if any,
that N can demonstrate exceeds the fair market value of the dinner is a
qualified sponsorship payment.
Example 3. O coordinates sports tournaments for local charities. An
auto manufacturer agrees to underwrite the expenses of the tournaments.
O recognizes the auto manufacturer by including the manufacturer's name
and established logo in the title of each tournament as well as on
signs, scoreboards and other printed material. The auto manufacturer
receives complimentary admission passes and pro-am playing spots for
each tournament that have a combined fair market value in excess of 2%
of the total payment. Additionally, O displays the latest models of the
manufacturer's premier luxury cars at each tournament. O's use of the
manufacturer's name and logo and display of cars in the tournament area
constitute acknowledgment of the sponsorship. However, the admission
passes and pro-am playing spots are a substantial return benefit. Only
that portion of the payment, if any, that O can demonstrate exceeds the
fair market value of the admission passes and pro-am playing spots is a
qualified sponsorship payment.
Example 4. P conducts an annual college football bowl game. P sells
to commercial broadcasters the right to broadcast the bowl game on
television and radio. A major corporation agrees to be the exclusive
sponsor of the bowl game. The detailed contract between P and the
corporation provides that in
[[Page 229]]
exchange for a $1,000,000 payment, the name of the bowl game will
include the name of the corporation. In addition, the contract provides
that the corporation's name and established logo will appear on player's
helmets and uniforms, on the scoreboard and stadium signs, on the
playing field, on cups used to serve drinks at the game, and on all
related printed material distributed in connection with the game. P also
agrees to give the corporation a block of game passes for its employees
and to provide advertising in the bowl game program book. The fair
market value of the passes is $6,000, and the fair market value of the
program advertising is $10,000. The agreement is contingent upon the
game being broadcast on television and radio, but the amount of the
payment is not contingent upon the number of people attending the game
or the television ratings. The contract provides that television cameras
will focus on the corporation's name and logo on the field at certain
intervals during the game. P's use of the corporation's name and logo in
connection with the bowl game constitutes acknowledgment of the
sponsorship. The exclusive sponsorship arrangement is not a substantial
return benefit. Because the fair market value of the game passes and
program advertising ($16,000) does not exceed 2% of the total payment
(2% of $1,000,000 is $20,000), these benefits are disregarded and the
entire payment is a qualified sponsorship payment, which is not income
from an unrelated trade or business.
Example 5. Q organizes an amateur sports team. A major pizza chain
gives uniforms to players on Q's team, and also pays some of the team's
operational expenses. The uniforms bear the name and established logo of
the pizza chain. During the final tournament series, Q distributes free
of charge souvenir flags bearing Q's name to employees of the pizza
chain who come out to support the team. The flags are valued at less
than 2% of the combined fair market value of the uniforms and
operational expenses paid. Q's use of the name and logo of the pizza
chain in connection with the tournament constitutes acknowledgment of
the sponsorship. Because the fair market value of the flags does not
exceed 2% of the total payment, the entire amount of the funding and
supplied uniforms are a qualified sponsorship payment, which is not
income from an unrelated trade or business.
Example 6. R is a liberal arts college. A soft drink manufacturer
enters into a binding, written contract with R that provides for a large
payment to be made to the college's English department in exchange for R
agreeing to name a writing competition after the soft drink
manufacturer. The contract also provides that R will allow the soft
drink manufacturer to be the exclusive provider of all soft drink sales
on campus. The fair market value of the exclusive provider component of
the contract exceeds 2% of the total payment. R's use of the
manufacturer's name in the writing competition constitutes
acknowledgment of the sponsorship. However, the exclusive provider
arrangement is a substantial return benefit. Only that portion of the
payment, if any, that R can demonstrate exceeds the fair market value of
the exclusive provider arrangement is a qualified sponsorship payment.
Example 7. S is a noncommercial broadcast station that airs a
program funded by a local music store. In exchange for the funding, S
broadcasts the following message: ``This program has been brought to you
by the Music Shop, located at 123 Main Street. For your music needs,
give them a call today at 555-1234. This station is proud to have the
Music Shop as a sponsor.'' Because this single broadcast message
contains both advertising and an acknowledgment, the entire message is
advertising. The fair market value of the advertising exceeds 2% of the
total payment. Thus, the advertising is a substantial return benefit.
Unless S establishes that the amount of the payment exceeds the fair
market value of the advertising, none of the payment is a qualified
sponsorship payment.
Example 8. T, a symphony orchestra, performs a series of concerts. A
program guide that contains notes on guest conductors and other
information concerning the evening's program is distributed by T at each
concert. The Music Shop makes a $1,000 payment to T in support of the
concert series. As a supporter of the event, the Music Shop receives
complimentary concert tickets with a fair market value of $85, and is
recognized in the program guide and on a poster in the lobby of the
concert hall. The lobby poster states that, ``The T concert is sponsored
by the Music Shop, located at 123 Main Street, telephone number 555-
1234.'' The program guide contains the same information and also states,
``Visit the Music Shop today for the finest selection of music CDs and
cassette tapes.'' The fair market value of the advertisement in the
program guide is $15. T's use of the Music Shop's name, address and
telephone number in the lobby poster constitutes acknowledgment of the
sponsorship. However, the combined fair market value of the
advertisement in the program guide and complimentary tickets is $100
($15 + $85), which exceeds 2% of the total payment (2% of $1,000 is
$20). The fair market value of the advertising and complimentary
tickets, therefore, constitutes a substantial return benefit and only
that portion of the payment, or $900, that exceeds the fair market value
of the substantial return benefit is a qualified sponsorship payment.
Example 9. U, a national charity dedicated to promoting health,
organizes a campaign to inform the public about potential cures to
[[Page 230]]
fight a serious disease. As part of the campaign, U sends
representatives to community health fairs around the country to answer
questions about the disease and inform the public about recent
developments in the search for a cure. A pharmaceutical company makes a
payment to U to fund U's booth at a health fair. U places a sign in the
booth displaying the pharmaceutical company's name and slogan, ``Better
Research, Better Health,'' which is an established part of the company's
identity. In addition, U grants the pharmaceutical company a license to
use U's logo in marketing its products to health care providers around
the country. The fair market value of the license exceeds 2% of the
total payment received from the company. U's display of the
pharmaceutical company's name and slogan constitutes acknowledgment of
the sponsorship. However, the license granted to the pharmaceutical
company to use U's logo is a substantial return benefit. Only that
portion of the payment, if any, that U can demonstrate exceeds the fair
market value of the license granted to the pharmaceutical company is a
qualified sponsorship payment.
Example 10. V, a trade association, publishes a monthly scientific
magazine for its members containing information about current issues and
developments in the field. A textbook publisher makes a large payment to
V to have its name displayed on the inside cover of the magazine each
month. Because the monthly magazine is a periodical within the meaning
of paragraph (b) of this section, the section 513(i) safe harbor does
not apply. See Sec. 1.512(a)-1(f).
Example 11. W, a symphony orchestra, maintains a Web site containing
pertinent information and its performance schedule. The Music Shop makes
a payment to W to fund a concert series, and W posts a list of its
sponsors on its Web site, including the Music Shop's name and Internet
address. W's Web site does not promote the Music Shop or advertise its
merchandise. The Music Shop's Internet address appears as a hyperlink
from W's Web site to the Music Shop's Web site. W's posting of the Music
Shop's name and Internet address on its Web site constitutes
acknowledgment of the sponsorship. The entire payment is a qualified
sponsorship payment, which is not income from an unrelated trade or
business.
Example 12. X, a health-based charity, sponsors a year-long
initiative to educate the public about a particular medical condition. A
large pharmaceutical company manufactures a drug that is used in
treating the medical condition, and provides funding for the initiative
that helps X produce educational materials for distribution and post
information on X's Web site. X's Web site contains a hyperlink to the
pharmaceutical company's Web site. On the pharmaceutical company's Web
site, the statement appears, ``X endorses the use of our drug, and
suggests that you ask your doctor for a prescription if you have this
medical condition.'' X reviewed the endorsement before it was posted on
the pharmaceutical company's Web site and gave permission for the
endorsement to appear. The endorsement is advertising. The fair market
value of the advertising exceeds 2% of the total payment received from
the pharmaceutical company. Therefore, only the portion of the payment,
if any, that X can demonstrate exceeds the fair market value of the
advertising on the pharmaceutical company's Web site is a qualified
sponsorship payment.
[T.D. 8991, 67 FR 20438, Apr. 25, 2002]
Sec. 1.513-5 Certain bingo games not unrelated trade or business.
(a) In general. Under section 513(f), and subject to the limitations
in paragraph (C) of this section, in the case of an organization subject
to the tax imposed by section 511, the term unrelated trade or business
does not include any trade or business that consists of conducting bingo
games (as defined in paragraph (d) of this section).
(b) Exception. The provisions of this section shall not apply with
respect to any bingo game otherwise excluded from the term unrelated
trade or business by reason of section 513(a)(1) and Sec. 1.513-1(e)(1)
(relating to trades or businesses in which substantially all the work is
performed without compensation).
(c) Limitations--(1) Bingo games must be legal. Paragraph (a) of
this section shall not apply with respect to any bingo game conducted in
violation of State or local law.
(2) No commercial competition. Paragraph (a) of this section shall
not apply with respect to any bingo game conducted in a jurisdiction in
which bingo games are ordinarily carried out on a commercial basis.
Bingo games are ordinarily carried out on a commercial basis within a
jursidiction if they are regularly carried on (within the meaning of
Sec. 1.513-1(c)) by for-profit organizations in any part of that
jurisidiction. Normally, the entire State will constitute the
appropriate jurisdiction for determining whether bingo games are
ordinarily carried out on a commercial basis. However, if State law
permits local jurisdictions to determine whether bingo games may be
conducted by for-profit organizations, or if State law
[[Page 231]]
limits or confines the conduct of bingo games by for-profit
organizations to specific local jurisdictions, then the local
jurisdiction will constitute the appropriate jurisdiction for
determining whether bingo games are ordinarily carried out on a
commercial basis.
(3) Examples. The application of this paragraph is illustrated by
the examples that follow. In each example, it is assumed that the bingo
games referred to are operated by individuals who are compensated for
their services. Accordingly, none of the bingo games would be excluded
from the term unrelated trade or business under section 513 (a) (1).
Example 1. Church Z, a tax-exempt organization, conducts weekly
bingo games in State O. State and local laws in State O expressly
provide that bingo games may be conducted by tax-exempt organizations.
Bingo games are not conducted in State O by any for-profit businesses.
Since Z's bingo games are not conducted in violation of State or local
law and are not the type of activity ordinarily carried out on a
commercial basis in State O, Z's bingo games do not constitute unrelated
trade or business.
Example 2. Rescue Squad X, a tax-exempt organization, conducts
weekly bingo games in State M. State M has a statutory provision that
prohibits all forms of gambling including bingo games. However, that law
generally is not enforced by State officials against local charitable
organizations such as X that conduct bingo games to raise funds. Since
bingo games are illegal under State law, X's bingo games constitute
unrelated trade or business regardless of the degree to which the State
law is enforced.
Example 3. Veteran's organizations Y and X, both tax-exempt
organizations, are organized under the laws of State N. State N has a
statutory provision that permits bingo games to be conducted by tax-
exempt organizations. In addition, State N permits bingo games to be
conducted by for-profit organizations in city S, a resort community
located in county R. Several for-profit organizations conduct nightly
bingo games in city S. Y conducts weekly bingo games in city S. X
conducts weekly bingo games in county R. Since State law confines the
conduct of bingo games by for-profit organizations to city S, and since
bingo games are regularly carried on there by those organizations, Y's
bingo games conducted in city S constitute unrelated trade or business.
However, X's bingo games conducted in county R outside of city S do not
constitute unrelated trade or business.
(d) Bingo game defined. A bingo game is a game of chance played with
cards that are generally printed with five rows of five squares each.
Participants place markers over randomly called numbers on the cards in
an attempt to form a preselected pattern such as a horizontal, vertical,
or diagonal line, or all four corners. The first participant to form the
preselected pattern wins the game. As used in this section, the term
bingo game means any game of bingo of the type described above in which
wagers are placed, winners are determined, and prizes or other property
is distributed in the presence of all persons placing wagers in that
game. The term bingo game does not refer to any game of chance
(including, but not limited to, keno games, dice games, card games, and
lotteries) other than the type of game described in this paragraph.
(e) Effective date. Section 513(f) and this section apply to taxable
years beginning after December 31, 1969.
[T.D. 7699, 45 FR 33970, May 21, 1980]
Sec. 1.513-6 Certain hospital services not unrelated trade or business.
(a) In general. Under section 513(e), the furnishing of a service
listed in section 501(e)(1)(A) by a hospital to one or more other
hospitals will not constitute unrelated trade or business if--
(1) The service is provided solely to hospitals that have facilities
to serve not more than 100 inpatients,
(2) The service would, if performed by the recipient hospital,
constitute an activity consistent with that hospital's exempt purposes,
and
(3) The service is provided at a fee not in excess of actual cost,
including straight line depreciation and a reasonable rate of return on
the capital goods used to provide the service. For purposes of this
section, a rate of return on capital goods will be considered reasonable
provided that it does not exceed, on an annual basis, the percentage
described below which is based on the average of the rates of interest
on special issues of public debt obligations issued to the Federal
Hospital Insurance Trust Fund for each of the months included in the
taxable year of the hospital duringwhich the captial goods are used in
providing the service.
[[Page 232]]
Determinations as to the cost of services and the applicable rate of
return should be made as prescribed by 42 U.S.C. 1395x(v)(1) (A) and (B)
and the regulations thereunder (permitting a health care facility to be
reimbursed under the Medicare program for the reasonable cost of (its)
services, including, in the case of certain proprietary facilities, a
reasonable return on equity capital). For taxable years beginning on or
before May 14, 1986, the rate of return shall be one and one-half times
the average of the rates of interest on public debt obligations
described above which were in effect on or before April 20, 1983.
(b) Hospital defined. As used in this section the word hospital
means a hospital described in section 170(b)(1)(A)(iii).
(c) Example. The provisions of this section are illustrated by the
following example:
Example. A large metropolitan hospital provides various services to
other hospitals. The hospital furnishes a purchasing service to
hosptials N and O, a data processing service to hospitals R and S, and a
food service to hospitals X and Y. All the hospitals are described in
section 170(b)(1)(A)(iii). All the hospitals have facilities to serve
not more than 100 inpatients except hospital N. The services are
furnished at cost to all hospitals except that hospital R is charged a
fee in excess of cost for its use of the data processing service. The
purchasing service constitutes unrelated trade or business because it is
not provided solely to hospitals having facilities to serve not more
than 100 inpatients.
The data processing service constitutes unrelated trade or business
because it is provided at a fee in excess of cost. The food service
satisfies all three requirements of paragraph (a) of this section and
does not constitute unrelated trade or business.
(d) Effective date. Section 513(e) and this section apply to taxable
years beginning after December 31, 1953.
[T.D. 8075, 51 FR 5322, Feb. 13, 1986; 51 FR 8490, Mar. 12, 1986]
Sec. 1.513-7 Travel and tour activities of tax exempt organizations.
(a) Travel tour activities that constitute a trade or business, as
defined in Sec. 1.513-1(b), and that are not substantially related to
the purposes for which exemption has been granted to the organization
constitute an unrelated trade or business with respect to that
organization. Whether travel tour activities conducted by an
organization are substantially related to the organization's exempt
purpose is determined by looking at all relevant facts and
circumstances, including, but not limited to, how a travel tour is
developed, promoted and operated. Section 513(c) and Sec. 1.513-1(b)
also apply to travel tour activity. Application of the rules of section
513(c) and Sec. 1.513-1(b) may result in different treatment for
individual tours within an organization's travel tour program.
(b) Examples. The provisions of this section are illustrated by the
following examples. In all of these examples, the travel tours are
priced to produce a profit for the exempt organization. The examples are
as follows:
Example 1. O, a university alumni association, is exempt from
federal income tax under section 501(a) as an educational organization
described in section 501(c)(3). As part of its activities, O operates a
travel tour program. The program is open to all current members of O and
their guests. O works with travel agencies to schedule approximately 10
tours annually to various destinations around the world. Members of O
pay $x to the organizing travel agency to participate in a tour. The
travel agency pays O a per person fee for each participant. Although the
literature advertising the tours encourages O's members to continue
their lifelong learning by joining the tours, and a faculty member of
O's related university frequently joins the tour as a guest of the
alumni association, none of the tours includes any scheduled instruction
or curriculum related to the destinations being visited. The travel
tours made available to O's members do not contribute importantly to the
accomplishment of O's educational purpose. Rather, O's program is
designed to generate revenues for O by regularly offering its members
travel services. Accordingly, O's tour program is an unrelated trade or
business within the meaning of section 513(a).
Example 2. N is an organization formed for the purpose of educating
individuals about the geography and culture of the United States. It is
exempt from federal income tax under section 501(a) as an educational
and cultural organization described in section 501(c)(3). N engages in a
number of activities to accomplish its purposes, including offering
courses and publishing periodicals and books. As one of its activities,
N conducts study tours to national parks and other locations within the
UnitedStates. The study tours are conducted by teachers and other
[[Page 233]]
personnel certified by the Board of Education of the State of P. The
tours are directed toward students enrolled in degree programs at
educational institutions in P, as reflected in the promotional
materials, but are open to all who agree to participate in the required
study program. Each tour's study program consists of instruction on
subjects related to the location being visited on the tour. During the
tour, five or six hours per day are devoted to organized study,
preparation of reports, lectures, instruction and recitation by the
students. Each tour group brings along a library of material related to
the subject being studied on the tour. Examinations are given at the end
of each tour and the P StateBoard of Education awards academic credit
for tour participation. Because the tours offered by N include a
substantial amount of required study, lectures, report preparation,
examinations and qualify for academic credit, the tours are
substantially related to N's educational purpose. Accordingly, N's tour
program is not an unrelated trade or business within the meaning of
section 513(a).
Example 3. R is a section 501(c)(4) social welfare organization
devoted to advocacy on a particular issue. On a regular basis throughout
the year, R organizes travel tours for its members to Washington, DC.
While in Washington, the members follow a schedule according to which
they spend substantially all of their time during normal business hours
over several days attending meetings with legislators and government
officials and receiving briefings on policy developments related to the
issue that is R's focus. Members do have some time on their own in the
evenings to engage in recreational or social activities of their own
choosing. Bringing members to Washington to participate in advocacy on
behalf of the organization and learn about developments relating to the
organization's principal focus is substantially related to R's social
welfare purpose. Therefore, R's operation of the travel tours does not
constitute an unrelated trade or business within the meaning of section
513(a).
Example 4. S is a membership organization formed to foster cultural
unity and to educate X Americans about X, their country of origin. It is
exempt from federal income tax under section 501(a) and is described in
section 501(c)(3) as an educational and cultural organization.
Membership in S is open to all Americans interested in the X heritage.
As part of its activities, S sponsors a program of travel tours to X.
The tours are divided into two categories. Category A tours are trips to
X that are designed to immerse participants in the X history, culture
and language. Substantially all of the daily itinerary includes
scheduled instruction on the X language, history and cultural heritage,
and visits to destinations selected because of their historical or
cultural significance or because of instructional resources they offer.
Category B tours are also trips to X, but rather than offering scheduled
instruction, participants are given the option of taking guided tours of
various X locations included in their itinerary. Other than the optional
guided tours, Category B tours offer no instruction or curriculum.
Destinations of principally recreational interest, rather than
historical or cultural interest, are regularly included on Category B
tour itineraries. Based on the facts and circumstances, sponsoring
Category A tours is an activity substantially related to S's exempt
purposes, and does not constitute an unrelated trade or business within
the meaning of section 513(a). However, sponsoring Category B tours does
not contribute importantly to S's accomplishment of its exempt purposes
and, thus, constitutes an unrelated trade or business within the meaning
of section 513(a).
Example 5. T is a scientific organization engaged in environmental
research. T is exempt from federal income tax under section 501(a) as an
organization described in section 501(c)(3). T is engaged in a long-term
study of how agricultural pesticide and fertilizer use affects the
populations of various bird species. T collects data at several bases
located in an important agricultural region of country U. The minutes of
a meeting of T's Board of Directors state that, after study, the Board
has determined that non-scientists can reliably perform needed data
collection in the field, under supervision of T's biologists. The Board
minutes reflect that the Board approved offering one-week trips to T's
bases in U, where participants will assist T's biologists in collecting
data for the study. Tour participants collect data during the same hours
as T's biologists. Normally, data collection occurs during the early
morning and evening hours, although the work schedule varies by season.
Each base has rustic accommodations and few amenities, but country U is
renowned for its beautiful scenery and abundant wildlife. T promotes the
trips in its newsletter and on its Internet site and through various
conservation organizations. The promotional materials describe the work
schedule and emphasize the valuable contribution made by trip
participants to T's research activities. Based on the facts and
circumstances, sponsoring trips to T's bases in country U is an activity
substantially related to T's exempt purpose, and, thus, does not
constitute an unrelated trade or business within the meaning of section
513(a).
Example 6. V is an educational organization devoted to the study of
ancient history and cultures and is exempt from federal income tax under
section 501(a) as an organization described in section 501(c)(3). In
connection with its educational activities, V conducts archaeological
expeditions around the world,
[[Page 234]]
including in the Y region of country Z. In cooperation with the National
Museum of Z, V recently presented an exhibit on ancient civilizations of
the Y region of Z, including artifacts from the collection of the Z
National Museum. V instituted a program of travel tours to V's
archaeological sites located in the Y region. The tours were initially
proposed by V staff members as a means of educating the public about
ongoing field research conducted by V. V engaged a travel agency to
handle logistics such as accommodations and transportation arrangements.
In preparation for the tours, V developed educational materials relating
to each archaeological site to be visited on the tour, describing in
detail the layout of the site, the methods used by V's researchers in
exploring the site, the discoveries made at the site, and their
historical significance. V also arranged special guided tours of its
exhibit on the Y region for individuals registered for the travel tours.
Two archaeologists from V (both of whom had participated in prior
archaeological expeditions in the Y region) accompanied the tours. These
experts led guided tours of each site and explained the significance of
the sites to tour participants. At several of the sites, tour
participants also met with a working team of archaeologists from V and
the National Museum of Z, who shared their experiences. V prepared
promotional materials describing the educational nature of the tours,
including the daily trips to V's archaeological sites and the
educational background of the tour leaders, and providing a recommended
reading list. The promotional materials do not refer to any particular
recreational or sightseeing activities. Based on the facts and
circumstances, sponsoring trips to the Y region is an activity
substantially related to V's exempt purposes. The scheduled activities,
which include tours of archaeological sites led by experts, are part of
a coordinated educational program designed to educate tour participants
about the ancient history of the Y region of Z and V's ongoing field
research. Therefore, V's tour program does not constitute an unrelated
trade or business within the meaning of section 513(a).
Example 7. W is an educational organization devoted to the study of
the performing arts and is exempt from federal income tax under section
501(a) as an organization described in section 501(c)(3). In connection
with its educational activities, W presents public performances of
musical and theatrical works. Individuals become members of W by making
an annual contribution to W of $q. Each year, W offers members an
opportunity to travel as a group to one or more major cities in the
United States or abroad. In each city, tour participants are provided
tickets to attend a public performance of a play, concert or dance
program each evening. W also arranges a sightseeing tour of each city
and provides evening receptions for tour participants. W views its tour
program as an important means to develop and strengthen bonds between W
and its members, and to increase their financial and volunteer support
of W. W engaged a travel agency to handle logistics such as
accommodations and transportation arrangements. No educational materials
are prepared by W or provided to tour participants in connection with
the tours. Apart from attendance at the evening cultural events, the
tours offer no scheduled instruction, organized study or group
discussion. Although several members of W's administrative staff
accompany each tour group, their role is to facilitate member
interaction. The staff members have no special expertise in the
performing arts and play no educational role in the tours. W prepared
promotional materials describing the sightseeing opportunities on the
tours and emphasizing the opportunity for members to socialize
informally and interact with one another and with W staff members, while
pursuing shared interests. Although W's tour program may foster goodwill
among W members, it does not contribute importantly to W's educational
purposes. W's tour program is primarily social and recreational in
nature. The scheduled activities, which include sightseeing and
attendance at various cultural events, are not part of a coordinated
educational program. Therefore, W's tour program is an unrelated trade
or business within the meaning of section 513(a).
[T.D. 8874, 65 FR 5773, Feb. 7, 2000; 65 FR 16143, Mar. 27, 2000]
Sec. 1.514(a)-1 Unrelated debt-financed income and deductions.
(a) Income includible in gross income:
(1) Percentage of income taken into account--(i) In general. For
taxable years beginning after December 31, 1969, there shall be included
with respect to each debt-financed property (as defined in section 514
and Sec. 1.514(b)-1) as an item of gross income derived from an
unrelated trade or business the amount of unrelated debt-financed income
(as defined in subdivision (ii) of this subparagraph). See paragraph
(a)(5) of Sec. 1.514(c)-1 for special rules regarding indebtedness
incurred before June 28, 1966, applicable for taxable years beginning
before January 1, 1972, and for special rules applicable to churches or
conventions or associations of churches.
(ii) Unrelated debt-financed income. The unrelated debt-financed
income with respect to each debt-financed property
[[Page 235]]
is an amount which is the same percentage (but not in excess of 100
percent) of the total gross income derived during the taxable year from
or on account of such property as:
(a) The average acquisition indebtedness (as defined in subparagraph
(3) of this paragraph) with respect to the property is of
(b) The average adjusted basis of such property (as defined in
subparagraph (2) of this paragraph).
(iii) Debt/basis percentage. The percentage determined under
subdivision (ii) of this subparagraph is hereinafter referred to as the
debt/basis percentage.
(iv) Example. Subdivisions (i), (ii), and (iii) of this subparagraph
are illustrated by the following example. For purposes of this example
it is assumed that the property is debt-financed property.
Example. X, an exempt trade association, owns an office building
which in 1971 produces $10,000 of gross rental income. The average
adjusted basis of the building for 1971 is $100,000, and the average
acquisition indebtedness with respect to the building for 1971 is
$50,000. Accordingly, the debt/basis percentage for 1971 is 50 percent
(the ratio of $50,000 to $100,000). Therefore, the unrelated debt-
financed income with respect to the building for 1971 is $5,000 (50
percent of $10,000).
(v) Gain from sale or other disposition. If debt-financed property
is sold or otherwise disposed of, there shall be included in computing
unrelated business taxable income an amount with respect to such gain
(or loss) which is the same percentage (but not in excess of 100
percent) of the total gain (or loss) derived from such sale or other
disposition as:
(a) The highest acquisition indebtedness with respect to such
property during the 12-month period, preceding the date of disposition,
is of
(b) The average adjusted basis of such property.
The tax on the amount of gain (or loss) included in unrelated business
taxable income pursuant to the preceding sentence shall be determined in
accordance with the rules set forth in subchapter P, chapter 1 of the
Code (relating to capital gains and losses). See also section 511(d) and
the regulations thereunder (relating to the minimum tax for tax
preferences).
(2) Average adjusted basis--(i) In general. The average adjusted
basis of debt-financed property is the average amount of the adjusted
basis of such property during that portion of the taxable year it is
held by the organization. This amount is the average of:
(a) The adjusted basis of such property as of the first day during
the taxable year that the organization holds the property, and
(b) The adjusted basis of such property as of the last day during
the taxable year that the organization holds the property
See section 1011 and the regulations thereunder for determination of the
adjusted basis of property.
(ii) Adjustments for prior taxable years. For purposes of
subdivision (i) of this subparagraph, the determination of the average
adjusted basis of debt-financed property is not affected by the fact
that the organization was exempt from taxation for prior taxable years.
Proper adjustment must be made under section 1011 for the entire period
since the acquisition of the property. For example, adjustment must be
made for depreciation for all prior taxable years whether or not the
organization was exempt from taxation for any such years. Similarly, the
fact that only a portion of the depreciation allowance may be taken into
account in computing the percentage of deductions allowable under
section 514(a)(2) does not affect the amount of the adjustment for
depreciation which is used in determining average adjusted basis.
(iii) Cross reference. For the determination of the basis of debt-
financed property acquired in a complete or partial liquidation of a
corporation in exchange for its stock, see Sec. 1.514(d)-1.
(iv) Example. This subparagraph may be illustrated by the following
example. For purposes of this example it is assumed that the property is
debt-financed property.
Example. On July 10, 1970, X, an exempt educational organization,
purchased an office building for $510,000, using $300,000 of borrowed
funds. During 1970 the only adjustment to basis is $20,000 for
depreciation. As of December 31, 1970, the adjusted basis of the
building is $490,000 and the indebtedness is still $300,000. X files its
return on a calendar year basis. Under these circumstances,
[[Page 236]]
the debt/basis percentage for 1970 is 60 percent, calculated in the
following manner:
Basis
As of July 10, 1970 (acquisition date)..................... $510,000
As of December 31, 1970.................................... 490,000
------------
Total.................................................. 1,000,000
Average Adjusted basis:
[GRAPHIC] [TIFF OMITTED] TC08OC91.000
Debt/basis percentage:
Average acquisition indebtedness ($300,000) / Average adjusted basis
($500,000) = 60 percent
For an illustration of the determination of the debt/basis percentage as
changes in the acquisition indebtedness occur, see example 1 of
subparagraph (3)(iii) of this paragraph.
(3) Average acquisition indebtedness--(i) In general. The average
acquisition indebtedness with respect to debt-financed property is the
average amount of the outstanding principal indebtedness during that
portion of the taxable year the property is held by the organization.
(ii) Computation. The average acquisition indebtedness is computed
by determining the amount of the outstanding principal indebtedness on
the first day in each calendar month during the taxable year that the
organization holds the property, adding these amounts together, and then
dividing this sum by the total number of months during the taxable year
that the organization held such property. A fractional part of a month
shall be treated as a full month in computing average acquisition
indebtedness.
(iii) Examples. The application of this subparagraph may be
illustrated by the following examples. For purposes of these examples it
is assumed that the property is debt-financed property.
Example 1. Assume the facts as stated in the example in subparagraph
(2)(iv) of this paragraph, except that beginning July 20, 1970, the
organization makes payments of $21,000 a month ($20,000 of which is
attributable to principal and $1,000 to interest). In this situation,
the average acquisition indebtedness for 1970 is $250,000. Thus, the
debt/basis percentage for 1970 is 50 percent, calculated in the
following manner:
Indebtedness
on the first
day in each
calendar month
that the
property is
held
Month:
July.................................................. $300,000
August................................................ 280,000
September............................................. 260,000
October............................................... 240,000
November.............................................. 220,000
December.............................................. 200,000
---------------
Total............................................. 1,500,000
Average acquisition indebtedness:
$1,500,000 / 6 months = $250,000
Debt/basis percentage:
Average acquisition indebtedness ($250,000) / Average adjusted basis
($500,000) = 50 percent
Example 2. Y, an exempt organization, owns stock in a corporation
which it does not control. At the beginning of the year, Y has an
outstanding principal indebtedness with respect to such stock of
$12,000. Such indebtedness is paid off at the rate of $2,000 per month
beginning January 30, so that it is retired at the end of 6 months. The
average acquisition indebtedness for the taxable year is $3,500,
calculated in the following manner:
Indebtedness
on the first
day in each
calendar month
that the
property is
held
Month:
January............................................... $12,000
February.............................................. 10,000
March................................................. 8,000
April................................................. 6,000
May................................................... 4,000
June.................................................. 2,000
July thru December.................................... 0
---------------
Total............................................. 42,000
Average acquisition indebtedness:
[GRAPHIC] [TIFF OMITTED] TC08OC91.001
(4) Indeterminate price--(i) In general. If an exempt organization
acquires (or improves) property for an indeterminate price, the initial
acquisition indebtedness and the unadjusted basis shall be determined in
accordance with subdivisions (ii) and (iii) of this paragraph, unless
the organization has obtained the consent of the Commissioner to use
another method to compute such amounts.
(ii) Unadjusted basis. For purposes of this subparagraph, the
unadjusted basis of property (or of an improvement) is the fair market
value of the property (or improvement) on the date
[[Page 237]]
of acquisition (or the date of completion of the improvement). The
average adjusted basis of such property shall be determined in
accordance with paragraph (a)(2) of this section.
(iii) Initial acquisition indebtedness. For purposes of this
subparagraph, the initial acquisition indebtedness is the fair market
value of the property (or improvement) on the date of acquisition (or
the date of completion of the improvement) less any down payment or
other initial payment applied to the principal indebtedness. The average
acquisition indebtednessith respect to such property shall be computed
in accordance with paragraph (a)(3) of this section.
(iv) Example. The application of this subparagraph may be
illustrated by the following example. For purposes of this example it is
assumed that the property is debt-financed property.
Example. On January 1, 1971, X, an exempt trade association,
acquires an office building for a down payment of $310,000 and an
agreement to pay 10 percent of the income generated by the building for
10 years. Neither the sales price nor the amount which X is obligated to
pay in the future is certain. The fair market value of the building on
the date of acquisition is $600,000. The depreciation allowance for 1971
is $40,000. Unless X obtains the consent of the Commissioner to use
another method, the unadjusted basis of the property is $600,000 (the
fair market value of the property on the date of acquisition), and the
initial acquisition indebtedness is $290,000 (fair market value of
$600,000 less initial payment of $310,000). Under these circumstances,
the average adjusted basis of the property for 1971 is $580,000,
calculated as follows:
[Initial fair market value + (initial fair market value less
depreciation)] / 2 = [$600,000 + ($600,000 - $40,000)] / 2 =
$580,000.
If no payment other than the initial payment is made in 1971, the
average acquisition indebtedness for 1971 is $290,000. Thus, the debt/
basis percentage for 1971 is 50 percent, calculated as follows:
Average acquisition indebtedness / average adjusted basis = $290,000 /
$580,000 = 50 percent
(b) Deductions--(1) Percentage of deductions taken into account.
Except as provided in subparagraphs (4) and (5) of this paragraph, there
shall be allowed as a deduction with respect to each debt-financed
property an amount determined by applying the debt/basis percentage to
the sum of the deductions allowable under subparagraph (2) of this
paragraph.
(2) Deductions allowable. The deductions allowable are those items
allowed as deductions by chapter 1 of the Code which are directly
connected with the debt-financed property or the income therefrom
(including the dividends received deductions allowed by sections 243,
244, and 245), except that:
(i) The allowable deductions are subject to the modifications
provided by section 512(b) on computation of the unrelated business
taxable income, and
(ii) If the debt-financed property is of a character which is
subject to the allowance for depreciation provided in section 167, such
allowance shall be computed only by use of the straight-line method of
depreciation.
(3) Directly connected with. To be directly connected with debt-
financed property or the income therefrom, an item of deduction must
have proximate and primary relationship to such property or the income
therefrom. Expenses, depreciation, and similar items attributable solely
to such property are proximately and primarily related to such property
or the income therefrom, and therefore qualify for deduction, to the
extent they meet the requirements of subparagraph (2) of this paragraph.
Thus, for example, if the straight-line depreciation allowance for an
office building is $10,000 a year, an organization would be allowed a
deduction for depreciation of $10,000 if the entire building were debt-
financed property. However, if only one-half of the building were
treated as debt-financed property, then the depreciation allowed as a
deduction would be $5,000. (See example 2 of Sec. 1.514(b)-
1(b)(1)(iii).)
(4) Capital losses--(i) In general. If the sale or exchange of debt-
financed property results in a capital loss, the amount of such loss
taken into account in the taxable year in which the loss arises shall be
computed in accordance with paragraph (a)(1)(v) of this section. If,
however, any portion of such capital loss not taken into account in such
year may be carried back or carried over to another taxable year, the
debt/basis percentage is not applied to determine what portion of such
capital
[[Page 238]]
loss may be taken as a deduction in the year to which such capital loss
is carried.
(ii) Example. This subparagraph is illustrated by the following
example. For purposes of this example it is assumed that the property is
debt-financed property.
Example. X, an exempt educational organization, owns securities
which are capital assets and which it has held for more than 6 months.
In 1972 X sells the securities at a loss of $20,000. The debt/basis
percentage with respect to computing the gain (or loss) derived from the
sale of the securities is 40 percent. Thus, X has sustained a capital
loss of $8,000 (40 percent of $20,000) with respect to the sale of the
securities. For 1972 and the preceding three taxable years X has no
other capital transactions. Under these circumstances, the $8,000 of
capital loss may be carried over to the succeeding 5 taxable years
without further application of the debt/basis percentage.
(5) Net operating loss--(i) In general. If, after applying the debt/
basis percentage to the income derived from debt-financed property and
the deductions directly connected with such income, such deductions
exceed such income, the organization has sustained a net operating loss
for the taxable year. This amount may be carried back or carried over to
other taxable years in accordance with section 512(b)(6). However, the
debt/ basis percentage shall not be applied in such other years to
determine the amounts that may be taken as a deduction in those years.
(ii) Example. This subparagraph may be illustrated by the following
example. For purposes of this example it is assumed that the property is
debt-financed property.
Example. During 1974, Y, an exempt organization, receives $20,000 of
rent from a building which it owns. Y has no other unrelated business
taxable income for 1974. For 1974 the deductions directly connected with
this building are property taxes of $5,000, interest of $5,000 on the
acquisition indebtedness, and salary of $15,000 to the manager of the
building. The debt/basis percentage for 1974 with respect to the
building is 50 percent. Under these circumstances, Y shall take into
account in computing its unrelated business taxable income for 1974,
$10,000 of income (50 percent of $20,000) and $12,500 (50 percent of
$25,000) of the deductions directly connected with such income. Thus,
for 1974 Y has sustained a net operating loss of $2,500 ($10,000 of
income less $12,500 of deductions) which may be carried back or carried
over to other taxable years without further application of the debt/
basis percentage.
[T.D. 7229, 37 FR 28143, Dec. 21, 1972]
Sec. 1.514(a)-2 Business lease rents and deductions for taxable years
beginning before January 1, 1970.
(a) Effective date. This section applies to taxable years beginning
before January 1, 1970.
(b) In general--(1) Rents includible in gross income. There shall be
included with respect to each business lease, as an item of gross income
derived from an unrelated trade or business, an amount which is the same
percentage (but not in excess of 100 percent) of the total rents derived
during the taxable year under such lease as:
(i) The amount of the business lease indebtedness at the close of
the taxable year of the lessor tax-exempt organization, with respect to
the premises covered by such lease, is of
(ii) The adjusted basis of such premises at the close of such
taxable year
For definition of business lease as a lease for a term of more than 5
years, and for rules for determining the computation of such 5-year term
in certain specific situations, see Sec. 1.514(f)-1. For definition of
business lease indebtedness and allocation of business lease
indebtedness where only a portion of the property is subject to a
business lease, see Sec. 1.514(g)-1.
(2) Determination of basis. For purposes of the unrelated business
income tax the basis (unadjusted) of property is determined under
section 1012, and the adjusted basis of property is determined under
section 1011. The determination of the adjusted basis of property is not
affected by the fact that the organization was exempt from tax for prior
taxable years. Proper adjustment must be made under section 1011 for the
entire period since the acquisition of the property. Thus adjustment
must be made for depreciation for all taxable years whether or not the
organization was exempt from tax for any of such years. Similarly, for
taxable years during which the organization is subject to the tax on
unrelated business taxable income the fact that only a portion of the
deduction for depreciation
[[Page 239]]
is taken into account under paragraph (c)(1) of this section does not
affect the amount of the adjustment for depreciation.
(3) Examples. The application of this paragraph may be illustrated
by the following examples, in each of which it is assumed that the
taxpayer makes its returns under section 511 on the basis of the
calendar year, and that the lease is not substantially related to the
purpose for which the organization is granted exemption from tax.
Example 1. Assume that a tax-exempt educational organization
purchased property in 1952 for $600,000, using borrowed funds, and
leased the building for a period of 20 years. Assume further that the
adjusted basis of such building at the close of 1954 is $500,000 and
that, at the close of 1954, $200,000 of the indebtedness incurred to
acquire the property remains outstanding. Since the amount of the
outstanding indebtedness is two-fifths of the adjusted basis of the
building at the close of 1954, two-fifths of the gross rental received
from the building during 1954 shall be included as an item of gross
income in computing unrelated business taxable income. If, at the close
of a subsequent taxable year, the outstanding indebtedness is $100,000
and the adjusted basis of the building is $400,000, one-fourth of the
gross rental for such taxable year shall be included as an item of gross
income in computing unrelated business taxable income for such taxable
year.
Example 2. Assume that a tax-exempt organization owns a four-story
building, that in 1954 it borrows $100,000 which it uses to improve the
whole building, and that it thereafter in 1954 rents the first and
second floors of the building under six-year leases at rentals of $4,000
a year. The third and fourth floors of the building are leased on a
yearly basis during 1954. Assume, also, that the adjusted basis of the
real property at the end of 1954 (after reflecting the expenditures for
improving the building) is $200,000, allocable equally to each of the
four stories. Under these facts, only one-half of the real property is
subject to a business lease since only one-half is rented under a lease
for more than 5 years. See Sec. 1.514(f)-1. The percentage of the rent
under such lease which is taken into account is determined by the ratio
which the allocable part of the business lease indebtedness bears to the
allocable part of the adjusted basis of the real property, that is, the
ratio which one-half of the $100,000 of business lease indebtedness
outstanding at the close of 1954, or $50,000, bears to one-half of the
adjusted basis of the business lease premises at the close of 1954, or
$100,000. The percentage of rent which is business lease income for 1954
is, therefore, one-half (the ratio of $50,000 to $100,000) of $8,000, or
$4,000, and this amount of $4,000 is considered an item of gross income
derived from an unrelated trade or business.
(c) Deductions--(1) Deductions allowable against gross income. The
same percentage is used in determining both the portion of the rent and
the portion of the deductions taken into account with respect to the
business lease in computing unrelated business taxable income. Such
percentage is applicable only to the sum of the following deductions
allowable under section 161:
(i) Taxes and other expenses paid or accrued during the taxable year
upon or with respect to the real property subject to the business lease;
(ii) Interest paid or accrued during the taxable year on the
business lease indebtedness;
(iii) A reasonable allowance for exhaustion, wear and tear
(including a reasonable allowance for obsolescence) of the real property
subject to such lease.
Where only a portion of the real property is subject to the business
lease, there shall be taken into account only those amounts of the
above-listed deductions which are properly allocable to the premises
covered by such lease.
(2) Excess deductions. The deductions allowable under subparagraph
(1) of this paragraph with respect to a business lease are not limited
by the amount included in gross income with respect to the rent from
such lease. Any excess of such deductions over such gross income shall
be applied against other items of gross income in computing unrelated
business taxable income taxable under section 511(a).
(3) Example. The application of this paragraph may be illustrated by
the following example:
Example. Assume the same facts as those in example 1 in paragraph
(b)(3) of this section. Assume, also that for 1954 the organization pays
taxes of $4,000 on the property, interest of $6,000 on its business
lease indebtedness, and that the depreciation allowable for 1954 under
section 167 is $10,000. Under the facts set forth in such example 1 and
in this example, the deductions to be taken into account for 1954 in
computing unrelated business taxable income would be two-fifths of the
total of the deductions of $20,000, that is $8,000.
[T.D. 7229, 37 FR 28145, Dec. 21, 1972]
[[Page 240]]
Sec. 1.514(b)-1 Definition of debt-financed property.
(a) In general. For purposes of section 514 and the regulations
thereunder, the term debt-financed property means any property which is
held to produce income (e.g., rental real estate, tangible personal
property, and corporate stock), and with respect to which there is an
acquisition indebtedness (determined without regard to whether the
property is debt-financed property) at any time during the taxable year.
The term income is not limited to recurring income but applies as well
to gains from the disposition of property. Consequently, when any
property held to produce income by an organization which is not used in
a manner described in section 514(b)(1) (A), (B), (C), or (D) is
disposed of at a gain during the taxable year, and there was an
acquisition indebtedness outstanding with respect to such property at
any time during the 12-month period preceding the date of disposition
(even though such period covers more than 1 taxable year), such property
is debt-financed property. For example, assume that on June 1, 1972, an
organization is given mortgaged, unimproved property which it does not
use in a manner described in section 514(b)(1) (A), (B), (C), or (D) and
that the organization assumes payment ofthe mortgage on such property.
On July 15, 1972, the organization sells such property for a gain. Such
property is debt-financed property and such gain is taxable as unrelated
debt-financed income. See section 514(c) and Sec. 1.514(c)-1 for rules
relating to when there is acquisition indebtedness with respect to
property. See paragraph (a) of Sec. 1.514(a)-1 for rules determining
the amount of income or gain from debt-financed property which is
treated as unrelated debt-financed income.
(b) Exceptions--(1) Property related to certain exempt purposes. (i)
To the extent that the use of any property is substantially related
(aside from the need of the organization for income or funds or the use
it makes of the profits derived) to the exercise or performance by an
organization of its charitable, educational, or other purpose or
function constituting its basis for exemption under section 501 (or, in
the case of an organization described in section 511(a)(2)(B), to the
exercise or performance of any purpose or function designated in section
501(c)(3)) such property shall not be treated as debt-financed property.
See Sec. 1.513-1 for principles applicable in determining whether there
is a substantial relationship to the exempt purpose of the organization.
(ii) If substantially all of any property is used in a manner
described in subdivision (i) of this subparagraph, such property shall
not be treated as debt-financed property. In general the preceding
sentence shall apply if 85 percent or more of the use of such property
is devoted to the organization's exempt purpose. The extent to which
property is used for a particular purpose shall be determined on the
basis of all the facts and circumstances. These may include (where
appropriate):
(a) A comparison of the portion of time such property is used for
exempt purposes with the total time such property is used,
(b) A comparison of the portion of such property that is used for
exempt purposes with the portion of such property that is used for all
purposes, or
(c) Both the comparisons described in (a) and (b) of this
subdivision.
(iii) This subparagraph may be illustrated by the following
examples. For purposes of these examples it is assumed that the
indebtedness is acquisition indebtedness.
Example 1. W, an exempt organization, owns a computer with respect
to which there is an outstanding principal indebtedness and which is
used by W in the performance of its exempt purpose. W sells time for the
use of the computer to M corporation on occasions when the computer is
not in full-time use by W. W uses the computer in furtherance of its
exempt purpose more than 85 percent of the time it is in use and M uses
the computer less than 15 percent of the total operating time the
computer is in use. In this situation, substantially all the use of the
computer is related to the performance of W's exempt purpose. Therefore,
no portion of the computer is treated as debt-financed property.
Example 2. X, an exempt college, owns a four story office building
which has been purchased with borrowed funds. In 1971, the lower two
stories of the building are used to
[[Page 241]]
house computers which are used by X for administrative purposes. The top
two stories are rented to the public for purposes not described in
section 514(b)(1) (A), (B), (C), or (D). The gross income derived by X
from the building is $6,000, all of which is attributable to the rents
paid by tenants. There are $2,000 of expenses, allocable equally to each
use of the building. The average adjusted basis of the building for1971
is $100,000, and the outstanding principal indebtedness throughout 1971
is $60,000. Thus, the average acquisition indebtedness for 1971 is
$60,000. In accordance with subdivision (i) of this subparagraph, only
the upper half of the building is debt-financed property. Consequently,
only the rental income and the deductions directly connected with such
income are to be taken into account in computing unrelated business
taxable income. The portion of such amounts to be taken into account is
determined by multiplying the $6,000 of rental income and $1,000 of
deductions directly connected with such rental income by the debt/basis
percentage. The debt/basis percentage is the ratio which the allocable
part of the average acquisition indebtedness is of the allocable part of
the average adjusted basis of the property, that is, the ratio which
$30,000 (one-half of $60,000) bears to $50,000 (one-half of $100,000).
Thus, the debt/basis percentage for 1971 is 60 percent (the ratio of
$30,000 to $50,000). Under these circumstances, X shall include net
rental income of $3,000 in its unrelated business taxable income for
1971, computed as follows:
Total rental income......................................... $6,000
Deductions directly connected with rental income............ $1,000
Debt/basis percentage ($30,000/$50,000)..................... 60%
Rental income treated as gross income from an unrelated $3,600
trade or business (60 percent of $6,000)...................
Less the allowable portion of deductions directly connected $600
with such income (60 percent of $1,000)....................
-----------
Net rental income included by X in computing its unrelated $3,000
business taxable income pursuant to section 514............
===========
Example 3. Assume the facts as stated in example 2 except that on
December 31, 1971, X sells the building and realizes a long-term capital
gain of $10,000. This is X's only capital transaction for 1971. An
allocable portion of this gain is subject to tax. This amount is
determined by multiplying the gain related to the nonexempt use, $5,000
(one-half of $10,000), by the ratio which the debtedness for the 12-
month period preceding the date of sale, $30,000 (one-half of $60,000),
is of the allocable part of the average adjusted basis, $50,000 (one-
half of $100,000). Thus, the debt/basis percentage with respect to
computing the gain (or loss) derived from the sale of the building is 60
percent (the ratio of $30,000 to $50,000). Consequently, $3,000 (60
percent of $5,000) is a net section 1201 gain (capital gain net income
for taxable years beginning after December 31, 1976). The portion of
such gain which is taxable shall be determined in accordance with rules
contained in subchapter P, chapter 1 of the Code (relating to capital
gains and losses). See also section 511(d) and the regulations
thereunder (relating to the minimum tax for tax preferences).
(2) Property used in an unrelated trade or business--(i) In general.
To the extent that the gross income from any property is treated as
income from the conduct of an unrelated trade or business, such property
shall not be treated as debt-financed property. However, any gain on the
disposition of such property which is not included in the income of an
unrelated trade or business by reason of section 512(b)(5) is includible
as gross income derived from or on account of debt-financed property
under paragraph (a)(1) of Sec. 1.514(a)-1.
(ii) Amounts specifically taxable under other provisions of the
Code. Section 514 does not apply to amounts which are otherwise included
in the computation of unrelated business taxable income, such as rents
from personal property includible pursuant to section 512(b)(13) or
rents and interest from controlled organizations includible pursuant to
section 512(b)(3). See paragraph (1)(5) of Sec. 1.512(b)-1 for the
rules determining the manner in which amounts are taken into account
where such amounts may be included in the computation of unrelated
business taxable income by operation of more than one provision of the
Code.
(3) Examples. Subparagraphs (1) and (2) of this paragraph may be
illustrated by the following examples. For purposes of these examples it
is assumed that the indebtedness is acquisition indebtedness.
Example 1. X, an exempt scientific organization, owns a 10-story
office building. During 1972, four stories are occupied by X's
administrative offices, and the remaining six stories are rented to the
public for purposes not described in section 514(b)(1) (A), (B), (C), or
(D). On December 31, 1972, the building is sold and X realizes a long-
term capital gain of $100,000. This is X's only capital transaction for
1972. The debt/basis percentage with respect to computing the gain (or
loss) derived from the sale of the building is 30 percent. Since 40
percent of the building was used for X's exempt purpose, only 60 percent
[[Page 242]]
of the building is debt-financed property. Thus, only $60,000 of the
gain (60 percent of $100,000) is subject to this section. Consequently,
the amount of gain treated as unrelated debt-financed income is $18,000
($60,000 multiplied by the debt/basis percentage of 30 percent). The
portion of such $18,000 which is taxable shall be determined in
accordance with the rules contained in subchapter P, chapter 1 of the
Code. See also section 511(d) and the regulations thereunder (relating
to the minimum tax for tax preferences).
Example 2. Y, an exempt organization, owns two properties, a
restaurant and an office building. In 1972, all the space in the office
building, except for the portion utilized by Y to house the
administrative offices of the restaurant, is rented to the public for
purposes not described in section 514(b)(1) (A), (B), (C), or (D). The
average adjusted basis of the office building for 1972 is $2 million.
The outstanding principal indebtedness throughout 1972 is $1 million.
Thus, the highest acquisition indebtedness in the calendar year of 1972
is $1 million. It is determined that 30 percent of the space in the
office building is used for the administrative functions engaged in by
the employees of the organization with respect to the restaurant. Since
the income attributable to the restaurant is attributable to the conduct
of an unrelated trade or business, only 70 percent of the building is
treated as debt-financed property for purposes of determining the
portion of the rental income which is unrelated debt-financed income. On
December 31, 1972, the office building is sold and Y realizes a long-
term capital gain of $250,000. This is Y's only capital transaction for
1972. In accordance with subparagraph (2)(i) of this paragraph, all the
gain derived from this sale is taken into account in computing the
amount of such gain subject to tax. The portion of such gain which is
taxable is determined by multiplying the $250,000 gain by the debt/basis
percentage. The debt/basis percentage is the ratio which the highest
acquisition indebtedness for the 12-month period preceding the date of
sale, $1 million, is of the averageadjusted basis, $2 million. Thus, the
debt/basis percentage with respect to computing the gain (or loss)
derived from the sale of the building is 50 percent (the ratio of $1
million to $2 million). Consequently, $125,000 (50 percent of $250,000)
is a net section 1201 gain (net capital gain for taxable years beginning
after December 31, 1976). The amount of such gain which is taxable shall
be determined in accordance with the rules contained in subchapter P,
chapter 1 of the Code. See also section 511(d) and the regulations
thereunder.
Example 3. (a) Z, an exempt university, owns all the stock of M, a
nonexempt corporation. During 1971 M leases from Z University a factory
unrelated to Z's exempt purpose and a dormitory for the students of Z,
for a total annual rent of $100,000: $80,000 for the factory and $20,000
for the dormitory. During 1971, M has $500,000 of taxable income,
disregarding the rent paid to Z: $150,000 from the dormitory and
$350,000 from the factory. The factory is subject to a mortgage of
$150,000. Its average adjusted basis for 1971 is determined to be
$300,000. Z's deductions for 1971 with respect to the leased property
are $4,000 for the dormitory and $16,000 for the factory. In accordance
with subdivision (ii) of this subparagraph, section 514 applies only to
that portion of the rent which is excluded from the computation of
unrelated business taxable income by operation of section 512(b)(3) and
not included in such computation pursuant to section 512(b)(13). Since
all the rent received by Z is derived from real property, section
512(b)(3) would exclude all such rent from computation of Z's unrelated
business taxable income. However, 70 percent of the rent paid to Z with
respect to the factory and 70 percent of the deductions directly
connected with such rent shall be taken into account by Z in determining
its unrelated business taxable income pursuant to section 512(b)(15),
computed as follows:
M's taxable income (disregarding rent paid to Z)............ $500,000
Less taxable income from dormitory.......................... $150,000
-----------
Excess taxable income....................................... $350,000
Ratio ($350,000/$500,000)................................... \7/10\
Total rent paid to Z........................................ $100,000
Total deductions ($4,000 + $16,000)......................... $20,000
Rental income treated under section 512(b)(15) as gross $70,000
income from an unrelated trade or business (\7/10\ of
$100,000)..................................................
Less deductions directly connected with such income (\7/10\ $14,000
of $20,000)................................................
-----------
Net rental income included by Z in computing its unrelated $56,000
business taxable income pursuant to section 512(b)(15).....
(b) Since only that portion of the rent derived from the factory and
the deductions directly connected with such rent not taken into account
pursuant to section 512(b)(15) may be included in computing unrelated
business taxable income by operation of section 514, only $10,000
($80,000 minus $70,000) of rent and $2,000 ($16,000 minus $14,000) of
deductions are so taken into account. The portion of such amounts to be
taken into account is determined by multiplying the $10,000 of income
and $2,000 of deductions by the debt/basis percentage. The debt/basis
percentage is the ratio which the average acquisition indebtedness
($150,000) is of the average adjusted basis of the property ($300,000).
Thus, the debt/basis percentage for 1971 is 50 percent (the ratio of
$150,000 to $300,000). Under these circumstances, Z shall include net
rental income of $4,000 in its unrelated business taxable income for
1971, computed as follows:
Total rents................................................. $10,000
Deductions directly connected with such rents............... $2,000
[[Page 243]]
Debt/basis percentage ($150,000/$300,000)................... 50%
Rental income treated as gross income from an unrelated $5,000
trade or business (50 percent of $10,000)..................
Less the allowable portion of deductions directly connected $1,000
with such income (50 percent of $2,000)....................
Net rental income included by Z in computing its unrelated $4,000
business taxable income pursuant to section 514............
(4) Property related to research activities. To the extent that the
gross income from any property is derived from research activities
excluded from the tax on unrelated business income by paragraph (7),
(8), or (9) of section 512(b), such property shall not be treated as
debt-financed property.
(5) Property used in thrift shops, etc. To the extent that property
is used in any trade or business which is excepted from the definition
of unrelated trade or business by paragraph (1), (2), or (3) of section
513(a), such property shall not be treated as debt-financed property.
(6) Use by a related organization. For purposes of subparagraph (1),
(4), or (5) of this paragraph, use of property by a related exempt
organization (as defined in paragraph (c)(2)(ii) of this section) for a
purpose described in such subparagraphs shall be taken into account in
order to determine the extent to which such property is used for a
purpose described in such subparagraphs.
(c) Special rules--(1) Medical clinic. Property is not debt-financed
property if it is real property subject to a lease to a medical clinic,
and the lease is entered into primarily for purposes which are
substantially related (aside from the need of such organization for
income or funds or the use it makes of the rents derived) to the
exercise or performance by the lessor of its charitable, educational, or
other purpose or function constituting the basis for its exemption under
section 501. For example, assume that an exempt hospital leases all of
its clinic space to an unincorporated association of physicians and
surgeons who, by the provisions of the lease, agree to provide all of
the hospital's out-patient medical and surgical services and to train
all of the hospital's residents and interns. In this situation, the
rents received by the hospital from this clinic are not to be treated as
unrelated debt-financed income.
(2) Related exempt uses--(i) In general. Property owned by an exempt
organization and used by a related exempt organization or by an exempt
organization related to such related exempt organization shall not be
treated as debt-financed property to the extent such property is used by
either organization in furtherance of the purpose constituting the basis
for its exemption under section 501. Furthermore, property shall not be
treated as debt-financed property to the extent such property is used by
a related exempt organization for a purpose described in paragraph
(b)(4) or (5) of this section.
(ii) Related organizations. For purposes of subdivision (i) of this
subparagraph, an exempt organization is related to another exempt
organization only if:
(a) One organization is an exempt holding company described in
section 501(c)(2) and the other organization receives the profits
derived by such exempt holding company,
(b) One organization has control of the other organization within
the meaning of paragraph (1)(4) of Sec. 1.512(b)-1,
(c) More than 50 percent of the members of one organization are
members of the other organization, or
(d) Each organization is a local organization which is directly
affiliated with a common state, national, or international organization
which is also exempt.
(iii) Examples. This subparagraph may be illustrated by the
following examples. For purposes of these examples it is assumed that
the indebtedness is acquisition indebtedness.
Example 1. M, an exempt trade association described in section
501(c)(6), leases 70 percent of the space of an office building for
furtherance of its exempt purpose. The title to such building is held by
N, an exempt holding company described in section 501(c)(2), which
acquired title to the building with borrowed funds. The other 30 percent
of the space in this office building is leased to L, a nonstock exempt
trade association described in section 501(c)(6). L uses such office
space in furtherance of its exemptpurpose. The members of L's Board of
Trustees serves for fixed terms and M's Board of Directors has the power
to select all such members. N pays over to M all the profits it derives
from the leasing of space in this building to M and L. Accordingly, M is
related to N (as such term
[[Page 244]]
is defined in subdivision (ii)(a) of this subparagraph) and L is related
to M (as such term is defined in subdivision (ii)(b) of this
subparagraph). Under these circumstances, since all the available space
in the building is leased to either an exempt organization related to
the exempt organization holding title to the building or an exempt
organization related to such related exempt organization, no portion of
the building is treated as debt-financed property.
Example 2. W, an exempt labor union described in section 501(c)(5),
owns a 10-story office building which has been purchased with borrowed
funds. Five floors of the building are used by W in furtherance of its
exempt purpose. Four of the other floors are rented to X which is an
exempt voluntary employees' beneficiary association described in section
501(c)(9), operated for the benefit of W's members. X uses such office
space in furtherance of its exempt purpose. Seventy percent of the
members of W are also members of X. Accordingly, X is related to W (as
such term is defined in subdivision (ii)(c) of this subparagraph). The
remaining floor of the building is rented to the general public for
purposes not described in section 514(b)(1) (A), (B), (C), or (D). Under
thesecircumstances, no portion of this building is treated as debt-
financed property since more than 85 percent of the office space
available in this building is used either by W or X, an exempt
organization related to W, in furtherance of their respective exempt
purpose. See paragraph (b)(1) of this section for rules relating to the
use of property substantially related to an exempt purpose. See
paragraph (b)(6) of this section for rules relating to uses by related
exempt organizations.
Example 3. Assume the same facts as in example 2, except that W and
X are each exempt local labor unions described in section 501(c)(5)
having no common membership and are each affiliated with N, an exempt
international labor union described in section 501(c)(5). Under these
circumstances, no portion of this building is treated as debt-financed
property since more than 85 percent of the office space available in
this building is used either by W or X, an exempt organization related
to W, in furtherance of their respective exempt purpose.
Example 4. Assume the same facts as in example 3, except that W and
X are directly affiliated with different exempt international labor
unions and that W and X are not otherwise affiliated with, or members
of, a common exempt organization, other than an association of
international labor unions. Under these circumstances, the portions of
this building which are rented to X and to the general public are
treated as debt-financed property since X is not related to W and W uses
less than 85 percent of the building for its exempt purpose.
(3) Life income contracts. (i) Property shall not be treated as
debt-financed property when:
(a) An individual transfers property to a trust or a fund subject to
a contract providing that the income is to be paid to him or other
individuals or both for a period of time not to exceed the life of such
individual or individuals in a transaction in which the payments to the
individual or individuals do not constitute the proceeds of a sale or
exchange of the property so transferred, and
(b) The remainder interest is payable to an exempt organization
described in section 501(c)(3).
(ii) Subdivision (i) of this subparagraph is illustrated by the
following example.
Example. On January 1, 1967, A transfers property to X, an exempt
organization described in section 501(c)(3), which immediately places
the property in a fund. On January 1, 1971, A transfers additional
property to X, which property is also placed in the fund. In exchange
for each transfer, A receives income participation fund certificates
which entitle him to a proportionate part of the fund's income for his
life and for the life of another individual. None of the payments made
by X are treated by the recipients as the proceeds of a sale or exchange
of the property transferred. In this situation, none of the property
received by X from A is treated as debt-financed property.
(d) Property acquired for prospective exempt use--(1) Neighborhood
land--(i) In general. If an organization acquires real property for the
principal purpose of using the land in the exercise or performance of
its exempt purpose, commencing within 10 years of the time of
acquisition, such property will not be treated as debt-financed
property, so long as (a) such property is in the neighborhood of other
property owned by the organization which is used in the performance of
its exempt purpose, and (b) the organization does not abandon its intent
to use the land in such a manner within the 10-year period. The rule
expressed in this subdivision is hereinafter referred to as the
neighborhood land rule.
(ii) Neighborhood defined. Property shall be considered in the
neighborhood of property owned and used by the organization in the
performance of its exempt purpose if the acquired property
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is contiguous with the exempt purpose property or would be contiguous
with such property except for the interposition of a road, street,
railroad, stream, or similar property. If the acquired property is not
contiguous with exempt function property, it may still be in the
neighborhood of such property, but only if it is within 1 mile of such
property and the facts and circumstances of the particular situation
make the acquisition of contiguous property unreasonable. Some of the
criteria to consider in determining this question include the
availability of land and the intended future use of the land. For
example, a university attempts to purchase land contiguous to its
present campus but cannot do so because the owners either refuse to sell
or ask unreasonable prices. The nearest land of sufficient size and
utility is a block away from the campus. The university purchases such
land. Under these circumstances, the contiguity requirement is
unreasonable and the land purchased would be considered neighborhood
land.
(iii) Exception. The neighborhood land rule shall not apply to any
property after the expiration of 10 years from the date of acquisition.
Further, the neighborhood land rule shall apply after the first 5 years
of the 10-year period only if the organization establishes to the
satisfaction of the Commissioner that future use of the acquired land in
furtherance of the organization's exempt purpose before the expiration
of the 10-year period is reasonably certain. In order to satisfy the
Commissioner, the organization does not necessarily have to show binding
contracts. However, it must at least have a definite plan detailing a
specific improvement and a completion date, and some affirmative action
toward the fulfillment of such a plan. This information shall be
forwarded to the Commissioner of Internal Revenue, Washington, DC 20224,
for a ruling at least 90 days before the end of the fifth year after
acquisition of the land.
(2) Actual use. If the neighborhood land rule is inapplicable
because:
(i) The acquired land is not in the neighborhood of other property
used by the organization in performance of its exempt purpose, or
(ii) The organization (for the period after the first 5 years of the
10-year period) is unable to establish to the satisfaction of the
Commissioner that the use of the acquired land for its exempt purposes
within the 10-year period is reasonably certain
but the land is actually used by the organization in furtherance of its
exempt purpose within the 10-year period, such property (subject to the
provisions of subparagraph (4) of this paragraph) shall not be treated
as debt-financed property for any period prior to such conversion.
(3) Limitations--(i) Demolition or removal required. (a)
Subparagraphs (1) and (2) of this paragraph shall apply with respect to
any structure on the land when acquired by the organization, or to the
land occupied by the structure, only so long as the intended future use
of the land in furtherance of the organization's exempt purpose requires
that the structure be demolished or removed in order to use the land in
such a manner. Thus, during the first 5 years after acquisition (and for
subsequent years if there is a favorable ruling in accordance with
subparagraph (1)(iii) of this paragraph) improved property is not debt-
financed so long as the organization does not abandon its intent to
demolish the existing structures and use the land in furtherance of its
exempt purpose. Furthermore, if there is an actual demolition of such
structures, the use made of the land need not be the one originally
intended. Therefore, the actual use requirement of this subdivision may
be satisfied by using the land in any manner which furthers the exempt
purpose of the organization.
(b) Subdivision (i)(a) of this subparagraph may be illustrated by
the following examples. For purposes of the following examples it is
assumed that but for the application of the neighborhood land rule such
property would be debt-financed property.
Example 1. An exempt university acquires a contiguous tract of land
on which there is an apartment building. The university intends to
demolish the apartment building and build classrooms and does not
abandon this intent during the first 4 years after acquisition. In the
fifth year after acquisition it abandons the intent to demolish and
sells
[[Page 246]]
the apartment building. Under these circumstances, such property is not
debt-financed property for the first 4 years after acquisition even
though there was no eventual demolition or use made of such land in
furtherance of the university's exempt purpose. However, such property
is debt-financed property as of the time in the fifth year that the
intent to demolish the building is abandoned and any gain on the sale of
property is subject to section 514.
Example 2. Assume the facts as stated in Example 1 except that the
university did not abandon its intent to demolish the existing building
and construct a classroom building until the eighth year after
acquisition when it sells the property. Assume further that the
university did not receive a favorable ruling in accordance with
subparagraph (1)(iii) of this paragraph. Under these circumstances, the
building is debt- financed property for the sixth, seventh, and eighth
years. It is not, however, treated as debt-financed property for the
first 5 years after acquisition.
Example 3. Assume the facts as stated in Example 2 except that the
university received a favorable ruling in accordance with subparagraph
(1)(iii) of this paragraph. Under these circumstances, the building is
not debt-financed property for the first 7 years after acquisition. It
only becomes debt-financed property as of the time in the eighth year
when the university abandoned its intent to demolish the existing
structure.
Example 4. (1) Assume that a university acquires a contiguous tract
of land containing an office building for the principal purpose of
demolishing the office building and building a modern dormitory. Five
years later the dormitory has not been constructed, and the university
has failed to satisfy the Commissioner that the office building will be
demolished and the land will be used in furtherance of its exempt
purpose (and consequently has failed to obtain a favorable ruling under
subparagraph (1)(iii) of this paragraph). In the ninth taxable year
after acquisition the university converts the office building into an
administration building. Under these circumstances, during the sixth,
seventh, and eighth years after acquisition, the office building is
treated as debt-financed property because the office building was not
demolished or removed. Therefore, the income derived from such property
during these years shall be subject to the tax on unrelated business
income.
(2) Assume that instead of converting the office building to an
administration building, the university demolishes the office building
in the ninth taxable year after acquisition and then constructs a new
administration building. Under these circumstances, the land would not
be considered debt-financed property for any period following the
acquisition, and the university would be entitled to a refund of taxes
paid on the income derived from such property for the sixth through
eighth taxable years after the acquisition in accordance with
subparagraph (4) of this paragraph.
(ii) Subsequent construction. Subparagraphs (1) and (2) of this
paragraph do not apply to structures erected on the land after the
acquisition of the land.
(iii) Property subject to business lease. Subparagraphs (1) and (2)
of this paragraph do not apply to property subject to a lease which is a
business lease (as defined in Sec. 1.514(f)-1) whether the organization
acquired the property subject to the lease or whether it executed the
lease subsequent to acquisition. If only a portion of the real property
is subject to a lease, paragraph (c) of Sec. 1.514(f)-1 applies in
determining whether such lease is a business lease.
(4) Refund of taxes. (i) If an organization has not satisfied the
actual use condition of subparagraph (2) of this paragraph or paragraph
(e)(3) of this section before the date prescribed by law (including
extensions) for filing the return for the taxable year, the tax for such
year shall be computed without regard to the application of such actual
use condition. However, if:
(a) A credit or refund of any overpayment of taxes is allowable for
a prior taxable year as a result of the satisfaction of such actual use
condition, and
(b) Such credit or refund is prevented by the operation of any law
or rule of law (other than chapter 74, relating to closing agreements
and compromises)
such credit or refund may nevertheless be allowed or made, if a claim is
filed within 1 year after the close of the taxable year in which such
actual use condition is satisfied. For a special rule with respect to
the payment of interest at the rate of 4 percent per annum, see section
514(b)(3)(D), prior to its amendment by section 7(b) of the Act of
January 3, 1975 (Pub. L. 93-625, 88 Stat. 2115).
(ii) This subparagraph may be illustrated by the following example.
For purposes of this example it is assumed that but for the neighborhood
land rule such property would be debt-financed property.
Example. Y, a calendar year exempt organization, acquires real
property in January 1970, which is contiguous with other property
[[Page 247]]
used by Y in furtherance of its exempt purpose. However, Y does not
satisfy the Commissioner by January 1975, that the existing structure
will be demolished and the land will be used in furtherance of its
exempt purpose. In accordance with this subparagraph, from 1975 until
the property is converted to an exempt use, the income derived from such
property shall be subject to the tax on unrelated business income.
During July 1979, Y demolishes the existing structure on the land and
begins using the land in furtherance of its exempt purpose. At this time
Y may file claims for refund for the open years 1976 through 1978.
Further, in accordance with this subparagraph, Y may also file a claim
for refund for 1975, even though a claim for such taxable year may be
barred by the statute of limitations, provided such claim is filed
before the close of 1980.
(e) Churches--(1) In general. If a church or association or
convention of churches acquires real property, for the principal purpose
of using the land in the exercise or performance of its exempt purpose,
commencing within 15 years of the time of acquisition, such property
shall not be treated as debt-financed property so long as the
organization does not abandon its intent to use the land in such a
manner within the 15-year period.
(2) Exception. This paragraph shall not apply to any property after
the expiration of the 15-year period. Further, this paragraph shall
apply after the first 5 years of the 15-year period only if the church
or association or convention of churches establishes to the satisfaction
of the Commissioner that use of the acquired land in furtherance of the
organization's exempt purpose before the expiration of the 15-year
period is reasonably certain. For purposes of the preceding sentence,
the rules contained in paragraph (d)(1)(iii) of this section with
respect to satisfying the Commissioner that the exempt organization
intends to use the land within the prescribed time in furtherance of its
exempt purpose shall apply.
(3) Actual use. If the church or association or convention of
churches for the period after the first 5 years of the 15-year period is
unable to establish to the satisfaction of the Commissioner that the use
of the acquired land for its exempt purpose within the 15-year period is
reasonably certain, but such land is in fact converted to an exempt use
within the 15-year period, the land (subject to the provisions of
paragraph (d)(4) of this section) shall not be treated as debt-financed
property for any period prior to such conversion.
(4) Limitations. The limitations stated in paragraph (d)(3)(i) and
(ii) of this section shall similarly apply to the rules contained in
this paragraph.
[T.D. 7229, 37 FR 28146, Dec. 21, 1972; 39 FR 6607, Feb. 21, 1974, as
amended by T.D. 7384, 40 FR 49322, Oct. 22, 1975; T.D. 7632, 44 FR
42681, July 20, 1979; T.D. 7728, 45 FR 72651, Nov. 3, 1980]
Sec. 1.514(c)-1 Acquisition indebtedness.
(a) In general--(1) Definition of acquisition indebtedness. For
purposes of section 514 and the regulations thereunder, the term
acquisition indebtedness means, with respect to any debt-financed
property, the outstanding amount of:
(i) The principal indebtedness incurred by the organization in
acquiring or improving such property.
(ii) The principal indebtedness incurred before the acquisition or
improvement of such property if such indebtedness would not have been
incurred but for such acquisition or improvement; and
(iii) The principal indebtedness incurred after the acquisition or
improvement of such property if such indebtedness would not have been
incurred but for such acquisition or improvement and the incurrence of
such indebtedness was reasonably foreseeable at the time of such
acquisition or improvement
Whether the incurrence of an indebtedness is reasonably foreseeable
depends upon the facts and circumstances of each situation. The fact
that an organization did not actually foresee the need for the
incurrence of an indebtedness prior to the acquisition or improvement
does not necessarily mean that the subsequent incurrence of indebtedness
was not reasonably foreseeable.
(2) Examples. The application of subparagraph (1) of this paragraph
may be illustrated by the following examples:
Example 1. X, an exempt organization, pledges some of its investment
securities with a bank for a loan and uses the proceeds of such loan to
purchase an office building
[[Page 248]]
which it leases to the public for purposes other than those described in
section 514(b)(1) (A), (B), (C), or (D). The outstanding principal
indebtedness with respect to the loan constitutes acquisition
indebtedness incurred prior to the acquisition which would not have been
incurred but for such acquisition.
Example 2. Y, an exempt scientific organization, mortgages its
laboratory to replace working capital used in remodeling an office
building which Y rents to an insurance company for purposes not
described in section 514(b)(1) (A), (B), (C), or (D). The indebtedness
is acquisition indebtedness since such indebtedness, though incurred
subsequent to the improvement of the office building, would not have
been incurred but for such improvement, and the indebtedness was
reasonably foreseeable when, to make such improvement, Y reduced its
working capital below the amount necessary to continue current
operations.
Example 3. (a) U, an exempt private preparatory school, as its sole
educational facility owns a classroom building which no longer meets the
needs of U's students. In 1971, U sells this building for $3 million to
Y, a corporation which it does not control. U receives $1 million as a
down payment from Y and takes back a purchase money mortgage of $2
million which bears interest at 10 percent per annum. At the time U
became the mortgagee of the $2 million purchase money mortgage, U
realized that it would have to construct a new classroom building and
knew that it would have to incur an indebtedness in the construction of
the new classroom building. In 1972, U builds a new classroom building
for a cost of $4 million. In connection with the construction of this
building, U borrows $2.5 million from X Bank pursuant to a deed of trust
bearing interest at 6 percent perannum. Under these circumstances, $2
million of the $2.5 million borrowed to finance construction of the new
classroom building would not have been borrowed but for the retention of
the $2 million purchase money mortgage. Since such indebtedness was
reasonably foreseeable, $2 million of the $2.5 million borrowed to
finance the construction of the new classroom building is acquisition
indebtedness with respect to the purchase money mortgage and the
purchase money mortgage is debt-financed property.
(b) In 1972, U receives $200,000 in interest from Y (10 percent of
$2 million) and makes a $150,000 interest payment to X (6 percent of
$2.5 million). In addition, assume that for 1972 the debt/basis
percentage is 100 percent ($2 million/$2 million). Accordingly, all the
interest and all the deductions directly connected with such interest
income are to be taken into account in computing unrelated business
taxable income. Thus, $200,000 of interest income and $120,000 ($150,000
x $2 million/$2.5 million) of deductions directly connected with such
interest income are taken into account. Under these circumstances, U
shall include net interest income of $80,000 ($200,000 of income less
$120,000 of deductions directly connected with such income) in its
unrelated business taxable income for 1972.
Example 4. In 1972 X, an exempt organization, forms a partnership
with A and B. The partnership agreement provides that all three partners
shall share equally in the profits of the partnership, shall each invest
$3 million, and that X shall be a limited partner. X invests $1 million
of its own funds in the partnership and $2 million of borrowed funds.
The partnership purchases as its sole asset an office building which is
leased to the general public for purposes other than those described in
section 514(b)(1) (A), (B), (C), or (D). The office building cost the
partnership $24 million of which $15 million is borrowed from Y bank.
This loan is secured by a mortgage on the entire office building. By
agreement with Y bank, X is held not to be personally liable for payment
of such mortgage. By reason of section 702(b) the character of any item
realized by the partnership and included in the partner's distributive
share shall be determined as if the partner realized such item directly
from the source from which it was realized by the partnership and in the
same manner. Therefore, a portion of X's income from the building is
debt-financed income. Under these circumstances, since both the $2
million indebtedness incurred by X in acquiring its partnership interest
and $5 million, the allocable portion of the partnership'sindebtedness
incurred with respect to acquiring the office building which is
attributable to X in computing the debt/basis percentage (one-third of
$15 million), were incurred in acquiring income-producing property, X
has acquisition indebtedness of $7 million ($2 million plus $5 million).
Similarly, the allocable portion of the partnership's adjusted basis in
the office building which is attributable to X in computing the debt-
basis percentage is $8 million (one-third of $24 million). Assuming no
payment with respect to either indebtedness and no adjustments to basis
in 1972, X's average acquisition indebtedness is $7 million and X's
average adjusted basis is $8 million for such year. Therefore, X's debt/
basis percentage with respect to its share of the partnership income for
1972 is 87.5 percent ($7 million/$8 million).
(3) Changes in use of property. Since property used in a manner
described in section 514(b)(1) (A), (B), (C), or (D) is not considered
debt-financed property, indebtedness with respect to such property is
not acquisition indebtedness. However, if an organization converts such
property to a use which is not described in section 514(b)(1) (A), (B),
(C),
[[Page 249]]
or (D) and such property is otherwise treated as debt-financed property,
the outstanding principal indebtedness with respect to such property
will thereafter be treated as acquisition indebtedness. For example,
assume that in 1971 a university borrows funds to acquire an apartment
building as housing for married students. In 1974 the university rents
the apartment building to the public for purposes not described in
section 514(b)(1) (A), (B), (C), or (D). The outstanding principal
indebtedness is acquisition indebtedness as of the time in 1974 when the
building is first rented to the public.
(4) Continued indebtedness. If:
(i) An organization sells or exchanges property, subject to an
indebtedness (incurred in a manner described in subparagraph (1) of this
paragraph),
(ii) Acquires another property without retiring the indebtedness,
and
(iii) The newly acquired property is otherwise treated as debt-
financed property
the outstanding principal indebtedness with respect to the acquired
property is acquisition indebtedness, even though the original property
was not debt-financed property. For example, to house its administrative
offices, an exempt organization purchases a building with $600,000 of
its own funds and $400,000 of borrowed funds secured by a pledge of its
securities. It later sells the building for $1,000,000 without redeeming
the pledge. It uses these proceeds to purchase an apartment building
which it rents to the public for purposes not described in section
514(b)(1) (A), (B), (C), or (D). The indebtedness of $400,000 is
acquisition indebtedness with respect to the apartment building even
though the office building was not debt-financed property.
(5) Indebtedness incurred before June 28, 1966. For taxable years
beginning before January 1, 1972, acquisition indebtedness does not
include any indebtedness incurred before June 28, 1966, unless such
indebtedness was incurred on rental real property subject to a business
lease and such indebtedness constituted business lease indebtedness.
Furthermore, in the case of a church or convention or association of
churches, the preceding sentence applies without regard to whether the
indebtedness incurred before June 28, 1966, constituted business lease
indebtedness.
(b) Property acquired subject to lien--(1) Mortgages. Except as
provided in subparagraphs (3) and (4) of this paragraph, whenever
property is acquired subject to a mortgage, the amount of the
outstanding principal indebtedness secured by such mortgage is treated
as acquisition indebtedness with respect to such property even though
the organization did not assume or agree to pay such indebtedness. The
preceding sentence applies whether property is acquired by purchase,
gift, devise, bequest, or any other means. Thus, for example, assume
that an exempt organization pays $50,000 for real property valued at
$150,000 and subject to a $100,000 mortgage. The $100,000 of outstanding
principal indebtedness is acquisition indebtedness just as though the
organization had borrowed $100,000 to buy the property.
(2) Other liens. For purposes of this paragraph, liens similar to
mortgages shall be treated as mortgages. A lien is similar to a mortgage
if title to property is encumbered by the lien for the benefit of a
creditor. However, in the case where State law provides that a tax lien
attaches to property prior to the time when such lien becomes due and
payable, such lien shall not be treated as similar to a mortgage until
after it has become due and payable and the organization has had an
opportunity to pay such lien in accordance with State law. Liens similar
to mortgages include (but are not limited to):
(i) Deeds of trust,
(ii) Conditional sales contracts,
(iii) Chattel mortgages,
(iv) Security interests under the Uniform Commercial Code,
(v) Pledges,
(vi) Agreements to hold title in escrow, and
(vii) Tax liens (other than those described in the third sentence of
this subparagraph).
(3) Certain encumbered property acquired by gift, bequest or
devise--(i) Bequest or devise. Where property subject to a mortgage is
acquired by an organization by bequest or devise, the outstanding
principal indebtedness secured by such mortgage is not to be
[[Page 250]]
treated as acquisition indebtedness during the 10-year period following
the date of acquisition. For purposes of the preceding sentence, the
date of acquisition is the date the organization receives the property.
(ii) Gifts. If an organization acquires property by gift subject to
a mortgage, the outstanding principal indebtedness secured by such
mortgage shall not be treated as acquisition indebtedness during the 10-
year period following the date of such gift, so long as:
(a) The mortgage was placed on the property more than 5 years before
the date of the gift, and
(b) The property was held by the donor for more than 5 years before
the date of the gift
For purposes of the preceding sentence, the date of the gift is the date
the organization receives the property.
(iii) Limitation. Subdivisions (i) and (ii) of this subparagraph
shall not apply if:
(a) The organization assumes and agrees to pay all or any part of
the indebtedness secured by the mortgage, or
(b) The organization makes any payment for the equity owned by the
decedent or the donor in the property (other than a payment pursuant to
an annuity excluded from the definition of acquisition indebtedness by
paragraph (e) of this section)
Whether an organization has assumed and agreed to pay all or any part of
an indebtedness in order to acquire the property shall be determined by
the facts and circumstances of each situation.
(iv) Examples. The application of this subparagraph may be
illustrated by the following examples:
Example 1. A dies on January 1, 1971. His will devises an office
building subject to a mortgage to U, an exempt organization described in
section 501(c)(3). U does not at any time assume the mortgage. For the
period 1971 through 1980, the outstanding principal indebtedness secured
by the mortgage is not acquisition indebtedness. However, after December
31, 1980, the outstanding principal indebtedness secured by the mortgage
is acquisition indebtedness if the building is otherwise treated as
debt-financed property.
Example 2. Assume the facts as stated in example 1 except that on
January 1, 1975, U assumes the mortgage. After January 1, 1975, the
outstanding principal indebtedness secured by the mortgage is
acquisition indebtedness if the building is otherwise treated as debt-
financed property.
(4) Bargain sale before October 9, 1969. Where property subject to a
mortgage is acquired by an organization before October 9, 1969, the
outstanding principal indebtedness secured by such mortgage is not to be
treated as acquisition indebtedness during the 10-year period following
the date of acquisition if:
(i) The mortgage was placed on the property more than 5 years before
the purchase, and
(ii) The organization paid the seller a total amount no greater than
the amount of the seller's cost (including attorney's fees) directly
related to the transfer of such property to the organization, but in any
event no more than 10 percent of the value of the seller's equity in the
property transferred.
(c) Extension of obligations--(1) In general. An extension, renewal,
or refinancing of an obligation evidencing a preexisting indebtedness is
considered as a continuation of the old indebtedness to the extent the
outstanding principal amount thereof is not increased. Where the
principal amount of the modified obligation exceeds the outstanding
principal amount of the preexisting indebtedness, the excess shall be
treated as a separate indebtedness for purposes of section 514 and the
regulations thereunder. For example, if the interest rate on an
obligation incurred prior to June 28, 1966, by an exempt university is
modified subsequent to such date, the modified obligation shall be
deemed to have been incurred prior to June 28, 1966. Thus, such an
indebtedness will not be treated as acquisition indebtedness for taxable
years beginning before January 1, 1972, unless the original indebtedness
was business lease indebtedness (as defined in Sec. 1.514(g)-1).
(2) Extension or renewal. In general, any modification or
substitution of the terms of an obligation by the organization shall be
an extension or renewal of the original obligation, rather than the
creation of a new indebtedness to the extent that the outstanding
principal amount of the indebtedness is not increased. The following are
examples of
[[Page 251]]
acts which result in the extension or renewal of an obligation:
(i) Substitution of liens to secure the obligation;
(ii) Substitution of obligees, whether or not with the consent of
the organization;
(iii) Renewal, extension or acceleration of the payment terms of the
obligation; and
(iv) Addition, deletion, or substitution of sureties or other
primary or secondary obligors.
(3) Allocation. In cases where the outstanding principal amount of
the modified obligation exceeds the outstanding principal amount of the
unmodified obligation and only a portion of such refinanced indebtedness
is to be treated as acquisition indebtedness, payments on the amount of
the refinanced indebtedness shall be apportioned prorata between the
amount of the preexisting indebtedness and the excess amount. For
example, assume that an organization has an outstanding principal
indebtedness of $500,000 which is treated as acquisition indebtedness.
It borrows another $100,000, which is not acquisition indebtedness, from
the same lending institution and gives the lender a $600,000 note for
its total obligation. In this situation, a payment of $60,000 on the
amount of the total obligation would reduce the acquisition indebtedness
by $50,000 and the excess indebtedness by $10,000.
(d) Indebtedness incurred in performing exempt purpose. Acquisition
indebtedness does not include the incurrence of an indebtedness inherent
in the performance or exercise of the purpose or function constituting
the basis of the organization's exemption. Thus, acquisition
indebtedness does not include the indebtedness incurred by an exempt
credit union in accepting deposits from its members or the obligation
incurred by an exempt organization in accepting payments from its
members to provide such members with insurance, retirement or other
similar benefits.
(e) Annuities--(1) Requirements. The obligation to make payment of
an annuity is not acquisition indebtedness if the annuity meets all the
following requirements:
(i) It must be the sole consideration (other than a mortgage to
which paragraph (b)(3) of this section applies) issued in exchange for
the property acquired;
(ii) At the time of the exchange, the present value of the annuity
(determined in accordance with subparagraph (2) of this paragraph) must
be less than 90 percent of the value of the prior owner's equity in the
property received in the exchange;
(iii) The annuity must be payable over the life of one individual in
being at the time the annuity is issued, or over the lives of two
individuals in being at such time; and
(iv) The annuity must be payable under a contract which:
(a) Does not guarantee a minimum number of payments or specify a
maximum number of payments, and
(b) Does not provide for any adjustment of the amount of the annuity
payments by reference to the income received from the transferred
property or any other property.
(2) Valuation. For purposes of this paragraph, the value of an
annuity at the time of exchange shall be computed in accordance with
section 1011(b), Sec. 1.1011-2(e)(1)(iii)(b)(2), and section 3 of Rev.
Rul. 62-216, C.B. 1962-2, 30.
(3) Examples. The application of this paragraph may be illustrated
by the following examples. For purposes of these examples it is assumed
that the property transferred is used for purposes other than those
described in section 514(b)(1) (A), (B), (C), or (D).
Example 1. On January 1, 1971, X, an exempt organization, receives
property valued at $100,000 from donor A, a male aged 60. In return X
promises to pay A $6,000 a year for the rest of A's life, with neither a
minimum nor maximum number of payments specified. The annuity is payble
on December 31, of each year. The amounts paid under the annuity are not
dependent on the income derived from the property transferred to X. The
present value of this annuity is $81,156, determined in accordance with
Table A of Rev. Rul. 62-216. Since the value of the annuity is less than
90 percent of A's equity in the property transferred and the annuity
meets all the other requirements of subparagraph (1) of this paragraph,
the obligation to make annuity payments is not acquisition indebtedness.
Example 2. On January 1, 1971, B transfers an office building to Y,
an exempt university, subject to a mortgage. In return Y agrees to pay B
$5,000 a year for the rest of
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his life, with neither a minimum nor maximum number of payments
specified. The amounts paid under the annuity are not dependent on the
income derived from the property transferred to Y. It is determined that
the actual value of the annuity is less than 90 percent of the value of
B's equity in the property transferred. Y does not assume the mortgage.
For the taxable years 1971 through 1980, the outstanding principal
indebtedness secured by the mortgage is not treated as acquisition
indebtedness. Further, Y's obligation to make annuity payments to B
never constitutes acquisition indebtedness.
(f) Certain Federal financing. Acquisition indebtedness does not
include an obligation to finance the purchase, rehabilitation, or
construction of housing for low and moderate income persons to the
extent that it is insured by the Federal Housing Administration. Thus,
for example, to the extent that an obligation is insured by the Federal
Housing Administration under section 221(d)(3) (12 U.S.C. 1715(I)(d)(3))
or section 236 (12 U.S.C. 1715z-1) of title II of the National Housing
Act, as amended, the obligation is not acquisition indebtedness.
(g) Certain obligations of charitable remainder trusts. For purposes
of section 664(c) and Sec. 1.664-1(c), a charitable remainder trust (as
defined in Sec. 1.664-1(a)(1)(iii)(a) does not incur acquisition
indebtedness when the sole consideration it is required to pay in
exchange for unencumbered property is an annuity amount or a unitrust
amount (as defined in Sec. 1.664-1(a)(1)(iii)(b) and (c)).
[T.D. 7229, 37 FR 28151, Dec. 21, 1972; 38 FR 21918, Aug. 14, 1973; T.D.
7698, 45 FR 33973, May 21, 1980]
Sec. 1.514(c)-2 Permitted allocations under section 514(c)(9)(E).
(a) Table of contents. This paragraph contains a listing of the
major headings of this Sec. 1.514(c)-2.
(a) Table of contents.
(b) Application of section 514(c)(9)(E), relating to debt-financed
real property held by partnerships.
(1) In general.
(i) The fractions rule.
(ii) Substantial economic effect.
(2) Manner in which fractions rule is applied.
(i) In general.
(ii) Subsequent changes.
(c) General definitions.
(1) Overall partnership income and loss.
(i) Items taken into account in determining overall partnership
income and loss.
(ii) Guaranteed payments to qualified organizations.
(2) Fractions rule percentage.
(3) Definitions of certain terms by cross reference to partnership
regulations.
(4) Example.
(d) Exclusion of reasonable preferred returns and guaranteed
payments.
(1) Overview.
(2) Preferred returns.
(3) Guaranteed payments.
(4) Reasonable amount.
(i) In general.
(ii) Safe harbor.
(5) Unreturned capital.
(i) In general.
(ii) Return of capital.
(6) Timing rules.
(i) Limitation on allocations of income with respect to reasonable
preferred returns for capital.
(ii) Reasonable guaranteed payments may be deducted only when paid
in cash.
(7) Examples.
(e) Chargebacks and offsets.
(1) In general.
(2) Disproportionate allocations.
(i) In general.
(ii) Limitation on chargebacks of partial allocations.
(3) Minimum gain chargebacks attributable to nonrecourse deductions.
(4) Minimum gain chargebacks attributable to distribution of
nonrecourse debt proceeds.
(i) Chargebacks disregarded until allocations made.
(ii) Certain minimum gain chargebacks related to returns of capital.
(5) Examples.
(f) Exclusion of reasonable partner-specific items of deduction or
loss.
(g) Exclusion of unlikely losses and deductions.
(h) Provisions preventing deficit capital account balances.
(i) [Reserved]
(j) Exception for partner nonrecourse deductions.
(1) Partner nonrecourse deductions disregarded until actually
allocated.
(2) Disproportionate allocation of partner nonrecourse deductions to
a qualified organization.
(k) Special rules.
(1) Changes in partnership allocations arising from a change in the
partners' interests.
(2) De minimis interest rule.
(i) In general.
(ii) Example.
(3) De minimis allocations disregarded.
(4) Anti-abuse rule.
(l) [Reserved]
(m) Tiered partnerships.
(1) In general.
[[Page 253]]
(2) Examples.
(n) Effective date.
(1) In general.
(2) General effective date of the regulations.
(3) Periods after June 24, 1990, and prior to December 30, 1992.
(4) Periods prior to the issuance of Notice 90-41.
(5) Material modifications to partnership agreements.
(b) Application of section 514(c)(9)(E), relating to debt-financed
real property held by partnerships--(1) In general. This Sec. 1.514(c)-
2 provides rules governing the application of section 514(c)(9)(E). To
comply with section 514(c)(9)(E), the following two requirements must be
met:
(i) The fractions rule. The allocation of items to a partner that is
a qualified organization cannot result in that partner having a
percentage share of overall partnership income for any partnership
taxable year greater than that partner's fractions rule percentage (as
defined in paragraph (c)(2) of this section).
(ii) Substantial economic effect. Each partnership allocation must
have substantial economic effect. However, allocations that cannot have
economic effect must be deemed to be in accordance with the partners'
interests in the partnership pursuant to Sec. 1.704-1(b)(4), or (if
Sec. 1.704-1(b)(4) does not provide a method for deeming the
allocations to be in accordance with the partners' interests in the
partnership) must otherwise comply with the requirements of Sec. 1.704-
1(b)(4). Allocations attributable to nonrecourse liabilities or partner
nonrecourse debt must comply with the requirements of Sec. 1.704-2(e)
or Sec. 1.704-2(i).
(2) Manner in which fractions rule is applied--(i) In general. A
partnership must satisfy the fractions rule both on a prospective basis
and on an actual basis for each taxable year of the partnership,
commencing with the first taxable year of the partnership in which the
partnership holds debt-financed real property and has a qualified
organization as a partner. Generally, a partnership does not qualify for
the unrelated business income tax exception provided by section
514(c)(9)(A) for any taxable year of its existence unless it satisfies
the fractions rule for every year the fractions rule applies. However,
if an actual allocation described in paragraph (e)(4), (h), (j)(2), or
(m)(1)(ii) of this section (regarding certain allocations that are
disregarded or not taken into account for purposes of the fractions rule
until an actual allocation is made) causes the partnership to violate
the fractions rule, the partnership ordinarily is treated as violating
the fractions rule only for the taxable year of the actual allocation
and subsequent taxable years. For purposes of applying the fractions
rule, the term partnership agreement is defined in accordance with Sec.
1.704-1(b)(2)(ii)(h), and informal understandings are considered part of
the partnership agreement in appropriate circumstances. See paragraph
(k) of this section for rules relating to changes in the partners'
interests and de minimis exceptions to the fractions rule.
(ii) Subsequent changes. A subsequent change to a partnership
agreement that causes the partnership to violate the fractions rule
ordinarily causes the partnership's income to fail the exception
provided by section 514(c)(9)(A) only for the taxable year of the change
and subsequent taxable years.
(c) General definitions--(1) Overall partnership income and loss.
Overall partnership income is the amount by which the aggregate items of
partnership income and gain for the taxable year exceed the aggregate
items of partnership loss and deduction for the year. Overall
partnership loss is the amount by which the aggregate items of
partnership loss and deduction for the taxable year exceed the aggregate
items of partnership income and gain for the year.
(i) Items taken into account in determining overall partnership
income and loss. Except as otherwise provided in this section, the
partnership items that are included in computing overall partnership
income or loss are those items of income, gain, loss, and deduction
(including expenditures described in section 705(a)(2)(B)) that increase
or decrease the partners' capital accounts under Sec. 1.704-
1(b)(2)(iv). Tax items allocable pursuant to section 704(c) or Sec.
1.704-1(b)(2)(iv)(f)(4) are not included
[[Page 254]]
in computing overall partnership income or loss. Nonetheless,
allocations pursuant to section 704(c) or Sec. 1.704-1(b)(2)(iv)(f)(4)
may be relevant in determining that this section is being applied in a
manner that is inconsistent with the fractions rule. See paragraph
(k)(4) of this section.
(ii) Guaranteed payments to qualified organizations. Except to the
extent otherwise provided in paragraph (d) of this section--
(A) A guaranteed payment to a qualified organization is not treated
as an item of partnership loss or deduction in computing overall
partnership income or loss; and
(B) Income that a qualified organization may receive or accrue with
respect to a guaranteed payment is treated as an allocable share of
overall partnership income or loss for purposes of the fractions rule.
(2) Fractions rule percentage. A qualified organization's fractions
rule percentage is that partner's percentage share of overall
partnership loss for the partnership taxable year for which that
partner's percentage share of overall partnership loss will be the
smallest.
(3) Definitions of certain terms by cross reference to partnership
regulations. Minimum gain chargeback, nonrecourse deduction, nonrecourse
liability, partner nonrecourse debt, partner nonrecourse debt minimum
gain, partner nonrecourse debt minimum gain chargeback, partner
nonrecourse deduction, and partnership minimum gain have the meanings
provided in Sec. 1.704-2.
(4) Example. The following example illustrates the provisions of
this paragraph (c).
Example. Computation of overall partnership income and loss for a
taxable year. (i) Taxable corporation TP and qualified organization QO
form a partnership to own and operate encumbered real property. Under
the partnership agreement, all items of income, gain, loss, deduction,
and credit are allocated 50 percent to TP and 50 percent to QO. Neither
partner is entitled to a preferred return. However, the partnership
agreement provides for a $900 guaranteed payment for services to QO in
each of the partnership's first two taxable years. No part of the
guaranteed payments qualify as a reasonable guaranteed payment under
paragraph (d) of this section.
(ii) The partnership violates the fractions rule. Due to the
existence of the guaranteed payment, QO's percentage share of any
overall partnership income in the first two years will exceed QO's
fractions rule percentage. For example, the partnership might have
bottom-line net income of $5,100 in its first taxable year that is
comprised of $10,000 of rental income, $4,000 of salary expense, and the
$900 guaranteed payment to QO. The guaranteed payment would not be
treated as an item of deduction in computing overall partnership income
or loss because it does not qualify as a reasonable guaranteed payment.
See paragraph (c)(1)(ii)(A) of this section. Accordingly, overall
partnership income for the year would be $6,000, which would consist of
$10,000 of rental income less $4,000 of salary expense. See paragraph
(c)(1)(i) of this section. The $900 QO would include in income with
respect to the guaranteed payment would be treated as an allocable share
of the $6,000 of overall partnership income. See paragraph (c)(1)(ii)(B)
of this section. Therefore, QO's allocable share of the overall
partnership income for the year would be $3,450, whichwould be comprised
of the $900 of income pertaining to QO's guaranteed payment, plus QO's
$2,550 allocable share of the partnership's net income for the year (50
percent of $5,100). QO's $3,450 allocable share of overall partnership
income would equal 58 percent of the $6,000 of overall partnership
income and would exceed QO's fractions rule percentage, which is less
than 50 percent. (If there were no guaranteed payment, QO's fractions
rule percentage would be 50 percent. However, the existence of the
guaranteed payment to QO that is not disregarded for purposes of the
fractions rule pursuant to paragraph (d) of this section means that QO's
fractions rule percentage is less than 50 percent.)
(d) Exclusion of reasonable preferred returns and guaranteed
payments--(1) Overview. This paragraph (d) sets forth requirements for
disregarding reasonable preferred returns for capital and reasonable
guaranteed payments for capital or services for purposes of the
fractions rule. To qualify, the preferred return or guaranteed payment
must be set forth in a binding, written partnership agreement.
(2) Preferred returns. Items of income (including gross income) and
gain that may be allocated to a partner with respect to a current or
cumulative reasonable preferred return for capital (including
allocations of minimum gain attributable to nonrecourse liability (or
partner nonrecourse debt) proceeds distributed to the partner as a
reasonable preferred return) are disregarded
[[Page 255]]
in computing overall partnership income or loss for purposes of the
fractions rule. Similarly, if a partnership agreement effects a
reasonable preferred return with an allocation of what would otherwise
be overall partnership income, those items comprising that allocation
are disregarded in computing overall partnership income for purposes of
the fractions rule.
(3) Guaranteed payments. A current or cumulative reasonable
guaranteed payment to a qualified organization for capital or services
is treated as an item of deduction in computing overall partnership
income or loss, and the income that the qualified organization may
receive or accrue from the current or cumulative reasonable guaranteed
payment is not treated as an allocable share of overall partnership
income or loss. The treatment of a guaranteed payment as reasonable for
purposes of section 514(c)(9)(E) does not affect its possible
characterization as unrelated business taxable income under other
provisions of the Internal Revenue Code.
(4) Reasonable amount--(i) In general. A guaranteed payment for
services is reasonable only to the extent the amount of the payment is
reasonable under Sec. 1.162-7 (relating to the deduction of
compensation for personal services). A preferred return or guaranteed
payment for capital is reasonable only to the extent it is computed,
with respect to unreturned capital, at a rate that is commercially
reasonable based on the relevant facts and circumstances.
(ii) Safe harbor. For purposes of this paragraph (d)(4), a rate is
deemed to be commercially reasonable if it is no greater than four
percentage points more than, or if it is no greater than 150 percent of,
the highest long-term applicable federal rate (AFR) within the meaning
of section 1274(d), for the month the partner's right to a preferred
return or guaranteed payment is first established or for any month in
the partnership taxable year for which the return or payment on capital
is computed. A rate in excess of the rates described in the preceding
sentence may be commercially reasonable, based on the relevant facts and
circumstances.
(5) Unreturned capital--(i) In general. Unreturned capital is
computed on a weighted-average basis and equals the excess of--
(A) The amount of money and the fair market value of property
contributed by the partner to the partnership (net of liabilities
assumed, or taken subject to, by the partnership); over
(B) The amount of money and the fair market value of property (net
of liabilities assumed, or taken subject to, by the partner) distributed
by the partnership to the partner as a return of capital.
(ii) Return of capital. In determining whether a distribution
constitutes a return of capital, all relevant facts and circumstances
are taken into account. However, the designation of distributions in a
written partnership agreement generally will be respected in determining
whether a distribution constitutes a return of capital, so long as the
designation is economically reasonable.
(6) Timing rules--(i) Limitation on allocations of income with
respect to reasonable preferred returns for capital. Items of income and
gain (or part of what would otherwise be overall partnership income)
that may be allocated to a partner in a taxable year with respect to a
reasonable preferred return for capital are disregarded for purposes of
the fractions rule only to the extent the allocable amount will not
exceed--
(A) The aggregate of the amount that has been distributed to the
partner as a reasonable preferred return for the taxable year of the
allocation and prior taxable years, on or before the due date (not
including extensions) for filing the partnership's return for the
taxable year of the allocation; minus
(B) The aggregate amount of corresponding income and gain (and what
would otherwise be overall partnership income) allocated to the partner
in all prior years.
(ii) Reasonable guaranteed payments may be deducted only when paid
in cash. If a partnership that avails itself of paragraph (d)(3) of this
section would otherwise be required (by virtue of its method of
accounting) to deduct a reasonable guaranteed payment to a qualified
organization earlier than the taxable year in which it is paid in cash,
[[Page 256]]
the partnership must delay the deduction of the guaranteed payment until
the taxable year it is paid in cash. For purposes of this paragraph
(d)(6)(ii), a guaranteed payment that is paid in cash on or before the
due date (not including extensions) for filing the partnership's return
for a taxable year may be treated as paid in that prior taxable year.
(7) Examples. The following examples illustrate the provisions of
this paragraph (d).
Facts. Qualified organization QO and taxable corporation TP form a
partnership. QO contributes $9,000 to the partnership and TP contributes
$1,000. The partnership borrows $50,000 from a third party lender and
purchases an office building for $55,000. At all relevant times the safe
harbor rate described in paragraph (d)(4)(ii) of this section equals 10
percent.
Example 1. Allocations made with respect to preferred returns. (i)
The partnership agreement provides that in each taxable year the
partnership's distributable cash is first to be distributed to QO as a
10 percent preferred return on its unreturned capital. To the extent the
partnership has insufficient cash to pay QO its preferred return in any
taxable year, the preferred return is compounded (at 10 percent) and is
to be paid in future years to the extent the partnership has
distributable cash. The partnership agreement first allocates gross
income and gain 100 percent to QO, to the extent cash has been
distributed to QO as a preferred return. All remaining profit or loss is
allocated 50 percent to QO and 50 percent to TP.
(ii) The partnership satisfies the fractions rule. Items of income
and gain that may be specially allocated to QO with respect to its
preferred return are disregarded in computing overall partnership income
or loss for purposes of the fractions rule because the requirements of
paragraph (d) of this section are satisfied. After disregarding those
allocations, QO's fractions rule percentage is 50 percent (see paragraph
(c)(2) of this section), and under the partnership agreement QO may not
be allocated more than 50 percent of overall partnership income in any
taxable year.
(iii) The facts are the same as in paragraph (i) of this Example 1,
except that QO's preferred return is computed on unreturned capital at a
rate that exceeds a commercially reasonable rate. The partnership
violates the fractions rule. The income and gain that may be specially
allocated to QO with respect to the preferred return is not disregarded
in computing overall partnership income or loss to the extent it exceeds
a commercially reasonable rate. See paragraph (d) of this section. As a
result, QO's fractions rule percentage is less than 50 percent (see
paragraph (c)(2) of this section), and allocations of income and gain to
QO with respect to its preferred return could result in QO being
allocated more than 50 percent of the overall partnership income in a
taxable year.
Example 2. Guaranteed payments and the computation of overall
partnership income or loss. (i) The partnership agreement allocates all
bottom-line partnership income and loss 50 percent to QO and 50 percent
to TP throughout the life of the partnership. The partnership agreement
provides that QO is entitled each year to a 10 percent guaranteed
payment on unreturned capital. To the extent the partnership is unable
to make a guaranteed payment in any taxable year, the unpaid amount is
compounded at 10 percent and is to be paid in future years.
(ii) Assuming the requirements of paragraph (d)(6)(ii) of this
section are met, the partnership satisfies the fractions rule. The
guaranteed payment is disregarded for purposes of the fractions rule
because it is computed with respect to unreturned capital at the safe
harbor rate described in paragraph (d)(4)(ii) of this section.
Therefore, the guaranteed payment is treated as an item of deduction in
computing overall partnership income or loss, and the corresponding
income that QO may receive or accrue with respect to the guaranteed
payment is not treated as an allocable share of overall partnership
income or loss. See paragraph (d)(3) of this section. Accordingly, QO's
fractions rule percentage is 50 percent (see paragraph (c)(2) of this
section), and under the partnership agreement QO may not be allocated
more than 50 percent of overall partnership income in any taxable year.
(e) Chargebacks and offsets--(1) In general. The following
allocations are disregarded in computing overall partnership income or
loss for purposes of the fractions rule--
(i) Allocations of what would otherwise be overall partnership
income that may be made to chargeback (i.e., reverse) prior
disproportionately large allocations of overall partnership loss (or
part of the overall partnership loss) to a qualified organization, and
allocations of what would otherwise be overall partnership loss that may
be made to chargeback prior disproportionately small allocations of
overall partnership income (or part of the overall partnership income)
to a qualified organization;
[[Page 257]]
(ii) Allocations of income or gain that may be made to a partner
pursuant to a minimum gain chargeback attributable to prior allocations
of nonrecourse deductions to the partner;
(iii) Allocations of income or gain that may be made to a partner
pursuant to a minimum gain chargeback attributable to prior allocations
of partner nonrecourse deductions to the partner and allocations of
income or gain that may be made to other partners to chargeback
compensating allocations of other losses, deductions, or section
705(a)(2)(B) expenditures to the other partners; and
(iv) Allocations of items of income or gain that may be made to a
partner pursuant to a qualified income offset, within the meaning of
Sec. 1.704-1(b)(2)(ii)(d).
(v) Allocations made in taxable years beginning on or after January
1, 2002, that are mandated by statute or regulation other than
subchapter K of chapter 1 of the Internal Revenue Code and the
regulations thereunder.
(2) Disproportionate allocations--(i) In general. To qualify under
paragraph (e)(1)(i) of this section, prior disproportionate allocations
may be reversed in full or in part, and in any order, but must be
reversed in the same ratio as originally made. A prior allocation is
disproportionately large if the qualified organization's percentage
share of that allocation exceeds its fractions rule percentage. A prior
allocation is disproportionately small if the qualified organization's
percentage share of that allocation is less than its fractions rule
percentage. However, a prior allocation (or allocations) is not
considered disproportionate unless the balance of the overall
partnership income or loss for the taxable year of the allocation is
allocated in a manner that would independently satisfy the fractions
rule.
(ii) Limitation on chargebacks of partial allocations. Except in the
case of a chargeback allocation pursuant to paragraph (e)(4) of this
section, and except as otherwise provided by the Internal Revenue
Service by revenue ruling, revenue procedure, or, on a case-by-case
basis, by letter ruling, paragraph (e)(1)(i) of this section applies to
a chargeback of an allocation of part of the overall partnership income
or loss only if that part consists of a pro rata portion of each item of
partnership income, gain, loss, and deduction (other than nonrecourse
deductions, as well as partner nonrecourse deductions and compensating
allocations) that is included in computing overall partnership income or
loss.
(3) Minimum gain chargebacks attributable to nonrecourse deductions.
Commencing with the first taxable year of the partnership in which a
minimum gain chargeback (or partner nonrecourse debt minimum gain
chargeback) occurs, a chargeback to a partner is attributable to
nonrecourse deductions (or separately, on a debt-by-debt basis, to
partner nonrecourse deductions) in the same proportion that the
partner's percentage share of the partnership minimum gain (or
separately, on a debt-by-debt basis, the partner nonrecourse debt
minimum gain) at the end of the immediately preceding taxable year is
attributable to nonrecourse deductions (or partner
nonrecoursedeductions). The partnership must determine the extent to
which a partner's percentage share of the partnership minimum gain (or
partner nonrecourse debt minimum gain) is attributable to deductions in
a reasonable and consistent manner. For example, in those cases in which
none of the exceptions contained in Sec. 1.704-2(f) (2) through (5) are
relevant, a partner's percentage share of the partnership minimum gain
generally is attributable to nonrecourse deductions in the same ratio
that--
(i) The aggregate amount of the nonrecourse deductions previously
allocated to the partner but not charged back in prior taxable years;
bears to
(ii) The sum of the amount described in paragraph (e)(3)(i) of this
section, plus the aggregate amount of distributions previously made to
the partner of proceeds of a nonrecourse liability allocable to an
increase in partnership minimum gain but not charged back in prior
taxable years.
(4) Minimum gain chargebacks attributable to distribution of
nonrecourse debt proceeds--(i) Chargebacks disregarded until allocations
made. Allocations of items of income and gain that may be made pursuant
to a provision in the
[[Page 258]]
partnership agreement that charges back minimum gain attributable to the
distribution of proceeds of a nonrecourse liability (or a partner
nonrecourse debt) are taken into account for purposes of the fractions
rule only to the extent an allocation is made. (See paragraph (d)(2) of
this section, pursuant to which there is permanently excluded chargeback
allocations of minimum gain that are attributable to proceeds
distributed as a reasonable preferred return.)
(ii) Certain minimum gain chargebacks related to returns of capital.
Allocations of items of income or gain that (in accordance with Sec.
1.704-2(f)(1)) may be made to a partner pursuant to a minimum gain
chargeback attributable to the distribution of proceeds of a nonrecourse
liability are disregarded in computing overall partnership income or
loss for purposes of the fractions rule to the extent that the
allocations (subject to the requirements of paragraph (e)(2) of this
section) also charge back prior disproportionately large allocations of
overall partnership loss (or part of the overall partnership loss) to a
qualified organization. This exception applies only to the extent the
disproportionately large allocation consisted of depreciation from real
property (other than items of nonrecourse deduction or partner
nonrecourse deduction) that subsequently was used to secure the
nonrecourse liability providing the distributed proceeds, and only if
those proceeds were distributed as a return of capital and in the same
proportion as the disproportionately large allocation.
(5) Examples. The following examples illustrate the provisions of
this paragraph (e).
Example 1. Chargebacks of disproportionately large allocations of
overall partnership loss. (i) Qualified organization QO and taxable
corporation TP form a partnership. QO contributes $900 to the
partnership and TP contributes $100. The partnership agreement allocates
overall partnership loss 50 percent to QO and 50 percent to TP until
TP's capital account is reduced to zero; then 100 percent to QO until
QO's capital account is reduced to zero; and thereafter 50 percent to QO
and 50 percent to TP. Overall partnership income is allocated first 100
percent to QO to chargeback overall partnership loss allocated 100
percent to QO, and thereafter 50 percent to QO and 50 percent to TP.
(ii) The partnership satisfies the fractions rule. QO's fractions
rule percentage is 50 percent. See paragraph (c)(2) of this section.
Therefore, the 100 percent allocation of overall partnership loss to QO
is disproportionately large. See paragraph (e)(2)(i) of this section.
Accordingly, the 100 percent allocation to QO of what would otherwise be
overall partnership income (if it were not disregarded), which charges
back the disproportionately large allocation of overall partnership
loss, is disregarded in computing overall partnership income and loss
for purposes of the fractions rule. The 100 percent allocation is in the
same ratio as the disproportionately large loss allocation, and the rest
of the allocations for the taxable year of the disproportionately large
loss allocation will independently satisfy the fractions rule. See
paragraph (e)(2)(i) of this section. After disregarding the chargeback
allocation of 100 percent of what would otherwise be overall partnership
income, QO will not be allocated a percentage share of overall
partnership income in excess of its fractions rule percentage for any
taxable year.
Example 2. Chargebacks of disproportionately small allocations of
overall partnership income. (i) Qualified organization QO and taxable
corporation TP form a partnership. QO contributes $900 to the
partnership and TP contributes $100. The partnership purchases real
property with money contributed by its partners and with money borrowed
by the partnership on a recourse basis. In any year, the partnership
agreement allocates the first $500 of overall partnership income 50
percent to QO and 50 percent to TP; the next $100 of overall partnership
income 100 percent to TP (as an incentive for TP to achieve significant
profitability in managing the partnership'soperations); and all
remaining overall partnership income 50 percent to QO and 50 percent to
TP. Overall partnership loss is allocated first 100 percent to TP to
chargeback overall partnership income allocated 100 percent to TP at any
time in the prior three years and not reversed; and thereafter 50
percent to QO and 50 percent to TP.
(ii) The partnership satisfies the fractions rule. QO's fractions
rule percentage is 50 percent because qualifying chargebacks are
disregarded pursuant to paragraph (e)(1)(i) in computing overall
partnership income or loss. See paragraph (c)(2) of this section. The
zero percent allocation to QO of what would otherwise be overall
partnership loss is a qualifying chargeback that is disregarded because
it is in the same ratio as the income allocation it charges back,
because the rest of the allocations for the taxable year of that income
allocation will independently satisfy the fractions rule (see paragraph
(e)(2)(i) of this section), and because it
[[Page 259]]
charges back an allocation of zero overall partnership income to QO,
which is proportionately smaller (i.e., disproportionately small) than
QO's 50 percent fractions rule percentage. After disregarding the
chargeback allocation of 100 percent of what would otherwise be overall
partnership loss, QO will not be allocated a percentage share of overall
partnership income in excess of its fractions rule percentage for any
taxable year.
Example 3. Chargebacks of partner nonrecourse deductions and
compensating allocations of other items. (i) Qualified organization QO
and taxable corporation TP form a partnership to own and operate
encumbered real property. QO and TP each contribute $500 to the
partnership. In addition, QO makes a $300 nonrecourse loan to the
partnership. The partnership agreement contains a partner nonrecourse
debt minimum gain chargeback provision and a provision that allocates
partner nonrecourse deductions to the partner who bears the economic
burden of the deductions in accordance with Sec. 1.704-2. The
partnership agreement also provides that to the extent partner
nonrecourse deductions are allocated to QO in any taxable year, other
compensating items of partnership loss or deduction (and, if
appropriate, section 705(a)(2)(B) expenditures) will first be allocated
100 percent to TP. In addition, to the extent items of income or gain
are allocated to QO in any taxable year pursuant to a partner
nonrecourse debt minimum gain chargeback of deductions, items of
partnership income and gain will first be allocated 100 percent to TP.
The partnership agreement allocates all other overall partnership income
or loss 50 percent to QO and 50 percent to TP.
(ii) The partnership satisfies the fractions rule on a prospective
basis. The allocations of the partner nonrecourse deductions and the
compensating allocation of other items of loss, deduction, and
expenditure that may be made to TP (but which will not be made unless
there is an allocation of partner nonrecourse deductions to QO) are not
taken into account for purposes of the fractions rule until a taxable
year in which an allocation is made. See paragraph (j)(1) of this
section. In addition, partner nonrecourse debt minimum gain chargebacks
of deductions and allocations of income or gain to other partners that
chargeback compensating allocations of other deductions are disregarded
in computing overall partnership income or loss for purposes of the
fractions rule. See paragraph (e)(1)(iii) of this section. Since all
other overall partnership income and loss is allocated 50 percent to QO
and 50 percent to TP, QO's fractions rule percentage is 50 percent (see
paragraph (c)(2) of this section), and QO will not be allocated a
percentage share of overall partnership income in excess of its
fractions rule percentage for any taxable year.
(iii) The facts are the same as in paragraph (i) of this Example 3,
except that the partnership agreement provides that compensating
allocations of loss or deduction (and section 705(a)(2)(B) expenditures)
to TP will not be charged back until year 10. The partners expect $300
of partner nonrecourse deductions to be allocated to QO in year 1 and
$300 of income or gain to be allocated to QO in year 2 pursuant to the
partner nonrecourse debt minimum gain chargeback provision.
(iv) The partnership fails to satisfy the fractions rule on a
prospective basis under the anti-abuse rule of paragraph (k)(4) of this
section. If the partners' expectations prove correct, at the end of year
2, QO will have been allocated $300 of partner nonrecourse deductions
and an offsetting $300 of partner nonrecourse debt minimum gain.
However, the $300 of compensating deductions and losses that may be
allocated to TP will not be charged back until year 10. Thus, during the
period beginning at the end of year 2 and ending eight years later,
there may be $300 more of unreversed deductions and losses allocated to
TP than to QO, which would be inconsistent with the purpose of the
fractions rule.
Example 4. Minimum gain chargeback attributable to distributions of
nonrecourse debt proceeds. (i) Qualified organization QO and taxable
corporation TP form a partnership. QO contributes $900 to the
partnership and TP contributes $100. The partnership agreement generally
allocates overall partnership income and loss 90 percent to QO and 10
percent to TP. However, the partnership agreement contains a minimum
gain chargeback provision, and also provides that in any partnership
taxable year in which there is a chargeback of partnership minimum gain
to QO attributable to distributions of proceeds of nonrecourse
liabilities, all other items comprising overall partnership income or
loss will be allocated in a manner such that QO is not allocated more
than 90 percent of the overall partnership income for the year.
(ii) The partnership satisfies the fractions rule on a prospective
basis. QO's fractions rule percentage is 90 percent. See paragraph
(c)(2) of this section. The chargeback that may be made to QO of minimum
gain attributable to distributions of nonrecourse liability proceeds is
taken into account for purposes of the fractions rule only to the extent
an allocation is made. See paragraph (e)(4) of this section.
Accordingly, that potential allocation to QO is disregarded in applying
the fractions rule on a prospective basis (see paragraph (b)(2) of this
section), and QO is treated as not being allocated a percentage share of
overall partnership income in excess of its fractions rule percentage in
any taxable year. (Similarly, QO is treated as not being allocated items
of income or gain in a
[[Page 260]]
taxable year when the partnership has an overall partnership loss.)
(iii) In year 3, the partnership borrows $400 on a nonrecourse basis
and distributes it to QO as a return of capital. In year 8, the
partnership has $400 of gross income and cash flow and $300 of overall
partnership income, and the partnership repays the $400 nonrecourse
borrowing.
(iv) The partnership violates the fractions rule for year 8 and all
future years. Pursuant to the minimum gain chargeback provision, the
entire $400 of partnership gross income is allocated to QO. Accordingly,
notwithstanding the curative provision in the partnership agreement that
would allocate to TP the next $44 (($400 / .9) x 10%) of income and gain
included in computing overall partnership income, the partnership has no
other items of income and gain to allocate to QO. Because the $400 of
gross income actually allocated to QO is taken into account for purposes
of the fractions rule in the year an allocation is made (see paragraph
(e)(4) of this section), QO's percentage share of overall partnership
income in year 8 is greater than 100 percent. Since this exceeds QO's
fractions rule percentage (i.e., 90 percent), the partnership violates
the fractions rule for year 8 and all subsequent taxable years. See
paragraph (b)(2) of this section.
(f) Exclusion of reasonable partner-specific items of deduction or
loss. Provided that the expenditures are allocated to the partners to
whom they are attributable, the following partner-specific expenditures
are disregarded in computing overall partnership income or loss for
purposes of the fractions rule--
(1) Expenditures for additional record-keeping and accounting
incurred in connection with the transfer of a partnership interest
(including expenditures incurred in computing basis adjustments under
section 743(b));
(2) Additional administrative costs that result from having a
foreign partner;
(3) State and local taxes or expenditures relating to those taxes;
and
(4) Expenditures designated by the Internal Revenue Service by
revenue ruling or revenue procedure, or, on a case-by-case basis, by
letter ruling. (See Sec. 601.601(d)(2)(ii)(b) of this chapter).
(g) Exclusion of unlikely losses and deductions. Unlikely losses or
deductions (other than items of nonrecourse deduction) that may be
specially allocated to partners that bear the economic burden of those
losses or deductions are disregarded in computing overall partnership
income or loss for purposes of the fractions rule, so long as a
principal purpose of the allocation is not tax avoidance. To be excluded
under this paragraph (g), a loss or deduction must have a low likelihood
of occurring, taking into account all relevant facts, circumstances, and
information available to the partners (including bona fide financial
projections). The types of events that may give rise to unlikely losses
or deductions, depending on the facts and circumstances, include tort
and other third-party litigation that give rise to unforeseen
liabilities in excess of reasonable insurance coverage; unanticipated
labor strikes; unusual delays in securing required permits or licenses;
abnormal weather conditions (considering the season and the job site);
significant delays in leasing property due to an unanticipated severe
economic downturn in the geographic area; unanticipated cost overruns;
and the discovery of environmental conditions that require remediation.
No inference is drawn as to whether a loss or deduction is unlikely from
the fact that the partnership agreement includes a provision for
allocating that loss or deduction.
(h) Provisions preventing deficit capital account balances. A
provision in the partnership agreement that allocates items of loss or
deduction away from a qualified organization in instances where
allocating those items to the qualified organization would cause or
increase a deficit balance in its capital account that the qualified
organization is not obligated to restore (within the meaning of Sec.
1.704-1(b)(2)(ii) (b) or (d)), is disregarded for purposes of the
fractions rule in taxable years of the partnership in which no such
allocations are made pursuant to the provision. However, this exception
applies only if, at the time the provision becomes part of the
partnership agreement, all relevant facts, circumstances, and
information (including bona fide financial projections) available to the
partners reasonably indicate that it is unlikely that an allocation will
be made pursuant to the provision during the life of the partnership.
(i) [Reserved]
[[Page 261]]
(j) Exception for partner nonrecourse deductions--(1) Partner
nonrecourse deductions disregarded until actually allocated. Items of
partner nonrecourse deduction that may be allocated to a partner
pursuant to Sec. 1.704-2, and compensating allocations of other items
of loss, deduction, and section 705(a)(2)(B) expenditures that may be
allocated to other partners, are not taken into account for purposes of
the fractions rule until the taxable years in which they are allocated.
(2) Disproportionate allocation of partner nonrecourse deductions to
a qualified organization. A violation of the fractions rule will be
disregarded if it arises because an allocation of partner nonrecourse
deductions to a qualified organization that is not motivated by tax
avoidance reduces another qualified organization's fractions rule
percentage below what it would have been absent the allocation of the
partner nonrecourse deductions.
(k) Special rules--(1) Changes in partnership allocations arising
from a change in the partners' interests. A qualified organization that
acquires a partnership interest from another qualified organization is
treated as a continuation of the prior qualified organization partner
(to the extent of that acquired interest) for purposes of applying the
fractions rule. Changes in partnership allocations that result from
other transfers or shifts of partnership interests will be closely
scrutinized (to determine whether the transfer or shift stems from a
prior agreement, understanding, or plan or could otherwise be expected
given the structure of the transaction), but generally will be taken
into account only in determining whether the partnership satisfies the
fractions rule in the taxable year of the change and subsequent taxable
years.
(2) De minimis interest rule--(i) In general. Section
514(c)(9)(B)(vi) does not apply to a partnership otherwise subject to
that section if--
(A) Qualified organizations do not hold, in the aggregate, interests
of greater than five percent in the capital or profits of the
partnership; and
(B) Taxable partners own substantial interests in the partnership
through which they participate in the partnership on substantially the
same terms as the qualified organization partners.
(ii) Example. Partnership PRS has two types of limited partnership
interests that participate in partnership profits and losses on
different terms. Qualified organizations (QOs) only own one type of
limited partnership interest and own no general partnership interests.
In the aggregate, the QOs own less than five percent of the capital and
profits of PRS. Taxable partners also own the same type of limited
partnership interest that the QOs own. These limited partnership
interests owned by the taxable partners are 30 percent of the capital
and profits of PRS. Thirty percent is a substantial interest in the
partnership. Therefore, PRS satisfies paragraph (k)(2) of this section
and section 514(c)(9)(B)(vi) does not apply.
(3) De minimis allocations disregarded. A qualified organization's
fractions rule percentage of the partnership's items of loss and
deduction, other than nonrecourse and partner nonrecourse deductions,
that are allocated away from the qualified organization and to other
partners in any taxable year are treated as having been allocated to the
qualified organization for purposes of the fractions rule if--
(i) The allocation was neither planned nor motivated by tax
avoidance; and
(ii) The total amount of those items of partnership loss or
deduction is less than both--
(A) One percent of the partnership's aggregate items of gross loss
and deduction for the taxable year; and
(B) $50,000.
(4) Anti-abuse rule. The purpose of the fractions rule is to prevent
tax avoidance by limiting the permanent or temporary transfer of tax
benefits from tax-exempt partners to taxable partners, whether by
directing income or gain to tax-exempt partners, by directing losses,
deductions, or credits to taxable partners, or by some other similar
manner. This section may not be applied in a manner that is inconsistent
with the purpose of the fractions rule.
(l) [Reserved]
(m) Tiered partnerships--(1) In general. If a qualified organization
holds an indirect interest in real property through
[[Page 262]]
one or more tiers of partnerships (a chain), the fractions rule is
satisfied only if--
(i) The avoidance of tax is not a principal purpose for using the
tiered-ownership structure (investing in separate real properties
through separate chains of partnerships so that section 514(c)(9)(E) is,
effectively, applied on a property-by-property basis is not, in and of
itself, a tax avoidance purpose); and
(ii) The relevant partnerships can demonstrate under any reasonable
method that the relevant chains satisfy the requirements of paragraphs
(b)(2) through (k) of this section. For purposes of applying Sec.
1.704-2(k) under the independent chain approach described in Example 3
of paragraph (m)(2) of this section, allocations of items of income or
gain that may be made pursuant to a provision in the partnership
agreement that charges back minimum gain are taken into account for
purposes of the fractions rule only to the extent an allocation is made.
(2) Examples. The following examples illustrate the provisions of
this paragraph (m).
Example 1. Tiered partnerships--collapsing approach. (i) Qualified
organization QO3 and taxable individual TP3 form upper-tier partnership
P2. The P2 partnership agreement allocates overall partnership income 20
percent to QO3 and 80 percent to TP3. Overall partnership loss is
allocated 30 percent to QO3 and 70 percent to TP3. P2 and taxable
individual TP2 form lower-tier partnership P1. The P1 partnership
agreement allocates overall partnership income 60 percent to P2 and 40
percent to TP2. Overall partnership loss is allocated 40 percent to P2
and 60 percent to TP2. The only asset of P2 (which has no outstanding
debt) is its interest in P1. P1 purchases real property with money
contributed by its partners and with borrowed money. There is no tax
avoidance purpose for the use of the tiered-ownership structure, which
is illustrated by the following diagram.
[GRAPHIC] [TIFF OMITTED] TR13MY94.006
(ii) P2 can demonstrate that the P2/P1 chain satisfies the
requirements of paragraphs (b)(2) through (k) of this section by
collapsing the tiered-partnership structure. On a collapsed basis, QO3's
fractions rule percentage is 12 percent (30 percent of 40 percent). See
paragraph (c)(2) of this section. P2 satisfies the fractions rule
because QO3 may not be allocated more than 12 percent (20 percent of 60
percent) of overall partnership income in any taxable year.
Example 2. Tiered partnerships--entity-by-entity approach. (i)
Qualified organization QO3A is a partner with taxable individual TP3A in
upper-tier partnership P2A. Qualified organization QO3B is a partner
with taxable individual TP3B in upper-tier partnership P2B. P2A, P2B,
and taxable individual TP2 are partners in lower-tier partnership P1,
which owns encumbered real estate. None of QO3A, QO3B, TP3A, TP3B or TP2
has a direct or indirect ownership interest in each other. P2A has been
established for the purpose of investing in numerous real estate
properties independently of P2B and its partners. P2B has been
established for the purpose of investing in numerous real estate
properties independently of P2A and its partners. Neither P2A nor P2B
has outstanding debt. There is no tax avoidance purpose for the use of
the tiered-ownership structure, which is illustrated by the following
diagram.
[GRAPHIC] [TIFF OMITTED] TR13MY94.007
(ii) The P2A/P1 chain (Chain A) will satisfy the fractions rule if
P1 and P2A can demonstrate in a reasonable manner that they satisfy the
requirements of paragraphs (b)(2) through (k) of this section. The P2B/
P1 chain (Chain B) will satisfy the fractions rule if P1 and P2B can
demonstrate in a reasonable manner that they satisfy the requirements of
paragraphs (b)(2) through (k) of this section. To meet its burden, P1
treats P2A and P2B as qualified organizations. Provided that the
allocations that may be made by P1 would satisfy the fractions rule if
P2A and P2B were direct qualified organization partners in P1, Chain A
will satisfy the fractions rule (for the benefit of QO3A) if the
allocations that may be made by P2A satisfy the
[[Page 263]]
requirements of paragraphs (b)(2) through (k) of this section.
Similarly, Chain B will satisfy the fractions rule (for the benefit of
QO3B) if the allocations that may be made by P2B satisfy the
requirements of paragraphs (b)(2) through (k) of this section. Under
these facts, QO3A does not have to know how income and loss may be
allocated by P2B, and QO3B does not have to know how income and loss may
be allocated by P2A. QO3A's and QO3B's burden would not change even if
TP2 were not a partner in P1.
Example 3. Tiered partnerships--independent chain approach. (i)
Qualified organization QO3 and taxable corporation TP3 form upper-tier
partnership P2. P2 and taxable corporation TP2 form lower-tier
partnership P1A. P2 and qualified organization QO2 form lower-tier
partnership P1B. P2 has no outstanding debt. P1A and P1B each purchase
real property with money contributed by their respective partners and
with borrowed money. Each partnership's real property is completely
unrelated to the real property owned by the other partnership. P1B's
allocations do not satisfy the requirements of paragraphs (b)(2) through
(k) of this section because of allocations that may be made to QO2.
However, if P2's interest in P1B were completely disregarded, the P2/P1A
chain would satisfy the requirements of paragraphs (b)(2) through (k) of
this section. There is no tax avoidance purpose for the use of the
tiered-ownership structure, which is illustrated by the following
diagram.
[GRAPHIC] [TIFF OMITTED] TR13MY94.008
(ii) P2 satisfies the fractions rule with respect to the P2/P1A
chain, but only if the P2 partnership agreement allocates those items
allocated to P2 by P1A separately from those items allocated to P2 by
P1B. For this purpose, allocations of items of income or gain that may
be made pursuant to a provision in the partnership agreement that
charges back minimum gain, are taken into account for purposes of the
fractions rule only to the extent an allocation is made. See paragraph
(m)(1)(ii) of this section. P2 does not satisfy the fractions rule with
respect to the P2/P1B chain.
(n) Effective date--(1) In general. Section 514(c)(9)(E), as amended
by sections 2004(h) (1) and (2) of the Technical and Miscellaneous
Revenue Act of 1988, Pub. L. 100-647, applies generally with respect to
property acquired by partnerships after October 13, 1987, and to
partnership interests acquired after October 13, 1987.
(2) General effective date of the regulations. Section 1.514(c)-2
(a) through (m) applies with respect to partnership agreements entered
into after December 30, 1992, property acquired by partnerships after
December 30, 1992, and partnership interests acquired by qualified
organizations after December 30, 1992 (other than a partnership interest
that at all times after October 13, 1987, and prior to the acquisition
was held by a qualified organization). For this purpose, paragraphs (a)
through (m) of this section will be treated as satisfied with respect to
partnership agreements entered into on or before May 13, 1994, property
acquired by partnerships on or before May 13, 1994, and partnership
interests acquired by qualified organizations on or before May 13, 1994,
if the guidance set forth in (paragraphs (a) through (m) of Sec.
1.514(c)-2 of) PS-56-90, published at 1993-5 I.R.B. 42, February 1,
1993, is satisfied. (See Sec. 601.601(d)(2)(ii)(b) of this chapter).
(3) Periods after June 24, 1990, and prior to December 30, 1992. To
satisfy the requirements of section 514(c)(9)(E) with respect to
partnership agreements entered into after June 24, 1990, property
acquired by partnerships after June 24, 1990, and partnership interests
acquired by qualified organizations after June 24, 1990, (other than a
partnership interest that at all times after October 13, 1987, and prior
to the acquisition was held by a qualified organization) to which
paragraph (n)(2) of this section does not apply, paragraphs (a) through
(m) of this section must be satisfied as of the first day that section
514(c)(9)(E) applies with respect to the partnership, property, or
acquired interest. For this purpose, paragraphs (a) through (m) of this
section will be treated as satisfied if the guidance in sections I
through VI of Notice 90-41, 90-1 C.B. 350, (see Sec.
601.601(d)(2)(ii)(b) of this chapter) has been followed.
(4) Periods prior to the issuance of Notice 90-41. With respect to
partnerships commencing after October 13, 1987, property acquired by
partnerships after
[[Page 264]]
October 13, 1987, and partnership interests acquired by qualified
organizations after October 13, 1987, to which neither paragraph (n)(2)
nor (n)(3) of this section applies, the Internal Revenue Service will
not challenge an interpretation of section 514(c)(9)(E) that is
reasonable in light of the underlying purposes of section 514(c)(9)(E)
(as reflected in its legislative history) and that is consistently
applied as of the first day that section 514(c)(9)(E) applies with
respect to the partnership, property, or acquired interest. A reasonable
interpretation includes an interpretation that substantially follows the
guidance in either sections I through VI of Notice 90-41, (see Sec.
601.601(d)(2)(ii)(b) of this chapter) or paragraphs (a) through (m) of
this section.
(5) Material modifications to partnership agreements. A material
modification will cause a partnership agreement to be treated as a new
partnership agreement in appropriate circumstances for purposes of this
paragraph (n).
[T.D. 8539, 59 FR 24928, May 13, 1994, as amended by T.D. 9047, 68 FR
12825, Mar. 18, 2003]
Sec. 1.514(d)-1 Basis of debt-financed property acquired in corporate
liquidation.
(a) If debt-financed property is acquired by an exempt organization
in a complete or partial liquidation of a corporation in exchange for
its stock, the organization's basis in such property shall be the same
as it would be in the hands of the transferor corporation, increased by
the amount of gain recognized to the transferor corporation upon such
distribution and by the amount of any gain which is includible, on
account of such distribution, in the gross income of the organization as
unrelated debt-financed income.
(b) The application of this section may be illustrated by the
following example:
Example. On July 1, 1970, T, an exempt trust, exchanges $15,000 of
borrowed funds for 50 percent of the shares of M Corporation's stock. M
uses $35,000 of borrowed funds in acquiring depreciable assets which are
not used at any time for purposes described in section 514(b)(1) (A),
(B), (C), or (D). On July 1, 1978, and for the 12-month period preceding
this date, T's acquisition indebtedness with respect to M's stock has
been $3,000. On this date, there is a complete liquidation of M
Corporation to which section 331(a)(1) applies. In the liquidation T
receives a distribution in kind of depreciable assets and assumes $7,000
of M's indebtedness which remains unpaid with respect to the depreciable
assets. On this date, M's adjusted basis of these depreciable assets is
$9,000, and such assets have a fair market value of $47,000. M
recognizes gain of $6,000 with respect to this liquidation pursuant to
sections 1245 and 1250. T realizes a gain of $25,000 (the difference
between the excess of fair market value of the property received over
the indebtedness assumed, $40,000 ($47,000-$7,000) and T's basis in M's
stock, $15,000). A portion of this gain is to be treated as unrelated
debt-financed income. This amount is determined by multiplying T's gain
of $25,000 by the debt/basis percentage. The debt/basis percentage is 20
percent, the ratio which the average acquisition indebtedness ($3,000)
is of the average adjusted basis ($15,000). Thus, $5,000 (20 percent of
$25,000) is unrelated debt-financed income. This amount and the gain
recognized pursuant to sections 1245 and 1250 are added to M's basis to
determine T's basis in the property received. Consequently, T's basis in
the property received from M Corporation is $20,000, determined as
follows:
M Corporation's adjusted basis.............................. $9,000
Gain recognized by M Corporation on the distribution........ 6,000
Unrelated debt-financed income recognized by T with respect 5,000
to the distribution........................................
-----------
T's transferred basis....................................... 20,000
[T.D. 7229, 37 FR 28153, Dec. 21, 1972]
Sec. 1.514(e)-1 Allocation rules.
Where only a portion of property is debt-financed property, proper
allocation of the basis, indebtedness, income, and deductions with
respect to such property must be made to determine the amount of income
or gain derived from such property which is to be treated as unrelated
debt-financed income. See examples 2 and 3 of paragraph (b)(1)(iii) of
Sec. 1.514(b)-1 and examples 1, (2), and (3) of paragraph (b)(3)(iii)
of Sec. 1.514(b)-1 for illustrations of proper allocation.
[T.D. 7229, 37 FR 28153, Dec. 21, 1972]
Sec. 1.514(f)-1 Definition of business lease.
(a) In general. The term business lease means any lease, with
certain exceptions discussed in paragraph (c) of this
[[Page 265]]
section, for a term of more than 5 years of real property by an
organization subject to section 511 (or by a partnership of which it is
a member) if at the close of the organization's taxable year there is a
business lease indebtedness as defined in section 514(g) and Sec.
1.514(g)-1 with respect to such property. For the purpose of this
section the term real property and the term premises include personal
property of the lessor tax-exempt organization leased by it to a lessee
of its real estate if the lease of such personal property is made under,
or in connection with, the lease of such real estate. For amounts of
business lease rents and deductions to be included in computing
unrelated business taxable income for taxable years beginning before
January 1, 1970, see Sec. 1.514(a)-2.
(b) Special rules. (1) In computing the term of the lease, the
period for which a lease may be renewed or extended by reason of an
option contained therein shall be considered as part of the term. For
example, a 3-year lease with an option for renewal for another such
period is considered a lease for a term of 6 years. Another example is
the case of a 1-year lease with option of renewal for another such term,
where the parties at the end of each year renew the arrangement. In this
case, during the fifth year (but not during the first 4 years), the
lease falls within the 5-year rule, since the lease then involves 5
years and there is an option for the sixth year. In determining the term
of the lease, an option for renewal of the lease is taken into account
whether or not the exercise of the option depends upon conditions or
contingencies.
(2) If the property is acquired subject to a lease, the term of such
lease shall be considered to begin on the date of such acquisition. For
example, if an exempt organization purchases, in whole or in part with
borrowed funds, real property subject to a 10-year lease which has 3
years left to run, and such lease contains no right of renewal or
extension, the lease shall be considered a 3-year lease and hence does
not meet the definition of a business lease in section 514(f) and
paragraph (a) of this section. However, if this lease contains an option
to renew for a period of 3 years or more, it is a business lease.
(3) Under the provisions of section 514(f)(2)(B) a lease is
considered as continuing for more than 5 years if the same lessee has
occupied the premises for a total period of more than 5 years, whether
the occupancy is under one or more leases, renewals, extensions, or
continuations. Continued occupancy shall be considered to be by the same
lessee if the occupants during the period are so related that losses in
respect of sales or exchanges of property between them would be
disallowed under section 267(a). Such period shall be considered as
commencing not earlier than the date of the acquisition of the property
by the tax-exempt organization or trust. This rule is applicable only in
the sixth and succeeding years of such occupancy by the same lessee.
See, however, paragraph (c)(3) of this section.
(c) Exceptions. (1) A lease shall not be considered a business lease
if such lease is entered into primarily for a purpose which is
substantially related (aside from the need of such organization for
income or funds, or the use it makes of the rents derived) to the
exercise or performance by such organization of its charitable,
educational, or other purpose or function constituting the basis for its
exemption. For example, where a tax-exempt hospital leases real property
owned by it to an association of doctors for use as a clinic, the rents
derived under such lease would not be included in computing unrelated
business taxable income if the clinic is substantially related to the
carrying on of hospital functions. See Sec. 1.513-1 for principles
applicable in determining whether there is a substantial relationship to
the exempt purpose of an organization.
(2) A lease is not a business lease if the lease is of premises in a
building primarily designed for occupancy and occupied by the tax-exempt
organization.
(3) If a lease for more than 5 years to a tenant is for only a
portion of the real property, and space in the real property is rented
during the taxable year under a lease for not more than 5 years to any
other tenant of the tax-exempt organization, all leases of the real
property for more than 5 years
[[Page 266]]
shall be considered as business leases during the taxable year only if:
(i) The rents derived from the real property during the taxable year
under leases for more than 5 years represent 50 percent or more of the
total rents derived during the taxable year from the real property; or
the area of the premises occupied under leases for more than 5 years
represents, at any time during the taxable year, 50 percent or more of
the total area of the real property rented at such time; or
(ii) The rent derived from the real property during the taxable year
from any tenant under a lease for more than 5 years, or from a group of
tenants (under such leases) who are either members of an affiliated
group (as defined in section 1504) or are partners, represents more than
10 percent of the total rents derived during the taxable year from such
property; or the area of the premises occupied by any one such tenant,
or by any such group of tenants, represents at any time during the
taxable year more than 10 percent of the total area of the real property
rented at such time
In determining whether 50 percent or more of the total rents are derived
from leases for more than 5 years, or whether 50 percent or more of the
total area is occupied under leases for more than 5 years:
(iii) An occupancy which is considered to be a lease of more than 5
years solely by reason of the provisions of paragraph (b)(3) of this
subparagraph shall not be treated as such a lease for purposes of
subdivision (i) of this subparagraph, and
(iv) An occupancy which is considered to be a lease of more than 5
years solely by reason of the provisions of paragraph (b)(3) of this
section shall be treated as such a lease for purposes of subdivision
(ii) of this subparagraph, and
(v) If during the last half of the term of a lease a new lease is
made to take effect after the expiration of such lease, the unexpired
portion of the first lease will not be added to the second lease to
determine whether such second lease is a lease for more than 5 years for
purposes of subdivision (i) of this subparagraph.
(4) The application of subparagraph (3) of this paragraph may be
illustrated by the following example:
Example. In 1954 an educational organization, which is on the
calendar year basis, begins the erection of an 11-story apartment
building using funds borrowed for that purpose, and immediately leases
for a 10-year term the first floor to a real estate development company
to sublet for stores and shops. As fast as the new apartments are
completed, they are rented on an annual basis. At the end of 1959 all
except the 10th and 11th floors are rented. Those two floors are
completed during 1960 and rented. Assume that for 1954 and each
subsequent taxable year through 1959, and for the taxable year 1963, the
gross rental for the first floor represents more than 10 percent of the
total gross rents derived during the taxable year from the building.
Under this set of facts the 10-year lease of the first floor would be
considered to be a business lease for all except the taxable years 1961,
1962, and 1964.
[T.D. 7229, 37 FR 28154, Dec. 21, 1972]
Sec. 1.514(g)-1 Business lease indebtedness.
(a) Definition. The term business lease indebtedness means, with
respect to any real property leased by a tax-exempt organization for a
term of more than 5 years, the unpaid amount of:
(1) The indebtedness incurred by the lessor tax-exempt organization
in acquiring or improving such property;
(2) The indebtedness incurred by the lessor tax-exempt organization
prior to the acquisition or improvement of such property if such
indebtedness would not have been incurred but for such acquisition or
improvement; and
(3) The indebtedness incurred by the lessor tax-exempt organization
subsequent to the acquisition or improvement of such property if such
indebtedness would not have been incurred but for such acquisition or
improvement and the incurrence of the indebtedness was reasonably
foreseeable at the time of such acquisition or improvement
See paragraph (i) of this section with respect to subsidiary
corporations.
(b) Examples. The rules of section 514(g) respecting business leases
also cover certain cases where the leased property itself is not subject
to an indebtedness. For example, they apply to cases such as the
following:
[[Page 267]]
Example 1. A university pledges some of its investment securities
with a bank for a loan and uses the proceeds of such loan to purchase
(either directly or through a subsidiary corporation) a building, which
building is subject to a lease that then has more than 5 years to run.
This would be an example of a business lease indebtedness incurred prior
to the acquisition of the property which would not have been incurred
but for such acquisition.
Example 2. If the building itself in example 1 in this paragraph is
later mortgaged to raise funds to release the pledged securities, the
lease would continue to be a business lease.
Example 3. If a scientific organization mortgages its laboratory
building to replace working capital used in remodeling another one of
its buildings or a building held by its subsidiary corporation, which
other building is free of indebtedness and is subject to a lease that
then has more than 5 years to run, the lease would be a business lease
inasmuch as the indebtedness though incurred subsequent to the
improvement of such property would not have been incurred but for such
improvement, and the incurrence of the indebtedness was reasonably
foreseeable when, to make such improvement, the organization reduced its
working capital below the amount necessary to continue current
operations.
(c) Property acquired subject to lien. Where real property is
acquired subject to a mortgage or similar lien, whether the acquisition
be by gift, bequest, devise, or purchase, the amount of the indebtedness
secured by such mortgage or lien is a business lease indebtedness
(unless paragraph (d)(1) of this section applies) even though the lessor
does not assume or agree to pay the indebtedness. For example, a
university pays $100,000 for real estate valued at $300,000 and subject
to a $200,000 mortgage. For the purpose of the tax on unrelated business
taxable income, the result is the same as if $200,000 of borrowed funds
had been used to buy the property.
(d) Certain property acquired by gifts, etc. (1) Where real property
was acquired by gift, bequest, or devise, before July 1, 1950, subject
to a mortgage or other similar lien, the amount of such mortgage or
other similar lien shall not be considered as an indebtedness of the
lessor tax-exempt organization incurred in acquiring such property. An
indebtedness not otherwise covered by this exception is not brought
within the exception by reason of a transfer of the property between a
parent and its subsidiary corporation.
(2) Where real property was acquired by gift, bequest, or devise,
before July 1, 1950, subject to a lease requiring improvements in such
property upon the happening of stated contingencies, indebtedness
incurred in improving such property in accordance with the terms of such
lease shall not be considered as indebtedness described in section
514(g) and in this section. An indebtedness not otherwise covered by
this exception is not brought within the exception by reason of a
transfer of the property between a parent and its subsidiary
corporation.
(e) Certain corporations described in section 501(c)(2). In the case
of a title holding corporation described in section 501(c)(2), all of
the stock of which was acquired before July 1, 1950, by an organization
described in section 501(c) (3), (5), or (6) (and more than one-third of
such stock was acquired by such organization by gift or bequest), any
indebtedness incurred by such corporation before July 1, 1950, and any
indebtedness incurred by such corporation on or after such date in
improving real property in accordance with the terms of a lease entered
into before such date, shall not be considered an indebtedness described
in section 514(g) and in this section with respect to either such
section 501(c)(2) corporation or such section 501(c) (3), (5), or (6)
organization.
(f) Certain trusts described in section 401(a). In the case of a
trust described in section 401(a), or in the case of a corporation
described in section 501(c)(2) all of the stock of which was acquired
before March 1, 1954, by such a trust, any indebtedness incurred by such
trust or such corporation before such date, in connection with real
property which is leased before such date, and any indebtedness incurred
by such trust or such corporation on or after such date necessary to
carry out the terms of such lease, shall not be considered as an
indebtedness described in section 514(g) and in this section.
(g) Business lease on portion of property. Where only a portion of
the real property is subject to a business lease, proper allocation of
the indebtedness applicable to the whole property must
[[Page 268]]
be made to the premises covered by the lease. See example 2 of paragraph
(b)(3) of Sec. 1.514(a)-2.
(h) Special rule applicable to trusts described in section 401(a).
If an employees' trust described in section 401(a) lends any money to
another such employees' trust of the same employer, for the purpose of
acquiring or improving real property, such loan will not be treated as
an indebtedness of the borrowing trust except to the extent that the
loaning trust:
(1) Incurs any indebtedness in order to make such loan;
(2) Incurred indebtedness before the making of such loan which would
not have been incurred but for the making of such loan; or
(3) Incurred indebtedness after the making of such loan which would
not have been incurred but for the making of such loan and which was
reasonably foreseeable at the time of making such loan.
(i) Subsidiary corporations. The provisions of section 514(f), (g),
and (h) are applicable whether or not a subsidiary corporation of the
type described in section 501(c)(2) is availed of in making the business
lease. For example, assume a parent organization borrows funds to
purchase realty and sets up a separate section 501(c)(2) corporation as
a subsidiary to hold the property. Such subsidiary corporation leases
the property for a period of more than 5 years, collects the rents and
pays over all of the income, less expenses, to the parent organization,
the parent organization being liable for the indebtedness. Under these
assumed facts, the lease by section 501(c)(2) subsidiary corporation
would be a business lease with respect to such subsidiary corporation,
and the rental income would be subject to the tax, whether or not the
subsidiary itself assumes the indebtedness and whether or not the
property is subject to the indebtedness.
(j) Certain trusts described in section 501(c)(17). (1) In the case
of a supplemental unemployment benefit trust described in section
501(c)(17), or in the case of a corporation described in section
501(c)(2) all of the stock of which was acquired before January 1, 1960,
by such a trust, any indebtedness incurred by such trust or such
corporation before such date, in connection with real property which is
leased before such date, and any indebtedness incurred by such trust or
such corporation on or after such date necessary to carry out the terms
of such lease, shall not be considered as an indebtedness described in
section 514(g) and in this section.
(2) If a supplemental unemployment benefit trust described in
section 501(c)(17) lends any money to another such supplemental
unemployment benefit trust forming part of the same plan, for the
purpose of acquiring or improving real property, such loan will not be
treated as an indebtedness of the borrowing trust except to the extent
that the loaning trust:
(i) Incurs any indebtedness in order to make such loan;
(ii) Incurred indebtedness before the making of such loan which
would not have been incurred but for the making of such loan; or
(iii) Incurred indebtedness after the making of such loan which
would not have been incurred but for the making of such loan and which
was reasonably foreseeable at the time of making such loan.
[T.D. 7229, 37 FR 28155, Dec. 21, 1972]
Farmers' Cooperatives
Sec. 1.521-1 Farmers' cooperative marketing and purchasing associations;
requirements for exemption under section 521.
(a)(1) Cooperative associations engaged in the marketing of farm
products for farmers, fruit growers, livestock growers, dairymen, etc.,
and turning back to the producers the proceeds of the sales of their
products, less the necessary operating expenses, on the basis of either
the quantity or the value of the products furnished by them, are exempt
from income tax except as otherwise provided in section 522, or part I,
subchapter T chapter 1 of the Code, and the regulations thereunder. For
instance, cooperative dairy companies which are engaged in collecting
milk and disposing of it or the products thereof and distributing the
proceeds, less necessary operating expenses, among the producers upon
the basis of either the quantity or the
[[Page 269]]
value of milk or of butterfat in the milk furnished by such producers,
are exempt from the tax. If the proceeds of the business are distributed
in anyother way than on such a proportionate basis, the association does
not meet the requirements of the Code and is not exempt. In other words,
nonmember patrons must be treated the same as members insofar as the
distribution of patronage dividends is concerned. Thus, if products are
marketed for nonmember producers, the proceeds of the sale, less
necessary operating expenses, must be returned to the patrons from the
sale of whose goods such proceeds result, whether or not such patrons
are members of the association. In order to show its cooperative nature
and to establish compliance with the requirement of the Code that the
proceeds of sales, less necessary expenses, be turned back to all
producers on the basis of either the quantity or the value of the
products furnished by them, it is necessary for such an association to
keep permanent records of the business done both with members and
nonmembers. The Code does not require, however, that the association
keep ledger accounts with each producer selling through the association.
Any permanent records which show that the association was operating
during the taxable year on a cooperative basis in the distribution of
patronage dividends to all producers will suffice. While under the Code
patronage dividends must be paid to all producers on the same basis,
this requirement is complied with if an association instead of paying
patronage dividends to nonmember producers incash, keeps permanent
records from which the proportionate shares of the patronage dividends
due to nonmember producers can be determined, and such shares are made
applicable toward the purchase price of a share of stock or of a
membership in the association. See, however, paragraph (c)(1) of Sec.
1.1388-1 for the meaning of payment in money for purposes of qualifying
a written notice of allocation.
(2) An association which has capital stock will not for such reason
be denied exemption (i) if the dividend rate of such stock is fixed at
not to exceed the legal rate of interest in the State of incorporation
or 8 percent per annum, whichever is greater, on the value of the
consideration for which the stock was issued, and (ii) if substantially
all of such stock (with the exception noted below) is owned by producers
who market their products or purchase their supplies and equipment
through the association. Any ownership of stock by others than such
actual producers must be satisfactorily explained in the association's
application for exemption. The association will be required to show that
the ownership of its capital stock has been restrictedas far as possible
to such actual producers. If by statutory requirement all officers of an
association must be shareholders, the ownership of a share of stock by a
nonproducer to qualify him as an officer will not destroy the
association's exemption. Likewise, if a shareholder for any reason
ceases to be a producer and the association is unable, because of a
constitutional restriction or prohibition or other reason beyond the
control of the association, to purchase or retire the stock of such
nonproducer, the fact that under such circumstances a small amount of
the outstanding capital stock is owned by shareholders who are no longer
producers will not destroy the exemption. The restriction placed on the
ownership of capital stock of an exempt cooperative association shall
not apply to nonvoting preferred stock, provided the owners of such
stock are not entitled or permitted to participate, directly or
indirectly, in the profits of the association, upon dissolution or
otherwise, beyond the fixed dividends.
(3) The accumulation and maintenance of a reserve required by State
statute, or the accumulation and maintenance of a reasonable reserve or
surplus for any necessary purpose, such as to provide for the erection
of buildings and facilities required in business or for the purchase and
installation of machinery and equipment or to retire indebtedness
incurred for such purposes, will not destroy the exemption. An
association will not be denied exemption because it markets the products
of nonmembers, provided the value of the products marketed for
nonmembers does not exceed the value of the products marketed for
members.
[[Page 270]]
Anyone who shares in the profits of a farmers' cooperative marketing
association, and is entitled to participate in the management of the
association, must be regarded as a member of such association within the
meaning of section 521.
(b) Cooperative associations engaged in the purchasing of supplies
and equipment for farmers, fruit growers, livestock growers, dairymen,
etc., and turning over such supplies and equipment to them at actual
cost, plus the necessary operating expenses, are exempt. The term
supplies and equipment as used in section 521 includes groceries and all
other goods and merchandise used by farmers in the operation and
maintenance of a farm or farmer's household. The provisions of paragraph
(a) of this section relating to a reserve or surplus and to capital
stock shall apply to associations coming under this paragraph. An
association which purchases supplies and equipment for nonmembers will
not for such reason be denied exemption, provided the value of the
purchases for nonmembers does not exceed the value of the supplies and
equipment purchased for members, and provided the value of the purchases
made for nonmembers who are not producers does not exceed 15 percent of
the value of all its purchases.
(c) In order to be exempt under either paragraph (a) or (b) of this
section an association must establish that it has no taxable income for
its own account other than that reflected in a reserve or surplus
authorized in paragraph (a) of this section. An association engaged both
in marketing farm products and in purchasing supplies and equipment is
exempt if as to each of its functions it meets the requirements of the
Code. Business done for the United States or any of its agencies shall
be disregarded in determining the right to exemption under section 521
and this section. An association to be entitled to exemption must not
only be organized but actually operated in the manner and for the
purposes specified in section 521.
(d) Cooperative organizations engaged in occupations dissimilar from
those of farmers, fruit growers, and the like, are not exempt.
(e) An organization is not exempt from taxation under this section
merely because it claims that it complies with the requirements
prescribed therein. In order to establish its exemption every
organization claiming exemption under section 521 is required to file a
Form 1028. The Form 1028, executed in accordance with the instructions
on the form or issued therewith, should be filed with the district
director for the internal revenue district in which is located the
principal place of business or principal office of the organization.
However, an organization which has been granted exemption under the
provisions of the Internal Revenue Code of 1939 or prior law may rely on
that ruling, unless affected by substantive changes in the Internal
Revenue Code of 1954 or any changes in the character, purposes, or
methods of operation of the organization, and it is not necessary in
such case for the organization to request a new determination as to its
exempt status.
(f) A cooperative association will not be denied exemption merely
because it makes payments solely in nonqualified written notices of
allocation to those patrons who do not consent as provided in section
1388 and Sec. 1.1388-1, but makes payments of 20 percent in cash and
the remainder in qualified written notices of allocation to those
patrons who do so consent. Nor will such an association be denied
exemption merely because, in the case of patrons who have so consented,
payments of less than $5 are made solely in nonqualified written notices
of allocation while payments of $5 or more are made in the form of 20
percent in cash and the remainder in qualified written notices of
allocation. In addition, a cooperative association will not be denied
exemption if it pays a smaller amount of interest or dividends on
nonqualified written notices of allocation held by persons who have not
consented as provided in section 1388 and Sec. 1.1388-1 (or on per-unit
retain certificates issued to patrons who are not qualifying patrons
with respect thereto within the meaning of Sec. 1.61-5(d)(2)) than it
pays on qualified written notices of allocation held by persons who have
so consented (or on per-unit retain certificates issued to patrons who
are qualifying patrons with
[[Page 271]]
respect thereto) provided that the amount of the interest or dividend
reduction isreasonable in relation to the fact that the association
receives no tax benefit with respect to such nonqualified written
notices of allocation (or such certificates issued to nonqualifying
patrons) until redeemed. However, such an association will be denied
exemption if it otherwise treats patrons who have not consented (or are
not qualifying patrons) differently from patrons who have consented (or
are qualifying patrons), either with regard to the original payment or
allocation or with regard to the redemption of written notices of
allocation or per-unit retain certificates. For example, if such an
association pays patronage dividends in the form of written notices of
allocation accompanied by qualified checks, and provides that any patron
who does not cash his check within a specified time will forfeit the
portion of the patronage dividend represented by such check, then the
cooperative association will be denied exemption under this section as
it does not treat all patrons alike.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6643, 28 FR
3162, Apr. 2, 1963; T.D. 6855, 30 FR 13135, Oct. 15, 1965]
Sec. 1.522-1 Tax treatment of farmers' cooperative marketing and
purchasing associations exempt under section 521.
(a) In general. (1) Section 522 is applicable to farmers', fruit
growers', or like associations organized and operated on a cooperative
basis in the manner prescribed in section 521. Although such an
association is subject to both normal tax and surtax, as in the case of
corporations generally, certain special rules for the computation of
taxable income are provided in section 522(b) and Sec. 1.522-2. For the
purpose of any law which refers to organizations exempt from income
taxes such an association shall, however, be considered as an
organization exempt under section 501. Thus, the provisions of section
243, providing a credit for dividends received from a domestic
corporation subject to taxation, are not applicable to dividends
received from a cooperative association subject to section 522. The
provisions of section 1501, relating to consolidated returns, are
likewise not applicable.
(2) Rules governing the manner in which amounts allocated as
patronage dividends, refunds, or rebates are to be taken into account in
computing the taxable income of such an association are set forth in
Sec. 1.522-3. For the tax treatment, as to patrons, of amounts received
during the taxable year as patronage dividends, rebates, or refunds, see
section 61 and Sec. 1.61-5.
(b) Meaning of terms. For purposes of Sec. Sec. 1.522-1 to 1.522-3,
inclusive, Sec. Sec. 1.6044-1 and 1.61-5, the following terms shall
have the meaning ascribed below:
(1) Cooperative association. The term cooperative association
includes any corporation operating on a cooperative basis and allocating
amounts to patrons on the basis of the business done with or for such
patrons, except that the term does not include any cooperative or
nonprofit corporation (including any cooperative or nonprofit
corporation engaged in rural electrification) exempt from taxation under
section 501(a) and described in section 501(c) (12) or (15) or any
corporation subject to a tax imposed by subchapter L, chapter 1 of the
Code (relating to insurance companies).
(2) Patron. The term patron includes any person with whom or for
whom the cooperative association does business on a cooperative basis,
whether a member or a nonmember of the cooperative association, and
whether an individual, a trust, estate, partnership, company,
corporation, or cooperative association.
(3) Allocation. The term allocation includes distributions made by a
cooperative association to a patron in cash, merchandise, capital stock,
revolving fund certificates, retain certificates, certificates of
indebtedness, letters of advice, similar documents, or in any other
manner whereby there is disclosed to a patron the dollar amount
apportioned on the books of the association for the account of such
patron. Thus, a mere credit to the account of a patron on the books of
the cooperative association, without disclosure to the patron, is not an
allocation.
(4) Patronage dividends, rebates, and refunds. The term patronage
dividend, rebate, or refund includes any amount
[[Page 272]]
allocated by a cooperative association, to the account of a patron on
the basis of the business done with or for such patron. The following
are not patronage dividends, rebates, or refunds:
(i) Amounts distributed in redemption of capital stock, or in
redemption or satisfaction of certificates of indebtedness, revolving
fund certificates, retain certificates, letters of advice, or other
similar documents;
(ii) Amounts allocated (whether in cash, merchandise, capital stock,
revolving fund certificates, retain certificates, certificates of
indebtedness, letters of advice, or in some other manner that discloses
to each patron the amount of such dividend, refund, or rebate) by the
association for products of members or other patrons to the extent such
amounts are fixed without reference to the earnings of the cooperative
association. For this purpose, the term earnings includes the excess of
amounts retained (or assessed) by the association to cover expenses or
other items over the amount of such expenses or other items.
(c) Examples. The application of paragraph (b) of this section may
be illustrated by the following examples:
Example 1. Cooperative A, a marketing association operating on a
pooling basis, receives the products of patron W on January 5, 1954. On
the same day Cooperative A advances to W 45 cents per unit for the
products so delivered and allocates to him a retain certificate having a
face value calculated at the rate of 5 cents per unit. During the
operatiion of the pool, and before substantially all the products in the
pool are disposed of, Cooperative A advances to W an additional 40 cents
per unit, the amount being determined by reference to the market price
of the products sold and the anticipated price of the unsold products.
At the close of the pool on November 10, 1954, Cooperative A determines
the excess of its receipts over the sum of its expenses and its previous
advances to patrons, and allocates to W an additional 3 cents per unit
and shares of the capital stock of A having an aggregate of face value
calculated at the rate of 2 cents per unit.
The amount of patronage dividends, rebates, or refunds allocated to
W during 1954 amount to 5 cents per unit, consisting of the aggregate of
the following per-unit allocations: The amount of cash distribution (3
cents), and the face value of the capital stock of A (2 cents), which
are fixed with reference to the earnings of A. The amount of the two
distributions in cash (85 cents) and the face amount of the retain
certificate (5 cents), which are fixed without reference to the earnings
of A, do not constitute patronage dividends, rebates, or refunds.
Example 2. Cooperative B, a marketing association operating on a
pooling basis, receives the products of patron X on March 5, 1954. On
the same day Cooperative B pays to X $1.00 per unit for such products,
this amount being determined by reference to the market price of the
product when received, and issues to him a participation certificate
having no face value but which entitles X on the close of the pool to
the proceeds derived from the sale of his products less the previous
payment of $1.00 and the expenses and other charges attributable to such
products. On March 5, 1957, Cooperative B, having sold the products in
the pool, having deducted the previous payments for such products, and
having determined the expenses and other charges of the pool, redeems
the participation certificate of X in cash for 10 cents per unit. The
allocation made to X during 1957, amounting to 10 cents per unit, is a
patronage dividend, rebate, or refund. Neither the payment to X in 1954
of $1.00 nor the issuance to him of the participation certificate in
that year constitutes a patronage dividend, rebate, or refund within the
meaning of this section.
Example 3. Cooperative C, a purchasing association, obtains supplies
for patron Y on May 1, 1954, and receives in return therefor $100. On
February 1, 1955, Cooperative C, having determined the excess of its
receipts over its costs and expenses, allocates to Y a cash distribution
of $1.00 and a revolving fund certificate of a face amount of $1.00. The
amount of patronage dividends, rebates, or refunds allocated to Y for
1955 is $2.00, the aggregate of the cash distribution of $1.00, and the
face amount, $1.00, of the revolving fund certificate.
Example 4. Cooperative D, a service association, sells the products
of members on a fee basis. It receives the products of patron Z under an
agreement not to pool his products with those of other members, to sell
his products, and to deliver to him the proceeds of the sale. Patron Z
makes payments to Cooperative D during 1954 aggregating $75 for service
rendered him by Cooperative D during that year. On May 15, 1955,
Cooperative D, having determined the excess of its receipts over its
costs and expenses, allocates to Z a cash distribution of $2.00. Such
amount is a patronage dividend, rebate, or refund allocated by
Cooperative D during 1955.
(d) Returns of exempt cooperative associations. For requirements of
annual returns by exempt cooperative associations, see sections 6012 and
6072(d) and paragraph (f) of Sec. 1.6012-2.
[[Page 273]]
Sec. 1.522-2 Manner of taxation of cooperative associations subject
to section 522.
(a) In general. Farmers', fruit growers', or like associations,
organized and operated in compliance with the requirements of section
521 and Sec. 1.521-1 shall be subject to the taxes imposed by section
11 or section 1201, except that there shall be allowed as deductions
from gross income, in addition to the other deductions allowable under
chapter 1 of the Code, certain special deductions provided in section
522(b)(1)(A) and paragraph (c) of this section, and section 522(b)(1)(B)
and paragraph (d) of this section. Amounts allocated as patronage
dividends, refunds, or rebates, whether in cash, merchandise, capital
stock, revolving fund certificates, retain certificates, certificates of
indebtedness, letters of advice, or in some other manner that discloses
to each patron the dollar amount allocated, with respect to patronage
for the taxable year or for preceding taxable years, shall be taken into
account in the manner provided in section 522 and in Sec. 1.522-3.
(b) Cooperative association exempt from tax before January 1, 1952.
(1) For the purpose of determining the method of accounting under
section 446 in the case of a cooperative association which was exempt
from tax for taxable years beginning prior to January 1, 1952, the
method of accounting, recognized under sections 41, 42, and 43 of the
Internal Revenue Code of 1939 and the regulations prescribed thereunder
and utilized in the return of such association for its last taxable year
to which the Internal Revenue Code of 1939 was applicable, shall be
deemed to constitute the method of accounting regularly employed by the
cooperative association. Any change from this method may be made only if
permission is obtained from the Commissioner to change to another
recognized method in accordance with section 446 and the regulations
thereunder.
(2) In any case where inventories are an income-producing factor,
see sections 471 and 472 and the regulations thereunder. The elective
method of inventorying goods provided in section 472 may be adopted by
the cooperative association for any taxable year beginning after
December 31, 1953, inaccordance with the requirements of section 472 and
the regulations thereunder. However, in order to use such method for
such a taxable year the cooperative association (unless it has used such
method for a taxable year beginning after 1951 and before 1954 pursuant
to an election exercised as provided in 26 CFR (1939) 39.22(d)-3
(Regulations 118) must exercise the election provided in section 472 and
the regulations thereunder, even if it may have utilized such method for
accounting purposes for taxable years beginning before January 1, 1952.
(3) The following rules shall be applicable in computing the net
operating loss deduction provided in section 172: No net operating loss
carryover shall be allowed from a taxable year beginning prior to
January 1, 1952, for which the cooperative association was exempt from
tax under section 101(12) of the Internal Revenue Code of 1939. In the
case of a taxable year beginning prior to January 1, 1952, for which the
association was not exempt under section 101(12) of the Internal Revenue
Code of 1939 and of any taxable year beginning after December 31, 1951,
the amount of the net operating loss carryback or carryover from such
year shall not be reduced by reference to the income of any taxable year
beginning prior to January 1, 1952, for which the association was exempt
from tax under section 101(12) of the Internal Revenue Code of 1939.
However, any taxable year beginning prior to January 1, 1952, for which
the cooperative association was exempt under section 101(12) of the
Internal Revenue Code of 1939 shall be taken into account in determining
the period for which a net operating loss may be carried back or carried
over, as the case may be.
(4) The adjustments to the cost or other basis provided in sections
1011 and 1016 and the regulations thereunder, are applicable for the
entire period since the acquisition of the property. Thus, proper
adjustment to basis must be made under section 1016 for depreciation,
obsolescence, amortization, and depletion for all taxable years
beginning prior to January 1, 1952, although the cooperative association
was exempt from tax under section 521 or
[[Page 274]]
corresponding provisions of prior law for such years. However, no
adjustment for percentage or discovery depletion is to be made for any
year during which the association was exempt from tax. If a cooperative
association has made a proper election in accordance with section 1020
and the regulations prescribed thereunder with respect to a taxable year
beginning before 1952 in which the association was not exempt from tax,
the adjustment to basis for depreciation for such years shall be limited
in accordance with the provisions of section 1016(a)(2).
(5) In the case of tax exempt and partially taxable bonds purchased
at a premium and subject to amortization under section 171, proper
adjustment to basis must be made to reflect amortization with respect to
such premium from the date of acquisition of the bond. (For principles
governing the method of computation, see the example in paragraph (b) of
Sec. 1.1016-9, relating to mutual savings banks, building and loan
associations, and cooperative banks.) The basis of a fully taxable bond
purchased at a premium shall be adjusted from the date of the election
to amortize such premium in accordance with the provisions of section
171 except that no adjustment shall be allowable for such portion of the
premium attributable to the period prior to the election.
(6) In the case of a mortgage acquired at a premium where the
principal of such mortgage is payable in installments, adjustments to
the basis for the premium must be made for all taxable years (whether or
not the association was exempt from tax under section 521 during such
years) in which installment payments are received. Such adjustments may
be made on an individual mortgage basis or on a composite basis by
reference to the average period of payments of the mortgage loans of
such association. For the purpose of this adjustment, the term premium
includes the excess of the acquisition value of the mortgage over its
maturity value. The acquisition value of the mortgage is the cost
including buying commissions, attorneys' fees or brokerage fees, but
such value does not include amounts paid for accrued interest.
(c) Deduction for dividends paid. There is allowable as a deduction
from the gross income of a cooperative association operated in
compliance with the requirements of section 521 and Sec. 1.521-1,
amounts paid as dividends during the taxable year upon the capital stock
of the cooperative association. For the purpose of the preceding
sentence, the term capital stock includes common stock (whether voting
or nonvoting), preferred stock, or any other form of capital represented
by capital retain certificates, revolving fund certificates, letters of
advice, or other evidence of a proprietary interest in a cooperative
association. Such deduction is applicable only to the taxable year in
which the dividends are actually or constructively paid to the holder of
capital stock or other proprietary interest of the cooperative
association. If a dividend is paid by check and the check bearing a date
within the taxable year is deposited in the mail, in a cover properly
stamped and addressed tothe shareholder at his last known address, at
such time that in the ordinary handling of the mails the check would be
received by such holder within the taxable year, a presumption arises
that the dividend was paid to such holder in such year. The
determination of whether a dividend has been paid to such holder by the
corporation during its taxable year is in no way dependent upon the
method of accounting regularly employed by the corporation in keeping
its books. For further rules as to the determination of the right to a
deduction for dividends paid, under certain specific circumstances, see
section 561 and the regulations thereunder.
(d) Deduction for amounts allocated from income not derived from
patronage. There is allowable as a deduction from the gross income of a
cooperative association operated in compliance with the requirements of
section 521 and Sec. 1.521-1 amounts allocated during the taxable year
to patrons with respect to its income not derived from patronage
(whether or not such income was derived during such taxable year)
whether such amounts are paid in cash, merchandise, capital stock,
revolving fund certificates, retain certificates, certificates of
indebtedness, letters of advice, or in some other manner that discloses
[[Page 275]]
to each patron the dollar amount allocated to him. For this purpose,
allocations made after the close of the taxable year and on or before
the 15th day of the ninth month following the close of the taxable year
shall be considered as made on the last day of such taxable year to the
extent that such allocations are attributable toincome derived during
the taxable year or during years prior to the taxable year. As used in
this paragraph, the term income not derived from patronage means
incidental income derived from sources not directly related to the
marketing, purchasing, or service activities of the cooperative
association. For example, income derived from the lease of premises,
from investment in securities, from the sale or exchange of capital
assets, constitutes income not derived from patronage. Business done
with the United States shall constitute income not derived from
patronage. In order that the deduction for income not derived from
patronage may be applicable, it is necessary that the amount sought to
be deducted be allocated on a patronage basis in proportion, insofar as
is practicable, to the amount of business done by or for patrons during
the period to which such income is attributable. Thus, if capital gains
are realized from the sale or exchange of capital assets acquired and
disposed of during the taxable year, income realized from such gains
must be allocated to patrons of such year in proportion to theamount of
business done by such patrons during the taxable year. Similarly, if
capital gains are realized by the association from the sale or exchange
of capital assets held for a period of more than one taxable year income
realized from such gains must be allocated, in proportion insofar as is
practicable, to the patrons of the taxable years during which the asset
was owned by the association, and to the amount of business done by such
patrons during such taxable years.
Sec. 1.522-3 Patronage dividends, rebates, or refunds; treatment as
to cooperative associations entitled to tax treatment under section 522.
(a) General rule. Patronage dividends, refunds, or rebates,
allocated by a cooperative association entitled to tax treatment under
section 522 to a patron shall be taken into account in computing the
gross income of such association for the taxable year, as an increase in
its other cost of goods sold in the case of an association marketing
products for patrons, or as a reduction in its gross receipts, in the
case of an association purchasing supplies and equipment or performing
services for patrons, as the case may be, if:
(1) The allocation is made in fulfillment and satisfaction of a
valid obligation of such association to the patron, which obligation was
in existence prior to the receipt by the cooperative association of the
amount allocated, and
(2) The allocation is made on or before the 15th day of the ninth
month following the close of the taxable year in which the amounts
allocated were received by the cooperative association
For the purpose of subparagraph (1) of this paragraph, amounts allocated
by a cooperative association entitled to tax treatment under section 522
will be deemed allocated in fulfillment and satisfaction of a valid
enforceable obligation, if made pursuant to provisions of the bylaws,
articles of incorporation, or other contract, whereby the association is
obligated to make such allocation after the retention of reasonable
reserves and after payment of dividends on capital stock or other
proprietary capital interests. Notwithstanding the provisions of
subparagraphs (1) and (2) of this paragraph, amounts allocated as
patronage dividends, refunds, or rebates during the taxable year, on or
before the 15th day of the ninth month following the close of such year,
with respect to patronage for years preceding the taxable year, shall be
taken into account as an increase in its other cost of goods sold, or as
a reduction in gross receipts, for the taxable year, as the case may be,
where retention as reasonable reserves of the amounts so allocated
beyond the year in which earned was proper in accordance with the
provisions of section 521 and where the allocation is made to the patron
on a patronage basis is proportion insofar as is practicable, to the
amount of business done by such patrons during the taxable year or years
in which the retained amounts were received by the cooperative
association.
[[Page 276]]
(b) Examples. This section may be illustrated by the following
examples:
Example 1. E, a cooperative association entitled to tax treatment
under section 522, organized without capital stock, is engaged in the
business of marketing products for its patrons on a non-pool basis. The
by-laws of Cooperative E provide that there shall be allocated to
patrons as patronage dividends within a reasonable time following the
close of the year all of the gross returns from sales, less expenses of
operation for the year and amounts retained as reasonable reserves
necessary to the operation of Cooperative E. At the close of the taxable
year, 1954, it is determined that from the gross returns from sales less
operating expenses and all taxes for such year, $5,000 is to be retained
as reasonable reserves for various necessary purposes of Cooperative E.
It is assumed that the retention of such amount is proper in accordance
with the provisions of section 521. Such $5,000 is apportioned on the
books of Cooperative E to patrons of 1954 on a patronage basis, or
permanent records are kept from which an apportionment to such patrons
can be made. On March 1, 1955, pursuant tothe terms of the by-laws,
$200,000, the balance of the gross returns for the taxable year, is
allocated to patrons of 1954 on the basis of patronage. $100,000 of such
$200,000 is allocated in cash. The remaining $100,000 is allocated in
retain certificates, bearing no interest and redeemable in the
discretion of the Board of Directors of Cooperative E. There may be
added to the cost of goods sold by Cooperative E for 1954, $200,000
($100,000 in cash, $100,000 in retain certificates), the total amount
allocated as patronage dividends, rebates, or refunds in fulfillment and
satisfaction of the obligation of the by-laws, on March 1, 1955, before
the 15th day of the ninth month following the close of 1954. There may
not be added to the cost of goods sold by Cooperative E for 1954,
$5,000, the amount retained as reserves apportioned on the books, but
not allocated as patronage dividends, rebates, or refunds.
Example 2. The facts are the same as example 1, it additionally
appearing that at the close of 1955 it is determined by Cooperative E to
allocate as cash patronage dividends, rebates, or refunds to patrons of
1954, $5,000, the amount retained as reasonable reserves for 1954 in
accordance with the provisions of section 521. On March 1, 1956, such
amount is allocated. There may be added to the cost of goods sold by
Cooperative E for 1955, $5,000, the amount allocated with respect to
patronage of a preceding year, 1954, properly maintained as a reserve
under section 521.
Sec. 1.522-4 Taxable years affected.
Section 522 and Sec. Sec. 1.522-1, 1.522-2, and 1.522-3, are
applicable to taxable years beginning before January 1, 1963, and also
to amounts paid during taxable years beginning after December 31, 1962,
the tax treatment of which is not prescribed in section 1382 and the
regulations thereunder.
[T.D. 6643, 28 FR 3163, Apr. 2, 1963]
Sec. 1.527-1 Political organizations; generally.
Section 527 provides that a political organization is considered an
organization exempt from income taxes for the purpose of any law which
refers to organizations exempt from income taxes. A political
organization is subject to tax only to the extent provided in section
527. In general, a political organization is an organization that is
organized and operated primarily for an exempt function as defined in
Sec. 1.527-2(c). Section 527 provides that a political organization is
taxed on its political organization taxable income (see Sec. 1.527-4)
which, in general, does not include the exempt function income (see
Sec. 1.527-3) of the political organization. Furthermore, section 527
provides that an exempt organization, other than a political
organization, may be subject to tax under section 527 when it expends an
amount for an exempt function, see Sec. 1.527-6. The taxation of
newsletter funds is provided under section 527(g) and Sec. 1.527-7. A
special rule for principal campaign committees is provided under section
527(h) and Sec. 1.527-9.
[T.D. 8041, 50 FR 30817, July 30, 1985]
Sec. 1.527-2 Definitions.
For purposes of section 527 and these regulations:
(a) Political organization--(1) In general. A political organization
is a party, committee, association, fund, or other organization (whether
or not incorporated) organized and operated primarily for the purpose of
directly or indirectly accepting contributions or making expenditures
for an exempt function activity (as defined in paragraph (c) of this
section). Accordingly, a political organization may include a committee
or other group which accepts contributions or makes expenditures for the
purpose of promoting the nomination of an individual for an
[[Page 277]]
elective public office in a primary election, or in a meeting or caucus
of a political party. A segregated fund (as defined in paragraph (b) of
this section) established and maintained by an individual may qualify as
a political organization.
(2) Organizational test. A political organization meets the
organizational test if its articles of organization provide that the
primary purpose of the organization is to carry on one or more exempt
functions. A political organization is not required to be formally
chartered or established as a corporation, trust, or association. If an
organization has no formal articles of organization, consideration is
given to statements of the members of the organization at the time the
organization is formed that they intend to operate the organization
primarily to carry on one or more exempt functions.
(3) Operational test. A political organization does not have to
engage exclusively in activities that are an exempt function. For
example, a political organization may:
(i) Sponsor nonpartisan educational workshops which are not intended
to influence or attempt to influence the selection, nomination,
election, or appointment of any individual for public office,
(ii) Pay an incumbent's office expenses, or
(iii) Carry on social activities which are unrelated to its exempt
function,
provided these are not the organization's primary activities. However,
expenditures for purposes described in the preceding sentence are not
for an exempt function. See Sec. 1.527-2 (c) and (d). Furthermore, it
is not necessary that a political organization operate in accordance
with normal corporate formalities as ordinarily established in bylaws or
under state law.
(b) Segregated fund--(1) General rule. A segregated fund is a fund
which is established and maintained by a political organization or an
individual separate from the assets of the organization or the personal
assets of the individual. The purpose of such a fund must be to receive
and segregate exempt function income (and earnings on such income) for
use only for an exempt function or for an activity necessary to fulfill
an exempt function. Accordingly, the amounts in the fund must be
dedicated for use only for an exempt function. Thus, expenditures for
the establishment or administration of a political organization or the
solicitation of political contributions may be made from the segregated
fund, if necessary to fulfill an exempt function. The fund must be
clearly identified and established for the pruposes intended. A savings
or checking account into which only contributions to the political
organization are placed and from which only expenditures for exempt
functions are made may be a segregated fund. If an organization that had
designated a fund to be a segregated fund for purposes of segregating
amounts referred to in section 527(c)(3) (A) through (D), expends more
than an insubstantial amount from the segregated fund for activities
that are not for an exempt function during a taxable year, the fund will
not be treated as a segregated fund for such year. In such a case
amounts referred to in section 527(c)(3)(A)-(D),segregated in such fund
will not be exempt function income. Further, if more than insubstantial
amounts segregated for an exempt function in prior years are expended
for other than an exempt function the facts and circumstances may
indicate that the fund was never a segregated fund as defined in this
paragraph.
(2) Record keeping. The organization or individual maintaining a
segregated fund must keep records that are adequate to verify receipts
and disbursements of the fund and identify the exempt function activity
for which each expenditure is made.
(c) Exempt function--(1) Directly related expenses. An exempt
function, as defined in section 527(e)(2), includes all activities that
are directly related to and support the process of influencing or
attempting to influence the selection, nomination, election, or
appointment of any individual to public office or office in a political
organization (the selection process). Whether an expenditure is for an
exempt function depends upon all the facts and circumstances. Generally,
where an organization supports an individual's campaign for public
office, the organization's activities and expenditures in
[[Page 278]]
futherance of the individual's election or appointment to that office
are for an exempt function of the organization. The individual does not
have to be an announced candidate for the office. Furthermore, the fact
that an individual never becomes a candidate is not crucial in
determining whether an organization is engaging in an exempt function.
An activity engaged in between elections which is directly related to,
and supports, the process of selection, nomination, or election of an
individual in the next applicable political campaign is an exempt
function activity.
(2) Indirect expenses. Expenditures that are not directly related to
influencing or attempting to influence the selection process may also be
an expenditure for an exempt function by a political organization. These
are expenses which are necessary to support the directly related
activities of the political organization. Activities which support the
directly related activities are those which must be engaged in to allow
the political organization to carry out the activity of influencing or
attempting to influence the selection process. For example, expenses for
overhead and record keeping are necessary to allow the political
organization to be established and to engage in political activities.
Similarly, expenses incurred in soliciting contributions to the
political organization are necessary to support the activities of the
political organization.
(3) Terminating activities. An exempt function includes an activity
which is in furtherance of the process of terminating a political
organization's existence. For example, where a political organization is
established for a single campaign, payment of campaign debts after the
conclusion of the campaign is an exempt function activity.
(4) Illegal expenditures. Expenditures which are illegal or are for
a judicially determined illegal activity are not considered expenditures
in furtherance of an exempt function, even though such expenditures are
made in connection with the selection process.
(5) Examples. The following examples illustrate the principles of
paragraph (c) of this section. The term exempt function when used in the
following examples means exempt function within the meaning of section
527(e)(2).
(i) Example 1. A wants to run for election to public office in State
X. A is not a candidate. A travels throughout X in order to rally
support for A's intended candidacy. While in X, A attends a convention
of an organization for the purpose of attempting to solicit its support.
The amount expended for travel, lodging, food, and similar expenses are
for an exempt function.
(ii) Example 2. B, a member of the United States House of
Representatives, is a candidate for reelection. B travels with B's
spouse to the district B represents. B feels it is important for B's
reelection that B's spouse accompany B. While in the district, B makes
speeches and appearances for the purpose of persuading voters to reelect
B. The travel expenses of B and B's spouse are for an exempt function.
(iii) Example 3. C is a candidate for public office. In connection
with C's campaign, C takes voice and speech lessons to improve C's
skills. The expenses for these lessons are for an exempt function.
(iv) Example 4. D, an officeholder and candidate for reelection,
purchases tickets to a testimonial dinner. D's attendance at the dinner
is intended to aid D's reelection. Such expenditures are for an exempt
function.
(v) Example 5. E, an officeholder, expends amounts for periodicals
of general circulation in order to keep informed on national and local
issues. Such expenditures are not for an exempt function.
(vi) Example 6. N is an organization described in section 501(c) and
is exempt from taxation under section 501(a). F is employed as president
of N. F, as a representative of N, testifies in response to a written
request from a Congressional committee in support of the confirmation of
an individual to a cabinet position. The expenditures by N that are
directly related to F's testimony are not for an exempt function.
(vii) Example 7. P is a political organization described in section
527(e)(2). Between elections P does not support any particular
individual for public office. However, P does train staff members for
the next election, drafts party
[[Page 279]]
rules, implements party reform proposals, and sponsors a party
convention. The expenditures for these activities are for an exempt
function.
(viii) Example 8. Q is a political organization described in section
527(e)(2). Q finances seminars and conferences which are intended to
influence persons who attend to support individuals to public office
whose political philosophy is in harmony with the political philosophy
of Q. The expenditures for these activities are for an exempt function.
(d) Public office. The facts and circumstances of each case will
determine whether a particular Federal, State, or local office is a
public office. Principles consistent with those found under Sec.
53.4946-1(g)(2) (relating to the definition of public office) will be
applied.
(e) Principal campaign committee. A principal campaign committee is
the political committee designated by a candidate for Congress as his or
her principal campaign committee for purposes of section 302(e) of the
Federal Election Campaign Act of 1971 (2 U.S.C. section 432(e)), as
amended, and section 527(h) and Sec. 1.527-9.
[T.D. 7744, 45 FR 85731, Dec. 30, 1980, as amended by T.D. 8041, 50 FR
30817, July 30, 1985]
Sec. 1.527-3 Exempt function income.
(a) General rule. (1) For purposes of section 527, exempt function
income consists solely of amounts received as:
(i) Contributions of money or other property,
(ii) Membership dues, fees, or assessments from a member of a
political organization, or
(iii) Proceeds from a political fund raising or entertainment event,
or proceeds from the sale of political campaign materials, which are not
received in the ordinary course of any trade or business,
but only to the extent such income is segregated for use only for exempt
functions of the political organization.
(2) Income will be considered segregated for use only for an exempt
function only if it is received into and disbursed from a segregated
fund as defined in Sec. 1.527-2(b).
(b) Contributions. The rules of section 271(b)(2) apply in
determining whether the transfer of money or other property constitutes
a contribution. Generally, money or other property, whether solicited
personally, by mail, or through advertising, qualifies as a
contribution. In addition, to the extent a political organization
receives Federal, State, or local funds under the $1 checkoff provision
(sections 9001-9013), or any other provision for financing of campaigns,
such amounts are to be treated as contributions.
(c) Dues, fees, and assessments. Amounts received as membership fees
and assessments from members of a political organization may constitute
exempt function income to the political organization. Membership fees
and assessments received in consideration for services, goods, or other
items of value do not constitute exempt function income. However, filing
fees paid by an individual directly or indirectly to a political party
in order that the individual may run as a candidate in a primary
election of the party (or run in a general election as a candidate of
that party) are to be treated as exempt function income. For example,
some States provide that a certain percentage of the first year's salary
of the office sought must be paid to the State as a filing (or
qualifying) fee and party assessment. The State then transfers part of
this fee to the candidate's party. In such a case, the entire amount
transferred to the party is to be treated as exempt function income.
Furthermore, amounts paid by an individual directly to the party as a
qualification fee are treated similarly.
(d) Fund raising events--(1) In general. Amounts received from fund
raising and entertainment events are eligible for treatment as exempt
function income if the events are political in nature and are not
carried on in the ordinary course of a trade or business. Whether an
event is political in nature depends on all facts and circumstances. One
factor that indicates an event is a political event is the extent to
which the event is related to a political activity aside from the need
of the organization for income or funds. For example, an event that is
intended to rally and encourage support for an individual for public
office would be a political fund raising event. Examples of political
[[Page 280]]
events can include dinners, breakfasts, receptions, picnics, dances, and
athletic exhibitions.
(2) Ordinary course of any trade or business. Whether an activity is
in the ordinary course of a trade or business depends on the facts and
circumstances of each case. Generally, proceeds from casual, sporadic
fund raising or entertainment events are not in the ordinary course of a
trade or business. Factors to be taken into account in determining
whether an activity is a trade or business include the frequency of the
activity, the manner in which the activity is conducted, and the span of
time over which the activity is carried on.
(e) Sale of campaign materials. Amounts received from the sale of
campaign materials are eligible for treatment as exempt function income
if the sale is not carried on in the ordinary course of a trade or
business (as defined in paragraph (d)(2) of this section), and is
related to a political activity of the organization aside from the need
of such organization for income or funds. Proceeds from the sale of
political memorabilia, bumper stickers, campaign buttons, hats, shirts,
political posters, stationery, jewelry, or cookbooks are related to such
a political acitivity where such items can be identified as relating to
distributing political literature or organizing voters to vote for a
candidate for public office.
[T.D. 7744, 45 FR 85732, Dec. 30, 1980]
Sec. 1.527-4 Special rules for computation of political organization
taxable income.
(a) In general. Political organization taxable income is determined
according to the provisions of section 527(b) and the rules set forth in
this section.
(b) Limitation on capital losses. If for any taxable year a
political organization has a net capital loss, the rules of sections
1211(a) and 1212(a) apply.
(c) Allowable deductions--(1) In general. To be deductible in
computing political organization taxable income, expenses, depreciation,
and similar items must not only qualify as deductions allowed by chapter
1 of the Code, but must also be directly connected with the production
of political organization taxable income.
(2) Directly connected with defined. To be directly connected with
the production of political organization taxable income, an item of
deduction must have a proximate and primary relationship to the
production of such income and have been incurred in the production of
such income. Items of deduction attributable solely to items of
political organization taxable income are proximately and primarily
related to such income. Whether an item of deduction is incurred in the
production of political organization taxable income is determined on the
basis of all the facts and circumstances of each case.
(3) Dual use of facilities or personnel. Expenses, depreciation, and
similar items that are attributable to the production of exempt function
income and political organization taxable income shall be allocated
between the two on a reasonable and consistent basis. For example, where
facilities are used both for an exempt function of the organization and
for the production of political organization taxable income, expenses,
depreciation, and similar items attributable to such facilities (for
example, items of overhead) shall be allocated between the two uses of a
reasonable and consistent basis. Similarly, where personnel are employed
both for an exempt function and for the production of political
organization taxable income, expenses and similar items attributable to
such personnel (for example, items of salary) shall be allocated between
the activities on a reasonable and consistent basis. The portion of any
such item so allocated to the production of political organization
taxable income is directly connected with such income and is allowable
as a deduction in computing political organization taxable income to the
extent that it qualifies as an item of deduction allowed by chapter 1 of
the Code. Thus, for example, assume that X, a political organization,
pays its manager a salary of $10,000 a year and that it derives
political organization taxable income. If 10 percent of the manager's
time during the year is devoted to deriving X's gross income (other than
exempt function income), a deduction of $1,000 (10 percent of $10,000)
[[Page 281]]
would generally be allowable for purposes of computing X's political
organization taxable income.
[T.D. 7744, 45 FR 85733, Dec. 30, 1980]
Sec. 1.527-5 Activities resulting in gross income to an individual or
political organization.
(a) In general--(1) General rule. Amounts expended by a political
organization for an exempt function are not income to the individual or
individuals on whose behalf such expenditures are made. However, where a
political organization expends any other amount for the personal use of
any individual, the individual on whose behalf the amount is expended
will be in receipt of income. Amounts are expended for the personal use
of an individual where a direct or indirect financial benefit accrues to
such individual. For example, if a political organization pays a
personal legal obligation of a candidate for public office, such as the
candidate's federal income tax liability, the amount paid is includible
in such candidate's gross income. Similarly, if a political organization
expends anyamount of its exempt function income for other than an exempt
function, and the expenditure results in a direct or indirect financial
benefit to the political organization, it must include the amount of
such expenditure in its gross income. For example, if a political
organization expends exempt function income for making an improvement or
addition to its facilities, or for equipment, which is not necessary for
or used in carrying out an exempt function, the amount of the
expenditure will be included in the political organization's gross
income. However, if a political organization expends exempt function
income to make ordinary and necessary repairs on the facilities the
political organization uses in conducting its exempt function, such
amounts will not be included in the political organization's gross
income.
(2) Expenditure for an illegal activity. Expenditures by a political
organization that are illegal or for an activity that is judicially
determined to be illegal are treated as amounts not segregated for use
only for the exempt function and shall be included in the political
organization's taxable income. However, expenses incurred in defense of
civil or criminal suits against the organization are not treated as
taxable to the organization. Similarly, voluntary reimbursement to the
participants in the illegal activity for similar expenses incurred by
them are not taxable to the organization if the organization can
demonstrate that such payments do not constitute a part of the
inducement to engage in the illegal activity or part of the agreed upon
compensation therefor. However, if the organization entered into an
agreement with the participants to defray such expenses as part of the
inducement, such payments would be treated as an expenditure for an
illegal activity. Except where necessary to prevent the period of
limitation for assessment and collection of a tax from expiring, a
notice of deficiency will not generally be issued until after there has
been a final determination of illegality by an appropriate court in a
criminal proceeding.
(b) Certain uses not treated as income to a candidate. Except as
otherwise provided in paragraph (a) of this section, if a political
organization:
(1) Contributes any amount to or for the use of any political
organization described in section 527(e)(1) or newsletter fund described
in section 527(g),
(2) Contributes any amount to or for the use of any organization
described in paragraph (1) and (2) of section 509(a) which is exempt
from taxation under section 501(a), or
(3) Deposits any amount in the general fund of the U.S. Treasury or
in the general fund of any State or local government,
such amount shall not be treated as an amount expended for the personal
use of a candidate or other person. No deduction shall be allowed under
the Internal Revenue Code of 1954 for the contribution or deposit
described in the preceding sentence.
(c) Excess funds--(1) General rule. Generally, funds controlled by a
political organization or other person after a campaign or election are
excess funds and are treated as expended for the personal use of the
person having control over the ultimate use of such funds.
[[Page 282]]
However, such funds will not be treated as excess funds to the extent
they are:
(i) Transferred within a reasonable period of time by the person
controlling the funds in accordance with paragraph (b) of this section,
or
(ii) Held in reasonable anticipation of being used by the political
organization for future exempt functions.
(2) Excess funds transferred at death. Where excess funds are held
by an individual who dies, and these funds go to the individual's estate
or any other person (other than an organization or fund described in
paragraph (b) of this section), the funds are income of the decedent and
will be included in the decedent's gross estate unless the estate or
other person receiving such funds transfers the funds within a
reasonable period of time in accordance with paragraph (b) of this
section.
This paragraph (c)(2) will not apply where the individual who dies
provides that the funds be transferred to an organization or fund
described in paragraph (b) of this section.
[T.D. 7744, 45 FR 85733, Dec. 30, 1980]
Sec. 1.527-6 Inclusion of certain amounts in the gross income of an
exempt organization which is not a political organization.
(a) Exempt organizations--General rule. If an organization described
in section 501(c) which is exempt from tax under section 501(a) expends
any amount for an exempt function, it may be subject to tax. There is
included in the gross income of such organization for the taxable year
an amount equal to the lesser of:
(1) The net investment income of such organization for the taxable
year, or
(2) The aggregate amount expended during the taxable year for an
exempt function.
The amount included will be treated as political organization taxable
income.
(b) Exempt function expenditures--(1) Directly related expenses. (i)
Except as provided in this section, the term exempt function will
generally have the same meaning it has in Sec. 1.527-2(c). Thus,
expenditures which are directly related to the selection process as
defined in Sec. 1.527-2(c)(1) are expenditures for an exempt function.
Expenditures for indirect expenses as defined in Sec. 1.527-2(c)(2),
when made by a section 501(c) organization are for an exempt function
only to the extent provided in paragraph (b)(2) of this section.
Expenditures of a section 501 (c) organization which are otherwise
allowable under the Federal Election Campaign Act or similar State
statute are for an exempt function only to the extent provided in
paragraph (b)(3) of this section.
(ii) An expenditure may be made for an exempt function directly or
through another organization. A section 501(c) organization will not be
absolutely liable under section 527(f)(1) for amounts transferred to an
individual or organization. A section 501(c) organization is, however,
required to take reasonable steps to ensure that the transferee does not
use such amounts for an exempt function.
(2) Indirect expenses. [Reserved]
(3) Expenditures allowed by Federal Election Campaign Act.
[Reserved]
(4) Appointments or confirmations. Where an organization described
in paragraph (a) of this section appears before any legislative body in
response to a written request by such body for the purpose of
influencing the appointment or confirmation of an individual to a public
office, any expenditure directly related to such appearance is not
treated as an expenditure for an exempt function.
(5) Nonpartisan activity. Expenditures for nonpartisan activities by
an organization to which paragraph (a) of this section applies are not
expenditures for an exempt function. Nonpartisan activities include
voter registration and get-out-the-vote campaigns. To be nonpartisan
voter registration and get-out-the-vote campaigns must not be
specifically identified by the organization with any candidate or
political party.
(c) Character of items included in gross income--(1) General rule.
The items of income included in the gross income of an organization
under paragraph (a) of this section retain their character as ordinary
income or capital gain.
(2) Special rule in determining character of item. If the amount
included in gross income is determined under paragraph (a)(2)(ii) of
this section, the character of the items of income is determined
[[Page 283]]
by multiplying the total amount included in gross income under such
paragraph by a fraction, the numerator of which is the portion of the
organization's net investment income that is gain from the sale or
exchange of a capital asset, and the denominator of which is the
organization's net investment income. For example, if $5,000 is included
in the gross income of an organization under paragraph (a)(2) of this
section, and the organization had $100,000 of net investment income of
which $10,000 is long term capital gain, then $500 would be treated as
long term capital gain:
[GRAPHIC] [TIFF OMITTED] TC08OC91.002
(d) Modifications. The modifications described in section 527(c)(2)
apply in computing the tax under paragraph (a)(2) of this section. Thus,
no net operating loss is allowed under section 172 nor is any deduction
allowed under part VIII of subchapter B. However, there is allowed a
specific deduction of $100.
(e) Transfer not treated as exempt function expenditures. Provided
the provisions of this paragraph (e) are met, a transfer of political
contributions or dues collected by a section 501(c) organization to a
separate segregated fund as defined in paragraph (f) of this section is
not treated as an expenditure for an exempt function (within the meaning
of Sec. 1.527-2(c)). Such transfers must be made promptly after the
receipt of such amounts by the section 501(c) organization, and must be
made directly to the separate segregated fund. A transfer is considered
promptly and directly made if:
(1) The procedures followed by the section 501(c) organization
satisfy the requirements of applicable Federal or State campaign law and
regulations;
(2) The section 501(c) organization maintains adequate records to
demonstrate that amounts transferred in fact consist of political
contributions or dues, rather than investment income; and
(3) The political contributions or dues transferred were not used to
earn investment income for the section 501(c) organization.
(f) Separate segregated fund. An organization or fund described in
section 527(f)(3) is a separate segregated fund. To avoid the
application of paragraph (a) of this section, an organization described
in section 501(c) that is exempt from taxation under section 501(a) may,
if it is consistent with its exempt status, establish and maintain such
a separate segregated fund to receive contributions and make
expenditures in a political campaign. If such a fund meets the
requirements of Sec. 1.527-2(a) (relating to the definition of a
political organization), it shall be treated as a political organization
subject to the provisions of section 527. A segregated fund established
under the Federal Election Campaign Act will continue to be treated as a
segregated fund when it engages in exempt function activities as defined
in Sec. 1.527-2(c), relating to State campaigns.
(g) Effect of expenditures on exempt status. Section 527(f) and this
section do not sanction the intervention in any political campaign by an
organization described in section 501(c) if such activity is
inconsistent with its exempt status under section 501(c). For example,
an organization described in section 501(c)(3) is precluded from
engaging in any political campaign activities. The fact that section 527
imposes a tax on the exempt function (as defined in Sec. 1.527-2(c))
expenditures of section 501(c) organizations and permits such
organizations to establish separate segregated funds to engage in
campaign
[[Page 284]]
activities does not sanction the participation in these activities by
section 501(c)(3) organizations.
[T.D. 7744, 45 FR 85734, Dec. 30, 1980]
Sec. 1.527-7 Newsletter funds.
(a) In general. For purposes of this section, a fund established and
maintained by an individual who holds, has been elected to, or is a
candidate (within the meaning of section 41(c)(2)) for nomination or
election to, any Federal, State, or local elective public office for the
use by such individual exclusively for an exempt function, as defined in
paragraph (c) of this section, shall be a newsletter fund. If assets of
a newsletter fund are used for any purpose other than the exempt
function of the newsletter fund as defined in paragraph (c) of this
section, such amount shall be treated as expended for the personal use
of the individual who established and maintained such fund. In addition,
future contributions to such fund are treated as income to the
individual who established and maintained the fund. In such a case, the
facts and circumstances may indicate that the fund was never established
and maintained exclusively for an exempt function as defined in
paragraph (c) of this section.
(b) Determination of taxable income. A newsletter fund shall be
treated as if it were a political organization for purposes of
determining its taxable income. However, the specific $100 deduction
provided by section 527(c)(2)(A) shall not be allowed.
(c) Exempt function. For purposes of this section, the exempt
function of a newsletter fund consists solely of the preparation and
circulation of the newsletter. Among the expenditures treated as
preparation and circulation expenditures of the newsletter are:
(1) Secretarial services,
(2) Printing,
(3) Addressing, and
(4) Mailing.
(d) Nonexempt function purposes. Newsletter fund assets may not be
used for campaign activities. Therefore, an exempt function of a
newsletter fund does not include:
(1) Expenditures for an exempt function as defined in Sec. 1.527-
2(c) or
(2) Transfers of unexpended amounts to a political organization
described in section 527(e)(1).
(e) Excess funds. Excess funds held by a newsletter fund which has
ceased to engage in the preparation and circulation of the newsletter
are treated as expended for the personal use of the individual who
established and maintained such fund. However, to the extent such excess
funds are within a reasonable period of time:
(1) Contributed to or for the use of any organization described in
paragraph (1) or (2) of section 509(a) which is exempt from taxation
under section 501(a),
(2) Deposited in the general fund of the U.S. Treasury or in the
general fund of any State or local government (including the District of
Columbia), or
(3) Contributed to any other newsletter fund as described in
paragraph (a) of this section,
the excess funds are not treated as expended for the personal use of
such individual. In such a case the individual is not allowed a
deduction under the Internal Revenue Code of 1954 for such contribution
or deposit.
[T.D. 7744, 45 FR 85735, Dec. 30, 1980]
Sec. 1.527-8 Effective date; filing requirements; and miscellaneous
provisions.
(a) Assessment and collections. Since the taxes imposed by section
527 are taxes imposed by subtitle A of the Code, all provisions of law
and of the regulations applicable to the taxes imposed by subtitle A are
applicable to the assessment and collection of the taxes imposed by
section 527. Organizations subject to the tax imposed by section 527 are
subject to the same provisions, including penalties, as are provided for
corporations, in general, except that the requirements of section 6154
concerning the payment of estimated tax do not apply. See, generally,
sections 6151, et. seq., and the regulations prescribed thereunder, for
provisions relating to payment of tax.
(b) Returns. For requirements of filing annual returns with respect
to political organization taxable income, see section 6012 (a) (6) and
the applicable regulations.
[[Page 285]]
(c) Taxable years, method of accounting, etc. The taxable year
(fiscal year or calendar year, as the case may be) of a political
organization is determined without regard to the fact that such
organization may have been exempt from tax during any prior period. See
sections 441 and 446, and the regulations thereunder in this part, and
section 7701 and the regulations in Part 301 of this chapter
(Regulations on Procedure and Administration). Similarly, in computing
political organization taxable income, the determination of the taxable
year for which an item of income or expense is taken into account is
made under the provisions of sections 441, 446, 451, 461, and the
regulations thereunder, whether or not the item arose during a taxable
year beginning before, on, or after the effective date of the provisions
imposing a tax upon political organization taxable income. If a method
for treating bad debts was selected in a return of income (other than an
information return) for a previous taxable year, the taxpayer must
follow such method in its returns under section 527, unless such method
is changed inaccordance with the provisions of Sec. 1.166-1. A taxpayer
who has not previously selected a method for treating bad debts may, in
its first return under section 6012 (a) (6), exercise the option granted
in Sec. 1.166-1.
(d) Effective date. Except as provided in paragraph (b)(2) of Sec.
1.527-6 and in paragraph (a) of Sec. 1.527-9, the regulations under
section 527 apply to taxable years beginning after December 31, 1974.
[T.D. 7744, 45 FR 85735, Dec. 30, 1980, as amended by T.D. 8041, 50 FR
30817, July 30, 1985]
Sec. 1.527-9 Special rule for principal campaign committees.
(a) In general. Effective with respect to taxable years beginning
after December 31, 1981, the tax imposed by section 527(b) on the
political organization taxable income of a principal campaign committee
shall be computed by multiplying the political organization taxable
income by the appropriate rates of tax specified in section 11(b). The
political organization taxable income of a campaign committee not a
principal campaign committee is taxed at the highest rate of tax
specified in section 11(b). A candidate for Congress may designate one
political committee to serve as his or her principal campaign committee
for purposes of section 527(h)(1). If a designation is made, it shall be
made in accordance with the requirements of paragraph (b) of this
section. A candidate for Congress may have only one designation in
effect at any time. Under 11 CFR 102.12, no political committee may be
designated as the principal campaign committee of more than one
candidate for Congress. Further, no political committee that supports or
has supported more than one candidate for Congress may be designated as
a principal campaign committee. No designation need be made where there
is only one political campaign committee with respect to a candidate.
(b) Manner of designation. If a candidate for Congress elects to
make a designation under section 527(h) and this section, he or she
shall designate his or her principal campaign committee by appending a
copy of his or her Statement of Candidacy (that is, the Federal Election
Commission Form 2, or equivalent statement that the candidate filed with
the Federal Election Commission under 11 CFR 101.1(a)), to the Form
1120-POL filed by the principal campaign committee for each taxable year
for which the designation is effective. This designation may also be
made by appending to the Form 1120-POL statement containing the
following information: The name and address of the candidate for
Congress; his or her taxpayer identification number; his or her party
affiliation and the office sought; the district and State in which the
office is sought; and the name and address of the principal campaign
committee. This designation shall be made on or before the due date (as
extended) for filing Form 1120-POL. Only a candidate for Congress may
make a designation in accordance with this paragraph.
(c) Manner of revoking designation. A designation of a principal
campaign committee that has been filed in accordance with this section
may be revoked only with the consent of the
[[Page 286]]
Commissioner. In general, the Commissioner will grant such consent in
every case where the candidate for Congress has revoked his or her
designation in compliance with the requirements of the Federal Election
Commission by filing an amended Statement of Organization or its
equivalent pursuant to 11 CFR 102.2(a)(2). In the case of the revocation
of the designation of a principal campaign committee by a candidate
followed by the designation of another principal campaign committee by
such candidate, for purposes of determining the appropriate rate of tax
under section 11(b) for a taxable year, the political organization
taxable income of the first principal campaign committee shall be
treated as that of the subsequent principal campaign committee. In a
case where consent to revoke a designation of a principal campaign
committee is granted and a new designation is filed, the Commissioner
may condition his consent upon the agreement of the candidate for
Congress to insure compliance with the preceding sentence.
[T.D. 8041, 50 FR 30817, July 30, 1985]
Homeowners Associations
Sec. 1.528-1 Homeowners associations.
(a) In general. Section 528 only applies to taxable years of
homeowners associations beginning after December 31, 1973. To qualify as
a homeowners association an organization must either be a condominium
management association or a residential real estate management
association. For the purposes of Section 528 and the regulations under
that section, the term homeowners association shall refer only to an
organization described in section 528. Cooperative housing corporations
and organizations based on a similar form of ownership are not eligible
to be taxed as homeowners associations. As a general rule, membership in
either a condominium management association or a residential real estate
management association is confined to the developers and the owners of
the units, residences, or lots. Furthermore, membership in either type
of association is normally required as a condition of such ownership.
However, if the membership of an organization consists of other
homeowners associations, the owners of units, residences, or lots who
are members of such other homeowners associations will be treated as the
members of the organization for the purposes of the regulations under
section 528.
(b) Condominium. The term condominium means an interest in real
property consisting of an undivided interest in common in a portion of a
parcel of real property (which may be a fee simple estate or an estate
for years, such as a leasehold or subleasehold) together with a separate
interest in space in a building located on such property. An interest in
property is not a condominium unless the undivided interest in the
common elements are vested in the unit holders. In addition, a
condominium must meet the requirements of applicable state or local law
relating to condominiums or horizontal property regimes.
(c) Residential real estate management association. Residential real
estate management associations are normally composed of owners of
single-family residential units located in a subdivision, development,
or similar area. However, they may also include as members, owners of
multiple-family dwelling units located in such areas. They are commonly
formed to administer and enforce covenants relating to the architecture
and appearance of the real estate development as well as to perform
certain maintenance duties relating to common areas.
(d) Tenants. Tenants will not be considered members for purposes of
meeting the source of income test under section 528(c)(1)(B) and Sec.
1.528-5. However, the fact that tenants of members of a homeowners
association are permitted to be members of the association will not
disqualify an association under section 528(c)(1) if it otherwise meets
the requirements of section 528(c) and these regulations.
[T.D. 7692, 45 FR 26321, Apr. 18, 1980]
Sec. 1.528-2 Organized and operated to provide for the acquisition,
construction, management, maintenance and care of association property.
(a) Organized and operated--(1) Organized. To be treated as a
homeowners
[[Page 287]]
association an organization must be organized and operated primarily for
the purpose of carrying on one or more of the exempt functions of a
homeowners association. For the purposes of section 528 and these
regulations, the exempt functions of a homeowners association are the
acquisition, construction, management, maintenance, and care of
association property. In determining whether an organization is
organized and operated primarily to carry on one or more exempt
functions, all the facts and circumstances of each case shall be
considered. For example, when an organization provides in its articles
of organization that its sole purpose is to carry on one or more exempt
functions, in the absence of other relevant factors it will be
considered to have met the organizational test. (The term articles of
organization means the organization's corporate charter, trust
instruments, articles of association or other instrument by which it is
created.)
(2) Operated. An organization will be treated as being operated for
the purpose of carrying on one or more of the exempt functions of a
homeowners association if it meets the provisions of Sec. Sec. 1.528-5
and 1.528-6.
(b) Terms to be interpreted according to common meaning and usage.
As used in section 528 and these regulations, the terms acquisition,
construction, management, maintenance, and care are to be interpreted
according to their common meaning and usage. For example, maintenance of
association property includes the painting and repairing of such
property as well as the gardening and janitorial services associated
with its upkeep. Similarly, the term construction of association
property includes covenants or other rules for preserving the
architectural and general appearance of the area. The term also includes
regulations relating to the location, color and allowable building
materials to be used in all structures. (For the definition of
association property see Sec. 1.528-3.)
[T.D. 7692, 45 FR 26321, Apr. 18, 1980]
Sec. 1.528-3 Association property.
(a) Property owned by the organization. Association property
includes real and personal property owned by the organization or owned
as tenants in common by the members of the organization. Such property
must be available for the common benefit of all members of the
organization and must be of a nature that tends to enhance the
beneficial enjoyment of the private residences by their owners. If two
or more facilities or items of property of a similar nature are owned by
a homeowners association, and if the use of any particular facility or
item is restricted to fewer than all association members, such
facilities or items neverthelesswill be considered association property
if all association members are treated equitably and have similar rights
with respect to comparable items or facilities. Among the types of
property that ordinarily will be considered association property are
swimming pools and tennis courts. On the other hand, facilities or areas
set aside for the use of nonmembers, or in fact used primarily by
nonmembers, are not association property for the purposes of this
section. For example, property owned by an organization for the purpose
of leasing it to groups consisting primarily of nonmembers to be used as
a meeting place or a retreat will not be considered association
property.
(b) Property normally owned by a governmental unit. Association
property also includes areas and facilities traditionally recognized and
accepted as being of direct governmental concern in the exercise of the
powers and duties entrusted to governments to regulate community health,
safety and welfare. Such areas and facilities would normally include
roadways, parklands, sidewalks, streetlights and firehouses. Property
described in this paragraph will be considered association property
regardless of whether it is owned by the organization itself, by its
members as tenants in common or by a governmental unit and used for the
benefit of the residents of such unit including the members of the
organization.
(c) Privately owned property. Association property may also include
property owned privately by members of the organization. However, to be
so included the condition of such property must affect the overall
appearance or structure of the residential units which
[[Page 288]]
make up the organization. Such property may include the exterior walls
and roofs of privately owned residences as well as the lawn and
shrubbery on privately owned land and any other privately owned property
the appearance of which may directly affect the appearance of the entire
organization. However, privately owned property will not be considered
association property unless:
(1) There is a covenant or similar requirement relating to exterior
appearance or maintenance that applies on the same basis to all such
property (or to a reasonable classification of such property);
(2) There is a pro rata mandatory assessment (at least once a year)
on all members of the association for maintaining such property; and
(3) Membership in the organization is a condition of ownership of
such property.
[T.D. 7692, 45 FR 26321, Apr. 18, 1980]
Sec. 1.528-4 Substantiality test.
(a) In general. In order for an organization to be considered a
condominium management association or a residential real estate
management association (and therefore in order for it to be considered a
homeowners association), substantially all of its units, lots or
buildings must be used by individuals for residences. For the purposes
of applying paragraph (b) or (c) of this section, and organization which
has attributes of both a condominium management association and a
residential real estate management association shall be considered that
association which, based on all the facts and circumstances, it more
closely resembles. In addition, those paragraphs shall be applied based
on conditions existing on the last day of the organization's taxable
year.
(b) Condominium management associations. Substantially all of the
units of a condominium management association will be considered as used
by individuals for residences if at least 85% of the total square
footage of all units within the project is used by individuals for
residential purposes. If a completed unit has never been occupied, it
will nonetheless be considered as used for residential purposes if,
based on all the facts and circumstances, it appears to have been
constructed for use as a residence. Similarly, a unit which is not
occupied but which has been in the past will be considered as used for
residential purposes if, based on all the facts and circumstances, it
appears that it was constructed for use as a residence, and the last
individual to occupy it did in fact use it as a residence. Units which
are used for purposes auxiliary to residential use (such as laundry
areas, swimming pools, tennis courts, storage rooms and areas used by
maintenance personnel) shall be considered used for residential
purposes.
(c) Residential real estate management associations. Substantially
all of the lots or buildings of a residential real estate management
association (including unimproved lots) will be considered as used by
individuals as residences if at least 85% of the lots are zoned for
residential purposes. Lots shall be treated as zoned for residential
purposes even if under such zoning lots may be used for parking spaces,
swimming pools, tennis courts, schools, fire stations, libraries,
churches and other similar purposes which are auxiliary to residential
use. However, commercial shopping areas (and their auxiliary parking
areas) are not lots zoned for residential purposes.
(d) Exception. Notwithstanding any other provision of this section,
a unit, or building will not be considerd used for residential purposes,
if for more than one-half the days in the association's taxable year,
such unit, or building is occupied by a person or series of persons,
each of whom so occupies such unit, or building for less than 30 days.
[T.D. 7692, 45 FR 26322, Apr. 18, 1980; T.D. 7692, 45 FR 24879, May 23,
1980]
Sec. 1.528-5 Source of income test.
An organization cannot qualify as a homeowners association under
section 528 for a taxable year unless 60 percent or more of its gross
income for such taxable year is exempt function income as defined in
Sec. 1.528-9. The
[[Page 289]]
determiniation of whether an organization meets the provisions of this
section shall be made after the close of the organization's taxable
year.
[T.D. 7692, 45 FR 26322, Apr. 18, 1980]
Sec. 1.528-6 Expenditure test.
(a) In general. An organization cannot qualify as a homeowners
association under section 528 for a taxable year unless 90 percent or
more of its expenditures for such taxable year are qualifying
expenditures as defined in paragraphs (b) and (c) of this section. The
determination of whether an organization meets the provisions of this
section shall be made after the close of the organization's taxable
year. Investments or transfers of funds to be held to meet future costs
shall not be taken into account as expenditures. For example, transfers
to a sinking fund account for the replacement of a roof would not be
considered an expenditure for the purposes of this section even if the
roof is association property. In addition, excess assessments which are
either rebated to members or applied against the members' following
year's assessments will not be considered an expenditure for the
purposes of this section.
(b) Qualifying expenditures. Qualifying expenditures are
expenditures by an organization for the acquisition, construction,
management, maintenance, and care of the organization's association
property. They include both current operating and capital expenditures
on association property. Qualifying expenditures include expenditures on
association property despite the fact that such property may produce
income which is not exempt function income. Thus expenditures on a
swimming pool are qualifying expenditures despite the fact that fees
from guests of members using the pool are not exempt function income.
Where expenditures by an organization are used both for association
property as well as other property, an allocation shall be made between
the two uses on a reasonable basis. Only that portion of the
expenditures which is properly allocable to the acquisition,
construction, management, maintenance or care of association property,
shall constitute qualifying expenditures.
(c) Examples of qualifying expenditures. Qualifying expenditures may
include (but are not limited to) expenditures for:
(1) Salaries of an association manager and secretary;
(2) Paving of streets;
(3) Street signs;
(4) Security personnel;
(5) Legal fees;
(6) Upkeep of tennis courts;
(7) Swimming pools;
(8) Recreation rooms and halls;
(9) Replacement of common buildings, facilities, air conditioning,
etc;
(10) Insurance premiums on association property;
(11) Accountant's fees;
(12) Improvement of private property to the extent it is association
property; and
(13) Real estate and personal property taxes imposed on association
property by a State or local government.
[T.D. 7692, 45 FR 26322, Apr. 18, 1980]
Sec. 1.528-7 Inurement.
An organization is not a homeowners association if any part of its
net earnings inures (other than as a direct result of its engaging in
one or more exempt functions) to the benefit of any private person.
Thus, to the extent that members receive a benefit from the general
maintenance, etc., of association property, this benefit generally would
not constitute inurement. If an organization pays rebates from amounts
other than exempt function income, such rebates will constitute
inurement. In general, in determining whether an organization is in
violation of this section, the principles used in making similar
determinations under Section 501(c) will be applied.
[T.D. 7692, 45 FR 26323, Apr. 18, 1980]
Sec. 1.528-8 Election to be treated as a homeowners association.
(a) General rule. An organization wishing to be treated as a
homeowners association under section 528 and this section for a taxable
year must elect to be so treated. Except as otherwise provided in this
section such election shall be made by the filing of a properly
completed Form 1120-H (or such other form as the Secretary may
prescribe).
[[Page 290]]
A separate election must be made for each taxable year.
(b) Taxable years ending after December 30, 1976. For taxable years
ending after December 30, 1976, the election must be made not later than
the time, including extensions, for filing an income tax return for the
year in which the election is to apply.
(c) Taxable years ending before December 31, 1976, for which a
return was filed before January 31, 1977. For taxable years ending
before December 31, 1976, for which a return was filed before January
31, 1977, the election must be made not later than the time provided by
law for filing a claim for credit or refund of overpayment of taxes for
the year in which the election is to apply. Such an election shall be
made by filing an amended return on Form 1120-H (or such other form as
the Secretary may prescribe).
(d) Taxable years ending before December 31, 1976, for which a
return was not filed before January 31, 1977. For taxable years ending
before December 31, 1976, for which a return was not filed before
January 31, 1977, the election must be made by October 20, 1980. Instead
of making such an election in the manner described in paragraph (a) of
this section, such an election may be made by a statement attached to
the applicable income tax return or amended return for the year in which
the election is made. The statement should identify the election being
made, the period for which it applies and the taxpayer's basis for
making the election.
(e) Revocation of exempt status. If an organization is notified
after the close of a taxable year that its exemption for such taxable
year under section 501(a) is being revoked retroactively, it may make a
timely election under section 528 for such taxable year. Notwithstanding
any other provisions of this section, such an election will be
considered timely if it is made within 6 months after the date of
revocation. The preceding sentence shall apply to revocations made after
April 18, 1980. If the revocation was made on or before April 18, 1980,
the election will be considered timely if it is made before the
expiration of the period for filing a claim for credit or refund for the
taxable year for which it is to apply.
(f) Effect of election--(1) Revocation. An election to be treated as
an organization described in section 528 is binding on the organization
for the taxable year and may not be revoked without the consent of the
Commissioner.
(2) Exception. Notwithstanding paragraph (f)(1) of this section, an
election under this section may be revoked prior to July 18, 1980. Such
a revocation shall be made by filing a statement with the director of
the Internal Revenue Service Center with whom the return of the
organization for the year in which the revocation is to apply was filed.
The statement shall include the following information:
(i) The name of the organization.
(ii) The fact that it is revoking an election made under section
528.
(iii) The taxable year for which the revocation is to apply.
[T.D. 7692, 45 FR 26323, Apr. 18, 1980]
Sec. 1.528-9 Exempt function income.
(a) General rule. For the purposes of section 528 exempt function
income consists solely of income which is attributable to membership
dues, fees, or assessments of owners of residential units or residential
lots. It is not necessary that the source of income be labeled as
membership dues, fees, or assessments. What is important is that such
income be derived from owners of residential units or residential lots
in their capacity as owner-members rather than in some other capacity
such as customers for services. Generally, for the membership dues,
fees, or assessments with respect to a residential unit or lot to be
exempt function income, the unit must be used for (or the unit or lot
must be expected to be used) for residential purposes. However, dues,
fees, or assessments paid to an organization by a developerwith respect
to unfinished or finished but unsold units or lots shall be exempt
function income even though the developer does not use the units or
lots. If an assessment is more in the nature of a fee for the provision
of services in the course of a trade or business than a fee for a common
activity undertaken by a collective group of owners for the purpose of
enhancing or maintaining the value of their residences, the assessment
will
[[Page 291]]
not be considered exempt function income to the organization.
Furthermore, income attributable to dues, fees, or assessments will not
be considered exempt function income unless each member's liability for
payment arises solely from membership in the association. Dues, fees, or
assessments that are based on the extent, if any, to which a member
avails him or herself of a facility or facilities are not exempt
function income. For the purposes of section 528, dues, fees, or
assessments which are based on the assessed value or size of property
will be considered as arising solely as a result of membership in the
organization. Regardless of the organization's method of accounting,
excess assessments during a taxable year which are either rebated to the
members or applied to their future assessments are not considered gross
income and therefore will not be considered exempt function income for
such taxable year. However, if such excess assessments are applied to a
future year's assessments, they will be considered gross income and
exempt function income for that future year. In addition, assessments in
a taxable year, such as an assessment for a capital improvement, which
are not treated as gross income do not enter into the determination of
whether the organization meets the source of income test for that
taxable year.
(b) Examples of exempt function income. Assessments which are
considered more in the nature of a fee for common activity than for the
providing of services and which will therefore generally be considered
exempt function income include assessments made for the purpose of:
(1) Paying the principal and interest on debts incurred for the
acquisition of association property;
(2) Paying real estate taxes on association property;
(3) Maintaining association property;
(4) Removing snow from public areas; and
(5) Removing trash.
(c) Examples of receipts which are not exempt function income.
Exempt function income does not include:
(1) Amounts which are not includible in the organization's gross
income other than by reason of section 528 (for example, tax-exempt
interest);
(2) Amounts received from persons who are not members of the
association;
(3) Amounts received from members for special use of the
organization's facilities, the use of which is not available to all
members as a result of having paid the dues, fees or assessments
required to be paid by all members;
(4) Interest earned on amounts set aside in a sinking fund;
(5) Amounts received for work done on privately owned property which
is not association property; or
(6) Amounts received from members in return for their transportation
to or from shopping areas, work location, etc.
(d) Special rule. Notwithstanding paragraphs (a) and (c)(3) of this
section, amounts received from members or tenants of residential units
owned by members (notwithstanding Sec. 1.528-1(d)) for special use of
an association's facilities will be considered exempt function income
if:
(1) The amounts paid by the members are not paid more than once in
any 12 month period; and
(2) The privilege obtained from the payment of such amounts lasts
for the entire 12 month period or portion thereof in which the facility
is commonly in use.
Thus, amounts received as the result of payments by members of a yearly
fee for use of tennis courts or a swimming pool shall be considered
exempt function income. However, amounts received for the use of a
building for an evening, weekend, week, etc., shall not be considered
exempt function income.
[T.D. 7692, 45 FR 26323, Apr. 18, 1980]
Sec. 1.528-10 Special rules for computation of homeowners association
taxable income and tax.
(a) In general. Homeowners association taxable income shall be
determined according to the provisions of section 528(d) and the rules
set forth in this section.
(b) Limitation on capital losses. If for any taxable year a
homeowners association has a net capital loss, the rules of sections
1211(a) and 1212(a) shall apply.
[[Page 292]]
(c) Allowable deductions--(1) In general. To be deductible in
computing the unrelated business taxable income of a homeowners
association, expenses, depreciation and similar items must not only
qualify as items of deduction allowed by chapter 1 of the Code but must
also be directly connected with the production of gross income
(excluding exempt function income). To be directly connected with the
production of gross income (excluding exempt function income), an item
of deduction must have both proximate and primary relationship to the
production of such income and have been incurred in the production of
such income. Items of deduction attributable solely to items of gross
income (excluding exempt function income) are proximately and primarily
related to such income. Whether an item of deduction is incurred in the
production of gross income (excluding exempt function income) is
determined on the basis of all the facts and circumstances involved in
each case.
(2) Dual use of facilities or personnel. Where facilities are used
both for exempt functions of the organization and for the production of
gross income (excluding exempt function income), expenses, depreciation
and similar items attributable to such facilities (for example, items of
overhead) shall be allocated between the two uses on a reasonable basis.
Similarly where personnel are employed both for exempt functions and for
the production of gross income (excluding exempt function income),
expenses and similar items attributable to such personnel (for example,
items of salary) shall be allocated between the two activities on a
reasonable basis. The portion of any such item so allocated to the
production of gross income (excluding exempt function income) is
directly connected with such income and shall be allowable as a
deduction in computing homeowners association taxable income to the
extent that it qualifies as an item of deduction allowed by chapter 1 of
the Code. Thus, for example, assume that X, a homeowners association,
pays its manager a salary of $10,000 a year and that it derives gross
income other than exempt function income. If 10 percent of the manager's
time during the year is devoted to deriving X's gross income (other than
exempt function income), a deduction of $1,000 (10 percent of $10,000)
would generally be allowable for purposes of computing X's homeowners
association taxable income.
(d) Investment credit. A homeowners association is not entitled to
an investment credit.
(e) Cross reference. For the definition of exempt function income,
see Sec. 1.528-9.
[T.D. 7692, 45 FR 26324, Apr. 18, 1980]
Qualified ABLE Programs
Source: T.D. 9923, 85 FR 74034, Nov. 19, 2020, unless otherwise
noted.
Sec. 1.529A-0 Table of contents.
This section lists the following captions contained in Sec. Sec.
1.529A-1 through 1.529A-8.
Sec. 1.529A-1 Exempt status of qualified ABLE program and definitions.
(a) In general.
(b) Definitions.
(1) ABLE account.
(2) Contribution.
(3) Designated beneficiary.
(4) Disability certification.
(5) Distribution.
(6) Earnings.
(7) Earnings ratio.
(8) Eligible individual.
(9) Excess contribution.
(10) Excess aggregate contribution.
(11) Investment in the account.
(12) Member of the family.
(13) Program-to-program transfer.
(14) Qualified ABLE program.
(15) Qualified disability expenses.
(16) Rollover.
(c) Applicability date.
Sec. 1.529A-2 Qualified ABLE program.
(a) In general.
(b) Established and maintained by a State or agency or
instrumentality of a State.
(1) Established.
(2) Maintained.
(i) In general.
(ii) Multiple States, agencies, or instrumentalities.
(3) Community Development Financial Institutions (CDFIs).
(c) Establishment of an ABLE account and signature authority.
(1) Establishment of the ABLE account.
(2) Signature authority.
(3) Only one ABLE account.
(4) Beneficial interest.
(d) Eligible individual.
[[Page 293]]
(1) Documentation.
(2) Frequency of recertification.
(3) Loss of qualification as an eligible individual.
(e) Disability certification.
(1) In general.
(2) Marked and severe functional limitations.
(3) Compassionate allowance list.
(4) Additional guidance.
(5) Restriction on use of certification.
(f) Change of designated beneficiary.
(1) In general.
(2) Change effective upon death.
(g) Contributions.
(1) Permissible property.
(2) Annual contributions limit.
(3) Cumulative limit.
(4) Return of excess contributions, excess compensation
contributions, and excess aggregate contributions.
(5) Restriction of contributors.
(h) Qualified disability expenses.
(1) In general.
(2) Example.
(i) Separate accounting.
(j) Program-to-program transfers.
(k) Carryover of attributes.
(1) In general.
(2) Annual contribution limit.
(3) Investment direction limit.
(l) Investment direction.
(m) No pledging of interest as security.
(n) No sale or exchange.
(o) Post-death payments.
(p) Reporting requirements.
(q) Applicability date.
Sec. 1.529A-3 Tax treatment.
(a) Taxation of distributions.
(1) In general.
(2) Additional period.
(b) Additional exclusions from gross income.
(1) Rollover.
(2) Program-to-program transfers.
(3) Change of designated beneficiary.
(4) Payments to creditors post-death.
(c) Computation of earnings.
(d) Additional tax on amounts includible in gross income.
(1) In general.
(2) Exceptions.
(e) Tax on excess contributions.
(f) Filing requirements.
(g) No inference outside section 529A.
(h) Applicability date.
Sec. 1.529A-4 Gift, estate, and generation-skipping transfer taxes.
(a) Contributions.
(1) In general.
(2) Generation-skipping transfer (GST) tax.
(3) Designated beneficiary as contributor.
(b) Distributions.
(c) Transfer to another designated beneficiary.
(d) Transfer tax on death of designated beneficiary.
(e) Applicability date.
Sec. 1.529A-5 Reporting of the establishment of and contributions to an
ABLE account.
(a) In general.
(b) Additional definitions.
(1) Filer.
(2) TIN.
(c) Requirement to file return.
(1) Form of return.
(2) Information included on return.
(3) Time and manner of filing return.
(d) Requirement to furnish statement.
(1) In general.
(2) Time and manner of furnishing statement.
(3) Copy of Form 5498-QA.
(e) Request for TIN of designated beneficiary.
(f) Penalties.
(1) Failure to file return.
(2) Failure to furnish TIN.
(g) Applicability date.
Sec. 1.529A-6 Reporting of distributions from and termination of an
ABLE account.
(a) In general.
(b) Requirement to file return.
(1) Form of return.
(2) Information included on return.
(3) Information excluded.
(4) Time and manner of filing return.
(c) Requirement to furnish statement.
(1) In general.
(2) Time and manner of furnishing statement.
(3) Copy of Form 1099-QA.
(d) Request for TIN of contributor(s).
(1) In general.
(2) Exception.
(e) Penalties.
(1) Failure to file return.
(2) Failure to furnish TIN.
(f) Applicability date.
Sec. 1.529A-7 Electronic furnishing of statements to designated
beneficiaries and contributors.
(a) Electronic furnishing of statements.
(1) In general.
(2) Consent.
(3) Required disclosures.
(4) Format.
(5) Notice.
(6) Access period.
(b) Applicability date.
Sec. 1.529A-8 Applicability dates and transition relief.
(a) Applicability dates.
(b)Transition relief.
(1) In general.
(2) Transition period.
(3) Compliance after transition period.
[[Page 294]]
Sec. 1.529A-1 Exempt status of qualified ABLE program and definitions.
(a) In general. A qualified ABLE program described in section 529A
is exempt from Federal income tax, except for the tax imposed under
section 511 on any unrelated business taxable income of that program.
See Sec. 1.511-2(e).
(b) Definitions. For purposes of section 529A, this section and
Sec. Sec. 1.529A-2 through 1.529A-8--
(1) ABLE account means an account established under a qualified ABLE
program and owned by the designated beneficiary of that account.
(2) Contribution means any payment directly allocated to an ABLE
account for the benefit of a designated beneficiary, including amounts
transferred to an ABLE account between December 22, 2017, and January 1,
2026, from a qualified tuition program described in section 529.
(3) Designated beneficiary means the individual for whom the account
was established at a time when he or she was an eligible individual or
who has succeeded the former designated beneficiary in that capacity
(successor designated beneficiary). The designated beneficiary is the
owner of the ABLE account. If the designated beneficiary is not able to
exercise signature authority over his or her ABLE account or chooses to
have an ABLE account established but not to exercise signature
authority, references to the designated beneficiary with respect to his
or her actions include actions by the person with signature authority
over the account. See Sec. 1.529A-2(c)(1) and (2).
(4) Disability certification means a certification to establish a
certain level of an individual's physical or mental impairment that
meets the requirements described in Sec. 1.529A-2(e).
(5) Distribution means any payment from an ABLE account. However, a
program-to-program transfer, a Medicaid reimbursement under Sec.
1.529A-2(o), or a payment of administrative or investment fees charged
by a qualified ABLE program is not a distribution.
(6) Earnings attributable to an ABLE account are the excess of the
total account balance on a particular date over the investment in the
account as of that date.
(7) Earnings ratio as applied to a particular distribution means the
amount of earnings attributable to the ABLE account as of the date of
the distribution, divided by the total account balance on that same
date.
(8) Eligible individual for a taxable year means an individual who
either:
(i) Is receiving benefits under title II or XVI of the Social
Security Act based on blindness or disability or whose entitlement to
such benefits under title XVI has been suspended solely due to excess
income or resources, provided that such blindness or disability occurred
before the date on which the individual attained age 26 (and, for this
purpose, an individual is deemed to attain age 26 on his or her 26th
birthday); or
(ii) Is the subject of a disability certification filed with the
Secretary of the Treasury or his delegate (Secretary) for that taxable
year.
(9) Excess contribution means the amount by which the amount
contributed during the taxable year of the designated beneficiary to an
ABLE account exceeds the limit in effect under section 2503(b) for the
calendar year in which the taxable year of the designated beneficiary
begins.
(10) Excess aggregate contribution means--
(i) The amount contributed during the taxable year of the designated
beneficiary that causes the total of amounts contributed since the
establishment of the ABLE account (or of an ABLE account for the same
designated beneficiary that was rolled into the current ABLE account) to
exceed the limit in effect under section 529(b)(6); or
(ii) In the context of the safe harbor in Sec. 1.529A-2(g)(3), the
amount contributed that causes the account balance to exceed the limit
in effect under section 529(b)(6).
(11) Investment in the account means--
(i) The sum of all contributions made to the ABLE account, reduced
by the aggregate amount of contributions included in distributions, if
any, made from the account; or
(ii) In the case of a rollover contribution into an ABLE account,
the amount of the rollover contribution that constituted the amount
described
[[Page 295]]
in paragraph (b)(11)(i) of this section with respect to the ABLE account
from which the rollover contribution was made.
(12) Member of the family means a sibling, whether by blood or by
adoption, and includes a brother, sister, stepbrother, stepsister, half-
brother, and half-sister.
(13) Program-to-program transfer means--
(i) The direct transfer of the entire balance of an ABLE account
into an ABLE account of the same designated beneficiary after which the
transferor ABLE account is closed upon completion of the transfer; or
(ii) The direct transfer of part or all of the balance to an ABLE
account of another eligible individual who is a member of the family of
the former designated beneficiary.
(14) Qualified ABLE program means a program established and
maintained by a State, or agency or instrumentality of a State, under
which an ABLE account may be established by and for the benefit of the
account's designated beneficiary who is an eligible individual, and that
meets the requirements described in Sec. 1.529A-2.
(15) Qualified disability expenses means any expenses incurred at a
time when the designated beneficiary is an eligible individual that
relate to the blindness or disability of the designated beneficiary of
an ABLE account, including expenses that are for the benefit of the
designated beneficiary in maintaining or improving his or her health,
independence, or quality of life. See Sec. 1.529A-2(h). However, any
expenses incurred at a time when a designated beneficiary is neither
disabled nor blind within the meaning of Sec. 1.529A-1(b)(8)(i) or
Sec. 1.529A-2(e)(1)(i), even if the designated beneficiary is an
eligible individual for that entire taxable year, do not relate to
blindness or disability and therefore are not qualified disability
expenses.
(16) Rollover means a contribution to an ABLE account of a
designated beneficiary (or of an eligible individual who is a member of
the family of the designated beneficiary) of all or a portion of an
amount distributed from the designated beneficiary's ABLE account,
provided the contribution is made within 60 days of the date of the
withdrawal and, in the case of a rollover to the designated
beneficiary's ABLE account, no rollover has been made to an ABLE account
of the designated beneficiary within the 12 month period immediately
preceding the rollover to the ABLE account.
(c) Applicability date. This section applies to calendar years
beginning on or after January 1, 2021. See Sec. 1.529A-8 for the
provision of transition relief.
Sec. 1.529A-2 Qualified ABLE program.
(a) In general. A qualified ABLE program is a program established
and maintained by a State, or an agency or instrumentality of a State,
that satisfies all of the requirements of this section and under which--
(1) An ABLE account may be established for the purpose of meeting
the qualified disability expenses of the designated beneficiary of the
account;
(2) A designated beneficiary is limited to only one ABLE account at
a time except as otherwise provided in paragraph (c)(3) of this section;
(3) Any person may make contributions to such an ABLE account,
subject to the limitations described in paragraph (g) of this section;
and
(4) Distributions (other than returns of contributions as described
in paragraph (g)(4) of this section) may be made only to or for the
benefit of the designated beneficiary of the ABLE account.
(b) Established and maintained by a State or agency or
instrumentality of a State--(1) Established. A program is established by
a State or its agency or instrumentality if the program is initiated by
State statute or regulation or by an act of a State official or agency
with the authority to act on behalf of the State.
(2) Maintained--(i) In general. A program is maintained by a State
or an agency or instrumentality of a State if--
(A) The State or its agency or instrumentality sets all of the terms
and conditions of the program, including but not limited to who may
contribute to the program, who may be a designated beneficiary of the
program, and what benefits the program may provide; and
[[Page 296]]
(B) The State or its agency or instrumentality is actively involved
on an ongoing basis in the administration of the program, including
supervising the implementation of decisions relating to the investment
of assets contributed under the program. Factors that are relevant in
determining whether a State or its agency or instrumentality is actively
involved in the administration of the program include, but are not
limited to: Whether the State or its agency or instrumentality provides
services to designated beneficiaries that are not provided to persons
who are not designated beneficiaries; whether the State or its agency or
instrumentality establishes detailed operating rules for administering
the program; whether officials of the State or its agency or
instrumentality play a substantial role in the operation of the program,
including selecting, supervising, monitoring, auditing, and terminating
the relationship with any private contractors that provide services
under the program; whether the State or its agency or instrumentality
holds the private contractors that provide services under the program to
the same standards and requirements that apply when private contractors
handle funds that belong to the State or its agency or instrumentality
or provide services to the State or its agency or instrumentality;
whether the State or its agency or instrumentality provides funding for
the program; and whether the State or its agency or instrumentality acts
as trustee or holds program assets directly or for the benefit of the
designated beneficiaries. For example, if the State or its agency or
instrumentality exercises the same authority over the funds invested in
the program as it does over the investments in or pool of funds of a
State employees' defined benefit pension plan, then the State or its
agency or instrumentality will be considered actively involved on an
ongoing basis in the administration of the program.
(ii) Multiple States, agencies, or instrumentalities. A program may
be maintained by two or more States or the agencies or instrumentalities
of two or more States if the program meets the requirements of paragraph
(b)(2)(i) of this section for each of the States represented. If a State
or an agency or instrumentality of a State participates in such a
consortium of States or agencies or instrumentalities of States, the
consortium's program is considered to be the program of each State
represented.
(3) Community Development Financial Institutions (CDFIs). In
addition to having the ability to contract with private contractors as
provided in paragraph (b)(2)(i)(B) of this section, a State or its
agency or instrumentality or qualified ABLE program may contract with
one or more Community Development Financial Institutions (CDFIs) (as
defined in 12 U.S.C. 4702(5) and 12 CFR 1805.104) to perform some or all
of the services described in paragraphs (b)(2)(i)(A) and (B) of this
section.
(c) Establishment of an ABLE account and signature authority--(1)
Establishment of the ABLE account--(i) In general. A qualified ABLE
program must provide that an ABLE account may be established only for an
eligible individual.
(A) The ABLE account may be established by the eligible individual;
(B) The ABLE account may be established by a person selected by the
eligible individual; or
(C) If an eligible individual (whether a minor or adult) is unable
to establish his or her own ABLE account, an ABLE account may be
established on behalf of the eligible individual by the eligible
individual's agent under a power of attorney or, if none, by a
conservator or legal guardian, spouse, parent, sibling, grandparent of
the eligible individual, or a representative payee appointed for the
eligible individual by the Social Security Administration (SSA), in that
order.
(ii) Authority. A qualified ABLE program may accept a certification,
made under penalties of perjury, from the person seeking to establish an
ABLE account as to the basis for the person's authority to establish the
ABLE account, and that there is no other person with a higher priority,
under paragraphs (c)(1)(i)(A), (B), and (C) of this section, to
establish the ABLE account.
(2) Signature authority--(i) Signatory. In general, the designated
beneficiary will have signature authority over his
[[Page 297]]
or her ABLE account. However, if an individual other than the designated
beneficiary establishes the account in accordance with paragraph
(c)(1)(i)(B) or (C) of this section, such individual will have signature
authority.
(A) At any time, the designated beneficiary may remove and replace
any person with signature authority over the designated beneficiary's
ABLE account. The replacement may be the designated beneficiary or any
other person selected by the designated beneficiary.
(B) The designated beneficiary may designate a successor to the
person with signature authority. In the absence of any designation of a
successor by the designated beneficiary, a person with signature
authority over the designated beneficiary's ABLE account may designate a
successor, consistent with the ordering rules in paragraph (c)(1)(i)(C)
of this section.
(ii) Co-signatories. A qualified ABLE program may permit an ABLE
account to have co-signatories, consistent with paragraph (c)(1)(i)(C)
of this section. If co-signatories are permitted, all of the other
provisions of this paragraph (c)(2) continue to apply, and references to
the signatory refer to the co-signatories acting separately or jointly,
as determined by that qualified ABLE program.
(iii) Authority over sub-accounts. The person with signature
authority over the ABLE account may appoint and from time to time may
remove, replace, or name a successor for any person with signature
authority over a sub-account described in paragraph (c)(3)(iii) of this
section.
(3) Only one ABLE account--(i) In general. Except as provided in
paragraph (c)(3)(ii) of this section, a designated beneficiary is
limited to one ABLE account at a time, regardless of where located. To
ensure that this requirement is met, a qualified ABLE program must
obtain a verification, signed under penalties of perjury by the person
establishing the ABLE account, that the individual establishing the ABLE
account neither knows nor has reason to know that the eligible
individual already has an existing ABLE account (other than an ABLE
account that will terminate with the rollover or program-to-program
transfer of its assets into the new ABLE account) before that program
can permit the establishment of an ABLE account for that eligible
individual. In the case of a rollover, the ABLE account from which
amounts were distributed must be closed as of the 60th day after the
date of the distribution in order to allow the account receiving the
rollover to be treated as an ABLE account.
(ii) Treatment of additional accounts. If an individual is the
designated beneficiary of an ABLE account established in accordance with
paragraph (c)(1) of this section, no other account subsequently
established for that individual under a qualified ABLE program
(additional account) will be an ABLE account. The preceding sentence
does not apply to an additional account, and that additional account is
an ABLE account, if--
(A) The additional account is established for the purpose of
receiving a rollover or program-to-program transfer;
(B) All of the contributions to the additional account are returned
in accordance with the rules that apply to the return of excess
contributions and excess aggregate contributions under paragraph (g)(4)
of this section; or
(C) All amounts in the additional account are transferred to the
designated beneficiary's preexisting ABLE account and any excess
contributions and excess aggregate contributions are returned in
accordance with the rules that apply to the return of excess
contributions and excess aggregate contributions under paragraph (g)(4)
of this section.
(iii) Sub-accounts. A qualified ABLE program may establish an ABLE
account (primary account) that may include multiple sub-accounts. The
person with signature authority over the ABLE account, at any time and
from time to time, may create one or more sub-accounts, may transfer
funds in the ABLE account to one or more of the sub-accounts, and may
close one or more of the sub-accounts, to facilitate the acquisition of
certain goods or services for the designated beneficiary. Each sub-
account may have a different person with signature authority over
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that sub-account, appointed in accordance with the rules of paragraph
(c)(2)(iii) of this section, and that person's authority is limited to
making distributions from that sub-account. The primary account and the
sub-accounts collectively constitute a single ABLE account and therefore
must be aggregated for all purposes, including without limitation the
limit on the number of permissible changes in investment direction under
paragraph (l) of this section, the contribution limits under paragraphs
(g)(2) and (3) of this section, the computation of gross income and
other tax provisions, and the reporting requirements.
(iv) Investment options. A qualified ABLE program may offer
different investment options within each ABLE account without violating
the only-one-ABLE-account rule in this paragraph (c)(3). For example, an
ABLE account may include a cash fund as well as one or more stock or
bond funds.
(4) Beneficial interest. A person other than the designated
beneficiary with signature authority over the ABLE account of the
designated beneficiary may neither have nor acquire any beneficial
interest in the ABLE account during the lifetime of the designated
beneficiary and must administer the ABLE account for the benefit of the
designated beneficiary of the account.
(d) Eligible individual--(1) Documentation--(i) In general. Whether
an individual is an eligible individual is determined for each taxable
year of that individual, and that determination applies for the entire
year. A qualified ABLE program must specify the documentation that an
individual must provide, both at the time an ABLE account is established
and thereafter, in order to ensure that the designated beneficiary of
the ABLE account is, and continues to be, determined an eligible
individual. For purposes of determining whether an individual is an
eligible individual, a disability certification as described in
paragraph (e)(1) of this section will be deemed to be filed with the
Secretary once the qualified ABLE program has received the disability
certification or a disability certification has been deemed to have been
received under the rules of the qualified ABLE program, which
information the qualified ABLE program will file in accordance with the
filing requirements under Sec. 1.529A-5(c)(2)(iv).
(ii) Safe harbor. A qualified ABLE program may establish that an
individual is an eligible individual if the person establishing the ABLE
account certifies under penalties of perjury--
(A) The basis for the individual's status as an eligible individual
(entitlement to benefits based on blindness or disability under title II
or XVI of the Social Security Act, or a disability certification
described in paragraph (e)(1) of this section);
(B) That the individual is blind or has a medically determinable
physical or mental impairment as described in paragraph (e)(1)(i) of
this section;
(C) That such blindness or disability occurred before the date on
which the individual attained age 26 (and, for this purpose, an
individual is deemed to attain age 26 on his or her 26th birthday);
(D) If the basis of the individual's eligibility is a disability
certification, that the individual has received and agrees to retain a
written diagnosis as described in paragraph (e)(1)(iii) of this section,
accompanied by the name and address of the diagnosing physician and the
date of the written diagnosis;
(E) The applicable diagnostic code from those listed on Form 5498-QA
(or in the instructions to such form) identifying the type of the
individual's impairment;
(F) That the person establishing the account is the individual who
will be the designated beneficiary of the account or is the person
authorized under paragraph (c)(1)(i) of this section to establish the
account; and
(G) If required by the qualified ABLE program, the information
provided by the diagnosing physician as to the categorization of the
disability that may be used to determine, under the particular State's
program, the appropriate frequency of required recertifications.
(2) Frequency of recertification--(i) In general. A determination of
eligibility must be made annually unless the qualified ABLE program
adopts a different method of ensuring a designated beneficiary's
continuing status as an eligible individual. Alternative methods may
include, without limitation,
[[Page 299]]
the use of certifications by the designated beneficiary under penalties
of perjury, and the imposition of different recertification frequencies
for different types of impairments.
(ii) Considerations. In developing its rules on recertification, a
qualified ABLE program may take into consideration whether an impairment
is incurable and, if so, the likelihood that a cure may be found in the
future. For example, a qualified ABLE program may provide that the
initial certification will be deemed to be valid for a stated number of
years, which may vary with the type of impairment. Even if the qualified
ABLE program imposes an enforceable obligation on the designated
beneficiary or other person with signature authority over the ABLE
account to promptly report changes in the designated beneficiary's
condition that would result in the designated beneficiary's failing to
satisfy the definition of an eligible individual, the designated
beneficiary will be considered an eligible individual until the end of
the taxable year in which the change in the designated beneficiary's
condition occurred. A qualified ABLE program that is compliant with the
rules regarding recertification will not be considered to be
noncompliant solely because a designated beneficiary fails to comply
with this enforceable obligation.
(3) Loss of qualification as an eligible individual. If the
designated beneficiary of an ABLE account ceases to be an eligible
individual, then for each taxable year in which the designated
beneficiary is not an eligible individual, the account will continue to
be an ABLE account, the designated beneficiary will continue to be the
designated beneficiary of the ABLE account (and will be referred to as
such), and the ABLE account will not be deemed to have been distributed.
However, beginning on the first day of the designated beneficiary's
first taxable year for which the designated beneficiary does not satisfy
the definition of an eligible individual, additional contributions to
the designated beneficiary's ABLE account must not be accepted by the
qualified ABLE program. In addition, no expense incurred at a time when
a designated beneficiary is neither disabled nor blind within the
meaning of Sec. 1.529A-1(b)(8)(i) or Sec. 1.529A-2(e)(1)(i), whichever
had applied, is a qualified disability expense even if the individual is
an eligible individual for the rest of the year under paragraph
(d)(1)(i) of this section. If the designated beneficiary subsequently
again satisfies the definition of an eligible individual, contributions
to the designated beneficiary's ABLE account again may be accepted,
subject to the contribution limits under section 529A, and expenses that
are incurred thereafter may meet the definition of a qualified
disability expense in Sec. 1.529A-1(b)(15) and paragraph (h) of this
section.
(e) Disability certification--(1) In general. Except as provided in
paragraph (e)(3) of this section or in additional guidance described in
paragraph (e)(4) of this section, a disability certification with
respect to an individual, that will be deemed filed with the Secretary
as provided in paragraph (d)(1)(i) of this section, and is deemed
satisfactory to the Secretary, is a certification signed under penalties
of perjury by the individual, or by another individual establishing the
ABLE account for the individual, that--
(i) Certifies that the individual--
(A) Has a medically determinable physical or mental impairment that
results in marked and severe functional limitations (as defined in
paragraph (e)(2) of this section), and that--
(1) Can be expected to result in death; or
(2) Has lasted or can be expected to last for a continuous period of
not less than 12 months; or
(B) Is blind (within the meaning of section 1614(a)(2) of the Social
Security Act);
(ii) Certifies that such blindness or disability occurred before the
date on which the individual attained age 26 (and, for this purpose, an
individual is deemed to attain age 26 on his or her 26th birthday); and
(iii) Includes a certification that the individual has obtained and
will continue to retain a copy of the individual's diagnosis relating to
the individual's relevant impairment or impairments, signed by a
physician meeting the criteria of section 1861(r)(1) of the
[[Page 300]]
Social Security Act (42 U.S.C. 1395x(r)) and including the name and
address of the diagnosing physician and the date of the diagnosis.
(2) Marked and severe functional limitations. For purposes of
paragraph (e)(1) of this section, the phrase marked and severe
functional limitations means the standard of disability in the Social
Security Act for children claiming Supplemental Security Income for the
Aged, Blind, and Disabled (SSI) benefits based on disability (see 20 CFR
416.906), but without regard to age or to whether the individual engages
in substantial gainful activity. Specifically, this is a level of
severity that meets, medically equals, or functionally equals the
severity of any listing in appendix 1 of subpart P of 20 CFR part 404.
See 20 CFR 416.906, 416.924 and 416.926a. Such phrase also includes any
impairment or standard of disability identified in future guidance
published in the Internal Revenue Bulletin (see Sec. 601.601(d)(2) of
this chapter). Consistent with the regulations promulgated by the SSA,
the level of severity is determined by taking into account the effect of
the individual's prescribed treatment. See 20 CFR 416.930.
(3) Compassionate allowance list. Conditions listed in the ``List of
Compassionate Allowances Conditions'' maintained by the SSA are deemed
to meet the requirements of section 529A(e)(1)(B) regarding the filing
of a disability certification, if the condition was present and produced
marked and severe functional limitations before the date on which the
individual attained age 26. To establish that an individual with such a
condition satisfies the definition of an eligible individual, the
individual must identify the condition and certify to the qualified ABLE
program both the presence of the condition and its resulting marked and
severe functional limitations prior to age 26, in a manner specified by
the qualified ABLE program.
(4) Additional guidance. Additional guidance on conditions deemed to
meet the requirements of section 529A(e)(1)(B) may be identified in
future guidance published in the Internal Revenue Bulletin. See Sec.
601.601(d)(2) of this chapter.
(5) Restriction on use of certification. No inference may be drawn
from a disability certification described in this paragraph (e) for
purposes of establishing eligibility for benefits under title II, XVI,
or XIX of the Social Security Act.
(f) Change of designated beneficiary--(1) In general. A qualified
ABLE program must permit a change in the designated beneficiary of an
ABLE account made during the life of the designated beneficiary. At the
time when the change becomes effective, the successor designated
beneficiary must be an eligible individual. However, a qualified ABLE
program may limit the change in designated beneficiary to a member of
the family as defined in Sec. 1.529A-1(b)(12) of the current designated
beneficiary.
(2) Change effective upon death. A qualified ABLE program may permit
a change in the designated beneficiary of an ABLE account, made during
the life of the designated beneficiary, to take effect upon the death of
the designated beneficiary. The amount to be transferred pursuant to
such a beneficiary designation is first subject to the payment of any
qualified disability expenses incurred before the designated
beneficiary's death but not yet paid and those described in paragraph
(o) of this section, and is subject to the provisions of Sec. 1.529A-4.
(g) Contributions--(1) Permissible property. Except in the case of a
program-to-program transfer or a change in designated beneficiary to a
new designated beneficiary who is an eligible individual and a member of
the family of the former designated beneficiary, contributions to an
ABLE account may be made only in cash. A qualified ABLE program may
allow cash contributions to be made in the form of a check, money order,
credit card, electronic transfer, after-tax payroll deduction, or
similar method.
(2) Annual contributions limit--(i) In general. Except as provided
in paragraph (g)(2)(ii) of this section, a qualified ABLE program must
provide that no contribution to an ABLE account will be accepted to the
extent such contribution, when added to all other contributions (whether
from the designated beneficiary or one or more
[[Page 301]]
other persons) to that ABLE account made during the designated
beneficiary's taxable year causes the total of such contributions during
that year to exceed the amount in effect under section 2503(b) for the
calendar year in which the designated beneficiary's taxable year begins.
See paragraph (k)(2) of this section for purposes of applying the rules
in this paragraph (g)(2) to rollovers, program-to-program transfers, and
designated beneficiary changes.
(ii) Additional contributions by an employed designated
beneficiary--(A) In general. An employed designated beneficiary defined
in paragraph (g)(2)(iii)(A) of this section may contribute amounts up to
the limit specified in paragraph (g)(2)(ii)(B) of this section in
addition to the amount specified in paragraph (g)(2)(i) of this section.
Although a designated beneficiary's contributions subject to this
compensation income limit do not have to be made from that compensation
income, any contribution of the designated beneficiary's compensation
income made directly by the designated beneficiary's employer is a
contribution made by the designated beneficiary. Once the designated
beneficiary has made contributions equal to the limit described in
paragraph (g)(2)(ii)(B) of this section, additional contributions by the
designated beneficiary may be made if permissible under paragraph
(g)(2)(i) of this section.
(B) Amount of additional permissible contribution. Any additional
contribution made by the designated beneficiary pursuant to paragraph
(g)(2)(ii)(A) of this section is limited to the lesser of--
(1) The designated beneficiary's compensation as defined by section
219(f)(1) for the taxable year; or
(2) An amount equal to the applicable poverty line, as defined in
paragraph (g)(2)(iii)(B) of this section, for a one-person household for
the calendar year preceding the calendar year in which the designated
beneficiary's taxable year begins.
(iii) Additional definitions. In addition to the definitions in
Sec. 1.529A-1(b), the following definitions also apply for the purposes
of this section--
(A) Employed designated beneficiary means a designated beneficiary
who is an employee (including an employee within the meaning of section
401(c)), with respect to whom no contribution is made for the taxable
year to--
(1) A defined contribution plan (within the meaning of section
414(i)) with respect to which the requirements of sections 401(a) or
403(a) are met;
(2) An annuity contract described in section 403(b); and
(3) An eligible deferred compensation plan described in section
457(b).
(B) Applicable poverty line means the amount provided in the poverty
guidelines updated periodically in the Federal Register by the U.S.
Department of Health and Human Services under the authority of 42 U.S.C.
9902(2) for the State of residence of the employed designated
beneficiary. If the designated beneficiary lives in more than one State
during the taxable year, the applicable poverty line is the poverty line
for the State in which the designated beneficiary resided longer than in
any other State during that year.
(C) Excess compensation contribution means the amount by which the
amount contributed during the taxable year of an employed designated
beneficiary to the designated beneficiary's ABLE account exceeds the
limit in effect under section 529A(b)(2)(B)(ii) and paragraph
(g)(2)(ii)(B) of this section for the calendar year in which the taxable
year of the employed designated beneficiary begins.
(iv) Example. The provisions of paragraph (g)(2)(ii) of this section
may be illustrated by the following example: In 2020, A, an employed
designated beneficiary as defined in paragraph (g)(2)(iii)(A) of this
section, lives in Hawaii. A's compensation, as defined by section
219(f)(1), for 2020 is $20,000. The poverty line for a one-person
household in Hawaii was $14,380 in 2019. Because A's compensation
exceeded the applicable poverty line amount, A's additional permissible
contribution in 2019 is limited to $14,380, the amount of the 2019
applicable poverty line.
[[Page 302]]
(v) Ensuring contribution limit is met--(A) Responsibility. The
employed designated beneficiary, or the person acting on his or her
behalf, is solely responsible for ensuring that the requirements in
section 529A(b)(2)(B)(ii) and paragraph (g)(2)(ii) of this section are
met and for maintaining adequate records for that purpose.
(B) Certification. A qualified ABLE program may allow a designated
beneficiary (or the person acting on his or her behalf) to certify,
under penalties of perjury, and in the manner specified by the qualified
ABLE program that--
(1) The designated beneficiary is an employed designated
beneficiary; and
(2) The designated beneficiary's contributions of compensation are
not excess compensation contributions.
(3) Cumulative limit--(i) In general. A qualified ABLE program must
provide adequate safeguards to prevent aggregate contributions on behalf
of a designated beneficiary in excess of the limit established by that
State under section 529(b)(6). For purposes of the preceding sentence,
aggregate contributions on behalf of a designated beneficiary include
contributions to any prior ABLE account maintained by any State or its
agency or instrumentality for the same designated beneficiary, or any
former designated beneficiary to the extent his or her ABLE account
funds were transferred to the designated beneficiary's ABLE account. The
transfer of a designated beneficiary's ABLE account from one qualified
ABLE program to another with a lower cumulative limit will not violate
this rule, but qualified ABLE programs must prohibit subsequent
contributions under this general rule. For purposes of this paragraph
(g)(3), contributions do not include rollovers, program-to-program
transfers or a designated beneficiary change to a new designated
beneficiary who is an eligible individual and member of the family of
the former designated beneficiary as defined in Sec. 1.529A-1(b)(12).
(ii) Safe harbor. A qualified ABLE program maintained by a State or
its agency or instrumentality satisfies the requirement under section
529A(b)(6) if it refuses to accept any additional contribution to an
ABLE account (except as provided to the contrary in paragraph (g)(3)(i)
of this section) while the balance in that account equals or exceeds the
limit established by that State under section 529(b)(6). Nevertheless,
without regard to the categories of transfers that caused the account
balance to exceed the State limit, once the account balance falls below
that limit, additional contributions, subject to the annual
contributions limit under paragraph (g)(2) of this section and the limit
established by such State under section 529(b)(6), again may be
accepted.
(4) Return of excess contributions, excess compensation
contributions, and excess aggregate contributions. If an excess
contribution as defined in Sec. 1.529A-1(b)(9), an excess compensation
contribution as defined in paragraph (g)(2)(iii)(C) of this section, or
an excess aggregate contribution as defined in Sec. 1.529A-1(b)(10) is
deposited into or allocated to the ABLE account of a designated
beneficiary, a qualified ABLE program must return that excess
contribution, excess compensation contribution, or excess aggregate
contribution, including all net income attributable to that
contribution, as determined under the rules set forth in Sec. 1.408-11
(treating references to an IRA as references to an ABLE account and
references to returned contributions under section 408(d)(4) as
references to excess contributions or excess aggregate contributions),
to the person or persons who made that contribution. Each excess
contribution, excess compensation contribution, and excess aggregate
contribution must be returned to its contributor(s) on a last-in-first-
out basis until the entire excess, along with all net income
attributable to such excess, has been returned. In the case of an excess
compensation contribution, the employed designated beneficiary, or the
person acting on the employed designated beneficiary's behalf, is
responsible for identifying any excess compensation contribution and for
requesting the return of the excess compensation contribution. Returned
contributions must be received by the contributor(s) on or before the
due date (including extensions) of the Federal income tax return of the
designated beneficiary for the taxable year in which the excess
contribution or excess
[[Page 303]]
aggregate contribution was made. See Sec. 1.529A-3(a) for Federal
income tax considerations for the contributor(s). If an excess
contribution or excess aggregate contribution and the net income
attributable to the excess contribution or excess aggregate contribution
are returned to a contributor other than the designated beneficiary, the
qualified ABLE program must notify the designated beneficiary of such
return at the time of the return. No notification is required if amounts
are rejected by the qualified ABLE program before they are deposited
into or allocated to the designated beneficiary's ABLE account.
(5) Restriction of contributors. A qualified ABLE program may allow
the designated beneficiary, from time to time, to restrict who may make
contributions to the designated beneficiary's ABLE account.
(h) Qualified disability expenses--(1) In general. Qualified
disability expenses are expenses incurred that relate to the blindness
or disability of the designated beneficiary of the ABLE account and are
for the benefit of that designated beneficiary in maintaining or
improving his or her health, independence, or quality of life. See Sec.
1.529A-1(b)(15). Such expenses include, but are not limited to, expenses
related to the designated beneficiary's education, housing,
transportation, employment training and support, assistive technology
and related services, personal support services, health, prevention and
wellness, financial management and administrative services, legal fees,
expenses for oversight and monitoring, and funeral and burial expenses,
as well as other expenses that may be identified from time to time in
future guidance published in the Internal Revenue Bulletin. See Sec.
601.601(d)(2) of this chapter. Qualified disability expenses include
basic living expenses and are not limited to items for which there is a
medical necessity or which solely benefit an individual with a
disability.
(2) Example. The following example illustrates this paragraph (h):
B, an individual, has a medically determined mental impairment that
causes marked and severe limitations on B's ability to navigate and
communicate. A smart phone would enable B to navigate and communicate
more safely and effectively, thereby helping B to maintain B's
independence and to improve B's quality of life. Therefore, the expense
of buying, using, and maintaining a smart phone that is used by B would
be a qualified disability expense.
(i) Separate accounting. A program will not be treated as a
qualified ABLE program unless it provides separate accounting for each
ABLE account. Separate accounting requires that contributions for the
benefit of a designated beneficiary and any earnings attributable
thereto must be allocated to that designated beneficiary's ABLE account.
Whether or not a program provides each designated beneficiary an annual
account statement showing the total account balance, the investment in
the account, the accrued earnings, and the distributions from the
account, the program must give this information to the designated
beneficiary upon request.
(j) Program-to-program transfers. A qualified ABLE program may
permit a change of qualified ABLE program or a change of designated
beneficiary by means of a program-to-program transfer as defined in
Sec. 1.529A-1(b)(13). In that event, subject to any contrary provisions
or limitations adopted by the qualified ABLE program, rules similar to
the rules of Sec. 1.401(a)(31)-1, Q&A-3 and 4 (which apply for purposes
of a direct rollover from a qualified plan to an eligible retirement
plan) apply for purposes of determining whether an amount is paid in the
form of a program-to-program transfer.
(k) Carryover of attributes--(1) In general. Upon a rollover,
program-to-program transfer, or change of designated beneficiary, all of
the attributes of the former ABLE account relevant for purposes of
calculating the investment in the account are applicable to the
recipient ABLE account. The portion of the rollover or transfer amount
that constituted investment in the account from which the distribution
or transfer was made is added to investment in the recipient ABLE
account. In addition, the portion of the rollover or transfer amount
that constituted earnings of the account from which the distribution or
transfer was made is added to
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the earnings of the recipient ABLE account.
(2) Annual contribution limit. Upon a rollover or program-to-program
transfer, for purposes of applying the annual contribution limit under
paragraph (g)(2) of this section to the transferee account, annual
contributions to the designated beneficiary's transferor ABLE account
during the taxable year in which the rollover or program-to-program
transfer occurs are included. However, upon a change of designated
beneficiary, or upon a rollover or program-to-program transfer to the
ABLE account of a different designated beneficiary who is both a member
of the family as defined in Sec. 1.529A-1(b)(12) and an eligible
individual, no amounts contributed to the prior designated beneficiary's
ABLE account are included when applying the annual contribution limit
under paragraph (g)(2) of this section.
(3) Investment direction limit. Upon a rollover or program-to-
program transfer, the number of investment directions by the designated
beneficiary include the number of investment directions made prior to
the rollover or program-to-program transfer during the same taxable year
for purposes of paragraph (l) of this section. However, upon a change of
designated beneficiary, or upon a rollover or program-to-program
transfer to the ABLE account of a different designated beneficiary who
is both a member of the family as defined in Sec. 1.529A-1(b)(12) and
an eligible individual, the number of investment directions made for the
prior designated beneficiary's ABLE account are not included in
determining the number of investment directions made for the new
designated beneficiary's ABLE account in that same year.
(l) Investment direction. A program will not be treated as a
qualified ABLE program unless it provides that the designated
beneficiary of an ABLE account established under such program may
direct, whether directly or indirectly, the investment of any
contributions to the program (or any earnings thereon) no more than two
times in any calendar year. Such an investment direction does not
include a request to transfer any part of the account balance from an
investment option to a cash equivalent option to effectuate a
distribution, or the automatic rebalancing of the assets of an ABLE
account to maintain the asset allocation level chosen when the account
was established or by a subsequent investment direction.
(m) No pledging of interest as security for a loan. A program will
not be treated as a qualified ABLE program unless the terms of the
program, or a State statute or regulation that governs the program,
prohibit any interest in the program or any portion thereof from being
used as security for a loan. For this purpose, the program
administrator's advance of funds to satisfy a withdrawal request during
the period between the sale of an asset in the ABLE account (whose value
is sufficient to satisfy the withdrawal request) and the clearing or
settlement of that sale, does not constitute a loan, pledge, or grant of
security for a loan. Similarly, the use of checking accounts or debit
cards to facilitate a qualified ABLE program's ability to make
distributions will not be treated as a pledge or grant of security for a
loan during the period between the use of the check or debit card and
the clearing or settlement of that transaction, provided that the ABLE
program does not advance funds to a designated beneficiary in excess of
the amount in the designated beneficiary's ABLE account.
(n) No sale or exchange. A qualified ABLE program must ensure that
no interest in an ABLE account may be sold or exchanged.
(o) Post-death payments. A qualified ABLE program must provide that
a portion or all of the balance remaining in the ABLE account of a
deceased designated beneficiary must be distributed to a State that
files a claim against the designated beneficiary or the ABLE account
itself with respect to benefits provided to the designated beneficiary
under that State's Medicaid plan established under title XIX of the
Social Security Act. The payment of such claim (if any) will be made
only after providing for the payment from the designated beneficiary's
ABLE account of the designated beneficiary's funeral and burial expenses
(including the unpaid balance of a pre-death contract for those
services) and all outstanding
[[Page 305]]
payments due for his or her other qualified disability expenses, and
will be limited to the amount of the total medical assistance paid for
the designated beneficiary after the establishment of the ABLE account
over the amount of any premiums paid, whether from the ABLE account or
otherwise by or on behalf of the designated beneficiary, to a Medicaid
Buy-In program under any such State Medicaid plan. The establishment of
the ABLE account is the date on which the ABLE account was established
or, if earlier, the date on which was established any ABLE account for
the same designated beneficiary from which amounts were rolled over or
transferred to the ABLE account, but in no event earlier than the date
on which the designated beneficiary became the designated beneficiary of
the account from which amounts were transferred. After the expiration of
the applicable statute of limitations for filing Medicaid claims against
the designated beneficiary's estate, a qualified ABLE program may
distribute the balance of the ABLE account to the successor designated
beneficiary or, if none, to the deceased designated beneficiary's
estate. A State law prohibiting the filing of such a claim against
either the ABLE account or the designated beneficiary's estate will not
prevent that State's program from being a qualified ABLE program.
(p) Reporting requirements. A qualified ABLE program must comply
with all applicable reporting requirements, including without limitation
those described in Sec. Sec. 1.529A-5 through 1.529A-7.
(q) Applicability date. This section applies to calendar years
beginning on or after January 1, 2021. See Sec. 1.529A-8 for the
provision of transition relief.
Sec. 1.529A-3 Tax treatment.
(a) Taxation of distributions--(1) In general. Each distribution
from an ABLE account consists of an earnings portion of the account
(computed in accordance with paragraph (c) of this section) and
investment in the account. If the total amount distributed from an ABLE
account to or for the benefit of the designated beneficiary of that ABLE
account during his or her taxable year does not exceed the qualified
disability expenses of the designated beneficiary paid during that year,
no amount distributed is includible in the gross income of the
designated beneficiary for that year. If the total amount distributed
from an ABLE account to or for the benefit of the designated beneficiary
of that ABLE account during his or her taxable year exceeds the
qualified disability expenses of the designated beneficiary paid during
that year (regardless of when incurred), the distributions from the ABLE
account, except to the extent excluded from gross income under this
section or any other provision of chapter 1 of the Internal Revenue
Code, must be included in the gross income of the designated beneficiary
in the manner provided under this section and section 72. The amount to
be included in gross income is based on the earnings portion of each
distribution, computed in accordance with paragraph (c) of this section.
The earnings portion that is includible in gross income is the sum of
the earnings portion of all distributions made in that year, reduced by
an amount that bears the same ratio to the total earnings portion as the
amount of qualified disability expenses paid during the year bears to
such total distributions during the year. If an excess contribution or
excess aggregate contribution is returned within the time period
required in Sec. 1.529A-2(g)(4), any net income distributed is
includible in the gross income of the contributor(s) in the taxable year
in which the excess contribution or excess aggregate contribution was
made.
(2) Additional period. The designated beneficiary may treat as
having been paid during the preceding taxable year qualified disability
expenses paid on or before the 60th day immediately following the end of
the designated beneficiary's preceding taxable year. Qualified
disability expenses treated, pursuant to the rule in the preceding
sentence, as having been paid during the designated beneficiary's
taxable year immediately prior to the year of their actual payment may
not be included in the total qualified disability expenses for the year
in which they were paid.
(b) Additional exclusions from gross income--(1) Rollover. A
rollover as defined in Sec. 1.529A-1(b)(16) is not included in
[[Page 306]]
gross income under paragraph (a) of this section.
(2) Program-to-program transfers. A program-to-program transfer as
defined in Sec. 1.529A-1(b)(13) is not a distribution and is not
included in gross income under paragraph (a) of this section.
(3) Change of designated beneficiary--(i) In general. A change of
designated beneficiary of an ABLE account is not treated as a
distribution for purposes of section 529A, and is not included in gross
income under paragraph (a) of this section, if the successor designated
beneficiary is--
(A) An eligible individual for the taxable year in which the change
is made; and
(B) A member of the family (as defined in Sec. 1.529A-1(b)(12)) of
the former designated beneficiary.
(ii) Other designated beneficiary changes. In the case of any change
of designated beneficiary not described in paragraph (b)(3)(i) of this
section, the former designated beneficiary of that ABLE account will be
treated as having received a distribution of the fair market value of
the assets in that ABLE account on the date on which the change is made
to the new designated beneficiary.
(4) Payments to creditors post-death. Distributions made after the
death of the designated beneficiary in payment of outstanding
obligations due for qualified disability expenses, as well as the
funeral and burial expenses of the designated beneficiary, are not
included in gross income of the designated beneficiary or his or her
estate. Included among these obligations is the post-death payment of
any part of a claim filed against the deceased designated beneficiary or
his or her estate or ABLE account by a State with respect to benefits
provided to the designated beneficiary under that State's Medicaid plan.
(c) Computation of earnings. The earnings portion of a distribution
is equal to the product of the amount of the distribution and the
earnings ratio, as defined in Sec. 1.529A-1(b)(7). The balance of the
distribution (the amount of the distribution minus the earnings portion
of that distribution) is the portion of that distribution that
constitutes the return of investment in the account.
(d) Additional tax on amounts includible in gross income--(1) In
general. If any amount of a distribution from an ABLE account is
includible in the gross income of a person for any taxable year under
paragraph (a) of this section (includible amount), the income tax
imposed on that person by chapter 1 of the Internal Revenue Code will be
increased by an amount equal to 10 percent of the includible amount.
(2) Exceptions--(i) Distributions on or after the death of the
designated beneficiary. Paragraph (d)(1) of this section does not apply
to any distribution made from the ABLE account on or after the death of
the designated beneficiary to the estate of the designated beneficiary,
to an heir or legatee of the designated beneficiary, or to a creditor
described in paragraph (b)(4) of this section.
(ii) Returned excess contributions and additional accounts.
Paragraph (d)(1) of this section does not apply to any return made in
accordance with Sec. 1.529A-2(g)(4) of an excess contribution as
defined in Sec. 1.529A-1(b)(9), an excess compensation contribution as
defined in Sec. 1.529A-2(g)(2)(iii)(C), excess aggregate contribution
as defined in Sec. 1.529A-1(b)(10), or an additional account as
referenced in Sec. 1.529A-2(c)(3)(ii)(A), (B), or (C).
(e) Tax on excess contributions. Under section 4973(h), a
contribution to an ABLE account in excess of the annual contributions
limit described in Sec. 1.529A-2(g)(2) is subject to an excise tax in
an amount equal to 6 percent of the excess contribution. However, any
the excess contribution or excess compensation contribution as defined
in Sec. 1.529A-2(g)(2)(iii)(C) returned in accordance with the
provisions of Sec. 1.529A-2(g)(4) is not treated as a contribution.
(f) Filing requirements. A qualified ABLE program is not required to
file Form 990, ``Return of Organization Exempt From Income Tax,'' Form
1041, ``U.S. Income Tax Return for Estates
[[Page 307]]
and Trusts,'' or Form 1120, ``U.S. Corporation Income Tax Return.''
However, a qualified ABLE program is required to file Form 990-T,
``Exempt Organization Business Income Tax Return,'' if such filing would
be required under the rules of Sec. Sec. 1.6012-2(e) and 1.6012-3(a)(5)
if the ABLE program were an organization described in those sections.
(g) No inference outside section 529A. The rules provided in this
section concerning the Federal tax treatment of contributions apply only
for purposes of the application of section 529A. No inference is
intended with respect to the application of any other Code provisions or
Federal tax doctrines. For example, a contribution made by an employer
to the ABLE account of an employee or an employee's family member is
subject to the rules governing the Federal taxation of compensation.
(h) Applicability date. This section applies to calendar years
beginning on or after January 1, 2021. See Sec. 1.529A-8 for the
provision of transition relief.
Sec. 1.529A-4 Gift, estate, and generation-skipping transfer taxes.
(a) Contributions--(1) In general. Each contribution by a person to
an ABLE account other than by the designated beneficiary of that account
is treated as a completed gift to the designated beneficiary of the
account for gift tax purposes. Under the applicable Federal gift tax
rules, a contribution from a corporation, partnership, trust, estate, or
other entity is treated as a gift by the shareholders, partners, or
other beneficial owners in proportion to their respective ownership
interests in the entity. See Sec. 25.2511-1(c) and (h) of this chapter.
A gift to an ABLE account is not treated as either a gift of a future
interest in property, or a qualified transfer under section 2503(e). To
the extent a contributor's gifts to the designated beneficiary,
including gifts paid into the designated beneficiary's ABLE account, do
not exceed the annual limit in section 2503(b), the contribution is not
a taxable gift. This provision, however, does not change any other
provision applicable to the transfer. For example, a contribution by the
employer of the designated beneficiary's parent continues to constitute
earned income to the parent and then a gift by the parent to the
designated beneficiary. The timely return of an excess contribution or
an excess aggregate contribution in accordance with Sec. 1.529A-2(g)(4)
is not a taxable gift.
(2) Generation-skipping transfer (GST) tax. To the extent the
contribution into an ABLE account is a nontaxable gift for Federal gift
tax purposes, the inclusion ratio for purposes of the GST tax will be
zero pursuant to section 2642(c)(1).
(3) Designated beneficiary as contributor. A designated beneficiary
may make a contribution to fund his or her own ABLE account. That
contribution is not a gift.
(b) Distributions. No distribution from an ABLE account to or for
the benefit of the designated beneficiary is treated as a taxable gift
to that designated beneficiary.
(c) Transfer to another designated beneficiary. Neither gift tax nor
generation-skipping transfer tax applies to the transfer (by rollover,
program-to-program transfer, or change of beneficiary) of part or all of
an ABLE account to the ABLE account of a different designated
beneficiary if the successor designated beneficiary is both an eligible
individual and a member of the family (as described in Sec. 1.529A-
1(b)(12)) of the designated beneficiary. Any other transfer will
constitute a gift by the designated beneficiary to the successor
designated beneficiary, and the usual gift and GST tax rules will apply.
(d) Transfer tax on death of designated beneficiary. Upon the death
of the designated beneficiary, the designated beneficiary's ABLE account
is includible in his or her gross estate for estate tax purposes under
section 2031. The payment of outstanding qualified disability expenses
and the payment of certain claims made by a State under its Medicaid
plan may be deductible for estate tax purposes if the requirements of
section 2053 are satisfied.
(e) Applicability date. This section applies to calendar years
beginning on or after January 1, 2021. See Sec. 1.529A-8 for the
provision of transition relief.
[[Page 308]]
Sec. 1.529A-5 Reporting of the establishment of and contributions to
an ABLE account.
(a) In general. A filer defined in paragraph (b)(1) of this section
must, with respect to each ABLE account--
(1) File an annual information return, as described in paragraph (c)
of this section, with the Internal Revenue Service; and
(2) Furnish an annual statement, as described in paragraph (d) of
this section, to the designated beneficiary of the ABLE account.
(b) Additional definitions. In addition to the definitions in Sec.
1.529A-1(b), the following definitions also apply for purposes of this
section--
(1) Filer means the State or its agency or instrumentality that
establishes and maintains the qualified ABLE program under which an ABLE
account is established. The filing may be done by either an officer or
employee of the State or its agency or instrumentality having control of
the qualified ABLE program, or the officer's or employee's designee.
(2) TIN means taxpayer identification number as defined in section
7701(a)(41).
(c) Requirement to file return--(1) Form of return. For purposes of
reporting the information described in paragraph (c)(2) of this section,
the filer must file Form 5498-QA, ``ABLE Account Contribution
Information,'' or any successor form, together with Form 1096, ``Annual
Summary and Transmittal of U.S. Information Returns.''
(2) Information included on return. With respect to each ABLE
account, the filer must include on the return--
(i) The name, address, and TIN of the designated beneficiary of the
ABLE account;
(ii) The name, address, and TIN of the filer;
(iii) Information regarding the establishment of the ABLE account,
as required by the form and its instructions;
(iv) Information regarding the disability certification or other
basis for eligibility of the designated beneficiary, as required by the
form and its instructions. For further information regarding eligibility
and disability certification, see Sec. 1.529A-2(d) and (e),
respectively;
(v) The total amount of any contributions made with respect to the
ABLE account during the calendar year; such contributions do not include
any contribution rejected and returned to the contributor before being
deposited into or allocated to the ABLE account or any excess
contributions, excess compensation contributions, or excess aggregate
contributions returned as described in Sec. 1.529A-2(g)(4);
(vi) The fair market value of the ABLE account as of the last day of
the calendar year; and
(vii) Any other information required by the form, its instructions,
or published guidance. See Sec. Sec. 601.601(d) and 601.602 of this
chapter.
(3) Time and manner of filing return--(i) In general. Except as
provided in paragraph (c)(3)(ii) of this section, the information
returns required under this paragraph must be filed on or before May 31
of the year following the calendar year with respect to which the return
is being filed, in accordance with the forms and their instructions.
(ii) Extensions of time. See Sec. Sec. 1.6081-1 and 1.6081-8 for
rules relating to extensions of time to file information returns
required in this section.
(iii) Electronic filing. See Sec. 301.6011-2 of this chapter for
rules relating to electronic filing. See also Instructions for Forms
1099-QA and 5498-QA, Distributions From ABLE Accounts and ABLE Account
Contribution Information.
(iv) Substitute forms. The filer may file the returns required under
this paragraph (c) on an acceptable substitute form. See Publication
1179, ``General Rules and Specifications for Substitute Forms 1096,
1098, 1099, 5498, and Certain Other Information Returns.''
(d) Requirement to furnish statement--(1) In general. The filer must
furnish a statement to the designated beneficiary of the ABLE account
for which it is required to file a Form 5498-QA (or any successor form).
The statement must include--
(i) The information required under paragraph (c)(2) of this section;
(ii) A legend that identifies the statement as important tax
information that is being furnished to the Internal Revenue Service; and
[[Page 309]]
(iii) The name and address of the office or department of the filer
that is the information contact for questions regarding the ABLE account
to which the Form 5498-QA relates.
(2) Time and manner of furnishing statement--(i) In general. Except
as provided in paragraph (d)(2)(ii) of this section, the filer must
furnish the statement described in paragraph (d)(1) of this section to
the designated beneficiary on or before March 15 of the year following
the calendar year with respect to which the statement is being
furnished. If mailed, the statement must be sent to the designated
beneficiary's last known address. The statement may be furnished
electronically, as provided in Sec. 1.529A-7.
(ii) Extensions of time. The Internal Revenue Service may, at its
discretion, grant an extension of time to furnish statements required in
this section.
(3) Copy of Form 5498-QA. The filer may satisfy the requirement of
this paragraph (d) by furnishing either a copy of Form 5498-QA (or
successor form) or an acceptable substitute form. See Publication 1179,
``General Rules and Specifications for Substitute Forms 1096, 1098,
1099, 5498, and Certain Other Information Returns.''
(e) Request for TIN of designated beneficiary. The filer must
request the TIN of the designated beneficiary at the time the ABLE
account is established if the filer does not already have a record of
the designated beneficiary's correct TIN. The filer must clearly notify
the designated beneficiary that the law requires the designated
beneficiary to furnish a TIN so that it may be included on an
information return to be filed by the filer. The designated beneficiary
may provide his or her TIN in any manner including orally, in writing,
or electronically. If the TIN is furnished in writing, no particular
form is required. Form W-9, ``Request for Taxpayer Identification Number
and Certification,'' may be used, or the request may be incorporated
into the forms related to the establishment of the ABLE account.
(f) Penalties--(1) Failure to file return. The section 6693 penalty
may apply to the filer that fails to file information returns at the
time and in the manner required by this section, unless it is shown that
such failure is due to reasonable cause. See section 6693 and Sec.
301.6693-1 of this chapter.
(2) Failure to furnish TIN. The section 6723 penalty may apply to
any designated beneficiary who fails to furnish his or her TIN to the
filer. See section 6723, and Sec. 301.6723-1 of this chapter, for rules
relating to the penalty for failure to furnish a TIN.
(g) Applicability date. The rules of this section apply to
information returns required to be filed, and payee statements required
to be furnished, after December 31, 2020. See Sec. 1.529A-8 for the
provision of transition relief.
Sec. 1.529A-6 Reporting of distributions from and termination of an
ABLE account.
(a) In general. The filer as defined in Sec. 1.529A-5(b)(1) must,
with respect to each ABLE account from which any distribution is made or
which is terminated during the calendar year--
(1) File an annual information return, as described paragraph (b) of
this section, with the Internal Revenue Service; and
(2) Furnish an annual statement, as described in paragraph (c) of
this section, to the designated beneficiary of the ABLE account and to
each contributor who received a returned contribution in accordance with
Sec. 1.529A-2(g)(4) attributable to the calendar year.
(b) Requirement to file return--(1) Form of return. For purposes of
reporting the information in paragraph (b)(2) of this section, the filer
must file Form 1099-QA, ``Distributions From ABLE Accounts,'' or any
successor form, together with Form 1096, ``Annual Summary and
Transmittal of U.S. Information Returns.''
(2) Information included on return. The filer must include on the
return--
(i) The name, address, and TIN of the recipient of the payment,
whether the designated beneficiary of the ABLE account or any
contributor who received a returned contribution in accordance with
Sec. 1.529A-2(g)(4) attributable to the calendar year;
(ii) The name, address, and TIN of the filer;
(iii) Whether the return is being filed with respect to the
designated beneficiary or to a contributor;
[[Page 310]]
(iv) The aggregate amount of distributions or returned contributions
(including net income attributable to the returned contributions) from
the ABLE account to the recipient during the calendar year;
(v) Information as to basis and earnings with respect to such
distributions or returns of contributions;
(vi) Information regarding termination (if any) of the ABLE account
if the recipient is the designated beneficiary;
(vii) Information regarding each program-to-program transfer from
the ABLE account during the designated beneficiary's taxable year; and
(viii) Any other information required by the form, its instructions,
or published guidance. See Sec. Sec. 601.601(d) and 601.602 of this
chapter.
(3) Information excluded. A State filing a claim against the estate
or ABLE account of a deceased designated beneficiary with respect to
benefits provided to the designated beneficiary under that State's
Medicaid plan is a creditor, and not a beneficiary, so the payment of
the claim is not a distribution from the ABLE account and should not be
reported as such on the Form 1099-QA for that year.
(4) Time and manner of filing return--(i) In general. Except as
provided in paragraph (b)(4)(ii) of this section, the Forms 1099-QA and
1096 must be filed on or before February 28 (March 31 if filing
electronically) of the year following the calendar year with respect to
which the return is being filed, in accordance with the forms and their
instructions.
(ii) Extensions of time. See Sec. Sec. 1.6081-1 and 1.6081-8 for
rules relating to extensions of time to file information returns
required in this section.
(iii) Electronic filing. See Sec. 301.6011-2 of this chapter for
rules relating to electronic filing. See also Instructions for Forms
1099-QA and 5498-QA, Distributions From ABLE Accounts and ABLE Account
Contribution Information.
(iv) Substitute forms. The filer may file the return required under
this paragraph (b) on an acceptable substitute form. See Publication
1179, ``General Rules and Specifications for Substitute Forms 1096,
1098, 1099, 5498, and Certain Other Information Returns.''
(c) Requirement to furnish statement--(1) In general. The filer must
furnish a statement to the designated beneficiary and each contributor
(if any) of the ABLE account for which it is required to file a Form
1099-QA (or any successor form). The statement must include--
(i) The information required under paragraph (b)(2) of this section.
(ii) A legend that identifies the statement as important tax
information that is being furnished to the Internal Revenue Service; and
(iii) The name and address of the office or department of the filer
that is the information contact for questions regarding the ABLE account
to which the Form 1099-QA relates.
(2) Time and manner of furnishing statement--(i) In general. Except
as provided in paragraph (c)(2)(ii) of this section, a filer must
furnish the statement described in paragraph (c)(1) of this section to
the designated beneficiary or contributor on or before January 31 of the
year following the calendar year with respect to which the statement is
being furnished. If mailed, the statement must be sent to the
recipient's last known address. The statement may be furnished
electronically, as provided in Sec. 1.529A-7.
(ii) Extensions of time. The Internal Revenue Service may, at its
discretion, grant an extension of time to furnish statements required in
this section.
(3) Copy of Form 1099-QA. A filer may satisfy the requirement of
this paragraph (c) by furnishing either a copy of Form 1099-QA (or
successor form) or an acceptable substitute form. See Publication 1179,
``General Rules and Specifications for Substitute Forms 1096, 1098,
1099, 5498, and Certain Other Information Returns.''
(d) Request for TIN of contributor(s)--(1) In general. Except as
provided in paragraph (d)(2) of this section, a filer must request the
TIN of each contributor to the ABLE account at the time a contribution
is made, if the filer does not already have a record of that person's
correct TIN.
(2) Exception. If the filer has a system in place to identify and
reject amounts that either would constitute an excess
[[Page 311]]
contribution or excess aggregate contribution (as defined in Sec.
1.529A-1(b)(9) or (10), respectively) or were contributed to an
additional ABLE account as described in Sec. 1.529A-2(c)(3)(ii)(C)
(excess amounts) before those excess amounts are deposited into or
allocated to an ABLE account, the filer need not request the TIN of each
contributor at the time of contribution. A filer with such a system must
request a contributor's TIN only if and when an excess contribution or
excess aggregate contribution nevertheless is deposited into or
allocated to an account and the filer must return the excess amounts
including net income to the contributor. The filer must clearly notify
each such contributor to the account that the law requires that person
to furnish a TIN so that it may be included on an information return to
be filed by the filer. The contributor may provide his or her TIN in any
manner including orally, in writing, or electronically. If the TIN is
furnished in writing, no particular form is required. Form W-9,
``Request for Taxpayer Identification Number and Certification,'' may be
used, or the request may be incorporated into the forms related to the
establishment of the ABLE account.
(e) Penalties--(1) Failure to file return. The section 6693 penalty
may apply to a filer that fails to file information returns at the time
and in the manner required by this section, unless it is shown that such
failure is due to reasonable cause. See section 6693 and Sec. 301.6693-
1 of this chapter.
(2) Failure to furnish TIN. The section 6723 penalty may apply to
any contributor who fails to furnish his or her TIN to the filer in
accordance with paragraph (d) of this section. See section 6723, and
Sec. 301.6723-1 of this chapter, for rules relating to the penalty for
failure to furnish a TIN.
(f) Applicability date. The rules of this section apply to
information returns required to be filed, and payee statements required
to be furnished, after December 31, 2020. See Sec. 1.529A-8 for the
provision of transition relief.
Sec. 1.529A-7 Electronic furnishing of statements to designated
beneficiaries and contributors.
(a) Electronic furnishing of statements--(1) In general. A filer
required under Sec. 1.529A-5 or Sec. 1.529A-6 to furnish a written
statement to a designated beneficiary of or contributor to an ABLE
account may furnish the statement in an electronic format in lieu of a
paper format. A filer who meets the requirements of paragraphs (a)(2)
through (6) of this section is treated as furnishing the required
statement.
(2) Consent--(i) In general. The recipient of the statement must
have affirmatively consented to receive the statement in an electronic
format. The consent may be made electronically in any manner that
reasonably demonstrates that the recipient can access the statement in
the electronic format in which it will be furnished to the recipient.
Alternatively, the consent may be made in a paper document if it is
confirmed electronically.
(ii) Withdrawal of consent. The consent requirement of this
paragraph (a)(2) is not satisfied if the recipient withdraws the consent
and the withdrawal takes effect before the statement is furnished. The
filer may provide that a withdrawal of consent takes effect either on
the date it is received by the filer or on another date no more than 60
days later. The filer also may provide that a request for a paper
statement will be treated as a withdrawal of consent.
(iii) Change in hardware or software requirements. If a change in
the hardware or software required to access the statement creates a
material risk that the recipient will not be able to access the
statement, the filer must, prior to changing the hardware or software,
provide the recipient with a notice. The notice must describe the
revised hardware and software required to access the statement and
inform the recipient that a new consent to receive the statement in the
revised electronic format must be provided to the filer if the recipient
does not want to withdraw the consent. After implementing the revised
hardware and software, the filer must obtain from the recipient, in the
manner described in paragraph (a)(2)(i) of this section, a new consent
[[Page 312]]
or confirmation of consent to receive the statement electronically.
(iv) Examples. For purposes of the following examples that
illustrate the rules of this paragraph (a)(2), assume that the
requirements of Sec. 1.529A-7(a)(3) have been met:
(A) Example 1. Filer F sends Recipient R a letter stating that R may
consent to receive statements required under Sec. 1.529A-5 or Sec.
1.529A-6 electronically on a website instead of in a paper format. The
letter contains instructions explaining how to consent to receive the
statements electronically by accessing the website, downloading the
consent document, completing the consent document, and emailing the
completed consent back to F. The consent document posted on the website
uses the same electronic format that F will use for the electronically
furnished statements. R reads the instructions and submits the consent
in the manner provided in the instructions. R has consented to receive
the statements electronically in the manner described in paragraph
(a)(2)(i) of this section.
(B) Example 2. Filer F sends Recipient R an email stating that R may
consent to receive statements required under Sec. 1.529A-5 or Sec.
1.529A-6 electronically instead of in a paper format. The email contains
an attachment instructing R how to consent to receive the statements
electronically. The email attachment uses the same electronic format
that F will use for the electronically furnished statements. R opens the
attachment, reads the instructions, and submits the consent in the
manner provided in the instructions. R has consented to receive the
statements electronically in the manner described in paragraph (a)(2)(i)
of this section.
(C) Example 3. Filer F posts a notice on its website stating that
Recipient R may receive statements required under Sec. 1.529A-5 or
Sec. 1.529A-6 electronically instead of in a paper format. The website
contains instructions on how R may access a secure web page and consent
to receive the statements electronically. By accessing the secure web
page and giving consent, R has consented to receive the statements
electronically in the manner described in paragraph (a)(2)(i) of this
section.
(3) Required disclosures--(i) In general. Prior to, or at the time
of, a recipient's consent, the filer must provide to the recipient a
clear and conspicuous disclosure statement containing each of the
disclosures described in paragraphs (a)(3)(ii) through (viii) of this
section.
(ii) Paper statement. The recipient must be informed that the
statement will be furnished on paper if the recipient does not consent
to receive it electronically.
(iii) Scope and duration of consent. The recipient must be informed
of the scope and duration of the consent. For example, the recipient
must be informed whether the consent applies to statements furnished
every year after the consent is given until it is withdrawn in the
manner described in paragraph (a)(3)(v)(A) of this section, or only to
the statement required to be furnished on or before the due date
immediately following the date on which the consent is given.
(iv) Post-consent request for a paper statement. The recipient must
be informed of any procedure for obtaining a paper copy of the
recipient's statement after giving the consent and whether a request for
a paper statement will be treated as a withdrawal of consent.
(v) Withdrawal of consent. The recipient must be informed that--
(A) The recipient may withdraw a consent by writing (electronically
or on paper) to the person or department whose name, mailing address,
and email address is provided in the disclosure statement;
(B) The filer will confirm, in writing (electronically or on paper),
the withdrawal and the date on which it takes effect; and
(C) A withdrawal of consent does not apply to a statement that was
furnished electronically in the manner described in this paragraph (a)
before the date on which the withdrawal of consent takes effect.
(vi) Notice of termination. The recipient must be informed of the
conditions under which a filer will cease furnishing statements
electronically to the recipient.
(vii) Updating information. The recipient must be informed of the
procedures for updating the information needed by
[[Page 313]]
the filer to contact the recipient. The filer must inform the recipient
of any change in the filer's contact information.
(viii) Hardware and software requirements. The recipient must be
provided with a description of the hardware and software required to
access, print, and retain the statement, and the date when the statement
will no longer be available on the website.
(4) Format. The electronic version of the statement must contain all
required information. See Publication 1179, ``General Rules and
Specifications for Substitute Forms 1096, 1098, 1099, 5498, and Certain
Other Information Returns.''
(5) Notice--(i) In general. If the statement is furnished on a
website, the filer must notify the recipient that the statement is
posted on a website. The notice may be delivered by mail, electronic
mail, or in person. The notice must provide instructions on how to
access and print the statement. The notice must include the following
statement in capital letters, ``IMPORTANT TAX RETURN DOCUMENT
AVAILABLE.'' If the notice is provided by electronic mail, the foregoing
statement must be in the subject line of the electronic mail.
(ii) Undeliverable electronic address. If an electronic notice
described in paragraph (a)(5)(i) of this section is returned as
undeliverable, and the correct electronic address cannot be obtained
from the filer's records or from the recipient, then the filer must
furnish the notice by mail or in person within 30 days after the
electronic notice is returned.
(iii) Corrected statements. If the filer has corrected a recipient's
statement that was furnished electronically, the filer must furnish the
corrected statement to the recipient electronically. If the recipient's
statement was furnished through a website posting and the filer has
corrected the statement, the filer must notify the recipient that it has
posted the corrected statement on the website within 30 days of such
posting in the manner described in paragraph (a)(5)(i) of this section.
The corrected statement or the notice must be furnished by mail or in
person if--
(A) An electronic notice of the website posting of an original
statement or the corrected statement was returned as undeliverable; and
(B) The recipient has not provided a new email address.
(6) Access period. Statements furnished on a website must be
retained on the website through October 15 of the year following the
calendar year to which the statements relate (or the first business day
after such October 15 if October 15 falls on a Saturday, Sunday, or
legal holiday). The filer must maintain access to corrected statements
that are posted on the website through October 15 of the year following
the calendar year to which the statements relate (or the first business
day after such October 15 if October 15 falls on a Saturday, Sunday, or
legal holiday) or the date 90 days after the corrected statements are
posted, whichever is later. The rules in this paragraph (a)(6) do not
replace the filer's obligation to keep records under section 6001 and
Sec. 1.6001-1(a).
(b) Applicability date. This section applies to statements required
to be furnished after December 31, 2020. See Sec. 1.529A-8 for the
provision of transition relief.
Sec. 1.529A-8 Applicability dates and transition relief.
(a) Applicability dates. Except as otherwise provided in paragraph
(b) of this section, Sec. Sec. 1.529A-1 through 1.529A-4 apply for
calendar years beginning on or after January 1, 2021, Sec. Sec. 1.529A-
5 and 1.529A-6 apply to information returns required to be filed, and
payee statements required to be furnished, after December 31, 2020, and
Sec. 1.529A-7 applies to statements required to be furnished after
December 31, 2020.
(b) Transition relief--(1) In general. Any program purporting to be
a qualified ABLE program will not be disqualified during the transition
period set forth in paragraph (b)(2) of this section (transition period)
solely because of noncompliance with one or more provisions of
Sec. Sec. 1.529A-1 through 1.529A-7, provided that the program is
established and operated in accordance with a reasonable, good faith
interpretation of section 529A. Similarly, no ABLE account established
and maintained
[[Page 314]]
under a program that meets the requirements of this paragraph will fail
to qualify as an ABLE account during the transition period. However, to
be a qualified ABLE program and an ABLE account under such a program
after the transition period, the program and each account established
and maintained under the program must be in compliance with Sec. Sec.
1.529A-1 through 1.529A-7 by the end of the transition period. In no
event, however, will a complete failure to file and furnish reports,
information returns and payee statements required under section
529A(d)(1) for any accounts established and maintained under the program
(including for calendar years beginning prior to January 1, 2021), be
deemed to be due to reasonable cause for purposes of avoiding penalties
imposed under section 6693.
(2) Transition period. For purposes of paragraph (b)(1) of this
section, the transition period begins with the establishment of the
program purporting to be a qualified ABLE program and continues through
the later of--
(i) November 21, 2022; or
(ii) The day immediately preceding the first day of the qualified
ABLE program's first taxable year beginning after the close of the first
regular session of the State legislature that begins after November 19,
2020. If a State has a two-year legislative session, each calendar year
of such session will be deemed to be a separate regular session of the
State legislature for purposes of this paragraph.
(3) Compliance after transition period. After the transition period,
a program and an account established and maintained under that program
must be in compliance with Sec. Sec. 1.529A-1 through 1.529A-7.
Corporations Used To Avoid Income Tax on Shareholders
Corporations Improperly Accumulating Surplus--Table of Contents
Sec. 1.531-1 Imposition of tax.
Section 531 imposes (in addition to the other taxes imposed upon
corporations by chapter 1 of the Code) a graduated tax on the
accumulated taxable income of every corporation described in section 532
and Sec. 1.532-1. In the case of an affiliated group which makes or is
required to make a consolidated return see Sec. 1.1502-43. All of the
taxes on corporations under chapter 1 of the Code are treated as one tax
for purposes of assessment, collection, payment, period of limitations,
etc. See section 535 and Sec. Sec. 1.535-1, 1.535-2, and 1.535-3 for
the definition and determination of accumulated taxable income.
(Secs. 1502 and 7805 of the Internal Revenue Code of 1954 (68A Stat.
637, 917; 26 U.S.C. 1502, 7805))
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7244, 37 FR
28897, Dec. 30, 1972; T.D. 7937, 49 FR 3462, Jan. 27, 1984]
Sec. 1.532-1 Corporations subject to accumulated earnings tax.
(a) General rule. (1) The tax imposed by section 531 applies to any
domestic or foreign corporation (not specifically excepted under section
532(b) and paragraph (b) of this section) formed or availed of to avoid
or prevent the imposition of the individual income tax on its
shareholders, or on the shareholders of any other corporation, by
permitting earnings and profits to accumulate instead of dividing or
distributing them. See section 533 and Sec. 1.533-1, relating to
evidence of purpose to avoid income tax with respect to shareholders.
(2) The tax imposed by section 531 may apply if the avoidance is
accomplished through the formation or use of one corporation or a chain
of corporations. For example, if the capital stock of the M Corporation
is held by the N Corporation, the earnings and profits of the M
Corporation would not be returned as income subject to the individual
income tax until such earnings and profits of the M Corporation were
distributed to the N Corporation and distributed in turn by the N
Corporation to its shareholders. If either the M Corporation or the N
Corporation was formed or is availed of for the purpose of avoiding or
preventing the imposition of the individual income tax upon the
shareholders of the N Corporation, the accumulated taxable income of the
corporation so formed or availed of (M or N, as the case may be) is
subject to the tax imposed by section 531.
[[Page 315]]
(b) Exceptions. The accumulated earnings tax imposed by section 531
does not apply to a personal holding company (as defined in section
542), to a foreign personal holding company (as defined in section 552),
or to a corporation exempt from tax under subchapter F, chapter 1 of the
Code.
(c) Foreign corporations. Section 531 is applicable to any foreign
corporation, whether resident or nonresident, with respect to any income
derived from sources, within the United States, if any of its
shareholders are subject to income tax on the distributions of the
corporation by reason of being (1) citizens or residents of the United
States, or (2) nonresident alien individuals to whom section 871 is
applicable, or (3) foreign corporations if a beneficial interest therein
is owned directly or indirectly by any shareholder specified in
subparagraph (1) or (2) of this paragraph.
Sec. 1.533-1 Evidence of purpose to avoid income tax.
(a) In general. (1) The Commissioner's determination that a
corporation was formed or availed of for the purpose of avoiding income
tax with respect to shareholders is subject to disproof by competent
evidence. Section 533(a) provides that the fact that earnings and
profits of a corporation are permitted to accumulate beyond the
reasonable needs of the business shall be determinative of the purpose
to avoid the income tax with respect to shareholders unless the
corporation, by the preponderance of the evidence, shall prove to the
contrary. The burden of proving that earnings and profits have been
permitted to accumulate beyond the reasonable needs of the business may
be shifted to the Commissioner under section 534. See Sec. Sec. 1.534-1
through 1.534-4. Section 533(b) provides that the fact that the taxpayer
is a mere holding or investment company shall be prima facie evidence of
the purpose to avoid income tax with respect to shareholders.
(2) The existence or nonexistence of the purpose to avoid income tax
with respect to shareholders may be indicated by circumstances other
than the conditions specified in section 533. Whether or not such
purpose was present depends upon the particular circumstances of each
case. All circumstances which might be construed as evidence of the
purpose to avoid income tax with respect to shareholders cannot be
outlined, but among other things, the following will be considered:
(i) Dealings between the corporation and its shareholders, such as
withdrawals by the shareholders as personal loans or the expenditure of
funds by the corporation for the personal benefit of the shareholders,
(ii) The investment by the corporation of undistributed earnings in
assets having no reasonable connection with the business of the
corporation (see Sec. 1.537-3), and
(iii) The extent to which the corporation has distributed its
earnings and profits.
The fact that a corporation is a mere holding or investment company or
has an accumulation of earnings and profits in excess of the reasonable
needs of the business is not absolutely conclusive against it if the
taxpayer satisfies the Commissioner that the corporation was neither
formed nor availed of for the purpose of avoiding income tax with
respect to shareholders.
(b) General burden of proof and statutory presumptions. The
Commissioner may determine that the taxpayer was formed or availed of to
avoid income tax with respect to shareholders through the medium of
permitting earnings and profits to accumulate. In the case of litigation
involving any such determination (except where the burden of proof is on
the Commissioner under section 534), the burden of proving such
determination wrong by a preponderance of the evidence, together with
the corresponding burden of first going forward with the evidence, is on
the taxpayer under principles applicable to income tax cases generally.
For the burden of proof in a proceeding before the Tax Court with
respect to the allegation that earnings and profits have been permitted
to accumulate beyond the reasonable needs of the business, see section
534 and Sec. Sec. 1.534-2 through 1.534-4. For a definition of a
holding or investment company, see paragraph (c) of this section. For
determination of the reasonable needs of the
[[Page 316]]
business, see section 537 and Sec. Sec. 1.537-1 through 1.537-3. If the
taxpayer is a mere holding or investment company, and the Commissioner
therefore determines that the corporation was formed or availed of for
the purpose of avoiding income tax with respect to shareholders, then
section 533(b) gives further weight to the presumption ofcorrectness
already arising from the Commissioner's determination by expressly
providing an additional presumption of the existence of a purpose to
avoid income tax with respect to shareholders. Further, if it is
established (after complying with section 534 where applicable) that
earnings and profits were permitted to accumulate beyond the reasonable
needs of the business and the Commissioner has therefore determined that
the corporation was formed or availed of for the purpose of avoiding
income tax with respect to shareholders, then section 533(a) adds still
more weight to the Commissioner's determination. Under such
circumstances, the existence of such an accumulation is made
determinative of the purpose to avoid income tax with respect to
shareholders unless the taxpayer proves to the contrary by the
preponderance of the evidence.
(c) Holding or investment company. A corporation having practically
no activities except holding property and collecting the income
therefrom or investing therein shall be considered a holding company
within the meaning of section 533(b). If the activities further include,
or consist substantially of, buying and selling stocks, securities, real
estate, or other investment property (whether upon an outright or
marginal basis) so that the income is derived not only from the
investment yield but also from profits upon market fluctuations, the
corporation shall be considered an investment company within the meaning
of section 533(b).
(d) Small business investment companies. A corporation which is
licensed to operate as a small business investment company under the
Small Business Investment Act of 1958 (15 U.S.C. ch. 14B) and the
regulations thereunder (13 CFR part 107) will generally be considered to
be a mere holding or investment company within the meaning of section
533(b). However, the presumption of the existence of the purpose to
avoid income tax with respect to shareholders which results from the
fact that such a company is a mere holding or investment company will be
considered overcome so long as such company:
(1) Complies with all the provisions of the Small Business
Investment Act of 1958 and the regulations thereunder; and
(2) Actively engages in the business of providing funds to small
business concerns through investment in the equity capital of, or
through the disbursement of long-term loans to, such concerns in such
manner and under such terms as the company may fix in accordance with
regulations promulgated by the Small Business Administration (see secs.
304 and 305 of the Small Business Investment Act of 1958, as amended (15
U.S.C. 684, 685)).
On the other hand, if such a company violates or fails to comply with
any of the provisions of the Small Business Investment Act of 1958, as
amended, or the regulations thereunder, or ceases to be actively engaged
in the business of providing funds to small business concerns in the
manner provided in subparagraph (2) of this paragraph, it will not be
considered to have overcome the presumption by reason of any rules
provided in this paragraph.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6652, 28 FR
4786, May 14, 1963]
Sec. 1.533-2 Statement required.
The corporation may be required to furnish a statement of its
accumulated earnings and profits, the payment of dividends, the name and
address of, and number of shares held by, each of its shareholders, the
amounts that would be payable to each of the shareholders if the income
of the corporation were distributed and other information required under
section 6042.
Sec. 1.534-1 Burden of proof as to unreasonable accumulations generally.
For purposes of applying the presumption provided for in section
533(a) and in determining the extent of the accumulated earnings credit
under section 535(c)(1), the burden of proof with
[[Page 317]]
respect to an allegation by the Commissioner that all or any part of the
earnings and profits of the corporation have been permitted to
accumulate beyond the reasonable needs of the business may vary under
section 534 as between litigation in the Tax Court and that in any other
court. In case of a proceeding in a court other than the Tax Court, see
paragraph (b) of Sec. 1.533-1.
Sec. 1.534-2 Burden of proof as to unreasonable accumulations in cases
before the Tax Court.
(a) Burden of proof on Commissioner. Under the general rule provided
in section 534(a), in any proceeding before the Tax Court involving a
notice of deficiency based in whole or in part on the allegation that
all or any part of the earnings and profits have been permitted to
accumulate beyond the reasonable needs of the business, the burden of
proof with respect to such allegation is upon the Commissioner if:
(1) A notification, as provided for in section 534(b) and paragraph
(c) of this section, has not been sent to the taxpayer; or
(2) A notification, as provided for in section 534(b) and paragraph
(c) of this section, has been sent to the taxpayer and, in response to
such notification, the taxpayer has submitted a statement, as provided
in section 534(c) and paragraph (d) of this section, setting forth the
ground or grounds (together with facts sufficient to show the basis
thereof) on which it relies to establish that all or any part of its
earnings and profits have not been permitted to accumulate beyond the
reasonable needs of the business. However, the burden of proof in the
latter case is upon the Commissioner only with respect to the relevant
ground or grounds set forth in the statement submitted by the taxpayer,
and only if such ground or grounds are supported by facts (contained in
the statement) sufficient to show the basis thereof.
(b) Burden of proof on the taxpayer. The burden of proof in a Tax
Court proceeding with respect to an allegation that all or any part of
the earnings and profits have been permitted to accumulate beyond the
reasonable needs of the business is upon the taxpayer if:
(1) A notification, as provided for in section 534(b) and paragraph
(c) of this section, has been sent to the taxpayer and the taxpayer has
not submitted a statement, in response to such notification, as provided
in section 534(c) and paragraph (d) of this section; or
(2) A statement has been submitted by the taxpayer in response to
such notification, but the ground or grounds on which the taxpayer
relies are not relevant to the allegation or, if relevant, the statement
does not contain facts sufficient to show the basis thereof.
(c) Notification to the taxpayer. Under section 534(b) a
notification informing the taxpayer that the proposed notice of
deficiency includes an amount with respect to the accumulated earnings
tax imposed by section 531 may be sent by registered mail (or by
certified or registered mail, if the notification is mailed after
September 2, 1958) to the taxpayer at any time before the mailing of the
notice of deficiency in the case of a taxable year beginning after
December 31, 1953, and ending after August 16, 1954. See Sec. 1.534-4
for rules relating to taxable years subject to the Internal Revenue Code
of 1939. See section 534(d) and Sec. 1.534-3 with respect to a
notification in the case of a jeopardy assessment.
(d) Statement by taxpayer. (1) A taxpayer who has received a
notification, as provided in section 534(b) and paragraph (c) of this
section, that the proposed notice of deficiency includes an amount with
respect to the accumulated earnings tax imposed by section 531, may,
under section 534(c), submit a statement that all or any part of the
earnings and profits of the corporation have not been permitted to
accumulate beyond the reasonable needs of the business. Such statement
shall set forth the ground or grounds (together with facts sufficient to
show the basis thereof) on which the taxpayer relies to establish that
there has been no accumulation of earnings and profits beyond the
reasonable needs of the business. See paragraphs (a) and (b) of this
section for rules concerning the effect of the statement with respect to
burden of proof. See Sec. Sec. 1.537-1 to 1.537-3, inclusive, relating
to reasonable needs of the business.
[[Page 318]]
(2) The taxpayer's statement, under section 534(c) and this
paragraph, must be submitted to the Internal Revenue office which issued
the notification (referred to in section 534(b) and paragraph (c) of
this section) within 60 days after the mailing of such notification. If
the taxpayer is unable, for good cause, to submit the statement within
such 60-day period, an additional period not exceeding 30 days may be
granted upon receipt in the Internal Revenue office concerned (before
the expiration of the 60-day period provided herein) of a request from
the taxpayer, setting forth the reasons for such request. See section
534(d) and Sec. 1.534-3 with respect to a statement in the case of a
jeopardy assessment.
Sec. 1.534-3 Jeopardy assessments in Tax Court cases.
In the case of a jeopardy assessment, a notice of deficiency is
required to be sent to the taxpayer by registered mail (or by certified
or registered mail, if the notice is mailed after September 2, 1958)
within 60 days after the making of the assessment. See section 6861. If
a jeopardy assessment is made before the mailing of the deficiency
notice, then in the case of a proceeding in the Tax Court, if the
deficiency notice informs the taxpayer that an amount of accumulated
earnings tax is included in the deficiency, such notice shall constitute
the notification provided for in section 534(b) and paragraph (c) of
Sec. 1.534-2. Under such circumstances the statement described in
section 534(c) and paragraph (d) of Sec. 1.534-2 shall instead be
included in the taxpayer's petition to the Tax Court, if the taxpayer
desires to submit such statement. See paragraph (b) of Sec. 1.534-2,
relating to burden of proof on the taxpayer.
Sec. 1.535-1 Definition.
(a) The accumulated earnings tax is imposed by section 531 on the
accumulated taxable income. Accumulated taxable income is the taxable
income of the corporation with the adjustments prescribed by section
535(b) and Sec. 1.535-2, minus the sum of the dividends paid deduction
and the accumulated earnings credit. See section 561 and the regulations
thereunder, relating to the definition of the deduction for dividends
paid, and section 535(c) and Sec. 1.535-3, relating to the accumulated
earnings credit.
(b) In the case of a foreign corporation, whether resident or
nonresident, which files or causes to be filed a return, the accumulated
taxable income shall be the taxable income from sources within the
United States with the adjustments prescribed by section 535(b) and
Sec. 1.535-2 minus the sum of the dividends paid deduction and the
accumulated earnings credit. In the case of a foreign corporation which
files no return, the accumulated taxable income shall be the gross
income from sources within the United States without allowance of any
deductions (including the accumulated earnings credit).
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7244, 37 FR
28897, Dec. 30, 1972]
Sec. 1.535-2 Adjustments to taxable income.
(a) Taxes--(1) United States taxes. In computing accumulated taxable
income for any taxable year, there shall be allowed as a deduction the
amount by which Federal income and excess profits taxes accrued during
the taxable year exceed the credit provided by section 33 (relating to
taxes of foreign countries and possessions of the United States), except
that no deduction shall be allowed for (i) the accumulated earnings tax
imposed by section 531 (or a corresponding section of a prior law), (ii)
the personal holding company tax imposed by section 541 (or a
corresponding section of a prior law), and (iii) the excess profits tax
imposed by subchapter E, chapter 2 of the Internal Revenue Code of 1939,
for taxable years beginning after December 31, 1940. The deduction is
for taxes accrued during the taxable year, regardless of whether the
corporation uses an accrual method of accounting, the cash receipts and
disbursements method, or any other allowable method of accounting. In
computing the amount of taxes accrued, an unpaid tax which is being
contested is not considered accrued until the contest is resolved.
(2) Taxes of foreign countries and United States possessions. In
determining accumulated taxable income for any taxable year, if the
taxpayer
[[Page 319]]
chooses the benefits of section 901 for such taxable year, a deduction
shall be allowed for:
(i) The income, war profits, and excess profits taxes imposed by
foreign countries or possessions of the United States and accrued during
such taxable year, and
(ii) In the case of a domestic corporation, the foreign income taxes
deemed to be paid for such taxable year under section 902(a) in
accordance with Sec. Sec. 1.902-1 and 1.902-2 or section 960(a)(1) in
accordance with Sec. 1.960-7.
In no event shall the amount under subdivision (ii) of this subparagraph
exceed the amount includible in gross income with respect to such taxes
under section 78 and Sec. 1.78-1. The credit for such taxes provided by
section 901 shall not be allowed against the accumulated earnings tax
imposed by section 531. See section 901(a).
(b) Charitable contributions. Section 535(b)(2) provides that, in
computing the accumulated taxable income of a corporation, the deduction
for charitable contributions shall be computed without regard to section
170(b)(2). Thus, the amount of charitable contributions made during the
taxable year not allowable as a deduction under section 170 by reason of
the limitations imposed by section 170(b)(2) shall be allowed as a
deduction in computing accumulated taxable income for the taxable year.
However, any excess of the amount of the charitable contributions made
in a prior taxable year over the amount allowed as a deduction under
section 170 for such year shall not be allowed as a deduction from
taxable income in computing accumulated taxable income for the taxable
year.
(c) Special deductions disallowed. Sections 241 through 248 provide
for the allowance of special deductions for such items as partially tax-
exempt interest, certain dividends received, dividends paid on certain
preferred stock of public utilities, and organizational expenses. Such
special deductions, except the deduction provided by section 248
(relating to organizational expenses) shall be disallowed in computing
accumulated taxable income.
(d) Net operating loss. The net operating loss deduction provided in
section 172 is not allowed for purposes of computing accumulated taxable
income.
(e) Capital losses. (1) Losses from sales or exchanges of capital
assets during the taxable year, which are disallowed as deductions under
section 1211(a) in computing taxable income, shall be allowed as
deductions in computing accumulated taxable income.
(2) The computation of the capital losses allowable as a deduction
in computing accumulated taxable income may be illustrated by the
following example:
Example. X Corporation has capital losses of $30,000 which are
disallowed under section 1211(a) for the taxable year ended December 31,
1956. This amount represents a loss of $25,000 from the sale or exchange
of capital assets during the taxable year ended December 31, 1956, plus
a $5,000 capital loss carryover resulting from the sale or exchange of
capital assets during the taxable year ended December 31, 1955. In
computing accumulated taxable income for the taxable year ended December
31, 1956, only the loss of $25,000 arising from the sale or exchange of
capital assets during that taxable year will be allowed as a deduction.
(f) Long-term capital gains. (1) There is allowed as a deduction in
computing accumulated taxable income, the excess of the net long-term
capital gain for the taxable year over the net short-term capital loss
for such year (determined without regard to the capital loss carryover
provided in section 1212) minus the taxes attributable to such excess as
provided by section 535(b)(6). The tax attributable to such excess is
the difference between:
(i) The taxes (except the accumulated earnings tax) imposed by
subtitle A of the Code for such year, and
(ii) The taxes (except the accumulated earnings tax) imposed by
subtitle A computed for such year as if taxable income were reduced by
the excess of the net long-term capital gain over net short-term capital
loss (including the capital loss carryover to such year)
Where the tax (except the accumulated earnings tax) imposed by subtitle
A includes an amount computed under section 1201(a)(2), the tax
attributable to such excess is such amount computed under section
1201(a)(2).
[[Page 320]]
(2) The application of the rule in subparagraph (1) of this
paragraph may be illustrated by the following example:
Example. Assume that D Corporation, for the taxable year ended
December 31, 1956, has taxable income of $103,000 of which $8,000 is the
excess of net long-term capital gain of $12,000 over a net short-term
capital loss of $9,000. The $9,000 net short-term capital loss includes
a capital loss carryover of $5,000. The amount allowable as a deduction
under section 535(b)(6) and subparagraph (1) of this paragraph is
$7,250, computed as follows: Net long-term capital gain less net short-
term capital loss (computed without regard to the capital loss
carryover) is $8,000 (that is, $12,000 net long-term capital gain less
$4,000 net short-term capital loss computed without regard to the
capital loss carryover of $5,000). The tax attributable to the excess of
net long-term capital gain over net short-term capital loss (computed by
taking the capital loss carryover into account) is $750, that is, 25
percent of such excess of $3,000, computed under section 1201(a)(2). The
difference of $7,250 ($8,000 less $750) is the amount allowable as a
deduction in computing accumulated taxable income.
(3) Section 631(c) (relating to gain or loss in the case of disposal
of coal or domestic iron ore) shall have no application in determining
the amount of the deduction allowable under section 535(b)(6).
(g) Capital loss carrybacks and carryovers. Capital losses carried
to a taxable year under section 1212(a) shall have no application for
purposes of computing accumulated taxable income for such year.
(h) Bank affiliates. There is allowed the deduction provided by
section 601 in the case of bank affiliates (as defined in section 2 of
the Banking Act of 1933; 12 U. S. C. 221a(c)).
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6805, 30 FR
3209, Mar. 9, 1965; T.D. 6841, 30 FR 9305, July 27, 1965; T.D. 7301, 39
FR 964, Jan. 4, 1974; T.D. 7649, 44 FR 60086, Oct. 18, 1979]
Sec. 1.535-3 Accumulated earnings credit.
(a) In general. As provided in section 535(a) and Sec. 1.535-1, the
accumulated earnings credit, provided by section 535(c), reduces taxable
income in computing accumulated taxable income. In the case of a
corporation, not a mere holding or investment company, the accumulated
earnings credit is determined as provided in paragraph (b) of this
section and, in the case of a holding or investment company, as provided
in paragraph (c) of this section.
(b) Corporation which is not a mere holding or investment company--
(1) General rule. (i) In the case of a corporation, not a mere holding
or investment company, the accumulated earnings credit is the amount
equal to such part of the earnings and profits of the taxable year which
is retained for the reasonable needs of the business, minus the
deduction allowed by section 535(b)(6) (see paragraph (f) of Sec.
1.535-2, relating to the deduction for long-term capital gains). In no
event shall the accumulated earnings credit be less than the minimum
credit provided for in section 535(c)(2) and subparagraph (2) of this
paragraph. The amount of the earnings and profits for the taxable year
retained is the amount by which the earnings and profits for the taxable
year exceed the dividends paid deduction for such taxable year. See
section 561 and Sec. Sec. 1.561-1 and 1.561-2, relating to the
deduction for dividends paid.
(ii) In determining whether any amount of the earnings and profits
of the taxable year has been retained for the reasonable needs of the
business, the accumulated earnings and profits of prior years will be
taken into consideration. Thus, for example, if such accumulated
earnings and profits of prior years are sufficient for the reasonable
needs of the business, then any earnings and profits of the current
taxable year which are retained will not be considered to be retained
for the reasonable needs of the business. See section 537 and Sec. Sec.
1.537-1 and 1.537-2.
(2) Minimum credit. Section 535(c)(2) provides for the allowance of
a minimum accumulated earnings credit in the case of a corporation which
is not a mere holding or investment company. Except as otherwise
provided in section 243(b)(3) and Sec. 1.243-5 (relating to effect of
100-percent dividends received deduction under section 243(b)) and
sections 1561, 1562, and 1564 (relating to limitations on certain tax
benefits in the case of certain controlled corporations), in the case of
such a corporation, this minimum credit shall in no case be less than
the amount by which $150,000 ($100,000 in the case of taxable years
beginning before January
[[Page 321]]
1, 1975) exceeds the accumulated earnings and profits of the corporation
at the close of the preceding taxable year. See paragraph (d) of this
section for the effect of dividends paid after the close of the taxable
year in determining accumulated earnings and profits at the close of the
preceding taxable year. In determining the amount of the minimum credit
allowable under section 535(c)(2), the needs of the business are not
taken into consideration. If the taxpayer has accumulated earnings and
profits at the close of the preceding taxable year equal to or in excess
of $150,000 ($100,000 in the case of taxable years beginning before
January 1, 1975), thecredit, if any, is determined without regard to
section 535(c)(2). It is not intended that the provision for the minimum
credit shall in any way create an inference that an accumulation in
excess of $150,000 ($100,000 in the case of taxable years beginning
before January 1, 1975) is unreasonable. The reasonable needs of the
business may require the accumulation of more or less than $150,000
($100,000 in the case of taxable years beginning before January 1,
1975), depending upon the circumstances in the case, but such needs
shall not be taken into consideration to any extent in cases where the
minimum accumulated earnings credit is applicable. For a discussion of
the reasonable needs of the business, see section 537 and Sec. Sec.
1.537-1, 1.537-2, and 1.537-3.
(3) Illustrations of accumulated earnings credit. The computation of
the accumulated earnings credit provided by section 535(c) may be
illustrated by the following examples:
Example 1. The X Corporation, which is not a mere holding or
investment company, has accumulated earnings and profits in the amount
of $125,000 as of December 31, 1974. Thus, the minimum credit provided
by section 535(c)(2) exceeds the accumulated earnings and profits of X
by $25,000. It has earnings and profits for the taxable year ended
December 31, 1975, in the amount of $100,000 and has a dividends paid
deduction under section 561 in the amount of $30,000 so that the
earnings and profits for the taxable year which are retained in the
business amount to $70,000. Assume that it has been determined that the
earnings and profits for the taxable year which may be retained for the
reasonable needs of the business amount to $55,000 and that a deduction
has been allowed under section 535(b)(6) in the amount of $5,000. Since
the amount by which $150,000 exceeds the accumulated earnings and
profits at the close of the preceding taxable year is less than $50,000
($55,000-$5,000), the minimum credit provided by section 535(c)(2) will
not apply and the accumulated earnings credit must be computed under
section 535(c)(1) on the basis of the reasonable needs of the business.
In this case, the accumulated earnings credit for the taxable year ended
December 31, 1975, will be $50,000 computed as follows:
Earnings and profits of the taxable year determined to be $55,000
retained for the reasonable needs of the business............
Less: The deduction for long-term capital gains (less 5,000
applicable tax) allowed under sec. 535(b)(6).................
---------
Accumulated earnings credit allowable under sec. 535(c)(1) 50,000
Example 2. The Z Corporation which is not a mere holding or
investment company, has accumulated earnings and profits in the amount
of $45,000 as of December 31, 1974; it has earnings and profits for the
taxable year ended December 31, 1975, in the amount of $115,000 and has
a dividends paid deduction under section 561 in the amount of $10,000,
so that the earnings and profits for the taxable year which are retained
amount to $105,000. Assume that it has been determined that the
accumulated earnings and profits of the taxable year which may be
retained for the reasonable needs of the business amount to $20,000 and
that no deduction is allowable for long-term capital gains under section
535(b)(6). The accumulated earnings credit allowable under section
535(c)(1) on the basis of the reasonable needs of the business is
determined to be only $20,000. However, since the amount by which
$150,000 exceeds the accumulated earnings and profits at the close of
the preceding taxable year is more than $20,000, the minimum accumulated
earnings credit provided by section 535(c)(2) is applicable. The
allowable credit will be the amount by which $150,000 exceeds the
accumulated earnings and profits at the close of the preceding taxable
year (i.e., $105,000, $150,000 less $45,000 of accumulated earnings and
profits at the close of the preceding taxable year).
(c) Holding and investment companies. Section 535(c)(3) provides
that, in the case of a mere holding or investment company, the
accumulated earnings credit shall be the amount, if any, by which
$150,000 ($100,000 in the case of taxable years beginning before January
1, 1975) exceeds the accumulated earnings and profits of the corporation
at the close of the preceding taxable year. Thus, if such a corporation
has accumulated earnings equal to or in excess of $150,000 ($100,000 in
the case of taxable years beginning before January 1,
[[Page 322]]
1975) at the close of its preceding taxable year, no accumulated
earnings credit is allowable in computing the accumulated taxable
income. See paragraph (c) of Sec. 1.533-1 for a definition of a holding
or investment company. For the accumulated earnings credit of a mere
holding or investment company which is a member of an affiliated group
which has elected the 100-percent dividends received deduction under
section 243(b), see section 243(b)(3) and Sec. 1.243-5. For the
accumulated earnings credit of a mere holding or investment company
which is a component member of a controlled group of corporations (as
defined in section 1563), see sections 1561, 1562, and 1564.
(Sec. 1561(a) (83 Stat. 599; 26 U.S.C. 1561(a)))
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6992, 34 FR
826, Jan. 18, 1969; T.D. 7181, 37 FR 8066, Apr. 25, 1972; T.D. 7244, 37
FR 28897, Dec. 30, 1972; T.D. 7376, 40 FR 42744, Sept. 16, 1975; T.D.
7528, 42 FR 64694, Dec. 28, 1977]
Sec. 1.536-1 Short taxable years.
Accumulated taxable income for a taxable year consisting of a period
of less than 12 months shall not be placed on an annual basis for the
purpose of the accumulated earnings tax imposed by section 531. In such
cases accumulated taxable income shall be computed on the basis of the
taxable income for such period of less than 12 months, adjusted in the
manner provided by section 535(b) and Sec. 1.535-2.
Sec. 1.537-1 Reasonable needs of the business.
(a) In general. The term reasonable needs of the business includes
(1) the reasonably anticipated needs of the business (including product
liability loss reserves, as defined in paragraph (f) of this section),
(2) the section 303 redemption needs of the business, as defined in
paragraph (c) of this section, and (3) the excess business holdings
redemption needs of the business as described in paragraph (d) of this
section. See paragraph (e) of this section for additional rules relating
to the section 303 redemption needs and the excess business holdings
redemption needs of the business. An accumulation of the earnings and
profits (including the undistributed earnings and profits of prior
years) is in excess of the reasonable needs of the business if it
exceeds the amount that a prudent businessman would consider appropriate
for the present business purposes and for the reasonably anticipated
future needs of the business. The need to retain earnings and profits
must be directly connected with the needs of thecorporation itself and
must be for bona fide business purposes. For purposes of this paragraph
the section 303 redemption needs of the business and the excess business
holdings redemption needs of the business are deemed to be directly
connected with the needs of the business and for a bona fide business
purpose. See Sec. 1.537-3 for a discussion of what constitutes the
business of the corporation. The extent to which earnings and profits
have been distributed by the corporation may be taken into account in
determining whether or not retained earnings and profits exceed the
reasonable needs of the business. See Sec. 1.537-2, relating to grounds
for accumulation of earnings and profits.
(b) Reasonable anticipated needs. (1) In order for a corporation to
justify an accumulation of earnings and profits for reasonably
anticipated future needs, there must be an indication that the future
needs of the business require such accumulation, and the corporation
must have specific, definite, and feasible plans for the use of such
accumulation. Such an accumulation need not be used immediately, nor
must the plans for its use be consummated within a short period after
the close of the taxable year, provided that such accumulation will be
used within a reasonable time depending upon all the facts and
circumstances relating to the future needs of the business. Where the
future needs of the business are uncertain or vague, where the plans for
the future use of an accumulation are not specific, definite, and
feasible, or where the execution of such a plan is postponed
indefinitely, an accumulation cannot be justified on the grounds of
reasonably anticipated needs of the business.
(2) Consideration shall be given to reasonably anticipated needs as
they exist on the basis of the facts at the
[[Page 323]]
close of the taxable year. Thus, subsequent events shall not be used for
the purpose of showing that the retention of earnings or profits was
unreasonable at the close of the taxable year if all the elements of
reasonable anticipation are present at the close of such taxable year.
However, subsequent events may be considered to determine whether the
taxpayer actually intended to consummate or has actually consummated the
plans for which the earnings and profits were accumulated. In this
connection, projected expansion or investment plans shall be reviewed in
the light of the facts during each year and as they exist as of the
close of the taxable year. If a corporation has justified an
accumulation for future needs by plans never consummated, the amount of
such an accumulation shall be taken into account in determining the
reasonableness of subsequent accumulations.
(c) Section 303 redemption needs of the business. (1) The term
section 303 redemption needs means, with respect to the taxable year of
the corporation in which a shareholder of the corporation died or any
taxable year thereafter, the amount needed (or reasonably anticipated to
be needed) to redeem stock included in the gross estate of such
shareholder but not in excess of the amount necessary to effect a
distribution to which section 303 applies. For purposes of this
paragraph, the term shareholder includes an individual in whose gross
estate stock of the corporation is includable upon his death for Federal
estate tax purposes.
(2) This paragraph applies to a corporation to which section 303(c)
would apply if a distribution described therein were made.
(3) If stock included in the gross estate of a decedent is stock of
two or more corporations described in section 303(b)(2)(B), the amount
needed by each such corporation for section 303 redemption purposes
under this section shall, unless the particular facts and circumstances
indicate otherwise, be that amount which bears the same ratio to the
amount described in section 303(a) as the fair market value of such
corporation's stock included in the gross estate of such decedent bears
to the fair market value of all of the stock of such corporations
included in the gross estate. For example, facts and circumstances
indicating that the allocation prescribed by this subparagraph is not
required would include notice given to the corporations by the executor
or administrator of the decedent's estate that he intends to request the
redemption of stock of only one of such corporations or the redemption
of stock of such corporations in a ratio which is unrelated to the
respective fair market values of the stock of the corporations included
in the decedent's gross estate.
(4) The provisions of this paragraph apply only to taxable years
ending after May 26, 1969.
(d) Excess business holdings redemption needs. (1) The term excess
business holdings redemption needs means, with respect to taxable years
of the corporation ending after May 26, 1969, the amount needed (or
reasonably anticipated to be needed) to redeem from a private foundation
stock which:
(i) Such foundation held on May 26, 1969 (or which was received by
such foundation pursuant to a will or irrevocable trust to which section
4943(c)(5) applies), and either
(ii) Constituted excess business holdings on such date or would have
constituted excess business holdings as of that date if there were taken
into account (a) stock received pursuant to a will or trust described in
subdivision (i) of this subparagraph and (b) the reduction in the total
outstanding stock of the corporation which would have resulted solely
from the redemption of stock held by the private foundation, or
(iii) Constituted stock redemption of which before January 1, 1975,
or after October 4, 1976, and before January 1, 1977, is, by reason of
section 101(l)(2)(B) of the Tax Reform Act of 1969, as amended by
section 1309 of the Tax Reform Act of 1976, and Sec. 53.4941(d)-4(b),
permitted without imposition of tax under section 4941, but only to the
extent such stock is to be redeemed before January 1, 1975 or after
October 4, 1976, and before January 1, 1977, or is to be redeemed
thereafter pursuant to the terms of a binding contract entered into on
or before such date to redeem
[[Page 324]]
all of the stock of the corporation held by the private foundation on
such date.
(2) The purpose of subparagraph (1) of this paragraph is to
facilitate a private-foundation's disposition of certain excess business
holdings, in order for the private foundation not to be liable for tax
under section 4943. See section 4943(c) and the regulations thereunder
for the definition of excess business holdings. For purposes of section
537(b)(2) and this paragraph, however, any determination of the
existence of excess business holdings shall be made without taking into
account the provisions of section 4943(c)(4) which treat certain excess
business holdings as held by a disqualified person (rather than by the
private foundation), except that the periods described in section
4943(c)(4) (B), (C), and (D), if applicable, shall be taken into account
in determining the period during which an excess business holdings
redemption need may be deemed to exist. Thus, an excess business
holdings redemption need may, depending upon the facts and
circumstances, be deemed to exist for a part or all of the 20-year, 15-
year, or 10-year period specified in section 4943(c)(4)(B) during which
the interest in the corporation held by the private foundation is
treated as held by a disqualified person rather than by the private
foundation, and, if applicable, (i) any suspension of such 20-year, 15-
year, or 10-year period as provided by section 4943(c)(4)(C) and (ii)
the 15-year second phase specified in section 4943(c)(4)(D). The
foregoing sentence is not to be construed to prevent an accumulation of
earnings and profits for the purpose of effecting a redemption of excess
business holdings at a time or times prior to expiration of the periods
described in such sentence. This subparagraph is not to be construed to
prevent an accumulation of earnings and profits for the purpose of
effecting a redemption described in subdivision (iii) of subparagraph
(1) of this paragraph.
(3) The extent of an excess business holdings redemption need cannot
exceed the total number of shares of stock so held or received by the
private foundation (i) redemption of which alone would sufficiently
reduce such private foundation's proportionate share of the
corporation's total outstanding stock in order for the private
foundation not to be liable for tax under section 4943, or (ii)
redemption of which is, by reason of Sec. 53.4941(d)-4(b), permitted
without imposition of tax under section 4941 provided that such
redemption is accomplished within the period and in the manner
prescribed in subdivision (iii) of subparagraph (1) of this paragraph.
Thus, excess business holdings of a private foundation attributable to
an increase in the private foundation's proportionate share of the
corporation's total outstanding stock by reason of a redemption of stock
after May 26, 1969, from any person other than the private foundation do
not give rise to an excess business holdings redemption need.
(4) For purposes of subdivision (ii) of subparagraph (1) of this
paragraph, an excess business holdings redemption need can arise with
respect to shares of the corporation's stock under section 537(a)(3)
only following actual acquisition by the private foundation of such
shares and their characterization as an excess business holding. Thus,
this paragraph does not apply to an accumulation of earnings and profits
in one taxable year in anticipation of redemption of excess business
holdings to be acquired by a private foundation in a subsequent year
pursuant to a will or irrevocable trust to which section 4943(c)(5)
applies or in anticipation of shares held becoming excess business
holdings of the private foundation in a subsequent year by reason of
additional shares to be received by the private foundation in such
subsequent year pursuant to a will or irrevocable trust to which section
4943(c)(5) applies. Once having arisen, however, an excess business
holdings redemption need may continue until redemption of the private
foundation's excess business holdings described in this paragraph or
other disposition of such excess business holdings by the private
foundation.
(5) Notwithstanding any other provision of this paragraph, an excess
business holdings redemption need will not be deemed to exist with
respect to stock held by a private foundation the redemption of which
would subject any person to tax under section 4941.
[[Page 325]]
(6) For purposes of subdivision (ii) of subparagraph (1) of this
paragraph, the number of shares of stock held by a private foundation on
May 26, 1969 (or received pursuant to a will or irrevocable trust to
which section 4943(c)(5) applies), redemption of which alone would
sufficiently reduce such foundation's proportionate share of a
corporation's total outstanding stock in order for the foundation not to
be liable for tax under section 4943 may be determined by application of
the following formula:
[GRAPHIC] [TIFF OMITTED] TC14NO91.159
X = Number of shares to be redeemed.
Y = Maximum percentage of outstanding stock which private foundation can
hold without being liable for tax under section 4943.
PH = Number of shares of stock held by private foundation on May 26,
1969, or received pursuant to a will or irrevocable trust to
which section 4943(c)(5) applies.
SO = Total number of shares of stock outstanding unreduced by any
redemption from a person other than the private foundation.
(7) The provisions of this paragraph may be illustrated by the
following example:
Example. (i) On May 26, 1969, Private Foundation A holds 60 of the
100 outstanding shares of the capital stock of corporation X, which is
not a disqualified person with respect to A. None of the remaining 40
shares is owned by a disqualified person within the meaning of section
4946(a). On June 1, 1975, X redeems 10 shares of its stock from
individual B, thus reducing its outstanding stock to 90 shares. On June
1, 1976, A receives 20 additional shares of X stock by bequest under a
will to which section 4943(c)(5) applies. As of June 1, 1976, then, A
holds 80 of the 90 outstanding shares of X. Solely for purposes of this
example and to illustrate the application of this paragraph, it will be
assumed that in order not to be liable for the initial tax under section
4943, A must, before the close of the second phase described in section
4943(c)(4)(D), reduce its proportionate stock interest in X to 35
percent. A requests X to redeem from it a sufficient number of its
shares to so reduce its proportionate stock interest in X to 35 percent,
and X agrees to effect such a redemption.
(ii) As of May 26, 1969, A's excess business holdings are 25 shares
of X, the number of shares which A would be required to dispose of to a
person other than X in order to reduce its proportionate holdings in X
to no more than 35percent. If the disposition is to be by means of a
redemption, however, A's excess business holdings on May 26, 1969, for
purposes of determining X's excess business holdings redemption needs,
are 39 shares, i.e., the number of shares X would be required to redeem
in order to reduce A's proportionate stock interest to 35 percent.
Although the redemption of 10 shares from B on June 1, 1975, creates
additional excess business holdings of A because it effectively
increases A's proportionate stock interest in X, this increase does not
create an additional excess business holdings redemption need because it
resulted from a redemption from a person other than A. The bequest of 20
shares of X received by A on June 1, 1976, creates a further excess
business holdings redemption need as of that date in the amount needed
(or reasonably anticipated to be needed) to redeem an additional 31
shares from A, i.e., the number of shares which, when added to the
excess business holdings of A on May 26, 1969, would have to be redeemed
to reduce A's proportionate stock interest in X to 35 percent without
taking the earlier redemption from B into account.
(e)(1) A determination whether and to what extent an amount is
needed (or reasonably anticipated to be needed) for the purpose
described in subparagraph (1) of paragraph (c) or (d) of this section is
dependent upon the particular circumstances of the case, including the
total amount of earnings and profits accumulated in prior years which
may be available for such purpose and the existence of a reasonable
expectation that a redemption described in paragraph (c) or (d) of this
section will in fact be effected. Although paragraph (c) or (d) of this
section may apply even though no redemption of stock is in fact
effected, the failure to effect such redemption may be taken into
account in determining whether the accumulation was needed (or
reasonably anticipated to be needed) for a purpose described in
paragraph (c) or (d).
(2) In applying subparagraph (1) of paragraph (c) or (d) of this
section, the discharge of an obligation incurred to make a redemption
shall be treated as the making of the redemption.
(3) In determining whether an accumulation is in excess of the
reasonable needs of the business for a particular year, the fact that
one of the exceptions specified in paragraph (c) or (d) of this section
applies in a subsequent
[[Page 326]]
year is not to give rise to an inference that the accumulation would not
have been for the reasonable needs of the business in the prior year.
Also, no inference is to be drawn from the enactment of section 537(a)
(2) and (3) that accumulations in any prior year would not have been for
the reasonable needs of the business in the absence of such provisions.
Thus, the reasonableness of accumulations in years prior to a year in
which one of the exceptions specified in paragraph (c) or (d) of this
section applies is to be determined solely upon the facts and
circumstances existing at the times the accumulations occur.
(f) Product liability loss reserves. (1) The term product liability
loss reserve means, with respect to taxable years beginning after
September 30, 1979, reasonable amounts accumulated for the payment of
reasonably anticipated product liability losses, as defined in section
172(j) and Sec. 1.172-13(b)(1).
(2) For purposes of this paragraph, whether an accumulation for
anticipated product liability losses is reasonable in amount and whether
such anticipated product liability losses are likely to occur shall be
determined in light of all facts and circumstances of the taxpayer
making such accumulation. Some of the factors to be considered in
determining the reasonableness of the accumulation include the
taxpayer's previous product liability experience, the extent of the
taxpayer's coverage by commercial product liability insurance, the
income tax consequences of the taxpayer's ability to deduct product
liability losses and related expenses, and the taxpayer's potential
future liability due to defective products in light of the taxpayer's
plans to expand the production of products currently being manufactured,
provided such plans are specific, definite and feasible. Additionally, a
factor to be considered in determining whether the accumulation is
reasonable in amount is whether the taxpayer, in accounting for its
potential future liability, took into account the reasonably estimated
present value of the potential future liability.
(3) Only those accumulations made with respect to products that have
been manufactured, leased, or sold shall be considered as accumulations
made under this paragraph. Thus, for example, accumulations with respect
to a product which has not progressed beyond the development stage are
not reasonable accumulations under this paragraph.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7165, 37 FR
5022, Mar. 9, 1972, 37 FR 5703, Mar. 18, 1972; T.D. 7678, 44 FR 12416,
Feb. 26, 1980; T.D. 8096, 51 FR 30483, Aug. 27, 1986]
Sec. 1.537-2 Grounds for accumulation of earnings and profits.
(a) In general. Whether a particular ground or grounds for the
accumulation of earnings and profits indicate that the earnings and
profits have been accumulated for the reasonable needs of the business
or beyond such needs is dependent upon the particular circumstances of
the case. Listed below in paragraphs (b) and (c) of this section are
some of the grounds which may be used as guides under ordinary
circumstances.
(b) Reasonable accumulation of earnings and profits. Although the
following grounds are not exclusive, one or more of such grounds, if
supported by sufficient facts, may indicate that the earnings and
profits of a corporation are being accumulated for the reasonable needs
of the business provided the general requirements under Sec. Sec.
1.537-1 and 1.537-3 are satisfied:
(1) To provide for bona fide expansion of business or replacement of
plant;
(2) To acquire a business enterprise through purchasing stock or
assets;
(3) To provide for the retirement of bona fide indebtedness created
in connection with the trade or business, such as the establishment of a
sinking fund for the purpose of retiring bonds issued by the corporation
in accordance with contract obligations incurred on issue;
(4) To provide necessary working capital for the business, such as,
for the procurement of inventories;
(5) To provide for investments or loans to suppliers or customers if
necessary in order to maintain the business of the corporation; or
(6) To provide for the payment of reasonably anticipated product
liability losses, as defined in section 172(j), Sec. Sec. 1.172-
13(b)(1), and 1.537-1(f).
[[Page 327]]
(c) Unreasonable accumulations of earnings and profits. Although the
following purposes are not exclusive, accumulations of earnings and
profits to meet any one of such objectives may indicate that the
earnings and profits of a corporation are being accumulated beyond the
reasonable needs of the business:
(1) Loans to shareholders, or the expenditure of funds of the
corporation for the personal benefit of the shareholders;
(2) Loans having no reasonable relation to the conduct of the
business made to relatives or friends of shareholders, or to other
persons;
(3) Loans to another corporation, the business of which is not that
of the taxpayer corporation, if the capital stock of such other
corporation is owned, directly or indirectly, by the shareholder or
shareholders of the taxpayer corporation and such shareholder or
shareholders are in control of both corporations;
(4) Investments in properties, or securities which are unrelated to
the activities of the business of the taxpayer corporation; or
(5) Retention of earnings and profits to provide against unrealistic
hazards.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 8096, 51 FR
30484, Aug. 27, 1986]
Sec. 1.537-3 Business of the corporation.
(a) The business of a corporation is not merely that which it has
previously carried on but includes, in general, any line of business
which it may undertake.
(b) If one corporation owns the stock of another corporation and, in
effect, operates the other corporation, the business of the latter
corporation may be considered in substance, although not in legal form,
the business of the first corporation. However, investment by a
corporation of its earnings and profits in stock and securities of
another corporation is not, of itself, to be regarded as employment of
the earnings and profits in its business. Earnings and profits of the
first corporation put into the second corporation through the purchase
of stock or securities or otherwise, may, if a subsidiary relationship
is established, constitute employment of the earnings and profits in its
own business. Thus, the business of one corporation may be regarded as
including the business of another corporation if such other corporation
is a mere instrumentality of the first corporation; that may be
established by showing that the first corporation owns at least 80
percent of the voting stock of the second corporation. If the taxpayer's
ownership of stock is less than 80 percent in the other corporation, the
determination of whether the funds are employed in a business operated
by the taxpayer will depend upon the particular circumstances of the
case. Moreover, the business of one corporation does not include the
business of another corporation if such other corporation is a personal
holding company, an investment company, or a corporation not engaged in
the active conduct of a trade or business.
Personal Holding Companies
Sec. 1.541-1 Imposition of tax.
(a) Section 541 imposes a graduated tax upon corporations classified
as personal holding companies under section 542. This tax, if
applicable, is in addition to the tax imposed upon corporations
generally under section 11. Unless specifically excepted under section
542(c) the tax applies to domestic and foreign corporations and, to the
extent provided by section 542(b), to an affiliated group of
corporations filing a consolidated return. Corporations classified as
personal holding companies are exempt brom the accumulated earnings tax
imposed under section 531 but are not exempt from other income taxes
imposed upon corporations, generally, under any other provisions of the
Code. Unlike the accumulated earnings tax imposed under section 531, the
personal holding company tax imposed by section 541 applies to all
personal holding companies as defined in section 542, whether or not
they were formed or availed of to avoid income tax upon shareholders.
See section 6501(f) and Sec. 301.6501(f)-1 of this chapter (Regulations
on Procedure and Administration) with respect to the period of
limitation on assessment of personal holding company tax upon failure to
file a
[[Page 328]]
schedule of personal holding company income.
(b) A foreign corporation, whether resident or nonresident, which is
classified as a personal holding company is subject to the tax imposed
under section 541 with respect to its income from sources within the
United States, even though such income is not fixed or determinable
annual or periodical income specified in section 881. A foreign
corporation is not classified as a personal holding company subject to
tax under section 541 if it is a foreign personal holding company as
defined in section 552 or if it meets the requirements of the exception
provided in section 542(c)(10).
Sec. 1.542-1 General rule.
A personal holding company is any corporation (other than one
specifically excepted under section 542(c)) which, for the taxable year,
meets:
(a) The gross income requirement specified in section 542(a)(1) and
Sec. 1.542-2, and
(b) The stock ownership requirement specified in section 542(a)(2)
and Sec. 1.542-3.
Both requirements must be satisfied with respect to each taxable year.
Sec. 1.542-2 Gross income requirement.
To meet the gross income requirement it is necessary that at least
80 percent of the total gross income of the corporation for the taxable
year be personal holding company income as defined in section 543 and
Sec. Sec. 1.543-1 and 1.543-2. For the definition of gross income see
section 61 and Sec. Sec. 1.61-1 through 1.61-14. Under such provisions
gross income is not necessarily synonymous with gross receipts. Further,
in the case of transactions in stocks and securities and in commodities
transactions, gross income for personal holding company tax purposes
shall include only the excess of gains over losses from such
transactions. See section 543(b), paragraph (b) (5) and (6) of Sec.
1.543-1 and Sec. 1.543-2. For determining the character of the amount
includible in gross income under section 951(a), see paragraph (a) of
Sec. 1.951-1.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6795, 30 FR
934, Jan. 29, 1965]
Sec. 1.542-3 Stock ownership requirement.
(a) General rule. To meet the stock ownership requirement, it is
necessary that at some time during the last half of the taxable year
more than 50 percent in value of the outstanding stock of the
corporation be owned, directly or indirectly, by or for not more than 5
individuals. Any organization or trust to which subparagraph (1) of this
paragraph applies shall be considered as one individual for purposes of
this stock ownership requirement subject, however, to the exception in
subparagraph (2) of this paragraph which is applicable only to taxable
years beginning after December 31, 1954. Thus, if an organization or
trust which is considered as an individual owns 51 percent in value of
the outstanding stock of the corporation at any time during the last
half of the taxable year, the stock ownership requirement will be met by
ownership of the required percentage by one individual. See section 544
and Sec. Sec. 1.544-1 through 1.544-7 for the determination of stock
ownership.
(1) An organization or trust considered as an individual. Any of the
following organizations or trusts shall be considered as an individual:
(i) An organization to which section 503 applies, namely, any
organization described in section 501(c)(3) (relating to charitable,
etc., organizations) or section 401(a) (relating to employees' pension
trust, etc.) other than an organization excepted from the application of
section 503 by paragraphs (1) to (5) of section 503(b). Therefore, a
religious organization (other than a trust) excepted under section
503(b)(1) is not considered an individual for purposes of the stock
ownership requirement of section 542(a)(2).
(ii) A portion of a trust permanently set aside or to be used
exclusively for the purposes described in section 642(c), relating to
amounts set aside for charitable purposes, or described in a
corresponding provision of the prior income tax law (such as section
162(a), Internal Revenue Code of 1939).
(2) Exception. For taxable years beginning after December 31, 1954,
an organization or trust to which subparagraph (1) of this paragraph
applies shall
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not be considered an individual if all of the following conditions are
met:
(i) It was organized or created before July 1, 1950.
(ii) At all times on or after July 1, 1950, and before the close of
the taxable year, it owned all of the common stock and at least 80
percent of the total number of shares of all other classes of stock of
the corporation.
(iii) For the taxable year it is not denied exemption under section
504(a) or the unlimited charitable deduction under section 681(c). In
determining whether, for the purpose of section 542(a)(2), exemption is
not denied under section 504(a) or the unlimited charitable deduction is
not denied under section 681(c) all the income of the corporation which
is available for distribution as dividends to its shareholders shall be
deemed to have been distributed at the close of the taxable year whether
or not any portion of such income was in fact distributed. If the
amounts described in section 504(a) or section 681(c), increased by the
income of the corporation deemed distributed pursuant to the preceding
sentence, would be sufficient to deny exemption or the unlimited
charitable deduction, the organization or trust will be considered to be
an individual for the purpose of section 542(a)(2). For the purpose of
this subdivision the restrictions in sections 504(a)(1) and 681(c)(1)
against unreasonable accumulations will not apply to income attributable
to property of a decedent dying before January 1, 1951, which was
transferred during his lifetime to a trust or property that was
transferred under his will to such trust, and
(iv) This subparagraph is illustrated by the following example:
Example. The X Charitable Foundation (an organization described in
section 501(c)(3) to which section 503 is applicable) has owned all of
the stock of the Y Corporation since Y's organization in 1949. Both X
and Y are calendar-year corporations. At the end of the year 1955, X has
accumulated $100,000 out of income and has actually paid out only
$75,000 of this amount, leaving a balance of $25,000 on December 31,
1955. X was not denied an exemption under section 504(a) for the year
1955. Y, during the calendar year 1955, has $400,000 taxable income of
which $200,000 is available for distribution as dividends at the end of
the year. X will be considered to have accumulated out of income during
the calendar year 1955 the amount of $225,000 for the purpose of
determining whether it would have been denied an exemption under section
504(a)(1). If X would have been denied an exemption under section
504(a)(1) by reason of having been deemed to have accumulated $225,000,
the stock ownership requirement of section 542(a)(2) and this section
will have been satisfied. If Y Corporation also satisfies the gross
income requirement of section 542(a)(1) and Sec. 1.542-2 it will be a
personal holding company.
(b) Changes in stock outstanding. It is necessary to consider any
change in the stock outstanding during the last half of the taxable
year, whether in the number of shares or classes of stock, or in the
ownership thereof. Stock subscribed and paid for will be considered as
stock outstanding, whether or not such stock is evidenced by issued
certificates. Treasury stock shall not be considered as stock
outstanding.
(c) Value of stock outstanding. The value of the stock outstanding
shall be determined in the light of all the circumstances. The value may
be determined upon the basis of the company's net worth, earning and
dividend paying capacity, appreciation of assets, together with such
other factors as have a bearing upon the value of the stock. If the
value of the stock is greatly at variance with that reflected by the
corporate books, the evidence of such value should be filed with the
return. In any case where there are two or more classes of stock
outstanding, the total value of all the stock should be allocated among
the different classes according to the relative value of each class.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6739, 29 FR
7713, June 17, 1964]
Sec. 1.542-4 Corporations filing consolidated returns.
(a) General rule. A consolidated return under section 1501 shall
determine the application of the personal holding company tax to the
group and to any member thereof on the basis of the consolidated gross
income and consolidated personal holding company income of the group, as
determined under the regulations prescribed pursuant to section 1502
(relating to consolidated returns); however, this rule shall not
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apply to either (1) an ineligible affiliated group as defined in section
542(b)(2) and paragraph (b) of this section, or (2) an affiliated group
of corporations a member of which is excluded from the definition of a
personal holding company under section 542(c) and paragraph (c) of this
section. Thus, in the latter two instances the gross income requirement
provided in section 542(a)(1) and Sec. 1.542-2 shall apply to each
individual member of the affiliated group of corporations.
(b) Ineligible affiliated group. (1) Except for certain affiliated
railroad corporations, as provided in subparagraph (2) of this
paragraph, an affiliated group of corporations is an ineligible
affiliated group and therefore may not use its consolidated gross income
and consolidated personal holding company income to determine the
liability of the group or any member thereof for personal holding
company tax (as provided in paragraph (a) of this section), if (i) any
member of such group, including the common parent, derived gross income
from sources outside the affiliated group for the taxable year in an
amount equal to 10 percent or more of its gross income from all sources
for that year and (ii) 80 percent or more of the gross income from
sources outside the affiliated group consists of personal holding
company income as defined in section 543 and Sec. Sec. 1.543-1 and
1.543-2. For purposes of subdivision (i) of this subparagraph gross
income shall not include certain dividend income receivedby a common
parent from a corporation not a member of the affiliated group which
qualifies under section 542(b)(4) and paragraph (d) of this section. See
particularly the examples contained in paragraph (d)(2) of this section.
Intercorporate dividends received by members of the affiliated group
(including the common parent) are to be included in the gross income
from all sources for purposes of the test in subdivision (i) of this
subparagraph. For purposes of subdivision (ii) of this subparagraph,
section 543 and paragraph (a) of Sec. 1.543-1 shall be applied as if
the amount of gross income derived from sources outside the affiliated
group by a corporation which is a member of such group is the gross
income of such corporation.
(2) An affiliated group of railroad corporations shall not be
considered to be an ineligible affiliated group, notwithstanding any
other provisions of section 542(b)(2) and this paragraph, if the common
parent of such group would be eligible to file a consolidated return
under section 141 of the Internal Revenue Code of 1939 prior to its
amendment by the Revenue Act of 1942 (56 Stat. 798).
(3) See section 562(d) and Sec. 1.562-3 for dividends paid
deduction in the case of a distribution by a member of an ineligible
affiliated group.
(4) The determination of whether an affiliated group of corporations
is an ineligible group under section 542(b)(2) and this paragraph, may
be illustrated by the following examples:
Example 1. Corporations X, Y, and Z constitute an affiliated group
of corporations which files a consolidated return for the calendar year
1954; Corporations Y and Z are wholly-owned subsidiaries of Corporation
X and derive no gross income from sources outside the affiliated group;
Corporation X, the common parent, has gross income in the amount of
$250,000 for the taxable year 1954. $200,000 of such gross income
consists of dividends received from Corporations Y and Z. The remaining
$50,000 was derived from sources outside the affiliated group, $40,000
of which represents personal holding company income as defined in
section 543. The $50,000 included in the gross income of Corporation X
and derived from sources outside the affiliated group is more than 10
percent of X's gross income ($50,000/$250,000) and the $40,000 which
represents personal holding company income is 80 percent of $50,000 (the
amount considered to be the gross income of Corporation X). Accordingly,
Corporations X, Y, and Z would be an ineligible affiliated group and the
gross income requirement under section 542(a)(1) and Sec. 1.542-2 would
be applied to each corporation individually.
Example 2. If, in the above example, only $30,000 of the $50,000
derived from sources outside the affiliated group by Corporation X
represented personal holding company income, this group of affiliated
corporations would not be an ineligible affiliated group. Although the
$50,000 representing the gross income of Corporation X from sources
outside the affiliated group is more than 10 percent of its total gross
income, the amount of $30,000 representing personal holding company
income is not 80 percent or more of the amount considered to be gross
income for the purpose of this test. Under section 542(b)(2) and
subparagraph (1) of this paragraph both the gross income and the
personal holding company income requirements
[[Page 331]]
must be satisfied in determining that an affiliated group constitutes an
ineligible group. Since both of these requirements have not been
satisfied in this example this group of affiliated corporations would
not be an ineligible group.
(c) Excluded corporations. The general rule for determining
liability of an affiliated group under paragraph (a) of this section
shall not apply if any member thereof is a corporation which is
excluded, under section 542(c), from the definition of a personal
holding company.
(d) Certain dividend income received by a common parent. (1)
Dividends received by the common parent of an affiliated group from a
corporation which is not a member of the affiliated group shall not be
included in gross income or personal holding company income, for the
purpose of the test under section 542(b)(2):
(i) If such common parent owned, directly or indirectly, more than
50 percent of the outstanding voting stock of the dividend paying
corporation at the time such common parent became entitled to the
dividend, and
(ii) If the dividend paying corporation is not a personal holding
company for the taxable year in which the dividends are paid
Thus, if the tests in subdivisions (i) and (ii) of this subparagraph are
met, the dividend income received by the common parent from such other
corporation will not be considered gross income for purposes of the test
in section 542(b)(2)(A) (paragraph (b) of this section), that is, either
to determine gross income from sources outside the affiliated group or
to determine gross income from all sources.
(2) The application of subparagraph (1) of this paragraph may be
illustrated by the following examples:
Example 1. Corporation X is the common parent of Corporation Y and
Corporation Z and together they constitute an affiliated group which
files a consolidated return under section 1501. Corporation Y and
Corporation Z derived no income from sources outside the affiliated
group. Corporation X, the common parent, had gross income of $100,000
for the calendar year 1954 of which amount $20,000 represented a
dividend received from Corporation W, and $4,000 represented interest
from Corporation T. The remaining gross income of X, $76,000, was
received from Corporations Y and Z. Corporation X, for its entire
taxable year, owned 60 percent of the voting stock of Corporation W
which was not a personal holding company for the calendar year 1954. For
the purpose of the gross income and personal holding company income test
under section 542(b)(2) and paragraph (b) of this section, the $20,000
dividend received from Corporation W would not be included in the gross
income or personal holding company income of Corporation X. The
affiliated group would not be an ineligible group under section
542(b)(2) because 10 percent or more of its gross income was not from
sources outside the affiliated group as required by section
542(b)(2)(A). Inasmuch as the $20,000 dividend from Corporation W is not
included in the gross income of Corporation X for purposes of section
542(b)(2) Corporation X only has $4,000 gross income from sources
outside the affiliated group which is only 5 percent of its gross income
from all sources, $80,000.
Example 2. If, in example 1, Corporation X owned 50 percent or less
of the voting stock of Corporation W at the time X became entitled to
the dividend, or if Corporation W had been a personal holding company
for the taxable year in which the dividends were paid, the $20,000
dividends received by Corporation X would be included in gross income
and personal holding company income of Corporation X for the purpose of
the test under section 542(b)(2) and paragraph (b) of this section.
Thus, the affiliated group would be an ineligible affiliated group under
section 542(b)(2) because 24 percent of its gross income was from
sources outside the affiliated group ($24,000/$100,000) and 100 percent
of this $24,000 was personal holding company income.
Sec. 1.543-1 Personal holding company income.
(a) General rule. The term personal holding company income means the
portion of the gross income which consists of the classes of gross
income described in paragraph (b) of this section. See section 543(b)
and Sec. 1.543-2 for special limitations on gross income and personal
holding company income in cases of gains from stocks', securities', and
commodities' transactions.
(b) Definitions--(1) Dividends. The term dividends includes
dividends as defined in section 316 and amounts required to be included
in gross income under section 551 and Sec. Sec. 1.551-1--1.551-2
(relating to foreign personal holding company income taxed to United
States shareholders).
[[Page 332]]
(2) Interest. The term interest means any amounts, includible in
gross income, received for the use of money loaned. However, (i)
interest which constitutes rent shall not be classified as interest but
shall be classified as rents (see subparagraph (10) of this paragraph)
and (ii) interest on amounts set aside in a reserve fund under section
511 or 607 of the Merchant Marine Act, 1936 (46 U.S.C. 1161 or 1177),
shall not be included in personal holding company income.
(3) Royalties (other than mineral, oil, or gas royalties or certain
copyright royalties). The term royalties (other than mineral, oil, or
gas royalties or certain copyright royalties) includes amounts received
for the privilege of using patents, copyrights, secret processes and
formulas, good will, trade marks, trade brands, franchises, and other
like property. It does not, however, include rents. For rules relating
to rents see section 543(a)(7) and subparagraph (10) of this paragraph.
For rules relating to mineral, oil, or gas royalties, see section
543(a)(8) and subparagraph (11) of this paragraph. For rules relating to
certain copyright royalties for taxable years beginning after December
31, 1959, see section 543(a)(9) and subparagraph (12) of this paragraph.
(4) Annuities. The term annuities includes annuities only to the
extent includible in the computation of gross income. See section 72 and
Sec. Sec. 1.72-1--1.72-14 for rules relating to the inclusion of
annuities in gross income.
(5) Gains from the sale or exchange of stock or securities. (i)
Except in the case of regular dealers in stock or securities as provided
in subdivision (ii) of this subparagraph, gross income and personal
holding company income include the amount by which the gains exceed the
losses from the sale or exchange of stock or securities. See section
543(b)(1) and Sec. 1.543-2 for provisions relating to this limitation.
For this purpose, there shall be taken into account all those gains
includible in gross income (including gains from liquidating dividends
and other distributions from capital) and all those losses deductible
from gross income which are considered under chapter 1 of the Code to be
gains or losses from the sale or exchange of stock or securities. The
term stock or securities as used in section 543(a)(2) and this
subparagraph includes shares or certificates of stock, stock rights or
warrants, or interest in any corporation (including any joint stock
company, insurance company, association, or other organization
classified as a corporation by the Code), certificates of interest or
participation in any profit-sharing agreement, or in any oil, gas, or
other mineral property, or lease, collateral trust certificates, voting
trust certificates, bonds, debentures, certificates of indebtedness,
notes, car trust certificates, bills of exchange, obligations issued by
or on behalf of a State, Territory, or political subdivision thereof.
(ii) In the case of regular dealers in stock or securities there
shall not be included gains or losses derived from the sale or exchange
of stock or securities made in the normal course of business. The term
regular dealer in stock or securities means a corporation with an
established place of business regularly engaged in the purchase of stock
or securities and their resale to customers. However, such corporations
shall not be considered as regular dealers with respect to stock or
securities which are held for investment. See section 1236 and Sec.
1.1236-1.
(6) Gains from futures transactions in commodities. Gross income and
personal holding company income include the amount by which the gains
exceed the losses from futures transactions in any commodity on or
subject to the rules of a board of trade or commodity exchange. See
Sec. 1.543-2 for provisions relating to this limitation. In general,
for the purpose of determining such excess, there are included all gains
and losses on futures contracts which are speculative. However, for the
purpose of determining such excess, there shall not be included gains or
losses from cash transactions, or gains or losses by a producer,
processor, merchant, or handler of the commodity, which arise out of
bona fide hedging transactions reasonably necessary to the conduct of
its business in the manner in which such business is customarily and
usually conducted by others. See section 1233 and Sec. 1.1233-1.
[[Page 333]]
(7) Estates and trusts. Under section 543(a)(4) personal holding
company income includes amounts includible in computing the taxable
income of the corporation under part I, subchapter J, chapter 1 of the
Code (relating to estates, trusts, and beneficiaries); and any gain
derived by the corporation from the sale or other disposition of any
interest in an estate or trust.
(8) Personal service contracts. (i) Under section 543(a)(5) amounts
received under a contract under which the corporation is to furnish
personal services, as well as amounts received from the sale or other
disposition of such contract, shall be included as personal holding
company income if:
(a) Some person other than the corporation has the right to
designate (by name or by description) the individual who is to perform
the services, or if the individual who is to perform the services is
designated (by name or by description) in the contract; and
(b) At any time during the taxable year 25 percent or more in value
of the outstanding stock of the corporation is owned, directly or
indirectly, by or for the individual who has performed, is to perform,
or may be designated (by name or by description) as the one to perform,
such services. For this purpose, the amount of stock outstanding and its
value shall be determined in accordance with the rules set forth in the
last two sentences of paragraph (b) and in paragraph (c) of Sec. 1.542-
3. It should be noted that the stock ownership requirement of section
543(a)(5) and this subparagraph relates to the stock ownership at any
time during the taxable year. For rules relating to the determination of
stock ownership, see section 544 and Sec. Sec. 1.544-1 through 1.544-7.
(ii) If the contract, in addition to requiring the performance of
services by a 25-percent stockholder who is designated or who could be
designated (as specified in section 543(a)(5) and subdivision (i) of
this subparagraph), requires the performance of services by other
persons which are important and essential, then only that portion of the
amount received under such contract which is attributable to the
personal services of the 25-percent stockholder shall constitute
personal holding company income. Incidental personal services of other
persons employed by the corporation to facilitate the performance of the
services by the 25-percent stockholder, however, shall not constitute
important or essential services. Under section 482 gross income,
deductions, credits, or allowances between or among organizations,
trades, or businesses may be allocated if it is determined that
allocation is necessary in order to prevent evasion of taxes or clearly
to reflect the income of any such organizations, trades, or businesses.
(iii) The application of section 543(a)(5) and this subparagraph may
be illustrated by the following examples:
Example 1. A, whose profession is that of an actor, owns all of the
outstanding capital stock of the M Corporation. The M Corporation
entered into a contract with A under which A was to perform personal
services for the person or persons whom the M Corporation might
designate, in consideration of which A was to receive $10,000 a year
from the M Corporation. The M Corporation entered into a contract with
the O Corporation in which A was designated to perform personal services
for the O Corporation in consideration of which the O Corporation was to
pay the M Corporation $500,000 a year. The $500,000 received by the M
Corporation from the O Corporation constitutes personal holding company
income.
Example 2. Assume the same facts as in example 1, except that, in
addition to A's contract with the M Corporation, B, whose profession is
that of a dancer and C, whose profession is that of a singer, were also
under contract to the M Corporation to perform personal services for the
person or persons whom the M Corporation might designate, in
consideration of which they were each to receive $25,000 a year from the
M Corporation. Neither B nor C were stockholders of the M Corporation.
The contract entered into by the MCorporation with the O Corporation, in
addition to designating that A was to perform personal services for the
O Corporation, designated that B and C were also to perform personal
services for the O Corporation. Although the O Corporation particularly
desired the services of A for an entertainment program it planned, it
also desired the services of B and C, who were prominent in their
fields, to provide a good supporting cast for the program. The services
of B and C required under the contract are determined to be important
and essential; therefore, only that portion of the $500,000 received by
the M Corporation which is attributable to the personal services of A
constitutes personal holding company income. The same result would
obtain although the dancer and the singer
[[Page 334]]
required by the contract were not designated by name but the contract
gave the M Corporation discretion to select and provide the services of
a singer and a dancer for the program and such services were provided.
Example 3. The N Corporation is engaged in engineering. Its entire
outstanding capital stock is owned by four individuals. The N
Corporation entered into a contract with the R Corporation to perform
engineering services in consideration of which the R Corporation was to
pay the N Corporation $50,000. The individual who was to perform the
services was not designated (by name or by description) in the contract
and no one but the N Corporation had the right to designate (by name or
by description) such individual. The $50,000 received by the N
Corporation from the R Corporation does not constitute personal holding
company income.
(9) Compensation for use of property. Under section 543(a)(6)
amounts received as compensation for the use of, or right to use,
property of the corporation shall be included as personal holding
company income if, at any time during the taxable year, 25 percent or
more in value of the outstanding stock of the corporation is owned,
directly or indirectly, by or for an individual entitled to the use of
the property. Thus, if a shareholder who meets the stock ownership
requirement of section 543(a)(6) and this subparagraph uses, or has the
right to use, a yacht, residence, or other property owned by the
corporation, the compensation to the corporation for such use, or right
to use, the property constitutes personal holding company income. This
is true even though the shareholder may acquire the use of, or the right
to use, the property by means of a sublease or under any other
arrangement involving parties other than the corporation and the
shareholder. However, if the personal holding company income of the
corporation (after excluding any such income described in section
543(a)(6) and this subparagraph, relating to compensation for use of
property, and after excluding any such income described in section
543(a)(7) and subparagraph (10) of this paragraph, relating to rents) is
not more than 10 percent of its grossincome, compensation for the use of
property shall not constitute personalholding company income. For
purposes of the preceding sentence, in determining whether personal
holding company income is more than 10 percent of gross income,
copyright royalties constitute personal holding company income,
regardless of whether such copyright royalties are excluded from
personal holding company income under section 543(a)(9) and subparagraph
(12)(ii) of this paragraph. For purposes of applying section 543(a)(6)
and this subparagraph, the amount of stock outstanding and its value
shall be determined in accordance with the rules set forth in the last
two sentences of paragraph (b) and in paragraph (c) of Sec. 1.542-3. It
should be noted that the stock ownership requirement of section
543(a)(6) and this subparagraph relates to the stock outstanding at any
time during the entire taxable year. For rules relating to the
determination of stock ownership, see section 544 and Sec. Sec. 1.544-1
through 1.544-7.
(10) Rents (including interest constituting rents). Rents which are
to be included as personal holding company income consist of
compensation (however designated) for the use, or right to use, property
of the corporation. The term rents does not include amounts includible
in personal holding company income under section 543(a)(6) and
subparagraph (9) of this paragraph. The amounts considered as rents
include charter fees, etc., for the use of, or the right to use,
property, as well as interest on debts owed to the corporation (to the
extent such debts represent the price for which real property held
primarily for sale to customers in the ordinary course of the
corporation's trade or business was sold or exchanged by the
corporation). However, if the amount of the rents includible under
section 543(a)(7) and this subparagraph constitutes 50 percent or more
of the gross income of the corporation, such rents shall not be
considered to be personal holding company income.
(11) Mineral, oil, or gas royalties. (i) The income from mineral,
oil, or gas royalties is to be included as personal holding company
income, unless (a) the aggregate amount of such royalties constitutes 50
percent or more of the gross income of the corporation for the taxable
year and (b) the aggregate amount of deductions allowable under section
162 (other than compensation for personal services rendered by the
[[Page 335]]
shareholders of the corporation) equals 15 percent or more of the gross
income of the corporation for the taxable year.
(ii) The term mineral, oil, or gas royalties means all royalties,
including overriding royalties and, to the extent not treated as loans
under section 636, mineral production payments, received from any
interest in mineral, oil, or gas properties. The term mineral includes
those minerals which are included within the meaning of the term
minerals in the regulations under section 611.
(iii) The first sentence of subdivision (ii) of this subparagraph
shall apply to overriding royalties received from the sublessee by the
operating company which originally leased and developed the natural
resource property in respect of which such overriding royalties are
paid, and to mineral, oil, or gas production payments, only with respect
to amounts received after September 30, 1958.
(12) Copyright royalties--(i) In general. The income from copyright
royalties constitutes, generally, personal holding company income.
However, for taxable years beginning after December 31, 1959, those
copyright royalties which come within the definition of copyright
royalties in section 543(a)(9) and subdivision (iv) of this subparagraph
shall be excluded from personal holding company income only if the
conditions set forth in subdivision (ii) of this subparagraph are
satisfied.
(ii) Exclusion from personal holding company income. For taxable
years beginning after December 31, 1959, copyright royalties (as defined
in section 543(a)(9) and subdivision (iv) of this subparagraph) shall be
excluded from personal holding company income only if the conditions set
forth in (a), (b), and (c) of this subdivision are met.
(a) Such copyright royalties for the taxable year must constitute 50
percent or more of the corporation's gross income. For this purpose,
copyright royalties shall be computed by excluding royalties received
for the use of, or the right to use, copyrights or interests in
copyrights in works created, in whole or in part, by any person who, at
any time during the corporation's taxable year, is a shareholder.
(b) Personal holding company income for the taxable year must be 10
percent or less of the corporation's gross income. For this purpose,
personal holding company income shall be computed by excluding (1)
copyright royalties (except that there shall be included royalties
received for the use of, or the right to use, copyrights or interests in
copyrights in works created, in whole or in part, by any shareholder
owning, at any time during the corporation's taxable year, more than 10
percent in value of the outstanding stock of the corporation), and (2)
dividends from any corporation in which the taxpayer owns, on the date
the taxpayer becomes entitled to the dividends, at least 50 percent of
all classes of stock entitled to vote and at least 50 percent of the
total value of all classes of stock, provided the corporation which pays
the dividends meets the requirements of subparagraphs (A), (B), and (C)
of section 543(a)(9).
(c) The aggregate amount of the deductions allowable under section
162 must constitute 50 percent or more of the corporation's gross income
for the taxable year. For this purpose, the deductions allowable under
section 162 shall be computed by excluding deductions for compensation
for personal services rendered by, and deductions for copyright and
other royalties to, shareholders of the corporation.
(iii) Determination of stock value and stock ownership. For purposes
of section 543(a)(9) and this subparagraph, the following rules shall
apply:
(a) The amount and value of the outstanding stock of a corporation
shall be determined in accordance with the rules set forth in the last
two sentences of paragraph (b) and in paragraph (c) of Sec. 1.542-3.
(b) The ownership of stock shall be determined in accordance with
the rules set forth in section 544 and Sec. Sec. 1.544-1 through 1.544-
7.
(c) Any person who is considered to own stock within the meaning of
section 544 and Sec. Sec. 1.544-1 through 1.544-7 shall be a
shareholder.
(iv) Copyright royalties defined. For purposes of section 543(a)(9)
and this subparagraph, the term copyright royalties means compensation,
however designated, for the use of, or the right to
[[Page 336]]
use, copyrights in works protected by copyright issued under title 17 of
the United States Code (other than by reason of section 2 or 6 thereof),
and to which copyright protection is also extended by the laws of any
foreign country as a result of any international treaty, convention, or
agreement to which the United States is a signatory. Thus, copyright
royalties includes not only royalties from sources within the United
States under protection of United States laws relating to statutory
copyrights but also royalties from sources within a foreign country with
respect to United States statutory copyrights protected in such foreign
country by any international treaty, convention, or agreement to which
the United States is a signatory. The term copyright royalties includes
compensation for the use of, or right to use, an interest in any such
copyrighted works as well as payments from any person for performing
rights in any such copyrighted works.
(v) Compensation which is rent. Section 543(a)(9) and subdivisions
(i) through (iv) of this subparagraph shall not apply to compensation
which is rent within the meaning of the second sentence of section
543(a)(7).
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6739, 29 FR
7713, June 17, 1964; T.D. 7261, 38 FR 5467, Mar. 1, 1973]
Sec. 1.543-2 Limitation on gross income and personal holding company
income in transactions involving stocks, securities, and commodities.
(a) Under section 543(b)(1) the gains which are to be included in
gross income, and in personal holding company income with respect to
transactions described in section 543(a)(2) and paragraph (b)(5) of
Sec. 1.543-1, shall be the net gains from the sale or exchange of stock
or securities. If there is an excess of losses over gains from such
transactions, such excess (or net loss) shall not be used to reduce
gross income or personal holding company income for purposes of the
personal holding company tax. Similarly, under section 543(b)(2) the
gains which are to be included in gross income, and in personal holding
company income with respect to transactions described in section
543(a)(3) and paragraph (b)(6) of Sec. 1.543-1, shall be the net gains
from commodity transactions which reflect personal holding company
income. Any excess of losses over gains from such transactions
(resulting in a net loss) shall not be used to reduce gross income or
personal holding company income. The capital loss carryover under
section 1212 shall not be taken into account.
(b) The application of section 543(b) may be illustrated by the
following examples:
Example 1. The P Corporation, not a regular dealer in stocks and
securities, received rentals of $250,000 for its property from a 25-
percent shareholder, and also had gains of $50,000 during the taxable
year from the sale of stocks and securities. It also had losses on the
sale of stocks and securities in the amount of $30,000. Accordingly, P
Corporation had gross income during the taxable year of $270,000
($250,000 plus $20,000 net gain from the sales of stocks and
securities). It had personal holding company income of $20,000. (The
rentals of $250,000 would not be personal holding company income under
section 543(a)(6) since the personal holding company income of the
corporation, $20,000 (after excluding any such income described in
section 543(a)(6)), is not more than 10 percent of its gross income.)
Example 2. The R Corporation, not a regular dealer in stocks or
securities, realized total gains during the taxable year of $900,000
from commodity futures transactions and $200,000 from the sales of
stocks and securities. It also sustained total losses of $1,000,000 on
such commodity futures transactions, resulting in a net gain for the
taxable year or $100,000. None of the commodity futures transactions are
hedging or other types of futures transactions excluded from the
application of section 543(a)(3). No part of the loss on commodity
futures transactions is to be taken into account in determining personal
holding company income and gross income for personal holding company tax
purposes for the taxable year. The full amount of the $200,000 in gains
from the sales of stocks and securities is to be included in personal
holding company income and in gross income for personal holding company
tax purposes for the taxable year.
Sec. 1.544-1 Constructive ownership.
(a) Rules relating to the constructive ownership of stock are
provided by section 544 for the purpose of determining whether the stock
ownership requirements of the following sections are satisfied:
[[Page 337]]
(1) Section 542(a)(2), relating to ownership of stock by five or
fewer individuals.
(2) Section 543(a)(5), relating to personal holding company income
derived from personal service contracts.
(3) Section 543(a)(6), relating to personal holding company income
derived from property used by shareholders.
(4) Section 543(a)(9), relating to personal holding company income
derived from copyright royalties.
(b) Section 544 provides four general rules with respect to
constructive ownership. These rules are:
(1) Constructive ownership by reason of indirect ownership. See
section 544(a)(1) and Sec. 1.544-2.
(2) Constructive ownership by reason of family and partnership
ownership. See section 544(a) (2), (4), (5), and (6), and Sec. Sec.
1.544-3, 1.544-6, and 1.544-7.
(3) Constructive ownership by reason of ownership of options. See
section 544(a) (3), (4), (5), and (6), and Sec. Sec. 1.544-4, 1.544-6,
and 1.544-7.
(4) Constructive ownership by reason of ownership of convertible
securities. See section 544(b) and Sec. 1.544-5.
Each of the rules referred to in subparagraphs (2), (3), and (4) of this
paragraph is applicable only if it has the effect of satisfying the
stock ownership requirement of the section to which applicable; that is,
when applied to section 542(a)(2), its effect is to make the corporation
a personal holding company, or when applied to section 543(a)(5),
section 543(a)(6), or section 543(a)(9), its effect is to make the
amounts described in such provisions includible as personal holding
company income.
(c) All forms and classes of stock, however denominated, which
represent the interests of shareholders, members, or beneficiaries in
the corporation shall be taken into consideration in applying the
constructive ownership rules of section 544.
(d) For rules applicable in treating constructive ownership,
determined by one application of section 544, as actual ownership for
purposes of a second application of section 544, see section 544(a)(5)
and Sec. 1.544-6.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6739, 29 FR
7715, June 17, 1964]
Sec. 1.544-2 Constructive ownership by reason of indirect ownership.
The following example illustrates the application of section
544(a)(1), relating to constructive ownership by reason of indirect
ownership:
Example. A and B, two individuals, are the exclusive and equal
beneficiaries of a trust or estate which owns the entire capital stock
of the M Corporation. The M Corporation in turn owns the entire capital
stock of the N Corporation. Under such circumstances the entire capital
stock of both the M Corporation and the N Corporation shall be
considered as being owned equally by A and B as the individuals owning
the beneficial interest therein.
Sec. 1.544-3 Constructive ownership by reason of family and partnership
ownership.
(a) The following example illustrates the application of section
544(a)(2), relating to constructive ownership by reason of family and
partnership ownership.
Example. The M Corporation at some time during the last half of the
taxable year, had 1,800 shares of outstanding stock, 450 of which were
held by various individuals having no relationship to one another and
none of whom were partners, and the remaining 1,350 were held by 51
shareholders as follows:
----------------------------------------------------------------------------------------------------------------
Relationships Shares Shares Shares Shares Shares
----------------------------------------------------------------------------------------------------------------
An individual................... (A)100 (B)20 (C)20 (D)20 (E)20
His father...................... (AF)10 (BF)10 (CF)10 (DF)10 (EF)10
His wife........................ (AW)10 (BW)40 (CW)40 (DW)40 (EW)40
His brother..................... (AB)10 (BB)10 (CB)10 (DB)10 (EB)10
His son......................... (AS)10 (BS)40 (CS)40 (DS)40 (ES)40
His daughter by former marriage
(son's.........................
half-sister)................. (ASHS)10 (BSHS)40 (CSHS)40 (DSHS)40 (ESHS)40
His brother's wife.............. (ABW)10 (BBW)10 (CBW)10 (DBW)160 (EBW)10
His wife's father............... (AWF)10 (BWF)10 (CWF)110 (DWF)10 (EWF)10
His wife's brother.............. (AWB)10 (BWB)10 (CWB)10 (DWB)10 (EWB)10
His wife's brother's wife....... (AWBW)10 (BWBW)10 (CWBW)10 (DWBW)10 (EWBW)110
Individual's partner............ (AP)10 .............. .............. .............. ..............
----------------------------------------------------------------------------------------------------------------
[[Page 338]]
By applying the statutory rule provided in section 544(a)(2) five
individuals own more than 50 percent of the outstanding stock as
follows:
A (including AF, AW, AB, AS, ASHS, AP).......................... 160
B (including BF, BW, BB, BS, BSHS).............................. 160
CW (including C, CS, CWF, CWB).................................. 220
DB (including D, DF, DBW)....................................... 200
EWB (including EW, EWF, EWBW)................................... 170
-------
Total, or more than 50 percent.............................. 910
Individual A represents the obvious case where the head of the family
owns the bulk of the family stock and naturally is the head of the
group. A's partner owns 10 shares of the stock. Individual B represents
the case where he is still head of the group because of the ownership of
stock by his immediate family. Individuals C and D represent cases where
the individuals fall in groups headed in C's case by his wife and in D's
case by his brother because of the preponderance of holdings on the part
of relatives by marriage. Individual E represents the case where the
preponderant holdings of others eliminate that individual from the
group.
(b) For the restriction on the applicability of the family and
partnership ownership rules of this section, see paragraph (b) of Sec.
1.544-1. For rules relating to constructive ownership as actual
ownership, see Sec. 1.544-6.
Sec. 1.544-4 Options.
The shares of stock which may be acquired by reason of an option
shall be considered to be constructively owned by the individual having
the option to acquire such stock. For example: If C, an individual, on
March 1, 1955, purchases an option, or otherwise comes into possession
of an option, to acquire 100 shares of the capital stock of M
Corporation, such 100 shares of stock shall be considered to be
constructively owned by C as if C had actually acquired the stock on
that date. If C has an option on an option (or one of a series of
options) to acquire such stock, he shall also be considered to have
constructive ownership of the stock which may be acquired by reason of
the option (or the series of options). Under such circumstances, C shall
be considered to have acquired constructive ownership of the stock on
the date he acquired his option. For the restriction on the
applicability of the rule of this section, see paragraph (b) of Sec.
1.544-1.
Sec. 1.544-5 Convertible securities.
Under section 544(b) outstanding securities of a corporation such as
bonds, debentures, or other corporate obligations, convertible into
stock of the corporation (whether or not convertible during the taxable
year) shall be considered as outstanding stock of the corporation. The
consideration of convertible securities as outstanding stock is subject
to the exception that, if some of the outstanding securities are
convertible only after a later date than in the case of others, the
class having the earlier conversion date may be considered as
outstanding stock although the others are not so considered, but no
convertible securities shall be considered as outstanding stock unless
all outstanding securities having a prior conversion date are also so
considered. For example, if outstanding securities are convertible in
1954, 1955 and 1956, those convertible in 1954 can be properly
considered as outstanding stock without so considering those convertible
in 1955 or 1956, and those convertible in 1954 and 1955 can be properly
considered as outstanding stock without so considering those convertible
in 1956. However, the securities convertible in 1955 could not be
properly considered as outstanding stock without so considering those
convertible in 1954 and the securities convertible in 1956 could not be
properly considered as outstanding stock without so considering those
convertible in 1954 and 1955. For the restriction on the applicability
of the rule of this section, see paragraph (b) of Sec. 1.544-1.
Sec. 1.544-6 Constructive ownership as actual ownership.
(a) General rules. (1) Stock constructively owned by a person by
reason of the application of the rule provided in section 544(a)(1),
relating to stock not owned by an individual, shall be considered as
actually owned by such person for the purpose of again applying such
rule or of applying the family and partnership rule provided in section
544(a)(2), in order to make another person the constructive owner of
such stock, and
(2) Stock constructively owned by a person by reason of the
application of the option rule provided in section
[[Page 339]]
544(a)(3) shall be considered as actually owned by such person for the
purpose of applying either the rule provided in section 544(a)(1),
relating to stock not owned by an individual, or the family and
partnership rule provided in section 544(a)(2) in order to make another
person the constructive owner of such stock, but
(3) Stock constructively owned by an individual by reason of the
application of the family and partnership rule provided in section
544(a)(2) shall not be considered as actually owned by such individual
for the purpose of again applying such rule in order to make another
individual the constructive owner of such stock.
(b) Examples. The application of this section may be illustrated by
the following examples:
Example 1. A's wife, AW, owns all the stock of the M Corporation,
which in turn owns all the stock of the O Corporation. The O Corporation
in turn owns all the stock of the P Corporation. Under the rule provided
in section 544(a)(1), relating to stock not owned by an individual, the
stock in the P Corporation owned by the O Corporation is considered to
be owned constructively by the M Corporation, the sole shareholder of
the O Corporation. Such constructive ownership of the stock of the M
Corporation is considered as actual ownership for the purpose of again
applying such rule in order to make AW, the sole shareholder of the M
Corporation, the constructive owner of the stock of the P Corporation.
Similarly, the constructive ownership of the stock by AW is considered
as actual ownership for the purpose of applying the family and
partnership rule provided in section 544(a)(2) in order to make A the
constructive owner of the stock of the P Corporation, if such
application is necessary for any of the purposes set forth in paragraph
(b) of Sec. 1.544-1. But the stock thus constructively owned by A may
not be considered as actual ownership for the purpose of again applying
the family and partnership rule in order to make another member of A's
family, for example, A's father, the constructive owner of the stock of
the P Corporation.
Example 2. B, an individual, owns all the stock of the R Corporation
which has an option to acquire all the stock of the S Corporation, owned
by C, an individual, who is not related to B. Under the option rule
provided in section 544(a)(3) the R Corporation may be considered as
owning constructively the stock of the S Corporation owned by C. Such
constructive ownership of the stock by the R Corporation is considered
as actual ownership for the purpose of applying the rule provided in
section 544(a)(1), relating to stock not owned by an individual, in
order to make B, the sole shareholder of the R Corporation, the
constructive owner of the stock of the S Corporation. The stock thus
constructively owned by B by reason of the application of the rule
provided in section 544(a)(1) likewise is considered as actual ownership
for the purpose, if necessary, of applying the family and partnership
rule provided in section 544(a)(2), in order to make another member of
B's family, for example, B's wife, BW, the constructive owner of the
stock of the S Corporation. However, the family and partnership rule
could not again be applied so as to make still another individual the
constructive owner of the stock of the S Corporation, that is, the stock
constructively owned by BW could not be considered as actually owned by
her in order to make BW's father the constructive owner of such stock by
a second application of the family and partnership rule.
Sec. 1.544-7 Option rule in lieu of family and partnership rule.
(a) If, in determining the ownership of stock, such stock may be
considered as constructively owned by an individual by an application of
either the family and partnership rule (section 544(a)(2)) or the option
rule (section 544(a)(3)), such stock shall be considered as owned
constructively by the individual by reason of the application of the
option rule.
(b) The application of this section may be illustrated by the
following example:
Example. Two brothers, A and B, each own 10 percent of the stock of
the M Corporation, and A's wife, AW, also owns 10 percent of the stock
of such corporation. AW's husband, A, has an option to acquire the stock
owned by her at any time. It becomes necessary, for one of the purposes
stated in section 544(a)(4), to determine the stock ownership of B in
the M Corporation. If the family and partnership rule were the only rule
that applied in the case, B would be considered, under that rule, as
owning 20 percent of the stock of the M Corporation, namely, his own
stock plus the stock owned by his brother. In that event, B could not be
considered as owning the stock held by AW since (1) AW is not a member
of B's family and (2) the constructive ownership of such stock by A
through the application of the family and partnership rule in his case
is not considered as actual ownership so as to make B the constructive
owner by a second application of the same rule with respect to the
ownership of the
[[Page 340]]
stock. However, there is more than the family and partnership rule
involved in this example. As the holder of an option upon the stock, A
may be considered the constructive owner of his wife's stock by the
application of the option rule and without reference to the family
relationship between A and AW. If A is considered as owning the stock of
his wife by application of the option rule, then such constructive
ownership by A is regarded as actual ownership for the purpose of
applying the family and partnership rule so as to make another member of
A's family, for example, B, the constructive owner of the stock. Hence,
since A may be considered as owning his wife's stock by applying either
the family-partnership rule or the option rule, the provisions of
section 544(a)(6) apply and accordingly A must be considered the
constructive owner of his wife's stock under the option rule rather than
the family-partnership rule. B thus becomes the constructive owner of 30
percent of the stock of the M corporation, namely, his own 10 percent,
A's 10 percent, and AW's 10 percent constructively owned by A as the
holder of an option on the stock.
Sec. 1.545-1 Definition.
(a) Undistributed personal holding company income is the amount
which is subject to the personal holding company tax imposed under
section 541. Undistributed personal holding company income is the
taxable income of the corporation adjusted in the manner described in
section 545(b) and Sec. 1.545-2, and section 545(c) and Sec. 1.545-3,
less the deduction for dividends paid. See part IV (section 561 and
following), subchapter G, chapter 1 of the Code, and the regulations
thereunder, relating to the dividends paid deduction.
(b) For purposes of the imposition of the personal holding company
tax on a foreign corporation, resident or nonresident, which files or
causes to be filed a return, the undistributed personal holding company
income shall be computed on the basis of the taxable income from sources
within the United States, and such income shall be adjusted in
accordance with the principles of section 545(b) and Sec. 1.545-2, and
section 545(c) and Sec. 1.545-3. For purposes of the imposition of such
tax on a foreign corporation, resident or nonresident, which files no
return, the undistributed personal holding company income shall be
computed on the basis of the gross income from sources within the United
States without allowance of any deductions. For purposes of this
paragraph, a nonresident foreign corporation will be considered to have
filed a return for any taxable year ending before September 9, 1958, if
the return for any such taxable year is filed on or before February 5,
1960.
[T.D. 6949, 33 FR 5525, Apr. 9, 1968]
Sec. 1.545-2 Adjustments to taxable income.
(a) Taxes--(1) General rule. (i) In computing undistributed personal
holding company income for any taxable year, there shall be allowed as a
deduction the amount by which Federal income and excess profits taxes
accrued during the taxable year exceed the credit provided by section 33
(relating to taxes of foreign countries and possessions of the United
States), and the income, war profits, and excess profits taxes of
foreign countries and possessions of the United States accrued during
the taxable year (to the extent provided by subparagraph (3) of this
paragraph), except that no deduction shall be allowed for (a) the
accumulated earnings tax imposed by section 531 (or a corresponding
section of a prior law), (b) the personal holding company tax imposed by
section 541 (or a corresponding section of a prior law), and (c) the
excess profits tax imposed by subchapter E, chapter 2 of the Internal
Revenue Code of 1939, for taxable years beginning after December 31,
1940. The deduction is for taxes for the taxable year, determined under
the accrual method of accounting, regardless of whether the corporation
uses an accrual method of accounting, the cash receipts and disbursement
method, or any other allowable method of accounting. In computing the
amount of taxes accrued, an unpaid tax which is being contested is not
considered accrued until the contest is resolved.
(ii) However, the taxpayer shall deduct taxes paid, rather than
taxes accrued, if it used that method with respect to Federal taxes for
each taxable year for which it was subject to the tax imposed by section
500 of the Internal Revenue Code of 1939, unless an election is made
under subparagraph (2) of this paragraph to deduct taxes accrued.
(2) Election by taxpayer which deducted taxes paid. (i) If the
corporation was
[[Page 341]]
subject to the personal holding company tax imposed by section 500 of
the Internal Revenue Code of 1939 and, for the purpose of that tax,
deducted Federal taxes paid rather than such taxes accrued for each
taxable year for which it was subject to such taxes, the corporation may
elect for any taxable year ending after June 30, 1954, to deduct taxes
accrued, including taxes of foreign countries and possessions of the
United States, rather than taxes paid, for the purposes of the tax
imposed by section 541 of the Internal Revenue Code of 1954. The
election shall be made by deducting such taxes accrued on Schedule PH,
Form 1120, to be filed with the return. The schedule shall, in addition,
contain a statement that the corporation has made such election and
shall set forth the year to which such election was first applicable.
The deduction of taxes accrued in the year of election precludes the
deduction of taxes paid during such year. The election, if made, shall
be irrevocable and the deduction for taxes accrued shall be allowed for
the year of election and for all subsequent taxable years.
(ii) Pursuant to section 7851(a)(1)(C), the election provided for in
subdivision (i) of this subparagraph may be made with respect to a
taxable year ending after June 30, 1954, even though such taxable year
is subject to the Internal Revenue Code of 1939.
(3) Taxes of foreign countries and United States possessions. In
determining undistributed personal holding company income for any
taxable year, if the taxpayer chooses the benefits of section 901 for
such taxable year, a deduction shall be allowed for:
(i) The income, war profits, and excess profits taxes imposed by
foreign countries or possessions of the United States and accrued (or
paid, if required under subparagraph (1)(ii) of this paragraph) during
such taxable year, and
(ii) In the case of a domestic corporation, the foreign income taxes
deemed to be paid for such taxable year under section 902(a) in
accordance with Sec. Sec. 1.902-1 and 1.902-2 or section 960(a)(1) in
accordance with Sec. 1.960-7.
In no event shall the amount under subdivision (ii) of this subparagraph
exceed the amount includible in gross income with respect to such taxes
under section 78 and Sec. 1.78-1. The credit for such taxes provided by
section 901 shall not be allowed against the personal holding company
tax imposed by section 541. See section 901(a).
(b) Charitable contributions--(1) Taxable years beginning before
January 1, 1970. (i) Section 545(b)(2) provides that, in computing the
deduction for charitable contributions for purposes of determining
undistributed personal holding company income of a corporation for
taxable years beginning before January 1, 1970, the limitations in
section 170(b)(1) (A) and (B), relating to charitable contributions by
individuals, shall apply and section 170(b) (2) and (5), relating to
charitable contributions by corporations and carryover of certain excess
charitable contributions made by individuals, respectively, shall not
apply.
(ii) Although the limitations of section 170(b)(1) (A) and (B) are
10 and 20 percent, respectively, of the individual's adjusted gross
income, the limitations are applied for purposes of section 545(b)(2) by
using 10 and 20 percent, respectively, of the corporation's taxable
income as adjusted for purposes of section 170(b)(2), that is, the same
amount of taxable income to which the 5-percent limitation applied.
Thus, the term adjusted gross income when used in section 170(b)(1)
means the corporation's taxable income computed with the adjustments,
other than the 5-percent limitation, provided in the first sentence of
section 170(b)(2). However, a further adjustment for this purpose is
that the taxable income shall also be computed without the deduction of
the amount disallowed under section 545(b)(8), relating to expenses and
depreciation applicable to property of the taxpayer. The carryover of
charitable contributions made in a prior year, otherwise allowable as a
deduction in computing taxable income to the extent provided in section
170(b)(2) and, with respect to contributions paid in taxable years
beginning after December 31, 1963, in section 170(b)(5), shall not be
allowed as a deduction in computing undistributed personal holding
company income for any taxable year.
(iii) See Sec. 1.170-2 with respect to the charitable contributions
to which the
[[Page 342]]
10-percent limitation is applicable and the charitable contributions to
which the 20-percent limitation is applicable.
(2) Taxable years beginning after December 31, 1969. (i) Section
545(b)(2) provides that, in computing the deduction allowable for
charitable contributions for purposes of determining undistributed
personal holding company income of a corporation for taxable years
beginning after December 31, 1969, the limitations in section 170(b)(1)
(A), (B), and (D)(i) (relating to charitable contributions by
individuals) shall apply, and section 170(b)(1)(D)(ii) (relating to
excess charitable contributions by individuals of certain capital gain
property, section 170(b)(2) (relating to the 5-percent limitation on
charitable contributions by corporations), and section 170(d) (relating
to carryovers of excess contributions of individuals and corporations)
shall not apply.
(ii) Although the limitations of section 170(b)(1) (A), (B), and
(D)(i) are 50, 20, and 30 percent, respectively, of an individual's
contribution base, these limitations are applied for purposes of section
545(b)(2) by using 50, 20, and 30 percent, respectively, of the
corporation's taxable income as adjusted for purposes of section
170(b)(2), that is, the same amount of taxable income to which the 5-
percent limitation applies. Thus, the term contribution base when used
in section 170(b)(1) means the corporation's taxable income computed
with the adjustments, other than the 5-percent limitation, provided in
section 170(b)(2). However, a further adjustment for this purpose is
that the taxable income shall also be computed without the deduction of
the amount disallowed under section 545(b)(8), relating to expenses and
depreciation applicable to property of the taxpayer. The carryover of
charitable contributions made in a prior year, otherwise allowable as a
deduction in computing taxable income to the extent provided in section
170(b)(1)(D)(ii) and (d), shall not be allowed as a deduction in
computing undistributed personal holding company income for any taxable
year.
(iii) See Sec. 1.170A-8 for the rules with respect to the
charitable contributions to which the 50-, 20-, and 30-percent
limitations apply.
(c) Special deductions disallowed. Part VIII, subchapter B, chapter
1 of the Code, allows corporations, in computing taxable income, special
deductions for such matters as partially tax- exempt interest, certain
dividends received, dividends paid on certain preferred stock of public
utilities, organizational expenses, etc. See section 241. Such special
deductions, except the deduction provided by section 248 (relating to
organizational expenses) shall be disallowed in computing undistributed
personal holding company income.
(d) Net operating loss. The net operating loss deduction provided in
section 172 is not allowed for purposes of the computation of
undistributed personal holding company income. For purposes of such a
computation, however, there is allowed as a deduction the amount of the
net operating loss (as defined in section 172(c)) for the preceding
taxable year, except that, in computing undistributed personal holding
company income for a taxable year beginning after December 31, 1957, the
amount of such net operating loss shall be computed without the
deductions provided in part VIII (section 241 and following, except
section 248), subchapter B, chapter 1 of the Code.
(e) Long-term capital gains. (1) There is allowed as a deduction the
excess of the net long-term capital gain for the taxable year over the
net short-term capital loss for such year, minus the taxes attributable
to such excess, as provided in section 545(b)(5).
(2) Section 631(c) (relating to gain or loss in the case of disposal
of coal or domestic iron ore) shall have no application.
(f) Bank affiliates. There is allowed the deduction provided by
section 601 in the case of bank affiliates (as defined in section 2 of
the Banking Act of 1933; 12 U.S.C. 221a (c)).
(g) Payment of indebtedness incurred prior to January 1, 1934--(1)
General rule. In computing undistributed personal holding company
income, section 545(b)(7) provides that there shall be allowed as a
deduction amounts used or irrevocably set aside to pay or to retire
indebtedness of any kind incurred before January 1, 1934, if such
amounts are reasonable with reference to the size and terms of such
indebtedness.
[[Page 343]]
See Sec. 1.545-3 for the deduction in computing undistributed personal
holding company income of amounts used or irrevocably set aside to pay
or retire qualified indebtedness (as defined in paragraph (d) of Sec.
1.545-3).
(2) Indebtedness. The term indebtedness means an obligation absolute
and not contingent, to pay on demand or within a given time, in cash or
other medium, a fixed amount. The term indebtedness does not include the
obligation of a corporation on its capital stock. The indebtedness must
have been incurred (or, if incurred by assumption, assumed) by the
taxpayer before January 1, 1934. An indebtedness evidenced by bonds,
notes, or other obligations issued by a corporation is ordinarily
incurred as of the date such obligations are issued and the amount of
such indebtedness is the amount represented by the face value of the
obligations. In the case of refunding, renewal, or other change in the
form of an indebtedness, the giving of a new promise to pay by the
taxpayer will not have the effect of changing the date the indebtedness
was incurred.
(3) Amounts used or irrevocably set aside. The deduction is
allowable, in any taxable year, only for amounts used or irrevocably set
aside in that year. The use or irrevocable setting aside must be to
effect the extinguishment or discharge of indebtedness. In the case of
refunding, renewal, or other change in the form of an indebtedness, the
mere giving of a new promise to pay by the taxpayer will not result in
an allowable deduction. If amounts are set aside in one year, no
deduction is allowable for such amounts for a later year in which
actually paid. As long as all other conditions are satisfied, the
aggregate amount allowable as a deduction for any taxable year includes
all amounts (from whatever source) used and all amounts (from whatever
source) irrevocably set aside, irrespective of whether in cash or other
medium. Double deductions shall not be allowed.
(4) Reasonableness of the amounts with reference to the size and
terms of the indebtedness. (i) The reasonableness of the amounts used or
irrevocably set aside must be determined by reference to the size and
terms of the particular indebtedness. Hence, all the facts and
circumstances with respect to the nature, scope, conditions, amount,
maturity, and other terms of the particular indebtedness must be shown
in each case.
(ii) Ordinarily an amount used to pay or retire an indebtedness, in
whole or in part, at or prior to the maturity and in accordance with the
terms thereof will be considered reasonable, and may be allowable as a
deduction for the year in which so used. However, if an amount has been
set aside in a prior year for payment or retirement of the same
indebtedness, the amount so set aside shall not be allowed as a
deduction in the year of the payment.
(iii) All amounts irrevocably set aside for the payment or
retirement of an indebtedness in accordance with and pursuant to the
terms of the obligation, for example, the annual contribution to
trustees required by the provisions of a mandatory sinking fund
agreement, will be considered as complying with the requirement of
reasonableness. To be considered reasonable, it is not necessary that
the plan of retirement provide for a retroactive setting aside of
amounts for years prior to that in which the plan is adopted. However,
if a voluntary plan was adopted before 1934, no adjustment is allowable
in respect of the amounts set aside in the years prior to 1934.
(5) Burden of proof. The burden of proof will rest upon the taxpayer
to sustain the deduction claimed. Therefore, the taxpayer must furnish
the information required by the return, and such other information as
the district director may require in substantiation of the deduction
claimed.
(6) Allowance to a successor corporation. For allowance of deduction
for pre-1934 indebtedness to a successor corporation, see section
381(c)(15).
(h) Expenses and depreciation applicable to property of the
taxpayer. (1) In computing undistributed personal holding company income
in the case of a personal holding company which owns or operates
property, section 545(b)(8) provides a specific limitation with respect
to the allowance of deductions for trade or business expenses and
depreciation allocable to the operation or maintenance of such property.
Under
[[Page 344]]
this limitation, these deductions shall not be allowed in an amount in
excess of the aggregate amount of the rent or other compensation
received for the use of, or the right to use, the property, unless it is
established to the satisfaction of the Commissioner:
(i) That the rent or other compensation received was the highest
obtainable, or if none was received, that none was obtainable;
(ii) That the property was held in the course of a business carried
on bona fide for profit; and
(iii) Either that there was reasonable expectation that the
operation of the property would result in a profit, or that the property
was necessary to the conduct of the business.
(2) The burden of proof will rest upon the taxpayer to sustain the
deduction claimed. If, in computing undistributed personal holding
company income, a personal holding company claims deductions for
expenses and depreciation allocable to the operation and maintenance of
property owned or operated by the company, in an aggregate amount in
excess of the rent or other compensation received for the use of, or the
right to use, the property, it shall attach to its income tax return a
statement setting forth its claim for allowance of the additional
deductions, together with a complete statement of the facts and
circumstances pertinent to its claim and the arguments on which it
relies. Such statement shall set forth:
(i) A description of the property;
(ii) The cost or other basis to the corporation and the nature and
value of the consideration paid for the property;
(iii) The name and address of the person from whom the property was
acquired and the date the property was acquired;
(iv) The name and address of the person to whom the property is
leased or rented, or the person permitted to use the property, and the
number of shares of stock, if any, held by such person and the members
of his family;
(v) The nature and gross amount of the rent or other compensation
received for the use of, or the right to use, the property during the
taxable year and for each of the five preceding years and the amount of
the expenses incurred with respect to, and the depreciation sustained
on, the property for such years;
(vi) Evidence that the rent or other compensation was the highest
obtainable or, if none was received, a statement of the reasons
therefore;
(vii) A copy of the contract, lease or rental agreement;
(viii) The purpose for which the property was used;
(ix) The business, carried on by the corporation, with respect to
which the property was held and the gross income, expenses, and taxable
income derived from the conduct of such business for the taxable year
and for each of the five preceding years;
(x) A statement of any reasons which existed for expectation that
the operation of the property would be profitable, or a statement of the
necessity for the use of the property in the business of the
corporation, and the reasons why the property was acquired; and
(xi) Any other information pertinent to the taxpayer's claim.
(i) Amount of a lien in favor of the United States. (1) If notices
of lien are filed in the manner provided in section 6323(f), the amount
of the liability to the United States outstanding at the close of the
taxable year, and secured by such liens which are in effect at that
time, shall be allowed as a deduction in computing undistributed
personal holding company income. However, the amount of such deduction
which may be allowed for any taxable year shall not exceed the taxable
income (as adjusted for purposes of determining the undistributed
personal holding company income, but without regard to the deduction
under section 545(b)(9)) for such year. The fact that the amount of, or
any part of, the outstanding obligation to the United States was
deducted for one taxable year does not prevent its deduction for a
subsequent taxable year to the extent the obligation is still
outstanding at the close of the subsequent taxable year and is secured
by a lien, notice of which has been filed.
(2) Subparagraph (1) of this paragraph may be illustrated by the
following example:
[[Page 345]]
Example. If the taxpayer (on the calendar year basis) is subject to
a lien (notice of which has been properly filed) in the amount of
$500,000 at the close of the calendar year 1954 and has taxable income
of $400,000 for such taxable year, the deduction allowable by reason of
the lien for the calendar year 1954 is $400,000. If, at the close of the
taxable year ended December 31, 1955, the taxpayer is still subject to
the same lien of $500,000 and it has taxable income of $450,000, a
deduction is allowed by reason of such lien in the amount of $450,000.
(3) When the obligation secured by the lien in favor of the United
States has been satisfied or released, the sum of the amounts which have
been allowed as deductions under section 545(b)(9) in respect of such
obligation shall be restored to taxable income for the year in which
such lien is satisfied or released. If only a part of the obligation
secured by the lien has been satisfied, the sum of the amounts which
have been allowed as deductions under section 545(b)(9) in respect of
such part shall be included in taxable income for the year of the
satisfaction for the purpose of determining undistributed personal
holding company income. It should be noted, however, that only the sum
of the amounts which have been allowed as deductions under section
545(b)(9) and subparagraph (1) of this paragraph shall be included in
taxable income. Thus, any amounts which were allowed as deductions under
section 504(e) of the Internal Revenue Code of 1939 shall not be
included as taxable income for any taxable year under section 545(b)(9)
and subparagraph (1) of this paragraph.
(4) The application of subparagraph (3) of this paragraph may be
illustrated by the following example:
Example. Assume the same facts as in the example in subparagraph (2)
of this paragraph, and assume further that the corporation has $100,000
taxable income both for 1956 (before including the $400,000 described
below) and for 1957. In 1956, the corporation pays $200,000 of the
obligation, thereby reducing its liability from $500,000 to $300,000. In
such case, $400,000 is included in taxable income in computing its
undistributed personal holding company income for 1956, that is, the sum
of the $200,000 deduction for 1954 and the $200,000 deduction for 1955
in respect of the liability which is paid in 1956. In 1957, property of
the corporation is discharged from the lien by reason of the fact that
the value of the remaining property of the corporation exceeds double
the outstanding liability. (See section 6325(b)(1).) Since this was not
a release or satisfaction of the lien, no amount is added to taxable
income for 1957 with respect to the property discharged from the lien.
In 1958, the remaining property is released from the lien by reason of a
bond being accepted under section 6325(a)(2). There is added to taxable
income in computing undistributed personal holding company income for
1958, $850,000, that is, the sum of the deductions allowed for 1954,
1955, 1956, and 1957 in respect of the $300,000 liability, the lien for
which was released in 1958. This amount of $850,000, is computed as
follows:
----------------------------------------------------------------------------------------------------------------
Amount
Deduction attributable Amount
Outstanding Taxable as limited to part attributable
Year liability income by taxable payment of to release
income $200,000 in of lien in
1956 1958
----------------------------------------------------------------------------------------------------------------
1954........................................... $500,000 $400,000 $400,000 $200,000 $200,000
1955........................................... 500,000 450,000 450,000 200,000 250,000
1956........................................... 300,000 500,000 300,000 ............ 300,000
1957........................................... 300,000 100,000 100,000 ............ 100,000
=============
Total...................................... ........... .......... .......... ............ 850,000
----------------------------------------------------------------------------------------------------------------
(5)(i) If an amount has been included in undistributed personal
holding company income of the personal holding company by reason of
section 545(b)(9), any shareholder of the company may elect to compute
his income tax with respect to such of his dividends as are attributable
to such amount as though such dividends were received ratably over the
period the lien was in effect.
(ii) For purposes of section 545(b)(9), the dividends paid during
the taxable year of the personal holding company (computed as of the
close of such year) shall be deemed attributable first to undistributed
personal holding company income by reason of section
[[Page 346]]
545(b)(9) (computed as of the close of the taxable year of the personal
holding company). If the period over which the lien was in effect
consists of several taxable years of the personal holding company, the
dividend deemed received for any taxable year shall be deemed received
on the last day of such taxable year of the personal holding company.
(iii) Such election shall be made in a statement showing the amount
of the deduction under section 545(b)(9) for each taxable year of the
period in which the lien was in effect, the amount of such deduction, if
any, which was added to undistributed personal holding company income in
a later year or years as a result of partial satisfaction or release of
such lien, and the details thereof, the taxable year or years to which
such dividends are allocable, and a computation of tax, on the basis of
the election, for all taxable years affected by such ratable allocation
of the dividends. Further, the statement shall show the district
director's office in which the returns, for the years to which the
dividends are allocable, were filed, the kind of returns which were
filed (separate returns or joint returns), and the name and address
under which the returns were filed. The statement shall be attached to
the shareholder's return for the taxable year for which the dividend
would be reported but for such election.
(iv) The operation of this subparagraph may be illustrated as
follows: If, in the example under subparagraph (4) of this paragraph,
shareholder A owns 75 percent in value of the outstanding stock of the
personal holding company, and receives a dividend of $540,000 from such
company during 1958 (the total dividend distribution being $720,000) he
may elect to compute his income tax with respect to the $540,000 in
dividends for 1958 as if he had received $127,058.82 of such dividends
for 1954 ($200,000/850,000 of $540,000), $158,823.53 of such dividends
for 1955 ($250,000/850,000 of $540,000), $190,588.23 of such dividends
for 1956 ($300,000/850,000 of $540,000), and $63,529.41 of such
dividends for 1957 ($100,000/850,000 of $540,000). Accordingly, the tax
computed for 1958 with respect to such dividends shall be the aggregate
of the taxes attributable to such amounts had they been distributed in
the respective years.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6805, 30 FR
3209, Mar. 9, 1965; T.D. 6841, 30 FR 9305, July 27, 1965; T.D. 6949, 33
FR 5526, Apr. 9, 1968; T.D. 7207, 37 FR 20796, Oct. 5, 1972; T.D. 7429,
41 FR 35492, Aug. 23, 1976; T.D. 7649, 44 FR 60086, Oct. 18, 1979]
Sec. 1.545-3 Special adjustment to taxable income.
(a) In general. In computing undistributed personal holding company
income for any taxable year beginning after December 31, 1963, section
545(c) (1) provides that, except as otherwise provided in section
545(c), there shall be allowed as a deduction amounts used or amounts
irrevocably set aside (to the extent reasonable with reference to the
size and terms of the indebtedness) during such year to pay or retire
qualified indebtedness (as defined in section 545(c)(3) and paragraph
(d) of this section). The reasonableness of amounts irrevocably set
aside shall be determined under the rules of paragraph (g)(4) of Sec.
1.545-2.
(b) Amounts used or irrevocably set aside--(1) In general. The
deduction is allowable, in any taxable year, only for amounts used or
irrevocably set aside in that year to extinguish or discharge qualified
indebtedness. If amounts are set aside in 1 year, no deduction is
allowable for a later year in which such amounts are actually paid. As
long as all other conditions are satisfied, the aggregate amount
allowable as a deduction for any taxable year includes all amounts (from
whatever source) used and all amounts (from whatever source) irrevocably
set aside, irrespective of whether in cash or other medium. The same
item shall not be deducted more than once.
(2) Refunding, etc., of qualified indebtedness. (i) A refunding,
renewal or mere change in the form of a qualified indebtedness which
does not involve a substantial change in the economic terms of the
indebtedness will not result in an allowable deduction whether or not
funds are obtained from such refunding, renewal, or change in form, and
whether or not such funds are applied on the prior obligation, and will
not constitute a reduction in the
[[Page 347]]
amount of such qualified indebtedness. For purposes of this section, if,
in connection with a refunding, renewal, or other change in the form of
an indebtedness, the rate of interest or principal amount of such debt,
or the date when payment is due with respect to such debt or
significantly changed, or if, after the refunding, renewal, or other
change in the form of such debt, the creditor to whom such debt is owed
is neither the creditor to whom such debt was owed before such
refunding, renewal, or other change, nor a person standing in a
relationship to such creditor described in section 267(b), then a
substantial change in the economic terms of such indebtedness will
normally have occurred.
(ii) The application of this subparagraph may be illustrated by the
following examples:
Example 1. On December 31, 1963, M owes $10,000 to X represented by
a 6-percent, 90-day note payable on January 31, 1964. On January 31,
1964, M renews the debt, giving X a new 6-percent, 90-day note (payable
on Apr. 30, 1964) and paying the accrued interest on the old note. Since
the date when payment is due has been significantly changed, a
substantial change in the economic terms of the indebtedness has
occurred.
Example 2. On December 31, 1963, S owes $5,000 to T represented by a
6-percent note payable on January 1, 1965. On December 23, 1964, S
liquidates the note, giving T a new note for $5,000 due on January 2,
1965, and bearing interest at 6 percent. Since the transaction does not
involve a substantial change in the economic terms of the indebtedness,
the transaction will not result in an allowable deduction, and the
amount of the qualified indebtedness will not be reduced.
Example 3. (i) On December 31, 1963, Q owes $45,000 to R represented
by a demand note. On July 1, 1964, Q renews $30,000 of the indebtedness
by issuing a new demand note to R and liquidates $15,000 of the debt.
Since the principal amount of the debt has been significantly changed,
there has been a substantial change in the economic terms of the
indebtedness.
(ii) If Q had issued renewal notes for $44,000 and had paid only
$1,000 of the total indebtedness, then a significant change in the
principal amount of the debt would not have occurred and Q would have
been entitled to only a $1,000 deduction (the amount actually paid
during the taxable year). In addition, the amount of qualified
indebtedness would have been reduced to $44,000.
(c) Corporations to which applicable. Section 545(c)(2) describes
the corporations to which section 545(c) applies. In order to qualify
under section 545(c)(2), the corporation must be one:
(1) Which for at least one of its two most recent taxable years
ending before February 26, 1964, was not a personal holding company
under section 542, but which would have been a personal holding company
under section 542 for such taxable year if the law applicable for the
first taxable year beginning after December 31, 1963, had been
applicable to such taxable year; or
(2) Which is an acquiring corporation treated as a corporation
described in subparagraph (1) of this paragraph by reason of section
381(c)(15) (relating to the carryover of certain indebtedness in
corporate acquisitions), but only to the extent of the qualified
indebtedness to which it has succeeded under section 381(c)(15) and the
indebtedness referred to in paragraph (d)(1)(ii) of this section
incurred to replace qualified indebtedness to which it has succeeded
under section 381(c)(15)
The law applicable for the first taxable year beginning after December
31, 1963, for purposes of this paragraph means part II (section 541 and
following), subchapter G, chapter 1 of the Code as applicable to such
year but does not include amendments to other parts of the Code first
applicable with respect to such year. For an example of a corporation
described in subparagraph (1) of this paragraph see paragraph (f)(1) of
Sec. 1.333-5.
(d) Qualified indebtedness--(1) General definition. Except as
provided in subparagraphs (2), (3), and (4) of this paragraph the term
qualified indebtedness means:
(i) The outstanding indebtedness (as defined in subparagraph (6) of
this paragraph) incurred after December 31, 1933, and before January 1,
1964, by the taxpayer (or to which the taxpayer succeeded in a
transaction to which section 381(c)(15) applies), and
(ii) The outstanding indebtedness (as defined in subparagraph (6) of
this paragraph) incurred after December 31, 1963, by the taxpayer (or to
which the taxpayer succeeded in a transaction to which section
381(c)(15) applies) for the purpose of making a payment or set-aside
referred to in paragraph (a) of this section in the same taxable year of
[[Page 348]]
the debtor in which such indebtedness was incurred. An indebtedness
shall be deemed not to have been incurred for the purpose of making a
payment or set-aside referred to in paragraph (a) of this section when
such indebtedness is a consequence of a refunding, renewal or mere
change in the form of a qualified indebtedness which does not involve a
substantial change in the economic terms of the qualified indebtedness.
(See paragraph (b)(2) of this section for the meaning of substantial
change in the economic terms of the indebtedness.) In the case of such a
payment or set-aside which is made on or after the first day of the
first taxable year beginning after December 31, 1963, such indebtedness
incurred after December 31, 1963, is treated as qualified indebtedness
only to the extent that the deduction from taxable income otherwise
allowed by section 545(c)(1) with respect to such payment or set-aside
is treated as non-deductible by reason of the election referred to in
paragraph (e) of this section.
(2) Exception for indebtedness owed to certain shareholders. For
purposes of subparagraph (1) of this paragraph, qualified indebtedness
does not include any amounts which were, at any time after December 31,
1963, and before the payment or set-aside to which this section applies,
owed directly or indirectly to a person who at such time owned more than
10 percent in value of the taxpayer's outstanding stock. The rules of
section 318(a) and the regulations thereunder apply for the purpose of
determining ownership under this subparagraph. Amounts which cease to be
qualified indebtedness by reason of this subparagraph may not
subsequently become qualified indebtedness as a result of any change in
the facts (for example, a subsequent sale of stock by the person to whom
the amounts are directly or indirectly owed).
(3) Reduction for amounts irrevocably set aside. For purposes of
subparagraph (1) of this paragraph, qualified indebtedness with respect
to a particular contract is reduced when and to the extent that amounts
are irrevocably set aside to pay or retire such indebtedness. An amount
is not considered to be irrevocably set aside if any person could use
such amount for any purpose other than the retirement of the qualified
indebtedness with respect to which it was set aside. No deduction is
allowed under section 545(c)(1) and this section for payments out of
amounts previously set aside. Thus, for example, if a corporation, which
is a June 30 fiscal year taxpayer, incurs indebtedness of $1 million on
February 1, 1962, and, in accordance with its contract of indebtedness,
irrevocably sets aside $50,000 in a sinking fund on February 1, of each
of the years 1963, 1964, and 1965, then its qualified indebtedness on
January 1, 1964, is $950,000 ($1 million less one set-aside of $50,000
in 1963). The corporation is not allowed a deduction under section
545(c)(1) for the set-aside of $50,000 made during its taxable year
ending on June 30, 1964, since section 545(c) is applicable only to
taxable years beginning after December 31, 1963, but the qualified
indebtedness is nevertheless reduced by such amount. The corporation is
allowed a deduction of $50,000 for its taxable year ending June 30,
1965, as a result of the set-aside made during such taxable year, and
qualified indebtedness on July 1, 1965, is $850,000. No deduction is
allowed to the corporation for a payment in any subsequent taxable year
from the amounts so set aside.
(4) Reduction on disposition of certain property. (i) Section
545(c)(6) provides that the total amount of the taxpayer's qualified
indebtedness (as determined under subdivision (ii) of this subparagraph)
shall be reduced if property of a character subject to the allowance for
exhaustion, wear and tear, obsolescence, amortization, or depletion is
disposed of after December 31, 1963. The reduction is made pro rata (in
accordance with subdivision (iii) of this subparagraph) for the taxable
year of such disposition and is equal in total amount to the excess, if
any, of:
(a) The adjusted basis of the property disposed of (determined under
section 1011 and the regulations thereunder) immediately before such
disposition; over
(b) The amount of qualified indebtedness which ceased to be
qualified indebtedness with respect to the taxpayer by reason of the
assumption of indebtedness by the transferee of the
[[Page 349]]
property disposed of (whether or not such indebtedness was incurred by
the taxpayer in connection with the property disposed of).
For purposes of (b) of this subdivision, the transferee will be treated
as having assumed qualified indebtedness if such transferee acquires
real estate of which the taxpayer is the legal or equitable owner
immediately before the transfer and which is subject to indebtedness
that, with respect to the taxpayer, is qualified indebtedness
immediately before the transfer, provided the taxpayer shows to the
satisfaction of the Commissioner that under all the facts and
circumstances it no longer bears the burden of discharging such
indebtedness.
(ii) The indebtedness reduced under the rule of this subparagraph is
the qualified indebtedness which is outstanding with respect to the
taxpayer immediately after the disposition referred to in subdivision
(i) of this subparagraph.
(iii) The reduction with respect to any particular contract of
indebtedness under the rules of this subparagraph shall be determined by
multiplying the total reduction (determined under subdivision (i) of
this subparagraph) by the ratio which the amount of the qualified
indebtedness owed with respect to such contract by the taxpayer on the
date referred to in subdivision (ii) of this subparagraph bears to the
aggregate qualified indebtedness owed by the taxpayer with respect to
all contracts on such date.
(5) Total debt consisting of both qualified and nonqualified
indebtedness. In any case where, with respect to a particular contract
of indebtedness, a part of the total indebtedness owed with respect to
such contract is qualified indebtedness and the other part is
indebtedness which is not qualified indebtedness, then, any amount paid
or irrevocably set aside with respect to such contract shall be
allocated between both such parts pro rata unless the taxpayer clearly
indicates in its return the part of the payment or set-aside which shall
be allocated to the qualified indebtedness.
(6) Outstanding indebtedness. For purposes of determining qualified
indebtedness, the term indebtedness has the same meaning that it has
under section 545(b)(7) and paragraph (g)(2) of Sec. 1.545-2.
Indebtedness ceases to be outstanding when the taxpayer no longer has an
obligation absolute and not contingent with respect to the payment of
such debt. An indebtedness evidenced by bonds, notes, or other
obligations issued by a corporation is ordinarily incurred as of the
date such obligations are issued, and the amount of such indebtedness is
the amount represented by the face value of the obligations. However, a
refunding, renewal, or mere change in the form of an indebtedness which
does not involve a substantial change in the economic terms of the
indebtedness will not have the effect of changing the date the
indebtedness was incurred. (See paragraph (b)(2) of this section for the
meaning of substantial change in the economic terms of the
indebtedness.) For purposes of this section, the outstanding
indebtedness of a taxpayer includes a mortgage or other security
interest on real estate of which such taxpayer is the legal or equitable
owner (even though the taxpayer is not directly liable on the underlying
evidence of indebtedness secured by such mortgage or security interest)
provided such taxpayer shows to the satisfaction of the Commissioner
that under all of the facts and circumstances it bears the burden of
discharging such indebtedness. Thus, for example, if X acquires from Y
property which is subject to a mortgage (X not assuming the indebtedness
underlying such mortgage) and if X actually bears the burden of
discharging the indebtedness, then, after the date of acquisition, such
underlying indebtedness is outstanding indebtedness with respect to X,
and, since Y's obligation to pay is in fact contingent upon X failing to
discharge the indebtedness, such indebtedness is not outstanding
indebtedness with respect to Y.
(7) Examples. The application of this paragraph may be illustrated
by the following examples:
Example 1. M Corporation, a calendar year taxpayer has $600,000 of
indebtedness outstanding on December 31, 1963 (which was incurred after
1933), represented by three demand notes. Individuals A and B (who are
not shareholders) each hold one of M Corporation's notes in the amount
of $150,000
[[Page 350]]
and N Corporation (which is not a shareholder) holds M Corporation's
note in the amount of $300,000. The note held by N Corporation is
secured by a mortgage on certain depreciable real estate owned by M
Corporation which has an adjusted basis to it on July 1, 1964, of
$500,000. On July 1, 1964, M Corporation sells the depreciable real
estate to O Corporation in consideration for $200,000 in cash and the
assumption by O Corporation of the indebtedness on the note held by N
Corporation. M Corporation borrows $200,000 on September 30, 1964, of
which amount $150,000 is simultaneously applied to liquidate the note
held by B. M Corporation's qualified indebtedness is reduced on July 1,
1964, by $300,000, the qualified indebtedness which ceased to be
outstanding by reason of the transfer. In addition, the reduction
(computed under section 545(c)(6) and subparagraph (4) of this
paragraph) of M Corporation's qualified indebtedness by reason of the
disposition of depreciable property on July 1, 1964, is as follows:
Outstanding qualified indebtedness after reduction of $300,000
qualified indebtedness which ceased to be outstanding by
reason of the transfer but before the sec. 545(c)(6)
reduction..................................................
Reduced by:
The excess of the adjusted basis of depreciable real 200,000
estate disposed of on July 1, 1964 ($500,000), over the
amount of qualified indebtedness assumed by O Corporation
($300,000)...............................................
-----------
Qualified indebtedness after reductions from transfer and 100,000
assumption of indebtedness.................................
The pro-rata share of the reduction with respect to each debt is
computed as follows:
Note held by A:
Qualified indebtedness owed by taxpayer on the note held $150,000
by A before the disposition of depreciable property......
Less the pro-rata share of the total reduction computed 100,000
under subparagraph (4) of this paragraph allocable to
such note $200,000 x ($150,000 / $300,000)...............
-----------
Qualified indebtedness owed on the note held by A after the 50,000
transfer...................................................
===========
Note held by B:
Qualified indebtedness owed by taxpayer on the note held $150,000
by B before the transfer of depreciable property.........
Less the pro-rata share of the total reduction computed 100,000
under subparagraph (4) of this paragraph allocable to
such note $200,000 x ($150,000 / $300,000)...............
-----------
Qualified indebtedness owed on the note held by B after 50,000
the transfer.............................................
===========
Of the $150,000 paid by M Corporation on September 30, 1964, to retire
the note held by B only $50,000 qualified as a use of an amount to pay
or retire qualified indebtedness and, thus, only $50,000 is allowable as
a deduction for purposes of computing undistributed personal holding
company income for 1964.
Example 2. The facts are the same as in example 1 except that M
Corporation elects in accordance with paragraph (e) of this section not
to deduct $25,000 of the $50,000 amount otherwise deductible. Then
$25,000 of the $200,000 of new indebtedness incurred by M Corporation is
qualified indebtedness. If the payment on the note held by B had not
been made until January 1, 1965, then the new indebtedness would not be
qualified indebtedness since the payment was not made in the taxable
year in which the new indebtedness was incurred. If M Corporation pays
$40,000 on April 1 and July 1, 1965, on the indebtedness incurred
September 30, 1964, then (unless M indicates otherwise in its return for
1965 in accordance with subparagraph (5) of this paragraph) the payments
made on such dates must be allocated between qualified and nonqualified
indebtedness in the following manner:
------------------------------------------------------------------------
Qualfied Nonqualified
------------------------------------------------------------------------
April 1 payment:
$40,000 x $25,000 (qualified) / $200,000 $5,000
(total indebtedness).........................
$40,000 x $175,000 (nonqualified) / $200,000 ........ $35,000
(total indebtedness).........................
July 1 payment:
$40,000 x $20,000 (qualified) / $160,000 5,000
(total indebtedness).........................
$40,000 x $140,000 (nonqualified) / $160,000 ........ 35,000
(total indebtedness).........................
-----------------------
Total..................................... 10,000 70,000
------------------------------------------------------------------------
Thus, a total of $10,000 of the two payments would be considered used to
pay or retire qualified indebtedness. The results in examples 1 and 2
would be the same if O Corporation purchased the real estate subject to
the indebtedness (not assuming the indebtedness) on the note held by N
Corporation, provided M Corporation does not bear the burden of
discharging such indebtedness after July 1, 1964.
Example 3. C owns all of the 1000 shares of outstanding capital
stock of P Corporation. On December 31, 1963, P Corporation, a calendar
year taxpayer, owes $200,000 of outstanding indebtedness to D
and$500,000 of outstanding indebtedness to E. These debts were incurred
after 1933. On January 15, 1964, P Corporation pays $100,000 in partial
liquidation of the $500,000 indebtedness. On March 15, 1964, P
Corporation pays $50,000 into a sinking fund with respect to the
$200,000 indebtedness owed to D. On April 15, 1964, D purchases one-half
of the shares owned by C, constituting 50 percent in value of P
Corporation's outstanding stock. P Corporation, on June 15, 1964, pays
$50,000 into a sinking fund with respect to the indebtedness owed to D.
For purposes of the March 15, 1964, set-aside, the indebtedness owed to
D ($200,000) is qualified indebtedness. However, the indebtedness owed
to D is not qualified
[[Page 351]]
indebtedness for purposes of the June set-aside with respect to such
indebtedness since D is a person who after December 31, 1963, and before
the June set-aside, owned more than 10 percent in value of P
Corporation's outstanding stock. Moreover, any subsequent set-asides
made with respect to the indebtedness owed to D will not be made with
respect to qualified indebtedness even if the shares owned by D are
subsequently sold. Assuming no payments or set-asides are made by P
Corporation after June 15, 1964, the P Corporation is entitled to a
deduction of $150,000 under section 545(c)(1) for the calendar year 1964
for amounts paid and for amounts irrevocably set aside to pay or retire
qualified indebtedness, and the total qualified indebtedness at the end
of 1964 is $400,000. No additional deduction is allowed in subsequent
taxable years for amounts paid out of the amounts set aside in 1964.
(e) Election not to deduct--(1) In general. Section 545(c)(4)
provides that a taxpayer may elect to treat as nondeductible amounts
otherwise deductible under section 545(c)(1) for the taxable year. The
election shall be in the form of a statement of election filed on or
before the 15th day of the third month following the close of the
taxable year with respect to which the election applies. The election
shall be irrevocable after such date.
(2) Statement of election. The statement of election referred to in
subparagraph (1) of this paragraph shall be attached to the taxpayer's
Schedule PH (Form 1120) for the year with respect to which such election
applies, if such schedule is filed on or before the date referred to in
subparagraph (1) of this paragraph. If the taxpayer's Schedule PH (Form
1120) is not filed on or before such date, then the statement of
election shall clearly set forth the taxpayer's name, address, and
employer identification number, shall be signed by an officer of the
taxpayer who is authorized to sign a return of the taxpayer with respect
to income, and shall be filed with the district director for the
internal revenue district in which the taxpayer's income tax return (for
the year with respect to which the election is applicable) would be
filed. The following information shall be included in the statement of
election:
(i) A statement that the taxpayer wishes to elect in accordance with
section 545(c)(4);
(ii) The amounts paid or set aside which are to be treated as
nondeductible under section 545(c)(4) and this section;
(iii) All information necessary to identify the qualified
indebtedness with respect to which such amounts were paid or set aside;
(iv) The date on which such payments or set-asides were made; and
(v) All information necessary to identify the indebtedness (referred
to in section 545(c)(3)(A)(ii) and paragraph (d)(1)(ii) of this section)
incurred for the purpose of making the payments or set-asides which the
taxpayer elects to treat as nondeductible, including:
(a) The date on which such indebtedness was incurred;
(b) The amount of such indebtedness;
(c) The person or persons to whom such indebtedness is owed; and
(d) A statement that such person or persons do not own more than 10
percent in value of the taxpayer's outstanding stock.
(f) Limitation on deduction--(1) In general. Section 545(c)(5)
provides certain limitations on the deduction otherwise allowed by
section 545(c)(1). Such deduction is reduced by the sum of the following
amounts:
(i) The amount, if any, by which:
(a) The deductions allowed for the taxable year and all preceding
taxable years beginning after December 31, 1963, for exhaustion, wear
and tear, obsolescence, amortization, or depletion (other than such
deductions which are disallowed in computing undistributed personal
holding company income under the rule of paragraph (h) of Sec. 1.545-
2), exceed
(b) Any reduction, by reason of section 545(c)(5)(A) and this
subdivision (i), of the deductions otherwise allowed by section
545(c)(1) for such preceding years; and
(ii) The amount, if any, by which:
(a) The deductions allowed under section 545(b)(5) (relating to
long-term capital gain deduction) in computing undistributed personal
holding company income for the taxable year and all preceding taxable
years beginning after December 31, 1963, exceed
(b) Any reduction, by reason of section 545(c)(5)(B) and this
subdivision
[[Page 352]]
(ii), of the deductions otherwise allowed by section 545(c)(1) for such
preceding years.
(2) Allocation of reduction. If the total reduction required by
subparagraph (1) of this paragraph is greater than the amount of the
payment or set-aside made in respect of qualified indebtedness in a
taxable year, then the portion of the reduction which is attributable to
either section 545(c)(5)(A) or section 545(c)(5)(B), as the case may be,
is that portion which bears the same ratio to the total reduction as the
total reduction available under either section 545(c)(5)(A) or section
545(c)(5)(B), respectively, bears to the total reduction available under
both such sections.
(3) Example. The provisions of this paragraph may be illustrated by
the following example:
Example. (i) Q Corporation, a calendar year taxpayer, has qualified
indebtedness of $400,000 on January 1, 1964, with respect to which
payments of $50,000 are made on April 15, 1964, and 1965, and $300,000
on April 15, 1966. In the years 1964 and 1966, Q Corporation is allowed
a deduction under section 545(b)(5) of $50,000 for the excess of its net
long-term capital gain over its net short-term capital loss, minus the
taxes attributable to such excess. Q Corporation is allowed a
depreciation deduction of $50,000 for each of its taxable years 1964
through 1966. Q Corporation is a personal holding company with taxable
income of $200,000 in each of the years 1964 and 1966.
(ii) For 1964, in computing undistributed personal holding company
income, Q Corporation's taxable income is reduced by $50,000 by reason
of the deduction under section 545(b)(5). No part of the depreciation
deduction is disallowed under the rule of paragraph (h) of Sec. 1.545-
2. Q Corporation's deduction for payment of qualified indebtedness
otherwise allowable under section 545(c)(1) and this section is reduced
to zero by reason of the depreciation deduction and the capital gains
deduction. The reduction by reason of section 545(c)(5)(A) and
subparagraph (1)(i) of this paragraph (depreciation) is $25,000
[($50,000 / $100,000) x $50,000], and the reduction by reason of section
545(c)(5)(B) and subparagraph (1) (ii) of this paragraph (capital gain)
is $25,000 [($50,000 / $100,000) x $50,000].
(iii) For 1966, Q Corporation is allowed a deduction for payment of
qualified indebtedness of $100,000 computed as follows:
Amount paid in 1966 to retire .......... .......... $300,000
qualified indebtedness.............
Less the sum of:
(a) Depreciation deductions $150,000
allowed for 1964 through 1966 (3
x $50,000).......................
Reduction of deductions in 25,000 $125,000
preceding taxable years
(1964).......................
-----------------------------------
(b) Deduction allowed under 100,000
section 545(b)(5) (relating to
long-term capital gains) for 1964
through 1966.....................
Reduction of deductions in 25,000 75,000 200,000
preceding taxable years
(1964).......................
-----------------------------------
Deduction after reduction..... .......... .......... 100,000
(iv) If, in the year 1966, Q Corporation's depreciation deduction had
been limited for purposes of computing undistributed personal holding
company income to $25,000 by reason of section 545(b)(8), then Q
Corporation's deduction for payment of qualified indebtedness would be
$125,000, computed as follows:
Amounts paid in 1966 to retire .......... .......... $300,000
qualified indebtedness.............
Less the sum of:
(a) Depreciation deductions $125,000
allowed for 1964 through 1966....
Reduction of deductions in 25,000
preceding taxable year (1964)
-----------------------------------
$100,000
(b) Deduction allowed under 100,000
section 545(b)(5) (relating to
long-term capital gains) for 1964
through 1966.....................
Reduction of deductions in 25,000 75,000 175,000
preceding taxable years
(1964).......................
-----------------------------------
Deduction after reduction..... .......... .......... 125,000
(g) Burden of proof. The burden of proof rests upon the taxpayer to
sustain the deduction claimed under this section. In addition to any
information required by this section, the taxpayer must furnish the
information required by the return, and such other information as the
district director may require in substantiation of the deduction
claimed.
(h) Application of section 381(c)(15). Under section 381(c)(15), if
an acquiring corporation assumes liability for qualified indebtedness in
a transaction to which section 381(a) applies, then the acquiring
corporation is considered to be the distributor or transferor
corporation for purposes of section 545(c). Paragraph (c)(2) of this
section reflects the application of section 381(c)(15) by
[[Page 353]]
including an acquiring corporation within the definition of corporation
to which this section applies. Thus, the acquiring corporation is not
required to meet the requirements of paragraph (c)(1) or paragraph
(d)(1) of this section with respect to such acquired qualified
indebtedness to which section 381(c)(15) is applicable. All the other
provisions of this section apply in full to the acquiring corporation
with respect to such acquired indebtedness.
[T.D. 6949, 33 FR 5526, Apr. 9, 1968; 33 FR 6091, Apr. 20, 1968]
Sec. 1.547-1 General rule.
Section 547 provides a method under which, by virtue of dividend
distributions, a corporation may be relieved from the payment of a
deficiency in the personal holding company tax imposed by section 541
(or by a corresponding provision of a prior income tax law), or may be
entitled to a credit or refund of a part or all of any such deficiency
which has been paid. The method provided by section 547 is to allow an
additional deduction for a dividend distribution (which meets the
requirements of this section) in computing undistributed personal
holding company income for the taxable year for which a deficiency in
personal holding company tax is determined. The additional deduction for
deficiency dividends will not, however, be allowed for the purpose of
determining interest, additional amounts, or assessable penalties,
computed with respect to the personal holding company tax prior to the
allowance of the additional deduction for deficiency dividends. Such
amounts remain payable as if section 547 had not been enacted.
Sec. 1.547-2 Requirements for deficiency dividends.
(a) In general. There are certain requirements which must be
fulfilled before a deduction is allowed for a deficiency dividend under
section 547 and this section. These are:
(1) The taxpayer's liability for personal holding company tax shall
be determined only in the manner provided in section 547(c) and
paragraph (b)(1) of this section.
(2) The deficiency dividend shall be paid by the corporation on, or
within 90 days after, the date of such determination and prior to the
filing of a claim under section 547(e) and paragraph (b)(2) of this
section for deduction for deficiency dividends. This claim must be filed
within 120 days after such determination.
(3) The deficiency dividend must be of such a nature as would have
permitted its inclusion in the computation of a deduction for dividends
paid under section 561 for the taxable year with respect to which the
liability for personal holding company tax exists, if it had been
distributed during such year. See section 562 and Sec. Sec. 1.562-1
through 1.562-3. In this connection, it should be noted that under
section 316(b)(2), the term dividend means (in addition to the usual
meaning under section 316(a)) any distribution of property (whether or
not a dividend as defined in section 316(a)) made by a corporation to
its shareholders, to the extent of its undistributed personal holding
company income (determined under section 545 and Sec. Sec. 1.545-1 and
1.545-2 without regard to section 316(b)(2)) for the taxable year in
respect of which the distribution is made.
(b) Special rules--(1) Nature and details of determination. (i) A
determination of a taxpayer's liability for personal holding company tax
shall, for the purposes of section 547, be established in the manner
specified in section 547(c) and this subparagraph.
(ii) The date of determination by a decision of the Tax Court of the
United States is the date upon which such decision becomes final, as
prescribed in section 7481.
(iii) The slate upon which a judgment of a court becomes final,
which is the date of the determination in such cases, must be determined
upon the basis of the facts in the particular case. Ordinarily, a
judgment of a United States district court becomes final upon the
expiration of the time allowed for taking an appeal, if no such appeal
is duly taken within such time; and a judgment of the United States
Court of Claims becomes final upon the expiration of the time allowed
for filing a petition for certiorari if no such petition is duly filed
within such time.
(iv) The date of determination by a closing agreement, made under
section
[[Page 354]]
7121, is the date such agreement is approved by the Commissioner.
(v) A determination under section 547(c)(3) may be made by an
agreement signed by the district director or such other official to whom
authority to sign the agreement is delegated, and by or on behalf of the
taxpayer. The agreement shall set forth the total amount of the
liability for personal holding company tax for the taxable year or
years. An agreement under this subdivision which is signed by the
district director (or such other official to whom authority to sign the
agreement is delegated) on or after July 15, 1963, shall be sent to the
taxpayer at his last known address by either registered or certified
mail. For further guidance regarding the definition of last known
address, see Sec. 301.6212-2 of this chapter. If registered mail is
used for such purpose, the date of registration shall be treated as the
date of determination; if certified mail is used for such purpose, the
date of the postmark on the sender's receipt for such mail shall be
treated as the date of determination. However, if a dividend is paid by
the corporation before such registration or postmark date but on or
after the date such agreement is signed by the district director or such
other official to whom authority to sign the agreement is delegated, the
date of determination shall be such date of signing. The date of
determination with respect to an agreement which is signed by the
district director (or such other official to whom authority to sign the
agreement is delegated) before July 15, 1963, shall be the date of the
postmark on the cover envelope in which such agreement is sent by
ordinary mail, except that if a dividend is paid by the corporation
before such postmark date but on or after the date such agreement is
signed by the district director or such other official to whom authority
to sign the agreement is delegated, the date of determination shall be
such date of signing.
(2) Claim for deduction--(i) Contents of claim. A claim for
deduction for a deficiency dividend shall be made with the requisite
declaration, on Form 976 and shall contain the following information:
(a) The name and address of the corporation;
(b) The place and date of incorporation;
(c) The amount of the deficiency determined with respect to the tax
imposed by section 541 (or a corresponding provision of a prior income
tax law) and the taxable year or years involved; the amount of the
unpaid deficiency or, if the deficiency has been paid in whole or in
part, the date of payment and the amount thereof; a statement as to how
the deficiency was established, if unpaid; or if paid in whole or in
part, how it was established that any portion of the amount paid was a
deficiency at the time when paid and, in either case whether it was by
an agreement under section 547(c)(3), by a closing agreement under
section 7121, or by a decision of the Tax Court or court judgment and
the date thereof; if established by a final judgment in a suit against
the United States for refund, the date of payment of the deficiency, the
date the claim for refund was filed, and the date the suit was brought;
if established by a Tax Court decision or court judgment, a copy thereof
shall be attached, together with an explanation of how the decision
became final; if established by an agreement under section 547(c)(3), a
copy of such agreement shall be attached;
(d) The amount and date of payment of the dividend with respect to
which the claim for the deduction for deficiency dividends is filed;
(e) A statement setting forth the various classes of stock
outstanding, the name and address of each shareholder, the class and
number of shares held by each on the date of payment of the dividend
with respect to which the claim is filed, and the amount of such
dividend paid to each shareholder;
(f) The amount claimed as a deduction for deficiency dividends; and
(g) Such other information as may be required by the claim form.
(ii) Filing of claim and corporate resolution. The claim together
with a certified copy of the resolution of the board of directors or
other authority, authorizing the payment of the dividend with respect to
which the claim is
[[Page 355]]
filed, shall be filed with the district director for the internal
revenue district in which the return is filed.
(iii) Carryover of deficiency dividends paid by acquiring
corporation. In the case of the acquisition of assets of a corporation
by another corporation in a distribution or transfer described in
section 381(a), the distributor or transferor corporation shall be
entitled to a deduction for any deficiency dividends (as defined in
section 547(d)) paid by the acquiring corporation with respect to such
distributor or transferor corporation. See section 381(c)(17).
(68A Stat. 192, 917; 26 U.S.C. 547(c), 7805)
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6657, 28 FR
5720, June 12, 1963; T.D. 7604, 44 FR 18661, Mar. 29, 1979; T.D. 8939,
66 FR 2819, Jan. 12, 2001]
Sec. 1.547-3 Claim for credit or refund.
(a) If a deficiency in personal holding company tax is asserted for
any taxable year, and the corporation has paid any portion of such
asserted deficiency, it is entitled to a credit or refund of such
payment to the extent that such payment constitutes an overpayment as
the result of a deduction for a deficiency dividend as provided in
section 547 and Sec. Sec. 1.547-1 through 1.547-7. It should be noted
that a determination under section 547(c) and paragraph (b)(1) of Sec.
1.547-2, of taxpayer's liability for personal holding company tax may
take place subsequent to the time the deficiency was paid. To secure
credit or refund of such overpayment, the taxpayer must file a claim on
Form 843 in addition to the claim for the deduction for deficiency
dividends required under section 547(e) and paragraph (b)(2) of Sec.
1.547-2.
(b) No interest shall be allowed on such credit or refund.
(c) Such credit or refund will be allowed as if, on the date of the
determination under section 547(c) and paragraph (b)(1) of Sec. 1.547-
2, two years remained before the expiration of the period of limitation
on the filing of claim for refund for the taxable year to which the
overpayment relates.
Sec. 1.547-4 Effect on dividends paid deduction.
The deficiency dividends deduction shall be allowed as of the date
the claim is filed. No duplication of deductions with respect to any
deficiency dividends is permitted. If a corporation claims and receives
the benefit of the provisions of section 547 (or the corresponding
section 506 of the Internal Revenue Code of 1939, or section 407 of the
Revenue Act of 1938 (52 Stat. 447)), based upon a distribution of
deficiency dividends, that distribution does not become a part of the
dividends paid deduction under section 561. Likewise, it will not be
made the basis of a dividends paid deduction under section 561 by reason
of the application of section 563(b), relating to dividends paid after
the close of the taxable year and on or before the 15th day of the third
month following the close of such taxable year.
Sec. 1.547-5 Deduction denied in case of fraud or wilful failure to
file timely return.
No deduction for deficiency dividends shall be allowed under section
547(a) if the determination contains a finding that any part of the
deficiency is due to fraud with intent to evade tax, or to wilful
failure to file an income tax return within the time prescribed by law
or prescribed by the Secretary or his delegate in pursuance of law. See
Sec. 1.547-7 for effective date.
Sec. 1.547-6 Suspension of statute of limitations and stay of collection.
(a) Statute of limitations. If the corporation files a claim for a
deduction for deficiency dividends under section 547(e) and paragraph
(b)(2) of Sec. 1.547-2, the running of the statute of limitations upon
assessment, distraint, and collection in court in respect of the
deficiency, and all interest, additional amounts, or assessable
penalties, shall be suspended for a period of two years after the date
of the determination under section 547(c) and paragraph (b)(1) of Sec.
1.547-2.
(b) Stay of collection. If a deficiency in personal holding company
tax is established by a determination under section 547(c) and paragraph
(b)(1) of Sec. 1.547-2, collection by distraint or court proceeding
(except in case of
[[Page 356]]
jeopardy), of the deficiency and all interest, additional amounts, and
assessable penalties, shall be stayed for a period of 120 days after the
date of such determination, and, to the extent any part of such
deficiency remains after deduction for deficiency dividends, for an
additional period until the date the claim is disallowed. After such
claim is allowed or rejected, either in whole or in part, the amount of
the deficiency which was not eliminated by the application of section
547, together with interest, additional amounts and assessable
penalties, will be assessed and collected in the usual manner.
Sec. 1.547-7 Effective date.
The deduction for deficiency dividends, in computing personal
holding company tax for any taxable year, is allowable only with respect
to determinations under section 547(c) made after November 14, 1954 (the
date falling 90 days after the date of enactment of the Internal Revenue
Code of 1954). If the taxable year with respect to which the deficiency
is asserted began before January 1, 1954, the deficiency dividends
deduction shall include only the amounts which would have been
includible in the computation of the basic surtax credit for such
taxable year under the Internal Revenue Code of 1939. Section 547(g),
relating to the denial of a deficiency dividends deduction if the
determination contains a finding that any part of the deficiency is due
to fraud, etc., shall apply only if the taxable year with respect to
which the deficiency is asserted begins after December 31, 1953.
Foreign Personal Holding Companies
Sec. 1.551-1 General rule.
Part III (section 551 and following), subchapter G, chapter 1 of the
Code, does not impose a tax on foreign personal holding companies. The
undistributed foreign personal holding company income of such companies,
however, must be included in the manner and to the extent set forth in
section 551, in the gross income of their United States shareholders,
that is, the shareholders who are individual citizens or residents of
the United States, domestic corporations, domestic partnerships, and
estates or trusts other than estates or trusts the gross income of which
under subtitle A of the Code includes only income from sources within
the United States.
Sec. 1.551-2 Amount included in gross income.
(a) The undistributed foreign personal holding company income is
included only in the gross income of the United States shareholders who
were shareholders in the company on the last day of its taxable year on
which a United States group (as defined in section 552(a)(2)) existed
with respect to the company. Such United States shareholders,
accordingly, are determined by the stock holdings as of such specified
time. This rule applies to every United States shareholder who was a
shareholder in the company at the specified time regardless of whether
the United States shareholder is included within the United States
group. For example, a domestic corporation which is a United States
shareholder at the specified time must return its distributive share in
the undistributed foreign personal holding company income even though
the domestic corporation cannot be included within the United States
group since, under section 554, the stock it owns in the foreign
corporation is considered as being owned proportionately by its
shareholders for the purpose of determining whether the foreign
corporation is a foreign personal holding company.
(b) The United States shareholders must include in their gross
income their distributive shares of that proportion of the undistributed
foreign personal holding company income for the taxable year of the
company which is equal in ratio to that which the portion of the taxable
year up to and including the last day on which the United States group
with respect to the company existed bears to the entire taxable year.
Thus, if the last day in the taxable year on which the required United
States group existed was also the end of the taxable year, the portion
of the taxable year up to and incding such last day would be equal to
100 percent and, in such case, the United States shareholders would be
required to return their distributive
[[Page 357]]
shares in the entire undistributed foreign personal holding company
income. But if the last day on which the required United States group
existed was September 30, and the taxable year was a calendar year, the
portion of the taxable year up to and including such last day would be
equal to nine-twelfths and, in that case, the United States shareholders
would be required to return their distributive shares in only nine-
twelfths of the undistributed foreign personal holding company income.
(c) The amount which each United States shareholder must return is
that amount which he would have received as a dividend if the above-
specified portion of the undistributed foreign personal holding company
income had in fact been distributed by the foreign personal holding
company as a dividend on the last day of its taxable year on which the
required United States group existed. Such amount is determined,
therefore, by the interest of the United States shareholder in the
foreign personal holding company, that is, by the number of shares of
stock owned by the United States shareholder and the relative rights of
his class of stock, if there are several classes of stock outstanding.
Thus, if a foreign personal holding company has both common and
preferred stock outstanding and the preferred shareholders are entitled
to a specified dividend before any distribution may be made to the
common shareholders, then the assumed distribution of the stated portion
of the undistributed foreign personal holding company income must first
be treated as a payment of the specified dividend on the preferred stock
before any part may be allocated as a dividend on the common stock.
(d) The assumed distribution of the required portion of the
undistributed foreign personal holding company income must be returned
as dividend income by the United States shareholders for their
respective taxable years in which or with which the taxable year of the
foreign personal holding company ends. For example, if the M
Corporation, whose taxable year is the calendar year, is a foreign
personal holding company for 1954 and if A, one of its United States
shareholders, makes returns on a calendar year basis, while B, another
United States shareholder, makes returns on the basis of a fiscal year
ending November 30, A must return his assumed dividend as income for the
taxable year 1954 and B must return his distributive share as income for
the fiscal year ending November 30, 1955. In applying this rule, the
date as of which the United States group last existed with respect to
the company is immaterial. Thus, in the foregoing example, if September
30, 1954, was the last day on which the United States group with respect
to the M Corporation existed, B would still be required to return his
assumed dividend as income for the fiscal year ending November 30, 1955,
even though September 30, 1954, the date as of which the distribution is
assumed to have been made, does not fall within such fiscal year.
(e) For the treatment of gain on the sale of certain stock, see
section 306(f) and paragraph (h) of Sec. 1.306-3.
Deduction for Dividends Paid
Sec. 1.561-1 Deduction for dividends paid.
(a) The deduction for dividends paid is applicable in determining
accumulated taxable income under section 535, undistributed personal
holding company income under section 545, undistributed foreign personal
holding company income under section 556, investment company taxable
income under section 852, and real estate investment trust taxable
income under section 857. The deduction for dividends paid includes:
(1) The dividends paid during the taxable year;
(2) The consent dividends for the taxable year, determined as
provided in section 565; and
(3) In the case of a personal holding company, the dividend
carryover computed as provided in section 564.
(b) For dividends for which the dividends paid deduction is
allowable, see section 562 and Sec. 1.562-1. As to when dividends are
considered paid, see Sec. 1.561-2.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6598, 27 FR
4093, Apr. 28, 1962]
[[Page 358]]
Sec. 1.561-2 When dividends are considered paid.
(a) In general. (1) A dividend will be considered as paid when it is
received by the shareholder. A deduction for dividends paid during the
taxable year will not be permitted unless the shareholder receives the
dividend during the taxable year for which the deduction is claimed. See
section 563 for special rule with respect to dividends paid after the
close of the taxable year.
(2) If a dividend is paid by check and the check bearing a date
within the taxable year is deposited in the mails, in a cover properly
stamped and addressed to the shareholder at his last known address, at
such time that in the ordinary handling of the mails the check would be
received by the shareholder within the taxable year, a presumption
arises that the dividend was paid to the shareholder in such year.
(3) The payment of a dividend during the taxable year to the
authorized agent of the shareholder will be deemed payment of the
dividend to the shareholder during such year.
(4) If a corporation, instead of paying the dividend directly to the
shareholder, credits the account of the shareholder on the books of the
corporation with the amount of the dividend, the deduction for a
dividend paid will not be permitted unless it be shown to the
satisfaction of the Commissioner that such crediting constituted payment
of the dividend to the shareholder within the taxable year.
(5) A deduction will not be permitted for the amount of a dividend
credited during the taxable year upon an obligation of the shareholder
to the corporation unless it is shown to the satisfaction of the
Commissioner that such crediting constituted payment of the dividend to
the shareholder within the taxable year.
(6) If the dividend is payable in obligations of the corporation,
they should be entered or registered in the taxable year on the books of
the corporation, in the name of the shareholder (or his nominee or
transferee), and, in the case of obligations payable to bearer, should
be received in the taxable year by the shareholder (or his nominee or
transferee) to constitute payment of the dividend within the taxable
year.
(7) In the case of a dividend from which the tax has been deducted
and withheld as required by chapter 3 (section 1441 and following), of
the Code the dividend is considered as paid when such deducting and
withholding occur.
(b) Methods of accounting. The determination of whether a dividend
has been paid to the shareholder by the corporation during its taxable
year is in no way dependent upon the method of accounting regularly
employed by the corporation in keeping its books or upon the method of
accounting upon the basis of which the taxable income of the corporation
is computed.
(c) Records. Every corporation claiming a deduction for dividends
paid shall keep such permanent records as are necessary (1) to establish
that the dividends with respect to which such deduction is claimed were
actually paid during the taxable year and (2) to supply the information
required to be filed with the income tax return of the corporation. Such
corporation shall file with its return (i) a copy of the dividend
resolution; and (ii) a concise statement of the pertinent facts relating
to the payment of the dividend, clearly specifying (a) the medium of
payment and (b) if not paid in money, the fair market value and adjusted
basis (or face value, if paid in its own obligations) on the date of
distribution of the property distributed and the manner in which such
fair market value and adjusted basis were determined. Canceled dividend
checks and receipts obtained from shareholders acknowledging payment of
dividends paid otherwise than by check need not be filed with the return
but shall be kept by the corporation as a part of its records.
Sec. 1.562-1 Dividends for which the dividends paid deduction is
allowable.
(a) General rule. Except as otherwise provided in section 562 (b)
and (d), the term dividend, for purposes of determining dividends
eligible for the dividends paid deduction, refers only to a dividend
described in section 316 (relating to definition of dividends for
purposes of corporate distributions). No distribution, however, which is
preferential within the meaning of section 562(c) and Sec. 1.562-2
shall be eligible for
[[Page 359]]
the dividends paid deduction. Moreover, when computing the dividends
paid deduction with respect to a U.S. person (as defined in section
957(d)), no distribution which is excluded from the gross income of a
foreign corporation under section 959(b) with respect to such person or
from gross income of such person under section 959(a) shall be eligible
for suchdeduction. Further, for purposes of the dividends paid
deduction, the term dividend does not include a distribution in
liquidation unless the distribution is treated as a dividend under
section 316(b)(2) and paragraph (b)(2) of Sec. 1.316-1, or under
section 333(e)(1) and paragraph (c) of Sec. 1.333-4 or paragraph
(c)(2), (d)(1)(ii), or (d)(2) of Sec. 1.333-5, or qualifies under
section 562(b) and paragraph (b) of this section. If a dividend is paid
in property (other than money) the amount of the dividends paid
deduction with respect to such property shall be the adjusted basis of
the property in the hands of the distributing corporation at the time of
the distribution. See paragraph (b)(2) of this section for special rules
with respect to liquidating distributions by personal holding companies
occurring during a taxable year of the distributing corporation
beginning after December 31, 1963. Also see section 563 for special
rules with respect to dividends paid after the close of the taxable
year.
(b) Distributions in liquidation--(1) General rule--(i) In general.
In the case of amounts distributed in liquidation by any corporation
during a taxable year of such corporation beginning before January 1,
1964, or by a corporation other than a personal holding company (as
defined in section 542) or a foreign personal holding company (as
defined in section 552) during a taxable year of such a corporation
beginning after December 31, 1963, section 562(b) makes an exception to
the general rule that a deduction for dividends paid is permitted only
with respect to dividends described in section 316. In order to qualify
under that exception, the distribution must be one either in complete or
partial liquidation of a corporation pursuant to sections 331, 332, or
333. See subparagraph (2) of this paragraph for rules relating to the
treatment of distributions in complete liquidation made by a corporation
which is a personal holding company to corporate shareholders during a
taxable year of such distributing corporation beginning after December
31, 1963. As provided by section 346(a), for the purpose of section
562(b), a partial liquidation includes a redemption of stock to which
section 302 applies. Amounts distributed in liquidation in a transaction
which is preceded, or followed, by a transfer to another corporation of
all or part of the assets of the liquidating corporation, may not be
eligible for the dividends paid deduction.
(ii) Amount of dividends paid deduction allowable--(a) General rule.
In the case of distributions in liquidation with respect to which a
deduction for dividends paid is permissible under subdivision (i) of
this subparagraph, the amount of the deduction is equal to the part of
such distribution which is properly chargeable to the earnings and
profits accumulated after February 28, 1913. To determine the amount
properly chargeable to the earnings and profits accumulated after
February 28, 1913, there must be deducted from the amount of the
distribution that part allocable to capital account. The capital
account, for the purposes of this subdivision, includes not only amounts
representing the par or stated value of the stock with respect to which
the liquidation distribution is made, but also that stock's proper share
of the paid-in surplus, and such other corporate items, if any, which,
for purposes of income taxation, are treated like capital in that they
are not taxable dividends when distributed but are applied against and
reduce the basis of the stock. The remainder of the distribution in
liquidation is, ordinarily, properly chargeable to the earnings and
profits accumulated after February 28, 1913. Thus, if there is a deficit
in earnings and profits on the first day of a taxable year, and the
earnings and profits for such taxable year do not exceed such deficit,
no dividends paid deduction would be allowed for such taxable year with
respect to a distribution in liquidation; if the earnings and profits
for such taxable year exceed the deficit in earnings and profits which
existed on the first day of such taxable
[[Page 360]]
year, then a dividends paid deduction would be allowed to the extent of
such excess.
(b) Special rule. Section 562(b)(1)(B) provides that in the case of
a complete liquidation occurring within 24 months after the adoption of
a plan of liquidation the amount of the deduction is equal to the
earnings and profits for each taxable year in which distributions are
made. Thus, if there is a distribution in liquidation pursuant to
section 333, or a distribution in complete liquidation pursuant to
section 331(a)(1) or 332 which occurs within a 24-month period after the
adoption of a plan of liquidation, a dividends paid deduction will be
allowable to the extent of the current earnings and profits for the
taxable year or years even though there was a deficit in earnings and
profits on the first day of such taxable year or years. In computing the
earnings and profits for the taxable year in which the distributions are
made, computation shall be made with the inclusion of capital gains and
without any deduction for capital losses.
(c) Examples. The application of this subparagraph may be
illustrated by the following examples:
Example 1. The Y Corporation, which makes its income tax returns on
the calendar year basis, was organized on January 1, 1910, with an
authorized and outstanding capital stock of 2,000 shares of common stock
of a par value of $100 each and 1,000 shares of participating preferred
stock of a par value of $100 each. The preferred stock was to receive
annual dividends of $7 per share and $100 per share on complete
liquidation of the corporation in priority to any payments on common
stock, and was to participate equally with the common stock in either
instance after the common stock had received a similar amount. However,
the preferred stock was redeemable in whole or in part at the option of
the board of directors at any time at $106 per share plus its proportion
of the earnings of the company at the time of such redemption. In 1910
the preferred stock was issued at $106 per share, for a total of
$106,000 and the common stock was issued, at $100 per share, for a total
of $200,000. On July 15, 1954, the company had a paid-in surplus of
$6,000, consisting of the premium received on the preferred stock;
earnings and profits of $30,000 accumulated prior to March 1, 1913; and
earnings and profits accumulated since February 28, 1913, of $75,000. On
July15, 1954, the option with respect to the preferred stock was
exercised and the entire amount of such stock was redeemed at $141 per
share or a total of $141,000 in a transaction upon which gain or loss to
the distributees resulting from the exchange was determined and
recognized under section 302(a). The amount of the distribution
allocable to capital account was $116,000 ($100,000 attributable to par
value, $6,000 attributable to paid-in surplus, and $10,000 attributable
to earnings and profits accumulated prior to March 1, 1913). The
remainder, $25,000 ($141,000, the amount of the distribution, less
$116,000, the amount allocable to capital account) is properly
chargeable to the earnings and profits accumulated since February 28,
1913, and is deductible as dividends paid.
Example 2. The M Corporation, a calendar year taxpayer, is
completely liquidated on November 1, 1955, pursuant to a plan of
liquidation adopted April 1, 1955. On January 1, 1955, the M Corporation
has a deficit in earnings and profits of $100,000. During the period
January 1, 1955, to the date of liquidation, November 1, 1955, it has
earnings and profits of $10,000. The M Corporation is entitled to a
dividends paid deduction in the amount of $10,000 as a result of its
distribution in complete liquidation on November 1, 1955.
Example 3. The N Corporation, a calendar year taxpayer, is
completely liquidated on July 1, 1958, pursuant to a plan of liquidation
adopted February 1, 1955. No distributions in liquidation were made
pursuant to the plan of liquidation adopted February 1, 1955, until the
distribution in complete liquidation on July 1, 1958. On January 1,
1958, N Corporation had a deficit in earnings and profits of $30,000.
During the period January 1, 1958, to the date of liquidation, July 1,
1958, the N Corporation has earnings and profits of $5,000. The N
Corporation is not entitled to any deduction for dividends paid as a
result of the distribution in complete liquidation on July 1, 1958. If
the earnings and profits for the period January 1, 1958, to July 1,
1958, had been $32,000, the N Corporation would have been entitled to a
deduction for dividends paid in the amount of $2,000.
(2) Special rule--(i) Distributions to corporate shareholders. In
the case of amounts distributed in complete liquidation of a personal
holding company (as defined in section 542) within 24 months after the
adoption of a plan of liquidation, section 562(b)(2) makes a further
exception to the general rule that a deduction for dividends paid is
permitted only with respect to dividends described in section 316. The
exception referred to in the preceding sentence applies only to
distributions made in any taxable year of the distributing corporation
beginning after December 31, 1963. Under the exception,
[[Page 361]]
the amount of any distribution within the 24-month period pursuant to
the plan shall be treated as a dividend for purposes of computing the
dividends paid deduction, but:
(a) Only to the extent that such amount is distributed to corporate
distributees, and
(b) Only to the extent that such amount represents such corporate
distributees' allocable share of undistributed personal holding company
income for the taxable year of such distribution (computed without
regard to section 316(b)(2)(B) and section 562(b)(2))
Amounts distributed in liquidation in a transaction which is preceded,
or followed, by a transfer to another corporation of all or part of the
assets of the liquidating corporation, may not be eligible for the
dividends paid deduction.
(ii) Corporate distributees' allocable share. For purposes of
subdivision (i)(b) of this subparagraph:
(a) Except as provided in (b) of this subdivision, the corporate
distributees' allocable share of undistributed personal holding company
income for the taxable year of the distribution (computed without regard
to sections 316(b)(2)(B) and 562(b)(2)) shall be determined by
multiplying such undistributed personal holding company income by the
ratio which the aggregate value of the stock held by all corporate
shareholders immediately before the record date of the last liquidating
distribution in such year bears to the total value of all stock
outstanding on such date. For rules applicable in a case where the
distributing corporation has more than one class of stock, see (c) of
this subdivision (ii).
(b) If more than one liquidating distribution was made during the
year, and if, after the record date of the first distribution but before
the record date of the last distribution, there was a change in the
relative shareholdings as between corporate shareholders and
noncorporate shareholders, then the corporate distributees' allocable
share of undistributed personal holding company income for the taxable
year of the distributions (computed without regard to sections
316(b)(2)(B) and 562(b)(2)) shall be determined as follows:
(1) First, allocate the corporation's undistributed personal holding
company income for the taxable year among the distributions made during
such year by reference to the ratio which the aggregate amount of each
distribution bears to the total amount of all distributions during such
year;
(2) Second, determine the corporate distributees' allocable share of
the corporation's undistributed personal holding company income for each
distribution by multiplying the amount determined under (1) of this
subdivision (b) for each distribution by the ratio which the aggregate
value of the stock held by all corporate shareholders immediately before
the record date of such distribution bears to the total value of all
stock outstanding on such date; and
(3) Last, determine the sum of the corporate distributees' allocable
share of the corporation's undistributed personal holding company income
for all such distributions
For rules applicable in a case where the distributing corporation has
more than one class of stock, see (c) of this subdivision (ii).
(c) Where the distributing corporation has more than one class of
stock:
(1) The undistributed personal holding company income for the
taxable year in which, or in respect of which, the distribution was made
shall be treated as a fund from which dividends may properly be paid and
shall be allocated between or among the classes of stock in a manner
consistent with the dividend rights of such classes under local law and
the pertinent governing instruments, such as, for example, the
distributing corporation's articles or certificate of incorporation and
bylaws;
(2) The corporate distributees' allocable share of the undistributed
personal holding company income for each class of stock shall be
determined separately in accordance with the rules set forth in (a) and
(b) of this subdivision (ii) as if each class of stock were the only
class of stock outstanding; and
(3) The sum of the corporate distributees' allocable share of the
undistributed personal holding company income for the taxable year in
which, or in respect of which, the distribution
[[Page 362]]
was made shall be the sum of the corporate distributees' allocable share
of the undistributed personal holding company income for all classes of
stock.
(d) For purposes of this subdivision (ii), in any case where the
record date of a liquidating distribution cannot be ascertained, the
record date of the distribution shall be the date on which the
liquidating distribution was actually made.
(iii) Example. The application of this subparagraph may be
illustrated by the following example:
Example. O Corporation, a calendar year taxpayer is completely
liquidated on December 31, 1964, pursuant to a plan of liquidation
adopted July 1, 1964. No distributions in liquidation were made pursuant
to the plan of liquidation adopted July 1, 1964, until the distribution
in complete liquidation on December 31, 1964. O Corporation has
undistributed personal holding company income of $300,000 for the year
1964 (computed without regard to section 316(b)(2)(B) and section
562(b)(2)). On December 31, 1964, immediately before the record date of
the distribution in complete liquidation, P Corporation owns 100 shares
of O Corporation's outstanding stock and individual A owns the remaining
200 shares. All shares are equal in value. The amount which represents P
Corporation's allocable share of undistributed personal holding company
income is $100,000(100 shares / 300 shares x $300,000), and for purposes
of computing the dividends paid deduction, such amount is treated as a
dividend under section 562(b)(2) provided that the liquidating
distribution to P Corporation equals or exceeds $100,000. P Corporation
does not treat the $100,000 distributed to it as a dividend to which
section 301 applies. For an example of the treatment of the distribution
to individual A see example 5 of paragraph (e) of Sec. 1.316-1.
(iv) Distributions to noncorporate shareholders. For the rules for
determining the extent to which distributions in complete liquidation
made to noncorporate shareholders by a personal holding company are
dividends within the meaning of section 562(a), see section 316(b)(2)(B)
and paragraph (b)(2) of Sec. 1.316-1.
(c) Special definition of dividend for nonliquidating distributions
by personal holding companies. Section 316(b)(2)(A) provides that in the
case of a corporation which, under the law applicable to the taxable
year in which or in respect of which a distribution is made, is a
personal holding company, the term dividend (in addition to the general
meaning set forth in section 316(a)) also means a nonliquidating
distribution to its shareholders to the extent of the corporation's
undistributed personal holding company income (determined under section
545 without regard to such distributions) for the taxable year in which
or in respect of which the distribution is made. See paragraph (b)(1) of
Sec. 1.316-1.
[T.D. 6949, 33 FR 5529, Apr. 9, 1968, as amended by T.D. 7767, 46 FR
11265, Feb. 6, 1981]
Sec. 1.562-2 Preferential dividends.
(a) Section 562(c) imposes a limitation upon the general rule that a
corporation is entitled to a deduction for dividends paid with respect
to all dividends which it actually pays during the taxable year. Before
a corporation may be entitled to any such deduction with respect to a
distribution regardless of the medium in which the distribution is made,
every shareholder of the class of stock with respect to which the
distribution is made must betreated the same as every other shareholder
of that class, and no class of stock may be treated otherwise than in
accordance with its dividend rights as a class. The limitation imposed
by section 562(c) is unqualified, except in the case of an actual
distribution made in connection with a consent distribution (see section
565), if the entire distribution composed of such actual distribution
and consent distribution is not preferential. The existence of a
preference is sufficient to prohibit the deduction regardless of the
fact (1) that such preference is authorized by all the shareholders of
the corporation or (2) that the part of the distribution received by the
shareholder benefited by the preference is taxable to him as a dividend.
A corporation will not be entitled to a deduction for dividends paid
with respect to any distribution upon a class of stock if there is
distributed to any shareholder of such class (in proportion to the
number of shares held by him) more or less than his pro rata part of the
distribution as compared with the distribution made to any other
shareholder of the same class. Nor will a corporation be entitled to a
deduction for
[[Page 363]]
dividends paid in the case of any distribution upon a class of stock if
there is distributed upon such class of stock more or less than the
amount to which it is entitled as compared with any other class of
stock. A preference exists if any rights to preference inherent in any
class of stock are violated. The disallowance, where any preference in
fact exists, extends to the entire amount of the distribution and not
merely to a part of such distribution. As used in this section, the term
distribution includes a dividend as defined in subchapter C, chapter 1
of the Code, and a distribution in liquidation referred to in section
562(b).
(b) The application of the provisions of section 562(c) may be
illustrated by the following examples:
Example 1. A, B, C, and D are the owners of all the shares of class
A common stock in the M Corporation, which makes its income tax returns
on a calendar year basis. With the consent of all the shareholders, the
M Corporation on July 15, 1954, declared a dividend of $5 a share
payable in cash on August 1, 1954, to A. On September 15, 1954, it
declared a dividend of $5 a share payable in cash on October 1, 1954, to
B, C, and D. No allowance for dividends paid for the taxable year 1954
is permitted to the M Corporation with respect to any part of the
dividends paid on August 1, 1954, and October 1, 1954.
Example 2. The N Corporation, which makes its income tax returns on
the calendar year basis, has a capital of $100,000 (consisting of 1,000
shares of common stock of a par value of $100) and earnings or profits
accumulated after February 28, 1913, in the amount of $50,000. In the
year 1954, the N Corporation distributes $7,500 in cancellation of 50
shares of the stock owned by three of the four shareholders of the
corporation. No deduction for dividends paid is permissible under
section 562(c) and paragraph (a) of this section with respect to such
distribution.
Example 3. The P Corporation has two classes of stock outstanding,
10 shares of cumulative preferred, owned by E, entitled to $5 per share
and on which no dividends have been paid for two years, and 10 shares of
common, owned by F. On December 31, 1954, the corporation distributes a
dividend of $125, $50 to E, and $75 to F. The corporation is entitled to
no deduction for any part of such dividend paid, since there has been a
preference to F. If, however, the corporation had distributed $100 to E
and $25 to F, it would have been entitled to include $125 as a dividend
paid deduction.
Sec. 1.562-3 Distributions by a member of an affiliated group.
A personal holding company which files or is required to file a
consolidated return with other members of an affiliated group may be
required to file a separate personal holding company schedule by reason
of the limitations and exceptions provided in section 542(b) and Sec.
1.542-4. Section 562(d) provides that in such case the dividends paid
deduction shall be allowed to the personal holding company, with respect
to a distribution made to any member of the affiliated group, if such
distribution would constitute a dividend if it were made to a
shareholder which is not a member of the affiliated group.
Sec. 1.563-1 Accumulated earnings tax.
In the determination of the dividends paid deduction for purposes of
the accumulated earnings tax imposed by section 531, a dividend paid
after the close of any taxable year and on or before the 15th day of the
third month following the close of such taxable year shall be considered
as paid during such taxable year, and shall not be included in the
computation of the dividends paid deduction for the year of payment.
However, the rule provided in section 563(a) is not applicable to
dividends paid during the first two and one-half months of the first
taxable year of the corporation subject to tax under chapter 1 of the
Internal Revenue Code of 1954.
Sec. 1.563-2 Personal holding company tax.
In the case of a personal holding company subject to the provisions
of section 541, dividends paid after the close of the taxable year and
before the 15th day of the third month thereafter shall be included in
the computation of the dividends paid deduction for the taxable year
only if the taxpayer so elects in its return for such taxable year. The
election shall be made by including such dividends in computing its
dividends paid deduction. The amount of such dividends which may be
included in computing the dividends paid deduction for the taxable year
shall not exceed either:
[[Page 364]]
(a) The undistributed personal holding company income of the
corporation for the taxable year, computed without regard to this
section, or
(b) In the case of a taxable year beginning after December 31, 1969,
20 percent (10 percent, in the case of a taxable year beginning before
Jan. 1, 1970) of the sum of the dividends paid during the taxable year
(not including consent dividends), computed without regard to this
section
In computing the amount of the dividends paid deduction allowable for
any taxable year, the amount allowed by reason of section 563(b) for any
preceding taxable year is considered a dividend paid in such preceding
taxable year and not in the year of actual distribution. Thus, a double
deduction is not allowable.
[T.D. 7079, 35 FR 18587, Dec. 8, 1970]
Sec. 1.563-3 Dividends considered as paid on last day of taxable year.
(a) General rule. Where a distribution made after the close of the
taxable year is considered as paid during such taxable year, for
purposes of applying section 562(a) the distribution shall be considered
as made on the last day of such taxable year.
(b) Personal holding company tax. In the case of a corporation which
under the law applicable to the taxable year in respect of which a
distribution is made under section 563(b) and Sec. 1.563-2 is a
personal holding company under the law applicable to such taxable year,
section 316(b)(2) provides that the term dividend means (in addition to
the general rule under section 316(a)) any distribution to the extent of
the corporation's undistributed personal holding company income
(determined under section 545 without regard to distributions under
section 316(b)(2)) for such year. See paragraph (b) of Sec. 1.316-1.
(c) Dividends paid on or before December 15, 1955. The Act of June
15, 1955 (Public Law 74, 84th Cong., 69 Stat. 136), repealed sections
452 and 462 of the Code, relating to prepaid income and reserve for
estimated expenses. Under section 4(c)(4) of that Act, dividends paid
after the 15th day of the third month following the close of the taxable
year and on or before December 15, 1955, may be treated as having been
paid on the last day of the taxable year for purposes of the accumulated
earnings tax or the personal holding company tax and in the case of
regulated investment companies, but only to the extent that such
dividends are attributable to an increase in taxable income for the
taxable year by reason of the repeal of sections 452 and 462. See
paragraph (b) of Sec. 1.9000-8, relating to treatment of certain
dividends, prescribed pursuant to section 4(c)(4) of the Act of June 15,
1955.
Sec. 1.564-1 Dividend carryover.
(a) General rule. The dividend carryover from the two preceding
years, allowable only to personal holding companies, is includible in
the dividends paid deduction under section 561. It is computed as
follows:
(1) If, for each of the preceding two years, the deduction for
dividends paid under section 561 (determined without regard to the
dividend carryover to each such year) exceeds the taxable income
(adjusted as provided in section 545 for purposes of determining
undistributed personal holding company income) then the dividend
carryover to the taxable year is the sum of both such excess amounts.
(2) If the deduction for dividends paid under section 561 for the
second preceding year (determined without regard to the dividend
carryover to such year) exceeds the taxable income for such year
(adjusted as provided in section 545), and if the taxable income for the
first preceding year (as so adjusted) exceeds the dividends paid
deduction for such first preceding year (as so determined), then the
dividend carryover to the taxable year shall be such excess amount for
the second preceding year, less such excess amount for the first
preceding year.
(3) If for the first preceding year the deduction for dividends paid
under section 561 (determined without regard to the dividend carryover
to such year) exceeds the taxable income (adjusted as provided in
section 545) for such year, and such excess is not present in the second
preceding year, then the dividend carryover to the taxable year
[[Page 365]]
shall be such excess amount for the first preceding year.
(b) Dividend carryover from year in which taxpayer was not a
personal holding company. In computing the dividend carryover, the
taxable income as adjusted under section 545 of any preceding taxable
year shall be determined as if the corporation was, under the law
applicable to such taxable year, a personal holding company.
(c) Dividend carryover from year in which taxpayer was subject to
1939 Code. In a case where the first or the second preceding taxable
year began before the taxpayer's first taxable year under the Internal
Revenue Code of 1954, the amount of the dividend carryover shall be
determined under the Internal Revenue Code of 1939.
(d) Statement to be filed with return. Every corporation claiming a
dividend carryover for any taxable year shall file with its return for
such year a concise statement setting forth the amount of the dividend
carryover claimed and all material and pertinent facts relative thereto,
including a detailed schedule showing the computation of the dividend
carryover claimed.
(e) Computation of dividend carryover. The computation of the
dividend carryover may be illustrated by the following examples:
Example 1. The X Corporation, which files its income tax returns on
the calendar year basis, has taxable income, adjusted as required by
section 545, in the amount of $110,000 and has a dividends paid
deduction of $150,000 for the year 1954. For 1955, its taxable income,
adjusted as required by section 545, is $200,000 and its dividends paid
deduction is $300,000. The dividend carryover to the year 1956 is
$140,000, computed as follows:
Dividends paid deduction for 1954........................... $150,000
Taxable income for 1954..................................... 110,000
-----------
Dividend carryover from 1954................................ 40,000
===========
Dividends paid deduction for 1955........................... 300,000
Taxable income for 1955..................................... 200,000
-----------
Dividend carryover from 1955................................ 100,000
===========
Dividend carryover for 2 preceding taxable years, allowable 140,000
as a deduction for the year 1956...........................
Example 2. The Y Corporation, which files its income tax returns on
the calendar year basis, has taxable income, adjusted as required by
section 545, in the amount of $100,000 and has a dividends paid
deduction of $150,000 for the year 1954. For 1955, its taxable income,
adjusted as required by section 545, is $200,000 and its dividends paid
deduction is $170,000. The dividend carryover to the year 1956 is
$20,000 computed as follows:
Dividends paid deduction for 1954........................... $150,000
Taxable income for 1954..................................... 100,000
-----------
Dividend carryover from 1954................................ 50,000
===========
Taxable income for 1955..................................... 200,000
Dividends paid deduction for 1955........................... 170,000
-----------
Excess of taxable income over dividends paid deduction...... 30,000
===========
Dividend carryover for second preceding taxable year, 20,000
allowable as a deduction for the year 1956.................
Sec. 1.565-1 General rule.
(a) Consent dividends. The dividends paid deduction, as defined in
section 561, includes the consent dividends for the taxable year. A
consent dividend is a hypothetical distribution (as distinguished from
an actual distribution) made by:
(1) A corporation that has a reasonable basis to believe that it is
subject to the accumulated earnings tax imposed in part I of subchapter
G, chapter 1 of the Code, or
(2) A corporation described in part II (personal holding companies
or a corporation with adjusted income from rents described in section
543(a)(2)(A) which utilizes the consent dividends described in section
543(a)(2)(B)(iii) to avoid personal holding company status) or part III
(foreign personal holding companies) of subchapter G or in part I
(regulated investment companies) or part II (real estate investment
trusts) of subchapter M, chapter 1 of the Code.
A consent dividend may be made by a corporation described in this
paragraph to any person who owns consent stock on the last day of the
taxable year of such corporation and who agrees to treat the
hypothetical distribution as an actual dividend, subject to the
limitations in section 565, Sec. 1.565-2, and paragraph (c)(2) of this
section, by filing a consent at the time and in the manner specified in
paragraph (b) of this section.
(b) Making and filing of consents. (1) A consent shall be made on
Form 972 in accordance with this section and the
[[Page 366]]
instructions on the form issued therewith. It may be made only by or on
behalf of a person who was the actual owner on the last day of the
corporation's taxable year of any class of consent stock, that is, the
person who would have been required to include in gross income any
dividends on such stock actually distributed on the last day of such
year. Form 972 shall contain or be verified by a written declaration
that it is made under the penalties of perjury. In the consent such
person must agree to include in gross income for his taxable year in
which or with which the taxable year of the corporation ends a specific
amount as a taxable dividend.
(2) See paragraph (c) of this section and Sec. 1.565-2 for the
rules as to when all or a portion of the amount so specified will be
disregarded for tax purposes.
(3) A consent may be filed at any time not later than the due date
(including extensions) of the corporation's income tax return for the
taxable year for which the dividends paid deduction is claimed. With
such return, and not later than the due date (including extensions)
thereof, the corporation must file Forms 972 for each consenting
shareholder, and a return on Form 973 showing by classes the stock
outstanding on the first and last days of the taxable year, the dividend
rights of such stock, distributions made during the taxable year to
shareholders, and giving all the other information required by the form.
For taxable years beginning before January 1, 2003, the Form 973 filed
with the corporation's income tax return shall contain or be verified by
a written declaration that is made under the penalties of perjury and
the Forms 972 filed with the return must be duly executed by the
consenting shareholders. For taxable years beginning after December 31,
2002, the Form 973 filed with the corporation's income tax return shall
be verified by signing the return and the Forms 972 filed with the
return must be duly executed by the consenting shareholders or, if
unsigned, must contain the same information as the duly executed
originals. If the corporation submits unsigned Forms 972 with its return
for a taxable year beginning after December 31, 2002, the duly executed
originals are records that the corporation must retain and keep
available for inspection in the manner required by Sec. 1.6001-1(e).
(c) Taxability of amounts specified in consents. (1) The filing of a
consent is irrevocable, and except as otherwise provided in section
565(b), Sec. 1.565-2, and paragraph (c)(2) of this section, the full
amount specified in a consent filed by a shareholder of a corporation
described in paragraph (a) of this section shall be included in the
gross income of the shareholder as a taxable dividend. Where the
shareholder is taxable on a dividend only if received from sources
within the United States, the amount specified in the consent of the
shareholder shall be treated as a dividend from sources within the
United States in the same manner as if the dividend has been paid in
money to the shareholder on the last day of the corporation's taxable
year. See paragraph (b) of this section relating to the making and
filing of consents, and section 565(e) and Sec. 1.565-5, with respect
to the payment requirement in the case of nonresident aliens and foreign
corporations.
(2) To the extent that the Commissioner determines that the
corporation making a consent dividend is not a corporation described in
paragraph (a) of this section, the amount specified in the consent is
not a consent dividend and the amount specified in the consent will not
be included in the gross income of the shareholder. In addition, where a
corporation is described in paragraph (a)(1) but not paragraph (a)(2) of
this section, to the extent that the Commissioner determines that the
amount specified in a consent is larger than the amount of earnings
subject to the accumulated earnings tax imposed by part I of subchapter
G, such excess is not a consent dividend under paragraph (a) of this
section and will not be included in the gross income of the shareholder.
(3) Except as provided in section 565(b), Sec. 1.565-2 and
paragraph (c)(2) of this section, once a shareholder's consent is filed,
the full amount specified in such consent must be included in the
shareholder's gross income as a taxable dividend, and the ground upon
which a deduction for consent dividends is denied the corporation does
not affect the
[[Page 367]]
taxability of a shareholder whose consent has been filed for the amount
specified in the consent. For example, although described in part I, II,
or III of subchapter G, or part I or II of subchapter M, chapter 1 of
the Code, the corporation's taxable income (as adjusted under section
535(b), 545(b), 556(b), 852(b)(2), or 857(b)(2), as appropriate) may be
less than the total of the consent dividends.
(4) A shareholder who is a nonresident alien or a foreign
corporation is taxable on the full amount of the consent dividend that
otherwise qualifies under this section even though that payment has not
been made as required by section 565(e) and Sec. 1.565-5.
(5) Income of a foreign corporation is not subject to the tax on
accumulated earnings under part I of subchapter G, chapter 1 of the Code
except to the extent of U.S. source income, adjusted as permitted under
section 535. See section 535 (b) and (d) and Sec. 1.535-1(b).
Therefore, foreign source earnings (other than those distributions
subject to resourcing under section 535(d)) of a foreign corporation
that is not described in paragraph (a)(2) of this section cannot qualify
for consent dividend treatment. Accordingly, a consent dividend made by
a foreign corporation described in paragraph (a)(1) of this section
shall not be effective with respect to all of the corporation's
earnings, but shall relate solely to earnings which would have been, in
the absence of the consent dividend, subject to the accumulated earnings
tax.
[T.D. 8244, 54 FR 10538, Mar. 14, 1989, as amended by T.D. 9100, 68 FR
70705, Dec. 19, 2003; T.D. 9300, 71 FR 71042, Dec. 8, 2006]
Sec. 1.565-2 Limitations.
(a) General rule. Amounts specified in consents filed by
shareholders or other beneficial owners of a corporation described in
Sec. 1.565-1(a) are not treated as consent dividends to the extent
that--
(1) They would constitute a preferential dividend or
(2) They would not constitute a dividend (as defined in section
316),
if distributed in money to shareholders on the last day of the taxable
year of the corporation. If any portion of any amount specified in a
consent filed by a shareholder of a corporation described in the
preceding sentence is not treated as a consent dividend under section
565(b) and this section, it is disregarded for all tax purposes. For
example, it is not taxable to the consenting shareholder, and paragraph
(c) of Sec. 1.565-1 is not applicable to this portion of the amount
specified in the consent.
(b) Preferential distribution. (1) A preferential distribution is an
actual distribution, or a consent distribution, or a combination of the
two, which involves a preference to one or more shares of stock as
compared with other shares of the same class or to one class of stock as
compared with any other class of stock. See section 562(c) and Sec.
1.562-2.
(2) The application of section 565 (b) (1) and Sec. 1.565-2 (b) may
be illustrated by the following examples:
Example 1. The X Corporation, a personal holding company, which
makes its income tax returns on the calendar year basis, has 200 shares
of stock outstanding, owned by A and B in equal amounts. On December 15,
1987, the corporation distributes $600 to B and $100 to A. As a part of
the same distribution, A executes a consent to include $500 in his gross
income as a taxable dividend although such amount is not distributed to
him. The X Corporation, assuming the other requirements of section 565
have been complied with, is entitled to a consent dividends deduction of
$500. Although the consent dividend is deemed to have been paid on
December 31, 1987, the last day of the taxable year of the corporation,
the total amount of all distributions constitutes a single
nonpreferential distribution of $1200.
Example 2. The Y corporation, a personal holding company, which
makes its income tax returns on the calendar year basis, has one class
of consent stock outstanding, owned in equal amounts by A, B, and C. If
A and B each receive a distribution in cash of $5,000 and C consents to
include $3,000 in gross income as a taxable dividend, the combined
actual and consent distribution of $13,000 is preferential. See section
562 (c) and Sec. 1.562-2 (a). Similarly, if no one receives a
distribution in cash, but A and B each consents to include $5,000 as a
taxable dividend in gross income and C agrees to include only $3,000,
the entire consent distribution is preferential.
Example 3. The Z Corporation, which makes its income tax returns on
the calendar year basis and is subject, for the taxable year in
question, to the accumulated earnings tax, has only two classes of stock
outstanding,
[[Page 368]]
each class being consent stock and consisting of 500 shares. Class A,
with a par value of $40 per share, is entitled to two-thirds of any
distribution of earnings and profits. Class B, with a par value of $20
per share, is entitled to one-third of any distribution of earnings and
profits. On December 15, 1987, there is distributed on the class B stock
$2 per share, or $1,000, and shareholders of the class A stock consent
to include in gross income amounts equal to $2 per share, or $1,000. The
entire distribution of $2,000 is preferential, inasmuch as the class B
stock has received more than its pro rata share of the combined amounts
of the actual distributions and the consent distributions.
(c) Section 316 limitation. (1) An additional limitation under
section 565 (b) is that the amounts specified in consents which may be
treated as consent dividends cannot exceed the amounts which would
constitute a dividend (as defined in section 316) if the corporation had
distributed the total specified amounts in money to shareholders on the
last day of the taxable year of the corporation. If only a portion of
such total would constitute a dividend, then only a corresponding
portion of each specified amount is treated as a consent dividend.
(2) The application of section 565 (b) (2) and Sec. 1.565-2 (c) may
be illustrated by the following example:
Example. The X Corporation, a corporation described in Sec. 1.565-
(a) (1) or (2), which makes its income tax returns on the calendar year
basis, has only one class of stock outstanding, owned in equal amounts
by A and B. It makes no distributions during the taxable year 1987. Its
earnings and profits for the calendar year 1987 amount to $8,000, there
being at the beginning of such year no accumulated earnings or profits.
A and B execute proper consents to include $5,000 each in their gross
income as a dividend received by them on December 31, 1987. The sum of
the amounts specified in the consents executed by A and B is $10,000,
but if $10,000 had actually been distributed by the X corporation on
December 31, 1987, only $8,000 would have constituted a dividend under
section 316 (a). The amount which could be considered as consent
dividends in computing the dividends paid deduction for purposes of the
accumulated earnings tax is limited to $8,000, or $4,000 of the $5,000
specified in each consent. The remaining $1,000 in each consent is
disregarded for all tax purposes. (In the case of a personal holding
company, see also the example in Sec. 1.565-3(b).)
[T.D. 8244, 54 FR 10539, Mar. 14, 1989]
Sec. 1.565-3 Effect of consent.
(a) General rule. The amount of the consent dividend that is
described in paragraph (a) of Sec. 1.565-1 shall be considered, for all
purposes of the Code, as if it were distributed in money by the
corporation to the shareholder on the last day of the taxable year of
the corporation, received by the shareholder on such day, and
immediately contributed by the shareholder as paid-in capital to
thecorporation on such day. Thus, the amount of the consent dividend
will be treated by the shareholder as a dividend. The shareholder will
be entitled to the dividends received deduction under section 243 or 245
with respect to such consent dividend. The basis of the shareholder's
consent stock in a corporation will be increased by the amount thus
treated in his hands as a dividend which he is considered as having
contributed to the corporation as paid-in capital. The amount of the
current dividend will also be treated as a dividend received from
sources within the United States in the same manner as if the dividend
had been paid in money to the shareholders. Among other effects of the
consent dividend, the earnings and profits of the corporation will be
decreased by the amount of the consent dividends. Moreover, if the
shareholder is a corporation, its accumulated earnings and profits will
be increased by the amount of the consent dividend with respect to which
it makes a consent.
(b) Example. The application of section 565 (c) may be illustrated
by the following example:
Example. Corporation A, a personal holding company and a calendar
year taxpayer, has one shareholder, individual B, whose consent to
include $10,000 in his gross income for the calendar year 1987 has been
timely filed. A has $8,000 of earnings and profits at the beginning of
1987. A has $10,000 of undistributed personal holding company income
(determined without regard to distributions under section 316(b)(2)) for
1987. B must include $10,000 in his gross income as a taxable income and
is treated as having immediately contributed $10,000 to A as paid-in
capital. See section 316(b)(2).
[T.D. 8244, 54 FR 10540, Mar. 14, 1989]
[[Page 369]]
Sec. 1.565-4 Consent dividends and other distributions.
Section 565(d) provides a rule applicable where a distribution is
made in part in consent dividends and in part in money or other
property. With respect to such a distribution the entire amount
specified in the consents and the amount of such money or other property
shall be considered together. Thus, if as a part of the same
distribution consents are filed by some of the shareholders and cash is
distributed to other shareholders, for example, those who may be
unwilling to sign consents, the total amount of the cash and the amounts
specified in the consents will be viewed as a single distribution to
determine the tax effects of such distribution. For example, the total
of such amounts must be considered to determine whether the distribution
(including the amounts specified in the consents) is preferential and
whether any part of such distribution would not be dividends if the
total amounts specified in the consents were distributed in cash. See
paragraph (b)(2) of Sec. 1.565-2 for examples illustrating the
treatment of distributions which consist in part of consent dividends
and in part of other property.
Sec. 1.565-5 Nonresident aliens and foreign corporations.
(a) Withholding. In the event that a corporation makes a consent
dividend, as described in Sec. 1.565-1 (a), to a shareholder that is
subject to a withholding tax under section 1441 or 1442 on a
distribution of cash or other property, the corporation must remit an
amount of tax equal to the withholding tax that would be imposed under
section 1441 or 1442 if an actual cash distribution equal to the consent
dividend had been paid to the shareholder on the last day of the
corporation's taxable year. Such payment must be in one of the following
forms:
(1) Cash,
(2) United States postal money order,
(3) Certified check drawn on a domestic bank, provided that the law
of the place where the bank is located does not permit the certification
to be rescinded prior to presentation,
(4) A cashier's check of a domestic bank, or
(5) A draft on a domestic bank or a foreign bank maintaining a
United States agency or branch and payable in United States funds.
The amount of such payment shall be credited against the tax imposed on
the shareholder.
(b) [Reserved]
[T.D. 8244, 54 FR 10540, Mar. 14, 1989]
Sec. 1.565-6 Definitions.
(a) Consent stock. (1) The term consent stock includes what is
generally known as common stock. It also includes participating
preferred stock, the participation rights of which are unlimited.
(2) The definition of consent stock may be illustrated by the
following example:
Example. If in the case of the X Corporation, a personal holding
company, there is only one class of stock outstanding, it would all be
consent stock. If, on the other hand, there were two classes of stock,
class A and class B, and class A was entitled to 6 percent before any
distribution could be made on class B, but class B was entitled to
everything distributed after class A had received its 6 percent, only
class B stock would be consent stock. Similarly, if class A, after
receiving its 6 percent, was to participate equally or in some fixed
proportion with class B until it had received a second 6 percent, after
which class B alone was entitled to any further distributions, only
class B stock would be consent stock. The same result would follow if
the order of preferences were class A 6 percent, then class B 6 percent,
then class A a second 6 percent, either alone or in conjunction with
class B, then class B the remainder. If, however, class A stock is
entitled to ultimate participation without limit as to amount, then it,
too, may be consent stock. For example, if class A is to receive 3
percent and then share equally or in some fixed proportion with class B
in the remainder of the earnings or profits distributed, both class A
stock and class B stock are consent stock.
(b) Preferred dividends. (1) The term preferred dividends includes
all fixed amounts (whether determined by percentage of par value, a
stated return expressed in a certain number of dollars per share, or
otherwise) the distribution of which on any class of stock is a
condition precedent to a further distribution of earnings or profits
(not including a distribution in partial or complete liquidation). A
distribution, though expressed in terms of a
[[Page 370]]
fixed amount, is not a preferred dividend, however, unless it is
preferred over a subsequent distribution within the taxable year upon
some class or classes of stock other than one on which it is payable.
(2) The definition of preferred dividends may be illustrated by the
following example:
Example. If, in the case of the X Corporation, there are only two
classes of stock outstanding, class A and class B, and class A is
entitled to a distribution of 6 percent of par, after which the balance
of the earnings and profits are distributable on class B exclusively,
class A's 6 percent is a preferred dividend. If the order of preferences
is class A $6 per share, class B $6 per share, then class A and class B
in fixed proportions until class A receives $3 more per share, then
class B the remainder, all of class A's $9 per share and $6 per share of
the amount distributable on class B are preferred dividends. The amount
which class B is entitled to receive in conjunction with the payment to
class A of its last $3 per share is not a preferred dividend, because
the payment of such amount is preferred over no subsequent distribution
except one made on class B itself. Finally, if a distribution must be $6
on class A, $6 on class B, then on class A and class B share and share
alike, the distribution on class A of $6 and the distribution on class B
of $6 are both preferred dividends.
[54 FR 10540, Mar. 14, 1989]
Banking Institutions
Rules of General Application to Banking Institutions--Table of Contents
Sec. 1.581-1 Banks.
(a) In order to be a bank as defined in section 581, an institution
must be a corporation for federal tax purposes. See Sec. 301.7701-2(b)
of this chapter for the definition of a corporation.
(b) This section is effective as of January 1, 1997.
[T.D. 8697, 61 FR 66588, Dec. 18, 1996]
Sec. 1.581-2 Mutual savings banks, building and loan associations,
and cooperative banks.
(a) While the general principles for determining the taxable income
of a corporation are applicable to a mutual savings bank, a building and
loan association, and a cooperative bank not having capital stock
represented by shares, there are certain exceptions and special rules
governing the computation in the case of such institutions. See section
593 for special rules concerning reserves for bad debts. See section 591
and Sec. 1.591-1, relating to dividends paid by banking corporations,
for special rules concerning deductions for amounts paid to, or credited
to the accounts of, depositors or holders of withdrawable accounts as
dividends. See also section 594 and Sec. 1.594-1 for special rules
governing the taxation of a mutual savings bank conducting a life
insurance business.
(b) For the purpose of computing the net operating loss deduction
provided in section 172, any taxable year for which a mutual savings
bank, building and loan association, or a cooperative bank not having
capital stock represented by shares was exempt from tax shall be
disregarded. Thus, no net operating loss carryover shall be allowed from
a taxable year beginning before January 1, 1952, and, in the case of any
taxable year beginning after December 31, 1951, the amount of the net
operating loss carryback or carryover from such year shall not be
reduced by reference to the income of any taxable year beginning before
January 1, 1952.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. 8697, 61 FR 66588, Dec. 18, 1996]
Sec. 1.581-3 Definition of bank prior to September 28, 1962.
Prior to September 28, 1962, for purposes of sections 582 and 584,
the term bank means a bank or trust company incorporated and doing
business under the laws of the United States (including laws relating to
the District of Columbia), of any State, or of any Territory, a
substantial part of the business of which consists of receiving deposits
and making loans and discounts, or of exercising fiduciary powers
similar to those permitted to national banks under section 11(k) of the
Federal Reserve Act (38 Stat. 262; 12 U.S.C. 248(k)), and which is
subject by law to supervision and examination by State, Territorial, or
Federal authority having supervision over banking institutions. Such
term also means a domestic building and loan association.
[T.D. 6651, 28 FR 4950, May 17, 1963]
[[Page 371]]
Sec. 1.582-1 Bad debts, losses, and gains with respect to securities
held by financial institutions.
(a) Bad debt deduction for banks. A bank, as defined in section 581,
is allowed a deduction for bad debts to the extent and in the manner
provided by subsections (a), (b), and (c) of section 166 with respect to
a debt which has become worthless in whole or in part and which is
evidenced by a security (a bond, debenture, note, certificate, or other
evidence of indebtedness to pay a fixed or determinable sum of money)
issued by any corporation (including governments and their political
subdivisions), with interest coupons or in registered form.
(b) Worthless stock in affiliated bank. For purposes of section
165(g)(1), relating to the deduction for losses involving worthless
securities, if the taxpayer is a bank (as defined in section 581) and
owns directly at least 80 percent of each class of stock of another
bank, stock in such other bank shall not be treated as a capital asset.
(c) Pre-1970 sales and exchanges of bonds, etc., by banks. For
taxable years beginning before July 12, 1969, with respect to the
taxation under subtitle A of the Code of a bank (as defined in section
581), if the losses of the taxable year from sales or exchanges of
bonds, debentures, notes, or certificates, or other evidences of
indebtedness, issued by any corporation (including one issued by a
government or political subdivision thereof), exceed the gains of the
taxable year from such sales or exchanges, no such sale or exchange
shall be considered a sale or exchange of a capital asset.
(d) Post-1969 sales and exchanges of securities by financial
institutions. For taxable years beginning after July 11, 1969, the sale
or exchange of a security is not considered the sale or exchange of a
capital asset if such sale or exchange is made by a financial
institution to which any of the following sections applies: Section 585
(relating to banks), 586 (relating to small business investment
companies and business development corporations), or 593 (relating to
mutual savings banks, domestic building and loan associations, and
cooperative banks). This paragraph shall apply to determine the
character of gain or loss from the sale or exchange of a security
notwithstanding any other provision of subtitle A of the Code, such as
section 1233 (relating to short sales). However, this paragraph shall
have no effect in the determination of whether a security is a capital
asset under section 1221 for purposes of applying any other provision of
the Code, such as section 1232 (relating to original issue discount).
For purposes of this paragraph, a security is a bond, debenture, note,
or certificate or other evidence of indebtedness, issued by any person.
See paragraphs (e) and (f) of this section for special transitional
rules applicable, respectively, to banks and to small business
investment companies and business development corporations.
(e) Transition rule for qualifying securities held by banks--(1) In
general. Notwithstanding the provisions of paragraph (d) of this
section, if the net long-term capital gain from sales and exchanges of
qualifying securities exceeds the net short-term capital loss from such
sales and exchanges in any taxable year beginning after July 11, 1969,
such excess shall be treated as long-term capital gain, but in an amount
not to exceed the net gain from sales and exchanges of securities in
such year. For purposes of computing such net gain, a capital loss
carried to the taxable year under section 1212 shall not be taken into
account. See section 1222 and the regulations thereunder for definitions
of the terms net long-term capital gain and net short-term capital loss.
For purposes of this paragraph:
(i) The term security means a security within the meaning of
paragraph (d) of this section.
(ii) The term qualifying security means a security which is held by
the bank on July 11, 1969, and continuously thereafter until it is first
sold or exchanged by the bank
See also subparagraph (4) of this paragraph for rules under which the
time certain securities are held is deemed to include a period of time
determined under section 1223 (1) and (2) with respect to such security.
(2) Computation of capital gain or loss. For purposes of this
paragraph, the amount of gain or loss from the sale or
[[Page 372]]
exchange of a qualifying security treated as capital gain or loss is
determined by multiplying the amount of gain or loss recognized from
such sale or exchange by a fraction the numerator of which is the number
of days before July 12, 1969, that such security was held by the bank
and the denominator of which is the sum of the number of days included
in the numerator and the number of days the security was held by the
bank after July 11, 1969.
(3) Special rules. For purposes of subparagraphs (1) and (2) of this
paragraph, the following items are not taken into account:
(i) Any amount treated as original issue discount under section
1232, and
(ii) Any amount which, without regard to section 582(c) and this
section, would be treated as gain or loss from the sale or exchange of
property which is not a capital asset, such as an amount which is
realized from the sale or exchange of a security which is held by a bank
as a dealer in securities.
(4) Holding period in certain cases. For purposes of this paragraph:
(i) The time a security received in an exchange is deemed to have
been held by a bank includes a period of time determined under section
1223(1) with respect to such security.
(ii) The time a security transferred to a bank from another bank is
deemed to have been held by the transferee bank includes a period of
time determined under section 1223(2) with respect to such security
For example, if a bank on December 3, 1972, surrendered an obligation of
the United States which it held as a capital asset on July 11, 1969, in
a transaction to which section 1037 applied, the time during which the
newly received obligation is deemed to have been held includes the time
during which the surrendered obligation was deemed to have been held by
the bank. Because the surrendered obligation was held on July 11, 1969,
the newly acquired obligation is deemed to have been held on that date
and is a qualifying security. The period during which the surrendered
obligation is deemed to have been held is taken into account in
computing the fraction determined under subparagraph (2) of this
paragraph with respect to the newly received obligation.
(5) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. Bank A, a calendar year taxpayer, purchased a qualifying
security on July 14, 1968, and held it to maturity on August 20, 1970,
when it was redeemed. The redemption resulted in a taxable gain of
$10,000. The security was held by the bank for 363 days before July 12,
1969, and for a total of 768 days. During the taxable year, the bank had
no other gains and no losses from sales or exchanges of qualifying
securities, but had a net loss of $4,000 from sales of securities other
than qualifying securities. The portion of the gain from the redemption
of the qualifying security treated as capital gain under subparagraph
(2) of this paragraph is $4,726.56 (363/768 x $10,000). Because the net
gain of the taxable year from sales and exchanges of securities, $6,000
($10,000-$4,000), exceeds the portion of the gain on the sale of the
qualifying security treated as capital gain under this paragraph,
$4,726.56 is treated as long-term capital gain on the sale of the
qualifying security for the taxable year.
Example 2. Assume the same facts as in example 1, except that the
bank's net loss of the taxable year from the sale of securities other
than qualifying securities was $7,000. The amount considered as long-
term capital gain under this paragraph is limited by the amount of gain
on the sale of securities to $3,000 ($10,000-$7,000).
(f) Small business investment companies and business development
corporations--(1) Election. In the case of a small business investment
company or a business development corporation, described in section
586(a), section 582(c) does not apply for taxable years beginning after
July 11, 1969, and before July 11, 1974, unless the taxpayer elects that
such section shall apply. In the case of a small business investment
company, see paragraph (a)(1) of Sec. 1.1243-1 if such an election is
made, but see paragraph (a)(2) of Sec. 1.1243-1 if such an election is
not made. Such election applies to all such taxable years and, except as
provided in subparagraph (3) of this paragraph, is irrevocable. Such
election must be made not later than (i) the time, including extensions
thereof, prescribed by law for filing the taxpayer's income tax return
for its first taxable year beginning after July 11, 1969, or (ii) June
8, 1970, whichever is later.
[[Page 373]]
(2) Manner of making election. An election pursuant to the
provisions of this paragraph is made by the taxpayer by a written
statement attached to the taxpayer's income tax return (or an amended
return) for its first taxable year beginning after July 11, 1969. Such
statement shall indicate that the election is made pursuant to section
433(d) of the Tax Reform Act of 1969 (83 Stat. 624). The taxpayer shall
attach to its income tax return for each subsequent taxable year to
which such election is applicable a statement indicating that the
election has been made and the amount to which it applies for such year.
(3) Revocation of election. An election made pursuant to
subparagraph (2) of this paragraph shall be irrevocable unless:
(i) A written application for consent to revoke the election,
setting forth the reasons therefor, is filed with the Commissioner
within 90 days after the permanent regulations relating to section
433(d)(2) of the Tax Reform Act of 1969 (83 Stat. 624) are filed with
the Office of the Federal Register, and
(ii) The Commissioner consents to the revocation.
The revocation is effective for all taxable years to which the election
applied.
[T.D. 7171, 37 FR 5620, Mar. 17, 1972; 37 FR 6400, Mar. 29, 1972]
Sec. 1.584-1 Common trust funds.
(a) Method of taxation. A common trust fund maintained by a bank is
not subject to taxation under this chapter and is not considered a
corporation. Its participants are taxed on their proportionate share of
income from the common trust fund.
(b) Conditions for qualification. (1) For a fund to be qualified as
a common trust fund it must be maintained by a bank (as defined in
section 581) in conformity with the rules and regulations of the
Comptroller of the Currency, exclusively for the collective investment
and reinvestment of contributions to the fund by the bank. The bank may
either act alone or with one or more other fiduciaries, but it must act
solely in its capacity as one or a combination of the following: (i) As
a trustee of a trust created by will, deed, agreement, declaration of
trust, or order of court; (ii) as an executor of a will or as an
administrator of an estate; (iii) as a guardian (by whatever name known
under local law) of the estate of an infant, of an incompentent
individual, or of an absent individual; or (iv) on or after October 3,
1976, as a custodian of a UniformGifts to Minors account. A Uniform
Gifts to Minors account is an account established pursuant to a State
law substantially similar to the Uniform Gifts to Minors Act. (See the
Uniform Gifts to Minors Act of 1956 or the Uniform Gifts to Minors Act
of 1966, as published by the National Conference of Commissioners on
Uniform State Laws.) The Commissioner will publish a list of the States
whose laws he determines to be substantially similar to such uniform
acts. A bank that maintains a Uniform Gifts to Minors Act account must
establish, to the satisfaction of the Commissioner or his delegate, that
with respect to the account the bank has duties and responsibilities
similar to the duties and responsibilities of a trustee or guardian.
(2) A common trust fund may be a participant in another common trust
fund.
(c) Affiliated groups. For taxable years beginning after December
31, 1975, two or more banks that are members of the same affiliated
group (within the meaning of section 1504) are treated, for purposes of
section 584, as one bank for the period of their affiliation. A common
trust fund may be maintained by one or by more than one member of an
affiliated group. Any member of the group may, but need not, contribute
to the fund. Further, for purposes of this paragraph, members of an
affiliated group may be, but need not be, co-trustees of the common
trust fund.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7935, 49 FR
1694, Jan. 13, 1984]
Sec. 1.584-2 Income of participants in common trust fund.
(a) Each participant in a common trust fund is required to include
in computing its taxable income for its taxable year within which or
with which the taxable year of the fund ends, whether or not distributed
and whether or not distributable:
[[Page 374]]
(1) Its proportionate share of short-term capital gains and losses,
computed as provided in Sec. 1.584-3;
(2) Its proportionate share of long-term capital gains and losses,
computed as provided in Sec. 1.584-3; and
(3) Its proportionate share of the ordinary taxable income or the
ordinary net loss of the common trust fund, computed as provided in
Sec. 1.584-3.
(b) Any tax withheld at the source from income of the fund (e.g.,
under section 1441) is deemed to have been withheld proportionately from
the participants to whom such income is allocated.
(c)(1) The proportionate share of each participant's short-term
capital gains and losses, long-term capital gains and losses, ordinary
taxable income or ordinary net loss, dividends and interest received,
and tax withheld at the source shall be determined under the method of
accounting adopted by the bank in accordance with the written plan by
which the common trust fund is established and administered, provided
such method clearly reflects the income of each participant.
(2) Items of income and deductions shall be allocated to the periods
between valuation dates established by the plan within the taxable year
in which they were realized. Ordinary taxable income or ordinary net
loss, short-term capital gains and losses, long-term capital gains and
losses, and tax withheld at the source shall be computed for each
period. The participants' proportionate shares of income and losses for
each period shall then be determined.
(3) For taxable years beginning on or after September 22, 1980, any
amount of income or loss of the common trust fund which is included in
the computation of a participant's taxable income for the taxable year
shall be treated as income or loss from an unrelated trade or business
to the extent that such amount would have been income or loss from an
unrelated trade or business if such participant had made directly the
investments of the common trust fund.
(4) The provisions of this paragraph may be illustrated by the
following example:
Example. (i) The plan of a common trust fund provides for quarterly
valuation dates and for the computation and the distribution of the
income upon a quarterly basis, except that there shall be no
distribution of capital gains. The participants are as follows: Trusts
A, B, C, and D for the first quarter; Trusts A, B, C, and E for the
second quarter; and Trusts A, B, F, and G for the third and fourth
quarters, the participants having equal participating interests. As
computed upon the quarterly basis, the ordinary taxable income, the
short-term capital gain, and the long-term capital loss for the taxable
year were as follows:
----------------------------------------------------------------------------------------------------------------
First Second Third Fourth
quarter quarter quarter quarter Total
----------------------------------------------------------------------------------------------------------------
Ordinary taxable income.......................................... $200 $300 $200 $400 $1,100
Short-term capital gain.......................................... 200 100 200 100 600
Long-term capital loss........................................... 100 200 100 200 600
----------------------------------------------------------------------------------------------------------------
(ii) The participants' shares of ordinary taxable income are as
follows:
Participants' Shares of Ordinary Taxable Income
----------------------------------------------------------------------------------------------------------------
First Second Third Fourth
Participant quarter quarter quarter quarter Total
----------------------------------------------------------------------------------------------------------------
A................................................................ $50 $75 $50 $100 $275
B................................................................ 50 75 50 100 275
C................................................................ 50 75 ....... ....... 125
D................................................................ 50 ....... ....... ....... 50
E................................................................ ....... 75 ....... ....... 75
F................................................................ ....... ....... 50 100 150
G................................................................ ....... ....... 50 100 150
----------------------------------------------
Total.......................................................... 200 300 200 400 1,100
----------------------------------------------------------------------------------------------------------------
(iii) The participants' shares of the short-term capital gain are as
follows:
Participants' Shares of Short-Term Capital Gain
------------------------------------------------------------------------
First Second Third Fourth
Participant quarter quarter quarter quarter Total
------------------------------------------------------------------------
A............................ $50 $25 $50 $25 $150
B............................ 50 25 50 25 150
C............................ 50 25 ....... ....... 75
D............................ 50 ....... ....... ....... 50
E............................ ....... 25 ....... ....... 25
F............................ ....... ....... 50 25 75
G............................ ....... ....... 50 25 75
------------------------------------------
Total...................... 200 100 200 100 600
------------------------------------------------------------------------
(iv) The participants' shares of the long-term capital loss are as
follows:
[[Page 375]]
Participants' Shares of Long-Term Capital Loss
------------------------------------------------------------------------
First Second Third Fourth
Participant quarter quarter quarter quarter Total
------------------------------------------------------------------------
A............................ $25 $50 $25 $50 $150
B............................ 25 50 25 50 150
C............................ 25 50 ....... ....... 75
D............................ 25 ....... ....... ....... 25
E............................ ....... 50 ....... ....... 50
F............................ ....... ....... 25 50 75
G............................ ....... ....... 25 50 75
------------------------------------------
Total...................... 100 200 100 200 600
------------------------------------------------------------------------
(v) If in the above example the common trust fund also had short-
term capital losses and long-term capital gains, the treatment of such
gains or losses would be similar to that accorded to the short-term
capital gains and long-term capital losses in the above example.
(vi) Assume in the above example that participant Trust A qualified
as a trust forming part of a pension, profit sharing, or stock bonus
plan under section 401(a). Assume further that 20 percent of the
ordinary taxable income of the common trust fund would be unrelated
business taxable income (as defined under section 512(a)(1)) if received
directly by Trust A. Under paragraph (c)(3), participant Trust A, for
purposes of computing its taxable income, must treat its proportionate
share of the common trust fund's ordinary taxable income as income from
an unrelated trade or business to the extent such amount would have been
income from an unrelated trade or business if Trust A had directly made
the investments of the common trust fund. Therefore, participant Trust A
must take into account 20 percent of its proportionate share of the
common trust fund's ordinary taxable income as income from an unrelated
trade or business.
(d) The provisions of part I, subchapter J, chapter 1 of the Code,
or, as the case may be, the provisions of subchapters D, F, or H of
chapter 1 of the Code, are applicable in determining the extent to which
each participant's proportionate share of any income or loss of the
common trust fund is taxable to the participant, or to a person other
than the participant.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7935, 49 FR
1694, Jan. 13, 1984; T.D. 8662, 61 FR 19546, May 2, 1996]
Sec. 1.584-3 Computation of common trust fund income.
The taxable income of the common trust fund shall be computed in the
same manner and on the same basis as in the case of an individual,
except that:
(a) No deduction shall be allowed under section 170 (relating to
charitable, etc., contributions and gifts);
(b) The gains and losses from sales or exchanges of capital assets
of the common trust fund are required to be segregated. A common trust
fund is not allowed the benefit of the capital loss carryover provided
by section 1212; and
(c) The ordinary taxable income (the excess of the gross income over
deductions) or the ordinary net loss (the excess of the deductions over
the gross income) shall be computed after excluding all items of gain
and loss from sales or exchanges of capital assets.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 7935, 49 FR
1694, Jan. 13, 1984]
Sec. 1.584-4 Admission and withdrawal of participants in the common
trust fund.
(a) Gain or loss. The common trust fund realizes no gain or loss by
the admission or withdrawal of a participant, and the basis of the
assets and the period for which they are deemed to have been held by the
common trust fund for the purposes of section 1202 are unaffected by
such an admission or withdrawal. For taxable years of participants
ending after April 7, 1976, and for transfers occurring after that date,
the transfer of property by a participant to a common trust fund is
treated as a sale or exchange of the property transferred. If a
participant withdraws the whole or any part of its participating
interest from the common trust fund, such withdrawal shall be treated as
a sale or exchange by the participant of the participating interest or
portion thereof which is so withdrawn. A participant is not deemed to
have withdrawn any part of its participating interest in the common
trust fund so as to have completed a closed transaction by reason of the
segregation and administration of an investment of the fund, pursuant to
the provisions of 12 CFR 9.18(b)(7) (or, for periods before September
28, 1962, 12 CFR206.17(c)(7)), for the benefit of all the then
participants in the common trust fund. Such segregated investment shall
be considered as held by, or on behalf of, the
[[Page 376]]
common trust fund for the benefit ratably of all participants in the
common trust fund at the time of segregation, and any income or loss
arising from its administration and liquidation shall constitute income
or loss to the common trust fund apportionable among the participants
for whose benefit the investment was segregated. When a participating
interest is transferred by a bank, or by two or more banks that are
members of the same affiliated group (within the meaning of section
1504), as a result of the combination of two or more common trust funds
or the division of a single common trust fund, the transfer to the
surviving or divided fund is not considered to be an admission or a
withdrawal if the combining, dividing, and resulting common trust funds
have diversified portfolios. For purposes of this paragraph (a), a
common trust fund has a diversified portfolio if it satisfies the 25 and
50-percent tests of section 368(a)(2)(F)(ii), applying the relevant
provisions of section 368(a)(2)(F). However, Government securities are
included in total assets for purposes of the denominator of the 25 and
50-percent tests (unless the Government securities are acquired to meet
the 25 and 50-percent tests), but are not treated as securities of an
issuer for purposes of the numerator of the 25 and 50-percent tests. In
addition, for a transfer of a participating interest in a division of a
common trust fund not to be considered an admission or withdrawal, each
participant's pro ratainterest in each of the resulting common trust
funds must be substantially the same as was the participant's pro rata
interest in the dividing fund. However, in the case of the division of a
common trust fund maintained by two or more banks that are members of
the same affiliated group resulting from the termination of such
affiliation, the division will be treated as meeting the requirements of
the preceding sentence if the written plans of operation of the
resulting common trust funds are substantially identical to the plan of
operation of the dividing common trust fund, each of the assets of the
dividing common trust fund are distributed substantially pro rata to
each of the resulting common trust funds, and each participant's
aggregate interest in the assets of the resulting common trust funds of
which he or she is a participant is substantially the same as was the
participant's pro rata interest in the assets of the dividing common
trust fund. The plan of operation of a resulting common trust fund will
not be considered to be substantially identical to that of the dividing
common trust fund where, for example, the plan of operation of the
resulting common trust fund contains restrictions as to the types of
participants that may invest in the common trust fund where such
restrictions were not present in the plan of operation of the dividing
common trust fund.
(b) Basis for gain or loss upon withdrawal. The participant's gain
or loss upon withdrawal of its participating interest or portion thereof
shall be measured by the difference between the amount received upon
such withdrawal and the adjusted basis of the participating interest or
portion thereof withdrawn plus the additions prescribed in paragraph (c)
of this section and minus the reductions prescribed in paragraph (d) of
this section. The amount received by the participant shall be the sum of
any money plus the fair market value of property (other than money)
received upon such withdrawal. The basis of the participating interest
or portion thereof withdrawn shall be the sum of any money plus the fair
market value of any property (other than money) contributed by the
participant to the common trust fund to acquire the participating
interest or portion thereof withdrawn. Such basis shall not be reduced
on account of the segregation of any investment in the common trust fund
pursuant to the provisions of 12 CFR 9.18(b)(7) (or, for periods before
September 28, 1962, 12 CFR 206.17(c)(7)). For the purpose of making the
adjustments, additions, and reductions with respect to basis as
prescribed in this paragraph, the ward, rather than the guardian, shall
be deemed to be the participant; and the grantor, rather than the trust,
shall be deemed to be the participant, to the extent that the income of
the trust is taxable to the grantor under subpart E (section 671 and
following), part I, subchapter J, chapter 1 of the Code.
[[Page 377]]
(c) Additions to basis. As prescribed in paragraph (b) of this
section, in computing the gain or loss upon the withdrawal of a
participating interest or portion thereof, there shall be added to the
basis of the participating interest or portion thereof withdrawn an
amount equal to the aggregate of the following items (to the extent that
they were properly allocated to the participant for a taxable year of
the common trust fund and were not distributed to the participant prior
to withdrawal):
(1) Wholly exempt income of the common trust fund for any taxable
year,
(2) Net income of the common trust fund for the taxable years
beginning after December 31, 1935, and prior to January 1, 1938,
(3) Net short-term capital gain of the common trust fund for each
taxable year beginning after December 31, 1937,
(4) The excess of the gains over the losses recognized to the common
trust fund upon sales or exchanges of capital assets held (i) for more
than 18 months for taxable years beginning after December 31, 1937, and
before January 1, 1942, (ii) for more than 6 months for taxable years
beginning after December 31, 1941, and before January 1, 1977, (iii) for
more than 9 months for taxable years beginning in 1977, and (iv) for
more than 1 year for taxable years beginning after December 31, 1977,
and
(5) Ordinary net or taxable income of the common trust fund for each
taxable year beginning after December 31, 1937.
(d) Reductions in basis. As prescribed in paragraph (b) of this
section, in computing the gain or loss upon the withdrawal of a
participating interest or portion thereof, the basis of the
participating interest or portion thereof withdrawn shall be reduced by
such portions of the following items as were allocable to the
participant with respect to the participating interest or portion
thereof withdrawn:
(1) The amount of the excess of the allowable deductions of the
common trust fund over its gross income for the taxable years beginning
after December 31, 1935, and before January 1, 1938, and
(2) The amount of the net short-term capital loss, net long-term
capital loss, and ordinary net loss of the common trust fund for each
taxable year beginning after December 31, 1937.
(e) Effective date. The eighth sentence of paragraph (a) of this
section is effective for combinations and divisions of common trust
funds completed on or after May 2, 1996.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6651, 28 FR
4950, May 17, 1963; T.D. 7935, 49 FR 1695, Jan. 13, 1984; T.D. 8662, 61
FR 19546, May 2, 1996; 61 FR 39072, July 26, 1996]
Sec. 1.584-5 Returns of banks with respect to common trust funds.
For rules applicable to filing returns of common trust funds, see
section 6032 and the regulations thereunder.
Sec. 1.584-6 Net operating loss deduction.
The net operating loss deduction is not allowed to a common trust
fund. Each participant in a common trust fund, however, will be allowed
the benefits of such deduction. In the computation of such deduction, a
participant in a common trust fund shall take into account its pro rata
share of items of income, gain, loss, deduction, or credit of the common
trust fund. The character of any such item shall be determined as if the
participant had realized such item directly from the source from which
realized by the common trust fund, or incurred such item in the same
manner as incurred by the common trust fund.
Sec. 1.585-1 Reserve for losses on loans of banks.
(a) General rule. As an alternative to a deduction from gross income
under section 166(a) for specific debts which become worthless in whole
or in part, a financial institution to which section 585 and this
section apply shall be allowed a deduction under section 585(a) (or, for
taxable years beginning before January 1, 1987, section 166(c)), for a
reasonable addition to a reserve for bad debts provided such financial
institution has adopted or adopts the reserve method of treating bad
debts in accordance with paragraph (b) of Sec. 1.166-1. In the case of
such a taxpayer the amount
[[Page 378]]
of the reasonable addition to such reserve for a taxable year beginning
after July 11, 1969, shall be an amount determined by the taxpayer which
does not exceed the amount computed under Sec. 1.585-2. Such reasonable
addition for the taxable year shall be an amount at least equal to the
amount provided by Sec. 1.585-2(a)(2). For each taxable year the
taxpayer must include in its income tax return (or amended return) for
that year a computation of the amount of the addition determined under
this section showing the method used to determine that amount. The use
of a particular method in the return for a taxable year is not a binding
election by the taxpayer to apply such method either for such taxable
year or for subsequent taxable years. A financial institution to which
section 585 and this section apply which adopts the reserve method is
not entitled to charge off any bad debts pursuant to section 166(a) with
respect to a loan (as defined in Sec. 1.585-2(e)(2). Except as provided
by Sec. 1.585-3, the reserve for bad debts of a financial institution
to which section 585 and this section apply shall be established and
maintained in the same manner as is provided by section 585 (or, for
taxable years beginning before January 1, 1987, section 166(c)) and
theregulations under section 166 with respect to reserves for bad debts.
Except as provided by this section, no deduction is allowable for an
addition to a reserve for losses on loans as defined in Sec. 1.585-
2(e)(2) of a financial institution to which section 585 and this section
apply. For rules relating to deduction with respect to debts which are
not loans (as defined in Sec. 1.585-2(e)(2)), see section 166(a) and
the regulations thereunder. For rules relating to a debt evidenced by a
security (as defined in section 165(g)(2)(C), see sections 166 and
582(a) and the regulations thereunder. For the definition of certain
terms, see paragraph (e) of Sec. 1.585-2. For rules relating to a
transaction to which section 381(a) applies, see Sec. 1.585-4. For
rules relating to large banks, see Sec. Sec. 1.585-5 through 1.585-8.
(b) Application of section--(1) In general. Except as provided in
paragraph (b)(2) of this section, section 585 and this section apply to
the following financial institutions--
(i) Any bank (as defined in section 581 and the regulations
thereunder) other than a mutual savings bank, domestic building and loan
association, or cooperative bank, to which section 593 applies; and
(ii) Any corporation to which paragraph (b)(1)(i) of this section
would apply except for the fact that it is a foreign corporation and in
the case of any such foreign corporation, the rules provided by section
585(a) and (b), this section, Sec. Sec. 1.585-2, 1.585-3, and 1.585-4
apply only with respect to loans outstanding the interest on which is
effectively connected with the conduct of a banking business within the
United States.
(2) Exception. For taxable years beginning after December 31, 1986,
section 585(a) and (b) and this section do not apply to any large bank
(as defined in Sec. 1.585-5(b)). For these years, a large bank may not
deduct any amount under section 585 or any other section for an addition
to a reserve for bad debts.
(Sec. 585(b)(4), of the Internal Revenue Code of 1954 (83 Stat. 618; (26
U.S.C. 585(b)(4))))
[T.D. 7532, 43 FR 3109, Jan. 23, 1978, as amended by T.D. 8513, 58 FR
68757, Dec. 29, 1993; 59 FR 15502, Apr. 1, 1994]
Sec. 1.585-2 Addition to reserve.
(a) In general--(1) Maximum addition. For taxable years beginning
before January 1, 1988, the maximum reasonable addition to the reserve
for losses on loans as defined in paragraph (e)(2) of this section is
the amount allowable under the percentage method provided by paragraph
(b) of this section or the experience method provided by paragraph (c)
of this section, whichever is greater. For taxable years beginning after
December 31, 1987, the maximum reasonable addition to the reserve for
losses on loans is the amount determined under the experience method
provided by paragraph (c) of this section.
(2) Minimum addition. For taxable years beginning after December 31,
1976, and before January 1, 1988, a taxpayer to which this section
applies shall make a minimum addition to the reserve for losses on loans
as defined in paragraph (e)(2) of this section. For purposes of this
subparagraph, the
[[Page 379]]
term minimum addition means an addition to the reserve for losses on
loans in an amount equal to the lesser of (i) the amount allowable under
section 585 (b)(3)(A) and paragraph (c)(1)(ii) of this section, or (ii)
the maximum amount allowable under section 585 (b)(2) and paragraph (b)
of this section. For taxable years beginning after December 31, 1987, a
taxpayer to which this section applies shall make a minimum addition to
the reserve for losses on loans for each taxable year in an amount equal
to the amount allowable under section 585 (b)(3)(A) and paragraph
(c)(1)(ii) of this section.
(b) Percentage method--(1) In general--(i) Maximum addition. Except
as limited under subparagraph (2) of this paragraph, the maximum
reasonable addition to the reserve for losses on loans under the
percentage method for a taxable year is the amount determined under
paragraph (b)(1) (ii), (iii), or (iv) of this section, whichever is
applicable. For purposes of this paragraph, the term allowable
percentage means 1.8 percent for taxable years beginning before 1976;
1.2 percent for taxable years beginning after 1975 but before 1982; 1.0
percent for taxable years beginning in 1982; and 0.6 percent for taxable
years beginning after 1982 and before 1988. This paragraph does not
apply for taxable years beginning after 1987.
(ii) Reserve less than allowable percentage of eligible loans. (A)
If the reserve for losses on loans as of the close of the base year is
less than the allowable percentage for the taxable year multiplied by
the eligible loans outstanding at the close of the base year, the amount
determined under this subdivision for the taxable year is the amount
necessary to increase the balance of the reserve for losses on loans as
of the close of the taxable year to an amount equal to the allowable
percentage for the taxable year multiplied by the eligible loans
outstanding at the close of that year, except that the amount determined
with respect to the reserve deficiency shall not exceed one-fifth of the
reserve deficiency. For purposes of this section, the term reserve
deficiency means the excess of the allowable percentage for the taxable
year multiplied by the eligible loans outstanding at the close of the
base year over the reserve forlosses on loans as of the close of the
base year. Where a taxpayer has recoveries of bad debts for a taxable
year which exceed the bad debts sustained for such year, the taxpayer is
not required to reduce its otherwise permissible current addition by the
amount of the net recovery. A reasonable addition attributable to an
increase in eligible loans outstanding at the close of the taxable year
over eligible loans outstanding at the close of the base year may be
made only for the portion of such increase which does not exceed the
excess of eligible loans outstanding at the close of the taxable year
over the sum of the amount of eligible loans outstanding at the close of
the base year and the amount of previous increases in such loans for
which an addition was made in taxable years ending after the close of
the base year. For purposes of this subdivision, the order in which the
factors which make up the annual reserve addition shall be claimed is:
(1) An amount equal to one-fifth of the reserve deficiency;
(2) Net bad debts charged to the reserve; and
(3) An amount attributable to an increase in the amount of eligible
loans outstanding.
(B) For its first taxable year, a newly organized financial
institution to which Sec. 1.585-1 and this section apply shall be
considered to have no reserve deficiency. For example, a new financial
institution would compute its annual reserve addition by including in
such addition an amount not in excess of the sum of (1) the amount of
its net bad debts charged to the reserve for the taxable year, and (2)
the allowable percentage of the increase in its eligible loans
outstanding at the close of the taxable year over the amount of its
loans outstanding (zero) at the end of the year preceding its first
taxable year. Such amount would be subject to the 0.6 percent
limitations provided in subparagraph (2) of the paragraph.
(C) The application of the rules provided by this subdivision may be
illustrated by the following example:
Example. The X Bank is a commercial bank which has a calendar year
as its taxable year. X adopted the reserve method of accounting for bad
debts in 1950. On December
[[Page 380]]
31, 1969, X has $1,000,000 of outstanding eligible loans and a balance
of $13,000 in its reserve for losses on loans. The base year is 1969
and, consequently, X has a reserve deficiency of $5,000 ((1.8% x
$1,000,000) - $13,000).
(a) During 1970, X has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1970, X has $1,050,000 of
outstanding eligible loans. The maximum reasonable addition under the
percentage method is $2,900 which consists of $1,000 of reserve
deficiency (\1/5\ x $5,000), the $1,000 in net bad debts charged to the
reserve for losses on loans, and $900 attributable to the increase in
the balance of eligible loans (1.8% x ($1,050,000 - $1,000,000)).
Assuming that X makes an addition to the reserve for losses on loans of
$2,900 for the year, the balance of the reserve as of December 31, 1970
is $14,900 ($13,000 - $1,000 + $2,900).
(b) During 1971, X has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1971, X has $800,000 of
outstanding eligible loans. The allowable percentage of eligible loans
is $14,400 (1.8% x $800,000). The maximum reasonable addition under the
percentage method is $500 which is a portion of one-fifth of the reserve
deficiency. Assuming that X makes an addition to the reserve for losses
on loans of $500 for the year, the balance of the reserve as of December
31, 1971, is $14,400 ($14,900 - $1,000 + $500).
(c) During 1972, X has net bad debts of $600 charged to the reserve
for losses on loans. On December 31, 1972, X has $850,000 of outstanding
eligible loans. The allowable percentage of eligible loans is $15,300
(1.8% x $850,000). The maximum reasonable addition under the percentage
method is $1,500 which consists of $1,000 of reserve deficiency (\1/5\ x
$5,000) and $500 of the net bad debts charged to the reserve for losses
on loans in 1971. Even though the full addition with respect to the
reserve deficiency in 1971 was not made, the amount of the addition that
can be made in 1972 with respect to the reserve deficiency is limited to
one-fifth of such deficiency. Assuming that X makes an addition to the
reserve for losses on loans of $1,500 for the year, the balance of the
reserve as of December 31, 1972, is $15,300 ($14,400 - $600 + $1,500).
(d) During 1973, X did not have any net bad debts charged to the
reserve for losses on loans. On December 31, 1973, X has $1,000,000 of
outstanding eligible loans. The allowable percentage of eligible loans
is $18,000 (1.8% x $1,000,000). The maximum reasonable addition under
the percentage method is $2,100 which consists of $1,000 of reserve
deficiency (\1/5\ x $5,000), $500 of net bad debts charged to the
reserve for losses in 1971, and $600 of net bad debts charged to the
reserve in 1972. Although outstanding eligible loans increased from
$850,000 in 1972 to $1,000,000 in 1973, no addition is permitted with
respect to the increase because the amount of eligible loans outstanding
at the close of 1973 ($1,000,000) does not exceed the sum of the amount
of such loans at the close of the base year ($1,000,000) and the amount
of previous increases in such loans for which an addition was made in
taxable years ending after the close of the base year ($50,000 loan
increase in 1970). Assuming that X makes an addition to the reserve for
losses on loans of $2,100, the balance of the reserve as of December 31,
1973, is $17,400 ($15,300 + $2,100).
(iii) Reserve equal to or greater than allowable percentage and
eligible loans have not declined. If the reserve for losses on loans as
of the close of the base year is equal to or greater than the allowable
percentage for the taxable year multiplied by the eligible loans
outstanding at the close of the base year and if the amount of eligible
loans outstanding at the close of the taxable year is equal to or
greater than the amount of eligible loans outstanding at the close of
the base year, the amount determined under this subdivision is the
amount necessary to increase the reserve to the greater of (A) the
allowable percentage for the taxable year multiplied by the eligible
loans outstanding at the close of the year, or (B) the balance of the
reserve as of the close of the base year. The application of the rule
provided by this subdivision may be illustrated by the following
example:
Example. The M Bank is a commercial bank which has a calendar year
as its taxable year. M adopted the reserve method of accounting for bad
debts in 1950. On December 31, 1969, M has $1,000,000 of outstanding
eligible loans and a balance of $20,000 in its reserve for losses on
loans.
(a) During 1970, M has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1970, M has $1,100,000 of
outstanding eligible loans. The allowable percentage of eligible loans
is $19,800 (1.8% x $1,100,000). The maximum reasonable addition under
the percentage method is $1,000 which is the amount sufficient to
increase the balance of the reserve as of the close of the taxable year
to the balance of the reserve as of the close of the 1969 base year
($20,000). Assuming that M makes an addition to the reserve for losses
on loans of $1,000 for the year, the balance of the reserve as of
December 31, 1970, is $20,000 ($20,000 - $1,000 + $1,000).
(b) During 1971, M has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1971, M has $1,300,000 of
outstanding eligible loans. The allowable percentage of eligible loans
is $23,400 (1.8% x
[[Page 381]]
$1,300,000). The maximum reasonable addition under the percentage method
is $4,400 which is the amount sufficient to increase the balance of the
reserve to the allowable percentage of eligible loans outstanding at the
close of the taxable year. Assuming that M makes an addition to the
reserve for losses on loans of $4,400 for the year, the balance of the
reserve as of December 31, 1971, is $23,400 ($20,000 - $1,000 + $4,400).
(c) During 1972, M has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1972, M has $1,200,000 of
outstanding eligible loans. The allowable percentage of eligible loans
is $21,600 (1.8% x $1,200,000). No reasonable addition may be made under
the percentage method because the reserve for losses on loans ($22,400,
i.e., $23,400-$1,000) is greater than the allowable percentage of
eligible loans outstanding at the close of the taxable year ($21,600)
and the balance of the reserve as of the close of the base year
($20,000). Assuming that no amount is added under the experience method
provided by paragraph (c) of this section, the balance of the reserve
for losses on loans as of December 31, 1972, is $22,400 ($23,400-
$1,000).
(d) During 1973, M has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1973, M has $1,200,000 of
outstanding eligible loans. The allowable percentage of eligible loans
is $21,600 (1.8% x $1,200,000). The maximum reasonable addition under
the percentage method is $200 which is the amount sufficient to increase
the reserve for losses on loans to the allowable percentage of eligible
loans outstanding at the close of the taxable year. Assuming that M
makes an addition to the reserve for losses on loans of $200 for the
year, the balance of the reserve as of December 31, 1973, is $21,600
($22,400-$1,000 + $200).
(iv) Reserve greater than allowable percentage and eligible loans
have declined. If the reserve for losses on loans as of the close of the
base year is equal to or greater than the allowable percentage of
eligible loans outstanding at such time and if the amount of eligible
loans at the close of the taxable year is less than the amount of
eligible loans outstanding at the close of the base year, the amount
determined under this subdivision is the amount necessary to increase
the balance of the reserve to the amount which bears the same ratio to
eligible loans outstanding at the close of the taxable year as the
balance of the reserve as of the close of the base year bears to the
amount of eligible loans outstanding at the close of the base year. The
application of the rule provided by this subdivision may be illustrated
by the following example:
Example. The N Bank is a commercial bank which has a calendar year
as its taxable year. N adopted the reserve method of accounting for bad
debts in 1950. On December 31, 1969, N has $1,000,000 of outstanding
eligible loans and a balance of $20,000 in its reserve for losses on
loans.
(a) During 1970, N has net bad debts of $3,000 charged to the
reserve for losses on loans. On December 31, 1970, N has $900,000 of
outstanding eligible loans. The maximum reasonable addition under the
percentage method is $1,000, which is the amount necessary to increase
the balance of the reserve to the amount ($18,000) which bears the same
ratio to eligible loans outstanding at the close of the taxable year
($900,000) as the balance of the reserve as of the close of the base
year ($20,000) bears to the amount of the eligible loans outstanding at
the close of the base year ($1,000,000). Assuming that N makes an
addition to the reserve for losses on loans of $1,000 for the year, the
balance of the reserve as of December 31, 1970, is $18,000 ($20,000-
$3,000 + $1,000).
(b) During 1971, N has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1971, N has $1,100,000 of
outstanding eligible loans. The maximum reasonable addition under the
percentage method, determined under subdivision (iii) of this
subparagraph, is $3,000 which is the amount necessary to increase the
balance of the reserve to the greater of the allowable percentage of
eligible loans outstanding at the close of the taxable year ($19,800) or
the balance of the reserve at the close of the base year ($20,000).
Assuming that N makes an addition to the reserve for losses on loans of
$3,000 for the year, the balance of the reserve as of December 31, 1971
is $20,000 ($18,000-$1,000 + $3,000).
(2) Limitations. Notwithstanding any other provision of this
paragraph, the maximum reasonable addition to the reserve for losses on
loans under the percentage method shall not exceed the greater of:
(i) Six-tenths of 1 percent of the eligible loans outstanding at the
close of the taxable year, or
(ii) An amount sufficient to increase the reserve for losses on
loans at the close of the taxable year to six-tenths of 1 percent of the
eligible loans outstanding at the close of the taxable year.
The application of the rules provided by this subparagraph may be
illustrated by the following example:
[[Page 382]]
Example. The Y Bank begins business as a commercial bank on July 1,
1974. Y adopts the calendar year as its taxable year and the reserve
method of accounting for bad debts.
(a) During 1974, Y has net bad debts of $1,000. On December 31,
1974, Y has $1,000,000 of outstanding eligible loans. Under subparagraph
(1)(ii)(B) of this paragraph, because Y is a newly-organized financial
institution, there is no reserve deficiency. Except for the limitations
of this subparagraph, the maximum reasonable addition under subparagraph
(1)(ii)(A) of this paragraph would be the amount of net bad debts
charged to the reserve for losses ($1,000) plus the allowable percentage
of outstanding eligible loans at the close of the taxable year $18,000
(1.8% x $1,000,000). However, because of the limitations of this
subparagraph, the maximum reasonable addition to the reserve for losses
on loans under the percentage method is an amount sufficient to increase
the balance of the reserve for losses on loans to $6,000 which is 0.6
percent of the eligible loans outstanding at the close of the taxable
year. Assuming that Y makes an addition to the reserve for losses on
loans of $7,000 for the year, the balance of the reserve as of December
31, 1974, is $6,000 ($7,000-$1,000). The $7,000 consists of the $1,000
in net bad debts and $6,000 attributable to the increase in eligible
loans outstanding.
(b) During 1975, Y has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1975, Y has $1,000,000 of
outstanding eligible loans. Except for the limitations of this
subparagraph, the maximum reasonable addition under subparagraph
(1)(ii)(A) of this paragraph would be the amount of net bad debts
charged to the reserve for losses ($1,000) plus an amount attributable
to the increase in the amount of eligible loans outstanding with respect
to which no reasonable addition was allowed in 1974 ($12,000, i.e.,
$18,000-$6,000). However, because of the limitations of this paragraph,
the maximum reasonable addition to the reserve for losses on loans under
the percentage method is $6,000 which is an amount equal to 0.6 percent
of the eligible loans outstanding at the close of the taxable year. This
amount consists of net bad debts of $1,000 and $5,000 attributable to a
portion of the increase in eligible loans in 1974 with respect to which
no reasonable addition was allowable for 1974. Assuming that Y makes an
addition to the reserve for losses on loans of $6,000 for the year, the
balance of the reserve as of December 31, 1975, is $11,000 ($6,000-
$1,000 + $6,000).
(c) During 1976, Y has net bad debts charged to the reserve for
losses on loans of $1,000. On December 31, 1976, Y has $1,000,000 in
outstanding eligible loans. At the close of 1975 (Y's base year for
1976), the amount of outstanding eligible loans was also $1,000,000.
Consequently, there is a reserve deficiency of $1,000 ((1.2% x
$1,000,000)--$11,000). The maximum reasonable addition to the reserve
for losses under subparagraph (1)(ii)(A) of this paragraph is $1,200
which consists of one-fifth of the reserve deficiency ($1,000 x \1/5\ =
$200) and the net bad debts charged to the reserve for losses on loans
for the year ($1,000). Because that amount is less than 0.6 percent of
the eligible loans outstanding at the close of the taxable year (0.6% x
$1,000,000 = $6,000), the limitations of this subparagraph do not apply.
Assuming that Y makes an addition to the reserve for losses on loans of
$1,200 for the year, the balance of the reserve as of December 31, 1976,
is $11,200 ($11,000-$1,000 + $1,200).
(c) Experience method--(1) In general--(i) Maximum addition. The
amount determined under this paragraph for a taxable year is the amount
necessary to increase the balance of the reserve for losses on loans (as
of the close of the taxable year) to the greater of the amount
determined under subdivision (ii) or (iii) of this subparagraph. For
special rules for a new financial institution, see subparagraph (2) of
this paragraph.
(ii) Six-year moving average amount. The amount determined under
this subdivision is the amount which bears the same ratio to loans
outstanding at the close of the taxable year as (A) the total bad debts
sustained during the taxable year and the 5 preceding taxable years (or,
with the approval of the Commissioner, a shorter period), adjusted for
recoveries of bad debts during such period, bears to (B) the sum of the
loans outstanding at the close of such 6 (or fewer) taxable years. For
purposes of applying this subdivision, a period shorter than 6 years
generally would be appropriate only where there is a change in the type
of a substantial portion of the loans outstanding such that the risk of
loss is substantially increased. For example, if the major portion of a
bank's portfolio of loans changes fromagricultural loans to industrial
loans which results in a substantial increase in the risk of loss, a
period shorter than 6 years may be appropriate. Similarly, a bank which
has recently altered its lending practices to include in its portfolio
of loans consumer-installment loans, when it had previously made only
commercial loans, may also qualify to use a period shorter than six
years. A decline in the general economic conditions in the
[[Page 383]]
area, which substantially increase the risk of loss, is a relevant
factor which may be considered. In any case, however, approval to use a
shorter period will not be granted unless the taxpayer supplies specific
evidence that the loans outstanding at the close of the taxable years
for the shorter period requested are not comparable in nature and risk
to loans outstanding at the close of the six taxable years. The fact
that a bank's bad debt experience has shown a substantial increase is
not, by itself, sufficient to justify use of a shorter period. If
approval is granted to use a shorter period, the experience for those
taxable years which are excluded shall not be used for any subsequent
year. A request for approval to exclude the experience of a prior
taxable year shall not be considered unless it is sent to the
Commissioner at least 30 days before the close of the first taxable year
for which such approval is requested.
(iii) Base year amount. The amount determined under this subdivision
is the lower of (A) the balance of the reserve as of the close of the
base year, or (B) if the amount of loans outstanding at the close of the
taxable year is less than the amount of loans outstanding at the close
of the base year, the amount which bears the same ratio to loans
outstanding at the close of the taxable year as the balance of the
reserve as of the close of the base year bears to the amount of loans
outstanding at the close of the base year.
(2) Special rules for new financial institutions--(i) In general. In
the case of any taxable year preceded by less than 5 authorization years
(as defined in paragraph (e)(5) of this section), subparagraph (1) of
this paragraph shall be applied with the adjustments provided by
subdivision (ii) of this subparagraph.
(ii) Adjustments. (A) The total bad debts for the 6-year period
computed under subparagraph (1)(ii)(A) of this paragraph shall be the
sum of:
(1) The bad debts sustained by the taxpayer during its authorization
years, adjusted for recoveries of bad debts for such years, and
(2) That fraction of the total bad debts sustained by a comparable
bank (as defined in paragraph (e)(7) of this section) during the
comparison years (as defined in paragraph (e)(6) of this section),
adjusted for recoveries of bad debts for such years, which bears the
same ratio to such total as the average loans outstanding of the
taxpayer during the authorization years bears to the average loans
outstanding of the comparable bank during the comparison years.
(B) The total amount of loans outstanding during the 6-year period
computed under subparagraph (1)(ii)(B) of this paragraph shall be six
times the average loans outstanding of the taxpayer during the
authorization years.
(d) Change in accounting method from specific charge-off method to
reserve method of treating bad debts--(1) In general. If a bank is
granted permission in accordance with Sec. 1.446-1(e)(3) to change its
method of accounting for bad debts from a method under which specific
bad debt items are deducted to the reserve method of treating bad debts,
the taxpayer shall effect the change as provided in subparagraphs (2)
and (3) of this paragraph.
(2) Initial balance of the reserve. The initial balance of the
reserve at the close of the year of change shall be no less than the
minimum addition as described in paragraph (a)(2) of this section and
shall be no larger than the greater of:
(i) The allowable percentage of eligible loans outstanding at the
close of the taxable year of change, or
(ii) The amount which bears the same ratio to loans outstanding at
the close of the taxable year as the total bad debts sustained during
the taxable year and the 5 preceding taxable years (or, with the
approval of the Commissioner, a shorter period), adjusted for recoveries
of bad debts during such period, bears to the sum of the loans
outstanding at the close of such 6 or fewer taxable years.
In the case of taxable years beginning after 1987, the initial balance
of the reserve at the end of the year of change shall be the amount
specified in subdivision (ii) of this subparagraph.
(3) Deduction with respect to initial balance. The deduction with
respect to the initial balance of the reserve at the close of the
taxable year of change, determined under subparagraph (2) of this
[[Page 384]]
paragraph, is allowable ratably over a period of 10 years commencing
with the taxable year of change (or a shorter period as may be approved
by the Commissioner). Thus, the bad debt deduction under section 166 for
the taxable year of change will consist of the amount of debts
determined to be wholly or partially worthless and charged-off during
such taxable year plus one-tenth (if a 10-year period is used) of the
amount of the reserve determined under subparagraph (2) of this
paragraph. For each of the 9 taxable years following the taxable year of
change, the bad debt deduction will consist of the reasonable addition
to the reserve for bad debts for each such year as provided by section
585, as otherwise determined, plus one-tenth of the amount determined to
be theinitial balance of the reserve under subparagraph (2) of this
paragraph. The amount established as a bad debt reserve for the taxable
year of change under subparagraph (2) of this paragraph shall be
considered as the balance of the reserve for purposes of determining the
amount of subsequent additions to such reserve, even though the entire
amount of the reserve may not have been deducted under section 585(a)(1)
or former section 166(c) because of the requirement that it be deducted
over a number of years.
(e) Definitions--(1) Base year--(i) Percentage method. For purposes
of paragraph (b) of this section (relating to the percentage method),
the term base year means: For years beginning before 1976, the last
taxable year beginning on or before July 11, 1969; for taxable years
beginning after 1975 but before 1983, the last taxable year beginning
before 1976; and, for taxable years beginning after 1982, the last
taxable year beginning before 1983. However, for purposes of section
585(b)(2)(A) the term base year means the last taxable year before the
most recent adoption of the percentage method, if later than the base
year as determined under the preceding sentence.
(ii) Experience method. For purposes of paragraph (c) of this
section (relating to the experience method), the term base year means
(A) the last taxable year before the most recent adoption of the
experience method, or (B) the last taxable year beginning on or before
July 11, 1969, which ever is later; and for taxable years beginning
after 1987, the last taxable year beginning before 1988.
(iii) Example. The application of the rules provided by this
subparagraph may be illustrated by the following example:
Example. The T Bank is a commercial bank which has a calendar year
as its taxable year. T adopted the reserve method of accounting for bad
debts in 1950. On December 31, 1969, T has $1,000,000 of outstanding
eligible loans and a balance of $19,300 in its reserve for losses on
loans.
(a) During 1970, T has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1970, T has $1,050,000 of
outstanding eligible loans. T elects the percentage method. The base
year is 1969. The maximum reasonable addition under the percentage
method of $1,000 which is the amount sufficient to increase the balance
of the reserve as of the close of the taxable year to the balance of the
reserve as of the close of the base year 1969 ($19.300). Assuming that T
makes an addition to the reserve for losses on loans of $1,000 for the
year, the balance of the reserve for losses on loans as of December 31,
1970, is $19,300 ($19,300-$1,000 + $1,000).
(b) During 1971, T has net bad debts of $8,000 charged to the
reserve for losses on loans. On December 31, 1971, T has $1,100,000 of
outstanding eligible loans. T elects the experience method. The base
year is 1970. The maximum reasonable addition under the experience
method is $8,000 which is the amount sufficient to increase the balance
of the reserve as of the close of the taxable year to the balance of the
reserve as of the close of the 1970 base year ($19,300). Assuming that T
makes an addition to the reserve for losses on loans of $8,000 for the
year, the balance of the reserve for losses on loans as of December 31,
1971, is $19,300, ($19,300-$8,000 + $8,000).
(c) During 1972, T has net bad debts of $1,000 charged to the
reserve for losses on loans. On December 31, 1972, T has $1,200,000 of
outstanding eligible loans. T elects the percentage method. The base
year is 1971 and there is a reserve deficiency of $500 ((1.8% x
$1,100,000)-$19,300). The maximum reasonable addition under the
percentage method is $2,900 which consists of $100 of reserve deficiency
(\1/5\ x $500), the $1,000 in net bad debts charged to the reserve for
losses on loans, and $1,800 attributable to the increase in the balance
of eligible loans (1.8% x ($1,200,000-$1,100,000)). Assuming that T
makes an addition to the reserve for losses on loans of $2,900 for the
year, the balance of the reserve for losses on loans as of December 31,
1972, is $21,200 ($19,300-$1,000 + $2,900).
[[Page 385]]
(2) Loan--(i) General rule. For purposes of this section and
Sec. Sec. 1.585-1, 1.585-3, and 1.585-4, the term loan means debt as
the term debt is used in section 166 and the regulations thereunder. The
term loan includes (but is not limited to) the following items:
(A) An overdraft in one or more deposit accounts by a customer in
good faith whether or not other deposit accounts of the same customer
have balances in excess of the overdraft;
(B) A bankers acceptance purchased or discounted by a bank; and
(C) A loan participation to the extent that the taxpayer bears a
risk of loss.
For purposes of (B) of this subdivision (i), a bankers acceptance
shall be considered as a loan made by the bank which purchased or
discounted the bankers acceptance and not a loan made by the originating
bank.
(ii) Exceptions. Notwithstanding the provisions of subdivision (i)
of this subparagraph, the term loan does not include the following
items:
(A) Discount or interest receivable reflected in the face amount of
an outstanding loan, which discount or interest has not been included in
gross income;
(B) For taxable years beginning after December 31, 1976, commercial
paper, however acquired by the bank, including, for example, short-term
promissory notes which may be purchased on the open market;
(C) For taxable years beginning after December 31, 1976, a debt
evidenced by a security (as defined in section 165(g)(2)(C) and the
regulations thereunder);
(D) Any loan which is entered into or acquired for the primary
purpose of enlarging the otherwise available bad debt deduction;
(E) Loans which have been contractually committed to the extent that
funds have not been disbursed to the borrower or disbursed on behalf of
the borrower; and
(F) Any transaction which is in violation of a Federal or State
statute that governs the activities of the financial institution.
(3) Eligible loan--(i) General rule. For purposes of this section
and Sec. Sec. 1.585-3 and 1.585-4, the term eligible loan means a loan
(as defined in subparagraph (2) of this paragraph) which is incurred in
the course of the normal customer loan activities of a financial
institution and which is not a loan described in subdivision (ii) of
this subparagraph. Nothing within the preceding sentence will be
construed to exclude from the term eligible loan a bona fide loan in a
new market or under a novel repayment arrangement if the likelihood of
nonrepayment is at least as great as that of other customer loans of the
financial institution.
(ii) Exceptions. Loans which do not constitute eligible loans
include:
(A) A loan to a bank (as defined in section 581 and the regulations
thereunder) or to a domestic branch of a foreign corporation to which
Sec. 1.585-1 applies, including a repurchase transaction or other
similar transaction;
(B) Bank funds on deposit in any bank (foreign or domestic) such as
a deposit represented by a certificate of deposit or any other form of
instrument evidencing the deposit of a sum of money with the issuing
bank that will be available on or after a stated date or period of time;
(C) A sale or loan of Federal funds irrespective of the purchaser or
borrower;
(D) A loan, to the extent that it is directly or indirectly made to,
guaranteed by, or insured by the United States, a possession or
instrumentality thereof, or a State or political subdivision thereof;
and
(E) A loan which is secured by a deposit in the lending financial
institution or in a bank as defined in section 581 or a domestic branch
of a foreign corporation to which this section applies to the extent
that the financial institution has control over withdrawal of such
deposit.
(iii) Definition of loan which is secured by a deposit. For purposes
of subdivision (ii)(E) of this subparagraph:
(A) A loan is considered secured if the loan is on the security of
any instrument which makes the deposit specific security for the payment
of the loan, provided that such instrument is of such a nature that in
the event of default the deposit could be subjected to the satisfaction
of the loan;
(B) A deposit includes a guarantee deposit in the form of a
holdback,
[[Page 386]]
pledged collateral that has been reduced to cash, and loan payments that
are maintained in a separate account; and
(C) Control over the withdrawal of a deposit is evidenced by
possession of a passbook, certificate of deposit, note, or other similar
instrument the possession of which is normally required to permit
withdrawal. The lending financial institution does not have control over
withdrawal of the deposit if the deposit can be withdrawn without
consent of the lending financial institution. Thus, the lending
financial institution normally does not have control over the withdrawal
of a deposit in an account merely because the borrower agrees to
maintain a minimum, average, or compensating balance.
(4) Predecessor. For purposes of this section, the term predecessor
means (i) any taxpayer which transferred more than 50 percent of the
total amount of its assets to the taxpayer and is described in Sec.
1.585-1, or (ii) any predecessor of such predecessor.
(5) Authorization years. For purposes of this section, the term
authorization years means the number of years, containing 12 complete
months, between (i) the first day of the first full taxable year of the
taxpayer for which it (or any predecessor) was authorized to do business
as a financial institution described in Sec. 1.585-1, and (ii) the
taxable year.
(6) Comparison years. For purposes of this section, the term
comparison years means those consecutive taxable years containing 12
complete months of a comparable bank, the last of which ends within 12
months immediately preceding the beginning of the first taxable year of
the taxpayer, which are equal in number to six minus the number of
authorization years of the taxpayer.
(7) Comparable bank. For purposes of this section, the term
comparable bank means all the financial institutions described in Sec.
1.585-1 located within the same Federal Reserve district.
(8) Average loans outstanding. For purposes of this section, the
term average loans outstanding means the sum of the loans outstanding at
the close of each taxable year of a period divided by the number of
taxable years in such period.
(9) Adjusted for recoveries of bad debts. For purposes of this
section, the term adjusted for recoveries of bad debts means an
adjustment for the full amount recovered with respect to bad debts
previously charged to the reserve during any of the applicable taxable
years.
(Sec. 585(b)(4), of the Internal Revenue Code of 1954 (83 Stat. 618; (26
U.S.C. 585(b)(4))))
[T.D. 7532, 43 FR 3109, Jan. 23, 1978, as amended by T.D. 7835, 47 FR
42342, Sept. 27, 1982; T.D. 8513, 58 FR 68757, Dec. 29, 1993]
Sec. 1.585-3 Special rules.
(a) Treatment of reserve. For taxable years beginning after July 11,
1969, if a financial institution to which section 585 and Sec. 1.585-1
apply establishes a reserve pursuant to section 585(a) (or, for taxable
years beginning before January 1, 1987, section 166(c)), any bad debt in
respect of a loan (whether or not such loan is an eligible loan) must be
charged to the reserve for losses on loans provided for by Sec. 1.585-1
for the taxable year in which the bad debt occurs. For such a year, any
recovery of a bad debt previously charged to the reserve account in
respect of a loan (whether or not such loan is an eligible loan) must be
credited to such reserve in the taxable year of recovery regardless of
whether such credit causes the reserve to exceed the permissible amount.
If, as a result of net recoveries during the taxable year, the reserve
balance exceeds the permissible amount, a taxpayer is not required to
report the excess as taxable income. In such a case, the excess over the
otherwise permissible amount in the reserve account precludes current
reasonable additions to the reserve and may affect future reasonable
additions. Recoveries of bad debts which were not charged to the reserve
shall not be credited to such reserve, but shall be treated as taxable
income subject to the provisions of section 111. No item other than a
loan as defined in Sec. 1.585-2 (e)(2) shall be charged to the reserve
for losses on loans.
(b) Accounting for reserve. A financial institution to which section
585 and Sec. 1.585-1 apply which establishes a reserve pursuant to
section 585(a) (or, for taxable years beginning before January 1, 1987,
section 166(c)) shall establish and maintain a permanent record of
[[Page 387]]
such reserve. Copies of Federal income tax returns and amended returns
with attached schedules satisfy the requirements of this paragraph
provided that such returns are permanently maintained by the financial
institution and the balance of the reserve for losses on loans
established pursuant to section 585(a) (or former section 166(c)) can be
readily reconciled with the reservefor losses on loans maintained by the
financial institution for financial statement purposes. The requirements
of this paragraph would also be satisfied if a financial institution
establishes and maintains a permanent subsidiary ledger reflecting an
account for the reserve for losses on loans established pursuant to
section 585(a) (or former section 166(c)) provided the balance in such
account can be readily reconciled with the balance of the reserve for
losses on loans for financial statement purposes maintained in any other
ledger. The permanent records maintained pursuant to this section must
reflect any changes in the amount initially added to the reserve for
losses on loans and the amount finally determined by the taxpayer to be
a reasonable addition to the reserve for losses on loans.
(Sec. 585(b)(4), of the Internal Revenue Code of 1954 (83 Stat. 618; (26
U.S.C. 585(b)(4))))
[T.D. 7532, 43 FR 3114, Jan. 23, 1978, as amended by T.D. 8513, 58 FR
68757, Dec. 29, 1993]
Sec. 1.585-4 Reorganizations and asset acquisitions.
(a) In general. In computing a reasonable addition to the reserve
for losses on loans for the first taxable year ending after a
transaction to which section 381(a) applies and for subsequent taxable
years, the separate reserves for losses on loans, the amount of loans
outstanding, the total bad debts sustained (adjusted for recoveries),
and the amount of eligible loans outstanding of the distributor or
transferor corporation and the acquiring corporation (or, in the case of
a consolidation, the transferor corporations) shall be combined for all
applicable years. Thus, for example, in applying Sec. 1.585-2(c)(1)(i)
for the first taxable year ending after the distribution or transfer,
the total bad debts sustained during the 5 preceding taxable years are
the sum of the bad debts sustained by the acquiring corporation for the
5 preceding taxable years and bad debts sustained by the distributor or
transferor corporation for the taxable year ending on the date of
distribution or transfer and the 4 preceding taxable years.
(b) Base year and base year amounts of acquiring corporation--(1)
Base year. For transactions to which section 381(a) applies, the base
year of the acquiring corporation for the first taxable year ending
after the date of distribution or transfer shall be the last taxable
year ending on or before the date of distribution or transfer. The
balance of the reserve, the amount of loans outstanding, and the amount
of eligible loans outstanding at the close of such base year shall be
determined in accordance with the provisions of subparagraph (2)(i) of
this paragraph. For taxable years subsequent to the first taxable year
ending after the date of distribution or transfer, the base year of the
acquiring corporation shall be the more recent of the base year provided
by the first sentence of this subparagraph or the base year provided by
Sec. 1.585-2(e)(1). If Sec. 1.585-2(e)(1) provides the more recent
base year, the balance of the reserve for losses on loans, the amount of
loans outstanding, and the amount of eligible loans outstanding shall be
determined at the close of such base year without regard to this
paragraph.
(2) Base year amounts--(i) Method of determination. The balance of
the reserve for losses on loans, the amount of loans outstanding, and
the amount of eligible loans outstanding at the close of the base year
provided by the first sentence of subparagraph (1) of this paragraph
shall be the total of such amounts of the distributor or transferor
corporation and the acquiring corporation (or, in the case of a
consolidation, the transferor corporations) at the close of what would
have been their respective base years determined under Sec. 1.585-
2(e)(1) if the distribution or transfer to which section 381(a) applies
had not occurred, except that the method (experience or percentage) used
or adopted by the acquiring corporation to determine its reasonable
addition to a reserve for losses on loans for the first taxable year
ending after the
[[Page 388]]
date of the distribution or transfer shall be considered to be the
method that the distributor or transferor corporation (or, in the case
of a consolidation, that the transferor corporation) would have used or
adopted for its first taxable year ending after the date of distribution
or transfer if the distribution or transfer had not occurred.
(ii) Examples. The application of the rule provided by this
subparagraph may be illustrated by the following examples:
Example 1. The X Corporation and the Y Corporation are commercial
banks both of which have a calendar year as a taxable year. Both X and Y
adopted the reserve method of accounting for bad debts prior to July 11,
1969. For the taxable year 1970 through 1973, X and Y determined their
reasonable additions to a reserve for losses on loans as defined in
Sec. 1.585-2(e)(2) under the percentage method. On June 30, 1974, the X
Bank is merged into the Y Bank; for its short taxable year ending on
June 30, 1974, X determines its reasonable addition under the percentage
method. If, for the taxable year ending on December 31, 1974 (the first
taxable year ending after the date of distribution or transfer), Y
determines its reasonable addition to a reserve for losses on loans
under the percentage method, then at the close of the base year the
reserve balance, the amount of outstanding loans, and the amount of
eligible loans outstanding are the sum of X's and Y's respective amounts
at the close of the taxable year endingDecember 31, 1969 (the base year
of both X and Y determined under Sec. 1.585-2(e)(1) as if the
distribution or transfer had not taken place). If, instead of the above,
Y adopts the experience method of determining its reasonable addition to
a reserve for losses for the taxable year 1974, than at the close of the
base year (1973) the reserve balances, the amount of loans outstanding,
and the amount of eligible loans outstanding are the sum of X's
respective amounts at the close of its short taxable year ending on June
30, 1974 (X's last taxable year before its (Y's) most recent adoption of
the experience method) and of Y's respective amounts at the close of its
taxable year 1973 (Y's last taxable year before its most recent adoption
of the experience method).
Example 2. The M Corporation and the N Corporation are commercial
banks. M has a fiscal year ending September 30, as its taxable year and
N has a calendar year as its taxable year. Both M and N adopted the
reserve method of accounting for bad debts prior to July 11, 1969. For
the taxable years ending in 1970, 1971, and 1972, M determined its
reasonable addition to a reserve for losses under the percentage method;
for the taxable year ending in 1973 M adopted the experience method. For
the taxable years 1970 through 1973 N determined its reasonable addition
under the percentage method. M is merged into N on June 30, 1974, and
for its short taxable year ending on June 30, 1974, M determines its
reasonable addition under the experience method. If, for the taxable
year ending on December 31, 1974 (thefirst taxable year ending after the
date of distribution or transfer), N determines its reasonable addition
to a reserve for losses under the percentage method, then at the close
of the base year (1973) the reserve balance, the amount of loans
outstanding, and the amount of eligible loans outstanding are the sum of
M's respective amounts at the close of (a) if M had a reserve deficiency
as of June 30, 1974, its short taxable year ending on June 30, 1974 (M's
last taxable year before its (N's) most recent adoption of the
percentage method), or (b) if M did not have a reserve deficiency, the
taxable year ending on September 30, 1969, and N's respective amounts at
the close of its taxable year 1979. If, instead of the above, N adopts
the experience method for the taxable year 1974, then at the close of
the base year the reserve balance, the amount of outstanding loans, and
the amount of eligible loans outstanding are the sum of M's respective
amounts at the close of its taxable year ending on September 30, 1972
(the last taxable year before M's most recent adoption of the experience
method), and N's respective amounts at the close of the taxable year
1973 (the last taxable year ending before N's most recent adoption of
the experience method).
(Sec. 585(b)(4), of the Internal Revenue Code of 1954 (83 Stat. 618; (26
U.S.C. 585(b)(4))))
[T.D. 7532, 43 FR 3114, Jan. 23, 1978]
Sec. 1.585-5 Denial of bad debt reserves for large banks.
(a) General rule. For taxable years beginning after December 31,
1986, a large bank (as defined in paragraph (b) of this section) may not
deduct any amount under section 585 or any other section for an addition
to a reserve for bad debts. However, for these years, except as provided
in Sec. 1.585-7, a large bank may deduct amounts allowed under section
166(a) for specific debts that become worthless in whole or in part. Any
large bank that maintained a reserve for bad debts under section 585 for
the taxable year immediately preceding its disqualification year (as
defined in paragraph (d)(1) of this section) must follow the rules
prescribed by Sec. 1.585-6 or Sec. 1.585-7 for changing from the
reserve method of accounting
[[Page 389]]
for bad debts that is allowed by section 585, to the specific charge-off
method of accounting for bad debts, in its disqualification year.
However, except as may be provided otherwise in regulations prescribed
under section 593, the rules prescribed by Sec. Sec. 1.585-6 and 1.585-
7 do not apply to a large bank that maintained a reserve for bad debts
under section 593 for the taxable year immediately preceding its
disqualification year.
(b) Large bank--(1) General definition. For purposes of this
section, a large bank is any institution described in Sec. 1.585-
1(b)(1) (i) or (ii) if, for the taxable year (or for any preceding
taxable year beginning after December 31, 1986)--
(i) The average total assets of the institution (determined under
paragraph (c) of this section) exceed $500,000,000; or
(ii) The institution is a member of a parent-subsidiary controlled
group (as defined in paragraph (d)(2) of this section) and the average
total assets of the group exceed $500,000,000.
(2) Large bank resulting from transfer by large bank--(i) In
general. If a corporation acquires the assets of a large bank (as
defined in this paragraph (b)) in an acquisition to which paragraph
(b)(2) (ii), (iii) or (iv) of this section applies, the acquiring
corporation (the acquiror) is treated as a large bank for any taxable
year ending after the date of the acquisition in which it is an
institution described in Sec. 1.585-1(b)(1) (i) or (ii).
(ii) Transfer of significant portion of assets where control is
retained. This paragraph (b)(2)(ii) applies to any direct or indirect
acquisition of a significant portion of a large bank's assets if, after
the acquisition, the transferor large bank owns more than 50 percent (by
vote or value) of the outstanding stock of the acquiror. For this
purpose, stock of an acquiror is considered owned by a transferor bank
if the stock is owned by any member of a parent-subsidiary controlled
group (as defined in paragraph (d)(2) of this section) of which the bank
is a member, by any related party within the meaning of section 267(b)
or 707(b), or by any person that received the stock in a transaction to
which section 355 applies.
(iii) Transfer to which section 381 applies. This paragraph
(b)(2)(iii) applies to any acquisition to which section 381(a) applies
if, immediately after the acquisition, the acquiror's principal method
of accounting for bad debts (determined under Sec. 1.381(c)(4)-1(c)(2))
with respect to its banking business is the specific charge-off method.
In applying Sec. 1.381(c)(4)-1(c)(2) for this purpose, the following
rules apply: A transferor large bank is considered to use the specific
charge-off method for all of its loans immediately before the
acquisition; an acquiror is considered to use a reserve method for all
of its loans immediately before the acquisition; and all banking
businesses of the acquiror immediately after the acquisition are treated
as one integrated business. See Sec. Sec. 1.585-6(c)(3) and 1.585-
7(d)(2) for rules on the treatment of assets acquired from large banks
in section 381(a) transactions.
(iv) Transfer of substantially all assets to related party. This
paragraph (b)(2)(iv) applies to any direct or indirect acquisition of
substantially all of a large bank's assets if the transferor large bank
and the acquiror are related parties before or after the acquisition and
a principal purpose of the acquisition is to avoid treating the acquired
assets as those of a large bank. A transferor bank and an acquiror are
considered to be related parties for this purpose if they are members of
the same parent-subsidiary controlled group (as defined in paragraph
(d)(2) of this section) or related parties within the meaning of section
267(b) or 707(b).
(3) Examples. The following examples illustrate the principles of
this paragraph (b):
Example 1. Bank M, a calendar year taxpayer, is an institution
described in Sec. 1.585-1(b)(1)(i). For its taxable year beginning on
January 1, 1987, M has average total assets of $600 million. Since M's
average total assets for 1987 exceed $500 million, M is a large bank for
that year. Pursuant to Sec. 1.585-5(d)(1), 1987 is M's disqualification
year. If M maintained a bad debt reserve under section 585 for its
immediately preceding taxable year (1986), M must change in 1987 to the
specific charge-off method of accounting for bad debts, in accordance
with Sec. 1.585-6 or Sec. 1.585-7.
Example 2. Assume the same facts as in Example 1. Also assume that
in 1988 M disposes of a portion of its assets and, as a result, M's
average total assets for taxable year 1988 fall
[[Page 390]]
to $400 million. M remains a large bank for taxable year 1988 and
succeeding taxable years, since its average total assets for a preceding
taxable year (1987) beginning after December 31, 1986, exceeded $500
million.
Example 3. Bank P, a calendar year taxpayer, is an institution
described in Sec. 1.585-1(b)(1)(i). P has average total assets of $300
million for its taxable year beginning on January 1, 1988. For the same
year, P is a member of a parent-subsidiary controlled group (within the
meaning of Sec. 1.585-5(d)(2)) that has average total assets of $800
million. In February 1989, the group sells its stock in P to several
individual investors. P is a large bank for taxable year 1988 because it
is a member of a group described in Sec. 1.585-5(b)(1)(ii) for that
year. P also is a large bank for taxable year 1989 and succeeding
taxable years because it was a member of a group described in Sec.
1.585-5(b)(1)(ii) for a preceding taxable year (1988) beginning after
December 31, 1986.
Example 4. Assume the same facts as in Example 3, except that P's
stock is purchased by a corporation that is not a large bank under Sec.
1.585-5(b). Also assume that the purchasing corporation elects under
section 338 to treat the stock purchase as an asset acquisition. Under
section 338, P is considered to have sold all of its assets on the
purchase date and is treated as a new corporation that purchased these
assets on the next day. Since P is treated as a new corporation, its
prior membership in a group described in Sec. 1.585-5(b)(1)(ii) does
not cause it to be treated as a large bank for taxable years ending
after the date of its sale by the group. However, P may be treated as a
large bank because of new membership in such a group or pursuant to
Sec. 1.585-5(b)(1)(i) or (b)(2).
Example 5. Bank Q is a large bank, within the meaning of Sec.
1.585-5(b)(1), for its taxable year beginning on January 1, 1988, and
hence for all later years. On March 1, 1989, Q transfers $200 million of
its $600 million of assets to Bank R, a newly created subsidiary, in a
transaction to which section 351 applies; these assets are R's only
assets. On the same day, Q then spins off R in a transaction to which
section 355 applies. After these transactions, the shareholders of Q own
more than 50 percent of R's outstanding stock. Although R's average
total assets do not exceed $500 million, R becomes a large bank on March
1, 1989, pursuant to Sec. 1.585-5(b)(2)(ii). These transactions do not
affect Q's status as a large bank.
Example 6. Bank S is a large bank, within the meaning of Sec.
1.585-5(b)(1)(ii), for its taxable year beginning on January 1, 1987. As
a result, S changes to the specific charge-off method of accounting for
bad debts in that year. Bank T, which is not a large bank under Sec.
1.585-5(b), uses the reserve method of accounting for bad debts. On June
30, 1988, T acquires substantially all of S's assets in a transaction to
which section 381(a) applies. Immediately before the acquisition, S's
banking business has total assets of $200 million, and T's has total
assets of $250 million. To determine whether T is a large bank under
Sec. 1.585-5(b)(2)(iii) for taxable years ending after the acquisition,
it is necessary to determine T's principal method of accounting for bad
debts with respect to its banking business immediately after the
acquisition. This determination requires an application of Sec.
1.381(c)(4)-1(c)(2). For this purpose, T's original and acquired banking
businesses are treated as an integrated business. Applying Sec.
1.381(c)(4)-1(c)(2), it is determined that the business's principal
method of accounting for bad debts immediately after the acquisition is
the reserve method. Hence, the acquisition does not cause T to become a
large bank under Sec. 1.585-5(b)(2)(iii).
(c) Average total assets--(1) In general. For purposes of paragraph
(b)(1) of this section, and except as otherwise provided in paragraph
(c)(3)(ii) of this section, the average total assets of an institution
or group for any taxable year are determined by--
(i) Computing, for each report date (as defined in paragraph (c)(2)
of this section) within the taxable year, the amount of total assets (as
defined in paragraph (c)(3) of this section) held by the institution or
group as of the close of business on the report date;
(ii) Adding these amounts; and
(iii) Dividing the sum of these amounts by the number of report
dates within the taxable year.
(2) Report date--(i) Institutions--(A) In general. A report date for
an institution generally is the last day of the regular period for which
the institution must report to its primary Federal regulatory agency.
However, an institution that is required to report to its primary
Federal regulatory agency more frequently than quarterly may choose the
last day of the calendar quarter as its report date, and an institution
that is required to report to its primary Federal regulatory agency less
frequently than quarterly must choose the last day of the calendar
quarter as its report date. If an institution does not have a Federal
regulatory agency, its primary State regulatory agency is considered its
primary Federal regulatory agency for purposes of this paragraph
(c)(2)(i)(A). In the case of a short taxable year that does not
otherwise include a report date, the first or last
[[Page 391]]
day of the taxable year is the institution's report date for the year.
(B) Alternative report date. In lieu of the report date prescribed
by paragraph (c)(2)(i)(A) of this section, for any taxable year an
institution may choose as its report date the last day of any regular
interval in the taxable year that is more frequent than quarterly (such
as bi-monthly, monthly, weekly, or daily).
(ii) Groups. If all members of a parent-subsidiary controlled group
have the same taxable year, a report date for the group is the report
date, determined under paragraph (c)(2)(i) of this section, for any one
member of the group that is an institution described in Sec. 1.585-
1(b)(1) (i) or (ii). The same report date must be used in applying
paragraph (b)(1)(ii) of this section to all members of the group for a
taxable year. If all members of a parent-subsidiary controlled group do
not have the same taxable year, a report date for the group must be
determined under similar principles.
(iii) Member of group for only part of taxable year. If an
institution is a member of a parent-subsidiary controlled group for only
part of a taxable year, paragraph (b)(1)(ii) of this section is applied
to the institution for that year on the basis of the group's average
total assets for the portion of the year that the institution is a
member of the group. Thus, only the group's report dates (as determined
under paragraph (c)(2)(ii) of this section) that are included in that
portion of the year are taken into account in determining the group's
average total assets for purposes of applying paragraph (b)(1)(ii) of
this section to the institution. If no report date of the group is
included in that portion of the year, the first or last day of that
portion of the year must be treated as the group's report date for
purposes of this paragraph (c)(2)(iii).
(3) Total assets--(i) All corporations. The amount of total assets
held by an institution or group is the amount of cash, plus the sum of
the adjusted bases of all other assets, held by the institution or
group. For this purpose, the adjusted basis of an asset generally is its
basis for Federal income tax purposes, determined under sections 1012,
1016 and other applicable sections of the Internal Revenue Code. In
determining the amount of total assets held by a group, any asset of a
member of the group that is an interest in another member of the group
is not to be counted.
(ii) Foreign corporations. In determining the amount of total assets
held by a foreign corporation, all of the corporation's assets are taken
into account, including those that are not effectively connected with
the conduct of a banking business within the United States. In the case
of a foreign corporation that is not engaged in a trade or business in
the United States, the adjusted basis of an asset must be determined
substantially in accordance with United States tax principles as
provided in regulations under section 964. In the case of a foreign
corporation that is engaged in a trade or business in the United States,
the amount of its average total assets for a taxable year (within the
meaning of paragraph (c)(1) of this section) is the amount of the
corporation's average worldwide assets used for purposes of computing
the interest expense deduction allowable under section 882 and Sec.
1.882-5 for the taxable year.
(4) Estimated adjusted tax bases--(i) In general. The amount of the
adjusted Federal income tax bases (tax bases) of assets held on a report
date may be estimated, for purposes of applying paragraph (c)(3) of this
section. This estimate must be based on the adjusted bases of the assets
on that date as determined by reference to the asset holder's books and
records maintained for financial reporting purposes (book bases). The
estimate must reflect any change in the ratio between the asset holder's
tax and book bases of assets that occurs during the taxable year, and
the estimate must assume that this change occurs ratably. If an
institution or group member estimates the tax bases of assets held on
any report date during a taxable year, it must do so for all assets
(other than cash) held on that report date, and it must do so for all
other report dates during the year. However, the tax bases of assets may
not be estimated for any report date that is the first or last day of
the taxable year or that is determined
[[Page 392]]
under paragraph (c)(2)(i)(B) of this section.
(ii) Formulas. The estimated amount of the tax bases of assets held
on any report date during a taxable year is based on the following
variables: The total book bases of the assets on the report date (B);
the asset holder's tax/book ratio as of the close of the preceding
taxable year (R); and the result (whether positive or negative) obtained
when R is subtracted from the asset holder's tax/book ratio as of the
close of the current taxable year (Y). For purposes of determining R and
Y, an asset holder's tax/book ratio is the ratio of the total tax bases
of all of the holder's assets (other than cash), to the total book bases
of those assets. If an asset holder's taxable year is the calendar year
and its report date is the last day of the calendar quarter, its
estimated tax bases of assets held on the first three report dates of
the year are determined under the following formulas:
1st Report Date = B x (R + \1/4\Y)
2nd Report Date = B x (R + \1/2\Y)
3rd Report Date = B x (R + \3/4\Y)
(5) Examples. The following examples illustrate the principles of
this paragraph (c):
Example 1. Bank U is a fiscal year taxpayer, and its fiscal year
ends on January 31. U reports to its primary Federal regulatory agency
as of the last day of the calendar quarter. U does not choose under
Sec. 1.585-5(c)(2)(i)(B) a report date more frequent than quarterly.
Thus, U's report dates under Sec. 1.585-5(c)(2)(i)(A) are March 31,
June 30, September 30, and December 31. For its taxable year beginning
on February 1, 1987, U has total assets (within the meaning of Sec.
1.585-5(c)(3)) of $480 million on March 31, $490 million on June 30,
$510 million on September 30, and $540 million on December 31. Thus,
pursuant to Sec. 1.585-5(c)(1), U's average total assets for its
taxable year beginning on February 1, 1987, are $505 million.
Example 2. Bank W is a calendar year taxpayer, and its report date
(within the meaning of Sec. 1.585-5(c)(2)(i)(A)) is the last day of the
calendar quarter. Pursuant to Sec. 1.585-5(c)(4), W chooses to estimate
the tax bases of its assets for 1990. Therefore, W must estimate the tax
bases of all of its assets (other than cash) for its first three report
dates in 1990. Since W's fourth report date (December 31) is the last
day of its taxable year, the tax bases of its assets may not be
estimated for this date. The adjusted tax bases ofall of W's assets
(other than cash) are $450z on December 31, 1989, and $480z on December
31, 1990. The book bases of those assets are $500z on December 31, 1989;
$520z on March 31, 1990; $540z on June 30, 1990; $560z on September 30,
1990; and $600z on December 31, 1990. Applying the formulas provided in
Sec. 1.585-5(c)(4)(ii), W's tax/book ratio as of the close of 1989 (R),
is 0.9 (450z/500z). W's tax/book ratio as of the close of 1990 is 0.8
(480z/600z). Thus, Y is -0.1. The estimated adjusted tax bases of all of
W's assets (other than cash) on the first three report dates of 1990 are
as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.160
(d) Definitions. The following definitions apply for purposes of
this section and Sec. Sec. 1.585-6, 1.585-7 and 1.585-8:
(1) Disqualification year. A bank's disqualification year is its
first taxable year beginning after December 31, 1986, for which the bank
is a large bank within the meaning of paragraph (b) of this section.
(2) Parent-subsidiary controlled group. A parent-subsidiary
controlled group includes all of the members of a controlled group of
corporations described in section 1563(a)(1). The members of such a
group are determined without regard to whether any member is an excluded
member described in section 1563(b)(2), a foreign entity, or a
commercial bank.
(3) Example. The following example illustrates the principles of
this paragraph (d):
Example. Bank X is a large bank within the meaning of Sec. 1.585-
5(b)(1)(i). Bank Y is not a large bank under Sec. 1.585-5(b), and it
maintains a bad debt reserve under section 585. In 1988, X purchases all
of the stock of Y. If the acquisition causes Y to become a member of a
parent-subsidiary controlled group described in Sec. 1.585-5(b)(1)(ii),
Y is a large bank beginning in its first taxable year that ends after
the date of the acquisition. Pursuant to Sec. 1.585-5(d)(1), this year
is Y's disqualification
[[Page 393]]
year. Y must change in this year to the specific charge-off method of
accounting for bad debts, in accordance with Sec. 1.585-6 or Sec.
1.585-7.
[T.D. 8513, 58 FR 68757, Dec. 29, 1993; 59 FR 15502, Apr. 1, 1994]
Sec. 1.585-6 Recapture method of changing from the reserve method
of section 585.
(a) General rule. This section applies to any large bank (as defined
in Sec. 1.585-5(b)) that maintained a reserve for bad debts under
section 585 for the taxable year immediately preceding its
disqualification year (as defined in Sec. 1.585-5(d)(1)) and that does
not elect the cut-off method set forth in Sec. 1.585-7. Except as
otherwise provided in paragraphs (c) and (d) of this section, any bank
to which this section applies must include in income the amount of its
net section 481(a) adjustment (as defined in paragraph (b)(3) of this
section) over the four-year period beginning with the bank's
disqualification year. If a bank follows the rules prescribed by
thissection, its change to the specific charge-off method of accounting
for bad debts in its disqualification year will be treated as a change
in accounting method that is made with the consent of the Commissioner.
Paragraph (b) of this section specifies the portion of the net section
481(a) adjustment to be included in income in each year of the recapture
period; paragraph (c) of this section provides rules on the effect of
disposing of loans; and paragraph (d) of this section provides rules on
the suspension of recapture by financially troubled banks.
(b) Four-year spread of net section 481(a) adjustment--(1) In
general. If a bank to which this section applies does not make the
election allowed by paragraph (b)(2) of this section, the bank must
include in income the following portions of its net section 481(a)
adjustment in each year of the four-year recapture period: 10 percent in
the bank's disqualification year; 20 percent in its first taxable year
after its disqualification year; 30 percent in its second taxable year
after its disqualification year; and 40 percent in its third taxable
year after its disqualification year.
(2) Election to include more than 10 percent in disqualification
year. A bank to which this section applies may elect to include in
income, in its disqualification year, any percentage of its net section
481(a) adjustment that is larger than 10 percent. Any such election must
be made at the time and in the manner prescribed by Sec. 1.585-8. If a
bank makes such an election, the bank must include in income the
remainder, if any, of its net section 481(a) adjustment in the following
portions: \2/9\ of the remainder in the bank's first taxable year after
its disqualification year; \1/3\ of the remainder in its second taxable
year after its disqualification year; and \4/9\ of the remainder in its
third taxable year after its disqualification year. For this purpose,
the remainder of a bank's net section 481(a) adjustment is any portion
of the adjustment that the bank does not elect to include in income in
its disqualification year.
(3) Net section 481(a) adjustment. For purposes of this section, the
amount of a bank's net section 481(a) adjustment is the amount of the
bank's reserve for bad debts as of the close of the taxable year
immediately preceding its disqualification year. Since the change from
the reserve method of section 585 is initiated by the taxpayer, the
amount of the bank's bad debt reserve for this purpose is not reduced by
amounts attributable to taxable years beginning before 1954.
(4) Examples. The following examples illustrate the principles of
this paragraph (b):
Example 1. Bank M is a large bank within the meaning of Sec. 1.585-
5(b). M's disqualification year is its taxable year beginning on January
1, 1989, and M maintained a bad debt reserve under section 585 for the
preceding taxable year. Pursuant to Sec. 1.585-5(a), M must change from
the reserve method of accounting for bad debts to the specific charge-
off method in its disqualification year. M does not elect the cut-off
method set forth in Sec. 1.585-7. Thus, M must follow the recapture
method set forth in this Sec. 1.585-6. M's net section 481(a)
adjustment, as defined in Sec. 1.585-6(b)(3), is $2 million. M does not
make the election allowed by Sec. 1.585-6(b)(2). Pursuant to Sec.
1.585-6(b)(1), M must include the following amounts in income: $200,000
in taxable year 1989; $400,000 in 1990; $600,000 in 1991; and $800,000
in 1992.
Example 2. Assume the same facts as in Example 1, except that M
elects under Sec. 1.585-6(b)(2) to recapture 55 percent of its net
section 481(a) adjustment in its disqualification
[[Page 394]]
year. Pursuant to Sec. 1.585-6(b)(2), M must include the following
amounts in income: $1,100,000 in taxable year 1989; $200,000 in 1990;
$300,000 in 1991; and $400,000 in 1992.
(c) Effect of disposing of loans--(1) In general. Except as provided
in paragraphs (c)(2) and (c)(3) of this section, if a bank to which this
section applies sells or otherwise disposes of any of its outstanding
loans on or after the first day of its disqualification year, the
disposition does not affect the bank's obligation under this section to
include in income the amount of its net section 481(a) adjustment, and
the disposition does not affect the amount of this adjustment.
(2) Cessation of banking business--(i) In general. If a bank to
which this section applies ceases to engage in the business of banking
before it is otherwise required to include in income the full amount of
its net section 481(a) adjustment, the bank must include in income the
remaining amount of the adjustment in the taxable year in which it
ceases to engage in the business of banking. For this purpose, and
except as provided in paragraph (c)(2)(ii) of this section, whether a
bank ceases to engage in the business of banking is determined under the
principles of Sec. 1.446-1(e)(3)(ii) and its administrative procedures.
(ii) Transition rule. A bank that ceases to engage in the business
of banking as the result of a transaction to which section 381(a)
applies is not treated as ceasing to engage in the business of banking
if, on or before March 29, 1994, either the transaction occurs or the
bank enters into a binding written agreement to carry out the
transaction.
(3) Certain section 381 transactions. This paragraph (c)(3) applies
if a bank to which this section applies transfers outstanding loans to
another corporation on or after the first day of the bank's
disqualification year (and before it has included in income the full
amount of its net section 481(a) adjustment) in a transaction to which
section 381(a) applies, and under paragraph (c)(2) (i) or (ii) of this
section the transferor bank is not treated as ceasing to engage in the
business of banking as a result of the transaction. If this paragraph
(c)(3) applies, the acquiring corporation (the acquiror) steps into the
shoes of the transferor with respect to using the recapture method
prescribed by this section and assumes all of the transferor's rights
and obligations under paragraph (b) of this section. The unrecaptured
balance of the transferor's net section 481(a) adjustment carries over
in the transaction to the acquiror, and the acquiror must complete the
four-year recapture procedure begun by the transferor. In applying this
procedure, the transferor's taxable year that ends on or includes the
date of the acquisition and the acquiror's first taxable year ending
after the date of the acquisition represent two consecutive taxable
years within the four-year recapture period.
(4) Examples. The following examples illustrate the principles of
this paragraph (c):
Example 1. Bank P is a bank to which this Sec. 1.585-6 applies. P's
disqualification year is its taxable year beginning on January 1, 1989,
and P recaptures 10 percent of its net section 481(a) adjustment in that
year pursuant to Sec. 1.585-6(b)(1). In July 1990 P disposes of a
portion of its loan portfolio in a transaction to which section 381(a)
does not apply, and P continues to engage in the business of banking.
Pursuant to Sec. 1.585-6(c)(1), the disposition does not affect P's
obligation under Sec. 1.585-6(b)(1) to recapture the remainder of its
net section 481(a) adjustment in 1990, 1991 and 1992. Nor does the
disposition affect the amount of the adjustment.
Example 2. Assume the same facts as in Example 1, except that P
ceases to engage in the business of banking in 1990, as determined under
the principles of Sec. 1.446-1(e)(3)(ii) and its administrative
procedures. Pursuant to Sec. 1.585-6(c)(2)(i), in 1990 P must include
in income the remaining 90 percent of its net section 481(a) adjustment.
Example 3. Assume the same facts as in Example 1, except that P's
1990 disposition of loans is a transaction to which section 381(a)
applies, P ceases to engage in the business of banking as a result of
the transaction, and P's taxable year ends on the date of the
transaction. Thus, in the transaction, P transfers substantially all of
its loans to an acquiring corporation (Q). Q is a calendar year
taxpayer. Because the transaction occurred before March 29, 1994, the
transition rule of Sec. 1.585-6(c)(2)(ii) applies, and P is not treated
as ceasing to engage in the business of banking. Pursuant to Sec.
1.585-6(c)(3), Q steps into P's shoes with respect to using the
recapture method prescribed by Sec. 1.585-6. The unrecaptured balance
of P's net section 481(a) adjustment carries over to Q in the
[[Page 395]]
section 381(a) transaction, and Q must complete the four-year recapture
procedure begun by P. Pursuant to Sec. Sec. 1.585-6(b) and 1.585-
6(c)(3), P includes 20 percent of its net section 481(a) adjustment in
income in its taxable year ending on the date of the section 381(a)
transaction, and Q includes 30 percent of the adjustment in income in
1990 and 40 percent in 1991.
Example 4. Assume the same facts as in Example 3. Assume also that Q
becomes a large bank under Sec. 1.585-5(b) as a result of the
transaction and maintained a bad debt reserve immediately before the
transaction. Q must change to the specific charge-off method for all of
its loans in the first taxable year that it is a large bank. Thus, Q not
only completes the recapture procedure begun by P but also follows the
rules prescribed by Sec. 1.585-6 or Sec. 1.585-7 with respect to its
own reserve.
Example 5. Assume the same facts as in Example 3. Assume also that Q
is not a large bank after the transaction and properly establishes a bad
debt reserve for the loans it receives in the transaction. This
establishment of the reserve results in a new negative section 481(a)
adjustment. Thus, Q not only completes the recapture procedure begun by
P but also takes into account the new negative adjustment as required
under section 381.
(d) Suspension of recapture by financially troubled banks--(1) In
general. Except as provided in paragraph (d)(2) of this section, a bank
that is financially troubled (within the meaning of paragraph (d)(3) of
this section) for any taxable year must not include any amount in income
under paragraphs (a) and (b) of this section for that taxable year and
must disregard that taxable year in applying paragraphs (a) and (b) of
this section to other taxable years. See paragraph (d)(4) of this
section for rules on determining estimated tax payments of financially
troubled banks, and see paragraph (d)(5) of this section for examples
illustrating this paragraph (d).
(2) Election to recapture. A bank that is financially troubled
(within the meaning of paragraph (d)(3) of this section) for its
disqualification year may elect to include in income, in one taxable
year, any percentage of its net section 481(a) adjustment that is
greater than 10 percent. This election may be made for the bank's
disqualification year, for the first taxable year after the
disqualification year in which the bank is not financially troubled
(within the meaning of paragraph (d)(3) of this section), or for any
intervening taxable year. Any such election must be made at the time and
in the manner prescribed by Sec. 1.585-8. A bank that makes this
election must include an amount in income under paragraphs (a) and (b)
of this section in the year for which the election is made (election
year) and must not disregard this year in applying paragraphs (a) and
(b) of this section to other taxable years. Such a bank must follow the
rules of paragraph (b)(2) of this section in applying paragraph (b) of
this section to later taxable years, treating the election year as the
disqualification year for purposes of applying paragraph (b)(2) of this
section. However, if the bank is financially troubled for any year after
its election year, the bank must not include any amount in income under
paragraphs (a) and (b) of this section for the later year and must
disregard the later year in applying paragraphs (a) and (b) of this
section to other taxable years.
(3) Definition of financially troubled--(i) In general. For purposes
of this section, a bank is considered financially troubled for any
taxable year if the bank's nonperforming loan percentage for that year
exceeds 75 percent. For this purpose, a bank's nonperforming loan
percentage is the percentage determined by dividing the sum of the
outstanding balances of the bank's nonperforming loans (as defined in
paragraph (d)(3)(iii) of this section) as of the close of each quarter
of the taxable year, by the sum of the amounts of the bank's equity (as
defined in paragraph (d)(3)(iv) of this section) as of the close of each
such quarter. The quarters for a short taxable year of at least 3 months
are the same as those of the bank's annual accounting period, except
that quarters ending before or after the short year are disregarded. If
a taxable year consists of less than 3 months, the first or last day of
the taxable year is treated as the last day of its only quarter. In lieu
of determining its nonperforming loan percentageon the basis of loans
and equity as of the close of each quarter of the taxable year, a bank
may, for all years, determine this percentage on the basis of loans and
equity as of the close of each
[[Page 396]]
report date (as defined in Sec. 1.585-5(c)(2), without regard to Sec.
1.585-5(c)(2)(i)(B)). In the case of a bank that is a foreign
corporation, all nonperforming loans and equity of the bank are taken
into account, including loans and equity that are not effectively
connected with the conduct of a banking business within the United
States.
(ii) Parent-subsidiary controlled groups--(A) In general. If a bank
is a member of a parent-subsidiary controlled group (as defined in Sec.
1.585-5(d)(2)) for the taxable year, the nonperforming loans and the
equity of all members of the bank's financial group (as determined under
paragraph (d)(3)(ii)(B) of this section) are treated as the
nonperforming loans and the equity of the bank for purposes of paragraph
(d)(3)(i) of this section. However, any equity interest that a member of
a bank's financial group holds in another member of this group is not to
be counted in determining equity. Similarly, any loan that a member of a
bank's financial group makes to another member of the group is not to be
counted in determining nonperforming loans. All banks that are members
of the same parent-subsidiary controlled group must (for all taxable
years that they are members of this group) determine their nonperforming
loan percentage on the basis of the close of each quarter of the taxable
year, or all must (for all such taxable years) determine this percentage
on the basis of the close of each report date (as determined under Sec.
1.585-5(c)(2)(ii), applied without regard to Sec. 1.585-5(c)(2)(i)(B)).
(B) Financial group--(1) In general. All banks that are members of
the same parent-subsidiary controlled group must (for all taxable years
that they are members of this group) determine their financial group
under paragraph (d)(3)(ii)(B)(2) of this section, or all must (for all
such taxable years) determine their financial group under paragraph
(d)(3)(ii)(B)(3) of this section.
(2) Financial institution members of parent-subsidiary controlled
group. A bank's financial group, determined under this paragraph
(d)(3)(ii)(B)(2), consists of all financial institutions within the
meaning of section 265(b)(5) (and comparable foreign financial
institutions) that are members of the parent-subsidiary controlled group
of which the bank is a member.
(3) All members of parent-subsidiary controlled group. A bank's
financial group, determined under this paragraph (d)(3)(ii)(B)(3),
consists of all members of the parent-subsidiary controlled group of
which the bank is a member.
(iii) Nonperforming loan--(A) In general. For purposes of this
section, a nonperforming loan is any loan (as defined in paragraph
(d)(3)(iii)(B) of this section) that is considered to be nonperforming
by the holder's primary Federal regulatory agency. Nonperforming loans
include the following types of loans as defined by the Federal Financial
Institutions Examination Council: Loans that are past due 90 days or
more and still accruing; loans that are in nonaccrual status; and loans
that are restructured troubled debt. A loan is not considered to be
nonperforming merely because it is past due, if it is past due less than
90 days. The outstanding balances of nonperforming loans are determined
on the basis of amounts that are required to be reported to the holder's
primary Federal regulatory agency. For purposes of this paragraph
(d)(3)(iii)(A), a holder that does not have a Federal regulatory agency
is treated as Federally regulated under the standards prescribed by the
Federal Financial Institutions Examination Council.
(B) Loan. For purposes of paragraph (d)(3)(iii)(A) of this section,
a loan is any extension of credit that is defined and treated as a loan
under the standards prescribed by the Federal Financial Institutions
Examination Council. (Accordingly, a troubled debt restructuring that is
in substance a foreclosure or repossession is not considered a loan.) In
addition, a debt evidenced by a security issued by a foreign government
is treated as a loan if the security is issued as an integral part of a
restructuring of one or more troubled loans to the foreign government
(or an agency or instrumentality thereof). Similarly, a deposit with the
central bank of a foreign country is treated as a loan if the deposit is
made under a deposit facility agreement that is entered into as an
integral part of a restructuring of one or more troubled
[[Page 397]]
loans to the foreign country's government (or an agency or
instrumentality thereof).
(iv) Equity. For purposes of this section, the equity of a bank or
other financial institution is its equity (i.e., assets minus
liabilities) as required to be reported to the institution's primary
Federal regulatory agency (or, if the institution does not have a
Federal regulatory agency, as required under the standards prescribed by
the Federal Financial Institutions Examination Council). The balance in
a reserve for bad debts is not treated as equity.
(4) Estimated tax payments of financially troubled banks. For
purposes of applying section 6655(e)(2)(A)(i) with respect to any
installment of estimated tax, a bank that is financially troubled as of
the due date of the installment is treated as if no amount will be
included in income under paragraphs (a) and (b) of this section for the
taxable year. For this purpose, a bank is considered financially
troubled as of the due date of an installment of estimated tax only if
its nonperforming loan percentage (computed under paragraph (d)(3) of
this section) would exceed 75 percent for a short taxable year ending on
that date. For purposes of computing this nonperforming loan percentage,
the ending of such a short taxable year would not cause the last day of
that year to be treated as the last day of a quarter of the taxable
year.
(5) Examples. The following examples illustrate the principles of
this paragraph (d):
Example 1. Bank R is a bank to which this Sec. 1.585-6 applies. R's
disqualification year is its taxable year beginning on January 1, 1987.
R is not financially troubled (within the meaning of Sec. 1.585-
6(d)(3)) for taxable year 1987 or for any taxable year after 1989, but
it is financially troubled for taxable years 1988 and 1989. Since R is
not financially troubled for its disqualification year, R must include
an amount in income under Sec. 1.585-6 (a) and (b) for that year
(taxable year 1987). R may make the election allowed by Sec. 1.585-
6(b)(2) for that year. Since R is financially troubled for taxable years
1988 and 1989, pursuant to Sec. 1.585-6(d)(1) R does not include any
amount in income under Sec. 1.585-6 (a) and (b) for these years, and it
treats taxable years 1990, 1991 and 1992 as the first, second and third
taxable years after its disqualification year for purposes of applying
Sec. 1.585-6 (a) and (b).
Example 2. Assume the same facts as in Example 1, except that R is
financially troubled for taxable year 1987 (its disqualification year).
R may make the election allowed by Sec. 1.585-6(d)(2) for 1987 (the
disqualification year), for 1990 (the first year after the
disqualification year in which R is not financially troubled), or for
1988 or 1989 (the intervening years). R elects to include 60 percent of
its net section 481(a) adjustment in income in 1987. Thus, the remainder
of the adjustment, for purposes of applying the rules of Sec. 1.585-
6(b)(2), is 40 percent. R must include in income \2/9\ of the remainder
in 1990, \1/3\ of the remainder in 1991, and \4/9\ of the remainder in
1992.
Example 3. Bank S, which is not a member of a parent-subsidiary
controlled group, is a bank to which this Sec. 1.585-6 applies. S's
disqualification year is its taxable year beginning on January 1, 1987.
S determines its nonperforming loan percentage under Sec. 1.585-6(d)(3)
on a quarterly basis. S is not financially troubled for taxable year
1987 and includes 10 percent of its net section 481(a) adjustment in
income in that year. S's outstanding balance of nonperforming loans (as
defined in Sec. 1.585-6(d)(3)(iii)) is $80 million on March 31, 1988;
$68 million on June 30, 1988; and $59 million on September 30, 1988. The
amount of S's equity (as defined in Sec. 1.585-6(d)(3)(iv)) is $100
million on each of these threedates. Thus, S's nonperforming loan
percentage, computed under Sec. 1.585-6(d)(3), would be 80 percent (80/
100) for a short taxable year ending on April 15 or June 15, 74 percent
[(80 + 68) / 200] for a short taxable year ending on September 15, and
69 percent [(80 + 68 + 59) / 300] for a short taxable year ending on
December 15. Since S's nonperforming loan percentage for a short taxable
year ending on April 15 or June 15 would exceed 75 percent, pursuant to
Sec. 1.585-6(d)(4) S is considered financially troubled as of these
dates. Thus, S is treated as if no amount will be included in income
under Sec. 1.585-6 (a) and (b) for the year for purposes of applying
section 6655(e)(2)(A)(i) with respect to the installments of estimated
tax that are due on April 15, 1988, and June 15, 1988. However, since
S's nonperforming loan percentage for a short taxable year ending on
September 15 or December 15 would not exceed 75 percent, S is not
considered financially troubled as of these dates. Thus, S is treated as
if 20 percent of its net section 481(a) adjustment will be included in
income under Sec. 1.585-6 (a) and (b) for the year for purposes of
applying section 6655(e)(2)(A)(i) with respect to the installments of
estimated tax that are due on September 15, 1988, and December 15, 1988.
[T.D. 8513, 58 FR 68760, Dec. 29, 1993; 59 FR 15502, Apr. 1, 1994]
[[Page 398]]
Sec. 1.585-7 Elective cut-off method of changing from the reserve
method of section 585.
(a) General rule. Any large bank (as defined in Sec. 1.585-5(b))
that maintained a reserve for bad debts under section 585 for the
taxable year immediately preceding its disqualification year (as defined
in Sec. 1.585-5(d)(1)) may elect to use the cut-off method set forth in
this section. Any such election must be made at the time and in the
manner prescribed by Sec. 1.585-8. If a bank makes this election, the
bank must maintain its bad debt reserve for its pre- disqualification
loans, as prescribed in paragraph (b) of this section, and the bank must
include in income any excess balance in this reserve, as required by
paragraph (c) of this section. The bank may not deduct, for its
disqualification year or any subsequent taxable year, any amount allowed
under section 166(a) for pre-disqualification loans (as defined in
paragraph (b)(2) of this section) that become worthless in whole or in
part, except as allowed by paragraph (b)(1) of this section. However,
except as provided in paragraph (d)(3) of this section, the bank may
deduct, for its disqualification year or any subsequent taxable year,
amounts allowed under section 166(a) for loans that the bank originates
or acquires on or after the first day of its disqualification year and
that become worthless in whole or in part. If a bank makes the election
allowed by this paragraph (a), its change to the specific charge-off
method of accounting for bad debts in its disqualification year does not
give rise to a section 481(a) adjustment.
(b) Maintaining reserve for pre-disqualification loans--(1) In
general. A bank that makes the election allowed by paragraph (a) of this
section must maintain its bad debt reserve for its pre-disqualification
loans (as defined in paragraph (b)(2) of this section). Except as
provided in paragraph (d)(3) of this section, the bank must charge
against the reserve the amount of any losses resulting from these loans
(including losses resulting from the sale or other disposition of these
loans), and the bank must add to the reserve the amount of recoveries
with respect to these loans. In general, the reserve must be maintained
in the manner provided by former section 166(c) of the Internal Revenue
Code and the regulations thereunder. However, after the balance in the
reserve is reduced to zero, the bank is to account for any losses and
recoveries with respect to outstanding pre-disqualification loans under
the specific charge-off method of accounting for bad debts, as if the
bank always had accounted for these loans under this method.
(2) Definition of pre-disqualification loans. For purposes of this
section, a pre-disqualification loan of a bank is any loan that the bank
held on the last day of its taxable year immediately preceding its
disqualification year (as defined in Sec. 1.585-5(d)(1)). If the amount
of a pre-disqualification loan is increased during or after the
disqualification year, the amount of the increase is not treated as a
pre-disqualification loan.
(c) Amount to be included in income when reserve balance exceeds
loan balance. If, as of the close of any taxable year, the balance in a
bank's reserve that is maintained under paragraph (b) of this section
exceeds the balance of the bank's outstanding pre-disqualification
loans, the bank must include in income the amount of the excess for the
taxable year. The balance in the reserve is then reduced by the amount
of this excess. See paragraph (d) of this section for rules on the
application of this paragraph (c) when a bank disposes of loans.
(d) Effect of disposing of loans--(1) In general. Except as provided
in paragraphs (d)(2) and (d)(3) of this section, if a bank that makes
the election allowed by paragraph (a) of this section sells or otherwise
disposes of any of its outstanding pre-disqualification loans, the bank
is to reduce the balance of its outstanding pre-disqualification loans
by the amount of the loans disposed of, for purposes of applying
paragraph (c) of this section.
(2) Section 381 transactions. If a bank that makes the election
allowed by paragraph (a) of this section transfers outstanding pre-
disqualification loans to another corporation in a transaction to which
section 381(a) applies, the acquiring corporation (the acquiror) must
follow the rules of paragraph (d)(2)(i) or (ii) of this section.
[[Page 399]]
(i) Acquiror completes cut-off method of change. Except as provided
in paragraph (d)(2)(ii) of this section, the acquiror steps into the
shoes of the transferor in the section 381(a) transaction with respect
to using the cut-off method of change. Thus, the transferor's bad debt
reserve immediately before the section 381(a) transaction carries over
to the acquiror, and the acquiror must complete the cut-off method begun
by the transferor. For purposes of completing the transferor's cut-off
method, the acquiror's balance of outstanding pre-disqualification loans
immediately after the section 381(a) transaction is the balance of these
loans that it receives in the transaction, and the acquiror assumes all
of the transferor's rights and obligations under this section.
(ii) Acquiror uses reserve method. If the acquiror is not a large
bank (within the meaning of Sec. 1.585-5(b)) immediately after the
section 381(a) transaction and uses a reserve method of accounting for
bad debts attributable to the pre-disqualification loans (and any other
loans) received in the transaction, the acquiror does not step into the
shoes of the transferor with respect to using the cut-off method of
change. The transferor's bad debt reserve immediately before the section
381(a) transaction carries over to the acquiror, but the acquiror does
not continue the cut-off method begun by the transferor. If the six-year
moving average amount (as defined in Sec. 1.585-2(c)(1)(ii)) for all of
the loans received in the transaction exceeds the balance of the reserve
that carries over to the acquiror, the acquiror increases this balance
by the amount of the excess. Any such increase in the reserve results in
a negative section 481(a) adjustment that is taken into account as
required under section 381.
(3) Dispositions intended to change the status of pre-
disqualification loans. This paragraph (d)(3) applies if a bank that
makes the election allowed by paragraph (a) of this section sells,
exchanges, or otherwise disposes of a significant amount of its pre-
disqualification loans (as defined in paragraph (b)(2) of this section)
and a principal purpose of the transaction is to avoid the provisions of
this section by increasing the amount of loans for which deductions are
allowable under the specific charge-off method. If this paragraph (d)(3)
applies, the District Director may disregard the disposition for
purposes of paragraphs (b)(1) and (d)(1) of this section or treat the
replacement loans as pre-disqualification loans. If loans are so treated
as pre-disqualification loans, no deductions are allowable under the
specific charge-off method for the loans, except as provided in
paragraph (b)(1) of this section, and the disposition that causes the
loans to be so treated may be disregarded for purposes of paragraphs
(b)(1) and (d)(1) of this section. If a bank sells pre-disqualification
loans and uses the proceeds of the sale to originate new loans, this
paragraph (d)(3) does not apply to the transaction.
(e) Examples. The following examples illustrate the principles of
this section:
Example 1. Bank M is a bank that properly elects to use the cut-off
method set forth in this Sec. 1.585-7. M's disqualification year is its
taxable year beginning on January 1, 1987. On December 31, 1986, M had
outstanding loans of $700 million (pre-disqualification loans), and the
balance in its bad debt reserve was $10 million. M must maintain its
reserve for its pre-disqualification loans in accordance with Sec.
1.585-7(b), and it may not deduct any addition to this reserve for
taxable year 1987 or any later year. For these years, M may deduct
amounts allowed under section 166(a) for loans that it originates or
acquires after December 31, 1986, and that become worthless in whole or
in part.
Example 2. Assume the same facts as in Example 1. Also assume that
in 1987 M collects $150 million of its pre- disqualification loans, M
determines that $2 million of its pre-disqualification loans are
worthless, and M recovers $1 million of pre-disqualification loans that
it had previously charged against the reserve as worthless. On December
31, 1987, the balance in M's bad debt reserve is $9 million ($10 million
- $2 million + $1 million), and the balance of its outstanding pre-
disqualification loans is $548 million ($700 million - $150 million - $2
million).
Example 3. Assume the same facts as in Examples 1 and 2. Also assume
that on December 31, 1990, the balance in M's bad debt reserve is $5
million and the balance of its outstanding pre-disqualification loans is
$25 million. In 1991 M collects $21 million of its outstanding pre-
disqualification loans and determines that $1 million of its outstanding
pre-disqualification loans are worthless. Thus, on December 31, 1991,
the balance in M's bad debt reserve is $4 million ($5 million
[[Page 400]]
- $1 million), and the balance of its outstanding pre-disqualification
loans is $3 million ($25 million - $21 million - $1 million).
Accordingly, M must include $1 million ($4 million - $3 million) in
income in taxable year 1991, pursuant to Sec. 1.585-7(c). On January 1,
1992, the balance in M's reserve is $3 million ($4 million - $1
million).
Example 4. Assume the same facts as in Examples 1 through 3. Also
assume that in 1992 M transfers substantially all of its assets to
another corporation (N) in a transaction to which section 381(a)
applies, and N is treated as a large bank under Sec. 1.585-5(b)(2) for
taxable years ending after the date of the transaction. Pursuant to
Sec. 1.585-7(d)(2)(i), N steps into M's shoes with respect to using the
cut-off method. M's bad debt reserve immediately before the section
381(a) transaction carries over to N, and N must complete the cut-off
procedure begun by M. For this purpose, N's balance of outstanding pre-
disqualification loans immediately after the section 381(a) transaction
is the balance of these loans that it receives from M.
Example 5. Assume the same facts as in Examples 1 through 4, except
that N is not treated as a large bank after the section 381(a)
transaction. Also assume that N uses the reserve method of section 585
and plans to use this method for all of the loans it acquires from M
(including loans that were not pre-disqualification loans). Pursuant to
Sec. 1.585-7(d)(2)(ii), M's bad debt reserve immediately before the
section 381(a) transaction carries over to N in the transaction;
however, N does not continue the cut-off procedure begun by M and does
not treat any loan as a pre-disqualification loan. If the six-year
moving average amount (as defined in Sec. 1.585-2(c)(1)(ii)) for all of
N's newly acquired loans exceeds the balance of the reserve that carries
over to N, N increases this balance by the amount of the excess. Any
such increase in the reserve results in a negative section 481(a)
adjustment that is taken into account as required under section 381.
[T.D. 8513, 58 FR 68762, Dec. 29, 1993; 59 FR 15502, Apr. 1, 1994]
Sec. 1.585-8 Rules for making and revoking elections under Sec.
Sec. 1.585-6 and 1.585-7.
(a) Time of making elections--(1) In general. Any election under
Sec. 1.585-6(b)(2), Sec. 1.585-6(d)(2) or Sec. 1.585-7(a) must be
made on or before the later of--
(i) February 28, 1994; or
(ii) The due date (taking extensions into account) of the electing
bank's original tax return for its disqualification year (as defined in
Sec. 1.585-5(d)(1)) or, for elections under Sec. 1.585-6(d)(2), the
year for which the election is made.
(2) No extension of time for payment. Payments of tax due must be
made in accordance with chapter 62 of the Internal Revenue Code.
However, if an election under Sec. 1.585-6(b)(2), Sec. 1.585-6(d)(2)
or Sec. 1.585-7(a) is made or revoked on or before February 28, 1994
and the making or revoking of the election results in an underpayment of
estimated tax (within the meaning of section 6655(a)) with respect to an
installment of estimated tax due on or before the date the election was
so made or revoked, no addition to tax will be imposed under section
6655(a) with respect to the amount of the underpayment attributable to
the making or revoking of the election.
(b) Manner of making elections--(1) In general. Except as provided
in paragraph (b)(2) of this section, an electing bank must make any
election under Sec. 1.585-6(b)(2), Sec. 1.585-6(d)(2) or Sec. 1.585-
7(a) by attaching a statement to its tax return (or amended return) for
its disqualification year or, for elections under Sec. 1.585-6(d)(2),
the year for which the election is made. This statement must contain the
following information:
(i) The name, address and taxpayer identification number of the
electing bank;
(ii) The nature of the election being made (i.e., whether the
election is to include in income more than 10 percent of the bank's net
section 481(a) adjustment under Sec. 1.585-6 (b)(2) or (d)(2) or to use
the cut-off method under Sec. 1.585-7); and
(iii) If the election is under Sec. 1.585-6(b)(2) or (d)(2), the
percentage being elected.
(2) Certain tax returns filed before December 29, 1993. A bank is
deemed to have made an election under Sec. 1.585-6(b)(2) or (d)(2) if
the bank evidences its intent to make an election under section
585(c)(3)(A)(iii)(I) or section 585(c)(3)(B)(ii) for its
disqualification year (or, for elections under Sec. 1.585-6(d)(2), the
election year), by designating a specific recapture amount on its tax
return or amended return for that year (or attaching a statement in
accordance with Sec. 301.9100-7T(a)(3)(i) of
[[Page 401]]
this chapter), and the return is filed before December 29, 1993. A bank
is deemed to have made an election under Sec. 1.585-7(a) if the bank
evidences its intent to make an election under section 585(c)(4) for its
disqualification year by attaching a statement in accordance with Sec.
301.9100-7T(a)(3)(i) of this chapter to its tax return or amended return
for that year, and the return is filed before December 29, 1993.
(c) Revocation of elections--(1) On or before final date for making
election. An election under Sec. 1.585-6(b)(2), Sec. 1.585-6(d)(2) or
Sec. 1.585-7(a) may be revoked without the consent of the Commissioner
on or before the final date prescribed by paragraph (a)(1) of this
section for making the election. To do so, the bank that made the
election must file an amended tax return for its disqualification year
(or, for elections under Sec. 1.585-6(d)(2), the year for which the
election was made) and attach a statement that--
(i) Includes the bank's name, address and taxpayer identification
number;
(ii) Identifies and withdraws the previous election; and
(iii) If the bank is making a new election under Sec. 1.585-
6(b)(2), Sec. 1.585-6(d)(2) or Sec. 1.585-7(a), contains the
information described in paragraphs (b)(1)(ii) and (b)(1)(iii) of this
section.
(2) After final date for making election. An election under Sec.
1.585-6(b)(2), Sec. 1.585-6(d)(2) or Sec. 1.585-7(a) may be revoked
only with the consent of the Commissioner after the final date
prescribed by paragraph (a)(1) of this section for making the election.
The Commissioner will grant this consent only in extraordinary
circumstances.
(d) Elections by banks that are members of parent-subsidiary
controlled groups. In the case of a bank that is a member of a parent-
subsidiary controlled group (as defined in Sec. 1.585-5(d)(2)), any
election under Sec. 1.585-6(b)(2), Sec. 1.585-6(d)(2) or Sec. 1.585-
7(a) with respect to the bank is to be made separately by the bank. An
election made by one member of such a group is not binding on any other
member of the group.
(e) Elections made or revoked by amended return on or before
February 28, 1994. This paragraph (e) applies to any election that a
bank seeks to make under paragraph (b) of this section, or revoke under
paragraph (c) of this section, by means of an amended return that is
filed on or before February 28, 1994. To make or revoke an election to
which this paragraph (e) applies, a bank must file (before expiration of
each applicable period of limitations under section 6501) this amended
return and amended returns for all taxable years after the taxable year
for which the election is made or revoked by amended return, to any
extent necessary to report the bank's tax liability in a manner
consistent with the making or revoking of the election by amended
return.
[T.D. 8513, 58 FR 68764, Dec. 29, 1993; 59 FR 4583, Feb. 1, 1994; 59 FR
15502, Apr. 1, 1994]
Mutual Savings Banks, Etc.
Sec. 1.591-1 Deduction for dividends paid on deposits.
(a) In general. (1) In the case of a taxpayer described in paragraph
(c)(1) or (2) of this section, whichever is applicable, there are
allowed as deductions from gross income amounts which during the taxable
year are paid to, or credited to the accounts of, depositors or holders
of accounts as dividends or interest on their deposits or withdrawable
accounts, if such amounts paid or credited are withdrawable on demand
subject only to customary notice of intention to withdraw.
(2) The deduction provided in section 591 is applicable to the
taxable year in which amounts credited as dividends or interest become
withdrawable by the depositor or holder of an account subject only to
customary notice of intention to withdraw. Thus, amounts which, as of
the last day of the taxable year, are credited as dividends or interest,
but which are not withdrawable by depositors or holders of accounts
until the following business day, are deductible under section 591 in
the year subsequent to the taxable year in which they were so credited.
A deduction under this section will not be denied by reason of the fact
that the amounts credited as dividends or interest, otherwise deductible
under section 591, are subject to the terms of a pledge agreement
between the taxpayer and the depositor or holder of an account. In the
[[Page 402]]
case of a domestic building and loan association having nonwithdrawable
capital stock represented by shares, no deduction is allowable under
this section for amounts paid or credited as dividends on such shares.
In the case of a taxable year ending after December 31, 1962, for
special rules governing the treatment of dividends or interest paid or
credited for periods representing more than 12 months, see section
461(e).
(b) Serial associations, bonus plans, etc. If a taxpayer described
in paragraph (c)(1) or (2) of this section, whichever is applicable,
operates in whole or in part as a serial association, maintains a bonus
plan, or issues shares, or accepts deposits, subject to fines,
penalties, forfeitures, or other withdrawal fees, it may deduct under
section 591 the total amount credited as dividends or interest upon such
shares or deposits, credited to a bonus account for such shares or
deposits, or allocated to a series of shares for the taxable year,
notwithstanding that as a customary condition of withdrawal:
(1) Amounts invested in, and earnings credited to, series shares
must be withdrawn in multiples of even shares, or
(2) Such taxpayer has the right, pursuant to bylaw, contract, or
otherwise, to retain or recover a portion of the total amount invested
in, or credited as earnings upon, such shares or deposits, such bonus
account, or series of shares, as a fine, penalty, forfeiture, or other
withdrawal fee
In any taxable year in which the right referred to in subparagraph (2)
of this paragraph is exercised, there is includible in the gross income
of such taxpayer for such taxable year amounts retained or recovered by
the taxpayer pursuant to the exercise of such right. If the provisions
of paragraph (a) of Sec. 1.163-4 (relating to deductions for original
issue discount) apply to deposits made with respect to a certificate of
deposit, time deposit, bonus plan or other deposit arrangement, the
provisions of this paragraph shall not apply.
(c) Effective date. The provisions of paragraphs (a) and (b) of this
section shall apply to:
(1) Dividends or interest paid or credited after October 16, 1962,
by any taxpayer which (at the time of such payment or credit) qualifies
as (i) a mutual savings bank not having capital stock represented by
shares, (ii) a domestic building and loan association (as defined in
section 7701(a)(19)), (iii) a cooperative bank (as defined in section
7701(a)(32)), or (iv) any other savings institution chartered and
supervised as a savings and loan or similar association under Federal or
State law; and
(2) Dividends paid or credited before October 17, 1962, by any
taxpayer which (at the time of such payment or credit) qualifies as (i)
a mutual savings bank not having capital stock represented by shares,
(ii) a cooperative bank without capital stock organized and operated for
mutual purposes and without profit, or (iii) a domestic building and
loan association (as defined in section 7701(a)(19) before amendment by
section 6(c) of the Revenue Act of 1962 (76 Stat. 982)).
[T.D. 6728, 29 FR 5855, May 5, 1964, as amended by T.D. 7154, 36 FR
24997, Dec. 28, 1971]
Sec. 1.592-1 Repayment of certain loans by mutual savings banks,
building and loan associations, and cooperative banks.
There is deductible, under section 592, from the gross income of a
mutual savings bank not having capital stock represented by shares, a
domestic building and loan association, or a cooperative bank without
capital stock organized and operated for mutual purposes and without
profit, amounts paid by such institutions during the taxable year in
repayment of loans made before September 1, 1951, by the United States
or any agency or instrumentality thereof which is wholly owned by the
United States, or by any mutual fund established under the authority of
the laws of any State. For example, amounts paid by such institution in
repayment of loans made by the Reconstruction Finance Corporation before
September 1, 1951, are deductible under this section. Section 592 is not
applicable, however, in the case of amounts paid in repayment of loans
made by an agency or instrumentality not wholly owned by the United
States.
[[Page 403]]
Sec. 1.594-1 Mutual savings banks conducting life insurance business.
(a) Scope of application. Section 594 applies to the case of a
mutual savings bank not having capital stock represented by shares which
conducts a life insurance business, if:
(1) The conduct of the life insurance business is authorized under
State law,
(2) The life insurance business is carried on in a separate
department of the bank,
(3) The books of account of the life insurance business are
maintained separately from other departments of the bank, and
(4) The life insurance department of the bank would, if it were
treated as a separate corporation, qualify as a life insurance company
under section 801.
(b) Computation of tax. In the case of a mutual savings bank
conducting a life insurance business to which section 594 is applicable,
the tax upon such bank consists of the sum of the following:
(1) A partial tax computed under section 11 upon the taxable income
of the bank determined without regard to any items of income or
deduction properly allocable to the life insurance department, and
(2) A partial tax computed on the income (or, in the case of taxable
years beginning before January 1, 1955, the taxable income (as defined
in section 803)) of the life insurance department determined without
regard to any items of income or deduction not properly allocable to
such department, at the rates and in the manner provided in subchapter L
(section 801 and following), chapter 1 of the Code, with respect to life
insurance companies.
Sec. 1.596-1 Limitation on dividends received deduction.
(a) In general. For taxable years beginning after July 11, 1969, in
the case of mutual savings banks, domestic building and loan
associations, and cooperative banks, if the addition to the reserve for
losses on qualifying real property loans for the taxable year is
determined under section 593(b)(2) (relating to the percentage of
taxable income method), the total amount allowed as a deduction with
respect to dividends received under part VIII, subchapter B, chapter 1,
subtitle A of the Code (section 241 et seq.) (determined without regard
to section 596 and this section) for such taxable year is reduced as
provided by this section. In such case, the dividends received deduction
otherwise determined under part VIII, subchapter B, chapter 1, subtitle
A of the Code, is reduced by an amount equal to the applicable
percentage for such year (determined solely under subparagraphs (A) and
(B) of section 593(b)(2) and the regulations thereunder) of such total
amount.
(b) Example. The provisions of this section may be illustrated by
the following example:
Example. X Corporation, a domestic building and loan association,
determines the addition to its reserve for losses on qualifying real
property loans under section 593(b)(2) for its taxable year beginning in
1971. During that taxable year, X Corporation received a total of
$100,000 as dividends from domestic corporations subject to tax under
chapter 1 of the Code. X Corporation received no other dividends during
the taxable year. Under part VIII, subchapter B, chapter 1, subtitle A
of the Code, a deduction, determined without regard to section 596 and
this section, of $85,000 would be allowed with respect to the dividends.
For the taxable year, the applicable percentage, determined under
subparagraphs (A) and (B) of section 593(b)(2), is 54 percent. Under
section 596 and this section, the amount allowed as a deduction under
section 243 and the regulations thereunder is reduced by $45,900 (54
percent of $85,000) to $39,100 ($85,000 less $45,900).
(c) Dividends received by members of a controlled group. If a thrift
institution that computes a deduction under section 593(b)(2) is a
member of a controlled group of corporations (within the meaning of
section 1563(a), determined by substituting 50 percent for 80 percent
each place it appears therein) and if the thrift institution, without a
bona fide business purpose, transfers stock, directly or indirectly, to
another member of the group, the Commissioner may allocate any dividends
with respect to the stock to the thrift institution. If the Commissioner
allocates a dividend to a thrifty institution under this paragraph (c),
the Commissioner will also make appropriate correlative adjustments to
the income of any other member of the group involved in the allocation,
at a time and
[[Page 404]]
in a manner consistent with the procedures of Sec. 1.482-1(d)(2). This
paragraph (c) applies to taxable years ending on or after August 30,
1975.
[T.D. 7149, 36 FR 20944, Nov. 2, 1971, as amended by T.D. 7631, 44 FR
40496, July 11, 1979; T.D. 9849, 84 FR 9235, Mar. 14, 2019]
Sec. 1.597-1 Definitions.
For purposes of the regulations under section 597--
(a) Unless the context otherwise requires, the terms consolidated
group, member and subsidiary have the meanings provided in Sec. 1.1502-
1; and
(b) The following terms have the meanings provided below--
Acquiring. The term Acquiring means a corporation that is a
transferee in a Taxable Transfer, other than a deemed transferee in a
Taxable Transfer described in Sec. 1.597-5(b).
Agency. The term Agency means the Resolution Trust Corporation, the
Federal Deposit Insurance Corporation, any similar instrumentality of
the United States government, and any predecessor or successor of the
foregoing (including the Federal Savings and Loan Insurance
Corporation).
Agency Control. An Institution or entity is under Agency Control if
Agency is conservator or receiver of the Institution or entity, or if
Agency has the right to appoint any of the Institution's or entity's
directors.
Agency Obligation. The term Agency Obligation means a debt
instrument that Agency issues to an Institution or to a direct or
indirect owner of an Institution.
Agency Receivership. An Instit ution or entity is under Agency
Receivership if an Agency is acting as receiver for such Institution or
entity.
Average Reimbursement Rate. The term Average Reimbursement Rate
means the percentage of losses (as determined under the terms of the
Loss Share Agreement) that would be reimbursed by an Agency or a
Controlled Entity if every asset subject to a Loss Share Agreement were
disposed of for the Third-Party Price. The Average Reimbursement Rate is
determined at the time of the Taxable Transfer and is not adjusted for
any changes in Third-Party Price over the life of any asset subject to
the Loss Share Agreement or the prior disposition of any asset subject
to the Loss Share Agreement.
Bridge Bank. The term Bridge Bank means an Institution that is
organized by Agency to hold assets and liabilities of another
Institution and that continues the operation of the other Institution's
business pending its acquisition or liquidation, and that is any of the
following--
(1) A national bank chartered by the Comptroller of the Currency
under section 11(n) of the Federal Deposit Insurance Act (12 U.S.C.
1821(n)) or section 21A(b)(10)(A) of the Federal Home Loan Bank Act (12
U.S.C. 1441a(b)(10)(A)) or any successor sections;
(2) A Federal savings association chartered by the Director of the
Office of Thrift Supervision under section 21A(b)(10)(A) of the Federal
Home Loan Bank Act (12 U.S.C. 1441a(b)(10)(A)) or any successor section;
or
(3) A similar Institution chartered under any other statutory
provisions.
Consolidated Subsidiary. The term Consolidated Subsidiary means a
corporation that both:
(i) Is a member of the same consolidated group as an Institution;
and
(ii) Would be a member of the affiliated group that would be
determined under section 1504(a) if the Institution were the common
parent thereof.
Continuing Equity. An Institution has Continuing Equity for any
taxable year if, on the last day of the taxable year, the Institution is
not a Bridge Bank, in Agency Receivership, or treated as a New Entity.
Controlled Entity. The term Controlled Entity means an entity under
Agency Control.
Covered Asset. The term Covered Asset means an asset subject to a
Loss Guarantee. The fair market value of a Covered Asset equals the
asset's Expected Value.
Expected Value. The term Expected Value means the sum of the Third-
Party Price for a Covered Asset and the amount that an Agency or a
Controlled Entity would pay under the Loss Guarantee if the asset
actually were sold for the Third-Party Price. For purposes of the
preceding sentence, if an asset is subject to a Loss Share Agreement,
the amount that an Agency or a Controlled Entity would pay
[[Page 405]]
under a Loss Guarantee with respect to the asset is determined by
multiplying the amount of loss that would be realized under the terms of
the Loss Share Agreement if the asset were disposed of at the Third-
Party Price by the Average Reimbursement Rate.
Federal Financial Assistance (FFA). The term Federal Financial
Assistance (FFA), as defined by section 597(c), means any money or
property provided by Agency to an Institution or to a direct or indirect
owner of stock in an Institution under section 406(f) of the National
Housing Act (12 U.S.C. 1729(f)), section 21A(b)(4) of the Federal Home
Loan Bank Act (12 U.S.C. 1441a(b)(4)), section 11(f) or 13(c) of the
Federal Deposit Insurance Act (12 U.S.C. 1821(f), 1823(c)), or under any
similar provision of law. Any such money or property is FFA, regardless
of whether the Institution or any of its affiliates issues Agency a note
or other obligation, stock, warrants, or other rights to acquire stock
in connection with Agency's provision of the money or property. FFA
includes Net Worth Assistance, Loss Guarantee payments, yield
maintenance payments, cost to carry or cost of funds reimbursement
payments, expense reimbursement or indemnity payments, and interest
(including original issue discount) on an Agency Obligation.
Institution. The term Institution means an entity that is, or
immediately before being placed under Agency Control was, a bank or
domestic building and loan association within the meaning of section 597
(including a Bridge Bank). Except as otherwise provided in the
regulations under section 597, the term Institution includes a New
Entity or Acquiring that is a bank or domestic building and loan
association within the meaning of section 597.
Loss Guarantee. The term Loss Guarantee means an agreement pursuant
to which an Agency or a Controlled Entity guarantees or agrees to pay an
Institution a specified amount upon the disposition or charge-off (in
whole or in part) of specific assets, an agreement pursuant to which an
Institution has a right to put assets to an Agency or a Controlled
Entity at a specified price, a Loss Share Agreement, or a similar
arrangement.
Loss Share Agreement. The term Loss Share Agreement means an
agreement pursuant to which an Agency or a Controlled Entity agrees to
reimburse the guaranteed party a percentage of losses realized.
Net Worth Assistance. The term Net Worth Assistance means money or
property (including an Agency Obligation to the extent it has a fixed
principal amount) that Agency provides as an integral part of a Taxable
Transfer, other than FFA that accrues after the date of the Taxable
Transfer. For example, Net Worth Assistance does not include Loss
Guarantee payments, yield maintenance payments, cost to carry or cost of
funds reimbursement payments, or expense reimbursement or indemnity
payments. An Agency Obligation is considered to have a fixed principal
amount notwithstanding an agreement providing for its adjustment after
issuance to reflect a more accurate determination of the condition of
the Institution at the time of the acquisition.
New Entity. The term New Entity means the new corporation that is
treated as purchasing all of the assets of an Old Entity in a Taxable
Transfer described in Sec. 1.597-5(b).
Old Entity. The term Old Entity means the Institution or
Consolidated Subsidiary that is treated as selling all of its assets in
a Taxable Transfer described in Sec. 1.597-5(b).
Residual Entity. The term Residual Entity means the entity that
remains after an Institution transfers deposit liabilities to a Bridge
Bank.
Taxable Transfer. The term Taxable Transfer has the meaning provided
in Sec. 1.597-5(a)(1).
Third-Party Price. The term Third-Party Price means the amount that
a third party would pay for an asset absent the existence of a Loss
Guarantee.
[T.D. 8641, 60 FR 66094, Dec. 21, 1995, as amended by T.D. 9825, 82 FR
48619, Oct. 19, 2017]
Sec. 1.597-2 Taxation of FFA.
(a) Inclusion in income--(1) In general. Except as otherwise
provided in the regulations under section 597, all FFA is includible as
ordinary income to the recipient at the time the FFA is received or
accrued in accordance with
[[Page 406]]
the recipient's method of accounting. The amount of FFA received or
accrued is the amount of any money, the fair market value of any
property (other than an Agency Obligation), and the issue price of any
Agency Obligation (determined under Sec. 1.597-3(c)(2)). An Institution
(and not the nominal recipient) is treated as receiving directly any FFA
that an Agency provides in a taxable year to a direct or indirect
shareholder of the Institution, to the extent the money or property is
transferred to the Institution pursuant to an agreement with an Agency.
(2) Cross references. See paragraph (c) of this section for rules
regarding the timing of inclusion of certain FFA. See paragraph (d) of
this section for additional rules regarding the treatment of FFA
received in connection with transfers of money or property to an Agency
or a Controlled Entity, or paid pursuant to a Loss Guarantee. See Sec.
1.597-5(c)(1) for additional rules regarding the inclusion of Net Worth
Assistance in the income of an Institution.
(b) Basis of property that is FFA. If FFA consists of property, the
Institution's basis in the property equals the fair market value of the
property (other than an Agency Obligation) or the issue price of the
Agency Obligation (as determined under Sec. 1.597-3(c)(2)).
(c) Timing of inclusion of certain FFA--(1) Scope. This paragraph
(c) limits the amount of FFA an Institution must include in income
currently under certain circumstances and provides rules for the
deferred inclusion in income of amounts in excess of those limits. This
paragraph (c) does not apply to a New Entity or an Acquiring.
(2) Amount currently included in income by an Institution without
Continuing Equity. The amount of FFA an Institution without Continuing
Equity must include in income in a taxable year under paragraph (a)(1)
of this section is limited to the sum of--
(i) The excess at the beginning of the taxable year of the
Institution's liabilities over the adjusted bases of the Institution's
assets; and
(ii) The amount by which the excess for the taxable year of the
Institution's deductions allowed by chapter 1 of the Internal Revenue
Code (Code) (other than net operating and capital loss carryovers) over
its gross income (determined without regard to FFA) is greater than the
excess at the beginning of the taxable year of the adjusted bases of the
Institution's assets over the Institution's liabilities.
(3) Amount currently included in income by an Institution with
Continuing Equity. The amount of FFA an Institution with Continuing
Equity must include in income in a taxable year under paragraph (a)(1)
of this section is limited to the sum of--
(i) The excess at the beginning of the taxable year of the
Institution's liabilities over the adjusted bases of the Institution's
assets;
(ii) The greater of--
(A) The excess for the taxable year of the Institution's deductions
allowed by chapter 1 of the Code (other than net operating and capital
loss carryovers) over its gross income (determined without regard to
FFA); or
(B) The excess for the taxable year of the deductions allowed by
chapter 1 of the Code (other than net operating and capital loss
carryovers) of the consolidated group of which the Institution is a
member on the last day of the Institution's taxable year over the
group's gross income (determined without regard to FFA); and
(iii) The excess of the amount of any net operating loss carryover
of the Institution (or in the case of a carryover from a consolidated
return year of the Institution's current consolidated group, the net
operating loss carryover of the group) to the taxable year over the
amount described in paragraph (c)(3)(i) of this section.
(4) Deferred FFA--(i) Maintenance of account. An Institution must
establish a deferred FFA account commencing in the first taxable year in
which it receives FFA that is not currently included in income under
paragraph (c)(2) or (3) of this section, and must maintain that account
in accordance with the requirements of this paragraph (c)(4). The
Institution must add the amount of any FFA that is not currently
included in income under paragraph (c)(2) or (3) of this section to its
deferred FFA account. The Institution must decrease the balance of its
deferred FFA account by the amount of
[[Page 407]]
deferred FFA included in income under paragraphs (c)(4)(ii), (iv), and
(v) of this section. (See also paragraphs (d)(4) and (d)(5)(i)(B) of
this section for other adjustments that decrease the deferred FFA
account.) If, under paragraph (c)(3) of this section, FFA is not
currently included in income in a taxable year, the Institution
thereafter must maintain its deferred FFA account on a FIFO (first in,
first out) basis (for example, for purposes of the first sentence of
paragraph (c)(4)(iv) of this section).
(ii) Deferred FFA recapture. In any taxable year in which an
Institution has a balance in its deferred FFA account, it must include
in income an amount equal to the lesser of the amount described in
paragraph (c)(4)(iii) of this section or the balance in its deferred FFA
account.
(iii) Annual recapture amount--(A) Institutions without Continuing
Equity--(1) In general. In the case of an Institution without Continuing
Equity, the amount described in this paragraph (c)(4)(iii) is the amount
by which--
(i) The excess for the taxable year of the Institution's deductions
allowed by chapter 1 of the Code (other than net operating and capital
loss carryovers) over its gross income (taking into account FFA included
in income under paragraph (c)(2) of this section) is greater than
(ii) The Institution's remaining equity as of the beginning of the
taxable year.
(2) Remaining equity. The Institution's remaining equity is--
(i) The amount at the beginning of the taxable year in which the
deferred FFA account was established equal to the adjusted bases of the
Institution's assets minus the Institution's liabilities (which amount
may be positive or negative); plus
(ii) The Institution's taxable income (computed without regard to
any carryover from any other year) in any subsequent taxable year or
years; minus
(iii) The excess in any subsequent taxable year or years of the
Institution's deductions allowed by chapter 1 of the Code (other than
net operating and capital loss carryovers) over its gross income.
(B) Institutions with Continuing Equity. In the case of an
Institution with Continuing Equity, the amount described in this
paragraph (c)(4)(iii) is the amount by which the Institution's
deductions allowed by chapter 1 of the Code (other than net operating
and capital loss carryovers) exceed its gross income (taking into
account FFA included in income under paragraph (c)(3) of this section).
(iv) Additional deferred FFA recapture by an Institution with
Continuing Equity. To the extent that, as of the end of a taxable year,
the cumulative amount of FFA deferred under paragraph (c)(3) of this
section that an Institution with Continuing Equity has recaptured under
this paragraph (c)(4) is less than the cumulative amount of FFA deferred
under paragraph (c)(3) of this section that the Institution would have
recaptured if that FFA had been included in income ratably over the six
taxable years immediately following the taxable year of deferral, the
Institution must include that difference in income for the taxable year.
An Institution with Continuing Equity must include in income the balance
of its deferred FFA account in the taxable year in which it liquidates,
ceases to do business, transfers (other than to a Bridge Bank)
substantially all of its assets and liabilities, or is deemed to
transfer all of its assets under Sec. 1.597-5(b).
(v) Optional accelerated recapture of deferred FFA. An Institution
that has a deferred FFA account may include in income the balance of its
deferred FFA account on its timely filed (including extensions) original
federal income tax return for any taxable year that it is not under
Agency Control. The balance of its deferred FFA account is income on the
last day of that year.
(5) Exceptions to limitations on use of losses. In computing an
Institution's taxable income or alternative minimum taxable income for a
taxable year, sections 56(d)(1), 382, and 383 and Sec. Sec. 1.1502-15,
1.1502-21, and 1.1502-22 (or Sec. Sec. 1.1502-15A, 1.1502-21A, and
1.1502-22A, as appropriate) do not limit the use of the attributes of
the Institution to the extent, if any, that the inclusion of
[[Page 408]]
FFA (including recaptured FFA) in income results in taxable income or
alternative minimum taxable income (determined without regard to this
paragraph (c)(5)) for the taxable year. This paragraph (c)(5) does not
apply to any limitation under section 382 or 383 or Sec. 1.1502-15,
Sec. 1.1502-21, or Sec. 1.1502-22 (or Sec. 1.1502-15A, Sec. 1.1502-
21A, or Sec. 1.1502-22A, as appropriate) that arose in connection with
or prior to a corporation becoming a Consolidated Subsidiary of the
Institution.
(6) Operating rules--(i) Bad debt reserves. For purposes of
paragraphs (c)(2), (3), and (4) of this section, the adjusted bases of
an Institution's assets are reduced by the amount of the Institution's
reserves for bad debts under section 585 or 593, other than supplemental
reserves under section 593.
(ii) Aggregation of Consolidated Subsidiaries. For purposes of this
paragraph (c), an Institution is treated as a single entity that
includes the income, expenses, assets, liabilities, and attributes of
its Consolidated Subsidiaries, with appropriate adjustments to prevent
duplication.
(iii) Alternative minimum tax. To compute the alternative minimum
taxable income attributable to FFA of an Institution for any taxable
year under section 55, the rules of this section, and related rules, are
applied by using alternative minimum tax basis, deductions, and all
other items required to be taken into account. All other alternative
minimum tax provisions continue to apply.
(7) Earnings and profits. FFA that is not currently included in
income under this paragraph (c) is included in earnings and profits for
all purposes of the Code to the extent and at the time it is included in
income under this paragraph (c).
(d) Transfers of money or property to an Agency, and Covered
Assets--(1) Transfers of property to an Agency. Except as provided in
paragraph (d)(4)(iii) of this section, the transfer of property to an
Agency or a Controlled Entity is a taxable sale or exchange in which the
Institution is treated as realizing an amount equal to the property's
fair market value.
(2) FFA with respect to Covered Assets other than on transfer to an
Agency--(i) FFA provided pursuant to a Loss Guarantee with respect to a
Covered Asset is included in the amount realized with respect to the
Covered Asset.
(ii) If an Agency makes a payment to an Institution pursuant to a
Loss Guarantee with respect to a Covered Asset owned by an entity other
than the Institution, the payment will be treated as made directly to
the owner of the Covered Asset and included in the amount realized with
respect to the Covered Asset when the Covered Asset is sold or charged
off. The payment will be treated as further transferred through chains
of ownership to the extent necessary to reflect the actual receipt of
such payment. Any such transfer, if a deemed distribution, will not be a
preferential dividend for purposes of sections 561, 562, 852, or 857.
(iii) For the purposes of this paragraph (d)(2), references to an
amount realized include amounts obtained in whole or partial
satisfaction of loans, amounts obtained by virtue of charging off or
marking to market a Covered Asset, and other amounts similarly related
to property, whether or not disposed of.
(3) Treatment of FFA received in exchange for property. FFA included
in the amount realized for property under this paragraph (d) is not
includible in income under paragraph (a)(1) of this section. The amount
realized is treated in the same manner as if realized from a person
other than an Agency or a Controlled Entity. For example, gain
attributable to FFA received with respect to a capital asset retains its
character as capital gain. Similarly, FFA received with respect to
property that has been charged off for federal income tax purposes is
treated as a recovery to the extent of the amount previously charged
off. Any FFA provided in excess of the amount realized under this
paragraph (d) is includible in income under paragraph (a)(1) of this
section.
(4) Adjustment to FFA--(i) In general. If an Institution pays or
transfers money or property to an Agency or a Controlled Entity, the
amount of money and the fair market value of the property is an
adjustment to its FFA to the extent the amount paid and transferred
exceeds the amount of
[[Page 409]]
money and the fair market value of any property that an Agency or a
Controlled Entity provides in exchange.
(ii) Deposit insurance. This paragraph (d)(4) does not apply to
amounts paid to an Agency with respect to deposit insurance.
(iii) Treatment of an interest held by an Agency or a Controlled
Entity--(A) In general. For purposes of this paragraph (d), an interest
described in Sec. 1.597-3(b) is not treated as property when
transferred by the issuer to an Agency or a Controlled Entity nor when
acquired from an Agency or a Controlled Entity by the issuer.
(B) Dispositions to persons other than issuer. On the date an Agency
or a Controlled Entity transfers an interest described in Sec. 1.597-
3(b) to a holder other than the issuer, an Agency, or a Controlled
Entity, the issuer is treated for purposes of this paragraph (d)(4) as
having transferred to an Agency an amount of money equal to the sum of
the amount of money and the fair market value of property that was paid
by the new holder as consideration for the interest.
(iv) Affiliated groups. For purposes of this paragraph (d), an
Institution is treated as having made any transfer to an Agency or a
Controlled Entity that was made by any other member of its affiliated
group. The affiliated group must make appropriate basis adjustments or
other adjustments to the extent the member transferring money or other
property is not the member that received FFA.
(5) Manner of making adjustments to FFA--(i) Reduction of FFA and
deferred FFA. An Institution adjusts its FFA under paragraph (d)(4) of
this section by reducing in the following order and in an aggregate
amount not greater than the adjustment--
(A) The amount of any FFA that is otherwise includible in income for
the taxable year (before application of paragraph (c) of this section);
and
(B) The balance (but not below zero) in the deferred FFA account, if
any, maintained under paragraph (c)(4) of this section.
(ii) Deduction of excess amounts. If the amount of the adjustment
exceeds the sum of the amounts described in paragraph (d)(5)(i) of this
section, the Institution may deduct the excess to the extent the
deduction does not exceed the amount of FFA included in income for prior
taxable years reduced by the amount of deductions allowable under this
paragraph (d)(5)(ii) in prior taxable years.
(iii) Additional adjustments. Any adjustment to FFA in excess of the
sum of the amounts described in paragraphs (d)(5)(i) and (ii) of this
section is treated--
(A) By an Institution other than a New Entity or an Acquiring, as a
deduction of the amount in excess of FFA received that is required to be
transferred to an Agency under section 11(g) of the Federal Deposit
Insurance Act (12 U.S.C. 1821(g)); or
(B) By a New Entity or an Acquiring, as an adjustment to the
purchase price paid in the Taxable Transfer (see Sec. 1.338-7).
(e) Examples. The following examples illustrate the provisions of
this section:
Example 1. Timing of inclusion of FFA in income. (i) Institution M,
a calendar-year taxpayer without Continuing Equity because it is in
Agency Receivership, is not a member of a consolidated group and has not
been acquired in a Taxable Transfer. On January 1, 2018, M has assets
with a total adjusted basis of $100 million and total liabilities of
$120 million. M's deductions do not exceed its gross income (determined
without regard to FFA) for 2018. The Agency provides $30 million of FFA
to M in 2018. The amount of this FFA that M must include in income in
2018 is limited by paragraph (c)(2) of this section to $20 million, the
amount by which M's liabilities ($120 million) exceed the total adjusted
basis of its assets ($100 million) at the beginning of the taxable year.
Pursuant to paragraph (c)(4)(i) of this section, M must establish a
deferred FFA account for the remaining $10 million.
(ii) If the Agency instead lends M the $30 million, M's indebtedness
to the Agency is disregarded and the results are the same as in
paragraph (i) of this Example 1 under section 597(c), paragraph (b) of
Sec. 1.597-1, and paragraph (b) of Sec. 1.597-3.
Example 2. Transfer of property to an Agency. (i) Institution M, a
calendar-year taxpayer without Continuing Equity because it is in Agency
Receivership, is not a member of a consolidated group and has not been
acquired in a Taxable Transfer. At the beginning of 2018, M's remaining
equity is $0 and M has a deferred FFA account of $10 million. The Agency
does not provide any FFA to M
[[Page 410]]
in 2018. During the year, M transfers property not subject to a Loss
Guarantee to the Agency and does not receive any consideration. The
property has an adjusted basis of $5 million and a fair market value of
$1 million at the time of the transfer. M has no other taxable income or
loss in 2018.
(ii) Under paragraph (d)(1) of this section, M is treated as selling
the property for $1 million, its fair market value, thus recognizing a
$4 million loss ($5 million-$1 million). In addition, because M did not
receive any consideration from the Agency, under paragraph (d)(4) of
this section M has an adjustment to FFA of $1 million, the amount by
which the fair market value of the transferred property ($1 million)
exceeds the consideration M received from the Agency ($0). Because no
FFA is provided to M in 2018, this adjustment reduces the balance of M's
deferred FFA account to $9 million ($10 million-$1 million) under
paragraph (d)(5)(i)(B) of this section. Because M's $4 million loss
causes M's deductions to exceed its gross income by $4 million in 2018
and M has no remaining equity, under paragraph (c)(4)(iii)(A) of this
section M must include $4 million of deferred FFA in income and must
decrease the remaining $9 million balance of its deferred FFA account by
the same amount, leaving a balance of $5 million.
Example 3. Loss Guarantee. Institution Q, a calendar-year taxpayer,
holds a Covered Asset (Asset Z). Q's adjusted basis in Asset Z is
$10,000. Q sells Asset Z to an unrelated third party for $4,000.
Pursuant to the Loss Guarantee, an Agency pays Q $6,000 ($10,000-
$4,000). Q's amount realized from the sale of Asset Z is $10,000 ($4,000
from the third party and $6,000 from the Agency) under paragraph (d)(2)
of this section. Q realizes no gain or loss on the sale ($10,000-$10,000
= $0), and therefore includes none of the $6,000 of FFA it receives
pursuant to the Loss Guarantee in income under paragraph (d)(3) of this
section.
[T.D. 9825, 82 FR 48620, Oct. 19, 2017]
Sec. 1.597-3 Other rules.
(a) Ownership of assets. For all federal income tax purposes, an
Agency is not treated as the owner of assets subject to a Loss
Guarantee, yield maintenance agreement, or cost to carry or cost of
funds reimbursement agreement, regardless of whether it otherwise would
be treated as the owner under general federal income tax principles.
(b) Debt and equity interests received by an Agency. Debt
instruments, stock, warrants, or other rights to acquire stock of an
Institution (or any of its affiliates) that an Agency or a Controlled
Entity receives in connection with a transaction in which FFA is
provided are not treated as debt, stock, or other equity interests of or
in the issuer for any purpose of the Internal Revenue Code while held by
an Agency or a Controlled Entity. On the date an Agency or a Controlled
Entity transfers an interest described in this paragraph (b) to a holder
other than an Agency or a Controlled Entity, the interest is treated as
having been newly issued by the issuer to the holder with an issue price
equal to the sum of the amount of money and the fair market value of
property paid by the new holder in exchange for the interest.
(c) Agency Obligations--(1) In general. Except as otherwise provided
in this paragraph (c), the original issue discount rules of sections
1271 et seq. apply to Agency Obligations.
(2) Issue price of Agency Obligations provided as Net Worth
Assistance. The issue price of an Agency Obligation that is provided as
Net Worth Assistance and that bears interest at either a single fixed
rate or a qualified floating rate (and provides for no contingent
payments) is the lesser of the sum of the present values of all payments
due under the obligation, discounted at a rate equal to the applicable
Federal rate (within the meaning of section 1274(d)(1) and (3)) in
effect for the date of issuance, or the stated principal amount of the
obligation. The issue price of an Agency Obligation that bears a
qualified floating rate of interest (within the meaning of Sec. 1.1275-
5(b)) is determined by treating the obligation as bearing a fixed rate
of interest equal to the rate in effect on the date of issuance under
the obligation.
(3) Adjustments to principal amount. Except as provided in Sec.
1.597-5(d)(2)(iv), this paragraph (c)(3) applies if an Agency modifies
or exchanges an Agency Obligation provided as Net Worth Assistance (or a
successor obligation). The issue price of the modified or new Agency
Obligation is determined under paragraphs (c)(1) and (2) of this
section. If the issue price is greater than the adjusted issue price of
the existing Agency Obligation, the difference is treated as FFA. If the
issue price is less than the adjusted issue price of the
[[Page 411]]
existing Agency Obligation, the difference is treated as an adjustment
to FFA under Sec. 1.597-2(d)(4).
(d) Successors. To the extent necessary to effectuate the purposes
of the regulations under section 597, an entity's treatment under the
regulations applies to its successor. A successor includes a transferee
in a transaction to which section 381(a) applies or a Bridge Bank to
which another Bridge Bank transfers deposit liabilities.
(e) [Reserved]
(f) Losses and deductions with respect to Covered Assets. Prior to
the disposition of a Covered Asset, the asset cannot be charged off,
marked to a market value, depreciated, amortized, or otherwise treated
in a manner that supposes an actual or possible diminution of value
below the asset's fair market value. See Sec. 1.597-1(b).
(g) Anti-abuse rule. The regulations under section 597 must be
applied in a manner consistent with the purposes of section 597.
Accordingly, if, in structuring or engaging in any transaction, a
principal purpose is to achieve a federal income tax result that is
inconsistent with the purposes of section 597 and the regulations
thereunder, the Commissioner can make appropriate adjustments to income,
deductions, and other items that would be consistent with those
purposes.
[T.D. 9825, 82 FR 48622, Oct. 19, 2017]
Sec. 1.597-4 Bridge Banks and Agency Control.
(a) Scope. This section provides rules that apply to a Bridge Bank
or other Institution under Agency Control and to transactions in which
an Institution transfers deposit liabilities (whether or not the
Institution also transfers assets) to a Bridge Bank.
(b) Status as taxpayer. A Bridge Bank or other Institution under
Agency Control is a corporation within the meaning of section 7701(a)(3)
for all purposes of the Internal Revenue Code (Code) and is subject to
all Code provisions that generally apply to corporations, including
those relating to methods of accounting and to requirements for filing
returns, even if an Agency owns stock of the Institution.
(c) No section 382 ownership change. The imposition of Agency
Control, the cancellation of Institution stock by an Agency, a
transaction in which an Institution transfers deposit liabilities to a
Bridge Bank, and an election under paragraph (g) of this section are
disregarded in determining whether an ownership change has occurred
within the meaning of section 382(g).
(d) Transfers to Bridge Banks--(1) In general. Except as otherwise
provided in paragraph (g) of this section, the rules of this paragraph
(d) apply to transfers to Bridge Banks. In general, a Bridge Bank and
its associated Residual Entity are together treated as the successor
entity to the transferring Institution. If an Institution transfers
deposit liabilities to a Bridge Bank (whether or not it also transfers
assets), the Institution recognizes no gain or loss on the transfer and
the Bridge Bank succeeds to the transferring Institution's basis in any
transferred assets. The associated Residual Entity retains its basis in
any assets it continues to hold. Immediately after the transfer, the
Bridge Bank succeeds to and takes into account the transferring
Institution's items described in section 381(c) (subject to the
conditions and limitations specified in section 381(c)), taxpayer
identification number (TIN), deferred FFA account, and account
receivable for future FFA as described in paragraph (g)(4)(ii) of this
section. The Bridge Bank also succeeds to and continues the transferring
Institution's taxable year.
(2) Transfers to a Bridge Bank from multiple Institutions. If two or
more Institutions transfer deposit liabilities to the same Bridge Bank,
the rules in paragraph (d)(1) of this section are modified to the extent
provided in this paragraph (d)(2). The Bridge Bank succeeds to the TIN
and continues the taxable year of the Institution that transfers the
largest amount of deposits. The taxable years of the other transferring
Institutions close at the time of the transfer. If all the transferor
Institutions are members of the same consolidated group, the Bridge
Bank's carryback of losses to the Institution that transfers the largest
amount of deposits is not limited by section 381(b)(3). The limitations
of section 381(b)(3) do apply to the Bridge Bank's
[[Page 412]]
carrybacks of losses to all other transferor Institutions. If the
transferor Institutions are not all members of the same consolidated
group, the limitations of section 381(b)(3) apply with respect to all
transferor Institutions. See paragraph (g)(6)(ii) of this section for
additional rules that apply if two or more Institutions that are not
members of the same consolidated group transfer deposit liabilities to
the same Bridge Bank.
(e) Treatment of Bridge Bank and Residual Entity as a single entity.
A Bridge Bank and its associated Residual Entity or Entities are treated
as a single entity for federal income tax purposes and must file a
single combined federal income tax return. The Bridge Bank is
responsible for filing all federal income tax returns and statements for
this single entity and is the agent of each associated Residual Entity
to the same extent as if the Bridge Bank were the agent for a
consolidated group, within the meaning of Sec. 1.1502-77, including the
Residual Entity. The term Institution includes a Residual Entity that
files a combined return with its associated Bridge Bank.
(f) Rules applicable to members of consolidated groups--(1) Status
as members. Unless an election is made under paragraph (g) of this
section, Agency Control of an Institution does not terminate the
Institution's membership in a consolidated group. Stock of a subsidiary
that is canceled by an Agency is treated as held by the members of the
consolidated group that held the stock prior to its cancellation. If an
Institution is a member of a consolidated group immediately before it
transfers deposit liabilities to a Bridge Bank, the Bridge Bank succeeds
to the Institution's status as the common parent or, unless an election
is made under paragraph (g) of this section, as a subsidiary of the
group. If a Bridge Bank succeeds to an Institution's status as a
subsidiary, its stock is treated as held by the shareholders of the
transferring Institution, and the stock basis or excess loss account of
the Institution carries over to the Bridge Bank. A Bridge Bank is
treated as owning stock owned by its associated Residual Entities,
including for purposes of determining membership in an affiliated group.
(2) Coordination with consolidated return regulations. The
provisions of the regulations under section 597 take precedence over
conflicting provisions in the regulations under section 1502.
(g) Elective disaffiliation--(1) In general. A consolidated group of
which an Institution is a subsidiary may elect irrevocably not to
include the Institution in its affiliated group if the Institution is
placed in Agency Receivership (whether or not assets or deposit
liabilities of the Institution are transferred to a Bridge Bank). See
paragraph (g)(6) of this section for circumstances under which a
consolidated group is deemed to make this election.
(2) Consequences of election. If the election under this paragraph
(g) is made with respect to an Institution, the following consequences
occur immediately before the subsidiary Institution to which the
election applies is placed in Agency Receivership (or, in the case of a
deemed election under paragraph (g)(6) of this section, immediately
before the consolidated group is deemed to make the election) and in the
following order--
(i) All adjustments of the Institution and its Consolidated
Subsidiaries under section 481 are accelerated;
(ii) Deferred intercompany gains and losses and intercompany items
with respect to the Institution and its Consolidated Subsidiaries are
taken into account and the Institution and its Consolidated Subsidiaries
take into account any other items required under the regulations under
section 1502 for members that become nonmembers within the meaning of
Sec. 1.1502-32(d)(4);
(iii) The taxable year of the Institution and its Consolidated
Subsidiaries closes and the Institution includes the amount described in
paragraph (g)(3) of this section in income as ordinary income as its
last item for that taxable year;
(iv) The members of the consolidated group owning the common stock
of the Institution include in income any excess loss account with
respect to the Institution's stock under Sec. 1.1502-19 and any other
items required under the regulations under section 1502 for members that
own stock of corporations that become nonmembers within the meaning of
Sec. 1.1502-32(d)(4); and
[[Page 413]]
(v) If the Institution's liabilities exceed the aggregate fair
market value of its assets on the date the Institution is placed in
Agency Receivership (or, in the case of a deemed election under
paragraph (g)(6) of this section, on the date the consolidated group is
deemed to make the election), the members of the consolidated group
treat their stock in the Institution as worthless. (See Sec. Sec.
1.337(d)-2, 1.1502-35(f), and 1.1502-36 for rules applicable when a
member of a consolidated group is entitled to a worthless stock
deduction with respect to stock of another member of the group.) In all
other cases, the consolidated group will be treated as owning stock of a
nonmember corporation until such stock is disposed of or becomes
worthless under rules otherwise applicable.
(3) Toll charge. The amount described in this paragraph (g)(3) is
the excess of the Institution's liabilities over the adjusted bases of
its assets immediately before the Institution is placed in Agency
Receivership (or, in the case of a deemed election under paragraph
(g)(6) of this section, immediately before the consolidated group is
deemed to make the election). In computing this amount, the adjusted
bases of an Institution's assets are reduced by the amount of the
Institution's reserves for bad debts under section 585 or 593, other
than supplemental reserves under section 593. For purposes of this
paragraph (g)(3), an Institution is treated as a single entity that
includes the assets and liabilities of its Consolidated Subsidiaries,
with appropriate adjustments to prevent duplication. The amount
described in this paragraph (g)(3) for alternative minimum tax purposes
is determined using alternative minimum tax basis, deductions, and all
other items required to be taken into account. In computing the increase
in the group's taxable income or alternative minimum taxable income,
sections 56(d)(1), 382, and 383 and Sec. Sec. 1.1502-15, 1.1502-21, and
1.1502-22 (or Sec. Sec. 1.1502-15A, 1.1502-21A, and 1.1502-22A, as
appropriate) do not limit the use of the attributes of the Institution
and its Consolidated Subsidiaries to the extent, if any, that the
inclusion of the amount described in this paragraph (g)(3) in income
would result in the group having taxable income or alternative minimum
taxable income (determined without regard to this sentence) for the
taxable year. The preceding sentence does not apply to any limitation
under section 382 or 383 or Sec. 1.1502-15, Sec. 1.1502-21, or Sec.
1.1502-22 (or Sec. 1.1502-15A, Sec. 1.1502-21A, or Sec. 1.1502-22A,
as appropriate) that arose in connection with or prior to a corporation
becoming a Consolidated Subsidiary of the Institution.
(4) Treatment of Institutions after disaffiliation--(i) In general.
If the election under this paragraph (g) is made with respect to an
Institution, immediately after the Institution is placed in Agency
Receivership (or, in the case of a deemed election under paragraph
(g)(6) of this section, immediately after the consolidated group is
deemed to make the election), the Institution and each of its
Consolidated Subsidiaries are treated for federal income tax purposes as
new corporations that are not members of the electing group's affiliated
group. Each new corporation retains the TIN of the corresponding
disaffiliated corporation and is treated as having received the assets
and liabilities of the corresponding disaffiliated corporation in a
transaction to which section 351 applies (and in which no gain was
recognized under section 357(c) or otherwise). Thus, the new corporation
has no net operating or capital loss carryforwards. An election under
this paragraph (g) does not terminate the single entity treatment of a
Bridge Bank and its Residual Entities provided in paragraph (e) of this
section.
(ii) FFA. A new Institution is treated as having a non-interest
bearing, nontransferable account receivable for future FFA with a basis
equal to the amount described in paragraph (g)(3) of this section. If a
disaffiliated Institution has a deferred FFA account at the time of its
disaffiliation, the corresponding new Institution succeeds to and takes
into account that deferred FFA account.
(iii) Filing of consolidated returns. If a disaffiliated Institution
has Consolidated Subsidiaries at the time of its disaffiliation, the
corresponding new Institution is required to file a consolidated federal
income tax return with
[[Page 414]]
the subsidiaries in accordance with the regulations under section 1502.
(iv) Status as Institution. If an Institution is disaffiliated under
this paragraph (g), the resulting new corporation is treated as an
Institution for purposes of the regulations under section 597 regardless
of whether it is a bank or domestic building and loan association within
the meaning of section 597.
(v) Loss carrybacks. To the extent a carryback of losses would
result in a refund being paid to a fiduciary under section 6402(k), an
Institution or Consolidated Subsidiary with respect to which an election
under this paragraph (g) (other than under paragraph (g)(6)(ii) of this
section) applies is allowed to carry back losses as if the Institution
or Consolidated Subsidiary had continued to be a member of the
consolidated group that made the election.
(5) Affirmative election--(i) Original Institution--(A) Manner of
making election. Except as otherwise provided in paragraph (g)(6) of
this section, a consolidated group makes the election provided by this
paragraph (g) by sending a written statement by certified mail to the
affected Institution on or before 120 days after its placement in Agency
Receivership. The statement must contain the following legend at the top
of the page: ``THIS IS AN ELECTION UNDER Sec. 1.597-4(g) TO EXCLUDE THE
INSTITUTION AND CONSOLIDATED SUBSIDIARIES REFERENCED IN THIS STATEMENT
FROM THE AFFILIATED GROUP,'' and must include the names and TINs of the
common parent and of the Institution and Consolidated Subsidiaries to
which the election applies, and the date on which the Institution was
placed in Agency Receivership. The consolidated group must send a
similar statement to all subsidiary Institutions placed in Agency
Receivership during the consistency period described in paragraph
(g)(5)(ii) of this section. (Failure to satisfy the requirement in the
preceding sentence, however, does not invalidate the election with
respect to any subsidiary Institution placed in Agency Receivership
during the consistency period described in paragraph (g)(5)(ii) of this
section.) The consolidated group must retain a copy of the statement
sent to any affected or subsidiary Institution (and the accompanying
certified mail receipt) as proof that it mailed the statement to the
affected Institution, and the consolidated group must make the statement
and receipt available for inspection by the Commissioner upon request.
The consolidated group must include an election statement as part of its
first federal income tax return filed after the due date under this
paragraph (g)(5) for such statement. A statement must be attached to
this return indicating that the individual who signed the election was
authorized to do so on behalf of the consolidated group. The agent for
the group, within the meaning of Sec. 1.1502-77, takes all actions
required under this paragraph (g)(5)(i)(A) to make the election provided
under this paragraph (g)(5) for the consolidated group. An Agency cannot
make the election provided under this paragraph (g)(5) under the
authority of section 6402(k) or otherwise.
(B) Consistency limitation on affirmative elections. A consolidated
group may make an affirmative election under this paragraph (g)(5) with
respect to a subsidiary Institution placed in Agency Receivership only
if the group made, or is deemed to have made, the election under this
paragraph (g) with respect to every subsidiary Institution of the group
placed in Agency Receivership within five years preceding the date the
subject Institution was placed in Agency Receivership.
(ii) Effect on Institutions placed in receivership simultaneously or
subsequently. An election under this paragraph (g), other than under
paragraph (g)(6)(ii) of this section, applies to the Institution with
respect to which the election is made or deemed made (the original
Institution) and each subsidiary Institution of the group placed in
Agency Receivership or deconsolidated in contemplation of Agency Control
or the receipt of FFA simultaneously with the original Institution or
within five years thereafter.
(6) Deemed election--(i) Deconsolidations in contemplation. If one
or more members of a consolidated
[[Page 415]]
group deconsolidate (within the meaning of Sec. 1.1502-19(c)(1)(ii)(B))
a subsidiary Institution in contemplation of Agency Control or the
receipt of FFA, the consolidated group is deemed to make the election
described in this paragraph (g) with respect to the Institution on the
date the deconsolidation occurs. A subsidiary Institution is
conclusively presumed to have been deconsolidated in contemplation of
Agency Control or the receipt of FFA if either event occurs within six
months after the deconsolidation.
(ii) Transfers to a Bridge Bank from multiple groups. On the day an
Institution's transfer of deposit liabilities to a Bridge Bank results
in the Bridge Bank holding deposit liabilities from both a subsidiary
Institution and an Institution not included in the subsidiary
Institution's consolidated group, each consolidated group of which a
transferring Institution or the Bridge Bank is a subsidiary is deemed to
make the election described in this paragraph (g) with respect to its
subsidiary Institution. If deposit liabilities of another Institution
that is a subsidiary member of any consolidated group subsequently are
transferred to the Bridge Bank, the consolidated group of which the
Institution is a subsidiary is deemed to make the election described in
this paragraph (g) with respect to that Institution at the time of the
subsequent transfer.
(h) Examples. The following examples illustrate the provisions of
this section:
Facts. Corporation X, the common parent of a consolidated group,
owns all the stock (with a basis of $4 million) of Institution M, an
insolvent Institution with no Consolidated Subsidiaries. At the close of
business on April 30, 2018, M has $4 million of deposit liabilities, $1
million of other liabilities, and assets with an adjusted basis of $4
million and a fair market value of $3 million.
Example 1. Effect of receivership on consolidation. On May 1, 2018,
M is placed in Agency Receivership and the Agency begins liquidating M.
X does not make an election under paragraph (g) of this section. M
remains a member of the X consolidated group after May 1, 2018 under
paragraph (f)(1) of this section.
Example 2. Effect of Bridge Bank on consolidation--(i) Additional
facts. On May 1, 2018, M is placed in Agency Receivership and the Agency
causes M to transfer all of its assets and deposit liabilities to Bridge
Bank MB.
(ii) Consequences without an election to disaffiliate. M recognizes
no gain or loss from the transfer and MB succeeds to M's basis in the
transferred assets, M's items described in section 381(c) (subject to
the conditions and limitations specified in section 381(c)), and TIN
under paragraph (d)(1) of this section. (If M had a deferred FFA
account, MB would also succeed to that account under paragraph (d)(1) of
this section.) MB continues M's taxable year and succeeds to M's status
as a member of the X consolidated group after May 1, 2018 under
paragraphs (d)(1) and (f) of this section. MB and M are treated as a
single entity for federal income tax purposes under paragraph (e) of
this section.
(iii) Consequences with an election to disaffiliate. If, on July 1,
2018, X makes an election under paragraph (g) of this section with
respect to M, the following consequences are treated as occurring
immediately before M was placed in Agency Receivership. M must include
$1 million ($5 million of liabilities -$4 million of adjusted basis) in
income as of May 1, 2018 under paragraph (g)(2) and (3) of this section.
M is then treated as a new corporation that is not a member of the X
consolidated group and that has assets (including a $1 million account
receivable for future FFA) with a basis of $5 million and $5 million of
liabilities received from disaffiliated corporation M in a section 351
transaction. New corporation M retains the TIN of disaffiliated
corporation M under paragraph (g)(4) of this section. Immediately after
the disaffiliation, new corporation M is treated as transferring its
assets and deposit liabilities to Bridge Bank MB. New corporation M
recognizes no gain or loss from the transfer and MB succeeds to M's TIN
and taxable year under paragraph (d)(1) of this section. Bridge Bank MB
is treated as a single entity that includes M and has $5 million of
liabilities, an account receivable for future FFA with a basis of $1
million, and other assets with a basis of $4 million under paragraph
(d)(1) of this section.
[T.D. 9825, 82 FR 48623, Oct. 19, 2017]
Sec. 1.597-5 Taxable Transfers.
(a) Taxable Transfers--(1) Defined. The term Taxable Transfer
means--
(i) A transaction in which an entity transfers to a transferee other
than a Bridge Bank--
(A) Any deposit liability (whether or not the Institution also
transfers assets), if FFA is provided in connection with the
transaction; or
(B) Any asset for which an Agency or a Controlled Entity has any
financial obligation (for example, pursuant to a
[[Page 416]]
Loss Guarantee or Agency Obligation); or
(ii) A deemed transfer of assets described in paragraph (b) of this
section.
(2) Scope. This section provides rules governing Taxable Transfers.
Rules applicable to both actual and deemed asset acquisitions are
provided in paragraphs (c) and (d) of this section. Special rules
applicable only to deemed asset acquisitions are provided in paragraph
(e) of this section.
(b) Deemed asset acquisitions upon stock purchase--(1) In general.
In a deemed transfer of assets under this paragraph (b), an Institution
(including a Bridge Bank or a Residual Entity) or a Consolidated
Subsidiary of the Institution (the Old Entity) is treated as selling all
of its assets in a single transaction and is treated as a new
corporation (the New Entity) that purchases all of the Old Entity's
assets at the close of the day immediately preceding the occurrence of
an event described in paragraph (b)(2) of this section. However, such an
event results in a deemed transfer of assets under this paragraph (b)
only if it occurs--
(i) In connection with a transaction in which FFA is provided;
(ii) While the Institution is a Bridge Bank;
(iii) While the Institution has a positive balance in a deferred FFA
account (see Sec. 1.597-2(c)(4)(v) regarding the optional accelerated
recapture of deferred FFA); or
(iv) With respect to a Consolidated Subsidiary, while the
Institution of which it is a Consolidated Subsidiary is under Agency
Control.
(2) Events. A deemed transfer of assets under this paragraph (b)
results if the Institution or Consolidated Subsidiary--
(i) Becomes a non-member (within the meaning of Sec. 1.1502-
32(d)(4)) of its consolidated group, other than pursuant to an election
under Sec. 1.597-4(g);
(ii) Becomes a member of an affiliated group of which it was not
previously a member, other than pursuant to an election under Sec.
1.597-4(g); or
(iii) Issues stock such that the stock that was outstanding before
the imposition of Agency Control or the occurrence of any transaction in
connection with the provision of FFA represents 50 percent or less of
the vote or value of its outstanding stock (disregarding stock described
in section 1504(a)(4) and stock owned by an Agency or a Controlled
Entity).
(3) Bridge Banks and Residual Entities. If a Bridge Bank is treated
as selling all of its assets to a New Entity under this paragraph (b),
each associated Residual Entity is treated as simultaneously selling its
assets to a New Entity in a Taxable Transfer described in this paragraph
(b).
(c) Treatment of transferor--(1) FFA in connection with a Taxable
Transfer. A transferor in a Taxable Transfer is treated as having
directly received immediately before a Taxable Transfer any Net Worth
Assistance that an Agency provides to the New Entity or the Acquiring in
connection with the transfer. (See Sec. 1.597-2(a) and (c) for rules
regarding the inclusion of FFA in income and Sec. 1.597-2(a)(1) for
related rules regarding FFA provided to shareholders.) The Net Worth
Assistance is treated as an asset of the transferor that is sold to the
New Entity or the Acquiring in the Taxable Transfer.
(2) Amount realized in a Taxable Transfer. In a Taxable Transfer
described in paragraph (a)(1)(i) of this section, the amount realized is
determined under section 1001(b) by reference to the consideration paid
for the assets. In a Taxable Transfer described in paragraph (a)(1)(ii)
of this section, the amount realized is the sum of the grossed-up basis
of the stock acquired in connection with the Taxable Transfer (excluding
stock acquired from the Old or New Entity), plus the amount of
liabilities assumed or taken subject to in the deemed transfer, plus
other relevant items. The grossed-up basis of the acquired stock equals
the acquirers' basis in the acquired stock divided by the percentage of
the Old Entity's stock (by value) attributable to the acquired stock.
(3) Allocation of amount realized--(i) In general. The amount
realized under paragraph (c)(2) of this section is allocated among the
assets transferred in the Taxable Transfer in the same manner as amounts
are allocated among assets under Sec. 1.338-6(b) and (c)(1) and (2).
(ii) Modifications to general rule. This paragraph (c)(3)(ii)
modifies certain of
[[Page 417]]
the allocation rules of paragraph (c)(3)(i) of this section. Agency
Obligations and Covered Assets in the hands of the New Entity or the
Acquiring are treated as Class II assets. Stock of a Consolidated
Subsidiary is treated as a Class II asset to the extent the fair market
value of the Consolidated Subsidiary's Class I and Class II assets (see
Sec. 1.597-1(b)) exceeds the amount of its liabilities. The fair market
value of an Agency Obligation is deemed to equal its adjusted issue
price immediately before the Taxable Transfer.
(d) Treatment of a New Entity and an Acquiring--(1) Purchase price.
The purchase price for assets acquired in a Taxable Transfer described
in paragraph (a)(1)(i) of this section is the cost of the assets
acquired. See Sec. 1.1060-1(c)(1). All assets transferred in related
transactions pursuant to an option included in an agreement between the
transferor and the Acquiring in the Taxable Transfer are included in the
group of assets among which the consideration paid is allocated for
purposes of determining the New Entity's or the Acquiring's basis in
each of the assets. The purchase price for assets acquired in a Taxable
Transfer described in paragraph (a)(1)(ii) of this section is the sum of
the grossed-up basis of the stock acquired in connection with the
Taxable Transfer (excluding stock acquired from the Old or New Entity),
plus the amount of liabilities assumed or taken subject to in the deemed
transfer, plus other relevant items. The grossed-up basis of the
acquired stock equals the acquirers' basis in the acquired stock divided
by the percentage of the Old Entity's stock (by value) attributable to
the acquired stock. FFA provided in connection with a Taxable Transfer
is not included in the New Entity's or the Acquiring's purchase price
for the acquired assets. Any Net Worth Assistance so provided is treated
as an asset of the transferor sold to the New Entity or the Acquiring in
the Taxable Transfer.
(2) Allocation of basis--(i) In general. Except as otherwise
provided in this paragraph (d)(2), the purchase price determined under
paragraph (d)(1) of this section is allocated among the assets
transferred in the Taxable Transfer in the same manner as amounts are
allocated among assets under Sec. 1.338-6(b) and (c)(1) and (2).
(ii) Modifications to general rule. The allocation rules contained
in paragraph (c)(3)(ii) of this section apply to the allocation of basis
among assets acquired in a Taxable Transfer. No basis is allocable to an
Agency's agreement to provide Loss Guarantees, yield maintenance
payments, cost to carry or cost of funds reimbursement payments, or
expense reimbursement or indemnity payments. A New Entity's basis in
assets it receives from its shareholders is determined under general
federal income tax principles and is not governed by this paragraph (d).
(iii) Allowance and recapture of additional basis in certain cases.
The basis of Class I and Class II assets equals their fair market value.
See Sec. 1.597-1(b). If the fair market value of the Class I and Class
II assets exceeds the purchase price for the acquired assets, the excess
is included ratably as ordinary income by the New Entity or the
Acquiring over a period of six taxable years beginning in the year of
the Taxable Transfer. The New Entity or the Acquiring must include as
ordinary income the entire amount remaining to be recaptured under the
preceding sentence in the taxable year in which an event occurs that
would accelerate inclusion of an adjustment under section 481.
(iv) Certain post-transfer adjustments--(A) Agency Obligations. If
an adjustment to the principal amount of an Agency Obligation or cash
payment to reflect a more accurate determination of the condition of the
Institution at the time of the Taxable Transfer is made before the
earlier of the date the New Entity or the Acquiring files its first
post-transfer federal income tax return or the due date of that return
(including extensions), the New Entity or the Acquiring must adjust its
basis in its acquired assets to reflect the adjustment. In making
adjustments to the New Entity's or the Acquiring's basis in its acquired
assets, paragraph (c)(3)(ii) of this section is applied by treating an
adjustment to the principal amount of an Agency Obligation pursuant to
the first sentence of this paragraph (d)(2)(iv)(A) as occurring
immediately before the Taxable Transfer.
[[Page 418]]
(See Sec. 1.597-3(c)(3) for rules regarding other adjustments to the
principal amount of an Agency Obligation.)
(B) Covered Assets. If, immediately after a Taxable Transfer, an
asset is not subject to a Loss Guarantee but the New Entity or the
Acquiring has the right to designate specific assets that will be
subject to the Loss Guarantee, the New Entity or the Acquiring must
treat any asset so designated as having been subject to the Loss
Guarantee at the time of the Taxable Transfer. The New Entity or the
Acquiring must adjust its basis in the Covered Assets and in its other
acquired assets to reflect the designation in the manner provided by
paragraph (d)(2) of this section. The New Entity or the Acquiring must
make appropriate adjustments in subsequent taxable years if the
designation is made after the New Entity or the Acquiring files its
first post-transfer federal income tax return or the due date of that
return (including extensions) has passed.
(e) Special rules applicable to Taxable Transfers that are deemed
asset acquisitions--(1) Taxpayer Identification Numbers. Except as
provided in paragraph (e)(3) of this section, the New Entity succeeds to
the TIN of the Old Entity in a deemed sale under paragraph (b) of this
section.
(2) Consolidated Subsidiaries--(i) In general. A Consolidated
Subsidiary that is treated as selling its assets in a Taxable Transfer
under paragraph (b) of this section is treated as engaging immediately
thereafter in a complete liquidation to which section 332 applies. The
consolidated group of which the Consolidated Subsidiary is a member does
not take into account gain or loss on the sale, exchange, or
cancellation of stock of the Consolidated Subsidiary in connection with
the Taxable Transfer.
(ii) Certain minority shareholders. Shareholders of the Consolidated
Subsidiary that are not members of the consolidated group that includes
the Institution do not recognize gain or loss with respect to shares of
Consolidated Subsidiary stock retained by the shareholder. The
shareholder's basis for that stock is not affected by the Taxable
Transfer.
(3) Bridge Banks and Residual Entities--(i) In general. A Bridge
Bank or Residual Entity's sale of assets to a New Entity under paragraph
(b) of this section is treated as made by a single entity under Sec.
1.597-4(e). The New Entity deemed to acquire the assets of a Residual
Entity under paragraph (b) of this section is not treated as a single
entity with the Bridge Bank (or with the New Entity acquiring the Bridge
Bank's assets) and must obtain a new TIN.
(ii) Treatment of consolidated groups. At the time of a Taxable
Transfer described in paragraph (a)(1)(ii) of this section, treatment of
a Bridge Bank as a subsidiary member of a consolidated group under Sec.
1.597-4(f)(1) ceases. However, the New Entity that is deemed to acquire
the assets of a Residual Entity is a member of the selling consolidated
group after the deemed sale. The group's basis or excess loss account in
the stock of the New Entity that is deemed to acquire the assets of the
Residual Entity is the group's basis or excess loss account in the stock
of the Bridge Bank immediately before the deemed sale, as adjusted for
the results of the sale.
(4) Certain returns. If an Old Entity without Continuing Equity is
not a subsidiary of a consolidated group at the time of the Taxable
Transfer, the controlling Agency must file all federal income tax
returns for the Old Entity for periods ending on or prior to the date of
the deemed sale described in paragraph (b) of this section that are not
filed as of that date.
(5) Basis limited to fair market value. If all of the stock of the
corporation is not acquired on the date of the Taxable Transfer, the
Commissioner may make appropriate adjustments under paragraphs (c) and
(d) of this section to the extent using a grossed-up basis of the stock
of a corporation results in an aggregate amount realized for, or basis
in, the assets other than the aggregate fair market value of the assets.
(f) Examples. The following examples illustrate the provisions of
this section. For purposes of these examples, an Institution's loans are
treated as if they were a single asset. However, in applying these
regulations, the fair market value of each loan (including,
[[Page 419]]
for purposes of a Covered Asset, the Third-Party Price and the Expected
Value) must be determined separately.
Example 1. Branch sale resulting in Taxable Transfer. (i)
Institution M is a calendar-year taxpayer in Agency Receivership. M is
not a member of a consolidated group. On January 1, 2018, M has $200
million of liabilities (including deposit liabilities) and assets with
an adjusted basis of $100 million. M has no income or loss for 2018 and,
except as otherwise described in this paragraph (i), M receives no FFA.
On September 30, 2018, the Agency causes M to transfer six branches
(with assets having an adjusted basis of $1 million) together with $120
million of deposit liabilities to N. In connection with the transfer,
the Agency provides $121 million in cash to N.
(ii) The transaction is a Taxable Transfer in which M receives $121
million of Net Worth Assistance under paragraph (a)(1) of this section.
(M is treated as directly receiving the $121 million of Net Worth
Assistance immediately before the Taxable Transfer under paragraph
(c)(1) of this section.) M transfers branches having a basis of $1
million and is treated as transferring $121 million in cash (the Net
Worth Assistance) to N in exchange for N's assumption of $120 million of
liabilities. Thus, M realizes a loss of $2 million on the transfer. The
amount of the FFA M must include in its income in 2018 is limited by
paragraph (c) of Sec. 1.597-2 to $102 million, which is the sum of the
$100 million excess of M's liabilities ($200 million) over the total
adjusted basis of its assets ($100 million) at the beginning of 2018 and
the $2 million excess for the taxable year (which results from the
Taxable Transfer) of M's deductions (other than carryovers) over its
gross income other than FFA. M must establish a deferred FFA account for
the remaining $19 million of FFA under paragraph (c)(4) of Sec. 1.597-
2.
(iii) N, as the Acquiring, must allocate its $120 million purchase
price for the assets acquired from M among those assets. Cash is a Class
I asset. The branch assets are in Classes III and IV. N's adjusted basis
in the cash is its amount, that is, $121 million under paragraph (d)(2)
of this section. Because this amount exceeds N's purchase price for all
of the acquired assets by $1 million, N allocates no basis to the other
acquired assets and, under paragraph (d)(2) of this section, must
recapture the $1 million excess at an annual rate of $166,667 in the six
consecutive taxable years beginning with 2018 (subject to acceleration
for certain events).
Example 2. Stock issuance by Bridge Bank causing Taxable Transfer.
(i) On April 1, 2018, Institution P is placed in Agency Receivership and
the Agency causes P to transfer assets and liabilities to Bridge Bank
PB. On August 31, 2018, the assets of PB consist of $20 million in cash,
loans outstanding with an adjusted basis of $50 million and a Third-
Party Price of $40 million, and other non-financial assets (primarily
branch assets and equipment) with an adjusted basis of $5 million. PB
has deposit liabilities of $95 million and other liabilities of $5
million. P, the Residual Entity, holds real estate with an adjusted
basis of $10 million and claims in litigation having a zero basis. P
retains no deposit liabilities and has no other liabilities (except its
liability to the Agency for having caused its deposit liabilities to be
satisfied).
(ii) On September 1, 2018, the Agency causes PB to issue 100 percent
of its common stock for $2 million cash to X. On the same day, the
Agency issues a $25 million note to PB. The note bears a fixed rate of
interest in excess of the applicable Federal rate in effect for
September 1, 2018. The Agency provides Loss Guarantees guaranteeing PB a
value of $50 million for PB's loans outstanding.
(iii) The stock issuance is a Taxable Transfer in which PB is
treated as selling all of its assets to a new corporation, New PB, under
paragraph (b)(1) of this section. PB is treated as directly receiving
$25 million of Net Worth Assistance (the issue price of the Agency
Obligation) immediately before the Taxable Transfer under paragraph
(c)(2) of Sec. 1.597-3 and paragraph (c)(1) of this section. The amount
of FFA PB must include in income is determined under paragraphs (a) and
(c) of Sec. 1.597-2. PB in turn is deemed to transfer the note (with a
basis of $25 million) to New PB in the Taxable Transfer, together with
$20 million of cash, all its loans outstanding (with a basis of $50
million) and its other non-financial assets (with a basis of $5
million). The amount realized by PB from the sale is $100 million (the
amount of PB's liabilities deemed to be assumed by New PB). This amount
realized equals PB's basis in its assets; thus, PB realizes no gain or
loss on the transfer to New PB.
(iv) Residual Entity P also is treated as selling all its assets
(consisting of real estate and claims in litigation) for $0 (the amount
of consideration received by P) to a new corporation (New P) in a
Taxable Transfer under paragraph (b)(3) of this section. (P's only
liability is to the Agency and a liability to the Agency is not treated
as a debt under paragraph (b) of Sec. 1.597-3.) P's basis in its assets
is $10 million; thus, P realizes a $10 million loss on the transfer to
New P. The combined return filed by PB and P for 2018 will reflect a
total loss on the Taxable Transfer of $10 million ($0 for PB and $10
million for P) under paragraph (e)(3) of this section. That return also
will reflect FFA income from the Net Worth Assistance, determined under
paragraphs (a) and (c) of Sec. 1.597-2.
(v) New PB is treated as having acquired the assets it acquired from
PB for $100 million, the amount of liabilities assumed. In allocating
basis among these assets, New PB
[[Page 420]]
treats the Agency note and the loans outstanding (which are Covered
Assets) as Class II assets. For the purpose of allocating basis, the
fair market value of the Agency note is deemed to equal its adjusted
issue price immediately before the transfer ($25 million), and the fair
market value of the loans is their Expected Value, $50 million (the sum
of the $40 million Third-Party Price and the $10 million that the Agency
would pay if PB sold the loans for $40 million) under paragraph (b) of
Sec. 1.597-1. Alternatively, if the Third-Party Price for the loans
were $60 million, then the fair market value of the loans would be $60
million, and there would be no payment from the Agency.
(vi) New P is treated as having acquired its assets for no
consideration. Thus, its basis in its assets immediately after the
transfer is zero. New PB and New P are not treated as a single entity
under paragraph (e)(3) of this section.
Example 3. Taxable Transfer of previously disaffiliated Institution.
(i) Corporation X, the common parent of a consolidated group, owns all
the stock of Institution M, an insolvent Institution with no
Consolidated Subsidiaries. On April 30, 2018, M has $4 million of
deposit liabilities, $1 million of other liabilities, and assets with an
adjusted basis of $4 million. On May 1, 2018, M is placed in Agency
Receivership. X elects under paragraph (g) of Sec. 1.597-4 to
disaffiliate M. Accordingly, as of May 1, 2018, new corporation M is not
a member of the X consolidated group. On May 1, 2018, the Agency causes
M to transfer all of its assets and liabilities to Bridge Bank MB. Under
paragraphs (e) and (g)(4) of Sec. 1.597-4, MB and M are thereafter
treated as a single entity which has $5 million of liabilities, an
account receivable for future FFA with a basis of $1 million, and other
assets with a basis of $4 million.
(ii) During May 2018, MB earns $25,000 of interest income and
accrues $20,000 of interest expense on depositor accounts and there is
no net change in deposits other than the additional $20,000 of interest
expense accrued on depositor accounts. MB pays $5,000 of wage expenses
and has no other items of income or expense.
(iii) On June 1, 2018, the Agency causes MB to issue 100 percent of
its stock to Corporation Y. In connection with the stock issuance, the
Agency provides an Agency Obligation for $2 million and no other FFA.
(iv) The stock issuance results in a Taxable Transfer under
paragraph (b) of this section. MB is treated as receiving the Agency
Obligation immediately prior to the Taxable Transfer under paragraph
(c)(1) of this section. MB has $1 million of basis in its account
receivable for FFA. This receivable is treated as satisfied, offsetting
$1 million of the $2 million of FFA provided by the Agency in connection
with the Taxable Transfer. The status of the remaining $1 million of FFA
as includible income is determined as of the end of the taxable year
under paragraph (c) of Sec. 1.597-2. However, under paragraph (b) of
Sec. 1.597-2, MB obtains a $2 million basis in the Agency Obligation
received as FFA.
(v) Under paragraph (c)(2) of this section, in the Taxable Transfer,
Old Entity MB is treated as selling, to New Entity MB, all of Old Entity
MB's assets, having a basis of $6,020,000 (the original $4 million of
asset basis as of April 30, 2018, plus $20,000 net cash from May 2018
activities, plus the $2 million Agency Obligation received as FFA), for
$5,020,000, the amount of Old Entity MB's liabilities assumed by New
Entity MB pursuant to the Taxable Transfer. Therefore, Old Entity MB
recognizes, in the aggregate, a loss of $1 million from the Taxable
Transfer.
(vi) Because this $1 million loss causes Old Entity MB's deductions
to exceed its gross income (determined without regard to FFA) by $1
million, Old Entity MB must include in its income the $1 million of FFA
not offset by the FFA receivable under paragraph (c) of Sec. 1.597-2.
(As of May 1, 2018, Old Entity MB's liabilities ($5 million) did not
exceed MB's $5 million adjusted basis of its assets. For the taxable
year, MB's deductions of $1,025,000 ($1 million loss from the Taxable
Transfer, $20,000 interest expense and $5,000 of wage expense) exceeded
its gross income (disregarding FFA) of $25,000 (interest income) by $1
million. Thus, under paragraph (c) of Sec. 1.597-2, MB includes in
income the entire $1 million of FFA not offset by the FFA receivable.)
(vii) Therefore, Old Entity MB's taxable income for the taxable year
ending on the date of the Taxable Transfer is $0.
(viii) Residual Entity M is also deemed to engage in a deemed sale
of its assets to New Entity M under paragraph (b)(3) of this section,
but there are no federal income tax consequences as M has no assets or
liabilities at the time of the deemed sale.
(ix) Under paragraph (d)(1) of this section, New Entity MB is
treated as purchasing Old Entity MB's assets for $5,020,000, the amount
of New Entity MB's liabilities. Of this, $2 million is allocated to the
$2 million Agency Obligation, and $3,020,000 is allocated to the other
assets New Entity MB is treated as purchasing in the Taxable Transfer.
Example 4. Loss Guarantee. On January 1, 2018, Institution N
acquires assets and assumes liabilities of another Institution in a
Taxable Transfer. In exchange for assuming $1,100,000 of the
transferring Institution's liabilities, N acquires Net Worth Assistance
of $200,000, loans with an unpaid principal balance of $1 million, and
two foreclosed properties each having a book value of $100,000 in the
hands of the transferring Institution. In connection with the Taxable
Transfer, an Agency guarantees N a price of $800,000 on the disposition
or charge-off of the loans and a price of $80,000 on the disposition or
[[Page 421]]
charge-off of each of the foreclosed properties. This arrangement
constitutes a Loss Guarantee. The Third-Party Price is $500,000 for the
loans and $50,000 for each of the foreclosed properties. For basis
allocation purposes, the loans and foreclosed properties are Class II
assets because they are Covered Assets, and N must allocate basis to
such assets equal to their fair market value under paragraphs (c)(3)(ii)
and (d)(2)(ii) and (iii) of this section. The fair market value of the
loans is their Expected Value, $800,000 (the sum of the $500,000 Third-
Party Price and the $300,000 that the Agency would pay if N sold the
loans for $500,000). The fair market value of each foreclosed property
is its Expected Value, $80,000 (the sum of the $50,000 Third-Party Price
and the $30,000 that the Agency would pay if N sold the foreclosed
property for $50,000) under paragraph (b) of Sec. 1.597-1. Accordingly,
N's basis in the loans and in each of the foreclosed properties is
$800,000 and $80,000, respectively. Because N's aggregate basis in the
cash, loans, and foreclosed properties ($1,160,000) exceeds N's purchase
price ($1,100,000) by $60,000, N must include $60,000 in income ratably
over six years under paragraph (d)(2)(iii) of this section.
Example 5. Loss Share Agreement. (i) The facts are the same as in
Example 4 of this paragraph (f) except that, in connection with the
Taxable Transfer, the Agency agrees to reimburse Institution N in an
amount equal to zero percent of any loss realized (based on the $1
million unpaid principal balance of the loans and the $100,000 book
value of each of the foreclosed properties) on the disposition or
charge-off of the Covered Assets up to $200,000; 50 percent of any loss
realized between $200,000 and $700,000; and 95 percent of any additional
loss realized. This arrangement constitutes a Loss Guarantee that is a
Loss Share Agreement. Thus, the Covered Assets are Class II assets, and
N allocates basis to such assets equal to their fair market value under
paragraphs (c)(3)(ii) and (d)(2)(ii) and (iii) of this section. Because
the Third-Party Price for all of the Covered Assets is $600,000
($500,000 for the loans and $50,000 for each of the foreclosed
properties), the Average Reimbursement Rate is 33.33% ((($200,000 x 0%)
+ ($400,000 x 50%) + ($0 x 95%))/$600,000). The Expected Value of the
loans is $666,667 ($500,000 Third-Party Price + $166,667 (the amount of
the loss if the loans were disposed of for the Third-Party Price x
33.33%)), and the Expected Value of each foreclosed property is $66,667
($50,000 Third-Party Price + $16,667 (the amount of the loss if the
foreclosed property were sold for the Third-Party Price x 33.33%)) under
paragraph (b) of Sec. 1.597-1. For purposes of allocating basis, the
fair market value of the loans is $666,667 (their Expected Value), and
the fair market value of each foreclosed property is $66,667 (its
Expected Value) under paragraph (b) of Sec. 1.597-1.
(ii) At the end of 2018, the Third-Party Price for the loans drops
to $400,000, and the Third-Party Price for each of the foreclosed
properties remains at $50,000. The fair market value of the loans at the
end of Year 2 is their Expected Value, $600,000 ($400,000 Third-Party
Price + $200,000 (the amount of the loss if the loans were disposed of
for the Third-Party Price x 33.33%) (the Average Reimbursement Rate does
not change)). Thus, if the loans otherwise may be charged off, marked to
a market value, depreciated, or amortized, then the loans may be marked
down to $600,000. The fair market value of each of the foreclosed
properties remains at $66,667 ($50,000 Third-Party Price + $16,667 (the
amount of the loss if the foreclosed property were sold for the Third-
Party Price x 33.33%)). Therefore, the foreclosed properties may not be
charged off or depreciated in 2018.
[T.D. 9825, 82 FR 48625, Oct. 19, 2017, as amended at 82 FR 61177, Dec.
27, 2017]
Sec. 1.597-6 Limitation on collection of federal income tax.
(a) Limitation on collection where federal income tax is borne by an
Agency. If an Institution without Continuing Equity (or any of its
Consolidated Subsidiaries) is liable for federal income tax that is
attributable to the inclusion in income of FFA or gain from a Taxable
Transfer, the federal income tax will not be collected if it would be
borne by an Agency. The final determination of whether the federal
income tax would be borne by an Agency is within the sole discretion of
the Commissioner. In determining whether federal income tax would be
borne by an Agency, the Commissioner will disregard indemnity, tax-
sharing, or similar obligations of an Agency, an Institution, or its
Consolidated Subsidiaries. Collection of the several federal income tax
liability under Sec. 1.1502-6 from members of an Institution's
consolidated group other than the Institution or its Consolidated
Subsidiaries is not affected by this section. Federal income tax will
continue to be subject to collection except as specifically limited in
this section. This section does not apply to taxes other than federal
income taxes.
(b) Amount of federal income tax attributable to FFA or gain on a
Taxable Transfer. For purposes of paragraph (a) of this section, the
amount of federal
[[Page 422]]
income tax in a taxable year attributable to the inclusion of FFA or
gain from a Taxable Transfer in the income of an Institution (or a
Consolidated Subsidiary) is the excess of the actual federal income tax
liability of the Institution (or the consolidated group in which the
Institution is a member) over the federal income tax liability of the
Institution (or the consolidated group in which the Institution is a
member) determined without regard to FFA or gain or loss on the Taxable
Transfer.
(c) Reporting of uncollected federal income tax. A taxpayer must
specify on a statement included with its Form 1120 (U.S. Corporate
Income Tax Return) the amount of federal income tax for the taxable year
that is potentially not subject to collection under this section. If an
Institution is a subsidiary member of a consolidated group, the amount
specified as not subject to collection is zero.
(d) Assessments of federal income tax to offset refunds. Federal
income tax that is not collected under this section will be assessed
and, thus, used to offset any claim for refund made by or on behalf of
the Institution, the Consolidated Subsidiary, or any other corporation
with several liability for the federal income tax.
(e) Collection of federal income taxes from an Acquiring or a New
Entity--(1) Acquiring. No federal income tax liability (including the
several liability for federal income taxes under Sec. 1.1502-6) of a
transferor in a Taxable Transfer will be collected from an Acquiring.
(2) New Entity. Federal income tax liability (including the several
liability for federal income taxes under Sec. 1.1502-6) of a transferor
in a Taxable Transfer will be collected from a New Entity only if stock
that was outstanding in the Old Entity remains outstanding as stock in
the New Entity or is reacquired or exchanged for consideration.
(f) Effect on section 7507. This section supersedes the application
of section 7507, and the regulations thereunder, for the assessment and
collection of federal income tax attributable to FFA.
[T.D. 9825, 82 FR 48629, Oct. 19, 2017]
Sec. 1.597-7 Effective/applicability dates.
(a) FIRREA effective date. Section 597, as amended by section 1401
of the Financial Institutions Reform, Recovery, and Enforcement Act of
1989 (Public Law 101-73, 103 Stat 183 (1989)) (FIRREA) is generally
effective for any FFA received or accrued by an Institution on or after
May 10, 1989, and for any transaction in connection with which such FFA
is provided, unless the FFA is provided in connection with an
acquisition occurring prior to May 10, 1989. See Sec. 1.597-8 for rules
regarding FFA received or accrued on or after May 10, 1989, that relates
to an acquisition that occurred before May 10, 1989.
(b) Applicability date of Sec. Sec. 1.597-1 through 1.597-6.
Sections 1.597-1 through 1.597-6 apply on or after October 19, 2017,
except with respect to FFA provided pursuant to a written agreement that
is binding before October 19, 2017, and that continues to be binding at
all times after such date, in which case Sec. Sec. 1.597-1 through
1.597-6 as contained in 26 CFR part 1, revised April 1, 2017, will
continue to apply unless the taxpayer elects to apply Sec. Sec. 1.597-1
through 1.597-6 on a retroactive basis pursuant to paragraph (c) of this
section.
(c) Elective application to prior years and transactions--(1) In
general. Except as limited in this paragraph (c), an election is
available to apply Sec. Sec. 1.597-1 through 1.597-6 to taxable years
beginning prior to October 19, 2017. A consolidated group may elect to
apply Sec. Sec. 1.597-1 through 1.597-6 for all members of the group in
all taxable years to which section 597, as amended by FIRREA, applies.
The agent for the group, within the meaning of Sec. 1.1502-77, makes
the election provided by this paragraph (c) for the consolidated group.
An entity that is not a member of a consolidated group may elect to
apply Sec. Sec. 1.597-1 through 1.597-6 to all taxable years to which
section 597, as amended by FIRREA, applies for which it is not a member
of a consolidated group. The election provided by this paragraph (c) is
irrevocable.
(2) Election unavailable if statute of limitations closed. The
election provided by this paragraph (c) cannot be made if the period for
assessment and collection of federal income tax has expired
[[Page 423]]
under the rules of section 6501 for any taxable year in which Sec. Sec.
1.597-1 through 1.597-6 would affect the determination of the electing
entity's or group's income, deductions, gain, loss, basis, or other
items.
(3) Manner of making election. An Institution or consolidated group
makes the election provided by this paragraph (c) by including a written
statement as a part of the taxpayer's or consolidated group's first
annual federal income tax return filed on or after October 19, 2017. The
statement must contain the following legend at the top of the page:
``THIS IS AN ELECTION UNDER Sec. 1.597-7(c),'' and must contain the
name, address, and taxpayer identification number of the taxpayer or
agent for the group making the election. The statement must include a
declaration that ``TAXPAYER AGREES TO EXTEND THE STATUTE OF LIMITATIONS
ON ASSESSMENT FOR THREE YEARS FROM THE DATE OF THE FILING OF THIS
ELECTION UNDER Sec. 1.597-7(c), IF THE LIMITATIONS PERIOD WOULD EXPIRE
EARLIER WITHOUT SUCH EXTENSION, FOR ANY ITEMS AFFECTED IN ANY TAXABLE
YEAR BY THE FILING OF THIS ELECTION,'' and a declaration that either
``AMENDED RETURNS WILL BE FILED FOR ALL TAXABLE YEARS AFFECTED BY THE
FILING OF THIS ELECTION WITHIN 180 DAYS OF MAKING THIS STATEMENT, UNLESS
SUCH REQUIREMENT IS WAIVED IN WRITING BY THE INTERNAL REVENUE SERVICE''
or ``ALL RETURNS PREVIOUSLY FILED ARE CONSISTENT WITH THE PROVISIONS OF
Sec. Sec. 1.597-1 THROUGH 1.597-6.'' An election with respect to a
consolidated group must be made by the agent for the group, not an
Agency, and applies to all members of the group.
[T.D. 9825, 82 FR 48629, Oct. 19, 2017]
Sec. 1.597-8 Transitional rules for Federal financial assistance.
(a) Scope. This section provides transitional rules for the tax
consequences of Federal financial assistance received or accrued on or
after May 10, 1989, if the assistance payment relates to an acquisition
that occurred before that date.
(b) Transitional rules. The tax consequences of any payment of
Federal financial assistance received or accrued on or after May 10,
1989, are governed by the applicable provisions of section 597 that were
in effect prior to the Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (``FIRREA'') if either--
(1) The payment--
(i) Is pursuant to an acquisition of a bank or domestic building and
loan association before May 10, 1989,
(ii) Is provided pursuant to an assistance agreement executed before
May 10, 1989,
(iii) Is provided to a party to that agreement or to such other
party as the Commissioner may determine appropriate by letter ruling or
other written guidance, and
(iv) Would, if provided before May 10, 1989, have been governed by
applicable provisions of section 597 that were in effect prior to
FIRREA; or
(2) The payment--
(i) Represents a prepayment of (or a payment in lieu of) a fixed or
contingent right to Federal financial assistance that would have
satisfied the conditions of paragraphs (b)(1)(i), (ii) and (iv) of this
section, and
(ii) Is provided to a party described in paragraph (b)(1)(iii) of
this section
(c) Definition of Federal financial assistance. Federal financial
assistance for purposes of this section has the meaning prescribed by
section 597(c) as amended by FIRREA.
(d) Examples. The following examples illustrate the provisions of
this section:
Example 1. X corporation acquired Y, a domestic building and loan
association on September 10, 1988. Pursuant to a written agreement
executed at the time of the acquisition, Y received Federal financial
assistance that included a note bearing a market rate of interest, the
right to future payments if certain assets were sold at a loss, and the
right to future payments if the income produced by certain assets was
less than an agreed upon amount. On December 1, 1991, an agreement was
executed in which Y relinquished its rights to Federal financial
assistance under the September 10, 1988 agreement in return for a lump
sum payment. The lump sum payment represented a prepayment of the
principal and accrued but unpaid interest for the note, and the rights
to the contingent future loss and income payments. The entire
[[Page 424]]
prepayment is excluded from the income of Y because it is a prepayment
of Federal financial assistance and the assistance (i) would have been
provided pursuant to an acquisition that occurred before May 10, 1989,
would have been provided pursuant to an assistance agreement executed
before May 10, 1989, and would, if it had been provided prior to May 10,
1989, have been governed by a pre-FIRREA version of section 597; and
(ii) the prepayment is paid to a party to the assistance agreement.
Example 2. The facts are the same as those in Example 1, except that
the note bears an above market rate of interest and part of the lump sum
represents a premium payment for the note. The portion of the lump sum
allocable to the premium payment is also excluded from the income of Y
because the payment represents the present value of the right to future
Federal financial assistance in the form of interest.
Example 3. The facts are the same as those in Example 1, except that
a portion of the lump sum payment represents compensation for additional
expenses Y may incur in the future because of termination of the
September 10, 1988 agreement. The portion of the lump sum payment
allocable to the compensation for additional expenses must be included
in the income of Y because it is not a prepayment of Federal financial
assistance provided for by a written agreement entered into prior to May
10, 1989.
Example 4. The facts are the same as those in Example 1, except that
instead of a new assistance agreement, the September 10, 1988 assistance
agreement was modified on December 1, 1991. The modified agreement
provided new Federal financial assistance in addition to the amounts
previously agreed to. None of the new Federal financial assistance is
governed by this regulation because the new assistance was not provided
for by a written agreement entered into prior to May 10, 1989. The
modification does not, however, affect the tax treatment of assistance
provided for by the agreement prior to its modification.
(e) Effective date. This section is effective April 23, 1992 for
assistance received or accrued on or after May 10, 1989 in connection
with acquisitions before that date.
[T.D. 8406, 57 FR 14795, Apr. 23, 1992. Redesignated and amended by T.D.
8471, 58 FR 18149, Apr. 8, 1993]
Bank Affiliates
Sec. 1.601-1 Special deduction for bank affiliates.
(a) The special deduction described in section 601 is allowed:
(1) To a holding company affiliate of a bank, as defined in section
2 of the Banking Act of 1933 (12 U.S.C. 221a), which holding company
affiliate holds, at the end of the taxable year, a general voting permit
granted by the Board of Governors of the Federal Reserve System.
(2) In the amount of the earnings or profits of such holding company
affiliate which, in compliance with section 5144 of the Revised Statutes
(12 U.S.C. 61), has been devoted by it during the taxable year to the
acquisition of readily marketable assets other than bank stock.
(3) Upon certification by the Board of Governors of the Federal
Reserve System to the Commissioner that such an amount of the earnings
or profits has been so devoted by such affiliate during the taxable year
No deduction is allowable under section 601 for the amount of readily
marketable assets in excess of what is required by section 5144 of the
Revised Statutes (12 U.S.C. 61) to be acquired by such affiliate, or in
excess of the taxable income for the taxable year computed without
regard to the special deductions for corporations provided in part VIII
(section 241 and following), subchapter B, chapter 1 of the Code. Nor
may the aggregate of the deductions allowable under section 601 and the
credits allowable under the corresponding provision of any prior income
tax law for all taxable years exceed the amount required to be devoted
under such section 5144 to the acquisition of readily marketable assets
other than bank stock.
(b) Every taxpayer claiming a deduction provided for in section 601
shall attach to its return a supplementary statement setting forth all
the facts and information upon which the claim is predicated, including
such facts and information as the Board of Governors of the Federal
Reserve System may prescribe as necessary to enable it, upon the request
of the Commissioner subsequent to the filing of the return, to certify
to the Commissioner the amount of earnings or profits devoted to the
acquisition of such readily marketable assets. A certified copy of such
supplementary statement shall be forwarded by the taxpayer to the Board
of
[[Page 425]]
Governors at the time of the filing of the return. The holding company
affiliate shall also furnish the Board of Governors such further
information as the Board shall require. For the requirements with
respect to the amount of such readily marketable assets which must be
acquired and maintained by a holding company affiliate to which a voting
permit has been granted, see section 5144(b) and (c) of the Revised
Statutes (12 U.S.C. 61).
Natural Resources
Deductions--Table of Contents
Sec. 1.611-0 Regulatory authority.
Sections 1.611-1 through 1.614-8, inclusive, are prescribed under
the authority granted the Secretary or his delegate by section 611(a) of
the Code to prescribe regulations under which a reasonable allowance for
depletion and depreciation of improvements shall be allowed, according
to the peculiar conditions in each case, in the case of mines, oil and
gas wells, other natural deposits and timber.
[T.D. 6965, 33 FR 10692, July 26, 1968]
Sec. 1.611-1 Allowance of deduction for depletion.
(a) Depletion of mines, oil and gas wells, other natural deposits,
and timber--(1) In general. Section 611 provides that there shall be
allowed as a deduction in computing taxable income in the case of mines,
oil and gas wells, other natural deposits, and timber, a reasonable
allowance for depletion. In the case of standing timber, the depletion
allowance shall be computed solely upon the adjusted basis of the
property. In the case of other exhaustible natural resources the
allowance for depletion shall be computed upon either the adjusted
depletion basis of the property (see section 612, relating to cost
depletion) or upon a percentage of gross income from the property (see
section 613, relating to percentage depletion), whichever results in the
greater allowance for depletion for any taxable year. In no case will
depletion based upon discovery value be allowed.
(2) See Sec. 1.611-5 for methods of depreciation relating to
improvements connected with mineral or timber properties.
(3) See paragraph (d) of this section for definition of terms.
(b) Economic interest. (1) Annual depletion deductions are allowed
only to the owner of an economic interest in mineral deposits or
standing timber. An economic interest is possessed in every case in
which the taxpayer has acquired by investment any interest in mineral in
place or standing timber and secures, by any form of legal relationship,
income derived from the extraction of the mineral or severance of the
timber, to which he must look for a return of his capital. For an
exception in the case of certain mineral production payments, see
section 636 and the regulations thereunder. A person who has no capital
investment in the mineral deposit or standing timber does not possess an
economic interest merely because through a contractual relation he
possesses a mere economic or pecuniary advantage derived from
production. For example, an agreement between the owner of an economic
interest and another entitling the latter to purchase or process the
product upon production or entitling the latter to compensation for
extraction or cutting does not convey a depletable economic interest.
Further, depletion deductions with respect to an economic interest of a
corporation are allowed to the corporation and not to its shareholders.
(2) No depletion deduction shall be allowed the owner with respect
to any timber, coal, or domestic iron ore that such owner has disposed
of under any form of contract by virtue of which he retains an economic
interest in such timber, coal, or iron ore, if such disposal is
considered a sale of timber, coal, or domestic iron ore under section
631 (b) or (c).
(c) Special rules--(1) In general. For the purpose of the equitable
apportionment of depletion among the several owners of economic
interests in a mineral deposit or standing timber, if the value of any
mineral or timber must be ascertained as of any specific date for the
determination of the basis for depletion, the values of such several
interests therein may be determined separately, but, when determined as
of the
[[Page 426]]
same date, shall together never exceed the value at that date of the
mineral or timber as a whole.
(2) Leases. In the case of a lease, the deduction for depletion
under section 611 shall be equitably apportioned between the lessor and
lessee. In the case of a lease or other contract providing for the
sharing of economic interests in a mineral deposit or standing timber,
such deduction shall be computed by each taxpayer by reference to the
adjusted basis of his property determined in accordance with sections
611 and 612, or computed in accordance with section 613, if applicable,
and the regulations thereunder.
(3) Life tenant and remainderman. In the case of property held by
one person for life with remainder to another person, the deduction for
depletion under section 611 shall be computed as if the life tenant were
the absolute owner of the property so that he will be entitled to the
deduction during his life, and thereafter the deduction, if any, shall
be allowed to the remainderman.
(4) Mineral or timber property held in trust. If a mineral property
or timber property is held in trust, the allowable deduction for
depletion is to be apportioned between the income beneficiaries and the
trustee on the basis of the trust income from such property allocable to
each, unless the governing instrument (or local law) requires or permits
the trustee to maintain a reserve for depletion in any amount. In the
latter case, the deduction is first allocated to the trustee to the
extent that income is set aside for a depletion reserve, and any part of
the deduction in excess of the income set aside for the reserve shall be
apportioned between the income beneficiaries and the trustee on the
basis of the trust income (in excess of the income set aside for the
reserve) allocable to each. For example:
(i) If under the trust instrument of local law the income of a trust
computed without regard to depletion is to be distributed to a named
beneficiary, the beneficiary is entitled to the deduction to the
exclusion of the trustee.
(ii) If under the trust instrument or local law the income of a
trust is to be distributed to a named beneficiary, but the trustee is
directed to maintain a reserve for depletion in any amount, the
deduction is allowed to the trustee (except to the extent that income
set aside for the reserve is less than the allowable deduction). The
same result would follow if the trustee sets aside income for a
depletion reserve pursuant to discretionary authority to do so in the
governing instrument
No effect shall be given to any allocation of the depletion deduction
which gives any beneficiary or the trustee a share of such deduction
greater than his pro rata share of the trust income, irrespective of any
provisions in the trust instrument, except as otherwise provided in this
paragraph when the trust instrument or local law requires or permits the
trustee to maintain a reserve for depletion.
(5) Mineral or timber property held by estate. In the case of a
mineral property or timber property held by an estate the deduction for
depletion under section 611 shall be apportioned between the estate and
the heirs, legatees, and devisees on the basis of income of the estate
from such property which is allocable to each.
(d) Definitions. As used in this part, and the regulations
thereunder, the term:
(1) Property means--(i) in the case of minerals, each separate
economic interest owned in each mineral deposit in each separate tract
or parcel of land or an aggregation or combination of such mineral
interests permitted under section 614 (b), (c), (d), or (e); and (ii) in
the case of timber, an economic interest in standing timber in each
tract or block representing a separate timber account (see paragraph (d)
of Sec. 1.611-3). For rules with respect to waste or residue of prior
mining, see paragraph (c) of Sec. 1.614-1. When, in the regulations
under this part, either the word mineral or timber precedes the word
property, such adjectives are used only to classify the type of property
involved. For further explanation of the term property, see section 614
and the regulations thereunder.
(2) Fair market value of a property is that amount which would
induce a willing seller to sell and a willing buyer to purchase.
(3) Mineral enterprise is the mineral deposit or deposits and
improvements,
[[Page 427]]
if any, used in mining or in the production of oil and gas, and only so
much of the surface of the land as is necessary for purposes of mineral
extraction. The value of the mineral enterprise is the combined value of
its component parts.
(4) Mineral deposit refers to minerals in place. When a mineral
enterprise is acquired as a unit, the cost of any interest in the
mineral deposit or deposits is that proportion of the total cost of the
mineral enterprise which the value of the interest in the deposit or
deposits bears to the value of the entire enterprise at the time of its
acquisition.
(5) Minerals includes ores of the metals, coal, oil, gas, and all
other natural metallic and nonmetallic deposits, except minerals derived
from sea water, the air, or from similar inexhaustible sources. It
includes but is not limited to all of the minerals and other natural
deposits subject to depletion based upon a percentage of gross income
from the property under section 613 and the regulations thereunder.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6841, 30 FR
9305, July 27, 1965; T.D. 7261, 38 FR 5467, Mar. 1, 1973]
Sec. 1.611-2 Rules applicable to mines, oil and gas wells, and other
natural deposits.
(a) Computation of cost depletion of mines, oil and gas wells, and
other natural deposits. (1) The basis upon which cost depletion is to be
allowed in respect of any mineral property is the basis provided for in
section 612 and the regulations thereunder. After the amount of such
basis applicable to the mineral property has been determined for the
taxable year, the cost depletion for that year shall be computed by
dividing such amount by the number of units of mineral remaining as of
the taxable year (see subparagraph (3) of this paragraph), and by
multiplying the depletion unit, so determined, by the number of units of
mineral sold within the taxable year (see subparagraph (2) of this
paragraph). In the selection of a unit of mineral for depletion,
preference shall be given to the principal or customary unit or units
paid for in the products sold, such as tons of ore, barrels of oil, or
thousands of cubic feet of natural gas.
(2) As used in this paragraph, the phrase number of units sold
within the taxable year:
(i) In the case of a taxpayer reporting income on the cash receipts
and disbursements method, includes units for which payments were
received within the taxable year although produced or sold prior to the
taxable year, and excludes units sold but not paid for in the taxable
year, and
(ii) In the case of a taxpayer reporting income on the accrual
method, shall be determined from the taxpayer's inventories kept in
physical quantities and in a manner consistent with his method of
inventory accounting under section 471 or 472
The phrase does not include units with respect to which depletion
deductions were allowed or allowable prior to the taxable year.
(3) The number of units of mineral remaining as of the taxable year
is the number of units of mineral remaining at the end of the year to be
recovered from the property (including units recovered but not sold)
plus the number of units sold within the taxable year as defined in this
section.
(4) In the case of a natural gas well where the annual production is
not metered and is not capable of being estimated with reasonable
accuracy, the taxpayer may compute the cost depletion allowance in
respect of such property for the taxable year by multiplying the
adjusted basis of the property by a fraction, the numerator of which is
equal to the decline in rock pressure during the taxable year and the
denominator of which is equal to the expected total decline in rock
pressure from the beginning of the taxable year to the economic limit of
production. Taxpayers computing depletion by this method must keep
accurate records of periodical pressure determinations.
(5) If an aggregation of two or more separate mineral properties is
made during a taxable year under section 614, cost depletion for each
such property shall be computed separately for that portion of the
taxable year ending immediately before the effective date of the
aggregation. Cost depletion with respect to the aggregated property
shall be computed for that portion of
[[Page 428]]
the taxable year beginning on such effective date. The allowance for
cost depletion for the taxable year shall be the sum of such cost
depletion computations. For purposes of this paragraph, each such
portion of the taxable year shall be considered as a taxable year.
Similar rules shall be applied where a separate mineral property is
properly removed from an existing aggregation during a taxable year. See
section 614 and the regulations thereunder for rules relating to the
effective date of an aggregation of mineral interests and for rules
relating to the adjusted basis of an aggregation.
(6) The apportionment of the deduction among the several owners of
economic interests in the mineral deposit or deposits will be made as
provided in paragraph (c) of Sec. 1.611-1.
(b) Depletion accounts of mineral property. (1) Every taxpayer
claiming and making a deduction for depletion of mineral property shall
keep a separate account in which shall be accurately recorded the cost
or other basis provided by section 1012, of such property together with
subsequent allowable capital additions to each account and all the other
adjustments required by section 1016.
(2) Mineral property accounts shall thereafter be credited annually
with the amounts of the depletion so computed in accordance with section
611 or 613 and the regulations thereunder; or the amounts of the
depletion computed in shall be credited to depletion reserve accounts.
No further deductions for cost depletion shall be allowed when the sum
of the credits for depletion equals the cost or other basis of the
property, plus allowable capital additions. However, depletion
deductions may be allowable thereafter computed upon a percentage of
gross income from the property. See section 613 and the regulations
thereunder. In no event shall percentage depletion in excess of cost or
other basis of the property be credited to the improvements account or
the depreciation reserve account.
(c) Determination of mineral contents of deposits. (1) If it is
necessary to estimate or determine with respect to any mineral deposit
as of any specific date the total recoverable units (tons, pounds,
ounces, barrels, thousands of cubic feet, or other measure) of mineral
products reasonably known, or on good evidence believed, to have existed
in place as of that date, the estimate or determination must be made
according to the method current in the industry and in the light of the
most accurate and reliable information obtainable. In the selection of a
unit of estimate, preference shall be given to the principal unit (or
units) paid for in the product marketed. The estimate of the recoverable
units of the mineral products in the deposit for the purposes of
valuation and depletion shall include as to both quantity and grade:
(i) The ores and minerals in sight, blocked out, developed, or
assured, in the usual or conventional meaning of these terms with
respect to the type of the deposits, and
(ii) Probable or prospective ores or minerals (in the corresponding
sense), that is, ores or minerals that are believed to exist on the
basis of good evidence although not actually known to occur on the basis
of existing development. Such probable or prospective ores or minerals
may be estimated:
(a) As to quantity, only in case they are extensions of known
deposits or are new bodies or masses whose existence is indicated by
geological surveys or other evidence to a high degree of probability,
and
(b) As to grade, only in accordance with the best indications
available as to richness.
(2) If the number of recoverable units of mineral in the deposit has
been previously estimated for the prior year or years, and if there has
been no known change in the facts upon which the prior estimate was
based, the number of recoverable units of mineral in the deposit as of
the taxable year will be the number remaining from the prior estimate.
However, for any taxable year for which it is ascertained either by the
taxpayer or the district director from any source, such as operations or
development work prior to the close of the taxable year, that the
remaining recoverable mineral units as of the taxable year are
materially greater or less than the number remaining from the prior
estimate, then the estimate of the remaining recoverable units shall
[[Page 429]]
be revised, and the annual cost depletion allowance with respect to the
property for the taxable year and for subsequent taxable years will be
based upon the revised estimate until a change in the facts requires
another revision. Such revised estimate will not, however, change the
adjusted basis for depletion.
(d) Determination of fair market value of mineral properties, and
improvements, if any. (1) If the fair market value of the mineral
property and improvements at a specified date is to be determined for
the purpose of ascertaining the basis, such value must be determined,
subject to approval or revision by the district director, by the owner
of such property and improvements in the light of the conditions and
circumstances known at that date, regardless of later discoveries or
developments or subsequent improvements in methods of extraction and
treatment of the mineral product. The district director will give due
weight and consideration to any and all factors and evidence having a
bearing on the market value, such as cost, actual sales and transfers of
similar properties and improvements, bona fide offers, market value of
stock or shares, royalties and rentals, valuation for local or State
taxation, partnership accountings, records of litigation in which the
value of the property and improvements was in question, the amount at
which the property and improvements may have been inventoried or
appraised in probate or similar proceedings, and disinterested
appraisals by approved methods.
(2) If the fair market value must be ascertained as of a certain
date, analytical appraisal methods of valuation, such as the present
value method will not be used:
(i) If the value of a mineral property and improvements, if any, can
be determined upon the basis of cost or comparative values and
replacement value of equipment, or
(ii) If the fair market value can reasonably be determined by any
other method.
(e) Determination of the fair market value of mineral property by
the present value method. (1) To determine the fair market value of a
mineral property and improvements by the present value method, the
essential factors must be determined for each mineral deposit. The
essential factors in determining the fair market value of mineral
deposits are:
(i) The total quantity of mineral in terms of the principal or
customary unit (or units) paid for in the product marketed,
(ii) The quantity of mineral expected to be recovered during each
operating period,
(iii) The average quality or grade of the mineral reserves,
(iv) The allocation of the total expected profit to the several
processes or operations necessary for the preparation of the mineral for
market,
(v) The probable operating life of the deposit in years,
(vi) The development cost,
(vii) The operating cost,
(viii) The total expected profit,
(ix) The rate at which this profit will be obtained, and
(x) The rate of interest commensurate with the risk for the
particular deposit.
(2) If the mineral deposit has been sufficiently developed, the
valuation factors specified in subparagraph (1) of this paragraph may be
determined from past operating experience. In the application of factors
derived from past experience, full allowance should be made for probable
future variations in the rate of exhaustion, quality or grade of the
mineral, percentage of recovery, cost of development, production,
interest rate, and selling price of the product marketed during the
expected operating life of the mineral deposit. Mineral deposits for
which these factors cannot be determined with reasonable accuracy from
past operating experience may also be valued by the present value
method; but the factors must be deduced from concurrent evidence, such
as the general type of the deposit, the characteristics of the district
in which it occurs, the habit of the mineral deposits, the intensity of
mineralization, the oil-gas ratio, the rate at which additional mineral
has been disclosed by exploitation, the stage of the operating life of
the deposit, and any other evidence tending to establish
[[Page 430]]
a reasonable estimate of the required factors.
(3) Mineral deposits of different grades, locations, and probable
dates of extraction should be valued separately. The mineral content of
a deposit shall be determined in accordance with paragraph (c) of this
section. In estimating the average grade of the developed and
prospective mineral, account should be taken of probable increases or
decreases as indicated by the operating history. The rate of exhaustion
of a mineral deposit should be determined with due regard to the
limitations imposed by plant capacity, by the character of the deposit,
by the ability to market the mineral product, by labor conditions, and
by the operating program in force or reasonably to be expected for
future operations. The operating life of a mineral deposit is that
number of years necessary for the exhaustion of both the developed and
prospective mineral content at the rate determined as above. The
operating life of oil and gas wells is also influenced by the natural
decline in pressure and flow, and by voluntary or enforced curtailment
of production. The operating cost includes all current expense of
producing, preparing, and marketing the mineral product sold (due
consideration being given to taxes) exclusive of allowable capital
additions, as described in Sec. Sec. 1.612-2 and 1.612-4, and
deductions for depreciation and depletion, but including cost of
repairs. This cost of repairs is not to be confused with the
depreciation deduction by which the cost of improvements is returned to
the taxpayer free from tax. In general, no estimates of these factors
will be approved by the district director which are not supported by the
operating experience of the property or which are derived from different
and arbitrarily selected periods.
(4) The value of each mineral deposit is measured by the expected
gross income (the number of units of mineral recoverable in marketable
form multiplied by the estimated market price per unit) less the
estimated operating cost, reduced to a present value as of the date for
which the valuation is made at the rate of interest commensurate with
the risk for the operating life, and further reduced by the value at
that date of the improvements and of the capital additions, if any,
necessary to realize the profits. The degree of risk is generally lowest
in cases where the factors of valuation are fully supported by the
operating record of the mineral enterprise before the date for which the
valuation is made. On the other hand, higher risks ordinarily attach to
appraisals upon any other basis.
(f) Revaluation of mineral property not allowed. No revaluation of a
mineral property whose value as of any specific date has been determined
and approved will be made or allowed during the continuance of the
ownership under which the value was so determined and approved, except
in the case of misrepresentation or fraud or gross error as to any facts
known on the date as of which the valuation was made. Revaluation on
account of misrepresentation or fraud or such gross error will be made
only with the written approval of the Commissioner.
(g) Statement to be attached to return when valuation, depletion, or
depreciation of mineral property or improvements are claimed. (1) For
the first taxable year ending before December 31, 1967, for which a
taxpayer asserts a value for any mineral property or improvement as of a
specific date or claims a deduction for depletion, or depreciation,
there shall be attached to the return of the taxpayer for such taxable
year a statement setting forth, in complete, summary form, the pertinent
information required by this paragraph with respect to each such mineral
property or improvement (including oil and gas properties or
improvements). The summary statement shall be deemed a part of the
income tax return to which it relates. In addition to such summary
statement, the taxpayer must assemble, segregate and have readily
available at his principal place of business, all the supporting data
(listed in subparagraphs (2), (3), and (4) of this paragraph) which is
used in compiling the summary statement. For taxable years after such
first taxable year, and ending before December 31, 1967, the taxpayer
need attach to his return only an explanation of the changes, if any, in
the information previously furnished. For example, when a taxpayer has
filed
[[Page 431]]
adequate maps with the district director he may be relieved of filing
further maps of the same area, if all additional information necessary
for keeping the maps up-to-date is filed each year. In any case in which
any of the information required by this paragraph has been previously
filed by the taxpayer (including information furnished in accordance
with corresponding provisions of prior regulations), such information
need not be filed again, but a statement should be attached to the
return of the taxpayer indicating clearly when and in what form such
information was previously filed. For provisions relating to the data
which shall be submitted with returns for taxable years ending on or
after December 31, 1967, see subparagraph (5) of this paragraph.
(2) The information referred to in subparagraph (1) of this
paragraph is as follows:
(i) An adequate map showing the name, description, location, date of
surveys, and identification of the deposit or deposits;
(ii) A description of the character of the taxpayer's property,
accompanied by a copy of the instrument or instruments by which it was
acquired;
(iii) The date of acquisition of the property, the exact terms and
dates of expiration of all leases involved, and if terminated, the
reasons therefor;
(iv) The cost of the mineral property and improvements, stating the
amount paid to each vendor, with his name and address;
(v) The date as of which the mineral property and improvements are
valued, if a valuation is necessary to establish the basis as provided
by section 1012;
(vi) The value of the mineral property and improvements on that date
with a statement of the precise method by which it was determined;
(vii) An allocation of the cost or value among the mineral property,
improvements and the surface of the land for purposes other than mineral
production;
(viii) The estimated number of units of each kind of mineral at the
end of the taxable year, and also at the date of acquisition, if
acquired during the taxable year or at the date as of which any
valuation is made, together with an explanation of the method used in
the estimation, the name and address of the person making the estimate,
and an average analysis which will indicate the quality of the mineral
valued, including the grade or gravity in the case of oil;
(ix) The number of units sold and the number of units for which
payment was received or accrued during the year for which the return is
made (in the case of newly developed oil and gas deposits it is
desirable that this information be furnished by months);
(x) The gross amount received from the sale of mineral;
(xi) The amount of depreciation for the taxable year and the amount
of cost depletion for the taxable year;
(xii) The amounts of depletion and depreciation, if any, stated
separately, which for each and every prior year:
(a) Were allowed (see section 1016(a)(2)),
(b) Were allowable, and
(c) Would have been allowable without reference to percentage or
discovery depletion;
(xiii) The fractions (however measured) of gross production from the
deposit or deposits to which the taxpayer and other persons are entitled
together with the names and addresses of such other persons; and
(xiv) Any other data which will be helpful in determining the
reasonableness of the valuation asserted or of the deductions claimed.
(3) In the case of oil and gas properties, the following information
with respect to each property is required in addition to that
information set forth in subparagraph (2) of this paragraph:
(i) The number of acres of producing oil or gas land and, if
additional acreage is claimed to be proven, the amount of such acreage
and the reasons for believing it to be proven;
(ii) The number of wells producing at the beginning and end of the
taxable year;
(iii) The date of completion of each well finished during the
taxable year;
(iv) The date of abandonment of each well abandoned during the
taxable year;
(v) Maps showing the location of the tracts or leases and of the
producing and abandoned wells, dry holes, and proven oil and gas lands
(the maps
[[Page 432]]
should show depth, initial production, and date of completion of each
well, etc., to the extent that these data are available);
(vi) The number of pay sands and average thickness of each pay sand
or zone;
(vii) The average depth to the top of each of the different pay
sands;
(viii) The annual production of the deposit or of the individual
wells, if the latter information is available, from the beginning of its
productivity to the end of the taxable year, the average number of wells
producing during each year, and the initial daily production of each
well (the extent to which oil or gas is used for fuel on the premises
should be stated with reasonable accuracy);
(ix) All available data regarding change in operating conditions,
such as unit operation, proration, flooding, use of air-gas lift,
vacuum, shooting, and similar information, which have a direct effect on
the production of the deposit; and
(x) Available geological information having a probable bearing on
the oil and gas content; information with respect to edge water, water
drive, bottom hole pressures, oil-gas ratio, porosity of reservoir rock,
percentage of recovery, expected date of cessation of natural flow,
decline in estimated potential, and characteristics similar to
characteristics of other known fields.
(4) For rules relating to an additional statement to be attached to
the return when the depletion deduction is computed upon a percentage of
gross income from the property, see Sec. 1.613-6.
(5) A taxpayer who claims a total deduction of more than $200 for
depletion of mines, oil and gas wells, or other natural deposits for the
taxable year ending on or after December 31, 1967, and before December
31, 1968, shall submit with his return for such taxable year a filled-
out Form M (Mines and Other Natural Deposits--Depletion Data) or Form O
(Oil and Gas Depletion Data). See section 6011(a). For the purpose of
this subparagraph, the determination under section 631(c) of gain or
loss upon the disposition of coal or domestic iron ore with a retained
economic interest shall not be regarded as the claiming of a deduction
for depletion. Such forms shall be filed for any subsequent taxable year
if the Commissioner determines that the forms are required for such
year. Where appropriate, both Form M and Form O shall be filed. Forms M
and O shall be deemed to be part of the return to which they relate. If
a taxpayer mines more than one mineral, a separate Form M shall be filed
for each such mineral. If a taxpayer has both domestic and foreign
properties, separate forms shall be filed for each country in which a
taxpayer's properties are located. All data relating to a taxpayer's
domestic oil and gas properties shall be summarized on a single Form O,
and data relating to a taxpayer's domestic mineral properties (other
than oil and gas properties) shall be summarized on a single Form M for
each mineral. Similarly, all data relating to a taxpayer's oil and gas
properties in a specific foreign country shall be summarized on a single
Form O, and data relating to a taxpayer's mineral properties (other than
oil and gas properties) in a specific foreign country shall be
summarized on a single Form M for each mineral. In addition, the
taxpayer shall assemble, segregate, and have readily available at his
principal place of business, the data listed in subparagraphs (2), (3),
and (4) of this paragraph.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6938, 32 FR
17518, Dec. 7, 1967; T.D. 7170, 37 FR 5373, Mar. 15, 1972]
Sec. 1.611-3 Rules applicable to timber.
(a) Capital recoverable through depletion allowance in case of
timber. In general, the capital remaining in any year recoverable
through depletion allowances is the basis provided by section 612 and
the regulations thereunder. For the method of determining fair market
value and quantity of timber, see paragraphs (d), (e), and (f) of this
section. For capitalization of carrying charges, see section
1016(a)(1)(A). Amounts paid or incurred in connection with the planting
of timber (including planting for Christmas tree purposes) shall be
capitalized and recoverable through depletion allowances. Such amounts
include, for example, expenditures made for the preparation of the
timber site for planting or for natural seeding and
[[Page 433]]
the cost of seedlings. The apportionment of deductions between the
several owners of economic interests in standing timber will be made as
provided in paragraph (c) of Sec. 1.611-1.
(b) Computation of allowance for depletion of timber for taxable
year. (1) The depletion of timber takes place at the time timber is cut,
but the amount of depletion allowable with respect to timber that has
been cut may be computed when the quantity of cut timber is first
accurately measured in the process of exploitation. To the extent that
depletion is allowable in a particular taxable year with respect to
timber the products of which are not sold during such year, the
depletion so allowable shall be included as an item of cost in the
closing inventory of such products for such year.
(2) The depletion unit of the timber for a given timber account in a
given year shall be the quotient obtained by dividing (i) the basis
provided by section 1012 and adjusted as provided by section 1016, of
the timber on hand at the beginning of the year plus the cost of the
number of units of timber acquired during the year plus proper additions
to capital, by (ii) the total number of units of timber on hand in the
given account at the beginning of the year plus the cost of the number
of units of timber acquired during the year plus the number of units
acquired during the year plus (or minus) the number of units required to
be added (or deducted) by way of correcting the estimate of the number
of units remaining available in the account. The number of units of
timber of a given timber account cut during any taxable year multiplied
by the depletion unit of that timber account applicable to such year
shall be the amount of depletion allowable for the taxable year. Those
taxpayers who keep their accounts on a monthly basis may, at their
option, keep their depletion accounts on such basis, in which case the
amount allowable on account of depletion for a given month will be
determined in the manner outlined herein for a given year. The total
amount of the allowance for depletion in any taxable year shall be the
sum of the amounts allowable for the several timber accounts. For a
description of timber accounts, see paragraphs (c) and (d) of this
section.
(3) When a taxpayer has elected to treat the cutting of timber as a
sale or exchange of such timber under the provisions of section 631(a),
he shall reduce the timber account containing such timber by an amount
equal to the adjusted depletion basis of such timber. In computing any
further gain or loss on such timber, see paragraph (e) of Sec. 1.631-1.
(c) Timber depletion accounts on books. (1) Every taxpayer claiming
or expecting to claim a deduction for depletion of timber property shall
keep accurate ledger accounts in which shall be recorded the cost or
other basis provided by section 1012 of the property and land together
with subsequent allowable capital additions in each account and all
other adjustments provided by section 1016 and the regulations
thereunder.
(2) In such accounts there shall be set up separately the quantity
of timber, the quantity of land, and the quantity of other resources, if
any, and a proper part of the total cost or value shall be allocated to
each after proper provision for immature timber growth. See paragraph
(d) of this section. The timber accounts shall be credited each year
with the amount of the charges to the depletion accounts computed in
accordance with paragraph (b) of this section or the amount of the
charges to the depletion accounts shall be credited to depletion reserve
accounts. When the sum of the credits for depletion equals the cost or
other basis of the timber property, plus subsequent allowable capital
additions, no further deduction for depletion will be allowed.
(d) Aggregating timber and land for purposes of valuation and
accounting. (1) With a view to logical and reasonable valuation of
timber, the taxpayer shall include his timber in one or more accounts.
In general, each such account shall include all of the taxpayer's timber
which is located in one block. A block may be an operation unit which
includes all the taxpayer's timber which would logically go to a single
given point of manufacture. In those cases in which the point of
manufacture is at a considerable distance, or in which the logs or other
products will
[[Page 434]]
probably be sold in a log or other market, the block may be a logging
unit which includes all of the taxpayer's timber which would logically
be removed by a single logging development. Blocks may also be
established by geographical or political boundaries or by logical
management areas. Timber acquired under cutting contracts should be
carried in separate accounts and shall not constitute part of any block.
In exceptional cases, provided there are good and substantial reasons,
and subject to approval or revision by the district director on audit,
the taxpayer may divide the timber in a given block into two or more
accounts. For example, timber owned on February 28, 1913, and that
purchased subsequently may be kept in separate accounts, or timber owned
on February 28, 1913, and the timber purchased since that date in
several distinct transactions may be kept in several distinct accounts.
Individual tree species or groups of tree species may be carried in
distinct accounts, or special timber products may be carried in distinct
accounts. Blocks may be divided into two or more accounts based on the
character of the timber or its accessibility, or scattered tracts may be
included in separate accounts. If such a division is made, a proper
portion of the total value or cost, as the case may be, shall be
allocated to each account.
(2) The timber accounts mentioned in subparagraph (1) of this
paragraph shall not include any part of the value or cost, as the case
may be, of the land. In a manner similar to that prescribed in
subparagraph (1) of this paragraph, the land in a given block may be
carried in a single land account or may be divided into two or more
accounts on the basis of its character or accessibility. When such a
division is made, a proper portion of the total value or cost, as the
case may be, shall be allocated to each account.
(3) The total value or total cost, as the case may be, of land and
timber shall be equitably allocated to the timber and land accounts,
respectively. In cases in which immature timber growth is a factor, a
reasonable portion of the total value or cost shall be allocated to such
immature timber, and when the timber becomes merchantable such value or
cost shall be recoverable through depletion allowances.
(4) Each of the several land and timber accounts carried on the
books of the taxpayer shall be definitely described as to their location
on the ground either by maps or by legal descriptions.
(5) For good and substantial reasons satisfactory to the district
director, or as required by the district director on audit, the timber
or the land accounts may be readjusted by dividing individual accounts,
by combining two or more accounts, or by dividing and recombining
accounts.
(e) Determination of quantity of timber. Each taxpayer claiming or
expecting to claim a deduction for depletion is required to estimate
with respect to each separate timber account the total units (feet board
measure, log scale, cords, or other units) of timber reasonably known,
or on good evidence believed, to have existed on the ground on March 1,
1913, or on the date of acquisition of the property, whichever date is
applicable in determining the basis for cost depletion. This estimate
shall state as nearly as possible the number of units which would have
been found present by careful estimate made on the specified date with
the object of determining 100 percent of the quantity of timber which
the area covered by the specific account would have produced on that
date if all of the merchantable timber had been cut and utilized in
accordance with the standards of utilization prevailing in that region
at that time. If subsequently during the ownership of the taxpayer
making the return, as the result of the growth of the timber, of changes
in standards of utilization, of losses not otherwise accounted for, of
abandonment of timber, or of operations or development work, it is
ascertained either by the taxpayer or the district director that there
remain on the ground, available for utilization, more or less units of
timber at the close of the taxable year (or at the close of the month if
the taxpayer keeps his depletion accounts on a monthly basis) than
remain in the timber account or accounts on the basis of the original
estimate, then the original estimate (but not the basis for depletion)
shall be revised. The depletion
[[Page 435]]
unit shall be changed when such revision has been made. The annual
charge to the depletion account with respect to the property shall be
computed by using such revised unit for the taxable year for which the
revision is made and all subsequent taxable years until a change in
facts requires another revision.
(f) Determination of fair market value of timber property. (1) If
the fair market value of the property at a specified date is the basis
for depletion deductions, such value shall be determined, subject to
approval or revision by the district director upon audit, by the owner
of the property in the light of the most reliable and accurate
information available with reference to the condition of the property as
it existed at that date, regardless of all subsequent changes, such as
changes in surrounding circumstances, and methods of exploitation, in
degree of utilization, etc. Such factors as the following will be given
due consideration:
(i) Character and quality of the timber as determined by species,
age, size, condition, etc.;
(ii) The quantity of timber per acre, the total quantity under
consideration, and the location of the timber in question with reference
to other timber;
(iii) Accessibility of the timber (location with reference to
distance from a common carrier, the topography and other features of the
ground upon which the timber stands and over which it must be
transported in process of exploitation, the probable cost of
exploitation and the climate and the state of industrial development of
the locality); and
(iv) The freight rates by common carrier to important markets.
(2) The timber in each particular case will be valued on its own
merits and not on the basis of general averages for regions; however,
the value placed upon it, taking into consideration such factors as
those mentioned in this paragraph, will be coistent with that of other
similar timber in the region. The district director will give weight and
consideration to any and all facts and evidence having a bearing on the
market value, such as cost, actual sales and transfers of similar
properties, the margin between the cost of production and the price
realized for timber products, market value of stock or shares, royalties
and rentals, valuation for local or State taxation, partnership
accountings, records of litigation in which the value of the property
has been involved, the amount at which the property may have been
inventoried or appraised in probate or similar proceedings,
disinterested appraisals by approved methods, and other factors.
(g) Revaluation of timber property not allowed. No revaluation of a
timber property whose value as of any specific date has been determined
and approved will be made or allowed during the continuance of the
ownership under which the value was so determined and approved, except
in the case of misrepresentation or fraud or gross error as to any facts
known on the date as of which the valuation was made. Revaluation on
account of misrepresentation or fraud or such gross error will be made
only with the written approval of the Commissioner. The depletion unit
shall be revised when such a revaluation of a timber property has been
made and the annual charge to the depletion account with respect to the
property shall be computed by using such revised unit for the taxable
year for which such revision is made and for all subsequent taxable
years.
(h) Reporting and recordkeeping requirements--(1) Taxable years
beginning before January 1, 2002. A taxpayer claiming a deduction for
depletion of timber for a taxable year beginning before January 1, 2002,
shall attach to the income tax return of the taxpayer a filled-out Form
T (Timber) for the taxable year covered by the income tax return,
including the following information--
(i) A map where necessary to show clearly timber and land acquired,
timber cut, and timber and land sold;
(ii) Description of, cost of, and terms of purchase of timberland or
timber, or cutting rights, including timber or timber rights acquired
under any type of contract;
(iii) Profit or loss from sale of land, or timber, or both;
(iv) Description of timber with respect to which claim for loss, if
any, is made;
(v) Record of timber cut;
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(vi) Changes in each timber account as a result of purchase, sale,
cutting, reestimate, or loss;
(vii) Changes in improvements accounts as the result of additions to
or deductions from capital and depreciation, and computation of profit
or loss on sale or other disposition of such improvements;
(viii) Operation data with respect to raw and finished material
handled and inventoried;
(ix) Statement as to application of the election under section
631(a) and pertinent information in support of the fair market value
claimed thereunder;
(x) Information with respect to land ownership and capital
investment in timberland; and
(xi) Any other data which will be helpful in determining the
reasonableness of the depletion or depreciation deductions claimed in
the return.
(2) Taxable years beginning after December 31, 2001. A taxpayer
claiming a deduction for depletion of timber on a return filed for a
taxable year beginning after December 31, 2001, shall attach to the
income tax return of the taxpayer a filled-out Form T (Timber) for the
taxable year covered by the income tax return. In addition, the taxpayer
must retain records sufficient to substantiate the right of the taxpayer
to claim the deduction, including a map, where necessary, to show
clearly timber and land acquired, timber cut, and timber and land sold
for as long as their contents may become material in the administration
of any internal revenue law.
[T.D. 6500, 25 FR 11737, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. 8989, 67 FR 20031, Apr. 24, 2002; T.D. 9040, 68 FR 4921,
Jan. 31, 2003]