[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2003 Edition]
[From the U.S. Government Printing Office]
[[Page i]]
26
Part 1 (Secs. 1.441 to 1.500)
Revised as of April 1, 2003
Internal Revenue
Containing a codification of documents of general
applicability and future effect
As of April 1, 2003
With Ancillaries
Published by
Office of the Federal Register
National Archives and Records
Administration
A Special Edition of the Federal Register
[[Page ii]]
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
For sale by the Superintendent of Documents, U.S. Government Printing
Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area
(202) 512-1800
Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001
[[Page iii]]
Table of Contents
Page
Explanation................................................. v
Title 26:
Chapter I--Internal Revenue Service, Department of
the Treasury (Continued) 3
Finding Aids:
Table of CFR Titles and Chapters........................ 645
Alphabetical List of Agencies Appearing in the CFR...... 663
Table of OMB Control Numbers............................ 673
List of CFR Sections Affected........................... 691
[[Page iv]]
----------------------------
Cite this Code: CFR
To cite the regulations in
this volume use title,
part and section number.
Thus, 26 CFR 1.441-1T
refers to title 26, part
1, section 441-1T.
----------------------------
[[Page v]]
EXPLANATION
The Code of Federal Regulations is a codification of the general and
permanent rules published in the Federal Register by the Executive
departments and agencies of the Federal Government. The Code is divided
into 50 titles which represent broad areas subject to Federal
regulation. Each title is divided into chapters which usually bear the
name of the issuing agency. Each chapter is further subdivided into
parts covering specific regulatory areas.
Each volume of the Code is revised at least once each calendar year
and issued on a quarterly basis approximately as follows:
Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1
The appropriate revision date is printed on the cover of each
volume.
LEGAL STATUS
The contents of the Federal Register are required to be judicially
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie
evidence of the text of the original documents (44 U.S.C. 1510).
HOW TO USE THE CODE OF FEDERAL REGULATIONS
The Code of Federal Regulations is kept up to date by the individual
issues of the Federal Register. These two publications must be used
together to determine the latest version of any given rule.
To determine whether a Code volume has been amended since its
revision date (in this case, April 1, 2003), consult the ``List of CFR
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative
List of Parts Affected,'' which appears in the Reader Aids section of
the daily Federal Register. These two lists will identify the Federal
Register page number of the latest amendment of any given rule.
EFFECTIVE AND EXPIRATION DATES
Each volume of the Code contains amendments published in the Federal
Register since the last revision of that volume of the Code. Source
citations for the regulations are referred to by volume number and page
number of the Federal Register and date of publication. Publication
dates and effective dates are usually not the same and care must be
exercised by the user in determining the actual effective date. In
instances where the effective date is beyond the cut-off date for the
Code a note has been inserted to reflect the future effective date. In
those instances where a regulation published in the Federal Register
states a date certain for expiration, an appropriate note will be
inserted following the text.
OMB CONTROL NUMBERS
The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires
Federal agencies to display an OMB control number with their information
collection request.
[[Page vi]]
Many agencies have begun publishing numerous OMB control numbers as
amendments to existing regulations in the CFR. These OMB numbers are
placed as close as possible to the applicable recordkeeping or reporting
requirements.
OBSOLETE PROVISIONS
Provisions that become obsolete before the revision date stated on
the cover of each volume are not carried. Code users may find the text
of provisions in effect on a given date in the past by using the
appropriate numerical list of sections affected. For the period before
January 1, 2001, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, 1973-1985, or 1986-2000, published in 11 separate
volumes. For the period beginning January 1, 2001, a ``List of CFR
Sections Affected'' is published at the end of each CFR volume.
CFR INDEXES AND TABULAR GUIDES
A subject index to the Code of Federal Regulations is contained in a
separate volume, revised annually as of January 1, entitled CFR Index
and Finding Aids. This volume contains the Parallel Table of Statutory
Authorities and Agency Rules (Table I). A list of CFR titles, chapters,
and parts and an alphabetical list of agencies publishing in the CFR are
also included in this volume.
An index to the text of ``Title 3--The President'' is carried within
that volume.
The Federal Register Index is issued monthly in cumulative form.
This index is based on a consolidation of the ``Contents'' entries in
the daily Federal Register.
A List of CFR Sections Affected (LSA) is published monthly, keyed to
the revision dates of the 50 CFR titles.
REPUBLICATION OF MATERIAL
There are no restrictions on the republication of material appearing
in the Code of Federal Regulations.
INQUIRIES
For a legal interpretation or explanation of any regulation in this
volume, contact the issuing agency. The issuing agency's name appears at
the top of odd-numbered pages.
For inquiries concerning CFR reference assistance, call 202-741-6000
or write to the Director, Office of the Federal Register, National
Archives and Records Administration, Washington, DC 20408 or e-mail
info@fedreg.nara.gov.
SALES
The Government Printing Office (GPO) processes all sales and
distribution of the CFR. For payment by credit card, call toll free,
866-512-1800, or DC area, 202-512-1800, M-F 8 a.m. to 4 p.m. e.s.t. or
fax your order to 202-512-2250, 24 hours a day. For payment by check,
write to the Superintendent of Documents, Attn: New Orders, P.O. Box
371954, Pittsburgh, PA 15250-7954. For GPO Customer Service call 202-
512-1803.
ELECTRONIC SERVICES
The full text of the Code of Federal Regulations, the LSA (List of
CFR Sections Affected), The United States Government Manual, the Federal
Register, Public Laws, Public Papers, Weekly Compilation of Presidential
Documents and the Privacy Act Compilation are available in electronic
format at www.access.gpo.gov/nara (``GPO Access''). For more
information, contact Electronic Information Dissemination Services, U.S.
Government Printing Office. Phone 202-512-1530, or 888-293-6498 (toll-
free). E-mail, gpoaccess@gpo.gov.
[[Page vii]]
The Office of the Federal Register also offers a free service on the
National Archives and Records Administration's (NARA) World Wide Web
site for public law numbers, Federal Register finding aids, and related
information. Connect to NARA's web site at www.archives.gov/federal--
register. The NARA site also contains links to GPO Access.
Raymond A. Mosley,
Director,
Office of the Federal Register.
April 1, 2003.
[[Page ix]]
THIS TITLE
Title 26--Internal Revenue is composed of twenty volumes. The
contents of these volumes represent all current regulations issued by
the Internal Revenue Service, Department of the Treasury, as of April 1,
2003. The first thirteen volumes comprise part 1 (Subchapter A--Income
Tax) and are arranged by sections as follows: Secs. 1.0-1-1.60;
Secs. 1.61-1.169; Secs. 1.170-1.300; Secs. 1.301-1.400; Secs. 1.401-
1.440; Secs. 1.441-1.500; Secs. 1.501-1.640; Secs. 1.641-1.850;
Secs. 1.851-1.907; Secs. 1.908-1.1000; Secs. 1.1001-1.1400;
Secs. 1.1401-1.1503-2A; and Sec. 1.1551-1 to end. The fourteenth volume
containing parts 2-29, includes the remainder of subchapter A and all of
Subchapter B--Estate and Gift Taxes. The last six volumes contain parts
30-39 (Subchapter C--Employment Taxes and Collection of Income Tax at
Source); parts 40-49; parts 50-299 (Subchapter D--Miscellaneous Excise
Taxes); parts 300-499 (Subchapter F--Procedure and Administration);
parts 500-599 (Subchapter G--Regulations under Tax Conventions); and
part 600 to end (Subchapter H--Internal Revenue Practice).
The OMB control numbers for Title 26 appear in Sec. 602.101 of this
chapter. For the convenience of the user, Sec. 602.101 appears in the
Finding Aids section of the volumes containing parts 1 to 599.
[[Page x]]
[[Page 1]]
TITLE 26--INTERNAL REVENUE
(This book contains part 1, Secs. 1.441 to 1.500)
--------------------------------------------------------------------
Part
chapter i--Internal Revenue Service, Department of the
Treasury (Continued)...................................... 1
[[Page 3]]
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
--------------------------------------------------------------------
Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980,
deleting statutory sections from their regulations. In Chapter I cross-
references to the deleted material have been changed to the
corresponding sections of the IRS Code of 1954 or to the appropriate
regulations sections. When either such change produced a redundancy, the
cross-reference has been deleted. For further explanation, see 45 FR
20795, March 31, 1980.
SUBCHAPTER A--INCOME TAX (CONTINUED)
Part Page
1 Income taxes................................ 5
Supplementary Publication: Internal Revenue Service Looseleaf
Regulations System.
Additional supplementary publications are issued covering Alcohol and
Tobacco Tax Regulations, and Regulations Under Tax Conventions.
[[Page 5]]
SUBCHAPTER A--INCOME TAX (CONTINUED)
PART 1--INCOME TAXES--Table of Contents
Normal Taxes and Surtaxes
DEFERRED COMPENSATION, ETC.
ACCOUNTING PERIODS AND METHODS OF ACCOUNTING
Accounting Periods
Sec.
1.441-0 Table of contents.
1.441-1 Period for computation of taxable income.
1.441-2 Election of taxable year consisting of 52-53 weeks.
1.441-3 Taxable year of a personal service corporation.
1.441-4 Effective date.
1.442-1 Change of annual accounting period.
1.443-1 Returns for periods of less than 12 months.
1.444-0T Table of contents (temporary).
1.444-1T Election to use a taxable year other than the required taxable
year (temporary).
1.444-2T Tiered structure (temporary).
1.444-3T Manner and time of making section 444 election (temporary).
1.444-4 Tiered structure.
Methods of Accounting
Methods of Accounting in General
1.446-1 General rule for methods of accounting.
1.446-2 Method of accounting for interest.
1.446-3 Notional principal contracts.
1.446-4 Hedging transactions.
1.448-1 Limitation on the use of the cash receipts and disbursements
method of accounting.
1.448-1T Limitation on the use of the cash receipts and disbursements
method of accounting (temporary).
1.448-2T Nonaccrual of certain amounts by service providers
(temporary).
Taxable Year for Which Items of Gross Income Included
1.451-1 General rule for taxable year of inclusion.
1.451-2 Constructive receipt of income.
1.451-4 Accounting for redemption of trading stamps and coupons.
1.451-5 Advance payments for goods and long-term contracts.
1.451-6 Election to include crop insurance proceeds in gross income in
the taxable year following the taxable year of destruction or
damage.
1.451-7 Election relating to livestock sold on account of drought.
1.453-1--1.453-2 [Reserved]
1.453-3 Purchaser evidences of indebtedness payable on demand or
readily tradable.
1.453-4 Sale of real property involving deferred periodic payments.
1.453-5 Sale of real property treated on installment method.
1.453-6 Deferred payment sale of real property not on installment
method.
1.453-7--1.453-8 [Reserved]
1.453-9 Gain or loss on disposition of installment obligations.
1.453-10 Effective date.
1.453-11 Installment obligations received from a liquidating
corporation.
1.453-12 Allocation of unrecaptured section 1250 gain reported on the
installment method.
1.453A-0 Table of contents.
1.453A-1 Installment method of reporting income by dealers on personal
property.
1.453A-2 Treatment of revolving credit plans; taxable years beginning
on or before December 31, 1986.
1.453A-3 Requirements for adoption of or change to installment method
by dealers in personal property.
1.454-1 Obligations issued at discount.
1.455-1 Treatment of prepaid subscription income.
1.455-2 Scope of election under section 455.
1.455-3 Method of allocation.
1.455-4 Cessation of taxpayer's liability.
1.455-5 Definitions and other rules.
1.455-6 Time and manner of making election.
1.456-1 Treatment of prepaid dues income.
1.456-2 Scope of election under section 456.
1.456-3 Method of allocation.
1.456-4 Cessation of liability or existence.
1.456-5 Definitions and other rules.
1.456-6 Time and manner of making election.
1.456-7 Transitional rule.
1.457-1 Compensation deferred under eligible State deferred
compensation plans.
1.457-2 Eligible State deferred compensation plan defined.
1.457-3 Tax treatment of participants where plan is not an eligible
plan.
1.457-4 Transitional rules.
1.458-1 Exclusion for certain returned magazines, paperbacks, or
records.
1.458-2 Manner of and time for making election.
1.460-0 Outline of regulations under section 460.
1.460-1 Long-term contracts.
1.460-2 Long-term manufacturing contracts.
1.460-3 Long-term construction contracts.
1.460-4 Methods of accounting for long-term contracts.
1.460-5 Cost allocation rules.
[[Page 6]]
1.460-6 Look-back method.
Taxable Year for Which Deductions Taken
1.461-0 Table of contents.
1.461-1 General rule for taxable year of deduction.
1.461-2 Contested liabilities.
1.461-3 Prepaid interest. [Reserved]
1.461-4 Economic performance.
1.461-5 Recurring item exception.
1.461-6 Economic performance when certain liabilities are assigned or
are extinguished by the establishment of a fund.
1.463-1T Transitional rule for vested accrued vacation pay (temporary).
1.465-1T Aggregation of certain activities (temporary).
1.465-27 Qualified nonrecourse financing.
1.466-1 Method of accounting for the redemption cost of qualified
discount coupons.
1.466-2 Special protective election for certain taxpayers.
1.466-3 Manner of and time for making election under section 466.
1.466-4 Manner of and time for making election under section 373(c) of
the Revenue Act of 1978.
1.467-0 Table of contents.
1.467-1 Treatment of lessors and lessees generally.
1.467-2 Rent accrual for section 467 rental agreements without adequate
interest.
1.467-3 Disqualified leasebacks and long-term agreements.
1.467-4 Section 467 loan.
1.467-5 Section 467 rental agreements with variable interest.
1.467-6 Section 467 rental agreements with contingent payments.
[Reserved]
1.467-7 Section 467 recapture and other rules relating to dispositions
and modifications.
1.467-8 Automatic consent to change to constant rental accrual for
certain rental agreements.
1.467-9 Effective dates and automatic method changes for certain
agreements.
1.468A-0 Nuclear decommissioning costs; table of contents.
1.468A-1 Nuclear decommissioning costs; general rules.
1.468A-2 Treatment of electing taxpayer.
1.468A-3 Ruling amount.
1.468A-4 Treatment of nuclear decommissioning fund.
1.468A-5 Nuclear decommissioning fund qualification requirements;
prohibitions against self-dealing; disqualification of nuclear
decommissioning fund; termination of fund upon substantial
completion of decommissioning.
1.468A-6 Disposition of an interest in a nuclear power plant.
1.468A-7 Manner of and time for making election.
1.468A-8 Effective date and transitional rules.
1.468B Designated settlement funds.
1.468B-0 Table of contents.
1.468B-1 Qualified settlement funds.
1.468B-2 Taxation of qualified settlement funds and related
administrative requirements.
1.468B-3 Rules applicable to the transferor.
1.468B-4 Taxability of distributions to claimants.
1.468B-5 Effective dates and transition rules.
1.469-0 Table of contents.
1.469-1 General rules.
1.469-1T General rules (temporary).
1.469-2 Passive activity loss.
1.469-2T Passive activity loss (temporary).
1.469-3 Passive activity credit.
1.469-3T Passive activity credit (temporary).
1.469-4 Definition of activity.
1.469-4T Definition of activity (temporary).
1.469-5 Material participation.
1.469-5T Material participation (temporary).
1.469-6 Treatment of losses upon certain dispositions. [Reserved]
1.469-7 Treatment of self-charged items of interest income and
deduction.
1.469-8 Application of section 469 to trust, estates, and their
beneficiaries. [Reserved]
1.469-9 Rules for certain rental real estate activities.
1.469-10 Application of section 469 to publicly traded partnerships.
1.469-11 Effective date and transition rules.
Inventories
1.471-1 Need for inventories.
1.471-2 Valuation of inventories.
1.471-3 Inventories at cost.
1.471-4 Inventories at cost or market, whichever is lower.
1.471-5 Inventories by dealers in securities.
1.471-6 Inventories of livestock raisers and other farmers.
1.471-7 Inventories of miners and manufacturers.
1.471-8 Inventories of retail merchants.
1.471-9 Inventories of acquiring corporations.
1.471-10 Applicability of long-term contract methods.
1.471-11 Inventories of manufacturers.
1.472-1 Last-in, first-out inventories.
1.472-2 Requirements incident to adoption and use of LIFO inventory
method.
1.472-3 Time and manner of making election.
1.472-4 Adjustments to be made by taxpayer.
1.472-5 Revocation of election.
1.472-6 Change from LIFO inventory method.
[[Page 7]]
1.472-7 Inventories of acquiring corporations.
1.472-8 Dollar-value method of pricing LIFO inventories.
1.475-0 Table of contents.
1.475(a)-1--1.475(a)-2 [Reserved]
1.475(a)-3 Acquisition by a dealer of a security with a substituted
basis.
1.475(b)-1 Scope of exemptions from mark-to-market requirement.
1.475(b)-2 Exemptions--identification requirements.
1.475(b)-3 [Reserved]
1.475(b)-4 Exemptions--transitional issues.
1.475(c)-1 Definitions--dealer in securities.
1.475(c)-2 Definitions--security.
1.475(d)-1 Character of gain or loss.
1.475(e)-1 Effective dates.
Adjustments
1.481-1 Adjustments in general.
1.481-2 Limitation on tax.
1.481-3 Adjustments attributable to pre-1954 years where change was not
initiated by taxpayer.
1.481-4 Adjustments taken into account with consent.
1.481-5 Effective dates.
1.482-0 Outline of regulations under 482.
1.482-1 Allocation of income and deductions among taxpayers.
1.482-2 Determination of taxable income in specific situations.
1.482-3 Methods to determine taxable income in connection with a
transfer of tangible property.
1.482-4 Methods to determine taxable income in connection with a
transfer of intangible property.
1.482-5 Comparable profits method.
1.482-6 Profit split method.
1.482-7 Sharing of costs.
1.482-8 Examples of the best method rule.
1.483-1 Interest on certain deferred payments.
1.483-2 Unstated interest.
1.483-3 Test rate of interest applicable to a contract.
1.483-4 Contingent payments.
Regulations Applicable for Taxable Years Beginning on or Before April
21, 1993
1.482-1A Allocation of income and deductions among taxpayers.
1.482-2A Determination of taxable income in specific situations.
Authority: 26 U.S.C. 7805.
Section 1.441-2T also issued under 26 U.S.C. 441(f).
Section 1.441-3T also issued under 26 U.S.C. 441.
Section 1.442-2T and 1.442-3T also issued under 26 U.S.C. 422, 706,
and 1378.
Section 1.444-0T through 1.444-3T and
Section 1.444-4 is also issued under 26 U.S.C. 444(g)..
Section 1.446-1 also issued under 26 U.S.C. 446 and 461(h).
Section 1.446-4 also issued under 26 U.S.C. 1502.
Section 1.451-5 also issued under 96 Stat. 324, 493.
Section 1.453-11 also issued under 26 U.S.C. 453(j)(1) and (k).
Section 1.453A-3 also issued under 26 U.S.C. 453A.
Section 1.458-1 also issued under 26 U.S.C. 458.
Section 1.460-1 also issued under 26 U.S.C. 460(h).
Section 1.460-2 also issued under 26 U.S.C. 460(h).
Section 1.460-3 also issued under 26 U.S.C. 460(h).
Section 1.460-4 also issued under 26 U.S.C. 460(h) and 1502.
Section 1.460-5 also issued under 26 U.S.C. 460(h).
Section 1.460-6 also issued under 26 U.S.C. 460(h).
Section 1.461-1 also issued under 26 U.S.C. 461(h).
Section 1.461-2 also issued under 26 U.S.C. 461(h).
Section 1.461-4 also issued under 26 U.S.C. 461(h).
Section 1.461-4(d) also issued under 26 U.S.C. 460 and 26 U.S.C.
461(h).
Section 1.461-5 also issued under 26 U.S.C. 461(h).
Section 1.461-6 also issued under 26 U.S.C. 461(h).
Section 1.465-27 also issued under 26 U.S.C. 465(b)(6)(B)(iii).
Section 1.466-1 through 1.466-4 also issued under 26 U.S.C. 466.
Section 1.467-1 is also issued under 26 U.S.C. 467.
Section 1.467-2 is also issued under 26 U.S.C. 467.
Section 1.467-3 is also issued under 26 U.S.C. 467.
Section 1.467-4 is also issued under 26 U.S.C. 467.
Section 1.467-5 is also issued under 26 U.S.C. 467.
Section 1.467-6 is also issued under 26 U.S.C. 467.
Section 1.467-7 is also issued under 26 U.S.C. 467.
Section 1.467-8 is also issued under 26 U.S.C. 467.
Section 1.467-9 is also issued under 26 U.S.C. 467.
Section 1.468A-5 also issued under 26 U.S.C. 468A(e)(5).
Section 1.468B also issued under 26 U.S.C. 461(h) and 468B.
Section 1.468B-0 through 1.468B-5 also issued under 26 U.S.C. 461(h)
and 468B.
[[Page 8]]
Section 1.469-1 also issued under 26 U.S.C. 469.
Section 1.469-1T also issued under 26 U.S.C. 469.
Section 1.469-2 also issued under 26 U.S.C. 469(l).
Section 1.469-2T also issued under 26 U.S.C. 469(l).
Section 1.469-3 also issued under 26 U.S.C. 469(l).
Section 1.469-3T also issued under 26 U.S.C. 469(l).
Section 1.469-4 also issued under 26 U.S.C. 469(l).
Section 1.469-5 also issued under 26 U.S.C. 469(l).
Section 1.469-5T also issued under 26 U.S.C. 469(l).
Section 1.469-7 also issued under 26 U.S.C. 469(l).
Section 1.469-9 also issued under 26 U.S.C. 469(c)(6), (h)(2), and
(l)(1).
Section 1.469-11 also issued under 26 U.S.C. 469(l).
Section 1.471 also issued under 26 U.S.C. 471.
Section 1.471-4 also issued under 26 U.S.C. 263A.
Section 1.471-5 also issued under 26 U.S.C. 263A.
Section 1.471-6 also issued under 26 U.S.C. 471.
Section 1.472-8 also issued under 26 U.S.C. 472.
Section 1.475(a)-3 also issued under 26 U.S.C. 475(e).
Section 1.475(b)-1 also issued under 26 U.S.C. 475(b)(4) and 26
U.S.C. 475(e).
Section 1.475(b)-2 also issued under 26 U.S.C. 475(b)(2) and 26
U.S.C. 475(e).
Section 1.475(b)-4 also issued under 26 U.S.C. 475(b)(2), 26 U.S.C.
475(e), and 26 U.S.C. 6001.
Section 1.475(c)-1 also issued under 26 U.S.C. 475(e).
Section 1.475(c)-2 also issued under 26 U.S.C. 475(e) and 26 U.S.C.
860G(e).
Section 1.475(d)-1 also issued under 26 U.S.C. 475(e).
Section 1.475(e)-1 also issued under 26 U.S.C. 475(e).
Section 1.481-1 also issued under 26 U.S.C. 481.
Section 1.481-2 also issued under 26 U.S.C. 481.
Section 1.481-3 also issued under 26 U.S.C. 481.
Section 1.481-4 also issued under 26 U.S.C. 481.
Section 1.481-5 also issued under 26 U.S.C. 481.
Section 1.482-1 also issued under 26 U.S.C. 482 and 936.
Section 1.482-2 also issued under 26 U.S.C. 482.
Section 1.482-3 also issued under 26 U.S.C. 482.
Section 1.482-4 also issued under 26 U.S.C. 482.
Section 1.482-5 also issued under 26 U.S.C. 482.
Section 1.482-7 is also issued under 26 U.S.C. 482.
Section 1.482-2A also issued under 26 U.S.C. 482.
Section 1.483-1 through 1.483-3 also issued under 26 U.S.C. 483(f).
Section 1.483-4 also issued under 26 U.S.C. 483(f).
DEFERRED COMPENSATION, ETC. (CONTINUED)
ACCOUNTING PERIODS AND METHODS OF ACCOUNTING
Accounting Periods
Sec. 1.441-0 Table of contents.
This section lists the captions contained in Secs. 1.441-1 through
1.441-4 as follows:
Sec. 1.441-1 Period for computation of taxable income.
(a) Computation of taxable income.
(1) In general.
(2) Length of taxable year.
(b) General rules and definitions.
(1) Taxable year.
(1) Required taxable year.
(i) In general.
(ii) Exceptions.
(A) 52-53-week taxable years.
(B) Partnerships, S corporations, and PSCs.
(C) Specified foreign corporations.
(3) Annual accounting period.
(4) Calendar year.
(5) Fiscal year.
(i) Definition.
(ii) Recognition.
(6) Grandfathered fiscal year.
(7) Books.
(8) Taxpayer.
(c) Adoption of taxable year.
(1) In general.
(2) Approval required.
(i) Taxpayers with required taxable years.
(ii) Taxpayers without books.
(d) Retention of taxable year.
(e) Change of taxable year.
(f) Obtaining approval of the Commissioner or making a section 444
election.
Sec. 1.441-2 Election of taxable year consisting of 52-53 weeks
(a) In general.
(1) Election.
(2) Effect.
(3) Eligible taxpayer.
(4) Example.
[[Page 9]]
(b) Procedures to elect a 52-53-week taxable year.
(1) Adoption of a 52-53-week taxable year.
(i) In general.
(ii) Filing requirement.
(2) Change to (or from) a 52-53-week taxable year.
(i) In general.
(ii) Special rules for short period required to effect the change.
(3) Examples.
(c) Application of effective dates.
(1) In general.
(2) Examples.
(3) Changes in tax rates.
(4) Examples.
(d) Computation of taxable income.
(e) Treatment of taxable years ending with reference to the same
calendar month.
(1) Pass-through entities.
(2) Personal service corporations and employee-owners.
(3) Definitions.
(i) Pass-through entity.
(ii) Owner of a pass-through entity.
(4) Examples.
(5) Transition rule.
Sec. 1.441-3 Taxable year of a personal service corporation
(a) Taxable year.
(1) Required taxable year.
(2) Exceptions.
(b) Adoption, change, or retention of taxable year.
(1) Adoption of taxable year.
(2) Change in taxable year.
(3) Retention of taxable year.
(4) Procedures for obtaining approval or making a section 444 election.
(5) Examples.
(c) Personal service corporation defined.
(1) In general.
(2) Testing period.
(i) In general.
(ii) New corporations.
(3) Examples.
(d) Performance of personal services.
(1) Activities described in section 448(d)(2)(A).
(2) Activities not described in section 448(d)(2)(A).
(e) Principal activity.
(1) General rule.
(2) Compensation cost.
(i) Amounts included.
(ii) Amounts excluded.
(3) Attribution of compensation cost to personal service activity.
(i) Employees involved only in the performance of personal services.
(ii) Employees involved only in activities that are not treated as the
performance of personal services.
(iii) Other employees.
(A) Compensation cost attributable to personal service activity.
(B) Compensation cost not attributable to personal service activity.
(f) Services substantially performed by employee-owners.
(1) General rule.
(2) Compensation cost attributable to personal services.
(3) Examples.
(g) Employee-owner defined.
(1) General rule.
(2) Special rule for independent contractors who are owners.
(h) Special rules for affiliated groups filing consolidated returns.
(1) In general.
(2) Examples.
Sec. 1.441-4 Effective date
[T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.441-1 Period for computation of taxable income.
(a) Computation of taxable income--(1) In general. Taxable income
must be computed and a return must be made for a period known as the
taxable year. For rules relating to methods of accounting, the taxable
year for which items of gross income are included and deductions are
taken, inventories, and adjustments, see parts II and III (section 446
and following), subchapter E, chapter 1 of the Internal Revenue Code,
and the regulations thereunder.
(2) Length of taxable year. Except as otherwise provided in the
Internal Revenue Code and the regulations thereunder (e.g., Sec. 1.441-2
regarding 52-53-week taxable years), a taxable year may not cover a
period of more than 12 calendar months.
(b) General rules and definitions. The general rules and definitions
in this paragraph (b) apply for purposes of sections 441 and 442 and the
regulations thereunder.
(1) Taxable year. Taxable year means--
(i) The period for which a return is made, if a return is made for a
period of less than 12 months (short period). See section 443 and the
regulations thereunder;
(ii) Except as provided in paragraph (b)(1)(i) of this section, the
taxpayer's required taxable year (as defined in paragraph (b)(2) of this
section), if applicable;
(iii) Except as provided in paragraphs (b)(1)(i) and (ii) of this
section, the taxpayer's annual accounting period (as
[[Page 10]]
defined in paragraph (b)(3) of this section), if it is a calendar year
or a fiscal year; or
(iv) Except as provided in paragraphs (b)(1)(i) and (ii) of this
section, the calendar year, if the taxpayer keeps no books, does not
have an annual accounting period, or has an annual accounting period
that does not qualify as a fiscal year.
(2) Required taxable year--(i) In general. Certain taxpayers must
use the particular taxable year that is required under the Internal
Revenue Code and the regulations thereunder (the required taxable year).
For example, the required taxable year is--
(A) In the case of a foreign sales corporation or domestic
international sales corporation, the taxable year determined under
section 441(h) and Sec. 1.921-1T(a)(11), (b)(4), and (b)(6);
(B) In the case of a personal service corporation (PSC), the taxable
year determined under section 441(i) and Sec. 1.441-3;
(C) In the case of a nuclear decommissioning fund, the taxable year
determined under Sec. 1.468A-4(c)(1);
(D) In the case of a designated settlement fund or a qualified
settlement fund, the taxable year determined under Sec. 1.468B-2(j);
(E) In the case of a common trust fund, the taxable year determined
under section 584(i);
(F) In the case of certain trusts, the taxable year determined under
section 644;
(G) In the case of a partnership, the taxable year determined under
section 706 and Sec. 1.706-1;
(H) In the case of an insurance company, the taxable year determined
under section 843 and Sec. 1.1502-76(a)(2);
(I) In the case of a real estate investment trust, the taxable year
determined under section 859;
(J) In the case of a real estate mortgage investment conduit, the
taxable year determined under section 860D(a)(5) and Sec. 1.860D-
1(b)(6);
(K) In the case of a specified foreign corporation, the taxable year
determined under section 898(c)(1)(A);
(L) In the case of an S corporation, the taxable year determined
under section 1378 and Sec. 1.1378-1; or
(M) In the case of a member of an affiliated group that makes a
consolidated return, the taxable year determined under Sec. 1.1502-76.
(ii) Exceptions. Notwithstanding paragraph (b)(2)(i) of this
section, the following taxpayers may have a taxable year other than
their required taxable year:
(A) 52-53-week taxable years. Certain taxpayers may elect to use a
52-53-week taxable year that ends with reference to their required
taxable year. See, for example, Secs. 1.441-3 (PSCs), 1.706-1
(partnerships), 1.1378-1 (S corporations), and 1.1502-76(a)(1) (members
of a consolidated group).
(B) Partnerships, S corporations, and PSCs. A partnership, S
corporation, or PSC may use a taxable year other than its required
taxable year if the taxpayer elects to use a taxable year other than its
required taxable year under section 444, elects a 52-53-week taxable
year that ends with reference to its required taxable year as provided
in paragraph (b)(2)(ii)(A) of this section or to a taxable year elected
under section 444, or establishes a business purpose to the satisfaction
of the Commissioner under section 442 (such as a grandfathered fiscal
year).
(C) Specified foreign corporations. A specified foreign corporation
(as defined in section 898(b)) may use a taxable year other than its
required taxable year if it elects a 52-53-week taxable year that ends
with reference to its required taxable year as provided in paragraph
(b)(2)(ii)(A) of this section or makes a one-month deferral election
under section 898(c)(1)(B).
(3) Annual accounting period. Annual accounting period means the
annual period (calendar year or fiscal year) on the basis of which the
taxpayer regularly computes its income in keeping its books.
(4) Calendar year. Calendar year means a period of 12 consecutive
months ending on December 31. A taxpayer who has not established a
fiscal year must make its return on the basis of a calendar year.
(5) Fiscal year--(i) Definition. Fiscal year means--
(A) A period of 12 consecutive months ending on the last day of any
month other than December; or
[[Page 11]]
(B) A 52-53-week taxable year, if such period has been elected by
the taxpayer. See Sec. 1.441-2.
(ii) Recognition. A fiscal year will be recognized only if the books
of the taxpayer are kept in accordance with such fiscal year.
(6) Grandfathered fiscal year. Grandfathered fiscal year means a
fiscal year (other than a year that resulted in a three month or less
deferral of income) that a partnership or an S corporation received
permission to use on or after July 1, 1974, by a letter ruling (i.e.,
not by automatic approval).
(7) Books. Books include the taxpayer's regular books of account and
such other records and data as may be necessary to support the entries
on the taxpayer's books and on the taxpayer's return, as for example, a
reconciliation of any difference between such books and the taxpayer's
return. Records that are sufficient to reflect income adequately and
clearly on the basis of an annual accounting period will be regarded as
the keeping of books. See section 6001 and the regulations thereunder
for rules relating to the keeping of books and records.
(8) Taxpayer. Taxpayer has the same meaning as the term person as
defined in section 7701(a)(1) (e.g., an individual, trust, estate,
partnership, association, or corporation) rather than the meaning of the
term taxpayer as defined in section 7701(a)(14) (any person subject to
tax).
(c) Adoption of taxable year--(1) In general. Except as provided in
paragraph (c)(2) of this section, a new taxpayer may adopt any taxable
year that satisfies the requirements of section 441 and the regulations
thereunder without the approval of the Commissioner. A taxable year of a
new taxpayer is adopted by filing its first Federal income tax return
using that taxable year. The filing of an application for automatic
extension of time to file a Federal income tax return (e.g., Form 7004,
``Application for Automatic Extension of Time to File Corporation Income
Tax Return''), the filing of an application for an employer
identification number (i.e., Form SS-4, ``Application for Employer
Identification Number''), or the payment of estimated taxes, for a
particular taxable year do not constitute an adoption of that taxable
year.
(2) Approval required--(i) Taxpayers with required taxable years. A
newly-formed partnership, S corporation, or PSC that wants to adopt a
taxable year other than its required taxable year, a taxable year
elected under section 444, or a 52-53-week taxable year that ends with
reference to its required taxable year or a taxable year elected under
section 444 must establish a business purpose and obtain the approval of
the Commissioner under section 442.
(ii) Taxpayers without books. A taxpayer that must use a calendar
year under section 441(g) and paragraph (f) of this section may not
adopt a fiscal year without obtaining the approval of the Commissioner.
(d) Retention of taxable year. In certain cases, a partnership, S
corporation, electing S corporation, or PSC will be required to change
its taxable year unless it obtains the approval of the Commissioner
under section 442, or makes an election under section 444, to retain its
current taxable year. For example, a corporation using a June 30 fiscal
year that either becomes a PSC or elects to be an S corporation and, as
a result, is required to use the calendar year under section 441(i) or
1378, respectively, must obtain the approval of the Commissioner to
retain its current fiscal year. Similarly, a partnership using a taxable
year that corresponds to its required taxable year must obtain the
approval of the Commissioner to retain such taxable year if its required
taxable year changes as a result of a change in ownership. However, a
partnership that previously established a business purpose to the
satisfaction of the Commissioner to use a taxable year is not required
to obtain the approval of the Commissioner if its required taxable year
changes as a result of a change in ownership.
(e) Change of taxable year. Once a taxpayer has adopted a taxable
year, such taxable year must be used in computing taxable income and
making returns for all subsequent years unless the taxpayer obtains
approval from the Commissioner to make a change or the taxpayer is
otherwise authorized to change without the approval of the
[[Page 12]]
Commissioner under the Internal Revenue Code (e.g., section 444 or 859)
or the regulations thereunder.
(f) Obtaining approval of the Commissioner or making a section 444
election. See Sec. 1.442-1(b) for procedures for obtaining approval of
the Commissioner (automatically or otherwise) to adopt, change, or
retain an annual accounting period. See Secs. 1.444-1T and 1.444-2T for
qualifications, and 1.444-3T for procedures, for making an election
under section 444.
[T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.441-2 Election of taxable year consisting of 52-53 weeks.
(a) In general--(1) Election. An eligible taxpayer may elect to
compute its taxable income on the basis of a fiscal year that--
(i) Varies from 52 to 53 weeks;
(ii) Ends always on the same day of the week; and
(iii) Ends always on--
(A) Whatever date this same day of the week last occurs in a
calendar month; or
(B) Whatever date this same day of the week falls that is the
nearest to the last day of the calendar month.
(2) Effect. In the case of a taxable year described in paragraph
(a)(1)(iii)(A) of this section, the year will always end within the
month and may end on the last day of the month, or as many as six days
before the end of the month. In the case of a taxable year described in
paragraph (a)(1)(iii)(B) of this section, the year may end on the last
day of the month, or as many as three days before or three days after
the last day of the month.
(3) Eligible taxpayer. A taxpayer is eligible to elect a 52-53-week
taxable year if such fiscal year would otherwise satisfy the
requirements of section 441 and the regulations thereunder. For example,
a taxpayer that is required to use a calendar year under Sec. 1.441-
1(b)(2)(i)(D) is not an eligible taxpayer.
(4) Example. The provisions of this paragraph (a) are illustrated by
the following example:
Example. If the taxpayer elects a taxable year ending always on the
last Saturday in November, then for the year 2001, the taxable year
would end on November 24, 2001. On the other hand, if the taxpayer had
elected a taxable year ending always on the Saturday nearest to the end
of November, then for the year 2001, the taxable year would end on
December 1, 2001.
(b) Procedures to elect a 52-53-week taxable year--(1) Adoption of a
52-53-week taxable year--(i) In general. A new eligible taxpayer elects
a 52-53-week taxable year by adopting such year in accordance with
Sec. 1.441-1(c). A newly-formed partnership, S corporation or personal
service corporation (PSC) may adopt a 52-53-week taxable year without
the approval of the Commissioner if such year ends with reference to
either the taxpayer's required taxable year (as defined in Sec. 1.441-
1(b)(2)) or the taxable year elected under section 444. See Secs. 1.441-
3, 1.706-1, and 1.1378-1. Similarly, a newly-formed specified foreign
corporation (as defined in section 898(b)) may adopt a 52-53-week
taxable year if such year ends with reference to the taxpayer's required
taxable year, or, if the one-month deferral election under section
898(c)(1)(B) is made, with reference to the month immediately preceding
the required taxable year. See Sec. 1.1502-76(a)(1) for special rules
regarding subsidiaries adopting 52-53-week taxable years.
(ii) Filing requirement. A taxpayer adopting a 52-53-week taxable
year must file with its Federal income tax return for its first taxable
year a statement containing the following information--
(A) The calendar month with reference to which the 52-53-week
taxable year ends;
(B) The day of the week on which the 52-53-week taxable year always
will end; and
(C) Whether the 52-53-week taxable year will always end on the date
on which that day of the week last occurs in the calendar month, or on
the date on which that day of the week falls that is nearest to the last
day of that calendar month.
(2) Change to (or from) a 52-53-week taxable year--(i) In general.
An election of a 52-53-week taxable year by an existing eligible
taxpayer with an established taxable year is treated as a change in
annual accounting period
[[Page 13]]
that requires the approval of the Commissioner in accordance with
Sec. 1.442-1. Thus, a taxpayer must obtain approval to change from its
current taxable year to a 52-53-week taxable year, even if such 52-53-
week taxable year ends with reference to the same calendar month.
Similarly, a taxpayer must obtain approval to change from a 52-53-week
taxable year, or to change from one 52-53-week taxable year to another
52-53-week taxable year. However, a taxpayer may obtain approval for 52-
53-week taxable year changes automatically to the extent provided in
administrative procedures published by the Commissioner. See Sec. 1.442-
1(b) for procedures for obtaining such approval.
(ii) Special rules for the short period required to effect the
change. If a change to or from a 52-53-week taxable year results in a
short period (within the meaning of Sec. 1.443-1(a)) of 359 days or
more, or six days or less, the tax computation under Sec. 1.443-1(b)
does not apply. If the short period is 359 days or more, it is treated
as a full taxable year. If the short period is six days or less, such
short period is not a separate taxable year but instead is added to and
deemed a part of the following taxable year. (In the case of a change to
or from a 52-53-week taxable year not involving a change of the month
with reference to which the taxable year ends, the tax computation under
Sec. 1.443-1(b) does not apply because the short period will always be
359 days or more, or six days or less.) In the case of a short period
which is more than six days and less than 359 days, taxable income for
the short period is placed on an annual basis for purposes of
Sec. 1.443-1(b) by multiplying such income by 365 and dividing the
result by the number of days in the short period. In such case, the tax
for the short period is the same part of the tax computed on such income
placed on an annual basis as the number of days in the short period is
of 365 days (unless Sec. 1.443-1(b)(2), relating to the alternative tax
computation, applies). For an adjustment in deduction for personal
exemption, see Sec. 1.443-1(b)(1)(v).
(3) Examples. The following examples illustrate paragraph (b)(2)(ii)
of this section:
Example 1. A taxpayer having a fiscal year ending April 30, obtains
approval to change to a 52-53-week taxable year ending the last Saturday
in April for taxable years beginning after April 30, 2001. This change
involves a short period of 362 days, from May 1, 2001, to April 27,
2002, inclusive. Because the change results in a short period of 359
days or more, it is not placed on an annual basis and is treated as a
full taxable year.
Example 2. Assume the same conditions as Example 1, except that the
taxpayer changes for taxable years beginning after April 30, 2002, to a
taxable year ending on the Thursday nearest to April 30. This change
results in a short period of two days, May 1 to May 2, 2002. Because the
short period is less than seven days, tax is not separately computed.
This short period is added to and deemed part of the following 52-53-
week taxable year, which would otherwise begin on May 3, 2002, and end
on May 1, 2003.
(c) Application of effective dates--(1) In general. Except as
provided in paragraph (c)(3) of this section, for purposes of
determining the effective date (e.g., of legislative, regulatory, or
administrative changes) or the applicability of any provision of the
internal revenue laws that is expressed in terms of taxable years
beginning, including, or ending with reference to the first or last day
of a specified calendar month, a 52-53-week taxable year is deemed to
begin on the first day of the calendar month nearest to the first day of
the 52-53-week taxable year, and is deemed to end or close on the last
day of the calendar month nearest to the last day of the 52-53-week
taxable year, as the case may be. Examples of provisions of this title,
the applicability of which is expressed in terms referred to in the
preceding sentence, include the provisions relating to the time for
filing returns and other documents, paying tax, or performing other
acts, and the provisions of part II, subchapter B, chapter 6 (section
1561 and following) relating to surtax exemptions of certain controlled
corporations.
(2) Examples. The provisions of paragraph (c)(1) of this section may
be illustrated by the following examples:
Example 1. Assume that an income tax provision is applicable to
taxable years beginning on or after January 1, 2001. For that purpose, a
52-53-week taxable year beginning on any day within the period December
26, 2000, to January 4, 2001, inclusive, is treated as beginning on
January 1, 2001.
[[Page 14]]
Example 2. Assume that an income tax provision requires that a
return must be filed on or before the 15th day of the third month
following the close of the taxable year. For that purpose, a 52-53-week
taxable year ending on any day during the period May 25 to June 3,
inclusive, is treated as ending on May 31, the last day of the month
ending nearest to the last day of the taxable year, and the return,
therefore, must be made on or before August 15.
Example 3. Assume that a revenue procedure requires the performance
of an act by the taxpayer within ``the first 90 days of the taxable
year,'' by ``the 75th day of the taxable year,'' or, alternately, by
``the last day of the taxable year.'' The taxpayer employs a 52-53-week
taxable year that ends always on the Saturday closest to the last day of
December. These requirements are not expressed in terms of taxable years
beginning, including, or ending with reference to the first or last day
of a specified calendar month, and are accordingly outside the scope of
the rule stated in Sec. 1.441-2(c)(1). Accordingly, the taxpayer must
perform the required act by the 90th, 75th, or last day, respectively,
of its taxable year.
Example 4. X, a corporation created on January 1, 2001, elects a 52-
53-week taxable year ending on the Friday nearest the end of December.
Thus, X's first taxable year begins on Monday, January 1, 2001, and ends
on Friday, December 28, 2001; its next taxable year begins on Saturday,
December 29, 2001, and ends on Friday, January 3, 2003; and its next
taxable year begins on Saturday, January 4, 2003, and ends on Friday,
January 2, 2004. For purposes of applying the provisions of Part II,
subchapter B, chapter 6 of the Internal Revenue Code, X's first taxable
year is deemed to end on December 31, 2001; its next taxable year is
deemed to begin on January 1, 2002, and end on December 31, 2002, and
its next taxable year is deemed to begin on January 1, 2003, and end on
December 31, 2003. Accordingly, each such taxable year is treated as
including one and only one December 31st.
(3) Changes in tax rates. If a change in the rate of tax is
effective during a 52-53-week taxable year (other than on the first day
of such year as determined under paragraph (c)(1) of this section), the
tax for the 52-53-week taxable year must be computed in accordance with
section 15, relating to effect of changes, and the regulations
thereunder. For the purpose of the computation under section 15, the
determination of the number of days in the period before the change, and
in the period on and after the change, is to be made without regard to
the provisions of paragraph (b)(1) of this paragraph.
(4) Examples. The provisions of paragraph (c)(3) of this section may
be illustrated by the following examples:
Example 1. Assume a change in the rate of tax is effective for
taxable years beginning after June 30, 2002. For a 52-53-week taxable
year beginning on Friday, November 2, 2001, the tax must be computed on
the basis of the old rates for the actual number of days from November
2, 2001, to June 30, 2002, inclusive, and on the basis of the new rates
for the actual number of days from July 1, 2002, to Thursday, October
31, 2002, inclusive.
Example 2. Assume a change in the rate of tax is effective for
taxable years beginning after June 30, 2001. For this purpose, a 52-53-
week taxable year beginning on any of the days from June 25 to July 4,
inclusive, is treated as beginning on July 1. Therefore, no computation
under section 15 will be required for such year because of the change in
rate.
(d) Computation of taxable income. The principles of section 451,
relating to the taxable year for inclusion of items of gross income, and
section 461, relating to the taxable year for taking deductions,
generally are applicable to 52-53-week taxable years. Thus, except as
otherwise provided, all items of income and deduction must be determined
on the basis of a 52-53-week taxable year. However, a taxpayer may
determine particular items as though the 52-53-week taxable year were a
taxable year consisting of 12 calendar months, provided that practice is
consistently followed by the taxpayer and clearly reflects income. For
example, an allowance for depreciation or amortization may be determined
on the basis of a 52-53-week taxable year, or as though the 52-53-week
taxable year is a taxable year consisting of 12 calendar months,
provided the taxpayer consistently follows that practice with respect to
all depreciable or amortizable items.
(e) Treatment of taxable years ending with reference to the same
calendar month--(1) Pass-through entities. If a pass-through entity (as
defined in paragraph (e)(3)(i) of this section) or an owner of a pass-
through entity (as defined in paragraph (e)(3)(ii) of this section), or
both, use a 52-53-week taxable year and the taxable year of the pass-
through entity and the owner end with reference to the same calendar
month,
[[Page 15]]
then, for purposes of determining the taxable year in which items of
income, gain, loss, deductions, or credits from the pass-through entity
are taken into account by the owner of the pass-through, the owner's
taxable year will be deemed to end on the last day of the pass-through's
taxable year. Thus, if the taxable year of a partnership and a partner
end with reference to the same calendar month, then for purposes of
determining the taxable year in which that partner takes into account
items described in section 702 and items that are deductible by the
partnership (including items described in section 707(c)) and includible
in the income of that partner, that partner's taxable year will be
deemed to end on the last day of the partnership's taxable year.
Similarly, if the taxable year of an S corporation and a shareholder end
with reference to the same calendar month, then for purposes of
determining the taxable year in which that shareholder takes into
account items described in section 1366(a) and items that are deductible
by the S corporation and includible in the income of that shareholder,
that shareholder's taxable year will be deemed to end on the last day of
the S corporation's taxable year.
(2) Personal service corporations and employee-owners. If the
taxable year of a PSC (within the meaning of Sec. 1.441-3(c)) and an
employee-owner (within the meaning of Sec. 1.441-3(g)) end with
reference to the same calendar month, then for purposes of determining
the taxable year in which an employee-owner takes into account items
that are deductible by the PSC and includible in the income of the
employee-owner, the employee-owner's taxable year will be deemed to end
on the last day of the PSC's taxable year.
(3) Definitions--(i) Pass-through entity. For purposes of this
section, a pass-through entity means a partnership, S corporation,
trust, estate, closely-held real estate investment trust (within the
meaning of section 6655(e)(5)(B)), common trust fund (within the meaning
of section 584(i)), controlled foreign corporation (within the meaning
of section 957), foreign personal holding company (within the meaning of
section 552), or passive foreign investment company that is a qualified
electing fund (within the meaning of section 1295).
(ii) Owner of a pass-through entity. For purposes of this section,
an owner of a pass-through entity generally means a taxpayer that owns
an interest in, or stock of, a pass-through entity. For example, an
owner of a pass-through entity includes a partner in a partnership, a
shareholder of an S corporation, a beneficiary of a trust or an estate,
an owner of a closely-held real estate investment trust (within the
meaning of section 6655(e)(5)(A)), a participant in a common trust fund,
a U.S. shareholder (as defined in section 951(b)) of a controlled
foreign corporation, a U.S. shareholder (as defined in section 551(a))
of a foreign personal holding company, or a U.S. person that holds stock
in a passive foreign investment company that is a qualified electing
fund with respect to that shareholder.
(4) Examples. The provisions of paragraph (e)(2) of this section may
be illustrated by the following examples:
Example 1. ABC Partnership uses a 52-53-week taxable year that ends
on the Wednesday nearest to December 31, and its partners, A, B, and C,
are individual calendar year taxpayers. Assume that, for ABC's taxable
year ending January 3, 2001, each partner's distributive share of ABC's
taxable income is $10,000. Under section 706(a) and paragraph (e)(1) of
this section, for the taxable year ending December 31, 2000, A, B, and C
each must include $10,000 in income with respect to the ABC year ending
January 3, 2001. Similarly, if ABC makes a guaranteed payment to A on
January 2, 2001, A must include the payment in income for A's taxable
year ending December 31, 2000.
Example 2. X, a PSC, uses a 52-53-week taxable year that ends on the
Wednesday nearest to December 31, and all of the employee-owners of X
are individual calendar year taxpayers. Assume that, for its taxable
year ending January 3, 2001, X pays a bonus of $10,000 to each employee-
owner on January 2, 2001. Under paragraph (e)(2) of this section, each
employee-owner must include its bonus in income for the taxable year
ending December 31, 2000.
(5) Transition rule. In the case of an owner of a pass-through
entity (other than the owner of a partnership or S corporation) that is
required by this paragraph (e) to include in income for its first
taxable year ending on or after May 17, 2002 amounts attributable to
[[Page 16]]
two taxable years of a pass-through entity, the amount that otherwise
would be required to be included in income for such first taxable year
by reason of this paragraph (e) should be included in income ratably
over the four-taxable-year period beginning with such first taxable year
under principles similar to Sec. 1.702-3T, unless the owner of the pass-
through entity elects to include all such income in its first taxable
year ending on or after May 17, 2002.
[T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.441-3 Taxable year of a personal service corporation.
(a) Taxable year--(1) Required taxable year. Except as provided in
paragraph (a)(2) of this section, the taxable year of a personal service
corporation (PSC) (as defined in paragraph (c) of this section) must be
the calendar year.
(2) Exceptions. A PSC may have a taxable year other than its
required taxable year (i.e., a fiscal year) if it makes an election
under section 444, elects to use a 52-53-week taxable year that ends
with reference to the calendar year or a taxable year elected under
section 444, or establishes a business purpose for such fiscal year and
obtains the approval of the Commissioner under section 442.
(b) Adoption, change, or retention of taxable year--(1) Adoption of
taxable year. A PSC may adopt, in accordance with Sec. 1.441-1(c), the
calendar year, a taxable year elected under section 444, or a 52-53-week
taxable year ending with reference to the calendar year or a taxable
year elected under section 444 without the approval of the Commissioner.
See Sec. 1.441-1. A PSC that wants to adopt any other taxable year must
establish a business purpose and obtain the approval of the Commissioner
under section 442.
(2) Change in taxable year. A PSC that wants to change its taxable
year must obtain the approval of the Commissioner under section 442 or
make an election under section 444. However, a PSC may obtain automatic
approval for certain changes, including a change to the calendar year or
to a 52-53-week taxable year ending with reference to the calendar year,
pursuant to administrative procedures published by the Commissioner.
(3) Retention of taxable year. In certain cases, a PSC will be
required to change its taxable year unless it obtains the approval of
the Commissioner under section 442, or makes an election under section
444, to retain its current taxable year. For example, a corporation
using a June 30 fiscal year that becomes a PSC and, as a result, is
required to use the calendar year must obtain the approval of the
Commissioner to retain its current fiscal year.
(4) Procedures for obtaining approval or making a section 444
election. See Sec. 1.442-1(b) for procedures to obtain the approval of
the Commissioner (automatically or otherwise) to adopt, change, or
retain a taxable year. See Secs. 1.444-1T and 1.444-2T for
qualifications, and 1.444-3T for procedures, for making an election
under section 444.
(5) Examples. The provisions of paragraph (b)(4) of this section may
be illustrated by the following examples:
Example 1. X, whose taxable year ends on January 31, 2001, becomes a
PSC for its taxable year beginning February 1, 2001, and does not obtain
the approval of the Commissioner for using a fiscal year. Thus, for
taxable years ending before February 1, 2001, this section does not
apply with respect to X. For its taxable year beginning on February 1,
2001, however, X will be required to comply with paragraph (a) of this
section. Thus, unless X obtains approval of the Commissioner to use a
January 31 taxable year, or makes a section 444 election, X will be
required to change its taxable year to the calendar year under paragraph
(b) of this section by using a short taxable year that begins on
February 1, 2001, and ends on December 31, 2001. Under paragraph (b)(1)
of this section, X may obtain automatic approval to change its taxable
year to a calendar year. See Sec. 1.442-1(b).
Example 2. Assume the same facts as in Example 1, except that X
desires to change to a 52-53-week taxable year ending with reference to
the month of December. Under paragraph (b)(1) of this section X may
obtain automatic approval to make the change. See Sec. 1.442-1(b).
(c) Personal service corporation defined--(1) In general. For
purposes of this section and section 442, a taxpayer is a PSC for a
taxable year only if--
(i) The taxpayer is a C corporation (as defined in section
1361(a)(2)) for the taxable year;
(ii) The principal activity of the taxpayer during the testing
period is the performance of personal services;
[[Page 17]]
(iii) During the testing period, those services are substantially
performed by employee-owners (as defined in paragraph (g) of this
section); and
(iv) Employee-owners own (as determined under the attribution rules
of section 318, except that the language ``any'' applies instead of ``50
percent'' in section 318(a)(2)(C)) more than 10 percent of the fair
market value of the outstanding stock in the taxpayer on the last day of
the testing period.
(2) Testing period--(i) In general. Except as otherwise provided in
paragraph (c)(2)(ii) of this section, the testing period for any taxable
year is the immediately preceding taxable year.
(ii) New corporations. The testing period for a taxpayer's first
taxable year is the period beginning on the first day of that taxable
year and ending on the earlier of--
(A) The last day of that taxable year; or
(B) The last day of the calendar year in which that taxable year
begins.
(3) Examples. The provisions of paragraph (c)(2)(ii) of this section
may be illustrated by the following examples:
Example 1. Corporation A's first taxable year begins on June 1,
2001, and A desires to use a September 30 taxable year. However, if A is
a personal service corporation, it must obtain the Commissioner's
approval to use a September 30 taxable year. Pursuant to paragraph
(c)(2)(ii) of this section, A's testing period for its first taxable
year beginning June 1, 2001, is the period June 1, 2001 through
September 30, 2001. Thus, if, based upon such testing period, A is a
personal service corporation, A must obtain the Commissioner's
permission to use a September 30 taxable year.
Example 2. The facts are the same as in Example 1, except that A
desires to use a March 31 taxable year. Pursuant to paragraph (c)(2)(ii)
of this section, A's testing period for its first taxable year beginning
June 1, 2001, is the period June 1, 2001, through December 31, 2001.
Thus, if, based upon such testing period, A is a personal service
corporation, A must obtain the Commissioner's permission to use a March
31 taxable year.
(d) Performance of personal services--(1) Activities described in
section 448(d)(2)(A). For purposes of this section, any activity of the
taxpayer described in section 448(d)(2)(A) or the regulations thereunder
will be treated as the performance of personal services. Therefore, any
activity of the taxpayer that involves the performance of services in
the fields of health, law, engineering, architecture, accounting,
actuarial science, performing arts, or consulting (as such fields are
defined in Sec. 1.448-1T) will be treated as the performance of personal
services for purposes of this section.
(2) Activities not described in section 448(d)(2)(A). For purposes
of this section, any activity of the taxpayer not described in section
448(d)(2)(A) or the regulations thereunder will not be treated as the
performance of personal services.
(e) Principal activity--(1) General rule. For purposes of this
section, the principal activity of a corporation for any testing period
will be the performance of personal services if the cost of the
corporation's compensation (the compensation cost) for such testing
period that is attributable to its activities that are treated as the
performance of personal services within the meaning of paragraph (d) of
this section (i.e., the total compensation for personal service
activities) exceeds 50 percent of the corporation's total compensation
cost for such testing period.
(2) Compensation cost--(i) Amounts included. For purposes of this
section, the compensation cost of a corporation for a taxable year is
equal to the sum of the following amounts allowable as a deduction,
allocated to a long-term contract, or otherwise chargeable to a capital
account by the corporation during such taxable year--
(A) Wages and salaries; and
(B) Any other amounts, attributable to services performed for or on
behalf of the corporation by a person who is an employee of the
corporation (including an owner of the corporation who is treated as an
employee under paragraph (g)(2) of this section) during the testing
period. Such amounts include, but are not limited to, amounts
attributable to deferred compensation, commissions, bonuses,
compensation includible in income under section 83, compensation for
services based on a percentage of profits, and the cost of providing
fringe benefits that are includible in income.
[[Page 18]]
(ii) Amounts excluded. Notwithstanding paragraph (e)(2)(i) of this
section, compensation cost does not include amounts attributable to a
plan qualified under section 401(a) or 403(a), or to a simplified
employee pension plan defined in section 408(k).
(3) Attribution of compensation cost to personal service activity--
(i) Employees involved only in the performance of personal services. The
compensation cost for employees involved only in the performance of
activities that are treated as personal services under paragraph (d) of
this section, or employees involved only in supporting the work of such
employees, are considered to be attributable to the corporation's
personal service activity.
(ii) Employees involved only in activities that are not treated as
the performance of personal services. The compensation cost for
employees involved only in the performance of activities that are not
treated as personal services under paragraph (d) of this section, or for
employees involved only in supporting the work of such employees, are
not considered to be attributable to the corporation's personal service
activity.
(iii) Other employees. The compensation cost for any employee who is
not described in either paragraph (e)(3)(i) or (ii) of this section (a
mixed-activity employee) is allocated as follows--
(A) Compensation cost attributable to personal service activity.
That portion of the compensation cost for a mixed activity employee that
is attributable to the corporation's personal service activity equals
the compensation cost for that employee multiplied by the percentage of
the total time worked for the corporation by that employee during the
year that is attributable to activities of the corporation that are
treated as the performance of personal services under paragraph (d) of
this section. That percentage is to be determined by the taxpayer in any
reasonable and consistent manner. Time logs are not required unless
maintained for other purposes;
(B) Compensation cost not attributable to personal service activity.
That portion of the compensation cost for a mixed activity employee that
is not considered to be attributable to the corporation's personal
service activity is the compensation cost for that employee less the
amount determined in paragraph (e)(3)(iii)(A) of this section.
(f) Services substantially performed by employee-owners--(1) General
rule. Personal services are substantially performed during the testing
period by employee-owners of the corporation if more than 20 percent of
the corporation's compensation cost for that period attributable to its
activities that are treated as the performance of personal services
within the meaning of paragraph (d) of this section (i.e., the total
compensation for personal service activities) is attributable to
personal services performed by employee-owners.
(2) Compensation cost attributable to personal services. For
purposes of paragraph (f)(1) of this section--
(i) The corporation's compensation cost attributable to its
activities that are treated as the performance of personal services is
determined under paragraph (e)(3) of this section; and
(ii) The portion of the amount determined under paragraph (f)(2)(i)
of this section that is attributable to personal services performed by
employee-owners is to be determined by the taxpayer in any reasonable
and consistent manner.
(3) Examples. The provisions of this paragraph (f) may be
illustrated by the following examples:
Example 1. For its taxable year beginning February 1, 2001, Corp A's
testing period is the taxable year ending January 31, 2000. During that
testing period, A's only activity was the performance of personal
services. The total compensation cost of A (including compensation cost
attributable to employee-owners) for the testing period was $1,000,000.
The total compensation cost attributable to employee-owners of A for the
testing period was $210,000. Pursuant to paragraph (f)(1) of this
section, the employee-owners of A substantially performed the personal
services of A during the testing period because the compensation cost of
A's employee-owners was more than 20 percent of the total compensation
cost for all of A's employees (including employee-owners).
Example 2. Corp B has the same facts as corporation A in Example 1,
except that during the taxable year ending January 31, 2001, B also
participated in an activity that would not be characterized as the
performance of personal services under this section. The total
compensation cost of B (including compensation cost attributable to
employee-
[[Page 19]]
owners) for the testing period was $1,500,000 ($1,000,000 attributable
to B's personal service activity and $500,000 attributable to B's other
activity). The total compensation cost attributable to employee-owners
of B for the testing period was $250,000 ($210,000 attributable to B's
personal service activity and $40,000 attributable to B's other
activity). Pursuant to paragraph (f)(1) of this section, the employee-
owners of B substantially performed the personal services of B during
the testing period because more than 20 percent of B's compensation cost
during the testing period attributable to its personal service
activities was attributable to personal services performed by employee-
owners ($210,000).
(g) Employee-owner defined--(1) General rule. For purposes of this
section, a person is an employee-owner of a corporation for a testing
period if--
(i) The person is an employee of the corporation on any day of the
testing period; and
(ii) The person owns any outstanding stock of the corporation on any
day of the testing period.
(2) Special rule for independent contractors who are owners. Any
person who is an owner of the corporation within the meaning of
paragraph (g)(1)(ii) of this section and who performs personal services
for, or on behalf of, the corporation is treated as an employee for
purposes of this section, even if the legal form of that person's
relationship to the corporation is such that the person would be
considered an independent contractor for other purposes.
(h) Special rules for affiliated groups filing consolidated returns-
-(1) In general. For purposes of applying this section to the members of
an affiliated group of corporations filing a consolidated return for the
taxable year--
(i) The members of the affiliated group are treated as a single
corporation;
(ii) The employees of the members of the affiliated group are
treated as employees of such single corporation; and
(iii) All of the stock of the members of the affiliated group that
is not owned by any other member of the affiliated group is treated as
the outstanding stock of that corporation.
(2) Examples. The provisions of this paragraph (h) may be
illustrated by the following examples:
Example 1. The affiliated group AB, consisting of corporation A and
its wholly owned subsidiary B, filed a consolidated Federal income tax
return for the taxable year ending January 31, 2001, and AB is
attempting to determine whether it is affected by this section for its
taxable year beginning February 1, 2001. During the testing period
(i.e., the taxable year ending January 31, 2001), A did not perform
personal services. However, B's only activity was the performance of
personal services. On the last day of the testing period, employees of A
did not own any stock in A. However, some of B's employees own stock in
A. In the aggregate, B's employees own 9 percent of A's stock on the
last day of the testing period. Pursuant to paragraph (h)(1) of this
section, this section is effectively applied on a consolidated basis to
members of an affiliated group filing a consolidated Federal income tax
return. Because the only employee-owners of AB are the employees of B,
and because B's employees do not own more than 10 percent of AB on the
last day of the testing period, AB is not a PSC subject to the
provisions of this section. Thus, AB is not required to determine on a
consolidated basis whether, during the testing period, its principal
activity is the providing of personal services, or the personal services
are substantially performed by employee-owners.
Example 2. The facts are the same as in Example 1, except that on
the last day of the testing period A owns only 80 percent of B. The
remaining 20 percent of B is owned by employees of B. The fair market
value of A, including its 80 percent interest in B, as of the last day
of the testing period, is $1,000,000. In addition, the fair market value
of the 20 percent interest in B owned by B's employees is $50,000 as of
the last day of the testing period. Pursuant to paragraphs (c)(1)(iv)
and (h)(1) of this section, AB must determine whether the employee-
owners of A and B (i.e., B's employees) own more than 10 percent of the
fair market value of A and B as of the last day of the testing period.
Because the $140,000 [($1,000,000x.09)+$50,000] fair market value of the
stock held by B's employees is greater than 10 percent of the aggregate
fair market value of A and B as of the last day of the testing period,
or $105,000 [$1,000,000+$50,000x.10], AB may be subject to this section
if, on a consolidated basis during the testing period, the principal
activity of AB is the performance of personal services and the personal
services are substantially performed by employee-owners.
[T.D. 8996, 67 FR 35012, May 17, 2002]
[[Page 20]]
Sec. 1.441-4 Effective date.
Sections 1.441-0 through 1.441-3 are applicable for taxable years
ending on or after May 17, 2002.
[T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.442-1 Change of annual accounting period.
(a) Approval of the Commissioner. A taxpayer that has adopted an
annual accounting period (as defined in Sec. 1.441-1(b)(3)) as its
taxable year generally must continue to use that annual accounting
period in computing its taxable income and for making its Federal income
tax returns. If the taxpayer wants to change its annual accounting
period and use a new taxable year, it must obtain the approval of the
Commissioner, unless it is otherwise authorized to change without the
approval of the Commissioner under either the Internal Revenue Code
(e.g., section 444 and section 859) or the regulations thereunder (e.g.,
paragraph (c) of this section). In addition, as described in Sec. 1.441-
1(c) and (d), a partnership, S corporation, electing S corporation, or
personal service corporation (PSC) generally is required to secure the
approval of the Commissioner to adopt or retain an annual accounting
period other than its required taxable year. The manner of obtaining
approval from the Commissioner to adopt, change, or retain an annual
accounting period is provided in paragraph (b) of this section. However,
special rules for obtaining approval may be provided in other sections.
(b) Obtaining approval--(1) Time and manner for requesting approval.
In order to secure the approval of the Commissioner to adopt, change, or
retain an annual accounting period, a taxpayer must file an application,
generally on Form 1128, ``Application To Adopt, Change, or Retain a Tax
Year,'' with the Commissioner within such time and in such manner as is
provided in administrative procedures published by the Commissioner.
(2) General requirements for approval. An adoption, change, or
retention in annual accounting period will be approved where the
taxpayer establishes a business purpose for the requested annual
accounting period and agrees to the Commissioner's prescribed terms,
conditions, and adjustments for effecting the adoption, change, or
retention. In determining whether a taxpayer has established a business
purpose and which terms, conditions, and adjustments will be required,
consideration will be given to all the facts and circumstances relating
to the adoption, change, or retention, including the tax consequences
resulting therefrom. Generally, the requirement of a business purpose
will be satisfied, and adjustments to neutralize any tax consequences
will not be required, if the requested annual accounting period
coincides with the taxpayer's required taxable year (as defined in
Sec. 1.441-1(b)(2)), ownership taxable year, or natural business year.
In the case of a partnership, S corporation, electing S corporation, or
PSC, deferral of income to partners, shareholders, or employee-owners
will not be treated as a business purpose.
(3) Administrative procedures. The Commissioner will prescribe
administrative procedures under which a taxpayer may be permitted to
adopt, change, or retain an annual accounting period. These
administrative procedures will describe the business purpose
requirements (including an ownership taxable year and a natural business
year) and the terms, conditions, and adjustments necessary to obtain
approval. Such terms, conditions, and adjustments may include
adjustments necessary to neutralize the tax effects of a substantial
distortion of income that would otherwise result from the requested
annual accounting period including: a deferral of a substantial portion
of the taxpayer's income, or shifting of a substantial portion of
deductions, from one taxable year to another; a similar deferral or
shifting in the case of any other person, such as a beneficiary in an
estate; the creation of a short period in which there is a substantial
net operating loss, capital loss, or credit (including a general
business credit); or the creation of a short period in which there is a
substantial amount of income to offset an expiring net operating loss,
capital loss, or credit. See, for example, Rev. Proc. 2002-39, 2002-22
I.R.B., procedures for obtaining the Commissioner's prior
[[Page 21]]
approval of an adoption, change, or retention in annual accounting
period through application to the national office; Rev. Proc. 2002-37,
2002-22 I.R.B., automatic approval procedures for certain corporations;
Rev. Proc. 2002-38, 2002-22 I.R.B., automatic approval procedures for
partnerships, S corporations, electing S corporations, and PSCs; and
Rev. Proc. 66-50, 1966-2 C.B. 1260, automatic approval procedures for
individuals. For availability of Revenue Procedures and Notices, see
Sec. 601.601(d)(2) of this chapter.
(4) Taxpayers to whom section 441(g) applies. If section 441(g) and
Sec. 1.441-1(b)(1)(iv) apply to a taxpayer, the adoption of a fiscal
year is treated as a change in the taxpayer's annual accounting period
under section 442. Therefore, that fiscal year can become the taxpayer's
taxable year only with the approval of the Commissioner. In addition to
any other terms and conditions that may apply to such a change, the
taxpayer must establish and maintain books that adequately and clearly
reflect income for the short period involved in the change and for the
fiscal year proposed.
(c) Special rule for change of annual accounting period by
subsidiary corporation. A subsidiary corporation that is required to
change its annual accounting period under Sec. 1.1502-76, relating to
the taxable year of members of an affiliated group that file a
consolidated return, does not need to obtain the approval of the
Commissioner or file an application on Form 1128 with respect to that
change.
(d) Special rule for newly married couples. (1) A newly married
husband or wife may obtain automatic approval under this paragraph (d)
to change his or her annual accounting period in order to use the annual
accounting period of the other spouse so that a joint return may be
filed for the first or second taxable year of that spouse ending after
the date of marriage. Such automatic approval will be granted only if
the newly married husband or wife adopting the annual accounting period
of the other spouse files a Federal income tax return for the short
period required by that change on or before the 15th day of the 4th
month following the close of the short period. See section 443 and the
regulations thereunder. If the due date for any such short-period return
occurs before the date of marriage, the first taxable year of the other
spouse ending after the date of marriage cannot be adopted under this
paragraph (d). The short-period return must contain a statement at the
top of page one of the return that it is filed under the authority of
this paragraph (d). The newly married husband or wife need not file Form
1128 with respect to a change described in this paragraph (d). For a
change of annual accounting period by a husband or wife that does not
qualify under this paragraph (d), see paragraph (b) of this section.
(2) The provisions of this paragraph (d) may be illustrated by the
following example:
Example. H & W marry on September 25, 2001. H is on a fiscal year
ending June 30, and W is on a calendar year. H wishes to change to a
calendar year in order to file joint returns with W. W's first taxable
year after marriage ends on December 31, 2001. H may not change to a
calendar year for 2001 since, under this paragraph (d), he would have
had to file a return for the short period from July 1 to December 31,
2000, by April 16, 2001. Since the date of marriage occurred subsequent
to this due date, the return could not be filed under this paragraph
(d). Therefore, H cannot change to a calendar year for 2001. However, H
may change to a calendar year for 2002 by filing a return under this
paragraph (d) by April 15, 2002, for the short period from July 1 to
December 31, 2001. If H files such a return, H and W may file a joint
return for calendar year 2002 (which is W's second taxable year ending
after the date of marriage).
(e) Effective date. The rules of this section are applicable for
taxable years ending on or after May 17, 2002.
[T.D. 8996, 67 FR 35019, May 17, 2002]
Sec. 1.443-1 Returns for periods of less than 12 months.
(a) Returns for short period. A return for a short period, that is,
for a taxable year consisting of a period of less than 12 months, shall
be made under any of the following circumstances:
(1) Change of annual accounting period. In the case of a change in
the annual accounting period of a taxpayer, a separate return must be
filed for the short period of less than 12 months beginning with the day
following the
[[Page 22]]
close of the old taxable year and ending with the day preceding the
first day of the new taxable year. However, such a return is not
required for a short period of six days or less, or 359 days or more,
resulting from a change from or to a 52-53-week taxable year. See
section 441(f) and Sec. 1.441-2. The computation of the tax for a short
period required to effect a change of annual accounting period is
described in paragraph (b) of this section. In general, a return for a
short period resulting from a change of annual accounting period shall
be filed and the tax paid within the time prescribed for filing a return
for a taxday of the short period. For rules applicable to a subsidiary
corporation which becomes a member of an affiliated group which files a
consolidated return, see Sec. 1.1502-76.
(2) Taxpayer not in existence for entire taxable year. If a taxpayer
is not in existence for the entire taxable year, a return is required
for the short period during which the taxpayer was in existence. For
example, a corporation organized on August 1 and adopting the calendar
year as its annual accounting period is required to file a return for
the short period from August 1 to December 31, and returns for each
calendar year thereafter. Similarly, a dissolving corporation which
files its returns for the calendar year is required to file a return for
the short period from January 1 to the date it goes out of existence.
Income for the short period is not required to be annualized if the
taxpayer is not in existence for the entire taxable year, and, in the
case of a taxpayer other than a corporation, the deduction under section
151 for personal exemptions (or deductions in lieu thereof) need not be
reduced under section 443(c). In general, the requirements with respect
to the filing of returns and the payment of tax for a short period where
the taxpayer has not been in existence for the entire taxable year are
the same as for the filing of a return and the payment of tax for a
taxable year of 12 months ending on the last day of the short period.
Although the return of a decedent is a return for the short period
beginning with the first day of his last taxable year and ending with
the date of his death, the filing of a return and the payment of tax for
a decedent may be made as though the decedent had lived throughout his
last taxable year.
(b) Computation of tax for short period on change of annual
accounting period--(1) General rule. (i) If a return is made for a short
period resulting from a change of annual accounting period, the taxable
income for the short period shall be placed on an annual basis by
multiplying such income by 12 and dividing the result by the number of
months in the short period. Unless section 443(b)(2) and subparagraph
(2) of this paragraph apply, the tax for the short period shall be the
same part of the tax computed on the annual basis as the number of
months in the short period is of 12 months.
(ii) If a return is made for a short period of more than 6 days, but
less than 359 days, resulting from a change from or to a 52-53-week
taxable year, the taxable income for the short period shall be
annualized and the tax computed on a daily basis, as provided in section
441(f)(2)(B)(iii) and Sec. 1.441-2(b)(2)(ii).
(iii) For method of computation of income for a short period in the
case of a subsidiary corporation required to change its annual
accounting period to conform to that of its parent, see Sec. 1.1502-
76(b).
(iv) An individual taxpayer making a return for a short period
resulting from a change of annual accounting period is not allowed to
take the standard deduction provided in section 141 in computing his
taxable income for the short period. See section 142(b)(3).
(v) In computing the taxable income of a taxpayer other than a
corporation for a short period (which income is to be annualized in
order to determine the tax under section 443(b)(1)) the personal
exemptions allowed individuals under section 151 (and any deductions
allowed other taxpayers in lieu thereof, such as the deduction under
section 642(b)) shall be reduced to an amount which bears the same ratio
to the full amount of the exemptions as the number of months in the
short period bears to 12. In the case of the taxable income for a short
period resulting from a change from or to a 52-53-week taxable year to
which section 441(f)(2)(B)(iii) applies,
[[Page 23]]
the computation required by the preceding sentence shall be made on a
daily basis, that is, the deduction for personal exemptions (or any
deduction in lieu thereof) shall be reduced to an amount which bears the
same ratio to the full deduction as the number of days in the short
period bears to 365.
(vi) If the amount of a credit against the tax (for example, the
credits allowable under section 34 (for dividends received on or before
December 31, 1964), and 35 (for partially tax-exempt interest)) is
dependent upon the amount of any item of income or deduction, such
credit shall be computed upon the amount of the item annualized
separately in accordance with the foregoing rules. The credit so
computed shall be treated as a credit against the tax computed on the
basis of the annualized taxable income. In any case in which a
limitation on the amount of a credit is based upon taxable income,
taxable income shall mean the taxable income computed on the annualized
basis.
(vii) The provisions of this subparagraph may be illustrated by the
following examples:
Example (1). A taxpayer with one dependent who has been granted
permission under section 442 to change his annual accounting period
files a return for the short period of 10 months ending October 31,
1956. He has income and deductions as follows:
Income
Interest income........................ ........ ......... $10,000.00
Partially tax-exempt interest with ........ ......... 500.00
respect to which a credit is allowable
under section 35......................
Dividends to which sections 34 and 116 ........ ......... 750.00
are applicable........................
-----------
11,250.00
Deductions
Real estate taxes...................... ........ ......... 200.00
2 personal exemptions at $600 on an ........ ......... 1,200.00
annual basis..........................
The tax for the 10-month period is
computed as follows:
Total income as above.................. ........ ......... 11,250.00
Less:
Exclusion for dividends received..... ........ $50.00
2 personal exemptions ($1,200x\10/ ........ 1,000.00
12\)................................
Real estate taxes.................... ........ 200.00
-------- 1,250.00
-----------
Taxable income for 10-month period ........ ......... 10,000.00
before annualizing................
Taxable income annualized (10,000x\12/ ........ ......... 12,000.00
10\)..................................
Tax on $12,000 before credits.......... ........ ......... 3,400.00
Deduct credits:
Dividends received for 10-month $750.00
period..............................
Less: Excluded portion............... 50.00
----------
Included in gross income............. 700.00
Dividend income annualized ($700x\12/ 840.00
10\)................................
Credit (4 percent of $840)........... ........ 33.60
Partially tax-exempt interest 500.00
included in gross income for 10-
month period........................
Partially tax-exempt interest 600.00
(annualized) ($500x\12/10\).........
Credit (3 percent of $600)........... ........ 18.00
-------- 51.60
-----------
Tax on $12,000 (after credits)..... ........ ......... 3,348.40
-----------
Tax for 10-month period ($3,348.40x\10/ ........ ......... 2,790.33
12\)..................................
------------------------------------------------------------------------
Example (2). The X Corporation makes a return for the one-month
period ending September 30, 1956, because of a change in annual
accounting period permitted under section 442. Income and expenses for
the short period are as follows:
Gross operating income....................................... $126,000
Business expenses............................................ 130,000
------------
Net loss from operations..................................... (4,000)
Dividends received from taxable domestic corporations........ 30,000
------------
Gross income for short period before annualizing........... 26,000
Dividends received deduction (85 percent of $30,000, but not 22,100
in excess of 85 percent of $26,000).........................
------------
Taxable income for short period before annualizing......... 3,900
Taxable income annualized ($8,900x12)........................ 46,800
============
Tax on annual basis:
$46,800 at 52 percent........................... $24,336
Less surtax exemption........................... 5,500
-------- $18,836
==========
Tax for 1-month period ($18,836x\1/12\)...................... 1,570
Example (3). The Y Corporation makes a re- turn for the six-month
period ending June 30, 1957, because of a change in annual accounting
period permitted under section 442. Income for the short period is as
follows:
Taxable income exclusive of net long-term capital gain....... $40,000
Net long-term capital gain................................... 10,000
------------
Taxable income for short period before annualizing......... 50,000
[[Page 24]]
Taxable income annualized ($50,000x\12/6\)................... 100,000
============
Regular tax computation
Taxable income annualized.................................... 100,000
Tax on annual basis:
$100,000 at 52 percent.......................... $52,000
Less surtax exemption........................... 5,500
============
46,500
Tax for 6-month period ($46,500x\6/12\)...................... 23,250
============
Alternative tax computation
Taxable income annualized.................................... 100,000
Less annualized capital gain ($10,000x\12/6\)................ 20,000
------------
Annualized taxable income subject to partial tax........... 80,000
============
Partial tax on annual basis
$60,000 at 52 percent............................. $41,600
Less surtax exemption............................. 5,500
-------- 36,100
25 percent of annualized capital gain ($20,000).............. 5,000
------------
Alternative tax on annual basis............................ 41,100
Alternative tax for 6-month period ($41,100x\6/12\).......... 20,550
Since the alternative tax of $20,550 is less than the tax computed
in the regular manner ($23,250), the corporation's tax for the 6-month
short period is $20,550.
(2) Exception: computation based on 12-month period. (i) A taxpayer
whose tax would otherwise be computed under section 443(b)(1) (or
section 441(f)(2)(B)(iii) in the case of certain changes from or to a
52-53-week taxable year) for the short period resulting from a change of
annual accounting period may apply to the district director to have his
tax computed under the provisions of section 443(b)(2) and this
subparagraph. If such application is made, as provided in subdivision
(v) of this subparagraph, and if the taxpayer establishes the amount of
his taxable income for the 12-month period described in subdivision (ii)
of this subparagraph, then the tax for the short period shall be the
greater of the following--
(a) An amount which bears the same ratio to the tax computed on the
taxable income which the taxpayer has established for the 12-month
period as the taxable income computed on the basis of the short period
bears to the taxable income for such 12-month period; or
(b) The tax computed on the taxable income for the short period
without placing the taxable income on an annual basis.
However, if the tax computed under section 443(b)(2) and this
subparagraph is not less than the tax for the short period computed
under section 443(b)(1) (or section 441(f)(2)(B)(iii) in the case of
certain changes from or to a 52-53-week taxable year), then section
443(b)(2) and this subparagraph do not apply.
(ii) The term ``12-month period'' referred to in subdivision (i) of
this subparagraph means the 12-month period beginning on the first day
of the short period. However, if the taxpayer is not in existence at the
end of such 12-month period, or if the taxpayer is a corporation which
has disposed of substantially all of its assets before the end of such
12-month period, the term ``12-month period'' means the 12-month period
ending at the close of the last day of the short period. For the
purposes of the preceding sentence, a corporation which has ceased
business and distributed so much of the assets used in its business that
it cannot resume its customary operations with the remaining assets,
will be considered to have disposed of substantially all of its assets.
In the case of a change from a 52-53-week taxable year, the term ``12-
month period'' means the period of 52 or 53 weeks (depending on the
taxpayer's 52-53-week taxable year) beginning on the first day of the
short period.
(iii)(a) The taxable income for the 12-month period is computed
under the same provisions of law as are applicable to the short period
and is computed as if the 12-month period were an actual annual
accounting period of the taxpayer. All items which fall in such 12-month
period must be included even if they are extraordinary in amount or of
an unusual nature. If the taxpayer is a member of a partnership, his
taxable income for the 12-month period shall include his distributive
share of partnership income for any taxable year of the partnership
ending within or with such 12-month period, but no amount shall be
included with respect to a taxable year of the partnership ending before
or after such 12-month period. If any other item partially applicable to
such 12-month period can be determined only at the end of a taxable year
which includes only part of the 12-month period, the taxpayer, subject
to
[[Page 25]]
review by the Commissioner, shall apportion such item to the 12-month
period in such manner as will most clearly reflect income for the 12-
month period.
(b) In the case of a taxpayer permitted or required to use
inventories, the cost of goods sold during a part of the 12-month period
included in a taxable year shall be considered, unless a more exact
determination is available, as such part of the cost of goods sold
during the entire taxable year as the gross receipts from sales for such
part of the 12-month period is of the gross receipts from sales for the
entire taxable year. For example, the 12-month period of a corporation
engaged in the sale of merchandise, which has a short period from
January 1, 1956, to September 30, 1956, is the calendar year 1956. The
three-month period, October 1, 1956, to December 31, 1956, is part of
the taxpayer's taxable year ending September 30, 1957. The cost of goods
sold during the three-month period, October 1, 1956, to December 31,
1956, is such part of the cost of goods sold during the entire fiscal
year ending September 30, 1957, as the gross receipts from sales for
such three-month period are of the gross receipts from sales for the
entire fiscal year.
(c) The Commissioner may, in granting permission to a taxpayer to
change his annual accounting period, require, as a condition to
permitting the change, that the taxpayer must take a closing inventory
upon the last day of the 12-month period if he wishes to obtain the
benefits of section 443(b)(2). Such closing inventory will be used only
for the purposes of section 443(b)(2), and the taxpayer will not be
required to use such inventory in computing the taxable income for the
taxable year in which such inventory is taken.
(iv) The provisions of this subparagraph may be illustrated by the
following examples:
Example (1). The taxpayer in example (1) under paragraph (b)(1)(vii)
of this section establishes his taxable income for the 12-month period
from January 1, 1956, to December 31, 1956. The taxpayer has a short
period of 10 months, from January 1, 1956, to October 31, 1956. The
taxpayer files an application in accordance with subdivision (v) of this
subparagraph to compute his tax under section 443(b)(2). The taxpayer's
income and deductions for the 12-month period, as so established,
follow:
Income
Interest income............................................... $11,000
Partially tax-exempt interest with respect to which a credit 600
is allowable under section 35................................
Dividends to which sections 34 and 116 are applicable......... 850
---------
12,450
Deductions
Real estate taxes............................................. 200
2 personal exemptions at $600................................. 1,200
Tax computation for short period under section 443(b)(2)(A)(i)
Total income as above......................................... $12,450
Less:
Exclusion for dividends received...................... $50
Personal exemptions................................... 1,200
Deduction for taxes................................... 200
--------
1,450
---------
Taxable income for 12-month period........................ 11,000
=========
Tax before credits............................................ 3,020
Credit for partially tax-exempt interest (3 percent of 18
$600)................................................
Credit for dividends received (4 percent of ($850-50)) 32
--------
50
---------
Tax under section 443(b)(2)(A)(i) for 12-month period......... 2,970
Taxable income for 10-month short period from example (1) of 10,000
paragraph (b)(1)(vii) of this section before annualizing.....
Tax for short period under section 443(b)(2)(A)(i) 2,700
($2,970x$10,000 (taxable income for short period)/$11,000
(taxable income for 12-month period))........................
Tax computation for short period under section
443(b)(2)(A)(ii)
Total income for 10-month short period........................ 11,250
Less:
Exclusion for dividends received.................... 50
2 personal exemptions............................... 1,200
Real estate taxes................................... 200
--------
1,450
---------
Taxable income for short period without annualizing and 9,800
without proration of personal exemptions...................
Tax before credits............................................ 2,572
Less credits:
Partially tax-exempt interest (3 percent of $500)... 15
Dividends received (4 percent of ($750-50))......... 28
--------
43
---------
Tax for short period under section 443(b)(2)(A)(ii)....... 2,529
The tax of $2,700 computed under section 443(b)(2)(A)(i) is greater than
the tax of $2,529, computed under section 443(b)(2)(A)(ii), and is,
therefore, the tax under section 443(b)(2). Since the tax of $2,700
[[Page 26]]
(computed under section 443(b)(2)) is less than the tax of $2,790.33
(computed under section 443(b)(1)) on the annualized income of the short
period (see example (1) of paragraph (b)(1)(vii) of this section), the
taxpayer's tax for the 10-month short period is $2,700.
Example (2). Assume the same facts as in example (1) of this
subdivision, except that, during the month of November 1956, the
taxpayer suffered a casualty loss of $5,000. The tax computation for the
short period under section 443(b)(2) would be as follows:
Tax computation for short period under section 443(b)(2)(A)(i)
Taxable income for 12-month period from example (1)........... $11,000
Less: Casualty loss........................................... 5,000
-----------
Taxable income for 12-month period........................ 6,000
===========
Tax before credits.................................. $1,360
Credits from example (1)............................ 50
==========
Tax under section 443(b)(2)(A)(i) for 12-month 1,310
period.............................................
===========
Tax for short period ($1,310x $10,000/$6,000) under 2,183
section 443(b)(2)(A)(i)............................
Tax computation for short period under section
443(b)(2)(A)(ii)
Total income for the short period................... 11,250
Less:
Exclusion for dividends received.................. 50
2 personal exemptions............................. 1,200
Real estate taxes................................. 200
----------
1,450
---------
Taxable income for short period without annualizing and 9,800
without proration of personal exemptions...................
Tax before credits............................................ 2,572
Less credits:
Partially tax-exempt interest (3 percent of $500). 15
Dividends received (4 percent of $750-50))........ 28
-----------
43
---------
Tax for short period under section 443(b)(2)(A)(ii)........... 2,529
The tax of $2,529, computed under section 443(b)(2)(A)(ii) is greater
than the tax of $2,183 computed under section 443(b)(2)- (A)(i) and is,
therefore, the tax under section 443(b)(2). Since this tax is less than
the tax of $2,790.33, computed under section 443(b)(1) (see example (1)
of paragraph (b)(1)(vii) of this section), the taxpayer's tax for the
10-month short period is $2,529.
(v)(a) A taxpayer who wishes to compute his tax for a short period
resulting from a change of annual accounting period under section
443(b)(2) must make an application therefor. Except as provided in (b)
of this subdivision, the taxpayer shall first file his return for the
short period and compute his tax under section 443(b)(1). The
application for the benefits of section 443(b)(2) shall subsequently be
made in the form of a claim for credit or refund. The claim shall set
forth the computation of the taxable income and the tax thereon for the
12-month period and must be filed not later than the time (including
extensions) prescribed for filing the return for the taxpayer's first
taxable year which ends on or after the day which is 12 months after the
beginning of the short period. For example, assume that a taxpayer
changes his annual accounting period from the calendar year to a fiscal
year ending September 30, and files a return for the short period from
January 1, 1956, to September 30, 1956. His application for the benefits
of section 443(b)(2) must be filed not later than the time prescribed
for filing his return for his first taxable year which ends on or after
the last day of December 1956, the twelfth month after the beginning of
the short period. Thus, the taxpayer must file his application not later
than the time prescribed for filing the return for his fiscal year
ending September 30, 1957. If he obtains an extension of time for filing
the return for such fiscal year, he may file his application during the
period of such extension. If the district director determines that the
taxpayer has established the amount of his taxable income for the 12-
month period, any excess of the tax paid for the short period over the
tax computed under section 443(b)(2) will be credited or refunded to the
taxpayer in the same manner as in the case of an overpayment.
(b) If at the time the return for the short period is filed, the
taxpayer is able to determine that the 12-month period ending with the
close of the short period (see section 443(b)(2)- (B)(ii) and
subparagraph (2)(ii) of this paragraph) will be used in the computations
under section 443(b)(2), then the tax on the return for the short period
may be determined under the provisions of section 443(b)(2). In such
case, a return covering the 12-month period shall be attached to the
return for the short period as a part thereof, and the return and
attachment will then be considered as an application for the benefits of
section 443(b)(2).
[[Page 27]]
(c) Adjustment in deduction for personal exemption. For adjustment
in the deduction for personal exemptions in computing the tax for a
short period resulting from a change of annual accounting period under
section 443(b)(1) (or under section 441(f)(2)(B)(iii) in the case of
certain changes from or to a 52-53-week taxable year), see paragraph
(b)(1)(v) of this section.
(d) Adjustments in exclusion of computing minimum tax for tax
preferences. (1) If a return is made for a short period on account of
any of the reasons specified in subsection (a) of section 443, the
$30,000 amount specified in section 56 (relating to minimum tax for tax
preferences), modified as provided by section 58 and the regulations
thereunder, shall be reduced to the amount which bears the same ratio to
such specified amount as the number of days in the short period bears to
365.
(2) Example. The provisions of this paragraph may be illustrated by
the following example:
Example. A taxpayer who is an unmarried individual has been granted
permission under section 442 to change his annual accounting period
files a return for the short period of 4 months ending April 30, 1970.
The $30,000 amount specified in section 56 is reduced as follows:
(120/365)x$30,000=$9,835.89.
(e) Cross references. For inapplicability of section 443(b) and
paragraph (b) of this section in computing--
(1) Accumulated earnings tax, see section 536 and the regulations
thereunder;
(2) Personal holding company tax, see section 546 and the
regulations thereunder;
(3) Undistributed foreign personal holding company income, see
section 557 and the regulations thereunder;
(4) The taxable income of a regulated investment company, see
section 852(b)(2)(E) and the regulations thereunder; and
(5) The taxable income of a real estate investment trust, see
section 857(b)(2)(C) and the regulations thereunder.
[T.D. 6500, 25 F.R. 11705, Nov. 26, 1960, as amended by T.D. 6598, 27 FR
4093, Apr. 28, 1962; T.D. 6777, 29 FR 17808, Dec. 16, 1964; T.D. 7244,
37 FR 28897, Dec. 30, 1972, T.D. 7564, 43 FR 40494, Sept. 12, 1978; T.D.
7575, 43 FR 58816, Dec. 18, 1978; T.D. 7767, 465 FR 11265, Feb. 6, 1981;
T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.444-0T Table of contents (temporary).
This section lists the captions that appear in the temporary
regulations under section 444.
Sec. 1.444-1T Election to use a taxable year other than the required
taxable year (temporary).
(a) General rules.
(1) Year other than required year.
(2) Effect of section 444 election.
(i) In general.
(ii) Duration of section 444 election.
(3) Section 444 election not required for certain years.
(4) Required taxable year.
(5) Termination of section 444 election.
(i) In general.
(ii) Effective date of termination.
(iii) Example.
(iv) Special rule for entity that liquidates or is sold prior to
making a section 444 election, required return, or required payment.
(6) Re-activating certain S elections.
(i) Certain corporations electing S status that did not make a back-
up calendar year request.
(ii) Certain corporations that revoked their S status.
(iii) Procedures for re-activating an S election.
(iv) Examples.
(b) Limitation on taxable years that may be elected.
(1) General rule.
(2) Changes in taxable year.
(i) In general.
(ii) Special rule for certain existing corporations electing S
status.
(iii) Deferral period of the taxable year that is being changed.
(iv) Examples.
(3) Special rule for entities retaining 1986 taxable year.
(4) Deferral period.
(i) Retentions of taxable year.
(ii) Adoptions of and changes in taxable year.
(A) In general.
(B) Special rule.
[[Page 28]]
(C) Examples.
(5) Miscellaneous rules.
(i) Special rule for determining the taxable year of a corporation
electing S status.
(ii) Special procedure for cases where an income tax return is
superseded.
(A) In general.
(B) Procedure for superseding return.
(iii) Anti-abuse rule.
(iv) Special rules for partial months and 52-53-week taxable years.
(c) Effective date.
(d) Examples.
(1) Changes in taxable year.
(2) Special rule for entities retaining their 1986 taxable year.
Sec. 1.444-2T Tiered structure (temporary).
(a) General rule.
(b) Definition of a member of a tiered structure.
(1) In general.
(2) Deferral entity.
(i) In general.
(ii) Grantor trusts.
(3) Anti-abuse rule.
(c) De minimis rules.
(1) In general.
(2) Downstream de minimis rule.
(i) General rule.
(ii) Definition of testing period.
(iii) Definition of adjusted taxable income.
(A) Partnership.
(B) S corporation.
(C) Personal service corporation.
(iv) Special rules.
(A) Pro-forma rule.
(B) Reasonable estimates allowed.
(C) Newly formed entities.
(1) Newly formed deferral entities.
(2) Newly formed partnership, S corporation, or personal service
corporation desiring to make a section 444 election.
(3) Upstream de minimis rule.
(d) Date for determining the existence of a tiered structure.
(1) General rule.
(2) Special rule for taxable years beginning in 1987.
(e) Same taxable year exception.
(1) In general.
(2) Definition of tiered structure.
(i) General rule.
(ii) Special flow-through rule for downstream controlled
partnerships.
(3) Determining the taxable year of a partnership or S corporation.
(4) Special rule for 52-53-week taxable years.
(5) Interaction with de minimis rules.
(i) Downstream de minimis rule.
(A) In general.
(B) Special rule for members of a tiered structure directly owned by
a downstream controlled partnership.
(ii) Upstream de minimis rule.
(f) Examples.
(g) Effective date.
Sec. 1.444-3T Manner and time of making section 444 election
(temporary).
(a) In general.
(b) Manner and time of making election.
(1) General rule.
(2) Special extension of time for making an election.
(3) Corporation electing to be an S corporation.
(i) In general.
(ii) Examples.
(4) Back-up section 444 election.
(i) General rule.
(ii) Procedures for making a back-up section 444 election.
(iii) Procedures for activating a back-up section 444 election.
(A) Partnership and S corporations.
(1) In general.
(2) Special rule if Form 720 used to satisfy return requirement.
(B) Personal service corporations.
(iv) Examples.
(c) Administrative relief.
(1) Extension of time to file income tax returns.
(i) Automatic extension.
(ii) Additional extensions.
(iii) Examples.
(2) No penalty for certain late payments.
(i) In general.
(ii) Example.
(d) Effective date.
[T.D. 8205, 53 FR 19693, May 27, 1988]
Sec. 1.444-1T Election to use a taxable year other than the required taxable year (temporary).
(a) General rules--(1) Year other than required year. Except as
otherwise provided in this section and Sec. 1.444-2T, a partnership, S
corporation, or personal service corporation (as defined in Sec. 1.441-
3(c)) may make or continue an election (a ``section 444 election'') to
have a taxable year other than its required taxable year. See paragraph
(b) of this section for limitations on the taxable year that may be
elected. See Sec. 1.444-2T for rules that generally prohibit a
partnership, S corporation, or personal service corporation that is a
member of a tiered structure from making or continuing a section 444
election. See Sec. 1.444-3T for rules explaining how and when to make a
section 444 election.
(2) Effect of section 444 election--(i) In general. A partnership or
S corporation that makes or continues a section 444 election shall file
returns and make
[[Page 29]]
payments as required by Secs. 1.7519-1T and 1.7519-2T. A personal
service corporation that makes or continues a section 444 election is
subject to the deduction limitation of Sec. 1.280H-1T.
(ii) Duration of section 444 election. A section 444 election shall
remain in effect until the election is terminated pursuant to paragraph
(a)(5) of this section.
(3) Section 444 election not required for certain years. A
partnership, S corporation, or personal service corporation is not
required to make a section 444 election to use--
(i) A taxable year for which such entity establishes a business
purpose to the satisfaction of the Commissioner (i.e., approved under
section 4 or 6 of Rev. Proc. 87-32, 1987-28 I.R.B. 14, or any successor
revenue ruling or revenue procedure), or
(ii) A taxable year that is a ``grandfathered fiscal year,'' within
the meaning of section 5.01(2) of Rev. Proc. 87-32 or any successor
revenue ruling or revenue procedure.
Although a partnership, S corporation or personal service corporation
qualifies to use a taxable year described in paragraph (a)(3) (i) or
(ii) of this section, such entity may, if otherwise qualified, make a
section 444 election to use a different taxable year. Thus, for example,
assume that a personal service corporation that historically used a
January 31 taxable year established to the satisfaction of the
Commissioner, under section 6 of Rev. Proc. 87-32, a business purpose to
use a September 30 taxable year for its taxable year beginning February
1, 1987. Pursuant to this paragraph (a)(3), such personal service
corporation may use a September 30 taxable year without making a section
444 election. However, the corporation may, if otherwise qualified, make
a section 444 election to use a year ending other than September 30 for
its taxable year beginning February 1, 1987.
(4) Required taxable year. For purposes of this section, the term
``required taxable year'' means the taxable year determined under
section 706(b), 1378, or 441(i) without taking into account any taxable
year which is allowable either--
(i) By reason of business purpose (i.e., approved under section 4 or
6 of Rev. Proc. 87-32 or any successor revenue ruling or procedure), or
(ii) As a ``grandfathered fiscal year'' within the meaning of
section 5.01(2) of Rev. Proc. 87-32, or any successor revenue ruling or
procedure.
(5) Termination of section 444 election--(i) In general. A section
444 election is terminated when--
(A) A partnership, S corporation, or personal service corporation
changes to its required taxable year; or
(B) A partnership, S corporation, or personal service corporation
liquidates (including a deemed liquidation of a partnership under
Sec. 1.708-1 (b)(1)(iv)); or
(C) A partnership, S corporation, or personal service corporation
willfully fails to comply with the requirements of section 7519 or 280H,
whichever is applicable; or
(D) A partnership, S corporation, or personal service corporation
becomes a member of a tiered structure (within the meaning of
Sec. 1.444-2T), unless it is a partnership or S corporation that meets
the same taxable year exception under Sec. 1.444-2T (e); or
(E) An S corporation's S election is terminated; or
(F) A personal service corporation ceases to be a personal service
corporation.
However, if a personal service corporation, that has a section 444
election in effect, elects to be an S corporation, the S corporation may
continue the section 444 election of the personal service corporation.
Similarly, if an S corporation that has a section 444 election in effect
terminates its S election and immediately becomes a personal service
corporation, the personal service corporation may continue the section
444 election of the S corporation. If a section 444 election is
terminated under this paragraph (a)(5), the partnership, S corporation,
or personal service corporation may not make another section 444
election for any taxable year.
(ii) Effective date of termination. A termination of a section 444
election shall be effective--
(A) In the case of a change to the required year, on the first day
of the short year caused by the change;
[[Page 30]]
(B) In the case of a liquidating entity, on the date the liquidation
is completed for tax purposes;
(C) In the case of willful failure to comply, on the first day of
the taxable year (determined as if a section 444 election had never been
made) determined in the discretion of the District Director;
(D) In the case of membership in a tiered structure, on the first
day of the taxable year in which the entity is considered to be a member
of a tiered structure, or such other taxable year determined in the
discretion of the District Director;
(E) In the case of termination of S status, on the first day of the
taxable year for which S status no longer exists;
(F) In the case of a personal service corporation that changes
status, on the first day of the taxable year, for which the entity is no
longer a personal service corporation.
In the case of a termination under this paragraph (a)(5) that results in
a short taxable year, an income tax return is required for the short
period. In order to allow the Service to process the affected income tax
return in an efficient manner, a partnership, S corporation, or personal
service corporation that files such a short period return should type or
legibly print at the top of the first page of the income tax return for
the short taxable year--``SECTION 444 ELECTION TERMINATED.'' In
addition, a personal service corporation that changes its taxable year
to the required taxable year is required to annualize its income for the
short period.
(iii) Example. The provisions of paragraph (a)(5)(ii) of this
section may be illustrated by the following example.
Example. Assume a partnership that is 100 percent owned, at all
times, by calendar year individuals has historically used a June 30
taxable year. Also assume the partnership makes a valid section 444
election to retain a year ending June 30 for its taxable year beginning
July 1, 1987. However, for its taxable year beginning July 1, 1988, the
partnership changes to a calendar year, its required year. Based on
these facts, the partnership's section 444 election is terminated on
July 1, 1988, and the partnership must file a short period return for
the period July 1, 1988-December 31, 1988. Furthermore, pursuant to
Sec. 1.702-3T(a)(1), the partners in such partnership are not entitled
to a 4-year spread with respect to partnership items of income and
expense for the taxable year beginning July 1, 1988 and ending December
31, 1988.
(iv) Special rule for entity that liquidates or is sold prior to
making a section 444 election, required return, or required payment. A
partnership, S corporation, or personal service corporation that is
liquidated or sold for tax purposes before a section 444 election,
required return, or required payment is made for a particular year may,
nevertheless, make or continue a section 444 election, if otherwise
qualified. (See Secs. 1.7519-2T (a)(2) and 1.7519-1T (a)(3),
respectively, for a description of the required return and a definition
of the term ``required payment.'') However, the partnership, S
corporation, or personal service corporation (or a trustee or agent
thereof) must comply with the requirements for making or continuing a
section 444 election. Thus, if applicable, required payments must be
made and a subsequent claim for refund must be made in accordance with
Sec. 1.7519-2T(a)(6). The following examples illustrate the application
of this paragraph (a)(5)(iv).
Example (1). Assume an existing S corporation historically used a
June 30 taxable year and desires to make a section 444 election for its
taxable year beginning July 1, 1987. Assume further that the S
corporation is liquidated for tax purposes on February 15, 1988. If
otherwise qualified, the S corporation (or a trustee or agent thereof)
may make a section 444 election to have a taxable year beginning July 1,
1987, and ending February 15, 1988. However, if the S corporation makes
a section 444 election, it must comply with the requirements for making
a section 444 election, including making required payments.
Example (2). The facts are the same as in example (1), except that
instead of liquidating on February 15, 1988, the shareholders of the S
corporation sell their stock to a corporation on February 15, 1988.
Thus, the corporation's S election is terminated on February 15, 1988.
If otherwise qualified, the corporation may make a section 444 election
to have a taxable year beginning July 1, 1987, and ending February 14,
1988.
Example (3). The facts are the same as in example (2), except that
the new shareholders are individuals. Furthermore, the corporation's S
election is not terminated. Based on these facts, the S corporation, if
otherwise qualified, may make a section 444 election to retain a year
ending June 30 for
[[Page 31]]
its taxable year beginning July 1, 1987. Furthermore, the S corporation
may, if otherwise qualified, continue its section 444 election for
subsequent taxable years.
(6) Re-activating certain S elections--(i) Certain corporations
electing S status that did not make a back-up calendar year request. If
a corporation that timely filed Form 2553, Election by a Small Business
Corporation, effective for its first taxable year beginning in 1987--
(A) Requested a fiscal year based on business purpose,
(B) Did not agree to use a calendar year in the event its business
purpose request was denied, and
(C) Such business purpose request is denied or withdrawn,
such corporation may retroactively re-activate its S election by making
a valid section 444 election for its first taxable year beginning in
1987 and complying with the procedures in paragraph (a)(6)(iii) of this
section.
(ii) Certain corporations that revoked their S status. If a
corporation that used a fiscal year revoked its S election (pursuant to
section 1362(d)(1)) for its first taxable year beginning in 1987, such
corporation may retroactively re-activate its S election (i.e. rescind
its revocation) by making a valid section 444 election for its first
taxable year beginning in 1987 and complying with the procedures in
paragraph (a)(6)(iii) of this section.
(iii) Procedures for re-activating an S election. A corporation re-
activating its S election pursuant to paragraph (a)(6) (i) or (ii) of
this section must--
(A) Obtain the consents of all shareholders who have owned stock in
the corporation since the first day of the first taxable year of the
corporation beginning after December 31, 1986,
(B) Include the following statement at the top of the first page of
the corporation's Form 1120S for its first taxable year beginning in
1987--``SECTION 444 ELECTION--RE-ACTIVATES S STATUS,'' and
(C) Include the following statement with Form 1120S--``RE-ACTIVATION
CONSENTED TO BY ALL SHAREHOLDERS WHO HAVE OWNED STOCK AT ANY TIME SINCE
THE FIRST DAY OF THE FIRST TAXABLE YEAR OF THIS CORPORATION BEGINNING
AFTER DECEMBER 31, 1986.''
(iv) Examples. The provisions of this paragraph (a)(6) may be
illustrated by the following examples.
Example (1). Assume a corporation historically used a June 30
taxable year and such corporation timely filed Form 2553, Election by a
Small Business Corporation, to be effective for its taxable year
beginning July 1, 1987. On its Form 2553, the corporation requested
permission to retain its June 30 taxable year based on business purpose.
However, the corporation did not agree to use a calendar year in the
event its business purpose request was denied. On April 1, 1988, the
Internal Revenue Service notified the corporation that its business
purpose request was denied and therefore the corporation's S election
was not effective. Pursuant to paragraph (a)(6)(i) of this section, the
corporation may re-activate its S election by making a valid section 444
election and complying with the procedures in paragraph (a)(6)(iii) of
this section.
Example (2). The facts are the same as in example (1), except that
as of July 26, 1988, the Internal Revenue Service has not yet determined
whether the corporation has a valid business purpose to retain a June 30
taxable year. Based on these facts, the corporation may, if otherwise
qualified, make a back-up section 444 election as provided in
Sec. 1.444-3T(b)(4). If the corporation's business purpose request is
subsequently denied, the corporation should follow the procedures in
Sec. 1.444-3T(b)(4)(iii) for activating a back-up section 444 election
rather than the procedures provided in this paragraph (a)(6 for re-
activating an S election.
Example (3). Assume a corporation has historically been an S
corporation with a March 31 taxable year. However, for its taxable year
beginning April 1, 1987, the corporation revoked its S election pursuant
to section 1362 (d)(1). Pursuant to paragraph (a)(6)(ii) of this
section, such corporation may retroactively rescind its S election
revocation by making a valid section 444 election for its taxable year
beginning April 1, 1987, and complying with the procedures provided in
paragraph (a)(6)(iii) of this section. If the corporation retroactively
rescinds its S revocation, the corporation shall file a Form 1120S for
its taxable year beginning April 1, 1987.
(b) Limitation on taxable years that may be elected--(1) General
rule. Except as provided in paragraphs (b)(2) and (3) of this section, a
section 444 election may be made only if the deferral period (as defined
in paragraph (b)(4) of this section) of the taxable year to be elected
is not longer than three months.
[[Page 32]]
(2) Changes in taxable year--(i) In general. In the case of a
partnership, S corporation, or personal service corporation changing its
taxable year, such entity may make a section 444 election only if the
deferral period of the taxable year to be elected is not longer than the
shorter of--
(A) Three months, or
(B) The deferral period of the taxable year that is being changed,
as defined in paragraph (b)(2)(iii) of this section.
(ii) Special rule for certain existing corporations electing S
status. If a corporation with a taxable year other than the calendar
year--
(A) Elected after September 18, 1986, and before January 1, 1988,
under section 1362 of the Code to be an S corporation, and
(B) Elected to have the calendar year as the taxable year of the S
corporation,
then, for taxable years beginning before 1989, paragraph (b)(2)(i) of
this section shall be applied by taking into account the deferral period
of the last taxable year of the corporation prior to electing to be an S
corporation, rather than the deferral period of the taxable year that is
being changed. Thus, the provisions of the preceding sentence do not
apply to a corporation that elected to be an S corporation for its first
taxable year.
(iii) Deferral period of the taxable year that is being changed. For
purposes of paragraph (b)(2)(i)(B) of this section, the phrase
``deferral period of the taxable year that is being changed'' means the
deferral period of the taxable year immediately preceding the taxable
year for which the taxpayer desires to make a section 444 election.
Furthermore, the deferral period of such year will be determined by
using the required taxable year of the taxable year for which the
taxpayer desires to make a section 444 election. For example, assume P,
a partnership that has historically used a March 31 taxable year,
desires to change to a September 30 taxable year by making a section 444
election for its taxable year beginning April 1, 1987. Furthermore,
assume that pursuant to paragraph (a)(4) of this section, P's required
taxable year for the taxable year beginning April 1, 1987 is a year
ending December 31. Based on these facts the deferral period of the
taxable year being changed is nine months (the period from March 31 to
December 31).
(iv) Examples. See paragraph (d)(1) of this section for examples
that illustrate the provisions of this paragraph (b)(2).
(3) Special rule for entities retaining 1986 taxable year.
Notwithstanding paragraph (b)(2) of this section, a partnership, S
corporation, or personal service corporation may, for its first taxable
year beginning after December 31, 1986, if otherwise qualified, make a
section 444 election to have a taxable year that is the same as the
entity's last taxable year beginning in 1986. See paragraph (d)(2) of
this section for examples that illustrate the provisions of this
paragraph (b)(3).
(4) Deferral period--(i) Retentions of taxable year. For a
partnership, S corporation, or personal service corporation that desires
to retain its taxable year by making a section 444 election, the term
``deferral period'' means the months between the beginning of such year
and the close of the first required taxable year (as defined in
paragraph (a)(4) of this section). The following example illustrates the
application of this paragraph (b)(4)(i).
Example. AB partnership has historically used a taxable year ending
July 31. AB desires to retain its July 31 taxable year by making a
section 444 election for its taxable year beginning August 1, 1987.
Calendar year individuals, A and B, each own 50 percent of the profits
and capital of AB; thus, under paragraph (a)(4) of this section AB's
required taxable year is the year ending December 31. Pursuant to this
paragraph (b)(4)(i), if AB desires to retain its year ending July 31,
the deferral period is five months (the months between July 31 and
December 31).
(ii) Adoptions of and changes in taxable year--(A) In general. For a
partnership, S corporation, or personal service corporation that desires
to adopt or change its taxable year by making a section 444 election,
the term ``deferral period'' means the months that occur after the end
of the taxable year desired under section 444 and before the close of
the required taxable year.
(B) Special rule. If a partnership, S corporation or personal
service corporation is using the required taxable
[[Page 33]]
year as its taxable year, the deferral period is deemed to be zero.
(C) Examples. The provisions of this paragraph (b)(4)(ii) may be
illustrated by the following examples.
Example (1). Assume that CD partnership has historically used the
calendar year and that CD's required taxable year is the calendar year.
Under the special rule provided in paragraph (b)(4)(ii)(B) of this
section, CD's deferral period is zero. See paragraph (b)(2)(i) of this
section for rules that preclude CD from making a section 444 election to
change its taxable year.
Example (2). E, a newly formed partnership, began operations on
December 1, 1987, and is owned by calendar year individuals. E desires
to make a section 444 election to adopt a September 30 taxable year. E's
required taxable year is December 31. Pursuant to paragraph
(b)(4)(ii)(A) of this section E's deferral period for the taxable year
beginning December 1, 1987, is three months (the number of months
between September 30 and December 31).
Example (3). Assume that F, a personal service corporation, has
historically used a June 30 taxable year. F desires to make a section
444 election to change to an August 31 taxable year, effective for its
taxable year beginning July 1, 1987. For purposes of determining the
availability of a section 444 election for changing to the taxable year
ending August 31, the deferral period of an August 31 taxable year is
four months (the number of months between August 31 and December 31).
The deferral period for F's existing June 30 taxable year is six months
(the number of months between June 30 and December 31). Pursuant to
Sec. 1.444-1T(b)(2)(i), F may not make a section 444 election to change
to an August 31 taxable year.
(5) Miscellaneous rules--(i) Special rule for determining the
taxable year of a corporation electing S status. For purposes of this
section, and only for purposes of this section, a corporation that
elected to be an S corporation for a taxable year beginning in 1987 or
1988 and which elected to be an S corporation prior to September 26,
1988, will not be considered to have adopted or changed its taxable year
by virtue of information included on Form 2553, Election by a Small
Business Corporation. See example (8) in paragraph (d) of this section.
(ii) Special procedure for cases where an income tax return is
superseded--(A) In general. In the case of a partnership, S corporation,
or personal service corporation that filed an income tax return for its
first taxable year beginning after December 31, 1986, but subsequently
makes a section 444 election that would result in a different year end
for such taxable year, the income tax return filed pursuant to the
section 444 election will supersede the original return. However, any
payments of income tax made with respect to such superseded return will
be credited to the taxpayer's superseding return and the taxpayer may
file a claim for refund for such payments. See examples (5) and (7) in
paragraph (d)(2) of this section.
(B) Procedure for superseding return. In order to allow the Service
to process the affected income tax returns in an efficient manner, a
partnership, S corporation, or personal service corporation that desires
to supersede an income tax return in accordance with paragraph
(b)(5)(ii)(A) of this section, should type or legibly print at the top
of the first page of the income tax return for the taxable year elected-
-``SECTION 444 ELECTION--SUPERSEDES PRIOR RETURN.''
(iii) Anti-abuse rule-- If an existing partnership, S corporation or
personal service corporation (``predecessor entities''), or the owners
thereof, transfer assets to a related party and the principal purpose of
such transfer is to--
(A) Create a deferral period greater than the deferral period of the
predecessor entity's taxable year, or
(B) Make a section 444 election following the termination of the
predecessor entity's section 444 election,
then such transfer will be disregarded for purposes of section 444 and
this section, even if the deferral created by such change is effectively
eliminated by a required payment (within the meaning of section 7519) or
deferral of a deduction (to a personal service corporation under section
280H). The following example illustrates the application of this
paragraph (b)(5)(iii).
Example. Assume that P1 is a partnership that historically used the
calendar year and is owned by calendar year partners. Assume that P1
desires to make a section 444 election to change to a September year for
the taxable year beginning January 1, 1988. P1 may not make a section
444 election to change taxable years under section 444(b)(2) because its
current deferral period is zero.
[[Page 34]]
Assume further that P1 transfers a substantial portion of its assets to
a newly-formed partnership (P2), which is owned by the partners of P1.
Absent paragraph (b)(5)(iii) of this section, P2 could, if otherwise
qualified, make a section 444 election under paragraph (b)(1) of this
section to use a taxable year with a three month or less deferral period
(i.e., a September 30, October 31, or November 30 taxable year).
However, if the principal purpose of the asset transfer was to create a
one-, two-, or three-month deferral period by P2 making a section 444
election, the section 444 election shall not be given effect, even if
the deferral would be effectively eliminated by P2 making a required
payment under section 7519.
(iv) Special rules for partial months and 52-53-week taxable years.
Except as otherwise provided in Sec. 1.280H-1T(c)(2)(i)(A), for purposes
of this section and Secs. 1.7519-1T, 1.7519-2T and 1.280H-1T--
(A) A month of less than 16 days is disregarded, and a month of more
than 15 days is treated as a full month; and
(B) A 52-53-week taxable year with reference to the end of a
particular month will be considered to be the same as a taxable year
ending with reference to the last day of such month.
(c) Effective date. This section is effective for taxable years
beginning after December 31, 1986.
(d) Examples--(1) Changes in taxable year. The following examples
illustrate the provisions of paragraph (b)(2) of this section.
Example (1). A is a personal service corporation that historically
used a June 30 taxable year. A desires to make a section 444 election to
change to an August 31 taxable year, effective with its taxable year
beginning July 1, 1987. Under paragraph (b)(4)(ii) of this section, the
deferred period of the taxable year to be elected is four months (the
number of months between August 31 and December 31). Furthermore, the
deferral period of the taxable year that is being changed is six months
(the number of months between June 30 and December 31). Pursuant to
paragraph (b)(2)(i) of this section, a taxpayer may, if otherwise
qualified, make a section 444 election to change to a taxable year only
if the deferral period of the taxable year to be elected is not longer
than the shorter of three months or the deferred period of the taxable
year being changed. Since the deferral period of the taxable year to be
elected (August 31) is greater than three months, A may not make a
section 444 election to change to the taxable year ending August 31,
However, since the deferral period of the taxable year that is being
changed is three months or more, A may, if otherwise qualified, make a
section 444 election to change to a year ending September 30, 1987
(three-month deferral period), a year ending October 31, 1987 (two-month
deferral period), or a year ending November 30, 1987 (one-month deferral
period). In addition, instead of making a section 444 election to change
its taxable year, A could, if otherwise qualified, make a section 444
election to retain its June end, pursuant to paragraph (b)(3) of this
section.
Example (2). B, a corporation that historically used an August 31
taxable year, elected on November 1, 1986 to be an S corporation for its
taxable year beginning September 1, 1986. As a condition to having the S
election accepted, B agreed on Form 2553 to use calendar year. Pursuant
to the general effective date provided in paragraph (c) of this section,
B may not make a section 444 election for its taxable year beginning in
1986. Thus, B must file a short period income tax return for the period
September 1 to December 31, 1986.
Example (3). The facts are the same as in example (2), except that B
desires to make a section 444 election for its taxable year beginning
January 1, 1987. Absent paragraph (b)(2)(ii) of this section, B would
not be allowed to change its taxable year because the deferral period of
the taxable year being changed (i.e., the calendar year) is zero.
However, pursuant to the special rule provided in paragraph (b)(2)(ii)
of this section, B shall apply paragraph (b)(2)(i) of this section by
taking into account the deferral period of the last taxable year of B
prior to B's election to be an S corporation (four months), rather than
the deferral period of B's taxable year that is being changed (zero
months). Thus, if otherwise qualified, B may make a section 444 election
to change to a taxable year ending September 30, October 31, or November
30, for its taxable year beginning January 1, 1987.
Example (4). The facts are the same as in example (3), except that B
files a calendar year income tax return for 1987 rather than making a
section 444 election. However, for its taxable year beginning January 1,
1988, B desires to change its taxable year by making a section 444
election. Given that the special rule provided in paragraph (b)(2)(ii)
of this section applies to section 444 elections made in taxable years
beginning before 1989, B may, if otherwise qualified, make a section 444
election to change to a taxable year ending September 30, October 31, or
November 30 for its taxable year beginning January 1, 1988.
Example (5). C, a corporation that historically used a June 30
taxable year, elected on December 15, 1986 to be an S corporation for
its taxable year beginning July 1, 1987. As a condition to having the S
election accepted,
[[Page 35]]
C agreed on Form 2553 to use a calendar year. Although pursuant to
paragraph (b)(3) of this section, C would, if otherwise qualified, be
allowed to retain its June 30 taxable year, C desires to change to a
September 30 taxable year by making a section 444 election. Pursuant to
paragraph (b)(2) of this section, a taxpayer may, if otherwise
qualified, make a section 444 election to change to a taxable year only
if the deferral period of the taxable year to be elected is not longer
than the shorter of three months or the deferral period of the taxable
year being changed. Given these facts, the deferral period of the
taxable year to be elected is 3 months (September 30 to December 31)
while the deferral period of the taxable year being changed is 6 months
(June 30 to December 31). Thus, C may, if otherwise qualified, change to
a September 30 taxable year for its taxable year beginning July 1, 1987,
by making a section 444 election. The fact that C agreed on Form 2553 to
use a calendar year is not relevant.
Example (6). D, a corporation that historically used a March 31
taxable year, elects on June 1, 1988 to be an S corporation for its
taxable year beginning April 1, 1988. D desires to change to a June 30
taxable year by making a section 444 election for its taxable year
beginning April 1, 1988. Pursuant to paragraph (b)(2)(i) of this
section, D may not change to a June 30 taxable year because such year
would have a deferral period greater than 3 months. However, if
otherwise qualified, D may make a section 444 election to change to a
taxable year ending September 30, October 31, or November 30 for its
taxable year beginning April 1, 1988.
Example (7). E, a corporation that began operations on November 1,
1986, elected to be an S corporation on December 15, 1986, for its
taxable year beginning November 1, 1986. E filed a short period income
tax return for the period November 1 to December 31, 1986. E desires to
change to a September 30 taxable year by making a section 444 election
for its taxable year beginning January 1, 1987. Although E elected to be
an S corporation after September 18, 1986, and before January 1, 1988,
paragraph (b)(2)(ii) of this section does not apply to E since E was not
a C corporation prior to electing S status. Thus, E may not change its
taxable year for the taxable year beginning January 1, 1987, by making a
section 444 election.
Example (8). The facts are the same as in example (7), except that E
began operations on April 15, 1987, and elected to be an S corporation
on June 1, 1987, for its taxable year beginning April 15, 1987. As a
condition to being an S corporation, E agreed on Form 2553 to use a
calendar year. E desires to make a section 444 election to use a year
ending September 30 for its taxable year beginning April 15, 1987.
Pursuant to paragraph (b)(5)(i) of this section, E's agreement to use a
calendar year on Form 2553 does not mean that E has adopted a calendar
year. Thus, E's desire to make a section 444 election to use a September
30 taxable year will not be considered a change in taxable year and thus
paragraph (b)(2) of this section will not apply. Instead, E will be
subject to paragraph (b)(1) of this section. Since a September 30
taxable year would result in only a three-month deferral period
(September 30 to December 31), E may, if otherwise qualified, make a
section 444 election to use a year ending September 30 for its taxable
year beginning April 15, 1987.
(2) Special rule for entities retaining their 1986 taxable year. The
following examples illustrate the provisions of paragraph (b)(3) of this
section.
Example (1). F, an S corporation that elected to be an S corporation
several years ago, has historically used a June 30 taxable year. F
desires to retain its June 30 taxable year by making a section 444
election for its taxable year beginning July 1, 1987. Pursuant to
paragraph (b)(4)(i) of this section, the deferral period of the taxable
year being retained is 6 months (June 30 to December 31, F's required
taxable year). Absent the special rule provided in paragraph (b)(3) of
this section, F would be subject to the general rule provided in
paragraph (b)(1) of this section which limits the deferral period of the
taxable year elected to three months or less. However, pursuant to
paragraph (b)(3) of this section, F may, if otherwise qualified, make a
section 444 election to retain its year ending June 30 for its taxable
year beginning July 1, 1987.
Example (2). The facts are the same as in example (1), except that F
received permission from the Commissioner to change its taxable year to
the calendar year, and filed a short period income tax return for the
period July 1 to December 31, 1986. F desires to make a section 444
election to use a year ending June 30 for its taxable year beginning
January 1, 1987. Given that F had a December 31 taxable year for its
last taxable year beginning in 1986, the special rule provided in
paragraph (b)(3) of this section does not allow F to use a June 30
taxable year for its taxable year beginning January 1, 1987.
Furthermore, pursuant to paragraph (b)(2)(i) of this section, F is not
allowed to change its taxable year from December 31 to June 30 because
the deferral period of the taxable year being changed is zero months.
Example (3). G, a corporation that historically used an August 31
taxable year, elected be an S corporation on November 15, 1986, for its
taxable year beginning September 1, 1986. As a condition to obtaining S
status, G agreed to use a calendar year. Thus, G filed its first S
corporation return for the period September 1 to December 31, 1986. G
desires to make a section 444 election to use a year
[[Page 36]]
ending August 31 for its taxable year beginning January 1, 1987. Since
G's last taxable year beginning in 1986 was a calendar year, G cannot
use paragraph (b)(3) of this section, relating to retentions of taxable
years, to elect an August 31 taxable year. Thus, G is subject to
paragraph (b)(2)(i) of this section, relating to changes in taxable
year. Although G, if otherwise qualified, may use the special rule
provided in paragraph (b)(2)(ii) of this section, G may only change from
its current taxable year (i.e., the calendar year) to a taxable year
that has no more than a three-month deferral period (i.e., September 30,
October 31, or November 30).
Example (4). The facts are the same as in example (3), except that G
elected to be an S corporation for its taxable year beginning September
1, 1987, rather than its taxable year beginning September 1, 1986. As a
condition to making its S election, G agreed, on Form 2553, to use the
calendar year. However, G has not yet filed a short period income tax
return for the period September 1 to December 31, 1987. Given these
facts, paragraph (b)(3) of this section would allow G, if otherwise
qualified, to make a section 444 election to retain an August 31 taxable
year for its taxable year beginning September 1, 1987.
Example (5). The facts are the same as in example (4), except that G
has already filed a short period income tax return for the period
September 1 to December 31, 1987. Pursuant to paragraph (b)(5)(ii)(A) of
this section, G may supersede the return it filed for the period
September 1 to December 31, 1987. Thus, pursuant to paragraph (b)(3) of
this section, G may, if otherwise qualified, make a section 444 election
to retain an August 31 taxable year for the taxable year beginning
September 1, 1987. In addition, G should follow the special procedures
set forth in paragraph (b)(5)(ii)(B) of this section.
Example (6). H, a corporation that historically used a May 31
taxable year, elects to be an S corporation on June 15, 1988 for its
taxable year beginning June 1, 1988. H desires to make a section 444
election to use a taxable year other than the calendar year. Since the
taxable year in issue is not H's first taxable year beginning after
December 31, 1986, H may not use the special rule provided in paragraph
(b)(3)(i) and thus may not retain its May 31 year. However, H may, if
otherwise qualified, make a section 444 election under paragraph
(b)(2)(i) of this section, to change to a taxable year that has no more
than a three-month deferral period (i.e., September 30, October 31, or
November 30) for its taxable year beginning June 1, 1988.
Example (7). I is a partnership that has historically used a
calendar year. Sixty percent of the profits and capital of I are owned
by Q, a corporation (that is neither an S corporation nor a personal
service corporation) that has a June 30 taxable year, and 40 percent of
the profits and capital are owned by R, a calendar year individual.
Since the partner that has more than a fifty percent interest in I has a
June 30 taxable year, I's required taxable year is June 30. Accordingly,
I filed an income tax return for the period January 1 to June 30, 1987.
Based on these facts, I may, pursuant to paragraph (b)(5)(ii)(A) of this
section, disregard the income tax return filed for the period January 1
to June 30, 1987. Thus, if otherwise qualified, I may make a section 444
election under paragraph (b)(2)(i) of this section to use a calendar
year for its taxable year beginning January 1, 1987. If I makes such a
section 444 election, I should follow the special procedures set forth
in paragraph (b)(5)(ii)(B) of this section.
[T.D. 8205, 53 FR 19694, May 27, 1988, as amended by T.D. 8996, 67 FR
35012, May 17, 2002]
Sec. 1.444-2T Tiered structure (temporary).
(a) General rule. Except as provided in paragraph (e) of this
section, no section 444 election shall be made or continued with respect
to a partnership, S corporation, or personal service corporation that is
a member of a tiered structure on the date specified in paragraph (d) of
this section. For purposes of this section, the term ``personal service
corporation'' means a personal service corporation as defined in
Sec. 1.441-3(c).
(b) Definition of a member of a tiered structure-- (1) In general. A
partnership, S corporation, or personal service corporation is
considered a member of a tiered structure if--
(i) The partnership, S corporation, or personal service corporation
directly owns any portion of a deferral entity, or
(ii) A deferral entity directly owns any portion of the partnership,
S corporation, or personal service corporation.
However, see paragraph (c) of this section for certain de minimis rules,
and see paragraph (b)(3) of this section for an anti-abuse rule. In
addition, for purposes of this section, a beneficiary of a trust shall
be considered to own an interest in the trust.
(2) Deferral entity--(i) In general. For purposes of this section,
the term ``deferral entity'' means an entity that is a partnership, S
corporation, personal service corporation, or trust. In the
[[Page 37]]
case of an affiliated group of corporations filing a consolidated income
tax return that is treated as a personal service corporation pursuant to
Sec. 1.441-4T (i), such affiliated group is considered to be a single
deferral entity.
(ii) Grantor trusts. The term ``deferral entity'' does not include a
trust (or a portion of a trust) which is treated as owned by the grantor
or beneficiary under Subpart E, part I, subchapter J, chapter 1, of the
Code (relating to grantor trusts), including a trust that is treated as
a grantor trust pursuant to section 1361(d)(1)(A) of the Code (relating
to qualified subchapter S trusts). Thus, any taxpayer treated under
subpart E as owning a portion of a trust shall be treated as owning the
assets of the trust attributable to that ownership. The following
examples illustrate the provisions of this paragraph (b)(2)(ii).
Example (1). A, an individual, is the sole beneficiary of T. T is a
trust that owns 50 percent of the profits and capital of X, a
partnership that desires to make a section 444 election. Furthermore,
pursuant to Subpart E, Part I, subchapter J, chapter 1 of the Code, A is
treated as an owner of X. Based upon these facts, T is not a deferral
entity and 50 percent of X is considered to be directly owned by A.
Example (2). The facts are the same as in example (1), except that A
is a personal service corporation rather than an individual. Given these
facts, 50 percent of X is considered to be directly owned by A, a
deferral entity. Thus, X is considered to be a member of a tiered
structure.
(3) Anti-abuse rule. Notwithstanding paragraph (b)(1) of this
section, a partnership, S corporation, or personal service corporation
is considered a member of a tiered structure if the partnership, S
corporation, personal service corporation, or related taxpayers have
organized or reorganized their ownership structure or operations for the
principal purpose of obtaining a significant unintended tax benefit from
making or continuing a section 444 election. For purposes of the
preceding sentence, a significant unintended tax benefit results when a
partnership, S corporation, or personal service corporation makes a
section 444 election and, as a result, a taxpayer (not limited to the
entity making the election) obtains a significant deferral of income
substantially all of which is not eliminated by a required payment under
section 7519. See examples (15) through (19) in paragraph (f) of this
section.
(c) De minimis rules--(1) In general. For rules relating to a de
minimis exception to paragraph (b)(1)(i) of this section (the
``downstream de minimis rule''), see paragraph (c)(2) of this section.
For rules relating to a de minimis exception to paragraph (b)(1)(ii) of
this section (the ``upstream de minimis rule''), see paragraph (c)(3) of
this section. For rules relating to the interaction of the de minimis
rules provided in this paragraph (c) and the ``same taxable year
exception'' provided in paragraph (e) of this section, see paragraph
(e)(5) of this section.
(2) Downstream de minimis rule--(i) General rule. If a partnership,
S corporation, or personal service corporation directly owns any portion
of one or more deferral entities as of the date specified in paragraph
(d) of this section, such ownership is disregarded for purposes of
paragraph (b)(1)(i) of this section if, in the aggregate, all such
deferral entities accounted for--
(A) Not more than 5 percent of the partnership's, S corporation's,
or personal service corporation's adjusted taxable income for the
testing period (``5 percent adjusted taxable income test''), or
(B) Not more than 2 percent of the partnership's, S corporation's,
or personal service corporation's gross income for the testing period
(``2 percent gross income test''). See section 702 (c) for rules
relating to the determination of gross income of a partner in a
partnership.
See examples (3) through (5) in paragraph (f) of this section.
(ii) Definition of testing period. For purposes of this paragraph
(c)(2), the term ``testing period'' means the taxable year that ends
immediately prior to the taxable year for which the partnership, S
corporation, or personal service corporation desires to make or continue
a section 444 election. However, see the special rules provided in
paragraph (c)(2)(iv) of this section for certain special cases (e.g.,
the partnership, S corporation, personal service corporation or deferral
entity was not in existence during the entire testing
[[Page 38]]
period). The following example illustrates the application of this
paragraph (c)(2)(ii).
Example. A partnership desires to make a section 444 election for
its taxable year beginning November 1, 1987. The testing period for
purposes of determining whether deferral entities owned by such
partnership are de minimis under paragraph (c)(2) of this section is the
taxable year ending October 31, 1987. If either the partnership or the
deferral entities were not in existence for the entire taxable year
ending October 1, 1987, see the special rules provided in paragraph
(c)(2)(iv) of this section.
(iii) Definition of adjusted taxable income--(A) Partnership. In the
case of a partnership, adjusted taxable income for purposes of paragraph
(c)(2) of this section is an amount equal to the sum of the--
(1) Aggregate amount of the partnership items described in section
702(a) (other than credits and tax-exempt income),
(2) Applicable payments defined in section 7519(d)(3) that are
deducted in determining the amount described in paragraph
(c)(2)(iii)(A)(1) of this section, and
(3) Guaranteed payments defined in section 707(c) that are deducted
in determining the amount described in paragraph (c)(2)(iii)(A)(1) of
this section and are not otherwise included in paragraph
(c)(2)(iii)(A)(2) of this section. For purposes of determining the
aggregate amount of partnership items under paragraph (c)(2)(iii)(A)(1)
of this section, deductions and losses are treated as negative income.
Thus, for example, if under section 702(a) a partnership has $1,000 of
ordinary taxable income, $500 of specially allocated deductions, and
$300 of capital loss, the partnership's aggregate amount of partnership
items under paragraph (c)(2)(iii)(A)(1) of this section is $200 ($1,000-
$500-$300).
(B) S corporation. In the case of an S corporation, adjusted taxable
income for purposes of paragraph (c)(2) of this section is an amount
equal to the sum of the--
(1) Aggregate amount of the S corporation items described in section
1366(a) (other than credits and tax-exempt income), and
(2) Applicable payments defined in section 7519(d)(3) that are
deducted in determining the amount described in paragraph
(c)(2)(iii)(B)(1) of this section.
For purposes of determining the aggregate amount of S corporation items
under paragraph (c)(2)(iii)(B)(1) of this section, deductions and losses
are treated as negative income. Thus, for example, if under section
1366(a) an S corporation has $2,000 of ordinary taxable income, $1,000
of deductions described in section 1366(a)(1)(A) of the Code, and $500
of capital loss, the S corporation's aggregate amount of S corporation
items under paragraph (c)(2)(iii)(B)(1) of this section is $500 ($2,000-
$1,000-$500).
(C) Personal service corporation. In the case of a personal service
corporation, adjusted taxable income for purposes of paragraph (c)(2) of
this section is an amount equal to the sum of the--
(1) Taxable income of the personal service corporation, and
(2) Applicable amounts defined in section 280H(f)(1) that are
deducted in determining the amount described in paragraph
(c)(2)(iii)(C)(1) of this section.
(iv) Special rules--(A) Pro-forma rule. Except as provided in
paragraph (c)(iv)(C)(2) of this section, if a partnership, S
corporation, or personal service corporation directly owns any interest
in a deferral entity as of the date specified in paragraph (d) of this
section and such ownership interest is different in amount from the
partnership's, S corporation's, or personal service corporation's
interest on any day during the testing period, the 5 percent adjusted
taxable income test and the 2 percent gross income test must be applied
on a pro-forma basis (i.e., adjusted taxable income and gross income
must be calculated for the testing period assuming that the partnership,
S corporation, or personal service corporation owned the same interest
in the deferral entity that it owned as of the date specified in
paragraph (d) of this section). The following example illustrates the
application of this paragraph (c)(2)(iv)(A).
Example. A personal service corporation desiring to make a section
444 election for its taxable year beginning October 1, 1987, acquires a
25 percent ownership interest in a
[[Page 39]]
partnership on or after October 1, 1987. Furthermore, the partnership
has been in existence for several years. The personal service
corporation must modify its calculations of the 5 percent adjusted
taxable income test and the 2 percent gross income test for the testing
period ended September 30, 1987, by assuming that the personal service
corporation owned 25 percent of the partnership during such testing
period and the personal service corporation's adjusted taxable income
and gross income were correspondingly adjusted.
(B) Reasonable estimates allowed. If the information necessary to
complete the pro-forma calculation described in paragraph (c)(2)(iv)(A)
of this section is not readily available, the partnership, S
corporation, or personal service corporation may make a reasonable
estimate of such information.
(C) Newly formed entities--(1) Newly formed deferral entities. If a
partnership, S corporation, or personal service corporation owns any
portion of a deferral entity on the date specified in paragraph (d) of
this section and such deferral entity was not in existence during the
entire testing period (hereinafter referred to as a ``newly formed
deferral entity''), both the 5 percent adjusted taxable income test and
the 2 percent gross income test are modified as follows. First, the
partnership, S corporation, or personal service corporation shall
calculate the percentage of its adjusted taxable income or gross income
that is attributable to deferral entities, excluding newly formed
deferral entities. Second, the partnership, S corporation, or personal
service corporation shall calculate (on the date specified in paragraph
(d) of this section) the percentage of the tax basis of its assets that
are attributable to its tax basis with respect to its ownership
interests in all newly formed deferral entities. If the sum of the two
percentages is 5 percent or less, the deferral entities are considered
de minimis and are disregarded for purposes of paragraph (b)(1)(i) of
this section. If the sum of the two percentages is greater than 5
percent, the deferral entities do not qualify for the de minimis rule
provided in paragraph (c)(2) of this section and thus the partnership, S
corporation, or personal service corporation is considered to be a
member of a tiered structure for purposes of this section.
(2) Newly formed partnership, S corporation, or personal service
corporation desiring to make a section 444 election. If a partnership, S
corporation, or personal service corporation desires to make a section
444 election for the first taxable year of its existence, the 5 percent
adjusted taxable income test and the 2 percent gross income test are
replaced by a 5 percent of assets test. Thus, if on the date specified
in paragraph (d) of this section, 5 percent or less of the assets
(measured by reference to the tax basis of the assets) of the newly
formed partnership, S corporation, or personal service corporation are
attributable to the tax basis with respect to its ownership interests in
the deferral entities, the deferral entities will be considered de
minimis and will be disregarded for purposes of paragraph (b)(1)(i) of
this section.
(3) Upstream de minimis rule. If a partnership, S corporation, or
personal service corporation is directly owned by one or more deferral
entities as of the date specified in paragraph (d) of this section, such
ownership is disregarded for purposes of paragraph (b)(1)(ii) of this
section if on the date specified in paragraph (d) of this section the
deferral entities directly own, in the aggregate, 5 percent or less of--
(i) An interest in the current profits of the partnership, or
(ii) The stock (measured by value) of the S corporation or personal
service corporation.
See examples (6) and (7) in paragraph (f) of this section.
(d) Date for determining the existence of a tiered structure--(1)
General rule. For purposes of paragraph (a) of this section, a
partnership, S corporation, or personal service corporation will be
considered a member of a tiered structure for a particular taxable year
if the partnership, S corporation, or personal service corporation is a
member of a tiered structure on the last day of the required taxable
year (as defined in section 444 (e) of the Code) ending within such
year. If a particular taxable year does not include the last day of the
required taxable year for such year, the partnership, S corporation, or
personal service corporation will not be
[[Page 40]]
considered a member of a tiered structure for such year. The following
examples illustrate the application of this paragraph (d)(1).
Example (1). Assume that a newly formed partnership whose first
taxable year begins November 1, 1988, desires to adopt a September 30
taxable year by making a section 444 election. Furthermore, assume that
for its taxable year beginning November 1, 1988, the partnership's
required taxable year is December 31. If the partnership is a member of
a tiered structure on December 31, 1988, it will not be eligible to make
a section 444 election for a taxable year beginning November 1, 1988,
and ending September 30, 1989.
Example (2). Assume an S corporation that historically used a June
30 taxable year desires to make a section 444 election to change to a
year ending September 30 for its taxable year beginning July 1, 1987. If
the S corporation can make the section 444 election, it will have a
short taxable year beginning July 1, 1987, and ending September 30,
1987. Given these facts, the short taxable year beginning July 1, 1987,
does not include the last day of the S corporation's required taxable
year for such year (i.e., December 31, 1987). Thus, pursuant to
paragraph (d)(1) of this section, the S corporation will not be
considered a member of a tiered structure for its taxable year beginning
July 1, 1987, and ending September 30, 1987.
(2) Special rule for taxable years beginning in 1987. For purposes
of paragraph (a) of this section, a partnership, S corporation, or
personal service corporation will not be considered a member of a tiered
structure for a taxable year beginning in 1987 if the partnership, S
corporation, or personal service corporation is not a member of a tiered
structure on the day the partnership, S corporation, or personal service
corporation timely files its section 444 election for such year. The
following examples illustrate the application of this paragraph (d)(2).
Example (1). Assume that a partnership desires to retain a June 30
taxable year by making a section 444 election for its taxable year
beginning July 1, 1987. Furthermore, assume that the partnership's
required taxable year for such year is December 31 and that the
partnership was a member of a tiered structure on such date. Also assume
that the partnership was not a member of a tiered structure as of the
date it timely filed its section 444 election for its taxable year
beginning July 1, 1987. Based upon the special rule provided in this
paragraph (d)(2), the partnership will not be considered a member of a
tiered structure for its taxable year beginning July 1, 1987.
Example (2). Assume the same facts as in example (1), except that
the partnership was a member of a tiered structure on the date it filed
its section 444 election for its taxable year beginning July 1, 1987,
but was not a member of a tiered structure on December 31, 1987.
Paragraph (d)(1) of this section would still apply and thus the
partnership would not be considered part of a tiered structure for its
taxable year beginning July 1, 1987. However, the partnership would be
considered a member of a tiered structure for its taxable year beginning
July 1, 1988, if the partnership was a member of a tiered structure on
December 31, 1988.
(e) Same taxable year exception--(1) In general. Although a
partnership or S corporation is a member of a tiered structure as of the
date specified in paragraph (d) of this section, the partnership, S
corporation may make or continue a section 444 election if the tiered
structure (as defined in paragraph (e)(2) of this section) consists
entirely of partnerships or S corporations (or both), all of which have
the same taxable year as determined under paragraph (e)(3) of this
section. However, see paragraph (e)(5) of this section for the
interaction of the de minimis rules provided in paragraph (c) of this
section with the same taxable year exception. For purposes of this
paragraph (e), two or more entities are considered to have the same
taxable year if their taxable years end on the same day, even though
they begin on different days. See examples (8) through (14) in paragraph
(f) of this section.
(2) Definition of tiered structure--(i) General rule. For purposes
of the same taxable year exception, the members of a tiered structure
are defined to include the following entities--
(A) The partnership or S corporation that desires to qualify for the
same taxable year exception,
(B) A deferral entity (or entities) directly owned (in whole or in
part) by the partnership or S corporation that desires to qualify for
the same taxable year exception,
(C) A deferral entity (or entities) directly owning any portion of
the partnership or S corporation that desires to qualify for the same
taxable year exception, and
(D) A deferral entity (or entities) directly owned (in whole or in
part) by a
[[Page 41]]
``downstream controlled partnership,'' as defined in paragraph
(e)(2)(ii) of this section.
(ii) Special flow-through rule for downstream controlled
partnerships. If more than 50 percent of a partnership's profits and
capital are owned by a partnership or S corporation that desires to
qualify for the same taxable year exception, such owned partnership is
considered a downstream controlled partnership for purposes of paragraph
(e)(2)(i) of this section. Furthermore, if more than 50 percent of a
partnership's profits and capital are owned by a downstream controlled
partnership, such owned partnership is considered a downstream
controlled partnership for purposes of paragraph (e)(2)(i) of this
section.
(3) Determining the taxable year of a partnership or S corporation.
The taxable year of a partnership or S corporation to be taken into
account for purposes of paragraph (e)(1) of this section is the taxable
year ending with or prior to the date specified in paragraph (d) of this
section. Furthermore, the determination of such taxable year will take
into consideration any section 444 elections made by the partnership or
S corporation. See examples (10) and (11) in paragraph (f) of this
section.
(4) Special rule for 52-53-week taxable years. For purposes of this
paragraph (e), a 52-53-week taxable year with reference to the end of a
particular month will be considered to be the same as a taxable year
ending with reference to the last day of such month.
(5) Interaction with de minimis rules--(i) Downstream de minimis
rule--(A) In general. If a partnership or S corporation that desires to
make or continue a section 444 election is a member of a tiered
structure (as defined in paragraph (e)(2) of this section) and directly
owns any member (or members) of the tiered structure with a taxable year
different from the taxable year of the partnership or S corporation,
such ownership is disregarded for purposes of the same taxable year
exception of paragraph (e)(1) of this section provided that, in the
aggregate, the de minimis rule of paragraph (c)(2) of this section is
satisfied with respect to such owned member (or members). The following
example illustrates the application of this paragraph (e)(5)(i)(A).
Example. P, a partnership with a June 30 taxable year, owns 60
percent of P1, another partnership with a June 30 taxable year. P also
owns 1 percent of P2 and P3, calendar year partnerships. If, in the
aggregate, P's ownership interests in P2 and P3 are considered de
minimis under paragraph (c)(2) of this section, P meets the same taxable
year exception and may make a section 444 election to retain its June 30
taxable year.
(B) Special rule for members of a tiered structure directly owned by
a downstream controlled partnership. For purposes of paragraph
(e)(5)(i)(A) of this section, a partnership or S corporation desiring to
make or continue a section 444 election is considered to directly own
any member of the tiered structure (as defined in paragraph (e)(2) of
this section) directly owned by a downstream controlled partnership (as
defined in paragraph (e)(2)(ii) of this section). The adjusted taxable
income or gross income of the partnership or S corporation that is
attributable to a member of a tiered structure directly owned by a
downstream controlled partnership equals the adjusted taxable income or
gross income of such member multiplied by the partnership's or S
corporation's indirect ownership percentage of such member. The
following example illustrates the application of this paragraph
(e)(5)(i)(B).
Example. P, a partnership, desires to retain its June 30 taxable
year by making a section 444 election. However, as of the date specified
in paragraph (d) of this section, P owns 75 percent of P1, a June 30
partnership, and P1 owns 40 percent of P2, a calendar year partnership.
P also owns 25 percent of P3, a calendar year partnership. Pursuant to
paragraphs (e)(5)(i) (A) and (B) of this section, P may only qualify to
use the same taxable year exception if, in the aggregate, P2 and P3 are
de minimis with respect to P. Pursuant to paragraph (e)(5)(i)(B) of this
section, P's adjusted taxable income or gross income attributable to P2
equals 30 percent (75 percent times 40 percent) of P2's adjusted taxable
income or gross income.
(ii) Upstream de minimis rule. If a partnership or S corporation
that desires to make or continue a section 444 election is a member of a
tiered structure (as
[[Page 42]]
defined in paragraph (e)(2) of this section) and is owned directly by a
member (or members) of the tiered structure with taxable years different
from the taxable year of the partnership or S corporation, such
ownership is disregarded for purposes of the same taxable year exception
of paragraph (e)(1) of this section provided that, in the aggregate, the
de minimis rule of paragraph (c)(3) of this section is satisfied with
respect to such owning member (or members). See example (12) of
paragraph (f) of this section.
(f) Examples. The provisions of this section may be illustrated by
the following examples.
Example (1). A, a partnership, desires to make or continue a section
444 election. However, on the date specified in paragraph (d) of this
section, A is owned by a combination of individuals and S corporations.
The S corporations are deferral entities, as defined in paragraph (b)(2)
of this section. Thus, pursuant to paragraph (b)(1)(ii) of this section,
A will be a member of a tiered structure unless under paragraph (c)(3)
of this section, the S corporations, in the aggregate, own a de minimis
portion of A. If the S corporations' ownership in A is not considered de
minimis under paragraph (c)(3) of this section, A is a member of a
tiered structure and will be allowed to make or continue a section 444
election only if it meets the same taxable year exception provided in
paragraph (e) of this section.
Example (2). B, a partnership, desires to make or continue a section
444 election. However, on the date specified in paragraph (d) of this
section, B is a partner in two partnerships, B1 and B2. B1 and B2 are
deferral entities, as defined in paragraph (b)(2) of this section. Thus,
under paragraph (b)(1)(i) of this section, B will be a member of a
tiered structure unless B's aggregate ownership interests in B1 and B2
are considered de minimis under paragraph (c)(2) of this section. If B
is a member of a tiered structure on the date specified in paragraph (d)
of this section, B will be allowed to make or continue a section 444
election only if it meets the same taxable year exception provided in
paragraph (e) of this section.
Example (3). C, a partnership with a September 30 taxable year, is
100 percent owned by calendar year individuals. C desires to make a
section 444 election for its taxable year beginning October 1, 1987.
However, on the date specified in paragraph (d) of this section, C owns
a 1 percent interest in C1, a partnership. C does not own any other
interest in a deferral entity. For the taxable year ended September 30,
1987, 10 percent of C's adjusted taxable income (as defined in paragraph
(c)(2)(iii) of this section) was attributable to C's partnership
interest in C1. Furthermore, 4 percent of C's gross income for the
taxable year ended September 30, 1987, was attributable to C's
partnership interest in C1. Under paragraph (c)(2) of this section, C's
partnership interest in C1 is not de minimis because during the testing
period more than 5 percent of C's adjusted taxable income is
attributable to C1 and more than 2 percent of C's gross income is
attributable to C1. Thus, C is a member of a tiered structure for its
taxable year beginning October 1, 1987.
Example (4). The facts are the same as example (3), except that for
the taxable year ended September 30, 1987, only 2 percent of C's
adjusted taxable income was attributable to C1. Under paragraph (c)(2)
of this section, C's partnership interest in C1 is considered de minimis
for purposes of determining whether C is a member of a tiered structure
because not more than 5 percent of C's adjusted taxable income during
the testing period is attributable to C1. Thus, C is not a member of a
tiered structure for its taxable year beginning October 1, 1987.
Example (5). The facts are the same as example (4), except that in
addition to owning C1, C also owns 15 percent of C2, another
partnership. For the taxable year ended September 30, 1987, 2 percent of
C's adjusted taxable income is attributable to C1 and an additional 4
percent is attributable to C2. Furthermore, for the taxable year ended
September 30, 1987, 4 percent of C's gross income is attributable to C1
while 3 percent is attributable to C2. Under paragraph (c)(2) of this
section, C1 and C2 must be aggregated for purposes of determining
whether C meets either the 5 percent adjusted taxable income test or the
2 percent gross income test. Since C's adjusted taxable income
attributable to C1 and C2 is 6 percent (2 percent + 4 percent) and C's
gross income attributable to C1 and C2 is 7 percent (4 percent + 3
percent), C does not meet the downstream de minimis rule provided in
paragraph (c)(2) of this section. Thus, C is a member of a tiered
structure for its taxable year beginning October 1, 1987.
Example (6). The facts are the same as example (3), except that
instead of determining whether C is part of a tiered structure, the
issue is whether C1 is part of a tiered structure. In addition, assume
that on the date specified in paragraph (d) of this section, the
remaining 99 percent of C1 is owned by calendar year individuals and C1
does not own an interest in any deferral entity. Although C in Example
(3) was considered to be a part of a tiered structure by virtue of its
ownership interest in C1, C1 must be tested separately to determine
whether it is part of a tiered structure. Since C's interest in C1 is 5
percent or less, C's interest in C1 is de minimis with respect to C1.
See paragraph (c)(3) of this section. Thus, based upon these facts, C1
is not part of a tiered structure.
[[Page 43]]
Example (7). The facts are the same as example (6), except that the
remaining 99 percent of C1 is owned 94 percent by calendar year
individuals and 5 percent by C3, another partnership. Thus, deferral
entities own 6 percent of C1 (1 percent owned by C and 5 percent owned
by C3). Under paragraph (c)(3) of this section, deferral entities own
more than a de minimis interest (i.e., 5 percent) of C1, and thus C1 is
part of a tiered structure.
Example (8). D, a partnership with a September 30 taxable year,
desires to make a section 444 election for its taxable year beginning
October 1, 1987. On December 31, 1987, and the date D plans to file its
section 444 election, D is 10 percent owned by D1, a personal service
corporation with a September 30 taxable year, and 90 percent owned by
calendar year individuals. Furthermore, D1 will retain its September 30
taxable year because it previously established a business purpose for
such year. Since D is owned in part by D1, a personal service
corporation, and the ownership interest is not de minimis under
paragraph (c)(3) of this section, D is considered a member of a tiered
structure for its taxable year beginning October 1, 1987. Furthermore,
although D and D1 have the same taxable year, D does not qualify for the
same taxable year exception provided in paragraph (e) of this section
because D1 is a personal service corporation rather than a partnership
or S corporation. Thus, pursuant to paragraph (a) of this section, D may
not make a section 444 election for its taxable year beginning October
1, 1987.
Example (9). The facts are the same as example (8), except that D1
is a partnership rather than a personal service corporation. Based upon
these facts, D qualifies for the same taxable year exception provided in
paragraph (e) of this section. Thus, D may make a section 444 election
for its taxable year beginning October 1, 1987.
Example (10). The facts are the same as example (9), except that D1
has not established a business purpose for a September 30 taxable year.
In addition, D1 does not desire to make a section 444 election and,
under section 706(b), D1 will be required to change to a calendar year
for its taxable year beginning October 1, 1987. Pursuant to paragraph
(e)(3) of this section, D and D1 do not have the same taxable year for
purposes of the same taxable year exception provided in paragraph (e) of
this section. Thus, D may not make a section 444 election for its
taxable year beginning October 1, 1987.
Example (11). The facts are the same as example (8), except that D1
is a partnership with a March 31 taxable year. Furthermore, for its
taxable year beginning April 1, 1987, D1 will change to a September 30
taxable year by making a section 444 election. Pursuant to paragraph
(e)(3) of this section, D1 is considered to have a September 30 taxable
year for purposes of determining whether D qualifies for the same
taxable year exception provided in paragraph (e) of this section. Since
both D and D1 will have the same taxable year as of the date specified
in paragraph (d) of this section, D may make a section 444 election for
its taxable year beginning October 1, 1987.
Example (12). The facts are the same as example (11), except that
instead of the remaining 90 percent of D being owned by calendar year
individuals, it is owned 86 percent by individuals and 4 percent by D2,
a calendar year partnership. Thus, D, a September 30 partnership, is 10
percent owned by D1, a September 30 partnership, 86 percent owned by
calendar year individuals, and 4 percent owned by D2, a calendar year
partnership. Under paragraph (e)(5)(ii) of this section, D2's ownership
interest in D is considered de minimis for purposes of the same taxable
year exception. Since D2's ownership interest in D is considered de
minimis, it is disregarded for purposes of determining whether D
qualifies for the same taxable year exception provided in paragraph (e)
of this section. Thus, since both D and D1 will have the same taxable
year as of the date specified in paragraph (d) of this section, D may
make a section 444 election for its taxable year beginning October 1,
1987.
Example (13). E, a partnership with a June 30 taxable year, desires
to make a section 444 election for its taxable year beginning July 1,
1987. On the date specified in paragraph (d) of this section, E is 100
percent owned by calendar year individuals; E owns 99 percent of the
profits and capital of E1, a partnership with a June 30 taxable year;
and E1 owns 30 percent of the profits and capital of E2, a partnership
with a September 30 taxable year. E owns no other deferral entities.
Pursuant to paragraph (b)(1)(i) of this section, E is considered to be a
member of a tiered structure. Furthermore, pursuant to paragraph (e) of
this section, E does not qualify for the same taxable year exception
because E2 does not have the same taxable year as E and E1.
Example (14). The facts are the same as example (13), except that E
owns only 49 percent (rather than 99 percent) of the profits and capital
of E1. Pursuant to paragraph (e) of this section, E qualifies for the
same taxable year exception because E and E1 have the same taxable year.
Pursuant to paragraph (e) of this section, E1's ownership interest in E2
is disregarded since E does not own more than 50 percent of E1's profits
and capital.
Example (15). Prior to consideration of the anti-abuse rule provided
in paragraph (b)(3) of this section, H, a partnership that commenced
operations on October 1, 1987, is eligible to make a section 444
election for its taxable year beginning October 1, 1987. Although H may
obtain a significant deferral of income substantially all of which is
not
[[Page 44]]
eliminated by a required payment under section 7519 (since there will be
no required payment for H's first taxable year), the anti-abuse rule of
paragraph (b)(3) will not apply unless the principal purpose of
organizing H was the attainment of a significant deferral of income that
would result from making a section 444 election.
Example (16). F, a partnership with a January 31 taxable year,
desires to make a section 444 election to retain its January 31 taxable
year for the taxable year beginning February 1, 1987. F is 100 percent
owned by calendar year individuals. Prior to the date specified in
paragraph (d) of this section, F contributes substantially all of its
assets to F1, a partnership, in exchange for a 51 percent interest in
F1. The remaining 49 percent of F1 is owned by the calendar year
individuals owning 100 percent of F. If F is allowed to make a section
444 election to retain its January 31 taxable year, F1's required
taxable year will be January 31 since a majority of F1's partners use a
January 31 taxable year (see Sec. 1.706-3T). F's principal purpose for
creating F1 and contributing its assets to F1 is to obtain an 11-month
deferral on 49 percent of the income previously earned by F and now
earned by F1. Pursuant to paragraph (b)(3) of this section, F is not
allowed to make a section 444 election for its taxable year beginning
February 1, 1987.
Example (17). The facts are the same as in example (16), except that
F does not create F1 and contribute its assets to F1 until immediately
after F makes its section 444 election for the taxable year beginning
February 1, 1987. Thus, F is allowed to make a section 444 election for
its taxable year beginning February 1, 1987. However, pursuant to
paragraph (b)(3) of this section, F will have its section 444 election
terminated for subsequent years unless the tax deferral inherent in the
structure is eliminated (e.g., F1 is liquidated or the individual owners
of F contribute their interests in F1 to F) prior to the date specified
in paragraph (d) of this section for subsequent taxable years beginning
on or after February 1, 1988.
Example (18). The facts are the same as in example (16), except that
F1 is 99 percent owned by F and none of the individual owners of F own
any portion of F1. Furthermore, F obtained no tax benefit from creating
and contributing assets to F1. Given these facts paragraph (b)(3) of
this section does not apply and thus, F may make a section 444 election
for its taxable year beginning February 1, 1987.
Example (19). G, a partnership with an October 31 taxable year,
desires to retain its October 31 taxable year for its taxable year
beginning November 1, 1987. However, as of December 31, 1987, G owns a
30 percent interest in G1, a calendar year partnership. G owns no other
deferral entity, and G is 100 percent owned by calendar year
individuals. Furthermore, G's interest in G1 does not meet the de
minimis rule provided in paragraph (c)(3) of this section. Thus, in
order to avoid being a tiered structure, G sells its interest in G1 to
an unrelated third party prior to the date G timely makes it section 444
election for its taxable year beginning November 1, 1987. Although the
sale of G1 allows G to qualify to make a section 444 election, and
therefore to obtain a significant tax benefit, such benefit is not
unintended. Thus, paragraph (b)(3) of this section does not apply, and G
may make a section 444 election for its taxable year beginning November
1, 1987.
(g) Effective date. This section is effective for taxable years
beginning after December 31, 1986.
[T.D. 8205, 53 FR 19698, May 27, 1988, as amended by T.D. 8996, 67 FR
35012, May 17, 2002]
Sec. 1.444-3T Manner and time of making section 444 election (temporary).
(a) In general. A section 444 election shall be made in the manner
and at the time provided in this section.
(b) Manner and time of making election--(1) General rule. A section
444 election shall be made by filing a properly prepared Form 8716,
``Election to Have a Tax Year Other Than a Required Tax Year,'' with the
Service Center indicated by the instructions to Form 8716. Except as
provided in paragraphs (b) (2) and (4) of this section, Form 8716 must
be filed by the earlier of--
(i) The 15th day of the fifth month following the month that
includes the first day of the taxable year for which the election will
first be effective, or
(ii) The due date (without regard to extensions) of the income tax
return resulting from the section 444 election.
In addition, a copy of Form 8716 must be attached to Form 1065 or Form
1120 series form, whichever is applicable, for the first taxable year
for which the section 444 election is made. Form 8716 shall be signed by
any person who is authorized to sign Form 1065 or Form 1120 series form,
whichever is applicable. (See sections 6062 and 6063, relating to the
signing of returns.) The provisions of this paragraph (b)(1) may be
illustrated by the following examples.
Example (1). A, a partnership that began operations on September 10,
1988, is qualified
[[Page 45]]
to make a section 444 election to use a September 30 taxable year for
its taxable year beginning September 10, 1988. Pursuant to paragraph
(b)(1) of this section, A must file Form 8716 by the earlier of the 15th
day of the fifth month following the month that includes the first day
of the taxable year for which the election will first be effective
(i.e., February 15, 1989) or the due date (without regard to extensions)
of the partnership's tax return for the period September 10, 1988 to
September 30, 1988 (i.e., January 15, 1989). Thus, A must file Form 8716
by January 15, 1989.
Example (2). The facts are the same as in example (1), except that A
began operations on October 20, 1988. Based upon these facts, A must
file Form 8716 by March 15, 1989, the 15th day of the fifth month
following the month that includes the first day of the taxable year for
which the election will first be effective.
Example (3). B is a corporation that first becomes a personal
service corporation for its taxable year beginning September 1, 1988. B
qualifies to make a section 444 election to use a September 30 taxable
year for its taxable year beginning September 1, 1988. Pursuant to this
paragraph (b)(1), B must file Form 8716 by December 15, 1988, the due
date of the income tax return for the short period September 1 to
September 30, 1988.
(2) Special extension of time for making an election. If, pursuant
to paragraph (b)(1) of this section, the due date for filing Form 8716
is prior to July 26, 1988, such date is extended to July 26, 1988. The
provisions of this paragraph (b)(2) may be illustrated by the following
examples.
Example (1). B, a partnership that historically used a June 30
taxable year, is qualified to make a section 444 election to retain a
June 30 taxable year for its taxable year beginning July 1, 1987. Absent
paragraph (b)(2) of this section, B would be required to file Form 8716
by December 15, 1987. However, pursuant to paragraph (b)(2) of this
section, B's due date for filing Form 8716 is extended to July 26, 1988.
Example (2). C, a partnership that began operations on January 20,
1988, is qualified to make a section 444 election to use a year ending
September 30 for its taxable year beginning January 20, 1988. Absent
paragraph (b)(2) of this section, C is required to file Form 8716 by
June 15, 1988 (the 15th day of the fifth month following the month that
includes the first day of the taxable year for which the election will
first be effective). However, pursuant to paragraph (b)(2) of this
section, the due date for filing Form 8716 is July 26, 1988.
(3) Corporation electing to be an S corporation--(i) In general. A
corporation electing to be an S corporation is subject to the same time
and manner rules for filing Form 8716 as any other taxpayer making a
section 444 election. Thus, a corporation electing to be an S
corporation that desires to make a section 444 election is not required
to file Form 8716 with its Form 2553, ``Election by a Small Business
Corporation.'' However, a corporation electing to be an S corporation
after September 26, 1988, is required to state on Form 2553 its
intention to--
(A) Make a section 444 election, if qualified, or
(B) Make a ``back-up section 444 election'' as described in
paragraph (b)(4) of this section.
If a corporation electing to be an S corporation fails to state either
of the above intentions, the District Director may, at his discretion,
disregard any section 444 election for such taxpayer.
(ii) Examples. The provisions of this paragraph (b)(3) may be
illustrated by the following examples.
Example (1). D is a corporation that commences operations on October
1, 1988, and elects to be an S corporation for its taxable year
beginning October 1, 1988. All of D's shareholders use the calendar year
as their taxable year. D desires to adopt a September 30 taxable year. D
does not believe it has a business purpose for a September 30 taxable
year and thus it must make a section 444 election to use such year.
Based on these facts, D must, pursuant to the instructions to Form 2553,
state on Form 2553 that, if qualified, it will make a section 444
election to adopt a year ending September 30 for its taxable year
beginning October 1, 1988. If D is qualified (i.e., D is not a member of
a tiered structure on December 31, 1988) to make a section 444 election
for its taxable year beginning October 1, 1988, D must file Form 8716 by
March 15, 1989. If D ultimately is not qualified to make a section 444
election for its taxable year beginning October 1, 1988, D's election to
be an S corporation will not be effective unless, pursuant to the
instructions to Form 2553, D made a back-up calendar year election
(i.e., an election to adopt the calendar year in the event D ultimately
is not qualified to make a section 444 election for such year).
Example (2). The facts are the same as in example (1), except that D
believes it can establish, to the satisfaction of the Commissioner, a
business purpose for adopting a
[[Page 46]]
September 30 taxable year. However, D desires to make a ``back-up
section 444 election'' (see paragraph (b)(4) of this section) in the
event that the Commissioner does not grant permission to adopt a
September 30 taxable year based upon business purpose. Based on these
facts, D must, pursuant to the instructions to Form 2553, state on Form
2553 its intention, if qualified, to make a back-up section 444 election
to adopt a September 30 taxable year. If, by March 15, 1989, D has not
received permission to adopt a September 30 taxable year and D is
qualified to make a section 444 election, D must make a back-up election
in accordance with paragraph (b)(4) of this section.
(4) Back-up section 444 election--(i) General rule. A taxpayer that
has requested (or is planning to request) permission to use a particular
taxable year based upon business purpose, may, if otherwise qualified,
file a section 444 election (referred to as a ``back-up section 444
election''). If the Commissioner subsequently denies the business
purpose request, the taxpayer will, if otherwise qualified, be required
to activate the back-up section 444 election. See examples (1) and (2)
in paragraph (b)(4)(iv) of this section.
(ii) Procedures for making a back-up section 444 election. In
addition to following the general rules provided in this section, a
taxpayer making a back-up section 444 election should, in order to allow
the Service to process the affected returns in an efficient manner, type
or legibly print the words ``BACK-UP ELECTION'' at the top of Form 8716,
``Election to Have a Tax Year Other Than a Required Tax Year.'' However,
if such Form 8716 is filed on or after the date a Form 1128, Application
for Change in Accounting Period, is filed with respect to a period that
begins on the same date, the words ``FORM 1128 BACK-UP ELECTION'' should
be typed or legibly printed at the top of Form 8716.
(iii) Procedures for activating a back-up section 444 election--(A)
Partnerships and S corporations--(1) In general. A back-up section 444
election made by a partnership or S corporation is activated by filing
the return required in Sec. 1.7519-2T (a)(2)(i) and making the payment
required in Sec. 1.7519-1T. The due date for filing such return and
payment will be the later of--
(i) The due dates provided in Sec. 1.7519-2T, or
(ii) 60 days from the date the Commissioner denies the business
purpose request.
However, interest will be assessed (at the rate provided in section 6621
(a)(2)) on any required payment made after the due date (without regard
to any extension for a back-up election) provided in Sec. 1.7519-2T
(a)(4)(i) or (a)(4)(ii), whichever is applicable, for such payment.
Interest will be calculated from such due date to the date such amount
is actually paid. Interest assessed under this paragraph will be
separate from any required payments. Thus, interest will not be subject
to refund under Sec. 1.7519-2T.
(2) Special rule if Form 720 used to satisfy return requirement. If,
pursuant to Sec. 1.7519-2T (a)(3), a partnership or S corporation must
use Form 720, ``Quarterly Federal Excise Tax Return,'' to satisfy the
return requirement of Sec. 1.7519-2T (a)(2), then in addition to
following the general rules provided in Sec. 1.7519-2T, the partnership
or S corporation must type or legibly print the words ``ACTIVATING BACK-
UP ELECTION'' on the top of Form 720. A partnership or S corporation
that would otherwise file a Form 720 on or before the date specified in
paragraph (b)(4)(iii)(A)(1) of this section may satisfy the return
requirement by including the necessary information on such Form 720.
Alternatively, such partnership or S corporation may file an additional
Form 720 (i.e., a Form 720 separate from the Form 720 it would otherwise
file). Thus, for example, if the due date for activating an S
corporation's back-up election is November 15, 1988, and the S
corporation must file a Form 720 by October 31, 1988, to report
manufacturers excise tax for the third quarter of 1988, the S
corporation may use that Form 720 to activate its back-up election.
Alternatively, the S corporation may file its regular Form 720 that is
due October 31, 1988, and file an additional Form 720 by November 15,
1988, activating its back-up election.
(B) Personal service corporations. A back-up section 444 election
made by a personal service corporation is activated by filing Form 8716
with the personal service corporation's original or
[[Page 47]]
amended income tax return for the taxable year in which the election is
first effective, and typing or legibly printing the words--``ACTIVATING
BACK-UP ELECTION'' on the top of such income tax return.
(iv) Examples. The provisions of this paragraph (b)(4) may be
illustrated by the following examples. Also see example (2) in paragraph
(b)(3) of this section.
Example (1). E, a partnership that historically used a June 30
taxable year, requested (pursuant to section 6 of Rev. Proc. 87-32,
1987-28 I.R.B. 14) permission from the Commissioner to retain a June 30
taxable year for its taxable year beginning July 1, 1987. Furthermore, E
is qualified to make a section 444 election to retain a June 30 taxable
year for its taxable year beginning July 1, 1987. However, as of the
date specified in paragraph (b)(2) of this section, the Commissioner has
not determined whether E has a valid business purpose for retaining its
June 30 taxable year. Based on these facts, E may, by the date specified
in paragraph (b)(2) of this section, make a back-up section 444 election
to retain its June 30 taxable year.
Example (2). The facts are the same as in example (1). In addition,
on August 12, 1988, the Internal Revenue Service notifies E that its
business purpose request is denied. E asks for reconsideration of the
Service's decision, and the Service sustains the original denial on
September 30, 1988. Based on these facts, E must activate its back-up
section 444 election within 60 days after September 30, 1988.
Example (3). The facts are the same as in example (1), except that E
desires to make a section 444 election to use a year ending September 30
for its taxable year beginning July 1, 1987. Although E qualifies to
make a section 444 election to retain its June 30 taxable year, E may
make a back-up section 444 election for a September 30 taxable year.
(c) Administrative relief--(1) Extension of time to file income tax
returns--(i) Automatic extension. If a partnership, S corporation, or
personal service corporation makes a section 444 election (or does not
make a section 444 election, either because it is ineligible or because
it decides not to make the election, and therefore changes to its
required taxable year) for its first taxable year beginning after
December 31, 1986, the due date for filing its income tax return for
such year shall be the later of--
(A) The due date established under--
(1) Section 6072, in the case of Form 1065,
(2) Sec. 1.6037-1 (b), in the case of Form 1120S,
(3) Section 6072 (b), in the case of other Form 1120 series form; or
(B) August 15, 1988.
The words ``SECTION 444 RETURN'' should, in order to allow the Service
to process the affected returns in an efficient manner, be typed or
legibly printed at the top of the Form 1065 or Form 1120 series form,
whichever is applicable, filed under this paragraph (c)(1)(i).
(ii) Additional extensions. If the due date of the income tax return
for the first taxable year beginning after December 31, 1986, extended
as provided in paragraph (c)(1)(i)(B) of this section, occurs before the
date that is 6 months after the date specified in paragraph (c)(1)(i)(A)
of this section, the partnership, S corporation, or personal service
corporation may request an additional extension or extensions of time
(up to 6 months after the date specified in paragraph (c)(1)(i)(A) of
this section) to file its income tax return for such first taxable year.
The request must be made by the later of the date specified in paragraph
(c)(1)(i)(A) or (c)(1)(i)(B) of this section and must be made on Form
7004, ``Application for Automatic Extension of Time To File Corporation
Income Tax Return'', or Form 2758, ``Application for Extension of Time
to File U.S. Partnership, Fiduciary, and Certain Other Returns,''
whichever is applicable, in accordance with the form and its
instructions. In addition, the following words should be typed or
legibly printed at the top of the form--``SECTION 444 REQUEST FOR
ADDITIONAL EXTENSION.''
(iii) Examples. The provisions of paragraph (c)(1) of this section
may be illustrated by the following examples.
Example (1). G, a partnership that historically used a January 31
taxable year, makes a section 444 election to retain such year for its
taxable year beginning February 1, 1987. Absent paragraph (c)(1)(i) of
this section, G's Form 1065 for the taxable year ending January 31,
1988, is due on or before May 15, 1988. However, if G types or legibly
prints ``SECTION 444 RETURN'' at the top of Form 1065 for such year,
paragraph (c)(1)(i) of this section automatically extends the due date
of such return to August 15, 1988.
Example (2). The facts are the same as in example (1), except that G
desires to extend the due date of its income tax return for the
[[Page 48]]
year ending January 31, 1988, to a date beyond August 15, 1988. Pursuant
to paragraph (c)(1)(ii) of this section, G may extend such return to
November 15, 1988 (i.e., the date that is up to 6 months after May 15,
1988, the normal due date of the return). However, in order to obtain
this additional extension, G must file Form 2758 pursuant to paragraph
(c)(1)(i) of this section on or before August 15, 1988.
Example (3). H, a partnership that historically used a May 31
taxable year, makes a section 444 election to use a year ending
September 30 for its taxable year beginning on June 1, 1987. Absent
paragraph (c)(1)(i) of this section, H's Form 1065 for the taxable year
beginning June 1, 1987, and ending September 30, 1987, is due on or
before January 15, 1988. However, if H types or legibly prints ``SECTION
444 RETURN'' at the top of Form 1065 for such year, paragraph (c)(1)(i)
of this section automatically extends the due date of such return to
August 15, 1988.
Example (4). The facts are the same as in example (3), except H
desires to further extend (i.e., extend beyond August 15, 1988) the due
date of its income tax return for its taxable year beginning June 1,
1987, and ending September 30, 1987. Since August 15, 1988, is 6 months
or more after the due date (without extensions) of such return,
paragraph (c)(1)(ii) of this section prevents H from further extending
the time for filing such return.
Example (5). I, a partnership that historically used a June 30
taxable year, considered making a section 44 election to retain such
taxable year, but eventually decided to change to a December 31, taxable
year (I's required taxable year). Absent paragraph (c)(1)(i) of this
section, I's Form 1065 for the taxable year beginning July 1, 1987, and
ending December 31, 1987, is due on or before April 15, 1988. Pursuant
to paragraph (c)(1)(i) of this section, if I types or legibly prints
``SECTION 444 RETURN'' at the top of Form 1065 for such year, paragraph
(c)(1)(i) of this section automatically extends the due date of such
return to August 15, 1988. In addition, I may further extend such return
pursuant to paragraph (c)(1)(ii) of this section.
(2) No penalty for certain late payments--(i) In general. In the
case of a personal service corporation or S corporation described in
paragraph (c)(1)(i) of this section, no penalty under section 6651
(a)(2) will be imposed for failure to pay income tax (if any) for the
first taxable year beginning after December 31, 1986, but only for the
period beginning with the last date for payment and ending with the
later of the date specified in paragraph (c)(1)(i) or paragraph
(c)(1)(ii) of this section.
(ii) Example. The provisions of paragraph (c)(2)(i) of this section
may be illustrated by the following example.
Example. J, a personal service corporation that historically used a
January 31 taxable year, makes a section 444 election to retain such
year for its taxable year beginning February 1, 1987. The last date
(without extension) for payment of J's income tax (if any) for its
taxable year beginning February 1, 1987, is April 15, 1988. However,
under paragraph (c)(2)(i) of this section, no penalty under section
6651(a)(2) will be imposed on any underpayment of income tax for the
period beginning April 15, 1988 and ending August 15, 1988.
(d) Effective date. This section is effective for taxable years
beginning after December 31, 1986.
[T.D. 8205, 53 FR 19703, May 27, 1988]
Sec. 1.444-4 Tiered structure.
(a) Electing small business trusts. For purposes of Sec. 1.444-2T,
solely with respect to an S corporation shareholder, the term deferral
entity does not include a trust that is treated as an electing small
business trust under section 1361(e). An S corporation with an electing
small business trust as a shareholder may make an election under section
444. This paragraph is applicable to taxable years beginning on and
after December 29, 2000; however, taxpayers may voluntarily apply it to
taxable years of S corporations beginning after December 31, 1996.
(b) Certain tax-exempt trusts. For purposes of Sec. 1.444-2T, solely
with respect to an S corporation shareholder, the term deferral entity
does not include a trust that is described in section 401(a) or
501(c)(3), and is exempt from taxation under section 501(a). An S
corporation with a trust as a shareholder that is described in section
401(a) or section 501(c)(3), and is exempt from taxation under section
501(a) may make an election under section 444. This paragraph is
applicable to taxable years beginning on and after December 29, 2000;
however taxpayers may voluntarily apply it to taxable years of S
corporations beginning after December 31, 1997.
(c) Certain terminations disregarded--(1) In general. An S
corporation that is
[[Page 49]]
described in this paragraph (c)(1) may request that a termination of its
election under section 444 be disregarded, and that the S corporation be
permitted to resume use of the year it previously elected under section
444, by following the procedures of paragraph (c)(2) of this section. An
S corporation is described in this paragraph if the S corporation is
otherwise qualified to make a section 444 election, and its previous
election was terminated under Sec. 1.444-2T(a) solely because--
(i) In the case of a taxable year beginning after December 31, 1996,
a trust that is treated as an electing small business trust became a
shareholder of such S corporation; or
(ii) In the case of a taxable year beginning after December 31,
1997, a trust that is described in section 401(a) or 501(c)(3), and is
exempt from taxation under section 501(a) became a shareholder of such S
corporation.
(2) Procedure--(i) In general. An S corporation described in
paragraph (c)(1) of this section that wishes to make the request
described in paragraph (c)(1) of this section must do so by filing Form
8716, ``Election To Have a Tax Year Other Than a Required Tax Year,''
and typing or printing legibly at the top of such form--``CONTINUATION
OF SECTION 444 ELECTION UNDER Sec. 1.444-4.'' In order to assist the
Internal Revenue Service in updating the S corporation's account, on
Line 5 the Box ``Changing to'' should be checked. Additionally, the
election month indicated must be the last month of the S corporation's
previously elected section 444 election year, and the effective year
indicated must end in 2002.
(ii) Time and place for filing Form 8716. Such form must be filed on
or before October 15, 2002, with the service center where the S
corporation's returns of tax (Forms 1120S) are filed. In addition, a
copy of the Form 8716 should be attached to the S corporation's short
period Federal income tax return for the first election year beginning
on or after January 1, 2002.
(3) Effect of request--(i) Taxable years beginning on or after
January 1, 2002. An S corporation described in paragraph (c)(1) of this
section that requests, in accordance with this paragraph, that a
termination of its election under section 444 be disregarded will be
permitted to resume use of the year it previously elected under section
444, commencing with its first taxable year beginning on or after
January 1, 2002. Such S corporation will be required to file a return
under Sec. 1.7519-2T for each taxable year beginning on or after January
1, 2002. No payment under section 7519 will be due with respect to the
first taxable year beginning on or after January 1, 2002. However, a
required payment will be due on or before May 15, 2003, with respect to
such S corporation's second continued section 444 election year that
begins in calendar year 2002.
(ii) Taxable years beginning prior to January 1, 2002. An S
corporation described in paragraph (c)(1) of this section that requests,
in accordance with this paragraph, that a termination of its election
under section 444 be disregarded will not be required to amend any prior
Federal income tax returns, make any required payments under section
7519, or file any returns under Sec. 1.7519-2T, with respect to taxable
years beginning on or after the date the termination of its section 444
election was effective and prior to January 1, 2002.
(iii) Section 7519: required payments and returns. The Internal
Revenue Service waives any requirement for an S corporation described in
paragraph (c)(1) of this section to file the federal tax returns and
make any required payments under section 7519 for years prior to the
taxable year of continuation as described in paragraph (c)(3)(i) of this
section, if for such years the S corporation filed its federal income
tax returns on the basis of its required taxable year.
[T.D. 8994, 67 FR 34394, May 14, 2002]
Methods of Accounting
methods of accounting in general
Sec. 1.446-1 General rule for methods of accounting.
(a) General rule. (1) Section 446(a) provides that taxable income
shall be computed under the method of accounting on the basis of which a
taxpayer regularly computes his income in keeping his books. The term
``method
[[Page 50]]
of accounting'' includes not only the overall method of accounting of
the taxpayer but also the accounting treatment of any item. Examples of
such over-all methods are the cash receipts and disbursements method, an
accrual method, combinations of such methods, and combinations of the
foregoing with various methods provided for the accounting treatment of
special items. These methods of accounting for special items include the
accounting treatment prescribed for research and experimental
expenditures, soil and water conservation expenditures, depreciation,
net operating losses, etc. Except for deviations permitted or required
by such special accounting treatment, taxable income shall be computed
under the method of accounting on the basis of which the taxpayer
regularly computes his income in keeping his books. For requirement
respecting the adoption or change of accounting method, see section
446(e) and paragraph (e) of this section.
(2) It is recognized that no uniform method of accounting can be
prescribed for all taxpayers. Each taxpayer shall adopt such forms and
systems as are, in his judgment, best suited to his needs. However, no
method of accounting is acceptable unless, in the opinion of the
Commissioner, it clearly reflects income. A method of accounting which
reflects the consistent application of generally accepted accounting
principles in a particular trade or business in accordance with accepted
conditions or practices in that trade or business will ordinarily be
regarded as clearly reflecting income, provided all items of gross
income and expense are treated consistently from year to year.
(3) Items of gross income and expenditures which are elements in the
computation of taxable income need not be in the form of cash. It is
sufficient that such items can be valued in terms of money. For general
rules relating to the taxable year for inclusion of income and for
taking deductions, see sections 451 and 461, and the regulations
thereunder.
(4) Each taxpayer is required to make a return of his taxable income
for each taxable year and must maintain such accounting records as will
enable him to file a correct return. See section 6001 and the
regulations thereunder. Accounting records include the taxpayer's
regular books of account and such other records and data as may be
necessary to support the entries on his books of account and on his
return, as for example, a reconciliation of any differences between such
books and his return. The following are among the essential features
that must be considered in maintaining such records:
(i) In all cases in which the production, purchase, or sale of
merchandise of any kind is an income-producing factor, merchandise on
hand (including finished goods, work in process, raw materials, and
supplies) at the beginning and end of the year shall be taken into
account in computing the taxable income of the year. (For rules relating
to computation of inventories, see section 263A, 471, and 472 and the
regulations thereunder.)
(ii) Expenditures made during the year shall be properly classified
as between capital and expense. For example, expenditures for such items
as plant and equipment, which have a useful life extending substantially
beyond the taxable year, shall be charged to a capital account and not
to an expense account.
(iii) In any case in which there is allowable with respect to an
asset a deduction for depreciation, amortization, or depletion, any
expenditures (other than ordinary repairs) made to restore the asset or
prolong its useful life shall be added to the asset account or charged
against the appropriate reserve.
(b) Exceptions. (1) If the taxpayer does not regularly employ a
method of accounting which clearly reflects his income, the computation
of taxable income shall be made in a manner which, in the opinion of the
Commissioner, does clearly reflect income.
(2) A taxpayer whose sole source of income is wages need not keep
formal books in order to have an accounting method. Tax returns, copies
thereof, or other records may be sufficient to establish the use of the
method of accounting used in the preparation of the taxpayer's income
tax returns.
(c) Permissible methods--(1) In general. Subject to the provisions
of paragraphs (a) and (b) of this section, a taxpayer
[[Page 51]]
may compute his taxable income under any of the following methods of
accounting:
(i) Cash receipts and disbursements method. Generally, under the
cash receipts and disbursements method in the computation of taxable
income, all items which constitute gross income (whether in the form of
cash, property, or services) are to be included for the taxable year in
which actually or constructively received. Expenditures are to be
deducted for the taxable year in which actually made. For rules relating
to constructive receipt, see Sec. 1.451-2. For treatment of an
expenditure attributable to more than one taxable year, see section
461(a) and paragraph (a)(1) of Sec. 1.461-1.
(ii) Accrual method. (A) Generally, under an accrual method, income
is to be included for the taxable year when all the events have occurred
that fix the right to receive the income and the amount of the income
can be determined with reasonable accuracy. Under such a method, a
liability is incurred, and generally is taken into account for Federal
income tax purposes, in the taxable year in which all the events have
occurred that establish the fact of the liability, the amount of the
liability can be determined with reasonable accuracy, and economic
performance has occurred with respect to the liability. (See paragraph
(a)(2)(iii)(A) of Sec. 1.461-1 for examples of liabilities that may not
be taken into account until after the taxable year incurred, and see
Secs. 1.461-4 through 1.461-6 for rules relating to economic
performance.) Applicable provisions of the Code, the Income Tax
Regulations, and other guidance published by the Secretary prescribe the
manner in which a liability that has been incurred is taken into
account. For example, section 162 provides that a deductible liability
generally is taken into account in the taxable year incurred through a
deduction from gross income. As a further example, under section 263 or
263A, a liability that relates to the creation of an asset having a
useful life extending substantially beyond the close of the taxable year
is taken into account in the taxable year incurred through
capitalization (within the meaning of Sec. 1.263A-1(c)(3)) and may later
affect the computation of taxable income through depreciation or
otherwise over a period including subsequent taxable years, in
accordance with applicable Internal Revenue Code sections and related
guidance.
(B) The term ``liability'' includes any item allowable as a
deduction, cost, or expense for Federal income tax purposes. In addition
to allowable deductions, the term includes any amount otherwise
allowable as a capitalized cost, as a cost taken into account in
computing cost of goods sold, as a cost allocable to a long-term
contract, or as any other cost or expense. Thus, for example, an amount
that a taxpayer expends or will expend for capital improvements to
property must be incurred before the taxpayer may take the amount into
account in computing its basis in the property. The term ``liability''
is not limited to items for which a legal obligation to pay exists at
the time of payment. Thus, for example, amounts prepaid for goods or
services and amounts paid without a legal obligation to do so may not be
taken into account by an accrual basis taxpayer any earlier than the
taxable year in which those amounts are incurred.
(C) No method of accounting is acceptable unless, in the opinion of
the Commissioner, it clearly reflects income. The method used by the
taxpayer in determining when income is to be accounted for will
generally be acceptable if it accords with generally accepted accounting
principles, is consistently used by the taxpayer from year to year, and
is consistent with the Income Tax Regulations. For example, a taxpayer
engaged in a manufacturing business may account for sales of the
taxpayer's product when the goods are shipped, when the product is
delivered or accepted, or when title to the goods passes to the
customers, whether or not billed, depending on the method regularly
employed in keeping the taxpayer's books.
(iii) Other permissible methods. Special methods of accounting are
described elsewhere in chapter 1 of the Code and the regulations
thereunder. For example, see the following sections and the regulations
thereunder: Sections 61 and
[[Page 52]]
162, relating to the crop method of accounting; section 453, relating to
the installment method; section 460, relating to the long-term contract
methods. In addition, special methods of accounting for particular items
of income and expense are provided under other sections of chapter 1.
For example, see section 174, relating to research and experimental
expenditures, and section 175, relating to soil and water conservation
expenditures.
(iv) Combinations of the foregoing methods. (a) In accordance with
the following rules, any combination of the foregoing methods of
accounting will be permitted in connection with a trade or business if
such combination clearly reflects income and is consistently used. Where
a combination of methods of accounting includes any special methods,
such as those referred to in subdivision (iii) of this subparagraph, the
taxpayer must comply with the requirements relating to such special
methods. A taxpayer using an accrual method of accounting with respect
to purchases and sales may use the cash method in computing all other
items of income and expense. However, a taxpayer who uses the cash
method of accounting in computing gross income from his trade or
business shall use the cash method in computing expenses of such trade
or business. Similarly, a taxpayer who uses an accrual method of
accounting in computing business expenses shall use an accrual method in
computing items affecting gross income from his trade or business.
(b) A taxpayer using one method of accounting in computing items of
income and deductions of his trade or business may compute other items
of income and deductions not connected with his trade or business under
a different method of accounting.
(2) Special rules. (i) In any case in which it is necessary to use
an inventory the accrual method of accounting must be used with regard
to purchases and sales unless otherwise authorized under subdivision
(ii) of this subparagraph.
(ii) No method of accounting will be regarded as clearly reflecting
income unless all items of gross profit and deductions are treated with
consistency from year to year. The Commissioner may authorize a taxpayer
to adopt or change to a method of accounting permitted by this chapter
although the method is not specifically described in the regulations in
this part if, in the opinion of the Commissioner, income is clearly
reflected by the use of such method. Further, the Commissioner may
authorize a taxpayer to continue the use of a method of accounting
consistently used by the taxpayer, even though not specifically
authorized by the regulations in this part, if, in the opinion of the
Commissioner, income is clearly reflected by the use of such method. See
section 446(a) and paragraph (a) of this section, which require that
taxable income shall be computed under the method of accounting on the
basis of which the taxpayer regularly computes his income in keeping his
books, and section 446(e) and paragraph (e) of this section, which
require the prior approval of the Commissioner in the case of changes in
accounting method.
(iii) The timing rules of Sec. 1.1502-13 are a method of accounting
for intercompany transactions (as defined in Sec. 1.1502-13(b)(1)(i)),
to be applied by each member of a consolidated group in addition to the
member's other methods of accounting. See Sec. 1.1502-13(a)(3)(i). This
paragraph (c)(2)(iii) is applicable to consolidated return years
beginning on or after November 7, 2001.
(d) Taxpayer engaged in more than one business. (1) Where a taxpayer
has two or more separate and distinct trades or businesses, a different
method of accounting may be used for each trade or business, provided
the method used for each trade or business clearly reflects the income
of that particular trade or business. For example, a taxpayer may
account for the operations of a personal service business on the cash
receipts and disbursements method and of a manufacturing business on an
accrual method, provided such businesses are separate and distinct and
the methods used for each clearly reflect income. The method first used
in accounting for business income and deductions in connection with each
trade or business, as evidenced in the taxpayer's income tax return in
which
[[Page 53]]
such income or deductions are first reported, must be consistently
followed thereafter.
(2) No trade or business will be considered separate and distinct
for purposes of this paragraph unless a complete and separable set of
books and records is kept for such trade or business.
(3) If, by reason of maintaining different methods of accounting,
there is a creation or shifting of profits or losses between the trades
or businesses of the taxpayer (for example, through inventory
adjustments, sales, purchases, or expenses) so that income of the
taxpayer is not clearly reflected, the trades or businesses of the
taxpayer will not be considered to be separate and distinct.
(e) Requirement respecting the adoption or change of accounting
method. (1) A taxpayer filing his first return may adopt any permissible
method of accounting in computing taxable income for the taxable year
covered by such return. See section 446(c) and paragraph (c) of this
section for permissible methods. Moreover, a taxpayer may adopt any
permissible method of accounting in connection with each separate and
distinct trade or business, the income from which is reported for the
first time. See section 446(d) and paragraph (d) of this section. See
also section 446(a) and paragraph (a) of this section.
(2)(i) Except as otherwise expressly provided in chapter 1 of the
Code and the regulations thereunder, a taxpayer who changes the method
of accounting employed in keeping his books shall, before computing his
income upon such new method for purposes of taxation, secure the consent
of the Commissioner. Consent must be secured whether or not such method
is proper or is permitted under the Internal Revenue Code or the
regulations thereunder.
(ii)(a) A change in the method of accounting includes a change in
the overall plan of accounting for gross income or deductions or a
change in the treatment of any material item used in such overall plan.
Although a method of accounting may exist under this definition without
the necessity of a pattern of consistent treatment of an item, in most
instances a method of accounting is not established for an item without
such consistent treatment. A material item is any item which involves
the proper time for the inclusion of the item in income or the taking of
a deduction. Changes in method of accounting include a change from the
cash receipts and disbursement method to an accrual method, or vice
versa, a change involving the method or basis used in the valuation of
inventories (see sections 471 and 472 and the regulations thereunder), a
change from the cash or accrual method to a long-term contract method,
or vice versa (see Sec. 1.460-4), a change involving the adoption, use
or discontinuance of any other specialized method of computing taxable
income, such as the crop method, and a change where the Internal Revenue
Code and regulations thereunder specifically require that the consent of
the Commissioner must be obtained before adopting such a change.
(b) A change in method of accounting does not include correction of
mathematical or posting errors, or errors in the computation of tax
liability (such as errors in computation of the foreign tax credit, net
operating loss, percentage depletion or investment credit). Also, a
change in method of accounting does not include adjustment of any item
of income or deduction which does not involve the proper time for the
inclusion of the item of income or the taking of a deduction. For
example, corrections of items that are deducted as interest or salary,
but which are in fact payments of dividends, and of items that are
deducted as business expenses, but which are in fact personal expenses,
are not changes in method of accounting. In addition, a change in the
method of accounting does not include an adjustment with respect to the
addition to a reserve for bad debts or an adjustment in the useful life
of a depreciable asset. Although such adjustments may involve the
question of the proper time for the taking of a deduction, such items
are traditionally corrected by adjustments in the current and future
years. For the treatment of the adjustment of the addition to a bad debt
reserve, see the regulations under section 166 of the Code; for the
treatment of a change in the useful life of a depreciable asset, see the
regulations under section 167(b) of the Code.
[[Page 54]]
A change in the method of accounting also does not include a change in
treatment resulting from a change in underlying facts. On the other
hand, for example, a correction to require depreciation in lieu of a
deduction for the cost of a class of depreciable assets which has been
consistently treated as an expense in the year of purchase involves the
question of the proper timing of an item, and is to be treated as a
change in method of accounting.
(c) A change in an overall plan or system of identifying or valuing
items in inventory is a change in method of accounting. Also a change in
the treatment of any material item used in the overall plan for
identifying or valuing items in inventory is a change in method of
accounting.
(iii) A change in the method of accounting may be illustrated by the
following examples:
Example (1). Although the sale of merchandise is an income producing
factor, and therefore inventories are required, a taxpayer in the retail
jewelry business reports his income on the cash receipts and
disbursements method of accounting. A change from the cash receipts and
disbursements method of accounting to the accrual method of accounting
is a change in the overall plan of accounting and thus is a change in
method of accounting.
Example (2). A taxpayer in the wholesale dry goods business computes
its income and expenses on the accrual method of accounting and files
its Federal income tax returns on such basis except for real estate
taxes which have been reported on the cash receipts and disbursements
method of accounting. A change in the treatment of real estate taxes
from the cash receipts and disbursements method to the accrual method is
a change in method of accounting because such change is a change in the
treatment of a material item within his overall accounting practice.
Example (3). A taxpayer in the wholesale dry goods business computes
its income and expenses on the accrual method of accounting and files
its Federal income tax returns on such basis. Vacation pay has been
deducted in the year in which paid because the taxpayer did not have a
completely vested vacation pay plan, and, therefore, the liability for
payment did not accrue until that year. Subsequently, the taxpayer
adopts a completely vested vacation pay plan that changes its year for
accruing the deduction from the year in which payment is made to the
year in which the liability to make the payment now arises. The change
for the year of deduction of the vacation pay plan is not a change in
method of accounting but results, instead, because the underlying facts
(that is, the type of vacation pay plan) have changed.
Example (4). From 1968 through 1970, a taxpayer has fairly allocated
indirect overhead costs to the value of inventories on a fixed
percentage of direct costs. If the ratio of indirect overhead costs to
direct costs increases in 1971, a change in the underlying facts has
occurred. Accordingly, an increase in the percentage in 1971 to fairly
reflect the increase in the relative level of indirect overhead costs is
not a change in method of accounting but is a change in treatment
resulting from a change in the underlying facts.
Example (5). A taxpayer values inventories at cost. A change in the
basis for valuation of inventories from cost to the lower of cost or
market is a change in an overall practice of valuing items in inventory.
The change, therefore, is a change of method of accounting for
inventories.
Example (6). A taxpayer in the manufacturing business has for many
taxable years valued its inventories at cost. However, cost has been
improperly computed since no overhead costs have been included in
valuing the inventories at cost. The failure to allocate an appropriate
portion of overhead to the value of inventories is contrary to the
requirement of the Internal Revenue Code and the regulations thereunder.
A change requiring appropriate allocation of overhead is a change in
method of accounting because it involves a change in the treatment of a
material item used in the overall practice of identifying or valuing
items in inventory.
Example (7). A taxpayer has for many taxable years valued certain
inventories by a method which provides for deducting 20 percent of the
cost of the inventory items in determining the final inventory
valuation. The 20 percent adjustment is taken as a ``reserve for price
changes.'' Although this method is not a proper method of valuing
inventories under the Internal Revenue Code or the regulations
thereunder, it involves the treatment of a material item used in the
overall practice of valuing inventory. A change in such practice or
procedure is a change of method of accounting for inventories.
Example (8). A taxpayer has always used a base stock system of
accounting for inventories. Under this system a constant price is
applied to an assumed constant normal quantity of goods in stock. The
base stock system is an overall plan of accounting for inventories which
is not recognized as a proper method of accounting for inventories under
the regulations. A change in this practice is, nevertheless, a change of
method of accounting for inventories.
[[Page 55]]
(3)(i) Except as otherwise provided under the authority of paragraph
(e)(3)(ii) of this section, to secure the Commissioner's consent to a
taxpayer's change in method of accounting the taxpayer must file an
application on Form 3115 with the Commissioner during the taxable year
in which the taxpayer desires to make the change in method of
accounting. To the extent applicable, the taxpayer must furnish all
information requested on the Form 3115. This information includes all
classes of items that will be treated differently under the new method
of accounting, any amounts that will be duplicated or omitted as a
result of the proposed change, and the taxpayer's computation of any
adjustments necessary to prevent such duplications or omissions. The
Commissioner may require such other information as may be necessary to
determine whether the proposed change will be permitted. Permission to
change a taxpayer's method of accounting will not be granted unless the
taxpayer agrees to the Commissioner's prescribed terms and conditions
for effecting the change, including the taxable year or years in which
any adjustment necessary to prevent amounts from being duplicated or
omitted is to be taken into account. See section 481 and the regulations
thereunder, relating to certain adjustments resulting from accounting
method changes, and section 472 and the regulations thereunder, relating
to adjustments for changes to and from the last-in, first-out inventory
method. For any Form 3115 filed on or after May 15, 1997, see
Sec. 1.446-1T(e)(3)(i)(B).
(ii) Notwithstanding the provisions of paragraph (e)(3)(i) of this
section, the Commissioner may prescribe administrative procedures under
which taxpayers will be permitted to change their method of accounting.
The administrative procedures shall prescribe those terms and conditions
necessary to obtain the Commissioner's consent to effect the change and
to prevent amounts from being duplicated or omitted. The terms and
conditions that may be prescribed by the Commissioner may include terms
and conditions that require the change in method of accounting to be
effected on a cut-off basis or by an adjustment under section 481(a) to
be taken into account in the taxable year or years prescribed by the
Commissioner.
(iii) This paragraph (e)(3) applies to Forms 3115 filed on or after
December 31, 1997. For other Forms 3115, see Sec. 1.446-1(e)(3) in
effect prior to December 31, 1997 (Sec. 1.446-1(e)(3) as contained in
the 26 CFR part 1 edition revised as of April 1, 1997).
[T.D. 6500, 25 FR 11708, Nov. 26, 1960, as amended by T.D. 7073, 35 FR
17710, Nov. 18, 1970; T.D. 7285, 38 FR 26184, Sept. 19, 1973; T.D. 8067,
51 FR 378, Jan. 6, 1986; T.D. 8131, 52 FR 10084, Mar. 30, 1987; T.D.
8408, 57 FR 12419, Apr. 10, 1992; T.D. 8482, 58 FR 42233, Aug. 9, 1993;
T.D. 8608, 60 FR 40078, Aug. 7, 1995; T.D. 8719, 62 FR 26741, May 15,
1997; T.D. 8742, 62 FR 68169, Dec. 31, 1997; T.D. 8929, 66 FR 2223, Jan.
11, 2001; T.D. 9025, 67 FR 76985, Dec. 16, 2002]
Sec. 1.446-2 Method of accounting for interest.
(a) Applicability--(1) In general. This section provides rules for
determining the amount of interest that accrues during an accrual period
(other than interest described in paragraph (a)(2) of this section) and
for determining the portion of a payment that consists of accrued
interest. For purposes of this section, interest includes original issue
discount and amounts treated as interest (whether stated or unstated) in
any lending or deferred payment transaction. Accrued interest determined
under this section is taken into account by a taxpayer under the
taxpayer's regular method of accounting (e.g., an accrual method or the
cash receipts and disbursements method). Application of an exception
described in paragraph (a)(2) of this section to one party to a
transaction does not affect the application of this section to any other
party to the transaction.
(2) Exceptions--(i) Interest included or deducted under certain
other provisions. This section does not apply to interest that is taken
into account under--
(A) Sections 1272(a), 1275, and 163(e) (income and deductions
relating to original issue discount);
(B) Section 467(a)(2) (certain payments for the use of property or
services);
(C) Sections 1276 through 1278 (market discount);
[[Page 56]]
(D) Sections 1281 through 1283 (discount on certain short-term
obligations);
(E) Section 7872(a) (certain loans with below-market interest
rates); or
(F) Section 1.1272-3 (an election by a holder to treat all interest
on a debt instrument as original issue discount).
(ii) De minimis original issue discount. This section does not apply
to de minimis original issue discount (other than de minimis original
issue discount treated as qualified stated interest) as determined under
Sec. 1.1273-1(d). See Sec. 1.163-7 for the treatment of de minimis
original issue discount by the issuer and Secs. 1.1273-1(d) and 1.1272-3
for the treatment of de minimis original issue discount by the holder.
(b) Accrual of qualified stated interest. Qualified stated interest
(as defined in Sec. 1.1273-1(c)) accrues ratably over the accrual period
(or periods) to which it is attributable and accrues at the stated rate
for the period (or periods).
(c) Accrual of interest other than qualified stated interest.
Subject to the modifications in paragraph (d) of this section, the
amount of interest (other than qualified stated interest) that accrues
for any accrual period is determined under rules similar to those in the
regulations under sections 1272 and 1275 for the accrual of original
issue discount. The preceding sentence applies regardless of any
contrary formula agreed to by the parties.
(d) Modifications--(1) Issue price. The issue price of the loan or
contract is equal to--
(i) In the case of a contract for the sale or exchange of property
to which section 483 applies, the amount described in Sec. 1.483-
2(a)(1)(i) or (ii), whichever is applicable;
(ii) In the case of a contract for the sale or exchange of property
to which section 483 does not apply, the stated principal amount; or
(iii) In any other case, the amount loaned.
(2) Principal payments that are not deferred payments. In the case
of a contract to which section 483 applies, principal payments that are
not deferred payments are ignored for purposes of determining yield and
adjusted issue price.
(e) Allocation of interest to payments--(1) In general. Except as
provided in paragraphs (e)(2), (e)(3), and (e)(4) of this section, each
payment under a loan (other than payments of additional interest or
similar charges provided with respect to amounts that are not paid when
due) is treated as a payment of interest to the extent of the accrued
and unpaid interest determined under paragraphs (b) and (c) of this
section as of the date the payment becomes due.
(2) Special rule for points deductible under section 461(g)(2). If a
payment of points is deductible by the borrower under section 461(g)(2),
the payment is treated by the borrower as a payment of interest.
(3) Allocation respected in certain small transactions. [Reserved]
(4) Pro rata prepayments. Accrued but unpaid interest is allocated
to a pro rata prepayment under rules similar to those for allocating
accrued but unpaid original issue discount to a pro rata prepayment
under Sec. 1.1275-2(f). For purposes of the preceding sentence, a pro
rata prepayment is a payment that is made prior to maturity that--
(i) Is not made pursuant to the contract's payment schedule; and
(ii) Results in a substantially pro rata reduction of each payment
remaining to be paid on the contract.
(f) Aggregation rule. For purposes of this section, all contracts
calling for deferred payments arising from the same transaction (or a
series of related transactions) are treated as a single contract. This
rule, however, generally only applies to contracts involving a single
borrower and a single lender.
(g) Debt instruments denominated in a currency other than the U.S.
dollar. This section applies to a debt instrument that provides for all
payments denominated in, or determined by reference to, the functional
currency of the taxpayer or qualified business unit of the taxpayer
(even if that currency is other than the U.S. dollar). See Sec. 1.988-
2(b) to determine interest income or expense for debt instruments that
provide for payments denominated in, or determined by reference to, a
nonfunctional currency.
(h) Example. The following example illustrates the rules of this
section.
[[Page 57]]
Example. Allocation of unstated interest to deferred payments--(i)
Facts. On July 1, 1996, A sells his personal residence to B for a stated
purchase price of $1,297,143.66. The property is not personal use
property (within the meaning of section 1275(b)(3)) in the hands of B.
Under the loan agreement, B is required to make two installment payments
of $648,571.83 each, the first due on June 30, 1998, and the second due
on June 30, 2000. Both A and B use the cash receipts and disbursements
method of accounting and use a calendar year for their taxable year.
(ii) Amount of unstated interest. Under section 483, the agreement
does not provide for adequate stated interest. Thus, the loan's yield is
the test rate of interest determined under Sec. 1.483-3. Assume that
both A and B use annual accrual periods and that the test rate of
interest is 9.2 percent, compounded annually. Under Sec. 1.483-2, the
present value of the deferred payments is $1,000,000. Thus, the
agreement has unstated interest of $297,143.66.
(iii) First two accrual periods. Under paragraph (d)(1) of this
section, the issue price at the beginning of the first accrual period is
$1,000,000 (the amount described in Sec. 1.483-2(a)(1)(i)). Under
paragraph (c) of this section, the amount of interest that accrues for
the first accrual period is $92,000 ($1,000,000x.092) and the amount of
interest that accrues for the second accrual period is $100,464
($1,092,000x.092). Thus, $192,464 of interest has accrued as of the end
of the second accrual period. Under paragraph (e)(1) of this section,
the $648,571.83 payment made on June 30, 1998, is treated first as a
payment of interest to the extent of $192,464. The remainder of the
payment ($456,107.83) is treated as a payment of principal. Both A and B
take the payment of interest ($192,464) into account in 1998.
(iv) Second two accrual periods. The adjusted issue price at the
beginning of the third accrual period is $543,892.17
($1,092,000+$100,464-$648,571.83). The amount of interest that accrues
for the third accrual period is $50,038.08 ($543,892.17x.092) and the
amount of interest that accrues for the final accrual period is
$54,641.58, the excess of the amount payable at maturity ($648,571.83),
over the adjusted issue price at the beginning of the accrual period
($593,930.25). As of the date the second payment becomes due,
$104,679.66 of interest has accrued. Thus, of the $648,571.83 payment
made on June 30, 2000, $104,679.66 is treated as interest and
$543,892.17 is treated as principal. Both A and B take the payment of
interest ($104,679.66) into account in 2000.
(i) [Reserved]
(j) Effective date. This section applies to debt instruments issued
on or after April 4, 1994, and to lending transactions, sales, and
exchanges that occur on or after April 4, 1994. Taxpayers, however, may
rely on this section for debt instruments issued after December 21,
1992, and before April 4, 1994, and for lending transactions, sales, and
exchanges that occur after December 21, 1992, and before April 4, 1994.
[T.D. 8517, 59 FR 4804, Feb. 2, 1994]
Sec. 1.446-3 Notional principal contracts.
(a) Table of contents. This paragraph (a) lists captioned paragraphs
contained in Sec. 1.446-3.
Sec. 1.446-3 Notional principal contracts.
(a) Table of contents.
(b) Purpose.
(c) Definitions and scope.
(1) Notional principal contract.
(i) In general.
(ii) Excluded contracts.
(iii) Transactions within section 475.
(iv) Transactions within section 988.
(2) Specified index.
(3) Notional principal amount.
(4) Special definitions.
(i) Related person and party to the contract.
(ii) Objective financial information.
(iii) Dealer in notional principal contracts.
(d) Taxable year of inclusion and deduction.
(e) Periodic payments.
(1) Definition.
(2) Recognition rules.
(i) In general.
(ii) Rate set in arrears.
(iii) Notional principal amount set in arrears.
(3) Examples.
(f) Nonperiodic payments.
(1) Definition.
(2) Recognition rules.
(i) In general.
(ii) General rule for swaps.
(iii) Alternative methods for swaps.
(A) Prepaid swaps.
(B) Other nonperiodic swap payments.
(iv) General rule for caps and floors.
(v) Alternative methods for caps and floors that hedge debt
instruments.
(A) Prepaid caps and floors.
(B) Other caps and floors.
(C) Special method for collars.
(vi) Additional methods.
(3) Term of extendible or terminable contracts.
(4) Examples.
(g) Special rules.
(1) Disguised notional principal contracts.
(2) Hedged notional principal contracts.
(3) Options and forwards to enter into notional principal contracts.
[[Page 58]]
(4) Swaps with significant nonperiodic payments.
(5) Caps and floors that are significantly in-the-money. [Reserved]
(6) Examples.
(h) Termination payments.
(1) Definition.
(2) Taxable year of inclusion and deduction by original parties.
(3) Taxable year of inclusion and deduction by assignees.
(4) Special rules.
(i) Assignment of one leg of a contract.
(ii) Substance over form.
(5) Examples.
(i) Anti-abuse rule.
(j) Effective date.
(b) Purpose. The purpose of this section is to enable the clear
reflection of the income and deductions from notional principal
contracts by prescribing accounting methods that reflect the economic
substance of such contracts.
(c) Definitions and scope--(1) Notional principal contract--(i) In
general. A notional principal contract is a financial instrument that
provides for the payment of amounts by one party to another at specified
intervals calculated by reference to a specified index upon a notional
principal amount in exchange for specified consideration or a promise to
pay similar amounts. An agreement between a taxpayer and a qualified
business unit (as defined in section 989(a)) of the taxpayer, or among
qualified business units of the same taxpayer, is not a notional
principal contract because a taxpayer cannot enter into a contract with
itself. Notional principal contracts governed by this section include
interest rate swaps, currency swaps, basis swaps, interest rate caps,
interest rate floors, commodity swaps, equity swaps, equity index swaps,
and similar agreements. A collar is not itself a notional principal
contract, but certain caps and floors that comprise a collar may be
treated as a single notional principal contract under paragraph
(f)(2)(v)(C) of this section. A contract may be a notional principal
contract governed by this section even though the term of the contract
is subject to termination or extension. Each confirmation under a master
agreement to enter into agreements governed by this section is treated
as a separate notional principal contract.
(ii) Excluded contracts. A contract described in section 1256(b), a
futures contract, a forward contract, and an option are not notional
principal contracts. An instrument or contract that constitutes
indebtedness under general principles of Federal income tax law is not a
notional principal contract. An option or forward contract that entitles
or obligates a person to enter into a notional principal contract is not
a notional principal contract, but payments made under such an option or
forward contract may be governed by paragraph (g)(3) of this section.
(iii) Transactions within section 475. To the extent that the rules
provided in paragraphs (e) and (f) of this section are inconsistent with
the rules that apply to any notional principal contract that is governed
by section 475 and regulations thereunder, the rules of section 475 and
the regulations thereunder govern.
(iv) Transactions within section 988. To the extent that the rules
provided in this section are inconsistent with the rules that apply to
any notional principal contract that is also a section 988 transaction
or that is integrated with other property or debt pursuant to section
988(d), the rules of section 988 and the regulations thereunder govern.
(2) Specified index. A specified index is--
(i) A fixed rate, price, or amount;
(ii) A fixed rate, price, or amount applicable in one or more
specified periods followed by one or more different fixed rates, prices,
or amounts applicable in other periods;
(iii) An index that is based on objective financial information (as
defined in paragraph (c)(4)(ii) of this section); and
(iv) An interest rate index that is regularly used in normal lending
transactions between a party to the contract and unrelated persons.
(3) Notional principal amount. For purposes of this section, a
notional principal amount is any specified amount of money or property
that, when multiplied by a specified index, measures a party's rights
and obligations under the contract, but is not borrowed or loaned
between the parties as part of the contract. The notional principal
amount may vary over the term of the
[[Page 59]]
contract, provided that it is set in advance or varies based on
objective financial information (as defined in paragraph (c)(4)(ii) of
this section).
(4) Special definitions--(i) Related person and party to the
contract. A related person is a person related (within the meaning of
section 267(b) or 707(b)(1)) to one of the parties to the notional
principal contract or a member of the same consolidated group (as
defined in Sec. 1.1502-1(h)) as one of the parties to the contract. For
purposes of this paragraph (c), a related person is considered to be a
party to the contract.
(ii) Objective financial information. For purposes of this paragraph
(c), objective financial information is any current, objectively
determinable financial or economic information that is not within the
control of any of the parties to the contract and is not unique to one
of the parties' circumstances (such as one party's dividends, profits,
or the value of its stock). Thus, for example, a notional principal
amount may be based on a broadly-based equity index or the outstanding
balance of a pool of mortgages, but not on the value of a party's stock.
(iii) Dealer in notional principal contracts. A dealer in notional
principal contracts is a person who regularly offers to enter into,
assume, offset, assign, or otherwise terminate positions in notional
principal contracts with customers in the ordinary course of a trade or
business.
(d) Taxable year of inclusion and deduction. For all purposes of the
Code, the net income or net deduction from a notional principal contract
for a taxable year is included in or deducted from gross income for that
taxable year. The net income or net deduction from a notional principal
contract for a taxable year equals the total of all of the periodic
payments that are recognized from that contract for the taxable year
under paragraph (e) of this section and all of the nonperiodic payments
that are recognized from that contract for the taxable year under
paragraph (f) of this section.
(e) Periodic payments--(1) Definition. Periodic payments are
payments made or received pursuant to a notional principal contract that
are payable at intervals of one year or less during the entire term of
the contract (including any extension periods provided for in the
contract), that are based on a specified index described in paragraph
(c)(2)(i), (iii), or (iv) of this section (appropriately adjusted for
the length of the interval), and that are based on either a single
notional principal amount or a notional principal amount that varies
over the term of the contract in the same proportion as the notional
principal amount that measures the other party's payments. Payments to
purchase or sell a cap or a floor, however, are not periodic payments.
(2) Recognition rules--(i) In general. All taxpayers, regardless of
their method of accounting, must recognize the ratable daily portion of
a periodic payment for the taxable year to which that portion relates.
(ii) Rate set in arrears. If the amount of a periodic payment is not
determinable at the end of a taxable year because the value of the
specified index is not fixed until a date that occurs after the end of
the taxable year, the ratable daily portion of a periodic payment that
relates to that taxable year is generally based on the specified index
that would have applied if the specified index were fixed as of the last
day of the taxable year. If a taxpayer determines that the value of the
specified index as of the last day of the taxable year does not provide
a reasonable estimate of the specified index that will apply when the
payment is fixed, the taxpayer may use a reasonable estimate of the
specified index each year, provided that the taxpayer (and any related
person that is a party to the contract) uses the same method to make the
estimate consistently from year to year and uses the same estimate for
purposes of all financial reports to equity holders and creditors. The
taxpayer's treatment of notional principal contracts with substantially
similar specified indices will be considered in determining whether the
taxpayer's estimate of the specified index is reasonable. Any difference
between the amount that is recognized under this
[[Page 60]]
paragraph (e)(2)(ii) and the corresponding portion of the actual payment
that becomes fixed under the contract is taken into account as an
adjustment to the net income or net deduction from the notional
principal contract for the taxable year during which the payment becomes
fixed.
(iii) Notional principal amount set in arrears. Rules similar to the
rules of paragraph (e)(2)(ii) of this section apply if the amount of a
periodic payment is not determinable at the end of a taxable year
because the notional principal amount is not fixed until a date that
occurs after the end of the taxable year.
(3) Examples. The following examples illustrate the application of
paragraph (e) of this section.
Example 1. Accrual of periodic swap payments. (a) On April 1, 1995,
A enters into a contract with unrelated counterparty B under which, for
a term of five years, A is obligated to make a payment to B each April
1, beginning April 1, 1996, in an amount equal to the London Interbank
Offered Rate (LIBOR), as determined on the immediately preceding April
1, multiplied by a notional principal amount of $100 million. Under the
contract, B is obligated to make a payment to A each April 1, beginning
April 1, 1996, in an amount equal to 8% multiplied by the same notional
principal amount. A and B are calendar year taxpayers that use the
accrual method of accounting. On April 1, 1995, LIBOR is 7.80%.
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section, and both LIBOR and a fixed interest
rate of 8% are specified indices under paragraph (c)(2) of this section.
All of the payments to be made by A and B are periodic payments under
paragraph (e)(1) of this section because each party's payments are based
on a specified index described in paragraphs (c)(2)(iii) and (c)(2)(i)
of this section, respectively, are payable at periodic intervals of one
year or less throughout the term of the contract, and are based on a
single notional principal amount.
(c) Under the terms of the swap agreement, on April 1, 1996, B is
obligated to make a payment to A of $8,000,000 (8%x$100,000,000) and A
is obligated to make a payment to B of $7,800,000 (7.80%x$100,000,000).
Under paragraph (e)(2)(i) of this section, the ratable daily portions
for 1995 are the amounts of these periodic payments that are
attributable to A's and B's taxable year ending December 31, 1995. The
ratable daily portion of the 8% fixed leg is $6,010,929 (275 days/366
daysx$8,000,000), and the ratable daily portion of the floating leg is
$5,860,656 (275 days/366 daysx$7,800,000). The net amount for the
taxable year is the difference between the ratable daily portions of the
two periodic payments, or $150,273 ($6,010,929--$5,860,656).
Accordingly, A has net income of $150,273 from this swap for 1995, and B
has a corresponding net deduction of $150,273.
(d) The $49,727 unrecognized balance of the $200,000 net periodic
payment that is made on April 1, 1996, is included in A's and B's net
income or net deduction from the contract for 1996.
(e) If the parties had entered into the contract on February 1,
1995, the result would not change because no portion of either party's
obligation to make a payment under the swap relates to the period prior
to April 1, 1995. Consequently, under paragraph (e)(2) of this section,
neither party would accrue any income or deduction from the swap for the
period from February 1, 1995, through March 31, 1995.
Example 2. Accrual of periodic swap payments by cash method
taxpayer. (a) On April 1, 1995, C enters into a contract with unrelated
counterparty D under which, for a period of five years, C is obligated
to make a fixed payment to D each April 1, beginning April 1, 1996, in
an amount equal to 8% multiplied by a notional principal amount of $100
million. D is obligated to make semi-annual payments to C each April 1
and October 1, beginning October 1, 1995, in an amount equal to one-half
of the LIBOR amount as of the first day of the preceding 6-month period
multiplied by the notional principal amount. The payments are to be
calculated using a 30/360 day convention. C is a calendar year taxpayer
that uses the accrual method of accounting. D is a calendar year
taxpayer that uses the cash receipts and disbursements method of
accounting. LIBOR is 7.80% on April 1, 1995, and 7.46% on October 1,
1995.
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section, and LIBOR and the fixed interest rate
of 8% are each specified indices under paragraph (c)(2) of this section.
All of the payments to be made by C and D are periodic payments under
paragraph (e)(1) of this section because they are each based on
appropriate specified indices, are payable at periodic intervals of one
year or less throughout the term of the contract, and are based on a
single notional principal amount.
(c) Under the terms of the swap agreement, D pays C $3,900,000
(0.5x7.8%x$100,000,000) on October 1, 1995. In addition, D is obligated
to pay C $3,730,000 (0.5x7.46%x$100,000,000) on April 1, 1996. C is
obligated to pay D $8,000,000 on April 1, 1996. Under paragraph
(e)(2)(i) of this section, C's and D's ratable daily portions for 1995
are the amounts of the periodic payments that are attributable to their
taxable year ending December 31, 1995. The ratable daily portion of the
8% fixed leg is $6,000,000 (270 days/360 daysx$8,000,000), and
[[Page 61]]
the ratable daily portion of the floating leg is $5,765,000 ($3,900,000
+ (90 days/180 daysx$3,730,000)). Thus, C's net deduction from the
contract for 1995 is $235,000 ($6,000,000--$5,765,000) and D reports
$235,000 of net income from the contract for 1995.
(d) The net unrecognized balance of $135,000 ($2,000,000 balance of
the fixed leg--$1,865,000 balance of the floating leg) is included in
C's and D's net income or net deduction from the contract for 1996.
Example 3. Accrual of swap payments on index set in arrears. (a) The
facts are the same as in Example 1, except that A's obligation to make
payments based upon LIBOR is determined by reference to LIBOR on the day
each payment is due. LIBOR is 8.25% on December 31, 1995, and 8.16% on
April 1, 1996.
(b) On December 31, 1995, the amount that A is obligated to pay B is
not known because it will not become fixed until April 1, 1996. Under
paragraph (e)(2)(ii) of this section, the ratable daily portion of the
periodic payment from A to B for 1995 is based on the value of LIBOR on
December 31, 1995 (unless A or B determines that the value of LIBOR on
that day does not reasonably estimate the value of the specified index).
Thus, the ratable daily portion of the floating leg is $6,198,770 (275
days/366 daysx8.25%x$100,000,000), while the ratable daily portion of
the fixed leg is $6,010,929 (275 days/366 daysx$8,000,000). The net
amount for 1995 on this swap is $187,841 ($6,198,770--$6,010,929).
Accordingly, B has $187,841 of net income from the swap in 1995, and A
has a net deduction of $187,841.
(c) On April 1, 1996, A makes a net payment to B of $160,000
($8,160,000 payment on the floating leg--$8,000,000 payment on the fixed
leg). For purposes of determining their net income or net deduction from
this contract for the year ended December 31, 1996, B and A must adjust
the net income and net deduction they recognized in 1995 by $67,623 (275
days/366 daysx($8,250,000 presumed payment on the floating leg--
$8,160,000 actual payment on the floating leg)).
(f) Nonperiodic payments--(1) Definition. A nonperiodic payment is
any payment made or received with respect to a notional principal
contract that is not a periodic payment (as defined in paragraph (e)(1)
of this section) or a termination payment (as defined in paragraph (h)
of this section). Examples of nonperiodic payments are the premium for a
cap or floor agreement (even if it is paid in installments), the payment
for an off-market swap agreement, the prepayment of part or all of one
leg of a swap, and the premium for an option to enter into a swap if and
when the option is exercised.
(2) Recognition rules--(i) In general. All taxpayers, regardless of
their method of accounting, must recognize the ratable daily portion of
a nonperiodic payment for the taxable year to which that portion
relates. Generally, a nonperiodic payment must be recognized over the
term of a notional principal contract in a manner that reflects the
economic substance of the contract.
(ii) General rule for swaps. A nonperiodic payment that relates to a
swap must be recognized over the term of the contract by allocating it
in accordance with the forward rates (or, in the case of a commodity,
the forward prices) of a series of cash-settled forward contracts that
reflect the specified index and the notional principal amount. For
purposes of this allocation, the forward rates or prices used to
determine the amount of the nonperiodic payment will be respected, if
reasonable. See paragraph (f)(4) Example 7 of this section.
(iii) Alternative methods for swaps. Solely for purposes of
determining the timing of income and deductions, a nonperiodic payment
made or received with respect to a swap may be allocated to each period
of the swap contract using one of the methods described in this
paragraph (f)(2)(iii). The alternative methods may not be used by a
dealer in notional principal contracts (as defined in paragraph
(c)(4)(iii) of this section) for swaps entered into or acquired in its
capacity as a dealer.
(A) Prepaid swaps. An upfront payment on a swap may be amortized by
assuming that the nonperiodic payment represents the present value of a
series of equal payments made throughout the term of the swap contract
(the level payment method), adjusted as appropriate to take account of
increases or decreases in the notional principal amount. The discount
rate used in this calculation must be the rate (or rates) used by the
parties to determine the amount of the nonperiodic payment. If that rate
is not readily ascertainable, the discount rate used must be a rate that
is reasonable under the circumstances. Under this method, an upfront
payment is allocated by dividing each equal payment into its principal
recovery and time
[[Page 62]]
value components. The principal recovery components of the equal
payments are treated as periodic payments that are deemed to be made on
each of the dates that the swap contract provides for periodic payments
by the payor of the nonperiodic payment or, if none, on each of the
dates that the swap contract provides for periodic payments by the
recipient of the nonperiodic payment. The time value component is needed
to compute the amortization of the nonperiodic payment, but is otherwise
disregarded. See paragraph (f)(4) Example 5 of this section.
(B) Other nonperiodic swap payments. Nonperiodic payments on a swap
other than an upfront payment may be amortized by treating the contract
as if it provided for a single upfront payment (equal to the present
value of the nonperiodic payments) and a loan between the parties. The
discount rate (or rates) used in determining the deemed upfront payment
and the time value component of the deemed loan is the same as the rate
(or rates) used in the level payment method. The single upfront payment
is then amortized under the level payment method described in paragraph
(f)(2)(iii)(A) of this section. The time value component of the loan is
not treated as interest, but, together with the amortized amount of the
deemed upfront payment, is recognized as a periodic payment. See
paragraph (f)(4) Example 6 of this section. If both parties make
nonperiodic payments, this calculation is done separately for the
nonperiodic payments made by each party.
(iv) General rule for caps and floors. A payment to purchase or sell
a cap or floor must be recognized over the term of the agreement by
allocating it in accordance with the prices of a series of cash-settled
option contracts that reflect the specified index and the notional
principal amount. For purposes of this allocation, the option pricing
used by the parties to determine the total amount paid for the cap or
floor will be respected, if reasonable. Only the portion of the purchase
price that is allocable to the option contract or contracts that expire
during a particular period is recognized for that period. Thus, under
this paragraph (f)(2)(iv), straight-line or accelerated amortization of
a cap premium is generally not permitted. See paragraph (f)(4) Examples
1 and 2 of this section.
(v) Alternative methods for caps and floors that hedge debt
instruments. Solely for purposes of determining the timing of income and
deductions, if a cap or floor is entered into primarily to reduce risk
with respect to a specific debt instrument or group of debt instruments
held or issued by the taxpayer, the taxpayer may amortize a payment to
purchase or sell the cap or floor using the methods described in this
paragraph (f)(2)(v), adjusted as appropriate to take account of
increases or decreases in the notional principal amount. The alternative
methods may not be used by a dealer in notional principal contracts (as
defined in paragraph (c)(4)(iii) of this section) for caps or floors
entered into or acquired in its capacity as a dealer.
(A) Prepaid caps and floors. A premium paid upfront for a cap or a
floor may be amortized using the ``level payment method'' described in
paragraph (f)(2)(iii)(A) of this section. See paragraph (f)(4) Example 3
of this section.
(B) Other caps and floors. Nonperiodic payments on a cap or floor
other than an upfront payment are amortized by treating the contract as
if it provided for a single upfront payment (equal to the present value
of the nonperiodic payments) and a loan between the parties as described
in paragraph (f)(2)(iii)(B) of this section. Under the level payment
method, a cap or floor premium paid in level annual installments over
the term of the contract is effectively included or deducted from income
ratably, in accordance with the level payments. See paragraph (f)(4)
Example 4 of this section.
(C) Special method for collars. A taxpayer may also treat a cap and
a floor that comprise a collar as a single notional principal contract
and may amortize the net nonperiodic payment to enter into the cap and
floor over the term of the collar in accordance with the methods
prescribed in this paragraph (f)(2)(v).
(vi) Additional methods. The Commissioner may, by a revenue ruling
or a
[[Page 63]]
revenue procedure published in the Internal Revenue Bulletin, provide
alternative methods for allocating nonperiodic payments that relate to a
notional principal contract to each year of the contract. See
Sec. 601.601(d)(2)(ii)(b) of this chapter.
(3) Term of extendible or terminable contracts. For purposes of this
paragraph (f), the term of a notional principal contract that is subject
to extension or termination is the reasonably expected term of the
contract.
(4) Examples. The following examples illustrate the application of
paragraph (f) of this section.
Example 1. Cap premium amortized using general rule. (a) On January
1, 1995, when LIBOR is 8%, F pays unrelated party E $600,000 for a
contract that obligates E to make a payment to F each quarter equal to
one-quarter of the excess, if any, of three-month LIBOR over 9% with
respect to a notional principal amount of $25 million. Both E and F are
calendar year taxpayers. E provides F with a schedule of allocable
premium amounts indicating that the cap was priced according to a
reasonable variation of the Black-Scholes option pricing formula and
that the total premium is allocable to the following periods:
------------------------------------------------------------------------
Pricing
allocation
------------------------------------------------------------------------
1995.................................................... $55,000
1996.................................................... 225,000
1997.................................................... 320,000
---------------
$600,000
------------------------------------------------------------------------
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section, and LIBOR is a specified index under
paragraph (c)(2)(iii) of this section. Any payments made by E to F are
periodic payments under paragraph (e)(1) of this section because they
are payable at periodic intervals of one year or less throughout the
term of the contract, are based on an appropriate specified index, and
are based on a single notional principal amount. The $600,000 cap
premium paid by F to E is a nonperiodic payment as defined in paragraph
(f)(1) of this section.
(c) The Black-Scholes model is recognized in the financial industry
as a standard technique for pricing interest rate cap agreements.
Therefore, because E has used a reasonable option pricing model, the
schedule generated by E is consistent with the economic substance of the
cap, and may be used by both E and F for calculating their ratable daily
portions of the cap premium. Under paragraph (f)(2)(iv) of this section,
E recognizes the ratable daily portion of the cap premium as income, and
F recognizes the ratable daily portion of the cap premium as a deduction
based on the pricing schedule. Thus, E and F account for the contract as
follows:
------------------------------------------------------------------------
Ratable daily
portion
------------------------------------------------------------------------
1995.................................................... $55,000
1996.................................................... 225,000
1997.................................................... 320,000
---------------
$600,000
------------------------------------------------------------------------
(d) Any periodic payments under the cap agreement (that is, payments
that E makes to F because LIBOR exceeds 9%) are included in the parties'
net income or net deduction from the contract in accordance with
paragraph (e)(2) of this section.
Example 2. Cap premium allocated to proper period. (a) The facts are
the same as in Example 1, except that the cap is purchased by F on
November 1, 1994. The first determination date under the cap agreement
is January 31, 1995 (the last day of the first quarter to which the
contract relates). LIBOR is 9.1% on December 31, 1994, and is 9.15% on
January 31, 1995.
(b) E and F recognize $9,192 (61 days/365 daysx$55,000) as the
ratable daily portion of the nonperiodic payment for 1994, and include
that amount in their net income or net deduction from the contract for
1994. If E's pricing model allocated the cap premium to each quarter
covered by the contract, the ratable daily portion would be 61 days/92
days times the premium allocated to the first quarter.
(c) Under paragraph (e)(2)(ii) of this section, E and F calculate
the payments using LIBOR as of December 31, 1994. F recognizes as income
the ratable daily portion of the presumed payment, or $4,144 (61 days/92
daysx.25x.001x$25,000,000). Thus, E reports $5,048 of net income from
the contract for 1994 ($9,192-$4,144), and F reports a net deduction
from the contract of $5,048.
(d) On January 31, 1995, E pays F $9,375 (.25x.0015x$25,000,000)
under the terms of the cap agreement. For purposes of determining their
net income or net deduction from this contract for the year ended
December 31, 1995, E and F must adjust their respective net income and
net deduction from the cap by $2,072 (61 days/92 daysx($9,375 actual
payment under the cap on January 31, 1995--$6,250 presumed payment under
the cap on December 31, 1994)).
Example 3. Cap premium amortized using alternative method. (a) The
facts are the same as in Example 1, except that the cap provides for
annual payments by E and is entered into by F primarily to reduce risk
with respect to a debt instrument issued by F. F elects to
[[Page 64]]
amortize the cap premium using the alternative level payment method
provided under paragraph (f)(2)(v)(A) of this section. Under that
method, F amortizes the cap premium by assuming that the $600,000 is
repaid in 3 equal annual payments of $241,269, assuming a discount rate
of 10%. Each payment is divided into a time value component and a
principal component, which are set out below.
----------------------------------------------------------------------------------------------------------------
Time value Principal
Level payment component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $241,269 $60,000 $181,269
1996................................................... 241,269 41,873 199,396
1997................................................... 241,269 21,934 219,335
--------------------------------------------------------
$723,807 $123,807 $600,000
----------------------------------------------------------------------------------------------------------------
(b) The net of the ratable daily portions of the principal component
and the payments, if any, received from E comprise F's annual net income
or net deduction from the cap. The time value components are needed only
to compute the ratable daily portions of the cap premium, and are
otherwise disregarded.
Example 4. Cap premium paid in level installments and amortized
using alternative method. (a) The facts are the same as in Example 3,
except that F agrees to pay for the cap in three level installments of
$241,269 (a total of $723,807) on December 31, 1995, 1996, and 1997. The
present value of three payments of $241,269, discounted at 10%, is
$600,000. For purposes of amortizing the cap premium under the
alternative method provided in paragraph (f)(2)(v)(B) of this section, F
is treated as paying $600,000 for the cap on January 1, 1995, and
borrowing $600,000 from E that will be repaid in three annual
installments of $241,269. The time value component of the loan is
computed as follows:
----------------------------------------------------------------------------------------------------------------
Time value Principal
Loan balance component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $600,000 $60,000 $181,269
1996................................................... 418,731 41,873 199,396
1997................................................... 219,335 21,934 219,335
-------------------------------------
$123,807 $600,000
----------------------------------------------------------------------------------------------------------------
(b) F is treated as making periodic payments equal to the amortized
principal components from a $600,000 cap paid in advance (as described
in Example 3), increased by the time value components of the $600,000
loan, which totals $241,269 each year. The time value components of the
$600,000 loan are included in the periodic payments made by F, but are
not characterized as interest income or expense. The effect of the
alternative method in this situation is to allow F to amortize the cap
premium in level installments, the same way it is paid. The net of the
ratable daily portions of F's deemed periodic payments and the payments,
if any, received from E comprise F's annual net income or net deduction
from the cap.
Example 5. Upfront interest rate swap payment amortized using
alternative method. (a) On January 1, 1995, G enters into an interest
rate swap agreement with unrelated counterparty H under which, for a
term of five years, G is obligated to make annual payments at 11% and H
is obligated to make annual payments at LIBOR on a notional principal
amount of $100 million. At the time G and H enter into this swap
agreement, the rate for similar on-market swaps is LIBOR to 10%. To
compensate for this difference, on January 1, 1995, H pays G a yield
adjustment fee of $3,790,786. G provides H with information that
indicates that the amount of the yield adjustment fee was determined as
the present value, at 10% compounded annually, of five annual payments
of $1,000,000 (1%x$100,000,000). G and H are calendar year taxpayers.
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section. The yield adjustment fee is a
nonperiodic payment as defined in paragraph (f)(1) of this section.
(c) Under the alternative method described in paragraph
(f)(2)(iii)(A) of this section, the yield adjustment fee is recognized
over the life of the agreement by assuming that the $3,790,786 is repaid
in five level payments. Assuming a constant yield to maturity and annual
compounding at 10%, the ratable daily portions are computed as follows:
[[Page 65]]
----------------------------------------------------------------------------------------------------------------
Time value Principal
Level payment component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $1,000,000 $379,079 $620,921
1996................................................... 1,000,000 316,987 683,013
1997................................................... 1,000,000 248,685 751,315
1998................................................... 1,000,000 173,554 826,446
1999................................................... 1,000,000 90,909 909,091
--------------------------------------------------------
$5,000,000 $1,209,214 $3,790,786
----------------------------------------------------------------------------------------------------------------
(d) G also makes swap payments to H at 11%, while H makes swap
payments to G based on LIBOR. The net of the ratable daily portions of
the 11% payments by G, the LIBOR payments by H, and the principal
component of the yield adjustment fee paid by H determines the annual
net income or net deduction from the contract for both G and H. The time
value components are needed only to compute the ratable daily portions
of the yield adjustment fee paid by H, and are otherwise disregarded.
Example 6. Backloaded interest rate swap payment amortized using
alternative method. (a) The facts are the same as in Example 5, but H
agrees to pay G a yield adjustment fee of $6,105,100 on December 31,
1999. Under the alternative method in paragraph (f)(2)(iii)(B) of this
section, H is treated as paying a yield adjustment fee of $3,790,786
(the present value of $6,105,100, discounted at a 10% rate with annual
compounding) on January 1, 1995. Solely for timing purposes, H is
treated as borrowing $3,790,786 from G. Assuming annual compounding at
10%, the time value component is computed as follows:
----------------------------------------------------------------------------------------------------------------
Time value Principal
Loan balance component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $3,790,786 $379,079 0
1996................................................... 4,169,865 416,987 0
1997................................................... 4,586,852 458,685 0
1998................................................... 5,045,537 504,554 0
1999................................................... 5,550,091 555,009 6,105,100
----------------------------------------------------------------------------------------------------------------
(b) The amortization of H's yield adjustment fee is equal to the
amortization of a yield adjustment fee of $3,790,786 paid in advance (as
described in Example 5), increased by the time value component of the
$3,790,786 deemed loan from G to H. Thus, the amount of H's yield
adjustment fee that is allocated to 1995 is $1,000,000 ($620,921 +
$379,079). The time value components of the $3,790,786 loan are included
in the periodic payments paid by H, but are not characterized as
interest income or expense. The net of the ratable daily portions of the
11% swap payments by G, and the LIBOR payments by H, added to the
principal components from Example 5 and the time value components from
this Example 6, determines the annual net income or net deduction from
the contract for both G and H.
Example 7. Nonperiodic payment on a commodity swap amortized under
general rule. (a) On January 1, 1995, I enters into a commodity swap
agreement with unrelated counterparty J under which, for a term of three
years, I is obligated to make annual payments based on a fixed price of
$2.35 per bushel times a notional amount of 100,000 bushels of corn and
J is obligated to make annual payments equal to the spot price times the
same notional amount. Assume that on January 1, 1995, the price of a one
year forward for corn is $2.40 per bushel, of a two year forward $2.55
per bushel, and of a 3 year forward $2.75 per bushel. To compensate for
the below-market fixed price provided in the swap agreement, I pays J
$53,530 for entering into the swap. I and J are calendar year taxpayers.
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section, and $2.35 and the spot price of corn
are specified indices under paragraphs (c)(2)(i) and (iii) of this
section, respectively. The $53,530 payment is a nonperiodic payment as
defined by paragraph (f)(1) of this section.
(c) Assuming that I does not use the alternative methods provided
under paragraph (f)(2)(iii) of this section, paragraph (f)(2)(ii) of
this section requires that I recognize the nonperiodic payment over the
term of the agreement by allocating the payment to each forward contract
in accordance with the forward price of corn. Solely for timing
purposes, I treats the $53,530 nonperiodic payment as a loan that J will
repay in three
[[Page 66]]
installments of $5,000, $20,000, and $40,000, the expected payouts on
the in-the-money forward contracts. With annual compounding at 8%, the
ratable daily portions are computed as follows:
----------------------------------------------------------------------------------------------------------------
Expected forward Time value Principal
payment component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $5,000 $4,282 $718
1996................................................... 20,000 4,225 15,775
1997................................................... 40,000 2,963 37,037
--------------------------------------------------------
$65,000 $11,470 $53,530
----------------------------------------------------------------------------------------------------------------
(d) The ratable daily portion of the principal component is added to
I's periodic payments in computing its net income or net deduction from
the notional principal contract for each taxable year. The time value
components are needed only to compute the principal components, and are
otherwise disregarded.
(g) Special rules--(1) Disguised notional principal contracts. The
Commissioner may recharacterize all or part of a transaction (or series
of transactions) if the effect of the transaction (or series of
transactions) is to avoid the application of this section.
(2) Hedged notional principal contracts. If a taxpayer, either
directly or through a related person (as defined in paragraph (c)(4)(i)
of this section), reduces risk with respect to a notional principal
contract by purchasing, selling, or otherwise entering into other
notional principal contracts, futures, forwards, options, or other
financial contracts (other than debt instruments), the taxpayer may not
use the alternative methods provided in paragraphs (f)(2)(iii) and (v)
of this section. Moreover, where such positions are entered into to
avoid the appropriate timing or character of income from the contracts
taken together, the Commissioner may require that amounts paid to or
received by the taxpayer under the notional principal contract be
treated in a manner that is consistent with the economic substance of
the transaction as a whole.
(3) Options and forwards to enter into notional principal contracts.
An option or forward contract that entitles or obligates a person to
enter into a notional principal contract is subject to the general rules
of taxation for options or forward contracts. Any payment with respect
to the option or forward contract is treated as a nonperiodic payment
for the underlying notional principal contract under the rules of
paragraphs (f) and (g)(4) or (g)(5) of this section if and when the
underlying notional principal contract is entered into.
(4) Swaps with significant nonperiodic payments. A swap with
significant nonperiodic payments is treated as two separate transactions
consisting of an on-market, level payment swap and a loan. The loan must
be accounted for by the parties to the contract independently of the
swap. The time value component associated with the loan is not included
in the net income or net deduction from the swap under paragraph (d) of
this section, but is recognized as interest for all purposes of the
Internal Revenue Code. See paragraph (g)(6) Example 3 of this section.
For purposes of section 956, the Commissioner may treat any nonperiodic
swap payment, whether or not it is significant, as one or more loans.
(5) Caps and floors that are significantly in-the-money. [Reserved]
(6) Examples. The following examples illustrate the application of
paragraph (g) of this section.
Example 1. Cap hedged with options.(a) On January 1, 1995, K sells
to unrelated counterparty L three cash settlement European-style put
options on Eurodollar time deposits with a strike rate of 9%. The
options have exercise dates of January 1, 1996, January 1, 1997, and
January 1, 1998, respectively. If LIBOR exceeds 9% on any of the
exercise dates, L will be entitled, by exercising the relevant option,
to receive from K an amount that corresponds to the excess of LIBOR over
9% times $25 million. L pays K $650,000 for the three options.
Furthermore, K is related to F, the cap purchaser in paragraph (f)(4)
Example 1 of this section.
(b) K's option agreements with L reduce risk with respect to F's cap
agreement with E. Accordingly, under paragraph (g)(2) of this
[[Page 67]]
section, F cannot use the alternative methods provided in paragraph
(f)(2)(v) of this section to amortize the premium paid under the cap
agreement. F must amortize the cap premium it paid in accordance with
paragraph (f)(2)(iv) of this section.
(c) The method that E may use to account for its agreement with F is
not affected by the application of paragraph (g)(2) of this section to
F.
Example 2. Nonperiodic payment that is not significant. (a) On
January 1, 1995, G enters into an interest rate swap agreement with
unrelated counterparty H under which, for a term of five years, G is
obligated to make annual payments at 11% and H is obligated to make
annual payments at LIBOR on a notional principal amount of $100 million.
At the time G and H enter into this swap agreement, the rate for similar
on-market swaps is LIBOR to 10%. To compensate for this difference, on
January 1, 1995, H pays G a yield adjustment fee of $3,790,786. G
provides H with information that indicates that the amount of the yield
adjustment fee was determined as the present value, at 10% compounded
annually, of five annual payments of $1,000,000 (1%x$100,000,000). G and
H are calendar year taxpayers. (These facts are the same as in paragraph
(f)(4) Example 5 of this section.)
(b) In this situation, the yield adjustment fee of $3,790,786 is not
a significant nonperiodic payment within the meaning of paragraph (g)(4)
of this section, in light of the amount of the fee in proportion to the
present value of the total amount of fixed payments due under the
contract. Accordingly, no portion of the swap is recharacterized as a
loan for purposes of this section.
Example 3. Significant nonperiodic payment. (a) On January 1, 1995,
unrelated parties M and N enter into an interest rate swap contract.
Under the terms of the contract, N agrees to make five annual payments
to M equal to LIBOR times a notional principal amount of $100 million.
In return, M agrees to pay N 6% of $100 million annually, plus
$15,163,147 on January 1, 1995. At the time M and N enter into this swap
agreement the rate for similar on- market swaps is LIBOR to 10%, and N
provides M with information that the amount of the initial payment was
determined as the present value, at 10% compounded annually, of five
annual payments from M to N of $4,000,000 (4% of $100,000,000).
(b) Although the parties have characterized this transaction as an
interest rate swap, the $15,163,147 payment from M to N is significant
when compared to the present value of the total fixed payments due under
the contract. Accordingly, under paragraph (g)(4) of this section, the
transaction is recharacterized as consisting of both a $15,163,147 loan
from M to N that N repays in installments over the term of the
agreement, and an interest rate swap between M and N in which M
immediately pays the installment payments on the loan back to N as part
of its fixed payments on the swap in exchange for the LIBOR payments by
N.
(c) The yield adjustment fee is recognized over the life of the
agreement by treating the $15,163,147 as a loan that will be repaid with
level payments over five years. Assuming a constant yield to maturity
and annual compounding at 10%, M and N account for the principal and
interest on the loan as follows:
----------------------------------------------------------------------------------------------------------------
Interest Principal
Level payment component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $4,000,000 $1,516,315 $2,483,685
1996................................................... 4,000,000 1,267,946 2,732,054
1997................................................... 4,000,000 994,741 3,005,259
1998................................................... 4,000,000 694,215 3,305,785
1999................................................... 4,000,000 363,636 3,636,364
--------------------------------------------------------
$20,000,000 $4,836,853 $15,163,147
----------------------------------------------------------------------------------------------------------------
(d) M recognizes interest income, and N claims an interest
deduction, each taxable year equal to the interest component of the
deemed installment payments on the loan. These interest amounts are not
included in the parties' net income or net deduction from the swap
contract under paragraph (d) of this section. The principal components
are needed only to compute the interest component of the level payment
for the following period, and do not otherwise affect the parties' net
income or net deduction from this contract.
(e) N also makes swap payments to M based on LIBOR, and receives
swap payments from M at a fixed rate that is equal to the sum of the
stated fixed rate and the rate calculated by dividing the deemed level
annual payments on the loan by the notional principal amount. Thus, the
fixed rate on this swap is 10%, which is the sum of the stated rate of
6% and the rate calculated by dividing the annual loan payment of
$4,000,000 by the notional principal amount of $100,000,000, or 4%.
Using the methods provided in paragraph (e)(2) of this section, the swap
payments from M to N of $10,000,000 (10% of
[[Page 68]]
$100,000,000) and the LIBOR swap payments from N to M are included in
the parties' net income or net deduction from the contract for each
taxable year.
Example 4. Swaps recharacterized as a loan. (a) The facts are the
same as in Example 3, except that on January 1, 1995, N also enters into
an interest rate swap agreement with unrelated counterparty O under
which, for a term of five years, N is obligated to make annual payments
at 12% and O is obligated to make annual payments at LIBOR on a notional
principal amount of $100 million. At the time N and O enter into this
swap agreement, the rate for similar on-market swaps is LIBOR to 10%. To
compensate for this difference, O pays N an upfront yield adjustment fee
of $7,581,574. This yield adjustment fee equals the present value, at
10% compounded annually, of five annual payments of $2,000,000 (2% of
$100,000,000).
(b) In substance, these two interest rate swaps are the equivalent
of a fixed rate borrowing by N of $22,744,721 ($15,163,147 from M plus
$7,581,574 from O). Under paragraph (g)(2) of this section, if these
positions were entered into to avoid interest character on a net loan
position, the Commissioner may recharacterize the swaps as a loan which
N will repay with interest in five annual installments of $6,000,000
each (the difference between the 12% N pays under the swap with O and
the 6% N receives under the swap with M, multiplied by the $100,000,000
notional principal amount).
(c) N recognizes no net income or net deduction from these contracts
under paragraph (d) of this section because, as to N, there is no
notional principal contract income or expense. However, the
recharacterization of N's separate transactions as a loan has no effect
on the way M and O must each account for their notional principal
contracts under paragraphs (d) through (g) of this section.
(h) Termination payments--(1) Definition. A payment made or received
to extinguish or assign all or a proportionate part of the remaining
rights and obligations of any party under a notional principal contract
is a termination payment to the party making the termination payment and
the party receiving the payment. A termination payment includes a
payment made between the original parties to the contract (an
extinguishment), a payment made between one party to the contract and a
third party (an assignment), and any gain or loss realized on the
exchange of one notional principal contract for another. Where one party
assigns its remaining rights and obligations to a third party, the
original nonassigning counterparty realizes gain or loss if the
assignment results in a deemed exchange of contracts and a realization
event under section 1001.
(2) Taxable year of inclusion and deduction by original parties.
Except as otherwise provided (for example, in section 453, section 1092,
or Sec. 1.446-4), a party to a notional principal contract recognizes a
termination payment in the year the contract is extinguished, assigned,
or exchanged. When the termination payment is recognized, the party also
recognizes any other payments that have been made or received pursuant
to the notional principal contract, but that have not been recognized
under paragraph (d) of this section. If only a proportionate part of a
party's rights and obligations is extinguished, assigned, or exchanged,
then only that proportion of the unrecognized payments is recognized
under the previous sentence.
(3) Taxable year of inclusion and deduction by assignees. A
termination payment made or received by an assignee pursuant to an
assignment of a notional principal contract is recognized by the
assignee under the rules of paragraphs (f) and (g)(4) or (g)(5) of this
section as a nonperiodic payment for the notional principal contract
that is in effect after the assignment.
(4) Special rules--(i) Assignment of one leg of a contract. A
payment is not a termination payment if it is made or received by a
party in exchange for assigning all or a portion of one leg of a
notional principal contract at a time when a substantially proportionate
amount of the other leg remains unperformed and unassigned. The payment
is either an amount loaned, an amount borrowed, or a nonperiodic
payment, depending on the economic substance of the transaction to each
party. This paragraph (h)(4)(i) applies whether or not the original
notional principal contract is terminated as a result of the assignment.
(ii) Substance over form. Any economic benefit that is given or
received by a taxpayer in lieu of a termination payment is a termination
payment.
[[Page 69]]
(5) Examples. The following examples illustrate the application of
this paragraph (h). The contracts in the examples are not hedging
transactions as defined in Sec. 1.1221-2(b), and all of the examples
assume that no loss-deferral rules apply.
Example 1. Termination by extinguishment. (a) On January 1, 1995, P
enters into an interest rate swap agreement with unrelated counterparty
Q under which, for a term of seven years, P is obligated to make annual
payments based on 10% and Q is obligated to make semi-annual payments
based on LIBOR and a notional principal amount of $100 million. P and Q
are both calendar year taxpayers. On January 1, 1997, when the fixed
rate on a comparable LIBOR swap has fallen to 9.5%, P pays Q $1,895,393
to terminate the swap.
(b) The payment from P to Q extinguishes the swap contract and is a
termination payment, as defined in paragraph (h)(1) of this section, for
both parties. Accordingly, under paragraph (h)(2) of this section, P
recognizes a loss of $1,895,393 in 1997 and Q recognizes $1,895,393 of
gain in 1997.
Example 2. Termination by assignment. (a) The facts are the same as
in Example 1, except that on January 1, 1997, P pays unrelated party R
$1,895,393 to assume all of P's rights and obligations under the swap
with Q. In return for this payment, R agrees to pay 10% of $100 million
annually to Q and to receive LIBOR payments from Q for the remaining
five years of the swap.
(b) The payment from P to R terminates P's interest in the swap
contract with Q and is a termination payment, as defined in paragraph
(h)(1) of this section, for P. Under paragraph (h)(2) of this section, P
recognizes a loss of $1,895,393 in 1997. Whether Q also has a
termination payment with respect to the payment from P to R is
determined under section 1001.
(c) Under paragraph (h)(3) of this section, the assignment payment
that R receives from P is a nonperiodic payment for an interest rate
swap. Because the assignment payment is not a significant nonperiodic
payment within the meaning of paragraph (g)(1) of this section, R
amortizes the $1,895,393 over the five year term of the swap agreement
under paragraph (f)(2) of this section.
Example 3. Assignment of swap with yield adjustment fee. (a) The
facts are the same as in Example 2, except that on January 1, 1995, Q
paid P a yield adjustment fee to enter into the seven year interest rate
swap. In accordance with paragraph (f)(2) of this section, P and Q
included the ratable daily portions of that nonperiodic payment in their
net income or net deduction from the contract for 1995 and 1996. On
January 1, 1997, $300,000 of the nonperiodic payment has not yet been
recognized by P and Q.
(b) Under paragraph (h)(2) of this section, P recognizes a loss of
$1,595,393 ($1,895,393-$300,000) in 1997. R accounts for the termination
payment in the same way it did in Example 2; the existence of an
unamortized payment with respect to the original swap has no effect on
R.
Example 4. Assignment of one leg of a swap. (a) On January 1, 1995,
S enters into an interest rate swap agreement with unrelated
counterparty T under which, for a term of five years, S will make annual
payments at 10% and T will make annual payments at LIBOR on a notional
principal amount of $50 million. On January 1, 1996, unrelated party U
pays T $15,849,327 for the right to receive the four remaining
$5,000,000 payments from S. Under the terms of the agreement between S
and T, S is notified of this assignment, and S is contractually bound
thereafter to make its payments to U on the appropriate payment dates.
S's obligation to pay U is conditioned on T making its LIBOR payment to
S on the appropriate payment dates.
(b) Because T has assigned to U its rights to the fixed rate
payments, but not its floating rate obligations under the notional
principal contract, U's payment to T is not a termination payment as
defined in paragraph (h)(1) of this section, but is covered by paragraph
(h)(4)(i) of this section. The economic substance of the transaction
between T and U is a loan that does not affect the way that S and T
account for the notional principal contract under this section.
(i) Anti-abuse rule. If a taxpayer enters into a transaction with a
principal purpose of applying the rules of this section to produce a
material distortion of income, the Commissioner may depart from the
rules of this section as necessary to reflect the appropriate timing of
income and deductions from the transaction.
(j) Effective date. These regulations are effective for notional
principal contracts entered into on or after December 13, 1993.
[T.D. 8491, 58 FR 53128, Oct. 14, 1993; 59 FR 9411, Feb. 28, 1994, as
amended by T.D. 8554, 59 FR 36358, July 18, 1994]
Sec. 1.446-4 Hedging transactions.
(a) In general. Except as provided in this paragraph (a), a hedging
transaction as defined in Sec. 1.1221-2(b) (whether or not the character
of gain or loss from the transaction is determined under Sec. 1.1221-2)
must be accounted for under the rules of this section. To the
[[Page 70]]
extent that provisions of any other regulations governing the timing of
income, deductions, gain, or loss are inconsistent with the rules of
this section, the rules of this section control.
(1) Trades or businesses excepted. A taxpayer is not required to
account for hedging transactions under the rules of this section for any
trade or business in which the cash receipts and disbursements method of
accounting is used or in which Sec. 1.471-6 is used for inventory
valuations if, for all prior taxable years ending on or after September
30, 1993, the taxpayer met the $5,000,000 gross receipts test of section
448(c) (or would have met that test if the taxpayer were a corporation
or partnership). A taxpayer not required to use the rules of this
section may nonetheless use a method of accounting that is consistent
with these rules.
(2) Coordination with other sections. This section does not apply
to--
(i) Any position to which section 475(a) applies;
(ii) An integrated transaction subject to Sec. 1.1275-6;
(iii) Any section 988 hedging transaction if the transaction is
integrated under Sec. 1.988-5 or if other regulations issued under
section 988(d) (or an advance ruling described in 1.988-5(e)) govern
when gain or loss from the transaction is taken into account; or
(iv) The determination of the issuer's yield on an issue of tax-
exempt bonds for purposes of the arbitrage restrictions to which
Sec. 1.148-4(h) applies.
(b) Clear reflection of income. The method of accounting used by a
taxpayer for a hedging transaction must clearly reflect income. To
clearly reflect income, the method used must reasonably match the timing
of income, deduction, gain, or loss from the hedging transaction with
the timing of income, deduction, gain, or loss from the item or items
being hedged. Taking gains and losses into account in the period in
which they are realized may clearly reflect income in the case of
certain hedging transactions. For example, where a hedge and the item
being hedged are disposed of in the same taxable year, taking realized
gain or loss into account on both items in that taxable year may clearly
reflect income. In the case of many hedging transactions, however,
taking gains and losses into account as they are realized does not
result in the matching required by this section.
(c) Choice of method and consistency. For any given type of hedging
transaction, there may be more than one method of accounting that
satisfies the clear reflection requirement of paragraph (b) of this
section. A taxpayer is generally permitted to adopt a method of
accounting for a particular type of hedging transaction that clearly
reflects the taxpayer's income from that type of transaction. See
paragraph (e) of this section for requirements and limitations on the
taxpayer's choice of method. Different methods of accounting may be used
for different types of hedging transactions and for transactions that
hedge different types of items. Once a taxpayer adopts a method of
accounting, however, that method must be applied consistently and can
only be changed with the consent of the Commissioner, as provided by
section 446(e) and the regulations and procedures thereunder.
(d) Recordkeeping requirements--(1) In general. The books and
records maintained by a taxpayer must contain a description of the
accounting method used for each type of hedging transaction. The
description of the method or methods used must be sufficient to show how
the clear reflection requirement of paragraph (b) of this section is
satisfied.
(2) Additional identification. In addition to the identification
required by Sec. 1.1221-2(f), the books and records maintained by a
taxpayer must contain whatever more specific identification with respect
to a transaction is necessary to verify the application of the method of
accounting used by the taxpayer for the transaction. This additional
identification may relate to the hedging transaction or to the item,
items, or aggregate risk being hedged. The additional identification
must be made at the time specified in Sec. 1.1221-2(f)(2) and must be
made on, and retained as part of, the taxpayer's books and records.
(3) Transactions in which character of gain or loss is not
determined under Sec. 1.1221-2. A section 988 transaction, as
[[Page 71]]
defined in section 988(c)(1), or a qualified fund, as defined in section
988(c)(1)(E)(iii), is subject to the identification and recordkeeping
requirements of Sec. 1.1221-2(f). See Sec. 1.1221-2(a)(4).
(e) Requirements and limitations with respect to hedges of certain
assets and liabilities. In the case of certain hedging transactions,
this paragraph (e) provides guidance in determining whether a taxpayer's
method of accounting satisfies the clear reflection requirement of
paragraph (b) of this section. Even if these rules are satisfied,
however, the taxpayer's method, as actually applied to the taxpayer's
hedging transactions, must clearly reflect income by meeting the
matching requirement of paragraph (b) of this section.
(1) Hedges of aggregate risk--(i) In general. The method of
accounting used for hedges of aggregate risk must comply with the
matching requirements of paragraph (b) of this section. Even though a
taxpayer may not be able to associate the hedging transaction with any
particular item being hedged, the timing of income, deduction, gain, or
loss from the hedging transaction must be matched with the timing of the
aggregate income, deduction, gain, or loss from the items being hedged.
For example, if a notional principal contract hedges a taxpayer's
aggregate risk, taking into account income, deduction, gain, or loss
under the provisions of Sec. 1.446-3 may clearly reflect income. See
paragraph (e)(5) of this section.
(ii) Mark-and-spread method. The following method may be appropriate
for taking into account income, deduction, gain, or loss from hedges of
aggregate risk:
(A) The hedging transactions are marked to market at regular
intervals for which the taxpayer has the necessary data, but no less
frequently than quarterly; and
(B) The income, deduction, gain, or loss attributable to the
realization or periodic marking to market of hedging transactions is
taken into account over the period for which the hedging transactions
are intended to reduce risk. Although the period over which the hedging
transactions are intended to reduce risk may change, the period must be
reasonable and consistent with the taxpayer's hedging policies and
strategies.
(2) Hedges of items marked to market. In the case of a transaction
that hedges an item that is marked to market under the taxpayer's method
of accounting, marking the hedge to market clearly reflects income.
(3) Hedges of inventory--(i) In general. If a hedging transaction
hedges purchases of inventory, gain or loss on the hedging transaction
may be taken into account in the same period that it would be taken into
account if the gain or loss were treated as an element of the cost of
inventory. Similarly, if a hedging transaction hedges sales of
inventory, gain or loss on the hedging transaction may be taken into
account in the same period that it would be taken into account if the
gain or loss were treated as an element of sales proceeds. If a hedge is
associated with a particular purchase or sales transaction, the gain or
loss on the hedge may be taken into account when it would be taken into
account if it were an element of cost incurred in, or sales proceeds
from, that transaction. As with hedges of aggregate risk, however, a
taxpayer may not be able to associate hedges of inventory purchases or
sales with particular purchase or sales transactions. In order to match
the timing of income, deduction, gain, or loss from the hedge with the
timing of aggregate income, deduction, gain, or loss from the hedged
purchases or sales, it may be appropriate for a taxpayer to account for
its hedging transactions in the manner described in paragraph (e)(1)(ii)
of this section, except that the gain or loss that is spread to each
period is taken into account when it would be if it were an element of
cost incurred (purchase hedges), or an element of proceeds from sales
made (sales hedges), during that period.
(ii) Alternative methods for certain inventory hedges. In lieu of
the method described in paragraph (e)(3)(i) of this section, other
simpler, less precise methods may be used in appropriate cases where the
clear reflection requirement of paragraph (b) of this section is
satisfied. For example:
[[Page 72]]
(A) Taking into account realized gains and losses on both hedges of
inventory purchases and hedges of inventory sales when they would be
taken into account if the gains and losses were elements of inventory
cost in the period realized may clearly reflect income in some
situations, but does not clearly reflect income for a taxpayer that uses
the last-in, first-out method of accounting for the inventory; and
(B) Marking hedging transactions to market with resulting gain or
loss taken into account immediately may clearly reflect income even
though the inventory that is being hedged is not marked to market, but
only if the inventory is not accounted for under either the last-in,
first-out method or the lower-of-cost-or-market method and only if items
are held in inventory for short periods of time.
(4) Hedges of debt instruments. Gain or loss from a transaction that
hedges a debt instrument issued or to be issued by a taxpayer, or a debt
instrument held or to be held by a taxpayer, must be accounted for by
reference to the terms of the debt instrument and the period or periods
to which the hedge relates. A hedge of an instrument that provides for
interest to be paid at a fixed rate or a qualified floating rate, for
example, generally is accounted for using constant yield principles.
Thus, assuming that a fixed rate or qualified floating rate instrument
remains outstanding, hedging gain or loss is taken into account in the
same periods in which it would be taken into account if it adjusted the
yield of the instrument over the term to which the hedge relates. For
example, gain or loss realized on a transaction that hedged an
anticipated fixed rate borrowing for its entire term is accounted for,
solely for purposes of this section, as if it decreased or increased the
issue price of the debt instrument. Similarly, gain or loss realized on
a transaction that hedges a contingent payment on a debt instrument
subject to Sec. 1.1275-4(c) (a contingent payment debt instrument issued
for nonpublicly traded property) is taken into account when the
contingent payment is taken into account under Sec. 1.1275-4(c).
(5) Notional principal contracts. The rules of Sec. 1.446-3 govern
the timing of income and deductions with respect to a notional principal
contract unless, because the notional principal contract is part of a
hedging transaction, the application of those rules would not result in
the matching that is needed to satisfy the clear reflection requirement
of paragraph (b) and, as applicable, (e)(4) of this section. For
example, if a notional principal contract hedges a debt instrument, the
method of accounting for periodic payments described in Sec. 1.446-3(e)
and the methods of accounting for nonperiodic payments described in
Sec. 1.446-3(f)(2)(iii) and (v) generally clearly reflect the taxpayer's
income. The methods described in Sec. 1.446-3(f)(2)(ii) and (iv),
however, generally do not clearly reflect the taxpayer's income in that
situation.
(6) Disposition of hedged asset or liability. If a taxpayer hedges
an item and disposes of, or terminates its interest in, the item but
does not dispose of or terminate the hedging transaction, the taxpayer
must appropriately match the built-in gain or loss on the hedging
transaction to the gain or loss on the disposed item. To meet this
requirement, the taxpayer may mark the hedge to market on the date it
disposes of the hedged item. If the taxpayer intends to dispose of the
hedging transaction within a reasonable period, however, it may be
appropriate to match the realized gain or loss on the hedging
transaction with the gain or loss on the disposed item. If the taxpayer
intends to dispose of the hedging transaction within a reasonable period
and the hedging transaction is not actually disposed of within that
period, the taxpayer must match the gain or loss on the hedge at the end
of the reasonable period with the gain or loss on the disposed item. For
purposes of this paragraph (e)(6), a reasonable period is generally 7
days.
(7) Recycled hedges. If a taxpayer enters into a hedging transaction
by recycling a hedge of a particular hedged item to serve as a hedge of
a different item, as described in Sec. 1.1221-2(d)(4), the taxpayer must
match the built-in gain or loss at the time of the recycling to the gain
or loss on the original hedged item, items, or aggregate risk. Income,
deduction, gain, or loss attributable to the period after the recycling
must be
[[Page 73]]
matched to the new hedged item, items, or aggregate risk under the
principles of paragraph (b) of this section.
(8) Unfulfilled anticipatory transactions--(i) In general. If a
taxpayer enters into a hedging transaction to reduce risk with respect
to an anticipated asset acquisition, debt issuance, or obligation, and
the anticipated transaction is not consummated, any income, deduction,
gain, or loss from the hedging transaction is taken into account when
realized.
(ii) Consummation of anticipated transaction. A taxpayer consummates
a transaction for purposes of paragraph (e)(8)(i) of this section upon
the occurrence (within a reasonable interval around the expected time of
the anticipated transaction) of either the anticipated transaction or a
different but similar transaction for which the hedge serves to
reasonably reduce risk.
(9) Hedging by members of a consolidated group--(i) General rule:
single-entity approach. In general, a member of a consolidated group
must account for its hedging transactions as if all of the members were
separate divisions of a single corporation. Thus, the timing of the
income, deduction, gain, or loss on a hedging transaction must match the
timing of income, deduction, gain, or loss from the item or items being
hedged. Because all of the members are treated as if they were divisions
of a single corporation, intercompany transactions are neither hedging
transactions nor hedged items for these purposes.
(ii) Separate-entity election. If a consolidated group makes an
election under Sec. 1.1221-2(e)(2), then paragraph (e)(9)(i) of this
section does not apply. Thus, in that case, each member of the
consolidated group must account for its hedging transactions in a manner
that meets the requirements of paragraph (b) of this section. For
example, the income, deduction, gain, or loss from intercompany hedging
transactions (as defined in Sec. 1.1221-2(e)(2)(ii)) is taken into
account under the timing rules of Sec. 1.446-4 rather than under the
timing rules of Sec. 1.1502-13.
(iii) Definitions. For definitions of consolidated group, divisions
of a single corporation, intercompany transaction, and member, see
section 1502 and the regulations thereunder.
(iv) Effective date. This paragraph (e)(9) applies to transactions
entered into on or after March 8, 1996.
(f) Type or character of income and deduction. The rules of this
section govern the timing of income, deduction, gain, or loss on hedging
transactions but do not affect the type or character of income,
deduction, gain, or loss produced by the transaction. Thus, for example,
the rules of paragraph (e)(3) of this section do not affect the
computation of cost of goods sold or sales proceeds for a taxpayer that
hedges inventory purchases or sales. Similarly, the rules of paragraph
(e)(4) of this section do not increase or decrease the interest income
or expense of a taxpayer that hedges a debt instrument or a liability.
(g) Effective date. This section applies to hedging transactions
entered into on or after October 1, 1994.
(h) Consent to change methods of accounting. The Commissioner grants
consent for a taxpayer to change its methods of accounting for
transactions that are entered into on or after October 1, 1994, and that
are described in paragraph (a) of this section. This consent is granted
only for changes for the taxable year containing October 1, 1994. The
taxpayer must describe its new methods of accounting in a statement that
is included in its Federal income tax return for that taxable year.
[T.D. 8554, 59 FR 36358, July 18, 1994, as amended by T.D. 8653, 61 FR
519, Jan. 8, 1996; T.D. 8674, 61 FR 30138, June 14, 1996; T.D. 8985, 67
FR 12865, Mar. 20, 2002; 67 FR 31955, May 13, 2002]
Sec. 1.448-1 Limitation on the use of the cash receipts and disbursements method of accounting.
(a)-(f) [Reserved]
(g) Treatment of accounting method change and timing rules for
section 481(a) adjustment--(1) Treatment of change in accounting method.
Notwithstanding any other procedure published prior to January 7, 1991,
concerning changes from the cash method, any taxpayer to whom section
448 applies must change its method of accounting in accordance with the
provisions of this paragraph (g) and paragraph (h) of this section. In
the case of any taxpayer required by
[[Page 74]]
this section to change its method of accounting for any taxable year,
the change shall be treated as a change initiated by the taxpayer. The
adjustments required under section 481(a) with respect to the change in
method of accounting of such a taxpayer shall not be reduced by amounts
attributable to taxable years preceding the Internal Revenue Code of
1954. Paragraph (h)(2) of this section provides procedures under which a
taxpayer may change to an overall accrual method of accounting for the
first taxable year the taxpayer is subject to this section (``first
section 448 year''). If the taxpayer complies with the provisions of
paragraph (h)(2) of this section for its first section 448 year, the
change shall be treated as made with the consent of the Commissioner.
Paragraph (h)(3) of this section provides procedures under which a
taxpayer may change to other than an overall accrual method of
accounting for its first section 448 year. Unless the taxpayer complies
with the provisions of paragraph (h)(2) or (h)(3) of this section for
its first section 448 year, the taxpayer must comply with the provisions
of paragraph (h)(4) of this section. See paragraph (h) of this section
for rules to effect a change in method of accounting.
(2) Timing rules for section 481(a) adjustment--(i) In general.
Except as otherwise provided in paragraphs (g)(2)(ii) and (g)(3) of this
section, a taxpayer required by this section to change from the cash
method must take the section 481(a) adjustment into account ratably
(beginning with the year of change) over the shorter of--
(A) The number of taxable years the taxpayer used the cash method,
or
(B) 4 taxable years,
provided the taxpayer complies with the provisions of paragraph (h)(2)
or (h)(3) of this section for its first section 448 year.
(ii) Hospital timing rules--(A) In general. In the case of a
hospital that is required by this section to change from the cash
method, the section 481(a) adjustment shall be taken into account
ratably (beginning with the year of change) over 10 years, provided the
taxpayer complies with the provisions of paragraph (h)(2) or (h)(3) of
this section for its first section 448 year.
(B) Definition of hospital. For purposes of paragraph (g) of this
section, a hospital is an institution--
(1) Accredited by the Joint Commission on Accreditation of
Healthcare Organizations or its predecessor (the JCAHO) (or accredited
or approved by a program of the qualified governmental unit in which
such institution is located if the Secretary of Health and Human
Services has found that the accreditation or comparable approval
standards of such qualified governmental unit are essentially equivalent
to those of the JCAHO);
(2) Used primarily to provide, by or under the supervision of
physicians, to inpatients diagnostic services and therapeutic services
for medical diagnosis, treatment, and care of injured, disabled, or sick
persons;
(3) Requiring every patient to be under the care and supervision of
a physician; and
(4) Providing 24-hour nursing services rendered or supervised by a
registered professional nurse and having a licensed practical nurse or
registered nurse on duty at all times.
For purposes of this section, an entity need not be owned by or on
behalf of a governmental unit or by a section 501(c)(3) organization, or
operated by a section 501(c)(3) organization, in order to be considered
a hospital. In addition, for purposes of this section, a hospital does
not include a rest or nursing home, continuing care facility, daycare
center, medical school facility, research laboratory, or ambulatory care
facility.
(C) Dual function facilities. With respect to any taxpayer whose
operations consist both of a hospital, and other facilities not
qualifying as a hospital, the portion of the adjustment required by
section 481(a) that is attributable to the hospital shall be taken into
account in accordance with the rules of paragraph (g)(2) of this section
relating to hospitals. The portion of the adjustment required by section
481(a) that is not attributable to the hospital shall be taken into
account in accordance with the rules of paragraph (g)(2) of this section
not relating to hospitals.
[[Page 75]]
(iii) Untimely change in method of accounting to comply with this
section. Unless a taxpayer (including a hospital and a cooperative)
required by this section to change from the cash method complies with
the provisions of paragraph (h)(2) or (h)(3) of this section for its
first section 448 year within the time prescribed by those paragraphs,
the taxpayer must take the section 481 (a) adjustment into account under
the provisions of any applicable administrative procedure that is
prescribed by the Commissioner after January 7, 1991, specifically for
purposes of complying with this section. Absent such an administrative
procedure, a taxpayer must request a change under Sec. 1.446-1(e)(3) and
shall be subject to any terms and conditions (including the year of
change) as may be imposed by the Commissioner.
(3) Special timing rules for section 481(a) adjustment--(i) One-
third rule. If, during the period the section 481(a) adjustment is to be
taken into account, the balance of the taxpayer's accounts receivable as
of the last day of each of two consecutive taxable years is less than
66\2/3\ percent of the taxpayer's accounts receivable balance at the
beginning of the first year of the section 481(a) adjustment, the
balance of the section 481(a) adjustment (relating to accounts
receivable) not previously taken into account shall be included in
income in the second taxable year. This paragraph (g)(3)(i) shall not
apply to any hospital (within the meaning of paragraph (g)(2)(ii) of
this section).
(ii) Cooperatives. Notwithstanding paragraph (g)(2)(i) of this
section, in the case of a cooperative (within the meaning of section
1381(a)) that is required by this section to change from the cash
method, the entire section 481(a) adjustment may, at the cooperative's
option, be taken into account in the year of change, provided the
cooperative complies with the provisions of paragraph (h)(2) or (h)(3)
of this section for its first section 448 year.
(iii) Cessation of trade or business. If the taxpayer ceases to
engage in the trade or business to which the section 481(a) adjustment
relates, or if the taxpayer operating the trade or business terminates
existence, and such cessation or termination occurs prior to the
expiration of the adjustment period described in paragraph (g)(2) (i) or
(ii) of this section, the taxpayer must take into account, in the
taxable year of such cessation or termination, the balance of the
adjustment not previously taken into account in computing taxable
income. For purposes of this paragraph (g)(3)(iii), the determination as
to whether a taxpayer has ceased to engage in the trade or business to
which the section 481(a) adjustment relates, or has terminated its
existence, is to be made under the principles of Sec. 1.446-1(e)(3)(ii)
and its underlying administrative procedures.
(iv) De minimis rule for a taxpayer other than a cooperative.
Notwithstanding paragraph (g)(2)(i) and (ii) of this section, a taxpayer
other than a cooperative (within the meaning of section 1381(a)) that is
required to change from the cash method by this section may elect to
use, in lieu of the adjustment period described in paragraph (g)(2)(i)
and (ii) of this section, the adjustment period for de minimis section
481(a) adjustments provided in the applicable administrative procedure
issued under Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's
consent to a change in accounting method. A taxpayer may make an
election under this paragraph (g)(3)(iv) only if--
(A) The taxpayer's entire net section 481(a) adjustment (whether
positive or negative) is a de minimis amount as determined under the
applicable administrative procedure issued under Sec. 1.446-1(e)(3)(ii)
for obtaining the Commissioner's consent to a change in accounting
method,
(B) The taxpayer complies with the provisions of paragraph (h)(2) or
(3) of this section for its first section 448 year,
(C) The return for such year is due (determined with regard to
extensions) after December 27, 1993, and
(D) The taxpayer complies with any applicable instructions to Form
3115 that specify the manner of electing the adjustment period for de
minimis section 481(a) adjustments.
(4) Additional rules relating to section 481(a) adjustment. In
addition to the rules set forth in paragraph (g) (2) and (3) of this
section, the following rules
[[Page 76]]
shall apply in taking the section 481(a) adjustment into account--
(i) Any net operating loss and tax credit carryforwards will be
allowed to offset any positive section 481(a) adjustment,
(ii) Any net operating loss arising in the year of change or in any
subsequent year that is attributable to a negative section 481(a)
adjustment may be carried back to earlier taxable years in accordance
with section 172, and
(iii) For purposes of determining estimated income tax payments
under sections 6654 and 6655, the section 481(a) adjustment will be
recognized in taxable income ratably throughout a taxable year.
(5) Outstanding section 481(a) adjustment from previous change in
method of accounting. If a taxpayer changed its method of accounting to
the cash method for a taxable year prior to the year the taxpayer was
required by this section to change from the cash method (the section 448
year), any section 481(a) adjustment from such prior change in method of
accounting that is outstanding as of the section 448 year shall be taken
into account in accordance with the provisions of this paragraph (g)(5).
A taxpayer shall account for any remaining portion of the prior section
481(a) adjustment outstanding as of the section 448 year by continuing
to take such remaining portion into account under the provisions and
conditions of the prior change in method of accounting, or, at the
taxpayer's option, combining or netting the remaining portion of the
prior section 481(a) adjustment with the section 481(a) adjustment
required under this section, and taking into account under the
provisions of this section the resulting net amount of the adjustment.
Any taxpayer choosing to combine or net the section 481(a) adjustments
as described in the preceding sentence shall indicate such choice on the
Form 3115 required to be filed by such taxpayer under the provisions of
paragraph (h) of this section.
(6) Examples. The following examples illustrate the provisions of
paragraph (g) of this section.
Example (1). Y is required by this section to change from the cash
method of accounting for its taxable year beginning January 1, 1987. Y
changes to an overall accrual method. The adjustment required by section
481(a) to effect the change is $10,000. Y has been using the cash method
for the 10-year period preceding the year of change. Y is required by
paragraph (g)(2)(i) of this section to include the section 481(a)
adjustment in taxable income ratably over four consecutive taxable
years, beginning with 1987, i.e., $2,500 of the section 481(a)
adjustment should be included in income for each of the four years.
Example (2). The facts are the same as in example (1), except that Y
is required to change from the cash method and changes to an overall
accrual method of accounting for its taxable year beginning January 1,
1989. The result is the same as in example (1), except that the four-
year period for ratably taking the section 481(a) adjustment into
account begins with the 1989 taxable year.
Example (3). Assume that X is required by this section to change
from the cash method and that it changes to an overall accrual method
for its taxable year beginning January 1, 1987. The adjustment required
by section 481 (a) to effect the change is $10,000. X was formed on
January 1, 1986, and began business operations during that year. Since X
only used the cash method for one year, X is required by paragraph
(g)(2)(i) of this section to include all ($10,000) of the section 481(a)
adjustment in taxable income for the 1987 taxable year.
Example (4). The facts are the same as in example (1). In addition,
Y previously changed from an accrual method of accounting to the cash
method for its taxable year beginning January 1, 1983. As a result of
that prior change, Y was required to take into account a $5,000 negative
section 481(a) adjustment ratably over a ten-year period, beginning with
the 1983 taxable year.
As of the beginning of the 1987 taxable year $3,000 of that
adjustment had not been taken into account. Y may continue to take the
remaining negative $3,000 section 481(a) adjustment into account ratably
over the remaining adjustment period for the prior change in method of
accounting (i.e., six remaining years). Alternatively, Y may combine or
net the negative $3,000 adjustment with the positive $10,000 section
481(a) adjustment required by this section, and include the resulting
$7,000 amount in taxable income ratably over four consecutive taxable
years, beginning with 1987. Y is not allowed to take the entire
unamortized amount of the prior section 481(a) adjustment into account
for its 1987 taxable year.
(h) Procedures for change in method of accounting--(1)
Applicability. Paragraph (h) of this section applies to taxpayers who
change from the cash method as required by this section. Paragraph (h)
of this section does not apply to a
[[Page 77]]
change in accounting method required by any Code section (or regulations
thereunder) other than this section.
(2) Automatic rule for changes to an overall accrual method--(i)
Timely changes in method of accounting. Notwithstanding any other
available procedures to change to the accrual method of accounting, a
taxpayer to whom paragraph (h) of this section applies who desires to
make a change to an overall accrual method for its first section 448
year must make that change under the provisions of this paragraph
(h)(2). A taxpayer changing to an overall accrual method under this
paragraph (h)(2) must file a current Form 3115 by the time prescribed in
paragraph (h)(2)(ii). In addition, the taxpayer must set forth on a
statement accompanying the Form 3115 the period over which the section
481(a) adjustment will be taken into account and the basis for such
conclusion. Moreover, the taxpayer must type or legibly print the
following statement at the top of page 1 of the Form 3115: ``Automatic
Change to Accrual Method--Section 448.'' The consent of the Commissioner
to the change in method of accounting is granted to taxpayers who change
to an overall accrual method under this paragraph (h)(2). See paragraph
(g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is
applicable, for rules to account for the section 481(a) adjustment.
(ii) Time and manner for filing Form 3115--(A) In general. Except as
provided in paragraph (h)(2)(ii)(B) of this section, the Form 3115
required by paragraph (h)(2)(i) must be filed no later than the due date
(determined with regard to extensions) of the taxpayer's federal income
tax return for the first section 448 year and must be attached to that
return.
(B) Extension of filing deadline. Notwithstanding paragraph
(h)(2)(ii)(A) of this section, the filing of the Form 3115 required by
paragraph (h)(2)(i) shall not be considered late if such Form 3115 is
attached to a timely filed amended income tax return for the first
section 448 year, provided that--
(1) The taxpayer's first section 448 year is a taxable year that
begins (or, pursuant to Sec. 1.441-2(c), is deemed to begin) in 1987,
1988, 1989, or 1990,
(2) The taxpayer has not been contacted for examination, is not
before appeals, and is not before a federal court with respect to an
income tax issue (each as defined in applicable administrative
pronouncements), unless the taxpayer also complies with any requirements
for approval in those applicable administrative pronouncements, and
(3) Any amended return required by this paragraph (h)(2)(ii)(B) is
filed on or before July 8, 1991.
Filing an amended return under this paragraph (h)(2)(ii)(B) does not
extend the time for making any other election. Thus, for example,
taxpayers that comply with this section by filing an amended return
pursuant to this paragraph (h)(2)(ii)(B) may not elect out of section
448 pursuant to paragraph (i)(2) of this section.
(3) Changes to a method other than overall accrual method--(i) In
general. A taxpayer to whom paragraph (h) of this section applies who
desires to change to a special method of accounting must make that
change under the provisions of this paragraph (h)(3), except to the
extent other special procedures have been promulgated regarding the
special method of accounting. Such a taxpayer includes taxpayers who
change to both an accrual method of accounting and a special method of
accounting such as a long-term contract method. In order to change an
accounting method under this paragraph (h)(3), a taxpayer must submit an
application for change in accounting method under the applicable
administrative procedures in effect at the time of change, including the
applicable procedures regarding the time and place of filing the
application for change in method. Moreover, a taxpayer who changes an
accounting method under this paragraph (h)(3) must type or legibly print
the following statement on the top of page 1 of Form 3115: ``Change to a
Special Method of Accounting--Section 448.'' The filing of a Form 3115
by any taxpayer requesting a change of method of accounting under this
paragraph (h)(3) for its taxable year beginning in 1987 will not be
considered late if the form is filed with the appropriate office of the
Internal Revenue Service on or before the later of: the date that is the
[[Page 78]]
180th day of the taxable year of change; or September 14, 1987. If the
Commissioner approves the taxpayer's application for change in method of
accounting, the timing of the adjustment required under section 481 (a),
if applicable, will be determined under the provisions of paragraph
(g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is
applicable. If the Commissioner denies the taxpayer's application for
change in accounting method, or if the taxpayer's application is
untimely, the taxpayer must change to an overall accrual method of
accounting under the provisions of either paragraph (h)(2) or (h)(4) of
this section, whichever is applicable.
(ii) Extension of filing deadline. Notwithstanding paragraph
(h)(3)(i) of this section, if the events or circumstances which under
section 448 disqualify a taxpayer from using the cash method occur after
the time prescribed under applicable procedures for filing the Form
3115, the filing of such form shall not be considered late if such form
is filed on or before 30 days after the close of the taxable year.
(4) Untimely change in method of accounting to comply with this
section. Unless a taxpayer to whom paragraph (h) of this section applies
complies with the provisions of paragraph (h)(2) or (h)(3) of this
section for its first section 448 year, the taxpayer must comply with
the requirements of Sec. 1.446-1 (e)(3) (including any applicable
administrative procedure that is prescribed thereunder after January 7,
1991 specifically for purposes of complying with this section) in order
to secure the consent of the Commissioner to change to a method of
accounting that is in compliance with the provisions of this section.
The taxpayer shall be subject to any terms and conditions (including the
year of change) as may be imposed by the Commissioner.
(i) Effective date--(1) In general. Except as provided in paragraph
(i)(2), (3), and (4) of this section, this section applies to any
taxable year beginning after December 31, 1986.
(2) Election out of section 448--(i) In general. A taxpayer may
elect not to have this section apply to any (A) transaction with a
related party (within the meaning of section 267(b) of the Internal
Revenue Code of 1954, as in effect on October 21, 1986), (B) loan, or
(C) lease, if such transaction, loan, or lease was entered into on or
before September 25, 1985. Any such election described in the preceding
sentence may be made separately with respect to each transaction, loan,
or lease. For rules relating to the making of such election, see
Sec. 301.9100-7T (temporary regulations relating to elections under the
Tax Reform Act of 1986). Notwithstanding the provisions of this
paragraph (i)(2), the gross receipts attributable to a transaction,
loan, or lease described in this paragraph (i)(2) shall be taken into
account for purposes of the $5,000,000 gross receipts test described in
paragraph (f) of this section.
(ii) Special rules for loans. If the taxpayer makes an election
under paragraph (i)(2)(i) of this section with respect to a loan entered
into on or before September 25, 1985, the election shall apply only with
respect to amounts that are attributable to the loan balance outstanding
on September 25, 1985. The election shall not apply to any amounts
advanced or lent after September 25, 1985, regardless of whether the
loan agreement was entered into on or before such date. Moreover, any
payments made on outstanding loan balances after September 25, 1985,
shall be deemed to first extinguish loan balances outstanding on
September 25, 1985, regardless of any contrary treatment of such loan
payments by the borrower and lender.
(3) Certain contracts entered into before September 25, 1985. This
section does not apply to a contract for the acquisition or transfer of
real property or a contract for services related to the acquisition or
development of real property if--
(i) The contract was entered into before September 25, 1985; and
(ii) The sole element of the contract which was not performed as of
September 25, 1985, was payment for such property or services.
(4) Transitional rule for paragraphs (g) and (h) of this section. To
the extent the provisions of paragraphs (g) and (h) of this section were
not reflected in paragraphs (g) and (h) of Sec. 1.448-1T (as set forth
in 26 CFR part 1 as revised on April 1, 1993), paragraphs (g) and (h) of
[[Page 79]]
this section will not be adversely applied to a taxpayer with respect to
transactions entered into before December 27, 1993.
[T.D. 8514, 58 FR 68299, Dec. 27, 1993, as amended by T.D. 8996, 67 FR
35012, May 17, 2002]
Sec. 1.448-1T Limitation on the use of the cash receipts and disbursements method of accounting (temporary).
(a) Limitation on accounting method--(1) In general. This section
prescribes regulations under section 448 relating to the limitation on
the use of the cash receipts and disbursements method of accounting (the
cash method) by certain taxpayers.
(2) Limitation rule. Except as otherwise provided in this section,
the computation of taxable income using the cash method is prohibited in
the case of a--
(i) C corporation,
(ii) Partnership with a C corporation as a partner, or
(iii) Tax shelter.
A partnership is described in paragraph (a)(2)(ii) of this section, if
the partnership has a C corporation as a partner at any time during the
partnership's taxable year beginning after December 31, 1986.
(3) Meaning of C corporation. For purposes of this section, the term
``C corporation'' includes any corporation that is not an S corporation.
For example, a regulated investment company (as defined in section 851)
or a real estate investment trust (as defined in section 856) is a C
corporation for purposes of this section. In addition, a trust subject
to tax under section 511 (b) shall be treated, for purposes of this
section, as a C corporation, but only with respect to the portion of its
activities that constitute an unrelated trade or business. Similarly,
for purposes of this section, a corporation that is exempt from federal
income taxes under section 501 (a) shall be treated as a C corporation
only with respect to the portion of its activities that constitute an
unrelated trade or business. Moreover, for purposes of determining
whether a partnership has a C corporation as a partner, any partnership
described in paragraph (a)(2)(ii) of this section is treated as a C
corporation. Thus, if partnership ABC has a partner that is a
partnership with a C corporation, then, for purposes of this section,
partnership ABC is treated as a partnership with a C corporation
partner.
(4) Treatment of a combination of methods. For purposes of this
section, the use of a method of accounting that records some, but not
all, items on the cash method shall be considered the use of the cash
method. Thus, a C corporation that uses a combination of accounting
methods including the use of the cash method is subject to this section.
(b) Tax shelter defined--(1) In general. For purposes of this
section, the term ``tax shelter'' means any--
(i) Enterprise (other than a C corporation) if at any time
(including taxable years beginning before January 1, 1987) interests in
such enterprise have been offered for sale in any offering required to
be registered with any federal or state agency having the authority to
regulate the offering of securities for sale,
(ii) Syndicate (within the meaning of paragraph (b)(3) of this
section), or
(iii) Tax shelter within the meaning of section 6661 (b)(2)(C)(ii)
(relating to (A) a partnership or other entity, (B) any investment plan
or arrangement, or (C) any other plan or arrangement, whose principal
purpose is the avoidance or evasion of Federal income tax).
(2) Requirement of registration. For purposes of paragraph (b)(1)(i)
of this section, an offering is required to be registered with a federal
or state agency if, under the applicable federal or state law, failure
to register the offering would result in a violation of the applicable
federal or state law (regardless of whether the offering is in fact
registered). In addition, an offering is required to be registered with
a federal or state agency if, under the applicable federal or state law,
failure to file a notice of exemption from registration would result in
a violation of the applicable federal or state law (regardless of
whether the notice is in fact filed).
(3) Meaning of syndicate. For purposes of paragraph (b)(1)(ii) of
this section, the term ``syndicate'' means a partnership or other entity
(other than a C corporation) if more than 35 percent of
[[Page 80]]
the losses of such entity during the taxable year (for taxable years
beginning after December 31, 1986) are allocated to limited partners or
limited entrepreneurs. For purposes of this paragraph (b)(3), the term
``limited entrepreneur'' has the same meaning given such term in section
464 (e)(2). In addition, in determining whether an interest in a
partnership is held by a limited partner, or an interest in an entity or
enterprise is held by a limited entrepreneur, section 464 (c)(2) shall
apply in the case of the trade or business of farming (as defined in
paragraph (d)(2) of this section), and section 1256 (e)(3)(C) shall
apply in any other case. Moreover, for purposes of this paragraph
(b)(3), the losses of a partnership, entity, or enterprise (the
enterprise) means the excess of the deductions allowable to the
enterprise over the amount of income recognized by such enterprise under
the enterprise's method of accounting used for federal income tax
purposes (determined without regard to this section). For this purpose,
gains or losses from the sale of capital assets or section 1221 (2)
assets are not taken into account.
(4) Presumed tax avoidance. For purposes of paragraph (b)(1)(iii) of
this section, marketed arrangements in which persons carrying on farming
activities using the services of a common managerial or administrative
service will be presumed to have the principal purpose of tax avoidance
if such persons use borrowed funds to prepay a substantial portion of
their farming expenses (e.g., payment for farm supplies that will not be
used or consumed until a taxable year subsequent to the taxable year of
payment).
(5) Taxable year tax shelter must change accounting method. A
partnership, entity, or enterprise that is a tax shelter must change
from the cash method for the later of (i) the first taxable year
beginning after December 31, 1986, or (ii) the taxable year that such
partnership, entity, or enterprise becomes a tax shelter.
(c) Effect of section 448 on other provisions. Nothing in section
448 shall have any effect on the application of any other provision of
law that would otherwise limit the use of the cash method, and no
inference shall be drawn from section 448 with respect to the
application of any such provision. For example, nothing in section 448
affects the requirement of section 447 that certain corporations must
use an accrual method of accounting in computing taxable income from
farming, or the requirement of Sec. 1.446-1(c)(2) that an accrual method
be used with regard to purchases and sales of inventory. Similarly,
nothing in section 448 affects the authority of the Commissioner under
section 446(b) to require the use of an accounting method that clearly
reflects income, or the requirement under section 446(e) that a taxpayer
secure the consent of the Commissioner before changing its method of
accounting. For example, a taxpayer using the cash method may be
required to change to an accrual method of accounting under section
446(b) because such method clearly reflects that taxpayer's income, even
though the taxpayer is not prohibited by section 448 from using the cash
method. Similarly, a taxpayer using an accrual method of accounting that
is not prohibited by section 448 from using the cash method may not
change to the cash method unless the taxpayer secures the consent of the
Commissioner under section 446(e), and, in the opinion of the
Commissioner, the use of the cash method clearly reflects that
taxpayer's income under section 446(b).
(d) Exception for farming business--(1) In general. Except in the
case of a tax shelter, this section shall not apply to any farming
business. A taxpayer engaged in a farming business and a separate
nonfarming business is not prohibited by this section from using the
cash method with respect to the farming business, even though the
taxpayer may be prohibited by this section from using the cash method
with respect to the nonfarming business.
(2) Meaning of farming business. For purposes of paragraph (d) of
this section, the term ``farming business'' means--
(i) The trade or business of farming as defined in section
263A(e)(4) (including the operation of a nursery or sod farm, or the
raising or harvesting of trees bearing fruit, nuts, or other crops, or
ornamental trees), or
[[Page 81]]
(ii) The raising, harvesting , or growing of trees described in
section 263A(c)(5) (relating to trees raised, harvested, or grown by the
taxpayer other than trees described in paragraph (d)(2)(i) of this
section).
Thus, for purposes of this section, the term ``farming business''
includes the raising of timber. For purposes of this section, the term
``farming business'' does not include the processing of commodities or
products beyond those activities normally incident to the growing,
raising or harvesting of such products. For example, assume that a C
corporation taxpayer is in the business of growing and harvesting wheat
and other grains. The taxpayer processes the harvested grains to produce
breads, cereals, and similar food products which it sells to customers
in the course of its business. Although the taxpayer is in the farming
business with respect to the growing and harvesting of grain, the
taxpayer is not in the farming business with respect to the processing
of such grains to produce food products which the taxpayer sells to
customers. Similarly, assume that a taxpayer is in the business of
raising poultry or other livestock. The taxpayer uses the livestock in a
meat processing operation in which the livestock are slaughtered,
processed, and packaged or canned for sale to customers. Although the
taxpayer is in the farming business with respect to the raising of
livestock, the taxpayer is not in the farming business with respect to
the meat processing operation. However, under this section the term
``farming business'' does include processing activities which are
normally incident to the growing, raising or harvesting of agricultural
products. For example, assume a taxpayer is in the business of growing
fruits and vegetables. When the fruits and vegetables are ready to be
harvested, the taxpayer picks, washes, inspects, and packages the fruits
and vegetables for sale. Such activities are normally incident to the
raising of these crops by farmers. The taxpayer will be considered to be
in the business of farming with respect to the growing of fruits and
vegetables, and the processing activities incident to the harvest.
(e) Exception for qualified personal service corporation--(1) In
general. Except in the case of a tax shelter, this section does not
apply to a qualified personal service corporation.
(2) Certain treatment for qualified personal service corporation.
For purposes of paragraph (a)(2)(ii) of this section (relating to
whether a partnership has a C corporation as a partner), a qualified
personal service corporation shall be treated as an individual.
(3) Meaning of qualified personal service corporation. For purposes
of this section, the term ``qualified personal service corporation''
means any corporation that meets--
(i) The function test paragraph (e)(4) of this section, and
(ii) The ownership test of paragraph (e)(5) of this section.
(4) Function test--(i) In general. A corporation meets the function
test if substantially all the corporation's activities for a taxable
year involve the performance of services in one or more of the following
fields--
(A) Health,
(B) Law,
(C) Engineering (including surveying and mapping),
(D) Architecture,
(E) Accounting,
(F) Actuarial science,
(G) Performing arts, or
(H) Consulting.
Substantially all of the activities of a corporation are involved in the
performance of services in any field described in the preceding sentence
(a qualifying field), only if 95 percent or more of the time spent by
employees of the corporation, serving in their capacity as such, is
devoted to the performance of services in a qualifying field. For
purposes of determining whether this 95 percent test is satisfied, the
performance of any activity incident to the actual performance of
services in a qualifying field is considered the performance of services
in that field. Activities incident to the performance of services in a
qualifying field include the supervision of employees engaged in
directly providing services to clients, and the performance of
administrative and support services incident to such activities.
[[Page 82]]
(ii) Meaning of services performed in the field of health. For
purposes of paragraph (e)(4)(i)(A) of this section, the performance of
services in the field of health means the provision of medical services
by physicians, nurses, dentists, and other similar healthcare
professionals. The performance of services in the field of health does
not include the provision of services not directly related to a medical
field, even though the services may purportedly relate to the health of
the service recipient. For example, the performance of services in the
field of health does not include the operation of health clubs or health
spas that provide physical exercise or conditioning to their customers.
(iii) Meaning of services performed in the field of performing arts.
For purposes of paragraph (e)(4)(i)(G) of this section, the performance
of services in the field of the performing arts means the provision of
services by actors, actresses, singers, musicians, entertainers, and
similar artists in their capacity as such. The performance of services
in the field of the performing arts does not include the provision of
services by persons who themselves are not performing artists (e.g.,
persons who may manage or promote such artists, and other persons in a
trade or business that relates to the performing arts). Similarly, the
performance of services in the field of the performing arts does not
include the provision of services by persons who broadcast or otherwise
disseminate the performances of such artists to members of the public
(e.g., employees of a radio station that broadcasts the performances of
musicians and singers). Finally, the performance of services in the
field of the performing arts does not include the provision of services
by athletes.
(iv) Meaning of services performed in the field of consulting--(A)
In general. For purposes of paragraph (e)(4)(i)(H) of this section, the
performance of services in the field of consulting means the provision
of advice and counsel. The performance of services in the field of
consulting does not include the performance of services other than
advice and counsel, such as sales or brokerage services, or economically
similar services. For purposes of the preceding sentence, the
determination of whether a person's services are sales or brokerage
services, or economically similar services, shall be based on all the
facts and circumstances of that person's business. Such facts and
circumstances include, for example, the manner in which the taxpayer is
compensated for the services provided (e.g., whether the compensation
for the services is contingent upon the consummation of the transaction
that the services were intended to effect).
(B) Examples. The following examples illustrate the provisions of
paragraph (e)(4)(iv)(A) of this section. The examples do not address all
types of services that may or may not qualify as consulting. The
determination of whether activities not specifically addressed in the
examples qualify as consulting shall be made by comparing the service
activities in question to the types of service activities discussed in
the examples. With respect to a corporation which performs services
which qualify as consulting under this section, and other services which
do not qualify as consulting, see paragraph (e)(4)(i) of this section
which requires that substantially all of the corporation's activities
involve the performance of services in a qualifying field.
Example (1). A taxpayer is in the business of providing economic
analyses and forecasts of business prospects for its clients. Based on
these analyses and forecasts, the taxpayer advises its clients on their
business activities. For example, the taxpayer may analyze the economic
conditions and outlook for a particular industry which a client is
considering entering. The taxpayer will then make recommendations and
advise the client on the prospects of entering the industry, as well as
on other matters regarding the client's activities in such industry. The
taxpayer provides similar services to other clients, involving, for
example, economic analyses and evaluations of business prospects in
different areas of the United States or in other countries, or economic
analyses of overall economic trends and the provision of advice based on
these analyses and evaluations. The taxpayer is considered to be engaged
in the performance of services in the field of consulting.
Example (2). A taxpayer is in the business of providing services
that consist of determining a client's electronic data processing needs.
The taxpayer will study and examine the client's business, focusing on
the types of data and information relevant to the client and the needs
of the client's employees for
[[Page 83]]
access to this information. The taxpayer will then make recommendations
regarding the design and implementation of data processing systems
intended to meet the needs of the client. The taxpayer does not,
however, provide the client with additional computer programming
services distinct from the recommendations made by the taxpayer with
respect to the design and implementation of the client's data processing
systems. The taxpayer is considered to be engaged in the performance of
services in the field of consulting.
Example (3). A taxpayer is in the business of providing services
that consist of determining a client's management and business structure
needs. The taxpayer will study the client's organization, including, for
example, the departments assigned to perform specific functions, lines
of authority in the managerial hierarchy, personnel hiring, job
responsibility, and personnel evaluations and compensation. Based on the
study, the taxpayer will then advise the client on changes in the
client's management and business structure, including, for example, the
restructuring of the client's departmental systems or its lines of
managerial authority. The taxpayer is considered to be engaged in the
performance of services in the field of consulting.
Example (4). A taxpayer is in the business of providing financial
planning services. The taxpayer will study a particular client's
financial situation, including, for example, the client's present
income, savings and investments, and anticipated future economic and
financial needs. Based on this study, the taxpayer will then assist the
client in making decisions and plans regarding the client's financial
activities. Such financial planning includes the design of a personal
budget to assist the client in monitoring the client's financial
situation, the adoption of investment strategies tailored to the
client's needs, and other similar services. The taxpayer is considered
to be engaged in the performance of services in the field of consulting.
Example (5). A taxpayer is in the business of executing transactions
for customers involving various types of securities or commodities
generally traded through organized exchanges or other similar networks.
The taxpayer provides its clients with economic analyses and forecasts
of conditions in various industries and businesses. Based on these
analyses, the taxpayer makes recommendations regarding transactions in
securities and commodities. Clients place orders with the taxpayer to
trade securities or commodities based on the taxpayer's recommendations.
The taxpayer's compensation for its services is typically based on the
trade orders. The taxpayer is not considered to be engaged in the
performance of services in the field of consulting. The taxpayer is
engaged in brokerage services. Relevant to this determination is the
fact that the compensation of the taxpayer for its services is
contingent upon the consummation of the transaction the services were
intended to effect (i.e., the execution of trade orders for its
clients).
Example (6). A taxpayer is in the business of studying a client's
needs regarding its data processing facilities and making
recommendations to the client regarding the design and implementation of
data processing systems. The client will then order computers and other
data processing equipment through the taxpayer based on the taxpayer's
recommendations. The taxpayer's compensation for its services is
typically based on the equipment orders made by the clients. The
taxpayer is not considered to be engaged in the performance of services
in the field of consulting. The taxpayer is engaged in the performance
of sales services. Relevant to this determination is the fact that the
compensation of the taxpayer for its services it contingent upon the
consummation of the transaction the services were intended to effect
(i.e., the execution of equipment orders for its clients).
Example (7). A taxpayer is in the business of assisting businesses
in meeting their personnel requirements by referring job applicants to
employers with hiring needs in a particular area. The taxpayer may be
informed by potential employers of their need for job applicants, or,
alternatively, the taxpayer may become aware of the client's personnel
requirements after the taxpayer studies and examines the client's
management and business structure. The taxpayer's compensation for its
services is typically based on the job applicants, referred by the
taxpayer to the clients, who accept employment positions with the
clients. The taxpayer is not considered to be engaged in the performance
of services in the field of consulting. The taxpayer is involved in the
performance of services economically similar to brokerage services.
Relevant to this determination is the fact that the compensation of the
taxpayer for its services is contingent upon the consummation of the
transaction the services were intended to effect (i.e., the hiring of a
job applicant by the client).
Example (8). The facts are the same as in example (7), except that
the taxpayer's clients are individuals who use the services of the
taxpayer to obtain employment positions. The taxpayer is typically
compensated by its clients who obtain employment as a result of the
taxpayer's services. For the reasons set forth in example (7), the
taxpayer is not considered to be engaged in the performance of services
in the field of consulting.
Example (9). A taxpayer is in the business of assisting clients in
placing advertisements for their goods and services. The taxpayer
analyzes the conditions and trends in the client's particular industry,
and then makes
[[Page 84]]
recommendations to the client regarding the types of advertisements
which should be placed by the client and the various types of
advertising media (e.g., radio, television, magazines, etc.) which
should be used by the client. The client will then purchase, through the
taxpayer, advertisements in various media based on the taxpayer's
recommendations. The taxpayer's compensation for its services is
typically based on the particular orders for advertisements which the
client makes. The taxpayer is not considered to be engaged in the
performance of services in the field of consulting. The taxpayer is
engaged in the performance of services economically similar to brokerage
services. Relevant to this determination is the fact that the
compensation of the taxpayer for its services is contingent upon the
consummation of the transaction the services were intended to effect
(i.e., the placing of advertisements by clients).
Example (10). A taxpayer is in the business of selling insurance
(including life and casualty insurance), annuities, and other similar
insurance products to various individual and business clients. The
taxpayer will study the particular client's financial situation,
including, for example, the client's present income, savings and
investments, business and personal insurance risks, and anticipated
future economic and financial needs. Based on this study, the taxpayer
will then make recommendations to the client regarding the desirability
of various insurance products. The client will then purchase these
various insurance products through the taxpayer. The taxpayer's
compensation for its services is typically based on the purchases made
by the clients. The taxpayer is not considered to be engaged in the
performance of services in the field of consulting. The taxpayer is
engaged in the performance of brokerage or sales services. Relevant to
this determination is the fact that the compensation of the taxpayer for
its services is contingent upon the consummation of the transaction the
services were intended to effect (i.e., the purchase of insurance
products by its clients).
(5) Ownership test--(i) In general. A corporation meets the
ownership test, if at all times during the taxable year, substantially
all the corporation's stock, by value, is held, directly or indirectly,
by--
(A) Employees performing services for such corporation in connection
with activities involving a field referred to in paragraph (e)(4) of
this section,
(B) Retired employees who had performed such services for such
corporation,
(C) The estate of any individual described in paragraph (e)(5)(i)
(A) or (B) of this section, or
(D) Any other person who acquired such stock by reason of the death
of an individual described in paragraph (e)(5)(i) (A) or (B) of this
section, but only for the 2-year period beginning on the date of the
death of such individual.
For purposes of this paragraph (e)(5) of this section, the term
``substantially all'' means an amount equal to or greater than 95
percent.
(ii) Definition of employee. For purposes of the ownership test of
this paragraph (e)(5) of this section, a person shall not be considered
an employee of a corporation unless the services performed by that
person for such corporation, based on the facts and circumstances, are
more than de minimis. In addition, a person who is an employee of a
corporation shall not be treated as an employee of another corporation
merely by reason of the employer corporation and the other corporation
being members of the same affiliated group or otherwise related.
(iii) Attribution rules. For purposes of this paragraph (e)(5) of
this section, a corporation's stock is considered held indirectly by a
person if, and to the extent, such person owns a proportionate interest
in a partnership, S corporation, or qualified personal service
corporation that owns such stock. No other arrangement or type of
ownership shall constitute indirect ownership of a corporation's stock
for purposes of this paragraph (e)(5) of this section. Moreover, stock
of a corporation held by a trust is considered held by a person if, and
to the extent, such person is treated under subpart E, part I,
subchapter J, chapter 1 of the Code as the owner of the portion of the
trust that consists of such stock.
(iv) Disregard of community property laws. For purposes of this
paragraph (e)(5) of this section, community property laws shall be
disregarded. Thus, in determining the stock ownership of a corporation,
stock owned by a spouse solely by reason of community property laws
shall be treated as owned by the other spouse.
(v) Treatment of certain stock plans. For purposes of this paragraph
(e)(5) of
[[Page 85]]
this section, stock held by a plan described in section 401 (a) that is
exempt from tax under section 501 (a) shall be treated as held by an
employee described in paragraph (e)(5)(i)(A) of this section.
(vi) Special election for certain affiliated groups. For purposes of
determining whether the stock ownership test of this paragraph (e)(5) of
this section has been met, at the election of the common parent of an
affiliated group (within the meaning of section 1504 (a)), all members
of such group shall be treated as one taxpayer if substantially all
(within the meaning of paragraph (e)(4)(i) of this section) the
activities of all such members (in the aggregate) are in the same field
described in paragraph (e)(4)(i)(A)-(H) of this section. For rules
relating to the making of the election, see 26 CFR 5h.5 (temporary
regulations relating to elections under the Tax Reform Act of 1986).
(vii) Examples. The following examples illustrate the provisions of
paragraph (e) of this section:
Example (1). (i) X, a Corporation, is engaged in the business of
providing accounting services to its clients. These services consist of
the preparation of audit and financial statements and the preparation of
tax returns. For purposes of section 448, such services consist of the
performance of services in the field of accounting. In addition, for
purposes of section 448, the supervision of employees directly preparing
the statements and returns, and the performance of all administrative
and support services incident to such activities (including secretarial,
janitorial, purchasing, personnel, security, and payroll services) are
the performance of services in the field of accounting.
(ii) In addition, X owns and leases a portion of an office building.
For purposes of this section, the following types of activities
undertaken by the employees of X shall be considered as the performance
of services in a field other than the field of accounting: (A) services
directly relating to the leasing activities, e.g., time spent in leasing
and maintaining the leased portion of the building; (B) supervision of
employees engaged in directly providing services in the leasing
activity; and (C) all administrative and support services incurred
incident to services described in (A) and (B). The leasing activities of
X are considered the performance of services in a field other than the
field of accounting, regardless of whether such leasing activities
constitute a trade or business under the Code. If the employees of X
spend 95% or more of their time in the performance of services in the
field of accounting, X satisfies the function test of paragraph (e)(4)
of this section.
Example (2). Assume that Y, a C corporation, meets the function test
of paragraph (e)(4) of this section. Assume further that all the
employees of Y are performing services for Y in a qualifying field as
defined in paragraph (e)(4) of this section. P, a partnership, owns 40%,
by value, of the stock of Y. The remaining 60% of the stock of Y is
owned directly by employees of Y. Employees of Y have an aggregate
interest of 90% in the capital and profits of P. This, 96% of the stock
of Y is held directly, or indirectly, by employees of Y performing
services in a qualifying field. Accordingly, Y meets the ownership test
of paragraph (e)(5) of this section and is a qualified personal service
corporation.
Example (3). The facts are the same as in example (2), except that
40% of the stock of Y is owned by Z, a C corporation. The remaining 60%
of the stock is owned directly by the employees of Y. Employees of Y own
90% of the stock, by value, of Z. Assume that Z independently qualifies
as a personal service corporation. The result is the same as in example
(2), i.e., 96% of the stock of Y is held, directly or indirectly, by
employees of Y performing services in a qualifying field. Thus, Y is a
qualified personal service corporation.
Example (4). The facts are the same as in example (3), except that Z
does not independently qualify as a personal service corporation.
Because Z is not a qualified personal service corporation, the Y stock
owned by Z is not treated as being held indirectly by the Z
shareholders. Consequently, only 60% of the stock of Y is held, directly
or indirectly, by employees of Y. Thus, Y does not meet the ownership
test of paragraph (e)(5) of this section, and is not a qualified
personal service corporation.
Example (5). Assume that W, a C corporation, meets the function test
of paragraph (e)(4) of this section. In addition, assume that all the
employees of W are performing services for W in a qualifying field.
Nominal legal title to 100% of the stock of W is held by employees of W.
However, due solely to the operation of community property laws, 20% of
the stock of W is held by spouses of such employees who themselves are
not employees of W. In determining the ownership of the stock, community
property laws are disregarded. Thus, Y meets the ownership test of
paragraph (e)(5) of this section, and is a qualified personal service
corporation.
Example (6). Assume that 90% of the stock of T, a C corporation, is
directly owned by the employees of T. Spouses of T's employees directly
own 5% of the stock of T. The spouses are not employees of T, and their
ownership does not occur solely by operation
[[Page 86]]
of community property laws. In addition, 5% of the stock of T is held by
trusts (other than a trust described in section 401(a) that is exempt
from tax under section 501(a)), the sole beneficiaries of which are
employees of T. The employees are not treated as owners of the trusts
under subpart E, part I, subchapter J, chapter 1 of the Code. Since a
person is not treated as owning the stock of a corporation owned by that
person's spouse, or by any portion of a trust that is not treated as
owned by such person under subpart E, only 90% of the stock of T is
treated as held, directly or indirectly, by employees of T. Thus, T does
not meet the ownership test of paragraph (e)(5) of this section, and is
not a qualified personal service corporation.
Example (7). Assume that Y, a C corporation, directly owns all the
stock of three subsidiaries, F, G, and H. Y is a common parent of an
affiliated group within the meaning of section 1504(a) consisting of Y,
F, G, and H. Y is not engaged in the performance of services in a
qualifying field. Instead, Y is a holding company whose activities
consist of its ownership and investment in its operating subsidiaries.
Substantially all the activities of F involve the performance of
services in the field of engineering. In addition, a majority of (but
not substantially all) the activities of G involve the performance of
services in the field of engineering; the remainder of G's services
involve the performance of services in a nonqualifying field. Moreover,
a majority of (but not substantially all) the activities of H involve
the performance of services in the field of engineering; the remainder
of H's activities involve the performance of services in the field of
architecture. Nevertheless, substantially all the activities of the
group consisting of Y, F, G, and H, in the aggregate, involve the
performance of services in the field of engineering. Accordingly, Y
elects under paragraph (e)(5)(vi) of this section to be treated as one
taxpayer for determining the ownership test of paragraph (e)(5) of this
section. Assume that substantially all the stock of Y (by value) is held
by employees of F, G, or H who perform services in connection with a
qualifying field (engineering or architecture). Thus, for purposes of
determining whether any member corporation is a qualified personal
service corporation, the ownership test of paragraph (e)(5) of this
section has been satisfied. Since F and H satisfy the function test of
paragraph (e)(4) of this section, F and H are qualified personal service
corporations. However, since Y and G each fail the function test of
paragraph (e)(4) of this section, neither corporation is a qualified
personal service corporation.
Example (8). The facts are the same as in example (7), except that
less than substantially all the activities of the group consisting of Y,
F, G, and H, in the aggregate, are performed in the field of
engineering. Substantially all the activities of the group consisting of
Y, F, G, and H, are, in the aggregate, performed in two fields, the
fields of engineering and architecture. Y may not elect to have the
affiliated group treated as one taxpayer for purposes of determining
whether group members meet the ownership test of paragraph (e)(5) of
this section. The election is available only if substantially all the
activities of the group, in the aggregate, involve the performance of
services in only one qualifying field. Moreover, none of the group
members are qualified personal service corporations. Y fails the
function test of paragraph (e)(4) of this section because less than
substantially all the activities of Y are performed in a qualifying
field. In addition, F, G, and H fail the ownershp test of paragraph
(e)(5) of this section because substantially all their stock is owned by
Y and not by their employees. The owners of Y are not deemed to
indirectly own the stock owned by Y because Y is not a qualified
personal service corporation.
Example (9). (i) The facts are the same as in example (8), except Y
itself satisfies the function tests of paragraph (e)(4) of this section
because substantially all the activities of Y involve the performance of
services in the field of engineering. In addition, assume that all
employees of Y are involved in the performance of services in the field
of engineering, and that all such employees own 100% of Y's stock.
Moreover, assume that one-third of all the employees of Y are separately
employed by F. Similarly, another one-third of the employees of Y are
separately employed by G and H, respectively. None of the employees of Y
are employed by more than one of Y's subsidiaries. Also, no other
persons except the employees of Y are employed by any of the
subsidiaries.
(ii) Y is a personal service corporation under section 448 because Y
satisfies both the function and the ownership test of paragraphs (e) (4)
and (5) of this section. As in example (8), Y is unable to make the
election to have the affiliated group treated as one taxpayer for
purposes of determining whether group members meet the ownership test of
paragraph (e)(5) of this section because less than substantially all the
activities, in the aggregate, of the group members are performed in one
of the qualifying fields. However, because Y is a personal service
corporation, the stock owned by Y is treated as indirectly owned,
proportionately, by the owners of Y. Thus, the employees of F are
collectively treated as owning one-third of the stock of F, G, and H.
The employees of G and H are similarly treated as owning one-third of
each subsidiary's stock.
(iii) F, G, and H each fail the ownership test of paragraph (e)(5)
of this section because less than substantially all of each
corporation's stock is owned by the employees of the respective
corporation. Only one-third
[[Page 87]]
of each corporation's stock is owned by employees of that corporation.
Thus, F, G, and H are not qualified personal service corporations.
Example (10). (i) Assume that Y, a C corporation, directly owns all
the stock of three subsidiaries, F, G, and Z. Y is a common parent of an
affiliated group within the meaning of section 1504(a) consisting of Y,
F, and G. Z is a foreign corporation and is excluded from the affiliated
group under section 1504. Assume that Y is a holding company whose
activities consist of its ownership and investment in its operating
subsidiaries. Substantially all the activities of F, G, and Z involve
the performance of services in the field of engineering. Assume that
employees of Z own one-third of the stock of Y and that none of these
employees are also employees of Y, F, or G. In addition, assume that Y
elects to be treated as one taxpayer for determining whether group
members meet the ownership tests of paragraph (e)(5) of this section.
Thus, Y, F, and G are treated as one taxpayer for purposes of the
ownership test.
(ii) None of the members of the group are qualified personal service
corporations. Y, F, and G fail the ownership test of paragraph (e)(5) of
this section because less than substantially all the stock of Y is owned
by employees of either Y, F, or G. Moreover, Z fails the ownership test
of paragraph (e)(5) of this section because substantially all its stock
is owned by Y and not by its employees.
(6) Application of function and ownership tests. A corporation that
fails the function test of paragraph (e)(4) of this section for any
taxable year, or that fails the ownership test of paragraph (e)(5) of
this section at any time during any taxable year, shall change from the
cash method effective for the year in which the corporation fails to
meet the function test or the ownership test. For example, if a personal
service corporation fails the function test for taxable year 1987, such
corporation must change from the cash method effective for taxable year
1987. A corporation that fails the function or ownership test for a
taxable year shall not be treated as a qualified personal service
corporation for any part of that taxable year.
(f) Exception for entities with gross receipts of not more than $5
million--(1) In general. Except in the case of a tax shelter, this
section shall not apply to any C corporation or partnership with a C
corporation as a partner for any taxable year if, for all prior taxable
years beginning after December 31, 1985, such corporation or partnership
(or any predecessor thereof) meets the $5,000,000 gross receipts test of
paragraph (f)(2) of this section.
(2) The $5,000,000 gross receipts test--(i) In general. A
corporation meets the $5,000,000 gross receipts test of this paragraph
(f)(2) for any prior taxable year if the average annual gross receipts
of such corporation for the 3 taxable years (or, if shorter, the taxable
years during which such corporation was in existence) ending with such
prior taxable year does not exceed $5,000,000. In the case of a C
corporation exempt from federal income taxes under section 501(a), or a
trust subject to tax under section 511(b) that is treated as a C
corporation under paragraph (a)(3) of this section, only gross receipts
from the activities of such corporation or trust that constitute
unrelated trades or businesses are taken into account in determining
whether the $5,000,000 gross receipts test is satisfied. A partnership
with a C corporation as a partner meets the $5,000,000 gross receipts
test of this paragraph (f)(2) for any prior taxable year if the average
annual gross receipts of such partnership for the 3 taxable years (or,
if shorter, the taxable years during which such partnership was in
existence) ending with such prior year does not exceed $5,000,000. The
gross receipts of the corporate partner are not taken into account in
determining whether the partnership meets the $5,000,000 gross receipts
test.
(ii) Aggregation of gross receipts. For purposes of determining
whether the $5,000,000 gross receipts test has been satisfied, all
persons treated as a single employer under section 52 (a) or (b), or
section 414 (m) or (o) (or who would be treated as a single employer
under such sections if they had employees) shall be treated as one
person. Gross receipts attributable to transactions between persons who
are treated as a common employer under this paragraph shall not be taken
into account in determining whether the $5,000,000 gross receipts test
is satisified.
(iii) Treatment of short taxable year. In the case of any taxable
year of less than 12 months (a short taxable year), the gross receipts
shall be annualized by (A) multiplying the gross receipts
[[Page 88]]
for the short period by 12 and (B) dividing the result by the number of
months in the short period.
(iv) Determination of gross receipts--(A) In general. The term
``gross receipts'' means gross receipts of the taxable year in which
such receipts are properly recognized under the taxpayer's accounting
method used in that taxable year (determined without regard to this
section) for federal income tax purposes. For this purpose, gross
receipts include total sales (net of returns and allowances) and all
amounts received for services. In addition, gross receipts include any
income from investments, and from incidental or outside sources. For
example, gross receipts include interest (including original issue
discount and tax-exempt interest within the meaning of section 103),
dividends, rents, royalties, and annuities, regardless of whether such
amounts are derived in the ordinary course of the taxpayer's trade of
business. Gross receipts are not reduced by cost of goods sold or by the
cost of property sold if such property is described in section 1221 (1),
(3), (4) or (5). With respect to sales of capital assets as defined in
section 1221, or sales of property described in 1221 (2) (relating to
property used in a trade or business), gross receipts shall be reduced
by the taxpayer's adjusted basis in such property. Gross receipts do not
include the repayment of a loan or similar instrument (e.g., a repayment
of the principal amount of a loan held by a commercial lender). Finally,
gross receipts do not include amounts received by the taxpayer with
respect to sales tax or other similar state and local taxes if, under
the applicable state or local law, the tax is legally imposed on the
purchaser of the good or service, and the taxpayer merely collects and
remits the tax to the taxing authority. If, in contrast, the tax is
imposed on the taxpayer under the applicable law, then gross receipts
shall include the amounts received that are allocable to the payment of
such tax.
(3) Examples. The following examples illustrate the provisions of
paragraph (f) of this section:
Example (1). X, a calendar year C corporation, was formed on January
1, 1986. Assume that in 1986 X has gross receipts of $15 million. For
taxable year 1987, this section applies to X because in 1986, the period
during which X was in existence, X has average annual gross receipts of
more than $5 million.
Example (2). Y, a calendar year C corporation that is not a
qualified personal service corporation, has gross receipts of $10
million, $9 million, and $4 million for taxable years 1984, 1985, and
1986, respectively. In taxable year 1986, X has average annual gross
receipts for the 3-taxable-year period ending with 1986 of $7.67 million
($10 million + 9 million + 4 million /3). Thus, for taxable year 1987,
this section applies and Y must change from the cash method for such
year.
Example (3). Z, a C corporation which is not a qualified personal
service corporation, has a 5% partnership interest in ZAB partnership, a
calendar year cash method taxpayer. All other partners of ZAB
partnership are individuals. Z corporation has average annual gross
receipts of $100,000 for the 3-taxable-year period ending with 1986
(i.e., 1984, 1985 and 1986). The ZAB partnership has average annual
gross receipts of $6 million for the same 3-taxable-year period. Since
ZAB fails to meet the $5,000,000 gross receipts test for 1986, this
section applies to ZAB for its taxable year beginning January 1, 1987.
Accordingly, ZAB must change from the cash method for its 1987 taxable
year. The gross receipts of Z corporation are not relevant in
determining whether ZAB is subject to this section.
Example (4). The facts are the same as in example (3), except that
during the 1987 taxable year of ZAB, the Z corporation transfers its
partnership interest in ZAB to an individual. Under paragraph (a)(1) of
this section, ZAB is treated as a partnership with a C corporation as a
partner. Thus, this section requires ZAB to change from the cash method
effective for its taxable year 1987. If ZAB later desires to change its
method of accounting to the cash method for its taxable year beginning
January 1, 1988 (or later), ZAB must comply with all requirements of
law, including sections 446(b), 446(e), and 481, to effect the change.
Example (5). X, a C corporation that is not a qualified personal
service corporation, was formed on January 1, 1986, in a transaction
described in section 351. In the transaction, A, an individual,
contributed all of the assets and liabilities of B, a trade or business,
to X, in return for the receipt of all the outstanding stock of X.
Assume that in 1986 X has gross receipts of $4 million. In 1984 and
1985, the gross receipts of B, the trade or business, were $10 million
and $7 million respectively. The gross receipts test is applied for the
period during which X and its predecessor trade or business were in
existence. X has average annual gross receipts for the 3-taxable-year
period ending with 1986 of $7
[[Page 89]]
million ($10 million + $7 million + $4 million/3). Thus, for taxable
year 1987, this section applies and X must change from the cash method
for such year.
[T.D. 8143, 52 FR 22766, June 16, 1987, as amended by T.D. 8329, 56 FR
485, Jan. 7, 1991; T.D. 8514, 58 FR 68299, Dec. 27, 1993]
Sec. 1.448-2T Nonaccrual of certain amounts by service providers (temporary).
(a) In general. Except as otherwise provided, this section applies
to any person using an accrual method of accounting with respect to
amounts to be received from the performance of services by such person.
This section applies to such persons regardless of whether such persons
changed their method of accounting from the cash method under section
448. For example, this section applies to a taxpayer who used an overall
accrual method of accounting in taxable years prior to 1987.
(b) Nonaccrual-experience method; treatment as method of accounting.
Any person to whom this section applies is not required to accrue any
portion of amounts to be received from the performance of services
which, on the basis of experience, will not be collected. This
nonaccrual of amounts to be received for the performance of services
shall be treated as a method of accounting under the Code (the
nonaccrual-experience method).
(c) Method not available if interest charged on amounts due--(1) In
general. The nonaccrual-experience method of accounting may not be used
with respect to amounts due for which interest is required to be paid,
or for which there is any penalty for failure to timely pay any amounts
due. For this purpose, interest or penalties for late payment will be
deemed to be charged by a taxpayer if such treatment is in accordance
with the economic substance of a transaction, regardless of the
characterization of the transaction by the parties, or the treatment of
the transaction under state or local law. However, the offering of a
discount for early payment of an amount due will not be regarded as the
charging of interest or penalties for late payment under this section,
if (i) the full amount due is otherwise accrued as gross income by the
taxpayer at the time the services are provided, and (ii) the discount
for early payment is treated as an adjustment to gross income in the
year of payment, if payment is received within the time required for
allowance of such discount.
(2) Example. The provisions of this paragraph (c) may be illustrated
by the following example:
Example. X uses an accrual method of accounting for amounts to be
received from the provision of services. For such amounts, X has two
billing methods. Under one method, for amounts that are more than 90
days past due, X charges interest at a market rate until such amounts
(together with interest) are paid. Under the other billing method, X
charges no interest for amounts past due. X cannot use the nonaccrual-
experience method of accounting with respect to any of the amounts
billed under the method that charges interest on amounts that are more
than 90 days past due. X may, however, use the nonaccrual-experience
method with respect to the amounts billed under the method that does not
charge interest for amounts past due.
(d) Method not available for certain receivables. The nonaccrual-
experience method of accounting may be used only with respect to amounts
earned by the taxpayer and otherwise recognized in income (an account
receivable) through the performance of services by such taxpayer. For
example, the nonaccrual-experience method may not be used with respect
to amounts owed to the taxpayer by reason of the taxpayer's activities
with respect to (1) lending money; (2) selling goods; or (3) acquiring
receivables or other rights to receive payment from other persons
(including persons related to the taxpayer) regardless of whether those
other persons earned such amounts through the provision of services.
(e) Use of experience to estimate uncollectible amounts--(1) In
general. In determining the portion of any amount due which, on the
basis of experience, will not be collected, the formula prescribed by
paragraph (e)(2) of this section shall be used by the taxpayer with
respect to each separate trade or business of the taxpayer. No other
method or formula may be used by a taxpayer in determining the
uncollectible amounts under this section.
(2) Six-year moving average--(i) General rule. For any taxable year
the uncollectible amount of a receivable is
[[Page 90]]
the amount of that receivable which bears the same ratio to the account
receivable outstanding at the close of the taxable year as (A) the total
bad debts (with respect to accounts receivable) sustained throughout the
period consisting of the taxable year and the five preceding taxable
years (or, with the approval of the Commissioner, a shorter period),
adjusted for recoveries of bad debts during such period, bears to (B)
the sum of the accounts receivable earned throughout the entire six (or
fewer) taxable year period (i.e., the total amount of sales resulting in
accounts receivable) throughout the period. Accounts receivable
described in paragraphs (c) and (d) of this section are not taken into
account in computing the ratio.
(ii) Period of less than six years. A period shorter than six years
generally will be appropriate only if there is a change in the type of a
substantial portion of the outstanding accounts receivable such that the
risk of loss is substantially increased. A decline in the general
economic conditions in the area, which substantially increases the risk
of loss, is a relevant factor in determining whether a shorter period is
appropriate. However, approval to use a shorter period will not be
granted unless the taxpayer supplies specific evidence that the 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. A substantial increase in a
taxpayer's bad debt experience, is not, by itself, sufficient to justify
the use of a shorter period. If approval is granted to use a shorter
period, the experience for the excluded taxable years shall not be used
for any subsequent year. A request for approval to exclude the
experience of a prior taxable year shall be made in accordance with the
applicable procedures for requesting a letter ruling and shall include a
statement of the reasons such experience should be excluded. A request
will not be considered unless it is sent to the Commissioner at least 30
days before the close of the first taxable year for which such approval
is requested.
(iii) Special rule for new taxpayers. In the case of any current
taxable year which is preceded by less than 5 taxable years, paragraph
(e)(2)(i) of this section shall be applied by using the experience of
the current year and the actual number of preceding taxable years.
However, for this purpose, experience from preceding taxable years of a
predecessor trade or business may be used in applying paragraph
(e)(2)(i) of this section.
(3) Mechanics of nonaccrual-experience method. The nonaccrual-
experience method shall be applied with respect to each account
receivable of the taxpayer which is eligible for such method. With
respect to a particular account receivable, the taxpayer will determine,
in the manner prescribed in paragraph (e) of this section, the amount of
such account receivable that is not expected to be collected. Such
determination shall be made only once with respect to each account
receivable, regardless of the term of such receivable. The estimated
uncollectible amount shall not be recognized as gross income. Thus, the
amount recognized as gross income shall be the amount that would
otherwise be recognized as gross income with respect to the account
receivable, less the amount which is not expected to be collected. Upon
the collection of the account receivable, additional gross income shall
be recognized with respect to the collection of any amount not initially
expected to be collected. Similarly, no bad debt deduction under section
166 for a wholly or partially worthless account receivable shall be
allowed for any amount not previously taken into income under the
nonaccrual-experience method.
(4) Examples. The following examples illustrate the provisions of
paragraph (e) of this section:
Example (1). X is a calendar year service provider that uses an
accrual method of accounting with respect to the amounts (accounts
receivable) to be received from the provision of services. X does not
require the payment of interest or penalties with respect to past due
accounts receivable. Assume that under this section, X adopts for
taxable year 1987 the nonaccrual-experience method of accounting with
respect to its accounts receivable. Further, assume that X's total
accounts receivable and bad debt experience for the current and five
preceding taxable years is as follows:
[[Page 91]]
------------------------------------------------------------------------
Total accounts Bad debts adjusted
Years receivable for recoveries
------------------------------------------------------------------------
1982............................ $30,000 $5,700
1983............................ 40,000 7,200
1984............................ 50,000 11,000
1985............................ 60,000 10,200
1986............................ 70,000 14,000
1987............................ 80,000 16,800
---------------------------------------
330,000 64,900
------------------------------------------------------------------------
Thus, the ratio of the bad debts (adjusted for recoveries) for the
current and five preceding taxable years to the total accounts
receivable over the same period is 19.67% ($64,900/$330,000). Assume
that $49,300 of the total $80,000 of accounts receivable earned
throughout the taxable year 1987 are outstanding as of the close of such
year. Assume further that the $49,300 of the accounts receivable
outstanding as of the close of the tax year 1987 consist of 10 separate
accounts receivable. The uncollectible amount of each receivable is
19.67%. The amount of these accounts receivable and the uncollectible
amount of each is as follows:
------------------------------------------------------------------------
Accounts receivable Applicable ratio Uncollectible amount
------------------------------------------------------------------------
1. $5,200 .1967 $1,022.84
2. 7,300 .1967 1,435.91
3. 3,200 .1967 629.44
4. 4,300 .1967 845.81
5. 1,700 .1967 334.39
6. 4,000 .1967 786.80
7. 6,300 .1967 1,239.21
8. 8,000 .1967 1,573.60
9. 3,200 .1967 629.44
10. 6,100 .1967 1,199.87
--------------------- -------------------------
49,300 9,697.31
------------------------------------------------------------------------
For taxable year 1987, X will not accrue as income $9,697.31 of its
accounts receivable of $49,300 outstanding as of the close of the year.
Example (2). The facts are the same as in example (1). In 1988 the
entire amount of account receivable number 8 becomes wholly worthless.
Since in 1987 X did not accrue as income under the nonaccrual-experience
method $1,573.60 of that account receivable, no deduction under section
166 is allowable with respect to that amount of the account receivable;
a deduction of $6,426.40 under section 166 is allowable for 1988.
Example (3). The facts are the same as in example (1). In 1988 X
collects, in full, account receivable number 5. Accordingly, in 1988 X
must recognize additional gross income of $334.39, the amount of the
account receivable that was initially considered uncollectible.
(5) Special rule for estimated tax. For purposes of section 6654 or
6655 only (relating to the addition to tax for underpayment of estimated
tax), a taxpayer's income does not include eligible income attributable
to the period before May 16, 1988. A taxpayer's eligible income is the
excess (if any) of--
(i) Income (including the amount of any adjustment required under
section 481(a)) computed with a bad debt experience ratio using accounts
receivable earned throughout the period ending at the close of the six-
year period (or other shorter period) described in paragraph (e)(2)(i)
of this section, over
(ii) Income (including the amount of any adjustment required under
section 481(a)) computed with a bad debt experience ratio using the
year-end balances of accounts receivable over such six-year (or other
shorter) period.
(f) [Reserved]
(g) Coordination of change in accounting method with section 481--
(1) Taxpayers required to change their method of accounting under
section 448. The provisions of this paragraph (g)(1) apply to taxpayers
who under Sec. 1.448-1T(h) change from the cash method as required by
section 448 and who also change under paragraph (h) of this section to a
method of accounting that includes the nonaccrual-experience method.
With respect to such taxpayers, the section 481(a) adjustment resulting
from the change in method of accounting to the nonaccrual-experience
method shall be combined or netted with the section 481(a) adjustment
applicable to the change in method of accounting required under section
448. The resulting amount shall then be taken into account in accordance
with the provisions of Sec. 1.448-1T(g) applicable to the change in
method of accounting required by section 448.
(2) Taxpayers not required to change their method of accounting
under section 448. The provisions of this paragraph (g)(2) apply to
taxpayers who are not required by section 448 to change their method of
accounting (e.g., taxpayers who were using an accrual method of
accounting for taxable years preceding 1987) and who change to the
nonaccrual-experience method under paragraph (h)(3) of this section.
With respect to such taxpayers, the section 481(a) adjustment resulting
from the change in method of accounting to the nonaccrual-experience
method shall be taken into account ratably over four
[[Page 92]]
taxable years. The provisions of this paragraph (g)(2) shall apply to
any taxpayer regardless of whether such taxpayer was required to change
its method of accounting for bad debts under section 805 of the Tax
Reform Act of 1986.
(h) Changes in method of accounting to nonaccrual-experience method-
-(1) Automatic changes to overall accrual method. The provisions of this
paragraph (h)(1) apply to taxpayers who change from the cash method as
required by section 448, and change to an overall accrual method of
accounting under the automatic change provisions of Sec. 1.448-1T(h)(2).
Taxpayers to whom this paragraph (h)(1) applies may automatically change
their method of accounting to the nonaccrual-experience method under
this paragraph (h)(1), if they otherwise qualify under this section for
the use of such method. Taxpayers changing to the nonaccrual-experience
method under this paragraph (h)(1) shall comply with the provisions of
Sec. 1.448-1T(h)(2). Moreover, such taxpayers shall type or legibly
print the following statement at the top of page 1 of Form 315:
``Automatic Change to Nonaccrual Experience Method--Section 448.'' The
consent of the Commissioner to the change in method of accounting is
granted to taxpayers changing to the nonaccrual-experience method under
this paragraph (h)(1).
(2) Changes to a method other than overall accrual method. The
provisions of this paragraph (h)(2) apply to taxpayers who change from
the cash method as required by section 448 and who also change to a
permissible special method of accounting under Sec. 1.448-1T(h)(3).
Taxpayers to whom this paragraph (h)(2) applies may change their method
of accounting to the nonaccrual-experience method under this paragraph
(h)(2). Taxpayers changing to the nonaccrual-experience method under
this paragraph (h)(2) shall comply with the provisions of Sec. 1.448-
1T(h)(3). Moreover, such taxpayers shall type or legibly print the
following statement on the top of page 1 of Form 3115: ``Change to
Nonaccrual-Experience Method and Special Method of Accounting-Section
448.'' The consent of the Commissioner to the change in method of
accounting is granted to taxpayers changing to the nonaccrual-experience
method under this paragraph (h)(2).
(3) Taxpayers not required to change their method of accounting
under section 448. The provisions of this paragraph (h)(3) apply to
taxpayers who are not required by section 448 to change their method of
accounting for the taxable year in which such taxpayers desire to adopt
the nonaccrual-experience method (e.g., taxpayers who were using an
accrual method of accounting for taxable years preceding 1987). Such
taxpayers may automatically change their method of accounting to the
nonaccrual-experience method under the provisions of this paragraph
(h)(3), for their taxable year beginning in 1987, if they otherwise
qualify under the provisions of this section for the use of such method.
Taxpayers changing to the nonaccrual-experience method for their taxable
year beginning in 1987 shall complete and file a current Form 3115. The
Form 3115 shall be filed no later than the due date (including
extension) of the taxpayer's federal income tax return for the year of
change and shall be attached to that return, Moreover, the taxpayer
shall type or legibly print the following statement at the top of page 1
of Form 3115: ``Automatic Change to Nonaccrual Experience Method--
Taxpayer not Required to Change Method of Accounting Under Section
448.'' The consent of the Commissioner to the change in method of
accounting is granted to taxpayers changing to the nonaccrual-experience
method for their taxable year beginning in 1987 under this paragraph
(h)(3). With respect to taxpayers described in this paragraph (h)(3) who
desire to change to the nonaccrual-experience method for a taxable year
beginning after December 31, 1987, such taxpayers shall submit an
application for change in accounting method under the administrative
procedures applicable to taxpayers at the time of change, including the
applicable procedures regarding the time and place of filing the
application for change in method. Taxpayers described in the preceding
sentence include taxpayers who were required to change their method of
accounting under section 448 for an earlier taxable year, but
[[Page 93]]
who did not change to the nonaccrual-experience method at that time.
(i) Effective date. This section applies to any taxable year
beginning after December 31, 1986.
[T.D. 8143, 52 FR 22774, June 16, 1987, as amended by T.D. 8194, 53 FR
12513, Apr. 15, 1988]
taxable year for which items of gross income included
Sec. 1.451-1 General rule for taxable year of inclusion.
(a) General rule. Gains, profits, and income are to be included in
gross income for the taxable year in which they are actually or
constructively received by the taxpayer unless includible for a
different year in accordance with the taxpayer's method of accounting.
Under an accrual method of accounting, income is includible in gross
income when all the events have occurred which fix the right to receive
such income and the amount thereof can be determined with reasonable
accuracy. Therefore, under such a method of accounting if, in the case
of compensation for services, no determination can be made as to the
right to such compensation or the amount thereof until the services are
completed, the amount of compensation is ordinarily income for the
taxable year in which the determination can be made. Under the cash
receipts and disbursements method of accounting, such an amount is
includible in gross income when actually or constructively received.
Where an amount of income is properly accrued on the basis of a
reasonable estimate and the exact amount is subsequently determined, the
difference, if any, shall be taken into account for the taxable year in
which such determination is made. To the extent that income is
attributable to the recovery of bad debts for accounts charged off in
prior years, it is includible in the year of recovery in accordance with
the taxpayer's method of accounting, regardless of the date when the
amounts were charged off. For treatment of bad debts and bad debt
recoveries, see sections 166 and 111 and the regulations thereunder. For
rules relating to the treatment of amounts received in crop shares, see
section 61 and the regulations thereunder. For the year in which a
partner must include his distributive share of partnership income, see
section 706(a) and paragraph (a) of Sec. 1.706-1. If a taxpayer
ascertains that an item should have been included in gross income in a
prior taxable year, he should, if within the period of limitation, file
an amended return and pay any additional tax due. Similarly, if a
taxpayer ascertains that an item was improperly included in gross income
in a prior taxable year, he should, if within the period of limitation,
file claim for credit or refund of any overpayment of tax arising
therefrom.
(b) Special rule in case of death. (1) A taxpayer's taxable year
ends on the date of his death. See section 443(a)(2) and paragraph
(a)(2) of Sec. 1.443-1. In computing taxable income for such year, there
shall be included only amounts properly includible under the method of
accounting used by the taxpayer. However, if the taxpayer used an
accrual method of accounting, amounts accrued only by reason of his
death shall not be included in computing taxable income for such year.
If the taxpayer uses no regular accounting method, only amounts actually
or constructively received during such year shall be included. (For
rules relating to the inclusion of partnership income in the return of a
decedent partner, see subchapter K, chapter 1 of the Code, and the
regulations thereunder.)
(2) If the decedent owned an installment obligation the income from
which was taxable to him under section 453, no income is required to be
reported in the return of the decedent by reason of the transmission at
death of such obligation. See section 453(d)(3). For the treatment of
installment obligations acquired by the decedent's estate or by any
person by bequest, devise, or inheritance from the decedent, see section
691(a)(4) and the regulations thereunder.
(c) Special rule for employee tips. Tips reported by an employee to
his employer in a written statement furnished to the employer pursuant
to section 6053(a) shall be included in gross income of the employee for
the taxable year in which the written statement is furnished the
employer.
[[Page 94]]
For provisions relating to the reporting of tips by an employee to his
employer, see section 6053 and Sec. 31.6053-1 of this chapter
(Employment Tax Regulations).
(d) Special rule for ratable inclusion of original issue discount.
For ratable inclusion of original issue discount in respect of certain
corporate obligations issued after May 27, 1969, see section 1232(a)(3).
(e) Special rule for inclusion of qualified tax refund effected by
allocation. For rules relating to the inclusion in income of an amount
paid by a taxpayer in respect of his liability for a qualified State
individual income tax and allocated or reallocated in such a manner as
to apply it toward the taxpayer's liability for the Federal income tax,
see paragraph (f)(1) of Sec. 301.6361-1 of this chapter (Regulations on
Procedure and Administration).
(f) Timing of income from notional principal contracts. For the
timing of income with respect to notional principal contracts, see
Sec. 1.446-3.
(g) Timing of income from section 467 rental agreements. For the
timing of income with respect to section 467 rental agreements, see
section 467 and the regulations thereunder.
[T.D. 6500, 25 FR 11709, Nov. 26, 1960, as amended by T.D. 7001, 34 FR
997, Jan. 23, 1969; T.D. 7154, 36 FR 24996, Dec. 28, 1971; 43 FR 59357,
Dec. 20, 1978; T.D. 8491, 58 FR 53135, Oct. 14, 1993; T.D. 8820, 64 FR
26851, May 18, 1999]
Sec. 1.451-2 Constructive receipt of income.
(a) General rule. Income although not actually reduced to a
taxpayer's possession is constructively received by him in the taxable
year during which it is credited to his account, set apart for him, or
otherwise made available so that he may draw upon it at any time, or so
that he could have drawn upon it during the taxable year if notice of
intention to withdraw had been given. However, income is not
constructively received if the taxpayer's control of its receipt is
subject to substantial limitations or restrictions. Thus, if a
corporation credits its employees with bonus stock, but the stock is not
available to such employees until some future date, the mere crediting
on the books of the corporation does not constitute receipt. In the case
of interest, dividends, or other earnings (whether or not credited)
payable in respect of any deposit or account in a bank, building and
loan association, savings and loan association, or similar institution,
the following are not substantial limitations or restrictions on the
taxpayer's control over the receipt of such earnings:
(1) A requirement that the deposit or account, and the earnings
thereon, must be withdrawn in multiples of even amounts;
(2) The fact that the taxpayer would, by withdrawing the earnings
during the taxable year, receive earnings that are not substantially
less in comparison with the earnings for the corresponding period to
which the taxpayer would be entitled had he left the account on deposit
until a later date (for example, if an amount equal to three months'
interest must be forfeited upon withdrawal or redemption before maturity
of a one year or less certificate of deposit, time deposit, bonus plan,
or other deposit arrangement then the earnings payable on premature
withdrawal or redemption would be substantially less when compared with
the earnings available at maturity);
(3) A requirement that the earnings may be withdrawn only upon a
withdrawal of all or part of the deposit or account. However, the mere
fact that such institutions may pay earnings on withdrawals, total or
partial, made during the last three business days of any calendar month
ending a regular quarterly or semiannual earnings period at the
applicable rate calculated to the end of such calendar month shall not
constitute constructive receipt of income by any depositor or account
holder in any such institution who has not made a withdrawal during such
period;
(4) A requirement that a notice of intention to withdraw must be
given in advance of the withdrawal. In any case when the rate of
earnings payable in respect of such a deposit or account depends on the
amount of notice of intention to withdraw that is given, earnings at the
maximum rate are constructively received during the taxable year
regardless of how long the deposit
[[Page 95]]
or account was held during the year or whether, in fact, any notice of
intention to withdraw is given during the year. However, if in the
taxable year of withdrawal the depositor or account holder receives a
lower rate of earnings because he failed to give the required notice of
intention to withdraw, he shall be allowed an ordinary loss in such
taxable year in an amount equal to the difference between the amount of
earnings previously included in gross income and the amount of earnings
actually received. See section 165 and the regulations thereunder.
(b) Examples of constructive receipt. Amounts payable with respect
to interest coupons which have matured and are payable but which have
not been cashed are constructively received in the taxable year during
which the coupons mature, unless it can be shown that there are no funds
available for payment of the interest during such year. Dividends on
corporate stock are constructively received when unqualifiedly made
subject to the demand of the shareholder. However, if a dividend is
declared payable on December 31 and the corporation followed its usual
practice of paying the dividends by checks mailed so that the
shareholders would not receive them until January of the following year,
such dividends are not considered to have been constructively received
in December. Generally, the amount of dividends or interest credited on
savings bank deposits or to shareholders of organizations such as
building and loan associations or cooperative banks is income to the
depositors or shareholders for the taxable year when credited. However,
if any portion of such dividends or interest is not subject to
withdrawal at the time credited, such portion is not constructively
received and does not constitute income to the depositor or shareholder
until the taxable year in which the portion first may be withdrawn.
Accordingly, if, under a bonus or forfeiture plan, a portion of the
dividends or interest is accumulated and may not be withdrawn until the
maturity of the plan, the crediting of such portion to the account of
the shareholder or depositor does not constitute constructive receipt.
In this case, such credited portion is income to the depositor or
shareholder in the year in which the plan matures. However, in the case
of certain deposits made after December 31, 1970, in banks, domestic
building and loan associations, and similar financial institutions, the
ratable inclusion rules of section 1232(a)(3) apply. See Sec. 1.1232-3A.
Accrued interest on unwithdrawn insurance policy dividends is gross
income to the taxpayer for the first taxable year during which such
interest may be withdrawn by him.
[T.D. 6723, 29 FR 5342, Apr. 21, 1964; as amended by T.D. 7154, 36 FR
24997, Dec. 28, 1971; T.D. 7663, 44 FR 76782, Dec. 28, 1979]
Sec. 1.451-4 Accounting for redemption of trading stamps and coupons.
(a) In general--(1) Subtraction from receipts. If an accrual method
taxpayer issues trading stamps or premium coupons with sales, or an
accrual method taxpayer is engaged in the business of selling trading
stamps or premium coupons, and such stamps or coupons are redeemable by
such taxpayer in merchandise, cash, or other property, the taxpayer
should, in computing the income from such sales, subtract from gross
receipts with respect to sales of such stamps or coupons (or from gross
receipts with respect to sales with which trading stamps or coupons are
issued) an amount equal to--
(i) The cost to the taxpayer of merchandise, cash, and other
property used for redemptions in the taxable year,
(ii) Plus the net addition to the provision for future redemptions
during the taxable year (or less the net subtraction from the provision
for future redemptions during the taxable year).
(2) Trading stamp companies. For purposes of this section, a
taxpayer will be considered as being in the business of selling trading
stamps or premium coupons if--
(i) The trading stamps or premium coupons sold by him are issued by
purchasers to promote the sale of their merchandise or services,
(ii) The principal activity of the trade or business is the sale of
such stamps or coupons,
(iii) Such stamps or coupons are redeemable by the taxpayer for a
period of at least 1 year from the date of sale, and
[[Page 96]]
(iv) Based on his overall experience, it is estimated that not more
than two-thirds of the stamps or coupons sold which it is estimated,
pursuant to paragraph (c) of this section, will be ultimately redeemed,
will be redeemed within 6 months of the date of sale.
(b) Computation of the net addition to or subtraction from the
provision for future redemptions--(1) Determination of the provision for
future redemptions. (i) The provision for future redemptions as of the
end of a taxable year is computed by multiplying ``estimated future
redemptions'' (as defined in subdivision (ii) of this subparagraph) by
the estimated average cost of redeeming each trading stamp or coupon
(computed in accordance with subdivision (iii) of this subparagraph).
(ii) For purposes of this section, the term ``estimated future
redemptions'' as of the end of a taxable year means the number of
trading stamps or coupons outstanding as of the end of such year that it
is reasonably estimated will ultimately be presented for redemption.
Such estimate shall be determined in accordance with the rules contained
in paragraph (c) of this section.
(iii) For purposes of this section, the estimated average cost of
redeeming each trading stamp or coupon shall be computed by including
only the costs to the taxpayer of acquiring the merchandise, cash, or
other property needed to redeem such stamps or coupons. The term ``the
costs to the taxpayer of acquiring the merchandise, cash, or other
property needed to redeem such stamps or coupons'' includes only the
price charged by the seller (less trade or other discounts, except
strictly cash discounts approximating a fair interest rate, which may be
deducted or not at the option of the taxpayer provided a consistent
course is followed) plus transportation or other necessary charges in
acquiring possession of the goods. Items such as the costs of
advertising, catalogs, operating redemption centers, transporting
merchandise or other property from a central warehouse to a branch
warehouse (or from a warehouse to a redemption center), and storing the
merchandise or other property used to redeem stamps or coupons should
not be included in costs of redeeming stamps or premium coupons, but
rather should be accounted for in accordance with the provisions of
sections 162 and 263.
(2) Changes in provision for future redemptions. For purposes of
this section, a ``net addition to'' or ``net subtraction from'' the
provision for future redemptions for a taxable year is computed as
follows:
(i) Carry over the provision for future redemptions (if any) as of
the end of the preceding taxable year,
(ii) Compute the provision for future redemptions as of the end of
the taxable year in accordance with subparagraph (1) of this paragraph,
and
(iii) If the amount referred to in subdivision (ii) of this
subparagraph exceeds the amount referred to in subdivision (i) of this
subparagraph, such excess is the net addition to the provision for
future redemptions for the taxable year. On the other hand, if the
amount referred to in such subdivision (i) exceeds the amount referred
to in such subdivision (ii), such excess is the net subtraction from the
provision for future redemptions for the taxable year.
(3) Example. The provisions of this paragraph and paragraph (a)(1)
of this section may be illustrated by the following example:
Example. (a) X Company, a calendar year accrual method taxpayer, is
engaged in the business of selling trading stamps to merchants. In 1971,
its first year of operation, X sells 10 million stamps at $5 per 1,000;
it redeems 3 million stamps for merchandise and cash of an average value
of $3 per 1,000 stamps. At the end of 1971 it is estimated (pursuant to
paragraph (c) of this section) that a total of 9 million stamps of the
10 million stamps issued in 1971 will eventually be presented for
redemption. At this time it is estimated that the average cost of
redeeming stamps (as described in subparagraph (1)(iii) of this
paragraph) would continue to be $3 per 1,000 stamps. Under these
circumstances, X computes its gross income from sales of trading stamps
as follows:
Gross receipts from sales (10 million stamps at $5 ........ $50,000
per 1,000).........................................
Less:
Cost of actual redemptions (3 million stamps at $3 $9,000 ........
per 1,000).......................................
Provision for future redemptions on December 31, 18,000 ........
1971 (9 million stamps -- 3 million stamps x $3
per 1,000).......................................
----------
[[Page 97]]
27,000
---------
1971 gross income from sales of stamps.............. 23,000
(b) In 1972, X also sells 10 million stamps at $5 per 1,000 stamps.
During 1972 X redeems 7 million stamps at an average cost of $3.01 per
1,000 stamps. At the end of 1972 it is determined that the estimated
future redemptions (within the meaning of subparagraph (1)(ii) of this
paragraph) is 8 million. It is further determined that the estimated
average cost of redeeming stamps would continue to be $3.01 per 1,000
stamps. X thus computes its gross income from sales of trading stamps
for 1972 as follows:
Gross receipts from sales (10 million stamps at $5 per 1,000). $50,000
Less:
Cost of actual redemptions (7 million stamps at $21,070
$3.01 per 1,000).................................
Plus:
Provision for future redemptions on Dec. 31, 1972 24,080
(8 million stamps at $3.01 per 1,000)............
Minus provision for future redemptions on Dec. 31, 18,000
1971...............................................
----------
Addition to provision for future redemptions........ 6,080
----------
Total cost of redemptions................................. 27,150
---------
1972 Gross income from sales of stamps.............. ........ 22,850
(c) Estimated future redemptions--(1) In general. A taxpayer may use
any method of determining the estimated future redemptions as of the end
of a year so long as--
(i) Such method results in a reasonably accurate estimate of the
stamps or coupons outstanding at the end of such year that will
ultimately be presented for redemption,
(ii) Such method is used consistently, and
(iii) Such taxpayer complies with the requirements of this paragraph
and paragraphs (d) and (e) of this section.
(2) Utilization of prior redemption experience. Normally, the
estimated future redemptions of a taxpayer shall be determined on the
basis of such taxpayer's prior redemption experience. However, if the
taxpayer does not have sufficient redemption experience to make a
reasonable determination of his ``estimated future redemptions,'' or if
because of a change in his mode of operation or other relevant factors
the determination cannot reasonably be made completely on the basis of
the taxpayer's own experience, the experiences of similarly situated
taxpayers may be used to establish an experience factor.
(3) One method of determining estimated future redemptions. One
permissible method of determining the estimated future redemptions as of
the end of the current taxable year is as follows:
(i) Estimate for each preceding taxable year and the current taxable
year the number of trading stamps or coupons issued for each such year
which will ultimately be presented for redemption.
(ii) Determine the sum of the estimates under subdivision (i) of
this subparagraph for each taxable year prior to and including the
current taxable year.
(iii) The difference between the sum determined under subdivision
(ii) of this subparagraph and the total number of trading stamps or
coupons which have already been presented for redemption is the
estimated future redemptions as of the end of the current taxable year.
(4) Determination of an ``estimated redemption percentage.'' For
purposes of applying subparagraph (3)(i) of this paragraph, one
permissible method of estimating the number of trading stamps or coupons
issued for a taxable year that will ultimately be presented for
redemption is to multiply such number of stamps issued for such year by
an ``estimated redemption percentage.'' For purposes of this section the
term ``estimated redemption percentage'' for a taxable year means a
fraction, the numerator of which is the number of trading stamps or
coupons issued during a taxable year that it is reasonably estimated
will ultimately be redeemed, and the denominator of which is the number
of trading stamps or coupons issued during such year. Consequently, the
product of such percentage and the number of stamps issued for such year
equals the number of trading stamps or coupons issued for such year that
it is estimated will ultimately be redeemed.
(5) Five-year rule. (i) One permissible method of determining the
``estimated redemption percentage'' for a taxable year is to--
(a) Determine the percentage which the total number of stamps or
coupons redeemed in the taxable year and the 4
[[Page 98]]
preceding taxable years is of the total number of stamps or coupons
issued or sold in such 5 years; and
(b) Multiply such percentage by an appropriate growth factor as
determined pursuant to guidelines published by the Commissioner.
(ii) If a taxpayer uses the method described in subdivision (i) of
this subparagraph for a taxable year, it will normally be presumed that
such taxpayer's ``estimated redemption percentage'' is reasonably
accurate.
(6) Other methods of determining estimated future redemptions. (i)
If a taxpayer uses a method of determining his ``estimated future
redemptions'' (other than a method which applies the 5-year rule as
described in subparagraph (5)(i) of this paragraph) such as a
probability sampling technique, the appropriateness of the method
(including the appropriateness of the sampling technique, if any) and
the accuracy and reliability of the results obtained must, if requested,
be demonstrated to the satisfaction of the district director.
(ii) No inference shall be drawn from subdivision (i) of this
subparagraph that the use of any method to which such subdivision
applies is less acceptable than the method described in subparagraph
(5)(i) of this paragraph. Therefore, certain probability sampling
techniques used in determining estimated future redemptions may result
in reasonably accurate and reliable estimates. Such a sampling technique
will be considered appropriate if the sample is--
(a) Taken in accordance with sound statistical sampling principles,
(b) In accordance with such principles, sufficiently broad to
produce a reasonably accurate result, and
(c) Taken with sufficient frequency as to produce a reasonably
accurate result.
In addition, if the sampling technique is appropriate, the results
obtained therefrom in determining estimated future redemptions will be
considered accurate and reliable if the evaluation of such results is
consistent with sound statistical principles. Ordinarily, samplings and
recomputations of the estimated future redemptions will be required
annually. However, the facts and circumstances in a particular case may
justify such a recomputation being taken less frequently than annually.
In addition, the Commissioner may prescribe procedures indicating that
samples made to update the results of a sample of stamps redeemed in a
prior year need not be the same size as the sample of such prior year.
(d) Consistency with financial reporting--(1) Estimated future
redemptions. For taxable years beginning after August 22, 1972, the
estimated future redemptions must be no greater than the estimate that
the taxpayer uses for purposes of all reports (including consolidated
financial statements) to shareholders, partners, beneficiaries, other
proprietors, and for credit purposes.
(2) Average cost of redeeming stamps. For taxable years beginning
after August 22, 1972, the estimated average cost of redeeming each
stamp or coupon must be no greater than the average cost of redeeming
each stamp or coupon (computed in accordance with paragraph (b)(1)(iii)
of this section) that the taxpayer uses for purposes of all reports
(including consolidated financial statements) to shareholders, partners,
beneficiaries, other proprietors, and for credit purposes.
(e) Information to be furnished with return--(1) In general. For
taxable years beginning after August 22, 1972, a taxpayer described in
paragraph (a) of this section who uses a method of determining the
``estimated future redemptions'' other than that described in paragraph
(c)(5)(i) of this section shall file a statement with his return showing
such information as is necessary to establish the correctness of the
amount subtracted from gross receipts in the taxable year.
(2) Taxpayers using the 5-year rule. If a taxpayer uses the method
of determining estimated future redemptions described in paragraph
(c)(5)(i) of this section, he shall file a statement with his return
showing, with respect to the taxable year and the 4 preceding taxable
years--
(i) The total number of stamps or coupons issued or sold during each
year, and
(ii) The total number of stamps or coupons redeemed in each such
year.
[[Page 99]]
(3) Trading stamp companies. In addition to the information required
by subparagraph (1) or (2) of this paragraph, a taxpayer engaged in the
trade or business of selling trading stamps or premium coupons shall
include with the statement described in subparagraph (1) or (2) of this
paragraph such information as may be necessary to satisfy the
requirements of paragraph (a)(2)(iv) of this section.
[T.D. 7201, 37 FR 16911, Aug. 23, 1972, as amended by T.D. 7201, 37 FR
18617, Sept. 14, 1972]
Sec. 1.451-5 Advance payments for goods and long-term contracts.
(a) Advance payment defined. (1) For purposes of this section, the
term ``advance payment'' means any amount which is received in a taxable
year by a taxpayer using an accrual method of accounting for purchases
and sales or a long-term contract method of accounting (described in
Sec. 1.451-3), pursuant to, and to be applied against, an agreement:
(i) For the sale or other disposition in a future taxable year of
goods held by the taxpayer primarily for sale to customers in the
ordinary course of his trade or business, or
(ii) For the building, installing, constructing or manufacturing by
the taxpayer of items where the agreement is not completed within such
taxable year.
(2) For purposes of subparagraph (1) of this paragraph:
(i) The term ``agreement'' includes (a) a gift certificate that can
be redeemed for goods, and (b) an agreement which obligates a taxpayer
to perform activities described in subparagraph (1)(i) or (ii) of this
paragraph and which also contains an obligation to perform services that
are to be performed as an integral part of such activities; and
(ii) Amounts due and payable are considered ``received''.
(3) If a taypayer (described in subparagraph (1) of this paragraph)
receives an amount pursuant to, and to be applied against, an agreement
that not only obligates the taxpayer to perform the activities described
in subparagraph (1) (i) and (ii) of this paragraph, but also obligates
the taxpayer to perform services that are not to be performed as an
integral part of such activities, such amount will be treated as an
``advance payment'' (as defined in subparagraph (1) of this paragraph)
only to the extent such amount is properly allocable to the obligation
to perform the activities described in subparagraph (1) (i) and (ii) of
this paragraph. The portion of the amount not so allocable will not be
considered an ``advance payment'' to which this section applies. If,
however, the amount not so allocable is less than 5 percent of the total
contract price, such amount will be treated as so allocable except that
such treatment cannot result in delaying the time at which the taxpayer
would otherwise accrue the amounts attributable to the activities
described in subparagraph (1) (i) and (ii) of this paragraph.
(b) Taxable year of inclusion--(1) In general. Advance payments must
be included in income either--
(i) In the taxable year of receipt; or
(ii) Except as provided in paragraph (c) of this section.
(a) In the taxable year in which properly accruable under the
taxpayer's method of accounting for tax purposes if such method results
in including advance payments in gross receipts no later than the time
such advance payments are included in gross receipts for purposes of all
of his reports (including consolidated financial statements) to
shareholders, partners, beneficiaries, other proprietors, and for credit
purposes, or
(b) If the taxpayer's method of accounting for purposes of such
reports results in advance payments (or any portion of such payments)
being included in gross receipts earlier than for tax purposes, in the
taxable year in which includible in gross receipts pursuant to his
method of accounting for purposes of such reports.
(2) Examples. This paragraph may be illustrated by the following
examples:
Example (1). S, a retailer who uses for tax purposes and for
purposes of the reports referred to in subparagraph (1)(ii)(a) of this
paragraph, an accrual method of accounting under which it accounts for
its sales of goods when the goods are shipped, receives advance payments
for such goods. Such advance payments must be included in gross receipts
for tax purposes either in the taxable year the payments are received or
in the taxable year
[[Page 100]]
such goods are shipped (except as provided in paragraph (c) of this
section).
Example (2). T, a manufacturer of household furniture, is a calendar
year taxpayer who uses an accrual method of accounting pursuant to which
income is accrued when furniture is shipped for purposes of its
financial reports (referred to in subparagraph (1)(ii)(a) of this
paragraph) and an accrual method of accounting pursuant to which the
income is accrued when furniture is delivered and accepted for tax
purposes. See Sec. 1.446-1(c)(1)(ii). In 1974, T receives an advance
payment of $8,000 from X with respect to an order of furniture to be
manufactured for X for a total price of $20,000. The furniture is
shipped to X in December 1974, but it is not delivered to and accepted
by X until January 1975. As a result of this contract, T must include
the entire advance payment in its gross income for tax purposes in 1974
pursuant to subparagraph (1)(ii)(b) of this paragraph. T must include
the remaining $12,000 of the gross contract price in its gross income in
1975 for tax purposes.
(3) Long-term contracts. In the case of a taxpayer accounting for
advance payments for tax purposes pursuant to a long-term contract
method of accounting under Sec. 1.460-4, or of a taxpayer accounting for
advance payments with respect to a long-term contract pursuant to an
accrual method of accounting referred to in the succeeding sentence,
advance payments shall be included in income in the taxable year in
which properly included in gross receipts pursuant to such method of
accounting (without regard to the financial reporting requirement
contained in subparagraph (1)(ii) (a) or (b) of this paragraph). An
accrual method of accounting to which the preceding sentence applies
shall consist of any method of accounting under which the income is
accrued when, and costs are accumulated until, the subject matter of the
contract (or, if the subject matter of the contract consists of more
than one item, an item) is shipped, delivered, or accepted.
(4) Installment method. The financial reporting requirement of
subparagraph (1)(ii) (a) or (b) of this paragraph shall not be construed
to prevent the use of the installment method under section 453. See
Sec. 1.446-1(c)(1)(ii).
(c) Exception for inventoriable goods. (1)(i) If a taxpayer receives
an advance payment in a taxable year with respect to an agreement for
the sale of goods properly includible in his inventory, or with respect
to an agreement (such as a gift certificate) which can be satisfied with
goods or a type of goods that cannot be identified in such taxable year,
and on the last day of such taxable year the taxpayer--
(a) Is accounting for advance payments pursuant to a method
described in paragraph (b)(1)(ii) of this section for tax purposes,
(b) Has received ``substantial advance payments'' (as defined in
subparagraph (3) of this paragraph) with respect to such agreement, and
(c) Has on hand (or available to him in such year through his normal
source of supply) goods of substantially similar kind and in sufficient
quantity to satisfy the agreement in such year,
then all advance payments received with respect to such agreement by the
last day of the second taxable year following the year in which such
substantial advance payments are received, and not previously included
in income in accordance with the taxpayer's accrual method of
accounting, must be included in income in such second taxable year.
(ii) If advance payments are required to be included in income in a
taxable year solely by reason of subdivision (i) of this subparagraph,
the taxpayer must take into account in such taxable year the costs and
expenditures included in inventory at the end of such year with respect
to such goods (or substantially similar goods) on hand or, if no such
goods are on hand by the last day of such second taxable year, the
estimated cost of goods necessary to satisfy the agreement.
(iii) Subdivision (ii) of this subparagraph does not apply if the
goods or type of goods with respect to which the advance payment is
received are not identifiable in the year the advance payments are
required to be included in income by reason of subdivision (i) of this
subparagraph (for example, where an amount is received for a gift
certificate).
(2) If subparagraph (1)(i) of this paragraph is applicable to
advance payments received with respect to an agreement, any advance
payments received with respect to such agreement subsequent to such
second taxable year must be included in gross income in
[[Page 101]]
the taxable year of receipt. To the extent estimated costs of goods are
taken into account in a taxable year pursuant to subparagraph (1)(ii) of
this paragraph, such costs may not again be taken into account in
another year. In addition, any variances between the costs or estimated
costs taken into account pursuant to subparagraph (1)(ii) of this
paragraph and the costs actually incurred in fulfilling the taxpayer's
obligations under the agreement must be taken into account as an
adjustment to the cost of goods sold in the year the taxpayer completes
his obligations under such agreement.
(3) For purposes of subparagraph (1) of this paragraph, a taxpayer
will be considered to have received ``substantial advance payments''
with respect to an agreement by the last day of a taxable year if the
advance payments received with respect to such agreement during such
taxable year plus the advance payments received prior to such taxable
year pursuant to such agreement, equal or exceed the total costs and
expenditures reasonably estimated as includible in inventory with
respect to such agreement. Advance payments received in a taxable year
with respect to an agreement (such as a gift certificate) under which
the goods or type of goods to be sold are not identifiable in such year
shall be treated as ``substantial advance payments'' when received.
(4) The application of this paragraph is illustrated by the
following example:
Example. In 1971, X, a calendar year accrual method taxpayer, enters
into a contract for the sale of goods (properly includible in X's
inventory) with a total contract price of $100. X estimates that his
total inventoriable costs and expenditures for the goods will be $50. X
receives the following advance payments with respect to the contract:
1971......................................................... $35
1972......................................................... 20
1973......................................................... 15
1974......................................................... 10
1975......................................................... 10
1976......................................................... 10
The goods are delivered pursuant to the customer's request in 1977.
X's closing inventory for 1972 of the type of goods involved in the
contract is sufficient to satisfy the contract. Since advance payments
received by the end of 1972 exceed the inventoriable costs X estimates
that he will incur, such payments constitute ``substantial advance
payments''. Accordingly, all payments received by the end of 1974, the
end of the second taxable year following the taxable year during which
``substantial advance payments'' are received, are includible in gross
income for 1974. Therefore, for taxable year 1974 X must include $80 in
his gross income. X must include in his cost of goods sold for 1974 the
cost of such goods (or similar goods) on hand or, if no such goods are
on hand, the estimated inventoriable costs necessary to satisfy the
contract. Since no further deferral is allowable for such contract, X
must include in his gross income for the remaining years of the
contract, the advance payment received each year. Any variance between
estimated costs and the costs actually incurred in fulfilling the
contract is to be taken into account in 1977, when the goods are
delivered. See paragraph (c)(2) of this section.
(d) Information schedule. If a taxpayer accounts for advance
payments pursuant to paragraph (b)(1)(ii) of this section, he must
attach to his income tax return for each taxable year to which such
provision applies an annual information schedule reflecting the total
amount of advance payments received in the taxable year, the total
amount of advance payments received in prior taxable years which has not
been included in gross income before the current taxable year, and the
total amount of such payments received in prior taxable years which has
been included in gross income for the current taxable year.
(e) Adoption of method. (1) For taxable years ending on or after
December 31, 1969, and before January 1, 1971, a taxpayer (even if he
has already filed an income tax return for a taxable year ending within
such period) may secure the consent of the Commissioner to change his
method of accounting for such year to a method prescribed in paragraph
(b)(1)(ii) of this section in the manner prescribed in section 446 and
the regulations thereunder, if an application to secure such consent is
filed on Form 3115 within 180 days after March 23, 1971.
(2) A taxpayer who is already reporting his income in accordance
with a method prescribed in paragraph (b)(1)(ii)(a) of this section need
not secure the consent of the Commissioner to continue to utilize this
method. However, such a taxpayer, for all taxable years ending after
March 23, 1971, must comply with the requirements of paragraphs
(b)(1)(ii)(a) (including the
[[Page 102]]
financial reporting requirement) and (d) (relating to an annual
information schedule) of this section.
(f) Cessation of taxpayer's liability. If a taxpayer has adopted a
method prescribed in paragraph (b)(1)(ii) of this section, and if in a
taxable year the taxpayer dies, ceases to exist in a transaction other
than one to which section 381(a) applies, or his liability under the
agreement otherwise ends, then so much of the advance payment as was not
includible in his gross income in preceding taxable years shall be
included in his gross income for such taxable year.
(g) Special rule for certain transactions concerning natural
resources. A transaction which is treated as creating a mortgage loan
pursuant to section 636 and the regulations thereunder rather than as a
sale shall not be considered a ``sale or other disposition'' within the
meaning of paragraph (a)(1) of this section. Consequently, any payment
received pursuant to such a transaction, which payment would otherwise
qualify as an ``advance payment'', will not be treated as an ``advance
payment'' for purposes of this section.
[T.D. 7103, 36 FR 5495, Mar. 24, 1971, as amended by T.D. 7397, 41 FR
2641, Jan. 19, 1976; T.D. 8067, 51 FR 393, Jan. 6, 1986; T.D. 8929, 66
FR 2224, Jan. 11, 2001]
Sec. 1.451-6 Election to include crop insurance proceeds in gross income in the taxable year following the taxable year of destruction or damage.
(a) In general. (1) For taxable years ending after December 30,
1969, a taxpayer reporting gross income on the cash receipts and
disbursements method of accounting may elect to include insurance
proceeds received as a result of the destruction of, or damage to, crops
in gross income for the taxable year following the taxable year of the
destruction or damage, if the taxpayer establishes that, under the
taxpayer's normal business practice, the income from those crops would
have been included in gross income for any taxable year following the
taxable year of the destruction or damage. However, if the taxpayer
receives the insurance proceeds in the taxable year following the
taxable year of the destruction or damage, the taxpayer shall include
the proceeds in gross income for the taxable year of receipt without
having to make an election under section 451(d) and this section. For
the purposes of this section only, federal payments received as a result
of destruction or damage to crops caused by drought, flood, or any other
natural disaster, or the inability to plant crops because of such a
natural disaster, shall be treated as insurance proceeds received as a
result of destruction or damage to crops. The preceding sentence shall
apply to payments that are received by the taxpayer after December 31,
1973.
(2) In the case of a taxpayer who receives insurance proceeds as a
result of the destruction of, or damage to, two or more specific crops,
if such proceeds may, under section 451(d) and this section, be included
in gross income for the taxable year following the taxable year of such
destruction or damage, and if such taxpayer makes an election under
section 451(d) and this section with respect to any portion of such
proceeds, then such election will be deemed to cover all of such
proceeds which are attributable to crops representing a single trade or
business under section 446(d). A separate election must be made with
respect to insurance proceeds attributable to each crop which represents
a separate trade or business under section 446(d).
(b)(1) Time and manner of making election. The election to include
in gross income insurance proceeds received as a result of destruction
of, or damage to, the taxpayer's crops in the taxable year following the
taxable year of such destruction or damage shall be made by means of a
statement attached to the taxpayer's return (or an amended return) for
the taxable year of destruction or damage. The statement shall include
the name and address of the taxpayer (or his duly authorized
representative), and shall set forth the following information:
(i) A declaration that the taxpayer is making an election under
section 451(d) and this section;
(ii) Identification of the specific crop or crops destroyed or
damaged;
(iii) A declaration that under the taxpayer's normal business
practice the income derived from the crops which
[[Page 103]]
were destroyed or damaged would have been included in this gross income
for a taxable year following the taxable year of such destruction or
damage;
(iv) The cause of destruction or damage of crops and the date or
dates on which such destruction or damage occurred;
(v) The total amount of payments received from insurance carriers,
itemized with respect to each specific crop and with respect to the date
each payment was received;
(vi) The name(s) of the insurance carrier or carriers from whom
payments were received.
(2) Scope of election. Once made, an election under section 451(d)
is binding for the taxable year for which made unless the district
director consents to a revocation of such election. Requests for consent
to revoke an election under section 451(d) shall be made by means of a
letter to the district director for the district in which the taxpayer
is required to file his return, setting forth the taxpayer's name,
address, and identification number, the year for which it is desired to
revoke the election, and the reasons therefor.
[T.D. 7097, 36 FR 5215, Mar. 18, 1971, as amended by T.D. 7526, 42 FR
64624, Dec. 27, 1977; T.D. 8429, 57 FR 38595, Aug. 26, 1992]
Sec. 1.451-7 Election relating to livestock sold on account of drought.
(a) In general. Section 451(e) provides that for taxable years
beginning after December 31, 1975, a taxpayer whose principal trade or
business is farming (within the meaning of Sec. 6420 (c)(3)) and who
reports taxable income on the cash receipts and disbursements method of
accounting may elect to defer for one year a certain portion of income.
The income which may be deferred is the amount of gain realized during
the taxable year from the sale or exchange of that number of livestock
sold or exchanged solely on account of a drought which caused an area to
be designated as eligible for assistance by the Federal Government
(regardless of whether the designation is made by the President or by an
agency or department of the Federal Government). That number is equal to
the excess of the number of livestock sold or exchanged over the number
which would have been sold or exchanged had the taxpayer followed its
usual business practices in the absence of such drought. For example, if
in the past it has been a taxpayer's practice to sell or exchange
annually 400 head of beef cattle but due to qualifying drought
conditions 550 head were sold in a given taxable year, only income from
the sale of 150 head may qualify for deferral under this section. The
election is not available with respect to livestock described in section
1231(b)(3) (relating to cattle, horses (and other livestock) held by the
taxpayer for 24 months (12 months) and used for draft, breeding, dairy,
or sporting purposes).
(b) Usual business. The determination of the number of animals which
a taxpayer would have sold if it had followed its usual business
practice in the absence of drought will be made in light of all facts
and circumstances. In the case of taxpayers who have not established a
usual business practice, reliance will be placed upon the usual business
practice of similarly situated taxpayers in the same general region as
the taxpayer.
(c) Special rules--(1) Connection with drought area. To qualify
under section 451(e) and this section, the livestock need not be raised,
and the sale or exchange need not take place, in a drought area.
However, the sale or exchange of the livestock must occur solely on
account of drought conditions, the existence of which affected the
water, grazing, or other requirements of the livestock so as to
necessitate their sale or exchange.
(2) Sale prior to designation of area as eligible for Federal
assistance. The provisions of this section will apply regardless of
whether all or a portion of the excess number of animals were sold or
exchanged before an area becomes eligible for Federal assistance, so
long as the drought which caused such dispositions also caused the area
to be designated as eligible for Federal assistance.
(d) Classifications of livestock with respect to which the election
may be made. The election to have the provisions of section 451(e) apply
must be made separately for each broad generic classification of animals
(e.g., hogs, sheep, cattle) for which the taxpayer wishes the
[[Page 104]]
provisions to apply. Separate elections shall not be made solely by
reason of the animals' age, sex, or breed.
(e) Computation--(1) Determination of amount deferred. The amount of
income which may be deferred for a classification of livestock pursuant
to this section shall be determined in the following manner. The total
amount of income realized from the sale or exchange of all livestock in
the classification during the taxable year shall be divided by the total
number of all such livestock sold. The resulting quotient shall then be
multiplied by the excess number of such livestock sold on account of
drought.
(2) Example. The provisions of this paragraph may be illustrated by
the following example:
Example. A, a calendar year taxpayer, normally sells 100 head of
beef cattle a year. As the result of drought conditions existing during
1976, A sells 135 head during that year. A realizes $35,100 of income
from the sale of the 135 head. On August 9, 1976, as a result of the
drought, the affected area was declared a disaster area thereby eligible
for Federal assistance. The amount of income which A may defer until
1977, presuming the other provisions of this section are met, is
determined as follows:
$35,100 (total income from sales of beef cattle)/135 (total number of
beef cattle sold)x35 (excess number of beef cattle sold, i.e.
135-100)=$9,100 (amount which A may defer until 1977)
(f) Successive elections. If a taxpayer makes an election under
section 451(e) for successive years, the amount deferred from one year
to the next year shall not be deemed to have been received from the sale
or exchange of livestock during the later year. In addition, in
determining the taxpayer's normal business practice for the later year,
earlier years for which an election under section 451(e) was made shall
not be considered.
(g) Time and manner of making election. The election provided for in
this section must be made by the later of (1) the due date for filing
the income tax return (determined with regard to any extensions of time
granted the taxpayer for filing such return) for the taxable year in
which the early sale of livestock occurs, or (2) (the 90th day after the
date these regulations are published as a Treasury decision in the
Federal Register). The election must be made separately for each taxable
year to which it is to apply. It must be made by attaching a statement
to the return or an amended return for such taxable year. The statement
shall include the name and address of the taxpayer and shall set forth
the following information for each classification of livestock for which
the election is made:
(1) A declaration that the taxpayer is making an election under
section 451(e);
(2) Evidence of the existence of the drought conditions which forced
the early sale or exchange of the livestock and the date, if known, on
which an area was designated as eligible for assistance by the Federal
Government as a result of the drought conditions.
(3) A statement explaining the relationship of the drought area to
the taxpayer's early sale or exchange of the livestock;
(4) The total number of animals sold in each of the three preceding
years;
(5) The number of animals which would have been sold in the taxable
year had the taxpayer followed its normal business practice in the
absence of drought;
(6) The total number of animals sold, and the number sold on account
of drought, during the taxable year; and
(7) A computation, pursuant to paragraph (e) of this section, of the
amount of income to be deferred for each such classification.
(h) Revocation of election. Once an election under this section is
made for a taxable year, it may be revoked only with the approval of the
Commissioner.
(i) Cross reference. For provisions relating to the involuntary
conversion of livestock sold on account of drought see section 1033(e)
and the regulations thereunder.
[T.D. 7526, 42 FR 64624, Dec. 27, 1977]
Secs. 1.453-1--1.453-2 [Reserved]
Sec. 1.453-3 Purchaser evidences of indebtedness payable on demand or readily tradable.
(a) In general. A bond or other evidence of indebtedness
(hereinafter in this section referred to as an obligation) issued by any
person and payable
[[Page 105]]
on demand shall not be treated as an evidence of indebtedness of the
purchaser in applying section 453(b) to a sale or other disposition of
real property or to a casual sale or other casual disposition of
personal property. In addition, an obligation issued by a corporation or
a government or political subdivision thereof--
(1) With interest coupons attached (whether or not the obligation is
readily tradable in an established securities market),
(2) In registered form (other than an obligation issued in
registered form which the taxpayer establishes will not be readily
tradable in an established securities market), or
(3) In any other form designed to render such obligation readily
tradable in an established securities market shall not be treated as an
evidence of indebtedness of the purchaser in applying section 453(b) to
a sale or other disposition of real property or to a casual sale or
other casual disposition of personal property. For purposes of this
section, an obligation is to be considered in registered form if it is
registered as to principal, interest, or both and if its transfer must
be effected by the surrender of the old instrument and either the
reissuance by the corporation of the old instrument to the new holder or
the issuance by the corporation of a new instrument to the new holder.
(b) Treatment as payment. If under section 453(b)(3) an obligation
is not treated as an evidence of indebtedness of the purchaser, then--
(1) For purposes of determining whether the payments received in the
taxable year of the sale or disposition exceed 30 percent of the selling
price, and
(2) For purposes of returning income on the installment method
during the taxable year of the sale or disposition or in a subsequent
taxable year, the receipt by the seller of such obligation shall be
treated as a payment. The rules stated in this paragraph may be
illustrated by the following examples:
$250,000 payment (i.e., 250 of corporation
Y's registered bonds each with a principal
amount and fair market value of $1,000)
------------------------------------------- = 25 percent
$1 million selling price (i.e., $250,000
of corporation Y's registered bonds plus
promissory note of $750,000)
------------------------------------------------------------------------
Example (1). On July 1, 1970, A, an individual on the cash method of
accounting reporting on a calendar year basis, transferred all of his
stock in corporation X (traded on an established securities market and
having a fair market value of $1 million) to corporation Y in exchange
for 250 of corporation Y's registered bonds (which are traded in an
over-the-counter bond market) each with a principal amount and fair
market value of $1,000 (with interest payable at the rate of 8 percent
per year), and Y's unsecured promissory note, with a principal amount of
$750,000. At the time of such exchange A's basis in the corporation X
stock is $900,000. The promissory note is payable at the rate of $75,000
annually, due on July 1, of each year following 1970, until the
principal balance is paid. The note provides for the payment of interest
at the rate of 10 percent per year also payable on July 1 of each year.
Under the rule stated in subparagraph (1) of this paragraph, the 250
registered bonds of corporation Y are treated as a payment for purposes
of the 30 percent test described in section 453(b)(2)(A)(ii). The
payment on account of the bonds equals 25 percent of the selling price
determined as follows:
Since the payments received in the taxable year of the sale do not
exceed 30 percent of the selling price and the sales price exceeds
$1,000, A may report the income received on the sale of his corporation
X stock on the installment method. A elects to report the income on the
installment method. The gross profit to be realized when the corporation
X stock is fully paid for is 10 percent of the total contract price,
computed as follows: $100,000 gross profit (i.e., $1 million contract
price less $900,000 basis in corporation X stock) over $1 million
contract price. However, since subparagraph (2) of this paragraph also
treats the 250 corporation Y registered bonds as a payment for purposes
of reporting income, A must include $25,000 (i.e., 10 percent times
$250,000) in his gross income for calendar year 1970, the taxable year
of sale.
Example (2). Assume the same facts as in example (1). Assume further
that on July 1, 1971, corporation Y makes its first installment payment
to A under the terms of the unsecured promissory note with 75 more of
[[Page 106]]
its $1,000 registered bonds. A must include $7,500 (i.e., 10 percent
gross profit percentage times $75,000) in his gross income for calendar
year 1971. In addition, A includes the interest payment made by
corporation Y on July 1, in his gross income for 1971.
(c) Payable on demand. Under section 453(b)(3), an obligation shall
be treated as payable on demand only if the obligation is treated as
payable on demand under applicable state or local law.
(d) Designed to be readily tradable in an established securities
market--(1) In general. Obligations issued by a corporation or
government or political subdivision thereof will be deemed to be in a
form designed to render such obligations readily tradable in an
established securities market if--
(i) Steps necessary to create a market for them are taken at the
time of issuance (or later, if taken pursuant to an expressed or implied
agreement or understanding which existed at the time of issuance),
(ii) If they are treated as readily tradable in an established
securities market under subparagraph (2) of this paragraph, or
(iii) If they are convertible obligations to which paragraph (e) of
this section applies.
(2) Readily tradable in an established securities market. An
obligation will be treated as readily tradable in an established
securities market if--
(i) The obligation is part of an issue or series of issues which are
readily tradable in an established securities market, or
(ii) The corporation issuing the obligation has other obligations of
a comparable character which are described in subdivision (i) of this
subparagraph.
For purposes of subdivision (ii) of this subparagraph, the determination
as to whether there exist obligations of a comparable character depends
upon the particular facts and circumstances. Factors to be considered in
making such determination include, but are not limited to, substantial
similarity with respect to the presence and nature of security for the
obligation, the number of obligations issued (or to be issued), the
number of holders of such obligation, the principal amount of the
obligation, and other relevant factors.
(3) Readily tradable. For purposes of subparagraph (2)(i) of this
paragraph, an obligation shall be treated as readily tradable if it is
regularly quoted by brokers or dealers making a market in such
obligation or is part of an issue a portion of which is in fact traded
in an established securities market.
(4) Established securities market. For purposes of this paragraph,
the term established securities market includes (i) a national
securities exchange which is registered under section 6 of the
Securities and Exchange Act of 1934 (15 U.S.C. 78f), (ii) an exchange
which is exempted from registration under section 5 of the Securities
Exchange Act of 1935 (15 U.S.C. 78e) because of its limited volume of
transactions, and (iii) any over-the-counter market. For purposes of
this subparagraph, an over-the-counter market is reflected by the
existence of an interdealer quotation system. An interdealer quotation
system is any system of general circulation to brokers and dealers which
regularly disseminates quotations of obligations by identified brokers
or dealers, other than a quotation sheet prepared and distributed by a
broker or dealer in the regular course of his business and containing
only quotations of such broker or dealer.
(5) Examples. The rules stated in this paragraph may be illustrated
by the following examples:
Example (1). On June 1, 1971, 25 individuals owning equal interests
in a tract of land with a fair market value of $1 million sell the land
to corporation Y. The $1 million sales price is represented by 25 bonds
issued by corporation Y each having a face value of $40,000. The bonds
are not in registered form and do not have interest coupons attached,
and, in addition, are payable in 120 equal installments each due on the
first business day of each month. In addition, the bonds are negotiable
and may be assigned by the holder to any other person. However, the
bonds are not quoted by any brokers or dealers who deal in corporate
bonds, and, furthermore, there are no comparable obligations of
corporation Y (determined with reference to the characteristics set
forth in subparagraph (2) of this paragraph) which are so quoted.
Therefore, the bonds are not treated as readily tradable in an
established securities market. In addition, under the particular facts
and circumstances stated, the bonds will not be considered to be in a
form designed to render them readily tradeable in an established
securities market. Since the bonds are
[[Page 107]]
not in registered form, do not have coupons attached, are not in a form
designed to render them readily tradable in an established securities
market, the receipt of such bonds by the holder is not treated as a
payment for purposes of section 453(b), notwithstanding that they are
freely assignable.
Example (2). On April 1, 1972, corporation M purchases in a casual
sale of personal property a fleet of trucks from corporation N in
exchange for corporation M's negotiable notes, not in registered form
and without coupons attached. The corporation M notes are comparable to
earlier notes issued by corporation M, which notes are quoted in the
Eastern Bond section of the National daily quotation sheet, which is an
interdealer quotation system. Both issues of notes are unsecured, held
by more than 100 holders, have a maturity date of more than 5 years, and
were issued for a comparable principal amount. On the basis of these
similar characteristics it appears that the latest notes will also be
readily tradable. Since an interdealer system reflects an over-the-
counter market, the earlier notes are treated as readily tradable in an
established securities market. Since the later notes are obligations
comparable to the earlier ones, which are treated as readily tradable in
an established securities market, the later notes are also treated as
readily tradable in an established securities market (whether or not
such notes are actually traded).
(e) Special rule for convertible securities--(1) General rule. For
purposes of paragraph (d)(1) of this section, if an obligation contains
a right whereby the holder of such obligation may convert it directly or
indirectly into another obligation which would be treated as a payment
under paragraph (b) of this section or may convert it directly or
indirectly into stock which would be treated as readily tradable or
designed to be readily tradable in an established securities market
under paragraph (d) of this section, the convertible obligation shall be
considered to be in a form designed to render such obligation readily
tradable in an established securities market unless such obligation is
convertible only at a substantial discount. In determining whether the
stock or obligation, into which an obligation is convertible, is readily
tradable or designed to be readily tradable in an established securities
market, the rules stated in paragraph (d) of this section shall apply,
and for purposes of such paragraph (d) if such obligation is convertible
into stock then the term ``stock'' shall be substituted for the term
``obligation'' wherever it appears in such paragraph (d).
(2) Substantial discount rule. Whether an obligation is convertible
at a substantial discount depends upon the particular facts and
circumstances. A substantial discount shall be considered to exist if at
the time the convertible obligation is issued, the fair market value of
the stock or obligation into which the obligation is convertible is less
than 80 percent of the fair market value of the obligation (determined
by taking into account all relevant factors, including proper discount
to reflect the fact that the convertible obligation is not readily
tradable in an established securities market and any additional
consideration required to be paid by the taxpayer). Also, if a privilege
to convert an obligation into stock or an obligation which is readily
tradable in an established securities market may not be exercised within
a period of 1 year from the date the obligation is issued, a substantial
discount shall be considered to exist.
(f) Effective date. The provisions of this section shall apply to
sales or other dispositions occurring after May 27, 1969, which are not
made pursuant to a binding written contract entered into on or before
such date. No inference shall be drawn from this section as to any
question of law concerning the application of section 453 to sales or
other dispositions occurring on or before May 27, 1969.
[T.D. 7197, 37 FR 13532, July 11, 1972]
Sec. 1.453-4 Sale of real property involving deferred periodic payments.
(a) In general. Sales of real property involving deferred payments
include (1) agreements of purchase and sale which contemplate that a
conveyance is not to be made at the outset, but only after all or a
substantial portion of the selling price has been paid, and (2) sales in
which there is an immediate transfer of title, the vendor being
protected by a mortgage or other lien as to deferred payments.
(b) Classes of sales. Such sales, under either paragraph (a) (1) or
(2) of this section, fall into two classes when considered with respect
to the terms of sale, as follows:
[[Page 108]]
(1) Sales of real property which may be accounted for on the
installment method, that is, sales of real property in which (i) there
are no payments during the taxable year of the sale or (ii) the payments
in such taxable year (exclusive of evidences of indebtedness of the
purchaser) do not exceed 30 percent of the selling price, or
(2) Deferred-payment sales of real property in which the payments
received in cash or property other than evidences of indebtedness of the
purchaser during the taxable year in which the sale is made exceed 30
percent of the selling price.
(c) Determination of ``selling price''. In the sale of mortgaged
property the amount of the mortgage, whether the property is merely
taken subject to the mortgage or whether the mortgage is assumed by the
purchaser, shall, for the purpose of determining whether a sale is on
the installment plan, be included as a part of the ``selling price'';
and for the purpose of determining the payments and the total contract
price as those terms are used in section 453, and Secs. 1.453-1 through
1.453-7, the amount of such mortgage shall be included only to the
extent that it exceeds the basis of the property. The term ``payments''
does not include amounts received by the vendor in the year of sale from
the disposition to a third person of notes given by the vendee as part
of the purchase price which are due and payable in subsequent years.
Commissions and other selling expenses paid or incurred by the vendor
shall not reduce the amount of the payments, the total contract price,
or the selling price.
[T.D. 6500, 25 FR 11715, Nov. 26, 1960]
Sec. 1.453-5 Sale of real property treated on installment method.
(a) In general. In any transaction described in paragraph (b)(1) of
Sec. 1.453-4, that is, sales of real property in which there are no
payments during the year of sale or the payments in that year do not
exceed 30 percent of the selling price, the vendor may return as income
from each such transaction in any taxable year that proportion of the
installment payments actually received in that year which the gross
profit (as described in paragraph (b) of Sec. 1.453-1) realized or to be
realized when the property is paid for bears to the total contract
price. In any case, the sale of each lot or parcel of a subdivided tract
must be treated as a separate transaction and gain or loss computed
accordingly. (See paragraph (a) of Sec. 1.61-6.)
(b) Defaults and repossessions--(1) Effective date. This paragraph
shall apply only with respect to taxable years beginning before
September 3, 1964, in respect of which an election has not been properly
made to have the provisions of section 1038 apply. For rules applicable
to taxable years beginning after September 2, 1964, and for taxable
years beginning after December 31, 1957, to which such an election
applies, see section 1038, and Secs. 1.1038-1 through 1.1038-3.
(2) Gain or loss on reacquisition of property. If the purchaser of
real property on the installment plan defaults in any of his payments,
and the vendor returning income on the installment method reacquires the
property sold, whether title thereto had been retained by the vendor or
transferred to the purchaser, gain or loss for the year in which the
reacquisition occurs is to be computed upon any installment obligations
of the purchaser which are satisfied or discharged upon the
reacquisition or are applied by the vendor to the purchase or bid price
of the property. Such gain or loss is to be measured by the difference
between the fair market value at the date of reacquisition of the
property reacquired (including the fair market value of any fixed
improvements placed on the property by the purchaser) and the basis in
the hands of the vendor of the obligations of the purchaser which are so
satisfied, discharged, or applied, with proper adjustment for any other
amounts realized or costs incurred in connection with the reacquisition.
(3) Fair market value of reacquired property. If the property
reacquired is bid in by the vendor at a foreclosure sale, the fair
market value of the property shall be presumed to be the purchase or bid
price thereof in the absence of clear and convincing proof to the
contrary.
[[Page 109]]
(4) Basis of obligations. The basis in the hands of the vendor of
the obligations of the purchaser satisfied, discharged, or applied upon
the reacquisition of the property will be the excess of the face value
of such obligations over an amount equal to the income which would be
returnable were the obligations paid in full. For definition of the
basis of an installment obligation, see section 453(d)(2) and paragraph
(b)(2) of Sec. 1.453-9.
(5) Bad debt deduction. No deduction for a bad debt shall in any
case be taken on account of any portion of the obligations of the
purchaser which are treated by the vendor as not having been satisfied,
discharged, or applied upon the reacquisition of the property, unless it
is clearly shown that after the property was reacquired the purchaser
remained liable for such portion; and in no event shall the amount of
the deduction exceed the basis in the hands of the vendor of the portion
of the obligations with respect to which the purchaser remained liable
after the reacquisition. See section 166 and the regulations thereunder.
(6) Basis of reacquired property. If the property reacquired is
subsequently sold, the basis for determining gain or loss is the fair
market value of the property at the date of reacquisition, including the
fair market value of any fixed improvements placed on the property by
the purchaser.
[T.D. 6500, 25 FR 11716, Nov. 26, 1960, as amended by T.D. 6916, 32 FR
5923, Apr. 13, 1967]
Sec. 1.453-6 Deferred payment sale of real property not on installment method.
(a) Value of obligations. (1) In transactions included in paragraph
(b)(2) of Sec. 1.453-4, that is, sales of real property involving
deferred payments in which the payments received during the year of sale
exceed 30 percent of the selling price, the obligations of the purchaser
received by the vendor are to be considered as an amount realized to the
extent of their fair market value in ascertaining the profit or loss
from the transaction. Such obligations, however, are not considered in
determining whether the payments during the year of sale exceed 30
percent of the selling price.
(2) If the obligations received by the vendor have no fair market
value, the payments in cash or other property having a fair market value
shall be applied against and reduce the basis of the property sold and,
if in excess of such basis, shall be taxable to the extent of the
excess. Gain or loss is realized when the obligations are disposed of or
satisfied, the amount thereof being the difference between the reduced
basis as provided in the preceding sentence and the amount realized
therefor. Only in rare and extraordinary cases does property have no
fair market value.
(b) Repossession of property where title is retained by vendor--(1)
Gain or loss on repossession. If the vendor in sales referred to in
paragraph (a) of this section has retained title to the property and the
purchaser defaults in any of his payments, and the vendor repossesses
the property, the difference between--
(i) The entire amount of the payments actually received on the
contract and retained by the vendor plus the fair market value at the
time of repossession of fixed improvements placed on the property by the
purchaser, and
(ii) The sum of the profits previously returned as income in
connection therewith and an amount representing what would have been a
proper adjustment for exhaustion, wear and tear, obsolescence,
amortization, and depletion of the property during the period the
property was in the hands of the purchaser had the sale not been made,
will constitute gain or loss, as the case may be, to the vendor for the
year in which the property is repossessed.
(2) Basis of repossessed property. The basis of the property
described in subparagraph (1) of this paragraph in the hands of the
vendor will be the original basis at the time of the sale plus the fair
market value at the time of repossession of fixed improvements placed on
the property by the purchaser, except that, with respect to
repossessions occurring after September 18, 1958, the basis of the
property shall be reduced by what would have been a proper adjustment
for exhaustion, wear and tear, obsolescence, amortization, and
[[Page 110]]
depletion of the property during the period the property was in the
hands of the purchaser if the sale had not been made.
(c) Reacquisition of property where title is transferred to
purchaser--(1) Gain or loss on reacquisition. If the vendor in sales
described in paragraph (a) of this section has previously transferred
title to the purchaser, and the purchaser defaults in any of his
payments, and the vendor accepts a voluntary reconveyance of the
property, in partial or full satisfaction of the unpaid portion of the
purchase price, the receipt of the property so reacquired, to the extent
of its fair market value at that time, including the fair market value
of fixed improvements placed on the property by the purchaser, shall be
considered as the receipt of payment on the obligations satisfied. If
the fair market value of the property is greater than the basis of the
obligations of the purchaser so satisfied (generally, such basis being
the fair market value of such obligations previously recognized in
computing income), the excess constitutes ordinary income. If the value
of such property is less than the basis of such obligations, the
difference may be deducted as a bad debt if uncollectible, except that,
if the obligations satisfied are securities (as defined in section
165(g)(2)(C)), any gain or loss resulting from the transaction is a
capital gain or loss subject to the provisions of sections 1201 through
1241.
(2) Basis of reacquired property. If the reacquired property
described in subparagraph (1) of this paragraph is subsequently sold,
the basis for determining gain or loss is the fair market value of the
property at the date of reacquisition, including the fair market value
of the fixed improvements placed on the property by the purchaser. See
section 166 and the regulations thereunder with respect to property
reacquired by the vendor in a foreclosure proceeding.
(d) Effective date. Paragraphs (b) and (c) of this section shall
apply only with respect to taxable years beginning before September 3,
1964, in respect of which an election has not been properly made to have
the provisions of section 1038 apply. For rules applicable to taxable
years beginning after September 2, 1964, and for taxable years beginning
after December 31, 1957, to which such an election applies, see section
1038, and Secs. 1.1038-1 through 1.1038-3.
[T.D. 6500, 25 FR 11716, Nov. 26, 1960, as amended by T.D. 6916, 32 FR
5923, Apr. 13, 1967]
Secs. 1.453-7--1.453-8 [Reserved]
Sec. 1.453-9 Gain or loss on disposition of installment obligations.
(a) In general. Subject to the exceptions contained in section
453(d)(4) and paragraph (c) of this section, the entire amount of gain
or loss resulting from any disposition or satisfaction of installment
obligations, computed in accordance with section 453(d), is recognized
in the taxable year of such disposition or satisfaction and shall be
considered as resulting from the sale or exchange of the property in
respect of which the installment obligation was received by the
taxpayer.
(b) Computation of gain or loss. (1) The amount of gain or loss
resulting under paragraph (a) of this section is the difference between
the basis of the obligation and (i) the amount realized, in the case of
satisfaction at other than face value or in the case of a sale or
exchange, or (ii) the fair market value of the obligation at the time of
disposition, if such disposition is other than by sale or exchange.
(2) The basis of an installment obligation shall be the excess of
the face value of the obligation over an amount equal to the income
which would be returnable were the obligation satisfied in full.
(3) The application of subparagraphs (1) and (2) of this paragraph
may be illustrated by the following examples:
Example (1). In 1960 the M Corporation sold a piece of unimproved
real estate to B for $20,000. The company acquired the property in 1948
at a cost of $10,000. During 1960 the company received $5,000 cash and
vendee's notes for the remainder of the selling price, or $15,000,
payable in subsequent years. In 1962, before the vendee made any further
payments, the company sold the notes for $13,000 in cash. The
corporation makes its returns on the calendar year basis. The income to
be reported for 1962 is $5,500, computed as follows:
Proceeds of sale of notes........................... ........ $13,000
[[Page 111]]
Selling price of property........................... $20,000
Cost of property.................................... 10,000
----------
Total profit...................................... 10,000
Total contract price.............................. 20,000
==========
Percent of profit, or proportion of each payment
returnable as income, $10,000 divided by $20,000,
50 percent.
Face value of notes................................. 15,000
Amount of income returnable were the notes satisfied 7,500
in full, 50 percent of $15,000.....................
----------
Basis of obligation--excess of face value of notes 7,500
over amount of income returnable were the notes
satisfied in full..................................
----------
Taxable income to be reported for 1962.................... 5,500
Example (2). Suppose in example (1) the M Corporation, instead of
selling the notes, distributed them in 1962 to its shareholders as a
dividend, and at the time of such distribution, the fair market value of
the notes was $14,000. The income to be reported for 1962 is $6,500,
computed as follows:
Fair market value of notes.................................... $14,000
Basis of obligation--excess of face value of notes over amount 7,500
of income returnable were the notes satisfied in full
(computed as in example (1)).................................
=========
Taxable income to be reported for 1962...................... 6,500
(c) Disposition from which no gain or loss is recognized. (1)(i)
Under section 453(d)(4)(A), no gain or loss shall be recognized to a
distributing corporation with respect to the distribution made after
November 13, 1966, of installment obligations if (a) the distribution is
made pursuant to a plan for the complete liquidation of a subsidiary
under section 332, and (b) the basis of the such obligations in the
hands of the distributee is determined under section 334(b)(1).
(ii) Under section 453(d)(4)(B), no gain or loss shall be recognized
to a distributing corporation with respect to the distribution of
installment obligations if the distribution is made, pursuant to a plan
for the complete liquidation of a corporation which meets the
requirements of section 337, under conditions whereby no gain or loss
would have been recognized to the corporation had such installment
obligations been sold or exchanged on the day of the distribution. The
preceding sentence shall not apply to the extent that under section
453(d)(1) gain to the distributing corporation would be considered as
gain to which section 341(f)(2), 617(d)(1), 1245(a)(1), 1250(a)(1),
1251(c)(1), 1252(a)(1), or 1254(a)(1) applies, computed under the
principles of the regulations under such provisions. See paragraph (d)
of Sec. 1.1245-6, paragraph (c)(6) of Sec. 1.1250-1, paragraph (e)(6) of
Sec. 1.1251-1, paragraph (d)(3) of Sec. 1.1252-1, and paragraph (d) of
Sec. 1.1254-1.
(2) Where the Code provides for exceptions to the recognition of
gain or loss in the case of certain dispositions, no gain or loss shall
result under section 453(d) in the case of a disposition of an
installment obligation. Such exceptions include: Certain transfers to
corporations under sections 351 and 361; contributions of property to a
partnership by a partner under section 721; and distributions by a
partnership to a partner under section 731 (except as provided by
section 736 and section 751).
(3) Any amount received by a person in payment or settlement of an
installment obligation acquired in a transaction described in
subparagraphs (1) or (2) of this paragraph (other than an amount
received by a stockholder with respect to an installment obligation
distributed to him pursuant to section 337) shall be considered to have
the character it would have had in the hands of the person from whom
such installment obligation was acquired.
(d) Carryover of installment method. For the treatment of income
derived from installment obligations received in transactions to which
section 381 (a) is applicable, see section 381(c)(8) and the regulations
thereunder.
(e) Installment obligations transmitted at death. Where installment
obligations are transmitted at death, see section 691(a)(4) and the
regulations thereunder for the treatment of amounts considered income in
respect of a decedent.
(f) Losses. See subchapter P (section 1201 and following), chapter 1
of the Code, as to the limitation on capital losses sustained by
corporations and the limitation as to both capital gains and capital
losses of individuals.
(g) Disposition of installment obligations to life insurance
companies. (1) Notwithstanding the provisions of section 453(d)(4) and
paragraph (c) of this section or any provision of subtitle A relating to
the nonrecognition of gain, the entire amount of any gain realized
[[Page 112]]
on the disposition of an installment obligation by any person, other
than a life insurance company (as defined in section 801(a) and
paragraph (b) of Sec. 1.801-3), to a life insurance company or to a
partnership of which a life insurance company is a partner shall be
recognized and treated in accordance with section 453(d)(1) and
paragraphs (a) and (b) of this section. If a corporation which is a life
insurance company for the taxable year was a corporation which was not a
life insurance company for the preceding taxable year, such corporation
shall be treated, for purposes of section 453(d)(1) and this paragraph,
as having transferred to a life insurance company, on the last day of
the preceding taxable year, all installment obligations which it held on
such last day. The gain, if any, realized by reason of the installment
obligations being so transferred shall be recognized and treated in
accordance with section 453(d)(1) and paragraphs (a) and (b) of this
section. Similarly, a partnership of which a life insurance company
becomes a partner shall be treated, for purposes of section 453(d)(1)
and this paragraph, as having transferred to a life insurance company,
on the last day of the preceding taxable year of such partnership, all
installment obligations which it holds at the time such life insurance
company becomes a partner. The gain, if any, realized by reason of the
installment obligations being so transferred shall be recognized and
treated in accordance with section 453(d)(1) and paragraphs (a) and (b)
of this section.
(2) The provisions of section 453(d)(5) and subparagraph (1) of this
paragraph shall not apply to losses sustained in connection with the
disposition of installment obligations to a life insurance company.
(3) For the effective date of the provisions of section 453(d)(5)
and this paragraph, see paragraph (f) of Sec. 1.453-10.
(4) Application of the provisions of this paragraph may be
illustrated by the following examples:
Example (1). A, an individual, in a transaction to which section 351
applies, transfers in 1961 certain assets, including installment
obligations, to a new corporation, X, which qualifies as a life
insurance company (as defined in section 801(a)) for the year 1961. A
makes his return on the calendar year basis. Section 453(d)(5) provides
that the nonrecognition provisions of section 351 will not apply to the
installment obligations transferred by A to X Corporation. Therefore,
the entire amount of any gain realized by A on the transfer of the
installment obligations shall be recognized in 1961, with the amount of
any such gain computed in accordance with the provisions of section
453(d)(1) and paragraph (b) of this section.
Example (2). The M Corporation did not qualify as a life insurance
company (as defined in section 801(a)) for the taxable year 1958. On
December 31, 1958, it held $60,000 of installment obligations. The M
Corporation qualified as a life insurance company for the taxable year
1959. Accordingly, the M Corporation is treated as having transferred to
a life insurance company, on December 31, 1958, the $60,000 of
installment obligations it held on such date. The gain, if any, realized
by M by reason of such installment obligations being so transferred
shall be recognized in the taxable year 1958, with the amount of any
such gain computed in accordance with the provisions of section
453(d)(1) and paragraph (b) of this section.
Example (3). During its taxable year 1958, none of the partners of
the N partnership qualified as a life insurance company (as defined in
section 801(a)). The N partnership held $30,000 of installment
obligations on December 31, 1958. On July 30, 1959, the O Corporation, a
life insurance company (as defined in section 801(a)), became a partner
in the partnership. The N partnership held $50,000 of installment
obligations on July 30, 1959. Pursuant to section 453(d)(5), the N
partnership is treated as having transferred to a life insurance
company, on December 31, 1958, the $50,000 of installment obligations it
held on July 30, 1959. The gain, if any, realized by the N partnership
by reason of such installment obligations being so transferred shall be
recognized in the taxable year 1958, with the amount of any such gain
computed in accordance with the provisions of section 453(d)(1) and
paragraph (b) of this section.
Example (4). In 1960, the P Corporation, in a reorganization
qualifying under section 368(a), transferred certain assets (including
installment obligations) to the R Corporation, a life insurance company
as defined in section 801(a). P realized a loss upon the transfer of the
installment obligations, which was not recognized under section 361.
Pursuant to subparagraph (2) of paragraph (c) of this section, no loss
with respect to the transfer of these obligations will be recognized to
P under section 453(d)(1).
[T.D. 6500, 25 FR 11718, Nov. 26, 1960, as amended by T.D. 6590, 27 FR
1319, Feb. 13, 1962; T.D. 7084, 36 FR 267, Jan. 8, 1971; T.D. 7418, 41
FR 18812, May 7, 1976; T.D. 8586, 60 FR 2500, Jan. 10, 1995]
[[Page 113]]
Sec. 1.453-10 Effective date.
(a) Except as provided in this section, the provisions of section
453 and Secs. 1.453-1 through 1.453-9 shall apply to taxable years
beginning after December 31, 1953, and ending after August 16, 1954.
(b) The provisions of paragraphs (a) (2) and (3), (b), and (c) of
Sec. 1.453-8 shall apply to taxable years ending after December 17,
1958.
(c) Under the provisions of sections 453(b) and 7851(a)(1)(C),
section 453(b)(1) and the regulations with respect thereto shall also
apply--
(1) To a sale or other disposition during a taxable year beginning
before January 1, 1954, only if the income was returnable (by reason of
section 44(b) of the Internal Revenue Code of 1939) on the basis and in
the manner prescribed in section 44(a) of such code.
(2) To a sale or other disposition during a taxable year beginning
after December 31, 1953, and ending before August 17, 1954, though such
taxable year is subject to the provisions of the Internal Revenue Code
of 1939.
(d) Under the provisions of sections 453(c)(1)(B) and 7851(a)(1)(C)
section 453(c) and the regulations with respect thereto shall also apply
to taxable years beginning after December 31, 1953, and ending before
August 17, 1954, though such taxable years are subject to the provisions
of the Internal Revenue Code of 1939.
(e) The provisions of paragraph (b)(3) of Sec. 1.453-6 shall apply
to repossessions occurring after December 18, 1958.
(f) The provisions of section 453(d)(5) and paragraph (g) of
Sec. 1.453-9 shall apply to taxable years ending after December 31,
1957, but only as to transfers or other dispositions of installment
obligations occurring after such date.
[T.D. 6500, 25 FR 11718, Nov. 26, 1960, as amended by T.D. 6590, 27 FR
1320, Feb. 13, 1962; T.D. 6682, 28 FR 11177, Oct. 18, 1963]
Sec. 1.453-11 Installment obligations received from a liquidating corporation.
(a) In general--(1) Overview. Except as provided in section
453(h)(1)(C) (relating to installment sales of depreciable property to
certain closely related persons), a qualifying shareholder (as defined
in paragraph (b) of this section) who receives a qualifying installment
obligation (as defined in paragraph (c) of this section) in a
liquidation that satisfies section 453(h)(1)(A) treats the receipt of
payments in respect of the obligation, rather than the receipt of the
obligation itself, as a receipt of payment for the shareholder's stock.
The shareholder reports the payments received on the installment method
unless the shareholder elects otherwise in accordance with Sec. 15a.453-
1(d) of this chapter.
(2) Coordination with other provisions--(i) Deemed sale of stock for
installment obligation. Except as specifically provided in section
453(h)(1)(C), a qualifying shareholder treats a qualifying installment
obligation, for all purposes of the Internal Revenue Code, as if the
obligation is received by the shareholder from the person issuing the
obligation in exchange for the shareholder's stock in the liquidating
corporation. For example, if the stock of a corporation that is
liquidating is traded on an established securities market, an
installment obligation distributed to a shareholder of the corporation
in exchange for the shareholder's stock does not qualify for installment
reporting pursuant to section 453(k)(2).
(ii) Special rules to account for the qualifying installment
obligation--(A) Issue price. A qualifying installment obligation is
treated by a qualifying shareholder as newly issued on the date of the
distribution. The issue price of the qualifying installment obligation
on that date is equal to the sum of the adjusted issue price of the
obligation on the date of the distribution (as determined under
Sec. 1.1275-1(b)) and the amount of any qualified stated interest (as
defined in Sec. 1.1273-1(c)) that has accrued prior to the distribution
but that is not payable until after the distribution. For purposes of
the preceding sentence, if the qualifying installment obligation is
subject to Sec. 1.446-2 (e.g., a debt instrument that has unstated
interest under section 483), the adjusted issue price of the obligation
is determined under Sec. 1.446-2(c) and (d).
(B) Variable rate debt instrument. If the qualifying installment
obligation is a variable rate debt instrument (as defined in
Sec. 1.1275-5), the shareholder
[[Page 114]]
uses the equivalent fixed rate debt instrument (within the meaning of
Sec. 1.1275-5(e)(3)(ii)) constructed for the qualifying installment
obligation as of the date the obligation was issued to the liquidating
corporation to determine the accruals of original issue discount, if
any, and interest on the obligation.
(3) Liquidating distributions treated as selling price. All amounts
distributed or treated as distributed to a qualifying shareholder
incident to the liquidation, including cash, the issue price of
qualifying installment obligations as determined under paragraph
(a)(2)(ii)(A) of this section, and the fair market value of other
property (including obligations that are not qualifying installment
obligations) are considered as having been received by the shareholder
as the selling price (as defined in Sec. 15a.453-1(b)(2)(ii) of this
chapter) for the shareholder's stock in the liquidating corporation. For
the proper method of reporting liquidating distributions received in
more than one taxable year of a shareholder, see paragraph (d) of this
section. An election not to report on the installment method an
installment obligation received in the liquidation applies to all
distributions received in the liquidation.
(4) Assumption of corporate liability by shareholders. For purposes
of this section, if in the course of a liquidation a shareholder assumes
secured or unsecured liabilities of the liquidating corporation, or
receives property from the corporation subject to such liabilities
(including any tax liabilities incurred by the corporation on the
distribution), the amount of the liabilities is added to the
shareholder's basis in the stock of the liquidating corporation. These
additions to basis do not affect the shareholder's holding period for
the stock. These liabilities do not reduce the amounts received in
computing the selling price.
(5) Examples. The provisions of this paragraph (a) are illustrated
by the following examples. Except as otherwise provided, assume in each
example that A, an individual who is a calendar-year taxpayer, owns all
of the stock of T corporation. A's adjusted tax basis in that stock is
$100,000. On February 1, 1998, T, an accrual method taxpayer, adopts a
plan of complete liquidation that satisfies section 453(h)(1)(A) and
immediately sells all of its assets to unrelated B corporation in a
single transaction. The examples are as follows:
Example 1. (i) The stated purchase price for T's assets is
$3,500,000. In consideration for the sale, B makes a down payment of
$500,000 and issues a 10-year installment obligation with a stated
principal amount of $3,000,000. The obligation provides for interest
payments of $150,000 on January 31 of each year, with the total
principal amount due at maturity.
(ii) Assume that for purposes of section 1274, the test rate on
February 1, 1998, is 8 percent, compounded semi-annually. Also assume
that a semi-annual accrual period is used. Under Sec. 1.1274-2, the
issue price of the obligation on February 1, 1998, is $2,368,450.
Accordingly, the obligation has $631,550 of original issue discount
($3,000,000-$2,368,450). Between February 1 and July 31, $19,738 of
original issue discount and $75,000 of qualified stated interest accrue
with respect to the obligation and are taken into account by T.
(iii) On July 31, 1998, T distributes the installment obligation to
A in exchange for A's stock. No other property is ever distributed to A.
On January 31, 1999, A receives the first annual payment of $150,000
from B.
(iv) When the obligation is distributed to A on July 31, 1998, it is
treated as if the obligation is received by A in an installment sale of
shares directly to B on that date. Under Sec. 1.1275-1(b), the adjusted
issue price of the obligation on that date is $2,388,188 (original issue
price of $2,368,450 plus accrued original issue discount of $19,738).
Accordingly, the issue price of the obligation under paragraph
(a)(2)(ii)(A) of this section is $2,463,188, the sum of the adjusted
issue price of the obligation on that date ($2,388,188) and the amount
of accrued but unpaid qualified stated interest ($75,000).
(v) The selling price and contract price of A's stock in T is
$2,463,188, and the gross profit is $2,363,188 ($2,463,188 selling price
less A's adjusted tax basis of $100,000). A's gross profit ratio is thus
96 percent (gross profit of $2,363,188 divided by total contract price
of $2,463,188).
(vi) Under Secs. 1.446-2(e)(1) and 1.1275-2(a), $98,527 of the
$150,000 payment is treated as a payment of the interest and original
issue discount that accrued on the obligation from July 31, 1998, to
January 31, 1999 ($75,000 of qualified stated interest and $23,527 of
original issue discount). The balance of the payment ($51,473) is
treated as a payment of principal. A's gain recognized in 1999 is
$49,414 (96 percent of $51,473).
[[Page 115]]
Example 2. (i) T owns Blackacre, unimproved real property, with an
adjusted tax basis of $700,000. Blackacre is subject to a mortgage
(underlying mortgage) of $1,100,000. A is not personally liable on the
underlying mortgage and the T shares held by A are not encumbered by the
underlying mortgage. The other assets of T consist of $400,000 of cash
and $600,000 of accounts receivable attributable to sales of inventory
in the ordinary course of business. The unsecured liabilities of T total
$900,000.
(ii) On February 1, 1998, T adopts a plan of complete liquidation
complying with section 453(h)(1)(A), and promptly sells Blackacre to B
for a 4-year mortgage note (bearing adequate stated interest and
otherwise meeting all of the requirements of section 453) in the face
amount of $4 million. Under the agreement between T and B, T (or its
successor) is to continue to make principal and interest payments on the
underlying mortgage. Immediately thereafter, T completes its liquidation
by distributing to A its remaining cash of $400,000 (after payment of
T's tax liabilities), accounts receivable of $600,000, and the $4
million B note. A assumes T's $900,000 of unsecured liabilities and
receives the distributed property subject to the obligation to make
payments on the $1,100,000 underlying mortgage. A receives no payments
from B on the B note during 1998.
(iii) Unless A elects otherwise, the transaction is reported by A on
the installment method. The selling price is $5 million (cash of
$400,000, accounts receivable of $600,000, and the B note of $4
million). The total contract price also is $5 million. A's adjusted tax
basis in the T shares, initially $100,000, is increased by the $900,000
of unsecured T liabilities assumed by A and by the obligation (subject
to which A takes the distributed property) to make payments on the
$1,100,000 underlying mortgage on Blackacre, for an aggregate adjusted
tax basis of $2,100,000. Accordingly, the gross profit is $2,900,000
(selling price of $5 million less aggregate adjusted tax basis of
$2,100,000). The gross profit ratio is 58 percent (gross profit of
$2,900,000 divided by the total contract price of $5 million). The 1998
payments to A are $1 million ($400,000 cash plus $600,000 receivables)
and A recognizes gain in 1998 of $580,000 (58 percent of $1 million).
(iv) In 1999, A receives payment from B on the B note of $1 million
(exclusive of interest). A's gain recognized in 1999 is $580,000 (58
percent of $1 million).
(b) Qualifying shareholder. For purposes of this section, qualifying
shareholder means a shareholder to which, with respect to the
liquidating distribution, section 331 applies. For example, a creditor
that receives a distribution from a liquidating corporation, in exchange
for the creditor's claim, is not a qualifying shareholder as a result of
that distribution regardless of whether the liquidation satisfies
section 453(h)(1)(A).
(c) Qualifying installment obligation--(1) In general. For purposes
of this section, qualifying installment obligation means an installment
obligation (other than an evidence of indebtedness described in
Sec. 15a.453-1(e) of this chapter, relating to obligations that are
payable on demand or are readily tradable) acquired in a sale or
exchange of corporate assets by a liquidating corporation during the 12-
month period beginning on the date the plan of liquidation is adopted.
See paragraph (c)(4) of this section for an exception for installment
obligations acquired in respect of certain sales of inventory. Also see
paragraph (c)(5) of this section for an exception for installment
obligations attributable to sales of certain property that do not
generally qualify for installment method treatment.
(2) Corporate assets. Except as provided in section 453(h)(1)(C), in
paragraph (c)(4) of this section (relating to certain sales of
inventory), and in paragraph (c)(5) of this section (relating to certain
tax avoidance transactions), the nature of the assets sold by, and the
tax consequences to, the selling corporation do not affect whether an
installment obligation is a qualifying installment obligation. Thus, for
example, the fact that the fair market value of an asset is less than
the adjusted basis of that asset in the hands of the corporation; or
that the sale of an asset will subject the corporation to depreciation
recapture (e.g., under section 1245 or section 1250); or that the assets
of a trade or business sold by the corporation for an installment
obligation include depreciable property, certain marketable securities,
accounts receivable, installment obligations, or cash; or that the
distribution of assets to the shareholder is or is not taxable to the
corporation under sections 336 and 453B, does not affect whether
installment obligations received in exchange for those assets are
treated as qualifying installment obligations by
[[Page 116]]
the shareholder. However, an obligation received by the corporation in
exchange for cash, in a transaction unrelated to a sale or exchange of
noncash assets by the corporation, is not treated as a qualifying
installment obligation.
(3) Installment obligations distributed in liquidations described in
section 453(h)(1)(E)--(i) In general. In the case of a liquidation to
which section 453(h)(1)(E) (relating to certain liquidating subsidiary
corporations) applies, a qualifying installment obligation acquired in
respect of a sale or exchange by the liquidating subsidiary corporation
will be treated as a qualifying installment obligation if distributed by
a controlling corporate shareholder (within the meaning of section
368(c)) to a qualifying shareholder. The preceding sentence is applied
successively to each controlling corporate shareholder, if any, above
the first controlling corporate shareholder.
(ii) Examples. The provisions of this paragraph (c)(3) are
illustrated by the following examples:
Example 1. (i) A, an individual, owns all of the stock of T
corporation, a C corporation. T has an operating division and three
wholly-owned subsidiaries, X, Y, and Z. On February 1, 1998, T, Y, and Z
all adopt plans of complete liquidation.
(ii) On March 1, 1998, the following sales are made to unrelated
purchasers: T sells the assets of its operating division to B for cash
and an installment obligation. T sells the stock of X to C for an
installment obligation. Y sells all of its assets to D for an
installment obligation. Z sells all of its assets to E for cash. The B,
C, and D installment obligations bear adequate stated interest and meet
the requirements of section 453.
(iii) In June 1998, Y and Z completely liquidate, distributing their
respective assets (the D installment obligation and cash) to T. In July
1998, T completely liquidates, distributing to A cash and the
installment obligations respectively issued by B, C, and D. The
liquidation of T is a liquidation to which section 453(h) applies and
the liquidations of Y and Z into T are liquidations to which section 332
applies.
(iv) Because T is in control of Y (within the meaning of section
368(c)), the D obligation acquired by Y is treated as acquired by T
pursuant to section 453(h)(1)(E). A is a qualifying shareholder and the
installment obligations issued by B, C, and D are qualifying installment
obligations. Unless A elects otherwise, A reports the transaction on the
installment method as if the cash and installment obligations had been
received in an installment sale of the stock of T corporation. Under
section 453B(d), no gain or loss is recognized by Y on the distribution
of the D installment obligation to T. Under sections 453B(a) and 336, T
recognizes gain or loss on the distribution of the B, C, and D
installment obligations to A in exchange for A's stock.
Example 2. (i) A, a cash-method individual taxpayer, owns all of the
stock of P corporation, a C corporation. P owns 30 percent of the stock
of Q corporation. The balance of the Q stock is owned by unrelated
individuals. On February 1, 1998, P adopts a plan of complete
liquidation and sells all of its property, other than its Q stock, to B,
an unrelated purchaser for cash and an installment obligation bearing
adequate stated interest. On March 1, 1998, Q adopts a plan of complete
liquidation and sells all of its property to an unrelated purchaser, C,
for cash and installment obligations. Q immediately distributes the cash
and installment obligations to its shareholders in completion of its
liquidation. Promptly thereafter, P liquidates, distributing to A cash,
the B installment obligation, and a C installment obligation that P
received in the liquidation of Q.
(ii) In the hands of A, the B installment obligation is a qualifying
installment obligation. In the hands of P, the C installment obligation
was a qualifying installment obligation. However, in the hands of A, the
C installment obligation is not treated as a qualifying installment
obligation because P owned only 30 percent of the stock of Q. Because P
did not own the requisite 80 percent stock interest in Q, P was not a
controlling corporate shareholder of Q (within the meaning of section
368(c)) immediately before the liquidation. Therefore, section
453(h)(1)(E) does not apply. Thus, in the hands of A, the C obligation
is considered to be a third-party note (not a purchaser's evidence of
indebtedness) and is treated as a payment to A in the year of
distribution. Accordingly, for 1998, A reports as payment the cash and
the fair market value of the C obligation distributed to A in the
liquidation of P.
(iii) Because P held 30 percent of the stock of Q, section 453B(d)
is inapplicable to P. Under sections 453B(a) and 336, accordingly, Q
recognizes gain or loss on the distribution of the C obligation. P also
recognizes gain or loss on the distribution of the B and C installment
obligations to A in exchange for A's stock. See sections 453B and 336.
(4) Installment obligations attributable to certain sales of
inventory--(i) In general. An installment obligation acquired by a
corporation in a liquidation that satisfies section 453(h)(1)(A) in
respect of a broken lot of inventory is
[[Page 117]]
not a qualifying installment obligation. If an installment obligation is
acquired in respect of a broken lot of inventory and other assets, only
the portion of the installment obligation acquired in respect of the
broken lot of inventory is not a qualifying installment obligation. The
portion of the installment obligation attributable to other assets is a
qualifying installment obligation. For purposes of this section, the
term broken lot of inventory means inventory property that is sold or
exchanged other than in bulk to one person in one transaction involving
substantially all of the inventory property attributable to a trade or
business of the corporation. See paragraph (c)(4)(ii) of this section
for rules for determining what portion of an installment obligation is
not a qualifying installment obligation and paragraph (c)(4)(iii) of
this section for rules determining the application of payments on an
installment obligation only a portion of which is a qualifying
installment obligation.
(ii) Rules for determining nonqualifying portion of an installment
obligation. If a broken lot of inventory is sold to a purchaser together
with other corporate assets for consideration consisting of an
installment obligation and either cash, other property, the assumption
of (or taking property subject to) corporate liabilities by the
purchaser, or some combination thereof, the installment obligation is
treated as having been acquired in respect of a broken lot of inventory
only to the extent that the fair market value of the broken lot of
inventory exceeds the sum of unsecured liabilities assumed by the
purchaser, secured liabilities which encumber the broken lot of
inventory and are assumed by the purchaser or to which the broken lot of
inventory is subject, and the sum of the cash and fair market value of
other property received. This rule applies solely for the purpose of
determining the portion of the installment obligation (if any) that is
attributable to the broken lot of inventory.
(iii) Application of payments. If, by reason of the application of
paragraph (c)(4)(ii) of this section, a portion of an installment
obligation is not a qualifying installment obligation, then for purposes
of determining the amount of gain to be reported by the shareholder
under section 453, payments on the obligation (other than payments of
qualified stated interest) shall be applied first to the portion of the
obligation that is not a qualifying installment obligation.
(iv) Example. The following example illustrates the provisions of
this paragraph (c)(4). In this example, assume that all obligations bear
adequate stated interest within the meaning of section 1274(c)(2) and
that the fair market value of each nonqualifying installment obligation
equals its face amount. The example is as follows:
Example. (i) P corporation has three operating divisions, X, Y, and
Z, each engaged in a separate trade or business, and a minor amount of
investment assets. On July 1, 1998, P adopts a plan of complete
liquidation that meets the criteria of section 453(h)(1)(A). The
following sales are promptly made to purchasers unrelated to P: P sells
all of the assets of the X division (including all of the inventory
property) to B for $30,000 cash and installment obligations totalling
$200,000. P sells substantially all of the inventory property of the Y
division to C for a $100,000 installment obligation, and sells all of
the other assets of the Y division (excluding cash but including
installment receivables previously acquired in the ordinary course of
the business of the Y division) to D for a $170,000 installment
obligation. P sells \1/3\ of the inventory property of the Z division to
E for $100,000 cash, \1/3\ of the inventory property of the Z division
to F for a $100,000 installment obligation, and all of the other assets
of the Z division (including the remaining \1/3\ of the inventory
property worth $100,000) to G for $60,000 cash, a $240,000 installment
obligation, and the assumption by G of the liabilities of the Z
division. The liabilities assumed by G, which are unsecured liabilities
and liabilities encumbering the inventory property acquired by G,
aggregate $30,000. Thus, the total purchase price G pays is $330,000.
(ii) P immediately completes its liquidation, distributing the cash
and installment obligations, which otherwise meet the requirements of
section 453, to A, an individual cash-method taxpayer who is its sole
shareholder. In 1999, G makes a payment to A of $100,000 (exclusive of
interest) on the $240,000 installment obligation.
(iii) In the hands of A, the installment obligations issued by B, C,
and D are qualifying installment obligations because they were timely
acquired by P in a sale or exchange of
[[Page 118]]
its assets. In addition, the installment obligation issued by C is a
qualifying installment obligation because it arose from a sale to one
person in one transaction of substantially all of the inventory property
of the trade or business engaged in by the Y division.
(iv) The installment obligation issued by F is not a qualifying
installment obligation because it is in respect of a broken lot of
inventory. A portion of the installment obligation issued by G is a
qualifying installment obligation and a portion is not a qualifying
installment obligation, determined as follows: G purchased part of the
inventory property (with a fair market value of $100,000) and all of the
other assets of the Z division by paying cash ($60,000), issuing an
installment obligation ($240,000), and assuming liabilities of the Z
division ($30,000). The assumed liabilities ($30,000) and cash ($60,000)
are attributed first to the inventory property. Therefore, only $10,000
of the $240,000 installment obligation is attributed to inventory
property. Accordingly, in the hands of A, the G installment obligation
is a qualifying installment obligation to the extent of $230,000, but is
not a qualifying installment obligation to the extent of the $10,000
attributable to the inventory property.
(v) In the 1998 liquidation of P, A receives a liquidating
distribution as follows:
------------------------------------------------------------------------
Qualifying Cash and
Item installment other
obligations property
------------------------------------------------------------------------
Cash............................................ ........... $190,000
B note.......................................... $200,000 .........
C note.......................................... $100,000 .........
D note.......................................... $170,000 .........
F note.......................................... ........... $100,000
G note \1\...................................... $230,000 $ 10,000
-----------------------
Total....................................... $700,000 $300,000
------------------------------------------------------------------------
\1\ Face amount $240,000.
(vi) Assume that A's adjusted tax basis in the stock of P is
$100,000. Under the installment method, A's selling price and the
contract price are both $1 million, the gross profit is $900,000
(selling price of $1 million less adjusted tax basis of $100,000), and
the gross profit ratio is 90 percent (gross profit of $900,000 divided
by the contract price of $1 million). Accordingly, in 1998, A reports
gain of $270,000 (90 percent of $300,000 payment in cash and other
property). A's adjusted tax basis in each of the qualifying installment
obligations is an amount equal to 10 percent of the obligation's
respective face amount. A's adjusted tax basis in the F note, a
nonqualifying installment obligation, is $100,000, i.e., the fair market
value of the note when received by A. A's adjusted tax basis in the G
note, a mixed obligation, is $33,000 (10 percent of the $230,000
qualifying installment obligation portion of the note, plus the $10,000
nonqualifying portion of the note).
(vii) With respect to the $100,000 payment received from G in 1999,
$10,000 is treated as the recovery of the adjusted tax basis of the
nonqualifying portion of the G installment obligation and $9,000 (10
percent of $90,000) is treated as the recovery of the adjusted tax basis
of the portion of the note that is a qualifying installment obligation.
The remaining $81,000 (90 percent of $90,000) is reported as gain from
the sale of A's stock. See paragraph (c)(4)(iii) of this section.
(5) Installment obligations attributable to sales of certain
property--(i) In general. An installment obligation acquired by a
liquidating corporation, to the extent attributable to the sale of
property described in paragraph (c)(5)(ii) of this section, is not a
qualifying obligation if the corporation is formed or availed of for a
principal purpose of avoiding section 453(b)(2) (relating to dealer
dispositions and certain other dispositions of personal property),
section 453(i) (relating to sales of property subject to recapture), or
section 453(k) (relating to dispositions under a revolving credit plan
and sales of stock or securities traded on an established securities
market) through the use of a party bearing a relationship, either
directly or indirectly, described in section 267(b) to any shareholder
of the corporation.
(ii) Covered property. Property is described in this paragraph
(c)(5)(ii) if, within 12 months before or after the adoption of the plan
of liquidation, the property was owned by any shareholder and--
(A) The shareholder regularly sold or otherwise disposed of personal
property of the same type on the installment plan or the property is
real property that the shareholder held for sale to customers in the
ordinary course of a trade or business (provided the property is not
described in section 453(l)(2) (relating to certain exceptions to the
definition of dealer dispositions));
(B) The sale of the property by the shareholder would result in
recapture income (within the meaning of section 453(i)(2)), but only if
the amount of the recapture income is equal to or greater than 50
percent of the property's fair market value on the date of the sale by
the corporation;
(C) The property is stock or securities that are traded on an
established securities market; or
[[Page 119]]
(D) The sale of the property by the shareholder would have been
under a revolving credit plan.
(iii) Safe harbor. Paragraph (c)(5)(i) of this section will not
apply to the liquidation of a corporation if, on the date the plan of
complete liquidation is adopted and thereafter, less than 15 percent of
the fair market value of the corporation's assets is attributable to
property described in paragraph (c)(5)(ii) of this section.
(iv) Example. The provisions of this paragraph (c)(5) are
illustrated by the following example:
Example. Ten percent of the fair market value of the assets of T is
attributable to stock and securities traded on an established securities
market. T owns no other assets described in paragraph (c)(5)(ii) of this
section. T, after adopting a plan of complete liquidation, sells all of
its stock and securities holdings to C corporation in exchange for an
installment obligation bearing adequate stated interest, sells all of
its other assets to B corporation for cash, and distributes the cash and
installment obligation to its sole shareholder, A, in a complete
liquidation that satisfies section 453(h)(1)(A). Because the C
installment obligation arose from a sale of publicly traded stock and
securities, T cannot report the gain on the sale under the installment
method pursuant to section 453(k)(2). In the hands of A, however, the C
installment obligation is treated as having arisen out of a sale of the
stock of T corporation. In addition, the general rule of paragraph
(c)(5)(i) of this section does not apply, even if a principal purpose of
the liquidation was the avoidance of section 453(k)(2), because the fair
market value of the publicly traded stock and securities is less than 15
percent of the total fair market value of T's assets. Accordingly,
section 453(k)(2) does not apply to A, and A may use the installment
method to report the gain recognized on the payments it receives in
respect of the obligation.
(d) Liquidating distributions received in more than one taxable
year. If a qualifying shareholder receives liquidating distributions to
which this section applies in more than one taxable year, the
shareholder must reasonably estimate the gain attributable to
distributions received in each taxable year. In allocating basis to
calculate the gain for a taxable year, the shareholder must reasonably
estimate the anticipated aggregate distributions. For this purpose, the
shareholder must take into account distributions and other relevant
events or information that the shareholder knows or reasonably could
know up to the date on which the federal income tax return for that year
is filed. If the gain for a taxable year is properly taken into account
on the basis of a reasonable estimate and the exact amount is
subsequently determined the difference, if any, must be taken into
account for the taxable year in which the subsequent determination is
made. However, the shareholder may file an amended return for the
earlier year in lieu of taking the difference into account for the
subsequent taxable year.
(e) Effective date. This section is applicable to distributions of
qualifying installment obligations made on or after January 28, 1998.
[T.D. 8762, 63 FR 4170, Jan. 28, 1998]
Sec. 1.453-12 Allocation of unrecaptured section 1250 gain reported on the installment method.
(a) General rule. Unrecaptured section 1250 gain, as defined in
section 1(h)(7), is reported on the installment method if that method
otherwise applies under section 453 or 453A and the corresponding
regulations. If gain from an installment sale includes unrecaptured
section 1250 gain and adjusted net capital gain (as defined in section
1(h)(4)), the unrecaptured section 1250 gain is taken into account
before the adjusted net capital gain.
(b) Installment payments from sales before May 7, 1997. The amount
of unrecaptured section 1250 gain in an installment payment that is
properly taken into account after May 6, 1997, from a sale before May 7,
1997, is determined as if, for all payments properly taken into account
after the date of sale but before May 7, 1997, unrecaptured section 1250
gain had been taken into account before adjusted net capital gain.
(c) Installment payments received after May 6, 1997, and on or
before August 23, 1999. If the amount of unrecaptured section 1250 gain
in an installment payment that is properly taken into account after May
6, 1997, and on or before August 23, 1999, is less than the amount that
would have been taken into account under this section, the lesser amount
is used to determine the
[[Page 120]]
amount of unrecaptured section 1250 gain that remains to be taken into
account.
(d) Examples. In each example, the taxpayer, an individual whose
taxable year is the calendar year, does not elect out of the installment
method. The installment obligation bears adequate stated interest, and
the property sold is real property held in a trade or business that
qualifies as both section 1231 property and section 1250 property. In
all taxable years, the taxpayer's marginal tax rate on ordinary income
is 28 percent. The following examples illustrate the rules of this
section:
Example 1. General rule. This example illustrates the rule of
paragraph (a) of this section as follows:
(i) In 1999, A sells property for $10,000, to be paid in ten equal
annual installments beginning on December 1, 1999. A originally
purchased the property for $5000, held the property for several years,
and took straight-line depreciation deductions in the amount of $3000.
In each of the years 1999-2008, A has no other capital or section 1231
gains or losses.
(ii) A's adjusted basis at the time of the sale is $2000. Of A's
$8000 of section 1231 gain on the sale of the property, $3000 is
attributable to prior straight-line depreciation deductions and is
unrecaptured section 1250 gain. The gain on each installment payment is
$800.
(iii) As illustrated in the table in this paragraph (iii) of this
Example 1., A takes into account the unrecaptured section 1250 gain
first. Therefore, the gain on A's first three payments, received in
1999, 2000, and 2001, is taxed at 25 percent. Of the $800 of gain on the
fourth payment, received in 2002, $600 is taxed at 25 percent and the
remaining $200 is taxed at 20 percent. The gain on A's remaining six
installment payments is taxed at 20 percent. The table is as follows:
----------------------------------------------------------------------------------------------------------------
Total
1999 2000 2001 2002 2003 2004-2008 gain
----------------------------------------------------------------------------------------------------------------
Installment gain................... 800 800 800 800 800 4000 8000
Taxed at 25%....................... 800 800 800 600 ......... ......... 3000
Taxed at 20%....................... ......... ......... ......... 200 800 4000 5000
Remaining to be taxed at 25%....... 2200 1400 600 ......... ......... ......... .........
----------------------------------------------------------------------------------------------------------------
Example 2. Installment payments from sales prior to May 7, 1997.
This example illustrates the rule of paragraph (b) of this section as
follows:
(i) The facts are the same as in Example 1 except that A sold the
property in 1994, received the first of the ten annual installment
payments on December 1, 1994, and had no other capital or section 1231
gains or losses in the years 1994-2003.
(ii) As in Example 1, of A's $8000 of gain on the sale of the
property, $3000 was attributable to prior straight-line depreciation
deductions and is unrecaptured section 1250 gain.
(iii) As illustrated in the following table, A's first three
payments, in 1994, 1995, and 1996, were received before May 7, 1997, and
taxed at 28 percent. Under the rule described in paragraph (b) of this
section, A determines the allocation of unrecaptured section 1250 gain
for each installment payment after May 6, 1997, by taking unrecaptured
section 1250 gain into account first, treating the general rule of
paragraph (a) of this section as having applied since the time the
property was sold, in 1994. Consequently, of the $800 of gain on the
fourth payment, received in 1997, $600 is taxed at 25 percent and the
remaining $200 is taxed at 20 percent. The gain on A's remaining six
installment payments is taxed at 20 percent. The table is as follows:
----------------------------------------------------------------------------------------------------------------
Total
1994 1995 1996 1997 1998 1999-2003 gain
----------------------------------------------------------------------------------------------------------------
Installment gain................... 800 800 800 800 800 4000 8000
Taxed at 28%....................... 800 800 800 ......... ......... ......... 2400
Taxed at 25%....................... ......... ......... ......... 600 ......... ......... 600
Taxed at 20%....................... ......... ......... ......... 200 800 4000 5000
Remaining to be taxed at 25%....... 2200 1400 600 ......... ......... ......... .........
----------------------------------------------------------------------------------------------------------------
Example 3. Effect of section 1231(c) recapture. This example
illustrates the rule of paragraph (a) of this section when there are
non-recaptured net section 1231 losses, as defined in section
1231(c)(2), from prior years as follows:
(i) The facts are the same as in Example 1, except that in 1999 A
has non-recaptured net
[[Page 121]]
section 1231 losses from the previous four years of $1000.
(ii) As illustrated in the table in paragraph (iv) of this Example
3, in 1999, all of A's $800 installment gain is recaptured as ordinary
income under section 1231(c). Under the rule described in paragraph (a)
of this section, for purposes of determining the amount of unrecaptured
section 1250 gain remaining to be taken into account, the $800
recaptured as ordinary income under section 1231(c) is treated as
reducing unrecaptured section 1250 gain, rather than adjusted net
capital gain. Therefore, A has $2200 of unrecaptured section 1250 gain
remaining to be taken into account.
(iii) In the year 2000, A's installment gain is taxed at two rates.
First, $200 is recaptured as ordinary income under section 1231(c).
Second, the remaining $600 of gain on A's year 2000 installment payment
is taxed at 25 percent. Because the full $800 of gain reduces
unrecaptured section 1250 gain, A has $1400 of unrecaptured section 1250
gain remaining to be taken into account.
(iv) The gain on A's installment payment received in 2001 is taxed
at 25 percent. Of the $800 of gain on the fourth payment, received in
2002, $600 is taxed at 25 percent and the remaining $200 is taxed at 20
percent. The gain on A's remaining six installment payments is taxed at
20 percent. The table is as follows:
----------------------------------------------------------------------------------------------------------------
Total
1999 2000 2001 2002 2003 2004-2008 gain
----------------------------------------------------------------------------------------------------------------
Installment gain................... 800 800 800 800 800 4000 8000
Taxed at ordinary rates under 800 200 ......... ......... ......... ......... 1000
section 1231(c)...................
Taxed at 25%....................... ......... 600 800 600 ......... ......... 2000
Taxed at 20%....................... ......... ......... ......... 200 800 4000 5000
Remaining non-recaptured net 200 ......... ......... ......... ......... ......... .........
section 1231 losses...............
Remaining to be taxed at 25%....... 2200 1400 600 ......... ......... ......... .........
----------------------------------------------------------------------------------------------------------------
Example 4. Effect of a net section 1231 loss. This example
illustrates the application of paragraph (a) of this section when there
is a net section 1231 loss as follows:
(i) The facts are the same as in Example 1 except that A has section
1231 losses of $1000 in 1999.
(ii) In 1999, A's section 1231 installment gain of $800 does not
exceed A's section 1231 losses of $1000. Therefore, A has a net section
1231 loss of $200. As a result, under section 1231(a) all of A's section
1231 gains and losses are treated as ordinary gains and losses. As
illustrated in the following table, A's entire $800 of installment gain
is ordinary gain. Under the rule described in paragraph (a) of this
section, for purposes of determining the amount of unrecaptured section
1250 gain remaining to be taken into account, A's $800 of ordinary
section 1231 installment gain in 1999 is treated as reducing
unrecaptured section 1250 gain. Therefore, A has $2200 of unrecaptured
section 1250 gain remaining to be taken into account.
(iii) In the year 2000, A has $800 of section 1231 installment gain,
resulting in a net section 1231 gain of $800. A also has $200 of non-
recaptured net section 1231 losses. The $800 gain is taxed at two rates.
First, $200 is taxed at ordinary rates under section 1231(c),
recapturing the $200 net section 1231 loss sustained in 1999. Second,
the remaining $600 of gain on A's year 2000 installment payment is taxed
at 25 percent. As in Example 3, the $200 of section 1231(c) gain is
treated as reducing unrecaptured section 1250 gain, rather than adjusted
net capital gain. Therefore, A has $1400 of unrecaptured section 1250
gain remaining to be taken into account.
(iv) The gain on A's installment payment received in 2001 is taxed
at 25 percent, reducing the remaining unrecaptured section 1250 gain to
$600. Of the $800 of gain on the fourth payment, received in 2002, $600
is taxed at 25 percent and the remaining $200 is taxed at 20 percent.
The gain on A's remaining six installment payments is taxed at 20
percent. The table is as follows:
----------------------------------------------------------------------------------------------------------------
Total
1999 2000 2001 2002 2003 2004-2008 gain
----------------------------------------------------------------------------------------------------------------
Installment gain................... 800 800 800 800 800 4000 8000
Ordinary gain under section 1231(a) 800 ......... ......... ......... ......... ......... 800
Taxed at ordinary rates under ......... 200 ......... ......... ......... ......... 200
section 1231(c)...................
Taxed at 25%....................... ......... 600 800 600 ......... ......... 2000
Taxed at 20%....................... ......... ......... ......... 200 800 4000 5000
Net section 1231 loss.............. 200 ......... ......... ......... ......... ......... .........
Remaining to be taxed at 25%....... 2200 1400 600 ......... ......... ......... .........
----------------------------------------------------------------------------------------------------------------
[[Page 122]]
(e) Effective date. This section applies to installment payments
properly taken into account after August 23, 1999.
[T.D. 8836, 64 FR 45875, Aug. 23, 1999]
Sec. 1.453A-0 Table of contents.
This section lists the paragraphs and subparagraphs contained in
Secs. 1.453A-1 through 1.453A-3.
Sec. 1.453A-1 Installment method of reporting income by dealers in
personal property.
(a) In general.
(b) Effect of security.
(c) Definition of dealer, sale, and sale on the installment plan.
(d) Installment plans.
(1) Traditional installment plans.
(2) Revolving credit plans.
(e) Installment income of dealers in personal property.
(1) In general.
(2) Gross profit and total contract price.
(3) Carrying changes not included in total contract price.
(f) Other accounting methods.
(g) Records.
(h) Effective date.
Sec. 1.453A-2 Treatment of revolving credit plans; taxable years
beginning on or before December 31, 1986.
(a) In general.
(b) Coordination with traditional installment plan.
(c) Revolving credit plans.
(d) Effective date.
Sec. 1.453A-3 Requirements for adoption of or change to installment
method by dealers in personal property.
(a) In general.
(b) Time and manner of electing installment method reporting.
(1) Time for election.
(2) Adoption of installation method.
(3) Change to installment method.
(4) Deemed elections.
(c) Consent.
(d) Cut-off method for amounts previously accrued.
(e) Effective date.
[T.D. 8270, 54 FR 46376, Nov. 3, 1989]
Sec. 1.453A-1 Installment method of reporting income by dealers on personal property.
(a) In general. A dealer (as defined in paragraph (c)(1) of this
section) may elect to return the income from the sale of personal
property on the installment method if such sale is a sale on the
installment plan (as defined in paragraphs (c)(3) and (d) of this
section). Under the installment method of accounting, a taxpayer may
return as income from installment sales in any taxable year that
proportion of the installment payments actually received in that year
which the gross profit realized or to be realized when the property is
paid for bears to the total contract price. For this purpose, gross
profit means sales less cost of goods sold. See paragraph (d) of this
section for additional rules relating to the computation of income under
the installment method of accounting. In addition, see Sec. 1.453A-2 for
rules treating revolving credit plans as installment plans for taxable
years beginning on or before December 31, 1986.
(b) Effect of security. A dealer may adopt (but is not required to
do so) one of the following four ways of protecting against loss in case
of default by the purchaser:
(1) An agreement that title is to remain in the vendor until
performance of the purchaser's part of the transaction is completed;
(2) A form of contract in which title is conveyed to the purchaser
immediately, but subject to a lien for the unpaid portion of the selling
price;
(3) A present transfer of title to the purchaser, who at the same
time executes a reconveyance in the form of a chattel mortgage to the
vendor; or
(4) A conveyance to a trustee pending performance of the contract
and subject to its provisions.
(c) Definitions of dealer, sale, and sale on the installment plan.
For purposes of the regulations under section 453A--
(1) The term ``dealer'' means a person who regularly sells or
otherwise disposes of personal property on the installment plan;
(2) The term ``sale'' includes sales and other dispositions; and
(3) Except as provided in paragraph (d)(2) of this section, the term
``sale on the installment plan'' means--
(i) A sale of personal property by the taxpayer under any plan for
the sale of personal property, which plan, by its terms and conditions,
contemplates that each sale under the plan will be paid for in two or
more payments; or
[[Page 123]]
(ii) A sale of personal property by the taxpayer under any plan for
the sale of personal property--
(A) Which plan, by its terms and conditions, contemplates that such
sale will be paid for in two or more payments; and
(B) Which sale is in fact paid for in two or more payments.
(d) Installment plans--(1) Traditional installment plans. A
traditional installment plan usually has the following characteristics:
(i) The execution of a separate installment contract for each sale
or disposition of personal property; and
(ii) The retention by the dealer of some type of security interest
in such property.
Normally, a sale under a traditional installment plan meets the
requirements of paragraph (c)(3)(i) of this section.
(2) Revolving credit plans. Sales under a revolving credit plan
(within the meaning of Sec. 1.453A-2(c)(1))--
(i) Are treated, for taxable years beginning on or before December
31, 1986, as sales on the installment plan to the extent provided in
Sec. 1.453A-2, which provides for the application of the requirements of
paragraph (c)(3)(ii) of this section to sales under revolving credit
plans; and
(ii) Are not treated as sales on the installment plan for taxable
years beginning after December 31, 1986.
(e) Installment income of dealers in personal property--(1) In
general. The income from sales on the installment plan of a dealer may
be ascertained by treating as income that proportion of the total
payments received in the taxable year from sales on the installment plan
(such payments being allocated to the year against the sales of which
they apply) which the gross profit realized or to be realized on the
total sales on the installment plan made during each year bears to the
total contract price of all such sales made during that respective year.
However, if the dealer demonstrates to the satisfaction of the district
director that income from sales on the installment plan is clearly
reflected, the income from such sales may be ascertained by treating as
income that proportion of the total payments received in the taxable
year from sales on the installment plan (such payments being allocated
to the year against the sales of which they apply) which either:
(i) The gross profit realized or to be realized on the total credit
sales made during each year bears to the total contract price of all
credit sales during that respective year, or
(ii) The gross profit realized or to be realized on all sales made
during each year bears to the total contract price of all sales made
during that respective year.
A dealer who desires to compute income by the installment method shall
maintain accounting records in such a manner as to enable an accurate
computation to be made by such method in accordance with the provisions
of this section, section 446, and Sec. 1.446-1.
(2) Gross profit and total contract price. For purposes of paragraph
(e)(1) of this section, in computing the gross profit realized or to be
realized on the total sales on the installment plan, there shall be
included in the total selling price and, thus, in the total contract
price of all such sales.
(i) The amount of carrying charges or interest which is determined
at the time of each sale and is added to the established cash selling
price of such property and is treated as part of the selling price for
customer billing purposes, and
(ii) In the case of sales made in taxable years beginning on or
after January 1, 1960, the amount of carrying charges or interest
determined with respect to such sales which are added contemporaneously
with the sale on the books of account of the seller but are treated as
periodic service charges for customer billing purposes.
Any change in the amount of the carrying charges or interest in a year
subsequent to the sale will not affect the computation of the gross
profit for the year of sale but will be taken into account at the time
the carrying charges or interest are adjusted. The application of this
paragraph (e)(2) to carrying charges or interest described in paragraph
(e)(2)(ii) of this section may be illustrated by the following example:
Example. X Corporation makes sales on the traditional installment
plan. The customer's order specifies that the total price consists
[[Page 124]]
of a cash price plus a ``time price differential'' of 1\1/2\ percent per
month on the outstanding balance in the customer's account, and the
customer is billed in this manner. On its books and for purposes of
reporting to stockholders, X Corporation consistently makes the
following entries each month when it records its sales. A debit entry is
make to accounts receivable (for the total price) and balancing credit
entries are made to sales (for the established selling price) and to a
reserve account for collection expense (for the amount of the time price
differential). In computing the gross profit realized or to be realized
on the total sales on the installment plan, the total selling price and,
thus, the total contract price for purposes of this paragraph (e) would,
with respect to sales made in taxable years beginning on or after
January 1, 1960, include the time price differential.
(3) Carrying charges not included in total contract price. In the
case of sales by dealers in personal property made during taxable years
beginning after December 31, 1963, the income from which is returned on
the installment method, if the carrying charges or interest with respect
to such sales is not included in the total contract price, payments
received with respect to such sales shall be treated as applying first
against such carrying charges or interest.
(f) Other accounting methods. If the vendor chooses as a matter of
consistent practice to return the income from installment sales on an
accrual method (,) such a course is permissible.
(g) Records. In adopting the installment method of accounting the
seller must maintain such records as are necessary to clearly reflect
income in accordance with this section, section 446 and Sec. 1.446-1.
(h) Effective date. This section applies for taxable years beginning
after December 31, 1953, and ending after August 16, 1954, but generally
does not apply to sales made after December 31, 1987, in taxable years
ending after such date. For sales made after December 31, 1987, sales
made by a dealer in personal or real property shall not be treated as
sales on the installment plan. (However, see section 453(l)(2) for
exceptions to this rule.)
[T.D. 8270, 54 FR 46377, Nov. 3, 1989]
Sec. 1.453A-2 Treatment of revolving credit plans; taxable years beginning on or before December 31, 1986.
(a) In general. If a dealer sells or otherwise disposes of personal
property under a revolving credit plan--
(1) Such sales will be treated as sales on the installment plan to
the extent provided in paragraph (c) of this section;
(2) Income from sales treated as sales on the installment plan under
paragraph (c) of this section may be returned on the installment method;
and
(3) Income returned on the installment method is computed in
accordance with Sec. 1.453A-1, except that--
(i) The gross profit on such sales is computed without regard to
Sec. 1.453A- 1 (e)(2);
(ii) Under the circumstances described in paragraph (c)(6)(vi) of
this section, the taxpayer may, in computing income for a taxable year,
treat all such sales as sales made in such taxable year for purposes of
applying the gross profit percentage; and
(iii) The rule contained in Sec. 1.453A- 1 (e)(3) is applied in
accordance with paragraph (c)(6)(v) of this section.
(b) Coordination with traditional installment plan. A dealer who
makes sales of personal property under both a revolving credit plan and
a traditional installment plan (1) may elect to report only sales under
the traditional installment plan on the installment method, (2) may
elect to report only sales under the revolving credit plan on the
installment method, or (3) may elect to report both sales under the
revolving credit plan and the traditional installment plan on the
installment method.
(c) Revolving credit plans. (1) To the extent provided in this
paragraph (c) sales under a revolving credit plan will be treated as
sales on the installment plan. The term ``revolving credit plan''
includes cycle budget accounts, flexible budget accounts, continuous
budget accounts, and other similar plans or arrangements for the sale of
personal property under which the customer agrees to pay each billing-
month (as defined in paragraph (c)(6)(iii) of this section) a part of
the outstanding balance of the customer's account. Sales
[[Page 125]]
under a revolving credit plan do not constitute sales on the installment
plan merely by reason of the fact that the total debt at the end of a
billing-month is paid in installments. The terms and conditions of a
revolving credit plan do not contemplate that each sale under the plan
will be paid for in two or more payments and thus do not meet the
requirements of Sec. 1.453A-1(c)(3)(i). In addition, since under a
revolving credit plan payments are not generally applied to liquidate
any particular sale, and since the terms and conditions of such plan
contemplate that account balances may be paid in full or in
installments, it is generally impossible to determine that a particular
sale under a revolving credit plan is to be or is in fact paid for in
installments so as to meet the requirements of Sec. 1.453A-1 (c)(3)(ii).
However, paragraphs (c) (2) and (3) of this section provides rules under
which a certain percentage of charges under a revolving credit plan will
be treated as sales on the installment plan. For purposes of arriving at
this percentage, these rules, in general, treat as sales on the plan
those sales under a revolving installment credit plan:
(i) Which are of the type which the terms and conditions of the plan
contemplate will be paid for in two or more installments and
(ii) Which are charged to accounts on which subsequent payments
indicate that such sales are being paid for in two or more installments.
(2)(i) The percentage of charges under a revolving credit plan which
will be treated as sales on the installment plan shall be computed by
making an actual segregation of charges in a probability sample of the
revolving credit accounts and by applying the rules contained in
paragraph (c)(3) of this section to determine what percentage of charges
in the sample is to be treated as sales on the installment plan. (See
paragraph (c)(5) of this section for rules to be used if some of the
sales under a revolving credit plan are nonpersonal property sales (as
defined in paragraph (c)(6)(iv) of this section).) Such segregation
shall be made of charges which make up the balances in the sample
accounts as of the end of each customer's last billing-month ending
within the taxable year. (See paragraph (c)(6)(v) of this section for
rules to be used in determining which charges make up the balance of an
account.) However, in making such segregation, any account to which a
sale is charged during the taxable year on which no payment is credited
after the billing-month within which the sale is made (hereinafter
called the ``billing-month of sale'') and on or before the end of the
first billing-month ending in the taxpayer's next taxable year shall be
disregarded and not taken into account in the determination of what
percentage of charges in the sample is to be treated as sales on the
installment plan. In order to obtain a probability sample, the accounts
shall be selected in accordance with generally accepted probability
sampling techniques. The appropriateness of the sampling technique and
the accuracy and reliability of the results obtained must, if requested,
be demonstrated to the satisfaction of the district director. If the
district director is not satisfied that the taxpayer's sample is
appropriate or that the results obtained are accurate and reliable, the
taxpayer shall recompute the sample percentage or make appropriate
adjustments to the original computations in a manner satisfactory to the
district director. The taxpayer shall maintain records in sufficient
detail to show the method of computing and applying the sample.
(ii) For taxable years ending before January 31, 1964, a taxpayer
who has reported for income tax purposes all or a portion of sales under
a revolving credit plan as sales on the installment method may apply the
percentage obtained for the first taxable year ending on or after such
date in determining the percentage of charges under a revolving credit
plan for such prior taxable year (or years) which will be treated as
sales on the installment plan. However, in computing the percentage to
be applied in determining the percentage of charges under a revolving
credit plan which will be treated as sales on the installment plan for
such prior taxable year (or years), the rule stated in Sec. 1.453A-
1(e)(3) shall not apply. See paragraph (c)(6)(v) of this
[[Page 126]]
section for rules relating to the application of payments to finance
charges for such prior taxable years.
(3) For the purpose of determining the percentage described in
paragraph (c)(2) of this section, a charge under a revolving credit plan
will be treated as a sale on the installment plan only if such charge is
a sale (as defined in paragraph (c)(6) of this section) and meets the
following requirements:
(i) The sale must be of the type which the terms and conditions of
the plan contemplate will be paid for in two or more installments. If
the aggregate of sales charged during a billing-month to an account
under a revolving credit plan exceeds the required monthly payment, then
all sales during such billing-month shall be considered to be of the
type which the terms and conditions of such plan contemplate will be
paid for in two or more installments. The required monthly payment shall
be the amount of the payment which the terms and conditions of the
revolving credit contract require the customer to make with respect to a
billing-month. If the amount of such payment is not fixed at the date
the contract is entered into, but is dependent upon the balance of the
account, then such amount shall be the amount that the customer is
required to pay (but not including any past-due payments) as shown on
the statement either:
(A) For the last billing-month ending within the taxpayer's taxable
year or
(B) For the billing-month of sale, whichever method the taxpayer
adopts for all accounts. A taxpayer shall not change such method of
determining the required monthly payment based upon the balance of the
account without obtaining the consent of the district director. In any
case where the required monthly payment is not set in accordance with a
consistent method used during the entire taxable year, the district
director may determine the required monthly payment in accordance with
the method used during the major portion of such taxable year if the use
of such method is necessary in order to reflect properly the income from
sales under a revolving credit plan. The requirements stated in this
paragraph (c)(3)(i) may be illustrated by the following examples:
Example (1). Under the terms of a revolving credit plan the required
monthly payment to be made by customer A is $20. During the billing-
month ending in December, sales aggregating $80 are charged to customer
A's account, and during the next billing-month, ending in January, sales
aggregating $19.95 and finance charges of $.60 are charged to A's
account. Since the aggregate of sales charged to customer A's account
during the billing-month ending in December ($80) exceeds the required
monthly payment ($20), the terms and conditions of the plan contemplate
that the sales charged during such billing-month are of the type which
will be paid for in two or more installments. Since the aggregate of
sales charged to customer A's account during the billing-month ending in
January ($19.95) does not exceed the required monthly payment, the sales
making up the aggregate of sales in such billing-month are not of the
type which the terms and conditions of the plan contemplate will be paid
for in two or more installments.
Example (2). The terms of a revolving credit plan require a payment
of 20 percent of the balance of the customer's account as of the end of
the billing-month for which the statement is rendered. A customer makes
purchases aggregating $25 in the customer's next to the last billing-
month ending within the taxpayer's taxable year, and the balance at the
end of that month is $150. At the end of the customer's last billing-
month ending within the taxpayer's taxable year, the balance of the
account has decreased to $110. If the taxpayer determines the required
monthly payment by reference to the payment required on the statement
for the last billing-month ending within the taxable year and applies
such method consistently to all accounts, then the sales making up the
$25 aggregate of sales are of the type which the terms and conditions of
the plan contemplate will be paid for in two or more installments.
Although such aggregate was less than the $30 payment (20%x$150)
required on the statement rendered for the billing-month of sales. It
was more than the $22 (20%x$110) that the customer was required to pay
on the statement rendered for his last billing-month ending within the
taxable year, and thus meets the requirements of this paragraph
(c)(3)(i). If, however, the taxpayer determines the required monthly
payment by reference to the payment required on the statement for the
billing-month of sale, then the sales making up the aggregate of sales
during such billing-month do not meet the requirements of this paragraph
(c)(3)(i) because such aggregate was less than the $30 payment required
on the statement rendered for such month.
(ii) The sale must be charged to an account on which the first
payment
[[Page 127]]
after the billing-month of sale indicates that the sale is being paid in
installments. The first payment after the billing-month of sale
indicates that the sale is being paid in installments if, and only if,
such payment is an amount which is less than the balance of the account
as of the close of the billing-month of sale. For purposes of this
paragraph (c)(3)(ii), such balance shall be reduced by any return or
allowance credited to the account after the close of the billing-month
of sale and before the close of the billing-month within which the first
payment after the billing-month of sale is credited to the account,
unless the taxpayer demonstrates that the return or allowance was
attributable to a charge made in a month subsequent to the billing-month
of sale. The requirements stated in this paragraph (c)(3)(ii) may be
illustrated by the following examples, in which it is assumed that the
taxpayer's annual accounting period ends on January 31.
Example (1). Customer A's revolving credit account shows the
following sales and payments:
------------------------------------------------------------------------
Aggregate
Month ending sales in Payments Balance
month
------------------------------------------------------------------------
December 20............................... $150 0 $150
January 20................................ 75 $30 195
February 20............................... 0 195 0
------------------------------------------------------------------------
All sales made in the billing-month ending December 20 meet the
requirements of this paragraph (c)(3)(ii) because the first payment on
the account after such billing-month ($30) was less than the balance of
the account as of the close of such billing-month ($150); and none of
the sales made in the billing-month ending January 20 meets the
requirements of this paragraph (c)(3)(ii) because the balance of the
account as of the end of such billing-month was liquidated in one
payment. By application of the rules of paragraph (c)(6)(v) of this
section, the balance in the account as of the last billing-month ending
in the taxable year ($195) consists of $120 of the $150 of sales made in
the billing-month ending December 20 and all of the $75 of sales made in
the billing-month ending January 20. Therefore, $120 of the account
balance meets the requirements of this paragraph (c)(3)(ii) and $75 does
not.
Example (2). Customer B's revolving credit account shows the
following sales and payments:
------------------------------------------------------------------------
Aggregate
Month ending sales in Payments Balance
month
------------------------------------------------------------------------
December 20............................... $ 50 0 $ 50
January 20................................ 100 0 150
February 20............................... 0 $50 100
------------------------------------------------------------------------
None of the sales made in the billing-month ending December 20 meets the
requirements of this paragraph (c)(3)(ii) because the first payment
credited to the account after such billing-month ($50) is not less than
the balance of the account as of the close of such month ($50). All of
the sales made in the billing-month ending January 20 meet the
requirements of this paragraph (c)(3)(ii) because the first payment
after such billing-month ($50) is less than the balance of the account
as of the close of such month ($150).
Example (3). Customer C's revolving credit account shows the
following purchases and credits:
------------------------------------------------------------------------
Month ending Item Charges Credits Balance
------------------------------------------------------------------------
January 20.................... Coat........ $55 ....... .......
Dress....... 40 ....... .......
Shirt....... 5 ....... $100
February 20................... Return...... ........ $5 .......
Payments.... ........ 95 0
------------------------------------------------------------------------
None of the sales made in the billing-month ending January 20 meets the
requirements of this paragraph (c)(3)(ii) because the first payment
credited to the account after such billing-month ($95) was equal to the
balance of the account as of the end of such billing-month, $95. For
this purpose, the balance of $100 is reduced by the $5 return which was
credited to the account after the close of the billing-month of sale and
before the close of the billing-month within which the first payment
after the billing-month of sale is credited.
(4) The provisions of paragraphs (c) (2) and (3) of this section may
be illustrated by the following examples in which it is assumed that the
taxpayer is a dealer whose annual accounting period ends on January 31.
Example (1). Customer A's revolving credit ledger account shows the
following:
----------------------------------------------------------------------------------------------------------------
Aggregate
Month ending sales in Returns and Payments Finance Balance
month \1\ allowances charges
----------------------------------------------------------------------------------------------------------------
January 20..................................... $15.00 0 0 0 $15.00
[[Page 128]]
February 20.................................... 0 0 0 $0.15 15.15
----------------------------------------------------------------------------------------------------------------
\1\ Including sales of personal property and nonpersonal property sales.
For purposes of the segregation provided for in paragraph (c)(2)(i) of
this section, customer A's account will be disregarded and not taken
into account in the determination of what percentage of charges in the
sample is to be treated as sales on the installment plan because no
payment was credited to that account after the billing-month of sale and
on or before February 20.
Example (2). This example is applicable with respect to sales made
during taxable years beginning before January 1, 1964. Under the terms
of corporation X's revolving credit plan, payments are required in
accordance with the following schedule:
Required
monthly
payment
Unpaid balance:
0 to $99.99.............................................. $20
$100 to $199.99.......................................... 40
$200 to $299.99.......................................... 60
Customer B's revolving credit ledger account for the period
beginning on September 21, 1963, and ending February 20, 1964, shows the
following:
----------------------------------------------------------------------------------------------------------------
Aggregate
Month ending sales in Returns and Payments Finance Balances
month \1\ allowances charges
----------------------------------------------------------------------------------------------------------------
October 20..................................... $55.00 0 0 0 $55.00
November 20.................................... 45.00 0 $20.00 $0.35 80.35
December 20.................................... 20.00 0 20.00 .60 80.95
January 20..................................... 26.00 $5.00 20.00 .61 82.56
February 20.................................... 0 10.00 72.56 0 0
----------------------------------------------------------------------------------------------------------------
\1\ Including sales of personal property and nonpersonal property sales.
The three $20 payments and the $5 return or allowance made in the
billing-months ending in the taxable year are applied under the rules in
paragraph (c)(6)(v) of this section to liquidate the earliest
outstanding charges, first to the $55 aggregate of sales in the billing-
month ending October 20 and next to $10 of the aggregate of sales made
in the billing-month ending November 20. Thus, the balance of the
account as of the close of the billing-month ending January 20, $82.56,
is made up as follows:
Remainder of sales in billing-month ending Nov. 20 ($45-$10)... $35.00
Finance charges for billing-month ending Nov. 20............... 0.35
Sales for billing-month ending Dec. 20......................... 20.00
Finance charge for billing-month ending Dec. 20................ 0.60
Sales for billing-month ending Jan. 20......................... 26.00
Finance charge for billing-month ending Jan. 20................ 0.61
--------
Total.................................................... 82.56
The sales of $35 remaining from the aggregate of sales for the billing-
month ending November 20 meet the requirements of paragraph (c)(3)(i) of
this section because the aggregate of sales charged during such billing-
month ($45) exceeds the required monthly payment ($20), and such sales
meet the requirements of paragraph (c)(3)(ii) of this section because
the first payment after the billing-month of sale ($20) is an amount
less than the balance of the account as of the close of such month
($80.35). Therefore, $35 of sales will be treated as sales on the
installment plan. The $20 aggregate of sales charged during the billing-
month ending December 20 does not meet the requirements of paragraph
(c)(3)(i) of this section because it is in an amount which does not
exceed the required monthly payment ($20). (The finance charge of $0.60
added in the billing-month does not enter into the determination of the
aggregate of sales for the month because the term ``sales'' (as defined
in paragraph (c)(6)(i) of this section does not include finance
charges). The $26 aggregate of sales for the billing-month ending
January 20 does not meet the requirements of paragraph (c)(3)(ii) of
this section because the first payment after such billing-month ($72.56)
was equal to the balance of the account as of the close of such billing-
month ($72.56). For this purpose, the balance of $82.56 is reduced by
the $10 return or allowance which was credited after the billing-month
of sale and before February 20. Thus, of the $82.56 balance of B's
account as of the close of the last billing-month ending within
corporation X's
[[Page 129]]
taxable year, $35 will be treated as sales on the installment plan for
purposes of determining the percentage provided for paragraph (c)(2) of
this section.
Example (3). This example is applicable with respect to sales made
during taxable years beginning after December 31, 1963. Assume the facts
in example (2), except that Customer B's revolving credit ledger account
is for the period beginning on September 21, 1964 and ending February
20, 1965. Since payments received are first used to liquidate any
outstanding finance charges under the rule in paragraph (c)(6)(v) of
this section, the $20 payment in December liquidated the $0.35 finance
charge accrued at the end of the November billing-month and the $20
payment in January liquidated the $0.60 finance charge accrued at the
end of the December billing-month. The balance of the three $20 payments
($59.05) and the $5 return or allowance are applied (under the rules in
paragraph (c)(6)(v) of this section) to liquidate the earliest
outstanding sales, first to the $55 aggregate of sales in the billing-
month ending October 20 and next to $9.05 of the aggregate of sales made
in the billing-month ending November 20. Thus, the balance of the
account as of the close of the billing-month ending January 20, $82.56,
is made up as follows:
Remainder of sales in billing-month ending Nov. 20 ($45-$9.05). $35.95
Sales for billing-month ending Dec. 20......................... 20.00
Sales for billing-month ending Jan. 20......................... 26.00
Finance charge for billing-month ending Jan. 20................ 0.61
--------
Total.................................................... 82.56
The sales of $35.95 remaining from the aggregate of sales for the
billing-month ending November 20 meet the requirements of paragraph
(c)(3)(i) of this section because the aggregate of sales charged during
such billing-month ($45) exceeds the required monthly payment ($20), and
such sales meet the requirements of paragraph (c)(3)(ii) of this section
because the first payment after the billing-month of sale ($20) is an
amount less than the balance of the account as of the close of such
month ($80.35). Therefore, $35.95 of sales will be treated as sales on
the installment plan. The $20 aggregate of sales charged during the
billing-month ending December 20 does not meet the requirements of
paragraph (c)(3)(i) of this section because it is in an amount which
does not exceed the required monthly payment ($20). The $26 aggregate of
sales for the billing-month ending January 20 does not meet the
requirements of paragraph (c)(3)(ii) of this section because the first
payment after such billing-month ($72.56) was equal to the balance of
the account as of the close of such billing-month ($72.56). For this
purpose, the balance of $82.56 is reduced by the $10 return or allowance
which was credited after the billing-month of sale and before February
20. Thus, of the $82.56 balance of B's account as of the close of the
last billing-month ending within corporation X's taxable year $35.95
will be treated as sales on the installment plan for purposes of
determining the percentage provided for in paragraph (c)(2) of this
section.
(5) Sales under a revolving credit plan which are nonpersonal
property sales (as defined in paragraph (c)(6)(iv) of this section) do
not constitute sales on the installment plan. Therefore, the charges
under a revolving credit plan must be reduced by the nonpersonal
property sales, if any, under such plan, before application of the
sample percentage as provided for in paragraph (c)(2)(i) of this
section. The taxpayer may treat as the nonpersonal property sales under
the plan for the taxable year an amount which bears the same ratio to
the total sales under the revolving credit plan made in the taxable year
as the total nonpersonal property sales made in such year bears to the
total sales made in such year.
(6) For purposes of this paragraph (c)--
(i) The term ``sales'' includes sales of services, such as a charge
for watch repair, as well as sales of property, but does not include
finance or service charges.
(ii) The term ``charges'' includes sales of services and property as
well as finance or service charges.
(iii) A billing-month is that period of time for which a periodic
statement of charges and credits is rendered to a customer.
(iv) The term ``nonpersonal property sales'' means all sales which
are not sales of personal property made by the taxpayer. Thus, sales of
a department leased by the taxpayer to another are nonpersonal property
sales. Likewise, charges for services rendered by the taxpayer are
nonpersonal property sales unless such services are incidental to and
rendered contemporaneously with the sale of personal property, in which
case such charges shall be considered as constituting part of the
selling price of such property.
(v) Except as otherwise provided in this paragraph (c)(6)(v), each
payment received from a customer under a revolving credit plan before
the close of
[[Page 130]]
the last billing-month ending in the taxable year shall be applied to
liquidate the earliest outstanding charges under such plan,
notwithstanding any rule of law or contract provision to the contrary.
For purposes of determining which charges remain in the balance of an
account at the end of the last billing-month ending in the taxable year,
the taxpayer may apply returns and allowances which are credited before
the close of the last billing-month ending in the taxable year either
(A) to liquidate or reduce the charge for the specific item so returned
or for which an allowance is permitted, or (B) to liquidate or reduce
the earliest outstanding charges. The method so selected for applying
returns and allowances shall be followed on a consistent basis from year
to year unless the district director consents to a change. Additionally,
finance or service charges which are computed on the basis of the
balance of the account at the end of the previous billing-month (usually
reduced by payments during the current billing-month) are accrued at the
end of the current billing-month and are therefore considered, for
purposes of determining the earliest outstanding charges, as charged to
the account after any sales made during the current billing month.
However, for purposes of determining which charges remain in the balance
of an account at the end of the last billing-month ending in a taxable
year which began after December 31, 1963, payments received during such
year shall be applied first against any finance or service charges which
were outstanding at the time such payment was received. The preceding
sentence shall not apply with respect to a computation made for purposes
of applying the rule described in paragraph (c)(2)(ii) of this section.
(vi) The taxpayer shall allocate those sales under a revolving
credit plan which are treated as sales on the installment plan to the
proper year of sale in order to apply the appropriate gross profit
percentage as provided for in Sec. 1.453A-1(e). This allocation shall be
made on the basis of the percentages of charges treated as sales on the
installment plan which are attributable to each taxable year as
determined in the sample of accounts described in paragraph (c)(2) of
this section. However, if the taxpayer demonstrates to the satisfaction
of the district director that income from sales on the installment plan
is clearly reflected, all sales may be considered as being made in the
taxable year for purposes of applying the gross profit percentage.
(7) The provisions of this paragraph (c) may be illustrated by the
following example:
Example. Corporation X is a dealer and has elected to report on the
installment method those sales under its revolving credit plan which may
be treated as sales on the installment plan. Corporation X's taxable
year ends on January 31, and the total balance of all its revolving
credit accounts as of January 31, 1964, is $2,000,000. The total sales
made in the taxable year are $10,000,000 of which $500,000 are
nonpersonal property sales. The gross profit percentage realized or to
be realized on all sales made in the taxable year is 40 percent. The
amount of the gross profit contained in the year-end balance of
$2,000,000 which may be deferred to succeeding years is computed as
follows:
(i) In order to reduce the charges appearing in the year-end balance
of revolving credit accounts receivable by the nonpersonal property
sales contained therein, corporation X determines the amount of such
nonpersonal property sales under the method permitted in paragraph
(c)(5) of this section. Corporation X first determines the ratio which
total nonpersonal property sales made during the year ($500,000) bears
to total sales made during the year ($10,000,000), and then applies the
percentage (5 percent) thus obtained to the year-end balance of
revolving credit accounts receivable ($2,000,000). The nonpersonal
property sales thus determined ($100,000) is subtracted from such year-
end balance to obtain the charges under the revolving credit plan
appearing in the year-end balance ($1,900,000) to which the sample
percentage is to be applied.
(ii) In accordance with generally accepted sampling techniques, the
taxpayer selects a probability sample of all revolving credit accounts
having balances for billing-months ending in January 1964. The technique
employed results in a random selection of accounts with total balances
of $100,000.
(iii) Analysis of these sample accounts discloses that of the
$100,000 of balances, $10,000 of balances are in accounts on which no
payment was credited after a billing-month of sale and on or before the
end of the first billing-month ending in the taxable year beginning
February 1, 1964. These balances are, therefore, disregarded and not
taken into account in the determination of what percentage of sales in
the sample is to be treated as
[[Page 131]]
sales on the installment plan. Of the remaining $90,000 of balances, the
taxpayer determines, by analyzing the ledger cards in the sample, that
$63,000 of balances are composed of sales which meet the requirements of
paragraphs (c)(3) (i) and (ii) of this section and are thus treated as
sales on the installment plan. The remaining $27,000 of balances either
did not meet the requirements of paragraphs (c)(3) (i) and (ii) of this
section or were not sales (as defined in paragraph (c)(6)(i) of this
section). The percentage of charges in the sample treated as sales on
the installment plan is, therefore, 70 percent ($63,000 / $90,000).
(iv) The charges in the year-end balance which are to be treated as
sales on the installment plan, $1,330,000, are computed by multiplying
the charges to which the sample percentage is applied ($1,900,000) by
the sample percentage (70 percent).
(v) The deferred gross profit attributable to sales under the
revolving credit plan for the taxable year, $532,000, is determined by
multiplying the amount treated as sales on the installment plan
($1,330,000), by the gross profit percentage (40 percent). (Corporation
X will be able to demonstrate to the satisfaction of the district
director that (A) since the gross profit percentage for all sales does
not vary materially from the gross profit percentage for all sales made
under the revolving credit plan, (B) since only an insubstantial amount
of sales included in year-end account balances was made prior to the
taxable year, and (C) since the prior year's gross profit percentage
does not vary materially from the gross profit percentage for the
taxable year, income from sales on the installment plan will be clearly
reflected by applying the current year's gross profit percentage for all
sales under the revolving credit plan treated as sales on the
installment plan.)
(d) Effective date. This section applies for taxable years beginning
after December 31, 1953, and ending after August 16, 1954, but does not
apply for any taxable year beginning after December 31, 1986. For
taxable years beginning after December 31, 1986, sales under a revolving
credit plan shall not be treated as sales on the installment plan.
[T.D. 8269, 54 FR 46375, Nov. 3, 1989]
Sec. 1.453A-3 Requirements for adoption of or change to installment method by dealers in personal property.
(a) In general. A dealer (within the meaning of Sec. 1.453A-1(c)(1))
may adopt or change to the installment method for a type or types of
sales on the installment plan (within the meaning of Sec. 1.453A-1(c)(3)
and (d)) in the manner prescribed in this section. This section applies
only to dealers and only with respect to their sales on the installment
plan.
(b) Time and manner of electing installment method reporting--(1)
Time for election. An election to adopt or change to the installment
method for a type or types of sales must be made on an income tax return
for the taxable year of the election, filed on or before the time
specified (including extensions thereof) for filing such return.
(2) Adoption of installment method. A taxpayer who adopts the
installment method for the first taxable year in which sales are made on
an installment plan of any kind must indicate in the income tax return
for that taxable year that the installment method of accounting is being
adopted and specify the type or types of sales included within the
election. If a taxpayer in the year of the initial election made only
one type of sale on the installment plan, but during a subsequent
taxable year makes another type of sale on the installment plan and
adopts the installment method for that other type of sale, the taxpayer
must indicate in the income tax return for the subsequent year that an
election is being made to adopt the installment method of accounting for
the additional type of sale.
(3) Change to installment method. A taxpayer who changes to the
installment method for a particular type or types of sales on the
installment plan in acordance with this section must, for each type of
sale on the installment plan for which the installment method is to be
used, attach a separate statement to the income tax return for the
taxable year with respect to which the change is made. Each statement
must show the method of accounting used in computing taxable income
before the change and the type of sale on the installment plan for which
the installment method is being elected.
(4) Deemed elections. A dealer (including a person who is a dealer
as a result of the recharacterization of transactions as sales) is
deemed to have elected the installment method if the dealer treats a
sale on the installment plan as a transaction other than a sale
[[Page 132]]
and fails to report the full amount of gain in the year of the sale. For
example, if a transaction treated by a dealer as a lease is
recharacterized by the Internal Revenue Service as a sale on the
installment plan, the dealer will be deemed to have elected the
installment method assuming the dealer failed to report the full amount
of gain in the year of the transaction.
(c) Consent. A dealer may adopt or change to the installment method
for sales on the installment plan without the consent of the
Commissioner. However, a dealer may not change from the installment
method to the accrual method of accounting or to any other method of
accounting without the consent of the Commissioner.
(d) Cut-off method for amounts previously accrued. An election to
change to the installment method for a type of sale applies only with
respect to sales made on or after the first day of the taxable year of
change. Thus, payments received in the taxable year of the change, or in
subsequent years, in respect of an installment obligation which arose in
a taxable year prior to the taxable year of change are not taken into
account on the installment method, but rather must be accounted for
under the taxpayer's method of accounting in use in the prior year.
(e) Effective date. This section applies to sales by dealers in
taxable years ending after October 19, 1980, but generally does not
apply to sales made after December 31, 1987. For sales made after
December 31, 1987, sales by a dealer in personal or real property shall
not be treated as sales on the installment plan. (However, see section
453(l)(2) for certain exceptions to this rule.) For rules relating to
sales by dealers in taxable years ending before October 20, 1980, see 26
CFR 1.453-7 and 1.453-8 (rev. as of April 1, 1987).
[T.D. 8269, 54 FR 46375, Nov. 3, 1989]
Sec. 1.454-1 Obligations issued at discount.
(a) Certain non-interest-bearing obligations issued at discount--(1)
Election to include increase in income currently. If a taxpayer owns--
(i) A non-interest-bearing obligation issued at a discount and
redeemable for fixed amounts increasing at stated intervals (other than
an obligation issued by a corporation after May 27, 1969, as to which
ratable inclusion of original issue discount is required under section
1232(a)(3)), or
(ii) An obligation of the United States, other than a current income
obligation, in which he retains his investment in a matured series E
U.S. savings bond, or
(iii) A nontransferable obligation (whether or not a current income
obligation) of the United States for which a series E U.S. savings bond
was exchanged (whether or not at final maturity) in an exchange upon
which gain is not recognized because of section 1037(a) (or so much of
section 1031(b) as relates to section 1037),
and if the increase, if any, in redemption price of such obligation
described in subdivision (i), (ii), or (iii) of this subparagraph during
the taxable year (as described in subparagraph (2) of this paragraph)
does not constitute income for such year under the method of accounting
used in computing his taxable income, then the taxpayer may, at his
election, treat the increase as constituting income for the year in
which such increase occurs. If the election is not made and section 1037
(or so much of section 1031 as relates to section 1037) does not apply,
the taxpayer shall treat the increase as constituting income for the
year in which the obligation is redeemed or disposed of, or finally
matures, whichever is earlier. Any such election must be made in the
taxpayer's return and may be made for any taxable year. If an election
is made with respect to any such obligation described in subdivision
(i), (ii), or (iii) of this subparagraph, it shall apply also to all
other obligations of the type described in such subdivisions owned by
the taxpayer at the beginning of the first taxable year to which the
election applies, and to those thereafter acquired by him, and shall be
binding for the taxable year for which the return is filed and for all
subsequent taxable years, unless the Commissioner permits the taxpayer
to change to a different method of reporting income from such
obligations. See section 446(e) and paragraph (e) of Sec. 1.446-1,
relating to requirement respecting a
[[Page 133]]
change of accounting method. Although the election once made is binding
upon the taxpayer, it does not apply to a transferee of the taxpayer.
(2) Amount of increase in case of non-interest-bearing obligations.
In any case in which an election is made under section 454, the amount
which accrues in any taxable year to which the election applies is
measured by the actual increase in the redemption price occurring in
that year. This amount does not accrue ratably between the dates on
which the redemption price changes. For example, if two dates on which
the redemption price increases (February 1 and August 1) fall within a
taxable year and if the redemption price increases in the amount of 50
cents on each such date, the amount accruing in that year would be $1
($0.50 on February 1 and $0.50 on August 1). If the taxpayer owns a non-
interest-bearing obligation of the character described in subdivision
(i), (ii), or (iii) of subparagraph (1) of this paragraph acquired prior
to the first taxable year to which his election applies, he must also
include in gross income for such first taxable year (i) the increase in
the redemption price of such obligation occurring between the date of
acquisition of the obligation and the first day of such first taxable
year and (ii), in a case where a series E bond was exchanged for such
obligation, the increase in the redemption price of such series E bond
occurring between the date of acquisition of such series E bond and the
date of the exchange.
(3) Amount of increase in case of current income obligations. If an
election is made under section 454 and the taxpayer owns, at the
beginning of the first taxable year to which the election applies, a
current income obligation of the character described in subparagraph
(1)(iii) of this paragraph acquired prior to such taxable year, he must
also include in gross income for such first taxable year the increase in
the redemption price of the series E bond which was surrendered to the
United States in exchange for such current income obligation; the amount
of the increase is that occurring between the date of acquisition of the
series E bond and the date of the exchange.
(4) Illustrations. The application of this paragraph may be
illustrated by the following examples:
Example (1). Throughout the calendar year 1954, a taxpayer who uses
the cash receipts and disbursements method of accounting holds series E
U.S. savings bonds having a maturity value of $5,000 and a redemption
value at the beginning of the year 1954 of $4,050 and at the end of the
year 1954 of $4,150. He purchased the bonds on January 1, 1949, for
$3,750, and holds no other obligation of the type described in this
section. If the taxpayer exercises the election in his return for the
calendar year 1954, he is required to include $400 in taxable income
with respect to such bonds. Of this amount, $300 represents the increase
in the redemption price before 1954 and $100 represents the increase in
the redemption price in 1954. The increases in redemption value
occurring in subsequent taxable years are includible in gross income for
such taxable years.
Example (2). In 1958 B, a taxpayer who uses the cash receipts and
disbursements method of accounting and the calendar year as his taxable
year, purchased for $7,500 a series E United States savings bond with a
face value of $10,000. In 1965, when the stated redemption value of the
series E bond is $9,760, B surrenders it to the United States in
exchange solely for a $10,000 series H U.S. current income savings bond
in an exchange qualifying under section 1037(a), after paying $240
additional consideration. On the exchange of the series E bond for the
series H bond in 1965, B realizes a gain of $2,260 ($9,760 less $7,500),
none of which is recognized for that year by reason of section 1037(a).
B retains the series H bond and redeems it at maturity in 1975 for
$10,000, but in 1966 he exercises the election under section 454(a) in
his return for that year with respect to five series E bonds he
purchased in 1960. B is required to include in gross income for 1966 the
increase in redemption price occurring before 1966 and in 1966 with
respect to the series E bonds purchased in 1960; he is also required to
include in gross income for 1966 the $2,260 increase in redemption price
of the series E bond which was exchanged in 1965 for the series H bond.
(b) Short-term obligations issued on a discount basis. In the case
of obligations of the United States or any of its possessions, or of a
State, or Territory, or any political subdivision thereof, or of the
District of Columbia, issued on a discount basis and payable without
interest at a fixed maturity date not exceeding one year from the date
of issue, the amount of discount at which such
[[Page 134]]
obligation originally sold does not accrue until the date on which such
obligation is redeemed, sold, or otherwise disposed of. This rule
applies regardless of the method of accounting used by the taxpayer. For
examples illustrating rules for computation of income from sale or other
disposition of certain obligations of the type described in this
paragraph, see section 1221 and the regulations thereunder.
(c) Matured U.S. savings bonds--(1) Inclusion of increase in income
upon redemption or final maturity. If a taxpayer (other than a
corporation) holds--
(i) A matured series E U.S. savings bond,
(ii) An obligation of the United States, other than a current income
obligation, in which he retains his investment in a matured series E
U.S. savings bond, or
(iii) A nontransferable obligation (whether or not a current income
obligation) of the United States for which a series E U.S. savings bond
was exchanged (whether or not at final maturity) in an exchange upon
which gain is not recognized because of section 1037(a) (or so much of
section 1031(b) as relates to section 1037(a)),
the increase in redemption price of the series E bond in excess of the
amount paid for such series E bond shall be included in the gross income
of such taxpayer for the taxable year in which the obligation described
in subdivision (i), (ii), or (iii) of this subparagraph is redeemed or
disposed of, or finally matures, whichever is earlier, but only to the
extent such increase has not previously been includible in the gross
income of such taxpayer or any other taxpayer. If such obligation is
partially redeemed before final maturity, or partially disposed of by
being partially reissued to another owner, such increase in redemption
price shall be included in the gross income of such taxpayer for such
taxable year on a basis proportional to the total denomination of
obligations redeemed or disposed of. The provisions of section 454 (c)
and of this subparagraph shall not apply in the case of any taxable year
for which the taxpayer's taxable income is computed under an accrual
method of accounting or for a taxable year for which an election made by
the taxpayer under section 454(a) and paragraph (a) of this section
applies. For rules respecting the character of the gain realized upon
the disposition or redemption of an obligation described in subdivision
(iii) of this subparagraph, see paragraph (b) of Sec. 1.1037-1.
(2) Illustrations. The application of this paragraph may be
illustrated by the following examples, in which it is assumed that the
taxpayer uses the cash receipts and disbursements method of accounting
and the calendar year as his taxable year:
Example (1). On June 1, 1941, A purchased for $375 a series E U.S.
savings bond which was redeemable at maturity (10 years from issue date)
for $500. At maturity of the bond, A exercised the option of retaining
the matured series E bond for the 10-year extended maturity period. On
June 2, 1961, A redeemed the series E bond, at which time the stated
redemption value was $674.60. A never elected under section 454(a) to
include the annual increase in redemption price in gross income
currently. Under section 454(c), A is required to include $299.60
($674.60 less $375) in gross income for 1961 by reason of his redemption
of the bond.
Example (2). The facts are the same as in example (2) in paragraph
(a)(4) of this section. On redemption of the series H bond received in
the exchange qualifying under section 1037(a), B realizes a gain of
$2,260, determined as provided in example (5) in paragraph (b)(4) of
Sec. 1.1037-1. None of this amount is includible in B's gross income for
1975, such amount having already been includible in his gross income for
1966 because of his election under section 454(a).
Example (3). C, who had elected under section 454(a) to include the
annual increase in the redemption price of his non-interest-bearing
obligations in gross income currently, owned a $1,000 series E U.S.
savings bond, which was purchased on October 1, 1949, for $750, C died
on February 1, 1955, when the redemption value of the bond was $820. The
bond was immediately reissued to D, his only heir, who has not made an
election under section 454(a). On January 15, 1960, when the redemption
value of the bond is $1,000, D surrenders it to the United States in
exchange solely for a $1,000 series H U.S. savings bond in an exchange
qualifying under the provisions of section 1037(a). For 1960 D properly
does not return any income from the exchange of bonds, although he
returns the interest payments on the series H bond for the taxable years
in which they are received. On September 1, 1964, prior to maturity of
the series H bond, D redeems it for $1,000. For 1964, D must include
$180 in gross
[[Page 135]]
income under section 454(c) from the redemption of the series H bond,
that is, the amount of the increase in the redemption price of the
series E bond ($1,000 less $820) occurring between February 1, 1955, and
January 15, 1960, the period during which he owned the series E bond.
[T.D. 6500, 25 FR 11719, Nov. 26, 1960, as amended by T.D. 6935, 32 FR
15820, Nov. 17, 1967; T.D. 7154, 36 FR 24997, Dec. 28, 1971]
Sec. 1.455-1 Treatment of prepaid subscription income.
Effective with respect to taxable years beginning after December 31,
1957, section 455 permits certain taxpayers to elect with respect to a
trade or business in connection with which prepaid subscription income
is received, to include such income in gross income for the taxable
years during which a liability exists to furnish or deliver a newspaper,
magazine, or other periodical. If a taxpayer does not elect to treat
prepaid subscription income under the provisions of section 455, such
income is includible in gross income for the taxable year in which
received by the taxpayer, unless under the method or practice of
accounting used in computing taxable income such amount is to be
properly accounted for as of a different period.
[T.D. 6591, 27 FR 1798, Feb. 27, 1962]
Sec. 1.455-2 Scope of election under section 455.
(a) If a taxpayer makes an election under section 455 and
Sec. 1.455-6 with respect to a trade or business, all prepaid
subscription income from such trade or business shall be included in
gross income for the taxable years during which the liability exists to
furnish or deliver a newspaper, magazine, or other periodical. Such
election shall be applicable to all prepaid subscription income received
in connection with the trade or business for which the election is made;
except that the taxpayer may further elect to include in gross income
for the taxable year of receipt (as described in section 455(d)(3) and
paragraph (c) of Sec. 1.455-5) the entire amount of any prepaid
subscription income if the liability from which it arose is to end
within 12 months after the date of receipt, hereinafter sometimes
referred to as ``within 12 months'' election.
(b) If the taxpayer is engaged in more than one trade or business in
which a liability is incurred to furnish or deliver a newspaper,
magazine, or other periodical, a separate election 455 with respect to
each such trade or business. In addition, a taxpayer may make a separate
``within 12 months'' election for each separate trade or business for
which it has made an election under section 455.
(c) An election made under section 455 shall be binding for the
first taxable year for which the election is made and for all subsequent
taxable years, unless the taxpayer secures the consent of the
Commissioner to the revocation of such election. Thus, in any case where
the taxpayer has elected a method prescribed by section 455 for the
inclusion of prepaid subscription income in gross income, such method of
reporting income may not be changed without the prior approval of the
Commissioner. In order to secure the Commissioner's consent to the
revocation of such election, an application must be filed with the
Commissioner in accordance with section 446(e) and the regulations
thereunder. For purposes of subtitle A of the Code, the computation of
taxable income under an election made under section 455 shall be treated
as a method of accounting. For adjustments required by changes in method
of accounting, see section 481 and the regulations thereunder.
(d) An election made under section 455 shall not apply to any
prepaid subscription income received before the first taxable year to
which the election applies. For example, Corporation M, which computes
its taxable income under an accrual method of accounting and files its
income tax returns on the calendar year basis, publishes a monthly
magazine and customarily sells subscriptions on a 3-year basis. In 1958
it received $135,000 of 3-year prepaid subscription income for
subscriptions beginning during 1958, and in 1959 it received $142,000 of
prepaid subscription income for subscriptions beginning after December
31, 1958. In February 1959 it elected, with the consent of the
Commissioner, to report its prepaid subscription income under the
provisions of section 455 for the year 1959 and subsequent taxable
years. The
[[Page 136]]
$135,000 received in 1958 from prepaid subscriptions must be included in
gross income in full in that year, and no part of such 1958 income shall
be allocated to the years 1959, 1960, and 1961 during which M was under
a liability to deliver its magazine. The $142,000 received in 1959 from
prepaid subscriptions shall be allocated to the years 1959, 1960, 1961,
and 1962.
(e) No election may be made under section 455 with respect to a
trade or business if, in computing taxable income, the cash receipts and
disbursements method of accounting is used with respect to such trade or
business. However, if the taxpayer is on a ``combination'' method of
accounting under section 446(c)(4) and the regulations thereunder, it
may elect the benefits of section 455 if it uses an accrual method of
accounting for subscription income
[T.D. 6591, 27 FR 1798, Feb. 27, 1962]
Sec. 1.455-3 Method of allocation.
(a) Prepaid subscription income to which section 455 applies shall
be included in gross income for the taxable years during which the
liability to which the income relates is discharged or is deemed to be
discharged on the basis of the taxpayer's experience.
(b) For purposes of determining the period or periods over which the
liability of the taxpayer extends, and for purposes of allocating
prepaid subscription income to such periods, the taxpayer may aggregate
similar transactions during the taxable year in any reasonable manner,
provided the method of aggregation and allocation is consistently
followed.
[T.D. 6591, 27 FR 1798, Feb. 27, 1962]
Sec. 1.455-4 Cessation of taxpayer's liability.
(a) If a taxpayer has elected to apply the provisions of section 455
to a trade or business in connection with which prepaid subscription
income is received, and if its liability to furnish or deliver a
newspaper, magazine, or other periodical ends for any reason, then so
much of the prepaid subscription income attributable to such liability
as was not includible in its gross income under section 455 for
preceding taxable years shall be included in its gross income for the
taxable year in which such liability ends. A taxpayer's liability may
end, for example, because of the cancellation of a subscription. See
section 381(c)(4) and the regulations thereunder for the treatment of
prepaid subscription income in a transaction to which section 381(a)
applies.
(b) If a taxpayer who has elected to apply the provisions of section
455 to a trade or business dies or ceases to exist, then so much of the
prepaid subscription income attributable to such trade or business which
was not includible in its gross income under section 455 for preceding
taxable years shall be included in its gross income for the taxable year
in which such death or cessation of existence occurs. See section
381(c)(4) and the regulations thereunder for the treatment of prepaid
subscription income in a transaction to which section 381(a) applies.
[T.D. 6591, 27 FR 1799, Feb. 27, 1962]
Sec. 1.455-5 Definitions and other rules.
(a) Prepaid subscription income. (1) The term ``prepaid subscription
income'' means any amount includible in gross income which is received
in connection with, and is directly attributable to, a liability of the
taxpayer which extends beyond the close of the taxable year in which
such amount is received and which is income from a newspaper, magazine,
or other periodical. For example where Corporation X, a publisher of
newspapers, magazines, and other periodicals makes sales on a
subscription basis and the purchaser pays the subscription price in
advance, prepaid subscription income would include the amounts actually
received by X in connection with its liability to furnish or deliver the
newspaper, magazine, or other periodical.
(2) For purposes of section 455, prepaid subscription income does
not include amounts received by a taxpayer in connection with sales of
subscriptions on a prepaid basis where such taxpayer does not have the
liability to furnish or deliver a newspaper, magazine, or other
periodical. The provisions of this subparagraph may be illustrated by
the following example. Corporation D has a contract with each of several
large publishers which grants it the right to sell subscriptions
[[Page 137]]
to their periodicals. Corporation D collects the subscription price from
the subscribers, retains a portion thereof as its commission and remits
the balance to the publishers. The amount retained by Corporation D
represents commissions on the sale of subscriptions, and is not prepaid
subscription income for purposes of section 455 since the commissions
represent compensation for services rendered and are not directly
attributable to a liability of Corporation D to furnish or deliver a
newspaper, magazine, or other periodical.
(b) Liability. The term ``liability'' means a liability of the
taxpayer to furnish or deliver a newspaper, magazine, or other
periodical.
(c) Receipt of prepaid subscription income. For purposes of section
455, prepaid subscription income shall be treated as received during the
taxable year for which it is includible in gross income under section
451, relating to general rule for taxable year of inclusion, without
regard to section 455.
(d) Treatment of prepaid subscription income under an established
accounting method. Notwithstanding the provisions of section 455 and
Sec. 1.455-1, any taxpayer who, for taxable years beginning before
January 1, 1958, has reported prepaid subscription income for income tax
purposes under an established and consistent method or practice of
deferring such income may continue to report such income in accordance
with such method or practice for all subsequent taxable years to which
section 455 applies without making an election under section 455.
[T.D. 6591, 27 FR 1799, Feb. 27, 1962]
Sec. 1.455-6 Time and manner of making election.
(a) Election without consent. (1) A taxpayer may, without consent,
elect to treat prepaid subscription income of a trade or business under
section 455 for the first taxable year--
(i) Which begins after December 31, 1957, and
(ii) In which there is received prepaid subscription income from the
trade or business for which the election is made. Such an election shall
be made not later than the time prescribed by law for filing the income
tax return for such year (including extensions thereof), and shall be
made by means of a statement attached to such return.
(2) The statement shall indicate that the taxpayer is electing to
apply the provisions of section 455 to his trade or business, and shall
contain the following information:
(i) The name and a description of the taxpayer's trade or business
to which the election is to apply;
(ii) The method of accounting used in such trade or business;
(iii) The total amount of prepaid subscription income from such
trade or business for the taxable year;
(iv) The period or periods over which the liability of the taxpayer
to furnish or deliver a newspaper, magazine, or other periodical
extends;
(v) The amount of prepaid subscription income applicable to each
such period; and
(vi) A description of the method used in allocating the prepaid
subscription income to each such period.
In any case in which prepaid subscription income is received from more
than one trade or business, the statement shall set forth the required
information with respect to each trade or business subject to the
election.
(3) See paragraph (c) of this section for additional information
required to be submitted with the statement if the taxpayer also elects
to include in gross income for the taxable year of receipt the entire
amount of prepaid subscription income attributable to a liability which
is to end within 12 months after the date of receipt.
(b) Election with consent. A taxpayer may, with the consent of the
Commissioner, elect at any time to apply the provisions of section 455
to any trade or business in which it receives prepaid subscription
income. The request for such consent shall be in writing, signed by the
taxpayer or its authorized representative, and shall be addressed to the
Commissioner of Internal Revenue, Attention: T:R:C, Washington, D.C.
20224. The request must be filed on or before the later of the following
dates:
(1) 90 days after the beginning of the first taxable year to which
the election is to apply or
[[Page 138]]
(2) May 28, 1962, and must contain the information described in
paragraph (a)(2) of this section.
See paragraph (c) of this section for additional information required to
be submitted with the request if the taxpayer also elects to include in
gross income for the taxable year of receipt the entire amount of
prepaid subscription income attributable to a liability which is to end
within 12 months after the date of receipt.
(c) ``Within 12 months'' election. (1) A taxpayer who elects to
apply the provisions of section 455 to any trade or business may also
elect to include in gross income for the taxable year of receipt (as
described in section 455(d)(3) and paragraph (c) of Sec. 1.455-5) the
entire amount of any prepaid subscription income from such trade or
business if the liability from which it arose is to end within 12 months
after the date of receipt. Any such election is binding for the first
taxable year for which it is effective and for all subsequent taxable
years, unless the taxpayer secures permission from the Commissioner to
treat such income differently. Application to revoke or change a
``within 12 months'' election shall be made in accordance with the
provisions of section 446(e) and the regulations thereunder.
(2) The ``within 12 months'' election shall be made by including in
the statement required by paragraph (a) of this section or the request
described in paragraph (b) of this section, whichever is applicable, a
declaration that the taxpayer elects to include such income in gross
income in the taxable year of receipt, and the amount of such income. If
the taxpayer is engaged in more than one trade or business for which the
election under section 455 is made, it must include, in such statement
or request, a declaration for each trade or business for which it makes
the ``within 12 months'' election. See also paragraph (e) of Sec. 1.455-
2.
(3) If the taxpayer does not make the ``within 12 months'' election
for its trade or business at the time prescribed for making the election
to include prepaid subscription income in gross income for the taxable
years during which its liability to furnish or deliver a newspaper,
magazine, or other periodical exists for such trade or business, but
later wishes to make such election, it must apply for permission from
the Commissioner. Such application shall be made in accordance with the
provisions of section 446(e) and the regulations thereunder.
[T.D. 6591, 27 FR 1799, Feb. 27, 1962]
Sec. 1.456-1 Treatment of prepaid dues income.
Effective for taxable years beginning after December 31, 1960, a
taxpayer which is a membership organization (as described in paragraph
(c) of Sec. 1.456-5) and which receives prepaid dues income as described
in paragraph (a) of Sec. 1.456-5 in connection with its trade or
business of rendering services or making available membership privileges
may elect under section 456 to include such income in gross income
ratably over the taxable years during which its liability (as described
in paragraph (b) of Sec. 1.456-5) to render such services or extend such
privileges exists, if such liability does not extend over a period of
time in excess of 36 months. If the taxpayer does not elect to treat
prepaid dues income under section 456, or if such income may not be
reported under section 456, as for example, where the income relates to
a liability to render services or make available membership privileges
which extends beyond 36 months, then such income is includible in gross
income for the taxable year in which it is received (as described in
paragraph (d) of Sec. 1.456-5).
[T.D. 6937, 32 FR 16394, Nov. 30, 1967]
Sec. 1.456-2 Scope of election under section 456.
(a) An election made under section 456 and Sec. 1.456-6, shall be
applicable to all prepaid dues income received in connection with the
trade or business for which the election is made. However, the taxpayer
may further elect to include in gross income for the taxable year of
receipt the entire amount of any prepaid dues income attributable to a
liability extending beyond the close of the taxable year but ending
within 12 months after the date of receipt, hereinafter referred to as
the ``within 12 months'' election.
[[Page 139]]
(b) If the taxpayer is engaged in more than one trade or business in
connection with which prepaid dues income is received, a separate
election may be made under section 456 with respect to each such trade
or business. In addition, a taxpayer may make a separate ``within 12
months'' election for each separate trade or business for which it has
made an election under section 456.
(c) A section 456 election and a ``within 12 months'' election shall
be binding for the first taxable year for which the election is made and
for all subsequent taxable years, unless the taxpayer secures the
consent of the Commissioner to the revocation of either election. In
order to secure the Commissioner's consent to the revocation of the
section 456 election or the ``within 12 months'' election, an
application must be filed with the Commissioner in accordance with
section 446(e) and the regulations thereunder. However, an application
for consent to revoke the section 456 election or the ``within 12
months'' election in the case of all taxable years which end before
November 30, 1967 must be filed on or before February 28, 1968. For
purposes of Subtitle A of the Code, the computation of taxable income
under an election made under section 456 or under the ``within 12
months'' election shall be treated as a method of accounting. For
adjustments required by changes in method of accounting, see section 481
and the regulations thereunder.
(d) Except as provided in section 456(d) and Sec. 1.456-7, an
election made under section 456 shall not apply to any prepaid dues
income received before the first taxable year to which the election
applies. For example, Corporation X, a membership organization which
files its income tax returns on a calendar year basis, customarily sells
3-year memberships, payable in advance. In 1961 it received $160,000 of
prepaid dues income for 3-year memberships beginning during 1961, and in
1962 it received $185,000 of prepaid dues income for 3-year memberships
beginning on January 1, 1962. In March 1962 it elected, with the consent
of the Commissioner, to report its prepaid dues income under the
provisions of section 456 for the year 1962 and subsequent taxable
years. The $160,000 received in 1961 from prepaid dues must be included
in gross income in full in that year, and except as provided in section
456(d) and Sec. 1.456-7, no part of such income shall be allocated to
the taxable years 1962, 1963, and 1964 during which X was under a
liability to make available its membership privileges. The $185,000
received in 1962 from prepaid dues income shall be allocated to the
years 1962, 1963, and 1964.
(e) No election may be made under section 456 with respect to a
trade or business if, in computing taxable income, the cash receipts and
disbursements method (or a hybrid thereof) of accounting is used with
respect to such trade or business, unless the combination of the section
456 election and the taxpayer's hybrid method of accounting does not
result in a material distortion of income.
[T.D. 6937, 32 FR 16394, Nov. 30, 1967; 32 FR 17479, Dec. 6, 1967]
Sec. 1.456-3 Method of allocation.
(a) Prepaid dues income for which an election has been made under
section 456 shall be included in gross income over the period of time
during which the liability to render services or make available
membership privileges exists. The liability to render the services or
make available the membership privileges shall be deemed to exist
ratably over the period of time such services are required to be
rendered, or such membership privileges are required to be made
available. Thus, the prepaid dues income shall be included in gross
income ratably over the period of the membership contract. For example,
Corporation X, a membership organization, which files its income tax
returns on a calendar year basis, elects, for its taxable year beginning
January 1, 1961, to report its prepaid dues income in accordance with
the provisions of section 456. On March 31, 1961, it sells a 2-year
membership for $48 payable in advance, the membership to extend from May
1, 1961, to April 30, 1963. X shall include in its gross income for the
taxable year 1961 \8/24\ of the $48, or $16, and for the taxable year
1962 \12/24\ of the $48, or $24, and for the taxable year 1963 \4/24\ of
the $48, or $8.
[[Page 140]]
(b) For purposes of determining the period or periods over which the
liability of the taxpayer exists, and for purposes of allocating prepaid
dues income to such periods, the taxpayer may aggregate similar
transactions during the taxable year in any reasonable manner, provided
the method of aggregation and allocation is consistently followed.
[T.D. 6937, 32 FR 16395, Nov. 30, 1967]
Sec. 1.456-4 Cessation of liability or existence.
(a) If a taxpayer has elected to apply the provisions of section 456
to a trade or business in connection with which prepaid dues income is
received, and if the taxpayer's liability to render services or make
available membership privileges ends for any reason, as for example,
because of the cancellation of a membership then so much of the prepaid
dues income attributable to such liability as was not includible in the
taxpayer's gross income under section 456 for preceding taxable years
shall be included in gross income for the taxable year in which such
liability ends. This paragraph shall not apply to amounts includible in
gross income under Sec. 1.456-7.
(b) If a taxpayer which has elected to apply the provisions of
section 456 ceases to exist, then the prepaid dues income which was not
includible in gross income under section 456 for preceding taxable years
shall be included in the taxpayer's gross income for the taxable year in
which such cessation of existence occurs. This paragraph shall not apply
to amounts includible in gross income under Sec. 1.456-7.
(c) If a taxpayer is a party to a transaction to which section
381(a) applies and the taxpayer's method of accounting with respect to
prepaid dues income is used by the acquiring corporation under the
provisions of section 381(c)(4), then neither the liability nor the
existence of the taxpayer shall be deemed to have ended or ceased. In
such cases see section 381(c)(4) and the regulations thereunder for the
treatment of the portion of prepaid dues income which was not included
in gross income under section 456 for preceding taxable years.
[T.D. 6937, 32 FR 16395, Nov. 30, 1967]
Sec. 1.456-5 Definitions and other rules.
(a) Prepaid dues income. (1) The term ``prepaid dues income'' means
any amount for membership dues includible in gross income which is
received by a membership organization in connection with, and is
directly attributable to, a liability of the taxpayer to render services
or make available membership privileges over a period of time which
extends beyond the close of the taxable year in which such amount is
received.
(2) For purposes of section 456, prepaid dues income does not
include amounts received by a taxpayer in connection with sales of
memberships on a prepaid basis where the taxpayer does not have the
liability to furnish the services or make available the membership
privileges. For example, where a taxpayer has a contract with several
membership organizations to sell memberships in such organizations and
retains a portion of the amounts received from the sale of such
memberships and remits the balance to the membership organizations, the
amounts retained by such taxpayer represent commissions and do not
constitute prepaid dues income for purposes of section 456.
(b) Liability. The term ``liability'' means a liability of the
taxpayer to render services or make available membership privileges over
a period of time which does not exceed 36 months. Thus, if during the
taxable year a taxpayer sells memberships for more than 36 months and
also memberships for 36 months or less, section 456 does not apply to
the income from the sale of memberships for more than 36 months. For the
purpose of determining the duration of a liability, a bona fide renewal
of a membership shall not be considered to be a part of the existing
membership.
(c) Membership organization. (1) The term ``membership
organization'' means a corporation, association, federation, or other
similar organization meeting the following requirements:
(i) It is organized without capital stock of any kind.
(ii) Its charter, bylaws, or other written agreement or contract
expressly prohibits the distribution of any part of the net earnings
directly or indirectly, in money, property, or services, to any member,
and
[[Page 141]]
(iii) No part of the net earnings of which is in fact distributed to
any member either directly or indirectly, in money, property, or
services.
(2) For purposes of this paragraph an increase in services or
reduction in dues to all members shall generally not be considered
distributions of net earnings.
(3) If a corporation, association, federation, or other similar
organization subsequent to the time it elects to report its prepaid dues
income in accordance with the provisions of section 456, (i) issues any
kind of capital stock either to any member or nonmember, (ii) amends its
charter, bylaws, or other written agreement or contract to permit
distributions of its net earnings to any member or, (iii) in fact,
distributes any part of its net earnings either in money, property, or
services to any member, then immediately after such event the
organization shall not be considered a membership organization within
the meaning of section 456(e)(3).
(d) Receipt of prepaid dues income. For purposes of section 456,
prepaid dues income shall be treated as received during the taxable year
for which it is includible in gross income under section 451, relating
to the general rule for taxable year of inclusion, without regard to
section 456.
[T.D. 6937, 32 FR 16395, Nov. 30, 1967]
Sec. 1.456-6 Time and manner of making election.
(a) Election without consent. A taxpayer may make an election under
section 456 without the consent of the Commissioner for the first
taxable year beginning after December 31, 1960, in which it receives
prepaid dues income in the trade or business for which such election is
made. The election must be made not later than the time prescribed by
law for filing the income tax return for such year (including extensions
thereof). The election must be made by means of a statement attached to
such return. In addition, there should be attached a copy of a typical
membership contract used by the organization and a copy of its charter,
bylaws, or other written agreement or contract of organization or
association. The statement shall indicate that the taxpayer is electing
to apply the provisions of section 456 to the trade or business, and
shall contain the following information:
(1) The taxpayer's name and a description of the trade or business
to which the election is to apply.
(2) The method of accounting used for prepaid dues income in the
trade or business during the first taxable year for which the election
is to be effective and during each of 3 preceding taxable years, and if
there was a change in the method of accounting for prepaid dues income
during such 3-year period, a detailed explanation of such change
including the adjustments necessary to prevent duplications or omissions
of income.
(3) Whether any type of deferral method for prepaid dues income has
been used during any of the 3 taxable years preceding the first taxable
year for which the election is effective. Where any type of such
deferral method has been used during this period, an explanation of the
method and a schedule showing the amounts received in each such year and
the amounts deferred to each succeeding year.
(4) A schedule with appropriate explanations showing:
(i) The total amount of prepaid dues income received in the trade or
business in the first taxable year for which the election is effective
and the amount of such income to be included in each taxable year in
accordance with the election,
(ii) The total amount, if any, of prepayments of dues received in
the first taxable year for which the election is effective which are
directly attributable to a liability of the taxpayer to render services
or make available membership privileges over a period of time in excess
of 36 months, and
(iii) The total amount, if any, of prepaid dues income received in
the trade or business in--
(a) The taxable year preceding the first taxable year for which the
election is effective if all memberships sold by the taxpayer are for
periods of 1 year or less,
(b) Each of the 2 taxable years preceding the first taxable year for
which the election is effective if any memberships are sold for periods
in excess of 1
[[Page 142]]
year but none are sold for periods in excess of 2 years, or
(c) Each of the 3 taxable years preceding the first taxable year for
which the election is effective if any memberships are sold for periods
in excess of 2 years.
In each case there shall be set forth the amount of such income which
would have been includible in each taxable year had the election been
effective for the years for which the information is required.
In any case in which prepaid dues income is received from more than one
trade or business, the statement shall set forth separately the required
information with respect to each trade or business for which the
election is made. See paragraph (c) of this section for additional
information required to be submitted with the statement if the taxpayer
also elects to include in gross income for the taxable year of receipt
the entire amount of prepaid dues income attributable to a liability
which is to end within 12 months after the date of receipt.
(b) Election with consent. A taxpayer may elect with the consent of
the Commissioner, to apply the provisions of section 456 to any trade or
business in which it receives prepaid dues income. The request for such
consent shall be in writing, signed by the taxpayer or its authorized
representative, and shall be addressed to the Commissioner of Internal
Revenue, Washington, D.C. 20224. The request must be filed on or before
the later of the following dates:
(1) 90 days after the beginning of the first taxable year to which
the election is to apply, or
(2) February 28, 1968 and should contain the information described
in paragraph (a) of this section.
See paragraph (c) of this section for additional information required to
be submitted with the request if the taxpayer also elects to include in
gross income for the taxable year of receipt the entire amount of
prepaid dues income attributable to a liability which is to end within
12 months after the date of receipt.
(c) ``Within 12 months'' election. (1) The ``within 12 months''
election shall be made by including in the statement required by
paragraph (a) of this section or the request described in paragraph (b)
of this section, whichever is applicable, a declaration that the
taxpayer elects to include such income in gross income in the taxable
year of receipt, and the amount of such income for each taxable year to
which the election is to apply which has ended prior to the time such
statement or request is filed. If the taxpayer is engaged in more than
one trade or business for which the election under section 456 is made,
it must include, in such statement or request, a declaration for each
trade or business for which it wishes to make the ``within 12 months''
election.
(2) If the taxpayer does not make the ``within 12 months'' election
for a trade or business at the time it makes the election under
paragraph (a) or (b) of this section, but later wishes to make such
election, it must apply for permission from the Commissioner. Such
application shall be made in accordance with the provisions of section
446(e).
[T.D. 6937, 32 FR 16395, Nov. 30, 1967; 32 FR 17479, Dec. 6, 1967]
Sec. 1.456-7 Transitional rule.
(a) Under section 456(d)(1), a taxpayer making an election under
section 456 shall include in its gross income for the first taxable year
to which the election applies and for each of the 2 succeeding taxable
years not only that portion of prepaid dues income which is includible
in gross income for each such taxable year under section 456(a), but
also an additional amount equal to that portion of the total prepaid
dues income received in each of the 3 taxable years preceding the first
taxable year to which the election applies which would have been
includible in gross income for such first taxable year and such 2
succeeding taxable years had the election under section 456 been
effective during such 3 preceding taxable years. In computing such
additional amounts--
(1) In the case of taxpayers who did not include in gross income for
the taxable year preceding the first taxable year for which the election
is effective, that portion of the prepaid dues income received in such
year attributable to a liability which is to end within 12 months after
the date of receipt, no effect shall be given to a ``within 12
[[Page 143]]
months'' election made under paragraph (c) of Sec. 1.456-6, and
(2) There shall be taken into account only prepaid dues income
arising from a trade or business with respect to which an election is
made under section 456 and Sec. 1.456-6.
Section 481 and the regulations thereunder shall have no application to
the additional amounts includible in gross income under section 456(d)
and this section, but section 481 and the regulations thereunder shall
apply to prevent other amounts from being duplicated or omitted.
(b) A taxpayer who makes an election with respect to prepaid dues
income, and who includes in gross income for any taxable year to which
the election applies an additional amount computed under section
456(d)(1) and paragraph (a) of this section, shall be permitted under
section 456(d)(2) to deduct for such taxable year and for each of the 4
succeeding taxable years an amount equal to one-fifth of such additional
amount, but only to the extent that such additional amount was also
included in the taxpayer's gross income for any of the 3 taxable years
preceding the first taxable year to which such election applies. The
taxpayer shall maintain books and records in sufficient detail to enable
the district director to determine upon audit that the additional
amounts were included in the taxpayer's gross income for any of the 3
taxable years preceding such first taxable year. If, however, the
taxpayer ceases to exist, as described in paragraph (b) of Sec. 1.456-4,
and there is included in gross income, under such paragraph, of the year
of cessation the entire portion of prepaid dues income not previously
includible in gross income under section 456 for preceding taxable years
(other than for amounts received prior to the first year for which an
election was made), all the amounts not previously deducted under this
paragraph shall be permitted as a deduction in the year of cessation of
existence.
(c) The provisions of this section may be illustrated by the
following example:
Example. (1) Assume that X Corporation, a membership organization
qualified to make the election under section 456, elects to report its
prepaid dues income in accordance with the provisions of section 456 for
its taxable year ending December 31, 1961. Assume further that X
Corporation receives in the middle of each taxable year $3,000 of
prepaid dues income in connection with a liability to render services
over a 3-year period beginning with the date of receipt. Under section
456(a), X Corporation will report income received in 1961 and subsequent
years as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total
Year of receipt receipts 1961 1962 1963 1964 1965 1966 1967 1968
--------------------------------------------------------------------------------------------------------------------------------------------------------
1961.......................................................... $3,000 $500 $1,000 $1,000 $500 ........ ........ ........ ........
1962.......................................................... 3,000 ........ 500 1,000 1,000 $500 ........ ........ ........
1963.......................................................... 3,000 ........ ........ 500 1,000 1,000 $500 ........ ........
1964.......................................................... 3,000 ........ ........ ........ 500 1,000 1,000 $500 ........
1965.......................................................... 3,000 ........ ........ ........ ........ 500 1,000 1,000 $500
1966.......................................................... 3,000 ........ ........ ........ ........ ........ 500 1,000 1,000
1967.......................................................... 3,000 ........ ........ ........ ........ ........ ........ 500 1,000
1968.......................................................... 3,000 ........ ........ ........ ........ ........ ........ ........ 500
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total reportable under section 456(a)................................. 500 1,500 2,500 3,000 3,000 3,000 3,000 3,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
(2) Under section 456(d) (1), X Corporation must include in its
gross income for the first taxable year to which the election applies
and for each of the 2 succeeding taxable years, the amounts which would
have been included in those years had the election been effective 3
years earlier. If the election had been effective in 1958, the following
amounts received in 1958, 1959, and 1960 would have been reported in
1961 and subsequent years:
----------------------------------------------------------------------------------------------------------------
Years of including additional
Amount amounts
Year of receipt received -----------------------------------
1961 1962 1963
----------------------------------------------------------------------------------------------------------------
1958............................................................ $3,000 $500 .......... ..........
1959............................................................ 3,000 1,000 $500 ..........
1960............................................................ 3,000 1,000 1,000 $500
----------------------------------------------------------------------------------------------------------------
[[Page 144]]
Total additional amounts to be included under section 456(d)(1) 2,500 1,500 500
----------------------------------------------------------------------------------------------------------------
(3) Having included the additional amounts as required by section
456(d)(1), and assuming such amounts were actually included in gross
income in the 3 taxable years preceding the first taxable year for which
the election is effective, X Corporation is entitled to deduct under
section 456(d)(2) in the year of inclusion and in each of the succeeding
4 years an amount equal to one-fifth of the amounts included, as
follows:
----------------------------------------------------------------------------------------------------------------
Years of deduction
Year of inclusion Amount --------------------------------------------------------------
1961 1962 1963 1964 1965 1966 1967
----------------------------------------------------------------------------------------------------------------
1961................................... $2,500 $500 $500 $500 $500 $500 ....... .......
1962................................... 1,500 ....... 300 300 300 300 $300 .......
1963................................... 500 ....... ....... 100 100 100 100 $10
-----------
Total amount deductible under section 500 800 900 900 900 400 100
456(d)(2)...........................
----------------------------------------------------------------------------------------------------------------
(4) The net result of the inclusions under section 456(d)(1) and the
deductions under section 456(d)(2) may be summarized as follows:
----------------------------------------------------------------------------------------------------------------
1961 1962 1963 1964 1965 1966 1967 1968
----------------------------------------------------------------------------------------------------------------
Amount includible under section 456(a).. $500 $1,500 $2,500 $3,000 $3,000 $3,000 $3,000 $3,000
Amount includible under section 2,500 1,500 500 ....... ....... ....... ....... .......
456(d)(1)..............................
-----------------------------------------------------------------------
Total............................... 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
Amount deductible under section 500 800 900 900 900 400 100 .......
456(d)(2)..............................
-----------------------------------------------------------------------
Net amount reportable under section 2,500 2,200 2,100 2,100 2,100 2,600 2,900 3,000
456..................................
----------------------------------------------------------------------------------------------------------------
[T.D. 6937, 32 FR 16396, Nov. 30. 1967]
Sec. 1.457-1 Compensation deferred under eligible State deferred compensation plans.
(a) Year of inclusion in gross income--(1) In general. For taxable
years beginning after December 31, 1978, section 457(a) provides that
amounts deferred (within the meaning of Sec. 1.457-1(d)(3)) under an
eligible State deferred compensation plan that satisfies the
requirements of Sec. 1.457-2 (an ``eligible plan'') are includible in
gross income only for the taxable year in which paid or otherwise made
available to the participant or beneficiary under the plan.
(2) Maximum deferral; in general. Under section 457(c)(1), the
exclusion from gross income described in this paragraph (a) does not
apply to compensation deferred under one or more eligible plans to the
extent that the compensation so deferred during a participant's taxable
year exceeds the greater of--
(i) $7,500, or,
(ii) As applicable, the sum of the plan ceilings determined under
Sec. 1.457-2(f), to the extent such sum does not exceed $15,000.
(3) Maximum deferral; exclusions under section 403(b) taken into
account. Under section 457(c)(2), for a participant's taxable year for
which an amount is contributed to an annuity contract described in
section 403(b) (including a custodial account described in section
403(b)(7)) on behalf of the participant, subparagraph (2) of this
paragraph (a) is applied by substituting--
(i) For $7,500, an amount equal to $7,500, less the amount
excludable from the participant's gross income under section 403(b) for
the taxable year,
(ii) For the sum of the plan ceilings determined under Sec. 1.457-
2(f), an amount equal to the sum of the plan ceilings determined under
Sec. 1.457-2(f), less the amount excludable from the
[[Page 145]]
participant's gross income under section 403(b) for the taxable year, if
such amount is not taken into account under such Sec. 1.457-2(f), and
(iii) For $15,000, an amount equal to $15,000, less the amount
excludable from the participant's gross income under section 403(b) for
the taxable year.
(b) Amounts made available to participant or beneficiary--(1) In
general. For purposes of section 457(a) and this section, amounts
deferred under an eligible plan will not be considered made available to
the participant or beneficiary if under the plan the participant or
beneficiary may irrevocably elect, prior to the time any such amounts
become payable, to defer payment of some or all of such amounts to a
fixed or determinable future time. In addition, amounts deferred
(including amounts previously deferred) under an eligible plan will not
be considered made available to the participant solely because the
participant is permitted to choose among various investment modes under
the plan for the investment of such amounts whether before or after
payments have commenced under the plan.
(2) Examples. Further examples of when amounts deferred will or will
not be considered as being made available to the participant or
beneficiary are provided below:
Example (1). (i) C, an individual, is a participant in an eligible
State deferred compensation plan that provides the following:
(A) The total of the amounts deferred under the plan is payable to
the participant in 120 substantially equal monthly installments
commencing on the date 30 days after the participant attains normal
retirement age under the plan (age 65), unless the participant elects,
within the 90 day period ending on the date the participant attains
normal retirement age, to receive a single sum payment of the deferred
amounts. The single sum payment is payable to a participant on the date
the first of the monthly payment would otherwise be payable to the
participant.
(B) If a participant separates from the service of the State before
attaining normal retirement age, the total of the amounts deferred under
the plan is payable to the participant in a single sum payment on the
date 90 days after the date of the separation, unless, before the date
30 days after the separation, the participant elects not to receive the
single sum payment. The election is irrevocable. If the participant
makes the election, the total of the amounts deferred under the plan is
payable to the participant as described in (A), either in monthly
installments or, at the election of the participant, in a single sum
payment.
(ii) On June 6, 1982, C, a calendar year taxpayer aged 59, separates
from the service of the State. On June 18, 1982, C elects not to receive
the single sum payment payable on account of the separation. Because of
C's election, no amount deferred under the plan is considered made
available in 1982 by reason of C's right to receive the single sum
payment.
(iii) On February 6, 1988, C attains age 65. C did not, within the
90 day period elect the single sum payment that is payable in lieu of
the monthly installments. Amounts deferred under the plan are includible
in C's gross income as they are paid to C in the monthly installments.
No amount is considered made available by reason of C's right to elect
the single sum payment.
Example (2). Assume the same facts as in example (1), except that
the plan provides that notwithstanding that monthly installments have
commenced under the plan, as described in (i)(A), the participant may,
without restriction, elect to receive all or any portion of the amount
remaining payable to the participant. The total of the amounts deferred
under the plan is considered made available in 1988.
Example (3). Assume the same facts as in example (1), except that
the plan provides that once monthly installment payments have commenced
under the plan, as described in (i)(A), the participant may accelerate
the payment of the amount remaining payable to the participant upon the
occurrence of an unforeseeable emergency as described in Sec. 1.457-
2(h)(4) in an amount not exceeding that described in Sec. 1.457-2(h)(5).
No amount is considered made available to C on account of C's right to
accelerate payments upon the occurrence of an unforeseeable emergency.
Example (4). Under an eligible plan of which individual D is a
participant, normal retirement age is age 65 at which time payments must
begin. Payments may begin earlier upon a separation from the service.
Under the plan, a participant who separates from the service before age
65 or the participant's beneficiary (if the separation is due to the
participant's death) may elect to defer the distribution of the amounts
deferred until the year in which the participant attains or would have
attained age 65. This election may be made only prior to the time any
payments commence and once made may not be revoked. If such an election
is made, the participant, former participant, or beneficary need not
elect the method of payment, or if one is elected may change the method
elected, until the date 30 days preceding the date
[[Page 146]]
upon which payments are to commence. No amount is considered made
available by reason of D's right to defer the distribution of the
amounts deferred until age 65, nor on account of D's right to delay the
election of the method of payout. Similarly, if D dies at age 60, no
amount is considered made available to D's beneficiary by reason of the
beneficiary's right to defer the distribution of the amounts deferred
until the year in which D would have attained age 65, nor on account of
the beneficiary's right to delay the election of the method of payout.
Example (5). Under an eligible plan of which individual E is a
participant, the maximum that may be deferred in any taxable year is
33\1/3\% of includible compensation, not to exceed $7,500. The plan does
not provide for a catch-up deferral under section 457(b)(3). In one
taxable year, E elects to have amounts deferred in excess of the
limitation provided for under the plan. The amounts deferred in excess
of the limitation will be considered to have been made available to E in
the taxable year in which deferred.
Example (6). Assume the same facts as in example (5), except that
E's employer also contributes amounts for the purchase of an annuity
contract under section 403(b). In one taxable year, E has amounts
contributed for the annuity within the limitations of section 403(b)(2),
and also has amounts deferred under the eligible plan for the same year.
The aggregate of the amounts contributed for the annuity contract and
the amounts deferred under the plan exceed the deferral limitations
under the plan. The excess deferrals will be considered made available
to E in the year in which the amounts were deferred.
Example (7). Under an eligible plan of which F is a participant,
amounts deferred have been invested in a money market investment fund.
The plan then transfers the amounts deferred to a life insurance company
for the purchase of life insurance contracts as an investment medium.
However, the entity sponsoring the plan (1) retains all of the incidents
of ownership of the contracts, (2) is the sole beneficiary under the
contracts, and (3) is under no obligation to transfer the contracts or
to pass through the proceeds of the contracts to any participant or a
beneficiary of any participant. The movement of the amounts deferred to
the life insurance company (whether or not made at the request of any
plan participant) will not be considered to make the amounts available
to the plan's participants. The cost of current life insurance
protection under the life insurance contracts will not be considered
made available to the plan's participants.
(c) Life insurance proceeds and death benefits paid under eligible
plan. No amount received or made available under an eligible plan is
excludable from gross income under section 101(a) (relating to life
insurance contracts) or section 101(b) (relating to employees' death
benefits).
(d) Definitions. For purposes of Secs. 1.457-1 through 1.457-4:
(1) Participant. ``Participant'' means an individual who is eligible
under Sec. 1.457-2(d) to defer compensation under the plan.
(2) Beneficiary. ``Beneficiary'' means a beneficiary of a
participant, a participant's estate, or any other person whose interest
in the plan is derived from the participant.
(3) Amounts deferred. ``Amount(s) deferred'' under an eligible plan
means compensation deferred under the plan, plus income attributable to
compensation so deferred. Income attributable to compensation deferred
under an eligible plan includes gain from the disposition of property.
The term ``amounts deferred'' includes amounts deferred in taxable years
beginning before January 1, 1979, if such amounts were deferred under a
plan described in Sec. 1.457-2(b), and such amounts were made a part of
an eligible plan.
[T.D. 7836, 47 FR 42337, Sept. 27, 1982]
Sec. 1.457-2 Eligible State deferred compensation plan defined.
(a) In general. For purposes of Secs. 1.457-1 through 1.457-4, an
``eligible State deferred compensation plan'' (sometimes referred to as
``eligible plan'') is a plan satisfying the requirements of paragraphs
(c) through (k) of this section.
(b) Plan. For purposes of this section and Sec. 1.457-3, the term
``plan'' includes any agreement or arrangement between a State (within
the meaning of paragraph (c) of this section) and a participant or
participants, under which the payment of compensation is deferred, but
only if such agreement or arrangement is not described in Sec. 1.457-
3(b).
(c) State. The plan must be established and maintained by a State.
For this purpose, the term ``State'' includes:
(1) The 50 states of the United States and the District of Columbia;
(2) A political subdivision of a State;
(3) Any agency or instrumentality of a State or political
subdivision of a State;
[[Page 147]]
(4) An organization that is exempt from tax under section 501(a) and
engaged primarily in providing electrical service on a mutual or
cooperative basis; and
(5) An organization that is described in section 501(c)(4) or (6)
and exempt from tax under section 501(a) and at least 80% of the members
of which are organizations described in subparagraph (4).
Where it appears in this Sec. 1.457-2, the term ``State'' means the
entity described in this paragraph (c) that sponsors the plan.
(d) Participants. The plan must provide that only individuals who
perform services for the State, either as an employee of the State or as
an independent contractor, may defer compensation under the plan.
(e) Maximum deferrals--(1) In general. The plan must provide that
the amount of compensation that may be deferred under the plan for a
taxable year of a participant shall not exceed an amount specifed in the
plan (the ``plan ceiling''). Except as described in paragraph (f) of
this section, a plan ceiling shall not exceed the lesser of:
(i) $7,500, or
(ii) 33\1/3\% of the participant's includible compensation for the
taxable year, reduced by any amount excludable from the participant's
gross income for the taxable year under section 403(b) on account of
contributions made by the State.
(2) Includible compensation. For purposes of this section, a
participant's includible compensation for a taxable year includes only
compensation from the State that is attributable to services performed
for the State and that is includible in the participant's gross income
for the taxable year. Accordingly, a participant's includible
compensation for a taxable year does not include an amount payable by
the State that is excludable from the employee's gross income under
section 457(a) and Sec. 1.457-1 or under section 403(b) (relating to
annuity contracts purchased by section 501(c)(3) organizations or public
schools), section 105(d) (relating to wage continuation plans) or
section 911 (relating to citizens or residents of the United States
living abroad). A participant's includible compensation for a taxable
year is determined without regard to any community property laws.
(3) Compensation taken into account at its present value. For
purposes of subparagraph (1) of this paragraph, compensation deferred
under a plan shall be taken into account at its value in the plan year
in which deferred. However, if the compensation deferred is subject to a
substantial risk of forfeiture (as defined in section 457(e)(3)), such
compensation shall be taken into account at its value in the plan year
in which such compensation is no longer subject to a substantial risk of
forfeiture.
(f) Limited catch-up--(1) In general. The plan may provide that, for
1 or more of the participant's last 3 taxable years ending before the
participant attains normal retirement age, the plan ceiling is an amount
not in excess of the lesser of:
(i) $15,000, reduced by any amount excludable from the participant's
gross income for the taxable year under section 403(b) on account of
contributions made by the State, or
(ii) The amount determined under subparagraph (2) of this paragraph.
(2) Underutilized limitations. The amount determined under this
subparagraph (2) is the sum of:
(i) The plan ceiling established under paragraph (e)(1) of this
section for the taxable year, plus
(ii) The plan ceiling established under paragraph (e)(1) of this
section for any prior taxable year or years, less the amount of
compensation deferred under the plan for such prior taxable year or
years.
A prior taxable year shall be taken into account under subdivision (ii)
of this subparagraph (2) only if (A) it begins after December 31, 1978,
(B) the participant was eligible to participate in the plan during all
or any portion of the taxable year, and (C) compensation deferred (if
any) under the plan during the taxable year was subject to a plan
ceiling established under paragraph (e)(1) of this section. A
participant will be considered eligible to participate in the plan for a
taxable year if the participant is described in paragraph (d) of this
section for any part of that taxable year. A prior taxable year includes
a taxable year in which the participant
[[Page 148]]
was eligible to participate in an eligible plan sponsored by a different
entity, provided that the entities sponsoring the plans are located
within the same State as that term is used in Sec. 1.457-2(c)(1).
(3) Restriction on limited catch-up. The plan shall not provide that
a participant may elect to have the limited catch-up provision of this
paragraph (f) apply more than once, whether or not the limited catch-up
is utilized in less than all of the three taxable years ending before
the participant attains normal retirement age, and whether or not the
participant or former participant rejoins the plan or participates in
another eligible plan after retirement. For example, if the participant
elects to utilize the limited catch-up only for the one taxable year
ending before normal retirement age, and, after retirement at that age,
the participant renders services for the State as an independent
contractor or otherwise, the plan may not provide that the participant
may utilize the limited catch-up for any of the taxable years subsequent
to retirement.
(4) Normal retirement age. For purposes of this paragraph (f),
normal retirement age may be specified in the plan. If no normal
retirement age is specified in the plan, then the normal retirement age
is the later of the latest normal retirement age specified in the basic
pension plan of the State, or age 65. A plan may define normal
retirement age as any range of ages ending no later than age 70\1/2\ and
beginning no earlier than the earliest age at which the participant has
the right to retire under the State's basic pension plan without consent
of the State and to receive immediate retirement benefits without
actuarial or similar reduction because of retirement before some later
specified age in the State's basic pension plan. The plan may further
provide that in the case of a participant who continues to work beyond
the ages specified in the preceding two sentences, the normal retirement
age shall be that date or age designated by the participant, but such
date or age shall not be later than the mandatory retirement age
provided by the State, or the date or age at which the participant
separates from the service with the State.
(g) Agreement for deferral. The plan must provide that, in general,
compensation is to be deferred for any calendar month only if an
agreement providing for such deferral has been entered into before the
first day of the month. However, a plan may provide that, with respect
to a new employee, compensation is to be deferred for the calendar month
during which the participant first becomes an employee, if an agreement
providing for such deferral is entered into on or before the first day
on which the participant becomes an employee.
(h) Payments under the plan--(1) In general. The plan may not
provide that amounts payable under the plan will be paid or made
available to a participant or beneficiary before the participant
separates from service with the State, or, if the plan provides for
payment in the case of an unforeseeable emergency, before the
participant incurs an unforeseeable emergency.
(2) Separation from service; general rule. An employee is separated
from service with the State if there is a separation from the service
within the meaning of section 402(e)(4)(A)(iii), relating to lump sum
distributions, and on account of the participant's death or retirement.
(3) Separation from service; independent contractor--(i) In general.
An independent contractor is considered separated from service with the
State upon the expiration of the contract (or in the case of more than
one contract, all contracts) under which services are performed for the
State, if the expiration constitutes a good-faith and complete
termination of the contractual relationship. An expiration will not
constitute a good faith and complete termination of the contractual
relationship if the State anticipates a renewal of a contractual
relationship or the independent contractor becoming an employee. For
this purpose, a State is considered to anticipate the renewal of the
contractual relationship with an independent contractor if it intends to
again contract for the services provided under the expired contract, and
neither the State nor the independent
[[Page 149]]
contractor has eliminated the independent contractor as a possible
provider of services under any such new contract. Further, a State is
considered to intend to again contract for the services provided under
an expired contract, if the State's doing so is conditioned only upon
the State's incurring a need for the services, or the availability of
funds or both.
(ii) Special rule. Notwithstanding subdivision (i), if, with respect
to amounts payable to a participant who is an independent contractor, a
plan provides that--
(A) No amount shall be paid to the participant before a date at
least 12 months after the day on which the contract expires under which
services are performed for the State (or, in the case of more than one
contract, all such contracts expire), and
(B) No amount payable to the participant on that date shall be paid
to the participant if, after the expiration of the contract (or
contracts) and before that date, the participant performs services for
the State as an independent contractor or an employee,
the plan is considered to satisfy the requirement described in
subparagraph (1) that no amounts payable under the plan will be paid or
made available to the participant before the participant separates from
service with the State.
(4) Unforeseeable emergency. For purposes of this paragraph (h), an
unforeseeable emergency is, and if the plan provides for payment in the
case of an unforeseeable emergency must be defined in the plan as,
severe financial hardship to the participant resulting from a sudden and
unexpected illness or accident of the participant or of a dependent (as
defined in section 152(a)) of the participant, loss of the participant's
property due to casualty, or other similar extraordinary and
unforeseeable circumstances arising as a result of events beyond the
control of the participant. The circumstances that will constitute an
unforeseeable emergency will depend upon the facts of each case, but, in
any case, payment may not be made to the extent that such hardship is or
may be relieved--
(i) Through reimbursement or compensation by insurance or otherwise,
(ii) By liquidation of the participant's assets, to the extent the
liquidation of such assets would not itself cause severe financial
hardship, or
(iii) By cessation of deferrals under the plan.
Examples of what are not considered to be unforeseeable emergencies
include the need to send a participant's child to college or the desire
to purchase a home.
(5) Emergency withdrawals. Withdrawals of amounts because of an
unforeseeable emergency must only be permitted to the extent reasonably
needed to satisfy the emergency need.
(i) Distributions of deferrals--(1) Commencement of distributions. A
plan is not an eligible plan unless under the plan the payment of
amounts deferred will commence not later than the later of--
(i) 60 days after the close of the plan year in which the
participant or former participant attains (or would have attained)
normal retirement age (within the meaning of Sec. 1.457-2(f)(4)), or
(ii) 60 days after the close of the plan year in which the
participant separates from service (within the meaning of Secs. 1.457-
2(h) (2) and (3)) with the State.
A plan is not other than an eligible plan merely because, prior to
October 27, 1982, the distribution of amounts deferred under the plan
may commence no later than the close of the participant's taxable year
in which the participant attains age 70\1/2\.
(2) Limitations on distributions. Distributions must be made
primarily for the benefit of participants (or former participants).
Thus, the schedule selected by the participant for payments of benefits
under the plan must be such that benefits payable to a beneficiary are
not more than incidental. For example, if provision is made for payment
of a portion of the amounts deferred to a beneficiary, the amounts
payable to the participant or former participant (as determined by use
of the expected return multiples in Sec. 1.72-9, or, in the case of
payments under a contract issued by an insurance company, by use of the
mortality tables of such company), must exceed one-half of the maximum
that could have been payable to the participant if no provision were
made for payment to a beneficiary.
[[Page 150]]
(3) Distributions to beneficiaries. A plan is not an eligible plan
unless the plan provides that, if the participant dies before the entire
amount deferred is paid to the participant, the entire amount deferred
(or the remaining part of such deferrals if payment thereof has
commenced) must be paid to a beneficiary over--
(i) The life of the beneficiary (or any shorter period), if the
beneficiary is the participant's surviving spouse, or
(ii) A period not in excess of 15 years, if the beneficiary is not
the participant's surviving spouse.
(j) Administration of plan. A plan is not an eligible plan unless
all amounts deferred under the plan, all property and rights to property
(including rights as a beneficiary of a contract providing life
insurance protection) purchased with the amounts, and all income
attributable to the amounts, property, or rights to property, remain
(until paid or made available to the participant or beneficiary under
the plan) solely the property and rights of the State (without being
restricted to the benefits under the plan) subject to the claims of the
general creditors of the State only. However, nothing in this paragraph
(j) prohibits a plan's permitting participants to direct, from among
different modes under the plan, the investment of the above amounts (see
Sec. 1.457-1(b)).
(k) Plan-to-plan transfers. The plan may provide for the transfer of
amounts deferred by a former participant to another eligible plan of
which the former participant has become a participant if the following
conditions are met--
(1) The entities sponsoring the plans are located within the same
State (as that term is used in Sec. 1.457-2(c)(1)),
(2) The plan receiving such amounts provides for the acceptance of
the amounts, and
(3) The plan provides that if the participant separates from service
in order to accept employment with another such entity, payout will not
commence upon separation from service, regardless of any other provision
of the plan, and amounts previously deferred will automatically be
transferred.
(l) Effect on plan when not administered in accordance with
paragraphs (c) through (k). A plan that is administered in a manner
which is inconsistent with one or more of the requirements of paragraphs
(c) through (k) of this section ceases to be an eligible plan on the
first day of the first plan year beginning more than 180 days after the
date of written notification by the Internal Revenue Service that the
requirements are not satisfied, unless the inconsistency is corrected
before the first day of that plan year.
(m) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. A, born on June 1, 1917, is a participant in an eligible
State deferred compensation plan providing a normal retirement age of
65. The plan provides limitations on deferrals up to the maximum
permitted under Sec. 1.457-2 (e) and (f).
For 1979, A, who will be 62, is scheduled to receive a salary of
$20,000 from the State. A desires to defer the maximun amount possible
in 1979. The maximum amount that A may defer under the plan is the
lesser of $7,500, or 33\1/3\% of A's includible compensation (generally
the equivalent of 25 percent of gross compensation). Accordingly, the
maximum that A may defer for 1979 is $5,000 [$5,000=$20,000x.25].
Although A's taxable year 1979 is one of A's last 3 taxable years before
the year in which A attains normal retirement age under the plan, A is
not able to utilize the catch-up provisions of Sec. 1.457-2(f) in 1979
because only taxable years beginning after December 31, 1978, may be
taken into account under those provisions.
Example 2. Assume the same facts as in example 1. In A's taxable
year 1980, A receives a salary of $20,000, and elects to defer only
$1,000 under the plan. In A's taxable year 1981, A again receives a
salary of $20,000 and elects to defer the maximum amount permissible
under the plan's catch-up provisions prescribed under Sec. 1.457-2(f).
The applicable limit on deferrals under the catch-up provision is the
lesser of $15,000 or the sum of the normal plan ceiling for 1981, plus
any underutilized deferrals for any taxable year before 1981. Thus, the
maximum amount that A may defer in 1981 is $9,000, the normal plan
ceiling for 1981, $5,000, plus the under-utilized deferrals for 1980,
$4,000.
Example 3. Assume the same facts as in examples 1 and 2. In A's
taxable year 1982, the year in which A will attain age 65, normal
retirement age under the plan, A desires to defer the maximum amount
possible under the plan. For 1982 the normal limitations of Sec. 1.457-
2(e) are applicable, and the maximum amount that A may defer is $5,000,
assuming that A's salary for 1982 was again $20,000. The plan's catch-up
provisions prescribed under Sec. 1.457-2(f) are not applicable because
1982 is
[[Page 151]]
not a year ending before the year in which A attains normal retirement
age.
[T.D. 7836, 47 FR 42338, Sept. 27, 1982]
Sec. 1.457-3 Tax treatment of participants where plan is not an eligible plan.
(a) In general. If a State (within the meaning of Sec. 1.457-2(c))
provides for a deferral of compensation (after the effective date
described in paragraph (c)) under any agreement or arrangement described
in Sec. 1.457-2(b) that is not an eligible plan within the meaning of
Sec. 1.457-2--
(1) Compensation deferred under the agreement or arrangement shall
be includible in the gross income of the participant of beneficiary for
the first taxable year in which there is no substantial risk of
forfeiture (within the meaning of section 457(e)(3)) of the rights to
such compensation,
(2) Earnings credited on the compensation deferred under the
agreement of arrangement shall be includible in the gross income of the
participant or beneficiary only when paid or made available, provided
that the interest of the participant or beneficiary in the assets
(including amounts deferred under the plan) of the entity sponsoring the
plan is not senior to the entity's general creditors, and
(3) Amounts paid or made available under the plan to a participant
or beneficiary shall be taxable to the participant or beneficiary under
section 72, relating to annuities.
(b) Exceptions. Paragraph (a) does not apply with respect to--
(1) A plan described in section 401(a) which includes a trust exempt
from tax under section 501(a),
(2) An annuity plan or contract described in section 403,
(3) A qualified bond purchase plan described in section 405(a),
(4) That portion of any plan which consists of a transfer of
property described in section 83, and
(5) That portion of any plan which consists of a trust to which
section 402(b) applies.
(c) Effective date. This section is effective for taxable years
beginning after December 31, 1981. For rules applicable in taxable years
beginning after December 31, 1978, and before January 1, 1982, see
Sec. 1.457-4.
[T.D. 7836, 47 FR 42341, Sept. 27, 1982; 47 FR 46497, Oct. 19, 1982]
Sec. 1.457-4 Transitional rules.
(a) In general. Subject to the limitations described in paragraphs
(b) and (c) of this section, amounts deferred (within the meaning of
Sec. 1.457-1(d)(3)) in taxable years beginning after December 31, 1978,
and before January 1, 1982 under a plan described in Sec. 1.457-2(b)
(including an eligible plan within the meaning of Sec. 1.457-2, but not
including a plan described in section 457(e)(2) and Sec. 1.457-3(b))
shall be includible in gross income only for the taxable year in which
paid or otherwise made available to the participant or other
beneficiary.
(b) General limitation. Except as described in paragraph (c) of this
section, and excluding amounts deferred in taxable years beginning
before January 1, 1979, compensation deferred under one or more plans
described in paragraph (a) of this section is excludable from a
participant's gross income under this section for a taxable year only to
the extent it does not exceed the lesser of--
(1) $7,500, or
(2) 33\1/3\% of the participant's includible compensation (within
the meaning of Sec. 1.457-2(e)(2)) for the taxable year, reduced by any
amount excludable from the participant's gross income for the taxable
year under section 403(b) on account of contributions made by the State
(within the meaning of Sec. 1.457-2(c)). For purposes of this paragraph,
compensation deferred under a plan shall be taken into account at its
value in the plan year in which deferred. However, if the compensation
deferred is subject to a substantial risk of forfeiture (as defined in
section 457(e)(3)), such compensation shall be taken into account at its
value in the plan year in which such compensation is no longer subject
to a substantial risk of forfeiture.
(c) Limited catch-up. This paragraph (c) applies if all plans
described in paragraph (a) of this section in which an individual is a
participant are eligible plans within the meaning of Sec. 1.457-2, and
the participant's taxable year is a taxable year described in section
457(b)(3) and Sec. 1.457-2(f). In such a case,
[[Page 152]]
compensation deferred under the plans for the taxable year is excluded
from gross income under paragraph (a) of this section to the extent it
does not exceed the amount determined under Sec. 1.457-1(a)(2) or, as
applicable, Sec. 1.457-1(a)(3).
(d) Example. The provisions of this section may be illustrated by
the following example:
Example. A is a participant in a State deferred compensation plan
that is not an eligible plan within the meaning of Sec. 1.457-2. The
plan provides no limitations on the amount of compensation that may be
deferred during any taxable year. For the taxable years 1979, 1980, and
1981 A has includible compensation of $40,000. In each of those years, A
has deferred $10,000 of compensation. Under the transitional rules
described in this section, $7,500 of A's deferrals in each year will be
includible in gross income in the taxable year in which paid or made
available to A or A's beneficiary. The remaining $2,500 of each year's
deferrals ($10,000 - $7,500) are includible in A's gross income for the
deferral year. Thus, $2,500 is includible in A's gross income for each
of the taxable years 1979, 1980, and 1981. The tax treatment of amounts
deferred by A in taxable years after 1981 is described in Sec. 1.457-3.
[T.D. 7836, 47 FR 42341, Sept. 27, 1982]
Sec. 1.458-1 Exclusion for certain returned magazines, paperbacks, or records.
(a) In general--(1) Introduction. For taxable years beginning after
September 30, 1979, section 458 allows accrual basis taxpayers to elect
to use a method of accounting that excludes from gross income some or
all of the income attributable to qualified sales during the taxable
year of magazines, paperbacks, or records, that are returned before the
close of the applicable merchandise return period for that taxable year.
Any amount so excluded cannot be excluded or deducted from gross income
for the taxable year in which the merchandise is returned to the
taxpayer. For the taxable year in which the taxpayer first uses this
method of accounting, the taxpayer is not allowed to exclude from gross
income amounts attributable to merchandise returns received during the
taxable year that would have been excluded from gross income for the
prior taxable year had the taxpayer used this method of accounting for
that prior year. (See paragraph (e) of this section for rules describing
how this amount should be taken into account.) The election to use this
method of accounting shall be made in accordance with the rules
contained in section 458(c) and in Sec. 1.458-2 and this section. A
taxpayer that does not elect to use this method of accounting can reduce
income for returned merchandise only for the taxable year in which the
merchandise is actually returned unsold by the purchaser.
(2) Effective date. While this section is generally effective only
for taxable years beginning after August 31, 1984, taxpayers may rely on
the provisions of paragraphs (a) through (f) of this section in taxable
years beginning after September 30, 1979.
(b) Definitions--(1) Magazine. ``Magazine'' means a publication,
usually paper-backed and sometimes illustrated, that is issued at
regular intervals and contains stories, poems, articles, features, etc.
This term includes periodicals, but does not include newspapers or
volumes of a single publication issued at various intervals. However,
volumes of a single publication that are issued at least annually, are
related by title or subject matter to a magazine, and would otherwise
qualify as a magazine, will be treated as a magazine.
(2) Paperback. ``Paperback'' means a paperback book other than a
magazine. Unlike a hardback book, which usually has stiff front and back
covers that enclose pages bound to a separate spine, a paperback book is
characterized by a flexible outer cover to which the pages of the book
are directly affixed.
(3) Record. ``Record'' means a disc, tape, or similar item on which
music, spoken or other sounds are recorded. However, the term does not
include blank records, tapes, etc., on which it is expected the ultimate
purchaser will record. The following items, provided they carry pre-
recorded sound, are examples of ``records'': audio and video cassettes,
eight-track tapes, reel-to-reel tapes, cylinders, and flat, compact, and
laser discs.
(4) Qualified sale. In order for a sale to be considered a qualified
sale, both of the following conditions must be met:
[[Page 153]]
(i) The taxpayer must be under a legal obligation (as determined by
applicable State law), at the time of sale, to adjust the sales price of
the magazine, paperback, or record on account of the purchaser's failure
to resell it; and
(ii) The taxpayer must actually adjust the sales price of the
magazine, paperback, or record to reflect the purchaser's failure to
resell the merchandise. The following are examples of adjustments to the
sales price of unsold merchandise: Cash refunds, credits to the account
of the purchaser, and repurchases of the merchandise. The adjustment
need not be equal to the full amount of the sales price of the item.
However, a markdown of the sales price under an agreement whereby the
purchaser continues to hold the merchandise for sale or other
disposition (other than solely for scrap) does not constitute an
adjustment resulting from a failure to resell.
(5) Merchandise return period--(i) In general. Unless the taxpayer
elects a shorter period, the ``merchandise return period'' is the period
that ends 2 months and 15 days after the close of the taxable year for
sales of magazines and 4 months and 15 days after the close of the
taxable year for sales of paperbacks and records.
(ii) Election to use shorter period. The taxpayer may select a
shorter merchandise return period than the applicable period set forth
in paragraph (b)(5)(i) of this section.
(iii) Change in merchandise return period. Any change in the
merchandise return period after its initial establishment will be
treated as a change in method of accounting.
(c) Amount of the exclusion--(1) In general. Except as otherwise
provided in paragraph (g) of this section, the amount of the gross
income exclusion with respect to any qualified sale is equal to the
lesser of--
(i) The amount covered by the legal obligation referred to in
paragraph (b)(4)(i) of this section; or
(ii) The amount of the adjustment agreed to by the taxpayer before
the close of the merchandise return period.
(2) Price adjustment in excess of legal obligation. The excess, if
any, of the amount described in paragraph (c)(1)(ii) of this section
over the amount described in paragraph (c)(1)(i) of this section should
be excluded in the taxable year in which it is properly accruable under
section 461.
(d) Return of the merchandise--(1) In general. (i) The exclusion
from gross income allowed by section 458 applies with respect to a
qualified sale of merchandise only if the seller receives, before the
close of the merchandise return period, either--
(A) The physical return of the merchandise; or
(B) Satisfactory evidence that the merchandise has not been and will
not be resold (as defined in paragraph (d)(2) of this section).
(ii) For purposes of this paragraph (d), evidence of a return
received by an agent of the seller (other than the purchaser who
purchased the merchandise from the seller) will be considered to be
received by the seller at the time the agent receives the merchandise or
evidence.
(2) Satisfactory evidence. Evidence that merchandise has not been
and will not be resold is satisfactory only if the seller receives--
(i) Physical return of some portion of the merchandise (e.g.,
covers) provided under either the agreement between the seller and the
purchaser or industry practice (such return evidencing the fact that the
purchaser has not and will not resell the merchandise); or
(ii) A written statement from the purchaser specifying the
quantities of each title not resold, provided either--
(A) The statement contains a representation that the items specified
will not be resold by the purchaser; or
(B) The past dealings, if any, between the parties and industry
practice indicate that such statement constitutes a promise by the
purchaser not to resell the items.
(3) Retention of evidence. In the case of a return of merchandise
(described in paragraph (d)(1)(i)(A) of this section) or portion thereof
(described in paragraph (d)(2)(i) of this section), the seller has no
obligation to retain physical evidence of the returned merchandise or
portion thereof, provided the seller maintains documentary evidence that
describes the quantity of physical
[[Page 154]]
items returned to the seller and indicates that the items were returned
before the close of the merchandise return period.
(e) Transitional adjustment--(1) In general. An election to change
from some other method of accounting for the return of magazines,
paperbacks, or records to the method of accounting described in section
458 is a change in method of accounting that requires a transitional
adjustment. Section 458 provides special rules for transitional
adjustments that must be taken into account as a result of this change.
See paragraph (e)(2) of this section for special rules applicable to
magazines and paragraphs (e) (3) and (4) of this section for special
rules applicable to paperbacks and records.
(2) Magazines: 5-year spread of decrease in taxable income. For
taxpayers who have elected to use the method of accounting described in
section 458 to account for returned magazines for a taxable year,
section 458(d) and this paragraph (e)(2) provide a special rule for
taking into account any decrease in taxable income resulting from the
adjustment required by section 481(a)(2). Under these provisions, one-
fifth of the transitional adjustment must be taken into account in the
taxable year of the change and in each of the 4 succeeding taxable
years. For example, if the application of section 481(a)(2) would
produce a decrease in taxable income of $50 for 1980, the year of
change, then $10 (one-fifth of $50) must be taken into account as a
decrease in taxable income for 1980, 1981, 1982, 1983, and 1984.
(3) Suspense account for paperbacks and records--(i) In general. For
taxpayers who have elected to use the method of accounting described in
section 458 to account for returned paperbacks and records for a taxable
year, section 458(e) provides that, in lieu of applying section 481, an
electing taxpayer must establish a separate suspense account for its
paperback business and its record business. The initial opening balance
of the suspense account is described in paragraph (e)(3)(ii)(A) of this
section. An initial adjustment to gross income for the year of election
is described in paragraph (e)(3)(ii)(B) of this section. Annual
adjustments to the suspense account are described in paragraph
(e)(3)(iii)(A) of this section. Gross income adjustments are described
in paragraph (e)(3)(iii)(B) of this section. Examples are provided in
paragraph (e)(4) of this section. The effect of the suspense account is
to defer all, or some part, of the deduction of the transitional
adjustment until the taxpayer is no longer engaged in the trade or
business of selling paperbacks or records, whichever is applicable.
(ii) Establishing a suspense account--(A) Initial opening balance.
To compute the initial opening balance of the suspense account for the
first taxable year for which an election is effective, the taxpayer must
determine the section 458 amount (as defined in paragraph (e)(3)(ii)(C)
of this section) for each of the three preceding taxable years. The
initial opening balance of the account is the largest of the section 458
amounts.
(B) Initial year adjustment. If the initial opening balance in the
suspense account exceeds the section 458 amount (as defined in paragraph
(e)(3)(ii)(C) of this section) for the taxable year immediately
preceding the year of election, the excess is included in the taxpayer's
gross income for the first taxable year for which the election was made.
(C) Section 458 amount. For purposes of paragraph (e)(3)(ii) of this
section, the section 458 amount for a taxable year is the dollar amount
of merchandise returns that would have been excluded from gross income
under section 458(a) for that taxable year if the section 458 election
had been in effect for that taxable year.
(iii) Annual adjustments--(A) Adjustment to the suspense account.
Adjustments are made to the suspense account each year to account for
fluctuations in merchandise returns. To compute the annual adjustment,
the taxpayer must determine the amount to be excluded under the election
from gross income under section 458(a) for the taxable year. If the
amount is less than the opening balance in the suspense account for the
taxable year, the balance in the suspense account is reduced by the
difference. Conversely, if the amount is greater than the opening
balance in the suspense account for the
[[Page 155]]
taxable year, the account is increased by the difference, but not to an
amount in excess of the initial opening balance described in paragraph
(e)(3)(ii)(A) of this section. Therefore, the balance in the suspense
account will never be greater than the initial opening balance in the
suspense account determined in paragraph (e)(3)(ii)(A) of this section.
However, the balance in the suspense account after adjustments may be
less than this initial opening balance in the suspense account.
(B) Gross income adjustments. Adjustments to the suspense account
for years subsequent to the year of election also produce adjustments in
the taxpayer's gross income. Adjustments which reduce the balance in the
suspense account reduce gross income for the year in which the
adjustment to the suspense account is made. Adjustments which increase
the balance in the suspense account increase gross income for the year
in which the adjustment to the suspense account is made.
(4) Example. The provisions of paragraph (e)(3) of this section may
be illustrated by the following example:
Example: (i) X corporation, a paperback distributor, makes a timely
section 458 election for its taxable year ending December 31, 1980. If
the election had been in effect for the taxable years ending on December
31, 1977, 1978, and 1979, the dollar amounts of the qualifying returns
would have been $5, $8, and $6, respectively. The initial opening
balance of X's suspense account on January 1, 1980, is $8, the largest
of these amounts. Since the initial opening balance ($8), is larger than
the qualifying returns for 1979 ($6), the initial adjustment to gross
income for 1980 is $2 ($8-$6).
(ii) X has $5 in qualifying returns for its taxable year ending
December 31, 1980. X must reduce its suspense account by $3, which is
the excess of the opening balance ($8) over the amount of qualifying
returns for the 1980 taxable year ($5). X also reduces its gross income
for 1980 by $3. Thus, the net amount excludable from gross income for
the 1980 taxable year after taking into account the qualifying returns,
the gross income adjustment, and the initial year adjustment is $6
($3+$5-$2).
(iii) X has qualifying returns of $7 for its taxable year ending
December 31, 1981. X must increase its suspense account balance by $2,
which is the excess of the amount of qualifying returns for 1981 ($7)
over X's opening balance in the suspense account ($5). X must also
increase its gross income by $2. Thus, the net income excludable from
gross income for the 1981 taxable year after taking into account the
qualifying returns and the gross income adjustment is $5 ($7-$2).
(iv) X has qualifying returns of $10 for its taxable year ending
December 31, 1982. The opening balance in X's suspense account of $7
will not be increased in excess of the initial opening balance ($8). X
must also increase gross income by $1. Thus, the net amount excludable
from gross income for the 1982 taxable year is $9 ($10-$1).
(v) This example is summarized by the following table:
----------------------------------------------------------------------------------------------------------------
Years Ending December 31
-----------------------------------------------------------------------------
1977 1978 1979 1980 \1\ 1981 1982
----------------------------------------------------------------------------------------------------------------
Facts:
Qualifying returns during $5 $8 $6 $5 $7 $10
merchandise return period for
the taxable year.............
=============================================================================
Adjustment to suspense account:
Opening balance............... ........... ........... ........... $8 $5 $7
Addition to account \2\....... ........... ........... ........... ........... 2 1
Reduction to account \3\...... ........... ........... ........... (3) ........... ...........
-----------------------------------------------------------------------------
Opening balance for next ........... ........... ........... $5 $7 $8
year.......................
=============================================================================
Amount excludable from income:
Initial year adjustment....... ........... ........... ........... $(2) ........... ...........
Amount excludable as ........... ........... ........... 5 $7 $10
qualifying returns in
merchandise return period....
Adjustment for increase in ........... ........... ........... ........... (2) (1)
suspense account.............
Adjustment for decrease in ........... ........... ........... 3 ........... ...........
suspense account.............
-----------------------------------------------------------------------------
Net amount excludable for ........... ........... ........... $6 $5 $9
the year...................
----------------------------------------------------------------------------------------------------------------
\1\ Year of Change.
[[Page 156]]
\2\ Applies when qualifying returns during the merchandise return period exceed the opening balance; the
addition is not to cause the suspense account to exceed the initial opening balance.
\3\ Applies when qualifying returns during the merchandise return period are less than the opening balance.
(f) Subchapter C transactions--(1) General rule. If a transfer of
substantially all the assets of a trade or business in which paperbacks
or records are sold is made to an acquiring corporation, and if the
acquiring corporation determines its basis in these assets, in whole or
part, with reference to the basis of these assets in the hands of the
transferor, then for the purposes of section 458(e) the principles of
section 381 and Sec. 1.381(c)(4)-1 will apply. The application of this
rule is not limited to the transactions described in section 381(a).
Thus, the rule also applies, for example, to transactions described in
section 351.
(2) Special rules. If, in the case of a transaction described in
paragraph (f)(1) of this section, an acquiring corporation acquires
assets that were used in a trade or business that was not subject to a
section 458 election from a transferor that is owned or controlled
directly (or indirectly through a chain of corporations) by the same
interests, and if the acquiring corporation uses the acquired assets in
a trade or business for which the acquiring corporation later makes an
election to use section 458, then the acquiring corporation must
establish a suspense account by taking into account not only its own
experience but also the transferor's experience when the transferor held
the assets in its trade or business. Furthermore, the transferor is not
allowed a deduction or exclusion for merchandise returned after the date
of the transfer attributable to sales made by the transferor before the
date of the transfer. Such returns shall be considered to be received by
the acquiring corporation.
(3) Example. The provisions of paragraph (f)(2) of this section may
be illustrated by the following example.
Example. Corporation S, a calendar year taxpayer, is a wholly owned
subsidiary of Corporation P, a calendar year taxpayer. On December 31,
1982, S acquires from P substantially all of the assets used in a trade
or business in which records are sold. P had not made an election under
section 458 with respect to the qualified sale of records made in
connection with that trade or business. S makes an election to use
section 458 for its taxable year ending December 31, 1983, for the trade
or business in which the acquired assets are used. P's qualified record
returns within the 4 month and 15 day merchandise return period
following the 1980 and 1981 taxable years were $150 and $170,
respectively. S's qualified record returns during the merchandise return
period following 1982 were $160. S must establish a suspense account by
taking into account both P's and S's experience for the 3 immediately
preceding taxable years. Thus, the initial opening balance of S's
suspense account is $170. S must also make an initial year adjustment of
$10 ($170--$160), which S must include in income for S's taxable year
ending December 31, 1983. P is not entitled to a deduction or exclusion
for merchandise received after the date of the transfer (December 31,
1982) attributable to sales made by the transferor before the date of
transfer. Thus, P is not entitled to a deduction or exclusion for the
$160 of merchandise received by S during the first 4 months and 15 days
of 1983.
(g) Adjustment to inventory and cost of goods sold. (1) If a
taxpayer makes adjustments to gross receipts for a taxable year under
the method of accounting described in section 458, the taxpayer, in
determining excludable gross income, is also required to make
appropriate correlative adjustments to purchases or closing inventory
and to cost of goods sold for the same taxable year. Adjustments are
appropriate, for example, where the taxpayer holds the merchandise
returned for resale or where the taxpayer is entitled to receive a price
adjustment from the person or entity that sold the merchandise to the
taxpayer. Cost of goods sold must be properly adjusted in accordance
with the provisions of Sec. 1.61-3 which provides, in pertinent part,
that gross income derived from a manufacturing or merchandising business
equals total sales less cost of goods sold.
(2) The provisions of this paragraph (g) may be illustrated by the
following examples. These examples do not, however, reflect any required
adjustments under paragraph (e)(3) of this section.
Example 1. (i) In 1986, P, a publisher, properly elects under
section 458 of the Code not to include in its gross income in the year
of sale, income attributable to qualified sales
[[Page 157]]
of paperback books returned within the specified statutory merchandise
return period of 4 months and 15 days. P and D, a distributor, agree
that P shall provide D with a full refund for paperback books that D
purchases from P and is unable to resell, provided the merchandise is
returned to P within four months following the original sale. The
agreement constitutes a legal obligation. The agreement provides that
D's return of the covers of paperback books within the first four months
following their sale constitutes satisfactory evidence that D has not
resold and will not resell the paperback books. During P's 1989 taxable
year, pursuant to the agreement, P sells D 500 paperback books for $1
each. In 1990, during the merchandise return period, D returns covers
from 100 unsold paperback books representing $100 of P's 1989 sales of
paperback books. P's cost attributable to the returned books is $25. No
adjustment to cost of goods sold is required under paragraph (g)(1) of
this section because P is not holding returned merchandise for resale.
P's proper amount excluded from its 1989 gross income under section 458
is $100.
(ii) If D returns the paperback books, rather than the covers, to P
and these same books are then held by P for resale to other customers,
paragraph (g)(1) of this section applies. Under paragraph (g)(1), P is
required to decrease its cost of goods sold by $25, the amount of P's
cost attributable to the returned merchandise. The proper amount
excluded from P's 1989 gross income under section 458 is $75, resulting
from adjustments to sales and cost of sales [(100x$1)--$25].
Example 2. (i) In 1986, D, a distributor, properly elects under
section 458 of the Code not to include in its gross income in the year
of sale, income attributable to qualified sales of paperback books
returned within the specified statutory merchandise return period of
four months and 15 days. D and R, a retailer, agree that D shall provide
a full refund for paperback books that R purchases from it and is unable
to resell. D and R also have agreed that the merchandise must be
returned to D within four months following the original sale. The
agreement constitutes a legal obligation. D is similarly entitled to a
full refund from P, the publisher, for the same paperback books. In
1990, during the merchandise return period, R returns paperback books to
D representing $100 of 1989 sales. D's cost relating to these sales is
$50. Under paragraph (g)(1) of this section, D must decrease its costs
of goods sold by $50. D's proper amount excluded from its 1989 gross
income under section 458 is $50 resulting from adjustments to sales and
costs of sales ($100--$50).
(ii) If D is instead only entitled to a 50 percent refund from P, D
is required under paragraph (g)(1) of this section to decrease its costs
of goods sold by $25, the amount of refund from P. D's proper amount
excluded from its 1989 gross income under section 458 is $75, resulting
from adjustments to sales and cost of sales ($100--$25).
[T.D. 8426, 57 FR 38596, Aug. 26, 1992; 57 FR 45879, Oct. 5, 1992]
Sec. 1.458-2 Manner of and time for making election.
(a) Scope. For taxable years beginning after September 30, 1979,
section 458 provides a special method of accounting for taxpayers who
account for sales of magazines, paperbacks, or records using an accrual
method of accounting. In order to use the special method of accounting
under section 458, a taxpayer must make an election in the manner
prescribed in this section. The election does not require the prior
consent of the Internal Revenue Service. The election is effective for
the taxable year for which it is made and for all subsequent taxable
years, unless the taxpayer secures the prior consent of the Internal
Revenue Service to revoke such election.
(b) Separate election for each trade or business. An election is
made with respect to each trade or business of a taxpayer in connection
with which qualified sales (as defined in section 458(b)(5)) of a
category of merchandise were made. Magazines, paperbacks, and records
are each treated as a separate category of merchandise. If qualified
sales of two or more categories of merchandise are made in connection
with the same trade or business, then solely for purposes of section
458, each category is treated as a separate trade or business. For
example, if a taxpayer makes qualified sales of both magazines and
paperbacks in the same trade or business, then solely for purposes of
section 458, the qualified sales relating to magazines are considered
one trade or business and the qualified sales relating to paperbacks are
considered a separate trade or business. Thus, if the taxpayer wishes to
account under section 458 for the qualified sales of both magazines and
paperbacks, such taxpayer must make a separate election for each
category.
(c) Manner of, and time for, making election. An election is made
under section 458 and this section by filing a statement of election
containing the
[[Page 158]]
information described in paragraph (d) of this section with the
taxpayer's income tax return for first taxable year for which the
election is made. The election must be made no later than the time
prescribed by law (including extensions) for filing the income tax
return for the first taxable year for which the election is made. Thus,
the election may not be filed with an amended income tax return after
the prescribed date (including extensions) for filing the original
return for such year.
(d) Required information. The statement of election required by
paragraph (c) of this section must indicate that an election is being
made under section 458(c) and must set forth the following information:
(1) The taxpayer's name, address, and identification number;
(2) A description of each trade or business for which an election is
made;
(3) The first taxable year for which an election is made for each
trade or business;
(4) The merchandise return period (as defined in section 458(b)(7))
for each trade or business for which an election is made;
(5) With respect to an election that applies to magazines, the
amount of the adjustment computed under section 481(a) resulting from
the change to the method of accounting described in section 458; and
(6) With respect to an election that applies to paperbacks or
records, the initial opening balance (computed in accordance with
section 458(e)) in the suspense account for each trade or business for
which an election is made.
The statement of election should be made on a Form 3115 which need
contain no information other than that required by this paragraph.
[T.D. 7628, 44 FR 33398, June 11, 1979. Redesignated by T.D. 8426, 57 FR
38599, Aug. 26, 1992]
Sec. 1.460-0 Outline of regulations under section 460.
This section lists the paragraphs contained in Sec. 1.460-1 through
Sec. 1.460-6.
Sec. 1.460-1 Long-term contracts.
(a) Overview.
(1) In general.
(2) Exceptions to required use of PCM.
(i) Exempt construction contract.
(ii) Qualified ship or residential construction contract.
(b) Terms.
(1) Long-term contract.
(2) Contract for the manufacture, building, installation, or
construction of property.
(i) In general.
(ii) De minimis construction activities.
(3) Allocable contract costs.
(4) Related party.
(5) Contracting year.
(6) Completion year.
(7) Contract commencement date.
(8) Incurred.
(9) Independent research and development expenses.
(10) Long-term contract methods of accounting.
(c) Entering into and completing long-term contracts.
(1) In general.
(2) Date contract entered into.
(i) In general.
(ii) Options and change orders.
(3) Date contract completed.
(i) In general.
(ii) Secondary items.
(iii) Subcontracts.
(iv) Final completion and acceptance.
(A) In general.
(B) Contingent compensation.
(C) Assembly or installation.
(D) Disputes.
(d) Allocation among activities.
(1) In general.
(2) Non-long-term contract activity.
(e) Severing and aggregating contracts.
(1) In general.
(2) Facts and circumstances.
(i) Pricing.
(ii) Separate delivery or acceptance.
(iii) Reasonable businessperson.
(3) Exceptions.
(i) Severance for PCM.
(ii) Options and change orders.
(4) Statement with return.
(f) Classifying contracts.
(1) In general.
(2) Hybrid contracts.
(i) In general.
(ii) Elections.
(3) Method of accounting.
(4) Use of estimates.
(i) Estimating length of contract.
(ii) Estimating allocable contract costs.
[[Page 159]]
(g) Special rules for activities benefitting long-term contracts of a
related party.
(1) Related party use of PCM.
(i) In general.
(ii) Exception for components and subassemblies.
(2) Total contract price.
(3) Completion factor.
(h) Effective date.
(1) In general.
(2) Change in method of accounting.
(i) [Reserved]
(j) Examples.
Sec. 1.460-2 Long-term manufacturing contracts.
(a) In general.
(b) Unique.
(1) In general.
(2) Safe harbors.
(i) Short production period.
(ii) Customized item.
(iii) Inventoried item.
(c) Normal time to complete.
(1) In general.
(2) Production by related parties.
(d) Qualified ship contracts.
(e) Examples.
Sec. 1.460-3 Long-term construction contracts.
(a) In general.
(b) Exempt construction contracts.
(1) In general.
(2) Home construction contract.
(i) In general.
(ii) Townhouses and rowhouses.
(iii) Common improvements.
(iv) Mixed use costs.
(3) $10,000,000 gross receipts test.
(i) In general.
(ii) Single employer.
(iii) Attribution of gross receipts.
(c) Residential construction contracts.
Sec. 1.460-4 Methods of accounting for long-term contracts.
(a) Overview.
(b) Percentage-of-completion method.
(1) In general.
(2) Computations.
(3) Post-completion-year income.
(4) Total contract price.
(i) In general.
(A) Definition.
(B) Contingent compensation.
(C) Non-long-term contract activities.
(ii) Estimating total contract price.
(5) Completion factor.
(i) Allocable contract costs.
(ii) Cumulative allocable contract costs.
(iii) Estimating total allocable contract costs.
(iv) Pre-contracting-year costs.
(v) Post-completion-year costs.
(6) 10-percent method.
(i) In general.
(ii) Election.
(7) Terminated contract.
(i) Reversal of income.
(ii) Adjusted basis.
(iii) Look-back method.
(c) Exempt contract methods.
(1) In general.
(2) Exempt-contract percentage-of-completion method.
(i) In general.
(ii) Determination of work performed.
(d) Completed-contract method.
(1) In general.
(2) Post-completion-year income and costs.
(3) Gross contract price.
(4) Contracts with disputed claims.
(i) In general.
(ii) Taxpayer assured of profit or loss.
(iii) Taxpayer unable to determine profit or loss.
(iv) Dispute resolved.
(e) Percentage-of-completion/capitalized-cost method.
(f) Alternative minimum taxable income.
(1) In general.
(2) Election to use regular completion factors.
(g) Method of accounting.
(h) Examples.
(i) [Reserved]
(j) Consolidated groups and controlled groups.
(1) Intercompany transactions.
(i) In general.
(ii) Definitions and nomenclature.
(2) Example.
(3) Effective dates.
(i) In general.
(ii) Prior law.
(4) Consent to change method of accounting.
(k) Mid-contract change in taxpayer.
(1) In general.
(2) Constructive completion transactions.
(i) Scope.
[[Page 160]]
(ii) Old taxpayer.
(iii) New taxpayer.
(iv) Special rules relating to distributions of certain contracts by
a partnership. [Reserved]
(3) Step-in-the-shoes transactions.
(i) Scope.
(ii) Old taxpayer.
(A) In general.
(B) Gain realized on the transaction.
(iii) New taxpayer.
(A) Method of accounting.
(B) Contract price.
(C) Contract costs.
(iv) Special rules related to certain corporate transactions.
(A) Old taxpayer--basis adjustment.
(1) In general.
(2) Basis adjustment in excess of stock basis.
(3) Subsequent dispositions of certain contracts.
(B) New taxpayer.
(1) Contract price adjustment.
(2) Basis in contract.
(v) Special rules related to certain partnership transactions.
[Reserved]
(4) Anti-abuse rule.
(5) Examples.
(6) Effective date.
Sec. 1.460-5 Cost allocation rules.
(a) Overview.
(b) Cost allocation method for contracts subject to PCM.
(1) In general.
(2) Special rules.
(i) Direct material costs.
(ii) Components and subassemblies.
(iii) Simplified production methods.
(iv) Costs identified under cost-plus long-term contracts and federal
long-term contracts.
(v) Interest.
(A) In general.
(B) Production period.
(C) Application of section 263A(f).
(vi) Research and experimental expenses.
(vii) Service costs.
(A) Simplified service cost method.
(1) In general.
(2) Example.
(B) Jobsite costs.
(C) Limitation on other reasonable cost allocation methods.
(c) Simplified cost-to-cost method for contracts subject to the PCM.
(1) In general.
(2) Election.
(d) Cost allocation rules for exempt construction contracts reported
using CCM.
(1) In general.
(2) Indirect costs.
(i) Indirect costs allocable to exempt construction contracts.
(ii) Indirect costs not allocable to exempt construction contracts.
(3) Large homebuilders.
(e) Cost allocation rules for contracts subject to the PCCM.
(f) Special rules applicable to costs allocated under this section.
(1) Nondeductible costs.
(2) Costs incurred for non-long-term contract activities.
(g) Method of accounting.
Sec. 1.460-6 Look-back method.
(a) In general.
(1) Introduction.
(2) Overview.
(b) Scope of look-back method.
(1) In general.
(2) Exceptions from section 460.
(3) De minimis exception.
(4) Alternative minimum tax.
(5) Effective date.
(c) Operation of the look-back method.
(1) Overview.
(i) In general.
(ii) Post-completion revenue and expenses.
(A) In general.
(B) Completion.
(C) Discounting of contract price and contract cost adjustments
subsequent to completion; election not to discount.
(1) General rule.
(2) Election not to discount.
(3) Year-end discounting convention.
(D) Revenue acceleration rule.
(2) Look-back Step One.
(i) Hypothetical reallocation of income among prior tax years.
(ii) Treatment of estimated future costs in year of completion.
(iii) Interim reestimates not considered.
(iv) Tax years in which income is affected.
(v) Costs incurred prior to contract execution; 10-percent method.
(A) General rule.
(B) Example.
(vi) Amount treated as contract price.
[[Page 161]]
(A) General rule.
(B) Contingencies.
(C) Change orders.
(3) Look-back Step Two: Computation of hypothetical overpayment or
underpayment of tax.
(i) In general.
(ii) Redetermination of tax liability.
(iii) Hypothetical underpayment or overpayment.
(iv) Cumulative determination of tax liability.
(v) Years affected by look-back only.
(vi) Definition of tax liability.
(4) Look-back Step Three: Calculation of interest on underpayment or
overpayment.
(i) In general.
(ii) Changes in the amount of a loss or credit carryback or carryover.
(iii) Changes in the amount of tax liability that generated a subsequent
refund.
(d) Simplified marginal impact method.
(1) Introduction.
(2) Operation.
(i) In general.
(ii) Applicable tax rate.
(iii) Overpayment ceiling.
(iv) Example.
(3) Anti-abuse rule.
(4) Application.
(i) Required use by certain pass-through entities.
(A) General rule.
(B) Closely held.
(C) Examples.
(D) Domestic contracts.
(1) General rule.
(2) Portion of contract income sourced.
(E) Application to foreign contracts.
(F) Effective date.
(ii) Elective use.
(A) General rule.
(B) Election requirements.
(C) Consolidated group consistency rule.
(e) Delayed reapplication method.
(1) In general.
(2) Time and manner of making election.
(3) Examples.
(f) Look-back reporting.
(1) Procedure.
(2) Treatment of interest on return.
(i) General rule.
(ii) Timing of look-back interest.
(3) Statutes of limitations and compounding of interest on look-back
interest.
(g) Mid-contract change in taxpayer.
(1) In general.
(2) Constructive completion transactions.
(3) Step-in-the-shoes transactions.
(i) General rules.
(ii) Application of look-back method to pre-transaction period.
(A) Contract Price
(B) Method.
(C) Interest accrual period.
(D) Information old taxpayer must provide.
(iii) Application of look-back method to post-transaction years.
(iv) S corporation elections.
(4) Effective date.
(h) Examples.
(1) Overview.
(2) Step One.
(3) Step Two.
(4) Post-completion adjustments.
(5) Alternative minimum tax.
(6) Credit carryovers.
(7) Net operating losses.
(8) Alternative minimum tax credit.
(9) Period for interest.
(i) [Reserved]
(j) Election not to apply look-back method in de minimis cases.
[T.D. 9315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8597, 60 FR
36683, July 18, 1995; T.D. 8756, 63 FR 1918, Jan. 13, 1998; T.D. 8775,
63 FR 36181, July 2, 1998; T.D. 8929, 66 FR 2224, Jan. 11, 2001; T.D.
8995, 67 FR 34605, May 15, 2002]
Sec. 1.460-1 Long-term contracts.
(a) Overview--(1) In general. This section provides rules for
determining whether a contract for the manufacture, building,
installation, or construction of property is a long-term contract under
section 460 and what activities must be accounted for as a single long-
term contract. Specific rules for long-term manufacturing and
construction contracts are provided in Secs. 1.460-2 and 1.460-3,
respectively. A taxpayer generally must determine the income from a
long-term contract using the percentage-of-completion method described
in Sec. 1.460-4(b) (PCM) and the cost allocation rules described in
Sec. 1.460-5(b) or (c). In addition, after a
[[Page 162]]
contract subject to the PCM is completed, a taxpayer generally must
apply the look-back method described in Sec. 1.460-6 to determine the
amount of interest owed on any hypothetical underpayment of tax, or
earned on any hypothetical overpayment of tax, attributable to
accounting for the long-term contract under the PCM.
(2) Exceptions to required use of PCM--(i) Exempt construction
contract. The requirement to use the PCM does not apply to any exempt
construction contract described in Sec. 1.460-3(b). Thus, a taxpayer may
determine the income from an exempt construction contract using any
accounting method permitted by Sec. 1.460-4(c) and, for contracts
accounted for using the completed-contract method (CCM), any cost
allocation method permitted by Sec. 1.460-5(d). Exempt construction
contracts that are not subject to the PCM or CCM are not subject to the
cost allocation rules of Sec. 1.460-5 except for the production-period
interest rules of Sec. 1.460-5(b)(2)(v). Exempt construction contractors
that are large homebuilders described in Sec. 1.460-5(d)(3) must
capitalize costs under section 263A. All other exempt construction
contractors must account for the cost of construction using the
appropriate rules contained in other sections of the Internal Revenue
Code or regulations.
(ii) Qualified ship or residential construction contract. The
requirement to use the PCM applies only to a portion of a qualified ship
contract described in Sec. 1.460-2(d) or residential construction
contract described in Sec. 1.460-3(c). A taxpayer generally may
determine the income from a qualified ship contract or residential
construction contract using the percentage-of-completion/capitalized-
cost method (PCCM) described in Sec. 1.460-4(e), but must use a cost
allocation method described in Sec. 1.460-5(b) for the entire contract.
(b) Terms--(1) Long-term contract. A long-term contract generally is
any contract for the manufacture, building, installation, or
construction of property if the contract is not completed within the
contracting year, as defined in paragraph (b)(5) of this section.
However, a contract for the manufacture of property is a long-term
contract only if it also satisfies either the unique item or 12-month
requirements described in Sec. 1.460-2. A contract for the manufacture
of personal property is a manufacturing contract. In contrast, a
contract for the building, installation, or construction of real
property is a construction contract.
(2) Contract for the manufacture, building, installation, or
construction of property--(i) In general. A contract is a contract for
the manufacture, building, installation, or construction of property if
the manufacture, building, installation, or construction of property is
necessary for the taxpayer's contractual obligations to be fulfilled and
if the manufacture, building, installation, or construction of that
property has not been completed when the parties enter into the
contract. If a taxpayer has to manufacture or construct an item to
fulfill its obligations under the contract, the fact that the taxpayer
is not required to deliver that item to the customer is not relevant.
Whether the customer has title to, control over, or bears the risk of
loss from, the property manufactured or constructed by the taxpayer also
is not relevant. Furthermore, how the parties characterize their
agreement (e.g., as a contract for the sale of property) is not
relevant.
(ii) De minimis construction activities. Notwithstanding paragraph
(b)(2)(i) of this section, a contract is not a construction contract
under section 460 if the contract includes the provision of land by the
taxpayer and the estimated total allocable contract costs, as defined in
paragraph (b)(3) of this section, attributable to the taxpayer's
construction activities are less than 10 percent of the contract's total
contract price, as defined in Sec. 1.460-4(b)(4)(i). For the purposes of
this paragraph (b)(2)(ii), the allocable contract costs attributable to
the taxpayer's construction activities do not include the cost of the
land provided to the customer. In addition, a contract's estimated total
allocable contract costs include a proportionate share of the estimated
cost of any common improvement that benefits the subject matter of the
contract if the taxpayer is contractually obligated, or required by law,
to construct the common improvement.
[[Page 163]]
(3) Allocable contract costs. Allocable contract costs are costs
that are allocable to a long-term contract under Sec. 1.460-5.
(4) Related party. A related party is a person whose relationship to
a taxpayer is described in section 707(b) or 267(b), determined without
regard to section 267(f)(1)(A) and determined by replacing ``at least 80
percent'' with ``more than 50 percent'' for the purposes of determining
the ownership of the stock of a corporation in sections 267(b)(2), (8),
(10)(A), and (12).
(5) Contracting year. The contracting year is the taxable year in
which a taxpayer enters into a contract as described in paragraph (c)(2)
of this section.
(6) Completion year. The completion year is the taxable year in
which a taxpayer completes a contract as described in paragraph (c)(3)
of this section.
(7) Contract commencement date. The contract commencement date is
the date that a taxpayer or related party first incurs any allocable
contract costs, such as design and engineering costs, other than
expenses attributable to bidding and negotiating activities. Generally,
the contract commencement date is relevant in applying Sec. 1.460-
6(b)(3) (concerning the de minimis exception to the look-back method
under section 460(b)(3)(B)); Sec. 1.460-5(b)(2)(v)(B)(1)(i) (concerning
the production period subject to interest allocation); Sec. 1.460-2(d)
(concerning qualified ship contracts); and Sec. 1.460-3(b)(1)(ii)
(concerning the construction period for exempt construction contracts).
(8) Incurred. Incurred has the meaning given in Sec. 1.461-1(a)(2)
(concerning the taxable year a liability is incurred under the accrual
method of accounting), regardless of a taxpayer's overall method of
accounting. See Sec. 1.461-4(d)(2)(ii) for economic performance rules
concerning the PCM.
(9) Independent research and development expenses. Independent
research and development expenses are any expenses incurred in the
performance of research or development, except that this term does not
include any expenses that are directly attributable to a particular
long-term contract in existence when the expenses are incurred and this
term does not include any expenses under an agreement to perform
research or development.
(10) Long-term contract methods of accounting. Long-term contract
methods of accounting, which include the PCM, the CCM, the PCCM, and the
exempt-contract percentage-of-completion method (EPCM), are methods of
accounting that may be used only for long-term contracts.
(c) Entering into and completing long-term contracts--(1) In
general. To determine when a contract is entered into under paragraph
(c)(2) of this section and completed under paragraph (c)(3) of this
section, a taxpayer must consider all relevant allocable contract costs
incurred and activities performed by itself, by related parties on its
behalf, and by the customer, that are incident to or necessary for the
long-term contract. In addition, to determine whether a contract is
completed in the contracting year, the taxpayer may not consider when it
expects to complete the contract.
(2) Date contract entered into--(i) In general. A taxpayer enters
into a contract on the date that the contract binds both the taxpayer
and the customer under applicable law, even if the contract is subject
to unsatisfied conditions not within the taxpayer's control (such as
obtaining financing). If a taxpayer delays entering into a contract for
a principal purpose of avoiding section 460, however, the taxpayer will
be treated as having entered into a contract not later than the contract
commencement date.
(ii) Options and change orders. A taxpayer enters into a new
contract on the date that the customer exercises an option or similar
provision in a contract if that option or similar provision must be
severed from the contract under paragraph (e) of this section.
Similarly, a taxpayer enters into a new contract on the date that it
accepts a change order or other similar agreement if the change order or
other similar agreement must be severed from the contract under
paragraph (e) of this section.
(3) Date contract completed--(i) In general. A taxpayer's contract
is completed upon the earlier of--
[[Page 164]]
(A) Use of the subject matter of the contract by the customer for
its intended purpose (other than for testing) and at least 95 percent of
the total allocable contract costs attributable to the subject matter
have been incurred by the taxpayer; or
(B) Final completion and acceptance of the subject matter of the
contract.
(ii) Secondary items. The date a contract accounted for using the
CCM is completed is determined without regard to whether one or more
secondary items have been used or finally completed and accepted. If any
secondary items are incomplete at the end of the taxable year in which
the primary subject matter of a contract is completed, the taxpayer must
separate the portion of the gross contract price and the allocable
contract costs attributable to the incomplete secondary item(s) from the
completed contract and account for them using a permissible method of
accounting. A permissible method of accounting includes a long-term
contract method of accounting only if a separate contract for the
secondary item(s) would be a long-term contract, as defined in paragraph
(b)(1) of this section.
(iii) Subcontracts. In the case of a subcontract, a subcontractor's
customer is the general contractor. Thus, the subject matter of the
subcontract is the relevant subject matter under paragraph (c)(3)(i) of
this section.
(iv) Final completion and acceptance--(A) In general. Except as
otherwise provided in this paragraph (c)(3)(iv), to determine whether
final completion and acceptance of the subject matter of a contract have
occurred, a taxpayer must consider all relevant facts and circumstances.
Nevertheless, a taxpayer may not delay the completion of a contract for
the principal purpose of deferring federal income tax.
(B) Contingent compensation. Final completion and acceptance is
determined without regard to any contractual term that provides for
additional compensation that is contingent on the successful performance
of the subject matter of the contract. A taxpayer must account for all
contingent compensation that is not includible in total contract price
under Sec. 1.460-4(b)(4)(i), or in gross contract price under
Sec. 1.460-4(d)(3), using a permissible method of accounting. For
application of the look-back method for contracts accounted for using
the PCM, see Sec. 1.460-6(c)(1)(ii) and (2)(vi).
(C) Assembly or installation. Final completion and acceptance is
determined without regard to whether the taxpayer has an obligation to
assist or supervise assembly or installation of the subject matter of
the contract where the assembly or installation is not performed by the
taxpayer or a related party. A taxpayer must account for the gross
receipts and costs attributable to such an obligation using a
permissible method of accounting, other than a long-term contract
method.
(D) Disputes. Final completion and acceptance is determined without
regard to whether a dispute exists at the time the taxpayer tenders the
subject matter of the contract to the customer. For contracts accounted
for using the CCM, see Sec. 1.460-4(d)(4). For application of the look-
back method for contracts accounted for using the PCM, see Sec. 1.460-
6(c)(1)(ii) and (2)(vi).
(d) Allocation among activities--(1) In general. Long-term contract
methods of accounting apply only to the gross receipts and costs
attributable to long-term contract activities. Gross receipts and costs
attributable to long-term contract activities means amounts included in
total contract price or gross contract price, whichever is applicable,
as determined under Sec. 1.460-4, and costs allocable to the contract,
as determined under Sec. 1.460-5. Gross receipts and costs attributable
to non-long-term contract activities (as defined in paragraph (d)(2) of
this section) generally must be taken into account using a permissible
method of accounting other than a long-term contract method. See section
446(c) and Sec. 1.446-1(c). However, if the performance of a non-long-
term contract activity is incident to or necessary for the manufacture,
building, installation, or construction of the subject matter of one or
more of the taxpayer's long-term contracts, the gross receipts and costs
attributable to that activity must be allocated to the long-term
contract(s) benefitted as provided in Secs. 1.460-4(b)(4)(i) and 1.460-
5(f)(2), respectively.
[[Page 165]]
Similarly, if a single long-term contract requires a taxpayer to perform
a non-long-term contract activity that is not incident to or necessary
for the manufacture, building, installation, or construction of the
subject matter of the long-term contract, the gross receipts and costs
attributable to that non-long-term contract activity must be separated
from the contract and accounted for using a permissible method of
accounting other than a long-term contract method. But see paragraph (g)
of this section for related party rules.
(2) Non-long-term contract activity. Non-long-term contract activity
means the performance of an activity other than manufacturing, building,
installation, or construction, such as the provision of architectural,
design, engineering, and construction management services, and the
development or implementation of computer software. In addition,
performance under a guaranty, warranty, or maintenance agreement is a
non-long-term contract activity that is never incident to or necessary
for the manufacture or construction of property under a long-term
contract.
(e) Severing and aggregating contracts--(1) In general. After
application of the allocation rules of paragraph (d) of this section,
the severing and aggregating rules of this paragraph (e) may be applied
by the Commissioner or the taxpayer as necessary to clearly reflect
income (e.g., to prevent the unreasonable deferral (or acceleration) of
income or the premature recognition (or deferral) of loss). Under the
severing and aggregating rules, one agreement may be treated as two or
more contracts, and two or more agreements may be treated as one
contract. Except as provided in paragraph (e)(3)(ii) of this section, a
taxpayer must determine whether to sever an agreement or to aggregate
two or more agreements based on the facts and circumstances known at the
end of the contracting year.
(2) Facts and circumstances. Whether an agreement should be severed,
or two or more agreements should be aggregated, depends on the following
factors:
(i) Pricing. Independent pricing of items in an agreement is
necessary for the agreement to be severed into two or more contracts. In
the case of an agreement for similar items, if the price to be paid for
the items is determined under different terms or formulas (e.g., if some
items are priced under a cost-plus incentive fee arrangement and later
items are to be priced under a fixed-price arrangement), then the
difference in the pricing terms or formulas indicates that the items are
independently priced. Similarly, interdependent pricing of items in
separate agreements is necessary for two or more agreements to be
aggregated into one contract. A single price negotiation for similar
items ordered under one or more agreements indicates that the items are
interdependently priced.
(ii) Separate delivery or acceptance. An agreement may not be
severed into two or more contracts unless it provides for separate
delivery or separate acceptance of items that are the subject matter of
the agreement. However, the separate delivery or separate acceptance of
items by itself does not necessarily require an agreement to be severed.
(iii) Reasonable businessperson. Two or more agreements to perform
manufacturing or construction activities may not be aggregated into one
contract unless a reasonable businessperson would not have entered into
one of the agreements for the terms agreed upon without also entering
into the other agreement(s). Similarly, an agreement to perform
manufacturing or construction activities may not be severed into two or
more contracts if a reasonable businessperson would not have entered
into separate agreements containing terms allocable to each severed
contract. Analyzing the reasonable businessperson standard requires an
analysis of all the facts and circumstances of the business arrangement
between the taxpayer and the customer. For purposes of this paragraph
(e)(2)(iii), a taxpayer's expectation that the parties would enter into
another agreement, when agreeing to the terms contained in the first
agreement, is not relevant.
(3) Exceptions--(i) Severance for PCM. A taxpayer may not sever
under this paragraph (e) a long-term contract that would be subject to
the PCM without obtaining the Commissioner's prior written consent.
[[Page 166]]
(ii) Options and change orders. Except as provided in paragraph
(e)(3)(i) of this section, a taxpayer must sever an agreement that
increases the number of units to be supplied to the customer, such as
through the exercise of an option or the acceptance of a change order,
if the agreement provides for separate delivery or separate acceptance
of the additional units.
(4) Statement with return. If a taxpayer severs an agreement or
aggregates two or more agreements under this paragraph (e) during the
taxable year, the taxpayer must attach a statement to its original
federal income tax return for that year. This statement must contain the
following information--
(i) The legend NOTIFICATION OF SEVERANCE OR AGGREGATION UNDER SEC.
1.460-1(e);
(ii) The taxpayer's name; and
(iii) The taxpayer's employer identification number or social
security number.
(f) Classifying contracts--(1) In general. After applying the
severing and aggregating rules of paragraph (e) of this section, a
taxpayer must determine the classification of a contract (e.g., as a
long-term manufacturing contract, long-term construction contract, non-
long-term contract) based on all the facts and circumstances known no
later than the end of the contracting year. Classification is determined
on a contract-by-contract basis. Consequently, a requirement to
manufacture a single unique item under a long-term contract will subject
all other items in that contract to section 460.
(2) Hybrid contracts--(i) In general. A long-term contract that
requires a taxpayer to perform both manufacturing and construction
activities (hybrid contract) generally must be classified as two
contracts, a manufacturing contract and a construction contract. A
taxpayer may elect, on a contract-by-contract basis, to classify a
hybrid contract as a long-term construction contract if at least 95
percent of the estimated total allocable contract costs are reasonably
allocable to construction activities. In addition, a taxpayer may elect,
on a contract-by-contract basis, to classify a hybrid contract as a
long-term manufacturing contract subject to the PCM.
(ii) Elections. A taxpayer makes an election under this paragraph
(f)(2) by using its method of accounting for similar construction
contracts or for manufacturing contracts, whichever is applicable, to
account for a hybrid contract entered into during the taxable year of
the election on its original federal income tax return for the election
year. If an electing taxpayer's method is the PCM, the taxpayer also
must use the PCM to apply the look-back method under Sec. 1.460-6 and to
determine alternative minimum taxable income under Sec. 1.460-4(f).
(3) Method of accounting. Except as provided in paragraph (f)(2)(ii)
of this section, a taxpayer's method of classifying contracts is a
method of accounting under section 446 and, thus, may not be changed
without the Commissioner's consent. If a taxpayer's method of
classifying contracts is unreasonable, that classification method is an
impermissible accounting method.
(4) Use of estimates--(i) Estimating length of contract. A taxpayer
must use a reasonable estimate of the time required to complete a
contract when necessary to classify the contract (e.g., to determine
whether the five-year completion rule for qualified ship contracts under
Sec. 1.460-2(d), or the two-year completion rule for exempt construction
contracts under Sec. 1.460-3(b), is satisfied, but not to determine
whether a contract is completed within the contracting year under
paragraph (b)(1) of this section). To be considered reasonable, an
estimate of the time required to complete the contract must include
anticipated time for delay, rework, change orders, technology or design
problems, or other problems that reasonably can be anticipated
considering the nature of the contract and prior experience. A contract
term that specifies an expected completion or delivery date may be
considered evidence that the taxpayer reasonably expects to complete or
deliver the subject matter of the contract on or about the date
specified, especially if the contract provides bona fide penalties for
failing to meet the specified date. If a taxpayer classifies a contract
based on a
[[Page 167]]
reasonable estimate of completion time, the contract will not be
reclassified based on the actual (or another reasonable estimate of)
completion time. A taxpayer's estimate of completion time will not be
considered unreasonable if a contract is not completed within the
estimated time primarily because of unforeseeable factors not within the
taxpayer's control, such as third-party litigation, extreme weather
conditions, strikes, or delays in securing permits or licenses.
(ii) Estimating allocable contract costs. A taxpayer must use a
reasonable estimate of total allocable contract costs when necessary to
classify the contract (e.g., to determine whether a contract is a home
construction contract under Sec. 1.460-(3)(b)(2)). If a taxpayer
classifies a contract based on a reasonable estimate of total allocable
contract costs, the contract will not be reclassified based on the
actual (or another reasonable estimate of) total allocable contract
costs.
(g) Special rules for activities benefitting long-term contracts of
a related party--(1) Related party use of PCM--(i) In general. Except as
provided in paragraph (g)(1)(ii) of this section, if a related party and
its customer enter into a long-term contract subject to the PCM, and a
taxpayer performs any activity that is incident to or necessary for the
related party's long-term contract, the taxpayer must account for the
gross receipts and costs attributable to this activity using the PCM,
even if this activity is not otherwise subject to section 460(a). This
type of activity may include, for example, the performance of
engineering and design services, and the production of components and
subassemblies that are reasonably expected to be used in the production
of the subject matter of the related party's contract.
(ii) Exception for components and subassemblies. A taxpayer is not
required to use the PCM under this paragraph (g) to account for a
component or subassembly that benefits a related party's long-term
contract if more than 50 percent of the average annual gross receipts
attributable to the sale of this item for the 3-taxable-year-period
ending with the contracting year comes from unrelated parties.
(2) Total contract price. If a taxpayer is required to use the PCM
under paragraph (g)(1)(i) of this section, the total contract price (as
defined in Sec. 1.460-4(b)(4)(i)) is the fair market value of the
taxpayer's activity that is incident to or necessary for the performance
of the related party's long-term contract. The related party also must
use the fair market value of the taxpayer's activity as the cost it
incurs for the activity. The fair market value of the taxpayer's
activity may or may not be the same as the amount the related party pays
the taxpayer for that activity.
(3) Completion factor. To compute a contract's completion factor (as
described in Sec. 1.460-4(b)(5)), the related party must take into
account the fair market value of the taxpayer's activity that is
incident to or necessary for the performance of the related party's
long-term contract when the related party incurs the liability to the
taxpayer for the activity, rather than when the taxpayer incurs the
costs to perform the activity.
(h) Effective date--(1) In general. Except as otherwise provided,
this section and Secs. 1.460-2 through 1.460-5 are applicable for
contracts entered into on or after January 11, 2001.
(2) Change in method of accounting. Any change in a taxpayer's
method of accounting necessary to comply with this section and
Secs. 1.460-2 through 1.460-5 is a change in method of accounting to
which the provisions of section 446 and the regulations thereunder
apply. For the first taxable year that includes January 11, 2001, a
taxpayer is granted the consent of the Commissioner to change its method
of accounting to comply with the provisions of this section and
Secs. 1.460-2 through 1.460-5 for long-term contracts entered into on or
after January 11, 2001. A taxpayer that wants to change its method of
accounting under this paragraph (h)(2) must follow the automatic consent
procedures in Rev. Proc. 99-49 (1999-52 I.R.B. 725) (see
Sec. 601.601(d)(2) of this chapter), except that the scope limitations
in section 4.02 of Rev. Proc. 99-49 do not apply. Because a change under
this paragraph (h)(2) is made on a cut-off basis, a section 481(a)
adjustment is not permitted or required. Moreover, the
[[Page 168]]
taxpayer does not receive audit protection under section 7 of Rev. Proc.
99-49 for a change in method of accounting under this paragraph (h)(2).
A taxpayer that wants to change its exempt-contract method of accounting
is not granted the consent of the Commissioner under this paragraph
(h)(2) and must file a Form 3115, ``Application for Change in Accounting
Method,'' to obtain consent. See Rev. Proc. 97-27 (1997-1 C.B. 680) (see
Sec. 601.601(d)(2) of this chapter).
(i) [Reserved]
(j) Examples. The following examples illustrate the rules of this
section:
Example 1. Contract for manufacture of property. B notifies C, an
aircraft manufacturer, that it wants to purchase an aircraft of a
particular type. At the time C receives the order, C has on hand several
partially completed aircraft of this type; however, C does not have any
completed aircraft of this type on hand. C and B agree that B will
purchase one of these aircraft after it has been completed. C retains
title to and risk of loss with respect to the aircraft until the sale
takes place. The agreement between C and B is a contract for the
manufacture of property under paragraph (b)(2)(i) of this section, even
if labeled as a contract for the sale of property, because the
manufacture of the aircraft is necessary for C's obligations under the
agreement to be fulfilled and the manufacturing was not complete when B
and C entered into the agreement.
Example 2. De minimis construction activity. C, a master developer
whose taxable year ends December 31, owns 5,000 acres of undeveloped
land with a cost basis of $5,000,000 and a fair market value of
$50,000,000. To obtain permission from the local county government to
improve this land, a service road must be constructed on this land to
benefit all 5,000 acres. In 2001, C enters into a contract to sell a
1,000-acre parcel of undeveloped land to B, a residential developer, for
its fair market value, $10,000,000. In this contract, C agrees to
construct a service road running through the land that C is selling to B
and through the 4,000 adjacent acres of undeveloped land that C has sold
or will sell to other residential developers for its fair market value,
$40,000,000. C reasonably estimates that it will incur allocable
contract costs of $50,000 (excluding the cost of the land) to construct
this service road, which will be owned and maintained by the county. C
must reasonably allocate the cost of the service road among the
benefitted parcels. The portion of the estimated total allocable
contract costs that C allocates to the 1,000-acre parcel being sold to B
(based upon its fair market value) is $10,000 ($50,000x($10,000,000/
$50,000,000)). Construction of the service road is finished in 2002.
Because the estimated total allocable contract costs attributable to C's
construction activities, $10,000, are less than 10 percent of the
contract's total contract price, $10,000,000, C's contract with B is not
a construction contract under paragraph (b)(2)(ii) of this section.
Thus, C's contract with B is not a long-term contract under paragraph
(b)(2)(i) of this section, notwithstanding that construction of the
service road is not completed in 2001.
Example 3. Completion--customer use. In 2002, C, whose taxable year
ends December 31, enters into a contract to construct a building for B.
In November of 2003, the building is completed in every respect
necessary for its intended use, and B occupies the building. In early
December of 2003, B notifies C of some minor deficiencies that need to
be corrected, and C agrees to correct them in January 2004. C reasonably
estimates that the cost of correcting these deficiencies will be less
than five percent of the total allocable contract costs. C's contract is
complete under paragraph (c)(3)(i)(A) of this section in 2003 because in
that year, B used the building and C had incurred at least 95 percent of
the total allocable contract costs attributable to the building. C must
use a permissible method of accounting for any deficiency-related costs
incurred after 2003.
Example 4. Completion--customer use. In 2001, C, whose taxable year
ends December 31, agrees to construct a shopping center, which includes
an adjoining parking lot, for B. By October 2002, C has finished
constructing the retail portion of the shopping center. By December
2002, C has graded the entire parking lot, but has paved only one-fourth
of it because inclement weather conditions prevented C from laying
asphalt on the remaining three-fourths. In December 2002, B opens the
retail portion of the shopping center and the paved portion of the
parking lot to the general public. C reasonably estimates that the cost
of paving the remaining three-fourths of the parking lot when weather
permits will exceed five percent of C's total allocable contract costs.
Even though B is using the subject matter of the contract, C's contract
is not completed in December 2002 under paragraph (c)(3)(i)(A) of this
section because C has not incurred at least 95 percent of the total
allocable contract costs attributable to the subject matter.
Example 5. Completion--customer use. In 2001, C, whose taxable year
ends December 31, agrees to manufacture 100 machines for B. By December
31, 2002, C has delivered 99 of the machines to B. C reasonably
estimates that the cost of finishing the related work on the contract
will be less than five percent of the total allocable contract costs.
C's contract is not complete under paragraph (c)(3)(i)(A) of this
section in 2002 because in
[[Page 169]]
that year, B is not using the subject matter of the contract (all 100
machines) for its intended purpose.
Example 6. Non-long-term contract activity. On January 1, 2001, C,
whose taxable year ends December 31, enters into a single long-term
contract to design and manufacture a satellite and to develop computer
software enabling B to operate the satellite. At the end of 2001, C has
not finished manufacturing the satellite. Designing the satellite and
developing the computer software are non-long-term contract activities
that are incident to and necessary for the taxpayer's manufacturing of
the subject matter of a long-term contract because the satellite could
not be manufactured without the design and would not operate without the
software. Thus, under paragraph (d)(1) of this section, C must allocate
these non-long-term contract activities to the long-term contract and
account for the gross receipts and costs attributable to designing the
satellite and developing computer software using the PCM.
Example 7. Non-long-term contract activity. C agrees to manufacture
equipment for B under a long-term contract. In a separate contract, C
agrees to design the equipment being manufactured for B under the long-
term contract. Under paragraph (d)(1) of this section, C must allocate
the gross receipts and costs related to the design to the long-term
contract because designing the equipment is a non-long-term contract
activity that is incident to and necessary for the manufacture of the
subject matter of the long-term contract.
Example 8. Severance. On January 1, 2001, C, a construction
contractor, and B, a real estate investor, enter into an agreement
requiring C to build two office buildings in different areas of a large
city. The agreement provides that the two office buildings will be
completed by C and accepted by B in 2002 and 2003, respectively, and
that C will be paid $1,000,000 and $1,500,000 for the two office
buildings, respectively. The agreement will provide C with a reasonable
profit from the construction of each building. Unless C is required to
use the PCM to account for the contract, C is required to sever this
contract under paragraph (e)(2) of this section because the buildings
are independently priced, the agreement provides for separate delivery
and acceptance of the buildings, and, as each building will generate a
reasonable profit, a reasonable businessperson would have entered into
separate agreements for the terms agreed upon for each building.
Example 9. Severance. C, a large construction contractor whose
taxable year ends December 31, accounts for its construction contracts
using the PCM and has elected to use the 10-percent method described in
Sec. 1.460-4(b)(6). In September 2001, C enters into an agreement to
construct four buildings in four different cities. The buildings are
independently priced and the contract provides a reasonable profit for
each of the buildings. In addition, the agreement requires C to complete
one building per year in 2002, 2003, 2004, and 2005. As of December 31,
2001, C has incurred 25 percent of the estimated total allocable
contract costs attributable to one of the buildings, but only five
percent of the estimated total allocable contract costs attributable to
all four buildings included in the agreement. C does not request the
Commissioner's consent to sever this contract. Using the 10-percent
method, C does not take into account any portion of the total contract
price or any incurred allocable contract costs attributable to this
agreement in 2001. Upon examination of C's 2001 tax return, the
Commissioner determines that C entered into one agreement for four
buildings rather than four separate agreements each for one building
solely to take advantage of the deferral obtained under the 10-percent
method. Consequently, to clearly reflect the taxpayer's income, the
Commissioner may require C to sever the agreement into four separate
contracts under paragraph (e)(2) of this section because the buildings
are independently priced, the agreement provides for separate delivery
and acceptance of the buildings, and a reasonable businessperson would
have entered into separate agreements for these buildings.
Example 10. Aggregation. In 2001, C, a shipbuilder, enters into two
agreements with the Department of the Navy as the result of a single
negotiation. Each agreement obligates C to manufacture a submarine.
Because the submarines are of the same class, their specifications are
similar. Because C has never manufactured submarines of this class,
however, C anticipates that it will incur substantially higher costs to
manufacture the first submarine, to be delivered in 2007, than to
manufacture the second submarine, to be delivered in 2010. If the
agreements are treated as separate contracts, the first contract
probably will produce a substantial loss, while the second contract
probably will produce substantial profit. Based upon these facts,
aggregation is required under paragraph (e)(2) of this section because
the submarines are interdependently priced and a reasonable
businessperson would not have entered the first agreement without also
entering into the second.
Example 11. Aggregation. In 2001, C, a manufacturer of aircraft and
related equipment, agrees to manufacture 10 military aircraft for
foreign government B and to deliver the aircraft by the end of 2003.
When entering into the agreement, C anticipates that it might receive
production orders from B over the next 20 years for as many as 300 more
of these aircraft. The negotiated contract price reflects C's and B's
consideration of the expected total cost of manufacturing the 10
[[Page 170]]
aircraft, the risks and opportunities associated with the agreement, and
the additional factors the parties considered relevant. The negotiated
price provides a profit on the sale of the 10 aircraft even if C does
not receive any additional production orders from B. It is unlikely,
however, that C actually would have wanted to manufacture the 10
aircraft but for the expectation that it would receive additional
production orders from B. In 2003, B accepts delivery of the 10
aircraft. At that time, B orders an additional 20 aircraft of the same
type for delivery in 2007. When negotiating the price for the additional
20 aircraft, C and B consider the fact that the expected unit cost for
this production run of 20 aircraft will be lower than the unit cost of
the 10 aircraft completed and accepted in 2003, but substantially higher
than the expected unit cost of future production runs. Based upon these
facts, aggregation is not permitted under paragraph (e)(2) of this
section. Because the parties negotiated the prices of both agreements
considering only the expected production costs and risks for each
agreement standing alone, the terms and conditions agreed upon for the
first agreement are independent of the terms and conditions agreed upon
for the second agreement. The fact that the agreement to manufacture 10
aircraft provides a profit for C indicates that a reasonable
businessperson would have entered into that agreement without entering
into the agreement to manufacture the additional 20 aircraft.
Example 12. Classification and completion. In 2001, C, whose taxable
year ends December 31, agrees to manufacture and install an industrial
machine for B. C elects under paragraph (f) of this section to classify
the agreement as a long-term manufacturing contract and to account for
it using the PCM. The agreement requires C to deliver the machine in
August 2003 and to install and test the machine in B's factory. In
addition, the agreement requires B to accept the machine when the tests
prove that the machine's performance will satisfy the environmental
standards set by the Environmental Protection Agency (EPA), even if B
has not obtained the required operating permit. Because of technical
difficulties, C cannot deliver the machine until December 2003, when B
conditionally accepts delivery. C installs the machine in December 2003
and then tests it through February 2004. B accepts the machine in
February 2004, but does not obtain the operating permit from the EPA
until January 2005. Under paragraph (c)(3)(i)(B) of this section, C's
contract is finally completed and accepted in February 2004, even though
B does not obtain the operating permit until January 2005, because C
completed all its obligations under the contract and B accepted the
machine in February 2004.
[T.D. 8929, 66 FR 2225, Jan. 11, 2001; 66 FR 18357, Apr. 6, 2001]
Sec. 1.460-2 Long-term manufacturing contracts.
(a) In general. Section 460 generally requires a taxpayer to
determine the income from a long-term manufacturing contract using the
percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A
contract not completed in the contracting year is a long-term
manufacturing contract if it involves the manufacture of personal
property that is--
(1) A unique item of a type that is not normally carried in the
finished goods inventory of the taxpayer; or
(2) An item that normally requires more than 12 calendar months to
complete (regardless of the duration of the contract or the time to
complete a deliverable quantity of the item).
(b) Unique--(1) In general. Unique means designed for the needs of a
specific customer. To determine whether an item is designed for the
needs of a specific customer, a taxpayer must consider the extent to
which research, development, design, engineering, retooling, and similar
activities (customizing activities) are required to manufacture the item
and whether the item could be sold to other customers with little or no
modification. A contract may require the taxpayer to manufacture more
than one unit of a unique item. If a contract requires a taxpayer to
manufacture more than one unit of the same item, the taxpayer must
determine whether that item is unique by considering the customizing
activities that would be needed to produce only the first unit. For the
purposes of this paragraph (b), a taxpayer must consider the activities
performed on its behalf by a subcontractor.
(2) Safe harbors. Notwithstanding paragraph (b)(1) of this section,
an item is not unique if it satisfies one or more of the safe harbors in
this paragraph (b)(2). If an item does not satisfy one or more safe
harbors, the determination of uniqueness will depend on the facts and
circumstances. The safe harbors are:
[[Page 171]]
(i) Short production period. An item is not unique if it normally
requires 90 days or less to complete. In the case of a contract for
multiple units of an item, the item is not unique only if it normally
requires 90 days or less to complete each unit of the item in the
contract.
(ii) Customized item. An item is not unique if the total allocable
contract costs attributable to customizing activities that are incident
to or necessary for the manufacture of the item do not exceed 10 percent
of the estimated total allocable contract costs allocable to the item.
In the case of a contract for multiple units of an item, this comparison
must be performed on the first unit of the item, and the total allocable
contract costs attributable to customizing activities that are incident
to or necessary for the manufacture of the first unit of the item must
be allocated to that first unit.
(iii) Inventoried item. A unique item ceases to be unique no later
than when the taxpayer normally includes similar items in its finished
goods inventory.
(c) Normal time to complete--(1) In general. The amount of time
normally required to complete an item is the item's reasonably expected
production period, as described in Sec. 1.263A-12, determined at the end
of the contracting year. Thus, in general, the expected production
period for an item begins when a taxpayer incurs at least five percent
of the costs that would be allocable to the item under Sec. 1.460-5 and
ends when the item is ready to be held for sale and all reasonably
expected production activities are complete. In the case of components
that are assembled or reassembled into an item or unit at the customer's
facility by the taxpayer's employees or agents, the production period
ends when the components are assembled or reassembled into an operable
item or unit. To the extent that several distinct activities related to
the production of the item are expected to occur simultaneously, the
period during which these distinct activities occur is not counted more
than once. Furthermore, when determining the normal time to complete an
item, a taxpayer is not required to consider activities performed or
costs incurred that would not be allocable contract costs under section
460 (e.g., independent research and development expenses (as defined in
Sec. 1.460-1(b)(9)) and marketing expenses). Moreover, the time normally
required to design and manufacture the first unit of an item for which
the taxpayer intends to produce multiple units generally does not
indicate the normal time to complete the item.
(2) Production by related parties. To determine the time normally
required to complete an item, a taxpayer must consider all relevant
production activities performed and costs incurred by itself and by
related parties, as defined in Sec. 1.460-1(b)(4). For example, if a
taxpayer's item requires a component or subassembly manufactured by a
related party, the taxpayer must consider the time the related party
takes to complete the component or subassembly and, for purposes of
determining the beginning of an item's production period, the costs
incurred by the related party that are allocable to the component or
subassembly. However, if both requirements of the exception for
components and subassemblies under Sec. 1.460-1(g)(1)(ii) are satisfied,
a taxpayer does not consider the activities performed or the costs
incurred by a related party when determining the normal time to complete
an item.
(d) Qualified ship contracts. A taxpayer may determine the income
from a long-term manufacturing contract that is a qualified ship
contract using either the PCM or the percentage-of-completion/
capitalized-cost method (PCCM) of accounting described in Sec. 1.460-
4(e). A qualified ship contract is any contract entered into after
February 28, 1986, to manufacture in the United States not more than 5
seagoing vessels if the vessels will not be manufactured directly or
indirectly for the United States Government and if the taxpayer
reasonably expects to complete the contract within 5 years of the
contract commencement date. Under Sec. 1.460-1(e)(3)(i), a contract to
produce more than 5 vessels for which the PCM would be required cannot
be severed in order to be classified as a qualified ship contract.
(e) Examples. The following examples illustrate the rules of this
section:
[[Page 172]]
Example 1. Unique item and classification. In December 2001, C
enters into a contract with B to design and manufacture a new type of
industrial equipment. C reasonably expects the normal production period
for this type of equipment to be eight months. Because the new type of
industrial equipment requires a substantial amount of research, design,
and engineering to produce, C determines that the equipment is a unique
item and its contract with B is a long-term contract. After delivering
the equipment to B in September 2002, C contracts with B to produce five
additional units of that industrial equipment with certain different
specifications. These additional units, which also are expected to take
eight months to produce, will be delivered to B in 2003. C determines
that the research, design, engineering, retooling, and similar
customizing costs necessary to produce the five additional units of
equipment does not exceed 10 percent of the first unit's share of
estimated total allocable contract costs. Consequently, the additional
units of equipment satisfy the safe harbor in paragraph (b)(2)(ii) of
this section and are not unique items. Although C's contract with B to
produce the five additional units is not completed within the
contracting year, the contract is not a long-term contract since the
additional units of equipment are not unique items and do not normally
require more than 12 months to produce. C must classify its second
contract with B as a non-long term contract, notwithstanding that it
classified the previous contract with B for a similar item as a long-
term contract, because the determination of whether a contract is a
long-term contract is made on a contract-by-contract basis. A change in
classification is not a change in method of accounting because the
change in classification results from a change in underlying facts.
Example 2. 12-month rule--related party. C manufactures cranes. C
purchases one of the crane's components from R, a related party under
Sec. 1.460-1(b)(4). Less than 50 percent of R's gross receipts
attributable to the sale of this component comes from sales to unrelated
parties; thus, the exception for components and subassemblies under
Sec. 1.460-1(g)(1)(ii) is not satisfied. Consequently, C must consider
the activities of R as R incurs costs and performs the activities rather
than as C incurs a liability to R. The normal time period between the
time that both C and R incur five percent of the costs allocable to the
crane and the time that R completes the component is five months. C
normally requires an additional eight months to complete production of
the crane after receiving the integral component from R. C's crane is an
item of a type that normally requires more than 12 months to complete
under paragraph (c) of this section because the production period from
the time that both C and R incur five percent of the costs allocable to
the crane until the time that production of the crane is complete is
normally 13 months.
Example 3. 12-month rule--duration of contract. The facts are the
same as in Example 2, except that C enters into a sales contract with B
on December 31, 2001 (the last day of C's taxable year), and delivers a
completed crane to B on February 1, 2002. C's contract with B is a long-
term contract under paragraph (a)(2) of this section because the
contract is not completed in the contracting year, 2001, and the crane
is an item that normally requires more than 12 calendar months to
complete (regardless of the duration of the contract).
Example 4. 12-month rule--normal time to complete. The facts are the
same as in Example 2, except that C (and R) actually complete B's crane
in only 10 calendar months. The contract is a long-term contract because
the normal time to complete a crane, not the actual time to complete a
crane, is the relevant criterion for determining whether an item is
subject to paragraph (a)(2) of this section.
Example 5. Normal time to complete. C enters into a multi-unit
contract to produce four units of an item. C does not anticipate
producing any additional units of the item. C expects to perform the
research, design, and development that are directly allocable to the
particular item and to produce the first unit in the first 24 months. C
reasonably expects the production period for each of the three remaining
units will be 3 months. This contract is not a contract that involves
the manufacture of an item that normally requires more than 12 months to
complete because the normal time to complete the item is 3 months.
However, the contract does not satisfy the 90-day safe harbor for unique
items because the normal time to complete the first unit of this item
exceeds 90 days. Thus, the contract might involve the manufacture of a
unique item depending on the facts and circumstances.
[T.D. 8929, 66 FR 2230, Jan. 11, 2001; 66 FR 18191, Apr. 6, 2001]
Sec. 1.460-3 Long-term construction contracts.
(a) In general. Section 460 generally requires a taxpayer to
determine the income from a long-term construction contract using the
percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A
contract not completed in the contracting year is a long-term
construction contract if it involves the building, construction,
reconstruction, or rehabilitation of real property; the installation of
an integral component to real property; or the improvement of
[[Page 173]]
real property (collectively referred to as construction). Real property
means land, buildings, and inherently permanent structures, as defined
in Sec. 1.263A-8(c)(3), such as roadways, dams, and bridges. Real
property does not include vessels, offshore drilling platforms, or
unsevered natural products of land. An integral component to real
property includes property not produced at the site of the real property
but intended to be permanently affixed to the real property, such as
elevators and central heating and cooling systems. Thus, for example, a
contract to install an elevator in a building is a construction contract
because a building is real property, but a contract to install an
elevator in a ship is not a construction contract because a ship is not
real property.
(b) Exempt construction contracts--(1) In general. The general
requirement to use the PCM and the cost allocation rules described in
Sec. 1.460-5(b) or (c) does not apply to any long-term construction
contract described in this paragraph (b) (exempt construction contract).
Exempt construction contract means any--
(i) Home construction contract; and
(ii) Other construction contract that a taxpayer estimates (when
entering into the contract) will be completed within 2 years of the
contract commencement date, provided the taxpayer satisfies the
$10,000,000 gross receipts test described in paragraph (b)(3) of this
section.
(2) Home construction contract--(i) In general. A long-term
construction contract is a home construction contract if a taxpayer
(including a subcontractor working for a general contractor) reasonably
expects to attribute 80 percent or more of the estimated total allocable
contract costs (including the cost of land, materials, and services),
determined as of the close of the contracting year, to the construction
of--
(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I),
contained in buildings containing 4 or fewer dwelling units (including
buildings with 4 or fewer dwelling units that also have commercial
units); and
(B) Improvements to real property directly related to, and located
at the site of, the dwelling units.
(ii) Townhouses and rowhouses. Each townhouse or rowhouse is a
separate building.
(iii) Common improvements. A taxpayer includes in the cost of the
dwelling units their allocable share of the cost that the taxpayer
reasonably expects to incur for any common improvements (e.g., sewers,
roads, clubhouses) that benefit the dwelling units and that the taxpayer
is contractually obligated, or required by law, to construct within the
tract or tracts of land that contain the dwelling units.
(iv) Mixed use costs. If a contract involves the construction of
both commercial units and dwelling units within the same building, a
taxpayer must allocate the costs among the commercial units and dwelling
units using a reasonable method or combination of reasonable methods,
such as specific identification, square footage, or fair market value.
(3) $10,000,000 gross receipts test--(i) In general. Except as
otherwise provided in paragraphs (b)(3)(ii) and (iii) of this section,
the $10,000,000 gross receipts test is satisfied if a taxpayer's (or
predecessor's) average annual gross receipts for the 3 taxable years
preceding the contracting year do not exceed $10,000,000, as determined
using the principles of the gross receipts test for small resellers
under Sec. 1.263A-3(b).
(ii) Single employer. To apply the gross receipts test, a taxpayer
is not required to aggregate the gross receipts of persons treated as a
single employer solely under section 414(m) and any regulations
prescribed under section 414.
(iii) Attribution of gross receipts. A taxpayer must aggregate a
proportionate share of the construction-related gross receipts of any
person that has a five percent or greater interest in the taxpayer. In
addition, a taxpayer must aggregate a proportionate share of the
construction-related gross receipts of any person in which the taxpayer
has a five percent or greater interest. For this purpose, a taxpayer
must determine ownership interests as of the first day of the taxpayer's
contracting year and must include indirect interests in any corporation,
partnership, estate, trust, or sole proprietorship according
[[Page 174]]
to principles similar to the constructive ownership rules under sections
1563(e), (f)(2), and (f)(3)(A). However, a taxpayer is not required to
aggregate under this paragraph (b)(3)(iii) any construction-related
gross receipts required to be aggregated under paragraph (b)(3)(i) of
this section.
(c) Residential construction contracts. A taxpayer may determine the
income from a long-term construction contract that is a residential
construction contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in
Sec. 1.460-4(e). A residential construction contract is a home
construction contract, as defined in paragraph (b)(2) of this section,
except that the building or buildings being constructed contain more
than 4 dwelling units.
[T.D. 8929, 66 FR 2231, Jan. 11, 2001]
Sec. 1.460-4 Methods of accounting for long-term contracts.
(a) Overview. This section prescribes permissible methods of
accounting for long-term contracts. Paragraph (b) of this section
describes the percentage-of-completion method under section 460(b) (PCM)
that a taxpayer generally must use to determine the income from a long-
term contract. Paragraph (c) of this section lists permissible methods
of accounting for exempt construction contracts described in Sec. 1.460-
3(b)(1) and describes the exempt-contract percentage-of-completion
method (EPCM). Paragraph (d) of this section describes the completed-
contract method (CCM), which is one of the permissible methods of
accounting for exempt construction contracts. Paragraph (e) of this
section describes the percentage-of-completion/capitalized-cost method
(PCCM), which is a permissible method of accounting for qualified ship
contracts described in Sec. 1.460-2(d) and residential construction
contracts described in Sec. 1.460-3(c). Paragraph (f) of this section
provides rules for determining the alternative minimum taxable income
(AMTI) from long-term contracts that are not exempted under section 56.
Paragraph (g) of this section provides rules concerning consistency in
methods of accounting for long-term contracts. Paragraph (h) of this
section provides examples illustrating the principles of this section.
Paragraph (j) of this section provides rules for taxpayers that file
consolidated tax returns. Finally, paragraph (k) of this section
provides rules relating to a mid-contract change in taxpayer of a
contract accounted for using a long-term contract method of accounting.
(b) Percentage-of-completion method--(1) In general. Under the PCM,
a taxpayer generally must include in income the portion of the total
contract price, as defined in paragraph (b)(4)(i) of this section, that
corresponds to the percentage of the entire contract that the taxpayer
has completed during the taxable year. The percentage of completion must
be determined by comparing allocable contract costs incurred with
estimated total allocable contract costs. Thus, the taxpayer includes a
portion of the total contract price in gross income as the taxpayer
incurs allocable contract costs.
(2) Computations. To determine the income from a long-term contract,
a taxpayer--
(i) Computes the completion factor for the contract, which is the
ratio of the cumulative allocable contract costs that the taxpayer has
incurred through the end of the taxable year to the estimated total
allocable contract costs that the taxpayer reasonably expects to incur
under the contract;
(ii) Computes the amount of cumulative gross receipts from the
contract by multiplying the completion factor by the total contract
price;
(iii) Computes the amount of current-year gross receipts, which is
the difference between the amount of cumulative gross receipts for the
current taxable year and the amount of cumulative gross receipts for the
immediately preceding taxable year (the difference can be a positive or
negative number); and
(iv) Takes both the current-year gross receipts and the allocable
contract costs incurred during the current year into account in
computing taxable income.
(3) Post-completion-year income. If a taxpayer has not included the
total contract price in gross income by the completion year, as defined
in Sec. 1.460-1(b)(6), the taxpayer must include the remaining portion
of the total contract
[[Page 175]]
price in gross income for the taxable year following the completion
year. For the treatment of post-completion-year costs, see paragraph
(b)(5)(v) of this section. See Sec. 1.460-6(c)(1)(ii) for application of
the look-back method as a result of adjustments to total contract price.
(4) Total contract price--(i) In general--(A) Definition. Total
contract price means the amount that a taxpayer reasonably expects to
receive under a long-term contract, including holdbacks, retainages, and
cost reimbursements. See Sec. 1.460-6(c)(1)(ii) and (2)(vi) for
application of the look-back method as a result of changes in total
contract price.
(B) Contingent compensation. Any amount related to a contingent
right under a contract, such as a bonus, award, incentive payment, and
amount in dispute, is included in total contract price as soon as the
taxpayer can reasonably predict that the amount will be earned, even if
the all events test has not yet been met. For example, if a bonus is
payable to a taxpayer for meeting an early completion date, the bonus is
includible in total contract price at the time and to the extent that
the taxpayer can reasonably predict the achievement of the corresponding
objective. Similarly, a portion of the contract price that is in dispute
is includible in total contract price at the time and to the extent that
the taxpayer can reasonably predict that the dispute will be resolved in
the taxpayer's favor (regardless of when the taxpayer actually receives
payment or when the dispute is finally resolved). Total contract price
does not include compensation that might be earned under any other
agreement that the taxpayer expects to obtain from the same customer
(e.g., exercised option or follow-on contract) if that other agreement
is not aggregated under Sec. 1.460-1(e). For the purposes of this
paragraph (b)(4)(i)(B), a taxpayer can reasonably predict that an amount
of contingent income will be earned not later than when the taxpayer
includes that amount in income for financial reporting purposes under
generally accepted accounting principles. If a taxpayer has not included
an amount of contingent compensation in total contract price under this
paragraph (b)(4)(i) by the taxable year following the completion year,
the taxpayer must account for that amount of contingent compensation
using a permissible method of accounting. If it is determined after the
taxable year following the completion year that an amount included in
total contract price will not be earned, the taxpayer should deduct that
amount in the year of the determination.
(C) Non-long-term contract activities. Total contract price includes
an allocable share of the gross receipts attributable to a non-long-term
contract activity, as defined in Sec. 1.460-1(d)(2), if the activity is
incident to or necessary for the manufacture, building, installation, or
construction of the subject matter of the long-term contract. Total
contract price also includes amounts reimbursed for independent research
and development expenses (as defined in Sec. 1.460-1(b)(9)), or for
bidding and proposal costs, under a federal or cost-plus long-term
contract (as defined in section 460(d)), regardless of whether the
research and development, or bidding and proposal, activities are
incident to or necessary for the performance of that long-term contract.
(ii) Estimating total contract price. A taxpayer must estimate the
total contract price based upon all the facts and circumstances known as
of the last day of the taxable year. For this purpose, an event that
occurs after the end of the taxable year must be taken into account if
its occurrence was reasonably predictable and its income was subject to
reasonable estimation as of the last day of that taxable year.
(5) Completion factor--(i) Allocable contract costs. A taxpayer must
use a cost allocation method permitted under either Sec. 1.460-5(b) or
(c) to determine the amount of cumulative allocable contract costs and
estimated total allocable contract costs that are used to determine a
contract's completion factor. Allocable contract costs include a
reimbursable cost that is allocable to the contract.
(ii) Cumulative allocable contract costs. To determine a contract's
completion factor for a taxable year, a taxpayer must take into account
the cumulative allocable contract costs that have been
[[Page 176]]
incurred, as defined in Sec. 1.460-1(b)(8), through the end of the
taxable year.
(iii) Estimating total allocable contract costs. A taxpayer must
estimate total allocable contract costs for each long-term contract
based upon all the facts and circumstances known as of the last day of
the taxable year. For this purpose, an event that occurs after the end
of the taxable year must be taken into account if its occurrence was
reasonably predictable and its cost was subject to reasonable estimation
as of the last day of that taxable year. To be considered reasonable, an
estimate of total allocable contract costs must include costs
attributable to delay, rework, change orders, technology or design
problems, or other problems that reasonably can be predicted considering
the nature of the contract and prior experience. However, estimated
total allocable contract costs do not include any contingency allowance
for costs that, as of the end of the taxable year, are not reasonably
predicted to be incurred in the performance of the contract. For
example, estimated total allocable contract costs do not include any
costs attributable to factors not reasonably predictable at the end of
the taxable year, such as third-party litigation, extreme weather
conditions, strikes, and delays in securing required permits and
licenses. In addition, the estimated costs of performing other
agreements that are not aggregated with the contract under Sec. 1.460-
1(e) that the taxpayer expects to incur with the same customer (e.g.,
follow-on contracts) are not included in estimated total allocable
contract costs for the initial contract.
(iv) Pre-contracting-year costs. If a taxpayer reasonably expects to
enter into a long-term contract in a future taxable year, the taxpayer
must capitalize all costs incurred prior to entering into the contract
that will be allocable to that contract (e.g., bidding and proposal
costs). A taxpayer is not required to compute a completion factor, or to
include in gross income any amount, related to allocable contract costs
for any taxable year ending before the contracting year or, if
applicable, the 10-percent year defined in paragraph (b)(6)(i) of this
section. In that year, the taxpayer is required to compute a completion
factor that includes all allocable contract costs that have been
incurred as of the end of that taxable year (whether previously
capitalized or deducted) and to take into account in computing taxable
income the related gross receipts and the previously capitalized
allocable contract costs. If, however, a taxpayer determines in a
subsequent year that it will not enter into the long-term contract, the
taxpayer must account for these pre-contracting-year costs in that year
(e.g., as a deduction or an inventoriable cost) using the appropriate
rules contained in other sections of the Code or regulations.
(v) Post-completion-year costs. If a taxpayer incurs an allocable
contract cost after the completion year, the taxpayer must account for
that cost using a permissible method of accounting. See Sec. 1.460-
6(c)(1)(ii) for application of the look-back method as a result of
adjustments to allocable contract costs.
(6) 10-percent method--(i) In general. Instead of determining the
income from a long-term contract beginning with the contracting year, a
taxpayer may elect to use the 10-percent method under section 460(b)(5).
Under the 10-percent method, a taxpayer does not include in gross income
any amount related to allocable contract costs until the taxable year in
which the taxpayer has incurred at least 10 percent of the estimated
total allocable contract costs (10-percent year). A taxpayer must treat
costs incurred before the 10-percent year as pre-contracting-year costs
described in paragraph (b)(5)(iv) of this section.
(ii) Election. A taxpayer makes an election under this paragraph
(b)(6) by using the 10-percent method for all long-term contracts
entered into during the taxable year of the election on its original
federal income tax return for the election year. This election is a
method of accounting and, thus, applies to all long-term contracts
entered into during and after the taxable year of the election. An
electing taxpayer must use the 10-percent method to apply the look-back
method under Sec. 1.460-6 and to determine alternative minimum taxable
income under paragraph (f) of this section. This election is not
available if a taxpayer uses the
[[Page 177]]
simplified cost-to-cost method described in Sec. 1.460-5(c) to compute
the completion factor of a long-term contract.
(7) Terminated contract--(i) Reversal of income. If a long-term
contract is terminated before completion and, as a result, the taxpayer
retains ownership of the property that is the subject matter of that
contract, the taxpayer must reverse the transaction in the taxable year
of termination. To reverse the transaction, the taxpayer reports a loss
(or gain) equal to the cumulative allocable contract costs reported
under the contract in all prior taxable years less the cumulative gross
receipts reported under the contract in all prior taxable years.
(ii) Adjusted basis. As a result of reversing the transaction under
paragraph (b)(7)(i) of this section, a taxpayer will have an adjusted
basis in the retained property equal to the cumulative allocable
contract costs reported under the contract in all prior taxable years.
However, if the taxpayer received and retains any consideration or
compensation from the customer, the taxpayer must reduce the adjusted
basis in the retained property (but not below zero) by the fair market
value of that consideration or compensation. To the extent that the
amount of the consideration or compensation described in the preceding
sentence exceeds the adjusted basis in the retained property, the
taxpayer must include the excess in gross income for the taxable year of
termination.
(iii) Look-back method. The look-back method does not apply to a
terminated contract that is subject to this paragraph (b)(7).
(c) Exempt contract methods--(1) In general. An exempt contract
method means the method of accounting that a taxpayer must use to
account for all its long-term contracts (and any portion of a long-term
contract) that are exempt from the requirements of section 460(a). Thus,
an exempt contract method applies to exempt construction contracts, as
defined in Sec. 1.460-3(b); the non-PCM portion of a qualified ship
contract, as defined in Sec. 1.460-2(d); and the non-PCM portion of a
residential construction contract, as defined in Sec. 1.460-3(c).
Permissible exempt contract methods include the PCM, the EPCM described
in paragraph (c)(2) of this section, the CCM described in paragraph (d)
of this section, or any other permissible method. See section 446.
(2) Exempt-contract percentage-of-completion method--(i) In general.
Similar to the PCM described in paragraph (b) of this section, a
taxpayer using the EPCM generally must include in income the portion of
the total contract price, as described in paragraph (b)(4) of this
section, that corresponds to the percentage of the entire contract that
the taxpayer has completed during the taxable year. However, under the
EPCM, the percentage of completion may be determined as of the end of
the taxable year by using any method of cost comparison (such as
comparing direct labor costs incurred to date to estimated total direct
labor costs) or by comparing the work performed on the contract with the
estimated total work to be performed, rather than by using the cost-to-
cost comparison required by paragraphs (b)(2)(i) and (5) of this
section, provided such method is used consistently and clearly reflects
income. In addition, paragraph (b)(3) of this section (regarding post-
completion-year income), paragraph (b)(6) of this section (regarding the
10-percent method) and Sec. 1.460-6 (regarding the look-back method) do
not apply to the EPCM.
(ii) Determination of work performed. For purposes of the EPCM, the
criteria used to compare the work performed on a contract as of the end
of the taxable year with the estimated total work to be performed must
clearly reflect the earning of income with respect to the contract. For
example, in the case of a roadbuilder, a standard of completion solely
based on miles of roadway completed in a case where the terrain is
substantially different may not clearly reflect the earning of income
with respect to the contract.
(d) Completed-contract method--(1) In general. Except as otherwise
provided in paragraph (d)(4) of this section, a taxpayer using the CCM
to account for a long-term contract must take into account in the
contract's completion year, as defined in Sec. 1.460-1(b)(6), the gross
contract price and all allocable
[[Page 178]]
contract costs incurred by the completion year. A taxpayer may not treat
the cost of any materials and supplies that are allocated to a contract,
but actually remain on hand when the contract is completed, as an
allocable contract cost.
(2) Post-completion-year income and costs. If a taxpayer has not
included an item of contingent compensation (i.e., amounts for which the
all events test has not been satisfied) in gross contract price under
paragraph (d)(3) of this section by the completion year, the taxpayer
must account for this item of contingent compensation using a
permissible method of accounting. If a taxpayer incurs an allocable
contract cost after the completion year, the taxpayer must account for
that cost using a permissible method of accounting.
(3) Gross contract price. Gross contract price includes all amounts
(including holdbacks, retainages, and reimbursements) that a taxpayer is
entitled by law or contract to receive, whether or not the amounts are
due or have been paid. In addition, gross contract price includes all
bonuses, awards, and incentive payments, such as a bonus for meeting an
early completion date, to the extent the all events test is satisfied.
If a taxpayer performs a non-long-term contract activity, as defined in
Sec. 1.460-1(d)(2), that is incident to or necessary for the
manufacture, building, installation, or construction of the subject
matter of one or more of the taxpayer's long-term contracts, the
taxpayer must include an allocable share of the gross receipts
attributable to that activity in the gross contract price of the
contract(s) benefitted by that activity. Gross contract price also
includes amounts reimbursed for independent research and development
expenses (as defined in Sec. 1.460-1(b)(9)), or bidding and proposal
costs, under a federal or cost-plus long-term contract (as defined in
section 460(d)), regardless of whether the research and development, or
bidding and proposal, activities are incident to or necessary for the
performance of that long-term contract.
(4) Contracts with disputed claims--(i) In general. The special
rules in this paragraph (d)(4) apply to a long-term contract accounted
for using the CCM with a dispute caused by a customer's requesting a
reduction of the gross contract price or the performance of additional
work under the contract or by a taxpayer's requesting an increase in
gross contract price, or both, on or after the date a taxpayer has
tendered the subject matter of the contract to the customer.
(ii) Taxpayer assured of profit or loss. If the disputed amount
relates to a customer's claim for either a reduction in price or
additional work and the taxpayer is assured of either a profit or a loss
on a long-term contract regardless of the outcome of the dispute, the
gross contract price, reduced (but not below zero) by the amount
reasonably in dispute, must be taken into account in the completion
year. If the disputed amount relates to a taxpayer's claim for an
increase in price and the taxpayer is assured of either a profit or a
loss on a long-term contract regardless of the outcome of the dispute,
the gross contract price must be taken into account in the completion
year. If the taxpayer is assured a profit on the contract, all allocable
contract costs incurred by the end of the completion year are taken into
account in that year. If the taxpayer is assured a loss on the contract,
all allocable contract costs incurred by the end of the completion year,
reduced by the amount reasonably in dispute, are taken into account in
the completion year.
(iii) Taxpayer unable to determine profit or loss. If the amount
reasonably in dispute affects so much of the gross contract price or
allocable contract costs that a taxpayer cannot determine whether a
profit or loss ultimately will be realized from a long-term contract,
the taxpayer may not take any of the gross contract price or allocable
contract costs into account in the completion year.
(iv) Dispute resolved. Any part of the gross contract price and any
allocable contract costs that have not been taken into account because
of the principles described in paragraph (d)(4)(i), (ii), or (iii) of
this section must be taken into account in the taxable year in which the
dispute is resolved. If a taxpayer performs additional work under the
contract because of the dispute, the term taxable year in which the
dispute is resolved means the taxable
[[Page 179]]
year the additional work is completed, rather than the taxable year in
which the outcome of the dispute is determined by agreement, decision,
or otherwise.
(e) Percentage-of-completion/capitalized-cost method. Under the
PCCM, a taxpayer must determine the income from a long-term contract
using the PCM for the applicable percentage of the contract and its
exempt contract method, as defined in paragraph (c) of this section, for
the remaining percentage of the contract. For residential construction
contracts described in Sec. 1.460-3(c), the applicable percentage is 70
percent, and the remaining percentage is 30 percent. For qualified ship
contracts described in Sec. 1.460-2(d), the applicable percentage is 40
percent, and the remaining percentage is 60 percent.
(f) Alternative minimum taxable income--(1) In general. Under
section 56(a)(3), a taxpayer (not exempt from the AMT under section
55(e)) must use the PCM to determine its AMTI from any long-term
contract entered into on or after March 1, 1986, that is not a home
construction contract, as defined in Sec. 1.460-3(b)(2). For AMTI
purposes, the PCM must include any election under paragraph (b)(6) of
this section (concerning the 10-percent method) or under Sec. 1.460-5(c)
(concerning the simplified cost-to-cost method) that the taxpayer has
made for regular tax purposes. For exempt construction contracts
described in Sec. 1.460-3(b)(1)(ii), a taxpayer must use the simplified
cost-to-cost method to determine the completion factor for AMTI
purposes. Except as provided in paragraph (f)(2) of this section, a
taxpayer must use AMTI costs and AMTI methods, such as the depreciation
method described in section 56(a)(1), to determine the completion factor
of a long-term contract (except a home construction contract) for AMTI
purposes.
(2) Election to use regular completion factors. Under this paragraph
(f)(2), a taxpayer may elect for AMTI purposes to determine the
completion factors of all of its long-term contracts using the methods
of accounting and allocable contract costs used for regular federal
income tax purposes. A taxpayer makes this election by using regular
methods and regular costs to compute the completion factors of all long-
term contracts entered into during the taxable year of the election for
AMTI purposes on its original federal income tax return for the election
year. This election is a method of accounting and, thus, applies to all
long-term contracts entered into during and after the taxable year of
the election. Although a taxpayer may elect to compute the completion
factor of its long-term contracts using regular methods and regular
costs, an election under this paragraph (f)(2) does not eliminate a
taxpayer's obligation to comply with the requirements of section 55 when
computing AMTI. For example, although a taxpayer may elect to use the
depreciation methods used for regular tax purposes to compute the
completion factor of its long-term contracts for AMTI purposes, the
taxpayer must use the depreciation methods permitted by section 56 to
compute AMTI.
(g) Method of accounting. A taxpayer that uses the PCM, EPCM, CCM,
or PCCM, or elects the 10-percent method or special AMTI method (or
changes to another method of accounting with the Commissioner's consent)
must apply the method(s) consistently for all similarly classified long-
term contracts, until the taxpayer obtains the Commissioner's consent
under section 446(e) to change to another method of accounting. A
taxpayer-initiated change in method of accounting will be permitted only
on a cut-off basis (i.e., for contracts entered into on or after the
year of change), and thus, a section 481(a) adjustment will not be
permitted or required.
(h) Examples. The following examples illustrate the rules of this
section:
Example 1. PCM--estimating total contract price. C, whose taxable
year ends December 31, determines the income from long-term contracts
using the PCM. On January 1, 2001, C enters into a contract to design
and manufacture a satellite (a unique item). The contract provides that
C will be paid $10,000,000 for delivering the completed satellite by
December 1, 2002. The contract also provides that C will receive a
$3,000,000 bonus for delivering the satellite by July 1, 2002, and an
additional $4,000,000 bonus if the satellite successfully performs its
mission for five years. C is unable to reasonably predict if the
satellite will successfully perform its mission for five years. If on
December 31, 2001, C should reasonably expect to deliver
[[Page 180]]
the satellite by July 1, 2002, the estimated total contract price is
$13,000,000 ($10,000,000 unit price + $3,000,000 production-related
bonus). Otherwise, the estimated total contract price is $10,000,000. In
either event, the $4,000,000 bonus is not includible in the estimated
total contract price as of December 31, 2001, because C is unable to
reasonably predict that the satellite will successfully perform its
mission for five years.
Example 2. PCM--computing income. (i) C, whose taxable year ends
December 31, determines the income from long-term contracts using the
PCM. During 2001, C agrees to manufacture for the customer, B, a unique
item for a total contract price of $1,000,000. Under C's contract, B is
entitled to retain 10 percent of the total contract price until it
accepts the item. By the end of 2001, C has incurred $200,000 of
allocable contract costs and estimates that the total allocable contract
costs will be $800,000. By the end of 2002, C has incurred $600,000 of
allocable contract costs and estimates that the total allocable contract
costs will be $900,000. In 2003, after completing the contract, C
determines that the actual cost to manufacture the item was $750,000.
(ii) For each of the taxable years, C's income from the contract is
computed as follows:
------------------------------------------------------------------------
Taxable Year
-----------------------------------------
2001 2002 2003
------------------------------------------------------------------------
(A) Cumulative incurred costs. $200,000 $600,000 $750,000
(B) Estimated total costs..... 800,000 900,000 750,000
-----------------------------------------
(C) Completion factor: (A) / 25.00% 66.67% 100.00%
(B)..........................
-----------------------------------------
(D) Total contract price...... 1,000,000 1,000,000 1,000,000
-----------------------------------------
(E) Cumulative gross receipts: 250,000 666,667 1,000,000
(C)x(D)......................
(F) Cumulative gross receipts (0) (250,000) (666,667)
(prior year).................
-----------------------------------------
(G) Current-year gross 250,000 416,667 333,333
receipts.....................
-----------------------------------------
(H) Cumulative incurred costs. 200,000 600,000 750,000
(I) Cumulative incurred costs (0) (200,000) (600,000)
(prior year).................
-----------------------------------------
(J) Current-year costs........ 200,000 400,000 150,000
-----------------------------------------
(K) Gross income: (G) - (J)... $50,000 $16,667 $183,333
------------------------------------------------------------------------
Example 3. PCM--computing income with cost sharing. (i) C, whose
taxable year ends December 31, determines the income from long-term
contracts using the PCM. During 2001, C enters into a contract to
manufacture a unique item. The contract specifies a target price of
$1,000,000, a target cost of $600,000, and a target profit of $400,000.
C and B will share the savings of any cost underrun (actual total
incurred cost is less than target cost) and the additional cost of any
cost overrun (actual total incurred cost is greater than target cost) as
follows: 30 percent to C and 70 percent to B. By the end of 2001, C has
incurred $200,000 of allocable contract costs and estimates that the
total allocable contract costs will be $600,000. By the end of 2002, C
has incurred $300,000 of allocable contract costs and estimates that the
total allocable contract costs will be $400,000. In 2003, after
completing the contract, C determines that the actual cost to
manufacture the item was $700,000.
(ii) For each of the taxable years, C's income from the contract is
computed as follows (note that the sharing of any cost underrun or cost
overrun is reflected as an adjustment to C's target price under
paragraph (b)(4)(i) of this section):
------------------------------------------------------------------------
Taxable Year
-----------------------------------------
2001 2002 2003
------------------------------------------------------------------------
(A) Cumulative incurred costs. $200,000 $300,000 $700,000
(B) Estimated total costs..... 600,000 400,000 700,000
-----------------------------------------
(C) Completion factor: (A) / 33.33% 75.00% 100.00%
(B)..........................
=========================================
(D) Target price.............. $1,000,000 $1,000,000 $1,000,000
-----------------------------------------
(E) Estimated total costs..... 600,000 400,000 700,000
(F) Target costs.............. 600,000 600,000 600,000
-----------------------------------------
(G) Cost (underrun)/overrun: 0 (200,000) 100,000
(E) - (F)....................
[[Page 181]]
(H) Adjustment rate........... 70% 70% 70%
-----------------------------------------
(I) Target price adjustment... 0 (140,000) 70,000
-----------------------------------------
(J) Total contract price: (D) $1,000,000 $860,000 $1,070,000
+ (I)........................
=========================================
(K) Cumulative gross receipts: $333,333 $645,000 $1,070,000
(C)x(J)......................
(L) Cumulative gross receipts (0) (333,333) (645,000)
(prior year):................
-----------------------------------------
(M) Current-year gross 333,333 311,667 425,000
receipts.....................
-----------------------------------------
(N) Cumulative incurred costs. 200,000 300,000 700,000
(O) Cumulative incurred costs (0) (200,000) (300,000)
(prior year):................
-----------------------------------------
(P) Current-year costs........ 200,000 100,000 400,000
-----------------------------------------
(Q) Gross income: (M) - (P)... $133,333 $211,667 $25,000
------------------------------------------------------------------------
Example 4. PCM--10 percent method. (i) C, whose taxable year ends
December 31, determines the income from long-term contracts using the
PCM. In November 2001, C agrees to manufacture a unique item for
$1,000,000. C reasonably estimates that the total allocable contract
costs will be $600,000. By December 31, 2001, C has received $50,000 in
progress payments and incurred $40,000 of costs. C elects to use the 10
percent method effective for 2001 and all subsequent taxable years.
During 2002, C receives $500,000 in progress payments and incurs
$260,000 of costs. In 2003, C incurs an additional $300,000 of costs, C
finishes manufacturing the item, and receives the final $450,000
payment.
(ii) For each of the taxable years, C's income from the contract is
computed as follows:
------------------------------------------------------------------------
Taxable Year
-----------------------------------------
2001 2002 2003
------------------------------------------------------------------------
(A) Cumulative incurred costs. $40,000 $300,000 $600,000
(B) Estimated total costs..... 600,000 600,000 600,000
-----------------------------------------
(C) Completion factor (A) / 6.67% 50.00% 100.00%
(B)..........................
-----------------------------------------
(D) Total contract price...... 1,000,000 1,000,000 1,000,000
-----------------------------------------
(E) Cumulative gross receipts: 0 500,000 1,000,000
(C)x(D)*.....................
(F) Cumulative gross receipts (0) (0) (500,000)
(prior year):................
-----------------------------------------
(G) Current-year gross 0 500,000 500,000
receipts.....................
-----------------------------------------
(H) Cumulative incurred costs. 0 300,000 600,000
(I) Cumulative incurred costs (0) (0) (300,000)
(prior year):................
-----------------------------------------
(J) Current-year costs........ 0 300,000 300,000
-----------------------------------------
(K) Gross income: (G) - (J)... $0 $200,000 $200,000
------------------------------------------------------------------------
*Unless (C) <10 percent.
Example 5. PCM--contract terminated. C, whose taxable year ends
December 31, determines the income from long-term contracts using the
PCM. During 2001, C buys land and begins constructing a building that
will contain 50 condominium units on that land. C enters into a contract
to sell one unit in this condominium to B for $240,000. B gives C a
$5,000 deposit toward the purchase price. By the end of 2001, C has
incurred $50,000 of allocable contract costs on B's unit and estimates
that the total allocable contract costs on B's unit will be $150,000.
Thus, for 2001, C reports gross receipts of $80,000 ($50,000/
$150,000x$240,000), current-year costs of $50,000, and gross income of
$30,000 ($80,000 - $50,000). In 2002, after C has incurred an additional
$25,000 of allocable contract costs on B's unit, B files for bankruptcy
protection and defaults on the contract with C, who is permitted to keep
B's $5,000 deposit as liquidated damages. In 2002, C reverses the
transaction with B under paragraph (b)(7) of this section and reports a
loss of $30,000
[[Page 182]]
($50,000-$80,000). In addition, C obtains an adjusted basis in the unit
sold to B of $70,000 ($50,000 (current-year costs deducted in 2001)-
$5,000 (B's forfeited deposit) + $25,000 (current-year costs incurred in
2002). C may not apply the look-back method to this contract in 2002.
Example 6. CCM--contracts with disputes from customer claims. In
2001, C, whose taxable year ends December 31, uses the CCM to account
for exempt construction contracts. C enters into a contract to construct
a bridge for B. The terms of the contract provide for a $1,000,000 gross
contract price. C finishes the bridge in 2002 at a cost of $950,000.
When B examines the bridge, B insists that C either repaint several
girders or reduce the contract price. The amount reasonably in dispute
is $10,000. In 2003, C and B resolve their dispute, C repaints the
girders at a cost of $6,000, and C and B agree that the contract price
is not to be reduced. Because C is assured a profit of $40,000
($1,000,000 - $10,000 - $950,000) in 2002 even if the dispute is
resolved in B's favor, C must take this $40,000 into account in 2002. In
2003, C will earn an additional $4,000 profit ($1,000,000 - $956,000 -
$40,000) from the contract with B. Thus, C must take into account an
additional $10,000 of gross contract price and $6,000 of additional
contract costs in 2003.
Example 7. CCM--contracts with disputes from taxpayer claims. In
2003, C, whose taxable year ends December 31, uses the CCM to account
for exempt construction contracts. C enters into a contract to construct
a building for B. The terms of the contract provide for a $1,000,000
gross contract price. C finishes the building in 2004 at a cost of
$1,005,000. B examines the building in 2004 and agrees that it meets the
contract's specifications; however, at the end of 2004, C and B are
unable to agree on the merits of C's claim for an additional $10,000 for
items that C alleges are changes in contract specifications and B
alleges are within the scope of the contract's original specifications.
In 2005, B agrees to pay C an additional $2,000 to satisfy C's claims
under the contract. Because the amount in dispute affects so much of the
gross contract price that C cannot determine in 2004 whether a profit or
loss will ultimately be realized, C may not taken any of the gross
contract price or allocable contract costs into account in 2004. C must
take into account $1,002,000 of gross contract price and $1,005,000 of
allocable contract costs in 2005.
Example 8. CCM--contracts with disputes from taxpayer and customer
claims. C, whose taxable year ends December 31, uses the CCM to account
for exempt construction contracts. C constructs a factory for B pursuant
to a long-term contract. Under the terms of the contract, B agrees to
pay C a total of $1,000,000 for construction of the factory. C finishes
construction of the factory in 2002 at a cost of $1,020,000. When B
takes possession of the factory and begins operations in December 2002,
B is dissatisfied with the location and workmanship of certain heating
ducts. As of the end of 2002, C contends that the heating ducts are
constructed in accordance with contract specifications. The amount of
the gross contract price reasonably in dispute with respect to the
heating ducts is $6,000. As of this time, C is claiming $14,000 in
addition to the original contract price for certain changes in contract
specifications which C alleges have increased his costs. B denies that
these changes have increased C's costs. In 2003, the disputes between C
and B are resolved by performance of additional work by C at a cost of
$1,000 and by an agreement that the contract price would be revised
downward to $996,000. Under these circumstances, C must include in his
gross income for 2002, $994,000 (the gross contract price less the
amount reasonably in dispute because of B's claim, or $1,000,000 -
$6,000). In 2002, C must also take into account $1,000,000 of allocable
contract costs (costs incurred less the amounts in dispute attributable
to both B's and C's claims, or $1,020,000 - $6,000 - $14,000). In 2003,
C must take into account an additional $2,000 of gross contract price
($996,000 - $994,000) and $21,000 of allocable contract costs
($1,021,000 - $1,000,000).
(i) [Reserved]
(j) Consolidated groups and controlled groups--(1) Intercompany
transactions--(i) In general. Section 1.1502-13 does not apply to the
income, gain, deduction, or loss from an intercompany transaction
between members of a consolidated group, and section 267(f) does not
apply to these items from an intercompany sale between members of a
controlled group, to the extent--
(A) The transaction or sale directly or indirectly benefits, or is
intended to benefit, another member's long-term contract with a
nonmember;
(B) The selling member is required under section 460 to determine
any part of its gross income from the transaction or sale under the
percentage-of-completion method (PCM); and
(C) The member with the long-term contract is required under section
460 to determine any part of its gross income from the long-term
contract under the PCM.
(ii) Definitions and nomenclature. The definitions and nomenclature
under Sec. 1.1502-13 and Sec. 1.267(f)-1 apply for purposes of this
paragraph (j).
[[Page 183]]
(2) Example. The following example illustrates the principles of
paragraph (j)(1) of this section.
Example. Corporations P, S, and B file consolidated returns on a
calendar-year basis. In 1996, B enters into a long-term contract with X,
a nonmember, to manufacture 5 airplanes for $500 million, with delivery
scheduled for 1999. Section 460 requires B to determine the gross income
from its contract with X under the PCM. S enters into a contract with B
to manufacture for $50 million the engines that B will install on X's
airplanes. Section 460 requires S to determine the gross income from its
contract with B under the PCM. S estimates that it will incur $40
million of total contract costs during 1997 and 1998 to manufacture the
engines. S incurs $10 million of contract costs in 1997 and $30 million
in 1998. Under paragraph (j) of this section, S determines its gross
income from the long-term contract under the PCM rather than taking its
income or loss into account under section 267(f) or Sec. 1.1502-13.
Thus, S includes $12.5 million of gross receipts and $10 million of
contract costs in gross income in 1997 and includes $37.5 million of
gross receipts and $30 million of contract costs in gross income in
1998.
(3) Effective dates--(i) In general. This paragraph (j) applies with
respect to transactions and sales occurring pursuant to contracts
entered into in years beginning on or after July 12, 1995.
(ii) Prior law. For transactions and sales occurring pursuant to
contracts entered into in years beginning before July 12, 1995, see the
applicable regulations issued under sections 267(f) and 1502, including
Secs. 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) (as contained in the 26
CFR part 1 edition revised as of April 1, 1995).
(4) Consent to change method of accounting. For transactions and
sales to which this paragraph (j) applies, the Commissioner's consent
under section 446(e) is hereby granted to the extent any changes in
method of accounting are necessary solely to comply with this section,
provided the changes are made in the first taxable year of the taxpayer
to which the rules of this paragraph (j) apply. Changes in method of
accounting for these transactions are to be effected on a cut-off basis.
(k) Mid-contract change in taxpayer--(1) In general. The rules in
this paragraph (k) apply if prior to the completion of a long-term
contract accounted for using a long-term contract method by a taxpayer
(old taxpayer), there is a transaction that makes another taxpayer (new
taxpayer) responsible for accounting for income from the same contract.
For purposes of this paragraph (k) and Sec. 1.460-6(g), an old taxpayer
also includes any old taxpayer(s) (e.g., predecessors) of the old
taxpayer. In addition, a change in status from taxable to tax exempt or
from domestic to foreign, or vice versa, will be considered a change in
taxpayer. Finally, a contract will be treated as the same contract if
the terms of the contract are not substantially changed in connection
with the transaction, whether or not the customer agrees to release the
old taxpayer from any or all of its obligations under the contract. The
rules governing constructive completion transactions are provided in
paragraph (k)(2) of this section, while the rules governing step-in-the-
shoes transactions are provided in paragraph (k)(3) of this section.
Special rules related to the treatment of certain partnership
transactions are reserved under paragraphs (k)(2)(iv) and (k)(3)(v) of
this section. For application of the look-back method to mid-contract
changes in taxpayers for contracts accounted for using the PCM, see
Sec. 1.460-6(g).
(2) Constructive completion transactions--(i) Scope. The
constructive completion rules in this paragraph (k)(2) apply to
transactions (constructive completion transactions) that result in a
change in the taxpayer responsible for reporting income from a contract
and that are not described in paragraph (k)(3)(i) of this section.
Constructive completion transactions generally include, for example,
taxable sales under section 1001 and deemed asset sales under section
338.
(ii) Old taxpayer. The old taxpayer is treated as completing the
contract on the date of the transaction. The total contract price (or,
gross contract price in the case of a long-term contract accounted for
under the CCM) for the old taxpayer is the sum of any amounts realized
from the transaction that are allocable to the contract and any amounts
the old taxpayer has received or reasonably expects to receive under the
contract. Total contract price (or gross contract price) is reduced by
any
[[Page 184]]
amount paid by the old taxpayer to the new taxpayer, and by any
transaction costs, that are allocable to the contract. Thus, the old
taxpayer's allocable contract costs determined under paragraph (b)(5) of
this section do not include any consideration paid, or costs incurred,
as a result of the transaction that are allocable to the contract. In
the case of a transaction subject to section 338 or 1060, the amount
realized from the transaction allocable to the contract is determined by
using the residual method under Secs. 1.338-6 and 1.338-7.
(iii) New taxpayer. The new taxpayer is treated as entering into a
new contract on the date of the transaction. The new taxpayer must
evaluate whether the new contract should be classified as a long-term
contract within the meaning of Sec. 1.460-1(b) and account for the
contract under a permissible method of accounting. For a new taxpayer
who accounts for a contract using the PCM, the total contract price is
any amount the new taxpayer reasonably expects to receive under the
contract consistent with paragraph (b)(4) of this section. Total
contract price is reduced by the amount of any consideration paid by the
new taxpayer as a result of the transaction, and by any transaction
costs, that are allocable to the contract and is increased by the amount
of any consideration received by the new taxpayer as a result of the
transaction that is allocable to the contract. Similarly, the gross
contract price for a contract accounted for using the CCM is all amounts
the new taxpayer is entitled by law or contract to receive consistent
with paragraph (d)(3) of this section, adjusted for any consideration
paid (or received) by the new taxpayer as a result of the transaction,
and for any transaction costs, that are allocable to the contract. Thus,
the new taxpayer's allocable contract costs determined under paragraph
(b)(5) of this section do not include any consideration paid, or costs
incurred, as a result of the transaction that are allocable to the
contract. In the case of a transaction subject to sections 338 or 1060,
the amount of consideration paid that is allocable to the contract is
determined by using the residual method under Secs. 1.338-6 and 1.338-7.
(iv) Special rules relating to distributions of certain contracts by
a partnership. [Reserved]
(3) Step-in-the-shoes transactions--(i) Scope. The step-in-the-shoes
rules in this paragraph (k)(3) apply to the following transactions that
result in a change in the taxpayer responsible for reporting income from
a contract accounted for using a long-term contract method of accounting
(step-in-the-shoes transactions)--
(A) Transfers to which section 361 applies if the transfer is in
connection with a reorganization described in section 368(a)(1)(A), (C)
or (F);
(B) Transfers to which section 361 applies if the transfer is in
connection with a reorganization described in section 368(a)(1)(D) or
(G), provided the requirements of section 354(b)(1)(A) and (B) are met;
(C) Distributions to which section 332 applies, provided the
contract is transferred to an 80-percent distributee;
(D) Transfers described in section 351;
(E) Transfers to which section 361 applies if the transfer is in
connection with a reorganization described in section 368(a)(1)(D) with
respect to which the requirements of section 355 (or so much of section
356 as relates to section 355) are met;
(F) Transfers (e.g., sales) of S corporation stock;
(G) Conversion to or from an S corporation;
(H) Members joining or leaving a consolidated group;
(I) Contributions to which section 721(a) applies;
(J) Transfers of partnership interests;
(K) Distributions to which section 731 applies (other than the
distribution of the contract); and
(L) Any other transaction designated in the Internal Revenue
Bulletin by the Internal Revenue Service. See Sec. 601.601(d)(2)(ii) of
this chapter.
(ii) Old taxpayer--(A) In general. The new taxpayer will ``step into
the shoes'' of the old taxpayer with respect to the contract. Thus, the
old taxpayer's obligation to account for the contract terminates on the
date of the transaction and is assumed by the new taxpayer, as set forth
in paragraph
[[Page 185]]
(k)(3)(iii) of this section. As a result, an old taxpayer using the PCM
is required to recognize income from the contract based on the
cumulative allocable contract costs incurred as of the date of the
transaction. Similarly, an old taxpayer using the CCM is not required to
recognize any revenue and may not deduct allocable contract costs
incurred with respect to the contract.
(B) Gain realized on the transaction. The amount of gain the old
taxpayer realizes on the transfer of a contract in a step-in-the-shoes
transaction must be determined after application of paragraph
(k)(3)(ii)(A) of this section using the rules of paragraph (k)(2) of
this section that apply to constructive completion transactions. (The
amount of gain realized on a transfer of a contract is relevant, for
example, in determining the amount of gain recognized with respect to
the contract in a section 351 transaction in which the old taxpayer
receives from the new taxpayer money or property other than stock of the
transferee.)
(iii) New taxpayer--(A) Method of accounting. Beginning on the date
of the transaction, the new taxpayer must account for the long-term
contract by using the same method of accounting used by the old taxpayer
prior to the transaction. The same method of accounting must be used for
such contract regardless of whether the old taxpayer's method is the new
taxpayer's principal method of accounting under Sec. 1.381(c)(4)-1(b)(3)
or whether the new taxpayer is otherwise eligible to use the old
taxpayer's method. Thus, if the old taxpayer uses the PCM to account for
the contract, the new taxpayer steps into the shoes of the old taxpayer
with respect to its completion factor and percentage of completion
methods (such as the 10-percent method), even if the new taxpayer has
not elected such methods for similarly classified contracts. Similarly,
if the old taxpayer uses the CCM, the new taxpayer steps into the shoes
of the old taxpayer with respect to the CCM, even if the new taxpayer is
not otherwise eligible to use the CCM. However, the new taxpayer is not
necessarily bound by the old taxpayer's method for similarly classified
contracts entered into by the new taxpayer subsequent to the transaction
and must apply general tax principles, including section 381, to
determine the appropriate method to account for these subsequent
contracts. To the extent that general tax principles allow the taxpayer
to account for similarly classified contracts using a method other than
the old taxpayer's method, the taxpayer is not required to obtain the
consent of the Commissioner to begin using such other method.
(B) Contract price. In the case of a long-term contract that has
been accounted for under PCM, the total contract price for the new
taxpayer is the sum of any amounts the old taxpayer or the new taxpayer
has received or reasonably expects to receive under the contract
consistent with paragraph (b)(4) of this section. Similarly, the gross
contract price in the case of a long-term contract accounted for under
the CCM includes all amounts the old taxpayer or the new taxpayer is
entitled by law or by contract to receive consistent with paragraph
(d)(3) of this section.
(C) Contract costs. Total allocable contract costs for the new
taxpayer are the allocable contract costs as defined under paragraph
(b)(5) of this section incurred by either the old taxpayer prior to, or
the new taxpayer after, the transaction. Thus, any payments between the
old taxpayer and the new taxpayer with respect to the contract in
connection with the transaction are not treated as allocable contract
costs.
(iv) Special rules related to certain corporate transactions--(A)
Old taxpayer--basis adjustment--(1) In general. Except as provided in
paragraph (k)(3)(iv)(A)(2) of this section, in the case of a transaction
described in paragraph (k)(3)(i)(D) or (E) of this section, the old
taxpayer must adjust its basis in the stock of the new taxpayer by--
(i) Increasing such basis by the amount of gross receipts the old
taxpayer has recognized under the contract; and
(ii) Reducing such basis by the amount of gross receipts the old
taxpayer has received or reasonably expects to receive under the
contract.
(2) Basis adjustment in excess of stock basis. If the old and new
taxpayer do not join in the filing of a consolidated
[[Page 186]]
Federal income tax return, the old taxpayer may not adjust its basis in
the stock of the new taxpayer under paragraph (k)(3)(iv)(A)(1) of this
section below zero and the old taxpayer must recognize ordinary income
to the extent the basis in the stock of the new taxpayer otherwise would
be adjusted below zero. If the old and new taxpayer join in the filing
of a consolidated Federal income tax return, the old taxpayer must
create an (or increase an existing) excess loss account to the extent
the basis in the stock of the new taxpayer otherwise would be adjusted
below zero under paragraph (k)(3)(iv)(A)(1) of this section. See
Secs. 1.1502-19 and 1.1502-32(a)(3)(ii).
(3) Subsequent dispositions of certain contracts. If the old
taxpayer disposes of a contract in a transaction described in paragraph
(k)(3)(i)(D) or (E) of this section that the old taxpayer acquired in a
transaction described in paragraph (k)(3)(i)(D) or (E) of this section,
the basis adjustment rule of this paragraph (k)(3)(iv)(A) is applied by
treating the old taxpayer as having recognized the amount of gross
receipts recognized by the previous old taxpayer under the contract and
any amount recognized by the previous old taxpayer with respect to the
contract in connection with the transaction in which the old taxpayer
acquired the contract. In addition, the old taxpayer is treated as
having received or as reasonably expecting to receive under the contract
any amount the previous old taxpayer received or reasonably expects to
receive under the contract. Similar principles will apply in the case of
multiple successive transfers described in paragraph (k)(3)(i)(D) or (E)
of this section involving the contract.
(B) New Taxpayer--(1) Contract price adjustment. Generally, payments
between the old taxpayer and the new taxpayer with respect to the
contract in connection with the transaction do not affect the contract
price. Notwithstanding the preceding sentence and paragraph
(k)(3)(iii)(B) of this section, however, in the case of transactions
described in paragraph (k)(3)(i)(B), (D) or (E) of this section, the
total contract price (or gross contract price) must be reduced to the
extent of any amount recognized by the old taxpayer with respect to the
contract in connection with the transaction (e.g., any amount recognized
under section 351(b) or 357 that is attributable to the contract and any
income recognized by the old taxpayer pursuant to the basis adjustment
rule of paragraph (k)(3)(iv)(A)).
(2) Basis in Contract. The new taxpayer's basis in a contract
(including the uncompleted property, if applicable) acquired in a
transaction described in paragraphs (k)(3)(i)(A) through (E) of this
section will be computed under section 362 or section 334, as
applicable. Upon a new taxpayer's completion (actual or constructive) of
a CCM or a PCM contract acquired in a transaction described in
paragraphs (k)(3)(i)(A) through (E) of this section, the new taxpayer's
basis in the contract (including the uncompleted property, if
applicable) is reduced to zero. The new taxpayer is not entitled to a
deduction or loss in connection with any basis reduction pursuant to
this paragraph (k)(3)(iv)(B)(2).
(v) Special rules related to certain partnership transactions.
[Reserved]
(4) Anti-abuse rule. Notwithstanding this paragraph (k), in the case
of a transaction entered into with a principal purpose of shifting the
tax consequences associated with a long-term contract in a manner that
substantially reduces the aggregate U.S. Federal income tax liability of
the parties with respect to that contract, the Commissioner may allocate
to the old (or new) taxpayer the income from that contract properly
allocable to the old (or new) taxpayer. For example, the Commissioner
may reallocate income from a long-term contract in a transaction in
which a contract accounted for using the CCM, or using the PCM where the
old taxpayer has received advance payments in excess of its contribution
to the contract, is transferred to a tax indifferent party (e.g., a
foreign person not subject to U.S. Federal income tax).
(5) Examples. The following examples illustrate the rules of this
paragraph (k). For purposes of these examples, it is assumed that the
contract is a long-term construction contract accounted for using the
PCM prior to the transaction unless stated otherwise and the
[[Page 187]]
contract is not transferred with a principal purpose of shifting the tax
consequences associated with a long-term contract in a manner that
substantially reduces the aggregate U.S. Federal income tax liability of
the parties with respect to that contract. The examples are as follows:
Example 1. Constructive completion--PCM--(i) Facts. In Year 1, X
enters into a contract. The total contract price is $1,000,000 and the
estimated total allocable contract costs are $800,000. In Year 1, X
incurs costs of $200,000. In Year 2, X incurs additional costs of
$400,000 before selling the contract as part of a taxable sale of its
business in Year 2 to Y, an unrelated party. At the time of sale, X has
received $650,000 in progress payments under the contract. The
consideration allocable to the contract under section 1060 is $150,000.
Pursuant to the sale, the new taxpayer Y immediately assumes X's
contract obligations and rights. Y is required to account for the
contract using the PCM. In Year 2, Y incurs additional allocable
contract costs of $50,000. Y correctly estimates at the end of Year 2
that it will have to incur an additional $75,000 of allocable contract
costs in Year 3 to complete the contract.
(ii) Old taxpayer. For Year 1, X reports receipts of $250,000 (the
completion factor multiplied by total contract price ($200,000/
$800,000x$1,000,000)) and costs of $200,000, for a profit of $50,000. X
is treated as completing the contract in Year 2 because it sold the
contract. For purposes of applying the PCM in Year 2, the total contract
price is $800,000 (the sum of the amounts received under the contract
and the amount realized in the sale ($650,000 + $150,000)) and the total
allocable contract costs are $600,000 (the sum of the costs incurred in
Year 1 and Year 2 ($200,000 + $400,000)). Thus, in Year 2, X reports
receipts of $550,000 (total contract price minus receipts already
reported ($800,000 - $250,000)) and costs incurred in year 2 of
$400,000, for a profit of $150,000.
(iii) New taxpayer. Y is treated as entering into a new contract in
Year 2. The total contract price is $200,000 (the amount remaining to be
paid under the terms of the contract less the consideration paid
allocable to the contract ($1,000,000 - $650,000 - $150,000)). The
estimated total allocable contract costs at the end of Year 2 are
$125,000 (the allocable contract costs that Y reasonably expects to
incur to complete the contract ($50,000 + $75,000)). In Year 2, Y
reports receipts of $80,000 (the completion factor multiplied by the
total contract price [($50,000/$125,000)x$200,000] and costs of $50,000
(the costs incurred after the purchase), for a profit of $30,000. For
Year 3, Y reports receipts of $120,000 (total contract price minus
receipts already reported ($200,000 - $80,000)) and costs of $75,000,
for a profit of $45,000.
Example 2. Constructive completion--CCM--(i) Facts. The facts are
the same as in Example 1, except that X and Y properly account for the
contract under the CCM.
(ii) Old taxpayer. X does not report any income or costs from the
contract in Year 1. In Year 2, the contract is deemed complete for X,
and X reports its gross contract price of $800,000 (the sum of the
amounts received under the contract and the amount realized in the sale
($650,000 + $150,000)) and its total allocable contract costs of
$600,000 (the sum of the costs incurred in Year 1 and Year 2 ($200,000 +
$400,000)) in that year, for a profit of $200,000.
(iii) New taxpayer. Y is treated as entering into a new contract in
Year 2. Under the CCM, Y reports no gross receipts or costs in Year 2. Y
reports its gross contract price of $200,000 (the amount remaining to be
paid under the terms of the contract less the consideration paid
allocable to the contract ($1,000,000 - $650,000 - $150,000)) and its
total allocable contract costs of $125,000 (the allocable contract costs
that Y incurred to complete the contract ($50,000 + $75,000)) in Year 3,
the completion year, for a profit of $75,000.
Example 3. Step-in-the-shoes--PCM--(i) Facts. The facts are the same
as in Example 1, except that X transfers the contract (including the
uncompleted property) to Y in exchange for stock of Y in a transaction
that qualifies as a statutory merger described in section 368(a)(1)(A)
and does not result in gain or loss to X under section 361(a).
(ii) Old taxpayer. For Year 1, X reports receipts of $250,000 (the
completion factor multiplied by total contract price ($200,000/
$800,000x$1,000,000)) and costs of $200,000, for a profit of $50,000.
Because the mid-contract change in taxpayer results from a transaction
described in paragraph (k)(3)(i) of this section, X is not treated as
completing the contract in Year 2. In Year 2, X reports receipts of
$500,000 (the completion factor multiplied by the total contract price
and minus the Year 1 gross receipts [($600,000/$800,000x$1,000,000)-
$250,000]) and costs of $400,000, for a profit of $100,000.
(iii) New taxpayer. Because the mid-contract change in taxpayer
results from a step-in-the-shoes transaction, Y must account for the
contract using the same methods of accounting used by X prior to the
transaction. Total contract price is the sum of any amounts that X and Y
have received or reasonably expect to receive under the contract, and
total allocable contract costs are the allocable contract costs of X and
Y. Thus, the estimated total allocable contract costs at the end of Year
2 are $725,000 (the cumulative allocable contract costs of X and the
estimated total allocable contract costs of Y ($200,000 + $400,000 +
$50,000 + $75,000)). In Year 2, Y reports receipts of $146,552 (the
[[Page 188]]
completion factor multiplied by the total contract price minus receipts
reported by the old taxpayer ([($650,000/$725,000)x$1,000,000]-$750,000)
and costs of $50,000, for a profit of $96,552. For Year 3, Y reports
receipts of $103,448 (the total contract price minus prior year receipts
($1,000,000-$896,552)) and costs of $75,000, for a profit of $28,448.
Example 4. Step-in-the-shoes--CCM--(i) Facts. The facts are the same
as in Example 3, except that X properly accounts for the contract under
the CCM.
(ii) Old taxpayer. X reports no income or costs from the contract in
Years 1, 2 or 3.
(iii) New taxpayer. Because the mid-contract change in taxpayer
results from a step-in-the-shoes transaction, Y must account for the
contract using the same method of accounting used by X prior to the
transaction. Thus, in Year 3, the completion year, Y reports receipts of
$1,000,000 and total contract costs of $725,000, for a profit of
$275,000.
Example 5. Step in the shoes--PCM--basis adjustment. The facts are
the same as in Example 3, except that X transfers the contract
(including the uncompleted property) with a basis of $0 and $125,000 of
cash to a new corporation, Z, in exchange for all of the stock of Z in a
section 351 transaction. Thus, under section 358(a), X's basis in the Z
stock is $125,000. Pursuant to paragraph (k)(3)(iv)(A)(1) of this
section, X must increase its basis in the Z stock by the amount of gross
receipts X recognized under the contract, $750,000 ($250,000 receipts in
Year 1 + $500,000 receipts in Year 2), and reduce its basis by the
amount of gross receipts X received under the contract, the $650,000 in
progress payments. Accordingly, X's basis in the Z stock is $225,000.
All other results are the same.
Example 6. Step in the shoes--CCM--basis adjustment--(i) Facts. The
facts are the same as in Example 4, except that X receives progress
payments of $800,000 (rather than $650,000) and transfers the contract
(including the uncompleted property) with a basis of $600,000 and
$125,000 of cash to a new corporation, Z, in exchange for all of the
stock of Z in a section 351 transaction. X and Z do not join in filing a
consolidated Federal income tax return.
(ii) Old taxpayer. X reports no income or costs under the contract
in Years 1, 2, or 3. Under section 358(a), X's basis in Z is $725,000.
Pursuant to paragraph (k)(3)(iv)(A)(1), X must reduce its basis in the
stock of Z by $800,000, the progress payments received by X. However, X
may not reduce its basis in the Z stock below zero pursuant paragraph
(k)(3)(iv)(A)(2) of this section. Accordingly, X's basis in the Z stock
is reduced by $725,000 to zero and X must recognize ordinary income of
$75,000.
(iii) New taxpayer. Upon completion of the contract in Year 3, Z
reports gross receipts of $925,000 ($1,000,000 original contract price--
$75,000 income recognized by the old taxpayer pursuant to the basis
adjustment rule of paragraph (k)(3)(iv)(A)) and total contract costs of
$725,000, for a profit of $200,000.
Example 7. Step in the shoes--PCM--gain recognized in transaction--
(i) Facts. The facts are the same as in Example 3, except that X
transfers the contract (including the uncompleted property) with a basis
of $0 and an unrelated capital asset with a value of $100,000 and a
basis of $0 to a new corporation, Z, in exchange for stock of Z with a
value of $200,000 and $50,000 of cash in a section 351 transaction.
(ii) Old taxpayer. For year 1, X reports receipts of $250,000
($200,000/$800,000x$1,000,000) and costs of $200,000, for a profit of
$50,000. X is not treated as completing the contract in Year 2. In Year
2, X reports receipts of $500,000 (($600,000/$800,000x$1,000,000 =
$750,000 cumulative gross receipts)--$250,000 prior year cumulative
gross receipts) and costs of $400,000, for a profit of $100,000. Under
paragraph (k)(3)(ii)(B) of this section, X determines that the gain
realized on the transfer of the contract to Z under the constructive
completion rules of paragraph (k)(2)(ii) of this section is $50,000
(total contract price of $800,000 ($150,000 value allocable to the
contract + $650,000 progress payments)--$750,000 previously recognized
cumulative gross receipts--$0 costs incurred but not recognized). The
gain realized on the transfer of the unrelated capital asset to Z is
$100,000. The amount of gain X must recognize due to the receipt of
$50,000 cash in the exchange is $50,000, of which $30,000 is allocated
to the contract ($150,000 value of contract/$250,000 total value of
property transferred to Z x $50,000) and is treated as ordinary income,
and $20,000 is allocated to the unrelated capital asset ($100,000 value
of capital asset/$250,000 total value of property transferred to Z x
$50,000). Under section 358(a), X's basis in the Z stock is $0. However,
pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X must increase
its basis in the Z stock by $750,000, the amount of gross receipts
recognized under the contract, and must reduce its basis in the Z stock
by $650,000, the amount of gross receipts X received under the contract.
Therefore, X's basis in the Z stock is $100,000.
(iii) New taxpayer. Z must account for the contract using the same
PCM method used by X prior to the transaction. Pursuant to paragraph
(k)(3)(iv)(B)(1) of this section, the total contract price is $970,000
($1,000,000 amount X and Z have received or reasonably expect to receive
under the contract--$30,000 income recognized by X with respect to the
contract as a result of the receipt of $50,000 cash in the transaction).
In Year 2, Z reports gross receipts of $119,655 ($650,000/
$725,000x$970,000 = $869,655 current year cumulative gross receipts--
$750,000 cumulative gross receipts reported by the old taxpayer)
[[Page 189]]
and costs of $50,000, for a profit of $69,655. In Year 3, Z reports
gross receipts of $100,345 ($970,000-$869,655) and costs of $75,000, for
a profit of $25,345.
Example 8. Step in the shoes--CCM--gain recognized in transaction--
(i) Facts. The facts are the same as in Example 4, except that X
transfers the contract (including the uncompleted property) with a basis
of $600,000 and an unrelated capital asset with a value of $125,000 and
a basis of $0 to a new corporation, Z, in exchange for all the stock of
Z with a value of $175,000 and $100,000 of cash in a section 351
transaction. X and Z do not join in filing a consolidated Federal income
tax return.
(ii) Old taxpayer. X reports no income or costs under the contract
in Years 1, 2, or 3. Under paragraph (k)(3)(ii)(B), X determines that
the gain realized on the transfer of the contract to Z under the
constructive completion rules of paragraph (k)(2)(ii) of this section is
$200,000 ($800,000 total contract price ($150,000 value allocable to the
contract + $650,000 progress payments)--$600,000 costs incurred but not
recognized). The gain realized on the transfer of the unrelated capital
asset to Z is $125,000. The amount of gain X must recognize due to the
receipt of $100,000 of cash in the exchange is $100,000, of which
$54,545 is allocated to the contract ($150,000 value of the contract/
$275,000 total value of property transferred to Zx$100,000) and is
treated as ordinary income, and $45,455 is allocated to the unrelated
capital asset ($125,000 value of capital asset/$275,000 total value of
property transferred to Zx$100,000). Under section 358(a), X's basis in
the Z stock is $600,000 ($600,000 basis in the contract and unrelated
capital asset transferred--$100,000 cash received + $100,000 gain
recognized). Pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X
must reduce its basis in the stock of Z by $650,000, the progress
payments received under the contract. However, X may not reduce its
basis in the Z stock below zero pursuant to paragraph (k)(3)(iv)(A)(2)
of this section. Accordingly, X's basis in the Z stock is reduced by
$600,000 to zero and X must recognize income of $50,000.
(iii) New taxpayer. Z must account for the contract using the same
CCM used by X prior to the transaction. Pursuant to paragraph
(k)(3)(iv)(B)(1) of this section, the total contract price is $895,455
($1,000,000 original contract price--$54,545 income recognized by old
taxpayer with respect to the contract as a result of the receipt of cash
in the transaction--$50,000 income recognized by the old taxpayer
pursuant to the basis adjustment rule of paragraph (k)(3)(iv)(A)).
Accordingly, upon completion of the contract in Year 3, Z reports gross
receipts of $895,455 and total contract costs of $725,000, for a profit
of $170,455.
(6) Effective date. This paragraph (k) is applicable for
transactions on or after May 15, 2002. Application of the rules of this
paragraph (k) to a transaction that occurs on or after May 15, 2002 is
not a change in method of accounting.
[T.D. 8597, 60 FR 36684, July 18, 1995, as amended by T.D. 8929, 66 FR
2232, Jan. 11, 2001; 66 FR 18191, Apr. 6, 2001; T.D 8995, 67 FR 34605,
May 15, 2002]
Sec. 1.460-5 Cost allocation rules.
(a) Overview. This section prescribes methods of allocating costs to
long-term contracts accounted for using the percentage-of-completion
method described in Sec. 1.460-4(b) (PCM), the completed-contract method
described in Sec. 1.460-4(d) (CCM), or the percentage-of-completion/
capitalized-cost method described in Sec. 1.460-4(e) (PCCM). Exempt
construction contracts described in Sec. 1.460-3(b) accounted for using
a method other than the PCM or CCM are not subject to the cost
allocation rules of this section (other than the requirement to allocate
production-period interest under paragraph (b)(2)(v) of this section).
Paragraph (b) of this section describes the regular cost allocation
methods for contracts subject to the PCM. Paragraph (c) of this section
describes an elective simplified cost allocation method for contracts
subject to the PCM. Paragraph (d) of this section describes the cost
allocation methods for exempt construction contracts reported using the
CCM. Paragraph (e) of this section describes the cost allocation rules
for contracts subject to the PCCM. Paragraph (f) of this section
describes additional rules applicable to the cost allocation methods
described in this section. Paragraph (g) of this section provides rules
concerning consistency in method of allocating costs to long-term
contracts.
(b) Cost allocation method for contracts subject to PCM--(1) In
general. Except as otherwise provided in paragraph (b)(2) of this
section, a taxpayer must allocate costs to each long-term contract
subject to the PCM in the same manner that direct and indirect costs are
capitalized to property produced by a taxpayer under Sec. 1.263A-1(e)
through (h). Thus, a taxpayer must allocate to each long-term contract
subject to the PCM
[[Page 190]]
all direct costs and certain indirect costs properly allocable to the
long-term contract (i.e., all costs that directly benefit or are
incurred by reason of the performance of the long-term contract).
However, see paragraph (c) of this section concerning an election to
allocate contract costs using the simplified cost-to-cost method. As in
section 263A, the use of the practical capacity concept is not
permitted. See Sec. 1.263A-2(a)(4).
(2) Special rules--(i) Direct material costs. The costs of direct
materials must be allocated to a long-term contract when dedicated to
the contract under principles similar to those in Sec. 1.263A-11(b)(2).
Thus, a taxpayer dedicates direct materials by associating them with a
specific contract, including by purchase order, entry on books and
records, or shipping instructions. A taxpayer maintaining inventories
under Sec. 1.471-1 must determine allocable contract costs attributable
to direct materials using its method of accounting for those inventories
(e.g., FIFO, LIFO, specific identification).
(ii) Components and subassemblies. The costs of a component or
subassembly (component) produced by the taxpayer must be allocated to a
long-term contract as the taxpayer incurs costs to produce the component
if the taxpayer reasonably expects to incorporate the component into the
subject matter of the contract. Similarly, the cost of a purchased
component (including a component purchased from a related party) must be
allocated to a long-term contract as the taxpayer incurs the cost to
purchase the component if the taxpayer reasonably expects to incorporate
the component into the subject matter of the contract. In all other
cases, the cost of a component must be allocated to a long-term contract
when the component is dedicated, under principles similar to those in
Sec. 1.263A-11(b)(2). A taxpayer maintaining inventories under
Sec. 1.471-1 must determine allocable contract costs attributable to
components using its method of accounting for those inventories (e.g.,
FIFO, LIFO, specific identification).
(iii) Simplified production methods. A taxpayer may not determine
allocable contract costs using the simplified production methods
described in Sec. 1.263A-2(b) and (c).
(iv) Costs identified under cost-plus long-term contracts and
federal long-term contracts. To the extent not otherwise allocated to
the contract under this paragraph (b), a taxpayer must allocate any
identified costs to a cost-plus long-term contract or federal long-term
contract (as defined in section 460(d)). Identified cost means any cost,
including a charge representing the time-value of money, identified by
the taxpayer or related person as being attributable to the taxpayer's
cost-plus long-term contract or federal long-term contract under the
terms of the contract itself or under federal, state, or local law or
regulation.
(v) Interest--(A) In general. If property produced under a long-term
contract is designated property, as defined in Sec. 1.263A-8(b) (without
regard to the exclusion for long-term contracts under Sec. 1.263A-
8(d)(2)(v)), a taxpayer must allocate interest incurred during the
production period to the long-term contract in the same manner as
interest is allocated to property produced by a taxpayer under section
263A(f). See Secs. 1.263A-8 to 1.263A-12 generally.
(B) Production period. Notwithstanding Sec. 1.263A-12(c) and (d),
for purposes of this paragraph (b)(2)(v), the production period of a
long-term contract--
(1) Begins on the later of--
(i) The contract commencement date, as defined in Sec. 1.460-
1(b)(7); or
(ii) For a taxpayer using the accrual method of accounting for long-
term contracts, the date by which 5 percent or more of the total
estimated costs, including design and planning costs, under the contract
have been incurred; and
(2) Ends on the date that the contract is completed, as defined in
Sec. 1.460-1(c)(3).
(C) Application of section 263A(f). For purposes of this paragraph
(b)(2)(v), section 263A(f)(1)(B)(iii) (regarding an estimated production
period exceeding 1 year and a cost exceeding $1,000,000) must be applied
on a contract-by-contract basis; except that, in the case of a taxpayer
using an accrual method of accounting, that section must be applied on a
property-by-property basis.
[[Page 191]]
(vi) Research and experimental expenses. Notwithstanding
Sec. 1.263A-1(e)(3)(ii)(P) and (iii)(B), a taxpayer must allocate
research and experimental expenses, other than independent research and
development expenses (as defined in Sec. 1.460-1(b)(9)), to its long-
term contracts.
(vii) Service costs--(A) Simplified service cost method--(1) In
general. To use the simplified service cost method under Sec. 1.263A-
1(h), a taxpayer must allocate the otherwise capitalizable mixed service
costs among its long-term contracts using a reasonable method. For
example, otherwise capitalizable mixed service costs may be allocated to
each long-term contract based on labor hours or contract costs allocable
to the contract. To be considered reasonable, an allocation method must
be applied consistently and must not disproportionately allocate service
costs to contracts expected to be completed in the near future.
(2) Example. The following example illustrates the rule of this
paragraph (b)(2)(vii)(A):
Example. Simplified service cost method. During 2001, C, whose
taxable year ends December 31, produces electronic equipment for
inventory and enters into long-term contracts to manufacture specialized
electronic equipment. C's method of allocating mixed service costs to
the property it produces is the labor-based, simplified service cost
method described in Sec. 1.263A-1(h)(4). For 2001, C's total mixed
service costs are $100,000, C's section 263A labor costs are $500,000,
C's section 460 labor costs (i.e., labor costs allocable to C's long-
term contracts) are $250,000, and C's total labor costs are $1,000,000.
To determine the amount of mixed service costs capitalizable under
section 263A for 2001, C multiplies its total mixed service costs by its
section 263A allocation ratio (section 263A labor costs / total labor
costs). Thus, C's capitalizable mixed service costs for 2001 are $50,000
($100,000x$500,000/$1,000,000). Thereafter, C allocates its
capitalizable mixed service costs to produced property remaining in
ending inventory using its 263A allocation method (e.g., burden rate,
simplified production). Similarly, to determine the amount of mixed
service costs that are allocable to C's long-term contracts for 2001, C
multiplies its total mixed service costs by its section 460 allocation
ratio (section 460 labor / total labor costs). Thus, C's allocable mixed
service contract costs for 2001 are $25,000 ($100,000x$250,000/
$1,000,000). Thereafter, C allocates its allocable mixed service costs
to its long-term contracts proportionately based on its section 460
labor costs allocable to each long-term contract.
(B) Jobsite costs. If an administrative, service, or support
function is performed solely at the jobsite for a specific long-term
contract, the taxpayer may allocate all the direct and indirect costs of
that administrative, service, or support function to that long-term
contract. Similarly, if an administrative, service, or support function
is performed at the jobsite solely for the taxpayer's long-term contract
activities, the taxpayer may allocate all the direct and indirect costs
of that administrative, service, or support function among all the long-
term contracts performed at that jobsite. For this purpose, jobsite
means a production plant or a construction site.
(C) Limitation on other reasonable cost allocation methods. A
taxpayer may use any other reasonable method of allocating service
costs, as provided in Sec. 1.263A-1(f)(4), if, for the taxpayer's long-
term contracts considered as a whole, the--
(1) Total amount of service costs allocated to the contracts does
not differ significantly from the total amount of service costs that
would have been allocated to the contracts under Sec. 1.263A-1(f)(2) or
(3);
(2) Service costs are not allocated disproportionately to contracts
expected to be completed in the near future because of the taxpayer's
cost allocation method; and
(3) Taxpayer's cost allocation method is applied consistently.
(c) Simplified cost-to-cost method for contracts subject to the PCM-
-(1) In general. Instead of using the cost allocation method prescribed
in paragraph (b) of this section, a taxpayer may elect to use the
simplified cost-to-cost method, which is authorized under section
460(b)(3)(A), to allocate costs to a long-term contract subject to the
PCM. Under the simplified cost-to-cost method, a taxpayer determines a
contract's completion factor based upon only direct material costs;
direct labor costs; and depreciation, amortization, and cost recovery
allowances on equipment and facilities directly used to manufacture or
construct the subject matter of the contract. For this purpose, the
[[Page 192]]
costs associated with any manufacturing or construction activities
performed by a subcontractor are considered either direct material or
direct labor costs, as appropriate, and therefore must be allocated to
the contract under the simplified cost-to-cost method. An electing
taxpayer must use the simplified cost-to-cost method to apply the look-
back method under Sec. 1.460-6 and to determine alternative minimum
taxable income under Sec. 1.460-4(f).
(2) Election. A taxpayer makes an election under this paragraph (c)
by using the simplified cost-to-cost method for all long-term contracts
entered into during the taxable year of the election on its original
federal income tax return for the election year. This election is a
method of accounting and, thus, applies to all long-term contracts
entered into during and after the taxable year of the election. This
election is not available if a taxpayer does not use the PCM to account
for all long-term contracts or if a taxpayer elects to use the 10-
percent method described in Sec. 1.460-4(b)(6).
(d) Cost allocation rules for exempt construction contracts reported
using the CCM--(1) In general. For exempt construction contracts
reported using the CCM, other than contracts described in paragraph
(d)(3) of this section (concerning contracts of homebuilders that do not
satisfy the $10,000,000 gross receipts test described in Sec. 1.460-
3(b)(3) or will not be completed within two years of the contract
commencement date), a taxpayer must annually allocate the cost of any
activity that is incident to or necessary for the taxpayer's performance
under a long-term contract. A taxpayer must allocate to each exempt
construction contract all direct costs as defined in Sec. 1.263A-
1(e)(2)(i) and all indirect costs either as provided in Sec. 1.263A-
1(e)(3) or as provided in paragraph (d)(2) of this section.
(2) Indirect costs--(i) Indirect costs allocable to exempt
construction contracts. A taxpayer allocating costs under this paragraph
(d)(2) must allocate the following costs to an exempt construction
contract, other than a contract described in paragraph (d)(3) of this
section, to the extent incurred in the performance of that contract--
(A) Repair of equipment or facilities;
(B) Maintenance of equipment or facilities;
(C) Utilities, such as heat, light, and power, allocable to
equipment or facilities;
(D) Rent of equipment or facilities;
(E) Indirect labor and contract supervisory wages, including basic
compensation, overtime pay, vacation and holiday pay, sick leave pay
(other than payments pursuant to a wage continuation plan under section
105(d) as it existed prior to its repeal in 1983), shift differential,
payroll taxes, and contributions to a supplemental unemployment benefits
plan;
(F) Indirect materials and supplies;
(G) Noncapitalized tools and equipment;
(H) Quality control and inspection;
(I) Taxes otherwise allowable as a deduction under section 164,
other than state, local, and foreign income taxes, to the extent
attributable to labor, materials, supplies, equipment, or facilities;
(J) Depreciation, amortization, and cost-recovery allowances
reported for the taxable year for financial purposes on equipment and
facilities to the extent allowable as deductions under chapter 1 of the
Internal Revenue Code;
(K) Cost depletion;
(L) Administrative costs other than the cost of selling or any
return on capital;
(M) Compensation paid to officers other than for incidental or
occasional services;
(N) Insurance, such as liability insurance on machinery and
equipment; and
(O) Interest, as required under paragraph (b)(2)(v) of this section.
(ii) Indirect costs not allocable to exempt construction contracts.
A taxpayer allocating costs under this paragraph (d)(2) is not required
to allocate the following costs to an exempt construction contract
reported using the CCM--
(A) Marketing and selling expenses, including bidding expenses;
(B) Advertising expenses;
(C) Other distribution expenses;
(D) General and administrative expenses attributable to the
performance of services that benefit the taxpayer's activities as a
whole (e.g., payroll expenses, legal and accounting expenses);
[[Page 193]]
(E) Research and experimental expenses (described in section 174 and
the regulations thereunder);
(F) Losses under section 165 and the regulations thereunder;
(G) Percentage of depletion in excess of cost depletion;
(H) Depreciation, amortization, and cost recovery allowances on
equipment and facilities that have been placed in service but are
temporarily idle (for this purpose, an asset is not considered to be
temporarily idle on non-working days, and an asset used in construction
is considered to be idle when it is neither en route to nor located at a
job-site), and depreciation, amortization and cost recovery allowances
under chapter 1 of the Internal Revenue Code in excess of depreciation,
amortization, and cost recovery allowances reported by the taxpayer in
the taxpayer's financial reports;
(I) Income taxes attributable to income received from long-term
contracts;
(J) Contributions paid to or under a stock bonus, pension, profit-
sharing, or annuity plan or other plan deferring the receipt of
compensation whether or not the plan qualifies under section 401(a), and
other employee benefit expenses paid or accrued on behalf of labor, to
the extent the contributions or expenses are otherwise allowable as
deductions under chapter 1 of the Internal Revenue Code. Other employee
benefit expenses include (but are not limited to): Worker's
compensation; amounts deductible or for whose payment reduction in
earnings and profits is allowed under section 404A and the regulations
thereunder; payments pursuant to a wage continuation plan under section
105(d) as it existed prior to its repeal in 1983; amounts includible in
the gross income of employees under a method or arrangement of employer
contributions or compensation which has the effect of a stock bonus,
pension, profit-sharing, or annuity plan, or other plan deferring the
receipt of compensation or providing deferred benefits; premiums on life
and health insurance; and miscellaneous benefits provided for employees
such as safety, medical treatment, recreational and eating facilities,
membership dues, etc.;
(K) Cost attributable to strikes, rework labor, scrap and spoilage;
and
(L) Compensation paid to officers attributable to the performance of
services that benefit the taxpayer's activities as a whole.
(3) Large homebuilders. A taxpayer must capitalize the costs of home
construction contracts under section 263A and the regulations
thereunder, unless the contract will be completed within two years of
the contract commencement date and the taxpayer satisfies the
$10,000,000 gross receipts test described in Sec. 1.460-3(b)(3).
(e) Cost allocation rules for contracts subject to the PCCM. A
taxpayer must use the cost allocation rules described in paragraph (b)
of this section to determine the costs allocable to the entire qualified
ship contract or residential construction contract accounted for using
the PCCM and may not use the simplified cost-to-cost method described in
paragraph (c) of this section.
(f) Special rules applicable to costs allocated under this section--
(1) Nondeductible costs. A taxpayer may not allocate any otherwise
allocable contract cost to a long-term contract if any section of the
Internal Revenue Code disallows a deduction for that type of payment or
expenditure (e.g., an illegal bribe described in section 162(c)).
(2) Costs incurred for non-long-term contract activities. If a
taxpayer performs a non-long-term contract activity, as defined in
Sec. 1.460-1(d)(2), that is incident to or necessary for the
manufacture, building, installation, or construction of the subject
matter of one or more of the taxpayer's long-term contracts, the
taxpayer must allocate the costs attributable to that activity to such
contract(s).
(g) Method of accounting. A taxpayer that adopts or elects a cost
allocation method of accounting (or changes to another cost allocation
method of accounting with the Commissioner's consent) must apply that
method consistently for all similarly classified contracts, until the
taxpayer obtains the Commissioner's consent under section 446(e) to
change to another cost allocation method. A taxpayer-initiated change in
cost allocation method will be permitted only on a cut-off basis (i.e.,
for contracts entered into on or
[[Page 194]]
after the year of change) and thus, a section 481(a) adjustment will not
be permitted or required.
[T.D. 8929, 66 FR 2237, Jan. 11, 2001]
Sec. 1.460-6 Look-back method.
(a) In general--(1) Introduction. With respect to income from any
long-term contract reported under the percentage of completion method, a
taxpayer is required to pay or is entitled to receive interest under
section 460(b) on the amount of tax liability that is deferred or
accelerated as a result of overestimating or underestimating total
contract price or contract costs. Under this look-back method, taxpayers
are required to pay interest for any deferral of tax liability resulting
from the underestimation of the total contract price or the
overestimation of total contract costs. Conversely, if the total
contract price is overestimated or the total contract costs are
underestimated, taxpayers are entitled to receive interest for any
resulting acceleration of tax liability. The computation of the amount
of deferred or accelerated tax liability under the look-back method is
hypothetical; application of the look-back method does not result in an
adjustment to the taxpayer's tax liability as originally reported, as
reported on an amended return, or as adjusted on examination. Thus, the
look-back method does not correct for differences in tax liability that
result from over- or under-estimation of contract price and costs and
that are permanent because, for example, tax rates change during the
term of the contract.
(2) Overview. Paragraph (b) explains which situations require
application of the look-back method to income from a long-term contract.
Paragraph (c) explains the operation of the three computational steps
for applying the look-back method. Paragraph (d) provides guidance
concerning the simplified marginal impact method. Paragraph (e) provides
an elective method to minimize the number of times the look-back method
must be reapplied to a single long-term contract. Paragraph (f)
describes the reporting requirements for the look-back method and the
tax treatment of look-back interest. Paragraph (g) provides rules for
applying the look-back method when there is a transaction that changes
the taxpayer that reports income from a long-term contract prior to the
completion of a contract. Paragraph (h) provides examples illustrating
the three computational steps for applying the look-back method.
Paragraph (j) of this section provides guidance concerning the election
not to apply the look-back method in de minimis cases.
(b) Scope of look-back method--(1) In general. The look-back method
applies to any income from a long-term contract within the meaning of
section 460(f) that is required to be reported under the percentage of
completion method (as modified by section 460) for regular income tax
purposes or for alternative minimum tax purposes. If a taxpayer uses the
percentage of completion-capitalized cost method for long-term
contracts, the look-back method applies for regular tax purposes only to
the portion (40, 70, or 90 percent, whichever applies) of the income
from the contract that is reported under the percentage of completion
method. To the extent that the percentage-of-completion method is
required to be used under Sec. 1.460-1(g) with respect to income and
expenses that are attributable to activities that benefit a related
party's long-term contract, the look-back method also applies to these
amounts, even if those activities are not performed under a contract
entered into directly by the taxpayer.
(2) Exceptions from section 460. The look-back method generally does
not apply to the regular taxable income from any long-term construction
contract within the meaning of section 460(e)(4) that:
(i) Is a home construction contract within the meaning of section
460(e)(1)(A), or
(ii) Is not a home construction contract but is estimated to be
completed within a 2-year period by a taxpayer whose average annual
gross receipts for the 3 tax years preceding the tax year the contract
is entered into do not exceed $10,000,000 (as provided in section
460(e)(1)(B)). These contracts are not subject to the look-back method
for regular tax purposes, even if the taxpayer uses a version of the
percentage
[[Page 195]]
of completion method permitted under Sec. 1.451-3, unless the taxpayer
has properly changed its method of accounting for these contracts to the
percentage of completion method as modified by section 460(b). The look-
back method, however, applies to the alternative minimum taxable income
from a contract of this type, unless it is exempt from the required use
of the percentage of completion method under section 56(a)(3).
(3) De minimis exception. Notwithstanding that the percentage of
completion method is otherwise required to be used, the look-back method
does not apply to any long-term contract that:
(i) Is completed within 2 years of the contract commencement date,
and
(ii) Has a gross contract price (as of the completion of the
contract) that does not exceed the lesser of $1,000,000 or 1 percent of
the average annual gross receipts of the taxpayer for the 3 tax years
preceding the tax year in which the contract is completed.
This de minimis exception is mandatory and, therefore, precludes
application of the look-back method to any contract that meets the
requirements of the exception. The de minimis exception applies for
purposes of computing both regular taxable income and alternative
minimum taxable income. Solely for this purpose, the determination of
whether a long-term contract meets the gross receipts test for both
alternative minimum tax and regular tax purposes is made based only on
the taxpayer's regular taxable income.
(4) Alternative minimum tax. For purposes of computing alternative
minimum taxable income, section 56(a)(3) generally requires long-term
contracts within the meaning of section 460(f) (generally without regard
to the exceptions in section 460(e)) to be accounted for using only the
percentage of completion method as defined in section 460(b), including
the look-back method of section 460(b), with respect to tax years
beginning after December 31, 1986. However, section 56(a)(3) (and thus
the look-back method) does not apply to any long-term contract entered
into after June 20, 1988, and before the beginning of the first tax year
that begins after September 30, 1990, that meets the conditions of both
section 460(e)(1)(A) and clauses (i) and (ii) of section 460(e)(1)(B),
and does not apply to any long-term contract entered into in a tax year
that begins after September 30, 1990, that meets the conditions of
section 460(e)(1)(A). A taxpayer that applies the percentage of
completion method (and thus the look-back method) to income from a long-
term contract only for purposes of determining alternative minimum
taxable income, and not regular taxable income, must apply the look-back
method to the alternative minimum taxable income in the year of contract
completion and other filing years whether or not the taxpayer was liable
for the alternative minimum tax for the filing year or for any prior
year. Interest is computed under the look-back method to the extent that
the taxpayer's total tax liability (including the alternative minimum
tax liability) would have differed if the percentage of completion
method had been applied using actual, rather than estimated, contract
price and contract costs.
(5) Effective date. The look-back method, including the de minimis
exception, applies to long-term contracts entered into after February
28, 1986. With respect to activities that are subject to section 460
solely because they benefit a long-term contract of a related party, the
look-back method generally applies only if the related party's long-term
contract was entered into after June 20, 1988, unless a principal
purpose of the related-party arrangement is to avoid the requirements of
section 460.
(c) Operation of the look-back method--(1) Overview--(i) In general.
The amount of interest charged or credited to a taxpayer under the look-
back method is computed in three steps. This paragraph (c) describes the
three steps for applying the look-back method. These steps are
illustrated by the examples in paragraph (h). The first step is to
hypothetically reapply the percentage of completion method to all long-
term contracts that are completed or adjusted in the current year (the
``filing year''), using the actual, rather than estimated, total
contract price and contract costs. Based on this reapplication, the
taxpayer determines the
[[Page 196]]
amount of taxable income (and alternative minimum taxable income) that
would have been reported for each year prior to the filing year that is
affected by contracts completed or adjusted in the filing year if the
actual, rather than estimated, total contract price and costs had been
used in applying the percentage of completion method to these contracts,
and to any other contracts completed or adjusted in a year preceding the
filing year. If the percentage of completion method only applies to
alternative minimum taxable income for contracts completed or adjusted
in the filing year, only alternative minimum taxable income is
recomputed in the first step. The second step is to compare what the tax
liability would have been under the percentage of completion method (as
reapplied in the first step) for each tax year for which the tax
liability is affected by income from contracts completed or adjusted in
the filing year (a ``redetermination year'') with the most recent
determination of tax liability for that year to produce a hypothetical
underpayments or overpayment of tax. The third step is to apply the rate
of interest on overpayments designated under section 6621 of the Code,
compounded daily, to the hypothetical underpayment or overpayment of tax
for each redetermination year to compute interest that runs, generally,
from the due date (determined without regard to extensions) of the
return for the redetermination year to the due date (determined without
regard to extensions) of the return for the filing year. The net amount
of interest computed under the third step is paid by or credited to the
taxpayer for the filing year. Paragraph (d) provides a simplified
marginal impact method that simplifies the second step--the computation
of hypothetical underpayments or overpayments of tax liability for
redetermination years--and, in some cases, the third step--the
determination of the time period for computing interest.
(ii) Post-completion revenue and expenses--(A) In general. Except as
otherwise provided in section 460(b)(6) (see Sec. 1.460-6(j) for method
of electing) or Sec. 1.460-6(e), a taxpayer must apply the look-back
method to a long-term contract in the completion year and in any post-
completion year for which the taxpayer must adjust total contract price
or total allocable contract costs, or both, under the PCM. Any year in
which the look-back method must be reapplied is treated as a filing
year. See Example (3) of paragraph (h)(4) for an illustration of how the
look-back method is applied to post-completion adjustments.
(B) Completion. A contract is considered to be completed for
purposes of the look-back method in the year in which final completion
and acceptance within the meaning of Sec. 1.460-1(c)(3) have occurred.
(C) Discounting of contract price and contract cost adjustments
subsequent to completion; election not to discount--(1) General rule.
The amount of any post-completion adjustment to the total contract price
or contract costs is discounted, solely for purposes of applying the
look-back method, from its value at the time the amount is taken into
account in computing taxable income to its value at the completion of
the contract. The discount rate for this purpose is the Federal mid-term
rate under section 1274(d) in effect at the time the amount is properly
taken into account. For purposes of applying the look-back method for
the completion year, no amounts are discounted, even if they are
received after the completion year.
(2) Election not to discount. Notwithstanding the general
requirement to discount post-completion adjustments, a taxpayer may
elect not to discount contract price and contract cost adjustments with
respect to any contract. The election not to discount is to be made on a
contract-by-contract basis and is binding with respect to all post-
completion adjustments that arise with respect to a contract for which
an election has been made. An election not to discount with respect to
any contract is made by stating that an election is being made on the
taxpayer's timely filed Federal income tax return (determined with
regard to extensions) for the first tax year after completion in which
the taxpayer takes into account (i.e., includes in income or deducts)
any adjustment to the contract price or contract costs. See
Sec. 301.9100-8 of this chapter.
[[Page 197]]
(3) Year-end discounting convention. In the absence of an election
not to discount, any revisions to the contract price and contract costs
must be discounted to their value as of the completion of the contract
in reapplying the look-back method. For this purpose, the period of
discounting is the period between the completion date of the contract
and the date that any adjustment is taken into account in computing
taxable income. Although taxpayers may use the period between the months
in which these two events actually occur, in many cases, these dates may
not be readily identifiable. Therefore, for administrative convenience,
taxpayers are permitted to use the period between the end of the tax
years in which these events occur as the period of discounting provided
that the convention is used consistently with respect to all post-
completion adjustments for all contracts of the taxpayer the adjustments
to which are discounted. In that case, the taxpayer must use as the
discount rate the Federal mid-term rate under section 1274(d) as of the
end of the tax year in which any revision is taken into account in
computing taxable income.
(D) Revenue acceleration rule. Section 460(b)(1) imposes a special
rule that requires a taxpayer to include in gross income, for the tax
year immediately following the year of completion, any previously
unreported portion of the total contract price (including amounts that
the taxpayer expects to receive in the future) determined as of that
year, even if the percentage of completion ratio is less than 100
percent because the taxpayer expects to incur additional allocable
contract costs in a later year. At the time any remaining portion of the
contract price is includible in income under this rule, no offset
against this income is permitted for estimated future contract costs. To
achieve the requirement to report all remaining contract revenue without
regard to additional estimated costs, a taxpayer must include only costs
actually incurred through the end of the tax year in the denominator of
the percentage of completion ratio in applying the percentage of
completion method for any tax years after the year of completion. The
look-back method also must be reapplied for the year immediately
following the year of completion if any portion of the contract price is
includible in income in that year by reason of section 460(b)(1). For
purposes of reapplying the look-back method as a result of this
inclusion in income, the taxpayer must only include in the denominator
of the percentage of completion ratio the actual contract costs incurred
as of the end of the year, even if the taxpayer reasonably expects to
incur additional allocable contract costs. To the extent that costs are
incurred in a subsequent tax year, the look-back method is reapplied in
that year (or a later year if the delayed reapplication method is used),
and the taxpayer is entitled to receive interest for the post-completion
adjustment to contract costs. Because this reapplication occurs
subsequent to the completion year, only the cumulative costs incurred as
of the end of the reapplication year are includible in the denominator
of the percentage of completion ratio.
(2) Look-back Step One--(i) Hypothetical reallocation of income
among prior tax years. For each filing year, a taxpayer must allocate
total contract income among prior tax years, by hypothetically applying
the percentage of completion method to all contracts that are completed
or adjusted in the filing year using the rules of this paragraph (c)(2).
The taxpayer must reallocate income from those contracts among all years
preceding the filing year that are affected by those contracts using the
total contract price and contract costs, as determined as of the end of
the filing year (``actual contract price and costs''), rather than the
estimated contract price and contract costs. The taxpayer then must
determine the amount of taxable income and the amount of alternative
minimum taxable income that would have been reported for each affected
tax year preceding the filing year if the percentage of completion
method had been applied on the basis of actual contract price and
contract costs in reporting income from all contracts completed or
adjusted in the filing year and in any preceding year. If the percentage
of completion method only applies to alternative minimum taxable
[[Page 198]]
income from the contract, only alternative minimum taxable income is
recomputed in the first step. For purposes of reallocating income (and
costs if the 10-percent year changes for a taxpayer using the 10-percent
method of section 460(b)(5)) under the look-back method, the method of
computing the percentage of completion ratio is the same method used to
report income from the contract on the taxpayer's return. (Thus, an
election to use the 10-percent method or the simplified cost-to-cost
method is taken into account). See Example (1) of paragraph (h)(2) for
an illustration of Step One.
(ii) Treatment of estimated future costs in year of completion. If a
taxpayer reasonably expects to incur additional allocable contract costs
in a tax year subsequent to the year in which the contract is completed,
the taxpayer includes the actual costs incurred as of the end of the
completion year plus the additional allocable contract costs that are
reasonably expected to be incurred (to the extent includible under the
taxpayer's percentage of completion method) in the denominator of the
percentage of completion ratio. The completion year is the only filing
year for which the taxpayer may include additional estimated costs in
the denominator of the percentage of completion ratio in applying the
look-back method. If the look-back method is reapplied in any year after
the completion year, only the cumulative costs incurred as of the end of
the year of reapplication are includible in the denominator of the
percentage of completion ratio in reapplying the look-back method.
(iii) Interim reestimates not considered. The look-back method
cannot be applied to a contract before it is completed. Accordingly, for
purposes of applying Step One, the actual total contract price and
contract costs are substituted for the previous estimates of total
contract price and contract costs only with respect to contracts that
have been completed in the filing year and in a tax year preceding the
filing year. No adjustments are made under Step One for contracts that
have not been completed prior to the end of the current filing year,
even if, as of the end of this year, the estimated total contract price
or contract costs for these uncompleted contracts is different from the
estimated amount that was used during any tax year for which taxable
income is recomputed with respect to completed contracts under the look-
back method for the current filing year.
(iv) Tax years in which income is affected. In general, because
income under the percentage of completion method is generally reported
as costs are incurred, the taxable income and alternative minimum
taxable income are recomputed only for each year in which allocable
contract costs were incurred. However, there will be exceptions to this
general rule. For example, a taxpayer may be required to cumulatively
adjust the income from a contract in a year in which no allocable
contract costs are incurred if the estimated total contract price or
contract costs was revised in that year. However, in applying the look-
back method, no contract income is allocated to that year. Thus, there
may be a difference between the amount of contract income originally
reported for that year and the amount of contract income as reallocated.
Similarly, because of the revenue acceleration rule of section
460(b)(1), income may be reported in the year immediately following the
completion year even though no costs were incurred during that year and,
in applying the look-back method in that year or another year, if
additional costs are incurred or the contract price is adjusted in a
later year, no income is allocated to the year immediately following the
completion year.
(v) Costs incurred prior to contract execution; 10-percent method--
(A) General rule. The look-back method does not require allocation of
contract income to tax years before the contract was entered into. Costs
incurred prior to the year a contract is entered into are first taken
into account in the numerator of the percentage of completion ratio in
the year the contract is entered into. A taxpayer using the 10-percent
method must also use the 10-percent method in applying the look-back
method, using actual total contract costs to determine the 10-percent
year.
[[Page 199]]
Thus, contract income is never reallocated to a year before the 10-
percent year as determined on the basis of actual contract costs. If the
10-percent year is earlier as a result of applying Step One of the look-
back method, contract costs incurred up to and including the new 10-
percent year (as determined based on actual contract costs), are
reallocated from the original 10-percent year to the new 10-percent, and
costs incurred in later years but before the old 10-percent year are
reallocated to those years. If the 10-percent year is later as a result
of applying Step One of the look-back method, contract costs incurred up
to and including the new 10-percent year are reallocated from all prior
years to the new 10-percent year. This is the only case in which costs
are reallocated under the look-back method.
(B) Example. The application of the look-back method by a taxpayer
using the 10-percent method is illustrated by the following example:
Example. Z elected to use the 10-percent method of section 460(b)(5)
for reporting income under the percentage of completion method. Z
entered into a contract in 1990 for a fixed price of $1,000x. During
1990, Z incurred allocable contract costs of $80x and estimated that it
would incur a total of $900x for the entire contract. Since $80x is less
than 10 percent of total estimated contract costs, Z reported no revenue
from the contract in 1990 and deferred the $80x of costs incurred. In
1991, Z incurred an additional $620x of contract costs, and completed
the contract. Accordingly, in its 1991 return, Z reported the entire
contract price of $l,000x, and deducted the $620x of costs incurred in
1991 and the $80x of costs incurred in 1990.
Under section 460(b)(5), the 10-percent method applies both for
reporting contract income and the look-back method. Under the look-back
method, since the costs incurred in 1990 ($80x) exceed 10 percent of the
actual total contract costs ($700x), Z is required to allocate $114x of
contract revenue ($80x/$700xx$1,000x) and the $80x of costs incurred to
1990. Thus, application of the 1ook-back method results in a net
increase in taxable income for 1990 of $34x, solely for purposes of the
look-back method.
(vi) Amount treated as contract price--(A) General rule. The amount
that is treated as total contract price for purposes of applying the
percentage of completion method and reapplying the percentage of
completion method under the look-back method under Step One includes all
amounts that the taxpayer expects to receive from the customer. Thus,
amounts are treated as part of the contract price as soon as it is
reasonably estimated that they will be received, even if the all-events
test has not yet been met.
(B) Contingencies. Any amounts related to contingent rights or
obligations, such as incentive fees or amounts in dispute, are not
separated from the contract and accounted for under a non-long-term
contract method of accounting, notwithstanding any provision in
Sec. 1.460-4(b)(4)(i), to the contrary. Instead, those amounts are
treated as part of the total contract price in applying the look-back
method. For example, if an incentive fee under a contract to manufacture
a satellite is payable to the taxpayer after a specified period of
successful performance, the incentive fee is includible in the total
contract price at the time and to the extent that it can reasonably be
predicted that the performance objectives will be met, . A portion of
the contract price that is in dispute is included in the total contract
price at the time and to the extent that the taxpayer can reasonably
expect the dispute will be resolved in the taxpayer's favor (without
regard to when the taxpayer receives payment for the amount in dispute
or when the dispute is finally resolved).
(C) Change orders. In applying the look-back method, a change order
with respect to a contract is not treated as a separate contract unless
the change order would be treated as a separate contract under the rules
for severing and aggregating contracts provided in Sec. 1.460-1(e).
Thus, if a change order is not treated as a separate contract, the
contract price and contract costs attributable to the change order must
be taken into account in allocating contract income to all tax years
affected by the underlying contract.
(3) Look-back Step Two: Computation of hypothetical overpayment or
underpayment of tax--(i) In general. Step Two involves the computation
of a hypothetical overpayment or underpayment of tax for each year in
which the tax liability is affected by income from contracts that are
completed or adjusted
[[Page 200]]
in the filing year (a ``redetermination year''). The application of Step
Two depends on whether the taxpayer uses the simplified marginal impact
method contained in paragraph (d) or the actual method described in this
paragraph (c)(3). The remainder of this paragraph (c)(3) does not apply
if a taxpayer uses the simplified marginal impact method.
(ii) Redetermination of tax liability. Under the method described in
this paragraph (c)(3) (the ``actual method''), a taxpayer, first, must
determine what its regular and alternative minimum tax liability would
have been for each redetermination year if the amounts of contract
income allocated in Step One for all contracts completed or adjusted in
the filing year and in any prior year were substituted for the amounts
of contract income reported under the percentage of completion method on
the taxpayer's original return (or as subsequently adjusted on
examination, or by amended return). See Example (2) of paragraph (h)(3)
for an illustration of Step Two.
(iii) Hypothetical underpayment or overpayment. After redetermining
the income tax liability for each tax year affected by the reallocation
of contract income, the taxpayer then determines the amount, if any, of
the hypothetical underpayment or overpayment of tax for each of these
redetermination years. The hypothetical underpayment or overpayment for
each affected year is the difference between the tax liability as
redetermined under the look-back method for that year and the amount of
tax liability determined as of the latest of the following:
(A) The original return date;
(B) The date of a subsequently amended or adjusted return (if,
however, the amended return is due to a carryback described in section
6611(f), see paragraph (c)(4)(iii)); or,
(C) The last previous application of the look-back method (in which
case, the previous hypothetical tax liability is used).
(iv) Cumulative determination of tax liability. The redetermination
of tax liability resulting from previous applications of the look-back
method is cumulative. Thus, for example, in computing the amount of a
hypothetical overpayment or underpayment of tax for a redetermination
year, the current hypothetical tax liability is compared to the
hypothetical tax liability for that year determined as of the last
previous application of the look-back method.
(v) Years affected by look-back only. A redetermination of income
tax liability under Step Two is required for every tax year for which
the tax liability would have been affected by a change in the amount of
income or loss for any other year for which a redetermination is
required. For example, if the allocation of contract income under Step
One changed the amount of a net operating loss that was carried back to
a year preceding the year the taxpayer entered into the contract, the
tax liability for the earlier year must be redetermined.
(vi) Definition of tax liability. For purposes of Step Two, the
income tax liability must be redetermined by taking into account all
applicable additions to tax, credits, and net operating loss carrybacks
and carryovers. Thus, the tax, if any, imposed under section 55
(relating to alternative minimum tax) must be taken into account. For
example, if the taxpayer did not pay alternative minimum tax, but would
have paid alternative minimum tax for that year if actual rather than
estimated contract price and costs had been used in determining contract
income for the year, the amount of any hypothetical overpayment or
underpayment of tax must be determined by comparing the hypothetical
total tax liability (including hypothetical alternative minimum tax
liability) with the actual tax liability for that year. The effect of
taking these items into account in applying the look-back method is
illustrated in Examples (4) through (7) of paragraphs (h)(5) through
(h)(8) below.
(4) Look-back Step Three: Calculation of interest on underpayment or
overpayment--(i) In general. After determining a hypothetical
underpayment or overpayment of tax for each redetermination year, the
taxpayer must determine the interest charged or credited on each of
these amounts. Interest on the amount determined under Step Two is
determined by applying the overpayment rate designated under
[[Page 201]]
section 6621, compounded daily. In general, the time period over which
interest is charged on hypothetical underpayments or credited on
hypothetical overpayments begins at the due date (not including
extensions) of the return for the redetermination year for which the
hypothetical underpayment or overpayment determined in Step Two is
computed. This time period generally ends on the earlier of:
(A) The due date (not including extensions) of the return for the
filing year, and
(B) The date both
(1) The income tax return for the filing year is filed, and
(2) The tax for that year has been paid in full. If a taxpayer uses
the simplified marginal impact method contained in paragraph (d), the
remainder of this paragraph (c)(4) does not apply.
(ii) Changes in the amount of a loss or credit carryback or
carryover. The time period for determining interest may be different in
cases involving loss or credit carrybacks or carryovers in order to
properly reflect the time period during which the taxpayer (in the case
of an underpayment) or the Government (in the case of an overpayment)
had the use of the amount determined to be a hypothetical underpayment
or overpayment. Thus, if a reallocation of contract income under Step
One results in an increase or decrease to a net operating loss carryback
(but not a carryforward), the interest due or to be refunded must be
computed on the increase or decrease in tax attributable to the change
to the carryback only from the due date (not including extensions) of
the return for the redetermination year that generated the carryback and
not from the due date of the return for the redetermination year in
which the carryback was absorbed. In the case of a change in the amount
of a carryover as a result of applying the lookback method, interest is
computed from the due date of the return for the year in which the
carryover was absorbed. See Examples (8) and (9) of paragraph (h)(9) for
an illustration of these rules.
(iii) Changes in the amount of tax liability that generated a
subsequent refund. If the amount of tax liability for a redetermination
year (as reported on the taxpayer's original return, as subsequently
adjusted on examination, as adjusted by amended return, or as
redetermined by the last previous application of the look-back method)
is decreased by the application of the look-back method, and any portion
of the redetermination year tax liability was absorbed by a loss or
credit carryback arising in a year subsequent to the redetermination
year, the look-back method applies as follows to properly reflect the
time period of the use of the tax overpayment. To the extent the amount
of tax absorbed because of the carryback exceeds the total hypothetical
tax liability for the year (as redetermined under the look-back method)
the taxpayer is entitled to receive interest only until the due date
(not including extensions) of the return for the year in which the
carryback arose.
Example. Upon the completion of a long-term contract in 1990, the
taxpayer redetermines its tax liability for 1988 under the look-back
method. This redetermination results in a hypothetical reduction of tax
liability from $1,500x (actual liability originally reported) to $1,200x
(hypothetical liability). In addition, the taxpayer had already received
a refund of some or all of the actual 1988 tax by carrying back a net
operating loss (NOL) that arose in 1989. The time period over which
interest would be computed on the hypothetical overpayment of $300x for
1988 would depend on the amount of the refund generated by the
carryback, as illustrated by the following three alternative situations:
(A) If the amount refunded because of the NOL is $1,500x: interest
is credited to the taxpayer on the entire hypothetical overpayment of
$300x from the due date of the 1988 return, when the hypothetical
overpayment occurred, until the due date of the 1989 return, when the
taxpayer received a refund for the entire amount of the 1988 tax,
including the hypothetical overpayment.
(B) If the amount refunded because of the NOL is $1,000x: interest
is credited to the taxpayer on the entire amount of the hypothetical
overpayment of $300x from the due date of the 1988 return, when the
hypothetical overpayment occurred, until the due date of the 1990
return. In this situation interest is credited until the due date of the
return for the completion year of the contract, rather than the due date
of the return for the year in which the carryback arose, because the
amount refunded was less than the redetermined tax liability. Therefore,
no portion of the hypothetical overpayment is treated
[[Page 202]]
as having been refunded to the taxpayer before the filing year.
(C) If the amount refunded because of the NOL is $1,300x-: interest
is credited to the taxpayer on $100x ($1,300x-$1,200x) from the due date
of the 1988 return until the due date of the 1989 return because only
this portion of the total hypothetical overpayment is treated as having
been refunded to the taxpayer before the filing year. However, the
taxpayer did not receive a refund for the remaining $200x of the
overpayment at that time and, therefore, is credited with interest on
$200x through the due date of the tax return for 1990, the filing year.
See Examples (10) and (11) of paragraph (h)(9) for a further
illustration of this rule.
(d) Simplified marginal impact method--(1) Introduction. This
paragraph (d) provides a simplified method for calculating look-back
interest. Any taxpayer may elect this simplified marginal impact method,
except that pass-through entities described in paragraph (d)(4) of this
section are required to apply the simplified marginal impact method at
the entity level with respect to domestic contracts and the owners of
those entities do not apply the look-back method to those contracts.
Under the simplified marginal impact method, a taxpayer calculates the
hypothetical underpayments or overpayments of tax for a prior year based
on an assumed marginal tax rate. A taxpayer electing to use the
simplified marginal impact method must use the method for each long-term
contract for which it reports income (except with respect to domestic
contracts if the taxpayer is an owner in a widely held pass-through
entity that is required to use the simplified marginal impact method at
the entity level for those contracts).
(2) Operation--(i) In general. Under the simplified marginal impact
method, income from those contracts that are completed or adjusted in
the filing year is first reallocated in accordance with the procedures
of Step One contained in paragraph (c)(2) of this section. Step Two is
modified in the following manner. The hypothetical underpayment or
overpayment of tax for each year of the contract (a ``redetermination
year'') is determined by multiplying the applicable regular tax rate (as
defined in paragraph (d)(2)(iii)) by the increase or decrease in regular
taxable income (or, if it produces a greater amount, by multiplying the
applicable alternative minimum tax rate by the increase or decrease in
alternative minimum taxable income, whether or not the taxpayer would
have been subject to the alternative minimum tax) that results from
reallocating income to the tax year under Step One. Generally, the
product of the alternative minimum tax rate and the increase or decrease
in alternative minimum taxable income will be the greater of the two
amounts described in the preceding sentence only with respect to
contracts for which a taxpayer uses the full percentage of completion
method only for alternative minimum tax purposes and uses the completed
contract method, or the percentage of completion-capitalized cost
method, for regular tax purposes. Step Three is then applied. Interest
is credited to the taxpayer on the net overpayment and is charged to the
taxpayer on the net underpayment for each redetermination year from the
due date (determined without regard to extensions) of the return for the
redetermination year until the earlier of
(A) The due date (determined without regard to extensions) of the
return for the filing year, and
(B) The first date by which both the return is filed and the tax is
fully paid.
(ii) Applicable tax rate. For purposes of determining hypothetical
underpayments or overpayments of tax under the simplified marginal
impact method, the applicable regular tax rate is the highest rate of
tax in effect for the redetermination year under section 1 in the case
of an individual and under section 11 in the case of a corporation. The
applicable alternative minimum tax rate is the rate of tax in effect for
the taxpayer under section 55(b)(1). The highest rate is determined
without regard to the taxpayer's actual rate bracket and without regard
to any additional surtax imposed for the purpose of phasing out multiple
tax brackets or exemptions.
(iii) Overpayment ceiling. The net hypothetical overpayment of tax
for any redetermination year is limited to the taxpayer's total federal
income tax liability for the redetermination year reduced by the
cumulative amount of net hypothetical overpayments of tax for that
redetermination year resulting
[[Page 203]]
from earlier applications of the look-back method. If the reallocation
of contract income results in a net overpayment of tax and this amount
exceeds the actual tax liability (as of the filing year) for the
redetermination year, as adjusted for past applications of the look-back
method and taking into account net operating loss, capital loss, or
credit carryovers and carrybacks to that year, the actual tax so
adjusted is treated as the overpayment for the redetermination year.
This overpayment ceiling does not apply when the simplified marginal
impact method is applied at the entity level by a widely held pass-
through entity in accordance with paragraph (d)(4) of this section.
(iv) Example. The application of the simplified marginal impact
method is illustrated by the following example:
Example. Corporation X, a calendar-year taxpayer, reports income
from long-term contracts and elected the simplified marginal impact
method when it filed its income tax return for 1989. X uses only the
percentage of completion method for both regular taxable income and
alternative minimum taxable income. X completed contracts A, B, and C in
1989 and, therefore, was required to apply the look-back method in 1989.
Income was actually reported for these contracts in 1987, 1988, and
1989. X's applicable tax rate, as determined under section 11, for the
redetermination years 1987 and 1988 was 40 percent and 34 percent,
respectively. The amount of contract income originally reported and
reallocated for contracts A, B, and C, and the net overpayments and
underpayments for the redetermination years are as follows:
------------------------------------------------------------------------
1987 1988
------------------------------------------------------------------------
Contract A:
Originally reported........................... $5,000x $4,000x
Reallocated................................... 3,000x 5,000x
Increase/(Decrease)........................... (2,000x) 1,000x
Contract B:
Originally reported........................... 6,000x 2,000x
Reallocated................................... 7,000x 1,500x
Increase/(Decrease)........................... 1,000x (500x)
Contract C:
Originally reported........................... 8,000x 5,000x
Reallocated................................... 4,000x 7,000x
Increase/(Decrease)........................... (4,000x) 2,000x
Net Increase/(Decrease)......................... (5,000x) 2,500x
Tentative (Underpayment)/Overpayment:
@ .40....................................... 2,000x ..........
@ .34....................................... .......... (850x)
Ceiling:
Actual Tax Liability (After Carryovers and 1,500x 500x
Carrybacks)..................................
Final (Underpayment)/Overpayment................ 1,500x (850x)
------------------------------------------------------------------------
Under the simplified marginal impact method, X determined a
tentative hypothetical net overpayment for 1987 and a net underpayment
for 1988. X determined these amounts by first aggregating the difference
for contracts A, B, and C between the amount of contract price
originally reported and the amount of contract price as reallocated and,
then, applying the highest regular tax rate to the aggregate decrease in
income for 1987 and the aggregate increase in income for 1988.
However, X's overpayment for 1987 is subject to a ceiling based on
X's total tax liability. Because the tentative net overpayment of tax
for 1987 exceeds the actual tax liability for that year after taking
into account carryovers and carrybacks to that year, the final
overpayment under the simplified marginal impact method is the amount of
tax liability paid instead of the tentative net overpayment. Since
application of the look-back method for 1988 results in a tentative
underpayment of tax, it is not subject to a ceiling. If the look-back
method is applied in 1991, the ceiling amount for 1987 will be zero and
the ceiling amount for 1988 will be $1,350.
X is entitled to receive interest on the hypothetical overpayment
from March 15, 1988, to March 15, 1990. X is required to pay interest on
the underpayment from March 15, 1989, to March 15, 1990.
(3) Anti-abuse rule. If the simplified marginal impact method is
used with respect to any long-term contract (including a contract of a
widely held pass-through entity), the district director may recompute
interest for the contract (including domestic contracts of widely held
pass-through entities) under the look-back method using the actual
method (and without regard to the simplified marginal impact method).
The district director may make such a recomputation only if the amount
of income originally reported with respect to the contract for any
redetermination year exceeds the amount of income reallocated under the
look-back method with respect to that contract for that year (using
actual contract price and contract costs) by the lesser of $1,000,000 or
20 percent of the amount of income as reallocated (i.e., based on actual
contract price and contract costs) under the look-back method with
respect to that contract for that year. In determining whether to
exercise this authority upon examination of the Form 8697, the district
director may take into account whether the taxpayer overreported income
[[Page 204]]
for a purpose of receiving interest under the look-back method on a
hypothetical overpayment determined at the applicable tax rate. The
district director also may take into account whether the taxpayer
underreported income for the year in question with respect to other
contracts. Notwithstanding the look-back method, the district director
may require an adjustment to the tax liability for any open tax year if
the taxpayer did not apply the percentage of completion method properly
on its original return.
(4) Application--(i) Required use by certain pass-through entities--
(A) General rule. The simplified marginal impact method is required to
be used with respect to income reported from domestic contracts by a
pass-through entity that is either a partnership, an S corporation, or a
trust, and that is not closely held. With respect to contracts described
in the preceding sentence, the simplified marginal impact method is
applied by the pass-through entity at the entity level. For determining
the amount of any hypothetical underpayment or overpayment, the
applicable regular and alternative minimum tax rates, respectively, are
generally the highest rates of tax in effect for corporations under
section 11 and section 55 (b)(1). However, the applicable regular and
alternative minimum tax rates are the highest rates of tax imposed on
individuals under section 1 and section 55 (b)(1) if, at all times
during the redetermination year involved (i.e., the year in which the
hypothetical increase or decrease in income arises), more than 50
percent of the interests in the entity were held by individuals directly
or through 1 or more pass-through entities.
(B) Closely held. A pass-through entity is closely held if, at any
time during any redetermination year, 50 percent of more (by value) of
the beneficial interests in that entity are held (directly or
indirectly) by or for 5 or fewer persons. For this purpose, the term
``person'' has the same meaning as in section 7701(a)(1), except that a
pass-through entity is not treated as a person. In addition, the
constructive ownership rules of section 1563(e) apply by substituting
the term ``beneficial interest'' for the term ``stock'' and by
substituting the term ``pass-through entity'' for the term,
``corporation'' used in that section, as appropriate, for purposes of
determining whether a beneficial interest in a pass-through entity is
indirectly owned by any person.
(C) Examples. The following examples illustrate the application of
the rules of paragraph (d)(4)(i):
Example (1). P, a partnership, began a long-term contract on March
1, 1986, and completed this contract in its tax year ending December 31,
1989. P used the percentage of completion method for all contract
income. Substantially all of the income from the contract arose from
U.S. sources. At all times during all of the years for which income was
required to be reported under the contract, exactly 25 percent of the
value of P's interests was owned by Corporation M. The remaining 75
percent of the value of P's interests was owned in equal shares by 15
unrelated individuals, who are also unrelated to Corporation M. M's
ownership of P represents less than 50 percent of the value of the
beneficial interests in P, and, therefore, viewed alone, is insufficient
to make P a closely held partnership. In addition, because no 4 of the
individual owners together own 25 percent or more of the remaining value
of P's beneficial interests, there is no group of 5 owners that together
own, directly or indirectly, 50 percent or more by value of the
beneficial interests in P. Therefore, P is not closely held pass-through
entity.
Because P is not a closely held pass-through entity, and because P
completed the contract after the effective date of section 460(b)(4), P
is required to use the simplified marginal impact method. Any interest
computed under the look-back method will be paid to, or collected from,
P, rather than its partners, and must be reported to each of the
partners on Form 1065 as interest income or expense. Further, assume
that, for the redetermination years, Corporation M is subject to
alternative minimum tax at the rate of 20 percent and 3 of the
individuals who own interests in P are subject to the highest marginal
tax rate of 33 percent in 1988. Regardless of the actual marginal tax
rates of its partners, P is required to determine the underpayment or
overpayment of tax for each redetermination year at the entity level by
applying a single rate to the increase or decrease in income resulting
from the reallocation of contract income under the look-back method.
Because more than 50 percent of the interests in P are held by
individuals, P must use the highest rate specified in section 1 for each
redetermination year. Thus, the rate applied by P is 50 percent for
1986, 38.5 percent for 1987, and 28 percent for 1988.
[[Page 205]]
Example (2). Assume the same facts as in Example (1), except that
one of the individuals, Individual I, who directly owns 5 percent of the
value of the interests of P, also owns 100 percent of the stock of
Corporation M. Section 1563(e)(4) of the Code provides that stock owned
directly or indirectly by or for a corporation is considered to be owned
by any person who owns 5 percent or more in value of its stock in that
proportion which the value of the stock which that person so owns bears
to the value of all the stock in that corporation. Because section
460(b)(4)(C)(iii) and this paragraph (d)(4) provide that rules similar
to the constructive ownership rules of section 1563(e) apply in
determining whether a pass-through entity is closely held, all of M's
interest in P is attributed to I because I owns 100 percent of the value
of the stock in M. Accordingly, because I's direct 5 percent and
constructive 25 percent ownership of P, plus the interests owned by any
4 other individual partners, equals 50 percent or more of the value of
the beneficial interests of P, P is a closely held pass-through entity
within the meaning of section 460(b)(4)(C)(iii). Therefore, P cannot use
the simplified marginal impact method at the entity level. Accordingly,
each of the partners of P must separately apply the look-back method to
their respective interests in the income and expenses attributable to
the contract, but each partner may elect to use the simplified marginal
impact method with respect to the partner's share of income from the
contract.
(D) Domestic contracts--(1) General rule. A domestic contract is any
contract substantially all of the income of which is from sources in the
United States. For this purpose, ``substantially all'' of the income
from a long-term contract is considered to be from United States sources
if 95 percent or more of the gross income from the contract is from
sources within the United States as determined under the rules in
sections 861 through 865.
(2) Portion of contract income sourced. In determining whether
substantially all of the gross income from a long-term contract is from
United States sources, taxpayers must apply the allocation and
apportionment principles of sections 861 through 865 only to the portion
of the contract accounted for under the percentage of completion method.
Under the percentage of completion method, gross income from a long-term
contract includes all payments to be received under the contract (i.e.,
any amounts treated as contract price). Similarly, all costs taken into
account in the computation of taxable income under the percentage of
completion method are deducted from gross income rather than added to a
cost of goods sold account that reduces gross income. Therefore,
allocable contract costs are not considered in determining whether a
long-term contract is a domestic contract or a foreign contract, even
if, under the taxpayer's facts, the allocation of contract costs to any
portion of a contract not accounted for under the percentage of
completion method would affect the relative percentages of United States
and foreign source gross income from the entire contract if this portion
of the contract were taken into account in applying the 95-percent test.
(E) Application to foreign contracts. If a widely held pass-through
entity has some foreign contracts and some domestic contracts, the
owners of the pass-through entity each apply the look-back method
(using, if they elect, the simplified marginal impact method) to their
respective share of the income and expense from foreign contracts.
Moreover, in applying the look-back method to foreign contracts at the
owner level, the owners do not take into account their share of
increases or decreases in contract income resulting from the application
of the simplified marginal impact method with respect to domestic
contracts at the entity level.
(F) Effective date. The simplified marginal impact method must be
applied to pass-through entities described in paragraph (d)(4)(i) of
this section with respect to domestic contracts completed or adjusted in
tax years for which the due date of the return (determined with regard
to extensions) of the pass-through entity is after November 9, 1988.
(ii) Elective use--(A) General rule. As provided in paragraph
(d)(4)(i) of this section, the simplified marginal impact method must be
used by certain pass-through entities with respect to domestic
contracts. C corporations, individuals, and owners of closely held pass-
through entities may elect the simplified marginal impact method. Owners
of other pass-through entities may
[[Page 206]]
also elect the simplified marginal impact method with respect to all
contracts other than those for which the simplified marginal impact
method is required to be applied at the entity level. This rule applies
to foreign contracts of widely held pass-through entities. In the case
of an electing owner in a pass-through entity, the simplified marginal
impact method is applied at the owner level, instead of at the entity
level, with respect to the owner's share of the long-term contract
income and expense reported by the pass-through entity.
(B) Election requirements. A taxpayer elects the simplified marginal
impact method by stating that the election is being made on a timely
filed income tax return (determined with regard to extensions) for the
first tax year the election is to apply. An election to use the
simplified marginal impact method applies to all applications of the
look-back method to all eligible long-term contracts for the tax year
for which the election is made and for any subsequent tax year. The
election may not be revoked without the consent of the Commissioner.
(C) Consolidated group consistency rule. In the case of a
consolidated group of corporations as defined in Sec. 1.1502-1(h), an
election to use the simplified marginal impact method is made by the
common parent of the group. The election is binding on all other
affected members of the group (including members that join the group
after the election is made with respect to all applications of the look-
back method after joining). If a member subsequently leaves the group,
the election remains binding as to that member unless the Commissioner
consents to a revocation of the election. If a corporation using the
simplified marginal impact method joins a group that does not use the
method, the election is automatically revoked with respect to all
applications of the look-back method after it joins the group.
(e) Delayed reapplication method--(1) In general. For purposes of
reapplying the look-back method after the year of contract completion, a
taxpayer may elect the delayed reapplication method to minimize the
number of required reapplications of the look-back method. Under this
method, the look-back method is reapplied after the year of completion
of a contract (or after a subsequent application of the look-back
method) only when the first one of the following conditions is met with
respect to the contract:
(i) The net undiscounted value of increases or decreases in the
contract price occurring since the time of the last application of the
look-back method exceeds the lesser of $1,000,000 or 10 percent of the
total contract price as of that time,
(ii) The net undiscounted value of increases or decreases in the
contract costs occurring since the time of the last application of the
look-back method exceeds the lesser of $1,000,000 or 10 percent of the
total contract price as of that time,
(iii) The taxpayer goes out of existence,
(iv) The taxpayer reasonably believes the contract is finally
settled and closed, or
(v) Neither condition (e)(1) (i), (ii), (iii), nor (iv) above is met
by the end of the fifth tax year that begins after the last previous
application of the look-back method.
(2) Time and manner of making election. An election to use the
delayed reapplication method may be made for any filing year for which
the due date of the return (determined with regard to extensions) is
after June 12, 1990. The election is made by a statement to that effect
on the taxpayer's timely filed Federal income tax return (determined
with regard to extensions) for the first tax year the election is to be
effective. An election to use the delayed reapplication method is
binding with respect to all long-term contracts for which the look-back
method would be reapplied without regard to the election in the year of
election and any subsequent year unless the Commissioner consents to a
revocation of the election. In the case of a consolidated group of
corporations as defined in Sec. 1.1502-1(h), an election to use the
delayed reapplication method is made by the common parent of the group.
The election is binding on all other affected members of the group
(including members that join the group after the election is made with
respect to contracts
[[Page 207]]
adjusted after joining). If a member subsequently leaves the group, the
election remains binding as to that member unless the Commissioner
consents to a revocation of the election. If a corporation that has made
the election joins a consolidated group that has not made the election,
the election is treated as revoked with respect to contracts adjusted
after joining.
(3) Examples. The operation of this delayed reapplication method is
illustrated by the following examples:
Example (1). X completes a contract in 1987, and applies the look-
back method when its return for 1987 is filed. X properly uses $600,000
as the actual contract price in applying the look-back method. In 1990,
as a result of the settlement of a dispute with its customer, X
redetermines total contract price to be $640,000, and includes $40,000
in gross income. On its return for 1990, X states it is electing the
delayed reapplication method. X is not required to reapply the look-back
method at that time, because $40,000 does not exceed the lesser of
$1,000,000 or 10 percent of the unadjusted contract price of $600,000,
and 5 years have not passed since the last application of the look-back
method.
Example (2). Assume the same facts as in Example (1), except that at
the end of 1992, the fifth year after completion of the contract, no
other adjustments to contract price or contract costs have occurred. X
is required to reapply the look-back method in 1992 and, accordingly,
redetermine its tax liability for each redetermination year. After
redetermining the underpayment of tax for those years, X must compute
the amount of interest charged on the underpayments. Although 1992 is
the filing year, interest is due on the amount of each underpayment
resulting from the adjustment only from the due date of the return for
each redetermination year to the due date of the return for 1990 because
the tax liability for the adjustment was fully paid in 1990. However,
from the due of the 1990 return until the due date of the 1992 return,
when the look-back method is reapplied for the adjustment, interest is
due on the amount of interest attributable to the underpayments.
(f) Look-back reporting--(1) Procedure. The amount of any interest
due from, or payable to, a taxpayer as a result of applying the look-
back method is computed on Form 8697 for any filing year. In general,
the look-back method is applied by the taxpayer that reports income from
a long-term contract. See paragraph (g) of this section to determine who
is responsible for applying the look-back method when, prior to the
completion of a long-term contract, there is a transaction that changes
the taxpayer that reports income from the contract.
(2) Treatment of interest on return--(i) General rule. The amount of
interest required to be paid by a taxpayer is treated as an income tax
under subtitle A, but only for purposes of subtitle F of the Code (other
than sections 6654 and 6655), which addresses tax procedures and
administration. Thus, a taxpayer that fails to pay the amount of
interest due is subject to any applicable penalties under subtitle F,
including, for example, an underpayment penalty under section 6651, and
the taxpayer also is liable for underpayment interest under section
6601. However, interest required to be paid under the look-back method
is treated as interest expense for purposes of computing taxable income
under subtitle A, even though it is treated as income tax liability for
subtitle F purposes. Interest received under the look-back method is
treated as taxable interest income for all purposes, and is not treated
as a reduction in tax liability or a tax refund. The determination of
whether or not interest computed under the look-back method is treated
as tax is determined on a ``net'' basis for each filing year. Thus, if a
taxpayer computes for the current filing year both hypothetical
overpayments and hypothetical underpayments for prior years, the
taxpayer has an increase in tax only if the interest computed on the
underpayments for all those prior years exceeds the interest computed on
the overpayments for all those prior years, for all contracts completed
or adjusted for the year.
(ii) Timing of look-back interest. For purposes of determining
taxable income under subtitle A of the Code, any amount of interest
payable to the taxpayer under the look-back method is includible in
gross income as interest income in the tax year it is properly taken
into account under the taxpayer's method of accounting for interest
income. Any amount of interest required to be paid is taken into account
as interest expense arising from an underpayment of income tax in the
tax year it is properly taken into account under the taxpayer's method
of accounting for interest expense. Thus,
[[Page 208]]
look-back interest required to be paid by an individual, or by a pass-
through entity on behalf of an individual owner (or beneficiary) under
the simplified marginal impact method, is personal interest and,
therefore, is disallowed in accordance with Sec. 1.163-9T(b)(2).
Interest determined at the entity level under the simplified marginal
impact method is allocated among the owners (or beneficiaries) for
reporting purposes in the same manner that interest income and interest
expense are allocated to owners (or beneficiaries) and subject to the
requirements of section 704 and any other applicable rules.
(3) Statute of limitations and compounding of interest on look-back
interest. For guidance on the statute of limitations applicable to the
assessment and collection of look-back interest owed by a taxpayer, see
sections 6501 and 6502. A taxpayer's claim for credit or refund of look-
back interest previously paid by or collected from a taxpayer is a claim
for credit or refund of an overpayment of tax and is subject to the
statute of limitations provided in section 6511. A taxpayer's claim for
look-back interest (or interest payable on look-back interest) that is
not attributable to an amount previously paid by or collected from a
taxpayer is a general, non-tax claim against the federal government. For
guidance on the statute of limitations that applies to general, non-tax
claims against the federal government, see 28 U.S.C. sections 2401 and
2501. For guidance applicable to the compounding of interest when the
look-back interest is not paid, see sections 6601 to 6622.
(g) Mid-contract change in taxpayer--(1) In general. The rules in
this paragraph (g) apply if, as described in Sec. 1.460-4(k), prior to
the completion of a long-term contract accounted for using the PCM or
the PCCM by a taxpayer (old taxpayer), there is a transaction that makes
another taxpayer (new taxpayer) responsible for accounting for income
from the same contract. The rules governing constructive completion
transactions are provided in paragraph (g)(2) of this section, while the
rules governing step-in-the-shoes transactions are provided in paragraph
(g)(3) of this section. For purposes of this paragraph, pre-transaction
years are all taxable years of the old taxpayer in which the old
taxpayer accounted for (or should have accounted for) gross receipts
from the contract, and post-transaction years are all taxable years of
the new taxpayer in which the new taxpayer accounted for (or should have
accounted for) gross receipts from the contract.
(2) Constructive completion transactions. In the case of a
transaction described in Sec. 1.460-4(k)(2)(i) (constructive completion
transaction), the look-back method is applied by the old taxpayer with
respect to pre-transaction years upon the date of the transaction and,
if the new taxpayer uses the PCM or the PCCM to account for the
contract, by the new taxpayer with respect to post-transaction years
upon completion of the contract. The contract price and allocable
contract costs to be taken into account by the old taxpayer or the new
taxpayer in applying the look-back method are described in Sec. 1.460-
4(k)(2).
(3) Step-in-the-shoes transactions--(i) General rules. In the case
of a transaction described in Sec. 1.460-4(k)(3)(i) (step-in-the-shoes
transaction), the look-back method is not applied at the time of the
transaction, but is instead applied for the first time when the contract
is completed by the new taxpayer. Upon completion of the contract, the
look-back method is applied by the new taxpayer with respect to both
pre-transaction years and post-transaction years, taking into account
all amounts reasonably expected to be received by either the old or new
taxpayer and all allocable contract costs incurred during both periods
as described in Sec. 1.460-4(k)(3). The new taxpayer is liable for
filing the Form 8697 and for interest computed on hypothetical
underpayments of tax, and is entitled to receive interest with respect
to hypothetical overpayments of tax, for both pre- and post-transaction
years. The old taxpayer will be secondarily liable for any interest
required to be paid with respect to pre-transaction years reduced by any
interest on pre-transaction overpayments.
(ii) Application of look-back method to pre-transaction period--(A)
Contract price. The actual contract price for pre-
[[Page 209]]
transaction taxable years must be determined by the new taxpayer without
regard to any contract price adjustment described in paragraph
(k)(3)(iv)(B)(1) of this section.
(B) Method. The new taxpayer may apply the look-back method to each
pre-transaction taxable year that is a redetermination year using the
simplified marginal impact method described in paragraph (d) of this
section (regardless of whether or not the old taxpayer would have
actually used that method and without regard to the tax liability
ceiling). But see paragraph (d)(4) of this section, which requires use
of the simplified marginal impact method by certain pass-through
entities.
(C) Interest accrual period. With respect to any hypothetical
underpayment or overpayment of tax for a pre-transaction taxable year,
interest accrues from the due date of the old taxpayer's tax return (not
including extensions) for the taxable year of the underpayment or
overpayment until the due date of the new taxpayer's return (not
including extensions) for the completion year or the year of a post-
completion adjustment, whichever is applicable.
(D) Information old taxpayer must provide. In order to help the new
taxpayer to apply the look-back method with respect to pre-transaction
taxable years, any old taxpayer that accounted for income from a long-
term contract under the PCM or PCCM for either regular or alternative
minimum tax purposes is required to provide the information described in
this paragraph to the new taxpayer by the due date (not including
extensions) of the old taxpayer's income tax return for the first
taxable year ending on or after a step-in-the-shoes transaction
described in Sec. 1.460-4(k)(3)(i). The required information is as
follows--
(1) The portion of the contract reported by the old taxpayer under
PCM for regular and alternative minimum tax purposes (i.e., whether the
old taxpayer used PCM, the 40/60 PCCM method, or the 70/30 PCCM method);
(2) Any submethods used in the application of PCM (e.g., the
simplified cost-to-cost method or the 10-percent method);
(3) The amount of total contract price reported by year;
(4) The numerator and the denominator of the completion factor by
year;
(5) The due date (not including extensions) of the old taxpayer's
income tax returns for each taxable year in which income was required to
be reported;
(6) Whether the old taxpayer was a corporate or a noncorporate
taxpayer by year; and
(7) Any other information required by the Commissioner by
administrative pronouncement.
(iii) Application of look-back method to post-transaction years.
With respect to post-transaction taxable years, the new taxpayer must
use the same look-back method it uses for other contracts (i.e., the
simplified marginal impact method or the actual method) to determine the
amount of any hypothetical overpayment or underpayment of tax and the
time period for computing interest on these amounts.
(iv) S corporation elections. Following the conversion of a C
corporation into an S corporation, the look-back method is applied at
the entity level with respect to contracts entered into prior to the
conversion, notwithstanding section 460(b)(4)(B)(i).
(4) Effective date. This paragraph (g) is applicable for
transactions on or after May 15, 2002.
(h) Examples--(1) Overview. This paragraph provides computational
examples of the rules of this section. Except as otherwise noted, the
examples involve calendar-year taxpayers and involve long-term contracts
subject to section 460 that are accounted for using the percentage of
completion method, rather than the percentage of completion-capitalized
cost method. If the percentage of completion-capitalized cost method
were used by a taxpayer described in the examples, the amounts of
contract income and expenses shown in the examples would be reduced, for
purposes of determining regular taxable income, to the appropriate
fraction (40, 70, or 90 percent) of contract items accounted for under
the percentage of completion method. Tens of thousands of dollars ($
00,000's) are
[[Page 210]]
omitted from the figures in the examples. The contracts described in the
examples are assumed to be the taxpayers' only contracts that are
subject to the look-back method of section 460. Except as otherwise
stated, the examples assume that the taxpayer has no adjustments and
preferences for purposes of section 55, so that alternative minimum
taxable income is the same as taxable income, and no alternative minimum
tax is imposed for the years involved. The examples assume that the
taxpayer does not elect the 10-percent method, the simplified marginal
impact method, or the delayed reapplication method.
(2) Step One. The following example illustrates the application of
paragraph (c)(2):
Example (1). In 1989, W completes three long-term contracts, A, B,
and C, entered into on January 1 of 1986, 1987, and 1988, respectively.
For Contract A, W used the completed contract method of accounting. For
Contract B, W used the percentage of completion-capitalized cost method
of accounting, taking into account 60 percent of contract income under
W's normal method of accounting, which was the completed contract
method. For Contract C, W used the percentage of completion method of
accounting. The total price for each contract was $1,000. In computing
alternative minimum taxable income, W is required to use the percentage
of completion method for Contracts B and C. W used regular tax costs for
purposes of determining the degree of contract completion under the
alternative minimum tax.
Contract A is not taken into account for purposes of applying the
look-back method, because it is subject to neither section 460 nor
section 56(a)(3). Thus, even if W had used the percentage of completion
method as permitted under Sec. 1.451-3, instead of the completed
contract method, the look-back method would not be applicable because
the Contract A was entered into before the effective date of section
460.
The actual costs allocated to Contracts B and C under section 460(c)
and incurred in each year of the contract were as follows:
------------------------------------------------------------------------
Contract 1987 1988 1989 Total
------------------------------------------------------------------------
B......................................... $200 $400 $200 $800
C......................................... 100 300 400 800
------------------------------------------------------------------------
In applying the look-back method, the first step is to allocate the
contract price among tax years preceding and including the completion
year. That allocation would produce the following amounts of gross
income for purposes of the regular tax. Note that no income from
Contract C is allocated to 1987, the year before the contract was
entered into, even though contract costs were incurred in 1987:
----------------------------------------------------------------------------------------------------------------
Contract 1987 1988 1989
----------------------------------------------------------------------------------------------------------------
B.................................. $100 $200 $700
(40%X$200/$800X$1000) ((40%X$600/$800X$1000)-$100) .......
C.................................. 0 500 500
............................ ($400/$800X$1000) .......
----------------------------------------------------------------------------------------------------------------
Because the percentage of completion-capitalized cost method may not
be used for alternative minimum tax purposes, the allocation of contract
income would produce the following amounts of gross income for purposes
of computing alternative minimum taxable income:
----------------------------------------------------------------------------------------------------------------
Contract 1987 1988 1989
----------------------------------------------------------------------------------------------------------------
B................................................. $250 $500 $250
($200/$800X$1000) (($600/$800X$1000)-$250) .......
C................................................. 0 500 500
----------------------------------------------------------------------------------------------------------------
(3) Step Two. The following example illustrates the application of
paragraph (c)(3):
Example (2). (i) X enters into two long-term contracts (D and E) in
1988. X determines its tax liability for 1988 as follows:
e=estimate
a=amount originally reported (actual)
h=hypothetical
[[Page 211]]
------------------------------------------------------------------------
1988
------------------------ Total
D E
------------------------------------------------------------------------
1988 contract costs................. $3,000a $2,000a ..........
Total contract costs................ 8,000e 8,000e ..........
Total contract price................ 10,000e 10,000e ..........
1988 completion %................... 37.5e 25e ..........
1988 gross income................... 3,750a 2,500a ..........
Less, 1988 costs.................... (3,000a) (2,000a) ..........
-----------------------------------
1988 net contract income...... 750a 500a $1,250a
Other 1988 net income (loss)........ .......... .......... (2,000a)
-----------------------------------
Taxable income (NOL).......... .......... .......... (750a)
-----------------------------------
Tax........................... .......... .......... 0a
Refund from NOL carryback fully .......... .......... 345a
absorbed in 1985, at 46%...........
------------------------------------------------------------------------
(ii) X completes Contract D during 1989. X determines its taxable
income for 1989 as follows:
------------------------------------------------------------------------
1989
------------------------ Total
D E
------------------------------------------------------------------------
1989 contract costs................. $3,000a 0a ..........
Total contract costs................ 6,000a $9,000e ..........
Total contract price................ 10,000a 10,000e ..........
1989 completion %................... 100a 22.2e ..........
1989 gross income/(loss)............ 6,250a (278a) ..........
Less, 1989 costs.................... (3,000a) 0a ..........
-----------------------------------
1989 net contract income...... 3,250a (278a) $2,972a
Other 1989 net income (loss)........ .......... .......... 0a
-----------------------------------
Taxable income (NOL).......... .......... .......... 2,972a
Tax at 34%.......................... .......... .......... 1,011a
------------------------------------------------------------------------
(iii) For purposes of the look-back method, X must reallocate the
actual total contract D price between 1988 and 1989 based on the actual
total contract D costs. This results in the following hypothetical
underpayment of tax for 1988 for purposes of the look-back method. Note
that X does not reallocate the contract E price in applying the look-
back method in 1989 because contract E has not been completed, even
though X's estimate of contract E costs has changed. The following
computation is only for purposes of applying the look-back method, and
does not result in the assessment of a tax deficiency.
------------------------------------------------------------------------
1988
------------------------ Total
D E
------------------------------------------------------------------------
1988 contract costs................. $3,000a $2,000a ..........
Total contract costs................ 6,000a 8,000e ..........
Total contract price................ 10,000a 10,000e ..........
1988 completion %................... 50a 25e ..........
1988 gross income................... 5,000h 2,500a ..........
Less, 1988 costs.................... (3,000a) (2,000a) ..........
-----------------------------------
1988 net contract income...... 2,000h 500a $2,500h
Other 1988 net income (loss)........ .......... .......... (2,000a)
-----------------------------------
Taxable income (NOL).......... .......... .......... 500h
Tax at 34%.......................... .......... .......... 170h
Less, previously computed tax....... .......... .......... -0a
Underpayment of 1988 tax............ .......... .......... 170h
Underpayment of 1985 tax from NOL .......... .......... 345h
carryback refund in 1988...........
-----------------------------------
Total underpayment of tax..... .......... .......... 515h
------------------------------------------------------------------------
[[Page 212]]
For purposes of any subsequent application of the look-back method
for which 1989 is a redetermination year, because the reallocation of
contract income and redetermination of tax liability are cumulative, X
will use for 1989 the amount of contract D income and the amount of tax
liability that would have been reported in 1989 if X had used actual
contract costs instead of the amounts that were originally reported
using the estimate of $8,000. Assuming no subsequent revisions (due to,
for example, adjustments to contract D price and costs determined after
the end of 1989), this amount would be determined as follows:
------------------------------------------------------------------------
1989
------------------------ Total
D E
------------------------------------------------------------------------
1989 contract costs................. $3,000a 0a ..........
Total contract costs................ 6,000a $9,000e ..........
Total contract price................ 10,000a 10,000e ..........
1989 completion %................... 100a 22.2e ..........
1989 gross income................... 5,000h (278a) ..........
Less, 1989 costs.................... (3,000a) 0a ..........
-----------------------------------
1989 net contract income...... 2,000h (278a) $1,722h
Other 1989 net income (loss)........ .......... .......... 0a
-----------------------------------
Taxable income (NOL).......... .......... .......... 1,722h
Tax at 34%.......................... .......... .......... 585h
------------------------------------------------------------------------
(iv) X completes contract E during 1990. X determines its taxable
income for 1990 as follows:
------------------------------------------------------------------------
1990
------------------------ Total
D E
------------------------------------------------------------------------
1990 contract costs................. .......... $7,000a ..........
Total contract costs................ .......... 9,000a ..........
Total contract price................ .......... 10,000a ..........
1990 completion %................... .......... 100a ..........
1990 gross income................... .......... 7,778a ..........
Less, 1990 costs.................... .......... (7,000a) ..........
-----------------------------------
1990 net contract income...... .......... 778a $778a
Other 1990 net income (loss)........ .......... .......... 0a
-----------------------------------
Taxable income (NOL).......... .......... .......... 778a
Tax at 34%.......................... .......... .......... 265a
------------------------------------------------------------------------
(v) For purposes of the look-back method, X must reallocate the
actual total contract E price between the 1988, 1989, and 1990, based on
the actual total contract E costs.
This results in the following hypothetical overpayment of tax for 1988.
Note that X uses the amount of income for contract D determined in the
last previous application of the look-back method, and not the amount of
income actually reported:
------------------------------------------------------------------------
1988
------------------------ Total
D E
------------------------------------------------------------------------
1988 contract costs................. $3,000a $2,000a ..........
Total contract costs................ $6,000a $9,000a ..........
Total contract price................ $10,000a $10,000a ..........
1988 completion (%)................. 50a 22.2a ..........
1988 gross income................... $5,000h $2,222h ..........
Less, 1988 costs.................... ($3,000a) ($2,000a) ..........
-----------------------------------
1988 net contract income...... $2,000h $222h $2,222h
Other 1988 net income (loss)........ .......... .......... ($2,000a)
-----------------------------------
Taxable income (NOL).......... .......... .......... $222h
-----------------------------------
Tax at 34%.................... .......... .......... $75h
[[Page 213]]
Less, previously computed tax (based .......... .......... $170h
on most recent application of the
look-back method)..................
-----------------------------------
Overpayment of 1988 tax....... .......... .......... ($95h)
------------------------------------------------------------------------
In applying the look-back method to 1989, X again uses the amounts
substituted as of the last previous application of the look-back method
with respect to contract D. Thus, X computes its hypothetical
underpayment for 1989 as follows:
------------------------------------------------------------------------
1989
------------------------ Total
D E
------------------------------------------------------------------------
1989 contract costs................. $3,000a 0a ..........
Total contract costs................ $6,000a $9,000a ..........
Total contract price................ $10,000a $10,000a ..........
1989 completion (%)................. 100a 22.2a ..........
1989 gross income................... $5,000h $0h ..........
Less, 1989 costs.................... ($3,000a) ($0a) ..........
-----------------------------------
1989 net contract income...... $2,000h 0a $2,000h
Other 1989 net income (loss)........ .......... .......... ($0a)
-----------------------------------
Taxable income (NOL)................ .......... .......... $2,000h
Tax at 34%.......................... .......... .......... $680h
Less, previously computed tax....... .......... .......... $585h
-----------------------------------
Underpayment of 1989 tax...... .......... .......... $95h
------------------------------------------------------------------------
For purposes of any subsequent application of the look-back method
for which 1990 is a redetermination year, X will use for 1990 the amount
of Contract E income, and the amount of tax liability, that was
originally reported in 1990 because X's estimate of the total contract
costs from $8,000 to $9,000 did not change after 1989. Without regard to
any subsequent revisions, these amounts are the same as in the table in
paragraph (h)(3)(iv) above.
(4) Post-completion adjustments. The following example illustrates
the application of paragraph (c)(1)(ii):
Example (3). The facts are the same as in Example (2). In 1991, X
settles a lawsuit against its customer in Contract E. The customer pays
X an additional $3,000, without interest, in 1991. Applying the Federal
mid-term rate then in effect, this $3,000 has a discounted value at the
time of contract completion in 1990 of $2,700. X is required to apply
the look-back method for 1991 even though no contract was completed in
1991. X must include the full $3,000 adjustment (which was not
previously includible in total contract price) in gross income for 1991.
X does not elect not to discount adjustments to the contract price or
costs. Thus, X adjusts the contract price by the discounted amount of
the adjustment and, therefore, uses $12,700 (not $13,000) for total
Contract E price, rather than $10,000, which was used when the look-back
method was first applied with respect to Contract E.
For purposes of the look-back method, X must allocate the revised
total Contract E price of $12,700 between 1988, 1989 and 1990 based on
the actual total Contract E costs, and compare the resulting revised tax
liability with the tax liability determined for the last previous
application of the look-back method involving those years. This results
in the following hypothetical underpayments of tax for purposes of the
look-back method:
r=revised
------------------------------------------------------------------------
1988
------------------------- Total
D E
------------------------------------------------------------------------
1988 contract costs................ $3,000a $2,000a ..........
Total contract costs............... $6,000a $9,000a ..........
Total contract price............... $10,000a $12,700r ..........
1988 completion (%)................ 50a 22.2a ..........
1988 gross income.................. $5,000h $2,822rh ..........
Less, 1988 costs................... ($3,000a) ($2,000a) ..........
------------------------------------
[[Page 214]]
1988 net contract income..... $2,000h 822rh $2,222rh
Other 1988 net income (loss)....... .......... ........... ($2,000a)
------------------------------------
Taxable income............... .......... ........... $822rh
Tax at 34%................... .......... ........... $279rh
Less, previously computed tax...... .......... ........... $75h
Underpayment of 1988 tax..... .......... ........... $204rh
------------------------------------------------------------------------
No Contract E costs were incurred in 1989, and there is no
hypothetical underpayment for 1989.
------------------------------------------------------------------------
1990
--------------------------------------
D E Total
------------------------------------------------------------------------
1990 contract costs.............. ........... $7,000a ...........
Total contract costs............. ........... $9,000a ...........
Total contract price............. ........... $12,700r ...........
1990 completion (%).............. ........... 100a ...........
1990 gross income................ ........... $9,878rh ...........
Less 1990 costs.................. ........... ($7,000a) ...........
--------------------------------------
1990 net contract income... ........... $2,878rh $2,878rh
Other 1990 net income (loss)..... ........... ........... 0a
--------------------------------------
Taxable income (NOL)............. ........... ........... $2,878rh
Tax at 34%....................... ........... ........... $978rh
Less, previously computed tax.... ........... ........... $265h
--------------
Underpayment of 1990 tax... ........... ........... $713rh
------------------------------------------------------------------------
In 1992, X incurs an additional cost of $1,000 allocable to the
contract, which was not previously includible in total contract costs.
Applying the Federal mid-term rate then in effect, the $1,000 has a
discounted value at the time of contract completion of $800. X deducts
this additional $1,000 in expenses in 1992. Based on this increase to
contract costs, X reapplies the look-back method, and determines the
following hypothetical underpayments for 1988, 1989 and 1990 for
purposes of the look-back method:
------------------------------------------------------------------------
1988
-------------------------- Total
D E
------------------------------------------------------------------------
1988 contract costs.............. $3,000a $2,000a ...........
Total contract costs............. $6,000a $9,800r ...........
Total contract price............. $10,000a $12,700r ...........
1988 completion (%).............. 50a 20.4r ...........
1988 gross income................ $5,000h $2,592rh ...........
Less, 1988 costs................. ($3,000a) ($2,000a) ...........
--------------------------------------
1988 net contract income... $2,000h 592rh $2,592rh
Other 1988 net income (loss)..... ........... ........... ($2,000a)
--------------------------------------
Taxable income (NOL)....... ........... ........... $592rh
Tax at 34%....................... ........... ........... $201rh
Less, previously computed tax.... ........... ........... $279rh
--------------------------------------
Overpayment of 1988 tax.... ........... ........... ($78rh)
------------------------------------------------------------------------
No Contract E costs were incured in 1989, and there is no
hypothetical underpayment for 1989.
[[Page 215]]
------------------------------------------------------------------------
1990
------------------------- Total
D E
------------------------------------------------------------------------
1990 contract costs............... .......... ........... $7,000a
Total contract costs.............. .......... 9,800r ...........
Total contract price.............. .......... 12,700r ...........
1990 completion (%)............... .......... 92a ...........
1990 gross income................. .......... 9,071rh ...........
Less, 1990 costs.................. .......... (7,000a) ...........
-------------------------------------
1990 Net contract income.......... .......... 2,071rh $2,071rh
Other 1990 net income (loss)...... .......... ........... 0a
-------------------------------------
Taxable income (NOL)........ .......... ........... 2,071rh
Tax at 34%........................ .......... ........... 704rh
Less, previously computed tax..... .......... ........... 978rh
-------------------------------------
Overpayment of 1990 tax..... .......... ........... (274rh)
------------------------------------------------------------------------
(5) Alternative minimum tax. The operation of the look-back method
in the case of a taxpayer liable for the alternative minimum tax as
provided in paragraph (c)(3)(vi) is illustrated by the following
examples:
Example (4). Y enters into a long-term contract in 1988 that is
completed in 1989. Y used regular tax costs for purposes of determining
the degree of contract completion under the alternative minimum tax.
(i) Y determines its tax liability for 1988 as follows:
1988 contract costs........................................ $4,000a
Total contract costs....................................... $8,000e
Total contract price....................................... $20,000e
1988 completion (%)........................................ 50e
1988 gross income.......................................... $10,000a
Less, 1988 contract costs.................................. ($4,000a
------------
1988 net contract income............................. $6,000a
Other 1988 net income/(loss)............................... ($3,400a)
Taxable income............................................. $2,600a
Regular tax at 34%......................................... 884a
Adjustments and preferences to produce alternative minimum $600a
taxable income............................................
Alternative minimum taxable income......................... $3,200a
Tentative minimum tax at 20%............................... 640a
Tax liability.............................................. $884a
In 1989, Y determines the following amounts:
1989 contract costs.......................................... $6,000a
Total contract costs......................................... $10,000a
Total contract price......................................... $20,000a
(ii) For purposes of applying the look-back method, Y redetermines
its tax liability for 1988, which results in a hypothetical overpayment
of tax. This hypothetical overpayment is determined by comparing Y's
original regular tax liability for 1988 with the hypothetical total tax
liability (including alternative minimum tax liability) for that year
because Y would have paid the alternative minimum tax if Y had used its
actual contract costs to report income:
1988 contract costs......................................... $4,000a
Total contract costs........................................ $10,000a
Total contract price........................................ $20,000a
1988 completion(%).......................................... 40a
1988 gross income........................................... $8,000h
less, 1988 contract costs................................... ($4,000a)
1988 net contract income.................................... $4,000h
Other 1988 net income/(loss)................................ ($3,400a)
Taxable income.............................................. $600h
Regular tax at 34%.......................................... $204h
Adjustments and preferences to produce alternative minimum $600a
taxable income.............................................
Alternative minimum taxable income.......................... $1,200h
Tentative minimum tax at 20%................................ 240h
Alternative minimum tax..................................... $36h
Total tax liability......................................... $240h
less, previously computed tax............................... $884a
Underpayment/(overpayment).................................. ($644h)
(6) Credit carryovers. The operation of the look-back method in the
case of credit carryovers as provided in paragraph (c)(3)(v) is
illustrated by the following example:
Example (5). Z enters into a contract in 1986 that is completed in
1987. Z determines its tax liability for 1986 as follows:
1986 contract costs.......................................... $400a
Total contract costs......................................... $1,000e
Total contract price......................................... $2,000e
1986 completion (%).......................................... 40e
1986 gross income............................................ $800a
Less, 1986 costs............................................. ($400a)
1986 net contract income..................................... $400a
Other 1986 net income........................................ $0a
Taxable income............................................... $400a
Tax at 46%................................................... $184a
Unused tax credits carried forward from 1985 allowable in $350a
1986........................................................
Net tax due.................................................. $0a
Z determines the following amounts for 1987:
1987 contract costs.......................................... $400a
[[Page 216]]
Total contract price......................................... $2,000a
Total contract costs......................................... $800a
If Z had used actual rather than estimated contract costs in
determining gross income for 1986, Z would have reported tax liability
of $276 (46%x$600) rather than $184. However, Z would have paid no
additional tax for 1986 because its unused tax credits carried forward
from 1985 would have been sufficient to offset this increased tax
liability. Therefore, there is no hypothetical underpayment for 1986 for
purposes of the look-back method. However, this hypothetical earlier use
of the credit may increase the hypothetical tax liability for 1987 (or
another subsequent year) for purposes of subsequent applications of the
look-back method.
(7) Net operating losses. The operation of the look-back method in
the case of net operating loss (``NOL'') carryovers as provided in
paragraph (c)(3)(v) is illustrated by the following example:
Example (6). A entered into a long-term contract in 1986, which was
completed in 1987. A determined its tax liability for 1986 as follows:
1986 contract costs......................................... $400a
Total contract costs........................................ $1,000e
Total contract price........................................ $2,000e
1986 completion (%)......................................... 40e
1986 gross income........................................... $800a
Less, 1986 costs............................................ ($400a)
1986 net contract income.................................... $400a
Other 1986 net income/(loss)................................ ($1,000a)
Taxable income/(NOL)........................................ ($600a)
Tax......................................................... $0a
A elected to carry this loss forward to 1987 pursuant to section
172(b)(3)(C).
For 1987, A determined the following amounts:
1987 contract costs........................................... $400a
Total contract costs.......................................... $800a
Total contract price.......................................... $2,000a
If actual rather than estimated contract costs had been used in
determining gross income for 1986, A would have reported $1,000 of gross
income from the contract rather than $800, and thus would have reported
a loss of $400 rather than $600. However, since A would have paid no tax
for 1986 regardless of whether actual or estimated contract costs had
been used, A does not have an underpayment for 1986 for purposes of the
look-back method. If A had, instead, carried back the 1986 NOL, and this
NOL had been absorbed in the tax years 1983 through 1985, it would have
resulted in refunds of tax for those years in 1986. When A applies the
look-back method, a hypothetical underpayment of tax would have resulted
for those years due to a hypothetical reduction in the amount that would
have been refunded if income had been reported on the basis of actual
contract costs. See Example (2)(iii).
(8) Alternative minimum tax credit. The following example
illustrates the application of the look-back method if affected by the
alternative minimum tax credit as provided in paragraph (c)(3)(vi):
(i) Example (4), above illustrates that the reallocation of contract
income under the look-back method can result in a hypothetical
underpayment or overpayment determined using the alternative minimum tax
rate, even though the taxpayer actually paid only the regular tax for
that year. However, application of the look-back method had no effect on
the difference between the amount of alternative minimum taxable income
and the amount of regular taxable income taken into account in that year
because the taxpayer was required to use the percentage of completion
method for both regular and alternative minimum tax purposes and used
the same version of the percentage of completion method for both regular
and alternative minimum tax purposes (i.e., the taxpayer had made an
election to use regular tax costs in determining the percentage of
completion for purposes of computing alternative minimum taxable
income).
(ii) The following example illustrates the application of the look-
back method in the case of a taxpayer that does not use the percentage
of completion method of accounting for long-term contracts in computing
taxable income for regular tax purposes and thus must make an adjustment
to taxable income to determine alternative minimum taxable income. The
example also shows how interest is computed under the look-back method
when the taxpayer is entitled to a credit under section 53 for minimum
tax paid because of this adjustment.
Example (7). X is a taxpayer engaged in the construction of real
property under contracts that are completed within a 24-month period and
whose average annual gross receipts do not exceed $10,000,000. As
permitted by section 460(e)(1)(B), X uses the completed contract method
(``CCM'') for regular tax purposes. However, X is engaged in the
construction of commercial real property and, therefore, is required to
use the percentage of completion method (``PCM'') for alternative
minimum tax (``AMT'') purposes.
[[Page 217]]
Assume that for 1988, 1989, and 1990, X has only one long-term
contract, which is entered into in 1988 and completed in 1990. Assume
further that X estimates gross income from the contract to be $2,000,
total contract costs to be $1,000, and that the contract is 25 percent
complete in 1988 and 75 percent complete in 1989. In 1990, the year of
completion, the percentage of completion does not change but, upon
completion, gross income from the contract is actually $3,000, instead
of $2,000, and costs are actually $1,000.
For 1988, 1989, and 1990, X's income and tax liability using
estimated contract price and costs are as follows:
------------------------------------------------------------------------
Estimates 1988 1989 1990
------------------------------------------------------------------------
Regular tax:
Long-term:
Contract-CCM............. 0 0 $2,000
Other Income............. 0 $5,000 0
Total Income......... 0 $5,000 $2,000
Tax @ 34%........................ 0 $1,700 $680
AMT
Gross Income................. $500 $1,000 $1,500
Deductions................... $(250) $(500) $(250)
Total long-term:
Contract-PCM............. $250 $500 $1,250
Other Income............. 0 $5,000 0
Total Income......... $250 $5,500 $1,250
Tax @ 20%........................ $50 $1,100 $250
Tentative Minimum Tax............ $50 $1,100 $250
Regular Tax...................... 0 $1,700 $680
Minimum Tax Credit............... 0 $(50) 0
Net Tax Liability............ $50 $1,650 $680
------------------------------------------------------------------------
When X files its tax return for 1990, X applies the look-back method
to the contract. For 1988, 1989, and 1990, X's income and tax liability
using actual contract price and costs are as follows:
------------------------------------------------------------------------
Actual 1988 1989 1990
------------------------------------------------------------------------
Regular tax:
Long-term:
Contract-CCM............. 0 0 $2,000
Other Income............. 0 $5,000 0
Total Income......... 0 $5,000 $2,000
Tax @ 34%........................ 0 $1,700 $680
AMT
Gross Income................. $750 $1,500 $750
Deductions................... $(250) $(500) $(250)
Total long-term:
Contract-PCM............. $500 $1,000 $500
Other Income............. 0 $5,000 0
Total Income......... $500 $6,000 $500
Tax @ 20%........................ $100 $1,200 $100
Tentative Minimum Tax............ $100 $1,200 $100
Regular Tax...................... 0 $1,700 $680
Minimum Tax Credit............... 0 $(100) 0
Net Tax Liability............ $100 $1,600 $680
Underpayment..................... $50
Overpayment...................... $50
------------------------------------------------------------------------
As shown above, application of the look-back method results in a
hypothetical underpayment of $50 for 1988 because X was subject to the
alternative minimum tax for that year. Interest is charged to X on this
$50 underpayment from the due date of X's 1988 return until the due date
of X's 1990 return.
In 1989, although X was required to compute alternative minimum
taxable income using the percentage of completion method, X was not
required to pay alternative minimum tax. Nevertheless, the look-back
method must be applied to 1989 because use of actual rather than
estimated contract price in computing alternative minimum taxable income
for 1988 would have changed the amount of the alternative minimum tax
credit carried to 1989. Interest is paid to X on the resulting $50
overpayment from the due date of X's 1989 return until the due date of
X's 1990 return.
[[Page 218]]
(9) Period for interest. The following Examples (8) through (11)
illustrate how to determine the period for computing interest as
provided in paragraph (c)(4):
Example (8). The facts are the same as in Example (6), except that
the contract is completed in 1988, and A determined the following
amounts for 1987 and 1988:
For 1987:
1987 contract costs....................................... 0
Total contract costs...................................... $1,000e
Total contract price...................................... $2,000e
1987 completion (%)....................................... $40e
1987 gross income......................................... 0a
Less, 1987 costs.......................................... 0a
Other 1987 net income..................................... $600a
Net operating loss carryforward from 1986................. $(600a)
Taxable income............................................ 0a
Tax....................................................... 0a
For 1988:
1988 contract costs....................................... $400a
Total contract costs...................................... $800a
Total contract price...................................... $2,000a
If actual rather than estimated contract costs had been used in
determining gross income for 1986, A would have reported $1,000 of gross
income from the contract for 1986 rather than $800, and would have
reported a net operating loss carryforward to 1987 of $400 rather than
$600. Therefore, A would have reported taxable income of $200, and would
have paid tax of $80 (i.e., $200x40%) for 1987. The due date for filing
A's Federal income tax return for its 1988 taxable year is March 15. A
obtains an extension and files its 1988 return on September 15, 1989.
Under the look-back method, A is required to pay interest on the amount
of this hypothetical underpayment ($80) computed from the due date
(determined without regard to extensions) for A's return for 1987 (not
1986, even though 1986 was the year in which the net operating loss
arose) until March 15 (not September 15), the due date (without regard
to extensions) of A's return for 1988. A is required to pay additional
interest from March 15 until September 15 on the amount of interest
outstanding as of March 15 with respect to the hypothetical underpayment
of $80.
Example (9). The facts are the same as in Example (6), except that A
carries the net operating loss of $600 back to 1983 rather than forward
to 1987, and receives a refund of $276 ($600 reduction in 1983 taxable
income x 46% rate in effect in 1983). As in Example (6), if actual
contract costs had been used, A would have reported a loss for 1986 of
$400 rather than $600. Thus, A would have received a refund of 1983 tax
of $184 ($400x46%) rather than $276. Under the look-back method A is
required to pay interest on the difference in these two amounts ($92)
computed from the due date (determined without regard to extensions) of
A's return for 1986 (the year in which the carryback arose rather than
1983, the year in which it was used) until the due date of A's return
for 1988.
Example (10). B enters into a long-term contract in 1986 that is
completed in 1988. B determines its 1986 tax liability as follows:
1986 contract costs.......................................... $400a
Total contract costs......................................... $1,000e
Total contract price......................................... $2,000e
1986 completion (%).......................................... 40e
1986 gross income............................................ $800a
Less, 1986 costs............................................. ($400a)
1986 net contract income..................................... $400a
Other 1986 net income........................................ $2,000a
Taxable income............................................... $2,400a
Tax at 46%................................................... $1,104a
B determines its tax liability for 1987 as follows:
1987 contract costs.......................................... $400a
Total contract costs......................................... $1,600e
Total contract price......................................... $2,000e
1987 completion (%).......................................... 50e
1987 gross income............................................ $200a
(=(50%x$2,000);$800 previously reported) less, 1987 costs.... ($400a)
1987 net contract income..................................... ($200a)
Other 1987 net income/(loss)................................. ($2,200a)
Taxable income (NOL)......................................... ($2,400a)
Tax.......................................................... 0a
Assume that B had no taxable income in either 1984 or 1985, so that
the entire amount of the $2,400 net operating loss is carried back to
1986, and B receives a refund, with interest from the due date of B's
1987 return, of the entire $1,104 in tax that it paid for 1986.
In 1988, B determines the following amounts:
1988 contract costs........................................... $800a
Total contract costs.......................................... $1,600a
Total contract price.......................................... $2,000a
If B had used actual contract costs rather than estimated costs in
determining its gross income for 1986, B would have had gross income
from the contract of $500 rather than $800, and thus would have had
taxable income of $2,100 rather than $2,400, and would have paid tax of
$966 rather than $1,104. B is entitled to receive interest on the
difference between these two amounts, the hypothetical overpayment of
tax of $138. Interest is computed from the due date (without regard to
extensions) of B's return for 1986 until the due date for B's return for
1987. Interest stops running at this date, because B's hypothetical
overpayment of tax ended when B filed its original 1987 return and
received a refund for the carryback to 1986, and interest on this refund
began to run only from the due date of B's 1987 return. See section
6611(f).
Example (11). C enters into a long-term contract in 1986, its first
year in business, which is completed in 1988. C determines its tax
liability for 1986 as follows:
[[Page 219]]
1986 contract costs......................................... $400a
Total contract costs........................................ $1,000e
Total contract price........................................ $2,000e
1986 completion (%)......................................... 40e
1986 gross income........................................... $800a
less, 1986 costs............................................ ($400a)
1986 net contract income.................................... $400a
Other 1986 net income....................................... $2,000a
Taxable income (NOL)........................................ $2,400a
Tax at 46%.................................................. $1,104a
C determines its tax liability for 1987 as follows:
1987 contract costs......................................... $400a
Total contract costs........................................ $1,066e
Total contract price........................................ $2,000e
1987 completion (%)......................................... 75e
1987 gross income........................................... $700a
Less, 1987 costs............................................ ($400a)
1987 net contract income.................................... $300a
Other 1987 net income....................................... ($2,450a)
Taxable income (NOL)........................................ ($2,150a)
Tax......................................................... $10a
C carries back the net operating loss to 1986, and files an amended
return for 1986, showing taxable income of $250, and receives a refund
of $989 (46%x$2,150). Interest on this refund begins to run only as of
the due date of C's 1987 return. See section 6611(f).
In 1988, when the contract is completed, C determines the following
amounts:
1988 contract costs......................................... $800a
Total contract costs........................................ $1,600a
Total contract price........................................ $2,000a
If C had used actual contract price and contract costs in
determining gross income for 1986, it would have reported gross income
from the contract of $500 rather than $800, taxable income of $2,100
rather than $2,400, and tax liability of $966 rather than $1,104.
If C had used actual contract price and contract costs in
determining gross income for 1987, it would have reported gross income
from the contract of $500 rather than $700, and would have reported a
net operating loss of $2,350, rather than $2,150, which would have been
carried back to 1986.
Under the look-back method, C receives interest with respect to a
total 1986 hypothetical overpayment of $138 ($1,104 minus $966). C is
credited with interest on $23 of this amount only from the due date of
C's 1986 return until the due date of C's 1987 tax return, because this
portion of C's total hypothetical overpayment for 1986 was refunded to C
with interest computed from the due date of C's 1987 return and,
therefore, was no longer held by the government. However, because the
remainder of the total hypothetical overpayment of $115 was not refunded
to C, C is credited with interest on this amount from the due date of
C's 1986 return until the due date of C's 1988 tax return.
Under the look-back method, C receives no interest with respect to
1987, because C had no tax liability for 1987 using either estimated or
actual contract price and costs.
(i) [Reserved]
(j) Election not to apply look-back method in de minimis cases.
Section 460(b)(6) provides taxpayers with an election not to apply the
look-back method to long-term contracts in de minimis cases, effective
for contracts completed in taxable years ending after August 5, 1997. To
make an election, a taxpayer must attach a statement to its timely filed
original federal income tax return (including extensions) for the
taxable year the election is to become effective or to an amended return
for that year, provided the amended return is filed on or before March
31, 998. This statement must have the legend ``NOTIFICATION OF ELECTION
UNDER SECTION 460(b)(6)''; provide the taxpayer's name and identifying
number and the effective date of the election; and identify the trades
or businesses that involve long-term contracts. An election applies to
all long-term contracts completed during and after the taxable year for
which the election is effective. An election may not be revoked without
the Commissioner's consent. For taxpayers who elected to use the delayed
reapplication method under paragraph (e) of this section, an election
under this paragraph (j) automatically revokes the election to use the
delayed reapplication method for contracts subject to section 460(b)(6).
A consolidated group of corporations, as defined in Sec. 1.1502-1(h), is
subject to consistency rules analogous to those in paragraph (e)(2) of
this section and in paragraph (d)(4)(ii)(C) of this section (concerning
election to use simplified marginal impact method).
[T.D. 8315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8775, 63 FR
36181, July 2, 1998; T.D. 8929, 66 FR 2240, Jan. 11, 2001; T.D. 8995, 67
FR 34609, May 15, 2002]
taxable year for which deductions taken
Sec. 1.461-0 Table of contents.
This section lists the captions that appear in the regulations under
section 461 of the Internal Revenue Code.
[[Page 220]]
Sec. 1.461-1 General rule for taxable year of deduction.
(a) General rule.
(1) Taxpayer using cash receipts and disbursements method.
(2) Taxpayer using an accrual method.
(3) Effect in current taxable year of improperly accounting for a
liability in a prior taxable year.
(4) Deductions attributable to certain foreign income.
(b) Special rule in case of death.
(c) Accrual of real property taxes.
(1) In general.
(2) Special rules.
(3) When election may be made.
(4) Binding effect of election.
(5) Apportionment of taxes on real property between seller and
purchaser.
(6) Examples.
(d) Limitation on acceleration of accrual of taxes.
(e) Dividends or interest paid by certain savings institutions on
certain deposits or withdrawable accounts.
(1) Deduction not allowable.
(2) Computation of amounts not allowed as a deduction.
(3) When amounts allowable.
Sec. 1.461-2 Contested liabilities.
(a) General rule.
(1) Taxable year of deduction.
(2) Exception.
(3) Refunds includible in gross income.
(4) Examples.
(5) Liabilities described in paragraph (g) of Sec. 1.461-4.
[Reserved]
(b) Contest of asserted liability.
(1) Asserted liability.
(2) Definition of the term ``contest.''
(3) Example.
(c) Transfer to provide for the satisfaction of an asserted
liability.
(1) In general.
(2) Examples.
(d) Contest exists after transfer.
(e) Deduction otherwise allowed.
(1) In general.
(2) Example.
(f) Treatment of money or property transferred to an escrowee,
trustee, or court and treatment of any income attributable thereto.
[Reserved]
(g) Effective dates.
Sec. 1.461-3 Prepaid interest. [Reserved]
Sec. 1.461-4 Economic performance.
(a) Introduction.
(1) In general.
(2) Overview.
(b) Exceptions to the economic performance requirement.
(c) Definitions.
(1) Liability.
(2) Payment.
(d) Liabilities arising out of the provision of services, property,
or the use of property.
(1) In general.
(2) Services or property provided to the taxpayer.
(3) Use of property provided to the taxpayer.
(4) Services or property provided by the taxpayer.
(5) Liabilities that are assumed in connection with the sale of a
trade or business.
(6) Rules relating to the provision of services or property to a
taxpayer.
(7) Examples.
(e) Interest.
(f) Timing of deductions from notional principal contracts.
(g) Certain liabilities for which payment is economic performance.
(1) In general.
(2) Liabilities arising under a workers compensation act or out of
any tort, breach of contract, or violation of law.
(3) Rebates and refunds.
(4) Awards, prizes, and jackpots.
(5) Insurance, warranty, and service contracts.
(6) Taxes.
(7) Other liabilities.
(8) Examples.
(h) Liabilities arising under the Nuclear Waste Policy Act of 1982.
(i) [Reserved]
(j) Contingent liabilities. [Reserved]
(k) Special effective dates.
(1) In general.
(2) Long-term contracts.
(3) Payment liabilities.
(l) [Reserved]
(m) Change in method of accounting required by this section.
(1) In general.
(2) Change in method of accounting for long-term contracts and
payment liabilities.
Sec. 1.461-5 Recurring item exception.
(a) In general.
(b) Requirements for use of the exception.
(1) General rule.
(2) Amended returns.
(3) Liabilities that are recurring in nature.
(4) Materiality requirement.
(5) Matching requirement.
(c) Types of liabilities not eligible for treatment under the
recurring item exception.
(d) Time and manner of adopting the recurring item exception.
(1) In general.
(2) Change to the recurring item exception method for the first
taxable year beginning after December 31, 1991.
(3) Retroactive change to the recurring item exception method.
(e) Examples.
[[Page 221]]
Sec. 1.461-6 Economic performance when certain liabilities are assigned
or are extinguished by the establishment of a fund.
(a) Qualified assignments of certain personal injury liabilities
under section 130.
(b) Section 468B.
(c) Payments to other funds or persons that constitute economic
performance. [Reserved]
(d) Effective dates.
[T.D. 8408, 57 FR 12420, Apr. 10, 1992, as amended by T.D. 8593, 60 FR
18743, Apr. 13, 1995]
Sec. 1.461-1 General rule for taxable year of deduction.
(a) General rule--(1) Taxpayer using cash receipts and disbursements
method. Under the cash receipts and disbursements method of accounting,
amounts representing allowable deductions shall, as a general rule, be
taken into account for the taxable year in which paid. Further, a
taxpayer using this method may also be entitled to certain deductions in
the computation of taxable income which do not involve cash
disbursements during the taxable year, such as the deductions for
depreciation, depletion, and losses under sections 167, 611, and 165,
respectively. If an expenditure results in the creation of an asset
having a useful life which extends substantially beyond the close of the
taxable year, such an expenditure may not be deductible, or may be
deductible only in part, for the taxable year in which made. An example
is an expenditure for the construction of improvements by the lessee on
leased property where the estimated life of the improvements is in
excess of the remaining period of the lease. In such a case, in lieu of
the allowance for depreciation provided by section 167, the basis shall
be amortized ratably over the remaining period of the lease. See section
178 and the regulations thereunder for rules governing the effect to be
given renewal options in determining whether the useful life of the
improvements exceeds the remaining term of the lease where a lessee
begins improvements on leased property after July 28, 1958, other than
improvements which on such date and at all times thereafter, the lessee
was under a binding legal obligation to make. See section 263 and the
regulations thereunder for rules relating to capital expenditures. See
section 467 and the regulations thereunder for rules under which a
liability arising out of the use of property pursuant to a section 467
rental agreement is taken into account.
(2) Taxpayer using an accrual method--(i) In general. Under an
accrual method of accounting, a liability (as defined in Sec. 1.446-
1(c)(1)(ii)(B)) is incurred, and generally is taken into account for
Federal income tax purposes, in the taxable year in which all the events
have occurred that establish the fact of the liability, the amount of
the liability can be determined with reasonable accuracy, and economic
performance has occurred with respect to the liability. (See paragraph
(a)(2)(iii)(A) of this section for examples of liabilities that may not
be taken into account until a taxable year subsequent to the taxable
year incurred, and see Secs. 1.461-4 through 1.461-6 for rules relating
to economic performance.) Applicable provisions of the Code, the Income
Tax Regulations, and other guidance published by the Secretary prescribe
the manner in which a liability that has been incurred is taken into
account. For example, section 162 provides that the deductible liability
generally is taken into account in the taxable year incurred through a
deduction from gross income. As a further example, under section 263 or
263A, a liability that relates to the creation of an asset having a
useful life extending substantially beyond the close of the taxable year
is taken into account in the taxable year incurred through
capitalization (within the meaning of Sec. 1.263A-1(c)(3)), and may
later affect the computation of taxable income through depreciation or
otherwise over a period including subsequent taxable years, in
accordance with applicable Internal Revenue Code sections and guidance
published by the Secret