[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2011 Edition]
[From the U.S. Government Printing Office]



[[Page i]]

          

          Title 26

Internal Revenue


________________________

Part 1 (Sec. Sec.  1.441 to 1.500)

                         Revised as of April 1, 2011

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2011
                    Published by the Office of the Federal Register 
                    National Archives and Records Administration as a 
                    Special Edition of the Federal Register

[[Page ii]]

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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     815
      Alphabetical List of Agencies Appearing in the CFR......     835
      Table of OMB Control Numbers............................     845
      List of CFR Sections Affected...........................     863

[[Page iv]]





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

                     Cite this Code: CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.441-0 
                       refers to title 26, part 
                       1, section 441-0.

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

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2011), 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 
April 1, 2001, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, 1973-1985, or 1986-2000, published in eleven separate 
volumes. For the period beginning April 1, 2001, a ``List of CFR 
Sections Affected'' is published at the end of each CFR volume.

``[RESERVED]'' TERMINOLOGY

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

INCORPORATION BY REFERENCE

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

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

[[Page vii]]

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

REPUBLICATION OF MATERIAL

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in the Code of Federal Regulations.

INQUIRIES

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volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-741-6000 
or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, 8601 Adelphi Road, College Park, MD 
20740-6001 or e-mail fedreg.info@nara.gov.

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ELECTRONIC SERVICES

    The full text of the Code of Federal Regulations, the LSA (List of 
CFR Sections Affected), The United States Government Manual, the Federal 
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information. Connect to NARA's web site at www.archives.gov/federal-
register.

    Raymond A. Mosley,
    Director,
    Office of the Federal Register.
    April 1, 2011.







[[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, 
2011. The first thirteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Sec. Sec.  1.0-1.60; 
Sec. Sec.  1.61-1.169; Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; 
Sec. Sec.  1.401-1.440; Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; 
Sec. Sec.  1.641-1.850; Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; 
Sec. Sec.  1.1001-1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to 
end of part 1. The 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.

    For this volume, Michele Bugenhagen was Chief Editor. The Code of 
Federal Regulations publication program is under the direction of 
Michael L. White, assisted by Ann Worley.


[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




         (This book contains part 1, Sec. Sec. 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)




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

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes (Continued)....................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering Alcohol and 
Tobacco Tax Regulations, and Regulations Under Tax Conventions.

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)



PART 1_INCOME TAXES (CONTINUED)--Table of Contents



                  Normal Taxes and Surtaxes (Continued)

                 DEFERRED COMPENSATION, ETC. (CONTINUED)

              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.
1.446-5 Debt issuance costs.
1.446-6 REMIC inducement fees.
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).
1.448-2 Nonaccrual of certain amounts by service providers.

          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 General overviews of section 457.
1.457-2 Definitions.
1.457-3 General introduction to eligible plans.
1.457-4 Annual deferrals, deferral limitations, and deferral agreements 
          under eligible plans.
1.457-5 Individual limitation for combined annual deferrals under 
          multiple eligible plans.
1.457-6 Timing of distributions under eligible plans.
1.457-7 Taxation of Distribution Under Eligible Plans.
1.457-8 Funding rules for eligible plans.

[[Page 6]]

1.457-9 Effect on eligible plans when not administered in accordance 
          with eligibility requirements.
1.457-10 Miscellaneous provisions.
1.457-11 Tax treatment of participants if plan is not an eligible plan.
1.457-12 Effective dates.
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.
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.
1.465-1T Aggregation of certain activities (temporary).
1.465-8 General rules; interest other than that of a creditor.
1.465-20 Treatment of amounts borrowed from certain persons and amounts 
          protected against loss.
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 Special transfers to qualified funds pursuant to section 
          468A(f).
1.468A-9 Effective/applicability date.
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 applicable to qualified 
          settlement funds.
1.468B-6 Escrow accounts, trusts, and other funds used during deferred 
          exchanges of like-kind property under section 1031(a)(3).
1.468B-7 Pre-closing escrows.
1.468B-8 Contingent-at-closing escrows. [Reserved]
1.468B-9 Disputed ownership funds.
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.

[[Page 7]]

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.
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(a)-4 Valuation safe harbor.
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(g)-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 section 482.
1.482-0T Outline of regulations under section 482 (temporary).
1.482-1 Allocation of income and deductions among taxpayers.
1.482-1T Allocation of income and deductions among taxpayers 
          (temporary).
1.482-2 Determination of taxable income in specific situations.
1.482-2T Determination of taxable income in specific situations 
          (temporary).
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.
1.482-4T Methods to determine taxable income in connection with a 
          transfer of intangible property (temporary).
1.482-5 Comparable profits method.
1.482-6 Profit split method.
1.482-7T Methods to determine taxable income in connection with a cost 
          sharing arrangement (temporary).
1.482-8 Examples of the best method rule.
1.482-8T Examples of the best method rule (temporary).
1.482-9 Methods to determine taxable income in connection with a 
          controlled services transaction.
1.482-9T Methods to determine taxable income in connection with a 
          controlled services transaction (temporary).
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.
1.482-7A Methods to determine taxable income in connection with a cost 
          sharing arrangement.
1.484-1.500 [Reserved]

    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 1.446-6 also issued under 26 U.S.C. 446 and 26 U.S.C. 860G.
    Section 1.451-5 also issued under 96 Stat. 324, 493.

[[Page 8]]

    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 1.465-8 also issued under 26 U.S.C. 465.
    Section 1.465-20 also issued under 26 U.S.C. 465.
    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 1.468A-5T also issued under 26 U.S.C. 468A(e)(5).
    Section 1.468B-1 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-2 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-3 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-4 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-5 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-7 also issued under 26 U.S.C. 461(h) and 468B(g).
    Section 1.468B-9 also issued under 26 U.S.C. 461(h) and 468B(g).
    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(a)-4 also issued under 26 U.S.C. 475(g).
    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.

[[Page 9]]

    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 1.482-9 also issued under 26 U.S.C. 482.
    Section 1.482-2A also issued under 26 U.S.C. 482.
    Section 1.482-7A also issued under 26 U.S.C. 482.
    Section 1.482-9 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 Sec. Sec. 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.
(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).

[[Page 10]]

(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 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);

[[Page 11]]

    (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, Sec. Sec. 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
    (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

[[Page 12]]

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 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 Sec. Sec. 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.

[[Page 13]]

    (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 Sec. Sec. 
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 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

[[Page 14]]

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.
    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.


[[Page 15]]


    (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, 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

[[Page 16]]

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 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

[[Page 17]]

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 Sec. Sec. 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;
    (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

[[Page 18]]

(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.
    (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

[[Page 19]]

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-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;

[[Page 20]]

    (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]



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.

[[Page 21]]

    (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 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

[[Page 22]]

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 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

[[Page 23]]

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, 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\)................................

[[Page 24]]

 
  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
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

[[Page 25]]

    (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 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-

[[Page 26]]

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 
(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

[[Page 27]]

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).
    (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

[[Page 28]]

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.
    (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.

[[Page 29]]

     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 payments as required by Sec. Sec. 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.

[[Page 30]]

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;
    (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

[[Page 31]]

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 Sec. Sec. 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 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.''

[[Page 32]]

    (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.
    (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

[[Page 33]]

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 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

[[Page 34]]

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. 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 Sec. Sec. 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

[[Page 35]]

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, 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

[[Page 36]]

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 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

[[Page 37]]

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 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

[[Page 38]]

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 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

[[Page 39]]

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 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

[[Page 40]]

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 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

[[Page 41]]

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 ``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

[[Page 42]]

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 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

[[Page 43]]

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.
    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

[[Page 44]]

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 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

[[Page 45]]

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 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,

[[Page 46]]

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 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

[[Page 47]]

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 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,

[[Page 48]]

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 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.


[[Page 49]]


    (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 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.

[[Page 50]]

    (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 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

[[Page 51]]

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 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 
Sec. Sec. 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

[[Page 52]]

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 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

[[Page 53]]

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 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 that 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 under sections 
471 and 472), a change from the cash or accrual method to a long-term 
contract method, or vice versa (see Sec. 1.460-4), certain changes in 
computing depreciation or amortization (see paragraph (e)(2)(ii)(d) of 
this

[[Page 54]]

section), 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 
under the Internal Revenue Code 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 that 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 that are in fact payments of dividends, and of items that are 
deducted as business expenses, but that 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. Although such adjustment may 
involve the question of the proper time for the taking of a deduction, 
such items are traditionally corrected by adjustment in the current and 
future years. For the treatment of the adjustment of the addition to a 
bad debt reserve (for example, for banks under section 585 of the 
Internal Revenue Code), see the regulations under section 166 of the 
Internal Revenue Code. A change in the method of accounting also does 
not include a change in treatment resulting from a change in underlying 
facts. For further guidance on changes involving depreciable or 
amortizable assets, see paragraph (e)(2)(ii)(d) of this section and 
Sec. 1.1016-3(h).
    (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.
    (d) Changes involving depreciable or amortizable assets--(1) Scope. 
This paragraph (e)(2)(ii)(d) applies to property subject to section 167, 
168, 197, 1400I, 1400L(c), to section 168 prior to its amendment by the 
Tax Reform Act of 1986 (100 Stat. 2121) (former section 168), or to an 
additional first year depreciation deduction provision of the Internal 
Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)).
    (2) Changes in depreciation or amortization that are a change in 
method of accounting. Except as provided in paragraph (e)(2)(ii)(d)(3) 
of this section, a change in the treatment of an asset from 
nondepreciable or nonamortizable to depreciable or amortizable, or vice 
versa, is a change in method of accounting. Additionally, a correction 
to require depreciation or amortization in lieu of a deduction for the 
cost of depreciable or amortizable assets that had been consistently 
treated as an expense in the year of purchase, or vice versa, is a 
change in method of accounting. Further, except as provided in paragraph 
(e)(2)(ii)(d)(3) of this section, the following changes in computing 
depreciation or amortization are a change in method of accounting:
    (i) A change in the depreciation or amortization method, period of 
recovery, or convention of a depreciable or amortizable asset.
    (ii) A change from not claiming to claiming the additional first 
year depreciation deduction provided by, for example, section 168(k), 
1400L(b), or 1400N(d), for, and the resulting change to the amount 
otherwise allowable as a depreciation deduction for the remaining 
adjusted depreciable basis (or similar basis) of, depreciable property 
that qualifies for the additional first year depreciation deduction (for 
example, qualified property, 50-percent bonus depreciation property, 
qualified New York Liberty Zone property, or qualified Gulf Opportunity 
Zone property), provided the taxpayer did not make the election out of 
the additional first year depreciation deduction (or did not make a 
deemed election out of the additional first year depreciation deduction; 
for further guidance, for example, see Rev. Proc. 2002-33 (2002-1 C.B. 
963), Rev. Proc. 2003-50 (2003-2 C.B. 119), Notice 2006-77 (2006-40 
I.R.B. 590), and

[[Page 55]]

Sec. 601.601(d)(2)(ii)(b) of this chapter) for the class of property in 
which the depreciable property that qualifies for the additional first 
year depreciation deduction (for example, qualified property, 50-percent 
bonus depreciation property, qualified New York Liberty Zone property, 
or qualified Gulf Opportunity Zone property) is included.
    (iii) A change from claiming the 30-percent additional first year 
depreciation deduction to claiming the 50-percent additional first year 
depreciation deduction for depreciable property that qualifies for the 
50-percent additional first year depreciation deduction, provided the 
property is not included in any class of property for which the taxpayer 
elected the 30-percent, instead of the 50-percent, additional first year 
depreciation deduction (for example, 50-percent bonus depreciation 
property or qualified Gulf Opportunity Zone property), or a change from 
claiming the 50-percent additional first year depreciation deduction to 
claiming the 30-percent additional first year depreciation deduction for 
depreciable property that qualifies for the 30-percent additional first 
year depreciation deduction, including property that is included in a 
class of property for which the taxpayer elected the 30-percent, instead 
of the 50-percent, additional first year depreciation deduction (for 
example, qualified property or qualified New York Liberty Zone 
property), and the resulting change to the amount otherwise allowable as 
a depreciation deduction for the property's remaining adjusted 
depreciable basis (or similar basis). This paragraph 
(e)(2)(ii)(d)(2)(iii) does not apply if a taxpayer is making a late 
election or revoking a timely valid election under the applicable 
additional first year depreciation deduction provision of the Internal 
Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)) (see 
paragraph (e)(2)(ii)(d)(3)(iii) of this section).
    (iv) A change from claiming to not claiming the additional first 
year depreciation deduction for an asset that does not qualify for the 
additional first year depreciation deduction, including an asset that is 
included in a class of property for which the taxpayer elected not to 
claim any additional first year depreciation deduction (for example, an 
asset that is not qualified property, 50-percent bonus depreciation 
property, qualified New York Liberty Zone property, or qualified Gulf 
Opportunity Zone property), and the resulting change to the amount 
otherwise allowable as a depreciation deduction for the property's 
depreciable basis.
    (v) A change in salvage value to zero for a depreciable or 
amortizable asset for which the salvage value is expressly treated as 
zero by the Internal Revenue Code (for example, section 168(b)(4)), the 
regulations under the Internal Revenue Code (for example, Sec. 1.197-
2(f)(1)(ii)), or other guidance published in the Internal Revenue 
Bulletin.
    (vi) A change in the accounting for depreciable or amortizable 
assets from a single asset account to a multiple asset account 
(pooling), or vice versa, or from one type of multiple asset account 
(pooling) to a different type of multiple asset account (pooling).
    (vii) For depreciable or amortizable assets that are mass assets 
accounted for in multiple asset accounts or pools, a change in the 
method of identifying which assets have been disposed. For purposes of 
this paragraph (e)(2)(ii)(d)(2)(vii), the term mass assets means a mass 
or group of individual items of depreciable or amortizable assets that 
are not necessarily homogeneous, each of which is minor in value 
relative to the total value of the mass or group, numerous in quantity, 
usually accounted for only on a total dollar or quantity basis, with 
respect to which separate identification is impracticable, and placed in 
service in the same taxable year.
    (viii) Any other change in depreciation or amortization as the 
Secretary may designate by publication in the Federal Register or in the 
Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
    (3) Changes in depreciation or amortization that are not a change in 
method of accounting. Section 1.446-1(e)(2)(ii)(b) applies to determine 
whether a change in depreciation or amortization is not a change in 
method of accounting. Further, the following changes in depreciation or 
amortization are not a change in method of accounting:

[[Page 56]]

    (i) Useful life. An adjustment in the useful life of a depreciable 
or amortizable asset for which depreciation is determined under section 
167 (other than under section 168, section 1400I, section 1400L(c), 
former section 168, or an additional first year depreciation deduction 
provision of the Internal Revenue Code (for example, section 168(k), 
1400L(b), or 1400N(d))) is not a change in method of accounting. This 
paragraph (e)(2)(ii)(d)(3)(i) does not apply if a taxpayer is changing 
to or from a useful life (or recovery period or amortization period) 
that is specifically assigned by the Internal Revenue Code (for example, 
section 167(f)(1), section 168(c), section 168(g)(2) or (3), section 
197), the regulations under the Internal Revenue Code, or other guidance 
published in the Internal Revenue Bulletin and, therefore, such change 
is a change in method of accounting (unless paragraph 
(e)(2)(ii)(d)(3)(v) of this section applies). See paragraph 
(e)(2)(ii)(d)(5)(iv) of this section for determining the taxable year in 
which to correct an adjustment in useful life that is not a change in 
method of accounting.
    (ii) Change in use. A change in computing depreciation or 
amortization allowances in the taxable year in which the use of an asset 
changes in the hands of the same taxpayer is not a change in method of 
accounting.
    (iii) Elections. Generally, the making of a late depreciation or 
amortization election or the revocation of a timely valid depreciation 
or amortization election is not a change in method of accounting, except 
as otherwise expressly provided by the Internal Revenue Code, the 
regulations under the Internal Revenue Code, or other guidance published 
in the Internal Revenue Bulletin. This paragraph (e)(2)(ii)(d)(3)(iii) 
also applies to making a late election or revoking a timely valid 
election made under section 13261(g)(2) or (3) of the Revenue 
Reconciliation Act of 1993 (107 Stat. 312, 540) (relating to amortizable 
section 197 intangibles). A taxpayer may request consent to make a late 
election or revoke a timely valid election by submitting a request for a 
private letter ruling. For making or revoking an election under section 
179 of the Internal Revenue Code, see section 179(c) and Sec. 1.179-5.
    (iv) Salvage value. Except as provided under paragraph 
(e)(2)(ii)(d)(2)(v) of this section, a change in salvage value of a 
depreciable or amortizable asset is not treated as a change in method of 
accounting.
    (v) Placed-in-service date. Except as otherwise expressly provided 
by the Internal Revenue Code, the regulations under the Internal Revenue 
Code, or other guidance published in the Internal Revenue Bulletin, any 
change in the placed-in-service date of a depreciable or amortizable 
asset is not treated as a change in method of accounting. For example, 
if a taxpayer changes the placed-in-service date of a depreciable or 
amortizable asset because the taxpayer incorrectly determined the date 
on which the asset was placed in service, such a change is a change in 
the placed-in-service date of the asset and, therefore, is not a change 
in method of accounting. However, if a taxpayer incorrectly determines 
that a depreciable or amortizable asset is nondepreciable property and 
later changes the treatment of the asset to depreciable property, such a 
change is not a change in the placed-in-service date of the asset and, 
therefore, is a change in method of accounting under paragraph 
(e)(2)(ii)(d)(2) of this section. Further, a change in the convention of 
a depreciable or amortizable asset is not a change in the placed-in-
service date of the asset and, therefore, is a change in method of 
accounting under paragraph (e)(2)(ii)(d)(2)(i) of this section. See 
paragraph (e)(2)(ii)(d)(5)(v) of this section for determining the 
taxable year in which to make a change in the placed-in-service date of 
a depreciable or amortizable asset that is not a change in method of 
accounting.
    (vi) Any other change in depreciation or amortization as the 
Secretary may designate by publication in the Federal Register or in the 
Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
    (4) Item being changed. For purposes of a change in depreciation or 
amortization to which this paragraph (e)(2)(ii)(d) applies, the item 
being changed generally is the depreciation

[[Page 57]]

treatment of each individual depreciable or amortizable asset. However, 
the item is the depreciation treatment of each vintage account with 
respect to a depreciable asset for which depreciation is determined 
under Sec. 1.167(a)-11 (class life asset depreciation range (CLADR) 
property). Similarly, the item is the depreciable treatment of each 
general asset account with respect to a depreciable asset for which 
general asset account treatment has been elected under section 168(i)(4) 
or the item is the depreciation treatment of each mass asset account 
with respect to a depreciable asset for which mass asset account 
treatment has been elected under former section 168(d)(2)(A). Further, a 
change in computing depreciation or amortization under section 167 
(other than under section 168, section 1400I, section 1400L(c), former 
section 168, or an additional first year depreciation deduction 
provision of the Internal Revenue Code (for example, section 168(k), 
1400L(b), or 1400N(d))) is permitted only with respect to all assets in 
a particular account (as defined in Sec. 1.167(a)-7) or vintage 
account.
    (5) Special rules. For purposes of a change in depreciation or 
amortization to which this paragraph (e)(2)(ii)(d) applies--
    (i) Declining balance method to the straight line method for MACRS 
property. For tangible, depreciable property subject to section 168 
(MACRS property) that is depreciated using the 200-percent or 150-
percent declining balance method of depreciation under section 168(b)(1) 
or (2), a taxpayer may change without the consent of the Commissioner 
from the declining balance method of depreciation to the straight line 
method of depreciation in the first taxable year in which the use of the 
straight line method with respect to the adjusted depreciable basis of 
the MACRS property as of the beginning of that year will yield a 
depreciation allowance that is greater than the depreciation allowance 
yielded by the use of the declining balance method. When the change is 
made, the adjusted depreciable basis of the MACRS property as of the 
beginning of the taxable year is recovered through annual depreciation 
allowances over the remaining recovery period (for further guidance, see 
section 6.06 of Rev. Proc. 87-57 (1987-2 C.B. 687) and Sec. 
601.601(d)(2)(ii)(b) of this chapter).
    (ii) Depreciation method changes for section 167 property. For a 
depreciable or amortizable asset for which depreciation is determined 
under section 167 (other than under section 168, section 1400I, section 
1400L(c), former section 168, or an additional first year depreciation 
deduction provision of the Internal Revenue Code (for example, section 
168(k), 1400L(b), or 1400N(d))), see Sec. 1.167(e)-1(b), (c), and (d) 
for the changes in depreciation method that are permitted to be made 
without the consent of the Commissioner. For CLADR property, see Sec. 
1.167(a)-11(c)(1)(iii) for the changes in depreciation method for CLADR 
property that are permitted to be made without the consent of the 
Commissioner. Further, see Sec. 1.167(a)-11(b)(4)(iii)(c) for how to 
correct an incorrect classification or characterization of CLADR 
property.
    (iii) Section 481 adjustment. Except as otherwise expressly provided 
by the Internal Revenue Code, the regulations under the Internal Revenue 
Code, or other guidance published in the Internal Revenue Bulletin, no 
section 481 adjustment is required or permitted for a change from one 
permissible method of computing depreciation or amortization to another 
permissible method of computing depreciation or amortization for an 
asset because this change is implemented by either a cut-off method (for 
further guidance, for example, see section 2.06 of Rev. Proc. 97-27 
(1997-1 C.B. 680), section 2.06 of Rev. Proc. 2002-9 (2002-1 C.B. 327), 
and Sec. 601.601(d)(2)(ii)(b) of this chapter) or a modified cut-off 
method (under which the adjusted depreciable basis of the asset as of 
the beginning of the year of change is recovered using the new 
permissible method of accounting), as appropriate. However, a change 
from an impermissible method of computing depreciation or amortization 
to a permissible method of computing depreciation or amortization for an 
asset results in a section 481 adjustment. Similarly, a change in the 
treatment of an asset from nondepreciable or nonamortizable to 
depreciable or amortizable (or vice versa) or a change in the

[[Page 58]]

treatment of an asset from expensing to depreciating (or vice versa) 
results in a section 481 adjustment.
    (iv) Change in useful life. This paragraph (e)(2)(ii)(d)(5)(iv) 
applies to an adjustment in the useful life of a depreciable or 
amortizable asset for which depreciation is determined under section 167 
(other than under section 168, section 1400I, section 1400L(c), former 
section 168, or an additional first year depreciation deduction 
provision of the Internal Revenue Code (for example, section 168(k), 
1400L(b), or 1400N(d))) and that is not a change in method of accounting 
under paragraph (e)(2)(ii)(d) of this section. For this adjustment in 
useful life, no section 481 adjustment is required or permitted. The 
adjustment in useful life, whether initiated by the Internal Revenue 
Service (IRS) or a taxpayer, is corrected by adjustments in the taxable 
year in which the conditions known to exist at the end of that taxable 
year changed thereby resulting in a redetermination of the useful life 
under Sec. 1.167(a)-1(b) (or if the period of limitation for assessment 
under section 6501(a) has expired for that taxable year, in the first 
succeeding taxable year open under the period of limitation for 
assessment), and in subsequent taxable years. In other situations (for 
example, the useful life is incorrectly determined in the placed-in-
service year), the adjustment in the useful life, whether initiated by 
the IRS or a taxpayer, may be corrected by adjustments in the earliest 
taxable year open under the period of limitation for assessment under 
section 6501(a) or the earliest taxable year under examination by the 
IRS but in no event earlier than the placed-in-service year of the 
asset, and in subsequent taxable years. However, if a taxpayer initiates 
the correction in useful life, in lieu of filing amended Federal tax 
returns (for example, because the conditions known to exist at the end 
of a prior taxable year changed thereby resulting in a redetermination 
of the useful life under Sec. 1.167(a)-1(b)), the taxpayer may correct 
the adjustment in useful life by adjustments in the current and 
subsequent taxable years.
    (v) Change in placed-in-service date. This paragraph 
(e)(2)(ii)(d)(5)(v) applies to a change in the placed-in-service date of 
a depreciable or amortizable asset that is not a change in method of 
accounting under paragraph (e)(2)(ii)(d) of this section. For this 
change in placed-in-service date, no section 481 adjustment is required 
or permitted. The change in placed-in-service date, whether initiated by 
the IRS or a taxpayer, may be corrected by adjustments in the earliest 
taxable year open under the period of limitation for assessment under 
section 6501(a) or the earliest taxable year under examination by the 
IRS but in no event earlier than the placed-in-service year of the 
asset, and in subsequent taxable years. However, if a taxpayer initiates 
the change in placed-in-service date, in lieu of filing amended Federal 
tax returns, the taxpayer may correct the placed-in-service date by 
adjustments in the current and subsequent taxable years.
    (iii) Examples. The rules of this paragraph (e) are 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

[[Page 59]]

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 in 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 under the 
Internal Revenue Code. 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 under the 
Internal Revenue Code, 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.
    Example 9. In 2003, A1, a calendar year taxpayer engaged in the 
trade or business of manufacturing knitted goods, purchased and placed 
in service a building and its components at a total cost of $10,000,000 
for use in its manufacturing operations. A1 classified the $10,000,000 
as nonresidential real property under section 168(e). A1 elected not to 
deduct the additional first year depreciation provided by section 168(k) 
on its 2003 Federal tax return. As a result, on its 2003, 2004, and 2005 
Federal tax returns, A1 depreciated the $10,000,000 under the general 
depreciation system of section 168(a), using the straight line method of 
depreciation, a 39-year recovery period, and the mid-month convention. 
In 2006, A1 completes a cost segregation study on the building and its 
components and identifies items that cost a total of $1,500,000 as 
section 1245 property. As a result, the $1,500,000 should have been 
classified in 2003 as 5-year property under section 168(e) and 
depreciated on A1's 2003, 2004, and 2005 Federal tax returns under the 
general depreciation system, using the 200-percent declining balance 
method of depreciation, a 5-year recovery period, and the half-year 
convention. Pursuant to paragraph (e)(2)(ii)(d)(2)(i) of this section, 
A1's change to this depreciation method, recovery period, and convention 
is a change in method of accounting. This method change results in a 
section 481 adjustment. The useful life exception under paragraph 
(e)(2)(ii)(d)(3)(i) of this section does not apply because the assets 
are depreciated under section 168.
    Example 10. In 2003, B, a calendar year taxpayer, purchased and 
placed in service new equipment at a total cost of $1,000,000 for use in 
its plant located outside the United States. The equipment is 15-year 
property under section 168(e) with a class life of 20 years. The 
equipment is required to be depreciated under the alternative 
depreciation system of section 168(g). However, B incorrectly 
depreciated the equipment under the general depreciation system of 
section 168(a), using the 150-percent declining balance method, a 15-
year recovery period, and the half-year convention. In 2010, the IRS 
examines B's 2007 Federal income tax return and changes the depreciation 
of the equipment to the alternative depreciation system, using the 
straight line method of depreciation, a 20-year recovery period, and the 
half-year convention. Pursuant to paragraph (e)(2)(ii)(d)(2)(i) of this 
section, this change in depreciation method and recovery period made by 
the IRS is a change in method of accounting. This method change results 
in a section 481 adjustment. The useful life exception under paragraph 
(e)(2)(ii)(d)(3)(i) of this section does not apply because the assets 
are depreciated under section 168.

[[Page 60]]

    Example 11. In May 2003, C, a calendar year taxpayer, purchased and 
placed in service equipment for use in its trade or business. C never 
held this equipment for sale. However, C incorrectly treated the 
equipment as inventory on its 2003 and 2004 Federal tax returns. In 
2005, C realizes that the equipment should have been treated as a 
depreciable asset. Pursuant to paragraph (e)(2)(ii)(d)(2) of this 
section, C's change in the treatment of the equipment from inventory to 
a depreciable asset is a change in method of accounting. This method 
change results in a section 481 adjustment.
    Example 12. Since 2003, D, a calendar year taxpayer, has used the 
distribution fee period method to amortize distributor commissions and, 
under that method, established pools to account for the distributor 
commissions (for further guidance, see Rev. Proc. 2000-38 (2000-2 C.B. 
310) and Sec. 601.601(d)(2)(ii)(b) of this chapter). A change in the 
accounting of distributor commissions under the distribution fee period 
method from pooling to single asset accounting is a change in method of 
accounting pursuant to paragraph (e)(2)(ii)(d)(2)(vi) of this section. 
This method change results in no section 481 adjustment because the 
change is from one permissible method to another permissible method.
    Example 13. Since 2003, E, a calendar year taxpayer, has accounted 
for items of MACRS property that are mass assets in pools. Each pool 
includes only the mass assets that are placed in service by E in the 
same taxable year. E is able to identify the cost basis of each asset in 
each pool. None of the pools are general asset accounts under section 
168(i)(4) and the regulations under section 168(i)(4). E identified any 
dispositions of these mass assets by specific identification. Because of 
changes in E's recordkeeping in 2006, it is impracticable for E to 
continue to identify disposed mass assets using specific identification. 
As a result, E wants to change to a first-in, first-out method under 
which the mass assets disposed of in a taxable year are deemed to be 
from the pool with the earliest placed-in-service year in existence as 
of the beginning of the taxable year of each disposition. Pursuant to 
paragraph (e)(2)(ii)(d)(2)(vii) of this section, this change is a change 
in method of accounting. This method change results in no section 481 
adjustment because the change is from one permissible method to another 
permissible method.
    Example 14. In August 2003, F, a calendar year taxpayer, purchased 
and placed in service a copier for use in its trade or business. F 
incorrectly classified the copier as 7-year property under section 
168(e). F elected not to deduct the additional first year depreciation 
provided by section 168(k) on its 2003 Federal tax return. As a result, 
on its 2003 and 2004 Federal tax returns, F depreciated the copier under 
the general depreciation system of section 168(a), using the 200-percent 
declining balance method of depreciation, a 7-year recovery period, and 
the half-year convention. In 2005, F realizes that the copier is 5-year 
property and should have been depreciated on its 2003 and 2004 Federal 
tax returns under the general depreciation system using a 5-year 
recovery period rather than a 7-year recovery period. Pursuant to 
paragraph (e)(2)(ii)(d)(2)(i) of this section, F's change in recovery 
period from 7 to 5 years is a change in method of accounting. This 
method change results in a section 481 adjustment. The useful life 
exception under paragraph (e)(2)(ii)(d)(3)(i) of this section does not 
apply because the copier is depreciated under section 168.
    Example 15. In 2004, G, a calendar year taxpayer, purchased and 
placed in service an intangible asset that is not an amortizable section 
197 intangible and that is not described in section 167(f). G amortized 
the cost of the intangible asset under section 167(a) using the straight 
line method of depreciation and a determinable useful life of 13 years. 
The safe harbor useful life of 15 or 25 years under Sec. 1.167(a)-3(b) 
does not apply to the intangible asset. In 2008, because of changing 
conditions, G changes the remaining useful life of the intangible asset 
to 2 years. Pursuant to paragraph (e)(2)(ii)(d)(3)(i) of this section, 
G's change in useful life is not a change in method of accounting 
because the intangible asset is depreciated under section 167 and G is 
not changing to or from a useful life that is specifically assigned by 
the Internal Revenue Code, the regulations under the Internal Revenue 
Code, or other guidance published in the Internal Revenue Bulletin.
    Example 16. In July 2003, H, a calendar year taxpayer, purchased and 
placed in service ``off-the-shelf'' computer software and a new 
computer. The cost of the new computer and computer software are 
separately stated. H incorrectly included the cost of this software as 
part of the cost of the computer, which is 5-year property under section 
168(e). On its 2003 Federal tax return, H elected to depreciate its 5-
year property placed in service in 2003 under the alternative 
depreciation system of section 168(g) and H elected not to deduct the 
additional first year depreciation provided by section 168(k). The class 
life for a computer is 5 years. As a result, because H included the cost 
of the computer software as part of the cost of the computer hardware, H 
depreciated the cost of the software under the alternative depreciation 
system, using the straight line method of depreciation, a 5-year 
recovery period, and the half-year convention. In 2005, H realizes that 
the cost of the software should have been amortized under section 
167(f)(1), using the straight line method of depreciation, a 36-month 
useful life, and a monthly convention. H's change from 5-years to 36-
months is a change in

[[Page 61]]

method of accounting because H is changing to a useful life that is 
specifically assigned by section 167(f)(1). The change in convention 
from the half-year to the monthly convention also is a change in method 
of accounting. Both changes result in a section 481 adjustment.
    Example 17. On May 1, 2003, I2, a calendar year taxpayer, purchased 
and placed in service new equipment at a total cost of $500,000 for use 
in its business. The equipment is 5-year property under section 168(e) 
with a class life of 9 years and is qualified property under section 
168(k)(2). I2 did not place in service any other depreciable property in 
2003. Section 168(g)(1)(A) through (D) do not apply to the equipment. I2 
intended to elect the alternative depreciation system under section 
168(g) for 5-year property placed in service in 2003. However, I2 did 
not make the election. Instead, I2 deducted on its 2003 Federal tax 
return the 30-percent additional first year depreciation attributable to 
the equipment and, on its 2003 and 2004 Federal tax returns, depreciated 
the remaining adjusted depreciable basis of the equipment under the 
general depreciation system under 168(a), using the 200-percent 
declining balance method, a 5-year recovery period, and the half-year 
convention. In 2005, I2 realizes its failure to make the alternative 
depreciation system election in 2003 and files a Form 3115, 
``Application for Change in Accounting Method,'' to change its method of 
depreciating the remaining adjusted depreciable basis of the 2003 
equipment to the alternative depreciation system. Because this equipment 
is not required to be depreciated under the alternative depreciation 
system, I2 is attempting to make an election under section 168(g)(7). 
However, this election must be made in the taxable year in which the 
equipment is placed in service (2003) and, consequently, I2 is 
attempting to make a late election under section 168(g)(7). Accordingly, 
I2's change to the alternative depreciation system is not a change in 
accounting method pursuant to paragraph (e)(2)(ii)(d)(3)(iii) of this 
section. Instead, I2 must submit a request for a private letter ruling 
under Sec. 301.9100-3 of this chapter, requesting an extension of time 
to make the alternative depreciation system election on its 2003 Federal 
tax return.
    Example 18. On December 1, 2004, J, a calendar year taxpayer, 
purchased and placed in service 20 previously-owned adding machines. For 
the 2004 taxable year, J incorrectly classified the adding machines as 
items in its ``suspense'' account for financial and tax accounting 
purposes. Assets in this suspense account are not depreciated until 
reclassified to a depreciable fixed asset account. In January 2006, J 
realizes that the cost of the adding machines is still in the suspense 
account and reclassifies such cost to the appropriate depreciable fixed 
asset account. As a result, on its 2004 and 2005 Federal tax returns, J 
did not depreciate the cost of the adding machines. Pursuant to 
paragraph (e)(2)(ii)(d)(2) of this section, J's change in the treatment 
of the adding machines from nondepreciable assets to depreciable assets 
is a change in method of accounting. The placed-in-service date 
exception under paragraph (e)(2)(ii)(d)(3)(v) of this section does not 
apply because the adding machines were incorrectly classified in a 
nondepreciable suspense account. This method change results in a section 
481 adjustment.
    Example 19. In December 2003, K, a calendar year taxpayer, purchased 
and placed in service equipment for use in its trade or business. 
However, K did not receive the invoice for this equipment until January 
2004. As a result, K classified the equipment on its fixed asset records 
as being placed in service in January 2004. On its 2004 and 2005 Federal 
tax returns, K depreciated the cost of the equipment. In 2006, K 
realizes that the equipment was actually placed in service during the 
2003 taxable year and, therefore, depreciation should have began in the 
2003 taxable year instead of the 2004 taxable year. Pursuant to 
paragraph (e)(2)(ii)(d)(3)(v) of this section, K's change in the placed-
in-service date of the equipment is not a change in method of 
accounting.
    (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

[[Page 62]]

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).
    (4) Effective date--(i) In general. Except as provided in paragraphs 
(e)(3)(iii) and (e)(4)(ii) of this section, paragraph (e) of this 
section applies on or after December 30, 2003. For the applicability of 
regulations before December 30, 2003, see Sec. 1.446-1(e) in effect 
prior to December 30, 2003 (Sec. 1.446-1(e) as contained in 26 CFR part 
1 edition revised as of April 1, 2003).
    (ii) Changes involving depreciable or amortizable assets. With 
respect to paragraph (e)(2)(ii)(d) of this section, paragraph 
(e)(2)(iii) Examples 9 through 19 of this section, and the language 
``certain changes in computing depreciation or amortization (see 
paragraph (e)(2)(ii)(d) of this section)'' in the last sentence of 
paragraph (e)(2)(ii)(a) of this section--
    (A) For any change in depreciation or amortization that is a change 
in method of accounting, this section applies to such a change in method 
of accounting made by a taxpayer for a depreciable or amortizable asset 
placed in service by the taxpayer in a taxable year ending on or after 
December 30, 2003; and
    (B) For any change in depreciation or amortization that is not a 
change in method of accounting, this section applies to such a change 
made by a taxpayer for a depreciable or amortizable asset placed in 
service by the taxpayer in a taxable year ending on or after December 
30, 2003.

[T.D. 6500, 25 FR 11708, Nov. 26, 1960]

    Editorial Note: For Federal Register citations affecting Sec. 
1.446-1, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.fdsys.gov.



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);

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    (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 Sec. Sec. 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 64]]


    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 65]]

    (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 66]]

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 67]]

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 68]]

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 69]]

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 70]]

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 71]]

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 72]]



----------------------------------------------------------------------------------------------------------------
                                                                                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 73]]

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 74]]

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 75]]

$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 76]]

    (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 77]]

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 78]]

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 79]]

    (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 80]]

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. 1.446-5  Debt issuance costs.

    (a) In general. This section provides rules for allocating debt 
issuance costs over the term of the debt. For purposes of this section, 
the term debt issuance costs means those transaction costs incurred by 
an issuer of debt (that is, a borrower) that are required to be 
capitalized under Sec. 1.263(a)-5. If these costs are otherwise 
deductible, they are deductible by the issuer over the term of the debt 
as determined under paragraph (b) of this section.
    (b) Method of allocating debt issuance costs--(1) In general. Solely 
for purposes of determining the amount of debt

[[Page 81]]

issuance costs that may be deducted in any period, these costs are 
treated as if they adjusted the yield on the debt. To effect this, the 
issuer treats the costs as if they decreased the issue price of the 
debt. See Sec. 1.1273-2 to determine issue price. Thus, debt issuance 
costs increase or create original issue discount and decrease or 
eliminate bond issuance premium.
    (2) Original issue discount. Any resulting original issue discount 
is taken into account by the issuer under the rules in Sec. 1.163-7, 
which generally require the use of a constant yield method (as described 
in Sec. 1.1272-1) to compute how much original issue discount is 
deductible for a period. However, see Sec. 1.163-7(b) for special rules 
that apply if the total original issue discount on the debt is de 
minimis.
    (3) Bond issuance premium. Any remaining bond issuance premium is 
taken into account by the issuer under the rules of Sec. 1.163-13, 
which generally require the use of a constant yield method for purposes 
of allocating bond issuance premium to accrual periods.
    (c) Examples. The following examples illustrate the rules of this 
section:

    Example 1. (i) On January 1, 2004, X borrows $10,000,000. The 
principal amount of the loan ($10,000,000) is repayable on December 31, 
2008, and payments of interest in the amount of $500,000 are due on 
December 31 of each year the loan is outstanding. X incurs debt issuance 
costs of $130,000 to facilitate the borrowing.
    (ii) Under Sec. 1.1273-2, the issue price of the loan is 
$10,000,000. However, under paragraph (b) of this section, X reduces the 
issue price of the loan by the debt issuance costs of $130,000, 
resulting in an issue price of $9,870,000. As a result, X treats the 
loan as having original issue discount in the amount of $130,000 (stated 
redemption price at maturity of $10,000,000 minus the issue price of 
$9,870,000). Because this amount of original issue discount is more than 
the de minimis amount of original issue discount for the loan determined 
under Sec. 1.1273-1(d) ($125,000 ($10,000,000 x .0025 x 5)), X must 
allocate the original issue discount to each year based on the constant 
yield method described in Sec. 1.1272-1(b). See Sec. 1.163-7(a). Based 
on this method and a yield of 5.30%, compounded annually, the original 
issue discount is allocable to each year as follows: $23,385 for 2004, 
$24,625 for 2005, $25,931 for 2006, $27,306 for 2007, and $28,753 for 
2008.
    Example 2. (i) Assume the same facts as in Example 1, except that X 
incurs debt issuance costs of $120,000 rather than $130,000.
    (ii) Under Sec. 1.1273-2, the issue price of the loan is 
$10,000,000. However, under paragraph (b) of this section, X reduces the 
issue price of the loan by the debt issuance costs of $120,000, 
resulting in an issue price of $9,880,000. As a result, X treats the 
loan as having original issue discount in the amount of $120,000 (stated 
redemption price at maturity of $10,000,000 minus the issue price of 
$9,880,000). Because this amount of original issue discount is less than 
the de minimis amount of original issue discount for the loan determined 
under Sec. 1.1273-1(d) ($125,000), X does not have to use the constant 
yield method described in Sec. 1.1272-1(b) to allocate the original 
issue discount to each year. Instead, under Sec. 1.163-7(b)(2), X can 
choose to allocate the original issue discount to each year on a 
straight-line basis over the term of the loan or in proportion to the 
stated interest payments ($24,000 each year). X also could choose to 
deduct the original issue discount at maturity of the loan. X makes its 
choice by reporting the original issue discount in a manner consistent 
with the method chosen on X's timely filed federal income tax return for 
2004. If X wanted to use the constant yield method, based on a yield of 
5.279%, compounded annually, the original issue discount is allocable to 
each year as follows: $21,596 for 2004, $22,736 for 2005, $23,937 for 
2006, $25,200 for 2007, and $26,531 for 2008.

    (d) Effective date. This section applies to debt issuance costs paid 
or incurred for debt instruments issued on or after December 31, 2003.
    (e) Accounting method changes--(1) Consent to change. An issuer 
required to change its method of accounting for debt issuance costs to 
comply with this section must secure the consent of the Commissioner in 
accordance with the requirements of Sec. 1.446-1(e). Paragraph (e)(2) 
of this section provides the Commissioner's automatic consent for 
certain changes.
    (2) Automatic consent. The Commissioner grants consent for an issuer 
to change its method of accounting for debt issuance costs incurred for 
debt instruments issued on or after December 31, 2003. Because this 
change is made on a cut-off basis, no items of income or deduction are 
omitted or duplicated and, therefore, no adjustment under section 481 is 
allowed. The consent granted by this paragraph (e)(2) applies provided--

[[Page 82]]

    (i) The change is made to comply with this section;
    (ii) The change is made for the first taxable year for which the 
issuer must account for debt issuance costs under this section; and
    (iii) The issuer attaches to its federal income tax return for the 
taxable year containing the change a statement that it has changed its 
method of accounting under this section.

[T.D. 9107, 69 FR 464, Jan. 5, 2004]



Sec. 1.446-6  REMIC inducement fees.

    (a) Purpose. This section provides specific timing rules for the 
clear reflection of income from an inducement fee received in connection 
with becoming the holder of a noneconomic REMIC residual interest. An 
inducement fee must be included in income over a period reasonably 
related to the period during which the applicable REMIC is expected to 
generate taxable income or net loss allocable to the holder of the 
noneconomic residual interest.
    (b) Definitions. For purposes of this section:
    (1) Applicable REMIC. The applicable REMIC is the REMIC that issued 
the noneconomic residual interest with respect to which the inducement 
fee is paid.
    (2) Inducement fee. An inducement fee is the amount paid to induce a 
person to become the holder of a noneconomic residual interest in an 
applicable REMIC.
    (3) Noneconomic residual interest. A REMIC residual interest is a 
noneconomic residual interest if it is a noneconomic residual interest 
within the meaning of Sec. 1.860E-1(c)(2).
    (4) Remaining anticipated weighted average life. The remaining 
anticipated weighted average life is the anticipated weighted average 
life determined using the methodology set forth in Sec. 1.860E-
1(a)(3)(iv) applied as of the date of acquisition of the noneconomic 
residual interest.
    (5) REMIC. The term REMIC has the same meaning in this section as 
given in Sec. 1.860D-1.
    (c) General rule. All taxpayers, regardless of their overall method 
of accounting, must recognize an inducement fee over the remaining 
expected life of the applicable REMIC in a manner that reasonably 
reflects, without regard to this paragraph, the after-tax costs and 
benefits of holding that noneconomic residual interest.
    (d) Special rule on disposition of a residual interest. If any 
portion of an inducement fee received with respect to becoming the 
holder of a noneconomic residual interest in an applicable REMIC has not 
been recognized in full by the holder as of the time the holder 
transfers, or otherwise ceases to be the holder for Federal tax purposes 
of, that residual interest in the applicable REMIC, then the holder must 
include the unrecognized portion of the inducement fee in income at that 
time. This rule does not apply to a transaction to which section 
381(c)(4) applies.
    (e) Safe harbors. If inducement fees are recognized in accordance 
with a method described in this paragraph (e), that method complies with 
the requirements of paragraph (c) of this section.
    (1) The book method. Under the book method, an inducement fee is 
recognized in accordance with the method of accounting, and over the 
same period, used by the taxpayer for financial reporting purposes 
(including consolidated financial statements to shareholders, partners, 
beneficiaries, and other proprietors and for credit purposes), provided 
that the inducement fee is included in income for financial reporting 
purposes over a period that is not shorter than the period during which 
the applicable REMIC is expected to generate taxable income.
    (2) The modified REMIC regulatory method. Under the modified REMIC 
regulatory method, the inducement fee is recognized ratably over the 
remaining anticipated weighted average life of the applicable REMIC as 
if the inducement fee were unrecognized gain being included in gross 
income under Sec. 1.860F-2(b)(4)(iii).
    (3) Additional safe harbor methods. The Commissioner, by revenue 
ruling or revenue procedure (see Sec. 1.601(d)(2) of this chapter), may 
provide additional safe harbor methods for recognizing inducement fees 
relating to noneconomic REMIC residual interests.
    (f) Method of accounting. The treatment of inducement fees is a 
method of accounting to which the provisions of sections 446 and 481 and 
the regulations

[[Page 83]]

thereunder apply. A taxpayer is generally permitted to adopt a method of 
accounting for inducement fees that satisfies the requirements of 
paragraph (c) of this section. Once a taxpayer adopts a method of 
accounting for inducement fees, that method must be applied consistently 
to all inducement fees received in connection with noneconomic REMIC 
residual interests and may be changed only with the consent of the 
Commissioner, as provided by section 446(e) and the regulations and 
procedures thereunder.
    (g) Effective date. This section is applicable for taxable years 
ending on or after May 11, 2004.

[T.D. 9128, 69 FR 26041, May 11, 2004]



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 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 net section 481(a) adjustment into account over the 
section 481(a) adjustment period as determined under the applicable 
administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for 
obtaining the Commissioner's consent to a change in accounting method 
(for example, see Rev. Proc. 2002-9 (2002-1 C.B. 327) and Rev. Proc. 97-
27 (1997-1 C.B. 680) (also see Sec. 601.601(d)(2) of this chapter)), 
provided the taxpayer complies with the provisions of paragraph (h)(2) 
or (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

[[Page 84]]

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.
    (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)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)(i), 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.
    (ii) 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)(ii) 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

[[Page 85]]

    (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 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.
    (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 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

[[Page 86]]

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 
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.

[[Page 87]]

    (i) Effective date--(1) In general. Except as provided in paragraph 
(i)(2), (3), (4), and (5) 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 
this section will not be adversely applied to a taxpayer with respect to 
transactions entered into before December 27, 1993.
    (5) Effective date of paragraph (g)(2)(i). Paragraph (g)(2)(i) of 
this section applies to taxable years ending on or after June 16, 2004.

[T.D. 8514, 58 FR 68299, Dec. 27, 1993, as amended by T.D. 8996, 67 FR 
35012, May 17, 2002; T.D. 9131, 69 FR 33572, June 16, 2004]



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

[[Page 88]]

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 6662(d)(2)(C).
    (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 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

[[Page 89]]

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
    (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

[[Page 90]]

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.
    (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

[[Page 91]]

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 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

[[Page 92]]

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 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

[[Page 93]]

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 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)

[[Page 94]]

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 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

[[Page 95]]

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 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

[[Page 96]]

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 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

[[Page 97]]

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 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; T.D. 9174, 70 
FR 704, Jan. 5, 2005]



Sec. 1.448-2  Nonaccrual of certain amounts by service providers.

    (a) In general. This section applies to taxpayers qualified to use a 
nonaccrual-experience method of accounting provided for in section 
448(d)(5) with respect to amounts to be received for the performance of 
services. A taxpayer that satisfies the requirements of this section is 
not required to accrue any portion of amounts to be received from the 
performance of services that, on the basis of the taxpayer's experience, 
and to the extent determined under the computation or formula used by 
the taxpayer and allowed under this section, will not be collected. 
Except as otherwise provided in this section, a taxpayer is qualified to 
use a nonaccrual-experience method of accounting if the taxpayer uses an 
accrual method of accounting with respect to amounts to be received for 
the performance of services by the taxpayer and either--
    (1) The services are in fields referred to in section 448(d)(2)(A) 
and described in Sec. 1.448-1T(e)(4) (health, law, engineering, 
architecture, accounting, actuarial science, performing arts, or 
consulting); or
    (2) The taxpayer meets the $5 million annual gross receipts test of 
section 448(c) and Sec. 1.448-1T(f)(2) for all prior taxable years.
    (b) Application of method and treatment as method of accounting. The 
rules of section 448(d)(5) and the regulations are applied separately to 
each taxpayer. For purposes of section 448(d)(5), the term taxpayer has 
the same meaning as the term person defined in section

[[Page 98]]

7701(a)(1) (rather than the meaning of the term defined in section 
7701(a)(14)). The nonaccrual of amounts to be received for the 
performance of services is a method of accounting (a nonaccrual-
experience method). A change to a nonaccrual-experience method, from one 
nonaccrual-experience method to another nonaccrual-experience method, or 
to a periodic system (for example, see Notice 88-51 (1988-1 C.B. 535) 
and Sec. 601.601(d)(2)(ii)(b) of this chapter), is a change in method 
of accounting to which the provisions of sections 446 and 481 and the 
regulations apply. See also paragraphs (c)(2)(i), (c)(5), (d)(4), and 
(e)(3)(i) of this section. Except as provided in other published 
guidance, a taxpayer who wishes to adopt or change to any nonaccrual-
experience method other than one of the safe harbor methods described in 
paragraph (f) of this section must request and receive advance consent 
from the Commissioner in accordance with the applicable administrative 
procedures issued under Sec. 1.446-1(e)(3)(ii) for obtaining the 
Commissioner's consent.
    (c) Definitions and special rules--(1) Accounts receivable--(i) In 
general. Accounts receivable include only amounts that are earned by a 
taxpayer and otherwise recognized in income through the performance of 
services by the taxpayer. For purposes of determining a taxpayer's 
nonaccrual-experience under any method provided in this section, amounts 
described in paragraph (c)(1)(ii) of this section are not taken into 
account. Except as otherwise provided, for purposes of this section, 
accounts receivable do not include amounts that are not billed (such as 
for charitable or pro bono services) or amounts contractually not 
collectible (such as amounts in excess of a fee schedule agreed to by 
contract). See paragraph (g) Examples 1 and 2 of this section for 
examples of this rule.
    (ii) Method not available for certain receivables--(A) Amounts not 
earned and recognized through the performance of services. A nonaccrual-
experience method of accounting may not be used with respect to amounts 
that are not earned by a taxpayer and otherwise recognized in income 
through the performance of services by the taxpayer. For example, a 
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 lending money, selling goods, or acquiring accounts receivable or 
other rights to receive payment from other persons (including persons 
related to the taxpayer) regardless of whether those persons earned the 
amounts through the provision of services. However, see paragraph (d)(3) 
of this section for special rules regarding acquisitions of a trade or 
business or a unit of a trade or business.
    (B) If interest or penalty charged on amounts due. A 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, a 
taxpayer will be treated as charging interest or penalties for late 
payment if the contract or agreement expressly provides for the charging 
of interest or penalties for late payment, regardless of the practice of 
the parties. If the contract or agreement does not expressly provide for 
the charging of interest or penalties for late payment, the 
determination of whether the taxpayer charges interest or penalties for 
late payment will be made based on all of the facts and circumstances of 
the transaction, and not merely on the characterization 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--
    (1) The full amount due is otherwise accrued as gross income by the 
taxpayer at the time the services are provided; and
    (2) 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 the discount. See paragraph (g) Example 3 
of this section for an example of this rule.
    (2) Applicable period--(i) In general. The applicable period is the 
number of taxable years on which the taxpayer bases its nonaccrual-
experience method. A change in the number of taxable

[[Page 99]]

years included in the applicable period is a change in method of 
accounting to which the procedures of section 446 apply. A change in the 
inclusion or exclusion of the current taxable year in the applicable 
period is a change in method of accounting to which the procedures of 
section 446 apply. A change in the number of taxable years included in 
the applicable period or the inclusion or exclusion of the current 
taxable year in the applicable period is made on a cut-off basis.
    (ii) Applicable period for safe harbors. For purposes of the safe 
harbors under paragraph (f) of this section the applicable period may 
consist of at least three but not more than six of the immediately 
preceding consecutive taxable years. Alternatively, the applicable 
period may consist of the current taxable year and at least two but not 
more than five of the immediately preceding consecutive taxable years. A 
period shorter than six taxable years is permissible only if the period 
contains the most recent preceding taxable years and all of the taxable 
years in the applicable period are consecutive.
    (3) Bad debts. Bad debts are accounts receivable determined to be 
uncollectible and charged off.
    (4) Charge-offs. Amounts charged off include only those amounts that 
would otherwise be allowable under section 166(a).
    (5) Determination date. The determination date in safe harbor 2 
provided in paragraph (f)(2) of this section is used as a cut-off date 
for determining all known data to be taken into account in the 
computation of the taxable year's uncollectible amount. The 
determination date may not be later than the earlier of the due date, 
including extensions, for filing the taxpayer's Federal income tax 
return for that taxable year or the date on which the taxpayer timely 
files the return for that taxable year. The determination date may be 
different in each taxable year. However, once a determination date is 
selected and used for a particular taxable year, it may not be changed 
for that taxable year. The choice of a determination date is not a 
method of accounting.
    (6) Recoveries. Recoveries are amounts previously excluded from 
income under a nonaccrual-experience method or charged off that the 
taxpayer recovers.
    (7) Uncollectible amount. The uncollectible amount is the portion of 
any account receivable amount due that, under the taxpayer's nonaccrual-
experience method, will be not collected.
    (d) Use of experience to estimate uncollectible amounts--(1) In 
general. In determining the portion of any amount due that, on the basis 
of experience, will not be collected, a taxpayer may use any nonaccrual-
experience method that clearly reflects the taxpayer's nonaccrual-
experience. The determination of whether a nonaccrual-experience method 
clearly reflects the taxpayer's nonaccrual-experience is made in 
accordance with the rules under paragraph (e) of this section. 
Alternatively, the taxpayer may use any one of the five safe harbor 
nonaccrual-experience methods of accounting provided in paragraphs 
(f)(1) through (f)(5) of this section, which are presumed to clearly 
reflect a taxpayer's nonaccrual-experience.
    (2) Application to specific accounts receivable. The nonaccrual-
experience method is applied with respect to each account receivable of 
the taxpayer that is eligible for this method. With respect to a 
particular account receivable, the taxpayer determines, in the manner 
prescribed in paragraphs (d)(1) or (f)(1) through (f)(5) of this section 
(whichever applies), the uncollectible amount. The determination is 
required to be made only once with respect to each account receivable, 
regardless of the term of the receivable. The uncollectible amount is 
not recognized as gross income. Thus, the amount recognized as gross 
income is the amount that would otherwise be recognized as gross income 
with respect to the account receivable, less the uncollectible amount. A 
taxpayer that excludes an amount from income during a taxable year as a 
result of the taxpayer's use of a nonaccrual-experience method may not 
deduct in any subsequent taxable year the amount excluded from income. 
Thus, the taxpayer may not deduct the excluded amount in a subsequent 
taxable year in which the taxpayer actually determines that the

[[Page 100]]

amount is uncollectible and charges it off. If a taxpayer using a 
nonaccrual-experience method determines that an amount that was not 
excluded from income is uncollectible and should be charged off (for 
example, a calendar-year taxpayer determines on November 1st that an 
account receivable that was originated on May 1st of the same taxable 
year is uncollectible and should be charged off), the taxpayer may 
deduct the amount charged off when it is charged off, but must include 
any subsequent recoveries in income. The reasonableness of a taxpayer's 
determination that amounts are uncollectible and should be charged off 
may be considered on examination. See paragraph (g) Example 12 of this 
section for an example of this rule.
    (3) Acquisitions and dispositions--(i) Acquisitions. If a taxpayer 
acquires the major portion of a trade or business of another person 
(predecessor) or the major portion of a separate unit of a trade or 
business of a predecessor, then, for purposes of applying this section 
for any taxable year ending on or after the acquisition, the experience 
from preceding taxable years of the predecessor attributable to the 
portion of the trade or business acquired, if available, must be used in 
determining the taxpayer's experience.
    (ii) Dispositions. If a taxpayer disposes of a major portion of a 
trade or business or the major portion of a separate unit of a trade or 
business, and the taxpayer furnished the acquiring person the 
information necessary for the computations required by this section, 
then, for purposes of applying this section for any taxable year ending 
on or after the disposition, the experience from preceding taxable years 
attributable to the portion of the trade or business disposed may not be 
used in determining the taxpayer's experience.
    (iii) Meaning of terms. For the meaning of the terms acquisition, 
separate unit, and major portion, see paragraph (b) of Sec. 1.52-2. The 
term acquisition includes an incorporation or a liquidation.
    (4) New taxpayers. The rules of this paragraph (d)(4) apply to any 
newly formed taxpayer to which the rules of paragraph (d)(3)(i) of this 
section do not apply. Any newly formed taxpayer that wants to use a safe 
harbor nonaccrual-experience method of accounting described in paragraph 
(f)(1), (f)(2), (f)(3), (f)(4), or (f)(5) of this section applies the 
methods by using the experience of the actual number of taxable years 
available in the applicable period. A newly formed taxpayer that wants 
to use one of the safe harbor nonaccrual-experience methods of 
accounting described in paragraph (f)(2), (f)(4), or (f)(5) of this 
section in its first taxable year and does not have any accounts 
receivable upon formation may not exclude any portion of its year-end 
accounts receivable from income for its first taxable year. The taxpayer 
must begin creating its moving average in its second taxable year by 
tracking the accounts receivable as of the first day of its second 
taxable year. The use of one of the safe harbor nonaccrual-experience 
methods of accounting described in paragraph (f)(2), (f)(4), or (f)(5) 
of this section in a taxpayer's second taxable year in this situation is 
not a change in method of accounting. Although the taxpayer must 
maintain the books and records necessary to perform the computations 
under the adopted safe harbor nonaccrual-experience method, the taxpayer 
is not required to affirmatively elect the method on its Federal income 
tax return for its first taxable year.
    (5) Recoveries. Regardless of the nonaccrual-experience method of 
accounting used by a taxpayer under this section, the taxpayer must take 
recoveries into account. If, in a subsequent taxable year, a taxpayer 
recovers an amount previously excluded from income under a nonaccrual-
experience method or charged off, the taxpayer must include the 
recovered amount in income in that subsequent taxable year. See 
paragraph (g) Example 13 of this section for an example of this rule.
    (6) Request to exclude taxable years from applicable period. A 
period shorter than the applicable period generally is permissible only 
if the period consists of consecutive taxable years and 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

[[Page 101]]

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 evidence that the accounts 
receivable outstanding at the close of the taxable years for the shorter 
period requested are more comparable in nature and risk to accounts 
receivable outstanding at the close of the current taxable year. 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 may not be used for any subsequent taxable year. A request 
for approval to exclude the experience of a prior taxable year must be 
made in accordance with the applicable procedures for requesting a 
letter ruling and must include a statement of the reasons the 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 the approval is requested.
    (7) Short taxable years. A taxpayer with a short taxable year that 
uses a nonaccrual-experience method that compares accounts receivable 
balance to total bad debts during the taxable year should make 
appropriate adjustments.
    (8) Recordkeeping requirements--(i) A taxpayer using a nonaccrual-
experience method of accounting must keep sufficient books and records 
to establish the amount of any exclusion from gross income under section 
448(d)(5) for the taxable year, including books and records 
demonstrating--
    (A) The nature of the taxpayer's nonaccrual-experience method;
    (B) Whether, for any particular taxable year, the taxpayer qualifies 
to use its nonaccrual-experience method (including the self-testing 
requirements of paragraph (e) of this section (if applicable));
    (C) The taxpayer's determination that amounts are uncollectible;
    (D) The proper amount that is excludable under the taxpayer's 
nonaccrual-experience method; and
    (E) The taxpayer's determination date under paragraph (c)(5) of this 
section (if applicable).
    (ii) If a taxpayer does not maintain records of the data that are 
sufficient to establish the amount of any exclusion from gross income 
under section 448(d)(5) for the taxable year, the Internal Revenue 
Service may change the taxpayer's method of accounting on examination. 
See Sec. 1.6001-1 for rules regarding records.
    (e) Requirements for nonaccrual method to clearly reflect 
experience--(1) In general. A nonaccrual-experience method clearly 
reflects the taxpayer's experience if the taxpayer's nonaccrual-
experience method meets the self-test requirements described in this 
paragraph (e). If a taxpayer is using one of the safe harbor nonaccrual-
experience methods described in paragraphs (f)(1) through (f)(4) of this 
section, its method is deemed to clearly reflect its experience and is 
not subject to the self-testing requirements in paragraphs (e)(2) and 
(e)(3) of this section.
    (2) Requirement to self-test--(i) In general. A taxpayer using, or 
desiring to use, a nonaccrual-experience method must self-test its 
nonaccrual-experience method for its first taxable year for which the 
taxpayer uses, or desires to use, that nonaccrual-experience method 
(first-year self-test) and every three taxable years thereafter (three-
year self-test). Each self-test must be performed by comparing the 
uncollectible amount (under the taxpayer's nonaccrual-experience method) 
with the taxpayer's actual experience. A taxpayer using the safe harbor 
under paragraph (f)(5) of this section must self-test using the safe 
harbor comparison method in paragraph (e)(3) of this section.
    (ii) First-year self-test. The first-year self-test must be 
performed by comparing the uncollectible amount with the taxpayer's 
actual experience for its first taxable year for which the taxpayer 
uses, or desires to use, that nonaccrual-experience method. If the 
uncollectible amount for the first-year self-test is less than or equal 
to the taxpayer's actual experience for its

[[Page 102]]

first taxable year for which the taxpayer uses, or desires to use, that 
nonaccrual-experience method, the taxpayer's nonaccrual-experience 
method is treated as clearly reflecting its experience for the first 
taxable year. If, as a result of the first-year self-test, the 
uncollectible amount for the test period is greater than the taxpayer's 
actual experience, then--
    (A) The taxpayer's nonaccrual-experience method is treated as not 
clearly reflecting its experience;
    (B) The taxpayer is not permitted to use that nonaccrual-experience 
method in that taxable year; and
    (C) The taxpayer must change to (or adopt) for that taxable year 
either--
    (1) Another nonaccrual-experience method that clearly reflects 
experience, that is, a nonaccrual-experience method that meets the 
first-year self-test requirement; or
    (2) A safe harbor nonaccrual-experience method described in 
paragraphs (f)(1) through (f)(5) of this section.
    (iii) Three-year self-test--(A) In general. The three-year self-test 
must be performed by comparing the sum of the uncollectible amounts for 
the current taxable year and prior two taxable years (cumulative 
uncollectible amount) with the sum of the taxpayer's actual experience 
for the current taxable year and prior two taxable years (cumulative 
actual experience amount).
    (B) Recapture. If the cumulative uncollectible amount for the test 
period is greater than the cumulative actual experience amount for the 
test period, the taxpayer's uncollectible amount is limited to the 
cumulative actual experience amount for the test period. Any excess of 
the taxpayer's cumulative uncollectible amount over the taxpayer's 
cumulative actual nonaccrual-experience amount excluded from income 
during the test period must be recaptured into income in the third 
taxable year of the three-year self-test period.
    (C) Determination of whether method is permissible or impermissible. 
If the cumulative uncollectible amount is less than 110 percent of the 
cumulative actual experience amount, the taxpayer's nonaccrual-
experience method is treated as a permissible method and the taxpayer 
may continue to use its alternative nonaccrual-experience method, 
subject to the three-year self-test requirement of this paragraph 
(e)(2)(iii). If the cumulative uncollectible amount is greater than or 
equal to 110 percent of the cumulative actual experience amount, the 
taxpayer's nonaccrual-experience method is treated as impermissible in 
the taxable year subsequent to the three-year self-test year and does 
not clearly reflect its experience. The taxpayer must change to another 
nonaccrual-experience method that clearly reflects experience, 
including, for example, one of the safe harbor nonaccrual-experience 
methods described in paragraphs (f)(1) through (f)(5) of this section, 
for the subsequent taxable year. A change in method of accounting from 
an impermissible method under this paragraph (e)(2)(iii)(C) to a 
permissible method in the taxable year subsequent to the three-year 
self-test year is made on a cut-off basis.
    (iv) Determination of taxpayer's actual experience. [Reserved]
    (3) Safe harbor comparison method--(i) In general. A taxpayer using, 
or desiring to use, a nonaccrual-experience method under the safe harbor 
in paragraph (f)(5) of this section must self-test its nonaccrual-
experience method for its first taxable year for which the taxpayer 
uses, or desires to use, that nonaccrual-experience method (first-year 
self-test) and every three taxable years thereafter (three-year self-
test). A nonaccrual-experience method under the safe harbor in paragraph 
(f)(5) of this section is deemed to clearly reflect experience provided 
all the requirements of the safe harbor comparison method of this 
paragraph (e)(3) are met. Each self-test must be performed by comparing 
the uncollectible amount (under the taxpayer's nonaccrual-experience 
method) with the uncollectible amount that would have resulted from use 
of one of the safe harbor methods described in paragraph (f)(1), (f)(2), 
(f)(3), or (f)(4) of this section. A change from a nonaccrual-experience 
method that uses the safe harbor comparison method for self-testing to a 
nonaccrual-experience method that does not use the safe harbor 
comparison method for self-testing, and vice versa,

[[Page 103]]

is a change in method of accounting to which the provisions of sections 
446 and 481 and the regulations apply. A change solely to use or 
discontinue use of the safe harbor comparison method for purposes of 
determining whether the nonaccrual-experience method clearly reflects 
experience must be made on a cut-off basis and without audit protection.
    (ii) Requirements to use safe harbor comparison method--(A) First-
year self-test. The first-year self-test must be performed by comparing 
the uncollectible amount with the uncollectible amount determined under 
any of the safe harbor methods described in paragraph (f)(1), (f)(2), 
(f)(3), or (f)(4) of this section (safe harbor uncollectible amount) for 
its first taxable year for which the taxpayer uses, or desires to use, 
that nonaccrual-experience method. If the uncollectible amount for the 
first-year self-test is less than or equal to the safe harbor 
uncollectible amount, then the taxpayer's nonaccrual-experience method 
is treated as clearly reflecting its experience for the first taxable 
year. If, as a result of the first-year self-test, the uncollectible 
amount for the test period is greater than the safe harbor uncollectible 
amount, then--
    (1) The taxpayer's nonaccrual-experience method is treated as not 
clearly reflecting its experience;
    (2) The taxpayer is not permitted to use that nonaccrual-experience 
method in that taxable year; and
    (3) The taxpayer must change to (or adopt) for that taxable year 
either--
    (i) Another nonaccrual-experience method that clearly reflects 
experience, that is, a nonaccrual-experience method that meets the 
first-year self-test requirement; or
    (ii) A safe harbor nonaccrual-experience method described in 
paragraphs (f)(1) through (f)(5) of this section.
    (B) Three-year self-test. The three-year self-test must be performed 
by comparing the sum of the uncollectible amounts for the current 
taxable year and prior two taxable years (cumulative uncollectible 
amount) with the sum of the uncollectible amount determined under any of 
the safe harbor methods described in paragraph (f)(1), (f)(2), (f)(3), 
or (f)(4) of this section for the current taxable year and prior two 
taxable years (cumulative safe harbor uncollectible amounts). If the 
cumulative uncollectible amount for the three-year self-test is less 
than or equal to the cumulative safe harbor uncollectible amount for the 
test period, then the taxpayer's nonaccrual-experience method is treated 
as clearly reflecting its experience for the test period and the 
taxpayer may continue to use that nonaccrual-experience method, subject 
to a requirement to self-test again after three taxable years. If the 
cumulative uncollectible amount for the test period is greater than the 
cumulative safe harbor uncollectible amount for the test period, the 
taxpayer's uncollectible amount is limited to the cumulative safe harbor 
uncollectible amount for the test period. Any excess of the taxpayer's 
cumulative uncollectible amount over the taxpayer's cumulative safe 
harbor uncollectible amount excluded from income during the test period 
must be recaptured into income in the third taxable year of the three-
year self-test period. If the cumulative uncollectible amount is less 
than 110 percent of the cumulative safe harbor uncollectible amount, the 
taxpayer's nonaccrual-experience method is treated as a permissible 
method and the taxpayer may continue to use its alternative nonaccrual-
experience method, subject to the three-year self-test requirement of 
this paragraph (e)(3)(ii)(B). If the cumulative uncollectible amount is 
greater than or equal to 110 percent of the cumulative safe harbor 
uncollectible amount, the taxpayer's nonaccrual-experience method is 
treated as impermissible in the taxable year subsequent to the three-
year self-test year and does not clearly reflect its experience. The 
taxpayer must change to another nonaccrual-experience method that 
clearly reflects experience, including, for example, one of the safe 
harbor nonaccrual-experience methods described in paragraphs (f)(1) 
through (f)(5) of this section, for the subsequent taxable year. A 
change in method of accounting from an impermissible method under this 
paragraph (e)(3)(ii)(B) to a permissible method in the taxable year

[[Page 104]]

subsequent to the three-year self-test year is made on a cut-off basis.
    (4) Methods that do not clearly reflect experience. [Reserved]
    (5) Contemporaneous documentation. For purposes of this paragraph 
(e), including the safe harbor comparison method of paragraph (e)(3) of 
this section, a taxpayer must document in its books and records, in the 
taxable year any first-year or three-year self-test is performed, the 
method used to conduct the self-test, including appropriate 
documentation and computations that resulted in the determination that 
the taxpayer's nonaccrual-experience method clearly reflected the 
taxpayer's nonaccrual-experience for the applicable test period.
    (f) Safe harbors--(1) Safe harbor 1: revenue-based moving average 
method. A taxpayer may use a nonaccrual-experience method under which 
the taxpayer determines the uncollectible amount by multiplying its 
accounts receivable balance at the end of the current taxable year by a 
percentage (revenue-based moving average percentage). The revenue-based 
moving average percentage is computed by dividing the total bad debts 
sustained, adjusted by recoveries received, throughout the applicable 
period by the total revenue resulting in accounts receivable earned 
throughout the applicable period. See paragraph (g) Example 4 of this 
section for an example of this method. Thus, the uncollectible amount 
under the revenue-based moving average method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.003

    (2) Safe harbor 2: actual experience method--(i) Option A: single 
determination date. A taxpayer may use a nonaccrual-experience method 
under which the taxpayer determines the uncollectible amount by 
multiplying its accounts receivable balance at the end of the current 
taxable year by a percentage (moving average nonaccrual-experience 
percentage) and then increasing the resulting amount by 5 percent. See 
paragraph (g) Example 5 of this section for an example of safe harbor 2 
in general, and paragraph (g) Example 6 of this section for an example 
of the single determination date option of safe harbor 2. The taxpayer's 
moving average nonaccrual-experience percentage is computed by dividing 
the total bad debts sustained, adjusted by recoveries that are allocable 
to the bad debts, by the determination date of the current taxable year 
related to the taxpayer's accounts receivable balance at the beginning 
of each taxable year during the applicable period by the sum of the 
accounts receivable at the beginning of each taxable year during the 
applicable period. Thus, the uncollectible amount under Option A of the 
actual experience method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.004

    (ii) Option B: multiple determination dates. Alternatively, in 
computing its bad debts related to the taxpayer's accounts receivable 
balance at the beginning of each taxable year during the applicable 
period, a taxpayer may use

[[Page 105]]

the original determination date for each taxable year during the 
applicable period. That is, the taxpayer may use bad debts sustained, 
adjusted by recoveries received that are allocable to the bad debts, by 
the determination date of each taxable year during the applicable period 
rather than the determination date of the current taxable year. See 
paragraph (g) Example 7 of this section for an example of the multiple 
determination date option of safe harbor 2. Thus, the uncollectible 
amount under Option B of the actual experience method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.005

    (iii) Tracing of recoveries--(A) In general. Bad debts related to 
the taxpayer's accounts receivable balance at the beginning of each 
taxable year during the applicable period must be adjusted by the 
portion, if any, of recoveries received that are properly allocable to 
the bad debts.
    (B) Specific tracing. If a taxpayer, without undue burden, can trace 
all recoveries to their corresponding charge-offs, the taxpayer must 
specifically trace all recoveries.
    (C) Recoveries cannot be traced without undue burden. If a taxpayer 
has any recoveries that cannot, without undue burden, be traced to 
corresponding charge-offs, the taxpayer may allocate those or all 
recoveries between charge-offs of amounts in the relevant beginning 
accounts receivable balances and other charge-offs using an allocation 
method that is reasonable under all of the facts and circumstances.
    (1) Reasonable allocations. An allocation method is reasonable if 
there is a cause and effect relationship between the allocation base or 
ratio and the recoveries. A taxpayer may elect to trace recoveries that 
are traceable and allocate all untraceable recoveries to charge-offs of 
amounts in the relevant beginning accounts receivable balances. Such an 
allocation method will be deemed to be reasonable under all the facts 
and circumstances.
    (2) Allocations that are not reasonable. Allocation methods that 
generally will not be considered reasonable include, for example, 
methods in which there is not a cause and effect relationship between 
the allocation base or ratio and methods in which receivables for which 
the nonaccrual-experience method is not allowed to be used are included 
in the allocation. See paragraph (c)(1)(ii) of this section for examples 
of receivables for which the nonaccrual-experience method is not 
allowed.
    (3) Safe harbor 3: modified Black Motor method. A taxpayer may use a 
nonaccrual-experience method under which the taxpayer determines the 
uncollectible amount by multiplying its accounts receivable balance at 
the end of the current taxable year by a percentage (modified Black 
Motor moving average percentage) and then reducing the resulting amount 
by the bad debts written off during the current taxable year relating to 
accounts receivable generated during the current taxable year. The 
modified Black Motor moving average percentage is computed by dividing 
the total bad debts sustained, adjusted by recoveries received, during 
the applicable period by the sum of accounts receivable at the end of 
each taxable year during the applicable period. See paragraph (g) 
Example 8 of this section for an example of this method. Thus, the 
uncollectible amount under the modified Black Motor method is computed:

[[Page 106]]

[GRAPHIC] [TIFF OMITTED] TR06SE06.006

    (4) Safe harbor 4: modified moving average method. A taxpayer may 
use a nonaccrual-experience method under which the taxpayer determines 
the uncollectible amount by multiplying its accounts receivable balance 
at the end of the current taxable year by a percentage (modified moving 
average percentage). The modified moving average percentage is computed 
by dividing the total bad debts sustained, adjusted by recoveries 
received, during the applicable period other than bad debts that were 
written off in the same taxable year the related accounts receivable 
were generated by the sum of accounts receivable at the beginning of 
each taxable year during the applicable period. See paragraph (g) 
Example 9 of this section for an example of this method. Thus, the 
uncollectible amount under the modified moving average method is 
computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.007

    (5) Safe harbor 5: alternative nonaccrual-experience method. A 
taxpayer may use an alternative nonaccrual-experience method that 
clearly reflects the taxpayer's actual nonaccrual-experience, provided 
the taxpayer's alternative nonaccrual-experience method meets the self-
test requirements described in paragraph (e)(3) of this section.
    (g) Examples. The following examples illustrate the provisions of 
this section. In each example, the taxpayer uses a calendar year for 
Federal income tax purposes and an accrual method of accounting, does 
not require the payment of interest or penalties with respect to past 
due accounts receivable (except in the case of Example 3) and, in the 
case of Examples 5 through 7, selects an appropriate determination date 
for each taxable year. The examples are as follows:

    Example 1. Contractual allowance or adjustment. B, a healthcare 
provider, performs a medical procedure on individual C, who has health 
insurance coverage with IC, an insurance company. B bills IC and C for 
$5,000, B's standard charge for this medical procedure. However, B has a 
contract with IC that obligates B to accept $3,500 as full payment for 
the medical procedure if the procedure is provided to a patient insured 
by IC. Under the contract, only $3,500 of the $5,000 billed by B is 
legally collectible from IC and C. The remaining $1,500 represents a 
contractual allowance or contractual adjustment. Under paragraph 
(c)(1)(i) of this section, the remaining $1,500 is not a contractually 
collectible amount for purposes of this section and B may not use a 
nonaccrual-experience method with respect to this portion of the 
receivable.
    Example 2. Charitable or pro bono services. D, a law firm, agrees to 
represent individual E in a legal matter and to provide services to E on 
a pro bono basis. D normally charges $500 for these services. Because D 
provides its services to E pro bono, D's services are never billed or 
intended to result in revenue.

[[Page 107]]

Thus, under paragraph (c)(1)(i) of this section, the $500 is not a 
collectible amount for purposes of this section and D may not use a 
nonaccrual-experience method with respect to this portion of the 
receivable.
    Example 3. Charging interest and/or penalties. Z has two billing 
methods for the amounts to be received from Z's provision of services 
described in paragraph (a)(1) of this section. Under one method, for 
amounts that are more than 90 days past due, Z charges interest at a 
market rate until the amounts (together with interest) are paid. Under 
the other billing method, Z charges no interest for amounts past due. 
Under paragraph (c)(1)(ii) of this section, A may not use a 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. Z 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.
    Example 4. Safe harbor 1: Revenue-based moving average method. (i) F 
uses the revenue-based moving average method described in paragraph 
(f)(1) of this section with an applicable period of six taxable years. 
F's total accounts receivable and bad debt experience for the 2006 
taxable year and the five immediately preceding consecutive taxable 
years are as follows:

------------------------------------------------------------------------
                                          Total accounts
                                            receivable       Bad debts
              Taxable year                 earned during   adjusted for
                                            the taxable     recoveries
                                               year
------------------------------------------------------------------------
2001....................................         $40,000          $5,700
2002....................................          40,000           7,200
2003....................................          40,000          11,000
2004....................................          60,000          10,200
2005....................................          70,000          14,000
2006....................................          80,000          16,800
                                         -------------------------------
  Total.................................         330,000          64,900
------------------------------------------------------------------------

    (ii) F's revenue-based moving average percentage is 19.67% ($64,900/
$330,000). If $49,300 of accounts receivable remains outstanding as of 
the close of that taxable year (2006), F's uncollectible amount using 
the revenue-based moving average safe harbor method is computed by 
multiplying $49,300 by the revenue-based moving average percentage of 
19.67%, or $9,697. Thus, F may exclude $9,697 from gross income for 
2006.
    Example 5. Safe harbor 2: Actual experience method . (i) G is 
eligible to use a nonaccrual-experience method and wishes to adopt the 
actual experience method of paragraph (f)(2) of this section. G elects 
to use a three-year applicable period consisting of the current and two 
immediately preceding consecutive taxable years. G determines that its 
actual accounts receivable collection experience is as follows:

------------------------------------------------------------------------
                                                            Bad debts,
                                                           adjusted for
                                             Total A/R      recoveries,
              Taxable year                  balance at    related to A/R
                                           beginning of     balance at
                                           taxable year    beginning of
                                                           taxable year
------------------------------------------------------------------------
2006....................................      $1,000,000         $35,000
2007....................................         760,000          75,000
2008....................................       1,975,000          65,000
                                         -------------------------------
  Total.................................       3,735,000         175,000
------------------------------------------------------------------------

    (ii) G's ending A/R Balance on December 31, 2008, is $880,000. In 
2008, G computes its uncollectible amount by using a three-year moving 
average under paragraph (f)(2) of this section. G's moving average 
nonaccrual-experience percentage is 4.7%, determined by dividing the sum 
of the amount of G's accounts receivable outstanding on January 1 of 
2006, 2007, and 2008, that were determined to be bad debts (adjusted for 
recoveries allocable to the bad debts) on or before the corresponding 
determination date(s), by the sum of the amount of G's accounts 
receivable outstanding on January 1 of 2006, 2007, and 2008 ($175,000/
$3,735,000 or 4.7%). G's uncollectible amount for 2008 is determined by 
multiplying this percentage by the balance of G's accounts receivable on 
December 31, 2008 ($880,000x4.7%=$41,360), and increasing this amount by 
105% ($41,360x105%=$43,428). G may exclude $43,428 from gross income for 
2008.
    Example 6. Safe harbor 2: Single determination date (Option A). H is 
eligible to use a nonaccrual-experience method and wishes to adopt the 
actual experience method of paragraph (f)(2) of this section. H elects 
to use a six-year applicable period consisting of the current and five 
immediately preceding taxable years. H also elects to use a single 
determination date in accordance with paragraph (f)(2)(i) of this 
section. H selects December 31, its taxable year-end, as its 
determination date. Since H is using a single determination date from 
the current taxable year, its determination date for the 2001-2006 
applicable period is December 31, 2006. H has a $800 charge-off in 2003 
of an account receivable in the 2003 beginning accounts receivable 
balance. In 2005, H has a recovery of $100 which is traceable, without 
undue burden, to the $800 charge-off in 2003. Since the $100 recovery 
occurred prior to H's December 31, 2006, determination date, it reduces 
the amount of H's bad debts in the numerator of the formula for purposes 
of determining H's moving average nonaccrual-experience percentage. In 
addition, H must include the $100 recovery in income in 2005 (see 
paragraph (d)(5) of this section regarding recoveries).
    Example 7. Safe harbor 2: Multiple determination dates (Option B). 
The facts are the same as in Example 6, except H elects to use multiple 
determination dates in accordance with

[[Page 108]]

paragraph (f)(2)(ii) of this section. Consequently, H's determination 
date is December 31, 2001, for its calculations of the portion of the 
numerator relating to the 2001 taxable year, December 31, 2002, for its 
calculations of the portion of the numerator relating to the 2002 
taxable year, and so on through the final taxable year (2006), which has 
a determination date of December 31, 2006. Since the $100 recovery did 
not occur until after December 31, 2003 (the determination date for the 
2003 taxable year), it does not reduce the amount of H's bad debts in 
the numerator of the formula for purposes of determining H's moving 
average nonaccrual-experience percentage. However, H still must include 
the $100 recovery in income in 2005 (see paragraph (d)(5) of this 
section regarding recoveries).
    Example 8. Safe harbor 3: Modified Black Motor method. (i) J uses 
the modified Black Motor method described in paragraph (f)(3) of this 
section and a six-year applicable period. J's total accounts receivable 
and bad debt experience for the 2006 taxable year and the five 
immediately preceding consecutive taxable years are as follows:

------------------------------------------------------------------------
                                             Accounts
                                           receivable at     Bad debts
              Taxable year                end of taxable   (adjusted for
                                               year         recoveries)
------------------------------------------------------------------------
2001....................................        $130,000          $9,100
2002....................................         140,000           7,000
2003....................................         140,000          14,000
2004....................................         160,000          14,400
2005....................................         170,000          20,400
2006....................................         180,000          10,800
                                         -------------------------------
  Total.................................         920,000          75,700
------------------------------------------------------------------------

    (ii) J's modified Black Motor moving average percentage is 8.228% 
($75,700/$920,000). If the accounts receivable generated and written off 
during the current taxable year are $3,600, J's uncollectible amount is 
$11,210, computed by multiplying J's accounts receivable on December 31, 
2006 ($180,000) by the modified Black Motor moving average percentage of 
8.228% and reducing the resulting amount by $3,600 (J's accounts 
receivable generated and written off during the 2006 taxable year). J 
may exclude $11,210 from gross income for 2006.
    Example 9. Safe harbor 4: Modified moving average method. (i) The 
facts are the same as in Example 8, except that the balances represent 
accounts receivable at the beginning of the taxable year, and J uses the 
modified moving average method described in paragraph (f)(4) of this 
section and a six-year applicable period. Furthermore, the accounts 
receivable that were written off in the same taxable year they were 
generated, adjusted for recoveries of bad debts during the period are as 
follows:

------------------------------------------------------------------------
                                                             Accounts
                                                            receivable
                                                          written off in
                                                           same taxable
                      Taxable year                            year as
                                                             generated
                                                           (adjusted for
                                                            recoveries)
------------------------------------------------------------------------
2001....................................................          $3,033
2002....................................................           2,333
2003....................................................           4,667
2004....................................................           4,800
2005....................................................           6,800
2006....................................................           3,600
                                                         ---------------
  Total.................................................          25,233
------------------------------------------------------------------------

    (ii) J's modified moving average percentage is 5.486% (($75,700-
$25,233)/$920,000). J's uncollectible amount is $9,875, computed by 
multiplying J's accounts receivable on December 31, 2006 ($180,000) by 
the modified moving average percentage of 5.486%. J may exclude $9,875 
from gross income for 2006.
    Example 10. First-year self-test. Beginning in 2006, K is eligible 
to use a nonaccrual-experience method and wants to adopt an alternative 
nonaccrual-experience method under paragraph (f)(5) of this section, and 
consequently is subject to the safe harbor comparison method of self-
testing under paragraph (e)(3) of this section. K elects to self-test 
against safe harbor 1 for purposes of conducting its first-year self-
test. K's uncollectible amount for 2006 is $22,000. K's safe harbor 
uncollectible amount under safe harbor 1 is $21,000. Because K's 
uncollectible amount for 2006 ($22,000) is greater than the safe harbor 
uncollectible amount ($21,000), K's alternative nonaccrual-experience 
method is treated as not clearly reflecting its nonaccrual experience 
for 2006. Accordingly, K must adopt either another nonaccrual-experience 
method that clearly reflects experience (subject to the self-testing 
requirements of paragraph (e)(2)(ii) of this section, or a safe harbor 
nonaccrual-experience method described in paragraph (f)(1) (revenue-
based moving average), (f)(2) (actual experience method), (f)(3) 
(modified Black Motor method), (f)(4) (modified moving average method) 
of this section, or another alternative nonaccrual-experience method 
under paragraph (f)(5) of this section that meets the self-testing 
requirements of paragraph (e)(3) of this section.
    Example 11. Three-year self-test. The facts are the same as in 
Example 10, except that K's safe harbor uncollectible amount under safe 
harbor 1 for 2006 is also $22,000. Consequently, K meets the first-year 
self-test requirement and may use its alternative nonaccrual-experience 
method. Subsequently, K's cumulative uncollectible amount for 2007 
through 2009 is $300,000. K's safe harbor uncollectible amount for 2007 
through 2009 under its chosen safe harbor method for self-testing (safe 
harbor 1) is $295,000. Because K's cumulative uncollectible amount for 
the

[[Page 109]]

three-year test period (taxable years 2007 through 2009) is greater than 
its safe harbor uncollectible amount for the three-year test period 
($295,000), under paragraph (e)(3)(ii)(B) of this section, the $5,000 
excess of K's cumulative uncollectible amount over K's safe harbor 
uncollectible amount for the three-year test period must be recaptured 
into income in 2009 in accordance with paragraph (e)(3)(ii)(B) of this 
section. Since K's cumulative uncollectible amount for the three-year 
test period ($300,000) is less than 110% of its safe harbor 
uncollectible amount ($295,000x110%=$324,500), under paragraph 
(e)(3)(ii)(B) of this section, K may continue to use its alternative 
nonaccrual-experience method, subject to the three-year self-test 
requirement.
    Example 12. Subsequent worthlessness of year-end receivable. The 
facts are the same as in Example 4, except that one of the accounts 
receivable outstanding at the end of 2002 was for $8,000, and in 2003, 
under section 166, the entire amount of this receivable becomes wholly 
worthless. Because F does not accrue as income $1,573 of this account 
receivable ($8,000x.1967) under the nonaccrual-experience method in 
2002, under paragraph (d)(2) of this section F may not deduct this 
portion of the account receivable as a bad debt deduction under section 
166 in 2003. F may deduct the remaining balance of the receivable in 
2003 as a bad debt deduction under section 166 ($8,000-$1,574=$6,426).
    Example 13. Subsequent collection of year-end receivable. The facts 
are the same as in Example 4. In 2007, F collects in full an account 
receivable of $1,700 that was outstanding at the end of 2006. Under 
paragraph (d)(5) of this section, F must recognize additional gross 
income in 2007 equal to the portion of this receivable that F excluded 
from gross income in the prior taxable year ($1,700x.1967=$334). That 
amount ($334) is a recovery under paragraph (d)(5) of this section.

    (h) Effective date. This section is applicable for taxable years 
ending on or after August 31, 2006.

[T.D. 9285, 71 FR 52437, Sept. 6, 2006]

          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

[[Page 110]]

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. 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

[[Page 111]]

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 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

[[Page 112]]

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
    (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

[[Page 113]]

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).......................................
                                                     ----------
                                                      ........    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

[[Page 114]]

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 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.

[[Page 115]]

    (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.
    (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

[[Page 116]]

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 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

[[Page 117]]

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 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

[[Page 118]]

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 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

[[Page 119]]

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 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

[[Page 120]]

(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 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:

[[Page 121]]

    (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]



Sec. Sec. 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 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:

[[Page 122]]

[GRAPHIC] [TIFF OMITTED] TR25SE06.004

    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 
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

[[Page 123]]

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 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

[[Page 124]]

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:
    (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 Sec. Sec. 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]

[[Page 125]]



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 Sec. Sec. 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.
    (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

[[Page 126]]

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 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

[[Page 127]]

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 Sec. Sec. 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]



Sec. Sec. 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
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

[[Page 128]]

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 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

[[Page 129]]

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]



Sec. 1.453-10  Effective date.

    (a) Except as provided in this section, the provisions of section 
453 and Sec. Sec. 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

[[Page 130]]

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 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

[[Page 131]]

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 Sec. Sec. 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).
    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

[[Page 132]]

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 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.

[[Page 133]]

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 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

[[Page 134]]

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 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

[[Page 135]]

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
    (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.


[[Page 136]]


    (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 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:

[[Page 137]]



----------------------------------------------------------------------------------------------------------------
                                                                                                         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 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...............

[[Page 138]]

 
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  .........  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    (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 
Sec. Sec. 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.

[[Page 139]]

    (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
    (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

[[Page 140]]

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 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

[[Page 141]]

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 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

[[Page 142]]

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 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

[[Page 143]]

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 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

[[Page 144]]

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
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

[[Page 145]]

 
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 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

[[Page 146]]

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 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

[[Page 147]]

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 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]

[[Page 148]]



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 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]

[[Page 149]]



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 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

[[Page 150]]

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 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

[[Page 151]]

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 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

[[Page 152]]

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 $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

[[Page 153]]

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 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

[[Page 154]]

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
    (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

[[Page 155]]

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.
    (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

[[Page 156]]

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.
    (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]

[[Page 157]]



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
    (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

[[Page 158]]

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 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

[[Page 159]]

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 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

[[Page 160]]

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
----------------------------------------------------------------------------------------------------------------
 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..................................
----------------------------------------------------------------------------------------------------------------


[[Page 161]]


[T.D. 6937, 32 FR 16396, Nov. 30. 1967]



Sec. 1.457-1  General overviews of section 457.

    Section 457 provides rules for nonqualified deferred compensation 
plans established by eligible employers as defined under Sec. 1.457-
2(d). Eligible employers can establish either deferred compensation 
plans that are eligible plans and that meet the requirements of section 
457(b) and Sec. Sec. 1.457-3 through 1.457-10, or deferred compensation 
plans or arrangements that do not meet the requirements of section 
457(b) and Sec. Sec. 1.457-3 through 1.457-10 and that are subject to 
tax treatment under section 457(f) and Sec. 1.457-11.

[T.D. 9075, 68 FR 41234, July 11, 2003]



Sec. 1.457-2  Definitions.

    This section sets forth the definitions that are used under 
Sec. Sec. 1.457-1 through 1.457-11.
    (a) Amount(s) deferred. Amount(s) deferred means the total annual 
deferrals under an eligible plan in the current and prior years, 
adjusted for gain or loss. Except as provided at Sec. Sec. 1.457-
4(c)(1)(iii) and 1.457-6(a), amount(s) deferred includes any rollover 
amount held by an eligible plan as provided under Sec. 1.457-10(e).
    (b) Annual deferral(s)--(1) Annual deferral(s) means, with respect 
to a taxable year, the amount of compensation deferred under an eligible 
plan, whether by salary reduction or by nonelective employer 
contribution. The amount of compensation deferred under an eligible plan 
is taken into account as an annual deferral in the taxable year of the 
participant in which deferred, or, if later, the year in which the 
amount of compensation deferred is no longer subject to a substantial 
risk of forfeiture.
    (2) If the amount of compensation deferred under the plan during a 
taxable year is not subject to a substantial risk of forfeiture, the 
amount taken into account as an annual deferral is not adjusted to 
reflect gain or loss allocable to the compensation deferred. If, 
however, the amount of compensation deferred under the plan during the 
taxable year is subject to a substantial risk of forfeiture, the amount 
of compensation deferred that is taken into account as an annual 
deferral in the taxable year in which the substantial risk of forfeiture 
lapses must be adjusted to reflect gain or loss allocable to the 
compensation deferred until the substantial risk of forfeiture lapses.
    (3) If the eligible plan is a defined benefit plan within the 
meaning of section 414(j), the annual deferral for a taxable year is the 
present value of the increase during the taxable year of the 
participant's accrued benefit that is not subject to a substantial risk 
of forfeiture (disregarding any such increase attributable to prior 
annual deferrals). For this purpose, present value must be determined 
using actuarial assumptions and methods that are reasonable (both 
individually and in the aggregate), as determined by the Commissioner.
    (4) For purposes solely of applying Sec. 1.457-4 to determine the 
maximum amount of the annual deferral for a participant for a taxable 
year under an eligible plan, the maximum amount is reduced by the amount 
of any deferral for the participant under a plan described at paragraph 
(k)(4)(i) of this section (relating to certain plans in existence before 
January 1, 1987) as if that deferral were an annual deferral under 
another eligible plan of the employer.
    (c) Beneficiary. Beneficiary means a person who is entitled to 
benefits in respect of a participant following the participant's death 
or an alternate payee as described in Sec. 1.457-10(c).
    (d) Catch-up. Catch-up amount or catch-up limitation for a 
participant for a taxable year means the annual deferral permitted under 
section 414(v) (as described in Sec. 1.457-4(c)(2)) or section 
457(b)(3) (as described in Sec. 1.457-4(c)(3)) to the extent the amount 
of the annual deferral for the participant for the taxable year is 
permitted to exceed the plan ceiling applicable under section 457(b)(2) 
(as described in Sec. 1.457-4(c)(1)).
    (e) Eligible employer. Eligible employer means an entity that is a 
State that

[[Page 162]]

establishes a plan or a tax-exempt entity that establishes a plan. The 
performance of services as an independent contractor for a State or 
local government or a tax-exempt entity is treated as the performance of 
services for an eligible employer. The term eligible employer does not 
include a church as defined in section 3121(w)(3)(A), a qualified 
church-controlled organization as defined in section 3121(w)(3)(B), or 
the Federal government or any agency or instrumentality thereof. Thus, 
for example, a nursing home which is associated with a church, but which 
is not itself a church (as defined in section 3121(w)(3)(A)) or a 
qualified church-controlled organization as defined in section 
3121(w)(3)(B)), would be an eligible employer if it is a tax-exempt 
entity as defined in paragraph (m) of this section.
    (f) Eligible plan. An eligible plan is a plan that meets the 
requirements of Sec. Sec. 1.457-3 through 1.457-10 that is established 
and maintained by an eligible employer. An eligible governmental plan is 
an eligible plan that is established and maintained by an eligible 
employer as defined in paragraph (l) of this section. An arrangement 
does not fail to constitute a single eligible governmental plan merely 
because the arrangement is funded through more than one trustee, 
custodian, or insurance carrier. An eligible plan of a tax-exempt entity 
is an eligible plan that is established and maintained by an eligible 
employer as defined in paragraph (m) of this section.
    (g) Includible compensation. Includible compensation of a 
participant means, with respect to a taxable year, the participant's 
compensation, as defined in section 415(c)(3), for services performed 
for the eligible employer. The amount of includible compensation is 
determined without regard to any community property laws.
    (h) Ineligible plan. Ineligible plan means a plan established and 
maintained by an eligible employer that is not maintained in accordance 
with Sec. Sec. 1.457-3 through 1.457-10. A plan that is not established 
by an eligible employer as defined in paragraph (e) of this section is 
neither an eligible nor an ineligible plan.
    (i) Nonelective employer contribution. A nonelective employer 
contribution is a contribution made by an eligible employer for the 
participant with respect to which the participant does not have the 
choice to receive the contribution in cash or property. Solely for 
purposes of section 457 and Sec. Sec. 1.457-2 through 1.457-11, the 
term nonelective employer contribution includes employer contributions 
that would be described in section 401(m) if they were contributions to 
a qualified plan.
    (j) Participant. Participant in an eligible plan means an individual 
who is currently deferring compensation, or who has previously deferred 
compensation under the plan by salary reduction or by nonelective 
employer contribution and who has not received a distribution of his or 
her entire benefit under the eligible plan. Only individuals who perform 
services for the eligible employer, either as an employee or as an 
independent contractor, may defer compensation under the eligible plan.
    (k) Plan. Plan includes any agreement or arrangement between an 
eligible employer and a participant or participants (including an 
individual employment agreement) under which the payment of compensation 
is deferred (whether by salary reduction or by nonelective employer 
contribution). The following types of plans are not treated as 
agreements or arrangements under which compensation is deferred: a bona 
fide vacation leave, sick leave, compensatory time, severance pay, 
disability pay, or death benefit plan described in section 
457(e)(11)(A)(i) and any plan paying length of service awards to bona 
fide volunteers (and their beneficiaries) on account of qualified 
services performed by such volunteers as described in section 
457(e)(11)(A)(ii). Further, the term plan does not include any of the 
following (and section 457 and Sec. Sec. 1.457-2 through 1.457-11 do 
not apply to any of the following)--
    (1) Any nonelective deferred compensation under which all 
individuals (other than those who have not satisfied any applicable 
initial service requirement) with the same relationship with the 
eligible employer are covered under the same plan with no individual

[[Page 163]]

variations or options under the plan as described in section 457(e)(12), 
but only to the extent the compensation is attributable to services 
performed as an independent contractor;
    (2) An agreement or arrangement described in Sec. 1.457-11(b);
    (3) Any plan satisfying the conditions in section 1107(c)(4) of the 
Tax Reform Act of 1986 (100 Stat. 2494) (TRA '86) (relating to certain 
plans for State judges); and
    (4) Any of the following plans or arrangements (to which specific 
transitional statutory exclusions apply)--
    (i) A plan or arrangement of a tax-exempt entity in existence prior 
to January 1, 1987, if the conditions of section 1107(c)(3)(B) of the 
TRA '86, as amended by section 1011(e)(6) of the Technical and 
Miscellaneous Revenue Act of 1988 (102 Stat. 3700) (TAMRA), are 
satisfied (see Sec. 1.457-2(b)(4) for a special rule regarding such 
plan);
    (ii) A collectively bargained nonelective deferred compensation plan 
in effect on December 31, 1987, if the conditions of section 6064(d)(2) 
of TAMRA are satisfied;
    (iii) Amounts described in section 6064(d)(3) of TAMRA (relating to 
certain nonelective deferred compensation arrangements in effect before 
1989); and
    (iv) Any plan satisfying the conditions in section 1107(c)(4) or (5) 
of TRA '86 (relating to certain plans for certain individuals with 
respect to which the Service issued guidance before 1977).
    (l) State. State means a State (treating the District of Columbia as 
a State as provided under section 7701(a)(10)), a political subdivision 
of a State, and any agency or instrumentality of a State.
    (m) Tax-exempt entity. Tax-exempt entity includes any organization 
exempt from tax under subtitle A of the Internal Revenue Code, except 
that a governmental unit (including an international governmental 
organization) is not a tax-exempt entity.
    (n) Trust. Trust means a trust described under section 457(g) and 
Sec. 1.457-8. Custodial accounts and contracts described in section 
401(f) are treated as trusts under the rules described in Sec. 1.457-
8(a)(2).

[T.D. 9075, 68 FR 41234, July 11, 2003; 68 FR 51446, Aug. 27, 2003]



Sec. 1.457-3  General introduction to eligible plans.

    (a) Compliance in form and operation. An eligible plan is a written 
plan established and maintained by an eligible employer that is 
maintained, in both form and operation, in accordance with the 
requirements of Sec. Sec. 1.457-4 through 1.457-10. An eligible plan 
must contain all the material terms and conditions for benefits under 
the plan. An eligible plan may contain certain optional features not 
required for plan eligibility under section 457(b), such as 
distributions for unforeseeable emergencies, loans, plan-to-plan 
transfers, additional deferral elections, acceptance of rollovers to the 
plan, and distributions of smaller accounts to eligible participants. 
However, except as otherwise specifically provided in Sec. Sec. 1.457-4 
through 1.457-10, if an eligible plan contains any optional provisions, 
the optional provisions must meet, in both form and operation, the 
relevant requirements under section 457 and Sec. Sec. 1.457-2 through 
1.457-10.
    (b) Treatment as single plan. In any case in which multiple plans 
are used to avoid or evade the requirements of Sec. Sec. 1.457-4 
through 1.457-10, the Commissioner may apply the rules under Sec. Sec. 
1.457-4 through 1.457-10 as if the plans were a single plan. See also 
Sec. 1.457-4(c)(3)(v) (requiring an eligible employer to have no more 
than one normal retirement age for each participant under all of the 
eligible plans it sponsors), the second sentence of Sec. 1.457-4(e)(2) 
(treating deferrals under all eligible plans under which an individual 
participates by virtue of his or her relationship with a single employer 
as a single plan for purposes of determining excess deferrals), and 
Sec. 1.457-5 (combining annual deferrals under all eligible plans).

[T.D. 9075, 68 FR 41234, July 11, 2003]



Sec. 1.457-4  Annual deferrals, deferral limitations, and deferral agreements 

under eligible plans.

    (a) Taxation of annual deferrals. Annual deferrals that satisfy the 
requirements of paragraphs (b) and (c) of this section are excluded from 
the gross income of a participant in the year deferred or contributed 
and are not includible in gross income until paid to

[[Page 164]]

the participant in the case of an eligible governmental plan, or until 
paid or otherwise made available to the participant in the case of an 
eligible plan of a tax-exempt entity. See Sec. 1.457-7.
    (b) Agreement for deferral. In order to be an eligible plan, the 
plan must provide that compensation may be deferred for any calendar 
month by salary reduction only if an agreement providing for the 
deferral has been entered into before the first day of the month in 
which the compensation is paid or made available. A new employee may 
defer compensation payable in the calendar month during which the 
participant first becomes an employee if an agreement providing for the 
deferral is entered into on or before the first day on which the 
participant performs services for the eligible employer. An eligible 
plan may provide that if a participant enters into an agreement 
providing for deferral by salary reduction under the plan, the agreement 
will remain in effect until the participant revokes or alters the terms 
of the agreement. Nonelective employer contributions are treated as 
being made under an agreement entered into before the first day of the 
calendar month.
    (c) Maximum deferral limitations--(1) Basic annual limitation. (i) 
Except as described in paragraphs (c)(2) and (3) of this section, in 
order to be an eligible plan, the plan must provide that the annual 
deferral amount for a taxable year (the plan ceiling) may not exceed the 
lesser of--
    (A) The applicable annual dollar amount specified in section 
457(e)(15): $11,000 for 2002; $12,000 for 2003; $13,000 for 2004; 
$14,000 for 2005; and $15,000 for 2006 and thereafter. After 2006, the 
$15,000 amount is adjusted for cost-of-living in the manner described in 
paragraph (c)(4) of this section; or
    (B) 100 percent of the participant's includible compensation for the 
taxable year.
    (ii) The amount of annual deferrals permitted by the 100 percent of 
includible compensation limitation under paragraph (c)(1)(i)(B) of this 
section is determined under section 457(e)(5) and Sec. 1.457-2(g).
    (iii) For purposes of determining the plan ceiling under this 
paragraph (c), the annual deferral amount does not include any rollover 
amounts received by the eligible plan under Sec. 1.457-10(e).
    (iv) The provisions of this paragraph (c)(1) are illustrated by the 
following examples:

    Example 1. (i) Facts. Participant A, who earns $14,000 a year, 
enters into a salary reduction agreement in 2006 with A's eligible 
employer and elects to defer $13,000 of A's compensation for that year. 
A is not eligible for the catch-up described in paragraph (c)(2) or (3) 
of this section, participates in no other retirement plan, and has no 
other income exclusions taken into account in computing includible 
compensation.
    (ii) Conclusion. The annual deferral limit for A in 2006 is the 
lesser of $15,000 or 100 percent of includible compensation, $14,000. 
A's annual deferral of $13,000 is permitted under the plan because it is 
not in excess of $14,000 and thus does not exceed 100 percent of A's 
includible compensation.
    Example 2. (i) Facts. Assume the same facts as in Example 1, except 
that A's eligible employer provides an immediately vested, matching 
employer contribution under the plan for participants who make salary 
reduction deferrals under A's eligible plan. The matching contribution 
is equal to 100 percent of elective contributions, but not in excess of 
10 percent of compensation (in A's case, $1,400).
    (ii) Conclusion. Participant A's annual deferral exceeds the 
limitations of this paragraph (c)(1). A's maximum deferral limitation in 
2006 is $14,000. A's salary reduction deferral of $13,000 combined with 
A's eligible employer's nonelective employer contribution of $1,400 
exceeds the basic annual limitation of this paragraph (c)(1) because A's 
annual deferrals total $14,400. A has an excess deferral for the taxable 
year of $400, the amount exceeding A's permitted annual deferral 
limitation. The $400 excess deferral is treated as described in 
paragraph (e) of this section.
    Example 3. (i) Facts. Beginning in year 2002, Eligible Employer X 
contributes $3,000 per year for five years to B's eligible plan account. 
B's interest in the account vests in 2006. B has annual compensation of 
$50,000 in each of the five years 2002 through 2006. B is 41 years old. 
B is not eligible for the catch-up described in paragraph (c)(2) or (3) 
of this section, participates in no other retirement plan, and has no 
other income exclusions taken into account in computing includible 
compensation. Adjusted for gain or loss, the value of B's benefit when 
B's interest in the account vests in 2006 is $17,000.
    (ii) Conclusion. Under this vesting schedule, $17,000 is taken into 
account as an annual deferral in 2006. B's annual deferrals under the 
plan are limited to a maximum of $15,000 in 2006. Thus, the aggregate of 
the amounts deferred, $17,000, is in excess of B's maximum

[[Page 165]]

deferral limitation by $2,000. The $2,000 is treated as an excess 
deferral described in paragraph (e) of this section.

    (2) Age 50 catch-up--(i) In general. In accordance with section 
414(v) and the regulations thereunder, an eligible governmental plan may 
provide for catch-up contributions for a participant who is age 50 by 
the end of the year, provided that such age 50 catch-up contributions do 
not exceed the catch-up limit under section 414(v)(2) for the taxable 
year. The maximum amount of age 50 catch-up contributions for a taxable 
year under section 414(v) is as follows: $1,000 for 2002; $2,000 for 
2003; $3,000 for 2004; $4,000 for 2005; and $5,000 for 2006 and 
thereafter. After 2006, the $5,000 amount is adjusted for cost-of-
living. For additional guidance, see regulations under section 414(v).
    (ii) Coordination with special section 457 catch-up. In accordance 
with sections 414(v)(6)(C) and 457(e)(18), the age 50 catch-up described 
in this paragraph (c)(2) does not apply for any taxable year for which a 
higher limitation applies under the special section 457 catch-up under 
paragraph (c)(3) of this section. Thus, for purposes of this paragraph 
(c)(2)(ii) and paragraph (c)(3) of this section, the special section 457 
catch-up under paragraph (c)(3) of this section applies for any taxable 
year if and only if the plan ceiling taking into account paragraph 
(c)(1) of this section and the special section 457 catch-up described in 
paragraph (c)(3) of this section (and disregarding the age 50 catch-up 
described in this paragraph (c)(2)) is larger than the plan ceiling 
taking into account paragraph (c)(1) of this section and the age 50 
catch-up described in this paragraph (c)(2) (and disregarding the 
special section 457 catch-up described in paragraph (c)(3) of this 
section). Thus, if a plan so provides, a participant who is eligible for 
the age 50 catch-up for a year and for whom the year is also one of the 
participant's last three taxable years ending before the participant 
attains normal retirement age is eligible for the larger of--
    (A) The plan ceiling under paragraph (c)(1) of this section and the 
age 50 catch-up described in this paragraph (c)(2) (and disregarding the 
special section 457 catch-up described in paragraph (c)(3) of this 
section) or
    (B) The plan ceiling under paragraph (c)(1) of this section and the 
special section 457 catch-up described in paragraph (c)(3) of this 
section (and disregarding the age 50 catch-up described in this 
paragraph (c)(2)).
    (iii) Examples. The provisions of this paragraph (c)(2) are 
illustrated by the following examples:

    Example 1. (i) Facts. Participant C, who is 55, is eligible to 
participate in an eligible governmental plan in 2006. The plan provides 
a normal retirement age of 65. The plan provides limitations on annual 
deferrals up to the maximum permitted under paragraphs (c)(1) and (3) of 
this section and the age 50 catch-up described in this paragraph (c)(2). 
For 2006, C will receive compensation of $40,000 from the eligible 
employer. C desires to defer the maximum amount possible in 2006. The 
applicable basic dollar limit of paragraph (c)(1)(i)(A) of this section 
is $15,000 for 2006 and the additional dollar amount permitted under the 
age 50 catch-up is $5,000 for 2006.
    (ii) Conclusion. C is eligible for the age 50 catch-up in 2006 
because C is 55 in 2006. However, C is not eligible for the special 
section 457 catch-up under paragraph (c)(3) of this section in 2006 
because 2006 is not one of the last three taxable years ending before C 
attains normal retirement age. Accordingly, the maximum that C may defer 
for 2006 is $20,000.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that, in 2006, C will attain age 62. The maximum amount that C can elect 
under the special section 457 catch-up under paragraph (c)(3) of this 
section is $2,000 for 2006.
    (ii) Conclusion. The maximum that C may defer for 2006 is $20,000. 
This is the sum of the basic plan ceiling under paragraph (c)(1) of this 
section equal to $15,000 and the age 50 catch-up equal to $5,000. The 
special section 457 catch-up under paragraph (c)(3) of this section is 
not applicable since it provides a smaller plan ceiling.
    Example 3. (i) Facts. The facts are the same as in Example 2, except 
that the maximum additional amount that C can elect under the special 
section 457 catch-up under paragraph (c)(3) of this section is $7,000 
for 2006.
    (ii) Conclusion. The maximum that C may defer for 2006 is $22,000. 
This is the sum of the basic plan ceiling under paragraph (c)(1) of this 
section equal to $15,000, plus the additional special section 457 catch-
up under paragraph (c)(3) of this section equal to $7,000. The 
additional dollar amount permitted under the age 50 catch-up is not 
applicable to C for 2006 because it provides a smaller plan ceiling.


[[Page 166]]


    (3) Special section 457 catch-up--(i) In general. Except as provided 
in paragraph (c)(2)(ii) of this section, an eligible plan may provide 
that, for one or more of the participant's last three taxable years 
ending before the participant attains normal retirement age, the plan 
ceiling is an amount not in excess of the lesser of--
    (A) Twice the dollar amount in effect under paragraph (c)(1)(i)(A) 
of this section; or
    (B) The underutilized limitation determined under paragraph 
(c)(3)(ii) of this section.
    (ii) Underutilized limitation. The underutilized amount determined 
under this paragraph (c)(3)(ii) is the sum of--
    (A) The plan ceiling established under paragraph (c)(1) of this 
section for the taxable year; plus
    (B) The plan ceiling established under paragraph (c)(1) of this 
section (or under section 457(b)(2) for any year before the 
applicability date of this section) for any prior taxable year or years, 
less the amount of annual deferrals under the plan for such prior 
taxable year or years (disregarding any annual deferrals under the plan 
permitted under the age 50 catch-up under paragraph (c)(2) of this 
section).
    (iii) Determining underutilized limitation under paragraph 
(c)(3)(ii)(B) of this section. A prior taxable year is taken into 
account under paragraph (c)(3)(ii)(B) of this section only if it is a 
year beginning after December 31, 1978, in which the participant was 
eligible to participate in the plan, and in which compensation deferred 
(if any) under the plan during the year was subject to a plan ceiling 
established under paragraph (c)(1) of this section. This paragraph 
(c)(3)(iii) is subject to the special rules in paragraph (c)(3)(iv) of 
this section.
    (iv) Special rules concerning application of the coordination limit 
for years prior to 2002 for purposes of determining the underutilized 
limitation--(A) General rule. For purposes of determining the 
underutilized limitation for years prior to 2002, participants remain 
subject to the rules in effect prior to the repeal of the coordination 
limitation under section 457(c)(2). Thus, the applicable basic annual 
limitation under paragraph (c)(1) of this section and the special 
section 457 catch-up under this paragraph (c)(3) for years in effect 
prior to 2002 are reduced, for purposes of determining a participant's 
underutilized amount under a plan, by amounts excluded from the 
participant's income for any prior taxable year by reason of a 
nonelective employer contribution, salary reduction or elective 
contribution under any other eligible section 457(b) plan, or a salary 
reduction or elective contribution under any 401(k) qualified cash or 
deferred arrangement, section 402(h)(1)(B) simplified employee pension 
(SARSEP), section 403(b) annuity contract, and section 408(p) simple 
retirement account, or under any plan for which a deduction is allowed 
because of a contribution to an organization described in section 
501(c)(18) (pre-2002 coordination plans). Similarly, in applying the 
section 457(b)(2)(B) limitation for includible compensation for years 
prior to 2002, the limitation is 33\1/3\ percent of the participant's 
compensation includible in gross income.
    (B) Coordination limitation applied to participant. For purposes of 
determining the underutilized limitation for years prior to 2002, the 
coordination limitation applies to pre-2002 coordination plans of all 
employers for whom a participant has performed services, whether or not 
those are plans of the participant's current eligible employer. Thus, 
for purposes of determining the amount excluded from a participant's 
gross income in any prior taxable year under paragraph (c)(3)(ii)(B) of 
this section, the participant's annual deferrals under an eligible plan, 
and salary reduction or elective deferrals under all other pre-2002 
coordination plans, must be determined on an aggregate basis. To the 
extent that the combined deferrals for years prior to 2002 exceeded the 
maximum deferral limitations, the amount is treated as an excess 
deferral under paragraph (e) of this section for those prior years.
    (C) Special rule where no annual deferrals under the eligible plan. 
A participant who, although eligible, did not defer any compensation 
under the eligible plan in any year before 2002 is not subject to the 
coordinated deferral limit, even though the participant may have 
deferred compensation under one

[[Page 167]]

of the other pre-2002 coordination plans. An individual is treated as 
not having deferred compensation under an eligible plan for a prior 
taxable year if all annual deferrals under the plan are distributed in 
accordance with paragraph (e) of this section. Thus, to the extent that 
a participant participated solely in one or more of the other pre-2002 
coordination plans during a prior taxable year (and not the eligible 
plan), the participant is not subject to the coordinated limitation for 
that prior taxable year. However, the participant is treated as having 
deferred an amount in a prior taxable year, for purposes of determining 
the underutilized limitation for that prior taxable year under this 
paragraph (c)(3)(iv)(C), to the extent of the participant's aggregate 
salary reduction contributions and elective deferrals under all pre-2002 
coordination plans up to the maximum deferral limitations in effect 
under section 457(b) for that prior taxable year. To the extent an 
employer did not offer an eligible plan to an individual in a prior 
given year, no underutilized limitation is available to the individual 
for that prior year, even if the employee subsequently becomes eligible 
to participate in an eligible plan of the employer.
    (D) Examples. The provisions of this paragraph (c)(3)(iv) are 
illustrated by the following examples:

    Example 1. (i) Facts. In 2001 and in years prior to 2001, 
Participant D earned $50,000 a year and was eligible to participate in 
both an eligible plan and a section 401(k) plan. However, D had always 
participated only in the section 401(k) plan and had always deferred the 
maximum amount possible. For each year before 2002, the maximum amount 
permitted under section 401(k) exceeded the limitation of paragraph 
(c)(3)(i) of this section. In 2002, D is in the 3-year period prior to 
D's attainment of the eligible plan's normal retirement age of 65, and D 
now wants to participate in the eligible plan and make annual deferrals 
of up to $30,000 under the plan's special section 457 catch-up 
provisions.
    (ii) Conclusion. Participant D is treated as having no underutilized 
amount under paragraph (c)(3)(ii)(B) of this section for 2002 for 
purposes of the catch-up limitation under section 457(b)(3) and 
paragraph (c)(3) of this section because, in each of the years before 
2002, D has deferred an amount equal to or in excess of the limitation 
of paragraph (c)(3)(i) of this section under all of D's coordinated 
plans.
    Example 2. (i) Facts. Assume the same facts as in Example 1, except 
that D only deferred $2,500 per year under the section 401(k) plan for 
one year before 2002.
    (ii) Conclusion. D is treated as having an underutilized amount 
under paragraph (c)(3)(ii)(B) of this section for 2002 for purposes of 
the special section 457 catch-up limitation. This is because D has 
deferred an amount for prior years that is less than the limitation of 
paragraph (c)(1)(i) of this section under all of D's coordinated plans.
    Example 3. (i) Facts. Participant E, who earned $15,000 for 2000, 
entered into a salary reduction agreement in 2000 with E's eligible 
employer and elected to defer $3,000 for that year under E's eligible 
plan. For 2000, E's eligible employer provided an immediately vested, 
matching employer contribution under the plan for participants who make 
salary reduction deferrals under E's eligible plan. The matching 
contribution was equal to 67 percent of elective contributions, but not 
in excess of 10 percent of compensation before salary reduction 
deferrals (in E's case, $1,000). For 2000, E was not eligible for any 
catch-up contribution, participated in no other retirement plan, and had 
no other income exclusions taken into account in computing taxable 
compensation.
    (ii) Conclusion. Participant E's annual deferral equaled the maximum 
limitation of section 457(b) for 2000. E's maximum deferral limitation 
in 2000 was $4,000 because E's includible compensation was $12,000 
($15,000 minus the deferral of $3,000) and the applicable limitation for 
2000 was one third of the individual's includible compensation (one-
third of $12,000 equals $4,000). E's salary reduction deferral of $3,000 
combined with E's eligible employer's matching contribution of $1,000 
equals the limitation of section 457(b) for 2000 because E's annual 
deferrals totaled $4,000. E's underutilized amount for 2000 is zero.

    (v) Normal retirement age--(A) General rule. For purposes of the 
special section 457 catch-up in this paragraph (c)(3), a plan must 
specify the normal retirement age under the plan. A plan may define 
normal retirement age as any age that is on or after the earlier of age 
65 or the age at which participants have the right to retire and 
receive, under the basic defined benefit pension plan of the State or 
tax-exempt entity (or a money purchase pension plan in which the 
participant also participates if the participant is not eligible to 
participate in a defined benefit plan), immediate retirement benefits 
without actuarial or similar reduction because

[[Page 168]]

of retirement before some later specified age, and that is not later 
than age 70\1/2\. Alternatively, a plan may provide that a participant 
is allowed to designate a normal retirement age within these ages. For 
purposes of the special section 457 catch-up in this paragraph (c)(3), 
an entity sponsoring more than one eligible plan may not permit a 
participant to have more than one normal retirement age under the 
eligible plans it sponsors.
    (B) Special rule for eligible plans of qualified police or 
firefighters. An eligible plan with participants that include qualified 
police or firefighters as defined under section 415(b)(2)(H)(ii)(I) may 
designate a normal retirement age for such qualified police or 
firefighters that is earlier than the earliest normal retirement age 
designated under the general rule of paragraph (c)(3)(i)(A) of this 
section, but in no event may the normal retirement age be earlier than 
age 40. Alternatively, a plan may allow a qualified police or 
firefighter participant to designate a normal retirement age that is 
between age 40 and age 70\1/2\.
    (vi) Examples. The provisions of this paragraph (c)(3) are 
illustrated by the following examples:

    Example 1. (i) Facts. Participant F, who will turn 61 on April 1, 
2006, becomes eligible to participate in an eligible plan on January 1, 
2006. The plan provides a normal retirement age of 65. The plan provides 
limitations on annual deferrals up to the maximum permitted under 
paragraphs (c)(1) through (3) of this section. For 2006, F will receive 
compensation of $40,000 from the eligible employer. F desires to defer 
the maximum amount possible in 2006. The applicable basic dollar limit 
of paragraph (c)(1)(i)(A) of this section is $15,000 for 2006 and the 
additional dollar amount permitted under the age 50 catch-up in 
paragraph (c)(2) of this section for an individual who is at least age 
50 is $5,000 for 2006.
    (ii) Conclusion. F is not eligible for the special section 457 
catch-up under paragraph (c)(3) of this section in 2006 because 2006 is 
not one of the last three taxable years ending before F attains normal 
retirement age. Accordingly, the maximum that F may defer for 2006 is 
$20,000. See also paragraph (c)(2)(iii) Example 1 of this section.
    Example 2. (i) Facts. The facts are the same as in Example 1 except 
that, in 2006, F elects to defer only $2,000 under the plan (rather than 
the maximum permitted amount of $20,000). In addition, assume that the 
applicable basic dollar limit of paragraph (c)(1)(i)(A) of this section 
continues to be $15,000 for 2007 and the additional dollar amount 
permitted under the age 50 catch-up in paragraph (c)(2) of this section 
for an individual who is at least age 50 continues to be $5,000 for 
2007. In F's taxable year 2007, which is one of the last three taxable 
years ending before F attains the plan's normal retirement age of 65, F 
again receives a salary of $40,000 and elects to defer the maximum 
amount permissible under the plan's catch-up provisions prescribed under 
paragraph (c) of this section.
    (ii) Conclusion. For 2007, which is one of the last three taxable 
years ending before F attains the plan's normal retirement age of 65, 
the applicable limit on deferrals for F is the larger of the amount 
under the special section 457 catch-up or $20,000, which is the basic 
annual limitation ($15,000) and the age 50 catch-up limit of section 
414(v) ($5,000). For 2007, F's special section 457 catch-up amount is 
the lesser of two times the basic annual limitation ($30,000) or the sum 
of the basic annual limitation ($15,000) plus the $13,000 underutilized 
limitation under paragraph (c)(3)(ii) of this section (the $15,000 plan 
ceiling in 2006, minus the $2,000 contributed for F in 2006), or 
$28,000. Thus, the maximum amount that F may defer in 2007 is $28,000.
    Example 3. (i) Facts. The facts are the same as in Examples 1 and 2, 
except that F does not make any contributions to the plan before 2010. 
In addition, assume that the applicable basic dollar limitation of 
paragraph (c)(1)(i)(A) of this section continues to be $15,000 for 2010 
and the additional dollar amount permitted under the age 50 catch-up in 
paragraph (c)(2) of this section for an individual who is at least age 
50 continues to be $5,000 for 2010. In F's taxable year 2010, the year 
in which F attains age 65 (which is the normal retirement age under the 
plan), F desires to defer the maximum amount possible under the plan. 
F's compensation for 2010 is again $40,000.
    (ii) Conclusion. For 2010, the maximum amount that F may defer is 
$20,000. The special section 457 catch-up provisions under paragraph 
(c)(3) of this section are not applicable because 2010 is not a taxable 
year ending before the year in which F attains normal retirement age.

    (4) Cost-of-living adjustment. For years beginning after December 
31, 2006, the $15,000 dollar limitation in paragraph (c)(1)(i)(A) of 
this section will be adjusted to take into account increases in the 
cost-of-living. The adjustment in the dollar limitation is made at the 
same time and in the same manner as under section 415(d) (relating to 
qualified plans under section 401(a)), except that the base period is 
the calendar quarter beginning July 1, 2005 and any

[[Page 169]]

increase which is not a multiple of $500 will be rounded to the next 
lowest multiple of $500.
    (d) Deferrals after severance from employment, including sick, 
vacation, and back pay under an eligible plan--(1) In general. An 
eligible plan may provide that a participant who has not had a severance 
from employment may elect to defer accumulated sick pay, accumulated 
vacation pay, and back pay under an eligible plan if the requirements of 
section 457(b) are satisfied. For example, the plan must provide, in 
accordance with paragraph (b) of this section, that these amounts may be 
deferred for any calendar month only if an agreement providing for the 
deferral is entered into before the beginning of the month in which the 
amounts would otherwise be paid or made available and the participant is 
an employee on the date the amounts would otherwise be paid or made 
available. For purposes of section 457, compensation that would 
otherwise be paid for a payroll period that begins before severance from 
employment is treated as an amount that would otherwise be paid or made 
available before an employee has a severance from employment. In 
addition, deferrals may be made for former employees with respect to 
compensation described in Sec. 1.415(c)-2(e)(3)(i) (relating to certain 
compensation paid by the later of 2\1/2\ months after severance from 
employment or the end of the limitation year that includes the date of 
severance from employment). For this purpose, the calendar year is 
substituted for the limitation year. In addition, compensation described 
in Sec. 1.415(c)-2(e)(4), (g)(4), or (g)(7) (relating to compensation 
paid to participants who are permanently and totally disabled or 
compensation relating to qualified military service under section 
414(u)), provided those amounts represent compensation described in 
Sec. 1.415(c)-2(e)(3)(i).
    (2) Examples. The provisions of this paragraph (d) are illustrated 
by the following examples:

    Example 1. (i) Facts. Participant G, who is age 62 in year 2007, is 
an employee who participates in an eligible plan providing a normal 
retirement age of 65 and a bona fide sick leave and vacation pay program 
of the eligible employer. Under the terms of G's employer's eligible 
plan and the sick leave and vacation pay program, G is permitted to make 
a one-time election to contribute amounts representing accumulated sick 
pay to the eligible plan. G has a severance from employment on January 
12, 2008, at which time G's accumulated sick and vacation pay that is 
payable on March 15, 2008, totals $12,000. G elects, on February 4, 
2008, to have the $12,000 of accumulated sick and vacation pay 
contributed to the eligible plan.
    (ii) Conclusion. Under the terms of the eligible plan and the sick 
and vacation pay program, G may elect before March 1, 2008, to defer the 
accumulated sick and vacation pay because the agreement providing for 
the deferral is entered into before the beginning of the month in which 
the amount is currently available and the amount is bona fide 
accumulated sick and vacation pay, as described in Sec. 1.415(c)-
2(e)(3)(ii), and that is payable by the later of 2\1/2\ months after 
severance from employment or the end of the calendar year that includes 
the date of severance from employment by G. Thus, under this section and 
Sec. 1.415(c)-2(e)(3)(ii), the $12,000 is included in G's includible 
compensation for purposes of determining G's includible compensation in 
year 2008.
    Example 2. (i) Facts. Same facts as in Example 1, except that G's 
severance from employment is on May 31, 2008, G's $12,000 of accumulated 
sick and vacation pay is payable on September 15, 2008 (which is by the 
later of 2\1/2\ months after severance from employment or the end of the 
calendar year that includes the date of severance from employment by G), 
and G's election to defer the accumulated sick and vacation pay is made 
before May 1, 2008.
    (ii) Conclusion. Under this section and Sec. 1.415(c)-2(e)(3)(ii), 
the $12,000 is included in G's includible compensation for purposes of 
determining G's includible compensation in year 2008.
    Example 3. (i) Facts. Employer X maintains an eligible plan and a 
vacation leave plan. Under the terms of the vacation leave plan, 
employees generally accrue three weeks of vacation per year. Up to one 
week's unused vacation may be carried over from one year to the next, so 
that in any single year an employee may have a maximum of four weeks' 
vacation time. At the beginning of each calendar year, under the terms 
of the eligible plan (which constitutes an agreement providing for the 
deferral), the value of any unused vacation time from the prior year in 
excess of one week is automatically contributed to the eligible plan, to 
the extent of the employee's maximum deferral limitations. Amounts in 
excess of the maximum deferral limitations are forfeited.
    (ii) Conclusion. The value of the unused vacation pay contributed to 
X's eligible plan pursuant to the terms of the plan and the terms of the 
vacation leave plan is treated as

[[Page 170]]

an annual deferral to the eligible plan for January of the calendar 
year. No amounts contributed to the eligible plan will be considered 
made available to a participant in X's eligible plan.

    (e) Excess deferrals under an eligible plan--(1) In general. Any 
amount deferred under an eligible plan for the taxable year of a 
participant that exceeds the maximum deferral limitations set forth in 
paragraphs (c)(1) through (3) of this section, and any amount that 
exceeds the individual limitation under Sec. 1.457-5, constitutes an 
excess deferral that is taxable in accordance with Sec. 1.457-11 for 
that taxable year. Thus, an excess deferral is includible in gross 
income in the taxable year deferred or, if later, the first taxable year 
in which there is no substantial risk of forfeiture.
    (2) Excess deferrals under an eligible governmental plan other than 
as a result of the individual limitation. In order to be an eligible 
governmental plan, the plan must provide that any excess deferral 
resulting from a failure of a plan to apply the limitations of 
paragraphs (c)(1) through (3) of this section to amounts deferred under 
the eligible plan (computed without regard to the individual limitation 
under Sec. 1.457-5) will be distributed to the participant, with 
allocable net income, as soon as administratively practicable after the 
plan determines that the amount is an excess deferral. For purposes of 
determining whether there is an excess deferral resulting from a failure 
of a plan to apply the limitations of paragraphs (c)(1) through (3) of 
this section, all plans under which an individual participates by virtue 
of his or her relationship with a single employer are treated as a 
single plan (without regard to any differences in funding). An eligible 
governmental plan does not fail to satisfy the requirements of 
paragraphs (a) through (d) of this section or Sec. Sec. 1.457-6 through 
1.457-10 (including the distribution rules under Sec. 1.457-6 and the 
funding rules under Sec. 1.457-8) solely by reason of a distribution 
made under this paragraph (e)(2). If such excess deferrals are not 
corrected by distribution under this paragraph (e)(2), the plan will be 
an ineligible plan under which benefits are taxable in accordance with 
Sec. 1.457-11.
    (3) Excess deferrals under an eligible plan of a tax-exempt employer 
other than as a result of the individual limitation. If a plan of a tax-
exempt employer fails to comply with the limitations of paragraphs 
(c)(1) through (3) of this section, the plan will be an ineligible plan 
under which benefits are taxable in accordance with Sec. 1.457-11. 
However, a plan may distribute to a participant any excess deferrals 
(and any income allocable to such amount) not later than the first April 
15 following the close of the taxable year of the excess deferrals. In 
such a case, the plan will continue to be treated as an eligible plan. 
However, any excess deferral is included in the gross income of a 
participant for the taxable year of the excess deferral. If the excess 
deferrals are not corrected by distribution under this paragraph (e)(3), 
the plan is an ineligible plan under which benefits are taxable in 
accordance with Sec. 1.457-11. For purposes of determining whether 
there is an excess deferral resulting from a failure of a plan to apply 
the limitations of paragraphs (c)(1) through (3) of this section, all 
eligible plans under which an individual participates by virtue of his 
or her relationship with a single employer are treated as a single plan.
    (4) Excess deferrals arising from application of the individual 
limitation. An eligible plan may provide that an excess deferral that is 
a result solely of a failure to comply with the individual limitation 
under Sec. 1.457-5 for a taxable year may be distributed to the 
participant, with allocable net income, as soon as administratively 
practicable after the plan determines that the amount is an excess 
deferral. An eligible plan does not fail to satisfy the requirements of 
paragraphs (a) through (d) of this section or Sec. Sec. 1.457-6 through 
1.457-10 (including the distribution rules under Sec. 1.457-6 and the 
funding rules under Sec. 1.457-8) solely by reason of a distribution 
made under this paragraph (e)(4). Although a plan will still maintain 
eligible status if excess deferrals are not distributed under this 
paragraph (e)(4), a participant must include the excess amounts in 
income as provided in paragraph (e)(1) of this section.

[[Page 171]]

    (5) Examples. The provisions of this paragraph (e) are illustrated 
by the following examples:

    Example 1. (i) Facts. In 2006, the eligible plan of State Employer X 
in which Participant H participates permits a maximum deferral of the 
lesser of $15,000 or 100 percent of includible compensation. In 2006, H, 
who has compensation of $28,000, nevertheless defers $16,000 under the 
eligible plan. Participant H is age 45 and normal retirement age under 
the plan is age 65. For 2006, the applicable dollar limit under 
paragraph (c)(1)(i)(A) of this section is $15,000. Employer X discovers 
the error in January of 2007 when it completes H's 2006 Form W-2 and 
promptly distributes $1,022 to H (which is the sum of the $1,000 excess 
and $22 of allocable net income).
    (ii) Conclusion. Participant H has deferred $1,000 in excess of the 
$15,000 limitation provided for under the plan for 2006. The $1,000 
excess must be included by H in H's income for 2006. In order to correct 
the failure and still be an eligible plan, the plan must distribute the 
excess deferral, with allocable net income, as soon as administratively 
practicable after determining that the amount exceeds the plan deferral 
limitations. In this case, $22 of the distribution of $1,022 is included 
in H's gross income for 2007 (and is not an eligible rollover 
distribution). If the excess deferral were not distributed, the plan 
would be an ineligible plan with respect to which benefits are taxable 
in accordance with Sec. 1.457-11.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that X uses a number of separate arrangements with different trustees 
and annuity insurers to permit employees to defer and H elects deferrals 
under several of the funding arrangements none of which exceeds $15,000 
for any individual funding arrangement, but which total $16,000.
    (ii) Conclusion. The conclusion is the same as in Example 1.
    Example 3. (i) Facts. The facts are the same as in Example 1, except 
that H's deferral under the eligible plan is limited to $11,000 and H 
also makes a salary reduction contribution of $5,000 to an annuity 
contract under section 403(b) with the same Employer X.
    (ii) Conclusion. H's deferrals are within the plan deferral 
limitations of Employer X. Because of the repeal of the application of 
the coordination limitation under former paragraph (2) of section 
457(c), H's salary reduction deferrals under the annuity contract are no 
longer considered in determining H's applicable deferral limits under 
paragraphs (c)(1) through (3) of this section.
    Example 4. (i) Facts. The facts are the same as in Example 1, except 
that H's deferral under the eligible governmental plan is limited to 
$14,000 and H also makes a deferral of $4,000 to an eligible 
governmental plan of a different employer. Participant H is age 45 and 
normal retirement age under both eligible plans is age 65.
    (ii) Conclusion. Because of the application of the individual 
limitation under Sec. 1.457-5, H has an excess deferral of $3,000 (the 
sum of $14,000 plus $4,000 equals $18,000, which is $3,000 in excess of 
the dollar limitation of $15,000). The $3,000 excess deferral, with 
allocable net income, may be distributed from either plan as soon as 
administratively practicable after determining that the combined amount 
exceeds the deferral limitations. If the $3,000 excess deferral is not 
distributed to H, each plan will continue to be an eligible plan, but 
the $3,000 must be included by H in H's income for 2006.
    Example 5. (i) Facts. Assume the same facts as in Example 3, except 
that H's deferral under the eligible governmental plan is limited to 
$14,000 and H also makes a deferral of $4,000 to an eligible plan of 
Employer Y, a tax-exempt entity.
    (ii) Conclusion. The results are the same as in Example 3, namely, 
because of the application of the individual limitation under Sec. 
1.457-5, H has an excess deferral of $3,000. If the $3,000 excess 
deferral is not distributed to H, each plan will continue to be an 
eligible plan, but the $3,000 must be included by H in H's income for 
2006.
    Example 6. (i) Facts. Assume the same facts as in Example 5, except 
that X is a tax-exempt entity and thus its plan is an eligible plan of a 
tax-exempt entity.
    (ii) Conclusion. The results are the same as in Example 5, namely, 
because of the application of the individual limitation under Sec. 
1.457-5, H has an excess deferral of $3,000. If the $3,000 excess 
deferral is not distributed to H, each plan will continue to be an 
eligible plan, but the $3,000 must be included by H into H's income for 
2006.

[T.D. 9075, 68 FR 41234, July 11, 2003; 68 FR 51446, Aug. 27, 2003; T.D. 
9319, 72 FR 16930, Apr. 5, 2007]



Sec. 1.457-5  Individual limitation for combined annual deferrals under 

multiple eligible plans

    (a) General rule. The individual limitation under section 457(c) and 
this section equals the basic annual deferral limitation under Sec. 
1.457-4(c)(1)(i)(A), plus either the age 50 catch-up amount under Sec. 
1.457-4(c)(2), or the special section 457 catch-up amount under Sec. 
1.457-4(c)(3), applied by taking into account the combined annual 
deferral for the participant for any taxable year under all eligible 
plans. While an eligible plan may include provisions under which it will 
limit deferrals to meet the individual limitation under section 457(c)

[[Page 172]]

and this section, annual deferrals by a participant that exceed the 
individual limit under section 457(c) and this section (but do not 
exceed the limits under Sec. 1.457-4(c)) will not cause a plan to lose 
its eligible status. However, to the extent the combined annual 
deferrals for a participant for any taxable year exceed the individual 
limitation under section 457(c) and this section for that year, the 
amounts are treated as excess deferrals as described in Sec. 1.457-
4(e).
    (b) Limitation applied to participant. The individual limitation in 
this section applies to eligible plans of all employers for whom a 
participant has performed services, including both eligible governmental 
plans and eligible plans of a tax-exempt entity and both eligible plans 
of the employer and eligible plans of other employers. Thus, for 
purposes of determining the amount excluded from a participant's gross 
income in any taxable year (including the underutilized limitation under 
Sec. 1.457-4 (c)(3)(ii)(B)), the participant's annual deferral under an 
eligible plan, and the participant's annual deferrals under all other 
eligible plans, must be determined on an aggregate basis. To the extent 
that the combined annual deferral amount exceeds the maximum deferral 
limitation applicable under Sec. 1.457-4 (c)(1)(i)(A), (c)(2), or 
(c)(3), the amount is treated as an excess deferral under Sec. 1.457-
4(e).
    (c) Special rules for catch-up amounts under multiple eligible 
plans. For purposes of applying section 457(c) and this section, the 
special section 457 catch-up under Sec. 1.457-4 (c)(3) is taken into 
account only to the extent that an annual deferral is made for a 
participant under an eligible plan as a result of plan provisions 
permitted under Sec. 1.457-4 (c)(3). In addition, if a participant has 
annual deferrals under more than one eligible plan and the applicable 
catch-up amount under Sec. 1.457-4 (c)(2) or (3) is not the same for 
each such eligible plan for the taxable year, section 457(c) and this 
section are applied using the catch-up amount under whichever plan has 
the largest catch-up amount applicable to the participant.
    (d) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. (i) Facts. Participant F is age 62 in 2006 and 
participates in two eligible plans during 2006, Plans J and K, which are 
each eligible plans of two different governmental entities. Each plan 
includes provisions allowing the maximum annual deferral permitted under 
Sec. 1.457-4(c)(1) through (3). For 2006, the underutilized amount 
under Sec. 1.457-4 (c)(3)(ii)(B) is $20,000 under Plan J and is $40,000 
under Plan K. Normal retirement age is age 65 under both plans. 
Participant F defers $15,000 under each plan. Participant F's includible 
compensation is in each case in excess of the deferral. Neither plan 
designates the $15,000 contribution as a catch-up permitted under each 
plan's special section 457 catch-up provisions.
    (ii) Conclusion. For purposes of applying this section to 
Participant F for 2006, the maximum exclusion is $20,000. This is equal 
to the sum of $15,000 plus $5,000, which is the age 50 catch-up amount. 
Thus, F has an excess amount of $10,000 which is treated as an excess 
deferral for Participant F for 2006 under Sec. 1.457-4(e).
    Example 2. (i) Facts. Participant E, who will turn 63 on April 1, 
2006, participates in four eligible plans during year 2006: Plan W which 
is an eligible governmental plan; and Plans X, Y, and Z which are each 
eligible plans of three different tax-exempt entities. For year 2006, 
the limitation that applies to Participant E under all four plans under 
Sec. 1.457-4(c)(1)(i)(A) is $15,000. For year 2006, the additional age 
50 catch-up limitation that applies to Participant E under all four 
plans under Sec. 1.457-4(c)(2) is $5,000. Further, for year 2006, 
different limitations under Sec. 1.457-4(c)(3) and (c)(3)(ii)(B) apply 
to Participant E under each of these plans, as follows: under Plan W, 
the underutilized limitation under Sec. 1.457-4(c)(3)(ii)(B) is $7,000; 
under Plan X, the underutilized limitation under Sec. 1.457-
4(c)(3)(ii)(B) is $2,000; under Plan Y, the underutilized limitation 
under Sec. 1.457-4(c)(3)(ii)(B) is $8,000; and under Plan Z, Sec. 
1.457-4(c)(3) is not applicable since normal retirement age is 62 under 
Plan Z. Participant E's includible compensation is in each case in 
excess of any applicable deferral.
    (ii) Conclusion. For purposes of applying this section to 
Participant E for year 2006, Participant E could elect to defer $23,000 
under Plan Y, which is the maximum deferral limitation under Sec. 
1.457-4(c)(1) through (3), and to defer no amount under Plans W, X, and 
Z. The $23,000 maximum amount is equal to the sum of $15,000 plus 
$8,000, which is the catch-up amount applicable to Participant E under 
Plan Y and which is the largest catch-up amount applicable to 
Participant E under any of the four plans for year 2006. Alternatively, 
Participant E could instead elect to defer the following combination of 
amounts: An aggregate total of $15,000 to Plans X, Y, and Z, if no 
contribution is made to Plan W; an aggregate total of $20,000 to

[[Page 173]]

any of the four plans, assuming at least $5,000 is contributed to Plan 
W; or $22,000 to Plan W and none to any of the other three plans.
    (iii) If the underutilized amount under Plans W, X, and Y for year 
2006 were in each case zero (because E had always contributed the 
maximum amount or E was a new participant) or an amount not in excess of 
$5,000, the maximum exclusion under this section would be $20,000 for 
Participant E for year 2006 ($15,000 plus the $5,000 age 50 catch-up 
amount), which Participant E could contribute to any of the plans 
assuming at least $5,000 is contributed to Plan W.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51446, Aug. 26, 2003; T.D. 
9319, 72 FR 16930, Apr. 5, 2007; 72 FR 28854, May 23, 2007]



Sec. 1.457-6  Timing of distributions under eligible plans.

    (a) In general. Except as provided in paragraph (c) of this section 
(relating to distributions on account of an unforeseeable emergency), 
paragraph (e) of this section (relating to distributions of small 
accounts), Sec. 1.457-10(a) (relating to plan terminations), or Sec. 
1.457-10(c) (relating to domestic relations orders), amounts deferred 
under an eligible plan may not be paid to a participant or beneficiary 
before the participant has a severance from employment with the eligible 
employer or when the participant attains age 70\1/2\, if earlier. For 
rules relating to loans, see paragraph (f) of this section. This section 
does not apply to distributions of excess amounts under Sec. 1.457-
4(e). However, except to the extent set forth by the Commissioner in 
revenue rulings, notices, and other guidance published in the Internal 
Revenue Bulletin (see Sec. 601.601(d) of this chapter), this section 
applies to amounts held in a separate account for eligible rollover 
distributions maintained by an eligible governmental plan as described 
in Sec. 1.457-10(e)(2).
    (b) Severance from employment--(1) Employees. An employee has a 
severance from employment with the eligible employer if the employee 
dies, retires, or otherwise has a severance from employment with the 
eligible employer. See regulations under section 401(k) for additional 
guidance concerning severance from employment.
    (2) Independent contractors--(i) In general. An independent 
contractor is considered to have a severance from employment with the 
eligible employer upon the expiration of the contract (or in the case of 
more than one contract, all contracts) under which services are 
performed for the eligible employer if the expiration constitutes a 
good-faith and complete termination of the contractual relationship. An 
expiration does not constitute a good faith and complete termination of 
the contractual relationship if the eligible employer anticipates a 
renewal of a contractual relationship or the independent contractor 
becoming an employee. For this purpose, an eligible employer is 
considered to anticipate the renewal of the contractual relationship 
with an independent contractor if it intends to contract again for the 
services provided under the expired contract, and neither the eligible 
employer nor the independent contractor has eliminated the independent 
contractor as a possible provider of services under any such new 
contract. Further, an eligible employer is considered to intend to 
contract again for the services provided under an expired contract if 
the eligible employer's doing so is conditioned only upon incurring a 
need for the services, the availability of funds, or both.
    (ii) Special rule. Notwithstanding paragraph (b)(2)(i) of this 
section, the plan is considered to satisfy the requirement described in 
paragraph (a) of this section that no amounts deferred under the plan be 
paid or made available to the participant before the participant has a 
severance from employment with the eligible employer if, with respect to 
amounts payable to a participant who is an independent contractor, an 
eligible plan provides that--
    (A) No amount will 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 eligible employer (or, in the case of 
more than one contract, all such contracts expire); and
    (B) No amount payable to the participant on that date will be paid 
to the participant if, after the expiration of the contract (or 
contracts) and before that date, the participant performs services for 
the eligible employer as an independent contractor or an employee.

[[Page 174]]

    (c) Rules applicable to distributions for unforeseeable 
emergencies--(1) In general. An eligible plan may permit a distribution 
to a participant or beneficiary for an unforeseeable emergency. The 
distribution must satisfy the requirements of paragraph (c)(2) of this 
section.
    (2) Requirements--(i) Unforeseeable emergency defined. An 
unforeseeable emergency must be defined in the plan as a severe 
financial hardship of the participant or beneficiary resulting from an 
illness or accident of the participant or beneficiary, the participant's 
or beneficiary's spouse, or the participant's or beneficiary's dependent 
(as defined in section 152, and, for taxable years beginning on or after 
January 1, 2005, without regard to section 152(b)(1), (b)(2), and 
(d)(1)(B)); loss of the participant's or beneficiary's property due to 
casualty (including the need to rebuild a home following damage to a 
home not otherwise covered by homeowner's insurance, such as damage that 
is the result of a natural disaster); or other similar extraordinary and 
unforeseeable circumstances arising as a result of events beyond the 
control of the participant or the beneficiary. For example, the imminent 
foreclosure of or eviction from the participant's or beneficiary's 
primary residence may constitute an unforeseeable emergency. In 
addition, the need to pay for medical expenses, including non-refundable 
deductibles, as well as for the cost of prescription drug medication, 
may constitute an unforeseeable emergency. Finally, the need to pay for 
the funeral expenses of a spouse or a dependent (as defined in section 
152, and, for taxable years beginning on or after January 1, 2005, 
without regard to section 152(b)(1), (b)(2), and (d)(1)(B)) of a 
participant or beneficiary may also constitute an unforeseeable 
emergency. Except as otherwise specifically provided in this paragraph 
(c)(2)(i), the purchase of a home and the payment of college tuition are 
not unforeseeable emergencies under this paragraph (c)(2)(i).
    (ii) Unforeseeable emergency distribution standard. Whether a 
participant or beneficiary is faced with an unforeseeable emergency 
permitting a distribution under this paragraph (c) is to be determined 
based on the relevant facts and circumstances of each case, but, in any 
case, a distribution on account of unforeseeable emergency may not be 
made to the extent that such emergency is or may be relieved through 
reimbursement or compensation from insurance or otherwise, by 
liquidation of the participant's assets, to the extent the liquidation 
of such assets would not itself cause severe financial hardship, or by 
cessation of deferrals under the plan.
    (iii) Distribution necessary to satisfy emergency need. 
Distributions because of an unforeseeable emergency must be limited to 
the amount reasonably necessary to satisfy the emergency need (which may 
include any amounts necessary to pay for any federal, state, or local 
income taxes or penalties reasonably anticipated to result from the 
distribution).
    (d) Minimum required distributions for eligible plans. In order to 
be an eligible plan, a plan must meet the distribution requirements of 
section 457(d)(1) and (2). Under section 457(d)(2), a plan must meet the 
minimum distribution requirements of section 401(a)(9). See section 
401(a)(9) and the regulations thereunder for these requirements. Section 
401(a)(9) requires that a plan begin lifetime distributions to a 
participant no later than April 1 of the calendar year following the 
later of the calendar year in which the participant attains age 70\1/2\ 
or the calendar year in which the participant retires.
    (e) Distributions of smaller accounts--(1) In general. An eligible 
plan may provide for a distribution of all or a portion of a 
participant's benefit if this paragraph (e)(1) is satisfied. This 
paragraph (e)(1) is satisfied if the participant's total amount deferred 
(the participant's total account balance) which is not attributable to 
rollover contributions (as defined in section 411(a)(11)(D)) is not in 
excess of the dollar limit under section 411(a)(11)(A), no amount has 
been deferred under the plan by or for the participant during the two-
year period ending on the date of the distribution, and there has been 
no prior distribution under the plan to the participant under this 
paragraph (e). An eligible plan is not required to

[[Page 175]]

permit distributions under this paragraph (e).
    (2) Alternative provisions possible. Consistent with the provisions 
of paragraph (e)(1) of this section, a plan may provide that the total 
amount deferred for a participant or beneficiary will be distributed 
automatically to the participant or beneficiary if the requirements of 
paragraph (e)(1) of this section are met. Alternatively, if the 
requirements of paragraph (e)(1) of this section are met, the plan may 
provide for the total amount deferred for a participant or beneficiary 
to be distributed to the participant or beneficiary only if the 
participant or beneficiary so elects. The plan is permitted to 
substitute a specified dollar amount that is less than the total amount 
deferred. In addition, these two alternatives can be combined; for 
example, a plan could provide for automatic distributions for up to 
$500, but allow a participant or beneficiary to elect a distribution if 
the total account balance is above $500.
    (f) Loans from eligible plans--(1) Eligible plans of tax-exempt 
entities. If a participant or beneficiary receives (directly or 
indirectly) any amount deferred as a loan from an eligible plan of a 
tax-exempt entity, that amount will be treated as having been paid or 
made available to the individual as a distribution under the plan, in 
violation of the distribution requirements of section 457(d).
    (2) Eligible governmental plans. The determination of whether the 
availability of a loan, the making of a loan, or a failure to repay a 
loan made from a trustee (or a person treated as a trustee under section 
457(g)) of an eligible governmental plan to a participant or beneficiary 
is treated as a distribution (directly or indirectly) for purposes of 
this section, and the determination of whether the availability of the 
loan, the making of the loan, or a failure to repay the loan is in any 
other respect a violation of the requirements of section 457(b) and the 
regulations, depends on the facts and circumstances. Among the facts and 
circumstances are whether the loan has a fixed repayment schedule and 
bears a reasonable rate of interest, and whether there are repayment 
safeguards to which a prudent lender would adhere. Thus, for example, a 
loan must bear a reasonable rate of interest in order to satisfy the 
exclusive benefit requirement of section 457(g)(1) and Sec. 1.457-
8(a)(1). See also Sec. 1.457-7(b)(3) relating to the application of 
section 72(p) with respect to the taxation of a loan made under an 
eligible governmental plan, and Sec. 1.72(p)-1 relating to section 
72(p)(2).
    (3) Example. The provisions of paragraph (f)(2) of this section are 
illustrated by the following example:

    Example. (i) Facts. Eligible Plan X of State Y is funded through 
Trust Z. Plan X permits an employee's account balance under Plan X to be 
paid in a single sum at severance from employment with State Y. Plan X 
includes a loan program under which any active employee with a vested 
account balance may receive a loan from Trust Z. Loans are made pursuant 
to plan provisions regarding loans that are set forth in the plan under 
which loans bear a reasonable rate of interest and are secured by the 
employee's account balance. In order to avoid taxation under Sec. 
1.457-7(b)(3) and section 72(p)(1), the plan provisions limit the amount 
of loans and require loans to be repaid in level installments as 
required under section 72(p)(2). Participant J's vested account balance 
under Plan X is $50,000. J receives a loan from Trust Z in the amount of 
$5,000 on December 1, 2003, to be repaid in level installments made 
quarterly over the 5-year period ending on November 30, 2008. 
Participant J makes the required repayments until J has a severance from 
employment from State Y in 2005 and subsequently fails to repay the 
outstanding loan balance of $2,250. The $2,250 loan balance is offset 
against J's $80,000 account balance benefit under Plan X, and J elects 
to be paid the remaining $77,750 in 2005.
    (ii) Conclusion. The making of the loan to J will not be treated as 
a violation of the requirements of section 457(b) or the regulations. 
The cancellation of the loan at severance from employment does not cause 
Plan X to fail to satisfy the requirements for plan eligibility under 
section 457. In addition, because the loan satisfies the maximum amount 
and repayment requirements of section 72(p)(2), J is not required to 
include any amount in income as a result of the loan until 2005, when J 
has income of $2,250 as a result of the offset (which is a permissible 
distribution under this section) and income of $77,750 as a result of 
the distribution made in 2005.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51446, Aug. 27, 2003; T.D. 
9319, 72 FR 16930, Apr. 5, 2007]

[[Page 176]]



Sec. 1.457-7  Taxation of Distributions Under Eligible Plans.

    (a) General rules for when amounts are included in gross income. The 
rules for determining when an amount deferred under an eligible plan is 
includible in the gross income of a participant or beneficiary depend on 
whether the plan is an eligible governmental plan or an eligible plan of 
a tax-exempt entity. Paragraph (b) of this section sets forth the rules 
for an eligible governmental plan. Paragraph (c) of this section sets 
forth the rules for an eligible plan of a tax-exempt entity.
    (b) Amounts included in gross income under an eligible governmental 
plan--(1) Amounts included in gross income in year paid under an 
eligible governmental plan. Except as provided in paragraphs (b)(2) and 
(3) of this section (or in Sec. 1.457-10(c) relating to payments to a 
spouse or former spouse pursuant to a qualified domestic relations 
order), amounts deferred under an eligible governmental plan are 
includible in the gross income of a participant or beneficiary for the 
taxable year in which paid to the participant or beneficiary under the 
plan.
    (2) Rollovers to individual retirement arrangements and other 
eligible retirement plans. A trustee-to-trustee transfer in accordance 
with section 401(a)(31) (generally referred to as a direct rollover) 
from an eligible government plan is not includible in gross income of a 
participant or beneficiary in the year transferred. In addition, any 
payment made from an eligible government plan in the form of an eligible 
rollover distribution (as defined in section 402(c)(4)) is not 
includible in gross income in the year paid to the extent the payment is 
transferred to an eligible retirement plan (as defined in section 
402(c)(8)(B)) within 60 days, including the transfer to the eligible 
retirement plan of any property distributed from the eligible 
governmental plan. For this purpose, the rules of section 402(c)(2) 
through (7) and (9) apply. Any trustee-to-trustee transfer under this 
paragraph (b)(2) from an eligible government plan is a distribution that 
is subject to the distribution requirements of Sec. 1.457-6.
    (3) Amounts taxable under section 72(p)(1). In accordance with 
section 72(p), the amount of any loan from an eligible governmental plan 
to a participant or beneficiary (including any pledge or assignment 
treated as a loan under section 72(p)(1)(B)) is treated as having been 
received as a distribution from the plan under section 72(p)(1), except 
to the extent set forth in section 72(p)(2) (relating to loans that do 
not exceed a maximum amount and that are repayable in accordance with 
certain terms) and Sec. 1.72(p)-1. Thus, except to the extent a loan 
satisfies section 72(p)(2), any amount loaned from an eligible 
governmental plan to a participant or beneficiary (including any pledge 
or assignment treated as a loan under section 72(p)(1)(B)) is includible 
in the gross income of the participant or beneficiary for the taxable 
year in which the loan is made. See generally Sec. 1.72(p)-1.
    (4) Examples. The provisions of this paragraph (b) are illustrated 
by the following examples:

    Example 1. (i) Facts. Eligible Plan G of a governmental entity 
permits distribution of benefits in a single sum or in installments of 
up to 20 years, with such benefits to commence at any date that is after 
severance from employment (up to the later of severance from employment 
or the plan's normal retirement age of 65). Effective for participants 
who have a severance from employment after December 31, 2001, Plan X 
allows an election--as to both the date on which payments are to begin 
and the form in which payments are to be made--to be made by the 
participant at any time that is before the commencement date selected. 
However, Plan X chooses to require elections to be filed at least 30 
days before the commencement date selected in order for Plan X to have 
enough time to be able to effectuate the election.
    (ii) Conclusion. No amounts are included in gross income before 
actual payments begin. If installment payments begin (and the 
installment payments are payable over at least 10 years so as not to be 
eligible rollover distributions), the amount included in gross income 
for any year is equal to the amount of the installment payment paid 
during the year.
    Example 2. (i) Facts. Same facts as in Example 1, except that the 
same rules are extended to participants who had a severance from 
employment before January 1, 2002.
    (ii) Conclusion. For all participants (that is, both those who have 
a severance from employment after December 31, 2001, and those who have 
a severance from employment before January 1, 2002, including those 
whose benefit payments have commenced before January 1, 2002), no 
amounts are included in

[[Page 177]]

gross income before actual payments begin. If installment payments begin 
(and the installment payments are payable over at least 10 years so as 
not to be eligible rollover distributions), the amount included in gross 
income for any year is equal to the amount of the installment payment 
paid during the year.

    (c) Amounts included in gross income under an eligible plan of a 
tax-exempt entity--(1) Amounts included in gross income in year paid or 
made available under an eligible plan of a tax-exempt entity. Amounts 
deferred under an eligible plan of a tax-exempt entity are includible in 
the gross income of a participant or beneficiary for the taxable year in 
which paid or otherwise made available to the participant or beneficiary 
under the plan. Thus, amounts deferred under an eligible plan of a tax-
exempt entity are includible in the gross income of the participant or 
beneficiary in the year the amounts are first made available under the 
terms of the plan, even if the plan has not distributed the amounts 
deferred. Amounts deferred under an eligible plan of a tax-exempt entity 
are not considered made available to the participant or beneficiary 
solely because the participant or beneficiary is permitted to choose 
among various investments under the plan.
    (2) When amounts deferred are considered to be made available under 
an eligible plan of a tax-exempt entity--(i) General rule. Except as 
provided in paragraphs (c)(2)(ii) through (iv) of this section, amounts 
deferred under an eligible plan of a tax-exempt entity are considered 
made available (and, thus, are includible in the gross income of the 
participant or beneficiary under this paragraph (c)) at the earliest 
date, on or after severance from employment, on which the plan allows 
distributions to commence, but in no event later than the date on which 
distributions must commence pursuant to section 401(a)(9). For example, 
in the case of a plan that permits distribution to commence on the date 
that is 60 days after the close of the plan year in which the 
participant has a severance from employment with the eligible employer, 
amounts deferred are considered to be made available on that date. 
However, distributions deferred in accordance with paragraphs (c)(2)(ii) 
through (iv) of this section are not considered made available prior to 
the applicable date under paragraphs (c)(2)(ii) through (iv) of this 
section. In addition, no portion of a participant or beneficiary's 
account is treated as made available (and thus currently includible in 
income) under an eligible plan of a tax-exempt entity merely because the 
participant or beneficiary under the plan may elect to receive a 
distribution in any of the following circumstances:
    (A) A distribution in the event of an unforeseeable emergency to the 
extent the distribution is permitted under Sec. 1.457-6(c).
    (B) A distribution from an account for which the total amount 
deferred is not in excess of the dollar limit under section 
411(a)(11)(A) to the extent the distribution is permitted under Sec. 
1.457-6(e).
    (ii) Initial election to defer commencement of distributions--(A) In 
general. An eligible plan of a tax-exempt entity may provide a period 
for making an initial election during which the participant or 
beneficiary may elect, in accordance with the terms of the plan, to 
defer the payment of some or all of the amounts deferred to a fixed or 
determinable future time. The period for making this initial election 
must expire prior to the first time that any such amounts would be 
considered made available under the plan under paragraph (c)(2)(i) of 
this section.
    (B) Failure to make initial election to defer commencement of 
distributions. Generally, if no initial election is made by a 
participant or beneficiary under this paragraph (c)(2)(ii), then the 
amounts deferred under an eligible plan of a tax-exempt entity are 
considered made available and taxable to the participant or beneficiary 
in accordance with paragraph (c)(2)(i) of this section at the earliest 
time, on or after severance from employment ( but in no event later than 
the date on which distributions must commence pursuant to section 
401(a)(9)), that distribution is permitted to commence under the terms 
of the plan. However, the plan may provide for a default payment 
schedule that applies if no election is made. If the plan provides for a 
default payment schedule, the amounts deferred are includible in the 
gross income of the participant or beneficiary

[[Page 178]]

in the year the amounts deferred are first made available under the 
terms of the default payment schedule.
    (iii) Additional election to defer commencement of distribution. An 
eligible plan of a tax-exempt entity is permitted to provide that a 
participant or beneficiary who has made an initial election under 
paragraph (c)(2)(ii)(A) of this section may make one additional election 
to defer (but not accelerate) commencement of distributions under the 
plan before distributions have commenced in accordance with the initial 
deferral election under paragraph (c)(2)(ii)(A) of this section. Amounts 
payable to a participant or beneficiary under an eligible plan of a tax-
exempt entity are not treated as made available merely because the plan 
allows the participant to make an additional election under this 
paragraph (c)(2)(iii). A participant or beneficiary is not precluded 
from making an additional election to defer commencement of 
distributions merely because the participant or beneficiary has 
previously received a distribution under Sec. 1.457-6(c) because of an 
unforeseeable emergency, has received a distribution of smaller amounts 
under Sec. 1.457-6(e), has made (and revoked) other deferral or method 
of payment elections within the initial election period, or is subject 
to a default payment schedule under which the commencement of benefits 
is deferred (for example, until a participant is age 65).
    (iv) Election as to method of payment. An eligible plan of a tax-
exempt entity may provide that an election as to the method of payment 
under the plan may be made at any time prior to the time the amounts are 
distributed in accordance with the participant or beneficiary's initial 
or additional election to defer commencement of distributions under 
paragraph (c)(2)(ii) or (iii) of this section. Where no method of 
payment is elected, the entire amount deferred will be includible in the 
gross income of the participant or beneficiary when the amounts first 
become made available in accordance with a participant's initial or 
additional elections to defer under paragraphs (c)(2)(ii) and (iii) of 
this section, unless the eligible plan provides for a default method of 
payment (in which case amounts are considered made available and taxable 
when paid under the terms of the default payment schedule). A method of 
payment means a distribution or a series of periodic distributions 
commencing on a date determined in accordance with paragraph (c)(2)(ii) 
or (iii) of this section.
    (3) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. (i) Facts. Eligible Plan X of a tax-exempt entity 
provides that a participant's total account balance, representing all 
amounts deferred under the plan, is payable to a participant in a single 
sum 60 days after severance from employment throughout these examples, 
unless, during a 30-day period immediately following the severance, the 
participant elects to receive the single sum payment at a later date 
(that is not later than the plan's normal retirement age of 65) or 
elects to receive distribution in 10 annual installments to begin 60 
days after severance from employment (or at a later date, if so elected, 
that is not later than the plan's normal retirement age of 65). On 
November 13, 2004, K, a calendar year taxpayer, has a severance from 
employment with the eligible employer. K does not, within the 30-day 
window period, elect to postpone distributions to a later date or to 
receive payment in 10 fixed annual installments.
    (ii) Conclusion. The single sum payment is payable to K 60 days 
after the date K has a severance from employment (January 12, 2005), and 
is includible in the gross income of K in 2005 under section 457(a).
    Example 2. (i) Facts. The terms of eligible Plan X are the same as 
described in Example 1. Participant L participates in eligible Plan X. 
On November 11, 2003, L has a severance from the employment of the 
eligible employer. On November 24, 2003, L makes an initial deferral 
election not to receive the single-sum payment payable 60 days after the 
severance, and instead elects to receive the amounts in 10 annual 
installments to begin 60 days after severance from employment.
    (ii) Conclusion. No portion of L's account is considered made 
available in 2003 or 2004 before a payment is made and no amount is 
includible in the gross income of L until distributions commence. The 
annual installment payable in 2004 will be includible in L's gross 
income in 2004.
    Example 3. (i) Facts. The facts are the same as in Example 1, except 
that eligible Plan X also provides that those participants who are 
receiving distributions in 10 annual installments may, at any time and 
without restriction, elect to receive a cash out of all remaining 
installments. Participant M elects

[[Page 179]]

to receive a distribution in 10 annual installments commencing in 2004.
    (ii) Conclusion. M's total account balance, representing the total 
of the amounts deferred under the plan, is considered made available and 
is includible in M's gross income in 2004.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that, instead of providing for an unrestricted cashout of remaining 
payments, the plan provides that participants or beneficiaries who are 
receiving distributions in 10 annual installments 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-
6(c)(1) in an amount not exceeding that described in Sec. 1.457-
6(c)(2).
    (ii) Conclusion. No amount is considered made available to 
participant M on account of M's right to accelerate payments upon the 
occurrence of an unforeseeable emergency.
    Example 5. (i) Facts. Eligible Plan Y of a tax-exempt entity 
provides that distributions will commence 60 days after a participant's 
severance from employment unless the participant elects, within a 30-day 
window period following severance from employment, to defer 
distributions to a later date (but no later than the year following the 
calendar year the participant attains age 70\1/2\). The plan provides 
that a participant who has elected to defer distributions to a later 
date may make an election as to form of distribution at any time prior 
to the 30th day before distributions are to commence.
    (ii) Conclusion. No amount is considered made available prior to the 
date distributions are to commence by reason of a participant's right to 
defer or make an election as to the form of distribution.
    Example 6. (i) Facts. The facts are the same as in Example 1, except 
that the plan also permits participants who have made an initial 
election to defer distribution to make one additional deferral election 
at any time prior to the date distributions are scheduled to commence. 
Participant N has a severance from employment at age 50. The next day, 
during the 30-day period provided in the plan, N elects to receive 
distribution in the form of 10 annual installment payments beginning at 
age 55. Two weeks later, within the 30-day window period, N makes a new 
election permitted under the plan to receive 10 annual installment 
payments beginning at age 60 (instead of age 55). When N is age 59, N 
elects under the additional deferral election provisions, to defer 
distributions until age 65.
    (ii) Conclusion. In this example, N's election to defer 
distributions until age 65 is a valid election. The two elections N 
makes during the 30-day window period are not additional deferral 
elections described in paragraph (c)(2)(iii) of this section because 
they are made before the first permissible payout date under the plan. 
Therefore, the plan is not precluded from allowing N to make the 
additional deferral election. However, N can make no further election to 
defer distributions beyond age 65 (or accelerate distribution before age 
65) because this additional deferral election can only be made once.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec. 1.457-8  Funding rules for eligible plans.

    (a) Eligible governmental plans--(1) In general. In order to be an 
eligible governmental plan, all amounts deferred under the plan, all 
property and rights purchased with such amounts, and all income 
attributable to such amounts, property, or rights, must be held in trust 
for the exclusive benefit of participants and their beneficiaries. A 
trust described in this paragraph (a) that also meets the requirements 
of Sec. Sec. 1.457-3 through 1.457-10 is treated as an organization 
exempt from tax under section 501(a), and a participant's or 
beneficiary's interest in amounts in the trust is includible in the 
gross income of the participants and beneficiaries only to the extent, 
and at the time, provided for in section 457(a) and Sec. Sec. 1.457-4 
through 1.457-10.
    (2) Trust requirement. (i) A trust described in this paragraph (a) 
must be established pursuant to a written agreement that constitutes a 
valid trust under State law. The terms of the trust must make it 
impossible, prior to the satisfaction of all liabilities with respect to 
participants and their beneficiaries, for any part of the assets and 
income of the trust to be used for, or diverted to, purposes other than 
for the exclusive benefit of participants and their beneficiaries.
    (ii) Amounts deferred under an eligible governmental plan must be 
transferred to a trust within a period that is not longer than is 
reasonable for the proper administration of the participant accounts (if 
any). For purposes of this requirement, the plan may provide for amounts 
deferred for a participant under the plan to be transferred to the trust 
within a specified period after the date the amounts would otherwise 
have been paid to the participant. For example, the plan could provide 
for amounts deferred under the plan at the election of the participant 
to be contributed to

[[Page 180]]

the trust within 15 business days following the month in which these 
amounts would otherwise have been paid to the participant.
    (3) Custodial accounts and annuity contracts treated as trusts--(i) 
In general. For purposes of the trust requirement of this paragraph (a), 
custodial accounts and annuity contracts described in section 401(f) 
that satisfy the requirements of this paragraph (a)(3) are treated as 
trusts under rules similar to the rules of section 401(f). Therefore, 
the provisions of Sec. 1.401(f)-1(b) will generally apply to determine 
whether a custodial account or an annuity contract is treated as a 
trust. The use of a custodial account or annuity contract as part of an 
eligible governmental plan does not preclude the use of a trust or 
another custodial account or annuity contract as part of the same plan, 
provided that all such vehicles satisfy the requirements of section 
457(g)(1) and (3) and paragraphs (a)(1) and (2) of this section and that 
all assets and income of the plan are held in such vehicles.
    (ii) Custodial accounts--(A) In general. A custodial account is 
treated as a trust, for purposes of section 457(g)(1) and paragraphs 
(a)(1) and (2) of this section, if the custodian is a bank, as described 
in section 408(n), or a person who meets the nonbank trustee 
requirements of paragraph (a)(3)(ii)(B) of this section, and the account 
meets the requirements of paragraphs (a)(1) and (2) of this section, 
other than the requirement that it be a trust.
    (B) Nonbank trustee status. The custodian of a custodial account may 
be a person other than a bank only if the person demonstrates to the 
satisfaction of the Commissioner that the manner in which the person 
will administer the custodial account will be consistent with the 
requirements of section 457(g)(1) and (3). To do so, the person must 
demonstrate that the requirements of Sec. 1.408-2(e)(2) through (6) 
(relating to nonbank trustees) are met. The written application must be 
sent to the address prescribed by the Commissioner in the same manner as 
prescribed under Sec. 1.408-2(e). To the extent that a person has 
already demonstrated to the satisfaction of the Commissioner that the 
person satisfies the requirements of Sec. 1.408-2(e) in connection with 
a qualified trust (or custodial account or annuity contract) under 
section 401(a), that person is deemed to satisfy the requirements of 
this paragraph (a)(3)(ii)(B).
    (iii) Annuity contracts. An annuity contract is treated as a trust 
for purposes of section 457(g)(1) and paragraph (a)(1) of this section 
if the contract is an annuity contract, as defined in section 401(g), 
that has been issued by an insurance company qualified to do business in 
the State, and the contract meets the requirements of paragraphs (a)(1) 
and (2) of this section, other than the requirement that it be a trust. 
An annuity contract does not include a life, health or accident, 
property, casualty, or liability insurance contract.
    (4) Combining assets. [Reserved]
    (b) Eligible plans maintained by tax-exempt entity--(1) General 
rule. In order to be an eligible plan of a tax-exempt entity, the plan 
must be unfunded and plan assets must not be set aside for participants 
or their beneficiaries. Under section 457(b)(6) and this paragraph (b), 
an eligible plan of a tax-exempt entity must provide that 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 such amounts, and all income attributable to 
such amounts, property, or rights, must remain (until paid or made 
available to the participant or beneficiary) solely the property and 
rights of the eligible employer (without being restricted to the 
provision of benefits under the plan), subject only to the claims of the 
eligible employer's general creditors.
    (2) Additional requirements. For purposes of paragraph (b)(1) of 
this section, the plan must be unfunded regardless of whether or not the 
amounts were deferred pursuant to a salary reduction agreement between 
the eligible employer and the participant. Any funding arrangement under 
an eligible plan of a tax-exempt entity that sets aside assets for the 
exclusive benefit of participants violates this requirement, and amounts 
deferred are generally immediately includible in the gross income of 
plan participants and beneficiaries. Nothing in this paragraph (b)

[[Page 181]]

prohibits an eligible plan from permitting participants and their 
beneficiaries to make an election among different investment options 
available under the plan, such as an election affecting the investment 
of the amounts described in paragraph (b)(1) of this section.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec. 1.457-9  Effect on eligible plans when not administered in accordance 

with eligibility requirements.

    (a) Eligible governmental plans. A plan of a State ceases to be an 
eligible governmental plan on the first day of the first plan year 
beginning more than 180 days after the date on which the Commissioner 
notifies the State in writing that the plan is being administered in a 
manner that is inconsistent with one or more of the requirements of 
Sec. Sec. 1.457-3 through 1.457-8 or 1.447-10. However, the plan may 
correct the plan inconsistencies specified in the written notification 
before the first day of that plan year and continue to maintain plan 
eligibility. If a plan ceases to be an eligible governmental plan, 
amounts subsequently deferred by participants will be includible in 
income when deferred, or, if later, when the amounts deferred cease to 
be subject to a substantial risk of forfeiture, as provided at Sec. 
1.457-11. Amounts deferred before the date on which the plan ceases to 
be an eligible governmental plan, and any earnings thereon, will be 
treated as if the plan continues to be an eligible governmental plan and 
will not be includible in participant's or beneficiary's gross income 
until paid to the participant or beneficiary.
    (b) Eligible plans of tax-exempt entities. A plan of a tax-exempt 
entity ceases to be an eligible plan on the first day that the plan 
fails to satisfy one or more of the requirements of Sec. Sec. 1.457-3 
through 1.457-8, or Sec. 1.457-10. See Sec. 1.457-11 for rules 
regarding the treatment of an ineligible plan.

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]



Sec. 1.457-10  Miscellaneous provisions.

    (a) Plan terminations and frozen plans--(1) In general. An eligible 
employer may amend its plan to eliminate future deferrals for existing 
participants or to limit participation to existing participants and 
employees. An eligible plan may also contain provisions that permit plan 
termination and permit amounts deferred to be distributed on 
termination. In order for a plan to be considered terminated, amounts 
deferred under an eligible plan must be distributed to all plan 
participants and beneficiaries as soon as administratively practicable 
after termination of the eligible plan. The mere provision for, and 
making of, distributions to participants or beneficiaries upon a plan 
termination will not cause an eligible plan to cease to satisfy the 
requirements of section 457(b) or the regulations.
    (2) Employers that cease to be eligible employers--(i) Plan not 
terminated. An eligible employer that ceases to be an eligible employer 
may no longer maintain an eligible plan. If the employer was a tax-
exempt entity and the plan is not terminated as permitted under 
paragraph (a)(2)(ii) of this section, the tax consequences to 
participants and beneficiaries in the previously eligible (unfunded) 
plan of an ineligible employer are determined in accordance with either 
section 451 if the employer becomes an entity other than a State or 
Sec. 1.457-11 if the employer becomes a State. If the employer was a 
State and the plan is neither terminated as permitted under paragraph 
(a)(2)(ii) of this section nor transferred to another eligible plan of 
that State as permitted under paragraph (b) of this section, the tax 
consequences to participants in the previously eligible governmental 
plan of an ineligible employer, the assets of which are held in trust 
pursuant to Sec. 1.457-8(a), are determined in accordance with section 
402(b) (section 403(c) in the case of an annuity contract) and the trust 
is no longer to be treated as a trust that is exempt from tax under 
section 501(a).
    (ii) Plan termination. As an alternative to determining the tax 
consequences to the plan and participants under paragraph (a)(2)(i) of 
this section, the employer may terminate the plan and distribute the 
amounts deferred (and all plan assets) to all plan participants as soon 
as administratively practicable in accordance with

[[Page 182]]

paragraph (a)(1) of this section. Such distribution may include eligible 
rollover distributions in the case of a plan that was an eligible 
governmental plan. In addition, if the employer is a State, another 
alternative to determining the tax consequences under paragraph 
(a)(2)(i) of this section is to transfer the assets of the eligible 
governmental plan to an eligible governmental plan of another eligible 
employer within the same State under the plan-to-plan transfer rules of 
paragraph (b) of this section.
    (3) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples:

    Example 1. (i) Facts. Employer Y, a corporation that owns a State 
hospital, sponsors an eligible governmental plan funded through a trust. 
Employer Y is acquired by a for-profit hospital and Employer Y ceases to 
be an eligible employer under section 457(e)(1) or Sec. 1.457-2(e). 
Employer Y terminates the plan and, during the next 6 months, 
distributes to participants and beneficiaries all amounts deferred that 
were under the plan.
    (ii) Conclusion. The termination and distribution does not cause the 
plan to fail to be an eligible governmental plan. Amounts that are 
distributed as eligible rollover distributions may be rolled over to an 
eligible retirement plan described in section 402(c)(8)(B).
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that Employer Y decides to continue to maintain the plan.
    (ii) Conclusion. If Employer Y continues to maintain the plan, the 
tax consequences to participants and beneficiaries will be determined in 
accordance with either section 402(b) if the compensation deferred is 
funded through a trust, section 403(c) if the compensation deferred is 
funded through annuity contracts, or Sec. 1.457-11 if the compensation 
deferred is not funded through a trust or annuity contract. In addition, 
if Employer Y continues to maintain the plan, the trust will no longer 
be treated as exempt from tax under section 501(a).
    Example 3. (i) Facts. Employer Z, a corporation that owns a tax-
exempt hospital, sponsors an unfunded eligible plan. Employer Z is 
acquired by a for-profit hospital and is no longer an eligible employer 
under section 457(e)(1) or Sec. 1.457-2(e). Employer Z terminates the 
plan and distributes all amounts deferred under the eligible plan to 
participants and beneficiaries within a one-year period.
    (ii) Conclusion. Distributions under the plan are treated as made 
under an eligible plan of a tax-exempt entity and the distributions of 
the amounts deferred are includible in the gross income of the 
participant or beneficiary in the year distributed.
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that Employer Z decides to maintain instead of terminate the plan.
    (ii) Conclusion. If Employer Z maintains the plan, the tax 
consequences to participants and beneficiaries in the plan will 
thereafter be determined in accordance with section 451.

    (b) Plan-to-plan transfers--(1) General rule. An eligible 
governmental plan may provide for the transfer of amounts deferred by a 
participant or beneficiary to another eligible governmental plan if the 
conditions in paragraphs (b)(2), (3), or (4) of this section are met. An 
eligible plan of a tax-exempt entity may provide for transfers of 
amounts deferred by a participant to another eligible plan of a tax-
exempt entity if the conditions in paragraph (b)(5) of this section are 
met. In addition, an eligible governmental plan may accept transfers 
from another eligible governmental plan as described in the first 
sentence of this paragraph (b)(1), and an eligible plan of a tax-exempt 
entity may accept transfers from another eligible plan of a tax-exempt 
entity as described in the preceding sentence. However, a State may not 
transfer the assets of its eligible governmental plan to a tax-exempt 
entity's eligible plan and the plan of a tax-exempt entity may not 
accept such a transfer. Similarly, a tax-exempt entity may not transfer 
the assets of its eligible plan to an eligible governmental plan and an 
eligible governmental plan may not accept such a transfer. In addition, 
if the conditions in paragraph (b)(4) of this section (relating to 
permissive past service credit and repayments under section 415) are 
met, an eligible governmental plan of a State may provide for the 
transfer of amounts deferred by a participant or beneficiary to a 
qualified plan (under section 401(a)) maintained by a State. However, a 
qualified plan may not transfer assets to an eligible governmental plan 
or to an eligible plan of a tax-exempt entity, and an eligible 
governmental plan or the plan of a tax-exempt entity may not accept such 
a transfer.

[[Page 183]]

    (2) Requirements for post-severance plan-to-plan transfers among 
eligible governmental plans. A transfer under paragraph (b)(1) of this 
section from an eligible governmental plan to another eligible 
governmental plan is permitted if the following conditions are met--
    (i) The transferor plan provides for transfers;
    (ii) The receiving plan provides for the receipt of transfers;
    (iii) The participant or beneficiary whose amounts deferred are 
being transferred will have an amount deferred immediately after the 
transfer at least equal to the amount deferred with respect to that 
participant or beneficiary immediately before the transfer; and
    (iv) In the case of a transfer for a participant, the participant 
has had a severance from employment with the transferring employer and 
is performing services for the entity maintaining the receiving plan.
    (3) Requirements for plan-to-plan transfers of all plan assets of 
eligible governmental plan. A transfer under paragraph (b)(1) of this 
section from an eligible governmental plan to another eligible 
governmental plan is permitted if the following conditions are met--
    (i) The transfer is from an eligible governmental plan to another 
eligible governmental plan within the same State;
    (ii) All of the assets held by the transferor plan are transferred;
    (iii) The transferor plan provides for transfers;
    (iv) The receiving plan provides for the receipt of transfers;
    (v) The participant or beneficiary whose amounts deferred are being 
transferred will have an amount deferred immediately after the transfer 
at least equal to the amount deferred with respect to that participant 
or beneficiary immediately before the transfer; and
    (vi) The participants or beneficiaries whose deferred amounts are 
being transferred are not eligible for additional annual deferrals in 
the receiving plan unless they are performing services for the entity 
maintaining the receiving plan.
    (4) Requirements for plan-to-plan transfers among eligible 
governmental plans of the same employer. A transfer under paragraph 
(b)(1) of this section from an eligible governmental plan to another 
eligible governmental plan is permitted if the following conditions are 
met--
    (i) The transfer is from an eligible governmental plan to another 
eligible governmental plan of the same employer (and, for this purpose, 
the employer is not treated as the same employer if the participant's 
compensation is paid by a different entity);
    (ii) The transferor plan provides for transfers;
    (iii) The receiving plan provides for the receipt of transfers;
    (iv) The participant or beneficiary whose amounts deferred are being 
transferred will have an amount deferred immediately after the transfer 
at least equal to the amount deferred with respect to that participant 
or beneficiary immediately before the transfer; and
    (v) The participant or beneficiary whose deferred amounts are being 
transferred is not eligible for additional annual deferrals in the 
receiving plan unless the participant or beneficiary is performing 
services for the entity maintaining the receiving plan.
    (5) Requirements for post-severance plan-to-plan transfers among 
eligible plans of tax-exempt entities. A transfer under paragraph (b)(1) 
of this section from an eligible plan of a tax-exempt employer to 
another eligible plan of a tax-exempt employer is permitted if the 
following conditions are met--
    (i) The transferor plan provides for transfers;
    (ii) The receiving plan provides for the receipt of transfers;
    (iii) The participant or beneficiary whose amounts deferred are 
being transferred will have an amount deferred immediately after the 
transfer at least equal to the amount deferred with respect to that 
participant or beneficiary immediately before the transfer; and
    (iv) In the case of a transfer for a participant, the participant 
has had a severance from employment with the transferring employer and 
is performing services for the entity maintaining the receiving plan.

[[Page 184]]

    (6) Treatment of amount transferred following a plan-to-plan 
transfer between eligible plans. Following a transfer of any amount 
between eligible plans under paragraphs (b)(1) through (b)(5) of this 
section--
    (i) The transferred amount is subject to the restrictions of Sec. 
1.457-6 (relating to when distributions are permitted to be made to a 
participant under an eligible plan) in the receiving plan in the same 
manner as if the transferred amount had been originally been deferred 
under the receiving plan if the participant is performing services for 
the entity maintaining the receiving plan, and
    (ii) In the case of a transfer between eligible plans of tax-exempt 
entities, except as otherwise determined by the Commissioner, the 
transferred amount is subject to Sec. 1.457-7(c)(2) (relating to when 
amounts are considered to be made available under an eligible plan of a 
tax-exempt entity) in the same manner as if the elections made by the 
participant or beneficiary under the transferor plan had been made under 
the receiving plan.
    (7) Examples. The provisions of paragraphs (b)(1) through (6) of 
this section are illustrated by the following examples:

    Example 1. (i) Facts. Participant A, the president of City X's 
hospital, has accepted a position with another hospital which is a tax-
exempt entity. A participates in the eligible governmental plan of City 
X. A would like to transfer the amounts deferred under City X's eligible 
governmental plan to the eligible plan of the tax-exempt hospital.
    (ii) Conclusion. City X's plan may not transfer A's amounts deferred 
to the tax-exempt employer's eligible plan. In addition, because the 
amounts deferred would no longer be held in trust for the exclusive 
benefit of participants and their beneficiaries, the transfer would 
violate the exclusive benefit rule of section 457(g) and Sec. 1.457-
8(a).
    Example 2. (i) Facts. County M, located in State S, operates several 
health clinics and maintains an eligible governmental plan for employees 
of those clinics. One of the clinics operated by County M is being 
acquired by a hospital operated by State S, and employees of that clinic 
will become employees of State S. County M permits those employees to 
transfer their balances under County M's eligible governmental plan to 
the eligible governmental plan of State S.
    (ii) Conclusion. If the eligible governmental plans of County M and 
State S provide for the transfer and acceptance of the transfer (and the 
other requirements of paragraph (b)(1) of this section are satisfied), 
then the requirements of paragraph (b)(2) of this section are satisfied 
and, thus, the transfer will not cause either plan to violate the 
requirements of section 457 or these regulations.
    Example 3. (i) Facts. City Employer Z, a hospital, sponsors an 
eligible governmental plan. City Employer Z is located in State B. All 
of the assets of City Employer Z are being acquired by a tax-exempt 
hospital. City Employer Z, in accordance with the plan-to-plan transfer 
rules of paragraph (b) of this section, would like to transfer the total 
amount of assets deferred under City Employer Z's eligible governmental 
plan to the acquiring tax-exempt entity's eligible plan.
    (ii) Conclusion. City Employer Z may not permit participants to 
transfer the amounts to the eligible plan of the tax-exempt entity. In 
addition, because the amounts deferred would no longer be held in trust 
for the exclusive benefit of participants and their beneficiaries, the 
transfer would violate the exclusive benefit rule of section 457(g) and 
Sec. 1.457-8(a).
    Example 4. (i) Facts. The facts are the same as in Example 3, except 
that City Employer Z, instead of transferring all of its assets to the 
eligible plan of the tax-exempt entity, decides to transfer all of the 
amounts deferred under City Z's eligible governmental plan to the 
eligible governmental plan of County B in which City Z is located. 
County B's eligible plan does not cover employees of City Z, but is 
willing to allow the assets of City Z's plan to be transferred to County 
B's plan, a related state government entity, also located in State B.
    (ii) Conclusion. If City Employer Z's (transferor) eligible 
governmental plan provides for such transfer and the eligible 
governmental plan of County B permits the acceptance of such a transfer 
(and the other requirements of paragraph (b)(1) of this section are 
satisfied), then the requirements of paragraph (b)(3) of this section 
are satisfied and, thus, City Employer Z may transfer the total amounts 
deferred under its eligible governmental plan, prior to termination of 
that plan, to the eligible governmental plan maintained by County B. 
However, the participants of City Employer Z whose deferred amounts are 
being transferred are not eligible to participate in the eligible 
governmental plan of County B, the receiving plan, unless they are 
performing services for County B.
    Example 5. (i) Facts. State C has an eligible governmental plan. 
Employees of City U in State C are among the eligible employees for 
State C's plan and City U decides to adopt another eligible governmental 
plan only for its employees. State C decides to allow employees to elect 
to transfer all of the

[[Page 185]]

amounts deferred for an employee under State C's eligible governmental 
plan to City U's eligible governmental plan.
    (ii) Conclusion. If State C's (transferor) eligible governmental 
plan provides for such transfer and the eligible governmental plan of 
City U permits the acceptance of such a transfer (and the other 
requirements of paragraph (b)(1) of this section are satisfied), then 
the requirements of paragraph (b)(4) of this section are satisfied and, 
thus, State C may transfer the total amounts deferred under its eligible 
governmental plan to the eligible governmental plan maintained by City 
U.

    (8) Purchase of permissive service credit by plan-to-plan transfers 
from an eligible governmental plan to a qualified plan--(i) General 
rule. An eligible governmental plan of a State may provide for the 
transfer of amounts deferred by a participant or beneficiary to a 
defined benefit governmental plan (as defined in section 414(d)), and no 
amount shall be includible in gross income by reason of the transfer, if 
the conditions in paragraph (b)(8)(ii) of this section are met. A 
transfer under this paragraph (b)(8) is not treated as a distribution 
for purposes of Sec. 1.457-6. Therefore, such a transfer may be made 
before severance from employment.
    (ii) Conditions for plan-to-plan transfers from an eligible 
governmental plan to a qualified plan. A transfer may be made under this 
paragraph (b)(8) only if the transfer is either--
    (A) For the purchase of permissive service credit (as defined in 
section 415(n)(3)(A)) under the receiving defined benefit governmental 
plan; or
    (B) A repayment to which section 415 does not apply by reason of 
section 415(k)(3).
    (iii) Example. The provisions of this paragraph (b)(8) are 
illustrated by the following example:

    Example. (i) Facts. Plan X is an eligible governmental plan 
maintained by County Y for its employees. Plan X provides for 
distributions only in the event of death, an unforeseeable emergency, or 
severance from employment with County Y (including retirement from 
County Y). Plan S is a qualified defined benefit plan maintained by 
State T for its employees. County Y is within State T. Employee A is an 
employee of County Y and is a participant in Plan X. Employee A 
previously was an employee of State T and is still entitled to benefits 
under Plan S. Plan S includes provisions allowing participants in 
certain plans, including Plan X, to transfer assets to Plan S for the 
purchase of service credit under Plan S and does not permit the amount 
transferred to exceed the amount necessary to fund the benefit resulting 
from the service credit. Although not required to do so, Plan X allows 
Employee A to transfer assets to Plan S to provide a service benefit 
under Plan S.
    (ii) Conclusion. The transfer is permitted under this paragraph 
(b)(8).

    (c) Qualified domestic relations orders under eligible plans--(1) 
General rule. An eligible plan does not become an ineligible plan 
described in section 457(f) solely because its administrator or sponsor 
complies with a qualified domestic relations order as defined in section 
414(p), including an order requiring the distribution of the benefits of 
a participant to an alternate payee in advance of the general rules for 
eligible plan distributions under Sec. 1.457-6. If a distribution or 
payment is made from an eligible plan to an alternate payee pursuant to 
a qualified domestic relations order, rules similar to the rules of 
section 402(e)(1)(A) shall apply to the distribution or payment.
    (2) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. (i) Facts. Participant C and C's spouse D are divorcing. 
C is employed by State S and is a participant in an eligible plan 
maintained by State S. C has an account valued at $100,000 under the 
plan. Pursuant to the divorce, a court issues a qualified domestic 
relations order on September 1, 2003 that allocates 50 percent of C's 
$100,000 plan account to D and specifically provides for an immediate 
distribution to D of D's share within 6 months of the order. Payment is 
made to D in January of 2004.
    (ii) Conclusion. State S's eligible plan does not become an 
ineligible plan described in section 457(f) and Sec. 1.457-11 solely 
because its administrator or sponsor complies with the qualified 
domestic relations order requiring the immediate distribution to D in 
advance of the general rules for eligible plan distributions under Sec. 
1.457-6. In accordance with section 402(e)(1)(A), D (not C) must include 
the distribution in gross income. The distribution is includible in D's 
gross income in 2004. If the qualified domestic relations order were to 
provide for distribution to D at a future date, amounts deferred 
attributable to D's share will be includible in D's gross income when 
paid to D.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that S is a tax-exempt entity, instead of a State.

[[Page 186]]

    (ii) Conclusion. State S's eligible plan does not become an 
ineligible plan described in section 457(f) and Sec. 1.457-11 solely 
because its administrator or sponsor complies with the qualified 
domestic relations order requiring the immediate distribution to D in 
advance of the general rules for eligible plan distributions under Sec. 
1.457-6. In accordance with section 402(e)(1)(A), D (not C) must include 
the distribution in gross income. The distribution is includible in D's 
gross income in 2004, assuming that the plan did not make the 
distribution available to D in 2003. If the qualified domestic relations 
order were to provide for distribution to D at a future date, amounts 
deferred attributable to D's share would be includible in D's gross 
income when paid or made available to D.

    (d) Death benefits and life insurance proceeds. A death benefit plan 
under section 457(e)(11) is not an eligible plan. In addition, no amount 
paid or made available under an eligible plan as death benefits or life 
insurance proceeds is excludable from gross income under section 101.
    (e) Rollovers to eligible governmental plans--(1) General rule. An 
eligible governmental plan may accept contributions that are eligible 
rollover distributions (as defined in section 402(c)(4)) made from 
another eligible retirement plan (as defined in section 402(c)(8)(B)) if 
the conditions in paragraph (e)(2) of this section are met. Amounts 
contributed to an eligible governmental plan as eligible rollover 
distributions are not taken into account for purposes of the annual 
limit on annual deferrals by a participant in Sec. 1.457-4(c) or Sec. 
1.457-5, but are otherwise treated in the same manner as amounts 
deferred under section 457 for purposes of Sec. Sec. 1.457-3 through 
1.457-9 and this section.
    (2) Conditions for rollovers to an eligible governmental plan. An 
eligible governmental plan that permits eligible rollover distributions 
made from another eligible retirement plan to be paid into the eligible 
governmental plan is required under this paragraph (e)(2) to provide 
that it will separately account for any eligible rollover distributions 
it receives. A plan does not fail to satisfy this requirement if it 
separately accounts for particular types of eligible rollover 
distributions (for example, if it maintains a separate account for 
eligible rollover distributions attributable to annual deferrals that 
were made under other eligible governmental plans and a separate account 
for amounts attributable to other eligible rollover distributions), but 
this requirement is not satisfied if any such separate account includes 
any amount that is not attributable to an eligible rollover 
distribution.
    (3) Example. The provisions of this paragraph (e) are illustrated by 
the following example:

    Example. (i) Facts. Plan T is an eligible governmental plan that 
provides that employees who are eligible to participate in Plan T may 
make rollover contributions to Plan T from amounts distributed to an 
employee from an eligible retirement plan. An eligible retirement plan 
is defined in Plan T as another eligible governmental plan, a qualified 
section 401(a) or 403(a) plan, or a section 403(b) contract, or an 
individual retirement arrangement (IRA) that holds such amounts. Plan T 
requires rollover contributions to be paid by the eligible retirement 
plan directly to Plan T (a direct rollover) or to be paid by the 
participant within 60 days after the date on which the participant 
received the amount from the other eligible retirement plan. Plan T does 
not take rollover contributions into account for purposes of the plan's 
limits on amounts deferred that conform to Sec. 1.457-4(c). Rollover 
contributions paid to Plan T are invested in the trust in the same 
manner as amounts deferred under Plan T and rollover contributions (and 
earnings thereon) are available for distribution to the participant at 
the same time and in the same manner as amounts deferred under Plan T. 
In addition, Plan T provides that, for each participant who makes a 
rollover contribution to Plan T, the Plan T record-keeper is to 
establish a separate account for the participant's rollover 
contributions. The record-keeper calculates earnings and losses for 
investments held in the rollover account separately from earnings and 
losses on other amounts held under the plan and calculates disbursements 
from and payments made to the rollover account separately from 
disbursements from and payments made to other amounts held under the 
plan.
    (ii) Conclusion. Plan T does not lose its status as an eligible 
governmental plan as a result of the receipt of rollover contributions. 
The conclusion would not be different if the Plan T record-keeper were 
to establish two separate accounts, one of which is for the 
participant's rollover contributions attributable to annual deferrals 
that were made under an eligible governmental plan and the other of 
which is for other rollover contributions.


[[Page 187]]


    (f) Deemed IRAs under eligible governmental plans. See regulations 
under section 408(q) for guidance regarding the treatment of separate 
accounts or annuities as individual retirement plans (IRAs).

[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003; T.D. 
9319, 72 FR 16931, Apr. 5, 2007]



Sec. 1.457-11  Tax treatment of participants if plan is not an eligible plan.

    (a) In general. Under section 457(f), if an eligible employer 
provides for a deferral of compensation under any agreement or 
arrangement that is an ineligible plan--
    (1) Compensation deferred under the agreement or arrangement is 
includible in the gross income of the participant or beneficiary for the 
first taxable year in which there is no substantial risk of forfeiture 
(within the meaning of section 457(f)(3)(B)) of the rights to such 
compensation;
    (2) If the compensation deferred is subject to a substantial risk of 
forfeiture, the amount includible in gross income for the first taxable 
year in which there is no substantial risk of forfeiture includes 
earnings thereon to the date on which there is no substantial risk of 
forfeiture;
    (3) Earnings credited on the compensation deferred under the 
agreement or arrangement that are not includible in gross income under 
paragraph (a)(2) of this section are includible in the gross income of 
the participant or beneficiary only when paid or made available to the 
participant or beneficiary, provided that the interest of the 
participant or beneficiary in any assets (including amounts deferred 
under the plan) of the entity sponsoring the agreement or arrangement is 
not senior to the entity's general creditors; and
    (4) Amounts paid or made available to a participant or beneficiary 
under the agreement or arrangement are includible in the gross income of 
the participant or beneficiary under section 72, relating to annuities.
    (b) Exceptions. Paragraph (a) of this section 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) That portion of any plan which consists of a transfer of 
property described in section 83;
    (4) That portion of any plan which consists of a trust to which 
section 402(b) applies; or
    (5) A qualified governmental excess benefit arrangement described in 
section 415(m).
    (c) Amount included in income. The amount included in gross income 
on the applicable date under paragraphs (a)(1) and (a)(2) of this 
section is equal to the present value of the compensation (including 
earnings to the extent provided in paragraph (a)(2) of this section) on 
that date. For purposes of applying section 72 on the applicable date 
under paragraphs (a)(3) and (4) of this section, the participant is 
treated as having paid investment in the contract (or basis) to the 
extent that the deferred compensation has been taken into account by the 
participant in accordance with paragraphs (a)(1) and (a)(2) of this 
section.
    (d) Coordination of section 457(f) with section 83--(1) General 
rules. Under paragraph (b)(3) of this section, section 457(f) and 
paragraph (a) of this section do not apply to that portion of any plan 
which consists of a transfer of property described in section 83. For 
this purpose, a transfer of property described in section 83 means a 
transfer of property to which section 83 applies. Section 457(f) and 
paragraph (a) of this section do not apply if the date on which there is 
no substantial risk of forfeiture with respect to compensation deferred 
under an agreement or arrangement that is not an eligible plan is on or 
after the date on which there is a transfer of property to which section 
83 applies. However, section 457(f) and paragraph (a) of this section 
apply if the date on which there is no substantial risk of forfeiture 
with respect to compensation deferred under an agreement or arrangement 
that is not an eligible plan precedes the date on which there is a 
transfer of property to which section 83 applies. If deferred 
compensation payable in property is

[[Page 188]]

includible in gross income under section 457(f), then, as provided in 
section 72, the amount includible in gross income when that property is 
later transferred or made available to the service provider is the 
excess of the value of the property at that time over the amount 
previously included in gross income under section 457(f).
    (2) Examples. The provisions of this paragraph (d) are illustrated 
in the following examples:

    Example 1. (i) Facts. As part of an arrangement for the deferral of 
compensation, an eligible employer agrees on December 1, 2002 to pay an 
individual rendering services for the eligible employer a specified 
dollar amount on January 15, 2005. The arrangement provides for the 
payment to be made in the form of property having a fair market value 
equal to the specified dollar amount. The individual's rights to the 
payment are not subject to a substantial risk of forfeiture (within the 
meaning of section 457(f)(3)(B)).
    (ii) Conclusion. In this Example 1, because there is no substantial 
risk of forfeiture with respect to the agreement to transfer property in 
2005, the present value (as of December 1, 2002) of the payment is 
includible in the individual's gross income for 2002. Under paragraph 
(a)(4) of this section, when the payment is made on January 15, 2005, 
the amount includible in the individual's gross income is equal to the 
excess of the fair market value of the property when paid, over the 
amount that was includible in gross income for 2002 (which is the basis 
allocable to that payment).
    Example 2. (i) Facts. As part of an arrangement for the deferral of 
compensation, individuals A and B rendering services for a tax-exempt 
entity each receive in 2010 property that is subject to a substantial 
risk of forfeiture (within the meaning of section 457(f)(3)(B) and 
within the meaning of section 83(c)(1)). Individual A makes an election 
to include the fair market value of the property in gross income under 
section 83(b) and individual B does not make this election. The 
substantial risk of forfeiture for the property transferred to 
individual A lapses in 2012 and the substantial risk of forfeiture for 
the property transferred to individual B also lapses in 2012. Thus, the 
property transferred to individual A is included in A's gross income for 
2010 when A makes a section 83(b) election and the property transferred 
to individual B is included in B's gross income for 2012 when the 
substantial risk of forfeiture for the property lapses.
    (ii) Conclusion. In this Example 2, in each case, the compensation 
deferred is not subject to section 457(f) or this section because 
section 83 applies to the transfer of property on or before the date on 
which there is no substantial risk of forfeiture with respect to 
compensation deferred under the arrangement.
    Example 3. (i) Facts. In 2004, Z, a tax-exempt entity, grants an 
option to acquire property to employee C. The option lacks a readily 
ascertainable fair market value, within the meaning of section 83(e)(3), 
has a value on the date of grant equal to $100,000, and is not subject 
to a substantial risk of forfeiture (within the meaning of section 
457(f)(3)(B) and within the meaning of section 83(c)(1)). Z exercises 
the option in 2012 by paying an exercise price of $75,000 and receives 
property that has a fair market value (for purposes of section 83) equal 
to $300,000.
    (ii) Conclusion. In this Example 3, under section 83(e)(3), section 
83 does not apply to the grant of the option. Accordingly, C has income 
of $100,000 in 2004 under section 457(f). In 2012, C has income of 
$125,000, which is the value of the property transferred in 2012, minus 
the allocable portion of the basis that results from the $100,000 of 
income in 2004 and the $75,000 exercise price.
    Example 4. (i) Facts. In 2010, X, a tax-exempt entity, agrees to pay 
deferred compensation to employee D. The amount payable is $100,000 to 
be paid 10 years later in 2020. The commitment to make the $100,000 
payment is not subject to a substantial risk of forfeiture. In 2010, the 
present value of the $100,000 is $50,000. In 2018, X transfers to D 
property having a fair market value (for purposes of section 83) equal 
to $70,000. The transfer is in partial settlement of the commitment made 
in 2010 and, at the time of the transfer in 2018, the present value of 
the commitment is $80,000. In 2020, X pays D the $12,500 that remains 
due.
    (ii) Conclusion. In this Example 4, D has income of $50,000 in 2010. 
In 2018, D has income of $30,000, which is the amount transferred in 
2018, minus the allocable portion of the basis that results from the 
$50,000 of income in 2010. (Under section 72(e)(2)(B), income is 
allocated first. The income is equal to $30,000 ($80,000 minus the 
$50,000 basis), with the result that the allocable portion of the basis 
is equal to $40,000 ($70,000 minus the $30,000 of income).) In 2020, D 
has income of $2,500 ($12,500 minus $10,000, which is the excess of the 
original $50,000 basis over the $40,000 basis allocated to the transfer 
made in 2018).

[T.D. 9075, 68 FR 41240, July 11, 2003]



Sec. 1.457-12  Effective dates.

    (a) General effective date. Except as otherwise provided in this 
section, Sec. Sec. 1.457-1 through 1.457-11 apply for taxable years 
beginning after December 31, 2001.
    (b) Transition period for eligible plans to comply with EGTRRA. For 
taxable years beginning after December 31,

[[Page 189]]

2001, and before January 1, 2004, a plan does not fail to be an eligible 
plan as a result of requirements imposed by the Economic Growth and Tax 
Relief Reconciliation Act of 2001 (115 Stat. 385) (EGTRRA) (Public Law 
107-16) June 7, 2001, if it is operated in accordance with a reasonable, 
good faith interpretation of EGTRRA.
    (c) Special rule for distributions from rollover accounts. The last 
sentence of Sec. 1.457-6(a) (relating to distributions of amounts held 
in a separate account for eligible rollover distributions) applies for 
taxable years beginning after December 31, 2003.
    (d) Special rule for options. Section 1.457-11(d) does not apply 
with respect to an option without a readily ascertainable fair market 
value (within the meaning of section 83(e)(3)) that was granted on or 
before May 8, 2002.
    (e) Special rule for qualified domestic relations orders. Section 
1.457-10(c) (relating to qualified domestic relations orders) applies 
for transfers, distributions, and payments made after December 31, 2001.

[T.D. 9075, 68 FR 41240, July 11, 2003]



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 190]]

    (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 191]]

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 192]]

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.............
                                   -----------------------------------------------------------------------------

[[Page 193]]

 
      Net amount excludable for     ...........  ...........  ...........           $6           $5           $9
       the year...................
----------------------------------------------------------------------------------------------------------------
\1\ Year of Change.
\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

[[Page 194]]

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 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

[[Page 195]]

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 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.

[[Page 196]]

    (ii) Elections.
    (3) Method of accounting.
    (4) Use of estimates.
    (i) Estimating length of contract.
    (ii) Estimating 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.
    (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.
    (ii) Old taxpayer.
    (iii) New taxpayer.
    (iv) Special rules relating to distributions of certain contracts by 
a partnership.
    (A) In general.
    (B) Old taxpayer.
    (C) New taxpayer.
    (D) Basis rules.
    (E) Section 751.
    (1) In general.
    (2) Ordering rules.
    (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.

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    (B) Contract price.
    (C) Contract costs.
    (iv) Special rules related to certain corporate and partnership 
transactions.
    (A) Old taxpayer--basis adjustment.
    (1) In general.
    (2) Basis adjustment in excess of stock or partnership interest 
basis.
    (3) Subsequent dispositions of certain contracts.
    (B) New taxpayer.
    (1) Contract price adjustment.
    (2) Basis in contract.
    (C) Definition of old taxpayer and new taxpayer for certain 
partnership transactions.
    (D) Exceptions to step-in-the-shoes rules for S corporations.
    (v) Special rules relating to certain partnership transactions.
    (A) Section 704(c).
    (1) Contributions of contracts.
    (2) Revaluations of partnership property.
    (3) Allocation methods.
    (B) Basis adjustments under sections 743(b) and 734(b).
    (C) Cross reference.
    (D) Exceptions to step-in-the-shoes rules.
    (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.
    (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.

[[Page 198]]

    (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.
    (1) In general.
    (2) Special rules for certain pass-through entity transactions.
    (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; T.D. 9137, 69 FR 42553, July 16, 2004]



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 Sec. Sec. 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 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

[[Page 199]]

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.
    (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

[[Page 200]]

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--
    (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

[[Page 201]]

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 Sec. Sec. 1.460-4(b)(4)(i) and 
1.460-5(f)(2), respectively. 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)

[[Page 202]]

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.
    (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-

[[Page 203]]

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 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

[[Page 204]]

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 Sec. Sec. 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 
Sec. Sec. 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 
Sec. Sec. 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 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

[[Page 205]]

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 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

[[Page 206]]

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 
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.

[[Page 207]]

    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:
    (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

[[Page 208]]

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:

    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

[[Page 209]]

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 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

[[Page 210]]

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 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

[[Page 211]]

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 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

[[Page 212]]

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 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

[[Page 213]]

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 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

[[Page 214]]

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 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

[[Page 215]]

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 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,

[[Page 216]]

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 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:

[[Page 217]]



------------------------------------------------------------------------
                                              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)....................
(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
------------------------------------------------------------------------


[[Page 218]]

    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 ($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

[[Page 219]]

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).
    (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 
Sec. Sec. 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) (as contained in 
the 26

[[Page 220]]

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 relating to the treatment of certain partnership 
transactions are provided in 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 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 Sec. Sec. 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

[[Page 221]]

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 Sec. Sec. 1.338-6 and 1.338-7.
    (iv) Special rules relating to distributions of certain contracts by 
a partnership--(A) In general. The constructive completion rules of 
paragraph (k)(2) of this section apply both to the distribution of a 
contract accounted for under a long-term contract method of accounting 
by a partnership to a partner and to the distribution of an interest in 
a partnership (lower-tier partnership) holding (either directly or 
through other partnerships) one or more contracts accounted for under a 
long-term contract method of accounting by another partnership (upper-
tier partnership). Notwithstanding the previous sentence, the 
constructive completion rules of paragraph (k)(2) of this section do not 
apply to a transfer by a partnership (transferor partnership) of all of 
its assets and liabilities to a second partnership (transferee 
partnership) in an exchange described in section 721, followed by a 
distribution of the interest in the transferee partnership in 
liquidation of the transferor partnership, under Sec. 1.708-1(b)(4) 
(relating to terminations under section 708(b)(1)(B)) or Sec. 1.708-
1(c)(3)(i) (relating to certain partnership mergers). If a partnership 
that holds a contract accounted for under a long-term contract method of 
accounting terminates under section 708(b)(1)(A) because the number of 
its owners is reduced to one, the entire contract will be treated as 
being distributed from the partnership for purposes of the constructive 
completion rules, and the partnership must apply paragraph (k)(2) of 
this section immediately prior to the transaction or transactions 
resulting in the termination of the partnership.
    (B) Old taxpayer. The partnership that distributes the contract is 
treated as the old taxpayer for purposes of paragraph (k)(2)(ii) of this 
section. For purposes of determining the total contract price (or gross 
contract price) under paragraph (k)(2)(ii) of this section, the fair 
market value of the contract is treated as the amount realized from the 
transaction. For purposes of determining each partner's distributive 
share of partnership items, any income or loss resulting from the 
constructive completion must be allocated among the partners of the old 
taxpayer as though the partnership closed its books on the date of the 
distribution.
    (C) New taxpayer. The partner receiving the distributed contract is 
treated as the new taxpayer for purposes of paragraph (k)(2)(iii) of 
this section. For purposes of determining the total contract price (or 
gross contract price) under paragraph (k)(2)(iii) of this section, the 
new taxpayer's basis in the contract (including the uncompleted 
property, if applicable) after the